Effective for tax years beginning after December 31, 2014, certain deductions for royalties or other fees paid by a corporation subject to Pennsylvania corporate net income tax are subject to addback. Specifically, no deduction will be allowed for (1) an intangible expense or cost, or (2) an interest expense or cost directly related to an intangible expense or cost, that is paid, accrued or incurred, directly or indirectly, in connection with one or more transactions with certain affiliated entities, unless an express statutory exception applies. The Pennsylvania Department of Revenue recently issued a discussion draft of an information notice addressing the application and scope of the addback provisions and the statutory exceptions.
The notice first discusses the types of intangible and interest expenses that may be disallowed and cautions that the classification or label applied to a transaction is not determinative of whether the expense will be required to be added back. Taxpayers are reminded that both direct and indirect expenses may be subject to add back. An indirect intangible cost or expense deduction may arise where the Pennsylvania taxpayer acquires and then amortizes an intangible asset and, thus, deducts all or part of the cost of the intangible asset. Second, an indirect expense or cost is broadly construed to include costs that are not themselves royalty or licensing expenses per se, but are included or embedded in other costs, such as cost of goods sold.
The draft notice also addresses the numerous exceptions to the addback requirement. First, expense disallowance is not required for a transaction that was not principally undertaken to avoid tax and was done at arm’s-length terms. With respect to this exception, the draft notice states that the principal purpose of the transaction must be a non-tax valid business purpose that is supported by contemporaneous documentation. Tax avoidance is presumed for transactions among affiliates that did not change the overall economic position of the entities in a meaningful way. The transaction must also be conducted at arm’s length rate and terms. Terms will be considered arm’s length where “the terms of the transaction under consideration are such as would have been arrived at in independent transactions with or between unrelated parties under similar circumstances.” The documentation used to support the so-called principal purpose/arm’s length exception must establish the manner in which the affiliated entity obtained the intangible asset.
The second exception applies if the affiliated entity is domiciled in a foreign nation that has entered into a comprehensive income tax treaty (meeting certain requirements) with the U.S. The notice defines certain terms, such as “foreign nation” and “comprehensive income tax treaty” and sets forth requirements for claiming the foreign treaty exception.
The third exception, the so-called conduit exception, applies where the affiliated entity directly or indirectly pays, accrues or incurs a payment to a non-affiliated entity, if the payment is equal to or less than the taxpayer’s proportional share of the transaction. The draft notice states that, on request, taxpayers seeking to claim a conduit exception may be required to furnish the Department certain information, such as the timing and payment of consideration from the taxpayer to the affiliate and to the third-party, as well as any agreements substantiating the payments or consideration.
Finally, the last part of the draft notice provides details on the “addback credit” that is allowed a taxpayer required to add back intangible expenses or intangible-related interest expenses. Specifically, under the addback statute a taxpayer is allowed a credit against its Pennsylvania tax for an amount equal to the taxpayer’s Pennsylvania apportionment factor multiplied by the greater of (1) the tax liability of the affiliated entity with respect to the portion of its income representing the intangible expense or cost or the interest expense or cost, or (2) the tax liability that would have been paid by the affiliated entity if that tax liability had not been offset by credits. The draft notice sets forth a formula for determining this credit that reflects the Department’s position that certain taxes are not counted in determining the tax liability of the affiliated entity. For instance, only net income taxes paid by the affiliated entity with respect to amounts received from the taxpayer are counted in determining the addback credit. Furthermore, state income taxes paid in combined reporting states are disregarded in computing the credit. Thus, if the affiliated entity does not have any corporate state net income tax liability in separate company states, the taxpayer will not receive an addback credit. The draft notice then walks through several examples of how the addback credit is calculated. Please contact Howard Sklaroff at (267) 256-2891 with questions on this draft notice.