United States

New Jersey: A Taxpayer Qualifies for the “Unreasonable Exception” to New Jersey’s Intangible Expense Addback Statute

Jun 05, 2017
From KPMG TaxWatch

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The New Jersey Tax Court recently ruled that a taxpayer that paid royalties to its parent qualified for the so-called “unreasonable exception” to the state’s intangible expense addback statute. The entities at issue were both subject to New Jersey Corporation Business Tax. The parent created and developed computer software programs. The parent and taxpayer entered into a licensing agreement that granted the taxpayer a non-exclusive right to license, market, and distribute the parent’s prewritten computer software. The taxpayer paid a portion of its “gross license and maintenance revenue” to the parent as a “royalty” for each product it licensed to end users. A transfer pricing study supported the reasonableness of the rate. The parent and subsidiary also entered into similar, although not identical, agreements with third parties.

Under New Jersey law, royalties and other intangible expenses paid to a related party are required to be added back in determining taxable income. There are various exceptions to the addback requirement, including if requiring the addback would be “unreasonable.” The taxpayer reported the payments at issue as intangible expenses paid to an affiliate but deducted most of the payments on the basis that the parent paid tax on the intangible income. However, while the parent reported the intangible income, it paid no New Jersey tax for the years at issue due to a net operating loss deduction and the dividend income exclusion. The Division of Taxation, on audit, adjusted the taxpayer’s income by disallowing the deductions related to royalty income reported by its parent. The taxpayer protested and the matter went to the tax court. Before the court, the taxpayer raised two alternative arguments to support its deduction of the royalties: 1) the payments were not intangible expenses but were payments for the purchase of tangible personal property (prewritten software) which the taxpayer resold to end-users, and 2) if the payments were “intangible expenses,” denying the deduction would be “unreasonable.”

The tax court first determined that the payments at issue were for the use of intangible property, rather than the sale of tangible personal property for resale. Notably, the parties had structured the transaction as a licensing agreement in exchange for royalties and the parent retained full ownership of the intellectual property rights in the software. The court distinguished the transaction between the parent and taxpayer from the taxpayer’s transactions with customers and found it unpersuasive that the taxpayer sometimes collected sales tax from end users. Having determined that the transactions fell within the scope of the intangible addback statute, the tax court next held that disallowing the deduction would be “unreasonable.” Applying guidance from an earlier case addressing the interest expense addback statute, the tax court concluded that the deduction for the royalty payments should be allowed because they were “substantially equivalent to an unrelated party transaction.” Furthermore, neither the parent nor the taxpayer was a “shell entity” passively holding intangible assets. Both had substantial business operations, with employees and offices nationwide. Therefore, the taxpayer’s payments qualified for the unreasonable exception to the intangible expense addback statute. For more information on BMC Software, Inc. v. Division of Taxation, please contact Jim Venere at 973-912-6349.

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.