United States

Indiana: Tax Court Holds Gain on Sale of Subsidiary was Nonbusiness Income; Intercompany Loans Had Substance; No Deduction Allowed for R&D Expenses

Jul 17, 2017
From KPMG TaxWatch

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Recently, the Indiana Tax Court addressed a number of issues stemming from a taxpayer’s corporate income tax audit, including liability those arose as a result of the Department of Revenue reclassifying the taxpayer’s gain from the sale of a subsidiary as business income. The subsidiary was originally formed as a joint venture with a third-party. Later, the subsidiary became wholly-owned by an affiliate of the taxpayer. The subsidiary, at all times, operated independently of the taxpayer until it was sold in 2001. On its consolidated Indiana returns, the taxpayer treated the gain from the sale as nonbusiness income. The Department of Revenue subsequently audited the taxpayer for the 2005-2007 tax years and determined that it had improperly classified the gain from the sale of the subsidiary as business income resulting in an overstated 2001 net operating loss.  The Department adjusted the NOLs reported in 2005-2007 accordingly and assessed additional corporate income tax. The taxpayer protested and the matter eventually made its way to the tax court.

The first issue the court addressed it its opinion was whether the Department could adjust the NOL incurred and reported in 2001, which was a result of classifying the gain as nonbusiness income, when 2001 was a closed year. The tax court, noting that the accuracy of the NOLs reported in 2005-2007 were dependent on the accuracy of the NOL calculated in 2001, held that nothing in Indiana law prohibited the Department from making adjustments to returns outside the statute of limitations (i.e., to closed tax years). Although the Department had the authority to adjust the 2001 NOL, the taxpayer next argued that the gain from the sale was property classified as nonbusiness income. The tax court, applying the functional and transactional tests for business income that were applicable for the tax years at issue, agreed.  Under the so-called transactional test, the sale of the subsidiary had to occur in the regular course of the taxpayer’s trade or business. Although the taxpayer frequently sold companies and its number of affiliates fluctuated from year to year, the tax court determined that the taxpayer’s regular business was industrial, agricultural, and chemical manufacturing, not selling subsidiaries. Under the functional test, the tax court looked at whether the asset whose sale generated the gain (here the subsidiary) was acquired, managed, and disposed of by the taxpayer in its regular trade or business operations. The evidence showed that the taxpayer played no role in the management of the subsidiary and the subsidiary maintained its own management team, research agenda and operating policies and procedures. Therefore, the tax court concluded that the taxpayer properly characterized the gain as nonbusiness income.

The next issue was whether the Department erred when it disallowed $3.1 billion in interest expense deductions because the loans lacked business purpose and economic substance and were in essence sham transactions. Notably, no actual interest or principal payments were made on the loans and the Department asserted that the interest rate was “too high.” The tax court again rejected the Department’s position. It noted that the parties had accrued interest expense and interest income and that accruals, for purposes of financial reporting, are treated as if actual cash has been exchanged. The court concluded that the Department “cried wolf” by implying that interest payments that exist merely as book entries, without money changing hands, have no economic substance. With respect to the interest rate on the loans, the rate was arm’s-length under IRC section 482, which the court determined applied in Indiana due to the similarities between section 482 and Indiana’s statutory equivalent. Therefore, the court concluded that the Department erroneously disallowed the interest deductions. Finally, the last issue was whether the taxpayer was able to deduct R&D expenses when, at the federal level, the taxpayer took a credit for such expenses. Although Indiana does not specifically allow a deduction for R&D expenses, the taxpayer nevertheless took a deduction in computing Indiana taxable income. The tax court disallowed the deduction, noting that the starting point in computing Indiana taxable income is federal adjusted gross income and there was no deduction for R&D expenses not deducted for federal purposes. Furthermore, the decision to claim a federal R&D tax credit had consequences that the taxpayer had to accept (i.e., the expenses could not be deducted for Indiana purposes). Please contact Marc Caito at 317-951-2434 with questions on E.I. Dupont De Nemours and Co. v. Indiana Department of State Revenue.

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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.