State Tax Snapshot: Nexus, Addback Statutes, and the Sham Transaction Doctrine

“We pay all the taxes we owe. Every single dollar,” Apple Chief Executive Officer Timothy Cook told the Senate Permanent Subcommittee on Investigations last month. “We don't depend on tax gimmicks,” he added.

But that is exactly what Chairman Carl Levin (D-Mich.) accused Apple of doing, according to a recent Daily Tax Report article. The company’s tax planning strategy allowed it to move its “crown jewels” by shifting the economic rights to its intellectual property—the source of much of Apple's profit—to Irish subsidiaries that pay little or no tax, Levin said.

The dispute over whether a taxing authority must respect similar types of arrangements involving intangible property has been largely settled at the state level. After Geoffrey Inc. v. South Carolina Tax Dept., 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993), nearly every state has adopted an income tax nexus standard based on “economic presence,” which allows it to impose an income-based tax on an out-of-state company that uses intangible personal property in the jurisdiction.

Many states have enacted so-called royalty interest “addback” statutes, which disallow the deduction of interest and royalty expenses claimed at the federal level that arise from transactions with related parties.

Another weapon in the state tax department arsenal is the sham transaction theory. This was recently employed by the Massachusetts Appellate Tax Board in Allied Domecq Spirits and Wines USA Inc. v. Massachusetts Comr. of Rev., No. C282807 (Mass. App. Tax Bd.,, May 22, 2013). The board disregarded as a sham transaction a tax plan in which an out-of-state parent corporation sought to establish nexus in Massachusetts for the purpose of allowing its in-state subsidiary to offset income with the parent's losses

To carry out the plan, t he parent subleased office space from one of the in-state affiliates and the taxpayer then transferred employees from three of its business departments to the parent.

But just as many of the Geoffrey-type cases involved Delaware-based holding companies where there was often little more substance than a post office box, the taxpayer in Allied Domecq Spirits and Wines USA Inc.was unable to prove that its tax plan had economic substance.

“The taxpayer would have had a much stronger argument had they produced concrete evidence of the physical transfer of employees, rather than simply attempt to create nexus by way of a journal entry,” said Jack Cronin, former tax partner of Deloitte & Touche.

A llied Domecq Spirits and Wines USA Inc. is a cautionary tale to those seeking to implement state tax minimization strategies. “It is clear that a legitimate reorganization of an ongoing business that affects economic relationships should be respected, even if it was tax motivated; ... [it also] is clear that any internal reorganization or intercompany arrangement is fair game to auditors using the sham doctrine these days,” said Matt Hedstrom with Alston & Bird, LLP.

 By Steven Roll

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