Does your business operate within a commonly controlled group of corporations? If so, you most likely have intercompany transactions between the entities in the group. These transactions can cause problems from a state and local income tax perspective if not managed adequately.
The state and local tax planning of the '90s saw companies create structures which allowed businesses to isolate profitable companies in no or low tax states, while companies with losses or neutral income filed in multiple states. This result was created mostly by intercompany transactions between entities within the group.
As a result of this tax planning, states have responded by creating "addback" statutes or requiring commonly controlled groups to file "combined" income tax returns. The addback of intercompany expenses, or filing of combined returns seeks to eliminate the isolation or transferring of tax liability from one entity to another with the goal of determining what the fair reflection of income is in the state.
What scenarios may cause a state to addback intercompany transactions or force combination?
- Lack of economic substance and business purpose for the transactions or structure
- No evidence of expecting or receiving a return of cash or effort to repay an intercompany loan
- A circular flow of funds
- Holding intangibles and never licensing them to a third party
- Parent company retaining control of intangible property and maintaining the benefits and burdens of ownership
- Asset transferred within the group with charge back to transferring entity
- Motivation for restructuring or transaction
- Related party transactions not at fair market value (FMV)
- Income not accurately reflected in state due to intercompany transactions
There are more factors that come into play, but the above are some of the most common.
How do you fight against addback statutes and forced combination?
- Have a strong business purpose and ecomonic substance to your intercompany transactions and structure
- Keep related party transactions at arms-length pricing or fair market value
- Document all transactions and meet specific state exceptions to addback statutes (i.e., New Jersey)
- Complete analysis to confirm that state income is an accurate reflection of income in state
These are just a few tips or points to consider. Each situation is different and requires appropriate analysis.
Bottom line: Analyzing or re-analyzing your intercompany transactions may provide opportunities to reduce tax, mitigate exposure and/or reduce your FIN 48 reserve and effective tax rate.