Source: http://www.in.gov/legislative/iac/20130828-IR-045130367NRA.xml.html
Timestamp: 2016-08-27 08:33:39
Document Index: 362478974

Matched Legal Cases: ['§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 63', '§ 1', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6', '§ 6']

02-20120690.LOF
Letter of Findings: 02-20120690
I. Corporate Income Tax–Subsidiary Corporation Filing Separate Return.
Authority: IC § 6-3-2-1; IC § 6-3-2-2; IC § 6-3-4-1; IC § 6-8.1-5-1.
Taxpayer argues that the proper filing method requires Taxpayer and Subsidiary Corporation to file separate corporate income tax returns.
II. Corporate Income Tax–Disallowance of Expenses.
Authority: IC § 6-3-1-3.5; IC § 6-3-2-1; IC § 6-3-2-2; IC § 6-3-2-20; IC § 6-3-4-1; IC § 6-8.1-5-1; 45 IAC 3.1-1-8; I.R.C. § 63; Bethlehem Steel Corp. v. Ind. Dept. of State Revenue, 597 N.E.2d 1327 (Ind. Tax 1992), aff'd 639 N.E.2d 264 (Ind. 1994); Treas. Reg. § 1.482-1(b).
Taxpayer argues that the Department of Revenue erred in disallowing certain business expenses claimed by Taxpayer on its income tax returns.
III. Tax Administration–Underpayment of Estimated Tax Penalty.
Taxpayer asks that the Department abate the underpayment of estimated tax penalty.
Taxpayer, a retail merchant and service provider, is incorporated in the state of Delaware, and is headquartered outside Indiana. Taxpayer operates business locations inside Indiana and outside Indiana. The Indiana Department of Revenue ("Department") conducted an audit review of Taxpayer's business records and tax returns for the tax years ending January 28, 2007, February 3, 2008, and February 1, 2009 ("Tax Years"). The audit resulted in the assessment of additional adjusted gross income tax. The Department determined that certain business expenses which Taxpayer paid to its wholly owned subsidiary corporation ("Subsidiary Corporation") should be disallowed in order to fairly reflect Taxpayer's Indiana income. Taxpayer protested. An administrative hearing was conducted, and this Letter of Findings results. Additional facts will be provided as necessary.
As a threshold issue, it is Taxpayer's responsibility to establish that the tax assessment is incorrect. As stated in IC § 6-8.1-5-1(c), "The notice of proposed assessment is prima facie evidence that the department's claim for the unpaid tax is valid. The burden of proving that the proposed assessment is wrong rests with the person against whom the proposed assessment is made."
II. Corporate Income Tax – Disallowance of Expenses.
The expense issues stemmed from Taxpayer's 1999 decision to form Subsidiary Corporation incorporated in Delaware and headquartered outside Indiana. As described in Taxpayer's corporate minutes, this "holding company" was organized in 1999 "to undertake certain activities currently conducted by [Taxpayer]." When Subsidiary Corporation was formed, Taxpayer transferred certain assets and liabilities to Subsidiary Corporation. Subsidiary Corporation recorded those assets and liabilities on its books. The amount of assets on its books totaled approximately $652,000,000, including, but not limited to, cash, an accounting system, fixed assets, equipment, and "trademarks and leases." The "trademarks and leases" were valued collectively at approximately $1,600,000. Subsidiary Corporation also claimed as an asset a $575,000,000 promissory note, executed on the same date that Subsidiary Corporation was formed. This promissory note represented a loan in which Taxpayer was the borrower and Subsidiary Corporation was the lender. The $575,000,000 loan – together with the other above named assets – was then used to purchase 100 percent of the Subsidiary Corporation's stock. In other words, in order to purchase Subsidiary Corporation, Taxpayer contributed assets and $575,000,000 which it had borrowed from Subsidiary Corporation that same day. The entire $652,000,000 was then recorded on Taxpayer's
books as an "investment" in Subsidiary Corporation. Thereafter, Taxpayer began to pay Subsidiary Corporation royalties, interest, management expenses as follows:
Mark-up Expenses: The audit report explained that Subsidiary Corporation existed in part to provide, "Corporate headquarters, strategic management services, general accounting, finance, legal, tax, treasury, cash management, investor relations, data processing, human resources and benefit services, advertising and marketing [services]" to Taxpayer. As noted in the audit report, prior to the formation of Subsidiary Corporation, these expenses were paid directly by Taxpayer. The audit report also notes that all of the officers' compensation expense continues to be recorded solely on the books of Taxpayer and not on the books of the Subsidiary Corporation whom Taxpayer is paying to perform the management services. The service agreement provides that Taxpayer will reimburse Subsidiary Corporation for all the expenses incurred by Subsidiary Corporation in providing these services. In addition to the reimbursement of the actual expenses, the agreement provides for Taxpayer to pay Subsidiary Corporation "a certain percentage" consisting of a "mark-up" on the actual expenses. The "mark-up" charge is based upon Taxpayer's sales revenue. For example, for the fiscal year ending February 1, 2009, the "mark-up" charge was approximately 4.6 percent of Taxpayer's sales revenue. For the Tax Years, the "mark-up" on the actual expenses that Taxpayer paid to Subsidiary Corporation exceeded $143
million, $123 million, and $222 million, respectively.
IC § 6-3-2-2(l)-(m), provide as follows:
Accordingly, IC § 6-3-2-2 addresses issues of "adjusted gross income derived from sources within Indiana." Specifically, section (l) and (m) allow the Department or a taxpayer to employ an alternate method, if necessary, to fairly reflect and report the taxpayer's income derived from sources within Indiana. IC § 6-3-2-2(l)(4) clearly contemplates the use of "any other method [intended] to effectuate an equitable allocation and apportionment of the taxpayer's income."
The law provides that it is Taxpayer's responsibility to establish that the tax assessment is incorrect. As stated in IC § 6-8.1-5-1(c), "The notice of proposed assessment is prima facie evidence that the department's claim for the unpaid tax is valid. The burden of proving that the proposed assessment is wrong rests with the person against whom the proposed assessment is made."
Without reverting to the "intangibles expense add backs" listed in IC § 6-3-2-20–that a taxpayer is required to disclose and add back to properly compute "Indiana adjusted gross income" under IC § 6-3-1-3.5(b)–IC § 6-3-2-2(l) and (m) specifically provide for the "employment of any other method to effectuate an equitable apportionment of the taxpayers income . . ." if the normal allocation and apportionment provisions "do not fairly represent the taxpayer's income." Taxpayer, in arguing that only those "intangible expenses listed in IC § 6-3-2-20 can be added back, places too stringent an interpretation on the authority granted the Department under IC § 6-3-2-2(l) and (m). The plain language of the law states that "[i]f the allocation and apportionment provisions of this article do not fairly represent the taxpayer's income derived from sources within the state of Indiana . . . the department may require, in respect to all or any part of the taxpayer's business activity . . . the employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer's income." While IC § 6-3-2-20 requires that a taxpayer disclose and add back certain "intangible expenses" in computing its Indiana adjusted gross income, there is nothing in the statute which states that the Department does not have the authority to add back those same intangible expenses or any
other expenses. To the contrary, IC § 6-3-2-2(p) reinforces the proposition cautioning the Department not to include other "income, deductions, and credits" unless "the department is unable to fairly reflect the taxpayer's adjusted gross income for the taxable year through use of other powers granted to the department by subsections (l) and (m)."
Nonetheless, regardless of which statute the royalty add backs fall under, the Department when considering the elements of distortion and unfair reflection under IC § 6-3-2-2(l) and (m) will necessarily demonstrate that the elements for the exception under IC § 6-3-2-20(c)(6) would not be met by that taxpayer. Pursuant to IC § 6-3-2-20(b), a taxpayer subject to Indiana adjusted gross income tax, is required to add back its federal deductions relating to intangible expenses and any directly related intangible interest expenses which are paid, accrued, or incurred with one or more members of the same affiliated group or with one or more foreign corporations. IC § 6-3-2-20(c) allows for certain exceptions from this requirement. Under IC § 6-3-2-20(c)(6), a taxpayer that makes the disclosure of the exception on its return, files the information necessary to substantiated the requirements with its return, and can establish by a preponderance of the evidence that it has met the requirements will not have to add back the intangible expense. Two of those requirements are that the taxpayer demonstrate by a preponderance of the evidence that its intangible company has "substantial business activities" and that the "the principal purpose of tax avoidance [does not] exceed[] any other valid business purpose." IC § 6-3-2-20(c), (f). The Department when establishing the elements of distortion and unfair
reflection under IC § 6-3-2-2(l) and (m) will necessarily demonstrate that the taxpayer's transactions that caused the distortion/income shifting 1) do not have a valid business purpose that exceeds the avoidance of state taxes and 2) do not have substance as the transactions were made with a company set up only to handles these intercompany transactions.
At the outset of this relationship, Subsidiary Corporation was the beneficiary of assets previously held by Taxpayer but which were "invested" in Subsidiary Corporation. Included among those assets was a "note" valued at $575,000,000 compromising eighty-seven percent of the assets "invested." In effect, Taxpayer gave Subsidiary Corporation an IOU for $575,000,000 after which a loan was established in which Taxpayer borrowed the IOU back from Subsidiary Corporation. Taxpayer then used the IOU together with its $78,000,000 of other assets (net of liabilities) to purchase 100 percent of Subsidiary Corporation's stock upon the formation of Subsidiary Corporation. Taxpayer's "borrowing" this large part of the stock's purchase price from Subsidiary Corporation, obligated Taxpayer to pay 8.75 percent in interest each year for seven years. Taxpayer then claimed these interest payments, made from September 1999 to October of 2006, as "ordinary and necessary" business expenses and deducted them from its income for the respective tax years. The February 2006 to October 2006 payments fall in the first of the Tax Years in question here. In October of 2006, in the last few month of the $575,000,000 IOU payment schedule, Taxpayer paid off the remaining balance of the IOU and gave a second $575,000,000 IOU to Subsidiary Corporation with an interest rate of 8.25 percent to be paid each year for seven years.
Taxpayer claimed these interest payments as "ordinary and necessary" business expenses and deducted them from its income for Tax Years.
During the audit and the hearing, Taxpayer was asked to provide documentation that substantiated the valuation of Subsidiary Corporation at the $652,000,000 purchase price. However, Taxpayer could not provide any documentation of the performance of a valuation of Subsidiary Corporation. Apparently, the purchase price of Subsidiary Corporation was based solely on the value of the assets Taxpayer transferred of which the $575,000,000 IOU that Taxpayer "borrowed" from Subsidiary Corporation that very same day constituted eighty-seven percent of the asset value. Moreover, the multiple transfers of the $575,000,000 between two closely related parties–from Subsidiary Corporation to Taxpayer and, then, from Taxpayer to the same Subsidiary Corporation on the same date which Subsidiary Corporation was formed–makes it difficult to discern which party is the "borrower" and which is the "lender." The multiple transfers of this $575,000,000 bring into question the financial realities necessary to justify claiming the 8.75 percent interest payments as "ordinary and necessary" business expenses. Additionally, Taxpayer's failure to provide any explanation or reasoning behind the refinancing of the "loan" for an additional $575,000,000 for seven more years also brings into question the financial realities necessary to justify claiming the 8.25 percent interest payments as "ordinary and necessary" business
In summary, Taxpayer failed to provide sufficient documentation to substantiate its claim that interest, royalty, and "mark-up" payments to its wholly-owned subsidiary were "ordinary and necessary" business expenses, and that it was entitled to deductions which reduced its income for the Tax Years. Rather, Taxpayer's documentation demonstrated that Taxpayer, in a single day, created a Delaware Subsidiary Corporation, gave a $575,000,000 IOU to Subsidiary Corporation without receiving anything in return, transferred the $575,000,000 IOU and $77,000,000 of other assets to Subsidiary Corporation to purchase the stock of Subsidiary Corporation, agreed to millions of dollar of interest payments on the $575,000,000 IOU, entered into a licensing agreement to pay millions of dollars to use the trademarks that were immediately transferred to Subsidiary Corporation, and entered into service agreements to pay millions of dollars for services that Taxpayer previously performed. Thus, the effect of this single day's events with; (1) the creation of the Delaware subsidiary corporation; (2) the purported loans and payments of interest; (3) the purported transfer of its domestic trademarks and subsequent licenses in exchange for payments of royalty, as well as; (4) the transfer of "back office" functions and payments for those services, artificially created "expenses" for Taxpayer and, at the same time, shifted nearly $800,000,000
of Taxpayer's otherwise taxable net income to its wholly-owned Subsidiary Corporation which pays no state income tax under Delaware law. After which, as noted in the audit report, the Subsidiary Corporation returns the "shifted income" back to Taxpayer in the form of tax-free distributions. Therefore, Taxpayer's income, as filed, did not fairly represent its income derived from sources within the state of Indiana and the audit properly disallowed those "expenses" pursuant to IC § 6-3-2-2 (l) and (m).
Taxpayer's protest of the Department's disallowance of the interest, royalty, and "mark-up" expenses is respectfully denied.
The Department found Taxpayer was subject to the underpayment penalty under IC § 6-3-4-4.1(e) for the Tax Years and issued assessments. Taxpayer protests the imposition of the underpayment penalty. IC § 6-3-4-4.1(d) provides:
(d) Every corporation subject to the adjusted gross income tax liability imposed by this article shall be required to report and pay an estimated tax equal to twenty-five percent (25 [percent]) of such corporation's estimated adjusted gross income tax liability for the taxable year. A taxpayer who uses a taxable year that ends on December 31 shall file the taxpayer's estimated adjusted gross income tax returns and pay the tax to the department on or before April 20, June 20, September 20, and December 20 of the taxable year. If a taxpayer uses a taxable year that does not end on December 31, the due dates for filing estimated adjusted gross income tax returns and paying the tax are on or before the twentieth day of the fourth, sixth, ninth, and twelfth months of the taxpayer's taxable year. The department shall prescribe the manner and forms for such reporting and payment.
Taxpayer's protest of the imposition of underpayment of estimated tax penalty is sustained, as discussed in Issue III. However, the remainder of Taxpayer's protest is respectfully denied.
Composed: Aug 27,2016 4:33:38AM EDT