The use of captive intangible companies, commonly referred to as Delaware holding companies, has been a common state tax planning vehicle for C corporations. They have been particularly popular for corporations based in Pennsylvania because they could generate significant savings and were rarely challenged by the Department of Revenue. A legislative change, however, in conjunction with a recently issued notice from the Department of Revenue, may spell the end of Delaware holding companies (“DHCs”) for many Pennsylvania taxpayers.
Taxpayers typically established a Delaware holding company (“DHC”) by having an operating company transfer a tradename and/or other intangible property to a wholly-owned subsidiary. After the transfer, the operating company paid the DHC a royalty or other fee which reduced its taxable income in Pennsylvania and other separate company return states. The DHC was domiciled in a state such as Delaware where the royalty income was not taxed. This basic planning idea subsequently gave rise to a significant number of variations both in terms of the types of assets/income transferred to the DHC and the location of the captive (e.g. Nevada, consolidated return states).
Most states took one of three approaches for attacking DHC arrangements. Some required the DHC to file a combined or consolidated tax return with the operating company. Other states taxed the DHC directly based on the position that the use of the intangible property in the state created a taxable presence or nexus. See, Geoffrey, Inc. v South Carolina Tax Comm’n, 437 S.E. 2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993). Finally, a number of states enacted statutes that required taxpayers to add back royalties and other expenses paid to a DHC.
In 2013, Pennsylvania enacted an add-back provision applicable to tax years beginning after December 31, 2014. 72 P. S. §7401(3)1.(t). The provision was similar to ones enacted in other states with one major difference. The provision did not apply unless the principal purpose of the transactions was to avoid the payment of Pennsylvania corporate net income tax, and the terms and pricing were arm’s length.
The Department of Revenue recently addressed how it will interpret and apply the add-back provision in Information Notice Corporation Taxes 2016-1 (the “Notice”). The most significant portions of the Notice pertain to the principal purpose exception.
The Notice provides that in order to fall under the exception, the principal purpose for establishing the arrangement must be a valid business purpose that is supported by contemporaneous documentation. In addition, the avoidance of tax is presumed for transactions that did not change the overall economic position of the taxpayer and its affiliates in a meaningful way.
The Notice also clarifies:
• When the provision applies to amortization expense, embedded intangible costs and interest expense.
• How to calculate a tax credit when the DHC is paying state income tax on its intangible income.
• The exception for transactions with non-US affiliates.
The Notice is troublesome for many taxpayers because it takes a narrow interpretation of the principal purpose exception. Some taxpayers will be unable to find contemporaneous documentation of a valid business purpose – either because they failed to document it or because they can’t find it. Many taxpayers will also find it difficult to rebut the presumption of tax avoidance because they may be unable to establish that their overall economic position has changed. Arguments can be raised that some of the provisions are overreaching, but it will likely take a judicial challenge to overturn them.
Taxpayers with DHCs should review their documentation and the Notice to determine if they are subject to the add-back provision. If they are, it would be prudent to review alternatives for terminating the DHC arrangement, as it may not be generating any tax savings and, in some instances, could result in higher taxes.
Feel free to contact Jeff Kessel @ 412-454-0202 or firstname.lastname@example.org if you have any questions regarding these changes.