Surveying Constitutional Theories for Challenges to the Add Back Statutes

Over the last few years, eleven separate-company filing states have enacted so-called "add back statutes" that disallow a deduction for certain payments made to affiliates. 1 All of these states target royalties paid for the use of trademarks, tradenames or patents. Most also disallow interest deductions. 2 In this article, we briefly survey the basic structure of these statutes with the purpose of identifying Commerce Clause arguments that might be available for challenging all or parts of these statutes. 3

The Basic Add Back Statute

Add back statutes are directed at what states perceive to be an abusive transaction, i.e., a transaction in which a taxpayer creates deductions in separate-company filing states while sourcing the related income to states with favorable tax regimes (e.g., tax regimes that either as a matter of theory or legislative grace don't tax such income or tax it at a favorable rate).

Maryland's add back statute is typical. Like most states, Maryland imposes a corporate income tax on a corporation's Maryland taxable income, which is generally defined as the corporation's federal taxable income, as modified. See Md. Code ßß 10-102, 10-301 and 10-304(1). With the passage of its add back statute, one of the modifications is a requirement that taxpayers add back the following expenses when calculating their Maryland income:

[O]therwise deductible interest expense or intangible expense if the interest expense or intangible expense is directly or indirectly paid, accrued, or incurred to, or in connection directly or indirectly with one or more direct or indirect transactions with, one or more related members.

Md. Code ß 10-306.1(b)(2). For this purpose, "interest expense" is defined as "an amount directly or indirectly allowed as a deduction under section 163 of the Internal Revenue Code . . . ." Md. Code ß 10-306.1(a)(7). Maryland defines "intangible expense" broadly; it includes an expense directly or indirectly related to the "acquisition, use, maintenance, management, ownership, sale, exchange or any other disposition of intangible property," a loss in connection with discounting and factoring transactions, a "royalty, patent, technical or copyright fee," a licensing fee, as well as any other similar cost or fee. Md. Code ß 10-306.1(a)(5). 4 "Related members" include stockholders and entities related to them within the meaning of Internal Revenue Code ("IRC") ß318 that own at least 50% of the taxpayer's outstanding stock, component members within the meaning of IRC ß 1563, and persons to or from whom there is an attribution of stock ownership within the meaning of IRC ß 1563. See Md. Code ß 10-306.1(a)(8)-(9).

In contrast to this typical model, North Carolina's add back statute takes a slightly different tack. Instead of disallowing the expense itself (essentially on a pre-apportioned basis), the North Carolina statute targets only royalty payments received for the use of trademarks in North Carolina and treats all such payments effectively as taxable income derived from doing business in the state. See N.C. Gen. Stat. ß 105-130.7A.(a). In the event the payor and the recipient of the royalties are related members, the payments may either (a) be included in the income of the recipient and deducted by the payor, or (b) added back to the income of the payor and excluded from the income of the recipient. See N.C. Gen. Stat. ß 105-130.7A.(a). Thus, North Carolina effectively allocates to the state all royalties relating to use of trademarks within the state and then provides the parties a choice as to which (related) entity is to report and pay tax on the income.

Exceptions to the Disallowance

Various exceptions provided in the statutes or the regulations temper the broad sweep of the add back statutes. Although the scope and requirements of these exceptions vary between the states, 5 the types of exceptions found in the add back statutes may be placed in broad categories to provide a framework for considering their constitutionality.

Business Purpose and Arm's Length Pricing

Before discussing the specifics, it is important to note that certain of the exceptions described below require the taxpayer to demonstrate that the transaction was not entered into for tax avoidance purposes and that the payments reflect arm's length pricing. 6 Moreover, certain of the add back exceptions require the taxpayer to seek approval from the state's tax agency before the exception may be claimed.7 Because these requirements do not appear to implicate the constitutionality of the statutes directly, we do not dwell on them further. Nonetheless, these requirements play an important role in qualifying for many of the exceptions, and thus taxpayers seeking to avoid, rather than challenge, the add back statutes should consult with the state's requirements to determine whether they should obtain documentation of a business purpose and arm's length pricing to support their claim of an exception.

Categorizing the Exceptions

In general, the exceptions to the add back statutes fall into seven broad categories. The first exception discussed is the most important and requires a somewhat more extensive discussion. Thereafter we address the other exceptions in a more summary form.

The recipient is taxable on the income by the add back state or another state.

Although the specific form of this exception varies from state to state, several states allow taxpayers to avoid the add back requirement if the recipient is subject to state tax on the associated income.8 The key variants among statutes adopting this exception are (1) the benchmark for determining whether the related income is subject to tax, (2) the method for establishing the recipient's tax burden, and (3) the manner for calculating the add back.

The Benchmark

The most distinctive variant is the benchmark, or standard, for determining whether the recipient is subject to a sufficient amount of tax on the related income. Virginia's exception is the broadest, and merely requires that the recipient be subject to "a tax based on or measured by net income or capital," without specifying a minimum tax rate. Va. Code ß 58:1-402(B)(8)(a)(1), (9)(a)(4)(i); see also Ark. Code ß 26-51-423(g)(1)(A). The instructions to the Virginia return specify that the inclusion of the income in the recipient's net income or capital must result "in a non-trivial increase in tax liability (or reduction of an operating loss) after consideration of all of the deductions, credits, exemptions and other tax policies and preferences affecting the tax liability...

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