New York affirms foreign affiliate royalties payment requirement

On April 23, 2024, the New York Court of Appeals released an opinion affirming two lower appellate court decisions holding that major multinational taxpayers, the Walt Disney Co. (Disney) and International Business Machines Corp. (IBM), could not exclude royalty payments from foreign affiliates in computing their New York corporation franchise tax under the law in effect prior to 2013.¹ The Court of Appeals held that the Appellate Division of the New York Supreme Court correctly interpreted the applicable New York statute to permit a tax deduction for the royalty payments only where a related subsidiary was subject to the addback requirement. Furthermore, any burden on interstate or foreign commerce created by this tax scheme was incidental and did not violate the dormant Commerce Clause.

Background

Disney, a multinational, diversified entertainment business, develops, owns, and uses intangible property (IP) through licensing to domestic and foreign subsidiaries. Disney and its related entities filed combined tax returns in New York. From 2008 to 2010, Disney received more than $5.4 billion of royalty payments from its foreign affiliates for use of its IP and paid tax on the portion of its income allocable to New York business activity.² For the 2009 and 2010 tax years, Disney deducted royalty payments received from its foreign subsidiaries from its taxable income. Disney also filed an amended tax return for 2008 seeking a refund for the royalty payments included in income. Disney was audited by the New York Department of Taxation and Finance, which denied its refund request and issued a notice of deficiency of nearly $4 million.

IBM, a multinational technology and consulting company, operates in more than 170 countries worldwide, primarily through locally incorporated subsidiaries. The subsidiary responsible for international operations is IBM World Trade Corp. (WTC), a Delaware corporation based in New York. The various foreign subsidiaries paid royalties to IBM or WTC for use and distribution rights to IBM’s software, hardware, and for the right to provide services related to IBM products. From 2007 to 2012, IBM and its U.S. subsidiaries filed combined returns in New York. IBM received a total of nearly $50.7 billion in royalty payments from its foreign subsidiaries during this period.³ IBM deducted royalty payments received from its subsidiaries for the 2011 and 2012 tax years, and later requested refunds for taxes paid on that income for the 2007 to 2010 tax years. In response, the Tax Department audited IBM, denied its refund requests, and issued a notice of deficiency for the 2011 and 2012 tax years, as well as interest charges and penalties.

New York exclusion of royalty payments

Prior to 2013, New York law provided for a royalty income exclusion that allowed taxpayers to deduct royalty payments received from a related member to the extent included in a taxpayer’s federal taxable income, “unless such royalty payments would not be required to be added back” under the expense disallowance provisions or similar provisions of New York tax law.⁴ This provision required a taxpayer to add back royalty payments made to a related member in computing earned net income (ENI) to the extent they were deductible in computing federal taxable income, unless: (i) the royalty payor was included in the combined report with the payee; (ii) the payee later paid the royalty amounts to an unrelated party during the taxable year; or (iii) the royalty payments were made to a non-U.S. related member subject to a comprehensive tax treaty with the United States.⁵ None of these exceptions applied to Disney or IBM in the tax years at issue.

Administrative and judicial proceedings

After deficiencies were assessed, both taxpayers challenged the denial of their royalty deductions and notices of deficiency with the New York State Division of Tax Appeals. In each case, following a hearing, an administrative law judge (ALJ) determined that, under the plain meaning of the statute, the deduction only applied if the royalty came from a subsidiary that had been subject to the addback requirement. In both cases, the ALJ explained that the deduction did not discriminate against out-of-state interests as it was only permitted after a related company had already paid an in-state tax. The New York Tax Appeals Tribunal subsequently affirmed both decisions.⁶ Both taxpayers filed appeals with the Appellate Division of the New York Supreme Court. The Appellate Division affirmed the determinations and dismissed the petitions, holding in separate decisions that the plain meaning of the statute supported the Tribunal’s decision and that there was no differential treatment between in-state and out-of-state commerce.⁷ Both taxpayers appealed to the New York Court of Appeals.

Court of appeals decision 

The New York Court of Appeals affirmed the prior decisions and held that the taxpayers improperly deducted the royalty payments they received from their affiliates in foreign countries that were not subject to New York tax. On appeal, the taxpayers unsuccessfully argued that the denial of the deductions was contrary to the clear language of the relevant statute and violated the dormant Commerce Clause’s prohibition on discrimination against foreign commerce. 

No deduction of royalties received from foreign affiliates 

In rejecting the taxpayers’ arguments that the deduction should be allowed, the Court of Appeals held that the Tribunal properly interpreted the statutory language to disallow the deduction of royalties received from foreign affiliates. The court determined that the plain meaning of the statutory language is clear: “[A] taxpayer shall not be allowed to deduct royalty payments directly or indirectly received from a related member during the taxable year to the extent included in the taxpayer’s federal taxable income unless such royalty payments would not be required to be added back under subparagraph two of this paragraph or other similar provision in this chapter.”⁸ The court explained that by its plain terms, the statute allows parent companies to deduct royalties only if that money had already been included in a New York tax return through an addback to the subsidiary’s income. Because the relevant language only applies to corporations subject to New York tax, the court reasoned that the deduction was only available to corporations receiving royalties from related entities that were subject to the addback.

The court further explained that even if the statute were not clear on its face, the court would consider the objective that the legislature sought to achieve. In enacting the deduction and addback scheme, the court opined that the legislature was attempting to close a loophole allowing international corporate groups to avoid paying state taxes on royalty payments between related members of the corporate group. The court rejected the taxpayers’ argument that the statute should be interpreted to provide that the deduction was available to corporations receiving royalties from related entities that would be subject to addback if they were subject to New York taxes. According to the court, this interpretation would not accomplish the legislature’s goal and would produce the opposite outcome. The court noted that corporate structures with out-of-state subsidiaries would be able to take a deduction without first paying a New York tax on the royalties. Because the plain language and the purpose behind the statute supported the Tribunal’s interpretation, the court agreed with this reading of the statute.

Dormant Commerce Clause not violated

The court rejected the taxpayers’ argument that the statute facially violated the dormant Commerce Clause. As explained by the court, the dormant Commerce Clause prohibits states from unjustifiably discriminating against or burdening interstate commerce. Generally, to withstand a challenge under the dormant Commerce Clause, a state tax: (i) must be “applied to an activity with a substantial nexus with the taxing State;” (ii) must be “fairly apportioned,” meaning internally and externally consistent; (iii) may not discriminate against cross-border commerce; and (iv) must be “fairly related to the services provided by the State.”⁹

The taxpayers failed to convince the court that the challenged statute facially discriminated against out-of-state commerce. With respect to the discrimination prong, the court determined that the taxpayers did not show that the tax scheme was facially discriminatory against out-of-state commerce, that it mandated “economic protectionism,” or that it was a measure “designed to benefit in-state economic interests by burdening out-of-state competitors.”¹⁰ The court explained that under the former statute, royalty payments made by a New York taxpayer were treated in the same manner as royalty payments made by a non-New York taxpayer because the income only had to be included on a New York tax return once, resulting in a neutral economic impact on the corporate group as a whole.

The court also held that the contested statute did not violate the U.S. Supreme Court’s internal consistency test used as one of two measures to determine whether a tax is fairly apportioned. This test instructs courts to assume the challenged tax scheme applies in every jurisdiction in determining if such application would inherently produce impermissible interference with the flow of commerce.¹¹ In applying the internal consistency test, the U.S. Supreme Court has explained that “tax schemes that create disparate incentives to engage in interstate commerce (and sometimes result in double taxation) only as a result of the interaction of two different but nondiscriminatory and internally consistent schemes” do not violate the Constitution.¹² After determining that the New York tax scheme fell within this permissible category, the court held that even if every other jurisdiction applied the same tax scheme found in the former New York statute, there would be no impermissible burden on interstate commerce. The court held that the taxpayers failed to show that, under the internal consistency test, the challenged tax necessarily discriminates against interstate commerce in its ordinary application. As explained by the court, it is not sufficient to show that sometimes, in some situations, the conflicting laws may result in a greater tax. The court concluded that even though duplicative taxation may sometimes occur, this incidentally results from “the interaction of two different but nondiscriminatory and internally consistent schemes.”¹³

Concurring opinion

An extensive concurring opinion joined by two judges agreed with the majority’s interpretation of the statutory language. The concurrence also believed that the statute does not violate the dormant Commerce Clause, but for different reasons than those relied on by the majority. According to the concurrence, the contested statute is not a measure that imposes benefits or burdens depending upon where a business is located, where goods are produced, or where payments are made. Instead, the statute is fundamentally a tax filing provision in which the availability of the deduction depends on whether a subsidiary is a New York taxpayer, not on whether the royalty payment crosses jurisdictional lines. Applying this view of the statute, the concurrence would hold that the taxpayers failed to show that the statute violated the dormant Commerce Clause.

Commentary

The decision by the New York Court of Appeals affirms a series of lower appellate decisions holding that the former statute requires the inclusion of royalty payments received from foreign affiliates. Consistent with the prior decisions, the court determined that the plain statutory language and legislative intent required the deduction of royalties received from foreign affiliates to be disallowed. The court went beyond the literal text of the statute (interpreting the statute as requiring an affiliate to be subject to New York tax) and holistically looked at the purpose of the exclusion and addback regimes, as a means to arrive at a result that would ensure that related-party royalty transactions are effectively taxed once, and more importantly do not escape taxation altogether. Also, the court agreed with the prior rulings that the contested statute did not violate the dormant Commerce Clause. Although this decision was predictable, it is noteworthy because New York’s highest court provides clarity regarding the interpretation and application of the former statute.

The treatment of royalties substantially changed as a result of the New York budget legislation enacted in 2013.¹⁴ Replacing the royalty income exclusion is a related-party royalty expense addback provision, with four exceptions from the addback potentially available for taxpayers: (i) if the taxpayer’s related member paid significant taxes on the royalty payment in other jurisdictions; (ii) if the related member paid all or part of the royalty payment it received to a third party for a valid business purpose; (iii) if the related member is organized under the laws of a foreign country that has a tax treaty with the U.S.; or (iv) if the taxpayer and the Department agree with alternative adjustments that more appropriately reflect the taxpayer’s income.¹⁵ This change made New York more consistent with other states’ treatment of related-party transactions involving royalty payments. Also, ambiguity over the term “related member” has been resolved by linking this term to the definition in Internal Revenue Code Sec. 465(b)(3)(c), but substituting 50% for the 10% ownership threshold.¹⁶

1 Walt Disney Co. v. Tax Appeals Tribunal, New York Court of Appeals, No. 34; International Business Machines Corp. v. Tax Appeals Tribunal, New York Court of Appeals, No. 35, April 23, 2024.
2 The record contains no indication of whether Disney or its subsidiaries paid any taxes on this income in the foreign jurisdictions
3 As with Disney, there was no indication that any foreign taxing authority required any of IBM’s foreign subsidiaries to add back the royalty payments to IBM or WTC or any evidence as to tax liabilities imposed on its subsidiaries.
4 N.Y. TAX LAW § 208.9(o) was subsequently amended to eliminate the royalty income exclusion effective for tax years beginning on or after Jan. 1, 2013. Ch. 59 (S.B. 2609), Laws 2013, amending N.Y. TAX LAW § 208.9(o)(2) and repealing N.Y. TAX LAW § 208.9(o)(3).
5 Former N.Y. TAX LAW § 208.9(o)(2).
6 Matter of the Walt Disney Co., New York State Tax Appeals Tribunal, DTA No. 828304, Aug. 6, 2020; Matter of International Business Machines Corp., New York State Tax Appeals Tribunal, DTA Nos. 827825, 827997 and 827998, March 5, 2021.
7 Walt Disney Co. v. Tax Appeals Tribunal, 176 N.Y.S.3d 356 (N.Y. App. Div. 3d Dept. 2022); International Business Machines Corp. v. Tax Appeals Tribunal, 185 N.Y.S.3d 823 (N.Y. App. Div. 3d Dept. 2023). For further discussion of the Disney decision, see GT SALT Alert: New York requires inclusion of royalty payments received from foreign affiliates.
8 Former N.Y. TAX LAW § 208.9(o)(3) (emphasis added by court).
9 Complete Auto Transit, Inc. v Brady, 430 U.S. 274, 279 (1977). For foreign commerce, the U.S. Supreme Court has identified two additional prongs: “first, whether the tax, notwithstanding apportionment, creates a substantial risk of international multiple taxation, and, second, whether the tax prevents the Federal Government from speaking with one voice when regulating commercial relations with foreign governments.” Japan Line, Ltd. v County of Los Angeles, 441 U.S. 434, 451 (1979) (internal quotation marks omitted).
10 National Pork Producers Council v. Ross, 548 U.S. 356, 370 (2023).
11 Container Corp. v. Franchise Tax Board, 463 U.S. 159, 169 (1983).
12 Comptroller v. Wynne, 575 U.S. 542, 562 (2015).
13 Id. at 562.
14 Ch. 59 (A.B. 3009 / S.B. 2609), Laws 2013, Part E
15 N.Y. TAX LAW § 208.9(o)(2)(B); Summary of Tax Provisions in SFY 2013-14 Budget, New York State Department of Taxation and Finance, Office of Tax Policy Analysis, April 2013.
16 N.Y. TAX LAW § 208.9(o)(1)(A).