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On Jan. 31, 2019, the New Jersey Tax Court ruled that for purposes of the state and local tax addback statute, a taxpayer was required to include its portion of the total tax liability in non-separate filing states in the addback calculation.1
The Court, however, denied the New Jersey Division of Taxation’s position that intercompany payments made consistent with a tax-sharing agreement were required to be added back as well. This decision provides taxpayers with clarity and guidance on the scope of the state and local tax addback statute and the treatment of tax-sharing agreements.
The taxpayer, Daimler Investments US Corp., a wholly-owned subsidiary of Daimler North America Corp. (Parent), is primarily involved in the investing and financing activities of a division of a multinational automobile manufacturing enterprise, including the ownership a number of single member limited liability companies (SMLLCs). The taxpayer is one of Parent’s many subsidiaries and, like Parent, has a New Jersey filing requirement (through the activities of the SMLLCs and other partnerships in which the taxpayer owned interests). Along with a number of separate company filings, Parent is also the designated agent and responsible for making the necessary tax payments for the 35 non-separate state filings.
On May 1, 2007, Parent joined a tax–sharing agreement with the taxpayer, its other subsidiaries and the SMLLCs in order to fairly apportion each member’s share of tax. Under the agreement, the subsidiaries multiplied their respective federal taxable income by their effective tax rate per state. The result was reported on each entity’s pro forma tax return as an intercompany payment. Because these payments were computed on a separate company basis, they were not equal to the subsidiary’s true share of the combined group’s tax liability.
In order to remain uniform, each subsidiary reported its intercompany payments on Line 17 “Taxes and Licenses” of Federal Form 1120. When preparing its New Jersey corporate business tax (CBT) return, the taxpayer would add back its state tax expense without regard to its share of the combined state tax liability, which was paid by Parent. In the 2008 and 2009 tax years, the taxpayer received more intercompany payments from its SMLLCs than its share of tax expense under the tax-sharing agreement, which generated a negative intercompany tax expense. The opposite occurred during the 2010 and 2011 tax years, generating a positive intercompany tax expense. The negative amount was added back to federal taxable income on the taxpayer’s CBT return for 2008. However, the taxpayer treated the adjustment as an “ordinary and necessary business expense” in the 2009-2011 tax years.
New Jersey audit
The Division initiated an audit of the taxpayer’s 2008-2011 tax years in December 2012. Following the audit, the Division recomputed the taxpayer’s entire net income (ENI).2
There were two major differences between the taxpayer’s originally reported ENI and the auditor’s recomputed amount. First, the Division rejected the taxpayer’s classification of intercompany payments as ordinary and necessary business expenses and disallowed the deductions. The disallowance of deductions increased the taxpayer’s state taxable income. Second, the Division determined that the positive intercompany payment balance in the taxpayer’s 2010 and 2011 tax years, which occurred because the taxpayer paid more in tax expense than it received, should ultimately be added back. In accordance with state law, a taxpayer, when computing ENI for CBT purposes, must add back “taxes paid or accrued to the United States, . . . a state, . . . or the District of Columbia . . . on or measured by profits or income, or business presence or business activity.”3
The adjustments made to the taxpayer’s ENI resulted in additional taxes, penalties and interest of nearly $4.9 million. The taxpayer and the Division both filed motions for summary judgment with the New Jersey Tax Court.
Application of state tax addback statute
During a summary judgment hearing before the Tax Court, the taxpayer challenged the Division’s final determination by citing the plain language of the tax addback statute. The taxpayer argued that the addback only applies to the entity making the payment, which in this case was Parent, and that as a result, the taxpayer should not be required to add back any state taxes. Furthermore, the taxpayer contended that the intercompany payments were merely estimates of tax and not the actual liability. The Division argued that the taxpayer was required to add back the intercompany payments because they were effectively state tax expenses, the nature of the payments was “distortive and raised income shifting concerns,” and such amounts were included on Line 17 of the Federal Form 1120 and described as state income taxes.
The Court agreed with the taxpayer that the intercompany payments were not payments of tax or purposely distortive, but were merely an accounting mechanism used to help Parent fairly apportion its share of tax. The Court however disagreed with the taxpayer’s position that the tax addback only applies to the taxpayer making the payment. It explained that non-separate filing states require subsidiaries to apportion their income and share a portion of the tax. Although payments of tax may be made at the parent level, these subsidiaries still have a tax liability. Ultimately, the Court determined that the taxpayer needed to adjust its addback to include its pro rata share of Parent’s tax liability in the non-separate filing states. However, following such adjustment, the taxpayer’s tax obligation should be reduced by any overpayment of CBT made by Parent on the taxpayer’s behalf during the 2008-2011 tax years. Finally, the Court concluded that once the taxpayer determines its CBT liability, any additional amounts to be paid are subject to statutory interest, but not penalty.
The Tax Court took a relatively equitable approach to the case. The Court concluded that the Division had overinflated the state tax addback by including the positive intercompany tax payments as measures of taxes actually paid. Also, the Court recognized that the taxpayer had excluded from the state tax addback its share of tax for the non-separate state filings.
When considering the full impact of this decision as it pertains to all New Jersey CBT filers, it is important to note the state’s recent tax reform. For tax years ending on or after July 31, 2019, New Jersey is changing from a separate company filing jurisdiction to a mandatory combined filing jurisdiction.4
As a result, tax-sharing agreements prospectively will have more limited effect in New Jersey. Historically, a tax-sharing agreement afforded a taxpayer the opportunity to effectively shift income from a high-tax state to a low-tax state, facilitating the entity in decreasing its effective tax rate. Although benefits of these agreements will be limited in New Jersey and other combined filing states, they will continue to help combined groups manage cash flows and share expenses. While the New Jersey filing method used by the taxpayer in this case is no longer in effect, the Court’s analysis in clarifying how certain state adjustments should be made and its treatment of tax-sharing agreements could remain relevant, and could be of particular interest to entities with tax periods still open under the statute of limitation that may now wish to consider amending CBT returns.
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