New York disallows exclusion of foreign royalties


Matthew DiDonato
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Art Burkard 
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Howard Polonetsky 
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Spiro Dorizas
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Jamie C. Yesnowitz
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Chuck Jones 
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Lori Stolly 
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Patrick Skeehan
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A New York administrative law judge (ALJ) recently held that a taxpayer was not allowed to exclude royalty payments received from foreign affiliates from its entire net income (ENI) for the 2007 through 2012 tax years.1 The ALJ also concluded that the denial of the exclusion because the affiliates paying the royalties were not New York taxpayers did not violate the Dormant Commerce Clause of the U.S. Constitution.

Background The taxpayer, International Business Machines Corporation (IBM), is a New York corporation and the parent of a worldwide group of companies. IBM owns 100% of IBM World Trade Corporation (WTC), a Delaware corporation headquartered in New York that conducts IBM’s international activities and serves as the holding company of IBM’s alien affiliates. During the 2007 through 2012 tax years at issue, IBM and WTC filed as part of a federal consolidated return and New York corporation franchise tax combined report, along with numerous other domestic affiliates. IBM and WTC indirectly owned 100% of the alien affiliates’ outstanding stock. The alien affiliates engaging in sales to third party customers (Alien S&D Affiliates) were not included in IBM’s federal consolidated returns or New York combined reports. Furthermore, the Alien S&D Affiliates did not file their own New York corporation franchise tax returns.

For the tax years at issue, the Alien S&D Affiliates made four different types of payments (collectively described as alien payments) to IBM or WTC. Specifically, the Alien S&D Affiliates paid IBM or WTC 60% of their revenue for the rights under IBM’s intellectual property to use, distribute and market IBM computer software programs (software payments). Also, the Alien S&D Affiliates paid WTC a percentage (typically 5% to 10%) of their sales for the right to manufacture and sell IBM computer hardware (hardware payments). The Alien S&D Affiliates also paid WTC for the right to provide services relating to IBM products (service payments). Finally, the Alien S&D Affiliates paid IBM or WTC for the economic rights to already existing intangible property to create cost-shared intangibles with IBM and distribute IBM products within their regions (buy-in/other payments). The alien payments were included as royalty income on IBM’s federal returns.
IBM filed amended New York corporation franchise tax returns for the 2007 through 2010 tax years that subtracted the alien payments and requested refunds. For the 2011 and 2012 tax years, IBM subtracted the alien payments on its original New York returns. IBM requested a refund on its 2011 return and the credit of an overpayment to the next period on its 2012 return. Following an audit, the New York Division of Taxation determined that IBM could not deduct the alien payments in computing its combined ENI for the relevant tax years. IBM appealed the Division’s denial of its refunds.

New York exclusion of royalty payments During the relevant tax years, New York corporate taxpayers reported their tax liability as the greatest amount due as computed by different methods or bases, including the ENI base used by IBM.2 Prior to 2013, New York law provided a royalty income exclusion that allowed taxpayers to deduct royalty payments received from a related member to the extent included in the taxpayer’s federal taxable income unless the payments were not required to be added back under the expense disallowance provisions or similar provisions of New York tax law.3 Royalty payments to related members were not required to be added back if: (i) the related members were part of a combined group (combined reporting exception); (ii) the related member paid the royalty to a non-related member for a valid business purpose in an arm’s-length deal (conduit exception); or (iii) the royalty payments were paid to a related member organized under the laws of a foreign country subject to a tax treaty with the U.S. and the payments were taxed in that country at a rate equal to or greater than the rate in New York (treaty exception).4

Royalty payments were not excluded from ENI The ALJ held that the royalty payments that IBM and WTC received from the Alien S&D Affiliates could not be excluded from ENI because the affiliates were not New York taxpayers. In reaching its decision, however, the ALJ first determined that all four of the different types of alien payments constituted royalties. The Division acknowledged that the hardware and service payments were royalties, but argued that the software payments and buy-in/other payments did not qualify as royalties. Because the software payment percentage of 60% was much greater than the other payment percentages, the Division argued that this was a revenue-sharing arrangement rather than a royalty payment. In rejecting this argument, the ALJ concluded that the payments fell directly within the statutory definition of “royalty payments”5 and there was nothing in the record to indicate that this was a revenue sharing arrangement. Similarly, the buy-in/other payments fell “squarely within the definition of a royalty.”

After determining that the alien payments were royalties, the ALJ considered whether such royalties could be excluded from ENI. IBM argued that the alien payments would not have to be added back to ENI if the Alien S&D Affiliates were New York taxpayers because they did not meet the statutory combined reporting, conduit or tax treaty exceptions. Because the definition of “related member” includes corporations with a controlling interest whether or not the entity is a taxpayer, IBM contended that the royalty exclusion applied regardless of whether the entity paying the royalty was a taxpayer. In contrast, the Division argued that because the Alien S&D Affiliates were not federal or New York taxpayers, the alien payments would never be added back and the exceptions would not apply.

In concluding that the royalty payments could not be excluded from ENI, the ALJ explained that the statutory addback and exclusion provisions “work in tandem to ensure that royalty transactions between related members are taxed only once, and do not escape taxation altogether.” IBM’s argument overlooked that the alien payments would not be required to be added back to federal taxable income because the foreign affiliates were not New York or U.S. taxpayers. Under IBM’s interpretation, the royalty income would completely escape taxation. The ALJ also rejected IBM’s argument that the 2013 amendments to the statute that removed the royalty income exclusion supported IBM’s interpretation of the statute. According to the ALJ, the legislature’s statement for the 2013 statutory amendment supports the Division’s position that the statute required the related member that paid the royalty to be a New York taxpayer in order for the recipient of the payment to receive the royalty income exclusion.

Denial of exclusion does not violate Dormant Commerce Clause The ALJ also rejected IBM’s argument that the Division’s interpretation of the royalty exclusion requiring the related entity paying the royalty to be a New York taxpayer violates the Dormant Commerce Clause of the U.S. Constitution.6 In Complete Auto Transit, Inc. v. Brady, the U.S. Supreme Court created a four-prong test that a taxing scheme must satisfy under the Dormant Commerce Clause.7 The instant case concerned the anti-discrimination requirement. Based on Kraft General Foods, Inc. v. Iowa Department of Revenue,8 IBM argued that limiting the royalty exclusion to taxpayers that receive payments from a New York taxpayer is facially discriminatory. In response, the ALJ prefaced its consideration by stating that while an ALJ does not have jurisdiction to consider a facial constitutional challenge, an ALJ may consider the constitutionality of a statute as applied to a taxpayer. In Kraft General Foods, the U.S. Supreme Court held that an Iowa statute that taxed only the dividends paid by foreign corporations out of their foreign earnings facially discriminated against interstate commerce. Unlike the Iowa statute at issue in Kraft General Foods, the former New York statute did not impose a greater burden on the royalty income depending on the payer’s location. As explained by the ALJ, the transaction was subject to taxation only once regardless of whether the payer is a New York taxpayer.

Commentary This is the latest decision to consider the availability of New York’s former royalty income exclusion if the related party making the royalty payment is not a New York taxpayer. In 2013, budget legislation repealed the royalty income exclusion and amended the exceptions to the royalty addback requirement.9 The ALJ’s decision to deny the exclusion in this case is consistent with the opinion recently issued in the Moody’s case.10 While the royalty income exclusion was only in effect prior to 2013, consideration of the statute continues on in Department audits, appeals and litigation. The availability of the royalty exclusion is highly dependent on the taxpayer’s particular facts and circumstances. As explained by the ALJ, the former addback and exclusion provisions are intended to work together to tax the royalty transactions between related members only once. However, the statute should not be interpreted in a way that would allow royalty payments to completely avoid taxation. 

The ALJ’s broad interpretation of the statutory definition of “royalty payments” remains relevant because this definition continues to apply to the post-2012 royalty addback provisions.11 Under the ALJ’s decision, payments that might be subject to the royalty addback requirement conceivably could be expanded. Furthermore, a broad reading of what constitutes a “royalty” potentially could have an impact on the apportionment of certain income by expanding the income subject to the sales factor sourcing rules for royalties.12

1 In re International Business Machines Corp., New York Division of Tax Appeals, Administrative Law Judge Unit, DTA No. 827825, Dec. 19, 2019.
2 Former N.Y. TAX LAW § 201.1(a)–(d). ENI is based on a measure of federal taxable income.
3 Former N.Y. TAX LAW § 208.9(o)(3). 
4 Former N.Y. TAX LAW § 208.9(o)(2)(B).
5 See N.Y. TAX LAW § 208.9(o)(1)(C).
6 As explained by the U.S. Supreme Court, the Dormant Commerce Clause prohibits states from imposing taxes that “benefit in-state economic interests by burdening out-of-state competitors.” Fulton Corp. v. Faulkner, 516 U.S. 325, 330 (1996). 
7 430 U.S. 274 (1977). The taxing scheme must satisfy the following: (1) there must be a substantial nexus between the taxpayer and the state; (2) the tax must be fairly apportioned; (3) the tax must not discriminate against interstate commerce; and (4) the tax must be fairly related to the services provided by the state.
8 505 U.S. 71 (1992).
9 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). As explained by the New York State Department of Taxation and Finance, the legislation provides the following exceptions to the addback requirement: (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 to alternative adjustments to more appropriately reflect the taxpayer’s income. 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.    
10 In re Moody’s Corp., New York Division of Tax Appeals, Administrative Law Judge Unit, DTA Nos. 828094 and 828203, Oct. 24, 2019. For a discussion of this decision, see GT SALT Alert: New York ALJ allows alternative apportionment. 
11 N.Y. TAX LAW § 208.9(o)(1)(C).
12 See N.Y. TAX LAW § 210-A.3(b).

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