The Pennsylvania Department of Revenue (Department) recently circulated to the Pennsylvania tax practitioner community a discussion draft of a notice (Information Notice Corporation Taxes 2016-1 (Notice)) describing its interpretation, explanation and illustration of Pennsylvania's add-back rule, which disallows corporate income tax deductions for certain related-party transactions. We understand the Department will consider any comments received and then plans to redraft and publish the Notice. The Department may also consider submitting the Notice as a proposed regulation.

In 2013, the Pennsylvania legislature modified the Commonwealth's corporate net income tax (CNIT) to disallow the deduction for certain related-party intangible expenses and costs for tax years beginning after December 31, 2014 (see Act 52 of 2013 (Act 52)). The Notice sets forth the Department's view of the scope of the add-back rule, the exceptions to add-back and the manner in which the credit to the add-back is to be calculated.

Scope of the add-back

Except when a taxpayer meets one of three exceptions, Act 52 expressly provides that:¹

"... for taxable years beginning after December 31, 2014, and in addition to any authority the Department has on the effective date of this paragraph to deny a deduction related to a fraudulent or sham transaction, no deduction shall be allowed for an intangible expense or cost, or an interest expense or cost, paid, accrued or incurred directly or indirectly in connection with one or more transactions with an affiliated entity."

²

"Intangible assets" subject to the add-back rule include patents, patent applications, trade names, trademarks, service marks, copyrights, mask works and other similar expenses and cost (e.g., franchise rights, know-how, trade secrets, goodwill, contract rights). The Department notes that the list of "intangible assets" to which add-back applies is not exhaustive, and that the classification or label of a transaction is not determinative. Rather, the substance of a transaction is determinative.

The Department provides guidance on when a direct or indirect intangible expense or cost arises from a transaction between a Pennsylvania corporate taxpayer and an affiliated entity, noting that a corporation could be subject to add-back through an indirect transaction, even when the corporation and the affiliated entity are not parties to the same agreement with respect to an intangible asset. Further, an indirect intangible expense or cost deduction also may arise through amortization of intangible property³ or through the use of embedded intangibles. The Department interprets the definition of "intangible expense or cost" found in 72 P.S. 7401(8)⁴ to include embedded intangible costs. The Department reasons that embedded intangible costs are "expense deductions to acquire, use, maintain, manage, sell, exchange, or otherwise dispose of (or otherwise acquire) legal rights to an intangible asset, when the purported cost or expense is included in deductions or expenses that are called something other than 'royalties, trademarks, etc.,' such as costs of goods sold or a separate service charge (e.g., management fee)." The Notice includes examples.

In Example 1, a Pennsylvania taxpayer purchases products from an affiliated entity that had licensed trademarks from another affiliated entity. Under this scenario, "the amount charged for the goods purchased [that] included costs [for the affiliated entity's] use of the trademarks" must be added back to determine state taxable income, because the Pennsylvania taxpayer "is deemed to indirectly incur intangible costs or expense" related to the affiliated entity's license of trademarks.⁵

The Department also provides guidance on the disallowance of interest expense directly related to intangible expenses or cost. Such a deduction will be disallowed under the add-back rules "where the interest was incurred on a liability by a PA corporate taxpayer to an affiliate entity to the extent the interest represents, in the hands of an affiliated entity, income from loaning or advancing money received as a result of an intangible property transaction with a PA corporate taxpayer."⁶ Further, "interest paid to an affiliated entity is presumed to be related to an intangible property transaction if the Pennsylvania corporate taxpayer has incurred intangible expenses or costs with respect to the same or any other affiliated entity in the same tax year."⁷ Per the Notice, it will not be necessary to trace the source and application of funds among the affiliated entities. The Notice includes various examples.

Exceptions to the add-back

In general, related-party intangible expenses and costs are required to be added back unless one of the exceptions is met. Exceptions include the principal purpose/arm's-length exception, the foreign treaty exception, or the conduit exception. Taxpayers must maintain documentation to support the exception.

In order to meet the principal purpose/arm's-length exception, a taxpayer must show "that (i) the transaction did not have a principal purpose of avoiding CNIT; and (ii) the transaction was conducted at arm's length rates and terms."⁸ In discussing when the "principal purpose" of a taxpayer's transaction was "not to avoid CNIT," the Department said that it is irrelevant whether the statute used the phrase "a principal purpose," "the principal purpose" or "the primary purpose," finding that these phrases have the same meaning. The Department reasoned that "there can be only one principal purpose and that is the single and most significant reason for which a transaction was conducted."⁹ According to the Department, the principal purpose must be a non-tax business purpose that, either alone or in combination with other non-tax business purposes, is the primary motivation for entering into the transaction. Certain statements and claims — such as "mere statements or assertions" that a taxpayer engaged in a transaction to generally enhance management or intangible asset efficiency "or similarly unsubstantiated claims" — will not be sufficient to substantiate a claim of a principal non-tax business purpose. In addition, the Department will presume the tax avoidance for transactions between or among affiliates that generate intangible expenses or deductions that did not change the overall economic position of the Pennsylvania corporate taxpayer and its affiliated entities in a meaningful way.

In regard to the arm's-length exception, the Department will consider the terms to be at arm's-length when "the terms of the transaction under consideration are such as would have been arrived at in independent transactions with or between unrelated parties under similar circumstances."¹⁰

The Notice includes guidance on requirements taxpayers will have to meet in order to substantiate the claim that the transactions meet either the principal purpose or arm's-length exceptions, including the type of information the documentation must support.

Concerning the foreign treaty exception, the Department defines "foreign nation" and "comprehensive income tax treaty" — which Act 52 does not define — by leveraging the definitions for these terms in Georgia's add-back statute. The Notice also provides guidance on the evidence that a taxpayer relying on the comprehensive income tax treaty exception must provide. Information that a taxpayer must provide to the Department upon request includes:

— A description of the business purpose of the transactions between the Pennsylvania corporate taxpayer and the affiliated entity
— Documentation that all of the terms of the transactions with affiliated entities are at arm's-length rates and terms¹¹

A taxpayer also must include a description of the comprehensive tax treaty and a complete copy of such treaty.

Credits

The statute provides a credit in certain situations. In discussing the application of the credits, the Notice quotes the statute; however, it veers away from the statutory language by stating that the credit "does not apply to taxes based upon capital, gross receipts taxes, or business and occupation taxes."¹² The Notice also includes detailed examples illustrating the manner in which it views the credit to be calculated.

Lastly, while the Notice provides helpful examples, it is questionable whether example 7 — in which the taxpayer is denied a credit because the recipient of the intangible expense does not have any income tax liability in another state — aligns properly with the statute.

Implications

The Department's interpretation of the add-back requirements in certain aspects seems to go beyond the authority the legislature granted to it in the statute, and may confuse more than clarify. Accordingly, affected taxpayers should review the discussion draft and consider submitting comments on the Notice to the Department.

———————————————

———————————————
ENDNOTES

¹ The three exceptions are the "business purpose and arm's-length exception," the "comprehensive income tax treaty exception" and the "conduit exception." 72 P. S. Section 7401(3)1.(t)(2) - (4).

² 72 P. S. Section 7401(3)1.(t)(1).

³ Per the Notice, the amortization expense would be disallowed for CNIT purposes as the amortization of the cost of the intangible asset constitutes a recovery of an "intangible expense or cost" paid, accrued or incurred in connection with a transaction with an affiliated entity. The Department, in a footnote, noted that this treatment is consistent with other state add-back provisions.

⁴ 72 P.S. Section 7401(8) defines "intangible expense or cost" as "royalties, licenses or fees paid for the acquisition, use, maintenance, management, ownership, sale, exchange or other disposition of patents, patent applications, trade names, trademarks, service marks, copyrights, mask works or other similar expense or costs."

⁵ (emphasis added) Notice at page 4-5.

⁶ Notice at page 5.

⁷ (emphasis added) Notice at page 5.

⁸ Notice at page 7.

⁹ Notice at page 7.

¹⁰ Notice at page 8.

¹¹ Notice at page 9.

¹² Notice at page 11.