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In Lorillard Tobacco Company v. Director, Division of Taxation (Lorillard II),¹ the New Jersey Tax Court (tax court) held that the New Jersey Division of Taxation (DOT) improperly applied N.J.S.A. 54:10A-4.4(b) by requiring a taxpayer (Taxpayer) to add back royalties paid to one or more of its related subsidiaries (a Related Subsidiary) in computing its entire net income (ENI). The tax court ruled that it was unreasonable to require Taxpayer to add back its royalty payments to its Related Subsidiary when that subsidiary: (i) filed its own New Jersey Corporation Business Tax (CBT) returns, (ii) included the income from the royalty payments received from Taxpayer on those returns, and (3) properly allocated its income to New Jersey. Having concluded that the DOT failed to properly apply the statute, the tax court declined to address the constitutionality of the DOT's regulation, N.J.A.C. 18:7-5.18(b)(3), which the DOT had argued allows only for a partial refund to a royalty payor to the extent the royalty recipient pays New Jersey CBT.

Background

Taxpayer, an operating company in New Jersey, filed its 2002–2005 New Jersey CBT returns on a separate-company basis, reporting its federal taxable income as its New Jersey ENI. Due to amendments to the CBT law brought about by enactment of the Business Tax Reform Act (BTRA) of 2002, Taxpayer was required to add back the entire amount of intercompany royalty payments made to a Related Subsidiary, which Taxpayer had deducted from its federal taxable income, under N.J.S.A. 54:10A-4.4(b).

In 2006, the DOT assessed the Related Subsidiary for amounts related to the BTRA's "throw-out" rule, resulting in an increased New Jersey apportionment for the Related Subsidiary. (New Jersey's since-repealed "throw-out" rule required a taxpayer to exclude from both the numerator and denominator of its sale factor any amounts attributable to a state in which that taxpayer was not subject to state income tax. The result would generally be to increase the overall New Jersey apportionment factor. Even after applying the "throw-out" rule, the Related Subsidiary's apportionment to New Jersey was still lower than Taxpayer's New Jersey apportionment for the relevant period). For more information on this aspect of Taxpayer's dispute with the DOT see the related opinion in Lorillard Licensing Co., LLC v. Director, Div. of Taxation, 28 N.J. Tax 590 (Tax 2014), aff'd, 29 N.J. Tax 275, 277-78 (App. Div. 2015), certif. denied, 226 N.J. 212 (2012). (Lorillard I).

In 2007, Taxpayer filed refund claims for tax years 2002–2005 claiming that it would be "improper, unreasonable, and unconstitutional" to deny a deduction if the Related Subsidiary was subjected to New Jersey CBT on the same amounts, even if the subsidiary's apportionment was lower.

Subsequent to the refund claims and the tax court's ruling in favor of the Related Subsidiary in Lorillard I, the DOT granted partial refunds to Taxpayer for the amounts related to the "throw-out" rule. Taxpayer then initiated a motion for summary judgment on the issue of being excepted from the addback rule entirely since the Related Subsidiary, in fact, reported the royalty amount to New Jersey and paid tax on that amount. The DOT denied this additional refund claim and Taxpayer brought the action in the current matter.

In its opinion, the tax court applied both the royalty addback statute and the DOT's regulation providing for the exception to Taxpayer's facts and concluded that it was unreasonable for Taxpayer to be required to add back the royalty payments made to its subsidiary to its ENI since such amounts, as required by the statute, were actually subject to CBT on the Related Subsidiary's CBT return. The DOT argued that the exception to the addback was effectuated by Schedule G-2, which was referenced in the regulatory history of N.J.A.C. 18:7-5.18. Schedule G-2 allows for the exception to the extent the royalty recipient pays at least 9% CBT on the entire royalty deduction amount. Anything less would be met with only a partial exception. The tax court noted that the DOT's position effectively prevented payors from receiving a full exception if the royalty payor's New Jersey allocation factor was greater than the royalty recipient's allocation factor. The tax court saw no support for this position when it examined the royalty addback statute, the corresponding statutory history, and the exception set forth in the DOT's own regulation. The tax court noted that the BTRA included the addback requirement in the CBT statute to prevent taxpayers from avoiding New Jersey's higher CBT rate by making payments to related parties that were not subject to New Jersey taxation. The tax court found that those scenarios did not apply here. It also found that a payment to a related New Jersey taxpayer that included the income on its New Jersey CBT return and then properly allocated its income to New Jersey did not correspond with the anti-tax avoidance purpose that the BTRA amendments were intended to address. Therefore, the tax court found that DOT's position of providing Taxpayer only with partial relief from the addback statute was unreasonable.

The tax court rejected, however, Taxpayer's call to eliminate or limit DOT's discretion to review royalty addbacks. The tax court found that DOT is still entitled to discretion when exercising its duty to review royalty expenses.

Implications

The tax court's published decision in Lorillard II establishes a precedent for all taxpayers affected by the royalty addback insofar as they can show that they were limited in their exception (partial or full denial) and can show that the royalties paid to their related member (RM) were included in their RM's income base for CBT purposes, with the RM paying CBT to New Jersey under its own allocation factor. The tax court left open the possibility that other factors could lead to a different outcome without opining on what those factors could be. The tax court's decision applies very broad relief to Taxpayer by providing a full deduction for the intercompany royalty. It is likely that the DOT will appeal the decision, seeking either a reversal of the tax court's decision or a narrower remedy. In New Jersey, appeals must be made within 45 days of final judgment, which in this case was entered February 28, 2019.

Despite the potential overbreadth of the tax court's decision and the possibility of modification on appeal, the holding in this case presents a significant New Jersey CBT refund opportunity for taxpayers that added back royalty payments in similar circumstances and were denied partial or full relief. For taxpayers that filed tax year 2014 tax returns on or before April 15, 2015, the refund period for the tax year may end on April 15, 2019, so immediate action may be required.

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ENDNOTES

¹ Lorillard Tobacco Company v. Director, Division of Taxation, Dkt. No. 008305–2007 (N.J. Tax Ct. 2019) (Approved for Publication).