Understanding Pennsylvania’s Corporate Tax Add-Back Notice
On Feb. 19, 2016, the Pennsylvania Department of Revenue issued Information Notice Corporation Taxes 2016-01. The notice provides guidance regarding the add-back provision enacted in July 2013. Effective for tax years beginning after Dec. 31, 2014, the add-back disallows certain Pennsylvania corporate net income tax deductions for transactions between affiliates involving intangible expenses and costs.
by Scott L. Austin, JD, Jennifer T. Loughery, CPA, and Ilya A. Lipin, JD Dec 20, 2019, 13:17 PM
On Feb. 19, 2016, the Pennsylvania Department of Revenue (DOR) issued Information Notice Corporation Taxes 2016-01. The notice provides guidance regarding the add-back provision enacted in July 2013. Effective for tax years beginning after Dec. 31, 2014, the add-back disallows certain Pennsylvania corporate net income tax (CNIT) deductions for transactions between affiliates involving intangible expenses and costs. The notice, therefore, provides further insight regarding the DOR’s intended application of the add-back, its exceptions, and the credit for taxes paid.
Application and Scope
As provided under 72 P.S. Section 7401(3)1.(t), “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.”1 The term “intangible expense or cost” includes “[r]oyalties, 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 expenses or costs.”2 “Interest expense or cost” means a deduction allowed under IRC Section 163 if it is directly related to an intangible expense or cost.3 Per the notice, the list of intangible assets is not exhaustive, and the substance of the transaction, rather than its classification, determines whether or not the add-back applies.
The notice provides that the add-back disallows intangible expenses or costs in at least two instances. First, it disallows deductions for the purchase price of an intangible asset that was acquired by a taxpayer from an affiliate. While all or part of the purchase price is amortized for federal income tax purposes, the add-back disallows such amortization deductions. Second, the add-back disallows “embedded costs” or indirect expenses or costs that are not royalty or licensing expenses per se, but are included in other costs, such as cost of goods sold or a separate service charge (such as management fees). While other states may have the authority to require the addition of these types of deductions, Pennsylvania’s statute does not expressly require the addition of embedded costs or such amortization deductions. Thus, the DOR’s broad interpretation in these instances goes beyond the scope of the add-back statute.
Per the 2016-01 notice, the add-back disallows interest expenses or costs that are directly related to the acquisition or use of an intangible where the taxpayer and an affiliate engage in any intangible transaction during the tax year in which such interest was paid. The notice provides an example of where the add-back would apply: a corporation obtains a loan from a third-party bank to acquire intangible assets from an affiliate. Based on this example, the DOR has expanded the add-back, which is only intended to apply to related-party transactions, to third-party transactions. Additionally, if funds are borrowed from an affiliate to purchase real estate, the interest expense is disallowed unless the taxpayer can demonstrate that it did not use the proceeds to acquire an intangible asset. Thus, the notice creates a rebuttable presumption that general related-party interest deductions are subject to the add-back unless the taxpayer substantiates that the interest was not directly related to intangibles. Consequently, the DOR has shifted the burden of proof to the taxpayer. Furthermore, third-party interest deductions and general related-party interest deductions do not appear within the scope of the add-back statute.
The notice provides that the add-back disallows intangible expenses or costs in at least two instances. First, it disallows deductions for the purchase price of an intangible asset that was acquired by a taxpayer from an affiliate. While all or part of the purchase price is amortized for federal income tax purposes, the add-back disallows such amortization deductions. Second, the add-back disallows “embedded costs” or indirect expenses or costs that are not royalty or licensing expenses per se, but are included in other costs, such as cost of goods sold or a separate service charge (such as management fees). While other states may have the authority to require the addition of these types of deductions, Pennsylvania’s statute does not expressly require the addition of embedded costs or such amortization deductions. Thus, the DOR’s broad interpretation in these instances goes beyond the scope of the add-back statute.
Per the 2016-01 notice, the add-back disallows interest expenses or costs that are directly related to the acquisition or use of an intangible where the taxpayer and an affiliate engage in any intangible transaction during the tax year in which such interest was paid. The notice provides an example of where the add-back would apply: a corporation obtains a loan from a third-party bank to acquire intangible assets from an affiliate. Based on this example, the DOR has expanded the add-back, which is only intended to apply to related-party transactions, to third-party transactions. Additionally, if funds are borrowed from an affiliate to purchase real estate, the interest expense is disallowed unless the taxpayer can demonstrate that it did not use the proceeds to acquire an intangible asset. Thus, the notice creates a rebuttable presumption that general related-party interest deductions are subject to the add-back unless the taxpayer substantiates that the interest was not directly related to intangibles. Consequently, the DOR has shifted the burden of proof to the taxpayer. Furthermore, third-party interest deductions and general related-party interest deductions do not appear within the scope of the add-back statute.
Exceptions
The DOR notice provides guidance regarding the business purpose, foreign treaty, and conduit exceptions that, if satisfied, would allow for the deduction of otherwise disallowed intangible expenses.
Per the notice, the add-back does not apply if a taxpayer establishes that a principal purpose of the transaction was not the avoidance of CNIT and the transaction was conducted at arm’s length rates and terms. While the statute provides that the add-back does not apply to a transaction that did not have as “the” principal purpose the avoidance of CNIT,4 the DOR’s use of the word “a” greatly narrows the applicability of this exception. Furthermore, a principal business purpose is determined by evaluating the taxpayer’s reasons for the original and any subsequent transaction that produced the deduction. CNIT avoidance is assumed for transactions that generate intangible expenses or deductions without meaningfully changing the overall economic position of the taxpayer and its affiliates. Furthermore, the exception must be substantiated by contemporaneous documentation, which must demonstrate that the principal purpose of the transaction was to improve the taxpayer’s economic position apart from tax effects. Other evidence may be required to show that the transaction conformed to the documentation and was necessary for and had a reasonable chance of accomplishing the principal purpose. Mere statements that a transaction was intended to achieve improved management or use of intangible assets, or similarly unsubstantiated claims, are not sufficient. Accordingly, the notice creates a presumption of CNIT avoidance and expanded substantiation requirements that do not appear within the add-back statute.
The add-back does not apply to transactions between a taxpayer and an affiliate domiciled in a foreign nation that has a comprehensive income tax treaty with the United States. The notice defines “foreign nation” and “comprehensive income tax treaty,” which are not defined in the statute. Further, taxpayers must provide, upon request, the amount of the intangible or interest expense and the foreign affiliate’s name, Federal Employer Identification Number, and country of domicile for substantiation purposes. Lastly, the add-back does not apply to intangible expenses or costs where the affiliate pays expenses to a third party for the same intangible asset. The notice provides that a taxpayer seeking to claim this exception must substantiate its claim.
Per the notice, the add-back does not apply if a taxpayer establishes that a principal purpose of the transaction was not the avoidance of CNIT and the transaction was conducted at arm’s length rates and terms. While the statute provides that the add-back does not apply to a transaction that did not have as “the” principal purpose the avoidance of CNIT,4 the DOR’s use of the word “a” greatly narrows the applicability of this exception. Furthermore, a principal business purpose is determined by evaluating the taxpayer’s reasons for the original and any subsequent transaction that produced the deduction. CNIT avoidance is assumed for transactions that generate intangible expenses or deductions without meaningfully changing the overall economic position of the taxpayer and its affiliates. Furthermore, the exception must be substantiated by contemporaneous documentation, which must demonstrate that the principal purpose of the transaction was to improve the taxpayer’s economic position apart from tax effects. Other evidence may be required to show that the transaction conformed to the documentation and was necessary for and had a reasonable chance of accomplishing the principal purpose. Mere statements that a transaction was intended to achieve improved management or use of intangible assets, or similarly unsubstantiated claims, are not sufficient. Accordingly, the notice creates a presumption of CNIT avoidance and expanded substantiation requirements that do not appear within the add-back statute.
The add-back does not apply to transactions between a taxpayer and an affiliate domiciled in a foreign nation that has a comprehensive income tax treaty with the United States. The notice defines “foreign nation” and “comprehensive income tax treaty,” which are not defined in the statute. Further, taxpayers must provide, upon request, the amount of the intangible or interest expense and the foreign affiliate’s name, Federal Employer Identification Number, and country of domicile for substantiation purposes. Lastly, the add-back does not apply to intangible expenses or costs where the affiliate pays expenses to a third party for the same intangible asset. The notice provides that a taxpayer seeking to claim this exception must substantiate its claim.
Add-Back Credit
The add-back credit is available when the taxpayer is engaged in one or more transactions with an affiliate that was subject to tax in Pennsylvania or another state or possession of the United States on a tax base that included the intangible expense paid, accrued, or incurred by the taxpayer. The credit is computed after the application of net operating losses and before the application of credits against the affiliate’s state income tax liabilities. The credit is limited to the increase in the taxpayer’s CNIT due to application of the add-back, and applies only to state income taxes. It does not apply to income taxes paid in combined reporting states and is based on the aggregate amount of taxes paid by the affiliate. As such, the notice further narrows the application of the credit by excluding combined reporting states, where the taxpayer and affiliate would not receive the benefit of the deduction, from the calculation. Similarly, this is not expressly required by the add-back statute.
DOR’s 2016-01 notice adopts a broad interpretation of the types of deductions subject to the add-back and a narrow view of exceptions. It should be noted that the notice represents guidance from the DOR and does not carry the same weight of authority as a statute or regulation. However, the courts have stated on numerous occasions that deference should be given to interpretations of statutes by the DOR. Taxpayers seeking an alternative interpretation are well advised to perform an analysis of their factual circumstances under the statutory provisions.
DOR’s 2016-01 notice adopts a broad interpretation of the types of deductions subject to the add-back and a narrow view of exceptions. It should be noted that the notice represents guidance from the DOR and does not carry the same weight of authority as a statute or regulation. However, the courts have stated on numerous occasions that deference should be given to interpretations of statutes by the DOR. Taxpayers seeking an alternative interpretation are well advised to perform an analysis of their factual circumstances under the statutory provisions.
1 72 P.S. Section 7401(3)1.(t).
2 72 P.S. Section 7401(8).
3 72 P.S. Section 7401(9).
4 72 P.S. Section 7401(3)(1)(t)(2).
2 72 P.S. Section 7401(8).
3 72 P.S. Section 7401(9).
4 72 P.S. Section 7401(3)(1)(t)(2).
Scott L. Austin, JD, is a principal at PricewaterhouseCoopers LLP in Philadelphia. He can be reached at scott.l.austin@pwc.com.
Jennifer T. Loughery, CPA, is a director at PricewaterhouseCoopers LLP in Philadelphia. She can be reached at jennifer.t.loughery@pwc.com.
Ilya A. Lipin, JD, is a manager at PricewaterhouseCoopers LLP in Philadelphia. He can be reached at ilya.a.lipin@pwc.com.
