On February 19, 2016, the Pennsylvania Department of Revenue (“Department”) released Information Notice Corporation Taxes 2016-1 (“Notice”) regarding the Act 52-2013 add-back provision that disallows corporate net income tax deductions for transactions between affiliated members for tax years beginning after December 31, 2014.
According to the Notice, deductions for royalties, licensing, or other fees paid, accrued, or incurred by a corporate taxpayer to an affiliated entity are disallowed. The provision refers to direct or indirect costs or expense deductions claimed by a corporate taxpayer as a result of transactions with an affiliated entity. The Notice explains direct and indirect intangible expenses and costs, including amortization of intangible property and embedded intangible costs, and provides examples.
The add-back provision also disallows interest expenses that are directly related to an intangible expense or cost. Interest paid to an affiliated entity is presumed to be directly related to the acquisition or use of an intangible asset if the corporate taxpayer and the affiliated entity engage in any intangible transaction during the tax year in which the interest was paid. Tracing the source and application of funds among the affiliated entities is not necessary.
The add-back provision disallows all intangible costs or expenses paid by a corporate taxpayer to an affiliated entity unless a statutory exception applies. The exceptions to the add-back provision are:
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the principal purpose and arm’s length exception,
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the foreign treaty exception, and
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the conduit exception.
For the principal purpose and arm’s length exception to apply, a corporate taxpayer must establish that the transaction did not have a principal purpose of avoiding the corporate net income tax and the transaction was conducted at arm’s length rates and terms.
The foreign treaty exception applies to transactions between a corporate taxpayer and an affiliated entity that is domiciled in a foreign nation that has in force a comprehensive income tax treaty with the United States. The treaty must provide for the allocation of all categories of income subject to tax, or the withholding of tax, on royalties, licenses, fees and interest for the prevention of double taxation of the respective nations’ residents and the sharing of information.
Under the conduit exception, intangible expenses or costs are not disallowed where, and to the extent that, the affiliated entity pays expenses to an unaffiliated entity for the same intangible asset.
Corporate taxpayers must maintain contemporaneous documentation to support an exception and must produce it at the Department’s request.
The Notice is based upon the Georgia, Alabama, and Connecticut’s statutes and regulations regarding add-backs. These statutes and regulations are much broader than the Act 52 add-back provision. Accordingly, the add-back guidance issued by the Department goes beyond what the statute requires or what the General Assembly arguably intended.
Please bear in mind that the Notice is not the law. It is just the Department’s interpretation of the add-back provision. Thus, because we believe the Department’s guidance overreaches the provisions of the statute, it may lead to Department applications that are unreasonable.
If you have any questions regarding the Notice or are experiencing a situation in which the Department is asserting its interpretation of the add-back provision upon your company, please contact one of our SALT attorneys for advice.
