Intercompany Transactions: How Diligent Documentation Can Help You Avoid B&O Tax Liability
Although intercompany transactions will typically net out for income tax purposes, that isn’t necessarily the case for states that impose gross receipts taxes. Taxpayers should properly document their intercompany transactions in order to qualify for any applicable exemptions; otherwise, both the payor and payee could owe tax on the same revenues.
By: Tina M. Chunn, CPA, State and Local Tax Senior Manager at Aprio
Most corporate organizations with more than one entity will have some transactions between the entities that may include management or shared service fees, the sale and transfer of assets, and intercompany loans and interest. In states that impose a net income tax, these intercompany payments typically net out (i.e., income for one entity and a deduction for the other).
However, in a state like Washington — which imposes a gross income tax known as the business and occupation (B&O) tax, where deductions are not provided — these intercompany transactions can create tax liability if they are not structured properly. To address this, Washington recently issued a tax decision requiring intercompany payments to be included as gross income for B&O tax purposes.
Examining a B&O tax case study
A recent case in the state of Washington helped influence this decision. The taxpayer is a general contractor engaged in the construction of residential housing and a contractor for a local school district. The taxpayer is wholly owned by a single individual (owner). The owner also wholly owned another affiliated business (affiliate) operating as a custom builder and speculative builder for constructing residential homes. The taxpayer and the affiliate operated independently within the business structure.
In 2016, the affiliate made several payments by check that were deposited in the taxpayer’s bank accounts. Upon auditing these payments, the Washington Department of Revenue noted discrepancies between the taxpayer’s business records and the amounts reported on the taxpayer’s B&O tax returns as gross income, and it reclassified these intercompany payments as taxable gross income.
The taxpayer argued that these payments were reimbursements as business loans made to the affiliate. Specifically, when the affiliate began operations in 2016, the taxpayer, as an older company, had available funds and established credit. Therefore, the owner used the taxpayer as a paymaster to pay business expenses for the affiliate. These transactions were documented by the taxpayer with the use of a specific building code in their business records that was related to the affiliate; these transactions were treated as if they had been loaned by the taxpayer to the affiliate. Once the affiliate developed sufficient income, it made a payment to the taxpayer during the last three quarters of 2016.
So, where did the taxpayer go wrong?
Washington includes transactions between two separate entities (even if the entities are related) in the gross income of a business unless there is evidence of a true agency relationship for that transaction, and the transaction is a qualifying reimbursement.
However, WAC 458-20-111 (Rule 111) does provide that payments made as reimbursements for expenses that pass through a business solely in the business’s capacity as an agent for the customer are not taxable to the business and are excluded from the business’s gross income. To qualify, a payment must meet three requirements:
- It must be a customary reimbursement for advances made to pay costs for the customer;
- It must involve goods or services that the taxpayer does not or cannot render; and
- It must not involve an obligation the taxpayer is liable for, except as an agent.
Although the taxpayer provided receipts, bank records, a spreadsheet with an itemized list of transactions and handwritten notes regarding these transactions, it did not have any formal documents — such as a contract, loan document or other evidence — showing that it operated under the affiliate’s direction (i.e., as its agent), or that the affiliate was solely liable for the payment made by the taxpayer. Therefore, the state concluded that these intercompany payments did not meet the requirements for exclusion from the taxpayer’s gross income.
The bottom line
This tax case illustrates a point that all businesses should note: it is always important to maintain proper documentation to support any exclusions or deductions, specifically related to intercompany transactions.
Aprio’s State & Local Tax (SALT) team is experienced in reviewing these types of issues for businesses. We can assist to ensure that your transactions are documented in accordance with each state’s tax requirements so that you obtain the desired tax outcome in the event of an audit.
Our team constantly monitors these and other important state tax topics, so you are always up-to-speed on the legislative and tax code changes that impact your business’s tax situation. Keep an eye out for significant developments on this topic in future issues of the Aprio SALT Newsletter.
This article was featured in the February 2021 SALT Newsletter.
 Washington Det. No. 18-0294, 40 WTD 016, January 8, 2021.
 WAC 458-20-111 (Rule 111).