Iowa Rules that Parent is not Includable in Consolidated Group and Subsidiaries Can’t Deduct Interest
In a case highlighting the issues that often affect consolidated/affiliated groups, a state income tax inefficiency was created when a consolidated group was sold and the parent financed the former owner’s stock redemption.
By Jess Johannesen, SALT manager
On May 3, 2017, the Iowa Court of Appeals issued a decision in which it held that (i) an affiliated group’s parent company must be excluded from the Iowa consolidated group because it lacked taxable nexus with Iowa, and (ii) the affiliated group subsidiaries were not permitted to deduct interest expenses incurred and paid by the parent. 
Romantix Holdings, Inc. (HoldCo) owned several subsidiaries and intangible property (the group’s trademark). Each subsidiary had a different operating role within the group’s business. Most of the subsidiaries operated retail locations (nine of which were in Iowa), one subsidiary acted as a management company for the retail subsidiaries and another subsidiary owned and operated the group’s airplane. Each day, all of the revenue from the retail store subsidiaries was transferred to the management company subsidiary, which would use the money to pay the retail stores’ expenses as well as the airplane expenses. HoldCo, by itself, did not sell products or provide services in Iowa as it merely owned the subsidiaries and the trademark.
In 2007, the affiliated group was purchased by a new owner, and the former owner’s stock was redeemed. The redemption was financed through debt incurred by HoldCo, and the subsidiaries were guarantors of the debt. HoldCo paid the debt using the funds received from the subsidiaries, and for GAAP purposes, the expenses related to the debt payments were allocated to the subsidiaries in proportion to the revenue that each subsidiary generated, a concept known as pushdown accounting. At issue in the case were the 2009 and 2010 consolidated Iowa income tax returns. In 2009, the Iowa consolidated group included HoldCo. In 2010, the Iowa consolidated group did not include HoldCo, but the subsidiaries took a deduction for the debt expenses allocated to them via pushdown accounting.
First, the Court addressed the inclusion of HoldCo in the 2009 consolidated group return. Like many states that require or permit affiliated entities to file a consolidated income tax return, one of the Iowa requirements is that only affiliated members that are subject to Iowa income tax (i.e., have Iowa income tax nexus) can be included in the return.  The court held that HoldCo could not be included in Iowa’s consolidated group because its activities fell within Iowa’s safe harbor for exclusion from state income tax. Iowa statutes provide that an out-of-state corporation is not considered to have income tax nexus in Iowa if its only activities include ownership and control of subsidiaries that operated in Iowa.  HoldCo argued that it exceeded this safe harbor since the retail subsidiaries in Iowa used the trademark owned by HoldCo. The Court never specifically addressed that issue; instead, it relied on a prior case in asserting that HoldCo’s activities alone were related only to the ownership and control of the subsidiaries, and thus were within the safe harbor exclusion. 
The Court then addressed the second issue, whether the Iowa subsidiaries should be allowed to deduct the allocated (i.e., pushed-down) debt expenses. This is a common state income tax issue for consolidated groups where there is acquisition indebtedness, because such debt is usually with the parent holding company that has no income to offset the interest expense, thereby trapping net operating losses. The operating subsidiaries have taxable income and want to be able to claim the interest deduction. The result is a tax-inefficient mismatch of income and expenses.
The court ultimately held that for income tax purposes, the internal accounting treatment (i.e., pushdown accounting) was irrelevant, and that since the debt incurred by HoldCo was not paid by the operating subsidiaries, the subsidiaries were not permitted to take the tax deduction.
This case highlights a couple of the state income tax issues that often affect federal consolidated/affiliated groups. These often result because advisors don’t always consider the state income tax implications of transactions, particularly when there is no federal income tax concern. For example, in this case, the fact that the parent has the interest expense (but no income) is not an issue for federal income tax purposes because all of the entities are part of the federal consolidated group, and therefore, the parent’s loss is offset by the subsidiaries’ income. However, for Iowa income tax purposes, since the parent was not permitted to be included in Iowa’s consolidated group, the mismatch of expense and income creates a state income tax inefficiency.
Aprio’s SALT team focuses on these state tax issues and can make sure that businesses structure their transactions to achieve multi-state income tax efficiencies. We constantly monitor these and other important state tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.
This article was featured in the July 2017 SALT Newsletter. You can view the full newsletter here.
 Romantix Holdings, Inc. et. al. vs. Iowa Dept. of Revenue, Iowa Court of Appeals No. 16-0416, May 3, 2017.
 Iowa Code §422.37. This is distinguishable from a combined or unitary report, which includes the income and apportionment factors of all entities that meet the ownership requirements and that are engaged in a unitary business with each other, regardless of any particular entity’s nexus with the particular state.
 Iowa Code §422.34A(5).
 Myria Holdings, Inc. v. Iowa Dept. of Revenue, Iowa Supreme Court No. 15-0296, March 24, 2017. In this case, the parent’s intangible assets were its stock investment in its subsidiaries and cash, which it allowed its subsidiaries to use under a cash management arrangement.
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.