New Jersey Rules that Intercompany Royalty Expense is Deductible
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Payments under a software licensing agreement between the parent and its distribution subsidiary were ruled deductible under New Jersey’s “unreasonable” exception to its add-back rule.
Intercompany agreements are common among groups of related entities, and they can involve (i) the provision of services from one entity to another, (ii) an intercompany loan or (iii) the licensing of intellectual property or some other intangible right. For several decades, companies that entered into intercompany arrangements for business reasons were able to achieve – as a side benefit – state income tax savings in separate reporting states (i.e., states that do not require related entities to file on a combined or consolidated basis). For example, if the recipient of the intercompany payment is located in a state without an income tax, then the group benefits from a tax deduction by the payor in the state(s) in which the payor operates, but the recipient does not pay tax on the income. 
Over the last 15 years, states have changed their tax rules and/or policies, such as enacting mandatory combined reporting and imposing nexus on the recipient, to negate the state income tax advantage of these intercompany arrangements. The most successful of these was called the “addback statute,” and it required the payor to add back on its state income tax return the deduction it took on its federal income tax return for the payment made pursuant to the intercompany agreement if such agreement was for interest or other intangible expenses. By disallowing the deduction to the payor, the state income tax benefit was eliminated.
These addback statutes also had exceptions, which varied by state.  One of New Jersey’s exceptions is if the taxpayer can prove by clear and convincing evidence that the addback is “unreasonable.”  On May 24, 2017, the New Jersey Tax Court issued a decision applying the unreasonable exception to rule that deductions for royalty payments made by a subsidiary to its parent company should not be added back. 
BMC Software, Inc. (“BMC” or the “company”) is a Delaware company that is headquartered in Texas. The company develops computer software programs and markets the software in many places, including New Jersey. BMC Distribution, Inc. (“Distribution”), a subsidiary of BMC, was primarily engaged in selling BMC’s software programs. In 2002, BMC and Distribution entered into a non-exclusive licensing agreement in which BMC licensed to Distribution the right to license, market and distribute BMC’s software. Distribution paid 55 percent of its gross license revenue to BMC as consideration under the license. BMC retained all control rights in the oversight of the software programs.
Upon audit, the New Jersey Division of Taxation required Distribution to add back the deduction for payments made to BMC and issued a $7 million assessment. Upon appeal, the Tax Court first determined that such payments from Distribution to BMC were for intangible expenses, and thus were subject to the addback provision. It then addressed the taxpayer’s argument under the “unreasonable” exception. It noted initially that under the facts of this case, BMC included the royalty income on its New Jersey return; however, due to prior year NOLs that it carried forward, it never paid more than the minimum tax for any of the years under audit. Under prior New Jersey case law, payment of the minimum tax does not meet the “subject to tax” exception. 
The Tax Court then addressed whether requiring Distribution to add back its deduction for the royalty payment to BMC was “unreasonable.” The taxpayer made several arguments as to why the addback was unreasonable, and the Tax Court agreed with only one – that the license agreement between BMC and Distribution was barely different than the license agreements that BMC and Distribution had with unrelated third parties. All license agreements were for the exact same software license and had the same objective – to sell to end users. Additionally, both BMC and Distribution were active businesses rather than one being the shell entity with no purpose other than to passively hold an asset, receive income, etc. Accordingly, the Tax Court ruled that Distribution’s payments to BMC “were substantively equivalent to an unrelated party transaction,” and therefore, they did qualify for an “unreasonable” exception to the addback rule and were deductible.
Intercompany arrangements always add complexity and require additional scrutiny when it comes to sorting out any state income tax implications (e.g., combined reporting treatment, 482/transfer pricing issues, addback statutes, etc.). Aprio’s SALT team is experienced in understanding how to analyze these transactions to ensure that they are structured in a way that allows taxpayers to minimize any potentially unfavorable state income tax treatment. We constantly monitor these and other important state tax issues and 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.
 In states that require combined or consolidated reporting, the intercompany payment is eliminated; therefore, the state income tax impact of the intercompany arrangement is neutral.
 Many of the exceptions include the following: (i) if the income is allocated and/or apportioned to and taxed by a state that imposes a tax measured by income (sometimes referred to as the “subject to tax” exception); (ii) if the payment is at arm’s length rates; (iii) if the payment is made to a related member located in a foreign country which has a comprehensive income tax treaty with the U.S.; (iv) if the payment is ultimately paid to an unrelated member or (v) the arrangement has a valid business purpose. It is worth noting that an exception made require more than one of these to be satisfied.
 N.J.S.A. § 54:10A-4.4(c)(1)(b).
 BMC Software, Inc. v. Division of Taxation, N.J. Tax Court, Docket. No. 000403-2012 (May 24, 2017).
 Morgan Stanley & Co, Inc. v. Director, Division of Taxation, 28 N.J. Tax 197 (2014).
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