The ins and outs of related party add-backs

Tax Executive, The, May-June, 2005 by Giles Sutton, Todd Zoellick

Overview

Historically, business performance measurement has relied on various financial measurements. The ability to efficiently manage capital structures and leverage assets is a key indicator of a successful businesses enterprise. Increasingly, to perform these functions effectively, resources must be devoted to identifying key, often hidden, assets and ensuring the financial performance of business units are measured in comparatively meaningful ways.

In today's economy, most companies have created or accumulated through acquisition, a variety of valuable intangible assets. For many companies, these intangibles are the organization's most valuable assets. Other than investment assets, the range of intangibles that a company might own include patents, copyrights, trade names, trademarks, service marks, formulas, processes, proprietary data of various types, and customer lists. At a minimum, maintenance of those intangibles is an increasingly important business function. Identification, valuation, protection, and management of a wide range of intellectual property can be a challenging task.

For a variety of reasons, many companies conduct operations through a number of separate business units. As such, it is common that one unit will use intangibles owned by another related, but separately measured, unit. Effective business unit measurement requires the computation of operating income based upon the value drivers contained within that particular business unit. Therefore, charging the proper arm's-length price for the use of such intangibles is essential to accurate business unit performance measurement as well as effective enterprise-wide management.

Historic Uses of Holding Companies

Holding companies are corporations of a passive nature that typically own passive assets such as investments including the stock of other, often subsidiary, companies. (1) Holding companies have often facilitated the objectives of effective financial and asset management. Segregating functions and assets into discrete legal entities can provide businesses with various benefits, including a functional focus, enhanced liability protection, access to state courts in the jurisdiction of domicile, compliance with regulatory requirements, and the efficient acquisition or disposition of assets. It is the ability of holding company structures to facilitate state tax planning, however, that has made them the focus of intense scrutiny.

Finance Companies

Where a parent company holds debt from its subsidiaries, savings may be realized by the use of a corporate financing company. The subsidiaries continue to deduct the interest payments, but the subsidiary notes held by the parent are transferred to a finance company that has an effective state tax rate that is lower than the parent, reducing the associated tax liabilities. (2)

In addition, a finance company structure can be used to consolidate external debt of subsidiaries that might be subject to different rates of interest. For example, one subsidiary might be paying six percent on its external debt, while another is paying eight percent. Such circumstances make it difficult to compare financial results between operating subsidiaries. The use of a single, centralized, finance company can alleviate these business concerns and, as with subsidiary notes held by the parent, reduce the overall tax liability of the group where the finance company's effective state tax rate is lower than that of the various operating subsidiaries. (3)

Internal leverage, without the use of a designated finance company, can be created by distributing as dividends cash or notes payable. (4) Such dividends will typically qualify for a dividends-received deduction within a federal affiliated group and will also often qualify for a dividends-received deduction at the state level. (5)

Royalty Companies

Historically, companies often placed intangibles into tax-favored special purpose entities operating solely in jurisdictions that have favorable tax rules regarding the taxation of royalty income. Often states having no corporate income tax (for example, Nevada) or states having special holding company regimes (for example, Delaware) were utilized. (6) Alternatively, placing intangibles in entities having a reporting requirement only in combined reporting states provided an income shift from related entities operating in separate entity reporting states.

Often stated business purposes for segregating valuable intangibles from other operating assets included:

* To better protect the intellectual property;

* To facilitate tax efficient acquisitions and dispositions;

* To better manage, and thereby maximize the value of the intellectual property;

* To facilitate third-party licensing of the property;

* To facilitate borrowing and asset securitization; and

* To avail the holding company of favorable corporate and state intellectual property laws.

Attacks on Related Party Transactions

States have long been concerned about efforts by corporate taxpayers to use certain related party charges to manage their state tax liabilities. (7) Attempts by state taxing authorities to combat these types of transactions have evolved in the past ten years. From the perspective of state taxing authorities, the simple fix is arguably to adopt a mandatory combined reporting regime. Lawmakers in separate entity reporting states worry, however, that such a course may actually reduce revenues. (8)