State & Local Tax. Advisory. California Annual LLC Fee Held Unconstitutional Potential Refund Claims For LLCs.

Transcription

1 State & Local Tax Advisory April 3, 2006 Insights Into Recent Regulatory, Judicial and Legislative Developments Atlanta Charlotte New York Research Triangle Washington, D.C. California Annual LLC Fee Held Unconstitutional Potential Refund Claims For LLCs On March 3, 2006, a California Superior Court issued a proposed statement of decision in Northwest Energetic Services LLC v. California Franchise Tax Board, No. CGC (Cal. Sup. Ct. (S.F. Cty.) Mar. 3, 2006), holding that California s annual fee on limited liability companies is unconstitutional. Under Cal. Rev. & Tax. Code 17942, California generally imposes an annual fee on LLCs that are formed in California, doing business in California or qualified to do business in California, if the LLC is classified as either a partnership or a disregarded entity for California income tax purposes. 1 The fee is based on the LLC s annual total income (i.e., gross income plus the cost of goods sold that are connected with the LLC s trade or business) from all sources according to the following schedule: Total Annual Income of Limited Liability Company Fee Less than $250,000 $0 $250,000 or more, but less than $500,000 $900 $500,000 or more, but less than $1,000,000 $2,500 $1,000,000 or more, but less than $5,000,000 $6,000 $5,000,000 or more $11,790 Jack Cummings Editor 601 Pennsylvania Avenue, N.W. North Building, 10th Floor Washington, D.C Fax: One of Fortune magazine s 100 Best Companies to Work For Northwest Energetic Services involved an LLC that was formed in Washington and distributed explosives and explosives-related services to customers located solely outside California. The LLC conducted no business activities in California, had no operations, property, employees or agents in California, and made no deliveries or solicitations to customers or potential customers in California. The LLC s only connection to California was that it was registered with the California Secretary of State. The LLC argued that the annual fee was in fact a tax and, as such, violated the fair apportionment requirement of the Commerce and Due Process Clauses of the United States Constitution because it applies to the LLC s total income, without apportionment. The court held that the annual LLC fee was indeed a tax because its purpose was to raise revenue. The legislative history of the fee indicated that it was designed to offset the expected loss in corporate tax revenues when California first authorized 1 California also generally levies an annual $800 minimum tax on LLCs formed in California, doing business in California or qualified to do business in California. However, the constitutionality of the minimum tax was not at issue in Northwest Energetic.

2 the use of LLCs. Moreover, the fee was intended to be used (and was used) solely for general governmental purposes, rather than for a specific purpose (as would generally be the case for a non-tax). The court also considered the annual fee to be a tax because it bore no relationship to benefits received by or burdens imposed on the LLC (unlike, for example, a licensing fee). The court also held that the annual LLC fee violates both the Due Process and Commerce Clauses of the United States Constitution. It is well-established in U.S. Supreme Court jurisprudence that these provisions of the Constitution require that a state tax be fairly apportioned among the different states in which the taxpayer does business i.e., it must be calibrated to the level of the taxpayer s activity in each state. See Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977); Oklahoma Tax Comm n v. Jefferson Lines, Inc., 514 U.S. 175, 189 (1995); Hans Rees Sons, Inc. v. North Carolina, 283 U.S. 123, 134 (1931). The court found that the annual LLC tax was clearly not calibrated to the taxpayer s activities within California because, in this case, the taxpayer had no such activities. The state attorney general filed objections to the court s proposed statement of decision on March 20, 2006, and Northwest Energetic filed a reply on March 29, In its objections, the attorney general disputed the court s finding that the annual LLC fee is a tax, arguing that the fee was intended to cover the cost of LLC administration rather than to raise general revenue for the state. Northwest Energetic asked the judge to reject the objections, pointing out that the issues raised were already addressed at trial. The judge has not yet indicated when a final decision will be rendered. However, assuming the proposed decision becomes finalized (which appears likely), the California Franchise Tax Board (the FTB ) will most certainly file an appeal. Another case involving the constitutionality of the annual LLC fee Ventas Finance I LLC v. California Franchise Tax Board, No (Cal. Super. Ct.) has recently been filed in California Superior Court with a trial date of May 8, In this case, less than 10% of the LLC s business activity was in California. Based on the proposed decision in Northwest Energetic (which appears to be fairly sound), LLCs that have been paying the annual LLC fee should begin filing protective refund claims, regardless of the level of their business activities in California. These protective refund claims should be filed for all prior tax years for which the statute of limitations has not yet expired. Under Cal. Rev. & Tax. Code 19306, a refund claim must be made prior to the expiration of the later of: 4 years from the date the return was filed, if filed within the time prescribed by law, including extensions (the LLC s return is due on the 15th day of the 4th month following the close of the LLC s taxable year i.e., April 15th for calendar-year taxpayers); 2 4 years from the last day prescribed for filing the return, determined without regard to any extensions; or 1 year from the date of overpayment. 2 California also provides for an automatic 6-month extension. 2

3 Accordingly, LLCs may be eligible to file refund claims for taxable years as far back as LLCs filing refund claims for fees paid in 2001 through 2005 may receive a total refund of up to $58,950 in taxes, plus accrued interest thereon. However, the deadlines for filing the earliest of such refund claims are quickly approaching. For example, calendar-year LLCs must file protective refund claims for 2001 by April 15, 2006, if an extension was not requested for that year. In order to file a protective claim, the LLC or its representative should send a letter to the FTB that includes the following information: The LLC s name and identification number, as issued by the California Secretary of State (unregistered LLCs should use the identification number issued by the FTB); A statement indicating that the LLC is filing a protective claim; The tax years involved; The amount of the claim, which should match the amount of the annual fee paid by the LLC; A description of the issue (a statement that the LLC fee is unconstitutional is sufficient); and The name, telephone number and fax number of a contact person. The letter must be signed by a representative with power of attorney or by the LLC s managing member. The letter must be either faxed to the FTB at (916) or mailed to the FTB at the following address: FRANCHISE TAX BOARD P.O. Box Sacramento, CA Upon receiving the protective claim, the FTB will send a fax confirmation of receipt. The FTB will defer action on all claims pending a final appellate decision on the issue of the LLC fee s constitutionality. Taxpayers should retain a copy of their original claims, as well as the FTB s confirmation receipt, for their files. For more information regarding the California annual LLC fee or the process for obtaining a refund of such fee, please contact Ethan D. Millar at (404) or emillar@alston.com. 3

4 Minimizing Corporate Income Tax Liability in New York State and City in View of Recent Forced Combination Decisions and the Addback Statute During the last few years, the New York State ( State ) and City ( City ) taxation departments have aggressively asserted their forced combination powers. By way of background, the State and City are separate-company corporate tax filing jurisdictions. However, the State and City taxation departments have the discretion to require taxpayers to file combined corporate tax reports with affiliated corporations if, based on inter-company transactions, they deem such reports necessary to properly reflect the tax liability. The State and City corporate tax regulations provide that the taxation departments may require combined tax reports if three conditions are met including: (1) a stock ownership test; (2) a unitary business test; and (3) a distortion of income test. Those regulations provide that distortion is presumed if there are substantial intercorporate transactions among the corporations. Two recent decisions required State taxpayers to file combined corporate franchise tax reports with related intangible property holding company ( IPHC ) subsidiaries. On April 5, 2005, the New York Court of Appeals refused to review the New York Supreme Court, Appellate Division, decision to uphold the determination of the New York Division of Tax Appeals, Tax Appeals Tribunal ( TAT ) in In the Matter of The Sherwin-Williams Company v. Tax Appeals Tribunal, N.Y. App. Div., No (October 28, 2004). In that case, the State combined The Sherwin-Williams Co. ( Sherwin-Williams ) with its IPHC subsidiaries for corporate franchise tax purposes. The administrative law judge had determined that Sherwin-Williams was not required to file a combined return because Sherwin-Williams overcame the presumption of distortion. However, the TAT reversed and found that Sherwin-Williams did not rebut the presumption and forced combination was necessary because the transactions between Sherwin-Williams and the IPHC lacked business purpose and economic substance. Further, the TAT agreed with the State that the royalties were not at arm s-length because the transfer pricing studies provided by Sherwin-Williams to establish arm s-length licensing transactions between Sherwin-Williams and its IPHC subsidiaries were flawed. The State did not conduct its own transfer pricing analysis. Rather, the State offered expert testimony to establish that Sherwin-Williams transfer pricing studies were flawed. The New York Supreme Court, in upholding the decision of the TAT, did not address the issue of the validity of the taxpayer s transfer pricing studies. Rather, that court upheld the decision of the TAT based on the TAT s conclusion that the transactions lacked business purpose and economic substance. It should be noted that the Sherwin-William s decision is binding on the City because the TAT s decision in favor of the State has been affirmed by the State courts. Therefore, the City taxation department can take the position that the taxpayer victory in TOYS R US-NYTEX, N.Y.C. Tax App. Trib., TAT(E) (GC) (Jan. 14, 2004), is limited to the facts and circumstances of that case. In another appeal involving forced combination, In re Lowe s Home Centers, Inc., N.Y. Div. Tax App., No (September 30, 2004), the New York Division of Tax Appeals, Administrative Law Judge Unit ( DTA ) agreed with the State s position that Lowe s Home Centers, Inc. ( LHC ) was required to file on a combined basis with LF Corporation ( LF ), an IPHC subsidiary of LHC. The DTA found in the State s favor based, for the most part, on the conclusion that the intercompany transfer pricing studies to establish arm s-length licensing transactions between the two corporations were flawed and therefore combination was necessary to correct the distortion of LHC s income. Again, the State did not conduct its own transfer pricing analysis. Rather, the State offered expert testimony to establish that LHC s transfer pricing studies were flawed. 4

5 The result of these two decisions is to add further support to the State s position that State taxpayers should be combined with out-of-state IPHC subsidiaries. The State s position is strong because there is a presumption of distortion in the State s favor if there are substantial intercompany transactions between a taxpayer and its affiliate and the State has been successful in establishing that the transactions at issue lack business purpose and economic substance. Moreover, the State has been successful in finding flaws in taxpayers transfer pricing studies based on expert testimony to cast doubt on the validity of the transfer pricing methodology. However, taxpayers with strong business purposes and economic substance are in a much stronger position than those with standard IPHC structures. An example of this is the recent In re Hallmark Manufacturing Corporation, N.Y. Div. Tax App., No (January 26, 2006). In that appeal, the DTA found in favor of the taxpayer and did not require the combination of the taxpayer, a marketing corporation and not a standard IPHC, with its parent corporation. The primary issue in this case was the validity of the taxpayer s transfer pricing study. The Division did not argue that the taxpayer did not have a business purpose or economic substance because of the taxpayer s strong facts in those areas. Moreover, the taxpayer s transfer pricing study, although heavily scrutinized by the Division s experts, was found to be adequate for Internal Revenue Code section 482 purposes. Considering that the New York addback statutes are effective for royalties paid to affiliates on or after January 1, 2003, 3 and that it is very difficult to prevail in the State or City regarding a combination appeal with a traditional IPHC structure involving intercompany royalty payments, taxpayers should review their State and City tax liabilities to determine a reasonable method to minimize their State and City corporate tax. Combination of various entities may be preferable to the addback of royalties because the addback of royalties results in the addition of income without expenses to the tax base. Taxpayers may want to consider restructuring their business operations so that the separate company and combination provisions apply to protect tax advantaged structures. In addition, filing a combined report with the federal consolidated group may be advantageous in some cases. Although the State has prevailed in two significant forced combination appeals, both Sherwin-Williams and Lowe s are appeals involving standard IPHC structures in that the taxpayers were operating companies and the subsidiaries were IPHCs with standard substance facts and standard business purposes. Taxpayers with strong business purpose and economic substance facts and adequate transfer pricing studies may very well prevail in the State and City, especially considering the recent decision in Hallmark. Prior to a State or City corporate tax audit, taxpayers should review their business purpose and economic substance facts and, if needed, bolster those two issues to withstand State and City scrutiny. Moreover, taxpayers should review the transfer pricing studies to ensure that those studies comply with all of the Internal Revenue Code section 482 concepts. It may be beneficial to hire a third-party transfer pricing expert to provide a critical review of those studies. In addition to the review and bolstering of the business purpose, economic substance and transfer pricing facts, taxpayers involved in forced combination appeals based on transfer pricing issues should consider three strategies that have not been used in prior State and City forced combination appeals. First, taxpayers should argue that forced combination is not the appropriate remedy to correct the underreporting of tax. Rather, the appropriate remedy is for the Department to use other statutory provisions to compute the correct separate-company tax based on arm s-length rates. Second, during litigation, taxpayers should provide expert rebuttal testimony to challenge the taxation department s experts regarding the validity 3 See N.Y. Tax Law 208(9)(o); N.Y.C. Admin. Code (8)(n). 5

6 of the transfer pricing study at issue. That rebuttal testimony should be provided by a third-party expert rather than the party that prepared the transfer pricing study to provide additional support to the taxpayer s position. Finally, if possible, taxpayers should provide evidence that, even if the taxation department s expert testimony regarding flaws in the transfer pricing study is valid, the adjustment of the intercompany charges based on that testimony results in an intercompany charge that remains within the inter-quartile range of valid arm s-length rates pursuant to Internal Revenue Code section 482. For more information regarding New York State or City tax issues, please contact Richard Kariss at (212) or Aaron Young at (212) This State and Local Tax Advisory is published by Alston & Bird to provide a summary of significant developments to our clients and friends. It is intended to be informational and does not constitute legal advice regarding any specific situation. This material may also be considered advertising under the applicable court rules. Alston & Bird LLP has offices in Atlanta, Charlotte, New York, Research Triangle and Washington, D.C. Its SALT Group is one of the largest groups of attorneys devoted to the regular practice of state and local tax in a law firm in the United States. The attorneys in the SALT Group are: David A. Agosto david.agosto@alston.com Mary T. Benton mbenton@alston.com John L. Coalson, Jr. jcoalson@alston.com Jasper L. Cummings, Jr. jcummings@alston.com Jennifer L. Dowell jdowell@alston.com Tim L. Fallaw tim.fallaw@alston.com Jeffrey C. Glickman jglickman@alston.com Richard C. Kariss rkariss@alston.com James H. Lavin jlavin@alston.com Ethan D. Millar emillar@alston.com Maureen R. Monaghan mmonaghan@alston.com Timothy J. Peaden tpeaden@alston.com Michael T. Petrik Group Leader mpetrik@alston.com Lee R. Rimler lrimler@alston.com Margaret W. Scott mscott@alston.com Aaron M.Young ayoung@alston.com If others in your organization would like to be added to the mailing list for this Report, or if you would like to be deleted from the list, please SALT.advisory@alston.com. Alston & Bird LLP