By Scott Booth and Timothy Gustafson

The Arizona Department of Revenue concluded in a Taxpayer Information Ruling that court-ordered proceeds from a patent infringement lawsuit were properly characterized as business income. The taxpayer held more than 200 patents that it developed or acquired for use in its own manufacturing process or patent licensing activities, one of which had been infringed by a competing manufacturer. The taxpayer filed a patent infringement lawsuit, which it successfully prosecuted, and was awarded a judgment intended to compensate the taxpayer for lost profits and reasonable royalties, plus punitive damages, attorney’s fees and interest. The taxpayer requested a ruling addressing Arizona’s corporate income tax characterization of the expected judgment proceeds. The Department determined the taxpayer’s ability to generate revenue was contingent upon effectively managing its patents. Accordingly, because the award was “the result of loss of business or royalties resulting from the patent infringement of a particular patent that was acquired by [the taxpayer] for use in its regular trade or business,” the Department concluded that the award was properly characterized as business income. The Department also determined that the income derived from the 931 total patents in the affiliated group’s manufacturing operations was at the “core of the group’s income producing capabilities,” and as such the income from the patent infringement lawsuit was properly treated as business income when viewed on the whole. Ariz. TIR LR13-004 (Released Nov. 2013).

StephanieThumbnail.jpgMeet Henry P. Wienerman, the four-month-old Boston Terrier of Sutherland SALT legal secretary Stephanie Fulps and her husband, Jason. Henry is the latest addition to Stephanie and Jason’s family; his older “sisters,” Abby and Olive, were featured previously as Pets of the Month.

Henry came to live with Stephanie and Jason two months ago and loves being a little brother to Abby and Olive. He is 100% puppy and full of mischief. When not chasing his sisters or stealing their toys, Henry enjoys chewing bull stick treats and lounging in the sun. He is an excellent cuddler and makes a great napping companion, but do not expect to sleep peacefully if Henry starts snoring!HenryThumbnail.jpg

Henry can be startled and confused by his reflection. He will often run up to the full-length mirror and scratch at it, trying to play with the handsome puppy looking back at him. Once the sun goes down, if he sees his reflection in the glass doors that lead to the backyard, he goes into protective mode and barks and howls to scare away the backyard intruder while Abby and Olive relax on the couch.

By Mary Alexander and Timothy Gustafson

The Arizona Court of Appeals held that a liquidation exception to the functional test for business income does not exist in Arizona and that a taxpayer’s sale of its wholly owned subsidiary was business income. The parties to the sale made an I.R.C. § 338(h)(10) election, which required the taxpayer to treat the sale of the subsidiary’s stock as an asset sale. Arizona statutes and regulations adopt a functional test for business income whereby gain from property qualifies as business income if the property was used in the taxpayer’s trade or business. The court held that a liquidation exception was inconsistent with the functional test because it focused on the “nature of the transaction” instead of on the “relationship between the property and the taxpayer’s business.” The frequency of a transaction was considered irrelevant in determining the relationship of the property to the business. As the taxpayer had previously treated the income that resulted from the subsidiary’s assets as “arising in the regular course of business,” the sale of the subsidiary’s stock constituted business income as well. First Data Corp. v. Ariz. Dep’t of Rev., Dkt. No. 1 CA-TX 11-0008 (Ariz. Ct. App. Nov. 26, 2013).

By Suzanne Palms and Andrew Appleby

The Arizona Court of Appeals held that Home Depot U.S.A., Inc. (Home Depot) was required to include in its combined Arizona income tax return the income of an out-of-state subsidiary that licensed the retailer’s trademarks. Relying on R.R. Donnelley & Sons Co. v. Arizona Dep’t of Rev., 229 P.3d 266 (Ariz. Ct. App. 2010), the court concluded the trademark subsidiary was a part of Home Depot’s unitary business because the operations of the two entities were substantially interdependent. The court found the subsidiary’s sole business was the management of Home Depot’s trademarks, and that without Home Depot’s continuing efforts to promote its brand, the trademarks that constituted the subsidiary’s only assets would have been worthless. The court also found that although the subsidiary had substantial income during the tax years in question, it had only four employees, which was indicative, in the court’s opinion, that the subsidiary’s income was generated solely by Home Depot’s marketing efforts. Home Depot U.S.A., Inc. v. Arizona Dep’t of Rev., No. 1 CA-TX 12-0005 (Ariz. Ct. App. Dec. 5, 2013).

Can’t get enough of the SALT Pet of the Month?! Think your best friend has what it takes to win? Download the new Sutherland SALT Shaker mobile app today, and enter your pet in our Pet of the Year Contest for a chance to win a $100 Amazon.com gift card! Awards will be given to the top dog, cat and other exotic pet. Runners-up will receive Sutherland SALT gear specially designed for our furry friends. Here’s how to enter:

1. Download the Sutherland SALT Shaker mobile app on your smartphone.

Available in iTunes App Store.png          Amazon Appstore Logo.jpg          GooglePlay Logo.jpg         

2. Navigate to the Pet of the Month page using the menu button in the top left corner.

3. Click “Submit a Pet” to upload a photo and enter details about your pet.

Don’t delay. The deadline to enter is December 31.

Good luck!

The Sutherland SALT Team

By Derek Takehara and Andrew Appleby

The Virginia Tax Commissioner determined that the Department of Taxation was permitted to make net operating loss deduction (NOLD) adjustments for taxable years outside the statute of limitations because the adjustments were necessary to determine the correct federal taxable income for the taxable years at issue. The taxpayer, an affiliated group, originally filed its Virginia corporate income tax returns on a consolidated basis. In later years, including the years at issue, the group filed returns on a combined basis—instead of on a consolidated basis—without obtaining permission from the Department. The auditor adjusted the taxpayer’s returns to a consolidated basis and correspondingly recomputed the taxpayer’s NOLDs for net operating losses incurred prior to the years at issue. The taxpayer objected and argued that the auditor’s adjustments to the NOLDs were made beyond the state’s three-year statute of limitations for assessments. Virginia uses federal taxable income as the starting point for computing Virginia taxable income, and the Tax Commissioner explained that the adjustments were necessary to accurately reflect the taxpayer’s federal taxable income for the taxable years at issue. As such, the Tax Commissioner determined that the adjustments did not constitute assessments prohibited by the statute of limitations and permitted the auditor’s recomputations. Va. Pub. Doc. Rul. No. 13-213 (Nov. 18, 2013).

Following in the footsteps of Ohio more than 20 years ago, more than 20 states have enacted addback statutes, which generally limit taxpayers from reducing their state income tax liability by deducting interest and intangible expenses paid to out-of-state related parties. In this edition of A Pinch of SALT, Sutherland SALT’s Michele Borens and Jessica Kerner outline the three basic components shared by all addback statutes, analyze litigation involving those components and explore the lack of litigation on addback statutes.

Read “20 Years of Ambiguity in Addback Statutes,” reprinted with permission from State Tax Notes.

Click here to read our November 2013 posts on stateandlocaltax.com or read each article by clicking on the title. You may also view a printable PDF here.

By Sahang-Hee Hahn and Timothy Gustafson

The New York Supreme Court, Appellate Division, held that interest income derived from Xerox Corporation’s equipment financing agreements with governmental customers failed to qualify as “investment income” for New York Corporation Franchise Tax purposes. Xerox’s financing agreements consisted of two types: fixed purchase option leases and installment sales. Xerox argued that the interest income from these agreements was properly characterized as “investment income” because the underlying financing agreements qualified as “investment capital,” which New York law defines to include investments in “stocks, bonds and other securities.” N.Y. Tax Law § 208(5)&(6). Xerox took the position that the financing agreements constituted “debt instruments” issued by governmental entities, thereby satisfying the Department of Taxation and Finance’s own regulatory definition of “other securities.” 20 NYCRR 3-3.2(c)(2). The Appellate Court rejected this argument. Noting the absence of a statutory definition for “stocks, bonds [or] other securities,” the court applied two securities law tests to determine whether Xerox’s financing agreements, which the court described as “basic sale or lease contracts,” were of a similar nature to stocks or bonds or otherwise qualified as securities and concluded that they did not. The court also found no evidence that the financing agreements were intended to be considered debt instruments and that such agreements qualified as debts “issued by” a governmental entity under the Department’s regulation, or that such agreements should be considered debts of governmental customers in light of state restrictions on government assumption of debt. The court held that the financing agreements were business capital whether the purchaser was a governmental or private entity. Xerox Corporation v. N.Y. Tax App. Trib., 2013 WL 5745853 (N.Y.A.D. 3 Dept., Oct. 24, 2013).

 

By Maria Todorova

The Indiana Department of Revenue determined that a taxpayer and its two affiliated entities were not required to report their income using a “separate accounting” method because the Department’s audit staff failed to prove the standard apportionment formula did not fairly reflect the taxpayer’s business activities in Indiana. The taxpayer, a manufacturer of automotive parts, filed a separate Indiana income tax return until 2005, when it began filing a consolidated income tax return with two affiliated entities. On audit, the Department’s audit staff concluded that the standard method of apportionment did not fairly represent the taxpayer’s income from Indiana sources because the taxpayer and one of its affiliated entities had substantial disparities in both the amount of their Indiana activities and their respective amounts of income and loss. As a result, audit staff required separate accounting for the companies. On appeal, the taxpayer presented evidence that the affiliated entity in question maintained resident and non-resident employees in Indiana who regularly conducted business activities within the state that exceeded the protections under P.L. 86-272 and that such entity had taxable income in years prior to the audit years. The Department reasoned that while sufficient differences in the method of doing business may be justification for separate classification and differential tax treatment, the Department has the burden of establishing that the standard apportionment method does not fairly reflect the taxpayer’s Indiana sourced income. Consequently, the Department concluded that the taxpayer established that the affiliated entity in question had substantial contacts with the state and that the Department audit staff failed to demonstrate that a departure from the standard apportionment formula was necessary. On a separate issue involving the disallowance of royalty expenses, the Department ruled in favor of the taxpayer, concluding that its audit staff failed to establish such royalty payments distorted the taxpayer’s Indiana source income. Letter of Findings 02-20130215 (Ind. Dep’t of Rev. Oct. 30, 2013).