Taxpayer produces various consumer products. Taxpayer sells these products to customers both inside Indiana and outside Indiana. During the years at issue, Taxpayer operated an Indiana based facility.
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Starting in 2007, Taxpayer began excluding on its Indiana income tax return royalty income earned from foreign subsidiaries. According to the audit report, "The basis for this exclusion is that the transactions generating [Taxpayer's] royalties have no Indiana situs and are not derived from sources within the state." The audit disagreed with Taxpayer's analysis and found that the consumer products – which formed the basis for the royalty agreements – were developed in the regular course of the Taxpayer's business and that under the "transactional and functional tests," the intangible property generating the royalty income constituted an "integral" part of the Taxpayer's business and consisted of "apportionable business income."
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Taxpayer disagrees with the audit's decision to include the income explaining as follows:
During the 2007 through 2009 tax years, [Taxpayer] deducted the royalty income received from its foreign subsidiaries on its duly filed Indiana Adjusted Gross Income Tax returns because such income was not subject to tax in Indiana based on existing Indiana tax law.
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Taxpayer maintains that because IC § 6-3-2-2.2 does not specifically list "royalties," that specific form of income is not "attributable to this state" unless the intangible property is itself located in this state.
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Taxpayer's royalty income is derived from foreign subsidiaries in which Taxpayer holds a controlling ownership interest. As stated in the audit report, Taxpayer has agreements with these subsidiaries by which Taxpayer shares "its own expertise and know-how, patents, trademarks and trade secrets...." In exchange for sharing its intellectual property with the subsidiaries, the subsidiaries pay Taxpayer royalties. Taxpayer is in the business of developing and selling consumer products. In the course of developing those products, Taxpayer developed or acquired valuable intellectual property. As such, the royalty income derived from licensing that intellectual property is derived from "intangible property" arises from "transactions and activity in the regular course of the taxpayer's trade or business...." IC § 6-3-1-20.
Nonetheless, Taxpayer argues that the "business" or "non-business" distinction is not relevant to the issue at hand. According to Taxpayer, the Indiana Tax Court has "held unequivocally that income from intangible personal property must have been classified as income derived from sources within the state of Indiana... prior to deciding whether the income was business or non-business income." The Department must disagree with Taxpayer's assertion because it flies in the face of the Tax Court's decision in Hunt.
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Taxpayer's intellectual property was developed in the ordinary course of Taxpayer's business and the royalty income Taxpayer receives from allowing its subsidiaries to exploit that intellectual property constitutes business income under IC § 6-3-1-20 and should have been included in the calculation of Taxpayer's Indiana income tax.
