In 2008, Taxpayer formed a management company (Management Company) and placed certain clerical functions and management functions under the control of Management Company. As part of the creation of Management Company, Taxpayer and Management Company entered into an agreement. The agreement called for Taxpayer to reimburse Management Company for Management Company's actual expenses. In addition, each company was to receive or retain an amount equal to its respective operating costs plus a specified percentage for each company. Thus, Management Company was also paid an additional percentage of its actual operating costs. Further, the agreement called for the sharing of Taxpayer's profits between Taxpayer and Management Company. Taxpayer claimed a deduction for the portion of costs (including markup) and profits paid to Management Company.
The Indiana Department of Revenue ("Department") audited Taxpayer and determined that Taxpayer's deduction for the portion of profits paid to Management Company should be disallowed. The Department separately disallowed Taxpayer's claimed research expense credits for the tax years. As a result, the Department issued proposed assessments for tax and interest for the tax years, along with a penalty for failure to remit sufficient estimated taxes for one of the years. Taxpayer protested the disallowance of the deduction for fees paid to Management Company and the estimated tax penalty. At hearing, Taxpayer conceded the research expense credit issue.
At the time of the Department's audit, Taxpayer indicated that it had overreported its Indiana receipts for apportionment purposes. The effect of this overreporting was that Taxpayer's Indiana apportionment factor as originally reported was higher than the proper apportionment factor. Taxpayer first provided the revised apportionment factors to the Department's auditor, who did not act upon the information. Amended returns were then filed reflecting the amended apportionment factors and seeking a refund. The Department denied the refund claims. Taxpayer also protested the refund denial.
...
...
Taxpayer argues that the payment of a portion of Taxpayer's profits to Management Company was a properly allowable deduction. In particular, Taxpayer and Management Company entered into an agreement based on a transfer pricing study. The transfer pricing study determined that the best method of allocating costs and profits between Taxpayer and Management Company was the "residual profit method."
The residual profit method involves two levels of analysis. For example, assume two companies, Company A and Company B, have a combined $1,295,000,000 in revenues and had $1,000,000,000 in operating expenses resulting from Company A's business and Company B's activities on behalf of Company A. Of these expenses, $900,000,000 is Company A's operating expenses and $100,000,000 is Company B's operating expenses.
The first level of analysis requires review of the routine profits relating to each company's operations. For instance, if businesses in Company A's line of business averaged a profit of ten percent of their costs, Company A's "routine profit" would be ten percent of Company A's $900,000,000 costs, or $90,000,000. Similarly, if businesses in Company B's line of business averaged a profit of five percent of their costs, Company B's "routine profit" would be five percent of $100,000,000, or $5,000,000.
These "routine profits" of Company A and Company B are subtracted from the overall profits. Thus, in this example, the overall profits are $295,000,000, while the routine profits are $95,000,000. The $200,000,000 is the "residual profit." The "residual profit" is then allocated to the respective companies based on their overall contributions to the generation of the "residual profit." Thus, if Company A is considered to have contributed forty-five percent to the extraordinary profit and Company B fifty-five percent, Company A is required to pay Company B $110,000,000 for Company B's contributions. However, if the "residual profit" is somehow negative, Company B is required to pay Company A the negative "residual profit."
In Taxpayer's case, the Department allowed Taxpayer's deduction for Management Company's operating expenses plus the percentage markup specified in the transfer pricing study. However, the Department disallowed Taxpayer's deduction for the "residual profit" paid to Management Company. The issue is whether the Department's disallowance of the deduction for the "residual profits" was proper. Secondarily, if a disallowance of the deduction is proper, the issue is how much of a deduction for the "residual profits" is allowable.
...
...
Both Taxpayer and the Department cite to IC § 6-3-2-2(m), which states:
In the case of two (2) or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests, the department shall distribute, apportion, or allocate the income derived from sources within the state of Indiana between and among those organizations, trades, or businesses in order to fairly reflect and report the income derived from sources within the state of Indiana by various taxpayers.
The Department cited to this subsection as its authority for disallowing the deduction for the "residual profits" paid to Management Company. On the other hand, Taxpayer cites to IC § 6-3-2-2(m) for the proposition that the subsection is Indiana's version of I.R.C. § 482. In other words, Taxpayer asserts that, if the deduction is determined to be arms'-length under I.R.C. § 482, then the deduction is allowable.
In support of the proposition that the arrangement between Taxpayer and Management Company reflected an arms'-length transaction, Taxpayer received a "Transfer Pricing Analysis" dated December 16, 2008, (the "TPA") from a national accounting firm.
However, page eight of the TPA states "The tax advice set forth herein addresses specific U.S. federal income tax issues. [Taxpayer] has not requested us to consider, and we have not considered, any other U.S. federal income tax issue; any non-income tax issues; or any state, local or foreign income tax issues. Accordingly, we do not reach any conclusions regarding any other U.S. federal income tax; no-income tax; or state, local or foreign tax issues."
Aside from the limitations contained in the TPA, there are various issues with the TPA and its application. For instance, the Department's audit report raises the issues of whether the "residual profit" is determined before or after interest and taxes. In addition, the TPA uses various companies in Taxpayer's industry which exhibited increased percentage profitability based on size, yet the TPA used an arithmetic mean to determine the "routine profits" percentage for Taxpayer. However, such issues are not necessary for analysis under IC § 6-3-2-2(m).
In Taxpayer's case, Taxpayer paid over $250,000,000 to Management Company in "residual profits" for the audit period. Management Company had over 200 employees. During the protested years, no money was transferred from Management Company to Taxpayer as dividends. However, in periods after the protested periods, Management Company paid Taxpayer dividends.
The effect of these transactions is that Taxpayer claimed a $100,000,000 deduction for one year. A portion of the $100,000,000 may have been used for Management Company's expenses. Eventually, when Management Company had money in excess of its expenses, Management Company returned the excess to Taxpayer as a dividend. The dividend was not subject to Indiana tax. Assuming Management Company incurred $20,000,000 in expenses, with the remainder returned as a dividend, Taxpayer received a $100,000,000 net deduction yet had a real-world cost of less than $100,000,000.
The Department is led to the conclusion that Taxpayer's reporting did not reflect the economic realities of its operations or of Management Company's operations. Taxpayer is entitled to deductions for legitimate business expenses, and the Department does not dispute the legitimacy of Management Company's expenses on behalf of Taxpayer and Taxpayer's affiliated companies. However, to permit a deduction in excess of those expenses when that excess will be simply returned to Taxpayer does not reflect the real-world income of Taxpayer. Even though an actual circular flow did not exist until after the years in question, a circular flow of money resulting in a deduction and non-taxable dividend of any excess amounts deducted existed. Thus, Taxpayer's protest is denied with regard to the portion of the amount paid to Management Company and disallowed by the Department's audit.
...
...
