The Indiana Department of Revenue ("Department") conducted a corporate income tax audit of Taxpayer for the years 2005 through 2007. As a result of the audit, the Department adjusted Taxpayer's corporate income tax returns for the years 1999 through 2007 which resulted in proposed assessments of tax for 2006 and 2007.
For the years audited by the Department, Taxpayer reported carry-forward net operating losses ("NOLs") on its returns. These NOLs were created in 2001 as a result of Taxpayer's treatment of income from the sale of a specialized industry subsidiary ("SUB") as non-business income on its Indiana corporate income tax return for that year. Taxpayer's treatment of the revenue as non-business income meant that Taxpayer allocated the income to its domiciliary state. This classification removed the revenue from the sale of SUB's assets from the income apportionable to Indiana and therefore created Indiana NOLs.
Pursuant to the audit of the years 2005 through 2007, the Department reclassified the revenue from the sale of these assets as business income. As a result of the Department's reclassification of the income, Taxpayer no longer had the benefit of the NOLs resulting from the subtraction of this gain from Taxpayer's 2001 federal taxable income. This reduction of gain in 2001 affected Taxpayer's remaining NOLs for several years, including the audit years, resulting in taxable income for two of the audit years, 2006 and 2007.
Taxpayer protested the reclassification of the income from the sale of SUB. Taxpayer argues the sale of SUB was unrelated to Taxpayer's primary business purpose, SUB was merely an investment, and Taxpayer's interest in the subsidiary was merely an "oversight interest."
However, Taxpayer's own Securities and Exchange Commission ("SEC") records, its website, and public statements over the years by its top executives, document Taxpayer's history of developing its specialized industry business over a period of decades. This history includes a joint venture with an experienced specialized industry company – a predecessor to SUB – which began in the early 1990s. At that time Taxpayer was implementing a strategy to expand its sciences division. The joint venture developed several important products over the years. Taxpayer acquired its venture partner's interest in the late 1990s and operated as SUB. SUB continued its predecessor's research track record and developed several revolutionary products. In 2001, SUB was acquired by an unrelated specialized industry company when Taxpayer decided that it could no longer carry the research and development costs of SUB (at the time SUB represented 5 percent of Taxpayer's revenue but used up just under 30 percent of its research and development budget). As stated in Taxpayer's SEC records leading up to the sale of SUB, Taxpayer would use the proceeds to pay down debt, buy back shares, and make acquisitions – all decisions directly related to Taxpayer's business operations.
Under the application of the "functional test," as illustrated by May, the income generated from the sale of SUB therefore unquestionably qualifies as business income. As in May, the acquisition and management of the assets in this case were integral to Taxpayer's business operations in its specialized industry line of business since the assets of SUB were essential to the creation of this line of business dating back to the 1990s and before. And, unlike the forced disposition of assets in May, the disposition of the SUB assets in this case was an unforced, voluntary business decision on the part of Taxpayer, therefore integral to Taxpayer's business operations.
Arguably, Taxpayer's revenue from the sale of SUB also qualifies as business income under the "transactional test" – as the audit proposes. As a conglomerate with several lines of business, Taxpayer regularly engages in the acquisition and sale of divisions and subsidiaries as it seeks to consolidate or divest a particular line of business. However, having met the "functional test" there is no need to reach the "transactional test."
Taxpayer also appears to make the argument that because SUB was not unitary with Taxpayer. In support of this argument, Taxpayer makes extensive reference and comparisons to MeadWestvaco Corp. v. Illinois Department of Revenue, 553 U.S. 16 (2008) (" Mead") for the proposition that the unitary business principal is the key factor in determining whether a state may tax a portion of the gain from the sale of a business enterprise. Taxpayer argues, for example, that Taxpayer did not assume any day-to-day management of SUB, that SUB operated as a "discrete business unit responsible for the development and marketing of [specialized industry] products . . . It maintained it own sales and marketing division. It did not share its facilities, customer lists or research and development with other [Taxpayer] entities. There were few intercompany transactions between [SUB] and [Taxpayer]."
Taxpayer suggests that in Mead the U.S. Supreme Court determined that Lexis lacked a unitary relationship with Mead and therefore the income resulting from the sale of Lexis was non-business income. Taxpayer argues that the sale of SUB by Taxpayer tracks comparable facts and history to Mead's sale of Lexis.
The Department cannot agree with Taxpayer's proposition because Taxpayer fundamentally misreads the Mead decision. A correct understanding of the Mead decision requires an understanding of the procedural history of that case. The Illinois Circuit Court of Cook County concluded that Lexis and Mead were not a unitary business, but nevertheless concluded that Illinois could tax an apportioned share of Mead's capital gain because Lexis served an "operational function" in Mead's business. Mead 553 U.S. at 23. The Illinois Appellate Court affirmed the trial court's "operational function" analysis and did not address the question of whether Mead and Lexis formed a unitary enterprise. Id. Again, the Illinois Appellate Court did not address the trial court's finding that the companies were not unitary. Instead the Illinois Appellate Court found that Lexis did indeed serve an operational purpose in Mead's business and therefore the revenue from the sales of Lexis was business income to Mead. The Illinois Appellate Court relied on Allied-Signal v. Director of Taxation, 504 U.S. 768 (1992) to arrive at its conclusion. The U.S. Supreme Court, in its Mead decision, clarified that the "operational function" test for apportionable income articulated in Allied-Signal must be applied narrowly to assets used in the taxpayer's business, but not to the relationship between business entities or businesses. The U.S. Supreme Court found that it was a "fundamental error" for the Illinois Appellate Court to consider whether Lexis served an operational purpose in Mead's business without determining that Lexis and Mead were unitary and therefore vacated the Illinois Appellate Court's decision. Mead 553 U.S. at 24. However, the U.S. Supreme Court noted that, on remand, the Illinois Appellate Court could take up the question of whether Mead and Lexis should be considered a unitary business, contrary to the Illinois trial judge's factual findings. Also, the U.S. Supreme Court noted that the lower court could also revisit the issue of whether a distinction exists between a sale of separate subsidiary and a sale of a division.
The question, therefore, of whether Lexis and Mead were unitary is not one addressed by the Mead decision as Taxpayer suggests.
Therefore, based on the above, the Department's audit correctly recharacterized the income from the sale of SUB from non-business to business income.
The Department made adjustments for the audit years disallowing a deduction for interest expense payments made by Taxpayer to a subsidiary ("LOAN SUB"). The Department found that these intercompany transactions among a controlled group of affiliated companies did not "fairly reflect" Taxpayer's Indiana source income and should therefore be disallowed.
According to the Department's audit summary, allowing Taxpayer to claim the interest expense deduction did not fairly reflect Taxpayer's Indiana source income for several reasons:
- No payments were ever made on the loan. At the end of the year [Taxpayer] records interest expense for this loan as an account payable. [LOAN SUB] records interest income as an account receivable. No money ever changes hands. The balance on the loan grows each year as interest is piled on top of principal increasing the balance due each year.
- [LOAN SUB] has no employees. They only hold the notes and record a paper transaction with no real business purpose to the corporation. As such, their only activity is to hold a master note for a line of credit between [Taxpayer] and [LOAN SUB]. Taxpayer explained that [LOAN SUB] borrowed cash to send estimated payments to the IRS as required on their income. However, when returns are filed, all of the income of [LOAN SUB] is eliminated on the consolidated return and as a result do not pay any federal tax on their income.
- The interest rate on the loans does not reflect true market rates. If these were true loans, during the period of 2002 and 2003 when the rate was 4.25[percent] to 4.00[percent] the taxpayer could have easily refinanced them to obtain a favorable market rate instead of continuing to accrue interest at 8.5[percent] (over two times the going rate). This would have saved several hundred million dollars in interest. Any prudent financial person would have refinanced a true loan in this instance. However, since this was an internal paper transaction with no money changing hands, no effort to refinance was ever made.
- At the end of the term the loan is rolled over into a new loan. The new loan includes all of the interest accrued over the last 10 years. The same terms exist on the new loan as no money ever changes hands. Taxpayer's interest expense deducted on its federal return will grow for another 10 years. Even though the loan is due at the end of 10 years, it's never actually paid off.
- On the consolidated federal return this deduction is eliminated and has no effect on federal taxable income reported to the IRS and therefore [Taxpayer] would have no interest in adjusting it.
- This adjustment only [a]ffects state taxable income as [LOAN SUB] (the company which records the interest income) has no nexus with Indiana.
- The huge interest expense has eliminated most of taxpayer's Indiana taxable income for the past 10 years and severely distorted income from operations.
Assuming for the moment that the Department had the authority to disallow the interest expense, did the audit correctly determine that Taxpayer's returns – as originally filed and as determined under I.R.C. § 63 – did not "fairly reflect" Taxpayer's Indiana source income? The question is not inconsequential; the audit disallowed approximately 3.1 billion dollars in interest expenses.
The Department's audit reasons that during the years at issue Taxpayer made substantial profits from its operations in Indiana, however the income apportioned to Indiana on Taxpayer's return was severely distorted by the intercompany interest deduction resulting from the intercompany loan transactions. According to the Department audit, Taxpayer and its related parties entered into loan transactions which led to interest expenses of several billion dollars. As quoted above, these were loans to which the parties agreed to an interest rate approximately twice that of the prime rate during the audit years, were loans for which there is no timely expectation of repayment, and were loans apparently structured in such a way as to gain a substantial and disproportionate state tax advantage.
For the reasons set out above by the Department's audit, the audit determined that the loan transactions lacked economic substance and should have been eliminated as an intercompany transaction as it was on Taxpayer's federal return.
Taxpayer protests arguing that the transactions had "economic substance" because without the loans from LOAN SUB, Taxpayer would not, for example, have been able to purchase SUB's predecessor. Taxpayer argues it would have needed to obtain loans from other third party lenders. Accordingly, Taxpayer believes the transactions were entered into for a business purpose other than simply harvesting state tax benefits.
In determining the nature of a business transaction and the resultant tax consequences, the Department is required to look at "the substance rather than the form of the transaction." Bethlehem Steel Corp. v. Ind. Dept. of State Revenue, 597 N.E.2d 1327, 1331 (Ind. Tax Ct. 1992). While Taxpayer styled this transaction as a loan, in substance LOAN SUB was merely a paper company with no employees. In substance, for the years at issue the loan rate was twice that of the prime interest rate and the interest was never actually paid to LOAN SUB but simply accrued along with the original loan. In substance, not only was the loan not repaid, but at the end of the loan's term, the loan was rolled over into a new loan including all of the accrued interest. While, it may be true that Taxpayer would not have been able to purchase SUB without LOAN SUB's influx of money, the fact remains that the transaction was not in substance a loan. LOAN SUB's influx of money could be treated as a capital contribution or some relevant accounting of the money, but the form of the loan is a "sham." Taxpayer cannot, therefore, utilize the interest expense deduction to distort its Indiana income tax obligations by unfairly reducing its taxable Indiana income.
Under IC § 6-8.1-5-1(c), Taxpayer has failed to meet its burden of demonstrating that the Department lacked the authority under IC § 6-3-2-2(l), (m) to disallow the interest expenses. Under IC § 6-3-2-2(l), (m), the audit was authorized to resort to "any other method to effectuate an equitable allocation and apportionment of the [T]axpayer's income" in order to "fairly reflect and report the income derived from sources within the state of Indiana . . . ." IC § 6-3-2-2(p) circumscribes that power " unless the department is unable to fairly reflect the [T]axpayer's adjusted gross income for the taxable year . . . ."
Based on the above, under IC § 6-3-2-20(b), a taxpayer who is subject to Indiana AGIT, is required to add back its federal deductions relating to intangible expenses and any directly related intangible interest expenses which are paid, accrued, or incurred with one or more members of the same affiliated group or with one or more foreign corporations. IC § 6-3-2-20(c) allows for certain exceptions from this requirement, but Taxpayer has not argued and/or substantiated any of these requirements. Furthermore, under IC § 6-3-2-20(f), as demonstrated above, Taxpayer's state tax avoidance exceeds any other valid business purpose.
Taxpayer has failed to meet its burden under IC § 6-8.1-5-1(c). The Department must conclude that the transactions were "motivated by nothing other than the [T]axpayer's desire to secure the attached tax benefit." Horn, 968 F.2d 1326.
The Department's audit added back research and development ("R & D") expense deductions Taxpayer had taken for the 2007 year on its Indiana return. The disallowance of this deduction increased Taxpayer's taxable income. The audit's summary report explained that in calculating its Indiana adjusted gross income, Taxpayer must begin with federal taxable income as defined under I.R.C. § 63. Taxpayer's federal taxable income as defined under I.R.C. § 63 did not include a federal deduction for qualifying R & D expenses. Therefore, Taxpayer could not then deduct those R & D expenses from Indiana adjusted gross income. Taxpayer did not take a federal deduction for those expenses because Taxpayer had instead taken a federal credit for the expenses. Because Taxpayer had taken a credit for the R & D expenses, a deduction was therefore not available at the federal level.
Taxpayer protests as follows:
Since Indiana does not allow the federal R & D tax credit as part of its corporate income tax starting point, Taxpayer's actual R & D expenses of $30,748,141, which would otherwise be deductible for Federal income tax purposes, should be deductible in calculating Taxpayer's IN corporate income tax base. Therefore Taxpayer respectfully requests that the Department adjust the assessment for the 2007 tax year by reversing the auditor's add-back of $43,776,706 and permitting Taxpayer's deduction of $30,748,141.
Under IC § 6-3-1-3.5(b), the starting point of Indiana taxable income is I.R.C. § 63 with then a number of Indiana-specific enumerated adjustments. None of the Indiana adjustments include a deduction for federal R & D expenses taken at the federal level as credit instead of a deduction. Accordingly, the Department's audit correctly disallowed the deduction Taxpayer took on its 2007 return for R & D expenses.
Of the three substantive issues contested in Taxpayer's protest, the loan interest expense issue represents the lion's share of the proposed assessment. Taxpayer's treatment of the loan interest expense issue does not demonstrate "reasonable cause" and therefore the underpayment penalty is not waived.