A New York state tribunal upheld a $64.6 million corporate franchise tax assessment against IBM, finding that the company couldn’t exclude from income royalty payments from foreign affiliates.
IBM argued for an outcome that was called for by the statute, but clearly contrary to legislative intent. Even though the statute was not ambiguous, and seemingly favored IBM, the court held in favor of the government, based on its understanding of the purpose of the statute (Matter of International Business Machines Corp., DTA No. 827825 (N.Y. Tax App. Div. 12/19/19)).
IBM is a New York corporation. IBM World Trade Corp. (WTC) is a Delaware corporation. IBM owns 100% of the stock of WTC. IBM and WTC filed as part of IBM’s New York State combined report.
IBM operates in over 170 countries primarily through locally incorporated subsidiary companies (alien affiliates). WTC served as the holding company for IBM’s alien affiliates for the tax years at issue. The subset of affiliates which engaged in sales to third party customers are referred to as “alien S&D affiliates.”
IBM served as the legal owner to all IBM intangible property, including the IBM brand. IBM and WTC granted the alien affiliates the right to exploit IBM’s intangible property in a designated region in exchange for specified payments by the alien S&D affiliate. During the periods at issue, IBM, WTC, and certain alien S&D affiliates were parties to a cost sharing arrangement. The payments received by IBM from WTC and the alien affiliates as part of these cost sharing arrangements were not included as royalty payments and were not deducted on line 15, other subtractions, of IBM’s original or amended New York Forms CT-3-A for the periods at issue.
During the periods at issue, the alien S&D affiliates paid:
- IBM and WTC 60% of their revenue for the rights under IBM’s patents, trademarks, etc., to use, distribute, and market IBM’s computer software programs;
- WTC a percentage of their gross charges for the rights under IBM’s patents and trademarks to manufacture and sell IBM computer hardware;
- WTC for the right to provide services relating to IBM products; and
- IBM or WTC for the economic rights to already existing intangible property for the purpose of creating cost-shared intangibles with IBM and distributing IBM products within their respective regions.
For federal income tax purposes, IBM included the payments IBM and WTC received from the alien S&D affiliates pursuant to the hardware, software, and services agreements (alien payments), on line 7 of its federal Forms 1120, gross royalties. IBM and WTC did not file with the alien S&D affiliates as part of IBM’s combined report for New York state corporation franchise tax purposes for the periods at issue. The alien S&D affiliates did not file corporation franchise tax returns in New York state for any of the periods at issue. On its amended forms CT-3-A for 2007-2010, IBM deducted the alien payments on line 15, other subtractions. On its amended forms CT-3-A for 2007-2010, IBM requested refunds totaling approximately $50 million. On its original forms CT-3-A for 2011 and 2012, IBM deducted the alien payments on line 15 and requested refunds of nearly $33 million.
The N.Y. Division of Taxation denied IBM’s claims for refund for 2007-2010 and issued a notice of deficiency asserting additional corporation franchise tax and the Metropolitan Transit Authority surcharge in the amount of $64.6 million for the 2011 and 2012 tax years, plus interest and penalty for substantial under reporting of the amount asserted due. IBM challenged the assessment in the N.Y. Division of Tax Appeals (court).
Spirit Rather Than Letter of Law Resolves Dispute
A corporation’s entire net income (ENI) generally consists of its investment income and its business income. The investment income and business income are allocated to New York pursuant to the corporation’s investment allocation percentage (IAC) and its business allocation percentage (BAP), respectively. ENI means the “total net income from all sources, which shall be presumably the same as the entire taxable income, subject to certain modifications.”
The modifications at issue are contained in N.Y. Tax Law former Section 208(9)(o), which provided that a taxpayer was allowed to deduct royalty payments received from a related member during the taxable year to the extent such was included in the taxpayer’s federal taxable income, unless the royalty payments were not required to be added back under the expense disallowance provisions or other similar provisions of the Tax Law. Royalty payments were not required to be added back if, and only if:
(i) the related members were part of a combined report;
(ii) the related member paid the royalty during the same tax year to a non-related member for a valid business purpose in an arm’s-length deal; and
(iii) the royalty payments were paid to a related member organized under the laws of a foreign country subject to a comprehensive tax treaty with the United States and the payments were taxed in that country at a rate equal to or greater than the rate in New York.
The division took the position that not all of the payments in question were, in the first instance, royalty payments. The court rejected the division’s arguments. With respect to the software payments, the facts provided that they were for the rights under IBM’s patents, trademarks, copyrights, mask works, knowledge and technical know-how related thereto to use, distribute, and market IBM computer software programs. “These payments fall directly within the definition of a royalty,” the court said. “Likewise, with respect to the buy-in/other payments, these payments were for the economic rights to already existing intangible property for the purpose of creating cost-shared intangibles with IBM and distributing IBM products within their respective region. These payments fall squarely within the definition of a royalty.” Accordingly, the alien payments were royalties.
The next issue was whether such amounts could be properly excluded from ENI. The statute provides that: “For the purpose of computing entire net income…a taxpayer shall be allowed to deduct royalty payments…received from a related member during the taxable year to the extent included in the taxpayer’s federal taxable income unless such royalty payments would not be required to be added to under subparagraph two of this paragraph or other similar provision in this chapter.” See former Section 208(9)(o)(3).
IBM contended that its alien affiliates would not be required to add back the royalty payments under subparagraph two, which provides as follows:
(A) For the purpose of computing entire net income…a taxpayer must add back royalty payments to a related member during the taxable year to the extent deductible in calculating federal taxable income;
(B) The add back…shall not be required if and to the extent that such payments meet either of the following conditions:
(i) the related member during the same taxable year…paid or incurred the amount to a person or entity that is not a related member
(ii) the royalty payments are paid or incurred to a related member organized under the laws of a country other than the United States, are subject to a comprehensive income tax treaty between such country and the United States, and are taxed in such country at a tax rate at least equal to that imposed by this state.
IBM contended that “under the plain wording of the statute,” the alien payments would have to be added back if the alien S&D affiliates were New York taxpayers because they did not meet the combined reporting exception, the conduit exception, or the tax treaty exception. IBM argued that the legislature intended that the royalty income exclusion apply regardless of whether the payer was a taxpayer or not.
In contrast, the division argued that since the alien S&D affiliates were not New York taxpayers nor were they federal taxpayers, the alien payments would never have to be added back to taxable income and, therefore, the exceptions do not apply. The court agreed with the division.
The purpose of the statute, the court noted, “was to address a common tax avoidance strategy whereby a corporation transferred its intangible assets to a related corporation and paid a royalty for the use of those intangible assets thereby reducing its taxable earnings in New York.” Excluding royalty payments from IBM’s ENI in this instance did not advance this legislative purpose. The add back and exclusion provisions “work in tandem” to ensure that royalty transactions between related members are taxed only once, and do not escape taxation altogether.
IBM’s interpretation of the statute effectively added words that were not present (i.e., if the payer were a New York taxpayer). Here, IBM could not exclude royalty payments received from its alien affiliates in computing ENI. IBM’s arguments overlooked the fact that the foreign affiliate payments would not be required to added back to federal taxable income because the foreign affiliates were not New York taxpayers, much less U.S. taxpayers, the court said.
Although IBM argued that “resort to legislative history was inappropriate as the statute was clear, courts have recognized that the absence of facial ambiguity is rarely, if ever, conclusive and, where the plain meaning is at variance with legislative purpose, sound principles may require examination of the statute’s legislative history and context,” the court said.
Under the IBM’s interpretation, the royalty income would escape taxation altogether, a result that the legislature surely did not intend. Former Section 208(9)(o)(3) required the related member royalty payer to be a New York taxpayer (and be required to add back the royalty payment) in order for the payee to be qualified for the royalty income exclusion.
This case seems ripe for appeal. The court’s decision to eschew the literal language of what appears to be an unambiguous statute in favor of its legislative history is unorthodox and contrary to accept canons of construction.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.