INSIGHT: Lorillard Escapes New Jersey Add-Back of Royalty Expense

Lorillard Tobacco Co. didn’t owe New Jersey corporation business tax on royalties paid to a subsidiary, because the subsidiary had already paid tax on the royalties.

The New Jersey Division of Taxation did not exercise its discretion fairly by deeming only a portion of the royalties as excepted from the requirement to add back those payments into Lorillard’s net income, the New Jersey Tax Court ruled in Lorillard Tobacco Co. v. Director, Div. of Taxation, No. 008305-2007 (N.J. Tax Ct. 2/27/19).

Lorillard was a Delaware corporation that manufactured, marketed, distributed, and sold cigarettes throughout the U.S. Prior to being acquired by Reynolds American Inc. in 2015, Lorillard maintained its headquartered in North Carolina. Lorillard Subsidiary Co. was organized under the laws of North Carolina in November 1999. After the subsidiary was created, Lorillard assigned all of its intellectual property (IP) to the subsidiary. Lorillard and the subsidiary then entered into a license agreement. Therein, the subsidiary, as the sole owner of the IP, granted Lorillard the right to use the same in Lorillard’s business. Lorillard was obligated to pay to the subsidiary a royalty in the amount of 13 percent of its monthly net sales.

For tax years 2002-2005, Lorillard deducted nearly $2 billion in royalty payments. Pursuant to N.J. Statute Section 54:10A-4.4(b), Lorillard added back those payments to entire net income (ENI) for each tax year. Lorillard then calculated its New Jersey corporation business tax (CBT) based upon a percentage of its ENI allocable to New Jersey, which was based on the ratio of its property, payroll, and sales receipts in New Jersey to those same factors everywhere, and then averaged.

In 2006, the New Jersey Division of Taxation assessed the subsidiary for tax years 1999-2004. After the division assessed the subsidiary, Lorillard promptly filed refund claims for tax years 2002-2005. Lorillard claimed “it would be improper, unreasonable and unconstitutional” to deny it a deduction if “at the same time,” New Jersey subjected the subsidiary “to tax on such amounts.” Only a portion of the requested refund was granted by the division. Lorillard sought the balance of the requested refund in the New Jersey Tax Court.

Matching Allocation Factors

Section 54:10-A-4.4(a) defines “intangible expenses” as including “royalty...fees.” Subsection (b), the so-called “royalty add-back statute,” then provides that: “For purposes of computing its ENI...a taxpayer shall add back otherwise deductible...intangible expenses and costs directly and indirectly paid, accrued or incurred to...one or more related members (emphasis added).”

However, the add-back adjustments shall not apply if the taxpayer establishes that the adjustments are unreasonable. See Section 54:10A-4.4(c)(1)(b), the so-called “royalty U-E-T-A statute.” The division’s regulations reiterate the royalty add-back statute. They provide that “a deduction shall be permitted...if the taxpayer establishes that the adjustments are unreasonable by showing the extent that the payee pays tax to New Jersey on the income stream.” See N.J. Administrative Code Section 18:7-518(b)(3), the “royalty U-E-T-A regulation.”

Lorillard argued that the royalty add-back statute, together with the royalty U-E-T-A statute, shows that the exception to the add-back is an all-or-nothing proposition. It argued that, as a matter of pure statutory interpretation, no deference is required to the division’s determination. The court was not willing to go quite that far. It rejected Lorillard’s “overly broad” argument that an interpretation of the royalty U-E-T-A statute is always a pure legal exercise and the court need not afford any deference to the division. Rather, the division “is not limited in its authority to use discretion for achieving a fair measure of justice.”

The purpose, the court noted, of the royalty U-E-T-A regulation is avoidance of double taxation. “It cannot be credibly argued that allowing relief from dual taxation is an invalid exercise of the division’s discretion,” the court said. The regulation states that “an add-back is not required ‘to the extent that the payee pays tax to New Jersey on the income stream.’ While the phrase ‘on the income stream’ is undefined, the allusion in the regulatory history to the terms, ‘same income stream,’ and ‘corresponding deduction,’ would seemingly mean that the royalty expense deduction” of the paying entity should generate a corresponding royalty income in the same amount to the payee.

There is nothing in the royalty U-E-T-A regulation to indicate that even if the amounts reported by each are identical, the add-back would only be partial. Rather, the plain language of the regulation indicates that as long as the royalty recipient pays CBT to New Jersey on the royalty income, the case here, an add-back is not required for the paying entity. It is only after completion of the computation on Schedule G-2 (which is neither incorporated into or referenced in the regulation) is it known that unless the royalty recipient pays 9 percent CBT on the entire royalty deduction amount, the paying entity will not receive a full deduction for the same, the court said.

The legislative intent behind the add-back rule was to prevent “income shifting” and “tax avoidance.” Where, as here, the out-of-state related member and royalty recipient admitted to New Jersey’s jurisdiction, filed CBT returns, and reported royalty income that corresponded to the amount claimed by Lorillard as a deduction, the loophole closure was achieved. It is undisputed that the subsidiary reported as its ENI all of the royalty payments claimed as a deduction by Lorillard for each tax year. The subsidiary paid CBT on the royalty income allocated to New Jersey. “At this point, then, the legislative concerns of income shifting, or exporting income tax-free out of New Jersey, should conceivably be allayed,” the court said.

The alleged mismatch of the royalty expense versus royalty income arose solely due to differing allocation factors of Lorillard and the subsidiary, respectively. Here, however, the subsidiary complied with the requirements of separate reporting by filing its own CBT returns, and paying CBT, and using its own allocation factor. Under such a circumstance, the division could not, without more, credibly maintain that Lorillard’s and the subsidiary’s allocation factor should be the same for Lorillard to obtain a deduction of the full amount of royalties paid. The division’s claim that the legislative goal is frustrated because the subsidiary’s allocated royalty income does not match Lorillard’s royalty deduction solely due to the difference in their respective allocation factors is not persuasive grounds for requiring a portion of the royalty deduction to be added back.

In the absence of any allegations that the subsidiary’s allocation factor did not properly represent its allocable income to New Jersey, “the court is hard pressed to accept the division’s argument that there was a mismatch of income and expense solely due to the difference in the unchallenged allocation factors of Lorillard and the subsidiary,” the court said.

Therefore, the court concluded, the division did not exercise its discretion (which the court, remember, was willing to afford it) fairly by deeming only a portion of the royalties paid by Lorillard to the subsidiary as excepted from add-back. Accordingly, the court granted summary judgment to Lorillard and ordered the division to remit to Lorillard the remainder of its requested refund claims for tax years 2002-2005, with the statutorily permitted interest.

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.