Utah has enacted a statutory remedy in response to the tax commission’s recent loss at the state high court in the See’s Candies transfer pricing litigation.
H.B. 268 — a tax and fee cleanup bill signed into law in March — contains an intercompany royalty addback provision requested by the Utah State Tax Commission after the measure reached the Senate. The newly enacted language requires corporate taxpayers to add back to unadjusted income any deduction for royalties or other fees paid to a captive insurance company for the license of intangibles.
The targeted legislative response has caused some initial confusion because it addresses neither the narrow fact pattern at issue in Utah State Tax Commission v. See’s Candies Inc. nor the standards and methods the tax commission uses when applying its discretionary authority to reallocate income under Utah Code Annotated section 59-7-113. The correct interpretation of that section, which is similar to IRC section 482, was the primary issue in the case.
“The See’s case did not involve a captive insurance company, so it is unaffected by the bill,” said Steven Young of Holland & Hart LLP, one of the lawyers who represented See’s Candies at the Utah Supreme Court. In an email to Tax Notes, Young — who worked on the legislative language with the Utah State Tax Commission — added that the state supreme court and district court both said that the case involved an arm’s-length ordinary and necessary business expense with economic substance and business purpose.
“That being said, there were some in Utah who felt taxpayers may be able to use the See’s case as a roadmap to easily create a captive insurance company and easily decrease Utah state tax,” Young said. “The legislation was drafted to prevent this, without being so broad as to create collateral damage by disallowing arm’s-length ordinary and necessary business expenses with economic substance and business purpose.”
Closes 'Loophole’
See’s Candies involved two wholly owned subsidiaries of Warren Buffet’s Berkshire Hathaway Inc. conglomerate. See’s Candies, a Utah retailer, sold its intellectual property — the See’s Candies trade name — to Columbia Insurance Co. in exchange for stock, then made royalty payments to the insurance company to license back the use of the name. Insurance companies are not subject to Utah franchise tax; they pay a tax on premiums. See’s Candies deducted its royalty payments to the insurance company, reducing See’s Utah corporate franchise tax by 82 percent per year for 1999 through 2007.
The Utah State Tax Commission disallowed the deduction under section 59-17-113. In 2016 a Utah district court found that the tax commission abused its discretion when it denied the full deduction “based on a classification of the transaction as per se outside of arm’s length rather than analyze it under federal standards the Legislature impliedly incorporated in the statutory scheme surrounding section 59-7-113.” After reviewing the transfer pricing study and unrebutted testimony regarding the business purpose of the transactions, the district court found the transfer to be at arm’s length.
In October 2018 the Utah Supreme Court concluded that the lower court had correctly determined that the tax commission must look to IRC section 482 and its accompanying regulations when applying the state’s code section.
“The Legislature did not like the result in the case,” said John Valentine, chair of the Utah State Tax Commission, in April 25 comments at the Multistate Tax Commission’s spring committee meetings.
Valentine said See’s Candies was paying the insurance company an initial 18 percent of its net domestic sales in exchange for the right to use the trade name, “which we thought was just outlandish.” The net payment wound up being 16.5 percent of the net domestic sales of See’s Candies, because the insurance company was paying See’s 1.5 percent of the royalties for maintaining and protecting the trade name. The district court reduced See's deduction by 10 percent, based on the lowest royalty rate in the transfer pricing study.
“We went to the Legislature, and the Legislature said no, we don’t want that result, that’s not what we intended,” Valentine said. “We intended that the statute that you used to be used to avoid these kinds of situations.”
Valentine then described the new addback for any royalties paid to a captive insurance company for the license of intangibles. “So, they basically just overturned the supreme court’s decision by statute,” he said.
University of Connecticut law professor Richard Pomp, who served as an expert witness in the case for See’s Candies, disagreed.
“In See’s, the royalties were paid to Columbia Insurance. Columbia is not a captive insurance company,” Pomp said. “If the statute was meant to overturn See’s it fails. The better fix would be to tax insurance companies on income from Utah sources.”
During the legislative process, Valentine told state lawmakers that See’s Candies was more complicated and involved significant additional issues not addressed in the targeted legislative response, but that the new statutory language “closes the potential for this to be used as a loophole” in some transfers involving captive insurance companies.
Rep. Steve Waldrip (R), the measure’s chief sponsor, said during a February committee hearing that Utah in 2008 and 2010 similarly closed down the ability to avoid state taxes through some transfers involving nontaxable real estate investment trusts and foreign operating companies, respectively.
“This is sort of the third step in that as people find creative ways to avoid state taxes,” Waldrip said.
No state lawmaker voted against the measure after the fiscal note for the royalty addback provision estimated that it would generate an additional $1 million annually for the state education fund.
Holding Intact
Valentine last fall said the Utah State Tax Commission might seek legislation following the See’s Candies decision. At that time, he did not indicate whether the commission would seek clarification of its discretionary authority or targeted legislation addressing a specific type of intercompany transfer. Valentine said then that three similar transfer pricing cases were pending on the tax commission’s appeals docket, and that more were in the audit process; he did not indicate how many of those involve captive insurance companies specifically.
Clark Calhoun of Alston & Bird LLP, whose firm is representing Trader Joe’s in a transfer pricing dispute pending at the Georgia Tax Tribunal, said that because the new addback provision applies to tax years beginning on or after January 1, 2019, taxpayers with similar transactions should have received the full benefit of the taxpayer’s victory in See’s Candies for years before 2019.
“Furthermore, this legislative change in no way undermines the principal holding of the case, which is that the Utah State Tax Commission was not permitted to apply its discretionary authority without being tethered to a set of guidelines that the agency and a reviewing court can apply in a reasonable, consistent way,” Calhoun said.
Young, meanwhile, said that in his view, broader legislative language would not have been a good idea.
“The See’s case is a good example of how taxpayers engage in legitimate business transactions of this nature, for legitimate business reasons. The government should not be in the business of second-guessing legitimate private sector decisions,” Young said.
In See’s Candies, the government challenged the business decision “solely because See’s income decreased,” Young said. “This happens often where businesses make legitimate decisions that decrease income — including short-term investments made to produce long-term results,” he added.
Young provided the example of high-tech companies, which often do not make a profit before going public. This is considered valuable in the market, he said, whereas early income is a sign that high-tech companies are not investing enough back into their business. “It would be wrong for the government to assess a high-tech company in the early years for making legitimate business decisions, even though those decisions decreased income and even generated” a net operating loss, he said.
“The same thing happens with capital investments in production facilities, or in investments like See’s made,” Young said. “These are private sector decisions made for good and valid business reasons, and the government should not second-guess those decisions.”