A New York administrative law judge held that Kimberly-Clark Corp. and its combined affiliates properly accounted for prepaid royalties in the year they were received, but the group could not exclude foreign affiliates’ royalty payments from its entire net income.
ALJ Nicholas A. Behuniak of the New York Division of Tax Appeals ruled April 15 in Matter of Kimberly-Clark Corp. that Kimberly-Clark must include the foreign royalties when calculating its combined entire net income for purposes of the corporation franchise tax, citing two recent decisions of the New York Tax Appeals Tribunal.
Kimberly-Clark filed amended combined New York corporation franchise tax returns to subtract royalty payments from foreign affiliates amounting to approximately $260 million for tax year 2009, $300 million for tax year 2010, and $560 million for tax year 2011. It also deducted royalty payments from foreign affiliates on its original 2012 tax return.
The New York Division of Taxation audited Kimberly-Clark and concluded that it could not deduct the royalty payments, and adjusted its business allocation percentage by including the payments in the denominator of the receipts factor.
Under N.Y. Tax Law section 208.9(o)(3), a taxpayer could exclude royalty income received from a related member from its entire net income unless the royalty payments were not required to be added back. The exclusion was eliminated for tax years beginning on or after January 1, 2013.
The taxation division concluded that the royalties could not be excluded because the foreign affiliates are not New York taxpayers and, therefore, the royalty payments would not be required to be added back to the affiliates’ federal taxable income.
Kimberly-Clark protested, arguing that the royalty payments could be excluded regardless of whether the affiliates were New York taxpayers, and that the division’s approach violates the federal commerce clause.
The ALJ noted that while this case was pending, the tax tribunal decided in Matter of The Walt Disney Co. and Matter of IBM Corp. that the exclusion for royalty income was not available in situations when the affiliate is not a New York taxpayer and that this approach did not discriminate against foreign commerce.
“The Tribunal noted that both the add back and exclusion provisions were enacted together and that the add back was expressly intended to eliminate a loophole by which a corporation reduced its [entire net income] base by transferring intangible assets to a related corporation and paid a royalty for the use of such assets,” Behuniak wrote.
The judge continued that when “both the royalty payer and payee are New York taxpayers, the add back and income exclusion together simply shift the incidence of tax on the royalties from payee to payer and thereby avoid subjecting the same revenue to franchise tax twice.”
Behuniak noted that Kimberly-Clark did not contend that any of the facts in this case were different from the facts in Disney or IBM, but only claimed that the tribunal’s constitutional analysis in Disney was unreasonable and fundamentally flawed. He concluded that the royalty payments could not be excluded.
Prepaid Royalties
The taxation division also challenged roughly $60 million of the tax year 2011 royalty payments, which represented prepayments of royalties for 2013, arguing that the company could not take advantage of a potential favorable tax treatment available in one year by prepaying royalties for a subsequent year in which the favorable tax treatment would not be available.
Behuniak acknowledged that whether Kimberly-Clark properly accounted for the prepaid royalties for 2013 when they were received in 2011 did not affect its tax liability, but he addressed the issue to provide a complete record for consideration on appeal.
Noting that the license agreements allowed for royalties to be prepaid, the judge added that New York generally follows federal tax law regarding the year that income is recognized, and that it appeared irrelevant whether the taxpayer filed on a cash or accrual basis.
The ALJ stated that the U.S. Tax Court in Joyner Family Limited Partnership v. Commissioner, held that IRC section 451(a) requires taxpayers to include amounts in income for the year they are received unless the amounts would be properly accounted for in a different period under the taxpayer’s method of accounting. Therefore, he ruled, Kimberly-Clark correctly accounted for the prepaid royalties as income in 2011, the year in which they were received.
The taxpayers in Matter of Kimberly-Clark Corp. (DTA No. 828259) were represented by attorneys from Pillsbury Winthrop Shaw Pittman LLP.