Alternative Apportionment Disallowed in Indiana

Alternative Apportionment Disallowed in Indiana

The Indiana Department of Revenue (“Department”) sustained a taxpayer’s protest of an audit proposal requiring the taxpayer, an automobile manufacturer that filed a consolidated return with two other entities, to use an alternative apportionment method and to add back royalty expenses in order to fairly reflect Indiana-source income for corporation income tax purposes. [See Letter of Findings No. 02-20130215, Indiana Department of Revenue, October 30, 2013.]

The audit concluded that the standard method of apportioning income did not fairly reflect the taxpayer’s Indiana-source income. The audit determined that the losses were produced almost entirely outside of Indiana by an affiliate and eliminated income that was produced entirely in Indiana by the taxpayer under the standard method of apportionment. The audit took the position that the combination of dissimilar Indiana activity levels and income under the standard method of apportionment did not fairly represent the consolidated group’s income derived from sources within Indiana.

The taxpayer argued that, as a consolidated group, the taxpayer and the affiliate had positive Indiana taxable income during 2008 and 2010, that the taxpayer experienced losses in its 2009 returns, while the affiliate had Indiana taxable income in its 2005 and 2006 returns. The taxpayer also argued that the department’s audit placed too much weight on the disparities between the affiliate and the taxpayer's property and payroll factors.

The taxpayer was able to establish that the affiliate had more significant contacts with Indiana than the department first understood. In these particular circumstances and for these particular years, the audit failed to demonstrate that it was necessary to depart from the standard apportionment formula.

Further, the audit incorrectly required the taxpayer to add back royalty expenses. In the audit, the department found that the taxpayer paid multi-million-dollar royalties each year to a related corporation, which had the effect of distorting the taxpayer’s Indiana-source income. The taxpayer presented documentation establishing that:

  1. the related corporation acquired the intangible property pursuant to agreements under which the corporation made payments totaling $10,460,000 to acquire certain rights to that intellectual property;
  2. an independent assessment was made to arrive at that purchase price; and
  3. the price paid for the property was commensurate with the income produced by the property.

The taxpayer admitted that it experienced federal and Indiana losses during the audited years and that the royalty fees increased the amount of losses. However, the royalty fees were not sufficient enough to change the taxpayer from a profit or a loss position in any year. Therefore, the Department concluded that:

  • the taxpayer met its burden of proof of establishing that these specific royalty payments did not significantly change its financial results;
  • the royalty payments were commensurate with the value of the intellectual property;
  • the particular payments to and from the corporation did not constitute an abusive intercompany circular flow of money that had no commercial business purpose; and
  • the money earned from licensing the intellectual property was legitimately administered pursuant to the parent company's centralized cash management process.

Taxpayers should be refreshed to see a state tax department reach what appears to be a result based on the law and not one driven by the outcome, and in light of this decision, Indiana taxpayers and tax advisors should review their own apportionment method and treatment of inter-company royalty expenses for any possible tax planning opportunities.

LEXIS users can view Letter of Findings No. 02-20130215 replicated in "Indiana DOR: Company and Affiliates Entitled to Standard Apportionment Formula," taxanalysts® State Tax Today, November 1, 2013.

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