Earlier this year, the Tennessee Department of Revenue released several 2012 revenue and letter rulings1 addressing a variety of franchise and excise (income) tax questions. In particular, the Department discussed the rules with respect to a not-for-profit's franchise and excise tax liability. In addition, the Department ruled that an out-of-state intangible holding company's licensing agreement with an out-of-state affiliated company was not sufficient to create Tennessee franchise or excise tax nexus, and that accounts receivable was not an "intangible expense" subject to the related-party expense addback rules for excise tax purposes.
"Not-for-Profit" LLC Subject to Franchise and Excise Tax to Limited Extent
The Department issued a letter ruling addressing the applicability of the franchise and excise taxes to a "not-for-profit" limited liability company (LLC) doing business in Tennessee.2 The LLC's sole indirect owner was a non-corporate government plan, and since the government plan owned the LLC through a series of disregarded entities, the LLC was treated as a disregarded entity for federal income tax purposes. Although an LLC doing business in Tennessee is generally subject to the state's franchise or excise tax, including a single member LLC that is not owned by a corporation, the Department found that the taxpayer qualified for an exclusion based on its "not-for-profit" status. In determining that the taxpayer qualified as a "not-for-profit," the Department gave weight to the fact that the taxpayer was a disregarded entity for federal income tax purposes, and as such, treated as a division of a member trust or organization classified as an IRC Sec. 401(a) governmental retirement savings plan.3
In spite of the general applicability of the "not-for-profit entity" exclusion from franchise and excise taxation, the Department cautioned that the taxpayer would be subject to excise tax to the extent its net earnings constituted unrelated business taxable income under IRC Sec. 5124 or are otherwise subject to income tax under Subchapter A of the IRC.5 In addition, excise tax would apply to any net earnings attributable to activities unrelated to or outside the scope of activities that give the taxpayer its exempt status. The taxpayer would be subject to franchise tax with respect to its net worth, or property (both real and tangible) owned or used, which is attributable to activities subject to income tax under IRC Sec. 512 or any other provision of Subchapter A of the IRC. Finally, franchise tax would apply to all of the taxpayer's net worth, or property (both real and tangible) owned or used, that is attributable to unrelated activities outside the scope of the activities giving the taxpayer its exempt status.
Out-of-State Intangible Holding Company Lacks Nexus
In a revenue ruling, the Department adopted the position that an out-of-state intangible holding company's licensing agreement with an affiliated entity, another out-of-state company shipping products into the state through a partnership in which the affiliated entity had a minimal ownership interest, did not by itself create Tennessee franchise or excise tax nexus.6 Where the out-of-state licensor's sole connection to the state is its outof- state licensee's eventual sale and delivery of items (manufactured outside the state and using the licensor's patents) into the state, the out-of-state licensor is not deemed to be "doing business in Tennessee." The Department noted that the licensing company did not specifically solicit licensing opportunities in Tennessee. The fact that the royalties paid to the licensor were based on a percentage of the licensee's sales, some of which are distributed within Tennessee, did not change this conclusion.
Accounts Receivable Discounts Are Not Considered Intangible Expenses for Purposes of Related-Party Expense Addback
The Department examined the treatment of a discount charged on a taxpayer's trade accounts receivable, specifically whether such discount could be characterized as an intangible expense for purposes of the Tennessee related-party expense addback rules.7
The taxpayer had established a subsidiary to which it contributed a stock of accounts receivable, originating in the normal course of the taxpayer's business or sales of its products, to serve as collateral for a line of credit. Through a factoring arrangement, the subsidiary periodically purchased additional accounts receivable at a discount with the cash it received from existing receivables. The issue before the Department was whether the discount charged could be considered an intangible expense paid to an affiliated entity.
Under current Tennessee law, "[a]ny intangible expense, or portion thereof, that is paid, accrued or incurred in connection with a transaction with one (1) or more affiliates" is required to be added to the taxpayer's net earnings or losses on the taxpayer's franchise and excise tax return, and then these expenses can be subsequently deducted on the same return if the taxpayer obtained approval to take the deduction and the determination was made that the expense did not have as its principal purpose the avoidance of excise tax.8 In order for an expense to qualify as an "intangible expense," the Department stated that the expense must be related to a disposition of "intangible property."9 In looking at the definition of "intangible property," the Department concluded that the accounts receivable to which the discount related did not qualify because such items are not considered to be "patents, patent applications, trade names, trademarks, service marks, franchise rights, copyrights, licenses, research, formula, designs, patterns, processes, formats, or similar types of intangible assets."10 Therefore, the discount charged was not an intangible expense subject to the related-party expense addback rules.
Commentary
The Tennessee Department of Revenue's ruling on the applicability of franchise and excise taxes to a not-for-profit entity serves as a reminder that this type of entity may be subject to tax if it has unrelated business taxable income. As explained by the Department, not-for-profit entities may be required to pay both the Tennessee franchise tax and excise tax.
The ruling on the intangible holding company's nexus question seems to go against the general trend of states following an economic nexus approach. In this ruling, the Department follows the position adopted by both the Oklahoma and West Virginia supreme courts earlier last year, that an out-of-state licensor whose only connection to the state is limited to a licensing arrangement with another out-of-state entity does not have franchise, excise or corporate income tax nexus.11 It should be noted that in the Department's ruling, the entity that ultimately entered the Tennessee market was a partnership minimally related to the out-of-state licensor and licensee. Query whether the result would have changed if the relationship between the partnership and the licensor and licensee was more direct.
With respect to the applicability of related-party expense addbacks arising from transactions involving intangibles, taxpayers should be aware of the legislation requiring that for tax years ending on or after July 1, 2012, an application to the Commissioner for approval of these deductions is required to be made.12 While the new legislation expanded the definition of "intangible expenses" to include certain interest expenses, the definition does not encompass charges relating to all types of intangibles. Given the new procedure for allowing these types of deductions, it is not surprising that the Department already has addressed a situation that potentially could have implicated the use of these rules in the form of a ruling.
Footnotes
1 Note that letter rulings are binding on the Department only with respect to the taxpayer being addressed in the ruling, whereas revenue rulings are merely advisory in nature and not binding on the Department, even with respect to the taxpayer being addressed in the ruling.
2 Letter Ruling No. 12-26, Tennessee Department of Revenue, Nov. 14, 2012, released Jan. 8, 2013.
3 Treas. Reg. § 301.7701-2(a) treats such a disregarded taxpayer as a division of its owner for federal income tax purposes. In addition, TENN. CODE ANN. § 67-4-2004(33) defines "not-for-profit" as "any person described in Sections 401 ... 501 ... of the Internal Revenue Code." IRC § 501(a) exempts from federal income taxation an organization described in IRC § 401(a).
4 Under IRC § 512(a)(1), "unrelated business taxable income" means the gross income derived by any organization from any unrelated trade or business regularly carried on by it less certain deductions and modifications, if applicable.
5 Subchapter A addresses the determination of tax liability for Chapter 1 Normal Taxes and Surtaxes (i.e. tax on individuals, tax on corporations, etc.).
6 Revenue Ruling No. 12-27, Tennessee Department of Revenue, Nov. 14, 2012, released Jan. 8, 2013.
7 Letter Ruling No. 12-32, Tennessee Department of Revenue, Dec. 19, 2012, released Jan. 8, 2013.
8 TENN. CODE ANN. § 67-4-2006(b)(1)(K); Franchise and Excise Tax Notice No. 12-16, Tennessee Department of Revenue, Oct. 2012.
9 The Department relied on the definition of "intangible expense" in TENN. CODE ANN. § 67-4-2004(23)(A).
10 TENN. CODE ANN. § 67-4-2004(25).
11 See In re Scioto Insurance Co., 279 P.3d 782 (Okla. 2012); Tax Commissioner v. ConAgra Brands, Inc., 728 S.E.2d 74 (W. Va. 2012).
12 Ch. 842 (H.B. 2372), Laws 2012. For more information on the 2012 legislation, please see GT Alert: Tennessee Enacts Legislation Impacting Related-Party Addback Rules and Net Worth Group Membership, June 1, 2012.
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