Mary Bernard
Related Party Addbacks Embraced by States

Intercompany transactions are being closely scrutinized by states in need of revenue to balance their budget.

December 9, 2010
by Mary Bernard, CPA

The Beginning

In an effort to close a perceived loophole in multistate tax planning, South Carolina Supreme Court held in 1993 that licensing intangibles for use in the state by an out of state related intangible holding company created a “substantial nexus” between the state and the holding company. (Under separate company filing rules, affiliated groups could establish a holding company in a no-tax state to license intangibles to related entities, thereby reducing state tax liabilities in high tax states.) Although the holding company had no property or employees in South Carolina, the state felt that the receipt of royalty income from the licensing of intangibles within the state established sufficient connection to subject the holding company to income tax. This “economic nexus” theory encompasses a substantial nexus in the state without any physical presence. (Geoffrey, Inc. v. South Carolina Tax Commission, (313 S.C. 15, 437 SE2d (1993))). 

Ohio was the first state to impose an addback provision in 1991 requiring the addback of intercompany intangible expenses and interest. The statute originally applied only to affiliated groups meeting certain asset, sales, and taxable income limits, but was extended to all corporations beginning with the 1999 tax year. In the last decade or so, an additional 23 states have included addback provisions containing common themes in their law. 

Related Member

The first hurdle in the process of determining the correct state tax adjustment is the determination of who is a related member subject to the addback provision. Although there are similarities among the states, a related member is not defined consistently in all states. Generally, a related member would include 1) a member of a controlled group under Internal Revenue Code (IRC) Section 1563; 2) a person to whom there is an attribution of stock under IRC Section 1563(e); or some other type of related entity who directly, indirectly, or constructively owns 50 percent or more of the stock in the taxpayer. 

New York, however, defines a controlling interest as either 30 percent or more of the combined voting power or beneficial interest in the voting stock of a corporation. Illinois extends the definition to include even entities excluded from the consolidated federal group, such as a member with more than 80 percent business activities outside of the country. Alabama’s addback provision defines a related member to include all entities reported in the federal consolidated group, as well as any disregarded entity or partnership, a majority of whose income is included in the taxpayer’s federal income tax return. 

Types of Addbacks

Generally, the addback provisions were designed for separate company filing states to eliminate the advantage of deducting intercompany expenses. Typically, the following types of transactions are impacted by these provisions:

1. Intangible expenses Royalty fees, licensing fees, costs related to the acquisition, use, maintenance and sale of intangible assets, which include patents, patent applications, trademarks, trade names, copyrights, trade secrets and similar intangible assets.

2. Interest expense Related to an intercompany loan, or related to the acquisition, maintenance, management, ownership, sale, exchange or disposition of intangible property, or any deductible interest expense paid, accrued, or incurred to, or in connection to, one or more related members.

3. Other expenses Intercompany management fees (e.g., Wisconsin and Kentucky); amounts in excess of reasonable rent expense (e.g., Tennessee); factoring or discounting transactions (e.g., Massachusetts); and “other related party transactions” that effectively exceed the cost that would have resulted if the transaction would have been carried out at arm’s length (Kentucky).


As you would expect, there are notable exceptions to the addback provisions which vary greatly by state. Generally, the exceptions fall into three categories:

1. Subject to tax Most states allow a deduction for intercompany expenses if the related payee’s income is subject to tax in a state or foreign country. Some states, like New Jersey, dictate that the effective tax rate paid in that other jurisdiction must fall within 3 percentage points of the rate of tax applied to taxable interest in New Jersey. For international transactions, some states have a treaty exception for transactions with countries with valid treaties in force with the United States. In addition, there may be a distinction that “subject to tax” actually requires the payment of tax on such income. Some additional requirements may be necessary to invoke the treaty exception, such as a valid business purpose, arms’ length rates, and involvement of substantial business activities other than management of intangibles.

2. Conduit payments — Where a member of an affiliated group acts as a conduit to remit payments to a third party on behalf of a related member, many states will allow the deduction if there is clear evidence that tax avoidance was not a motive for the transaction and if arms’ length terms are included.

3. Unreasonable result — There are other exceptions to the addback provisions if the result would be unreasonable if, for example, double taxation would result. Many states are amenable to an alternative adjustment in this type of situation, but additional administrative procedures may be required. In Connecticut certain disclosures are required to request relief and New Jersey requires that the tax be remitted first before a refund can be requested for unreasonable exception relief.


Taxpayers with significant intercompany transactions should be cognizant of the pitfalls multistate taxation can encompass as states continue to search for additional sources of revenue. By adding back otherwise deductible expenses in a group of related entities, separate company filing states can attempt to approximate the same tax effect of states requiring combined filing for affiliated groups through the control of intercompany deductions. 
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Mary F. Bernard, CPA, is director — income/franchise tax, at the Dallas, Texas-headquartered tax services firm of Ryan. Bernard formerly worked as principal, director of State & Local Tax Services, at Providence, RI-basedKahn, Litwin, Renza & Co., Ltd.