UT: Federal section 482 Regulations Apply In Interpreting State Discretionary Authority Statute

The Utah Supreme Court recently affirmed a district court decision holding that Utah’s discretionary authority statute.

Podcast Transcript

The Utah Supreme Court recently affirmed a district court decision holding that Utah’s discretionary authority statute (allowing the taxing authority to allocate income, deductions, etc. among affiliated entities to clearly reflect income), which is almost identical to IRC § 482, must be interpreted by applying the federal IRC § 482 regulations. The taxpayer at issue, a unitary business engaged in manufacturing and selling candy, sold its intellectual property (IP) to a related insurance company in exchange for stock in a tax-free transaction. After the sale, the insurance company licensed the IP back to the taxpayer at a rate that, per a transfer pricing study prepared by an accounting firm, would be paid by an unrelated party. The insurance company holding the IP was not included in the taxpayer’s unitary corporate income tax returns for the tax years at issue (1999 to 2007). The taxpayer deducted royalties paid to the insurance subsidiary for the tax years at issue, which served to reduce its Utah tax liability. The insurance subsidiary did not pay tax on the royalty income, as it paid tax in Utah only on premiums received. The taxpayer was audited by the Multistate Tax Commission for earlier tax years (1995 to 1998), and the royalty deduction was eventually accepted with a ten percent reduction. 

The Utah Tax Commission (Commission) subsequently audited the taxpayer for the tax years at issue and invoked its discretionary authority statute to disallow the royalty deductions entirely. The taxpayer protested the adjustment, and the Commission upheld the assessment, finding that its discretionary authority to allocate income and deductions were not required to adhere to an arm’s length standard and stood apart from IRC § 482. Before the trial court, the primary issue was whether the Utah Legislature incorporated the intent and effect of federal law and regulations involved in IRC § 482 when it adopted the discretionary authority statute, which was substantially similar to IRC § 482. If it did, the taxpayer would prevail, as the regulations supported the taxpayer’s royalty deduction. The trial court, in a lengthy opinion, concluded that “notwithstanding” the strength of the Commission’s case, the Commission’s discretion was intended to be limited by the federal authorities. The Commission subsequently appealed.

On appeal, Utah’s highest court first concluded that the language of the discretionary authority statute was ambiguous because it did not “plainly speak” about when it is “necessary” for the Commission to intervene to allocate income and deductions and what “clearly to reflect” income means. Because the statutory language was ambiguous, the court was required to look to legislative history to determine what the legislature intended when it enacted the statute.  In the Commission’s view, the lack of a citation to IRC § 482 or a reference to the federal regulations evidenced that the Utah Legislature did not intend to incorporate the federal provisions into Utah’s law. As support for this position, the Commission cited to a number of instances when Utah adopted federal provisions by specific reference. The court, however, noted that the provisions cited by the Commission were definitions, rather than operational provisions. The taxpayer argued, in contrast, that by adopting almost identical language to IRC § 482, the legislature intended to adopt the federal interpretations. The court, after reviewing the history of the enactment of § 482 and the Utah equivalent, concluded that the use of similar language indicated a legislative intent to adopt not just the language of a federal statute, but to also adopt the accompanying “cluster of ideas.” In the court’s view, this “dovetailed” with the approaches other states have employed. Accordingly, the court concluded that absent evidence of a contrary legislative intent, when the Utah legislature copies a federal statute, federal interpretations of the statute constitute persuasive authority as to the statute’s meaning. Having reached this determination, the court concluded the district court properly applied the federal authorities to reach its conclusion that the Commission was prevented from exercising its discretionary authority because the transactions were at arm’s length. Please contact Michael Larkin at 801-237-1335 with questions on Utah Tax Commission v. See’s Candies. 

To view past weeks of TWIST that you may have missed, please visit our TWIST homepage.

To receive the TWIST e-mail each Monday, make sure that State and Local Tax is checked off as one of your topics of interest on the KPMG Tax subscription site.