NJ: Tax Court Rules in Taxpayer’s Favor in Addback Dispute

In a decision certified for publication, the New Jersey Tax Court recently addressed whether a taxpayer was entitled to a refund of Corporation Business Tax (CBT) when its subsidiary filed CBT returns and paid CBT on its royalty income.  The requested refund was based on the taxpayer deducting the full amount of the royalties paid to the subsidiary. Under New Jersey law, royalties and other intangible expenses paid to a related party are required to be added back in determining taxable income. There are various statutory exceptions to the addback requirement, including situations in which requiring the addback would be “unreasonable.”  A regulation provides that a deduction will be permitted if the taxpayer establishes that the adjustments are unreasonable by showing “the extent that the payee pays tax to New Jersey on the income stream.”  The New Jersey tax return form for computing the addback amount (Schedule G-2), which is not incorporated into the regulation, provides that unless the royalty recipient pays CBT on the entire royalty deduction amount, the royalty payor will not receive a full deduction for the royalty payment. In the instant case, the subsidiary’s reported royalty income closely matched the taxpayer’s royalty deductions. However, because the parties’ had different apportionment percentages (the subsidiary had a lower apportionment percentage), the Division of Taxation allowed only a partial deduction for the royalties. The taxpayer appealed to the tax court, arguing that it was entitled to full deduction.

The tax court, after reviewing the legislative history of the addback statute, noted that the legislature was concerned with income shifting and exporting income tax-free out of New Jersey. It was undisputed that in the case at hand, the subsidiary filed returns and paid CBT on its royalty income and the income and deduction amounts were similar. Thus, court observed that the legislative concerns about shifting income should “conceivably be allayed.”  The alleged mismatch arose solely because the subsidiary and the taxpayer had differing apportionment factors, which, in the court’s view, was entirely expected given that each entity is treated as a separate and distinct entity under New Jersey’s separate reporting regime. Consequently, the tax court rejected the Division’s position that the addback statute’s goal was frustrated because the subsidiary’s royalty income did not match the taxpayer’s royalty deduction due to the difference in their respective apportionment factors. Absent any evidence that the subsidiary’s apportionment factor did not fairly represent its income attributed to New Jersey, the court concluded that the Division should allow the taxpayer to deduct the full royalty payment and issue the remainder of the taxpayer’s claimed refunds. Please contact Jim Venere at 973-912-6349 with questions on Lorillard Tobacco Company v. Division of Taxation.