James F. McDonough
September 21, 2012
Businesses seek to reduce costs in an effort to improve profitability and taxes are a cost. Auto companies establish plants in states where there are no unions and property taxes are less in an effort to reduce labor costs and overhead. Despite these efforts, a business will sell its products in states where tax corporate income tax rates are high, such as California, New York and New Jersey. Businesses seek to reduce taxable income earned in high-tax states through the payment of fees paid to affiliates located in low or no-tax states such as Nevada. The discussion of one such technique follows.
Businesses with multi-state operations establish a holding company in a low-tax jurisdiction to own patents, know-how, trademarks and service marks (hereinafter “Intangibles”). The holding company leases the right to use the Intangibles to operating subsidiaries in high tax states in exchange for a royalty payment. The royalty payment reduces income subject to tax in the high-tax state. This technique worked because a taxpayer must have a physical presence (Nexus”) in the state before that state’s income tax could be imposed.
The concept of Nexus evolved in the 1990s as states fought back and enacted laws that changed the definition of Nexus. In 2003, Lanco
was decided and held that the use of intangibles in New Jersey was a sufficient Nexus to give the state the right to tax the royalty payments notwithstanding that the licensor had no physical presence in the state. Taxpayers have been unsuccessful in their efforts to overturn the holding in Lanco
in the cases that followed.
The New Jersey Division of Taxation
has issued a notice whereby it is seeking to make it easier for taxpayers to come into compliance with current law. Taxpayers with this issue are being offered an opportunity to come forward and incur reduced penalties. The Division will waive all penalties except a 5% amnesty penalty. The Voluntary Disclosure Program will look back to tax years beginning after December 31, 2003 or the date business commenced if later. This is a considerable benefit to taxpayers because Lanco
tax years as far back as 1997. The state is also willing to consider reaching a settlement on the application of the ‘throw-out” rule, which has been repealed. Taxpayers seeking to make Voluntary Disclosure of Intangibles are not required to reach agreement on the application of the throw-out rule.
The Voluntary Disclosure Program represents an opportunity for taxpayers to avoid most penalties and eliminate audit risk for years before 2004. Taxpayers should act before the expiration of the program on January 15, 2013.