2013 - Issue 1—Background
There are many reasons for changes in a taxpayer’s organizational structure. An acquisition or divestiture, for example, can result in considerable changes to the structure of a taxpayer’s organization chart. Changes to a taxpayer’s trade or business operations (such as changes in a company’s supply chain footprint) can also result in a new intercompany structure.
Typically, corporate tax departments get involved in analyzing various structuring alternatives to suggest structures that, all other things being equal, result in the most efficient federal and state tax results.
Specifically, with respect to state taxes, intercompany changes can have a dramatic effect on the resulting overall state income tax. For example, intercompany transactions are recognized and have state income tax effects in separate filing states (i.e., states that do not allow or require combined or consolidated reporting). Furthermore, even in combined or consolidated states, depending on the type of entity involved, intercompany changes and transactions can affect the group’s tax liability. For example, captive insurance companies and real estate investment trusts may not be allowed to file together with the rest of the combined or consolidated group in certain states. Accordingly, transactions between these types of entities and the rest of the group may have profound state income tax effects in both separate filing and combined or consolidated filing states.
However, even the most well-designed and best-implemented structures run the risk of failing dramatically if the structure is not properly maintained. As a result, there can be tremendous state income tax assessment risks in such circumstances.
This article analyzes common pitfalls in the maintenance of entity structuring and suggests action steps to help lower the chances of unfavorable audit adjustments when such structures are examined by state taxing authorities.
Entity Structuring — Step by Step
Most structures are implemented using a combination of the following four steps:
- Evaluating the various structuring alternatives;
- Selecting the optimal structure and designing the detailed structure;
- Implementing the structure; and
- Maintaining the structure
As stated above, this analysis focuses on the maintenance of structures (step four, above). However, before a detailed analysis of step four is performed, a few brief comments on step three are offered.
Generally, when any structure is implemented, common action steps include:
- Creation of the actual structure itself (including creating new required legal entities or liquidating old, unnecessary entities), obtaining the necessary board approvals to create the structure, legally incorporating the entities, and taking other steps necessary to create the actual intercompany structure;
- The movement of assets or employees into or out of the new entities (including the necessary board approvals and contribution agreements for assets, and the review of any HR-related issues surrounding the transfer of employees);
- The creation of intercompany agreements between the new entities and the rest of the group (including intercompany sales agreements, intercompany services agreements, intercompany licensing agreements, intercompany financing agreements, tax-sharing agreements, etc.). A very important component of crafting such agreements is ensuring that a transfer pricing analysis is conducted to ensure compliance with Internal Revenue Code Section 482 and related state statutes.
However, the Best Intentions…
In reality, the maintenance of intercompany structures is arguably the most important step of any of the four described above. However, maintenance probably receives less attention than any of the other steps. This is understandable; after the effort of the structure design and implementation ends, structure issues are generally no longer high on the tax department’s priority list. Many tax departments are very lean and have no shortage of immediately pressing responsibilities. The periodic evaluation and maintenance of intercompany structures can naturally slip down the to-do list, especially as time passes since the implementation.
However, it is critical that the structure be regularly reviewed. State taxing authorities do not audit an intercompany structure at the time of its implementation; rather, any state examination of the structure will occur later (often much later). Therefore, it is crucial to understand what has happened with the structure between the time of implementation and the time it is potentially examined by state taxing authorities.
Potential Problem Areas
When auditing intercompany structures, most state taxing authorities attempt to go beyond the formation documents to try to understand how the structure is actually working. Thus, it is critical that the structure, in operation, follow the operating plan that was conceived at the time of formation. Following is a discussion of three major areas where states generally focus on post-implementation structures.
- Structural integrity — One of the first areas of inquiry for a state taxing authority is how thoroughly the substance of the contemplated legal structure is being followed. In other words, even if the entities are properly incorporated, registered with various secretaries of state, etc., a typical audit will go beyond such implementation documents and examine whether or not the separate entities are being reflected as such in the detailed books and records of the company.
In its simplest form, an auditor might ask for separate financial statements for each legal entity. If the taxpayer is unable to produce contemporaneous income statements or balance sheets on a per entity basis, the auditor may be skeptical of whether or not each separate legal entity is a “real” entity. Additionally, an auditor may focus on whether or not assets transferred to the entities are properly titled by the new entity or whether employees transferred to the new entities are properly reflected in the books and records (including the payroll records) of the new entity.
It is generally not enough to just show the auditor formation documents and original asset and employee transfer documents. Most auditors will want to understand that the entity structure as contemplated at implementation is actually in existence and is reflected in the company’s books and records (financial and otherwise). The inability to demonstrate such structural substance after formation can lead to an auditor attempting to disregard the new entity structure.
- Intercompany operations — Normally, at formation, intercompany agreements are created to govern business transactions between members of the group. Typically, these agreements can be intercompany purchase and sale agreements, intercompany financing agreements, intercompany services agreements or intercompany licensing agreements. Of course, there are state income tax consequences with some of these types of arrangements (for example, the disallowance of intercompany royalty or interest payments among members of a common group in certain states); presumably, any such consequences are analyzed during the structure’s implementation. Further, as stated above, it is also important that the transfer pricing implications of such agreements are analyzed at implementation.
Upon any examination of an intercompany structure, it is critical that these agreements be retained, updated as necessary and followed in practice. In an examination by state taxing authorities, usually an auditor will ask for documentation that the intercompany agreements are being followed. Many intercompany agreements are vague about the mechanics of intercompany transactions. However, in an audit situation, an auditor wants to see specific proof that the terms are being followed. For example, an auditor might request samples of intercompany invoices. Such documents may or may not exist. If they do, they may be created on a transaction by transaction basis, or may be represented by an open agreement upon which orders can be drawn, or by some other method.
Auditors will also look to understand how intercompany transactions are settled — does cash change hands? If so, how frequently are the accounts settled — are they settled on a transaction by transaction basis? On a periodic basis (monthly, for example)? Many times, in an intercompany situation, actual cash transfers aren’t made at all. Instead, intercompany payables and receivables are created, often in one overall “due-to, due-from” intercompany account. The difficulty of analyzing such an account for transactions relating to intercompany agreements often leads an auditor to conclude that no proper documentation of the intercompany transactions exists, which can result in a disallowance of the transactions.
Of course, these issues only result if intercompany agreements exist and are in place. If there are no such agreements, taxing authorities generally disregard intercompany transactions. Many companies, for accounting purposes, “push down” certain expenses to subsidiaries that may benefit from such expenditures. However, without properly documented intercompany agreements, such expenses will be disallowed by state taxing authorities, as the subsidiary may not have any legal responsibility for the expenses without such agreements.
- Other changes that may impact the structure — It is critical that business and tax changes to the organization that may have occurred after implementation be reviewed in light of the effects they may have upon the structure.
For example, if any new intercompany agreements are created (among the U.S. group and any international subsidiaries, among different members of the group, etc.) such agreements should be reviewed and analyzed to determine if the terms of the new agreements may impact the existing agreements. State taxing authorities have, in recent years, begun to emphasize the arm’s-length requirements of intercompany agreements. If newer agreements exist, and have terms markedly different from existing agreements, the inconsistencies can lead to unfavorable audit adjustments. It is not uncommon to see new international agreements be created without any analysis of how their terms may impact existing intercompany agreements for state tax purposes.
Similarly, if another taxing authority (such as the IRS or a foreign country taxing authority) has reviewed a similar intercompany agreement and made audit adjustments, such adjustments should be reviewed for applicability to the existing intercompany agreements that were created when the structure was first implemented.
Whenever there is a merger or acquisition, the structure of the joining entity should be reviewed for all of the reasons stated above. In particular, are all of the implementation documents in place? Are all of the necessary intercompany agreements in place? If so, are the terms consistent with the acquiring company’s similarly situated agreements? The documents should be reviewed to determine what effect they might have on the taxpayer’s existing agreements (and vice versa).
After an intercompany structure is put in place, it is critical to maintain the tax treatment of the structure by periodically reviewing and documenting the company’s adherence to the terms of the structure. If there is a continuum, from absolutely no documentation or substance to the complete documentation and substance of a structure, most taxpayers fall somewhere in between. The regular review and related adjustment to a company’s structure will go a long way toward minimizing tax headaches post-implementation.
Alvarez & Marsal Taxand Says:
While the design and implementation of an intercompany structure are undoubtedly important, the post-implementation maintenance of the structure is equally if not more important. Even the most well-designed structures can result in unfavorable audit adjustments if the structure and resulting agreements are not followed. Unfortunately, it is more common for the maintenance of structures to receive less emphasis than the implementation of the structures (and less and less emphasis as time passes). It is essential that any intercompany structure be periodically revisited to ensure that it will best withstand scrutiny from state taxing authorities.
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