Massachusetts Denies Sales Factor COP Determination

A group of corporate subsidiaries that redetermined their Massacushetts sales factor using costs of performance (COP) were not entitled to a refund of excise tax. This redetermination resulted in the apportionment of all their income to another state. The taxpayers also were not allowed tax relief based on:

  • interest expense deductions for intercompany debt;
  • federal income tax audit changes; and
  • an error in the Department of Revenue’s (Department) electronic return processing system.

The subsidiary taxpayers held cable franchise licenses with Massachusetts cities and towns to provide video and internet services.

Sales Factor Determination

The taxpayers filed returns on a combined reporting basis. Their sales factor included receipts from sales of video and internet services to subscribers located in Massachusetts. A COP study later identified the principal direct costs of the taxpayers’ services as those related to the corporate parent’s national operations, including its:

  • headquarters in Pennsylvania;
  • network facilities in Colorado, New Jersey, and Pennsylvania; and
  • division headquarters in New Hampshire.

Later, the taxpayers concluded the determination of their sales factor was in error because the costs of performing their income producing activities were greater outside of Massachusetts. They then amended their returns to source their income outside of Massachusetts. On the amended return, the taxpayers claimed that Pennsylvania was the state with the highest costs of performance.

However, the taxpayers were not directly engaged in any operations, so they should have analyzed COP on a direct, not operational, basis. A shared personnel and facilities agreement specifically stated that each of the cable franchise companies did not itself have the direct resources necessary to operate and manage the business.

Massachusetts law mandated the holding of a license in order to provide the corporate parent’s video and internet services to subscribers. Consequently, the corporate parent chose to maintain separate entities to function as cable franchise licensees in Massachusetts. The taxpayers’ COP analysis should have focused on the separate entities, not the corporate parent’s national operations. While the parent company may have ignored the separate entities in day-to-day operations, the taxpayers could not unilaterally ignore the legal entity structure for tax purposes. The only activity directly engaged in by the taxpayers that resulted in the income-producing activity was to hold cable franchise licenses. Thus, the taxpayers’ income producing activities were performed wholly in Massachusetts. Or, at the very least, the costs of performing those activities were greater in Massachusetts then in any other state.

Intercompany Expense Deductions

The taxpayers claimed an interest expense deduction for debt assigned to them from third-party loans made to certain top-level corporate members. In Massachusetts, taxpayers must addback otherwise deductible interest expenses, unless the taxpayer:

  • shows the interest expense is supported by true debt; and
  • establishes that disallowing the deduction is unreasonable.

Lack of Genuine Debt and Arm’s Length Negotiations

Here, the intercompany promissory and credit notes reflected neither a genuine debt nor a correlation to the amounts claimed as interest expense deductions. No cash was transferred at the time of the loan origination, no payment of either principal or interest was made, and no demand for payment was ever made. Notes that recited a date for payment were extinguished and replaced with other notes.

Furthermore, there was no evidence that arm’s length negotiations preceded execution of the notes or that the taxpayers could have entered into loans with outside creditors on the same terms. Even if true debt existed, the taxpayers did not establish they were entitled to the unreasonableness exception. In addition, evidence did not show that disallowing the deduction would result in an unconstitutional distortion of income taxed by the state.

Income Allocated to Another State

The taxpayers also did not qualify for an interest expense deduction for debt used to fund dividend income from a related, but non-unitary, subsidiary. The subsidiary reported all of the dividend income to Pennsylvania, the location of its business operations. It also took an interest expense deduction on its Pennsylvania returns. Under Massachusetts law, a taxpayer cannot claim a deduction for an expense if it is for income allocated to a state other than Massachusetts. Moreover, the dividend income lacks the constitutional link required under the unitary business principle applied in Allied-Signal, Inc. v. Director, Division o£ Taxation, 504 U.S. 768 (1992). As a result, a related expense lacks the link too.

Federal Audit Changes

The taxpayers failed on numerous levels to provide factual and legal bases sufficient to prove that they were entitled to tax relief based on federal changes. These federal changes included net operating losses (NOLs) from a company acquired by the corporate parent which were assigned to each member of the taxpayers’ combined filing group. Other than summary schedules showing the NOL assignments, the taxpayers did not show how they calculated the NOLs for each member. They also did not address regulatory limitations on the use of NOLs following mergers or ownership changes.

Return Processing Error

The Department’s processing error involved the taxpayers’ non-income measure of their corporate excise tax liability for one tax year. The taxpayers reported the liability and paid that tax. However, the Department’s electronic processing system failed to capture the tax paid. This resulted in a tax overpayment that was applied to a later tax year. Massachusetts law authorizes tax relief if a tax is excessive in amount or illegal. The Department’s audit adjustment calculated the non-income measure as originally reported by the taxpayers. Therefore, the amount represented a tax lawfully due.

Comcast of Massachusetts I, Inc. v. Massachusetts Comissioner of Revenue, Massachusetts Appellate Tax Board, Nos. C321986, C321987, C321988, C321989, C321990, C321991, C321992, C321993, C321994, C322268, November 10, 2017, ¶401-637

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All stories by: CCHTaxGroup