New Jersey Tax Court Rules in "Unreasonable" Exception to Addback Rule

DALLAS, June 1, 2017 /PRNewswire/ -- On May 24, 2017, the New Jersey Tax Court ("Court") ruled that the taxpayer was not required to add back a royalty paid to its parent.¹ In this case, the subsidiary, BMC Distribution Inc., licensed its parent's prewritten software to unrelated third parties. The subsidiary paid the parent a percentage of its license and maintenance revenue as a royalty. The subsidiary's payments were substantially similar to payments made by third-party distributors of the software and were supported by independent transfer pricing studies.

The Court extensively analyzed the nature of the payments and concluded that they were in fact royalties, thus coming under the addback rules of N.J.S.A. 54:10A-4.4.b. The addback rules were developed to prevent the shifting of income by related parties to avoid tax.² The Court then considered whether the payments met any of the exceptions to the addback rules contained in 54:10A-4.4.c. The taxpayer contended that the recipient of the royalties paid tax on the income by using its net operating loss (NOL) to offset the income. In addition, it claimed that the expense to the subsidiary and income to the parent was not motivated by tax avoidance purposes. These positions did not persuade the Court that the addbacks were "unreasonable."  

However, the Court found it persuasive that the royalties between the subsidiary and the parent were substantially similar to the royalty payments between third-party distributors, who also licensed the software, and the parent company. In addition, the payment made by the subsidiary was supported as an arm's-length payment by an independent transfer pricing study. Based on these two findings, the Court held that the "unreasonable" test was met and that the subsidiary was not required to add back the royalty payment to its income. 

While the decision is very fact specific, there is now precedent at the New Jersey Tax Court to analyze an intercompany payment and conclude that adding back the payment to income would be unreasonable.

¹ BMC Software Inc. v. Div. of Taxation, New Jersey Tax Court, Release Date: May 24, 2017 (Doc 2017-55860).
² Business Tax Reform Act L. 2002, c. 40, Statement to Assembly No. 2501 (June 27, 2002).

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