The negotiation:
Massachusetts controversy
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Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015
Today’s presenters
Representing the Massachusetts Department of Revenue
Brian Marks
Jason Zorfas
Ernst & Young LLP
Boston, MA
Ernst & Young LLP
Boston, MA
Representing the Taxpayer, XYZ Widget Company
Kate Gruber
Dan Lipton
Ernst & Young LLP
Boston, MA
Ernst & Young LLP
Boston, MA
Mediator
Steven N.J. Wlodychak
Ernst & Young LLP
Washington, DC
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Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015
Background
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XYZ Widget Company manufactures and sells widgets.
During the 2004 and 2005 tax years, XYZ Company developed and
sold product directly to customers.
In 2006, the Company transferred the intangible property (IP) related
to its products from XYZ to Company B.
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XYZ continues to perform some research and development (R&D) and
performs all headquarter functions.
Company B performs R&D. Company B is only located in unitary states.
In 2007, XYZ terminates the royalty arrangement with Company B
and enters into a buy-sell arrangement with Company B.
Massachusetts audits the Company for the 2007 and 2008 tax years.
The Company and the Department agree to enter the Early Mediation
(EM) Program.
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Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015
Massachusetts EM Program
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EM Program is offered by the Massachusetts Department of Revenue as an
option for settling cases – ideally settled in one day.
EM Program is available when the proposed assessment of tax is in excess of
$250,000.
Either the Department (usually the audit division) or the taxpayer can request
it, but both parties must agree to participate. If that application is accepted by
the Commissioner, a date for mediation is scheduled. The process must be
completed within a four-month period.
The program is not designed to develop facts and therefore shouldn’t be used
when there are outstanding questions of facts.
Both sides must be represented by authorized decision-makers. The mediator
is typically an appeals officer at the Department.
EM Program is designed for the resolution of legal issues such as economic
nexus and apportionment. All issues must be settled as part of the process.
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Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015
Issues for consideration at EM Program
Issue
Amount in dispute
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Embedded royalties
$10m
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Economic nexus
$7m
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Cash management system
$5m
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Add back of intercompany interest
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Reclass debt and equity
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Sham transaction
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§35A penalties
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Part of the amounts above
$4.4m
Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015
XYZ Widget Company
Tax years: 2004-2005
XYZ
Company
Finance
Company
Sale to Customer
Other
operating
companies
XYZ Company
► Develops and manufactures product
► Sells product directly to customer
► Has nexus in MA and other states
► Substantial intercompany liability due to Finance Company as a result of
Cash Management System
► Intercompany liability continues to grow year after year; XYZ makes
no transfers of cash to Finance Company to settle the intercompany account
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Customer
Finance Company
► Operates cash management
system
► Supported by intercompany notes,
arm’s-length interest rates and
transfer pricing study
Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015
XYZ Widget Company
Tax year: 2006
XYZ
Company
Royalty
Finance
Company
Sale to Customer
R&D service
Transfer
of IP
Company
B
Other
operating
companies
XYZ Company
► Transfers IP related to the product to Company B
► Continues to perform some R&D on the product (compensated by Company B
via a service fee) and continues to perform headquarter functions for the group
► Pays a royalty to Company B for right to market and sell product to customers
► Continues to sell to customers
► Continues to have nexus in Massachusetts
► All intercompany transactions satisfy IRC Sec. 482 requirements
and are supported by a transfer pricing study
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Customer
Company B
► Performs some R&D
► Employs legal staff to manage IP
► Does not have a physical presence
in Massachusetts
► Only has nexus in other
unitary states
Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015
XYZ Widget Company – Massachusetts audit
Audit period: 2007 and 2008
XYZ
Company
Customer
R&D service
Sale of
product
•
Sale to Customer
.
Finance
Company
Company
B
XYZ Company
► Terminated royalty arrangement with Company B and has entered
into a buy-sell arrangement with Company B
► Purchases the product from Company B
► Sells product direct to customers at a markup
► Continues to perform certain R&D services for Company B
► All intercompany transactions (including the markup) satisfy IRC
Sec. 482 requirements and are supported by a transfer pricing study
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Other
operating
companies
Company B
► Acquires a manufacturing facility located in
another unitary state (not Massachusetts),
where it manufactures the product
► Sells product to XYZ as a sale for resale
► Does not have a physical presence in
Massachusetts and only has nexus in other
unitary states
Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015
Massachusetts EM Program – final
observations
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EM Program settlements are typically based on a dollar amount, i.e.,
they are not precedential regarding the underlying issues.
For EM Program to be successful, both the taxpayer and the
Department of Revenue must be willing to make a material
concession from their position.
If EM Program does not result in a settlement, then the taxpayer may
re-enter the traditional appeals process.
Under the traditional appeals process, taxpayer may seek a
determination and/or settlement.
The mediators must destroy all records of the mediation including any
taxpayer submissions or offers in settlement, i.e., the appeals officers
may not know of or be influenced by the failed EM Program.
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Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015
Questions?
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Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015
Contacts
Jason Zorfas
Dan Lipton
Ernst & Young LLP | Boston, MA
+1 617 585 3554
[email protected]
Ernst & Young LLP | Boston, MA
+1 617 585 1873
[email protected]
Brian Marks
Kate Gruber
Ernst & Young LLP | Boston, MA
+1 617 375 2408
[email protected]
Ernst & Young LLP | Boston, MA
+1 617 375 2462
[email protected]
Steven N.J. Wlodychak
Ernst & Young LLP | Washington, DC
+1 202 327 6988
[email protected]
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Sixth Annual Indirect, State and Local Tax Conference | Boston | 17 March 2015