Tennessee Sales Tax Update: Transactions with Affiliates Receive Additional Scrutiny from Tennessee Tax Department
Institute for Professionals in Taxation May 2014 Tax Report
Transactions between related entities are sometimes overlooked from a sales tax perspective, which can result in tax liability that might have been avoided. Using a pending Tennessee case and a recent statutory change, this article highlights different scenarios in which these issues often come into play, and provides tips on how to avoid exposure in this area and maximize the benefits available under statutes exempting certain affiliate transactions.
The focus of sales and use tax compliance departments is often on making sure that sales tax is being properly applied to transactions with third-parties, that exemptions are properly documented, and that use tax is being assessed and remitted when appropriate. Transactions that can often be overlooked, however, are those that involve the interaction between the taxpayer and its affiliates.
In Tennessee, the Department of Revenue has begun focusing on these affiliated-party transactions during audits, asserting that sales tax is due depending on the nature of the transaction between affiliates.
In one case now pending before the Davidson County Chancery Court in Tennessee, a taxpayer served as the central purchasing agent for its various affiliates. Purchases of tangible personal property were made by the parent, and sales tax was paid on those purchases. The purchased goods were then transferred to the various affiliates, and the costs were shared pursuant to an Intercompany Cost Allocation Agreement. Significantly, the Agreement also provided for the allocation of costs for a variety of administrative and management services, which included (1) personnel services, (2) financial, legal and accounting services, (3) other administrative services, and (4) investment management services. The taxpayer also provided information technology services, including the development of certain software projects that, once developed, allowed the taxpayer’s affiliates to access software maintained by the taxpayer at its centralized servers. The Department issued an assessment based on the provision of all these services to the taxpayer’s affiliates.
Tennessee has a long history of targeting affiliated-party transactions dating back to Standard Advertising v. Jackson, 735 S.W.2d 441 (Tenn. 1987), in which the Department successfully asserted that charges between Service Merchandise and its affiliated advertising entity were subject to sales and use tax. More recently, Tennessee has attempted to disregard transactions between affiliates involving the sale and lease of an aircraft, when the application of the resale exemption was at issue. CAO Holdings, Inc. v. Trost, 333 S.W.3d 73 (Tenn. 2010).
The Tennessee Court of Appeals added a twist to this area of the law with its decision in OakTenn, Inc. v. Chumley, No. E2007-02411-COA-R3-CV, 2008 WL 2600685 (Tenn. Ct. App. 2008), in which the Court concluded that the operation of a laundry among hotels was not taxable if the operation of the laundry was a joint venture between the hotels. In OakTenn, the affiliated hotels all shared the costs of operating a laundry for all the hotels as a joint venture. The Department attempted to impose sales tax on all the amounts paid for the laundry operation. The taxpayer prevailed on the legal issue, but the case was remanded for additional factual development. The premise of the Court’s ruling was based in large part on the conclusion that the members of the joint venture were operating in furtherance of the common goals of the joint venture and were not operating as separate companies with respect to the laundry operation.
The Tennessee legislature has also enacted provisions to define what transactions between affiliates are exempt from sales and use tax. In particular, section 67-6-350(a)(2) formerly exempted services rendered by a corporation to an affiliated corporation provided that there was no profit and that the services were not provided to unaffiliated entities. This exemption was replaced in 2009 with Tenn. Code Ann. § 67-6-395(b), which exempts “the repair of computer software or any other services otherwise taxable that are rendered by a company for an affiliated company.” Accordingly, the revised statute does not limit the application of the exemption to taxpayers that exclusively provide services to affiliates and do not receive a profit for the service.
The main argument now asserted by the taxpayer in the Davidson County case is that the intercompany services that the Department is now attempting to tax are exempt under the statutory exemption from the sales tax for transactions between affiliates. Based on the 2009 change that removed the requirement that no mark-up be charged and the requirement that services could only be provided to affiliates, the taxpayer appears poised to prevail on the language of the exemption statute. In the alternative, the taxpayer also argues that it is entitled to a credit for sales and use tax paid on its purchases of taxable items. Alternative arguments focus on whether the information technology services result in the transfer of computer software.
This case highlights the significance of intercompany agreements between affiliates that involve central purchasing or the transfer of tangible personal property or taxable services. Absent language in a state statute that provides for an exemption, those transactions may otherwise be taxable. Properly identifying the end user in these transactions and utilizing resale certificates will help make sure that these affiliated transactions do not get lost in the shuffle and result in an inadvertent tax liability.
The Tennessee statute, as amended in 2009, removed the requirements that make it much more difficult to qualify for the exemption for affiliated intercompany services. These types of statutes, however, vary significantly from state to state, so taxpayers should make sure to understand the requirements of these affiliated party exemption statutes and ensure that the intercompany agreements for services are structured to maximize the benefits offered by these statutes.
While not addressed in the Davidson County pleadings, issues involving sales tax and affiliated party transactions often present proof issues because those intercompany transactions are often consummated with journal entries rather than actual intercompany payments. Care should be taken that procedures are in place from an accounting perspective to make sure that these charges are properly documented, so that the separate nature of the entities and the transactions can be established with the supporting documentation.
Another significant issue highlighted by this case is the risks involved with utilizing catch-all intercompany agreements that include both taxable and nontaxable items. Here, personnel, management, and administrative services are not taxable services in Tennessee and only become taxable because the charges are included in a contract that involves the sale of tangible personal property. The use of severable contracts for the taxable and nontaxable items will help avoid or at least minimize the impact of sales tax on transactions between affiliates.
While the Davidson County case focuses on the sales and use tax assessment, there is a related business license tax assessment. In Tennessee, the business license tax applies to a broader set of services and there is no exemption for intercompany amounts paid to an affiliate. Instead, there is only a deduction from the sales price for a reasonable allocation of the cost incurred in providing the service. Thus, even within Tennessee’s taxing structure, it is clear that the terms of the affiliated party transaction statutes will often be determinative of the application of the tax to the transaction.
The Tennessee case only provides one example of how affiliated party transactions can result in disputes with state taxing authorities. Tax professionals should be careful to identify affiliated party transactions that have transaction tax implications, plan to minimize the exposure where possible and include these transactions in the tax compliance program. This task will prove to be a daunting one because the business operations of companies rarely remain stagnant. Thus, it will be a continuous process to evaluate what your business counterparts are doing, where they are doing it, and with whom, but evaluating these issues will put you in a better position in the event that Tennessee or some other state comes calling and reviews your transactions with affiliated entities.
Republished with permission. This article first appeared in the Institute for Professionals in Taxation May 2014 Tax Report.