6 Best Practices for Transfer Pricing and Documentation to Comply with Louisiana’s Tax Addback Law

Background

In March 2016, Louisiana joined the ranks of states that enacted corporate expense addback rules.  Louisiana R.S. 47:287.82 provides that a) interest expenses and costs; b) intangible expenses and costs and c) management fees, that are directly or indirectly paid to a related member, shall be added back to the corporation’s gross income.  This statute applies to all tax years beginning on and after January 1, 2016.

The Louisiana Department of Revenue issued La. Reg. 61:I.1115 (the “LDR Reg.”), effective April 20, 2018, that specifies four categories of exceptions to the addback:  a) “Subject to Tax”; b) “Not Tax Avoidance”; c)  “Conduit”; and d) “Add-Back is Unreasonable.”  If the expenses comply with one or more exceptions, the addbacks are not necessary.

Best Practices

1. Consult with professionals. Transfer pricing is a highly technical and specialized area that requires expertise across multiple disciplines, and is likely to require the assistance of state and local tax (SALT) attorneys, tax accountants, and valuation/transfer pricing specialists.

2. Identify which related-party transactions are impacted.
   • Interest Expenses and Costs: The balance sheets of related entities and schedules of all related party loans along with principal balances, and notes or other legal contracts that define the terms and conditions of the loans serve as a good starting point.
   • Intangible Expenses and Costs: This is a broad category that could relate to many different aspects of intellectual property and other intangible assets.  The LDR Reg provides a definition of Intangible Expenses as follows:
     • Includes but is not limited to:

     a.) expenses, accruals and costs for, related to, or directly or indirectly incurred in connection with the acquisition, use, maintenance, management, ownership, sale, exchange, or any other disposition of intangible property. “Intangible Property” includes stocks, bonds, financial instruments, patents, patent applications, trade names, trademarks, service marks, copyrights, mask works, trade secrets, “know how”, and similar types of intangible assets;

     b.) costs related to, or incurred in connection directly or indirectly with, factoring transactions or discounting transactions;

      c.) royalty, patent, technical, and copyright fees;

     d.) licensing fees;

     e.) other similar expenses, accruals and costs.

   • Management Fees: This includes consideration paid between related entities for various types of management services defined in the LDR Regs as follows:
     • Includes but is not limited to expenses and costs, including intercompany administrative charges, pertaining to accounts receivable, accounts payable, employee benefit plans, insurance, legal matters, payroll, data processing, including assembled workforce and/or employment data processing, purchasing, procurement, organizational matters, business structuring matters, taxation, financial matters, securities, accounting, marketing, reporting, and compliance matters or similar activities.

3. Perform a risk and materiality assessment of your inter-state related party transactions. The more material the related party transactions, the greater the potential scrutiny during an audit.  Although aimed at an international transfer pricing audience, many of the factors that potentially increase the risk of audit are discussed in the Organization for Economic Cooperation and Development’s DRAFT HANDBOOK ON TRANSFER PRICING RISK ASSESSMENT, dated April 30, 2013.  A summary of those factors follow:
   • Significant transactions with related-parties in low tax jurisdictions;
   • Transfers of intangible assets to related parties;
   • A recent business restructuring that involves the transfer of intangible or other assets or significant changes in the terms of related party transactions;
   • The existence of specific types of related party payments including interest expense, insurance premiums or royalty payments;
   • Multiple years of losses by an entity that makes related party payments where there is no attempt made to change business operations or financing;
   • Poor results or profit margins in comparison to industry norms;
   • Poor or non-existent documentation to support that the related party transactions contain terms and conditions comparable to a similar arm’s length transaction between unrelated parties; and
   • Excessive amounts of related party debt that would be in excess of the amount that an entity could borrow if it were a free-standing entity, or interest rates that appear to be in excess of market. The LDR Reg provides a test in Paragraph D.6 (shown below) to determine if the interest expense meets the “Addback is Unreasonable” exception:

With respect to interest expense, if the taxpayer’s debt over asset percentage exceeds the consolidated unrelated third-party debt over asset percentage of its federal consolidated group (as represented by interest bearing debt reported on the schedule L balance sheet(s) included in the consolidated and pro forma federal income tax returns), then the interest expense associated with the excess debt must be added back and cannot qualify for the exception described in Paragraph B.5 of this Section (add-back is unreasonable). The debt over asset test only applies to the unreasonable exception.

4. Prepare contemporaneous general documentation that outlines the rationale, business purpose and economic substance for the related party transactions. S. 47:287.82 specifically addresses “business purpose” and “economic substance” by stating that if the relevant related party transactions have “a substantial business purpose and economic substance and contain terms and conditions comparable to a similar arm’s length transaction between unrelated parties, the transaction shall be presumed to not have as its principal purpose tax avoidance.”  The statute does not, however, define these concepts.  While neither the statute nor the LDR Reg provides any guidance on what documentation is necessary, the list of “principal documents” mentioned in Treasury Reg. §1.6662-6(d)(2)(iii)(B)(1)-(10) can serve as a useful starting point.  All documentation must be prepared contemporaneously with the tax return.  Documentation will be considered contemporaneous if it is in existence and compiled before the due date (including extensions) for the filing of a tax return containing the related party transactions.

5. Get a transfer pricing study to determine the arm’s length terms and conditions for all relevant related party transactions. While neither R.S. 47:287.82 nor the LDR Reg. provide any guidance on what methods should be used to determine the arm’s length terms for related party transactions, the U.S. Treasury section 1.482 regulations do provide some guidance.

6. Periodically review the terms of all material inter-state related party transactions to determine if arm’s length terms and transfer pricing studies have to be updated due to changing market or other conditions.

For more information on transfer pricing or documentation for Louisiana’s Corporate Addbacks, contact Vanessa Brown Claiborne (vbrown@chaffe-associates.com) or Marc Katsanis (mkatsanis@chaffe-associates.com).