Lorillard Tobacco Company v. Director, Division of Taxation
For purposes of computing the CBT base, the general rule is that related-party royalty expenses must be added back.1 In Lorillard Tobacco Company,2 the taxpayer paid royalties to a subsidiary that was filing returns and paying CBT to New Jersey on the income stream. The taxpayer claimed a complete addback exception based on the so-called “unreasonable exception,” which provides that addback is not required if the taxpayer can prove by clear and convincing evidence that denying a deduction would be unreasonable. The Division’s policy, however, is to narrowly construe this exception.3 The Division’s regulation provides that the unreasonable exception applies only to “the extent that the payee pays tax to New Jersey on the income stream.”4 And under the Division’s tax return instructions, the value of the exception is capped at the amount of CBT paid by the affiliated licensor on the royalty stream.
In effect, if the affiliated licensor’s New Jersey apportionment is less than the licensee’s New Jersey apportionment, the Division has historically allowed the licensor to claim only a partial addback exception.
In Lorillard, the taxpayer argued that it would be unreasonable to add back its related-party royalty expense because the affiliate paid New Jersey tax on the royalty stream. The Tax Court agreed. In rejecting the Division’s longstanding policy, the court determined that the legislative intent of the royalty addback statute was to prevent income shifting. According to the court, the relative apportionment of the licensor and licensee was immaterial. As long as the affiliate paid at least some tax on the income stream, the legislative intent was satisfied and the licensee is entitled to fully deduct its royalty expense.5
Interestingly, the court’s decision does not discuss whether a taxpayer is entitled to an addback exception if the affiliate does not pay tax on the income stream due to net operating losses (NOLs) or credits.6 A prior decision issued by the same judge suggests that addback is not required in such situations. But the court’s analysis in Lorillard calls that conclusion into question.
Accordingly, if your company added back any royalty expense whatsoever, it should consider filing a refund claim based on the unreasonable exception.
Crown Packaging Technology, Inc. v. Director, Division of Taxation
In Crown Packaging,7 the issue was whether an intangible holding company had CBT nexus as a result of receiving royalty income from an affiliate that did business in New Jersey. The taxpayer argued that subjecting it to tax would violate the Commerce Clause and the Due Process Clause of the United States Constitution.
The court held that it lacked sufficient facts to definitively rule on the nexus issue. But the decision is nonetheless significant because the court determined that the Supreme Court of New Jersey’s decision in Lanco, Inc. v. Director, Division of Taxation,8 was not necessarily controlling. Lanco established the rule in New Jersey that physical presence is not required for CBT nexus.9 In both Lanco and Crown Packaging, the taxpayer received royalty income from an affiliate that did business in the state. But the Tax Court distinguished Lanco because Crown Packaging’s affiliated licensee did not operate retail stores in New Jersey and thus had a more limited connection to the state.
If your holding company conceded nexus following Lanco, it may have a refund opportunity. The decision may also be relevant beyond mere intangible holding company arrangements. For example, if your company conducts a financial or media business and derives receipts from New Jersey but lacks physical presence in the state, it should reconsider whether it has sufficient contacts with the state.
- See N.J.S.A. 54:10A–4.4b. (requiring add back of “otherwise deductible . . . intangible expenses and costs directly or indirectly paid . . . [to] one or more related members”).
- Docket No. 008305–2007 (Decided Feb. 27, 2019). The decision can be found at www.njcourts.gov.
- See N.J.S.A. 54:10A–4.4c.(1)(b).
- See N.J.A.C. 18:7–5.18(b)3.
- See Docket No. 008305–2007, p. 15 (Decided Feb. 27, 2019).
- See BMC Software, Inc. v. Director, Division of Taxation, 30 N.J. Tax 92, 114, 115 (N.J. Tax 2017).
- Docket No. 003249–2012 (Decided Feb. 26, 2019). The decision can be found at www.njcourts.gov.
- 908 A.2d 176.
- See Lanco, Inc. v. Director, Division of Taxation, 908 A.2d 176 (N.J. 2006).
Client Alert 2019-056
