The Louisiana Department of Revenue proposed a new regulation expansively interpreting Louisiana’s recently enacted related party expense addback statute. La. Reg. vol. 42, no. 10, pg. 1767 (Oct. 20, 2016) (the Proposed Regulation). Earlier this year, Louisiana enacted a new statute requiring taxpayers to add back interest expenses, intangible expenses, and management fees paid to related members, subject to certain exceptions. The Proposed Regulation seeks to adopt definitions, impose compliance and documentation requirements, and place additional limitations on intercompany expense deductions. Comments on the Proposed Regulation should be due by November 29,1 with a public hearing scheduled for November 30.
Background: The Addback Statute
On March 10, 2016, Louisiana enacted a new law requiring taxpayers to add back otherwise deductible “interest expenses and costs, intangible expenses and costs, and management fees” paid to related members. La. Acts 2016, 1st Ex. Sess., No. 16, § 1 (Mar. 10, 2016) (H.B. 55) (enacting La. R.S. 47:287.82). The new law is effective for tax years beginning on or after January 1, 2016.
The statute provides three exceptions to the expense addback requirement: (1) a subject to tax exception, (2) a business purpose exception, and (3) a conduit exception. La. R.S. 47:287.82(A)(1)-(3).
The Department’s Proposed Regulation
The Proposed Regulation arguably expands the scope of Louisiana’s addback requirement. Most notably, the Proposed Regulation would: (1) adopt broad definitions of the terms not defined by the statute; (2) require “contemporaneous documentation” to substantiate the business purpose exception; (3) limit certain interest expense deductions based on a “debt over asset” percentage test; and (4) require a written return statement to qualify for exceptions.
The Proposed Regulation would adopt broad definitions of the terms “interest expenses,” “intangible expenses,” “intangible property,” and “management fees.” For example, “management fees” would include, but would not be limited to, “expenses and costs, including intercompany administrative charges, pertaining to accounts receivable, accounts payable, employee benefit plans, insurance, legal matters, payroll, data processing, purchasing, taxation, financial matters, securities, accounting, or reporting and compliance matters or similar activities.”2
The Proposed Regulation also includes an example of when an intangible expense is “indirectly paid” that could potentially cause expenses for products sold between related parties to be partially subject to the addback requirement.
Sutherland Observation: The terms defined in the Proposed Regulation are not defined by the addback statute. The proposed definitions are very broad and would cast a wide net over intercompany expenses potentially subject to the addback requirement. The Department’s expansive definitions, however, arguably go beyond merely filling gaps left by the statute and potentially exceed the statute’s scope.
“Contemporaneous Documentation” for Business Purpose Exception
To claim the business purpose exception, the Proposed Regulation would require “contemporaneous documentation” to substantiate the “business purpose exception.” The Proposed Regulation adds that “[m]ere statements or assertions that a transaction was intended to allow for better management or greater utilization of intangible assets, or similarly unsubstantiated claims are not sufficient to establish a principal non-tax business purpose.”
Sutherland Observation: The proposed “contemporaneous documentation” requirement should sound eerily familiar to taxpayers following the I.R.C. § 385 regulations recently promulgated by the Internal Revenue Service. These U.S. Treasury regulations require that taxpayers prepare certain “contemporaneous documents” to support related party debt to avoid having the debt reclassified as equity.
“Debt Over Asset” Percentage Test
The Proposed Regulation would limit certain intercompany interest expense deductions based on a “debt over asset” percentage test. Under the test, interest expenses paid to a related party on “excess debt” would be required to be added back to the extent the payor/borrower’s “debt over asset percentage exceeds the consolidated unrelated third party debt over asset percentage of its federal consolidated group.” This calculation compares the payor’s separate company debt-to-assets ratio (debt/assets, measured using the payor’s pro forma federal Schedule L balance sheet) to the consolidated group’s third-party debt-to-assets ratio (third-party debt/assets measured using the federal consolidated Schedule L balance sheet). The payor has “excess debt” that “must be added back” to the extent that its debt-to-assets ratio exceeds that of the federal consolidated group.
Sutherland Observation: The addback statute contains no mention of a “debt over assets” limitation. Although the Proposed Regulation provides that interest expenses for “excess debt” cannot qualify for unreasonable exception (an exception also not expressly provided for by the statute), it is unclear how the “excess debt” limitation would apply, if at all, with respect to other exceptions, such as the “business purpose” or “conduit” exceptions.
Reporting Requirements for Claiming an Exception to Add Back
The Proposed Regulation would require taxpayers claiming an exception from the addback requirement to show that the expense qualifies for an exception “in a written statement and/or other document” attached to the taxpayer’s Louisiana income tax return. It is unclear whether this requirement would be limited to checking a box on a return attachment or would impose more burdensome compliance requirements on taxpayers claiming an exception.
Taxpayers doing business in Louisiana that have material intercompany transactions should evaluate the potential impacts of the new Proposed Regulation on their tax liabilities. Some of the more onerous portions of the Proposed Regulation potentially exceed the scope of the Department’s statutory authority, and affected taxpayers should consider submitting comments.