United States

Minnesota tax court addresses foreign disregarded entities

Presents limited review opportunity for tax years 2012 and earlier

INSIGHT ARTICLE  | 

Minnesota taxpayers with open 2012 tax years and earlier should consider the impact of including foreign disregarded entities in their combined returns following a recent Minnesota Tax Court decision. On June 6, 2016, the Minnesota Tax Court issued its decision in Ashland Inc. and Affiliates vs. Commissioner of Revenue, finding that a foreign disregarded entity was properly included in the income and apportionment factors of a parent’s Minnesota combined returns. 

Ashland overturns the Commissioner’s longstanding position and treatment of foreign disregarded entities under audit. The decision may result in an opportunity for taxpayers with foreign subsidiaries to re-examine their Minnesota filing positions for tax years 2012 and earlier that might still be open under the statute of limitations. However, in 2013, Minnesota revised its statute to require the income and apportionment factors of any foreign entity to be included in the Minnesota return, other than from an entity treated as a C corporation, thus rendering this entire issue moot. Taxpayers with similar facts as in Ashland should review the opinion closely.

Ashland Inc. (Ashland), a worldwide chemical manufacturer, included in its 2009, 2010 and 2011 consolidated federal income tax and Minnesota combined (unitary) corporate franchise tax returns, its wholly-owned subsidiary, Hercules, Inc. (Hercules). Hercules owned 100 percent of Hercules Investments SARL, (SARL) a Luxembourg entity. Prior to the years at issue, SARL elected to be disregarded as an entity separate from its owner under Reg. section 301.7701 et. seq. (the ‘check-the-box regulations’). As a foreign disregarded entity under the check-the-box regulations, SARL was deemed to have liquidated and distributed its assets and liabilities to its single owner, meaning that Hercules reported SARL’s assets, liabilities, income, and deductions as its own. Accordingly, Ashland’s Minnesota tax returns included the income and apportionment factors of SARL during the years at issue.

Under audit, the Minnesota Commissioner of Revenue determined that items of income and apportionment attributable to SARL were improperly included in Hercules’s income and apportionment on the Minnesota return because the state’s unitary statute at the time, Minn. Stat. section 290.17, subd. 4(f), did not permit the net income of foreign corporations or foreign entities to be included in a combined report even though they may be part of a unitary business. The Commissioner also relied on Revenue Notice #98-08, which generally provided that Minnesota will generally follow federal check-the-box elections where an entity elects to be disregarded as a separate entity, but also provided that the Department would not recognize the check-the-box election made by a foreign eligible entity with a single C corporation owner that is electing to be disregarded as a separate entity for federal tax purposes.

The Tax Court found that the starting point in computing Minnesota taxable income was federal taxable income, as defined in the Internal Revenue Code, and incorporating any elections made by the taxpayer. For federal tax purposes, SARL was deemed to have liquidated into Hercules, and its activity deemed to be that of Hercules itself. The Tax Court found that by recognizing SARL’s check the box election, it followed the legislature’s directive that Minnesota recognize federal income tax elections. By recognizing the check-the-box election, SARL no longer existed for Minnesota franchise tax purposes, and therefore there was no income or apportionment factors from a foreign entity to be excluded from the Minnesota return.

The Commissioner made a number of challenges to the Tax Court’s determination. First, the Commissioner alleged that SARL still existed as a legal entity in Luxembourg and therefore must be excluded as a foreign entity. The court found that argument contradicted the statutory mandate that the definition of ‘net income’ incorporate federal elections, which in this case was the election to be disregarded as an entity separate from its owner. Next, the Commissioner contended that the holding was inconsistent with the Minnesota Supreme Court’s decision in Manpower, Inc. v. Commissioner of Revenue, 724 N.W.2d 526 (Minn. 2006). The Tax Court countered that the issue in Manpower was whether a French subsidiary that elected to be treated as a partnership for federal tax purposes became a US organized entity that could be included in a Minnesota unitary combined return, or whether it must be excluded under Minn. Stat. section 290.17, subd. 4(f). The issue here was not whether SARL’s check-the-box election made it a U.S. organized entity, rather it was whether a foreign entity checking the box to be treated as a disregarded entity into a domestic entity was, for purposes of Minnesota’s unitary statutes, still an entity at all that would be excluded from the Minnesota unitary group.

Finally, the Commissioner contended that the court should defer to the “long standing position” in Revenue Notice #98-08 that a foreign disregarded entity’s check-the-box election is not valid for Minnesota purposes. To this point, the Tax Court noted that Revenue Notices only provide general guidance to taxpayers, and agency interpretations are consulted only when a statute is ambiguous. By allowing SARL’s federal election to be disregarded, the Tax Court concluded that there was no ambiguity, nor was there even a foreign entity to be excluded under Minnesota law.

Taxpayers should be cognizant of the limited review opportunity that Ashland may provide taxpayers with foreign subsidiaries. In 2013, Revenue Notice #98-08 was revoked due to statutory amendments requiring the addition of income and apportionment factors of foreign entities in a unitary business's combined Minnesota return if that income is part of the group's federal taxable income.

 

 

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