Since 2001, Alabama has required an addback for intercompany interest expenses and intangible expenses to the extent the expenses were paid to a related member. Under current law, the state allows for an exception to the required add-back in certain circumstances, one of which is when the taxpayer can support that the related member receiving the payment is “subject-to-tax” on the income in another jurisdiction (see Ala. section 40-18-35(b)). In a July 28, 2022, decision, the Alabama tax tribunal issued a taxpayer-favorable verdict and provided clarity on how the intercompany add-back and subject-to-tax exception provisions should apply.
During the tax year at issue in the case, the taxpayer paid $658 million in interest expense to a foreign-affiliated entity operating in Ireland. This amount of intercompany interest expense was included in interest income by the Ireland affiliate but was fully offset by a corresponding deduction of the same amount related to interest expense paid by the Ireland affiliate to one of its affiliates operating in Luxembourg. Ireland’s tax code for the year at issue provides that corporations should be subjected to tax on all profits, regardless of where they were earned.
The taxpayer filed Alabama returns claiming a deduction for the $658 million of intercompany interest expense under the premise that the inclusion of the interest income in the affiliate’s Ireland return satisfied the requirements of Alabama’s subject-to-tax exception, and, therefore, no intercompany addback was required. Upon review of the taxpayer’s separate Alabama corporate income tax return, the Alabama Department of Revenue adjusted the amount of Alabama net operating losses generated to add back the interested expense paid by the taxpayer to the Ireland affiliate. The taxpayer appealed the department’s decision to the Alabama tax tribunal, requesting a ruling on the proper interpretation of the state’s subject-to-tax exception to the intercompany add-back rules.
Alabama law and the tribunal’s interpretation
Alabama’s subject-to-tax exception to the intercompany interest add-back specifically provides that the exception will apply when the recipient affiliate is subject to tax in a foreign jurisdiction which has an income tax treaty with the United States, and the affiliate is considered a “resident” of the foreign jurisdiction under treaty definitions, and the payment is included in income by the affiliate and not eliminated in a combined filing. Further, Ala. section 40-18-35(b)(1) provides that “the portion of an item of income which is attributed to a taxing jurisdiction having a tax on net income shall be considered subject to a tax even if no actual taxes are paid on such item of income in the taxing jurisdiction by reason of deductions or otherwise.”
The question at issue, in this case, was whether the interest income at the Ireland affiliate was truly "subject to a tax" in Ireland. The department’s position urged that consideration must be given to the overall economic impact of the back-to-back intercompany transaction, which effectively included no income as subject to tax if the transactions between the taxpayer and the Ireland affiliate and between the Ireland affiliate and its Luxembourg affiliate were considered on a net basis. The tax tribunal determined that the taxpayer’s intercompany transaction with the Ireland affiliate clearly met the requirements of the subject-to-tax exception. The tribunal found that because the Ireland affiliate included the interest payment in the computation of income subject to tax in Ireland, the tax treaty and residency requirements were therefore satisfied, and thus the entire amount was properly attributable to Ireland under the country’s sourcing methodology. In the tribunal’s analysis, the fact that Ireland allowed the affiliate a deduction for interest expense paid to its Luxembourg affiliate should have no bearing on whether the income was considered subject to a tax in Ireland, in keeping with the provisions of Alabama’s statutory language related to the definition of “subject to tax.”
In a climate where states are increasingly departing from applying the letter of the law in favor of approaches that consider broad economic impacts, the tribunal’s decision is a somewhat surprising and potentially significant win for taxpayers. Although the taxpayer’s Ireland affiliate was seemingly only serving as a conduit or pass-through for intercompany interest expense in the back-to-back transactions described by the facts, the tax tribunal held that the transaction between the taxpayer and the Ireland affiliate as well as the affiliate’s treatment of the transaction for tax purposes satisfied the specific requirements of the subject-to-tax exception to the state’s intercompany add-back rules. Alabama has routinely examined intercompany transactions under audit, requires extensive disclosures with returns claiming an addback exception, and often adopts narrow interpretations of their statutory exceptions to the intercompany add-back rules.
Taxpayers who are currently adding back intercompany interest or other intangible expenses should carefully consider whether the recent decision’s interpretation of the requirements of the subject-to-tax exception may provide an opportunity to reduce Alabama corporate income tax liability. Note that, in the context of domestic intercompany transactions, the portion of income that is subject to a tax for the purposes of the exception is considered on a post-apportionment basis. Since the case at hand involved an international affiliate, this issue was not immediately relevant to the tax tribunal’s decision, but it could impact the analysis of how the decision may benefit taxpayers with domestic intercompany transactions subject to addback. Please consult your state and local tax adviser with questions related to Alabama’s intercompany add-back requirements or the tribunal’s decision.