• Massachusetts: Parent/Sub Reverse-Nexus Sham Transaction Sniffed Out By State Tax Board
  • July 16, 2013 | Authors: David M. Kall; Susan Millradt McGlone
  • Law Firm: McDonald Hopkins LLC - Cleveland Office
  • In a recent decision issued by the Massachusetts Appellate Tax Board (the Board), it found that a parent corporation’s attempt to establish reverse nexus to Massachusetts through its subsidiary operating in Massachusetts was a sham transaction. Reverse nexus occurs where a parent company establishes nexus in a given state by creating the necessary presence in a state through interaction with its subsidiaries. Massachusetts recognizes the “sham transaction doctrine,” which gives the commissioner the authority “to disregard, for taxing purposes, transactions that have no economic substance or business purpose other than tax avoidance.”

    In the decision, the parent company was an international conglomerate that owned hundreds of subsidiary companies. The taxpayer at issue was a subsidiary company of the parent that was the principal reporting corporation for a combined group of affiliated corporations. Each affiliated corporation in the group was also a subsidiary of the parent company. The group and its affiliated corporations, conducted business in Massachusetts. On the other hand, the parent company was based out of England. The parent wanted to offset its corporate losses by establishing a presence in Massachusetts via its subsidiary companies operating in Massachusetts. Accordingly, the parent company formulated a tax plan that would create a physical existence for the parent in Massachusetts. After extensive review of the tax plan, the Board ruled that the parent’s activities constituted a sham transaction that was motivated solely for tax avoidance and served no legitimate economic or business purpose. Thus, the parent did not have sufficient nexus with Massachusetts to be included in the subsidiary’s tax returns.

    The Board’s review of several of the parent’s internal communications revealed the company’s “state tax planning project.” The Board expressed general concern with certain statements made in the company’s internal memos including a statement that the “state tax planning project” was “intended to have tax ramifications only” and the motivation behind the plan was to have the tax liability “reduced to nil.”

    The core of the companies’ “state tax planning project” was to:

    1. Sublease office space from the subsidiary to the parent company;
    2. Transfer employees to create an in-state payroll for the parent;
    3. Have the parent purchase office furniture and equipment to be used in the leased space; and
    4. Have the parent charge the subsidiary company annual “administrative service fees.”

    These documents and the resulting plan executed by the companies were scrutinized by the Board and ultimately the Board found several red flags indicating ulterior motives for the tax relief.

    Examples of these “red flags” include:

    1. The lease: The lease was backdated and made no provisions for the employees’ work spaces. In addition, the lease payments fluctuated dramatically from $280,000 in the first year, to $24,000 in the second year, and $7,480 for the third year. After the initial three years, there were no renewals or additional payments.
    2. The employees: The employees continued to receive W-2s from the subsidiary and their payroll information indicated they were still paid by the subsidiary company.
    3. The office furniture and equipment: The office furniture did not change and even office locations of the parent’s new “employees” did not change with their transfer to working for the parent.
    4. The administrative service fees: These fees were sourced inconsistently with respect to other charges. The Board determined that this inconsistent treatment of the charges indicated they were completely tax driven and seemed to be just large enough each time to import the parent’s significant losses to the subsidiary.

    The Board heatedly closed the opinion by stating that the memorandum reported the company’s “concern was merely to ‘get our foot in the door’ days before the end of the tax year and not be concerned with ‘refin[ing] the position’ with the actual details until the next fiscal year. Yet as the facts indicated, many of those details never materialized.”

    This case was a perfect storm of bad facts making for a fairly easy determination that the transaction was a sham. However, the case also exemplifies the necessity for companies acting with tax relief motivations to tread carefully, plan in advance and ensure the transaction structure has economic substance. The sham transaction doctrine has been utilized by states with increasing frequency. Legitimate reorganizations that have economic substance ought to be respected, even if there are tax motivations. However, cases like this are textbook examples of the use of improper tax planning techniques.