When to Appeal a Disallowance of an Interest Expense Deduction in Louisiana

Louisiana Department of Revenue income tax auditors are increasingly coming up with significant assessments by misapplying a formula in a Department regulation (La. Admin. Code 61:I.1130(B ) ; the rule “). The regulation is based on a law designed to prevent deductions related to attributable and non-taxable income and contains a formula that aims to determine a percentage of a taxpayer’s assets that produce income that is not taxable by the state. Under this all-encompassing approach, which ignores whether the assets entered into the formula are held to produce attributable or allocated income (or whether they produce income at all), audit assessments result from a denial proportion of expenses otherwise deductible by the taxpayer. In particular, in these audits, the Department improperly denies a taxpayer’s interest expense deductions by attributing, for example, interest expense on acquisition loans or other income-producing expenses attributable, to non-taxable income or to attributable income not taxable by the State. This approach ultimately distorts the taxpayer’s taxable income in Louisiana. By improperly over-allocating a taxpayer’s interest expense to their attributable, non-taxable income through the systematic enforcement of the unenforceable rule, the Department is forcing taxpayers with operations in multiple states into costly and time-consuming audits.

Under Louisiana law, the state can tax its share of income attributable to the taxpayer as well as any income attributable to the state.[1] Louisiana cannot tax income that is allocated elsewhere or tax-exempt income, including interest and dividend income that was previously attributable income but is no longer subject to tax after the changes in Louisiana Corporation Income Tax Act of 2005.[2] As we will explain, the Ministry’s revisions to the Regulations to take into account the 2005 revisions to the taxation of interest and dividend income created many of the problems that now regularly arise in auditing and frequently the subject of disputes.

Before a taxpayer can determine his net attributable and attributable net income (which ultimately make up the taxpayer’s net income in Louisiana), he must determine his allowable deductions.[3] But “in computing Louisiana net income or Louisiana taxable income, no deduction shall under any circumstances be allowed in respect of any amount otherwise allowable as a deduction which is attributable to income which, for whatever reason whatsoever, will not bear the tax charged by [Louisiana corporation income tax law].”[4] Louisiana law is analogous to the Internal Revenue Code sec. 265 but, with respect to interest income, the Department, in its regulations, adopts the approach of federal regulations under IRC sec. 861. IRC sec. 265 adopts the direct tracing approach for the purpose of determining the amount of a taxpayer’s interest expense arising from debt related to tax-exempt interest income, for which no deduction is permitted, and , only when direct screening is not possible, turns to a formulary approach.[5] However, the Ministry’s regulatory mechanism for allocating deductible income expenses to attributable income is similar to IRC sec’s asset-based allocation method. 861 regulations. Under Louisiana law, before a taxpayer can determine the amount of his deductions to be deducted from his attributable gross and attributable gross income, the taxpayer must allocate a portion of his otherwise deductible expenses to his non-taxable income because no deduction for such expenses is allowed.

The Department, however, ignores the direct search method entirely. Specifically, the Department’s regulations adopt a broad asset-based allocation method for allocating a taxpayer’s interest expense deductions from allocable and allocated income, regardless of the reason for which the expense was actually incurred. engaged. On the other hand, under IRC sec. 265, the use of an asset-based allocation method to allocate interest expense to tax-exempt income is permitted only if the debt proceeds are not directly attributable to the holding of debt. an instrument that produces tax-exempt income.[6]

The Department’s regulatory approach is based on the premise that money is fungible and therefore, unless an exception applies, a taxpayer’s deductible interest expense must be allocated across all activities and all property of the taxpayer, whatever the purpose of the loan.[7] For this reason, the Regulation provides that interest expense attributable to total assets producing or held to produce attributable income “shall be determined by multiplying the total amount of interest expense by a ratio whose numerator is the value average of the assets which produce or which are held for the purpose of producing assignable income, and whose denominator is the average value of all the taxpayer’s assets”.[8] This approach has the unfortunate effect of overestimating Louisiana taxable income.

In addition to being inconsistent with how comparable federal IRC sec. 265 is administered, the regulation does not comply with Louisiana law. Louisiana’s statutory definitions of attributable net income and attributable net income mandate the use of the direct tracking method, as recognized by the Louisiana Board of Tax Appeals in Ampacet Corporation. In Ampacet, the Board considered that the statutory definitions for determining attributable net income and attributable net income, which rely on direct monitoring similar to Article 265 of the Code, must be applied before the regulation allocating the interest expense of the department can be taken into account. Other states with comparable state statutes inspired by IRC sec. 265 also relied on direct tracing because it is appropriate under the logic of these statutes. See for example, Call from Zenith National Insurance Corp. and Apple, Inc. c. Franchise Tax Bd. Nonetheless, the Department continued to assert that the form approach in the Regulations applies to the exclusion of direct search methods even where the result is absurd. This is the crux of the matter and this approach has unfortunately led to a significant increase in litigation.

The settlement states that the department disassociates itself from the IRC sec. 265 and statutory definitions of attributable and attributable net income as necessary for “commodity of calculation” – but not for a compelling political reason.[9] Admittedly, the Department does not have the power to set aside the direct search method in the absence of an amendment by the legislator prohibiting the use of such a method for the purpose of determining the interest expenses deductible from a taxpayer.

Asset-based allocation allocates an expense among gross income categories by multiplying the expense by a ratio whose numerator is the value of the assets that generate the relevant income category and whose denominator is the value of the taxpayer’s total income assets.[10] As mentioned above, according to Commerce’s reasoning, interest on borrowed money is never capable of being directly attributed to any specific income and must always be allocated according to that formula. During the audit, the Department regularly incorrectly includes assets that do not or cannot produce attributable income in the numerator of the ratio. These assets include items such as goodwill, technology (for example, patents and proprietary technology), capitalized costs related to long-term customer contracts, licenses, advertising costs and non-competition covenants. , many of which generally do not produce attributable revenue, except for example, where technology is licensed to third parties and produces royalties. For example, the taxpayer cannot sell to a competitor the right to benefit from its advertising campaign or concede its goodwill to another party.

Most of these assets exist only because generally accepted accounting principles in the United States require a taxpayer to capitalize and amortize these expenses over time, rather than expense them in the year they are incurred. Moreover, taxpayers incur these types of costs solely for the purpose of producing and selling goods or services, the sales of which generate attributable income. These assets are not part of the numerator of Louisiana’s interest expense attribution ratio. From a practical point of view, inflating the numerator of the attribution ratio in this way could, for example, cause the Department to adopt the absurd position that, in fact, a taxpayer incurs a large part of his debt to earn a tiny amount non-taxable income and attributable income producing absurd and inequitable results.

Similarly, the Department, given that dividend income is not taxable, will include investments in subsidiaries in the numerator of its regulatory expense attribution ratio. Investments are generally held for the ultimate purpose of producing net gains in the value of the investments, ie attributable income. The department has resisted determining whether investments like these actually produce dividend income, whether or not they produce non-taxable or attributable income during audit periods. Nevertheless, since dividend income is not taxable, the portion of interest expense to be disallowed should be determined based on the straight-forward approach required by the statutory definitions of net attributable income and net income attributable to determine whether investments produce attributable income, for example, selling products to customers.

In general, where a regulation imposes conditions not contained in the statute that the regulation purports to interpret, resulting in audit assessments that are not supported by the substance or rationale of the statute at issue, the taxpayer should consider challenging the proposed adjustment. It is important to challenge, in a timely manner, an assessment based on rote application of the rules. One size does not fit all situations like this.

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