Information Release

CFT 2000 - 01 - IRC Section 482 Study: Taxpayers seeking to Avoid Ohio Corporate Franchise Tax Report Required or Expanded Combinations, Issued June, 2000; Revised January, 2005

Several Ohio tax practitioners have requested further clarification regarding the Department’s statutory authority under Ohio Revised Code section (“R.C.”)5733.052 (attached) either to require or to expand Ohio corporation franchise tax combinations. While R.C. 5733.052(A) grants the tax commissioner discretion either to require a combination or to add additional members to a combination elected by the taxpayers, R.C. 5733.052(C) states as follows:

"No combination of net income under division (A) of this section shall be required unless the commissioner determines that, in order to properly reflect income, such a combination is necessary because of intercorporate transactions and the tax liability imposed by section 5733.06 of the Revised Code."

Thus, R.C. 5733.052 requires that, as a condition precedent to the Department's requiring either a combination or an expanded combination, the tax commissioner must show that a combination is necessary in order to properly reflect Ohio income. That is, the tax commissioner must show that a combination or expanded combination is necessary in order to eliminate a distortion of Ohio income.

Accordingly, the Ohio Department of Taxation will require franchise tax combinations and will pursue expanded franchise tax combinations where the Department ascertains that the failure to combine income distorts the amount of income fairly apportioned and allocated to Ohio. For purposes of ascertaining whether such income distortion exists, the Department will consider all relevant evidence. With respect to a qualifying controlled group whose members do not include (i) a real estate investment trust and/or (ii) a corporation conducting passive investment operations,¹relevant evidence includes whether the taxpayer has attached to its timely-filed Ohio franchise tax report a valid and complete Internal Revenue Code ("IRC") section 482–type study for the taxable year.² The study must support and justify both the fees charged and the costs incurred with respect to related party transactions even if the corporations are unitary.³ With respect to a qualifying controlled group whose members do include (i) a real estate investment trust and/or (ii) a corporation conducting passive investment operations, the Department is actively pursuing a combination of such corporations with the taxpayer(s).

In addition to those situations addressed above, set forth below are additional examples of some (but not the only) situations where the Department will actively pursue combination or expanded combination:

• A combination may be necessary to correct the distorted amount of profit reported by a sales corporation because of “vertical” operations between a corporation subject to Ohio’s corporation franchise tax and related corporations (whether or not the related corporations are subject to Ohio’s corporate franchise tax). For example, the corporation subject to Ohio’s corporation franchise tax may be the sales corporation responsible for making all the sales on behalf of the manufacturer corporation. Frequently, the sales corporation is guaranteed a minimal profit (in one situation, the sales corporation received a profit of only one tenth of one percent of sales).
  
• An expanded combination may be necessary to better reflect the true cost and profit of the Ohio corporate taxpayer where the corporate group has the benefit of large volume purchases, but the benefit of such purchases is not reflected in the income of the Ohio corporate taxpayer. The Ohio corporate taxpayer is one of several operating companies. Each company individually buys its raw material for $1.00 per pound from a common supplier. Because of the volume of purchases made by the entire corporate group, the supplier agrees to adjust the raw material price to $.90 per pound. The supplier further agrees to rebate the $.10 per pound difference directly to the parent holding company (thus, each of the operating subsidiaries shows a cost for raw materials of $1.00 per pound rather than the true cost of $.90 per pound).

IRC section 482 authorizes the Internal Revenue Service to distribute, apportion, or allocate gross income, deductions, credits, or allowances where the same interests own or control two or more organizations, trades, or businesses if the Internal Revenue Service determines that the distribution, apportionment or allocations are necessary either to prevent evasion of taxes or clearly to reflect income of any organization, trade, or business.⁴ The standard to be applied is that of a taxpayer dealing at "arm's length" with an uncontrolled and/or unrelated third party.

The U. S. Treasury regulations for IRC section 482 state that the arm's length result of a controlled transaction (that is, a transaction between related parties) must be determined using the method that under the facts and circumstances provides the most reliable method of arm's length result (that is, "the best method rule"). These regulations provide detailed discussion relating to the application of the best method rule under various methods to various types of transactions. These methods include the following:

• Comparable uncontrolled price method,
• Resale price method,
• Cost plus method,
• Comparable uncontrolled transaction method,
• Comparable profits method,
• Comparable split method under the profits split method, and
• Residual profits split under the profit split method.

A taxpayer seeking to minimize the likelihood that the Department will require either a combination or an expanded combination should provide the Department with all available evidence the taxpayer has that its report as filed does not result in a distortion of Ohio income. That evidence may include an IRC section 482-type study, conducted in a good faith and reasonable manner in compliance with U. S. Treasury regulations. The purpose of this study is to support the validity of an arm's length transaction with another related party. A taxpayer fully complying with the U. S. Treasury regulations⁵ and successfully establishing that all its transactions with related parties, both domestic and foreign, have been executed on an arm's length basis minimizes the likelihood that it will be subject to either a required combination or an expanded combination.⁶ It is important that the taxpayer conduct its IRC section 482-study in a timely and reasonable manner and fully comply with all the requirements set forth in the U. S. Treasury regulations.

In summary, the Department will generally pursue combinations or expanded combinations in those situations where either the failure to combine or the failure to expand the combination may result in the filing of a corporation franchise tax report which does not properly reflect income and does not properly reflect the tax liability imposed by R.C. 5733.06. Other than for those situations and circumstances which this information release expressly addresses, a timely-conducted IRC section 482-type study conforming with the requirements set forth in IRC section 482 and in the applicable U.S. Treasury regulations minimizes the likelihood that the Department will seek either a combination or an expanded combination.

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¹A person is conducting passive investment operations if the person's primary activities in any one state or province are (i) the maintenance and management of intangible investments or of the intangible investments of other persons and (ii) the collection and distribution of the income from such investments or from tangible property located outside Ohio. As a general rule, such activities in any one state or province are the primary activities of that person in any one state of province if in that state or province (i) the person's gross receipts are primarily derived from such activities and/or (ii) the person's assets are primarily used for such activities.

²In lieu of attaching to the franchise tax report the study, the taxpayer can attach on top of the report a fully-completed Ohio form FT-HELP setting forth (i) that the taxpayer has prepared such a study and (ii) that the taxpayer will make the entire study available to the tax commissioner upon request.

³While R.C. 5733.052 neither expressly refers to nor includes language similar to Internal Revenue Code (“IRC”) section 482, the above-quoted language in R.C. 5733.052(C) intimates that a "482-type" standard is one possible condition precedent to the Tax Commissioner's requiring either a combination or an expanded a combination. IRC section 482 states as follows:

"In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible."

Nothing in this information release should be construed to suggest that an IRC section 482-type study will avoid in every circumstance, or, alternatively, is the only means to avoid, this Department's requiring either a combination or an expanded combination. On the other hand, the absence of a timely-prepared IRC section 482-type study requires that the taxpayer and the Tax Department evaluate each situation by scrutinizing the specific facts and circumstances unique to that taxpayer. However, in all situations the tax-payer must provide evidence that the taxpayer’s unique facts and circumstances do not warrant either a required or expanded combi-nation. For example, if the facts establish that corporations are not unitary, then generally a required combination or an expanded combination is not warranted. Furthermore, these same facts and circumstances may also be evaluated by the Department to ascertain whether (i) the requirements for a properly-elected combination or (ii) a taxpayer's request to include additional members subsequent to the initial election to combine will be permitted pursuant to R.C. 5733.052(A).

⁴This portion of the information release draws heavily upon RIA's Federal Tax Coordinator 2d.

⁵As part of fully complying with the U. S. Treasury regulations, the taxpayer must apply the arm's length standard as provided in the regulations at the time the taxpayer files its original franchise tax report, and the taxpayer must have contemporaneous documentation establishing such compliance as provided for in IRC section 6662(e) and the U. S. Treasury regulations issued thereunder.

⁶The reader should not infer that failing to provide such a study will, ipso facto, result in the Department's requiring either a combina-tion or an expanded combination; rather, providing such a study may avoid the Department’s requiring that the taxpayer establish that the facts and circumstances do not warrant either a required combination or an expanded combination.


If you have any questions regarding this matter, please contact the Department at 614-433-7617.

R.C. 5733.052 Combined reports.

(A) At the discretion of the tax commissioner, any taxpayer that owns or controls either directly or indirectly more than fifty per cent of the capital stock with voting rights of one or more other corporations, or has more than fifty per cent of its capital stock with voting rights owned or controlled either directly or indirectly by another corporation, or by related interests that own or control either directly or indirectly more than fifty per cent of the capital stock with voting rights of one or more other corporations, may be required or permitted, for purposes of computing the value of its issued and outstanding shares of stock under division (B) of section 5733.05 of the Revised Code, to combine its net income with the net income of any such other corporations.

(B) A combination of net income may also be made at the election of any two or more tax-payers each having income, other than dividend or distribution income, from sources within Ohio, provided the ownership or control requirements contained in the division (A) of this section are satisfied and such combination is elected in a timely report which sets forth such information as the commissioner requires. This election, once made by two or more such taxpayers, may not be changed by such taxpayers with respect to amended reports or reports for future years without the written consent of the commissioner. As used in this section, "income from sources within Ohio" means income that would be allocated or apportioned to Ohio if the taxpayer computed its franchise tax without regard to this section.

(C) No combination of net income under division (A) of this section shall be required unless the commissioner determines that, in order to properly reflect income, such a combination is necessary because of intercorporate transactions and the tax liability imposed by section 5733.06 of the Revised Code.

(D) In case of a combination of income, the net income of each taxpayer shall be measured by the combined net income of all the corporations included in the combination. For purposes of such measurement, each corporation's net income shall be determined in the same manner as if the corporation were a taxpayer under this chapter. In computing combined net income, intercorporate transactions, including dividends or distributions, between corporations included in the combination shall be eliminated. If the computation of net income on a combination of income involves the use of any of the formulas set forth in this chapter, the factors used in the formulas shall be the combined totals of the factors for each corporation included in the combination after the elimination of any intercorporate transactions. The exemptions and deductions permitted under this chapter shall be taken in the same manner as if each corporation filed a separate report.

(E) For purposes of division (B) of section 5733.05 of the Revised Code, each taxpayer's net income allocated or apportioned to this state shall be computed as follows: to compute the taxpayer's net income allocated to this state for purposes of division (B)(1) of section 5733.05 of the Revised Code, the taxpayer's net income for sources allocated under section 5733.051 of the Revised Code shall be separately determined, eliminating intercorporate transactions, and allocated to this state as provided by section 5733.051 of the Revised Code. To compute the taxpayer's net income apportioned to this state for purposes of division (B)(2) of section 5733.05 of the Revised Code, the combined net income, other than net income from sources allocated under section 5733.051 of the Revised Code, shall be apportioned to Ohio and then prorated to the taxpayer on the basis of its proportionate part of the factors used to apportion the total of such net income to Ohio.