The Indiana Department of Revenue ruled that it was “entirely reasonable” to eliminate a Manufacturer’s inter-company interest expenses.

In a September 2014 ruling, a multi-national manufacturer with Indiana locations protested the Indiana Department of Revenue’s decision to add back interest expenses claimed on its corporate income tax returns.  Manufacturer and its affiliates filed separate Indiana income tax returns.  Upon audit, the Department asserted that Manufacturer’s reported adjusted gross income did not “fairly reflect” its Indiana source income for the 2008 to 2010 tax years.  Consequently, the Department made adjustments resulting in the assessment of income tax.

The Department noted that most of Manufacturer’s $4.2 billion of gross profits during the tax years were offset on the original returns by interest expenses, the vast majority of which were inter-company expenses.  Manufacturer borrowed money from and paid interest to its affiliates. The audit report asserted that Manufacturer paid the expenses to operate its affiliates, allowing them to “earn the most money.”  Moreover, the “technically insolvent” company continued operating only because centralized treasury functions allowed it to “sweep cash” from the affiliates into the main bank account administered by Manufacturer.  Therefore, according to the audit report, Manufacturer cannot “survive on its own on an arms-length basis” and the “inter-company loans are nothing more than an elaborate attempt to shift income away from separate return states.”

The audit report’s remedy was to add back the inter-company interest expenses to Manufacturer’s net federal taxable income, reasoning this addressed the “major source” of distortion.  Manufacturer argued that the Department was “improperly and arbitrarily attempting to change the definition of ‘taxable income’ as strictly defined” by Indiana statute.  The Department disagreed, explaining that Manufacturer “essentially negates its state tax liability by claiming interest expenses for money borrowed from its own affiliates on loans for which there is no indication it has or ever will repay” and that eliminating the interest expense was an “entirely reasonable” method to “effectuate an equitable allocation and apportionment of the taxpayer’s income.”  According to the Department, Manufacturer’s position would nullify the Department’s statutory “fairly represent” remedies under Indiana Code § 6-3-2-2(l), (m).