A New York intermediate appellate court upheld a New York State Tax Appeals Tribunal determination finding that International Business Machines Corp. and its combined affiliates (together, “IBM”) improperly deducted royalty payments from related foreign entities. Matter of International Business Machs. Corp. & Combined Affiliates v. Tax Appeals Trib. of the State of N.Y., 2023 N.Y. App. Div. LEXIS 1356, 2023 NY Slip Op 01326 (3d Dep’t 2023). The Court found that IBM could not deduct royalties received from foreign affiliates for the use of intangible assets because the affiliates were not New York taxpayers subject to the state’s addback laws and the royalty payments would escape taxation.

The Facts: IBM is organized under the laws of New York and specializes in, among other things, developing and selling computer hardware and software. IBM owns certain intangible property, including the IBM brand, and operates partly outside of the United States through subsidiary companies ("foreign affiliates"). IBM World Trade Corporation (“WTC”), a wholly owned subsidiary of IBM headquartered in New York, manages and develops the marketing of IBM’s products and equipment outside the United States. Foreign affiliates paid royalty payments to IBM and WTC in exchange for, among other things, the right to exploit intangible property relating to IBM’s hardware and software. IBM and WTC deducted the royalty payments received from the foreign affiliates in calculating their New York State tax liability.

The Decision: IBM argued that New York law permitted taxpayers to deduct royalty payments received from related entities regardless of whether the related entity was itself a New York taxpayer. The Court rejected IBM’s statutory argument determining that it was “nearly identical” to the argument raised and decided by the Court in the recent case Matter of Walt Disney Co. & Consol. Subsidiaries v. Tax Appeals Trib. of the State of N.Y., 210 A.D.3d 86 (3d Dep’t 2022), stating that “we find no reason to depart from our recent holding on this issue.” The Court then went on to address IBM’s dormant Commerce Clause arguments which were “distinguishable” from those raised in Walt Disney. Specifically, IBM argued that the State’s interpretation of the royalty income exclusion failed both the internal and external consistency tests. To pass internal consistency, a tax must be structured so that if every state imposed the identical tax, no multiple taxation would result. IBM argued that if every state imposed the royalty expense addback and the royalty income exclusion, transactions with non-New York licensees would be taxed more than those with New York licensees. The Court rejected the argument as “too narrow,” because it neglects “the fact that there are two taxable events occurring, one being the payment and the other being receipt of that payment.” The Court determined that “[w]hen these two actions are properly recognized and balanced based on the whole scheme of taxation, non-New York licensees would not be subject to greater taxation than those with New York licensees because non-New York licensees would be able to realize a deduction.”

Turning to the external consistency test, which asks whether a state has taxed values not fairly attributable to the taxpayer’s activity within the state, the Court highlighted that IBM was organized under New York law and that both IBM and WTC have their head offices in New York. The Court went on to determine that IBM “has enjoyed rather significant tax credits under the New York tax scheme it now complains of; when measured against the challenged royalty income exclusion, it cannot be said that these benefits are unreasonable in comparison.”