Tax Law Alert: Imputed Revenues Derived from Services Performed for Affiliates without Compensation
The Washington Court of Appeals recently issued a decision in Getty Images v. City of Seattle
, Docket No. 65113-7 (Sept. 12, 2011). This decision is a classic case of bad facts leading to bad law, with potentially wide-ranging effects. The facts found by the court involve:
- An administrative services affiliate that was formed outside Washington with no employees and no assets;
- A below-cost subcontract between that affiliate and the Seattle-based parent; and
- Payments to the parent characterized as loans that covered the remaining costs.
An expansive reading of the court's opinion could call into question the tax treatment of legitimate intercompany transactions. Moreover, while the case involves only Seattle business and occupation tax, the court's reasoning could be applied to state business and occupation tax and to taxes imposed by other cities.
The pertinent facts of the case are as follows:
- Getty Images (Seattle), Inc. ("Getty Seattle") is a parent corporation with 60 affiliated companies with offices in more than 25 countries. It licenses and sells stock photographs, video footage, and editorial images for a fee. In prior years, Getty Seattle had provided a wide range of administrative services for its affiliates, apparently free of charge. But as a result of a 2001 foreign audit, Getty Seattle decided it needed to charge its affiliates the full cost of these services so that they, in turn, could show the full cost of their business operations. Apparently, this would allow each of these affiliates to apportion their net income in relationship to where these costs were incurred, which would reduce their foreign tax costs. However, if Getty Seattle directly charged the affiliates for its full cost of providing these services, it would be subject to Washington state and Seattle city B&O taxes on the resulting revenues.
- Getty Seattle tried to avoid these adverse local tax consequences by creating a new subsidiary, Getty Images (Management Company) LLC ("Getty Management") in California. Getty Management had no employees, no physical assets, and performed no direct services. Nevertheless, Getty Management entered into direct contracts with each of the affiliate entities to provide administrative services to them. The affiliates, in turn, agreed to pay Getty Management the full costs of these services, i.e., from $25,000,000 to $98,000,000 per year. (During the five year audit period, Getty Management received a total of $307,000,000 from those affiliates.) Getty Management then "subcontracted" the performance of these services to Getty Seattle under an agreement whereby Getty Seattle only invoiced Getty Management $1,000,000 per year. Getty Seattle employed 450 people in Seattle to perform these services.
- Because the $1,000,000 per year of contract payments that Getty Seattle received each year from Getty Management was far less than the actual cost of performing these services, Getty Seattle "borrowed" money from Getty Management by making withdrawals from the cash management concentration account it managed for itself and all of the affiliates. With each withdrawal of cash to meet actual expenses, Getty Seattle recorded a simple "Account Payable" that it owed to Getty Management. There were no actual payments from Getty Seattle to Getty Management to satisfy this account payable, nor were there any other evidences of a debt owed.
The City of Seattle claimed that Getty Seattle was liable for city B&O tax on the full amount of its costs for performing these services. In this instance, the City of Seattle imposed its city business and occupation tax on both the $1,000,000 per year actual payments as well as the additional withdrawals that were recorded in the Account Payable account. When Getty Seattle appealed this tax assessment to the Seattle City Hearing Examiner, the hearing examiner upheld the tax assessment. Upon appeal to the King County Superior Court, the court entered judgment upholding the hearing examiner's decision.
On appeal from the superior court's judgment, Division One of the Washington Court of Appeals also agreed that Getty Seattle's total "gross revenues" or "compensation for the rendition of services" included both the actual payments Getty Management made, as well as the additional funds that Getty Seattle withdrew from the cash management account that were recorded as "Accounts Payable." The Court of Appeals concluded that the definition of "gross revenue" includes "emoluments however designated" and these additional withdrawals fell within the scope of that language. The taxpayer has stated its intention to seek discretionary review of this decision by the Washington Supreme Court, but we will not know whether the Supreme Court will accept review of the decision for several weeks.
We believe this decision creates a danger to other taxpayers who perform services for their affiliates, with or without compensation. The logic of the Getty Images decision could be used to assert state and city B&O taxes against any taxpayer that performs services for affiliates without compensation, or to increase the amount of asserted revenues that are subject to tax, as was the case for Getty Seattle. In the past, few businesses worried about such activities because they did not view the activities as generating any "gross revenues" that could be subject to tax. The Getty Images decision suggests that other taxpayers cannot be sure they will be left alone on future tax audits. The Washington Department of Revenue or any city finance department might claim that any stream of funds flowing from an affiliate to the service-providing parent constitutes a stream of "gross revenues" that are subject to taxation. There are also several apportionment issues that will be impacted by this decision, particularly under the state's new single factor apportionment rules, where gross revenues are now allocated to the location where the service-recipient is deemed to realize the "benefit" of those services. This means that a non-Washington corporation with no direct business activities in the state might be held liable for Washington taxes if one of its affiliates or subsidiaries is deemed to realize, in Washington, the benefit of services performed outside the state.
Any businesses with concerns about how this decision might affect their activities should contact their qualified state tax counsel or a member of the Stoel Rives Tax Group to determine their potential tax exposure and what steps they should take to minimize or eliminate that exposure.