When a parent company's foreign-possessions subsidiary uses the federal Profit Split Method to allocate income from intangibles, how do the parent's resulting receipts get sourced in Tennessee's excise tax apportionment formula?

Plain-English summary

This ruling involves a fairly exotic piece of federal tax law: IRC § 936, which let a U.S. corporation earning most of its income in U.S. possessions (like Puerto Rico) take a tax credit against federal income tax. Congress became concerned that companies were transferring valuable intangibles (patents, trademarks, know-how) tax-free to a § 936 subsidiary, letting the subsidiary capture all the resulting profit tax-free — the Joint Committee on Taxation's classic example: a pharmaceutical company develops a drug in the U.S. (taking deductions and R&D credits along the way), then transfers the patent to its § 936 subsidiary, which then earns the drug's very high profit margin essentially tax-free. Congress responded with § 936(h), which forces the U.S. parent to recognize some of that intangibles-driven income itself.

One method for doing that allocation is the Profit Split Method (P.S.M.): the parent and subsidiary's combined income from the subsidiary's product is treated as one pot, split 50/50 between them, and separately, the parent must charge the subsidiary a formula-based fee tied to the parent's own R&D costs (which the parent recognizes as its own income). The taxpayer here — a Tennessee-doing-business parent whose subsidiary made a valid § 936 election — asked how this federal income-splitting mechanism should be sourced for purposes of Tennessee's excise tax apportionment formula (the property/payroll/receipts formula that determines how much of a multistate company's income Tennessee gets to tax).

The Department split the analysis into the P.S.M.'s two income streams:

1. The 50% of product-sales income assigned to the parent is, at bottom, income from selling tangible personal property — so it's sourced under Tennessee's ordinary destination rule: it counts toward Tennessee's receipts numerator only if the product is actually delivered to a purchaser located in Tennessee, regardless of where anything was made or shipped from.
2. The R&D fee the parent charges the subsidiary is treated as income from performing services (not a sale of property, and — the ruling specifically checked and ruled out — not licensing/royalty income, since nothing in the facts showed the intangibles were actually licensed rather than simply used internally by the subsidiary). Service income sources to Tennessee under a "greater cost of performance" test: it lands in Tennessee's numerator only if a greater share of the R&D costs that generated the fee were incurred in Tennessee than in any other single state.

The Department couldn't finish the sourcing analysis on these facts because the ruling request didn't say where the R&D actually happened or where its costs were incurred — that's a factual determination the taxpayer has to make itself from its own cost records.

What this means for you

Multistate companies with foreign-possessions subsidiaries or complex intangibles-income-splitting arrangements

Federal income-allocation mechanisms (like the § 936 Profit Split Method) don't automatically translate into a single Tennessee apportionment treatment — each component income stream has to be independently characterized (sale of property vs. services vs. royalties) and sourced under its own Tennessee rule. Don't assume a single federal "type" of income gets one uniform state sourcing treatment; break it into its component pieces the way this ruling did.

Accountants and tax professionals

This ruling is a useful worked example of Tennessee's destination rule for tangible-property sales (§ 67-4-2012(h)) versus the greater-cost-of-performance rule for services (§ 67-4-2012(i), Rule 34) versus the royalty-sourcing rule (§ 67-4-2012(j)) — and a reminder to check whether an intangibles-related income stream is actually a licensing arrangement (royalty sourcing) or just an internal cost allocation/fee (service sourcing) before picking a sourcing rule. Note this ruling predates many later Tennessee apportionment amendments; confirm the current version of § 67-4-2012 before relying on its mechanics.

Common questions

Q: How does Tennessee source income from selling tangible products under this kind of profit-split arrangement?
A: Under the ordinary destination rule -- it's included in Tennessee's receipts numerator only if the product is delivered to a purchaser located in Tennessee.

Q: How does Tennessee source the R&D fee income?
A: As service income, using a "greater cost of performance" test -- it's included in the Tennessee numerator only if a greater share of the R&D costs were incurred in Tennessee than in any other single state.

Q: Why didn't the royalty/licensing sourcing rule apply instead?
A: Because nothing in the facts indicated the taxpayer had actually licensed the intangibles to the subsidiary -- the R&D charge was a formula-based cost allocation/fee, not a royalty for the use of licensed IP.

Q: Can another company with a similar arrangement rely on this ruling?
A: No. A Tennessee letter ruling binds the Department only as to the specific taxpayer and facts it was issued to, and it can be revoked or modified by the Commissioner. This is also an unusually old and narrow federal-law-dependent ruling (IRC § 936 possessions credits were later phased out federally) -- confirm current relevance with a tax professional before relying on it.

Citations and references

Tennessee statutes and rules (Tenn. Code Ann. unless noted):

• § 67-4-2007 (excise tax on persons doing business in Tennessee)
• § 67-4-2012 (apportionment formula -- property, payroll, receipts factors)
• § 67-4-2012(h) (tangible personal property sales sourced by destination)
• § 67-4-2012(i) (service income sourced by greater cost of performance)
• § 67-4-2012(j) (royalty/licensing income sourced to Tennessee if licensed to a TN licensee -- not applicable here)
• § 67-4-2111(h) (parallel franchise tax apportionment provision)
• Tenn. Comp. R. & Regs. 1320-6-1-.34 (Rule 34) ("earnings producing activity" and "costs of performance" defined)

Federal law cited by the ruling:

• I.R.C. § 936, § 936(h) (possessions tax credit; recognition of intangibles-related income)
• I.R.C. § 936(h)(5)(C)(ii), (ii)(III) (Profit Split Method)
• Staff of Joint Comm. on Taxation, 97th Cong., 2d Sess., General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (legislative history/purpose of § 936(h))

Source

• Landing page: https://www.tn.gov/revenue/tax-resources/legal-resources/tax-rulings.html
• Original PDF: https://www.tn.gov/content/dam/tn/revenue/documents/rulings/fae/06-01fe.pdf

Original ruling text

TENNESSEE DEPARTMENT OF REVENUE
LETTER RULING # 06-01
WARNING
Letter rulings are binding on the Department only with respect to the individual taxpayer
being addressed in the ruling. This presentation of the ruling in a redacted form is
informational only. Rulings are made in response to particular facts presented and are not
intended necessarily as statements of Department policy.
SUBJECT
Tennessee excise tax treatment of income recognized under the Profit Split Method of IRC §
936(h)(5)(C)(ii).
SCOPE
This letter ruling is an interpretation and application of the tax law as it relates to a specific set of
existing facts furnished to the Department by the Taxpayer. The rulings herein are binding on
the Department and are applicable only to the individual taxpayer being addressed.
This letter ruling may be revoked or modified by the Commissioner at any time.
Such revocation or modification shall be effective retroactively unless the following conditions
are met, in which case the revocation shall be prospective only:
(A) The taxpayer must not have misstated or omitted
material facts involved in the transaction;
(B) Facts that develop later must not be materially
different from the facts upon which the ruling was based;
(C) The applicable law must not have been changed or
amended;
(D) The ruling must have been issued originally with
respect to a prospective or proposed transaction; and
(E) The taxpayer directly involved must have acted in
good faith in relying upon the ruling and a retroactive
revocation of the ruling must inure to his detriment.
FACTS
The Taxpayer is a [INDUSTRY] company authorized to do business in Tennessee. The
Taxpayer is the sole shareholder of a subsidiary company which has made a valid election under
Internal Revenue Code (“I.R.C.”) § 936. For federal tax purposes, the Taxpayer recognizes
income pursuant to the Profit Split Method (“P.S.M.”) outlined in I.R.C. § 936(h)(5)(C)(ii).

Pursuant to I.R.C. § 936, the subsidiary is not included in the Taxpayer’s consolidated federal
income tax return.
Under I.R.C. § 936, a U.S. corporation earning the majority of its income in U.S. possessions
(including Puerto Rico and the Virgin Islands) can take a possession tax credit to offset federal
income tax liability, regardless of whether a possession tax was ever paid. In 1982, Congress
enacted I.R.C. § 936(h) to require U.S. shareholders of a § 936 corporation to recognize income
generated from intangible property. The Joint Committee on Taxation (“J.C.T.”) outlined the
reasons for adding this provision noting that “under prior law, some taxpayers had taken the
position that they could make tax-free transfers of intangible assets created or acquired in the
United States (such as patents, secret processes, and trademarks) to an electing § 936
corporation, and that no allocation of income generated by those intangibles to the U.S. parent
was required.” To illustrate the need for this provision, the J.C.T. used the example of a
pharmaceutical company:
“For instance, a U.S. pharmaceutical company could spend (and deduct or
amortize and take a research and development tax credit for) large sums for
research and development of new drugs. When it developed an effective drug, it
could transfer the patent on the drug and the know-how to manufacture the drug
to a § 936 subsidiary in a purportedly tax-free exchange. Thereafter, the 936
company could manufacture the drug and claim for itself the extremely high
profits which typically result for the sale of pharmaceutical products. It was
Congress’ understanding that high profits on certain pharmaceutical products
must be realized because, according to the industry, the profits from the relatively
few successful drugs must, in effect, amortize the development costs of all the
unsuccessful products and finance the necessary research and development for
future products. This results in the creation of extremely valuable intangibles
(e.g. patents and trademarks) in the drug industry. If there is no allocation of
income from the intangibles to the developer (the U.S. parent) a distortion of
income results, with the parent obtaining deductions for its efforts while the 936
company realizes tax-free income.”1
Thus, I.R.C. § 936(h) was enacted “to subject to U.S. tax income attributable to intangibles that
add value to the products produced by a § 936 corporation.”2 I.R.C. § 936(h)(5) allows a
shareholder of an I.R.C. § 936 company to compute its income pursuant to either the Cost
Sharing Method or P.S.M. As noted above, [THE TAXPAYER] has elected to recognize income
under this section using the P.S.M.
The P.S.M. essentially views the affiliated group’s combined income from the subsidiary’s
product or service as a single effort. Sales from the group to third parties represent the group’s
revenue. Revenue less the costs incurred by the affiliated group in the development, production,
and sale of the product equals the group’s net income. Fifty percent (50%) of the income related

1

Staff of Joint Comm. On Taxation, 97th Cong., 2d Sess. General Explanation of the revenue Provisions of the Tax
Equity and Fiscal Responsibility Act of 1982 at 83 (Comm. Print 1982).
2
Ibid.

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to these products is included in the parent’s federal consolidated group’s income. The remaining
fifty percent (50%) is assigned to the subsidiary.
In addition, pursuant to the P.S.M., the parent is required to charge the subsidiary a minimum
amount related to the Taxpayer’s research and development expenses. This is calculated based
on a formula provided in § 936. The parent recognizes this charge as income.
For federal income tax purposes, the Internal Revenue Service requires that the net income
recognized under the P.S.M. be reported on Line 10, Form 1120, as “Other Income.” Receipts
and expenses associated with the goods manufactured by the subsidiary should not be reflected
elsewhere on Form 1120.
QUESTION
How should the receipts associated with the I.R.C. § 936 company impact the calculation of the
receipts factor of the Taxpayer’s apportionment formula for excise tax purposes?
RULING
Under the P.S.M., the combined taxable income associated with the subsidiary’s product is
divided equally between the Taxpayer and the subsidiary. Thus, half the income (that amount
attributed to the Taxpayer) will be included in the denominator of the Taxpayer’s receipts factor.
For purposes of the receipts numerator, these receipts will be sourced based on the destination
state of the recipient of the product. Additionally, the Taxpayer is required to recognize income
related to its research and development activities. The research and development income will be
included in the denominator of the Taxpayer’s receipts factor. For purposes of the receipts factor
numerator, these receipts will be sourced to each state based on the location where the services
are performed.
ANALYSIS
Tenn. Code Ann. § 67-4-2007 imposes an excise tax on certain persons doing business in
Tennessee. Tenn. Code Ann. § 67-4-2012 provides that the apportionment formula for excise
tax shall consist of three factors: property, payroll and receipts. The receipts factor is counted
twice in the numerator of the formula. These factors are then divided by a denominator of four
(4).
Regarding the receipts factor, Tenn. Code Ann. § 67-4-2012, provides the following:
(h) Sales of tangible personal property are in this state if:
(1) The property is delivered or shipped to a purchaser, other than the United States
government, inside this state regardless of the F.O.B. point or other conditions of the
sale; or
(2) The property is shipped from an office, store, warehouse, factory or other place of
storage in this state and the purchaser is the United States government.

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(i) Sales, other than sales of tangible personal property, are in this state if the earningsproducing activity is performed:
(1) In this state; or
(2) Both in and outside this state and a greater portion of the earnings-producing
activity is performed in this state than in any other state, based on the costs of
performance.
The same provisions apply to franchise tax. See Tenn. Code Ann. § 67-4-2111(h).
Tenn. Comp. R. & Regs. 1320-6-1-.34 (Rule 34) provides further guidance by defining the terms
“earning producing activity” and “cost of performance” as follows:
(2) The term “earnings producing activity” applies to each separate item of income and
means the transactions and activity directly engaged in by the taxpayer in the regular
course of its trade or business for the ultimate purpose of obtaining gain or profit.
(3) The term “costs of performance” means direct costs determined in a manner
consistent with generally accepted accounting principles and in accordance with accepted
conditions or practices in the trade or business of the taxpayer.
The Taxpayer’s question concerns two sources of income. First, as noted in the facts, under the
P.S.M., the income from the subsidiary’s sales is split so that the fifty percent (50%) of the
income related to their product sales is assigned to the subsidiary and the remaining fifty percent
(50%) is assigned to the other members of the affiliated group, in this case, the Taxpayer.
Second, under the P.S.M. the Taxpayer charges the subsidiary a fee related to the Taxpayer’s
research and development expenses. The Taxpayer recognizes this fee as income.
On first glance, it might appear the provisions of Tenn. Code Ann. § 67-4-2012(j) regarding
royalties from licensing intangibles would apply. That section provides, in pertinent part, “…any
person doing business in Tennessee, who licenses the use of patents, trademarks, tradenames,
copyrights, or know-how, or other intellectual property to another person in Tennessee, and who
is paid royalties or other income based on the sale of products or other activity in Tennessee by
the licensee, shall source such income to Tennessee for purposes of its apportionment formula
receipts factor.” However, there is nothing in the facts indicating the Taxpayer has licensed
these intangibles. Thus, Tenn. Code Ann. § 67-4-2012(h) and (i), as quoted above, are the
applicable subsections.
Under IRC § 936(h)(5)(C)(ii)(III), half of the affiliated group’s income derived from the sales
of the subsidiary’s products are assigned to the Taxpayer. The Taxpayer, therefore, recognizes
income from the sale of tangible personal property that will be sourced pursuant to Tenn. Code
Ann. § 67-4-2012(h). That income will be included in the Taxpayer’s receipts factor, sourced to
the appropriate state based on the destination of the sale.
Under the P.S.M., the Taxpayer is required to charge the subsidiary for a percentage of the
research and development costs attributed to the development of the subsidiary’s product. The
income from this charge is considered income from the performance of services and should be
included in the Taxpayer’s receipts factor. Pursuant to Tenn. Code Ann. § 67-4-2012(i) and

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Rule 34, the income would be included in the numerator for Tennessee if the activities that
resulted in the income were performed solely in Tennessee or the earnings producing activities
were performed inside and outside Tennessee with the greater proportion of the earnings
producing activity having been performed in Tennessee. That determination is based on the
“costs of performance” as defined in Rule 34. In this case, the cost of performance is the
research and development expense the Taxpayer incurred developing the intangibles
(manufacturing processes, patents, trademarks, etc.) that the Taxpayer transferred to the
subsidiary.
The facts presented do not indicate in what state the earnings producing activities occurred. If
the taxpayer performed the research and development in Tennessee and incurred the costs, or at
least a majority of those costs in Tennessee, than in any other state, the income will be sourced to
Tennessee and included in the numerator of the Taxpayer’s receipts factor. If the taxpayer
incurred a greater portion of those costs outside Tennessee, the income will not be included in
the numerator of the Taxpayer’s receipts factor.

Craig A. Jenkins
Tax Counsel

APPROVED: Loren L. Chumley
Commissioner of Revenue
DATE:

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01/09/2006