For many years, companies nationwide have used a Delaware holding company structure to control and minimize state income taxes. Under the Delaware holding company structure, trademarks or other intellectual property were transferred to or acquired by a Delaware corporation, which then gave licenses to one or more operating companies to use the intellectual property in return for payment of a royalty to the Delaware holding company. This had the effect of reducing the operating company’s income allocated to states other than Delaware, and saving substantial state income tax for multi-state corporations because Delaware did not impose a tax on the royalty income. Since the 1980s, the use of the Delaware holding company structure was a well accepted structure that minimized state income tax for multi-state corporations.

Starting around 2000, various states began to attack the structure, claiming the holding company lacked substance in Delaware and had a nexus sufficient to the states where the operating company operated to require the holding company to file tax returns and pay income tax in such states based on the royalty income. Similarly, various states enacted legislation either to require consolidated tax returns of the operating company and the Delaware holding company – or alternatively to require the operating company to calculate its state income with an “add back” for a pro-rata part of the royalty payments made to the Delaware holding company.

This issue has been debated in Pennsylvania for many years, and the Pennsylvania General Assembly acted this month to eliminate the benefit of the Delaware holding company structure – unless the taxpayer can qualify under certain stated exceptions.

HB 465 was signed in the Pennsylvania Senate on July 3 and the House of Representatives on July 8, 2013. It was signed by Governor Corbett on July 9, and is now Act 52.

Act 52 adopts the “add back” method of eliminating the Delaware holding company tax benefit.

Explanation of new requirement. The change is being made by amending definition provisions and adding now provisions to the Pennsylvania Tax Reform Code of 1971 corporate net income tax rules. In particular, the changes provide that as of January 1, 2015, “no deduction shall be allowed for an intangible expense or cost, or an interest expense or cost, paid, accrued or incurred directly or indirectly in connection with one or more transactions with an affiliated entity.”

An “intangible expense or cost” is defined under new § 401(8) as “[r]oyalties, licenses or fees paid for the acquisition, use, maintenance, management, ownership, sale, exchange or other disposition of patents, patent applications, trade names, trademarks, service marks, copyrights, mask works or other similar expenses or costs.”

An “interest expense or cost” is defined under new § 401(9) as a “deduction allowed under section 163 of the Internal Revenue Code of 1986 (26 U.S.C. § 163) to the extent that such deduction is directly related to an intangible expense or cost.”

An “affiliated entity” is defined under new § 401(10) as a person with a relationship to the taxpayer during all or a portion of the taxable year that is one of the following:

(i) A stockholder who is an individual, or a member of the stockholder’s family holding more than 50% of the taxpayer’s outstanding stock;

(ii) A stockholder (including an entity) that holds more than 50% of value of taxpayer’s outstanding stock;

(iii) A corporation, or a party related to corporation under the attribution rules of the Internal Revenue Code of 1986 (“IRC”), if the taxpayer owns 50% or more of the outstanding stock of the corporation;

(iv) A component member under 1563(b) of the IRC;

(v) A person from whom there is attribution of stock ownership under 1563(e) of the IRC.

The net effect of these definitions and rules is that starting in 2015 – unless the taxpayer can qualify under certain stated exceptions – companies operating in Pennsylvania will no longer be permitted to deduct royalties paid to related Delaware companies that hold intellectual property rights used by the Pennsylvania company. In effect, a Pennsylvania company will add back to its Pennsylvania income the amount it has paid to a related Delaware holding company.

Exception to requirement. There are certain exceptions to the “add back” requirement. The exceptions state that the “add back” requirement does not apply:

(2) to a transaction that did not have as the principal purpose the avoidance of tax due and that was done at arm’s length rates and terms; or

(3) to a transaction between a Pennsylvania corporation and an affiliated entity domiciled in a foreign nation which has a tax treaty within the United States; or

(4) to a transaction where an affiliated entity directly or indirectly paid, accrued or incurred a payment to a person who is not an affiliated entity, if the payment is paid, accrued or incurred on the intangible expense or cost, or interest expense or cost, and is equal to or less than the taxpayer’s proportional share of the transaction.

Tax planning required. Companies with the Delaware holding company structure will need to determine if they can qualify for one of the stated exceptions. For example, if a company can defensibly establish that the principal purpose of the holding company was protection of intellectual property from creditors of one or more operating companies, or that the principal purpose was to manage the ownership of intellectual property, this might qualify the company for the exception applicable when the transaction did not have the principal purpose of tax avoidance. The exceptions will be helpful to some but not to many companies using the Delaware holding company structure. Companies that cannot establish qualification for an exception will need to calculate and budget for additional Pennsylvania tax based on this significant law change. In addition, such companies will need to determine the best method of addressing and possibly undoing the existing Delaware holding company structure.

Cautionary notes. The Pennsylvania legislation is prospective. However, this does not necessarily protect against back tax claims. Some states that have implemented “add back” legislation have pursued companies for back taxes prior to the effective date of the “add back” legislation. Such claims have been based on the allegations mentioned above that the holding company lacked substance in Delaware and had a nexus sufficient to the states where the operating company operated to require the holding company to file tax returns and pay income tax in such states based on royalty income. In pursuing this path, such states have often claimed significant penalties and interest to obtain leverage in negotiating a back tax settlement. Companies planning for the change in Pennsylvania should also consider this potential.

There have been numerous court challenges to “add back” legislation and back tax nexus claims. However, such litigation generally has not been successful – and the United States Supreme Court has to date declined to hear constitutional challenges.

If you have any questions regarding any business law matter, including the issues discussed in this newsletter, please do not hesitate to contact us at 717/392-1100, or email us at the following addresses:



Corporate and Business Law Group

(717) 392-1100

Charles F. Blumenstock, Jr. 

Rhonda F. Lord                       

Jason T. Confair                      

Anita Henkel Blumenstock   

Clarence C. Kegel, Jr.             

Lindi R. Barton-Brobst          

© 2013 Kegel Kelin Almy & Lord LLP. All Rights Reserved.

This publication is designed to provide general information on the topics presented. If legal or other professional advice is required, the services of a professional should be sought.