www.pwc.com
UC Davis
Summer Tax Institute
Advanced Income Tax Track
Day 3: June 14, 2017
Table of Contents
Section
Overview
1.
Tax Base Issues
2.
Apportionment Factors –Payroll & Property
3.
The Sales Factor
4.
Sales Factor—Market Sourcing
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Section 1
Tax Base Issues
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Table of Contents
Section
Overview
1.
Tax Base Issues
A. Overview/Introduction
B. State Modifications--Typical Addition Modifications
C. State Modifications--Typical Subtraction Modifications
D. Combined Reporting Tax Base Issues and Mechanics
E. Alternative Tax Bases
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Advanced Income Tax Track
Overview
Overview of State Taxable Income Computation and Federal
Taxable Income Starting Point
• As will be discussed, most states which impose state income taxes
begin the State computation with federal taxable income (“FTI”) –
either before special deductions (line 28) or after such (line 30).
- “Special deductions” are items such as the federal net operating
loss (“NOL”) deduction and dividends received deduction
(“DRD”).
• The determination of the appropriate FTI to use is made more
complicated in States which do not reference the current version of
the Internal Revenue Code (“IRC”).
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Advanced Income Tax Track
Overview
• Further complications arise due to differences between federal and
State filing methodology and the need to redetermine FTI on a “pro
forma” basis which is consistent with the state filing method (e.g.
Separate filing, nexus combined, domestic/water’s edge combination
or worldwide combination).
• Various modifications are made to the FTI base in arriving at State
net income, after which allocation and apportionment is typically
applied.
• The computation of state taxable income can be complex in
combined reporting states, particularly those which include foreign
operations.
• Finally, a number of states employ alternative tax bases – a few of
which will be explored.
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Advanced Income Tax Track
Overview
Overview of State Income Tax Base Computation
Federal Taxable Income (Line 28 or 30)
+/- State Modifications
Total Taxable Income
-
Allocable Non-business Income
Apportionable Business Income
x
Apportionment Percentage
Business Income Apportioned to State
+
Nonbusiness Income Allocated to State
State Taxable Income
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Advanced Income Tax Track
Overview
IRC Conformity - Federal Taxable Income as the Starting Point
• Nearly all states conform to federal income tax provisions to one
degree or another. Most do so by conforming to line 28 or line 30 of
Form 1120 on a current basis (“moving conformity” states) or as
computed under the IRC as of a set point in time (“static
conformity”). Such states then subject the federal taxable income
(“FTI”) starting point to specific state level modifications to adapt
FTI to state taxable income.
- Examples of static conformity states include: AZ, FL, GA, ID, IA,
KY, ME, MN, NC, SC, TX, VT, WV and WI.
- Examples of moving conformity date states include: AK, CO, DE,
DC, IL, KS, LA, MD, MA, MO, MT, NE, NM, ND, OK, PA, RI, TN
and UT.
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Advanced Income Tax Track
Overview
Example 1: Impact of Static Conformity Date
• In 2009, ABC Corp (based in Kentucky) repurchases bonds it had
issued in 2004 with a face value of $10 million for $5 million.
• For federal tax purposes, the $5 million of cancellation of
indebtedness income (“CODI”) it would otherwise have recognized
under IRC §61 is deferred under IRC §108(i)(1), an amendment made
as part of the American Recovery and Investment Act of 2009.
• Federal taxable income is a loss of $2 million.
• For Kentucky purposes, the tax base would be $3 million since
Kentucky referred to the IRC as of December 31, 2006 during the
year at issue and the above deferral would not apply.
• Note that Kentucky subsequently updated its IRC reference date.
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Advanced Income Tax Track
Overview
Impact of Differences in Filing Methodology
• Affiliated groups typically elect to file a consolidated return for federal
income tax purposes. The treasury regulations issued under IRC 1502
contain provisions which impact the determination of federal taxable income
which would not apply in states which do not allow consolidated filings.
• While such states include separate reporting states, they also include certain
combined states which do not adopt the consolidated regulations (e.g.
California, with the exception of the 1502-13 intercompany transaction
regulations), as well as combined States in general, to the extent that the
composition of the combined/consolidated State filing differs from federal.
• As a result various adjustments may need to be made in order to determine
FTI on a pro forma/”as-if” basis which is consistent with the State filing
methodology.
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Advanced Income Tax Track
Overview
Typical pro forma adjustments include:
• Disallowance of capital losses which offset the capital gains of other
consolidated return members
• Current recognition of income, gains, losses, deductions etc from
transactions with consolidated return members which are deferred
for federal income tax purposes.
• Inclusion of dividends in income which were eliminated in
consolidation
• Removal of - 32 “investment adjustments” to subsidiary stock basis
for purposes of determining gain or loss on sale of subsidiary stock.
• “Reactivation” of federal provisions which are “turned off” in
consolidation such as IRC §§ 304 and 357(c).
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Advanced Income Tax Track
Overview
Example 2 – Pro forma Adjustments to FTI
• Parent (P) and Subsidiary (S) file a federal consolidated return. S
files in North Carolina, a separate reporting state.
• S distributes a patent to P with a fair market value (“FMV”) of $20
million and a basis of $0.
• For federal income tax purposes, the distribution results in $20
million of gain under IRC § 311(b) which is deferred in consolidation.
• For North Carolina tax purposes the consolidated return regulations
are not available and FTI may need to be re-determined so as to
include current gain recognition.
• Query whether this fairly reflects income from NC and whether a
petition to file on a combined basis might be possible. . . .
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Advanced Income Tax Track
Overview
NIHC, Inc. v. Comptroller of the Treasury, Maryland Court of Appeals, No. 03C-10-9151, 8/18/2014
• The Maryland Court of Appeals upheld the tax assessed on NIHC (a
Nordstrom subsidiary) resulting from its filing of a separate Maryland
return, even though the gain was deferred over 15 years under the federal
consolidated rules.
• Note that while Maryland taxable income is based on separate entity
“proforma” federal taxable income (FTI), the Taxpayer had originally
included the deferred gain in Maryland taxable income during the years at
issue.
• Query: Would the court have reached a different conclusion had the taxpayer
originally used proforma separate company income or amended its returns
to report such prior to audit? NIHC was found to lack economic substance.
Would the court have reached a different conclusion if NIHC had economic
substance?
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Advanced Income Tax Track
Overview
MCI Communication Services, Inc. v. Director, Division of Taxation,
N.J. Tax Court, No. 013905-2010, July 20, 2015
• The New Jersey Tax Court disallowed a taxpayer’s attempt to claim a
state modification to reverse the effect of ‘push down’ depreciable
asset basis reduction under the consolidated return regulations
resulting from excluded cancellation of debt (“COD”) income at the
parent level. Query whether taxpayer would have been successful
had it reported pro forma separate company income to begin with.
Sherwin-Williams Company v. Alabama Department of Revenue,
Alabama Tax Tribunal, Nov. 30, 2016.
• The Alabama Tax Tribunal held that the taxable income limitation
for purposes of computing the IRC 199 deduction for Alabama
purposes is pro forma separate company federal taxable income, not
separate company Alabama income after state specific adjustments.
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Advanced Income Tax Track
Overview
• A small minority of states do not adopt FTI as the starting point in
their state taxable income computations. Instead, these “selective
conformity” states adopt selected provisions of the IRC, subject to
state modifications as well as a number of state specific provisions
which impact the calculation of state taxable income.
• California is an example of a selective conformity state. Great care
must be taken in determining which IRC provisions are or are not
adopted.
• A further complication in selective conformity states is the many
references to non adopted IRC sections which may be contained in
IRC sections which are specifically adopted.
• See for example, Fujitsu IT Holdings, Inc. v. Franchise Tax Board,
120 Cal.App.4th 459 (2004) and Chief Counsel Announcement 2003
-1 in California.
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Advanced Income Tax Track
Overview
Example 3: California Treatment of Subpart F/“PTI”
• Corporation A owns a 50% interest in Corporation B, a controlled foreign corporation
(“CFC”) based in Ireland which is owned 50% by a third party U.S. shareholder.
• In year 1, Corp B generates $10 million of income which is treated as Subpart F income
under IRC §952 and $5 million (50%) is included in Corp A’s gross income as a
dividend under IRC §951 along with $1 million IRC §78 “gross up” due to IRC §902
deemed foreign taxes paid by Corp A related to the distribution for which Corp A will
claim a federal foreign income tax credit (“FTC”).
• In year 2, Corp B generates $2 million of subpart F income (50% of which is a deemed
dividend to Corp A) and distributes $5 million to Corp A, which is excluded from Corp
A’s federal income as previously taxed income or “PTI” under IRC §959.
• California does not adopt IRC §§ 951, 952, 959, 902, or 78. As a result, Corp A has no
dividend income in year 1 and $5 million of dividend income in year 2.
• Note that in a Water’s Edge environment, majority owned unitary CFCs with Subpart F
income are subject to partial inclusion in the combined report.
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Advanced Income Tax Track
Overview
Federal 1120
Year 1
Year 2
Taxable Income of
Corp A
9,000,000
9,000,000
Subpart F Income
5,000,000
0
IRC §78 Gross-Up
1,000,000
0
FTI (before credits)
15,000,000
9,000,000
California 1o0
Year 1
Year 2
FTI (before mods)
15,000,000
9,000,000
Subpart F Income
(5,000,000)
0
IRC §78 Gross-Up
(1,000,000)
0
0
5,000,000
9,000,000
14,000,000
Dividend Income
CA Taxable Income
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• In year 2, Corp B
distributes $5 million to
Corp A, which is excluded
from Corp A’s federal
income as PTI.
• For California purposes,
Corp A has no dividend
income in year 1 and $5
million of dividend income
in year 2.
• Note that in a Water’s Edge
environment, majority
owned unitary CFCs with
Subpart F income are
subject to partial inclusion
in the combined report.
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Advanced Income Tax Track
Overview
• California’s adoption of IRC provisions is further complicated by fixed date IRC
references and Proposition 26 (“Prop 26”).
• On April 12, 2010, SB 401, the Conformity Act of 2010 was passed. The Act changes
California’s IRC reference date from January 1, 2005, to January 1, 2009. The act is
operative for taxable years beginning on or after January 1, 2010, except as otherwise
noted.
• Subsequently, California voters passed Prop 26 requiring, among other things, a twothirds supermajority vote in each house of the California State Legislature for tax
measures which increased any taxpayer’s liability. Prop 26 applies retroactively to
legislation enacted after January 1, 2010. Previous legislation impacted by the
retroactive application of Prop 26 would need to be re-enacted by the anniversary date
of Prop 26’s passage to remain in effect.
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Advanced Income Tax Track
Overview
Franchise Tax Board Legal Division Guidance 2011-01-01 (Impact of
Proposition 26 on SB 401):
• FTB says SB 401 is the law and that they are required to apply the provisions
of SB 401 for the periods for which it is applicable.
• Section 3.5 of Article III of the California Constitution prohibits an
administrative agency from declaring a statute unenforceable. Therefore,
Section 3.5 of Article III requires the FTB to enforce SB 401 until an
appellate court has made a determination that some portion or all of SB 401
is ‘void’ pursuant to Proposition 26.
Note: The most recent conformity bill, AB 154 of the 2015-16 Regular Session,
passed with a supermajority and updated the IRC reference date to January 1,
2015 for tax years beginning on or after that date and included legislative
findings and declarations stating that SB 401 is valid (“[i]t is the intent of the
Legislature to confirm the validity and ongoing effect of Senate Bill No. 401 of
the 2009–10 Regular Session”).
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Advanced Income Tax Track
Overview
• Cal. Chief Counsel Ruling 2012-06 (Oct. 25, 2012) held that for California
franchise tax purposes, Treas. Reg. §1.337(d)-2(a)(1) does not operate to
disallow a worthless stock deduction upon the conversion of certain insolvent
entities that were included in a federal consolidated group and that filed a
California combined tax return. The FTB reasoned that since such Treas.
Reg. only applied to taxpayers that filed a consolidated federal return, it
would not be applicable for California purposes because California does not
generally provide for the filing of consolidated returns.
• Because Treas. Reg. 1.337(d)-2(a)(1) provides that for transactions involving
loss shares of subsidiary stock occurring on or after September 17, 2008, a
position exists that the unified loss rule does not apply to California under
the same rationale.
• Query: Would states, in addition to California, which do not adopt or follow
the federal consolidated return rules hold that the loss limitation rules and
the unified loss rule are not applicable?
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Advanced Income Tax Track
Overview
Impact of Federal Regulations on State Tax Base
Proposed section 385 regulations
• Guidance released on April 4, 2016 with temporary Section 7847
anti-inversion regulations, with stated intent to limit ‘earnings
stripping’
• Section 385 proposed regulations are not limited to inverted
companies, but apply to both US- and foreign-headquartered
companies operating in the United States
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Advanced Income Tax Track
Overview
Impact of Federal Regulations on State Tax Base (continued)
• Proposed section 385 regulation:
- Affect broad categories of related-party debt transactions,
regardless of the debt instrument’s characteristics or purpose
- Impact typical day-to-day international treasury management
practices, such as cash pooling and related-party financing
- Allow IRS on audit to recharacterize debt as equity or part equity /
part debt
- Require contemporaneous documentation with respect to the
characterization of related-party financial instruments as debt
- Apply retroactively to financial instruments issued after April 4,
2016, once regulations are finalized
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Advanced Income Tax Track
Overview
Impact of Federal Regulations on State Tax Base (continued)
Final section 385 regulations
• In October, 2016 the IRS released the final and temporary section 385
regulations. The regulations:
- Are far narrower in scope than the proposed regulations in order to better
focus on related party financings that can potentially erode the tax base.
- For example, intercompany loans between members of a consolidated
return group are generally excluded under the “one entity” approach.
• Questions include whether the conformity to this federal regulation is
automatic in states with general IRC references, whether the “one entity”
exception would apply in separate filing states and combined states like
California which do not adopt the federal consolidated return regulations
and how these regulations will interact with pre-existing debt v. equity
classification case law.
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Advanced Income Tax Track
Overview
Pre-existing State Challenges involving debt v. equity classification
Mass. Mutual Life Insurance Co. v. Mass. Commissioner of Revenue,
Massachusetts Appellate Tax Board, Nos. C305276, C305277, June 12, 2015
• These appeals concern whether certain intercompany advances made by
Massachusetts Mutual Life Insurance Company ("MMLIC") to its whollyowned subsidiary, MMH, constituted bona fide debt for Massachusetts tax
purposes.
• The Board found and ruled that:
1. The amounts advanced to MMH were used for the valid business purposes
of funding and expanding the operations of its subsidiaries;
2. In advancing the funds in the form of loans instead of equity, MMLIC was
motivated by regulatory concerns, not by a desire to avoid tax; and
3. The MMH Notes constituted bona fide indebtedness with economic
substance.
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Advanced Income Tax Track
Overview
Entire Net Income States
These states refer to FTI but expand such to include income which may be broader than
FTI.
• New York - Matter of Reuters Limited v. Tax Appeals Tribunal, 82 N.Y.2d. 112 (1991):
Holding that a foreign corporation had to report pro forma worldwide income to NY,
not just the effectively connected income that was reported on the 1120F.
- Effective 2015 the new law limits the entire net income base to income that is
effectively connected with the conduct of a U.S. trade or business, which is more
analogous to federal taxable income.
• New Jersey - International Business Machines Corporation v. Director, Division of
Taxation, N.J. Tax Court No. 011630-2008, 1/26/11: The Court held that export profits
of a U.S. company which had been excluded under the former federal "extraterritorial
income exclusion" or "ETI" provisions could not be added back to ENI - such was not
really excluded income so much as a deduction that NJ adopted through reference to
FTI.
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Advanced Income Tax Track
Overview
Schlumberger Technology Corp. & Subsidiaries v. Alaska Department
of Revenue, Alaska Supreme Court, No. S-14729, July 18, 2014
• The Alaska Supreme Court found that the Internal Revenue Code
§882, which requires a foreign corporation to report only income
‘effectively connected with the conduct of a trade or business within
the United States’ has not been adopted by reference into the Alaska
Net Income Tax Act.
• The court provided that that IRC §882 uses various sourcing rules in
determining whether a taxpayer’s income is derived from a source
inside or outside the United States. These sourcing rules are
inconsistent with the state’s three factor apportionment formula.
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Advanced Income Tax Track
State Modifications – Typical Addition Modifications
Typical additions modifications:
• State income taxes
• Federal bonus depreciation
• Foreign income taxes
• Payments to Related Entities
• Local income taxes
• Federal deduction for domestic
production activities
• Interest from state obligations
• Excess ACRS depreciation
• Federal N.O.L. C/O
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• Discharge of Indebtedness - IRC
Section 108 deferral
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Typical Subtraction Modifications
• Dividends (General)
• Federal income tax
• Dividends controlled corporations
• Interest - U.S. obligations
• Federal jobs credit wages
• State income tax refunds
• State NOL Deduction
• Subpart F income
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
State and Local Income Taxes
• Most states do not allow a deduction for their own income tax. Many
states disallow a deduction for all state and local income taxes. The
laws of those states requiring an add back of state income taxes must
be reviewed to determine which taxes fall within the modification
provisions (e.g., income taxes versus franchise taxes not based on
income).
• Dayton Hudson Corporation, 94-SBE-003 (Cal. St. Bd. of Equal.
Feb. 3, 1994):
- The SBE found that the Michigan Single Business Tax (“SBT”)
included in its base an element of cost of goods sold and, therefore,
the tax was not measured by income. Since the tax was not on or
measured by income, the SBE found the tax deductible.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Appeal of Kelly Service Inc., 97-SBE-010 (Cal. St. Bd. of Equal. May 8,
1997).
• The FTB had argued that the Michigan SBT was nondeductible to a
service organization that did not have any costs of goods sold. The
SBE held against the FTB, finding that the SBT was not applied
differently depending upon the activities of the taxpayer and,
therefore, the SBT should be deductible regardless of the components
in the taxpayer's tax base. Accordingly, the Michigan SBT should be
fully deductible in California.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
FTB Notice 2010-2:
• The FTB addressed the eligibility of the Texas Margin Tax (“TMT”) for the
other state tax credit (“OSTC”) or a deduction for California income and
franchise tax purposes.
• Due to the fact that the TMT offers a few methods to determine “margin,” the
FTB declined to offer a clear uniform rule. Instead, it said that the
determination of whether a taxpayer is eligible for an OSTC or a deduction is
a highly fact-specific inquiry and must be made on a case-by-case basis.
• Despite the ambiguity in the Notice, Attachment 1 to the Notice provides a
summary of what the outcome may be depending upon whether the tax is
classified as a gross receipts tax (deductible), or a gross income or net income
tax (non-deductible).
• FTB Notice 2014-01 withdrew FTB Notice 2010-02. The department is
currently evaluating its position and exploring alternative methods to issue
authoritative guidance.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
FTB Legal Ruling 2017-01:
• The FTB re-examined when taxpayers can claim the OSTC, and specifically
the OSTC for the Revised Texas Franchise Tax, as previously addressed by
FTB Notice 2010-2. This ruling replaces Notice 2010-2.
• The ruling states “a case-by-case analysis of a particular taxpayer’s situation
is not appropriate and is not determinative of whether a tax has a measure
based on income.”
• Rather, the other state’s taxing scheme should be characterized universally
for all taxpayers. Determining whether the tax is a gross income tax is done
by reviewing the state’s entire methodology.
• Whether a tax payment is eligible for the OSTC turns on if the tax is:
• 1. properly characterized as a tax on or measured by income, and
• 2. whether the tax is properly characterized as a net income tax.
• If the tax is not OSTC eligible, the taxpayer may take a deduction assuming
all other requirements are met.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Revised Texas Franchise Tax (Texas Margins Tax)
• Alternative methods to compute:
Total Revenue
Minus:
From Federal From 1120, 1065, or other
applicable From (less certain items for specific
industries)
Greatest of:
(1) Cost of goods sold, (2) Compensation, (3)
30% of total revenue, or (4) $1 million
Equals:
Taxable margin before apportionment
Multiplied by:
Equals:
Apportionment factor (single factor of gross
receipts)
Apportioned margin
Minus:
Allowable deductions
Equals:
Taxable margin
Multiplied by:
Minus:
Tax rate (0.375% for retailer or wholesaler;
0.75% for most other entities)
Allowable credits
Equals:
Tax due on margin
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Texas Margins Tax (continued)
• What is it?
• Gross Receipts, Gross Income, or Net Income?
• CRTC section 18001 allows an S corporation shareholder to take an other
state tax credit for “any taxes on, or according to, or measured by, income or
profits paid or accrued”
• Credit allowed for tax on Gross or Net Income, but not Gross Receipts
• Would also affect deduction for Corporations allowed under section 24245
• FTB Legal Ruling 2017-01
• A California taxpayer may deduct Texas franchise tax paid, rather than
claim the OSTC, regardless of the specific components of its Texas
franchise tax base. The Texas franchise tax is not a tax on or measured by
income, regardless of how the taxpayer’s taxable margin is determined.
The Texas franchise tax is a single, indivisible tax, as a taxpayer can only
be subject to paying one tax on one base in any year.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Indiana
• Indiana Department of Revenue Supplemental Letter of Findings No.
02-20130209 (3/26/14) provided that the Texas Margin Tax is
measured by income and therefore should be added back.
• It also found that the Michigan Business Tax ‘modified gross receipts
tax’ portion of the tax is an income tax, therefore amounts paid under
the MBT should be added back to Indiana corporate income tax.
California
• In Gillette, the MI SBT was found not to be an income tax despite
starting with FTI.
Michigan
• However, in Emco Enterprises, the Michigan Court of Claims found
that the SBT is an income tax for purposes of the Compact.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
New Jersey
PPL Electric Utilities Corp. v. Director, Division of Taxation, N.J. Tax Ct., Dkt.
No. 000005-2011, October 2, 2014
•
The New Jersey Tax Court held that Pennsylvania Gross Receipts Tax and
Pennsylvania Capital Stock Tax were properly excluded from the calculation of
taxpayer’s New Jersey Corporate Business Tax Liability (CBT).
•
New Jersey requires an addback for state taxes paid measured by income,
profits, business presence, or activity. New Jersey also provides that property
taxes, excise taxes, payroll taxes and sales taxes are not considered ‘business
presence’ or ‘business activity’ taxes.
•
The Court held that the Pennsylvania Gross Receipts Tax is an excise tax
because it measured by taxpayer’s sales of electricity and, therefore, it is not
subject to the addback in computing entire net income for CBT purposes. The
Court also found that the Pennsylvania Capital Stock Tax is a property tax that
is measured by the value of taxpayer’s assets, which is not subject to addback.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
New Jersey
Duke Energy Corporation v. Director, Division of Taxation, N.J. Tax Ct., Dkt.
No. 010448-2008, December 2, 2014
•
The New Jersey Tax Court held that electric utilities taxes paid to North
Carolina and South Carolina were properly excluded from the calculation of
Taxpayer’s New Jersey corporate business tax liability (CBT).
•
New Jersey requires an addback for state taxes paid measured by income,
profits, business presence, or activity.
•
The utilities taxes were found to be industry specific assessments based on
gross receipts imposed in addition to a net corporate income tax. The Court
concluded that ‘add back provision is intended to capture only taxes paid to
other States on a taxpayer’s net corporate income,’ and, therefore, ‘utilities
taxes do not fit into this category.’
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Foreign Income Taxes
• In the Mater of the Appeal of CTI Holdings, Inc. (96-SBE-003):
- California law prohibits deductions of state, federal, or foreign
taxes "on or according to or measured by income or profits,"
including taxes imposed on intercompany dividends paid by one
member of a unitary group to another member of the unitary
group and eliminated from the income of the recipient.
(Sec. 24345(b), Rev. & Tax. Code)
- Thus, the BOE held that foreign taxes paid on eliminated income
items were nondeductible despite the elimination of the underlying
income.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Puerto Rico Excise Tax
• The tax is an excise tax on a nonresident’s acquisition from an affiliate of
certain personal property manufactured and certain services performed in
Puerto Rico. Thus, the tax is imposed on purchases, rather than income.
• IRC sections 901 and 903 allow a foreign income tax credit to offset federal
income tax liability by the amount of foreign income taxes paid.
• Specifically, IRC section 903 expands the definition of creditable taxes for
federal income purposes to include certain foreign taxes if the tax is in lieu of
an income tax.
• For California tax purposes, would this be deductible or not?
• Likely it would be deductible in a state like California that does not adopt
IRC section 903.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Federal Income Tax
• A few states allow a deduction or partial deduction for federal income
taxes paid (e.g., AL, IA [limitations apply], LA, MO [50% limitation]).
• A primary question is whether the amount should be determined on a
proforma basis or an allocation of the amount paid by the federal
consolidated group.
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Advanced Income Tax Track
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Kinney Shoe Corporation v. State, 552 N.W.2d 788 (N.D. Supreme
Court
Sept. 3, 1996):
• A subsidiary that filed consolidated federal corporate income tax
returns, but filed separate North Dakota corporate income tax
returns, was required to limit its share of federal tax deductions for
North Dakota corporate income tax purposes to its allocated share of
consolidated tax liability actually paid by the parent to the federal
government.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
• CC Dickson Company v. Alabama Department of Revenue, Ala.
Admin. Law Div., Docket No. BIT 09-238, 6/9/09:
- An Alabama corporation was entitled to a full deduction for its
federal tax due on a recapture of LIFO deductions upon its
conversion to an S corporation, even though the corporation only
paid a portion of the total federal liability in the tax year at issue.
- The ALD reasoned that because the taxpayer became legally liable
for the entire tax amount resulting from the LIFO recapture in the
year of its final federal C corporation return, the federal tax
liability accrued in that year. Therefore, the taxpayer was entitled
to a full deduction on its final C corporation return.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Municipal Interest
• Many states require federal taxable income to be increased by the
amount of interest received on state and municipal obligations that
are exempt from U.S. tax. Any related expenses that were not allowed
as deductions for federal purposes may reduce this income.
• Some states, which require this modification, exclude interest
received on their own bonds or on bonds issued by their political
subdivisions from this provision (e.g., AL and CO).
• Department of Revenue of Kentucky v. Davis, No 06-666, 5/19/08:
- U.S. Supreme Court overturned a decision of the Kentucky Court
of Appeals that held that the state's tax on interest income derived
from bonds issued by states other than Kentucky is facially
discriminatory in violation of the Commerce Clause.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Municipal Interest
• Branch Banking & Trust Co. v. Comptroller of the Treasury, No. 13-IN-OO0076, 2016 WL 5922589, at *1 (Md. Tax Sept. 30, 2016)
- A Maryland tax statute allows the subtraction from Maryland income of
exempt federal obligation interest, such as that on federal bonds, which is
included in federal taxable income.
- The Comptroller’s policy was to allow corporations to deduct the federal
obligation interest during the year it was received, until the corporation
has zero taxable income for that year. If the corporation has an NOL then
no subtraction is allowed. The Comptroller did not allow carryforwards of
unsubtracted exempt federal obligation interest.
- The court found that the Comptroller’s policy violates the Maryland tax
statute and the Supremacy Clause of the U.S. Constitution.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Depreciation and Depletion
• Beginning with the federal ACRS provision in 1981, through the more recent
enactment of Bonus Depreciation, a number of states have chosen not to
conform to such federal accelerated depreciation for fiscal policy reasons.
• In addition, questions have arisen in states which statutorily allocate (as
opposed to apportion) gains from the sale of property as to the proper
treatment of depreciation ordinary income recapture.
• The American Taxpayer Relief Act of 2012, enacted on January 2, 2013,
extends 50-percent bonus depreciation for qualified property through the
end of 2013 and decouples bonus depreciation from the Section 460
percentage of completion method of accounting for assets with a depreciable
life of seven years or less that are placed in service in 2013. The legislation
also allows taxpayers to elect to accelerate some AMT credits in lieu of bonus
depreciation.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Beatrice Cheese, Inc. v. Wisconsin Department of Revenue, Nos. 91-I100, 101, 102 (Wis. Tax App. Comm. Feb. 24, 1993):
• Wisconsin allowed a deduction for accelerated depreciation only for property
located in state. The taxpayer claimed the statute discriminated against
interstate commerce in violation of the Commerce Clause. The Commission
found the statute established differential treatment of taxpayers depending
on the location of their property, resulting in a higher WI franchise tax
burden on businesses that located property outside of WI. The Commission
found the statute to be “clearly designed to have discriminatory economic
effects on corporations locating depreciable property outside the state.” The
Commission also found that the economic effect of this provision exerted
“inexorable pressure” on taxpayers to locate their property in the State and,
therefore, impermissibly burdened interstate commerce.
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June 14, 2017
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
R.J. Reynolds Tobacco Co. v. City of New York Dept. of Finance, 257
A.D.2d 6 (N.Y. A.D. Dec. 9, 1997), appeal dismissed, 694 N.E.2d 865
(N.Y. Apr. 7, 1998):
• The New York Supreme Court held the City ordinances treating inState property differently than out-of-state property violated the
Commerce Clause and were, therefore, invalid.
• The New York Department of Taxation and Finance announced, in
TSB-M-99(1)(I), 02/16/1999, that the R.J. Reynolds decision would
be followed for New York State purposes.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
CNA Holdings, Inc. v. Delaware Dir. of Rev., 818 A. 2d 953 (2003):
• The Delaware Supreme Court ruled that statutory provisions that
require a taxpayer to allocate gains attributable to depreciation
recapture entirely to the state where the property is located, rather
than to apportion such gains using the statutory income
apportionment formula, are clear and unambiguous and do not
produce an unreasonable result.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Bonus Depreciation
With respect to adjustments for bonus depreciation, there are many
variations on the state modification. Some states allow the federal
depreciation without modification. Other states require a full add back
for the bonus depreciation. In these full add back states, generally there
is an additional subtraction modification that is permitted. This
subtraction modification is based on federal depreciation that could
have been taken had the basis of the bonus depreciation assets included
the bonus depreciation that was added back.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Pennsylvania
• Pennsylvania provides a unique example of the gradual subtraction
modification that is permitted to recover the 30% and 50% bonus
depreciation amounts that are required to be added back. Pennsylvania
allows an additional depreciation deduction for each year computed as
3/7ths of the regular federal depreciation amount on these assets. This
deduction is allowed until the bonus depreciation has been fully recovered.
72 P.S. §§ 7401(3)(q) & (r).
• A catch-up deduction is permitted for the 50% bonus depreciation assets in
the last year that those assets are depreciated for federal income tax
purposes.
• Pennsylvania will not require an add back for depreciation based on the
100% bonus depreciation federal provisions even though these states
otherwise require an add back for 30% and 50% bonus depreciation. Penn.
Dept. of Rev., Corporate Income Tax Bulletin #2011-01, 2/24/11.
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Advanced Income Tax Track
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Federal Net Operating Losses
• Many states adopt FTI on line 28 of Form 1120, before the NOL deduction.
Such states typically allow their own, post-apportionment NOL.
• Other states start with line 30, but may nonetheless require the add back of
the federal NOL and the subtraction of a state NOL which reflects state
modifications.
- Before the Corporate Tax Reform, New York took a hybrid approach
under which a pre-apportioned NY NOL is allowed but is limited to the
amount of federal NOL deducted on a pro forma basis which reflects the
NY filing group and limited NOL carryback ($10,000).
- Please note that with the legislation passed in 2014 and effective 2015,
New York no longer limits the NOL deduction to the amount of federal
NOL deducted.
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Advanced Income Tax Track
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Example 4: New York NOL Limitation
• Corp A and Corp B file a federal consolidated return but Corp B alone files in
NY.
• In 2010, Corp A & B had $5 million and ($15 million) FTI respectively. The
consolidated loss of $10 million was carried back and deducted in 2008
under IRC § 172.
• In 2011, the Corp A & B federal consolidated group reports $10 million of
income, without any NOL carryovers. Corp B’s FTI is $5 million.
• Assume Corp B had no separate income in 2008 or 2009. For NY tax
purposes, Corp B has a $15 million NY NOL carryover to 2011 of which on a
pro forma basis $5 million would be deductable.
- Under the new rules effective for tax years beginning on or after January
1, 2015, NOLs are carried over on a post-apportioned basis and not limited
to the federal NOL deduction taken.
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New York Net Operating Losses
• The new law allows two NOL deductions:
- Deductions for NOLs generated in tax years beginning on or after
1/1/2015
◦ The new law provides that an NOL deduction is taken on a postapportionment basis without reference to the federal NOL
deduction amount.
- Prior NOL Conversion Subtraction “PNOL”
◦ Due to the change in New York’s NOL deduction under the new
legislation, a computation must be performed to convert NOL
carryforwards that were generated during tax years prior to the
tax year starting on or after January 1, 2015.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
• The PNOL conversion subtraction is computed as follows:
- Determine the NOL carryforward existing in the tax year prior to
the effective date of the tax reform (the “unabsorbed NOL”);
- Determine the taxpayer’s apportionment percentage from the final
tax year prior to the effective date of the tax reform (the “base
year”);
- Multiply the unabsorbed NOL by the base year apportionment
percentage;
- Multiply the apportioned unabsorbed NOL by the tax rate that
would have applied to the taxpayer in the base year (i.e., 7.1% for
certain NYS taxpayers; 8.85% for certain NYC taxpayers); and
- Divide that amount by the current year business income tax rate
(generally, 6.5% for NYS and 8.85% for NYC).
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Advanced Income Tax Track
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Example: X Corp. - PNOL Conversion Subtraction Computation
Income/(Loss)
BAP %
2012
(100,000)
10%
2013
(200,000)
30%
2014
(300,000)
50%
Total
(600,000)
Step 1: Assuming no federal limits are imposed, X Corp's total unabsorbed NOL is (600,000).
Step 2: X Corp's total unabsorbed NOL of (600,000) is multiplied by the base year (2014)
apportionment percentage (50%) = (300,000).
Step 3: The product from Step 2 is multiplied by the taxpayer's base year (2014) tax rate (7.1%)
= (21,300).
Step 4: The product from Step 3 is divided by 6.5% = (327,692). This is X Corp's PNOL pool.
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Advanced Income Tax Track
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In the Matter of the Petition of TD Holdings II, Inc., State of
New York Tax Appeals Tribunal, No. 825329, April 7, 2016
• The New York Tax Appeals Tribunal reversed an administrative law judge (ALJ)
determination and found that a taxpayer was required to utilize a net operating
loss (NOL) deduction to reduce its entire net income for New York bank franchise
tax purposes in a year when the tax was measured on a base other than entire net
income.
• In so ruling, the Tribunal concluded that the state law in effect for the years at
issue requires that entire net income, inclusive of applicable net operating losses,
be computed whether or not tax is actually paid on the base of net income.
• Taxpayers with NOL carryforwards that may have paid tax on an alternative base
in prior years should carefully review their unabsorbed New York NOL
carryforward balance, especially in years when tax was paid on an alternative
base. With tax reform starting in the 2015 tax year, the NOL carryover
calculation is of particular concern when determining the carryovers available for
purposes of the PNOL conversion subtraction.
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In the Matter of Plasmanet, Inc., NYC TAT, TAT (E) 12-17(GC),
January 20, 2017
• The NYC TAT upheld the DOF’s application of the “same source
year rule”, that requires that the NYC NOL deducted must have its
source from the same loss year as the NOL deducted for federal tax
purposes. Due to the differing amounts of NYC and federal NOLs,
this can produce limitations on the amount of NYC NOL deducted
in addition to the limitation that the NOL deducted not exceed the
federal deduction.
• The NYC TAT rejected the DOF’s SOL related argument and
allowed NOL carryovers to be increased by charitable
contributions not originally deducted due to income limitations on
the originally filed returns.
• Note that for the years at issue NY State had similar provisions.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Hillenga v. Department of Revenye, Ore. Sup. Ct., No. SC S062603,
November 13, 2015
• The Oregon Supreme Court concluded that the statute of limitations
does not bar review of a net operating loss carryover applied in an
open tax year.
• By attempting to carry over their 2004 net operating loss to apply
against their 2006 tax liability, the taxpayers put the validity of their
2004 net operating loss at issue.
• Because the Oregon Department of Revenue was not trying to assess
a deficiency for 2004, the statute of limitations did not apply.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Nextel Communications of the Mid-Atlantic, Inc., v. Commonwealth of
Pennsylvania, Pa. Commonwealth Court, No, 98 F.R. 2012, November
23, 2015
•
The Commonwealth Court of Pennsylvania held that the net loss carryover (NLC)
deduction allowed for purposes of the Pennsylvania corporate net income (CNI) tax,
as applied to Nextel Communications, violates the Uniformity Clause of the
Pennsylvania Constitution.
•
The court concluded the NLC deduction creates classes of taxpayers according to their
taxable income.
•
Taxpayers with taxable income in excess of $3 million could not reduce their CNI
liability to zero whereas similarly-situated taxpayers with $3 million or less in taxable
income could reduce their CNI liability to zero.
•
The court found such classification unreasonable and not related to any legitimate
state purpose.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
California Net Operating Losses
• California suspended NOL deductions for 2008 to 2011. Taxpayers may
deduct NOLs in taxable years beginning on or after January 1, 2012.
- For tax years beginning on or after January 1, 2013, a California NOL
must be carried back to the prior 2 taxable years and any remaining NOL
is then carried forward 20 taxable years as follows:
◦ For NOLs generated in 2013, 50% of the NOL can be carried back to the
earlier of the 2011 and 2012 tax years and then forward for 20 years as
available;
◦ For NOLs generated in 2014, 75% of the NOL can be carried back to the
earlier of the 2012 and 2013 tax years and then forward for 20 years as
available; and
◦ For NOLs generated in 2015 and forward, 100% of the NOL can be
carried back 2 years and then forward for 20 years as available.
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Indiana Department of State of Revenue v. Caterpillar, Inc. No. 49S10-1402TA-79, August 25, 2014
• Indiana Supreme Court held taxpayer may not deduct foreign source
dividends when calculating Indiana NOLs.
• Indiana’s adjusted gross income calculation provides for a foreign source
dividend deduction.
• Indiana’s NOL is defined by reference to a taxpayer’s federal NOL with
certain state adjustments, none specifically reference foreign source dividend
deduction.
Branch Banking & Trust Co. v. Comptroller of the Treasury, No. 13-IN-OO0076, 2016 WL 5922589, at *1 (Md. Tax Sept. 30, 2016)
• The court held that the Maryland Comptroller’s policy violated a state statute
and the Constitution. The policy essentially did not allow the subtraction for
federal obligation interest to increase the amount of Maryland NOL
carryovers.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
State Adoption of I.R.C. §382
• While some states specifically adopt IRC §382 (e.g. CA), adoption in other
states may still be unclear.
• Idaho State Tax Commission, Decision No. 19151 (Jan. 23, 2007)
- Taxpayer did not deduct its Idaho net operating losses due to the federal 382
limitation and carried losses forward as permitted under federal tax law. However,
the Idaho State Tax Commission held that the Idaho deduction for the NOL of an
acquired corporation is not subject to the federal 382 limitation. Consequently, the
NOLs should have been deducted in the prior taxable years rather than carried
forward and deducted. Since the earlier years were beyond statute, refunds were
not available, but the carryovers to later years still had to be reduced by the amount
allowable in prior years.
• Effective on January 1, 2010, Idaho now conforms to Code Section 382, at
least with respect to ownership changes which arise out of a merger. (Idaho
Code § 63–3021(c).)
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Apportionment of Federal Limitation
• In states which adopt IRC §382 , should the federal limitation be subject to
apportionment?
• Express Scripts, Inc. v. Commissioner of Revenue, Minnesota Tax Court,
Ramsey County, Docket No. 8272R, 8/20/12
- A taxpayer's corporate acquisition triggered an IRC Sec. 382 limitation of
the acquired company's NOL carryovers equal to approximately $30
million. The DOR apportioned that limitation using the apportionment
ratio of the income years, which reduced the amount of available loss to
approximately $120,000.
- Despite Department guidance to the contrary, there was no statutory
authority for the Department's position to apportion the section 382
limitation.
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Apportionment of Federal Limitation
• Express Scripts, Inc. v. Commissioner of Revenue, Minnesota Tax Court,
Ramsey County, Docket No. 8272R, 8/20/12
- Accordingly, the Tax Court found that the application of an apportioned
382 limitation is not supported by the plain language of the statute and
would create an "unnecessary disconnect between Minnesota and federal
law."
• In Express Scripts, Inc. v. Commissioner of Revenue, No. A12-1966, Minn.
Sup. Ct. (1/18/13), the MN Supreme Court concluded that the appeal of the
Tax Court decision that the Department could not apportion an IRC sec. 382
limitation was not timely, effectively rendering the Tax Court's decision final.
• Nonetheless, we understand that at audit the Minnesota Department of
Revenue is still requiring taxpayers to apportion the IRC sec. 382 limit.
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Apportionment of Federal Limitation
• California FTB Technical Advice Memorandum (TAM) 2017-03
- The TAM provides that the IRC section 382(b)(1) limitation for net
operating losses (NOLs) and 383(a)(1) limitation for excess credits are to
be applied on a pre-apportionment basis, while items of net income such
as realized built-in gains (RBIGs) and losses (RBILs) and net unrealized
built-in gains (NUBIGs) and losses (NUBILs) are to be determined on a
post-apportionment basis.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Payments to Related Entities
• A number of states require that certain expenses paid to related members be
added back to income.
• Expenses subject to add back may include:
- Intangible expenses such as royalties paid for use of patents, trademarks,
etc.
- Interest expenses related to intangible expenses, such as where the related
party loans the funds from royalties received back to the operating
company which paid them.
• A few states may also require addback of management fees, intercompany
rent charges and the dividends paid deduction allowed by captive REITs.
• One state (TN) currently requires pre-approval of specified related party
intangible expenses.
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Most states provide exceptions to add back.
Typical exceptions include:
• Related party is subject to tax on the royalty income in the same or another
state.
- Most states agree that related parties which report losses are nonetheless
subject to tax, however, related parties which are based in tax haven states
or combined reporting states are not.
- Some states require that the related party be subject to tax at an effective
rate within a certain range of the add back state’s rate, while others give a
prorated reduction based on the degree to which tax is actually paid.
- A limited few provide a credit (Oregon).
• Related party pays the same amount received to a third party lender/licensor
(a conduit exception).
• Related party is not primarily engaged in related party lending/licensing, has
economic substance, third party activity and deals at arms-length.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
On August 17, 2007, the Multistate Tax Commission adopted a two-part model
expense addback statute:
• The first part requires the add back of otherwise deductible intangible
expense directly or indirectly paid, accrued or incurred in connection with
one or more direct or indirect transactions with one or more related
members.
• The second requires a similar add back for interest expense (not limited to
interest related to intangibles).
• The two parts were enacted in such a way that an adopting state may choose
to require the add back of intangible expense without the broader add back
of interest expense.
• Effective for tax years beginning on or after 1/1/13, New York adopts the
provisions of the MTC’s model add back statute
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Alabama Related Party Limitation
• Effective for tax years beginning after December 31, 2000, limits for the
deduction for expenses, losses, and costs for, related to, or incurred in
connection with the acquisition, use, maintenance, management, ownership,
sale, exchange, or disposition of intangible property; expenses or losses
related to factoring or discounting transactions; and royalties, patents,
technical and copyright licensing fees; and other similar expenses or costs
paid to a related party. Also requires the add back of interest expenses and
costs paid to a related member. (Ala. Code Sec. 40-18-35(b), amended by Act
2001-1088 (H.B. 2), 4th Sp. Sess., p. 1095, Sec. 1, enacted 12/21/01, eff. for
tax years beginning after 12/31/00).
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State Modifications – Typical Subtraction Modifications
Alabama Safe Harbors
• Sets forth a "substantial business purpose" requirement, and provides that
deductions will not be limited where the taxpayer establishes that the
transaction giving rise to the deduction does not have the principle purpose
of tax avoidance and the related member is not primarily engaged in the
acquisition, use, licensing, maintenance, management, ownership, sale,
exchange, or disposition of intangible property; or in the financing of related
entities.
• A transaction will be deemed not to be entered into primarily for purposes of
tax avoidance where the transaction has a substantial business purpose and
economic substance, and contains terms and conditions comparable to
similar arm's-length transactions between unrelated parties.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Alabama Regulation Sec. 810-3-35-.02 specifies the extent of the interest and
intangible expense/cost add back, and provides that add back in not required
where the taxpayer established to the department's satisfaction that:
• The addition is "unreasonable" (see definition below);
• The corporation and the commissioner agree to the use of alternative
adjustments or computations (see further requirements below);
• The primary purpose of the transactions that generated the deductions is not
Alabama tax avoidance; or
• The items of income received by the related member that correspond to the
taxpayer's expense were subject to tax in Alabama, another state, or foreign
country.
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Alabama Dep't of Revenue v. VFJ Ventures, Inc., Ala. Civ. App., No. 2060478,
2/8/08:
• Upheld by the Alabama Supreme Court, the Alabama Court of Civil Appeals
reversed a Circuit Court holding that the state's "add back statute" for certain
intercompany intangible and interest expenses resulted in an "unreasonable"
denial of deductions for legitimate business expenses.
• The court noted the Department had applied the unreasonableness exception
to situations where a corporation's tax would be "out of proportion with what
could reasonably be said to be attributed to the State".
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Related Party Limitations
New Jersey
• Effective for tax years beginning on or after 1/1/02, taxpayers are required to
add back interest paid, accrued or incurred to a related member.
• Effective for tax years beginning on or after 1/1/02, taxpayers are required to
add back otherwise deductible intangible expenses and costs and related
interest expenses and costs and directly or indirectly paid, accrued or
incurred to, or in connection directly or indirectly with one or more direct or
indirect.
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Related Party Limitations (continued)
Beneficial New Jersey, Inc. v. Director, Division of Taxation, N.J. Tax Ct.,
No. 009886-2007, 8/31/2010:
• Reversing an assessment based on related party interest expense add back,
finding that the "unreasonableness" exception applied based on a "totality" of
factors including economic substance and business purpose.
• In Beneficial, the taxpayer’s parent borrowed money from a lender and
loaned the proceeds to its subsidiary.
• Although NJ did not have an explicit conduit exception to add back, the
Court concurred that add back was unreasonable.
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Related Party Limitations (continued)
Morgan Stanley & Co., Inc. v. Director, Division of Taxation, N.J. Tax Court
No. 07557-2007 (10/29/14):
• On October 29, 2014, the Tax Court of New Jersey found that a taxpayer
could deduct related party interest expenses because the Division of Taxation
failed to properly apply the unreasonable exception.
• Although the decision didn’t reach a substantive ‘unreasonable’ analysis of
the taxpayer’s transactions, New Jersey taxpayers may still find elements of
the decision instructive, including general examples of what could qualify
under the unreasonable exception.
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Related Party Limitations (continued)
Kraft Foods Global, Inc. v. Director, Division of Taxation, New Jersey Tax
Court, No. 017974-2009, April 25, 2016
• The NJ Tax Court concluded that interest expense on debt which a parent
had intended to “push down” to its subsidiary did not meet the
unreasonableness exception to addback. The Tax Court concluded that the
related party debt did not result in the subsidiary being ultimately
responsible for the external debt and was distinguishable from its earlier
decision in Morgan Stanley.
• Kraft Foods Global, Inc.’s (Tp’s) parent company, Kraft Foods, Inc., had
issued public debt aggregating $9.5 billion and transferred amounts equal to
the proceeds of these bonds to Tp, which used those funds to pay off
amounts owed to a related party (wholly owned by Phillip Morris).
Thereafter, Tp made payments back to its parent company of interest in
roughly the amount carried by the parent company’s public bonds.
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Related Party Limitations (continued)
BMC Software, Inc. v. Director, Division of Taxation, N.J. Tax Court No.
0004032012 (5/24/17)
• On May 24, 2017, following the parties’ respective motions for summary
judgment, the New Jersey Tax Court found that a subsidiary’s intangible
expenses paid to its parent qualified for the state’s unreasonable addback
exception because the payments were substantively equivalent to an
unrelated party transaction.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Spring Licensing Group, Inc. v. Director, Division of Taxation, N.J.
Tax Court, No. 010001-2010, August 14, 2015
• The New Jersey Tax Court ruled that an out-of-state company had a
Corporate Business Tax reporting responsibility and had to pay tax on
royalty income despite an in-state affiliate adding back royalty expense paid
to the company.
• The court disagreed that the prospect of double taxation precludes the
company’s New Jersey filing obligation.
• The court suggested that the potential for double taxation is alleviated by the
payor seeking an exception to the addback or the payee seeking alternative
apportionment relief.
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Staples, Inc. v. Commission or Revenue, Mass App. Tax Bd. No. C310639,
September 4, 2015
• The Massachusetts Appellate Tax Board found that intercompany transfers
under a taxpayer’s cash management system did not give rise to bona fide
debt. Therefore, interest payments related to the purported debt were not
deductible under either the income or the net worth measures of the excise
tax.
• The Board reached its determination with particular focus on facts indicating
that excess cash advances were not intended or expected to be repaid, and
were not, in fact, repaid.
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State Modifications – Typical Subtraction Modifications
Pennsylvania Information Notice 2016-01 (Feb. 19, 2016)
• Embedded Intangible Costs
• “Embedded intangible costs are included within the definition of an
‘intangible expense or cost’ and are, therefore, subject to the Add-Back.
Embedded intangible costs are expenses paid to acquire, use, maintain,
manage, sell, exchange, or otherwise dispose of (or otherwise acquire) an
intangible asset, where the purported cost or expense is included in
deductions or expenses that are called something other than ‘[r]oyalties,
licenses or fees paid,’ such as cost of goods sold or a separate service
charge (e.g., management fees).” (internal citations omitted)
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State Modifications – Typical Subtraction Modifications
Letter of Findings No. 02-20130268, Indiana Dept. or Revenue (September 24,
2014), released October 2014:
•
A multi-national manufacturer of industrial products and its affiliates filed separate
company Indiana returns. The Indiana Department of Revenue assessed additional tax
on the basis that intercompany interest and royalty expenses should have been added
back to net federal taxable income.
•
The Letter of Findings provides that in order to reasonably attempt to ‘effectuate an
equitable allocation and apportionment of the taxpayer’s income,’ the Department
reallocated intercompany interest expenses claimed by the taxpayer on its original
Indiana return.
Rhode Island, H.B. 7133, enacted on June 19, 2014
•
Repeals add back to net income for related party (1) intangible expenses and costs (2)
interest relating to intangibles.
•
Effective for tax years beginning on, or after, January, 1, 2015.
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Wendy’s Int’l, Inc. v. Virginal Dep’t of Taxation, Case No. CL09-3757 (Cir. Ct.
of the City of Richmond):
• On 3/29/12, a Virginia Circuit Court concluded that the related-party add
back exception requiring licensors to derive at least one-third of their gross
revenues from the licensing of intangible property to unrelated members
does not mandate that the royalty income be derived directly from
unrelated members.
• The fact that the licensor received the revenue from a related-party conduit
does not disqualify the licensor from the exception.
• The add back exception at issue in Wendy’s was incorporated into Virginia’s
2004 add back statute at the request of a trade organization representing
franchisors. The exception should apply to any business that derives more
than one-third of its licensing revenue from unrelated third parties, whether
received directly or indirectly.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Domestic Production Activities (“DPA”) Deduction
• A number of the states which impose income tax conform to the DPA
deduction, however, there are many that do not (e.g., AL, AR, CA, and CT).
• When a state adopts line 28 FTI, it adopts a DPA deduction which in effect
has been impacted, for better or for worse, by items of income and deduction
at the federal level which may not be treated consistently for state purposes.
• Complexities in determining the allowable Sec. 199 deduction at the state
level may arise when the state employs a different filing method (e.g.
separate or unitary vs. federal consolidated) than that used by taxpayers at
the federal level. Issues may also arise regarding pass-through entities, where
at the federal level, the deduction passes through to the owners or members;
whereas some states tax impose a tax directly on the entity.
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State Modifications – Typical Subtraction Modifications
Compute I.R.C. Sec. 199 deduction on a proforma basis:
GKN Westland Aerospace, Inc. v. Ala. Dept. of Rev., Admin. Law Div., Dkt. No.
BIT.10-988, 7/25/2011:
• An I.R.C. §199 domestic production activities deduction may be computed
and claimed on a separate company basis for purposes of Alabama income
tax if an Alabama taxpayer has sufficient taxable income to claim the
deduction, even where the deduction is limited for federal purposes because
of a consolidated group's lack of taxable income.
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State Modifications – Typical Subtraction Modifications
Compute I.R.C. Sec. 199 deduction on an allocated basis:
Virginia Ruling (P.D. 11-181):
• The Virginia tax commissioner ruled that a company that files a consolidated
federal income tax return as part of an affiliated group but files a separate
Virginia return may claim its proportional share of the I.R.C. Sec. 199
deduction for VA income tax purposes since this amount would be the same
had it filed a separate federal return.
• The Virginia Legislature followed this up by passing SB 462, which allows the
total amount of the federal deduction for domestic production activities to be
deducted for Virginia income tax purposes for tax years beginning on or after
January 1, 2013.
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Domestic Production Activities (“DPA”) Deduction:
• Further, the federal DPA deduction may have been limited by federal NOL
carryovers which do not exist or do not exist to the same degree for state
income tax purposes
(or vice versa).
- Without state modification, query whether a federal DPA deduction might
even increase a state NOL carryover, contrary to the general application of
the DPA provisions at the federal level.
• While the above situations suggest that state modifications to adjust the DPA
deduction might be appropriate, at this point only KY has done so.
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State Modifications – Typical Subtraction Modifications
• The U.S. Supreme Court in Kraft General Foods, Inc. v. Iowa Department of
Revenue and Finance, 505 U.S. 71 (1992) held that Iowa’s conformity to the
federal dividends received deduction (“DRD”) regime via its conformity to
FTI, violated the Foreign Commerce clause to the extent no state level DRD
was allowed for foreign dividends.
- The Kraft decision raises interesting questions with respect to the DPA
which may one day be addressed through litigation.
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State Modifications – Typical Subtraction Modifications
Basic Illustrations of State DPA Deduction
Example - Assume the following for AB Corp:
CA
AZ
Activities
HQ & MFNG
Sales
WAGES
$29 million
$1 million
QPAI
N/A *
$20 million
Fed DPA (6 %)
$480,000
$1.2 million
State Appor. %
50%
50%
Apportioned DPA
$600,000
State Tax Rate
6.968%
State Benefit of DPA
$42 K
*CA
does not adopt the DPA deduction
Observation: AB Corp receives a DPA deduction in AZ despite conducting no qualifying
activities and employing minimal people in the state and receives no benefit in CA where
such activities are conducted.
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State Modifications – Typical Subtraction Modifications
The Alabama Tax Tribunal held on November 30, 2016 in Sherwin-Williams
Company v. Alabama Department of Revenue that the taxable income
limitation for purposes of computing the IRC 199 deduction for Alabama
purposes is pro forma separate company federal taxable income, not separate
company Alabama income after state specific adjustments. (Alabama Tax
Tribunal, Docket Nos. BIT 13-359 & BIT 11-741 (11/30/2016).)
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Discharge of Indebtedness – IRC Section 108 Deferral
• The American Recovery and Reinvestment Act of 2009, enacted 2/12/09,
modifies federal provisions dealing with the recognition of income from the
cancellation or repurchase by a taxpayer of its debt for an amount less than
its adjusted issue price.
• § 108 provides that a taxpayer must recognize cancellation of debt income
(CODI) in an amount equal to the excess of the old debt's adjusted issue price
over the repurchase price in the year the debt is cancelled or reacquired.
• However, Sec. 108(i)(1) allows certain businesses to recognize CODI over 10
years for specified types of business debt reacquired by the business after
12/31/08, and before 1/1/11.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Dividends
States differ in their treatment of dividend income. However, there are some
common variations:
• State DRD same as federal.
• State DRD limited to dividends distributed from in-state income.
• State DRD extended to foreign dividends
• The IRC Section 78 deemed-paid gross-up on foreign (country) dividends are
usually excluded from dividend income.
• Subpart F income may be treated the same as other foreign dividends or
subtracted entirely.
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State DRD Same as Federal
• Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, 505
U.S. 71 (1992):
- Iowa’s taxation of dividends violated the Foreign Commerce Clause. Iowa
used federal taxable income as the starting point for the computation of
Iowa taxable income. No adjustment for dividends was written into the
statute and, as a result, corporations were entitled to deduct domestic
dividends to the extent they were deductible under federal provisions, but
were taxed on foreign dividends taxable under the IRC.
- Footnote 23: In relation to a state employing unitary combined
apportionment, the possibility that a state that imposes its tax on the
taxpayer's income including its foreign dividend income, and also on the
income of a domestic subsidiary doing business in its borders, may well
not be discriminating in violation of the Foreign Commerce Clause.
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• Conoco, Inc. and Intel Corporation v. New Mexico Taxation and Revenue
Dept., 931 P.2d 730 (N.M. Nov. 26, 1996):
- The New Mexico Supreme Court reversed the State Court of Appeals and
held New Mexico’s scheme of exempting domestic dividends while taxing
foreign dividends under the Detroit formula to violate the Foreign
Commerce Clause of the U.S. Constitution.
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State DRD Limited to Dividends Distributed From In-State Income
Farmer Brothers Co. v. Franchise Tax Board, 108 Cal.App.4th 976 (2003):
• California Court of Appeals ruled that statutory provisions that tie the
general corporation dividends received deduction to the payor's level of
California in-state activity create an unconstitutional burden on interstate
commerce and are invalid.
• The Court concluded that Section 24402 is discriminatory on its face because
it favors dividend-paying corporations doing business in and paying taxes to
California over dividend-paying corporations that do not do business in and
pay no taxes to California.
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State DRD Limited to Dividends Distributed From In-State Income
• Abbott Laboratories v. California Franch. Tax Bd., 175 Cal. App. 4th 1346
(July 21, 2009), mod. 2009 Cal.App.LEXIS 1298 (Aug. 6, 2009) deemed the
DRD provisions invalid in their entirety (i.e., DRD denied to all taxpayers)
and that it would be inconsistent with legislative intent to reform the DRD
provisions to permit a DRD regardless of the payor’s California in-state
activity.
• In D.D.I., Inc. v. Clayburgh, 657 N.W.2d 228 (2003), the Supreme Court of
North Dakota held that the state’s dividends received deduction violated the
Commerce Clause since the deduction applied only to the extent that the
dividend payor's income was subject to North Dakota corporate income tax,
but did not allow the deduction if the payor's income was not subject to
North Dakota corporate income tax.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
General Electric Company, Inc. v. New Hampshire Dep't of Revenue Admin.,
N.H., No. 2005-668, 12/5/06:
• The New Hampshire Supreme Court held that a statute that allows a parent to take a
business profits tax deduction for dividends received from subsidiaries that do business
in the state but not for dividends received from subsidiaries that do not business in the
state does not facially discriminate against foreign commerce.
Mississippi Department of Revenue v. AT & T Corporation (Miss. 2016) 202
So.3d 1207
•
The Mississippi Supreme Court ruled that the state’s dividends received deduction,
which applies only to dividends received from affiliates doing business in Mississippi
and filing state income tax returns, unconstitutionally discriminates against interstate
commerce.
• The court struck the unconstitutional phrase from the statute and allowed the taxpayer
to deduct dividends received from affiliates not doing business and filing income tax
returns in Mississippi.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Kodak Company v. Connecticut Commissioner of Revenue Services, 27 Conn.
L. Rptr. 273 (2000):
• The Connecticut Superior Court ruled that a department policy disallowing a
portion of the deduction for commissions paid to a foreign sales corporation
arbitrarily treats the commissions as non-deductible expenses related to
dividend income, and is nothing more than a vehicle to allow the state to
indirectly tax income that it is prohibited from taxing directly.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Apple, Inc. v. Franchise Tax Board, 132 Cal.Rptr.3d 401 (2011):
• The California Court of Appeal, First District, affirmed a superior court
decision in favor of the FTB’s method of ordering CFC dividends.
Specifically, dividends from the accumulated earnings of a partially included
CFC of a water's edge filer are governed by the last-in-first-out ("LIFO")
ordering provisions and must be treated as coming from current year
earnings until exhausted and then from the most recent years' earnings,
without regard to whether the earnings represent previously taxed income.
• Also, the appeals court affirmed the superior court's holding that interest
expense attributable to funds proven to have some economic connection to
the generation of California taxable income qualify for deduction.
• The California Supreme Court denied review.
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State Modifications – Typical Subtraction Modifications
Section 78 Gross-Up
Most states allow a subtraction due to not allowing foreign tax credits. This may
differ in states that allow federal income tax deductions.
• Amerada Hess Corp. v. Fong, N.D., No. 20040378, 8/31/05:
- The North Dakota Supreme Court held that a taxpayer's I.R.C. § 78 grossup amounts are ineligible for a partial exclusion from North Dakota
corporate income tax as foreign dividends.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Subpart F Dividends
The states differ on the treatment of federal Subpart F dividends. For example,
California does not recognize Subpart F dividends as income. Some states, such
as Kansas, include Subpart F dividends in income, but may allow a DRD.
• New York - TSB-A-02(5)C, 5/31/02:
- The Department of Taxation and Finance ruled that Subpart F income
generated by a foreign tier-two subsidiary is an excludable dividend from
subsidiary capital.
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Advanced Income Tax Track
State Modifications – Typical Subtraction Modifications
Interest on Federal Obligations
The states are prohibited from taxing federal obligation income under the
intergovernmental immunity doctrine. However, this doctrine only applies to
state taxes imposed directly on net income as opposed to those taxes
measured by net income. States imposing a direct net income tax are
required to provide for a subtraction modification for U.S. interest. States
levying franchise taxes measured by net income generally tax such income.
• Example:
- CA Franchise Tax – federal obligation income is not deductible
- CA Income Tax – federal obligation income is not taxable
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Nebraska Dept. of Rev. v. Lowenstein, 513 U.S. 123 (1994):
• The U.S. Supreme Court found that although income derived from
repurchase agreement (“repo”) transactions are in the nature of “interest”
and where federal securities were used as collateral, such “interest” was not
exempt from state taxation as “interest on obligations of the United States”
since the federal securities underlying the repo served as security for the
financing rather than as a source of interest.
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State Modifications – Typical Subtraction Modifications
Bell Federal Savings & Loan Association v. Wagner, 675 N.E.2d 135 (Ill. Ct.
App. Dec. 13, 1996):
• The Illinois Court of Appeals held that interest paid by the Federal Home
Loan Bank (FHLB) was not exempt from State taxation. The Court noted that
the DID account was not a debt instrument issued by the FHLB because it
was not an executed writing that contained a promise to pay specified
amounts at specified times. As a result, the court held the interest paid by the
FHLB on Bell’s DID accounts was not exempt from State taxation.
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State Modifications – Typical Subtraction Modifications
In the Matter of Sumitomo Trust and Banking Company v. Commissioner of
Taxation, 720 N.Y.S. 2d. (2001):
• The New York Supreme Court held that interest income earned on
certificates guaranteed by the U.S. Small Business Administration is not
deductible in determining corporate franchise tax because such certificates
are not U.S. government obligations.
• The certificates were not obligations of the United States because the binding
promise by the U.S. government is not a fixed and certain obligation, but a
secondary and contingent one, the court noted.
• The Court found it significant that the Federal government received none of
the proceeds of the certificates. Absent a showing that that obligation would
impose a burden on the borrowing power of the United States, the interest
income is not deductible, the court said.
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State Modifications – Typical Subtraction Modifications
Federal Tax Credits
Some states provide specific subtractions for reductions in federal deductions
due to claiming a federal tax credit. In some states the subtraction is worded
broadly, and in other states only specific federal credits are mentioned.
• Potlatch Corp. v. Idaho State Tax Com’n, 913P.2d 1157 (1996): The Supreme
Court of Idaho held that a taxpayer that elects to claim federal credits rather
than deductions for contributions to an employee stock ownership program
(ESOP) and for research and development expenses, was not entitled to
claim deductions for these expenses on their state income tax returns.
• Utah Rev. & Tax § 59-7-106(f): Allows “any decrease in any expense
deduction for federal income tax purposes due to claiming any other federal
credit” to be subtracted from unadjusted income.
• Oregon Revised Statutes § 317.303: If the federal credit taken is not allowed
for Oregon purposes, the taxpayer shall be allowed the deduction or
appropriate adjustment to basis to derive Oregon taxable income.
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Advanced Income Tax Track
State Modification – Possible Federal Tax Reform
Congress has proposed business tax reform legislation in 2017, including a
lower corporate tax rate, a new passthrough business income tax system,
elimination of deductions, full expensing of business costs (with no deduction
for net business interest expense), a move to a territorial dividend exemption
system, a onetime mandatory repatriation of foreign earnings, and border
adjustments that would exempt export sales from taxable income and preclude
foreign costs of goods sold expenses from being deducted.
Based on the U.S. Supreme Court’s decision in Kraft, state level conformity to
some of these proposals may present Constitutional issues, for example the so
called “border adjustment” provisions.
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State Modification – Possible Federal Tax Reform
This reform will bring with it considerable tax opportunities as well as State
conformity issues. For example:
• How will the mandatory repatriation of foreign earnings and profits be treated at the
state level?
• Would state level adoption of the border adjustment provisions pass Constitutional
muster?
• Will states decouple from full capital investment expensing?
• Will states decouple from the elimination of the current deduction for net business
interest expense? Will there be separate rules for financial service companies?
• Will states conform to passthrough business income taxation and what will be the
impact on jurisdictions that have an unincorporated business tax (e.g., NYC, DC)?
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Advanced Income Tax Track
Combined Report Tax Base Issues
• The tax base of state combined/consolidated returns can vary substantially
from the Federal treatment, because many states do not adopt the Federal
consolidated return regulations.
• A “combined report” is a method by which the income and activities of
commonly owned corporations operating as a unitary business are combined
into a single report for purposes of calculating income, and then
apportioning that income to the various entities involved and to the
jurisdictions in which the business is taxable.
• To determine the total group combined report business income in California,
each member of a combined reporting group must first identify its total
separate net income for the period beginning and ending with the accounting
period of the principal member of the combined reporting group (CCR
§25106.5(c)(1)).
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Combined Report Tax Base Issues
• After adjustments for intercompany transactions within the Combined
Reporting Group are made, this number is then combined with the total
separate net incomes of the other group members to arrive at the total group
combined report income (CCR §25106.5(c)(1)(A)).
• Once the total group combined report business income is determined, it is
multiplied by the Taxpayer Member’s California apportionment percentage
to arrive at that member’s California source combined report business
income (CCR §25106.5(c)(7)).
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Combined Report Tax Base Issues
Elements of the California Combined Report
As described in greater detail in FTB 1061, a combined report should contain
the following schedules:
• A Combined Profit and Loss Statement showing the profit and loss of each
corporation.
• A Schedule Converting Net Income to Unitary Business Income Subject to
Apportionment.
• A Schedule Showing the Combined Apportionment Formula.
• Schedule Computing California Net Income and Tax.
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Combined Report Tax Base Issues
World-wide with water’s-edge election
• World-wide combined reporting (“WWCR”) is the default filing methodology
in California.
- The U.S. Supreme Court in Container Corp. v. FTB, 463 U.S. 159 (1983)
held that WWCR was constitutional as applied to a U.S. based
multinational and that the application of the UDITPA three factor formula
to Container’s worldwide income produced a fair result.
• In Barclays v. FTB, 10 Cal.App. 4th 1742 (1992), the Court clarified that
combined reporting was a tool used to determine the amount of income
earned by the domestic entities as opposed to the direct taxation of foreign
entities. The Court saw WWCR as an alternative to IRC 482 arms length
pricing, with neither system inherently better than the other.
- Although the taxpayer reported effectively under the IRC 482 arms length
method in excluding its foreign affiliates, the Court upheld the state’s use
of WWCR as a reasonable alternative.
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Advanced Income Tax Track
Combined Report Tax Base Issues
World-wide with water’s-edge election
• A “water’s edge” election provision was adopted by California in 1986, in
response to recommendations of a U.S. Treasury Working Group and intense
political pressure from taxpayers, the federal government and foreign
governments.
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Advanced Income Tax Track
Combined Report Tax Base Issues
To What Extent are Foreign Affiliates Included In a Water’s-Edge Return?
• In California, CRTC 25110 provides for inclusion of foreign affiliates as
follows:
1. Full inclusion of domestic entities.
2. Full inclusion of non banking foreign affiliates with 20% or more of their
average factors in the U.S.
3. Foreign corps to the extent of their effectively corrected income (ECI).
Non-ECI also included if federal or CA income/franchise tax avoidance is
principal purpose
4. Partial inclusion of CFCs based on the ratio of their Subpart F to current
year E&P
• By way of contrast, in Illinois, corporations, domestic or foreign, with 80% or
more of their activity overseas are excluded from the combined group.
- See Zebra Technologies, Ill. App. 3d 474 (2003), however, where the
parent’s U.S. activities were attributed to a subsidiary
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Combined Report Tax Base Issues
Example: Subpart F partial inclusion for California water’s-edge return:
• California based parent company filing on a water’s-edge basis is unitary
with its CFC which has $300 of Subpart F (i.e., IRC §952) income and $1200
of current year E&P. The CFC has net income for the year of $1000, and
average property, payroll and sales everywhere of $1500 each (no CA
property, payroll or sales).
- The “inclusion ratio” is 25% (i.e., $300/$1200)
- The CFC income to be included in the parent’s CA return is $250 (i.e.,
$1000 x 25%)
- $375 (i.e., $1500 x 25%) is included in each denominator of the California
combined reporting group’s property, payroll and sales factors.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Tax Havens and State Issues – Potential Impact of State Legislation
• Several states have enacted tax haven provisions.
- The number of states that have recently proposed or enacted legislation
specifically directed at tax havens likely indicates that tax haven issues will
be of increased importance in the coming years.
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Combined Report Tax Base Issues
Tax Havens – Tracking State Legislation
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Advanced Income Tax Track
Combined Report Tax Base Issues
Tax Havens – Tracking State Legislation
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Advanced Income Tax Track
Combined Report Tax Base Issues
Tax Havens – Tracking State Legislation
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Advanced Income Tax Track
Combined Report Tax Base Issues
Tax Havens – Tracking State Legislation
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Advanced Income Tax Track
Combined Report Tax Base Issues
Tax Havens – Tracking State Legislation
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Advanced Income Tax Track
Combined Report Tax Base Issues
Tax Havens – Tracking State Legislation
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Advanced Income Tax Track
Combined Report Tax Base Issues
Tax Havens – Tracking State Legislation
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Advanced Income Tax Track
Combined Report Tax Base Issues
Tax Havens – Tracking State Legislation
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Advanced Income Tax Track
Combined Report Tax Base Issues
Tax Havens – Tracking State Legislation
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Advanced Income Tax Track
Combined Report Tax Base Issues
Tax Havens – Tracking State Legislation
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Combined Report Tax Base Issues
Combined Computation, But Separate Taxpayers
• In a California combined return, the computation includes all unitary
affiliates, even those in special industries that use special formulas. As a
general exception, insurance companies that pay premium tax instead of
corporate tax are not included.
- However, see:
i. Appeal of EDS, SBE 8/8/2008 – Out of state corporation registered as
an insurance company was includible given that it did not actually
assume underlying risks and was, in substance, a plan administrator.
ii. Appeal of Argonaut, SBE 1/23/2009 – Premiums of excluded insurance
company subsidiaries were included in a holding company’s special
apportionment formula.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Combined Computation, But Separate Taxpayers
• Each member of the group is a separate taxpayer. This has implications for
apportionment, use of tax attributes, and certain procedural issues, such as
accounting methods and elections
• Apportionment – generally, separate determination entity by entity for the
applicable industry apportionment method.
• California has issued numerous special industry apportionment regulations
covering industries ranging from motion picture production, bank and
financial corporations, air transportation, railroads, trucking, print media,
etc.
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Combined Report Tax Base Issues
Combined Computation, But Separate Taxpayers
• The combination of financial and non-financial corporations is quite complex
in California:
1. An assessment of each corporation’s status as either a financial or nonfinancial corporation taking into account both gross receipts and gross
income is made:
◦ This determination affects the tax rate as well as the construction of the
entity’s apportionment factors
2. Combined groups whose predominant activity is financial measured by
gross receipts use an evenly weighted three factor formula while
predominantly non-financial groups use a double weighted sales factor.
Note that for years beginning on/after January 1, 2013 under Prop. 39 all
but certain excluded industries (such as financial institutions) must
apportion income using a single sales factor.
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Advanced Income Tax Track
Combined Report Tax Base Issues
• The combination of financial and non-financial corporations is quite complex
in California:
3. Combined groups which are predominantly financial vs. non-financial
based on gross income use different apportionment regulations:
◦ e.g. Under the predominantly non-financial reg:
a. Financial corps include only 20% of the value of includible intangible
property
b. General corps include 20% of the value of certain receivables
• Note that in the Appeal of Swift Transportation Co., Inc. and Swift
Transportation Corporation, SBE Letter Decision No. 266318 (petition for
rehearing granted 12/16/2008) the SBE upheld the FTB’s application of the
trucking industry special apportionment provisions to all unitary group
members, not just the member that was directly engaged as a motor carrier.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Finnigan sourcing (Repeal of Joyce and Huffy) – SBX3 15 (2009)
• Chronology:
- Joyce(1966)/Finnigan(1988)/Joyce(Huffy)(1999)/Back to Finnigan
(2011)
• California has been the pioneer – started with Joyce, went to Finnigan.
Other states adopted Joyce. In Huffy, the Court looked to Joyce states for the
basis of its decision.
• Is California consistent with other states in adopting Finnigan? NY, MA, WI
• Finnigan sourcing is effective for taxable years beginning on or after
January 1, 2011.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Joyce Sourcing
• Inbound sales: Sales of TPP to California by combined reporting group
members are included in the California sales factor numerator only if the
group member making the sale has California nexus. Group members with
California nexus are not presumed to be agents for non-nexus members.
- See: The Reader's Digest Association, Inc. v. FTB, 94 Cal. App. 4th 1240
(2001) – nexus existed for parent company because subsidiary was, in
fact, acting as its agent in soliciting sales.
- Compare: Airborne Navigation Corp. v. Arizona DOR, Arizona Board of
Tax Appeals, No. 395-85-I , February 5, 1987 – nexus existed for parent
solely due to in-state manufacturing activities of sub – held that unitary
group is considered one “person’ for determining whether P.L. 86-272
protection applies (i.e., whether the “person’s activities are limited to sales
solicitation).
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Advanced Income Tax Track
Combined Report Tax Base Issues
Joyce Sourcing
• Outbound sales: Sales of tangible personal property shipped from California
are included in the sales factor numerator (i.e., “throwback”) unless the
group member making the sale is taxable in the state of the purchaser.
• Joyce effectively treats the group members as “separate taxpayers.”
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Advanced Income Tax Track
Combined Report Tax Base Issues
Finnigan Sourcing
• Outbound sales (Finnigan I): Sales of tangible personal property are excluded
from the sales factor numerator (i.e., no “throwback”) if any member of the
combined reporting group is taxable in the state of the purchaser.
• Inbound sales (Finnigan II): All sales of tangible personal property by members
of the combined reporting group are included in the numerator of the California
sales factor, regardless of whether the member of the combined group making the
sale is subject to California tax.
- This affects inbound sourcing of TPP sales shipped into California by “no
nexus” unitary affiliates. Non-nexus sales are attributed to other members of
the group. Is this indirect taxation of entities which lack nexus?
- Note: The Brown Group Retail case questioned whether inclusion of these
receipts was a violation of PL 86-272.
• Finnigan sourcing effectively treats the combined group as “one taxpayer”.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Use of attributes
• In California, use of attributes such as tax credits and NOLs is limited to the
entity generating them.
- General Motors Corp. v. FTB, 139 P.3d 1183 (2006) – California Supreme
Court held that research credits could only be claimed by the entity that
generated them.
- Same rule for NOLs – a California loss carryover for one combined group
member cannot be used by another member – FTB Pub. 1061 and Form
3805Q instructions
• The elimination of intercompany sales can produce severe credit utilization
limitations in states such as California (under current law) which restrict
credit utilization to the liability of the entity generating the credit.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Use of attributes
By way of contrast, in Illinois the group’s designated agent is to compute any
credit allowed by the Illinois Income Tax Act based on the combined activities
of the members of the combined group and such credit is to be applied against
the combined liability of the combined group. (Ill. Adm. Code Sec.
100.5270(d)(1).)
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Advanced Income Tax Track
Combined Report Tax Base Issues
Use of attributes - Credits
Example: Manufacturing/R&D Company and Sales Company
• Corp. A has substantial operations in California, where it is headquartered,
engages in substantial R&D and manufacturing and sells its products to
Corp. B, its subsidiary
• Corp. B is a sales subsidiary which takes title, possession and control in
California of inventory purchased from Corp A. Corp B sells half of its
product in California.
• Corp A generates a $100 R&D credit in California
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Advanced Income Tax Track
Combined Report Tax Base Issues
Example 5:
Corp A
Corp B
Combined
$800
$200
$1,000
800
50
85 %
1,000
1,000
800
50
1,000
1,000
0
5,000
10,000
10,000
Appor %
40%
15%
55%
Income
400
150
550
8.84%
8.84%
8.84%
$35
$13
$48
< 35 >
0
< 35 >
0
13
13
T.I.
Property
Payroll
Sales
Tax Rate
Tax
Credits
Net
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50%
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Advanced Income Tax Track
Combined Report Tax Base Issues
• Despite generating credits in excess of its overall tax liability as a group, Corp
B has a liability of $13. Note that Corp A could use the credit assignment
provisions to assign excess credits on a one time basis to Corp B. Similar
issues would arise in the case of NOLs, however there are no assignment
provisions with respect to NOLs
- Query: Is this separate taxpayer calculation consistent with combined
reporting theory? Would it be more reasonable not to eliminate Corp A’s
sales to Corp B for purposes of a special credit utilization limitation?
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Advanced Income Tax Track
Combined Report Tax Base Issues
Example 6: Impact of Single Sales Factor on Combined Groups with Sales Companies
Property
Payroll
Sales
Corp A
Corp B
Combined
T.I.
800
200
1,000
Separate
800
100
90 %
1,000
1,000
800
100
1,000
1,000
0
2,000
10,000
10,000
0%
20%
20%
0
200
200
<50>
<50>
<50>
0
150
150
8.84%
8.84%
8.84%
0
13
13
< 35 >
0
0
$0
$13
$13
Combined
Separate
Combined
Separate
Combined
Appor %
Income
NOLs
Income after NOL
deduction
Tax Rate
Tax
Credits
Net
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20%
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Advanced Income Tax Track
Combined Report Tax Base Issues
• Credit Assignment
- Credits earned in years beginning before July 1, 2008 (even if non-unitary
in such years), may be shared if the assignee was unitary with the
assigning corporation as of:
◦ June 30, 2008, and
◦ The last day of the year when the credits were assigned.
- Note:
◦ If not unitary as of the end of the year, will not qualify.
◦ Cannot share pre-July 1, 2008 credits with companies acquired and
unitary on or after July 1, 2008.
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Advanced Income Tax Track
Combined Report Tax Base Issues
• Credit Assignment
- Credits earned in years beginning on or after July 1, 2008, may be shared
if the assignee was unitary with the assigning corporation as of:
◦ The last day of the first year in which the credit was allowed to the
assigning corp., and
◦ The last day of the year when the credits were assigned.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Accounting Methods and Elections Credit Assignment
• Each taxpayer in a combined group is authorized to elect its own accounting
method and make its own elections, independently of other group members.
Reg. §25106.5-3
- Once accounting method or other election is made for a member, that
member’s net income must be consistently treated in all combined
reports.
• The combined group members can elect to have the parent company make
elections on behalf of all members. If parent does not have nexus, a nexus
company can make the election on behalf of the parent for all the members.
• Form 100, Schedule R-7: Members elect to make the group return, and are
jointly and severally liable for the tax.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Intercompany Transactions
• Reg. § 25106.5-1: California conforms to deferral method under the federal
consolidated regulations as in effect March 17, 1997 for intercompany
transactions (Treas. Reg. §1.1502-13)
- Applicable to intercompany transactions on or after January 1, 2001.
- General rule is one of deferring gains/losses from intercompany
transactions to produce the effect of transactions between divisions of the
same corporation.
- Applies only to unitary “business income”
- Applies to transactions with partially included (i.e., “water’s edge) CFCs to
the extent the income, gain, loss or deduction would be included in a
water’s edge combined report
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Advanced Income Tax Track
Combined Report Tax Base Issues
Intercompany Transactions
Franchise Tax Board Chief Counsel Ruling 2012-02, 7/26/12
• The sale of a partnership interest from a corporation to a disregarded LLC
whose sole owner is a partnership does not qualify as a transaction between
corporations.
• Accordingly, any gain resulting from the partnership interest sale would not
be deferred under the intercompany transaction regulations.
• Rather, the sale should be currently recognized by the seller corporation.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Deferred Intercompany Stock Accounts (DISA)
• IRC §301(c)(3) distributions to parent – creates income, which is deferred
• Deferred Intercompany Stock Account (“DISA”) – distributee corp uses this
account to report and track non-dividend distributions in excess of stock
basis in distributor corp with which it is unitary, until required to be
recognized. The DISA account balance must be disclosed annually on the tax
return.
- Reg. §25106.5-1(j)(7) provides that non-disclosure could result in
recognition of part or all of the DISA balance, at the FTB’s discretion.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Deferred Intercompany Stock Accounts (DISA)
Example:
Corp A owns Corp B and the two have always been unitary and file a federal
consolidated return. Corp A has a $2,000 and $1,000 basis in Corp B for
federal and California tax purposes, respectively. Corp B has $1,000 of E&P.
Corp B borrows $5,000 and distributes such to Corp A.
Federal ELA
California DISA
5,000
5,000
Less E&P
(1,000)
(1,000)
Basis
(2,000)
(1,000)
Distribution
Excess Loss Account
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2,000 DISA
3,000
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Advanced Income Tax Track
Combined Report Tax Base Issues
Treatment of Deferred Intercompany Stock Accounts (DISA)
• Amended California Code of Regulations section 25106.5-1 was approved by
the Office of Administrative Law on 1/1/2014
• The new provisions are applicable to transactions occurring on or after
January 1, 2001. Taxpayers may elect to have the changes apply
prospectively starting April 1, 2014. The changes include:
- Allow a DISA to be reduced by a subsequent capital contribution
- DISA will not be triggered upon a merger between combined reporting
group members that are owned by other members of the combined
reporting group
- Allow only 1 DISA to arise from a distribution through multiple tiers of a
combined reporting group
- Taxpayers will be required to annual report reductions to DISAs brought
about by subsequent capital contributions
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Advanced Income Tax Track
Combined Report Tax Base Issues
Treatment of Deferred Intercompany Stock Accounts (DISA)
• Taxpayers the previously triggered a DISA, reported it and paid tax, should
consider filing a claim for refund to the extent the DISA is cured under
retroactive application of the new regulations.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Dividend Elimination Provisions
• Dividends from pre-unitary E&P
- CA Rev.& Tax Code §25106 – allows “elimination” of a dividend paid out
of certain unitary income.
- See Willamette v. FTB, 33 Cal. App. 4th 1242 (1995) – to qualify for
elimination under CA Rev.& Tax Code §25106, a dividend must be paid
from “income” of a unitary business, and the income must have been
determined by reference to the income and apportionment factors of both
the dividend payor and the dividend recipient.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Example:
Facts: Corp A purchased Corp B and was instantly unitary. Corp A is 100%
California and Corp B is 100% Oregon. The combined California apportionment
is 50%. In the current year, Corp B distributed dividends to Corp A in the
amount of $2,000. $1,000 of the dividends were distributed from current year
unitary E&P. The remainder was distributed from accumulated E&P prior to
acquisition.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Corp A – w/limitation on
pre-acq E&P
Taxable Inc w/o dividend
Dividends Rec’d
500
2000
Corp A – w/o limitation Corp B – E&P
500 PreAcq E&P 1000
2000 CY E&P 1000
Interco Elim
(1000)
Total Income
1500
500 CY Div. paid to A (2000)
Apportionment
50%
50%
8.84%
8.84%
66
22
CA Tax Rate
Tax Due
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(2000)
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Advanced Income Tax Track
Combined Report Tax Base Issues
Massachusetts - Overview
• The Massachusetts excise is comprised of a tax on income and a tax on a
non-income measure based generally on tangible personal property.
• Effective for tax years beginning on or after January 1, 2009, a corporation
engaged in a unitary business with one or more corporations "subject to
combination" must calculate its taxable net income based on its share of the
apportionable income or loss of the combined group attributable to
Massachusetts.
• The non-income measure of corporate excise continues to be calculated on a
separate entity basis.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Massachusetts - Worldwide group election
• The taxable members of a combined group may make a voluntary 10-year
election to determine the group's taxable income on a worldwide basis.
• The election must be made on the principal reporting corporation's return,
which must be filed by the extended due date of the corporate return.
• Methods of determining income of foreign entities included in the
Massachusetts combined group.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Water’s Edge Group includes:
• Taxable members
• Nontaxable members
- Domestic entities
- 80/20 Companies – any member if the average of its property, payroll and
sales in the U.S. is 20% or more,
- Intercompany inclusion – income and factors of intercompany
transactions related to services or intangibles are included if an affiliate
outside the group earned more than 20% of its gross income from such
transactions and members of the group can deduct the costs federally.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Water’s edge default
Recent regulatory amendments
• Foreign corporations include:
- Income that is effectively connected with the conduct of a U.S. trade or
business; and
- U.S. source income that is not effectively connected.
• Treaty “Exception”
- Wording renders exception meaningless.
- U.S. source income and the effectively connected income should not be
reduced on account of any U.S. bilateral income tax treaty, “except to
the extent, if any, that such treaty results in the exclusion of an
item from such member’s federal gross income as determined
under the Code…”
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Advanced Income Tax Track
Combined Report Tax Base Issues
80/20 Companies
• Domestic or foreign entity included if 20% or more of its average property,
payroll and sales are within the United States.
Issues to consider:
• All three factors apply which could pull in affiliates not otherwise included in
other 80/20 states.
• Applies three factor equally weighted formula, irrespective of whether the
entity is subject to a different regime.
• Intercompany sales included in 80/20 test and then eliminated in combined
group apportionment.
• De minimis factors disregarded.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Intercompany inclusion
Current law
• Includes income less expenses, but not below zero, related to the
intercompany transactions
Issues to consider
• Services - Broadly interprets “services” to include financing
• Intangible/interest add back – If the 20% threshold is not satisfied, the
payment deducted may be subject to addback.
• Factor inclusion –include property and payroll factors that produced such
income, but eliminate associated receipts.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Dividends
• Dividends paid from post-2008 unitary earnings and profits are eliminated.
• In general, dividends paid from pre-2009, or non-unitary, earnings and
profits are subject to a 95% dividends received deduction.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Apportionment
• Massachusetts corporate taxpayers may be subject to different tax regimes,
different apportionment formulas, and even different rates.
• The Legislation attempted to preserve these diverse rules in a combined
reporting setting.
• Each taxable member of the Massachusetts combined group should
determine its own apportionment percentage to apply against the group's
combined taxable income based on the particular apportionment formula
such taxpayer is required to utilize.
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Advanced Income Tax Track
Combined Report Tax Base Issues
“Common Denominator” Approach
• The legislation adopts “common denominator” approach.
- Each member determines its denominator(s) based upon its applicable
apportionment provisions, and
- Denominators of all members are aggregated.
• Property and payroll factor denominators include the property and payroll of
all members, including those members subject to a single sales factor
formula.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Apportionment Numerator
• Each “taxable member” computes the numerator of its apportionment
factors pursuant to the rules that apply to such member.
• Finnigan rule adopted—a taxpayer is considered taxable in any state in
which any member of its combined group is subject to tax.
• Receipts of non-taxable members are allocated to taxable members based on
their relative Massachusetts sales.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Net operating losses
• Generated in Tax Years Beginning on or after Jan. 1, 2009
- Shift to Post-Apportionment Carryforwards
- Sharing of NOLs Carryforwards With Other Group Members
- Shifts in Combined Group
- Potential Issues in Sales Company Structures
• Generated in Tax Years Beginning Prior to Effective Date of Legislation
- Determining Amount to be Carried Forward
- Income Limitation
- Ability to Share with Other Group Members
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Advanced Income Tax Track
Combined Report Tax Base Issues
Credits
• Generated in Tax Years Beginning on or after Jan. 1, 2009
- Sharing of Credit Carryforwards
- Shifts in Combined Group
- Recapture Issues
• Generated in Tax Years Beginning Prior to Effective Date of Legislation
- Ability to Share with Other Group Members
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Advanced Income Tax Track
Combined Report Tax Base Issues
Who is in the Group?
• Illinois: Corporate taxpayers that are members of the same unitary business
group are treated as one taxpayer and required to file a combined return.
(See IITA Sec. 502(e).).
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Advanced Income Tax Track
Combined Report Tax Base Issues
Is the Group Treated as One Taxpayer?
• Illinois: Corporations (other than Subchapter S corporations) that are
members of the same unitary business group are treated as one taxpayer for
purposes of any original return, amended return that includes the same
taxpayers of the unitary group which joined in filing the original return,
extension, claim for refund, assessment, collection and payment and
determination of the group’s tax liability under the Act. (IITA Sec. 502(e); Ill.
Adm. Code Sec. 100.5200.)
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Advanced Income Tax Track
Combined Report Tax Base Issues
Combined Reporting Issues - Net Operating Losses:
• New York: Generally, NOLs may be used to offset the income of other
companies in the combined group.
- Under the new rules effective for tax years beginning on or after January
1, 2015, New York generally treats the combined group as if it were a
single entity and PNOL, NOLs and capital losses can be used by the group,
not just the entity that generated them.
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Advanced Income Tax Track
Combined Report Tax Base Issues
Corporations Operating Wholly Within California:
• At one time, a unitary business operating wholly within California was not
permitted to use the combined report method. (See, e.g., Appeals of O.S.C.
Corporation, et al., Cal. St. Bd. of Equal., Dec. 3, 1985.) However, for income
years beginning on or after January 1, 1980, Section 25101.15 allows two or
more corporations that are engaged in a unitary business solely within
California to elect to file a combined report.
• In Harley-Davidson Inc. v. Franchise Tax Board, the California Court of
Appeals on May 28, 2015 upheld the San Diego Superior Court’s earlier
decision on May 1, 2013, that certain special purpose entities (SPEs) had
nexus in California. The Court, however, reversed the trial court in agreeing
that the above elective combination provisions discriminated against
interstate commerce and remanded the case for determination as to whether
such discrimination served a ‘legitimate’ reason that could not be addressed
with ‘reasonable, non-discriminatory alternatives.’
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Advanced Income Tax Track
Combined Report Tax Base Issues
Harley-Davidson, Inc. v. Franchise Tax Board, California Supreme Court, No.
S227652, petition for review denied, September 16, 2015
• The California Supreme Court denied the taxpayer’s petition for review of a
court of appeal decision that concluded California’s tax scheme allowing only
intrastate unitary taxpayers the discretion to file on a separate or combined
basis while mandating unitary combined reporting for interstate taxpayers
was facially discriminatory. The combined return issue has been remanded
to the lower court.
Harley-Davidson, Inc. v. Franchise Tax Board, San Diego Superior Court, No.
37-2011-00100846-CU-MC-CTL, October 31, 2016
• On remand, the San Diego Superior Court denied the taxpayer’s motion for
summary judgment and granted the FTB ‘s motion for summary judgment.
The court determined that although the statute may be discriminatory, the
state nevertheless has a legitimate interest in “ensur[ing] that all business
income from interstate business is accurately accounted for.”
**Harley-Davidson filed a Notice of Appeal on December 27, 2016
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Advanced Income Tax Track
Combined Report Tax Base Issues
Corporations Operating Wholly Within California:
• In Abercrombie & Fitch v. Franchise Tax Board, Fresno Superior Court Case
No. 12CEGC03408, the taxpayer has alleged that the FTB improperly
discriminates against multistate unity corporate taxpayers by requiring them
to compute their California taxable income by using the combined reporting
method as opposed to letting them choose between the combined reporting
method or the separate reporting method.
• On January 21, 2015, the Court issued a Tentative Ruling staying
proceedings pending the Court of Appeal decision in Harley Davidson v.
Franchise Tax Board.
• On January 22, 2015, Counsel for Plaintiff requested the case remain active.
• After taking the matter under submission, the Superior Court affirmed its
Tentative Ruling and has stayed proceeding pending the Court of Appeal
decision in Harley Davidson v. Franchise Tax Board.
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Advanced Income Tax Track
Alternative Bases
Alternative Bases – Gross Receipts Tax
The state corporate income tax base generally starts on line 28 or 30 of a
taxpayer's federal return. However, gross receipts taxes are different. The
measure of the Texas tax on gross receipts, called the Margin Tax, starts with
line 1c. Michigan* and Ohio specifically define what is included in gross
receipts.
* The Michigan Business tax is repealed and replaced with a tax based on income,
effective for taxable years beginning on or after January 1, 2012.
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Advanced Income Tax Track
Alternative Bases
What is a Gross Receipts Tax?
• Texas Margin Tax (“TMT”):
- TMT base is equal to total revenue less the greater of Cost of Goods Sold
or Compensation Deduction.
- Tax base capped at 70% of total revenue or total revenue less $1 million.
• Ohio Commercial Activity Tax (CAT):
- Tax base includes Ohio sourced gross receipts from trade or business with
very limited exceptions.
- Gross receipts are broadly defined as the total amount realized by a
person, without deduction for the cost of goods sold or most other
expenses incurred.
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Section 2
Apportionment Factors – Property &
Payroll
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Table of Contents
Section
Overview
2.
Apportionment Factors – Property & Payroll
A.
Apportionment Principles
i.
Right to Apportion
ii.
Apportionment Formula
iii.
Examples of State Apportionment
iv.
MTC
v.
Fair Apportionment
vi.
Division of Tax Base
B.
The Property Factor
C.
The Payroll Factor
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Advanced Income Tax Track
Apportionment Principles
• UDIPTA written in a simpler world (e.g., mining, manufacturing, and
mercantile).
• Reflects full accountability.
• Must give rise to business income.
• Not necessary for a factor to include everything (e.g., property factor where
intangibles are excluded).
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Advanced Income Tax Track
Apportionment Principles – Right to Apportion
“Taxable” in Another State:
• In most states, a taxpayer must be “taxable in another state” before it may
apportion its income. A business is considered taxable in another jurisdiction
if:
- It is subject to net income tax, franchise tax measured by net income,
franchise tax for the privilege of doing business, or corporate stock tax in
another state, or
- The other state has jurisdiction to subject the taxpayer to net income taxes
regardless of whether the state chooses to impose a tax. See Uniform
Division of Income for Tax Purposes Act (UDITPA) § 3.
◦ See also Appeal of Craiglist, Inc., Cal. St. Bd. of Equal., Jan. 15, 2016.
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Advanced Income Tax Track
Apportionment Principles – Right to Apportion
• California has adopted UDITPA § 3.
• California has adopted a factor presence nexus standard in 2011.
- Query: Is this the standard for right to apportion and apportionment in
general? If so, what is the effective date? Is actually filing returns in other
states required?
◦ Amray, Inc. v. Commissioner of Revenue, No. 119875 (Mass. App. Tax
Bd. April 17, 1986): the Massachusetts Appellate Tax Board held that
the company was “subject to tax” in other jurisdictions due to activities
of its service personnel despite its failure to file returns in the other
states.
◦ Technical Assistance Advisement 95(C)1-008, Fla. Dept. of Rev.,
August 30, 1995: A Florida corporation licensing a patent outside the
State was not entitled to apportion its income within and without the
State.
◦ Alternative apportionment methods that deviate from the standard
UDITPA method will be discussed on Day Four.
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Advanced Income Tax Track
Apportionment Principles – Apportionment Formula
• The traditional formula that had been used by most states for the
apportionment of multistate business income is an average of three factors property, payroll and sales. That formula is termed the “Massachusetts
formula” in recognition of the fact that Massachusetts was the first state to
employ the formula. However, few states today use an equally-weighted
three factor formula.
General Formula:
Property w/i state
______________
Property
everywhere
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Payroll w/i state Receipts w/i state
+ ____________ + ______________ ÷ 3
Payroll
Receipts
everywhere
everywhere
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Advanced Income Tax Track
Apportionment Principles – Apportionment Formula
Trend Toward Heavier Weighting of the Sales Factor
• In order to create incentives for businesses to locate within a particular state,
and perhaps in recognition of the importance of the market state in the
production of income, many states have increased the weight of the sales
factor, and some have shifted to a single sales factor formula.
- Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978), the Supreme Court
upheld Iowa's use of a single factor receipts-based formula.
- Effective for taxable years beginning on or after January 1, 2011, California
provides that any apportioning trade or business, other than an
apportioning trade or business described in Cal. Rev. & Tax. Code Sec.
25128(b), may make an annual irrevocable election on an original timely
filed return to use a single sales factor for apportionment. (Cal. Rev. &
Tax. Code § 25128.5).
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Advanced Income Tax Track
Apportionment Principles – Apportionment Formula
Trend Toward Heavier Weighting of the Sales Factor
• In order to create incentives for businesses to locate within a particular state,
and perhaps in recognition of the importance of the market state in the
production of income, many states have increased the weight of the sales
factor, and some have shifted to a single sales factor formula.
- The FTB has provided additional guidance regarding the mechanics of the
election in Cal. Code Regs., tit. 18, §§ 25128.5 and 25136-2.
- Under Proposition 39, Single Sales Factor is mandatory, except for
excluded industries (e.g. banks and financials), for 2013 and beyond
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Advanced Income Tax Track
Apportionment Principles – Apportionment Formulas* – 1998
WA
MT
ME
ND
MN
OR
VT
NH
ID
WI
SD
MI
CT
WY
RI
NV
PA
IA
NE
IL
UT
CA
MA
NY
NJ
IN
MD
WV
CO
KS
DE
OH
VA
MO
KY
DC
NC
TN
AZ
OK
NM
AR
SC
MS
AK
TX
HI
AL
GA
LA
FL
Equally weighted three factor formula
*Does not address industry-specific or optional formulas
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Double weighted sales factor
Triple or greater weighted or single sales factor
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Advanced Income Tax Track
Apportionment Principles – Apportionment Formulas* – 2003
WA
MT
ME
ND
MN
OR
VT
NH
ID
WI
SD
MI
NY
CT
WY
RI
NV
PA
IA
NE
IL
UT
CA
MA
NJ
MD
WV
CO
KS
DE
OH
IN
VA
MO
KY
DC
NC
TN
AZ
OK
NM
AR
SC
MS
AK
TX
HI
AL
GA
LA
FL
Equally weighted three factor formula
*Does not address industry-specific or optional formulas
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Double weighted sales factor
Triple or greater weighted or single sales factor
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Advanced Income Tax Track
Apportionment Principles – Apportionment Formulas*– 2017
WA
MT
ME
ND
MN
OR
VT
NH
ID
WI
SD
MI
NY
CT
WY
RI
NV
PA
IA
NE
IL
UT
CA
MA
NJ
MD
WV
CO
KS
DE*
OH
IN
VA
MO
KY
DC
NC
TN
AZ
OK
NM
AR
SC
MS
AK
TX
HI
AL
GA
LA
FL
Equally weighted three factor formula
*Does not address industry-specific or optional formulas
*Reflects changes enacted in 2015 that might take effect later
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Double weighted sales factor
Triple or greater weighted or single sales factor
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Advanced Income Tax Track
Apportionment Principles – Examples of State Apportionment
Examples of States Using Single Sales Factor Today
• CA
• IN
• CO
• ME
• DE (Phased in by 2020)
• MN (Phased in by 2014)
• GA
• NC (Effective in 2018)
• IA
• NE
• IL
• NJ (Phased in by 2014)
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Advanced Income Tax Track
Examples of State Apportionment -- Missouri Apportionment Options
Three general apportionment methods in Missouri (excluding industry specific
and alternative apportionment methods)
• Multistate Allocation and Three Factor Apportionment – Multistate Tax
Compact – RSMo Section 32.200
• Business Transaction Single Factor Apportionment – RSMo Section
143.451.2(2)
• Optional Single Sales Factor Apportionment – RSMo Section 143.451.2(3)
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Advanced Income Tax Track
Examples of State Apportionment – Missouri Enactment
House Bill (“H.B”) 128, enacted, 7/12/13
• Provides alternative single sales factor income tax apportionment formula,
which provides that:
- sales of tangible personal property are included in the numerator if the purchaser’s
destination point is in Missouri (without regard to the FOB point or other condition
of the sale)
- sales of tangible personal property are not included in the numerator if the
destination point is outside Missouri, regardless of the shipping point location
- investment or reinvestment of taxpayer’s own funds, or the sale of any such
investment or reinvestment, is excluded from the sales numerator or denominator.
• The Missouri Department of Revenue adopted a new regulation addressing
the new apportionment election provided under H.B. 128 providing that the
new single sales factor may be elected on an original income tax return filed
on or after August 28, 2013, regardless of the taxable year for which the
original income tax return is being filed.
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Advanced Income Tax Track
Examples of State Apportionment – Missouri Enactment
Senate Bill (“S.B.”) 19, enacted, 5/6/15
• Provides that receipts from sales of services and intangibles are subject to
market-based sourcing under the new single sales factor apportionment.
• Prior to S.B. 19, the Department had interpreted the new election to apply only
to sellers of tangible personal property. S.B. 19 provides that all taxpayers are
eligible for the new single sales factor election.
• Because market based sourcing is applicable only within the new single sales
factor election, sellers of services and intangibles should engage in a
determination of the most beneficial apportionment method annually,
comparing:
- (1) the standard 3 factor method under §32.200 (a cost of performance approach),
- (2) the old single factor sales method under §143.451.2(2) (a partially within or wholly
within/without approach), or
- (3) the new single factor method under 143.451.2(3) (a market based sourcing
approach).
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Advanced Income Tax Track
Apportionment Principles – MTC
MTC Election to Use Evenly Weighted Three Factors
• In certain states that are full members of the Multistate Tax Compact (‘the
Compact’), a taxpayer may be able to elect to use the equally weighted
apportionment formula, as well as other provisions of the Compact, in lieu of
the state's specific apportionment methods set forth in the state's statute.
• At its July 30, 2014 annual meeting, the MTC adopted amendments to Art.
IV.9 to remove the three-factor apportionment formula requirement and
instead provide a suggestion (but not a requirement) that the state use a
double-weighted sales factor formula.
The provision now reads: “All business income shall be apportioned to this
State by multiplying the income by a fraction, [State should define its factor
weighting fraction here. Recommended definition: “the numerator of which is
the property factor plus the payroll factor plus two times the sales factor, and
the denominator of which is four.”]
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Advanced Income Tax Track
Apportionment Principles – MTC
• Possible election in California to use three factor apportionment formula
under the MTC provisions
- Single weighted sales
- §38001 adopts the Multistate Tax Compact into law
- §38006 allows the taxpayer to elect MTC apportionment
- There is nothing in California law that explicitly “decouples” from the
MTC apportionment provisions overall, although as will be discussed on
Day 4 the State is arguing that the term “notwithstanding” contained in
CRTC 25128 effectively does so with respect to the weighting of the sales
factor.
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Advanced Income Tax Track
Multistate Tax Compact Issues
•
Refund Litigation over Article III/IV Elections
-
California - Gillette Co. v. Franchise Tax Bd., 62 Cal. 4th 468 (2015) (holding CA legislature not bound by
compact’s election provision).
-
Michigan – ** All MTC cases denied certiorari by USSC on May 22, 2017
 IBM v. Department of Treasury
 Gillette Commercial Operations N.A. & Subsidiaries v. Dep’t of Treasury
 AK Steel Holding Corporation v. Dep’t of Treasury
•
-
Oregon - Health Net v. Oregon – Oral arguments heard in Oregon Supreme Court in Sept. 2016
-
Texas - Graphic Packaging v. Combs – Texas Supreme Court undecided on review of case as of May 26,
2017
-
Minnesota – Kimberly Clark v. Commissioner of Revenue – Denied cert by USSC on Dec. 12, 2016
Audit Challenges
-
Non-party states
-
Party states sharing taxpayer confidential information
-
Inefficiency of audits when uniformity is severely lacking
*The MTC election and issues will be covered in greater depth on Day 4.
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Advanced Income Tax Track
Apportionment Principles – Fair Apportionment
Internal and External Consistency Tests
• A tax must be fairly apportioned in order to avoid offending the Commerce
Clause of the United States Constitution. See Container Corp. of America v.
Franchise Tax Board, 463 U.S. 159, 103 S. Ct. 2933 (1983). That means the
tax must be both internally and externally consistent.
- Internal Consistency: To be internally consistent, the tax must be
structured so that if, hypothetically, each state imposed an identical tax,
no multiple taxation would result.
- External Consistency: The external consistency test requires that the
state’s apportionment formula reasonably reflects the activities of the
taxpayer that produces income.
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Advanced Income Tax Track
Apportionment Principles – Division of the Tax Base
Methods of Dividing the Tax Base
• State taxation of multistate corporations is restricted by the Commerce and
Due Process Clauses of the United States Constitution. In that context, the
income tax base subject to tax by the state is limited to the portion of the
income attributable to the taxing state. Methods employed by the states for
determining that portion of the tax base attributable to the state are separate
accounting, allocation, and formulary apportionment.
- See business/non-business section.
- See constitutional limitations section.
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Table of Contents
Section
Overview
B. The Property Factor
1. General Rules
2. Special Issues
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Advanced Income Tax Track
Property Factor – General Rules
• Property is included in the property factor when it is used or capable of being
used in the taxpayer's trade or business. See MTC Reg. Sec. IV.10.(b). That
essentially means only property which produces apportionable business
income is includible in the property factor.
• Property is removed from the property factor when “its permanent
withdrawal is established by an identifiable event such as its conversion to
the production of non-business income, its sale, or the lapse of an extended
period of time (normally five years) during which the property is no longer
held for use in the trade or business.” MTC Reg. Sec. IV. 10.(b).
• In order to avoid distortion, many states exclude allocable, nonbusiness
income producing property from the property factor.
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Advanced Income Tax Track
Property Factor – General Rules
Denominator
• The denominator includes the average value of all real and tangible personal
property owned or rented and used during the tax period in the regular
course of the trade or business.
Inclusions in Property Factor:
Exclusions from Property Factor:
• Land
• Cash
• Buildings
• Property or equipment under
construction during the tax period
• Leasehold improvements
• Machinery
• Inventory
• Property used in connection with
the production of nonbusiness
income
• Equipment
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Advanced Income Tax Track
Property Factor – General Rules
Numerator:
• The numerator includes the average value of the real and tangible personal
property owned or rented by the taxpayer that is used in this state during the
tax period.
• Property in transit between locations of the taxpayer to which it belongs shall
be considered to be at the destination for purposes of the property factor.
• Property in transit between a buyer and seller that is included by a taxpayer
in its property factor denominator (in accordance with its regular accounting
practices) must be included in the numerator according to the state of
destination.
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Advanced Income Tax Track
Property Factor – General Rules
Valuation of Owned Property
• Property owned by the taxpayer shall be valued at its original cost--that is
cost before any allowance for depreciation.
• If the original cost of property is unascertainable, it is included in the factor
at its fair market value as of the date of acquisition by the taxpayer.
• May need to average on monthly basis (e.g., acquisition/disposition)
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Advanced Income Tax Track
Property Factor – General Rules
Valuation of Rented Property
• Rental property is valued at eight times its net annual rental rate.
• The net annual rental rate is the annual rental paid less the aggregate annual
subrentals paid by subtenants of the taxpayer.
• Subrents are not deducted when they constitute business income because the
property that produces the subrents is used in the taxpayer’s regular course
of a trade or business.
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Advanced Income Tax Track
Property Factor – General Rules
Averaging Property Values
• As a general rule, the average value of property owned by the taxpayer shall
be determined by averaging the values at the beginning and end of the tax
period.
• However, the tax administrator may require or allow averaging by monthly
values if such method of averaging is required to properly reflect the average
value of the taxpayer’s property for the tax period.
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Advanced Income Tax Track
Property Factor – Special Issues
• Intangible Property
• Property Under Construction
• Property Used But Not Owned or Rented by Taxpayer
• Property in Transit
• Outer Jurisdictional Property
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Advanced Income Tax Track
Property Factor – Special Issues
Intangible Property
Banks & Financial Corporations:
• Cal. Civ. Reg. § 25137-4.2(d)(1):
- “[The property factor] shall include the average value of the taxpayer's loans
and credit card receivables located or used within and without this state during
the income year.”
- See also Crocker Equipment Leasing, Oregon Supreme Court 1992
Software Companies:
Microsoft Corporation v. Franchise Tax Board, Court of Appeal, First Appellate
District, No. A131964, 12/18/12
• While the primary issue before the appellate court was the proper sourcing of
royalties from licensing software to original equipment manufacturers (“OEMs”),
Microsoft had unsuccessfully argued at trial that the value of its intangibles,
including its software should be included in the property factor. This argument
was later dropped and was not before the appellate court.
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Advanced Income Tax Track
Property Factor – Special Issues
Property Under Construction
Commissioner of Revenue v. New England Power Co., 411 Mass. 418, 582
N.E.2d 543 (1991):
• The Massachusetts Supreme Court held that, in contrast to the general rule,
property under construction is includible in the property factor. The
taxpayer, an electric power company, was regularly constructing large
amounts of new property. Although the property under construction did not
directly generate income during the taxable year, the Court found that it
nevertheless contributed to the taxpayer’s overall revenue production,
especially in light of the fact that the costs of the property under construction
were factors in setting the power company's rate base. Thus, the Court found
that the property was “used” by the taxpayer within the meaning of the
statute, and thus includible in the property factor.
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Advanced Income Tax Track
Property Factor – Special Issues
FTB TAM 2011-01:
• A homebuilder/developer’s real property classified as Construction in
Progress (CIP) must be excluded from the property factor because it is not
regarded as property owned or rented and used in California.
• Specified items that have not yet become CIP or may be treated as CIP in the
future, or that have been completed and are held for sale or other
disposition, should be treated as property that is available to be used in the
taxpayer's regular trade or business and not as CIP, and should be included
in the property factor.
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Advanced Income Tax Track
Property Factor – Special Issues
Property Used At Below Market or Zero Rental Rates
• If property is rented for a nominal charge or without charge, following the
usual rules for valuation of rented property may result in property factor
distortion since it will potentially understate the true extent of the taxpayer's
business activities within a state.
• McDonnell Douglas v. Franchise Tax Board, 446 P.2d 313 (Cal. 1968):
- The California Supreme Court held that the FTB’s exclusion of
government owned property produced an unreasonable result and
remanded the case in order to determine a proper remedy.
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Advanced Income Tax Track
Property Factor – Special Issues
• Cal. Reg. 25137(b)(1)(B):
- “If property owned by others is used by the taxpayer at no charge or
rented by the taxpayer for a nominal rate, the net annual rental rate for
such property shall be determined on the basis of a reasonable market
rental rate for such property.”
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Advanced Income Tax Track
Property Factor – Special Issues
• Government Owned Property Used by Taxpayer:
- Appeal of The Proctor & Gamble Manufacturing Company, et al., 89SBE-028 (Cal. St. Bd. of Equal. Sept. 26, 1989):
The issue was whether the taxpayer properly included in the property
factor government-owned property that was used by the taxpayer in its
unitary business and, if so, the amount to be included.
The taxpayer in its combined report included $399 million in the
denominator of the property factor, which purportedly represented the
fair market value of the entire timberland in 1974, the year that the
taxpayer stated the land was placed in productive use. The FTB disallowed
that inclusion.
The SBE concluded that the taxpayer must use the reasonable market
rental value of the property rather than its fair market value.
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Advanced Income Tax Track
Property Factor – Special Issues
• Matter of Weyerhaeuser Co. and Subsidiaries, No. 103555 (Cal. St. Bd. of
Equal. Jan. 26, 2005):
- The SBE concluded that the taxpayer failed to attribute a reasonable value
to land leased from Canadian provincial governments for purposes of
including such land in its property factor denominator. For property
factor purposes, property rented by the taxpayer is valued at eight times
the net annual rental rate, and annual rent includes consideration paid for
the use of the property whether it is a fixed sum or a percentage of sales or
profits. However, annual rent does not include "royalties based on
extraction of natural resources." Under regulation 25137,"[i]f property
owned by others is used by the taxpayer at no charge or rented by the
taxpayer for a nominal rate, the net annual rental rate for such property
shall be determined on the basis of a reasonable market rental rate for
such property."
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Advanced Income Tax Track
Property Factor – Special Issues
Property in Transit
Mercedes Benz of North America Inc. v. Comptroller of Treasury, (Md. Tax Ct.
Oct. 7, 1988):
• The taxpayer had inventory in transit at the time it calculated its property
factor. The taxpayer included the inventory destined for Maryland from
Germany in its Maryland property factor denominator, but excluded it from
the Maryland numerator.
• In rejecting this treatment, the Court stated “[i]f Petitioner wishes to include
in-transit property in the denominator, in order to avoid a skewing of the
factor in favor of tax avoidance, it must likewise include Maryland property
in the numerator. If, as Petitioner suggests, in-transit inventory has no situs
in Maryland and therefore should not be included in the numerator, then we
believe that it has no situs anywhere and should not be included in the
denominator.”
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Advanced Income Tax Track
Property Factor – Special Issues
Property in Transit
Mercedes Benz of North America Inc. v. Comptroller of Treasury, (Md. Tax Ct.
Oct. 7, 1988):
• Maryland has since adopted MD Reg. 03.04.03.08, which provides that
property in transit shall be sourced to the destination state for purposes of
calculating the property factor.
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Advanced Income Tax Track
Property Factor – Special Issues
Loan Inclusion and Sourcing for Financial Instituti0ons
Some states, e.g. CA and Mass., continue to use a property factor for financial
institutions for which loans are included. The proper sourcing for loans can be
unclear.
• California – Cal. Reg. 25137-4.2 provides for sourcing of loans based on
solicitation, investigation, negotiation, approval, and administration
(SINAA)
• How are loans sourced which are acquired from third parties?
• Massachusetts –First Marblehead
Mass. Supreme Court did not attribute third party activity (such as
servicing) to the third party resulting in 100% sourcing of the loan to First
Marblehead in Mass., the state of its commercial domicile.
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Advanced Income Tax Track
Property Factor – Special Issues
Extraterritorial Property
• Communications Satellite Corporation v. Franchise Tax Board, 156
Cal.App.3d 726 (1984):
- The Court held that a satellite and a ground station function only when
used together, and because the ground station is located in California, the
satellite is also “used” in California. Therefore, both the ground station
and the satellite must be placed in the property factor numerator.
• In contrast, the MTC regulations recommend throwout of
extraterritorial/nowhere property.
• See also Twentieth Century Fox Films, Oregon Supreme Court (1985)
wherein the court held that the value of films attributed to Oregon should
include the total value of the films, including the value of film negatives
located in California, and not merely the much lower value of film positives
actually located in Oregon. California’s Motion Picture etc Producer special
apportionment regulation essentially takes the same approach.
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Table of Contents
Section
Overview
B. The Payroll Factor
1. Overview
2. Variations
3. Special Issues
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Advanced Income Tax Track
Payroll Factor – Overview
What is Payroll
General Rules
• Under UDITPA and the Multistate Tax Commission (MTC) Regulations, the
payroll factor includes amounts paid for compensation by the taxpayer in the
regular course of its trade or business.
Compensation
• Compensation is defined as “wages, salaries, commissions and any other
form of remuneration paid to employees for personal services.” UDITPA §
1(c). The states generally interpret compensation as encompassing any item,
whether paid in cash or in kind, that constitutes gross income under the
Internal Revenue Code.
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Advanced Income Tax Track
Payroll Factor – Overview
• Compensation does not include any amounts paid to independent
contractors or any other person not properly classified as an employee.
UDITPA does not define the term “employee,” but it is interpreted using the
common law rules governing the Federal Insurance Contributions Act
(FICA).
• Some states exclude executive compensation from the payroll factor on the
theory that it tends to distort the factor.
Other Rules for Inclusion and Exclusion
• Payroll that is capitalized in the basis of a self-constructed asset is also
included in the payroll factor. See MTC Reg. Sec. IV.13.(a)(2).
• Payroll related to activities generating non-business income should be
excluded from the payroll factor. See MTC Reg. Sec. IV.13.(a)(2).
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Advanced Income Tax Track
Payroll Factor – Variations
Where is the Source
• The numerator of the payroll factor includes compensation paid to
employees for services rendered within the state. See UDITPA Sec. 13.
• If an employee works both within and without the state, then the wages are
sourced in accordance with the rules set forth in the Model Unemployment
Compensation Act, which require application of four successive tests (see
below) for sourcing the wages. This is an “all or nothing” sourcing rule -- the
compensation paid to employees working in multiple states is not divided
among the various states' numerators.
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Advanced Income Tax Track
Payroll Factor – Variations
4 Tests (applied successively)
1. Source to state where majority of services are performed, if only incidental
services are performed outside the state.
2. If employee’s services outside the state are more than incidental, source
wages to the state that is the base of operations for the employee, as long as
some services are performed in that state.
a. “Base of Operations”: Place of more or less permanent nature from which
the employee starts work and to which he/she ordinarily returns to
complete work.
3. If second test does not apply, source wages to the state from which
the employer exercises direction and control, only as long as some
services are performed in that state.
4. If the employee’s wages cannot be sourced under the three preceding tests,
use his/her state of residence.
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Advanced Income Tax Track
Payroll Factor – Variations
Creation of “Nowhere” Income
• To the extent that payroll is assignable to a state where the taxpayer lacks
nexus, the payroll escapes inclusion in any state's numerator, thereby
generating “nowhere” income.
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Advanced Income Tax Track
Payroll Factor – Special Issues
All or Nothing Sourcing
• Cooper Tire & Rubber Co. v. Tax Commissioner, 639 N.E.2d 27 (1994):
- The Supreme Court of Ohio rejected an Ohio-based manufacturer's
argument that compensation paid to its employee operators of mobile
property used inside and outside the state should be sourced to Ohio's
payroll factor in accordance with percentage of use methods.
• Appeal of New York Football Giants, Inc., Cal. St. Bd. of Equal.
(Feb. 3, 1977)
- The Board of Equalization held that compensation should be sourced to
California’s payroll factor on a pro rata basis.
• Section 25137-8.2, Motion Picture and Television Film Producers,
Distributors, and Television Networks
- “Compensation of employees in the production of a film on location shall
be attributed to the state where the services are or were performed.”
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Advanced Income Tax Track
Payroll Factor – Special Issues
Base of Operations
In re Appeal of Photo-Marker Corporation of California, Cal. St. Bd. of Equal.,
Nov. 19, 1986:
• The taxpayer argued that the employees’ executive duties in New York were
more important and permanent than their jobs in California, and that the
base of operations for the employees was New York at the parent’s corporate
headquarters. The California State Board of Equalization disagreed, and
cited Regulation 25133 which provides that if the employee’s services are
performed both within and without California, the compensation will be
attributed to California if the employee’s “base of operations” is in California.
The Board found the evidence demonstrated the base of operations was in
California, based upon the long-term presence of the individuals in
California and their business-related duties in California.
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Advanced Income Tax Track
Payroll Factor – Special Issues
A.W. Chesterton v. Commissioner of Revenue, 37 Mass. App. Ct. 936, 641
N.E.2d 1353 (1994):
• The Appeals Court of Massachusetts upheld the Appellate Tax Board's ruling
that wages were properly sourced to the numerator of the Massachusetts
payroll factor where the corporation had employees working out of their
homes outside of the state, but spending some time in the state. The
corporation failed to meet its burden of proving that its employees had a
base of operations outside of the state, or alternatively, that its employees
were directed and controlled from outside of the state.
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Advanced Income Tax Track
Payroll Factor – Special Issues
Fully Reimbursed
In the matter of Appeal of Hercules, Inc., Kansas Board of Tax Appeals, Docket
No. 1998-1666-DT, 03/15/2000
• The Taxpayer was required to include payroll for munitions factory
employees in the payroll factor, even though the U.S. government
reimbursed the taxpayer for operating the property and payroll expenses.
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Advanced Income Tax Track
Payroll Factor – Special Issues
Loaned Employees
Intercompany Use of Employees
• It is not unusual for affiliated companies to loan employees to one another
under cost reimbursement arrangements, whereby the company
compensating the employee is reimbursed by the company for which the
employee performed the services. In this context, the question arises which
company's payroll factor should include the employee compensation.
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Advanced Income Tax Track
Payroll Factor – Special Issues
C&D Chemical Products Inc. v. State of Alabama Department of Revenue, No.
CORP. 00-258 (Feb. 9, 2001):
The Alabama Department of Revenue, Administrative Law Division, ruled that
in computing the payroll factor, compensation includes amounts paid to
another as reimbursement for services provided by shared employees.
In finding that the taxpayer properly included its distributive share of the
partnership's payroll in its payroll factor, which included the administrative fee
that related to reimbursement for shared employee services, the ALJ noted that
“compensation” includes amounts paid in reparation for services. There was
nothing in the statute which excluded from the payroll factor amounts paid for
services provided by indirect employees. The shared employees contributed to
the production of the partnership's income, and thus the compensation paid
was properly included in the apportionment formula.
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Advanced Income Tax Track
Payroll Factor – Special Issues
Leased Employees
Which company should include the compensation of the leased employee in its
payroll factor - the lessor or the lessee (or both). Most of the states addressing
this issue seem to be moving toward inclusion in the lessee's payroll factor.
• Massachusetts Regulations provide that “[c]ompensation paid for personal
services rendered by leased employees is includible in the payroll factor of
the taxpayer if the taxpayer is the recipient of the services of the leased
employee. Compensation for personal services rendered by leased employees
to client companies is excluded from the payroll factor of employee leasing
companies.” 830 C.M.R. 63.38.1(8)(e)(1).
• Query: If leased property is included in both the lessor and lessee’s property
factor, should leased employees be included in both party’s payroll factor?
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Payroll Factor – Special Issues
Contractors
• Appeal of Lipps, Inc. (87-SBE-017): Only amounts paid directly to
"employees" are included in the payroll factor. Citing Ca. Admin. Code §
25132(a)(3), “Payments made to an independent contractor or-any other
person not properly classifiable as an employee are excluded.”
• Lancaster Colony Corp. et al. v. Limbach, 524 NE2d 1389: The Supreme
Court of Ohio agreed with the Commissioner that contractors are not
employees and may not be used in the calculation of the payroll factor.
However, the court went on to say that the Commissioner may approve an
alternative method of apportionemnt, including one that modifies the payroll
factor to include independent contractors if it more fairly reflects the
taxpayer’s business activity in Ohio.
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Section 3
The Sales Factor
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Table of Contents
Section
Overview
3.
The Sales Factor
A.
Sourcing Sales of Tangible Personal Property
B.
Throwback and Throwout
C.
Variations on Throwback and Throwout
D.
Sourcing Receipts from Services and Intangibles
E.
Gross Receipts
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Sourcing Sales of Tangible Personal Property
UDITPA Definition
• Under UDITPA § 16, sales of tangible personal property are sourced to the
state if:
- the property is delivered or shipped to a purchaser, other than the United
States government, within this state regardless of the f.o.b. point or other
conditions of the sale; or
- the property is shipped from an office, store, warehouse, factory, or other
place of storage in this state and (1) the purchaser is the United States
government or
(2) the taxpayer is not taxable in the state of the purchaser.
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Sourcing Sales of Tangible Personal Property
MTC Regulations
MTC Reg.IV.16.(a):
1. Gross receipts from sales of tangible personal property are in this state:
- if the property is delivered or shipped to a purchaser within this state
regardless of the f.o.b. point or other conditions of sale; or
- if the property is shipped from an office, store, warehouse, factory, or
other place of storage in this state and the taxpayer is not taxable in the
state of the purchaser.
2. Property shall be deemed to be delivered or shipped to a purchaser within
this state if the recipient is located in this state, even though the property is
ordered from outside this state.
3. Property is delivered or shipped to a purchaser within this state if the
shipment terminates in this state, even though the property is subsequently
transferred by the purchaser to another state.
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Sourcing Sales of Tangible Personal Property
4. The term "purchaser within this state" shall include the ultimate recipient of
the property if the taxpayer in this state, at the designation of the purchaser,
delivers to or has the property shipped to the ultimate recipient within this
state.
5. When property being shipped by a seller from the state of origin to a
consignee in another state is diverted while en route to a purchaser in this
state, the sales are in this state.
6. If the taxpayer is not taxable in the state of the purchaser, the sale is
attributed to this state if the property is shipped from an office, store,
warehouse, factory, or other place of storage in this state.
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Sourcing Sales of Tangible Personal Property
7. If a taxpayer whose salesman operates from an office located in this state
makes a sale to a purchaser in another state in which the taxpayer is not
taxable and the property is shipped directly by a third party to the purchaser,
the following rules apply:
a. If the taxpayer is taxable in the state from which the third party ships the
property, then the sale is in that state.
b. If the taxpayer is not taxable in the state from which the property is
shipped, then the sale is in this state.
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Advanced Income Tax Track
Sourcing Sales of Tangible Personal Property
Sales of Tangible Personal Property to U.S. Government
• Gross receipts from sales of tangible personal property to the United States
Government are in this state if the property is shipped from an office, store,
warehouse, factory, or other place of storage in this state. For the purposes of
this regulation, only sales for which the United States Government makes
direct payment to the seller pursuant to the terms of a contract constitute
sales to the United States Government. MTC Reg.IV.16.(b).
• Thus, as a general rule, sales by a subcontractor to the prime contractor, the
party to the contract with the United States Government, do not constitute
sales to the United States Government.
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Advanced Income Tax Track
Sourcing Sales of Tangible Personal Property
Issue of Dock Sales
• Department of Revenue v. Parker-Banana Co., 391 So.2d 762 (Fla. Dist. Ct.
App. 1980): Parker Banana imports bananas and all of Parker’s purchasers
arrange their own pickup and transportation. Parker treated all sales to
purchasers from outside Florida as sales not in this state. Department
contends that those out-of-state purchasers who pick up their bananas other
than by common carrier take delivery as a matter of law at dockside.
Therefore, the Department argues that each such case is a delivery and sale
within this state.
• The Court disagreed and held that a purchaser from outside this state does
not become a “purchaser within this state” merely by sending a
representative to pick up the goods in Florida; if, however, the destination of
the goods is a point within Florida, then the purchaser is within this state.
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Advanced Income Tax Track
Sourcing Sales of Tangible Personal Property
Issue of Dock Sales
• Pennsylvania v. Gilmour Manufacturing Company, No. 66 MAP 2000,
4/28/03: the Pennsylvania Supreme Court ruled that receipts from the sale
of tangible personal property picked up by an out-of-state purchaser at a
seller's place of business in Pennsylvania and ultimately removed from the
state are excluded from the numerator of the sales factor.
• Rival Co. v. Director of Rev., No. 97-001155 RI, (Mo. Adm. Hrg. Comn.,
9/16/95): The Missouri Administrative Hearing Commission ruled that
Missouri dock sales to out-of-state customers should be treated as out-ofstate destination sales for purposes of the Missouri single sales factor. The
commission found that the term “destination” means a “place which is set for
the end of a journey or to which something is sent.” Because the taxpayer
placed all the goods at issue on a shipping dock to be picked up for delivery
to points outside Missouri, the commission found the destination point was
outside the state and therefore the sales should be treated as partially within
and partially without Missouri.
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Advanced Income Tax Track
Sourcing Sales of Tangible Personal Property
Issue of Dock Sales
• Strickland v. Patcraft Mills, Inc., 302 SE2d 544 (Ga. 1983): The Georgia
Supreme Court held that receipts from carpet sales by a Georgia
manufacturer to out-of-state customers, who took possession at the
manufacturer's place of business in Georgia for resale out of state, were not
taxable gross receipts for Georgia purposes. The destination of goods test, as
opposed to the “transfer of physical possession” theory advanced by the
Commissioner of Revenue, was easy to apply and not subject to manipulation
by taxpayers.
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Advanced Income Tax Track
Sourcing Sales of Tangible Personal Property
Issue of Dock Sales
• McDonnell Douglas v. Franchise Tax Board, 26 Cal.App.4th 1789 (1994):
The seller manufactured aircraft in California and transferred physical
possession of the aircraft to its customer's employees in this state. The
customer's employees then flew the aircraft to another state or country for
use in out-of-state operations. After reviewing a number a cases in other
states, the Court of Appeal held that the phrase "within this state" modified
the word "purchaser." Despite the fact that the purchasers' employees or
agents were in the state of California at the time that possession of the
aircraft was transferred to them, the court held that the purchasers were not
"in this state," if the goods were "destined for use" in another state. In so
doing, the court emphasized the drafter's objective of the sales factor: to
reflect contributions of the consumer state in the production of the
taxpayer's income
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Advanced Income Tax Track
Sourcing Sales of Tangible Personal Property
Issue of Dock Sales
• Appeal of Mazda Motors, Inc. , 94-SBE-009 (November 29, 1994):
The taxpayer imported cars into the U.S. through California ports. The
vehicles stayed at the port, while modifications were made to the vehicles.
The Court held that if the purchaser takes possession (or constructive
possession through an agent or bailee) in California for purposes such as
warehousing, repackaging, adding accessories, etc., the property is
"delivered. . . to a purchaser within the state," and the sale is a California
sale.
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Advanced Income Tax Track
Sourcing Sales of Tangible Personal Property
Ultimate Destination
CA Chief Counsel Ruling 2013-03
• Sales ultimately destined for another state but shipped to a third party public
warehouse in California for temporary storage pending shipment in the same
form as received to the ultimate destination state are not considered sales
within California pursuant to Revenue and Taxation Code section 25135.
• Cited Legal Ruling 95-3 which provides that while there is a presumption
that goods taken into possession by the purchaser in California are presumed
to be delivered or shipped to California for purposes of sales factor
assignment, that presumption can be overcome by evidence proving that the
property was not used in the state and was transported to another state.
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Advanced Income Tax Track
Sourcing Sales of Tangible Personal Property
Ultimate Destination
CA Chief Counsel Ruling 2013-03
• The goods were stored in California for a limited period of time and shipped
in the same form received to the ultimate destination known at the time of
shipment. As such, the goods were not used in CA through activities such as
warehousing, repackaging, etc.
• Since the ultimate destination was designated by the taxpayer at the time of
the initial order and was separately billed to the division in the ultimate state
of destination, the temporary storage in CA was merely for purposes of
further shipment elsewhere in the stream of interstate commerce.
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Advanced Income Tax Track
Sourcing Sales of Tangible Personal Property
Mississippi Senate Bill 2933, signed on March 31, 2014
• Provides a new method of apportionment for a major medical or pharmaceutical
supplier of a Mississippi distribution facility whose business activity is taxable both
within and without the state
- The percentage is made up of a payroll factor, a property factor, both counted twice,
and a sales factor, counted once. The sum of the factors is then divided by five.
Ohio CAT Exclusion
•
Current law provides a CAT exclusion for a certain percentage of receipts from the sale
of tangible personal property delivered by suppliers to a qualified Ohio distribution
center (“QDC”).
Proposed Tennessee Revenue Modernization Act
•
Provides that qualifying taxpayers may elect to exclude “certified distribution sales”
from the numerator of the sales factor for apportionment purposes.
-
“Certified distribution sales” are defined to include sales of tangible personal
property made in Tennessee to distributors when such goods are certified as having
been sold for resale and ultimate use outside Tennessee.
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Advanced Income Tax Track
Throwback
UDITPA § 16(b) provides that sales of tangible personal property are thrown
back to the state if “the property is shipped from an office, store, warehouse,
factory, or other place of storage in this state and (1) the purchaser is the United
States government or (2) the taxpayer is not taxable in the state of the
purchaser.”
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Advanced Income Tax Track
Throwback
• The throwback rule is justified on the grounds that if the destination state
lacks the power to tax the seller, either because of limitations imposed by the
United States Constitution or Federal legislation, then sales to purchasers
within the destination state will escape inclusion in any state's numerator,
thereby creating nowhere income.
• In order to curtail the creation of nowhere sales, the throwback rule may be
supplemented by the double throwback rule, which applies to drop
shipments. MTC Reg. Sec. IV.16.(a)(7).
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Advanced Income Tax Track
Throwback
• Throwback – Taxability in Destination State
- Dover Corporation v. Illinois Dept. of Rev., 271 Ill. App. 3d 700, 648
N.E.2d 1089 (Ill. App. Ct. 1995): An Illinois court held that sales made by
a taxpayer to customers located in other states and in various foreign
countries should have been thrown back to Illinois even though the
taxpayer was subject to net income taxes in those other jurisdictions
because the taxpayer did not in fact pay tax to the other jurisdictions.
- California: Technical Advice Memorandum 2012-01 (11/29/12): For tax
years beginning before January 1, 2011, a California taxpayer must
demonstrate physical presence (either directly or through agents or
independent contractors) in the destination state in order to avoid the
application of the throwback rule.
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Advanced Income Tax Track
Throwback
• Throwback – Sales to Foreign Countries
- Some states look to the laws of the foreign country in order to determine
whether the taxpayer is “taxable in the [country] of the purchaser.” See Scott &
Williams Inc. v. Board of Taxation, 117 NH 189, 400 A2d 786 (1977). Not all of
the states that follow this approach take treaty provisions into account.
- Other states, such as California, Oregon, and. Alabama, apply the same
constitutional jurisdictional standards used for determining whether a
taxpayer is taxable in a particular state. In several of the states that employ
that standard, Public Law 86-272 is not taken into account in making the
determination.
- Appeal of Dresser Industries, Inc., (82-SBE-307, June 29, 1982, rehearing 83SBE-118, Oct. 26, 1983): The California State Board of Equalization ruled that
P.L. 86-272 was inapplicable in the determination of whether a corporation
was taxable in a foreign country for purposes of the California throwback rule
to foreign sales. That determination is made based solely upon U.S.
constitutional nexus standards.
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Advanced Income Tax Track
Throwback
Chief Counsel Ruling 2012-03 (8/28/12)
• The Franchise Tax Board found that a taxpayer does not have to throw back tangible
personal property sales where it has more than $500,000 of sales in a foreign
jurisdiction.
• A taxpayer does not have to throw back domestic tangible personal property sales
when a member of its California unitary group has more than $500,000 of sales,
including sales of other than tangible personal property, in the destination state.
Chief Counsel Ruling 2016-03 (7/5/16)
• The Franchise Tax Board found that a taxpayer had to aggregate sales of tangible
personal property (TPP) with royalties received from licensing agreements in the state
and allowed to exclude sales of TPP to other states
• The taxpayer is not required to throw back sales to other states the taxpayer has
tangible personal property (and general gross receipts such as services, interest, and
dividends) because activities exceed protections of Public Law 86-272 and taxpayer
would be subject to income tax in those states
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Advanced Income Tax Track
Throwback
Joyce/Finnigan
• In Appeal of Joyce, Inc., Cal. St. Bd. of Equal, Nov. 23, 1966, the California
SBE held that sales to California customers by an out-of-state seller that was
part of a unitary business could not be included in the California sales factor
of the combined report for members of the unitary business that were subject
to California taxation, because the seller itself was immune from taxation in
California under P.L. 86-272.
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Advanced Income Tax Track
Throwback
• In Appeal of Finnigan Corporation (“Finnigan I”), Cal. St. Bd. of Equal.,
Aug. 25, 1988, the SBE was presented with the issue of whether the FTB, for
purposes of calculating the sales factor of the apportionment formula,
properly applied the “throw-back” rule to the non-California destination
sales made by the taxpayer’s unitary subsidiary. The SBE concluded the sales
should not be thrown back to California even though the subsidiary, as a
separate corporate entity, was not taxable in those states, since another
member of the unitary group, Finnigan Corporation, was taxable in the state
into which the sales were made.
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Advanced Income Tax Track
Throwback
• Airborne Navigation Corporation v. Arizona Department of Revenue, Bd.
Of Tax Appeals, Docket No. 395-85-I (February 5, 1987):
- In terms of its end result, Arizona effectively adopted the Finnigan
approach to determine the numerator of a unitary group's apportionment
formula. The court essentially attributed nexus of in-state members to out
of state members of the combined group by interpreting the term “person”
in PL 86 – 272 to include the entire combined group.
- Therefore, when a group of companies is conducting a unitary business
and a part of that unitary business is conducted within the state, the
activities of all members of the unitary group will be included in both the
numerator and denominator of the sales factor.
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Advanced Income Tax Track
Throwback
Matter of Disney Enterprises, Inc., N.Y. Tax App. Trib., No. 818378, 10/13/05:
Ruling of the Tax Appeals Tribunal, affirmed by the New York Supreme Court,
Appellate Division, on March 1, 2007 (830 N.Y.S.2d 614). The court agreed with
the tribunal's conclusions, finding that by including the nontaxpayer member's
New York sales receipts in the numerator of the business allocation percentage,
the Department of Taxation and Finance "is not imposing a tax" upon the
nontaxpayer member itself, but is rather "attempting to best measure the
combined group's taxable in-state activities by use of a formula." This
apportionment method as applied to the combined group "does not offend the
purpose for which Public Law 86-272 was adopted," the court concluded.
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Advanced Income Tax Track
Throwback
• Effective January 1, 2011, California amended CRTC Section 25135 to adopt
the Finnigan rule in assigning sales from tangible personal property to
California. Under Finnigan, all sales by members of the combined reporting
group properly assigned to the state are included in the numerator of the
California sales factor, regardless of whether the member of the combined
group making the sale is subject to California tax. For throwback purposes,
sales are excluded from the sales factor numerator if a member of the
combined reporting group is taxable in the state of the purchaser.
• This change, coupled with the California 'doing business' rules effective
January 1, 2011, is likely to create litigation over the constitutional validity of
attributing protected P.L. 86-272 sales, under Finnigan, to other members of
the combined report that are 'doing business' in California.
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Advanced Income Tax Track
Throwout
Is Throwout Constitutional?
• Whirlpool Properties, Inc. v. Director, Division of Taxation, 208 N.J. 141
(July 28, 2011):
- The New Jersey Supreme Court held that the throwout rule may operate
constitutionally, under a fair apportionment analysis, when applied to
untaxed receipts from those states that lack jurisdiction to tax the
corporate taxpayer due to insufficient business activity in that state, but
not when applied to receipts that are untaxed due to a state’s
determination not to have an income or similar business activity tax
- Assembly Bill A2722 (Dec. 2008) repealed the throwout rule, effective for
tax years beginning after June 30, 2010
• Paris Manufacturing Co. v. Commissioner, 505 Pa. 15 (1984): The
Pennsylvania Supreme Court held that the throwout rule, although not
unconstitutional, was contrary to the intent of the legislature.
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Advanced Income Tax Track
Variations on Throwback and Throwout
Variations
• No throwback
• Throwout
- Formerly in PA and NJ.
◦ Lorillard Licensing Co., LLC v. Director, N.J. Tax Court
- CA: Appeal of Craiglist, Inc., Cal. St. Bd. of Equal., Jan. 15, 2016
• Throwback to place where sale made
- Massachusetts provides that sales are to be thrown back to Massachusetts if
“the corporation is not taxable in the state of the purchaser and the property
was not sold by an agent or agencies chiefly situated at, connected with or sent
out from premises for the transaction of business owned or rented by the
corporation outside this commonwealth.” M.G.L. c. 63, Sec. 38(f). Regulations
interpret that provision as looking to the state where the sale was “negotiated
and effected.” 830 C.M.R. 63.38.1(9).
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
Sales Other than Sales of Tangible Personal Property
UDITPA
• UDITPA § 17 states that Sales, other than sales of tangible personal property,
are in this state if:
a. The income-producing activity is performed in this state; or
b. The income-producing activity is performed both in and outside this state
and a greater proportion of the income-producing activity is performed in
this state than in any other state, based on costs of performance.
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
AT&T Corp. v. Commissioner of Revenue, Mass. App. Tax Bd., No. C293831,
6/8/2011:
• Sales of telecommunications services to Massachusetts customers should be
sourced using the costs of performance associated with a service provider’s
integrated telecommunications network rather than costs associated with
each individual call.
• Accordingly, because the service provider’s income-producing activity was
the provision of a complex and comprehensive, reliable telecommunications
network and not the connection of individual transmissions over specifically
designated wires, costs of performance were primarily incurred at the
taxpayer’s global operations network and not at the location of a customer.
• On appeal, the Massachusetts Court of Appeal affirmed the ATB’s ruling. See
Mass. Ct. App., No. 11-P-1462 (7/3/12).
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
Different Approaches to Cost of Performance:
• Item-by-item or total:
AT& T Corp. v. Department of Revenue, Oregon Tax Court No. TC 4814,
January 12, 2012:
• The case turned on what activity or object should be the subject of a cost-ofperformance analysis. The taxpayer sought to look to the level of activity
where the costs incurred where not differentiated – the level of the products,
lines or services. However, the Tax Court looked to the individual calls made
and determined that receipts from interstate and international calls that
begin or terminate in Oregon were properly sourced to Oregon based on a
cost-of-performance methodology.
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
Letter of Findings, Indiana Department of Revenue, No. 02-20130359 (11/26/14)
• An Indiana Letter of Findings determined that under the state’s income
producing activity provisions, revenue from Indiana students receiving online
instruction was attributable to Indiana.
• The LOF provided that Indiana has adopted a ‘transaction’ based approach
when applying a cost of performance apportionment methodology.
- Under this approach, only the direct activity for which value is exchanged is
considered. In this instance, it was where the students purchased the
services that controlled.
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
In the Matter of the Petition of Expedia, Inc., et al, DTA Nos. 825025, 825026,
(2/5/15)
• Receipts of an online travel reservation service were receipts from the
performance of services and must, therefore, be sourced to where such
services were performed, a New York administrative law concluded.
• In this instance, these services were performed outside the state.
• The Division of Taxation improperly characterized the receipts as ‘other
business receipts,’ and the ALJ rejected the attempt to impose customer
based sourcing.
• Notably, the ALJ rejected the argument that human involvement at the
moment of the transaction was required for the provision of a service.
• Additionally, the ALJ found that receipts from online advertising revenue
were from ‘services’ rather than from ‘other business receipts.’
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Sourcing Receipts from Services and Intangibles
Dish DBS Corp. f/k/a EchoStar, DBS Corp, and Affiliates v. South Carolina
Department of Revenue, S.C. Admin. Law Court, No. 14-ALJ- 17-0285-cc
(2/10/15)
• A digital television provider asserted that South Carolina law requires
apportioning service revenue based on costs of performance.
• In an order denying motions for summary judgment, the South Carolina
Administrative Law Court disagreed, in part, because ‘costs of performance’
language is absent from South Carolina’s apportionment statute.
• Proceedings before the court continue to determine the taxpayer’s incomeproducing activity and where such activity occurred.
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Sourcing Receipts from Services and Intangibles
Cable One, Inc. v. Idaho State Tax Commission, Idaho Supreme Court No.
41305-2013, October 29, 2014
•
The Idaho Supreme Court upheld a lower court’s decision that a taxpayer’s
greater costs of internet access services were performed in Idaho.
•
The taxpayer asserted that relevant costs for providing internet access
services to Idaho customers should include total costs associated with its
Arizona internet backbone facility.
•
The Idaho Supreme Court disagreed, and identified costs that were allocated
solely to Idaho activity and used those costs to evaluate where the greater
costs of performance occurred.
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
Contractors
• General Motors Corp. v. Commonwealth, 602 S.E.2d 123 (2004):
- The term "costs of performance" includes direct costs incurred by a
taxpayer and indirect costs incurred by third-party contractors, the
Virginia Supreme Court held. Accordingly, a Department of Taxation
regulation that limits "cost of performance" to direct costs is inconsistent
with the plain language of the statute.
UC Davis Summer Tax Institute
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June 14, 2017
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
• CA FTB Legal Ruling 2006-2:
- Under Regulation 25136(b), receipts from services or sales of intangible
personal property are assigned to the state where the “income-producing
activity” was performed, based on where the greater costs of performance
occurred. Income-producing activity generally does not include activities
performed on behalf of a taxpayer, such as those of an independent
contractor.
- When a contractor and subcontractor are members of the same unitary
combined reporting group, the activities of the subcontractor will be
considered income-producing activities directly engaged in by the
contractor for purposes of the “on behalf of” rule.
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
In 2007, the MTC cost-of-performance regulation (Reg. IV.17.(2)) was amended
to state: "Such activity includes transactions and activities performed on behalf
of a taxpayer, such as those conducted on its behalf by an independent
contractor. Accordingly, income producing activity includes but is not limited to
the following:
A. The rendering of personal services by employees or by an agent or
independent contractor acting on behalf of the taxpayer or the utilization of
tangible and intangible property by the taxpayer or by an agent or
independent contractor acting on behalf of the taxpayer in performing a
service.”
California also amended its regulations to mirror the MTC to include
independent contractor costs as an income producing activity. See Cal. Code of
Regs. § 25136(b).
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
MTC Regulations
MTC Article IV.17.(1) provides for the inclusion in the numerator of the sales
factor of gross receipts from transactions other than sales of tangible personal
property (including transactions with the United States Government); under
this section, gross receipts are attributed to this state if the income producing
activity which gave rise to the receipts is performed wholly within this state.
Also, gross receipts are attributed to this state if, with respect to a particular
item of income, the income producing activity is performed within and without
this state but the greater proportion of the income producing activity is
performed in this state, based on costs of performance.
In other words, if the income producing activity takes place in more than one
state, then the receipts are sourced to the state that bears a greater portion of
the cost of performance in relation to the costs of performance incurred in any
other state.
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
Income-Producing Activity:
• As amended by the MTC on August 2, 2007, income producing activity (IPA)
means “the transactions and activity engaged in by the taxpayer in the
regular course of its trade or business for the ultimate purpose of obtaining
gains or profit.” MTC Reg.IV.17.(2).
Costs of Performance
• The MTC Regulations (Reg. IV.17.(3).) define the phrase "costs of
performance" (“COP”), as used for purposes of the income producing activity
test, as "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."
• Interplay between UDITPA Sections 17 and 18 (distortion), especially in the
COP and market-based sourcing context, have hindered the MTC’s efforts to
amend its Section 17 regulations.
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
Income From Intangibles
• There are a variety of approaches toward the inclusion of receipts from
intangibles, which are distinct from UDITPA/MTC Regulations, in that some
states tend to assign such receipts to the state of commercial domicile. Other
examples include:
- Connecticut, which apportions all income, assigns gains from the sale or
other disposition of intangible assets managed or controlled within the
state to that state's sales factor numerator. Cf. Trans-Lux Corp. v.
Meehan, No. 384914, Conn. Super. Ct. (Dec. 3, 1993).
- New Jersey, which likewise apportions all income, generally assigns
receipts from intangibles to the sales factor numerator of the owner's
domicile, unless the intangible has acquired a taxable situs in the state, in
which case they are assigned to the taxable situs. N.J. Admin.
Code § 18:7-8.12(e).
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Advanced Income Tax Track
Sourcing Receipts from Services and Intangibles
• Note that the UDITPA COP "all or nothing approach" for sourcing sales other
than sales of personal property can lead to inequitable results in instances
where substantial costs are incurred in more than one state. Some states will
receive no tax in connection with the receipts, even though a substantial part
of the income producing activity may have been performed within its
borders. On the other hand, the state where the receipts are sourced may
receive a windfall, since much of the income producing activity may have
been performed outside of the state.
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Advanced Income Tax Track
Distinguishing Between Receipts from Tangible Personal
Property, Services and Intangibles
• In Appeal of PacifiCorp, Cal. State Bd. of Equal., No. 2002-SBE-005,
9/12/02, the SBE ruled that the generation and transmission of electricity
sold to California customers is the sale of a service excluded from the
numerator of the apportionment sales factor, where the services were
performed for the most part outside the state.
• Similarly, in EUA Ocean State Corp. v. Commissioner of Revenue, Mass.
App. Tax Bd., Nos. C258405-406, C258424-425, C258882-883, C259158159, C259653, and C262566-568, 4/24/06, the Massachusetts Appellate Tax
Board (“ATB”) ruled that the taxpayers' sales of electricity were properly
attributed to Rhode Island, the state in which the taxpayers incurred the
costs of performing the income-producing activities.
- The ATB concluded that electricity is not considered “tangible personal
property” for corporate excise apportionment purposes.
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Advanced Income Tax Track
Distinguishing Between Receipts from Tangible Personal
Property, Services and Intangibles
• Contrast the two prior rulings with Powerex Corp. v. Dept. of Revenue 357
Or. 40 (Or. 3/26/15).
- The Oregon Supreme Court ruled that sales of natural gas, stipulated by
the parties as tangible personal property, were sourced to their ultimate
destination.
- Conditions of the sales such as title passing in Oregon did not alter the
conclusion that sales of tangible personal property are sourced to their
ultimate destination.
- The court also concluded that electricity is tangible personal property for
income tax sourcing purposes.
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June 14, 2017
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Advanced Income Tax Track
Distinguishing Between Receipts from Tangible Personal
Property, Services and Intangibles
BNP Media II LLC v. Department of Treasury, Mich. App. Ct., No. 314458,
5/20/14
•
The Michigan Court of Appeals ruled that advertising services were
incidental to a taxpayers’ business activity of producing and distributing
trade journals and, therefore, allowed the taxpayer to apportion its revenue
from trade journal sales on a destination basis.
•
Taxpayer‘s advertising sales were inextricably linked to its circulation of the
printed journals because Taxpayer:
1.
did not provide advertising or marketing services,
2.
created and distributed a tangible product, and
3.
did not match advertisers to customers.
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June 14, 2017
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Advanced Income Tax Track
Distinguishing Between Receipts from Tangible Personal
Property, Services and Intangibles
• Royalty v. Sales – Alticor Inc, v. Dep’t of Treasury, Case No. 323350 (2016)
•
The Court of Appeals found that certain payments from subsidiaries under a
license for use of a customer list were royalties rather than sales.
•
The Department asserted that such payment should be ‘sales’ because royalty
payments must be based on a percentage of sales of the licensed product (in
this case, the customer list).
•
The court disagreed with the Department, providing that following such a rule
would lead to a result that would disallow royalties for the use of the customer
list in this case unless the list was later was sold.
•
Accordingly, the court found that payments measured by a percentage of
sales, facilitated by the use of the customer list, constituted ‘royalties’ for SBT
purposes.
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Advanced Income Tax Track
Distinguishing Between Receipts from Tangible Personal
Property, Services and Intangibles
In the Matter of the Petition of Expedia, Inc., et al, DTA Nos. 825025, 825026,
(2/5/15)
• Receipts of an online travel reservation service were receipts from the
performance of services and must, therefore, be sourced to where such
services were performed, a New York administrative law concluded.
• In this instance, these services were performed outside the state.
• The Division of Taxation improperly characterized the receipts as ‘other
business receipts,’ and the ALJ rejected the attempt to impose customer
based sourcing.
• Notably, the ALJ rejected the argument that human involvement at the
moment of the transaction was required for the provision of a service.
• Additionally, the ALJ found that receipts from online advertising revenue
were from ‘services’ rather than from ‘other business receipts.’
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Advanced Income Tax Track
Distinguishing Between Receipts from Tangible Personal
Property, Services and Intangibles
Illinois Private Letter Ruling IT 14-0003 PLR (April 24, 2014 released June
2014)
• The Illinois Department of Revenue ruled that agreements for information
technology hosting and cloud computing are properly characterized as
service contracts for Illinois sales factor apportionment purposes.
• Because Taxpayer is engaged in provision of services, the Department ruled
that receipts from those contracts should be sourced to Illinois if the services
are received in the state.
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Advanced Income Tax Track
Gross Receipts
California Supreme Court: Microsoft & GM
• Microsoft Corp. v. Franchise Tax Bd., 39 Cal. 4th 750 (8/17/06):
- Entire redemption price of marketable securities includable as gross
receipts in the sales factor.
- However, FTB may use an alternative apportionment formula to include
net rather than gross proceeds from the redemption of securities in the
sales factor, where the use of gross proceeds distorts the amount of
income reported to the State.
- The concept of distortion will be discussed further on Day Four.
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Advanced Income Tax Track
Gross Receipts
• General Motors Corp. v. Franchise Tax Bd., 39 Cal. 4th 773 (8/17/06):
- Repurchase agreement (“repo”) transactions are akin to secured loans
rather than sales of commodities -- only the net proceeds (i.e., interest)
generated from a repo may be included in the sales factor.
Microsoft/GM Ramifications
Sales of Securities → Include in Sales Factor
Redemption of Securities → Include in Sales Factor
Repo Agreements → Exclude from Sales Factor
Sales of Commodities → Include in Sales Factor
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Advanced Income Tax Track
Gross Receipts
• General Mills, Inc. v. Franchise Tax Bd., 172 Cal.App.4th 1535 (4/15/09):
- The full sales price of a company's commodity futures sales contracts
should be included as gross receipts in the denominator of the sales factor
for purposes of determining the amount of business income subject to tax
in California.
- Citing Microsoft, the court held that the "gross receipts" from a futures
sales contract are equivalent to the full sales price of the contract. The
court explained that if a futures sales contract results in physical delivery,
General Mills receives the full sales price in cash. When a futures sales
contract results in offset, General Mills receives consideration in the form
of being relieved of the obligation to purchase or sell the commodity. That
consideration equals the full sales price of the contract, the court
concluded.
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Advanced Income Tax Track
Gross Receipts
• General Mills, Inc. v. Franchise Tax Board Cal. Ct. App., No. A131477,
8/29/12
- Although the California Appellate Court held that the proceeds from
hedging transaction activity were properly included as “gross receipts”
under section 25120(e) in sales factor, the Court found that gross receipts
from hedging transaction did not fairly represent a taxpayer's business
activity because: (1) the hedging transactions were qualitatively different
from the taxpayer's business of selling consumer food products and (2)
inclusion of the gross receipts in the sales factor substantially distorted the
percentage of the taxpayer's California apportioned income.
- Accordingly, the FTB was allowed to apply an alternative apportionment
methodology, which required the taxpayer to include only net gains (as
opposed to gross receipts) received from its hedging transactions.
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Advanced Income Tax Track
Gross Receipts
Square D Company v. California Franchise Tax Board, Cal. Super. Ct.,
No. CGC 05-442465, 4/11/07.
• Court ruled that receipts from Eurodollar time deposits held to maturity
were "investments," not loans
- Thus, constituted gross receipts for sales-factor purposes.
• As in Microsoft, the court found that the FTB had proven that the standard
apportionment formula failed to fairly reflect Square D's business activity in
California.
The Limited Stores, Inc. v. Franchise Tax Board, 62 Cal. Rptr. 3d 191 (Cal. Ct.
App. 2007)
• The full redemption price of debt instruments held to maturity was a "gross
receipt.”
• Taxpayer's treasury functions were qualitatively different from its principal
business of selling clothing and bath products, and the quantitative
distortion from inclusion of its investments receipts was substantial.
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Advanced Income Tax Track
Gross Receipts
Duke Energy Corp. v. Department of Revenue, Supreme Court of South Carolina,
2014-002736; SC 27606, February 7, 2016
• The South Carolina Supreme Court affirmed the appellate court’s determination that
receipts from the sale of short-term investments may not be included in the sales
factor.
• The Court reasoned that including the principal recovered from the sale of short-term
investments would lead to absurd results by greatly distorting the calculation and by
defeating the intent and purpose of the applicable statutes.
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Advanced Income Tax Track
Gross Receipts
Sales of Assets
• Receipts from the incidental or occasional sale of a significant/fixed asset,
such as a plant, are excluded from the sales factor under the theory that
inclusion could distort the overall apportionment of income in a given year
by giving undue weight to a particular state. MTC Regs. IV.18.(c)(1). These
receipts are excludible under the regulation, even though the asset was used
in the taxpayer’s regular trade or business.
- In Appeal of Triangle Publications (84-SBE-096): The Board concluded
that respondent was not permitted to rely upon its own regulation under
RTC §25137, but was required to show that the usual statutory formula,
which the foregoing regulation was intended to modify, did not fairly
represent the extent of the taxpayer's business activity in California.
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Advanced Income Tax Track
Gross Receipts
Sales of Assets
-
In Appeal of Fluor Corporation (95-SBE-016): The Board held that any party wishing to deviate
from the apportionment method prescribed by a regulation under RTC §25137 must first establish by
"clear and convincing evidence" that the regulation does not fairly represent the extent of the
taxpayer's activities in California.
-
In Appeal of Emmis Communications Corp., SBE Case No. 547964,
June 11, 2013, the BOE found that gross receipts from a diversified media corporation’s sale of 13 TV
stations located outside of California were not excluded from the sales factor under the occasional
sale rule of California Code of Regulations (CCR) section 25137(c)(1)(A).
-
Chief Counsel Ruling 2014-02: The FTB issued a Chief Counsel Ruling finding that gross receipts
from asset sales while implementing a Plan of Reorganization under Chapter 11 bankruptcy were
within the taxpayer’s normal course of business and occurred frequently. Therefore, those receipts
were not excluded from the sales factor under CCR section 25137(c)(1)(A).
-
Chief Counsel Ruling 2015-01: In CCR 2015-01, the taxpayer operated two lines of unitary
businesses. The taxpayer disposed of one line of its two businesses and shifted its focus entirely to the
remaining line of business. The FTB found that the taxpayer’s disposition of an entire line of business
was a substantial and occasional sale under CCR section 25137(c)(1)(A). Therefore, the receipts from
the sale were excluded from the sales factor.
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Advanced Income Tax Track
Gross Receipts
Gross Receipts Definition
UDITPA Definition
• UDITPA § 1(g) defines “sales” as “all gross receipts of the taxpayer not
allocated under sections 4 through 8 of this Act.”
• MTC proposal to amend Art. IV.1(g) to update the definition to include only
receipts from transactions and activity in the regular course of the taxpayer’s
trade or business.
• On May 8, 2014 the Executive Committee passed motions to release these
changes for a Bylaw 7 Survey. If a majority of Compact member states
respond affirmatively to the Bylaw 7 Survey (which is non-binding), the
matter will be referred to the full MTC for possible adoption as a uniformity
recommendation. The full MTC meets annually with the next meeting is
July 30, 2014.
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Advanced Income Tax Track
Gross Receipts
Gross Receipts Definition
MTC Regulations
• Reg. IV.15.(a)(1): “for the purposes of the sales factor of the apportionment
formula for each trade or business of the taxpayer, the term ‘sales’ means all
gross receipts derived by the taxpayer from transactions and activity in the
regular course of the trade or business.”
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Advanced Income Tax Track
Gross Receipts
MTC Regulations
• In the case of a taxpayer engaged in manufacturing and selling or purchasing
and reselling goods or products, "sales" includes all gross receipts from the
sales of such goods or products (or other property of a kind which would
properly be included in the inventory of the taxpayer if on hand at the close
of the tax period) held by the taxpayer primarily for sale to customers in the
ordinary course of its trade or business. Gross receipts for this purpose
means gross sales less returns and allowances, and includes all interest
income, service charges, carrying charges, or time-price differential charges
incidental to such sales. Federal and state excise taxes (including sales taxes)
shall be included as part of such receipts if the taxes are passed on to the
buyer or included as part of the selling price of the product. MTC
Reg.IV.15.(a)(1)(A).
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Advanced Income Tax Track
Gross Receipts
• In the case of a taxpayer engaged in providing services, such as the operation
of an advertising agency or the performance of equipment service contracts
or research and development contracts, "sales" includes the gross receipts
from the performance of such services, including fees, commissions, and
similar items. MTC Reg.IV.15.(a)(1)(C).
• In the case of a taxpayer engaged in renting real or tangible property, "sales“
includes the gross receipts from the rental, lease, or licensing the use of the
property. MTC Reg.IV.15.(a)(1)(D).
• In the case of a taxpayer engaged in the sale, assignment, or licensing of
intangible personal property such as patents and copyrights, "sales" includes
the gross receipts therefrom. MTC Reg.IV.15.(a)(1)(E).
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Advanced Income Tax Track
Gross Receipts
• In the case of cost plus fixed fee contracts, such as the operation of a
government-owned plant for a fee, "sales" includes the entire reimbursed
cost plus the fee. MTC Reg.IV.15.(a)(1)(B).
- Historically, the FTB has taken the position that contractors should
exclude from the sales factor the value of "client furnished materials" used
under "cost-plus" contracts. However, in Appeals of Bechtel Power
Corporation, Bechtel Corporation, Sequoia Ventures, Inc., Bechtel Group,
Inc., and Fremont Investors, Inc., Cal. St. Bd. of Equal, Mar. 19, 1997 the
SBE decided that the FTB improperly excluded from the taxpayer’s
California sales factor client furnished materials used to fulfill a “costplus” contract.
- All costs associated with the taxpayer’s business should be included in
order to provide a better measure of the taxpayer’s in-state economic
activity.
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Advanced Income Tax Track
Gross Receipts
If a taxpayer derives receipts from the sale of equipment used in its business,
those receipts constitute sales. For example, a truck express company owns a
fleet of trucks and sells its trucks under a regular replacement program. The
gross receipts from the sales of the trucks are included in the sales factor. MTC
Reg.IV.15.(a)(1)(F).
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Advanced Income Tax Track
Gross Receipts
Exclusions From Gross Receipts
In some cases certain gross receipts should be disregarded in determining the
sales factor in order that the apportionment formula will operate fairly to
apportion to this state the income of the taxpayer's trade or business. MTC
Reg.IV.15.(a)(2).
Receipts from Investments
• In some states, receipts from the frequent sale of treasury investments are
either excluded from the sales factor altogether, or included in the factor only
to the extent of net gain.
• Effective tax years beginning on or after January 1, 1995, the Oregon sales
factor excludes gross receipts from the sale of intangible assets, including
securities, unless the receipts are derived from the taxpayer's primary
business.
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Advanced Income Tax Track
Gross Receipts
California Treasury Receipts Regulation Amendments
• On 11/28/07, FTB adopted amendments to Reg §25137(c)(1)(D) dealing with
the treasury receipts issue.
• Regulation, effective for tax years beginning on or after 1/1/07, excludes
interest, dividends, gross receipts and net gains from intangible assets held
in connection with a treasury function from the sales factor.
• A “treasury function” defined as pooling, managing and investing in
intangible assets for the purpose of satisfying the cash flow needs of the
business. Treasury function includes use of futures and options to hedge
foreign currency. Treasury function does not include trading function for the
purpose of hedging price risk of products/commodities consumed, produced
or sold by the taxpayer.
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Advanced Income Tax Track
Gross Receipts
Amendments do not apply to:
a. Taxpayers principally engaged in the business of dealing with intangible
assets, such as registered broker dealers; and
b. Financial institutions.
Chief Counsel Ruling 2012-01
• The California Franchise Tax Board concluded that gross receipts resulting
from a non-financial broker-dealer’s principal trading activity were
includible in the California sales factor.
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Advanced Income Tax Track
Gross Receipts
Cal. Rev. & Tax Code § 25120(f)(2): In 2009, effective for tax year 2011, California
adopted a statutory definition of gross receipts to exclude net gains as well as amounts
received from intangible assets held in connection with a treasury functions, as well as:
• Repayment, maturity, or redemption of
the principal of a loan, bond, or mutual
fund or certificate of deposit.
• The principal amount received under a
repurchase agreement or loan.
• Proceeds from the issuance of the
taxpayer’s own stock or from a sale of
treasury stock.
• Damages and other litigation rewards;
property acquired by an agent on behalf
of another.
UC Davis Summer Tax Institute
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• Tax refunds and recoveries.
• Pension reversions.
• Contributions to capital, except for sales
of securities by a securities dealer.
• Forgiveness of indebtedness income.
• Amounts realized from exchanges of
inventory that are not recognized by the
IRC.
• Amounts received from hedging
transactions.
June 14, 2017
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Section 4
Sales factor – Market sourcing
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Advanced Income Tax Track
Sales Factor – Market Sourcing
In recent years, many states have replaced the method for sourcing of sales
from income producing activity/cost of performance formulas to sourcing based
on where the ultimate recipient of the item or service is located--a marketbased sourcing regime. These states include: California (explained below),
Georgia, Iowa, Illinois, Michigan, Minnesota, Ohio, Utah and Wisconsin.
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Advanced Income Tax Track
Market-Based Sourcing
WA
MT******
ME
ND
MN
OR
VT NH
ID
WI
SD
MI
NY
WY
NV
CA*
PA*
IA
NE
IL
UT
OH
IN
MD
MA
CT***** RI***
NJ
DE
WV
CO
KS
VA
MO****
DC***
KY
NC
TN*****
AZ**
OK
NM
AR
SC
MS
AK
TX
HI
AL
GA
LA*****
FL
* Service Receipts Only (effective in 2014)
** Elective for deemed multistate service providers
*** Effective in 2015
**** Elective optional single sales factor only
***** Starting in 2016
****** Starting in tax year 2018
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Advanced Income Tax Track
Market-Based Sourcing
MTC Update:
• Article IV.17 deals with sales factor sourcing for services and intangibles and
provides for market sourcing to replace the cost-of-performance provisions
of Article IV.
• Services are sourced where service is “delivered,” intangibles are sourced
where they are “use(d),” and certain intangible receipts are thrown out of the
numerator and denominator.
• On May 8, 2014 the Executive Committee passed motions to release these
changes for a Bylaw 7 Survey. If a majority of Compact member states
respond affirmatively to the Bylaw 7 Survey (which is non-binding), the
matter will be referred to the full MTC for possible adoption as a uniformity
recommendation. The full MTC meets annually with the next meeting is
July 30, 2014.
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Advanced Income Tax Track
Market-Based Sourcing
MTC Update (continued):
• On May 12, 2016, the MTC Executive Committee heard recommendations of
the hearing officer as well as public comments on those recommendations.
- In general, groups submitting additional comments urged the Committee
to delay approval of draft amendments related to Sections 1 and 17
(namely, all amendments including those which would implement
market-based sourcing).
• On June 1, 2016, a memorandum providing a briefing on the comments was
released for the Uniformity Committee.
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Advanced Income Tax Track
Market-Based Sourcing
California
• Beginning with the 2013 tax year for all taxpayers, and beginning with the
2011 tax year for taxpayers that elected to use the single-sales
factor apportionment formula, sales of other than tangible personal
property are sourced to California if the taxpayer's market for the sale is in
the state. (Cal. Rev. & Tax Code Section 25136.)
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Market-Based Sourcing
California
CRTC Section 25136 provides:
• (a)(1)Sales from services are in this state to the extent the purchaser of the
service received the benefit of the services in this state.
• (a)(2) Sales from intangible property are in this state to the extent the
property is used in this state. In the case of marketable securities, sales are in
this state if the customer is in this state.
• (a)(3) Sales from the sale, lease, rental, or licensing of real property are in
this state if the real property is located in this state.
• (a)(4) Sales from the rental, lease, or licensing of tangible personal property
are in this state if the property is located in this state.
• (b) The Franchise Tax Board may prescribe regulations as necessary or
appropriate to carry out the purposes of this section.
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Market-Based Sourcing
Regulation §25136-2
•
Implements market sourcing rules for taxpayers that elect single sales factor in 2011
and 2012. Note that beginning in 2013, single sales factor is mandatory for most
taxpayers, while market sourcing is now mandatory for all taxpayers, including those
in industries excluded from the use of single sales factor.
•
The original regulation did not address some items (including government services,
marketable securities, dividends, goodwill, etc.)
•
The regulation was amended effective Jan. 1, 2017 and was to be applied to taxable
years beginning on or after Jan. 1, 2015. The amendments addressed sourcing of
marketable securities, interest, dividends, and goodwill. Taxpayers could elect to
retroactively apply the amendments back to taxable years 2012.
•
FTB will discuss further proposed amendments to this Regulation in an Interested
Parties Meeting on June 16, 2017.
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Regulation §25136-2
• Regulation presumes that the benefit of services rendered to individuals is received at
their billing address, although this presumption can be overcome with evidence to the
contrary.
• Cascading sourcing rules are provided for services rendered to businesses, which begin
with the location indicated in the contract or in the taxpayer’s books and records.
Customer billing address is a last resort for such sourcing after other avenues,
including reasonable approximations are exhausted.
• Regulation also provides a cascading approach to determine where intangibles are
considered used for purposes of sourcing proceeds from the sale of such, as well as
gross receipts from the licensing of such.
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Regulation §25136-2 – 9/5/16 updates applicable for 2015 tax year and onwards:
•
Elective applicability for Reg to apply to taxable years beginning or after 2012 if these yeas
are open to adjustment under applicable statute of limitations
•
Marketable securities defined for 1) securities and commodities dealers; 2) everyone else
•
Assignment rules for marketable securities as location of customer: billing address for
individuals; commercial domicile for corporate/business entities; reasonable approximation
for all else
•
Dividends/ Sale of Stock / Flow Through Entity: 1) If 50% or more of underlying entity’s
assets consist of real or TPP, receipts assigned by averaging payroll and property factors in
CA of entity for most recent 12-month taxable year preceding sale to extend indicated by
taxpayer’s books and records. 2) If 50% or more consist of intangible property, sale of stock
or ownership interest assigned by using sales factor of corporation or p’ship entity in CA
•
Interest: 1) interest from loans assigned to CA if loan is secured by real property located in
CA, or if not secured by real property but borrower is located in CA; 2) interest from
investments assigned to CA if investment managed in CA
•
Other dividends/goodwill/interest: if assignment rules can’t practically be applied, then
location where intangible property is used is reasonably approximated; if can’t be reasonably
approximated, then assigned to purchaser’s billing address
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Sales From Complete Transfer of Rights in
Intangible Property
CCR § 25136-2(d)(1).
Complete transfer of all property rights in
intangible property.
How to determine the location of the use of the
intangible property?
[Specific Rules]
Is the Property the Sale of Stock (or Dividend) or
Some Other Property?
Sale of Stock (or
Dividend)
Is the sale of intangible property: (i) sale of shares of stock in a
corporation; or (ii) sale of an ownership interest in a pass-through
entity (PTE)?
[Other than sales of marketable securities]
Some Other
Property
The rules depends on the predominant nature of the assets of the
corporation or the PTE.
[Presumption]
Does 50% of more of the entity’s assets consist of (i) real and/or
tangible personal property; or (ii) intangible property?
The location of use is presumed to be California if (i) the
contract between the taxpayer and customer; or (ii) the
taxpayer’s books and records indicate that the property is
used in California at the time of sale.
It should be noted that, the books and records showing
taxpayer used the intangible property in the 12 months prior to
sale may be considered.
Overcome
Presumption?
Not Determinable?
Location of use cannot be determined by
contract or books/records.
≥ 50% Real/Tangible
Sale of the stock or interest will be assigned by
averaging the payroll and property factors of the
corporation of PTE in California for the most recent
12 months prior to the time of the sale.
Taxpayer of FTB shows Buyer’s actual location
of use of property at time of purchase was
inconsistent with contracts or books and
records.
> 50% Intangible
Sale of the stock or interest will be assigned by
using the sales factor of the corporation or PTE in
California for the most recent 12 months prior to the
time of sale.
Not Determinable or Presumption Overcome
The Location of use shall be reasonably
approximated.
Not Determinable?
Assign gross receipts to Buyer’s billing address
in California.
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Example
Benefit of the Service - Business Entity, subsection (c)(2)(A). Payroll Services
Corp contracts with Customer Corp to provide all payroll services. Customer
Corp is commercially domiciled in this state and has employees in a number of
other states. The contract between Payroll Services Corp and Customer Corp
does not specify where the service will be used by Customer Corp. Payroll
Services Corp's books and records indicate the number of employees of
Customer Corp in each state where Customer Corp conducts its business.
Payroll Services Corp shall assign its receipts from its contract with Customer
Corp by determining the ratio of employees of Customer Corp in this state
compared to all employees of Customer Corp and assign that percentage of the
receipts from Customer Corp to this state.
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FTB Chief Counsel Ruling 2015-03
•
For purposes of assigning sales of non-marketing services under CRTC Section 25136 and
Reg. 25136-2, the taxpayer shall assign the sales of its services to California to the extent that
the Taxpayer’s direct customer (not it’s customer’s customer) receives the benefit of the
service in California
•
CPU data associated with the customer’s use of the taxpayer’s services collected in the
regular course of business (and is kept in the taxpayer’s books and records) can be used as a
reasonable proxy for financial data in measuring the extent of the benefit received in
California.
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• AL: Market-based sourcing required for sales of services and intangible
property tax years beginning on or after 12/31/10. (Ala. Code Sec.
40-27-1.IV(17)(a)(3)-(4)).
• AZ: Effective from and after 2013, qualified multistate service providers can
elect market-based sourcing. (Ariz. Rev. Stat. Ann. 43-1147(B)).
• CA: Market-based sourcing required for sourcing service receipts and
receipts from intangible/marketable securities in tax years beginning on or
after January 1, 2011, but only if taxpayer elects single factor sourcing.
(Cal. Rev. & Tax Code §25136). Mandatory market sourcing for years
beginning on or after January 1, 2013.
• CO: Market-based sourcing required for intangible property receipts, but not
for service receipts, for tax years beginning on or after 1/1/09. (Colo. Rev.
Stat. §39-22-303.5(4)(c)(V), Colo. Reg. §39-22-303.5.4(c)(V) & (VI)).
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• GA: Market-based sourcing required for tax years beginning on or after
1/1/06, although Georgia historically applied a market-based approach even
before the state issued regulatory guidance requiring it. (Ga. Comp. R &
Regs. §560-7-7-.03(5)(c)1 -6).
• IL: Market-based sourcing required for tax years ending on or after
12/31/08. (35 ILCS 5/304(a)(3)(B-1)-(C-5)(iv)).
• IA: Market-based sourcing required. Income derived from business other
than the manufacture or sale of tangible personal property shall be attributed
to Iowa in the proportion which the Iowa gross receipts bear to the total
gross receipts. (Iowa Code §422.33(2)(b)(3), Iowa Admin.
Code 701-54.6(422)).
• ME: Market-based sourcing required for tax years beginning on or after
6/7/07, except for sales to federal government. (Me. Rev. Stat. Ann. tit. 36,
§5211(16-A)(A)).
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• MD: Market-based sourcing required. (Md. Regs. Code
§§03.04.03.08(C)(3)(c)-03.04.03.08(D)(3)).
• MI: Market-based sourcing applies to Michigan Business Tax (MBT), which
is based in part on income and in part on gross receipts. Market-based
sourcing applies to both services and intangible revenue for both measures of
the tax. (Mich. Comp. Laws Ann. §208.1305). Also, for purposes of the
Michigan Corporate Income Tax, market-based sourcing is required. (Mich.
Cons. Laws Sec. 205.581).
• MN: Market-based sourcing required. (Minn. Stat. §290.191.Subd.5).
• NE: Effective for tax years beginning on or after 1/1/14, market sourcing
rules are adopted. (Neb. Rev. Stat. Sec. 77-2734.14(3)).
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• OH: Market-based sourcing required for Ohio CAT. Generally, the same
broad principles for sourcing services and intangible receipts to the CAT and
franchise tax. (Ohio Rev. Code Ann. §5751.033).
• OK: While the statute is silent on the sourcing rules for sales of other than
TPP, regulatory amendments adopted in May 2010, and “effective” 7/11/10,
require market based sourcing to apportion service receipts. (Oklahoma
Admin. Code 710:50-17-71(A)).
• UT: Market-based sourcing required for tax years beginning on or after
1/1/09. (Utah Code Ann. §§59-7-319(3)-(4)).
• WI: Market-based sourcing required for service receipts for tax years
beginning on or after 1/1/05, and required for intangible receipts for tax
years beginning on or after 1/1/09. (Wis. Admin Code §§2.39(6)).
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Alternative Sourcing
In the Matter of the Petition of The McGraw-Hill Companies., New
York City Tax Appeals Tribunal, TAT (E) 10-19 (GC) et al., October
28, 2015.
• The New York City Tax Appeals Tribunal ruled that a financial information
publisher providing credit ratings to the public could not allocate receipts from its
public credit rating services using an audience-based or circulation-based method
for NYC general corporation tax purposes
• The Tribunal found that the Petitioner failed to prove that it was a First
Amendment speaker similarly situated to advertising, program broadcasting, and
subscriptions and entitled to use an audience-based method for allocating
receipts
• The Tribunal noted the lack of proof by taxpayer that the place-of-performance
method did not fairly represent Petitioner’s activity in New York City and
secondly, that the taxpayer failed to prove that an audience-based allocation
method did fairly represent the its activity in New York City.
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Example 1:
A company performs testing of aerospace equipment for the U.S.
government. The testing is done by a California-based company at a
facility in New Mexico. The aerospace equipment itself is military
equipment used overseas. The government agency is based in DC,
where the contract was signed.
• Where should this be sourced?
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Example 2:
Small Pharma Co. signs a co-development agreement with Big Pharma Co. for a drug that
they are developing. Under this agreement, Big makes payments to Small along the way if
certain clinical trials are successful. If drugs are approved, Small is to produce and sell the
drugs exclusively to Big, and Big will sell to distributors that sell to pharmacies
throughout the U.S. under a brand name company owned by Small and Big. Big and
Small will share profits.
In Year 3, the FDA approves a Phase I clinical trial and under the terms of the agreement,
Big pays Small $300 million. In Year 5, the final trial is passed and the drug is approved.
Big sells the product and ships it to a distributor warehouse in Tennessee. The distributor
sells the drug throughout the U.S. Based on final sales by pharmacies and after all
discountes/rebates/etc., Big makes an additional payment of 50% of the profits from
ultimate sales of the product.
•
How should these be sourced?
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