IPT ANNUAL CONFERENCE
GET A GRIP ON COMBINED
REPORTING: A CASE STUDY
ON MULTISTATE ISSUES
Jordan M. Goodman
Partner
Horwood Marcus & Berk Chartered
Chicago, Illinois
[email protected]
UNITARY BUSINESS PRINCIPLE
■The “Linchpin” of Apportionability
Due Process Clause requires minimum
connection between state and activity that it
seeks to tax; and
A rational relationship between income
attributed to the state and intrastate values
of the enterprise
■Applies to Multiple Divisions
Connection and relationship relate to income
that arises from a unitary business
■Applies to Multiple Entities
IPT 2014 ANNUAL CONFERENCE
WHY COMBINED REPORTING?
■Some reasons given for combined reporting:
Curtailing tax planning;
Better measurement of in-state activity;
Simplification; and
Impact on state economy.
IPT 2014 ANNUAL CONFERENCE
STATE INCOME TAX FILING OPTIONS
 Advantages and disadvantages to each type of filing
 Advantages of Combined Filing may consist of
 Accelerated utilization of net operating losses
 Elimination of intercompany transactions
 Ease of administration
 Dilution of apportionment
 Decreased tax base
 Water’s edge election may limit pool of unitary income to
U.S.
 Disadvantages of Combined Filing can include
 Neutralization of separate state tax planning
 Binding election may make future tax planning difficult
 Increased tax base
 Exclusion of foreign affiliates through water’s edge election
may cause increase in state apportionment factors
IPT 2014 ANNUAL CONFERENCE
WHAT IS IMPACT OF UNITARY REPORTING?
■ Impact of unitary reporting depends on:
▪ Related entities' contacts with the taxing state;
▪ Relative profitability of members (i.e., does loss of
X offset gain of Y?);
▪ Relative apportionment factors of members
(increase denominator, reduce apportionment
ratio); and
▪ Relevant income tax apportionment formulas
(single sales factor) and rates in each state.
■ What is revenue impact to state?
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—COMPOSITION OF THE GROUP
Historic cases:
Adams Express (“unit rule”);
Butler Brothers (separate accounting losses
not dispositive); and
Edison Stores (separate incorporation not
dispositive).
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—COMPOSITION OF THE GROUP
Tests for Determining “Unitary:”
Unities of ownership, operation and use;
Functional integration, economies of scale
and centralization of management; and
Contribution or dependency.
IPT 2014 ANNUAL CONFERENCE
T YPES OF UNITARY STATUTES
Tests for Determining “Unitary”
MTC regulation defines unitary business as
“single economic enterprise” of parts
“sufficiently interdependent, integrated and
interrelated through their activities so as to
provide a synergy and mutual benefit that
produces a sharing or exchange of value…”
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—COMPOSITION OF THE GROUP
Illustrative California Cases:
Tenneco (shipbuilding, farm equipment and
construction, packaging, and automotive
parts not unitary despite assertion of strong
centralized management); and
Dental Insurance (dental insurance consulting
business unitary with farms).
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—COMPOSITION OF THE GROUP
 Illustrative Non-California Cases:
 RR Donnelley (Arizona court finds PIC unitary but not
accounts receivable and factoring companies);
 Miami Corp. (Oregon court finds timberlands in
Florida, oil and gas reserves in Louisiana, securities
portfolio in Illinois, and a tree farm in Oregon unitary
because of the existence of strong centralized
management); and
 Envirodyne (Federal Appellate Court 7th Circuit finds
all entities must be unitary with each other).
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—COMPOSITION OF THE GROUP
 Holding companies as a subset of unitary:
 Are operations necessary to be combined?
 PBS Building Systems determines shared tax
benefits, loan guaranty and covenants not to
compete sufficient for unitary.
 See also FTB Legal Rulings 95-7 and 95-8.
 Matter of American Banknote (NYC Tax Tribunal,
11/08 - held that holding company was unitary
with subsidiary).
 If not combined, consider dividend and interest
issues.
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—COMPOSITION OF THE GROUP
Instant Unity
When do the operations of a newly acquired
business become sufficiently integrated to
become unitary with the existing business?
California generally requires some time to
lapse (i.e., rule should be called “no instant
unity”). How much time varies with facts and
circumstances. Colorado requires two tax
years before unitary.
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—CREDITS
Some states explicitly trap credits:
e.g., Hawaii, Minnesota
Some permit group use:
e.g., Idaho (ID Sec. Code 63-3029B(6))
What is the policy argument for leaving the
credits trapped?
Should the rules be the same for NOLs and
throwbacks?
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—INTRASTATE APPORTIONMENT
HYPO:
Assume ABC manufacturers product in 100%
sales factor state M; sells entire output to
distribution affiliate XYZ; and
Assume ABC generates enterprise zone
credits but has no income pursuant to
intrastate apportionment methodology.
Result: No credit.
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—NONBUSINESS ITEMS
Nonbusiness gains and losses – generally
trapped at the entity generating such losses,
to be added to post-apportioned income.
Nonbusiness interest deduction – Robert Half
suggests debt must contribute materially to
the production of business income.
 Hypo: Assume private equity fund acquisition Sub
acquires Target which then incurs debt to pay
dividend. Is the interest deductible?
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—CAPITAL GAINS AND LOSSES
California has an elaborate regulation calling
for separating and then netting various
preferred items.
What to do in states with no clear rules?
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—JOYCE/FINNIGAN
 Is it the selling taxpayer? Or the group?
 Some Finnigan states include:
 Arizona;
 California for mutual fund companies per RTC reg. 25137-14;
 Kansas;
 Massachusetts;
 New York (Disney Enterprises);
 Texas follows Joyce but requires taxpayers to provide information
on the apportionment percentage that would have resulted under
Finnigan;
 Utah; and
 Wisconsin.
 Should the rule be consistent with the rule for NOLs
and credits?
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—INTERCOMPANY GAINS
 Are intercompany sales eliminated or deferred?
 Does it matter if the state begins with federal
taxable income?
 After an inconsistent history, California now follows
federal “to the extent possible consistent with
combined reporting principles.”
 Vermont provides for similar treatment.
 In either case, transactions between group members
as to the unitary business would apparently no
longer implicate the states’ add back laws
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—INTERCOMPANY GAINS
Assuming elimination, the correct application
per unitary theory may lead to odd results:
Sub manufacturers goods at a cost of $40
in state M and sells to Parent for $75 in
state N; Parent then sells to third party for
$100 in state O.
Where/when is profit recognized?
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—INTERCOMPANY GAINS
 If state adopts federal deferral approach:
 May match federal unless the ownership standard is
less than 80%, or the group includes foreign members
 What apportionment percentage applies, year of
restoration or year of deferral?
 Are intercompany sales eliminated from the
apportionment factors?
 How to treat deferred items before taxpayer entered
the state, i.e., were there preexisting gains?
 Illinois treats members as if they constituted a
federal consolidated group and applies federal
regulations.
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—INTERCOMPANY SALES
Are intercompany sales eliminated from the
sales factor?
In Chase Brass the California court
concluded that intercompany sales should
be eliminated from the sales factor because
no net income is created from the
intercompany sale.
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—STOCK BASIS IN SUBSIDIARY
 Is basis the same as federal?
 California rules make clear the federal investment
account adjustments are not taking place (RapidAmerican Corp and Jim Beam Brands)
 Could result have been changed by dividend
upstream followed by contribution to capital?
 Appeal of Novartis holds "no" based on economic
substance, step transaction and substance over form
(SBE 2009)
 Oregon appears to follow federal adjustments since
it starts with federal taxable income and the list of
modifications does not include an adjustment. (Or.
Reg. OAR 150-317.356)
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—NET OPERATING LOSSES
Lack of uniformity in state rules:
California intrastate apportionment rules
make clear each taxpayer has its own share
of the group’s NOL
Some states treat NOL as that of the group:
e.g., Massachusetts
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—COP RULES
 Cost of performance rules are complicated for
separate taxpayers but some special complications
exist for combined reports:
 Direct costs generally don’t include costs incurred
“on behalf of” the taxpayer: e.g., independent
contractors
 FTB Legal Ruling 2006-02 extended costs to
include members of unitary group (excludes
foreign if water’s-edge election)
 MTC goes farther (Reg. IV.17.(2), (3) and (4))
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAXPAYER—DIVIDENDS
Dividends from unitary subsidiary:
eliminated? Eligible for dividends received
deduction?
Early California case holds dividends not
eliminated (Safeway Stores). Legislature
overrules in RTC Sec. 25106 so long as paid
from unitary earnings.
What of newly formed subsidiary or holding
company as part of reorganization, receiving
dividend from e&p generated prior to its
existence?
IPT 2014 ANNUAL CONFERENCE
WHO IS THE TAX PAYER—STATUTE OF LIMITATIONS, ELECTIO NS ,
METHODS
Does the group have a single, common
statute of limitations?
Assessments
Refunds
For combination itself (Turbodyne Corp;
Panavision)
Does the group have a single, common set of
elections? Must all be on same accounting
methods?
IPT 2014 ANNUAL CONFERENCE
INCREASED NEED FOR SPECIAL FORMULAS
Combining entities not on the same formula
presents unique problems
Determining net income of group “easy”
Financials and non-financials?
IPT 2014 ANNUAL CONFERENCE
TRANSITION ISSUES
What about pre-existing NOLs?
Unrealized appreciation or depreciation?
Hypo: A is operating in separate return state
M; Sub not in state. M adopts combined
reporting and in first year A sells assets of
Sub for substantial gain/loss. Can M tax?
IPT 2014 ANNUAL CONFERENCE
RECENT CASES
Tesaro Corporation – AK Supreme Court
(2/24)
Comcast CableVision – CA Los Angeles
Superior Court (3/14)
Wendy’s International – IL Appellate Court
(10/13)
Combs – TX Appellate Court (12/13)
IPT 2014 ANNUAL CONFERENCE
UNITARY PLANNING OPPORTUNITIES
Evaluate unitary position in each state
Consider open years
Evaluate whether more than one unitary
group is supportable and beneficial
If partnership interests are held, consider
unitary positions in each state
Consider water’s edge elections, where
applicable
For newly acquired businesses, consider
instant unity positions
IPT 2014 ANNUAL CONFERENCE
UNITARY DECISION TREE
 Are activities conducted in a single legal entity?
 Consider whether divisions are unitary (most taxpayers
concede unity)
 MTC: all divisions are unitary (centralized management,
likely integrated)
 Do activities constitute steps in a vertical process?
 MTC reg.: If group explores / develops / extracts / processes
/ sells natural resource, unity exists even if steps are
independently operated
 Exxon: U.S. Supreme Court found unity in such structure
even without centralized management
 Are activities in same general line of business – horizontal
integration?
 How broadly is "line" defined?
IPT 2014 ANNUAL CONFERENCE
CONTACT INFORMATION
Jordan Goodman
Horwood Marcus & Berk Chartered
500 W. Madison Street – Suite 3700
Chicago, IL 60661
(312) 606-3225
[email protected]
IPT 2014 ANNUAL CONFERENCE