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Current Corporate Income Tax Developments (Part II) This two-part article discusses a plethora of recent state developments issued in the corporate income tax area. Part I, in the last issue, addressed nexus and tax base; Part II examines apportionment and administration issues, as well as other income and nonincome tax developments.
Karen
J. Boucher, CPA
For more information about this article, contact Ms. Boucher at karen.j.boucher@us.arthurandersen.com.
Executive Summary
During 2000, an overwhelming number of state statutes were added, deleted or modified; court cases were decided; regulations were proposed, issued and modified; and bulletins and rulings were issued, released and withdrawn. Part I of this two-part article, in the last issue, focused on some of the more interesting items in the corporate income tax areas of nexus and tax base. Part II, below, discusses apportionment, administration and other significant income tax and nonincome tax developments.
Apportionment A multistate corporation's business income is apportioned among the states in which it does business, using an apportionment percentage for each state having jurisdiction to tax the corporation. To determine the apportionment percentage, a ratio is established for each of the factors included in the state's formula; each ratio is calculated by comparing the corporation's level of a specific business activity in the state to the total corporate activity of that type everywhere. The ratios are then summed, weighted (if required) and averaged to determine the corporation's apportionment percentage for the state; the apportionment percentage is then multiplied by total corporate business income to determine the income subject to tax by the state. Although apportionment formulas vary among jurisdictions, most states use a three-factor formula that includes sales, payroll and property factors. However, over the past several years, legislative changes to the apportionment formula have become common; more than half of the states now accord more weight to the sales factor than to the payroll or property factors. Use of a double-weighted sales factor tends to pull a larger percentage of an out-of-state corporation's income into the state's jurisdiction, but generally provides tax relief for in-state corporations. Changes in the apportionment formula may also be used to provide special relief or tax benefits to specific industries or to properly reflect a special industry's operations. Recent apportionment formula developments are summarized below.
Alabama As to the apportionment provisions for financial institutions, for tax years beginning after 1999, the Department of Revenue (DOR) must prescribe regulations substantially similar to the Multistate Tax Commission's (MTC's) financial institution apportionment provisions.54 The DOR has proposed, but not yet adopted, such regulations.
California A court of appeal affirmed55 the trial court's finding that there is nothing arbitrary or unconstitutional about assigning Citibank's (South Dakota) credit card sales and transactions to California based on Finnigan.56 The court also affirmed classifying as business income gain on the sale of four properties.
Connecticut According to Public Act No. 00-170, Laws 2000, single-sales-factor apportionment applies to manufacturers for income years beginning after 2000 and for broadcasters effective for income years beginning after Sept. 30, 2001.
Indiana The state tax court held that the proceeds from two stock sales were not "adjusted gross income from sources within the state of Indiana," and thus were not subject to adjusted gross income (AGI) tax.57 At the time, Indiana imposed a tax on AGI derived from sources within the state, under Ind. Code Ann. 6-3-2-1(b). The court noted that the taxpayer did not engage in the active trading of stocks or bonds as a trade or business; the sales of some of its subsidiary's stock were not transactions or activities conducted in the regular course of the taxpayer's trade or business; all activities and decisions pertaining to and surrounding its sales of Automotive common stock were made by its executive committee (located in Nebraska); no one at the Indiana facility either had the ability to or actually did influence the taxpayer's decisions to sell its shares of Automotive common stock; sale of the common stock did not affect the day-to-day operations of the Indiana facility; and the facility did not directly benefit from the proceeds of the common stock sales. Lacking an Indiana source, the court held that the capital gains in question could not be subjected to the state's AGI tax.
Kentucky The state court of appeals held that sales to overseas military clubs constituted sales to the U.S. government and, thus, were required to be included in the numerator of the sales factor.58
Maine Under Ch. 754, Laws 2000, effective for tax years beginning after 2000, certain mutual fund service providers can elect to apportion income using a single-receipts factor, rather than the three-factor formula. Taxpayers electing single-factor apportionment are not subject to the state's combined reporting requirements.
Massachusetts The DOR amended 830 CMR 63.38.1, Apportionment of Income, to allow all corporations to report their partnership interests on a consolidated basis if they are required to do so under generally accepted accounting principles. The change is retroactive to tax years beginning after Feb. 4, 1999.
Massachusetts The Appellate Tax Board (ATB) held that no portion of the gross proceeds or the gain realized from a deemed asset sale under Internal Revenue Code (IRC) Sec. 338(h)(10) was includible in either the numerator or the denominator of a subsidiary's sales factor.59 For purposes of determining a corporation's sales factor, G.L. c. 63, 38(f) defines "sales" as the "gross receipts of the corporation except...gross receipts from the...disposition of securities." Although the state follows the IRC in determining a taxpayer's starting point, the ATB noted that the apportionment formula contained in the state statute makes no reference to the IRC. Instead, it defines the necessary terms and provides that receipts generated from a stock sale are not "sales" for sales-factor purposes. Accordingly, the ATB ruled that the Federal treatment of the sale did not determine whether the transaction proceeds should be treated as "sales" for apportionment-formula purposes; be-cause the transaction was, in actuality, a stock sale, the proceeds should be excluded from the sales factor.
Michigan The Tax Tribunal ruled that the Department of Treasury (Department) was precluded from throwing back to Michigan the taxpayer's California intercompany sales in calculating the numerator of the apportionment-formula's sales factor.60 Most of Kaiser Optical Systems' (KOS's) accounting and financial functions (with minor exceptions) were performed for the company by personnel of a California affiliate. These personnel were compensated by the affiliated corporation, which, in turn, invoiced KOS on a monthly basis for apportioned compensation and corresponding fringe benefit costs consistent with the various time-spent ratios. In addition, all of KOS's accounting books and records, (including its general ledger and inventory records) were maintained and physically kept at the affiliate's California office. Aggregate amounts invoiced to KOS, for combined compensation and fringe benefits and use and occupancy charges, ranged from $56,400– $63,600 for each year at issue. According to the Tax Tribunal, if the identical functions had been performed by KOS's own full-time employees in California, the Department would not successfully argue a lack of nexus with California. The Tax Tribunal concluded that the result should be no different in the instant case.
New Jersey In August 1999, the state tax court ruled that a New Jersey manufacturer that ships products to out-of-state locations at the request of its wholly owned New Jersey-based sales subsidiary must include these sales in its state apportionment factor.61 The appellate division affirmed the tax court's opinion; the state supreme court has granted a petition for certification.
New York Effective for tax years beginning after 1999, N.Y. Reg. 4-4.2 has been amended to repeal the dock-sale rule; a strict destination rule has been adopted to allocate receipts from the sale of tangible personal property in determining the numerator of a taxpayer's state receipts factor. Under the destination rule, regardless of where possession is transferred, the receipts from a sale of tangible personal property are attributed to the location of the property's ultimate destination.
Oregon The state tax court ruled that the gross receipts from a public utility's invested working capital were correctly included in the denominator of the sales factor to determine state corporate excise (income) tax liability.62 Thus, the holding of Sherwin-Williams Co.63 was allowed for a utility taxable under Ore. Rev. Stat. 314.280.
Pennsylvania The commonwealth court, ruling en banc, reversed a panel of the same court and held that the taxpayer's corporate net income tax sales-factor apportionment numerator should exclude sales to purchasers not located in Pennsylvania who pick up the purchased property at the taxpayer's Pennsylvania loading dock and transport it outside the state (i.e., the sales were sourced based on ultimate destination).64
Texas Texas Tax Code Ann. 171.104 allows a deduction from state receipts for the taxable capital component of the franchise tax for sales of drugs, medicines or other products exempted under Texas Tax Code Ann. 151.313 and 151.314(a), to the extent such sales are shipped from outside the state directly to an ultimate consumer in Texas. The state court of appeals ruled that this deduction is not available in determining the receipts factor for the earned surplus (net income) component of the state franchise tax.65
Administration California A court of appeal ruled that if a taxpayer can deem a claim for a refund denied after a waiting period (e.g., six months), a statute of limitations (SOL) (to file suit) begins to run at the expiration of the waiting period and runs for the general time period under the Cal. Code of Civil Procedure (four years), unless some other specific period applies.66 Although this was a property tax case, the reasoning should apply to all California taxes.
Massachusetts To encourage voluntary compliance, the DOR announced in Technical Information Release (TIR) 00-1367 a reduction from seven to three years in the lookback period for most nonfiling taxpayers that voluntarily disclose their noncompliance. As a general rule, the lookback period for a taxpayer that voluntarily discloses its nonfiling will be the three most recent tax years. However, if the DOR determines (independent of any voluntary disclosure) that a taxpayer with a filing obligation has not filed returns, the seven-year lookback period of TIR 96-268 will generally apply.
Oregon The state tax court held that a taxpayer's extension agreements with the IRS did not extend the time for the DOR to issue deficiency notices.69 (The statute was changed in 1997 to remove the language limiting the DOR to the normal three-year SOL.)
Oregon The state supreme court held that an uncertified deficiency notice was invalid.70 Ore. Rev. Stat. 305.265 requires that deficiency notices (1) state the reason for each adjustment; (2) reference the statute, regulation or DOR ruling on which the adjustment is based; and (3) receive DOR certification that the adjustments are made in good faith and not for the purpose of extending the period of assessment, unless the deficiency is due to the correction of a math or clerical error. In 1992, the IRS notified the DOR that the taxpayers' Federal tax returns for 1977–1979 had been adjusted. The DOR concluded that those adjustments increased the taxpayers' state tax liability; the taxpayers contended that the deficiency notices were uncertified and thus invalid. The court concluded that the statute clearly revealed the legislature's intent to make certification a necessary condition for a valid deficiency notice.
Other Important Developments Tax Rate Changes Alabama In late 1999, Alabama enacted four bills to replace the estimated $120 million in annual franchise tax revenue lost when the U.S. Supreme Court declared Alabama's foreign corporation franchise tax unconstitutional in South Central Bell Telephone Co.71 The bills comprised a "replacement tax," consisting of a short-term "bridge tax" and a proposal for a long-term solution (requiring a constitutional referendum), that would raise the corporate income tax and financial institution excise tax rates. During 2000, Alabama voters approved by a landslide the corporate income tax and financial institution excise tax rate increases. Thus, effective in 2001, the corporate income tax rate increased from 5% to 6.5% and the financial institution excise tax rate increased from 6% to 6.5%; the new corporate shares tax will be entirely repealed after 2001.72
Alabama Act 2000-705, a technical corrections bill, amended the business privilege and corporate shares tax imposed on financial institutions. The amended law sets a new minimum aggregate of such tax to be paid by members of a financial institution group beginning after 1999.
Arizona Effective for tax year 2001, the corporate income tax rate is reduced from 7.968% to 6.968%, by Ch. 48 (HB 2329), Laws 2000.
Colorado For tax years beginning after 1999, the state income tax rate was reduced from 4.75% to 4.63%, by Ch. 296 (HB 1103), Laws 2000.
Pennsylvania Act 23 (SB 2), Laws 2000, included a phaseout of the capital stock and franchise tax by 2009. For tax years beginning after 1999, the rate is reduced by two mills to 8.99 mills (0.00899). In addition, the $200 minimum tax is repealed.
Flowthrough Entities Georgia A state court of appeals held that nonresident passive limited partners in an investment partnership doing business in Georgia are taxable on their share of the partnership's net profits.73 Prior to a 1997 legislative change, Ga. Code Ann. 48-7-24(a) provided that "[w]hen one or more of the individual members of a partnership doing business in this state are nonresidents of this state, the nonresidents shall be taxable on their share of the net profits of the partnership." The court held that this statute applies regardless of whether individual members qualify as doing business in Georgia. The taxpayers also contended that the partnership's investment activities did not constitute doing business in Georgia. However, the court held that, "[i]n the absence of any controlling authority for this position, we must be guided by the general principle of Georgia law that 'the phrase 'doing business' means any activity or transaction for the purpose of financial gain or profit.'"74 Thus, the partnership was doing business in Georgia and the partners were taxable on their share of the net profits. (In 1997, the legislature amended Ga. Code Ann. 48-7-24 to provide that nonresidents are not subject to state tax on income derived from certain investment partnerships.)
Georgia The DOR has proposed amending Reg. 560-7-7-.03 to provide that (1) a corporation will be deemed to own property or do business in the state if it is a general or limited partner in a partnership that owns property or does business there and (2) a corporate limited partner in a business partnership must include its pro-rata share of partnership property, payroll and gross receipts in its own three-factor apportionment formula. The existing rule so provides only for corporate general partners.
Louisiana HB 25 requires an entity treated as a partnership for state income tax purposes to file composite returns and make composite payments of tax on behalf of any or all of its nonresident partners or members who do not agree to file an individual tax return. The nonresident partners or members may agree to file their own returns and make payments based on their own share of the partnership's income. If such an agreement is not made, the partnership is liable for the composite tax due, plus any interest and penalty. The new law is effective for all tax periods beginning after 2000.
New Jersey Proposed legislation would impose tax on limited liability companies (LLCs) and limited partnerships (LPs). SB 1962 would require an LLC or LP classified as a partnership for Federal tax purposes to obtain the consent of each of its owners that are not individuals, trusts or estates that New Jersey has the right and jurisdiction to tax the business's entire net income. A business that does not have the consent for one of its owners would be required to pay corporation business tax on that owner's share of the business's New Jersey income. A business that does not comply with the consent and payment requirements would itself become a corporation business taxpayer.
Other Issues Alabama In 1999, the U.S. Supreme Court declared the Alabama foreign corporation franchise tax unconstitutional in South Central Bell, because it impermissibly discriminates against interstate commerce in violation of the Commerce Clause. In September 2000, Alabama and BellSouth reached a settlement on the $142 million of refunds at issue.75 The net present value of the credits that BellSouth will receive over a 10-year period is less than 19 cents on the dollar.
Alabama Effective Oct. 1, 2000, Act 211 provides that the state will permit cross-business-entity ("junction box") mergers and conversions. The act is intended to provide a convenient and simple way for different types of for-profit business entities to convert or merge and to provide one set of rules for merging or converting any type of for-profit entity.
California The SBE rejected the state's attempt to combine an oil and gas company with the taxpayer's other business segments, including chemical, automotive, aerospace, industry and technology (manufacturing).76 Intercompany product flow was insignificant (representing 1.1% of the parent's sales and 2.7% of the subsidiary's sales); any overlapping officers from the parent were relegated to nonoperational positions in the subsidiary's affairs; and the companies did not purchase inventory for each other, use a common sales force, market any product under a common brand name or engage in common marketing. The SBE concluded that "[T]he fact that one corporation is a cash cow and the other a cash drain is of limited unitary moment."
Connecticut A taxpayer successfully defended against a reallocation of interest expense among related parties.77 Carpenter Technology Corp. (CTC) had created a holding company subsidiary, Carpenter Investment, Inc. (CII), headquartered in Delaware, to which it contributed a large amount of capital. Subsequently, CII loaned the vast majority of the startup capital back to CTC at a commercially acceptable interest rate (prime plus 2%). CTC defended the creation and capitalization of CII as a way to shield CTC's assets from potential risks arising from overseas investments. In determining that the loans had economic substance, the state superior court focused on the facts that CII was formed for a legitimate business purpose, and evidenced its separate existence from CTC through proper creation and organization. CII was organized with employees, officers and a board of directors; it paid salaries to its 12 employees, in addition to taxes, rent and other corporate expenses. The court determined that CII was not a sham, but rather, a viable functioning corporation. The loans from CII to CTC had economic substance and a business purpose.
Kentucky and Wyoming Wyoming became the MTC's second Sovereignty Member State; Kentucky has upgraded its membership to become the third Sovereignty Member State. Wyoming's membership brings to 45 the number of states participating in the MTC. Wyoming also became the fortieth state to join the MTC National Nexus Program.
Massachusetts The ATB issued two opinions involving the use of Delaware holding companies to manage and hold intangibles.78 Both decisions upheld the Audit Division's denial of business expense deductions claimed by the taxpayers for large annual royalty payments made to their wholly owned Delaware subsidiaries. The ATB rejected the business purposes given by the taxpayers and held that the transactions at issue lacked any valid business purpose other than tax avoidance. Both cases are being appealed.
Mississippi The state supreme court ruled that a promissory note issued by a subsidiary to its parent has to be included as capital in computing the corporate franchise tax.79
New York The Tax Appeals Tribunal upheld an administrative law judge's (ALJ's) ruling that a corporation had to file a combined report with its affiliated group.80 The ALJ had concluded that the taxpayer failed to rebut the presumption of income distortion resulting from substantial intercompany transactions between the corporation and its affiliates. This was based on a finding that the test employed by the taxpayer to establish arm's-length transactions was flawed and, thus, insufficient to rebut the distortion presumption. On review, the Tax Tribunal agreed with the ALJ, relying on IRC Sec. 482 and its regulations to determine whether the taxpayer rebutted the distortion presumption.
New York Article 9-A taxpayers are subject to a tax on subsidiary capital allocated to the state. For tax years beginning after 1999, the subsidiary tax paid by such a taxpayer was eliminated for banking and insurance company subsidiaries.
Oregon The state tax court ruled that a taxpayer's Oregon unitary income includes the income of a foreign insurance company included in the taxpayer's Federal consolidated return, even though the foreign insurance company is not subject to Oregon excise tax.81
Pennsylvania The commonwealth court held that a contracting company is not liable for local business privilege tax imposed by the Township of Lower Merion if it does not maintain a base of operations there.82
Tennessee In two franchise tax cases pending in chancery court, taxpayers allege that the state unconstitutionally discriminates against out-of-state businesses in favor of similarly situated in-state businesses, by allowing a deduction for investments in corporations doing business in Tennessee, but disallowing the same deduction for investments in out-of-state corporations.83 Tenn. Code Ann. 67-4-905(b) provides a franchise tax deduction for the value of stock held by a taxpayer in a corporation doing business in the state and subject to the franchise tax. These cases contend the deduction is facially unconstitutional and violates the Commerce Clause. |
