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Current Corporate Income Tax Developments (Part II)
This
two-part article discusses the most significant recent state tax
developments in the corporate income tax area.
Part II describes some of the more
important developments in apportionment formulas, filing methods/unitary
groups, administration, tax increases and other significant
miscellaneous issues. Karen J. Boucher, CPA
For more information about this article, contact Ms. Boucher at
kboucher@deloitte.com. Executive Summary
During 2003, numerous 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cases were decided; regulations were proposed, issued and modified; and bulletins and rulings were issued, released and withdrawn.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 article, in the March 2004 issue, focused on nexus, tax base, business/nonbusiness income and trademark/tradename issues. Part II, below, covers some of the more important developments in apportionment formulas, unitary groups/filing methods, administration and other significant corporate state tax issues.
Apportionment A multistate corporations business income is apportioned among the states 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 states formula. Each ratio is calculated by comparing the corporations level of a specific activity in the state to the total corporation activity of that type everywhere; the ratios are then summed, weighted (if required) and averaged to determine the corporations apportionment percentage for the state. The apportionment percentage is then multiplied by total corporation business income. While apportionment formulas vary, many states use a three-factor formula that includes sales, payroll and property factors. Because use of a higher-weighted sales factor generally provides tax relief for in-state corporations, most states accord more weight to the sales factor than to the other factors. Changes in the apportionment formula may also be used to provide relief or tax benefits to specific industries or to properly reflect the operations of a particular industry. Recent apportionment developments are summarized below.
Alabama An administrative law judge (ALJ) sustained54 a Department of Revenue (DOR) audit position that, while a miles-traveled ratio may not exactly reflect the time leased railcars were physically present or used in the state, it provided a more reasonable approximation for the lessors sales factor than customers billing addresses.
California The Franchise Tax Board (FTB) ruled55 that dividends received are not included in the sales factor, even though they may be business income, unless the recipient participates in the dividend payers management or operations. Microsofts gross proceeds from a sale of marketable securities should be included in the sales factor of the apportionment formula.56 The court found it irrelevant whether such instruments were sold before, or at, maturity, and that the FTB did not present any significant evidence of distortion. The State Board of Equalization (SBE) held57 that Polaroids patent infringement award had to be included in its sales factor, because the receipts were analogous to unrealized profits from lost sales of cameras and film. The SBE also held that only the net income from short-term financial instruments should be included in the sales factor, because the activity was unrelated to the main line of business and gross proceeds would distort the sales factors purpose. In a Superior Court case,58 including gross proceeds from short-term investments held to maturity in the sales factor did not comport with a practical view of legislative intent. According to the court, the return of the taxpayers capital from such transaction would not reflect the market for goods/services captured by the sales factor. In another case,59 the gross method of reporting sales-factor receipts from treasury department functions was denied; when compared to the companys $26.7 billion of product sales, inclusion of $36.5 billion sourced to its New Jersey treasury department function would grossly distort the sales-factor denominator.
Delaware The State Supreme Court held60 that gain on the sale of real estate located in the state is fully allocable to Delaware, even though, after apportionment by other states, 187% of the gain was subject to tax. The court ruled that the statute was clear; any taxation disparity is diminished, because the state does not tax out-of-state real property sales.
Florida A Circuit Court granted61 the DOR summary judgment, ruling that a Florida financial organizations interest and dividend proceeds generated from securities managed by an investment committee in Alabama are included in the Florida sales-factor numerator, because the underlying assets could not be severed from the financial organization.
Illinois A member of an Illinois combined report cannot claim affiliate nexus to prevent throwback of its separate-company sales; the Appellate Court ruled62 that the word person, in the Illinois throwback provisions, refers only to an individual unitary member.
Indiana The DOR ruled63 that proceeds from insurance information, managed and assembled outside the state, are Indiana sales when the information is provided to in-state customers.
Massachusetts Under cost-of-performance sourcing rules, 100% of the Boston Professional Hockey Associations revenues from licensing broadcasting rights and trademarks and its pro-rata sales of its unitary limited partnership interest, were includible in its Massachusetts sales-factor numerator.64
Minnesota The state Supreme Court affirmed65 that the consumer of management services provided to a mutual fund is the mutual fund, not its ultimate investors. Thus, fees for such services are properly attributed to the state in which the mutual fund is located (Minnesota).
New Mexico The DOR66 ruled that a special allocation/apportionment agreement between the DOR and the Atchison, Topeka and Santa Fe (AT&SF) railway could not be applied once AT&SF ceased to exist after a merger with Burlington Northern. Despite the companies plan of merger, specifying that the survivor would succeed to all rights, privileges, powers and franchises of AT&SF, the allocation/apportionment agreement was personal, not a right that could be sold or assigned.
Ohio HB 95, Laws 2003, adopted the Uniform Division of Income for Tax Purposes Act (UDITPA) definition of business income, essentially eliminated Ohios prior allocation provisions and sourced sales of services based on greater cost of performance. HB 127, Laws 2003, amended the new sales sourcing rules to provide that sales of services are sourced based on where the benefit is received; the physical location where the purchaser ultimately uses or receives the benefit of the original purchase is paramount in determining the benefit. The Board of Tax Appeals held67 that ORIX Credit is a finance company and, thus, all of its gross rents and net business property gain/loss should be considered apportionable interest income for Ohio franchise tax purposes.
Oregon Under HB 3183, Laws 2003, the current 80% sales factor of the apportionment formula will increase to 90% for tax years beginning after June 30, 2006, and to 100% for tax years beginning after June 30, 2008. Cars leased for nonemployee sales consultants as part of Mary Kay Cosmetics Career Car Program were properly included in its property factor, because of the corporations degree of control over lease arrangements.68 The DOR has proposed69 adoption of the Multistate Tax Commissions model regulation defining gross receipts.
Pennsylvania The state Supreme Court held70 that the Philadelphia Eagles receipts from National Football League television broadcasts were subject to Philadelphias business privilege tax as copyright royalties for the licensing of a property right. However, the base was limited to 50% of receipts to reflect away game telecasts. Philadelphias taxation of 100% of the receipts would violate the Commerce Clause. The court also affirmed a Commonwealth Courts decision71 holding that dock sales to out-of-state customers should be excluded from the sales-factor numerator.
Rhode Island An optional double-weighted sales-factor formula will be phased in for manufacturers over a two-year period, beginning in 2004 (40% in 2004, 50% in 2005) under P.L. 03-376 (H-617A, Art. 7, 1).
South Carolina A corporation formed strictly to license Federal Communications Commission licenses, with its principal place of business in South Carolina, was allowed72 to apportion all its income outside that state, because it received royalties solely from licensees in other states.
Texas The Appeals Court held73 that training program production services were sourced to Texas because that was where the services were performed. The taxpayer claimed that its services, delivered to subscribers nationwide via satellite, were performed at the point of satellite broadcast reception and, thus, should be apportioned to the states where subscribers reside. According to a letter ruling,74 Internet advertising revenues should be sourced to the out-of-state location where the advertising services were performed. Revenue earned when a customer clicks-through an advertisement and purchases a product is deemed a commission, and is sourced to where the server is maintained that provides the link to the customer. Subscription revenue for extra mail storage space is also sourced to where the related server is maintained. For broadcasting live and on-demand events, performance occurs where the employees/equipment conduct the broadcasting services. Website development is performed where the employees are creating websites; website hosting is sourced to the servers location.
Virginia Proceeds from sales of manufacturing contracts made in conjunction with the sale of an out-of-state manufacturing division could be excluded from the sales-factor numerator, because a greater portion of the costs associated with the divisions sale occurred outside Virginia.75 In another ruling,76 a corporation did not have to reflect payments to sales personnel in its payroll factor because, under the U.S. Treasury regulations employee/independent contractor tests, a number of factors supported an independent contractor relationship. The original assessment was based on the presumption that such wages represented employee compensation, because the corporation incorrectly reported related wages to the Virginia Employment Commission.
Wisconsin Under 2003 Act 370, a single-sales-factor apportionment formula will be phased in over a three-year period (60% for tax years beginning in 2006, 80% for 2007 and 100% for years beginning after 2007).
Unitary Group/Filing Methods California A Superior Court77 ruled that PacBells current parent corporation (Pacific Telesis) was not entitled to a refund of taxes paid on gain realized by PacBells former sister-subsidiary on equipment sales to PacBell prior to AT&Ts divesture of PacBell in 1984. PacBell and Pacific Telesis continued to pay the tax through reduced depreciation deductions on the equipment, pursuant to an agreement with the IRS, followed by the taxpayers for California purposes. Pacific Telesis argued it was entitled to the refund because the gain should have been reported and taxed entirely to PacBells sister in 1983 (the year immediately preceding the divesture). However, the returns for that year were statutorily closed and the court determined there was no authority or equity that required a refund to Pacific Telesis.
Connecticut P.A. 03-6, Laws 2003, increased the combined corporation business tax return preference tax from $25,000 to $250,000, effective for tax years beginning after 2002.78 If the aggregate of the separate company taxes exceeds the combined tax liability, an additional tax is added, limited to $250,000. P.A. 03-1 (Sec. 91), Laws 2003, imposed an alternate combined tax on related corporations with certain intercompany transactions to determine the groups corporation business tax liability as if the group were one corporation (unitary-type reporting). HB 6806, Section 244, Laws 2003, repealed this provision and replaced it with the intercompany interest expense provision discussed in Part I of this article.
Illinois A Circuit Court concluded79 that two subsidiaries did not qualify for statutory investment company treatment, because most of their income was derived from affiliated entities as interest and dividends, and, thus, had to be included in their parents Illinois combined unitary report. The court noted that the two subsidiaries invested substantially all of their capital in the stocks of, and loans to, the parent and its other affiliated entities. In another case, the court denied80 Armstrongs motion to reconsider its original ruling, under which a subsidiary Vermont captive insurance company was included in the combined unitary report because the company was not recognized as an insurance company for Federal tax purposes. The court also held81 that Dow Chemical and its spun-off pharmaceutical subsidiary were not engaged in a unitary business after the latters first year of formation, because (1) less than 1% of Dows total sales were to the subsidiary, (2) intercompany loans were de minimis and, when made, were under arms-length contractual terms, (3) the subsidiary had autonomous finance, administration, research and development and marketing/sales departments and (4) Dow did not have actual control over the subsidiarys board of directors. In the subsidiarys first year of formation, the companies were unitary, because the spun-off entity relied on Dow personnel to staff its operations. In another case, the court held82 that Consols parent holding company (CEI) had to be included in Consols unitary group, because CEIs oversight was more than passive, despite its lack of employees and day-to-day control over either Consol or its operating subsidiaries. The court noted that: (1) the considerable number of interlocking directors and officers within the group suggested strong central management; (2) CEI guaranteed the subsidiaries outside loans; and (3) dividends paid by Consols operating subsidiaries were returned to the subsidiaries in significant amounts through internal lending. Zebra Technologies had to: (1) include its Bermuda intangibles subsidiaries in its unitary group, because it did not satisfy the 80/20 requirement when including the domestic payroll of related-company personnel that performed the intangibles development, protection and quality control; and (2) include the income of a domestic investment subsidiary to the extent such income was used to fund corporate acquisitions.83
Minnesota A foreign sales corporation (FSC) qualified for exclusion from a waters-edge unitary report, because its zero property and payroll in the U.S met the less than 20% statutory requirement.84 In Amoco Corp.,85 the Minnesota Supreme Court upheld a tax court decision that Amocos refining and marketing operations were not unitary with its exploration and production operations, because of the lack of mutual benefit, dependency or contribution. The court explicitly based its decision on a stricter standard of the unitary concept as set forth in Skelly,86 under notions of mutual benefit, dependency and contribution, as opposed to the broader Federal limits set forth in Containers87 three-unities test.
New York The Tax Appeals Tribunal held88 that Sherwin-Williams and two of its unitary trademark holding companies had to file a combined report to correct distortions of income. It determined that no business purpose or economic benefit would result from the holding companies formation, other than mere tax avoidance.
Virginia A group of affiliated corporations may change from filing a consolidated return to separate returns, or from separate or combined returns to a consolidated return, provided that the affiliated group has filed on the same basis for at least the preceding 20 years. Permission for the change will be granted if: (1) for the tax year immediately preceding the tax year of such change, there would have been no decrease in tax liability computed under the proposed change; and (2) the affiliated group agrees to file returns computing its income tax liability under both the new filing method and the former method and to pay the greater of the two amounts for the tax year in which such change is effective and for the immediately succeeding tax year; VA Tax Code 58.1-442(C), as amended by VA SB 1125, Laws 2003. Using its equitable adjustment authority, the Department of Taxation consolidated89 the income of two subsidiaries with their parent, because an intercompany accounts-receivable factoring arrangement did not resemble a typical transaction, and intercompany loan transactions lacked payment schedules, were not secured by collateral and did not contain failure-to-pay penalties. Also, one subsidiary was deemed to lack economic substance, as its intercompany transactions were merely bookkeeping entries. Similarly, consolidation was required90 when loan transactions between a parent and investment subsidiary primarily reflected paper transactions largely due to an untraditional ownership structure interposing the investment subsidiary between the parent and a subsidiary FSC. Although the FSC received commissions from the parent, the deemed dividends the FSC paid to the investment subsidiary were mere accounting entries; thus, the investment subsidiary lacked the monetary assets to make bona fide loans to the parent. A patent subsidiary was also consolidated with the parent due to a lack of substance.
Administration California SB614/AB1061, Laws 2003, established new state obligations for taxpayers and various professionals associated with tax shelters, and reportable and noneconomic substance transactions. It included new California registration, list maintenance and disclosure obligations, based on IRC Secs. 6111, 6112 and 6011, and incorporated these provisions and related regulations, as modified, into the California Revenue and Tax Code. The legislation also established new enhanced penalties, a voluntary compliance initiative that expires April 15, 2004 and an extended statute of limitations (SOL) for certain assessments. The waters-edge provisions were changed by SB 1061, Laws 2003, to a statutory election instead of a contract. Also, SB 1065, Laws 2003, requires California conformity to Federal elections made prior to an entity becoming subject to California tax. Rev. Proc. 2003-3391 addressed automatic extensions for IRC Sec. 338 elections made after April 2, 2003. The Federal rules will control when the same treatment is elected for California; however, the procedure does not control if a different California election is desired. The separate election must be filed within Californias prescribed time periods.92 The FTB ruled93 that California has not conformed to the Federal profit-split method allowed under IRC Sec. 936, for allocating income and deductions of a possessions corporation. Thus, income and deductions should be allocated according to IRC Sec. 482, without regard to the Federal profit-split election.
Florida CS/SB 1176, Laws 2003, reduced the voluntary disclosure period from five to three years and disallowed a successor rate for employment tax if the change is tax-motivated. Prop. Rul. 12C-1.04494 provided information as to when the DOR may require adjustments to corporate returns to clearly reflect Florida net income. For example, the proposed regulations allow adjustments when the transaction, arrangement or agreement has little or no business purpose other than tax reduction or avoidance.
Illinois The DOR amended Reg. 100.9710, by defining investment company as an entity that comes within the meaning of 15 U.S.C. Section 80a-3, and is predominantly engaged in the business of investing, reinvesting and trading securities. HB 235, Laws 2003, required that most entities receiving development assistance (e.g., tax credits and exemptions) must enter into development assistance agreements with the state that set forth the terms and conditions, such as job-creation targets and level of capital investment, and requires recapture of the funds if the recipient fails to meet them.
Indiana HB 1811, Laws 2003, provided that Indiana taxpayers must file an amended state return within 120 days after a modification to their Federal return that results in changes to their adjusted gross income (AGI).
Louisiana A waiver of the SOL signed by the taxpayers comptroller was invalid when the comptroller, as a nonofficer/nondirector, did not have the express authority to bind the company.95
Massachusetts SB 1949, Laws 2003, added new administrative authority, allowing the DOR to invoke sham-transaction or similar theories and placing the burden on the taxpayer to demonstrate by clear and convincing evidence that the transaction possessed a business purpose other than tax avoidance and had economic substance apart from the tax benefits. The taxpayer must also show that the business purpose asserted is commensurate with the tax benefit claimed.
Texas HB 1, Laws 2003, limited tax refund claims to $250,000 for the 20042005 biennium; claims exceeding the limit will not be paid until the legislature approves a specific appropriation (which, presumably, will not occur until the 2005 legislative session).
Virginia In most situations, HB 2538, Laws 2003, removed the current requirement that a taxpayer must first pay an assessment before taking an appeal to circuit court.
Washington Under HB 2269, Laws 2003, the DOR will impose an automatic 5% penalty on any tax found to be due, effective July 1, 2003. Unregistered taxpayers discovered by the DOR now face an automatic 55% penalty for all open periodsup to seven years, plus the current year.
Other Significant Developments Entity Classification and Flowthrough Entities Arkansas Act 965, Laws 2003, conformed Arkansas law to the Federal check-the-box provisions.
Connecticut Federal income tax principles consistent with Connecticut law allowed corporate partners a passthrough credit for municipal property taxes paid.96 The court noted that Federal rules require business tax credits that provide special economic objective incentives to maintain their own identity, instead of being merged into a lump-sum definition of distributive share.
Indiana The DOR found97 that, if a corporate partner and partnership are not unitary, distributions to the corporate partner should be treated as allocated income (based on the partnerships apportionment) for state AGI tax purposes and not apportioned to the partner based on its ownership percentage.
Maine Effective after 2002, under LD 1319, Laws 2003, flowthrough entities are required to withhold income tax at the highest marginal rate on the quarterly share of Maine source income of nonresident owners.
Massachusetts Chapter 4 of the Acts of 2003 permitted formation of domestic single-member limited liability companies (LLCs) and conversion of business trusts and partnerships to LLC form, by filing certificates of conversion and organization. In a letter ruling,98 a Massachusetts common law trust formed as an investment vehicle for funds (portfolio series) and other persons and entities was classified as a partnership for state purposes.
Michigan Effective Oct. 1, 2003, flowthrough entities must withhold taxes on nonresident owners shares of Michigan income available for distribution under P.A. 51 and P.A. 52 (HB 4558 and HB 4559, Laws 2003).
New York For tax years ending after 2002, flowthrough entities must withhold and pay estimated tax on income derived from New York sources on behalf of nonresident owners, under A 2106, Part L3, 1-6, Laws 2003.
Oklahoma Under HB 1356, Laws 2003, passthrough entities making distributions to nonresident owners must deduct and withhold 5% income tax on Oklahoma source income, effective Aug. 29, 2003.
Wyoming According to SF 74, Laws 2003, a conversion of entities to new forms (e.g., LLCs to corporations and foreign entities to domestic entities) is allowed if the proper form can be accommodated under foreign or domestic rules.
Tax Increases Alabama Voters defeated the governors $1.2 billion tax and accountability referendum.
Connecticut For the 2003 income year, a 20% tax surcharge was imposed under HB 6495, Laws 2003. The surcharge is 25% for income years beginning in 2004; see HB 6802, P.A. 03-1, Laws 2003, June 30th Special Session.
Delaware The maximum annual franchise tax has been increased from $150,000 to $165,000, under HB 267, Laws 2003.
Florida The DOR ruled99 that a Canadian corporation with Florida real estate interests is still subject to state corporate income tax, even if the IRS allows the corporation to treat its rental income as not effectively connected with a U.S. trade or business (but still subject to 30% withholding on gross rental receipts).
Indiana According to the DOR,100 a package-shipping companys insurance arrangements with its affiliated domestic insurer and a Bermuda reinsurer constituted sham transactions, because the risk of catastrophic loss remained with the same shareholders that bore the risk in the first place. Thus, the company had to report all of the excess value premiums as its own income.
Maryland The governor vetoed HB 753, which would have raised an estimated $139 million in new tax revenues by imposing a temporary corporate income tax surcharge and an insurance premium tax and curtailing some corporate tax-avoidance techniques.
Nevada Under SB 8, Laws 2003, new taxes include: (1) effective Oct. 1, 2003, a quarterly payroll tax on gross wages (0.7%, reduced to 0.65% effective July 1, 2004, for employers and 2% for financial institutions), with a dollar-for-dollar reduction for amounts paid by employers for employee health insurance coverage, and (2) effective Jan. 1, 2004, a $1,750 quarterly fee for each Nevada bank branch office in excess of one.
Ohio HB 95, Laws 2003, increased the minimum franchise tax from $50 to $1,000 for corporations with gross receipts in excess of $5 million annually or having more than 300 employees worldwide.
Miscellaneous California In contrast to a decision last year, the SBE held101 for the FTB that inventory sold in 1988 by a foreign parent corporation to its U.S. subsidiary took a carryover basis in a 1989 waters-edge election.
Massachusetts S1943/H 2022, Laws 2003, deleted an exemption from the personal income tax for corporate trusts with Massachusetts apportionment of less than 10%, and precludes security corporations from holding real estate investment trust (REIT) securities if the REIT is related to the security corporation. An appeals court held102 that Tenneco had to include management fees received from its Massachusetts subsidiaries in income, even though they were not reported on its Federal or state separate return and the subsidiaries did not include the related expense on their returns. The court concluded that the fees were not fictional paper transactions, because the subsidiaries were billed for actual services and Tenneco was not obligated to return the money.
Michigan The U.S. Supreme Court denied certiorari to Jefferson Smurfit; the Michigan Court of Appeals decision had held103 that the provisions of the site-specific capital acquisition deduction did not discriminate against interstate commerce.
Montana Effective after 2003, corporations filing a waters-edge return must include the income and apportionment factors for any unitary entity incorporated in a listed tax haven country, and any taxable income shifted to a tax haven is deemed income subject to apportionment. Disclosure of all more-than-50%-owned affiliated corporations, regardless of tax haven incorporation, is required when making the waters-edge election; see Ch. 521 (HB 721, Laws 2003). Taxpayers that currently file under the waters-edge election for tax periods beginning before and after Oct. 1, 2003, are permitted to rescind their election.
New York In Zelinsky,104 the New York Court of Appeals affirmed that the states convenience of the employer test did not violate the U.S. Constitution in allocating all of a Cordozo Law School professors salary to New York.
North Dakota HB 1471, Laws 2003, eliminated the deduction for Federal income taxes and reduced the income tax rate for non-waters-edge filers from 10.5% to 7% (for tax years beginning after 2003).
Oregon HB 2152, Laws 2003, was retroactively repealed in a state-wide referendum held on Feb. 3, 2004.105 As a result, HB 2152 is treated as if it had never been signed into law. As originally enacted, that bill eliminated the Federal extraterritorial income exclusion, reduced most corporate credits by 20% for calendar years 20032005, increased the corporate minimum tax and, as reported in Part I of this article, reduced the dividends-received deduction.
Tennessee The definition of financial institution includes an investment entity more than 50% indirectly owned by a holding company or a regulated financial corporation; see Ch. 355, HB 2073, Laws 2003, effective for tax years ending after June 14, 2003. A court of appeals affirmed106 the denial of a parents worthless stock deduction due to a lack of evidence of the specific state basis in the subsidiary and the event that caused it to become worthless. |
