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Current Corporate Income Tax Developments (Part I)
This two-part article discusses a myriad
of recent state tax activity in the corporate income tax area.
Part I addresses nexus, tax base, business/nonbusiness
income and trademark/tradename cases and determinations.
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cases were decided; regulations were proposed, issued and modified; and bulletins and rulings were issued, released and withdrawn. This two-part article focuses on some of the more interesting items in the following corporate income tax areas: nexus; tax base; business/nonbusiness income; trademark/tradename cases and determinations; apportionment formulas; and filing methods/unitary groups and administration; it also includes several other significant state tax developments. The first four areas are covered in Part I, below; the remaining areas will be covered in Part II of this article, in the April 2004 issue.
Nexus Alabama The chief administrative law judge (ALJ) held1 that Alabama did not have Constitutional jurisdiction over a nonresident limited partner whose only contact with the state was the ownership of a limited interest in an Alabama limited partnership. This holding was based on Alabamas adoption of the entity theory of partnerships, effective Jan. 1, 1997. Under that theory, the presence and activities of a partnership in Alabama cannot be attributed to its nonresident partners for nexus purposes. For years after 2000, Alabama law2 requires nonresident partners to consent to jurisdiction or be taxed through entity withholding.
Massachusetts In Alcoa Building Products, Inc.,3 the Massachusetts Supreme Court affirmed that Alcoas district sales managers exceeded P.L. 86-272 nexus protections for their nonancillary in-state warranty claim activities. The sales managers visited the state an average 1.5 times annually, as part of their perceived job function of initiating and investigating warranty claims to maintain customers and remain competitive in the marketplace. In another case,4 the Appellate Tax Board (ATB) ruled sales should not have been thrown back to Massachusetts, because certain product demonstrations, in service advice and troubleshooting activities in other jurisdictions were not ancillary to solicitation, and exceeded P.L. 86-272s nexus protections.
Michigan In Acco Brands, Inc.,5 the Michigan Court of Appeals held that the tax authoritys delay in changing guiding bulletins did not bar a nexus assessment through the doctrine of laches. The court first noted that Acco clearly had Michigan nexus through the presence of two resident sales personnel that solicited sales from in-state accounts. For laches to apply, Acco had to prove that the Department of Treasury (Department) lacked diligence and that the delay was prejudicial. According to the court, the Departments more-than-three year delay to audit Acco reflected the backlog of cases following the Gillette6 nexus decision, but not a lack of diligence. The delay in issuing a new bulletin was not prejudicial to Acco, as the Gillette decision put Acco on notice that the previous bulletins were not determinative of nexus.
New York The Department of Taxation and Finance ruled7 office space rented for the personal convenience of a president, chief executive officer and chairman of the board, and a listed telephone number for the corporation at that address, qualified as doing business nexus for the state corporate franchise tax.
North Carolina A Superior Court ruled8 that the presence of rented educational videos in the state did not create nexus. The state Attorney Generals office emphatically states that this case does not establish precedent, and has appealed.
Ohio Reversing the Board of Tax Appeals, the Ohio Supreme Court held9 the business activities that occur during the tax (accounting) year, not the business activities that occurred as of January 1 of the report year, are used to determine whether activities are subject to P.L. 86-272.
South Carolina The Department of Revenue (DOR) issued Rev. Rul. 03-4,10 which lists a number of activities and indicates whether they create nexus for corporate income tax purposes.
Tennessee The DOR found11 that a mortgage banker without physical presence in the state does not have nexus, but must still file a franchise and excise tax return and pay the minimum tax, because it is registered to do business. In another ruling,12 the aggregate of the taxpayers employees infrequent presence and the parents activities performed for the taxpayer by its in-state headquarters, created sufficient franchise and excise tax nexus. A regional manager employed by, and based in, the parents Tennessee headquarters offices, performed a majority of his services on the subsidiarys behalf, specifically as direct supervisor for the taxpayers business managers, with responsibility for implementing and maintaining set-standard high-quality performance and profitability. In addition, certain subsidiary officers and directors outlined and implemented strategy while in Tennessee; the subsidiarys business managers attended annual corporate three-day training sessions; and the subsidiarys accounting, tax, business and insurance records, as well as payroll processing, were kept with the parent company in the state.
Texas The mere holding of a lien on real property does not subject a corporation to the franchise tax; however, foreclosure on any loan related to a property lien that results in obtaining title to real property in the state creates franchise tax nexus.13
Virginia Financing subsidiaries having no office, employees or tangible assets in the state, but having their affairs conducted primarily by officers of an affiliated taxpayers in-state headquarters, had commercial domicile in Virginia and could, thus, be included in the taxpayers combined report.14
Trademarks/Tradenames Indiana The DOR again denied15 a corporations royalty expense deductions for payments to a Delaware holding company (DHC). On rehearing, the corporation argued that the previous ruling referred to a two-party transaction, but there really was a three-party arrangement: the intangible was contributed to the DHC; the DHC collected royalties from related subsidiaries and provided arms-length loans to the parent. According to the DOR, this structure still reflects no business or economic justification and, despite the arms-length pricing, it can properly disallow the related deduction as not fairly representing the income derived from sources in the state. The DOR also upheld16 an audit finding requiring a corporate group to file on a unitary basis, because the trademark/royalty relationships among the group were entirely illusory. The DOR found the groups business-purpose and economic-substance arguments unsupported, concluding (1) trademarks have no value once severed from the business, (2) business operations were not affected by the creation of the transactions and (3) the holding companies did not manage or enhance the trademarks value. The DOR also noted that the holding companies simply loaned back the royalty money received or invested the money on the payers behalf.
Maryland In a joint decision,17 the Maryland Court of Appeals reversed the Maryland Tax Court to hold that income from affiliated intellectual property DHCs is subject to tax based on the parents in-state business. The court explained that the subsidiaries did not have real economic substance as separate business entities, only a touch of window dressing designed to create an illusion of substance.
Massachusetts The ATB allowed18 royalty payments made to a trademark/candy formula affiliate to be treated as valid business expenses. The trademarks were never owned by the entity leasing them; instead, they were separately allocated when first acquired by the parent via a business growth strategy of purchasing new brands of candy. There was also was no circular income flow, because the lessee was separate from the entity that paid for the maintenance and administration of those trademarks. This separate maintenance of the intangibles, coupled with the higher profit margin realized by using the trademarks, provided sufficient factual circumstances to justify the deduction.
New Jersey The state Tax Court held19 an affiliated trademark/tradename company must have physical presence in the state to be subject to the corporate income tax. According to the court, physical presence is a necessary element of commerce clause nexus for taxation; any tax avoidance could be addressed by measures other than asserting income tax nexus, including disallowing the affiliate royalty payment deductions, as recently enacted into statute.
North Carolina In A&F Trademark, Inc.,20 a Superior Court affirmed a decision holding that nine wholly owned DHCs of The Limited Stores, Inc., that relicensed to retail affiliates trademark rights obtained from The Limited, were doing business for corporate income/franchise tax purposes. The court found that the value of the trademark subsidiaries rights could not exist apart from the established storefront businesses that paid the licensee fee.
Virginia The lack of economic substance in a trademark subsidiary arrangement was sufficient to authorize the Department of Taxation (DOT) to require consolidated reporting to equitably adjust the tax.21 According to the DOT, the corporate structure lacked a supportable arms-length royalty rate, evident economic and viable substance for the subsidiary and quality-control standards for trademark maintenance.
State Tax Base The majority of states imposing a corporate income-based tax begin the computation of state taxable income with taxable income as reflected on the Federal corporate income tax return (Form 1120, U.S. Corporate Income Tax return). These states use either taxable income before net operating loss (NOL) and special deductions (Line 28) or taxable income (Line 30); certain state-specific addition and subtraction modifications are then applied to arrive at the state tax base. Below is a summary of the recent significant changes to the states tax bases.
Nonconformity to Bonus Depreciation The Jobs and Growth Tax Relief Reconciliation Act of 2003 provided additional 50% bonus first-year depreciation for qualified property acquired after May 5, 2003 and before Jan. 1, 2005, and extended the placed-in-service date to Jan. 1, 2005 for the 30% bonus depreciation enacted as part of the Job Creation and Worker Assistance Act of 2002. Due to the negative revenue effect, the majority of states have decoupled from conformity to the Federal depreciation provisions.
DRD California The Court of Appeal ruled22 the general dividends-received deduction (DRD) (Rev. & Tax Code Section 24402) violates the Constitutions commerce clause, because it limits the DRD to the extent that the payers income was subject to California corporate income tax. The California Supreme Court denied review; the Franchise Tax Board petitioned for certiorari from the U.S. Supreme Court. SB 103, Laws 2003, clarified that dividends received by a California corporate shareholder from a regulated investment company (RIC) are generally not excludible from income.
Massachusetts S 1949/H 2022, Laws 2003, disallowed the DRD for real estate investment trust (REIT) dividends received by corporations and financial institutions. For tax years beginning after 2003, subsequent legislation (S 2149) disallowed the DRD for dividends received directly or indirectly from a RIC and extended the DRD disallowance to dividends received indirectly from a REIT.23
Minnesota In Hutchinson Technology, Inc.,24 the state Tax Court affirmed a plain statutory reading preventing the taxpayer from claiming the states DRD from its wholly owned foreign operating company (FOC). The court noted that the FOCs qualification as a Federal foreign sales corporation fell squarely within the statutes denial of all foreign sales corporation dividends, and found no need for exception, despite (1) the unitary relationship between the companies, (2) the fact that dividends were deemed rather than actually paid or (3) the fact that tax return instructions suggested different treatment.
North Carolina Under SB 236, Laws 2003, deductions are no longer allowed for dividends received from RICs and REITs.
North Dakota In D.D.I., Inc.,25 the state Supreme Court determined that the states DRD scheme is unconstitutional, because it limits the DRD to the extent the payers income was subject to the states corporate income tax. In reaction to this decision, SB 2099, Laws 2003, retroactively repealed the DRD to tax years beginning after 1999.
Oregon H 2152, Laws 2003, reduced the DRD from 70% to 35% for calendar years 20032005. Also, the DOR amended Admin. R. 150-317.267(B) to clarify the states DRD; the DRD is allowed for domestic and foreign dividends, including Subpart F income and Internal Revenue Code (IRC) Sec. 78 gross-up.
NOLs Illinois In ABC Reinsurance Co.,26 an ALJ explained that, although Illinois allows for a life insurance companys income to be developed using, in part, the IRCs special calculations for insurance companies, such adoption does not allow use of the IRCs special life insurance company three-year loss carryover. Instead, IRC Sec. 172 governs and limits the carryback to two years.
New Hampshire For tax periods ending after June 30, 2005, SB 58, Laws 2003, provides that taxpayers will no longer be required to carry back losses before carrying forward any remaining loss as a NOL deduction.
North Dakota For tax years beginning after 2003, HB 1471, Laws 2003, eliminated the states NOL carryback.
Disallowance of Intercompany Expenses Alabama The DOR finalized regulations27 restricting deductibility of certain related-company intangible/interest expenses and requiring specified tax return enclosures to sustain such deductions.
Arkansas For tax years beginning after 2003, interest and intangibles expenses paid to a related party are disallowed,28 unless: (1) the related income is subject to net income tax by a state or foreign treaty country; (2) the income was received pursuant to an arms-length contract or interest rate and the transaction is not intended to avoid Arkansas income tax; (3) the taxpayer and director enter into a written agreement allowing the deduction or providing an alternative apportionment method; or (4) the corresponding income recipient is in a nontax location, but operates an active trade or business with at least 50 full-time equivalent employees, $1 million of real or tangible property and revenues in excess of $1 million.
Connecticut For tax years beginning after 2002, corporate taxpayers are required to add back interest paid to related members.29 For a recipient company taxable in the state and receiving or accruing the interest income required under the new law to be added back by its related member, the company may exclude the amount received or accrued from its gross income and its receipt factor for apportionment purposes. Limited exceptions to the related member addback are provided.
Maryland HB 753, which passed but was vetoed by the governor, would have disallowed deductions for interest and intangible expenses/costs paid to related members, unless certain exceptions were met.
Massachusetts For tax years beginning after 2001, corporations generally must add back interest and intangible expenses/costs directly or indirectly paid to related members.30 However, intangibles expenses are not required to be added back if: (1) the corporation proves by a preponderance of the evidence that, during the same tax year, the related member paid or accrued the expenses to an unrelated member and the transaction giving rise to the expense did not have as a principal purpose the avoidance of Massachusetts tax; (2) the corporation establishes by clear and convincing evidence that the adjustment is unreasonable; or (3) the taxpayer and commissioner agree in writing to the use of an alternative apportionment method. Interest expenses are not required to be added back if: (1) the corporation establishes by clear and convincing evidence that the deduction disallowance is unreasonable; (2) the taxpayer and commissioner agree in writing to the application of an alternative apportionment method; or (3) a principal purpose of the transaction giving rise to the expense was not to avoid Massachusetts taxes, the interest is paid pursuant to an arms-length contract and the related member was subject to state or foreign net income tax on the income at a rate no less than the statutory rate applied to the taxpayer, minus three percentage points. Also, interest deductions related to dividend notes and deductions for third-party debt incurred in certain reorganizations are disallowed. The DORs explanation and guidance for the 2003 law changes (including the related intercompany addback provisions) is included in Technical Information Release 03-19.31 HB 3727, Laws 2003, allowed intercompany deductions when: (1) the related party is resident in a foreign country covered by a U.S. tax treaty; (2) the related party is not a controlled foreign corporation; and (3) the amounts are also deductible for Federal income tax purposes and arranged through arms-length pricing.
Mississippi
SB 2354, Laws 2003, removed the July 1, 2003 expiration date of: (1) the
factors to be considered in determining whether a corporate transaction
is at arms length for income tax purposes under MS Code Section 27-9-9;
and (2) the addback of related-
New York Prior to the enactment of the technical corrections bill (S 5725, Laws 2003), with limited exceptions, taxpayers would have been required to add back interest and royalty expenses paid to related members for tax years after 2002; see AB 2106, Laws 2003. However, S 5725 repealed the interest addback provision, other than for certain debt incurred in connection with intangible assets subject to the royalty addback provision. S 5725 also amends and broadens the exceptions applicable to the royalty addback rule. Interaffiliate royalty expenses do not have to be added back if the transaction was primarily for a valid business purpose other than the avoidance of New York tax, and (1) the related member paid or accrued the amount to an unrelated party, (2) the transaction giving rise to the expense was made pursuant to an arms-length contract or (3) the income receipt is paid to an affiliate organized under the laws of a country that has a comprehensive tax treaty with the U.S., provided the royalty income is taxed by that country at a tax rate at least equal to New Yorks rate.
Oregon Under proposed OAR 150-314.295, intercompany deductions for intangible assets are disallowed if (1) the owner and the user are not included in the same Oregon tax return and (2) the separation of ownership of the intangible asset from the user of the intangible asset results in either tax evasion or a computation of Oregon taxable income not clearly reflective of the business activity conducted in the state in comparison to business activity as a whole.
Other Modifications Indiana The DOR ruled32 that Washington business and occupation (B&O) taxes must be added back for purposes of determining state adjusted gross income, because it is reasonably measured by income produced.
Massachusetts The ATB ruled33 that combined filers must apply the charitable contribution deduction limit on a separate-entity basis.
Michigan For entities other than financial organizations, the single business tax (SBT) base excludes interest income and interest expense; however, the SBT law does not define interest. The Department provided guidance on the definition of that term.34 In addition to a broader, dictionary-style definition, the Department specifically requires a bona fide debtor-creditor relationship, with the charge based on a percentage of an account balance (not a flat fee), fixed by contract or law and reflecting the time value of money.
New York City The Department of Finance35 clarified that employers who have taken the Federal work opportunity credit for New York Liberty Zone employees and have been denied a Federal wage expense deduction under IRC Sec. 280C, are permitted to deduct such expenses for New York City purposes.
South Carolina Rev. Rul. 03-636 provides guidance on state taxes not allowed as a deduction from South Carolina taxable income. The ruling lists as deductible the Indiana gross receipts tax, Kentucky license tax, Michigan SBT, Washington and West Virginia B&O taxes, and other state net worth-based taxes, including the net worth portion of the Texas and Ohio franchise taxes.
Business/Nonbusiness Income Under the Uniform Division of Income for Tax Purposes Act (UDITPA), a multistate corporate taxpayers income is divided into two classesbusiness income and nonbusiness income. Business income is divided among the states in which the corporation has nexus by use of a statutory apportionment formula, while nonbusiness income generally is assigned to the state in which the corporation is domiciled or the property was disposed of is located. The courts are split as to whether the UDITPA business-income definition requires that both: (1) the transaction giving rise to the income is in the regular course of the corporations income (transactional test); and (2) the acquisition, management, use and disposition of the property are integral parts of the corporations regular business operations (functional test). In addition to UDITPAs business/nonbusiness distinction, a state is prohibited, under Allied Signal, Inc.,37 from taxing income not generated in the course of the corporations unitary business. Such income would not be includible in the corporations apportionable income.
Alabama An ALJ ruled that gains from separate sales of a paper mill and a subsidiarys sale of timberland met the definition of business income and, thus, the receipts should be included in the sales factor.38 The ALJ held that the parents gain from the mill sale constituted business income, because of the companys frequent purchases and sales of major businesses and business components under its long-term corporate strategy. The subsidiary received business income because it was created and operated to acquire, manage and sell timberland. The ALJ held that the related receipts should be included in the sales factor to fairly reflect the companies Alabama business activities, explaining that the rule that would have allowed sales-factor exclusion for incidental and occasional sales was voided when the Alabama Supreme Court rejected the functional test (on which the rule was predicated).
California In Appeal of American General Realty Investment Corp., Inc.,39 the State Board of Equalization (SBE) generally upheld a decision that the taxpayer could not deduct interest expenses on its California combined return related to dividend income from its insurance line of business. The SBE held that, regardless of the taxpayers nonbusiness-income treatment of the dividends, both the express language of CA Rev. & Tax Code Section 24425 and precedents mandated the disallowance of expenses allocable to nontaxable dividends before income allocation or apportionment. The SBE also held40 California does not recognize a cessation of business or liquidation exception to the functional-test classification of the gain as business income.
Connecticut The DOR held41 that IRC Sec. 338(h)(10) gain is business income and related deemed gain should be reflected in the target companys receipts factor, consistent with the election. According to the DOR, asset-sale treatment for factor purposes reflects the economic reality of the gain and is consistent with its long-standing position of following the Federal income tax law effects of an IRC Sec. 338(h)(10) election.
Illinois The DOR adopted IL Admin. Code 100.3500, to provide that whether an item of income is business or nonbusiness income is based on the facts and circumstances of the partnership itself; the trade or business activities of a partner or of any related party are irrelevant. In Mead Corp.,42 the trial court held that the gain from the sale of Lexis/Nexis is business income under the functional test. Although the court found no unitary relationship, it did find that the investment in Lexis/Nexis was of an operational nature, rather than an investment nature, and the disposition was part of Meads strategic business plan (to protect itself from takeover by restructuring debt and repurchasing capital with the sale proceeds). An Illinois Circuit Court ruled43 an IRC Sec. 338(h)(10) gain should be considered nonbusiness income, finding that a modified functional test can be applied when, through an IRC Sec. 338(h)(10) election in a consolidated group setting, the disposition of assets is made pursuant to a corporation liquidation in cessation of business, with proceeds distributed to its shareholders.
Indiana The DOR explained44 that distributions to a nonunitary out-of-state corporate partner should be treated as allocated income for state adjusted gross income tax purposes and not apportioned to the partner based on its ownership percentage. The DOR also affirmed45 an audit decision that a liquidating distribution received by a California entity from two nonunitary partnerships owning an Indiana hotel is classified as nonbusiness income sourced to Indiana. Also, due to no unitary ties with the partnerships, the California company could not use an NOL generated by the partnerships against nonpartnership income. In addition, the DOR determined46 IRC Sec. 338(h)(10) deemed-asset-sale gain constitutes business income under the functional test. Royalties received from a manufacturers foreign subsidiaries for use of its paint formulas constituted business income, regardless of any unitary relationship between the companies, because the royalties arose from its regular course of business.47 However, gain from the sale of certain lower-tiered subsidiaries was nonbusiness income, because the subsidiaries were purchased as a nontargeted part of an earlier, larger transaction. Income received from a chemical companys sale of its controlling interest in a pharmaceutical company was business income, whether analyzed from a unitary, functional or transactional approach.48
Massachusetts In W.R. Grace, Inc.,49 the Appeals Court held that W.R. Grace could exclude gains from the sale of its Hermans and El Torito retail and restaurant subsidiaries from apportionable income, due to lack of a unitary business enterprise. The court noted the subsidiaries were run by their own management teams, with W.R. Grace merely applying occasional oversight typical to an investment, and there were no joint or shared purchasing, research, advertising, planning, engineering, marketing, training programs, trademarks or facilities. Cash management and other intercompany services provided at arms length did not constitute a unitary flow of value. In General Mills, Inc.,50 the Supreme Judicial Court affirmed that: (1) gain from the sale of a subsidiary (Eddie Bauer) was nonapportionable, because the corporations were not unitary; (2) an IRC Sec. 338(h)(10) election pertaining to the sale of its Talbots subsidiary should be respected and the deemed gain was properly reflected in Talbots income as part of the combined return; (3) gain realized by a Talbots subsidiary from a sale of intangibles immediately prior to the Talbots sale reverted to Talbots under the step-transaction doctrine, because both the original transfer to the subsidiary and the subsequent sale lacked economic substance beyond the creation of tax benefits; and (4) the gain should be included in Talbots sales-factor numerator, to reflect the efforts of the employees involved in the catalog development process, who contributed most to the intangibles value.
Ohio HB 95, Laws 2003, made significant modifications to Ohios allocation statutes and adopted the business/nonbusiness provisions included in UDITPA.
Oregon In Nabisco Brands, Inc.,51 the state Supreme Court ruled that Nabisco received nonbusiness income from its sale of certain wholly or majority-owned subsidiaries, because Nabisco had acquired the subsidiaries as existing entities, preserved their independent character during ownership and successfully refuted the inferences and conclusions drawn by the DORs reference to annual reports, corporate minutes, various contracts and other written materials. The DOR has proposed amending OAR 150-314.610(1)-(A) to adopt the recently revised Multistate Tax Commissions business/nonbusiness income model regulations.
Pennsylvania In Canteen Corp.,52 a full panel of the Commonwealth Court reversed its Feb. 8, 2002 partial-panel decision, to hold that an IRC Sec. 338(h)(10) liquidation gain qualifies as nonbusiness (allocable) income. The court reached the same conclusion in Osram Sylvania, Inc.53 The commonwealth has appealed these decisions to the Pennsylvania Supreme Court. |
