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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, IRC Sec. 338(h)(10) transactions
and allocable/apportionable income.
Karen J. Boucher, CPA
Partner Deloitte & Touche LLP
Milwaukee, WI
Shona Ponda, J.D.
Senior Manager
Deloitte & Touche LLP
Atlanta, GA
For more information about this article,
contact Ms. Boucher at
kboucher@deloitte.com.
Executive Summary
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Two state courts affirmed that
the U.S. Supreme Court’s physical-presence requirement in Quill
applies only to sales and use taxes.
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Kentucky legislation corrected a
prior drafting error, thus disallowing certain related-party
intangible expenses.
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Several cases involved the
effect of DRDs, NOLs and intercompany expenses on the state tax
base.
During
2006, 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and bulletins and rulings were issued, released and withdrawn.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; Internal Revenue
Code (IRC) Sec. 338(h)(10) transactions; tax base;
allocable/apportionable income; 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, in the April 2007 issue.
Nexus
The Department of
Revenue (DOR) amended Rule 810-27-1-4-.19 to delete
classification of deliveries into the state via
taxpayer-owned trucks as an “unprotected” activity for
purposes of P.L. 86-272.
An Alabama circuit
court affirmed that an out-of-state railcar leasing company
was not doing business or deriving income from in-state
sources merely based on lessee use of railcars in the state.
The court agreed that the company generally derived income
from lease transactions in Illinois, noting that that is
where the leases were executed, the fixed lease payments
were made and (with Texas exceptions) the railcars were
retrieved and returned.1
In a situation
involving back-to-back purchases and sales of natural
gas to in-state customers, the DOR ruled2
that nexus is created if the taxpayer has title to the
natural gas for a moment in time (flash title) in
Indiana.
In another
situation, the DOR ruled3
that an out-of-state parent company that used its wholly
owned manufacturing subsidiary to drop-ship sales of
products to third-party purchasers in numerous states
(including Indiana) established substantial nexus for
adjusted-gross-income (AGI) tax purposes. The parent
exercised control over and directed the disposition of
the subsidiary’s in-state inventory, leading to a deemed
substance-over-form “agency relationship” with the
subsidiary.
In another
drop-shipment situation, the DOR similarly held4
that an out-of-state steel components manufacturer had
nexus with the state for AGI tax purposes, because it
was deemed to hold inventory within the state by
controlling products that were drop-shipped to its
Indiana customers through an in-state manufacturing
affiliate. Despite the fact that the affiliate retained
title to the goods for nearly the entire time between
their manufacture and ultimate delivery (save for the
out-of-state manufacturer’s “instantaneous title” on
customer acceptance), the out-of-state manufacturer
controlled the physical goods while they were located in
Indiana.
In a different
finding, the DOR ruled5
that a national retailer’s subsidiary that functioned as
a Federally chartered private-label credit card bank for
the retailer had nexus for the financial institutions
tax, even though it lacked an in-state physical
presence, as the underlying facts showed that it had
economic nexus with the state. Under the facts, the bank
solicited business in Indiana either through its parent,
its own advertising or a combination of the two.
A DOR
Policy Letter6
addressed whether corporation income tax nexus would
exist under various scenarios involving software and
application service providers. The mere grant of a
right to use the developer’s software does not, by
itself, create Iowa corporation income tax nexus;
however, sending an employee into the state to
install and/or train the user (or any physical
presence in the state by an employee of the software
developer) does create nexus.
The
Board of Tax Appeals held7
that, for the years at issue, a nonresident
corporation will not have nexus solely due to
its investment in a passthrough entity doing
business in the state.
HB 557,
Laws 2006, expanded the definition of “doing
business” in the state to include deriving
income (directly or indirectly) from a
single-member limited liability company that is
doing business in the state and is disregarded
as a separate entity for Federal income tax
purposes.
The DOR
issued amended rule 16:240, related to the nexus
standard for corporations and partnerships.
The
Appellate Tax Board (ATB) ruled8
that a nonresident corporate partner in a tiered
partnership was deemed to be conducting business
in the state by virtue of Massachusetts
activities undertaken by the lowest-tiered
entity, which owned and operated an in-state
hotel.
In a
case involving a trademark subsidiary, the state
supreme court affirmed9
that the U.S. Supreme Court’s physical-presence
ruling in Quill10
applies only to sales and use taxes; thus,
physical presence is not required for income tax
purposes.
Subsequent to the state supreme court’s Dec. 29,
2005 opinion in Kmart Corp.,11
the court of appeals released a “corrected”
version of its original 2001 opinion in the same
case on March 13, 2006, that leaves the court of
appeals’ holding generally intact.12
Following the state supreme court’s decision in
Kmart Corp., a hearing officer held13
that an intangible trademark holding-company
subsidiary did have sufficient state corporate
income/franchise tax nexus.
The DOR amended Rule 710:50-17-3 to
reflect policy that now includes deliveries into the state via taxpayer-owned
trucks as a protected activity under P.L. 86-272.
The DOR ruled14
that out-of-state corporations that performed all daily management functions and
operations outside the state have both state corporate net income and capital
stock franchise tax nexus, because their corporate officers were “doing
business” on behalf of the company when they performed high-level management
functions for the company and its affiliates from an affiliate’s building
located in the state.
In
another situation, the DOR ruled15
that two out-of-state companies providing
lease guarantees to their affiliates had
both state corporate net income and capital
stock franchise tax nexus, because an
affiliate acted as an agent for the two
companies in having its employees inspect
in-state store sites that were covered by
lease guarantees entered into by the two
companies.
The
chief administrative law judge (ALJ) ruled16
that an out-of-state company that sold
general repair/plumbing/security services to
in-state customers via the Internet had
sufficient constitutional nexus with Texas
to be subject to the state franchise tax.
Nexus was based on the activities of
third-party independent contractors that
performed such services in Texas on the
company’s behalf.
The state tax commission ruled17
that an in-state corporation that provided certain administrative “back office”
services in the state to unrelated offshore hedge-fund clients and customers did
not create state corporation franchise tax or personal income tax nexus as to
them.
The Department of Taxation (DOT) ruled18
that a company that rented equipment to
in-state customers on a regular basis
had nexus, because the renting of
property in the state exceeds P.L.
86-272 protection.
In
a different ruling, the DOT held19
that a holding company was considered
commercially domiciled in Virginia
post-acquisition, although it had no
office, employees or tangible assets;
its affairs were conducted primarily by
officers located at the acquiring
company’s Virginia headquarters.
In
another ruling, the DOT expl-ained20
that an out-of-state company does not
establish corporate income tax nexus if
its sole connection with the state is
limited to making phone calls and
writing letters to in-state debtors to
collect receivables. However, the use of
a Virginia attorney and an in-state
collection agency to perform these
functions may create nexus for the
out-of-state company if an examination
of their relationships shows that they
are not truly independent contractors.
The state supreme court of appeals (the
state’s highest court) held that the
physical-presence requirement delineated
in Quill applied only to sales
and use tax; thus, the imposition of
business franchise tax and corporate
income tax on an out-of-state bank with
no physical presence in the state did
not violate the U.S. Constitution’s
Commerce Clause.21
IRC Sec. 338(h)(10) Transactions
The Franchise Tax Board (FTB)
explained22
how gains resulting from an IRC Sec.
338(h)(10) or 338(g) election are
apportioned for state purposes.
The state tax commission ruled23
that a company filing a combined water’s-edge corporate income tax return was
required to include gains from an IRC Sec. 338(h)(10) deemed-asset sale of its
subsidiaries as apportionable business income under the state’s functional test,
because the business line had constituted an integral part of its unitary
business operations. The commission noted that, because the parent had included
the subsidiaries on its Idaho combined group returns over the past several
years, they were all presumed to be part of a unitary business.
The DOR ruled24
that gains from an IRC Sec.
338(h)(10) deemed-asset sale were
classified as apportionable business
income under the functional test,
rather than as allocable nonbusiness
income under the Indiana Tax Court’s
2001 ruling in May Department
Stores.25
Unlike the facts in that case, the
taxpayer in this ruling had a
business reason for disposing of the
property and was not legally
compelled by court order to sell it.
A court of appeals transferred26
to the state supreme court a case
involving whether an IRC Sec.
338(h)(10) gain is business or
nonbusiness income, because the
case’s resolution required
construing state revenue law that
fell within the state supreme
court’s exclusive appellate
jurisdiction.
An ALJ held27
that an IRC Sec. 338(h)(10)
deemed-asset sale transaction was a
recapture event under the governing
statute for state investment tax
credit (ITC) purposes and sustained
a substantial understatement
penalty, on the grounds that there
was no substantial authority for the
taxpayer’s position that no ITC
should be recaptured.
The DOR explained28
that the commonwealth court’s 2003
decision in Canteen,29
which held that IRC Sec. 338(h)(10)
liquidation gain qualifies as
allocable nonbusiness income, does
not apply to tax years after 1998,
due to legislative changes.
Allocable/Apportionable Income
A circuit court reaffirmed30
the state’s adherence to a
Blessing/White31
modified functional test for
classifying income and held that
the gain from the liquidation
sale of all U.S. retail grocery
store assets by a subsidiary of
a Canadian food
wholesaler/distributor was
nonbusiness income, because the
proceeds were not reinvested
into the U.S. business.
Similarly, the appellate court
af-firmed32
a trial court’s analysis
employing Blessing/White’s
modified functional test and
agreed that the liquidating sale
of an in-state partnership’s
trading technology (an
intangible) was nonbusiness
income to the partnership when
the proceeds were distributed to
its partners. The court also
agreed that the distributed gain
was nonbusiness income to the
nonresident partner recipient
and, accordingly, should be
allocated outside the state.
New Rule 100.3015 provides
guidance on how taxpayers may
elect to treat all income, other
than employee compensation, as
business income for purposes of
allocating and apportioning
income to the state for each tax
year beginning after 2002. The
election is made on an original
return for the tax year to which
the election applies, and can be
revoked only by filing a
corrected return by the original
return’s original or extended
due date.
The state tax court ruled33
that a research/engineering firm
operating in the state did not
owe state corporate income tax
on gain from the sale of
out-of-state subsidiary stock;
Maryland could not
constitutionally tax the gain,
because the firm’s acquisition
and ultimate sale of the stock
served purely as an investment
function. The court found that
there was no integration of the
subsidiary’s business into the
firm’s regular business
operations; purchase of the
subsidiary was not a short-term
investment of working capital
analogous to a bank account or
certificate of deposit; and the
firm acquired the subsidiary
with the goal of subsequently
selling it in a public offering.
A chancery court held34
that investment income earned on
a corporation’s excess capital
was nonbusiness income, because
the investments at issue served
an investment function, rather
than an operational function,
under the U.S. Supreme Court’s
analysis in Allied-Signal,
Inc.35
Under the facts, an automobile
industry parts manufacturer
earned the interest in-come on
treasury securities, and the
court found that this income
constituted surplus funds in
excess of the operational and
working-capital needs of the
manufacturer’s business.
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. Corporation
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 significant
changes to the states’ tax
bases.
Deductions Related to
Dividends
In addition to requiring
inclusion of four
subsidiaries in its
combined corporate
income tax return, a DOR
hearing officer ruled36
that the company could
not claim a deduction
for dividends received
from a real estate
investment trust (REIT),
because such
intercompany
transactions had to be
eliminated on the state
combined income tax
return.
In Appeal of River
Garden Retirement Home,37
the State Board of
Equalization (SBE) ruled
in favor of the FTB and
held that a taxpayer
that benefited from a
deduction for dividends
re-ceived that was
subsequently deemed
unconstitutional was
required to pay tax on
deductions taken in
prior years still open
under the state’s
statute of limitations.
The FTB had assessed the
tax based on the 2003
state court of appeals
decision in Farmer
Bros. Co.,38
which held that a
deduction applying only
to dividends paid from
corporate income
previously subject to
California tax was
unconstitutionally
discriminatory.
Contrary to the
California appellate
court’s 2004 decision in
Fujitsu IT Holdings,39
the SBE issued40
a formal opinion that
dividends paid by Apple
Computer’s foreign
subsidiaries should be
prorated, rather than
receive preferential
ordering treatment, for
purposes of determining
whether the dividends
are deductible under
several competing
statutes. The SBE
explained that, because
the paid dividends at
issue were not directly
traceable to either
included or excluded
income, they should be
prorated.
The tax commission has
proposed amendments to
Rule 600 to provide that
dividends received from
a REIT or regulated
investment company, that
are not included in the
pre-apportionment tax
base as a result of the
Federal dividends-paid
deduction, are not
eliminated as
intercompany
transactions in
computing state combined
income. Additionally,
under the proposed
amendments, a
corporation included in
a worldwide combined
group for Idaho income
tax purposes must treat
IRC Sec. 1248 dividends
as dividends for Idaho
income tax purposes. An
intercompany dividend
elimination is allowed
to the extent dividends
received are paid from
current- or prior-year
earnings previously
included in income
subject to
apportionment. The
proposed amendments also
explain that dividends
received from a stock
insurance subsidiary and
deducted by a mutual
insurance holding
company, or an
intermediate holding
company, are not
eliminated as
intercompany
transactions in
computing combined
income.
Among other provisions,
HF 785, Laws 2006,
clarified that the
Federal dividends
deduction allowed under
IRC Sec. 965 for the
repatriation of foreign
income must be added
back for state purposes.
The addback reference
was “inadvertently
omitted” from the
state’s 2005 Federal
update law.
A chancery court held41
that limiting the
dividends-received
deduction (DRD) to
dividends paid by an
entity doing business
and filing a return in
the state is
unconstitutional.
In contrast to the
Mississippi decision
above, the state supreme
court held42
that the state’s DRD
regime as a whole did
not facially
discriminate against
foreign commerce. The
statute in question
allows a parent to take
a deduction for
dividends received from
corporate subsidiaries,
but the deduction is
limited to the amount of
income already taxed in
New Hampshire under the
business profits tax.
The court examined the
aggregate tax imposed on
a unitary business,
explaining that both a
unitary business with a
foreign subsidiary
operating in New
Hampshire and a unitary
business with a foreign
subsidiary not operating
there would each be
taxed only once. Thus,
there is essentially no
“differential treatment”
that benefits the former
and burdens the latter.
The Division of Taxation
has adopted amendments
to Subchapter 7 of
N.J.A.C. 18 to provide
that the DRD is not
allowed for dividends
from a REIT paid after
Feb. 5, 2006.
NOLs
A U.S. District Court
affirmed43
a bankruptcy court’s
ruling that a holding
company did not waive
its right to carry back
certain NOLs merely
because it had chosen to
carry the losses forward
on a previously filed
return. The
court agreed that state
law incorporated the
Federal regulations
requiring a taxpayer to
affirmatively waive its
right to forgo a
carryback deduction
(i.e., by attaching such
a statement to the tax
return).
Louisiana
The DOR explained44
the extent to which the
state will limit an NOL
carryover from an
acquired corporation to
the surviving acquiring
corporation after a
merger.
The DOR ruled that,
because Louisiana does
not adopt the Federal
income tax provisions on
NOLs, any excess
charitable contribution
carryovers converted to
NOL carryovers for
Federal income tax
purposes will be lost
for state corporate
income tax purposes.45
Among other changes,
HB 859, Laws 2006,
increased the annual
NOL cap from $2
million to $3
million, or 12.5% of
the corporation’s
income, whichever is
greater.
HB 843, Laws 2006,
revised state NOL
carryforward
provisions; a
10-year carryforward
period with
available amounts
calculated in
proportion to
Federal NOL amounts
over a four-year
transition period
begins with losses
occurring in 2007.
Intercompany Expenses
Amended Rule
801-3-35-.02,
specifying
restrictions on the
deductibility of
certain
related-party
intangible and
interest expenses,
explains that
expenses “passed
through” to an
unrelated third
party are deductible
subject to certain
limits.
The DOR adopted Reg.
Sec. 100.2430, to
provide guidance on
a law enacted in
2004 disallowing a
deduction for
interest and
intangible expenses
and costs paid,
directly or
indirectly, to a
“foreign person”
(including an 80/20
company).
Among other
provisions, HB 1001,
Laws 2006, required
certain intangible
expenses and
directly related
intangible interest
expenses deducted
for Federal income
tax purposes to be
added back to a
corporation’s
taxable income for
state AGI tax
purposes. The DOR
issued emergency
rule LSA Document
No. 06-244(E) to
implement the new
intercompany-expense-disallowance
provision.
Among numerous other
tax changes, HB 403,
Laws 2006, corrected
a 2005 legislative
drafting error to
include “intangible
expenses” as part of
the state’s
related-party-expense
addback requirement,
retroactive to 2005.
In addition, the DOR
issued amended Rule
16:230 on the
related-party-expense
addback adjustment.
The DOR adopted 830
CMR 63.31.1, which
explains the addback
of related-member
interest or
intangible expense,
including the
addback of such
interest expense
derived from
dividends, notes or
similar obligations.
In addition to other
changes, HB 1891,
Laws 2006, provided
an additional
exception to the
state’s
related-member
royalty addback
requirement for
state corporate
income tax purposes,
effective on Jan. 1,
2006. Specifically,
the new law does not
require this addback
if the company can
establish that the
(1) related member
to whom the amount
was paid is
organized under the
laws of a non-U.S.
country; (2) country
has a comprehensive
income tax treaty
with the U.S.; and
(3) country imposes
a tax on the related
member’s royalty
income at a rate
that equals or
exceeds the
applicable North
Carolina tax rate.
Other Modifications
The DOR listed interest income items from
various U.S. government, territory and Federal agency obligations that are
exempt from state corporate income tax. In doing so, it explained46
that interest or other related expenses incurred to purchase or carry tax-exempt
obligations are not deductible.
In Davis v. DOR,47
the state court of appeals held that the state’s bond taxation scheme, which
taxes interest income derived from bonds issued by other states and excludes
interest derived from bonds issued by Kentucky
Kentucky and its
subdivisions, is
facially
unconstitutional
under the Commerce
Clause. The state
supreme court
declined review of
this decision; the
DOR filed a petition
for certiorari
with the U.S.
Supreme Court. 48
The DOR issued a
regulation
explaining the
state’s adherence to
the IRC Sec. 199
domestic production
activities deduction
(DPAD) on returns.49
The DOR explained50
how to calculate the IRC Sec. 199 DPAD for state corporation income tax
purposes.
The division
explained51
the 2005 law
that partially
decouples from
the IRC Sec. 199
DPAD.
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