Editor: Mary Van Leuven, J.D., LL.M.
State & Local Taxes
Determining whether a corporation is "subject to tax" or "taxable" in a given state is often not a simple matter. Unfortunately, for many corporations, this exercise must be repeated multiple times, in multiple contexts.
First, a corporation must determine whether it is subject to tax in a state for purposes of filing (or not filing) corporate income tax returns. Then, a multistate corporation must determine whether it is "taxable" in another state so that it is entitled to apportion its income among the states where it does business, rather than attributing 100% of its income to a single state. Next, in a number of states, a corporation may have to determine whether its affiliates are "subject to tax" in certain other states so that it can avoid adding back selected intercompany expenses deducted for federal income tax purposes. Finally, certain apportionment rules require a corporation to determine whether it is "subject to tax" or "taxable" in the state to which the receipts are attributed. These rules are the so-called throwout and throwback rules that various states have enacted, and they are the focus of this item.
Throwout and throwback rules are ostensibly designed to promote full apportionment of income; they also generally increase the tax base of states that employ them. A throwout rule generally requires a taxpayer to throw out or exclude receipts from the sales factor that are attributable to a state where the taxpayer is not subject to tax. In contrast, throwback rules apply to receipts from sales of tangible personal property and generally require a taxpayer to include the receipts in the origin state's sales factor numerator if the taxpayer is not taxable in the destination state.
The question thus arises as to what it means to be "subject to tax" or "taxable" in a particular state. Must a taxpayer actually file returns to be "subject to tax"? Does the taxpayer actually have to pay tax? What effect do the provisions of the Interstate Income Act of 1959, P.L. 86-272, have on the determination? Not surprisingly, the answers are not always clear-cut. And, not surprisingly, states are not always consistent with one another in how they administer these rules. This item next focuses on New Jersey's and California's recent approaches to answering these questions.
New Jersey's Approach
New Jersey's controversial, former throwout rule affected the computation of the New Jersey sales factor by excluding from the numerator and denominator—or "throwing out"—receipts attributable to a state or foreign country "in which the taxpayer is not subject to a tax on or measured by profits or income, or business presence or business activity" (N.J. Stat. §54:10A-6(B)(6) (amended 2008)). The constitutionality of this throwout rule has been the subject of much litigation. In Whirlpool Properties, Inc. v. Director, Division of Taxation, 208 N.J. 141 (2011), the New Jersey Supreme Court held that the rule operated permissibly for receipts attributed to states where the taxpayer was protected under P.L. 86-272 or simply did not have the requisite contacts to establish nexus, meaning receipts could be thrown out when attributed to those states. However, the rule was found to be facially unconstitutional for receipts attributable to states that could impose an income tax but had declined to do so. Almost three years later, the New Jersey Tax Court once again addressed the throwout rule. In Lorillard Licensing Co. v. Director, Division of Taxation,No. A-2033-13T1 (N.J. Tax Ct. 1/14/14), the issue was whether New Jersey could, in determining whether a taxpayer was "subject to tax" in a state for purposes of determining if receipts should be thrown out of the sales factor, use a different standard than the nexus standard used in determining whether an entity was subject to tax in New Jersey? The Division of Taxation (the Division) argued that the taxpayer was required to file returns in other states to be considered subject to tax and, thus, not subject to throwout. The taxpayer, on the other hand, argued that the state should apply the economic nexus standard ratified in Lanco, Inc. v. Director, Division of Taxation, 379 N.J. Super. 562(N.J. Super. Ct. App. Div. 8/24/05), to determine whether it was considered subject to tax in the other state. In other words, if the taxpayer would be subject to tax in the other state under Lanco, it argued that the throwout rule should not apply.
In a ruling amplified by a follow-up written opinion, the New Jersey Tax Court rejected the Division's argument that different standards apply for determining whether a taxpayer has New Jersey nexus and whether a taxpayer is considered subject to tax in another state for purposes of applying the throwout rule. The court said there is only one Due Process and one Commerce Clause, and they
mean the same thing in every jurisdiction to which they apply—whether we consider if a taxpayer has sufficient constitutional nexus to be taxed in New Jersey or whether we consider if a taxpayer has sufficient constitutional nexus to be taxed in any other State or jurisdiction in which [the U.S.] Constitution is in place.
As such, the economic nexus standard upheld in Lanco applies to determine whether taxpayers are subject to tax in New Jersey and whether taxpayers are considered subject to tax in other jurisdictions so that their receipts are not excluded from the sales factor. Unfortunately for the taxpayer in Lorillard, the litigation is not over, as the Division is appealing the tax court's ruling.
The California taxing authorities, in contrast to the New Jersey Division of Taxation, adopted an arguably more common-sense approach when addressing whether the state's throwback rule applies. Under California's throwback rule, sales of tangible personal property are sourced to California if the property is shipped from California and the taxpayer is not taxable in the purchaser's state. Thus, to determine whether the throwback rule applies, it is necessary to determine whether a taxpayer is "taxable" in the destination jurisdiction. For tax years beginning on or after Jan. 1, 2011, a taxpayer is deemed to have nexus with California by virtue of having a certain amount of California-sourced receipts. In general, the Franchise Tax Board (FTB) considers a corporation to have California corporate income/franchise tax nexus if it has more than $500,000 in California sales, $50,000 in California property, or $50,000 in California payroll.
In 2012, California issued two administrative policy documents addressing which standard should be applied to determine whether a taxpayer is "taxable" in the state of the purchaser so that sales should not be "thrown back" to California. In Chief Counsel Ruling 2012-03, the FTB applied California's post-2011 economic nexus standards to the taxpayer's activities in foreign countries, concluding that a taxpayer would be considered taxable in foreign jurisdictions where it had over $500,000 of sales. Furthermore, P.L. 86-272 would not protect the taxpayer from taxation because it does not extend to foreign commerce. As such, a taxpayer making sales into a foreign country will be considered "taxable" in that country if it meets the economic nexus standards applied in California for purposes of determining whether a filing requirement exists, and no sales would be thrown back to California from that jurisdiction.
In California Technical Advice Memorandum (TAM) 2012-01, the FTB addressed which standard applied to determine whether a sale should be thrown back to California for years before Jan. 1, 2011. Certain taxpayers took the position that having $500,000 of sales destined for a foreign country would be sufficient to create nexus under U.S. constitutional standards. As such, they argued, they were not required to include receipts from sales to foreign countries in the California sales factor numerator for years before 2011. In the TAM, the FTB observed that, historically, California courts and the State Board of Equalization have held that some physical presence is required to create substantial nexus. Although this position changed with the adoption of the factor-presence nexus standards in 2012, those standards applied prospectively only. As such, in the FTB's view, for tax years beginning before 2011, a taxpayer must have had a physical presence in a foreign jurisdiction to avoid throwback.
Some have criticized California's position as being somewhat arbitrary (see, e.g., Lim and McGovern, "'Doing Business' in California: Substantial Economic Presence Nexus and the 'Throwback' Rule," 44 The Tax Adviser 299 (May 2013)). Arguably, if the U.S. Constitution (which has not changed) allows a state to subject a taxpayer to tax based solely on economic contacts, the economic nexus standard should apply to pre-2011 years as well. Notwithstanding this criticism, at least the California FTB has been consistent in applying a uniform standard to determine whether a taxpayer is considered "taxable." In contrast, the New Jersey tax authority's perplexing stance that separate standards apply may be difficult to defend.
Although New Jersey's throwout rule has been repealed, certain states—Alabama, Maine, Massachusetts, and West Virginia—have throwout rules for certain types of receipts. Further, a number of states have throwback rules. As more and more states enact factor-presence or economic nexus standards, the issue of which standard applies for purposes of throwout and throwback is likely to continue to be a source of disagreement between taxpayers and taxing authorities.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP. The information contained in this item is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This item represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.