Ohio Tax. Workshop N. Advanced: Multistate Apportionment Sales Factor, Costs of Performance, Market-Based Sourcing & Alternative Apportionment

Transcription

1 27th Annual Tuesday & Wednesday, January 23 24, 2018 Hya Regency Columbus, Columbus, Ohio Ohio Tax Workshop N Advanced: Multistate Apportionment Sales Factor, Costs of Performance, Market-Based Sourcing & Alternative Apportionment Tuesday, January 23, :00 p.m. to 4:00 p.m.

2 Biographical Information Robert M. Woolley, Jr. CPA, MST; Partner, Plante Moran 250 South High Street, Suite 100, Columbus, OH Direct: Fax: Bob began his career in January 1993 in Plante Moran s Ann Arbor, MI office and moved to the Columbus, OH office in December Bob currently is the Director of Tax of the Columbus office and previously led the Ohio Region state and local tax practice. Bob primarily serves clients in both the manufacturing/distribution and service industries. Bob is known for working with his clients to manage their tax risks and exposures by providing them the information they need to make effective and realistic business decisions regarding the tax issues they face. Bob is a regular speaker at both internal and external technical trainings, including the AICPA, the Michigan Tax Conference, the Minnesota CPA Tax Conference, and the Ohio Tax Conference. Bob is a graduate of Michigan State University with a B.A. in Accounting and received a Masters of Science in Tax from Walsh College in Troy, Michigan. Thomas Cornett, Senior Tax Manager, Multistate Tax Services, Deloitte Tax LLP 600 Renaissance Ctr. Detroit, MI tcornett@deloitte.com Tom Cornett is a Senior Manager in the Detroit Multistate Tax Practice. He has 20 years of experience in state and local taxation and has consulted with clients in all aspects of multistate income, franchise, and Michigan business taxes. Tom is Deloitte s State Tax Desk contact for Michigan tax matters and coordinates technical reviews of various state and local tax matters for Deloitte s Washington National Tax group. His client experience includes audit and administrative appeals representation, multistate analysis of business reorganizations, tax provision attestation, and recommendations with respect to multistate savings strategies. Prior to joining Deloitte, Tom spent three years as State Tax Counsel for DaimlerChrysler. Tom received both his undergraduate degree (in Economics and History) and law degree from the University of Michigan. Nicole L. Johnson, Associate, State & Local Tax Group, Morrison & Foerster LLP 250 West 55th St., New York, NY NJohnson@mofo.com Nicole Johnson is an associate in the State + Local Tax Group in Morrison & Foerster LLP s New York office. Her practice focuses on state and local tax controversies at the audit, administrative, and judicial levels. Ms. Johnson s practice encompasses matters regarding sales and use taxes, property taxes, franchise and income taxes, gross receipts taxes, insurance taxes, and telecommunication taxes, among others. She has written and spoken on various state and local tax issues and is a co-editor of the firm s newsletter State + Local Tax Insights. Prior to joining Morrison & Foerster in 2010, Ms. Johnson was a state and local tax manager with one of the big four accounting firms, where she focused on complex state and local tax controversies and planning opportunities. Ms. Johnson graduated from University of Minnesota, Twin Cities (B.S.B. 2001), cum laude from William Mitchell College of Law (J.D., 2004) and clerked for the Honorable Michael B. Thornton of the United States Tax Court.

3 Multistate Apportionment... Sales Factor, Costs of Performance, Market-Based Sourcing & Alternative Apportionment 27 th Annual Ohio Tax Conference (Workshop N) January 23, 2018

4 Agenda Apportionment: Purpose Sales Factor Trends Costs of Performance Sourcing Market-Based Sourcing Alternative Apportionment Forced Apportionment Special Industry Rules 1

5 Apportionment: Purpose Goal of apportionment is to compute percentage of total profits attributable to a particular state. The U.S. Supreme Court has recognized the impracticality of assuming all income can be assigned to a single source. Trinova Corp. v. Dep t of Treasury (1991). A state may not tax value earned outside of its borders; however, businesses operating in interstate commerce are not immune from fairly apportioned state taxation. Mobil Oil Corp. v Comm r of Taxes of Vt. (1980). [T]he linchpin of apportionability in the field of state income taxation is the unitary-business principle. Mobil Oil Corp. Historical concept is that business profits are function of productive capital (property factor), labor (payroll factor), and market (sales factor) the standard three factor apportionment formula. In a 21st Century business environment, shortcomings of this historical three factor apportionment model include the following: Intangible assets are generally not included in property factor. Sales factor has evolved into dominant factor. Technology advancements have changed the nature and extent of how capital is used by businesses, meaning they can do more with less property and payroll. More service related businesses. 2

6 Sales Factor Trends Sales factor was traditionally single-weighted or double-weighted in the three factor apportionment formula (along with property and payroll factors). Sales factor is intended to give recognition to the importance of a customer and the benefits afforded to a seller by the customer s state. Trend now is to increase the weight of the sales factor, with many states moving to a single-sales factor apportionment formula. 3

7 Costs of Performance Sourcing General Rule: Prior to 2014, under the Compact, in determining a company s sales factor, sales of non-tpp (i.e., sales of services and intangibles) were sourced as follows: Sales, other than sales of tangible personal property, are in this state if: (a) the income-producing activity is performed in this state; or (b) the income-producing activity is performed both in and outside this state and a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance. (Compact, Article IV, UDITPA, Section 17). Therefore, for sales of services, receipts from the sales of services were sourced to the location where the income-producing activity was performed, based on where costs were incurred in performing those services. Regulations defining the terms income-producing activity and costs of performance were added. 4

8 Costs of Performance Sourcing Recent cases: Litigation continues across states regarding the appropriate interpretation of costs of performance. Louisiana Quest Diagnostics Clinical Labs., Inc. v. Barfield (La. Ct. App. 2016): The Louisiana Court of Appeal held that a company that performed medical diagnostic testing services mostly at its regional laboratory in Texas for its customers located in Louisiana must source those receipts to Texas inasmuch as the services were performed in Texas. The Court relied on the apportionment statute governing service enterprises, which provides that service receipts are sourced based on location-ofperformance. Oregon Apollo Educ. Grp., Inc. v. Dep t of Revenue (Or. T.C. Magistrate Div. 2017): The Magistrate Division of the Oregon Tax Court determined that a company that provided online educational services from outside of OR must source its receipts from its Oregon students to Oregon inasmuch as its costs for maintaining the online educational platform were not incremental costs arising from each transaction with an Oregon student. 5

9 Costs of Performance Sourcing Recent cases (cont d): South Carolina DirecTV, Inc. v. S.C. Dep t of Revenue (S.C. Ct. App. 2017): The S.C. Court of Appeals held that the income-producing activity of a satellite television provider was its delivery of a signal into the homes and onto the television sets of its customers and, therefore, the company s subscription receipts from South Carolina customers must be sourced to South Carolina. 6

10 Example Facts: ABC is a service company that is taxable in States Y and Z. Both states use single-sales factor formulas, and the costs of performance rule. ABC performs all of its income-producing activities in State Y. ABC has $100 million of profits. Sales by location of customer: State Y, 40%; State Z, 35%; Other states, 25%. Questions: How are ABC s profits taxed in States Y and Z under costs of performance? What portion of ABC s profits is nowhere income? 7

11 Market-Based Sourcing In 2014, the MTC recommended amending the Compact by changing the sourcing methodology for sales of non-tpp from costs of performance to market-based sourcing. Since then, and even before the MTC recommended the change, approximately half the states have adopted market-based sourcing rules for sales of non-tpp. States that have recently transitioned to market-based rules include: Arizona (elective phase-in ); California (elective in 2011 and 2012, mandatory in 2013); Connecticut (effective 2016 for corporations, 2017 for flow through entities); Louisiana (2016); Massachusetts (2014); Missouri (effective August 28, 2015); Montana (2018); Nebraska (2014); New York City (2015); New York State (2015); Oregon (2018); Pennsylvania (2014); Rhode Island (2015); Tennessee (July 1, 2016); Washington D.C. (2015. Many other states just do it without express authority. 8

12 Market-Based Sourcing General Rule: After 2014, under the Compact, in determining a company s sales factor, sales of non-tpp (i.e., sales of services and intangibles) are sourced as follows: For services: Where the services are delivered. For intangibles: Based on the use, and certain intangible receipts would be thrown out. States vary in their interpretation of what constitutes the market state. For example, for services, in Georgia, the market state is generally defined to be where the customer is located, while in Illinois, it is where the service is received. Further, there might be different rules based on the type of service, method of transmittal, or customer involved. 9

13 Market-Based Sourcing Practical Considerations What type of non-tpp sales do you deal with regularly? What s a real life example of a service or intangible-based revenue stream? Reality is that market-based sourcing can be difficult to apply regardless of whether based on location of delivery, client benefit or something else. Based on terms of contract? Location from where request for service is made/ordered? Based on a look-through to the client s customer s location? Location from which customer is billed and/or domiciled? What level of analysis and data collection is required by a seller? Consider complex services that appear to benefit an entire organization Where is the benefit received if the customer is a multistate (or multinational) company? Cloud computing services. Accounting and legal services. 10

14 Market-Based Sourcing Cascading Rules Services One approach to market-based sourcing is to source receipts of services to where the customer receives the benefit of the services performed. There are issues with and different approaches tor identifying where the benefit of the service is received: Generally, the benefit is received at the customer location. Benefits received in more than one state: Individual customers vs. business customers; Order location vs. billing location; Benefit location is indeterminable; or No nexus or fixed place of business in benefit location. 11

15 Market-Based Sourcing Cascading Rules California Regulation Section provides the following cascading rules for services: To individual customers: Billing address. Customer contract or books/records. Reasonable approximation. To corporation or business entity customers: Customer contract or books/records. Reasonable approximation. Where customer placed order. Billing address. California also has cascading rules for transfers and licenses of intangible property. 12

16 Market-Based Sourcing Cascading Rules Intangibles Issues associated with determining where intangibles are utilized. Where utilized by payor (e.g., licensee). Where licensee is located? Where licensee manufactures product? Where licensee sells product? What if location of utilization cannot be determined? What if taxpayer/licensor is not taxable where the intangibles are utilized? 13

17 Examples Example 1 Services (same facts) Facts: ABC is a service company that is taxable in States Y and Z. Both states use single-sales factor formulas, and the costs of performance rule. ABC performs all of its income-producing activities in State Y. ABC has $100 million of profits. Sales by location of customer: State Y, 40%; State Z, 35%; Other states, 25%. Questions: What portion of ABC s profits is nowhere income? How would the answer change if State Y used a market-based approach? 14

18 Examples Example 1 (cont d) Apportioned Income Market-based sourcing State Y taxable income $100 million x 40% (by location of customer) State Z taxable income (using COP) $100 million x 0% (no incomeproducing activities are here) Total taxable income Nowhere income $40 million None $40 million $60 million In contrast, under costs of performance (State Y), ABC would pay $100 million to State Y, $0 million to State Z, and $100 million in total, with $0 million in nowhere income. 15

19 Examples Example 2 Legal Services Facts: A SALT attorney with a major law firm works in the firm s NYC office. The law firm is retained by a corporate client for a SALT case in Ohio to be handled by the NYC-based attorney. Client is headquartered in Illinois, but the law firm was hired by the client s tax director, who works in North Carolina. SALT attorney successfully litigates the Ohio case for client; tax director gets a bonus from her employer. Questions: How should the law firm source legal fees received for its attorney s services? Where does the client received the benefit of the services? Where is the service delivered to the client? Where is the client located with respect to the matter for which the law firm was retained? 16

20 Alternative Apportionment Most states have a statute allowing for alternative apportionment which can be invoked by the taxpayer or the State. Usually, may be invoked only in specific cases where unusual fact situations (which ordinarily will be unique and non-recurring) produce incongruous results. Especially common for special industries or intangible income. 17

21 Alternative Apportionment Burden of Proof Generally, the party seeking to deviate from the standard apportionment formula has the burden of proof. In theory, must demonstrate formula as a whole does not fairly represent taxpayer s activities in the state. Proposed alternative must be reasonable. Question: What is the effect of deference given to administrative agencies charged with enforcing the tax laws? Question often turns on whether taxpayer can establish distortion (i.e., the standard apportionment formula results in a distortive sourcing of taxpayer s income to the state). Distortion requires a factual demonstration of the unreasonable apportionment percentage in relation to other reasonable benchmarks, such as: Customer location; customer billing address; or domestic population. What others? Question: What do you need to know to prove distortion? 18

22 Example Examples If you mistakenly source your receipts using a non-statutory method, can you later successfully argue that your receipts should be sourced using the statutory method? See Vodafone Ams. Holdings, Inc. v. Roberts (Tenn. 2016). If under the statutory three-factor formula, a company s apportionment would be 0%, can a State successfully argue that an affiliate s factor should be used instead? See Target Brands, Inc. v. Dep t of Revenue (Colo. Dist. Ct. 2017). 19

23 Alternative Apportionment Recent cases: Corp. Exec. Bd. v. VA. Dep t of Taxation (Va. Cir. Ct. 2017): The company, headquartered in Virginia, argued that its request to alternatively source its service revenue based on its customers billing addresses should be granted because application of the State s statutory costs of performance rule with respect to sourcing service revenue would result in taxation of income generated outside of Virginia. The Virginia Circuit Court held that the company failed to meet its burden of proving that either: (1) Virginia s statutory method as applied was unconstitutional; or (2) the company was entitled to alternative apportionment. Canon Fin. Serv. s, Inc. v. Dir., Div. of Taxation (N.J. Tax Ct. 2016): The taxpayer was a commercial financial services company headquartered in New Jersey, with lessees in all 50 states. The New Jersey Tax Court concluded that neither the 100% apportionment factor with credit for taxes paid to other states proposed by the State nor the three-factor apportionment formula accurately reflected the taxpayer s income earned in New Jersey. The Tax Court found that the State s method resulted in a liability that was 221% to 310% greater than using the standard three-factor formula and was, therefore, distortive. However, the Tax Court also found that the standard three-factor formula failed to accurately reflect the business activity of the taxpayer in New Jersey. 20

24 Alternative Apportionment Recent cases (cont d): Rent-A-Center W. Inc., v. S.C. Dep t of Revenue (S.C. Ct. App. 2016): The taxpayer (1) operated retail stores outside of South Carolina and (2) licensed intellectual property to a corporate affiliate doing business in and outside of South Carolina. The Department audited the taxpayer and used an alternative apportionment method to apportion the taxpayer s income, removing the taxpayer s retail receipts from its salesfactor denominator. The South Carolina Court of Appeals held that the Department s use of an alternative apportionment formula was improper because the Department did not meet its burden in proving that it was necessary to accurately reflect the taxpayer s income earned in South Carolina. The Department s petition for certiorari with the South Carolina Supreme Court is pending. 21

25 Alternative Apportionment Recent cases (cont d): Target Brands, Inc. v. Dep t of Revenue (Colo. Dist. Ct. 2017): On audit, the Department asserted that the company, an intangible management company, was required to apportion its income to Colorado under an alternative method whereby it multiplied its income by its parent s Colorado sales factor (under the statutory threefactor formula, the company s apportionment factor would have been zero). The Colorado District Court held that the Department s alternative apportionment method was unreasonable inasmuch as it did not account for the company s property and payroll, none of which was located in Colorado. Associated Bank, N.A. & Affiliates v. Comm r of Revenue (Minn. T.C. 2017): The Minnesota Tax Court held that the Department failed to justify its assertion of alternative apportionment, despite the fact that the company stipulated to the fact that its transactions were designed to avoid Minnesota tax, because the company followed the statute s requirements. On June 14, 2017, the Minnesota Supreme Court granted the State s petition for certiorari. Oral argument was held on November 1,

26 Forced Apportionment Throwback When a sale is not subject to tax in the destination state, the taxing state will include the sale receipts in the sales factor numerator of the taxing state. Throwout When a sale is not subject to tax in any state, the taxing state will remove the sale receipts from the sales factor denominator of the taxing state. 23

27 Forced Apportionment Recent cases: Lorillard Licensing Co. v. Dir., Div. of Taxation (N.J. 2016): New Jersey cannot apply dual nexus standards to determine whether a corporation could be subject to tax in another state for sales fraction throwout purposes, rather New Jersey must use its own nexus standard. Elan Pharm. Inc. v. Dir., Div. of Taxation (N.J. Tax Ct. 2017): New Jersey cannot apply the throwout rule to receipts that were attributable to States that could constitutionally tax the company s income or tax receipts by the application of a throwback rule. Appeal of Craigslist, Inc. (Cal. SBE 2016): In applying the throwout rule to its advertising receipts, the taxpayer determined it was taxable in all states in which it had $500,000 of receipts an economic-presence standard that California adopted for years subsequent to the years at issue. The FTB adjusted the taxpayer s sales factor based on its determination that the taxpayer was taxable only in those states in which it had a physical presence. The SBE concluded that the FTB applied the correct standard, notwithstanding California s adoption of an economic presence standard applicable to years subsequent to those at issue. 24

28 Special Industry Rules Special Industry Apportionment Many states have implemented apportionment rules applicable to specific industries. Some examples of special apportionment methodologies are: Exclusion of one or more factor(s). Replacement of one or more factor(s). Replacement of standard apportionment factors with industry appropriate factors. Special sourcing rules generally based on market sourcing. Statutes/regulations/administrative practice. These specific industries might include: Financial services industry. Media & entertainment industry. Publishing industry. 25

29 Special Industry Rules Financial Services Industry New York New York sourced deposits to the extent that such deposits were maintained by the taxpayer at the branch location. This was known as the deposits factor and had caused much controversy with regard to determining the location of maintenance and the branch location. New legislation in the state requires the use of market-based sourcing and eliminates the deposits factor for banking corporations for tax years beginning January 1, Under the new law, the following rules are a sample of how receipts from financial transactions may be sourced : Interest on loans secured by real property sourced to location of real property. Interest on other loans sourced to location of borrower. Net gains from sales of secured loans sourced based on ratio of gross proceeds from sales of New York secured loans over all secured loans. Net gains from sales of other loans sourced based on ratio of gross proceeds of such loans to purchasers located in New York to all such loan sales. 26

30 Special Industry Rules Media & Entertainment Industry Two market based methods generally exist for sourcing receipts earned by taxpayers in the media and entertainment industry such as advertising and licensing revenue: Audience Factor Approach looks to where content is viewed. Commercial Domicile Approach looks to where the commercial domicile of the advertiser or licensee of the content is located. 27

31 Special Industry Rules Publishing Industry Illinois Illinois adopted a circulation factor to determine when publishing and advertising services are sourced to Illinois for purposes of computing the sales factor. (86 Ill. Admin. Code ) The circulation factor is the ratio that a taxpayer s in-state circulation to purchasers and subscribers of the published material bears to its total circulation of the published material to purchasers and subscribers everywhere. Computed for each individual publication by the taxpayer of published material containing advertising. Can look to: Geographic information; Books and records; Rating statistics sources (e.g., Audit Bureau of Circulations, etc.). 28

32 Questions? 29

33 Presenters Bob Woolley Plante Moran, PLLC Tom Cornett Deloitte Tax LLP Nicole Johnson Morrison & Foerster LLP