SALT YEAR-END UPDATE PART 1 STATE INCOME TAX DEVELOPMENTS. November SALT Year-End Update Part 1: State Income Tax Developments

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1 SALT YEAR-END UPDATE PART 1 STATE INCOME TAX DEVELOPMENTS November

2 WITH YOU TODAY MARIANO SORI Partner State & Local Tax RICHARD SPENGLER Senior Director State & Local Tax SCOTT SMITH National Technical Practice Leader State & Local Tax

3 SALT 2017 YEAR-END UPDATE - PART 1 INCOME & FRANCHISE TAXES 3

4 OVERVIEW Significant 2017 State Tax Legislation Income/Franchise Taxes Direct Tax Nexus Controversies Business/Apportionable Income Developments Apportionment Trends Unitary Combined Reporting & Filing Options Related Party Transactions, Intercompany Debt, and Economic Substance Tax Base Flow-Through Entities 4

5 SIGNIFICANT 2017 STATE INCOME/FRANCHISE TAX LEGISLATION 5

6 SIGNIFICANT 2017 STATE TAX LEGISLATION Illinois S.B. 9 (July 4, 2017) Illinois General Assembly overrode Governor s veto. Effective July 1, 2017, corporate income tax rate increased to 7 percent from 5.25 percent; personal income tax rate increased to 4.95 percent from 3.75 percent. Taxpayer may divide full year net income proportionally based on the number of months subject to former rate and the new rate; or Taxpayer may irrevocably elect on its original return to specifically account for items of income and deduction based on when generated during the tax year. Other income tax changes: IRC 199 deduction must be added back to federal taxable income for years ending on or after December 31, R&D tax credit is retained and sunset date extended to January 1, 2022 from January 1, 2016 (and intended to apply continuously from 2004.) Effective for years ending on or after December 31, 2017, a unitary business group will now include formerly non-combinable members (i.e., group members required to use a different apportionment formula). Definition of United States is expanded to include an area over which the United States has asserted jurisdiction related to exploration and exploitation of natural resources. 6

7 SIGNIFICANT 2017 STATE TAX LEGISLATION North Carolina S.B. 257 (June 28, 2017) North Carolina General Assembly overrode the Governor s veto. For taxable years beginning on or after January 1, 2019, corporate income tax reduced to 2.5 percent from current 3 percent; personal income tax rate reduced to 5.25 percent from percent. Franchise tax on S corporations reduced from $1.50 per one thousand dollars of the tax base to $200 for the first $1 million of tax base and $1.50 per one thousand dollars of tax base greater than $1 million. 7

8 SIGNIFICANT 2017 STATE TAX LEGISLATION North Carolina (con t) S.B. 628 (August 11, 2017) Effective for taxable years beginning on or after January 1, 2016, a North Carolina taxpayer must: Add-back all interest expense paid or accrued to a related member to the extent that it exceeds the interest income received from a related member that is included in the taxpayer's gross income; and Deduct "qualified interest." Effective for tax years beginning on or after January 1, 2017, S.B. 628 narrows the deduction of "qualified interest" to the taxpayer's proportionate share of interest paid or accrued to a person who is not a related member during the same taxable year (subject to exceptions). Previously, "qualified interest" was defined as the "greater of 15% of the taxpayer's adjusted taxable income" or its proportionate share paid to an unrelated person. The new legislation eliminates the 15% qualified interest limitation. Further, the legislation also provides that in determining whether a debt instrument creates deductible interest expense, the covered debt instrument rules of the IRC 385 Treasury Regulations are not applicable. 8

9 DIRECT TAX NEXUS CONTROVERSIES 9

10 DIRECT TAX NEXUS CONTROVERSIES Economic Presence Nexus Colorado Target Brands, Inc. v. Dept. of Revenue, No. 2015CV33831 (Colo. Dist. Ct., Jan. 27, 2017) Intangible holding company licensing trademarks for use in Colorado (and other states) held to be doing business in and having a substantial nexus with Colorado. Quill physical presence requirement rejected. Department s Use of Single Sales Factor Alternative Apportionment Formula was Rejected by the Trial Court (see below) 10

11 DIRECT TAX NEXUS CONTROVERSIES Economic Presence Nexus (con t) Massachusetts Regulation (Working draft for practitioner comment issued 10/17/2017). Codifies economic nexus standard. A business corporation will be subject to the corporate excise tax if it owns or uses intangible property in Massachusetts where (1) the intangible property generates or is the source of gross receipts within Massachusetts; and (2) the activity in the state is purposeful. Purposeful activity includes contracts, licenses, and sublicenses. Provides an exception to jurisdiction if activity is limited to corporation s activity is limited to ownership of tangible personal property stored in a licensed public warehouse. Retains the nexus standard for business corporations that are partners (general or limited) in a partnership whose activities if conducted by the business corporation would subject the business corporation to the corporate excise tax. The activities of lower tiered partnerships are imputed to all higher level partnerships and partners. Also retains the exception to nexus if the business corporation s activity is limited to holding a limited partner interest in a publicly traded partnership. Imposes nexus standard for financial institutions and insurance companies. 11

12 DIRECT TAX NEXUS CONTROVERSIES Economic Presence Nexus (con t) Oregon Capital One Auto Finance, Inc. v. Dept. of Revenue, T.C (Ore. Tax Ct., Dec. 23, 2016) As have state courts from Illinois, Indiana, Massachusetts, and West Virginia, the court adopted the significant economic presence test and rejected a physical presence requirement for Oregon corporation excise tax and income tax purposes. Case also Illustrates Effect of Joyce v. Finnigan Apportionment Sourcing (see below) 12

13 DIRECT TAX NEXUS CONTROVERSIES Public Law Maryland Blue Buffalo Company v. Comptroller of Maryland, M.T.C. No. 16-IN (Md. Tax Ct., Aug. 30, 2017) Taxpayer, a Connecticut based seller of premium pet products, appealed the denial of its claim for refunds on corporate income taxes paid in 2011 and 2012 on the grounds that its in-state activities were protected under Public Law During the years in question Taxpayer employed in Maryland a Distributor Sales Manager, an Account Manager, two Regional Demo Managers, and several dozen Pet Detectives (in-store sales representatives). In-state employee activities included: (1) providing education, training and demonstrations on the benefit of Taxpayer s products; (2) attendance at pet-related community events; (3) gathering market data; (4) gathering data regarding competitors; (5) engaging in quality control; and (6) getting consumer s to make in-store purchases of Taxpayer s products. Maryland Tax Court found that the activities of Taxpayer s in-state employees when considered together exceeded the scope of protection afforded by Public Law

14 DIRECT TAX NEXUS CONTROVERSIES Public Law Oregon Cheng Shin Rubber USA, Inc. v. Dept. of Revenue, No. TC-MDC D (Ore. Tax Ct., Mar. 31, 2017) Taxpayer, a Georgia-based wholesale tire distributor, sold tires to an Oregon retail tire seller, repairer, and installer. Taxpayer s tires carried a limited warranty. Purchasers of tires were required to have defective or damaged tires covered by taxpayer s warranty inspected by an authorized dealer/distributor. If the authorized dealer/distributor finds the tire defective or damaged and covered by taxpayer s warranty, the dealer/distributor replaces the tire, issues a refund, or provides a discount toward a purchase of a new tire. Taxpayer may send a new tire to the dealer/distributor, but usually remits a monetary credit to the dealer/distributor. Taxpayer s activities in Oregon were limited to those permitted by Public Law Oregon dealer/distributor was an independent contractor and not a representative of taxpayer. However, Tax Court ruled that the performance of warranty repair services by the dealer/distributor were not entirely ancillary to requests for purchases and the performance of services exceeded the protections of Public Law

15 DIRECT TAX NEXUS CONTROVERSIES Flow-through Entities California Swart Enterprises, Inc. v. Franchise Tax Board, No. F (Cal. Ct. App., Jan. 12, 2017) Corporate member of LLC doing business in California held not doing business for purposes of California income and franchise tax. Member was engaged in no other business in California; held a 0.2 percent non-managing member interest. Ownership of a passive LLC interest held comparable to a limited partnership interest. FTB Legal Ruling rejected. California s $800 minimum franchise tax at issue. Case pre-dates California s adoption of economic factor-presence nexus effective with January 1, 2011 tax year. On February 28, 2017, the Franchise Tax Board issued FTB Notice announcing it would not appeal and indicating that if a taxpayer believes their situation has the same facts as in Swart, they should take that into consideration in determining if they have a return filing obligation and/or file a claim for refund, as appropriate. 15

16 DIRECT TAX NEXUS CONTROVERSIES Flow-through Entities New Jersey Preserve II, Inc. v. Director, Div. of Taxation, No (N.J. Tax Ct., Oct. 4, 2017) Corporate limited partner of limited partnership engaged in building and selling residential homes in NJ. Limited partner and general partner commonly owned by same parent corporation. In BIS LP, Inc. v. Director, Div. of Taxation (N.J. App. 2011), a passive corporate limited partner not engaged in the management or in the same line of business as the limited partnership was ruled not subject to NJ corporation business tax. Corporate limited partner in Preserve II distinguished from limited partner in BIS LP Key management responsible for the business of the limited partnerships were also officers in the limited and general partners. Court ruled the limited partner was not a passive investor because it had no authority to make, sell, or diversify investments. 16

17 DIRECT TAX NEXUS CONTROVERSIES Related Party Transactions Maryland Michigan Host, Inc. v. Comptroller of Maryland, No. 12-IN (Md. Tax Ct., Feb. 1, 2017) Michigan Host, a subsidiary of Host International, operates restaurants and retail space at airports and other facilities located outside Maryland. Comptroller issued an audit notice related to interest payments made by Host International to Michigan Host. Michigan Host failed to respond to the Comptroller s notice, which resulted in the Comptroller issuing tax assessments. Michigan Host argued that it had no nexus with Maryland and was not required to file Maryland corporation income tax returns. Maryland Tax Court found that Michigan Host lacked economic substance separate from its parent, Host International, based in Maryland. Consequently, the Tax Court found that Michigan Host had sufficient nexus with Maryland to require the filing of corporation income tax returns. 17

18 BUSINESS/APPORTIONABLE INCOME DEVELOPMENTS 18

19 BUSINESS/APPORTIONABLE INCOME DEVELOPMENTS Sales of Assets or Stock California Fidelity National Information Service, Inc. v. Franchise Tax Board, No. C (Cal. Ct. App., July 27, 2017) Taxpayer acquired 29 percent of the stock of an Indian IT services provider. As part of the deal, the taxpayer agreed to purchase $150 million of services from the Indian company. Taxpayer received three seats on the Indian company s board of directors. Arrangement did not go as planned and taxpayer sold its stock for a gain. California follows the transactional test and functional test interpretations of the definition of business income. Court ruled taxpayer and Indian company became integrated special relationship that provided valuable services to taxpayer s customers at lower cost to the taxpayer. Taxpayer also had some control, because its directors could veto some of the Indian company board s actions. However, taxpayer successfully argued the business/nonbusiness income determination must be made at the time of the decision to sell the property. Court remanded case to the trial court to determine whether the taxpayer and the Indian company remained integrated at the time the taxpayer decided to sell its stock. 19

20 BUSINESS/APPORTIONABLE INCOME DEVELOPMENTS Sales of Assets or Stock Indiana E.I. DuPont de Nemours and Company v. Indiana Dept. of State Revenue, No. 49T TA (Ind. Tax Ct., July 11, 2017) Taxpayer sold all of the stock of its pharmaceutical business generating a substantial gain. Indiana follows the transactional test and functional test interpretations of the definition of business income. Despite a number of other acquisitions and dispositions over the years by the taxpayer, the court rejected the Department s attempt to apply the transactional test to the stock sale. Manufacturing was the taxpayer s regular business, not the sale of subsidiaries. Court then ruled that, because the taxpayer operated and managed the pharmaceutical business as an independent, autonomous business unit, the taxpayer had not acquired, managed, and disposed of the business as an integral part of its regular business. 20

21 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS 21

22 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Status Market-Based Sourcing Market-Based Sourcing Market-Based Sourcing Market-Based Sourcing Where Benefit Received Where Service Received Where Service Delivered Where Customer Located Arizona (election) Connecticut Alabama Georgia California Illinois District of Columbia Maryland Iowa Maine Louisiana Nebraska Michigan Minnesota Massachusetts Oklahoma Missouri (election) New York New York City Rhode Island Montana Oregon Pennsylvania Tennessee Utah Wisconsin 22

23 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Status (cont d) Variety of State Approaches to Market-Based Sourcing 26 states now require or provide election to use market-based sourcing for corporate income tax purposes. General rules of sourcing services: Delivered to a location in the state Where benefit of the service is received Where receipts derived Hierarchy vs. Proportionate approach: Proportionate services receipts sourced in proportion to the benefit received by the recipient in the state. Hierarchy apply cascading rule; if cannot comply with rule, move to next. Examples of proportionate states: Georgia, Iowa, Michigan Examples of hierarchy states: MTC, California, Illinois, Massachusetts Key differences in hierarchy approaches can result in inconsistent sourcing results. 23

24 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Status (cont d) Variety of State Approaches to Market-Based Sourcing (cont d) Throw-out rules Look-thru rules for sales of services to customers of, or through, the customer Complex regulations vs. simple/general statutory standards Use of examples to illustrate (or implement) the rule Due diligence Some states impose specific due diligence requirements (e.g., New York) Contemporaneous record retention that explains the determination and method of sourcing services Document application of the hierarchy and determination to move to next priority rule Systems may need to be implemented or modified to conform Limitations/disclosure requirements on taxpayers when changing sourcing on future returns 24

25 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Developments The MTC Model Regulation MTC member states voted to approve the MTC s Model market-based sourcing regulations on February 24, Serves as the model for the Massachusetts, Rhode Island, and Tennessee market-based sourcing regulations. General rule of sourcing services: delivered to a location in the state. Throw-out rule. Look-through rule. Uses complex set of cascading rules to source sales of services. In-person services Professional services Services delivered to the customer or on behalf of the customer, or delivered electronically through the customer 25

26 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Developments (cont d) California Amended market-based sourcing regulations issued (18 Cal. Code Regs ) Provides sourcing rules for dividends and interest, gross receipts from sales of goodwill, and gross receipts from sales of marketable securities (for taxable years beginning on or after January 1, 2015). Dividends and receipts from sale of goodwill (if not excluded under 18 Cal. Code Regs ): - Distributing corporation or entity sold has 50% or greater tangible assets: source based on that entity s average property and payroll factors. - Distributing corporation or entity sold has 50% or greater intangible assets: source based on that entity s sales factor. Interest: - Interest from investments other than loans source to where investment is managed. - Interest from loans secured by real property sourced to location of the property. - Interest from unsecured loans sourced to borrower s location (commercial domicile?). Provides separate definitions and sourcing rules for sales of marketable securities by securities/commodities dealers and for non-dealers (assuming not excluded from sales factor by Cal. Rev. & Tax. Code 25120). Interested Parties Meeting Notice (Dec. 22, 2016) and the FTB s Discussion Topic Paper raised questions for discussion (on Jan. 20, 2017) on including/excluding dividends and sourcing of interest from business entity borrowers (commercial domicile?). 26

27 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Developments (cont d) California (con t) On Mar. 29, 2017, FTB issued Notice to provide late payment penalty relief due to the amended regulations retroactive January 1, 2015 effective date. FTB will presume reasonable cause and not wilful neglect if an underpayment results from the retroactive effect of the amended regulations. Taxpayers must request relief by filing form 2924 and including the following: Write Penalty Relief on the top of form 2924; Compute and explain the amount of the late payment attributable to the amended regulations; Identify the amount of the late payment penalty imposed and attach a copy of the notice received from the FTB showing the amount of the penalty imposed; and Enter zero for the refund amount if the form is being filed for prepayment relief of the late payment penalty. 27

28 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Developments (cont d) California (con t) Chief Counsel Ruling (April 7, 2017) Taxpayer provided health plan management services. Health plan enters agreements with its customers (typically employers or Plan Sponsors ) to provide health insurance services to the Plan Sponsors employees or members. The health plan can self-administer the services or outsource to the taxpayer to perform the services. The taxpayer s services were ruled to be non-marketing services because they do not market a product or other service. Under California s market-based sourcing regulations, the taxpayer s non-marketing services were: Sourced to where the taxpayer s direct customers (health plans) received the benefit of the services and not to where the Plan Sponsors or their employees/members received the benefit ( look-through rule was not applied). The benefit received by the health plan customers was the benefit of being relieved of the obligation to perform the health plan management services. The source of where the health plans were relieved of the obligation (i.e., the benefit) is to be determined using the regulations cascading rules, including a reasonable approximation. The ruling indicated that this location would be where the health plans would perform the services themselves, but for the taxpayer. 28

29 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Developments (cont d) Connecticut Special Notice 2017(1) (Apr. 17, 2017) Guidance issued to address market-based sourcing (and SSF) apportionment changes that are effective for taxable years beginning on or after Jan. 1, General rule: gross receipts for sales of services or licenses/sales of intangibles are sourced based on where the services/intangibles are used by the customer. Individual customer - Receipts from services that relate to property sourced to property location - Receipts from services that require physical presence of customer (i.e., in-person services) sourced to where services are performed - Receipts from all other services sourced to billing address of customer Business customer sourcing uses following hierarchy - Contract or taxpayer s books/records show where service is used - Method of reasonable approximation - Place of order - Billing address Look-through rule applies for intermediary transactions with a business customer 29

30 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Developments (cont d) Connecticut (con t) License of intangibles Individual customer billing address Business customer - Marketing intangibles generally sourced based on where underlying goods or services are sold based on license contract or taxpayer s books and records; may follow the business customer services sourcing hierarchy - Non-marketing or manufacturing intangibles generally sourced to place of use based on license contract or taxpayer s books and records; may follow the business customer services sourcing hierarchy - Mixed intangibles if royalties/fees are separately stated, then apply marketing and manufacturing intangibles sourcing, above; if not separately stated, then apply marketing intangibles sourcing 30

31 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Developments (cont d) Illinois 86 Ill. Admin. Code , , Amended market-based sourcing regulations The regulations generally align with prior statutory enactments sourcing of receipts from sales or licenses of patents, copyrights, trademarks and other intangibles interest income and receipts from sales of services. Additional interpretative guidance and examples of the regulations application are provided. The regulations also provide examples of receipts from occasional or isolated sales that are excluded from the sales factor, rules for petitions requesting an alternative method of apportionment, and rules for sales of electricity. In addition, the regulations eliminate Illinois' sales factor double throwback rule retroactive to tax years ending on or after December 31, 2008 The regulations are effective August 3,

32 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Developments (cont d) Montana H.B. 511 (May 3, 2017) Effective for taxable years starting after December 31, 2017, Montana will source receipts from services and licenses of intangibles using market-based sourcing instead of income-producing activity/costs of performance sourcing. Montana s statute follows the MTC model statute Services receipts are sourced based on the location of the market for the sales and the market for sales of services is the location of delivery of the service. Licenses of intangibles are sourced to where the intangible is used. - Marketing intangible is used where the marketed good or service is sold Sales of intangibles - Sale of intangible contingent on the productivity, use, or disposition of an intangible sourced as a license. - Sale of contract right, government license, or similar intangibles authorizing business in a specific geographic area sourced to states in that area. - All other receipts from sales of intangibles are excluded. If the taxpayer is not taxable in the state where receipts are sourced or if the sourcing cannot be determined, then a throw-out rule applies. 32

33 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Market-Based Sourcing Developments (cont d) Oregon S.B. 28 (July 3, 2017) Effective for taxable years beginning on or after January 1, 2018, Oregon will source receipts from services and licenses of intangibles using market-based sourcing instead of income-producing activity/costs of performance sourcing. Like Montana, Oregon s statute follows the MTC model statute However, the throw-out rule is not adopted. If the state or states of source cannot be determined, then a method of reasonable approximation is to be used to determine the source. 33

34 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Income-Producing Activity/CoP Sourcing South Carolina DIRECTV, Inc. v. S.C. Dept. of Revenue, No (S.C. Ct. App., Aug. 30, 2017) Taxpayer provides direct-to-home digital television entertainment via satellite. Taxpayer argued that receipts from subscription services should be sourced using cost of performance rather than SC income-producing activity sourcing. Taxpayer argued that its income-producing activity was content development, marketing, broadcast operations, and customer service. Department argued these activities were preparatory in nature and that Taxpayer s actual income-producing activity was the delivery of the television service to the customer s home or business. Court found that Taxpayer s claimed income-producing activities were anticipatory activities (done in anticipation of future profit), not Taxpayer s income-producing activity, which was the delivery of the signal to the customer. 34

35 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Income-Producing Activity/CoP Sourcing (con t) Wisconsin Microsoft Corp. v. Dept. of Revenue, No. 13-I-042 (Wis. Tax App. Comm., Aug. 10, 2017) Microsoft licensed software to original equipment manufacturers ( OEMs ) for installation on computer models and systems assembled by OEMs. OEMs paid a royalty to Microsoft based upon either the number of specific computer models manufactured or the number of copies the OEMs made of Taxpayer s software regardless of whether the software was actually loaded onto a computer or whether the computer was sold. Department of Revenue adjusted Taxpayer s sales factor to include receipts from OEMs to the extent that OEMs sold computers to customers located in Wisconsin on the basis that the receipts are from the use of software in Wisconsin. Tax Appeals Commission found that OEMs did not use the software and that the royalties should be sourced as sales other than sales of tangible personal property. For the years at issue (prior to Wisconsin s adoption of market-based sourcing), Microsoft s incomeproducing activity and costs of performance had no connection to Wisconsin. 35

36 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Single Sales Factor Formulas Majority of corporate income/franchise tax states now require or provide an election to apportion income using a single sales factor ( SSF ) formula. Delaware phasing in 2016 and full SSF in 2020 tax year (H.B. 235). North Carolina phasing in starting 2016 and full SSF 2018 tax year (S.B. 97). Tennessee IMPROVE Act (H.B. 534) provides SSF election for manufacturers effective for taxable years beginning on or after January 1, Enacted April 27,

37 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS SSF as the General Formula* Arizona (election) Indiana New York California Iowa New York City (2018) Colorado Louisiana North Carolina (2018) Connecticut Maine Oregon Delaware (2020) Michigan Pennsylvania District of Columbia Minnesota Rhode Island Georgia Missouri (election) South Carolina Illinois Nebraska Texas Indiana New Jersey Wisconsin *States may require SSF apportionment for specific industries (e.g., financial institutions, transportation companies, etc.). Maryland and Massachusetts require manufacturers to use SSF. Mississippi and Virginia require retailers to use SSF. Tennessee, Utah and Virginia provide an election to manufacturers to use SSF. 37

38 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS SSF Developments Massachusetts Genentech, Inc. v. Comm r of Revenue, No. SJC (Mass. Supreme Jud. Ct., Jan. 12, 2017) Biotechnology company treated as a manufacturer required to use the SSF. Genetic transformation of living cells in order to extract desired proteins used in pharmaceuticals qualified as manufacturing. Because 25 percent or more of the taxpayer s gross receipts were derived from products that it manufactured, the taxpayer was a manufacturer. Gross receipts calculation excluded taxpayer s gross receipts from its cash management and treasury investing activities. 38

39 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS SSF Developments (con t) Utah S.B. 132: Effective for taxable years beginning on or after January 1, 2018, taxpayers with greater than 50% of their total sales from automobile manufacturing (NAICS Code ) will be required to use the SSF for apportioning income to Utah. H.B. 61: Optional sales factor weighted taxpayers (computer and electronic product manufacturers under NAICS subsector code 334) having greater than 50% of total sales from such manufacturing may elect to use the SSF each taxable year. The election must be made by the original or extended due date for the taxable year s return. Law change is effective for taxable years beginning on or after January 1,

40 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Alternative Apportionment Formulas Colorado Target Brands, Inc. v. Dept. of Revenue, No. 2015CV33831 (Colo. Dist. Ct., Jan. 27, 2017) See economic presence nexus holding, above. Trial court rejected Department of Revenue s use of a single sales factor alternative apportionment formula. For tax years at issue ( ), Colorado used a three-factor formula (two-factor could be elected). Party invoking alternative, must show (a) the standard formula does not fairly reflect in-state business activity, and (b) the alternative formula is reasonable. Zero apportionment established that standard formula did not fairly reflect business activity. Sourcing receipts to location of use of intangibles, not costs of performance, also fairly reflected business activity. However, single sales factor formula was not reasonable, because the taxpayer s property and payroll made material contributions to the production of income. 40

41 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Alternative Apportionment Formulas (con t) Minnesota Associated Bank, N.A. v. Comm r of Revenue, No R (Minn. Tax Ct., Apr. 18, 2017) From 2007 through 2013, Minnesota phased in a SSF, including for financial corporations. Financial corporation property factor included loans and the sales factor included interest income; general business corporation property factor did not include intangibles and sales factor did not include interest income. Bank created two LLCs (taxed as partnerships) to hold Minnesota loans and receive interest income from Minnesota borrowers. Bank filed Minnesota unitary combined report; each unitary group member s factors computed separately according to formula applicable to that member. LLCs not allowed or required to use financial corporation apportionment formula. Therefore, loans were not included in LLCs property factors and interest income not included in LLCs sales factors that passed through to taxpayer and affiliated member of LLCs. The LLC structure reduced the combined group s Minnesota apportionment and taxable income. Citing HMN Financial, Inc. v. Comm r of Revenue, 782 N.W. 2d 558 (Minn. 2010), the Tax Court held: Taxpayer s Minnesota tax planning motivation insufficient to invoke alternative apportionment; and Despite the tax motivation, it was up to legislature to close the loophole. 41

42 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Alternative Apportionment Formulas (con t) Minnesota (con t) Associated Bank, N.A. v. Comm r of Revenue Oral arguments before the Minnesota Supreme Court were held on November 1, H.F. 1 Effective for tax years starting on or after January 1, 2017, any entity owned more than 50 percent by a financial institution will be included in the definition of financial institution. 42

43 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Alternative Apportionment Formulas (con t) New York Matter of Bayerische Beamtenkrankenkasse AG, DTA No (N.Y. Tax Apps. Trib., Sept. 11, 2017) German-based non-life insurance company with NY and US business limited to participation in two real estate partnerships. Insurance company was not authorizes to do an insurance business in NY. Insurance company s K-1 income was ECI for federal income tax purposes, but the company had no US source insurance premiums income. Tribunal first held the insurance company was not taxable under the Insurance Franchise Tax (on gross premiums) under N.Y. Tax Law 1502-a. Rather, company was subject to tax under N.Y. Tax Law 1501 as an alien insurance company using an entire net income base and three other bases for the audit years, including a two-factor apportionment formula of premiums and payroll. Insurance company had no US premiums and nominal payroll Division of Taxation allowed to apply an alternative apportionment formula under Matter of British Land v. Tax Apps. Trib. (NY 1995). Statutory formula did not properly reflect the insurance company s business activities because of the zero premiums factor. Payroll factor alone insufficient because only weighted 10%. The use of the general corporate franchise tax formula was reasonable, including limiting the factor amounts to US source amounts. 43

44 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Alternative Apportionment Formulas (con t) New York (con t) Matter of Bayerische Beamtenkrankenkasse AG However, insurance company successfully argued the use of an alternative apportionment formula was discriminatory under the U.S.-German Income Tax Treaty. Article 24 of the US-German Income Tax Treaty (and most US tax treaties) prohibits subjecting national or sub-national taxation that is other or more burdensome than the taxation and connected requirements to which nationals of that other State in the same circumstances are or may be subjected. Other or more burdensome does not mean less favourable taxation. The use of an alternative apportionment formula, and exclusion of worldwide factors, was other or more burdensome vis-àvis the German-based insurance company than US-based insurance companies would be subject. 44

45 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Other Apportionment Developments Massachusetts Technical Information Release, TIR 17-7 (Aug. 25, 2017) Department of Revenue announced a change in policy regarding the calculation of the non-income measure of the Massachusetts corporate excise tax by a non-us corporation that is subject to tax in Massachusetts but has one or more items of US tax treaty-exempt income. The treaty-exempt income will now be excluded from the computation of the non-us corporation's separate company apportionment percentage for the non-income measure. Change will be applied prospectively and to all open years. 45

46 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Other Apportionment Developments (con t) New Jersey General Foods Credit Investors #3 Corp. v. Director, Div. of Taxation, No (N.J. Tax Ct., Feb. 22, 2017) Taxpayer entered a leveraged sale-leaseback transaction with the New Jersey Transit Corp. ( NJT ) known as a SILO transaction (sale-in/lease-out). NJT leased 843 buses to the taxpayer (treated as a conditional sale ) for a 37 year term (buses had 25 year useful life) pursuant to a head lease. The taxpayer leased back the buses to NJT through a sub-lease with a year term (treated as a true lease). NJT responsible for costs of operating, insuring, and maintaining the buses. The purpose of the SILO was to transfer federal tax benefits to the taxpayer with no intention of using the buses in the taxpayer s business operations. Buses were excluded from the taxpayer s New Jersey property factor. 46

47 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Other Apportionment Developments (con t) New Jersey Elan Pharmaceuticals, Inc. v. Director, Div. of Taxation, No (N.J. Tax Ct., Feb. 6, 2017) Receipts excluded from another state s sales factor because inclusion was potentially distortive were not required to be excluded from the New Jersey sales factor under the former throw-out rule. Throw-out rule was effective from 2002 to Large capital gain from sale of intellectual property and employee rights in an anti-fungal medication were excluded from other state sales factors as distortive. 47

48 INCOME/FRANCHISE TAX APPORTIONMENT TRENDS Other Apportionment Developments (con t) Texas Letter No L (July 7, 2017) Texas Comptroller of Public Accounts announced a change in its policy regarding the treatment of net losses from the sale of investments and capital assets in calculating gross receipts for apportionment purposes. Change results from the Texas Supreme Court's decision in Hallmark Marketing Co. v. Hegar (2016). A net loss from the sale of all investments and capital assets will now not be included in the denominator of the taxpayer's Texas receipts factor ("gross receipts everywhere") and a net loss from the sale of all Texas investments and Texas capital assets is not included in the numerator ("Texas gross receipts"). To determine gross receipts everywhere, all gains and losses from all sales of investments and capital assets within the accounting period are added together to determine the net gain or net loss. Thus, if the combination results in a net loss, the gross receipts everywhere are zero. Texas gross receipts are determined by adding together Texas gains and losses from sales of Texas investments and Texas capital assets. If the combination results in a net loss, the entity Texas gross receipts are zero. 48

49 UNITARY COMBINED REPORTING & FILING OPTIONS 49

50 UNITARY COMBINED REPORTING Judicial and Administrative Developments California FTB Notice (Oct. 16, 2017) Extends FTB Notice (Sept. 9, 2016) for unitary foreign affiliates that become California taxpayers where the unitary group has a California water s-edge election in effect to taxable years starting on or before December 31, California taxpayers of a water s-edge combined group must consent to the water s-edge election Failure to consent could terminate election. Unitary foreign affiliates are generally excluded from the water s-edge group (subject to certain exceptions), but can become a non-consenting member because of California s economic/factor presence nexus statute. Under FTB Notice , if certain conditions met, the unitary foreign affiliate is deemed to have consented to the water s-edge election, but only if the foreign affiliate became a California taxpayer in a taxable year ending on or before December 31, FTB Notice now extends the relief to taxable years starting on or before December 31,

51 UNITARY COMBINED REPORTING Judicial and Administrative Developments (con t) California FTB Chief Counsel Ruling (Sept. 8, 2017) Addresses the effect on a California water s-edge election when a merger or acquisition occurs. When a water s-edge taxpayer (as acquirer or target) is involved in a merger or acquisition with a nonelecting water s-edge taxpayer, the non-electing taxpayer is deemed to make a water s-edge election if the value of its total business assets of the electing taxpayer are greater than those of the nonelecting taxpayer. CRTC 25113(c)(2). If the non-electing taxpayer s total business assets are greater in value, then the California water s-edge election is automatically terminated. Unitary foreign affiliates are generally excluded from the water s-edge group (subject to certain exceptions), but can become a non-consenting member because of California s economic/factor presence nexus statute. In Chief Counsel Ruling , the FTB ruled that the goodwill of the target (revalued at FMV for financial accounting purposes) is included in the target s total business assets. Target was a water s-edge electing taxpayer. Acquirer was a non-electing taxpayer. Inclusion of the value of target s goodwill caused the value of its total business assets to be greater than the value of the acquirer s and the acquirer was deemed to have made a water s-edge election. 51

52 UNITARY COMBINED REPORTING Judicial and Administrative Developments (cont d) California ComCon Production Services I, Inc. v. Franchise Tax Board, No. B (Cal. Ct. App., Dec. 14, 2016) Parent (cable TV system operator) and subsidiary (cable TV network) held not engaged in a unitary business. Entities shared overlapping officers and directors, parent s cable system carried subsidiary s programming, and parent received service fee income from the subsidiary. Court of Appeal held centralized management was lacking, because subsidiary s day-to-day operations and strategic business decisions were made solely by subsidiary management. Entities were not vertically integrated because programming and service fee income was pursuant to standard contracts used by the parent with other unrelated cable TV networks. On a separate issue, a merger termination fee received by the parent s unitary group was held to be apportionable, business income. 52

53 UNITARY COMBINED REPORTING Judicial and Administrative Developments (cont d) Colorado Agilent Technologies, Inc. v. Dept. of Revenue, No. 16CA0849 (Colo. Ct. App., Nov. 2, 2017) U.S. holding company owned interests in four foreign entities that were treated as disregarded entities for federal income tax purposes. The foreign entities had property and payroll, but the holding company did not. U.S. holding company used administrative staff and office equipment of its parent to fulfil corporate formalities, complete loan applications, and draft share purchase agreements. The parent filed a Colorado unitary combined report, but excluded the holding company. Court of appeals ruled that the holding company did not own or rent and had no legal interest in its parent s office equipment. The holding company was not the employer of the administrative staff. As a result, the holding company was not an includible C corporation because it did not have 20% or more of its property and payroll assigned to U.S. locations. Colorado will also exclude an 80/20 company from a combined report (80% or more of property and payroll assigned to overseas locations.) However, the court of appeal reasoned that a federal election could not be used to exclude an entity from a combined report. 53

54 UNITARY COMBINED REPORTING Judicial and Administrative Developments (cont d) Michigan LaBelle Management, Inc. v. Dept. of Treasury, No (Mich. Supreme Ct., Jan. 24, 2017) The Michigan Supreme Court declined to review the Court of Appeals decision in LaBelle Management, Inc. v. Dept. of Treasury, No (Mich. Ct. App. Mar. 31, 2016.) Two brothers each owned no more than a 50% direct interest in taxpayer, another corporation, and a partnership. Michigan unitary business ownership requirement: Direct or indirect ownership of more than 50%. Court of Appeals held indirect ownership does not mean constructive ownership; rather, it means ownership of stock through an intermediary. Taxpayer, other corporation, and limited partnership could not be unitary. The Court of Appeals decision had been stayed; now binding precedent. On February 28, 2017, the Department of Treasury issued a Notice regarding LaBelle Department will apply LaBelle retroactively to all open tax years. Decision eliminates constructive ownership or ownership by attribution as a means of satisfying the unitary ownership and control test. Applies to former Michigan Business Tax and current Corporate Income Tax. 54

55 UNITARY COMBINED REPORTING Judicial and Administrative Developments (cont d) Minnesota Ashland, Inc. v. Comm r of Revenue, No. A (Minn. Supreme Ct., Aug. 2, 2017) Minnesota Supreme Court affirmed the decision of the Minnesota Tax Court. Minnesota conforms with the federal income tax treatment of single member LLCs as disregarded entities. Foreign operations of the taxpayer were conducted using legal entities that were treated as disregarded entities for federal income tax purposes. Court rejected the Department of Revenue s policy that the revenues and factors of any foreign entity are excluded from a Minnesota water s-edge combined report. The taxpayer prevailed and the net income (or loss) and apportionment factors of foreign entities that are treated as disregarded entities for federal income tax purposes are included in the Minnesota combined report. 55

56 UNITARY COMBINED REPORTING 2017 Legislation Oregon S.B. 30 (May 30, 2017) Allows the Department of Revenue to consider the role of foreign affiliates when making the determination of whether two or more domestic U.S. affiliates included in the same federal consolidated return are engaged in a unitary business. Prior to the legislation, unitary entities were determined by whether the corporations were doing business in the United States and if they were subject to federal income tax. 56

57 UNITARY COMBINED REPORTING Joyce or Finnigan? Oregon Capital One Auto Finance, Inc. v. Dept. of Revenue, T.C (Ore. Tax Ct., Dec. 23, 2016) Out-of-state financial institutions held to have nexus with Oregon under the significant economic presence test, regardless of no physical presence with Oregon. Entities (and their net income) were already included in an Oregon consolidated return filed by another affiliate that had Oregon physical presence. Why did the Department of Revenue want the out-of-state financial institutions to have Oregon nexus? Answer: Joyce. Successful assertion of economic presence nexus resulted in the out-of-state financial institutions gross receipts sourced to the Oregon consolidated group s Oregon sales factor numerator. 57

58 UNITARY COMBINED REPORTING Joyce or Finnigan? Texas Letter No L (Sept. 12, 2017) Holding company was a member of a Texas unitary combined group, but had no nexus with Texas. Holding company sold all of its stock in another affiliate in a transaction in which the parties made an IRC 338(h)(10) election to treat the stock sale as an asset sale. For Texas apportionment purposes, the transaction was treated as a stock sale and the net gain is included in the Texas gross receipts factor denominator of the Texas unitary combined group. Texas follows Joyce, and the net gain was excluded from the group s gross receipts factor numerator because the holding company did not have stand-alone nexus with Texas. 58

59 WATER S-EDGE UNITARY COMBINED REPORTING Tax Havens Tax Haven Rules New: Alaska, Connecticut (2016), DC, Montana, Oregon, Rhode Island, and West Virginia. Blacklist approach: State s statute lists specific foreign countries as tax havens (MT, OR) and depends on whether the foreign corporation is incorporated in that jurisdiction. CT and DC eliminated their blacklist approach, but still include tax haven corporations in the water s-edge combined group. Criteria-based approach: Foreign country has no or a nominal tax on net income and has laws that prevent exchange of information, lacks transparency, substantive local presence not required, or has created a regime favorable for tax avoidance (CT, DC, RI, WV). MTC Model Combined Reporting Statute Alaska approach: Foreign country with no income tax or that imposes a rate that is 90% of the U.S. rate. 59

60 FILING OPTIONS Florida Technical Assistance Advisement, TAA 17(C)1-0XX (July 10, 2017) Once a Florida consolidated return election is made, the group must continue filing a Florida consolidated return as long as the taxpayer(s) remain members of the same affiliated group and file a federal consolidated return. The Department of Revenue may grant permission to cease filing a Florida consolidated return if good cause exists. The factors of good cause are listed in Rule 12C (3)(b), including changes in law or circumstances, including changes which do not affect income tax liability. The Department ruled that the taxpayer s overall restructuring, growth, and expanding markets were a sufficient change in business circumstances to constitute good cause to cease filing a Florida consolidated return. 60

61 FILING OPTIONS Iowa Myria Holdings, Inc. & Subsidiaries v. Iowa Dept. of Revenue, No (Ia. Supreme Ct., Mar. 24, 2017) Parent corporation based in Texas held stock in several subsidiaries doing business in Iowa, an 80% interest in an LLC doing business in Iowa, and the sole interest in a SMLLC doing business in Iowa. Iowa provides an election to file a nexus consolidated return; an Iowa affiliate must have taxable income from Iowa to join in the return. Iowa Supreme Court held that the parent was not includible in the Iowa nexus consolidated return. Parent s performance of management, administrative, and other corporate services in Texas did not constitute doing business in Iowa. Receipt of dividend income from subsidiaries was not income derived from Iowa sources. Taxpayer apparently did not argue that flow-through Iowa nexus from the LLCs (one taxed as a partnership for federal purposes and the other as a DRE for federal purposes) gave the parent nexus. Court did not address flow-through nexus. Court distinguished KFC Corp. v. Iowa Dept. of Revenue, 792 N.W. 2d 308 (Ia. 2010) parent did not receive royalties, license fees, or other earned fees in connection with an integral aspect of the affiliated group s business activities. 61

62 FILING OPTIONS Iowa Romantix Holdings, Inc. v. Iowa Dept. of Revenue, No (Ia. Supreme Ct., May 3, 2017) Ownership of intangible property by a non-iowa parent holding company that was used by subsidiaries in Iowa did not constitute doing business in Iowa for purposes of allowing the parent to be included in an Iowa nexus consolidated return. The Iowa Supreme Court also ruled that the Iowa subsidiaries were not entitled to deduct certain amortization expenses paid by their parent. 62