Ohio Tax. Workshop Q. Advanced: Multistate Apportionment Trends, Pitfalls & Opportunities. Tuesday, January 26 3 p.m. to 4 p.m.

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1 25th Annual Tuesday & Wednesday, January 26 27, 2016 Hya Regency Columbus, Columbus, Ohio Ohio Tax Workshop Q Advanced: Multistate Apportionment Trends, Pitfalls & Opportunities Tuesday, January 26 3 p.m. to 4 p.m.

2 Biographical Information Bob Woolley, Partner, Plant & Moran, PLLC 65 East State Street Suite 600, Columbus, OH Bob has more than 22 years of focused experience in state and local tax issues serving a diversified client base focusing on a wide range of industries from manufacturing to service companies. Bob currently serves as the leader of the State and Local Tax practice for Ohio, specializing in State and Local Tax matters, including sales and use tax as well as income and franchise taxes. His experience has given him a thorough knowledge of Michigan and Ohio taxation as well as multi-state taxation and planning. Bob is also a regular speaker at both internal and external technical trainings. Education Walsh College, Masters of Science in Taxation Michigan State University, Bachelor of Arts, Accounting Professional and Community Activities American Institute of Certified Public Accountants Michigan Association of Certified Public Accountants SALT Task Force Member ( ) Ohio Society of Certified Public Accountants Planning Committee for Ohio Tax Conference Tax Policy Committee of the Ohio Manufacturers Association 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. Mitchell A. Newmark, Partner, Morrison & Foerster LLP 1290 Avenue of the Americas New York, NY mnewmark@mofo.com Fax: Mitchell A. Newmark s practice is concentrated on state and local tax litigation and appeals before administrative and judicial bodies around the country. Mr. Newmark also advises companies and individuals with respect to sophisticated transactional matters involving the potential consequences of complex restructurings, planning transactions, and energy-industry financing transactions regarding all state and local taxes. He has written extensively in the area of state and local taxation and is also a frequent lecturer concerning state and local taxes. Prior to joining Morrison & Foerster, Mr. Newmark was a Deputy Attorney General of the New Jersey Attorney General s Office. In this capacity, he defended and counseled the Division of Taxation in Corporation Business Tax and Gross Income Tax matters. As part of his duties, he also counseled and defended the Commissioner of Banking and Insurance in complex financial services company conversions. Mr. Newmark is a member of the New Jersey Supreme Court Committee on the Tax Court. He is Chair of, and a member of the Executive Committee of, the Tax Section of the New Jersey Bar Association, and is a Co-Chair of the State Practice, Procedure and Liaison Committee of the Tax Section of the New Jersey Bar Association. Mr. Newmark graduated from Widener University School of Law, cum laude, where he was a board member of the law review, the Delaware Journal of Corporate Law. He also has an LL.M. in Taxation from Georgetown University Law Center and an M.B.A. from Rutgers University Graduate School of Management.

3 25th Annual Ohio Tax Conference (Workshop Q) Multistate Apportionment Trends, Pitfalls and Opportunities Tom Cornett, Deloitte Tax LLP Mitchell Newmark, Morrison & Foerster LLP Robert Woolley, Plante Moran PLLC January 26,

4 Presentation Outline Basics What is a sale when discussing apportionment Cost of Performance Market-Based Multistate Tax Compact Alternative Apportionment Industry Specific Recent Developments Covered throughout Examples 2

5 Basics What is a Sale? Sales tend to come from three categories: Sales of services Licensing of intangibles Sale of tangible property [real property or personal property (TPP)] Sales in ordinary course of business, i.e. inventory Sale of assets outside of ordinary course of business Capital asset or investment? Included or excluded? If included, net gains or gross proceeds? 3

6 Basics What is a Sale? What happens when you are not sure if it is a sale of a service or sale tangible property? Look at case law Look at sale contracts, etc. Consider nature of sale, i.e. what is customer really looking to receive? 4

7 Basics Cost of Performance The General Rule: Sales, other than sales of tangible personal property, are in this State if: (a) the income-producing activity (IPA) 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. (UDITPA, Article IV, Section 17) Costs of Performance Defined No Bright Line Test Taxpayer s costs as determined in a manner consistent with GAAP or the taxpayer s trade or business Common costs include wages, taxes, interest, depreciation, costs of materials consumed, etc. Direct costs versus indirect costs 5

8 Basics Cost of Performance COP approaches o Preponderance (all or nothing) source solely to state in which plurality of COP occurs o Proportionate (pro rata) source to each state in which COP occurs, or by some other measure of the service provider s activity o Time spent source to each state in which personnel perform services (particularly popular with personal services ) Costs defined MTC defines as direct costs determined in a manner consistent with generally accepted accounting principles and in accordance with accepted conditions or practices in the trade or business of the taxpayer. 6

9 Basics Cost of Performance What is an IPA? Transactions and activity directly engaged in by a taxpayer in the regular course of business for the ultimate purpose of obtaining gains or profits In certain instances, an IPA will lead to multiple sales because the IPA in each state will be deemed a separate IPA, e.g. personal services IPA s include the rendering of personal services by employees; use of tangible and intangible property in performing a service; the leasing, licensing, or other use of tangible personal property; and the sale, licensing, or other use of intangible personal property Generally, an IPA will not include activities performed on the taxpayer s behalf, e.g. those conducted by an independent contractor (though some states follow the MTC regulation as amended in 2007) The location of the ( IPA ) generally controls sourcing 7

10 Basics Cost of Performance When an IPA takes place in more than one state UDITPA says state with the greater proportion of the IPA based on COP gets the sale ( all or nothing rule ) Note that the MTC regulations and UDITPA are inconsistent MTC regulations do not provide an all or nothing approach, but split receipts based on where the work is performed, i.e. each service is a separate IPA When doing business in multiple states, some of which follow the MTC regulations, the result can be either > or < 100% of sales being included amongst the states Many states have modified provisions such that in order to be sourced to the state, COP has to be greater in-state than out-of-state, i.e. > 50% MTC voted in July 2014 and approved proposed amendments to adopt Market Based 8

11 Basics Cost of Performance Practical considerations Look at as multiple IPA s or as a single IPA? If possible, break down IPA s so that apportionment rules in each state are beneficial (i.e., search for nowhere sales) Where there is little guidance in a state, consider whether aggressive position may be supportable or requesting a ruling from the state What rules do the states involved use, could the taxpayer be whipsawed by inconsistent positions between these states or will there be a benefit? 9

12 Basics Market-Based The General Rule: Sales, other than sales of tangible personal property, are sourced to the state if the market for the sale is located in the state 10

13 Basics Market-Based Legislative Adoption of Market-Sourcing Principles Alabama Arizona (elective starting 2014) California Georgia Illinois Iowa Maine Maryland Massachusetts (2014) Michigan (MBT and CIT, not Individuals) Minnesota Missouri (effective August 28, 2015) Nebraska (2014) New York (2015) New York City (2015) Ohio (CAT) Oklahoma Pennsylvania (2014) Rhode Island (2015) Tennessee (July 1, 2016) Utah Washington (B&O) Washington D.C. (2015 pending) Wisconsin 11 Copyright 2013 Deloitte Development LLC. All rights reserved.

14 Basics Market-Based One approach to market-based sourcing is to source receipts of services to "where the customer receives the benefit" of the services performed. 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 the 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 billing and/or domiciled? What level of analysis is required by a seller? Consider complex services that appear to benefit an entire organization Where is the benefit received if the customer/client is a multistate (or multinational) company? Cloud computing services Accounting and legal services MTC amendment to Article IV, Section 17 adopted July 30, 2014 replaces costof-performance provisions with market-based sourcing rule for services and intangibles. Services are sourced based on where the service is delivered Intangibles are sourced based on use Certain intangible receipts (e.g. hedging/treasury receipts) are excluded from the numerator and denominator 12

15 Basics Multistate Tax Compact (MTC) In general, member states sign the Multistate Tax Compact under terms that require that require the state to adopt the provisions of UDITPA One such provision permits taxpayer to annually elect to apportion income using the rules of UDITPA in lieu of state apportionment rules: Election only applies to net income taxes. The election does not apply to activity of a financial or public utility Many states have statutorily modified the apportionment rules in UDITPA or have statutory provisions that override the rules of UDITPA Key provisions of UDITPA that may differ from state apportionment rules include: o Equally-weighted, three-factor apportionment formula; no super weighted sales factor o Cost-of-performance for sales of non-tpp; no market sourcing o Traditional business v. nonbusiness income definition 13

16 Basics MTC Litigation Update Minnesota Kimberly-Clark Corporation & Subsidiaries v. Commissioner of Revenue (Minn. Tax Court Docket No R, June ). The Minnesota Tax Court assumed (without deciding) that the Compact was a contract among Minnesota and the other States that adopted it and that the Compact created binding obligations. However, no Compact provision constitutes a clear and unmistakable promise to refrain from using the State s sovereign power to alter the apportionment election provided by Articles III and IV. Thus, the Minnesota Legislature s 1987 repeal of Articles III and IV of the Multistate Tax Compact (Compact) was valid and did not substantially impair a binding contractual obligation. Oregon: Health Net, Inc. and Subsidiaries v. Department of Revenue, (Or. Tax, Sept. 9, 2015.) The Oregon Tax Court held that the Oregon Legislature effectively disabled the ability of taxpayers to make an election under the Multistate Tax Compact to use the equally-weighted three-factor apportionment formula. The Tax Court also ruled that the enactment of Or. Rev. Stat did not violate any procedural or substantive provision of the Oregon Constitution, and did not violate the federal Compact Clause or the federal Contract Clause of the U.S. Constitution. 14

17 Basics MTC Litigation Update Texas: On July 28, 2015, the Texas Court of Appeals held that taxpayer was not entitled to use the Multistate Tax Compact s evenlyweighted, three-factor apportionment formula to compute the Texas Margin Tax. Instead, the Court of Appeals ruled that the taxpayer was required to use the single factor formula in Texas Tax Code section (a). 15

18 Basics MTC Litigation Update California Gillette decision: Gillette Company, et. Al. v. California Franchise Tax Board, No. S (Cal. 2015) On December 31, 2015, the CA Supreme Court (Court) unanimously reversed the CA Court of Appeal s decision from 2012 and denied the taxpayers election to change their corporation franchise tax apportionment formula to apply provisions of the Multistate Tax Compact ( Compact ). The taxpayers had sought to use the equally weighted, three-factor apportionment formula (property, payroll, sales) available under the Compact Election in lieu of the three-factor formula with double-weighted sales provided in California Revenue & Taxation Code. The Court held that the Compact was not a binding reciprocal agreement among the member states; thus, the CA legislature may eliminate the Compact s election provision. The Court applied a four-factor test derived from Northeast Bancorp v. Board of Governors, FRS, 472 U.S. 159 (1985) : Whether the Compact created reciprocal obligations among the member states, Whether the Compact s effectiveness depended on the conduct of the other members, Whether any provision prohibited unilateral member action, and Whether a joint organization or body had been established to regulate the members The California Supreme Court s decision is not yet final. 16

19 Basics MTC Litigation Update Michigan 2014 IBM decision: IBM vs. Michigan Dep t of Treasury, No (Mich. Sup. Ct. July 14, 2014) On July 14, 2014, a four justice majority of the Michigan Supreme Court reversed an earlier Michigan Court of Appeals decision and held that the enactment of the MBT did not repeal by implication the Compact election provision provided in Michigan s Revenue Act The Michigan Supreme Court also held that the MGRT element of the MBT fit the Compact s broad definition of an income tax Three member dissent (including the Chief Justice) would have held that repeal by implication did not apply and would have rejected the conclusion of the California Court of Appeal in Gillette that the Compact was a binding interstate compact (based on constitutional and contract law considerations) which a member state could not alter On November 14, the Michigan Supreme Court denied Treasury s motion for rehearing. 17

20 Basics MTC Litigation Update Michigan Retroactive Compact Repeal Legislation and 2015 Gillette decision: On September 12, 2014, Michigan Governor Snyder signed Public Act 282 of 2014, which retroactively repealed the entire Multistate Tax Compact section of Michigan s tax laws, effective January 1, On September 29, 2015, the Michigan Court of Appeals in Gillette et. al. upheld PA 282 and rejected Compact-based MBT refund claims in numerous pending cases. The Court held: The Compact was merely advisory and not a binding contract under federal compact law or Michigan law. The taxpayers have no vested interests in the continuance of tax legislation and under United States v. Carlton, 512 U.S. 26 (1994), the period of retroactivity is rationally related to the Legislature s legitimate purpose of protecting state revenues Characterized Michigan's active membership in the Multistate Tax Commission since January 1, 2008 as irrelevant. Affected taxpayers have sought leave to appeal to the Michigan Supreme Court 18

21 Basics Alternative Apportionment Constitutional Aspects of Fair Apportionment Out of All Appropriate Proportion: Hans Rees Sons v. North Carolina ex rel. Maxwell, 283 U.S. 123 (1931). United States Supreme Court held that a taxpayer has a constitutional right to alternative apportionment when the income apportioned to a state is out of all appropriate proportion to the activities conducted by the taxpayer in the state. The Constitution does not provide state revenue departments with a right to alternative apportionment. A state s authority to use alternative apportionment (other than to remedy situations that result in unconstitutional distortion to the detriment of a taxpayer) derives from state statutes and case law. 19

22 Basics Alternative Apportionment UDITPA and MTC: Many states have adopted UDITPA Section 18 and the MTC Model Regulations regarding UDITPA Section 18. UDITPA Section 18: If the allocation and apportionment provisions of this Article do not fairly represent the extent of the taxpayer s business activity in this state, the taxpayer may petition for or the tax administrator may require, in respect to all or any part of the taxpayer s business activity, if reasonable: o Separate accounting Exclusion of any one or more of the factors Inclusion of one or more additional factors which will fairly represent the taxpayer s business activity in the state; Use of another method to effectuate an equitable allocation and apportionment of the taxpayer s income. Taxpayer may apply for relied or the taxing authority may apply on its own initiative 20

23 Basics Industry-Specific MTC has adopted model industry-specific apportionment regulations: Airlines, construction contractors, financial institutions, railroads, telecommunications, trucking companies, TV and radio broadcasting, and publishing. MTC asserts that UDITPA Section 18 (MTC, Article IV) allows a state taxing authority to adopt industry-specific regulations that vary from the state s standard statutory method. 21

24 Example - 1 Facts: ABC is a service company that is taxable in States Y and Z. Both states use sales-only 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 marketbased approach? 22

25 Example - 1 (cont) Apportioned Income Costs of performance Market-based rule State Y taxable income $100 million x 100% (40%) $100 million $40 million State Z taxable income (using COP) $100 million x 0% Total taxable income $100 million $40 million Nowhere income None $60 million 23

26 Example 2 - Legal Services During calendar year 2015, an attorney in Michigan represented a client based in California at a trial that took place in New York. The attorney spent time related to the case in each state in the following percentages; MI 60%, NY 30%, and CA 10%. The fees at issue for the tax year are $1,000,000, and were the only receipts for the entire year. Cost of performance would mirror the time spent. Litigation relates to a California location for the client. How do you source the revenue between the three states? 24

27 Example 2 - Legal Services (cont) MI could seek100%. Assuming all partners are individuals, use COP rules with all or nothing test if Michigan is greater than all other states. CA could seek100%. California sources based on the benefit received of the service and since benefitting a CA client, presume CA would source to that location. NY could seek100%. Beginning in 2015, New York uses a hierarchy of 1. benefit received in the state, 2. delivery destination. Likely argued that benefit received in the state, but likely deemed delivery in the state with trial being held in state. 25

28 Example 3 - Consulting A consulting firm has an engagement in 2015 to perform training sessions for a client solely based in Georgia. For logistical reasons, the sessions will take place in Georgia, Indiana, and Ohio and the cost of performance will mirror the time spent in each state. The time spent by the consultants in each state is OH 80%, IN 15%, and GA 5%. How do you source revenue between the three states? 26

29 Example 3 Consulting(cont) For 2015, IN sources revenue based on COP using time spent for COP. OH and GA are benefit received states. Therefore, the sales factor in each state would be computed as follows on a lone $1,000,000 project for the year: OH - 0/1,000,000 = 0% IN - 150,000/1,000,000 = 15% GA - 1,000,000/1,000,000 = 100% Total amount included in factors is 115% of the total when considering all taxes. OH is zero because the customer is located in and operated from GA, despite the service being performed in OH. 27

30 Example 4 - Software License Facts: HHC is located in Chicago, IL. It has no offices outside of Illinois and its employees do not perform any services outside of IL. It licenses the use of research software throughout the U.S. HHC has two customers, Accountants R Us, LLC (operates in 5 states, including MI) and The Tax Man, Inc. (operates solely in OH) HHC bills its customers based on: - Entity user license (Accountants R Us, LLC) - Per user license (The Tax Man, Inc.) Issues: What are the income producing activities? How is revenue sourced? 28

31 Example 4 - Software License (cont) Analysis: What are the income producing activities? Use of intangible property o How is revenue sourced? MI - Income received from use of intangible property (including computer software) is attributed to the state in which property is used by the purchaser. If used in more than one state, apportioned pro rata according to portion used in this state. If portion of use in this state cannot be determined, income shall be excluded from both the numerator and denominator. OH - Receipts from the sale, exchange, disposition, or other grant of the right to use trademarks, trade names, patents, copyrights, and similar intellectual property shall be sitused to this state to the extent that the receipts are based on the amount of use of that property in this state. If the receipts are not based on the amount of use of that property, but rather on the right to use the property and the payor has the right to use the property in this state, then the receipts from the sale, exchange, disposition, or other grant of the right to use such property shall be sitused to this state to the extent the receipts are based on the right to use the property in this state. 29

32 Example 4 - Software License (cont) How do you determine portion used in this state? Accountants R Us, LLC Pro rata based on portion used in state. If cannot get information from company? Allocate amongst 5 states? or exclude from factor? The Tax Man, Inc. Entirely sourced to OH as they are single location For MI, what if you cannot determine and only have one customer, do you have a zero apportionment factor? 30

33 Example 5 - License of Patent Facts: Inventco, Inc. is located in Detroit, MI. It has no offices outside of MI, but each year its employees perform business activities in one or more jurisdictions outside of MI sufficient to satisfy the CIT nexus standards. It licenses a computer hardware patent to Computers, Inc., a CA based computer manufacturer with computer manufacturing plants in CA and FL. Such computers incorporate the licensed technology. The computers manufactured by Computers, Inc. are sold directly throughout the U.S., including sales to MI customers. Issues: Where does the licensee, Computers, Inc., use the intangible property? How does Inventco, Inc. determine such usage? 31

34 Example 5 - License of Patent (cont) Analysis A: The use of the patent is entirely outside of Michigan since the licensee has no manufacturing operations in Michigan, and there is no use in the regular course of business in Michigan? Note that use is determined regardless of the location of purchasers of the computers from Computers, Inc. 32

35 Example 5 - License of Patent (cont) Analysis B: Assume the facts change in year two, and Computers, Inc. opens a manufacturing plant in Michigan at which it produces 30% of its total output of computers in that year. In that year, the license revenue is sourced 30% to Michigan based upon the portion of use of the patent in Michigan. 33

36 Example 5 - License of Patent (cont) Analysis C: Assume that Computers, Inc. refuses to disclose to Inventco, Inc. the locations at which it manufactures computers using the licensed technology. Does Inventco, Inc. use the default method and exclude royalties from Computers, Inc. from both the numerator and denominator of its apportionment formula? What if Computers, Inc. is the only customer? 34

37 Example 5 - License of Patent (cont) Analysis D: Assume that one of Computers, Inc. plants is in OH. How do you source receipts to OH? What if you don t know usage between OH plant and other plants? What would change if Computers, Inc. was also headquartered in OH? 35

38 Example 6 - Call Center Facts: Call Me, Inc. is a call center located in MI that provides technical assistance specialists to handle incoming calls for the customers of Call Me, Inc. s customers. Call Me has several customers in the computer market and logs about 20,000 calls per day. Each call is tracked to determine the customer being supported and from where the call originated. Call Me bills its customers based on the call volume it handles on a monthly basis. None of Call Me s customers are headquartered in MI and all bills are addressed to customer locations outside of MI. Call Me has adequate nexus outside of MI to apportion. Issue: Where does Call Me s customers receive the benefit of the services? 36

39 Example 6 - Call Center (cont) Analysis: Is benefit received based on the origin of the call? Is benefit received at Call Me, Inc. s customer s location? What if Call Me did not track origin of the call, would that change answer? 37

40 Example 6 - Call Center (cont) Analysis: Same questions, but Call Me is located in OH Is benefit received based on the origin of the call? Is benefit received at Call Me, Inc. s customer s location? What if Call Me did not track origin of the call, would that change answer? 38

41 Thank you. Tom Cornett Senior Manager, Deloitte Tax LLP , Mitchell Newmark Partner, Morrison & Foerster LLP , Bob Woolley Partner, Plante Moran, PLLC , 39

42 About This Presentation This presentation contains general information only and the respective speakers and their firms are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. The respective speakers and their firms shall not be responsible for any loss sustained by any person who relies on this presentation. 40