State income and franchise tax quarterly update

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1 Third quarter 2014 State income tax developments State income and franchise tax quarterly update In this issue To our readers: Key developments The following provides a summary of the significant legislative, administrative and judicial actions that affected state and local income/ franchise taxes during the third quarter of Page 2 Page 2 Page 3 Multistate Tax Compact apportionment election Michigan update Court upholds taxpayer election retroactive legislative repeal New Jersey tax court allows company to adjust federal basis when determining gain from the sale of property District of Columbia income tax changes making their way through the arduous legislative process that runs through the US Congress Connect with us Follow us on Twitter at: EY_USStateTax Other noteworthy developments Page 3 Page 4 Page 5 Legislative developments in California, Massachusetts, Michigan and New York Judicial developments in Alaska, Indiana, Kentucky, Maryland and Vermont Administrative developments in California, Indiana, Missouri, New York, Oregon and South Carolina Developments to watch Page 6 California Page 6 District of Colombia Page 6 Georgia Page 6 New Jersey

2 Key developments Multistate Tax Compact apportionment election Michigan update Court upholds taxpayer election retroactive legislative repeal In its split decision in International Business Machines Corp. (IBM), 1 the Michigan Supreme Court (the Court) ruled that IBM (the Taxpayer) was permitted to elect to use the equally weighted, three-factor apportionment formula (MTC election) available under the Multistate Tax Compact (MTC) to determine tax liability under the since-repealed Michigan Business Tax (MBT). The Court also determined that the modified gross receipts tax (MGRT) portion of the MBT, the base for which was gross receipts less a variety of exclusions and deductions unrelated to specific transactions, qualified as an income tax within the MTC definition. Therefore, the MTC election likewise could be used to determine apportionment for the Taxpayer s related MGRT liability. Because the Court determined that the MTC election and MBT statutes could be harmonized, the lead opinion declined to discuss the contractual, compact law and constitutional considerations of the MTC. Subsequent to the ruling, the Michigan Attorney General on 4 August 2014 filed a motion with the Court, requesting reconsideration of its ruling (citing primarily the substantial fiscal impact on the state). On 11 September 2014, the legislature and Governor Rick Snyder, in an effort to prevent refunds from being paid in light of the IBM ruling, enacted legislation (SB 156) to expressly repeal the MTC retroactive to 1 January 2008 (MTC repeal legislation). Lastly, on 18 September 2014, the state s Attorney General petitioned the Court to do all of the following: [apply the] new [retroactive Compact repeal] statute, reverse its judgment, hold that IBM cannot elect to apportion its tax bases established under the [Michigan Business Tax Act], and affirm the Court of Claims grant of summary disposition to the Department. And on 19 September 2014, the Michigan Court of Appeals ordered the taxpayer in Anheuser-Busch, 2 a pending MTC election case, to brief the impact of the MTC repeal legislation on this case. Ernst & Young LLP s take We anticipate that taxpayers will raise legal challenges to the retroactive repeal of the MTC by the MTC repeal legislation. The challenges would likely raise issues such as the validity of retroactively withdrawing from the MTC, due process and separation of powers. Because the situation involving the Michigan MTC election is incredibly fluid with many elements that will require further attention, taxpayers should carefully assess their current position under Michigan law. New Jersey tax court allows company to adjust federal basis when determining gain from the sale of property In its ruling in Toyota Motor Credit Corp., 3 the New Jersey Tax Court (court) held that a vehicle leasing company that benefited from bonus depreciation for federal income tax purposes, but not for New Jersey Corporation Business Tax (CBT) purposes, is allowed to adjust its federal basis when determining gain from the sale of property for CBT purposes to reduce the gain recognized for the federal depreciation not taken for CBT purposes. The court also held that the state s decoupling from the 2001 federal bonus depreciation provisions commenced with the taxpayer s first fiscal year that begins after 1 January 2002 and applies to property purchased after 10 September 2001, even if the property was purchased before the start of the taxpayer s fiscal year. Lastly, the court held that the Division of Taxation erred in applying the throwout rule to the taxpayer s receipts sourced to Nevada, South Dakota and Wyoming (states that don t impose a corporate income tax) as the company had a sufficient presence in those states to create nexus; thus, the receipts to those states should not have been thrown out in computing the taxpayer s New Jersey sales factor. Ernst & Young LLP s take The Division has indicated that it will appeal the court s decision. If this ruling is ultimately upheld, the question remains how broadly it will be interpreted. For instance, this ruling could be narrowly construed to apply to its facts. Because the decision does not provide any limitation of what constitutes depreciation deductions not giving rise to a New Jersey tax benefit, it also is possible that the ruling may be read in the extreme to require a revised New Jersey basis equal to the federal basis of the property plus any federal depreciation deduction not giving rise to a New Jersey tax benefit for the taxpayer regardless of the circumstances that caused a New Jersey benefit not to have been received. For this reason, New Jersey taxpayers should review their factual circumstances to determine whether this decision may provide them with new support for refund claims. 2 State income and franchise tax quarterly update

3 District of Columbia income tax changes making their way through the arduous legislative process that runs through the US Congress An emergency bill (B20-849) enacted by the District of Columbia Council (DC Council), which is effective for only a 90 day period, adopts a single sales factor apportionment formula with market-based sourcing for services, effective for taxable years beginning after 31 December The bill also reduces the DC incorporated and unincorporated business franchise tax rates from 9.975% to 9.4% on 1 January 2015 and provides for additional rate reductions, ultimately to 8.25%, that will be phased-in on a scheduled basis when revenue thresholds are met. Because the provisions of B will expire on 12 October 2014, the business income tax changes in B will not take effect before the bill expires. Another bill (B20-750) will make the aforementioned business income tax law changes permanent. Although B has been approved by the DC Council and allowed to become law by Mayor Vincent Gray without his signature, the bill, under the federal laws that administer the DC government, must be sent to the US Congress for a mandatory 30 day in-session review period before it becomes law. This process could take a few months as the US Congress is out on recess until after the 4 November 2014 elections and is expected to be in session for only a few weeks before adjourning for the year. At the earliest, B s 30 day in-session review period could be satisfied by mid to late December, but it is more likely that the review period will be met in January or February Ernst & Young LLP s take Ernst & Young LLP s take: Given that the emergency bill (B20-849) will expire before the permanent bill will become law, it is anticipated that the DC government will enact another emergency bill or a temporary bill (which is effective for 255 days) to ensure that the changes contained in these bills are continuously effective. In fact, on 7 October 2014, the DC Council approved an emergency bill (B20-956) that contains the same tax law changes contained in B and B Other noteworthy developments Legislative California: Provisions of AB 2754, enacted 19 September 2014, adds the GO-Biz California Competes credit (CA Competes) in the order of credits allowed against the net tax for California corporate franchise tax purposes and allows corporate income taxpayers to use the CA Competes tax credit to reduce their taxes below the tentative minimum tax (TMT). These changes are effective for taxable years beginning on or after 1 January In addition, provisions of AB 1839, enacted on 18 September 2014, allow the film credit for qualified expenditures for the production of qualified motion pictures to reduce the TMT for corporation tax purposes, effective for taxable years beginning on or after 1 January Massachusetts: On 11 July 2014, Governor Patrick signed the FY 2015 budget bill (HB 4001), a key provision of which delays until 2016 the ability to take the FAS 109 deduction related to the adoption of combined reporting. Michigan: Legislation (SB 156) enacted on 11 September 2014 makes the following changes to the former MBT: Amends the MGRT base to exclude from gross receipts amounts attributable to a discharge of indebtedness as described in Internal Revenue Code Section 61(a)(12) Provides that if the Investment Tax Credit (ITC) has been claimed against the MBT, the adjusted proceeds from the sale or disposition of the eligible depreciable tangible assets will be recaptured to the extent the ITC was used and would be based on the ITC rate in effect when the credit was claimed Revises the calculation of the renaissance zone credit Amends dock sale provisions to provide that dock sales not picked up for 60 days or more are deemed to have come to rest at this ultimate destination and, therefore, are included in the sales factor base) These changes are retroactively effective to 1 January New York: Provisions of A 9462, enacted 9 September 2014, extend the expiration of certain tax rates and taxes in New York City, including the City s current general corporate State income and franchise tax quarterly update 3

4 tax rate through 31 December It should be noted that these taxes have been imposed for a number of years and are generally extended every few years. Judicial Alaska: In Schlumberger Technology Corp., 4 the Alaska Supreme Court (Court) determined that a foreign corporation was operating as part of a domestic company s unitary business group and, as a result, 20% of the foreign corporation s dividend income from foreign companies was appropriately includable in the combined group s Alaska water s edge combined report. In reaching this conclusion, the Court held that even though the Alaska Net Income Tax Act (ANITA) incorporated the exception from effectively connected income under Internal Revenue Code Section 882 (which excluded dividends from the determination of federal taxable income, the starting point for determining Alaska taxable income), it would be inconsistent to allow the exclusion when the state s formulary apportionment rule provided for under Alaska s adoption of the Multistate Tax Compact permitted only an 80% dividends received deduction for members of the water s edge group. Indiana: In reversing the state tax court, the Indiana Supreme Court (Court) in Caterpillar, Inc. 5 held that a multinational manufacturer is not allowed to deduct Foreign Source Dividends (FSDs) in calculating its Indiana net operating loss (NOL). The Court ruled that under a plain reading of the statutes, neither the state s NOL statute nor its taxable income modification provision included any reference to FSD as an appropriate deduction in determining the Indiana NOL (which is based on the taxpayer s federal NOL as a starting point). The Court also found the tax court s interpretation of the Indiana NOL statute as a mirror image of the adjusted gross income (AGI) calculation that incorporates all Indiana AGI adjustments, including FSD deductions, was inconsistent with the plain meaning of the NOL statute. Kentucky: In World Acceptance Corp., 6 the Kentucky Board of Tax Appeals held that an out-of-state parent corporation was not required to file a consolidated Kentucky corporation income tax return with its wholly owned subsidiary, which was doing business in the state, because the parent corporation did not have nexus with the state and it was not an includible corporation. Under Kentucky law, a corporation cannot be an includible corporation if the corporation realizes an NOL and its Kentucky payroll, property and sales factors are de minimis. In this case, the parent corporation had NOLs, and its state factors were de minimis; specifically, the parent corporation s sole employee in Kentucky performed some of her work in Kentucky but spent a majority of her time working in Tennessee; the car used by the employee while traveling in Kentucky could not be allocated to Kentucky under regulatory law; and income from the management fees was sourced to South Carolina because a greater proportion of the income-producing activity is performed in that state. In AT&T Corp., 7 the Kentucky Court of Appeals held that a national telephone company was not required to include non- Kentucky subsidiaries in its Kentucky consolidated return group for tax years and, therefore, was entitled to a refund of corporate income tax. Maryland: The Maryland Court of Appeals (Court), the state s highest court, held that an out-of-state subsidiary created by a multistate retailer to hold and license trademarks lacked economic substance apart from the retailer. As such, it concluded that the subsidiary was subject to Maryland corporate income tax and further, that it was appropriate to determine the subsidiary s apportionment to Maryland based upon the parent retailer s in-state activities and not on its own factors (which would have been 0%). Moreover, the Court held that the subsidiary was bound by the method under which it reported its income to Maryland under its original returns. The income in question was derived from a gain on the distribution of trademarks from the subsidiary to its parent under Internal Revenue Code Section 311(b) in an internal restructuring that occurred in 1999, a year in which neither the subsidiary nor, more significantly, the retailer were doing business in Maryland and would not have been subject to tax. The Court rejected the subsidiary s argument that the Section 311(b) gain was mistakenly reported on its 2002 and 2003 tax returns by applying principles under the federal consolidated return regulations. The Court categorically stated that it was not its job to reconsider the taxpayer s method or reporting on a separate company basis and whether that determination should be made under the federal consolidated return regulations or not. 8 Vermont: A unitary business group (group) consisting primarily of insurance and financial companies was not required to include a related entity doing business as a ski resort in the group s Vermont combined return. A Vermont Superior Court (Court) held the tax commissioner s finding the corporations to be unitary is outside the constitutional boundaries of the unitary business principle. The Court found the following facts supportive of this conclusion: (1) the ski resort s dealing with the group mostly were done at arm s length; (2) the group paid the same for conferences at the ski resort as unrelated parties; (3) the fact that the ski 4 State income and franchise tax quarterly update

5 resort may have benefited from below-market rate financing by itself is not sufficient to demonstrate it was unitary with the group; and (4) the record does not support a finding that the group used the ski resort for marketing purposes, exerted any significant managerial control over it, or lent any expertise to it. 9 Administrative California: In a News Flash issued 6 August 2014, the Franchise Tax Board (FTB) stated that a retailer that receives vendor allowances such as credits, rebates or cash for selling the vendor s products or services must include such allowances in gross receipts for purposes of determining its sales factor when all of the following apply: (1) the retailer sells a product or service back to the vendor, (2) the vendor pays the retailer for the product or service it receives, (3) the allowance is separate from the underlying product or service that the vendor sells to the retailer, and (4) the vendor s benefit is measurable. Allowance amounts that exceed the value the vendor receives reduce the retailer s cost of goods sold and are not treated as gross receipts for purposes of determining its California sales factor. In Legal Ruling (Ruling), issued 22 July 2014, the FTB published its longstanding position regarding its doing business standard for members of multiple-member limited liability companies (LLCs) classified as partnerships for federal income tax purposes. Generally, the FTB affirmed its position that if an LLC is doing business in California, all of its members are likewise deemed to be doing business in the state. This Ruling affects business entities not otherwise doing business in California, not organized or registered with the Secretary of State, or having no activities or factor presence in the state. Again, this is the FTB s legal position and has not been the subject of consideration by any court in California. On 1 September 2014, the FTB published its adjusted brightline doing business in California nexus brackets to reflect changes in the California consumer price index as required by law. The adjusted threshold values for 2014 are as follows: (1) taxpayer s in-state sales that exceed the lesser of $529,562 or 25% of the taxpayer s total sales; (2) taxpayer s real and tangible personal property in California exceeds the lesser of $52,956 or 25% of the taxpayer s total real and tangible personal property; and (3) taxpayer s in-state compensation exceeds the lesser of $52,956 or 25% of the total compensation paid by the taxpayer. Indiana: The Department of Revenue (Department) found that its auditor had the authority under the state s alternative apportionment provisions 10 to reallocate $3.85 billion in intercompany interest expenses claimed by a multinational manufacturer to more fairly reflect its Indiana source income. The Department rejected the manufacturer s argument that state law does not permit such an adjustment because Indiana AGI starts with federal AGI as defined by Internal Revenue Code Section 63 no more, no less. The Department found the auditor s decision to reallocate the interest expense an entirely reasonable attempt to effectuate an equitable allocation and apportionment of the [manufacturer s] income. The manufacturer also challenged the constitutionality of the state s intercompany intangible and interest and expense add-back provisions; however, the Department said that an administrative proceeding was not the proper venue to raise such issues. Lastly, the Department upheld the auditor s disallowance of net operating loss deductions accumulated during years prior to the years directly under audit. 11 Missouri: A multistate corporation and its subsidiaries (collectively the group) were not allowed to deduct the Missouri NOLs of its members which had been incurred in tax years when they filed separate Missouri returns. In reaching this conclusion, the Missouri Administrative Hearing Commission (AHC) held that contrary to the group s argument, the General Assembly did not direct the Director of Revenue (Director) to adopt a regulation that would enable an affiliated group filing a consolidated return to deduct the NOLs of its members that were incurred in separate return years. Rather, the Missouri Supreme Court has previously disallowed taxpayers attempts to modify a figure they calculated and reported on their federal returns in order to support their claims of what they owed in Missouri income tax. The AHC considered and rejected other arguments put forth by the group, and it noted that state deductions cannot be created by a regulation. 12 New York: In Knowledge Learning Corp., 13 the New York State Tax Appeals Tribunal (Tribunal) reversed an administrative law judge s (ALJ) ruling and held that a group of related corporations that provide learning and day care centers for children are required to file a New York combined report for tax year 2007 because the combined reporting law s substantial intercorporate transaction test was met. In addition, the Tribunal found that the ALJ erroneously concluded that the 2007 amendments to the state s combined reporting rules eliminated the distortion test for determining whether combined filing should be required. Instead, the Tribunal held that the 2007 amendment provides for combined reporting in the absence of State income and franchise tax quarterly update 5

6 substantial intercorporate transactions, where the ownership and unitary business conditions are met and combined reporting is necessary to properly reflect the taxpayer s income in the state. Oregon: Amendments to Ore. Admin. Rule (1)- (A) clarify that sales tax collected on behalf of a state or municipality are excluded from the sales factor, effective 31 July In addition, effective for tax years beginning after 1 January 2014, the exclusion from the sales factor of substantial amounts of gross receipts that arise from an incidental or occasional sale of a fixed asset used in the regular course of the taxpayer s trade or business applies to any intangible assets associated with the sale, including goodwill. This extension to intangible assets also applies to the exclusion from gross receipts of insubstantial amounts of gross receipts arising from incidental or occasional transactions or activities. This exclusion does not apply if such exclusion materially affects the amount of income apportioned to Oregon. The amended regulation was filed with the Secretary of State on 31 July A new rule, Ore. Admin. Rule , provides guidance to a corporation doing business in Oregon that is part of a unitary group that includes a member incorporated in a foreign jurisdiction (foreign corporation) listed in ORS Section (2)(b). The new rule describes how to compute income or loss of a foreign corporation that does not file a federal consolidated return and how to avoid double taxation and double deductions. The rule took effect 31 July Developments to watch California: The FTB announced its intention to consider adoption of proposed Regulation related to transfer of appreciated property to an insurer s annual statement. District of Columbia: Approved bill (B20-750) adopts a single sales factor apportionment formula with market-based sourcing for services and reduces the unincorporated and incorporated business franchise tax rates, effective starting in See also B20-956, an emergency bill approved by the DC Council on 7 October 2014 that would adopt the same changes. See the Key developments section for more on this development. Georgia: Proposed new Rule , Alternative Method of Determining Income, would provide guidance on the application process for permission to use an alternative apportionment method. New Jersey: Proposed bills (AB 3624, AB 3678 and SB 2361) would prohibit the award of New Jersey state contracts to certain US domestic corporations that reorganize overseas, i.e., the state legislation is targeted at domestic corporations that invert to foreign countries. South Carolina: The Department of Revenue announced that it will follow the final regulations under Internal Revenue Code Sections 162(a) and 263(a) (commonly known as the tangible property regulations ) related to when taxpayers have to capitalize or deduct expenses for amounts paid to acquire, produce or improve tangible personal property, to the extent the final regulations are applicable to the tax year(s) in question State income and franchise tax quarterly update

7 Endnotes 1 International Business Machines Corp. v. Dep t of Treasury, No (Mich. Sup. Ct. 14 July 2014). See also Lorillard Tobacco Co. v. Dep t of Treasury, No (Mich. Ct. App. 16 September 2014) (unpublished). 2 Anheuser-Busch v. Department of Treasury, Nos and (Mich. Ct. App. order of 19 September 2014). 3 Toyota Motor Credit Corp. v. Director, Div. of Taxn., No (N.J. Tax Ct. 1 August 2014). See also Ford Motor Credit Co. v. Director, Div. of Taxn., No (N.J. Tax Ct. 5 August 2014) (unpublished). 4 Schlumberger Technology Corp. & Subsidiaries v. Alaska Dep t of Revenue, No S (Alaska Sup. Ct. 18 July 2014). 5 Indiana Dep t of Revenue v. Caterpillar, Inc., No. 49S TA-79 (Ind. Sup. Ct. 25 August 2014). 6 World Acceptance Corp. and World Finance Corp. Ky. v. Finance and Admin. Cabinet Dep t of Revenue, Order No. K24682 (Ky. Bd. Tax App. 29 August 2014). 7 Dep t of Revenue v. AT&T Corp., No CA MR (Ky. Ct. App. 3 July 2014). 8 NIHC v. Comptroller of the Treasury, No. 03-C (Md. Ct. of App. 18 August 2014). 9 AIG Insurance Management Services Inc. v. Dep t of Taxes, No (Vt. Superior Ct. 30 July 2014). 10 Ind. Code Sections (l) and (m). 11 Ind. Dep t of Rev., Letter of Findings No (24 September 2014). 12 Express Scripts, Inc. and Subsidiaries v. Director of Revenue, No RI (Mo. Admin. Hearing Comm. 5 August 2014). 13 In the Matter of the Petitions of Knowledge Learning Corp. and Kindercare Learning Centers, Inc., DTA Nos and (N.Y. Tax App. Trib. 18 September 2014). 14 S.C. Dept. of Rev., S.C. Information Letter #14-11 (3 September 2014). For additional information, please contact one of the following Ernst & Young LLP professionals: National Tax Chris Gunder Financial Services Office Michael Memmolo Central Region Tim Kimmel Canada Kathryn Toal Northeast Region Scott Shreve Southeast Region Sid Silhan Southwest Region David Jackson West Region Todd Carper EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US Ernst & Young LLP. All Rights Reserved SCORE No. YY3426 ey.com