State & Local Tax Alert

Transcription

1 State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP Multistate Tax Commission Adopts Amendments to Model General Allocation and Apportionment Regulations On February 24, 2017, the Multistate Tax Commission (MTC) adopted amendments to its Model General Allocation and Apportionment Regulations (model regulations). 1 The amendments to the model regulations reflect recent changes made to key provisions of Article IV of the Multistate Tax Compact (Compact), including the adoption of marketbased sourcing for receipts from transactions other than sales of tangible personal property. Background In 1957, the Uniform Law Commission (ULC) promulgated the Uniform Division of Income for Tax Purposes Act (UDITPA) to provide uniform laws that states could adopt to assign the taxable income of multistate corporations among the states in which they do business. In 1967, the MTC created the Compact and included the UDITPA provisions in Article IV. The model regulations were adopted by the MTC to implement Article IV s UDITPA provisions. 2 In 2014 and 2015, the MTC revised Article IV of the Compact to: (1) clarify the definition of apportionable income; (2) narrow the definition of receipts; and (3) adopt market-based sourcing for receipts from transactions other than sales of tangible personal property. 3 In order to reflect the changes made to Article IV of the Compact, these amendments to the model regulations followed. Amendments Reflecting Article IV, Section 1 Definitional Changes The MTC amended Article IV, Section 1 of the Compact to change definitional terms for business income and sales. Business income 4 is now referred to as apportionable income 5 and the new definition of the term contains three major substantive changes Release date May 17, 2017 States All Issue/Topic Corporate Income Tax Contact details Jamie C. Yesnowitz Washington, DC T E jamie.yesnowitz@us.gt.com Chuck Jones Chicago T E chuck.jones@us.gt.com Lori Stolly Cincinnati T E lori.stolly@us.gt.com Priya D. Nair Washington, DC T E priya.nair@us.gt.com 1 Multistate Tax Commission, Model General Allocation and Apportionment Regulations, Feb. 24, Model General Allocation and Apportionment Regulations, Prefatory Notes. 3 Id. The MTC also revised Article IV, Section 9 to remove the requirement for equal weighting of the three-factor apportionment formula and Section 18 to make changes to the equitable apportionment authority and to provide certain procedural safeguards. 4 Former Multistate Tax Compact Art. IV.1(a). (a) Business income means income arising from transactions and activity in the regular course of the taxpayer s trade or business and includes income from tangible and intangible property if the acquisition, management and disposition of the property constitute integral parts of the taxpayer s regular trade or business operations. 5 Multistate Tax Compact Art. IV.1(a). (a) Apportionable income means: (i) all income that is apportionable under the Constitution of the United States and is not allocated under the laws of this state, including: (A) income arising from transactions and activity in the regular course of the taxpayer s trade or business, and (B) income arising from tangible and intangible property if the.

2 Grant Thornton LLP - 2 from the prior definition. The definition of apportionable income now reflects: (1) an explicit reference to the Constitution as the standard for determining what income is subject to formulary apportionment; (2) a clarification that the so-called transactional and functional tests are separate tests; and (3) an expansion of the reach of the functional test. 6 Additionally, the term sales is now referred to as receipts and, under the new definition, receipts that give rise to income that would meet the functional, but not the transactional, test for apportionable income are explicitly excluded. 7 Furthermore, certain types of receipts are explicitly excluded even if they give rise to income that would meet the transactional test. 8 Amendments were made throughout the model regulations to reflect these new terminologies and definitional changes. Article IV, Section 17 Market-Based Sourcing Rules The most notable and significant change made by the MTC to the Compact was to replace the existing cost of performance sourcing methodology contained in Article IV, Section 17 with market-based sourcing for receipts from transactions other than sales of tangible personal property. The bulk of the amendments to the model regulations are devoted to providing rules for this new sourcing methodology and are contained in Reg. IV.17. Reasonable Approximation and Throwout Rule Reg. IV.17 begins by providing several overarching principles that govern the sourcing of receipts under the section. Generally, a taxpayer is required to determine its method of assigning receipts in good faith, apply the method consistently with respect to similar transactions from year to year, and is required to retain contemporaneous records that provide an explanation of the determination and application of its method of assigning receipts. 9 The state of assignment is determined through the utilization of several sequential hierarchical rules, requiring that the taxpayer make a reasonable effort to apply the primary rule in the hierarchy before utilizing a secondary rule. 10 While Reg. IV.17 provides detailed rules for determining the state of assignment, the regulation allows for reasonable approximation if the state of assignment cannot be determined. 11 Reasonable approximation can take one of two forms. In some instances, the regulation may provide specific rules for assignment. 12 In other instances, the taxpayer is required to reasonably approximate the state of assignment using a method that reflects an effort to approximate the results that would be obtained under the Section 17 acquisition, management, employment, development or disposition of the property is or was related to the operation of the taxpayer s trade or business; and (ii) any income that would be allocable to this state under the Constitution of the United States, but that is apportioned rather than allocated pursuant to the laws of this state. 6 Model General Allocation and Apportionment Regulations, Prefatory Notes. The functional test has been expanded by changing the requirement that an activity constitute integral parts of the taxpayer s regular business to a requirement that it be related to the operation of the business. Id. 7 Id. 8 Id. 9 Model Apportionment Reg. IV.17.(a)(4)(A). 10 Model Apportionment Reg. IV.17.(a)(4)(B). 11 Model Apportionment Reg. IV.17.(a)(5)(A). 12 Id.

3 Grant Thornton LLP - 3 regulations. 13 Reg. IV.17 also contains a throwout rule that applies if the taxpayer cannot determine the state of assignment 14 or if the taxpayer is not taxable in the state to which the receipts from a sale are assigned. 15 Changes in Methodology Once a taxpayer files an original return using an assignment method that follows the rules set out in Reg. IV.17, neither the taxpayer nor a tax administrator can go back and change that method. 16 However, the taxpayer or tax administrator is allowed to, through the applicable administrative process, correct factual errors or calculation errors relating to the application of a filing methodology. 17 Reg. IV.17 also identifies six situations where a tax administrator has the ability to adjust the assignment of receipts on a return. 18 A taxpayer is permitted to change its method of assigning receipts on a prospective basis if, on its original return filed for the year of the change, it discloses that it has made the change. 19 Failure to adequately disclose can lead to the change being disregarded and being substituted with an assignment method deemed appropriate by the tax administrator. 20 Under Reg. IV.17, a tax administrator can require a taxpayer to change its method of assigning receipts and method of approximation for returns not yet filed if the administrator determines that a prior year s return did not reflect an accurate assignment of receipts and the change can be reasonably adopted by the taxpayer. 21 Sourcing of Receipts The remaining provisions of Reg. IV.17 are devoted to providing detailed sourcing rules for receipts from four major categories: (1) the sale of a service; (2) the license or lease of intangible property; (3) the sale of intangible property; and (4) special rules governing the sourcing of software transactions and the sale or license of digital goods and services. 22 As a general rule, sales of services are sourced to the location in which the service is delivered (as a proxy for the location of the taxpayer s market for the service, in contrast to historic cost of performance sourcing). 23 The sale of a service category is subdivided into 13 Id. In certain cases, a taxpayer may approximate based upon information on its known sales by using a geographic estimate to approximate sourcing on unknown sales. Model Apportionment Reg. IV.17.(a)(6)(B). 14 Model Apportionment Reg. IV.17.(a)(6)(C). 15 Model Apportionment Reg. IV.17.(a)(6)(D). 16 Model Apportionment Reg. IV.17.(a)(7)(B). 17 Id. 18 Model Apportionment Reg. IV.17.(a)(7)(C). 19 Model Apportionment Reg. IV.17.(a)(7)(D). 20 Id. 21 Model Apportionment Reg. IV.17.(a)(7)(E). 22 Model Apportionment Reg. IV.17.(d)-(g). Reg. IV.17 also provides sourcing rules for the sale, rental, lease or license of real property and the rental, lease or license of tangible personal property. Model Apportionment Reg. IV.17.(b), (c). 23 Model Apportionment Reg. IV.17.(d)(1).

4 Grant Thornton LLP - 4 in-person services, services delivered to the customer or on behalf of the customer or delivered electronically through the customer and professional services. 24 The general rule governing sales from the license or lease of intangible property is to source to the location where the intangible is used, meaning the location of the taxpayer s market for the use of the intangible property being licensed. 25 The license or lease of intangible property category is subdivided into several subcategories, including the license of a marketing, production or mixed intangible, and the license of intangible property where the substance of the transaction resembles a sale of goods or services. 26 With respect to sales of intangible property, specific sourcing rules apply depending upon whether the intangible authorizes business activity in a specific geographic area, and whether the sale resembles a license or in the alternative resembles a sale of goods and services. 27 Finally, with respect to special sourcing rules, the license or sale of prewritten software is treated as the sale of tangible personal property for purposes of sourcing, while other receipts from software are sourced depending upon the specific facts governing the transaction in line with the rules provided for sales of customer software or intangible property, or licenses of intangible property. 28 The sourcing of sales or licenses of digital goods or services generally is governed by the sourcing rules for services delivered to a customer or delivered through or on behalf of a customer. 29 Once the type of activity involved has been properly identified, the regulations provide assignment rules that are laid out in a hierarchical order that must be followed by the taxpayer. Distinctions in the sourcing rules often turn on whether the services are delivered to individual or business customers. In some instances, the rules provide for specific sourcing determination rules, primary and secondary rules of reasonable approximation as well as safe harbor provisions under which a particular sourcing method may be allowed as a means to simplify the sourcing analysis in cases where the taxpayer engages in a large volume of transactions. Substantial portions of Reg. IV.17 are devoted to examples showing the application of each sourcing rule. As a result, the regulations provide cascading levels of subcategories that are designed to ultimately lead a taxpayer to a sourcing rule that is narrowly tailored to the activity involved. Commentary The adoption of the amendments to the model regulations marks the end of a long process that began on July 31, 2014 when the MTC s Executive Committee requested the 24 Model Apportionment Reg. IV.17.(d)(2)-(4). 25 Model Apportionment Reg. IV.17.(e)(1). 26 Model Apportionment Reg. IV.17.(e)(2)-(5). 27 Model Apportionment Reg. IV.17.(f)(1)(A)-(C). Certain receipts from the sale of intangibles are excluded to the extent the sale does not give rise to receipts under Art. IV.1(g) of the Compact, or the intangible is not referenced in Article IV.17(a)(4)(i), (ii)(a) or (ii)(b). According to the regulations, excluded receipts consist of, but are not limited to, the sale of a partnership interest, the sale of business goodwill, the sale of non-compete agreements, or similar intangible value. Model Apportionment Reg. IV.17.(f)(1)(D). 28 Model Apportionment Reg. IV.17.(g)(1). 29 Model Apportionment Reg. IV.17.(g)(2).

5 Grant Thornton LLP - 5 Uniformity Committee to draft regulations to implement recommended changes to UDITPA Article IV provisions. 30 While the amendments reflect changes made to UDITPA definitions contained in Article IV, Section 1 of the Compact, the bulk of the amendments reflect the Section 17 shift to market-based sourcing for sales other than sales of tangible personal property. The Section 17 regulations rely heavily on Massachusetts market-based sourcing regulations, with the MTC s Uniformity Committee spending over a year studying Massachusetts market-based sourcing regulations and using them as a working draft for the model regulations. 31 The noteworthiness of the Section 17 regulations lies in the level of specificity provided by the MTC in the sourcing rules. However, this level of detail has resulted in sourcing rules that are highly complex. Prior to the adoption of these rules, a taxpayer may have relied on the billing address of the customer as a short-cut to source receipts, often as a means to come up with a relatively quick and presumably fair sourcing methodology that could be used on a multistate basis. This short-cut always had its limitations from an accuracy perspective, particularly in cost of performance jurisdictions. For states that ultimately follow the new market-based sourcing regime under the MTC regulations, the limitations of the billing short-cut method will remain, as a pure billing address sourcing methodology generally will not provide accurate results. Further, the regulations now place a heavier burden of compliance on taxpayers and practitioners alike, as an accurate characterization of each revenue stream and application of the proper sourcing rule will be necessary. Depending upon the facts and circumstances of the taxpayer, the analysis that may need to be undertaken to ensure correctness in this area may be staggering. While the adoption of the Section 17 market-based sourcing regulations by the MTC marks a major step, it is unlikely that uniformity among the states will be attainable in the near future. Many states continue to adhere to cost of performance standards with respect to the sourcing of services, and may not feel compelled to change their sourcing rules, particularly if the revenue impact of such a change is not positive. In addition, some states that are not tied to the Compact that recently have independently decided to move to market-based sourcing (like California and New York) have done so in a manner that is inconsistent with the Compact. For MTC member states, the process to conform to these detailed regulations is cumbersome. First, the state has to conform to the underlying changes made in the Compact through the adoption of legislation, which in many cases can be a significant hurdle to overcome. Second, to the extent that Compact amendments are adopted, the state tax authority has to complete the regulatory process to promulgate the regulations consistent with the MTC s model regulations. That step also could take a significant amount of time to complete. Having addressed many of the potential obstacles to conformity in this area, it should be noted that states are continuing to make the move from cost of performance to marketbased sourcing. Given the broad support that the MTC s model had from its state 30 Multistate Tax Commission, Resolution Adopting Amendments to the Multistate Tax Commission's Model General Allocation and Apportionment Regulations. 31 Model General Allocation and Apportionment Regulations, Prefatory Notes.

6 Grant Thornton LLP - 6 members, there is at least some chance of a group of states banding together and providing consistent guidance in this area. For states that are considering a move to market-based sourcing, the Section 17 regulations may serve as a useful roadmap when drafting their own regulations. In this regard, one unique feature of the amendments is the inclusion of detailed drafter s notes. According to the MTC, while the drafter s notes will not have any binding effect and are not to be considered as legislative, 32 they serve as an aid to understanding the 2017 amendments. 33 The drafter s notes are valuable not only for their summary of the changes that were made, but also for highlighting changes that were discussed but ultimately not adopted. Notably, the drafter s notes also provide potential guidance for states that may have similar, but not identical, statutory apportionment provisions. 34 The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circumstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed. 32 Amy Hamilton, MTC Staff Compiling Drafters Notes as New Form of Guidance, TAX ANALYSTS, Jan. 3, Model General Allocation and Apportionment Regulations, Prefatory Notes. 34 Model General Allocation and Apportionment Regulations, Drafter s Notes.