MACPA Chesapeake Tax Conference Martin s West. Current State Tax Developments Corporate Income/Franchise Tax. Friday, September 23, 2011

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1 MACPA Chesapeake Tax Conference Martin s West Current State Tax Developments Corporate Income/Franchise Tax Friday, September 23, 2011 Introductions/Agenda Renee Padousis, SALT Director McLean, Virginia Agenda: - State of the States - Combined Reporting - Nexus - Tax Base - Allocation and Apportionment - Other National Developments - Local Developments Slide 2 1

2 State of the States Slide 3 State Budget Deficits Projected Shortfalls WA OR MT ND MN ME CA NV ID UT WY CO SD NE KS WI IA IL MO IN MI KY OH WV VT NH MA NY CT R I PA NJ MDDE VA DC AZ NM OK AR TN NC SC AK TX LA MS AL GA HI FL Source McNichol, Elizabeth, Oliff, Phil, and Johnson, Nicholas. States Continue to Feel Recession s Impact." Center on Budget and Policy Priorities. 17 June 2011 < Slide 4 2

3 State Budget Deficits Largest on Record Source McNichol, Elizabeth, Oliff, Phil, and Johnson, Nicholas. States Continue to Feel Recession s Impact." Center on Budget and Policy Priorities. 17 June < Slide 5 State of the States - Responses Combined Reporting More aggressive nexus approaches Tax Base Changes - Decoupling from federal stimulus provisions - Related Party Addbacks - Anti-REIT/RIC Provisions Apportionment Changes - Sales Factor Weighting Other Changes - Surcharges - Tax on Wealthy - Amnesty - Increased Penalties Slide 6 3

4 Combined Reporting Slide 7 Combined Reporting Recent Enactments Vermont Applies to tax years beginning on or after January 1, 2006 West Virginia Any taxpayer engaged in a unitary business with one or more other corporations must file a combined report, effective January 1, 2009 Ohio CAT Consolidated or combined reporting required Texas Margin Tax Taxable entities that are part of an affiliated group engaged in a unitary business must file a combined report Michigan Taxpayers are required to file based on a unitary combined reporting system, effective January 1, 2008 (MBT) and effective January 1, 2012 (corporate income tax) Massachusetts adopted combined reporting, effective January 1, 2009 Wisconsin adopted combined reporting, effective for tax years beginning on or after January 1, 2009 Slide 8 4

5 Combined Reporting WA OR ID MT WY ND SD MN WI MI NY ME VT NH MA CT RI CA NV UT CO NE KS IA MO IL OH IN WV KY PA VA NJ DE MD DC AZ NM OK AR TN NC SC AK MS AL GA TX LA HI FL Combined Reporting Proposals Unitary/Combined States Remaining Separate Entity or Elective Consolidated Reporting/Other Slide 9 Combined Reporting 2011 WA OR ID MT WY ND SD MN WI MI NY* ME VT NH MA CT RI CA NV UT CO NE KS IA MO IL OH IN WV KY PA VA NJ DE MD DC AZ NM OK AR TN NC SC AK MS AL GA TX LA HI FL Combined Reporting Proposals Considered Recently and/or Currently Proposed Unitary/Combined States (now including the Ohio CAT, Texas Margin Tax and Michigan Business Tax) Remaining Separate Entity or Elective Consolidated Reporting/Other *New York requires related corporations to file a combined report upon the existence of substantial intercorporate transactions Slide 10 5

6 Combined Reporting Legislation 2011 Activity Arkansas H.B. 1495, withdrawn, 3/30/11 Connecticut H.B. 6628, died upon adjournment, 6/8/11 District of Columbia Mayor s budget proposal, introduced, 4/1/11, Enacted September 14, 2011 Florida H.B. 675, S.B. 1406, died upon adjournment, 4/30/10 Iowa S.S.B. 3122, died upon adjournment, 3/30/10 Maryland H.B. 731 and S.B. 305, failed to pass by session end on 4/12/11 Missouri H.B. 533, died upon adjournment.,5/11 New Mexico S.B. 6, died upon adjournment 3/11 North Carolina H.B 619, enacted 6/30/11 (forced combinations) Rhode Island H.B. 5894, enacted 6/29/11 (information reporting) Slide 11 Legislation - District of Columbia B , enrolled, released 7/8/11; Legislation Enacted September 14, 2011 and effective for tax years beginning after December 31, 2010 (See DC Council website Enter A for full details of legislation.) Combined reporting required for any taxpayer engaged in a unitary business with one or more corporations that are part of a water s edge combined group; unless taxpayer elects or alternate filing method determined to be required by District of Columbia Does not appear to include unincorporated businesses in combined reporting requirement. Adopts Joyce apportionment standard. Limits the use of credit and net operating losses to the member that earned such credits and losses Slide 12 6

7 Legislation - District of Columbia Enacted September 14, 2011 Charitable contributions allowed on a combined group basis. ASC 740 fix included (publicly traded companies) Where a combined group or member includes or owns and unincorporated business that would be subject to [the District unincorporated business tax] the group or member excludes from District taxable income its pre-apportioned distributive share of unincorporated business income in computing District taxable income. The group or member then makes an addition modification to include in District taxable income its distributive share of postapportioned unincorporated business income. Catch up Tax payment required by December 15, 2011 in addition to 4 th quarter estimated tax payment. Regulations and additional guidance forthcoming. Slide 13 Legislation - Massachusetts H.B. 3581, enacted 7/11/11 The 2008 tax package established a deduction for any combined group that experienced an increase in the group's net deferred tax liability as a result of the combined reporting requirements of unitary businesses. The deduction, which will be claimed over a seven-year period, was to take effect for tax years beginning in H.B postpones the implementation of the deduction for one year, by allowing deductions to first be claimed in Slide 14 7

8 Legislation - North Carolina H.B. 619, enacted, 6/30/11 If the Secretary believes that a corporation fails to accurately report its net income properly attributable to business carried on in the State through transactions between members of an affiliated group that lack economic substance or that are not at fair market value, the Secretary may ask corporation to provide information report regarding transactions. Upon review of the information provided, if the Secretary determines that the intercompany transactions lack economic substance or are not at fair market value, it may redetermine the corporation's net income properly attributable to the State by: adding back, eliminating, or otherwise adjusting the intercompany transactions. If such adjustments are not adequate the Secretary may require the corporation to file a combined return that includes all members of its affiliated group (regardless of whether the members are doing business in the state) that are conducting a unitary business. Slide 15 Legislation - Rhode Island H.B. 5894, enacted 6/29/11 Each corporation that is part of a unitary business to file a report with the corporation's tax return for tax years beginning after 12/31/10 but before1/1/13, containing the combined net income of the combined group, and providing: the difference in tax owed as a result of filing a combined report compared to the tax due under the current filing requirements; the difference in tax owed as a result of using a single sales factor apportionment method compared to the current three factor formula; volume of sales and taxable income in the state and worldwide. Does not apply to certain public service corporations, banks, and insurance companies. Income and apportionment factors of a foreign corporation are excluded if the average property, payroll and sales of the corporation are 80% or more outside the U.S. Slide 16 8

9 H.R. 1439, the Business Activity Tax Simplification Act of 2011, introduced 4/8/2011 Newly incorporated proposal, entitled "Group Returns" would require states that adopt combined reporting to use a Joyce rather than a Finnigan standard to apportion income. Specifically, where net income or other economic results (e.g., gross receipts) of affiliated persons are taken into account in determining a net income or other business activity tax liability of a person for a taxable year (1) the amount of combined or consolidated net income (or other economic results) subject to tax in a state "shall be computed using the methodology that is generally applicable to businesses conducting similar business activities"; and (2) if this methodology employs an apportionment formula, the denominator(s) shall include the aggregate factors of all persons whose net income or other economic results are included in such combined or consolidated net income (or other economic results), and the numerator(s) shall include the factors attributable to the state "of only those persons that are themselves subject to taxation by the State pursuant to the provisions of this Act and subject to all other legal constraints on State taxation of interstate or foreign commerce." Slide 17 Cases North Carolina Delhaize America, Inc. v. Secretary of Revenue of North Carolina, 06 CVS 08416, 01/12/11 - A decision by the North Carolina Secretary of Revenue to require a taxpayer to file combined income returns was not an abuse of discretion, nor was such decision arbitrary or unreasoned, the North Carolina Superior Court ruled. - However, the secretary did abuse its discretion when it ordered the taxpayer to pay a 25 percent penalty because such penalty was contrary to established law, violated due process, and resulted in the secretary exercising its taxing powers in an unjust and inequitable manner. - Delhaize and the Department have both appealed the decision Slide 18 9

10 Cases New York Interaudi Bank F/K/A Bank Audi (USA), New York Tax Appeals Tribunal, DTA No , 4/14/11 The New York Tax Appeals Tribunal (TAT) affirmed a decision to force the combination of a bank and its subsidiary because an interest deduction attributable to assets held by the subsidiary resulted in distortion of income. The Division of Taxation demonstrated that the transfer of bank s investments to Delaware subsidiary was an arrangement whereby expenses incurred in order to fund the purchase of assets were left with the bank, but the assets themselves (and associated income generated from such assets) were transferred to the subsidiary. This arrangement created a mismatching of related income and expenses and lead to Bank s overstating its deductions or understating its income a distortion eliminated by forcing combination. Slide 19 Nexus Slide 20 10

11 Nationwide Trends Nexus and Related Developments Economic Nexus and Factor Presence Nexus - Agency Business Activity Tax Legislation Slide 21 California S.B.X3 15 enacted, 2/20/09; effective January 1, Doing business includes: sales in the state for the taxable year exceed the lesser of $500,000 or 25% of the taxpayer's total sales (sales include sales by an agent or independent contractor of the taxpayer); having real property and tangible personal property in the state exceeding $50,000, or 25% of the taxpayer's total real and tangible personal property; or paying compensation in the state in excess of $50,000, or 25% of the total compensation paid by the taxpayer. Slide 22 11

12 Colorado Col. Code Regs. Sec , effective 4/30/10 Imposes factor presence nexus standards for corporate income taxes A corporation is doing business in Colorado when the minimum standards of PL are exceeded and it has substantial nexus with the state as provided: - Business entities organized or commercially domiciled in the state have substantial nexus in Colorado - Business entities organized outside of Colorado that are doing business in the state have substantial nexus when in any tax period the business s property, payroll or sales in Colorado exceed any of the following thresholds: $50,000 of property; $50,000 of payroll; $500,000 of sales; or 25% of total property, or total payroll, or total sales. Slide 23 Connecticut H.B. 6802, enacted without signature, 9/5/09 - Corporate business tax imposed on "any company that derives income from sources within the state, or that has a substantial economic presence within this state, evidenced by a purposeful direction of business toward this state, examined in light of the frequency, quantity and systematic nature of a company's economic contacts with this state, without regard to physical presence, and to the extent permitted by the Constitution of the United States." Slide 24 12

13 Connecticut S.B. 6652, enacted, 6/21/11 - Economic presence nexus does not apply to a foreign corporation under the I.R.C. that has no income effectively connected with a U.S. trade or business. - To the extent a foreign corporation has income effectively connected with a U.S. trade or business and has nexus, its gross income is limited to the effectively connected income. - Tax is imposed on a company that derives income from the state and has a substantial economic presence within the state. Slide 25 Connecticut Information Publication 2010(29), 9/23/10 - An out-of-state company, partnership, or S corporation will be deemed not to have economic nexus for a taxable year, if the frequency, quantity and systematic nature of its economic contacts with the state are such that its receipts from business activities in the state are less than $500,000 for the taxable year. - Examples of purposeful direction : an out-of-state bank that engages in active solicitation and that has significant receipts; an out-of-state entity that provides online financial services and that generates significant receipts; and an out-of-state car loan company that generates substantial interest and other income attributable to Connecticut customers. Slide 26 13

14 Connecticut Information Publication 2010(29), 9/23/10 (cont d) - The in-state ownership and use of intangible property by an entity in Connecticut would create economic nexus when: the intangible property generates gross receipts within the state; the activity through which the entity obtains such gross receipts from its intangible property is purposeful, and the entity's presence within the state, as indicated by its intangible property and its activities with respect to that property, generate receipts of $500,000 or more in a tax year. - Income arising from passive investment activity will not be considered as the basis for finding that an entity has nexus in the state, the notice provides. Slide 27 New Jersey Department Release Economic Nexus TAM-6, 1/10/11 - Department notice, cited 2002-enacted nexus standards and Lanco (NJ) and MBNA (WV) to explain that all corporations, including financial corporations, that solicit business within New Jersey or derive receipts from sources within the state, must file corporate business tax returns and pay the applicable tax to the state. Slide 28 14

15 Washington 2ESSB 6143 Effective June 1, 2010 Substantial nexus exists if a taxpayer has one of the following: - more than $50k of property in the state; - more than $50k of payroll in the state; - more than $250k of receipts from this state; or - at least 25% of the persons total property, total payroll, or total receipts in this state. - These standards apply to the activities taxable under the 'service and other' and royalties B&O tax classifications. For other taxpayers, substantial nexus exists upon a physical presence in the state, "which need only be demonstrably more than a slightest presence." Physical presence exists if the person has property or employees in the state, or if the person, either directly or through an agent or other representative, engages in activities in Washington that are significantly associated with the person's ability to establish or maintain an in-state market for its products. Slide 29 Wisconsin S.B. 62, enacted 2/19/09, generally effective for tax years beginning on or after January 1, 2009 Economic nexus - Doing business" in the state includes: Regularly selling products or services of any kind to customers in Wisconsin who receive the product or service in the state Regularly soliciting business from potential customers in Wisconsin Regularly performing services outside of Wisconsin for which the benefits are received in Wisconsin Regularly engaging in transactions with Wisconsin customers that involve intangible property and result in receipts flowing to the taxpayer from within Wisconsin Holding loans secured by real or tangible property located within Wisconsin Slide 30 15

16 Cases - Washington Lamtec Corp. v. Department of Revenue, Wash. Sup. Ct., No , 01/20/11. An out-of-state manufacturer with no physical presence in Washington was subject to the business and occupation tax because its employees' occasional visits to in-state customers established and maintained a sales market in the state, thereby creating substantial nexus. Slide 31 Cases - Iowa KFC Corporation, Appellant v. Iowa Department of Revenue, Appellee., Iowa Supreme Court, No , 12/30/2010 An out-of-state franchisor with no in-state property or payroll is subject to income tax because physical presence is not required in order to have sufficient nexus with the state and the income at issue is directly connected to the state. The court concluded that the Commerce Clause "is not offended by the imposition of Iowa income tax on KFC s royalties earned from the use of its intangibles within the State of Iowa because physical presence is not required to establish substantial nexus when a state imposes an income tax. The court stated that the U.S. Supreme Court " would likely find intangibles owned by KFC," but utilized in Iowa, to "be regarded as having a sufficient connection to Iowa to amount to the functional equivalent of 'physical presence' under Quill. Slide 32 16

17 Cases - Ohio L.L. Bean, Inc. Final Determination, 8/10/10 The Quill physical presence standard is limited to sales and use taxes and, therefore, does not apply to the Commercial Activity Tax. The taxpayer met (and did not contest) that it met the sales threshold under the CAT factor presence nexus standards. The Tax Commissioner concluded that substantial nexus under the Constitution was established by the taxpayer's continuous, systematic, and significant exploitation of the Ohio market. The Tax Commissioner may issue special final determinations on assessments that must be appealed directly to the Ohio Supreme Court if the petitioner s primary issue is the constitutionality of the bright-line presence provisions. The commissioner has chosen not to pursue this available faster appeal track so that a full factual record can be developed before the Ohio Board of Tax Appeals. Slide 33 Ruling - California Legal Ruling , 1/11/2011 The California activities performed by a disregarded entity are treated as activities of its owner, and cause the disregarded entity's owner to have nexus and be subject to the California franchise tax. Disregarded entities includes Qualified Subchapter S Subsidiaries ("QSubs") and Single Member Limited Liability Companies ("SMLLCs"). Cal. Rev. & Tax. Code Sec specifies that "activities" of a QSub "shall be treated as activities of the S Corporation." Therefore, if the QSub is doing business in California, so is its owner. When a SMLLC elects to be treated as a disregarded entity, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner. Therefore, if the disregarded SMLLC has business activities in California, its corporate owner will also be deemed to be engaged in those business activities in California. Slide 34 17

18 Business Activity Tax Legislation On April 8, 2011, US Representatives Bob Goodlatte (R-VA) and Bobby Scott (D-VA) introduced H.R. 1439, the Business Activity Tax Simplification Act of Expansion of Public Law codified physical presence nexus standard, 15-day de minimis period for the imposition of a business activity tax. Hearing held July 8, 2011, where various proposed amendments failed to pass. Slide 35 Nexus - Open Issues Is physical presence required for income/franchise tax? If so, when might the physical presence of an affiliate be relevant? If economic nexus is a valid concept, is there distinction between licensing activities such as trademark licensing and licensing patents? Do all types of licensing raise the same economic nexus concerns? MBNA involves third party activity, not inter-company activity. Is this an important distinction? U.S. Supreme Court passes on review of Lanco and MBNA. Is this a green light for economic nexus standards? What are the ramifications of an enhanced effort to pass the streamlined bill and the U.S. Supreme Court continually denying income tax nexus cases on the business activity bill? Slide 36 18

19 Tax Base Slide 37 Nationwide Trends Tax Base/Decoupling From I.R.C. Stimulus Provisions Internal Revenue Code conformity - Rolling conformity - Fixed-date conformity - Select provisions adopted States likely to decouple from provisions deemed too costly - Majority of states decoupled from bonus depreciation - Numerous states limited expense allowance - State-specific NOL provisions often limit carryover - Section 199 Domestic Production Activity - COD income deferral Slide 38 19

20 Nationwide Trends Tax Base/Related Party Addbacks Inclusion of related member interest payments and management fees, as well as royalties Broader provisions which require addback of intangible expenses along with expansive definitions of intangibles Typical safe harbors - Economic substance/arm s length rates & terms for transactions - Purpose other than state income tax avoidance - Payment of income tax by royalty recipient - Royalty recipient not primarily engaged in maintenance and management of intangibles (i.e., not an IHC) - Ultimate pass-through of expense to unrelated party - Requirement to make a disclosure to become eligible for a safe harbor - Unreasonableness exceptions Slide 39 Nationwide Trends Tax Base/Related Party Addbacks Deductibility of all types of intercompany charges are being challenged by state auditors, including intercompany management fees, finance charges and other overhead costs. States are concerned that deductions do not have a valid business purpose, are not based on arm s length pricing or are otherwise not legitimate. States are looking for transfer pricing studies for each type of charge. If taxpayers do not have transfer pricing studies, states are disallowing deductions, reallocating income and expenses, or adjusting mark-ups. Slide 40 20

21 Nationwide Trends Tax Base/Related Party Addbacks Intercompany Expenses: Questions - Intercompany expenses subject to addback does an exemption apply and can a claim of exemption be supported? - Intercompany charges other than interest and royalties are deductions valid, what is business purpose, is charge at arm s length, are charges settled? - Challenges to the "Add-back" statutes Will Taxpayer more likely than not be able to sustain a challenge when states' interpretation of "subject to tax in another state" or other exceptions are vague. Slide 41 Nationwide Trends Related Party Addbacks WA CA OR NV ID UT MT WY CO ND SD NE KS MN** WI IA IL MO ME MI NY VT NH MA CT RI PA NJ IN OH DE WV MD KY VA DC AZ NM OK AR TN NC SC* AK MS AL GA HI TX LA FL Related member expense addback required (including DC, NYC) Related Party expenses must be disclosed or addback is required (TN only) Related member expense addback legislative proposals considered in recent years No related party addback provisions imposed *South Carolina disallows deductions for an expense between related parties where a payment is accrued, but not actually paid and on interest deductions on obligations issued as a dividend or paid instead of a dividend **Minnesota requires addback of interest and intangible expenses, losses, and costs paid, accrued, or incurred by any member of the taxpayer's unitary group to a foreign operating corporation that is a member of the taxpayer's unitary business group, Slide 42 21

22 Unreasonableness Exception Litigation Beneficial New Jersey, Inc. v. Director, Division of Taxation, N.J. Tax Ct., No , 8/31/2010 The "unreasonableness" exception to related party addback applied based on a "totality" of factors including economic substance and business purpose. The court rejected the state's limited reading of this exception to instances of "double taxation" and as applied to centralized cash management systems, finding that this narrow reading was itself an unreasonable application of the statute. Slide 43 Economic Substance-Business Purpose Litigation HMN Financial, Inc. and Affiliates v. Commissioner of Revenue, Minn., No. A , 5/20/10 The Minnesota Commissioner of Revenue does not have the authority to disregard a taxpayer's captive real estate investment trust structure on the ground that the structure had the primary purpose of tax avoidance. There was a lack of support for the Commissioner's assertion of the business purpose and economic substance doctrines in either Minnesota statutes or in the common law. Slide 44 22

23 Sham Transaction Litigation IDC Research, Inc. v. Commissioner of Revenue, Mass. App. Ct. 09-P- 1533, 11/30/2010 The Massachusetts Appeals Court concluded that the transfer of a trademark from the taxpayer's parent company to a subsidiary was a sham transaction and required that the royalty income received by the subsidiary for such trademark be reallocated to the parent company. The court said that "transactions between related companies may be closely scrutinized 'to ensure that they have substance as well as form. Slide 45 Other Litigation River Garden Retirement Home v. Franchise Tax Board, First Appellate District, Division Four, No. A123316, 7/25/10 The retroactive denial of the dividends received deduction did not violate due process or provisions of the California Constitution. The court also upheld the penalty for not participating in the state's tax amnesty program because the taxpayer did not pay its amnestyeligible deficiency assessments until two years after the close of the amnesty period. Slide 46 23

24 Other Litigation ConAgra Foods, Inc. v. Bridges, La. Ct. App., 1st Cir., Dkt. No CA 0907, 10/29/2010 A corporation was entitled to claim the net operating loss (NOL) carryovers of three wholly-owned subsidiaries operating in Louisiana whose stock it sold to unrelated companies with which the former parent/seller made Sec. 338(h)(10) elections. The seller company was entitled to the NOL carryovers for state tax purposes as the "acquiring corporation" under La. Rev. Stat. Ann. Sec. 47:287.86(I)(1), which is similar to Sec Other provisions of Louisiana law that limited or differently defined or applied the term "acquiring corporation" were inapplicable where Sec. 47:287.86(I)(1) provided the controlling guidelines for determining the entity entitled to succeed and take into account the NOLs of distributors or transferor corporations. Slide 47 Other Litigation International Business Machines Corporation v. Director, Division of Taxation, N.J. Tax Court No , 1/26/11; Creston Electronics Corporation v. Director, Division of Taxation, N.J. Tax Court No , 1/26/11 Taxpayers could not be required to add back extraterritorial income for corporation business tax purposes because such income is not enumerated among the statutory exceptions to federal taxable income. The court found the Division of Taxation could not rely on the introductory sentence of the definitional statute of entire net income, while ignoring what comes after, and that the regulation does not require the addback of extraterritorial income. Slide 48 24

25 Other Litigation GKN Westland Aerospace, Inc. v. State Department of Revenue, Admin. Law Div. Dkt. No. BIT , 7/25/11 A corporate taxpayer properly calculated its IRC section 199 domestic production activities deduction by applying the taxable income limitation on a separate company basis for Alabama tax purposes. Alabama DOR disallowed the deduction because the taxpayer s consolidated group's federal deduction was zero, and, therefore, there was no deduction to allocate for state tax purposes. On appeal, the taxpayer contended that it was entitled to compute its state DPAD on a separate company basis, citing DOR regulations and a "long-standing administrative practice that requires taxpayers to apply certain limitations that are applied on a consolidated basis for federal income tax purposes on a separate company basis for Alabama tax purposes. ALJ agreed with the taxpayer, holding that Reg (4)(a) requires that for Alabama tax purposes the deduction and the income limitation in issue must be calculated on a separate entity basis. Slide 49 Other Developments Intercompany Pricing New Jersey Division of Taxation, TAM-17, 6/6/2011 The NJ Dept. of Taxation is not bound by advance pricing agreement between a taxpayer and the IRS in evaluating the appropriateness of intercompany pricing and may use other criteria in determining a "fair and reasonable tax" under New Jersey law. The Division will utilize IRC 482 standards in auditing and adjusting items above line 28 of Schedule A of the Corporation Business Tax return. Where a taxpayer can demonstrate that it has met the standards of IRC 482, no adjustments are likely to be made above Line However, NJ law "goes beyond IRC 482 situations," including a grant of authority to the Division to include a "fair profit" in a taxpayer's income. The Division notes that Section 482 is "not the only provision that relates to audits of related taxpayers, and other issues may arise in a particular audit such as 'nexus' rules for affiliates." Slide 50 25

26 Anti-RIC/REIT Activity Alabama (2008) Arkansas (2009) Colorado (2009) Connecticut (2010) Georgia (2009) Illinois (2007) Indiana (2007) Kentucky (2007) Maryland (2007) Requires the addback of the dividends paid deduction of a captive REIT Requires captive REITS add back the dividends paid deduction Requires disclosure of transactions involving a captive RIC or REIT Disallows the dividends-paid deduction for captive REITs Requires taxpayers to add back all expenses and costs paid, accrued, or incurred to a captive REIT Requires add back of any deduction under I.R.C. Sec. 857(b)(2)(B) for dividends paid to a corporation by a captive REIT Requires add back of federal deduction for dividends paid to shareholders of captive REITs Disallows the dividends-paid deduction for captive REITs Disallows the dividends-paid deduction for captive REITs Slide 51 Anti-RIC/REIT Activity Minnesota (2008) Minnesota (2010) Minnesota (2011) New York (2007, 2008, 2010) New York City (2009) North Carolina (2007) North Carolina (2008) North Dakota (2009) Requires addition for dividends attributable to income of an FOC that is a member of the taxpayer's unitary group, in an amount equal to the dividends paid deduction of a REIT for amounts paid or accrued by the REIT to the FOC Deduction for dividends received from a REIT disallowed if the dividends are not considered to be dividends under IRC sections 243(d)(3) and 857(c). Exclude dividends received from a REIT in calculating the deduction allowed to a corporation for dividends received from another corporation (DRD), effective for taxable years ending after 12/31/11 Requires combination of captive REITs and RICs with parent; requirement made permanent in Conformity to state provisions Disallows the dividends-paid deduction for captive REITs Prohibits a captive REIT from claiming a franchise tax deduction for the value of its investments Disallows the dividends-paid deduction for captive REITs Oklahoma (2008) Oklahoma (2009) Requires an addback of otherwise deductible rents and interest expenses paid to a captive REIT Disallows the dividends-paid deduction for captive REITs Slide 52 26

27 Anti-RIC/REIT Activity Oregon (2007) Oregon (2009) Rhode Island (2007) Tennessee (2008) Tennessee (2008) Utah (2008) Virginia (2009) West Virginia (2009) Wisconsin (2008) Under tax shelter program, listed transactions include certain transactions involving REITs and RICs that lack economic substance. Requires an affiliated group's consolidated state tax return to include RICs and REITs that would not otherwise be a member of a federal consolidated group Disallows the dividends-paid deduction for captive REITs Imposes captive REIT dividend disclosure requirements on financial institutions Redefines captive REITs, defines net earnings and net losses for a captive REIT affiliated group, and extends provisions that establish the property factor, payroll factor and receipts factor for taxpayers electing to compute net worth on a consolidated basis to members of a captive REIT affiliated group. Captive REITs in unitary group, disallowing dpd for captive REITs, and allow deductions for dividends received from a captive REIT by a unitary group member subject to combined reporting. Disallows the dividends-paid deduction for captive REITs Modifies provisions requiring REITs and RICs to add back the amount of the federal dividend paid deduction Disallows deductions for interest and rental expenses paid to related entities (one of the safe harbors related entity cannot be REIT other than a qualified REIT) Slide 53 Allocation and Apportionment Slide 54 27

28 Nationwide Trends Allocation and Apportionment Apportionment Trends - Shift in factor weighting - Sales factor Gross versus net Market source versus cost of performance Apportionment Cases Slide 55 Apportionment Formulas* WA CA OR NV ID AZ UT MT WY CO NM ND SD NE KS OK MN IA MO AR WI IL MI OH IN KY TN WV SC ME VT NH MA NY CT RI PA NJ DE VA NC MD DC AK MS AL GA TX LA HI FL *Does not address industry-specific or optional formulas Equally weighted three factor formula Double weighted sales factor Triple or greater weighted or single sales factor Slide 56 28

29 Apportionment Formulas* WA CA OR NV ID AZ UT MT WY CO NM ND SD NE KS OK MN IA MO AR WI IL MI OH IN KY TN WV SC ME VT NH MA NY CT RI PA NJ DE VA NC MD DC AK MS AL GA TX LA HI FL *Does not address industry-specific or optional formulas Equally weighted three factor formula Double weighted sales factor Triple or greater weighted or single sales factor Slide 57 Apportionment Formulas* WA CA OR NV ID AZ UT MT WY CO NM ND SD NE KS OK MN IA MO AR WI IL MI OH IN KY TN WV SC ME VT NH MA NY CT RI PA NJ DE VA NC MD DC AK MS AL GA TX LA HI FL *Does not address industry-specific or optional formulas Equally weighted three factor formula Double weighted sales factor Triple or greater weighted or single sales factor Slide 58 29

30 Market-Based Sourcing WA OR ID MT WY ND SD MN WI MI NY ME VT NH MA CT RI CA* NV UT CO NE KS IA MO IL IN KY OH WV PA NJ MD DE VA DC AZ NM OK AR TN NC SC AK MS AL GA TX LA HI FL *Effective in 2011, for taxpayers that elect single sales factor only Slide 59 Legislation California S.B. 858, enacted 10/19/10 (Background) Under legislation enacted in February 2009, for taxable years beginning on or after 1/1/11, corporate taxpayers may elect a single sales factor apportionment formula in lieu of the generally applicable three-factor, double-weighted sales formula, and market sourcing for sales of other than tangible personal property replaced "cost of performance" method. S.B. 858 revives the cost of performance method, providing, for taxable years beginning on or after 1/1/11, that cost of performance will apply to taxpayers that apportion with either the generally applicable three-factor, double-weighted sales formula or the equally-weighted formula of property, payroll, and sales applicable to certain taxpayers. Market-based sourcing will apply to taxpayers electing the single sales factor apportionment formula. Slide 60 30

31 Legislation California S.B. 858, enacted 10/19/10 S.B. 858 requires that under California's new factor presence nexus standard effective for tax years beginning on or after 1/1/11, market sourcing must be used to determine whether the $500,000 economic nexus threshold for "sales in this state" is met. S.B. 858 states the amendments to the cost of performance rules should create "no inference" that those rules, either before or after amendment, are intended to properly reflect the market for the activities giving rise to the income. The legislation further states that, taken together, the cost of performance and market sourcing rules.. "are intended to accomplish the goal of proper market reflection in the sales factor numerator." Slide 61 Legislation Wisconsin S.B. 62, enacted, 2/19/09, effective January 1, 2009 Repeals the cost of performance method in favor of market sourcing method. Wisconsin receipts from gross royalties, other gross receipts for use, license or sale of intangible property (excluding securities) include receipts from: - Intangible property used in a trade or business in Wisconsin. If property used in more than one states, divide receipts amongst states having jurisdiction to impose tax, based on the proportion of use. - Receipts billed for the purchase, license or use of intangible property at a location within Wisconsin. - The purchaser or licensee has its commercial domicile in Wisconsin. - If the taxpayer is not subject to either the income or franchise tax in the state to which the receipts would be sourced and the taxpayer is commercially domiciled in Wisconsin, 50 percent of the receipts would be included in the numerator of the Wisconsin sales factor. Slide 62 31

32 Legislation Washington Washington 2 E.S.S.B. 6143, enacted, 4/23/10 For service, royalty, and certain other B&O tax classifications, taxpayers must source such income to Washington based on a receipts factor A separate receipts factor is required for each tax classification under which the taxpayer is subject to tax. In general, for purposes of computing the receipts factor, gross income from each apportionable activity is attributed as follows: - First, to the state where the customer received the benefit of the taxpayer's service, or in the case of gross income from royalties, where the customer used the taxpayer's intangible property. - If the customer received the benefit of the services or used the intangible property in more than one state, gross income is attributed to the state in which the service was primarily received or in which the intangible was primarily used. Slide 63 Legislation Washington A separate receipts factor is required for each tax classification under which the taxpayer is subject to tax. In general, for purposes of computing the receipts factor, gross income from each apportionable activity is attributed as follows (cont d) - If the taxpayer cannot determine the state where the service was primarily received or where the intangible was primarily used, the gross income is sourced to the state where the customer's billing statements or invoices are sent by the taxpayer. - If the taxpayer cannot determine the state where the customer's billing statements or invoices were sent, the gross income is sourced to the state from which the customer submits payment to the taxpayer. If such state cannot be identified, the gross income is sourced to the state where the customer is located as indicated by the customer's address as shown in the taxpayer's business records maintained in the ordinary course of business or obtained during the sale or negotiation of the contract for services or for the use of the intangible property. - If the taxpayer is still unable to determine the proper state, such gross income would be sourced to the commercial domicile of the taxpayer. Slide 64 32

33 Legislation - Alabama House Bill 434 (enacted 6/9/11) Double weights the sales factor, effective for tax years beginning on or after December 31, Market-based sourcing adopted for sales of other than tangible personal property. If the state of assignment cannot be determined under the market sourcing, the legislation requires that the state of assignment be reasonably approximated. If the taxpayer is not taxable in a state to which a sale is assigned, or if the state of assignment cannot otherwise be determined or reasonably approximated, the sale would be excluded from the sales factor denominator. Any sale of intangible property not otherwise described in the statute is also excluded from the sales factor. Slide 65 Legislation - Arizona House Bill 2001 b (enacted 2/17/11) Current double weighted or 80% sales factor 2014 double or 85% sales factor 2015 double of 90% sales factor 2016 double or 95% sales factor 2017 double or 100% sales factor Slide 66 33

34 Legislation - New Jersey Senate Bill 2753 (enacted 4/28/11) Amends the current corporation business tax apportionment formula, which provides for a double-weighted sales factor, to provide for a 70% sales factor, for privilege periods beginning on or after January 1, 2012 but before January 1, 2013; a 90% sales factor, for privilege periods beginning on or after January 1, 2013 but before January 1, 2014; and a single sales factor, for privilege periods beginning on or after January 1, Modifies the sales factor with respect to airlines, by replacing the ratio based on departures with a ratio of an airline's revenue miles in the state divided by total revenue miles, effective for privilege periods ending on or after January 1, Slide 67 Cases Alaska Tesoro Corporation and Subsidiaries v. State of Alaska, Alaska Superior Court, No. 3AN CI, 4/28/11 Taxpayer failed to show that refusal to allow separate accounting under 18 was unconstitutional. Revenue stream that taxpayer claimed was unconnected to an Alaska subsidiary was apportionable based on the existence of a unitary business. Court rejected arguments that - segments that are not integrated either horizontally or vertically can never found to be unitary; - Separate accounting the only fair relief under 18. The modified 3-factor formula applied by the Department, which added an extraction factor to property and sales factors (that reduced taxpayer s liability by one-third) was upheld. Slide 68 34

35 Cases California General Mills et al. v. Franchise Tax Board, Cal. Superior Ct., No. CGC , 11/1/10 The issue was whether the full sales price of a company's commodity futures sales contracts should be included as gross receipts in the sales factor. On remand, the court found that the FTB met its burden of proving that the apportionment formula does not fairly represent General Mills' activity in California, warranting imposition of an alternative formula. The court held: The complete exclusion of treasury function gross receipts from the sales factor (current Regulation 25137) and the recent amendment of section to exclude receipts from hedging transactions from the definition of gross receipts under UDITPA from January 1, 2011 forward, indicate that the No Futures Gross Receipts alternate formula is a reasonable approach. Slide 69 Cases California Microsoft Corporation v. Franchise Tax Board, Cal. Sup. Ct., San Francisco Cty., Statement of Decision, No. CGC , 2/17/11 Royalties received from the license of canned software to original equipment manufacturers are treated as income from the sale of tangible personal property and must be sourced to the location of the purchaser. The value of intangible personal property may not be included in the property factor absent a taxpayer s ability to show that such modification of the standard property factor is necessary to properly reflect income earned in the state. Slide 70 35

36 Cases Louisiana BP Products North America, Inc. v. Bridges, La. Ct. Appls., 1 st Circuit, Dkt. No. 529,766, 8/10/11 The sale of a Louisiana oil refinery was deemed to yield apportionable income over the state s protest that the proceeds be allocated to Louisiana in their entirety. The Department argued that the sale was not in BP s regular course of business and that the sale of fixed assets should be allocated to the site of the asset. However, the sale was not only for fixed assets but of an operating business a business that BP remained engaged in after the sale. The transaction that was a regular practice of BP, and the sale was directly related to BP s overall business - to streamline refining to better serve the needs of all segments of the business. Slide 71 Cases New Jersey Whirlpool Properties, Inc. & Pfizer, Inc. v. Director, Division of Taxation, N.J. Dkt. No. A-25, 7/28/11 The "throwout rule" is facially constitutional when applied to untaxed receipts from states that lack jurisdiction to tax a corporation due to insufficient nexus or because of congressional actions, such as P.L However, the rule violates the U.S. Constitution when applied to receipts that are not taxed by another state because the state chooses not to impose an income tax. Slide 72 36

37 Cases New Mexico In the Matter of the Protest of Chevron USA, Inc., New Mexico Taxation and Revenue Department Decision and Order No , 12/16/2010 New Mexico did not adopt MTC regulation excluding royalties for the extraction of natural resources from the definition of annual rent and that royalties here fall within the broadly worded definition of annual rent in the state regulation. The taxpayer's method for calculating the value of its oil and gas leaseholds was reasonable because it produced a value equivalent to the value of the production from those properties. Slide 73 Cases New York In the Matter of the Petition of Meredith Corporation, NYS Tax Appeals Tribunal, Dkt. No , 03/10/2011 License fees paid by an out-of-state television broadcasting business for program broadcasting are excluded from the property factor, which is limited to the taxpayer's average value of real and tangible personal property. The license fees were paid exclusively for the right to broadcast a program, which is an intangible asset. The method of delivery of the program is not "is not dispositive of whether the payment for broadcast licenses could be included in the property factor." Slide 74 37

38 Cases North Carolina In re Final Agency Decision No. 09 REV 5669, North Carolina Department of Revenue, 4/21/11 Gain on the sale of a minority interest in a limited partnership is nonapportionable income where the taxpayer is a mere passive investor and not engaged in a unitary business operation with the limited partnership. Accordingly, the gain is fully allocable to the commercial domicile of the taxpayer. Slide 75 Cases Oregon CenturyTel, Inc. v. Department of Revenue, Oregon Tax Court, No. 4826, 8/9/10 The gain on the sale of stock treated as an asset sale pursuant to I.R.C. Sec. 338(h)(10) was deemed to generate business income to the seller. In so ruling, the court said that even if there was a liquidation exception under the functional test for determining business income, such exception would not apply in the present situation where the seller used the proceeds to further its business operations. Slide 76 38

39 Cases Oregon AT&T Corp. et al. v. Dep't of Revenue; TC 4814, 6/28/11 Receipts from interstate and international calls that begin or terminate in Oregon are properly sourced to Oregon based on a costof-performance methodology. Tax court rejected taxpayer's approach that the cost transaction focuses on lines of business or product lines because it ignores the location of costs of performance. Slide 77 Cases South Carolina Media General, Inc., et al. v. South Carolina Department of Revenue, Opinion No , June 14, 2010 The use by three affiliated taxpayers of the combined entity apportionment method under the state's alternative apportionment relief statute was upheld. The Court rejected the Department of Revenue's argument that use of this method runs afoul of the legislative intent that the state treats taxpayers as a single entity. Slide 78 39

40 Cases Tennessee Blue Bell Creameries, LP v. Commissioner, Tenn., No. M SC-R11-CV, 1/24/2011 The capital gain resulting from a one-time stock transaction between the taxpayer and its holding company was apportionable income under both the statutory "functional test" for "business earnings," and the constitutional unitary business test for apportionability. Slide 79 Cases Texas TGS-NOPEC Geophysical Co. v. Comptroller, Tex., No , 5/27/11 Gross receipts from the licensing of seismic and geophysical data are receipts from the sale of an intangible asset and are sourced to the domicile of the payor rather than place of use. The Court found that the term "license" as used in the sourcing statute refers to licenses that are themselves revenue-producing assets, and not to the mechanism of licensing. In this case, the revenue that TGS received from conveying its geophysical data was not derived from the use of a license but from the use of the data. As such, the receipts must be sourced to the domicile of the payor as receipts from "other business." Slide 80 40

41 Cases Wisconsin Ameritech Publishing, Inc. v. Wisconsin Department of Revenue, Wisc. Ct. App., Dist. IV, Dkt. No. 2009AP445, 6/24/10 An out-of-state corporation engaged in the business of solicitation, production, and delivery of telephone directory advertising was required to source its advertising receipts wholly to Wisconsin. The taxpayer's true income producing activity occurred when the intended audience received the directories containing the advertising in Wisconsin, instead of when solicitation, creation, development, design, assembly and production activities occurred, mostly outside of the state. Slide 81 Other Nationwide Developments Slide 82 41

42 Michigan Tax Reform House Bills 4361 and 4362: 1) House Bills 4361 and 4362 were enacted on May 25, ) HB 4361 (Chapter 10) New Corporate Income Tax - Definitions 3) HB 4361 (Chapter 11) Imposition of the new tax 4) HB 4361 (Chapter 12) Tax on insurance companies (same as under MBT) 5) HB 4361 (Chapter 13) Tax on financial institutions (same as under MBT) 6) HB 4361 (Chapter 14) Apportionment 7) HB 4361 (Chapter 15) Small Business Alternative Credit 8) HB 4361 (Chapter 16) Estimate/extensions /admin 9) HB 4362 Certificated Credits 83 Michigan Tax Reform New Corporate Income Tax Key Characteristics: Effective 1/1/12 Tax on income (no gross receipts/franchise component) C corporations only subject to tax Flow-thru entities not subject to the new tax 6% tax rate Unitary principle is retained Like MBT decouple from Sec. 199 and bonus depreciation Single sales factor (explicit language on excluding prop & payroll) Market based sourcing of service revenue Finnigan rule for sales apportionment 84 42