Slicing the Pie Update on State Tax Apportionment Litigation TEI Denver May 15, 2017 Maria Todorova Partner Ted Friedman Associate 2018 (US) LLP
Agenda Introduction Key Issues Recent Developments Sales factor Costs of performance sourcing Market sourcing Alternative apportionment Invoking alternative apportionment Standard Burden 2
Introduction
Introduction A state may tax a fair share of profits earned from activity conducted within its borders using apportionment. Underwood Typewriter v. Chamberlain, 254 U.S. 113 (1920). States have significant leeway in adopting an apportionment formula; however, the apportionment method selected by a state cannot be arbitrary and must not produce unreasonable results. Hans Rees Sons v. North Carolina, 283 U.S. 123 (1931). State apportionment methodologies vary. UDITPA s three-factor formula uses property, payroll, sales Other (single, double or triple-weighted factors) Why the emphasis on the sales factor? Because the standard apportionment formula may produce unreasonable results, Section 18 provides an alternative apportionment method. Acts as a pressure valve for when standard apportionment formula produces arbitrary and unreasonable results Intended to be applied only in unusual or unique circumstances 4
Key Issues
Key Issues Sales Factor Sales factor provisions for sales, other than sales of TPP Standard (UDITPA) costs of performance provision: Sales, other than sales of tangible personal property, are in this state if: (a) the income-producing activity is performed in this state; or (b) the income-producing activity is performed both in and outside this state and a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance. Standard (UDITPA) market sourcing provision: Receipts, other than receipts described in Section 16, are in this State if the taxpayer s market for the sales is in this state. The taxpayer s market for sales is in this state: (3) in the case of sale of a service, if and to the extent the service is delivered to a location in this state; and (4) in the case of intangible property, (i) that is rented, leased, or licensed, if and to the extent the property is used in this state, provided that intangible property utilized in marketing a good or service to a consumer is used in this state if that good or service is purchased by a consumer who is in this state 6
Key Issues Sales Factor Sales factor issues Sales, other than sales of TPP Costs of performance sourcing Income-producing activities What are the income-producing activities? What approach applies? Transaction approach Operational approach Whose activities? Costs What are the relevant costs? Direct costs Indirect costs Market sourcing What/where/who is the market? Where is the benefit received? Sales factor denominator issues 7
Key Issues Alternative Apportionment Standard (UDITPA) alt. apportionment provision: If a state s statutory method does not fairly represent the extent of the taxpayer s business activity in [the] state, the taxpayer may petition for or the [Department] may require, in respect to all or any part of the taxpayer s business activity, if reasonable: (a) Separate accounting; (b) The exclusion of one or more of the factors; (c) The inclusion of one or more additional factors which will fairly represent the taxpayer s business activity in this state; or (d) The employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer s income. 8
Key Issues Alternative Apportionment Alternative apportionment issues Does distortion exist? Is the proposed alternative method reasonable? What is the burden? Did the moving party satisfy the burden? 9
Recent Developments Sales Factor
Oregon Sales Factor (Sales of Online Classes) Apollo Educ. Grp. Inc. v. Or. Dep t of Revenue, TC-MD 150352C (Or. T.C. Aug. 24, 2017) The Oregon Tax Court upheld the Department s sourcing methodology, which sourced receipts from sales of online educational services based only on faculty cost data from a corporation s cost study. A taxpayer s income-producing activity is the activity the taxpayer obliges itself to perform when it accepts money from a customer. It is the service the taxpayer s customer has a right to expect. The court found that the corporation s IPA was the provision of a course section. Direct costs of an income-producing activity are incremental costs. The court found that the corporation s only direct costs for providing course sections were faculty costs. 11
Indiana Sales Factor (Sales of Online Classes) Univ. of Phoenix, Inc. v. Ind. Dep t of State Revenue, 88 N.E.3d 805 (Ind. T.C. Nov. 30, 2017) The Indiana Tax Court held that the Department incorrectly sourced a corporation s revenue according to the location of its market, rather than the location of the costs of its income-producing activities. According to the court, Indiana s COP sourcing statute sources a taxpayer s revenue to the Indiana numerator based on the seller s acts: the performance of acts from the perspective of sales, thus, the seller, not from the view of the buyer or consumer - to generate income. Accordingly, income producing activities are not limited to what those students directly pay for, as the Department urges, but encompass acts a seller directly engaged in with the purpose to generate revenue. The corporation was not required to use a transactionby-transaction approach as the basis of its cost study. 12
South Carolina Sales Factor (Subscription Receipts) DIRECTV Inc. v. S.C. Dep t of Revenue, No. 2015-001509 (S.C. Ct. App. Aug. 30, 2017) The South Carolina Court of Appeals found that a corporation s sole income-producing activity related to its South Carolina customer subscription receipts was the delivery of its satellite signal to those customers. The court held that all of the corporation s South Carolina customer subscription receipts were properly sourced to the state due to the location of its satellite signal delivery. The court found the proper burden of proof ( preponderance of evidence ) was applied to DIRECTV. The court affirmed the ALC s assessment of underpayment penalties because there was no reasonable cause for DIRECTV s underpayment. 13
New Jersey Sales Factor (Credit Card Service Fees) Bank of America Consumer Card Holdings v. Div. of Taxation, No. 0121945-2011 (N.J. Tax Ct. 2016) The New Jersey Tax Court held that the taxpayers must source 50% of their credit card service fees (e.g., late fees, return check fees, over the limit fees, non-sufficient fund fees, and annual fees) to New Jersey based on the State s regulatory 25/50/25 rule: 25% to where the service originates; 50% to where the service is performed; and 25% to where the service terminates. The court s opinion conflicts with New Jersey s statutory rules because New Jersey has not adopted market-based sourcing. The statute looks to the location of performance. 14
New York Sales Factor (Receipts from Services) In the Matter of Catalyst Repository Sys. Inc., No. 826545 (N.Y. Div. Tax. App. Aug. 24, 2017) The Administrative Law Judge (ALJ) determined that online litigation support services receipts are services and are allocated to the location where the services were performed, which were outside of New York. In the Matter of CheckFree Servs. Corp., Nos. 825971 & 825972 (N.Y. Div. Tax. App. Jan. 5, 2017) The ALJ determined that a taxpayer s electronic bill payment and presentation receipts constitute service receipts and not other business receipts, and are properly sourced where the service is performed. 15
Ohio Sales Factor (Receipts from Services) Defender Security Company v. Testa, No. 2016 1030 (Ohio Bd. Tax App. March 6, 2018) The taxpayer was an authorized dealer of security systems and sought to situs its Ohio CAT gross receipts based on the security system company's principal place of business Colorado, rather than the addresses of its Ohio customers. The Ohio Board of Tax Appeals (BTA) ruled against the taxpayer, noting that the Ohio CAT situses receipts where the purchaser s benefit is received. Although the taxpayer argued that the security system provider was the customer benefiting from the service contract, and not the ultimate consumer, the BTA reasoned that the property which performs the monitoring services in Ohio is the source of the benefit. Therefore, the taxpayer s sales on contracts should be sourced to the location of the monitoring equipment in Ohio. 16
Sales Factor - New Jersey (Throwout) Elan Pharmaceuticals, Inc. v. Dir., Div. of Taxation, No. 010589 2010 (N.J. Tax Ct. 2017) The company included sales of tangible personal property shipped from locations outside New Jersey to states in which the company was immune from tax under P.L. 86-272 in its sales factor denominator. On February 6, 2017, the New Jersey Tax Court rejected the Division of Taxation s attempt to apply the throwout rule to these receipts. The court found it irrelevant whether the receipts were actually included in the numerator of a sales factor of another state. 17
Recent Developments Alternative Apportionment
Alt. Apportionment Background Because the standard apportionment formula may produce unreasonable results, UDITPA Section 18 provides an alternative apportionment method. Standard (UDITPA) alt. apportionment provision: If a state s statutory method does not fairly represent the extent of the taxpayer s business activity in [the] state, the taxpayer may petition for or the [Department] may require, in respect to all or any part of the taxpayer s business activity, if reasonable: (a) Separate accounting; (b) The exclusion of one or more of the factors; (c) The inclusion of one or more additional factors which will fairly represent the taxpayer s business activity in this state; or (d) The employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer s income. 19
Alt. Apportionment Background Multistate Tax Commission (MTC) Regulation IV.18(a) provides: Original:.... only in specific cases where unusual fact situations (which usually will be unique and non-recurring) produce incongruous results.... As Amended:... only in limited and specific cases where the apportionment and allocation provisions contained in Article IV produce incongruous results.... States have increasingly applied alternative apportionment methodologies where the statutory apportionment formula results in less income apportioned to the state than the state believes is fair. 20
Alt. Apportionment Background Invoking Alternative Apportionment Moving Party Assert Distortion Yes No Proposed Alternative Reasonable Yes No Alternative Apportionment No Alternative Apportionment No Alternative Apportionment Burden of proof is on the party seeking to diverge from the standard apportionment formula to prove that distortion exists, and that a proposed alternative method is reasonable. 21
Alt. Apportionment Background Standard for Alternative Apportionment A proponent (a state or taxpayer) of an alternative apportionment method bears the burden of proof in showing that: (1)The statutory formula does not fairly represent the taxpayer s business activities in the state; and (2) A proposed alternative method is reasonable. 22
South Carolina Alt. Apportionment (Burden Not Met) Rent-A-Center West, Inc. v. S.C. Dep t of Revenue, 418 S.C. 320 (S.C. Ct. App. 2016) The South Carolina Court of Appeals determined that a corporation could utilize the state s standard three-factor apportionment formula, and rejected a challenge by the Department of Revenue to require alternative apportionment based on the argument that the statutory method used by the corporation was distortive. The party seeking to use an alternative apportionment method bears the burden of proving by a preponderance of the evidence that (1) the statutory formula does not fairly represent the taxpayer s business activity in South Carolina and (2) its alternative accounting method is reasonable. 23
Maryland Alt. Apportionment (Burden Not Met) Petition of Staples Inc. and Staples the Office Superstore, LLC, and the Decision of the Md. Tax Court, No. C-02-CV-15-002009 (Md. Cir. Ct. 2016) Affirmed that enterprise dependency with in-state affiliates created nexus for out-of-state entities. Affirmed the Comptroller s application of an alternative apportionment formula because the out-of-state entities failed to carry their burden of proving that the Comptroller s non-statutory formula produced a tax liability out of all appropriate proportion to the business transacted in Maryland or led to a grossly distorted result. Comptroller used an alternative apportionment method identical to used in Gore. 24
Virginia Alt. Apportionment (Rejected; COP Upheld) Corp. Exec. Bd. v. Va. Dep t of Taxation, No. CL16-1525 (Va. Cir. Ct. Sept. 1, 2017) The Virginia Circuit Court (Arlington County) held in favor of the Department of Taxation s use of the statutory COP method to apportion income from the sales of subscription-based services because use of the COP method did not lead to inequitable results and was not unconstitutional. The court found that under the COP method, most of the taxpayer s sales originated in Virginia and were attributable to the state. The court rejected the corporation s request for alternative apportionment using market-based sourcing and characterized the request as arbitrary. 25
New Jersey Alt. Apportionment (If Distortion, What s Appropriate?) Canon Financial Services, Inc. v. Dir., Div. of Taxation, No. 000404-2014 (N.J. Tax Ct. 2016) (unpublished) Under prior law, taxpayer without regular place of business outside New Jersey had to use 100% apportionment factor, while taxpayer with regular business outside state used three-factor formula. New Jersey-headquartered company without regular place of business outside state requested alternative apportionment on distortion grounds. New Jersey Tax Court concluded that 100% apportionment factor, even with credit for taxes paid in separate return states, was distortive; but taxpayer was not entitled to use three-factor formula. Remanded to Division of Taxation to craft appropriate relief. 26
Tennessee - Administrative Market-Based Sourcing Vodafone Am. Holdings, Inc. & Subs. v. Roberts, 486 S.W.3d 496 (Tenn. 2016) Tennessee Supreme Court upheld Department of Revenue s use of alternative apportionment for a wireless company because the statutory costs of performance method did not fairly represent the extent of the taxpayer s business activity in the state. Court held that the method employed by the Commissioner, which was similar to a market-based approach, satisfied regulatory standards for the imposition of alternative apportionment. 27
Colorado Alt. Apportionment (Improper) Target Brands, Inc. v. Dep t of Revenue, No. 2015CV33831 (Colo. 2nd Dist. Ct. 2017) On Jan. 20, 2017, a Colorado district court found that despite lacking any physical presence in state, subsidiary that managed company s brands had substantial nexus in Colorado because its IP licenses were used there. However, Department of Revenue s use of its alternative apportionment authority to exclude subsidiary s substantial out-of-state property and payroll from apportionment factors was unreasonable. 28
Minnesota Alt. Apportionment (Struck Down) Associated Bank, N.A. v. Comm r Revenue, No. 8851-R, (Minn. Tax Reg. Div. 2017) The Minnesota Tax Court found that the Commissioner could not invoke alternative apportionment to include interest income and intangible property in the apportionment factor of LLCs subject to the general apportionment formula, which excludes these items from the factors. The taxpayer s lawful business structure could not be disregarded. 29
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Contact us Maria Todorova Partner (US) LLP 404.853.8214 MariaTodorova@eversheds-sutherland.com Ted Friedman Associate (US) LLP 202.383.0829 TedFriedman@eversheds-sutherland.com stateandlocaltax.com eversheds-sutherland.com 2018 (US) LLP All rights reserved.