Multistate Tax Outline PDF

Table of Contents {#table-of-contents.TOCHeading} ================= [State and Local Tax Sources 2](#state-and-local-tax-sources) [Basic Elements in the Analysis of Taxes 2](#basic-elements-in-the-analysis-of-taxes) [Jurisdiction to Tax -- Analytical Framework 2](#jurisdiction-to-tax-analytical-f...

Table of Contents {#table-of-contents.TOCHeading} ================= [State and Local Tax Sources 2](#state-and-local-tax-sources) [Basic Elements in the Analysis of Taxes 2](#basic-elements-in-the-analysis-of-taxes) [Jurisdiction to Tax -- Analytical Framework 2](#jurisdiction-to-tax-analytical-framework) [U.S. Statutes 4](#u.s.-statutes) [State Constitution 4](#state-constitution) [Nexus 5](#nexus) [Computation of State Tax Liability 5](#computation-of-state-tax-liability) [Fair Apportionment (Third Prong) 5](#fair-apportionment-third-prong) [Weighing of Factors 6](#weighing-of-factors) [Apportionment 7](#apportionment) [Business vs. Nonbusiness Income 7](#business-vs.-nonbusiness-income) [Special Problems with the Sales Factor 9](#special-problems-with-the-sales-factor) [Sales of TPP 11](#sales-of-tpp) [Cost of Performance Sourcing: Focus on the Service in Terms of Sourcing 12](#cost-of-performance-sourcing-focus-on-the-service-in-terms-of-sourcing) [Market-Based Sourcing 13](#market-based-sourcing) [Unitary Business Principle 15](#unitary-business-principle) [Overview of the Unitary Business Principle 15](#overview-of-the-unitary-business-principle) [Historical Development 16](#historical-development) [U.S. Supreme Court Tests for Unity 16](#u.s.-supreme-court-tests-for-unity) [Modern US Supreme Court Decisions 16](#modern-us-supreme-court-decisions) [Special Issues in Unitary Taxation 18](#special-issues-in-unitary-taxation) [Versions of Unitary Combined Reporting Tax 18](#versions-of-unitary-combined-reporting-tax) [Forced Combination 18](#forced-combination) [Corporate Income Tax Base; Filing Methods 19](#corporate-income-tax-base-filing-methods) [State Corporate Income Tax Base 19](#state-corporate-income-tax-base) [Common Nonconformity Issues 19](#common-nonconformity-issues) [Return Filing Methods 20](#return-filing-methods) [Payments to Related Entities 21](#payments-to-related-entities) [Constitutional Distortion and Equitable Apportionment 23](#constitutional-distortion-and-equitable-apportionment) [What is "fair apportionment"? 23](#what-is-fair-apportionment) [Invoking Alternative Apportionment 24](#invoking-alternative-apportionment) [Corporate Income Tax Planning State Challenges 25](#corporate-income-tax-planning-state-challenges) [Economic Substance Doctrine 25](#economic-substance-doctrine) [Substance Over Form Doctrine 26](#substance-over-form-doctrine) [Business Purpose Doctrine 26](#business-purpose-doctrine) [Sham Transaction 26](#sham-transaction) [Step Transaction 27](#step-transaction) [Areas of Uncertainty 27](#areas-of-uncertainty) [Federal Codification (2010) 27](#federal-codification-2010) [State Codification 28](#state-codification) [Sales and Use Taxes 28](#sales-and-use-taxes) [What is a sales and use tax? 28](#what-is-a-sales-and-use-tax) [Who is liable for sales and use tax? 28](#who-is-liable-for-sales-and-use-tax) [Elements of a Taxable Transaction 29](#elements-of-a-taxable-transaction) [Taxable incident: What is a sale? 29](#taxable-incident-what-is-a-sale) [Taxable incident: What is a use? 29](#taxable-incident-what-is-a-use) [Jurisdictional Requirement (sourcing): Where is it taxable? 29](#jurisdictional-requirement-sourcing-where-is-it-taxable) [What is taxable? 30](#what-is-taxable) [How much is taxable? 31](#how-much-is-taxable) [Sale or Use Tax? & Exemptions 32](#sale-or-use-tax-exemptions) [Streamlined Sales and Use Tax Agreement 33](#streamlined-sales-and-use-tax-agreement) [Registration and Reporting Requirements 33](#registration-and-reporting-requirements) [Sale Tax Audits & Litigation 33](#sale-tax-audits-litigation) [Evaluating a Company's Position and Potential Exposure 33](#evaluating-a-companys-position-and-potential-exposure) [Gross Receipts Taxes 34](#gross-receipts-taxes) [Overview 34](#overview) [Key Issues 34](#key-issues) [Gross Receipts Tax Litigation 35](#gross-receipts-tax-litigation) **State and Local Tax Sources** =============================== - **[Property taxes]** - primary source of tax collections at the [local] level, responsible for 72.2 percent of local tax revenue in fiscal year 2020 - Once a significant driver of [state] budgets as well, their share of state collections has dropped to a mere 1.8 percent. - **[Corporate income]** - Taxes only generated 3.3 percent of [state and local tax] revenue in fiscal year 2020. - More volatile sources of revenue for states. - **[Individual income taxes]** - largest source of [state] tax revenue, though nine states forgo the taxation of wage income. - **[Sales taxes]** - generated 32.2 percent of [state] tax revenue in fiscal year 2020 - a significant source of revenue for all 45 states which impose them. - constitute a major local government revenue stream in some states. - **[Southwestern states]** rely the most on **[property and sales taxes]** as a source of state and local tax collections, while - **[Mideastern and New England]** states rely most on **[income taxes]**. - **[Severance taxes]** have an outsized influence in the more resource-rich **[Far West]**. - State tax structures vary widely. - The highest-income states rely more heavily on property taxes - the lowest-income states rely on sales and gross receipts taxes.  **Basic Elements in the Analysis of Taxes** ------------------------------------------- - What is the nature of the tax, i.e., how should the tax be classified? - Property taxes -- on the entire bundle of rights of ownership - Excise taxes -- on the activity or event, on the exercise of a specific right in property, or on a privilege granted. - Income taxes - What is the subject of the tax, i.e., on what is the tax imposed? - What is the measure of the tax, i.e., what is the tax base? Note on Statutory Construction - Plain meaning rule - If ambiguities, construed strictly against the government - If exemption, construed against the taxpayer - Judicial deference to administrative guidance Jurisdiction to Tax -- Analytical Framework =========================================== - State's jurisdiction to Tax = State's right to impose a tax - Analytical Framework for evaluating the validity of a state tax (i.e., state's right to impose the tax) -- analyze limitations in the following order: **U.S. Constitution** --------------------- The primary Constitutional limitations upon a state's ability to impose tax: - [The Due Process Clause] - 14^th^ Amendment, Section 1 states: *"...nor shall any State deprive any person of life, liberty, or property without due process of law..."* - Requires a "define link" and "minimum connection" between a State and the person, property or transaction it seeks to tax. - Income taxes "must be rationally related to values connected with the taxing State." - [The Commerce Clause] - Article I, Section 8, Clause 3: *\[The Congress shall have Power... \] to regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes;...* - Affirmative Commerce Clause vs. Dormant Commerce Clause - The Dormant Commerce Clause is used to prohibit state legislation that discriminates against interstate commerce. - ***Complete Auto Transit v. Brady*, 430 U.S. 274 (1977)** -- Four Prong Test: - (1) a taxpayer must have [substantial nexus] with the taxing jurisdiction; - (2) the tax may [not discriminate] against interstate commerce; - \(3) the tax must be [fairly apportioned]; and - (4) there must be a [reasonable relationship] between the tax imposed upon the taxpayer and the services provided by the taxing jurisdiction. - Nexus - ***South Dakota v. Wayfair,* 138 S. Ct. 2080 (2018) (Online Retail)** - Overruled the physical presence rule of *Quill* - State may require sellers with no physical presence in the state to collect and remit sales tax for goods sold within the state as long as they have a substantial nexus with the taxing state - Substantial nexus -- when taxpayer avails itself of the substantial privilege of carrying on business in that jurisdiction - Examine economic and virtual contacts the seller has with the state - [Undue burden analysis] - Revival of *Pike v. Brice* balancing test: Examine the burden on interstate commerce versus local (government) benefit. - The Court was not persuaded by the argument that complex tax systems would create a burden on interstate commerce, and instead encouraged those small businesses with *de minimis* contacts to pursue other theories - [The Supremacy Clause -- Article VI, Clause 2] - *This Constitution, and **the Laws of the United States** which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, **shall be the supreme Law of the Land**; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding.* - Federal law overrides conflicting state law - [The Equal Protection Clause, Const. Amend XIV, 1] - The Fourteenth Amendment provides "\[n\]o State shall make or enforce any law which... deny to any person within \[the State's\] jurisdiction the equal protection of the laws." - Protects against certain government classifications that burden or benefit one class of persons to the exclusion of others.  - [The First Amendment] - State and local tax laws often require taxpayers to charge and separately identify state and local taxes on customer invoices. Other tax statutes prohibit taxpayers from identifying the cost of state and local taxes to customers. - Both of these requirements regulate speech protected by the First Amendment. - *See BellSouth Telecomm. Inc. v. Farris*, 542 F.3d 499 (6th Cir. 2008). - Other Constitutional Provision **U.S. Statutes** ----------------- - Public Law 86-272 - [Restricts state power] to impose [net income] tax on interstate commerce by prohibiting tax on non domiciliary sellers of [tangible personal property] whose in-state activity is limited to solicitation - Provides additional protections where in-state independent contractors are used - ITFA - The permanent Internet Tax Freedom Act (ITFA), 47 U.S.C. §151 note, preempts state and local governments from levying (1) taxes on internet access and (2) multiple and discriminatory taxes on electronic commerce. **State Constitution** ---------------------- - Due Process/Lack of Notice - Uniformity - Does not always apply to all tax types - Tax Type Limitations - E.g., Income tax prohibitions -- a few states prohibit the imposition of state and local net income taxes - Texas Constitution contains a prohibition against imposing "a tax on the net income of natural persons." (the "Bullock Amendment") - Industry Limitations - E.g., Occupation prohibitions -- constitutional provision which restricts or limits the local taxation of certain occupations - Often not called an "occupation tax" -- important to look at the incidence of the tax rather than its title - Limits on tax base expansion - E.g., state tax law imposes sales tax on telecommunications services; cannot be expanded to include software services. - Voting Requirements **State Statutes** **State Court Decisions** **State Regulations** **State Administrative Decisions** **State Administrative Practice** **Nexus** --------- - [Economic presence nexus] -- exploiting a state's market. E.g., - Out-of-state companies licensing intangibles to in-state licensees - Out-of-state banks extending loans to in-state borrowers - Out-of-state franchisors that entered into franchise arrangements with in-state franchisees - Out-of0state corporations making sales within a state - [Factor presence nexus] - A growing trend in state taxation is the adoption of bright-line statutory nexus thresholds in determining what it means to be doing business or otherwise have nexus in a state - Multistate Tax Commission model rule - \$50,000 of property, - \$50,000 of payroll, - \$500,000 of sales, [or] - 25% of total property, total payroll, or total sales - Most states have taken the legislative position that an organization has economic nexus if: - It has annual retail sales of goods or services into the state that surpass a dollar threshold, e.g., \$100,000; or - It makes a specified number of sales transactions, e.g., 200 or more, into the state. - [Agency Nexus] - In-state contractors - -- no basis for distinguishing from an employee - [Affiliated Nexus] - Most states seem to agree that having an in-state affiliate, without something more, does not by itself create nexus for an out of state affiliate - An in-state affiliate may of course serve as an agent for an out of state affiliate in a manner which creates nexus - Some states have legislatively defined affiliated nexus whereby affiliates with a common trade name and business plan and which provide services to one another which are related to maintaining an in-state market creates nexus Computation of State Tax Liability ---------------------------------- +/- State-specific Modifications (addition or subtraction) = **State Tax Base** \- All Non-business Income = **Business income** \* Apportionment % = **Apportioned Business Income** \+ Non-business Income allocated to this state = **State Taxable Income** \* State tax rate = **State Tax Due** Fair Apportionment (Third Prong) -------------------------------- - One of the major differences between the federal system for taxing income and the system used by the states and sub-state units, is the need to divide the tax base of multistate taxpayers. - U.S. Supreme Court established that the U.S. Constitution's Due Process and Commerce Clauses prevents states from subjecting to tax a business' income derived from activities that do not occur within the taxing state. - 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). - To avoid constitutional infringements, states provide detailed rules by statute and/or regulation outlining the portion of a business's income that is subject to income taxation by the state. - **Commerce Clause: "Fair apportionment" prong of the *Complete Auto* 4-prong test** - **Internal consistency** --theoretical test; if every state imposed the identical tax, would the tax on interstate commerce be greater than commerce wholly in-state? - **External consistency** --economic test; is the value being taxed fairly attributable to the activity in the taxing state? - **Statutory "fair apportionment" for income/franchise taxes** - **UDITPA** §**18**: If the regular statutory method does not fairly represent the extent of the taxpayer\'s business activity in this State, the taxpayer may petition or the state may require, an alternative method - Three approaches to dividing the tax base: - [Allocation] -- attempts to trace the property, income or receipts to the state of its source and to include the item in full in the measure of that state's tax. - [Apportionment] -- apportionment by formula is based on the theory that certain factors or elements of a business will fairly reflect the measure of the tax attributable to a state - [Separate accounting] -- seeks to treat the taxpayer's business activities conducted within the state separately from its out-of-state business activities. - States have wide latitude to design their apportionment formulas - *Moorman Manufacturing Co. v. Bair*, 437, U.S. 267, 98 S.Ct. 2340 (1978) (Iowa's **single-factor apportionment formula** based on sales constitutional). - The Court made it clear that the dormant Commerce Clause did not require uniform division-of-income rules, because it was to Congress---not the Court---"that the Constitution has committed such policy decisions." - *Container Corp. of America v. Franchise*, Tax Board, 463 U.S. 159, 103 S.Ct. 2933 (1983)1 (foreign subsidiaries unitary with US operations; no distortion results from combination; world-wide combination is constitutional; "not only has **the three-factor formula** met our approval, but it has become... **something of a benchmark** against which other apportionment formulas are judged.") - Insert Apportionment Formula -- UDITPA Here - The **property factor** is generally a fraction with the numerator being value of real and tangible property in-state and denominator being of property everywhere. - The **payroll factor** is a fraction the numerator of which is the corporation's compensation in a particular state divided by the denominator which is the taxpayer's total compensation everywhere. - Compensation usually includes wages, salaries, commissions; generally anything showing up on an employee's W-2 or in the company's state unemployment reports. - The **sales factor** is a fraction the numerator of which is the corporation's sales in a state divided by the denominator which is its total sales everywhere Weighing of Factors ------------------- - Equally-weighed three-factor formula was the traditional formula *App't Factor = 1/3(Sales Factor) + 1/3(Payroll Factor) + 1/3(Property Factor)* - Over time, states have moved to hybrid weightings, including double-weighted sales factor formulas and single sales factor formulas - *Double-weighted sales factor:* *App't Factor = 2/4(Sales Factor) + 1/4(Payroll Factor) + 1/4(Property Factor)* - *Single sales factor:* *App't Factor = Sales Factor* Apportionment ------------- - [Right to apportion] - Allocation or apportionment of income is available only if a taxpayer is entitled to do so. - UDITPA § 2: a taxpayer is entitled to allocate and apportion its income only when it has "income from business activity which is taxable both within and without this state." - "\[A\] taxpayer is taxable in another state if (1) in that state he is subject to a net income tax, a franchise tax measured by net income, a franchise tax for the privilege of doing business, or a corporate stock tax, or (2) the state has jurisdiction to subject the taxpayer to a net income tax regardless of whether, in fact, the state does or does not." UDITPA § 3. - States' tests vary: "doing business"; "place of business"; filing tax returns - In *Comptroller of the Treasury of Maryland v. Wynne*, U.S. Supreme Ct., No. 13-485 107 (5/18/15), the U.S. Supreme Court found that the absence of a credit against the local portion of the state\'s personal income tax, with respect to tax paid to another state on pass-through income from an S corporation, was unconstitutional. - The tax failed the Commerce Clause's **[internal consistency test]** because if every state adopted Maryland's tax scheme, interstate commerce would be taxed at a higher rate than intrastate commerce. Business vs. Nonbusiness Income =============================== - Business income is apportioned among all the states in which the taxpayer does business. - Nonbusiness income is allocated - Net rents and royalties from real property -- state where property is located - Capital gains and losses -- state where property is located - Interest and dividends -- domiciliary state - Patent and copyright Royalties -- state where property is located - Under UDITPA, business income is subject to formulary apportionment while non business income is subject to allocation, typically to a single state where the property is deemed located. - While the U.S. Supreme Court has acknowledged that the business income definition may well be compatible with the unitary requirement for formulary apportionment in *Allied Signal*, the UDITPA definition consists of specific terms, which if such are to be given meaning, could well define a narrower standard for apportionability than the Constitution would otherwise allow. - Broken into its elements and with emphasis added, UDITPA § 1(a) defines Business Income as follows: - "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." - "Nonbusiness income" is "all income other then business income." UDITPA § 1(e). - If the above definition may be viewed as detailed, UDITPA's definition of non-business income as "all income other than business income" could hardly be simpler or, arguably, broader. - UDITPA's several statutes dealing with the allocation of non-business income from various types of property could also suggest that non-business income would not necessarily be an uncommon occurrence. - As interpreted by the MTC, however, business income is given broad application while non-business income is essentially a rare exception: - MTC Regulation § IV.I (a) - "In essence, all income which arises from the conduct of trade or business operations of a taxpayer is business income. For purposes of administration of Article IV, the income of a taxpayer is business income unless clearly classifiable as non-business income." - MTC Regulation § IV.I (c) further provides that gain or loss from the sale of property used in the unitary business constitutes business income. - While there may not be a Constitutional issue with (c) much of the controversy at the state level has focused on statutory construction and whether extraordinary transactions produce business income, such as: - The sale of a subsidiary or division or other major disposition of assets up to and including corporate liquidations. - Pension reversion income - Income from various investments - Income and expenses related to corporate reorganizations. - The MTC regulations are extremely influential in the construction of UDITPA - In 2015, the MTC recommended that states adopt changes to the original language of UDITPA by replacing the term "business income" with "apportionable income" and replacing the term "non-business income" with "non-apportionable income." - \(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 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. - Specific Allocations of Nonbusiness Income - Net Rents and Royalties from Real Property -- State Where Property is Located - Capital Gains and Losses -- State Where Property is Located - Interest and Dividends -- Domiciliary State - Patent and Copyright Royalties -- State Where Property is Located - One Test or Two - **Transactional Test: Did the transaction giving rise to the gain occur in the regular course of the taxpayer's trade or business?** - Income is considered business income if it arises from "transactions and activities in the regular course of the taxpayer's trade or business" - Focus is on the [regularity and frequency] of the type of transactions giving rise to the income and how this transaction relates to the taxpayer's regular trade or business as well as the subsequent use of the proceeds. - **Functional Test: Was income-producing property integrated into, or used in, business operations?** - Income is business income if the "acquisition, management, and disposition" of the asset that generates the income constitutes an integral part of the taxpayer's trade or business operations. - Primary focus is on the [relationship between the asset giving rise to the taxable income and the taxpayer's business operations], with several states also considering the role of the disposition in the regular trade or business. - Is the Functional Test a separate test? Or is it a sub-part of the Transactional Test? - Major Asset or Subsidiary Dispositions - A number of state cases have held that an extraordinary disposition of assets, to the extent such constitute a complete or partial liquidation do not meet the business income definition. - While such dispositions may involve the sale of unitary assets which may be apportionable under the Constitution, the Courts had trouble fitting such within the statutory definition. - Some states held that the gains were non-apportionable by applying only a transactional test. - Other states have found complete or partial liquidations to be non-business income even under the functional test since such states that the "acquisition, management **and** disposition" must be an integral part of regular trade or business operations. - In contrast, states which recognize a separate functional test have held that a substantial sale of business assets outside of a liquidation constitute business income - Some of the features which have distinguished liquidations from apportionable "substantial asset sales" have included: - A complete sale of all business assets or - A sale of a discrete segment of the business where the proceeds are distributed to the shareholders and not ploughed back into the business - Some state courts may have reached different conclusions under similar facts depending upon whether they were separate reporting vs. combined reporting states. - The above may be relevant in determining the tax treatment of gains recognized under stock sales which buyer and seller elect to treat as asset sales under IRC § 338 (h)(10). - In a 338 (h)(10) election, "old target" is deemed to sell its assets to a theoretical "new target" after which "old target" is deemed to liquidate. - Income from Minority Stockholdings - *Allied-Signal, Inc. v. Director, Division of Taxation*, 504 U.S. 768 (1992) - The US Supreme Court rejected NJ's attempt to apportion capital gains from the salThe court equated the gain with dividend income from a constitutional perspective and while it stated that unity is still the standard, unity need not always exist between a payor and payee where the asset serves **an operational function***\ *(e.g., working capital) - Here, Allied, as successor in interest to Bendix, had sold a 20% interest in ASARCO. Since ASARCO was not unitary and the investment was not working capital, the income could not be apportioned. - Court acknowledged that in many cases the UDITPA business income definition may be compatible with the unitary apportionment standard. - Query: Would *Allied* support apportionment of dividends from minority e of a minority stockholding. - interests in corporations which served as an important supplier? - *MeadWestvaco Corp. vs. IL,* U.S. Sct. 2008 - Mead, a corporation domiciled in Ohio, which was doing business in Illinois sold the Lexis/Nexis (Lexis) division at a substantial gain in 1994 - Mead treated the gain as non-business income allocable to Ohio and Illinois asserted business income treatment. - The trial court held the Lexis division was not unitary with Mead, but nonetheless served an "operational purpose" and upheld the DOR's assessment. The Illinois Appellate Court affirmed based on the "operational function" concept but did not address the question of unity. The court noted that Mead exercised control over Lexis' corporate form, approving significant capital expenditures, retaining tax benefits and control over Lexis' cash flow. Special Problems with the Sales Factor -------------------------------------- - Focus on the Sales Factor - The sales factor is a fraction the numerator of which is the corporation's sales in a state divided by the denominator which is its total sales everywhere - Instate Sales / Everywhere Sales - In the 21st century business environment, shortcomings of this historical three factor apportionment model include the following: - Intangible assets are generally not included in property factor - Sales factor has evolved into dominant factor - Technology advancements have changed the nature and extent of how capital is used by businesses, i.e., businesses can do more with less property and payroll - More service-related businesses - Sales factor was traditionally single-weighted or double-weighted in the overall three factor apportionment formula along with payroll and property factors - Sales factor is intended to give recognition to importance of customer and benefits afforded to seller by customer's state - Trend now is to increase the weight of the sales factor, with many states moving to single sales factor formula (27 for now) - Effectively shifts tax burden to out-of-state companies - Attracts businesses to relocate to the state - What is included? - Broader than receipts from sales of TPP - Includes receipts from services, rentals, royalties, and business operations generally. - UDITPA § 1(g): " 'sales' means all gross receipts of the taxpayer not allocated" - The MTC regulations specify that "sales" includes "all gross receipts derived by the taxpayer from transactions and activity in the regular course of the trade or business." - What is excluded? - MTC regulations exclude: - Substantial amounts of gross receipts from the occasional sale of fixed assets used in the taxpayer's business - Insubstantial amounts that do not materially affect the factors - Receipts on which the IPA cannot be localized - States have specific exclusions: - Receipts other than receipts from the principal business activity - Receipts from sale of certain assets - Receipts from income not included in the tax base - Types of Sales - Generally, three types of sales: - Tangible personal property (TPP) - Ex. A car tire - Intangibles - Ex. The name of the car tire brand - Services - Ex. Installing a car tire - Sales Factor Sourcing A screenshot of a computer Description automatically generated Sales of TPP ------------ - Generally, sourced to destination state, i.e., to the state to which the goods are shipped to the customer. *See also* UDITPA § 16. - **Dock sales** -- buyer takes possession of TPP at the loading dock of the in-state manufacturer. - Do the terms of delivery control the sales attribution rule? - Most courts construing UDITPA and similar statutes have likewise concluded that dock sales to out-of-state purchasers are not in-state sales under UDITPA's sales destination provision - MTC rule: "Property is delivered or shipped to a purchaser within this state if the shipment terminates in this state, even though the property is subsequently transferred by the purchaser to another state." MTC Reg. IV.16.(a).(3) - Some states' sales destination provisions specifically provide for an ultimately-received rather than a place-of-delivery rule for attribution purposes (e.g., LA). - **Drop Shipments** - T, a corporation engaged in business in Illinois, makes sales of goods to customers in State X, in which T is not taxable T orders the goods in question from a supplier, S, located in State Y, in which T likewise is not taxable, and, at T's request, S delivers the goods directly to T's customer in State X. - Includable in sales factor numerator under IL's UDITPA-based apportionment formula? - Most states that have considered this issue have taken the position that a manufacturer or wholesaler should assign receipts from a drop shipment to the state to which the goods are physically shipped. - **Throw-back rule** - Sales into states in which the taxpayer is not taxable (e.g., because of Public Law 86--272) are reassigned---or "thrown back"---from the state of destination to the state of origin. UDITPA § 16(a) (attributing sales of tangible personal property to the state of origin when "the taxpayer is not taxable in the state of the purchaser"). - Courts have construed the term "taxable in the state of the purchaser" as referring to the power of the purchaser's state to tax the vendor, whether or not the power has been exercised. - **Throw-out rule** - Receipts otherwise assigned to a state in which the taxpayer is not taxable are eliminated from---or "thrown out" of---both the numerator and denominator of the 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: - The income-producing activity is performed in this state; or - 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: - In the case of sale of a service, if and to the extent the service is delivered to a location in this state; and - In the case of intangible property, sthat 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..." Cost of Performance Sourcing: Focus on the Service in Terms of Sourcing ----------------------------------------------------------------------- - Two versions: - Preponderance (more than 50%) - "All or Nothing" - Proportionate - COP method, adopted by UDITPA (§ 17) and later the MTC, states that sales other than sales of TPP, are in this State if: - Income-producing activity (IPA) is performed in this State; or - IPS is performed both in and outside this State and greater proportion of income-producing activity is performed in this State than in any other State, based on costs of performance - IPA "applies to each separate item of income and means the transactions and activity directly engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of obtaining gains or profits." - COP Considerations - TPP or service/intangible? - Electricity? - Digital goods? - Income-producing activities - What are the income-producing activities? - What approach applies? - Transaction approach - costs associated with the individual transactions comprising those activities - Operational approach - aggregate costs associated with specific income-producing activities - Whose activities? - Costs - What are the relevant costs? - Direct costs - Indirect costs - ***Sirius XM Radio, Inc. v. Hegar*, 643 S.W.3d 402 (Tex. 2022) (proportionate)** - Under Texas Law, service receipts are sourced to the location where the service is performed. - Despite the law, the Texas Comptroller employed a market sourcing approach and argued that Sirius XM's satellite radio receipts should be sourced based on location of Sirius XM's subscribers. - The Comptroller relied on a "receipt-producing, end-product act" test and argued the relevant act was the decryption of the programming in the subscriber's car. - Texas Supreme Court rejected the Comptroller's approach and determined that the focus is on the performer of the service, not the recipient. - ***Target Enterprise Inc. v. Florida Dep't of Revenue,* Case No. 2021-CA-002158 (Fla. Cir. Ct., 2d Judicial Cir., Nov. 28, 2022) (preponderance)** - The Florida Department of Revenue assessed a Target Corporation (Target) subsidiary (TEI) using a market-based sourcing methodology; TEI provides Target with management services. - Florida regulations authorize the DOR to deviate from the state's costs-of-performance (COP) sourcing rule when there are "unusual or unique situations." - The DOR asserted that there were "unusual or unique situations" warranting sourcing receipts to the "customer locations," which it argued are Target's Florida stores. - TEI argued that there are no "unusual or unique situations" to warrant deviation from COP, and that its services are provided at Target's Minnesota headquarters. - Court rejected the DOR's argument in agreeing with TEI that the location of its "income-producing activity" is based on TEI's locations and not Target's. Market-Based Sourcing --------------------- - Why market-based sourcing? - Challenges in applying the IPA/COP test - Wanting to move away from an "all or nothing" approach - Desire to reduce burden on in-state businesses State approaches vary - Approx. 30 states currently apply market-based sourcing - General rules of sourcing services: - Service is delivered - Service is received - Benefit is received - Customer is located - Hierarchy vs. Proportionate approach: - Proportionate -- services receipts sourced in proportion to the benefit received by the recipient in the state. (Georgia, Iowa, Michigan) - Hierarchy -- apply cascading rule; if cannot comply with rule, move to next. (California, Illinois, Massachusetts) - Example: California - 18 CCR §25136-2 provides that sales from services are assigned to California to the extent the taxpayer's customer receives the benefit of the service in the state - "Benefit of a service is received" means the location where the taxpayer's customer has either directly or indirectly received value from delivery of that service - Different rules based on whether the customer is an individual or business - If the customer is an individual, then the location is presumed to be in California if the taxpayer's customer's billing address is in California - If the taxpayer's customer is a business entity, then the location is presumed to be in California to the extent the contract between the taxpayer and the taxpayer\'s customer or the taxpayer\'s books and records kept in the normal course of business, notwithstanding the billing address of the taxpayer\'s customer, indicate that the benefit of the service is in California - If presumption is overcome, then location(s) where benefit is received can be reasonably approximated -  - Throw-Back Rules (Market Sourcing Specific) - Under throwback rules, sales of tangible property that are not taxable in the destination state are "thrown back" into the state where the sale originated, even though that is not where the income was earned (19 states + DC). - This increases the numerator of the sales factor. - Potentially causes businesses to be taxed at multiples of the income they actually have earned in the state. - Throw-out Rules (Market Sourcing Specific) - If a taxpayer is not taxable in the state (does not establish nexus) in which the revenue is to be assigned under market-based sourcing rules then the sale is excluded from the numerator and denominator of the sales factor (3 states). - Look-through Rules - Services that are delivered electronically through or on behalf of a customer; a taxpayer's market for service revenue may be the customers of the customer.  \\ - *Express Scripts Inc. v. State Tax Assessor*, 304 A.3d 239 (Me. 2023). - Taxpayer sold prescriptions to insurers, employers, and health plans, which dispensed the prescriptions to their members. - Taxpayer sourced its receipts to the locations of the insurers, employers, and health plans. - Applying a "where the services are received" standard, the Maine Supreme Court concluded that the services were received by individual members of its customers. - The Washington Court of Appeals held that payments from clients were subject to the Washington B&O tax. - Taxpayer argued that the payments were not subject to the B&O tax because they were "pass-through" funds, which merely moved from the clients, through the taxpayer, to the pharmacies. - The court concluded that the taxpayer is not a mere pass-through agent and the compensation the taxpayer receives from its clients for the prescription drugs' value is "an integral part" of its business model. - Considerations Relative to Receipts - MTC pre-2017 Rule (throw-out rule): - Under the Multistate Tax Commission (MTC) regulations prior to 2017, business income from intangible property, such as dividends, royalties, or interest, is excluded from the sales factor numerator and denominator when it cannot be tied to a specific income-producing activity. For example, passive income from holding intangible property is excluded from the sales factor denominator under MTC Reg. IV.18.(c).(3). - Some states assign receipts from intangibles to the state of the commercial domicile - E.g., New Jersey apportions all constitutionally apportionable income but assigns receipts from intangibles to the sales factor numerator of the owner's domicile, unless the intangible has acquired a business situs in the state, in which case they are assigned to the business situs. N.J. Admin. Code § 18:7--8.12(e). - Gross v. net - While the sales factors of most states' apportionment formulas require that the "gross receipts" from the transaction be included in the factor, see, e.g., UDITPA §§ 1(g), 17, a number of states include only the *net* income from intangibles in the sales factor. - Joyce v. Finnigan - Whose sales ought to be included in the sales factor numerator of a group of corporations subject to combined reporting, where some members of the group have nexus with the taxing state and other members do not. - *Joyce* rule treats each combined group member as a separate entity, for apportionment purposes. Unless an entity has stand-alone nexus, its sales are not included in the sales factor numerator. - *Finnigan* rule treats all combined group members as one entity, for apportionment purposes - Example: Parent P is not a taxpayer in the destination state, where it is under the protection of P.L. 86-272. Subsidiary S is a taxpayer in the destination state, and is engaged in a unitary business there with P. In Part A, the destination state is Kansas, which uses the *Finnigan* rule. In Part B, the destination state is California, which uses *Joyce.* Unitary Business Principle ========================== Overview of the Unitary Business Principle ------------------------------------------ - What is Unitary? - No "bright-line" definition developed - Several tests have developed through: - Case law - Multistate Tax Commission - All definitions or tests are very subjective - State Statutory Application of Unitary Business Concept - New York -- substantial intercompany transactions/distortion - Colorado -- taxpayer's must meet three of six factors and have a 2 year holding period to include in unitary return Historical Development ---------------------- - Developed from property taxation cases - In *Union Pacific Railway Co. v. Ryan*, 113 U.S. 516 (1884), the Court recognized that the value of a railroad line could not be measured merely by looking to the value of the property located within a specific geographic area. - The Court approved the method enacted by the city of Cheyenne that taxed the value of the track within its city limits as a percentage of the value of the entire railroad line; - The value attributed to Cheyenne was calculated by determining the value of the entire line and dividing this value by the total number of miles of line to generate a valuation per mile of track. - Later applied to apportionment of income tax base - In *Underwood Typewriter v. Chamberlain*, 254 U.S. 113 (1920), for the first time, the Court approved a formula used by Connecticut to determine the amount of income from a multistate business that was attributable to Connecticut for state income tax purposes. - The Court commented: "The profits of the corporation were largely earned by a series of transactions beginning with manufacture in Connecticut, and ending with the sale in other states." U.S. Supreme Court Tests for Unity ---------------------------------- - US Supreme Court's Initial Guidance - U.S. Supreme Court in *Butler Bros. v. McColgan,* 315 U.S. 501 (1942), attempted to define a unitary business. - Butler Brothers operated seven distribution centers in separate divisions. - The corporation was profitable, but the California division was not. - All merchandise purchased centrally for each store, but the stores separately handled their accounting, inventory and sales. - Corporate overhead was allocated equally to the stores. - Court held that Butler Brothers operated a unitary business. - **Three Unities Test** - Unity of Ownership - The general rule in most states is that unity of ownership means direct or indirect control of more than 50% of a corporation's voting stock but the general rule becomes more complex in the context of partnerships and joint ventures, and in situations where attributional ownership is possible. - Unity of Operations - Centralized executive functions (management, purchasing, advertising and accounting) - Unity of Use - Centralized operations and executive force - **"Contribution\" or \"dependency\" test** - Business done within the state is dependent upon or contributes to the operation of the business without the state - **"Flow of Value" test** - Functional Integration, Centralized Management, Economies of Scale - **Hellerstein: "Operational Interdependence"** Modern US Supreme Court Decisions --------------------------------- - ***Mobil Oil Corp. v. Commissioner of Taxes,* 445 U.S. 425 *(1980)*** - The Court referred to a unitary business as one that exhibits "contributions to income resulting from functional integration, centralization of management and economies of scale." - ***Exxon Corp. v. Department of Revenue*, 447 U.S. 207 (1980)** - Income of a vertically integrated oil company is apportionable, even if profitable activities occurred outside the taxing state. - ***Container Corp. of America v. Franchise Tax Board,* 463 U.S. 159 (1983)** - The Court suggested another indicium of a unitary business, noting that "\[t\]he prerequisite to a constitutionally acceptable finding of a unitary business is a flow of value, not a flow of goods." - ***Allied-Signal, Inc. v. Director, Division of Taxation,* 504 U.S. 768 (1992)** - The Court found there to be a distinction between assets serving an investment function and those serving an operational function, and held that "functional integration" ("operational" function) rather than merely "common ownership" ("investment" function) were required to create a unitary relationship. - ***MeadWestvaco v. Bower*, 128 S. Ct. 1498 (2008)** - Gain on sale of Lexis/Nexis division not apportionable to Illinois; the "operational function" test of Allied Signal not a different test from the ordinary test for a unitary business. - ***ComCon Prod. Servs. I, Inc. v. Franchise Tax Bd., No. B259619, 2016 WL 7229830 (Cal. Ct. App. 2016)*.** - The court ruled for Comcast, which argued that it was not unitary with its majority owned subsidiary, QVC, under the *Mobil Oil* test, the three unities test, or the dependency or contribution test. - Although QVC and Comcast were commonly owned, the court found they "were not integrated in a way that transferred value between them." - Though Comcast had the *ability* to exert significant managerial control over QVC, QVC's management still independently conducted the company's business. - Further, the court held that "Comcast and QVC were not vertically integrated, lacked a centralized management, generated no economies of scale and produced no other flow of values." - Overall Summary of Modern US Supreme Court Decisions - **Centralized management** - common management or directors - shared staff functions - business decisions made for the group rather than separately by each member - **Functional Integration** - common programs (marketing) or systems (distribution system) - shared information or property (shared IP) - **Economies of Scale** - centralized business functions -- e.g., purchasing, accounting, advertising, marketing, legal services, pension plans, insurance - [Special Indicators] - Same type of business - Steps in a vertical process Multistate Tax Commission - MTC Reg. IV.1.(b) - A unitary business is a single economic enterprise that is made up either of separate parts of a single entity or of a commonly controlled group of entities that are sufficiently interdependent, integrated and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts. Special Issues in Unitary Taxation ---------------------------------- - Holding company unity - California and New York -- parent and intermediate holding companies are unitary even where 1) they are shells and 2) only hold acquisition debt. - *See Dep't of Revenue v. Agilent Techs.*, Inc., 2019 Co. 41 (2019). - Instant Unity -- When? - When do the operations of a newly acquired business become sufficiently integrated to become unitary with the existing business. - Most states do not have specific statutes or regulations that define and/or create presumptions concerning when unity may be established. - California requires some time to lapse -- how much time varies with facts and circumstances. - Colorado requires 2 tax years before unitary. - Other states have regulatory presumptions: Texas presumes instant unity; Oregon presumes unity is not established in the year of acquisition. Versions of Unitary Combined Reporting Tax ------------------------------------------ - Worldwide combination - Refers to the approach California took prior to 1988. - This approach required any corporation doing business in California to combine with worldwide related businesses. - Water's Edge Combination - Require combination of any related businesses doing business within the United States. - 80/20 Combination - Requires taxpayers to - include in a combined return those foreign entities that conduct at least 20 percent of their business in the United States (an inbound 80/20 company), and - exclude those domestic corporations that conduct at least 80 percent of their businesses outside the United States (an outbound 80/20 company). Forced Combination ------------------ - California and other states began to aggressively apply unitary principles to require worldwide combined reporting by multinational groups - U.S. Supreme Court addressed constitutionality of WWCR in *Container Corp. of America v. FTB,* 463 U.S. 159 (1983). - Court held that Foreign Commerce Clause is not a constitutional bar to worldwide combination when parent is organized in U.S. - Court specifically left open question of whether WWR for U.S. corporations with a foreign parent is constitutional. - *Barclays Bank, PLC v. Franchise Tax Bd. of Ca.*, 512 U.S. 298 (1994), resolved question of WWR where U.S. corporations have foreign parent. - Barclays was a foreign-based bank that operated in 60 countries with 220 subs, including two in California - U.S. Supreme Court held that there was no Federal Commerce Clause violation stating: - Translation costs (records) not an undue burden - Not a higher risk of double taxation for foreign taxpayers than U.S. taxpayers - No congressional objections - WWR constitutional for foreign-based multinational - Limitations on Forced Combination - Constitutional - Statutory - Tests and guidance provided by state courts Unitary Business Principle Decision tree 1. Are activities conducted in a single legal entity? - Consider whether divisions are unitary (most taxpayer's concede unity) - MTC -- all divisions are unitary (centralized management, likely integrated) 2. Do activities constitute steps in a vertical process? - MTC reg -- If group explores/develops/extracts/processes/sells natural resource, unity exists even if steps are independently operated - *Exxon --* Supreme Court found unity in such structure even without centralized management 3. Are activities in same general line of business -- horizontal integration? - How broadly is "line" defined? 4. Is there strong central management? - Is business closely held or managed? - Centralized management/executive force -- controls, shared plans - Illinois -- broader interpretation: are there centralized departments for "back-office", finance, etc. - Other states more narrow interpretation - *Container --* Is management role that parent plays grounded in its own operations expertise and overall operational strategy? 5\. Do other factors give rise to unitary/non-unitary finding? Corporate Income Tax Base; Filing Methods ========================================= State Corporate Income Tax Base ------------------------------- - **Federal Taxable Income as a Starting Point for Computing State Taxable Income.** - Most states which impose state income taxes begin the state computation with federal taxable income ("FTI") -- either [before] special deductions (line 28) or [after] such deductions (line 30). - "Special deductions" are items such as the federal net operating loss ("NOL") deduction and dividends received deduction ("DRD"). - Ex. New York -- "Generally, the \[line 1 starting\] amount to enter is your federal taxable income, ***[before]*** net operating loss and special deductions, as required to be reported to the U.S. Treasury Department." - Ex. Virginia -- "For most corporations "federal taxable income" for Virginia income tax purposes will be the amount shown on the line of federal form 1120 designated "taxable income" (***[after]*** net operating loss deduction and special deductions)." Common Nonconformity Issues --------------------------- - Internal Revenue Code Conformity Date - Return Filing Methods - Expense Disallowance - Net operating losses - Dividends - Treaty Protection - Foreign Source Income - Bonus Depreciation Internal Revenue Code Conformity Date - Nearly all states conform to federal income tax provisions to one degree or another. Most do so by conforming to line 28 or line 30 of Form 1120 (U.S. Corporation Income Tax Return). - Types of conformity - Static/Fixed - Rolling - Selective conformity - Scope of conformity - Federal regulations, rulings, case law - Federal consolidated return regulations - Treaties and treaty exemptions Return Filing Methods --------------------- - Affiliated groups typically elect to file a consolidated return for federal income tax purposes. The treasury regulations issued under IRC 1502 contain provisions which impact the determination of federal taxable income which would not apply in states which do not allow consolidated filings. - States'' filing methodologies differ. As a result, various adjustments may need to be made in order to determine FTI on a pro forma/"as-if" basis which is consistent with the State filing methodology. - Ex. Illinois -- "if you are filing as part of a federal consolidated group, you must compute federal taxable income as though you had filed a separate federal return" - [Separate company reporting] - The parent company and its affiliates are treated separately when determining taxable income. - Nexus is analyzed with regard to each company\'s contacts with the state. - [Consolidated reporting] - Similar basis of composition to federal filing group - Generally, the affiliated group is treated as a single taxpayer. - Focuses on ownership relationship between entities - Usually, 80% common ownership requirement - Types of consolidated reporting - Mandatory, required by statute - Elective/discretionary - Generally, these states require separate reporting, but will allow consolidated reporting if certain conditions are met. - [Combined reporting] - Affiliates that are unitary are included in the group. - Usually, 50% common ownership requirement - Types of Combined Reporting - Mandatory, required by statute - Elective/discretionary - Generally, these states require separate reporting, but will allow combined reporting if certain conditions are met. - Nexus combined reporting - All members with nexus in the state are included in return. - States vary regarding pre- and post-apportionment of income. - Pre- vs. post-apportionment - Pre-apportionment - Members of the group combine income and losses before apportioning income - The combined business income of the entire group is multiplied using the entire group's aggregate apportionment percentage - Post-apportionment - The income and losses of each member of the group are apportioned using each member's individual apportionment percentage. - Each entity's apportioned income is aggregated afterward to determine the taxable income of the group. - Questions to consider: - Who is ultimately included in the combined group? - Whose apportionment factors are included in the combined group? - Who can utilize the net operating losses generated within the combined group? - Who can utilize credits generated within the combined group? - Migration to Combined Reporting - States view combined reporting as a way to combat effective tax planning. - Prior to 2004, combined reporting was mandatory in about 16 states. - In 2004, Vermont became the first state in more than 20 years to adopt combined reporting (effective 2006). - By 2009, 23 of 45 states with corporate income tax moved to combined reporting. - Today, at least 29 states have a combined reporting rule. - [Worldwide vs. Water's Edge & Foreign Companies] - Worldwide combined reporting was held constitutional in the 1980's in *Container*. - Water's edge, foreign entities generally excluded. - California and Idaho default worldwide. Both provide water's edge election. - How to tax corporations with foreign operations? - Some states exclude all foreign corporations from the combined group. - Variety of "water's edge" definitions. - Many states include foreign incorporated entities under certain circumstances. Payments to Related Entities ---------------------------- - Expense Disallowance - Federal - Does not use intercompany expense disallowance. - Rely on consolidated reporting and IRC § 482. - States - A number of states require that certain expenses paid to related members be added back to income. - Expenses subject to add back may include: - Intangible expenses such as royalties paid for use of patents, trademarks, etc. - Interest expenses related to intangible expenses, such as where the related party loans the funds from royalties received back to the operating company which paid them. - A few states may also require addback of management fees, intercompany rent charges and the dividends paid deduction allowed by captive REITs - Most states provide exceptions to add back. - Typical exceptions include : - Related party is subject to tax on the royalty income in the same or another state - Some states require that the related party be subject to tax at an effective rate within a certain range of the add back state's rate, while others give a prorated reduction based on the degree to which tax is actually paid - Related party pays the same amount received to a third party lender/licensor (a conduit exception) - Related party is not primarily engaged in related party lending/licensing, has economic substance, third party activity and deals at arms-length - Net Operating Losses - **Computing Federal NOLs** - IRC § 172 allows taxpayers to carry NOLs back 2 and forward 20 years. - In a year when an NOL is generated, no NOL from previous years may be used. - **Computing State NOLs** - States may differ from the federal income tax provisions in the context of whether the state provides NOLs, the existence and length of carryforward and carryback periods, and the computation of the NOLs themselves. - In a case where a company joins in the filing of a federal consolidated return, but files a separate return for state purposes, NOL carryovers for state purposes are determined "as if" the company had filed separate federal income tax returns for all the years involved. - Most state laws provide that a company must have been subject to tax in that state in the year a loss is incurred, in order to avail itself of a NOL carryover in the present year. - NOL balances may be further altered from their federal counterparts based on the application of apportionment. - States tend to decouple from the federal NOL carryback provisions. - Additional state rules that may affect the computation of state attributes include rules on the transfer of attributes in the case of a merger, acquisition, or reorganization. - E.g., NOLs generated by an entity merged with and into another entity do not survive the merger transaction in the state - Dividends - Federal - Federal dividends received deduction is provided under IRC §§ 243 and 246 for a certain percentage of dividends received from another corporation to address triple taxation. - State - In general, broad conformity with federal dividends received deduction treatment. - States may conform, provide their own deduction, or disallow a deduction. - Treaty Protection - Federal - Foreign corporations in certain countries have treaty protection - States - Generally not binding - Some states respect treaty immunity. E.g., Florida, Massachusetts, South Carolina, Virginia - Other states will exempt only if the treaty excludes the income for state tax purposes. E.g., California - Foreign Source Income - Federal - Income that is effectively connected with the conduct of a U.S. trade or business (ECI) is subject to U.S. tax in essentially the same manner as it would be if it were recognized by a U.S. person. - States - States do not employ a source-based methodology, but rely on formulary apportionment to divide the taxable income of a unitary business among the states in which it conducts business. Constitutional Distortion and Equitable Apportionment ===================================================== What is "fair apportionment"? ----------------------------- - 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. - The United States Supreme Court has held that a taxpayer has a constitutional right to alternative apportionment to remedy an unfair apportionment result. *Hans Rees' Sons v. North Carolina*, 283 U.S. 123 (1931) (taxpayer evidence showed income taxed "out of all appropriate proportion to the business transacted" in the state). - **Constitutional "fair apportionment"** - Commerce Clause - *Complete Auto* 4-prong test - "Fair apportionment" prong - Internal consistency -- [theoretical test]; if every state imposed the identical tax, would the tax on interstate commerce be greater than commerce wholly in-state? - External consistency -- [economic test]; is the value being taxed fairly attributable to the activity in the taxing state? - **Statutory "fair apportionment"** - UDITPA § 18 - If the regular statutory method does not fairly represent the extent of the taxpayer\'s business activity in this State, the taxpayer may petition or the state may require, an alternative method - Differences - Burden of proof - Tax type Constitutional Fair Apportionment - *Hans Rees' Sons*, *Inc. v. North Carolina*, 283 U.S. 123 (1931) - Struck down single factor property formula which apportioned 80% of income to state because taxpayer evidence showed income taxed "out of all appropriate proportion to the business transacted" in the state - *Norfolk and Western Railway Company v. Missouri State Tax Commission*, 390 U.S. 317, 88 S.Ct. 995 (1968) - Struck down apportioned property tax under facts of this case as "out of all appropriate proportion". - *Central Greyhound Lines, Inc. v. Mealey*, 334 U.S. 653 (1948) - NY GRT imposed on seller of bus transportation across state lines - Struck down because not apportioned based on miles traveled thru various states - Compared to an income tax; no mention of local character of the levy - Seller exposed to taxation on same receipts in other states - *Jefferson Lines, Inc. v. Oklahoma Tax Comm'n*, 514 U.S. 175 (1995) - OK sales tax imposed on buyer of bus transportation across state lines - Upheld despite not being apportioned - Focused on discrete "local event" - No risk of multiple taxation -- "44 or 45 states that impose sales and use taxes permit credit... for similar taxes paid to other States." Statutory Fair Apportionment - State apportionment methodologies vary. - UDITPA's three-factor formula uses property, payroll and sales - Other (single, double or triple-weighted factors) - Because the standard apportionment formula may produce unreasonable results, UDITPA Section 18 provides an alternative apportionment method. - It acts as a pressure valve for when the standard apportionment formula produces arbitrary and unreasonable results. - It is intended to be applied only in unusual or unique circumstances. - **Standard (UDITPA Section 18) Alternative 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." - **Multistate Tax Commission (MTC) Regulation IV.18(a):** - [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...." Invoking Alternative Apportionment ---------------------------------- - proponent of an alternative apportionment method bears the burden of proof in showing that: - The statutory formula does not fairly represent the taxpayer's business activities in the state; and - A proposed alternative method is reasonable. - Does distortion exist? - *Microsoft Corp. v. Franchise Tax Board*, Cal. SCt, 39 Cal. 4th 750, 139 P3d 1169 (Aug. 17, 2006). - What is a "fair" representation of in-state activity? - Most states have found that the [constitutional] "gross distortion" requirement (*a la Hans Rees*) is not necessary to justify [statutory] alternative apportionment; some lesser standard usually applies - Consistent with Section 18 of UDITPA, many state [statutes] require only a showing that the statutory formula does not fairly reflect the extent of the taxpayer's in-state activities - But how does one measure what is "fair"? - More or less tax - Prevent over- or under-taxation - If distortion, is the proposed alternative method reasonable? - Adjusting number of factors - Including/excluding receipts from numerator/denominator - COP/Market sourcing - Matching principle - Combined reporting - Absurd Result - Who has the burden of proof? - Why does it matter? - What is the standard of proof? - Clear and convincing - Clear and cogent - Preponderance of the evidence - Prima facie - Abuse of discretion, *de novo* review, or something else - Did the moving party satisfy the burden? - Is alternative apportionment available? - Timing of request for alternative apportionment? (e.g., when tax return is filed) Corporate Income Tax Planning State Challenges ============================================== Economic Substance Doctrine --------------------------- - Historically a federal income tax concept arising from common law. - *Gregory v. Helvering*, 293 U.S. 465 (1935) - A series of corporate transactions were designed to conform to the Code as a \"reorganization,\" but for the sole purpose of transferring the shares in question to the taxpayer, with a resulting tax liability less than that which would have ensued from a direct transfer by way of dividend. - Held: While the plan conformed to the terms of the statute, there was no reorganization within the intent of the statute. - Judge Learned Hand, writing for the Second Circuit Court of Appeals found that, "\[a\]nyone may so arrange his affairs that his taxes shall be as low as possible" but "\[t\]o dodge the shareholders\' taxes is not one of the transactions contemplated as corporate 'reorganizations.'" - In general, this doctrine denies tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in federal income tax. - Two-prong test: - Has the taxpayer shown that the transaction materially altered the taxpayer's [economic position]? - Has the taxpayer shown that there was a [business purpose] for entering into the transaction, other than tax avoidance? - Circuit Split: - Conjunctive test: The transaction must have economic effect aside from tax benefits ***[and]*** a non-tax business purpose. (1st, 7th, and 11th). - Disjunctive test: The transaction must have economic effect aside from tax benefits ***[or]*** a non-tax business purpose. (2nd, 8th, and D.C. Circuits). - Totality of circumstances: the objective and subjective prongs are related factors "both of which inform the analysis of whether the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes." (3th, 6th, 9th, and 10th). - The economic substance doctrine has many siblings: - Substance over form - Business purpose - Sham transaction - Step transaction - These often overlap and have been used interchangeably and in conjunction with one another. Substance Over Form Doctrine ---------------------------- - Broadest of the anti-abuse doctrines - Originated in *Gregory v. Hilvering* - *"As a general rule, the incident of taxation depends on the substance rather than the form of the transaction."* - Generally raised when a taxpayer chooses a form that is inconsistent with the substance of the transaction and provides the taxpayer with a benefit that would not be available if the form was consistent with the substance. - Often raised in response to leasing transactions, related party transactions, and in debt/equity determinations. - Inquiries - Did substance of the transaction comport with the form asserted by the taxpayer? - Was the change in economic position that occurred, if any, consistent with the form asserted? - Was the claimed business purpose supported the particular tax benefits that were claimed? Business Purpose Doctrine ------------------------- - The business purpose doctrine involves a subjective inquiry into the motives of the taxpayer − that is, whether the taxpayer intended the transaction to serve some useful non-tax purpose. - In making this determination, some courts have bifurcated a transaction in which independent activities with non-tax objectives have been combined with an unrelated item having only tax-avoidance objectives in order to disallow the tax benefits of the overall transaction. Sham Transaction ---------------- - Sham in fact - Factual sham - The alleged transactions never took place or was substantially different than reported - Sham in substance - Economic sham - The alleged transactions actually took place, but are nonetheless without economic substance - Similar to the two-prong economic substance test Step Transaction ---------------- - Collapses or disregards a series of related but unnecessary transactions when there was no independent purpose behind the intervening steps other than to achieve a certain tax benefit. - Three tests: - [Binding commitment test]: separate steps in a transaction will be collapsed into a single transaction if, at the time the first step takes place, the taxpayer was under a binding commitment to complete the remaining steps. - Typically applicable where a substantial period of time has passed between the steps that are subject to scrutiny. - [The end result test]: amalgamates into a single transaction separate events which appear to be component parts of something undertaken to reach a particular result. - [Mutual interdependence test]: the steps are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series. Areas of Uncertainty -------------------- - Must a taxpayer establish the presence of both economic substance (i.e., the objective component) and business purpose (i.e., the subjective component)? Or is one enough to uphold the transaction? - What exactly is the non-tax economic benefit a taxpayer must establish in order to satisfy economic substance? - What is the proper balance between economic risk and profit potential versus tax benefits? - Do mere financial accounting benefits from the tax savings suffice? Is that a valid business purpose? - Does the involvement of tax-indifferent parties (e.g., tax-exempt entities) influence its application? - Who has the burden of proof? Federal Codification (2010) --------------------------- - In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if - \(A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer\'s economic position, ***[and]*** - \(B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. - "The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner **as if this subsection had never been enacted**." - The term "transaction" includes **a series of transactions**. - If "the relevant facts affecting the \[economic substance of the transaction\] are not adequately disclosed" on the return or an attachment to the return, the penalty jumps from 20% to a 40% penalty. - IRC §§ 7701(o)(5), 6662(i). State Codification ------------------ - States have applied these doctrines in familiar income tax contexts - Anti-PIC statutes ("passive investment company") - Alternative apportionment - Forced combination - Transfer pricing - Interest and related party expense disallowance - Nexus considerations **Sales and Use Taxes** ======================= What is a sales and use tax? ---------------------------- - [Sales] tax and [complementary] [use] tax are imposed by state and local jurisdictions on retailers or consumers for the privilege of selling ―tangible personal property in the jurisdictions. - Sales taxes are generally imposed on the final consumer of a product or service, and are therefore, referred to as consumption taxes. - 45 states and the District of Columba impose sales taxes. (NOMAD = NH, OR, MT, AK, DE) Who is liable for sales and use tax? ------------------------------------ - Generally, the [legal incidence] (i.e., imposition) of the tax is on the customer; could be on the retailer. - The responsibility of sales tax [collection] is generally borne by the seller, if the seller has the [minimum connection] necessary with the state to require the seller to collect and remit the tax. - If the seller does not have the minimum connection necessary to collect, then the purchaser must self-remit the [use] tax. - Joint and several liability. - Four categories of taxes: 1. [Seller's Privilege Tax]: A seller's privilege tax is imposed on the seller for the privilege of making sales to consumers (or engaging in business as a retailer) within the state. 2. [Transaction Sales Tax]: Transaction sales taxes are imposed on the transaction. The seller and purchaser are generally jointly liable for the tax. Where tax is not collected on the transaction, later payment of the tax by the seller may give rise to a debt from the purchaser to the seller for the tax. 3. [Consumer Tax]: Under a consumer tax the liability for the tax falls nominally on the purchaser with the seller obligated to collect and remit the tax to the state. 4. [Gross Receipts Tax]: The tax is imposed on the seller's gross receipts. - Shift, absorb, or separately state? - In those instances where the seller is primarily liable for the tax, states may permit the seller to pass the burden of the tax directly on to the purchaser (shifting). - Where the purchaser is primarily liable for the tax, absorption of the tax by the vendor may not permitted and the tax must be separately stated on invoices or other documentation of the sale. - First Amendment Right to Pass Through Taxes and Fees - The U.S. Court of Appeals for the Sixth Circuit struck down a Kentucky telecommunications law that prohibited providers from collecting the tax directly from consumers and separately stating the tax. *BellSouth Telecomm. Inc. v. Farris*, 542 F.3d 499 (6th Cir. 2008). - The Washington Supreme Court concluded that businesses may not add the Washington Business & Occupation (B&O) tax as a separate charge to its sales prices, regardless of any prior disclosure to customers. *Peck v. AT&T Mobility*, 375 P.3d 304 (2012). - Marketplace Facilitors - Marketplace facilitator laws grew from the idea that a state could collect all of the required sales tax from one entity rather than from hundreds of thousands of smaller companies.  - Who is a "marketplace facilitator"? - A business or organization that contracts with third parties to sell goods and services on its platform and facilitates retail sales. - E.g., EBay, Etsy, Amazon - Who is the retailer? - Who is liable for sales and use taxes? - Who is responsible for collecting the sales and use taxes? Elements of a Taxable Transaction --------------------------------- - In order for a state to impose sales or use tax on a particular transaction, each of the following must be present: - A Sale or use ([taxable incident] - usually requiring a purchase, but may involve a gift or bailment) - That occurs within the taxing state ([jurisdictional requirement]) - Of a taxable good or service ([taxable base]) - For a valuable consideration ([taxable measure]) Taxable incident: What is a sale? --------------------------------- - In the case of tangible personal property, a sale is generally defined for sales tax purposes as the transfer of title, ownership, [or] possession of the property for a valuable consideration. - For this purpose, states view the rental or lease of tangible personal property as a sale. ("true lease" vs. "capital lease") - The transfer of title without possession is still considered a sale for sales tax purposes. - Possession is generally defined as the exercise of physical dominion and control over property. In some states the grant of "constructive possession" (i.e., sufficient rights to control or dispose the property) is sufficient to create a sale for sales tax purposes. - Sales taxes are generally imposed on sales made at retail. - A retail sale is generally defined as a sale to a person who is a "consumer." - Sales taxes are generally imposed on sales made at retail. - A retail sale is generally defined as a sale to a person who is a "consumer." - Sale for resale is not a retail sale. Taxable incident: What is a use? -------------------------------- - Storage, use or consumption of a taxable item or service on which no sales tax has been paid - Imposed on the first use of the taxable article or service within the state as a consumer Jurisdictional Requirement (sourcing): Where is it taxable? ----------------------------------------------------------- - "Within the taxing state" - Origin -- taxing situs s the seller's location - Destination -- taxing situs is where the goods are consumed - Example \#2: ABC Corp. places an order for widgets from its supplier in another state. The goods are shipped by common carrier to ABC's plant from the supplier's warehouse outside the state. - Most states would treat the sale as occurring in the state where ABC's plant is located because that is where ABC took delivery. - Shipping terms such as where title passes and who pays the shipping charges generally do not alter where the sale takes place for sales tax purposes. - *Oracle USA Inc., et al. v. Commissioner of Revenue*, No. SJC-13013 (Mass. 2021) - Holding that the vendors can apportion sales tax on software purchased by a Massachusetts company to other states where the software was accessed and seek a tax refund - The Court rejected the Commissioner's argument that vendors could not seek apportionment through the abatement process for their refund claims - The Court also held that the legislature could not delegate the fundamental policy question of whether to allow apportionment of sales and use tax on software sold in Massachusetts but transferred out-of-state What is taxable? ---------------- - What items are generally subject to Sales and Use Tax? - Real Property - Intangible Property - Services - Scope of the tax: - The sale, storage, use or consumption of TPP by "persons" are taxable unless exempt. - The term tangible personal property means any kind of physical personal property that has a material existence and is perceptible to the human senses (in other words something you can see and touch) - What is *tangible personal property*? - NY Tax Bulletin ST-175: The term *tangible personal property* means any kind of physical personal property that has a material existence and is perceptible to the human senses (in other words, something you can see and touch) - Cal. Rev. and Tax. Cd. Sec. 6016: personal property which may be seen, weighed, measured, felt, or touched, or which is in any other manner perceptible to the senses - States may define items as TPP that may not meet the typical definition - [Services] are nontaxable unless specifically enumerated as taxable. - E.g., communications services, SaaS. - States are increasingly extending sales taxes to so-called "digital" products and services or "cloud computing" services, none of which fit neatly into traditional sales taxable categories. - *Bundling and Mixed Transactions* - Issue: one lump sum is paid for a transfer of both tangible personal property and services. - The taxpayer then has the burden of separating the transaction and proving the nontaxable portion. - "True object" or "inconsequential element" test. - *De minimus* threshold (10%) - *Software* - Issue: tangible or intangible? - Canned vs. custom vs. electronically transmitted - *Nortel Networks Inc. v. State Board of Equalization*, 191 Cal. App. 4th 1259, 119 Cal. Rptr. 3d 905 (2011). - A manufacturer of telephone switching equipment (Nortel) was not subject to California sales/use tax on software that it licensed to operate switching equipment in California, under the state's Technology Transfer Agreement (TTA) statutes. - The court found that the software was exempt under the TTA statutes because it (1) was copyrighted; (2) contained patented processes; and (3) enabled the licensee to copy the software and to make and sell products -- telephone calls -- using the patents and copyright. - *Digital Products & Services* - Issue: Do you know what CDs or VHS tapes are? - SaaS vs. Paas vs. IaaS - Saas - Google Workspace, Dropbox, Salesforce, Cisco WebEx, Concur, GoToMeeting - Paas - AWS Elastic Beanstalk, Windows Azure, Heroku, Force.com, Google App Engine, Apache Stratos, OpenShift - Iaas - DigitalOcean, Linode, Rackspace, Amazon Web Services (AWS), Cisco Metapod, Microsoft Azure, Google Compute Engine (GCE) - Streaming services - Subscription to remote access software (*Citrix Sys. Inc. v. Comm'r of Revenue*, 139 N.E.3d 293 (Mass. 2020) (taxable transfer of prewritten software) - Digital goods = TPP (e.g., CO) - State treatment varies - State DORs using various provisions (e.g., "telecommunications services") to impose tax - MTC's Uniformity Committee Reccomendation - "Digital products" include the "entire category of products made possible by digital or electronic technologies that are not, primarily, tangible or physical property or traditional services." - May include digital services. How much is taxable? -------------------- - Sales tax applies on **gross receip**ts including cash, credits and property of any kind - This includes Tarde-Ins and Barter - Sales tax applies to **gross receipts** of the transaction upon **taxable items** - Common inconsistencies among states - Shipping - Handling - Fabrication - Testing - Warranty - Other services *included or separately stated* - Sales tax is generally imposed on the [selling price] paid or contracted to be paid in exchange for the taxable property or service. - Typically, consists of all [consideration] furnished by the purchaser or another for the benefit of the purchaser. - Consideration can be anything given for value in exchange for the tangible personal property or taxable service sold. - Deductions may be allowed for certain items if they are separately stated in the contract of sale or invoice. - E.g., cash discounts or allowances, refunds, returns and finance charges. - Credits - Bad debt - Taxes paid to other states - Use tax is generally imposed on the fair market value of the property at the time put to use in the state Sale or Use Tax? & Exemptions ----------------------------- - Sales Tax -- imposed on the sale or lease of tangible personal property and certain enumerated services - Use Tax -- imposed on the purchase, use, or consumption of tangible personal property and certain enumerated services - Ex: Items purchased upon which no sales tax collected; From out-of-state vendors (generally); For own use - Ex: Items purchased without tax as resale; Items manufactured or assembled; Instead of selling the item, you use the item - Sales tax and use tax are complementary (i.e., they cannot both be imposed on the same transaction) - **Exemptions** - Generally, 3 categories: - Who is the purchaser? - What is being purchased? - How is it being purchased? - Common ex