Current corporate income tax developments.

• Author: Boucher, Karen J.
• Position: Part 2 - State taxation issues

EXECUTIVE SUMMARY

* Illinois and Virginia passed laws requiring flowthrough entities to withhold on the income of nonresident owners.

* Several states passed laws regarding the disclosure of reportable transactions and/or penalties for noncompliance with disclosure requirements.

* New York reduced its Article 9-A and Article 32 corporate tax rates for tax years beginning after 2006.

* Michigan replaced the Single Business Tax with the Michigan Business Tax.

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During 2007, numerous state statutes were added, deleted, or modified; court cases were decided; regulations were proposed, issued, and modified; and bulletins and rulings were issued, released, and withdrawn. Part I of this article, in the March 2008 issue, focused on nexus, Sec. 338(h)(10) transactions, allocable/ apportionable income, and tax base. Part II, below, covers some of the more important developments in apportionment formulas, unitary groups/filing methods, administration, flowthrough entities, and other significant corporate state tax issues.

Apportionment

A multistate corporation's business income is apportioned among the states using an apportionment percentage for each state having jurisdiction to tax the corporation. To determine the apportionment percentage, a ratio is established for each of the factors included in the state's formula. Each ratio is calculated by comparing the corporation's level of a specific activity in the state to the total corporation activity of that type everywhere; the ratios are then summed, weighted (if required), and averaged to determine the corporation's apportionment percentage for the state. The apportionment percentage is then multiplied by total corporation business income.

While apportionment formulas vary, many states use a three-factor formula that includes sales, payroll, and property factors. Because use of a higher-weighted sales factor generally provides tax relief for in-state corporations, most states accord more weight to the sales factor than to the other factors. Changes in the apportionment formula may also be used to provide relief or tax benefits to specific industries or to properly reflect the operations of a particular industry. Recent apportionment developments are summarized below.

Gross Versus Net Proceeds

* Arizona

The Department of Revenue (DOR) explained that only the net gain from the sale or other disposition of investments in short-term instruments should be included in the company's sales factor for state corporate income tax purposes. (1)

* California

On remand from the California Supreme Court, a California court of appeal further remanded the General Motors (2) case (involving whether California should include the entire gross proceeds generated by certain treasury activities in its state franchise tax sales factor) back to the trial court for further proceedings consistent with the California Supreme Court's decision in Microsoft Corp. (3) Because neither the trial court nor the court of appeal had previous occasion to address the California Franchise Tax Board's (FTB) alternative apportionment formula arguments, the California Supreme Court had remanded the case for further proceedings to allow the FTB to make its case.

In another decision, a state superior court held that the gross--as opposed to net--proceeds generated by certain treasury activities (Eurodollar time deposit short-term investments) should be taken into account for purposes of computing the sales factor under the state's standard franchise tax apportionment formula. However, the court ultimately held that, in this instance, the standard apportionment formula did not fairly represent the extent of the taxpayer's business activity in California. (4)

In a different decision, a California court of appeal held that the gross, as opposed to net, proceeds generated by returns of principal from short-term debt instruments held to maturity should be taken into account for purposes of computing the sales factor. However, the court also ultimately held that, in this instance, the standard apportionment formula did not fairly represent the extent of the taxpayer's business activity in California. (5)

In another decision, a California superior court held that the buying and selling of commodities futures contracts does not qualify as "sales income" under general Uniform Division of Income for Tax Purposes Act provisions and thus cannot be considered "gross receipts" for state sales factor apportionment purposes. (6) In addition, the FTB issued Technical Advice Memorandum (TAM) 2007-3 to its audit staff, discussing what information should be collected during an audit with respect to treasury activities as a result of the California Supreme Court decisions in Microsoft and General Motors. (7)

* Kansas

Relying on reasoning under the 2006 California Supreme Court rulings in General Motors (8) and Microsoft, (9) the DOR explained that a company's gross investment proceeds must be excluded from its sales factor denominator to prevent distortion. (10)

Other Apportionment Developments

* California

The State Board of Equalization (SBE) held that an airline company appropriately used the standard industry apportionment formula for air transportation companies as set forth in state regulations because the standard industry formula did not result in income distortion. The FTB could not alter the standard industry formula by grouping the company's aircraft by model because it failed to show that the standard industry formula resulted in income distortion. (11)

In another development, the FTB amended Regulation [section]25137-14, which details rules related to the apportionment of income earned by mutual fund service providers. The amended regulation generally sources receipts based on shareholder residency and includes a throwback sales rule that incorporates the Finnigan (12) rule.

In a Chief Counsel ruling, (13) the FTB determined that the investment activities of third-party investors that managed investments on behalf of a corporate taxpayer under written agreement did not constitute an "income-producing activity" for purposes of computing the taxpayer's corporate income tax apportionment formula sales factor because state regulations specify that activities performed "on behalf of" a taxpayer by independent contractors do not result in income-producing activities attributable to the taxpayer.

* Idaho

The State Tax Commission (STC) denied a retailer's use of an alternative apportionment method on its state combined return that would have included a unitary financial affiliate's intercompany interest income in the denominator of the sales factor and its intangible assets (such as commercial paper) in the denominator of the property factor. (14) The STC explained that the retailer failed to show that the standard apportionment formula resulted in sufficient distortion of its in-state business activity and that "advocating a better method than the standard formula" is not enough to satisfy this requirement. The STC also held that because the retailer failed to show where the costs of performance associated with gains from the sale of its credit card business had occurred, the income was excluded from its sales factor numerator and denominator.

* Illinois

SB 1544 and 783, Laws 2007, source sales of services and certain financial services based on market (rather than costs of performance); change the apportionment for transportation services to a ratio of Illinois gross receipts to gross receipts everywhere; and change the sourcing of telecommunications services and investment income of financial institutions.

* Indiana

The Indiana Tax Court held that the sales factor throwback statute clearly provides that being "subject to tax" in another state includes being subject to a state's franchise tax that is measured by either net income or some other standard (such as, in this case, the Michigan Single Business Tax for the privilege of doing business). (15)

* Kansas

SB 240, Laws 2007, allows single sales factor apportionment for qualifying manufacturers that construct a new facility in Kansas costing at least $100 million, employ at least 100 new employees at the new facility by December 31, 2009, and pay "higher-than-average" wages.

* Maine

Effective for tax years beginning after 2006, Ch. 240 (LD 499), Laws 2007, adopts a single sales factor apportionment formula (prior to this law change, the apportionment formula for corporate income tax purposes was a three-factor double-weighted sales apportionment formula) and generally adopts a market-sourcing approach for sales other than sales of tangible personal property.

* Michigan

The Michigan Supreme Court reversed the Court of Appeals and held that the state's sales factor statute is valid, even to the extent that it sources to Michigan receipts from engineering services performed entirely outside Michigan for construction projects located in Michigan. (16)

* New York

AB 4310C, Laws 2007, accelerated the phase-in of the single sales factor for Article 9-A taxpayers to tax years after 2006.

In a separate development, the New York Supreme Court, Appellate Division, affirmed the Tax Appeals Tribunal's decision that (1) sales by a nontaxpayer member of a combined reporting group must be included in the numerator of the receipts factor of the business allocation percentage (the Finnigan rule) and (2) film master tapes should not be reflected in the property factor at current fair market value, including reproduction rights, but rather at the historical costs of the tapes. (17)

* Oregon

On remand from the Oregon Supreme Court, the Oregon Tax Court held that while a subsequently...