Current corporate income tax developments.

• Author: Boucher, Karen J.
• Position: Part 1

EXECUTIVE SUMMARY

* In Hunt-Wesson Inc. v. FTB, the U.S. Supreme Court held that California's interest-deduction offset provision is not a reasonable allocation of expenses to income and is impermissible taxation of income outside the state's jurisdiction.

* An alien corporation operating in New York had to include foreign-source income on its franchise tax return, even though such income was not included on its Federal return.

* Effective Jan. 1, 2000, the Michigan legislature made substantial changes to the SBT, including its application to foreign persons.

This two-part article discusses a plethora of recent state pronouncements issued in the corporate income tax area. Part I addresses nexus and tax base; Part II, in the next issue, examines apportionment, administration and other developments.

During 2000, an overwhelming number of 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cases were decided; regulations were proposed, issued and modified; and bulletins and rulings were issued, released and withdrawn. Because it is impractical to summarize all of these activities, Part I of this two-part article focuses on some of the more interesting items in the corporate income tax areas of nexus and tax base. Part II, in the April 2001 issue, will discuss apportionment, administration and other significant income tax and nonincome tax developments.

Nexus

Application of P.L. 86-272

P.L. 86-272 prohibits a state from taxing a business when its only connection with the state is the solicitation of orders for sales of tangible personal property sent outside the state for approval or rejection and, if approved, are filled and shipped by the business from a point outside the state. Several cases, rulings and legislative bilk addressed whether a taxpayer's in-state activities fell within the protection of P.L. 86-272.

* Illinois

An appellate court held that the maintenance of an unmanned office and registration of a phone line in the state in connection with the registration of a truck fleet there created nexus for corporate income tax purposes.(1) The taxpayer leased an office for $500 per year; however, it did not otherwise take possession of or occupy the leased premises, did not own the property in the office and had no employees there. The court held that the maintenance of an office in the state exceeded the protection of P.L. 86-272 and that the ancillary and de minimis exceptions, did not apply. Further, the court held that even if the exceptions did apply, the taxpayer's activities were not ancillary to solicitation, because registration of its truck fleet under the international registration plan and maintenance of an office in Illinois served an independent business function apart from soliciting or delivering orders.

* Illinois

The DOR ruled that deliveries to in-state customers using company-owned vehicles or owned or leased railcars would establish nexus with the state, unless such activities were de minimis.(2)

* Texas

The Comptroller of Public Accounts ruled that if a manufacturer's only contact with Texas was the delivery of its product via its own trucks, it did not have nexus for purposes of the earned surplus component (which is based on taxable income).(3) An administrative law judge (ALJ) agreed with the petitioner that the delivery of goods into a state in company-operated vehicles, regardless of the frequency, is protected by P.L. 86-272.

* Virginia

The Department of Taxation (Department) ruled that the taxpayer's bundling of warranties (including parts and repairs) at its out-of-state facilities with its products did not exceed P.L. 86-272 protection, but warranty services carried on in Virginia are not protected.(4) The taxpayer did not provide onsite warranty service with its own employees; such warranties are purchased by the taxpayer from an unrelated third-party warrantor, who provides all needed onsite service.

The Department views these activities as if the taxpayer is purchasing the warranty services from a vendor and reselling them to its customers. Although P.L. 86-272 only applies to the sale of tangible personal property, Virginia applies the same "solicitation" test to sales of intangible personal property. Under these circumstances, sales of services on behalf of an independent third party would not create nexus for a corporation otherwise protected under P.L. 86-272. The Department will, however, take a different approach if a third-party warrantor is not independent of the taxpayer. The Department attributes unprotected activities performed by a party not independent to a corporation in determining whether the corporation has nexus with Virginia. Thus, a third-party onsite warrantor not independent of the taxpayer would be deemed to be providing services on the taxpayer's behalf to its customers.

Trademark/Tradename Companies

* Maryland

A circuit court upheld two decisions of the state tax court that an out-of-state Delaware subsidiary holding and managing trademarks, service marks and tradenames for an affiliated group is not subject to Maryland corporate income tax, because the affiliate is a nonphantom entity (i.e., it has substance).(5) Both decisions have been appealed to the state's highest court.

* New Mexico

The Taxation and Revenue Department (T&R Department) held that Kmart Properties, Inc. (KPI) was subject to franchise and gross receipts taxes.(6) KPI, a Kmart subsidiary, owned trademarks and tradenames and licensed them to Kmart retail locations doing business in the state. During the litigation, the T&R Department requested and received memoranda explaining how to set up a trademark company, how to operate it and the expected state tax savings. The trademark company generally operated with independent substance as a separate company: it moved into a separate building; it employed all of the trademark attorneys; any work done by the trademark attorneys for the other Kmart companies was billed at an hourly rate; and there were executed loan documents between Kmart and the trademark company (however, the loan documents provided for loans up to $500 million, much lower than the actual outstanding balance).

In attacking KPI, the T&R Department relied on trademark law, which provides that trademarks cannot be separated from goodwill; in essence, a trademark has no value (or would be considered abandoned) unless it is maintained by an ongoing business. The T&R Department also looked at the licensing requirements under trademark law, which require a licensor to maintain, control and protect a trademark. It found that there was substantive identity between KPI and Kmart, based on a direct correlation between Kmart's use of KPI's trademarks in New Mexico to promote sales and enhance its sales revenues and the revenues KPI receives as royalties (calculated as a percentage of those New Mexico sales). It further found that the Uniform Division of Income for Tax Purposes Act's (UDITPA's) three-factor formula did not fairly represent KPI's business activity in New Mexico, because its only business activity in the state is the licensing of its trademarks for use there. In addition, the T&R Department upheld the gross receipts tax assessment on KPI's royalty income in New Mexico, finding that payment of the royalties is a condition of the sale and is the consideration for the sale to the extent the sale occurs in the state. The decision has been appealed.

* North Carolina

The Assistant Secretary of Revenue ruled that nine nondomiciliary trademark holding companies are doing business in the state for corporate and franchise tax purposes, despite the fact that none of the companies has had offices or employees in the state.(7) The holding companies licensed trademarks, tradenames and service marks to related North Carolina retail stores, and the parties engaged in numerous intercompany-lending transactions.

Other Nexus-Creating Activities

* Georgia

The DOR proposed amending Reg. 560-7-7-.03 to provide that a corporation that is a limited or general partner in a partnership doing business or owning property in the state is subject to state corporate income tax.

* Illinois

An appellate court held that owning a limited partnership interest in a limited partnership doing business in the state is sufficient nexus to subject a corporate partner to the Illinois personal. property replacement income tax.(8) The taxpayer also challenged Illinois rules that do not allow the flowthrough of the investment tax credit (ITC) from an operating partnership to a corporate taxpayer; the taxpayer prevailed on this issue and could flow through the partnership's ITC.

* Illinois

An ALJ ruled that a Wisconsin corporation that rented and leased trucks to commercial businesses (including businesses located in Illinois) was not subject to Illinois corporate income tax, because it did not have sufficient contact with the state to satisfy either the Due Process or the Commerce Clause.(9) Under the terms of the lease agreements, the lessee has complete dominion and control over the leased vehicles. In addition, none of the lessees took possession of the vehicles in Illinois.

* Maine

The Bureau of Revenue Services modified Rule 808 (corporate income tax nexus) in May 2000. The most significant of the amendments provides that the activities in Maine of an independent contractor on behalf of a foreign corporation will be imputed to the corporation if they are more than de minimis and significantly associated with the latter's ability to establish and maintain a market in Maine, to the extent allowed by the U.S. Constitution and Federal law.

* Maryland

A circuit court denied the Comptroller's attempt to impose an income tax on an...