Current corporate income tax developments.

• Author: Boucher, Karen J.
• Position: Part 2

Part II of this two-part article addresses (1) state tax base computation issues, including state income taxes, dividends received and net operating loss deductions, and interest on Federal and state obligations and (2) apportionment factor and formula issues, such as sales factor sourcing rules for services and intangibles and factor relief for foreign royalties and interest.

In the August issue, Part I of this two-part article focused on significant nexus activities that will affect the majority of taxpayers and highlighted the novel approaches being demonstrated by some of the more aggressive states. Part II, below, addresses tax base and apportionment issues.

State Tax Base

The majority of states imposing a corporate income-based tax begin the computation of state taxable income with taxable income as reflected on the Federal corporate income tax return (Form 1120, U.S. Corporation Income Tax Return) . These states use either taxable income before net operating loss (NOL) and special deductions (Line 28) or taxable income (Line 30); certain state-specific addition and subtraction modifications are then applied to arrive at the state Max base. Over the past 15 months, there have been a number of statutory, regulatory and judicial changes to these modifications. Below is a summary of the significant changes to the states' addition and subtraction modifications.

State Income Taxes

In determining the state Max base, most states require a corporation to add back state taxes (based on or measured by net income) deducted in arriving at Federal taxable income. Some states require that only their income taxes be added back, while others require that all state income taxes be added back. While the distinction between an income tax and a franchise Max measured by net worth generally is significant in determining whether an addback is required, in making the addback determination, the Michigan single business Max (SBT) is the most controversial of all of the state taxes. Some states permit a deduction for the entire SBT, other states do not allow a deduction for any portion of it, and several states attempt to bifurcate the tax into a deductible and a nondeductible component. As is discussed below, California and Wisconsin courts reached similar conclusions on this issue; an Ohio court held that a resident individual cannot claim a credit for the SBT. In addition, the Virginia Tax Commissioner clarified the treatment of the Texas franchise tax and Arizona eliminated the deduction for its state income taxes.

Arizona

For tax years beginning from and after 1997, the corporate tax rate is reduced from 9% to 8%; however, there is no longer a deduction for Arizona income taxes paid or accrued.(23)

California

In 1994, in Appeal of Dayton Hudson Corp.,(24) the California State Board of Equalization (SBE) held that the SBT is fully deductible in computing the California corporate franchise/income tax, because it is not a tax measured by income and cannot be bifurcated into deductible and nondeductible portions. In response, the California Franchise Tax Board (FTB) modified its prior SBT bifurcation position to provide that the SBT is deductible for California corporate tax purposes (i.e., an addback is not required) if the taxpayer has incurred and deducted labor costs of goods sold (COGS) in the year in which the SBT is paid or accrued. If there is no return of capital in the form of labor COGS in the SBT base (e.g., businesses that exclusively provide services or that do not incur and deduct labor COGS), the deduction is not allowed.

During 1997, the SBE rejected the FTB'S modified SBT position. In Appeal of Kelly Service Inc.,(25) the taxpayer asked the SBE to expand its holding in Dayton Hudson to encompass situations in which there is no labor COGS in the SBT tax base for a particular taxpayer. The taxpayer is a service business providing temporary help to a variety of customers. As a service business, it has no inventory costs; thus, the SBT does not "contain an element of return of capital" in its tax base. The SBE affirmed Dayton Hudson and clarified that its holding applies equally to service businesses. Accordingly, the SBT is deductible for California tax purposes, regardless of the specific components of the SBT tax base of the taxpayer claiming the deduction.

Ohio

In Ardire v. Tracy,(26) the Ohio Supreme Court, relying on Gillette Co. v. Mich. Dep't of Treasury,(27) determined that the SBT was not a tax "measured by" net income for purposes of eligibility for Ohio's resident tax credit. The Ardire court noted that the SBT starting point is Federal taxable income (i.e., net income) with several addition adjustments, but the many addition adjustments prevent a conclusion that the SBT is a tax "measured by" net income.

Virginia

The Virginia Tax Commissioner (Commissioner) addressed whether the Texas franchise tax constitutes an addition modification in computing the Virginia corporate income tax.(28) Basically, the basis for the earned surplus component of the Texas franchise tax is Federal taxable income with several modifications. The Commissioner ruled that the earned surplus tax is based on net income and must be added back for Virginia tax purposes. The Texas net capital tax is based on stated capital plus surplus; thus, it is not required to be added back in determining Virginia taxable income.

Wisconsin

A Wisconsin Circuit Court reversed the decision of the Wisconsin Tax Appeals Commission (Commission) on the deductibility of the SBT in tax years prior to a 1994 legislative amendment clarifying that the SBT has to be added back to the Wisconsin tax base. In Delco Electronics Corp. v. Wisc. Dep't of Rev. (DOR),(29) the court held that the SBT can be deducted from Wisconsin corporate franchise tax, because the SBT is not a tax on or measured by all or a portion of income or gross receipts. The Commission had ruled that the SBT was not deductible in computing the Wisconsin franchise tax liability.

For the years at issue, the Wisconsin statutes disallowed a deduction for state taxes on or measured by "all or a portion" of net income, gross income, ,gross receipts or capital stock. The Commission had not been persuaded by the Michigan court's reasoning in Gillette that net income, which is an essential and clearly defined component of the total tax measure, loses its identity as a "measure" of the SBT. Accordingly, it concluded that the SBT was "measured by net income" within the unambiguous meaning of the Wisconsin statutes, because net income is a clearly defined, distinct and essential component of the SBT total tax base in the addition method used by the taxpayer. The Commission noted that the taxpayer might have prevailed if the statute applied only to taxes measured "solely or exclusively" by net income. The circuit court held that the SBT is not a tax on or measured by net income; rather, it is a value-added tax that does not have to be added back.

DRD

Alabama

Alabama law permits a deduction for dividends received (DRD) from a corporation subject to Alabama income tax. In Alabama DOR v. Sonat, Inc.,(30) Sonat received $185 million of dividends from a subsidiary whose only connection with Alabama was its lease of office furniture located in Alabama to another affiliate, which resulted in $87 of Alabama corporate income tax. The Alabama Court of Civil Appeals reversed a lower court decision, holding that the subsidiary's de minimis involvement in Alabama did not render its net income taxable there; thus, Sonat could not claim a deduction for the $185 million of dividends received from the subsidiary.

Arkansas

Arkansas legislation enacted in 1997, effective for tax years beginning after 1996, excludes from corporate income dividends received from a subsidiary owned at least 80% by the parent. Prior to this amendment, such dividends were excludible only if the parent owned at least 95% of the subsidiary. In addition, for dividends paid in tax years beginning after July 30, 1995, foreign corporations can claim a DRD for dividends paid by corporations at least 20% owned. Prior to this amendment, a DRD was allowed only for dividends paid by a subsidiary that was also subject to Alabama income tax.(31)

California

The U.S. Supreme Court's unanimous decision in Fulton Corp. v. Faulkner(32) calls into question the constitutionality of California's DRD statutes, Cal. Rev. & Tax. Code Sections 24402 and 24410, which permit a deduction only for dividends included in the measure of the distributing corporation's California franchise tax, alternative minimum tax or corporate income tax liability.(33)

District of Columbia

The D.C. City Council approved legislation(34) that provides a 100% DRD for dividends received from a wholly owned...