Current corporate income tax developments.

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

This two-part article discusses a variety of recent state tax activity in the corporate income tax area. Part I, in the last issue, addressed nexus, tax base and entity-classification conformity; Part II examines apportionment, administration, amnesty and other developments.

During 2001, 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cases were decided; regulations were proposed, issued and modified; and bulletins and rulings were issued, released and withdrawn.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 article, in the last issue, focused on some of the more interesting items in the corporate income tax areas of nexus, tax base and entity-classification conformity. Part II, below, discusses apportionment, filing methods, unitary groups and other significant income tax and nonincome tax developments.

Apportionment

A multistate corporation's business income is apportioned among the states in which it does business, using an apportionment percentage for each state with 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 business activity in the state to the total corporate 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 corporate business income to determine the income subject to tax by the state.

Although apportionment formulas vary among jurisdictions, most states use a three-factor formula that includes sales, payroll and property. However, over the past several years, legislative changes to the apportionment formula have become common; more than half of the states now accord more weight to the sales factor than to payroll and property. Use of a double-weighted sales factor tends to pull a larger percentage of an out-of-state corporation's income into the state's jurisdiction, but generally provides tax relief for in-state corporations. Changes in the apportionment formula may also be used to provide special relief or tax benefits to specific industries or to properly reflect the operations of a special industry. Recent apportionment formula developments are summarized below.

* Alabama

The chief administrative law judge (ALJ) decided (49) that a taxpayer is entitled to either a payroll factor or an alternative "compensation" factor under Ala. Code Section 40-27-1, Art. IV, [paragraph] 18. The taxpayer's sole purpose is to hold a 50% interest in a partnership doing business in the state; it has no employees nor owns any property. The partnership also has no employees of its own; it pays an administrative fee to related entities for services provided by those companies' employees. When filing its Alabama returns, the taxpayer computed its payroll factors based on the annual amounts the partnership paid for the services the related entities provided. On audit, the DOR eliminated the payroll factor from the returns, because the partnership had no employees, and thus did not have a payroll within the scope of Ala. Admin. Code Regulation 810-27-1-4-.13.

The ALJ agreed that the taxpayer did not have a payroll factor under the regulation, because it required amounts to be paid to "employees" and the partnership had none; however, he found that the regulation was inconsistent with the statute, which defines the payroll factor to include compensation paid (a term not limited to amounts paid to employees). Consequently, the amounts paid by the partnership for the services provided by the employees constituted "compensation paid" within the scope of the statute, and had to be included in the payroll factor. The regulations were rejected to the extent they conflicted with that finding.

The ALJ also decided that, even if the payroll-factor regulations are followed and the taxpayer's payroll factor eliminated, the taxpayer would be entitled to relief under Section 40-27-1, Art. IV, [paragraph]18. Use of only the property and sales factors would not fairly reflect the partnership's in-state activities, because the employees' income-producing activities would be ignored. Consequently, the partnership should be allowed an alternative factor pursuant to [paragraph] 18 based on the compensation it paid for those employees. The net effect would be an alternative factor identical to the one the DOR rejected.

* Arizona

The DOR explained (50) when to include computer software in the property-factor numerator and denominator. Computer software treated as tangible personal property and capitalized for Federal tax purposes is similarly treated for state tax purposes. Ariz. Rev. Stats. Section 43-1140 provides that the property-factor numerator includes real and tangible personal property used instate; thus, computer software is includible in the numerators of the states in which the software is actually used, not where the original program disk or tape is located.

* Arkansas

Effective for tax years beginning after 2000, a taxpayer will be "taxable in another state" under HB 1462 (enacted as Act 1228), and thus entitled to apportion income (and not required to throw back sales), if it 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 in another state and files the requisite tax return in the other state.

* California

Effective March 1, 2001, the Franchise Tax Board (FTB) amended Regulation Section 25137(c), alternative apportionment. Among the amendments was the expansion of the substantial-amount special-sales-factor rule to include certain intangible assets and provide guidance in defining "substantial." The amended regulation provides that, when substantial gross receipts arise from an occasional sale of a fixed asset or other property held or used in the regular course of a taxpayer's trade or business, such receipts must be excluded from the sales factor.

For example, gross receipts from the sale of a factory, patent or affiliate's stock are excluded if substantial. For purposes of this subsection, sales of assets to the same purchaser in a single year are aggregated to determine whether the combined gross receipts are substantial.

Further, a sale is substantial if its exclusion results in a 5%-or-greater decrease in the taxpayer's sales-factor denominator or, if the taxpayer is part of a combined reporting group, a 5%-or-greater decrease in the group's sales-factor denominator. A sale is occasional for this purpose if the transaction is outside of the taxpayer's normal course of business and occurs infrequently.

* California

A court of appeal affirmed (51) a trial court's findings that there is nothing arbitrary or unconstitutional about assigning a taxpayer's South Dakota credit-card sales and transactions to California based on Finnigan. (52) The court also affirmed classifying the gain on the sale of four properties as business income.

* California

The U.S. Supreme Court rejected Deluxe Corp.'s (53) petition for certiorari in its case on the application of Finnigan in typical inbound sales for tax years before Huffy. (54)

* California

The SBE held against Toys "R" Us. (55) The company maintains a treasury department in New Jersey responsible for working capital and maintaining liquid assets for inventory control purposes. For years ending 1991-1994, it included in its income gross receipts from that department's investment activities for sales-factor purposes. The gross receipts from such activities were disproportionate to the net income generated. Toys "R" Us argued that there was insufficient distortion to invoke Regulation Section 25137 relief; accordingly, the investment receipts had to be included in the sales factor. The SBE decided against the company and denied its petition for rehearing.

* Connecticut

The superior court ruled (56) that a taxpayer properly computed its corporation business tax using the three-factor apportionment method. The taxpayer used computers, telephones and other tangible personal property to produce market reports that ultimately resulted in revenue. The taxpayer contended that it was required to use the state's three-factor apportionment formula, because its revenue was derived from the use of personal property, as provided in Conn. Gen. Stat. [section] 12-218(b) (current version [section] 12-218(c)).

The state argued that the taxpayer provided a service; because the taxpayer's use of tangible personal property was not essential in providing the service, it had to use the single-factor apportionment formula. The court ruled that by deriving income from its use of tangible personal property, the taxpayer could apply the three-factor formula; such use fell within the express language of Conn. Gen. Stat. [section] 12-218(b).

* Florida

The DOR proposed amendments to several corporate tax rules (Fla. Regulation, Rules 12C-1.003, -1.013, -1.0153,-1.0155,-1.016,-1.023 and -1.034). The proposed amendment to Rule 12C-1.0153 (Property Factor for Apportionment) provides a definition for the term "unsecured loans." The proposed amendment to Rule 12C-1.0155 (Sales Factor for Apportionment) provides that interest received from loans made to customers located in-state (other than loans secured by real or tangible personal property located out-of-state) is included in the sales-factor numerator for apportionment purposes. Rule 12C-1.016 is being amended to change the title to "Business/Nonbusiness Income--Definitions and Examples" and to provide a definition and examples of "business income."

* Idaho

The state supreme court found (57) that proceeds from the sales of receivables should not be included in the sales factor under a provision allowing the state tax commission...