Current corporate income tax developments.

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

EXECUTIVE SUMMARY

* New Jersey legislation mandates the throwout of receipts from the sales-factor denominator to the extent a taxpayer is not taxable in the destination state, and caps any resulting additional liability at $5 million.

* Illinois amended regulations providing that every letter ruling is revoked 10 years after the date of issuance or July 1, 2002, whichever is later.

* Pennsylvania established a new Pass Through Business Unit to identify and resolve cases concerning passthrough entities and their owners.

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This two-part article discusses a myriad of recent state tax activity in the corporate income tax area. Part II examines developments on apportionment formulas, filing methods/unitary groups, administration and other significant state tax developments.

During 2002, a number of state statutes were added, deleted or modified; court cases were decided; regulations were proposed, issued and modified; and numerous bulletins and rulings were issued, released and withdrawn. 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, business/non-business income, and trademark/tradename cases and determinations. Part II, below, discusses apportionment, filing methods/unitary groups, administration and other significant income and franchise 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 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 business 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.

Apportionment formulas vary among jurisdictions; many states use a three-factor formula that includes sales, payroll and property factors. 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 the payroll or property factor. Use of a higher-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 relief or tax benefits to specific industries or to properly reflect the operations of a particular industry. Recent apportionment developments are summarized below.

* Arizona The tax court ruled (39) that gross treasury function proceeds are excluded from the sales factor and that a return of principal did not constitute gross receipts, but dividends and interest did. The court reasoned that once excess operational revenue was invested in securities or other interest-bearing mediums, it lost its gross receipts characterization and could not be counted as gross receipts a second time simply because the money was withdrawn from the investment.

The Arizona Department of Revenue (DOR) explained (40) that installment gains reported in the current year are apportioned based on the current-year's apportionment factors.

* California

A company was unsuccessful in its Appeal (41) that its sales factor should reflect the "return of capital" component of its sales of financial instruments. In challenging this method under the distortion provisions of the state's apportionment regulations, the Franchise Tax Board showed that between 12%-28% percent of the taxpayer's business activities would be shifted away from California under the asserted factor. The State Board of Equalization (SBE) agreed that a shift of this magnitude was consistent with the 11% threshold determined to be distortive in Appeal of Pacific Tel. & Tel. (42)

Similarly, another company was unsuccessful in its appeal (43) that its sales-factor denominator should include proceeds from short-term investment sales and gains from forward exchange contracts. The SBE decided that the short-term investment proceeds should be excluded, because the taxpayer failed to affirmatively establish where the related income-producing activity took place, other than claiming it occurred outside of California.

The SBE also stated that the investment activity did not produce any gross receipts that could be included in the sales factor, because the company used independent contractors for practically all investment work, and work on a taxpayer's behalf is omitted by rule from the "income-producing activity" analysis. The forward exchange contracts were excluded from the sales denominator under similar reasoning, because they were short-term investments in foreign currencies, with a goal of profiting from currency fluctuations.

* Idaho

On remand from the state supreme court, a state district court held (44) that inclusion of the sales of accounts receivable in the apportionment formula does not fairly represent the extent of business activity in Idaho. The court further found that deleting the proceeds of the receivables sales from the sales-factor denominator is a reasonable and more accurate alternative apportionment method.

* Illinois

A circuit court reversed (45) its previous summary judgment determination that allowed the gross receipts from sales of financial instruments to be included in a company's sales factor. The court reasoned that it would be improbable that the legislature would enact a statute that would allow the location of a company's treasury department to determine a major portion of the apportionment formula.

In another case, a circuit court held (46) that a corporation is not entitled to add an additional intangible property apportionment factor to reflect royalty income from foreign subsidiaries, because the corporation's taxable income is not limited to foreign royalty income and the standard apportionment formula takes such income into account.

Under amended regulation 86 Ill. Adm. Code Sec. 100.3380(c)(2), gross receipts from an incidental or occasional sale of assets are excluded from the Illinois sales factor, without regard to whether such receipts are substantial or insubstantial. Also, the Illinois DOR adopted 86 Ill. Adm. Code Sec. 100.3400, an apportionment regulation for financial organizations.

The DOR also...