Current corporate income tax developments.

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

EXECUTIVE SUMMARY

* In 2004, many state cases and rulings addressed a variety of apportionment and unitary group issues.

* Several states announced voluntary compliance programs and initiatives for taxpayers involved in tax shelter activity.

* Many states enacted significant statutory changes and issued important rulings on passthrough entities.

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This two-part article discusses significant state tax developments in the corporate income tax area. Part II addresses apportionment formulas, filing methods/unitary groups, administration and other important miscellaneous issues.

During 2004, 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cases were decided; regulations were proposed, issued and modified; and bulletins and rulings were issued, released and withdrawn.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 2005 issue, focused on nexus, Internal Revenue Code (IRC) Sec. 338(h)(10) transactions, tax base and business/nonbusiness income issues. Part II, below, covers some of the more important developments in apportionment formulas, unitary groups/filing methods, administration and other state corporate 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 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 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.

* Alaska

A Superior Court affirmed (59) that proof of unconstitutional distortion is not required for a company to receive alternative apportionment (Multistate Tax Commission (MTC) Section 18 relief); instead, the requesting party, either the taxpayer or Department of Revenue (DOR),has only to provide preponderant evidence that the (1) statutory formula does not fairly reflect Alaska business activity and (2) proposed alternative formula is reasonable.

* Arizona

The state Court of Appeals affirmed (60) that the return of principal from short-term investments is not includible in the sales factor denominator, because it is not a "sale"

* California

Similarly, the California Court of Appeal affirmed (61) that receipts from repurchase agreements and bond maturities within a taxpayer's treasury functions should not be included as gross receipts in the sales factor denominator, because they do not arise from sales transactions. The court also concluded that research and development credits earned by a unitary subsidiary or by other members of a unitary group could only be applied against the parent's tax liability. The state Supreme Court has accepted the appeal of this decision.

The FTB issued a notice (62) explaining that deviating from the standard apportionment and allocation rules, without receiving prior approval, can result in accuracy-related penalties when a substantial income understatement constitutes negligence; exceptions from the penalty are specifically noted.

* Idaho

The state Supreme Court affirmed (63) that excluding sales of accounts receivable from a taxpayer's sales factor was a reasonable alternative to correct an unusual fact situation.

* Illinois

A Circuit Court ruled (64) that a taxpayer's sales to certain foreign countries should not be thrown back to Illinois, because the taxpayer was subject to net income taxes in those countries on unrelated dividend and royalty income. The court found that being "taxable" in the destination state or country does not require the company to be "taxable on the sale at issue."

* Indiana

The DOR ruled (65) that an out-of-state construction equipment financier/lessor must include the value of leased equipment in its property factor, because it retains the rights to (1) unilaterally transfer title to a third party; (2) prevent the lessee from using the equipment in a manner not originally anticipated by the parties; and (3) restrict the lessee from moving the equipment to a location not contemplated in the agreement.

* Louisiana

The DOR explained (66) that there is no bright-line test to determine a corporation's commercial domicile; instead, each corporation's actual commercial practices, as a whole, must be examined to decide where business is directed and managed.

* Massachusetts

Ch. 262, HB 4744, Laws of 2004, provides (1) that, for the licensing of intangible property, the income-producing activity will be deemed to be performed in the state in which the property is used; and (2) when a purchasing corporation makes an election under IRC Sec. 338, for apportionment purposes, the target will be treated as having sold its assets.

* Minnesota

The DOR issued (67) a new form (Form ALT, Application for Alternative Methods of Allocation), required to petition to use an alternate income allocation method. Taxpayers must demonstrate the unfairness of the general income allocation method and the fairness of the proposed alternative method, along with a hypothetical computation of taxable net income under the latter.

* Montana

The DOR adopted the MTC apportionment provisions for publishers and television/radio broadcasters (68) and also formally adopted the Joyce (69) approach. (70)

* New Jersey

The Division of Taxation (Division) explained (71) that, under the new sales factor "throw-out" rule, (72) in the case of sales to a state or jurisdiction that does not impose a tax, any sales sourced to that jurisdiction must be "thrown out" of the receipts factor denominator. If the taxpayer is immune from income tax under P.L. 86-272, the sales are thrown out, unless the state subjects the taxpayer to a tax based on business presence or business activity.

* New York

A bus service's arrangement for berthing space with the Port Authority of New York and New Jersey was not the requisite interest in real property that would yield "rental" payments for property factor purposes. (73)

The New York State Department of Taxation and Finance (Department) advised (74) that property factor treatment for the use of satellite transponders depends on the degree of ownership and control of both the transponder and the satellite. When a company is leasing transponder capacity only for the right to use Federal Communications Commission-designated frequencies, such a...