Current corporate income tax developments: this two-part article discusses a myriad of recent state tax activity in the corporate income tax area. Part II addresses apportionment, unitary groups/filing methods, administration and other significant issues.

• Position: Part 2

EXECUTIVE SUMMARY

* Two California Supreme Court decisions address whether the entire gross proceeds of certain treasury activities should be included in the sales factor.

* A lawsuit has been filed in New Jersey challenging the Constitutionality of the throw-out rule.

* Texas legislation modified the state's franchise tax to provide a margins tax.

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During 2006, 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cases were decided; regulations were proposed, issued and modified; and bulletins and rulings were issued, released and withdrawn.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 2007 issue, focused on nexus, Internal Revenue Code (IRC) Sec. 338(h)(10) transactions, allocable/apportionable income and tax base. Part II, below, covers some of the more important developments in apportionment formulas, unitary groups/filing methods, administration and other significant corporate state 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 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.

While apportionment formulas vary, many states use a three-factor formula that includes sales, payroll and property. 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 reflect properly the operations of a particular industry. Recent apportionment developments are summarized below.

Increased Weighting of Sales Factor

* Indiana

Among other provisions, HB 1001, Laws 2006, provided for a transition to a single-factor formula for tax years beginning after 2010. The sales factor will be weighted at 60% for 2007; 70% for 2008; 80% for 2009; 90% for 2010; and 100% starting in 2011.

* Pennsylvania

HB 859, Laws 2006, increased the corporate income tax sales-factor weighting from 60% to 70%.

* South Carolina

For tax years beginning after 2006, HB 4874, Laws 2006, provided a single-sales-factor apportionment for taxpayers whose principal business in the state is manufacturing or any form of collecting, buying, assembling or processing goods and materials within the state, or selling, distributing or dealing in tangible personal property within the state. Qualifying taxpayers can take advantage of any resulting tax savings on a phased-in basis for tax years 2007-2010, relative to their tax liabilities owed under the previous standard four-factor double-weighted sales-factor apportionment formula.

Apportionment Factors

* Alabama

An administrative law judge (ALJ) ruled (52) that an interstate pipeline company could include in its payroll factor compensation paid to a parent for personnel that performed operational and administrative functions for the company. The ALJ explained that the "payroll factor" statute does not require that compensation be paid to direct employees and can include amounts paid for "loaned" nonemployees that perform the same services as direct employees, because both contribute to income production.

In another ruling, an ALJ held (53) that a truck manufacturer had to source to Alabama (i.e., include in the numerator of the sales factor) sales from trucks/parts that were ultimately delivered to customers in the state, even though initial physical delivery and tide passage occurred at its out-of-state facility, when third-party carriers retrieved the products on behalf of the Alabama customers.

* California

The most significant apportionment developments during 2006 were the California Supreme Court's decisions addressing whether the entire gross proceeds generated by certain treasury activities should be included in the sales factor. The state supreme court affirmed (54) the court of appeal to hold that the entire gross proceeds received by Microsoft Corp. on redemption of marketable securities at maturity constituted "gross receipts" under (1) the state's definitional provisions, (2) the legislative history behind the Uniform Division of Income for Tax Purposes Act (UDITPA) and (3) prior decisions of the State Board of Equalization (SBE). However, the court held that "in this instance" the Franchise Tax Board (FTB) met its burden of proving by "clear and convincing evidence" that the standard apportionment formula did not fairly represent the extent of Microsoft's business activity in California. Under the facts, Microsoft's income from marketable securities constituted 2% of total income and 73% of gross receipts.

Similarly, in General Motors Corp., (55) the state supreme court affirmed in part and reversed in part a court of appeal decision, remanding the case for further proceedings consistent with its Microsoft decision. Specifically, the state supreme court held that a repurchase agreement is more closely analogous to a secured loan than a sale for UDITPA purposes; thus, only the interest received under the agreement should be treated as a gross receipt. With regard to marketable securities held until maturity, the court stated that the conclusion in Microsoft applied equally to the marketable securities held to maturity by General Motors. Because neither the trial court nor the appeals court had occasion to address the FTB's alternative apportionment-formula arguments, the state supreme court remanded the case for further proceedings, to allow the FTB to make this case. The court of appeal then remanded the case to the trial court for examination of the distortion issue. With respect to the application of the research credit issue in General Motors, the court held that only the taxpaying corporation that performed the research is entitled to the credit.

The state supreme court declined to review two other "gross versus net sales factor" cases (Toys "R" Us, Inc., (56) and The Limited Stores, Inc. (57)) that it had previously accepted and put on hold, sending them back to the courts of appeal with instructions to vacate their prior decisions and reconsider in light of the court's recent rulings in Microsoft and General Motors.

In response to the Microsoft and General Motors decisions, FTB Notice 2006-3 (58) provides accuracy-related penalty protection for a taxpayer that reports in its sales factor only the interest income and net gains (and not gross receipts) from "the redemption of marketable securities as part of its treasury function."

In other sales-factor developments, the FTB issued two legal rulings. In the first, (59) it explained how to calculate the apportionment formula for taxpayers that generate both taxable and exempt nonbusiness income, excluding activities that give rise to income not included in the tax base from the apportionment formula. In the second, (60) the FTB explained how to assign receipts derived from sales of other than tangible personal property when a taxpayer-member of a combined reporting group pays another group member to perform activities related to the sale. The FTB stated:

[d]ue to the effects of combined reporting when the contractor and the subcontractor are in a unitary relationship and are members of the same combined reporting group, the activities of the subcontractor in performance of the contract will be considered income-producing activities directly engaged in by the contractor for purposes of the sales factor in order to more accurately assign the receipt to the place where the services were performed. (Emphasis in original.)

The FTB also proposed regulations section 25137-14, providing detailed rules on the apportionment of income earned by mutual fund service providers. In general, the proposed regulation addresses the types of services performed by these businesses and offers rules on the corresponding sales-factor assignment of receipts derived from these services. The proposed regulation adopts a shareholder-location sales factor, under which the sales factor is assigned using a ratio of shares owned by shareholders in California to shares owned by shareholders located everywhere.

* Idaho

Amended Income Tax Rule 35.01. 550 provides exceptions to the general rule that income-producing activity for purposes of the sales factor generally does not include transactions and activities performed on behalf of the taxpayer. The amendments provide that income-producing activity includes transactions and activities performed on behalf of a taxpayer when (1) the taxpayer sells its product exclusively through independent contractors; (2) the independent contractors can work only for the taxpayer; or (3) excluding the transactions and activities of the independent contractors would lead to an unreasonable result. The amendments also provide that only the direct costs paid by the taxpayer are...