What to expect when you are expecting state tax reform.

• Author: Lard, Todd A.

2013 is now over, and we take this opportunity to review a few of the state and local tax ("SALT") milestones and major stories covered last year, many of which we expect to continue to mold the state tax landscape this year. On the income tax side, the Multistate Tax Commission's ("MTC") efforts to rewrite the Uniform Division of Income for Tax Purposes Act ("UDITPA") and its apportionment rules very much dominated the SALT headlines this year, and--contrary to the expectations of some--the MTC continues to press on. Apportionment clashes have also come to a head in the form of challenges to the Multistate Tax Compact (not to be confused with the "Commission") apportionment election, which have now reached appellate courts in several states. Both of these issues promise to have a significant impact in 2014.

On the sales tax side, attributional nexus legislation and audit positions fuel litigation across the nation more than 20 years after Quill, the U.S. Supreme Court's last nexus case. The U.S. Supreme Court declined to decide whether New York's attributional nexus provision is facially unconstitutional, but other decisions in federal and state courts have implicated the U.S. Constitution and federal law. 2013 was also a year where many states stepped up efforts to clarify how they will apply sales tax to the digital economy. With the potential expiration of the Internet Tax Nondiscrimination Act in late 2014, both of the issues are prominently placed at the forefront of sales tax controversy and policy.

UDITPA Rewrite

The most notable income tax development in 2013 was Professor Richard Pomp's "Report of the Hearing Officer: Multistate Tax Compact Article IV (UDITPA) Proposed Amendments" ("Report"). (1) The MTC has discussed for many years its interest in revising key apportionment provisions of Article IV--which contains the foundation of many states' apportionment provisions. In 2013 they advanced their efforts by formally vetting draft amendments in a public hearing process led by Professor Pomp. And, in October, the MTC released the much anticipated Report on the public hearing, which provided a background to the amendments, summarized the Executive Committee's proposed revisions, and included commentary made during the public hearing, as well as the Hearing Officer's comments and recommendations.

The proposed amendments would make the following changes to corporate income tax apportionment:

1. Replace the current sales factor costs-of-performance sourcing rule (which is applicable to receipts from sales of intangible property and services) with market-based sourcing rules; (2)

2. Modify the Compact's current equally-weighted apportionment formula to recommend a double-weighted sales factor, but ultimately provide states with flexibility to define their own factor weighting fraction; (3)

3. Replace the term "business income" with "apportionable income" and replace "nonbusiness income" with the more limited definition of "nonapportionable income"; (4)

4. Narrow the definition of gross receipts included in the receipts factor to exclude treasury function, hedging, and production property-related receipts; (5) and

5. Provide explicit authorization for special industry-wide or issue-wide alternative apportionment rules. (6)

   Although all of the issues considered in the Report are important, the changes proposed to the alternative apportionment and market-based sourcing provisions generate the greatest debate. For instance, the market-based sourcing provisions were the primary focus of the MTC staff and state tax administrators at their meeting December 10-12 in New Orleans. At least two states (Alabama and Massachusetts) have adopted versions of the MTC draft model for market-based sourcing, even though the model has not been finalized by the MTC. (7) Numerous problems are well-documented in the Report and in comments submitted to the MTC prior to the hearing. Many commenters doubted that a simple market approach would offer a viable alternative to the current costs-of-performance sourcing rule.

   Interestingly, the Hearing Officer recommended revising the costs-of-performance method by replacing the "all-or-nothing" method under the current costs-of-performance standard with a proportionate approach, rather than adopting the market-based sourcing approach recommended by the MTC. However, the Hearing Officer noted that it was more likely that states would adopt the market-based sourcing approach, and if that was the case, draft model regulations needed to be drafted quickly so that the rules could be applied effectively.

   Alternative apportionment, which applies when the results of the apportionment formula do not fairly reflect a taxpayer's instate business activity, generated substantial attention during the drafting of the Report. The Hearing Officer proposes, among other things, to clarify that the party seeking to invoke alternative apportionment bears the burden of proof and that such burden of proof should be equivalent for taxpayers and state tax agencies.

   Notably, the MTC decided to retain the Hearing Officer's recommendations intact as a single proposal after debating whether the proposals should be vetted and adopted piecemeal. From a process perspective, the Hearing Officer's recommendations are currently in the Uniformity Committee for review and analysis, and the next step would be a vote before the MTC's Executive Committee. Irrespective of the MTC's process, it remains to be seen whether each state will be persuaded to change its statutes to conform to the revised provisions.

   MTC Elective Apportionment

   When states began to adopt the Multistate Tax Compact in the late 1960s, the Compact contained what seemed to be a nonthreatening provision allowing taxpayers to elect to apportion under either the prescribed apportionment formula contained in state law or under the formula contained within the Compact--which is identical to UDITPA. (8) This election provision was largely dormant for 40 years but has increasingly become the focus of taxpayers and tax administrators. By the end of 2013, the highest courts in Michigan and...