Multistate Income and Franchise Tax Developments in a Down Economy Title Subtitle Presented by: Bill LaVere Presented to: Month DD, YYYY May 28, 2010
Topics • Nexus • Combined Reporting • Receipts Factor • Limiting Use of Net Operating Losses and Tax Credits • Other California Developments
Nexus • Both the Commerce Clause and the Due Process Clause prohibit state taxation of interstate activities unless: • the tax is applied to an activity with a substantial nexus with the taxing State, • is fairly apportioned, • does not discriminate against interstate commerce, and • is fairly related to the services provided by the State. • The Battle Ground Issue – Does the commerce clause require physical presence in order to satisfy the “minimal connection” requirement necessary to establish substantial nexus?
Nexus – Is Physical Presence Required? • National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753 (1967) • Substantial nexus exists only if a corporation has a nontrivial physical presence in the state. • Quill Corp. v. North Dakota, 504 U.S. 298 (1992) • Economic presence in the state was sufficient to satisfy the Due Process Clause’s “minimal connection” requirement. • Economic presence was notsufficient to satisfy the Commerce Clause’s “substantial nexus” requirement. • Upheld National Bellas Hess physical presence requirement.
Nexus – U.S. Supreme Court Cases (cont.) • Scripto, Inc. v. Carson, 362 U.S. 207 (1960) • Scripto had no physical presence in Florida, and had no regular employees or agents in the state. • Regular solicitation of sales by independent brokers satisfies the due process requirement that there be a definite link or minimum connection between a state and the person, property or transaction it seeks to tax. • Standard Pressed Steel Co. v. Department of Revenue of Washington, 419 U.S. 560 (1975) • The presence of a single employee, an engineer whose office was in his home, was sufficient to establish nexus.
Nexus –U.S. Supreme Court Cases (cont.) • Tyler Pipe Industries, Inc. v. Washington State Department of Revenue, 483 U.S. 232 (1987) • “The crucial factor governing nexus is whether the activities performed in this state on behalf of the taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market in [the taxing state] for the sales.” • National Geographic Society v. California Board of Equalization, 430 U.S. 551 (1977) • Two advertising offices provided the minimal connection required for California to impose use tax collection obligation. • The fact that these offices were not involved in solicitation of sales was not relevant.
Activities of Affiliates and Third Parties • Borders Online, LLC v. State Board of Equalization,129 Cal. App. 4th 1179 (2005) • An out-of-state corporation that made online retail sales of TPP was liable for the collection and remittance of use tax because its brick-and-mortar affiliate acted as its agent when it accepted returns of merchandise purchased online. • Dell Catalog Sales L.P. v. Commissioner of Revenue Services, 48 Conn. Supp. 170 (2003) • Third party warranty repair company did not create nexus for Dell due to the lack of evidence on the extent of the activities of the in-state service provider. • Dell Catalog Sales L.P. v. New Mexico Taxation and Revenue Department, 199 P.3d 863 (2008) • Third party warranty repair company did create nexus for Dell. • 1,273 service calls and installation visits to New Mexico customers is more than “isolated” or “sporadic”. • U.S. Supreme Court has not yet addressed the question of whether a third party’s non-sales activities in the taxing state can constitute nexus.
Is Physical Presence Still Required for Sales/Use Tax Cases? • Amazon.com LLC v. New York Department of Taxation and Finance, New York Supreme Court No. 601247/08, 877 N.Y.S.2d 842 (2009) • The New York Supreme Court dismissed a lawsuit filed by Amazon.com challenging a previously enacted New York statutory provision that requires out-of-state Internet retailers with no physical presence in New York to collect New York sales and use taxes. • Specifically, the new statute created a rebuttable presumption that a retailer "solicits" business in New York if any in-state entity is compensated for directly or indirectly referring customers to the retailer, whether by a link on an Internet website or otherwise, and the cumulative gross receipts from these and other New York affiliate referrals exceed $10,000.
Public Law 86-272 • Prohibits a state from imposing a “net income tax” on a corporation organized in another state if the corporation’s only in-state activity is: • (1) solicitation of orders by company representatives, • (2) for sales of tangible personal property, • (3) which orders are sent outside the state for approval or rejection, and • (4) if approved, are filled by shipment or delivery from a point outside the state. • PL 86-272 does not protect service providers.
What Constitutes Solicitation of Orders • Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992) • An Illinois-based manufacturer that sold chewing gum nationwide was not immune from Wisconsin franchise taxes under P.L. 86-272, because the activities of its sales representatives in Wisconsin went beyond mere “solicitation of orders.” • The Court held that while “solicitation” is not limited to actual requests for purchases or to acts “essential” for making such requests, it does not extend to all activities “routinely associated with solicitation” or “customarily performed by salesmen.” • “solicitation” encompasses only those activities that are “entirely ancillary” to requests for purchases, i.e., those activities that serve no independent business function apart from their connection to requests for purchases. • The Court recognized that there is a de minimis exception to P.L. 86-272, which allows a taxpayer immunity from taxation if its non-immune activities constitute a trivial additional connection with the state. However, the exception did not apply in this case, because the taxpayer's non-immune activities, taken together, established a more than trivial connection with Wisconsin.
Is Physical Presence Required for Other Types of State Taxes? • West Virginia, Tax Commissioner v. MBNA America Bank, N.A., 640 S.E.2d 226 (2006) • The major question left open by the Supreme Court’s opinion in Quill is whether the physical presence requirement to collect use taxes on in-instate sales extends to other types of State taxes. • Held – The physical presence requirement for showing a substantial Commerce Clause nexus applies only to sales and use taxes and not to business franchise and corporation net income taxes. • Quill’s physical presence test for sales and use taxes was based in large part on the mail order industry’s reliance on Bellas Hess. • The Supreme Court appears to have expressly limited Quill’s scope to sales and use taxes.
MTC Factor Presence Nexus Standard • Substantial nexus is established if any of the following thresholds are exceeded during the tax period: • $50,000 of property; or • $50,000 of payroll; or • $500,000 of sales; or • 25% of total property, total payroll, or total sales
Factor Presence Nexus – Test Case • Capital One Bank and Capital One F.S.B. v. Commissioner of Revenue, Massachusetts Appellate Tax Board, Nos. C262391, C262598 (2007) • Imposition of MA Financial Institution Excise Tax was valid where taxpayers derived substantial economic gain from use of the state’s economic market. • Taxpayer was statutorily deemed to have nexus because they conducted activities with 100 or more MA residents and had receipts exceeding $500,000. • Appellate court rejected the argument that the Commerce Clause requires that a corporation must have physical presence in the taxing state.
California 2011 Nexus Standard • “Doing Business” means actively engaging in any transaction for the purpose of financial or pecuniary gain or profit. • For taxable years beginning on or after January 1, 2011, a taxpayer is doing business in this state if any of the following conditions has been satisfied: • The taxpayer is organized or commercially domiciled in California, • Sales in California exceed the lesser of $500,000 or 25% of total sales, • Real and tangible personal property in California exceed the lesser of $50,000 or 25% of total real and tangible personal property, • Payroll in California exceeds the lesser of $50,000 or 25% of total payroll
Combined Reporting Developments • States recently adopting combined reporting: • District of Columbia (2011) • Massachusetts (2009) • Michigan (2008) • West Virginia (2009) • Wisconsin (2009) • States considering combined reporting: • Iowa (SSB 3122) • Maryland (HB 584 and SB 354) • New Mexico (HB 62, HB 215 and SB 90) • Pennsylvania – Governor proposal • Rhode Island (SB 2272)
Receipts Factor • Market Based Sourcing of receipts from other than sales of tangible personal property • Joyce / Finnigan Throwback Rule • Single Receipts Factor or Heavily Weighted Receipts Factor • Treasury Function Receipts
Market Based Sourcing of Receipts From Sales Other Than Sales of Tangible Personal Property ReceiptsFactor
Market Based Sourcing of Receipts • States that Source Receipts from Sales Other Than Sales of Tangible Personal Property on a Market Basis; • AK, FL, GA, IL, IA, MN, RI • CA (beginning in 2011) • Arguments against Cost of Performance Sourcing; • Does not give appropriate weight to the market state, • Tends to replicate the payroll factor, • Difficult to audit
California Change in Sourcing of Certain Receipts to Market Based Sourcing • Effective for taxable years beginning on or after January 1, 2011 • Cal. Rev. & Tax. Code §25136 amended with respect to sales, other than sales of tangible personal property • Sales of services sourced to California to the extent the purchaser receives a benefit of the service in California • Sales of intangible property sourced to California to the extent the property is used in California • Marketable securities are sourced to the state of the customer • Sales, leases, rentals, or licensing of real property is sourced to California if the real property is located in California • Leases, rentals, or licensing of personal property is sourced to California if the personal property is located in California
California Goes Back…To The Future Trends Toward Finnigan Joyce / Finnigan Developments
Joyce / Finnigan Developments • California’s flip-flop: • 1966: Appeal of Joyce, Inc. • 1988: Appeal of Finnigan Corporation • 1999: Appeal of Huffy Corporation reverts to Joyce • 2011: Cal. Rev. & Tax Code Sec. 25135(b) reverts to Finnigan • While Joyce states still outnumber Finnigan states, many states that recently adopted combined reporting are following the Finnigan approach • Massachusetts, New York, Michigan, Wisconsin
Joyce v. Finnigan Developments • Policy and Fiscal Implications • Finnigan generally shifts more tax burden to companies not based in the state and provides a more favorable result for in-state companies selling outside the state • Finnigan is closer to treating the unitary group as a single taxpayer for apportionment purposes • Finnigan is less susceptible to structural tax planning
Sales Factor Developments • 14 states use single sales factor (SSF) apportionment for most taxpayers • CT, GA, IA, IL, LA, ME, MD, MI, MS, NE, NY, OR, TX, WI • Indiana and Minnesota are in the process of phasing in SSF • California adopts SSF election beginning in 2011 • Numerous states allow SSF for particular industries, particularly manufacturing • States with heavily weighted receipts factor • AZ, AR, CA, CT, FL, ID, KY, MD, MA, MN, NH, NJ, NC, OH, PA, SC, TN, UT, VT, VA, WV
Sales Factor Developments • States want to entice businesses to locate in their jurisdiction • SSF or “super-weighting” the sales factor benefits local businesses since the local property and payroll have no or little impact on the apportionment factor • The tax burden shifts more heavily toward companies taking advantage of the state’s marketplace but without a significant physical presence • Trend towards market sourcing rather than cost of performance with respect to the sourcing of service income has a similar effect
California Single Sales Factor Election • Cal. Rev. & Tax. Code §25128.5 • Effective for tax years beginning on or after January 1, 2011 • Irrevocable Annual Election on an Original Timely Filed Return • Certain Industries are Excluded from Making Election • Agricultural business • Extractive business • Savings & Loan activity • Banking or Financial Business Activity • AB 1935, Introduced on 2/17/2010, would eliminate the election and make single sales factor mandatory
Treasury Function Receipts California Tax Developments
California Treasury Function Receipts • General Motors Corporation v. FTB, 39 Cal. 4th 773 (2006) • California Supreme Court concluded that, except with respect to repurchase agreements (“repos”), gross proceeds from the sale of marketable securities in the course of treasury function activities, including redemptions on maturity, are to be included in the sales factor. The Court remanded for further proceedings the issue whether inclusion of such proceeds in the sales factor is distortive under RTC § 25137. In the case of repos, only the interest received from repos should be included in the sales factor. • The Court also concluded that research credits can only be used by the member of the unitary group which generated the credit, not the entire group. (See III.B. below.) • On January 29, 2007, the Court of Appeal remanded the case to the trial court to resolve the matter consistent with the Supreme Court’s decisions in General Motors and Microsoft.
California Treasury Function Receipts • Microsoft Corporation v. FTB, 39 Cal. 4th 750 (2006) • California Supreme Court held that gross proceeds from the sale of marketable securities, including redemptions on maturity, are includible in the sales factor. • Based on the specific facts in the case, the Court concluded that the FTB sustained its burden of proving that the inclusion of gross receipts from treasury function activities in the denominator of the sales factor created a distortion under RTC § 25137. (See II.B.1. below)
California Treasury Function Receipts • General Mills, Inc. & Subsidiaries v. FTB, California Court of Appeal, No. A120492 (Apr. 15, 2009) • Trial court concluded that commodity hedging transactions did not generate gross receipts for sales factor purposes. (Superior Court, Sept. 26, 2007) • Because of its holding above, the Superior court did not consider the issue whether inclusion of such receipts would be distortive under RTC § 25137. • On April 15, 2009, the Court of Appeal reversed the trial court’s decision. The Court concluded that the gross receipts from the hedging transactions should be included in the sales factor. However, since the trial court did not reach the RTC § 25137 issue, the case was remanded to the trial court to address that issue. • General Mills awarded costs of appeal
California Treasury Function Receipts • Home Depot USA, Inc., SBE Case No. 298683 (Dec. 16, 2008) • The SBE held that Home Depot could include its gross receipts from certain treasury functions in its sales factor. • Both parties agreed that a qualitative difference between the treasury receipts and receipts generated in the ordinary course of business must exist for the FTB to depart from the standard formula, and such difference existed in this case. However, the parties disagreed on the significance of the quantitative difference between the apportionment results with and without the inclusion of the gross receipts from treasury function. • Taxpayer argued that quantitatively, the apportionment results varied by only 3.3 percent with and without the inclusion of the gross receipts, and that this variation was insufficient to satisfy the necessary quantitative difference. • FTB argued that inclusion of gross receipts from a treasury function in the sales factor always results in failure of the standard apportionment formula where there is a qualitative difference between the treasury function and the taxpayer’s ordinary business operations. • The administrative cases that were deferred pending the resolution of Home Depot are now being re-activated before the State Board of Equalization.
California Treasury Function Receipts • FTB Notice 2006-3 (Sept. 28, 2006) • The FTB announced that, for purposes of applying FTB Notice 2004-5, a taxpayer that excludes from the sales factor the amount realized on the redemption of marketable securities as part of its treasury function, and includes only the interest income and net gains from such securities, will not be subject to the accuracy related penalty under RTC § 19164. • The FTB based its position on Microsoft and Pacific Telephone. • FTB Audit Practice. Currently, auditors are analyzing whether distortion exists in the treasury function setting under four different tests—Microsoft, Merrill Lynch, Pacific Telephone and Toys-R-Us. If the taxpayer fails any of the four tests, the auditors are instructed to remove the gross receipts from the sales factor.
California NOL Carrybacks • Beginning with the 2011 taxable year, California will phase-in NOL carrybacks (CR&T Code § 24416(d)) • NO NOL Carryback to any taxable year beginning before January 1, 2009 • 50% of NOL incurred in 2011 may be carried back • 75% of NOL incurred in 2012 may be carried back • 100% of NOL incurred in 2013 and thereafter may be carried back • California conforms to the carryback period defined in IRC § 172(b)(1) (currently a two year carryback)
Limitations on the Use of NOLs • California (AB 1936 – Introduced) • Would eliminate the recently enacted NOL carryback provisions for tax years beginning on or after 2011. • Colorado (HB 1199 - Enacted) • Limits the use of NOL’s to $250,000 annually for three years beginning with tax year 2011. • Taxpayers may add an additional year carryforward for each year that is affected by this new limit. • Indiana (S 236 – Pending) • Limit NOL carrybacks to two years (instead of five years) for NOLs incurred in tax years 2008 and 2009.
Limitations on the Use of Tax Credits • Arizona (HB 2160) • Would repeal the Agricultural Pollution Control Tax Credits found in Ariz. Rev. Stat. Secs. 43-1081.01 and 43-1170.01 • Would repeal the Agricultural Water Conservation System Credit
California Assignment of Credits • What credits can be assigned • Any credit under Chapter 3.5 generated by the taxpayer in a taxable year beginning on or after July 1, 2008 • Any credit under Chapter 3.5 generated in any taxable year beginning before July 1, 2008, that is eligible to be carried forward to the taxpayer’s first taxable year beginning on or after July 1, 2008 • Who can assign or receive credits • Assignor is the taxpayer that originally generated the eligible credit • Assignee is any affiliated corporation that is a member of the same combined reporting group (under RT&C §§ 25101 or 25110)
Assignment of Credits • When can credits be assigned • Credits can be assigned when taxpayers file their tax returns for taxable years beginning on or after July 1, 2008. • When can the assigned credits be used to offset a tax liability of the assignee • Assigned credits can be used to offset an assignee’s tax liability for taxable years that begin on or after January 1, 2010 • How do credits get assigned • To assign a credit, taxpayers will file form FTB 3544, “Election to Assign Credit Within Unitary Group” • The election is irrevocable, and is a one time assignment • The assignee is subject to the same credit limitations as the assignor (e.g. an assignee receiving EZ credits must be in that EZ zone in order to use the credits)
Questions? “The difference between death and taxes is death doesn’t get worse every time Congress meets.” - Will Rogers
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