Apportionment of corporate income between the states for items of income other than tangible - PowerPoint Presentation

Slide1

Apportionment of corporate income between the states for items of income other than tangible personal propertySlide2

DisclaimerErnst & Young refers to the global organization of member firms of Ernst & Young global limited, each of which is a separate legal entity.

Ernst & Young LLP is a client–serving member firm of Ernst & Young global limited located in the US

.

NMTRD refers to the New Mexico Department of Taxation and Revenue. 

AZDOR

refers to the Arizona Department of Revenue.

Ernst & Young and its member firms, NMTRD and AZDOR  expressly disclaim any liability in connection with use of this presentation or its contents by any third

party. These

slides are for educational purposes only and are not intended, and should not be relied upon, as accounting or legal advice

. The

views expressed by panelists in this webcast are not necessarily

those

of Ernst & Young

or its member firms,

NMTRD or AZDOR.Slide3

Your Presenters

Helen Armstrong

Brad Odell

Carl Joseph

Steve Shiffrin

If you need CPE/CLE don’t forget to sign the sheetSlide4

Uniform Division of Income for State Purposes Act (UDITPA)

General DescriptionSlide5

Basis for Apportionment and Allocation of Income

Complete Auto Transit, Inc. v. Brady

,

430 U.S. 274 (1977) – Provided test for determining if state tax violates commerce clause

there is substantial nexus between the state and the activity being taxed;

The tax is fairly apportioned;

The tax does not discriminate against interstate commerce; and

The tax is fairly related to the services provided by the state.Slide6

Defining Allocation and Apportionment

Allocation refers to the method of dividing a tax base by tracing particular property, receipts, or income to their source or other connection with a state, and attributing the item in its entirety to that state.

Hellerstein

, State Taxation

¶ 8.04

Apportionment uses selected factors for attributing the tax base to a particular state or states based on the taxpayer using its property, carrying on its activities, and earning income in that state or states.

Hellerstein

, State Taxation

¶ 8.05Slide7

Uniform Division of Income for Tax Purposes Act

UDITPA § 2 – taxpayer having income from business activity which is taxable both within and without the state … shall allocate and apportion its net income

UDITPA § 3 – test to determine if taxpayer is taxable in another state

taxpayer actually subject to a tax in another state

state has jurisdiction to subject the taxpayer to a tax regardless if it does or does notSlide8

Business v. Non-business Income under UDITPA § 1(A) & (E)

Business Income

– Income arising from transactions and activity in the regular course of the taxpayer’s trade or business and income from the disposition or liquidation of a business or segment of a business. Business income includes income from tangible and intangible property if the acquisition, management, or disposition of the property constitutes integral parts of the taxpayer’s regular trade or business operations

Non-business income

– everything elseSlide9

Allocation of Non-business Income – UDITPA §§ 4-8

Allocable Income is non-business income

Statutory and Regulatory Rules governing allocable income:

Net rents and royalties from real property

Net rents and royalties from tangible personal property

Capital gains and losses

Interest and Dividends

Patents and copyright royaltiesSlide10

Apportionment of Business Income – UDITPA §§ 9-17

All business income is apportioned to the states typically using a three factor formula

Property, payroll, and sales

Income is multiplied by a fraction consisting of the property factor plus the payroll factor plus the sales factor divided by 3

Many states are modifying their apportionment factors

New Mexico – single sales factors for manufacturers (phased in over time) and business headquarters

operations

Arizona – single sales factor phased in by tax year 2017

Other statesSlide11

Sales Factor – UDITPA §§ 15-17Calculation of sales factor

Numerator is total sales of the taxpayer in the state

Denominator is total sales of the taxpayer everywhere during the tax period

Determination of sales within the state depends on whether the sale relates to tangible personal property or everything elseSlide12

Determination of sales, other than sales of tangible personal property – UDITPA § 17

Sales, other than sales of tangible personal property, are in this state if:

The income producing activity is performed in this state; or

The income producing activity is performed both in and outside this state and a greater portion of the income-producing activity is performed in this state than in any other state, based on costs of performance.Slide13

Apportioning the Sale of Services

Defining first what is the income producing activity.

The transactions and activity engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of producing that item of income. MTC Reg. IV. 17(2); NMAC 3.5.18.8(a

); A.A.C. R15-2D-806(1).Slide14

Apportioning the Sale of Services

Cost of performance

Definition: direct costs determined in a manner consistent with generally accepted accounting principles and in accordance with conditions or practices in the trade or business of the taxpayer. MTC Reg. IV. 17(3); NMAC

3.5.18.8; A.A.C R15-2D-806(1).

Determination

Costs between taxing state and the costs in any other individual state (not aggregated) –

Clipper Express Co. v.

Comm’r

of Revenue

, No. 120514, 1986 WL 22656, at *4 (Mass. App. Tax Bd. Nov. 14, 1986)Slide15

Apportioning the Sale of Services

Market-State Approach

Attributing the receipts from services according to the taxpayer’s market

Customer location v. benefit of the service

Revised Section 17 of UDITPA

In 2014, the MTC adopted a revised section 17 of UDITPA to provide that receipts, other than receipts for the sale of tangible personal property, be sourced based on marketSlide16

MTC Article IV, § 17

Sales

, other than sales of tangible personal property, are in this State if:

(a) the income-producing activity is performed in this State; or

(b) the income-producing activity is performed both in and outside this State and a greater proportion of the income-producing activity is performed in this State than in any other State, based on costs of performance.

Arizona’s version: A.R.S. § 43-1147Slide17

MTC Reg. IV.17(2)

Sales

Factor: Sales Other Than Sales of Tangible

Personal Property

in This

State

(2)Income producing activity: defined.

The term "income producing

activity“ applies

to each separate item of income and means the transactions and activity

engaged in

by the taxpayer in the regular course of its trade or business for the ultimate purpose

of producing

that item of income.

Such activity includes transactions and

activities performed

on behalf of a taxpayer, such as those conducted on its behalf by

an independent

contractor

.

Source: MTC, emphasis added, as revised through 7/29/2010.Slide18

A.A.C. R15-2D-806(1)(d)

The term “income-producing activity” applies to

each separate

item of income and means the transactions

and activities

directly engaged in by a taxpayer in the

regular course

of its trade or business for the ultimate purpose

of obtaining

gains or profit.

Income-producing activity

does not

include transactions and activities performed

on behalf

of a taxpayer, such as those conducted on its

behalf by

an independent contractor.

Accordingly, “

income producing activity

” includes but is not limited to

the following: (d) The

sale, licensing, or other use of

intangible personal

property. The mere holding of

intangible personal

property is not, of itself, an

income producing activity.

Emphasis added.Slide19

Walter E. Heller Western, Inc. v. Arizona Dept. of

Revenue

1

Heller Western was

engaged in commercial

financing.

It was headquartered out-of-state but had a branch in Arizona that solicited new customers, checked credit, negotiated and serviced contracts.

Its

headquarters issued commercial paper to obtain cash to fund the lending process.

1

161 Ariz. 49

,

775 P.2d 1113 (1989)Slide20

Heller Western

With respect to IPA, the Arizona Supreme Court held that:

IPA

included

solicitation

,

investigation, negotiation

and

servicing of Arizona customers and contracts.

IPA

did not include

costs associated with borrowing of money by out-of-state headquarters to make loans to instate customers.

General focus on location of consumer was preserved.Slide21

M.D.C. Holdings, Inc. v. State

ex rel. Ariz.

Dept.

of

Revenue

MDC engaged in home building and

financing.

MDC earned

income from

(among other things), secondary

marketing

of the loans.

MDC argued that the IPA and COP for the secondary marketing took place in Colorado.

AZDOR argued that the secondary marketing was part of the entire transaction.

1

222 Ariz. 462, 216 P.3d 1208, (App. 2009)Slide22

M.D.C. Holdings, Inc.

With respect to IPA, the Arizona

Court of Appeals

held that:

Secondary marketing was a separate item of income with a separate IPA.

The direct costs included the salaries of the Colorado employees who conducted the secondary marketing.

The location of the customer (who purchased the mortgages) was not determinative. Slide23

MTC Reg. IV.18.(c)

Special

Rules: Sales Factor.

The following special rules

are established

in respect to the sales factor of the apportionment formula

:

[Included in the Sales Factor

]

Where

the income producing activity in respect to business income from intangible personal property can be readily identified, the income is included in the denominator of the sales factor and, if the income producing activity occurs in this state, in the numerator of the sales factor as well. Slide24

MTC Reg. IV.18.(c)(3)[Excluded from the Sales Factor]

Where business income from intangible property cannot readily be attributed to any particular income producing activity of the taxpayer, the income cannot be assigned to the numerator of the sales factor for any state and shall be excluded from the denominator of the sales factor.

For

example, where business income in the form of dividends received on stock, royalties received on patents or copyrights, or interest received on bonds, debentures or government securities results from the mere holding of the intangible personal property by the taxpayer, the dividends and interest shall be excluded from the denominator of the sales factor.

Arizona’s version: A.A.C. R15-2D-903(3)

Arizona’s version: A.A.C. R15-2D-903(3)Slide25

Issues with Sales of Services and Intangibles

What is an item of income?

Classes of income vs. individual items

Implications of each approach for states and taxpayers.

What is reasonable?Slide26

Issues with Sales of Services and Intangibles

What is an income producing activity?

Employees vs. agents and contractors

Sales activities vs. production activities

Situsing

of an income producing activity

People vs. machinesSlide27

Issues with Sales of Services and Intangibles

Cost of Performance vs. Market States

Market states: customer location vs. benefit of service

Effect of delivering sales across both types of states

Effect on Arizona of

Heller Western

caseSlide28

Issues with Sales of Services and Intangibles

Troublesome Industries

Information Technology including SaaS,

PaaS

and

IaaS

Financial services

Mergers and acquisitions including GoodwillSlide29

Arizona Multistate Service Provider

Laws 2012, Chapter 2, § 1, effective for taxable years from and after 12/31/2013 (SB 1046)

Provided for a phased-in market based sales for qualifying taxpayers.

Criteria must be met and election required.

Election binding for 5 consecutive taxable years.

Must meet the criteria again to renew election at 5 years intervals.Slide30

Arizona Multistate Service ProviderElection (Form MSP, PART A)

DRAFTSlide31

Arizona Multistate Service ProviderCalculation (Form MSP, PART B)

DRAFTSlide32

Arizona Multistate Service ProviderArizona Form 120, Question F

DRAFTSlide33

Arizona Multistate Service ProviderArizona Form 120, Schedule E

DRAFTSlide34

Alternative Apportionment

Methodology

-- Explanation

Standards for Invoking

Mathematical vs. “I know it when I see it”

What to Measure Against? Slide35

Alternative Apportionment - Explanation

History:

UDITPA § 18

- “permit the use of methods different from those prescribed in the Act only in unusual cases and in cases where the application of specifically prescribed methods might be held unconstitutional.”

Traditional State Apportionment - Various

t

hree-factor formula made up of

property

,

payroll

and

sales

Alternative Apportionment – permits use of alternative method(s) if standard does not “fairly represent” taxpayer’s business in state.

For example: Separate Accounting, Exclusion/inclusion of factors, or Catch all - “Employment of any other method to effectuate an equitable allocation and apportionment of income.” Slide36

Alternative Apportionment – Standards for Invoking

Distortion?

CA

Standard: Qualitative and Quantitative Distortion

Reasonable

Alternative?

Likely “reasonable

” when the party asserting alternative apportionment is able to show a close

connection between

the basis for deviating from the standard formula

AND the proposed alternative method

.

Burden of Proof?

Generally, the party

seeking to

apply alternative

apportionment

carries the

burden of

proving that

1)

distortion exists and 2

)

the proposed alternative is

reasonable

.

Clear and Convincing Evidence

: California -

Microsoft

Preponderance of the Evidence

: Oregon -

Twentieth

Century-Fox

Clear and Cogent Evidence

: New York –

British Land (Maryland) Inc.

Prima Facie

EvidenceSlide37

Alternative Apportionment - Mathematical vs. “I know it when I see it

”

Appeal

of Merrill, Lynch

, 89-SBE-017 (2 June 1989).

Franchise Tax Board (FTB) did not demonstrate the difference

between

apportionment rises

to

level

of distortion such that appellant's business activity in

CA is

unfairly reflected by

standard formula

. . .

Largest

difference between

apportionment

formula percentage as computed using

FTB's

method and

using standard

methods was for 1973, when FTB's method produced a final California apportionment formula of

5.8637%,

and

standard

method produced a final formula of

3.4323%…

[D]

ifference

of only 2.4314. . .

much

too slight to be justification for application of §25137

.Slide38

Alternative Apportionment - Mathematical vs. “I know it when I see it”

Hans Rees' Sons, Inc. v. North Carolina, 283 U.S. 123 (1931)

250

%

variance between formulary

apportionment and

taxpayer’s

calculation was deemed “out of all appropriate proportion to the business transacted by the [taxpayer] in that State.”

Hess Realty Corp. v. Dir., Div. of Taxation, New Jersey Dept. of Treasury, 10 N.J. Tax 63 (Tax Ct. 1988)

New

Jersey, 200% distortion generally is threshold for distortion

.

Director “has an obligation to adjust a particular allocation formula if

it

is unfair in that it does not ‘effect a fair and proper allocation of the [taxpayer’s] entire net income and the entire net worth reasonably attributable to the State

’.”

Media General

Comm.

v. South Carolina Dep’t of Revenue, No. 07-ALJ-17-0089-CC

(S.C. Admin. Law Ct. 4 May 2009),

aff’d

694 S.E.2d 525 (S.C. 2010)

435

%

differential found to be distortive. Slide39

Alternative Apportionment – What to Measure Against?

What

type of evidence

is acceptable for party seeking to demonstrate Single Sales Factor (SSF) apportionment unfairly represents business in the state?

Separate accounting has

been widely rejected as

means

of

establishing distortion.

So what should be measured?

Fair apportionment

demands factors

used in

formulary

apportionment must actually reflect a reasonable sense of how income is

generated.Slide40

Notable Cases, Statutes

Moorman Manufacturing Co. v. Bair, Director of Revenue of Iowa

Constitutionality of non-traditional factors (i.e

.,

single sales factor)

Hans Rees’ Sons v. State of North Carolina

Constitutionally permissible alternate apportionment methodology may

violate application for particular

taxpayer

Twentieth Century-Fox Film Corp. v.

Dept

of Revenue

Instruction on

reasonableness

of

alternative

formula

Microsoft Corp.

v. FTB

;

&

General

Mills Inc

.,

et al. v.

FTB

Proving fairness and reasonableness of

alternative

apportionment formula (i.e

.,

what is includable in the sales factor)Slide41

Questions?