Tax. COST 37 th Annual Meeting

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1 October 26, 2006 Publication COST 37 th Annual Meeting Sourcing and Other Apportionment Issues San Francisco, CA California by Jeffrey M. Vesely, Prentiss Willson Sourcing and Other Apportionment Issues I. Introduction. Business income is subject to apportionment using factors typically consisting of property, payroll and sales the factors considered to approximate where the income is earned. The sales factor reflects the contribution of the market state(s) to the production of income (i.e., where the consumer is located) while the payroll and property factors are indicative of the contribution of the state(s) in which the manufacturer/producer or vendor is located. The ratio of in-state factors to total factors is used to divide the income among the states in which the taxpayer conducts business. Each taxing state s formula determines the amount of the taxpayer s business income that is attributable to its activities in that state. Apportionment of the business income of corporations engaging in multistate operations is necessary to avoid double or multiple taxation of the same tax base by the various states in which the business activities are conducted. A. Formulary Apportionment Under UDITPA. Section 9 of the Uniform Division of Income for Purposes Act (UDITPA) provides that business income is to be apportioned to the taxing state by multiplying the income by a fraction, the numerator of which is the property factor plus the payroll factor plus the sales factor, and the denominator of which is three. UDITPA is incorporated and adopted by several states as Article IV of the Multistate Compact. The Multistate Commission (MTC) has promulgated allocation and apportionment regulations that address and elaborate upon each of these factors. B. Weighted Sales Factor Formulas. Although many states use the UDITPA three-factor apportionment formula consisting of equally-weighted payroll, property and sales factors, over half the states use a modified three-factor apportionment formula that assigns more weight to the sales factor than the other two factors. The majority of these states assign COST Outline Pillsbury Winthrop Shaw Pittman LLP 1

2 a double weight to the sales factor, i.e. 50 percent sales, 25 percent property, 25 percent payroll. 1 However, several states have adopted other variations in this formula. 2 C. Single Sales Factor Formula. A recent trend has led several states to consider adoption of a single sales-factor apportionment formula. For example, Massachusetts adopted a single sales factor formula for qualified defense contractors, mutual fund service corporations and manufacturers. Maine allows mutual fund service providers an election to use a single sales factor formula. Connecticut and Maryland have enacted a single sales factor formula for manufacturers. Georgia, Indiana, Minnesota, New York, and Wisconsin are phasing-in single sales factor formulas. Oregon just accelerated its phase in from July 1, 2008 to tax years beginning on or after July 1, In 2006 California considered (once again) a phased in single factor sales treatment (AB 1037) which did not pass. One can expect it to reappear next year. Use of a double-weighted sales factor or single sales factor formula tends to attribute a larger percentage of an out-of-state corporation s income within the taxing state because the corporation s major activity within the state is the sale of its product which is weighted more heavily than its payroll and property activities. However, those corporations that are domiciled in the state may benefit from a double-weighted sales factor formula because those corporations generally own significantly more property and incur greater payroll costs within the taxing state. Since the property and payroll factors are given relatively less weight in the apportionment formula than the sales factor, a corporation that sells most of its product out-of-state will realize lower income taxes. II. Requirements to Apportion Income. States vary as to the requirements for apportionment of business income. In some states, apportionment is permitted if the taxpayer is doing business outside the state or carries on a trade or business partly within and partly without the state. Other states are more stringent and require that a taxpayer be taxable in another state before allowing apportionment. UDITPA 2 generally provides that a taxpayer that has income from business activity which is taxable both within and without the taxing state must allocate and apportion its net income pursuant to UDITPA provisions. UDITPA 3 requires a taxpayer to be taxable in another state to avail itself of the right to apportion its income. Two tests are used to determine when a taxpayer is taxable in another state. First, the taxpayer is subject to a net income tax, a franchise tax measured by income, a franchise tax for the privilege of doing business or a corporate stock tax. Second, the taxpayer s activities in another state create sufficient nexus with the state to subject it to a net income tax, regardless of whether that state imposes such a tax on the taxpayer. III. Property Factor. The property factor is a fraction, the numerator of which is the average value of the corporation s real and tangible personal property owned or rented and used in the state during 1 Corporate income tax states that utilize a double-weighted sales factor apportionment formula include, but are not limited to, the following: Arizona, Arkansas, California, Florida, Idaho, Kentucky, Louisiana, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, North Carolina, South Carolina, Tennessee, Utah, Vermont, Virginia, and West Virginia. 2 States that have adopted more than 50% weighted sales factor apportionment formula include, but are not limited to, the following Georgia (phasing in a single sales factor), Illinois (100% sales), Indiana (phasing in a single sales factor), Michigan SBT (90% sales, 5% property and payroll), Minnesota (phasing in a single sales factor), New York (phasing in a single sales factor), Oregon (100% sales), Pennsylvania (60% sales, 20% property and payroll), and Wisconsin (phasing in a single sales factor). COST Outline Pillsbury Winthrop Shaw Pittman LLP 2

3 the taxable year. The denominator is the average value of all of the corporation s real and tangible property owned or rented and used during the taxable year wherever located. 3 The MTC regulations address the inclusion and exclusion of specific types of property; the inclusion of newly-acquired property; the exclusion of property that previously entered into the property factor; assignment of property to a specific state; and the valuation of items entering into the property factor. A. Specific Items Included or Excluded From the Property Factor. In general, Section 10 of UDITPA limits the property factor to the taxpayer s real and tangible property, whether owned or rented. Only property producing business income is includable in the factor. 4 Property typically used in the production of business income includes: inventory, land, buildings, machinery, equipment and property held as reserves or standby facilities (i.e., a temporarily idle plant). Property that is used both in the regular course of a taxpayer s business and in the production of nonbusiness income is included in the factor only to the extent of its business use. The portion of value to be included in the factor will depend on the facts of each case. In some circumstances an apportionment based on time is appropriate, e.g., conversion during the year of property to the production of nonbusiness income. In other cases, a division of the property s value, based on the relative amounts of business and nonbusiness income, might be a better division of value. Certain items of property are specifically excluded from the property factor. These include intangibles since by definition the property included in the factor is limited to real and tangible personal property. In addition, coins and currency are excluded. State statutes may provide other exclusions. For example, Florida excludes certain research and development property. Section (2)(c), Fla. Stats. provides that real or tangible personal property located in Florida and used exclusively in research and development activities performed pursuant to sponsored research contracts with a state university or certain nonpublic universities are excluded from the property factor for the duration of the contractual period for the conduct of the sponsored research. 5 Query: How does this obvious incentive to do local R&D compare constitutionally to a tax credit for R&D? 3 UDITPA 10. In 1999, the California FTB staff issued a discussion draft of a proposed addition to Regulation 25137(b)(1)(C) which addressed special rules for the property factor. 6 The proposed addition provided for the exclusion from the property factor of nonjurisdictional property, e.g., orbiting satellites and undersea transmission cables. The rationale for the draft regulation was that inclusion of such property in the property factor denominator results in nowhere income because the property would not be repre- 4 MTC Reg. IV.10(a). 5 Fla. Laws 1998, ch (H.B. 3351), effective July 1, FTB Notice 99-4 (Mar. 29, 1999). COST Outline Pillsbury Winthrop Shaw Pittman LLP 3

4 sented in the numerator of the property factor for any state. The draft regulation did not go forward. The FTB s current position is to apply the Court of Appeal decision in Communications Satellite Corp. v. FTB, 156 Cal. App. 3 rd 726 (1994). For orbiting satellites and international transmission cables, the full value of each will be included in the denominator of the property factor. A portion of the value of each will be included in the numerator of the property factor based on the connection between the satellite and cables with other California property. 7 Recently, the New York Appeals Tribunal upheld a decision that payments for use of space at bus terminal are not included in the property factor. Certain payments made by a multistate route and charter bus company headquartered in Massachusetts for space and services at the New York Port Authority Bus Terminal are not included in the property factor of the company's New York business apportionment percentage because no interest in real property passed to the company. The license agreement and privilege permit only granted the company a license or privilege to conduct certain acts at the bus terminal. Further, the company did not have exclusive control or possession of any bus spaces. The Port Authority could change the gates designated for the company's use at any time without the company's consent. Matter of Peter Pan Bus Lines, Inc., Nos and (N.Y. App. Trib. July 28, 2005). In reversing a tax court ruling, the Oregon Supreme Court held that the Department of Revenue had the authority to depart from the standard three factor apportionment formula for financial organizations applied at that time to require the inclusion of intangible personal property in the property factor of its apportionment formula for 1984 through 1992 tax years. U.S. Bancorp v. Department of Revenue, No. SC S51013 (Or. Sup. Ct. Dec. 16, 2004), cert. denied, Dkt. No (U.S. Sup. Ct. Oct. 3, 2005). B. Timing of Entry into the Property Factor. As a general rule, property is included in the property factor if it is actually used or is available for or capable of being used in the regular course of the taxpayer s trade or business. Property held as reserves or standby facilities, or property held as a reserve source of materials, e.g., a temporarily idle plant or raw materials reserves, are included in the factor. Property or equipment under construction (except inventoriable goods in process) is generally excluded from the property factor until such time that the property is actually used or is available for or capable of being used in the taxpayer s regular trade or business. However, in Commissioner of Revenue v. New England Power Company, 411 Mass. 418, 582 N.E.2d 543 (1991), a public utility company was allowed to include its construction work in progress (CWIP) costs of two nuclear energy plants in its property factor. The court determined that the taxpayer s maintenance and construction of energy plants was a necessary function of its business. In addition, because the value of its CWIP investment was included in the federally set rate base, the property indirectly generated income for the taxpayer. Therefore, the property was used in the taxpayer s trade or business and was properly included in its property factor. 7 See Cal. FTB Multistate Audit Technique Manual Section COST Outline Pillsbury Winthrop Shaw Pittman LLP 4

5 C. Removal From the Property Factor. Once property is included in the property factor, it generally stays there until its permanent withdrawal is established by an identifiable event (i.e., a sale). For example, when a taxpayer closes its manufacturing plant and rents the building pending sale, the plant is removed from the factor only upon sale. When the taxpayer closes its plant and leases the building under a five-year lease, however, the property is removed from the factor at the commencement of the lease. In another example, when a taxpayer that operates a chain of retail grocery stores closes a store, remodels it into three small nongrocery retail stores and leases the property to unrelated parties, the property is removed from the factor when remodeling commences, rather than the later date of the lease. The standard of an identifiable event appears to be satisfied in these examples. 8 D. Valuation of Property. Most states value property owned by the taxpayer at its original cost. 9 A few states, such as Connecticut and Louisiana, include depreciation and value property at its net book value. In addition, all states require that average values for property owned by the taxpayer be used in calculating the property factor. Average value is generally determined by averaging the values at the beginning and ending of the tax period. Property rented by the taxpayer is valued at eight times the net annual rental rate, i.e. rent net of subrentals. 10 If property owned by others (e.g., government owned) is used by a taxpayer in its unitary business operations at no charge or rented by the taxpayer for a nominal rate, the net annual rental rate for such property shall be determined on the basis of a reasonable market rental rate for such property. 11 Over a 20-year period, the FTB lost a series of decisions in which the foregoing regulation was applied. For example, in Appeal of Proctor & Gamble, 12 the taxpayer argued successfully for the inclusion in the denominator of the property factor of a reasonable market rental rate for government owned timberland. In Appeal of Union Carbide Corp., 13 the taxpayer was successful in arguing for the inclusion of a value for a government owned manufacturing facility. Prior to the promulgation of Regulation 25137(b)(1)(B), in McDonnell Douglas v. FTB, 14 the California Supreme Court held that the FTB s exclusion of government-owned property from the property factor used by the taxpayer in its unitary business operations was unreasonable and arbitrary since the property was essential to the production of the taxpayer s income. In order to attempt to eliminate disputes over how to calculate a reasonable market rental rate, the FTB amended Regulation 25137(b)(1)(B) to set forth a safe harbor calculation that focuses on the property which is used. The regulation does not take into account the property (e.g., timberland) which is available for use, but not actually used in a given year. 8 MTC Reg. IV.10(b). 9 MTC Reg. IV.11(a). 10 MTC Reg. IV.11(b). 11 California Regulation 25137(b)(1)(B) SBE-028 (Sept. 26, 1989). See also, Appeal of Kimberly Clark (SBE, 1994) (Kimberly Clark I); Appeal of Kimberly Clark (SBE, 2001) (Kimberly Clark II) SBE-057 (Apr. 5, 1984) (Union Carbide I); see also 93-SBE-003 (Jan. 13, 1993) (Union Carbide II) Cal. 2d 506 (1968) COST Outline Pillsbury Winthrop Shaw Pittman LLP 5

6 The issue of whether storage fees paid to a public warehouse constitute rent for property tax purposes has been addressed by a number of states. In Foodways National Inc. v. Crystal 232 Conn. 325, 654 A.2d 1228 (1995), the Connecticut Supreme Court held that fees paid for storage of frozen food in public warehouses constituted "gross rents" includible in a multistate corporation s property factor. In so holding, the court reversed the tax court decision that the fees did not constitute rents for the use of tangible property but payments to a bailee for services. Foodways had argued that its storage fees should be characterized as rent, for purposes of the property factor calculation. Foodways contracted with the warehouse to store a given quantity of its food products. The warehouse determined where the items would be stored; Foodways did not lease a particular section of the warehouse. In New Jersey, the Division of ation has taken the position that storage fees paid at a per carton/per day rate to a public warehouse are rent includible in the property factor; leased or rented property is valued at eight times its annual rent. N.J. State News, Summer 1994, p. 8. In Berman, TSB-A-94(6)C, April 7, 1994, the New York Commissioner of ation and Finance ruled that warehouse rental fees are included in the gross rents portion of the property factor if such fees are payable for a designated warehouse space that is under the taxpayer s control. It is immaterial whether there is a formal lease agreement or whether the rent is paid as a uniform charge or based on a per day rate. Further, Section 210.3(a)(1) of the Law provides that for purposes of determining the value of the taxpayer's real and tangible property, the value of rented property shall be eight times the gross rents payable for the rental of such property during the taxable year. Accordingly, the taxpayer must include in its property factor, both within and without New York State, eight times the gross rents for the use of the public warehouse space. If, however, the public warehouse storage or rental fees are payable for space not designated and not under control of the taxpayer, such fees are not included in the gross rents portion of the property factor. E. Assigning Property to Each State. For purposes of computing the numerator of the property factor, real and tangible personal property is assigned to a state to the extent that it is used in the state. Property in transit between locations of the taxpayer is considered located in the state of destination. For example, in McNaughton Affiliates, Inc., the New York State Commissioner of ation and Finance ruled that piece goods that were sent to New York for processing and returned to New Jersey for shipment comprised in-transit inventory that was located at its New Jersey destination for purposes of the property factor. 15 Property in transit between a buyer and seller that is included in the denominator of the taxpayer is considered located in the state of delivery. In Mercedes-Benz of North America, Inc. v. Comptroller, 16 in-transit inventory destined to a Maryland vehicle processing center, with a potential ultimate destination to a dealer outside the state, was includible in the numerator of 15 McNaughton Affiliates, Inc., TSB-A-94(9)C, N.Y. Comm r of ation and Finance, May 26, No /CL88967 (Md. Cir. Ct. July 21, 1989). COST Outline Pillsbury Winthrop Shaw Pittman LLP 6

7 the property factor. However, vehicles shipped through the Port of Baltimore, but processed in another state were excluded from the property factor numerator. Movable property such as construction equipment, trucks, etc. is assigned to a particular state based upon the total time spent in each state. Automobiles assigned to a traveling employee are included in the numerator of the state to which the employee s compensation is assigned under the payroll factor or in the numerator of the state in which the automobile is licensed. IV. Payroll Factor. The payroll factor is defined by UDITPA 13 as the total amount of compensation paid in the taxing state over compensation everywhere. What constitutes compensation and the assignment to a particular state is addressed by the MTC regulations. A. Elements of Compensation. The term compensation includes wages, salaries, commissions and any other form of remuneration paid directly to employees for personal services. Amounts considered paid directly include the value of board, rent, housing, lodging and other benefits or services, provided such amounts constitute income to the recipient under the Internal Revenue Code. Compensation associated with the production of nonbusiness income is excluded from the payroll factor. 17 The determination of an employee rests on the common law concept of an employeremployee relationship; however, as a general rule if the individual is an employee for purposes of the payroll taxes imposed by Federal Insurance Contributions Act (FICA), he or she is considered an employee for payroll factor purposes. 18 An officer of the corporation is an employee. However, some states, such as New York and South Carolina, exclude officers compensation from the computation of the payroll factor. In Philip Morris, Inc. v. Director of Revenue, 19 compensation paid to executives of a subsidiary was included in the parent s payroll factor when the parent made the payments, even though the executives worked solely for the subsidiary and the subsidiary reimbursed the parent for its cost. In making its determination, the court considered the following: the parent corporation issued the checks, made the payroll deductions for tax withholdings and FICA, supplied W-2 forms showing itself as employer and reported the executives salaries for unemployment compensation purposes, and the executives participated in an incentive compensation program controlled by the parent. A person s FICA classification is not dispositive. For example, Louisiana has adopted legislation which provides that an affiliated group member that serves as a common paymaster must eliminate from its wage ratio all payrolls that were paid on behalf of an affiliate, charged to the affiliate, and which do not represent salary, wages or other compensation of the common paymaster. These amounts must be included in the affiliated corporation s numerator and denominator of its salary, wages and other compen- 17 MTC Reg. IV.13(a). 18 MTC Reg. IV.13(a)(4) S.W.2d 888 (1988). COST Outline Pillsbury Winthrop Shaw Pittman LLP 7

8 sation apportionment ratio. La. Rev. Stat. 47:287.95(J) enacted by La. Laws 1998, Act 2 (H.B. 43), effective for taxable periods beginning after In C&D Chemical Products, Inc. v. State of Alabama Department of Revenue, 20 compensation paid for loaned or leased employees provided by a related corporation was included within the payroll factor, notwithstanding the fact the employees were not direct employees of the taxpayer. The Administrative Law Division held that even if the compensation paid for the loaned employees could not technically be included in the standard payroll factor, an alternative compensation factor should be employed pursuant to UDITPA 18. A company that offers payroll and other services for businesses is not required to include the amount of payroll that it processed for its clients in its gross payroll for purposes of the fixed dollar minimum tax under Art. 9-A. When computing the fixed dollar minimum tax, gross payroll is the same as the total wages, salaries, and other personal service compensation paid to all of the taxpayer's employees. In general, the employer and employee relationship exists when the taxpayer has the right to control and direct the individual not only as to the result to be accomplished but also as to the means by which such result is to be accomplished. In this case, the company does not have direct contact with its clients' employees. Thus, the clients' employees are not employees of the company for purposes of the payroll factor. Onondaga Employee Leasing Services, TSB-A-06(7)C (N.Y. Dept. of n. and Fin. Aug. 28, 2006). The Pennsylvania Supreme Court in a one line opinion affirmed the Commonwealth Court's ruling that a corporation was not entitled, nor required, to include amounts it transferred to an affiliated company to fund payroll costs for the individuals who performed the corporation's network planning and logistic functions in the payroll factor of its income/franchise tax apportionment formula. Because the corporation had no employees to compensate, it had no payroll expenses. Thus, the payroll factor must be disregarded in the tax apportionment calculation. UPS Worldwide Forwarding Inc. v. Pennsylvania, Nos. 1-4 MAP 2005 (Pa. Sup. Ct. Dec. 30, 2005). This case illustrates the loaned employee problem. UDITPA provides that the payroll factor is the amount paid by the taxpayer. What of common paymaster situations. For example, in Phillip Morris, Inc., v. Director of Revenue, 760 SW2d 888 (Mo. 1988), Phillip Morris paid the salaries of the top officials of a subsidiary, Seven Up. But since they were common law employees of Seven Up they argued the compensation should belong to Seven Up.. The court rejected the argument. A case reaching the opposite result is Cincinnati, New Orleans & Texas Pacific Railway v. Kentucky DOR, 684 Sw2d 303 (Ky. Ct. App. 1984) (indirect compensation reimbursed to common paymaster sufficient to permit payroll to be attributed to entity for which services were performed). B. Assignment of Compensation to a State. Compensation is included in the numerator of a state s payroll factor if: (1) the employee s service is performed entirely within the state; or 20 Docket No. Corp (Admin. Law Div. Feb. 19, 2001); see also Plantation Pipeline Co. v. State of Alabama, Docket No. Corp (Admin. Law Div. May 23, 2006). COST Outline Pillsbury Winthrop Shaw Pittman LLP 8

9 (2) the employee s service is performed both within and without the state, but the service without the state is incidental to the employee s service within the state. If the employee s services are performed both within and without the state and the services performed outside the state are not incidental, then the employee s compensation will be attributed to the state if: (1) the employee s base of operations is in the state; or (2) the service is directed or controlled from the state; or (3) the employee s state of residency is in the state. 21 The above rules apply even if the taxpayer is immune from state taxation by operation of Public Law Therefore it is possible that the sum of the numerators may be less than the denominator. Example: A taxpayer has employees in its state of legal domicile (State A) and is taxable in State B. In addition, the taxpayer has other employees whose services are performed entirely in State C where the taxpayer is immune from taxation by Public Law As to these latter employees, the compensation will be assigned to State C where their services are performed (i.e., included in the denominator but not the numerator of the payroll factor) even though the taxpayer is not taxable in State C. 22 A corporation's sole shareholder, who is also its president, is not physically present at and does not conduct any business out of the corporation's New York City office. Accordingly, the corporation's president is not deemed to be a salesman attached to the corporation's New York City office for purposes of allocating to New York State any of the corporation's receipts from compensation of services. In re Petition of Fallfield Steel Services Inc., TSB-A- 05(14)C (N.Y. Dept. of. and Fin. Oct. 24, 2005). V. Sales or Receipts Factor: Most states have substantially adopted rules similar to those set forth in UDITPA dealing with the makeup of the factors and the attribution of a particular factor component, e.g., the sourcing of sales when profit earning activities are conducted in more than one jurisdiction. Although the sales factor prescribed by UDITPA and contained in the Multistate Compact is commonly followed by the states, its construction often differs from state to state. For this reason, the sales or receipts factor yields the greatest planning opportunities for a multistate corporation. The sales factor is a fraction: the numerator is the total sales or gross receipts of the corporation in the state during the tax period; the denominator is the total sales or gross receipts of the corporation everywhere during the tax period. Only sales that generate business income are includible in the fraction. Thus, the factor includes business income from the sale of inventory or services, as well as interest, dividends, rentals, royalties, sales of assets, and other income that is classified as business income. A. Sourcing of Sales of Tangible Personal Property. Sales or gross receipts from the sale of tangible personal property are generally net of returns, allowances and discounts. Moreover, interest income, service charges, carrying charges, and time-price differential charges incidental to such sales are included in the sales factor. Federal and state excise taxes and 21 MTC Reg. IV MTC Reg. IV.13(b). COST Outline Pillsbury Winthrop Shaw Pittman LLP 9

10 state sales taxes generally are included in the factor if such taxes are either passed on to the buyer or included in the selling price of the goods. B. Dock Sales. Dock sales, or pickup sales, are sales of goods that are picked up at the seller s shipping dock by customers in their trucks for delivery outside the state. In determining the numerator of the sales factor for a seller of tangible personal property, most states source dock sales to the state in which the goods are picked up. Nevertheless, some states, either legislatively or through case law, source the sales to the state of their ultimate destination regardless of the state in which delivery to the purchaser occurs. Consequently, in-state sales are only those sales to purchasers with a destination point in that state; sales delivered to out-of-state purchasers for destination outside the state are attributable to the state of ultimate destination. Due to the lack of uniformity among the states with respect to the sourcing of such sales, there is significant potential for either the understatement or overstatement of dock sales in the seller s sales factor numerators. C. Throwback Rule. Many states have adopted the throwback rule, prescribed by UDITPA and the MTC rules, which provides that when goods are sold either to a purchaser located in a state in which the seller is not taxable or to the federal government, the receipts are included in, or thrown back to, the numerator of the state from which the shipment originated. Consequently, when the taxpayer is immune from taxation in the destination state under Public Law No , the sales are considered to be in-state sales of the origination state if that state has a throwback provision. Sales throwback may be required if the taxpayer is taxable in the destination state or foreign country but does not actually file a return and pay tax in the destination jurisdiction. 23 Approximately 20 states do not utilize the throwback rule and thus apply a pure destination test for determining whether a sale is sourced to the state. D. Throwback Rule in Combined Reporting States. Joyce and Finnigan Rules. A minority of states Arizona, Indiana, Kansas, Missouri, Tennessee and Utah apply the rationale of the California State Board of Equalization in Appeal of Finnigan 24 and take the position that sales shipped from a state by a corporation not taxable in the destination state are not thrown back if any member of the corporation s unitary group is taxable in that state 25. Other states, such as Alabama, Alaska, California, Colorado, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois 26, Kentucky, Maine, Minnesota, Montana, Nebraska, New Hampshire, New Mexico, North Dakota, Ohio, 23 See, e.g., Dover Corp. v. Department of Revenue, 271 Ill. App. 3d 700; 648 N.E.2d 1089 (1995) (This rule may apply even if other members of a combined unitary group paid income taxes in the state or foreign country) SBE-022-A (Aug. 28, 1988) ( taxpayer in Cal. Rev. &. Code 25135(b)(2) means all of the corporations within the unitary group; thus, when sales are shipped from California to another state by a member of a group conducting a unitary business, the throwback rule does not apply if any of the corporations within the unitary group are taxable in the other state. 25 A handful of other states, including Florida and Connecticut, require all taxpayer members of a group electing to file a consolidated return to agree to be treated as a single corporation). 26 See Hartmarx Corp. v. Bower, 309 Ill. App. 3 rd 959 (1 st Dist. 1999); Beatrice Companies v. Whitley, 292 Ill. App. 3d 532 (1 st Dist. 1997); and Dover Corp. v. Department of Rev., 271 Ill. App. 3d 700 (1 st Dist. 1995). COST Outline Pillsbury Winthrop Shaw Pittman LLP 10

11 Oregon, South Carolina, Vermont and Virginia follow the Joyce rule 27 which considers only the in-state activities of the taxpayer in determining application of the throw-back rule. In Appeal of Huffy Corp., 28 the Board adopted the Joyce approach prospectively for years beginning on or after April 22, It subsequently denied petitions for rehearing Huffy, 29 but did, however, amend its original opinion by holding that if a unitary group has members whose income years begin on different dates and are required to fiscalize their income to a common accounting period in order to apportion the group s business income, the Joyce rule applies prospectively to those common accounting periods that begin on or after September 1, Thus, Joyce is the law for calendar year taxpayers on January 1, 2000 and, for taxpayers with fiscal years ending on or after April 22, 1999, in their fiscal year ending In Citicorp North America Inc. v. Franchise Board, the California Court of Appeal held that no basis existed for overturning the Board s prospective application of Huffy. Further, the appeal court ruled that, pursuant to the Finnigan rule (the rule in effect at the time the taxpayer filed amended returns), a South Dakota affiliate's credit card sales and transactions actually occurring in California were properly assigned by the Franchise Board to the California sales and property factor numerators of the unitary group's formula used to apportion the group's California income. 31 Oregon New law establishes a throwback rule for goods shipped from a public warehouse. Specifically, for purposes of determining whether sales of tangible personal property are in Oregon, the sale of goods shipped from a public warehouse will not be deemed to have taken place in Oregon if: (1) the taxpayer's only activity in Oregon is the storage of the goods in the public warehouse prior to shipment; or (2) the taxpayer's only activities in Oregon are the storage of the goods in the public warehouse prior to shipment and the presence of employees within Oregon are solely for purposes of soliciting sales of the taxpayer's products. Or. Laws 2005, S.B. 31, enacted Sept. 1, Texas In reversing a lower court ruling, the Texas Court of Appeals held that the Texas franchise tax, as applied to a Texas-based wholesaler that sells to mostly out-of-state customers, is unfairly apportioned and thus unconstitutionally burdens interstate commerce. 27 Appeal of Joyce, Inc., 66-SBE-069 (Nov. 23, 1966) (only the in-state activities that are conducted by or on behalf of the taxpayer shall be considered when determining in-state nexus for throwback purposes) SBE-005 (Apr. 22, 1999). See also Appeal of The NutraSweet Company, 92-SBE-024 (October 29, 1992). 29 Rehearing in Appeal of Huffy Corp. 99-SBE-005A (Sept. 1, 1999). See also Appeal of Wynn s International, No. 98R-0857 (Cal. SBE, Sept. 1, 1999.) (Finnigan rule was properly applied retroactively by the Franchise Board to a corporation's income years ending on December 31, 1983 and 1984). 30 See also Cal. Reg (c)(5), which adopted the Joyce rule, effective December 1, The Finnigan rule applies for tax periods prior to April 22, 1999, the date the State Board of Equalization issued its decision in Appeal of Huffy Corp Cal. App.4 th 1433 (2000). The U.S. Supreme Court declined to decide the constitutionality of the Finnigan rule. Citicorp North America, Inc. & Affiliates v. Franchise Board, U.S. Supreme Court, Dkt , cert. denied, June 29, See also Deluxe Corp. v. Franchise Board, No. A (Cal. Ct. App., April 26, 2001), cert. denied, No (U.S. Sup. Ct. Jan. 7, 2002) (The California sales of nontaxpayer subsidiaries, Current and Colwell, were includable in the sales factor numerator although neither Current nor Colwell had any property or payroll in California during the years at issue. The reasoning in Finnigan and the apportionment methodology in Cal. FTB Notice 90-3 were fair in calculating and assigning to California that portion of the net income reasonably attributable to business conducted in the state). COST Outline Pillsbury Winthrop Shaw Pittman LLP 11

12 The taxpayer, Home Interiors & Gifts, is a wholesaler that conducts virtually all of its physical business operations in Texas and has no manufacturing, warehousing, or administrative facilities outside of Texas. During the years at issue, Home Interiors earned approximately 90% of its revenue from customers outside of Texas, and most of Home Interiors' revenue was derived by shipping tangible personal property from Texas to customers located in states in which Home Interiors was protected from net income taxation by Public Law Texas s corporate franchise tax is essentially imposed on two alternative tax bases, with the taxpayer paying the higher: (1) earned surplus (essentially net income) and (2) capital. Application of the earned surplus throwback rule causes Home Interiors to pay significant tax on net taxable earned surplus due to the application of P.L which doesn t apply to the tax on capital. Focusing on the "fair apportionment" prong of the Complete Auto, the court determined that the tax scheme failed internal consistency. In this case, the court found that the tax scheme at issue is not internally consistent because an interstate corporation could be subject to a tax on its capital in the destination state that an intrastate corporation would never bear. Home Interiors & Gifts, Inc. v. Strayhorn, No CV (Tex. Ct. App. July 28, 2005). Based on the decision in Home Interiors, a Texas based manufacturer that due to the throwback rule apportioned 100% of its gross receipts to Texas is considering amending its franchise tax report. The comptroller s office said that if the taxpayer decided to file an amended franchise tax report based on Home Interiors, the refund requested would be denied. The taxpayer would then need to properly request a refund hearing. The request would be held in hearings, along with similar requests from other entities, until the final appeal on Home Interiors is completed. Tex. Comp. of Pub. Accts., Letter Ruling No L (Sept. 28, 2005). Query, would the rule apply to a taxpayer operating entirely in Texas? Utah A financial services business that issues credit cards to individuals nationwide would not have to throwback receipts from credit card income, interchange fees and loan interest from loans not secured by real property collected from cardholders with billing addresses outside Utah, because the business is taxable in every state in which it has credit card holders. To the extent that another state concludes that the presence of the cardholders in that state is not sufficient to make the business's income subject to tax, the throwback rule could apply. Utah State Comm., Private Letter Ruling Op. No (July 26, 2006). E. California Throwback Rules for Sourcing of Foreign Sales. California applies unique nexus and sourcing rules to California taxpayers that have activities in foreign countries with respect to determining whether there is sufficient nexus with a destination country to prevent the throwback of outbound sales of goods shipped from California, or a country from which shipment originated in the case of inbound sales of goods delivered to California but destined for use in another state in which a client is not taxable and thus the sales would be thrown back to the country of origination. COST Outline Pillsbury Winthrop Shaw Pittman LLP 12

13 Under the decision of the California State Board of Equalization (SBE) in the Appeal of Dresser Industries, Inc., 32 PL does not apply to foreign commerce and, under U.S. jurisdictional standards, solicitation activity in a foreign country is sufficient to create nexus. Thus, minimal business activity conducted by, or on behalf of, the taxpayer in a foreign country will create nexus for the company and outbound sales to that country will not be thrown back to its California sales factor numerator. This rule does not apply with respect to sales of tangible personal property shipped from California to Puerto Rico. The Franchise Board issued Legal Ruling 99-1 on January 6, 1999 which states its position that commerce between Puerto Rico and the fifty states constitutes interstate commerce for purposes of P.L Thus, sales to Puerto Rico must be thrown back to California if the seller s activities in Puerto Rico are limited to solicitation of orders even though the seller is taxable in Puerto Rico under U.S. constitutional standards. Furthermore, inbound sales from the foreign country which are delivered to California but destined for use in another state in which the taxpayer is not taxable would be thrown back to the country of origination under the rationale of a California appellate court in McDonnell Douglas Corporation v. Franchise Board. 33 In McDonnell Douglas, the court held that delivery of property to a purchaser in the state is not a California sale within the meaning of Rev. and. Code if the property is ultimately destined for use in another state. In this case, a manufacturer s sales of aircraft which were delivered to purchasers in California but destined for use outside California were properly excluded by the taxpayer from its California sales factor numerator. In Appeal of Mazda Motors of America, Inc., 94-SBE-009 (Nov. 29, 1994), an automobile importer s sales receipts for vehicles that the importer stored, assembled, serviced, repaired and subsequently shipped to the purchaser in Texas were properly included in the numerator of the apportionment formula s sales factor for purposes of calculating the taxpayer s California taxable income. Unlike in McDonnell Douglas where the purchaser merely picked up the goods in this state for shipment to an out-of-state destination, the taxpayer exercised sufficient possession and control over the vehicles while they were in California to include the sales in the California numerator under Rev. &. Code and Cal. Code Regs. tit. 18, 25135(a)(3). The FTB issued Legal Ruling 95-3 indicating it will follow McDonnell Douglas, and revoking prior Legal Ruling 348. The ruling explained that if the purchaser takes possession in California for purposes such as warehousing, repackaging, accessorizing, or the like, the property is considered delivered within the state. However, if property is delivered for the mere purpose of immediate transportation to another state, the sale will not be sourced to California. California An in-state corporation involved in the design, manufacturing, marketing and sales of static random access memory is required to throw-back to California sales made to SBE-307 (June 29, 1982), affirmed on rehearing, 83-SBE-118 (October 26, 1983) Cal. App. 4 th 808 (1994). COST Outline Pillsbury Winthrop Shaw Pittman LLP 13

14 foreign countries. The corporation failed to show that the foreign countries in which the goods were sold had jurisdiction to subject the corporation to a net income tax under U. S. constitutional standards. Appeal of Galvantech, Inc., No (Cal. St. Bd. of Equal. Feb. 1, 2006). California Audit Practice--This case can serve as an illustration of recent audit practice in California. Auditors are requiring that taxpayers provide a filed tax return or prove that taxes have been paid in states or in foreign jurisdictions in order to avoid throwback sales for California numerator purposes. In addition, auditors have requested names of customers solicited, the frequency and purpose of the solicitation calls even when the representative lives in the foreign country. Finally, the auditor, if satisfied by the showing of a taxable presence in the other state, requests that the taxpayer sign a declaration of taxability for each such state and that the information may be shared with the other state. F. Dilution of the Sales Factor Denominator (Background to Microsoft and General Motors in the California Supreme Court). An issue that recently has received attention is the proper sales factor treatment of receipts from the sale or redemption of intangible assets, particularly short term financial instruments. Frequently, taxpayers will invest their excess cash in short term financial instruments such as United States Treasury instruments and commercial paper issued by corporations. Generally a taxpayer will maintain a cash management function, consisting of specific employees responsible for managing these highly liquid securities. These receipts generally should be included in the taxpayer s sales factor and sitused to the state in which the cash management function is located. The frequency and size of the sales can mean that a taxpayer s receipts factor can be quite large, producing a significant tax savings if the receipts are sourced outside of the taxing state. 1. Under UDITPA and similar state statutes, the income generated from the taxpayer s temporary cash investments is generally included in its apportionable income as business income. UDITPA 1(a) defines business income to include intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer s regular trade or business operations. 34 This provision is included and expanded upon in the Multistate Compact apportionment regulations and examples. Regulation IV.1.(c)(3) provides that [i]nterest is business income if the intangible with respect to which the interest was received arises out of or was created in the regular course of the taxpayer s trade or business operations where the purpose for acquiring and holding the intangible is related to or incidental to such trade or business operations. Example (v) of this regulation is directly on point: The taxpayer is engaged in a multistate manufacturing and selling business. The taxpayer usually has working capital and extra cash totaling $200,000 which it regularly invests in short term interest-bearing securities. The interest income is business income. 2. The receipts are thus includable in the sales factor denominator and generally sourced for purposes of the numerator to either the state of commercial domicile or, under the cost of performance test, the state in which the investment activity 34 See also Article IV of the Multistate Compact. COST Outline Pillsbury Winthrop Shaw Pittman LLP 14

15 occurred. An issue has arisen in many states as to whether the sales factor should include the gross receipts or only the net gain from the sale of these short-term investments. UDITPA defines sales as all gross receipts of the taxpayer not specifically allocated as nonbusiness income. 35 Following the plain meaning of the statute, the entire gross receipts from the taxpayer s temporary cash investments should be included in the sales or receipts factor without exclusion for return of capital. 3. Most states have adopted UDITPA, Article IV of the Multistate Compact or similar statutes. Several state courts have interpreted UDITPA and substantially similar statutes to require inclusion in the sales factor of the gross receipts from the sale of short-term investments. a. In California, Appeal of Merrill, Lynch, Pierce, Fenner & Smith, Inc., 89-SBE-017 (June 2, 1989), held that gross receipts rather than gross profits from the sales of securities traded on the taxpayer s own account were includable in the receipts factor. b. In Ohio, Illinois Tool Works, Inc. v. Lindley, 436 N.E.2d 220 (Ohio 1982), held that gross receipts from the sale of Treasury bills were properly includable in the sales factor. c. In Wisconsin, U.S. Steel Corp. v. Wisconsin Dept. of Revenue, [1985 Transfer Binder Wis.] St. Rptr. (CCH) ( App. Comm'n May 9, 1985), held that the sales factor must include gross receipts of sales and redemptions of CDs, U.S. Treasury securities and other similar short-term investments. 4. Other state courts have determined that only the net gain from the sales of these securities is includable in the sales or receipts factor. State taxing authorities have attempted to avoid the literal application of the statute by raising two primary objections: First, some taxing authorities have argued that inclusion of total gross receipts from the sale of intangible instruments is sufficiently distortive to warrant deviation from the standard apportionment formula under UDITPA 18. Under that section, deviation from the standard formula is permitted if UDITPA s allocation and apportionment provisions do not fairly represent the extent of the taxpayer s business activity in [the taxing] state. Relying on section 18, some taxing authorities have argued successfully that only net profit should be included in the sales factor while others have taken the position that the receipts should be thrown out of the formula entirely. See, e.g., Appeals of Pacific Tel. & Tel. Co., 78-SBE-028, (May 4, 1978); State Commission Decision No , Idaho State Commission, June 1998, Idaho St. Rptr. [CCH] (when intangibles in a manufacturer s cash management function are sold or mature, only the net gains are to be included in the sales factor); State Commission Decision No , Idaho State Commission, March 1997, Idaho CCH (large financial institu- 35 UDITPA 1(g) [emphasis added]. MTC Reg. IV.15(a)(1) similarly defines sales as all gross receipts derived by the taxpayer from transactions and activity in the regular course of such trade or business. The regulation s definition of sales goes beyond commercial sales transactions. COST Outline Pillsbury Winthrop Shaw Pittman LLP 15

16 tion required to include net, rather than gross, gains from securities dealing business 36 ); American Tel. & Tel. Co. v. State Appeals Board, 787 P.2d 754 (Mont. 1990); cf. American Tel. & Tel. Co. v. Director, Division of ation, 476 A.2d 800 (N.J. Super. 1984) (construing language of sales factor to exclude gross revenues received by AT&T from its holding and sale of investment paper because to do otherwise produces an absurd interpretation of the sales factor); Westinghouse Electric Corp. v. Porterfield, 261 N.E.2d 272 (Ohio 1970) (construing Ohio business done factor to exclude gross receipts from sale of marketable securities); see generally 1 Jerome R. Hellerstein & Walter Hellerstein, State ation 9.18[2] (2d ed. 1993); Walter Hellerstein, State ation of Corporate Income From Intangibles: Allied-Signal and Beyond, 48 L. Rev. 739, (1993). a. There is little authority regarding the level of distortion necessary to deviate from the standard apportionment formula. In Hans Rees Sons, Inc. v. North Carolina, 283 U.S. 123 (1930), the United States Supreme Court held that distortion of 250% was sufficient to deviate from the standard apportionment formula whereas in Container Corp of America v. Franchise Board, 463 U.S. 159 (1983), the Court held that a 14% distortion was insufficient. Logically, therefore, the level of distortion necessary to require that the standard formula be altered must be somewhere between 14% and 250%. b. In Appeal of Merrill Lynch, 89-SBE-017, (June 2, 1989), the Board determined that distortion of 23 to 36 percent was insufficient to allow exclusion of the proceeds from the sale of investment instruments from the receipts factor. In its decision, the Board stated that these figures [23-36%] are, as the Supreme Court said of the difference shown in Container Corp., supra, a far cry from the more than 250% difference which led us to strike down the state tax in Hans Rees Sons, Inc., and a figure certainly within the substantial margin of error inherent in any method of attributing business income among the components of a unitary business. The Board emphasized that rough approximation of income that is attributable to the taxing state satisfies the requirement that the formula fairly reflect the taxpayer s business activity in California. 5. Second, some taxing authorities have argued that MTC Reg. IV.18.(c)(3), or their state s equivalent, provides a basis for excluding the gross receipts from the sales factor entirely. That regulation provides in relevant part that where business income from intangible property cannot readily be attributed to any particular income producing activity of the taxpayer, such 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, dividends received on stock, royalties received on patents or copyrights, or interest received on bonds, debentures or government securities that result from the mere holding of the intangible personal property by the taxpayer must be excluded from the denominator of the sales factor Although the taxpayer lost this issue, it prevailed on its argument that the intangible assets should be included in the property factor. 37 The MTC regulations also specify that income-producing activity does not include the mere holding of intangible property. MTC Reg. IV.17(2). COST Outline Pillsbury Winthrop Shaw Pittman LLP 16

17 a. Relying on this MTC regulation, some state taxing authorities have taken the position that receipts from the sale of the intangible instruments result from the mere holding of the intangibles or at least cannot be attributed to any particular income producing activity and therefore the receipts should be thrown out of the sales factor altogether. b. The flaw in this argument is that taxpayers with excess cash invested in shortterm financial instruments virtually always have a cash management function in an identifiable location with employees devoted to the active management of the investments. Indeed, by definition short term investments require considerable attention. Thus, the income does not result from mere holding of intangible personal property and in fact can be assigned to the numerator of the sales factor for one or more states. c. This view is corroborated by Benjamin F. Miller, California Franchise Board counsel for multistate tax affairs, who, along with two co-authors, opined in an article: Presumably, activity exceeds mere holding when a formal cash management function exists. 38 (However, if the cash management function is outsourced, the throwout rule may apply.) An example of the ability to situs this activity was apparent in Appeals of Pacific Telephone and Telegraph Co., 78- SBE-028, (May 4, 1978), in which the Board determined that the income-producing activity associated with a pool of funds was performed exclusively in the state where the particular pool is located. In this case, the largest of the taxpayer s pools of working capital funds was determined to be located in New York because the securities and the individuals who managed the securities were located there. Accordingly, the regulation does not support exclusion of the gross receipts from the sales factor, at least in the case of short-term financial instruments. d. In Sherwin-Williams Co. v Department of Revenue (Number 4127, October 9, 1998), the Oregon Court ruled that the Department s administrative rule OAR (3) the state s equivalent of MTC Reg. IV.18.(c)(3) did not limit the inclusion in the sales factor of gross receipts from the taxpayer s investment securities. The taxpayer invested its excess working capital in a variety of securities. According to the stipulated facts, the taxpayer did not merely hold its investment securities but actively engaged in transactions for the ultimate purpose of obtaining gains or profit. In response to the Department s argument that distortion will result from the inclusion of gross receipts from the financial investments of excess working capital, the court said that while this may be true, it is the legislature not the department that must take corrective action. The court also noted that Section 18 permitted modification of the formula but not of the definitions in the statute Herbert, Miller, Weiss, Sales Factor and Intangibles: What s Up and What s Down, State Notes (Nov. 8, 1993) 1102, In 1995, the Oregon legislature amended Ore. Rev. Stat (6)(a) to specifically exclude from the sales factor the gross receipts arising from the sale of intangible assets unless those receipts are derived from the taxpayer s primary business activity. See also OAR (1)-(A)(1). In 1998, the Oregon legislature amended Ore. Rev. Stat to provide that "sales" includes "net Footnote continued on next page COST Outline Pillsbury Winthrop Shaw Pittman LLP 17

18 e. On the other hand, the Tennessee appellate court in The Sherwin-Williams Co. v. Johnson, 01-A CH (Tenn. Ct. App., Oct. 22, 1998), upheld the revenue commissioner s use of T.C.A (g)(1), the equitable apportionment (UDITPA 18) provision, to exclude from the sales factor denominator the amounts of principal returned on short-term investments of excess working capital. The court agreed with the taxpayer that the statute sales factor provisions clearly provides for the inclusion in the sales factor of gross receipts from the sale of intangibles; however, the inclusion of the gross receipts from the sale of short-term securities did not fairly represent the taxpayer s income attributable to the state. The equitable apportionment statute could be invoked by the commissioner without a showing of a grossly disproportionate ratio. 6. Some states, in recognition of the fact that their apportionment statutes, like UDITPA, require inclusion of the gross proceeds from the sale of short-term financial instruments in the receipts factor, have amended their statutes. a. Following the decision in U.S. Steel Corp., supra, the Wisconsin legislature amended the state s apportionment statutes to provide that gross receipts from the sale of investment instruments as were involved in that case would not be included in the receipts factor. See Wis. Stat (9)(f)(5). b. Colorado enacted a statute providing that [t]he gross receipts regarding the sale of intangible assets shall be the gain from the sale and not the total selling price. Colo. Rev. Stat (4)(b). c. In Western Elec. Co. v. Norberg, Inc., [R.I.] St. Rptr. (CCH) (D.R.I., 6th Div. March 30, 1983), cert. denied, 461 A.2d 619 (R.I. 1983), the court concluded the total gross receipts from the sale of short-term securities were includable in the taxpayer s sales factor since the statutory amendment to provide for the inclusion of only net interest and gains from the sale of the securities was not applicable during the period at issue. 7. Other states have addressed the issue by enacting special regulations restricting the inclusion in the sales factor of the proceeds from the sale of short-term investments to only net gain. a. For example, a Montana regulation adopted after litigation over the issue in the absence of a regulation, see American Tel. & Tel. Co. v. State Appeals Board, supra, provides that only the net receipts from the sale of tangible or intangible property (other than inventory) are included in the sales factor. Mont. Admin. R gain from the sale, exchange or redemption of intangible assets not derived from the primary business activity of the taxpayer but included in the taxpayer's business income." Ore. Laws 1999, S.B. 410, effective for tax years beginning after COST Outline Pillsbury Winthrop Shaw Pittman LLP 18

19 b. Other states that either exclude such proceeds entirely or allow only the inclusion of net gain in the sales factor based upon regulation or administrative policy include Arizona, Hawaii, Illinois, Kentucky, Maryland and New Hampshire. 40 c. The staff of California Franchise Board drafted a revision to 18 Cal. Code Regs to incorporate a proposed MTC regulation which would provide that where a taxpayer realizes gains or losses from the sale or other disposition of intangible property held as part of the taxpayer s operational investments, e.g., working capital, only the net gain from such sales or dispositions reported as taxable would be included in the sales factor. On August 8, 1998 the Executive Board of FTB refused to permit the project to go forward. 8. The Multistate Commission promulgated a regulation to address the issue through promulgation of a regulation, amending the definitions section of MTC Reg. IV.2.(a) to exclude certain proceeds, e.g., the repayment of principal of a loan, bond, or mutual fund or certificate of deposit or similar marketable instruments; pension reversions; amounts realized on the federally-unrecognized exchanges of inventory, from "gross receipts" even if the income is included in apportionable business income. G. Dilution of the Sales Factor Denominator Microsoft and General Motors in the California Supreme Court. 1. General Motors Corp. v. FTB, Cal. 4 th (2006) a. 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 Cal. Rev. & Code In the case of repos, only the interest received from repos should be included in the sales factor. b. On September 1, 2006, FTB filed a petition for rehearing. c. The Court extended the time to act on the rehearing petition to November 15, Microsoft Corporation v. FTB, Cal. 4 th (2006). 40 Ariz. Dept. Rev., CTR 99-4, May 25, 1999 (inclusion of the return of principal in the sales factor will not fairly apportion income from these investments); Ill. Reg (b)(6); Ky. Admin. Release, Revenue Policy 41P170, June 1, 1983; Hawaii Dept.., (f), Hawaii Admin. Rules, June 29, 1998; COMAR C(3) and B(3) and Petrie Stores Corp. v. Comptroller, No (Md. Ct. April 18, 1996); and N.H. Reg (a)(6) and (7). Most recently, the Idaho State Commission proposed an amendment to Reg , 99-9 to provide for the inclusion in the computation of the sales factor of only the net gain, not gross receipts, from the sale of liquid assets used in a treasury function which generate business income. Idaho Admin. Bull. 174 (Sept. 1, 1999). COST Outline Pillsbury Winthrop Shaw Pittman LLP 19

20 California Supreme Court held that gross proceeds from the sale of marketable securities, including redemptions on maturity, are includible in the sales factor. b. Based on the specific facts in the case, the Court held that the FTB met its burden of establishing that inclusion of the gross proceeds in the sales factor was distortive under Cal. Rev. & Code (See VIII, below.) c. On September 1, 2006, FTB filed a petition for rehearing. d. The Court extended the time to act on the rehearing petition to November 15, H Sourcing of Sales of Other Than Tangible Personal Property. Most states have adopted a cost of performance approach to apportioning sales other than those of tangible personal property. Under this approach, the receipts are assigned to the state where the income-producing activity giving rise to the receipts took place. Furthermore, UDITPA 17 provides that, when the income-producing activity is performed in more than one state, the receipts are included in the numerator of the state in which a greater proportion of the income-producing activity is performed, based on the costs of performance (i.e., the state where the greater costs of performance were incurred is attributed 100 percent of the receipts). Although the majority of states employ this all-or-nothing method, several states require that the receipts be attributed to the state in the proportion of the costs of performance incurred in that state to the total costs of performance. Costs of performance generally are defined as direct costs of the corporation determined consistently with generally accepted accounting principles (GAAP) and in accordance with accepted conditions or practices in the corporation's trade or business. Costs of performance typically do not include payments made to independent contractors for services performed on behalf of the corporation Services Sourced to the State in Which the Income Producing Activity Occurs. Most states source sales of services or intangible property to the state in which the income-producing activity is performed, based upon the costs of performance. There are generally two different rules which may apply when the costs of performance occur in more than one state. a. All or Nothing Rule States, such as California and Massachusetts, follow section 17 of UDITPA and provide that sales of services or intangibles occur within the state if the income-producing activity is performed in the state. If the income-producing activity is performed both within and outside of the state, then the sale will be taxable in the state if a greater proportion 41 Florida is one state which includes in costs of performance amounts paid to independent contractors used to complete a contract. Fla. Rule 12C (2)(e)2.b. See also Ruling of Commission, Va. Dept.. P.D , Nov. 22, 1996 (for purposes of apportioning a financial corporation s income, cost of performance includes both indirect and direct costs). COST Outline Pillsbury Winthrop Shaw Pittman LLP 20

21 of the income-producing activity is performed in the state than in any other state, based on the costs of performance. 42 b. Pro Rata Allocation Some states, such as Connecticut, source services based on the percentage of the costs of performance that were accrued within the state. Accordingly, even if a majority of the costs of performance were in another state, Connecticut will still seek to tax part of the service. 43 Texas apportions service receipts to the location where the service is performed. If services are performed inside and outside Texas, such receipts are Texas receipts on the basis of the fair value of the services rendered in Texas Direct or Indirect Costs. States also vary as to inclusion of direct or indirect costs in the definition of costs of performance. In California and Massachusetts, incomeproducing activity does not include transactions and activities performed by an independent contractor or subcontractor. Other jurisdictions, however, include such indirect activity in the definition of income-producing activity. In New York, receipts from services performed in New York will be sourced to New York, whether the services were performed by employees, agents, or subcontractors of the taxpayer, or by any other persons Services Sourced Where Consumed. A few states such as Iowa, Minnesota and Georgia include in the numerator of the sales factor the amount of receipts in proportion to the benefit received by the recipient in the state. 46 For example, in Iowa, all gross receipts are includable in the numerator if the recipient receives all of the benefit of the service in Iowa. If the recipient of the service receives some of the benefits of the service in Iowa, then the gross receipts are includable in proportion to the benefit of the service received in Iowa. 47 Similarly, in Minnesota, receipts from the performance of services must be attributed to the state where the services are received. 48 If intangible property is used in more than one state, the receipts must be apportioned to Minnesota in proportion to the amount of use in Minnesota Regardless of which rule is used, implementation is difficult. For example, the definition of income producing activity applies to each separate item of income. What does this mean? If a company performs installation services for numerous custom- 42 CAL. REV. & TAX CODE 25136; MASS. GEN. L. c (f); UDITPA 17. In some states such as Illinois, the all or nothing rule is slightly different, with sales sourced to Illinois only if the costs of performance in Illinois exceed the costs of performance outside the state. ILL. ADMIN. CODE tit. 86, (c)(3)(C)(ii). 43 CONN. GEN. STAT (c) TAC 3.557(e)(33). 45 N.Y. REG (a). 46 IOWA REG IOWA REG (1). 48 MINN. STAT Subd. 5(j). 49 MINN. STAT Subd. 5(i). COST Outline Pillsbury Winthrop Shaw Pittman LLP 21

22 ers, is it one item of income (installation services) or many items (from each customer)? While the latter would seem the more logical reading, consider Boston Professional Hockey Association, Inc. v. Commissioner of Revenue, 443 Mass 276, 820 NE2d 792 (2005) holding that with respect to gate receipts received by BPHA, the income-producing activity was the operation of an NHL franchise, not just the playing of individual games and that the activity included many subsidiary activities, including the playing of games, necessary to create a viable NHL franchise. 5. Another issue relates to the exclusion of activities performed on behalf of the taxpayer, such as those by an independent contractor. This is particularly a problem for unitary groups as it is not uncommon for one member to perform work for another. If these are excluded because on behalf of the taxpayer there could be a shift in the assignment of the receipt. Example: a power plant in Mexico sells its output to its California based sales subsidiary with all sales personnel operating only in California. If only the latter s activities are direct costs of performance, all the receipts are attributable to California despite the fact the overwhelming amount of costs occur in Mexico. 6. The definition of cost of performance leaves much to be desired. It states that these costs are direct costs in accordance with GAAP. However, GAAP deos not itself define direct costs. This is not surprising since financial accounting is concerned with assigning costs to a period in time rather than to an object. (Of course cost accounting defines direct costs but that is not the regulation s reference.) The definition of direct costs can significantly impact the answer. For instance, many taxpayers incur costs for the benefit of multiple customers, e.g., telecommunications companies, internet service providers, virtually all research and development costs. The addition of a new customer may require no expense beyond that which has already been incurred. Do these companies have direct costs for the fees paid by the new customers? If not, are the receipts thrown out? Are the only costs those incurred for the new customer sale? If prior period costs may be considered, is there a limit to how far back in time one goes? An example of these issues can be seen in the unpublished decision in Appeal of Adobe Systems, 96R-0722 (1997) where the SBE was faced with determining income producing activity and cost of performance related to royalties received for the use of intangibles. It determined that the income producing activity included R&D activities as well as negotiation activities, and concluded that the greater cost was in California. So it looked backward in time. But if R&D of the intellectual property is an income producing activity for all the agreements entered into, how are the costs split over all the agreements, or are they included in full for each one. If the latter, subsequent sales efforts and their costs will always be overwhelmed by the historical R&D costs. 7. In FTB Legal Ruling (May 3, 2006), the FTB explains how amounts paid by a member of a combined reporting group to another member of the group to per- COST Outline Pillsbury Winthrop Shaw Pittman LLP 22

23 form activities related to the sale of other than tangible personal property are considered in assigning receipts derived from that sale. The question presented is: When a taxpayer member of a combined reporting group has a sale of other than tangible personal property, how are amounts paid by that taxpayer member to another member of the combined reporting group to perform activities related to that sale considered in assigning receipts derived from that sale? In response, the FTB advised that the activities of Corporation S, which is a member of the same unitary group as Corporation P, are considered in determining the income-producing activity of Corporation P for sales factor purposes, because Corporation S s activities with regard to Corporation P s obligation to Z Corp are not in the nature of those performed by an independent contractor. Under CRTC 25136, receipts from a sale other than a sale of tangible personal property are included in the sales factor and are assigned to the state where a taxpayer s income-producing activity relating to such sales occurred. If the incomeproducing activity occurs in more than one state, the receipts are assigned to the state where the greater portion of the income-producing activity takes place, based on cost of performance. California Reg (b) defines income-producing activity as the transactions and activity directly engaged in by the taxpayer in the regular course of its trade or business. and excludes transactions and activities performed on behalf of a taxpayer (the on behalf of rule). According to the FTB, the on the behalf of provision cannot exclude all possible actors who perform services on behalf of a taxpayer. For example, a corporation is an artificial legal entity that can only act through its members, officers or agents and as such it can never literally perform an act itself. Moreover, the use of the phrase such as to describe the scope of the on behalf of rule indicates that the class of actors whose acts are not included in a taxpayer s income-producing activity includes not only independent contractors, but also others that perform transactions and activities on a taxpayer s behalf (some acts are clearly included as income-producing activity of a taxpayer such as those of employees, officers, and directors). Thus, the question which must be answered is: whether there are any acts performed on behalf of a taxpayer by other than the taxpayer s employees, officers, or directors that should be included in its income-producing activity for sales factor purposes? One class of possible actors that could perform services on behalf of a taxpayer is other members of the taxpayer s unitary group. If an independent subcontractor performs activities for the contracting taxpayer, its activities are excluded from the income-producing activities analysis by virtue of the on behalf of rule. When, however, a contractor and subcontractor are members of the same combined reporting group, it is inconsistent to disregard the activity of the subcontractor in determining the income-producing activity of the contractor because such activities are directly proximate to the generation of business income by the group. By considering only the acts of the contractor and ignoring the activities performed by other members of the same combined group relating to the same contract, the income-producing activity of the economic enterprise in performing services for third parties will not be COST Outline Pillsbury Winthrop Shaw Pittman LLP 23

24 reasonably reflected. Further, treating a member of the combined reporting group as an independent contractor could lead to the concentration of receipts in states where third party contracting decisions are made, regardless of where costs were incurred in performing the services. Due to the effects of combined reporting when the contractor and subcontractor are members of the same unitary combined reporting group, the FTB has advised that 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. This designation is necessary to more accurately assign the receipt to the place where the services were performed. If the contractor paid the subcontractor an amount reflecting an arm s-length price for the performance of the services, the payment will be deemed a payment by the contractor of a cost item and be used to measure the contractor s costs of performance, even if the intercompany income and expense for that item is not reported in the combined report during the taxable year for purposes of combined reporting. In situations where there is no payment or the payment is not arm s-length, the actual costs incurred by the subcontractor may be imputed to the contractor to measure the cost of performance. To the extent that entities are excluded from a combined report by operation of a water s-edge election, these entities are treated as third parties for combined reporting purposes. When a water s-edge combined report is filed, the on behalf of rule operates to exclude activities performed by entities that are not included in the combined report from the geographic determination of where the greater costs of performance occur for purposes of assigning gross receipts from sales other than sales of tangible personal property. 8. The MTC has adopted certain special rules, such as the rules under section 17 providing that gross receipts from the sale, lease or rent of real property are attributed to the state where the real property is located. A sensible rule but not without its legal problems as noted by Professor Hellerstein: The rule prescribed by UDITPA for attributing business income from sales other than sales of tangible personal property is the performance within the state of income-producing activity. The MTC s special rule abandons that test for a different rule, the locus of the property during the period at issue. This is a sensible rule, but unfortunately it does not respond to, and in fact is contrary to, the statutory test, since the statute provides that the extent of income-producing activity performed in a state is measured by costs of performance, not the location of the property. Hellerstein and Hellerstein, State ation, para. 9.18[2][b]. The FTB has also adopted numerous special industry rules for dealing with receipts from sales of other than TPP. Regulation (franchisors, assigning fees and royalties received from franchisees to the location of the franchisee); Regulation (motion picture receipts assigned based on location of theatres and TV stations, using an audience ratio). The Audit Division of FTB has informal guidelines allowing the use of alternative methods for some industries: e.g., stockbrokers may split commission receipts between location of the customer and exchange per the COST Outline Pillsbury Winthrop Shaw Pittman LLP 24

25 Multistate Audit Technique Manual (MATM) section 7800; telephone companies may assign receipts based on ratio of California net plant facilities used in the calls to total net plant facilities. MATM Query, can the informal rules be forced upon a taxpayer? 9. California In FTB Legal Ruling (December 4, 2003), the FTB addressed how dividends should be treated for sales factor purposes. Specifically, the FTB addressed the issue when income-producing activity exists with respect to a business income dividend so that the dividend is includible in the sales factor. The FTB concluded that a dividend payee that participates in the management and operations of the dividend payor is engaged in income-producing activity with respect to the dividend so that the dividend is includible in the payee s sales factor. This is a departure from the FTB s position set forth in its Multistate Audit Technique Manual Section This ruling becomes quite relevant in post-ceridian and post-farmer Bros. years where the FTB is disallowing deductions for CRTC and CRTC dividends. The FTB is applying this ruling on audit. 10. California In Appeal of Polaroid Corporation, SBE Case No (May 28, 2003), the question was whether proceeds from the Kodak patent infringement litigation should be included in the sales factor. The SBE concluded that the entire proceeds were to be included in the denominator and a portion thereof, based on the taxpayer s California sales factor, was to be included in the numerator. The SBE granted the taxpayer s petition for rehearing to reconsider this issue. Case ultimately settled. I. Sharing of Credits in a Combined Return 1. General Motors Corporation v. FTB, Cal. 4 th (2006) a. California Supreme Court rejected the taxpayer s argument that a research expense credit should be applied against the tax liability of the unitary group, or in the alternative, should be intrastate-apportioned against the tax liability of each of the taxpayer-members of the unitary group. b. The Court accepted the FTB s argument that the credit should be limited to the taxpayer which incurred the research expenses. c. On September 1, 2006, the FTB filed a petition for rehearing regarding the gross receipts issue. The credit issue was not included in the FTB s rehearing petition. J. Miscellaneous Sales Factor Developments Indiana A Wisconsin beer distributor's sales of products to Indiana customers that were shipped to the customer via a common carrier that the customer contracted with were not made in Indiana and, therefore, were not subject to the state's adjusted gross income tax. The distributor's customers have three options by which to transfer the product from the COST Outline Pillsbury Winthrop Shaw Pittman LLP 25

26 breweries to the proper destination. At issue in this case is the option under which the customer can arrange for a third-party common carrier to pick up the product and transport it to them. Regulation 45 IAC r (7) provides that "[s]ales are not 'in this state' if the purchaser picks up the goods at an out-of-state location and brings them back into Indiana in his own conveyance." The beer distributor argued, and the tax court agreed, that delivery of the product took place at the out-of-state breweries because the common carriers were acting as agents of the customer. When the products were loaded on the carriers' trucks, the beer distributor transferred possession, title and risk of loss of the products to the customers and, therefore, had no right or control over the products or the subsequent transportation. Accordingly, because the sales at issue were not made in Indiana, (as property was neither shipped nor delivered to a purchaser in Indiana), these sales should not have been included in the sales factor of the beer distributor's Indiana adjusted gross income tax apportionment formula. Miller Brewing Co. v. Indiana Dept. of Rev., No. 49T TA-82 (Ind. Ct. July 27, 2005). Maine In affirming a lower court ruling, the Maine Supreme Judicial Court held that the tax assessor properly calculated the denominator of the taxpayer's apportionment formula using a "water's edge" analysis, as opposed to a "worldwide basis" formula. In apportioning its Maine income, a Canadian corporation initially calculated and paid corporate income tax using only Maine property, sales and payroll figures in the denominator of the apportionment formula set forth in 36 M.R.S.A The corporation subsequently filed an amended corporate income tax return using a formula that applied worldwide property, payroll and sales figures. Upon audit, the Maine Revenue Services Department disallowed the corporation's inclusion of its worldwide sales, payroll and property amounts in the denominator. On appeal, the Maine Supreme Court upheld the disallowance and the rejection of the corporation's argument that Maine's tax laws should be construed as a hybrid of the "water's edge" and the worldwide combined reporting methods for the apportionment of taxation. The court held that: "Maine's apportionment statutes contemplate beginning with figures derived from corporations' federal taxable income,..., which is limited to income derived from United States business...to avoid an absurd result, each figure employed in the formula for determining apportionment must similarly be limited to property, payroll, and sales within the United States." In this case, the corporation's in-state income would be understated if the denominators, but not the numerators, in the apportionment formula were to include foreign property, payroll, and sales. Irving Pulp & Paper Ltd. v. Maine Revenue Services, No. Ken (Maine Supreme Judicial Ct. Aug. 9, 2005). North Carolina A corporation that obtained permission to use an alternative allocation formula for tax years 1983 to 1988 and a different formula for 1989 and thereafter was not allowed, after a statutory change increased the weight of the sales factor, to modify its approved alternative formula by using the double weighted sales factor. The plain language of N.C. Code (t), which allows a corporation to apply for permission to use an alternative formula, demonstrates that the formula set forth in the order granting permission to use an alternative formula exists independently from and substitutes the otherwise applicable statutory allocation formula. Accordingly, the alternative formula authorized by the tax review board substitutes that applicable statutory allocation formula. Philip Morris USA, Inc. v. Tolson, No. 00CVS (N.C. Ct. App. March 7, 2006). COST Outline Pillsbury Winthrop Shaw Pittman LLP 26

27 Query, if the change had caused an increase in tax liability, would the Department have forced the taxpayer off the agreed upon alternative? In response to the decision in Miller s, Ind. Code (e) was amended to clarify that the F.O.B. location of a sale does not affect whether the sale is an Indiana sale. Specifically, the law provides that [r]egardless of the f.o.b. point or other conditions of the sale, sales of tangible personal property are in this state if: (1) the property is delivered or shipped to a purchaser that is within Indiana, other than the United States government; or (2) the property is shipped from an office, a store, a warehouse, a factory, or other place of storage in this state and: (A) the purchaser is the United States government; or (B) the taxpayer is not taxable in the state of the purchaser. The change takes effect January 1, Ind. Laws 2006, H.B. 1001, enacted March 24, Mississippi In denying a motion for rehearing, the Mississippi Supreme Court upheld its prior ruling that an out-of-state oil refinery was liable for franchise tax on sales it made where title and control of the property sold was transferred to the purchaser in Mississippi. Under the terms of the sales at issue, title, possession and control of the product passed from the oil refinery to the purchaser when the product was injected from a Mississippi located terminal into a pipeline, also located in Mississippi. Once the product was injected into the pipeline, the oil refinery had no knowledge of the whereabouts of the product or where the product is ultimately off-loaded. The taxpayer did not include these sales as sales in any other state in determining the sales factor. On audit, an auditor reclassified these sales as Mississippi sales resulting in the assessment of additional franchise tax. On appeal, the Supreme Court held that notwithstanding the over-broad nature of Mississippi State Comm'n v. Chevron U.S.A., Inc., 650 So.2d 1353 (Miss. 1995) (court previously rejected the destination sales theory as a way to account for Mississippi receipts for franchise tax purposes) that the destination theory will never be used as the sole method of determining franchise taxes. Rather, a product's destination may be used as a factor for franchise tax assessment. After reviewing all the facts of the case, the Court ruled that the sales should be thrown-back to Mississippi. In reaching this conclusion the Court found the following facts persuasive: (1) the oil refinery accounted for the sales at issue by using Mississippi state code; (2) the product at issue was unsold when it was placed into the storage tank; (3) the oil refinery did not apportion the sales to any state, effectively creating a nowhere sale; (4) the product was stored and metered in Mississippi; (5) transfer of title, ownership, and control occurred in Mississippi; and (6) the oil refinery's product received public protection, among other advantages, while being stored in the state. Further, the court rejected the oil refinery's contention that the franchise tax violated the Commerce or Due Process Clauses of the U.S. Constitution. Mississippi State Comm'n v. Murphy Oil USA, Inc., No CA SCT (Miss. Sup. Ct. June 15, 2006). New York In affirming an Administrative Law Judge's ruling, the New York Appeal Tribunal held that the tax division had the authority to include New York destination sales of non-new York taxpaying subsidiary of Disney Enterprises, Inc. in the numerator of the receipts factor of the business allocation percentage (BAP) of the combined group. In reaching this decision, the tax tribunal rejected the taxpayer's argument that the subsidiary at issue is a nontaxpayer which is protected from New York income tax by Pub. Law because the activities in New York performed by and on behalf of the subsidiary did not exceed the solicitation of orders for sales of tangible personal property. As it held in Matter COST Outline Pillsbury Winthrop Shaw Pittman LLP 27

28 of Alpharama, Inc., the tribunal concluded that Pub. Law was not being violated by including the sales of a nontaxpayer member of the combined group in the numerator of the group's BAP. The inclusion of these sales in the numerator is necessary to arrive at the appropriate BAP, and is not an imposition of tax on sales by the nontaxpayer member. Lastly, the tribunal held that the value of the film masters (an intangible asset) cannot be included in the property factor of the combined group's numerator for its BAP. Matter of the Petition of Disney Enterprises, Inc. & Combined Subsidiaries, No (NY App. Trib. Oct. 13, 2005). Pennsylvania A package transportation company is entitled to use average receipts per mile earned in Pennsylvania when computing the numerator of the revenue miles apportionment fraction. The company charged customers for delivery based on a weight and zone of delivery system rather than a system based on the number of miles traveled. As a result, the average receipts received per mile varied by state. This resulted in the company having lower average receipts per mile in Pennsylvania when compared to average receipts per mile collected everywhere. The Department of Revenue argued that the company should compute its revenue miles apportionment fraction by using the average receipts per mile for transporting packages everywhere in both the numerator and the denominator. The company on the other hand argued that it should be allowed to use the average receipts per mile earned in Pennsylvania in the numerator while using the average receipts per mile for transporting packages everywhere in the denominator. In agreeing with the company, the Commonwealth Court noted that the Department s approach did not accurately reflect the company s Pennsylvania revenue because it assumes that the average receipts per mile for transporting packages is the same for every state when in reality it is not. FedEx Ground Package System, Inc. v. Pennsylvania, Nos. 302 F.R and 303 F.R (Pa. Commw. Ct. April 17, 2006). Pennsylvania The Department of Revenue issued a statement of policy to clarify the scope and application of Canteen Corp. v. Commonwealth, 818 A. 2d 594 (Pa. Commw. Ct. 2003), to the Corporate Net Income. It is the policy of the Department that part of the decision in Canteen that held that the functional sale of assets by the target corporation must be recognized by Pennsylvania will be followed so that the target corporation's sales factor will include, when required by law, the proceeds assigned to each asset which is deemed to have been sold. Pa. Dept. of Rev., Statement of Policy (Tit. 61 Pa. Code 170.3), effective March 24, Tennessee Letter ruling discusses how receipts associated with an IRC 936 company impacts the calculation of the taxpayer's receipts factor when the taxpayer recognizes income pursuant to the profit split method (PSM). Under the PSM, the combined taxable income associated with the subsidiary's product is divided equally between the taxpayer and the subsidiary. Thus, half the income will be included in the denominator of the taxpayer's receipts factor. For purposes of the numerator, receipts will be source based on the destination state of the recipient of the product. Further, the taxpayer is required to recognize income related to its research and development activities. This income will be included in the denominator of the taxpayer's receipts factor and included in the numerator of the receipts factor if the taxpayer performed the research and development in Tennessee and incurred the costs, or at least a majority of those costs, in Tennessee. Tenn. Dept. of Rev., Letter Ruling #06-01 (Jan. 9, 2006). COST Outline Pillsbury Winthrop Shaw Pittman LLP 28

29 Illinois A California based Internet marketer that has Illinois source receipts from advertising will have an Illinois sales factor apportionment numerator of zero because when cost of performance is applied to the company's income producing activities, a greater proportion of the costs are performed outside Illinois. Ill. Dept. of Rev., IT GIL (Oct. 26, 2005). Texas A company that issues credit cards is required to collect franchise tax on membership fee that allows the cardholder to use the card anywhere in the world. The sale of a membership fee, like an annual credit card fee, is the sale of an intangible right and, as such, the revenue for this transaction is sourced to Texas based on the location of the payor. In addition, amounts from discount fees (i.e., when a merchant accepts the credit card for payment and the taxpayer remits the amount minus a discount fee to the merchant) have been determined to be a processing fee for the performance of a service. Thus, revenue from the fees should be sourced to Texas based on the fair value of the service that is performed in Texas. Tex. Comp. of Pub. Accts., STAR Letter No L (June 26, 2006). Virginia On April 18, 2005, the Department of ation announced that it "will not change its interpretation of nexus standards until it has fully implemented policy changes attributable to the Virginia Supreme Court decision in General Motors Corporation v. Commonwealth, No (Va. Sup. Ct. Sept. 17, 2004)." In General Motors, the court held that the department's interpretation of the term "cost of performance," as embodied in 23 VAC to exclude third party costs is plainly inconsistent with the use of that term in Va. Code for purposes of calculating a financial corporation's cost of performance apportionment ratio. The department is currently reviewing its policies related to financial corporation apportionment. Among the policies to be developed are: (1) What criteria should be used to determine the location of an independent contractor's cost?, (2) What impact will new policies have on Virginia businesses?, and (3) What impact will new policies have on nexus?. Until the department can develop and implement policies that fully address the issues raised by the General Motors decision, it will apply the following principles to financial corporations: (1) at the election of the taxpayer, it will continue to accept returns prepared in accordance with 23 VAC to exclude costs of performance of independent contractors; (2) it will not use the court's interpretation of Va. Code to assert that nexus exists solely because of services performed in Virginia by an independent contractor, or the existence of an office of the independent contractor in Virginia; or (3) financial corporations that choose to rely on the decision to ignore 23 VAC and include costs attributable to independent contractors in their Virginia apportionment factor must disclose the criteria used to determine the location of such costs. Va. Dept. of n., Bulletin 05-3 (April 18, 2005). VI. Specialized Apportionment Formulas Use of Affiliates With Different Apportionment Formulas. As indicated, a small number of states have completely revamped the income producing activity rule to source receipts from all sales of services to the jurisdiction where the service is consumed. In general, however, most states have replaced the income producing activity rule only for selective industries. These industries include financial institutions, mutual funds, securities brokerage firms, broadcasting, publishing, telecommunications, airlines, railroads, ship transport, pipelines and motor carriers. COST Outline Pillsbury Winthrop Shaw Pittman LLP 29

30 A. Financial Institutions: The financial institution apportionment regulations promulgated by the Multistate Commission (MTC) or substantially similar rules have been adopted by over 20 states, including California, Massachusetts, New Hampshire, Oregon, and Rhode Island. These regulations include more than twenty new sourcing rules for financial institutions. Virtually all of these rules utilize a market state approach based upon where the customer or property is located. For example, the numerator of the receipts factor for receipts from credit card receivables includes interest from receivables if the billing address of the card holder is in the state. 50 The numerator of the receipts factor for interest received from loans secured by real property includes interest or loans secured by real property if the property is located within the state. 51 Several states have adopted the MTC financial institution allocation and apportionment rules, or substantially similar versions, either by statute or regulation. These states include Arkansas, California, Kansas, Maine, Maryland, Massachusetts, Mississippi, New Hampshire, New Mexico, Ohio, Oregon, Rhode Island and Washington. Some states, such as Alabama and Nebraska, follow the same rules that are applicable for general corporations. Still others apply a special formula to apportion the business income of financial institutions. For example, a single sales factor formula is applied by Connecticut, South Carolina and Tennessee. The State of Virginia is unique in that it utilizes a single cost of performance ratio to apportion the business income of financial organizations that are not subject to the bank franchise tax. B. Broadcasting and Publishing: The MTC has also promulgated a special regulation in connection with the apportionment of income for publishers. The regulation provides that the numerator of the sales factor includes gross receipts from the sale of advertising according to the ratio that the taxpayer s in-state circulation of purchasers and subscribers of its printed materials bears to its total circulation of purchasers and subscribers everywhere. 52 Additionally, the MTC has promulgated a special regulation with regard to apportionment for broadcasters. The regulation provides that the numerator of the sales factor includes gross receipts from the sale of advertising according to the ratio that the taxpayer s in-state listening/viewing audience bears to its total listening/viewing audience everywhere. 53 C. Telecommunications: While most states source sales of telecommunication services by the cost of performance rules, several states have adopted special market state rules that source sales based upon where the telecommunications service is consumed. For example, in Iowa, gross receipts or gross revenues from interstate toll services originating or terminating in the state are attributed to Iowa if they are charged to an Iowa service address. In addition, any other gross receipts or gross revenues from fees, access charges, toll ser- 50 MTC Reg. IV.18(i)(1)(g). 51 MTC Reg. IV.18(i)(1)(d). 52 MTC Reg. IV.18(j). 53 MTC Reg..IV.18(h). COST Outline Pillsbury Winthrop Shaw Pittman LLP 30

31 vices, or other charges for communications services charged to an Iowa service address are attributed to Iowa. D. Mutual Fund Industry: Several states including Massachusetts, Connecticut, Rhode Island, and Texas have specific sourcing rules for companies selling management and other services to or on behalf of a regulated investment company. These rules source the sales based upon where the shareholders of the regulated investment company are located, rather than where the services are provided. Some states, such as Illinois, prohibit the inclusion in a combined report of companies that use different apportionment formulas. Other states may allow or require the combination of a company engaged generally in manufacturing or mercantile and the specialized industry company; however, certain adjustments may be required to account for the difference in income-producing factors for the respective companies California Proposed Regulation The proposed regulation provides for an alternative apportionment methodology for mutual fund service providers that looks to the location of the underlying shareholders of the mutual funds, for purposes of assigning receipts to the numerator of the sales factor. See FTB Notice (Sept. 21, 2005). On June 12, 2006, the 3-member FTB approved proceeding with the formal regulation process. VII. Impact of Characterization of Product Sold and Varying Sourcing Rules: While progress has been made in creating market state rules in certain industries, the primary corporate income rule for sourcing sales of services or intangibles remains based, in whole or in part, upon the income producing activity rule. For electronic commerce, this cost of performance rule has far reaching implications. When goods and services such as music albums, information databases, videos and software are sold in tangible form, the sales will be sourced (for sales factor purposes) to the state of the consumer. However, when the very same products are sold electronically, the sales will generally be sourced to the state of the vendor. To the extent that taxing authorities determine that the character of the product sold via electronic commerce changes from tangible personal property to a service or intangible property, the application of the costs of performance rule may create an additional tax burden in the vendor s state of commercial domicile. 55 The characterization of goods and services as the sale of intangible personal property or services will have an impact also on the application of the throwback sales rules. A corporation that makes sales of tangible personal property into a state in which the corporation is not subject to tax will gen- 54 See, e.g., Mass. Dept. Rev., Letter Ruling 98-16, Nov. 4, 1998 (entity that satisfied the definitions of both a financial institution and a mutual fund service corporation was required to use (1) the single sales factor apportionment method to determine the taxable portion of net income from mutual fund sales and (2) the three-factor financial institutions apportionment formula to apportion any other net income to the state for bank excise (income) tax purposes). 55 A good example of the impact of the determination of whether a product is tangible or intangible is Appeal of PacifiCorp, 2002-SBE- 005, (Sept. 12, 2002) in which the SBE concluded that the sales of the generation and transmission of electricity were sales of services performed for the most part outside of California and thus not includible in the numerator of the sales factor. COST Outline Pillsbury Winthrop Shaw Pittman LLP 31

32 erally be required to throw back or source such sales to the state from which the property was shipped. Conversely, sales of services or intangible property are generally not subject to the sales throwback rules. 56 To a large degree, the lack of parity in the sourcing rules applied to manufacturers and service providers is attributable to an outdated taxing scheme. This scheme was developed primarily for an interstate manufacturing industry and an in-state service industry, but now is being applied to interstate services, such as electronic commerce. Ironically, as states begin to modernize their tax structures and move toward a market state sourcing rule for services, the short-term potential for double taxation increases. If a vendor is headquartered in a cost of performance state, and has customers in a market state, then it could pay tax on more than 100 percent of its sales. Conversely, the varying sourcing rules also create state tax planning opportunities. Query, Don t all the problems suggest that a destination approach is inevitable? And that it must be done by statute? VIII. Apportionment Factor Relief Under UDITPA 18. Section 18 of UDITPA provides that [i]f the allocation provisions of this Act do not fairly represent the extent of the taxpayer s business activity in this state, the taxpayer may petition for or the (tax administrator) may require, in respect to all or any part of the taxpayer s business activity, if reasonable: separate accounting the exclusion of any one or more of the factors; the inclusion of one or more additional factors which will fairly represent the taxpayer s business activity in this state; or the employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer s income. For example, a factor may be disregarded if it is not a material income-producing element in the taxpayer s trade or business. Appeal of Woodward, Baldwin & Co., Inc., 63-SBE-072 (May 28, 1963) (property factor disregarded in a sales representative business); Insulation Industries, Inc. v. Wisconsin Dept. of Revenue, Wis. St. Rptr. [CCH] (Wis. Cir. Ct. 1956) (factor disregarded if its presence in the state is negligible). Additionally, a factor may be disregarded if it can be show that its use will distort the result. In Miami Corp v. Illinois Dept. of Revenue 212 Ill. App. 3d 702, 571 N.E.2d 800 (Ill. App. Ct. 1991), a corporation was allowed to use separate accounting for its royalty income, although the rest of its income was apportioned, based upon the distortive results produced by the property and payroll factors. In recent cases, various state courts and state tax administrative bodies have addressed issues regarding the standard that must be met in determining whether the standard three-factor formula does not fairly represent the extent of the taxpayer s business activity in the taxing state. Some 56 However, the recent MTC regulation on apportionment of income for financial institutions has a throwback rule for the sale of financial services. COST Outline Pillsbury Winthrop Shaw Pittman LLP 32

33 states, such as California, require proof of distortion. In such instances, the question may arise as to whether the level of distortion must be of an unconstitutional proportion. States vary as to the required standard. California Under Regulation 25137(c)(1)(A), gross receipts from the sale of the taxpayer's headquarters was properly excluded from its sales factor. In situations where there is no special formula or method provided in the regulations, the standard UDITPA formula must be applied unless the party seeking to depart from it can prove distortion. However, if a relevant special formula is specifically provided for in the regulations and the conditions and circumstances delineated in such regulations are satisfied, the method of apportionment prescribed in those regulations must be applied. Any party that wishes to deviate from the special method prescribed by the regulation, when found to be applicable, must first establish that the regulation does not fairly represent the extent of the taxpayer's activities in the state. The opinions in Triangle Publications and Union Carbide will not be followed to the extent they conflict with the views expressed in this opinion. Appeal of Fluor Corporation, 95-SBE-016 (Dec. 12, 1995). Regulation 25137(c)(1)(A) was amended in 2001 to apply the throw-out rule where there are substantial gross receipts from an occasional sale of fixed assets or intangible assets (e.g., sales of stock). The regulation defines a sale as substantial if the exclusion of the gross receipts from the denominator of the sales factor results in a five percent or greater decrease in the sales factor denominator. Query: Should this rule be limited to sales of assets or should it be applied to other occasional transactions and activities which generate substantial gross receipts? (e.g., IRC 965) California Separate accounting for a unitary business's income is a reasonable alternative if the apportionment formula does not fairly represent the extent of a company's business activity in California. The taxpayer, a marketing and product sales subsidiary established by its Korean parent, was held to be instantly unitary with its parent; however, distortion was found to result from forced combination. Although the subsidiary conducted no income-generating activities and incurred a loss of $9 million during the taxable year, combination would attribute taxable income of $1.2 million, income which clearly was generated outside California. Appeal of Hyundai Motor America, Cal. SBE, No. 97A-0310, June 25, 1998, rehearing denied, Jan. 9, California payer contended that the standard UDITPA formula did not fairly represent the extent of its business activity in California because hyperinflation of the Mexican peso caused distortion in the calculation of both net income and the property factor in the apportionment formula. The SBE concluded that CRTC (UDITPA 18) provides no relief to the extent of any alleged distortion in the determination of income. The SBE stated the following: [t]he central question under Section is not whether some quantitative comparison has produced a large enough distortive figure. Rather, the question is whether there is an unusual fact situation that leads to an unfair reflection of business activity under the standard apportionment formula. The answer to this question lies in an analysis of the relationship between the structure and function of the apportionment formula and the circumstances of a particular taxpayer. If the analysis reveals some manner in which the standard formula does not adequately deal with the taxpayer s circum- COST Outline Pillsbury Winthrop Shaw Pittman LLP 33

34 stances, then section may apply. Section must be analyzed on a caseby-case basis; there is no bright line rule that determines when the standard formula does not adequately deal with a particular situation. The SBE concluded that the taxpayer failed to sustain its burden of proof that the standard formula did not fairly reflect the extent of its business activities in California. Appeal of Crisa Corporation, 2002-SBE-004 (June 20, 2002). California In Microsoft Corporation v. FTB, Cal. 4 th (2006), the California Supreme Court concluded that the FTB sustained its burden of proving the inclusion of gross receipts from treasury function activities in the denominator of the sales factor created a distortion under CRTC The Court further concluded that the FTB s cure for the distortion of including net receipts from the redemption transactions was reasonable. In reaching these conclusions, the Court emphasized the following: o o o o o o Section is not confined to correcting unconstitutional distortions. The comparison of low margin sales (treasury function) with higher margin sales (software transactions) presents a problem for UDITPA. The UDITPA s sales factor contains an implicit assumption that a corporation s margins will not vary inordinately from state to state. The comparison of margins in determining whether distortion exists under Section is not a prohibited separate accounting analysis. Section is not to be applied in only unique non-recurring situations. While the cure the FTB proposed in this case was reasonable, the Court cautioned that the FTB s approach might fail the test of reasonableness in another case. For example, if, unlike the instant case, the treasury operations provide a substantial portion of a taxpayer s income, the use of Section may be inappropriate. The party seeking to apply Section has the burden of proving by clear and convincing evidence that the standard formula does not fairly represent the extent of the taxpayer s business activities in California. The Court s decision opens the door for challenges to the standard apportionment formula for both taxpayers and the government. The endorsement of a comparison of margins between functions of the unitary business is a significant development. California 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. COST Outline Pillsbury Winthrop Shaw Pittman LLP 34

35 California FTB Notice (Sept. 28, 2006). o o The FTB announced that, for purposes of applying FTB Notice , 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 The FTB based its position on Microsoft and Pacific Telephone. Indiana Where parties elect to treat the sale of a subsidiary s stock as an asset sale by the subsidiary under I.R.C. 338(h)(10), the gain from the sale of the subsidiary s stock will be ignored and the gain on the subsidiary s deemed sale of its assets will be included in the taxpayer s group s consolidated adjusted gross income for adjusted gross income tax and supplemental net income tax purposes. The gain on the asset sale will be included in the group s apportionable business income. However, all receipts from the subsidiary s deemed asset sale (and the stock sale by the taxpayer) may be excluded from the numerator and denominator of the group s sales factor because inclusion, which could increase the factor over 300% over prior years, would distort the sales factor and did not fairly represent the group s income derived from Indiana. Ind. Dept. Rev., Revenue Ruling IT 99-01, Mar. 25, Missouri: Members of an affiliated group of newspaper companies that made a valid election to file consolidated Missouri corporate income tax returns and that accurately utilized the Missouri three-factor apportionment formula in computing the group s consolidated taxable income could not be required to file on a separate-return basis. The Director of Revenue could not retroactively revoke the affiliated group s filing status absent a showing that the consolidated returns did not clearly reflect the Missouri taxable income derived from sources within this state. Mo. Rev. State (3)(5); 12 CSR (38). Suburban Newspapers of Greater St. Louis, Inc. v.director of Revenue, 975 S.W.2d 107 (Mo. banc 1998). Oregon Corporations may petition the Department of Revenue to employ a more equitable method of income allocation and apportionment without first having to prove there was a violation of rights under the U.S. Constitution or the Oregon Constitution. This bill also authorizes the Department to adopt rules to promote uniformity and consistency with other states in the application of the Uniform Division of Income for Purposes Act (UDITPA). Ore. Laws 1999, S.B. 410, amending Ore. Rev. Stat , effective for tax years beginning after Pennsylvania Equitable relief must be granted taxpayer to alleviate the result of constructing the state s franchise tax base on a consolidated basis while calculating the apportionment factors on a separate-company basis. Inclusion as income the dividends received from its subsidiaries and as net worth the value of its investments in the subsidiaries but not its subsidiaries' property, payroll and sales in the apportionment formula was fundamentally unfair to the taxpayer. The disparity demonstrated by the taxpayer of 44.5% was found not to be of unconstitutional proportion but nevertheless required some form of equitable relief under 72 P.S. Section 7401(3)2.(a)(18) (UDITPA 18 equitable apportionment provision). The court declined to mandate inclusion of the subsidiaries property, payroll and sales in the three-factor formula but noted that this "would appear to be sensible approach and one that would serve the interests of accuracy promoted by Subsection (18)." The case was ordered remanded to the Department COST Outline Pillsbury Winthrop Shaw Pittman LLP 35

36 of Revenue for a determination as to the appropriate relief which will produce a fair and equitable result. Unisys Corporation v. Commonwealth, No. 151 F.R (Pa. Commonw. Ct., Mar. 8, 1999). Wisconsin Corporation engaged in business only in Wisconsin which holds a limited interest in a partnership doing business in Wisconsin and another state is entitled to allocate its partnership income under the separate accounting method where the other state asserts nexus with and subjects the corporate limited partner to corporate income tax. The resulting double taxation on that portion of its partnership income apportioned to the other state is thus mitigated. Wis. Dept. Rev., Private Letter Ruling No. W , Oct. 12, 1998 (rec'd April 1999). Pennsylvania: payer was denied apportionment factor relief under subsection 18 (72 P.S. 7401(3)(2)(a)(18)) for gains on the sale of real estate. payer, which acquired and held real estate for use of affiliated corporations, realized $70 million in gains on the sale of three improved parcels of real estate to an affiliate. The gains were excluded by the taxpayer from both the numerator and denominator of its sales factor for purposes of the state's corporate net income tax and capital stock/franchise tax. The court held that inclusion of the gains from the sales factor was not distortive, even though it resulted in the taxation of more than 100% of the taxpayer's income when considered with the results in other states, because 90% of the gains were derived from Pennsylvania real estate Citing Container Corp. of America v. Franchise Board, 463 U.S. 159 (1983), and Moorman Manufacturing Co. v. Bair, 437 U.S. 278 (1978), the court stated that the constitution tolerates some duplicate taxation. The court also ruled that, in contrast to Hans Rees' Sons, Inc. v. North Carolina, 283 U.S. 123 (1931), the apportionment fraction was not so grossly distortive as to violate due process. Penske Realty Inc. v. Commonwealth, No. 73 F.R. 1995, Pa. Commonwealth Ct., July 27, 1998 (unreported)).aff d without opinion, Nos and 0023 M.D. Appeal Dockets, 1999 (Penn. Sup. Ct. Sept. 29, 1999). 57 IX. Single Factor Sales and the Constitution. Before concluding on the sales factor, at the Hartman institute in Nashville last week the moot court debate related very much to these issues. The questions presented to the Honorable Supreme Court of Hartman were the following: (1) Does a single factor sales formula facially discriminate against taxpayer (should Moorman be overruled?); (2) Does the existence/application of totally different and inconsistent methodologies for determining where the sales are located viiolate the fair apportionment prong of Complete Auto Transit?; (3) Do the combination of single factor sales and different methodologies for determining where those sales take place violate the Commerce or Due Process Clauses as applied to this taxpayer? X. Business/Nonbusiness Income Of course, the threshold apportionment issue is what income is apportionable. Under UDITPA, business income is income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's trade or business operations. This provision has been interpreted as encom- 57 See also The Sherwin-Williams Co. v. Johnson, 01-A CH (Tenn. Ct. App., Oct. 22, 1998) (equitable apportionment statute could be invoked by the commissioner without a showing of a grossly disproportionate ratio). COST Outline Pillsbury Winthrop Shaw Pittman LLP 36

37 passing two tests, either of which would satisfy the definition of business income. Under the transactional test, income is classified as business income if it arises in the regular course of the taxpayer's trade or business. Income from tangible and intangible property is classified as business income under the functional test if the acquisition, management, and the disposition of the property constitute integral parts of the taxpayer's regular trade or business operations. Differing standards have been used in applying the functional test and some courts have chosen not to recognize that a separate functional test exists. 58 Nevertheless, many states take the position that the disposition of assets used in the business gives rise to business income, even if the income is derived from an occasional or extraordinary transaction. Rather than focusing on a particular transaction, the functional test focuses on the utilization of the property in the business. Several states have recently amended their laws to expand the definition of business income. For example, Alabama adopted a broader definition of business income in a bill that expressly overruled the state supreme court s decision in Uniroyal Tire Company v. Alabama Department of Revenue. 59 Mississippi has expanded its definition to specifically include a transactional test and a functional test 60 while Ohio has adopted a business/non-business classification similar to the UDITPA definition. 61 Two other states Illinois and Kansas allow taxpayers an election to treat all income as business income. 62 New Jersey law has been changed to assign 100% of a taxpayer s nonoperational income to the taxpayer s headquarter state to the extent permitted under the U.S. Constitution and statutes. 63 Illinois, North Carolina and the District of Columbia define business income to mean all income that is apportionable under the U.S. Constitution. 64 Pennsylvania has amended its law to include income arising from transactions in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if either the acquisition, the management or the disposition of the property constitutes an integral part of the taxpayer's regular 58 See, e.g., Appeal of Chief Industries Inc., 875 P.2d 278 (Kan. 1994), and Phillips Petroleum Co. v. Iowa Dept. of Revenue and Finance, 511 N.W.2d 608 (Iowa 1993). See also Laurel Pipe Line Company v. Commonwealth, 642 A.2d 472 (Pa. 1994)(gain on sale of pipeline running between Aliquippa, Pennsylvania and Cleveland, Ohio that had been idle for the previous three years was nonbusiness income). But see Texaco-Cities Service Pipeline Co. v. Department of Revenue, No. 93 L (Ill. Cir. Ct. 1995) (gain from the sale of pipeline assets located partly in Illinois constituted business income under the functional test). 59 Effective for taxable years beginning after December 31, 2001, Ala. Code defines business income as income arising from transactions or activity in the course of the taxpayer's trade or business; or income from tangible or intangible property if the acquisition, management, or disposition of the property constitute integral parts of the taxpayer's trade or business operations; or gain or loss resulting from the sale, exchange, or other disposition of real property or of tangible or intangible personal property, if the property while owned by the taxpayer was operationally related to the taxpayer's trade or business carried on in Alabama or operationally related to sources within Alabama, or the property was operationally related to sources outside this state and to the taxpayer's trade or business carried on in Alabama; or gain or loss resulting from the sale, exchange, or other disposition of stock in another corporation if the activities of the other corporation were operationally related to the taxpayer's trade or business carried on in Alabama while the stock was owned by the taxpayer. 60 Miss. Code Ann (2), effective for taxable years beginning on or after January 1, Ohio Laws 2003, Am. Sub. H.B. 95, effective for tax years beginning on or after June 26, Under prior law, certain specified items of income were allocated and all remaining items of income were apportioned. In addition, the new law creates a lookthrough mechanism allowing nonbusiness gains or losses to be sitused to Ohio based upon the percent of physical assets of the entire affiliated group of which the investee is a member ILCS 5/1501(a)(1), as amended by Ill. Laws 2002, Pub. Act. No (S.B. 2212), effective for each taxable year beginning on or after January 1, 2003 and Kan. Laws 2002, S.B. 472, effective July 1, N.J. Laws 2002, Pub. L. No. 2002, c. 40 (A. 5201), effective January 1, N.C. Gen Stat (a)(1), amended by N.C. Ch (S.B. 1115), effective for tax years beginning on or after January 1, D.C. Budget Bill approved by the City Council on May 14, 2004 and presented to U.S. Senate Appropriations Subcommittee on May 19, ILCS 5/1501(a)(1) amended by Ill. Laws 2004 (S.B. 2207), effective July 30, COST Outline Pillsbury Winthrop Shaw Pittman LLP 37

38 trade or business operations. This term includes all income that is apportionable under the U.S. Constitution. 65 Multistate Commission On August 1, 2003, the Multistate Commission amended its Allocation and Apportionment Regulations (Reg. IV.1.(a)) regarding the definition of business income. The amended rule, among other things, continues to employ the transactional and functional tests; defines trade or business, to contribute materially, property, acquisition, management, disposition, and integral part in the context of the functional test; more directly recognizes the concept of conversion of property from an asset held to produce income to one that produces nonbusiness income; and relies upon guidance provided by the U.S. Supreme Court to define the limits of apportionable income, including an explanation of the relationship of UDITPA s definition of business income that is an incorporated part of the Multistate Compact to the constitutional standard of apportionability. California In FTB Legal Ruling (April 28, 2006), the Franchise Board describes how activities related to income that are partially or completely excluded from the measure of the income or franchise tax should be reflected for apportionment factor purposes. The income of a multistate taxpayer is sourced to California per UDITPA (CRTC ). Under UDITPA, income is classified as either business income, which is apportioned to California, or nonbusiness income, which is allocated to a state(s). Once business income has been determined, it is apportioned using only those activities that gave rise to the income (i.e., the tax base) that is being apportioned. 66 Similarly, because nonbusiness income is allocated, the activities generating nonbusiness income are excluded from the apportionment formula. After determining that activities giving rise to income not included in the tax base should be excluded from the apportionment formula, it is then necessary to determine how this exclusion should be accomplished. Factors related to income that is wholly exempt from tax will be removed from both the numerator and denominator of the apportionment formula. Where the business engages in activities that support the production of both taxable business income and excluded income, it will be necessary to separate these activities into component parts (one part will be included in the apportionment formula, while the other part is excluded). A similar principle applies to the assignment of expenses to business and nonbusiness income. Thus, if an activity generates both income included in the measure of tax and income excluded from tax, only factors related to the production of the income subject to tax should be used to apportion that income. This may be accomplished as follows: (1) for payroll factor purposes using a time ratio for the employees engaged in the activities that generate exempt income as well as taxable income; (2) for property factor purposes through bifurcation in a manner similar to that provided for business and nonbusiness income; and (3) for sales factor purposes through the elimination of sales from the sales factor to the extent the sale relates to exempt income not subject to apportionment. California In upholding a lower court ruling, the California Court of Appeal held that gain realized from the sale of a subsidiary's stock constitutes apportionable business income under the functional test because the subsidiary was part of the taxpayer's unitary business. The Court declined to follow 65 Pa. Laws 2001, Act 23 (H.B. 334), effective retroactively to tax years beginning after December 31, See Chase Brass and Copper Co. Inc. v. Franchise Board, 70 Cal. App. 3d 457 (1977). See also FTB Legal Ruling 385 (March 28, 1975), in which the FTB ruled that the activities of an insurance company, which is exempt from the franchise tax should not be included in the combined report and should not be subject to UDITPA s apportionment provisions. COST Outline Pillsbury Winthrop Shaw Pittman LLP 38

39 the cessation of a line of business or partial liquidation exception theories which some other state courts have used. Further, the court rejected the taxpayer's argument that even if the gain was business income, it was entitled to an adjustment of its tax basis in the stock to reflect certain undistributed earnings and profits. While the California Revenue and ation Code permits various adjustments to basis, there are no provisions granting an adjustment to basis because of undistributed corporate earnings and profits. Jim Beam Brands v. California Franchise Board, 133 Cal. App. 4 th 514 (2005) petition for review denied, No. S139031, (Cal. Sup. Ct. Jan. 4, 2006). Illinois An Illinois appellate court held that income received by a nonresident partner was nonbusiness income because the distributed income related to the partnership s sale of an intangible asset made in conjunction with the partnership s cessation of business operations. The taxpayer, Leila Shakkour, was a general partner in O Connor Partners (the Partnership ), an Illinois partnership engaging in the trading of securities, options, currency, commodity options, and derivatives. The Partnership owned trading software used in the trading of financial products that it licensed to users that it eventually sold. The Illinois Department of Revenue argued that the distributive share of the proceeds from the sale of the trading software should be classified as business income allocable to Illinois because the software was an integral part of the Partnership s business operations. The court, in ruling for the taxpayer, held that the sale was an extraordinary event that was a marked departure from its previous business of licensing the software and fell within the business liquidation exception to the functional test. Shakkour and Thorne v. Bower, Dkt. No , (Ill. App. Sept. 1, 2006). California FTB Legal Ruling (July 8, 2005) addresses when income that is earned on IRC 965 cash dividends, pending the domestic reinvestment of those cash dividends, is properly characterized as business or nonbusiness income. California has not conformed to IRC 965. Moreover, IRC 965 does not affect the characterization of dividends as business or nonbusiness income; however, the requirement under IRC 965 that the dividends be used in certain types of investments may affect the characterization of any possible income earned on the dividends after such dividends are paid, pending their use in a qualified investment plan under IRC 965. Thus, in cases where the dividends are not immediately reinvested and generate income while waiting to be reinvested, the earmarking of the IRC 965 dividends for a particular purpose would control the characterization of the income. For example if Company A, a widget manufacturer and seller, intends to use its dividends from Company B to acquire another company in the widget manufacturing business, any earnings from the interim investment of the IRC 965 dividends would constitute business income. Illinois New Regulation provides guidance on making an election to treat all income as business income and the consequences of doing so. Effective for taxable years beginning on or after January 1, 2003, statutory law allows taxpayers to make an irrevocable election to treat all income other than compensation as business income. The election is made on the original return or on a corrected return filed prior to the due date (including extensions) for the return. An election made on an original return may be revoked on a timely-filed corrected return; however, once the due date has passed, the election made on the original or corrected return may no longer be revoked. In the case of a group of corporations filing a combined return, the election must be made each year by the designated agent of the group. The election applies to all income of the unitary business group required to be shown on the combined return, including income of members that do not join in the filing of the combined return. In the case of a partnership, an estate or trust, or an S corporation, an election made by the pass-through entity to treat all of its income as business income is binding on its partners, beneficiaries and shareholders. Ill. Adm. Code , effective May 23, COST Outline Pillsbury Winthrop Shaw Pittman LLP 39

40 Louisiana New law enacts the Louisiana Headquarters and Growth Act, provisions of which apply to income tax periods beginning after December 31, Under current law, dividend and interest income is classified as allocable income, subject to Louisiana corporation income tax if the recipient's commercial domicile is in the state. Provisions of H.B. 679 provide a deduction for dividend and interest income from Louisiana corporation income tax. A corporation, however, may elect to pay tax on interest income from a corporation that is controlled by the former through ownership of 50% or more of the voting stock of the latter. For franchise tax purposes, these provisions apply to tax periods beginning after December 31, Further, provisions of H.B. 679 provide for the apportionment of profits or losses from sales or exchanges of property not made in the regular course of business. Such profits are subject to Louisiana tax to the extent of the selling corporation's Louisiana apportionment rate. La. Laws 2005, Act 401 (H.B. 679). Missouri The taxpayer's gain from a deemed sale of its assets under IRC 338(h)(10) is nonbusiness income and is not apportionable by Missouri. In reaching this conclusion, the Administrative Hearing Commission rejected the revenue director's assertion that for purposes of the Missouri separate company return, the transaction at issue could be treated as an actual sale of stock rather than the deemed sale of assets. ABB C-E Nuclear Power Inc. v. Director of Revenue, No RI (Mo. Admin. Hearing Comm. June 23, 2005). Missouri In J.R. Simplot Co. v. Director of Revenue, No RF (Mo. Admin. Hearing Comm. May 13, 2005), the Missouri Administrative Hearing Commission concluded that J.R. Simplot Company's sale of common stock in a publicly traded company, Micron Technology, Inc., and the long-term capital gains arising from the transaction, were not integral to the taxpayer's Missouri operations and, therefore, could not be apportioned by Missouri. The AHC's decision turned on the meaning of the term working capital as applied in the functional test. Simplot's investment in Micron stock did not meet the definition of working capital when Simplot held the stock without dividends for 14 years and then used the proceeds to retire debt. The mere business use of investment proceeds does not convert what would otherwise be a non-business investment into an operational function. Pennsylvania The Department of Revenue issued a statement of policy to clarify the scope and application of Canteen Corp. v. Commonwealth, 818 A. 2d 594 (Pa. Cmwlth. 2003), to the Corporate Net Income. It is the policy of the Department that part of the decision in Canteen, which held that gains or losses from IRC 338 transactions produce nonbusiness income, does not apply to taxable years beginning after Dec. 31, 1998 because of statutory amendments to the definition of business income. Pursuant to 61 Pa. Code , taxable income generated as a result of a 338 election will be treated as business income. Pa. Dept. of Rev., Statement of Policy (Tit. 61 Pa. Code 170.3), effective March 24, California In FTB Legal Ruling , the FTB addresses how gains resulting from an IRC 338(h)(10) or IRC 338(g) election are apportioned for California purposes. The FTB analyzes three scenarios in which an IRC 338(h)(10) or IRC 338(g) election has been made and describes which apportionment factors should be used to report the gain from the deemed sale of assets pursuant to the election. The FTB does not directly address the issue whether the resulting gain is business or nonbusiness income, but instead assumes that, in each instance, the gain on the deemed asset sale is business income. COST Outline Pillsbury Winthrop Shaw Pittman LLP 40

41 Tennessee Interest an out-of-state corporation earned on investments in U.S. treasury securities is allocable nonbusiness income because the interest income was not put back into the corporation for operational and working capital needs. The corporation transferred its accumulated excess funds to its investment portfolio and earned interest on the investment funds. When the amount of accumulated cash significantly exceeded the daily operational and working capital needs of its business units, it transferred the excess funds from overnight investments in repurchase agreements to long term investments in U.S. treasury securities, including notes and bills. In the present case, the court found that the corporation's manufacturing activities in Tennessee are wholly unrelated to its investment activities in Missouri and that the securities interest earned served an investment function. In reaching that conclusion, the court found that the funds could not be classified as working capital because they were not needed and were not used by the corporation for capital replacement or expansion purposes or to fund day-to-day operations. Moreover, the funds were intended by the corporation in its long-term investment program for acquiring diversified businesses and were actually used for that purposes. Siegel-Robert, Inc. v. Johnson, No III (Tenn. Chancery Ct. Aug. 17, 2006). For further information, please contact: Jeffrey M. Vesely (bio) San Francisco This publication is issued periodically to keep Pillsbury Winthrop Shaw Pittman LLP clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The comments contained herein do not constitute legal opinion and should not be regarded as a substitute for legal advice Pillsbury Winthrop Shaw Pittman LLP. All Rights Reserved. COST Outline Pillsbury Winthrop Shaw Pittman LLP 41