Partnership Factor Flow-Through: New Jersey Takes an Unusual Approach

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1 If you have questions or would like additional information on the material covered in this text, please contact one of the authors: Kyle O. Sollie (Philadelphia) David J. Gutowski (Philadelphia) or the Reed Smith attorney with whom you regularly work. Partnership Factor Flow-Through: New Jersey Takes an Unusual Approach Most corporate partners generally believe that a partnership s apportionment factors flow through, to be combined with the corporation s own factors. For federal income tax purposes, partnerships generally have no formal federal filing requirements other than information returns, and, because a partnership is a conduit, items of partnership income, expense, gain, or loss pass through to the partners and are given tax effect at the partner level. For state and local tax purposes, however, a partnership can generate an array of complex tax issues. Corporations may invest in partnerships, or they may place certain operations or ventures in partnership form. For state income tax apportionment purposes, a particular state s approach in these areas dictates, among other things, whether, in apportioning its partnership income, a corporate partner must (1) combine its own apportionment factors with those of the partnership, (2) use only its own separate factors, or (3) use only those of the partnership. New Jersey corporate taxpayers (and perhaps corporations in other states as well) that own a partnership interest may have a refund opportunity, based on the New Jersey Division of Taxation s position in Chiron Corp. v. Director, Division of Taxation. 1 While most taxpayers probably think that a partnership s apportionment factors generally flow through to the corporate partner to be combined with the corporation s own factors, 2 the Division thinks otherwise. Thus, in determining state taxable income, taxpayers may be able to avoid picking up their share of a partnership s apportionment factors. Of course, whether a company would benefit from this treatment will depend on the relative income and apportionment of the partner and partnership. Background: The Chiron Case Chiron, a Delaware corporation with its corporate headquarters in California, is primarily a manufacturer of antigens and antibodies and other biological agents that are used to detect human diseases. Lacking adequate capabilities to manufacture, market, and sell test kits using its technology, Chiron entered into a license, research, and supply agreement with New Jersey-based Ortho Diagnostic Systems, Inc. (ODS), which had the experience and capabilities that Chiron lacked in the development, testing, manufacturing, and marketing of diagnostic products. Chiron and ODS shared equally in the profits generated by the joint business from the sale of testing kits, after reimbursement to them of their respective expenses as authorized. If the business suffered a loss, each party shared equally in the amount of the loss. For each of the years at issue in Chiron (1992, 1993 and 1994), the joint business filed a federal partnership income tax return, using its own federal identification number. The return identified the partnership as ODSI/Chiron HIV and Hepatitis Business and used This article appears in and is reproduced with the permission of the Journal of Multistate Taxation andincentives, Vol. 15, No. 4, July Published by Warren, Gorham & Lamont, a division of RIA. Copyright 2005 RIA. NEW YORK LONDON CHICAGO PARIS LOS ANGELES WASHINGTON, D.C. SAN FRANCISCO PHILADELPHIA PITTSBURGH OAKLAND MUNICH ABU DHABI PRINCETON N. VIRGINIA WILMINGTON BIRMINGHAM DUBAI CENTURY CITY RICHMOND GREECE r e e d s m i t h. c o m

2 the address of ODS s New Jersey offices. The Schedules K-1 issued to Chiron and ODS showed each as a 50% partner. The joint business did not file tax returns in New Jersey, either as a partnership or otherwise. Chiron filed its own New Jersey corporation business tax return and a federal income tax return for each of the years under appeal. In both returns, Chiron reported its income from the business with ODS as income from the Ortho Joint Venture. Computing State Income In determining its New Jersey income, Chiron argued that it was entitled to flow through the partnership s apportionment factors and combine them with its own factors. The Division of Taxation took the opposite position, arguing that the corporate partner could not flow through the factors, and had to separately apportion its partnership income and all its other income. The controversy involved N.J. Admin. Code 18:7-7.6(g). Under that regulation, the method a corporate partner uses to apportion partnership income depends on whether the corporation and the partnership are part of a unitary business. Flow-through accounting apportionment. If a corporate partner and the partnership are unitary, the corporation must combine its apportionment factors with its share of the partnership s factors. The combined factors are used to apportion the corporation s entire net income, including its distributive share of partnership income. 3 Separate accounting apportionment. 4 If a corporate partner and the partnership are not unitary, the corporation apportions its distributive share of partnership income using only its share of the partnership s own apportionment factors. Then, the corporation s entire net income from business it carries on directly (i.e., excluding its share of partnership income) is apportioned using its own apportionment factors (which excludes any receipts from the partnership). The two apportioned incomes then are added together to get net income for state tax purposes. 5 Were The Partner and the Partnership Unitary? Although the Chiron controversy centered around the familiar term unitary, the argument was anything but familiar. The Division was arguing that there is a presumption against finding a unitary relationship at least in the context of partnership factor flow-through. Unusual Presumption Against Finding a Unitary Relationship The New Jersey framework for partnership factor flow-through, hinging on the unitary/nonunitary distinction, is not peculiar to New Jersey. Indeed, many states have adopted a similar framework. 6 What is peculiar, however, is that in Chiron the Division argued that there is a presumption that a corporate partner is not unitary with the partnership at least insofar as factor flow-through is concerned. Furthermore, the Division argued that a partner and partnership should be considered unitary for this purpose only in rare circumstances for example, if the failure to flow through leads to distortion. The Division s Historical Position The Division s position with regard to factor flow-through is consistent with the public position that it took in 1991 in a technical bulletin. 7 At that time, the Division s position was that the normal method for partnership apportionment was the separate-accounting method. Thus, according to the bulletin, a corporate partner is not generally permitted to include the partnership s apportionment data with its own. Indeed, the presumption under the bulletin was so strong that a corporate partner was able to flow through partnership factors only if it - 2 -

3 established significant distortion absent such flow-through. The corporate partner would have to show that it was entitled to extra statutory relief under N.J. Stat. Ann. 54:10A-8 ( section 8 ), which is akin to 18 under the Uniform Division of Income for Tax Purposes Act. 8 That 1991 technical bulletin, at least on its face, expired in Later, in 1997, portions of the technical bulletin were incorporated into a regulation N.J. Admin. Code 18: The regulation, however, does not on its face reflect the technical bulletin s presumption against factor flowthrough. 9 For example, according to the text of the regulation, no finding of distortion is necessary for factor flow-through. Instead, under the regulation all that is necessary is that a partner and partnership be engaged in a unitary business. 10 As a result, many taxpayers (including Chiron) inferred that there no longer was a presumption against factor flow-through in the partnership context. In fact, since many courts have expressed a bias toward finding a unitary relationship, 11 taxpayers inferred that the presumption under the regulation was in favor of factor flowthrough. That inference, however, was wrong. The Division s arguments in Chiron just a year ago demonstrate its continuing bias against factor flow-through. In fact, through those arguments, the Division expressly stated that, despite the technical bulletin s declared 1992 expiration date, it still is vital. 12 Unitary Analysis: The Presumption Often Tips the Scale In Chiron, the New Jersey Tax Court seems to have accepted the nonunitary presumption, accepting the Division s argument that the separate-accounting method is generally applicable under the Division s regulation. 13 Moreover, the Tax Court seems to view the 1997 regulation at least as it relates to the flowthrough issue as simply a codification of the Division s bulletin. 14 This view would include the presumption in the bulletin against finding a unitary relationship. This presumption can have a significant effect on the outcome of a unitary analysis because such an inquiry involves balancing facts and circumstances. Moreover, in its regulation the Division lists several subjective factors to consider in the partnership context but gives no clear indication regarding how to resolve any particular unitary-business question. 15 And the Division itself has characterized standards for determining a unitary business as being incoherent and inconsistent, and as having spawned continuing litigation. 16 Often, therefore, unitary decisions can go either way. 17 Thus, a presumption against finding a unitary business for purposes of partnership flow-through could tip the scales against flow-through of apportionment factors. This presumption seemed to have an effect in Chiron. The Tax Court certainly could have gone either way based on the facts of the case, e.g., Chiron had a 50% interest in the partnership; each entity was in a similar business; the partnership generated much of Chiron s revenues and most of its income, and it shared technology and engaged in other significant intercompany transactions with Chiron. Indeed, the partnership s activities were so closely interrelated with Chiron s that it was not clear whether there was a partnership at all, or merely a collaborative venture with another company in a related industry. 18 Absent the presumption against finding a unitary business (and thus against factor flow-through), the Tax Court certainly could have reached the opposite result. Of course, not flowing through and combining the partnership factors contrasts vividly with the presumption of most states in favor of factor flow-through. 19 Likewise, non-flow-through treatment hinges on a presumption against finding a unitary relationship, which contrasts with U.S. Supreme Court decisions in which the presumption is in favor of finding a unitary relationship

4 Conclusion: Opportunity for Taxpayers The New Jersey Division of Taxation s position in Chiron may be surprising to many taxpayers, so it bears repeating: under the Division s position, the general rule is that partnership apportionment factors do not flow through to be combined with a partner s own factors. Instead, it expects partnership income to be apportioned using the separate accounting method. Only in rare circumstances may a corporation use the flow-through apportionment method. This position may have a significant impact on the taxable incomes of many corporations. It also may have an impact on a partnership s withholding obligations for nonresident partners. 21 What should a corporate partner do? Determine whether it is beneficial to flow through the partnership s apportionment factors. If it is not, a corporation that has done so on prior returns might consider filing refund claims for the years open under the state s statute of limitations. Indeed, the effect of the Division s position (and the Tax Court s decision) in Chiron is retroactive the Division has simply ratified the position it first announced in * * * * * * Practice Note: A Third Approach to Apportionment As noted briefly in the accompanying article, there is another but not often used method for apportioning a corporate partner s partnership income, whereby the partnership factors are ignored. That is, partnership income is apportioned to a state using only the corporate partner s own factors. This method was advocated by the Rhode Island Tax Administrator in Homart Development Co. v. Norberg, 529 A2d 115 (R.I., 1987). In that case, the court seemed to accept the Tax Administrator s premise that, under the state s generally applicable income apportionment statute, only a taxpayer s own factors (and not those of an investee partnership) are used to apportion the combined income of the corporation and the partnership. The court found, however, that in Homart s case the result would be distortive and would violate the Commerce Clause. Accordingly, the court held that flow-through was required under R.I. Gen. Laws , which is Rhode Island s version of UDITPA 18 (providing for separate accounting or modifications to the apportionment factors to remedy distortion arising from the use of an otherwise required formulary apportionment). It is not clear, however, that, under Homart, flow-through is required if it produces a better tax result for the state; the Commerce Clause is not there to protect a state from its own statutes. (See also, Smith and Fay, Allocating a Corporation s Partnership Income: The States Diverse Approaches, 13 J. Multistate Tax n 6 (January 2004).) * * * * * * Reed Smith is a top-15 global relationship law firm with more than 1,500 lawyers in 21 offices throughout the United States, the United Kingdom, Europe and the Middle East. Founded in 1877, the firm represents leading international businesses from Fortune 100 corporations to mid-market and emerging enterprises. Its attorneys provide litigation services in multi-jurisdictional matters and other high stake disputes, deliver regulatory counsel, and execute the full range of strategic domestic and cross-border transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising and media, shipping, international trade and commodities, real estate, manufacturing and education. For more information, visit reedsmith.com

5 NJ Tax 528, 2004 WL (2004). See, e.g., Smith and Fay, Allocating a Corporation s Partnership Income: The States Diverse Approaches, 13 J. Multistate Tax n 6 (January 2004). N.J. Admin. Code 18:7-7.6(g)(2) and Examples III and IV. See also Chiron, supra note 1, page 543. The Division s use of the term separate accounting is unfortunate. Ordinarily, this term is used to mean an accounting method that attributes income by identifying all items of income and costs which are related to a State, and constructing statewide net income from these items. See Report of the Special Subcommittee on State Taxation of Interstate Commerce of the House Committee on the Judiciary, H. Rep t No. 1480, 88th Cong., 2d Sess. 115 (1964). N.J. Admin. Code 18:7-7.6(g)(1) and Examples I and II. See also Chiron, supra note 1, page 543. See, e.g., 18 Cal. Code Regs (a), (f), and (g), and 86 Ill. Admin. Code (d)(1) (flow-up of partnership factors depends on unitary relationship of partner and partnership). See N.J. Div. of Tax n Technical Bulletin, No. TB-3, 6/21/91 (expired 6/30/92). See also New Jersey State Tax News (Vol. 20, No. 3; Div. of Tax n, May/June 1991) ( a corporate partner is not generally permitted to include the partnership s property, payroll and receipts in its allocation factor ). These sections provide generally that separate accounting or modifications to the apportionment factors may be used to remedy distortion arising from the use of an otherwise required formulary apportionment. See 29 N.J. Reg. 1686(a) and 4327(a) (1997) (adopting N.J. Admin. Code 18:7-7.6, effective 10/6/97). The Division did, however, foreshadow the continuing validity of Technical Bulletin, No. TB-3, supra note 8. In its response to public comments concerning N.J. Admin. Code 18:7-7.6, the Division noted repeatedly that it was basing this new regulation on its experimental policy outlined in TB N.J. Reg. 4327(a). The regulation s explanation of the unitary concept is similar to the unitary concept as defined by the U.S. Supreme Court and various state courts. Compare N.J. Admin. Code 18:7-7.6(g)(3) with, e.g., Butler Bros. v. McColgan, 17 Cal.2d 664, 111 P2d 334 (1941) (setting forth California s three unities approach), and Mobil Oil Corp. v. Comm r of Taxes of Vermont, 445 US 425, 63 L Ed 2d 510 (1980) (setting forth the standards of functional integration, centralization of management, and economies of scale). There are, however, subtle differences, which the Division itself acknowledges. See, e.g., 29 N.J. Reg. 4327(a) (10/6/97). An analysis of those differences is beyond the scope of this article. See, e.g., Container Corp. of America v. Franchise Tax Bd., 463 US 159, 77 L Ed 2d 545 (1983) (the taxpayer bears the distinct burden of showing by clear and cogent evidence that a unitary business does not exist). See Brief of the Division of Taxation, page 24, footnote, Chiron, supra note 1 ( Although TB-3 expired on June 30, 1992, neither the relevant portions of the CBT Act nor the related regulations were amended at that time to suggest a different approach than that set forth in TB-3. Thus, inasmuch as TB-3... explained how corporate taxpayers should treat their New Jersey partnership holdings, it remains of interest ). According to the Tax Court, [t]he separate entity approach, as generally applicable under the Director s Technical Bulletin and later regulation, does not result in a distortion of the sales fraction... Chiron, supra note 1. The Tax Court stated: In 1997, after the last year under appeal in this matter, the Director incorporated the contents of the Technical Bulletin into his regulations... Id. See N.J. Admin. Code 18:7-7.6(g)(3), which presents a nonexclusive list of [f]acts that either singly or in combination may suggest that a corporation and partnership are part of a unitary business. Brief for the New Jersey Division of Taxation on Reargument, page 12, Allied-Signal, Inc. v. Director, Division of Tax n, 504 US 768, 119 L Ed 2d 533 (1992). See Container Corp. of America, supra note 12 ( [t]he factual records in [unitary] cases... tend to be long and complex, and the line between historical fact and constitutional fact is often fuzzy at best ). See also Latcham, d T.M. (BNA), Income Taxes: Definition of a Unitary Business, section 0201 ( the courts have had difficulty in providing a realistic definition of a unitary business ). See Chiron, supra note 1. See, e.g., 830 Mass. Regs. Code (13) (presumes that corporate partner s share of partnership apportionment factors flows through for inclusion with corporation s own factors). See note 12, supra. See N.J. Admin. Code 18: and (partnerships must pay tax on behalf of nonresident corporate partners; a nonresident corporate partner does not include a partner that is unitary with a partnership that has a regular place of business in New Jersey)