Economic and bright-line nexus
Bright-line nexus standards, also known as factor presence nexus, are gaining in popularity. Pioneered by California and Ohio, they assert income, franchise, gross receipts or other business entity tax jurisdiction based on clearly defined parameters. The Multistate Tax Commission model statute defines nexus as in-state activity measured by:
- $500,000 of sales, $50,000 of property or $50,000 of sales
- 25 percent of total sales, property or payroll
Factor presence tests apply primarily to businesses that sell services or derive income from intangibles. Companies that sell tangible personal property still enjoy the protections provided by P.L. 86-272.
According to Bloomberg BNA’s “2017 Survey of State Tax Departments,” 13 states have adopted bright-line nexus standards. The latest to join the ranks are Tennessee and Alabama.
Note that many more states are casting a wider net under an economic nexus theory of which “factor presence” can be thought of as a subset. Under this theory, the mere act of exploiting a state’s marketplace or deriving monetary benefits gives it the right to require the filing of an income, franchise, net worth, gross receipts or other types of business entity return. No physical presence is required. According to the Bloomberg BNA survey, 33 states responded that they apply an economic nexus test. Wisconsin has been especially aggressive in this regard, assessing tax on advertising agencies, software companies and other businesses solely on the basis of trafficking with in-state customers.
Ten states in the survey indicated that they apply a physical presence test. States in this group include Delaware, Hawaii, Nebraska, New Mexico, Oklahoma and Rhode Island.
Taxpayers, it seems, face long odds when attempting to fend off state nexus attacks. They won a small victory recently in California. The Franchise Tax Board announced it will accept the ruling in Swart Enterprises, Inc. v. Franchise Tax Board, Court of Appeals of California Fifth District No. F070922, Jan. 12, 2017. In Swart, the court held that ownership of 0.2 percent in a limited liability company (LLC) by a corporation did not constitute doing business and require the payment of the $800 minimum tax. The corporation did not participate in the management of the LLC which operated an investment fund in the state.
Market-based sourcing of receipts from services
The movement by states away from cost-of-performance sales apportionment sourcing to market-based sourcing has accelerated. Tennessee will put market sourcing in place for tax years beginning on or after July 21, 2017. Montana adopted market sourcing for tax years beginning on or after Jan. 1, 2018. They will join the more than 20 states that require or permit the sourcing of sales for income tax purposes under various market-based approaches.
Certain states like California, Michigan and Pennsylvania use both market-based sourcing rules and cost-of-performance rules depending on the type of tax imposed on the entity (personal income tax or corporate income tax).
Market-based sourcing is also in use by states, including Nevada, Ohio and Washington, which impose nonincome business entity taxes.
Statute guidance on how to apply market-based sourcing rules ranges from little but the statutes to fairly extensive administrative rules, e.g., California. In addition, many businesses that render services or deal in intangibles have accounting systems that allow them to determine where their customers receive the benefit of their services or using intangible assets. Compliance can be exceedingly difficult as a result.
With the rise of aggressive nexus standards, it is more important than ever to carefully analyze revenue streams, develop an appropriate methodology and understand the available legal authority for sourcing receipts under market-based sourcing.
Business and nonbusiness income
Business and nonbusiness income classification questions continue to bedevil taxpayers. States assert jurisdiction to tax 100 percent of gains from the major capital transactions, e.g., IRC section 338(h)(10) deemed asset sale, disposal of a partnership interest as allocable nonbusiness income, when it is to their benefit, generally when the taxpayer is a resident of their state or the underlying business is based in their state. Yet, the same income is seen as apportionable income from a unitary business when the underlying assets or taxpayer does not reside within their borders.
The Oklahoma Tax Commission ruled that gains from the sales of S corporation stock pursuant to an IRC section 338(h)(10) election constituted apportionable business income. The gains, including the amount attributable to goodwill, arose from assets used in conducting a unitary business.
A different conclusion was reached by a New Jersey court in Xylem Dewatering Solutions Inc. v. Director, Div. of Taxation, Tax Court of New Jersey, Dkt./Court: 011704-2015, April 7, 2017. The court held that income from the deemed sale of assets by the owner of S corporation stock had to be sourced to New Jersey because the corporation was domiciled in the state. New Jersey subsequently changed the statute that applied during the year at issue such that IRC section 338(h)(10) income would now most likely be treated as apportionable business income.
Bloomberg BNA cast a glance at this issue in its 2017 survey. Twenty-eight states noted they would impose state taxes on gains realized on the disposition of a limited interest in a pass-through entity held by a corporation where the entity was doing business in their state. The number of states taking this position declined to 19 when the pass-through entity interest is held by an individual. When a state classifies such a gain as business income, further controversy can arise with respect to apportionment. Some states attempt to apportion the gain from the pass-through entity interest using the entity’s factors while other states like Illinois rely on the owner’s apportionment factors.
Retroactive tax legislation
States won a significant legal victory on May 22, 2017, when the U.S. Supreme Court refused to hear seven cases involving their power to retroactively change tax laws to deny relief to taxpayers. As a result, states appear to be able to correct prior-year statutory flaws and overturn unfavorable tax decisions made by their own judiciaries. This result has been to deny valid refund claims where state law initially supported the taxpayer’s position.
In Dot Foods, Inc. v. Wash. Dep’t of Revenue, U.S., No. 16-308, the taxpayer argued that a retroactive amendment restricting a business and occupation tax exemption violated the due process clause of the U.S. Constitution. Washington’s Supreme Court upheld the law change denying benefits to Dot Foods.
The other six cases came to the Supreme Court from Michigan and involved that state’s retroactive repeal of conformity to the Multistate Tax Compact. The language of the compact authorized taxpayers to elect for Michigan Business Tax (MBT) purposes three-factor apportionment based on the equally weighted property, payroll and sales ratios. For many companies, the election yielded significant tax savings relative to the single-sales-factor method prescribed by Michigan’s apportionment statute.
After a series of state court cases produced mixed decisions on whether the compact’s elective apportionment was allowable, the Michigan legislature took action in 2014. It amended the MBT statutes to require use of the single-sales-factor formula retroactive to the imposition date of the tax, Jan.1, 2008.
A number of large taxpayers challenged the 2014 law change. When it was upheld by the state Supreme Court, IBM, Gillette, Goodyear, DirecTV, Skadden and Sonoco pursued the issue in federal courts. Their appeals, however, will not be adjudicated after the U.S. Supreme Court’s denial of certiorari.
The long-term impact of the Supreme Court’s decision is being debated by legal scholars, businesses and state tax officials. It is not clear that the court approves of Washington and Michigan’s retroactive law changes. However, it reinforces the view held by many that the court is reluctant to intervene in state tax matters. It also leaves the impression that states can amend their tax codes to resolve prior-year disputes in their favor with few limitations to protect taxpayers. This will likely have a chilling effect on taxpayers considering litigating state tax disputes in the future.
State transfer pricing
Transfer pricing remains a concern for states and businesses. A case arising in Utah illustrates that a proper transfer pricing study is key to sustaining state tax planning strategies. In See’s Candies, Inc. v. Auditing Div. of the Utah State Tax Comm’n, Utah Dist. Ct., no. 140401556, Oct. 6, 2016, a state district court upheld a royalty deduction paid by the taxpayer to an affiliate organized as an insurance company. The taxpayer exchanged certain intellectual properties for the stock of a third related company. The Utah State Tax Commission sought to disallow a royalty deduction to the taxpayer because the royalty income was not taxable to the insurance company under the state’s franchise tax. As an insurer domiciled outside of Utah, it was only subject to a tax on the premium income received from in-state insured parties.
The district court held that Utah’s statute allowing the tax commission to reallocate gross income and deductions and losses between two or more related parties is virtually identical to the language contained in IRC section 482. As a result, the commission could not ignore the use of comparable “arm’s-length” transfer prices between uncontrolled businesses. The court held that the taxpayer’s transfer pricing study was reliable with respect to the royalty payments although the deductible amount was reduced to reflect the lower end of the arm’s-length price range. The commission argued unsuccessfully that the Utah reallocation statute was not linked to IRC section 482 and, therefore, it could disallow the royalty deductions in their entirety without the need for a transfer pricing analysis.
Transfer pricing may take on even greater importance if the U.S. moves to a “territorial” corporate tax regime as opposed to the “worldwide” approach that it now uses. Given that most states rely on some measure of federal taxable income as the starting point for their corporate income and franchise taxes, a change of this magnitude will certainly have an impact. A territorial system will be even more reliant on transfer pricing studies than is currently the case. As states have begun to demonstrate, they are not necessarily content to cede all transfer-pricing matters to the IRS.
We noted in our 2016 year-end tax planning letter that the Multistate Tax Commission proposed and approved a state arm’s-length pricing program. The rationale for the program was to provide training to state revenue officials with the idea of beginning transfer pricing audits in the near future. Impatience with the IRS and the European Economic Community in their efforts to rein in perceived international tax avoidance (base erosion and profit shifting) was a major source of motivation.
However, the MTC delayed the implementation date of its transfer pricing program after a somewhat lukewarm reception among its membership. The MTC is working to reformulate it with the hope of generating more interest. A move to a federal territorial corporate tax system and the restraints placed by the Trump administration on the IRS rulemaking could aid the MTC in this regard.
Another option open to states would be to adopt a system of worldwide combined reporting similar to California’s. To the extent that their fears regarding transfer pricing are not addressed, some adopting states might forgo a “water’s-edge election” allowing multinational unitary to groups to exclude their non-U.S. affiliates from their combined report.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
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