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Indiana Department of Revenue Rules Forced Disposition is Nonbusiness Income

by | Jan 21, 2015 | , , ,

In Letter of Finding No. 02-20140306 (Dec. 31, 2014), the Indiana Department of Revenue (Department) determined that income from the sale of two operating divisions of a business pursuant to an order of the Federal Trade Commission (FTC) was non-business income under Indiana law. Following the reasoning of the Indiana Tax Court in May Department Stores Co. v. Ind. Dep’t of State Revenue, 749 N.E.2d 651 (2001), the Department held that the gain constituted non-business income because the forced divestiture was not an integral part of the taxpayer’s business. Taxpayers facing the consequences of forced divestitures should consider whether similar positions can be taken, both in Indiana and in other Uniform Division of Income for Tax Purposes Act (UDITPA) jurisdictions.

Like many states that base their income apportionment provisions on UDITPA, Indiana defines “non-business income” as all income that is not business income. Indiana employs both the “functional test” and the “transactional test” to determine if a particular item of income qualifies as “business income.” Income may qualify as business income under either test; it is not required that both tests be met.

The functional test considers whether the income derives from the acquisition, management or disposition of property constituting an integral part of the taxpayer’s regular trade or business. Simply put, if a piece of property is used in the taxpayer’s regular course of business, a transaction involving that property will often result in business income. The transactional test, meanwhile, considers whether the income derives from a transaction or activity in which the taxpayer regularly engages.

In the Letter of Finding, the Department considered a taxpayer that sought to acquire, by merger, one of its competitors (“Target”), which consisted of four primary business divisions. The taxpayer and Target were part of a concentrated industry with very few competitors, so the acquisition created antitrust concerns. The taxpayer and Target sought advice from the FTC, which ordered that two of Target’s divisions be sold to a competitor if the merger were to take place. The taxpayer and Target complied with the FTC’s order, and Target sold the divisions to a competitor in 2006, prior to the merger. It classified its resulting income as non-business income. On audit, the Department reclassified the Target’s gain as business income, reducing the taxpayer’s Indiana net operating losses available for use in 2008-2010. The taxpayer appealed.

In examining the transaction, the Department first noted that the income from the sale of the divisions could not meet the transactional test because Target did not engage in the regular sale of business divisions. The Department then turned to the functional test. Arguably, the sale of the two operational business divisions should have resulted in business income because the divisions were used in the regular course of Target’s business. However, the Department observed that this fact alone was not enough to meet the functional test—“[t]he disposition too must be an integral part of the taxpayer’s regular trade or business operations.” Relying [...]

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Pennsylvania Unwraps Final Market-Sourcing Guidance

by | Dec 19, 2014 | , ,

The Pennsylvania Department of Revenue (the Department) recently finalized its Information Notice on sourcing of services for purposes of determining the appropriate net income and capital franchise tax apportionment factors.  The guidance also addresses the Department’s views on the sourcing of intangibles under the income producing activity test.  Since Pennsylvania is not a member of the Multistate Tax Compact, it is no surprise that the Department did not wait for the Multistate Tax Commission to complete its model market sourcing regulation before it issued its guidance.

Under the Pennsylvania statute (72 Pa. Stat. Ann. § 7401(3)(2)(a)(16.1)(C)), for tax years beginning after December 31, 2013, receipts from services are to be sourced according to the location where the service is delivered.  If the service is delivered both to a location in and outside Pennsylvania, the sale is sourced to Pennsylvania based upon the percentage of the total value of services delivered to a location in Pennsylvania.  In the case of customers who are individuals (other than sole proprietors), if the state or states of delivery cannot be determined for the customer, the service is deemed to be delivered at the customer’s billing address.  In the case of customers who are not individuals or who are sole proprietors, if the state or states of delivery cannot be determined for the customer, the service is deemed to be delivered at the location from which the service was ordered in the customer’s regular course of operations.  If the location from which the service was ordered in the customer’s regular course of operations cannot be determined, the service is deemed to be delivered at the customer’s billing address.

The statute generated more questions than it answered.  Key terms such as “delivered” and “location” were not defined.  The Department’s Information Notice provides answers to many of taxpayers’ questions.  However, unlike the draft Information Notice released in June 2014, the final Information Notice shies away from providing a succinct definition of “delivery” and resorts to defining the term through various examples.  (For our coverage of the Department’s draft Information Notice, click here.)  However, the Information Notice does define “location” stating that “location” generally means the location of the customer and, thus, delivery to a location not representative of where the customer for the service is located does not represent completed delivery of the service.

The Information Notice is chock full of examples to guide taxpayers.  The Department’s views relating to various scenarios when services are performed remotely on tangible personal property owned by customers are of interest.  If a customer ships a damaged cell phone to a repair facility that repairs and returns it, the Department deems the service to be delivered at the address of the customer.  Contrast that with a situation when a customer drops a car off for repair at a garage and later returns to pick it up.  One may conclude that the service should also be deemed to be delivered at the address of [...]

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Demystifying the Sales Factor: Conduit Receipts

by | Dec 17, 2014 | , ,

This is the sixth article in a series on the composition of the sales factor and the potential tax saving opportunities hidden within state statutes and regulations.  As more states shift to a single or more heavily weighted sales factor, it is important for taxpayers to understand the intricacies of the sales factor and the opportunities that exist in computing it.  This article will focus on issues that could arise and opportunities that may be available for conduit receipts.

Read the full article.



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Take Two: Massachusetts Department of Revenue Releases Revised Market-Based Sourcing Regulation

by | Nov 7, 2014 | , ,

Late last week, the Massachusetts Department of Revenue (the Department) released a revised draft regulation on Massachusetts’s new market-based sourcing law.  The changes made by the Department to purportedly address practitioner and taxpayer concerns were relatively modest.  The rules remain lengthy, complex and cumbersome.  There are still various assignment rules that apply to each of the following types of transactions: (1) in-person services, (2) professional services, and (3) services delivered to the customer, or through or on behalf of the customer (described in the new regulation as services delivered to the customer, on behalf of the customer, or delivered electronically through the customer, hereinafter “sales delivered to, by, or through a customer”).  For a more detailed discussion of these rules see our State Tax Notes article on market-based sourcing. 

The most noteworthy changes from the initial draft relate to the taxpayer’s ability to use a “reasonable approximation” method.  The initial draft regulation provided taxpayer’s with the ability to use a “reasonable approximation” when “the state or states of assignment” could not be determined.  The new regulation clarifies that a taxpayer must, in good faith, make a reasonable effort to apply the primary rule applicable to the sale (e.g., the specific assignment rules for in-person services, professional services, or sales to, by, or through a customer) before it may reasonably approximate.  Additionally, the regulation explicitly states that a method of reasonable approximation “must reflect an attempt to obtain the most accurate assignment of sales consistent with the regulatory standards set forth in [the regulation], rather than an attempt to lower the taxpayer’s tax liability.”  There is no guidance as to how a taxpayer would demonstrate that its reasonable approximation attempt was made to “obtain the most accurate assignment of sales.”  This raises a number of questions–for example, if a taxpayer determines that there are two equally reasonable methods by which it can reasonably approximate its Massachusetts sales, can it use the method that results in less tax?  Additionally, there does not seem to be any converse requirement that the Department make a similar demonstration (i.e., that any modifications to a taxpayer’s sourcing methodology not be an attempt to increase a taxpayer’s liability) when exercising its authority to adjust a taxpayer’s return (as discussed below).

In an attempt to make the regulation more even-handed, the Department’s revisions provide that neither a taxpayer nor the Department may adjust a “proper” method of assignment, including a method of reasonable approximation, unless it is to correct factual or calculation errors.  However, the revision isn’t all that meaningful because there are still a broad number of scenarios in which the Department can make changes, one of which is when a taxpayer uses a method of approximation and the Commissioner determines that the method of approximation employed by the taxpayer is not “reasonable.”  Additionally, when a taxpayer excludes a sale from both the numerator and denominator of its sales factor because it has determined that the assignment of the sale cannot be reasonably approximated, [...]

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D.C. Bill Ostensibly Lowers Tax on Capital Gains from QHTC Investments… But How?

by , and | Oct 9, 2014 | , , , ,

On September 23, District of Columbia Council Chairman Mendelson introduced the Promoting Economic Growth and Job Creation Through Technology Act of 2014 (Bill 20-0945 , hereinafter the “Act”) at the request of Mayor Vincent Gray.  This marks the second time that the Council has considered the introduced language; it was originally included as part of the Technology Sector Enhancement Act of 2012 (Bill 19-747), but was deleted prior to enactment.  The Act would add a new provision to the D.C. Code (§ 47-1817.07a) to impose a lower tax rate on capital gains from the sale of an investment in a Qualified High Technology Company (QHTC) beginning in 2015.  The rate would be 3 percent as compared with the current rate of 9.975 percent for business taxpayers.  Notably the proposed provision is limited in scope and only applies when the following three elements are satisfied:

  1. The investment was held by the investor for at least 24 continuous months;
  2. The investment is in common or preferred stock or options of the QHTC Company; and
  3. During the taxable year, the investor disposed or exchanged of some or all of his or her investment in the QHTC.

As introduced, the proposed tax is explicitly applied “notwithstanding” any provision of the income tax statutes.

Good Thought, Poor Drafting

The intent of this legislation is clear, but the practical application is not.  As a threshold matter, the second element requires the investment to be “in common of preferred stock or options,” which by definition excludes partnerships and limited liability companies since only corporations can issue stock.  On its face, the language of the bill appears to be limited to investments in a QHTC organized as a corporation, despite the fact that other entities are eligible for QHTC status under D.C. law.  Therefore, limited partners and members investing in pass-through QHTC’s appear to fall outside the scope of the proposed legislation.

Second, by imposing a different rate on only a certain type of income and by taxing the gains notwithstanding any other provision of the income tax statute, the proposal fails to account for basic tax calculations necessary to arrive at taxable income in the District for a business taxpayer.  For example, the allocation and apportionment provisions would seem to be negated both practically and legally.   What part of a multistate taxpayer’s gain from a QHTC is subject to the 3 percent rate?  Is it all of the gain; an apportioned part of the gain – and if so, based on whose apportionment percentage?  What if the gain would have been categorized as non-business income and the taxpayer is a non-resident?  The answer is certainly not obvious from the legislation.  Similarly, how do a taxpayer’s losses, both in the current year and carried over, affect the amount of gain available to tax?  Can all of the losses be used against other types of income first?  Can the losses be used at all against the QHTC gain?

Third, how is a taxpayer [...]

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Can Taxpayers Find an Advantage in Vodafone Nowhere Income Argument?

by , and | Sep 29, 2014 | , ,

It is difficult, but not impossible (and quite satisfactory), to find a silver lining for taxpayers in the alternative apportionment opinion Vodafone Americas Holdings Inc. v. Roberts, M2013-00947-COA-R3CV, 2014 WL 2895900 (Tenn. Ct. App. June 23, 2014).  In this much discussed case, the Tennessee Court of Appeals affirmed a variance from the statutory cost of performance sourcing method for the apportionment formula on the basis that this method failed to meet the higher goal of fairly representing the business Vodafone derives from Tennessee. As part of the rationale for the variance, the Commissioner and Court of Appeals relied on the need to avoid “nowhere income.”  As long as each state has independent sovereign authority to adopt the apportionment methodology of its choice, using the risk of nowhere income as a reason to support application of discretionary authority to vary from a statutory formula is contrary to the law and policy supporting alternative apportionment authority as well as basic concepts of our federal system.  However, until this case is overturned, looking to how other states tax income is relevant in Tennessee in determining whether Tennessee’s statutory formula should be applied.  The horse has left the hen house and taxpayers should take advantage of this.  Specifically, if a taxpayer finds that, based on the existing statutory formulas, its receipts are included in the numerator of both Tennessee and another state, the taxpayer should seek relief to remove these receipts from the Tennessee numerator.  This avoids the double taxation burden that is the flip side of Tennessee’s nowhere income fears.

It is useful to look specifically at what the court said.  In Vodafone, the court noted that:

“Because [the Commissioner’s authority to issue a variance] applies when the statutory formula does not ‘fairly represent the extent of the taxpayer’s business activities in this  state,’ the variance can apply where the state is entitled to receive more taxes as well as a situation where the taxpayer is entitled to pay less taxes. The fact that other states do not tax the Tennessee receipts indicates that it is not unfair for Tennessee to do so.” Id. at 23.

In the accompanying footnote, the Court of Appeals notes that the goal of UDITPA (the model statute which Tennessee’s variance statute is based) is to ensure that no more than 100 percent of a businesses’ corporate income is subject to tax in all jurisdictions and positing that “[t]axing otherwise untaxed income does not run afoul of this goal.” Id. at fn. 20.

Thus, in the same paragraph, the court both acknowledges that the variance should equally be used to reduce Tennessee taxes when appropriate and uses a reference to whether other states tax the Tennessee receipts as a relevant benchmark.

As of the drafting of this post, Vodafone is in the process of seeking review of the decision by the Tennessee Supreme Court. Assuming the decision of the Court of Appeals is precedential going forward, taxpayers in Tennessee should consider holding the Commissioner to his [...]

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How Will Michigan Courts Analyze a Legal Challenge to the Michigan Legislature’s Retroactive Repeal of the Multistate Tax Compact?

by | Sep 18, 2014 | , , , ,

In recent days, the state tax world has focused on the State of Michigan’s retroactive repeal of the Multistate Tax Compact (Compact).  Last week, the Michigan Legislature passed and Governor Snyder signed into law a bill (P.A. 282) that nullifies the effect of the state Supreme Court’s July 14, 2014 decision in International Business Machines v. Dep’t of Treasury, Dkt.  No. 146440.  In IBM, the state Supreme Court held that IBM may apportion its business income tax base and modified gross receipts tax base under the Michigan Business Tax (MBT) using the three-factor apportionment formula provided in the Compact, rather than the sales-factor apportionment formula provided by the MBT. Reflective of the urgency with which he views the situation, Michigan’s Governor Snyder signed the bill into law within twenty-four hours after its passage, with a statement that the state’s actions were an effort to ensure that “Michigan businesses are not penalized for investing in the State.”  The Michigan Department of Treasury (MDOT) made no attempt to sugar coat its statements in language that would reflect support for Michigan business interests.  Rather, it loudly proclaimed that the Legislature must act because the revenue impact to the State of the IBM decision was $1.1 billion.

The new law repeals L. 1969, P.A. 343, which enacted the Compact, retroactive to January 1, 2008, allegedly in order to express the original intent of the legislature regarding the application of M.C.L.A. §208.1403 of the MBT.  (Section 208.1403 specifies that a multistate taxpayer must apportion its tax base to Michigan using the sales factor.)  The law goes on to provide that the Legislature’s original “intended effect” of §208.1403 was to eliminate the ability for taxpayers to use the  Compact’s three factor apportionment election provision in computing their MBT, and to “clarify” that the election provision included in the Compact is not available to the Michigan Income Tax Act, which replaced the MBT in 2012.

The actions of the state are perhaps not surprising, given MDOT’s revenue estimate and the number of related claims (more than 130) that are reported to be pending before MDOT and/or the Michigan courts on this issue.  Earlier this week, the Michigan Court of Appeals issued an unpublished decision holding that the IBM ruling was dispositive on the issue of whether Lorillard Tobacco Company could elect to use a three-factor apportionment formula in computing its MBT for 2008 and 2009.  Lorillard Tobacco Co. v. Dep’t of Treasury, No. 313256 (Sept. 16, 2014).  Critics of the new law make strong arguments about the unfairness of the state’s recent actions, and tax pundits predict that the retroactivity of the law will soon be the subject of a court challenge.  What do Michigan court’s prior rulings on retroactivity teach us about how the Michigan courts are likely to address this issue?

This is not the first time in recent memory that the state has acted to retroactively repeal legislation with the potential for large, negative implications to Michigan’s revenue stream.  In General Motors Co. v. [...]

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MTC’s Market-Based Sourcing Recommendations for UDITPA: Too Little, Too Late?

by | Sep 3, 2014 | , , ,

Member states of the Multistate Tax Commission (MTC) voted to adopt proposed amendments to Article IV of the Multistate Tax Compact during their annual meeting in late July.  The proposed amendments likely to have the most widespread impact on taxpayers are the amendments to the Uniform Division of Income for Tax Purposes Act (UDITPA) Article IV section 17 sourcing rules that change the sales factor sourcing methodology for services and intangibles from a costs of performance (COP) method to a market-based sourcing method. 

The MTC’s recommended market approach provides that sales of services and intangibles “are in [the] State if the taxpayer’s market for the sales is in [the] state.”  In the case of services, a taxpayer’s market for sales is in the state “if and to the extent the service is delivered to a location in the state.”  The proposed amendments also provide that if the state of delivery cannot be determined, taxpayers are permitted to use a reasonable approximation.  At this point, there is no additional guidance from the MTC on the meaning of “delivered,” how to determine the location of delivery in the event that a service is delivered to multiple jurisdictions, or what constitutes a reasonable approximation.

While the proposed amendments may be touted by some as the death knell of COP sourcing, for these changes to take effect, they will still need to be adopted individually by legislatures in Compact member states or in any other states that may choose to adopt them.  As we have seen over the last several years, many states have already forged their own paths in this area.  (See our article discussing the wide variety of market-based sourcing rules.)  Moreover, while many states have enacted market-based sourcing provisions with respect to the sale of services, certain states, unlike the MTC proposed amendments, have declined to convert to market-based sourcing for intangibles (e.g., Pennsylvania).

The proposed amendments leave taxpayers with many unanswered questions.  For example, assume a corporate taxpayer (Corporation A) is in the business of offering a payroll processing service.  Corporation A provides this service to Corporation B.  Corporation B’s management of the contractual arrangement with Corporation A occurs in Massachusetts, which is also the location of Corporation B’s human resources function.  Corporation B has 10,000 employees, 2,000 of whom are located in a jurisdiction that has adopted the MTC’s market-based sourcing recommendation (State X).  What portion of Corporation A’s receipts from the performance of its payroll processing service for Corporation B should be sourced to State X?

One can reasonably argue that the service is delivered to Corporation B as a corporation (i.e., that the human resources function is the true beneficiary) and not individually to Corporation B’s employees—leaving State X with nothing.  However, does the MTC’s language “if and to the extent the service is delivered” create an opportunity for State X to argue that it should receive 1/5 (2,000 employees/10,000 employees) of Corporation A’s receipts?

In late August, the MTC launched a project to [...]

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Is 2015 the Beginning of Mandatory Single Sales Factor Apportionment for D.C. Taxpayers?

by and | Aug 13, 2014 | , , , , ,

On July 14, 2014, the Fiscal Year 2015 Budget Support Emergency Act of 2014 (2015 BSEA) was enacted after the D.C. Council voted to override Mayor Vincent Gray’s veto.  The act includes a tax relief package recommended by the D.C. Tax Revision Commission, and includes a change to D.C.’s apportionment formula, moving the city to single sales factor apportionment.

Since January 1, 2011, D.C. has required taxpayers to apportion their business income by the property-payroll double-weighted sales factor formula.  D.C. Code Ann. § 47-1810.02(d-1).  Among the provisions enacted in the 2015 BSEA, the District will require the apportionment of business income via a single sales factor formula, starting with tax years beginning after December 31, 2014.  D.C. Act 20-0377, § 7012(c)(10) (2014).  While the 2015 BSEA has only a temporary effect and expires on October 12, 2014, it serves as a stopgap until the process of enacting the permanent version, the Fiscal Year 2015 Budget Support Act of 2014 (2015 BSA) is completed.  (See the single sales factor apportionment provision at D.C. Bill 20-0750, § 7012(a)(10) (2014).)  The 2015 BSA has not yet been enrolled and transmitted to the mayor.  After the mayor signs the 2015 BSA or the D.C. Council overrides his veto, the 2015 BSA will be sent to Congress for review.  If Congress and the President do not enact a joint resolution disapproving of the 2015 BSA, the 2015 BSA will become law, and the switch to single sales factor apportionment will be effective as of January 1, 2015. 

Even with this legislative change, D.C. taxpayers may have an argument for apportioning their business income under the three-factor apportionment formula.  In 1981, the District adopted the Multistate Tax Compact (Compact) as 1981 D.C. Law 4-17.  The Compact provides for the use of the evenly weighted three-factor sales-property-payroll formula.  Multistate Tax Compact, art. IV, sec. 9.  The Compact permits the taxpayer to elect to apportion his business income under the city’s apportionment formula or under the Compact’s three-factor formula.  Multistate Tax Compact, art. III, sec. 1.  In 2013, D.C. repealed and reenacted the statute codifying the Compact, D.C. Code § 47-441.  However, D.C. did not re-enact Article III, Elements of Income Tax Laws, and Article IV, Division of Income.  The repeal of the two articles was effective as of July 30, 2013.  D.C. Act 20-130, §§ 7342(a), (b) (2013); D.C. Act 20-204, §§ 7342(a), (b) (2013); D.C. Law 20-61, §§ 7342(a), (b) (2013).

D.C. repealed and reenacted the Compact in reaction to litigation involving taxpayers that elected to use the three-factor apportionment formula under the Compact instead of the state-mandated apportionment formulas.  See Gillette Co. et al. v. Franchise Tax Bd., 209 Cal.App. 4th 938 (2012); Int’l Bus. Mach. Corp. v. Dep’t of Treasury, No. 146440 (Mich. Jul. 14, 2014); Health Net, Inc. v. Dep’t of Revenue, No. TC 5127 (Or. T.C. 2014).  The California Court of Appeal and Michigan Supreme Court have upheld the taxpayers’ use of the Compact election.

Following the theories being advanced in [...]

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Tax Reform in New York: Implications for Corporate America

by | Jul 17, 2014 | , , , , ,

The corporate tax reform portion of the New York State 2014–15 Budget Bill resulted in major changes for virtually all corporations—even many that are not currently New York taxpayers.  In this video (produced by SmartPros), McDermott partners Arthur Rosen, Maria Eberle, Lindsay LaCava and Leah Robinson will discuss the implications of New York State’s sweeping corporate tax reform, including changes to the Article 9-A traditional nexus standards, the combined reporting provisions, the composition of the tax bases and computation of tax, the apportionment provisions and the net operating loss calculation.

For more information on these issues, please click here for our Special Report, “Inside the New York Budget Bill: Corporate Tax Reform Enacted.”



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