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In-Depth Coverage of Issues Surrounding State and Local Tax
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In-Depth Coverage of Issues Surrounding State and Local Tax
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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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State Revenue Departments Misapplying Federal Tax Law

by | Sep 9, 2014 | , , , , , ,

State income tax laws generally build on federal tax law.  The typical pattern is to begin the calculation of state taxable income with federal taxable income and then to modify it by adding or subtracting items where state tax policies differ from federal tax policies.  As a result, a corporation’s state taxable income can be affected by the application of the federal Internal Revenue Code.  State revenue departments generally do not consider themselves bound by Internal Revenue Service determinations respecting the application of federal tax law and believe that they are free to interpret the Internal Revenue Code as they see fit.  Unfortunately, this has led to problems because state tax auditors often are not well trained in federal tax principles.  We had an instance earlier this year in which an auditor claimed that the merger of a wholly-owned subsidiary into its corporate parent was taxable because there was an increase in the parent’s retained earnings.  The merger was a plain vanilla tax-free liquidation under Sections 332 and 337 of the Internal Revenue Code (there was no intercompany debt and the subsidiary was clearly solvent), but sending copies of these provisions to the auditor left him unmoved.  We finally got him to back down by showing that the parent’s increase in retained earnings was matched by a decrease in the subsidiary’s retained earnings so that there was no overall increase.  As we explained to the client, a win is a win, even if for the wrong reasons.  Nevertheless, if the auditor had been properly versed in the most basic federal corporate tax principles, this exercise would not have been necessary.

Two recent decisions illustrate misapplications of federal tax law by state revenue departments.

The Idaho Tax Commission recently held that a subsidiary’s net operating loss (NOL) carryovers did not pass to its parent in a merger of the subsidiary into the parent.  The parent did not continue to operate the business of the merged subsidiary and the Commission held that “based on IRC §382, the Petitioner cannot carry the loss forward after the merger.”  Idaho State Tax Commission Ruling No. 25749 (Apr. 17, 2014).  The Commission’s statement of federal tax law is incorrect.  Section 382 of the Internal Revenue Code does not apply to a merger of a wholly-owned subsidiary into its parent.  Because of constructive ownership rules, no change in ownership is deemed to occur.  Moreover, Section 382 does not prevent an NOL from passing to the surviving company in a merger; it simply limits the extent to which the NOL can be used.  Although it is true that the limitation is zero for years in which the merged company’s business is discontinued, the NOL is not destroyed.  If the parent later sells assets received from the subsidiary that had built-in gain at the time of the merger, the loss can be used to offset the gain.

Discussions that we have had with the Commission after the decision came out indicate that the Commission had [...]

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New York ALJ Rejects Retroactive Application of Statute

by | Sep 8, 2014 | , , ,

State courts generally have allowed legislatures a fair amount of flexibility in adopting retroactive statutes, but a recent New York case held that, under the circumstances presented, the retroactive application of a statute was unconstitutional.   In Matter of Jeffrey and Melissa Luizza (DTA No. 824932) (Aug. 21, 2014), Mr. Luizza agreed to sell all of the stock of an S corporation to an unrelated buyer in a transaction governed by Section 338(h)(10) of the Internal Revenue Code.  Under Section 338(h)(10), Mr. Luizza’s sale of his stock was ignored for income tax purposes and the transaction was treated as if the corporation had sold its assets and distributed the proceeds to Mr. Luizza.  Under the Subchapter S rules, the liquidation was essentially tax-free.  The corporation’s gain was passed through to Mr. Luizza as the sole shareholder.  Mr. Luizza was a nonresident of New York and under the law in effect when the sale occurred (March 2008) it appeared that a nonresident shareholder was not taxed on the gain in a 338(h)(10) sale because the transaction was treated as a sale of stock.

In 2009, the State Tax Appeals Tribunal confirmed that although a 338(h)(10) transaction was treated as a sale of assets by the corporation for federal income tax purposes, it was in fact a sale of stock and, since nonresidents are not subject to New York State income tax on gains from the sale of stock, even of a corporation doing business in New York, a nonresident selling stock of an S corporation in a 338(h)(10) transaction cannot be taxed by New York State on the resulting gain.  In Matter of Gabriel S. and Frances B. Baum, et al., (DTA Nos. 820837, 820838) (Feb. 12. 2009) (McDermott Will & Emery filed an amicus brief supporting the taxpayer’s position in that case.)

The State Department of Taxation and Finance was not happy about the result of this litigation.  It convinced the legislature to reverse that result by amending the statute to provide that a shareholder’s share of the corporation’s gain in a 338(h)(10) transaction would be treated as New York source income that was taxable to nonresidents.  The legislation was adopted in 2010 and was made effective retroactively to all years open under the statute of limitations.

Mr. Luizza objected to the retroactive application of the statute to him, and the administrative law judge agreed that, on his facts, the retroactivity was so harsh as to be unconstitutional under the Due Process Clause of the United States Constitution.  The ALJ pointed out that the taxpayer relied on the law as it existed in 2008 and that at the time of the sale the prevailing authority was that the transaction was not taxable.  Mr. Luizza was advised by his tax advisors that there would be no additional New York tax due.  Because of his reliance, he did not have an opportunity to seek a higher sale price or to require the buyer to indemnify him for any additional taxes resulting from [...]

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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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Connecticut Hires Chainbridge Software LLC for Transfer Pricing Training

by and | Aug 21, 2014 | , , , ,

On July 15, 2014, the Connecticut Department of Revenue Services awarded Chainbridge Software LLC a contract worth $50,000 for on-site and remotely supported training for transfer pricing audits.  Chainbridge is infamous for being the contract auditor hired by the District of Columbia Office of Tax and Revenue to manufacture transfer pricing-based assessments.  In 2012, the District of Columbia Office of Administrative Hearings denounced Chainbridge’s methodology in Microsoft Corp. v. Office of Tax and Revenue.  Numerous other cases are in litigation following D.C.’s refusal to abide by that decision.

We have reviewed the Connecticut request for proposal drafted by the Department of Revenue Services.  While we do not yet have access to the final contract, it will likely be similar to the request for proposal.  The solicitation requests two to three days of training per week over the course of three months.  According to the RFP, Chainbridge will teach the Department’s employees about transfer pricing principles and methodologies, taxpayer planning, economic analysis of transactions between related parties, pre- and post-audit planning, and other related topics.

In light of the Connecticut Department of Revenue Services’ expected contract with Chainbridge, we anticipate that the Department will become more active in evaluating transfer pricing.  What is not certain is whether the analysis will follow the debunked method still being used in D.C.



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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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New York Corporate Tax Reform: Benefits (and Burdens?) for Qualified New York Manufacturers

by | Aug 7, 2014 | , ,

Earlier this year, New York enacted sweeping corporate tax reform that included a number of special benefits for qualified New York manufacturers.  (For a discussion of this corporate tax reform, see our Special Report.)  Unlike most of the corporate tax reform amendments (which are generally effective for tax years beginning on or after January 1, 2015), some of the benefits for qualified New York manufacturers are effective immediately for tax years beginning on or after January 1, 2014.

The new benefits available to qualified New York manufacturers are:

  1. A 0 percent tax rate for purposes of computing tax on the entire net income base (for 2014) or the business income base (for 2015 and later);
  2. New reduced tax rates for purposes of computing tax on the capital base (with the capital base tax to be fully phased out for all taxpayers by 2021)
    • Retention of the $350,000 cap on the capital base tax (while the cap was increased to  $5 million for other taxpayers);
  3. Lower fixed dollar minimum tax rates; and
  4. A refundable real property tax credit equal to 20 percent of the real property tax paid during the taxable year on property owned (and in some cases leased) by the taxpayer and principally used in manufacturing.

A corporation or a combined group is a “qualified New York manufacturer” if (1) more than 50 percent of the taxpayer’s or combined group’s gross receipts are from qualifying activities (e.g., manufacturing, processing or assembling) and (2) it has property meeting the Investment Tax Credit (ITC) requirements located in New York State with a basis of at least $1 million.  A taxpayer, or combined group, that fails the receipts test may still be a qualified New York manufacturer if it has at least 2,500 New York manufacturing employees and at least $100 million of manufacturing property in New York.

Notwithstanding these tax benefits, the Department’s recently released FAQs highlight a potential negative financial statement consequence for taxpayers with significant deferred tax assets, including New York net operating loss carryforwards.  In the FAQs, the Department confirms that the value of the prior net operation loss conversion subtraction for a qualified New York manufacturer “is $0 due to the 0 % ENI rate.”  In other words, a qualified New York manufacturer cannot carry forward or use its existing net operating loss carryforwards in future years, which may result in negative financial statement consequences.

Qualified New York manufacturers with significant New York credit carryforwards may also suffer a financial statement impact, but the forecast is not as bleak.  They may still have the ability to apply most unused credits against the capital base tax (until it is fully phased out).

Stay tuned for additional guidance regarding qualified New York manufacturers.  The Department is preparing a technical memorandum regarding qualified New York manufacturers that is expected to be released by the end of this year.



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Favorable Ruling: HMOs Not Taxable Under New York City General Corporation Tax

by | Jul 28, 2014 | , ,

A New York City Tax Appeals Tribunal Administrative Law Judge (ALJ) recently ruled in favor of Aetna, Inc. (Aetna) on the question of whether a health maintenance organization (HMO) was “doing an insurance business” in New York State, thereby exempting it from the New York City General Corporation Tax (GCT).  In Matter of Aetna, Inc., the ALJ determined that the HMO at issue was “doing an insurance business” in New York because insurance risk was present in contracts covering the members of the HMO, the members of the HMO spread the risk of loss due to unforeseen medical expenses to the HMO and the HMO was subject to significant regulation under New York State Insurance Law and Public Health Law.  Aetna Health, Inc. (Health), a subsidiary of Aetna, qualified as an HMO under Article 44 of the New York State Public Health Law.  Though the New York City Department of Finance (Department) argued that HMOs were subject to the GCT because they do not conduct insurance business, the ALJ engaged in a thorough examination of federal and New York State authorities on HMOs and concluded that Health was doing an insurance business in New York.  Of particular note, the ALJ, relying on the United States Supreme Court decision in Rush Prudential HMO v. Moran, noted that HMOs could be (and were) “both insurer[s] and corporation[s] which arrange[] for the provision of medical services.”  The Department has 30 days from the determination date to file an appeal.

McDermott is pleased to have represented Aetna, Inc. in this favorable ruling.   If you have any questions regarding this determination and its past, present, and future impact on your company, please contact a member of the McDermott State and Local Tax group.  For more please see McDermott’s On the Subject regarding this case.



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Was It Wirth It? The Pennsylvania Supreme Court Sets a Low Bar for Minimum Contacts

by and | Jul 28, 2014 | , , ,

In Wirth v. Commonwealth, the Supreme Court of Pennsylvania held that Pennsylvania personal income tax applied to non-resident limited partners whose only connection with the state was the ownership of a small interest in a partnership that owned Pennsylvania property.  This ruling has weakened the effectiveness of the Due Process Clause as a defense against Pennsylvania taxation.

In 1984 and 1985, the non-resident appellants purchased interests in a Connecticut limited partnership organized solely for the purchase and management of a skyscraper located in Pittsburgh.  The appellants each owned between one-quarter of a unit to one unit of the partnership.  One unit equated to a 0.151281 percent interest.  The opinion does not indicate whether any of the numerous non-appellant partners owned significantly larger shares.  Further, all of the appellants were only passive investors and did not take “an active role in managing the [p]roperty.”  After 20 years of losses, the lender foreclosed on the property.  The appellants lost their entire investments, but the partnership reported a gain on its tax filings consisting of the unpaid balance of the nonrecourse note’s principal and the accrued interest, totaling $2,628,491,551.  As a result, the Pennsylvania Department of Revenue assessed personal income tax against the appellants, plus interest and penalties.

The appellants argued that the Commerce and Due Process Clauses prohibited the imposition of the Pennsylvania personal income tax on them.  The court did not determine whether the Commerce Clause bars the imposition of the personal income tax on these non-residents because the appellants waived this defense by not sufficiently distinguishing between the Commerce Clause and Due Process Clause arguments.

The court did reach a decision on whether the Due Process Clause would bar relief and held that the limited interest in the partnership amounted to minimum contacts with Pennsylvania.  The court agreed with the Department, which argued that the appellants’ interests, while limited, were “hardly passive” because of the large amount of money invested by each appellant, the extensive lifespan of the partnership and the partnership’s ownership of the Pennsylvania skyscraper.  (Interestingly, this statement from the court’s opinion echoes the Department’s brief; however, the Department instead describes the appellants’ actions as passive “on a technical level” and describes the appellants’ involvement with the partnership as “hardly trivial.”  The Department’s statement works to clear up confusion as to how an interest that is, by definition, passive  could not be passive, but does raise the question as to why the court would opt to affirmatively state that the appellants’ involvement was “hardly passive.”)  The court was also particularly concerned by the fact that had the appellants not had minimum contacts with Pennsylvania, any income earned by the appellants would escape Pennsylvania tax.

Practice Note: This case does not mean that other non-resident limited partners should accept Pennsylvania taxation.  Because the appellants did not adequately argue the Commerce Clause issues, this line of argument remains viable.  Further, the court’s concern with the possibility that income related to Pennsylvania property could escape Pennsylvania tax should be a question [...]

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New York Releases Corporate Tax Reform FAQs

by | Jul 25, 2014 | , , , ,

Earlier this year, New York enacted sweeping corporate tax reform, generally effective for tax years beginning on or after January 1, 2015, including a new economic nexus standard, changes to New York’s combined reporting regime, changes to the tax base and traditional New York income classifications, changes to the receipts factor computation, and changes to the net operating loss calculation and certain tax credits and incentives.  (For a more detailed discussion of these changes, see our Special Report.

While this corporate reform is quite comprehensive, a number of open issues remain so taxpayers and practitioners have been eagerly awaiting additional guidance from the Department of Taxation and Finance.  As a first step in providing that much-needed guidance, the Department has released its first set of responses to frequently asked questions on a new “Corporate Tax Reform FAQs” section of its website.  Most notably, the responses clarify that the non-unitary presumption based on less than 20 percent stock ownership for purposes of determining exempt investment income is a rebuttable presumption.  The responses also clarify that the business capital base includes items of capital that generate exempt income.  Other topics addressed include economic nexus, credits, the Metropolitan Transportation Business Tax (MTA surcharge) and net operating losses.

The Department plans to update the Corporate Tax Reform FAQs on an ongoing basis as it continues to receive questions from taxpayers and practitioners, which can be submitted on the Department’s website.  We will be submitting questions and comments and can do so on behalf of companies that do not want to be identified.  The Department is also in the process of revising its current regulations (which are expected to be released before the end of 2015) and plans to issue two technical memoranda in the interim, one discussing qualified New York manufacturers and one discussing the new expense attribution rules.  Stay tuned for updates regarding this additional guidance.



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