The New York State Department of Taxation and Finance recently revised its Nonresident Audit Guidelines, updating the guidelines that had been in place since 2012. Included in the revised guidelines are changes to the Department’s views on both domicile and statutory residency audits. Individuals and practitioners involved in residency audits should be aware that certain of the revisions are taxpayer-friendly and can be employed favorably in audits and litigation.
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.”
In Allied Domecq Spirits & Wines USA, Inc. v. Commissioner of Revenue, the Massachusetts Court of Appeals held that the parent company of a Massachusetts taxpayer could not be included in the taxpayer’s Massachusetts nexus-combined returns because the parent’s nexus with Massachusetts was a sham. Regardless of the validity of the parent’s presence in the state, an argument exists that the nexus limitation on filing combined returns as it existed during the tax years discriminated against interstate commerce in violation of the Commerce Clause.
The parent company, ADNAC, was incorporated in Delaware and headquartered in Canada. ADNAC carried substantial losses. Beginning in August 1996, ADNAC engaged in activities to create a Massachusetts presence, such as reimbursing an affiliate with Massachusetts nexus for the salaries of insurance and tax employees and renting Massachusetts office space from the affiliate to house the employees. Further, ADNAC’s Massachusetts’ affiliate transferred three internal audit department employees working in Massachusetts to ADNAC. For the years in question, 1996 – 2004, Massachusetts required corporations to have in-state nexus in order to file combined reports and share losses with affiliated entities. Mass. Gen. Laws ch. 63, § 32B. As a result of these transactions, the taxpayer believed ADNAC had established nexus with Massachusetts and included ADNAC in its Massachusetts combined returns.
The Massachusetts Court of Appeals held that, because of the sham transaction doctrine, ADNAC did not have nexus with Massachusetts for tax purposes and could not file on a combined basis in the state. The court ruled, in part, that the transactions involving insurance and tax employees were shams because two memos developed by the taxpayer’s tax department described the plan as a “state tax planning project,” indicated the favorable tax consequences of the transaction, and stated that the plan would have “no impact to the management results.” The court viewed these communications as the taxpayer admitting that the transactions involving tax and insurance employees were conceived of entirely for tax planning purposes and for no business purpose. While the court could not point to any documents stating a tax purpose behind the movement of the internal audit department employees to Massachusetts, the court decided that because no contemporaneous records indicated a business motivation, the court would grant the use of the sham transaction doctrine.
Practice Note: The taxpayer did not argue that Massachusetts’ requirement of in-state nexus to file on a combined basis discriminated against interstate commerce and violated the Commerce Clause. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). Allied Domecq is similar to USX Corporation v. Revenue Cabinet, Kentucky, in which a Kentucky Circuit Court declared that a provision of Kentucky’s capital stock tax that limited to domestic corporations the ability to file on a combined basis or exclude investments in subsidiaries from its tax base discriminated against interstate commerce. USX Corp. v. Revenue Cabinet, No. 91-CI-01864 (Ky. Cir. Ct. 1992); see also Hellerstein & Hellerstein, State Taxation 4.14[3][j] (Thomson Reuters/Tax & Accounting, 3rd ed. 2001 & Supp. 2014-1). The court held [...]
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On June 10, 2014, the Supreme Court of the United States distributed three state and local tax cases for a conference to be held on June 26, 2014: Equifax, Inc. v. Mississippi Department of Revenue, Direct Marketing Association v. Brohl, and Alabama Department of Revenue v. CSX Transportation, Inc. The Supreme Court previously agreed to hear Comptroller of the Treasury v. Wynne and determine whether Maryland’s disallowance of a credit against its county income tax for taxes paid to other jurisdictions violated the Commerce Clause. We are eager to see if the Court will opt to hear the remaining three cases, clarifying answers to questions in the world of state taxation.
The taxpayer in Equifax filed a petition for a writ of certiorari on February 19, 2014, appealing a decision by the Mississippi Supreme Court. The state court upheld the Mississippi Department of Revenue’s application of market-based sourcing as an alternative apportionment formula instead of the statutory cost-of-performance sourcing for apportioning the income of Equifax, a credit reporting company. In making this determination, the court required the Mississippi chancery courts to use a highly deferential standard of review. The Institute for Professionals in Taxation, the Georgia Chamber of Commerce and the Council On State Taxation filed amicus curiae briefs.
The Direct Marketing Association filed a petition for a writ of certiorari on February 25, 2014. The Direct Marketing Association seeks review of a decision by the U.S. Court of Appeals for the Tenth Circuit that held that the Tax Injunction Act barred federal court jurisdiction over the Direct Marketing Association’s challenge to a Colorado sales and use tax reporting law. The law requires remote sellers that do not collect Colorado sales or use tax and have total annual gross sales in Colorado of $100,000 or more to inform the customer at the time of sale of the customer’s use tax obligation, to send annual notices to customers who purchased $500 or more in goods from the seller and to file a report with the state regarding a customer’s total purchases. An amicus curiae brief was filed by the Council On State Taxation. If the Supreme Court were to hear Direct Marketing Association v. Brohl, it would likely clarify the holding of Hibbs v. Winn to better clarify the scope of the TIA’s protection.
On October 30, 2013, the Alabama Department of Revenue filed a petition for a writ of certiorari in CSX Transportation. The Alabama Department of Revenue is challenging the U.S. Court of Appeals for the Eleventh Circuit’s decision that Alabama’s sales tax on diesel fuel discriminates against rail carriers in violation of the Railroad Revitalization and Regulatory Reform Act of 1976 (4-R Act) because motor carriers and interstate water carriers are not required to pay the 4 percent sales tax. The Supreme Court had previously issued a 2011 opinion stating that the taxpayer could challenge sales and use taxes under the 4-R Act, but the Supreme Court remanded the case to determine whether the tax was discriminatory. Amicus [...]
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The Pennsylvania Department of Revenue (PA Department) released a draft Information Notice containing guidance on how to source services under Pennsylvania’s new market-based sourcing scheme for tax years beginning after December 31, 2013. 72 Pa. Stat. Ann. § 7401(3)(2)(a)(16.1)(C). By statute, service receipts are sourced to Pennsylvania if the service is delivered to a location in Pennsylvania. If the service is delivered both to a location in and outside Pennsylvania, the sale is sourced to Pennsylvania based upon the portion of the total value of the service 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 other customers (e.g., corporations), 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.
Despite the new statutory scheme, taxpayers have been wondering exactly what “delivery” of a service to a Pennsylvania location means. The draft Information Notice released by the PA Department on June 16, 2014, attempts to answer that question.
According to the PA Department, delivery occurs “at a location where a person or entity may use the service.” The PA Department believes that this definition eliminates those parties that simply pay for the service (but do not actually use it) or other intermediaries. The PA Department’s view is that the statute’s use of billing address (for individual customers) and location of purchase or billing address (for corporate customers) are mere “defaults”—neither of which may represent the true marketplace for the service and should only be used as a last resort.
The PA Department’s guidance also addresses delivery in the context of electronically delivered services, stating that delivery may be established through IP address records or other network data. Interestingly, the PA Department’s guidance also provides that delivery of certain electronic data services to “the cloud” or other data storage device does not constitute delivery of those services—because those locations are not considered to be the locations of the user.
While the PA Department’s guidance provides some clarity it also exemplifies the ever divergent market sourcing regimes. See our article discussing the wide variety of market-based sourcing rules. For example, the PA Department draft guidance contains the following example:
Taxpayer is a provider of third-party payroll processing services for Company A. Half of Company A’s employees are located in PA and half are located in New York. Company A’s headquarters and human resources functions are located in PA. Taxpayer sources all of the payroll services to PA. Note in this example that payroll [...]
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Separate return state addback statutes, such as the Virginia addback statute, can overreach to produce an unfair and potentially unconstitutional overstatement of income assigned to the state. Recently Virginia amended its addback statute retroactively 10 years to taxable years beginning on or after January 1, 2004. The legislation is intended to codify an administrative interpretation that significantly limited an addback exception to the extent the income received by a related member is subject to taxes based on net income or capital imposed by Virginia, another state, or a foreign government with a comprehensive tax treaty with the United States (H.B. 5001, enacted April 1, 2004). The legislation limits the subject-to-tax exception so that it applies only on a post-apportionment basis, as illustrated in two rulings of the Commissioner, Ruling 07-153 (Oct 2, 2007) and Ruling 13-140 (July 19, 2013).
Taxpayers, in particular taxpayers that have a significant presence in unitary tax states, should not blindly add back legitimate business expenses to income where the result would be an overstatement of income. Consider this common situation as an example: a parent corporation, a manufacturer of high-tech products, pays a royalty for technology licensed to it by an R&D subsidiary. The R&D subsidiary is based in California, a combined report state. The parent corporation has $1,000 in gross receipts, pays $200 in royalties to R&D subsidiary, has $600 of other expenses and a net income of $200. The R&D subsidiary has gross receipts of the $200 in royalties, deductions for R&D expenses of $100 and a net income of $100. Together the federal consolidated income of the two entities (as well as GAAP income) is $300. The R&D subsidiary conducts R&D activities in California and in many foreign countries (some with U.S. tax treaties, some without) and has taxable nexus in one separate return state to which it apportions 1 percent of its net income of $100. Here is how Virginia applies its addback statute: Virginia adds the $200 royalty paid to the R&D subsidiary to the parent corporation’s income, but excepts from the addback 1 percent of the royalty, or $2, to reflect the separate return state. No exception from the addback is provided for the portion of the royalty apportioned to California. Thus, the parent corporation’s taxable income in Virginia is $398, an amount almost equal to the combined net income of the parent and the subsidiary, plus the bona fide amounts paid by the subsidiary in R&D expenses.
Taxpayers should carefully examine returns filed in addback statute states to see if they fail a sanity test, like the result in the hypothetical example. If the State Department of Revenue doesn’t agree to rational exceptions to the expense disallowance, there are multiple grounds for challenge in the courts.
Plain Meaning of the Statute
A typical addback statute provides an exception when the related member is subject to tax on net income in that state, another state, or a foreign government with a comprehensive tax treaty with the United States. Where the [...]
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The Supreme Court granted the petition for certiorari filed by the Maryland Comptroller of Treasury in Comptroller v. Wynne, Dkt. No. 13-485 (U.S. Sup. Ct., cert. granted May 27, 2014). The central issue in Wynne is whether a state must allow its residents a credit for income taxes paid to other states, in a manner sufficient to prevent double taxation of income from interstate commerce, to avoid violating the fair apportionment and discrimination prongs of the dormant Commerce Clause.
Like most states, Maryland taxes its residents on their entire income, wherever earned, and permits a credit for income tax paid to other states, limited to the amount of Maryland tax on the income taxed by other states. But Maryland’s income tax includes both a state and a county tax component, and Maryland permitted a credit for taxes paid to other states only with respect to its state income tax. The state rate was 4.75 percent and the county tax rate applicable to the Wynnes was 3.2 percent (which could vary by county). The county tax was imposed and administered by the state on the same tax base as the state income tax, and residents file a single return that reflects both state and county income taxes. Thus, Maryland provided a credit only against the Maryland state income tax, but not the substantial county income tax, on the income taxed by other states, resulting in a form of double taxation of that income (i.e., by the other state and by the Maryland county).
The Wynnes reported substantial income on their 2006 individual return from business activities in interstate commerce. They owned 2.4 percent of an S corporation doing business in 39 states, and paid income tax to most of those states on the income that flowed through to their individual return. The Wynnes reported $2.7 million of income and $126,636 of Maryland state income tax (not including the county income tax portion) prior to credits, and claimed a credit of $84,550 for taxes paid to other states. The Maryland Comptroller permitted the Wynnes to claim a credit against the state income tax, but not the county portion of the income tax, for taxes paid to other states. Maryland’s highest court, the Court of Appeals, agreed with the Wynnes that they suffered double taxation of the income in violation of the dormant Commerce Clause doctrine that taxation of multistate business requires fair apportionment and no discrimination against interstate commerce, citing Complete Auto Transit v. Brady, 430 U.S. 274 (1977) and other Supreme Court cases.
In its petition for certiorari, the Maryland Comptroller relied upon settled Due Process doctrine that states have plenary power to tax all of the income of their residents. The Comptroller’s petition essentially ignored the Commerce Clause issues raised by the Maryland Court of Appeals.
The U.S. solicitor general filed an amicus curiae brief supporting the Maryland Comptroller’s position, recognizing the different standards imposed by the Due Process Clause and the Commerce Clause but nonetheless contending that the longstanding [...]
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On May 28, 2014, the Tax Policy Subcommittees of the Illinois General Assembly’s Joint Revenue and Finance and State Government Administration Committees (Subcommittees) issued their long-awaited Report on Findings regarding the State of Illinois (Report). The Report was generated after months of hearings and solicitation of written comments from interested parties with respect to Illinois tax rates, tax incentives and tax policy issues.
The Report is chock full of facts and figures. Unfortunately, it fails to offer much clear direction for the state, as the members of the Subcommittees were unable to agree on the majority of the issues considered. For example, the Report provides that the state should “continue to explore” the question of whether Illinois should apply the sales tax to services, as do many surrounding states. Similarly, the Report concludes that while most members of the Subcommittees believe that the corporate income tax rate should be reduced, they could not agree on the amount of the reduction, what corresponding cuts in state spending would offset such a reduction, or even whether the Illinois personal property replacement tax should be considered as part of the corporate income tax rate when comparing Illinois’ income tax rates to those of other states. The Report also concludes that the Subcommittees are “strongly interested” in providing sales tax exemptions to customers who provide data centers in Illinois, but has not come to a consensus about how to move forward with that process. The Subcommittees also failed to reach a consensus regarding any changes needed to the Economic Development for a Growing Economy credit, instead offering only the platitude that “it is imperative to ensure that Illinois remains competitive in today’s economy.”
The Report does, however, contain the following findings:
In what appears to be an effort to boost the state’s image in the business community, the Report also references a number of favorable statements about Illinois’ business climate that the Report attributes to various business publications. The Report touts that Illinois ranks third in corporate expansions, according to Site Selection Magazine, that Illinois was identified as among the top five states for “technology and innovation” and “infrastructure” according to CNBC Top States for Business 2013 [...]
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The FY 2015 District of Columbia Budget Request Act (BRA, Bill 20-749) is currently being reviewed by the D.C. Council after being introduced on April 3 at the request of Mayor Vincent Gray. This year’s Budget Support Act (BSA, Bill 20-750), the supplementary bill implementing changes based on the BRA, contains several significant modifications to the tax provisions of the D.C. Code. The changes include provisions recently recommended by the D.C. Tax Revision Commission (TRC), an independent body created by the Council to evaluate possible changes to tax policy in the District with a focus on broadening the tax base and providing “fairness in tax apportionment.” In particular, the BSA proposes to adopt a single sales factor formula for the apportionment of business income and to reduce business income tax rates (both corporate and unincorporated) from nearly 10 to 9.4 percent. Two additional amendments are pulled directly from the Multistate Tax Commission (MTC) rewrite of the Uniform Division of Income for Tax Purposes Act (UDITPA), including a change to the District’s definition of “sale” and the elimination of cost-of-performance sourcing.
Under the District’s existing apportionment statute, all businesses must apportion business income using a four factor formula consisting of property, payroll and double weighted sales factors. If the BSA is enacted, the statute would be amended to also apportion all business income using a single sales factor. While it is clear that the intent of the BSA provision is to adopt a single sales factor in D.C. going forward, a major ambiguity exists in drafting that would require apportionment using both a single sales and double weighted sales factor formula for taxable years starting after December 31, 2014—which of course is impossible. Thus, without a legislative amendments by the D.C. Council prior to passage on May 28, it is unclear whether the single sales factor formula will be optional or mandatory (as recommended by the TRC) for FY 2015. The budget projection released by Mayor Gray in conjunction with the legislation suggests that the single sales factor would be mandatory, since it is projected that this change would raise an additional $20 million in tax revenue for the District for FY 2015. If the single sales factor were optional, it is unlikely the provision would raise that much revenue.
In addition to statutory modifications to the apportionment formula, the BSA also would reduce the tax rate imposed on corporate and unincorporated businesses from 9.975 percent to 9.4 percent. This is still higher than Maryland (8.25 percent) and Virginia (6 percent).
Picking up where the MTC left off with its ongoing UDITPA rewrite, the District would adopt the MTC draft definition of “sale” to explicitly exclude receipts from hedging transactions and other investment related activity (including the sale, exchange or other disposition of cash or securities).
In addition, BSA would adopt market-based sourcing for sales of intangibles and services, using the language of the MTC draft to do so. The BSA does not pick up the remaining provisions of the MTC [...]
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On April 15, 2014, the Supreme Court of Missouri held that income from a trust used to fund an executive deferred compensation plan (a “rabbi trust”) was apportionable business income. MINACT, Inc. v. Director of Revenue, No. SC93162 (Mo. Apr. 15, 2014). The taxpayer, MINACT, Inc., is a Mississippi-based corporation that contracts with the federal government to manage its education and job training programs.
MINACT reported the trust income as nonbusiness income on its 2007 Missouri corporate income tax return, allocating all the income to Mississippi. The Missouri director of revenue disagreed with the taxpayer and determined that the trust income was business income. MINACT appealed to the Administrative Hearing Commission, which overturned the director’s decision, finding that the trust income was nonbusiness income “because it was ‘not attributable to the acquisition, management, and disposition of property constituting an integral part of MINACT’s regular business. …’” (Opinion at 3.) The director appealed the decision to the Missouri Supreme Court.
The Missouri Supreme Court analyzed whether the trust income was business income under the state’s statutory UDITPA definition of “business income,” which Missouri interprets to include both a transactional and a functional test. (Opinion at 4-5.) See, e.g., ABB C-E Nuclear Power Inc. v. Dir. of Revenue, 215 S.W.3d 85 (Mo. 2007) (income must fail to satisfy both tests to be nonbusiness income). The Supreme Court agreed with the Commission that the trust income was not business income under the transactional test (MINACT earned the income from investing, not from its regular business of managing job training programs), but it found that the income was business income under the functional test because MINACT established its executive deferred compensation plan to attract and retain key employees who were engaged in MINACT’s regular business operations. (Opinion at 5.) The Court cited California and United States Tax Court cases for the notion that “attracting and retaining key employees is an important business purpose” and found that the employees who benefitted from the rabbi trust furthered MINACT’s business by providing capable leadership. (Opinion at 5, 7.) Using this same reasoning, the Court also rejected MINACT’s constitutional challenges.
This is the third ruling of which we are aware finding that income earned from investments in employee-related funds meet the functional test for business income. In Va. Tax Comm’r Ruling, No. 03-60 (Aug. 8, 2003), the Virginia Tax Commissioner held that rabbi trust income as nonbusiness income because “attracting and retaining quality corporate officers is an integral part of the operations of any business . . .” Similarly, in Hoechst Celanese Corp. v. Franchise Tax Bd., 106 Cal. Rptr. 2d 548, 570-71 (Cal. 2001), the California Supreme Court held that income from an employer’s reversion of pension plan assets was business income under the functional test because the employer created the plan to retain and attract employees, which the court found integral to the employer’s business operations.
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