Allocation/Apportionment

Determining financial statement impact from the state flow through of federal tax reform will be complicated by changes in state tax policy expected to be adopted. In our latest Tax Takes video, McDermott’s Steve Kranz and Diann Smith discuss the issues with Joe Henchman, Executive Vice President of the Tax Foundation. The group suggests options for companies to protect against negative policy changes.

Last year, Illinois enacted a mid-year income tax rate increase. Effective July 1, 2017, Illinois increased the income tax rate for individuals, trusts and estates from 3.75 percent to 4.95 percent, and for corporations from 5.25 percent to 7 percent. The Illinois Personal Property Replacement Tax (imposed on corporations, partnerships, trusts, S corporations and public utilities at various rates) was not changed.

As we previously reported, the Illinois Income Tax Act contains a number of provisions intended to resolve questions regarding how income should be allocated between the two income tax rates applicable in 2017. 35 ILCS 5/202.5(a). The default rule is a proration based on the number of days in each period (181/184). For taxpayers choosing this method, the Department of Revenue (Department) has recommended the use of a blended tax rate to calculate tax liability. A schedule of blended rates is included in the Department’s instructions for the 2017 returns. The blended rate is 4.3549 percent for calendar year individual taxpayers and 6.1322 percent for calendar year C corporation taxpayers. Continue Reading Choices for Illinois Taxpayers in Implementing the 2017 Income Tax Rate Increase

Many provisions of the House and Senate tax reform proposals would affect state and local tax regimes. SALT practitioners should monitor the progress of this legislation and consider contacting their state tax administrators and legislative bodies to voice their opinions.

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The White House and Republican congressional leadership released an outline this week to guide forthcoming legislation on federal tax reform. The states conform to the federal tax laws to varying degrees and the extent to which they will adopt any federal changes is uncertain. This memorandum outlines some of the key areas—individual taxation, general business taxation and international taxation— with which the states will be concerned as details continue to unfold.

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The California Franchise Tax Board has scheduled an Interested Parties Meeting to discuss proposed changes to its apportionment regulations. Several years ago, when the statute called for sourcing receipts from services and intangibles at the location of income producing activity, based on cost of performance, the FTB, after a series on interested parties meetings, adopted new regulation 25137-14 sourcing receipts for mutual fund service providers and asset management service providers not at the location of the service provider, but at location of customers.  That was good news for California service providers and bad news for out-of-state service providers.

The FTB scheduled on December 22, 2016 an Interested Parties Meeting for January 20, 2017 to discuss a series of issues arising under the new market- based sourcing regulations. A Discussion Topic Paper (attached) was issued on January 3, 2017, and included (1) draft examples of souring income from asset management fees, (2) a discussion of “reasonable approximation”, including who makes that reasonable approximation, (3) clarification of the term “benefit of a service” in several contexts, including timing, government contracts, R&D contracts and patent sales, (4) dividend assignment, (5) a freight forwarding example, (6) interest received from a business entity borrower and (7) marketing intangibles.

The FTB takes these Interested Parties Meetings seriously.  Taxpayers should pay immediate attention to whether any of these issues are of significance to them, and consider participating.

The California Franchise Tax Board (FTB) will hold a second Interested Parties Meeting at their office in Rancho Cordova on April 20, 2016, dealing with the apportionment of income for combined reporting groups with both financial and non-financial members.  The Notice of Interested Parties meeting provides a description of the sourcing methods used in other states and solicits comments on four specific proposals.

The current statute and regulations, applied literally, in effect assign the majority of combined income of bank(s) and broker-dealer(s) to the location of the bank(s) or broker-dealer(s) and its customers.  This can produce an issue worth many hundreds of millions of dollars to the bank or broker dealer.  We understand that the California FTB has issued ad hoc Notices of Proposed Assessment to some taxpayers based on a distortion theory; some of these cases have gone to the Settlement Bureau, where both the FTB and the taxpayers have settled and executed confidentiality agreements.

The FTB takes these Interested Parties Meetings very seriously.  They have an unusual format in that there is not a record of who said what, the goal being to have a full and frank discussion on a non-attribution basis. An early example of collaboration between the FTB and interested parties produced what is now Reg. 25137-10.  Before the regulation, many years ago Sears argued that it was not engaged in a unitary business with a finance company subsidiary.  Sears lost in the trial court on that issue, but the court also held that Sears was entitled to include intangible personal property in the property factor, and the situs of that property was Illinois, resulting in a refund for Sears. Regulation 25137-10 represented an effort to harmonize the income-producing character of intangible personal property with tangible property in the property factor, and the outcome was that intangible property would be included in the property factor at 20 percent of face value. This regulation and the bank regulation 25137-4.2 provide the current regulatory basis for modification of the statutory formula where high volume, low profit activity is combined with other activity in a combined return, but Reg. 24137-10 only applies where the principal business activity of the combined group is not financial.

Taxpayers should follow these regulatory activities carefully, as evidenced by the adoption of a regulation a few years ago on sourcing income of mutual fund service providers, which was favorable to California-based taxpayers. The statute provided for sourcing income from services at the location of income-producing activities, measured by cost of performance. The adopted regulation instead provides for a form of market sourcing.

In the first Vermont Supreme Court decision addressing combined unitary reporting since Vermont’s combined reporting regime became effective in 2006, the court affirmed a lower court’s decision that AIG, the multinational insurance company, was not unitary with a ski resort operated by a subsidiary in Vermont; accordingly, a combined report covering the two businesses was not required. The decision is important because it lays the foundation for future unitary cases in Vermont.

The court agreed with AIG that there were no economies of scale between the operations of AIG and the ski resort. “Because [the entity] is a ski resort and therefore its business type is not similar to AIG’s insurance and financial service business, there is no opportunity for common centralized distribution or sales, and no economy of scale realized by their operations.” On centralization of management, the court noted that although AIG controlled the appointments to the ski resort’s board and management, this did not translate into “actual control” over the ski resort’s operations. Lastly, the Vermont Department of Taxes attempted to argue functional integration based primarily on AIG’s influx of working capital to the ski resort. The court rejected this assertion stating the funding “served an investment rather than operational function. The financing was not part of an AIG operational goal to grow part of its business. Further, there is no operational integration between AIG’s insurance and financial businesses and the ski resort operated by [the resort].”

The case is interesting because it involved whether an instate entity was unitary with its parent. For the year at issue, Vermont had a three factor apportionment formula with a double-weighted sales factor. Presumably, the ski resort had a high Vermont apportionment factor and relatively little income, so including AIG in the combined group increased AIG’s Vermont apportionment factor without significantly  diluting its income.

Interestingly, the court addressed AIG’s burden of proof on the unitary issue. The taxpayer argued that a preponderance of the evidence standard should apply. The Vermont Supreme Court disagreed. Looking to the United States Supreme Court’s decision in Container Corp. as well as to decisions of other states, the taxpayer has the burden of proving by “clear and cogent” evidence that its operations are not unitary.  Interestingly, the court suggested that one California court decision that applied a preponderance of the evidence standard to a unitary question was distinguishable because that case involved a taxpayer claiming that unity existed — and AIG was claiming that unity did not exist. This disparate burden depending on the direction of the unitary argument may prove important to taxpayers seeking to bring entities or operations into a combined report in Vermont.

State tax professionals may react to this decision in a manner similar to the way many reacted when the Court of Appeals of Arizona decided Talley Industries and Woolworth. Those decisions engendered substantial hope that courts — and, ultimately, state revenue agencies — would analyze unitariness not on the basis of a “checklist” or as a knee-jerk reaction to some superficial facts, but rather on the basis of seeking to implement the whole purpose of unitary apportionment. That purpose is, of course, reflecting the amount of income earned in a particular taxing jurisdiction. In other words, was the profitability of the ski resort affected by the operations of AIG? It would seem that merging the incomes and apportionment factors of the ski resort with those of AIG would cause a gross distortion of the profitability of the two distinct businesses.

On November 17, the Illinois Joint Committee on Administration Rules approved a proposed regulation promulgated by the Illinois Department of Revenue (Department) implementing statutory changes to the apportionment formula for business income derived from providing transportation services. The changes are effective for tax years ending on or after December 31, 2008. See Prop. 86 Ill. Admin. Code § 100.3450 (Regulation).

The Regulation reflects recent statutory changes made to the apportionment formulas for both non-airline and airline transportation services. See 35 ILCS 5/304(d). It provides definitions of key terms, including “revenue mile” and “In this State.”

As finalized, the Regulation incorporates certain industry comments to the Department’s initial draft of the Regulation (See TFI comments) by adding a definition of “freight” and deleting language that created inconsistency in the definition of “revenue mile.” The Regulation does not reflect taxpayer criticisms of the language regarding the “transaction-by-transaction” approach in subpart (b)(4). This subpart states that in a “transaction” where a taxpayer transports a passenger or freight both by air and otherwise, gross receipts from airline services is equal to the portion of the total gross receipts from the “transaction” that is representative of airline miles or “any other reasonable method supported by … books and records.” In many cases in the transportation industry, tracking revenue on a transactional basis and per mode of transportation is not practical and is not an industry norm. Nor is it required by statute. Although the regulatory provision’s allowance of “any other reasonable method” could be helpful, its ambiguity provides little certainty to taxpayers regarding what alternative methodology would be acceptable to the Department.

On April 30, 2015, out-of-state professional football players earned victories against the City of Cleveland, Ohio.  In a pair of cases decided by the Ohio Supreme Court, the court first struck the City’s method of allocating a nonresident professional athlete’s compensation as unconstitutional, and later that day ruled that the city tax cannot reach the income of a nonresident athlete who was not present in the Cleveland when the Browns hosted his team.

In Hillenmeyer v. Cleveland Bd. of Review, Slip Opinion No. 2015-Ohio-1623 (Ohio Apr. 30, 2015), Hunter Hillenmeyer, a former linebacker for the Chicago Bears, appealed the denial of his claims for refunds of income taxes paid to Cleveland.  Hillenmeyer argued that he paid too much tax to the city because the city’s method of allocating his compensation overstated his income earned in the city.  Cleveland had applied a “games-played” method to allocate a nonresident professional athlete’s income, meaning that the city’s taxing ratio was the number of games played in Cleveland over the total number of games played during a year.  Under this method, a visiting football player who travels to Cleveland for one game out of a 20 game season (including preseason and regular season games in a non-playoff season) would have 5 percent of his income allocated to and taxable by the city.

Hillenmeyer argued that this method ignored the fact that his compensation, like that of other players in the National Football League (NFL), was based not only on games played, but also on a mandatory mini camp following the NFL draft, preseason training camp (including preseason games, practices and meetings), practices and game preparation during the regular season, and postseason games and practice (if necessary).  None of these other activities occurred in Cleveland.

The court agreed with Hillenmeyer, finding the city’s games-played method overstated Hillenmeyer’s Cleveland income tax liability.  The court ruled the games-played method unconstitutional on due process grounds on the basis that it imposed tax on income earned outside of Cleveland.  The court reasoned that for taxation of a nonresident’s compensation to comport with due process, the tax base—the work performed—must be performed in the taxing jurisdiction.  Additionally, relying on precedent applying the state income tax to a nonresident Cincinnati Reds player, the court also held that a nonresident professional athlete’s total work performed should include not only games played, but all activities for which the athlete was compensated, including preseason training.

Applying these principles, the court adopted Hillenmeyer’s proposed method of allocation—utilized by other jurisdictions—and termed the “duty-days” method, as consistent with due process.  Under the “duty-days” method, income is allocated based on the number of work days spent in a city over the total number of work days.  For Hillenmeyer, this equated to 2 days in Cleveland per game.  Applying this method to the years at issue, the court found that Hillenmeyer was entitled to refunds because less than 1.5 percent of his annual compensation was allocable to Cleveland.

Later the same day, in Saturday v. Cleveland Bd. of Review, Slip Opinion No. 2015-Ohio-1625 (Ohio Apr. 30, 2015), the court held for another nonresident NFL player, retired Indianapolis Colts center Jeffrey Saturday.  Here, the court did not reach the constitutional challenges, finding instead on statutory grounds that the city’s income tax did not reach any of Saturday’s compensation.  During the year at issue, for the Colts’ game at the Browns, Saturday was absent, remaining in Indianapolis to receive treatment for injuries.  Relying on the determination in Hillenmeyer that NFL athletes were paid for more than just game days and the language of the taxing statute, the court held that because Saturday did not perform any work in Cleveland, the city was precluded from taxing any portion of his compensation.

Practice Note

It is unlikely that these cases end the woes for Ohio’s municipal income taxes.  In light of the U.S. Supreme Court ruling last week in Comptroller of the Treasury of Maryland v. Wynne, No. 13-483 (May 18, 2015), some local Ohio taxing jurisdictions must re-examine their failure to give full credit for taxes paid on the same income to other jurisdictions. Click here to see Art Rosen and Mark Yopp’s post analyzing the Wynne decision.

Allied Domecq Spirits & Wines USA, Inc. v. Comm’r of Revenue, 85 Mass. App. Ct. 1125 (2014)

In a unique case, the Massachusetts Appeals Court affirmed a ruling of the Appellate Tax Board (ATB) that two corporations could not be combined for corporation excise tax purposes for 1996 through 2004. The distinctive aspect of this case was that a company was found not to have nexus with Massachusetts even though it rented property in the state and had employees in the state. If the company had been found to have nexus, it could have applied its losses to offset the income of an affiliated Massachusetts taxpayer in a combined report. The Appeals Court pointed to factual findings of the ATB that the transfer of employees located in Massachusetts to the company “had no practical economic effect other than the creation of a tax benefit and that tax avoidance was its motivating factor and only purpose.” The Massachusetts Supreme Judicial Court denied the taxpayer further review on August 1, 2014. Although this case is notable because the sham transaction doctrine rarely, if ever, has been applied to find that a company did not have nexus, a similar factual scenario likely would not occur today because Massachusetts adopted full unitary combination in 2009.

First Marblehead Corp. v. Comm’r of Revenue, 470 Mass. 497, 23 N.E.3d 892 (2015)

In a case that attracted the attention of, and an amicus brief from, the Multistate Tax Commission, the Supreme Judicial Court addressed how the property factor of a taxpayer subject to the Financial Institution Excise Tax (FIET) should be apportioned. The taxpayer, Gate Holdings, Inc. (Gate), had its commercial domicile in Massachusetts and held interests in a number of Delaware statutory trusts that purchased student loan portfolios. Below, the ATB held that Gate’s loans should be assigned to Massachusetts, resulting in a 100-percent property factor for apportionment purposes. The Supreme Judicial Court agreed and interpreted the Massachusetts sourcing provisions at issue, which are based on a model from the Multistate Tax Commission and incorporate the Solicitation, Investigation, Negotiation, Approval and Administration (SINAA) rules, as sourcing Gate’s loans to Massachusetts where Gates had its commercial domicile. The Supreme Judicial Court’s decision may be of interest in Massachusetts and other states because several states have adopted sourcing rules for financial institutions that are based on the Multistate Tax Commission’s model.

Genentech, Inc. v. Comm’r of Revenue, Mass. App. Tax Bd., Docket No. C282905, C293424, C298502, C298891 (2014)

The ATB held that Genentech, Inc., a biotechnology company, was engaged in substantial manufacturing and thus required to use single sales factor apportionment. Genentech is appealing the ruling.

National Grid Holdings, Inc. v. Comm’r of Revenue, Mass. App. Tax Bd., Docket No.  C292287; C292288; C292289 (2014); National Grid USA Service v. Comm’r of Revenue, Mass. App. Tax Bd., Docket No. C314926 (2014)

The ATB addressed whether an international utility corporation’s deferred subscription arrangements constituted debt for corporate excise purposes. The ATB held that it did not. In reaching its decision, the ATB noted that for United Kingdom tax purposes, the arrangements constituted debt; but that for United States, federal tax purposes the arrangements did not constitute debt. The ATB followed the United States federal tax treatment, which resulted in the taxpayer’s deduction of a liability against its net worth being disallowed. A few months later, in a related appeal, the ATB determined that by reporting federal changes to the Commissioner on a duplicative application for abatement, the taxpayer raised no new facts warranting a second application for abatement concerning the same assessment that was challenged earlier.

Direct, LLC v. Dep’t of Revenue, SJC-11658 (Feb. 18, 2015)

Two satellite television providers, DirecTV and Dish Network, challenged G.L. c. 64M, § 2, which imposes a five percent excise tax on satellite television services, as violating the dormant commerce clause since the tax does not apply to cable television services. The Supreme Judicial Court affirmed the Superior Court’s grant of summary judgment to the Department of Revenue. The court determined that the excise tax was not discriminatory because cable companies are subject to a variety of local government franchise fees that can be imposed at a rate of up to five percent, and that the differences between the satellite television and cable television industries, especially the heightened federal and local regulatory requirements imposed on cable providers, were significant enough to permit discrepancies in taxes imposed on the industries. The court noted that other courts have considered and rejected the satellite companies’ challenges to similar laws in other states.

Excel Orthopedic Specialists v. Comm’r of Revenue, Mass. App. Tax Bd., Docket No. C318083 (2014)

The ATB agreed with the taxpayer that braces sold by an orthopedic practice were exempt from use tax as artificial devices because the braces were individually designed, constructed or altered for the specific use of each of the taxpayer’s patients.

Regency Transportation, Inc. v. Comm’r of Revenue, Mass. App. Tax Bd., Docket No. C310361 (2014)

The ATB found a multi-state freight business liable for use tax on the full sales price of its vehicles that it stored and used in Massachusetts. In an interesting twist, the Department of Revenue attempted to assert penalties even though the taxpayer’s position was based on a departmental ruling. The ATB held that penalties should be abated for multiple reasons, including:  (i) the “taxpayer’s prior successful reliance on the ruling and the fact that its vehicles are exempt from tax in every state of purchase”; and (ii) that the “Commissioner continues to publish [the ruling] in the official compendium of public written statements without any caveat or other signal to taxpayers that its content was erroneous and should not be relied on”; and (iii) that “the Department’s own auditor with 30 years of experience came to a preliminary conclusion that [the ruling] was applicable to the [taxpayer’s] use of vehicles in the Commonwealth.”