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Inside the New York Budget Bill: Apportionment

The New York Legislature has passed  bills related to the 2015–2016 budget (S2009-B/A3009-B and S4610-A/A6721-A, collectively referred to herein as the “Budget Bill”) containing several significant “technical corrections” to the New York State corporate income tax reform enacted in 2014, along with sales tax provisions and amendments to reform New York City’s General Corporation Tax.  The Budget Bill’s technical corrections to last year’s corporate income tax reform include changes to the economic nexus, tax base and income classification, tax rate (including clarifications to rules applicable to certain taxpayers, such as qualified New York manufacturers), apportionment, combined reporting, net operating loss and tax credit provisions.  The technical corrections are effective on the same date as last year’s corporate income tax reform, which was generally effective for tax years beginning on or after January 1, 2015.

This post is the fourth in a series analyzing the New York Budget Bill, and summarizes the technical corrections to New York’s apportionment provisions.

Treatment of Excess Investment Income

As discussed in a previous blog post, the Budget Bill includes a “cap” whereby investment income cannot exceed 8 percent of a corporation’s (or a combined group’s) entire net income.  A follow-up issue is the impact of this cap and the “excess” investment income that it creates on the apportionment factor that will be applied to a taxpayer’s business income, assuming that inclusion of the excess investment income is Constitutional.

As a preliminary matter, the excess investment income will not be eligible for the 8 percent fixed sourcing election since such income cannot be considered income from qualified financial instruments (QFIs); a financial instrument that qualifies as investment capital cannot also qualify as a QFI.  Even though through operation of the cap excess investment income will be treated as business income and not investment income, there is no corresponding provision in the statute specifying that the character of investment capital that gave rise to such excess investment income will switch to business capital.  Thus, a taxpayer’s election to use the 8 percent fixed sourcing election will not apply to any excess investment income.  Instead, the excess investment income will need to be sourced under the general customer sourcing rules for financial instruments.  Under those general rules, dividends and net gains from sales of stock are not included in either the numerator or denominator of the apportionment formula, unless the Commissioner determines that inclusion is necessary to properly reflect the business income or capital of the taxpayer.  The Commissioner’s determination is governed by the Tax Law’s general provision on alternative apportionment, meaning that taxpayers can request factor representation to the extent necessary to properly reflect their business income or capital.  Interestingly, in those cases where the excess investment income is properly included in business income, inclusion in the apportionment formula should be required on Constitutional grounds (factors used in an apportionment formula must reasonably reflect how income is earned).

Description of QFI

The rule concerning what will qualify as a QFI for purposes of the 8 percent [...]

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Indiana Department of Revenue Rules Forced Disposition is Nonbusiness Income

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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One Thing’s Consistent—There’s No Duty of Consistency

Taxpayers resisting audit requests for tax returns filed in other states, or requests for details about the treatment of an item in another state, now have another quill in their arsenal besides the 2010 Oregon Tax Court decision in Oracle Corp. v. Dep’t of Rev., 2010 Ore. Tax LEXIS 32 (Or. T.C. 2-11-10).  The New Jersey Tax Court recently issued a letter opinion in Elan Pharmaceuticals, Inc. v. Director, Division of Taxation, Tax Court Dkt. 010589-2010 (May 1, 2014), reiterating that a taxpayer is not required to treat an item in exactly the same way it treats it in another state.

Like Oracle, Elan Pharmaceuticals involves the business/non-business distinction (called the operational/non-operational distinction in New Jersey vernacular).  Apparently, the company reported its gain from the sale of certain operations as business (i.e., “operational”) income on its California Franchise Tax Return, but reported the same gain as nonbusiness (i.e., “nonoperational”) income on its New Jersey Corporation Business Tax Return.  These facts largely mirror those in Oracle, except that the state involved was Oregon, not New Jersey.

During the Division of Taxation’s audit of the company, the gain was recharacterized as business income, which resulted in a substantial deficiency.  While the Division’s position was based on a number of factors, including its determination that the company never ceased conducting the line of business it purportedly disposed of, the Division was clearly influenced by the company’s treatment of the gain in California.  In fact, the Division asserted that because the company treated the gain as apportionable business income in California, it could not treat it as non-apportionable nonbusiness income elsewhere.

Like the Oregon Tax Court, the New Jersey Tax Court rejected such a purported duty of consistency.  The Court stated that a requirement of consistency, while “appealing under pure common sense, and in light of the purpose of the UDIPTA, . . . does not mean that [the company] is barred from seeking application of New Jersey law when challenging a New Jersey tax assessment.”  The Court continued:  “this court should be guided by N.J.S.A. 54:10A-6.1(a), New Jersey’s basis for taxing operational income, and the binding law construing that statute, not the consequent result of such treatment in another State.”

Ultimately, the Tax Court agreed with the Division of Taxation that the company’s gain was apportionable business income, relying largely on the unitary business principle (an aspect of the matter that appears not to have been fully developed on the record or addressed by the parties during briefing).  Still, the Court’s mandate that the actual treatment of an item in another state not be binding for New Jersey purposes is important.  It’s also entirely consistent with another recent Tax Court decision—Lorillard Licensing Co., LLC v. Director, Division of Taxation, N.J. Tax Ct. Dkt. A-2033-13T1 (Jan. 14, 2014), in which the Tax Court determined that whether or not another state actually imposes income tax on receipts is irrelevant for purposes of computing New Jersey’s now-defunct “throw out rule” so long as the other state [...]

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Show Me the Nonbusiness Income? Missouri Supreme Court Expansively Interprets Functional Test to Conclude Rabbi Trust Income is Business Income

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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