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Apportioning Service Revenue: Decoding Complex Laws and Regulations

Strategies for Mitigating Corporate Taxes in a Rapidly Evolving Environment

presents

Today's panel features:

Jon Zefi, Principal, Eisner, New York

Jeffrey Glickman, Partner, State and Local Tax Group, Alston & Bird, Atlanta

Eric Tresh, Partner, State and Local Tax, Sutherland, Atlanta

Michael Wynne, Partner, Reed Smith, Chicago

Wednesday, May 20, 2009

The conference begins at:1 pm Eastern12 pm Central

11 am Mountain10 am Pacific

The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions emailed to registrants to access the audio portion of the conference.

A Live 100-Minute Audio Conference with Interactive Q&A

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Apportioning Service Revenue Teleconference

May 19, 2009

Jon Zefi, Eisner Michael Wynne, Reed [email protected] [email protected]

Eric Tresh, Sutherland Jeff Glickman, Alston & [email protected] [email protected]

2

Today’s Program

• Overview Of Sales-Sourcing Approaches, slides 3 through 18 (Jon Zefi)

• Trends In State Apportionment Formulae, slides 19 through 34 (Michael Wynne)

• Future Of Cost-Of-Performance Sourcing, And Audit And Litigation Issues, slides 35 through 47 (Eric Tresh)

• Other Related Issues To Consider, slides 48 through 65 (Jeff Glickman)

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Overview Of Sales-Sourcing Approaches

4

Overview

• The Uniform Division of Income for Tax Purposes Act (“UDITPA”) was drafted in 1957 in response to the need for a uniform method of dividing income for tax purposes among the states

• Most states that have adopted UDITPA have applied it to all taxpayers, with the exception of certain industries

• Approximately 25 states have adopted UDITPA, either in full or in substantial part.

• The Multistate Tax Compact was formed in 1966 and created the Multistate Tax Commission (“MTC”), established a joint audit program for multi-state taxpayers and adopted UDITPA (Article IV) as an optional method of apportionment for member states

5

Overview (Cont.)

• Under UDITPA and the MTC regulations, business income is apportioned using an equally weighted, three-factor formula including:– Property – Payroll– Sales

• There are rules for establishing what is included in the factors, how items are sourced to a state, etc.

• Historically, the apportionment rules were established to accommodate the manufacturing industry; however with the trend toward a service economy and products not dependent on manufacturing, the three-factor formula is less representative of the way in which a multi-state business earns its income

• There has been a trend in states departing from the traditional three-factor formula and either double-weighting sales, heavily weighting sales or utilizing a single-sales factor

6

Sales Factor

• Generally, states source sales of tangible personal property (“TPP”) to the ultimate state of destination

• Generally, states mandate sourcing of sales other than sales of TPP based on one of two approaches:

– Income-producing activity/costs of performance

OR

– Market-based sourcing

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Sales Factor (Cont.)

• Some states have adopted standards different from the costs of performance and market-sourcing approaches for sourcing sales other than TPP, including:

– Income-producing activity/market hybrid

– Location of property/payroll

– Situs of income

– Management and control

8


Sales other than TPP – UDITPA and MTC regulations

• Under Article IV.17.(4) of the MTC regulations, sales other than sales of TPP are sourced to a particular state if:

– The income-producing activity which gave rise to the receipts is performed wholly within this state,

or

– The income-producing activity is performed within and without this state, but the greater proportion of the income producing activity is performed in this state than in any other state, based on costs of performance

9

Sales Factor (Cont.)• Income-producing activity

– An income producing activity applies to each separate item of income and is defined as the transactions and activity directly engaged in by the taxpayer in the regular course of its trade orbusiness for the ultimate purpose of obtaining gains or profits

– This includes:• The rendering of personal services by employees• The utilization of tangible and intangible personal property in

rendering a service• The sale, rental, leasing, licensing or other use of real property• The rental, leasing, licensing or other use of tangible and

intangible personal property

10

Sales Factor (Cont.)• Costs of performance

– If the income-producing activity is performed in two or more states, the sales are assigned to the state where the greatest proportion of the income producing activity is performed, based on costs of performance

– Under the MTC regulation, costs of performance are defined as direct costs determined in a manner consistent with generally accepted accounting principles (“GAAP”) and in accordance with accepted conditions or practices in the trade or business of thetaxpayer

– Direct costs include wages, taxes, interest, depreciation and other such costs involved with real and personal property

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– A debated aspect of sourcing based on the location of costs of performance relates to the correct comparison of costs

• For example, should costs incurred in one state be compared to costs incurred in all other states combined?

• This approach requires more than 50% of the costs of performance with respect to a particular income-producing activity to occur in a particular state in order to source the sales to that state (e.g. Virginia; sources sales other than sales of TPP to VA if the costs of performance in VA exceed the costs incurred outside VA)

• In states that utilize the 50% rule, if more costs are incurred in one state than in any other state but not the majority of their costs of performance in any one state, may end up sourcing no receipts related to the income-producing activity to any state

• Pennsylvania: Sources sales other than sales of TPP to PA if the majority of the costs of performance are in PA

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– A different approach compares costs in one state to costs in allstates, but on an individual state basis

• Receipts are sourced to the state where the majority of the costs of performance were incurred (Massachusetts uses this approach for receipts from services)

• For example, if 40% of the cost of performance is incurred in State X, 30% in State Y and 30% in State Z, the entire sale is assigned to State X

• This is called an all-or-nothing approach, whereby the entire sale is assigned to the single state in which the greatest proportion of the cost is incurred

– Another approach sources sales on a proportional basis rather than an all-or-nothing approach

– The MTC has expressed interest in replacing or modifying Section17 to adopt a market-based sourcing rule and started a project to reconsider the current income-producing activities test

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Sales Factor (Cont.)• Market sourcing

– Generally, receipts from services are assigned to the state in which the customer is located

– This is used to increase the tax burden on out-of-state service providers that have in-state customers, while reducing the tax burden on in-state service providers that have out-of-state customers

– States differ in how they determine the market for a particular sale. Some states will source sales of other than TPP based on the following:

• The location at which services are received • The location where the purchaser receives benefit of service• The location at which services are used• The location of the customer• The location of the payor• The location where the service is performed• The location of the use of the intangible

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Sales Factor (Cont.)State Market Sourcing Rules

California For taxable years beginning on or after 1/1/11, if the purchaser of services receives the benefit of services in CA, then the sales are sourced to CA

Georgia Customer has regular place of business in GA or if benefit of service is received in GA

Iowa If the benefit of the services are received in IA

Illinois If the services are received in IL and taxpayer has fixed place of business in IL

Minnesota If the services are received in MN and taxpayer has fixed place of business in MN

Maryland If receipts derived from customers domiciled in MD

Maine If the services are received in ME. If not able to determine, then if customer’s office or home is located in ME

Michigan If the benefit of the services are received in MI

Ohio If the services are used by purchaser in OH or the benefit of the services are received in OH

Utah If the purchaser of the service receives a greater benefit of the service in this state than in any other state (for taxable years beginning on or after 1/1/09, UT Code Sec. 59-7-319(3)(a))

Wisconsin If purchaser receives the benefit of services in WI. Also, different rules for different services related to real and tangible property and intangible property

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• Why would states want to increase the weight applied to the sales factor and what effect would it have?– Protects in-state capital investment– Generally, the increased investment takes the form of property and

payroll– New businesses can increase property values and create jobs for

residences of the target state without affecting its apportionment factor– There has been a trend in states departing from the traditional three-factor

formula and either double-weighting sales, heavily weighting sales or utilizing a single-sales factor

– Increasing the sales factor weighting for companies with a relatively small share of property or payroll in a state, but a significant amount of their sales in a particular state, will increase the amount of income sourced to that state and ultimately the amount of tax paid to that state

16

Sales Factor (Cont.)State Sales Factor Description

Arizona Elective superweighted factor phase in 2007–2009(requires $1 billion in capital investment, among other requirements)

California Election to use single-sales factor for tax years beginning on or after 1/1/11 (H.B. 08-1380 enacted May 20, 2008)

Colorado Single factor for tax years beginning on or after 1/1/09 (H.B. 08-1380 enacted May 20, 2008)

Georgia Single factor phase-in 2006–2008

Indiana Single factor phase-in 2007–2011

Kansas Single factor for qualifying taxpayers after 7/1/2007 but prior to 12/31/2009(requires $100 million in construction investment, among other requirements)

Louisiana Single factor for manufacturing/merchandising companies after 2005

Maine Single factor for tax years beginning on or after 1/1/2007

Michigan MBT - Single factor effective on or after 01/01/2008

Minnesota Single factor phase-in 2005–2014

New York State Single factor phase-in 2006–2008 (accelerated to tax year 2007)

Oregon Single factor for most industries on or after 7/1/2005

Pennsylvania Increase weighting to 70% after 2006

17


State Sales Factor DescriptionSouth Carolina Single factor for manufacturers after 2006

Texas Single factor for margins tax reports due 5/15/2008

Utah Elective double-weighted sales factor beginning 2006

Wisconsin Single factor phase-in 2007 – 2008

• Other states offering single-sales factor apportionment (for some or all industries):

State Sales Factor Description

Connecticut NAICS Code 31, 32, 33 – required single sales factor (Conn. Gen. Stat. 12-218(k))

Illinois Single factor (35 ILCS 304(h))

Iowa Single factor (Iowa Admin. Code 701--54.5 (422))

Mississippi Single factor for retailing, renting, servicing, merchandising, wholesaling (Miss. Admin. Code 35 III.8.06 Sec. 402.06)

Nebraska Single factor (Neb. Rev. Stat § 77-2734.16)

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Gross Receipts Tax– The number of states imposing gross receipts taxes are relatively small,

but may be growing– Michigan recently joined the group of states that impose gross receipts

taxes with the recently enacted Michigan Business Tax (“MBT”)– Other states that impose gross receipts taxes include Ohio with the Ohio

Commercial Activities Tax (“CAT”), Texas with the Franchise Tax on “margin”, and Washington with the Business and Occupation tax (“B&O”)

– New Jersey and Kentucky also have gross receipts components to their corporate tax structures, athough New Jersey’s Alternative Minimum Assessment (“AMA”) gross receipts tax was phased out on July 1, 2006, for all companies except those that can claim protection under Federal Public Law 86-272

– Generally, this type of tax does not consider whether a taxpayer has derived a profit when taxing a transaction. Gross receipts tax focuses on transactions and business classification of the transacting entity, not on profit

19

Trends In State Apportionment Formulae

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Trend In State Apportionment Formulae

• Moorman Manufacturing Co. v. Blair, 437 U.S. 267, 282-283 (1978), J. Blackmun, dissenting:

Today’s decision is bound to be regressive. Single-factor formulas are relics of the early days of state income taxation. The three-factor formulas were inevitable improvements and, while not perfect, reflect more accurately the realities of the business and tax world. With their almost universal adoption by the States, the Iowa system’s adverse and parochial impact on commerce comes vividly into focus. But with its single-factor formula now upheld by the Court, there is little reason why other states, perceiving or imagining a similar advantage to local interests, may not go back to the old days. The end result, in any event, is to exacerbate what the Commerce Clause, absent governing congressional action, was designed to avoid.

21

Sales-Biased States• In 1989, 44 of 46 states with a corporate income tax used some form of

three-factor apportionment. Between 2000 and 2007, 17 states increasedthe weighting of the sales factor, and no state decreased its weighting.

• Single-factor states today include: • Connecticut• Georgia• Illinois• Iowa• Louisiana• Maine• Michigan• Nebraska• New York• Oregon• Texas• Wisconsin

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Sales-Biased States (Cont.)

• Imminent single-factor states• California: Single-sales option beginning in 2011• Colorado: Single sales beginning in 2009• Indiana: Single sales beginning in 2011• Minnesota: Single sales beginning in 2014• South Carolina: In 2009, it allows only 60% of the reduced taxes from

single factor• Virginia: Manufacturers can use single sales in July 2014, quadruple

sales in July 2013, triple sales in July 2011• Whither goes UDITPA?

• 11 of 18 states that claim to adopt UDITPA tinkered with the sales factor

• Only nine “pure” evenly weighted three-factor (property/payroll/sales) states remain, seven of which adopted UDITPA

23

Sales-Biased States (Cont.)

• Trend: Export the tax burden/reward in-state investment• Double, triple or other weighting in favor of the sales factor• Elective or restricted single-sales factor• Mandatory single-sales factor

• Interim issue: Customize the sales factor• Services• Intangibles• Treasury functions • Special industries

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Service Income Sourcing

• Destination sourcing – market-based• Service performed• Benefit realized

• Cost-of-performance – activity based.• Service performed• Service controlled• Income-producing activity manipulation

• Special industry sourcing

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Service Income Sourcing (Cont.)

• Recent market-based examples

• 2006: Ohio Commercial Activity Tax (CAT) on gross receipts sources services in the proportion that the purchaser’s benefit in Ohio with respect to what was purchased bears to the purchaser’s benefit everywhere with respect to what was purchased. The physical location where the purchaser ultimately uses or receives the benefit of what was purchased “is paramount” in determining the proportion of the benefit received in Ohio

• 2007: Michigan Modified Gross Receipts Tax (MGRT) sources service receipts to Michigan if “the recipient of the services receives all of the benefit of the services” in Michigan; or, if the benefit is received within and without Michigan, then “in proportion to the extent that the recipient receives benefit of the services” in Michigan

26


• 2009: California adopted elective single-factor apportionment for 2011 and after

• Warning: For all companies, electing or not, California also changed the sourcing rules for intangibles and services to the place of delivery of the asset or service

• 2009: Illinois amended its income tax service apportionment in 2007 and 2008, for tax years ending after 12/31/08. First, it sourced to where the “benefit” of the service is “realized,” but before that became effective, it changed to the place where “the service is received”

• Warning: Throw-out rule in effect for service income• Warning: Regulations past-due for apportionment by broadcast,

cable, advertising, publishing and utility services

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• Recent market-based examples (Cont.):

• 2009: Wisconsin requires gross receipts from the use, license, or sale of intangible property to Wisconsin, by billing location and commercial domicile of the customer. In 2005 it required sourcing of sales of computer software and services to be where the benefits of the software and services were received. Intangibles, however, remained under“cost-of-performance” until 2009

• 2009: Virginia will allow manufacturers to use single-sales-factor apportionment, beginning July 1, 2014; but, they may use triple-weighted sales from July 1, 2011 through June 30, 2013 and quadruple-weighted sales from July 1, 2013 through June 30, 2014

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• “Cost-of-performance” status• Multistate Tax Commission (MTC) is interested in eliminating or

modifying the “cost-of-performance” rule and replacing it with a market-sourcing rule (to the location where the benefit of the service is received)

• Income-producing activity manipulation• Should be applied with respect to each “item of income” but is often

applied with regard to each business process • Carving out discrete activity or service occurring entirely within a state• Stealth “market” approach to cost-of-performance

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• Special industries• Increasing resort to designer apportionment for financial organizations,

telecommunications, broadcasting, electric utilities• Examples

• MTC draft telecommunications sourcing rule• Florida may adopt MTC formula for financial organizations• Illinois: Special statutory formula for financial services,

telecommunications, transportation, and by regulation for cable*, broadcast*, advertising*, publishing and utility services (* = legislation pending)

• Wisconsin: Special rules for air carriers, telecommunications companies, motor carriers, pipeline companies, railroads and brokerage houses

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Implications• Losing the concept of apportionment

• Apportionment is supposed to measure in-state activity of the taxpayer; instead, market-based approaches measure market exploitation regardless of activity

• Example: Illinois internal draft hedging regulations. “The purpose of the sales factor in Section 304(a) of the IITA is to apportion the business income of a taxpayer conducting an interstate business to this State based on this State’s relative share of the marketplace for the goods and services sold by the taxpayer in the course of its business.”

• Moorman Manufacturing Co. v. Blair, 437 U.S. 267, 292(1978), J. Powell and J. Blackmun, dissenting:• As suggested in General Motors (citation omitted), a sales-only

formula is probably the most illogical of all apportionment methods, since “the geographic distribution of a corporation’s sales is, by itself, of dubious significance in indicating the locus of either” a corporation’s sources of income or the social costs it generates

31

Implications (Cont.)

• Facilitating the adoption of economic nexus• Is in-state activity inferred from the factor?• If activity is inferred, is that not market/economic nexus?• Does the “fair relation” prong of the Complete Auto Due Process

component get inferred away?• UDITPA Section 18 looms large

• In states that adopted UDITPA Section 18 or a similar provision, the transition to single-factor raises the issue of whether the Legislature set a benchmark for “fair apportionment” when it first adopted Section 18, or whether Section 18’s benchmark moved each time the formula was amended

• Cost-of-performance analysis inherently considered capital and labor contributions, which are irrelevant in a market-based approach

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• Undeniable overlap from interaction of cost-of-performance and market-based approache.

• Likely overlaps from interaction of benefit-received and service-received or -performed approaches

• Likely overlaps from characterization of items of income as intangible, tangible or service

• Even without overlaps, external values are more heavily taxed than in-state values. Recall Container Corp., where the Court said a taxpayer claiming error bears the burden to demonstrate that there is “no rational relationship between the income attributed to the State and the intrastate values of the enterprise”

• How will the various interpretations of where the benefit of a service lies or of the place where a service is received fare, for ‘external consistency’purposes?

33


• Moorman Manufacturing Co. was a ‘failure of proof’ case; it did not validate single-sales factor formulae as a matter of law

• Consider the multiplier effect of other trends when combined with single-sales-factor formulas: • Economic or market nexus (fourth prong of Complete Auto)• Combined reporting (is there greater distortion from single-sales factor

in vertically integrated group than in a horizontally integrated group)• Finnegan (Wisconsin)• Throw-out (Illinois)

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• Takeaways• Thinly sliced income-producing activity approaches can approximate

market-method, for good or ill • Historical cost-of-performance data may be useful to establish

distortion (extra-territorial values)• Review your transactions and restructure accordingly (e.g., can an

integrated service offering be split into service and non-service components?)

• Overlaps will arise more often and be easier to identify in single-factor apportionment of service income; watch classifications

• UDITPA Section 18 becomes more relevant; consider appropriate supportable alternatives

35

Future Of Cost-Of-Performance Sourcing, And Audit And Litigation

Issues

36

Cost Of Performance Under Attack

• Current MTC Regulation IV.17(4)(a) sources receipts from transactions, other than sales of TPP, to a state if:– The income-producing activity that gave rise to the receipts is

performed wholly within the state, or– The income-producing activity is performed within and without the

state, but the greater proportion of the income-producing activity is performed in this state based on cost of performance

• However, the MTC has whittled away at this general rule by adopting special rules for a number of industries

• In addition, the MTC continues to seek the outright repeal of cost-of-performance sourcing

37

Cost Of Performance Under Attack (Cont.)

• MTC proposals to amend UDIPTA– MTC adopted an amendment regarding activity performed “on behalf

of” the taxpayer– MTC proposed a model regulation for apportionment of income from

sales of telecommunications and ancillary service income

• MTC has recommended an overhaul of UDIPTA

• Have the states adopted the MTC’s proposals?

38


• NCCUSL study committee recommended undertaking a UDITPA revisionproject

• NCCUSL executive committee approved a drafting committee to review all of UDITPA

• Prentiss Wilson and Richard Pomp have been named as reporters

• Interested parties can request to be advisors or observers; COST is an observer

• Process, if it moves forward, will likely take years.

39


• The scope of the NCCUSL project includes the following issues:– COP vs. market sourcing– Treatment of treasury function receipts– Special industry apportionment rules– Look-through sourcing– Throwout rule

40


• COST has formally opposed the NCCUSL effort• ABA tax section is participating for now, but many are concerned with the

tax section’s involvement and perceived support of the NCCUSL effort• Taxpayers generally oppose the process and have developed coalitions to

oppose and monitor NCCUSL’s efforts • On May 14, the study committee tentatively agreed to recommend to the

ULC scope and program committee that the study committee be authorized to continue its work until January 2010, to explore more broadly the feasibility of undertaking a project to revise the UDITPA

• A draft of a report to the scope and program committee making that recommendation will be circulated to all participants, including observers, in the study process in the near future. There will be an opportunity after the draft report is circulated to submit comments before the draft report is finalized

41

Common Audit Issues Related To COP Sourcing

• Does the taxpayer have the right to use COP? – The impact of special industry sourcing rules rules (e.g.,Swift)– Section 18 distortion

• What is the income producing activity? (Interface and Boston Hockey)

• What are the taxpayer’s costs of performance? – Proving your costsof performance– Direct vs. indirect costs– Inclusion of third-party costs

• What is the income-producing activity?

42

Does The Taxpayer Have The Right To Use COP?

• Issue often arises with regard to taxpayers in multiple lines of business, some of which are required to source their income using COP

• See e.g., Appeal of Swift Transp. Co., California BOE, No. 266318 (Feb. 4, 2008), where the BOE ruled that a freight-forwarder had to apportion as a trucking company, based on the special apportionment rules, in a unitary combined filing– The BOE held that Swift could not use different apportionment for the

freight-forwarder than for the trucking company. The BOE rules that to do otherwise would defeat the purpose of the unitary business principal

– This type of fact pattern plays out in many contexts– The case causes general concern for the use of COP positions in unitary

combined states, about whether a state will allow combined companies to apportion using different methods. This issue remains subject to interpertation in many states

43

What Is The Income-Producing Activity?

• Massachusetts example:– No statutory guidance regarding what constitutes an IPA – In Boston Professional Hockey Association, Inc. v. Commissioner, 820

N.E.2d 792 (Mass. 2005), the Mass. Supreme Court adopted the“operational approach,” concluding that the IPA was the operation of an NHL franchise and not the performance of each individual game

– However, in Interface v. Commissioner of Revenue, 888 N.E.2d 969 (Mass. App. Ct.) the Mass. Appellate Tax Board (“ATB”) held the operational approach should apply, based on Boston Hockey. However, the Appeals Court reversed and remanded the case, requiring the ATB to explain why the transactional approach should apply

– On remand, the ATB affirmed its original decision, holding that GMV was required to use the operational approach to determine its IPA. The ATB determined that GMV’s IPA was the overall operation of a public charter company, not the sale of individual travel packages to individual customers

44

Inclusion Of Third-Party Costs?

• On Aug. 2, 2007, the MTC amended the Multistate Tax Compact’s (“Compact”) allocation and apportionment regulations, modifying its longstanding position regarding COP

• Prior to the amendment, the Compact (like UDITPA) was silent on the inclusion of third-party costs in calculating a taxpayer’s COP

• As amended, the Compact provides that costs paid to third parties should be included in determining where a taxpayer’s COP are incurred

• Sec. IV.17.(3) of the Compact provides that: “included in the taxpayer's cost of performance are taxpayer’s payments to an agent or independent contractor for the performance of personal services and utilization of tangible and intangible property which give rise to the particular item of income”

45

Inclusion Of Third Party Costs? (Cont.)• State interpretations

– IPAs• California Chief Counsel Ruling 2007-2 (06/04/06)

– Held that investment activities performed by third-party investors are not IPAs, because an IPA as defined excludes transactions and activities performed on behalf of a taxpayer, such as those conducted by an independent contractor

• FTB 2006-02– Activities performed on a taxpayer’s behalf by a member of

the combined reporting group will be considered activities of taxpayer

– Direct costs• GM v. Commonwealth of VA, 268 Va. 289 (Va. 2004)

– Independent contractor costs can be included in direct costs• Michigan Internal Policy Directive 2006-8

– Direct costs may include activities performed by an independent contractor

46

Inclusion Of Third-Party Costs? (Cont.)

• Florida Revenue Department TAA, No. 08(C)1-002 (03/27/08)– The Revenue Department ruled that “income producing activity”

applies to each separate item of income and means the transactions and activity directly engaged in by the taxpayer; if independent contractors are used to complete a contract, the income-producing activity will include amounts paid to independent contractors

• Crystal Communications v. DOR, No. TC-MD 040026D (5/26/06)– Tax Court held that taxpayer’s operation of a cellular telephone system

was an income-producing activity, even though much of the activity in performing the service was performed by independent contractors

– The court noted that the taxpayer held the FCC licenses and usedequipment it owned to deliver cellular telephone service. These activities cannot be ignored, because none of the income-producing activities could be undertaken without the license and equipment

47

Does The Taxpayer Have The Right To Apportion Its income?

• New Jersey right to apportion – New Jersey Natural Gas Co. v. Director, 24 NJ Tax 59 (T.C. NJ 2008)

• Application of New Jersey’s “right to apportion” rules.• NJ taxpayers have the right to apportion income only if they have a

“regular place of business” outside the state• “Regular place of business” is defined as:

– Office, factory, warehouse or other space that is used by the taxpayer; and

– With one or more employees under direction of the taxpayer• Arguably unconstitutional per Mobil, because taxpayer will be

subject to apportioned tax in any state where it has nexus– Nexus standard is lower than “regular place of business”– Fair apportionment/internal consistency problem results

48

Other Related Issues To Consider

49

Receipt Characterization

• What is tangible personal property and what is a service/intangible?– Look to receipt; not necessary based on primary activity– E.g. Georgia

• Two basic sets of apportionment rules– One for taxpayers whose net business income is principally

derived from the manufacture, production, sale or lease of tangible personal property

– One for taxpayers whose net business income is principally derived from business other than from the manufacture, production, sale or lease of tangible personal property

• However, rules provide that if taxpayer in one category has receipts described in the other, then use rules based on type of receipt

50

Receipt Characterization (Cont.)• Computer software

– Derived from sales tax laws– Canned – tangible– Custom – services– Rules may also effect property factor

• Communications equipment– TV Guide (Illinois) case: Use of transponders on orbiting satellites was

lease of TPP– Showtime (Michigan) case: Sale of television programs delivered to

cable TV stations via microwave transmission was intangible service• “Intangible-type” property

– Nebraska held sale of customer lists to be sale of TPP because they were delivered in tangible form

• Buyer did not acquire “rights” (intangible) in the lists– New York held sale of gifts certificates over the Internet to be

intangible property

51

Receipt Characterization (Cont.)

• Utilities– Is electricity tangible or not? Some states treat electricity as tangible for

sales tax, but not necessarily for income tax apportionment purposes– Exelon Corp. v. Dep’t of Rev., Docket No. 105582, 2009 Ill. LEXIS

188 (Ill. Feb. 20, 2009)• Illinois Supreme Court reversed Appellate Court and concluded the

electricity is tangible personal property, for corporate income tax purposes

• Overturned 52 years of Illinois tax policy that treated electricity as an intangible

• Affects sourcing rules for apportionment purposes– But, see EUA Ocean State Corp v. Comm’r of Revenue (Mass. App.

Tax Board, April 24, 2006)(Electricity not TPP for sales factor sourcing)

52

Industry-Specific Issues

• Financial institutions– Inclusion of intangibles in property factor– Market-based receipts factor

• Interest on loans secured by real property sourced to state where real property located

• Interest from credit cards sourced to billing address

• Transportation (other than airlines and pipelines)– Use of a “miles traveled” or “ton miles” factor– Specialized rules for mobile property– Miles at sea (i.e., no state)

53

Industry-Specific Issues (Cont.)

• Airlines– Origin or termination– Overflight miles– Mileage factors

• Media– Circulation (publishing) and audience (TV) factors– Non-jurisdictional property (e.g., satellites in orbit)

• Pipeline companies– Traffic or barrel units used for receipts factor

54

Ohio’s CAT

• Under Ohio’s commercial activity tax (CAT), receipts from the sale of services are sitused to Ohio in the proportion that the purchaser’s benefit in Ohio, with respect to what was purchased, bears to the purchaser’s benefit everywhere– Physical location is where the purchaser ultimately uses or receives the

benefit of what was purchased and is paramount in determining the portion of the benefit in Ohio vs. the benefit everywhere

– Regulation (Ohio Admin. Code 5703-29-17) provides examples for a wide variety of services

– Many of the examples allow the service provider to elect to source the services according to the purchaser’s “principal place of business,” as long as the rule is applied in a reasonable, consistent and uniform manner

• “Principal place of business” refers to where the business unit that is being provided the service primarily maintains its operations

55

Ohio’s CAT (Cont.)• “Principal place of business” is determined in sequential order based on the

following measures, if known (e.g. accounting services)– (1) Branch, division or other unit where client primarily receives the

benefit of the service• New York division of large, multi-national corp. with operations in

Ohio pays an Ohio accountant a fee associated with division’s product liability suit

• Source of fees = New York– (2) The primary location of the management operations of the purchaser’s

business unit• Accounting firm provides valuation services for sale of a product line

for a large, multi-national manufacturer. The product line has locations in several states, but management is in Ohio

• Source of fees = Ohio (first rule n/a and management in Ohio)– (3) The billing address (if provided in good faith) as long as purchaser has

actual operations in that state (not just a post office box)• Same example as in (2), except that management is in several states• Source of fees = billing address

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Ohio’s CAT (Cont.)• “Catch-all” provision for services that related to various locations within and

without Ohio– Receipts may be sitused to Ohio using any reasonable, consistent and

uniform method of apportionment that is supported by the serviceprovider’s business records, as they existed at the time the service was provided or within a reasonable time thereafter

– Example: Engineering services• If services performed relate to property wholly within Ohio, then

receipts are sitused to Ohio• If services performed relate to property located within and without

Ohio, then receipts are sitused using any reasonable, consistent and uniform method of apportionment that is supported by the serviceprovider’s business records, as they existed at the time the service was provided or within a reasonable time thereafter

– Default: No. of properties in Ohio compared to no. of propertieseverywhere

– If 3 of 10 properties in Ohio, then 30% of receipts sitused to Ohio

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Michigan MBT

• MBT replaced single business tax effective 1/1/08– Consists of a business income tax and a modified gross receipts tax– Both tax bases apportion based on single-sales factor

• Michigan moved away from historic cost-of-performance rule (under the SBT) and has now adopted a market-based sourcing rule for service revenue

• Basic rule: Receipts from services are sourced to Michigan if the recipient received all of the benefit of the services in the state; otherwise, to the extent recipient receives benefit of the services in Michigan

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Michigan MBT (Cont.)• Industry-specific rules: Examples

– Loan-servicing fees• If loan secured by real property, look to location of real property

– If real property in more than one state, source to Michigan if either (1) more than 50% of FMV is in the state or (2) more than 50% of FMV is not in any state, and borrower is in Michigan (based on billing address)

• If loan not secured by real property, look to location of borrower– Transportation services

• General rule: Based on revenue-miles• Maritime: 50% if origin or termination in state, 100% if both in

state• Transportation of property and individuals: Based on passenger

miles and ton miles• Oil pipelines: Based on barrel miles• Gas pipelines: Based on 1,000 cubic feet-miles

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Michigan MBT (Cont.)• Industry-specific rules: Examples (cont.)

– Telecom and mobile telecom services• General rule: Based on customer’s place of primary use (i.e.,

residential street address or primary street address where customer’s use primarily occurs)

– For mobile, address must be within licensed service area of the customer’s home service provider

• For telecom services sold on a call-by-call basis: Source to Michigan if either (1) the call originates and terminates in the state or (2) call originates or terminates, and the service address is, in MI

• Prepaid service: Source to where purchase obtained card• Billing and ancillary services: Based on location of purchaser’s

customers; if not known or determinable, based on purchaser location

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Texas Margin Tax• Taxable entity’s total revenue less the greater of:

– Cost of goods sold,– Compensation or– 30% of total revenue

• Apportioning gross margin – maintains historic rule– Receipts from the performance of services are sourced to the state in which

the service is performed, except that receipts from servicing loans secured by real property are sourced to the state where the real property is situated

– Receipts from services that are performed both in and outside Texas are Texas receipts, based on the fair value of services that are rendered there

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Kentucky LLE Tax

• Kentucky imposed a limited liability entity (LLE) tax in 2006 oncorporations and limited liability pass-through entities (e.g., a partnership, S corporation, limited liability company) that affords any of its owners protection from general liability for the entity’s actions

• LLE tax is measured by the entity’s Kentucky gross receipts or gross profits, whichever produces the lower tax, with a minimum tax of $175. For apportionment purposes, receipts from the performance of services are sourced to Kentucky if the income-producing activity is:– Performed in Kentucky– Performed both in and outside Kentucky, with a greater proportion of

the activity performed in Kentucky than in any other state, based on costs of performance

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Sales Factor And Federal Tax Doctrines

• States are more aggressive in applying federal tax doctrines• Broad statutory authority (states beat Congress to the punch)

– Example: New Hampshire Rev. Stat. Ann § 21-J:38-a• Commissioner may disallow any sham transaction in ascertaining

taxpayer’s liability; burden on taxpayer when transaction is between members of a controlled group

• In administering any tax, commissioner may apply the doctrines of economic reality, substance over form, and step transaction

• If commissioner disallows a sham transaction, applicable statute of limitations period for assessing tax, interest and penalties is extended by the applicable SOL period (i.e., SOL period is doubled) – no extension for refunds

• “Sham transaction” means a transaction or series of transactions without economic substance, because there is no business purpose or expectation of profit other than obtaining tax benefits

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Economic Substance And Sourcing

• Idaho Tax Commission Ruling No. 15696 (Sept. 16, 2002)

– Issue: Whether taxpayer’s receipts from the first leg of a sale/buyback or repurchase transaction, and from the second leg of a buy/sellback or reverse repurchase transaction, should be “sales” for purposes of computing the sales factor of the apportionment formula

– Commission ruled these are not “sales” and found support in the step transaction doctrine

– Commission noted that Idaho income tax law expressly incorporates federal interpretations of income and deductions, for purposes of determining federal taxable income

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Economic Substance And Sourcing (Cont.)

• Idaho Tax Commission Ruling No. 15696, (Sept. 16, 2002) (Cont.)

– Commission then determined that the “sale” in a sell/buyback is cancelled out by the pre-arranged buyback that follows it, and that the “sale” in a buy/sellback is cancelled out by the pre-arranged buy that precedes it

– End result was to increase taxpayer’s sales factor to Idaho (by removing “sale” receipts from denominator; trading activity took place outside Idaho, so receipts did not go into numerator)

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Takeaways

• Trends toward single-sales factor and market-based sourcing of service revenue– Be proactive, to determine impact on aggregate apportionment percentage– Consider business restructuring to minimize percentage

• Small differences in application/interpretation of apportionment rules among the states can have significant impact– E.g.: What is tangible personal property and what is a service?– E.g.: For cost of performance states, what costs can be included?

• Be aware of different rules for certain industries• Consider FIN 48 implications

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