1 sjsu/tei high technology tax institute november 6, 2006 current developments in...

1

SJSU/TEI

High Technology Tax InstituteNovember 6, 2006

Current Developments in California/Multistate Taxation

Presenters:

Brian Pederson, Alvarez & MarsalAllan Smith, Grant ThorntonJim Songey, KPMG

2

Key Areas of Development

California New Matters

Multistate Legislative Roundup

Nexus

P.L. 86-272

Expense Disallowance Provisions & Related Party Transactions

Tax Base, Deductions, & Credits

3

Keys Areas of Development

Allocation & Apportionment

Combined and Consolidated Reporting

Franchise, Gross Receipts, and Net Worth Taxes

Sales & Use Taxes

Taxpayer Disclosure

4


Sales factor – gross versus net issueMicrosoft (Cal.)

Gross receipts does include gross proceeds from the redemption of marketable securitiesBut, FTB’s application of alternative apportionment was justified

Transactions generated under 2% of Microsoft’s business income, produced approximately 73% of gross receipts

General Motors (Cal.)Only interest from repurchase agreements (“repos”) included in sales factorRemanded to determine if alternative apportionment applicable to receipts from redemption of marketable securities

Tax CreditsResearch tax credit could only be used to offset tax liability of unitary group member that generated credit (General Motors)

5


Sales factor sourcing – other than tangible propertyCalifornia Legal Ruling 2006-2

Services performed by unitary affiliate not excluded – considered directly performed for affiliate not on behalf of affiliateCost of performance based on arm's length payment to affiliate or actual costs incurred by affiliate

Other sales factor issuesCalifornia

Legal Ruling 2006-01 discusses exclusion of property, payroll, sales related to nontaxable incomeLegal Ruling 2006-03

IRC § 338(h)(10) gains – occasional sale rule may apply; gain included using combined group factorsIRC § 338(g) gains – occasional sale rule and payroll factor not applicable if single day return required

6


Water's-edge legislation (S.B. 663)CFC that is a California taxpayer or that has ECI must include subpart F income in determining water's-edge income base

Proposed regulations 25137 (Telecommunications)FTB staff request for permission to become involved in MTC proposed regulation and consider adoption by California or prepare its own regulation

Proposed amendment to regulation 25110FTB staff request for permission to amend regulation regarding "non-effectively connected income" included in water's-edge income base. Regulation would describe how to determine deductions that would be allowed to arrive at "net NECI"

Tax clearance certificate requirement eliminated (A.B. 2341)

7


SBE adopts pro-ration method for allocating CFC's dividends

In a non-precedential Letter Decision (Appeal of Apple Computer), SBE held that dividends received from CFC partly included and partly excluded from water's-edge group should be prorated between Sec. 25016 elimination provisions and Sec. 24402.

This ruling is in contrast to Appellate Court's holding in Fujitsu that preferential ordering is the proper rule whereby dividends are deemed to be paid first out of income included in the water's-edge combined report (thus subjecting a larger portion of the dividends to elimination under Sec. 25106)

Elimination of dividends from pre-unitary E&P under Sec. 25106

In a Chief Counsel ruling issued earlier this year, the FTB held that dividends paid up through a corporate chain from lower tier subsidiaries up to the ultimate parent of a combined unitary group were properly eliminated under Sec. 25106 in the following scenario:

Ultimate parent (Company A), wholly owned first tier subsidiary (Company B), and wholly owned second tier subsidiary (Company C owned by Company B) are included in a unitary combined report in current year. In the current year, Company C pays a dividend up to Company B and, in turn, Company B pays a dividend up to Company A. Dividend paid from Company C to Company B is paid out of earnings and profits of prior year when Company B and Company C were part of a unitary combined report not including Company A.

FTB held that dividend paid by Company B to Company A was eliminated under Sec. 25106 because the dividend from Company C is considered apportionable business income with respect to Company B, notwithstanding the elimination of the dividends.

8

Legislative Roundup - Texas

H.B. 3 replaces franchise tax with alternative margin tax

Enacted May 18, 2006; effective for reports due on or after January 1, 2008“Alternative Margin” = Total revenue – (Cost of Goods sold or Compensation)

However, ceiling of 70 percent of total revenueCost of goods sold not tied exclusively to Internal Revenue CodeCompensation capped at $300,000 per employeeElect to deduct cost of goods sold or compensationElection applies to entire unitary group

9


TaxpayersVirtually all entities other than individuals and general partnerships owned entirely by natural personsIncludes limited partnershipsNumerous exclusions

Real estate investment trusts that do not hold real estatePassive entities

Combined reporting80 percent ownership threshold (not 50 percent)80/20 exclusionCombined margin computed pre-apportionment

10


ApportionmentSingle factorSourcing rules same as franchise taxNo throwback rule

Tax rateGenerally 1 percent; 0.5 percent for wholesalers and retailers

Transitional rules for “new” taxpayers (i.e., not previously subject to the franchise tax)

11

Legislative Roundup - Kentucky

Special Session H.B. 1 New limited liability entity (“LLE”) tax replaces AMC beginning in 2007

Corporations and pass through entities subject to LLE tax

Pass-through entities no longer subject to corporate income tax, income flows through to corporate owner

Doing business standard modified to include ownership of pass-through entities

Corporate owners get credit for LLE tax paid by pass-through entities

Credit an be used to offset corporate income or LLE taxCredit cannot be carried forward or back

H.B. 403 - Expense disallowance revised to include intangible expenses, retroactive to January 1, 2005

12

Legislative Roundup – New Jersey

A. 4901Attributional nexusSales tax rate increase from 6% to 7%Expansion of sales tax base, including digital goods and information services

A. 4706Corporate tax surcharge for three years

NOL limitation allowed to expireAMA allowed to sunset

13

Legislative Roundup – Pennsylvania

H.B. 859NOL cap increased from $2 million to greater of $3 million or 12.5% of taxable incomeIncreases sales factor from 60% to 70%, for corporate net income tax purposes only

S.B. 300Accelerates phase-out of capital stock/franchise taxChanges treatment of S corporations; instead of separate S election, federal S corporation status respected unless taxpayer opts out

No Graham Packaging fix

14

Legislative Roundup – Ohio

Ohio H.B. 530“Qualified distribution center” exemption

Original sourcing rules resulted in most receipts from distribution centers being sourced to Ohio, even if goods ultimately delivered out-of-stateUnless rejected by referendum, effective date is January 1, 2007

Consolidated group amended to include all foreign entities, not just foreign corporationsNumerous other technical revisions

15

Legislative Roundup – Other States

IdahoSales tax rate increased from 5 percent to 6 percent

MichiganSBT phase-out accelerated from 2009 to 2007

North CarolinaS.B. 1741 expense disallowance expanded to copyrights and patents; franchise tax extended to LLCsH.B. 1891 expense disallowance exception for payments to non-US related members

South Carolina H.B. 4874 Single factor apportionment for manufacturers/sellers

Tennessee H.B. 4048REIT franchise tax exemption eliminated

16

Legislative Roundup – Other States

Rejected measuresMinnesota foreign operating company additional substance requirementsCalifornia separate M-3 requirement

17

Nexus – Intangibles

KMart (N.M.)Court declined to address appellate court’s precedential holding that out-of-state intangible licensing company had income tax nexus But, reversed on gross receipts tax issue; held not subject to tax on statutory groundsSonic, follows KMart

Franchise fees paid to out-of-state restaurant corporation not subject to gross receipts tax

H.B. 583, enacted in response to KMart, receipts from intangible property located in the state are subject to gross receipts tax, prospectively

18


Geoffrey (Okla. Civ. Ct. App.)Intangible licensing company subject to income taxQuill physical presence rule only applies to sales and use taxesCourt relied heavily on A&F TrademarkCourt also upheld use of single factor apportionment formula

19


LANCO (N.J. Super. Ct., App. Div.)Decision affirmed by N.J. Supreme CourtIntangible licensing company had nexus; Tax Court decision reversedQuill not applicable to income taxesRelied heavily on A&F Trademark - - out of North Carolina Also relied on:

International Harvester, even though involved withholding taxGap (Apparel), even though not a decision on the merits and did not involve Commerce Clause

Did not address director’s arguments Attempt to reconnect Due Process and Commerce Clause nexus standardsAlso argued that licensing increased sales, increased need for fire, police, other protections

20

Nexus – Attribution, Remote Sellers

Georgia H.B. 111In-state affiliated retailer establishes nexus unless:

Does not sell, market, advertise or perform other services on behalf of remote sellerAccepts returns from third parties under same terms as returns from affiliate

Expands categories of actors that establish nexus through solicitationAmends provision establishing nexus through advertisement

Advertisement alone or common carrier delivery alone do not establish nexus

Effective July 1, 2006

21


New Jersey A. 4901Attributional nexus for related parties

Burden imposed on in-state seller to collect on sales made by out-of-state related seller if acting as “agent”Trigger criteria

Similar name, tradenameIntercompany service fee contingent on salesCommon business planServices to promote, maintain seller’s market

Is Quill satisfied just because incidence of tax on remote sale is shifted to an entity with nexus?

22


Massachusetts Letter Ruling 05-7Bricks and mortar retailer in state would not create nexus for affiliated remote sellersEven though retailer would accept returns of items purchased from remote sellers, as well as from unrelated sellersAccepting returns was only incidentalScripto/Tyler pipe marketing standard not satisfied because remote sellers’ markets already established and retailer would actually decrease their market shareAcknowledged, distinguished Borders Online

23


Arco Building Systems (Tenn. Ct. App.)Out-of-state seller had use tax nexus; manufacturer located in TennesseeShipments made by common carrierCommon carrier collected payment, turned over to manufacturer Arm’s-length sale; typical indicia of attributional nexus absentCourt concerned about double benefit

Seller registered as a dealer in Tennessee; purchased from manufacturers under resale certificateYet no tax collection obligation assuming seller lacked nexus

24

Nexus – Attribution, Other

Lanzi (Ala. App.)Nonresident limited partner not subject to taxAnalogized relationship to stock ownership

Mockingbird (Cal. SBE)Member managed LLC subject to minimum taxPresumed that business activities/decisions occurred in state because members resided there

Asworth (Ky. BTA)Corporate partner did not have nexus based on former physical presence nexus standardOpportunity limited to pre-2005 tax yearsDecision has been appealed by Department

25


Dell (La. Ct. App.)Reversed lower court; repairers established use tax nexus for out-of-state sellerDespite contract between repair company and customer, repair company acting on seller’s behalf

Dell (N.M. Tax. Rev. Dept.)Seller liable for gross receipts tax on computer sales and use tax on catalogs

26


Virginia (Dept. of Tax.)New distribution center would not create nexus for affiliatesBuy-sell arrangementCenter was single member LLC but elected to be taxed as a corporation

27

Nexus – Other

Tennessee Revenue Ruling 05-25One employee established nexus for online sellerMaintained website, not involved in sales

Buehner Block (Wyo.)Voluntary possession of vendor’s license plus use of common carrier to deliver goods sufficient to create substantial nexus

28

P.L. 86-272

Chester Asher (N.J. Tax Ct.)Activities of delivery persons not protectedCollected outstanding balances, picked up returned, spoiled and overshipped merchandise

New York rulingManufacturer’s R&D arrangement with university did not compromise P.L. 86-272 protection

29

Expense Disallowance

Narrower Broader

Royalties andintangible related interest

and all intercompany interest

North Carolina

Oregon1

District of ColumbiaGeorgiaIndianaNEW

MississippiNew YorkTennessee2

Virginia

AlabamaArkansas ConnecticutIllinois1 Maryland Massachusetts New JerseyOhio

andother expenses

Kentucky3

South Carolina4

1To recipient outside combined report 2For disclosure purposes only

3Management fees; but only intangible interest disallowed4If accrued but not paid

30

Related Party Expense Disallowance

Indiana H.B. 1001Applies to intangible expenses and directly related interestMany exceptions; most have business purpose and/or arm’s length requirementsExtensive disclosure requirementsNumerous exceptions; some twists

Subject to tax . . . in domicileConduit also applies to payments received from unrelated parties

Effective July 1, 2006

31

Related Party Expense Disallowance

Kentucky H.B. 403Intangible expenses disallowed retroactively to 2005Inadvertently omitted from 2005 legislation

North Carolina S.B. 1741 expands expense disallowance to copyrights and patentsH.B. 1891 creates foreign payment exception

AlabamaConduit exception added to regulationIncluded within unreasonable exceptionComplex limitations on deductibility

32

Related Party Transactions

VirginiaManagement fees deductible, represented payment for actual servicesNo deduction for markup Implies evidence of arm’s length profit component may be eligible for deduction

33

Tax Base

MichiganV&J Foods (Mich. Ct. App.)

Royalties did not include payment for services, must be added back

Ford Credit (Mich. Ct. App.)Deemed dividends from CFCs not gross receipts for purposes of determining eligibility for SBT reduction

Davis (Ky. Ct. App.)Exemption for Kentucky municipal bond interest unconstitutional where other state obligations taxedTaxpayer was an individual

34

Tax Base – Net Operating Losses

Louisiana Revenue Ruling 06-008State IRC § 382 limitation – use one of three methods:

Allowable federal NOL x Louisiana apportionment ratioAllowable federal NOL x (Louisiana income/federal income)Louisiana NOL x (Allowable federal NOL/total NOL)

Matter of Univisa (NY Div. of Tax App.)Federal election to reattribute NOLs generated by a subsidiary followed even though taxpayer filed separately in New York

PennsylvaniaNOL cap raised from $2 million to $3 million or 12.5 percent of taxable income

35

Tax Base - REITs

New JerseyRegulation amended to provide that REIT dividends ineligible for DRDEffective for distributions paid on or after February 6, 2006Draft regulation would have disallowed “indirect” distributions; language omitted from final versionAdministrative response to UNB decision

36

Credits

CunoOn May 15, 2006, the U.S. Supreme Court vacated Sixth Circuit decision which had held Ohio investment tax credit (ITC) unconstitutional Supreme Court’s ruling based solely on lack of standing; did not address merits

Plaintiffs did not show actual injuryImpact of incentives hypothetical, uncertain, remote, may actually benefit taxpayers

Invalidated Sixth Circuit’s order enjoining Ohio from enforcing the ITC

37

Allocation and Apportionment

Allocable or apportionable?

Science Applications (Md. Tax Ct.)Capital gain from sale of subsidiary not taxableSubsidiary at all times managed separately from parent Parent did business in Maryland, but subsidiary had no presenceGain had no nexus to MarylandTaxation of gain would have caused distortion

38


Allocable or apportionable?Siegel-Robert, Inc. (TN Chancery Ct,)

Interest from U.S. Treasury securities not apportionableFunds were intended and used solely to purchase diversified businesses for investmentEarnings not used for capital replacement, expansion or to fund day to day operationNo unitary relationship between manufacturing business and investment functions

39


Allocable or apportionable?

Indiana Letter of Findings 02-2004007Capital gain related to contribution of assets to a new partnership satisfied transactional testTaxpayer in the business of selling its business

Indiana Letter of Findings 02-0274Gain on sale of three subsidiaries created, sold three days later was nonbusiness incomeSubsidiaries held foreign interests not integral or essential to taxpayer’s business

40


Sales factor sourcing – tangible propertyIndiana

H.B. 1001 – dock sales sourced to destinationLegislatively overrules Miller Brewing (Ind. Tax Ct.) ruling that sales should be sourced to dock

Paccar (Ala. ALJ)Sourced to destination; issue of first impression

VirginiaSales made to Virginia distribution center under buy-sell arrangement sourced to Virginia regardless of destinationAlternative apportionment not justified

41


Sales factor sourcing - other than tangible propertyMassachusetts – Interface Group (App. Tax Bd.)

In-state company that assembled vacation packages must source all receipts to MassachusettsCosts not sourced to location of vendorsEach package not a separate income producing activityOperation of business as a whole was the income producing activity; cited Boston Professional Hockey Assoc.

Massachusetts – EUA Ocean State (App. Tax Bd.)Receipts from sale of electricity not sale of tangible personal property Department will not appeal, will follow ruling; refund opportunities

42


Sales factor sourcing - other than tangible propertyCalifornia Legal Ruling 2006-02

Services performed by unitary affiliate not excluded – considered directly performed for affiliate not on behalf of affiliateCost of performance based on arm’s length payment to affiliate or actual costs incurred by affiliate

Indiana Letter of Findings 2006-02ITInsurance company receipts sourced based on personal services ratio2005 ruling sourcing same receipts based on property and payroll factors withdrawn

New JerseyRegulation clarified – trademark receipts sourced based on licensee’s pro rata use in state according to its sales factor

43


Other sales factor issuesCalifornia

Legal Ruling 2006-01 discusses exclusion of property, payroll, sales related to nontaxable incomeLegal Ruling 2006-03

IRC § 338(h)(10) gains – occasional sale rule may apply; gain included using combined group factorsIRC § 338(g) gains – occasion sale rule and payroll factor not applicable if single day return required

ArizonaNonunitary partnership’s receipts not included in corporate partner’s sales factor numerator

44


Single factor apportionmentIndiana H.B. 1001 – phase-in beginning in 2007South Carolina H.B. 4874

For manufacturers and retailersIn lieu of phase-in, must compute under old three-factor and single factor methods; only portion of tax savings from single factor will be permitted from 2007 until 2011

Wal-Mart (N.M. Tax Rev. Dept.)Intangible licensing company required to use single factor and source according to location of use by licenseeWas held in abeyance pending KMartTaxpayer conceded nexus; argued zero apportionment

45


Payroll factorPlantation Pipeline (Ala. Dept. Rev.)

Payments to affiliate for administrative services included in payroll factor; not leased employeesRelied on C&D Chemical

UPS (Pa. Supreme Ct.)Company with employees furnished by affiliate did not have a payroll factor

46


Special industry formulasFedEx Ground (Pa. Commw. Ct.)

Formula = average receipts per mile x miles traveledTaxpayer could compute numerator using lower in-state average revenue miles rather than everywhere revenue miles

Constitutional issuesStonebridge (Ore. Tax Ct.)

Apportionment formula distortive; violated Due Process fair apportionmentCommerce Clause not at issue because insurance companyCourt ordered total tax refund because insurance company provisions do not authorize alternative apportionment

47

Combined and Consolidated Returns

Argonaut (Cal. SBE)Rejected taxpayer’s attempt to include insurance companies in combined reportConsistent with longstanding policyAlternative apportionment could not be invokedInclusion impractical since insurance companies do not have taxable income

Kidde America (Mo.)Amended return can be used to elect consolidated despite regulation requiring election by return due date

48

Combined and Consolidated Returns

New York forced combination Premier National Bancorp (N.Y. DTA)

Article 32 bank and Article 9-A subsidiary could not be required to file combinedEconomic substance existed; not solely motivated by tax considerations

Hallmark (N.Y. DTA)Sales company not required to file combined with manufacturerPricing study, concurrent documentation overcame presumption of distortionAffiliate established for valid business reasonsArm’s length pricing not required to include “valuable organizational intangibles,” such as customer lists

Neither ruling is precedential

49

Franchise and Other Taxes

AT&T (Ala. App. Ct.)Business privilege tax deduction for investment in other entities unconstitutional where tied to entities’ doing business in Alabama Risk of multiple taxation insufficient to satisfy compensatory tax doctrine

50

Pass Through Entities

Bender (D.C.)Unincorporated business tax did not violate Home Rule Act prohibition on taxation of nonresidents individualsUBT was enacted by Tax Act of 1947 and imposed by CongressHome Rule Act enacted in 1973, prohibition did not supersede or repeal UBTReversed lower court decision

51

Pass Through Entities

Northwest Energetic (Cal. Super. Ct.)Annual LLC fee ruled unconstitutionalLevy was a tax not a feeImposed on total income without apportionment; thus, violated constitutional fair apportionment requirementNot precedentialHowever, protective refund claims will be held in abeyance pending appeal

52

Sales and Use Taxes – Software, Digital Goods

Taxability of electronically transmitted softwareColorado

Software regulation revised effective May 30, 2006Software exempt unless three criteria met

PrepackagedNon-negotiable license agreement contained in packageDelivered via tangible medium (not counting load and leave)

Replaces obsolete regulation withdrawn several years ago that only provided limited exemption for custom software

PennsylvaniaState rescinded its prior Policy Statement. Current policy, beginning Nov. 1, 2005, is that canned software is taxable regardless of delivery format

53

Sales and Use Taxes – Software, Digital Goods

Taxability of electronically transmitted softwareMassachusetts

Taxable beginning April 1, 2006However, software development and sale will now qualify as manufacturing for purposes of qualifying for the corporate excise single factor apportionment formula

GeorgiaRegulation provides that electronically downloaded software is not subject to tax

54

Sales and Use Taxes – Manufacturing Exemptions

Southwestern Bell (Mo.)Middle of the system equipment exempt, even though some manufacturing occurs at customer site, on customer-owned equipmentOptional vertical billing services exemptDemonstrates broad application of exemptionCurrent law provides explicit exemption for telecommunications equipment

AT&T (Tenn. Ct. App.)Equipment not exempt because used to provide service

55

Sales and Use Taxes – Equipment Exemptions

Concentric (Pa. Commw. Ct.) – internet service provider’s equipment and wireline purchases taxable

Manufacturing exemption inapplicableUniformity clause challenge rejected because other industries subject to increased regulationNot exempt under Internet Tax Freedom Act because tax was grandfathered

56

Sales and Use Taxes – Other Exemptions

AirlinesAmerican Airlines (N.Y. DTA) - Electricity eligible for airline maintenance/repair property exemption

AdvertisingVerizon (Mass. App. Ct.)

Printing costs for telephone directories not eligible for former advertising exemption

Merion Publications (Pa. Commw. Ct.)Publisher eligible for direct mail advertising exemption even though advertising on behalf of others

57

Sales and Use Taxes – True Object Test

Virginia H.B. 5002/Tax Bulletin 06-4Legislation requires true object test to be applied on a statement of work basis, rather than an overall contract basis, for government contractsEffective for work orders entered into on or after July 1, 2006Under old policy

If overall contract was for services, contractor was subject to use tax on all purchasesIf overall contract was for goods, purchases were sales for resale and subsequent sale to governmental entity also exempt

58

Sales and Use Taxes – Subjectivity

DaimlerChrysler (Ohio Bd. Tax App.)Manufacturer, not dealer, subject to use tax on “goodwill” repair parts

Leasing - Citicorp (Md.)Lease termination payment not subject to sales taxLessee returned equipment, so no “sale” or “exchange” to lessee

Choice Hotels (S.Dak.)Franchisor not subject to tax on fees collected from franchisees and remitted to travel agentsTravel agent commissions generally exemptExemption not lost by franchisor acting as conduit

59

Sales and Use Taxes – Other Issues

Bad debt deduction – DaimlerChrysler (Mich. Ct. App.)Vehicle finance company entitled to bad debt deduction

Location of sale - AlabamaTaxpayers may control situs of local sales and use tax

Discrimination - DirectTV (N.C. Ct. App.)Imposition of sales tax on satellite but not traditional cable services did not violate Commerce ClauseDifferential tax treatment resulted from nature of businesses, not location of activities

60

Taxpayer Disclosure

Massachusetts H.B. 4169Penalty for failure to disclose an inconsistent return positionIRC § 6662-like penalty

Utah S.B. 139Disclosure, penalties for taxpayers and advisorsState level listed and reportable transactionsNo voluntary compliance initiativeEffective January 1, 2007

West Virginia H.B. 4630Disclosure, penalties for taxpayers and advisorsFederal transactions only, no state level transactionsVoluntary compliance August 1, 2006 through November 1, 2006

1 sjsu/tei high technology tax institute november 6, 2006 current developments in...

Documents

california taxpayer

california new matters

credits slide

watersedge group

kpmg slide

required slide

nontaxable income legal

watersedge comb