Service providers are entitled to use the AMA gross profits method and deduct their cost of services provided.
Taxpayers without a federal cost of good sold are not precluded from using the gross profits method to compute their AMA. Instead of using federal cost of goods sold, these taxpayers must compute their cost of goods sold using some “other input or expenditure” as may be necessary to equitably measure their business activity. N.J.S.A. § 54:10A-5a(a).
Under the gross profits method, the AMA tax base is New Jersey gross receipts less the taxpayer’s cost of goods sold. For this purpose, “cost of goods sold” means the taxpayer’s cost of goods sold as computed for federal income tax purposes or some “other input or expenditure, as determined by the director, as may be necessary to equitably measure the business activity of the taxpayer,” allocated to New Jersey using either the taxpayer’s New Jersey allocation factor or, at the taxpayer’s option, just its receipts factor. N.J.S.A. § 54:10A-5a(a); N.J.A.C. 18:7-18.1.
Service providers have no federal cost of goods sold. This is because the only types of companies that have a federal cost of goods sold are companies that produce property or acquire property for resale. See I.R.C. § 263A(b). Therefore, to “equitably measure” their business activity as required by the AMA statute and regulations, service providers should compute their New Jersey gross profits using their cost of providing services.
For example, service providers can compute their costs in a way analogous to how resellers of tangible personal property compute their cost of goods sold for federal income tax purposes. Under federal rules, cost of goods sold includes all direct costs and certain indirect costs allocable to property acquired for resale. Treas. Reg. § 1.263A-3(a). Direct costs include the cost of the property acquired for resale. Treas. Reg. § 1.263A-3(c)(1). Indirect costs include purchasing costs such as labor, supplies, occupancy expenses (i.e. rent, utilities, insurance), telephone, and general and administrative costs that are associated with taxpayer’s purchasing activities. Id. Therefore, “cost of services provided” should reflect costs of services purchased for resale to customers and indirect costs such as office operating expenses, labor, and equipment costs associated with the purchasing activity.
This approach is consistent with the legislative history of the AMA.
As originally proposed, the AMA statute provided that New Jersey gross profits was computed based solely on the taxpayer’s New Jersey gross receipts and federal costs of goods sold. A. 2501, 210th Leg. (introduced June 6, 2002). The legislature, however, recognized the hardship that would have resulted to low-margin service providers with no federal cost of goods sold: the original bill was amended in Committee to provide the Director with discretion to use some “other input or expenditure” as necessary to measure the taxpayer’s business activity. As amended, “the bill gives [the Director] the authority to expand or adjust the definition of ‘cost of goods sold’ if justified to achieve a more equitable result among the various types of businesses subject to the alternative calculation.” See Statement to A. 2501 at 6. We think that if the Director were to fail to exercise this discretion, the Director would be abusing his discretion.
Therefore, consistent with the legislature’s intent, service providers can take the position that they can use the gross profits method and deduct their cost of providing services—even if they have no federal cost of goods sold.
Cost of goods sold should be fairly allocated to New Jersey.
Under the gross profits method, AMA is computed by subtracting the taxpayer’s cost of goods sold from its New Jersey gross receipts. See N.J.S.A. 54:10A-5a. “Cost of goods sold,” for this purpose, is allocated to New Jersey by multiplying cost of goods sold by either the taxpayer’s three-fraction allocation factor (N.J.S.A. 54:10A-5a) or the taxpayer’s sales fraction (N.J.A.C. 18:7-18.1).
Thus, a taxpayer with a greater concentration of property and payroll in New Jersey than sales in New Jersey—that is, an in-state taxpayer—will benefit from using the three-fraction method. That method would allocate more costs against New Jersey gross receipts than the sales-fraction method. By contrast, a taxpayer with a lesser proportionate New Jersey presence will not benefit from the option to use the three-fraction method. Furthermore, not only do in-state taxpayers benefit from the option to use the three-fraction method, the benefit of that method increases in direct correlation to a greater proportionate presence in New Jersey. Accordingly, the greater a taxpayer’s New Jersey presence, the less AMA it pays in connection with a sale into New Jersey.
On its face and as applied, therefore, this method of allocating cost of goods sold favors in-state taxpayers over out-of-state taxpayers. We can illustrate this by considering a hypothetical consumer-products company, “Taxpayer,” which is headquartered outside New Jersey. Suppose Taxpayer made sales of $50 million of products that were shipped to locations in New Jersey during the 2002 privilege period. For this period, Taxpayer’s federal cost of goods sold was $2 billion; its sales fraction was 2%; and its three-fraction allocation factor was 1%. Thus, its allocated cost of goods sold for AMA purposes under the sales-fraction method was $40 million ($2 billion × 2%) and under the three-fraction method was $20 million ($2 billion × 1%). Obviously, between these two choices, the three-fraction method was not a viable option for Taxpayer. Instead, Taxpayer’s only viable option was the sales-fraction method. Under that method, its taxable New Jersey gross profits were $10 million ($50 million of New Jersey gross receipts less $40 million of allocated cost of goods sold). This results in AMA of $35,000. (The graduated tax rate on gross profits of $10 million is 3.5 mils, so $10 million × 0.35% = $35,000. See N.J.S.A. 54:10A-5a.)
But if this Taxpayer had been headquartered in New Jersey and had a 15% three-factor allocation factor, the result would have been different. In that case, Taxpayer’s cost of goods sold under the three-fraction method would have been $300 million ($2 billion × 15%, Taxpayer’s headquarters apportionment percentage). As a result, Taxpayer would have had $0 of taxable New Jersey gross profits for the 2002 privilege period ($50 million of New Jersey gross receipts less $300 million of allocated cost of goods sold). Therefore, if Taxpayer had been headquartered in New Jersey, it would have paid no AMA.
This preference for in-state taxpayers is prohibited by the Commerce Clause of the United States Constitution. U.S. Const. Art. I, § 8, cl. 3. Under the Commerce Clause, a state may not discriminate against interstate commerce. See Welton v. Missouri, 91 U.S. 275 (1876). This means that an in-state taxpayer cannot be favored over an out-of-state taxpayer. See, e.g., Fulton Corp. v. Faulkner, 516 U.S. 325 (1996).
As a matter of fact, the discrimination in this case is quite similar to the discrimination that was struck down by the Court in Fulton. Fulton involved a North Carolina tax on intangibles, such as stock in a corporation. If a taxpayer owned stock, North Carolina allowed a deduction from the tax base if the corporation was a North Carolina taxpayer. And the greater the corporation’s underlying North Carolina income-tax apportionment, the greater the deduction. So, just like New Jersey’s cost of goods sold deduction, under the North Carolina scheme, the greater the corporation’s proportionate presence in North Carolina, the lesser the tax. In Fulton, the Supreme Court concluded that this computation discriminated against interstate commerce. Likewise, if the courts were to review New Jersey’s cost of goods sold allocation method, they would conclude that it too discriminates against interstate commerce.
Therefore, if the standard statutory and regulatory methods for allocating cost of goods sold to New Jersey were to be followed mechanically, the result would violate the Commerce Clause and would be rejected by the courts. To avoid that, the Director should use his authority under N.J.S.A. 54:10A-8 to adjust the allocation factor used to allocate cost of goods sold against Taxpayer’s New Jersey gross receipts so that Taxpayer is treated the same as in-state taxpayers. Indeed, it is the Director’s obligation to use his discretion under section 8 when such an adjustment is appropriate, like in this case. See F. W. Woolworth Co. v. Director, 45 N.J 466 (1965).
One adjustment that accomplishes this goal is to treat Taxpayer as if Taxpayer were a New Jersey headquartered company. Under that approach, Taxpayer would use the three-fraction allocation percentage from its headquarters state to allocate its cost of goods sold. That way, Taxpayer’s cost of goods sold with respect to its New Jersey gross receipts would be the same as it would have been if Taxpayer were a New Jersey headquartered company. Under that approach, as described above, Taxpayer’s allocated cost of goods sold would exceed its New Jersey gross receipts. Thus, its taxable New Jersey gross profits, and its AMA, would be $0. The AMA cap must be fairly apportioned.
The maximum annual AMA for a single corporation is $5 million (or $20 million for an affiliated group). N.J.S.A. 54:10A-5a(d)(1). The statute and regulations do not provide for any apportionment of this $5 million cap. This violates the Commerce Clause of the United States Constitution.
The problem is that the Commerce Clause imposes a requirement that taxes be fairly apportioned. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). To be fairly apportioned, a tax must be “internally consistent.” To meet this standard, if the tax were hypothetically imposed by every state, a multi-state taxpayer must pay no more tax than an intra-state taxpayer with regard to the same level of business activity. Oklahoma Tax Comm'n v. Jefferson Lines, Inc., 514 U.S. 175, 185 (1995). The AMA, with its unapportioned cap, fails this standard. For example, if a taxpayer with $4 billion of gross receipts were to conduct its entire business in New Jersey, its AMA (but for the cap) would be $16 million. (The maximum tax rate on gross receipts is 4 mils, so $4 billion × 0.4% = $16 million. See N.J.S.A. 54:10A-5a.) But as a result of the cap, this taxpayer’s tax is only $5 million.
But suppose another taxpayer with the same amount of gross receipts were to conduct business equally in all 50 states, so that its gross receipts in each state was $80 million. If each of those states were to adopt New Jersey’s AMA regime, the taxpayer’s AMA in each state would be $320,000. ($80 million × 0.4% = $320,000.) As a result, the multi-state taxpayer would not hit the $5 million cap in any particular state. This means it would have to pay the full AMA, without the benefit of any cap, in each state. Its total AMA, therefore, on $4 billion of gross receipts would be $16 million—or $11 million more than the taxpayer that conducts business exclusively in New Jersey.
Since a multi-state taxpayer pays more tax than an intra-state taxpayer on the same level of business activity, the AMA fails the internal consistency standard. Thus, it is not fairly apportioned.
To avoid this result, the Director should use his authority under N.J.S.A. 54:10A-8 to apportion the $5 million cap based on the taxpayer’s activity in New Jersey. Specifically, multi-state taxpayers are entitled to apportion the $5 million based on their New Jersey sales factor. For example, if a taxpayer’s New Jersey sales-factor percentage is 2%, its maximum AMA is $100,000. (2% × $5 million = $100,000.) This meets the internal consistency standard because if every state were to impose the AMA using the same apportioned cap, the taxpayer’s total AMA would be $5 million—the same as if its activities were limited to New Jersey.
The AMA, as a gross receipts tax, must be fairly apportioned.
A gross receipts tax, such as the AMA, is a “variety of tax on income which [must be] apportioned to reflect the location of the various interstate activities by which it is earned.” Jefferson Lines, 514 U.S. at 189. Thus, although a state may impose an unapportioned sales tax on the entire value of a transaction simply because tangible personal property is delivered in a state, see McGoldrick v. Berwind-White Coal Mining Co., 309 U.S. 33 (1940), a gross receipts tax requires an apportionment between the in-state and out-of-state activities that contributed to the value associated with the transaction.
One reason for this distinction is that a sales tax allows for a credit for tax paid to another state, which avoids multiple taxation as tangible property moves in interstate commerce. Jefferson Lines, 514 U.S. at 192, n. 6. By contrast, a gross receipts tax does not allow for such a credit. Thus, one state could tax the unapportioned gross receipts from shipping a product (such as Delaware once did) and another could tax the unapportioned gross receipts on delivery of the product (as New Jersey now does). As a result, two states could try to tax, in full, the value of a single transaction without regard to the proportion of that value that was attributable to the taxing state.
Moreover, even if the entire gross receipts attributable to a single multi-state transaction could be taxed by a single state, the state of origin, not the state of delivery, would have exclusive claim to tax those receipts. For example, in Franklin Fibre-Lamitex Corp. v. Director, a Delaware superior court analyzed authority under the U.S. Constitution and ruled that the state of origin has exclusive claim to tax receipts from a sale transaction; by contrast, it held that the state of destination could not impose a tax on the same receipts. 505 A.2d 1296, 1299–1301 (Del. Sup. Ct. 1985).
Therefore, New Jersey’s AMA, by imposing an unapportioned gross receipts tax on the entire value of a transaction involving only the shipment of goods to locations in New Jersey, violates the Commerce Clause. To remedy this problem, the receipts from each transaction must be apportioned among the states that contributed to the value that is attributable to the transaction. In the alternative, if any one state may tax the receipts, then only the state of origin, not the state of destination, may tax them. Since New Jersey’s AMA is based on destination, no AMA would therefore apply to Taxpayer’s sales.