As state legislative sessions begin to wind down, several state legislatures have recently enacted significant tax changes. New York, Rhode Island and Maine have enacted numerous income tax changes that reflect the trend of states to look at combined reporting, market sourcing, related party addback provisions, throwback, gross receipts taxes, economic nexus and other measures to close perceived “tax loopholes.” In this regard, Michigan has dramatically changed the way corporations report and pay taxes in that state, by moving to a two-pronged tax including a gross receipts tax component. And Texas, which formerly utilized a two-pronged tax, has just “tuned up” its one-year-young Texas Margins Tax. Finally, legislative focus on MTC-style combined reporting in Wisconsin, as well as combined reporting bills and recommendations in Pennsylvania and North Carolina, will be fodder for continued action this year and into next year’s sessions.
Michigan Replaces the SBT with the Michigan Business Tax
After various proposals and discussions on the best tax regime to replace the Single Business Tax (“SBT”) when it expires at the end of 2007, the Senate settled on S.B. 94 which contains the new Michigan Business Tax. Governor Jennifer Granholm received S.B. 94 on June 28, and she is expected to sign the bill early this week. The new Michigan Business Tax is a combination of a gross receipts tax and an income tax, both of which are imposed on taxpayers and consist of: (1) a modified gross receipts tax at a rate of 0.8% imposed upon gross receipts less purchases of inventory and assets subject to amortization, depreciation or accelerated cost recovery, and (2) a business income tax based on federal taxable income imposed at a rate of 4.95%. However, the new Michigan Business Tax also incorporates most of the features other states have adopted to attack perceived corporate tax abuses and “loopholes,” including, but not limited to:
- Broad class of taxpayers including, but not limited to, corporations, partnerships, limited liability companies, S corporations and other similar entities;
- Low nexus threshold which is based on physical presence of more than one day or active solicitation (to be defined) of sales with gross receipts of $350,000;
- Single sales factor apportionment formula;
- Destination sourcing for sales of tangible property;
- Market sourcing based on “benefit received” for sales of services and intangibles; and
- Mandatory unitary combined filing for unitary businesses that are 50% or more commonly owned and a flow of value or contribution and dependency between them.
Rhode Island Adopts Addback and Throwback for 2008
On June 21, the Rhode Island House of Representatives and Senate overrode the gubernatorial veto of the state’s 2008 budget bill (H.B. 5300, Substitute A), thereby adopting an addback provision and throwback rule effective for tax years beginning after December 31, 2007.
Addback Provision. Similar to addback statutes enacted in other states, Rhode Island corporate taxpayers must add back to taxable income deductions for interest and intangible expenses and costs, directly or indirectly paid, accrued, or incurred to related members. Rhode Island’s addback provision contains “unreasonableness,” “arm’s-length,” and “business purpose” exceptions that apply to all such related-party payments. Further, the new legislation permits partial adjustments if the addback of related-party expenses produces an unreasonable result. An additional exception applies solely to related-party interest expense payments, where Rhode Island will not require a taxpayer to add back such interest expense if: (1) the principal purpose of the transaction was not tax avoidance, (2) the interest was paid under arm’s-length terms, and (3) the related member is subject to tax on its net income, the measure of the tax included the interest received from the taxpayer, and the effective rate of tax applied to the interest received by the related party is no less than the effective rate of tax applied to the taxpayer in Rhode Island minus 3%.
Throwback Rule. In addition to the addback provision, the Rhode Island budget bill enacts a “throwback” rule that requires taxpayers to include in the numerator of their respective Rhode Island sales factors, receipts derived from sales of tangible personal property shipped from Rhode Island to a state where the taxpayer is not taxable in the state of purchaser, e.g., due to P.L. 86-272 protection in the destination state.
Sutherland Observation: Rhode Island now joins approximately 19 other states and localities that have addback provisions or disclosure requirements. The list of separate company states that have not taken measures to prevent related party intangible and interest expense deductions continues to decline as states not only consider addback statutes, but also combined reporting regimes to counter perceived abuses in intercompany expenses.
Rhode Island’s enactment of throwback continues the trend of the states to ensure that taxpayers source all of their sales to the states. More than half of the states with a corporate income tax now have a throwback rule. Sutherland will advocate that the National Conference of Commissioners on Uniform State Laws carefully consider the throwback rule as part of its review of the Uniform Division of Income for Tax Purposes Act.
Maine Adopts Interesting Sales Factor Sourcing Provisions
In the last few days of the budget debate, Maine legislators managed to slip some significant sourcing changes into the bill that was signed by Governor John Baldacci on June 7. The changes, which are effective January 1, 2007, provide for:
- Market-based sourcing for the performance of services – services are sourced where the services are “received”;
- If the state where the services are received is not readily determinable, then the services are deemed to be received at: (1) the office of the business customer where the order for services was placed; or (2) the office of the customer to which the services are billed;
- Throwback sourcing of services based on costs of performance. If receipts are attributable to a state where the taxpayer is not taxable then receipts are attributed to Maine if a greater proportion of the costs of performance are in Maine than in any other state; and
- A single sales factor apportionment formula.
New Hampshire Legislature Advances Economic Nexus Legislation
On the heels of the U.S. Supreme Court’s denial of the petitions for certiorari in MBNA and Lanco1, the New Hampshire legislature has approved an “economic nexus” standard by redefining the statutory definition of “business activity” for purposes of the business profits tax. The expanded definition appears to be very similar to the “substantial economic presence” standard adopted by the West Virginia Supreme Court in MBNA. Specifically, the following is added to the definition of a “business activity” in the state: “a substantial economic presence evidenced by a purposeful direction of business toward the state examined in light of the frequency, quantity, and systematic nature of a business organization’s economic contacts with the state.” In what may become a continued trend among the states, the New Hampshire legislature has attempted to codify by statute an economic nexus standard that many states have adopted via regulation or departmental administrative practice. H.B. 2, Section 127, (N.H. 2007) was approved by the New Hampshire legislature on June 29, 2007 and is awaiting approval by the governor. If signed by the governor, the effective date of the legislation is July 1, 2007.
Sutherland Observation: While the U.S. Supreme Court has declined to address dormant Commerce Clause nexus standards since its decision in Quill in 1992, federal legislation – the Business Activity Tax Simplification Act of 2007 (“BATSA”) – that was recently reintroduced on June 28 – aims to thwart the trend of states to assert a “substantial economic presence” nexus standard. BATSA would restrict the states’ ability to impose a net income tax or tax measured by net income on taxpayers that do not have physical presence in the state. The enactment of BATSA would provide some level of certainty to taxpayers struggling with differing and changing state nexus standards.
New York Reduces Franchise Tax Rate, Accelerates Single Sales Factor and Clarifies Combined Reporting Rules
Corporate Franchise Tax Rate Reduction. The Budget provides several substantial rate reductions for corporations subject to the Article 9A Corporate Franchise Tax (“Corporate Franchise Tax”). For all corporations subject to the Corporate Franchise Tax, the rate for the income tax base has been reduced from 7.5% to 7.1%, effective for tax years beginning after December 31, 2006. In addition, the alternative minimum tax rate has been reduced from 2.5% to 1.5% for tax years starting after December 31, 2006. The Budget also contains a special rate reduction offered as an incentive for a “qualified New York manufacturer.” The special rate is reduced from 7.5% to 6.5% for tax years beginning after January 31, 2007. It is important to note that while the general reduction in the Corporate Franchise Tax rate is effective for tax years starting after December 31, 2006, the special reduction for qualified New York manufacturing corporations is not effective until tax years beginning after January 31, 2007.
Single Sales Factor Apportionment. The Budget accelerates the phase-in of the single sales factor apportionment formula for the business allocation percentage. Historically, the Corporate Franchise Tax business allocation percentage was computed using an equally income attributable to New York. To benefit taxpayers with in-state operational and manufacturing centers, New York had been migrating from a three factor formula to a single sales factor apportionment formula. The phase-in of the single sales factor was being accomplished by increasing the weight of the sales factor each year until the apportionment formula was a 100% sales factor. The phase-in was scheduled to be completed for tax years beginning on or after January 1, 2007. The Budget accelerates this adoption to tax years beginning on or after January 1, 2006. As a result of the Budget, taxpayers will determine their apportionment percentage using just a sales factor for the 2006 tax year. N.Y. Tax Law § 210(3)(a)(2).
Combined Reporting. The most significant change to the Corporate Franchise Tax that may negatively impact corporate taxpayers is the addition of Mandatory Combined Reporting for related corporations. As discussed more fully below, prior to the Budget, the New York Department of Taxation and Finance (the “Department”) was authorized to permit or require the filing of a combined report only if a separate report was an improper or inaccurate reflection of a company’s tax liability (i.e., separate reporting resulted in distortion). N.Y. Tax Law § 211(5). The Budget created an additional combined reporting condition, requiring combined reporting for taxpayers with “substantial intercorporate transactions” with a related corporation or group of related corporations, regardless whether such intercompany transactions create distortion. N.Y. Tax Law § 211(4)(a). It is important to note that the Budget does not modify in any manner the Department’s statutory authority to permit or require a combined return when a separate company return would result in distortion. As a result, if the related corporations do not have “substantial intercorporate transactions” that would require a combined report under the newly created mandatory combined filing requirement, the Department continues to have statutory authority to permit or require a combined report when a separate company return would result in distortion.
On June 25, 2007, the Department issued a Technical Service Bulletin to provide guidance with respect to the changes to New York Corporate Franchise Tax resulting from the Budget. TSB-M-07(6)C. The informal guidance is intended to provide taxpayers with some direction regarding the new Mandatory Combined Reporting provisions until the Department is able to complete the deliberate process of promulgating regulations. The Department’s interpretation provides a layered or stepped analysis to determine which related corporations should be included in Mandatory Combined Reporting. The layered analysis applies an expansive interpretation of substantial intercorporate transactions for purposes of the new Mandatory Combined Reporting requirement. Specifically, the Department has expanded the analysis of which related corporations have substantial intercorporate transactions with members of the combined group in two meaningful ways: (1) the aggregation of the intercorporate transactions of a non-attached group, to determine whether substantial intercorporate transactions exist; and (2) the inclusion of non-combinable related corporations in the determination of which related corporations have substantial intercorporate transactions with the combined group.
Texas Makes Technical Changes to Margins Tax
While the Texas Margins Tax will not officially become effective until January 1, 2008, the Texas legislature, after a year of heated discussions since the bill implementing the tax was passed, made several technical changes to the tax that impact how the tax is imposed and calculated. Texas House Bill 3928 and Texas Senate Bill 2017, as signed by Governor Rick Perry on June 15, 2007 and effective January 1, 2008, made the following changes to the Texas Margins Tax:
- Inclusion of limited liability partnerships to the list of taxable entities;
- Reduction of the amount of control required for inclusion of a related entity in a combined group from 80% to “more than 50%”;
- Clarification on what is meant by “total revenue”;
- Amendments to the cost of goods sold deduction;
- Inclusion of gross rental income of taxable partnerships instead of net rental income when determining total revenue;
- Corrections to provisions regarding tiered-partnerships;
- Conformity to the Internal Revenue Code as it existed on January 1, 2007;
- Amendments to the temporary credit calculation and also a change in the due date for notifying the Comptroller of Public Accounts of the taxpayer’s intent to utilize the temporary credit on taxable margin to the first report originally due on or after January 1, 2008 – now September 1, 2007;
- A discount for small businesses with total revenue between $300,000 and $900,000 calculated by applying a sliding scale ranging from an 80% discount for taxable entities with total revenue less than $400,000, to a 20% discount for taxable entities with total revenue greater than $700,000 but less than $900,000; and
- An “E-Z computation and rate,” which is an optional alternative method for calculating tax for businesses with total revenue of $10 million or less, whereby a qualified taxable entity calculates tax by multiplying apportioned total revenue by 0.575%.
While the methodology for sourcing receipts in the Texas combined unitary return was examined closely and consideration was made to change from the “Joyce” method to the “Finnigan” method (thus requiring taxpayers to include as a part of their Texas receipts for apportionment purposes those sales from affiliates that do not have nexus in Texas), the final bill that was ultimately passed fell short of making this change. However, as currently imposed, the Texas Margins Tax requires taxpayers to file an information report disclosing the Texas sales of their non-nexus affiliates (with a $10,000 penalty per affiliate for failing to do so). There was also some discussion and even a proposed version of the bill that imposed a “poison-pill” gross receipts tax of 0.63% with no deductions in lieu of the margins tax, should the margins tax ever be deemed unconstitutional. While the final bill has no direct “poison pill” provision, the new statutory language appears to have the same effect. A new 0.675% gross receipts tax is defined as the “franchise tax,” with the margins tax renamed the “elective franchise tax.” If a taxpayer files suit against the imposition of the margins tax and wins, since the tax was an “elective tax,” the taxpayer would still be subject to the 0.675% gross receipts tax.
North Carolina, Pennsylvania and Wisconsin Continue to Pursue Combined Reporting
North Carolina. In the 2007 Report released by the North Carolina Revenue Laws Study Committee (“Committee”), a group of legislators directed by the General Assembly to review the North Carolina tax code, the Committee recommended that the General Assembly adopt combined reporting with a water’s-edge election. With regard to the members of the unitary group included in the combined report, the Committee proposes that the taxpayer include only those unitary members that have “business activity” (defined as activity that would exceed the protections afforded under P.L. 86-272) in the state. In other words, the Committee’s combined report proposal adopts the “Joyce” approach to factor representation for unitary groups. At present, North Carolina adopts separate entity filing but authorizes the Secretary of Revenue to force combination.
Pennsylvania. Similarly, in Pennsylvania, the legislature continues to push for combined reporting. Pennsylvania House Bill 1186 provides for unitary combined reporting with a water’s-edge election. A “unitary business” is defined as: “A single economic enterprise that is made up of separate parts of a single corporation, of a commonly controlled group of corporations, or both, that are sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts.” The bill gives the Secretary of Revenue authority to make appropriate adjustments of the combined group to “fairly reflect the corporation’s share of the unitary business conducted in this State.”
In addition to combined reporting, Pennsylvania H.B. 1186 also removes the existing cap on the net operating loss deduction and reduces the corporate income tax rate from 9.99% to 7.9%. H.B. 1186 would become effective January 1, 2009, if passed. Pennsylvania also continues to consider single-sales factor apportionment – H.B. 1602 provides for adoption of a single-sales factor apportionment formula for taxable years beginning after December 31, 2006.
Wisconsin. Wisconsin is making another run at implementing combined reporting. Senate Bill 40, which was introduced and debated on June 26, contains provisions that would require corporations engaged in a unitary business to file a combined report. Similar to other states’ consideration of combined reporting, S.B. 40 provides that commonly controlled corporations are considered to be engaged in a unitary business if they operate as a single economic enterprise with sufficiently integrated activities to produce a flow and exchange of value. Corporations are considered commonly controlled if they are owned more than 50%, directly or indirectly, by a common parent or owner.
Unlike other states’ combination bills, S.B. 40 provides that a corporation that is doing business in a “tax haven” may be included in the water’s-edge combined return if the corporation’s activity is sufficient in the tax haven for that country to impose a tax on it under federal law. “Tax haven” means a jurisdiction that, for any taxable year, is identified by the Organization for Economic Cooperation and Development as a tax haven or as having a harmful, preferential tax regime or has no, or a nominal, effective tax on income, and all of the following apply:
- The jurisdiction has laws or practices that prevent the effective exchange of information, for tax purposes, with other governments on taxpayers benefiting from the tax regime;
- The details of the legislative, legal, or administrative provisions of the
- jurisdiction’s tax regime are not publicly available and apparent, or are not
- consistently applied to similarly situated taxpayers, or the information needed by tax
- authorities to determine a taxpayer’s correct tax liability, including accounting
- records and underlying documentation, is not adequately available;
- The jurisdiction facilitates the establishment of foreign-owned entities without requiring a local substantive presence or prohibits such entities from having any commercial impact on the local economy;
- The tax regime explicitly or implicitly excludes the jurisdiction’s resident
- taxpayers from taking advantage of the tax regime’s benefits or prohibits enterprises
- that benefit from the regime from operating in the jurisdiction’s domestic market; and
- The jurisdiction has created a tax regime that is favorable for tax avoidance,
- based upon an overall assessment of relevant factors, including whether the
- jurisdiction has a significant untaxed offshore financial or other services sector
- relative to its overall economy.
Sutherland Observation: Wisconsin has apparently based its combined reporting provisions on the Multistate Tax Commission (MTC) model combined reporting statute, which includes in a “water's-edge” group any (non-U.S.) company doing business in a tax haven. This provision will be very difficult for taxpayers to comply with, as it would require companies to monitor the activities of non-U.S. affiliates to determine whether the affiliates engage in business activities in one or more tax havens sufficient for the tax haven to impose a tax on such affiliates. This bill also underscores the importance of monitoring the MTC’s proposals.