Advanced Apportionment Issues Confronting Multi-State Companies Reporting Accurately and Strategically, Preparing for Problematic States, and Avoiding Potentially Costly Apportionment Errors Today’s faculty features: 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10. TUESDAY, OCTOBER 8, 2013 Presenting a live 110-minute teleconference with interactive Q&A Mark Nachbar, Principal, Ryan, Downers Grove, Ill. Gary Bingel, Partner, EisnerAmper, Iselin, N.J.
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Advanced Apportionment Issues
Confronting Multi-State Companies Reporting Accurately and Strategically, Preparing for Problematic States,
and Avoiding Potentially Costly Apportionment Errors
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
7
SOURCING OF SALES FROM SERVICES AND INTANGIBLES
Mark Nachbar, Ryan LLC
Sourcing Of Receipts From The Sale Of Non-Tangible Property
• Cost of performance
— Receipts from the sales of other than tangible personal property
— UDITPA Sect. 17
— Has been adopted by a majority of states
— Provides sales of tangible personal property are in a state
if:
— Income producing activity is in the state, or
— A greater proportion of income producing is in the
state.
— Sect. 17 prescribes the preponderance method.
— Alternative cost of performance measurements
— Majority of costs
— Proportionate method
9
Sourcing Of Receipts From The Sale Of Non-Tangible Property (Cont.)
— Basic issues
— What is an income-producing activity?
— At what level is it determined?
— What are direct costs?
— What costs are actually included?
— Administrative costs
— Third-party costs
— Independent contractors
— South Carolina PLR 133 (8/7/13)
— On the “behalf rule”
— Costs from other members of the unitary group
10
Sourcing Of Receipts From The Sale Of Non-Tangible Property (Cont.)
— Market-based sourcing
— Shift to market-based sourcing
— A number of states have changed their sales factor sourcing
rules, shifting from a cost of performance approach to adopt
market-based sourcing regimes for services and intangibles
receipts.
— Rationale for the shift
— The complexity of sourcing receipts from non-tangible
property
— Administrative burden on all parties to determine cost of
performance components
— Aimed at attributing revenue to the state-based “market” (i.e.,
state) that contributes to taxpayer’s income.
— If a pure market-sourcing approach applied, then the taxpayer’s
costs of performance would not be considered.
11
Sourcing Of Receipts From The Sale Of Non-Tangible Property (Cont.)
– Alternative methods for defining the “market”
– Where benefit of services is received by customers
– Where services are performed
– Where intangibles are used
– Where the customers are situated
– Where benefit of services is received – issues and approaches
– Generally, benefit is received at the customer location.
– Benefits received in more than one state
– Individual customers vs. business customers
– Order location vs. billing location
– Benefit location is indeterminable.
– No nexus or fixed place of business in benefit location
– AL Reg. Sec. 810-27-1-4-.17.01, (3/29/13, eff. 4/9/13)
12
Sourcing Of Receipts From The Sale Of Non-Tangible Property (Cont.)
• Where services are performed
— Focuses on taxpayer’s activities in performing the services. Is
this the true “market”?
• Issues
— Possible application of “market” approach by states
regardless of “where services are performed” rule
— Services performed in more than one state
— Location where services performed is not readily
determinable
— Ameritech Publishing (WI)
— AT&T(MA and OR)
— Michinana Metronet Inc., v. Michigan Dept. of Treasury,
(MI Ct of App, No. 306219, 11/8/12)
13
Sourcing Of Receipts From The Sale Of Non-Tangible Property (Cont.)
— Receipts from intangibles
— Sourcing receipts derived from the sale or license of intangible property
is difficult because intangibles, by their nature, do not have a definite
geographical locations.
— Receipts are derived from intangibles through the following transactions:
— Sales of intangibles
— Licensing of intangibles in exchange for royalties
— Where intangibles are utilized – issues
— Where utilized by payor (e.g., licensee)
— Is utilization where licensee is located?
— Where licensee manufactures product?
— Where licensee sells product?
— What if location of utilization cannot be determined?
— What if taxpayer/licensor not taxable where intangibles utilized?
14
IMPACT OF CALIFORNIA GILLETTE CASE ELSEWHERE
Mark Nachbar, Ryan LLC
Apportionment: MTC Article III
• Trend to more heavily weighted sales factor or single-sales factor formula
– Only eight of 19 MTC member states continue to use the equally weighted three-factor apportionment formula.
• MTC Article III obligates member states to offer their multi-state taxpayers the option of using either the Compact’s three-factor formula to apportion and allocate income for state income tax purposes or the state’s own alternative apportionment formula.
• California withdrew from the MTC on June 27, 2012 in anticipation of the decision in Gillette vs. FTB.
• Other state withdrawals/reinactments: OR, UT, DC, MN (considering)
• Is this valid?
16
• A California taxpayer was permitted to use the equally weighted three-factor MTC apportionment formula to calculate its California franchise tax.
― Gillette argued that the state’s mandate of apportionment using double-weighted sales factor violated California’s participation in the MTC.
― The California Court of Appeals determined that the Multistate Tax Compact is binding on the signatory states and that it calls for the option, under UDITPA, to apportion income on a equally weighted three-factor basis.
― The election is necessary to provide a taxpayer an option for uniformity when there are conflicting state statutes.
― The only way for a member state to eliminate this option is to withdraw from the MTC.
― Gillette Co. v. Franchise Tax Board, No. A130803, Court of Appeal of California, First District (Oct. 2, 2012)
― CA Supreme Court has accepted, and the case is fully briefed.
Apportionment: MTC Article III (Cont.)
17
Apportionment: MTC Article III (Cont.)
• IBM v. Michigan Dept. of Treasury (MI Ct. of App., unpublished decision, 10/20/12)
― Compact is not a binding contract under MI law.
― On appeal to the MI Supreme Court.
• Anhueser Bush v. Michigan Dept. of Treasury ( MI Ct of Claims, published decision, 6/6/13)
― Considered MBT in two parts:
― modified gross receipts portion is not an income tax, and not subject to the MTC election;
― can use 3 factor treatment for business income tax base
― Supreme Court would not consider under direct appeal
• Lorilard Tobacco v. Michigan Dept. of Treasury
― Fully briefed for court of claims
― Brief on income tax base
18
Apportionment: MTC Article III (Cont.)
• In an Oregon Tax Court case, an out-of-state taxpayer is asserting that it has a
right to elect to apportion its income under the Multistate Tax Compact’s
evenly weighted three-factor formula.
• The complaint to the tax court’s magistrate division was filed on July 2. The
parties met in a case management conference in August, and on Sept. 17 filed
for a petition of special designation to bypass the magistrate division and
start the proceedings in the regular division. That petition is awaiting a ruling
by the judge.
• Oregon adopted the compact in 1967 and is still a full member. However, in
1993, the state enacted Revised Statute 314.606, which says that when
Oregon enacts an apportionment formula that conflicts with the Multistate
Tax Compact election provision, the state statute is controlling.
• Oregon currently requires single-sales-factor apportionment.
• Health Net, Incorporated and Subsidiaries v. Department of Revenue (Case
No. 120649D)
19
Apportionment: MTC Article III (Cont.)
• In orders released by the Texas Controller of Public Accounts on 9/12/12,
5/16/13, 6/18/13 and 8/14/13, denied the refund claims of three
unidentified out-of-state businesses that attempted to elect to apportion
their income under the Multistate Tax Compact’s evenly weighted three-
factor formula.
• In the 6/18/13 case the taxpayer introduced the CA Gillette win into the
record. The Comptroller ruled that no weight can be given to Gillette as it
was depublished, and cert was granted by the California Supreme Court.
• Texas adopted the Multistate Tax Compact in 1967 and is still a full member,
with the compact codified as chapter 141 of the Texas Tax Code. However,
Sect. 171.106(a) of the Code requires that a taxable entity’s margin be
apportioned to Texas under a single-factor formula based on gross receipts.
• Texas is a bit more complex than California, as there is a question as to
whether the Texas gross margins tax is an “income tax.”
20
Slide Intentionally Left Blank
ALTERNATIVE APPORTIONMENT REQUESTS
Mark Nachbar, Ryan LLC
Alternative Apportionment
• The standard alternative apportionment provision is found in
UDITPA
18.
– “If the allocation and apportionment provisions of this Act
do not fairly represent the extent of the taxpayer’s
business activity in this state, the taxpayer may petition
for or the [tax administrator] may require” alternative
apportionment.
• Under UDITPA, the burden of proof is on the party (state tax
authority or taxpayer) seeking to diverge from the standard
apportionment formula to prove that distortion exists, and
that a proposed alternative method is reasonable.
23
Invoking Alternative Apportionment
• Many states have either adopted UDITPA or similar language granting them the authority to use an alternative apportionment method.
• When a state or taxpayer wants to use an alternative apportionment method, they carry the burden of proof in showing:
– Distortion exists, and
– That a proposed alternative method is reasonable.
• Example: In Microsoft Corp. v. Franchise Tax Board, the California Supreme Court stated:
– As the party invoking section 25137, the Board has the burden of proving by clear and convincing evidence that (1) the approximation provided by the standard formula is not a fair representation, and (2) its proposed alternative is reasonable.
– What standard of proof must be met for a taxpayer or state to prove distortion?
– Clear and convincing evidence
– Somewhere between preponderance of evidence and beyond a reasonable doubt
– Example: California – Microsoft v. Franchise Tax Board, 139 P.3d 1169 (Cal. 2006).
– Clear and cogent evidence
– Example: New York
– Must demonstrate by clear and cogent evidence that the standard apportionment formula does not properly reflect a taxpayer’s presence. British Land (Maryland) Inc. v. N.Y. Tax App. Trib., 85 N.Y.2d 139, 147-48 (N.Y. Ct. App. 1995)
– Prima facie evidence
25
Invoking Alternative Apportionment: Distortion
• What level of distortion must be shown in order for a taxpayer or state to be entitled to alternative apportionment?
• Constitutional “gross distortion”
– Twentieth Century-Fox Films v. Dep’t of Revenue, 700 P.2d 1035 (Ore. 1985)
– Oregon Supreme Court reviewed whether the department proved that the statutory three-factor apportionment formula did not fairly represent the extent of taxpayer’s business activity in this state, thus permitting the department to employ a different method.
– Court held that alternative apportionment is only applicable to remedy unconstitutional situations or when the UDITPA formula does not fairly represent the business activity of the taxpayer.
– Florida and Illinois – regulations provide if the statutory formula will lead to “grossly distorted” results in a particular case, a fair and accurate alternative method is appropriate. Fla. Admin. Code Ann.
12C-1.0152; 86 Ill. Admin. Code
100.3390(c)
26
Invoking Alternative Apportionment: Distortion (Cont.)
• Most states have found that the constitutional “gross
distortion” requirement is not necessary to justify alternative
apportionment – some lesser standard usually applies.
• Consistent with Sect. 18, many states require only a showing
that the statutory formula does not fairly reflect the extent of
the taxpayer’s activities in the state.
27
Invoking Alternative Apportionment: Distortion (Cont.)
• Illinois regulations provide:
– A departure from the required apportionment method is allowed only where such methods do not accurately and fairly reflect business activity in Illinois. An alternative apportionment method may not be invoked, either by the director or by a taxpayer, merely because it reaches a different apportionment percentage than the required statutory formula. However, if the application of the statutory formula will lead to a grossly distorted result in a particular case, a fair and accurate alternative method is appropriate.
– 86 Ill. Adm. Code
100.3390(c)
• Illinois General Information Letter No. IT 11-0010-GIL (June 20, 2011)
– An investment company that invested substantially all of its net assets in a portfolio of master limited partnerships requested that the apportionment factors of the underlying partnerships be used as an alternative apportionment method for its gain from sales of partnership interests.
– Department determined there is nothing inherently distortive or unfair in sourcing gross receipts from sales of partnership interests, based on the activities of the partner in managing its investment in the partnership.
28
Invoking Alternative Apportionment: Distortion (Cont.)
• California uses qualitative and quantitative analyses to determine if distortion exists.
― Qualitatively different
― The qualitative analysis examines the type of business conducted by the taxpayer in comparison to any activity that may create distortion.
― Quantitative distortion
― Quantitative distortion may be demonstrated by various methods including separate accounting, comparison of profit margins, comparison of apportionment percentages, comparison of income and gross receipts from various activities, etc.
― Profit margin from a taxpayer’s primary business is several orders of magnitude different from the profit margin on the treasury function.
― Courts in Microsoft and Square D found distortion where operational profit margin far exceeded treasury profit margin.
― Microsoft: Operational margin 167x greater than treasury profit margin.
― Court held that the commissioner could apply alternative apportionment
formula.
― Taxpayer sourced receipts in accordance with statute using cost of
performance (i.e., receipts sourced to Tennessee if a majority of
taxpayer’s income-producing activity occurs in Tennessee).
― Commissioner invoked an alternative apportionment formula and required
the taxpayer to use market sourcing rules.
― Court held that the commissioner established that the statutory formula
did not adequately represent the taxpayer’s business activity in the state,
based solely on the fact that BellSouth generated substantial revenue
from the distribution of advertising within the state.
― Court granted commissioner wide latitude to disregard the statutory
formula in any case in which the commissioner believes Tennessee should
be entitled to greater tax revenue, as opposed to extraordinary and
unique circumstances. 31
Invoking Alternative Apportionment: Distortion Cont.)
• While BAPCO’s “all or nothing” argument is appealing, in that the commissioner can virtually ignore the statutorily required cost of performance formula when the results are unfavorable to the Department, the fact remains that Tenn. Code Ann.
67–4–2014(a) and 67–4–2112(a) were enacted by the legislature to provide the commissioner with the authority to permit or require a departure from the standard apportionment formula, when application of the formula does not fairly represent the extent of the taxpayer’s business activity in Tennessee and the commissioner is given the authority to use any method to source receipts for purposes of the receipts factor or factors of the apportionment formula numerator or numerators.
32
Invoking Alternative Apportionment: Reasonable Alternative
• Carmax Auto Superstores West Coast, Inc. v. S.C. Dep’t of
Revenue, Op. No. 4953 (S.C. Ct. App. March 14, 2012)
― The court concluded that the department bears the burden
to prove both that the statutory formula does not fairly
represent CarMax West’s business activity in South
Carolina, and that the Department’s “alternative
accounting method is reasonable and more fairly represents
CarMax West’s business activity in South Carolina.”
― The court remanded the case to the ALC.
33
Invoking Alternative Apportionment (Cont.)
• Taxpayers, however, should consider asserting alternative
apportionment where appropriate.
– Media General, Inc. et al. v. S.C. Dep’t of Revenue, 694
S.E.2d 525 (S. Car. 2010)
– “The Department need not automatically use the
method requested by the taxpayer as it has the
discretion to select an alternative method that fairly
measures the taxpayer's income in South Carolina.”
– Upheld taxpayer’s assertion of alternative
apportionment using combined filing method, when
state stipulated to fact that separate filing resulted in
distortion
34
Recent Developments in Alternative Apportionment
• Equifax Inc. v. MS Dept. of Rev., MS, No. 2010-CT-01857-SCT, 6/20/13
• Equifax had 3 employees in MS and 800 customers
• Under cost of performance methodology taxpayer apportioned $0 in
income to MS
• MS Commissioner recalculated tax based on “market state” rules
resulting in an in state income of $22M
• Supreme Court sided with Commissioner stating that the COP rules did
not accurately reflect the taxpayers presence in the state, and that the
use of a market state rule was an alternative apportionment
methodology
• Moreover the Court placed the burden of proof on the taxpayer to prove
that the alternative method did not properly reflect its presence in the
state.
35
DESTINATION SOURCING
Mark Nachbar, Ryan LLC
Destination Sourcing
• Sales of tangible personal property are in this state if:
― (a) The property is delivered or shipped to a purchaser, other than the
United States government, within this state regardless of the f. o. b. point
or other conditions of the sale (UDITPA Art. IV Sect. 16)
― Generally means where the buyer obtained possession or control of the goods
• However the application of Sect. 16 is unclear in the case of dock sales
― Place of delivery, or
― Ultimate destination
• State courts have ruled that dock sales should be assigned to the purchasers
location
― “within this state” refers to “purchaser”
― The intended purpose of the sales factor is to measure the customer base
within a state
37
Destination Sourcing (Cont.)
• Department of Revenue v. Parker Banana, 391 So. 2d 762, FL 1980
― Involved the sale of bananas which were picked up in Florida by out of state
purchasers
• McDonnell Douglas Corp., v FTB 26 Cal. App. 4th 1789, 7/7/94
― Customer picks up aircraft from a facility located in CA, and transports the
aircraft to an out of state location
• Indiana Dept of Revenue v. Miller Brewing Co., Indiana Supreme Court Docket
Number 49S10-1203-TA-136. 7/26/12
― Sales of beer to Indiana distributors, picked up by the distributor at an Ohio
brewery, and brought into Indiana were Indiana sales
• Virginia PLR 12-168, 10/23/12
― Intercompany sales to an instate affiliate, held by the affiliate in VA prior to
the shipment out of state, were VA sales
38
Slide Intentionally Left Blank
JOYCE / FINNIGAN POSITIONS Gary Bingel, EisnerAmper
Joyce vs. Finnigan • Sales of tangible personal property are in this state if:
― (b) The property is shipped from an office, store, warehouse, factory, or
other place of storage in this state and ... the taxpayer is not taxable in
the state of the purchaser.
― Joyce: “Taxpayer” means particular entity making the sale.
― Finnigan: “Taxpayer” means the combined group.
• Joyce example: Texas receipts include “the gross receipts of each taxable
entity that is a member of the combined group and that has a nexus with
this state for the purpose of taxation.”(TX Tax Code Sect. 171.103)
• Finnigan example: In Wisconsin, “a taxpayer is considered to be within the
jurisdiction for income or franchise tax purposes of any state in which any
member of its combined group is within the jurisdiction for income or