United States: SALT Top Stories Of 2014

Finally, after much anticipation, tax reform has become reality this year in several high-profile jurisdictions including New York, the District of Columbia, and Rhode Island. The significant changes implemented by these "blue states" include modifications which follow the general trend towards single sales factor apportionment and market-based sourcing for sales of other than tangible personal property. New York is the prime example of a state enacting major tax reform legislation, but other states enacted or evaluated significant tax reform during 2014, and other states are certain to consider tax reform measures during 2015.

As the economy continues to improve, budgets at the state level generally seem to have become somewhat more stable. While many states appeared to be grappling for every dollar a few years ago, most appear to have breathed a collective sigh of relief, as evident from the lack of legislative action on the sales tax front. One exception to the relative lack of action lies in the efforts expended to impose nexus and ensure collection of sales tax by remote seller retailers.

The Multistate Tax Commission (MTC), as expected, formally adopted amendments to key provisions of Article IV of the Multistate Tax Compact.¹ These amendments address various topics including apportionment factor weighting, the definition of business income, the adoption of market-based sourcing, the definition of sales, and alternative apportionment. Notably, many of these topics were also key elements in significant controversies this year. As discussed in detail below, the Michigan Supreme Court issued a much-anticipated decision in IBM² regarding the availability of a three-factor apportionment election to taxpayers under the Multistate Tax Compact, which led directly to enactment of questionable retroactive legislation intended to mitigate the financial impact of the decision. Further, the Tennessee Court of Appeals issued a decision addressing the use of alternative apportionment and Mississippi lawmakers adopted legislation addressing last year's Equifax³ decision.

Other key state and local developments this year include three separate hearings at the United States Supreme Court addressing state and local tax issues, the use of central assessment to maximize property tax collections, and the continued use of incentives to drive business development.

1. Massive tax reform in New York

The transformative changes to New York's tax structure enacted in the FY14-15 budget,⁴ most of which are scheduled to take place for tax years beginning on or after January 1, 2015, are likely to substantially impact many taxpayers' ultimate corporate tax liability in the Empire State.⁵ The most material changes include the application of economic nexus, a merger of the banking corporation tax into the corporation franchise tax, adjustments to the bases on which the corporation franchise tax is calculated, the imposition of a mandatory unitary combined reporting system, substantial changes to the sourcing of sales for purposes of apportionment, a decrease in the state-level corporate franchise tax rate, and the creation of various tax incentives and rate reductions for "qualified manufacturers" in the state.

The economic nexus concept has been incorporated into numerous corporate income tax regimes in the past several years, and is intended to subject corporations that have no physical presence in a state to the corporate income tax if significant amounts of sales are sourced to the state (and such activity is not protected by P.L. 86-272). Corporations will now be taxable in New York for purposes of the corporation franchise tax and the metropolitan tax (MTA) surcharge if they derive $1 million or more of receipts from activity in New York.⁶ A corporation that is part of a combined group and has receipts derived from New York of less than $1 million but more than $10,000 satisfies the threshold requirement for combined reporting if the New York receipts of all group members who individually exceed $10,000 equal $1 million or more in the aggregate.⁷

Historically, companies had to determine whether they were subject to the Article 32 bank franchise tax or the Article 9-A corporation franchise tax, two completely separate tax regimes with stark differences in how the tax was calculated. The tax reform legislation eliminates this determination by repealing the Article 32 tax, subjecting banking corporations to the Article 9-A tax.⁸

With the repeal of Article 32, both business and banking corporations will determine their tax on the following three tax bases: business income base, capital base, and fixed dollar minimum base.⁹ The alternative minimum tax base and the subsidiary capital concept will be eliminated.¹⁰ Further, the capital base tax will be completely phased out by 2021.¹¹

The repeal of Article 32 also means that business and banking corporations may be included in the same combined filing group under Article 9-A, under completely new combined reporting standards.¹² The new standards eliminate the substantial intercorporate transactions requirement that was the focus of considerable litigation,¹³ and requires unitary combined reporting based on a more than 50 percent ownership requirement.¹⁴ Certain captive real estate investment trusts, regulated investment companies, combinable captive insurance companies and "domestic entity" alien corporations may be subject to combination as well.¹⁵ Excluded from combined reporting are entities taxable under the telecommunications or insurance tax regimes of Article 9 and Article 33 respectively, New York S corporations, and corporations with no New York nexus affiliates and who are subject to tax solely because of their interest in a limited partnership doing business in New York.¹⁶ Corporations may now elect an irrevocable and binding six-year option to be combined with any non-unitary affiliates if certain thresholds are met.¹⁷ Unless affirmatively revoked, the election would be automatically renewed for an additional seven years.

In the area of apportionment, the budget legislation modifies current New York apportionment to a single receipts factor with a set of intricate customer-based sourcing rules.¹⁸ Specific provisions exist for various types of sales including other business receipts, rents and royalties, and digital products. Taxpayers now have the option to make an annual and irrevocable election to use a fixed amount of 8 percent of all net income from qualified financial instruments in the apportionment numerator.¹⁹ Without this election, receipts and net gains from these instruments are sourced based on customer location. Intangible property, such as patents and trademarks, are now sourced to New York based on the extent activities related to the intangible take place in the state.²⁰ Receipts from services and other business receipts are sourced to the state based on a customer location hierarchy, specifically starting with where the customer receives the benefit of the transaction.²¹

As for net operating loss (NOL) provisions, NOLs historically have been calculated on a pre-apportioned basis and carried forward or backward in conjunction with federal NOLs. The legislation will apply prospectively starting on or after January 1, 2015 and will compute New York NOLs on a post-apportionment basis.²² While the NOL deduction for New York state purposes is no longer tied to the federal amount, the maximum deduction is limited to reducing the tax on entire net income to the higher of the tax on capital base or the fixed dollar minimum.²³ The legislation also creates a prior net operating loss (PNOL) conversion subtraction that may be applied against the business income before the NOL deduction is taken.²⁴

Regarding tax rates, the existing corporate franchise tax rate of 7.1 percent on business income is reduced to 6.5 percent effective January 1, 2016.²⁵ The MTA surcharge is increased to 25.6 percent effective for tax years beginning on or after January 1, 2015 and before January 1, 2016 with adjustments in rates at the Commissioner's discretion depending on the state's financial need.²⁶ Qualified New York manufacturers will have an effective tax rate of 0 percent on the business income base,²⁷ and a reduced capital base ax rate during the period in which such base is being phased out.²⁸ While the enacted legislation retains the current fixed dollar minimum tax base on New York-sourced receipts, it incrementally increases the current maximum tax due of $5,000 to a maximum tax due of $200,000 for taxpayers with over $1 billion in New York receipts.²⁹

2. Market-based sourcing guidance

New York was just one of several states that shifted its approach of sourcing the sale of items other than tangible personal property from a cost of performance (COP) to market-based sourcing method. The endorsement of market-based sourcing in the Multistate Tax Commission's revisions to the Multistate Tax Compact has provided other states that historically have utilized COP sourcing with a template to consider a change in future legislative sessions. Market-based sourcing was also a key component of the adoption of tax reform measures in Rhode Island and the District of Columbia. In addition, Pennsylvania released an information notice and Massachusetts issued draft regulatory guidance on the subject.

The Commission's decision to move away from the historic preponderance COP sourcing methodology, replacing it with a market-based sourcing approach, was intended to reflect the destination principle used to source sales of tangible personal property.³⁰ Under the Compact, sales of other than tangible personal property are sourced to a state if, and to the extent, the taxpayer's market for the sales is in the state. The sale of a service is sourced to a state if, and to the extent, the service is delivered to a location in the state. In addition, the provision includes a series of sub-rules that describes the sourcing for different types of transactions, including transactions involving intangible property.³¹ If the taxpayer is not taxable in a state to which a sale is assigned or if the state of assignment cannot be determined or reasonably approximated, the sale is excluded from the denominator of the sales factor (this is commonly termed a "throwout rule").³²

The Rhode Island statute governing market-based sourcing does not directly follow the approach taken under the Compact, and only provides one general rule, which will go into effect for tax years beginning on or after January 1, 2015. Gross income from the performance of services will be sourced to Rhode Island to the extent the recipient receives benefit of the service in Rhode Island.³³ The enacted statute does not specifically address how to source sales or income from intangibles, and therefore, the historic rule requiring sourcing of "all other receipts within the state" to Rhode Island is still in effect for these items.³⁴

In contrast, the District of Columbia market-based sourcing statute was drawn directly from the language adopted by the Commission for its recommended revisions to the Compact.³⁵ While it was widely assumed that market-based sourcing would be effective for tax years beginning on or after January 1, 2015, in line with other tax reforms enacted by the District, a closer reading of the budget language shows that the effective date of the market-based sourcing provision is actually October 1, 2014. Technical corrections are being proposed to change this date to January 1, 2015. Without such a change, most taxpayers with sales of items other than tangible personal property would have to apply two very different methods of sourcing to such sales during the 2014 taxable year.

On the regulatory front, Massachusetts released comprehensive guidance on how to implement the market-based sourcing rules that it adopted for the 2014 tax year and beyond in a draft regulation.³⁶ Notable in the regulation is the ability of a taxpayer to make a reasonable approximation where a taxpayer cannot make a sourcing determination.³⁷ The reasonable approximation must be determined in good faith, applied in good faith, and applied consistently with respect to similar transactions and on a year-to-year basis.³⁸ In addition, a taxpayer may have additional due diligence requirements to determine where a customer is located if the customer represents more than five percent of the taxpayer's sales.³⁹ The centerpiece of the regulation is the different sourcing approaches taken for three separate types of services. If the service is classified as an in-person service, the taxpayer sources the service to the location of performance.⁴⁰ Services delivered to the customer or through or on behalf of the customer (including digital services) are sourced to the location of delivery.⁴¹ Professional services are sourced according to the classification of the customer.⁴² If the customer is an individual, sales are sourced to the state of the customer's primary residence, or if undeterminable, the customer's billing address.⁴³ If the customer is a business, sales are sourced to the location where the contract of sale is principally managed by the customer, or if undeterminable, potentially the ordering or billing address.⁴⁴ Finally, detailed sourcing rules apply with respect to licenses, leases and sales of intangibles.⁴⁵ The regulation is expected to become final in the next few weeks, and the approach taken in the regulation could have wider application in the future, as the Commission recently announced that the Massachusetts regulation will serve as a starting point for the Commission's development of a market-based sourcing regulation.

Pennsylvania recently released guidance on market-based sourcing rules applicable for tax years beginning on or after January 1, 2014 in the form of an information notice.⁴⁶ As Pennsylvania looks to the location where a service is delivered to determine where to source the sale of services, the notice provides a table showing the delivery location of some common service situations.⁴⁷ Also, the notice discusses more complex delivery situations such as third-party delivery and electronic delivery. The notice lists guidelines to be used for 16 separate services and service industries.⁴⁸ Finally, as Pennsylvania retained a COP concept for the sale of intangibles, clarification on how to apply COP principles with respect to these sales has been provided.⁴⁹

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Footnotes

1 Multistate Tax Commission's Annual Conference, July 28-31, 2014.

2 International Business Machines Corp. v. Department of Treasury, 852 N.W.2d 865 (Mich. 2014).

3 Equifax, Inc. v. Department of Revenue, 125 So. 3d 36 (Miss. 2013), cert. denied, June 30, 2014.

4 Ch. 59 (A.B. 8559 / S.B. 6359), Laws 2014. For a detailed discussion of this legislation, see GT SALT Alert: New York Enacts FY14-15 Budget Legislation Providing Extensive Tax Reform.

5 Taxpayers should be aware that the budget's overhaul to New York State's tax regime does not apply to New York City at the present time. However, there is a growing sense that New York City will take steps to make changes that align with many of New York State's tax reforms in the coming year.

6 N.Y. TAX LAW §§ 209.1(b); 209-B.1(a).

7 N.Y. TAX LAW § 209.1(d).

8 Ch. 59 (A.B. 8559 / S.B. 6359), Part A, § 1.

9 N.Y. TAX LAW § 210.1.

10 Under this concept, entire net income did not include income, gains and losses from subsidiary capital. N.Y. TAX LAW § 208.9(1)(a). The subsidiary capital was subject to a separate tax. N.Y. TAX LAW § 210.1(e)(1). "Subsidiary capital" was investments in the stock of subsidiaries and any indebtedness from subsidiaries, excluding certain accounts receivable acquired in the ordinary course of business. N.Y. TAX LAW § 208.4.

11 The enacted legislation imposes the following capital base tax rates for general corporations: 0.15 percent for taxable years beginning before January 1, 2016; 0.125 percent for taxable years beginning in 2016; 0.10 percent for taxable years beginning in 2017; 0.075 percent for taxable years beginning in 2018; 0.05 percent for taxable years beginning in 2019; 0.025 percent for taxable years beginning in 2020; and 0.00 percent for tax years beginning on or after January 1, 2021. N.Y. TAX LAW § 210.1(b).

12 N.Y. TAX LAW § 210-C.

13 N.Y. TAX LAW § 211.4.

14 N.Y. TAX LAW § 210-C. Tax on combined reports will be the highest of (1) combined business income tax base multiplied by the applicable tax rate, (2) combined capital base multiplied by the applicable tax rate, or (3) the fixed dollar minimum of the designated agent of the combined group. Tax on combined reports will also include the fixed dollar minimum tax of each taxpayer in the group (see discussion regarding changes to fixed dollar minimum tax above). N.Y. TAX LAW § 210-C.1.

15 N.Y. TAX LAW § 210-C.2(b).

16 N.Y. TAX LAW § 210-C.2(c).

17 N.Y. TAX LAW § 210-C.3.

18 N.Y. TAX LAW § 210-A.

19 N.Y. TAX LAW § 210-A.5. "Qualified financial instruments" are defined as instruments that are assets marked-to-market under IRC §§ 475 or 1256, and specifically exclude loans secured by real property.

20 N.Y. TAX LAW § 210-A.3.

21 N.Y. TAX LAW § 210-A.10.

22 N.Y. TAX LAW § 210.1(a)(ix).

23 Id.

24 N.Y. TAX LAW § 210.1(a)(viii). The PNOL conversion subtraction is calculated by: (1) computing the tax value of the taxpayer's unabsorbed NOL for the base year (this value equals the product of (a) the amount of the taxpayer's unabsorbed NOL, (b) the taxpayer's base year business allocation percentage (BAP), and (c) the taxpayer's base year tax rate); and (2) dividing this amount by 6.5 percent (in the case of a qualified New York manufacturer, 5.7 percent). This amount is the taxpayer's PNOL conversion subtraction pool. The taxpayer's PNOL conversion subtraction for the taxable year equals 1/10 of its conversion subtraction pool plus any amount of unused PNOL conversion subtraction from preceding taxable years. In lieu of this subtraction, if the taxpayer so elects, the taxpayer's PNOL conversion subtraction for tax years beginning on or after January 1, 2015 and before January 1, 2017, equals for each year not more than ½ of its conversion subtraction pool.

25 N.Y. TAX LAW § 210.1(a).

26 N.Y. TAX LAW § 209-B.1(a).

27 N.Y. TAX LAW § 210.1(a)(vi). "Qualified New York manufacturers" are defined as manufacturers principally engaged in the production of goods who also have property in the state used for qualifying activities where: (1) the adjusted basis of such property for federal income tax purposes at the close of the taxable year is at least one million dollars; or (2) all of its real and personal property is located in the state. Id.

28 The newly enacted capital tax base rates for qualified New York manufacturers for these tax periods are 0.15 percent, 0.106 percent, 0.085 percent, 0.056 percent, 0.038 percent, 0.019 percent and 0.00 percent, respectively. N.Y. TAX LAW § 210.1(b).

29 N.Y. TAX LAW § 210.1(c).

30 Multistate Tax Compact Art IV.17. For further discussion of the changes to the Compact, see GT SALT Alert: Multistate Tax Commission Finalizes Compact Provision Amendments.

31 These sub-rules include provisions for sourcing such items as real property, tangible personal property, services and intangible property. Multistate Tax Compact Art IV.17(a).

32 Multistate Tax Compact Art IV.17(c).

33 R.I. GEN. LAWS § 44-11-14(b)(1)(ii). For further discussion of this legislation, see GT SALT Alert: Rhode Island Adopts Combined Reporting, Single Sales Factor Apportionment and Market-Based Sourcing.

34 R.I. GEN. LAWS § 44-11-14(b)(1)(vi).

35 D.C. CODE ANN. § 47-1810.02(g)(3)(A). This legislation is discussed in GT SALT Alert: District of Columbia Enacts Budget Including Single Sales Factor Apportionment, Market-Based Sourcing.

36 Proposed MASS. REGS. CODE tit. 830, § 63.38.1(9)(d).

37 Proposed MASS. REGS. CODE tit. 830, § 63.38.1(9)(d)1.e.

38 Proposed MASS. REGS. CODE tit. 830, § 63.38.1(9)(d)1.d.i.

39 Proposed MASS. REGS. CODE tit. 830, § 63.38.1(9)(d)4.c.ii(B)2.c, 4.d.ii(A).

40 Proposed MASS. REGS. CODE tit. 830, § 63.38.1(9)(d)4.b.

41 Proposed MASS. REGS. CODE tit. 830, § 63.38.1(9)(d)4.c.

42 Proposed MASS. REGS. CODE tit. 830, § 63.38.1(9)(d)4.d.

43 Proposed MASS. REGS. CODE tit. 830, § 63.38.1(9)(d)4.d.ii(A)1.

44 Proposed MASS. REGS. CODE tit. 830, § 63.38.1(9)(d)4.d.ii(A)2.

45 Proposed MASS. REGS. CODE tit. 830, § 63.38.1(9)(d)5.

46 Information Notice Corporation Taxes 2014-01, Pennsylvania Department of Revenue, Dec. 12, 2014.

47 Id.

48 Id.

49 Id.

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