United States: Indiana Department Of Revenue Requires Taxpayer To Use "Stacking" Method To Apportion Income On Consolidated Return

In a letter of findings, the Indiana Department of Revenue required a taxpayer that filed an Indiana consolidated corporate income tax return to use an alternative apportionment method to fairly reflect Indiana income.¹ In requiring alternative apportionment, the Department determined that the use of a "stacking" method to apportion income was appropriate.

Background

The taxpayer, a supplier of medical implants, instruments and cutting tools, elected to file federal and Indiana consolidated income tax returns for the 2007-2009 tax years that included five different entities. Three of the five entities (Advantage, Medical and Instruments) had a significant presence in the state and Indiana source income, but the remaining two entities (Technologies and Medical Instrument) had substantial federal taxable income or losses and little activity in the state. The taxpayer used the standard apportionment method on the Indiana consolidated return and reported over $4 million in losses for the three tax years at issue. The Department conducted an audit and concluded that the standard method of apportionment did not fairly represent the taxpayer's Indiana source income. As an alternative, the Department required the taxpayer to use a "stacking" or "separate accounting" method that resulted in an assessment of additional tax. In response to the taxpayer's protest, an administrative hearing was held and a letter of findings issued by the Department.

Apportionment of Income

For the tax years at issue, Indiana law provided for a three-factor apportionment formula that used property, payroll and sales factors.² If the standard apportionment provisions do not fairly represent the taxpayer's income from Indiana sources, the taxpayer may petition for, or the Department may require, the use of an alternative apportionment method.³ The apportionment statute lists different alternative methodologies, including separate accounting.⁴

Use of Alternative "Stacking" Method

The letter of findings affirmed the Department's use of the stacking method of apportionment at audit. The underlying audit concluded that the inclusion of Technologies and Medical Instrument distorted the amount of income apportioned to Indiana. Neither corporation had any Indiana property during the audit period. Technologies, which reported substantial losses, had very minor Indiana payroll and reported negative sales in the state. Medical Instrument had little or no Indiana payroll and less than one-half of one percent Indiana sales. If the Department had excluded these two entities from the consolidated return because they had marginal contact with Indiana, the taxpayer would have additional income tax liability of approximately $133,000.

However, this method would eliminate all of the apportionment factors of both entities. Rather than accepting the taxpayer's methodology that resulted in no Indiana tax or eliminating Technologies and Medical Instrument from the consolidated return, the Department employed a stacking method. The letter of findings explained that the apportionment statute lists "separate accounting" as an alternative method for calculating a taxpayer's gross income, but the audit used the term "stacking." For purposes of the letter of findings, the Department claimed that both terms had the same meaning and resulted in the same amount of adjusted gross income.

Under the stacking method advocated by the audit report, the Indiana adjusted gross income (IAGI) of each corporation was computed separately, as if separate returns were filed for each corporation. After each separate amount of IAGI was calculated, the amounts were then consolidated or stacked into one amount of IAGI for the tax year. This amount was then compared to the IAGI per return. This method resulted in a tax liability of slightly more than $89,000 for the three years at issue.

In affirming the use of the alternative apportionment method, the Department explained that the standard apportionment methodology allowed two companies that had minimal ties with the state to place the consolidated entity into a loss position. The taxpayer's original return had the effect of converting three combined entities with substantial ties with the state and over $1 million in Indiana source income into a consolidated entity with several million dollars of loss. In effect, the standard methodology resulted in the taxpayer "importing" substantial losses generated outside Indiana. The letter of findings concluded that the Department's alternative approach was reasonable.

Commentary

The Department's decision highlights the potentially expansive interpretation of separate accounting, even though at first blush, a pure separate accounting approach and the stacking method do not appear to be the same thing. The alternative apportionment approach used by the Department has the effect of converting Indiana's standard preapportionment consolidation methodology into a post-apportionment methodology for the taxpayer. The decision is likely to be frustrating to taxpayers which have elected to file on a consolidated basis, as Indiana nexus members of federally defined affiliated groups are allowed to file a consolidated return.⁵ While taxpayers electing consolidation must obtain Department approval to deconsolidate, the Department can unilaterally break (or substantially modify) the effect of the taxpayer's consolidation election by claiming that separate accounting, apparently in the form of stacking, is more appropriate.

Interestingly, the Department has dealt with the issue of stacking in the past, finding on at least one set of facts that stacked apportionment should not be used as an alternative to traditional apportionment.⁶ The use of the stacking method in consolidation appears to be available only when the Department desires that such method be used. The result in the letter of findings, while not facially consistent with past Department publications, may give other states the opportunity to follow a similar approach when the standard apportionment formula purportedly does not fairly reflect a taxpayer's income in the state. It will be interesting to see if the taxpayers that were the subject of the letter of findings try to obtain a reversal of the determination in the Indiana Tax Court, perhaps based on the rationale expressed in previous letters of findings that the traditional approach should normally be used in consolidated reporting.

Footnotes

1 Letter of Findings No. 02-20120134, Indiana Department of Revenue, Aug. 29, 2012.

2 IND. CODE § 6-3-2-2(b). Indiana historically used a three-factor apportionment formula with a double-weighted sales factor. For tax years beginning after December 31, 2006, Indiana began phasing to a single sales factor. Indiana has completely phased to a single sales factor for tax years beginning after December 31, 2010.

3 IND. CODE § 6-3-2-2(l).

4 Id.

5 IND. CODE § 6-3-4-14(a).

6 Letter of Findings No. 05-0301, Indiana Department of Revenue, Aug. 1, 2006. Also see Letter of Findings No. 05-0195, Indiana Department of Revenue, Dec. 1, 2005, where the Department explicitly stated that there were two methods of computing adjusted gross income in a consolidated group - the combined approach and the stacked approach - and the "strongly preferred method is the combined approach."

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