The Multistate Tax Commission’s ("MTC") 2006 Fall Committee Meetings were held last week (November 13-16, 2006) in St. Louis, Missouri. During these meetings, the Income and Franchise Tax Uniformity Subcommittee (the "Income and Franchise Subcommittee" or "Subcommittee") held extensive discussions on the current draft of its model proposed telecommunications apportionment regulation, as well as its recently drafted policy checklist that identifies perceived tax concerns with real estate investment trusts ("REITs") and regulated investment companies ("RICs"). In addition, the Subcommittee provided updates on several recently approved model statutes. This legal alert summarizes the most significant developments of that Subcommittee meeting.

Current Projects

States that participated in the Income and Franchise Tax Uniformity Subcommittee meeting included Alabama, California, Connecticut, Idaho, Illinois, Kansas, Minnesota, Montana, New Jersey, New Mexico, North Carolina, North Dakota, Ohio, Oregon, Utah and Washington. The Subcommittee worked on two current proposals, described below.

Telecommunications Apportionment Regulation

The Income and Franchise Subcommittee devoted a substantial portion of its meeting to review and discussion of the draft telecommunications apportionment regulation, including recent changes to such draft. The Subcommittee also entertained public comment on those changes. A working group of industry and state professionals had been formed to assist with revisions to the regulation; however, the MTC reported that while the states have been heavily involved, industry has provided minimal input recently.

Sutherland Observation: Note that industry representatives have been heavily involved in this process over the course of the past four years, providing education on the technologies and services encompassed in the scope of the regulation. As a result of this involvement, the MTC has significantly revised the definition of telecommunications and has made other changes that narrow the scope of the regulation and better reflect the way in which telecommunications services are structured and provided. For example, in light of industry comments, the regulation now excludes a broad array of non-telecommunications services that formerly were included in the definition of telecommunications because they were deemed to be "similar services."

Generally, the current draft regulation provides for a Streamlined Sales Tax ("SST") approach to sourcing sales of telecommunications services, i.e., source the sales to the ultimate service address. Recent changes to the regulation address issues with wholesale sales, i.e., sales of telecommunications services by carriers to other carriers, or as inputs to other services such as Internet access, and the proper method for determining the portion of the total price paid for bundled telecommunications services allocated to each individual service sold in the bundle.

The Subcommittee reviewed the following specific changes that were the subject of public comment: (1) the addition of language to the definition of telecommunications services for purposes of clarifying that although purchases of telecommunications services at wholesale are generally exempt from sales and use tax, wholesale transaction receipts are includible in the service provider’s sales factor and are to be sourced in accordance with this regulation; (2) the addition of two alternative sourcing methods for wholesale sales (i.e., the look-through method and the use of proxy data); and (3) the removal of the "books and records" method of determining the amount of gross proceeds attributable to individual services sold in a bundled transaction, and the addition of a method utilizing the proportionate value of the individual services when sold separately to determine the appropriate allocation ("proportionate price method"). The following describes the specific provisions and comments:

  • The draft regulation provides that with respect to the definition of telecommunications services, "[t]hese services constitute telecommunications services irrespective of whether (1) such service is provided to an end-user or is provided to another telecommunications carrier; and (2) the provider of any such telecommunications service is also in the business of offering Internet access; radio or video programming; entertainment, broadcast, cable or satellite TV; or other services or goods."

The drafting committee stated that this language is necessary to ensure that for income tax purposes, taxpayers understand that wholesale sales are included in the service provider’s sales factor, even though not subject to sales and use tax. Industry representatives commented that this language should not be added to the definition section of the proposed statute because of the potential risk it poses to the definition of telecommunications services provided in the model sales and use tax statute. The Subcommittee suggested possibly adding the language to regulations and referred the issue back to the drafting committee.

  • The draft regulation provides two alternative sourcing methods with respect to wholesale sales: (1) the look-through method, where the sale is sourced to the ultimate end-user of the reseller, or (2) utilizing estimated wholesale revenue proxy data generated by the Federal Communications Commission ("FCC") for purposes of determining Universal Service Fund ("USF") payments of telecommunications service providers as found on FCC Table 15.6 - Telecommunications Revenue by State.

Industry representatives commented that the look-through method is not a viable alternative because it is not legally possible for a carrier to obtain another carrier’s customer information under various competition and regulatory rules. Industry representatives also commented that the second alternative (i.e., use of FCC proxy data) was not viable because (1) the FCC proxy data is based on estimates using stale data (i.e., data generated in 2003 to produce the 2006 estimates); and (2) the table is utilized for purposes of implementing the USF and if Congress decides to use a different method, then it is probable that the FCC will no longer produce the data. The drafting group stated that the use of the proxy FCC estimates was a simpler method and provides an assurance of objectivity because the data is not supplied directly by the telecommunications industry. The drafting committee also commented that they have been continuously attempting to obtain feedback from the industry to no avail. The Subcommittee concluded that the use of the FCC proxy data alternative was preferable and referred the draft regulation back to the drafting group.

  • The draft regulation removes the "books and records" method and adds the proportionate price method whereby taxpayers determine the costs of individual services sold as a bundle by allocating the total price of the bundled services in proportion to the amount each service is sold for individually.

Industry representatives commented that this is not a viable method because some telecommunications service providers do not sell certain services separately and apart from the bundle. The Subcommittee suggested adding the "books and records" method back to the regulation as a fall-back method to the proportionate price method and referred the draft regulation back to the drafting group.

Sutherland Observation: This meeting provided another opportunity for industry members to submit comments and/or suggestions with respect to this model regulation. The sourcing treatment of wholesale receipts and bundled services is the latest iteration of long-running disputes between industry representatives and MTC member states over aspects of the telecommunications apportionment regulation that pose substantial compliance burdens on service providers or that bear little relation to the manner in which providers conduct business operations and create/track transaction-specific data.

REIT/RIC Uniform Statute

The Income and Franchise Subcommittee reviewed and discussed a draft policy checklist for a proposed Real Estate Investment Trust (REIT)/Regulated Investment Company (RIC) uniform statute, and allowed for public comment. The policy checklist enumerates several issues with respect to the state taxation of REITs and RICs. The drafting committee is concerned with a potential double deduction in states that do not follow federal income tax treatment with respect to dividends-received deductions (DRD), and nexus issues created by REITs where in-state property is converted into intangible income through dividends. A motion was made to address the issues with REITs and RICs in two separate model statutes, while keeping the project as a single project. The motion was seconded and approved by a majority vote.

Sutherland Observation: Certain taxpayers have successfully litigated their entitlement to a DRD deduction with respect to RIC and/or REIT dividends under state law, as a result of the failure of state legislatures to adjust their statutes so as to prevent a simultaneous dividends paid deduction to the payor and dividends received deduction to the recipient. The MTC has raised this issue/concern in a six-page policy checklist which we anticipate the MTC will turn into a model statute. In arguing that RICs and REITs are entitled to the state DRD, industry representatives have made the distinction between tax-favored entities and abusive structures; however, the MTC’s potential response may sweep more broadly than the perceived abuses that it is intended to redress.

Reports and Updates

The Income and Franchise Subcommittee provided brief reports and updates on various proposed model statutes that the full Commission has approved at recent MTC meetings.

Revision of Multistate Tax Compact Art. IV § 17 –

Sourcing Rules for Sales of Other than Tangible Personal Property

The MTC has solicited the National Conference of Commissioners on Uniform State Laws ("NCCUSL") to redraft the provision of the Uniform Division of Income for Tax Purposes Act ("UDITPA")—Section 17, which is encompassed within Article IV of the Multistate Tax Compact – so as to eliminate the costs of performance sourcing rule for receipts from services and intangibles. [The MTC members have indicated their general preference for a market-sourcing mechanism, although support for a wholesale shift from COP sourcing to market-based sourcing does not enjoy universal support among the states.] The MTC reported that NCCUSL has noted its receipt of the MTC’s letter request for assistance with this project, and has stated it will respond formally to the MTC’s request by February 2007.

Sutherland Observation: A shift from costs-of-performance sourcing of services revenue to market-based sourcing would have dramatic effects, which are difficult to anticipate. Assuming arguendo that 100% of a taxpayer’s services revenues are subject to apportionment, the state(s) that would benefit from this sea change in sourcing methodology cannot truly be predicted. Nevertheless, many states predict that market-based sourcing will avoid the "all or nothing" effect of COP rules that source all revenue to the single state (if any) in which either the preponderance or the majority of costs incurred to deliver the service are incurred. Supporters of the MTC’s UDITPA initiative predict a more balanced/equitable division of services revenue among states in which the taxpayer’s customers receive or utilize the services. As more states shift to single sales factor or super-weighted sales factor apportionment formulas, this debate over the proper sourcing methodology has become more heated.

Model Combined Reporting Statute

The full Commission adopted the proposed model statute (which requires combined reporting on a worldwide basis, with an election to file a water’s-edge return) on Aug. 17, 2006 at the Kansas meeting. The adopted model statute was primarily the same as the version passed on to the full Commission by the Executive Committee with one major technical amendment. More specifically, the approved model statute requires an entity included in a combined report to back-out all federal adjustments as if it were filing a separate return, regardless of any federal consolidated adjustments that were made with respect to that entity.

Model Reportable Transactions Statute / "51-State Spreadsheet"

The full Commission adopted the proposed model statute (which requires disclosure of certain reportable transactions) on September 6, 2006. The adopted statute remains substantially the same as the proposed statute passed on to the full Commission by the Executive Committee, except that the inconsistent filing position provisions were included in a separate proposed model statute, i.e., the Model Compilation of State Tax Return Data statute, upon the recommendation of the Executive Committee.

The proposed Model Compilation of State Tax Return Data statute was also adopted by the full Commission on September 6, 2006. Prior to the MTC’s adoption of this statute, a hearing officer report recommended removing the taxpayer burden of reviewing filings and reporting inconsistent filing positions in different states, and instead, only requiring taxpayers to provide a 51-state spreadsheet summary of their state filings. Upon consideration of the recommendation, the Executive Committee referred the proposed statute back to the drafting committee to make the requested change. The adopted model statute includes two major adjustments: (1) taxpayers are given a two-year period to allow time to acquire appropriate software for generating the 51-state spreadsheet; and (2) taxpayers are permitted to file copies of all state returns as an alternative to the 51-state spreadsheet.

Model Add-back Statute

The proposed model statute (which requires the add-back of certain intangible and interest payments made to related parties) was adopted by the full Commission on August 17, 2006 at the Kansas meeting. Generally, the model statute provides exceptions to the add-back provisions for (1) conduit transactions with a business purpose, (2) transactions with a business purpose where the related party/recipient paid tax in another state or foreign country (with a U.S. treaty in place) at a substantially similar rate as that imposed in the payor’s state, and (3) where an agreement in writing is established with the commissioner. Prior to approval of the model statute, the Executive Committee approved a hearing officer report recommendation to add a safe harbor from the add-back provisions in the form of a dollar-for-dollar credit where the related party/recipient paid tax in another state, possession or foreign territory at a substantially similar rate as that imposed in the payor’s state. The adopted model statute includes both the exceptions and above-referenced safe harbor provision.

© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.