UC Davis Summer Tax Institute Advanced Income Tax Track

UC Davis Summer Tax Institute Advanced Income Tax Track
UC Davis Summer Tax Institute Advanced Income Tax Track Day 3: June 14, 2017

Table of Contents Tax Base Issues
Section Overview Tax Base Issues Apportionment Factors –Payroll & Property The Sales Factor Sales Factor—Market Sourcing UC Davis Summer Tax Institute June 14, 2017

Section 1 Tax Base Issues
UC Davis Summer Tax Institute June 14, 2017

Table of Contents Tax Base Issues Overview/Introduction
Section Overview Tax Base Issues Overview/Introduction State Modifications--Typical Addition Modifications State Modifications--Typical Subtraction Modifications Combined Reporting Tax Base Issues and Mechanics Alternative Tax Bases UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Overview
Overview of State Taxable Income Computation and Federal Taxable Income Starting Point As will be discussed, most states which impose state income taxes begin the State computation with federal taxable income (“FTI”) – either before special deductions (line 28) or after such (line 30). “Special deductions” are items such as the federal net operating loss (“NOL”) deduction and dividends received deduction (“DRD”). The determination of the appropriate FTI to use is made more complicated in States which do not reference the current version of the Internal Revenue Code (“IRC”). UC Davis Summer Tax Institute June 14, 2017

Further complications arise due to differences between federal and State filing methodology and the need to redetermine FTI on a “pro forma” basis which is consistent with the state filing method (e.g. Separate filing, nexus combined, domestic/water’s edge combination or worldwide combination). Various modifications are made to the FTI base in arriving at State net income, after which allocation and apportionment is typically applied. The computation of state taxable income can be complex in combined reporting states, particularly those which include foreign operations. Finally, a number of states employ alternative tax bases – a few of which will be explored. UC Davis Summer Tax Institute June 14, 2017

Overview of State Income Tax Base Computation Federal Taxable Income (Line 28 or 30) +/- State Modifications Total Taxable Income - Allocable Non-business Income Apportionable Business Income x Apportionment Percentage Business Income Apportioned to State + Nonbusiness Income Allocated to State State Taxable Income UC Davis Summer Tax Institute June 14, 2017

IRC Conformity - Federal Taxable Income as the Starting Point Nearly all states conform to federal income tax provisions to one degree or another. Most do so by conforming to line 28 or line 30 of Form 1120 on a current basis (“moving conformity” states) or as computed under the IRC as of a set point in time (“static conformity”). Such states then subject the federal taxable income (“FTI”) starting point to specific state level modifications to adapt FTI to state taxable income. Examples of static conformity states include: AZ, FL, GA, ID, IA, KY, ME, MN, NC, SC, TX, VT, WV and WI. Examples of moving conformity date states include: AK, CO, DE, DC, IL, KS, LA, MD, MA, MO, MT, NE, NM, ND, OK, PA, RI, TN and UT. UC Davis Summer Tax Institute June 14, 2017

Example 1: Impact of Static Conformity Date In 2009, ABC Corp (based in Kentucky) repurchases bonds it had issued in 2004 with a face value of $10 million for $5 million. For federal tax purposes, the $5 million of cancellation of indebtedness income (“CODI”) it would otherwise have recognized under IRC §61 is deferred under IRC §108(i)(1), an amendment made as part of the American Recovery and Investment Act of 2009. Federal taxable income is a loss of $2 million. For Kentucky purposes, the tax base would be $3 million since Kentucky referred to the IRC as of December 31, 2006 during the year at issue and the above deferral would not apply. Note that Kentucky subsequently updated its IRC reference date. UC Davis Summer Tax Institute June 14, 2017

Impact of Differences in Filing Methodology Affiliated groups typically elect to file a consolidated return for federal income tax purposes. The treasury regulations issued under IRC contain provisions which impact the determination of federal taxable income which would not apply in states which do not allow consolidated filings. While such states include separate reporting states, they also include certain combined states which do not adopt the consolidated regulations (e.g. California, with the exception of the intercompany transaction regulations), as well as combined States in general, to the extent that the composition of the combined/consolidated State filing differs from federal. As a result various adjustments may need to be made in order to determine FTI on a pro forma/”as-if” basis which is consistent with the State filing methodology. UC Davis Summer Tax Institute June 14, 2017

Typical pro forma adjustments include: Disallowance of capital losses which offset the capital gains of other consolidated return members Current recognition of income, gains, losses, deductions etc from transactions with consolidated return members which are deferred for federal income tax purposes. Inclusion of dividends in income which were eliminated in consolidation Removal of - 32 “investment adjustments” to subsidiary stock basis for purposes of determining gain or loss on sale of subsidiary stock. “Reactivation” of federal provisions which are “turned off” in consolidation such as IRC §§ 304 and 357(c). UC Davis Summer Tax Institute June 14, 2017

Example 2 – Pro forma Adjustments to FTI Parent (P) and Subsidiary (S) file a federal consolidated return. S files in North Carolina, a separate reporting state. S distributes a patent to P with a fair market value (“FMV”) of $20 million and a basis of $0. For federal income tax purposes, the distribution results in $20 million of gain under IRC § 311(b) which is deferred in consolidation. For North Carolina tax purposes the consolidated return regulations are not available and FTI may need to be re-determined so as to include current gain recognition. Query whether this fairly reflects income from NC and whether a petition to file on a combined basis might be possible UC Davis Summer Tax Institute June 14, 2017

NIHC, Inc. v. Comptroller of the Treasury, Maryland Court of Appeals, No. 03- C , 8/18/2014 The Maryland Court of Appeals upheld the tax assessed on NIHC (a Nordstrom subsidiary) resulting from its filing of a separate Maryland return, even though the gain was deferred over 15 years under the federal consolidated rules. Note that while Maryland taxable income is based on separate entity “proforma” federal taxable income (FTI), the Taxpayer had originally included the deferred gain in Maryland taxable income during the years at issue. Query: Would the court have reached a different conclusion had the taxpayer originally used proforma separate company income or amended its returns to report such prior to audit? NIHC was found to lack economic substance. Would the court have reached a different conclusion if NIHC had economic substance? UC Davis Summer Tax Institute June 14, 2017

MCI Communication Services, Inc. v. Director, Division of Taxation, N.J. Tax Court, No , July 20, 2015 The New Jersey Tax Court disallowed a taxpayer’s attempt to claim a state modification to reverse the effect of ‘push down’ depreciable asset basis reduction under the consolidated return regulations resulting from excluded cancellation of debt (“COD”) income at the parent level. Query whether taxpayer would have been successful had it reported pro forma separate company income to begin with. Sherwin-Williams Company v. Alabama Department of Revenue, Alabama Tax Tribunal, Nov. 30, 2016. The Alabama Tax Tribunal held that the taxable income limitation for purposes of computing the IRC 199 deduction for Alabama purposes is pro forma separate company federal taxable income, not separate company Alabama income after state specific adjustments. UC Davis Summer Tax Institute June 14, 2017

A small minority of states do not adopt FTI as the starting point in their state taxable income computations. Instead, these “selective conformity” states adopt selected provisions of the IRC, subject to state modifications as well as a number of state specific provisions which impact the calculation of state taxable income. California is an example of a selective conformity state. Great care must be taken in determining which IRC provisions are or are not adopted. A further complication in selective conformity states is the many references to non adopted IRC sections which may be contained in IRC sections which are specifically adopted. See for example, Fujitsu IT Holdings, Inc. v. Franchise Tax Board, 120 Cal.App.4th 459 (2004) and Chief Counsel Announcement in California. UC Davis Summer Tax Institute June 14, 2017

Example 3: California Treatment of Subpart F/“PTI” Corporation A owns a 50% interest in Corporation B, a controlled foreign corporation (“CFC”) based in Ireland which is owned 50% by a third party U.S. shareholder. In year 1, Corp B generates $10 million of income which is treated as Subpart F income under IRC §952 and $5 million (50%) is included in Corp A’s gross income as a dividend under IRC §951 along with $1 million IRC §78 “gross up” due to IRC §902 deemed foreign taxes paid by Corp A related to the distribution for which Corp A will claim a federal foreign income tax credit (“FTC”). In year 2, Corp B generates $2 million of subpart F income (50% of which is a deemed dividend to Corp A) and distributes $5 million to Corp A, which is excluded from Corp A’s federal income as previously taxed income or “PTI” under IRC §959. California does not adopt IRC §§ 951, 952, 959, 902, or 78. As a result, Corp A has no dividend income in year 1 and $5 million of dividend income in year 2. Note that in a Water’s Edge environment, majority owned unitary CFCs with Subpart F income are subject to partial inclusion in the combined report. UC Davis Summer Tax Institute June 14, 2017

Federal 1120 Year 1 Year 2 Taxable Income of Corp A 9,000,000 Subpart F Income 5,000,000 IRC §78 Gross-Up 1,000,000 FTI (before credits) 15,000,000 In year 2, Corp B distributes $5 million to Corp A, which is excluded from Corp A’s federal income as PTI. For California purposes, Corp A has no dividend income in year 1 and $5 million of dividend income in year 2. Note that in a Water’s Edge environment, majority owned unitary CFCs with Subpart F income are subject to partial inclusion in the combined report. California 1o0 Year 1 Year 2 FTI (before mods) 15,000,000 9,000,000 Subpart F Income (5,000,000) IRC §78 Gross-Up (1,000,000) Dividend Income 5,000,000 CA Taxable Income 14,000,000 UC Davis Summer Tax Institute June 14, 2017

California’s adoption of IRC provisions is further complicated by fixed date IRC references and Proposition 26 (“Prop 26”). On April 12, 2010, SB 401, the Conformity Act of 2010 was passed. The Act changes California’s IRC reference date from January 1, 2005, to January 1, The act is operative for taxable years beginning on or after January 1, 2010, except as otherwise noted. Subsequently, California voters passed Prop 26 requiring, among other things, a two- thirds supermajority vote in each house of the California State Legislature for tax measures which increased any taxpayer’s liability. Prop 26 applies retroactively to legislation enacted after January 1, Previous legislation impacted by the retroactive application of Prop 26 would need to be re-enacted by the anniversary date of Prop 26’s passage to remain in effect. UC Davis Summer Tax Institute June 14, 2017

Franchise Tax Board Legal Division Guidance (Impact of Proposition 26 on SB 401): FTB says SB 401 is the law and that they are required to apply the provisions of SB 401 for the periods for which it is applicable. Section 3.5 of Article III of the California Constitution prohibits an administrative agency from declaring a statute unenforceable. Therefore, Section 3.5 of Article III requires the FTB to enforce SB 401 until an appellate court has made a determination that some portion or all of SB 401 is ‘void’ pursuant to Proposition 26. Note: The most recent conformity bill, AB 154 of the Regular Session, passed with a supermajority and updated the IRC reference date to January 1, for tax years beginning on or after that date and included legislative findings and declarations stating that SB 401 is valid (“[i]t is the intent of the Legislature to confirm the validity and ongoing effect of Senate Bill No. 401 of the 2009–10 Regular Session”). UC Davis Summer Tax Institute June 14, 2017

Cal. Chief Counsel Ruling (Oct. 25, 2012) held that for California franchise tax purposes, Treas. Reg. §1.337(d)-2(a)(1) does not operate to disallow a worthless stock deduction upon the conversion of certain insolvent entities that were included in a federal consolidated group and that filed a California combined tax return. The FTB reasoned that since such Treas. Reg. only applied to taxpayers that filed a consolidated federal return, it would not be applicable for California purposes because California does not generally provide for the filing of consolidated returns. Because Treas. Reg (d)-2(a)(1) provides that for transactions involving loss shares of subsidiary stock occurring on or after September 17, 2008, a position exists that the unified loss rule does not apply to California under the same rationale. Query: Would states, in addition to California, which do not adopt or follow the federal consolidated return rules hold that the loss limitation rules and the unified loss rule are not applicable? UC Davis Summer Tax Institute June 14, 2017

Impact of Federal Regulations on State Tax Base Proposed section 385 regulations Guidance released on April 4, 2016 with temporary Section anti-inversion regulations, with stated intent to limit ‘earnings stripping’ Section 385 proposed regulations are not limited to inverted companies, but apply to both US- and foreign-headquartered companies operating in the United States UC Davis Summer Tax Institute June 14, 2017

Impact of Federal Regulations on State Tax Base (continued) Proposed section 385 regulation: Affect broad categories of related-party debt transactions, regardless of the debt instrument’s characteristics or purpose Impact typical day-to-day international treasury management practices, such as cash pooling and related-party financing Allow IRS on audit to recharacterize debt as equity or part equity / part debt Require contemporaneous documentation with respect to the characterization of related-party financial instruments as debt Apply retroactively to financial instruments issued after April 4, 2016, once regulations are finalized UC Davis Summer Tax Institute June 14, 2017

Impact of Federal Regulations on State Tax Base (continued) Final section 385 regulations In October, 2016 the IRS released the final and temporary section 385 regulations. The regulations: Are far narrower in scope than the proposed regulations in order to better focus on related party financings that can potentially erode the tax base. For example, intercompany loans between members of a consolidated return group are generally excluded under the “one entity” approach. Questions include whether the conformity to this federal regulation is automatic in states with general IRC references, whether the “one entity” exception would apply in separate filing states and combined states like California which do not adopt the federal consolidated return regulations and how these regulations will interact with pre-existing debt v. equity classification case law. UC Davis Summer Tax Institute June 14, 2017

Pre-existing State Challenges involving debt v. equity classification Mass. Mutual Life Insurance Co. v. Mass. Commissioner of Revenue, Massachusetts Appellate Tax Board, Nos. C305276, C305277, June 12, 2015 These appeals concern whether certain intercompany advances made by Massachusetts Mutual Life Insurance Company ("MMLIC") to its wholly- owned subsidiary, MMH, constituted bona fide debt for Massachusetts tax purposes. The Board found and ruled that: The amounts advanced to MMH were used for the valid business purposes of funding and expanding the operations of its subsidiaries; In advancing the funds in the form of loans instead of equity, MMLIC was motivated by regulatory concerns, not by a desire to avoid tax; and The MMH Notes constituted bona fide indebtedness with economic substance. UC Davis Summer Tax Institute June 14, 2017

Entire Net Income States These states refer to FTI but expand such to include income which may be broader than FTI. New York - Matter of Reuters Limited v. Tax Appeals Tribunal, 82 N.Y.2d. 112 (1991): Holding that a foreign corporation had to report pro forma worldwide income to NY, not just the effectively connected income that was reported on the 1120F. Effective 2015 the new law limits the entire net income base to income that is effectively connected with the conduct of a U.S. trade or business, which is more analogous to federal taxable income. New Jersey - International Business Machines Corporation v. Director, Division of Taxation, N.J. Tax Court No , 1/26/11: The Court held that export profits of a U.S. company which had been excluded under the former federal "extraterritorial income exclusion" or "ETI" provisions could not be added back to ENI - such was not really excluded income so much as a deduction that NJ adopted through reference to FTI. UC Davis Summer Tax Institute June 14, 2017

Schlumberger Technology Corp. & Subsidiaries v. Alaska Department of Revenue, Alaska Supreme Court, No. S-14729, July 18, 2014 The Alaska Supreme Court found that the Internal Revenue Code §882, which requires a foreign corporation to report only income ‘effectively connected with the conduct of a trade or business within the United States’ has not been adopted by reference into the Alaska Net Income Tax Act. The court provided that that IRC §882 uses various sourcing rules in determining whether a taxpayer’s income is derived from a source inside or outside the United States. These sourcing rules are inconsistent with the state’s three factor apportionment formula. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track State Modifications – Typical Addition Modifications
Typical additions modifications: State income taxes Foreign income taxes Local income taxes Interest from state obligations Excess ACRS depreciation Federal N.O.L. C/O Federal bonus depreciation Payments to Related Entities Federal deduction for domestic production activities Discharge of Indebtedness - IRC Section 108 deferral UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track State Modifications – Typical Subtraction Modifications
Dividends (General) Dividends controlled corporations Federal jobs credit wages State NOL Deduction Federal income tax Interest - U.S. obligations State income tax refunds Subpart F income UC Davis Summer Tax Institute June 14, 2017

State and Local Income Taxes Most states do not allow a deduction for their own income tax. Many states disallow a deduction for all state and local income taxes. The laws of those states requiring an add back of state income taxes must be reviewed to determine which taxes fall within the modification provisions (e.g., income taxes versus franchise taxes not based on income). Dayton Hudson Corporation, 94-SBE-003 (Cal. St. Bd. of Equal. Feb. 3, 1994): The SBE found that the Michigan Single Business Tax (“SBT”) included in its base an element of cost of goods sold and, therefore, the tax was not measured by income. Since the tax was not on or measured by income, the SBE found the tax deductible. UC Davis Summer Tax Institute June 14, 2017

Appeal of Kelly Service Inc., 97-SBE-010 (Cal. St. Bd. of Equal. May 8, 1997). The FTB had argued that the Michigan SBT was nondeductible to a service organization that did not have any costs of goods sold. The SBE held against the FTB, finding that the SBT was not applied differently depending upon the activities of the taxpayer and, therefore, the SBT should be deductible regardless of the components in the taxpayer's tax base. Accordingly, the Michigan SBT should be fully deductible in California. UC Davis Summer Tax Institute June 14, 2017

FTB Notice : The FTB addressed the eligibility of the Texas Margin Tax (“TMT”) for the other state tax credit (“OSTC”) or a deduction for California income and franchise tax purposes. Due to the fact that the TMT offers a few methods to determine “margin,” the FTB declined to offer a clear uniform rule. Instead, it said that the determination of whether a taxpayer is eligible for an OSTC or a deduction is a highly fact-specific inquiry and must be made on a case-by-case basis. Despite the ambiguity in the Notice, Attachment 1 to the Notice provides a summary of what the outcome may be depending upon whether the tax is classified as a gross receipts tax (deductible), or a gross income or net income tax (non-deductible). FTB Notice withdrew FTB Notice The department is currently evaluating its position and exploring alternative methods to issue authoritative guidance. UC Davis Summer Tax Institute June 14, 2017

FTB Legal Ruling : The FTB re-examined when taxpayers can claim the OSTC, and specifically the OSTC for the Revised Texas Franchise Tax, as previously addressed by FTB Notice This ruling replaces Notice The ruling states “a case-by-case analysis of a particular taxpayer’s situation is not appropriate and is not determinative of whether a tax has a measure based on income.” Rather, the other state’s taxing scheme should be characterized universally for all taxpayers. Determining whether the tax is a gross income tax is done by reviewing the state’s entire methodology. Whether a tax payment is eligible for the OSTC turns on if the tax is: 1. properly characterized as a tax on or measured by income, and 2. whether the tax is properly characterized as a net income tax. If the tax is not OSTC eligible, the taxpayer may take a deduction assuming all other requirements are met. UC Davis Summer Tax Institute June 14, 2017

Revised Texas Franchise Tax (Texas Margins Tax) Alternative methods to compute: Total Revenue From Federal From 1120, 1065, or other applicable From (less certain items for specific industries) Minus: Greatest of: (1) Cost of goods sold, (2) Compensation, (3) 30% of total revenue, or (4) $1 million Equals: Taxable margin before apportionment Multiplied by: Apportionment factor (single factor of gross receipts) Apportioned margin Allowable deductions Taxable margin Tax rate (0.375% for retailer or wholesaler; 0.75% for most other entities) Allowable credits Tax due on margin UC Davis Summer Tax Institute June 14, 2017

Texas Margins Tax (continued) What is it? Gross Receipts, Gross Income, or Net Income? CRTC section allows an S corporation shareholder to take an other state tax credit for “any taxes on, or according to, or measured by, income or profits paid or accrued” Credit allowed for tax on Gross or Net Income, but not Gross Receipts Would also affect deduction for Corporations allowed under section 24245 FTB Legal Ruling A California taxpayer may deduct Texas franchise tax paid, rather than claim the OSTC, regardless of the specific components of its Texas franchise tax base. The Texas franchise tax is not a tax on or measured by income, regardless of how the taxpayer’s taxable margin is determined. The Texas franchise tax is a single, indivisible tax, as a taxpayer can only be subject to paying one tax on one base in any year. UC Davis Summer Tax Institute June 14, 2017

Indiana Indiana Department of Revenue Supplemental Letter of Findings No (3/26/14) provided that the Texas Margin Tax is measured by income and therefore should be added back. It also found that the Michigan Business Tax ‘modified gross receipts tax’ portion of the tax is an income tax, therefore amounts paid under the MBT should be added back to Indiana corporate income tax. California In Gillette, the MI SBT was found not to be an income tax despite starting with FTI. Michigan However, in Emco Enterprises, the Michigan Court of Claims found that the SBT is an income tax for purposes of the Compact. UC Davis Summer Tax Institute June 14, 2017

New Jersey PPL Electric Utilities Corp. v. Director, Division of Taxation, N.J. Tax Ct., Dkt. No , October 2, 2014 The New Jersey Tax Court held that Pennsylvania Gross Receipts Tax and Pennsylvania Capital Stock Tax were properly excluded from the calculation of taxpayer’s New Jersey Corporate Business Tax Liability (CBT). New Jersey requires an addback for state taxes paid measured by income, profits, business presence, or activity. New Jersey also provides that property taxes, excise taxes, payroll taxes and sales taxes are not considered ‘business presence’ or ‘business activity’ taxes. The Court held that the Pennsylvania Gross Receipts Tax is an excise tax because it measured by taxpayer’s sales of electricity and, therefore, it is not subject to the addback in computing entire net income for CBT purposes. The Court also found that the Pennsylvania Capital Stock Tax is a property tax that is measured by the value of taxpayer’s assets, which is not subject to addback. UC Davis Summer Tax Institute June 14, 2017

New Jersey Duke Energy Corporation v. Director, Division of Taxation, N.J. Tax Ct., Dkt. No , December 2, 2014 The New Jersey Tax Court held that electric utilities taxes paid to North Carolina and South Carolina were properly excluded from the calculation of Taxpayer’s New Jersey corporate business tax liability (CBT). New Jersey requires an addback for state taxes paid measured by income, profits, business presence, or activity. The utilities taxes were found to be industry specific assessments based on gross receipts imposed in addition to a net corporate income tax. The Court concluded that ‘add back provision is intended to capture only taxes paid to other States on a taxpayer’s net corporate income,’ and, therefore, ‘utilities taxes do not fit into this category.’ UC Davis Summer Tax Institute June 14, 2017

Foreign Income Taxes In the Mater of the Appeal of CTI Holdings, Inc. (96-SBE-003): California law prohibits deductions of state, federal, or foreign taxes "on or according to or measured by income or profits," including taxes imposed on intercompany dividends paid by one member of a unitary group to another member of the unitary group and eliminated from the income of the recipient. (Sec (b), Rev. & Tax. Code) Thus, the BOE held that foreign taxes paid on eliminated income items were nondeductible despite the elimination of the underlying income. UC Davis Summer Tax Institute June 14, 2017

Puerto Rico Excise Tax The tax is an excise tax on a nonresident’s acquisition from an affiliate of certain personal property manufactured and certain services performed in Puerto Rico. Thus, the tax is imposed on purchases, rather than income. IRC sections 901 and 903 allow a foreign income tax credit to offset federal income tax liability by the amount of foreign income taxes paid. Specifically, IRC section 903 expands the definition of creditable taxes for federal income purposes to include certain foreign taxes if the tax is in lieu of an income tax. For California tax purposes, would this be deductible or not? Likely it would be deductible in a state like California that does not adopt IRC section 903. UC Davis Summer Tax Institute June 14, 2017

Federal Income Tax A few states allow a deduction or partial deduction for federal income taxes paid (e.g., AL, IA [limitations apply], LA, MO [50% limitation]). A primary question is whether the amount should be determined on a proforma basis or an allocation of the amount paid by the federal consolidated group. UC Davis Summer Tax Institute June 14, 2017

Kinney Shoe Corporation v. State, 552 N.W.2d 788 (N.D. Supreme Court Sept. 3, 1996): A subsidiary that filed consolidated federal corporate income tax returns, but filed separate North Dakota corporate income tax returns, was required to limit its share of federal tax deductions for North Dakota corporate income tax purposes to its allocated share of consolidated tax liability actually paid by the parent to the federal government. UC Davis Summer Tax Institute June 14, 2017

CC Dickson Company v. Alabama Department of Revenue, Ala. Admin. Law Div., Docket No. BIT , 6/9/09: An Alabama corporation was entitled to a full deduction for its federal tax due on a recapture of LIFO deductions upon its conversion to an S corporation, even though the corporation only paid a portion of the total federal liability in the tax year at issue. The ALD reasoned that because the taxpayer became legally liable for the entire tax amount resulting from the LIFO recapture in the year of its final federal C corporation return, the federal tax liability accrued in that year. Therefore, the taxpayer was entitled to a full deduction on its final C corporation return. UC Davis Summer Tax Institute June 14, 2017

Municipal Interest Many states require federal taxable income to be increased by the amount of interest received on state and municipal obligations that are exempt from U.S. tax. Any related expenses that were not allowed as deductions for federal purposes may reduce this income. Some states, which require this modification, exclude interest received on their own bonds or on bonds issued by their political subdivisions from this provision (e.g., AL and CO). Department of Revenue of Kentucky v. Davis, No , 5/19/08: U.S. Supreme Court overturned a decision of the Kentucky Court of Appeals that held that the state's tax on interest income derived from bonds issued by states other than Kentucky is facially discriminatory in violation of the Commerce Clause. UC Davis Summer Tax Institute June 14, 2017

Municipal Interest Branch Banking & Trust Co. v. Comptroller of the Treasury, No. 13-IN-OO- 0076, 2016 WL , at *1 (Md. Tax Sept. 30, 2016) A Maryland tax statute allows the subtraction from Maryland income of exempt federal obligation interest, such as that on federal bonds, which is included in federal taxable income. The Comptroller’s policy was to allow corporations to deduct the federal obligation interest during the year it was received, until the corporation has zero taxable income for that year. If the corporation has an NOL then no subtraction is allowed. The Comptroller did not allow carryforwards of unsubtracted exempt federal obligation interest. The court found that the Comptroller’s policy violates the Maryland tax statute and the Supremacy Clause of the U.S. Constitution. UC Davis Summer Tax Institute June 14, 2017

Depreciation and Depletion Beginning with the federal ACRS provision in 1981, through the more recent enactment of Bonus Depreciation, a number of states have chosen not to conform to such federal accelerated depreciation for fiscal policy reasons. In addition, questions have arisen in states which statutorily allocate (as opposed to apportion) gains from the sale of property as to the proper treatment of depreciation ordinary income recapture. The American Taxpayer Relief Act of 2012, enacted on January 2, 2013, extends 50-percent bonus depreciation for qualified property through the end of 2013 and decouples bonus depreciation from the Section 460 percentage of completion method of accounting for assets with a depreciable life of seven years or less that are placed in service in The legislation also allows taxpayers to elect to accelerate some AMT credits in lieu of bonus depreciation. UC Davis Summer Tax Institute June 14, 2017

Beatrice Cheese, Inc. v. Wisconsin Department of Revenue, Nos. 91-I- 100, 101, 102 (Wis. Tax App. Comm. Feb. 24, 1993): Wisconsin allowed a deduction for accelerated depreciation only for property located in state. The taxpayer claimed the statute discriminated against interstate commerce in violation of the Commerce Clause. The Commission found the statute established differential treatment of taxpayers depending on the location of their property, resulting in a higher WI franchise tax burden on businesses that located property outside of WI. The Commission found the statute to be “clearly designed to have discriminatory economic effects on corporations locating depreciable property outside the state.” The Commission also found that the economic effect of this provision exerted “inexorable pressure” on taxpayers to locate their property in the State and, therefore, impermissibly burdened interstate commerce. UC Davis Summer Tax Institute June 14, 2017

R.J. Reynolds Tobacco Co. v. City of New York Dept. of Finance, 257 A.D.2d 6 (N.Y. A.D. Dec. 9, 1997), appeal dismissed, 694 N.E.2d 865 (N.Y. Apr. 7, 1998): The New York Supreme Court held the City ordinances treating in- State property differently than out-of-state property violated the Commerce Clause and were, therefore, invalid. The New York Department of Taxation and Finance announced, in TSB-M-99(1)(I), 02/16/1999, that the R.J. Reynolds decision would be followed for New York State purposes. UC Davis Summer Tax Institute June 14, 2017

CNA Holdings, Inc. v. Delaware Dir. of Rev., 818 A. 2d 953 (2003): The Delaware Supreme Court ruled that statutory provisions that require a taxpayer to allocate gains attributable to depreciation recapture entirely to the state where the property is located, rather than to apportion such gains using the statutory income apportionment formula, are clear and unambiguous and do not produce an unreasonable result. UC Davis Summer Tax Institute June 14, 2017

Bonus Depreciation With respect to adjustments for bonus depreciation, there are many variations on the state modification. Some states allow the federal depreciation without modification. Other states require a full add back for the bonus depreciation. In these full add back states, generally there is an additional subtraction modification that is permitted. This subtraction modification is based on federal depreciation that could have been taken had the basis of the bonus depreciation assets included the bonus depreciation that was added back. UC Davis Summer Tax Institute June 14, 2017

Pennsylvania Pennsylvania provides a unique example of the gradual subtraction modification that is permitted to recover the 30% and 50% bonus depreciation amounts that are required to be added back. Pennsylvania allows an additional depreciation deduction for each year computed as 3/7ths of the regular federal depreciation amount on these assets. This deduction is allowed until the bonus depreciation has been fully recovered. 72 P.S. §§ 7401(3)(q) & (r). A catch-up deduction is permitted for the 50% bonus depreciation assets in the last year that those assets are depreciated for federal income tax purposes. Pennsylvania will not require an add back for depreciation based on the 100% bonus depreciation federal provisions even though these states otherwise require an add back for 30% and 50% bonus depreciation. Penn. Dept. of Rev., Corporate Income Tax Bulletin # , 2/24/11. UC Davis Summer Tax Institute June 14, 2017

Federal Net Operating Losses Many states adopt FTI on line 28 of Form 1120, before the NOL deduction. Such states typically allow their own, post-apportionment NOL. Other states start with line 30, but may nonetheless require the add back of the federal NOL and the subtraction of a state NOL which reflects state modifications. Before the Corporate Tax Reform, New York took a hybrid approach under which a pre-apportioned NY NOL is allowed but is limited to the amount of federal NOL deducted on a pro forma basis which reflects the NY filing group and limited NOL carryback ($10,000). Please note that with the legislation passed in 2014 and effective 2015, New York no longer limits the NOL deduction to the amount of federal NOL deducted. UC Davis Summer Tax Institute June 14, 2017

Example 4: New York NOL Limitation Corp A and Corp B file a federal consolidated return but Corp B alone files in NY. In 2010, Corp A & B had $5 million and ($15 million) FTI respectively. The consolidated loss of $10 million was carried back and deducted in under IRC § 172. In 2011, the Corp A & B federal consolidated group reports $10 million of income, without any NOL carryovers. Corp B’s FTI is $5 million. Assume Corp B had no separate income in 2008 or For NY tax purposes, Corp B has a $15 million NY NOL carryover to 2011 of which on a pro forma basis $5 million would be deductable. Under the new rules effective for tax years beginning on or after January 1, 2015, NOLs are carried over on a post-apportioned basis and not limited to the federal NOL deduction taken. UC Davis Summer Tax Institute June 14, 2017

New York Net Operating Losses The new law allows two NOL deductions: Deductions for NOLs generated in tax years beginning on or after 1/1/2015 The new law provides that an NOL deduction is taken on a post- apportionment basis without reference to the federal NOL deduction amount. Prior NOL Conversion Subtraction “PNOL” Due to the change in New York’s NOL deduction under the new legislation, a computation must be performed to convert NOL carryforwards that were generated during tax years prior to the tax year starting on or after January 1, 2015. UC Davis Summer Tax Institute June 14, 2017

The PNOL conversion subtraction is computed as follows: Determine the NOL carryforward existing in the tax year prior to the effective date of the tax reform (the “unabsorbed NOL”); Determine the taxpayer’s apportionment percentage from the final tax year prior to the effective date of the tax reform (the “base year”); Multiply the unabsorbed NOL by the base year apportionment percentage; Multiply the apportioned unabsorbed NOL by the tax rate that would have applied to the taxpayer in the base year (i.e., 7.1% for certain NYS taxpayers; 8.85% for certain NYC taxpayers); and Divide that amount by the current year business income tax rate (generally, 6.5% for NYS and 8.85% for NYC). UC Davis Summer Tax Institute June 14, 2017

Example: X Corp. - PNOL Conversion Subtraction Computation 2012 2013 2014 Total Income/(Loss) (100,000) (200,000) (300,000) (600,000) BAP % 10% 30% 50% Step 1: Assuming no federal limits are imposed, X Corp's total unabsorbed NOL is (600,000). Step 2: X Corp's total unabsorbed NOL of (600,000) is multiplied by the base year (2014) apportionment percentage (50%) = (300,000). Step 3: The product from Step 2 is multiplied by the taxpayer's base year (2014) tax rate (7.1%) = (21,300). Step 4: The product from Step 3 is divided by 6.5% = (327,692). This is X Corp's PNOL pool. UC Davis Summer Tax Institute June 14, 2017

In the Matter of the Petition of TD Holdings II, Inc., State of New York Tax Appeals Tribunal, No , April 7, 2016 The New York Tax Appeals Tribunal reversed an administrative law judge (ALJ) determination and found that a taxpayer was required to utilize a net operating loss (NOL) deduction to reduce its entire net income for New York bank franchise tax purposes in a year when the tax was measured on a base other than entire net income. In so ruling, the Tribunal concluded that the state law in effect for the years at issue requires that entire net income, inclusive of applicable net operating losses, be computed whether or not tax is actually paid on the base of net income. Taxpayers with NOL carryforwards that may have paid tax on an alternative base in prior years should carefully review their unabsorbed New York NOL carryforward balance, especially in years when tax was paid on an alternative base. With tax reform starting in the 2015 tax year, the NOL carryover calculation is of particular concern when determining the carryovers available for purposes of the PNOL conversion subtraction. UC Davis Summer Tax Institute June 14, 2017

In the Matter of Plasmanet, Inc., NYC TAT, TAT (E) 12-17(GC), January 20, 2017 The NYC TAT upheld the DOF’s application of the “same source year rule”, that requires that the NYC NOL deducted must have its source from the same loss year as the NOL deducted for federal tax purposes. Due to the differing amounts of NYC and federal NOLs, this can produce limitations on the amount of NYC NOL deducted in addition to the limitation that the NOL deducted not exceed the federal deduction. The NYC TAT rejected the DOF’s SOL related argument and allowed NOL carryovers to be increased by charitable contributions not originally deducted due to income limitations on the originally filed returns. Note that for the years at issue NY State had similar provisions. UC Davis Summer Tax Institute June 14, 2017

Hillenga v. Department of Revenye, Ore. Sup. Ct., No. SC S062603, November 13, 2015 The Oregon Supreme Court concluded that the statute of limitations does not bar review of a net operating loss carryover applied in an open tax year. By attempting to carry over their 2004 net operating loss to apply against their 2006 tax liability, the taxpayers put the validity of their net operating loss at issue. Because the Oregon Department of Revenue was not trying to assess a deficiency for 2004, the statute of limitations did not apply. UC Davis Summer Tax Institute June 14, 2017

Nextel Communications of the Mid-Atlantic, Inc., v. Commonwealth of Pennsylvania, Pa. Commonwealth Court, No, 98 F.R. 2012, November 23, 2015 The Commonwealth Court of Pennsylvania held that the net loss carryover (NLC) deduction allowed for purposes of the Pennsylvania corporate net income (CNI) tax, as applied to Nextel Communications, violates the Uniformity Clause of the Pennsylvania Constitution. The court concluded the NLC deduction creates classes of taxpayers according to their taxable income. Taxpayers with taxable income in excess of $3 million could not reduce their CNI liability to zero whereas similarly-situated taxpayers with $3 million or less in taxable income could reduce their CNI liability to zero. The court found such classification unreasonable and not related to any legitimate state purpose. UC Davis Summer Tax Institute June 14, 2017

California Net Operating Losses California suspended NOL deductions for 2008 to Taxpayers may deduct NOLs in taxable years beginning on or after January 1, 2012. For tax years beginning on or after January 1, 2013, a California NOL must be carried back to the prior 2 taxable years and any remaining NOL is then carried forward 20 taxable years as follows: For NOLs generated in 2013, 50% of the NOL can be carried back to the earlier of the 2011 and 2012 tax years and then forward for 20 years as available; For NOLs generated in 2014, 75% of the NOL can be carried back to the earlier of the 2012 and 2013 tax years and then forward for 20 years as available; and For NOLs generated in 2015 and forward, 100% of the NOL can be carried back 2 years and then forward for 20 years as available. UC Davis Summer Tax Institute June 14, 2017

Indiana Department of State of Revenue v. Caterpillar, Inc. No. 49S TA-79, August 25, 2014 Indiana Supreme Court held taxpayer may not deduct foreign source dividends when calculating Indiana NOLs. Indiana’s adjusted gross income calculation provides for a foreign source dividend deduction. Indiana’s NOL is defined by reference to a taxpayer’s federal NOL with certain state adjustments, none specifically reference foreign source dividend deduction. Branch Banking & Trust Co. v. Comptroller of the Treasury, No. 13-IN-OO- 0076, 2016 WL , at *1 (Md. Tax Sept. 30, 2016) The court held that the Maryland Comptroller’s policy violated a state statute and the Constitution. The policy essentially did not allow the subtraction for federal obligation interest to increase the amount of Maryland NOL carryovers. UC Davis Summer Tax Institute June 14, 2017

State Adoption of I.R.C. §382 While some states specifically adopt IRC §382 (e.g. CA), adoption in other states may still be unclear. Idaho State Tax Commission, Decision No (Jan. 23, 2007) Taxpayer did not deduct its Idaho net operating losses due to the federal 382 limitation and carried losses forward as permitted under federal tax law. However, the Idaho State Tax Commission held that the Idaho deduction for the NOL of an acquired corporation is not subject to the federal 382 limitation. Consequently, the NOLs should have been deducted in the prior taxable years rather than carried forward and deducted. Since the earlier years were beyond statute, refunds were not available, but the carryovers to later years still had to be reduced by the amount allowable in prior years. Effective on January 1, 2010, Idaho now conforms to Code Section 382, at least with respect to ownership changes which arise out of a merger. (Idaho Code § 63–3021(c).) UC Davis Summer Tax Institute June 14, 2017

Apportionment of Federal Limitation In states which adopt IRC §382 , should the federal limitation be subject to apportionment? Express Scripts, Inc. v. Commissioner of Revenue, Minnesota Tax Court, Ramsey County, Docket No. 8272R, 8/20/12 A taxpayer's corporate acquisition triggered an IRC Sec. 382 limitation of the acquired company's NOL carryovers equal to approximately $30 million. The DOR apportioned that limitation using the apportionment ratio of the income years, which reduced the amount of available loss to approximately $120,000. Despite Department guidance to the contrary, there was no statutory authority for the Department's position to apportion the section 382 limitation. UC Davis Summer Tax Institute June 14, 2017

Apportionment of Federal Limitation Express Scripts, Inc. v. Commissioner of Revenue, Minnesota Tax Court, Ramsey County, Docket No. 8272R, 8/20/12 Accordingly, the Tax Court found that the application of an apportioned 382 limitation is not supported by the plain language of the statute and would create an "unnecessary disconnect between Minnesota and federal law." In Express Scripts, Inc. v. Commissioner of Revenue, No. A , Minn. Sup. Ct. (1/18/13), the MN Supreme Court concluded that the appeal of the Tax Court decision that the Department could not apportion an IRC sec limitation was not timely, effectively rendering the Tax Court's decision final. Nonetheless, we understand that at audit the Minnesota Department of Revenue is still requiring taxpayers to apportion the IRC sec. 382 limit. UC Davis Summer Tax Institute June 14, 2017

Apportionment of Federal Limitation California FTB Technical Advice Memorandum (TAM) The TAM provides that the IRC section 382(b)(1) limitation for net operating losses (NOLs) and 383(a)(1) limitation for excess credits are to be applied on a pre-apportionment basis, while items of net income such as realized built-in gains (RBIGs) and losses (RBILs) and net unrealized built-in gains (NUBIGs) and losses (NUBILs) are to be determined on a post-apportionment basis. UC Davis Summer Tax Institute June 14, 2017

Payments to Related Entities A number of states require that certain expenses paid to related members be added back to income. Expenses subject to add back may include: Intangible expenses such as royalties paid for use of patents, trademarks, etc. Interest expenses related to intangible expenses, such as where the related party loans the funds from royalties received back to the operating company which paid them. A few states may also require addback of management fees, intercompany rent charges and the dividends paid deduction allowed by captive REITs. One state (TN) currently requires pre-approval of specified related party intangible expenses. UC Davis Summer Tax Institute June 14, 2017

Most states provide exceptions to add back. Typical exceptions include: Related party is subject to tax on the royalty income in the same or another state. Most states agree that related parties which report losses are nonetheless subject to tax, however, related parties which are based in tax haven states or combined reporting states are not. Some states require that the related party be subject to tax at an effective rate within a certain range of the add back state’s rate, while others give a prorated reduction based on the degree to which tax is actually paid. A limited few provide a credit (Oregon). Related party pays the same amount received to a third party lender/licensor (a conduit exception). Related party is not primarily engaged in related party lending/licensing, has economic substance, third party activity and deals at arms-length. UC Davis Summer Tax Institute June 14, 2017

On August 17, 2007, the Multistate Tax Commission adopted a two-part model expense addback statute: The first part requires the add back of otherwise deductible intangible expense directly or indirectly paid, accrued or incurred in connection with one or more direct or indirect transactions with one or more related members. The second requires a similar add back for interest expense (not limited to interest related to intangibles). The two parts were enacted in such a way that an adopting state may choose to require the add back of intangible expense without the broader add back of interest expense. Effective for tax years beginning on or after 1/1/13, New York adopts the provisions of the MTC’s model add back statute UC Davis Summer Tax Institute June 14, 2017

Alabama Related Party Limitation Effective for tax years beginning after December 31, 2000, limits for the deduction for expenses, losses, and costs for, related to, or incurred in connection with the acquisition, use, maintenance, management, ownership, sale, exchange, or disposition of intangible property; expenses or losses related to factoring or discounting transactions; and royalties, patents, technical and copyright licensing fees; and other similar expenses or costs paid to a related party. Also requires the add back of interest expenses and costs paid to a related member. (Ala. Code Sec (b), amended by Act (H.B. 2), 4th Sp. Sess., p. 1095, Sec. 1, enacted 12/21/01, eff. for tax years beginning after 12/31/00). UC Davis Summer Tax Institute June 14, 2017

Alabama Safe Harbors Sets forth a "substantial business purpose" requirement, and provides that deductions will not be limited where the taxpayer establishes that the transaction giving rise to the deduction does not have the principle purpose of tax avoidance and the related member is not primarily engaged in the acquisition, use, licensing, maintenance, management, ownership, sale, exchange, or disposition of intangible property; or in the financing of related entities. A transaction will be deemed not to be entered into primarily for purposes of tax avoidance where the transaction has a substantial business purpose and economic substance, and contains terms and conditions comparable to similar arm's-length transactions between unrelated parties. UC Davis Summer Tax Institute June 14, 2017

Alabama Regulation Sec specifies the extent of the interest and intangible expense/cost add back, and provides that add back in not required where the taxpayer established to the department's satisfaction that: The addition is "unreasonable" (see definition below); The corporation and the commissioner agree to the use of alternative adjustments or computations (see further requirements below); The primary purpose of the transactions that generated the deductions is not Alabama tax avoidance; or The items of income received by the related member that correspond to the taxpayer's expense were subject to tax in Alabama, another state, or foreign country. UC Davis Summer Tax Institute June 14, 2017

Alabama Dep't of Revenue v. VFJ Ventures, Inc., Ala. Civ. App., No , 2/8/08: Upheld by the Alabama Supreme Court, the Alabama Court of Civil Appeals reversed a Circuit Court holding that the state's "add back statute" for certain intercompany intangible and interest expenses resulted in an "unreasonable" denial of deductions for legitimate business expenses. The court noted the Department had applied the unreasonableness exception to situations where a corporation's tax would be "out of proportion with what could reasonably be said to be attributed to the State". UC Davis Summer Tax Institute June 14, 2017

Related Party Limitations New Jersey Effective for tax years beginning on or after 1/1/02, taxpayers are required to add back interest paid, accrued or incurred to a related member. Effective for tax years beginning on or after 1/1/02, taxpayers are required to add back otherwise deductible intangible expenses and costs and related interest expenses and costs and directly or indirectly paid, accrued or incurred to, or in connection directly or indirectly with one or more direct or indirect. UC Davis Summer Tax Institute June 14, 2017

Related Party Limitations (continued) Beneficial New Jersey, Inc. v. Director, Division of Taxation, N.J. Tax Ct., No , 8/31/2010: Reversing an assessment based on related party interest expense add back, finding that the "unreasonableness" exception applied based on a "totality" of factors including economic substance and business purpose. In Beneficial, the taxpayer’s parent borrowed money from a lender and loaned the proceeds to its subsidiary. Although NJ did not have an explicit conduit exception to add back, the Court concurred that add back was unreasonable. UC Davis Summer Tax Institute June 14, 2017

Related Party Limitations (continued) Morgan Stanley & Co., Inc. v. Director, Division of Taxation, N.J. Tax Court No (10/29/14): On October 29, 2014, the Tax Court of New Jersey found that a taxpayer could deduct related party interest expenses because the Division of Taxation failed to properly apply the unreasonable exception. Although the decision didn’t reach a substantive ‘unreasonable’ analysis of the taxpayer’s transactions, New Jersey taxpayers may still find elements of the decision instructive, including general examples of what could qualify under the unreasonable exception. UC Davis Summer Tax Institute June 14, 2017

Related Party Limitations (continued) Kraft Foods Global, Inc. v. Director, Division of Taxation, New Jersey Tax Court, No , April 25, 2016 The NJ Tax Court concluded that interest expense on debt which a parent had intended to “push down” to its subsidiary did not meet the unreasonableness exception to addback. The Tax Court concluded that the related party debt did not result in the subsidiary being ultimately responsible for the external debt and was distinguishable from its earlier decision in Morgan Stanley. Kraft Foods Global, Inc.’s (Tp’s) parent company, Kraft Foods, Inc., had issued public debt aggregating $9.5 billion and transferred amounts equal to the proceeds of these bonds to Tp, which used those funds to pay off amounts owed to a related party (wholly owned by Phillip Morris). Thereafter, Tp made payments back to its parent company of interest in roughly the amount carried by the parent company’s public bonds. UC Davis Summer Tax Institute June 14, 2017

Related Party Limitations (continued) BMC Software, Inc. v. Director, Division of Taxation, N.J. Tax Court No 2012 (5/24/17) On May 24, 2017, following the parties’ respective motions for summary judgment, the New Jersey Tax Court found that a subsidiary’s intangible expenses paid to its parent qualified for the state’s unreasonable addback exception because the payments were substantively equivalent to an unrelated party transaction. UC Davis Summer Tax Institute June 14, 2017

Spring Licensing Group, Inc. v. Director, Division of Taxation, N.J. Tax Court, No , August 14, 2015 The New Jersey Tax Court ruled that an out-of-state company had a Corporate Business Tax reporting responsibility and had to pay tax on royalty income despite an in-state affiliate adding back royalty expense paid to the company. The court disagreed that the prospect of double taxation precludes the company’s New Jersey filing obligation. The court suggested that the potential for double taxation is alleviated by the payor seeking an exception to the addback or the payee seeking alternative apportionment relief. UC Davis Summer Tax Institute June 14, 2017

Staples, Inc. v. Commission or Revenue, Mass App. Tax Bd. No. C310639, September 4, 2015 The Massachusetts Appellate Tax Board found that intercompany transfers under a taxpayer’s cash management system did not give rise to bona fide debt. Therefore, interest payments related to the purported debt were not deductible under either the income or the net worth measures of the excise tax. The Board reached its determination with particular focus on facts indicating that excess cash advances were not intended or expected to be repaid, and were not, in fact, repaid. UC Davis Summer Tax Institute June 14, 2017

Pennsylvania Information Notice (Feb. 19, 2016) Embedded Intangible Costs “Embedded intangible costs are included within the definition of an ‘intangible expense or cost’ and are, therefore, subject to the Add-Back. Embedded intangible costs are expenses paid to acquire, use, maintain, manage, sell, exchange, or otherwise dispose of (or otherwise acquire) an intangible asset, where the purported cost or expense is included in deductions or expenses that are called something other than ‘[r]oyalties, licenses or fees paid,’ such as cost of goods sold or a separate service charge (e.g., management fees).” (internal citations omitted) UC Davis Summer Tax Institute June 14, 2017

Letter of Findings No , Indiana Dept. or Revenue (September 24, 2014), released October 2014: A multi-national manufacturer of industrial products and its affiliates filed separate company Indiana returns. The Indiana Department of Revenue assessed additional tax on the basis that intercompany interest and royalty expenses should have been added back to net federal taxable income. The Letter of Findings provides that in order to reasonably attempt to ‘effectuate an equitable allocation and apportionment of the taxpayer’s income,’ the Department reallocated intercompany interest expenses claimed by the taxpayer on its original Indiana return. Rhode Island, H.B. 7133, enacted on June 19, 2014 Repeals add back to net income for related party (1) intangible expenses and costs (2) interest relating to intangibles. Effective for tax years beginning on, or after, January, 1, 2015. UC Davis Summer Tax Institute June 14, 2017

Wendy’s Int’l, Inc. v. Virginal Dep’t of Taxation, Case No. CL (Cir. Ct. of the City of Richmond): On 3/29/12, a Virginia Circuit Court concluded that the related-party add back exception requiring licensors to derive at least one-third of their gross revenues from the licensing of intangible property to unrelated members does not mandate that the royalty income be derived directly from unrelated members. The fact that the licensor received the revenue from a related-party conduit does not disqualify the licensor from the exception. The add back exception at issue in Wendy’s was incorporated into Virginia’s add back statute at the request of a trade organization representing franchisors. The exception should apply to any business that derives more than one-third of its licensing revenue from unrelated third parties, whether received directly or indirectly. UC Davis Summer Tax Institute June 14, 2017

Domestic Production Activities (“DPA”) Deduction A number of the states which impose income tax conform to the DPA deduction, however, there are many that do not (e.g., AL, AR, CA, and CT). When a state adopts line 28 FTI, it adopts a DPA deduction which in effect has been impacted, for better or for worse, by items of income and deduction at the federal level which may not be treated consistently for state purposes. Complexities in determining the allowable Sec. 199 deduction at the state level may arise when the state employs a different filing method (e.g. separate or unitary vs. federal consolidated) than that used by taxpayers at the federal level. Issues may also arise regarding pass-through entities, where at the federal level, the deduction passes through to the owners or members; whereas some states tax impose a tax directly on the entity. UC Davis Summer Tax Institute June 14, 2017

Compute I.R.C. Sec. 199 deduction on a proforma basis: GKN Westland Aerospace, Inc. v. Ala. Dept. of Rev., Admin. Law Div., Dkt. No. BIT , 7/25/2011: An I.R.C. §199 domestic production activities deduction may be computed and claimed on a separate company basis for purposes of Alabama income tax if an Alabama taxpayer has sufficient taxable income to claim the deduction, even where the deduction is limited for federal purposes because of a consolidated group's lack of taxable income. UC Davis Summer Tax Institute June 14, 2017

Compute I.R.C. Sec. 199 deduction on an allocated basis: Virginia Ruling (P.D ): The Virginia tax commissioner ruled that a company that files a consolidated federal income tax return as part of an affiliated group but files a separate Virginia return may claim its proportional share of the I.R.C. Sec deduction for VA income tax purposes since this amount would be the same had it filed a separate federal return. The Virginia Legislature followed this up by passing SB 462, which allows the total amount of the federal deduction for domestic production activities to be deducted for Virginia income tax purposes for tax years beginning on or after January 1, 2013. UC Davis Summer Tax Institute June 14, 2017

Domestic Production Activities (“DPA”) Deduction: Further, the federal DPA deduction may have been limited by federal NOL carryovers which do not exist or do not exist to the same degree for state income tax purposes (or vice versa). Without state modification, query whether a federal DPA deduction might even increase a state NOL carryover, contrary to the general application of the DPA provisions at the federal level. While the above situations suggest that state modifications to adjust the DPA deduction might be appropriate, at this point only KY has done so. UC Davis Summer Tax Institute June 14, 2017

The U.S. Supreme Court in Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, 505 U.S. 71 (1992) held that Iowa’s conformity to the federal dividends received deduction (“DRD”) regime via its conformity to FTI, violated the Foreign Commerce clause to the extent no state level DRD was allowed for foreign dividends. The Kraft decision raises interesting questions with respect to the DPA which may one day be addressed through litigation. UC Davis Summer Tax Institute June 14, 2017

Basic Illustrations of State DPA Deduction Example - Assume the following for AB Corp: CA AZ Activities HQ & MFNG Sales WAGES $29 million $1 million QPAI N/A * $20 million Fed DPA (6 %) $480,000 $1.2 million State Appor. % 50% Apportioned DPA $600,000 State Tax Rate 6.968% State Benefit of DPA $42 K *CA does not adopt the DPA deduction Observation: AB Corp receives a DPA deduction in AZ despite conducting no qualifying activities and employing minimal people in the state and receives no benefit in CA where such activities are conducted. UC Davis Summer Tax Institute June 14, 2017

The Alabama Tax Tribunal held on November 30, 2016 in Sherwin-Williams Company v. Alabama Department of Revenue that the taxable income limitation for purposes of computing the IRC 199 deduction for Alabama purposes is pro forma separate company federal taxable income, not separate company Alabama income after state specific adjustments. (Alabama Tax Tribunal, Docket Nos. BIT & BIT (11/30/2016).) UC Davis Summer Tax Institute June 14, 2017

Discharge of Indebtedness – IRC Section 108 Deferral The American Recovery and Reinvestment Act of 2009, enacted 2/12/09, modifies federal provisions dealing with the recognition of income from the cancellation or repurchase by a taxpayer of its debt for an amount less than its adjusted issue price. § 108 provides that a taxpayer must recognize cancellation of debt income (CODI) in an amount equal to the excess of the old debt's adjusted issue price over the repurchase price in the year the debt is cancelled or reacquired. However, Sec. 108(i)(1) allows certain businesses to recognize CODI over 10 years for specified types of business debt reacquired by the business after 12/31/08, and before 1/1/11. UC Davis Summer Tax Institute June 14, 2017

Dividends States differ in their treatment of dividend income. However, there are some common variations: State DRD same as federal. State DRD limited to dividends distributed from in-state income. State DRD extended to foreign dividends The IRC Section 78 deemed-paid gross-up on foreign (country) dividends are usually excluded from dividend income. Subpart F income may be treated the same as other foreign dividends or subtracted entirely. UC Davis Summer Tax Institute June 14, 2017

State DRD Same as Federal Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, 505 U.S. 71 (1992): Iowa’s taxation of dividends violated the Foreign Commerce Clause. Iowa used federal taxable income as the starting point for the computation of Iowa taxable income. No adjustment for dividends was written into the statute and, as a result, corporations were entitled to deduct domestic dividends to the extent they were deductible under federal provisions, but were taxed on foreign dividends taxable under the IRC. Footnote 23: In relation to a state employing unitary combined apportionment, the possibility that a state that imposes its tax on the taxpayer's income including its foreign dividend income, and also on the income of a domestic subsidiary doing business in its borders, may well not be discriminating in violation of the Foreign Commerce Clause. UC Davis Summer Tax Institute June 14, 2017

Conoco, Inc. and Intel Corporation v. New Mexico Taxation and Revenue Dept., 931 P.2d 730 (N.M. Nov. 26, 1996): The New Mexico Supreme Court reversed the State Court of Appeals and held New Mexico’s scheme of exempting domestic dividends while taxing foreign dividends under the Detroit formula to violate the Foreign Commerce Clause of the U.S. Constitution. UC Davis Summer Tax Institute June 14, 2017

State DRD Limited to Dividends Distributed From In-State Income Farmer Brothers Co. v. Franchise Tax Board, 108 Cal.App.4th 976 (2003): California Court of Appeals ruled that statutory provisions that tie the general corporation dividends received deduction to the payor's level of California in-state activity create an unconstitutional burden on interstate commerce and are invalid. The Court concluded that Section is discriminatory on its face because it favors dividend-paying corporations doing business in and paying taxes to California over dividend-paying corporations that do not do business in and pay no taxes to California. UC Davis Summer Tax Institute June 14, 2017

State DRD Limited to Dividends Distributed From In-State Income Abbott Laboratories v. California Franch. Tax Bd., 175 Cal. App. 4th (July 21, 2009), mod Cal.App.LEXIS 1298 (Aug. 6, 2009) deemed the DRD provisions invalid in their entirety (i.e., DRD denied to all taxpayers) and that it would be inconsistent with legislative intent to reform the DRD provisions to permit a DRD regardless of the payor’s California in-state activity. In D.D.I., Inc. v. Clayburgh, 657 N.W.2d 228 (2003), the Supreme Court of North Dakota held that the state’s dividends received deduction violated the Commerce Clause since the deduction applied only to the extent that the dividend payor's income was subject to North Dakota corporate income tax, but did not allow the deduction if the payor's income was not subject to North Dakota corporate income tax. UC Davis Summer Tax Institute June 14, 2017

General Electric Company, Inc. v. New Hampshire Dep't of Revenue Admin., N.H., No , 12/5/06: The New Hampshire Supreme Court held that a statute that allows a parent to take a business profits tax deduction for dividends received from subsidiaries that do business in the state but not for dividends received from subsidiaries that do not business in the state does not facially discriminate against foreign commerce. Mississippi Department of Revenue v. AT & T Corporation (Miss. 2016) 202 So.3d 1207 The Mississippi Supreme Court ruled that the state’s dividends received deduction, which applies only to dividends received from affiliates doing business in Mississippi and filing state income tax returns, unconstitutionally discriminates against interstate commerce. The court struck the unconstitutional phrase from the statute and allowed the taxpayer to deduct dividends received from affiliates not doing business and filing income tax returns in Mississippi. UC Davis Summer Tax Institute June 14, 2017

Kodak Company v. Connecticut Commissioner of Revenue Services, 27 Conn. L. Rptr. 273 (2000): The Connecticut Superior Court ruled that a department policy disallowing a portion of the deduction for commissions paid to a foreign sales corporation arbitrarily treats the commissions as non-deductible expenses related to dividend income, and is nothing more than a vehicle to allow the state to indirectly tax income that it is prohibited from taxing directly. UC Davis Summer Tax Institute June 14, 2017

Apple, Inc. v. Franchise Tax Board, 132 Cal.Rptr.3d 401 (2011): The California Court of Appeal, First District, affirmed a superior court decision in favor of the FTB’s method of ordering CFC dividends. Specifically, dividends from the accumulated earnings of a partially included CFC of a water's edge filer are governed by the last-in-first-out ("LIFO") ordering provisions and must be treated as coming from current year earnings until exhausted and then from the most recent years' earnings, without regard to whether the earnings represent previously taxed income. Also, the appeals court affirmed the superior court's holding that interest expense attributable to funds proven to have some economic connection to the generation of California taxable income qualify for deduction. The California Supreme Court denied review. UC Davis Summer Tax Institute June 14, 2017

Section 78 Gross-Up Most states allow a subtraction due to not allowing foreign tax credits. This may differ in states that allow federal income tax deductions. Amerada Hess Corp. v. Fong, N.D., No , 8/31/05: The North Dakota Supreme Court held that a taxpayer's I.R.C. § 78 gross- up amounts are ineligible for a partial exclusion from North Dakota corporate income tax as foreign dividends. UC Davis Summer Tax Institute June 14, 2017

Subpart F Dividends The states differ on the treatment of federal Subpart F dividends. For example, California does not recognize Subpart F dividends as income. Some states, such as Kansas, include Subpart F dividends in income, but may allow a DRD. New York - TSB-A-02(5)C, 5/31/02: The Department of Taxation and Finance ruled that Subpart F income generated by a foreign tier-two subsidiary is an excludable dividend from subsidiary capital. UC Davis Summer Tax Institute June 14, 2017

Interest on Federal Obligations The states are prohibited from taxing federal obligation income under the intergovernmental immunity doctrine. However, this doctrine only applies to state taxes imposed directly on net income as opposed to those taxes measured by net income. States imposing a direct net income tax are required to provide for a subtraction modification for U.S. interest. States levying franchise taxes measured by net income generally tax such income. Example: CA Franchise Tax – federal obligation income is not deductible CA Income Tax – federal obligation income is not taxable UC Davis Summer Tax Institute June 14, 2017

Nebraska Dept. of Rev. v. Lowenstein, 513 U.S. 123 (1994): The U.S. Supreme Court found that although income derived from repurchase agreement (“repo”) transactions are in the nature of “interest” and where federal securities were used as collateral, such “interest” was not exempt from state taxation as “interest on obligations of the United States” since the federal securities underlying the repo served as security for the financing rather than as a source of interest. UC Davis Summer Tax Institute June 14, 2017

Bell Federal Savings & Loan Association v. Wagner, 675 N.E.2d 135 (Ill. Ct. App. Dec. 13, 1996): The Illinois Court of Appeals held that interest paid by the Federal Home Loan Bank (FHLB) was not exempt from State taxation. The Court noted that the DID account was not a debt instrument issued by the FHLB because it was not an executed writing that contained a promise to pay specified amounts at specified times. As a result, the court held the interest paid by the FHLB on Bell’s DID accounts was not exempt from State taxation. UC Davis Summer Tax Institute June 14, 2017

In the Matter of Sumitomo Trust and Banking Company v. Commissioner of Taxation, 720 N.Y.S. 2d. (2001): The New York Supreme Court held that interest income earned on certificates guaranteed by the U.S. Small Business Administration is not deductible in determining corporate franchise tax because such certificates are not U.S. government obligations. The certificates were not obligations of the United States because the binding promise by the U.S. government is not a fixed and certain obligation, but a secondary and contingent one, the court noted. The Court found it significant that the Federal government received none of the proceeds of the certificates. Absent a showing that that obligation would impose a burden on the borrowing power of the United States, the interest income is not deductible, the court said. UC Davis Summer Tax Institute June 14, 2017

Federal Tax Credits Some states provide specific subtractions for reductions in federal deductions due to claiming a federal tax credit. In some states the subtraction is worded broadly, and in other states only specific federal credits are mentioned. Potlatch Corp. v. Idaho State Tax Com’n, 913P.2d 1157 (1996): The Supreme Court of Idaho held that a taxpayer that elects to claim federal credits rather than deductions for contributions to an employee stock ownership program (ESOP) and for research and development expenses, was not entitled to claim deductions for these expenses on their state income tax returns. Utah Rev. & Tax § (f): Allows “any decrease in any expense deduction for federal income tax purposes due to claiming any other federal credit” to be subtracted from unadjusted income. Oregon Revised Statutes § : If the federal credit taken is not allowed for Oregon purposes, the taxpayer shall be allowed the deduction or appropriate adjustment to basis to derive Oregon taxable income. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track State Modification – Possible Federal Tax Reform
Congress has proposed business tax reform legislation in 2017, including a lower corporate tax rate, a new passthrough business income tax system, elimination of deductions, full expensing of business costs (with no deduction for net business interest expense), a move to a territorial dividend exemption system, a onetime mandatory repatriation of foreign earnings, and border adjustments that would exempt export sales from taxable income and preclude foreign costs of goods sold expenses from being deducted. Based on the U.S. Supreme Court’s decision in Kraft, state level conformity to some of these proposals may present Constitutional issues, for example the so called “border adjustment” provisions. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track State Modification – Possible Federal Tax Reform
This reform will bring with it considerable tax opportunities as well as State conformity issues. For example: How will the mandatory repatriation of foreign earnings and profits be treated at the state level? Would state level adoption of the border adjustment provisions pass Constitutional muster? Will states decouple from full capital investment expensing? Will states decouple from the elimination of the current deduction for net business interest expense? Will there be separate rules for financial service companies? Will states conform to passthrough business income taxation and what will be the impact on jurisdictions that have an unincorporated business tax (e.g., NYC, DC)? UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Combined Report Tax Base Issues
The tax base of state combined/consolidated returns can vary substantially from the Federal treatment, because many states do not adopt the Federal consolidated return regulations. A “combined report” is a method by which the income and activities of commonly owned corporations operating as a unitary business are combined into a single report for purposes of calculating income, and then apportioning that income to the various entities involved and to the jurisdictions in which the business is taxable. To determine the total group combined report business income in California, each member of a combined reporting group must first identify its total separate net income for the period beginning and ending with the accounting period of the principal member of the combined reporting group (CCR § (c)(1)). UC Davis Summer Tax Institute June 14, 2017

After adjustments for intercompany transactions within the Combined Reporting Group are made, this number is then combined with the total separate net incomes of the other group members to arrive at the total group combined report income (CCR § (c)(1)(A)). Once the total group combined report business income is determined, it is multiplied by the Taxpayer Member’s California apportionment percentage to arrive at that member’s California source combined report business income (CCR § (c)(7)). UC Davis Summer Tax Institute June 14, 2017

Elements of the California Combined Report As described in greater detail in FTB 1061, a combined report should contain the following schedules: A Combined Profit and Loss Statement showing the profit and loss of each corporation. A Schedule Converting Net Income to Unitary Business Income Subject to Apportionment. A Schedule Showing the Combined Apportionment Formula. Schedule Computing California Net Income and Tax. UC Davis Summer Tax Institute June 14, 2017

World-wide with water’s-edge election World-wide combined reporting (“WWCR”) is the default filing methodology in California. The U.S. Supreme Court in Container Corp. v. FTB, 463 U.S. 159 (1983) held that WWCR was constitutional as applied to a U.S. based multinational and that the application of the UDITPA three factor formula to Container’s worldwide income produced a fair result. In Barclays v. FTB, 10 Cal.App. 4th 1742 (1992), the Court clarified that combined reporting was a tool used to determine the amount of income earned by the domestic entities as opposed to the direct taxation of foreign entities. The Court saw WWCR as an alternative to IRC 482 arms length pricing, with neither system inherently better than the other. Although the taxpayer reported effectively under the IRC 482 arms length method in excluding its foreign affiliates, the Court upheld the state’s use of WWCR as a reasonable alternative. UC Davis Summer Tax Institute June 14, 2017

World-wide with water’s-edge election A “water’s edge” election provision was adopted by California in 1986, in response to recommendations of a U.S. Treasury Working Group and intense political pressure from taxpayers, the federal government and foreign governments. UC Davis Summer Tax Institute June 14, 2017

To What Extent are Foreign Affiliates Included In a Water’s-Edge Return? In California, CRTC provides for inclusion of foreign affiliates as follows: Full inclusion of domestic entities. Full inclusion of non banking foreign affiliates with 20% or more of their average factors in the U.S. Foreign corps to the extent of their effectively corrected income (ECI). Non-ECI also included if federal or CA income/franchise tax avoidance is principal purpose Partial inclusion of CFCs based on the ratio of their Subpart F to current year E&P By way of contrast, in Illinois, corporations, domestic or foreign, with 80% or more of their activity overseas are excluded from the combined group. See Zebra Technologies, Ill. App. 3d 474 (2003), however, where the parent’s U.S. activities were attributed to a subsidiary UC Davis Summer Tax Institute June 14, 2017

Example: Subpart F partial inclusion for California water’s-edge return: California based parent company filing on a water’s-edge basis is unitary with its CFC which has $300 of Subpart F (i.e., IRC §952) income and $1200 of current year E&P. The CFC has net income for the year of $1000, and average property, payroll and sales everywhere of $1500 each (no CA property, payroll or sales). The “inclusion ratio” is 25% (i.e., $300/$1200) The CFC income to be included in the parent’s CA return is $250 (i.e., $1000 x 25%) $375 (i.e., $1500 x 25%) is included in each denominator of the California combined reporting group’s property, payroll and sales factors. UC Davis Summer Tax Institute June 14, 2017

Tax Havens and State Issues – Potential Impact of State Legislation Several states have enacted tax haven provisions. The number of states that have recently proposed or enacted legislation specifically directed at tax havens likely indicates that tax haven issues will be of increased importance in the coming years. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Combined Report Tax Base Issues Tax Havens – Tracking State Legislation

Combined Computation, But Separate Taxpayers In a California combined return, the computation includes all unitary affiliates, even those in special industries that use special formulas. As a general exception, insurance companies that pay premium tax instead of corporate tax are not included. However, see: Appeal of EDS, SBE 8/8/2008 – Out of state corporation registered as an insurance company was includible given that it did not actually assume underlying risks and was, in substance, a plan administrator. Appeal of Argonaut, SBE 1/23/2009 – Premiums of excluded insurance company subsidiaries were included in a holding company’s special apportionment formula. UC Davis Summer Tax Institute June 14, 2017

Combined Computation, But Separate Taxpayers Each member of the group is a separate taxpayer. This has implications for apportionment, use of tax attributes, and certain procedural issues, such as accounting methods and elections Apportionment – generally, separate determination entity by entity for the applicable industry apportionment method. California has issued numerous special industry apportionment regulations covering industries ranging from motion picture production, bank and financial corporations, air transportation, railroads, trucking, print media, etc. UC Davis Summer Tax Institute June 14, 2017

Combined Computation, But Separate Taxpayers The combination of financial and non-financial corporations is quite complex in California: An assessment of each corporation’s status as either a financial or non- financial corporation taking into account both gross receipts and gross income is made: This determination affects the tax rate as well as the construction of the entity’s apportionment factors Combined groups whose predominant activity is financial measured by gross receipts use an evenly weighted three factor formula while predominantly non-financial groups use a double weighted sales factor. Note that for years beginning on/after January 1, 2013 under Prop. 39 all but certain excluded industries (such as financial institutions) must apportion income using a single sales factor. UC Davis Summer Tax Institute June 14, 2017

The combination of financial and non-financial corporations is quite complex in California: Combined groups which are predominantly financial vs. non-financial based on gross income use different apportionment regulations: e.g. Under the predominantly non-financial reg: Financial corps include only 20% of the value of includible intangible property General corps include 20% of the value of certain receivables Note that in the Appeal of Swift Transportation Co., Inc. and Swift Transportation Corporation, SBE Letter Decision No (petition for rehearing granted 12/16/2008) the SBE upheld the FTB’s application of the trucking industry special apportionment provisions to all unitary group members, not just the member that was directly engaged as a motor carrier. UC Davis Summer Tax Institute June 14, 2017

Finnigan sourcing (Repeal of Joyce and Huffy) – SBX3 15 (2009) Chronology: Joyce(1966)/Finnigan(1988)/Joyce(Huffy)(1999)/Back to Finnigan (2011) California has been the pioneer – started with Joyce, went to Finnigan. Other states adopted Joyce. In Huffy, the Court looked to Joyce states for the basis of its decision. Is California consistent with other states in adopting Finnigan? - NY, MA, WI Finnigan sourcing is effective for taxable years beginning on or after January 1, 2011. UC Davis Summer Tax Institute June 14, 2017

Joyce Sourcing Inbound sales: Sales of TPP to California by combined reporting group members are included in the California sales factor numerator only if the group member making the sale has California nexus. Group members with California nexus are not presumed to be agents for non-nexus members. See: The Reader's Digest Association, Inc. v. FTB, 94 Cal. App. 4th (2001) – nexus existed for parent company because subsidiary was, in fact, acting as its agent in soliciting sales. Compare: Airborne Navigation Corp. v. Arizona DOR, Arizona Board of Tax Appeals, No I , February 5, 1987 – nexus existed for parent solely due to in-state manufacturing activities of sub – held that unitary group is considered one “person’ for determining whether P.L protection applies (i.e., whether the “person’s activities are limited to sales solicitation). UC Davis Summer Tax Institute June 14, 2017

Joyce Sourcing Outbound sales: Sales of tangible personal property shipped from California are included in the sales factor numerator (i.e., “throwback”) unless the group member making the sale is taxable in the state of the purchaser. Joyce effectively treats the group members as “separate taxpayers.” UC Davis Summer Tax Institute June 14, 2017

Finnigan Sourcing Outbound sales (Finnigan I): Sales of tangible personal property are excluded from the sales factor numerator (i.e., no “throwback”) if any member of the combined reporting group is taxable in the state of the purchaser. Inbound sales (Finnigan II): All sales of tangible personal property by members of the combined reporting group are included in the numerator of the California sales factor, regardless of whether the member of the combined group making the sale is subject to California tax. This affects inbound sourcing of TPP sales shipped into California by “no nexus” unitary affiliates. Non-nexus sales are attributed to other members of the group. Is this indirect taxation of entities which lack nexus? Note: The Brown Group Retail case questioned whether inclusion of these receipts was a violation of PL Finnigan sourcing effectively treats the combined group as “one taxpayer”. UC Davis Summer Tax Institute June 14, 2017

Use of attributes In California, use of attributes such as tax credits and NOLs is limited to the entity generating them. General Motors Corp. v. FTB, 139 P.3d 1183 (2006) – California Supreme Court held that research credits could only be claimed by the entity that generated them. Same rule for NOLs – a California loss carryover for one combined group member cannot be used by another member – FTB Pub and Form 3805Q instructions The elimination of intercompany sales can produce severe credit utilization limitations in states such as California (under current law) which restrict credit utilization to the liability of the entity generating the credit. UC Davis Summer Tax Institute June 14, 2017

Use of attributes By way of contrast, in Illinois the group’s designated agent is to compute any credit allowed by the Illinois Income Tax Act based on the combined activities of the members of the combined group and such credit is to be applied against the combined liability of the combined group. (Ill. Adm. Code Sec (d)(1).) UC Davis Summer Tax Institute June 14, 2017

Use of attributes - Credits Example: Manufacturing/R&D Company and Sales Company Corp. A has substantial operations in California, where it is headquartered, engages in substantial R&D and manufacturing and sells its products to Corp. B, its subsidiary Corp. B is a sales subsidiary which takes title, possession and control in California of inventory purchased from Corp A. Corp B sells half of its product in California. Corp A generates a $100 R&D credit in California UC Davis Summer Tax Institute June 14, 2017

Example 5: Corp A Corp B Combined T.I. $800 $200 $1,000 Property 800 50 85 % 1,000 Payroll 85% Sales 5,000 50% 10,000 Appor % 40% 15% 55% Income 400 150 550 Tax Rate 8.84% Tax $35 $13 $48 Credits < 35 > Net 13 UC Davis Summer Tax Institute June 14, 2017

Despite generating credits in excess of its overall tax liability as a group, Corp B has a liability of $13. Note that Corp A could use the credit assignment provisions to assign excess credits on a one time basis to Corp B. Similar issues would arise in the case of NOLs, however there are no assignment provisions with respect to NOLs Query: Is this separate taxpayer calculation consistent with combined reporting theory? Would it be more reasonable not to eliminate Corp A’s sales to Corp B for purposes of a special credit utilization limitation? UC Davis Summer Tax Institute June 14, 2017

Example 6: Impact of Single Sales Factor on Combined Groups with Sales Companies Corp A Corp B Combined T.I. 800 200 1,000 Separate 100 90 % 90% 2,000 20% 10,000 Appor % 0% Income NOLs <50> Income after NOL deduction 150 Tax Rate 8.84% Tax 13 Credits < 35 > Net $0 $13 Property Payroll Sales UC Davis Summer Tax Institute June 14, 2017

Credit Assignment Credits earned in years beginning before July 1, 2008 (even if non-unitary in such years), may be shared if the assignee was unitary with the assigning corporation as of: June 30, 2008, and The last day of the year when the credits were assigned. Note: If not unitary as of the end of the year, will not qualify. Cannot share pre-July 1, 2008 credits with companies acquired and unitary on or after July 1, 2008. UC Davis Summer Tax Institute June 14, 2017

Credit Assignment Credits earned in years beginning on or after July 1, 2008, may be shared if the assignee was unitary with the assigning corporation as of: The last day of the first year in which the credit was allowed to the assigning corp., and The last day of the year when the credits were assigned. UC Davis Summer Tax Institute June 14, 2017

Accounting Methods and Elections Credit Assignment Each taxpayer in a combined group is authorized to elect its own accounting method and make its own elections, independently of other group members. Reg. § Once accounting method or other election is made for a member, that member’s net income must be consistently treated in all combined reports. The combined group members can elect to have the parent company make elections on behalf of all members. If parent does not have nexus, a nexus company can make the election on behalf of the parent for all the members. Form 100, Schedule R-7: Members elect to make the group return, and are jointly and severally liable for the tax. UC Davis Summer Tax Institute June 14, 2017

Intercompany Transactions Reg. § : California conforms to deferral method under the federal consolidated regulations as in effect March 17, 1997 for intercompany transactions (Treas. Reg. § ) Applicable to intercompany transactions on or after January 1, 2001. General rule is one of deferring gains/losses from intercompany transactions to produce the effect of transactions between divisions of the same corporation. Applies only to unitary “business income” Applies to transactions with partially included (i.e., “water’s edge) CFCs to the extent the income, gain, loss or deduction would be included in a water’s edge combined report UC Davis Summer Tax Institute June 14, 2017

Intercompany Transactions Franchise Tax Board Chief Counsel Ruling , 7/26/12 The sale of a partnership interest from a corporation to a disregarded LLC whose sole owner is a partnership does not qualify as a transaction between corporations. Accordingly, any gain resulting from the partnership interest sale would not be deferred under the intercompany transaction regulations. Rather, the sale should be currently recognized by the seller corporation. UC Davis Summer Tax Institute June 14, 2017

Deferred Intercompany Stock Accounts (DISA) IRC §301(c)(3) distributions to parent – creates income, which is deferred Deferred Intercompany Stock Account (“DISA”) – distributee corp uses this account to report and track non-dividend distributions in excess of stock basis in distributor corp with which it is unitary, until required to be recognized. The DISA account balance must be disclosed annually on the tax return. Reg. § (j)(7) provides that non-disclosure could result in recognition of part or all of the DISA balance, at the FTB’s discretion. UC Davis Summer Tax Institute June 14, 2017

Deferred Intercompany Stock Accounts (DISA) Example: Corp A owns Corp B and the two have always been unitary and file a federal consolidated return. Corp A has a $2,000 and $1,000 basis in Corp B for federal and California tax purposes, respectively. Corp B has $1,000 of E&P. Corp B borrows $5,000 and distributes such to Corp A. Federal ELA California DISA Distribution 5,000 Less E&P (1,000) Basis (2,000) Excess Loss Account 2,000 DISA 3,000 UC Davis Summer Tax Institute June 14, 2017

Date Advanced Income Tax Track Combined Report Tax Base Issues Treatment of Deferred Intercompany Stock Accounts (DISA) Amended California Code of Regulations section was approved by the Office of Administrative Law on 1/1/2014 The new provisions are applicable to transactions occurring on or after January 1, Taxpayers may elect to have the changes apply prospectively starting April 1, The changes include: Allow a DISA to be reduced by a subsequent capital contribution DISA will not be triggered upon a merger between combined reporting group members that are owned by other members of the combined reporting group Allow only 1 DISA to arise from a distribution through multiple tiers of a combined reporting group Taxpayers will be required to annual report reductions to DISAs brought about by subsequent capital contributions UC Davis Summer Tax Institute June 14, 2017

Date Advanced Income Tax Track Combined Report Tax Base Issues Treatment of Deferred Intercompany Stock Accounts (DISA) Taxpayers the previously triggered a DISA, reported it and paid tax, should consider filing a claim for refund to the extent the DISA is cured under retroactive application of the new regulations. UC Davis Summer Tax Institute June 14, 2017

Dividend Elimination Provisions Dividends from pre-unitary E&P CA Rev.& Tax Code §25106 – allows “elimination” of a dividend paid out of certain unitary income. See Willamette v. FTB, 33 Cal. App. 4th 1242 (1995) – to qualify for elimination under CA Rev.& Tax Code §25106, a dividend must be paid from “income” of a unitary business, and the income must have been determined by reference to the income and apportionment factors of both the dividend payor and the dividend recipient. UC Davis Summer Tax Institute June 14, 2017

Example: Facts: Corp A purchased Corp B and was instantly unitary. Corp A is 100% California and Corp B is 100% Oregon. The combined California apportionment is 50%. In the current year, Corp B distributed dividends to Corp A in the amount of $2,000. $1,000 of the dividends were distributed from current year unitary E&P. The remainder was distributed from accumulated E&P prior to acquisition. UC Davis Summer Tax Institute June 14, 2017

Corp A – w/limitation on pre-acq E&P Corp A – w/o limitation Corp B – E&P Taxable Inc w/o dividend 500 PreAcq E&P 1000 Dividends Rec’d 2000 CY E&P 1000 Interco Elim (1000) (2000) Total Income 1500 CY Div. paid to A (2000) Apportionment 50% CA Tax Rate 8.84% Tax Due 66 22 UC Davis Summer Tax Institute June 14, 2017

Massachusetts - Overview The Massachusetts excise is comprised of a tax on income and a tax on a non-income measure based generally on tangible personal property. Effective for tax years beginning on or after January 1, 2009, a corporation engaged in a unitary business with one or more corporations "subject to combination" must calculate its taxable net income based on its share of the apportionable income or loss of the combined group attributable to Massachusetts. The non-income measure of corporate excise continues to be calculated on a separate entity basis. UC Davis Summer Tax Institute June 14, 2017

Massachusetts - Worldwide group election The taxable members of a combined group may make a voluntary 10-year election to determine the group's taxable income on a worldwide basis. The election must be made on the principal reporting corporation's return, which must be filed by the extended due date of the corporate return. Methods of determining income of foreign entities included in the Massachusetts combined group. UC Davis Summer Tax Institute June 14, 2017

Water’s Edge Group includes: Taxable members Nontaxable members Domestic entities 80/20 Companies – any member if the average of its property, payroll and sales in the U.S. is 20% or more, Intercompany inclusion – income and factors of intercompany transactions related to services or intangibles are included if an affiliate outside the group earned more than 20% of its gross income from such transactions and members of the group can deduct the costs federally. UC Davis Summer Tax Institute June 14, 2017

Water’s edge default Recent regulatory amendments Foreign corporations include: Income that is effectively connected with the conduct of a U.S. trade or business; and U.S. source income that is not effectively connected. Treaty “Exception” Wording renders exception meaningless. U.S. source income and the effectively connected income should not be reduced on account of any U.S. bilateral income tax treaty, “except to the extent, if any, that such treaty results in the exclusion of an item from such member’s federal gross income as determined under the Code…” UC Davis Summer Tax Institute June 14, 2017

80/20 Companies Domestic or foreign entity included if 20% or more of its average property, payroll and sales are within the United States. Issues to consider: All three factors apply which could pull in affiliates not otherwise included in other 80/20 states. Applies three factor equally weighted formula, irrespective of whether the entity is subject to a different regime. Intercompany sales included in 80/20 test and then eliminated in combined group apportionment. De minimis factors disregarded. UC Davis Summer Tax Institute June 14, 2017

Intercompany inclusion Current law Includes income less expenses, but not below zero, related to the intercompany transactions Issues to consider Services - Broadly interprets “services” to include financing Intangible/interest add back – If the 20% threshold is not satisfied, the payment deducted may be subject to addback. Factor inclusion –include property and payroll factors that produced such income, but eliminate associated receipts. UC Davis Summer Tax Institute June 14, 2017

Dividends Dividends paid from post-2008 unitary earnings and profits are eliminated. In general, dividends paid from pre-2009, or non-unitary, earnings and profits are subject to a 95% dividends received deduction. UC Davis Summer Tax Institute June 14, 2017

Apportionment Massachusetts corporate taxpayers may be subject to different tax regimes, different apportionment formulas, and even different rates. The Legislation attempted to preserve these diverse rules in a combined reporting setting. Each taxable member of the Massachusetts combined group should determine its own apportionment percentage to apply against the group's combined taxable income based on the particular apportionment formula such taxpayer is required to utilize. UC Davis Summer Tax Institute June 14, 2017

“Common Denominator” Approach The legislation adopts “common denominator” approach. Each member determines its denominator(s) based upon its applicable apportionment provisions, and Denominators of all members are aggregated. Property and payroll factor denominators include the property and payroll of all members, including those members subject to a single sales factor formula. UC Davis Summer Tax Institute June 14, 2017

Apportionment Numerator Each “taxable member” computes the numerator of its apportionment factors pursuant to the rules that apply to such member. Finnigan rule adopted—a taxpayer is considered taxable in any state in which any member of its combined group is subject to tax. Receipts of non-taxable members are allocated to taxable members based on their relative Massachusetts sales. UC Davis Summer Tax Institute June 14, 2017

Net operating losses Generated in Tax Years Beginning on or after Jan. 1, 2009 Shift to Post-Apportionment Carryforwards Sharing of NOLs Carryforwards With Other Group Members Shifts in Combined Group Potential Issues in Sales Company Structures Generated in Tax Years Beginning Prior to Effective Date of Legislation Determining Amount to be Carried Forward Income Limitation Ability to Share with Other Group Members UC Davis Summer Tax Institute June 14, 2017

Credits Generated in Tax Years Beginning on or after Jan. 1, 2009 Sharing of Credit Carryforwards Shifts in Combined Group Recapture Issues Generated in Tax Years Beginning Prior to Effective Date of Legislation Ability to Share with Other Group Members UC Davis Summer Tax Institute June 14, 2017

Who is in the Group? Illinois: Corporate taxpayers that are members of the same unitary business group are treated as one taxpayer and required to file a combined return. (See IITA Sec. 502(e).). UC Davis Summer Tax Institute June 14, 2017

Is the Group Treated as One Taxpayer? Illinois: Corporations (other than Subchapter S corporations) that are members of the same unitary business group are treated as one taxpayer for purposes of any original return, amended return that includes the same taxpayers of the unitary group which joined in filing the original return, extension, claim for refund, assessment, collection and payment and determination of the group’s tax liability under the Act. (IITA Sec. 502(e); Ill. Adm. Code Sec ) UC Davis Summer Tax Institute June 14, 2017

Combined Reporting Issues - Net Operating Losses: New York: Generally, NOLs may be used to offset the income of other companies in the combined group. Under the new rules effective for tax years beginning on or after January 1, 2015, New York generally treats the combined group as if it were a single entity and PNOL, NOLs and capital losses can be used by the group, not just the entity that generated them. UC Davis Summer Tax Institute June 14, 2017

Corporations Operating Wholly Within California: At one time, a unitary business operating wholly within California was not permitted to use the combined report method. (See, e.g., Appeals of O.S.C. Corporation, et al., Cal. St. Bd. of Equal., Dec. 3, 1985.) However, for income years beginning on or after January 1, 1980, Section allows two or more corporations that are engaged in a unitary business solely within California to elect to file a combined report. In Harley-Davidson Inc. v. Franchise Tax Board, the California Court of Appeals on May 28, 2015 upheld the San Diego Superior Court’s earlier decision on May 1, 2013, that certain special purpose entities (SPEs) had nexus in California. The Court, however, reversed the trial court in agreeing that the above elective combination provisions discriminated against interstate commerce and remanded the case for determination as to whether such discrimination served a ‘legitimate’ reason that could not be addressed with ‘reasonable, non-discriminatory alternatives.’ UC Davis Summer Tax Institute June 14, 2017

Harley-Davidson, Inc. v. Franchise Tax Board, California Supreme Court, No. S227652, petition for review denied, September 16, 2015 The California Supreme Court denied the taxpayer’s petition for review of a court of appeal decision that concluded California’s tax scheme allowing only intrastate unitary taxpayers the discretion to file on a separate or combined basis while mandating unitary combined reporting for interstate taxpayers was facially discriminatory. The combined return issue has been remanded to the lower court. Harley-Davidson, Inc. v. Franchise Tax Board, San Diego Superior Court, No CU-MC-CTL, October 31, 2016 On remand, the San Diego Superior Court denied the taxpayer’s motion for summary judgment and granted the FTB ‘s motion for summary judgment. The court determined that although the statute may be discriminatory, the state nevertheless has a legitimate interest in “ensur[ing] that all business income from interstate business is accurately accounted for.” **Harley-Davidson filed a Notice of Appeal on December 27, 2016 UC Davis Summer Tax Institute June 14, 2017

Corporations Operating Wholly Within California: In Abercrombie & Fitch v. Franchise Tax Board, Fresno Superior Court Case No. 12CEGC03408, the taxpayer has alleged that the FTB improperly discriminates against multistate unity corporate taxpayers by requiring them to compute their California taxable income by using the combined reporting method as opposed to letting them choose between the combined reporting method or the separate reporting method. On January 21, 2015, the Court issued a Tentative Ruling staying proceedings pending the Court of Appeal decision in Harley Davidson v. Franchise Tax Board. On January 22, 2015, Counsel for Plaintiff requested the case remain active. After taking the matter under submission, the Superior Court affirmed its Tentative Ruling and has stayed proceeding pending the Court of Appeal decision in Harley Davidson v. Franchise Tax Board. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Alternative Bases
Alternative Bases – Gross Receipts Tax The state corporate income tax base generally starts on line 28 or 30 of a taxpayer's federal return. However, gross receipts taxes are different. The measure of the Texas tax on gross receipts, called the Margin Tax, starts with line 1c. Michigan* and Ohio specifically define what is included in gross receipts. * The Michigan Business tax is repealed and replaced with a tax based on income, effective for taxable years beginning on or after January 1, 2012. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Alternative Bases
What is a Gross Receipts Tax? Texas Margin Tax (“TMT”): TMT base is equal to total revenue less the greater of Cost of Goods Sold or Compensation Deduction. Tax base capped at 70% of total revenue or total revenue less $1 million. Ohio Commercial Activity Tax (CAT): Tax base includes Ohio sourced gross receipts from trade or business with very limited exceptions. Gross receipts are broadly defined as the total amount realized by a person, without deduction for the cost of goods sold or most other expenses incurred. UC Davis Summer Tax Institute June 14, 2017

Section 2 Apportionment Factors – Property & Payroll

Table of Contents Apportionment Factors – Property & Payroll
Section Overview Apportionment Factors – Property & Payroll Apportionment Principles Right to Apportion Apportionment Formula Examples of State Apportionment MTC Fair Apportionment Division of Tax Base The Property Factor The Payroll Factor UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles
UDIPTA written in a simpler world (e.g., mining, manufacturing, and mercantile). Reflects full accountability. Must give rise to business income. Not necessary for a factor to include everything (e.g., property factor where intangibles are excluded). UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles – Right to Apportion
“Taxable” in Another State: In most states, a taxpayer must be “taxable in another state” before it may apportion its income. A business is considered taxable in another jurisdiction if: It is subject to net income tax, franchise tax measured by net income, franchise tax for the privilege of doing business, or corporate stock tax in another state, or The other state has jurisdiction to subject the taxpayer to net income taxes regardless of whether the state chooses to impose a tax. See Uniform Division of Income for Tax Purposes Act (UDITPA) § 3. See also Appeal of Craiglist, Inc., Cal. St. Bd. of Equal., Jan. 15, 2016. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles – Right to Apportion
California has adopted UDITPA § 3. California has adopted a factor presence nexus standard in 2011. Query: Is this the standard for right to apportion and apportionment in general? If so, what is the effective date? Is actually filing returns in other states required? Amray, Inc. v. Commissioner of Revenue, No (Mass. App. Tax Bd. April 17, 1986): the Massachusetts Appellate Tax Board held that the company was “subject to tax” in other jurisdictions due to activities of its service personnel despite its failure to file returns in the other states. Technical Assistance Advisement 95(C)1-008, Fla. Dept. of Rev., August 30, 1995: A Florida corporation licensing a patent outside the State was not entitled to apportion its income within and without the State. Alternative apportionment methods that deviate from the standard UDITPA method will be discussed on Day Four. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles – Apportionment Formula
The traditional formula that had been used by most states for the apportionment of multistate business income is an average of three factors - property, payroll and sales. That formula is termed the “Massachusetts formula” in recognition of the fact that Massachusetts was the first state to employ the formula. However, few states today use an equally-weighted three factor formula. General Formula: Property w/i state Payroll w/i state Receipts w/i state ______________ ____________ + ______________ ÷ 3 Property Payroll Receipts everywhere everywhere everywhere UC Davis Summer Tax Institute June 14, 2017

Trend Toward Heavier Weighting of the Sales Factor In order to create incentives for businesses to locate within a particular state, and perhaps in recognition of the importance of the market state in the production of income, many states have increased the weight of the sales factor, and some have shifted to a single sales factor formula. Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978), the Supreme Court upheld Iowa's use of a single factor receipts-based formula. Effective for taxable years beginning on or after January 1, 2011, California provides that any apportioning trade or business, other than an apportioning trade or business described in Cal. Rev. & Tax. Code Sec (b), may make an annual irrevocable election on an original timely filed return to use a single sales factor for apportionment. (Cal. Rev. & Tax. Code § ). UC Davis Summer Tax Institute June 14, 2017

Trend Toward Heavier Weighting of the Sales Factor In order to create incentives for businesses to locate within a particular state, and perhaps in recognition of the importance of the market state in the production of income, many states have increased the weight of the sales factor, and some have shifted to a single sales factor formula. The FTB has provided additional guidance regarding the mechanics of the election in Cal. Code Regs., tit. 18, §§ and Under Proposition 39, Single Sales Factor is mandatory, except for excluded industries (e.g. banks and financials), for 2013 and beyond UC Davis Summer Tax Institute June 14, 2017

*Does not address industry-specific or optional formulas
Advanced Income Tax Track Apportionment Principles – Apportionment Formulas* – 1998 AK HI ME VT NH MA NY CT PA MD DE VA WV NC SC GA FL IL OH IN MI WI KY TN AL MS AR LA TX OK MO KS IA MN ND SD NE NM AZ CO UT WY MT WA OR ID NV CA DC NJ RI Equally weighted three factor formula Double weighted sales factor Triple or greater weighted or single sales factor *Does not address industry-specific or optional formulas UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles – Apportionment Formulas* – 2003 AK HI ME VT NH MA NY CT PA MD DE VA WV NC SC GA FL IL OH IN MI WI KY TN AL MS AR LA TX OK MO KS IA MN ND SD NE NM AZ CO UT WY MT WA OR ID NV CA DC NJ RI Equally weighted three factor formula Double weighted sales factor Triple or greater weighted or single sales factor *Does not address industry-specific or optional formulas UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles – Apportionment Formulas*– 2017 AK HI ME VT NH MA NY CT PA MD DE* VA WV NC SC GA FL IL OH IN MI WI KY TN AL MS AR LA TX OK MO KS IA MN ND SD NE NM AZ CO UT WY MT WA OR ID NV CA DC NJ RI **Delaware: single sales factor will be phased in (60% for 2018; 75% for 2019; 100% for after 2019) Equally weighted three factor formula Double weighted sales factor Triple or greater weighted or single sales factor *Does not address industry-specific or optional formulas *Reflects changes enacted in 2015 that might take effect later UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles – Examples of State Apportionment
Examples of States Using Single Sales Factor Today CA CO DE (Phased in by 2020) GA IA IL IN ME MN (Phased in by 2014) NC (Effective in 2018) NE NJ (Phased in by 2014) UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Examples of State Apportionment -- Missouri Apportionment Options
Three general apportionment methods in Missouri (excluding industry specific and alternative apportionment methods) Multistate Allocation and Three Factor Apportionment – Multistate Tax Compact – RSMo Section Business Transaction Single Factor Apportionment – RSMo Section (2) Optional Single Sales Factor Apportionment – RSMo Section (3) UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Examples of State Apportionment – Missouri Enactment
House Bill (“H.B”) 128, enacted, 7/12/13 Provides alternative single sales factor income tax apportionment formula, which provides that: sales of tangible personal property are included in the numerator if the purchaser’s destination point is in Missouri (without regard to the FOB point or other condition of the sale) sales of tangible personal property are not included in the numerator if the destination point is outside Missouri, regardless of the shipping point location investment or reinvestment of taxpayer’s own funds, or the sale of any such investment or reinvestment, is excluded from the sales numerator or denominator. The Missouri Department of Revenue adopted a new regulation addressing the new apportionment election provided under H.B. 128 providing that the new single sales factor may be elected on an original income tax return filed on or after August 28, 2013, regardless of the taxable year for which the original income tax return is being filed. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Examples of State Apportionment – Missouri Enactment
Senate Bill (“S.B.”) 19, enacted, 5/6/15 Provides that receipts from sales of services and intangibles are subject to market-based sourcing under the new single sales factor apportionment. Prior to S.B. 19, the Department had interpreted the new election to apply only to sellers of tangible personal property. S.B. 19 provides that all taxpayers are eligible for the new single sales factor election. Because market based sourcing is applicable only within the new single sales factor election, sellers of services and intangibles should engage in a determination of the most beneficial apportionment method annually, comparing: (1) the standard 3 factor method under § (a cost of performance approach), (2) the old single factor sales method under § (2) (a partially within or wholly within/without approach), or (3) the new single factor method under (3) (a market based sourcing approach). UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles – MTC
MTC Election to Use Evenly Weighted Three Factors In certain states that are full members of the Multistate Tax Compact (‘the Compact’), a taxpayer may be able to elect to use the equally weighted apportionment formula, as well as other provisions of the Compact, in lieu of the state's specific apportionment methods set forth in the state's statute. At its July 30, 2014 annual meeting, the MTC adopted amendments to Art. IV.9 to remove the three-factor apportionment formula requirement and instead provide a suggestion (but not a requirement) that the state use a double-weighted sales factor formula. The provision now reads: “All business income shall be apportioned to this State by multiplying the income by a fraction, [State should define its factor weighting fraction here. Recommended definition: “the numerator of which is the property factor plus the payroll factor plus two times the sales factor, and the denominator of which is four.”] UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles – MTC
Possible election in California to use three factor apportionment formula under the MTC provisions Single weighted sales §38001 adopts the Multistate Tax Compact into law §38006 allows the taxpayer to elect MTC apportionment There is nothing in California law that explicitly “decouples” from the MTC apportionment provisions overall, although as will be discussed on Day 4 the State is arguing that the term “notwithstanding” contained in CRTC effectively does so with respect to the weighting of the sales factor. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Multistate Tax Compact Issues
Refund Litigation over Article III/IV Elections California - Gillette Co. v. Franchise Tax Bd., 62 Cal. 4th 468 (2015) (holding CA legislature not bound by compact’s election provision). Michigan – ** All MTC cases denied certiorari by USSC on May 22, 2017 IBM v. Department of Treasury Gillette Commercial Operations N.A. & Subsidiaries v. Dep’t of Treasury AK Steel Holding Corporation v. Dep’t of Treasury Oregon - Health Net v. Oregon – Oral arguments heard in Oregon Supreme Court in Sept. 2016 Texas - Graphic Packaging v. Combs – Texas Supreme Court undecided on review of case as of May 26, 2017 Minnesota – Kimberly Clark v. Commissioner of Revenue – Denied cert by USSC on Dec. 12, 2016 Audit Challenges Non-party states Party states sharing taxpayer confidential information Inefficiency of audits when uniformity is severely lacking *The MTC election and issues will be covered in greater depth on Day 4. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles – Fair Apportionment
Internal and External Consistency Tests A tax must be fairly apportioned in order to avoid offending the Commerce Clause of the United States Constitution. See Container Corp. of America v. Franchise Tax Board, 463 U.S. 159, 103 S. Ct (1983). That means the tax must be both internally and externally consistent. Internal Consistency: To be internally consistent, the tax must be structured so that if, hypothetically, each state imposed an identical tax, no multiple taxation would result. External Consistency: The external consistency test requires that the state’s apportionment formula reasonably reflects the activities of the taxpayer that produces income. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Apportionment Principles – Division of the Tax Base
Methods of Dividing the Tax Base State taxation of multistate corporations is restricted by the Commerce and Due Process Clauses of the United States Constitution. In that context, the income tax base subject to tax by the state is limited to the portion of the income attributable to the taxing state. Methods employed by the states for determining that portion of the tax base attributable to the state are separate accounting, allocation, and formulary apportionment. See business/non-business section. See constitutional limitations section. UC Davis Summer Tax Institute June 14, 2017

Table of Contents The Property Factor General Rules Special Issues
Section Overview The Property Factor General Rules Special Issues UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Property Factor – General Rules
Property is included in the property factor when it is used or capable of being used in the taxpayer's trade or business. See MTC Reg. Sec. IV.10.(b). That essentially means only property which produces apportionable business income is includible in the property factor. Property is removed from the property factor when “its permanent withdrawal is established by an identifiable event such as its conversion to the production of non-business income, its sale, or the lapse of an extended period of time (normally five years) during which the property is no longer held for use in the trade or business.” MTC Reg. Sec. IV. 10.(b). In order to avoid distortion, many states exclude allocable, nonbusiness income producing property from the property factor. UC Davis Summer Tax Institute June 14, 2017

Denominator The denominator includes the average value of all real and tangible personal property owned or rented and used during the tax period in the regular course of the trade or business. Inclusions in Property Factor: Land Buildings Leasehold improvements Machinery Inventory Equipment Exclusions from Property Factor: Cash Property or equipment under construction during the tax period Property used in connection with the production of nonbusiness income UC Davis Summer Tax Institute June 14, 2017

Numerator: The numerator includes the average value of the real and tangible personal property owned or rented by the taxpayer that is used in this state during the tax period. Property in transit between locations of the taxpayer to which it belongs shall be considered to be at the destination for purposes of the property factor. Property in transit between a buyer and seller that is included by a taxpayer in its property factor denominator (in accordance with its regular accounting practices) must be included in the numerator according to the state of destination. UC Davis Summer Tax Institute June 14, 2017

Valuation of Owned Property Property owned by the taxpayer shall be valued at its original cost--that is cost before any allowance for depreciation. If the original cost of property is unascertainable, it is included in the factor at its fair market value as of the date of acquisition by the taxpayer. May need to average on monthly basis (e.g., acquisition/disposition) UC Davis Summer Tax Institute June 14, 2017

Valuation of Rented Property Rental property is valued at eight times its net annual rental rate. The net annual rental rate is the annual rental paid less the aggregate annual subrentals paid by subtenants of the taxpayer. Subrents are not deducted when they constitute business income because the property that produces the subrents is used in the taxpayer’s regular course of a trade or business. UC Davis Summer Tax Institute June 14, 2017

Averaging Property Values As a general rule, the average value of property owned by the taxpayer shall be determined by averaging the values at the beginning and end of the tax period. However, the tax administrator may require or allow averaging by monthly values if such method of averaging is required to properly reflect the average value of the taxpayer’s property for the tax period. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Property Factor – Special Issues
Intangible Property Property Under Construction Property Used But Not Owned or Rented by Taxpayer Property in Transit Outer Jurisdictional Property UC Davis Summer Tax Institute June 14, 2017

Intangible Property Banks & Financial Corporations: Cal. Civ. Reg. § (d)(1): “[The property factor] shall include the average value of the taxpayer's loans and credit card receivables located or used within and without this state during the income year.” See also Crocker Equipment Leasing, Oregon Supreme Court 1992 Software Companies: Microsoft Corporation v. Franchise Tax Board, Court of Appeal, First Appellate District, No. A131964, 12/18/12 While the primary issue before the appellate court was the proper sourcing of royalties from licensing software to original equipment manufacturers (“OEMs”), Microsoft had unsuccessfully argued at trial that the value of its intangibles, including its software should be included in the property factor. This argument was later dropped and was not before the appellate court. UC Davis Summer Tax Institute June 14, 2017

Property Under Construction Commissioner of Revenue v. New England Power Co., 411 Mass. 418, 582 N.E.2d 543 (1991): The Massachusetts Supreme Court held that, in contrast to the general rule, property under construction is includible in the property factor. The taxpayer, an electric power company, was regularly constructing large amounts of new property. Although the property under construction did not directly generate income during the taxable year, the Court found that it nevertheless contributed to the taxpayer’s overall revenue production, especially in light of the fact that the costs of the property under construction were factors in setting the power company's rate base. Thus, the Court found that the property was “used” by the taxpayer within the meaning of the statute, and thus includible in the property factor. UC Davis Summer Tax Institute June 14, 2017

FTB TAM : A homebuilder/developer’s real property classified as Construction in Progress (CIP) must be excluded from the property factor because it is not regarded as property owned or rented and used in California. Specified items that have not yet become CIP or may be treated as CIP in the future, or that have been completed and are held for sale or other disposition, should be treated as property that is available to be used in the taxpayer's regular trade or business and not as CIP, and should be included in the property factor. UC Davis Summer Tax Institute June 14, 2017

Property Used At Below Market or Zero Rental Rates If property is rented for a nominal charge or without charge, following the usual rules for valuation of rented property may result in property factor distortion since it will potentially understate the true extent of the taxpayer's business activities within a state. McDonnell Douglas v. Franchise Tax Board, 446 P.2d 313 (Cal. 1968): The California Supreme Court held that the FTB’s exclusion of government owned property produced an unreasonable result and remanded the case in order to determine a proper remedy. UC Davis Summer Tax Institute June 14, 2017

Cal. Reg (b)(1)(B): “If property owned by others is used by the taxpayer at no charge or rented by the taxpayer for a nominal rate, the net annual rental rate for such property shall be determined on the basis of a reasonable market rental rate for such property.” UC Davis Summer Tax Institute June 14, 2017

Government Owned Property Used by Taxpayer: Appeal of The Proctor & Gamble Manufacturing Company, et al., 89- SBE-028 (Cal. St. Bd. of Equal. Sept. 26, 1989): The issue was whether the taxpayer properly included in the property factor government-owned property that was used by the taxpayer in its unitary business and, if so, the amount to be included. The taxpayer in its combined report included $399 million in the denominator of the property factor, which purportedly represented the fair market value of the entire timberland in 1974, the year that the taxpayer stated the land was placed in productive use. The FTB disallowed that inclusion. The SBE concluded that the taxpayer must use the reasonable market rental value of the property rather than its fair market value. UC Davis Summer Tax Institute June 14, 2017

Matter of Weyerhaeuser Co. and Subsidiaries, No (Cal. St. Bd. of Equal. Jan. 26, 2005): The SBE concluded that the taxpayer failed to attribute a reasonable value to land leased from Canadian provincial governments for purposes of including such land in its property factor denominator. For property factor purposes, property rented by the taxpayer is valued at eight times the net annual rental rate, and annual rent includes consideration paid for the use of the property whether it is a fixed sum or a percentage of sales or profits. However, annual rent does not include "royalties based on extraction of natural resources." Under regulation 25137,"[i]f property owned by others is used by the taxpayer at no charge or rented by the taxpayer for a nominal rate, the net annual rental rate for such property shall be determined on the basis of a reasonable market rental rate for such property." UC Davis Summer Tax Institute June 14, 2017

Property in Transit Mercedes Benz of North America Inc. v. Comptroller of Treasury, (Md. Tax Ct. Oct. 7, 1988): The taxpayer had inventory in transit at the time it calculated its property factor. The taxpayer included the inventory destined for Maryland from Germany in its Maryland property factor denominator, but excluded it from the Maryland numerator. In rejecting this treatment, the Court stated “[i]f Petitioner wishes to include in-transit property in the denominator, in order to avoid a skewing of the factor in favor of tax avoidance, it must likewise include Maryland property in the numerator. If, as Petitioner suggests, in-transit inventory has no situs in Maryland and therefore should not be included in the numerator, then we believe that it has no situs anywhere and should not be included in the denominator.” UC Davis Summer Tax Institute June 14, 2017

Property in Transit Mercedes Benz of North America Inc. v. Comptroller of Treasury, (Md. Tax Ct. Oct. 7, 1988): Maryland has since adopted MD Reg , which provides that property in transit shall be sourced to the destination state for purposes of calculating the property factor. UC Davis Summer Tax Institute June 14, 2017

Loan Inclusion and Sourcing for Financial Instituti0ons Some states, e.g. CA and Mass., continue to use a property factor for financial institutions for which loans are included. The proper sourcing for loans can be unclear. California – Cal. Reg provides for sourcing of loans based on solicitation, investigation, negotiation, approval, and administration (SINAA) How are loans sourced which are acquired from third parties? Massachusetts –First Marblehead Mass. Supreme Court did not attribute third party activity (such as servicing) to the third party resulting in 100% sourcing of the loan to First Marblehead in Mass., the state of its commercial domicile. UC Davis Summer Tax Institute June 14, 2017

Extraterritorial Property Communications Satellite Corporation v. Franchise Tax Board, 156 Cal.App.3d 726 (1984): The Court held that a satellite and a ground station function only when used together, and because the ground station is located in California, the satellite is also “used” in California. Therefore, both the ground station and the satellite must be placed in the property factor numerator. In contrast, the MTC regulations recommend throwout of extraterritorial/nowhere property. See also Twentieth Century Fox Films, Oregon Supreme Court (1985) wherein the court held that the value of films attributed to Oregon should include the total value of the films, including the value of film negatives located in California, and not merely the much lower value of film positives actually located in Oregon. California’s Motion Picture etc Producer special apportionment regulation essentially takes the same approach. UC Davis Summer Tax Institute June 14, 2017

Table of Contents The Payroll Factor Overview Variations
Section Overview The Payroll Factor Overview Variations Special Issues UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Payroll Factor – Overview
What is Payroll General Rules Under UDITPA and the Multistate Tax Commission (MTC) Regulations, the payroll factor includes amounts paid for compensation by the taxpayer in the regular course of its trade or business. Compensation Compensation is defined as “wages, salaries, commissions and any other form of remuneration paid to employees for personal services.” UDITPA § 1(c). The states generally interpret compensation as encompassing any item, whether paid in cash or in kind, that constitutes gross income under the Internal Revenue Code. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Payroll Factor – Overview
Compensation does not include any amounts paid to independent contractors or any other person not properly classified as an employee. UDITPA does not define the term “employee,” but it is interpreted using the common law rules governing the Federal Insurance Contributions Act (FICA). Some states exclude executive compensation from the payroll factor on the theory that it tends to distort the factor. Other Rules for Inclusion and Exclusion Payroll that is capitalized in the basis of a self-constructed asset is also included in the payroll factor. See MTC Reg. Sec. IV.13.(a)(2). Payroll related to activities generating non-business income should be excluded from the payroll factor. See MTC Reg. Sec. IV.13.(a)(2). UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Payroll Factor – Variations
Where is the Source The numerator of the payroll factor includes compensation paid to employees for services rendered within the state. See UDITPA Sec. 13. If an employee works both within and without the state, then the wages are sourced in accordance with the rules set forth in the Model Unemployment Compensation Act, which require application of four successive tests (see below) for sourcing the wages. This is an “all or nothing” sourcing rule -- the compensation paid to employees working in multiple states is not divided among the various states' numerators. UC Davis Summer Tax Institute June 14, 2017

4 Tests (applied successively) Source to state where majority of services are performed, if only incidental services are performed outside the state. If employee’s services outside the state are more than incidental, source wages to the state that is the base of operations for the employee, as long as some services are performed in that state. “Base of Operations”: Place of more or less permanent nature from which the employee starts work and to which he/she ordinarily returns to complete work. If second test does not apply, source wages to the state from which the employer exercises direction and control, only as long as some services are performed in that state. If the employee’s wages cannot be sourced under the three preceding tests, use his/her state of residence. UC Davis Summer Tax Institute June 14, 2017

Creation of “Nowhere” Income To the extent that payroll is assignable to a state where the taxpayer lacks nexus, the payroll escapes inclusion in any state's numerator, thereby generating “nowhere” income. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Payroll Factor – Special Issues
All or Nothing Sourcing Cooper Tire & Rubber Co. v. Tax Commissioner, 639 N.E.2d 27 (1994): The Supreme Court of Ohio rejected an Ohio-based manufacturer's argument that compensation paid to its employee operators of mobile property used inside and outside the state should be sourced to Ohio's payroll factor in accordance with percentage of use methods. Appeal of New York Football Giants, Inc., Cal. St. Bd. of Equal. (Feb. 3, 1977) The Board of Equalization held that compensation should be sourced to California’s payroll factor on a pro rata basis. Section , Motion Picture and Television Film Producers, Distributors, and Television Networks “Compensation of employees in the production of a film on location shall be attributed to the state where the services are or were performed.” UC Davis Summer Tax Institute June 14, 2017

Base of Operations In re Appeal of Photo-Marker Corporation of California, Cal. St. Bd. of Equal., Nov. 19, 1986: The taxpayer argued that the employees’ executive duties in New York were more important and permanent than their jobs in California, and that the base of operations for the employees was New York at the parent’s corporate headquarters. The California State Board of Equalization disagreed, and cited Regulation which provides that if the employee’s services are performed both within and without California, the compensation will be attributed to California if the employee’s “base of operations” is in California. The Board found the evidence demonstrated the base of operations was in California, based upon the long-term presence of the individuals in California and their business-related duties in California. UC Davis Summer Tax Institute June 14, 2017

A.W. Chesterton v. Commissioner of Revenue, 37 Mass. App. Ct. 936, 641 N.E.2d 1353 (1994): The Appeals Court of Massachusetts upheld the Appellate Tax Board's ruling that wages were properly sourced to the numerator of the Massachusetts payroll factor where the corporation had employees working out of their homes outside of the state, but spending some time in the state. The corporation failed to meet its burden of proving that its employees had a base of operations outside of the state, or alternatively, that its employees were directed and controlled from outside of the state. UC Davis Summer Tax Institute June 14, 2017

Fully Reimbursed In the matter of Appeal of Hercules, Inc., Kansas Board of Tax Appeals, Docket No DT, 03/15/2000 The Taxpayer was required to include payroll for munitions factory employees in the payroll factor, even though the U.S. government reimbursed the taxpayer for operating the property and payroll expenses. UC Davis Summer Tax Institute June 14, 2017

Loaned Employees Intercompany Use of Employees It is not unusual for affiliated companies to loan employees to one another under cost reimbursement arrangements, whereby the company compensating the employee is reimbursed by the company for which the employee performed the services. In this context, the question arises which company's payroll factor should include the employee compensation. UC Davis Summer Tax Institute June 14, 2017

C&D Chemical Products Inc. v. State of Alabama Department of Revenue, No. CORP (Feb. 9, 2001): The Alabama Department of Revenue, Administrative Law Division, ruled that in computing the payroll factor, compensation includes amounts paid to another as reimbursement for services provided by shared employees. In finding that the taxpayer properly included its distributive share of the partnership's payroll in its payroll factor, which included the administrative fee that related to reimbursement for shared employee services, the ALJ noted that “compensation” includes amounts paid in reparation for services. There was nothing in the statute which excluded from the payroll factor amounts paid for services provided by indirect employees. The shared employees contributed to the production of the partnership's income, and thus the compensation paid was properly included in the apportionment formula. UC Davis Summer Tax Institute June 14, 2017

Leased Employees Which company should include the compensation of the leased employee in its payroll factor - the lessor or the lessee (or both). Most of the states addressing this issue seem to be moving toward inclusion in the lessee's payroll factor. Massachusetts Regulations provide that “[c]ompensation paid for personal services rendered by leased employees is includible in the payroll factor of the taxpayer if the taxpayer is the recipient of the services of the leased employee. Compensation for personal services rendered by leased employees to client companies is excluded from the payroll factor of employee leasing companies.” 830 C.M.R (8)(e)(1). Query: If leased property is included in both the lessor and lessee’s property factor, should leased employees be included in both party’s payroll factor? UC Davis Summer Tax Institute June 14, 2017

Contractors Appeal of Lipps, Inc. (87-SBE-017): Only amounts paid directly to "employees" are included in the payroll factor. Citing Ca. Admin. Code § (a)(3), “Payments made to an independent contractor or-any other person not properly classifiable as an employee are excluded.” Lancaster Colony Corp. et al. v. Limbach, 524 NE2d 1389: The Supreme Court of Ohio agreed with the Commissioner that contractors are not employees and may not be used in the calculation of the payroll factor. However, the court went on to say that the Commissioner may approve an alternative method of apportionemnt, including one that modifies the payroll factor to include independent contractors if it more fairly reflects the taxpayer’s business activity in Ohio. UC Davis Summer Tax Institute June 14, 2017

Section 3 The Sales Factor

Table of Contents The Sales Factor
Section Overview The Sales Factor Sourcing Sales of Tangible Personal Property Throwback and Throwout Variations on Throwback and Throwout Sourcing Receipts from Services and Intangibles Gross Receipts UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Sourcing Sales of Tangible Personal Property
UDITPA Definition Under UDITPA § 16, sales of tangible personal property are sourced to the state if: 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; or the property is shipped from an office, store, warehouse, factory, or other place of storage in this state and (1) the purchaser is the United States government or (2) the taxpayer is not taxable in the state of the purchaser. UC Davis Summer Tax Institute June 14, 2017

MTC Regulations MTC Reg.IV.16.(a): Gross receipts from sales of tangible personal property are in this state: if the property is delivered or shipped to a purchaser within this state regardless of the f.o.b. point or other conditions of sale; or if 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. Property shall be deemed to be delivered or shipped to a purchaser within this state if the recipient is located in this state, even though the property is ordered from outside this state. Property is delivered or shipped to a purchaser within this state if the shipment terminates in this state, even though the property is subsequently transferred by the purchaser to another state. UC Davis Summer Tax Institute June 14, 2017

The term "purchaser within this state" shall include the ultimate recipient of the property if the taxpayer in this state, at the designation of the purchaser, delivers to or has the property shipped to the ultimate recipient within this state. When property being shipped by a seller from the state of origin to a consignee in another state is diverted while en route to a purchaser in this state, the sales are in this state. If the taxpayer is not taxable in the state of the purchaser, the sale is attributed to this state if the property is shipped from an office, store, warehouse, factory, or other place of storage in this state. UC Davis Summer Tax Institute June 14, 2017

If a taxpayer whose salesman operates from an office located in this state makes a sale to a purchaser in another state in which the taxpayer is not taxable and the property is shipped directly by a third party to the purchaser, the following rules apply: If the taxpayer is taxable in the state from which the third party ships the property, then the sale is in that state. If the taxpayer is not taxable in the state from which the property is shipped, then the sale is in this state. UC Davis Summer Tax Institute June 14, 2017

Sales of Tangible Personal Property to U.S. Government Gross receipts from sales of tangible personal property to the United States Government are in this state if the property is shipped from an office, store, warehouse, factory, or other place of storage in this state. For the purposes of this regulation, only sales for which the United States Government makes direct payment to the seller pursuant to the terms of a contract constitute sales to the United States Government. MTC Reg.IV.16.(b). Thus, as a general rule, sales by a subcontractor to the prime contractor, the party to the contract with the United States Government, do not constitute sales to the United States Government. UC Davis Summer Tax Institute June 14, 2017

Issue of Dock Sales Department of Revenue v. Parker-Banana Co., 391 So.2d 762 (Fla. Dist. Ct. App. 1980): Parker Banana imports bananas and all of Parker’s purchasers arrange their own pickup and transportation. Parker treated all sales to purchasers from outside Florida as sales not in this state. Department contends that those out-of-state purchasers who pick up their bananas other than by common carrier take delivery as a matter of law at dockside. Therefore, the Department argues that each such case is a delivery and sale within this state. The Court disagreed and held that a purchaser from outside this state does not become a “purchaser within this state” merely by sending a representative to pick up the goods in Florida; if, however, the destination of the goods is a point within Florida, then the purchaser is within this state. UC Davis Summer Tax Institute June 14, 2017

Issue of Dock Sales Pennsylvania v. Gilmour Manufacturing Company, No. 66 MAP 2000, 4/28/03: the Pennsylvania Supreme Court ruled that receipts from the sale of tangible personal property picked up by an out-of-state purchaser at a seller's place of business in Pennsylvania and ultimately removed from the state are excluded from the numerator of the sales factor. Rival Co. v. Director of Rev., No RI, (Mo. Adm. Hrg. Comn., 9/16/95): The Missouri Administrative Hearing Commission ruled that Missouri dock sales to out-of-state customers should be treated as out-of- state destination sales for purposes of the Missouri single sales factor. The commission found that the term “destination” means a “place which is set for the end of a journey or to which something is sent.” Because the taxpayer placed all the goods at issue on a shipping dock to be picked up for delivery to points outside Missouri, the commission found the destination point was outside the state and therefore the sales should be treated as partially within and partially without Missouri. UC Davis Summer Tax Institute June 14, 2017

Issue of Dock Sales Strickland v. Patcraft Mills, Inc., 302 SE2d 544 (Ga. 1983): The Georgia Supreme Court held that receipts from carpet sales by a Georgia manufacturer to out-of-state customers, who took possession at the manufacturer's place of business in Georgia for resale out of state, were not taxable gross receipts for Georgia purposes. The destination of goods test, as opposed to the “transfer of physical possession” theory advanced by the Commissioner of Revenue, was easy to apply and not subject to manipulation by taxpayers. UC Davis Summer Tax Institute June 14, 2017

Issue of Dock Sales McDonnell Douglas v. Franchise Tax Board, 26 Cal.App.4th 1789 (1994): The seller manufactured aircraft in California and transferred physical possession of the aircraft to its customer's employees in this state. The customer's employees then flew the aircraft to another state or country for use in out-of-state operations. After reviewing a number a cases in other states, the Court of Appeal held that the phrase "within this state" modified the word "purchaser." Despite the fact that the purchasers' employees or agents were in the state of California at the time that possession of the aircraft was transferred to them, the court held that the purchasers were not "in this state," if the goods were "destined for use" in another state. In so doing, the court emphasized the drafter's objective of the sales factor: to reflect contributions of the consumer state in the production of the taxpayer's income UC Davis Summer Tax Institute June 14, 2017

Issue of Dock Sales Appeal of Mazda Motors, Inc. , 94-SBE-009 (November 29, 1994): The taxpayer imported cars into the U.S. through California ports. The vehicles stayed at the port, while modifications were made to the vehicles. The Court held that if the purchaser takes possession (or constructive possession through an agent or bailee) in California for purposes such as warehousing, repackaging, adding accessories, etc., the property is "delivered. . . to a purchaser within the state," and the sale is a California sale. UC Davis Summer Tax Institute June 14, 2017

Ultimate Destination CA Chief Counsel Ruling Sales ultimately destined for another state but shipped to a third party public warehouse in California for temporary storage pending shipment in the same form as received to the ultimate destination state are not considered sales within California pursuant to Revenue and Taxation Code section Cited Legal Ruling 95-3 which provides that while there is a presumption that goods taken into possession by the purchaser in California are presumed to be delivered or shipped to California for purposes of sales factor assignment, that presumption can be overcome by evidence proving that the property was not used in the state and was transported to another state. UC Davis Summer Tax Institute June 14, 2017

Ultimate Destination CA Chief Counsel Ruling The goods were stored in California for a limited period of time and shipped in the same form received to the ultimate destination known at the time of shipment. As such, the goods were not used in CA through activities such as warehousing, repackaging, etc. Since the ultimate destination was designated by the taxpayer at the time of the initial order and was separately billed to the division in the ultimate state of destination, the temporary storage in CA was merely for purposes of further shipment elsewhere in the stream of interstate commerce. UC Davis Summer Tax Institute June 14, 2017

Mississippi Senate Bill 2933, signed on March 31, 2014 Provides a new method of apportionment for a major medical or pharmaceutical supplier of a Mississippi distribution facility whose business activity is taxable both within and without the state The percentage is made up of a payroll factor, a property factor, both counted twice, and a sales factor, counted once. The sum of the factors is then divided by five. Ohio CAT Exclusion Current law provides a CAT exclusion for a certain percentage of receipts from the sale of tangible personal property delivered by suppliers to a qualified Ohio distribution center (“QDC”). Proposed Tennessee Revenue Modernization Act Provides that qualifying taxpayers may elect to exclude “certified distribution sales” from the numerator of the sales factor for apportionment purposes. “Certified distribution sales” are defined to include sales of tangible personal property made in Tennessee to distributors when such goods are certified as having been sold for resale and ultimate use outside Tennessee. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Throwback
UDITPA § 16(b) provides that sales of tangible personal property are thrown back to the state if “the property is shipped from an office, store, warehouse, factory, or other place of storage in this state and (1) the purchaser is the United States government or (2) the taxpayer is not taxable in the state of the purchaser.” UC Davis Summer Tax Institute June 14, 2017

The throwback rule is justified on the grounds that if the destination state lacks the power to tax the seller, either because of limitations imposed by the United States Constitution or Federal legislation, then sales to purchasers within the destination state will escape inclusion in any state's numerator, thereby creating nowhere income. In order to curtail the creation of nowhere sales, the throwback rule may be supplemented by the double throwback rule, which applies to drop shipments. MTC Reg. Sec. IV.16.(a)(7). UC Davis Summer Tax Institute June 14, 2017

Throwback – Taxability in Destination State Dover Corporation v. Illinois Dept. of Rev., 271 Ill. App. 3d 700, 648 N.E.2d 1089 (Ill. App. Ct. 1995): An Illinois court held that sales made by a taxpayer to customers located in other states and in various foreign countries should have been thrown back to Illinois even though the taxpayer was subject to net income taxes in those other jurisdictions because the taxpayer did not in fact pay tax to the other jurisdictions. California: Technical Advice Memorandum (11/29/12): For tax years beginning before January 1, 2011, a California taxpayer must demonstrate physical presence (either directly or through agents or independent contractors) in the destination state in order to avoid the application of the throwback rule. UC Davis Summer Tax Institute June 14, 2017

Throwback – Sales to Foreign Countries Some states look to the laws of the foreign country in order to determine whether the taxpayer is “taxable in the [country] of the purchaser.” See Scott & Williams Inc. v. Board of Taxation, 117 NH 189, 400 A2d 786 (1977). Not all of the states that follow this approach take treaty provisions into account. Other states, such as California, Oregon, and. Alabama, apply the same constitutional jurisdictional standards used for determining whether a taxpayer is taxable in a particular state. In several of the states that employ that standard, Public Law is not taken into account in making the determination. Appeal of Dresser Industries, Inc., (82-SBE-307, June 29, 1982, rehearing 83- SBE-118, Oct. 26, 1983): The California State Board of Equalization ruled that P.L was inapplicable in the determination of whether a corporation was taxable in a foreign country for purposes of the California throwback rule to foreign sales. That determination is made based solely upon U.S. constitutional nexus standards. UC Davis Summer Tax Institute June 14, 2017

Chief Counsel Ruling (8/28/12) The Franchise Tax Board found that a taxpayer does not have to throw back tangible personal property sales where it has more than $500,000 of sales in a foreign jurisdiction. A taxpayer does not have to throw back domestic tangible personal property sales when a member of its California unitary group has more than $500,000 of sales, including sales of other than tangible personal property, in the destination state. Chief Counsel Ruling (7/5/16) The Franchise Tax Board found that a taxpayer had to aggregate sales of tangible personal property (TPP) with royalties received from licensing agreements in the state and allowed to exclude sales of TPP to other states The taxpayer is not required to throw back sales to other states the taxpayer has tangible personal property (and general gross receipts such as services, interest, and dividends) because activities exceed protections of Public Law and taxpayer would be subject to income tax in those states Confirm that this is the right ruling: UC Davis Summer Tax Institute June 14, 2017

Joyce/Finnigan In Appeal of Joyce, Inc., Cal. St. Bd. of Equal, Nov. 23, 1966, the California SBE held that sales to California customers by an out-of-state seller that was part of a unitary business could not be included in the California sales factor of the combined report for members of the unitary business that were subject to California taxation, because the seller itself was immune from taxation in California under P.L UC Davis Summer Tax Institute June 14, 2017

In Appeal of Finnigan Corporation (“Finnigan I”), Cal. St. Bd. of Equal., Aug. 25, 1988, the SBE was presented with the issue of whether the FTB, for purposes of calculating the sales factor of the apportionment formula, properly applied the “throw-back” rule to the non-California destination sales made by the taxpayer’s unitary subsidiary. The SBE concluded the sales should not be thrown back to California even though the subsidiary, as a separate corporate entity, was not taxable in those states, since another member of the unitary group, Finnigan Corporation, was taxable in the state into which the sales were made. UC Davis Summer Tax Institute June 14, 2017

Airborne Navigation Corporation v. Arizona Department of Revenue, Bd. Of Tax Appeals, Docket No I (February 5, 1987): In terms of its end result, Arizona effectively adopted the Finnigan approach to determine the numerator of a unitary group's apportionment formula. The court essentially attributed nexus of in-state members to out of state members of the combined group by interpreting the term “person” in PL 86 – 272 to include the entire combined group. Therefore, when a group of companies is conducting a unitary business and a part of that unitary business is conducted within the state, the activities of all members of the unitary group will be included in both the numerator and denominator of the sales factor. UC Davis Summer Tax Institute June 14, 2017

Matter of Disney Enterprises, Inc., N.Y. Tax App. Trib., No , 10/13/05: Ruling of the Tax Appeals Tribunal, affirmed by the New York Supreme Court, Appellate Division, on March 1, 2007 (830 N.Y.S.2d 614). The court agreed with the tribunal's conclusions, finding that by including the nontaxpayer member's New York sales receipts in the numerator of the business allocation percentage, the Department of Taxation and Finance "is not imposing a tax" upon the nontaxpayer member itself, but is rather "attempting to best measure the combined group's taxable in-state activities by use of a formula." This apportionment method as applied to the combined group "does not offend the purpose for which Public Law was adopted," the court concluded. UC Davis Summer Tax Institute June 14, 2017

Effective January 1, 2011, California amended CRTC Section to adopt the Finnigan rule in assigning sales from tangible personal property to California. Under Finnigan, all sales by members of the combined reporting group properly assigned to the state are included in the numerator of the California sales factor, regardless of whether the member of the combined group making the sale is subject to California tax. For throwback purposes, sales are excluded from the sales factor numerator if a member of the combined reporting group is taxable in the state of the purchaser. This change, coupled with the California 'doing business' rules effective January 1, 2011, is likely to create litigation over the constitutional validity of attributing protected P.L sales, under Finnigan, to other members of the combined report that are 'doing business' in California. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Throwout
Is Throwout Constitutional? Whirlpool Properties, Inc. v. Director, Division of Taxation, 208 N.J (July 28, 2011): The New Jersey Supreme Court held that the throwout rule may operate constitutionally, under a fair apportionment analysis, when applied to untaxed receipts from those states that lack jurisdiction to tax the corporate taxpayer due to insufficient business activity in that state, but not when applied to receipts that are untaxed due to a state’s determination not to have an income or similar business activity tax Assembly Bill A2722 (Dec. 2008) repealed the throwout rule, effective for tax years beginning after June 30, 2010 Paris Manufacturing Co. v. Commissioner, 505 Pa. 15 (1984): The Pennsylvania Supreme Court held that the throwout rule, although not unconstitutional, was contrary to the intent of the legislature. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Variations on Throwback and Throwout
No throwback Throwout Formerly in PA and NJ. Lorillard Licensing Co., LLC v. Director, N.J. Tax Court CA: Appeal of Craiglist, Inc., Cal. St. Bd. of Equal., Jan. 15, 2016 Throwback to place where sale made Massachusetts provides that sales are to be thrown back to Massachusetts if “the corporation is not taxable in the state of the purchaser and the property was not sold by an agent or agencies chiefly situated at, connected with or sent out from premises for the transaction of business owned or rented by the corporation outside this commonwealth.” M.G.L. c. 63, Sec. 38(f). Regulations interpret that provision as looking to the state where the sale was “negotiated and effected.” 830 C.M.R (9). UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Sourcing Receipts from Services and Intangibles
Sales Other than Sales of Tangible Personal Property UDITPA UDITPA § 17 states that Sales, other than sales of tangible personal property, are in this state if: The income-producing activity is performed in this state; or The income-producing activity is performed both in and outside this state and a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance. UC Davis Summer Tax Institute June 14, 2017

AT&T Corp. v. Commissioner of Revenue, Mass. App. Tax Bd., No. C293831, 6/8/2011: Sales of telecommunications services to Massachusetts customers should be sourced using the costs of performance associated with a service provider’s integrated telecommunications network rather than costs associated with each individual call. Accordingly, because the service provider’s income-producing activity was the provision of a complex and comprehensive, reliable telecommunications network and not the connection of individual transmissions over specifically designated wires, costs of performance were primarily incurred at the taxpayer’s global operations network and not at the location of a customer. On appeal, the Massachusetts Court of Appeal affirmed the ATB’s ruling. See Mass. Ct. App., No. 11-P-1462 (7/3/12). UC Davis Summer Tax Institute June 14, 2017

Different Approaches to Cost of Performance: Item-by-item or total: AT& T Corp. v. Department of Revenue, Oregon Tax Court No. TC 4814, January 12, 2012: The case turned on what activity or object should be the subject of a cost-of- performance analysis. The taxpayer sought to look to the level of activity where the costs incurred where not differentiated – the level of the products, lines or services. However, the Tax Court looked to the individual calls made and determined that receipts from interstate and international calls that begin or terminate in Oregon were properly sourced to Oregon based on a cost-of-performance methodology. UC Davis Summer Tax Institute June 14, 2017

Letter of Findings, Indiana Department of Revenue, No (11/26/14) An Indiana Letter of Findings determined that under the state’s income producing activity provisions, revenue from Indiana students receiving online instruction was attributable to Indiana. The LOF provided that Indiana has adopted a ‘transaction’ based approach when applying a cost of performance apportionment methodology. Under this approach, only the direct activity for which value is exchanged is considered. In this instance, it was where the students purchased the services that controlled. UC Davis Summer Tax Institute June 14, 2017

In the Matter of the Petition of Expedia, Inc., et al, DTA Nos , , (2/5/15) Receipts of an online travel reservation service were receipts from the performance of services and must, therefore, be sourced to where such services were performed, a New York administrative law concluded. In this instance, these services were performed outside the state. The Division of Taxation improperly characterized the receipts as ‘other business receipts,’ and the ALJ rejected the attempt to impose customer based sourcing. Notably, the ALJ rejected the argument that human involvement at the moment of the transaction was required for the provision of a service. Additionally, the ALJ found that receipts from online advertising revenue were from ‘services’ rather than from ‘other business receipts.’ UC Davis Summer Tax Institute June 14, 2017

Dish DBS Corp. f/k/a EchoStar, DBS Corp, and Affiliates v. South Carolina Department of Revenue, S.C. Admin. Law Court, No. 14-ALJ cc (2/10/15) A digital television provider asserted that South Carolina law requires apportioning service revenue based on costs of performance. In an order denying motions for summary judgment, the South Carolina Administrative Law Court disagreed, in part, because ‘costs of performance’ language is absent from South Carolina’s apportionment statute. Proceedings before the court continue to determine the taxpayer’s income- producing activity and where such activity occurred. UC Davis Summer Tax Institute June 14, 2017

Cable One, Inc. v. Idaho State Tax Commission, Idaho Supreme Court No , October 29, 2014 The Idaho Supreme Court upheld a lower court’s decision that a taxpayer’s greater costs of internet access services were performed in Idaho. The taxpayer asserted that relevant costs for providing internet access services to Idaho customers should include total costs associated with its Arizona internet backbone facility. The Idaho Supreme Court disagreed, and identified costs that were allocated solely to Idaho activity and used those costs to evaluate where the greater costs of performance occurred. UC Davis Summer Tax Institute June 14, 2017

Contractors General Motors Corp. v. Commonwealth, 602 S.E.2d 123 (2004): The term "costs of performance" includes direct costs incurred by a taxpayer and indirect costs incurred by third-party contractors, the Virginia Supreme Court held. Accordingly, a Department of Taxation regulation that limits "cost of performance" to direct costs is inconsistent with the plain language of the statute. UC Davis Summer Tax Institute June 14, 2017

CA FTB Legal Ruling : Under Regulation 25136(b), receipts from services or sales of intangible personal property are assigned to the state where the “income-producing activity” was performed, based on where the greater costs of performance occurred. Income-producing activity generally does not include activities performed on behalf of a taxpayer, such as those of an independent contractor. When a contractor and subcontractor are members of the same unitary combined reporting group, the activities of the subcontractor will be considered income-producing activities directly engaged in by the contractor for purposes of the “on behalf of” rule. UC Davis Summer Tax Institute June 14, 2017

In 2007, the MTC cost-of-performance regulation (Reg. IV.17.(2)) was amended to state: "Such activity includes transactions and activities performed on behalf of a taxpayer, such as those conducted on its behalf by an independent contractor. Accordingly, income producing activity includes but is not limited to the following: The rendering of personal services by employees or by an agent or independent contractor acting on behalf of the taxpayer or the utilization of tangible and intangible property by the taxpayer or by an agent or independent contractor acting on behalf of the taxpayer in performing a service.” California also amended its regulations to mirror the MTC to include independent contractor costs as an income producing activity. See Cal. Code of Regs. § 25136(b). UC Davis Summer Tax Institute June 14, 2017

MTC Regulations MTC Article IV.17.(1) provides for the inclusion in the numerator of the sales factor of gross receipts from transactions other than sales of tangible personal property (including transactions with the United States Government); under this section, gross receipts are attributed to this state if the income producing activity which gave rise to the receipts is performed wholly within this state. Also, gross receipts are attributed to this state if, with respect to a particular item of income, the income producing activity is performed within and without this state but the greater proportion of the income producing activity is performed in this state, based on costs of performance. In other words, if the income producing activity takes place in more than one state, then the receipts are sourced to the state that bears a greater portion of the cost of performance in relation to the costs of performance incurred in any other state. UC Davis Summer Tax Institute June 14, 2017

Income-Producing Activity: As amended by the MTC on August 2, 2007, income producing activity (IPA) means “the transactions and activity engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of obtaining gains or profit.” MTC Reg.IV.17.(2). Costs of Performance The MTC Regulations (Reg. IV.17.(3).) define the phrase "costs of performance" (“COP”), as used for purposes of the income producing activity test, as "direct costs determined in a manner consistent with generally accepted accounting principles and in accordance with accepted conditions or practices in the trade or business of the taxpayer." Interplay between UDITPA Sections 17 and 18 (distortion), especially in the COP and market-based sourcing context, have hindered the MTC’s efforts to amend its Section 17 regulations. UC Davis Summer Tax Institute June 14, 2017

Income From Intangibles There are a variety of approaches toward the inclusion of receipts from intangibles, which are distinct from UDITPA/MTC Regulations, in that some states tend to assign such receipts to the state of commercial domicile. Other examples include: Connecticut, which apportions all income, assigns gains from the sale or other disposition of intangible assets managed or controlled within the state to that state's sales factor numerator. Cf. Trans-Lux Corp. v. Meehan, No , Conn. Super. Ct. (Dec. 3, 1993). New Jersey, which likewise apportions all income, generally assigns receipts from intangibles to the sales factor numerator of the owner's domicile, unless the intangible has acquired a taxable situs in the state, in which case they are assigned to the taxable situs. N.J. Admin. Code § 18:7-8.12(e). UC Davis Summer Tax Institute June 14, 2017

Note that the UDITPA COP "all or nothing approach" for sourcing sales other than sales of personal property can lead to inequitable results in instances where substantial costs are incurred in more than one state. Some states will receive no tax in connection with the receipts, even though a substantial part of the income producing activity may have been performed within its borders. On the other hand, the state where the receipts are sourced may receive a windfall, since much of the income producing activity may have been performed outside of the state. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Distinguishing Between Receipts from Tangible Personal Property, Services and Intangibles In Appeal of PacifiCorp, Cal. State Bd. of Equal., No SBE-005, 9/12/02, the SBE ruled that the generation and transmission of electricity sold to California customers is the sale of a service excluded from the numerator of the apportionment sales factor, where the services were performed for the most part outside the state. Similarly, in EUA Ocean State Corp. v. Commissioner of Revenue, Mass. App. Tax Bd., Nos. C , C , C , C , C259653, and C , 4/24/06, the Massachusetts Appellate Tax Board (“ATB”) ruled that the taxpayers' sales of electricity were properly attributed to Rhode Island, the state in which the taxpayers incurred the costs of performing the income-producing activities. The ATB concluded that electricity is not considered “tangible personal property” for corporate excise apportionment purposes. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Distinguishing Between Receipts from Tangible Personal Property, Services and Intangibles Contrast the two prior rulings with Powerex Corp. v. Dept. of Revenue 357 Or. 40 (Or. 3/26/15). The Oregon Supreme Court ruled that sales of natural gas, stipulated by the parties as tangible personal property, were sourced to their ultimate destination. Conditions of the sales such as title passing in Oregon did not alter the conclusion that sales of tangible personal property are sourced to their ultimate destination. The court also concluded that electricity is tangible personal property for income tax sourcing purposes. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Distinguishing Between Receipts from Tangible Personal Property, Services and Intangibles BNP Media II LLC v. Department of Treasury, Mich. App. Ct., No , 5/20/14 The Michigan Court of Appeals ruled that advertising services were incidental to a taxpayers’ business activity of producing and distributing trade journals and, therefore, allowed the taxpayer to apportion its revenue from trade journal sales on a destination basis. Taxpayer‘s advertising sales were inextricably linked to its circulation of the printed journals because Taxpayer: did not provide advertising or marketing services, created and distributed a tangible product, and did not match advertisers to customers. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Distinguishing Between Receipts from Tangible Personal Property, Services and Intangibles Royalty v. Sales – Alticor Inc, v. Dep’t of Treasury, Case No (2016) The Court of Appeals found that certain payments from subsidiaries under a license for use of a customer list were royalties rather than sales. The Department asserted that such payment should be ‘sales’ because royalty payments must be based on a percentage of sales of the licensed product (in this case, the customer list). The court disagreed with the Department, providing that following such a rule would lead to a result that would disallow royalties for the use of the customer list in this case unless the list was later was sold. Accordingly, the court found that payments measured by a percentage of sales, facilitated by the use of the customer list, constituted ‘royalties’ for SBT purposes. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Distinguishing Between Receipts from Tangible Personal Property, Services and Intangibles In the Matter of the Petition of Expedia, Inc., et al, DTA Nos , , (2/5/15) Receipts of an online travel reservation service were receipts from the performance of services and must, therefore, be sourced to where such services were performed, a New York administrative law concluded. In this instance, these services were performed outside the state. The Division of Taxation improperly characterized the receipts as ‘other business receipts,’ and the ALJ rejected the attempt to impose customer based sourcing. Notably, the ALJ rejected the argument that human involvement at the moment of the transaction was required for the provision of a service. Additionally, the ALJ found that receipts from online advertising revenue were from ‘services’ rather than from ‘other business receipts.’ UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Distinguishing Between Receipts from Tangible Personal Property, Services and Intangibles Illinois Private Letter Ruling IT PLR (April 24, 2014 released June 2014) The Illinois Department of Revenue ruled that agreements for information technology hosting and cloud computing are properly characterized as service contracts for Illinois sales factor apportionment purposes. Because Taxpayer is engaged in provision of services, the Department ruled that receipts from those contracts should be sourced to Illinois if the services are received in the state. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Gross Receipts
California Supreme Court: Microsoft & GM Microsoft Corp. v. Franchise Tax Bd., 39 Cal. 4th 750 (8/17/06): Entire redemption price of marketable securities includable as gross receipts in the sales factor. However, FTB may use an alternative apportionment formula to include net rather than gross proceeds from the redemption of securities in the sales factor, where the use of gross proceeds distorts the amount of income reported to the State. The concept of distortion will be discussed further on Day Four. UC Davis Summer Tax Institute June 14, 2017

General Motors Corp. v. Franchise Tax Bd., 39 Cal. 4th 773 (8/17/06): Repurchase agreement (“repo”) transactions are akin to secured loans rather than sales of commodities -- only the net proceeds (i.e., interest) generated from a repo may be included in the sales factor. Microsoft/GM Ramifications Sales of Securities → Include in Sales Factor Redemption of Securities → Include in Sales Factor Repo Agreements → Exclude from Sales Factor Sales of Commodities → Include in Sales Factor UC Davis Summer Tax Institute June 14, 2017

General Mills, Inc. v. Franchise Tax Bd., 172 Cal.App.4th 1535 (4/15/09): The full sales price of a company's commodity futures sales contracts should be included as gross receipts in the denominator of the sales factor for purposes of determining the amount of business income subject to tax in California. Citing Microsoft, the court held that the "gross receipts" from a futures sales contract are equivalent to the full sales price of the contract. The court explained that if a futures sales contract results in physical delivery, General Mills receives the full sales price in cash. When a futures sales contract results in offset, General Mills receives consideration in the form of being relieved of the obligation to purchase or sell the commodity. That consideration equals the full sales price of the contract, the court concluded. UC Davis Summer Tax Institute June 14, 2017

General Mills, Inc. v. Franchise Tax Board Cal. Ct. App., No. A131477, 8/29/12 Although the California Appellate Court held that the proceeds from hedging transaction activity were properly included as “gross receipts” under section 25120(e) in sales factor, the Court found that gross receipts from hedging transaction did not fairly represent a taxpayer's business activity because: (1) the hedging transactions were qualitatively different from the taxpayer's business of selling consumer food products and (2) inclusion of the gross receipts in the sales factor substantially distorted the percentage of the taxpayer's California apportioned income. Accordingly, the FTB was allowed to apply an alternative apportionment methodology, which required the taxpayer to include only net gains (as opposed to gross receipts) received from its hedging transactions. UC Davis Summer Tax Institute June 14, 2017

Square D Company v. California Franchise Tax Board, Cal. Super. Ct., No. CGC , 4/11/07. Court ruled that receipts from Eurodollar time deposits held to maturity were "investments," not loans Thus, constituted gross receipts for sales-factor purposes. As in Microsoft, the court found that the FTB had proven that the standard apportionment formula failed to fairly reflect Square D's business activity in California. The Limited Stores, Inc. v. Franchise Tax Board, 62 Cal. Rptr. 3d 191 (Cal. Ct. App. 2007) The full redemption price of debt instruments held to maturity was a "gross receipt.” Taxpayer's treasury functions were qualitatively different from its principal business of selling clothing and bath products, and the quantitative distortion from inclusion of its investments receipts was substantial. UC Davis Summer Tax Institute June 14, 2017

Duke Energy Corp. v. Department of Revenue, Supreme Court of South Carolina, ; SC 27606, February 7, 2016 The South Carolina Supreme Court affirmed the appellate court’s determination that receipts from the sale of short-term investments may not be included in the sales factor. The Court reasoned that including the principal recovered from the sale of short-term investments would lead to absurd results by greatly distorting the calculation and by defeating the intent and purpose of the applicable statutes. UC Davis Summer Tax Institute June 14, 2017

Sales of Assets Receipts from the incidental or occasional sale of a significant/fixed asset, such as a plant, are excluded from the sales factor under the theory that inclusion could distort the overall apportionment of income in a given year by giving undue weight to a particular state. MTC Regs. IV.18.(c)(1). These receipts are excludible under the regulation, even though the asset was used in the taxpayer’s regular trade or business. In Appeal of Triangle Publications (84-SBE-096): The Board concluded that respondent was not permitted to rely upon its own regulation under RTC §25137, but was required to show that the usual statutory formula, which the foregoing regulation was intended to modify, did not fairly represent the extent of the taxpayer's business activity in California. UC Davis Summer Tax Institute June 14, 2017

Sales of Assets In Appeal of Fluor Corporation (95-SBE-016): The Board held that any party wishing to deviate from the apportionment method prescribed by a regulation under RTC §25137 must first establish by "clear and convincing evidence" that the regulation does not fairly represent the extent of the taxpayer's activities in California. In Appeal of Emmis Communications Corp., SBE Case No , June 11, 2013, the BOE found that gross receipts from a diversified media corporation’s sale of 13 TV stations located outside of California were not excluded from the sales factor under the occasional sale rule of California Code of Regulations (CCR) section 25137(c)(1)(A). Chief Counsel Ruling : The FTB issued a Chief Counsel Ruling finding that gross receipts from asset sales while implementing a Plan of Reorganization under Chapter 11 bankruptcy were within the taxpayer’s normal course of business and occurred frequently. Therefore, those receipts were not excluded from the sales factor under CCR section 25137(c)(1)(A). Chief Counsel Ruling : In CCR , the taxpayer operated two lines of unitary businesses. The taxpayer disposed of one line of its two businesses and shifted its focus entirely to the remaining line of business. The FTB found that the taxpayer’s disposition of an entire line of business was a substantial and occasional sale under CCR section 25137(c)(1)(A). Therefore, the receipts from the sale were excluded from the sales factor. UC Davis Summer Tax Institute June 14, 2017

Gross Receipts Definition UDITPA Definition UDITPA § 1(g) defines “sales” as “all gross receipts of the taxpayer not allocated under sections 4 through 8 of this Act.” MTC proposal to amend Art. IV.1(g) to update the definition to include only receipts from transactions and activity in the regular course of the taxpayer’s trade or business. On May 8, 2014 the Executive Committee passed motions to release these changes for a Bylaw 7 Survey. If a majority of Compact member states respond affirmatively to the Bylaw 7 Survey (which is non-binding), the matter will be referred to the full MTC for possible adoption as a uniformity recommendation. The full MTC meets annually with the next meeting is July 30, 2014. UC Davis Summer Tax Institute June 14, 2017

Gross Receipts Definition MTC Regulations Reg. IV.15.(a)(1): “for the purposes of the sales factor of the apportionment formula for each trade or business of the taxpayer, the term ‘sales’ means all gross receipts derived by the taxpayer from transactions and activity in the regular course of the trade or business.” UC Davis Summer Tax Institute June 14, 2017

MTC Regulations In the case of a taxpayer engaged in manufacturing and selling or purchasing and reselling goods or products, "sales" includes all gross receipts from the sales of such goods or products (or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the tax period) held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business. Gross receipts for this purpose means gross sales less returns and allowances, and includes all interest income, service charges, carrying charges, or time-price differential charges incidental to such sales. Federal and state excise taxes (including sales taxes) shall be included as part of such receipts if the taxes are passed on to the buyer or included as part of the selling price of the product. MTC Reg.IV.15.(a)(1)(A). UC Davis Summer Tax Institute June 14, 2017

In the case of a taxpayer engaged in providing services, such as the operation of an advertising agency or the performance of equipment service contracts or research and development contracts, "sales" includes the gross receipts from the performance of such services, including fees, commissions, and similar items. MTC Reg.IV.15.(a)(1)(C). In the case of a taxpayer engaged in renting real or tangible property, "sales“ includes the gross receipts from the rental, lease, or licensing the use of the property. MTC Reg.IV.15.(a)(1)(D). In the case of a taxpayer engaged in the sale, assignment, or licensing of intangible personal property such as patents and copyrights, "sales" includes the gross receipts therefrom. MTC Reg.IV.15.(a)(1)(E). UC Davis Summer Tax Institute June 14, 2017

In the case of cost plus fixed fee contracts, such as the operation of a government-owned plant for a fee, "sales" includes the entire reimbursed cost plus the fee. MTC Reg.IV.15.(a)(1)(B). Historically, the FTB has taken the position that contractors should exclude from the sales factor the value of "client furnished materials" used under "cost-plus" contracts. However, in Appeals of Bechtel Power Corporation, Bechtel Corporation, Sequoia Ventures, Inc., Bechtel Group, Inc., and Fremont Investors, Inc., Cal. St. Bd. of Equal, Mar. 19, 1997 the SBE decided that the FTB improperly excluded from the taxpayer’s California sales factor client furnished materials used to fulfill a “cost- plus” contract. All costs associated with the taxpayer’s business should be included in order to provide a better measure of the taxpayer’s in-state economic activity. UC Davis Summer Tax Institute June 14, 2017

If a taxpayer derives receipts from the sale of equipment used in its business, those receipts constitute sales. For example, a truck express company owns a fleet of trucks and sells its trucks under a regular replacement program. The gross receipts from the sales of the trucks are included in the sales factor. MTC Reg.IV.15.(a)(1)(F). UC Davis Summer Tax Institute June 14, 2017

Exclusions From Gross Receipts In some cases certain gross receipts should be disregarded in determining the sales factor in order that the apportionment formula will operate fairly to apportion to this state the income of the taxpayer's trade or business. MTC Reg.IV.15.(a)(2). Receipts from Investments In some states, receipts from the frequent sale of treasury investments are either excluded from the sales factor altogether, or included in the factor only to the extent of net gain. Effective tax years beginning on or after January 1, 1995, the Oregon sales factor excludes gross receipts from the sale of intangible assets, including securities, unless the receipts are derived from the taxpayer's primary business. UC Davis Summer Tax Institute June 14, 2017

California Treasury Receipts Regulation Amendments On 11/28/07, FTB adopted amendments to Reg §25137(c)(1)(D) dealing with the treasury receipts issue. Regulation, effective for tax years beginning on or after 1/1/07, excludes interest, dividends, gross receipts and net gains from intangible assets held in connection with a treasury function from the sales factor. A “treasury function” defined as pooling, managing and investing in intangible assets for the purpose of satisfying the cash flow needs of the business. Treasury function includes use of futures and options to hedge foreign currency. Treasury function does not include trading function for the purpose of hedging price risk of products/commodities consumed, produced or sold by the taxpayer. UC Davis Summer Tax Institute June 14, 2017

Amendments do not apply to: Taxpayers principally engaged in the business of dealing with intangible assets, such as registered broker dealers; and Financial institutions. Chief Counsel Ruling The California Franchise Tax Board concluded that gross receipts resulting from a non-financial broker-dealer’s principal trading activity were includible in the California sales factor. UC Davis Summer Tax Institute June 14, 2017

Cal. Rev. & Tax Code § 25120(f)(2): In 2009, effective for tax year 2011, California adopted a statutory definition of gross receipts to exclude net gains as well as amounts received from intangible assets held in connection with a treasury functions, as well as: Repayment, maturity, or redemption of the principal of a loan, bond, or mutual fund or certificate of deposit. The principal amount received under a repurchase agreement or loan. Proceeds from the issuance of the taxpayer’s own stock or from a sale of treasury stock. Damages and other litigation rewards; property acquired by an agent on behalf of another. Tax refunds and recoveries. Pension reversions. Contributions to capital, except for sales of securities by a securities dealer. Forgiveness of indebtedness income. Amounts realized from exchanges of inventory that are not recognized by the IRC. Amounts received from hedging transactions. UC Davis Summer Tax Institute June 14, 2017

Section 4 Sales factor – Market sourcing

Advanced Income Tax Track Sales Factor – Market Sourcing
In recent years, many states have replaced the method for sourcing of sales from income producing activity/cost of performance formulas to sourcing based on where the ultimate recipient of the item or service is located--a market- based sourcing regime. These states include: California (explained below), Georgia, Iowa, Illinois, Michigan, Minnesota, Ohio, Utah and Wisconsin. UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Market-Based Sourcing
DC*** AK HI ME RI*** VT NH MA NY CT***** PA* NJ MD DE VA WV NC SC GA FL IL OH IN MI WI KY TN***** AL MS AR LA***** TX OK MO**** KS IA MN NE NM AZ** CO UT WY MT****** WA OR ID NV CA* ND SD CT: yes starting in 2016 MO: yes only for taxpayers electing optional single sales factor apportionment MT: yes starting for tax years after Dec. 31, 2017 * Service Receipts Only (effective in 2014) ** Elective for deemed multistate service providers *** Effective in 2015 **** Elective optional single sales factor only ***** Starting in 2016 ****** Starting in tax year 2018 UC Davis Summer Tax Institute June 14, 2017

MTC Update: Article IV.17 deals with sales factor sourcing for services and intangibles and provides for market sourcing to replace the cost-of-performance provisions of Article IV. Services are sourced where service is “delivered,” intangibles are sourced where they are “use(d),” and certain intangible receipts are thrown out of the numerator and denominator. On May 8, 2014 the Executive Committee passed motions to release these changes for a Bylaw 7 Survey. If a majority of Compact member states respond affirmatively to the Bylaw 7 Survey (which is non-binding), the matter will be referred to the full MTC for possible adoption as a uniformity recommendation. The full MTC meets annually with the next meeting is July 30, 2014. UC Davis Summer Tax Institute June 14, 2017

MTC Update (continued): On May 12, 2016, the MTC Executive Committee heard recommendations of the hearing officer as well as public comments on those recommendations. In general, groups submitting additional comments urged the Committee to delay approval of draft amendments related to Sections 1 and 17 (namely, all amendments including those which would implement market-based sourcing). On June 1, 2016, a memorandum providing a briefing on the comments was released for the Uniformity Committee. UC Davis Summer Tax Institute June 14, 2017

California Beginning with the 2013 tax year for all taxpayers, and beginning with the tax year for taxpayers that elected to use the single-sales factor apportionment formula, sales of other than tangible personal property are sourced to California if the taxpayer's market for the sale is in the state. (Cal. Rev. & Tax Code Section ) UC Davis Summer Tax Institute June 14, 2017

California CRTC Section provides: (a)(1)Sales from services are in this state to the extent the purchaser of the service received the benefit of the services in this state. (a)(2) Sales from intangible property are in this state to the extent the property is used in this state. In the case of marketable securities, sales are in this state if the customer is in this state. (a)(3) Sales from the sale, lease, rental, or licensing of real property are in this state if the real property is located in this state. (a)(4) Sales from the rental, lease, or licensing of tangible personal property are in this state if the property is located in this state. (b) The Franchise Tax Board may prescribe regulations as necessary or appropriate to carry out the purposes of this section. UC Davis Summer Tax Institute June 14, 2017

Regulation § Implements market sourcing rules for taxpayers that elect single sales factor in and Note that beginning in 2013, single sales factor is mandatory for most taxpayers, while market sourcing is now mandatory for all taxpayers, including those in industries excluded from the use of single sales factor. The original regulation did not address some items (including government services, marketable securities, dividends, goodwill, etc.) The regulation was amended effective Jan. 1, 2017 and was to be applied to taxable years beginning on or after Jan. 1, The amendments addressed sourcing of marketable securities, interest, dividends, and goodwill. Taxpayers could elect to retroactively apply the amendments back to taxable years 2012. FTB will discuss further proposed amendments to this Regulation in an Interested Parties Meeting on June 16, 2017. UC Davis Summer Tax Institute June 14, 2017

Regulation § Regulation presumes that the benefit of services rendered to individuals is received at their billing address, although this presumption can be overcome with evidence to the contrary. Cascading sourcing rules are provided for services rendered to businesses, which begin with the location indicated in the contract or in the taxpayer’s books and records. Customer billing address is a last resort for such sourcing after other avenues, including reasonable approximations are exhausted. Regulation also provides a cascading approach to determine where intangibles are considered used for purposes of sourcing proceeds from the sale of such, as well as gross receipts from the licensing of such. UC Davis Summer Tax Institute June 14, 2017

Regulation § – 9/5/16 updates applicable for 2015 tax year and onwards: Elective applicability for Reg to apply to taxable years beginning or after 2012 if these yeas are open to adjustment under applicable statute of limitations Marketable securities defined for 1) securities and commodities dealers; 2) everyone else Assignment rules for marketable securities as location of customer: billing address for individuals; commercial domicile for corporate/business entities; reasonable approximation for all else Dividends/ Sale of Stock / Flow Through Entity: 1) If 50% or more of underlying entity’s assets consist of real or TPP, receipts assigned by averaging payroll and property factors in CA of entity for most recent 12-month taxable year preceding sale to extend indicated by taxpayer’s books and records. 2) If 50% or more consist of intangible property, sale of stock or ownership interest assigned by using sales factor of corporation or p’ship entity in CA Interest: 1) interest from loans assigned to CA if loan is secured by real property located in CA, or if not secured by real property but borrower is located in CA; 2) interest from investments assigned to CA if investment managed in CA Other dividends/goodwill/interest: if assignment rules can’t practically be applied, then location where intangible property is used is reasonably approximated; if can’t be reasonably approximated, then assigned to purchaser’s billing address UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track

Sales From Complete Transfer of Rights in Intangible Property CCR § (d)(1). Complete transfer of all property rights in intangible property. How to determine the location of the use of the intangible property? Is the Property the Sale of Stock (or Dividend) or Some Other Property? Some Other Property Sale of Stock (or Dividend) [Presumption] The location of use is presumed to be California if (i) the contract between the taxpayer and customer; or (ii) the taxpayer’s books and records indicate that the property is used in California at the time of sale. It should be noted that, the books and records showing taxpayer used the intangible property in the 12 months prior to sale may be considered. Location of use cannot be determined by contract or books/records. Taxpayer of FTB shows Buyer’s actual location of use of property at time of purchase was inconsistent with contracts or books and records. The Location of use shall be reasonably approximated. Assign gross receipts to Buyer’s billing address in California. [Specific Rules] Is the sale of intangible property: (i) sale of shares of stock in a corporation; or (ii) sale of an ownership interest in a pass-through entity (PTE)? [Other than sales of marketable securities] The rules depends on the predominant nature of the assets of the corporation or the PTE. Does 50% of more of the entity’s assets consist of (i) real and/or tangible personal property; or (ii) intangible property? Sale of the stock or interest will be assigned by averaging the payroll and property factors of the corporation of PTE in California for the most recent 12 months prior to the time of the sale. Sale of the stock or interest will be assigned by using the sales factor of the corporation or PTE in California for the most recent 12 months prior to the time of sale. Not Determinable? Overcome Presumption? ≥ 50% Real/Tangible > 50% Intangible Not Determinable or Presumption Overcome UC Davis Summer Tax Institute June 14, 2017

Example Benefit of the Service - Business Entity, subsection (c)(2)(A). Payroll Services Corp contracts with Customer Corp to provide all payroll services. Customer Corp is commercially domiciled in this state and has employees in a number of other states. The contract between Payroll Services Corp and Customer Corp does not specify where the service will be used by Customer Corp. Payroll Services Corp's books and records indicate the number of employees of Customer Corp in each state where Customer Corp conducts its business. Payroll Services Corp shall assign its receipts from its contract with Customer Corp by determining the ratio of employees of Customer Corp in this state compared to all employees of Customer Corp and assign that percentage of the receipts from Customer Corp to this state. UC Davis Summer Tax Institute June 14, 2017

FTB Chief Counsel Ruling For purposes of assigning sales of non-marketing services under CRTC Section and Reg , the taxpayer shall assign the sales of its services to California to the extent that the Taxpayer’s direct customer (not it’s customer’s customer) receives the benefit of the service in California CPU data associated with the customer’s use of the taxpayer’s services collected in the regular course of business (and is kept in the taxpayer’s books and records) can be used as a reasonable proxy for financial data in measuring the extent of the benefit received in California. UC Davis Summer Tax Institute June 14, 2017

AL: Market-based sourcing required for sales of services and intangible property tax years beginning on or after 12/31/10. (Ala. Code Sec IV(17)(a)(3)-(4)). AZ: Effective from and after 2013, qualified multistate service providers can elect market-based sourcing. (Ariz. Rev. Stat. Ann (B)). CA: Market-based sourcing required for sourcing service receipts and receipts from intangible/marketable securities in tax years beginning on or after January 1, 2011, but only if taxpayer elects single factor sourcing. (Cal. Rev. & Tax Code §25136). Mandatory market sourcing for years beginning on or after January 1, 2013. CO: Market-based sourcing required for intangible property receipts, but not for service receipts, for tax years beginning on or after 1/1/09. (Colo. Rev. Stat. § (4)(c)(V), Colo. Reg. § (c)(V) & (VI)). UC Davis Summer Tax Institute June 14, 2017

GA: Market-based sourcing required for tax years beginning on or after 1/1/06, although Georgia historically applied a market-based approach even before the state issued regulatory guidance requiring it. (Ga. Comp. R & Regs. § (5)(c)1 -6). IL: Market-based sourcing required for tax years ending on or after 12/31/08. (35 ILCS 5/304(a)(3)(B-1)-(C-5)(iv)). IA: Market-based sourcing required. Income derived from business other than the manufacture or sale of tangible personal property shall be attributed to Iowa in the proportion which the Iowa gross receipts bear to the total gross receipts. (Iowa Code §422.33(2)(b)(3), Iowa Admin. Code (422)). ME: Market-based sourcing required for tax years beginning on or after 6/7/07, except for sales to federal government. (Me. Rev. Stat. Ann. tit. 36, §5211(16-A)(A)). UC Davis Summer Tax Institute June 14, 2017

MD: Market-based sourcing required. (Md. Regs. Code §§ (C)(3)(c) (D)(3)). MI: Market-based sourcing applies to Michigan Business Tax (MBT), which is based in part on income and in part on gross receipts. Market-based sourcing applies to both services and intangible revenue for both measures of the tax. (Mich. Comp. Laws Ann. § ). Also, for purposes of the Michigan Corporate Income Tax, market-based sourcing is required. (Mich. Cons. Laws Sec ). MN: Market-based sourcing required. (Minn. Stat. § Subd.5). NE: Effective for tax years beginning on or after 1/1/14, market sourcing rules are adopted. (Neb. Rev. Stat. Sec (3)). UC Davis Summer Tax Institute June 14, 2017

OH: Market-based sourcing required for Ohio CAT. Generally, the same broad principles for sourcing services and intangible receipts to the CAT and franchise tax. (Ohio Rev. Code Ann. § ). OK: While the statute is silent on the sourcing rules for sales of other than TPP, regulatory amendments adopted in May 2010, and “effective” 7/11/10, require market based sourcing to apportion service receipts. (Oklahoma Admin. Code 710: (A)). UT: Market-based sourcing required for tax years beginning on or after 1/1/09. (Utah Code Ann. §§ (3)-(4)). WI: Market-based sourcing required for service receipts for tax years beginning on or after 1/1/05, and required for intangible receipts for tax years beginning on or after 1/1/09. (Wis. Admin Code §§2.39(6)). UC Davis Summer Tax Institute June 14, 2017

Advanced Income Tax Track Alternative Sourcing
In the Matter of the Petition of The McGraw-Hill Companies., New York City Tax Appeals Tribunal, TAT (E) (GC) et al., October 28, 2015. The New York City Tax Appeals Tribunal ruled that a financial information publisher providing credit ratings to the public could not allocate receipts from its public credit rating services using an audience-based or circulation-based method for NYC general corporation tax purposes The Tribunal found that the Petitioner failed to prove that it was a First Amendment speaker similarly situated to advertising, program broadcasting, and subscriptions and entitled to use an audience-based method for allocating receipts The Tribunal noted the lack of proof by taxpayer that the place-of-performance method did not fairly represent Petitioner’s activity in New York City and secondly, that the taxpayer failed to prove that an audience-based allocation method did fairly represent the its activity in New York City. UC Davis Summer Tax Institute June 14, 2017

Example 1: A company performs testing of aerospace equipment for the U.S. government. The testing is done by a California-based company at a facility in New Mexico. The aerospace equipment itself is military equipment used overseas. The government agency is based in DC, where the contract was signed. Where should this be sourced? UC Davis Summer Tax Institute June 14, 2017

Example 2: Small Pharma Co. signs a co-development agreement with Big Pharma Co. for a drug that they are developing. Under this agreement, Big makes payments to Small along the way if certain clinical trials are successful. If drugs are approved, Small is to produce and sell the drugs exclusively to Big, and Big will sell to distributors that sell to pharmacies throughout the U.S. under a brand name company owned by Small and Big. Big and Small will share profits. In Year 3, the FDA approves a Phase I clinical trial and under the terms of the agreement, Big pays Small $300 million. In Year 5, the final trial is passed and the drug is approved. Big sells the product and ships it to a distributor warehouse in Tennessee. The distributor sells the drug throughout the U.S. Based on final sales by pharmacies and after all discountes/rebates/etc., Big makes an additional payment of 50% of the profits from ultimate sales of the product. How should these be sourced? UC Davis Summer Tax Institute June 14, 2017

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UC Davis Summer Tax Institute Advanced Income Tax Track

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