GET A GRIP ON COMBINED REPORTING: A CASE STUDY ON MULTISTATE ISSUES …€¦ · · 2016-08-03GET...

GET A GRIP ON COMBINED REPORTING: A CASE STUDY ON MULTISTATE ISSUES

Jordan M. Goodman Partner Horwood Marcus & Berk Chartered Chicago, I l l inois [email protected]

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IPT 2014 ANNUAL CONFERENCE

■The “Linchpin” of Apportionability Due Process Clause requires minimum

connection between state and activity that it seeks to tax; and A rational relationship between income

attributed to the state and intrastate values of the enterprise

■Applies to Multiple Divisions Connection and relationship relate to income

that arises from a unitary business ■Applies to Multiple Entities

UNITARY BUSINESS PRINCIPLE


WHY COMBINED REPORTING?

■Some reasons given for combined reporting: Curtailing tax planning; Better measurement of in-state activity; Simplification; and Impact on state economy.


Advantages and disadvantages to each type of filing Advantages of Combined Filing may consist of Accelerated utilization of net operating losses Elimination of intercompany transactions Ease of administration Dilution of apportionment Decreased tax base Water’s edge election may limit pool of unitary income to

U.S. Disadvantages of Combined Filing can include Neutralization of separate state tax planning Binding election may make future tax planning difficult Increased tax base Exclusion of foreign affiliates through water’s edge election

may cause increase in state apportionment factors

STATE INCOME TAX FILING OPTIONS


WHAT IS IMPACT OF UNITARY REPORTING?

■ Impact of unitary reporting depends on: ▪ Related entities' contacts with the taxing state; ▪ Relative profitability of members (i.e., does loss of

X offset gain of Y?); ▪ Relative apportionment factors of members

(increase denominator, reduce apportionment ratio); and

▪ Relevant income tax apportionment formulas (single sales factor) and rates in each state.

■ What is revenue impact to state?


WHO IS THE TAXPAYER—COMPOSITION OF THE GROUP

Historic cases:

Adams Express (“unit rule”);

Butler Brothers (separate accounting losses not dispositive); and

Edison Stores (separate incorporation not dispositive).



Tests for Determining “Unitary:”

Unities of ownership, operation and use;

Functional integration, economies of scale and centralization of management; and

Contribution or dependency.


TYPES OF UNITARY STATUTES

Tests for Determining “Unitary” MTC regulation defines unitary business as

“single economic enterprise” of parts “sufficiently interdependent, integrated and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value…”



Illustrative California Cases: Tenneco (shipbuilding, farm equipment and

construction, packaging, and automotive parts not unitary despite assertion of strong centralized management); and Dental Insurance (dental insurance consulting

business unitary with farms).



Illustrative Non-California Cases: RR Donnelley (Arizona court finds PIC unitary but not

accounts receivable and factoring companies); Miami Corp. (Oregon court finds timberlands in

Florida, oil and gas reserves in Louisiana, securities portfolio in Illinois, and a tree farm in Oregon unitary because of the existence of strong centralized management); and Envirodyne (Federal Appellate Court 7th Circuit finds

all entities must be unitary with each other).



Holding companies as a subset of unitary: Are operations necessary to be combined? PBS Building Systems determines shared tax

benefits, loan guaranty and covenants not to compete sufficient for unitary. See also FTB Legal Rulings 95-7 and 95-8. Matter of American Banknote (NYC Tax Tribunal,

11/08 - held that holding company was unitary with subsidiary).

If not combined, consider dividend and interest issues.



Instant Unity When do the operations of a newly acquired

business become sufficiently integrated to become unitary with the existing business? California generally requires some time to lapse (i.e., rule should be called “no instant unity”). How much time varies with facts and circumstances. Colorado requires two tax years before unitary.


WHO IS THE TAXPAYER—CREDITS

Some states explicitly trap credits: e.g., Hawaii, Minnesota

Some permit group use: e.g., Idaho (ID Sec. Code 63-3029B(6))

What is the policy argument for leaving the credits trapped? Should the rules be the same for NOLs and

throwbacks?


WHO IS THE TAXPAYER—INTRASTATE APPORTIONMENT

HYPO: Assume ABC manufacturers product in 100%

sales factor state M; sells entire output to distribution affiliate XYZ; and Assume ABC generates enterprise zone

credits but has no income pursuant to intrastate apportionment methodology.

Result: No credit.


WHO IS THE TAXPAYER—NONBUSINESS ITEMS

Nonbusiness gains and losses – generally trapped at the entity generating such losses, to be added to post-apportioned income.

Nonbusiness interest deduction – Robert Half suggests debt must contribute materially to the production of business income. Hypo: Assume private equity fund acquisition Sub

acquires Target which then incurs debt to pay dividend. Is the interest deductible?


WHO IS THE TAXPAYER—CAPITAL GAINS AND LOSSES

California has an elaborate regulation calling for separating and then netting various preferred items.

What to do in states with no clear rules?


WHO IS THE TAXPAYER—JOYCE/FINNIGAN

Is it the selling taxpayer? Or the group?

Some Finnigan states include: Arizona;

California for mutual fund companies per RTC reg. 25137-14;

Kansas;

Massachusetts;

New York (Disney Enterprises);

Texas follows Joyce but requires taxpayers to provide information on the apportionment percentage that would have resulted under Finnigan;

Utah; and

Wisconsin.

Should the rule be consistent with the rule for NOLs and credits?


WHO IS THE TAXPAYER—INTERCOMPANY GAINS

Are intercompany sales eliminated or deferred?

Does it matter if the state begins with federal taxable income?

After an inconsistent history, California now follows federal “to the extent possible consistent with combined reporting principles.”

Vermont provides for similar treatment.

In either case, transactions between group members as to the unitary business would apparently no longer implicate the states’ add back laws



Assuming elimination, the correct application per unitary theory may lead to odd results:

Sub manufacturers goods at a cost of $40 in state M and sells to Parent for $75 in state N; Parent then sells to third party for $100 in state O.

Where/when is profit recognized?



If state adopts federal deferral approach:

May match federal unless the ownership standard is less than 80%, or the group includes foreign members

What apportionment percentage applies, year of restoration or year of deferral?

Are intercompany sales eliminated from the apportionment factors?

How to treat deferred items before taxpayer entered the state, i.e., were there preexisting gains?

Illinois treats members as if they constituted a federal consolidated group and applies federal regulations.


WHO IS THE TAXPAYER—INTERCOMPANY SALES

Are intercompany sales eliminated from the sales factor?

In Chase Brass the California court concluded that intercompany sales should be eliminated from the sales factor because no net income is created from the intercompany sale.


WHO IS THE TAXPAYER—STOCK BASIS IN SUBSIDIARY

Is basis the same as federal?

California rules make clear the federal investment account adjustments are not taking place (Rapid-American Corp and Jim Beam Brands)

Could result have been changed by dividend upstream followed by contribution to capital?

Appeal of Novartis holds "no" based on economic substance, step transaction and substance over form (SBE 2009)

Oregon appears to follow federal adjustments since it starts with federal taxable income and the list of modifications does not include an adjustment. (Or. Reg. OAR 150-317.356)


WHO IS THE TAXPAYER—NET OPERATING LOSSES

Lack of uniformity in state rules:

California intrastate apportionment rules make clear each taxpayer has its own share of the group’s NOL

Some states treat NOL as that of the group: e.g., Massachusetts


WHO IS THE TAXPAYER—COP RULES

Cost of performance rules are complicated for separate taxpayers but some special complications exist for combined reports:

Direct costs generally don’t include costs incurred “on behalf of” the taxpayer: e.g., independent contractors

FTB Legal Ruling 2006-02 extended costs to include members of unitary group (excludes foreign if water’s-edge election)

MTC goes farther (Reg. IV.17.(2), (3) and (4))


WHO IS THE TAXPAYER—DIVIDENDS

Dividends from unitary subsidiary: eliminated? Eligible for dividends received deduction?

Early California case holds dividends not eliminated (Safeway Stores). Legislature overrules in RTC Sec. 25106 so long as paid from unitary earnings.

What of newly formed subsidiary or holding company as part of reorganization, receiving dividend from e&p generated prior to its existence?


WHO IS THE TAXPAYER—STATUTE OF LIMITATIONS, ELECTIONS, METHODS

Does the group have a single, common statute of limitations?

Assessments

Refunds

For combination itself (Turbodyne Corp; Panavision)

Does the group have a single, common set of elections? Must all be on same accounting methods?


INCREASED NEED FOR SPECIAL FORMULAS

Combining entities not on the same formula presents unique problems

Determining net income of group “easy”

Financials and non-financials?


TRANSITION ISSUES

What about pre-existing NOLs?

Unrealized appreciation or depreciation?

Hypo: A is operating in separate return state M; Sub not in state. M adopts combined reporting and in first year A sells assets of Sub for substantial gain/loss. Can M tax?


RECENT CASES

Tesaro Corporation – AK Supreme Court (2/24)

Comcast CableVision – CA Los Angeles Superior Court (3/14)

Wendy’s International – IL Appellate Court (10/13)

Combs – TX Appellate Court (12/13)


UNITARY PLANNING OPPORTUNITIES

Evaluate unitary position in each state

Consider open years

Evaluate whether more than one unitary group is supportable and beneficial

If partnership interests are held, consider unitary positions in each state

Consider water’s edge elections, where applicable

For newly acquired businesses, consider instant unity positions


UNITARY DECISION TREE

Are activities conducted in a single legal entity?

Consider whether divisions are unitary (most taxpayers concede unity)

MTC: all divisions are unitary (centralized management, likely integrated)

Do activities constitute steps in a vertical process?

MTC reg.: If group explores / develops / extracts / processes / sells natural resource, unity exists even if steps are independently operated

Exxon: U.S. Supreme Court found unity in such structure even without centralized management

Are activities in same general line of business – horizontal integration?

How broadly is "line" defined?


CONTACT INFORMATION

Jordan Goodman Horwood Marcus & Berk Chartered

500 W. Madison Street – Suite 3700 Chicago, IL 60661 (312) 606-3225

[email protected]

mailto:[email protected]

GET A GRIP ON COMBINED REPORTING: A CASE STUDY ON MULTISTATE ISSUES …€¦ · · 2016-08-03GET...

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Transcript of GET A GRIP ON COMBINED REPORTING: A CASE STUDY ON MULTISTATE ISSUES …€¦ · · 2016-08-03GET...