Omaha, NE – Tax Executives Institute Baker & McKenzie Consulting LLC provides tax advisory and...

Omaha, NE – Tax Executives Institute

Baker & McKenzie Consulting LLC provides tax advisory and economic services and does not provide legal advice or services. Baker & McKenzie LLC is a subsidiary of Baker & McKenzie LLP, a member firm of Baker & McKenzie International, a Swiss Verein of member law firms around the world. In accordance with the common terminology used in professional service organizations, reference within the organization to a “partner” means a person who is a partner, or equivalent, in a member firm or its affiliate. Similarly, reference to an “office” means an office of the member firm or affiliate.

State Income Tax Update

January 20, 2008

J. Pat [email protected](650) 856-5526

John [email protected](212) 626-4232


©2009 Baker & McKenzie 2

Topics• California Update

• Massachusetts Update

• Related Party Transactions



California Update



California Update• Recent Legislation

• Dividends Received Deduction

• LLC Tax

• Treasury Receipts and Apportionment

• Hyatt Case – Audit Practices

• Sales/Use Tax Developments

• Budget Woes



Recent Legislation• Net Operating Losses

• Substantial Understatement Penalty

• Estimated Tax Payment



Net Operating Losses

• Utilization Suspended for Tax Years Beginning in 2008-2009– Carryforward Period Extended

• For Losses in Years Beginning After January 1, 2008, Loss Carryforward Extended to 20 Years

• For Losses Incurred After January 1, 2011, Carryback For Two Years

• Loss Carryovers Based on Specific Entity, Not Group Basis

• Compare New Credit Carryforward Provisions



20% Substantial Understatement Penalty• For Understatement of $1 Million Determined on

Combined Group Basis– Automatic

– No-fault

– Applies to Years Beginning After January 1, 2003• Payment Before May 31, 2009 Relieves Penalty

– Taxpayer Dilemma

SFOIMAGE



Estimated Tax Payment• Amounts of Estimated Payments Increased for

Both Corporations and Individuals



Dividends Received Deduction (DRD)

• Dividends From Controlled Foreign Corporations– California Rev. & Tax. Code § 25106: Eliminate

Dividends From Income Included in Combined Report

– Background: Amdahl/Fujitsu Case (2004) Followed IRC § 959 on Previously Taxed Income

• Franchise Tax Board (FTB) Amended Regulation

• FTB and Board of Equalization Claimed That They Are Not Bound by Court of Appeal Decision in Amdahl/Fujitsu

• Apple Computer: Current Status



Dividends From Unrelated Corporations

• Aftermath of Farmer Brothers

• Statutory Background– Rev. & Tax. Code § 24402: DRD for Dividends

Declared From Income Included in the Measure of Tax

• Farmer Brothers Struck Down Discrimination

• Abbott Laboratories Case– Is Discriminatory Provision Eliminated?

OR

– Is Entire Statute Gone?



LLC Tax• As Originally Enacted, LLC “Fee” Was Based

On Gross Receipts Everywhere (Without Apportionment)

• LLC Tax Was Held To Violate Commerce Clause– Northwest Energetic

• FTB Pays Refunds to LLCs With No Receipts Apportioned to California

• Legislature Enacts Bill Apportioning Receipts, Purportedly On Retroactive Basis



LLC Tax• Ventas Finance 1 LLC (2008): Court Limited

Refund As If Statute Provided Apportionment Formula



Treasury Receipts And Apportionment

• In Microsoft, California Supreme Court Held That Gross Receipts Go Into Sales Factor, But Excluded Them As Distortive Under Rev. & Tax. Code § 25137.

• FTB Amended Reg. § 25137 to Exclude Treasury Receipts From Sales Factor Beginning after January 1, 2007.



Hyatt Case – Audit Practices• Hyatt v. FTB

– Las Vegas Jury Awarded Gilbert Hyatt $388 Million in Damages for Emotional Distress and Invasion of Privacy ($138 Million Compensatory and $250 Million Punitive)

– U.S. Supreme Court Ruled That Plaintiff Could Maintain Suit in Nevada Despite California Law Immunizing FTB From Tort Liability

– Abusive Audit Grew Out of Dispute as to When Mr. Hyatt Ceased to be California Resident



Sales/Use Tax Developments• Dell Computer

• Patton Music



Budget Woes• September 19, 2008 Budget Passed: Three

Months Late

• Budget Trailer Bills Enacted Without Adequate Review or Public Input

• Illusion of “Balanced Budget” Vanished Quickly

• Current: Deficit Projected Over Next 18 Months $42 Billion

• Political Problem Leading to Fiscal Disaster



Massachusetts Update



Overview• House Bill 4904 signed into law on July 3, 2008.

– Conformity to Federal Entity Classification Rules

– Combined Reporting Requirement• Shift from separate reporting jurisdiction to combined

reporting for unitary affiliates.

– Change in Public Law 86-272 Position

– Tax Rate Reductions

– Effective for tax years beginning on or after January 1, 2009.



Entity Classification• As of 1/1/09, Massachusetts generally adopts

the federal “check-the-box” rules for entity classification.– Corrects historical disparity for Massachusetts

business trusts, S-corporation subsidiaries (QSubs), and certain partnerships

– Eliminates rules historically applicable to the taxation of Massachusetts business trusts

– Reclassifies non-conforming entities as of 1/1/09



Reclassification Guidelines • Change from Partnership to Corporation

– Partnership deemed to contribute all its assets and liabilities to a new corporation.

– Then, partnership is deemed to liquidate and distribute the stock of the corporation to its partners.

• Change from Corporation to Partnership– Corporation deemed to liquidate and make

distribution to its shareholders.• Massachusetts gain may exist upon liquidation,

despite being a federal non-event.– Then, the shareholders are deemed to contribute

those assets and liabilities to the new partnership.



Reclassification Guidelines

• Change from Corporate Trust to Corporation– Treated generally as a tax-free reorganization.

• Shareholders’ basis in stock shares is the same as in the former trust, except for a reduction for all “tax-free” earnings and profits of the former corporate trust that have not been previously taxed to the former trust or the shareholders.

• Change from Corporate Trust to Partnership– Treated as a tax-free reorganization.

• All “tax-free” earnings and profits of the former corporate trust must be taxable as dividend income to partners on first return after conversion.



Reclassification Guidelines

• Change from Corporation to Disregarded Entity– Corporation deemed to liquidate and distribute all assets and

liabilities to shareholder.

– Massachusetts gain may exist upon liquidation, despite being a federal non-event.

• Change from Corporate Trust to Disregarded Entity– Corporate trust deemed to have liquidated.

– Generally no recognition of gain or loss; however, tax-free earnings and profits of the former trust must be recognized as taxable dividend income to the owner.



Combined Reporting – Composition of Combined Group

• Unitary Business Principle– The term “unitary business” shall mean the activities of a group

of 2 or more corporations

• Under common ownership (50%)

• Sufficiently interdependent, integrated or interrelated through their activities so as to provide mutual benefit

• Producing a significant sharing or exchange of value among them or a significant flow of value between the separate parts.

– The term “unitary business” shall be construed to the broadest extent permitted under the United States Constitution.




• Corporations – Group includes C corporations, S corporations, utility

corporations, financial institutions, REITs, RICs, and certain captive insurance companies.

• Security corporations, non-profits, and insurance companies will generally not be included.

• Partnerships– Any business conducted by a partnership will be treated as the

business of the partners.

• To the extent of the partner’s distributive share of the partnership’s income




• “Water’s edge” reporting required unless an election is made to the contrary.

• “Water’s edge” report includes:– Corporations incorporated in the U.S.;

– Corporations incorporated outside the U.S., if the average of the property, payroll, and sales factors within the U.S. is 20 percent or more; and

– Corporations that earn “more than 20 percent of its income, directly or indirectly, from intangible property or service-related activities, the costs of which generally are deductible for federal income tax purposes,… but only to the extent of that income and the apportionment factors related thereto.”



Combined Reporting – Alternatives to Water’s Edge Reporting• Worldwide Election

– Includes all corporations in the unitary group

• Affiliated Group Election– “Limits” the combined group to the federal affiliated group as

defined in IRC 1504, except it:• Includes corporations regardless of place of incorporation• Uses a 50% voting common ownership threshold (rather

than 80% vote and value)• Measures common ownership using the water’s edge group

– Group income is apportionable; no allocable income.

• Elections cannot be in effect simultaneously – Elections must be made on a timely-filed, original return– Binding for 10 years



Combined Reporting - Mechanics

• Calculation of Group Tax Base– To be addressed in regulations:

• Elimination of intercompany transactions

• Treatment of net operating losses and credits

• Addback rules

– Working Draft of 830 CMR 63.32B.1 was issued for public comment on 11/6/2008



Apportionment Mechanics• Apportionment Methodology

– Each member required to use its applicable apportionment formula

• Consider formulas applicable to general corporations, manufacturing corporations, financial institutions.

– Sales of non-taxable members attributed to taxable members

• Sales of non-taxable members attributed by ratio of taxable member Massachusetts sales to total Massachusetts sales of all taxable members.

– Sales factor uses a Finnigan approach

• Taxable member sales not subject to throwback where any group member has nexus with destination state.



FAS 109 Deduction

• For any increase in a “net deferred tax liability” as a result of combined reporting

• Pro-rated over seven years starting in 2012

• Only available for public companies

• Must file statement with DOR by July 1, 2009, specifying the total amount of the deduction to be claimed



Public Law 86-272• P.L. 86-272 generally prohibits states from

imposing income tax on entities whose business in the state is limited to the solicitation of sales of tangible personal property.

• As of 1/1/09, P.L. 86-272 does not protect taxpayers from the non-income measure of the Massachusetts corporate excise.– Massachusetts historically took the position that this

protection extended to the non-income measure of the corporate excise.



Rate Reduction• Corporate excise rate (Net income measure) of

9.5% applicable to business corporations (other than S corporations) will be gradually reduced over three years to 8.0%.

• Financial institution excise rate of 10.5% will be gradually reduced over three years to 9.0%.



Related Party Transactions



Related Party Transactions• Combined/Unitary Reporting

• Statutory Intercompany Expense Add Backs

• Economic Nexus



Combined/Unitary Reporting• Massachusetts: Effective January 1, 2009

• West Virginia: Effective January 1, 2009

• New York: Effective January 1, 2007

• Vermont: Effective January 1, 2008



Statutory Intercompany Expense Add Backs• Alabama: VFJ Ventures, Inc. and Statutory

Change

• Ohio: Family Dollar Stores of Ohio

• Tennessee: Disclosure Statement and 50% Penalties



Statutory Intercompany Expense Add Backs• Michigan

• Minnesota

• Rhode Island

• Wisconsin



Adjustments to Economic Nexus• U.S. Supreme Court Developments

– West Virginia: MBNA American Bank, cert., Petition Denied

– New Jersey: Lanco, Inc., cert., Petition Denied

• Where Do We Go From Here?



Adjustments to Economic Nexus• Louisiana: Geoffrey

• Maryland: Chicago Classics

• Alabama: Graduate Supply House

• New Jersey: Praxair

• Massachusetts: Capital One; Geoffrey

• New York: “Amazon” Law



Adjustments to Formulary Apportionment• Trend Towards Single Sales Factor

• Sourcing Service Revenue: Cost Of Performance Versus Market-Based Sourcing

• Throw-Out Rule: New Jersey– Status Of Litigation

– Repealed July 1, 2010



Other Developments• “Captive” REITS

– North Carolina: Wal-Mart Stores

– Massachusetts: Fleet Funding

• Disallowance of Dividends Paid Deductions

• Business/Non Business Income– MeadWestvaco v. Illinois

• Davis v. Kentucky– Sequel to Cuno v. DaimlerChrysler

– Implications for State Credits

Omaha, NE – Tax Executives Institute

Baker & McKenzie Consulting LLC provides tax advisory and economic services and does not provide legal advice or services. Baker & McKenzie LLC is a subsidiary of Baker & McKenzie LLP, a member firm of Baker & McKenzie International, a Swiss Verein of member law firms around the world. In accordance with the common terminology used in professional service organizations, reference within the organization to a “partner” means a person who is a partner, or equivalent, in a member firm or its affiliate. Similarly, reference to an “office” means an office of the member firm or affiliate.


January 20, 2008

J. Pat [email protected](650) 856-5526

John [email protected](212) 626-4232

Omaha, NE – Tax Executives Institute Baker & McKenzie Consulting LLC provides tax advisory and...

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