Tax Executive Institute – Omaha
January 2010
Presented by Jean Bartman and Steve Gatton
RSM McGladrey Inc.
RSM McGladrey, Inc. is a member firm of RSM International – an affiliation of separate and independent legal entities.

Jean Bartman
SALT Managing Director
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National economic downturn
Impact on state and local finances
• U.S. has lost 6.9 million jobs since Dec. 2007
• Only 2 states showed increase in economic index since 12/07 (AK &
ND)
• Decline in state taxes in 1 st quarter of 2009 was steepest decline in
46 years (-11.7%)
– Individual income taxes collected down 17.3%
– Corporate income taxes collected down 20%
– Sales taxes collected down 7.6%
– Property taxes collected up 7.2%
• Unlike the federal government, state and local governments can only spend what they collect
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National economic downturn
• Local (city/county) tax reductions yet to come: League of
Cities survey (9/09) expects fall of 0.4% in city general fund revenue in 2009 – lag of 18 to 24 months from start of recession to largest % reductions in local revenue.
• Recession is beginning to affect property and transfer taxes
– League of Cities projects a decrease in property taxes in
2010
• One-time federal aid has cushioned the blow -- $150 billion
(FY09 plus FY10) vs. $20 billion in 2001 recession
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Federal Stimulus Spending -- $ Billions – Flexible funding is essentially spent
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This time is different – Retail sales for 36 months following onset of recession
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The Lag Benchmarks to about 4 years based on other economic crisis
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Tax increases to come: discretionary state tax changes by year of enactment ($ billions)
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National economic downturn
Impact on state and local finances
• Making up deficits through revenue raisers
– Amnesties
– Combined reporting
– Gross receipts / hybrid taxes
– Tougher nexus standards
– Expand sales tax base
– Increased audit activity & enforcement
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National economic downturn
Impact on state and local finances
– Finding a more stable source of business tax revenue
• Corporate income taxes fell 24% in last recession, increased 115% in 5 years, and have fallen more than 20% in this recession
– Taxing all forms of doing business, not just corporations, to broaden the base, lower tax rates, reduce market distortions
– Finding an effective way to tax services and cross-border sales – issues of taxing business inputs and protection of Quill
– Changing perspective from ability-to-pay to benefits-received rationale for business taxes -- issue of low-profit or loss firms
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State Tax amnesty programs
• New York (January 15, 2010 through March 15, 2010)
• Pennsylvania (April 26, 2010 through June 18, 2010)
• Oregon (October 1, 2009 through January 19, 2010) (1 st ever)
• New Mexico (90 day amnesty program slated for early
2010)
• Others that have proposed for 2010
– Virginia, Maine, District of Columbia, Illinois
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Jean Bartman and Steve Gatton
RSM McGladrey
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Mandatory Unitary Combined Reporting
I.
Overview of combined reporting
II.
Why new wave of combined reporting
III.
What it is and What it means
IV.
State specific examples/compliance & administrative burdens
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Overview of combined reporting
• One of the most controversial business tax policy issues currently debated by state legislators, tax administrators, and corporate taxpayers is how a state should determine the corporate income tax base for multistate corporations.
• In effect, combined reporting treats the members of the unitary business as though they were a single company in determining their income. The income of the taxpayer or group is then distributed
(apportioned) by a formula to a specific state.
• States vary widely both on the composition of the combined group and the apportionment formula.
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Overview of combined reporting
Trend: Seven additional states have adopted combined reporting since
2004. Prior to 2004, no state had adopted combined reporting for 20 years.
• States that have recently passed legislation mandating combined reporting:
– Massachusetts (Effective 2009)
– Michigan (Effective 2008)
– Texas (Effective 2008)
– Wisconsin (Effective 2009)
– West Virginia (Effective 2009)
– New Mexico currently considering mandatory combined reporting/currently allowed
– Good time to review “combinable” entities as well as the method for apportioning such
“unitary” income. Using a “consistent” combined group from state to state without a hard scrub of the state rules, may lead to overpayments.
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Overview of combined reporting
• California Commission on the 21 st Century Economy (Sept. 2009)
– Business net receipts tax on all businesses (~4% VAT)
• Reduce and restructure the personal income tax
• Eliminate the corporation tax and the franchise minimum tax
• Eliminate the state general purpose sales tax
• Establish the Business Net Receipts Tax (BNRT)
• Create an independent tax dispute forum
• Small business (Receipts of $500K or less) would be exempt
• Studies proved state would tap into a much broader tax base that sales/use tax
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Comparison of State Marginal Tax Rates
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Why new wave of combined reporting
Generation of revenue
• Michigan, Ohio and Texas* — have adopted some form of mandatory unitary combined reporting recently, but all are in the context of gross receipts or hybrid business taxes
• Various state case studies of estimated increase in annual state revenue range from a 3% increase in corporate income tax revenue
(study conducted in Maryland in 2007) to a 20% increase (study conducted in New Mexico in 2008)
• The only available post-implementation study, conducted by
Minnesota in 1984 using actual tax return information, indicated no
change in state revenue from corporate income tax
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Why new wave of combined reporting
• Elimination of tax avoidance planning: Alternative approaches to combating tax avoidance, such as disallowance of deductions related to intangibles expenses paid to affiliates and imposition of taxing jurisdiction on out-of-state affiliates of in-state taxpayers
(Geoffrey v. South Carolina Tax Commission), such as REIT’s (Wal-
Mart Stores East, Inc., v. Wake County) have proven less successful and are susceptible to sophisticated tax planning
• Sixteen states — AL, AR, CT, DC, GA, IN, KY, MD, MA, MS, NJ,
NC, OH, RI, SC and VA — have adopted statutes requiring taxpayers to add back to income certain expenses paid to related parties
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Why new wave of combined reporting
• Leveling of playing field for corporations doing business wholly within a state
• Advocates of combined reporting believe that true level of
economic activity of a corporation is measured only through combined reporting, without regard to corporate structure
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Why new wave of combined reporting
Arguments against combined reporting requirement
• Improper taxation of extra-territorial income, which creates incentives for multistate corporations not to do business in state thereby impairing economic growth within adopting states
• Onerous administrative burden, particularly with respect to determination of which entities with a corporate group are to be included in and excluded from combined report
• Uncertainty due to lack of needed information on separate filing returns; inability to identify members of the unitary group; absence of information on carryover net operating losses and unused credits; insufficient data to estimate changes in apportionment formulas; and the interaction of combined reporting with addback statutes and other measures previously enacted to address income shifting in many separate filing states.
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Newest state to adopt combined reporting
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Wisconsin
• Effective Date: Tax years beginning on or after January
1, 2009
• Members of Unitary Group to be Included
• Default: All unitary income and apportionment of
domestic members of a commonly controlled group and foreign corporations with more than 20% of property, payroll and sales in the United States must be included
• US source income (as defined by IRC Sections 861-865) of foreign corporations shall be included in the measure of income
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Wisconsin
• Corporations must use combined reporting if three tests are met:
• Test 1: The corporations are part of a commonly
controlled group of corporations
• Test 2: The corporation and at least one other member of the commonly controlled group are engaged in a unitary
business, (unless the group chooses to make a controlled group election)
• Test 3: The corporation meets the "water's edge" test
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Wisconsin
Test 1
• Test 1: The corporations are part of a commonly controlled group of corporations
– Corporations are in a commonly controlled group if:
– There is common ownership (either directly or indirectly) of stock representing more than 50% (was 80%) of the voting power of each corporation in the group, or
– Stock representing more than 50% of the voting power in each corporation are interests that cannot be separately transferred
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Type 1:
Type 2:
Type 3:
Type 4:
Types of Commonly Controlled Groups
Parent-subsidiary chain, based on direct or indirect ownership
Brother-sister corporations with a single common owner, based on direct or indirect ownership
Corporations where stock cannot be separately transferred (“stapled entities”)
Brother-sister corporations owned by, or for the benefit of, family members
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ndirect Ownership of Stock
• The stock attribution rules of section 318 of the Internal Revenue Code are used to determine if indirect ownership exists, with the following
modifications:
– If an entity owns more than 50% of another entity, it is considered to own all of the stock or interests owned by that entity for purposes of determining which entities are in the commonly controlled group
– If a person has an option to acquire stock or interests, the stock or interests are not generally considered owned by the person
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Wisconsin
Test 2
• Test 2: The corporation and at least one other member of the commonly controlled group are engaged in a unitary
business, unless the group chooses to make a controlled group election
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Wisconsin
Test 2
• Entities are presumed to be a unitary business if the entities have unity of
ownership, operation, and use as indicated by the presence of one or more specific factors. These factors include:
• Centralized management;
• Centralized executive force;
• Centralized purchasing, advertising, or accounting;
• Intercorporate sales or leases;
• Intercorporate services, including administrative, employee benefits, human resources, legal, financial, or cash management services;
• Intercorporate debts;
• Intercorporate use of proprietary materials;
• Interlocking directorates or corporate officers.
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Wisconsin
Test 2
• From the State’s view if the answer is “yes” to either of the questions below, the participants in the commonly owned enterprise are engaged in a unitary business:
• Is there sharing, exchange, or flow of value within the commonly owned enterprise?
• Is there unity of operation and use in the commonly owned enterprise?
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Controlled Group Election
• A commonly controlled group of corporations can make an election to treat the entire commonly controlled group as if it is in the
same unitary business, regardless of whether any of the factors mentioned above exist. The election is binding for ten years.
• Election executed by the designated agent on an original, timely filed report
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Controlled Group Election
• Eliminates need to determine who is unitary
• Make the election by “checking the box” on Form 4R and submitting statement with the return that indicates each corporation has agreed to be bound by the election
• Election is binding for ten year period, including the year of election
• Applies to any corporations that subsequently enter the commonly controlled group during the ten year period
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Wisconsin
Test 3
• Test 3: The corporation meets the "water's edge" test
• The "water's edge" test determines whether a foreign corporation is includable in a combined report
• The water's edge test also determines whether any of a domestic corporation's foreign-source income is includable in the combined report
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Wisconsin
Test 3
• Test 3: The corporation meets the "water's edge" test
• A corporation meets the water's edge test if less than 80% of its worldwide income is "active foreign business income" as defined in section 861of the Internal Revenue Code
• "Active foreign business income" is income which is:
– Derived from non-U.S. sources, and
– Attributable to the active conduct of a trade or business by a corporation (or its subsidiary) in a foreign country or possession of the
U.S.
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Wisconsin
Test 3: Criteria
Criteria One: Whether the corporation is foreign or domestic
Criteria Two: Whether the corporation is an “80/20 corporation”
Criteria Three: Sourcing of the corporation’s income as either foreign source or U.S. source
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Wisconsin
Test 3: Criteria One
• Whether the corporation is foreign or domestic
• Generally based on where the corporation was incorporated or organized
• If an entity is organized in a foreign country and is recognized in that country as a corporation, but the entity’s owner elects to treat it as a branch or disregarded entity for U.S. purposes, then it is treated as a branch of its owner rather than a separate foreign corporation
• A foreign corporation that is also an “80/20” corporation is considered domestic if it elects to be included in a federal consolidated return
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Wisconsin
Test 3: Criteria Two
• “80/20” Status of Corporation
• A corporation is considered an “80/20 corporation” if 80% or more of its worldwide gross income during its taxable year is “active foreign business income” as defined in section 861(c)(1)(B) of the
Internal Revenue Code
• A disregarded entity’s active foreign business income and worldwide income must be combined with those of its owner
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(Assumes Test 1 and Test 2 are already met)
Is it an “80/20” corporation?
Not “80/20” “80/20”
Domestic
Corporation
Foreign
Corporation
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Wisconsin
Test 3: Criteria Three
• Sourcing of the corporation’s income as either foreign source or U.S. source
• Foreign source” vs. “U.S. source” is determined by sections 861 –
865 of the Internal Revenue Code
• All income that is “effectively connected” with conducting a trade or business within the U.S. is considered U.S. source
– “Effectively connected income” can still be “active foreign business income” for purposes of the 80/20 test, to the extent not inconsistent with
Internal Revenue Code
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Not “80/20”
What’s “in”:
Domestic
Corporation U.S. source items
Foreign source items
“80/20”
What’s “in”:
Only items that are both:
U.S. source*, and
Specifically listed in
71.255(2)(d)
Foreign
Corporation
What’s “in”:
U.S. source* items only (All items excluded)
*U.S. source items include all effectively connected income
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• For combined group members, items excluded from the combined items under the water’s edge test must still be reported to Wisconsin if they have a Wisconsin situs
– These items are called “separate entity items”
• If a corporation’s income is not taxable for federal purposes under the provisions of a federal treaty, it is not taxable for Wisconsin purposes and is not includable in the combined items
– Related expenses and apportionment factors must also be excluded
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Wisconsin Final Points
Add back Modifications
• Required in cases where an expense subject to addback is included in combined unitary income but the corresponding income is or was not included in the group’s combined unitary income, such as:
– An expense paid to a related entity that is not a combined group member
– An expense paid to a combined group member that excluded the corresponding income from the combined items under the water’s edge rules
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Wisconsin Final Points
Expenses Subject to Addback
• Interest expenses
• Rent expenses
• Intangible expenses
• Management fees
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Wisconsin Final Points
Finnigan/Joyce:
• Wisconsin adopted a Finnigan approach Section 71.255(5)(a)8 states “For purposes of determining the numerator of the modified sales factor or any apportionment factor or factors…
• a taxpayer is considered to be within the jurisdiction for income or franchise tax purposes of any state in which any member of its combined group is within the jurisdiction for income or franchise tax purposes
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Steve Gatton, SALT Director
RSM McGladrey, Inc. – Des Moines, Iowa
• Texas Gross Margins update
• Michigan MBT update
• Market-based Sourcing
• Questions
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Texas Gross Margins Update
• Legislature meets every two years
• Recent developments:
– Austin Court of Appeals
– Unclaimed property
– Comptroller’s Monthly Policy Note
• Recently adopted rules
• Contract manufacturing
• Compensation & conversions
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Michigan MBT Update
• Budget scenario
• MBT basics
• FAS 109 deduction
• Expansion of credits
• MTC apportionment opportunity
• Kmart SBT case
• Associated Press royalty issue – Mich. Appeals Ct.
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Market-Based Sourcing
• The Basics
– UDIPTA
– Services v. TPP
– Cost of Performance
• Iowa
• Illinois
• Wisconsin
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