special issues in apportionment and allocation

149 Pages·2015·0.53 MB·English

S I A A
PECIAL SSUES IN PPORTIONMENT AND LLOCATION

Council on State Taxation
2015 Advanced Income Tax School
May 19, 2015
Atlanta, Georgia

John F. Fletcher
Jones Walker LLP
190 E. Capitol St., Suite 800
Jackson, Mississippi 39201
Telephone: [phone]
E-Mail: [email protected]

Catherine A. Battin
McDermott Will & Emery LLP
227 W. Monroe St.Chicago, IL 60606
Telephone: [phone]
E-Mail: [email protected]

Lindsay M. LaCava
McDermott Will & Emery LLP
340 Madison Avenue
New York, NY 10017
Telephone: [phone]
E-Mail: [email protected]

DM_US 51832917-3.T10533.0010
TABLE OF CONTENTS

I. Introduction ............................................................................................................................. 1
A. The Perplexing Problem ...................................................................................................... 1
B. Allocation, Apportionment and Separate Accounting ........................................................ 2
II. UDITPA Approach to Dividing the Income Tax Base ........................................................... 6
A. General ................................................................................................................................ 6
B. Business versus Non-business Income ............................................................................... 7
C. Business versus Non-business Expenses .......................................................................... 49
III. Allocation of Non-Business Income ................................................................................. 49
A. General .............................................................................................................................. 49
B. Allocation of Non-business Income under UDITPA ........................................................ 49
IV. Apportionment of Business Income under UDITPA ........................................................ 50
A. General .............................................................................................................................. 50
B. States’ Reliance on the Sales Factor ................................................................................. 51
C. Property Factor .................................................................................................................. 55
D. Payroll Factor .................................................................................................................... 66
E. Sales Factor ....................................................................................................................... 71
F. Alternative Formulae for Certain Businesses ................................................................. 122
G. Equitable Relief under UDITPA § 18 ............................................................................. 126
V. Constitutional Limitations on Apportionment of Income from Intangible Property .......... 141
A. Overview ......................................................................................................................... 141
B. Operational versus Investment Income ........................................................................... 141
C. Relevant Cases ................................................................................................................ 141
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DM_US 51832917-3.T10533.0010
SPECIAL ISSUES IN APPORTIONMENT AND ALLOCATION
I. INTRODUCTION
A. THE PERPLEXING PROBLEM
1. General
a. Dividing the tax base of a multistate enterprise is perhaps one of the most
perplexing problems facing state and local tax practitioners.
b. The “perplexing problem” presents itself in situations where a taxpayer
owns property, earns income or derives receipts in more than one state and
is subject to the jurisdiction of the various states in which it owns property,
earns income or derives receipts.
c. It is not a simple task to divide the tax base of a multistate enterprise. For
example, it may not be an easy task to determine the precise location of the
property, income or receipts that may be subject to taxation in the various
states. It might be easy to determine the situs of real property, but perhaps
not mobile property that moves from state to state. Similarly, some
revenue-generating services might be performed in one state, but in the
current business environment that is dominated by advanced technology,
telecommunications, data processing, internet business and information
storage, sharing and retrieval, it often is difficult to determine a precise
location of such services, which may take place in many different states.
Even a sale of tangible personal property might be difficult to “locate.”
Although it would be easy to source a sale of tangible personal property to
the destination state, it also could be sourced to the state where the seller
accepted the order, the state from which the property was shipped, or the
state where the contract for the sale was negotiated.
d. Even if we could easily determine a situs for property, income, or receipts,
allocation of the property, income, or receipts to a single state might not
result in a fair representation of how the enterprise earns its income. It
might be more appropriate to spread the value of the property, the income,
or the receipts among several states in which the enterprise operates.
e. Over the years, states have adopted various approaches to dividing the
income tax base among states in which a multistate enterprise operates.
Although states have enjoyed a large degree of flexibility in their
approaches for dividing the tax base of a multistate enterprise, any approach
ultimately is subject to the limitations imposed by the Due Process and
Commerce Clauses of the United States Constitution. These limitations
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operate to insure that no state taxes more than its fair share of a taxpayer’s
property, income or receipts.
f. In order to make sound decisions regarding the reporting of property,
income and receipts of a multistate enterprise, it is necessary for the
practitioner to understand state statutes and regulations addressing the
division of the tax base of a multistate enterprise, the federal constitutional
limitations on states’ methods, and the interplay of the two. The following
materials are designed to give the practitioner the tools to undertake this
analysis.
B. ALLOCATION, APPORTIONMENT AND SEPARATE ACCOUNTING
1. General
a. There are three generally-recognized and distinct methods that states utilize
to divide the tax base of a multistate enterprise - allocation, apportionment,
and separate accounting.
b. The terms “allocation” and “apportionment” sometimes are used
interchangeably. In addition, the terms “allocation” or “specific allocation”
are used to refer to a non-formulary method for specifically attributing
items of income to a specific state or states.
c. For purposes of these materials, the term “allocation” will be used to refer
to the attribution of a particular type of property, income, or receipt to a
particular state. The term “apportionment” will be used to refer to the
division of the tax base by formula. This terminology generally is
consistent with the Uniform Division of Income for Tax Purposes Act
(“UDITPA”)1 and most state income tax laws, many of which have adopted
UDITPA either in whole or in part.
2. Allocation
a. Allocation of income is an attempt to trace property, income or receipts to a
source state and to include the entire value of the property, amount of
income or amount of receipts in the tax base for the source state. This
tracing method could apply to all of a taxpayer’s income or to specific items
or classes of property, income or receipts.

1 In 1957, the National Conference of Commissioners on Uniform State Laws drafted, and in 1958 approved, the Uniform
Division of Income for Tax Purposes Act. Since that time, 23 of the 46 states (including the District of Columbia) have
adopted UDITPA in some form.
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b. Most states do not use the allocation method as an overall method for
dividing the tax base of a multistate enterprise. Some states, however, still
allocate certain items of income or receipts. For example, some states limit
the allocation of net income to rents and royalties from real estate and
tangible personal property (including oil and mineral royalties) located in
the state, to patent and copyright royalties to the extent of use in the state, to
certain dividends and interest, to certain capital gains and losses and to
compensation for certain services. In such states, dividends and interest
might be allocated to the business situs of the stock or security that
produced the dividends or interest if such stock or securities were used in
such a manner that they acquired a business situs. In the absence of a
business situs, the income would be allocated to the commercial domicile of
the taxpayer. In those states that allocate certain specific items or classes of
income, all other income would be subject to formulary apportionment.
c. UDITPA and similar statutes, which dominate the state tax field, take a very
narrow approach to the treatment of certain items of income as allocable
income. In these states, rents and royalties from real and tangible personal
property, capital gains, interest, dividends, and patent and copyright
royalties are treated as allocable income only to the extent they constitute
non-business income.2 Otherwise, such income, along with all other
income, is apportioned by formula.
d. A few states (e.g., Maryland and Vermont) do not recognize allocation at
all. In these states, all income theoretically is subject to apportionment. As
discussed later in this outline, such statutes may be subject to constitutional
attack.
e. The UDITPA standards for specifically allocating non-business income are
in many respects similar to how states that do not follow UDITPA might
allocate specific items of income. The UDITPA provisions for allocating
items of non-business income are discussed in detail in Section III, below.
3. Apportionment
a. Because of the inherent problems that arise with attempts to specifically
allocate property, income or receipts to a specific state, most states use
some form of formulary apportionment to divide the tax base of a multistate
enterprise.

2 The concept of non-business income is discussed in detail in Section II.B of this outline.
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b. The underlying theory of this method is that certain factors of a business
enterprise can be used to fairly determine the measure of tax in a particular
state.
c. Although states use various formulae for apportioning the tax base, the most
widely used formula for income tax purposes is the so-called
“Massachusetts” formula, which utilizes three factors: property, payroll
and sales. These three factors are viewed as a rough approximation of how
many businesses earn their income.
d. Historically, each of the three factors was evenly weighted. More recently,
many states have began double-weighting the sales factor. Some states put
even more weight on the sales factor while others may use a single sales
factor. Still other states may vary the factors for specific businesses.
4. Separate Accounting
a. The separate accounting method generally is limited to income taxes, as
opposed to property taxes, capital stock taxes, etc.
b. This method attempts to treat the taxpayer’s in-state business activities
separately from its out-of-state activities and to compute the taxpayer’s
income as if the in-state, income-producing activity were confined solely to
the taxing state.
c. In the early days of state income taxes, separate accounting was prevalent in
many states. It was permitted so long as the taxpayer maintained separate,
geographical accounting records that enabled it to determine its net income
with reasonable accuracy.
d. Because of the imprecise nature of separate accounting in the context of a
unitary business, its use has diminished greatly over the years. In Mobil Oil
Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980), the U.S. Supreme
Court noted that the essential problem with separate accounting is that
“separate accounting, while it purports to isolate portions of income
received in various States, may fail to account for contributions to income
resulting from functional integration, centralization of management, and
economies of scale.”
5. Approaches to the Division of the Income Tax Base
a. States’ approaches to dividing the tax base for income tax purposes have in
large part been shaped by constitutional limitations. The two constitutional
restraints that bear heavily on the division of the income tax base are the
unitary business principle (discussed in Section V, below) and the fair
apportionment requirement of the Commerce Clause. The unitary business
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principle can be seen in the way states classify income as either allocable or
apportionable. The fair apportionment requirement is reflected in the
formulas that states use to divide apportionable income among the various
states that have a right to tax such apportionable income.
b. The majority of states that impose income taxes have adopted all or parts of
the UDITPA in one form or another to attempt to confine their income taxes
to income derived form a taxpayer’s activities in the taxing state. UDITPA
and similar statutes operate to divide a taxpayer’s tax base among the states
in which the taxpayer is taxable. These statutes are not all the same. A
practitioner must exercise caution when determining how a particular state
allocates and apportions income and must always be aware of potential
modifications to the basic UDITPA statutes.
c. Because UDITPA has become so prevalent in the state income tax field, this
outline will discuss the allocation and apportionment of income of a
multistate business in the context of UDITPA.
d. NOTE: In early 2008, the National Conference of Commissioners on
Uniform State Laws (“NCCUSL”), now called the Uniform Law
Commission (“ULC”), announced that it intended to rewrite UDITPA.
After a very lively debate among businesses and their organizations, tax
administrators and their organizations and state legislators and their
organizations, NCCUSL changed the “rewrite” committee to a “Study
Committee.” Some of the topics considered by the Study Committee
included: (i) the definition of business income; (ii) the requirements for
apportioning income; (iii) the allocation of non-business income; (iv)
appropriate weighting of the three factors; (v) the definition of sales; (vi)
the location of a sale of tangible personal property; (vii) the location of a
sale of other than tangible personal property; (viii) authority for alternative
apportionment; (ix) extension of UDITPA to partnerships and LLCs that are
subject to income tax and determination of how corporate entities should be
taxed on business income from partnerships; (x) adoption of mandatory
combined reporting provisions; and (xi) various procedural issues.
NCCUSL ultimately ended their revision efforts on July 21, 2009, when the
Study Committee was discharged. This decision seems to have been due to
the more recent focus by states on economic development and incentives
(resulting in, for example, the increased adoption of single-sales factor
apportionment by states), rather than on pure uniformity. NCCUSL has
noted that no subsequent drafting committee would be established.
On December, 6, 2012, the Multistate Tax Commission approved for public
hearing recommended amendments to Article IV of the Multistate Tax
Compact, which contains UDITPA. The MTC’s proposed amendments to
Article IV of the Multistate Tax Compact would: (i) broaden the definition
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and scope of business income to all income that is apportionable under the
U.S. Constitution; (ii) move from cost-of-performance to market-based
sourcing for services and intangibles; (iii) narrow the definition of “sales”
to exclude hedging transactions and treasury receipts from the sales factor;
(iv) give states the option to choose their own factor weighting, but include
a recommendation that states double-weight the sales factor; and (v) revise
the distortion relief provision to allow states to adopt alternative
apportionment rules for taxpayers involved in a particular industry,
transaction, or activity. Public hearings on the proposed amendments were
held in 2013 and the Hearing Officer, Professor Richard Pomp, submitted a
detailed report on October 25, 2013 with comments and recommendations.
Member states of the MTC voted to adopt proposed amendments to Article
IV of the Multistate Tax Compact during their annual meeting in late July
2014. The MTC’s recommended market approach provides that sales of
services and intangibles “are in [the] State if the taxpayer’s market for the
sales is in [the] state.” In the case of services, a taxpayer’s market for sales
is in the state “if and to the extent the service is delivered to a location in
the state.” The proposed amendments also provide that if the state of
delivery cannot be determined, taxpayers are permitted to use a reasonable
approximation. At this point, there is no final guidance from the MTC on
the meaning of “delivered,” how to determine the location of delivery in the
event that a service is delivered to multiple jurisdictions, or what constitutes
a reasonable approximation. However, the MTC is in the process of
drafting a regulation that will address those issues.

II. UDITPA APPROACH TO DIVIDING THE INCOME TAX BASE
A. GENERAL
1. This outline focuses on issues involving the allocation and apportionment of a
taxpayer’s income tax base.
2. Discussions of the computation of a taxpayer’s state income tax base and return-
filing methods are beyond the scope of this outline and are covered in other
sessions at the Council on State Taxation (“COST”) Advanced Income Tax School.
3. As a general matter, however, the process of dividing the tax base of a multistate
taxpayer usually begins with the taxpayer’s federal taxable income. Often, there
are specific statutory adjustments that are made to the taxpayer’s federal taxable
income. After making the specific adjustments, the state statutes generally require
that specific categories of income be allocated to a single state or, occasionally, to
several states. The balance, if any, of the taxpayer’s income after “carving out” the
allocable income, is apportioned among the states by formula.
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4. Under UDITPA, whether income is treated as allocable income or apportionable
income generally depends upon whether the income is business income or non-
business income. Business income is apportioned; non-business income is
allocated. Thus, the distinction between business and non-business income is
critical in states that follow UDITPA in whole or in part and is a logical starting
point for analyzing the allocation and apportionment of income.
B. BUSINESS VERSUS NON-BUSINESS INCOME
1. General
a. To determine a state’s share of a corporation’s total net income, the
corporation’s net income must be either allocated to a particular state or
apportioned among the states in which the corporation does business.
Whether income is subject to allocation or apportionment depends, in most
states, on the classification of income as either business income or non-
business income.
b. In states that apply the business/non-business analysis, income classified as
business income is subject to formulary apportionment among the various
taxing states while income classified as non-business income is subject to
specific allocation to a single taxing state under various principles discussed
below.
2. UDITPA Definitions
a. “Business income” means income arising from transactions and activity in
the regular course of the taxpayer’s trade or business and includes income
from tangible and intangible property if the acquisition, management, and
disposition of the property constitute integral parts of the taxpayer’s regular
trade or business operations. UDITPA §1(a).
b. “Non-business income” means all income other than business income.
UDITPA §1(e).
c. The regulations adopted by the Multistate Tax Commission (the “MTC”),
the administrative agency of the Multistate Tax Compact, which embodies
the UDITPA, that relate to the classification of income either as business
income or non-business income (Reg. IV.1.(a)) were amended by the MTC
on August 1, 2003, to effectively broaden the scope of the term “business
income.”
(1) Under the MTC’s traditional construction of UDITPA, there is a
presumption in favor of apportioning income. Recent amendments
to the MTC regulations continue the expansive definition of
“business income.”
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(2) The amended regulation provides in general as follows: (1) the
business income definition has both a transactional and a functional
test (Reg. IV.1.(a).(2)); (2) under the functional test, income from
isolated transactions, including a business liquidation, constitutes
business income if the property is or was used in the taxpayer’s trade
or business operations (Reg. IV.1.(a).(5)(B)); (3) property converted
from business use for a significant period of time does not generate
business income (Reg. IV.1.(a).(5)(A)); (4) income from an
intangible asset is analyzed under the operational vs. investment
function test (Reg. IV.1.(a).(5)(C)); (5) property is an integral part of
a taxpayer’s trade or business if it constitutes part of the composite
whole of the trade or business, each part of which gave value to
every other part, in a manner which materially contributes to the
production of business income (Reg. IV.1.(a).(5)); and (6) there is a
presumption that income is business income if the taxpayer has
taken deductions associated with the property or included the
property in the property factor (Reg. IV.1.(a).(5)(E)). The
relationship of the transactional and functional tests to the U.S.
Constitution, as seen through eyes of the MTC, is explained in Reg.
IV.1.(a).(6).
(3) As discussed below, courts have not always accepted the MTC’s
expansive view of the definition of “business income.”
3. UDITPA’s Test (or Tests) for Determining Business Income
a. The Oft-Debated Issue
(1) Courts have divided over whether UDITPA’s definition of business
income has one test or two tests for resolving whether income is
business income. The tests generally are referred to as the
“transactional test” and the “functional test.”
(2) Some courts have construed UDITPA’s business income definition
as establishing only one test - a transactional test. These courts
generally have concluded that gain from the sale of assets, even if
used in the business, does not constitute business income if the
transaction that generated the gain does not arise in the regular
course of the taxpayer’s trade or business. Thus, under the
transactional test, income from unusual or extraordinary transactions
generally is treated as allocable income rather than apportionable
income. See, e.g., In re Kimberly Clark Corp. and Kimberly-Clark
Worldwide, Inc. v. Alabama Dept. of Revenue, 69 So. 3d 144 (Al.
2010).
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