California as a Backdrop for Recent State Tax Developments

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recent California income and franchise tax developments and how those developments compare and contrast with income and franchise tax laws in other states.

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California as a Backdrop for Recent State Tax Developments

  1. 1. California as a Backdrop for Recent State Tax Developments Presented by Todd Harke, CPA Managing Director, National State and Local Tax Practice Brian McCuller, JD, CPA Managing Director, National State and Local Tax Practice
  2. 2. Agenda • Factor Presence Nexus • Market-Based Sourcing • Single Factor and Gillette • Incentives
  3. 3. Factor Presence Nexus No physical presence required – A lot of our clients sell products across state lines, and many of these businesses reach their customers through the internet. – Selling over the internet tends to mean that these businesses only establish a “physical presence” in one or two states, even though they may have customers in all 50 states. – Increasingly, the National SALT Practice fields calls from clients who are shocked to discover that they are subject to income tax in states where they have “economic nexus” but no physical presence.
  4. 4. Factor Presence Nexus Post-Quill in general – States have successfully argued Quill only applies to sales and use taxes o Sales and use tax – Some physical representation in state – Taxpayer or affiliate – Agent or representative o All other taxes, such as income/franchise taxes and business activity taxes – No physical presence required – Presence of intangibles – Stream of commerce
  5. 5. Factor Presence Nexus Multistate Tax Commission (“MTC”) – The MTC first developed the idea of factor presence in 2002. – The standard was meant to be a simple, certain and equitable standard for the collection of taxes. – In the MTC’s version of factor presence, substantial nexus is established if any of the following thresholds is exceeded during the tax period: $50,000 of property; $50,000 of payroll; or $500,000 of sales.
  6. 6. Factor Presence Nexus California – Effective Jan. 1, 2011, California adopted the MTC’s factor presence nexus thresholds for the state's income and franchise tax. • $500,000 of receipts, or $50,000 of property or payroll, or Greater than 25% of total receipts, payroll, or property – While California was not an early adopter of factor presence nexus, it is one of the few states with an income based tax that adopted these rules.
  7. 7. Factor Presence Nexus Similar States with Income Based Taxes – Connecticut: Effective Jan. 1, 2010, as part of the state's economic nexus standard, Connecticut imposed nexus upon any taxpayer with receipts from Connecticut-sourced business activities that exceed the bright-line test of $500,000. – Colorado: Effective April 30, 2010, Colorado adopted the MTC‘s factor presence nexus thresholds for the state's income tax. – Michigan: Effective Jan. 1, 2012, Michigan has repealed the MBT and instituted a corporate income tax (CIT). Substantial nexus for CIT purposes occurs when (1) a taxpayer has physical presence in Michigan for more than one day, or (2) a taxpayer actively solicits sales in Michigan and has $350,000 or more of gross receipts attributable to Michigan.
  8. 8. Factor Presence Nexus Interstate Income Act of 1959 – P.L. 86-272 applies to income based taxes. • Protects solicitation activities from creating nexus • Applies only to sales of tangible personal property • Order must be approved from out of state • Goods must be shipped from out of state • Immunity extends to independent contractors • Not applicable to sales/use, franchise, gross receipts
  9. 9. Factor Presence Nexus States with Significant Non-Income Taxes – OH: Commercial Activity Tax – MI: Michigan Business Tax (Until 1/1/2012) – OK: Business Activity Tax – WA: Business & Occupation Tax
  10. 10. Factor Presence Nexus Ohio – Effective July 1, 2005, Ohio became the first state to impose a factor presence nexus standard, adopting MTC thresholds for purposes of determining commercial activity tax (CAT) nexus. Michigan – The Michigan business tax (MBT), which became effective Jan. 1, 2008, is a tax on modified gross receipts, as well as net income. Substantial nexus for MBT purposes occurs when (1) a taxpayer has physical presence in Michigan for more than one day, or (2) a taxpayer activity solicits sales in Michigan and has $350,000 or more of gross receipts attributable to Michigan. [Effective Jan. 1, 2012, Michigan has repealed the MBT and instituted a corporate income tax (CIT)] Oklahoma – Effective Jan. 1, 2010, Oklahoma adopted the MTC's model factor presence nexus thresholds for the state's new business activity tax.
  11. 11. Factor Presence Nexus Washington – Effective June 1, 2010, Washington adopted a factor presence nexus standard for purposes of the B&O tax. An out-of state business is subject to B&O tax on service and royalty income if the business exceeds one of the following thresholds: (1) $50,000 of property; (2) $50,000 of payroll; (3) $500,000 of sales; or (4) 25 percent of total property, payroll or sales are in the state. – Note that the new nexus standard only applies to out-of-state entities that make sales to Washington customers classified as service or royalty income. The physical presence nexus standard continues to be required for retailing, wholesaling, and any other classification of business that is not subject to the single-factor apportionment formula.
  12. 12. Factor Presence Nexus Example – Company is based in Arizona – Company is organized as a C-corporation – Company has no physical presence outside of Arizona – Company makes online retail sales of clothing to consumers through its website – Company has retail sales to CA customers of $1,000,000 – Company has retail sales to WA customers of $1,000,000 – Company has retail sales to OH customers of $1,000,000 – Company has sales to other states of $10,000,000
  13. 13. Factor Presence Nexus Analysis – Sales Tax: Company does not have sales tax nexus in any of these states since physical presence is required under Quill. – Income Taxes and Other Taxes: • CA: Company’s sales exceed $500,000 threshold; however, Company is protected from income tax by PL 86-272. Company should file a CA return and pay the $800 minimum franchise tax. • WA: Company sales exceed $500,000; however, physical presence is still required for retailing activities. • OH: Company sales exceed $500,000; therefore, Company has nexus for OH CAT. PL 86-272 does not apply. Company must file OH return; however, the first $1M of OH gross receipts are exempt.
  14. 14. Factor Presence Nexus Analysis – What about the Company’s Arizona tax return? • The Company may have earned the right to apportion since it is taxable in Ohio. • Arizona does not have a throw back rule, therefore, the Company could exclude all out-of-state sales from the numerator of the Arizona sales factor.
  15. 15. Factor Presence Nexus Some FAQs – What if the Company has property or payroll in CA, but it is below the thresholds? • A: The company will have sales tax nexus due to in state physical presence. The company will not have factor presence nexus since the amounts are below the thresholds. The company is liable for the $800 minimum tax. – If the Company is protected by P.L. 86-272, no tax return is required, right? • A: Wrong. A tax return should be filed indicating the Company is protected by P.L. 86-272. Any minimum taxes, or other taxes, such as franchise taxes, should be paid.
  16. 16. Summary/Key Takeaways • Nexus for income/franchise taxes and business activity taxes can exist when the company has no in state physical presence. • If P.L. 86-272 applies, a tax return should be filed to claim the protection. • The sales factor in the Company’s home state should be reviewed for sales shipped outside the state and throwback sales, if applicable.
  17. 17. Further Reading In Touch Articles: – State Income Tax Nexus: No Physical Presence Required (May 2011) http://www.cbiz.com/page.asp?pid=9161 – Change Up: The Potential Evolution of the Throwback Rule (January 2013) http://www.cbiz.com/page.asp?pid=10199
  18. 18. Market-Based Sourcing What is market-based sourcing? • Method of assigning a taxpayer’s receipts to the numerator of a state’s receipts factor • Generally for receipts from sales of “other than tangible personal property” – Services, intangible property, interest, dividends • Alternative to cost-of-performance sourcing
  19. 19. Market-Based Sourcing Why market-based sourcing? • Criticism of cost of performance – Ignores customer base – Doubles up on location of payroll, property • Provides benefit to service providers with in-state facilities, but an out-of-state customer base • Shifts tax burden from service-provider taxpayers with in- state facilities to those with out-of-state facilities • “Aligns” sourcing of other than TPP with sourcing of TPP
  20. 20. Market-Based Sourcing California’s Adoption • Tied to single-factor sales – Optional for tax years beginning 1/1/11 – Mandatory for tax years beginning 1/1/13 • Lagged adoption by other states • Issued comprehensive regulatory guidance
  21. 21. Market-Based Sourcing California Law • Identifies five types of sales – Tangible personal property – Services – Intangibles – Real property – Leases of tangible personal property • Attempts to define identification of market for each • Market defined relative to benefit received by customer
  22. 22. Market-Based Sourcing Sale of services as an example • What is the benefit received? • Did the customer receive the benefit in California? – Entity • Taxpayer’s books and records (creates rebuttable presumption) • Reasonable approximation of benefit • Where service ordered • Billing address – Individual • Billing address (creates rebuttable presumption) • Taxpayer’s books and records • Reasonable approximation
  23. 23. Market-Based Sourcing Market Sourcing States • Alabama • California • Georgia • Illinois • Iowa • Maine • Maryland • Michigan Market Sourcing States • Minnesota • Nebraska (in 2014) • Ohio (CAT) • Oklahoma • Utah • Texas (sort of) • Washington (B&O) • Wisconsin
  24. 24. Market-Based Sourcing Other Market Sourcing States • Where the service is delivered – Alabama, Texas • Where the benefit is received – Iowa, Michigan, Ohio, Utah, Washington, Wisconsin • Where the service is received – Illinois, Maine, Minnesota • Where the customer is located – Georgia, Maryland, Oklahoma
  25. 25. Summary/Key Takeaways • Now three methods of sourcing – Majority cost of performance – Ratio cost of performance – Market-based • Rules among states that impose market-based sourcing vary and are open to interpretation • Complexity can mean uncertainty • Uncertainty causes controversy
  26. 26. Further Reading Wright, Kathleen, An Update on Market-Based Sourcing: Not Such a Simple Alternative. Tax Analysts (9/10/12) Eggerman, Daniel, A Flowchart Approach to California’s New Apportionment Regime. Tax Analysts (9/3/12)
  27. 27. Gillette vs. CA FTB Issue – Can a state that has adopted the Multistate Tax Compact unilaterally eliminate the compact's evenly weighted three-factor apportionment election and force taxpayers to use a different formula instead?
  28. 28. Gillette vs. CA FTB Recent Changes in CA Apportionment – California adopted the Multistate Tax Compact in 1974. – Effective January 1, 1993, California changed from a three-factor formula to a four factor formula with double-weighted sales for most multi-state businesses. – Beginning in tax year 2011 and continuing for tax year 2012, most multi-state business were permitted to elect to calculate their California apportionment using a single sales factor or the four factor formula with double weighted sales. – If a taxpayer elects single factor, then market based sourcing is used for sales of services and intangibles.
  29. 29. Gillette v. CA FTB Gillette Refund Claims – Gillette is a consolidated case. The additional appellants are Procter & Gamble Co., Kimberly-Clark Corp., Sigma-Aldrich Co., RB Holdings (USA) Inc., and Jones Apparel Group. – The taxpayers amended their tax returns and filed a refund claim for $4,137,590 plus interest for the years ended December 31, 1997 through 2004.
  30. 30. Gillette vs. CA FTB Gillette’s Position – The U.S. Supreme Court decision in Northwestern Portland Cement v. Minnesota, 356 U.S. 450 (1959), brought concerns about state taxation of interstate commerce to a head. – Congress ordered a study of state taxation of multistate businesses for the purpose of making recommendations to promote uniformity. – The Willis Commission completed the study in 1965 and issued a report that included a uniform apportionment formula as the sole method for dividing corporate income among the states.
  31. 31. Gillette v. CA FTB Gillette’s Position – States responded to this threat of federal preemption of their taxing authority by developing the Multistate Tax Compact. – The Multistate Tax Compact makes UDITPA available to each taxpayer on an optional basis, thereby preserving the substantial advantages with which lack of uniformity provides in some states. – The purpose of the election was to provide taxpayers with the right to avail themselves of uniformity among the taxing schemes of member states.
  32. 32. Gillette v. CA FTB FTB’s Position – The California Legislature adopted the four factor double-weighted sales formula in 1993 and, in clear and unambiguous language, indicated its intent for that formula to be mandatory. – The California Legislature specifically used the phrase “notwithstanding Section 38006” to mandate the use of the double-weighted sales apportionment formula in spite of, or despite, the existence of Section 38006. – Any other interpretation of the plain language would contravene the Legislature's clear intent to require the use of the double- weighted sales apportionment formula.
  33. 33. Gillette vs. CA FTB Procedural History – Trial Court: FTB won a demurrer. Gillette appealed. (November 2010) – Court of Appeal: Reversed the trial court’s judgment. (July 2012) – Court of Appeal: Affirmed on rehearing. (October 2012) – Supreme Court: FTB petitions for review. (November 2012) – Supreme Court: Court grants FTB petition (January 2013) – FTB files opening brief (April 2013) – Gillette files answer to FTB’s opening brief (July 2013)
  34. 34. Gillette vs. CA FTB CA Reactions to Gillette – CA Legislature passes S.B. 1015 to repeal the compact's provisions and enact language declaring that the doctrine of election requires that an election be made on an original return and be binding. – FTB issues Notice 2012-01 regarding procedures for filing protective refund claims. – California voters approved Proposition 39, which requires corporate taxpayers to use single-sales-factor apportionment for tax years beginning after January 1, 2013. (Nov. 2012)
  35. 35. Gillette vs. CA FTB Where do we stand in CA? – S.B. 1015 may be invalid since it passed without a super majority vote. 1. If declared invalid, CA did not withdraw and is still a member of the MTC. 2. The CA legislature could correct this in 2013 and it would be retroactive to the beginning of 2013. 3. The doctrine of elections is still problematic. – Gillette and Proposition 39 Unless Gillette is overturned, CA cannot repeal the MTC by implication.
  36. 36. Gillette vs. CA FTB Where do we stand in CA? – Two Options 1. Taxpayers have the option of filing original returns using the compact's equally weighted three-factor formula but risk that the California Supreme Court will overturn Gillette. (the large corporation underpayment penalty may apply). 2. Taxpayers can file using the state's double-weighted sales factor formula or single-sales-factor formula (after January 1, 2013), and file an amended return using the compact's formula and requesting an election. The risk with this option is that SB 1015 must be declared invalid or an election to use the compact's formula cannot be made on an amended return under the doctrine of election.
  37. 37. Gillette vs. CA FTB Other States in the Compact – Alabama, Alaska, Arkansas, Colorado, District of Columbia, Hawaii, Idaho, Kansas, Michigan, Minnesota, Missouri, Montana, New Mexico, North Dakota, Oregon, South Dakota, Texas, Utah, and Washington. – The compact allows a taxpayer to make an election to use the compact in one state without requiring the taxpayer to make the same election in other states. Taxpayers can pick and choose among states but not compact provisions.
  38. 38. Gillette vs. CA FTB Analysis in other states – Start with states that have adopted single sales factor apportionment and/or market based sourcing. • The Usual Suspects: Colorado, Michigan, Oregon, and Texas. – Requires a state-by-state analysis to determine if refund claims should be filed.
  39. 39. Gillette v. CA FTB Trends in states with single sales factor – Michigan: Courts are Split • Anheuser-Busch v. Michigan Dept. of Treas. (No. 11-85-MT), the Michigan Court of Claims ruled that multistate taxpayers are entitled to apportion their Michigan income under the Multistate Tax Compact (“MTC”) irrespective of statutes mandating otherwise. – However, the trial court also found that the modified gross receipts tax portion of the MBT is not an income tax for purposes of the compact and thus is not subject to the compact's provisions. Anheuser-Busch is appealing that determination. • IBM v. Michigan Dept. of Treas. (No. 306618), in an unpublished, nonbinding opinion, the Michigan Court of Appeals found the opposite and determined that state law prevails in such a circumstance.
  40. 40. Gillette v. CA FTB Trends in states with single sales factor – Texas: • Graphic Packaging Corp. is arguing that it had a right to file its 2010 margin tax report and refund claims for 2008 and 2009 using the evenly weighted three- factor apportionment formula in the Multistate Tax Compact. • The taxpayer lost in an administrative decision and filed suit. The case is scheduled for trial in December 2013. – Oregon: • Recently repealed the MTC and immediately re-enacted it without the corporate income apportionment and election provisions. • Health Net, Incorporated and Subsidiaries v. Department of Revenue (Case No. 120649D) is pending.
  41. 41. Summary/Key Takeaways • Calculate the before/after tax costs in Compact states. – Focus on states with single factor sales apportionment. • Consider filing protective refund claims for open years. – Decide whether current returns should elect three factor, or file using state’s method and amend. • If the client is under audit, definitely consider filing a refund claim to offset any underpayments.
  42. 42. Incentives New California Law • AB 93 Signed by Gov. Brown June 11, 2013 – Repeals as of 1/1/14: • Enterprise zones (“EZs”) • Targeted tax areas (“TTAs”) • Manufacturing enhancement areas (“MEAs”) • Local agency military base recovery areas (“LAMBRAs”) – Also eliminates current expense deductions, hiring credits, and sales and use tax credits
  43. 43. Incentives New California Law • AB 93 Signed by Gov. Brown June 11, 2013 – Creates as of 1/1/14 a new hiring credit and as of 7/1/14 a new sales and use tax exemption for qualified businesses located in: • A former EZ or LAMBRA (no provision for TTAs or MEAs); • A newly created Designated Census Tract; and • Designated areas of high unemployment. – The following businesses are not qualified: • Retail, food service, bars, • Casinos, temporary employment agencies, and • Adult live entertainment businesses.
  44. 44. Incentives Sales Tax Exemption • Statewide manufacturing and R&D equipment exemption • 4.19% exemption from state portion of sales taxes • Capped at $200M per combined reporting group • Existing sales tax credits repealed; 10-yr carryover • Operative dates 7/1/14 – 6/30/22 • No sales tax credit or exemption for 1/1/14 – 6/30/14
  45. 45. Incentives Hiring Credit • Applies only to net increase in jobs • Must be claimed on original return • Eligible hires: – 6-month unemployed workers – Veterans discharged within 12 months of hire – Persons receiving earned income tax credit – Ex-felons – Recipients of CalWORKs or general assistance
  46. 46. Incentives Hiring Credit, cont’d • Ineligible employees: temps; retail, restaurant, night club, and strip club workers • Eligible employee wages must be at least $12 per hour • Credit equal to 35% of 2014 wages • 25% of funding reserved for small businesses, defined as less than $2M gross receipts • Existing credits get 10-yr carryover • Operative dates 1/1/14 – 12/31/20
  47. 47. Incentives Increasing Scrutiny • Last 30 years have seen an increase in incentive programs to lure or keep businesses in a state • Force states to compete for business and jobs • Taxpayers and taxpayer groups increasingly questioning the ROI of incentive programs • Concerns raised regarding clawback when targets for hiring or investment not hit • Despite criticism, not going away
  48. 48. Summary/Key Takeaways • Wholesale change to California sales/use tax and hiring incentives • Gap in sales tax incentive effective dates – Avoid manufacturing and R&D expenditures 1/1/14-6/30/14 • Expanded benefit for manufacturing expenditures • Businesses in now-disallowed businesses or zones hire before end of year
  49. 49. QUESTIONS?
  50. 50. Upcoming Webinars – Save the Date Developments in Nonprofit Taxation: What Every Organization Needs to Know to Effectively Manage Their Risks on Tuesday, August 27th from 2:00 – 3:00 ET Eye on Washington: Quarterly Business Tax Update (3rd Quarter) on Wednesday, October 30th from 2:00 – 3:00 ET Registration is available on the Weekly Digest email.
  51. 51. CBIZ MHM, LLC Contact Information Todd Harke Managing Director  770.858.4465  tharke@cbiz.com Brian McCuller Managing Director  901.568.3182  bmcculler@cbiz.com
  52. 52. Thank You

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