Income Tax Reporting by Affiliates

1. Current Developments in Income
Tax Reporting By Affiliates
David A. Fruchtman, Moderator
Winston & Strawn LLP
Michael G. Galloway William H. Weissman
Bancroft, Susa & Galloway Morrison & Foerster LLP
American Bar Association Tax Section Winter 2005 Meeting
January 21, 2005

2. Example: Aaron Rents, Inc. v. Collins,
Fulton County Superior Court, Civil
Action No. D-96025, June 27, 1994,
CCH Georgia State Tax Reporter at par.
200-242
Rents
Transfers License
Trademarks Agreement
Investment

3. Example: Aaron Rents, Inc. v. Collins,
Fulton County Superior Court, Civil
Action No. D-96025, June 27, 1994,
CCH Georgia State Tax Reporter at par.
200-242
Rents
$2.5
$1.3 Million
Million
Royalty Interest
$1.3 Million Note Royalty
$2.5 Million Note Payment on
November 20, Payment
August 31, 1989 November 14, Notes
1989 August 29,
1989
1989
Investment
Delaware

4. MTC combined reporting model statute
• MTC Executive Committee approved draft model
combined reporting statute, dated November 11, 2004
• MTC holding public hearings in February and March
• Will issue a report in April
• Expect model statute to be before the full MTC for
adoption at annual meeting in July
• Will take written public comments until April 1, 2005

5. Structure of model statute
• Section 1: Definitions
• Section 2: When combined reporting required and when
discretionary
• Section 3: Determination of taxable income or loss using
a combined report
• Section 4: Designation of a surety
• Section 5: Water’s-edge election

6. Section 1: Definitions
• “Corporation”
– Business conducted by a partnership which is directly or
indirectly held by a corporation shall be considered the business
of the corporation to the extent of the corporation’s distributive
share of the partnership income
• “Unitary business”
– Definition is intended to be a summary of the MTC’s model
unitary business definition found in MTC Reg.IV.1.(b)
– Not intended to limit, narrow or otherwise change the common
law definitions or tests for a unitary enterprise

7. Section 2: When combined reporting is used
• General rule: Mandatory for all unitary businesses
• Discretionary rule: The Director may promulgate
regulations that require combined reporting for entities
other than corporations in order “to reflect proper
apportionment of income” to the entire unitary business
• Tax avoidance rule: If the Director determines that the
income or loss of a taxpayer engaged in a unitary
business with a non-corporate entity represents tax
avoidance or evasion, the Director may, on a case-by-
case basis, require a combined report with such entity
– Cannot be used “to reflect proper apportionment of income”
– Common law standards of tax avoidance and evasion apply

8. Section 3: Determining income
• Each taxpayer responsible for its own tax
– The Joyce rule applies, not Finnigan
– Credits and NOLs cannot be used by the unitary group
• Components of income to each taxpayer
– (1) Apportioned share of unitary business income; (2) other
distinct business income apportioned to taxpayer; (3) all income
from a business conducted wholly intrastate; (4) all income
sourced to the state on sale of exchange of capital assets and
involuntary conversions; (5) all nonbusiness income allocated to
the state; (6) income or loss allocated to an earlier year required
to be taken into account as state source income in the tax year;
and (7) NOLs

9. Section 3: Determining income
• Unitary business income is the total income of all
members of the combined group separately calculated
• Intercompany transactions deferred
• Intercompany dividends paid out of E&P are eliminated
• Charitable expenses limited to amount of business
income and excess is nonbusiness expense
• For each class of gain or loss, all gains or losses for
each class are combined and apportioned based on
member’s apportionment percentage and then netted
against nonbusiness gain or loss for that class

10. Section 4: Designation of a surety
• Allows for a single taxpayer to file a single return and pay
tax of all taxpaying members of the combined group
– Allowed as an administrative convenience
– If surety fails to perform, tax would be assessed to each member
accordingly
– Does not create joint and several liability

11. Section 5: Water’s-edge election
• World-wide combined reporting is default rule
• Water’s-edge election allowed
• Once made election is binding for all years thereafter
– The Director may allow termination for “reasonable cause based
on extraordinary hardship due to unforeseen changes in state tax
statutes, laws, or policy, and only with the written permission of
the Director.”
– Appears to be intended to mirror Treas. Reg. § 1.1502-75(c) but
seems more limited

12. Combined reporting v. separate entity
(or separate return) reporting
• Combined reporting based on the unitary concept
• For separate entity states, combined reporting can
capture transactions between affiliated entities
• Problems with combined reporting
– Inherently neutral, but . . .
– Likely will increase a taxpayer’s liability
– Complicated
– Simply shifts what taxpayers focus on: minimizing factors rather
than income in the taxing state

13. Various state proposals in 2004
• The Vermont legislation (Passed)
• The Arkansas legislation (Did not pass)
• The Maryland legislation (Did not pass)
• More to come?
– The MTC model statute will not slow the movement
– What ever happened to elective combination?

14. Gross receipts litigation: an overview
• The Treasury function and normal cash management
– Investing idle cash not used in daily operations
– Usually investing in short-term marketable securities like T-Bills,
CDs, REPOs, etc.
• Because cash is needed for operations, investments must be highly
liquid and low risk
– Activity occurs nearly daily
– Usually a specific operation in bigger companies

15. How does this activity affect the
apportionment factor?
• In the states where the treasury function does not occur:
– The sales factor denominator increases without changing the
sales factor numerator
– Reduces the taxpayer’s liability in the state
• Should the principal portion of the investment receipts be
included in the sales factor?

16. The states’ responses: two arguments
• The principle portion of investment receipts do not
constitute either “gross receipts” or “sales” for purposes
of the apportionment formula
– The investments are only loans
– The returns of principal do not constitute a “receipt”
• Even if the proceeds are gross receipts, they distort the
amount of the taxpayer’s business activities in the state
as measured by the standard apportionment formula
– The distortion justifies an alternative apportionment formula,
which usually means including only the income from the
investments (e.g., the interest component only)

17. The early cases
• The California SBE Cases
• AT&T v. Director, Div. of Tax., 476 A.2d 800 (N. J.
Super. Ct. App. Div. 1984) (Taxpayer lost)
• Sherwin-Williams Co. v. Ind. Dep’t of Rev., 673 N.E.2d
849 (Ind. Tax Ct. 1996) (Taxpayer lost)
• Sherwin-Williams Co. v. Johnson, 989 S.W.2d 710
(Tenn. Ct. App. 1998) (Taxpayer lost)
• Sherwin-Williams v. Ore. Dep’t of Rev., 996 P.2d 500
(Ore. Ct. App. 2000) (Taxpayer won)

18. The current litigation
• General Motors Corp. v. Franchise Tax Board, 120
Cal.App.4th 114 (Ct. App. 2004), modified on other
grounds, 120 Cal.App.4th 881 (Ct. App. 2004) (review
granted Oct. 13, 2004) (currently depublished) (Taxpayer
lost)
• Microsoft v. Franchise Tax Board, No. 400444 (Cal. Sup.
Ct., SF County, 2003) (on appeal) (Taxpayer won)
• Walgreen Arizona Drug Co. v. Ariz. Dep’t of Rev., 97
P.3d 896 (Ct. App. 2004) (Taxpayer lost) (petition for
review filed Nov. 23, 2004)

19. GM and Walgreen
• Same issue: do short-term investments of a company’s
idle cash generate “gross receipts” for apportionment
purposes?
– Walgreen relied on General Motors
– Will the Arizona Supreme Court care how the California
Supreme Court rules on the issue?

20. Microsoft
• Only taxpayer to recently win on the question of
distortion
– FTB failed to meet its burden of proof
• Raises additional questions:
– What constitutes statutory distortion?
– How should it be measured?
– How should a taxpayer’s business activities be defined?