Corporate Close-Up: Is 'Business Income' a Concept That Defies Definition?

 Corporations operating in more than one state must generally allocate nonbusiness income to the state in which they are based and apportion business income to the states in which they do business. For many years now there has been much confusion and litigation as to what “business income” really encompasses. The issue was highlighted by a recent legislative change in New Jersey as well as a recommendation to amend the model laws governing allocation and apportionment.

Most states have adopted a definition of “business income” that is derived from  Uniform Division of Income for Tax Purposes Act (UDITPA), which incorporates a functional test defining business income as “tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business” and a transactional test defining business income as “income arising from transactions and activity in the regular course of the taxpayer’s trade or business.”

Recently, New Jersey Assembly bill 3486/Senate bill 2268 amended the definition of business income (referred to as operational income in N.J.) to expand the types of transactions that produce apportionable income. This is important for two reasons:

  • the distinctions will determine whether or not a transaction must be allocated to one state or divided among the many states in which the corporation or business is located, and
  • the change will be applied retroactively for the tax year starting Jan. 1, 2014.

New Jersey previously utilized the functional definition of operational income as it was written in UDITPA. However, the new law changes the wording of part of the phrase to read “acquisition, management, [or] disposition of the property,” This change from “and” to “or” will have the effect of including as operational income transactions that otherwise would have been excluded for failing to meet all three parts of the test.

New Jersey seems to be late to the game for adopting what is known as the “disjunctive functional test,” with Tennessee and New Mexico changing their statutory definition to include “or” instead of “and” back in the 1990s. Unlike New Jersey, however, New Mexico and Tennessee use both the functional and the transactional definition of business income. In 2001, Pennsylvania changed its definition of business income to include the disjunctive functional test, and also added a provision stating business income includes all income that is apportionable under the U.S. Constitution.

In recent years, several states have started to use a constitutional business income standard, including Illinois, Kansas, North Carolina, West Virginia, and the District of Columbia.Under this standard, business income is defined as “all income that is apportionable under the U.S. Constitution.”

Some believe that it is time to change the definition of “business income” in UDITPA. Professor Richard Pomp, the hearing officer for the March 28 public session of the Multistate Tax Commission proposed in his report on Oct. 25, 2013 to change UDITPA’s definition of “business income” to not only include all income that is apportionable under the Constitution but to keep the transactional and functional tests, with a few changes to each

Pomp suggested (among other changes)to change to the disjunctive functional test, and amend the transactional test to delete the word “includes” at the end of the phrase, which had the effect of making the functional test a qualifying clause for income that is included only if it fits within the transactional test. Pomp’s attempts were met with much skepticism about the constitutional addition to UDIPTA but he pushed for its retention stating that it, along with the functional and transactional test provide the broadest definition of business income with the best statutory guidance.

Pomp’s has made a noble attempt at clarifying the definition of “business income” by broadening the definition to include all income apportionable under the Constitution, while keeping the transactional and functional tests in order to help businesses interpret the types of income that should be included. These proposed changes might prevent  practitioners from trying to prove transactions are not apportionable for failing to fit squarely within the transactional or functional tests; however, if history is any indicator, it is likely there would still be litigation testing the soundness of Pomp’s theory.  

Continue the discussion on LinkedIn: how do you believe states should define “business income”?

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By Erica Parra

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