Corporate Close-Up: Utah Clarifies Definition of Foreign Operating Companies and Rules on Inclusion of Proceeds from Buy-Sell Agreements in Receipts Factor

The Utah Tax Commission recently concluded that corporate taxpayers must have positive payroll and property factors in order to qualify as a foreign operating company (FOC) under rules that predate 2011 amendments to Utah Code § 59-7-401. In Utah Administrative Decision No 13-2552, the Commission denied the appeal from a corporate franchise tax audit deficiency because the taxpayer’s entities had no property or payroll either inside or outside of the U.S.

For taxpayers filing a water’s-edge return, an entity that qualifies as an FOC is able to deduct 50 percent of its adjusted income from its computation of Utah tax. Following amendments to Utah Code § 59-7-401, in order to qualify as an FOC, an entity must be incorporated in the United States, have 80 percent or more of their "business activity" conducted outside of the United States, and the corporation must have at least $1,000,000 of payroll and $2,000,000 of property located outside of the United States.

However, in the tax years at issue in the audit, business activity was determined under Utah Code § 59-7-401, using a two factor formula of property and payroll in accordance with the Utah UDITPA provisions. The Utah audit division denied the taxpayer’s classification of its related entities on the grounds that the taxpayer’s records indicated that none had any payroll whatsoever. The Tax Commission agreed, stating that "if the entity does not have property and payroll outside of the United States, it does not have ‘business activity’ under [Utah Code § 59-7-401]."

The Commission also addressed the inclusion of gross receipts from the taxpayer’s buy/sell exchange agreements in their state gross receipts or sales calculations under Utah Admin. Code § R865-6F-8(2)(e). The Commission found the inclusion of the receipts, otherwise excludable due to the exchanges of inventory exception, to be valid because the taxpayer reported the income from these sales on line 1 of the taxpayer’s federal return. The Utah audit division unsuccessfully argued that the receipts should be excluded because the proceeds were netted with an offsetting deduction for the other side of the transactions and produced no associated business income subject to apportionment.

The state claimed that to include such receipts under Utah Admin. Code § R865-6F-8(2)(e) would be to violate the reasonableness test of Utah Code § 59-7-320, Utah’s alternative apportionment statute. However, the Commission turned to case law from the Utah Supreme Court in Western Contracting Corp. v. State Tax Commission, 18 Utah 2d 23, 414 P.2d 579 (Utah 1966), which concluded that the burden falls on the party opposing the application of the statutory formula. It noted that the standard of proof "is ‘clear and convincing evidence’ that the taxes imposed are ‘grossly disproportionate’ to the business conducted in the state."

The Commission then cited Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978) in noting that an adjustment to the standard apportionment formula should not be made unless it is "proven by ‘clear and cogent evidence’ that the income attributed to the state is ‘out of all appropriate proportion’ to the business in the state." In the end, the Commission concluded that the audit division failed to provide what effect the use of the standard apportionment formula had on the sales factor.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Did the inclusion of gross receipts from the taxpayer’s buy/sell agreement in the sales factor ‘fairly represent’ its business activity in Utah?

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