The latest round of proposed amendments (Dec. 6, 2012) to Article IV of the Multistate Tax Compact would make a number of significant changes affecting businesses with income in more than one state. The proposed changes include:
BBNA spoke with Jamie Yesnowitz, principal at Grant Thornton LLP, about the implications of these revisions.BBNA: The proposed definition of “apportionable income” (what is now referred to as “business income”) would remove language specifying that such income must arise from activities that “constitute integral parts of the taxpayer’s regular trade or business operations. Replacing it would be a clause stating that the activity “is or was related to the operation of the taxpayer’s trade or business.” If adopted how would this change impact multistate taxpayers?
Jamie Yesnowitz: This change, along with the other proposed changes to the definition of business (apportionable) income, is designed to expand the types of transactions that would be subject to apportionment rather than allocation, particularly in situations where a sale of a business is involved. The change aligns with what appears to be a general policy to eliminate provisions in the Compact that often result in all-or-nothing outcomes to the states. The MTC states in its recommended amendments that it chose the term “related to the operation” to replace “integral part” because “related to the operation” was more concrete and specified how a property to be sold must contribute to the business. I think that under the revised definition, it will be very difficult to argue that a liquidation-type transaction could be classified as non-apportionable income. The impact of this change will vary among taxpayers, some of which will welcome the change, while others will find it problematic.
BBNA: In Gillette Co. et al. v. California Franch. Tax Bd., 147 Cal. Rptr. 3d 603 (Oct. 2, 2012), now pending before California’s highest court, the state’s intermediate appellate court found that the formula under the Multistate Tax Compact for allocating and apportioning income remains available to California multistate taxpayers, notwithstanding the state's attempt to repeal and supersede the Compact formula with a double-weighted sales factor for most business activity. Would amending UDITPA’s “Factor Weighting” provision by granting states flexibility in choosing an apportionment formula effectively address some of the arguments raised by the taxpayer in the Gillette case?
Yesnowitz: To begin, the MTC’s provision on factor weighting in Art.IV.9 recognizes that states are never going to reach complete uniformity with respect to the weighting of their apportionment factors. The MTC’s recommendation of a double-weighted sales factor may be reflective of what the active MTC states think is the proper approach, but my sense is that more states will continue to move to the single sales factor model over time. In fact, it would not be surprising to see the majority of states complete the shift to a single sales factor formula over the next several years. Considering that states are likely headed in that direction, the MTC’s recommendation to use a double-weighted sales factor is a non-binding approach that may not have much sway in states that are rethinking their apportionment formula. Moreover, one can question whether a statute is the appropriate place for a recommended, rather than required approach.
Presumably, a change in Article IV to allow states flexibility in factor weighting issues, along with the other proposed changes currently being addressed by the MTC, would essentially allow individual states to effectively reset the Compact and prospectively curb the effect of an election under Article III of the Compact. However, the change would not impact taxpayers still considering whether an election could be retroactively made in years prior to the changes to Article IV. Also, the states would still need to individually ratify the changes to Article IV, which is likely to take even more time. It is somewhat surprising to me that the MTC did not try to address the Compact election in Article III in some form or fashion, given that the election is the central focus of the Gillettecontroversy.
Finally, assuming the proposed Compact language is approved “as is,” the MTC’s recommendation that a formula containing a double-weighted sales factor should be followed conceivably could be problematic for states that do not follow such a recommendation down the road. The type of apportionment formula used by Compact members is a central tenet of the Compact, and non-uniformity in this area potentially calls into question whether a true Compact exists with members that decide to go against the recommendation and either retain the historic equally-weighted apportionment formula, or decide to use a single sales factor formula.
BBNA: The proposal would amend Section 17, which sets forth the method for sourcing “sales, other than sales of tangible personal property” by removing the current cost of performance method and replacing it with a market-based sourcing method. Alabama has recently adopted market-based sourcing provisions that mirror the MTC proposal. What are some issues that are likely to arise for multistate taxpayers if the proposed language is adopted by other states?
Yesnowitz: The shift from cost of performance to market-based sourcing is a means to eliminate an all-or-nothing provision in the Compact, ensuring that each state in which a multistate business is subject to tax receives a share of receipts earned by a multistate provider of services or intangibles. While it is true that many states are moving towards market-based sourcing for items other than tangible personal property, they are not doing so in a uniform manner. One of the main issues with adopting the MTC’s proposed market-based sourcing provisions is that the sourcing of sales based on where such services are delivered is a different approach than the current market-based sourcing provisions followed by several jurisdictions. Granted, in many cases it may be easier to determine where a service is being delivered rather than where a customer is receiving the benefit of a service. However, it might have been even more convenient to rely upon the customer’s billing or ordering addresses instead of using a more abstract concept of “delivery” location. Ultimately, regulations that govern how to determine the location of delivery will need to be promulgated, perhaps focusing on how to source sales to individual customers, versus how to source sales to business customers.
BBNA: The recent trend of states replacing “cost of performance” sourcing with market-based sourcing has been partly driven the perceived need to effectively tax electronic commerce. Market-based sourcing methods, such as sourcing receipts according to a customer’s address seem relatively straightforward. But at least one of the proposed MTC provisions seems more complex. Specifically, proposed Section 17(a)(4)(i) would source intangible property to a state in which it is used to market a good or service in the state. What are some issues that are likely to arise for multistate taxpayers that attempt to comply with this rule? Have any states already adopted a similar rule?
Yesnowitz: The amendments to the Compact relating to the sourcing of intangible property are fairly complicated. The general concept contained in proposed section 17(a)(4)(i) provides a sourcing rule for “marketing” intangibles that is generally in line with the new rule contained in California regulation 25136-2. The main issue that will be faced by taxpayers is getting relevant, timely and accurate information on where their customer’s consumers are actually purchasing the good or service. I would think explanatory regulations showing how this is done, and alternative methods to use in case such information cannot be obtained, could make this a viable approach.
I also think a comment on proposed sections 17(b) (reasonable approximation) and 17(c) (the throwout rule), is appropriate here. With respect to proposed section 17(b), if the taxpayer is unable to determine the proper state(s) of assignment under section 17(a), then the state(s) of assignment is to be reasonably approximated. Clearly, a model regulation would need to be promulgated that explains how a reasonable approximation can be made. I am hopeful that to the extent this provision needs to be used, state tax authorities will be flexible in accepting taxpayers’ methodologies in this area, noting the potential difficulties in taxpayers obtaining information on where the actual delivery point to customers is located (when a service is being provided) and where the actual point of use by customers is located (when an intangible is being provided).
As for proposed section 17(c), to the extent a taxpayer is not taxable in a state to which a sale is assigned using proposed sections (a) or (b), or if proposed sections (a) and (b) fail to provide a location of assignment, the sale is thrown out of the sales factor denominator. I think that the use of a throwout rule is problematic and inequitable to taxpayers, given the constitutional challenges and other issues that are likely to arise, including a need to determine what is meant by the term “not taxable in a state.”
BBNA: Section 18, regarding alternative apportionment, would be amended under the proposal to grant state tax administrators with the authority to establish rules or regulations aimed at taxpayers for which the standard formula does not achieve a fair result. In the Bloomberg BNA 2012 State Tax Department Survey, 11 state tax departments indicated that they offered no guidance on alternative apportionment. Do you think this proposed provision is likely to change that?
Yesnowitz: Taxpayers have a right to know when a state tax authority specifically may require alternative apportionment. Likewise, taxpayers should know when they specifically may utilize alternative apportionment. The proposed amendments provide that a state tax authority may create rules or regulations dealing with fact patterns applicable to an entire industry or directed at a particular transaction or activity. While this allows state tax authorities great latitude, it runs counter to the aim of uniformity, as some states will take the opportunity to create or expand upon regulations that govern certain industries, while others will not. In addition, the provision does not address taxpayer rights in the area of alternative apportionment.
I am doubtful that the 11 states (according to the survey) that currently do not provide guidance on alternative apportionment will suddenly begin to construct such guidance in response to this proposed change. Perhaps these states have consciously determined, as a matter of policy, that they are unwilling to provide guidance in this area, preferring to deal with these issues on an unpublished, case-by-case basis. While states certainly have the right to do this, such an approach ramps up the uncertainty for taxpayers that do not know when their apportionment will be challenged, and increases the odds that similarly situated taxpayers will be treated in a disparate manner.
By Steven Roll and Melissa Fernley
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