Current corporate income tax developments.

This two-part article discusses a myriad of recent state tax activity in the corporate income tax area. Part I addresses nexus, tax base and entity-classification conformity; Part II, in the next issue, examines apportionment, administration and other developments.

During 2001, an overwhelming number of state statutes were added, deleted or modified; court cases were decided; regulations were proposed, issued and modified; and bulletins and rulings were issued, released and withdrawn. Because it is impractical to summarize all of these activities, Part I of this article focuses on some of the more interesting items in the corporate income tax areas of nexus, tax base and entity-classification conformity. Part II, in the April 2002 issue, will discuss apportionment, filing methods and unitary groups. Both parts also address other significant income tax and nonincome tax developments.

Nexus

Application of P.L. 86-272

Public Law (P.L.) 86-272 prohibits a state from taxing a business when its only connection with the state is the solicitation of sales orders for tangible personal property sent outside the state for approval or rejection and, if approved, are filled and shipped by the business from a point outside the state. Several cases, rulings and legislative bills addressed whether a taxpayer's in-state activities fall within the protection of P.L. 86-272.

* MTC

At its annual meeting, the Multistate Tax Commission (MTC) adopted a resolution amending the MTC Statement of Information Concerning Practices of the MTC and Signatory States Under Public Law 86-272 by deleting section IV.A.20, which had identified as an unprotected activity the shipment or delivery of goods into the state by private or contract carrier.

* California

A court of appeals affirmed (1) a superior court decision that a parent with no contacts in California could be subject to tax based on a wholly owned subsidiary's offices there. Readers Digest Association (RDA) sold magazines into the state; the subsidiary sold or solicited sales of advertising pages in the U.S.

The parties had agreed that the subsidiary was engaged in selling (or soliciting orders for the sale of) tangible personal property (i.e., advertising pages). The court held that the subsidiary was not an independent contractor, because it did not hold itself out to the public as an agent for other magazines; thus, RDA was doing business in California through the subsidiary, subjecting RDA to taxation.

* Iowa

The Department of Revenue and Finance (DRF) amended Iowa Admin. Code, Chapter 52, subrule 52.1(2), to clarify that P.L. 86-272 protection does not extend to brokers, manufacturers' representatives or other persons or entities selling products for another person or entity.

* Iowa

The DRF addressed (2) whether a Nebraska taxpayer whose activities would otherwise be protected by P.L. 86-272 would establish income tax nexus under three scenarios. Under the first case, it ruled that nexus would not be established if a taxpayer paid a management fee to its Iowa subsidiary to compile and consolidate financial statements.

In the second situation, the taxpayer occasionally used legal services provided by the in-state subsidiary and paid fair value. According to the DRF, generally, this would not constitute nexus; however, if the Iowa corporation is authorized to represent the Nebraska taxpayer in non-de minimis activities not protected by P.L. 86-272 as part of the legal services contracted, nexus might exist. In the third case, the DRF ruled that arranging for a contract carrier to pick up and deliver raw material the taxpayer purchased from Iowa suppliers did not create nexus.

* Nebraska

In Rev. Rul. 24-01-01, (3) the Nebraska Department of Revenue (DOR) ruled that deliveries into the state by a company using its own vehicles are protected under P.L. 86-272. Such deliveries, by themselves, do not create nexus for income tax purposes; accordingly, having no other contact with Nebraska other than mere solicitation, the company has no income tax filing obligation with the state.

Trademark/Tradename Companies

* Louisiana

In Kevin Assodates, Inc., (4) which involved the use of a Delaware holding company to reduce Louisiana franchise tax, a court held for the taxpayer. Noting that the plan involved the transfer of assets to Delaware and citing SYL, Inc., (5) the court found that the purpose was to reduce Louisiana tax, a valid purpose. The DOR has appealed.

* New Mexico

The court of appeals ruled (6) that the imposition of gross receipts and income taxes against a Michigan trademark holding corporation did not violate the U.S. Constitution. The case involved a Kmart subsidiary, Kmart Properties Inc. (KPI), to which Kmart had transferred certain trademarks and tradenames (such as the Kmart logo). The subsidiary (which has no business locations in New Mexico) charges Kmart a royalty for their use. Kmart operated almost a dozen stores in the state at the time of the assessments. The transactions allowed Kmart to reduce or eliminate its taxable income in New Mexico, as it deducted the royalty payments.

The court found that the use of the marks within the state's economic market to generate income for KPI established nexus between that income and the state's legitimate interests sufficient to justify imposition of state income tax. The court further found that "the combination of Kmart Corporation's activities in New Mexico, together with the tangible presence of KPI's marks, constitutes the functional equivalent of physical presence" for taxing purposes. Kmart is expected to appeal.

* North Carolina

Effective Jan. 1, 2001, under HB 1157, Laws 2001, royalty payments received for the use of trademarks in the state are income derived from doing business there. In addition, certain deductions for royalty payments resulting from the use of a trademark or similar intangible property made to related members must be added back to net income, or the trademark entity must elect to file and pay the tax.

Other Nexus-creating Activities

* MTC

In September 2001, the MTC issued a response to the Internet Tax Fairness Coalition's document, Business Activity Taxes: Myth vs. Fact. The MTC's position is that businesses have nexus in states in which they have a significant customer base, whether or not they have a physical presence.

* Georgia

Effective for tax years beginning after 2001, the DOR amended Regulation 560-7-7-.03 to provide that a corporation will be deemed to own property or do business in the state whenever it is a partner (limited or general) in a partnership that owns property or does business there. It also provided that a corporation that is a limited partner in a business partnership must include its pro-rata share of partnership property, payroll and gross receipts in its own apportionment formula. The validity of the regulation is questionable, as it runs contrary to case law.

* Iowa

The DRF ruled (7) that the mere holding of a Certificate of Authority does not create income tax nexus.

* Massachusetts

The DOR ruled (8) that the filing of a Massachusetts business trust document with the secretary of state, in and of itself, does not subject that entity to taxation by the state.

* Massachusetts

The supreme judicial court ruled (9) that Adams International Trucks, Inc., which rents and leases trucks through a wholly owned division (Ideal Leasing), has nexus with Massachusetts. From 1992-1996, a portion of Adams's fleet of leased vehicles logged almost 15,000 miles on Massachusetts roads, sometimes making pickups or deliveries. Ideal Leasing also provided lessees with fuel-tax-licensing services. From 1992-1995, Adams purchased 164 fuel tax decals for its vehicles from the DOR.

In addition, Ideal Leasing remits fuel tax to each state and makes quarterly reports of fuel purchases and vehicle mileage. To provide licensing, registration and fuel tax services, Ideal Leasing requires lessees to submit reports detailing the number of miles traveled by each vehicle in each state.

The court concluded that the presence of Adams's vehicles in Massachusetts through its lease agreements established nexus. Adams's contacts were not the result of "the unilateral activity of another party or a third person"; instead, Adams paved the way for lessees to operate the vehicles throughout Massachusetts by providing the requisite registration and licensing services. Moreover, the court found that if Adams itself operated its vehicles within Massachusetts, the income it earned from this activity clearly could be the subject of a corporate excise tax. The fact that a lessee (rather than Adams) drove the trucks within Massachusetts did not dictate a different result.

* Massachusetts

The DOR ruled (10) that a company's provision of accounting, custodial, investment management, shareholder and other administrative services, and the receipt, generation and maintenance of relevant electronic and paper records and reports for investment companies (Funds) organized outside the U.S. does not cause the Funds to be subject to Massachusetts taxation.

* New York

The Department of Taxation and Finance (Department) ruled (11) that Company A, an out-of-state seller and manufacturer of industrial blowers, was subject to state franchise tax based on its maintenance of a constant supply at Company B's in-state facility.

A maintains a supply of blowers at B's facility to timely respond to custom orders. On receipt of an order for a modified blower, A relays it to B, which adds additional parts, then ships the blower directly to the customer. On average, A maintains a $35,000 inventory at B's facility.

The Department determined that A had nexus by virtue of "employing capital and owning personal property in New York on a regular basis." In addition, the Department found that B's activity of adding additional parts before shipping the blowers to A's customers exceeded "the use of fulfillment services" exception from tax provided under N.Y. Tax Law [section] 209.2(f). Accordingly, A was deemed to be subject to Article 9-A franchise tax.

* Ohio

The Department of Taxation (DOT) issued (12) information releases describing the nexus standards applied to determine whether an out-of-state taxpayer is subject to franchise (income) tax, passthrough-entity tax, personal income tax and use tax. The releases enumerate nexus-creating and safe-harbor activities and certain filing requirements.

* Ohio

The board of tax appeals held (13) that a corporation whose only contact with the state on January 1 is its registration to do business is not subject to the franchise tax's net-income basis.

* Oklahoma

Under Ch. 15 (SB 24), Laws 2001, effective April 2, 2001, nexus for income and sales/use tax purposes is not created if in-state activities are limited to (1) ownership of tangible or intangible property located at the in-state premises of a commercial printer to perform services for the owner; (2) periodic presence of employees at the commercial printer's premises directly related to the printer's services; and (3) printing (including printing-related activities and distribution of printed material) performed by the commercial printer in the state in the person's or entity's behalf.

* Pennsylvania

Question 12 from the 2000 annual meeting between the DOR and the Pennsylvania Institute of Certified Public Accountants' Committee on State Taxation concluded that [a] corporation that obtains a license to do business in Pennsylvania has nexus for Pennsylvania corporate tax purposes."

* Tennessee

The chancery court held (14) that America Online, Inc. (AOL), an Internet service provider, had no physical presence in the state. The state attempted to demonstrate AOL's nexus in Tennessee through customers entering into contracts, computer services originating or terminating in-state and being billed to in-state customers, use in the state of AOL's copyrighted and licensed software and AOL's providing Tennessee telephone numbers to access its computer in Virginia.

The state argued that AOL's presence is a sufficient "fingerprint" to satisfy the Commerce Clause; the court, rejecting this position, stated that economic ties to the state do not equal physical presence.

* Virginia

The DOT ruled (15) that the activities of a taxpayer's sales staff created nexus. According to the DOT, the following activities appear to go beyond mere solicitation: serving in a consultant's role for dealers' product-support operations; providing input for dealer business-plan development; providing sales-coverage analysis; providing dealer-operations studies; assessing dealer management capabilities and addressing deficiencies (including replacing dealers); assisting dealers in assessing sales personnel; providing technical training to a dealer's customers; and resolving user, customer and dealer disputes and problems.

The DOT noted that the information did not indicate whether the taxpayer's activities would be deemed de minimis; however, as a whole, it appeared likely that the unprotected activities would constitute a continuous pattern of non-de minimis activity and not trivial additions to the taxpayer's in-state business.

* Washington

The court of appeals held (16) that Seattle properly imposed business/occupation taxes on General Motors and Chrysler. Although neither maintains an office, bases employees or directly solicits business in the city, the court found that both companies conducted substantial marketing activities there.

* Wisconsin

Act 16, effective for tax years beginning after 2000, expanded the definition of "doing business" to include "owning, directly or indirectly, a general or limited partnership interest in a partnership that does business in Wisconsin, regardless of the percentage of ownership; and owning, directly or indirectly, an interest in a limited liability company that does business in this state, regardless of the percentage of ownership, if the limited liability company is treated as a partnership for federal income tax purposes." In addition, the new law provides that the limited partnership's or limited liability company's (LLC's) apportionment factors are attributed to its partners/members for purposes of computing their Wisconsin tax liability.

Entity-classification Conformity

* Alabama

The DOR ruled (17) that, for corporate income tax purposes, the classification of Delaware business trusts is governed by Ala. Code Section 19-3-67, not by the Federal check-the-box regulations.

* Louisiana

The DOR concluded (18) that the classification of LLCs for franchise tax purposes is not governed by the Federal check-the-box regulations. The ruling focused on entities that affirmatively checked the box to be taxed as corporations for Federal tax purposes. The ruling does not state whether an LLC member will be subject to franchise tax.

* Massachusetts

A non-U.S. business entity can elect classification under the Federal check-the-box rules, provided that it is not treated as a corporation per se. Massachusetts follows the Federal tax classification of a non-U.S. business entity if the entity is a foreign LLC. (19) Under Technical Information Release (TIR) 97-8, (20) an eligible foreign LLC that chooses to be treated as a partnership for Federal tax purposes will be treated as a Massachusetts partnership if it can be considered a foreign LLC. Likewise, an eligible foreign LLC that chooses to be treated as an ignored entity (and, thus, disregarded as a separate entity for Federal tax purposes) will also be disregarded under the corporate excise tax if it can be considered a foreign LLC. Directive 01-08 (21) classified the following non-U.S. business entities as foreign LLCs:

* Brazil, Sociedade civil por quotas de responsabilidade limitada.

* France, Societe a Responsibilite Limitee (SARL).

* Germany, Gesellschaft mit beschrankter Haftung (GmbH).

* Ireland, Private Limited Company.

* Italy, Societa Responsibilita Limitata (SRL).

* Japan, Yugen Kaisha (YK).

* Netherlands, Besloten vennootschap met berperkte aansprakelijkheid (BV).

* Russian Federation, Obschestvos ogranichennoi otvetstvennostyu (OOO).

* United Kingdom, Private Limited Company.

However, if the foreign law creating one of these entities substantially changes, the DOR may determine that such foreign entity will no longer be classified as a foreign LLC. In addition, if a foreign entity's charter, bylaws or other organizational documents significantly vary from (or its structure or operations are otherwise inconsistent with) the foreign jurisdiction's definition of that type of entity, the DOR may determine that the entity should not be classified as a foreign LLC. Non-U.S. business entities not addressed in Directive 01-08 may seek a ruling from the DOR to determine their tax treatment for Massachusetts purposes.

State Tax Base

The majority of states imposing a corporate income-based tax begin the computation of state taxable income with taxable income from Form 1120, U.S. Corporation Income Tax Return. These states use either taxable income before net operating loss (NOL) and special deductions (Line 28) or taxable income (Line 30); certain state-specific addition and subtraction modifications are then applied to arrive at the state tax base. Below is a summary of the recent significant changes to the states' tax base.

Apportionable Income (Business/ Nonbusiness Income)

Under the Uniform Division of Income for Tax Purposes Act (UDITPA), a multistate corporate taxpayer's income is divided into two classes--business income and nonbusiness income. Business or apportionable income is divided among the states in which the corporation has nexus by use of a statutory apportionment formula; nonbusiness income generally is assigned to the state in which the corporation is domiciled or the property that was disposed of is located.

The UDITPA generally defines "business income" as income arising from transactions and activity in the regular course of a corporation's trade or business and includes income from tangible and intangible property if the acquisition, management and/or disposition of the property constitute integral parts of the corporation's regular trade or business. All other income is nonbusiness income.

The courts are split as to whether the UDITPA business-income definition requires that both (1) the transaction giving rise to the income is in the regular course of the corporation's income (transactional test) and (2) the acquisition, management, use and disposition of the property are integral parts of the corporation's regular business operations (functional test). In addition to the UDITPA's business/ nonbusiness distinction, a state is prohibited under Allied-Signal, Inc. (22) from taxing income not generated in the course of a corporation's unitary business. Such income would not be includible in the corporation's apportionable income.

* Alabama

For tax years beginning after 2001, HB 7 (signed into law as Act 1113) adopted the broader definition of business income supported by the MTC and overruled the state supreme court's decision in Uniroyal Tire Co., (23) which had held that Alabama's statute defining business income (Ala. Code Section 40-27-1, Art. IV, 1.(a)) includes only a transactional (and not a separate functional) test. The new law expands the definition of business income to include both a transactional test and a functional test, and also includes gain or loss resulting from the sale, exchange or other disposition of real, tangible or intangible property operationally related to the taxpayer's trade or business.

* California

The state supreme court reversed (24) a court of appeals decision and held that pension-reversion income was taxable as apportionable business income. The court concluded that the statutory definition of business income established separate transactional and functional tests; the reversion met the functional test.

* Illinois

A circuit court held (25) that the proceeds from a complete liquidation distributed to the company's shareholders constituted nonbusiness income.

* Illinois

An appellate court held (26) that gain from the sale of 38.7% of the stock of a joint venture, to avoid a takeover, was nonbusiness income. The functional test was not met, because the stock's ownership served an investment function, not an operational function.

* Indiana

The state tax court held (27) that the definition of business income includes both transactional and functional tests. After determining that a sale did not satisfy the transactional test, the court held that the functional test requires that the disposition of the assets must, along with their acquisition and management, constitute an integral part of the taxpayer's regular trade or business operations. Because the taxpayer had divested an entire division for the benefit of a competitor pursuant to a court order, the court found that the divestiture was not an essential part of its department store retailing operations. Having found that neither the transactional nor the functional test was met, the court concluded that the gain from the disposition of the business division was not business income.

* Maryland

The court of special appeals reversed (28) a circuit court opinion and disallowed the state's attempt to apportion income from gain on a stock sale. The state sought to impose income tax on gain from Southland Corporation's sale of a 50% interest in Citgo stock. The state tax court previously ruled that Southland and Citgo did not have a unitary relationship and the stock sale produced nonunitary income; the income came from a "discrete business enterprise" and the sale was not an operational function. The circuit court reversed, finding that Citgo and Southland had an operational relationship. The court of special appeals reversed the circuit court's holding and reinstated the tax court's findings.

* Mississippi

HB 1695, Laws 2001, amended the definition of business income to include income described in either the transactional or functional test. The new law applies retroactively to 2001.

* North Carolina

The state supreme court held (29) that the liquidation of a subsidiary's assets did not create business income, because the sale was not an integral part of the parent's regular trade or business. The court determined that, when gain is generated from a transaction involving a complete or partial liquidation and cessation of a company's particular line of business and the proceeds are distributed to shareholders rather than reinvested, the gain is nonbusiness income under the functional test.

* North Carolina

The DOR addressed (30) the above decision and its effect on the determination of whether income is business or nonbusiness. Gain or loss on a company's disposition of real or tangible property is classified as nonbusiness income and is allocated to the property's situs if (1) the disposition is the liquidation of a separate and distinct company business line and results in the cessation of that line; and (2) the company distributes all of the liquidation proceeds to shareholders and does not reinvest them in the company.

* Pennsylvania

HB 334 (signed into law as Act 23) changed the definition of business income to include income from property if "the acquisition, management or disposition" of the property constitutes an integral part of a taxpayer's regular trade or business. Previously, the statute had included income if the "acquisition, management and disposition" were integral parts of the taxpayer's business. The DOR has taken the position that this legislative change merely clarified the statute; thus, it is retroactive to 1999. The bill also added a provision that defines business income as all income apportionable under the U.S. Constitution.

* Oregon

The state supreme court held (31) that proceeds from a tort settlement were taxable business income apportionable to the state. The court was persuaded that steps taken to acquire an interest in established oil reserves were taken in the regular course of the taxpayer's trade or business, in part because the settlement was based on the cost of developing one billion barrels or oil reserves. Thus, the court concluded that the proceeds were business income under the transactional test.

DRD

* Arkansas

The state supreme court held (32) that taxpayers that elect to file state consolidated returns may eliminate intercorporate dividends in calculating gross income.

* California

A Los Angeles superior court held (33) that the state's dividends-received deduction (DRD) is unconstitutional. According to the court, Cal. Rev. and Tax Code Section 24402 facially discriminates against interstate commerce.

* Idaho

The state supreme court held (34) that a taxpayer could not deduct dividends from its wholly owned, unitary insurance subsidiary. While Universe Life and AIA Services were unitary, they did not have the same tax liability (the former pays insurance premium tax, not income tax); thus, AIA Services could not file a combined report with Universe Life. The court then agreed that AIA Services could not take a DRD, because the requirements of former I.C. [section] 63-3022(f) were not met; Universe Life did not pay more than 50% of its premium taxes to Idaho. The court declined to consider AIA Services' Constitutional argument because it was first raised in a brief on its motion for reconsideration.

* Idaho

A manufacturer that received dividends from a foreign subsidiary had to include them in its apportionable income subject to Idaho corporate franchise (income) tax and delete the subsidiary's income and apportionment factors from its combined report, because it failed to include the subsidiary in its required list of affiliated corporations when it filed its return and made a water's-edge election. (35) Idaho requires the submission of a list of affiliated corporations with the return; the corporation's failure to comply with this procedural requirement gave the tax commission the authority to determine the taxpayer's income without the water's-edge election.

* Maryland

The state tax court ruled (36) that the state's taxation scheme for foreign-source dividends violated the Commerce Clause, treating similarly situated taxpayers (one receiving domestic-source dividends and the other foreign-source dividends) differently in tax years following a loss year.

The starting point in calculating the state corporate income tax base is Federal Form 1120, line 30. Among the modifications allowed is a subtraction for dividends received from a foreign corporation in which the taxpayer directly or indirectly owned at least 50%. A long-standing state tax policy was that a corporation could not use a subtraction modification to increase its NOL carryforward in excess of its Federal NOL. Because domestic-source dividends are deducted from Federal taxable income, the starting point in calculating Maryland taxable income will never include those dividends. Thus, if a taxpayer incurs a loss, it can carry forward the entire loss to future years for state tax purposes.

Alternatively, foreign-source dividends are included in Federal taxable income; Maryland allows those dividends to be deducted in the year received. However, if a loss is incurred, the amount subtracted cannot be used to increase the loss for the carryover year. The court found that the disparate treatment discriminates against foreign commerce, because it directly results in a higher state corporate income tax on taxpayers with foreign-source dividends.

* Maryland

The state tax court ruled (37) that the state's method of taxing foreign-source Internal Revenue Code (IRC) Sec. 78 gross-up dividends violates the Foreign Commerce Clause.

* North Carolina

Effective for tax years beginning after 2001, HB 1157, Laws 2001, eliminated the DRD for dividends received from corporations in which the taxpayer owned a more-than-50% interest, to the extent such income was included in Federal taxable income. The new law also provided deductions for dividends treated as received from sources outside the U.S. as determined under IRC Sec. 862, to the extent included in Federal taxable income, and any amount included in Federal taxable income under IRC Sec. 78 or 951.

* North Dakota

SB 2189, Laws 2001, provided a corporate income tax deduction for shareholder dividends paid by regulated investment companies (RICs) or funds of RICs.

Related-party Transactions

The past several years have seen a dramatic increase in the scrutiny of related-party structures and transactions by state taxing authorities, triggering an increase in litigation. The states have attacked related-party transactions primarily using four methods: (1) redistributing income or expenses between related parties; (2) forcing the filing of a combined or consolidated return with some or all related parties; (3) denying deductions for specific payments made to related parties; or (4) asserting jurisdiction over a nonfiling entity based on a related party's attributes in the state.

* Alabama

HB 2, Laws 2001, eliminated (for tax years beginning after 2000) deductions for certain payments to related companies of interest and royalties on copyrights, patents, trademarks and other intangibles.

* Connecticut

The state supreme court affirmed (38) a trial court's judgment that the taxpayer's deduction of interest paid on its wholly owned subsidiary's loan was appropriate, as the subsidiary's formation and the loan had legitimate business purpose and economic substance.

* Michigan

The court of appeals (39) held that the Department of Treasury (Dep't) could adjust the taxpayers' (parent's and subsidiaries') business income for Single Business Tax (SBT) purposes, even if there was no change to Federal taxable income. On audit, the Dep't found that the taxpayers had inappropriately allocated employee compensation between subsidiaries; accordingly, it adjusted the compensation addback the taxpayers reported and the business income line of the SBT returns to arrive at the correct SBT base.

The court held that, because the tax computations contained in the SBT returns depended on the validity of Federal tax statements, the Dep't could adjust the business income when Federal taxable income was incorrect. Further, the Dep't could make these adjustments between taxpayers, even though the subsidiaries did not file a consolidated state return. It was irrelevant that no adjustment was made to the Federal consolidated return; the misallocation of compensation on individual returns did not appear to affect the aggregate figures reported on the Federal consolidated return.

* Mississippi

Under HB 1695, Laws 2001, effective Jan. 1, 2001, the tax commissioner should consider a broad list of factors when determining whether related-party transactions occur at arm's length and a taxpayer must add back certain (otherwise deductible) intangible and interest expenses paid to related entities. In determining arm's length, the new law provided that the commissioner should consider whether:

1. The transaction complied with IRC Sec. 482.

2. The transaction was done for a valid business purpose.

3. The income shifted by the transaction is subject to tax in another state.

4. The transaction was consistent with the results that would have been realized had uncontrolled taxpayers engaged in the same transaction under the same circumstances.

5. Other factors support the conclusion that income was shifted to avoid income tax.

* New York

The tax tribunal disallowed (40) deductions for interest paid to a taxpayer's subsidiary. The tribunal rejected the taxpayer's argument that, because its interest expenses were incurred for legitimate business purposes, they could not be treated as directly attributable to subsidiary capital. Further, it was unclear how an intercompany note (as opposed to the initial cash contribution) helped the taxpayer insulate itself from its expansion into foreign countries and the attendant risks. The only reasonable explanation for an exchange of assets was to obtain a double tax benefit--the taxpayer would not have to include $300 million provided to the subsidiaries as part of its entire net income (ENI) under Tax Law Section 208(9) (which provides that ENI does not include income or gains from subsidiary capital); simultaneously, it could receive a substantial deduction for the interest payments it made to the subsidiary on the loan back from the subsidiary of the funds used to capitalize it. The interest expenses were directly attributable to subsidiary capital and had to be added back in computing ENI.

Other Modifications

* Alabama

An administrative law judge (ALJ) ruled (41) that a financial institution cannot claim NOLs generated by its nonfinancial subsidiaries merged into a subsidiary financial institution. Although not the basis for the ruling, the ALJ noted that there was no evidence of a valid business purpose for the merger other than tax avoidance (e.g., to obtain use of the NOLs), nor does state precedent require one.

* Alabama

HB 2, Laws 2001, suspended the deduction for NOLs from previous years, effective for the first tax year beginning after 2000.

* Arkansas

Reversing the state supreme court's decision in Central & Southern Companies, Inc., (42) effective for tax years beginning after 2000, each corporation included in a state consolidated corporate income tax return must determine its charitable contribution separately. (43)

* California

The FTB issued Notice 2000-9 (44) to explain the limits on deducting interest expense by apportioning corporations, as affected by the U.S. Supreme Court's decision in Hunt-Wesson, Inc. v. FTB. (45)

* Idaho

The state tax commission held (46) that Federal Home Loan Bank dividends are subject to corporate franchise (income) tax.

* Illinois

Regulation 86 Ill. Adm. Code 100.2330 clarifies that Illinois NOLs incurred in tax years ending after Dec. 30, 1999 must be carried back two years and forward 20 years. Illinois NOLs incurred in tax years ending before Dec. 31, 1999 are allowed as a carryforward or carryback deduction under IRC Sec. 172.

For all years, a taxpayer may elect to relinquish the entire carryback period. The election must be made on the taxpayer's return for the tax year in which the Illinois NOL is incurred, must be made by the return's due date and is irrevocable. For corporate income and replacement tax purposes, the regulation also provides for S corporation losses to be carried to C corporation years and for C losses to be carried to S years. The regulation further provides that partnership and S NOL carryovers may not be used to reduce the taxable income of any partner or shareholder of the taxpayer in the carryover year.

* Iowa

Among other items, 2001 Iowa Acts, House File 715, amended Iowa Code Sections 422.35 and 422.61 to provide that income from the sale of obligations issued by the state or its political subdivisions is taxable for corporation and franchise tax purposes, unless the law authorizing these obligations specifically exempted the income from the sale from such taxes. The new law applies retroactively to tax years beginning after 2000.

* New York

The appellate division affirmed (47) a tax appeals tribunal decision holding that interest income from loan-pool certificates guaranteed by the Federal Small Business Administration is not deductible, because the certificates are not primary obligations of the U.S.

* Wisconsin

The state court of appeals held (48) that a surviving corporation of a pre-1987 merger could carry forward NOLs to offset against current net income, in accordance with Federal tax treatment. The court held that the legislature's intent in passing 1987 statutory revisions was to harmonize state corporate franchise tax determinations with Federal taxable income. State tax law had been less favorable to the taxpayer than the IRC; the legislature's intent to change that was evident.

Thus, for 1987 forward, the taxpayer should receive the same treatment for its NOLs under state law as the parties agree it was entitled to receive under Federal law. Because the taxpayer could offset the NOL carryforwards against current income under Federal law, it could also do so under Wisconsin law.

EXECUTIVE SUMMARY

* A Tennessee court decided that AOL's provision of Internet services to in-state customers did not trigger nexus.

* Massachusetts DOR Directive 01-08 lists non-U.S. business entities treated as foreign LLCs; the state's tax treatment of such entities follows the Federal check-the-box classification.

* A Kmart trademark holding company located in Michigan was held liable for New Mexico gross receipts and income taxes.

For more information about this article, contact Ms. Boucher at [e-mail].

(1) Reader's Digest Ass'n v. Franchise Tax Board (FTB), Cal. Ct. of Apps., No. C036307 (12/31/01).

(2) Iowa DRF, Policy Letter 00240104 (7/28/00).

(3) Neb. DOR, Rev. Rul. 24-01-01 (2/22/01).

(4) Kevin Associates, Inc., La. 19th Jud'l Dist., Dkt No. 460-981 (7/30/01).

(5) SYL, Inc. v. Comptroller of the Treasury, Cir. Ct. for Baltimore City, No. 24-C-99-002389AA (3/17/00).

(6) Kmart Properties, Inc. v. Tax'n and Rev. Dep't, NM Ct. of Apps., No. 21,140 (11/28/01).

(7) Iowa DRF, Policy Letter 00240076 (5/30/00).

(8) Mass. DOR, Ltr. Rul. 01-12 (11/8/01).

(9) Truck Renting and Leasing Ass'n, Inc. v. Comm'r of Rev., Mass. Sup. Jud'l Ct., No. SJC-08308 (4/17/01).

(10) Mass. DOR, Ltr. Rul. 01-4 (5/29/01).

(11) NYS Dep't of Tax'n and Fin., TSB-A-01(14)C (1/11/01).

(12) Ohio DOT, PITs 2001-1 and 2001-2, CFT 2001-02 and ST 2001-01 (September 2001).

(13) LSDHC Corp. v. Roger W. Tracy, Tax Comm'r of Ohio, Ohio Bd. of Tax Apps., No. 98-J-896 (11/9/01).

(14) America Online, Inc. v. Ruth E. Johnson, Comm'r of Rev., State of Tenn., Davidson Chancery Ct., Part III, No. 97-3786-III (3/13/01).

(15) Va. Ruling of Comm'r, P.D. 01-70 (5/25/01).

(16) General Motors Corp. v. City of Seattle, Wa. Ct. of Apps., Nos. 46152-4-I, 47562-4-I and 47561-4-I (5/7/01).

(17) Ala. DOR, Rev. Rul. 00-005 (6/28/01).

(18) La. DOR, Rev. Rul. 01-013 (10/1/01).

(19) See Mass. DOR, Ltr. Ruls. 00-5 (3/20/00) and 00-11 (8/29/00).

(20) Mass. DOR, TIR 97-8 (6/16/97).

(21) Mass. DOR, Directive 01-08 (11/13/01).

(22) Allied-Signal, Inc., 504 US 768 (1992).

(23) Ex Parte Uniroyal Tire Co., Ala. Sup. Ct., No. 1981928 (8/4/00).

(24) Hoechst Celanese Corp. v. FTB, 25 Cal.4th 508 (2001), cert. denied.

(25) Blessing/White, Inc. v. Kenneth Zehnder, Dir. of Rev., Ill. Cir. Ct., No. 99 L 51087 (1/24/01).

(26) Hercules, Inc. v. DOR, 753 NE2d 418 (IL 2001).

(27) The May Department Stores v. Indiana Dep't of State Rev., No. 49T10-99-06-TA-144 (5/7/01).

(28) Southland Corp. v. Comptroller of the Treasury, Md. Ct. of Spec'l Apps., Dkt. No. 1661 (6/13/01).

(29) Lenox, Inc. v. Tolson, 353 NC 659 (2001).

(30) NC DOR, Directive CD-01-1 (11/20/01).

(31) Pennzoil Co. v. DOR, Ore. Sup. Ct., No. S47561 (10/4/01).

(32) Richard Barclay, Dir., Ark. Dep't of Fin. and Admin. v. First Paris Holding Co., Ark. Sup. Ct., No. 00-1128 (5/10/01).

(33) Farmer Bros. Co. v. FTB, Cal. Sup'r Ct., LA Cty., No. BC237663 (11/21/01).

(34) AIA Services Corp. v. Idaho State Tax Comm'n, Id. Sup. Ct., No. 26029 (7/31/01).

(35) Id. State Tax Comm'n, Dec. 14379 (1/24/01).

(36) Kraft General Foods, Inc. v. Md. Comptroller of the Treasury, Md. Tax Ct., No. 98-IN-OO-0353 (6/8/01).

(37) General Motors Acceptance Corp. v. State Dep't of Assessments & Tax'n, Md. Tax Ct., No. 98-FR-OO-0699 (11/1/01).

(38) Carpenter Technology Corp., Ct. Sup. Ct., No. SC 16438 (6/19/01).

(39) Advanced Boring & Tool Co. v. Dep't of Treasury, Mich. Ct. of Apps., No. 220352 (5/29/01).

(40) In the Matter of the Petition of Carpenter Technology Corp., NY Div. of Tax Apps., Tax Apps. Tribunal, DTA No. 816680 (4/12/01).

(41) The Colonial BancGroup v. State of Ala. DOR, Ala. DOR, Admin. Law Div., No. CORP.99-515 (1/5/01).

(42) Central & Southern Companies, Inc., 339 Ark 76 (1999).

(43) See HB 1439, Laws 2001.

(44) Cal. FTB, Notice 2000-9 (12/19/00).

(45) Hunt-Wesson, Inc. v. FTB, 120 S.Ct. 1022 (2000).

(46) Id. State Tax Comm'n, Dec. Nos. 14315 and 14316 (5/23/00).

(47) Sumitomo Trust and Banking Co., NY Sup. Ct., App. Div., Third Dep't, No. 86258 (2/1/01).

(48) Wisc. DOR v. Caterpillar, Inc., Wisc. Ct. of Apps., Dist. IV, No. 00-0284 (1/11/01).

Karen J. Boucher, CPA
Principal
Arthur Andersen LLP
Milwaukee, WI