Current corporate income tax developments.

Part II of this two-part article addresses (1) state tax base computation issues, including state income taxes, dividends received and net operating loss deductions, and interest on Federal and state obligations and (2) apportionment factor and formula issues, such as sales factor sourcing rules for services and intangibles and factor relief for foreign royalties and interest.

In the August issue, Part I of this two-part article focused on significant nexus activities that will affect the majority of taxpayers and highlighted the novel approaches being demonstrated by some of the more aggressive states. Part II, below, addresses tax base and apportionment issues.

State Tax Base

The majority of states imposing a corporate income-based tax begin the computation of state taxable income with taxable income as reflected on the Federal corporate income tax return (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 Max base. Over the past 15 months, there have been a number of statutory, regulatory and judicial changes to these modifications. Below is a summary of the significant changes to the states' addition and subtraction modifications.

State Income Taxes

In determining the state Max base, most states require a corporation to add back state taxes (based on or measured by net income) deducted in arriving at Federal taxable income. Some states require that only their income taxes be added back, while others require that all state income taxes be added back. While the distinction between an income tax and a franchise Max measured by net worth generally is significant in determining whether an addback is required, in making the addback determination, the Michigan single business Max (SBT) is the most controversial of all of the state taxes. Some states permit a deduction for the entire SBT, other states do not allow a deduction for any portion of it, and several states attempt to bifurcate the tax into a deductible and a nondeductible component. As is discussed below, California and Wisconsin courts reached similar conclusions on this issue; an Ohio court held that a resident individual cannot claim a credit for the SBT. In addition, the Virginia Tax Commissioner clarified the treatment of the Texas franchise tax and Arizona eliminated the deduction for its state income taxes.

Arizona

For tax years beginning from and after 1997, the corporate tax rate is reduced from 9% to 8%; however, there is no longer a deduction for Arizona income taxes paid or accrued.(23)

California

In 1994, in Appeal of Dayton Hudson Corp.,(24) the California State Board of Equalization (SBE) held that the SBT is fully deductible in computing the California corporate franchise/income tax, because it is not a tax measured by income and cannot be bifurcated into deductible and nondeductible portions. In response, the California Franchise Tax Board (FTB) modified its prior SBT bifurcation position to provide that the SBT is deductible for California corporate tax purposes (i.e., an addback is not required) if the taxpayer has incurred and deducted labor costs of goods sold (COGS) in the year in which the SBT is paid or accrued. If there is no return of capital in the form of labor COGS in the SBT base (e.g., businesses that exclusively provide services or that do not incur and deduct labor COGS), the deduction is not allowed.

During 1997, the SBE rejected the FTB'S modified SBT position. In Appeal of Kelly Service Inc.,(25) the taxpayer asked the SBE to expand its holding in Dayton Hudson to encompass situations in which there is no labor COGS in the SBT tax base for a particular taxpayer. The taxpayer is a service business providing temporary help to a variety of customers. As a service business, it has no inventory costs; thus, the SBT does not "contain an element of return of capital" in its tax base. The SBE affirmed Dayton Hudson and clarified that its holding applies equally to service businesses. Accordingly, the SBT is deductible for California tax purposes, regardless of the specific components of the SBT tax base of the taxpayer claiming the deduction.

Ohio

In Ardire v. Tracy,(26) the Ohio Supreme Court, relying on Gillette Co. v. Mich. Dep't of Treasury,(27) determined that the SBT was not a tax "measured by" net income for purposes of eligibility for Ohio's resident tax credit. The Ardire court noted that the SBT starting point is Federal taxable income (i.e., net income) with several addition adjustments, but the many addition adjustments prevent a conclusion that the SBT is a tax "measured by" net income.

Virginia

The Virginia Tax Commissioner (Commissioner) addressed whether the Texas franchise tax constitutes an addition modification in computing the Virginia corporate income tax.(28) Basically, the basis for the earned surplus component of the Texas franchise tax is Federal taxable income with several modifications. The Commissioner ruled that the earned surplus tax is based on net income and must be added back for Virginia tax purposes. The Texas net capital tax is based on stated capital plus surplus; thus, it is not required to be added back in determining Virginia taxable income.

Wisconsin

A Wisconsin Circuit Court reversed the decision of the Wisconsin Tax Appeals Commission (Commission) on the deductibility of the SBT in tax years prior to a 1994 legislative amendment clarifying that the SBT has to be added back to the Wisconsin tax base. In Delco Electronics Corp. v. Wisc. Dep't of Rev. (DOR),(29) the court held that the SBT can be deducted from Wisconsin corporate franchise tax, because the SBT is not a tax on or measured by all or a portion of income or gross receipts. The Commission had ruled that the SBT was not deductible in computing the Wisconsin franchise tax liability.

For the years at issue, the Wisconsin statutes disallowed a deduction for state taxes on or measured by "all or a portion" of net income, gross income, ,gross receipts or capital stock. The Commission had not been persuaded by the Michigan court's reasoning in Gillette that net income, which is an essential and clearly defined component of the total tax measure, loses its identity as a "measure" of the SBT. Accordingly, it concluded that the SBT was "measured by net income" within the unambiguous meaning of the Wisconsin statutes, because net income is a clearly defined, distinct and essential component of the SBT total tax base in the addition method used by the taxpayer. The Commission noted that the taxpayer might have prevailed if the statute applied only to taxes measured "solely or exclusively" by net income. The circuit court held that the SBT is not a tax on or measured by net income; rather, it is a value-added tax that does not have to be added back.

DRD 

Alabama

Alabama law permits a deduction for dividends received (DRD) from a corporation subject to Alabama income tax. In Alabama DOR v. Sonat, Inc.,(30) Sonat received $185 million of dividends from a subsidiary whose only connection with Alabama was its lease of office furniture located in Alabama to another affiliate, which resulted in $87 of Alabama corporate income tax. The Alabama Court of Civil Appeals reversed a lower court decision, holding that the subsidiary's de minimis involvement in Alabama did not render its net income taxable there; thus, Sonat could not claim a deduction for the $185 million of dividends received from the subsidiary.

Arkansas

Arkansas legislation enacted in 1997, effective for tax years beginning after 1996, excludes from corporate income dividends received from a subsidiary owned at least 80% by the parent. Prior to this amendment, such dividends were excludible only if the parent owned at least 95% of the subsidiary. In addition, for dividends paid in tax years beginning after July 30, 1995, foreign corporations can claim a DRD for dividends paid by corporations at least 20% owned. Prior to this amendment, a DRD was allowed only for dividends paid by a subsidiary that was also subject to Alabama income tax.(31)

California

The U.S. Supreme Court's unanimous decision in Fulton Corp. v. Faulkner(32) calls into question the constitutionality of California's DRD statutes, Cal. Rev. & Tax. Code Sections 24402 and 24410, which permit a deduction only for dividends included in the measure of the distributing corporation's California franchise tax, alternative minimum tax or corporate income tax liability.(33)

District of Columbia 

The D.C. City Council approved legislation(34) that provides a 100% DRD for dividends received from a wholly owned subsidiary after Feb. 28, 1997. Prior to this law change, in computing the D.C. corporate franchise tax, a DRD was allowed only if both the parent and subsidiary were subject to franchise tax and the parent did not provide any services to the subsidiary.

New Mexico 

In Conoco Inc. and Intel Corp. v. Tax'n and Rev. Dep't,(35) the New Mexico Supreme Court held that inclusion of dividends from foreign subsidiaries in the apportionable base for determining state income tax of a corporation filing as a separate entity violates the Foreign Commerce Clause. In response to its loss in Conoco, the New Mexico Taxation and Revenue Department recently proposed a new regulation governing the DRD for a corporation reporting to New Mexico as a separate entity. Under Prop. Reg. 3 NMAC 4.1.12, such taxpayers receive a DRD for foreign dividends in the same percentage as would be permitted under Code Sec. 243 had the payer of the dividends been a domestic corporation.

North Carolina 

According to North Carolina Technical Advice Memorandum No. 97-14,(36) effective for original returns filed after Sept. 14, 1997, all corporate taxpayers can deduct dividends from corporations in which they own more than 50% of the outstanding voting stock, without any loss of the deduction for related expenses. In addition, effective for tax years beginning after 1997, dividend income may be either business or nonbusiness income, depending on its nature.

NOL Deduction

Connecticut

In Cunningham Group, Inc. v. Comm'r,(37) a Connecticut Superior Court applied the continuity-of-business test and ruled that a surviving corporation could deduct premerger NOLs of the merged corporation.

District of Columbia

In Sovran Bank/D. C. National v. District of Columbia,(38) the D.C. Superior Court upheld the Office of Tax and Revenue's (OTR) interpretation of the NOL deduction statute. To allow a D.C. NOL deduction, the OTR interprets the D.C. Code as requiring (1) a Federal NOL deduction, (2) reported on a Federal tax return (3) for the same tax period in which the D.C. NOL deduction is claimed. Accordingly, a corporation required to file a separate D.C. return cannot claim an NOL deduction to the extent that an affiliated member of its Federal consolidated return absorbed the loss in the year in which it was generated.

Sovran Bank, as a separate corporation, sustained an NOL in 1991; a portion of this loss was used on its Federal consolidated return to offset the income of other affiliates. In 1993, Sovran filed franchise tax refund claims for 1989 and 1990, which were based, in part, on the carryback of a portion of the loss absorbed by its affiliates in 1991. The refund claims were denied, because there was no NOL deduction reported on Sovran's Federal consolidated return for 1989 and 1990.

Sovran argued that because it was required to file a separate D.C. corporate income tax return, the appropriate construction of the NOL provision is to determine NOL carrybacks as if it had filed a separate Federal return. However, the court found that the statute is unambiguous; the correct interpretation is that a corporation will be allowed an NOL deduction to the extent such deduction is reported on the corporation's Federal tax return for the same tax period. Noting, in part, that deductions are not granted by right, but by legislative grace, and that the legislature may allow or disallow them, the court held that the D.C. NOL statute did not violate the Due Process, Commerce or Equal Protection Clauses. The taxpayer is appealing.

Massachusetts

In Farrell v. Comm'r,(39) the Massachusetts Appellate Tax Board ruled that a parent cannot use NOL carryovers generated by three of its subsidiaries in prior years to offset the group's Massachusetts corporate income. The taxable net income of each corporation must first be separately determined and then added together to arrive at combined income. Because the taxpayer's three subsidiaries had no net income for the tax year in issue, they could not use the NOLs previously generated; accordingly, the NOL carryovers could not offset the combined group's positive net income.

North Carolina

At issue in BellSouth Telecommunications, Inc. v. North Carolina DOR,(40) was whether the merger of ASI into its parent, BellSouth Telecommunications, Inc. (Southern Bell), qualified as continuity of business enterprise so as to enable Southern Bell to deduct ASI's premerger losses against Southern Bell's post-merger gains.

In 1984, Southern Bell received an order from the Federal Communications Commission (FCC) providing that it could sell or lease customer premises telephone equipment (CPE) only through a separate subsidiary. Thus, Southern Bell formed ASI, a wholly owned subsidiary, to market and sell CPE. In 1988, ASI merged into Southern Bell after the FCC issued a structural relief order permitting Southern Bell to market and sell CPE directly. ASI incurred economic losses in tax years 1985 through 1988, its only years of operations.

Following the three tests enunciated by the North Carolina Supreme Court in Fieldcrest Mills, Inc. v. Coble,(41) the North Carolina Court of Appeals disallowed Southern Bell's deduction of ASI's premerger net economic losses, because: (1) Southern Bell failed to prove that ASI would have been able to claim the tax deduction "but for" the merger; (2) the merger failed to qualify as continuity of business enterprise under the assets test; and (3) the "substantially the same business" test was failed, because the merger materially altered and enlarged the assets of the former ASI.

Pennsylvania

Legislation enacted during 1998 extends to 10 years the corporate income tax carryover period for NOLs incurred during 1995 and subsequent years.(42) Prior to this change, 1995 NOLs could be carried over for only two years; NOLs incurred after 1995 could be carried over for only three years. The annual $1 million net loss deduction was not changed.

Tennessee

In Little Six Corp. v. Johnson,(43) the trial court held that the corporation surviving a statutory merger can use NOLs generated by the corporation dissolved as a result of the merger, if the assets generating the income for the surviving corporation are those that generated the losses for the predecessor.

Income from U.S. and State Obligations

Ohio

In NACCO Industries, Inc. v. Tracy,(44) the Ohio Supreme Court held that the gain on the sale or a U.S. Treasury bond is not exempt from the Ohio franchise tax under the intergovernmental immunity doctrine. The court held that USC Section 3124(a) exempts Federal obligations and the interest thereon from state taxation, but not gains from the sale of such obligations arising from the exchange of the obligation between two private parties. Similarly, the constitutional doctrine of intergovernmental immunity does not extend to the state taxation of gains resulting from a contract between two private parties. The U.S. Supreme Court has denied certiorari.

Wisconsin

The Wisconsin Court of Appeals has ruled that interest on U.S. government obligations is not subject to the Wisconsin franchise tax. In American Family Mutual Insurance Co. v. Wisc. DOR,(45) the court held that Wisconsin's taxing scheme was discriminatory because it taxed U.S. government interest, while exempting interest on certain types of Wisconsin obligations. The Wisconsin Supreme Court recently decided to hear the appeal of this decision.

Other Modifications

California

In Hunt-Wesson, Inc. v. FTB,(46) a Superior Court held that California's interest offset statute violates the Due Process, Commerce and Equal Protection Clauses, because it requires a dollar-for-dollar offset of otherwise deductible interest expenses with nontaxable dividend income of foreign corporations.

Massachusetts

In R.J. Reynolds Tobacco Co. v. Comm'r of Rev.,(47) the Massachusetts Appellate Tax Board (Board) ruled that taxpayers can rely on Regs. Sec. 1.1502-13(a)(2) when calculating their Massachusetts corporate excise tax. That regulation allows taxpayers to defer recognizing gains realized between members of an affiliated group until the property creating the gain is disposed of outside the group.

The taxpayer had distributed the stock of a subsidiary to its parent, RJR Nabisco, Inc., as a dividend, but deferred recognizing the gain on the distribution under Regs. Sec. 1.150213(a)(2). On audit, the Massachusetts Commissioner of Revenue (COR) argued that the taxpayer could not defer the gain, because the taxpayer and its parent did not file a combined Massachusetts excise tax return for the year the gain was realized.

In ruling for the taxpayer, the Board relied on the definition of gross income found in the Code and adopted by the COR. Because the taxpayer did not include the gain in gross income until its parent later disposed of the stock, the COR could not require the taxpayer to include the gain in its calculation of its current-year Massachusetts excise tax liability.

New York City 

In R.J. Reynolds Tabacco Co. v. New York City Dep't of Fin.,(48) the New York Supreme Court, Appellate Division, affirmed a lower court's decision holding that New York City's tax law, which allows more favorable depreciation deductions for property located in New York than property located outside of the state, is unconstitutional.

Texas

In computing the earned surplus component of the Texas franchise tax, most corporations are required to add back compensation paid to corporate officers and directors, under TAC Section 3.558; this addback significantly increases the franchise tax for many taxpayers. Traditionally, the Texas Comptroller (Comptroller) has required the addback to the earned surplus tax base of all compensation paid to corporate officers and directors, regardless of the scope of each individual officer's authority; however, under TAC Section 3.558(b)(5)(A), banks are required to add back only the compensation of officers who have direct authority to participate in the institution's "major policymaking functions."

Due to taxpayer challenges, it appears that the Comptroller will be changing its policy. Proposed amendments to Rule 3.558 provide that for limited liability companies (LLCs) and corporations (other than banking corporations), any person designated as an officer (or manager, in the case of an LLC) is presumed to be an officer and subject to compensation addback if that person: (1) holds an office created by the board of directors or pursuant to the corporate charter or bylaws and (2) has legal authority to bind the corporation with third parties by executing contracts or other legal documents. The proposed regulation also provides that a corporation may rebut the officer presumption if it conclusively shows that, through the person's job description or other documentation, the person does not participate in (or have authority to participate in) significant policymaking aspects of the corporate operations. These proposed rules may apply to the Texas franchise tax returns that were due on May 15, 1998 and prior years open under the statute of limitations.

Apportionment Factors and Formulas

Sales Factor Sourcing Rules for Services and Intangibles

Traditionally, only a handful of states source (i.e., include in the numerator of the sales factor) gross receipts derived from the provision of services or intangible assets based on the customer's location or where the service is consumed. Instead, most states use a "cost of performance" or similar rule that generally sources sales based on where the service is provided. However, the current trend is for movement away from the traditional "cost of performance rule" to a "market state" basis.

Maryland

During 1997, the Maryland Comptroller of the Treasury amended COMAR 03.04.03, Reg .08, to change the method of apportioning income of multistate contracting and service-related companies from a single sales factor (based on greater cost of performance) to a three-factor formula with double-weighted sales (based on market sourcing). Under a market-sourcing approach, receipts derived from customers in Maryland are included in the numerator of the receipts factor.

Because the states surrounding Maryland have not adopted a market-sourcing approach, service businesses located in those states with Maryland customers most likely will see a significant increase in their overall state income tax liability. Many of these businesses will pay state tax on substantially more than 100% of income, because they will be required to treat all of the receipts as attributable to the state in which the actual work is done and to include receipts to Maryland customers in the Maryland receipts factor.

Nebraska

Legislation (L.B. 1286) introduced, but not passed, during the 1998 session would have modified the sales factor sourcing of services. Currently, under Neb. Rev. Stats. Section 772734.14(3) (b), sales of services are assigned to the state in which the greater costs of performance are incurred. Under L.B. 1286, sales of services would have been sourced based on the customer's location. This change could have significantly increased the Nebraska tax liabilities of out-of-state corporations, because the state uses a single-sales-factor apportionment formula.

New Hampshire 

Under the New Hampshire DOR Administration's amended regulation, Rev. 304.04, the numerator of the sales factor has been expanded to include: (1) gross receipts from the licensing or other use of intangible property when such property is used in the state and (2) gross receipts from the rendering of personal services when the services are performed in the state. The rendering of personal services is included in the numerator of the New Hampshire sales factor if the activity performed in the state is a dependent component of a service performed both within and without the state and a greater proportion of the costs directly associated with performing such service are incurred in the state. In determining the costs directly associated with the performance of such service, the business organization must allocate all compensation costs (including benefits) of personnel rendering the service based on the amount of time spent rendering the service in New Hampshire, as compared to the time spent in rendering the service outside the state. Expenses incurred in obtaining or retaining customers or clients (including contract negotiations) are not costs directly associated with the performance of the service.

New Jersey

The New Jersey Division of Taxation recently amended various apportionment regulations to "clarify" the treatment for sourcing receipts from services, trademarks, Internet access and automated teller machines (ATMs). The amendments are a novel approach to sourcing certain service income. Under amended N.J.A.C. 18:7-8.10, receipts from services are sourced to a location "based upon the cost of performance or amount of time spent in the performance of such services or by some other reasonable method which should reflect the trade or business practice and economic realties underlying the generation of the compensation for services." For this purpose, the cost of performance is defined as "all direct costs incurred in the performance of the service, including direct costs of subcontractors"

The amended examples provide that a taxpayer who derives advertising revenues in the course of broadcasting television or radio programs and sets its advertising rates based on listening audience it has succeeded in reaching should source its advertising revenues based on the portion of its listening audience in New Jersey. Another example provides that a taxpayer earning income from long-distance telephone communication service that bills the originators of such calls directly and for all calls placed by them should source long-distance toll revenues based on billings for calls originating in New Jersey. Obviously, the amended rule provides anything but a clear receipts sourcing rule for taxpayers outside of the two industries identified in the examples.

For ATM transactions using credit cards and Internet transactions, the amendment takes into account the locations of the origination and termination of the transactions. The receipts from such services are sourced to New Jersey based on the following: (1) 25% to the state of origination; (2) 50% to the state in which the service is performed; and (3) 25% to the state in which the transaction terminates. For example, a taxpayer whose physical equipment allowing access is located outside of New Jersey provides on-line Internet access to customers located within and outside the state. The taxpayer must source 50% of its revenue from Internet access charges to New Jersey based on the origination and termination of such access from points within New Jersey. Absent specific identification of points of origination and termination, the customer's billing address serves to locate those activities.

Texas

Legislation passed in 1997 changed Texas's sourcing rules for income from the licensing of intangible assets (e.g., trademarks and trade names).(49) Under the new law, income from licensing these types of intangibles are Texas receipts (i.e., are included in the numerator of the Texas sales factor) if the intangibles are used in Texas. This sourcing rule, which is effective for franchise tax reports due after 1997, applies for both the earned surplus and capital tax components of the franchise tax.

Factor Relief for Foreign Royalties and Interest

Illinois

In Caterpillar Financial Services Corp. v,. Whitley,(50) the Appellate Court held that the Illinois combined water's-edge reporting method does not unconstitutionally discriminate against royalties and interest payments received by the taxpayer's domestic entities from its foreign subsidiaries. The taxpayer had argued that the inclusion of interest and royalties from foreign subsidiaries in the combined net income base, without the inclusion of the foreign subsidiaries' property, payroll and sales factors in the apportionment formula, caused a larger portion of the foreign payments to the unitary group to be included in Illinois allocable income, thereby discriminating against foreign commerce. However, the court found that under the water's-edge method of combined reporting, royalty- and interest-paying foreign subsidiaries are similar to nonrelated domestic third-party customers of the taxpayer, in that none of the foreign subsidiary's or the nonrelated third party's income is included in the income allocable to Illinois; thus, no discrimination results.

Minnesota

In Caterpillar, Inc. v. Comm'r of Rev,(51) the Minnesota Supreme Court held that the exclusion of foreign subsidiary factors from apportionment formula denominators in calculating Minnesota excise tax did not violate the Commerce Clause. Affirming the Minnesota Tax Court's decision, the Minnesota Supreme Court ruled that the state's water's-edge method of taxing unitary business groups does not facially discriminate against foreign commerce. Under the water's-edge reporting method, only the income and apportionment factors of domestic members of the unitary group are included in the combined report; consequently, interest and royalties received from foreign subsidiaries were included in the taxpayer's combined net income base without inclusion of the foreign subsidiaries' property, payroll and sales factors in the apportionment fraction denominators. The U.S. Supreme Court has denied certiorari.

Other Apportionment Changes

MTC 

In an effort to ensure that taxpayers do not include in the denominator of the sales factor proceeds from the sale of investment assets, the Multistate Tax Commission (MTC) amended Reg. IV. 18(c) in 1997, generally to require that only the overall net gains (rather than the gross proceeds) recognized from certain sales of liquid assets be included in the sales factor. A "liquid asset" is defined as an asset (other than functional currency or funds held in bank accounts) held to provide a relatively immediate source of funds to satisfy the trade's or business's liquidity needs. For this purpose, liquid assets include foreign currency (and trading positions therein) other than functional currency used in the regular course of the taxpayer's trade or business; marketable instruments (including stocks, bonds, debentures, options, warrants, futures contracts, etc.); and mutual funds that hold such liquid assets. An instrument is "marketable" if it is traded on an established stock or securities market and is regularly quoted by brokers or dealers in making a market. However, stock in a corporation that is unitary with the taxpayer (or that has a substantial business relationship with the taxpayer) is not marketable stock. No state has yet adopted the MTC's amended regulation.

Arizona

For tax years beginning from and after 1997, the sales factor throwback provision is eliminated and government sales of tangible personal property are sourced to the state of destination.(52)

California

In Bechtel Power Corp.(53) the SBE ruled that the costs of client-furnished materials under a cost-plus contract should be included in the California sales factor of a multistate contractor. Many of the taxpayers' contracts were cost-plus contracts, under which the customer agreed to pay the actual costs of materials and payroll, plus an additional fee for various services. In many situations, the supplier invoices were paid directly by the customer after the taxpayer's approval and the materials were considered to be client-furnished materials.

The FTB had argued that the taxpayers merely acted as agents when using client-furnished materials and, therefore, should not be permitted to include the cost of such materials in determining the sales factor of the apportionment formula. Noting that California law defines "sales" as" all gross receipts of the taxpayer" other than those related to items of nonbusiness income and that California regulations provide that, in the case of cost-plus contracts, sales include the entire reimbursed cost, plus the fee, the SBE found that the taxpayers' income-producing business activity and the taxable income therefrom were the same, regardless of whether procurement was from the taxpayers' account or from clients' accounts. It held that the level of income-producing business activity to be represented by the sales factor is best represented by inclusion of the full amount of the cost-plus contract, including the client-furnished materials.

Illinois

During August 1997, Governor Jim Edgar vetoed H.B. 585, which would have adopted a single-sales-factor formula for apportioning income and eliminated the sales factor throwback provision. Currently, business income is apportioned to Illinois by a factor consisting of property, payroll and double-weighted sales.

However, legislation enacted in 1998 provides for a three-year transition to a single sales factor for Illinois income tax apportionment purposes.(54) For tax years ending after 1998 and before 2000, the property and payroll factors will each be weighted 16 2/3% and the sales factor will be weighted 66 2/3%. For tax years ending after 1999 and before 2001, the property and payroll factors each will be weighted 8 1/3% and the sales factor will be weighted 83 1/3%. For tax years ending after 2000, the sales factor will be 100%. Special apportionment formulas for financial organizations, insurance companies and transportation companies are not affected by this legislation.

Unlike the legislation vetoed in 1997, the new law did not eliminate the sales factor throwback provision.

Illinois

The Illinois Appellate Court has upheld the DOR's ruling that sales shipped from Illinois by a member of a unitary business group to purchasers outside Illinois have to be "thrown back" to Illinois if the subsidiary making the sale was not separately subject to tax in the destination state, even though other group members were taxable there.(55)

Michigan

Effective for tax years beginning after 1996, the SBT apportionment formula is weighted 80% sales factor, 10% payroll factor and 10% property factor. Further, effective for tax years beginning after 1996, the capital acquisition deduction (CAD) is allowed only for depreciable assets located in Michigan; an exception applies for "mobile tangible assets."(56)

Because the changes to the CAD deduction may be challenged as unconstitutional, M.C.L. Section 208.23(i) includes a fall-back provision that allows a CAD deduction for all assets acquired after 1996, regardless of location. However, the apportionment percentage weighting reverts to 50% sales, 25% property and 25% payroll for tax years beginning in 1997 if the amended CAD provisions are not in effect. The fall-back provision will become effective if the Michigan Court of Appeals declares the Michigan-only CAD deduction unconstitutional. However, due to Michigan's 90-day statute of limitations for constitutional issues, only taxpayers that file protective refund claims within 90 days of the due date of their originally fried returns will be eligible for refunds. Accordingly, not all taxpayers will be due a refund if the CAD provisions are declared unconstitutional.

Legislation enacted during 1998 provides that for tax years beginning after 1997, Michigan sales consist of tangible personal property when the property is shipped or delivered to any purchaser within the state, regardless of the free on board point or other conditions.(57) In addition, the new law eliminates the sales factor throwback provision and changes the way sales of tangible personal property to the U.S. government are treated. Under the original statute, sales to the Federal government were Michigan sales if they were shipped from Michigan; the new law provides that sales to the government are Michigan sales if they are shipped to Michigan.

New York

The New York State Court of Appeals reversed the Appellate Division's decision in Siemens Corp. v. Tax Apps. Tribunal.(58) For purposes of the receipts factor of corporate taxpayers in the business of lending funds, interest income is sourced to the state in which it is earned. The New York State Department of Taxation and Finance (Department) has traditionally treated interest income of such taxpayers as earned at the location of the lender. However, the Appellate Division found such treatment was improper and held that interest income is earned at the location of the borrower.

In reversing, the Court of Appeals found that, to the extent interest income results from work performed in New York, the income is earned in New York. As a result of the court's decision, corporate taxpayers in the business of lending funds should source interest income based on where the activities connected to the loan are performed.

New York

In an advisory opinion, the Department ruled that sales of products manufactured in NewYork by a corporation to a Michigan LLC, 99% directly owned and 1% indirectly owned by the corporation, are not includible in the corporation's numerator and denominator of the receipts factor when the LLC's profits would be added to the corporation's profits for purposes of the corporate franchise tax.(59)

Virginia

Legislation recently signed by the Governor provides that, effective for tax years beginning after 1999, the sales factor will be double-weighted for corporations (other than motor carriers, financial corporations, construction corporations and railway companies), if the double-weighting provision is reenacted by the 1999 Session of the General Assembly.(60)

Wisconsin

Recently enacted legislation permits the DOR to authorize a corporation to use a different method of apportioning its state income and may specify the method of apportionment that the corporation may use.(61) The new law applies to companies whose restructuring would result in an unfair representation of the business activity in Wisconsin. The new law, which is effective for the 1998 tax year, will only apply to companies requesting an apportionment change before 2000. The law provides that the alternative apportionment method cannot result in less corporation franchise or income tax revenue to Wisconsin than the entity's current structure, given the same overall level of sales, payroll and property.

(23) S.B. 1007, Laws 1998.

(24) Appeal of Dayton Hudson Corp., California SBE, No. 94-SBE-003 (2/3/94).

(25) Appeal of Kelly Service Inc., California SBE, No. 97-SBE-010 (5/8/97).

(26) Ardire v. Tracy, 674 NE2d 1155 (1997).

(27) Gillette Co. v. Mich. Dep't of Treasury, 198 Mich. App. 303 (1993).

(28) Ruling of Comm'r, P.D. 97-376 (9/18/97).

(29) Delco Electronics Corp. v. Wisc. DOR, Wisc. Circ. Ct., Dane Cty., Branch 6, No. 97-CV-1908 (3/20/98), rev'g Wisc. Tax Apps. Comm'n, No. 95-I-112 (6/16/97).

(30) Alabama DOR v. Sonat, Inc., Ala. Ct. of Civil Apps., No. 2960274 (5/2/97).

(31) Act 1189, Laws 1997.

(32) Fulton Corp. v. Faulkner, 116 S.Ct. 848 (1996).

(33) See Herbert and Woodward, "Dividing the Pie: Is Your Dividend Deduction Slice Getting Bigger in California?," 4 Tax Mngmt. Multistate Tax Rep't 37 (2/28/97).

(34) D.C. Law 11-257.

(35) Conoco Inc. and Intel Corp. v. Tax, and Ret,. Dep't, 931 P2d 730 (1996), cert. denied.

(36) N.C. DOR Technical Advice Memorandum No. 97-14 (9/15/97).

(37) Cunningham Group, Inc. v. Corem'r, Conn. Super. Ct., Tax Session, No. CV-93-0526517 (12/4/97).

(38) Sovran Bank/D. C. National v. District of Columbia, D.C. Super. Ct., No. 6029-94 (12/3/97).

(39) Farrell v. Comm'r, Mass. App. Tax Bd., No. 215424 (6/25/97).

(40) BellSouth Telecommunications, Inc. v. North Carolina DOR, No. COA96-558 (6/3/97).

(41) Fieldcrest Mills, Inc. v. Coble, 290 NC 586 (1976).

(42) H.B. 1766, Laws 1998.

(43) Little Six Corp. v. Ruth Johnson, Comm'r of Rev. of the State of Tenn., Davidson Cty. Chancery Ct., Nos. 90-2044-111 and 95-2556-II (5/7/98).

(44) NACCO Industries, Inc. v. Tracy, Ohio Sup. Ct., No. 96-1535 (8/6/97), aff'g Ohio Bd. of Tax Apps., No. 95-K-1210 (1996).

(45) American Family Mutual Insurance Co. v. Wisc. DOR, Wisc. Ct. of Apps., Nos. 971105 and 97-1106 (10/30/97).

(46) Hunt-Wesson, Inc. v. FTB, Cal. Super. Ct., No. 976628 (6/24/97).

(47) R.J. Reynolds Tobacco Company v. Comm'r of Rev., Mass. App. Tax Bd., No 206404 (3/31/97).

(48) R.J. Reynolds Tobacco Co. v. New York City Dep't of Fin., NY Sup. Ct., App. Div., 1st Dep't, No. 61564 (12/9/97).

(49) S.B. 861, Laws 1997.

(50) Caterpillar Financial Services Corp. v. Whitley, Ill. App. Ct., Third District, No. 3-94-0830 (5/19/97).

(51) Caterpillar, Inc. v. Comm'r of Rev., 568 NW2d 695 (1997).

(52) S.B. 1007, Laws 1998.

(53) Bechtel Power Corp., California SBE, No. 97-SBE-002 (3/19/97).

(54) P. A. 90-0613, Laws 1998.

(55) Beatrice Companies Inc. v. Whitley, Ill. App. Ct., First Dist., No. 1-96-1070 (9/12/97).

(56) Act 282, Laws 1995.

(57) H.B. 4910, Laws 1998.

(58) Siemens Corp. v. Tax Apps. Tribunal, NY Ct. of Apps., No. 33 (4/1/97), rev'g 217 AD2d 247 (1996).

(59) TSB-A-97(13)C (6/26/97).

(60) TSB. 709, Laws 1997.

(61) 1997 Act 299.

RELATED ARTICLE: EXECUTIVE SUMMARY

* In determining the state tax base, the Michigan SBT is the most controversial addback of all of the state taxes.

* The MTC amended a regulation to require that only the overall net gains (rather than the gross proceeds) recognized from certain sales of liquid assets be included in the sales factor.

* While most states use a "cost of performance" or similar rule that generally sources sales based on where the service is provided, the current trend is for movement toward a "market state" basis.