Dividing the income tax base of multistate corporations.

Corporations that operate in a multistate environment must divide their income among those states in which they are subject to tax. The objective is twofold: 1) to ensure that multistate corporations are not subject to multiple taxation and 2) to provide an equitable process for dividing a corporation's income among the various states in which it conducts business. This column has been excerpted from the State Corporate Tax Issues Practice Guide, developed by the AICPA State and Local Taxation Committee to inform practitioners about multistate state corporate tax issues (such as nexus, apportionment and state net operating loss carryovers). The Practice Guide should be used in conjunction with the State Tax Return Preparation Guide For All States' CORPORATION State Tax Returns, which identifies the most common problems or unique issues encountered in the preparation of state corporate income tax returns (including issues surrounding the division of income) for each of the 50 states. Both guides can be found in the "Taxation Topics" section of the AICPA website at www.aicpa.org.

Corporations that do business on a multistate basis are potentially subject to taxation in multiple jurisdictions; all those states in which a multistate corporation has nexus may validly subject the corporation to tax. As states have attempted to ascertain the portion of a multistate corporation's income tax base that they may tax, the following methods of division have developed: 1) separate accounting, 2) specific allocation and 3) formulary apportionment.

Separate Accounting

Under the separate accounting method, the activities of a corporation within a state are considered separate and distinct from those outside the state. As a result, the corporation attempts to source each item of revenue and expense to the state in which it was generated. However, this method is geared for businesses with tax records that facilitate the separation of items of expense and income on a geographic basis.

Although this method was the first to be developed and previously was considered to be the most precise method of dividing the income of a multistate business, it is now only occasionally used. Separate accounting operates to ignore the integration of a unitary business (i.e., an interrelated and interdependent group of corporations or divisions that should be viewed collectively) doing business in numerous states. Specifically, separate accounting treats the unitary business as if it had separate and independent components and, accordingly, is not readily applied to unitary businesses. Due to its lack of accuracy and the ease with which it may be manipulated, this method is now used only in limited instances, such as the oil and gas industry.

Specific Allocation

Under the specific allocation method, certain types of income (and related expenses) are traced to their geographic source or other connection with a state and attributed solely to that state. Other types of income are apportioned among the states in which the corporation is doing business. In most states, income classified as nonbusiness may be specifically allocated to a jurisdiction; income classified as business is apportioned among all states in which the corporation is taxable.

Business and Nonbusiness Income

The distinction between business and nonbusiness income is significant. In general, nonbusiness income is allocable to either the taxpayer's state of commercial domicile or the situs of the property. In contrast, business income is divided among the states in which the multistate taxpayer does business, based on a mathematical apportionment formula.

The three main methods used to determine whether income is business or nonbusiness are 1) The Uniform Division of Income for Tax Purposes Act (UDITPA) definitions of business and nonbusiness income, 2) Multistate Tax Commission (MTC) regulations (when adopted by a state) and 3) United States Supreme Court cases.

UDITPA. Under UDITPA, business income is defined as income that arises from transactions and activities in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations (UDIPTA Section 1(a)). UDITPA defines nonbusiness income as all income other than business income (UDIPTA Section 1(e)). Most states interpret the UDITPA definition as incorporating two tests for determining whether income is business income. The tests are referred to as the "transactional test" and the "functional test." In most states, if income is classified as business income under either test, the income will be classified as business income.

Under the transactional test, income is considered business income if it arises from transactions and activities in the regular course of a taxpayer's trade or business. The focus is on the type of transaction that gives rise to the income and how the transaction relates to the taxpayer's regular trade or business. For example, the sale of a factory by a manufacturer normally would be considered unusual, extraordinary and occurring outside the normal course of business. As such, the gain would be considered nonbusiness income under the transactional test.

Under the functional test, income is considered business income if the acquisition, management and disposition of the asset that generates the income are integral parts of a taxpayer's regular trade or business operations. The functional test focuses on the relationship between the asset giving rise to the taxable income and the business itself. For example, gain or loss on the sale of a factory by a manufacturer likely would be considered business income under the functional test, because the factory was acquired and used in the taxpayer's regular trade or business.

MTC regulations. Under MTC regulations, which interpret UDITPA, there is a presumption in favor of classifying income as business income. In fact, according to the regulations, "the income of a taxpayer is business income unless clearly classifiable as nonbusiness income" (MTC Regulation Section IV.1.(a)). The regulations further specify that certain types of income are considered business income. For example, rents received from property used in or incidental to a taxpayer's trade or business constitute business income. Similarly, gains and losses from dispositions of real or personal property are business income if the property was used in the taxpayer's trade or business. Interest is considered to be business income if the intangible generating the interest is used or arose from the trade or business, or if the purpose for acquiring and holding the intangible is related or incidental to such trade or business operations. Business income also includes dividends, patents and copyright royalties, if the stock, patent or copyright arose out of, was acquired or created in the regular course of a taxpayer's trade or business operations or if the purpose for acquiring and holding the stock, patent or copyright was related or incidental to the taxpayer's trade or business. Most recently, the MTC released a Proposed Business Income Regulation that, while attempting to provide a uniform definition of business and nonbusiness income consistent with the Multistate Tax Compact and the latest judicial interpretations of the U.S. Constitution, continues the MTC's historical expansive definition of business income.

The United States Supreme Court. The U.S. Supreme Court has adopted yet another test to determine whether income is subject to apportionment. In Allied-Signal, Inc., 504 US 768 (1992), the Court held that only income from the taxpayer's unitary business is apportionable. If the taxpayer's activities and properties are part of a unitary business, income from such activity or property is considered to be derived from the regular course of the taxpayer's trade or business and deemed to be apportionable. In contrast, income unrelated to the taxpayer's unitary business is subject to allocation.

The Court held that the unitary test is not the exclusive means of meeting the constitutional requirements for apportioning income, and introduced the "operational versus investment" function test. Under this test, a transaction or activity may create apportionable income if it serves an operational function. The Court noted that interest earned by a corporation on short-term bank deposits used as working capital may be apportionable, regardless of whether the corporation and bank were engaged in a unitary business. Likewise, income received from stock of a company (supplier) held by a corporation to ensure a steady supply of raw materials for the corporation's production process would presumably be apportionable income, even if the supplier was not part of the corporation's unitary business. Similarly, income from stock investments that constitute interim uses of idle funds accumulated for future business operations would constitute apportionable income.

As in ASARCO v. Idaho State Tax Comm., 458 US 307 (1982), the Court rejected a "business purpose" test, stating that the mere fact that an intangible asset was acquired pursuant to a long-term corporate strategy of acquisitions and dispositions did not convert an otherwise passive investment into an operational function of the business.

Allocation of nonbusiness income. Once income has been classified as nonbusiness (a factual determination highly dependent on documentation), the next step is determining to which state the income should be allocated. Generally, the income is sourced to the state in which the property is located (for tangible assets) or to the taxpayer's commercial domicile (for intangible assets).

The identification of a corporation's state of commercial domicile can be a simple or complex factual determination, depending on the corporation. UDITPA defines a commercial domicile as the "principal place from which the trade or business of the taxpayer is directed or managed" (UDITPA Section 1(b)). Criteria typically used to determine the commercial domicile of a taxpayer include the site of board of directors' meetings, the location of stockholder meetings, the location and residence of the officers and the location of corporate records and bank accounts, etc. Although most states apportion business income and allocate nonbusiness income, not all states follow this practice. The inherent weakness in the specific allocation method is that, most likely, more than one state will claim to tax the same income of the multistate business. Accordingly, some states have limited the application of specific allocation to certain types of income that are easier to trace to a single state (e.g., interest, dividends, rents and royalties), while others have historically apportioned all types of income. Because the U.S. Supreme Court has stated that a distinction between business and nonbusiness income is required, these latter approaches are constitutionally suspect.

Formulary Apportionment

As indicated, states generally apportion income classified as "business" income. However, according to the U.S. Supreme Court, the U.S. Constitution requires that formulary apportionment be applied only to the income of a unitary business. As the Court has stated, "[t]he linchpin of apportionability in the field of state taxation is the unitary business principle" (Mobil Oil Corp., 445 US 425 (1980)).

Unitary business. Under the unitary business doctrine, a state may constitutionally apply formulary apportionment to the income of a corporation, or to the income derived by a related group of corporations, if the underlying business activities of the corporation or group of corporations are "unitary."

A unitary business is generally comprised of one or more business segments adequately related to one another, such that their business income may be aggregated and apportioned by a common apportionment formula. However, it is important to bear in mind that, while a group of related corporations may constitute a single unitary business, a single multidivisional corporation may constitute several separate businesses and therefore may file more than one tax return.

A number of methods for determining the scope of a unitary business have developed. Specifically, the following tests devised at the state level have gained widespread applicability: 1) the three unities test, 2) the contribution and dependency test, 3) the MTC test and (4) U.S. Supreme Court cases.

The three unities. The three unities approach was developed in Butler Brothers v. McColgan, 111 P2d 334 (Cal. 1941), and provides that the unitary nature of a business is established by the presence of unity of ownership, operation and use. Unity of ownership refers to a common ownership structure of a business and its affiliates. Although this test depends in large part on the particular provisions of each state's law, as a general rule, there must be greater-than-50% stock ownership before a group of businesses satisfies the unity of ownership requirement. Unity of operation is evidenced by centralized support functions, such as accounting, advertising, legal, personnel, purchasing, research and development, selling or other similar departments. Unity of use is shown by a central executive force and a general system of operations. Although unity of use appears to require executive direction to achieve corporate goals, it is unclear to what extent control must be exercised by the central executive force.

Although it may be difficult to differentiate between the unity of operation and unity of use tests, Chase Brass & Copper Co. v. FTB, 10 Cal. App. 3d 496 (1970), attempted to reconcile the two tests. This case specified that the unity of operation test referred to the personnel of an organization who furnish auxiliary and advisory services and did not directly participate in production. According to the case, the unity of use test referred to the personnel directly responsible for manufacturing and assembling functions in the various production stages.

Contribution and dependency. The contribution and dependency approach, set forth by the California Supreme Court in Edison California Stores v. McColgan, 183 P2d 16 (Cal. 1947), is the most widely used test to determine whether a unitary business exists. The court stated that when "the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business without the state, the operations are unitary."

Even though the contribution and dependency test does not suffer from the narrow scope of the three unities test, its breadth is also its primary weakness, because of its inability to identify what elements are important in making a unitary determination. Under this test, if any element of operational interdependence (however insubstantial) is sufficient to create a unitary business, any commonly controlled businesses would apparently constitute a unitary business (due to its common accounting and reporting systems, common officers, common insurance plans, etc.).Thus, for the unitary business concept to have any meaning under this test, some weight must be given to the substantiality of the interdependence.

MTC. The MTC has also issued guidance on the unitary business principle. Although the regulations refer only to the operations of one taxpayer, many states have chosen to apply the rules across legal entities. According to the MTC regulations, any of the following factors creates a strong presumption that the activities of the taxpayer constitute a unitary business: 1) same type of business, 2) steps in a vertical process and (3) strong centralized management (MTC Regulation Section IV.1.(b)).

United States Supreme Court cases. In Mobil Oil, the U.S. Supreme Court held that the income of a multistate business can be apportioned if its intrastate and out-of-state activities form a part of a unitary business. The Court set out the following factors as the basis for determining whether a business is unitary: functional integration, centralization of management and economies of scale.

Apportionment Formulas

Under the formulary apportionment method, there is no attempt to trace items of income to the state in which the income was generated. Rather, a formula is used to arrive at an approximation of a business's income that should be attributed to a particular state. Formulary apportionment divides a multistate corporation's tax base among the states in which it does business, by applying a fraction representing the ratio of in-state factors to total factors. Dividing the income of a corporation by the use of a statutory formula provides a rough approximation of the corporation's income reasonably attributable to the corporation's operations in the state.

Historically, the method used most often to apportion business income to a particular state is a three-factor, equally weighted formula that compares the ratio of in-state property, payroll and sales to overall property, payroll and sales. Under this method, a taxpayer first ascertains the income to be apportioned and multiplies this amount by the arithmetical average of three ratios: 1) in-state property to total property, 2) in-state payroll to total payroll and (3) in-state sales to total sales.

In general, the property factor consists of a taxpayer's real and tangible personal property owned or rented and used during the tax period in the regular course of the taxpayer's trade or business. Although only property used to produce business income (as opposed to nonbusiness income) is included in the property factor, usually intangible property is not included.

Generally, the payroll factor consists of compensation paid by the taxpayer in the regular course of its trade or business during the tax period as reported on Form 940. Compensation consists of taxable wages, salaries, commissions and any other form of remuneration paid to employees for personal services, but does not usually include amounts paid to independent contractors.

Finally, the sales factor consists of all gross receipts from transactions and activities in the regular course of the taxpayer's trade or business. The sales factor normally includes (but is not limited to) gross sales (less returns and allowances), fees and commissions received from the performance of services, rents and lease payments received from renting real or tangible property, proceeds from the disposition of other tangible and intangible assets, and royalties and other payments received from the sale, assignment or licensing of intangible personal property (such as patents and copyrights).

To prevent certain receipts from escaping inclusion in any state's sales factor numerator, a minority of states incorporate what is referred to as the "throwback" rule. Sales of tangible personal property to a destination state, in which the seller is not taxable (e.g., because its activities do not exceed solicitation under Public Law 86-272), are thrown back and included in the numerator of the state from which the goods were shipped.

Some states still use this standard three-factor formula, while many states now incorporate formulas that deviate slightly from the standard formula. For example, a majority of states double-weight the sales factor or use a formula with less than three factors (two-factor or single-factor formulas). In addition, some states provide different formulas depending on the taxpayer's industry (e.g., manufacturing).

Conclusion

The three methods described each attempt to offer a solution to divide the income of a multistate corporation among the states that may legitimately subject the corporation to tax. However, within each method, there are numerous approaches a state may use to determine the income attributable to a particular state.

Until all states adopt one uniform method for all taxpayers, taxpayers will be treated differently, depending on the types of businesses in which they are engaged, the states in which they conduct their business and the various methods and interpretations the various states use. It is an unusual multistate business that, in the aggregate, separately accounts, allocates or apportions all of its state income tax base as a result of the variety of state allocation and sourcing methods.

Editor's note: Ms. Boucher chairs the AICPA Tax Division's State and Local Taxation Committee. Mr. Kinney is a member of the committee.

If you would like more information about this article, contact Ms. Boucher at [phone].

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

John E. Kinney, CPA Suzanne J. Black, CPA Sharlene E. Amitay, CPA KPMG Peat Marwick LLP Washington, DC