States quickly modify apportionment provisions in reaction to changes in financial institutions industry.

In November 1994, the Multistate Tax Commission (MTC) adopted the "Uniform Method for Allocation and Apportionment of Net Income from Financial Institutions." With the enactment in September 1994 of the Riegle-Neal Interstate Banking and Branch Efficiency Act of 1994 (the Act), in retrospect, the adoption by the MTC of this regulation could not have been more timely.

This is primarily due to the fact that the Act and the changes it made in the banking laws have had a significant impact on the financial institutions industry. In general, with the passage of the Act, banks and bank holding companies can expand their U.S. interstate activities on a multistate basis. More specifically, the Act authorized adequately capitalized and adequately managed banks and bank holding companies to engage in interstate mergers, acquisitions and de novo banking (full interstate banking and branching was recently authorized by the Act). Finally, the Act also gave banks the ability to participate in interstate mergers under the 30-mile rule of the National Bank Act of 1864.

As a result of these changes, the number of financial organizations conducting business in a multistate arena has grown exponentially. Coupled with a simultaneous loosening of various regulatory restrictions, banks and other financial organizations are significantly expanding the services they offer. Not only are such organizations engaging in traditional banking services within a multistate arena, but they are also engaging in new businesses and expanding the delivery of existing products and services (e.g., use of the Internet, personal banking software and electronic bill payment processing). This rapidly changing environment has caused several states to review the manner in which financial institutions are taxed. Particular attention has been directed to how the income of multistate institutions is being apportioned among the states in which they conduct business.

Definitional and Apportionment Provisions

The overall state tax liability of an affiliated group of financial institutions, each operating solely within a given state, could change substantially if one or more of the entities are merged and therefore need to apportion the aggregated income among several states. Thus, in addition to the practical business considerations that normally accompany any merger or expansion of operations (such as expanding markets and reducing or eliminating duplicative costs), it is critical that the estimated change in state tax liability that will occur as a result of a merger or expansion also be reviewed.

Definition of "financial institution": Many states tax financial institutions differently from other corporations. These differences can include the composition of the tax base, as some states impose an income tax on regular corporations but impose a capital-based tax on financial institutions. Other differences include the tax rates assessed by the states on financial institutions; California, for example, imposes a higher franchise tax on financial corporations than on regular corporations. Finally, the apportionment provisions applicable to financial institutions differ from those applied to other corporations.

Due to these differences in tax structures, it is critical to review each state's definition of financial institutions or organizations to ensure that the appropriate tax base, apportionment provisions and tax rates are used. The MTC apportionment provision does not included such a definition; it was presumed that individual state legislatures had already determined which businesses should be treated as financial institutions. However, to assist states that do not currently have such a definition, the MTC apportionment provisions include a suggested definition in the appendix to the regulation. Under this definition, a "financial institution" is broadly defined to include all traditional financial institutions, as well as business entities that derive more than 50% of their gross income from activities that banks and savings and loan institutions are authorized to transact (i.e., entities in substantial competition with traditional financial institutions in the same marketplace). As a result of this broad definition, entities other than traditional financial institutions would be subject to the MTC apportionment rules.

The majority of states that have adopted apportionment provisions similar to the MTC had a definition of a financial institution already in place and, accordingly, did not need to adopt the appendix definition. However, these definitions vary significantly among the states. Because such differences do exist, it is critical to review each state's definition of a financial institution or organization to ensure that the appropriate tax computations are made.

Apportionment: A multistate business generally must apportion (or divide) its income among the states in which it is taxable. In defining its specific apportionment formula, each state separately defines the composition and the weight that it will assign to the factors that make up its apportionment formula. As a result, there are variations from state to state in the number and weighting of factors used in apportionment formulas, as well as variations in the computation of the factors themselves. Although a state may adopt any constitutionally valid apportionment method, the majority of states that have modified their financial institution apportionment provisions to account for the changing banking environment have adopted rules similar to the MTCs apportionment regulation.

MTCs apportionment provision: The MTCs financial institution apportionment provision, which was adopted as MTC Regulation IV 18 (1), represents a compromise between the money-center states, the market-center states and representatives from financial institutions. (The money-center or headquartered states are the net lending states (e.g., Delaware, New York and South Dakota); the market-center states are the net borrowing states (e.g., Indiana, Minnesota and Tennessee).) To effect such a compromise, the provision includes a combination of money-center and market-center approaches and, as requested by the industry, several simplified sourcing rules.

The MTCs financial institution apportionment provision is an evenly weighted, three-factor formula consisting of a sales factor, a payroll factor and a property factor. Several states that have adopted a financial institution provision similar to the MTC's have adopted a modified three-factor formula, under which the sales factor is assigned more weight than the other two factors; all but one of these states has assigned a double weight to the sales factor (i.e., 50% sales, 25% property and 25% payroll). Use of a double-weighted sales factor tends to pull a larger percentage of an out-of-state institution's income into the taxing jurisdiction of the state, as the entity's major activity into the state-revenues--is weighed more heavily than its payroll and property activities. Each of these factors is briefly described below.

[] Sales factor: The sales factor primarily is market-state focused, although it includes both market-state and money-center approaches. For example, interest from credit card receivables is sourced (i.e., included in the numerator of the sales factor) to the state of the cardholder's billing address. Similarly, interest on loans secured by real property is sourced to the state in which the real property is located.

The MTC provisions include several simplified sourcing rules that were requested by the industry. For example, a financial institution is not required to determine the gains on the sale of loans on a state-by-state basis; instead, the net gains from the sale of loans are first classified into two groups: those attributable to loans secured by real property and other loans. The net gains for each of these groups are sourced to the state based on the ratio of in-state interest from that loan group to the total interest from that loan group.

[] Throwback: Under the throwback provision, all receipts that would be assigned to a state in which the financial institution is not taxable are included in the numerator of the state in which it is commercially domiciled.

[] Property factor: In addition to including all real and tangible personal property owned or leased by the taxpayer, the property factor includes two intangible assets: loans and credit card receivables. For these purposes, "loan" is defined as any extension of credit resulting from direct negotiations between the taxpayer and its customer, and/or the purchase (in whole or in part) of such extension of credit from another.

In order to mitigate the impact of sourcing loans and credit card receivables to market-center states when determining the sales factor, the sourcing of these items for property factor purpose generally is the state in which they are properly assigned to a regular place of business of the taxpayer (i.e., money-center focused). A loan is properly assigned to the regular place of business with which it has a preponderance of substantive contacts.

[] Payroll factor: The payroll factor is identical to the general rules found in the Uniform Division of Income for Tax Purposes Act and the MTC regulations. In general, the payroll factor is a fraction, the numerator of which is total compensation paid in the particular state during the tax period and the denominator of which is the total compensation paid to everyone during the tax period.

States' Reaction to the MTC Formula

Since November 1994, 18 states have adopted the. MTC financial apportionment provisions or provisions similar to those of the MTC, either legislatively or by means of regulation or administrative rule. The table at right summarizes the states' regulatory and legislative actions, indicates the effective dates of the states' provisions and identifies whether the states' apportionment formulas are comprised of three equally weighted factors (property, payroll and sales), three factors with a double-weighted sales factor, or some other weighing of one or more factors.

States' Adoption of Apportionment Provisions

                                     Weighing of the apportionment
                                     factors:

                                                   2X
State              Effective date        Equal   sales   Other

Arkansas        Tax years beginning
                after 1995                 X
California      Income years beginning     X
                after 1995
Colorado        6/1/97                     X
Hawaii          Tax years beginning
                after 1995                 X
Kansas          1997 privilege year,
                which is based on 1996
                results                    X
Kentucky        1997 privilege year,
                which is based on 1996
                results                    X
Maine           Tax years beginning
                after 1996                         X
Maryland        1/1/98                             X
Massachusetts   Tax years beginning
                after 1994                 X
Mississippi     Tax years beginning
                after 1996                 X
New Hampshire   Tax years ending
                after 11/23/95                     X
New Mexico      Tax years beginning
                after 1995                         X
North Dakota    Tax years beginning
                after 1996                 X
Ohio            1998, tax year, which
                is based on 1997                         3-factor
                results                                  formula:
                                                         15%
                                                         property;
                                                         15%
                                                         payroll;
                                                         70% sales
Oregon          Tax years beginning
                after 1992 (language
                providing closer
                conformity to MTC
                is effective 12/31/95)             X
Rhode Island    Tax years beginning
                after 6/30/96              X
Utah            1/1/98                     X
Washington      6/16/97; elective
                transition period
                until 2000; earliest
                election would be for
                July 1997 returns          X