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Current corporate income tax developments: this two-part article discusses a myriad of recent state tax activity in the corporate income tax area.

During 2004, numerous 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cases were decided; regulations were proposed, issued and modified; and bulletins and rulings were issued, released and withdrawn. This two-part article focuses on some of the more interesting of these in the corporate income tax area. Part I, below, covers nexus; Internal Revenue Code (IRC) Sec. 338(h)(10) transactions; tax base; and business/nonbusiness income. Part II, in the April 2005 issue, will explore apportionment formulas; filing methods/unitary groups and administration; and several other significant state tax developments.


* Alabama

A circuit court reversed (1) an administrative law judge (ALJ) decision holding that the state lacked statutory authority to tax the income of a Georgia limited partner of an investment partnership. According to the court, Alabama had jurisdiction to tax the nonresident partner based on his "purposeful connection" with his family's Alabama-domiciled investment partnership.

* Indiana

The Department of Revenue (DOR) originally held (2) that a nonresident minority shareholder in four limited-partnership real estate investment trusts (REITs) domiciled outside Indiana, which each held interests in four respective Indiana shopping malls, had nexus as an owner of real property. However, on rehearing, (3) it was established that the taxpayer was a partner, but not actually a member, of the REIT; partnership income from the Indiana rental property was, thus, taxable in Indiana.

* Kansas

SB 29, Laws 2004, defined the term "doing business" for foreign entities. Among other provisions, "doing business" does not include conducting an isolated transaction completed within 30 days; creating or acquiring debt, mortgages or security interests in property; foreclosing mortgages or other security interests in property; and holding, protecting and maintaining property so acquired.

* Louisiana

The state Supreme Court reversed (4) a lower court decision to hold that a Delaware trademark holding company had Louisiana commercial domicile and, thus, was subject to income/franchise tax. The court explained that (1) the taxpayer functioned and was substantially managed in Louisiana through its parent company and (2) numerous board of director actions occurred in the state.

In a similar decision, the Court of Appeal held that trademarks licensed by Gap Apparel acquired an in-state business situs, as they were sufficiently used in the state to become an integral part of the licensee's in-state retail businesses. (5) Thus, under economic nexus principles, Gap Apparel was deemed subject to corporate income and franchise taxes, despite no physical presence.

In another decision, the Court of Appeal held that the mere ownership of stock in a corporate REIT that receives substantial rental income from Louisiana did not subject a Nevada corporation to tax. (6) The Louisiana Supreme Court has granted certiorari in this case. (7)

* Michigan

The Court of Appeals reversed (8) a trial court to hold that a four-person instate sales force established the necessary physical presence to impose the Single Business Tax.

* New Jersey

The state Tax Court held (9) that P.L. 86-272 did not protect a vendor against the corporate minimum flat tax, because that tax is not based on net income.

* New Mexico

A hearing officer ruled (10) that, when taken as a whole, the New Mexico trademark and franchise activities of a product's manufacturer and marketer exceeded the scope of P.L. 86-272, as a result of a relationship with an in-state distributorship.

* New York

Amended regulations provide a 14-day bright-line nexus text for foreign corporations participating in in-state trade shows, as long as the activity is limited to displaying goods or promoting services, no sales are made and any orders received are completed outside the state. (11)

The Department of Taxation and Finance (Department) advised (12) that accepting payments for orders at three one-day trade shows is not a protected activity, nor is it de minimis, under either P.L. 86-272 or New York's 14-day trade-show-participation rule.

In another ruling, the Department advised that a manufacturer did not have income/franchise tax nexus merely through a shareholder's phone book listing or warranty services provided by an authorized independent service center. (13)

* North Carolina

The Secretary of Revenue held (14) that two out-of-state intangible licensing companies had state corporate income/franchise tax nexus, because they purposefully availed themselves of the state's economic market, through regular and systematic use of their marks, tradenames and goodwill by their respective affiliated companies and third-party franchisees in over 250 in-state restaurant locations.

In a similar decision, (15) the Court of Appeal affirmed a superior court decision that the taxpayer had the requisite nexus for the state to impose income tax on its trademark companies. In reaching this decision, the court found that physical presence is not required under the Commerce Clause for income and franchise tax purposes.

* Pennsylvania

The state Supreme Court affirmed (16) a ruling that a subsidiary soliciting sales on behalf of its parent receives P.L. 86-272 protection, even if it does not hold title to the goods for sale.

The DOR described (17) the state's application of P.L. 86-272 and related de minimis standards. Among the de minimis standards provided are: installation, franchise tax solicitation, purchasing activities, trade shows and incidental personal property and incidental travel.

* Tennessee

A Chancery Court held (18) that an out-of-state credit card subsidiary had sufficient nexus for franchise/excise tax purposes, due to the frequency and nature of its contacts with the state. The company, a bank subsidiary of Dillard Department Stores, had a continuous and targeted program directed at in-state residents, through (1) activities provided by store personnel; (2) limited trips to Tennessee by the subsidiary's employees to solicit credit card accounts; (3) a third-party's instate solicitations of credit card accounts at college campuses; and (4) a third-party's in-state Dillard credit card collection and lawsuit activities on the subsidiary's behalf.

The state Attorney General opined that P.L. 86-272 protections do not apply to the state's franchise tax, because that tax is measured by net worth, not net income. (19)

* Texas

The Comptroller advised (20) that a California corporation would be subject to Texas Franchise Tax as the sole beneficiary of a Connecticut trust doing business in Texas merely through leasing railroad cars partly used in the state. For apportionment purposes, however, the trust's receipts would not flow through to the beneficiary.

In another letter ruling, (21) the Comptroller advised that a Delaware corporation would not have nexus merely from having a Texas resident serve as the corporation's sole officer and director, with business meetings being held outside Texas.

* Virginia

The Department of Taxation ruled that a canned software seller did not acquire income or sales/use tax nexus from software training activities provided by independent third-party contractors on its behalf. (22)

* West Virginia

The Office of Tax Appeals held (23) that a Delaware credit card bank did not have substantial nexus in the state due solely to the issuance of credit cards and the isolated and sporadic use of in-state attorney services and state courts.

IRC Sec. 338(h)(10) Transactions

* Illinois

An Appellate Court affirmed (24) the trial court's decision that gain on the sale of a foreign insurance company's stock was nonbusiness income under the Blessing/White (25) modified functional test, because the taxpayer's IRC Sec. 338(h)(10) deemed liquidation election constituted a cessation of the business.

* Massachusetts

Statutory changes provide that when a purchasing corporation makes an election under IRC Sec. 338, for apportionment purposes, the target will be treated as having sold its assets. (26)

* New York

An ALJ held (27) that an IRC Sec. 338(h)(10) election triggers recapture of investment tax credits, because the election constitutes a disposition of qualifying property.

* Ohio

The Department of Taxation issued an information release (28) summarizing the franchise tax effect of an IRC Sec. 338(h)(10) election; the target is not considered a "new" entity after the election and must combine the income of the two Federal short-period returns into one Ohio franchise tax report. The target must recognize the gain on the deemed asset sale and may depreciate the stepped-up basis resulting from it.

* Pennsylvania

The state Supreme Court affirmed (29) that an IRC Sec. 338(h)(10) liquidation gain qualifies as nonbusiness (allocable) income. Subsequently, however, the DOR stated that, due to legislative changes, that decision does not apply to tax years after 1998. (30)

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. Corporate 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 significant changes to the states' tax bases.


* California

Statutory changes (31) allow taxpayers to elect to claim dividends-received deductions (DRDs) from insurance companies at least 80% owned for years open to statute ending on or after Dec. 1, 1997 and beginning before 2004. Such dividends are 80% deductible for 1997-2007 and 85% deductible for 2008 forward; significant exceptions and limits apply to captives and insurance companies with excess investment income. Franchise Tax Board (FTB) Notice 2004-6 (32) explains this election; to avoid accuracy-related penalties, the election and any related payments due are required by March 28, 2005, on a filed return for any open year.

The FTB issued Departmental Procedures on the general corporate DRD under Cal. Rev. & Tax. Code Section 24402. In light of the Farmers Bros. Co. (33) decision, all general corporate DRDs are disallowed for tax years ending on or after Dec. 1, 1999. (34)

A Court of Appeal affirmed (35) that, in calculating the includible portion of controlled foreign corporation subpart F foreign-source income in its water's-edge report, the taxpayer could statutorily exclude dividends paid by certain second-tier subsidiaries to certain first-tier subsidiaries, because they were paid out of unitary income. The court also affirmed that the 75% partial deduction allowed for dividends from unitary foreign corporations not included in a water's-edge return is Constitutional. Advance corporation tax credits mandated by the U.S.-U.K. income tax treaty were also classified for state income tax purposes as dividend income to the receiving U.S. shareholders, subject to California's DRD or unitary return elimination.

* Massachusetts

For tax years beginning after 2003, the DRD for dividends received directly or indirectly from regulated investment companies is not allowed, under Ch. 143, Acts of 2003.

* New Jersey

The state Tax Court determined (36) that, without promulgating a regulation, the Division of Taxation cannot disallow a deduction for a REIT dividend by asserting state conformity to IRC Sec. 857(c), which denies a Federal DRD for REIT dividends. Although the disallowance was found to be consistent with legislative intent, the Division's action amounted to a "rule," which must be formally promulgated under the state's Administrative Practices Act.

* New Mexico

A hearing officer held (37) that the state's combined unitary return does not discriminate against foreign commerce by including dividends and subpart F income received from unitary foreign affiliates, but excluding income received from nonunitary domestic subsidiaries.


* Alabama

An ALJ permitted (38) a parent corporation filing a state consolidated income tax return to claim NOLs attributable to a company liquidated under IRC Sec. 332 into an affiliated consolidated subsidiary.

* Florida

A circuit court granted (39) summary judgment to the DOR in holding that the state's separate-return-limitation-year rule properly limited the use of NOLs generated by a non-nexus company to the subsequent income of that affiliate.

* Indiana

A taxpayer was entitled to carry over state NOLs from a corporate reorganization, even though it erroneously failed to carry over the losses on its Federal income tax return. (40)

* Louisiana

The DOR issued a rule (41) to clarify its long-standing practice of allowing taxpayers to change their elections to relinquish NOL carrybacks.

* Massachusetts

The state's highest court affirmed (42) that a taxpayer cannot carry forward and deduct premerger NOLs generated by four entities absorbed through various mergers, because the statute does not plainly authorize a survivor's use of premerger NOLs.

* Missouri

To permit taxpayers to use NOLs to offset addition modifications, SB 1394, Laws 2004, changed the starting point for determining state taxable income for tax years ending after June 30, 2002, by allowing that "Federal taxable income may be a positive or negative amount."

* New Jersey

For privilege years beginning in 2004 and 2005, the use of NOLs is restricted under Ch. 47 (AB 3110), Laws 2004. The amended statute allows a deduction for so much of the NOL carryover as reduces entire net income otherwise calculated by 50%.

* New York

The Department explained that Federal and New York NOL deductions must arise from the same source year and that a state NOL deduction cannot exceed the Federal NOL amount absorbed in that same year. (43)

Intercompany Expenses and Transactions

* California

The State Board of Equalization (SBE) confirmed that the value of intercompany inventory acquired from a foreign parent should be its carryover basis when converting from worldwide to water's-edge filing. (44)

* Connecticut

The DOR issued Special Notice 2003(22), (45) which summarizes the 2003 legislative change requiring corporations to add back certain otherwise deductible related-member interest expenses and costs.

* District of Columbia

Statutory changes disallow deductions for costs or expenses directly or indirectly paid to a related entity for the use of trademarks, patents or other intangible assets or investments and interest related to such intangibles. (46) Various exceptions, including valid business purpose and arm's-length payments, apply.

* Illinois

The state's FY 2005 Budget Legislation package (47) included tax law changes disallowing deductions for interest and intangible expenses and costs paid, directly or indirectly, to a "foreign person" (including an 80/20 company) that would be a member of the payer's unitary business group but for the foreign person's business activity outside the U.S.; a number of exceptions to disallowance are provided.

* Indiana

The DOR disallowed (48) royalty payments from an out-of-state manufacturer to a related Delaware holding company, holding that the corporation failed to demonstrate that the transaction was entered into for a legitimate business purpose.

* Maryland

HB 297, Laws 2004, requires Maryland corporate taxpayers to add back certain interest and intangible expenses paid to related entities. Various exceptions to the addback provisions are provided, including an exception for interest charges for banks if the transaction did not have as a principal purpose the avoidance of tax and the expenses are paid pursuant to an arm's-length contract at an arm's-length interest rate. (49) This legislation also authorizes the Comptroller to distribute, apportion or allocate certain tax attributes between and among such organizations, trades or businesses in certain circumstances.

Under an amnesty program, which ran from July 1, 2004 to Nov. 1, 2004, tax liabilities prior to 1995 and penalties were waived for intangible holding companies that paid income taxes for tax years 1995-2003 and a reduced 6.5% annual interest rate. (50)

* New Jersey

The state Tax Court affirmed (51) the Director's statutory and regulatory authority to impute interest on non-interest-bearing notes between legal entities, even though the absence of intercompany control would have prevented an adjustment under IRC Sec. 482.

* Oregon

A new regulation (52) disallows certain intercompany transactions when the related members do not file a combined return and the separation of an intangible asset's ownership from the user results in either tax evasion or a computation of state taxable income not clearly reflective of the business activity conducted in Oregon, in comparison to business activity as a whole.

* Tennessee

Business entities that deduct intangibles expenses incurred through transactions with an affiliated entity are required to disclose such transactions. Under HB 3483, laws 2004, failure to disclose such information results in a disallowance of such expenses and a negligence penalty.

* Virginia

HB 5018, Laws 2004, requires certain related-member intangible and interest expense deductions to be added back to Federal taxable income, subject to numerous delineated safe-harbor exceptions.

Other Modifications

* Iowa

HB 2581, Laws 2004, adopts the Federal 50% bonus depreciation provisions for qualified property acquired after May 5, 2003 and before 2005.

* Massachusetts

The state's highest court affirmed (53) that the charitable deduction for a Massachusetts combined group is computed on an individual-entity basis.

* Minnesota

The taxpayer was entitled to the state's deduction for 80% of fees paid from its wholly owned "foreign operating company" (FOC), even though such fees were (1) accrued annually for Federal tax purposes based on transfer-pricing principles; (2) received through an offset against fees due to the FOC, because they were supported by actual services rendered (conformed to generally accepted accounting principles); and (3) supported by written intercompany agreements that based fee accrual on Federal arm's-length pricing rules. (54)

Business/Nonbusiness Income

* Illinois

A state circuit court found (55) that the liquidating sale of an Illinois partnership's "trading technology" (an intangible) is nonbusiness income to the partnership when the proceeds were distributed to its partners; the gain is also nonbusiness income to a partner.

The FY 2005 Budget Legislation package included law changes that expanded the definition of business income to include all income apportionable under the U.S. Constitution. (56)

* Indiana

A computer vendor's gains from securities sales were classified as business income under both the transactional and functional tests, even though the investments were made from surplus cash by a separate corporate division with dedicated employees. (57)

In contrast, distributions from two partnerships operating in the state were classified as nonbusiness income to their respective 99% corporate limited partners due to a lack of a unitary relationship, because the limited partners lacked required day-to-day operational control under the respective partnership agreements, and the related general partner had full, exclusive and complete power to manage and control the partnerships' business and affairs. (58)

* Massachusetts

Chapter 262 (HB 4744) of the Acts of 2004, requires Massachusetts commercially domiciled corporations and financial institutions to allocate to the state that portion of taxable net income that nondomiciliary states are prohibited from taxing under the U.S. Constitution.

(1) AL Dep't of Rev. v. Joe E. Lanzi, III, AL Cir. Ct., No. CV-2003-2705 (11/17/2004), rev'g Admin. L. Div. Dkt. No. 02-721 (9/26/03); for a discussion of the ALJ ruling, see Boucher and Ponda, "Current Corporate Income Tax Developments" (Part I), 34 The Tax Adviser 156 (March 2004).

(2) IN DOR, Ltr. of Finding No. 00-0456 (1/1/04).

(3) IN DOR, Ltr. of Finding No. 00-456 (1/1/05).

(4) Kevin Associates, LLC v. Crawford, 865 So.2d 34 (LA Sup. Ct. 2004), rev'g 834 So.2d 465 (LA App. Ct., 1st Dist., 2002).

(5) LA DOR v. Gap Apparel, Inc., LA Ct. App., 1st Cir., Dkt. No. CW 0263 (6/25/04).

(6) LA DOR v. AutoZone Properties, 873 So.2d 25 (LA Ct. App. 2004).

(7) LA DOR v. AutoZone Properties, 876 So.2d 789 (LA Sup. Ct. 2004).

(8) Rayovac Corp. v. Dep't of Treasury, MI Ct. of App., Dkt. No. 251283 (11/23/04).

(9) Home Impressions, Inc. v. Dir., Div'n. of Tax'n, 21 NJ Tax 448 (2004).

(10) In the Matter of the Protest of Dart Industries, Inc., NM Dep't of Tax. and Rev., No. 02-152241 00-3, Assessment No. 1972584 (2/26/04).

(11) Amended Business Corp. Franchise Tax Regs. Secs. 1-3.3(a)(7) and 1-3.4(b)(9)(iv)(i) (2/11/04); NYS Dep't. of Tax'n and Fin. TSB-M-04(1)C (2/17/04).

(12) NYS Dep't of Tax'n and Fin., TSB-A-04(12)C (7/21/04).

(13) NYS Dep't of Tax'n and Fin., TSB-A-04(15)C (8/31/04).

(14) Sec'y of Rev. v. Taxpayer, NC Decision No. 01-550 (7/1/04).

(15) A&F Trademark Inc. v. Tolson, NC Ct. of App., Dkt. No. COA03-1203 (12/7/04).

(16) Schering-Plough Healthcare Products Sales Corp. v. Comm'th of PA, PA Sup. Ct., No. 161 MAP 2002 (10/20/04), aff'g 805 A2d 1284 (2002).

(17) PA DOR, Corp. Tax Bulletin No. 2004-01 (5/14/04).

(18) Dillard National Bank, N.A., v. Ruth E. Johnson, Comm'r of Rev., TN Chancery Court, No. 96-545-III (10/19/04).

(19) TN Off. of Atty. Gen., Op. No. 04-159 (11/8/04).

(20) TX Policy Ltr. Rul. No. 200401316L (1/9/04).

(21) TX Policy Ltr. Rul. No. 200311243L (11/25/03).

(22) VA Pub. Doc. No. P.D. 04-173 (10/5/04).

(23) MBNA America Bank, N.A. v. Steager, Tax Comm'r, WV Office of Tax Appeals, Docket Nos. 03-185 RN, 03-186 RFN, 04-074 RFN and 04-075 RN (2004).

(24) American States Insurance Co. v. Hamer, IL App. Ct., 1st Dist. (8/27/04).

(25) Blessing/White, Inc. v. Zehnder, 329 Ill. App. 3d 714 (2002).

(26) Ch. 262, HB 4744, Laws 2004.

(27) Matter of AIL Systems, Inc., NYS Div'n of Tax Appeals, ALJ Unit, DTA No. 819303 (10/4/04).

(28) OH Dep't of Tax'n, CFT Information Release 2004-02 (6/17/04).

(29) Canteen Corp. v. Comm'th of PA, PA Sup. Ct., Dkt. No. J-86 2004 (7/20/04).

(30) PA DOR, Corp. Tax Strut. of Policy No. 2004-1 (11/9/04).

(31) Ch. 868 (AB 263), Laws 2004.

(32) CA FTB Notice 2004-6 (11/2/04).

(33) Farmers Bros. Co. v. FTB, 108 Cal.App.4th 976 (2003).

(34) CA FTB, Departmental Procedure on Section 24402 (5/17/04).

(35) Fujitsu IT Holdings, Inc., f/k/a Amdahl Corp. v. FTB, CA App. Ct., 1st Dist. (7/7/04).

(36) UNB Investment Co. v. Dir., Div'n of Tax'n, 21 NJ Tax 354 (2004).

(37) Matter of Xerox Corp., NM DOR Hearing, No. 03-22 (12/3/03).

(38) Tee Jays Industries, Inc. v. AL DOR, Admin. L. Div., Dkt. No. Corp. 04- 150 (6/14/04).

(39) Bank of America Corp. v. FL DOR, FL 2d Cir. Ct., No. 01-CA-2782 (3/12/04).

(40) IN DOR, Ltr. of Finding 99-0630 (9/1/04).

(41) LAC 61 :I.1124 (11/20/04).

(42) Macy's East, Inc. v. Comm'r of Rev., 808 NE2d 1244 (MA Sup. Ct. 2004), cert. den.

(43) NYS Dep't of Tax'n and Fin., TSB-A-04(16)C (10/l/04).

(44) In the Matter of Mitsubishi Electric America, Inc., CA SBE, Case No. 207902 (2/18/04).

(45) CT DOR, Special Notice 2003(22) (7/08/04).

(46) DC Acts of Council Nos. 15-486 and 15-594.

(47) IL Pub. Act 093-0840, SB 2207.

(48) IN DOR, Ltr. of Finding 03-0406 (8/1/04).

(49) See Ch. 556 (HB 297), Laws 2004.

(50) See Ch. 557 (SB 187), Laws 2004.

(51) Metro Touch, Inc. v. Dir., Div'n of Tax'n, 21 NJ Tax 312 (5/26/04).

(52) OR Admin. Rules 150-314.295, et seq.; OR Bulletin (2/1/04).

(53) FMR Corp. v. Comm'r of Rev., 809 NE2d 498 (MA Sup. Ct., 5/27/04, corrected 6/25/04).

(54) Hutchinson Technology, Inc. v. Comm'r of Rev., MN Tax Court, Dkt. Nos. 7398R and 7504-R (5/10/04).

(55) Shakkour v. IL DOR, IL Cir. Ct., Cook Cry., No. 99 L 50548 (5/4/04).

(56) IL Public Act 093-0840 (SB 2207).

(57) IN DOR, Ltr. of Finding 02-0030 (10/1/04).

(58) IN DOR, Ltr. of Finding 02-0022 (7/1/04).


* Numerous rulings and decisions addressed nexus issues in many states; in New York, amended regulations provided a 14-day nexus test for participating in in-state trade shows.

* Several changes were made to the computation of state tax bases involving DRDs, NOLs and intercompany expenses and transactions.

* Many states addressed the effects of an IRC Sec. 338(h)(10) election; a few significant decisions addressed business/nonbusiness income issues.

Karen J. Boucher, CPA


Deloitte Tax LLP

Milwaukee, WI

Jason Clegg, CPA


Deloitte Tax LLP

Washington, DC

Shona Ponda, J.D.


Deloitte Tax LLP

Atlanta, GA

For more information about this article, contact Ms. Boucher at
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Title Annotation:part 1
Author:Ponda, Shona
Publication:The Tax Adviser
Date:Mar 1, 2005
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