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Factually speaking: an overview of the sales factor.

Tax executives of multistate corporations are no doubt aware that many state income tax controversies relate to formulary apportionment. Often, the central issue in these disputes is the computation of the sales, or gross receipts, factor. This article addresses several common issues that arise in determining what should be included in the sales factor.

Background: Evolution of the Sales Factor

Prior to the introduction of the three-factor apportionment formula, a taxpayer's income was apportioned by means of a single property factor. In 1957, in order to attain uniformity in state taxation methods, the National Conference of Commissioners on Uniform State Laws formulated the Uniform Division of Income for Tax Purposes Act (UDITPA). Since that time, 43 of the 46 states that impose corporation income taxes have adopted the entire model act or have adopted a similar version of UDITPA.

UDITPA [section] 9 provides for the apportionment of business income by the use of a three-factor formula consisting of property, payroll, and sales. The computation of the sales factor is addressed in sections 15 through 17 of the Act. Under UDITPA, the following "sales" are attributed to a state's sales factor numerator: (1) sales of tangible personal property and (2) all other sales.

In 1966, the Multistate Tax Compact was formed by the National Association of Attorneys General and the National Legislative Council to further the goal of uniformity. The Compact created the Multistate Tax Commission (MTC), an organization with authority to promulgate regulations and conduct multistate audits. States adopting the Compact may elect to use the allocation and apportionment provisions of UDITPA. Most of the Compact's members have adopted UDITPA as their governing apportionment law. Currently, 20 states have adopted the Compact and another 15 states are associate members of the MTC.

Throwback Sales

Section 16(b) of UDITPA sets forth the following "throwback rule":

Sales of tangible personal property are made within

this state if ... the property is shipped from an

office, store, warehouse, factory, or other place of

storage in this state and (1) the purchaser is the

United States government or (2) the taxpayer is

not taxable in the state of the purchaser....

The intent of this rule is to provide a solution to the "nowhere income" problem -- to deal with sales of tangible personal property that would otherwise "escape" inclusion in the sales factor numerator. Section 3 of UDITPA provides two tests for determining whether a taxpayer is "taxable in another state":

* A taxpayer is taxable in another state if it is subject in that state to a net income tax, a franchise tax measured by net income, a franchise tax for the privilege of doing business, or a corporate stock tax.

* A taxpayer is taxable in another state if the state has jurisdiction to subject the taxpayer to a net income tax regardless of whether the state does so in fact.

In the event neither test is met, sales of tangible personal property to purchasers in the other state must be included in (or "thrown back" to) the taxing state's sales factor numerator. These are commonly referred to as "throwback sales."

This article discusses the following issues relating to throwback sales: (1) Massachusetts's "home office" rule; (2) Michigan's jurisdictional test for single business tax purposes; (3) differing throwback rules for the taxable capital and earned surplus components of Texas franchise tax; and (4) application of throwback to combined returns.

Massachusetts law contains an unusual throwback rule which focuses on the "home offices" of sales personnel:

Sales of tangible personal property are in this commonwealth

if ... the corporation is not taxable in

the state of the purchaser and the property was

not sold by an agent or agencies chiefly situated

at, connected with or sent out from premises for

the transaction of business owned or rented by the

corporation outside this commonwealth. (Ch. 63,

Sec. 38(f), G.L.

Therefore, in order to avoid the Massachusetts throwback rule, products must be sold by a sales representative who is associated with a taxpayer's business location (i.e., sales office) outside Massachusetts. The Massachusetts Appellate Tax Board dealt with this issue in A.W. Chesterton Co. u. Commissioner of Revenue (Apr. 18, 1991). A.W. Chesterton, a Massachusetts corporation headquartered in the commonwealth, had no sales offices outside Massachusetts. Chesterton's sales personnel transacted business from their own home offices or hotel facilities paid for by the Company. In addition, there was no evidence to show that Chesterton was taxable in any other state. The Board held that the home offices and hotel facilities were not premises for the transaction of business owned or rented by the corporation outside this commonwealth." Accordingly, Chesterton's sales of tangible personal property were attributed to Massachusetts for sales factor apportionment purposes. The Chesterton case points out the importance of maintaining proper documentation with respect to throwback issues.

With respect to the Michigan Single Business Tax (SBT), several cases have addressed the jurisdictional test to be employed in determining whether Michigan sales should be "thrown back" from destination states. First, the Michigan Court of Appeals in Guardian Industries Corp. v. Department of Treasury, 198 Mich. App. 363, 499 N.W.2d 349 (Mar. 1, 1993), held that Public Law No. 86-272 is not applicable to the SBT, because it is not an income tax. Instead, jurisdiction must be determined under federal constitutional Due Process and Commerce Clause standards. Therefore, for Michigan SBT purposes, the physical presence of a small sales force, plant, or office in the destination state is sufficient to avoid throwback. More recently, the Michigan Court of Claims held that the physical presence of the taxpayer's small sales force in the destination state for at least ten business days per year s the substantial nexus requirement under the Commerce Clause. See Magnetek Controls Inc. v. Michigan Department of Treasury, Case No. 93-14739-CM (Mich. Ct. Cl. Sept. 30, 1994). Based on this reasoning, Michigan was prevented from applying its sales factor throwback rule.

The Texas franchise tax has two components in the tax base, net taxable capital and net taxable earned surplus. Net taxable capital is the sum of (1) stated capital and (2) surplus (including retained earnings, other stockholder's equity accounts, contingent liabilities, etc.). The earned surplus component consists of federal taxable income with adjustments for certain foreign dividends and officers and directors compensation. A single gross receipts factor is computed for each component. Since the "subject to taxation" criteria are different for the two components, application of the throwback rule may result in two different apportionment factors.

For earned surplus purposes, franchise tax rule 34 TAC [section] 3.557 defines sales to which the throwback rule applies. A corporation is subject to taxation in another state:

... if the corporation or limited liability company is

chartered or organized in that state, has a certificate

of authority in that state, or has sufficient

contact with that state so that a tax on net income

could be imposed on the corporation or limited

liability company without violating 15 U.S.C. [section]

381 [i.e., Public Law 86-2721 ....

With respect to the taxable capital component, franchise tax rule 34 TAC [section] 3.549 defines sales to which the throwback rule applies:

A corporation which performs any of the activities

listed in [sections] 3.546(c) of this title (relating to Taxable

Capital: Nexus) for taxation of taxable capital in

the other state will be considered subject to taxation

in the other state....

One of the specific activities listed in section 3.546(c) is solicitation. Therefore, a taxpayer whose activities are limited to solicitation in the other state will be considered subject to taxation for taxable capital purposes regardless of whether it actually pays tax in that state. In contrast, mere solicitation is not sufficient to avoid the throwback rule in respect of the earned surplus tax.

In the context of unitary combined reporting, one must consider additional rules in the computation of throwback sales. A significant question arises: Does the term "taxpayer" in the throwback rule refer to each selling corporation as a separate legal entity, or does it refer to the entire combined unitary group as one taxpaying entity?

Historically, most of the combination states have followed California's Joyce rule. Under the Joyce rule, established in a 1966 decision of California's State Board of Equalization (SBE), only the sales of unitary group members with nexus in the state are includable in the numerator of the California sales factor. For throwback purposes, California applied a reverse Jovee rule, requiring a separate throwback computation for each member with taxable nexus.

In Appeal of Finnigan Corporation, No. 88-022-A (Cal. S.B.E. Jan. 24, 1990), the SBE, after careful examination of UDITPA, overruled Joyce by concluding that the term "taxpayer" refers to the unitary group. According to Finnigan, sales should not be thrown back to the shipping state if any member of the unitary group is taxable in the destination state. Further, the SBE held that the sales factor numerator includes sales made by unitary group members that are not taxable in California. In Brown Group Retail, Inc. u. Franchise Tax Board, No. C714010 (Cal. Super. Ct., Los Angeles County, Oct. 8, 1993), a California trial court endorsed the SBE's position in Joyce. The court held that the Finnigan apportionment rule violated the provisions of Public Law No. 86-272 by requiring the inclusion of sales made by unitary group members not having nexus in California. The California Franchise Tax Board has appealed the lower court's decision.

Recently, there have been several decisions concerning throwback sales in connection with unitary combined reporting. In Great Northern Nekoosa Corp. v. State Tax Assessor, No. CV-93-615 (Ken. Cty Super. Ct. Mar. 3, 1995), the Maine Superior Court held, consistent with Finnigan, that the term 'taxpayer" in the UDITPA throwback rule refers to the unitary group. The court ruled that Maine may not throw back sales shipped from Maine into states where any member of the unitary group is taxable. An Illinois appellate court reached the opposite conclusion in Dover Corp., No. 1-93-3340 (Ill. App. Ct., First Dist., Fifth Div., Mar. 31, 1995). In that case, the court decided that the term "taxpayer" does not mean a unitary group of businesses. In addition, the court upheld the validity of an Illinois regulation requiring throwback of sales unless the taxpayer can prove it actually files a return and pays income tax to the destination state. The court concluded that the intent of the legislature was to have 100 percent of a taxpayer's income taxed somewhere. Therefore, to avoid the throwback rule, it is not sufficient that a taxpayer be subject to tax" in the destination state; it must actually be taxed.

Dock Sales

In general, the term "dock sales" refers to sales of goods picked up at the seller's location by an out-of-state purchaser in its own vehicles for transportation to an out-of-state location. These sales are sometimes called "dock pickup sales." The attribution of dock sales often becomes a disputed issue, particularly where both the dock state and the destination state claim that these sales should be included in their sales factor numerator.

UDITPA [sections] 16(a) provides that sales of tangible personal property are includable in the numerator of the sales factor if:

... the property is delivered or shipped to a purchaser,

other than the United States Government,

within this State, regardless of the F.O.B. point or

other conditions of the sale....

The language in UDITPA [sections] 16(a) has been the subject of litigation in various states since 1980. Specifically, the issue is whether the phrase "within this state" modifies the word "purchaser" or the word "delivered." The courts have consistently held that "within this state' modifies the word purchaser," thereby attributing dock sales to the state of ultimate destination. Courts in Florida, Minnesota, Wisconsin, and California have all interpreted the UDITPA language as requiring that sales be allocated based on the destination rule (i.e., the location of the customer). This is consistent with the general purpose of the sales factor: to recognize the contribution of market states in the production of income.

The significance of the dock sales rule is illustrated by the California appeals court's recent decision in McDonnell Douglas Corp. v. Franchise Tax Board, No. B064073 (Calif. Ct. App., Second App. Dist. July 7, 1994; modified Aug. 8, 1994). In this case, the California Court of Appeal held that the taxpayer need not include "dock sales" in its sales factor numerator for California franchise tax purposes. The principal issue was whether sales of aircraft destined for use outside California but delivered to purchasers California were California sales. The California statute is substantially identical to section 16 of UDITPA.

McDonnell Douglas Corporation (MDC), a Maryland corporation, is a manufacturer of commercial and military aircraft and aircraft parts. Most of the commercial aircraft MDC sold were delivered to customers at MDC's Long Beach, California, facility. The customers subsequently arranged for transportation of the aircraft to out-of-state locations. According to Franchise Tax Board regulations and Legal Ruling No. 348, such sales were to be sourced to California. The FTB's Legal Ruling No. 348 states that there is a California sale pursuant to Rev. & T.C. [sections] 25135(a), if either delivery without shipment is made in-state (i.e., purchaser picks up goods at buyer's California location) or goods are shipped to a purchaser within California. This interpretation of UDITPA emphasizes that the place of delivery, not the state of ultimate destination, determines the taxability of sales picked up by out-of-state purchasers.

The California Court of Appeal affirmed the trial court's holding that delivery to a buyer in California is not a California sale within the meaning of Rev. & T.C. [sections] 25135(a) if the aircraft is destined for use in other states. The court cited numerous cases from other states interpreting statutes virtually identical to section 25135. Each of these opinions upheld the destination rule as a basis for assigning sales. In rejecting California's interpretation, the court held that the words "within this state' means the location of the purchaser, not the place of delivery. The court also stated:

In addition to being contrary to the rule adopted

by several other states, an adoption of the rule

urged by the Board would run completely against

the primary purpose of UDITPA, that is to ensure

uniformity among the states in taxation matters....

In Rohm and Haas Kentucky, Inc. v. Revenue Cabinet, Order No. K-15075 (Jan. 7, 1994), the Kentucky Board of Tax Appeals reached contrary result. The Board held that, with respect to dock sales, the seller's goods were "delivered" to the purchaser at the seller's plant site in Kentucky and were therefore includable in the sales factor numerator. The Board came to its conclusion even though the purchaser merely took possession of the goods at the "dock" and those products were immediately removed from Kentucky. This administrative ruling has been appealed to the Franklin County Circuit Court.

Finally, recent rulings in Virginia and Tennessee have concluded that the destination test applies to dock sales. In P.D. 95-24, the Commissioner of the Virginia Department of Taxation ruled that sales are sourced on a destination basis if delivery is for purposes of transportation. The department observed that a taxpayer must have knowledge that the ultimate destination of the goods is outside Virginia. In this case, the purchaser maintained a fleet of trucks for delivering goods to its customers throughout the country. On the way back to its out-of-state facility, the purchaser picked-up raw materials at the taxpayer's location in Virginia. The taxpayer had done business with this purchaser on a regular basis and was well acquainted with its operations. Accordingly, since the taxpayer knew the goods were delivered for transportation outside Virginia, the department held that the sales should be sourced to the destination state.

In Revenue Ruling 95-05, the Tennessee Department of Revenue emphasized that Tennessee uses the destination test to determine where sales of tangible personal property should be sourced for corporate franchise and excise tax purposes. Sales to out-of-state purchasers are properly included in the sales factor numerator of the destination state. The department observed that most states apply the destination test to dock sales. When dock sales are made to a purchaser who immediately ships the goods to other states, the sales are assigned to the out-of-state locations.

Nearly all dock sales litigation has emanated from states which have not adopted UDITPA's "throwback rule." Obviously, it is more likely that a taxpayer would litigate a dock sales issue in a non-throwback state. In a non-throwback setting, a taxpayer would seek to attribute dock sales to other states (based on ultimate destination) where it is not subject to tax.

Occasional Sales

UDITPA [sections] 1(g) provides that "all gross receipts not allocated" are to be included in the sales factor denominator. This means that apportionable business income items of all types are included in the denominator while allocable (non-apportionable) income items are not. In addition to sales of tangible personal property, "gross receipts" covers apportionable income from services, dividends, rentals, royalties, sales of capital assets, and all other business income.

Although UDITPA's definition of sales seemingly encompasses all gross receipts, the MTC regulations carve out three exclusions from the sales factor denominator:

(1) substantial amounts of gross receipts from the occasional sale of a fixed asset used in the regular course of the taxpayer's trade or business;

(2) insubstantial amounts of gross receipts from incidental or occasional transactions unless such exclusion would materially affect the amount of income apportioned to this state, and

(3) income from intangibles that is not readily attributable to any particular income-producing activity of the taxpayer.

Each of these exclusions applies to all gross receipts other than sales of tangible personal property, but this article addresses only the exclusions relating to occasional sales.

With respect to the first exclusion, MTC Reg. IV.18.(c).(1) states that "[f]or example, gross receipts from the sale of a factory or plant will be excluded." Arguably, such income would be includable in the sales factor denominator if the state has adopted UDITPA but not the MTC regulations. This regulation was held to be invalid by the California SBE in Appeal of Triangle Publications, Inc., No. 84-SBE-096, (Cal. S.B.E. June 27, 1984). In that case, the SBE ruled that the regulation contradicted the plain meaning of the California statutes corresponding to UDITPA [subsection] 1(g) and 15:

The regulation, therefore, purports to authorize a

deviation from the statutory apportionment procedures

by excluding some gross receipts from the

sales factor which under the statutory procedures

would clearly be included. Deviations from the

statutory allocation and apportionment formula

are authorized by Revenue and Taxation Code section

25137, but only in exceptional circumstances

where those procedures "do not fairly represent

the extent of the taxpayer's business activity in

this state," and the party seeking to deviate from

the statutory formula bears the burden of proving

that such exceptional circumstances are present....

The Board concluded that the taxpayer failed to meet its burden of proof and must use the standard sales factor.

An analysis of the first exclusion uncovers an exception to the general rule that all apportionable business income is includable in the denominator of the apportionment factor. For example, according to the Arizona Revised Statute (A.R.S.) [sections] 43-1131.1, gain or loss on sale of assets used in the business is considered business income. In addition, A.R.S. [sections] 43-1145 provides that the sales factor of the apportionment ratio shall include all gross receipts from apportionable income. The Arizona Administrative Code, however, allows gross receipts to be excluded in unusual situations where their inclusion in the sales factor would preclude the fair apportionment of income (A.A.C. R15-2-1148). According to the Department of Revenue:

The sale of a factory or plant may result in an extremely large gross receipt from an occasional or unusual sale which may produce little or no net gain. However, the inclusion of this large sale into the sales factor would distort the proper apportionment of normal operating income. In such instances, the gross receipts may be excluded from the normal sales factor by means of the exception provided in A.A.C. R15-2-1148.

The qualification provided in the second exclusion in the MTC regulations is rather meaningless. It is difficult to envision a situation where the exclusion of insubstantial amounts of gross receipts would "materially affect the amount of income apportioned to this state." Examples provided in the MTC regulations include gross receipts from the sale of office furniture and business automobiles. In these days of corporate downsizing and limited resources, it might be more efficient to simply ignore such immaterial items in the compilation of apportionment data.


The equally-weighted three factor formula initially employed by the states is rapidly being replaced by alternative formulas. States have promoted these changes to improve their business climate and become more competitive with neighboring states.

Twenty-eight states have adopted a disproportionately-weighted sales factor. Currently, the most common method to apportion tax liability is the use of a double-weighted sales factor. Nearly every major industrial state has adopted the use of a double-weighted sales factor. The purpose of double-weighting is to diminish the effect of the property and payroll apportionment factors. This provides a tax incentive for companies to increase their investment in property and employment in the state. The trend continues as Arkansas, Georgia, New Jersey, Pennsylvania, and South Carolina have all passed legislation in 1995 adopting a double-weighted sales factor.

Three states employ a single-factor formula consisting of sales only: Iowa, Nebraska, and Texas. In a similar vein, Massachusetts business groups are proposing a change from the current three-factor formula (with double weighted-sales factor) to a single sales factor apportionment method. Proposed legislation in Michigan (substitute SB 342) would phase-in a single sales apportionment formula over a five-year period. Michigan currently uses a double-weighted sales factor. Finally, Minnesota's three-factor apportionment formula consists of 15-percent property, 15-percent payroll, and 70-percent sales.

In conclusion, computing the sales factor is often not a simple matter. Many other issues must be considered in addition to the topics addressed above. While the computation of property and payroll factors is relatively straightforward, the unique issues connected with the sales factor can create a compliance and audit nightmare! A careful analysis of the sales factor is advisable, especially in light of the recent trend from equally weighted toward disproportionately weighted sales factors.

EDITOR'S NOTE: On September 26, 1995, the Franklin Circuit Court reversed the Kentucky Board of Tax Appeals and held that the Kentucky Revenue Cabinet could not tax the dock sales of Rohm and Haas Kentucky, Inc. by including them in the numerator of the sales factor.

JONATHAN A. LISS is Supervisor of State Income and Franchise Taxes for Rohm and Haas Company in Philadelphia. He is a member of Tax Executives Institute's Philadelphia Chapter, as well as the Committee on State Taxation and the Philadelphia Chamber of Commerce-Local Tax Committee. He received a B.S. degree in accounting from Drexel University and an M.S. degree in taxation from Temple University.
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Title Annotation:state's corporate taxes
Author:Liss, Jonathan A.
Publication:Tax Executive
Date:Sep 1, 1995
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