franchise store front
Article

2018 Year-end tax letter | Other corporate income and franchise developments

Net operating losses

In Pennsylvania, issues relating to the use of NOLs continue to linger. In 2018, the U.S. Supreme Court denied the writ of certiorari in the Nextel case, where the Pennsylvania Supreme Court held that the $3 million fixed-dollar limitation cap for tax year 2007 violated the Uniformity Clause of the Pennsylvania Constitution. As a remedy, the decision retained the net loss carryover deduction percentage limitation. Subsequently, the state’s revenue department announced it will not apply the Nextel decision to taxable years beginning prior to Jan. 1, 2017, and allow taxpayers the greater of the flat dollar cap or the percentage cap.

However, the RB Alden case, dealing with the 2006 tax year that only had a fixed-dollar limitation (and no percentage limitation), was recently remanded from the Pennsylvania Supreme Court back to the Commonwealth Court to be decided in light of the decision in Nextel.

Continuing shift to market-based sourcing rules and single sales factor

The use of market-based sourcing of receipts from services and intangible assets to apportion income continues to gain state attention. Currently, 24 states have adopted market-based sourcing rules in various forms. It became effective in Montana in 2018. Colorado and New Jersey adopted it for tax years beginning on or after Jan. 1, 2019. Missouri will move to market-based sourcing with a throw-out provision for non-nexus sales, effective for tax years beginning on or after Jan. 1, 2020. For 2018, 23 continue to use the cost-of-performance approach in various forms.

More states are switching from a traditional three-factor apportionment formula to a more weighted or single sales factor formula. Maryland enacted legislation that phases in a single sales factor apportionment formula over four years but allows qualified “worldwide headquartered companies” to elect to use the existing three-factor formula, which incorporates property, payroll and a double-weighted sales factor. The legislation applies to tax years beginning after Dec. 31, 2017. Kentucky also replaced its three-factor apportionment formula to a single sales factor, effective for tax years beginning or after Jan. 1, 2018.

Complying with market-based sourcing rules can be a complex process for businesses as each state has its own guidance for compliance that is rarely as in-depth as needed. Because the onus is on multistate taxpayers to understand the available statutory, regulatory and administrative authority and develop an appropriate methodology for proper compliance in those states, we recommend consulting with your tax advisor.

Nexus

The Wayfair sales tax case is having a pronounced ripple effect, directing even more attention to income and franchise tax nexus concerns. A majority of states believe they have the statutory or administrative authority to assert some type of economic nexus, i.e., they can require multistate businesses to file an income or franchise tax return when physical presence is absent but some type of economic connection exists (for example, sales to in-state customers). Additionally, nexus policy in 14 states is based on factor presence, meaning that if a taxpayer’s activity in the state exceeds sales, property or payroll thresholds, the taxpayer is deemed to have nexus in the state.

Nearly 30 states responded to Bloomberg BNA’s “2018 Survey of State Tax Departments” that licensing prewritten software to in-state residents creates nexus, and 21 states believe they can assert nexus if a cloud computing business has a substantial number of in-state customers and substantial revenue in the state. Note that the term “substantial” is not defined. Further, 18 states responded to the survey that having a web hosting arrangement with a third party on an in-state server creates nexus.

This aggressive state attitude is a problem for companies that render services, license intangibles or sell something other than tangible personal property (TPP). Public Law 86-272 provides basic nexus protections for sellers of TPP and allows physical presence for net income tax purposes that facilitates the solicitation of sales orders.

The tax community is interested in seeing how states will react with respect to their income and franchise tax nexus standards in light of the ruling in Wayfair. While states have argued for years that the Quill case did not apply for income and franchise tax purposes, the U.S. Supreme Court decision to overturn the physical presence standard for sales and use tax nexus is likely to further embolden states. In states that have adopted economic nexus standards for sales and use tax, the question arises whether they will enact factor-presence nexus for income tax purposes. Some states that had “constitutional nexus” standards in the law or rules on their books but did not actively enforce them have begun to do so with more vigor.

Remote sellers of intangibles, services and software should analyze their income and franchise nexus situations as they move forward with sales and use tax registrations in the states with Wayfair registration requirements. It is possible, if not likely, they will receive an income or franchise tax nexus questionnaire as part of the process.

State transfer pricing

Transfer pricing continues to be an area of focus for states. It appears that in spite of the TCJA corporate income tax rate cut as well as other international tax provisions in the legislation, like foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI), U.S. corporations continue to move intangible assets overseas and, possibly, pursue inversion strategies. For states that do not employ worldwide combined reporting or actively enforce related-party expense add-back provisions, this means that multinational corporations can continue to drive down their state effective tax rates. The obvious tool to prevent this is the application of section 482 (arm’s-length) pricing rules and/or similar provisions that empower tax authorities to bar tax avoidance transactions.

In October 2018, the Utah Supreme Court upheld a lower court’s decision ruling that the Utah State Tax Commission improperly disallowed a deduction for royalty payments a taxpayer received from an affiliate (Utah State Tax Comm’n v. See’s Candies Inc.). In this case, the tax commission did not offer its own transfer pricing study nor dispute the accuracy of the taxpayer’s study. Rather, it attempted to deny the deductions solely on the theory that it was empowered to do so in order to clearly reflect income. Various parties, including the Multistate Tax Commission (MTC) and Council on State Taxation (COST), submitted amicus briefs on the proper scope of Utah’s version of section 482 and how much discretion the commission has to adjust related-party transactions.

The District of Columbia continues to wrangle with multinational corporations on the basis of consulting studies that have been determined to be flawed in some of the District’s legal venues. To date, settlements were reached with a number of large multinational taxpayers, including Exxon Mobil Oil Corporation and Eli Lilly, on assessments that topped $9 million. Other transfer pricing cases are pending.

The MTC’s state transfer pricing program, State Intercompany Transactions Advisory Service (SITAS), appears to be on pause, perhaps due to a lack of agreement on how to fund it or the direction it should take. Nevertheless, the MTC continues to push for stronger enforcement efforts in the section 482 area against multinational corporations engaging in global tax minimization strategies.

The rising number of states adopting mandatory unitary combined reporting for affiliated C corporations is an outgrowth of their concerns about transfer pricing.

Kentucky and New Jersey are the latest states to require combined reporting with the effective date for both being tax years beginning on or after Jan. 1, 2019. Their combined group definition is based on the water’s-edge approach. New Jersey permits a worldwide combination election. With respect to nexus, Kentucky adopted the “Finnigan” rule (i.e., any single member in a group has nexus in the state, all of them do and are accountable) while New Jersey opted to follow the “Joyce” approach (i.e., all members of a group are included in the combined return, but only those with nexus are liable).

View more insights in the 2018 year-end tax planning letter >

Download the 2018 year-end tax planning letter >

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

pen and calculator
Next up

2018 year-end tax letter | Income, franchise and business entity taxes