To Allocate or Apportion?
That is the question.
September 27, 2007
by John Karayan, JD/PhD
In a recent decision, a state tax appeals board stood by principle and determined that income generated by an out-of-state firm’s equity interest in a limited partnership was “business income” Sasol North America v. Commissioner of Revenue, Massachusetts Appellate Tax Board, No. C273084, (September 5, 2007).The rationale for this decision? Activities of the limited partnership were so closely related to a firm’s regular affairs that the investment in the partnership served an active operational function rather than a passive investment one. The result of this decision was that the income from the partnership was only partially taxable (“apportioned”) by Massachusetts, rather than being totally taxable (“allocated”) to the state. This illustrates a question on many a business tax practitioner’s mind:When can income from cross-border investments be allocated rather than apportioned?
The default rule is apportionment;the exception is based on a “facts and circumstances” determination of whether the income arose from transactions not in the ordinary course of business. The risk is that tax auditors will take an outcomes-based approach by viewing profitable investments and asset sales as business income, but losers as non-business. In this case, a state appeals board reduced that risk.
State and Local Tax Planning
The risk can be substantial. State and local taxes (“SALT”), and thus SALT tax planning, have become increasingly important over the past quarter centuryas advances in technology and changes in regulatory structures have spurred vast increases in the number and magnitude of multistate transactions. For the business tax practitioner,cross-border transactions are challenging because they may be subject to taxation by various state and local governments.
The decision largely depends on whether the firms involved in a multistate transaction have a sufficient connection (“nexus”) with a government to give it jurisdiction to tax the transaction. This is an interesting, changing, and complex subject in and of itself.Once it is determined that a firm has a taxable nexus with a state and local jurisdiction, the fun is not over. Because many governments may be entitled to tax a transaction, the question shifts to how the tax base (e.g., income) from the transaction should be divided among the various jurisdictions touched by the transaction.
Two primary methods to divvy up multi-state income have developed over the years: Allocation and apportionment. Unlike the Federal “arm’s length” rule — which is the international standard — of dividing income among jurisdictions, the allocation and apportionment approach does not look at the fairness of transactions between related companies. Instead, it seeks to fairly apportion to a jurisdiction all of a firm’s income which was generated by contacts with the state. For “business” income, this is done by apportionment: An averaging formula, typically based on the relative proportions of payroll, property, and sales within and without the jurisdiction, is applied to the firm’s total income. However, different formulas can and are applied by different jurisdictions, leading to the specter more than 100 percent of a firm’s income being taxed (often referred to as “double taxation”).
Multistate Tax Commission
The Multistate Tax Commission was formed to solve such problems through interstate cooperation. High on its agenda is minimizing double taxation by the use of fair apportionment, increasing tax compliance, and achieving uniformity in tax administration. The Commission has developed model rules embodying the guidelines it has developed:the Multistate Tax Compact and the Uniform Division for Income Tax Purposes Act (UDITPA).Most jurisdictions have adopted most of these guidelines.
Both the Multistate Tax Compact and UDITPA use the allocation and apportionment approach. Distinguishing business from non-business income is important: Business income is apportioned, and non-business income is allocated. A model three-factor formula is provided for apportioning a firm’s business income among the jurisdictions with which it has nexus. The default rule is that transactions generate business income “unless clearly classifiable as nonbusiness”. Multistate Tax Compact Regulation Section (“MTC Reg. §”)IV.1(a).More specifically, under Section 1(a) of UDITPA, transactions in the regular course of the taxpayer’s trade or business result in business income.This includes income from property if the acquisition, management or disposition of the property constitutes integral parts of the taxpayer’s regular trade or business operations.
Transactional and Functional Tests
Most jurisdictions that have adopted UDITPA utilize these rules into two alternative tests: The transactional test or the functional test.Income that meets either of these tests is considered business income.(Some states, however, only apply the transactional test.) The transactional test provides that income is business income if it arises from “transactions and activities in the regular course of the taxpayer’s trade or business.”Under this test, the rule of thumb is that revenue is apportionable business income unless it arises from non-business investments (e.g., a portfolio of cash equivalents or marketable securities) or the occasional disposition of fixed assets. The labels given to types of income are not determinative;“passive income” can be “business income” under UDITPA.The functional test helps determine the character of such “other income” from non-business investments or occasional sales of fixed assets.
This test provides that income generated from property is business income if the acquisition, management and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations. Thus, rents received from property used in or incidental to the taxpayer’s trade or business are business income.MTC Reg. § IV.1(c)(1). Similarly, gains or losses realized from the disposition of property that was used in the taxpayer’s trade or business are business income. MTC Reg. § IV.1 (c)(2). Interest generated by an asset used, arising from, or acquired and held for a purpose related or incidental to a trade or business also is business income. MTC Reg. § IV.1.(c)(3).Dividends from shares which arose from or were acquired in the regular course ofbusiness, or if the purpose of acquiring and holding the stock is related or incidental to the taxpayer’s trade or business, are business income.MTC Reg. § IV.1(c)(4). Again, if a patent or copyright results from or was created in the regular course of the taxpayer’s trade or business, or if the purpose of acquiring and holding the patent or copyright is related to or incidental to the taxpayer’s trade or business, then royalties from the patents or copyrights are business income.MTC Reg. §.IV.1(c)(5).
However, the same kinds of income — capital gains, interest, dividends, royalties — is classified as non-business income if they arise from non-business investments (e.g., a portfolio of cash equivalents or marketable securities) or the occasional disposition of fixed assets. Thus, interest income from trade receivables is business, but interest from the investment of temporaryidle funds is non-business. Similarly, dividends and capital gains from investments of idle funds, rather than from strategic investments to procure customers or suppliers, are non-business.
The same rules apply to investments in flow-through entities like partnerships. The facts and circumstances surrounding the investment are reviewed to see if it is an integral part of the taxpayer’s on-going business, or instead merely a portfolio investmentof funds not yet required by the firm’s business activities. A “tie” puts it in the“business” category. At issue in Sasol North America v. Commissioner of Revenue was an equity interest in a limited partnership. Despite the fact that limited partners by definition cannot be involved in the day-to-day management of the partnerships, and thus is by most definitions a passive rather than a business investment, the Board ruled that for state tax apportionment purposes, the investment generated business income. This was because activities of the limited partnership were so closely related to the firm’s regular affairs that the investment in the partnership served an active operational function rather than a passive investment one. In other words, the Board focused on the function of the investment for this taxpayer, rather than the general nature of the investment.
The bottom line is that transactions generate apportionable business income unless it can be shown clearly that the transaction deals with an asset that is not in the core of the firm’s business, but merely a place to invest idle funds. If it is the latter, however, it should be a non-business item, and must be allocated 100 percent to the firm’s commercial domicile.
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John E. Karayan, JD/PhD is Professor & Chair of Accounting at Woodbury University, and a testifying Expert Witness in complex business litigation on accounting and tax issues.