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Trends in Multi-State Income Tax Apportionment

The typical three-factor apportionment formula, with equal weight for sales, property and payroll is quickly changing across the country. The impact to your total state tax liability could be dramatic.

October 11, 2007
by Mary Bernard, CPA/MST

Multi-state corporations are allowed to apportion their income among the states in which they have established nexus due to their specific business operations within each state. Once the right to apportion income is granted, the real work begins. The days of a uniform three-factor apportionment formula are long gone. Even the tax base of net income has been changing in some states as popularity of the gross receipts concept spreads.

Super-Weighted Sales Factor

Historically, income was apportioned among the states based on the percentage of sales, tangible property and payroll located within the state as compared to these same factors located everywhere. Each factor was equally weighted in determining the income apportioned to each state. This concept originated in 1957 with the Uniform Division of Income for Tax Purposes Act, which contained a model law for apportioning income of a corporation that is taxable in two or more states. Over the past few years, however, this model has been changing.

Although many states allow for specialized apportionment formulas for specific industries, currently only about 10 states use the original three-factor apportionment formula with equally weighted factors for most industries. About 20 states double weight the sales factor, with an increasing number of states requiring the use of single factor apportionment based on sales. By 2008, Illinois, Iowa, Nebraska, Texas, Oregon, Georgia, New York and Wisconsin will all have single factor sales apportionment. Minnesota and Indiana are phasing in the concept. Some states like Michigan, have super-weighted sales, where sales account for 95 percent of the apportionment factor, and Ohio and Pennsylvania, both with 60 percent sales.

The concept of a heavy-weighted sales factor for apportionment is politically popular because it normally benefits in-state companies. Typically, in-state companies have large investments in property and high payroll expenses that would be given less weight. Out-of-state companies, on the other hand, seldom have large payroll and property factors. Their largest factor of business activity is usually sales. By putting the emphasis on the sales factor, out-of- state companies will generally see an increase in the amount of income apportioned to the state when the sales factor is prominently weighted in the apportionment formula.

Modifications to the Sales Factor Definition

In addition to increasing the significance of the sales factor in the apportionment formula, several states are changing the composition of the receipts included in the calculation. The California Franchise Tax Board dealt with several cases involving Microsoft, General Motors and The Limited, where material distortion resulted from the existing apportionment factor computation. As a result, California has recently submitted a proposal to completely remove interest, dividends and gross proceeds from the sale of securities from the sales factor. This would effectively remove the results of treasury operations from the apportionment factors. Arizona and Illinois are also redefining the definition of “gross receipts” to include only net gains rather than gross proceeds from the sale of investments.

Another change has occurred in the method of sourcing sales to a state. When services are performed outside of the state of the customer, many states have used the cost of performance concept to determine where to source the sale. For instance, if an Ohio company provides services to an Illinois company but all work is performed in Ohio, Illinois would normally consider this an Ohio sale, as the cost of performance is incurred outside of Illinois. Beginning in 2008, receipts from services and intangibles will be sourced to Illinois if the purchaser of the service resides in Illinois. Maine, among other states, is also changing sourcing rules to this market based sourcing rather than the previously more common method of cost of performance. Conflicts could easily arise from this trend when the two states involved use different sales sourcing methods. It is unsure at this time how this will be resolved.

Conclusion

There are other tax allocation trends gaining momentum around the country in response to recent court cases. States are now requiring the add-back of intercompany interest and intangible expenses. Mandatory combined reporting is also gaining popularity. States like Texas and Michigan replaced one gross-receipts-based tax with another similar based tax. The Lanco (NJ) and MBNA (WV) cases are fueling interest in economic presence as a determination of nexus for income tax purposes. The introduction in Congress of the Business Activity Tax Simplification Act of 2007 is, in part, a request to resolve the physical presence nexus controversy left by the Supreme Court’s refusal to consider the concept in Lanco and MBNA. We can expect more activity in this area before this year concludes.

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Mary F. Bernard, CPA/MST is a Tax Principal and Director of State and Local Tax Services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI. She has over 20 years of experience with national and local accounting firms working with a variety of individual, partnership and corporate clients, with particular focus on corporate multi-state tax issues. She has also provided advisory and compliance services to our extensive nonprofit clients. Bernard is a member of the AICPA, the Massachusetts Society of CPAs and serves as President-elect of the board of directors for the Rhode Island Society of CPAs.