Combined State Tax Reporting
Are you properly addressing the issues of combined reporting for state tax purposes?
June 12, 2008
by Mary Bernard, CPA/MST
Large multistate corporations may have to report their income under many different aggregate methods as they complete their state tax returns. A thorough understanding of the definitions of the terms is essential and will vary greatly from state to state. With the addition of West Virginia next year, there will be 20 states using a unitary approach to taxation of multistate entities, up from 12 states in the not too distant past. This trend will most likely continue, with Massachusetts, among others, now investigating the favorable effect that unitary reporting could have on its budget. A review of the possible impact of unitary reporting on your business could be essential to your bottom line.
The principle of combined unitary reporting originated in the 1800s to impose property taxes on railroad companies operating in various states. The idea was to treat a company's multistate business activities as a single entity, rather than as separate activities occurring in several states. A century later, the concept was applied to income tax principles at the U.S. Supreme Court level in the Mobil Oil case (Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980)). The court declared the unitary principle to be "the linchpin of apportionability in the field of state income taxation." Based on this concept, a state can require a corporation that has divisions operating within and outside of a state's borders to compute its combined income based on an apportionment formula rather than on a geographic-based separate accounting, if the business is unitary in nature.
What Is a Unitary Business Group?
Although there may be as many definitions as there are states implementing the principle, in general, a unitary business group can be either a vertically or horizontally integrated business. In a vertical group, separate divisions or subsidiaries perform independent steps that lead to a finished product when the steps are combined. A horizontal group usually consists of similar, parallel businesses operating in different states with centralized management.
There have been many judicial interpretations of the unitary principle over the years, beginning with the U.S. Supreme Court case, Butler Bros. v. McColgan (315 U.S. 501 (1942)). Under the Three Unities test established in this case, a unitary business exhibits unity of ownership, operation and use. Control can be established with more than 50 percent ownership. Centralized staff functions can include accounting, payroll, pension, advertising and purchasing to establish a unity of operations. Unity of use generally involves common officers and directors making decisions related to strategy and operations.
A dependency test was described in Edison Cal. Stores v. McColgan, (176 P. 2d 697 (Cal. 1987)), to include the presence of substantial intercompany loans, sales and exchanges of products or services, as well as a shared executive group and staff functions. Mobil Oil Corp. described the factors of profitability test to include functional integration, centralization of management and economies of scale. These factors have been interpreted to incorporate concepts of intercompany flow of goods, services and personnel, shared directors and officers, required parent approval, collective purchase of goods and common insurance policies and pensions. The prevalence of many of these factors would generally indicate a unitary business.
The Multistate Tax Commission (MTC) believes that the unitary concept promotes fairness and uniformity when implemented by states. They have proposed a model unitary statute for use by member states which identifies factors indicating a unitary business following the factors of profitability test. Although the mission of the MTC is to promote uniformity of state tax laws, members are free to adopt or modify any proposed regulation, as they see fit. This leads to the variety of interpretations and requirements among those states imposing the unitary principle.
Good News or Bad News?
As with almost every state taxation issue the answer ultimately is, "it depends." Businesses being required to file state income tax returns on a unitary basis may not necessarily face a higher overall state tax burden. The components of its business group will dictate whether unitary filing increases or decreases its total state tax liability.
If any of company's subsidiaries have losses or beneficial tax attributes, unitary filings may result in an improved tax position. The unitary concept can be imposed on a "water's edge basis" to include only U.S. operations or on a "worldwide basis" to include foreign operations as well, with vastly differing results. A detailed review of your business operations in light of the above listed tests may produce some interesting results.
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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.