Developments in State and Local Taxation - 2010
Recent Decisions
Arizona - Combined Reporting
In a decision addressing combined reporting, the Arizona Court of Appeals ruled that the key component for determining whether a company's activities are unitary is whether the activities serve an "accessory" or "operational" function for the unitary business. Companies performing services that are accessory to the business operations, such as centralized management, financing, research, legal, accounting and other internal services that could be separately charged, are generally not part of the unitary business, while companies performing core operational functions that are "embodied in the product or its delivery to customers" are unitary. Applying this rule, the Court found that a receivables factoring subsidiary and an investment management subsidiary performed only accessory services, and were therefore not part of the taxpayer's unitary business. However, an intangibles holding subsidiary was performing "a basic operational function," and therefore was required to be included in the taxpayer's combined return.
Companies doing business in Arizona and either filing or considering filing a combined return in the State should review the Court's decision (along with the Department's regulations) to determine the appropriate composition of the combined group. Refund opportunities may also exist to the extent that companies providing only accessory functions were previously included in a combined return for any open year. R.R. Donnelley & Sons Company v. Arizona Department of Revenue, Arizona Court of Appeals, April 29, 2010.
Georgia - IRC Sec. 338(h)(10) Elections
On March 1, 2010, the Georgia Supreme Court, in reversing a decision of the Court of Appeals, ruled that an Internal Revenue Code ("IRC") Sec. 338(h)(10) election does not apply for Georgia income tax purposes when the election is not "made by" the taxpayer, in accordance with Georgia Tax Law Sec. 48-7-21(b)(7). Such section provides that all elections made by corporate taxpayers under the IRC apply under Article 2 of the income tax law. In this case, the taxpayer was taxed as an S corporation for federal income tax purposes and a C corporation for Georgia income tax purposes. Since the IRC 338(h)(10) election was made by the taxpayer's shareholders on its behalf, the Court ruled that the election was not applicable.
This decision arguably applies in all situations in which a Georgia taxpayer, whether a C corporation or an S corporation, is the target corporation in an IRC Sec. 338(h)(10) transaction because the election is not made by the target in either case. However, it is unclear what happens when, for example, both the seller of the stock and the target are Georgia taxpayers. Arguably, neither company pays tax on the gain from the sale of stock or the deemed asset sale since the election should be respected for the seller if it actually makes the election and ignored for the target. At the very least, any corporation which reported gain to the State as a result of a deemed asset sale should consider filing a refund claim.
Recently enacted legislation in Georgia reverses the Court's decision prospectively. Specifically, the legislation provides that all elections under Sec. 338 of the IRC will apply under Article 2 of the Tax Law. The legislation became effective on June 3, 2010, and applies to all stock purchases and sales occurring on or after such date. Trawick Construction Company v. Georgia Department of Revenue, Supreme Court of Georgia, March 1, 2010.
New York - Excess Dividends and Gross Income Taxes
The New York Tax Appeals Tribunal recently ruled that a utility company's dividends were not subject to the "excess dividends tax" imposed under former NY Tax Law Sec. 186(1) because the dividends were not derived from ordinary profits from doing business. In addition, the Tribunal also ruled that the taxpayer met its burden of proof for determining the profit earned on the sale of assets for purposes of computing the gross income tax under Tax Law Sec. 186-a.
Pursuant to an agreement with the NYS Public Service Commission, Con Edison divested itself of certain generation assets, and subsequently made distributions to its shareholder. The Department assessed excess dividends tax on Con Ed's 3rd and 4th quarter dividends, arguing that Con Edison distributed regular business profits and not proceeds from the divestiture which would not have been taxable. In holding that the distributions were not subject to the excess dividends tax, the Tribunal noted that the advisory opinion issued to the taxpayer did not require the taxpayer to identify, segregate or account for the divestiture proceeds in a specific manner, and that there was nothing in the record which showed that the distributions were made from ordinary business profits. In connection with the gross income tax issue, the Tribunal agreed with Con Edison that the retired assets were among those transferred to the purchaser, and that the basis for computing profit on the sale of the divested assets was the amount paid for all of the assets sold less the original cost of such assets. Contrary to the Department's contention, the value of the retired assets was not relevant to this computation.
Since both the excess dividends tax and the gross income tax have been repealed effective for years ending after January 1, 2000 and beginning January 1, 2005, respectively, this decision may have limited utility for other taxpayers. Matter of Consolidated Edison Co. of New York, Inc., NYS Tax Appeals Tribunal, March 29, 2010.
New Jersey - Exception to Interest Add Back Requirement
The New Jersey Tax Court recently held that a taxpayer was not required to add-back interest paid to a related member in computing its New Jersey taxable income because disallowance of the deduction was "unreasonable." During the years at issue, the taxpayer, part of a consumer finance lending group, borrowed money from its parent company in order to fund its customer lending operations. The parent borrowed funds from unrelated third parties and loaned those funds to its subsidiaries, including the taxpayer, charging interest at the maximum applicable federal rate.
In reaching its decision, the Court determined that the legislature enacted the "unreasonable exception" to address this type of situation, and noted that the loans had economic substance, the reason proffered for the arrangement (i.e., to obtain more favorable financing rates) was credible and the parent company paid tax on the interest income in other jurisdictions. The Court refused to adopt the narrow interpretation of the unreasonable exception set forth by the Division of Taxation which would have allowed the exception only if necessary to avoid double taxation in New Jersey, or where the taxpayer utilized a centralized cash management system.
In addition, the Court also clarified two other exceptions to the interest add-back provisions: the "3% exception" which allows an interest deduction if, among other things, the rate of tax applied to the interest received by the related member is within 3 percentage points of the rate of tax applied to taxable interest in New Jersey, and the "guarantee or conduit exception" which allows the deduction if the interest is paid, directly or indirectly, to an independent lender and the taxpayer guarantees the debt on which the interest is required. With respect to the 3% exception, the Court held that the reference in the statute to "rate of tax" means the taxpayer's and related member's effective tax rate, and not the state statutory tax rate. With respect to the guarantee exception, the Court found that the funding agreement between the taxpayer and its parent was not sufficient proof that the debt was guaranteed by the taxpayer because the agreement did not specify the names of the third party lenders, either party could unilaterally withdraw from the agreement and the document did not use the term "guarantee."
In light of the Tax Court's broad interpretation of the unreasonable exception, taxpayers subject to the add-back requirement should review their facts to determine if they can show that disallowance of deductions for interest paid to related parties is unreasonable, particularly if there is a business purpose for the loans, the loans are properly documented and the related party pays tax on the interest income in other jurisdictions. The same interpretation may also apply to the unreasonable exception set forth in the New Jersey royalty add-back statute and in other jurisdictions that have similar exceptions in their add-back statutes. Beneficial New Jersey, Inc. v. Director, Division of Taxation, Tax Court of New Jersey, No. 009886-2007, August 31, 2010.
Ohio - Sales/Use Tax Refunds
The Ohio Supreme Court recently determined that sales and use tax refunds granted under Ohio Revenue Code Sec. 5739.071(A), which provides refunds of sales and use tax paid on the purchase of certain property and services by electronic information providers, do not bear interest. International Business Machines Corporation v. Ohio Tax Commissioner, Supreme Court of Ohio, May 5, 2010.
South Carolina - Alternative Apportionment Methodology
Although South Carolina does not generally allow the filing of combined/consolidated returns, the South Carolina Supreme Court recently ruled that S.C. Code Ann. Sec. 12-6-2320(A)(4) allows for the use of the combined entity apportionment method where the standard apportionment method does not fairly represent the taxpayer's business activity in the State. Under this method, the taxpayer was permitted to apportion its income to the State by means of an apportionment formula that included the apportionment factors of members of its unitary business, notwithstanding that combined reporting is not permitted.
Based on this decision, any taxpayer that is part of unitary business operating within South Carolina should review whether the standard apportionment formula fairly represents their activities in the State and, if not, consider petitioning for the use of the combined apportionment methodology. Media General Communications, Inc. and Media Broadcasting of South Carolina Holdings, Inc. v. South Carolina Department of Revenue, Supreme Court of South Carolina, June 14, 2010.