Narrow Interpretation of New Jersey Throw-Out Rule Creates Opportunities for Refunds
In Whirlpool Properties, Inc. v. Director, Division of Taxation (July 28, 2011), the New Jersey Supreme Court recently held that the throw-out rule was not unconstitutional on its face, provided it was applied only to receipts that were not taxed because a state lacked jurisdiction to tax the taxpayer either because of (i) the corporation's insufficient business activity in that state, or (ii) congressional action such as Public Law 86-272. Under this interpretation, throw-out does not apply to receipts that are untaxed because a state does not impose an income or similar business activity tax. Under the same rationale, throw-out should not apply to receipts which are not taxed because another state chooses not to tax them for some other reason, provided the taxpayer has the requisite contacts with the state to be constitutionally subject to tax.
Background
During the years at issue, New Jersey determined a corporate taxpayer's income tax liability using a three-factor apportionment formula, consisting of a property, payroll and receipts factor. Beginning in 2002, the State required corporations to exclude (or "throw-out") receipts from the denominator of the receipts factor if such receipts were assigned to a state in which the taxpayer was not "subject to a tax" on or measured by profits, income or business activity1. Under the State's interpretation of this rule, receipts were excluded from the denominator of the receipts factor if the taxpayer did not actually pay tax in the other state, the receipts were assigned to a state that did not impose a corporate income tax or the receipts were eliminated in a combined return. Such exclusion often substantially increased a corporation's overall apportionment percentage in New Jersey, particularly if the corporation's activities were centralized in a few jurisdictions.
The Whirlpool Decision
Application of the throw-out rule to the taxpayer in Whirlpool, a non-New Jersey corporation engaged in licensing intangibles to related parties, resulted in a substantial increase to its New Jersey apportionment percentage for the years at issue. Accordingly, Whirlpool challenged the facial constitutionality of the throw-out rule in the New Jersey Tax Court, and ultimately appealed the decision to the New Jersey Supreme Court.
As indicated above, the Supreme Court held that the throw-out rule was not unconstitutional on its face if it was applied in a limited manner consistent with the legislature's intent in enacting the statute. Specifically, the Court determined that the throw-out rule operates constitutionally when the category of receipts that may be thrown out is limited to receipts that are not taxed by another jurisdiction because the taxpayer does not have the requisite constitutional contacts with the jurisdiction, or because of Congressional action such as Public Law 86-272. It does not apply to receipts that are not taxed because a state chooses not to impose an income tax.
Refund Opportunities
It is currently unclear how the New Jersey Division of Taxation will interpret the decision in Whirlpool, and whether the taxpayer will appeal the decision to the U.S. Supreme Court. In light of the limited application of the throw-out rule as espoused by the New Jersey Supreme Court, multistate taxpayers should consider filing refund claims in appropriate circumstances.
In this regard, taxpayers should calculate the tax effect of including in the denominator of the receipts factor all receipts assigned to jurisdictions that could constitutionally subject the corporation to tax, including receipts assigned to jurisdictions without income or similar business activity taxes and receipts that would be subject to tax under the economic nexus standard adopted by the New Jersey Supreme Court even if the jurisdiction did not actually impose a tax on such receipts. Taxpayers should also include receipts included in/eliminated from combined returns if the taxpayer is constitutionally subject to tax in the combined state. In calculating the tax benefit derived from any throw-out refund claim, taxpayers should evaluate the impact of including additional receipts in the denominator of the receipts factor on the $5 million cap for affiliated groups and the addback for expenses paid to related parties.
1 The throw-out rule has been repealed for tax years beginning on or after July 1, 2010.