State and International Tax Overlaps - Eversheds Sutherland · 2020-06-15 · 3 © 2016 SUTHERLAND...

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

State and International Tax Overlaps

TEI Rochester Chapter March 2, 2016

Amy F. Nogid, Sutherland

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Overview Nexus: Who is Subject to Tax? Combined Reporting: Who is Included? Federal Conformity: How Is Income Computed? Transfer Pricing Apportionment States’ Responses to Inversion Activity

Agenda

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Overview

U.S. International Tax Framework

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Overview

ETB = Engaged in a U.S. trade or business - A foreign person is engaged in business only if its activities related

to the production of income (wherever located) are considerable, continuous and regular. Pinchot v. Comm’r, 113 F.2d 718 (2d Cir. 1940)

PE = Permanent establishment - Office or fixed place of business, a construction or installation site,

dependent agents - Does not include independent agents, storage of inventory, display

of samples, performance of clerical functions

ECI = Effectively connected income - Income attributable to a PE

The Lingo

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Overview

Foreign tax regimes generally employ a source-based methodology for determining whether a business’s income is subject to tax

U.S. state tax regimes generally do not employ a source-based methodology. Instead, they rely on formulary apportionment to divide the taxable income of a unitary business among the states in which the business operates. States use a variety of apportionment formulas including: - Three-factor formula (property, payroll and sales) - Weighted sales factor formula - Single sales factor formula Often coupled with market-based sourcing

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Nexus Federal tax limitations, such as engaging in a trade or business,

having a permanent establishment or other treaty limitations, do not apply to state taxes. - For example, since a permanent establishment does not include using a warehouse

for storing, displaying or delivering inventory, a company doing so could be subject to state tax and not federal tax.

Economic nexus vs. physical presence - Some states require a physical presence before a tax can be imposed. United Parcel Servs., Inc. v. Dep’t of Revenue, 995 N.E.2d 20 (Ind. T.C. 2013)

(foreign reinsurance companies had to be physically present in order to be “doing business” for purposes of the premiums tax).

J.C. Penney Nat’l Bank v. Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 2000) (franchise and excise taxes could not be imposed against a credit card bank that was not physically present in Tennessee).

- Other states maintain that “economic presence” provides a sufficient basis to impose a tax: “It is well settled that the taxpayer need not have a tangible, physical presence in a state for income to be taxable there.” Geoffrey, Inc. v. S.C. Tax Comm’n, 437 S.E.2d 13, 18 (S.C. 1993).

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Nexus

Connecticut - Has adopted a substantial economic presence nexus standard, but

excludes foreign corporations: “The [economic presence nexus standard] shall not apply to any

company that is treated as a foreign [non-US] corporation under the Internal Revenue Code and had no income effectively connected with a United States trade or business.” Conn. Gen. Stat. § 12-216a(b)(1).

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Nexus

Multistate Tax Commission in 2002 proposed a uniform state standard for determining corporate income and franchise tax nexus. - Under the proposal, “substantial factor presence” is established if any of the

following three thresholds are exceeded in a particular state: $50,000 of property or 25% of a company’s total property; $50,000 of payroll or 25% of a company’s total payroll; or $500,000 of sales or 25% of a company’s total sales.

Several states have adopted factor presence nexus statutes including: - Alabama, California, Colorado, Connecticut, Michigan, New York, Ohio (CAT),

Tennessee, Washington (B&O)

But compare to federal tax thresholds (ETB, ECI, PE)

Factor Presence Nexus

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Nexus

P. L. 86-272 applies to “interstate” commerce - Several states have announced that they will apply P. L. 86-272 to transactions in

foreign commerce (e.g., Alabama, Illinois, Kentucky, Michigan). - Other states explicitly do not apply P. L. 86-272 protection to foreign commerce. California applies only to U.S. states and Puerto Rico. In re Dresser Industries,

Inc., 82-SBE-307 (Cal. State Bd. of Equalization, June 29, 1982). - MTC’s guidelines apply only to U.S. commerce, but provide alternative language for

a state to use if it wants to apply Public Law 86-272 to foreign commerce. States that have adopted the MTC’s guidelines without the alternative language

(i.e., do not specifically exempt foreign commerce) include: Arkansas, Colorado, Hawaii, Idaho, Louisiana, Montana, New Jersey, New Mexico, North Dakota.

Is the exclusion of foreign corporations from P. L. 86-272 protection unconstitutional? - Treats similarly situated domestic and foreign companies differently. - Could violate international trade rules or provisions of U.S. tax treaties.

Foreign Corporations and Public Law 86-272

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Nexus

If a foreign corporation has state nexus but does not have federal taxable income by reason of treaty protection or lack of ECI, will it be subject to state income tax? - No: Tennessee, South Carolina, Massachusetts and states that

piggyback federal taxable income - Yes: New York, California, Michigan, Pennsylvania and states with

add-backs - Maybe: Many states have no clear authority

Consequences of state nexus is that a corporation is subject to state tax on an apportioned basis, without credits or assignment of income to a particular location.

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Combined Reporting

Unitary business principle - Functional integration - Centralization of management - Economies of scale

Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983) - Court held that worldwide combination was constitutional, and overseas subsidiaries

that were unitary with a domestic corporation could be included in the apportionment formula in determining the income of the taxpayer attributable to California. See also Barclays Bank PLC v. Franchise Tax Board, 512 U.S. 298 (1994)

(worldwide unitary combination of a foreign corporation with its subsidiaries is constitutional).

- In response to Container and at the behest of corporations, the U.S. Treasury formed a Worldwide Unitary Taxation Working Group which recommended in its 1984 report that states adopt water’s edge unitary combination for U.S. and foreign-based companies. Issued no recommendation on treatment of foreign dividends, domestic “80/20” corporations, or

the definition of “tax haven.” Stated that federal legislation would be introduced if states failed to give effect to Report’s

water’s edge recommendation.

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Combined Reporting

States adopting combined reporting differ on whether reporting is on a worldwide or water’s edge basis. Some states have adopted worldwide combined

reporting; currently all allow water’s edge elections. - Exception: oil companies in Alaska

Other states have adopted water’s edge combined reporting, but allow worldwide elections. Elections are usually binding for a set number of years.

Worldwide vs. Water’s Edge

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Combined Reporting

Worldwide combined reporting requires a taxpayer to include a foreign affiliate in its state group return if the foreign affiliate is part of the taxpayer’s unitary group.

Held constitutional in Container and Barclays Bank, but no state generally requires worldwide combined reporting without providing water’s edge election.

Worldwide combined reporting eliminates the tax advantages of an inversion by including the income and factors of the foreign affiliate in the state return, even if the foreign affiliate is excluded from the U.S. tax base.

Worldwide Combined Reporting

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Combined Reporting

Required in many states—e.g., Illinois, Wisconsin, Michigan, Minnesota. May be elected in several states that have adopted worldwide combination

as the default reporting method—e.g., California, Idaho, Utah, Massachusetts.

- Montana has proposed the elimination of the water’s edge election Generally excludes foreign affiliates with 20% or less activity in U.S.

- May be measured by sales or combination of factors. May include certain Subpart F income of non-U.S. members. Some states include non-U.S. members that earn more than 20% of income

from intangible property or services-related activities that are deductible by other members, to the extent of income and apportionment factors.

Other states exclude foreign and U.S. companies if 80% or more of the business activity is outside of the U.S.

Some states include the income of members of the group that are doing business in a tax haven.

Water’s Edge Combined Reporting

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Combined Reporting

1984 Treasury Working Group defined as U.S. corporations having at least 80% of their property and payroll outside of the U.S.

Definitions currently vary: - Illinois: measured by payroll, property (not sales) But Zebra Technologies Corp. v. Topinka, 344 Ill. App. 3d 474 (Ill. App.

Ct. 2003) (held that Bermuda IP subsidiaries did not qualify as 80/20 companies since activities were conducted on their behalf in the U.S.).

- Massachusetts: measured by payroll, property and sales; also includes “any member that earns more than 20 per cent of its income directly or indirectly, from intangible property or service-related activities . . . but only to the extent of that income and the apportionment factors related thereto.” Mass. G.L. ch. 63, § 32B(c)(3).

“80-20 Companies”

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Combined Reporting

Agilent Technologies, Inc. v. Dep’t of Revenue of the State of Colorado, 2014 CV 393 (Colo. Dist. Ct. Jan. 20, 2016) - Department sought to include in Agilent Technologies’ combined return a foreign

holding company (FHC) that had no U.S. property or payroll of its own, and had four subsidiaries that “checked-the- box” (were treated as disregarded entities) for federal income tax purposes; taken together the FHC and its subsidiaries also had less than 20% U.S. property and payroll.

- Department argued that it was not bound to follow the “check-the-box” rules, that the FHC was an “includible C corporation” despite its regulation providing to the contrary, that the FHC lacked economic substance and could be combined under Colorado’s IRC § 482 provision.

- District Court held that FHC could not be included in Agilent’s unitary return, but also held that the federal “check-the-box” rules did not have to be followed because taxpayers could make “creative” elections. Court also held that the Department could not ignore its regulation, that the Department could not use Colorado’s IRC § 482 provision to circumvent the combined return rules, and that the FHC had economic substance and there was no evidence that it was formed to avoid Colorado tax.

“80-20” Companies

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Combined Reporting

Many states require the add-back of related party interest or intangible expense deductions. - Generally, foreign treaty exceptions are provided, but the language

of the exceptions varies. Lower tax rate vs. exempts all the income from tax.

Related Party Add-Back Statutes

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Combined Reporting

Some states include in a water’s edge group the income and apportionment factors of foreign entities if they are organized in “tax havens.” “Tax haven” legislation generally either:

- Lists jurisdictions by name (“blacklist”); or - Provides multipronged indicia to be used to determine whether a

jurisdiction is a “tax haven.”

Tax Havens

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Combined Reporting

States that have enacted tax haven laws: - Alaska, Connecticut, District of Columbia, Montana, Oregon, Rhode

Island and West Virginia

States that have considered, but have not yet adopted tax haven laws: - Alabama, Colorado, Florida, Illinois, Kentucky, Louisiana, Maine,

Massachusetts, New Hampshire, New Jersey, Pennsylvania and Vermont

Tax Havens

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Combined Reporting

Example of “blacklist” - Oregon (39 jurisdictions): Andorra, Anguilla, Antigua and Barbuda, Aruba, the Bahamas,

Bahrain, Barbados, Belize, Bermuda, the British Virgin Islands, the Cayman Islands, the Cook Islands, Cyprus, Dominica, Gibraltar, Grenada, Guernsey-Sark-Alderney, the Isle of Man, Jersey, Liberia, Liechtenstein, Luxembourg, Malta, the Marshall Islands, Mauritius, Monaco, Montserrat, Nauru, the Netherlands Antilles, Niue, Samoa, San Marino, Seychelles, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, the Turks and Caicos Islands, the U.S. Virgin Islands and Vanuatu

Montana has a list of 43 jurisdictions, which must be updated by the Department every two years

Tax Havens

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Combined Reporting

Multipronged test: - Based on MTC’s definition of “tax haven” contained in the Proposed Model Statute

for Combined Reporting: Means a jurisdiction that has no or nominal tax rate on relevant income and:

- Has laws or practices that prevent effective exchange of information with other governments;

- Lacks transparency; - Permits the establishment of foreign-owned entities without requiring a local substantive

presence or prohibiting these entities from having commercial impact on the local economy;

- Explicitly or implicitly excludes the jurisdiction’s resident taxpayers from taking advantage of the tax regime’s benefits; or

- Has created a tax regime that is favorable for tax avoidance. - Connecticut, D.C., Rhode Island and West Virginia define a “tax haven” using five-

factor tests. Connecticut, D.C. and West Virginia originally had “blacklists.”

Tax Havens

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Combined Reporting

Many foreign countries labeled “tax havens” by state legislatures have opposed the legislation. - For example, Singapore, Great Britain, Switzerland and

Luxembourg sent letters in opposition to Montana and California Letter from Embassy of Switzerland to then-Governor

Schwarzenegger and Members of the California State Legislature, April 9, 2010 (in opposition to AB 1178) - “In general, I do not believe that blacklisting particular jurisdictions and

penalizing companies affiliated with them is an effective means of ensuring tax compliance.”

Tax Havens

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Federal Conformity

State tax base – conformity to federal taxable income - States generally are not limited by U.S. treaties. Reuters Limited v. Tax Appeals Tribunal, 82 N.Y.2d 112 (1993)

- Many states conform “mechanically” to the IRC. - Several states have specific provisions for conformity to federal

taxable income and treatment of foreign source income. E.g., New Jersey: “entire net income shall be deemed prima facie to be equal in

amount to the taxable income . . . which the taxpayer is required to report . . . for the purpose of computing its federal income tax.” N.J.S.A. § 54:10A-4.

- Some states base tax on federal income as if the excluded non-U.S. income was subject to federal tax.

- Some states require taxpayers to “add back” federal deductions for payments of royalties, interests and other costs and expenses to foreign affiliates.

What’s the Base?

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Federal Conformity

Examples of Non-Conformity - Pennsylvania requires a corporation that is not subject to federal tax due to a treaty to

report income that would have been reported if the income had not been exempted. - New York requires all corporate taxpayers to include all income from sources outside of

the U.S. that was not included in computing federal taxable income. See Reuters Ltd. v. Tax App. Trib., 82 N.Y.2d 112 (1993); Matter of Infosys Technologies Ltd., DTA No. 820669 (N.Y. Tax App. Trib. Feb. 21, 2008).

- New Jersey’s regulation requiring the inclusion of all income from sources outside of the U.S. that was not included in computing federal taxable income was declared invalid. IBM v. Dir., Div. of Taxation, 26 NJ Tax 102 (2011).

- California will only exclude income exempted by treaty under federal law if the treaty specifically applies to state income taxes (generally, U.S. tax treaties do not). FTB Pub. 1001, Supplemental Guidelines to California Adjustments (Cal. Franchise Tax Bd. 2013).

- Oregon will not exempt a foreign corporation exempt from federal income tax via U.S. treaty unless the treaty contains a provision exempting the foreign corporation from state taxes “upon or measured by net income.” Or. Admin. R. 150-317.010(10)-(B).

States have discretionary authority to adjust items of income.

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Federal Conformity

Schlumberger Tech. Corp. & Subsidiaries v. Alaska Dept. of Revenue, 331 P.3d 334 (Alaska 2014) - Alaska adopts by reference “Sections 26 U.S.C. 1-1399 and 6001 – 7872 (Internal

Revenue Code) … unless excepted to or modified by other provisions of this chapter.”

- Schlumberger is a domestic corporation doing business in Alaska and filed a water’s-edge combined return. Combined return included a foreign holding corporation that managed and received

substantial dividends from the group’s foreign subsidiaries. - Under federal law, dividends received by FHC from foreign subs not ECI and not

subject to federal tax. - Alaska’s water’s-edge reporting methodology had the effect of including 20% of

foreign dividends paid to FHC in a combined report, subjecting it to apportionment. - Court held that Alaska’s apportionment methodology was “simply inconsistent” with

federal sourcing rules and thereby modified the otherwise adopted federal treatment to tax the dividends.

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Federal Conformity

Effective January 1, 2015, an alien corporation that is not treated as a domestic corporation under IRC § 7701, can be taxed only on ECI within the U.S. as determined under IRC § 882.

New York Conformity

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Federal Conformity

If included in the federal tax base, it will generally be included in the state tax base unless specifically excluded. Examples of states with exclusions for foreign source

income: - Virginia: Excludes foreign source income. Va. Code Ann. § 58.1-

402(C)(8). However, expense attribution may be required. - Colorado: Excludes foreign source income based on a ratio based

on foreign taxes paid or deemed paid. Colo. Rev. Stat. § 39-22-303(10).

Foreign Source Income

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Federal Conformity

Dividends from domestic subsidiaries: - 100% dividends received deduction (DRD) allowed for 80% or

more owned U.S. subsidiaries. IRC § 243. - 80% deduction for 20%-80% owned domestic subsidiaries. - 70% deduction for other domestic subsidiaries.

Dividends from foreign subsidiaries: No DRD allowed, except: - DRD allowed for U.S. source portion of dividends received from a

foreign corporation that is at least 10% owned. IRC § 245(a). - 100% DRD for dividends received from foreign corporations whose

income is 100% ECI. IRC § 245(b). - No DRD if any member claims the foreign tax credit. IRC

§ 245(a)(8).

Dividends – Federal Treatment

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Federal Conformity

Kraft Gen. Foods, Inc. v. Iowa Dep’t of Revenue & Finance, 505 U.S. 71 (1992), held that the state could not provide a larger DRD for domestic dividends than foreign dividends. - In light of this decision, most states allow a subtraction modification

for foreign dividends that matches the DRD for dividends from domestic companies.

- Many allow a 100% subtraction for foreign dividends. - Some states that do not follow the federal DRD rules also do not

permit a subtraction of foreign dividends. See, e.g., Gen. Electric Co. v. Comm’r, N.H. Dep’t of Revenue Admin., 154 N.H. 457 (2006); In the Matter of the Appeal of Morton Thiokol, Inc., 254 Kan. 23 (1993).

Dividends – State Treatment

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Federal Conformity

What is it? - Includes foreign personal holding company income (e.g., interest,

dividends, rents and royalties), foreign base company sales income, and foreign base company service income.

Federal treatment - Subpart F income from a controlled foreign corporation (CFC) is

treated as a “deemed dividend” to the U.S. shareholder and is included in the U.S. shareholder’s taxable income. IRC § 951(a).

Subpart F Income

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Federal Conformity

State treatment - Separate filing states States that start with federal taxable income would include

Subpart F income in the state tax base, but may allow a DRD for the deemed Subpart F income.

- Combined filing states If the subsidiary generating the Subpart F income is included in

the combined report, no adjustment is required. If the subsidiary generating the Subpart F income is excluded

from the combined group, the state may include the Subpart F income in a water’s edge return.

Subpart F Income

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Transfer Pricing

Many states have enacted statutory provisions similar to IRC 482. See, for example: - Ala. Code § 40-2A-17 - Fla. Stat. § 220.44 - Ga. Code Ann. § 48-7-58 - Tenn. Code Ann. § 67-4-2014 - N.C. Gen. Stat. Ann. § 105-130.6

Some states leave their options open: New Jersey TAM 2012-1 (Feb. 16, 2012) (“in most circumstances, APAs and their content, including pricing methodologies, economic assumptions and analysis and market valuations, will be respected by the Division.”)

States use IRC 482 as a tool to disallow or adjust intercompany transactions, such as interest expense and management fees.

Use of State “IRC 482” Transfer Pricing Provisions to Disallow Expenses

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Transfer Pricing

Arm’s-Length Adjustment Service (ALAS) Advisory Group tasked with devising how, and to what extent, the MTC can incorporate transfer pricing services to member states. Third-party firms may assist with audit selection, State

Department training and economic analysis. - Firms may support their economic analysis at the audit, negotiation

and litigation levels. - ALAS predicts the project will conservatively recoup $25 million

annually.

MTC’s Transfer Pricing Initiative

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Apportionment

Irving Pulp & Paper Ltd. v. Maine State Tax Assessor, 879 A.2d 15 (Me. 2005) - Corporation that owned timberland reserves in Maine and had

Maine sales, but had no other property, payroll or sales in the U.S. was not permitted to include worldwide property, payroll or sales in its apportionment factor denominators.

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States’ Responses to Inversion Activity

Inversion refers to the conversion of a U.S. corporation into a foreign corporation. Purportedly results in “earnings stripping,” whereby

income earned in the U.S. appears to be earned in another country that either exempts such income from tax or taxes income at a lower rate. States have considered the following anti-inversion

strategies: - Worldwide combined reporting - “Tax haven” laws - Legislation denying state tax and financial benefits

Background

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New Jersey - SB 2397 (2014/2015 Session) would prohibit corporations from

qualifying for or maintaining state development subsidy grants if the corporation qualifies as an inverted domestic corporation.

- SB 2398 (2014/2015 Session) would prohibit New Jersey’s pension fund from investing in companies that have been involved in a corporate inversion.

- A3624 (2016-2017 Session) would prohibit some domestic corporations that reorganize overseas from being awarded state contracts. It would also require that the state treasurer be responsible for determining on behalf of the state or any independent state authority whether a corporation seeking a contract or subcontract is an inverted domestic corporation, according to the bill.

Legislative Proposals

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Michigan – HB 5920 (2014) - Would deny award of benefits for “all loan, grant, incentive, or

economic assistance programs” to any business that has undergone a tax inversion within the 10 years prior to the date of application for assistance.

- Defined “tax inversion” as the relocation of a business entity’s corporate headquarters to a lower-tax country, while its material operations are maintained in the U.S.

Legislative Proposals

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Questions?

Amy Nogid Counsel

Sutherland Asbill & Brennan LLP 212-389-5086

[email protected]

mailto:[email protected]

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State and International Tax Overlaps - Eversheds Sutherland · 2020-06-15 · 3 © 2016 SUTHERLAND...

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Transcript of State and International Tax Overlaps - Eversheds Sutherland · 2020-06-15 · 3 © 2016 SUTHERLAND...