State and Local Tax Topics

1. State and Local Tax Topics • Sales and use taxes • Income taxes • Internet taxation • Other state and local taxes (property taxes, franchise taxes, employment taxes) • State tax incentive programs

2. Sales Tax • Assessed on purchases of tangible personal property (and services in some jurisdictions) • Owed by purchaser, collected by seller and remitted to government • Jurisdiction to assess sales tax exists only if seller has nexus within the taxing jurisdiction • Traditionally requires a physical presence by the seller • Sales via mail or independent shipper do not create nexus

3. Use Tax • Complementary to sales tax systems • Assessed on purchaser of goods brought into a state without paying sales tax • Would apply to Internet and mail-order purchases • Self-compliance system • Out-of-state venders cannot be required to collect use tax from purchasers, so many transactions escape taxation

4. State Income Taxation • Issues for multi-state business operations • State-level definition of taxable income • States in which business has nexus • Apportionment of total taxable income to each state • 46 states and the district of Columbia currently impose the equivalent of an income tax on corporate business operations

5. State-Level Taxation of Multi-State Businesses • Each state has jurisdiction to tax • corporations incorporated within the state • corporations incorporated outside the state with sufficient activity in the state to establish nexus • definition of nexus varies by state and may differ from sales tax nexus • generally requires a physical presence • a manufacturing or sales facility • company personnel working within the state

6. State-Level Taxation continued • Some income tax nexus issues • PL 86-272: solicitation of orders for tangible personal property shipped from outside the state does not create nexus for income taxation • Does not apply to income from services • Economic nexus • Some states have taken the position that use of intangible assets (such as licenses or trademarks) within a state creates nexus

7. State-Level Taxable Income • Common approach • Federal taxable income before special deductions+ federal deduction for state income tax+ tax exempt interest income- federal bond interest income+/- differences for differing depreciation methods at state level versus federal level+/- other state-specific modifications= state-level taxable income

8. Example 1: State-Level Taxable Income • Santa Fe Corporation’s federal TI is $2.1 million before its deduction for state income taxes. Its books and records also reveal: • Tax-exempt muni bond income $ 15,000 • Interest income on federal bonds 25,000 • MACRS depreciation (federal) 400,000 • Straight-line depreciation (state) 320,000 • Calculate state-level taxable income • If all of Santa Fe’s operations are in one state with a 7% income tax rate, calculate federal taxable income and federal tax liability

9. Defining State Taxable Income • Direct accounting (tracing of sources income and deductions) • Apportionment of business income • Uniform Division of Income for Tax Purposes Act (UDIPTA) • 3-factor apportionment formula • sales factor = sales in state A/Total sales • payroll factor = payroll in state A/Total payroll • property factor = property in state A/Total property

10. Apportionment Formula • Portion of total taxable income taxed in state A =ws* sales factor + wpay* payroll factor + wprop* property factor • where ws, wpay, and wprop are the weights assigned to each factor, and ws+ wpay+ wprop = 1 • Traditionally, ws = wpay = wprop = 1/3 • Recent changes in state tax legislation have lead 28 states to double-weight the sales factor, so that ws= 1/2, wpay= wprop = 1/4 • 3 states use ws= 1, wpay= wprop = 0

11. Example 2: Apportionment Weighting Alternatives • Triad Inc. operates in 3 states. State-level taxable income before apportionment is $3 million and its apportionment factors are: State A State B State C Sales 33% 40% 27% Payroll 20 65 15 Property 10 80 10 • If all 3 states use equal weighting, determine income taxable in each state • If state A’s income tax rate is 7%, state B’s is 5% and state C’s is 10%, determine state tax liability • How would your answers change if state B uses double-weighting of the sales factor to apportion income?

12. Defining the Factors • Sales factor • gross sales less returns, allowances and discounts • sales of inventory and services (not occasional sales of business property) • Inclusion in numerator based on “point of ultimate destination” • Throw-back rule: sourced in state of origination if not taxed in destination state

13. Example 3: Sales Factor with and without Throwback • Amsalu Corporation sells products in 3 states with the following sales information: State A State B State C Gross sales $400,000 $300,000 $200,000 Returns and (10,000) (5,000) (1,000)discounts • Amsalu ships all products from state A, the location of 100% of its property and payroll. Total state-level taxable income is $300,000. State A assesses 10% income tax; state B assesses 5% income tax but Amsalu’s activities there do not establish nexus. State C assesses no income tax.

14. Example 3 continued • Assuming that state A does not apply throwback • Calculate the state A sales factor • Assuming equal weighting, calculate taxable income apportioned to state A and state A tax liability • How would your answers change if state A requires throwback? • How would your answers change if Amsalu had nexus in state B? • Calculate state B taxable income and tax liability using equally weighted apportionment, assuming Amsalu establishes nexus in state B

15. Defining the Factors continued • Payroll factor • Wages, salary, commissions, other compensation paid to employees • Inclusion in the numerator based on state in which employee primarily performs services • Property factor • Real and tangible personal property owned or used by the business • Historical cost of owned property • 8 times rental value of leased property

16. Example 4: Apportionment Factors - Payroll • Chimera Inc. operates in 2 states, with the following payroll information: State A State B Officer compensation $200,000 $100,000 Other compensation 800,000 700,000 • Calculate payroll factors for both states, assuming both include officer compensation • How would your answers change if state B does not include officer compensation in the payroll factor?

17. Example 5: Apportionment Factors - Property • Wave Inc. previously operated only in state A. This year it expanded into state B. It’s property information is as follows: State A State B Beg. Yr. End Yr. Beg. Yr. End Yr. Land $100,000 $100,000 $0 $200,000 Depr. Assets 500,000 600,000 0 400,000 Accum. Depr. (50,000) (60,000) 0 (20,000) Inventory 200,000 250,000 0 200,000 • Wave also leases property in state A for $25,000 annually • Calculate Wave’s property factors in each state. If Wave undertakes no further expansion, would you expect next year’s property factors to be comparable?

18. Unitary Reporting • For affiliated groups of corporations, most states require reporting only by those corporations with nexus in the state • Typically separate returns for each corporation, although some states allow consolidated reports • Unitary reporting (a few states) includes in a combined return the income, sales, payroll and property (in denominator) of all members of group, including those without nexus

19. Example 6: Unitary Reporting • Parenti Inc. operates entirely in state A; its subsidiary, Sub Corp. operates entirely in state B. 2001 state-level taxable income for Parenti was $400,000 and for Sub was $250,000. Other information: Parenti Sub Total Sales $2,000,000 $1,200,000 $3,200,000 Payroll 400,000 300,000 700,000 Property 900,000 400,000 1,300,000

20. Example 6 continued • If state A requires unitary reporting, uses double-weighting of sales, and has a 7% tax rate, calculate state A taxable income and tax liability • If state B requires separate (non-unitary) reporting, uses equal-weighting, and has a 10% tax rate, calculate state B taxable income and tax liability • How would your answers change if both states required unitary reporting? Both separate reporting?

21. Internet Taxation Issues • Nexus issues • Location of warehouses & retail stores establishes physical presence for sales and income taxation • Most bricks-and-mortar retailers have established separate legal entities for their Internet sales divisions • Economic nexus notion for income tax could extend to computer software • Other sales tax issues: is downloadable, digitally transmitted music or software a tangible product? • Internet Tax Freedom Act imposes moratorium on new Internet taxes

22. State Tax Incentive Programs • Vary from jurisdiction to jurisdiction • Some examples of types of incentives offered • Investment tax credits, property tax abatements • Jobs credits, payroll tax credits • State enterprise zones • Low-interest financing via industrial development bonds • Apportionment exclusions • Exemption from sales throwback • Exclusions of certain property additions • Tax increment financing

23. Incentive Program Requirements • Many substantial state incentive packages require advance negotiation directly with the taxing authority or state development agency • Legislative caps restrict overall funds available but do not specify allocation • Certification and documentation requirements are often voluminous, and failure to comply fully can result in loss of negotiated benefits • Specialized tax consultants can be of great assistance in negotiations and meeting compliance requirements