State Mandatory Combined Reporting! You're probably
wondering what this obscure state tax concept means and whether it
impacts your company's state corporate taxes. Before jumping
into today's discussion, here are a few questions to consider.
Is your company a subsidiary or affiliate within a
"controlled group" of corporations? Do any of the "controlled
group" corporations do business in multiple states? Are you considering
selling a majority interest in your company to another corporation which does business
or in multiple states or has subsidiaries with multi-state operations? Is the
prospective buyer a vendor, supplier or otherwise integrated with your
corporation? Have you been advised to reorganize your corporate structure and
create new legal entities? Will this reorganization involve transferring
intangible assets, such as technology, trademarks or patents; to a new legal
entity and having related corporations compensate each other for the use of
those assets?
If you answered yes to any of these
questions, understanding state mandatory combined reporting is important as
this filing method, employed by many states, could have a significant impact
on your company's state corporate tax liability.
A few years ago, mandatory combined reporting became a "hot button" issue when it was discovered that many large corporations were significantly reducing their state tax bills by exploiting "creative" restructuring techniques. More on that in a bit!
A few years ago, mandatory combined reporting became a "hot button" issue when it was discovered that many large corporations were significantly reducing their state tax bills by exploiting "creative" restructuring techniques. More on that in a bit!
What the Heck IS State Mandatory
Combined Reporting Anyway?
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Unless you're a tax or legal professional, there's a good
chance you've never even heard of state mandatory combined reporting. Actually,
unless they frequently deal with state tax issues, many CPAs and tax attorneys
don't completely understand it.
In a nutshell, it's a filing method required in
many states, in which multiple related corporations are taxed as a
single corporate taxpayer. (Technically, it's an apportionment
methodology....blah, blah - but let's keep it simple!)
In states that require or
"mandate" combined reporting, the taxable income of a group
of related corporations which meet certain criteria is aggregated and
this total combined group income is subject to the state's corporate income or
equivalent business tax. While this may sound benign, the impact of combined
reporting may seem harsher when you consider that only one corporation in the
related group with "nexus" to the taxing state pulls in all the other
related corporations even if those corporation do not engage in
business in the combined reporting state. In some combined reporting
states, even non-U.S. (foreign) corporations that meet certain thresholds are required to
file as part of the combined group.
What are some of the criteria that could cause a group of
related corporations to have to file on a "combined basis"? Though
every state has its own requirements, in general, corporations that
are related by ownership (e.g., a common parent owns more than 50% of the
voting control or value of its subsidiaries) and are interrelated or
interdependent with each other would meet the criteria for mandatory combined
filing. This connection and interdependence between the related corporations is
referred to as a "unitary" business relationship. For this reason,
mandatory combined reporting is often referred as "unitary" reporting
or the filing a "unitary" return. In general, if a controlled group
of corporations are functionally integrated, have centralized
management, and enjoy economies of scale, the controlled group is deemed
to be "unitary".
An example might include a group of commonly owned
corporations in which the management team is employed by the parent corporation
and the subsidiaries perform various "steps" in a process. (e.g., one
corporation designs and manufacturers a component part which is used in the
product of a related corporation who then sells the finished product to yet
another related corporation who then distributes the final product to end
users.)
Why Have State's Shown an Interest in Enacting State
Combined Reporting Laws in Recent Years?
Here's an interesting note - between 1985 and 2004,
not a single state enacted a mandatory combined reporting law. That's
right, for almost 20 years, combined reporting wasn't a hot state issue! So
what happened? Beginning in the 1990's and into the beginning of this
millennium, large corporate taxpayers got aggressive in their tax planning and
began taking advantage of "loopholes" that allowed them to greatly
reduce their state corporate taxes.
Though several variations of these "tax planning"
strategies evolved, the general idea involved splitting up a single corporation
into multiple corporations. Along with this "reorganization", various
assets were transferred to new corporations and "inter-company agreements"
were created that required the related corporations to pay one another for use
of the assets. Because state corporate rates vary from state to state, the
overall corporate group could ensure, by dictating the flow of income and
expenses between the corporate group members, that the corporations that earned
the highest income filed mostly in states with low rates or no corporate tax,
while the corporations with the lowest income filed elsewhere. Because each of
these corporations were separate legal entities, only the activity of that
specific entity would be taxed in "separate reporting" states - those
that tax only the activity of the specific legal entity doing business in, or
having "nexus" to, their state.
It wasn't long before these "strategies", and the
large corporations abusing them, were exposed. In 2007, The Wall Street Journal
published a scathing report which revealed how Wal-Mart avoided approximately
$350 million in state taxes over four years by transferring all of its real
estate (stores) to a Real Estate Investment Trust (REIT), an entity which often
pays little to no tax. By having the stores pay rent to the REIT, Wal-Mart was
able to create huge deductions which reduced its overall state taxes, while
paying little to no tax on the rent income earned by the REIT. (See
"Wal-Mart Cuts Taxes By Paying Rent to Itself", WSJ, 2/1/07)
A similar strategy involved transferring trademarks or
trade-names to a newly created entity that would in turn charge an
inter-company fee for use of those intangibles. These royalty or intangible
holding companies (IHCs) were often incorporated in low or no corporate tax
states, such as Delaware or Nevada. Like the Wal-Mart REIT strategy, the stores
received huge royalty expense deductions which in turn greatly reduced their
state taxable income, while the royalty or IHC paid little to no tax. Name just
about any mega retail chain - Toys "R" Us, The Gap, Home Depot,
Wal-Mart - and it's was good bet they had (or still have) one of these tax
planning "strategies" in place.
Eventually states realized these arrangements were draining
state revenues and attempted to apply "band-aid" approaches, such as
enacting laws that disallowed these "tax planning" deductions. When
these approaches were less than effective, more and more states began to
realize that enacting mandatory combined reporting was the best approach to
closing this "loophole". With combined reporting, those questionable
tax-planning deductions that reduced state taxes in separate reporting states
were eliminated, as collapsing the combined group members into one reporting
entity meant that the income and expense deductions would now offset each
other.
Sylvia's Summation
Although mandatory combined reporting has proven to be an
effective approach to closing certain state tax abuses, it is not without
criticism. For one, combined reporting laws are extremely complex!! They
require analysis of which entities must be included in the combined group, a
determination of what proportion of the group's total combined income should be
taxed in that state ("apportionment"), how to treat corporations that
become or cease to become combined group members (such as through an
acquisition or divestiture), and how losses and credits generated by individual
group members are shared (See Note A). And although these laws were intended to target
the mega-corporate abusers, any controlled group, regardless of its
size, that meets the requirements to file combined basis must do so in
mandatory states.
So which states have mandatory combined reporting laws? As of the beginning of 2011, they are...(drumroll please!): Alaska, Arizona, California, Colorado, Hawaii, Idaho, Illinois, Kansas, Maine, Massachusetts, Michigan, Minnesota, Missouri, Nebraska, New Hampshire, New York, North Dakota, Ohio, Oregon, Texas, Utah, Vermont, Wisconsin, and the District of Columbia.
State mandatory combined reporting. Complex! And I've only touched on the basics! So if you're concerned about its impact on your business, seek guidance from a CPA, attorney or consultant that specializes in state taxes (such as your author here, wink!).
So which states have mandatory combined reporting laws? As of the beginning of 2011, they are...(drumroll please!): Alaska, Arizona, California, Colorado, Hawaii, Idaho, Illinois, Kansas, Maine, Massachusetts, Michigan, Minnesota, Missouri, Nebraska, New Hampshire, New York, North Dakota, Ohio, Oregon, Texas, Utah, Vermont, Wisconsin, and the District of Columbia.
State mandatory combined reporting. Complex! And I've only touched on the basics! So if you're concerned about its impact on your business, seek guidance from a CPA, attorney or consultant that specializes in state taxes (such as your author here, wink!).
(Note A: Want to a little more sense of just how complex mandatory combined reporting can be? See my prior "Buzz" post, "Massachusetts Department of Revenue Offers an Opportunity to Withdraw 'Binding' 2009 Worldwide or Affiliated Group Election".)
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The above post was authored by me, Sylvia Dion, for AllBusiness.com, and was published on AllBusiness.com on 9/29/11. It has been reproduced here at The State and Local Tax "Buzz" for the benefit of the "Buzz" readers. See my "Contributions to Other Blogs" webpage for a full listing of all of my AllBusiness.com contributions.
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