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MULTISTATE CORPORATE TAX COURSE
John C. Healy | Michael S. Schadewald

2014
EDITION

CPE CoursE!

BONUS

Earn CPE Credit and stay on top of key Multistate Corporate Tax issues. Go to
CCHGroup.com/PrintCPE

2014
EDITION

MULTISTATE CORPORATE TAX COURSE
John C. Healy | Michael S. Schadewald

ii

Contributors

Authors ........................................................... John C. Healy, MST, CPA Michael S. Schadewald, PhD, CPA Technical Review ....................................................... Sharon Brooks, CPA Production Coordinator ................................................... Gabriel Santana Production ......................................................................... Lynn J. Brown Layout & Design..................................................................Laila Gaidulis This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

© 2013 CCH Incorporated. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 344 3734 CCHGroup.com

No claim is made to original government works; however, within this Product or Publication, the following are subject to CCH’s copyright: (1) the gathering, compilation, and arrangement of such government materials; (2) the magnetic translation and digital conversion of data, if applicable; (3) the historical, statutory and other notes and references; and (4) the commentary and other materials.

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MuLtIStAte CoRPoRAte tAx CouRSe (2014 edItIon)

Introduction
The state tax laws are always changing. The complex interrelationship of phased-in and delayed new law effective dates, changing state revenue department rules, and an ever-changing mix of taxpayer wins and losses in the courts creates the need for the tax practitioner to constantly stay on top of the new rules and reassess tax strategies at the start of every year. The rules this year are different from the rules last year, and the rules next year promise to be different from those governing this year. This is a fact of life for the modern-day state tax practitioner. CCH’s Multistate Corporate Tax Course (2014 Edition) is a helpful resource that provides explanations of significant laws, regulations, decisions and issues that affect multistate tax practitioners. Readers get guidance, insights and analysis on important provisions and their impact on multistate tax compliance and tax planning. This course is the top quality tax review and analysis that every state tax practitioner needs to keep a step ahead. The topics covered in the course include: Apportionment Formulas Understanding the Property and Payroll Factors Treatment of Nonbusiness Income State Treatment of Net Operating Losses State Tax Implications of Federal Section 338 Elections Income from Foreign Subsidiaries Pre-Audit Strategies and Opportunities Conducting the Sales and Use Tax Audit Post-Audit Strategies Electronic Sales Tax Issues
Study Questions. Throughout the course you will find Study Questions to

help you test your knowledge, and comments that are vital to understanding a particular strategy or idea. Answers to the Study Questions with feedback on both correct and incorrect responses are provided in a special section beginning on page 217.

Quizzer. This course is divided into two Modules. Take your time and re-

view both course Modules. When you feel confident that you thoroughly understand the material, turn to the CPE Quizzer. Complete one, or both, Module Quizzers for continuing professional education credit.

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M u lt i s tat e C o r p o r at e ta x C o u r s e ( 2 0 1 3 e d i t i o n )

Go to CCHGroup.com/PrintCPE to complete your CPE Quizzers online for immediate results and no Express Grading Fee. Further information is provided in the CPE Quizzer instructions on page 239. July 2013

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CCH’S PLEDGE TO QUALITy Thank you for choosing this CCH Continuing Education product. We will continue to produce high quality products that challenge your intellect and give you the best option for your Continuing Education requirements. Should you have a concern about this or any other CCH CPE product, please call our Customer Service Department at 1-800-248-3248. COURSE ObjECTIvES This course was prepared to provide the participant with an overview of multistate tax issues. Upon course completion, you will be able to: Understand the types of tax incentives used by states Articulate the arguments for and against state tax incentives Identify which assets are included in and excluded from the property factor Explain how assets are valued for purposes of the property factor Differentiate between the transactional and functional tests for determining whether an item is business income Describe the treatment of expenses attributable to nonbusiness income Describe the reasons for differences between state and federal NOL deductions Explain the impact of mergers and acquisitions on federal and state NOL deductions Explain the federal income tax consequences of making a Section 338 election Differentiate between the federal Section 338(g) and Section 338(h) (10) elections Explain how states tax Subpart F inclusions, Section 78 gross-up income, and dividends received from a foreign subsidiary Describe the state tax treatment of foreign income taxes Identify the issues involved in scheduling an audit Explain when and how to negotiate with an auditor Create and maintain an effective relationship with the auditor Determine what should and should not be provided to the auditor List the different types of penalties that may be assessed Explain common reasons for the imposition of penalties Describe the problems that may be encountered in determining sales and use tax liability when using prepaid phone cards and procurement cards Explain the sales and use tax issues involved with electronic data transmission and telecommunications services

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M u lt i s tat e C o r p o r at e ta x C o u r s e ( 2 0 1 3 e d i t i o n )

one complimentary copy of this course is provided with certain copies of CCH publications. Additional copies of this course may be downloaded from CCHGroup.com/PrintCPE or ordered by calling 1-800-248-3248 (ask for product 9-4284-500).

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MuLtIStAte CoRPoRAte tAx CouRSe (2014 edItIon)

Contents
ModuLe 1: CoRPoRAte InCoMe tAxAtIon

1
2 3

Apportionment Formulas

Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Allocation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Apportionment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Specialized Industry Formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Recent Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Understanding the Property and Payroll Factors

Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Formulary Apportionment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Property Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payroll Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Treatment of Nonbusiness Income

21 21 22 30 37 37 40 42 44 51 52 53 57 57 62 67 69

Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Constitutional Restrictions on Apportionable Income . . . . . . . . . . . . . . UDITPA Definition of Business Income . . . . . . . . . . . . . . . . . . . . . . . . State Definitions of Business Income . . . . . . . . . . . . . . . . . . . . . . . . . . . Controversy Regarding Functional Test . . . . . . . . . . . . . . . . . . . . . . . . . Study Nonbusiness Income Allocation Rules . . . . . . . . . . . . . . . . . . . . . Expenses Attributable to Nonbusiness Income . . . . . . . . . . . . . . . . . . . . Recent Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
State Treatment of Net Operating Losses

4 5 6

Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Versus State Net Operating Loss Carryovers . . . . . . . . . . . . . . . . Net Operating Loss Carryovers: Mergers and Acquisitions . . . . . . . . . . . Net Operating Loss Carryovers: Combined Reporting and Consolidated Returns . . . . . . . . . . . . . . . . Net Operating Losses: Recent Developments . . . . . . . . . . . . . . . . . . . . .
State Tax Implications of Federal Section 338 Elections

Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Federal Tax Treatment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 State Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
Income from Foreign Subsidiaries

Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 Federal Tax Treatment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 State Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

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ModuLe 2: SALeS And uSe tAxeS

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Pre-Audit Strategies and Opportunities

Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Initial Audit Contact and the Audit Tone . . . . . . . . . . . . . . . . . . . . . . . . 97 Entities Subject to Audit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Confirmation Letter from Auditor . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 Waiver of Statue of Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 Performing Self-Audits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 Reverse Audits and Refund Reviews . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Record Retention Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129 Responding to Audit and Nexus Questionnaires. . . . . . . . . . . . . . . . . . 130 Contracting Taxpayers Suspected of Engaging in Nexus-Creating Activities . . . . . . . . . . . . . . . . . . . . . . . 134
Conducting the Sales and Use Tax Audit

8

Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Initial Meeting with Auditor on First Day of Engagement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Refund Claims and Self-reported Adjustments . . . . . . . . . . . . . . . . . . . Transactional Reviews. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Plant Tour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transaction Review. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sampling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mechanics of Sampling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advantages and Disadvantages of Sampling . . . . . . . . . . . . . . . . . . . . .
Post-Audit Strategies

139 139 143 148 151 152 156 158 160 169 169 172 176 179 181 187 190 191 195 195 198 201 205 206

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Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Finalizing the Audit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Penalty Imposition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Meeting with the Auditor’s Supervisor . . . . . . . . . . . . . . . . . . . . . . . . . Verifying the Calculation of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . Successful Penalty Appeals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preparing for the Next Audit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate Officer and Responsible Person Statutes. . . . . . . . . . . . . . . . Audit Trends. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Electronic Sales Tax Issues

10

Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid Phone Cards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Procurement Cards. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Electronic Data Transmission and Miscellaneous Telecommunications Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cell Phones . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Computer Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Answers to Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CPE Quizzer Instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Quizzer Questions: Module 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Quizzer Questions: Module 2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Module 1: Answer Sheet. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Module 2: Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Evaluation Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

217 239 241 251 261 265 269

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ModuLe 1: CoRPoRAte InCoMe tAxAtIon — CHAPteR 1

Apportionment Formulas
LEARNING ObjECTIvES upon completion of this chapter, the reader should be able to: discuss how nonbusiness income is allocated among states explain how business income is apportioned among states describe the equitable relief provisions of udItPA Section18 Identify industries that use specialized apportionment formulas Indicate recent developments in state apportionment laws

This chapter focuses on how states allocate and apportion the income of a corporation doing business in more than one state. When a corporation does business in more than one state, such that the corporation is or could be taxed by more than one state, the question arises as to how to determine the portion of the corporation’s income attributable to each state. When, as is often the case, a corporation consists of separate but interdependent departments and divisions that are integrated vertically or horizontally, it is generally not possible to assign the corporation’s income precisely among the several states in which it does business. Because the results obtained by using a separate accounting method for each business unit are often arbitrary, states use allocation and apportionment procedures to determine the portion of a corporation’s income that is attributable to a particular state.
ALLOCATION

Allocation generally refers to the assignment of nonbusiness income to a particular state. Generally, “nonbusiness income” means all income other than business income, and “business income” means income arising from transactions and activity in the regular course of the taxpayer’s trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations.
EXAMPLE
Rental income received by a manufacturing corporation for the use of some vacant land that is located outside the state in which the corporation carries on its manufacturing activities and that is not related to those manufacturing activities is nonbusiness income.

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M u lt i s tat e C o r p o r at e ta x C o u r s e ( 2 0 1 4 e d i t i o n )

When an item of income is determined to be nonbusiness income, the entire amount is specifically allocated to a single state. The basic thrust of the allocation rules is that nonbusiness income derived from real and tangible personal property is allocable to the state in which the property is physically located, whereas nonbusiness income derived from intangible property is allocable to the state of commercial domicile. For example, nonbusiness rents, royalties, and gains derived from real property are generally allocable to the state in which the underlying property is located. Likewise, nonbusiness rents and gains derived from tangible personal property are generally allocable to the state in which the underlying property is located, assuming the corporation is taxable in that state. On the other hand, nonbusiness interest, dividends, and capital gains derived from the sale of stocks, bonds, and other intangible assets are generally allocable to the state of commercial domicile. Nonbusiness royalties derived from patents or copyrights are usually allocable to the state in which the intangible asset is used if the royalties are taxable in that state; otherwise, a throwback rule applies whereby the income is allocable to the state of commercial domicile. A corporation’s commercial domicile is the principal place from which the trade or business of the taxpayer is directed or managed.
APPORTIONMENT

A corporation that is taxable in more than one state has the constitutional right to have its income fairly apportioned among the taxing states. [Complete Auto Transit v. Brady, 430 U.S. 274 (1977)] A taxpayer apportions its income by computing the percentage of its business income that is taxable in each nexus state using the formulas provided by those states. To determine a state’s apportionment percentage, a ratio is established for each of the factors included in the state’s formula. Each ratio is calculated by comparing the level of a specific business activity within a state to the total corporate activity of that type. The ratios are then appropriately weighted and summed to determine the corporation’s apportionment percentage for each state. Apportionment does not necessarily provide a uniform division of a corporation’s income among the nexus states (i.e., a corporation’s apportionment percentages may not sum to 100 percent) because each state is free to choose the type and number of factors it will use as indicative of the amount of business activity conducted within its borders. Moreover, each state makes its own rules for computing the factors included in its apportionment formula. The lack of uniformity can result in either double taxation or “nowhere income.”

Module 1 — Chapter 1 — apportionment Formulas

3

In 1957, state tax officials promulgated the Uniform Division of Income for Tax Purposes Act (UDITPA), which is a model law for apportioning the income of a corporation that is taxable in two or more states. UDITPA provides for the use of an equally-weighted three-factor formula that includes a sales factor, property factor, and payroll factor. In Moorman Manufacturing Co. v. Bair [437 U.S. 267 (1978)], the Supreme Court ruled that a three-factor formula is not constitutionally required, and that Iowa could use a sales-only apportionment formula. Consistent with its prior rulings, the Court stated that a state’s choice of apportionment formulas generally will be upheld unless a taxpayer can prove by clear and cogent evidence that the formula attributes income to the state that is out of all appropriate proportion to the business transacted by the taxpayer in that state. At present, about 10 states use a three-factor apportionment formula that equally weights sales, property, and payroll. Most states use either a formula that assigns more weight to the sales factor than to the property or payroll factor, or a formula that includes only a sales factor. The political appeal of an apportionment formula that weights the sales factor more heavily than the property and payroll factors is that it tends to reduce the tax liabilities of corporations that are based in the state, while potentially increasing the tax liabilities of out-of-state corporations. Specifically, placing more weight on the sales factor tends to apportion a larger percentage of an out-of-state corporation’s income to the state because the corporation’s major activity within the state—sales of its product—is weighted more heavily than its payroll and property activities. For corporations that are based in the state, however, placing more weight on the sales factor provides tax relief because those corporations generally own significantly more property and incur more payroll costs (factors that are given relatively less weight in the apportionment formula) within the state than do out-of-state corporations. If a state uses a three-factor apportionment formula and one of the factors is not present (e.g., a corporation has no payroll), generally the computation of the apportionment percentage is adjusted accordingly.
EXAMPLE
If a state uses an equally weighted three-factor formula and the taxpayer has no payroll, the apportionment percentage is determined by dividing the sum of the property and sales factors by two [e.g., Rentco Trailer Corp. v. Director of Revenue, Missouri Administrative Hearing Commission (no. 97-001373 RI, July 31, 1998)].

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M u lt i s tat e C o r p o r at e ta x C o u r s e ( 2 0 1 4 e d i t i o n )

STUDy QUESTIONS
1. A corporation is taxable in States A, B, and C. It is commercially domiciled in State A. the corporation sells a parcel of land located in State B. the sale is not in the regular course of the taxpayer’s trade or business, and the land is not an integral part of the taxpayer’s regular business operations. Where should the income arising from the sale be allocated and apportioned? a. b. c. d. 2. State A only State B only State C only States A, B and C

Which of the following is true of apportionment? a. Apportionment assures a uniform division of a corporation’s income among the states in which it has nexus. b. Apportionment refers to the specific assignment of nonbusiness income to a single state. c. A taxpayer apportions its income by using formulas to determine the percentage of its business income that is taxable in each state in which the taxpayer has nexus. d. Apportionment assures the taxation of exactly 100 percent of a corporation’s income.

Right to Apportion

Not all corporations are entitled to apportion their income. The requirements for establishing the right to apportion income vary from state to state, but generally entail carrying on business in another state, maintaining a regular place of business in another state, or being taxable in another state. Some states take the restrictive position that permits apportionment only if the corporation is actually filing returns and paying tax in another state. UDITPA provides that any taxpayer having income from business activity that is taxable both within and without the state may allocate and apportion its income. [UDITPA Section 2] For this purpose, a corporation is “taxable in another state if: (1) in that state the corporation is subject to a net income tax, a franchise tax measured by net income, a franchise tax for the privilege of doing business, or a corporate stock tax, or (2) that state has jurisdiction to subject the corporation to a net income tax regardless of whether, in fact, the state does or does not.” [UDITPA Section 3]
Kentucky. In Publishers Printing Company and Subsidiaries v. Finance and Administration Cabinet [No. K08-R-10 (Ky. Bd. of Tax App., Jan. 20, 2010)], six affiliated companies filed a unitary return in Kentucky. Only

Module 1 — Chapter 1 — apportionment Formulas

5

one of the affiliates conducted business outside Kentucky, doing business in Colorado where the group also filed a unitary return. The Kentucky Board of Tax Appeals ruled that apportionment did not fairly represent the extent of the taxpayer’s business activity in Kentucky, and that because all of the taxpayer’s property and payroll was in Kentucky, all its net income was taxable by Kentucky. 2741-01T3 (N.J. Super. Ct., Mar. 14, 2003)], the New Jersey Superior Court ruled that the income of a New Jersey corporation was 100 percent taxable in New Jersey, because the taxpayer’s use of telemarketers in New York did not satisfy New Jersey’s statutory requirement that, in order to apportion its income, a taxpayer must “maintain a regular place of business” outside New Jersey. [N.J.S.A. §54:10A-6] In New Jersey Natural Gas Co. v. Division of Taxation [Nos. 0002402005 and 007284-2005 (N.J. Tax Ct., Apr. 17, 2008)], the New Jersey Tax Court ruled that the taxpayer must allocate all of its income to New Jersey, because an employee’s home office in Connecticut did not constitute a regular place of business outside New Jersey. In order for an out-of-state location to be considered the taxpayer’s regular place of business, the taxpayer must either own or rent the facility in its own name and must be directly responsible for the expenses incurred in maintaining the place of business. In this case, the taxpayer did not own or rent the employee’s home and the employee was contractually responsible for all expenses related to the home office. In December 2008, New Jersey enacted legislation to eliminate the requirement that a corporation have a “regular place of business” in another state in order to apportion its income, effective for privilege periods beginning on or after July 1, 2010. [A.B. 2722, Dec. 19, 2008]
Missouri. In Jay Wolfe Imports Missouri, Inc. v. Director of Revenue [No. SC89568 (Mo. Sup. Ct., May 5, 2009)], the Missouri Supreme Court ruled that a Missouri car dealership located two blocks from the Missouri-Kansas state line was not entitled to apportion its income, because it derived income from sources entirely in Missouri. The fact that some out-of-state customers purchased cars and then drove them back to their out-of-state addresses did not mean that the sales themselves were conducted partly within and partly outside the state. Missouri law provides that sales partly within and partly without the state occur only if the seller’s shipping point and the purchaser’s destination point are in different states. In this case, the dealership did not ship cars purchased at its Missouri facility to out-of-state customers. Instead, the out-of-state customers completed their sales transactions and took possession of their purchased car in Missouri and then drove them to their out-of-state addresses. New jersey. In River Systems, Inc. v. Division of Taxation [No. A-

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M u lt i s tat e C o r p o r at e ta x C o u r s e ( 2 0 1 4 e d i t i o n )

In Moberly Regional Center v. Director of Revenue [No. 07-0283 RI (Mo. Admin. Hearing Comm., Oct. 6, 2008)], the Missouri Administrative Hearing Commission ruled that a hospital located in and transacting business in Missouri that contracted with an affiliated out-of-state company to perform management functions was not entitled to apportion its income, because it did not employ any labor or capital outside Missouri. Paying an affiliated out-of-state company to perform management services did not constitute the employment of labor outside the state of Missouri. All of the hospital’s employees and property were located in Missouri, and all of its patients were treated in Missouri. The hospital did not earn any income in any other state and thus had no income to apportion between Missouri and any other state. In TSI Holding Co. v. Director of Revenue [No. SC85179, SC85180, and SC85181 (Mo. Sup. Ct., Nov. 4, 2003)], a case dealing with the Missouri franchise tax, the Missouri Supreme Court ruled that three related Missouri investment holding companies were not entitled to apportion their income because they did business solely in Missouri. The corporations did not do business in any other state, did not have offices in any other state, and did not file franchise tax returns in any other state.
Massachusetts. In Tech-Etch, Inc. v. Commissioner of Revenue [No. 05-

P-1012 (Mass. App. Ct., Nov. 3, 2006)], the Massachusetts Appeals Court ruled that a Massachusetts manufacturer was not entitled to apportion its income in connection with sales of goods shipped to customers located in foreign countries, because the taxpayer failed to establish that it was taxable in another state or foreign country.

Equitable Relief Provisions

The divergent apportionment formulas used by the states, along with different rules for computing the factors in each state’s formula, can result in a corporation’s being subject to tax on more than 100 percent of its income. Another adverse consequence of apportionment may result when the operations in a single state result in a loss, as determined by a separate geographic accounting, but the corporation as a whole generates a profit. The use of an apportionment formula results in the corporation incurring an income tax liability in the state in which the loss operation is located, even though no profit is generated in that state. To provide relief in such situations, UDITPA Section 18 provides that if the standard allocation and apportionment provisions do not fairly represent the extent of the taxpayer’s business activity in a state, the taxpayer may petition for, or the tax administrator may require, with respect to all or any part of the taxpayer’s business activity, if reasonable, use of separate accounting, exclusion of any one or more of the factors, inclusion of one or

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more additional factors, or employment of any other method that will result in “an equitable allocation and apportionment of the taxpayer’s income.” For example, California’s equivalent of UDITPA Section 18, California Revenue and Taxation Code Section 25137 (Equitable Adjustment of Standard Allocation or Apportionment), states: If the allocation and apportionment provisions of this act do not fairly represent the extent of the taxpayer’s business activity in this state, the taxpayer may petition for or the Franchise Tax Board may require, in respect to all or any part of the taxpayer’s business activity, if reasonable: (a) Separate accounting; (b) The exclusion of any one or more of the factors; (c) The inclusion of one or more additional factors which will fairly represent the taxpayer’s business activity in this state; or (d) The employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer’s income. California Code of Regulations Title 18, Section 25137, states that “Section 25137 may be invoked only in specific cases where unusual fact situations (which ordinarily will be unique and nonrecurring) produce incongruous results under the apportionment and allocation provisions contained in these regulations.” There is a presumption developed by judicial precedent that a state’s apportionment provisions are equitable. Consequently, to receive relief from the state’s standard formula, the corporation generally must prove by clear and convincing evidence that the apportionment formula grossly distorts the amount of income actually earned in the state. Taxpayers generally find it difficult to prove that a state’s standard apportionment provisions are inequitable. [E.g., Hans Rees’ Sons, Inc. v. North Carolina, 283 U.S. 123 (1931); Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159 (1983); and Colgate-Palmolive Company, Inc. v. Bower (No. 01 L 50195, Ill. Cir. Ct., Cook Cty., Oct. 15, 2002).] In Home Interiors & Gifts, Inc. v. Strayhorn [No. 03-04-00660-CV (Tex. Ct. of App., Sept. 22, 2005)], the Texas Court of Appeals ruled that the interplay between Public Law 86-272 and the Texas throwback provision caused the franchise tax to be internally inconsistent; therefore, it failed Complete Auto’s fair apportionment requirement. In Media General Communications, Inc. v. Department of Revenue [No. 26828 (S.C. Sup. Ct., June 14, 2010)], the South Carolina Supreme Court ruled that a group of communication companies could determine their taxable income on a combined basis under an equitable relief provision similar to UDITPA Section 18.

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In CarMax Auto Superstores West Coast, Inc. v. South Carolina Department of Revenue [No. 4953 (S.C. Ct. of App., Mar. 14, 2012)], the South Carolina Court of Appeals ruled that the party seeking to override the statutory apportionment method, whether it be the taxpayer or the state department of revenue, bears the burden of proving that the standard method does not accurately reflect the taxpayer’s business activity in South Carolina, and that the proposed alternative accounting method more accurately reflects the taxpayer’s business activity in the state.
STUDy QUESTION
3. Which of the following statements is true? a. Apportionment can result in a corporation incurring an income tax liability in a state where there is a loss, as determined by a separate geographic accounting. b. All corporations are entitled to apportion their income. c. udItPA §18 allows the use of an alternative formula only if it is requested by the taxpayer.

SPECIALIzED INDUSTRy FORMULAS
Overview

The UDITPA equally weighted three-factor property, payroll, and sales apportionment formula was designed to apportion the income of multistate manufacturing and mercantile businesses, and may not fairly apportion the income of businesses in other industries.
EXAMPLE
the conventional udItPA property factor is difficult to compute for property that regularly moves back-and-forth across state lines, such as the transportation equipment used by interstate trucking companies, airlines and railroads.

Likewise, the UDITPA Section 17 cost of performance rule for sourcing sales of services has been controversial. Many commentators have argued that its effect is often to merely mimic the property and payroll factor, rather than measure the customer base within a state. The drafters of UDITPA foresaw the limitations of the standard UDITPA apportionment formula, and, under Section 2, specifically excluded from UDITPA certain service businesses, including financial organizations (bank, trust company, savings bank, private banker, savings and loan association, credit union, investment company, or insurance company), and public utilities

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(defined as any business entity which owns or operates for public use any plant, equipment, property, franchise, or license for the transmission of communications, transportation of goods or persons, or the production, storage, transmission, sale, delivery, or furnishing of electricity, water, steam, oil, oil products or gas). To address these issues, many states provide special rules for computing apportionment percentages for businesses in certain industries. Typically, these special rules involve the modification or exclusion of the conventional factors, or the use of unique, industry-specific factors. In some instances, a primary motive for adopting specialized industry apportionment rules is to provide an economic incentive for certain businesses to maintain or locate operations within the state. Examples of industries for which states provide special apportionment rules include airlines, railroads, trucking companies, financial institutions, television and radio broadcasters, publishers, telecommunication services companies, mutual funds, pipeline companies, ship transportation companies, construction contractors, and professional sports franchises. In many cases, the equitable relief provisions of UDITPA Section 18, which numerous states have incorporated into their statutes, serves as the basis for state revenue departments to adopt specialized formulas. UDITPA Section 18 provides that if the standard apportionment formula does not fairly reflect a taxpayer’s in-state business activity, tax authorities may require the exclusion of one or more of the factors, or the inclusion of additional factors which will fairly represent the taxpayer’s business activity in the state. Under Section 18, the Multistate Tax Commission (MTC) has promulgated special apportionment regulations covering construction contractors (MTC Reg. IV.18(d)), airlines (MTC Reg. IV.18(e)), railroads (MTC Reg. IV.18(f )), trucking companies (MTC Reg. IV.18(g)), television and radio broadcasters (MTC Reg. IV.18(h)), and publishers (MTC Reg. IV.18(j)). The MTC has also promulgated a model statute for apportioning the income of financial institutions (Nov. 17, 1994). In July 2008, the MTC approved a proposed model regulation for the apportionment of income from telecommunications services. As a general rule, only those taxpayers engaged in the type of business activity for which the special apportionment rules were developed are permitted to apply the special rules (e.g., Cooper Tire & Rubber Co. v. Limbach, 70 Ohio St. 3d 347 [1994]; TTX Co. v. Whitley, No. 1-983604 [Ill. App. Ct., Mar. 31, 2000]). In most instances, when a corporation is required to use a specialized apportionment formula, all its income is apportioned using that formula.

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EXAMPLE
In Texaco-Cities Service Pipeline Company v. McGaw [182 Ill. 2d 269 (1998)], the Illinois Supreme Court ruled that the taxpayer’s gain from the sale of its 90 percent interest in a pipeline must be apportioned using a specialized single-factor barrel miles formula for “business income derived from furnishing transportation services,” rather than the standard three-factor apportionment formula. the taxpayer was is in the business of transporting crude oil and other petroleum products by pipeline, and the specialized formula applied to all income earned from that business, including the gain from the pipeline sale. on the other hand, in Buckeye Pipeline Co. v. Commonwealth [689 A.2d 366 (Pa. Commw. Ct. 1997)], an interstate pipeline management company was required to use the standard three-factor apportionment method, rather than the specialized singlefactor revenue barrel mile formula used by pipeline companies, to apportion most of its income because that income was derived from its management activities and not from the transportation of petroleum products.

STUDy QUESTION
4. under udItPA §2, financial organizations and public utilities are exempted from having to use udItPA’s standard three-factor apportionment formula. True or False? a. true b. False

Trucking Companies

Many states provide special apportionment formulas for trucking companies. MTC Regulation IV.18(g), which the MTC adopted in 1986 and amended in 1989, addresses the apportionment of a multistate trucking company’s business income. As discussed below, this regulation modifies the standard equally three-factor property, payroll, and sales formula, primarily by basing the computation of the factor numerators on the ratio of the mobile property miles in the state to the mobile property miles everywhere. Some states have adopted the MTC approach, in whole or in part. Other states have adopted their own special formulas, such as single-factor formulas based on revenue miles, or miles operated or traveled. MTC Regulation IV.18(g) defines a “trucking company” as a motor common carrier, a motor contract carrier, or an express carrier which primarily transports tangible personal property of others by motor vehicle for compensation.
Property Factor. In general, the denominator of the property factor includes

the average value of all owned and rented real and tangible personal property used by the trucking company in its trade or business. The numerator includes all owned and rented property used in the state. MTC Regulation

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IV.18(g) provides a special rule for sourcing mobile property (i.e., motor vehicles and trailers), which is included in the state’s numerator based on the ratio of mobile property miles in the state to total mobile property miles. A mobile property mile is defined as the movement of a unit of mobile property a distance of one mile, whether loaded or unloaded.
Payroll Factor. The denominator of the payroll factor includes all compensa-

tion paid everywhere by a trucking company, and the numerator is the total compensation paid in a particular state. MTC Regulation IV.18(g) provides a special rule for sourcing compensation paid to employees performing services within and without the state. The payroll of such employees is includible in the state’s payroll factor numerator based on the ratio of mobile property miles in the state to total mobile property miles.

Sales Factor. Under MTC Regulation IV.18(g), the denominator of the sales

factor includes all revenue derived from transactions and activities in the regular course of the trucking company’s trade or business, and the numerator is the trucking company’s total revenues in the state. The taxpayer in-state revenues from hauling freight, mail and express include the entire amount of the receipts from intrastate shipments (i.e., the shipment both originates and terminates within the state). In-state revenues also include a pro-rata portion of the receipts from interstate shipments (i.e., shipments passing through, into, or out of the state), determined by the ratio of the mobile property miles traveled by the shipment in the state to the total mobile property miles traveled by the shipment from its point of origin to its destination. The in-state portion of any revenues, other than revenue from hauling freight, mail and express, is determined under the standard UDITPA rules for sourcing sales. In FedEx Ground Package System, Inc. v. Pennsylvania [Nos. 302 F.R. 2003 and 303 F.R. 2003 (Penn. Commw. Ct., Apr. 27, 2007)], the Pennsylvania Commonwealth Court ruled that the numerator of a trucking company’s revenue miles apportionment formula should be computed by multiplying the total number of miles that the company transported packages in Pennsylvania by the company’s average receipts per mile for transporting packages “in Pennsylvania” (rather than the average receipts per mile “everywhere,” which was the Department of Revenue’s standard practice). For this purpose, revenue mile means the average receipts derived from the transportation by the taxpayer of persons or property for one mile. During the tax year in question, FedEx’s average receipts per mile everywhere were $3.93 per mile, and its average receipts per mile in Pennsylvania were $2.94. The court determined that its interpretation follows the plain language of the statute and is consistent with the principle that an apportionment factor numerator should only reflect activity in Pennsylvania. The Pennsylvania Supreme Court affirmed the lower court’s decision [Nos. 55-56 MAP 2007 (Pa. Sup. Ct., Dec. 27, 2007)]

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Airlines

Many states provide special apportionment formulas for airlines. MTC Regulation IV.18(e), which the MTC adopted in 1983, addresses the apportionment of a multistate airline’s business income. As discussed below, this regulation modifies the standard three-factor property, payroll, and sales formula, primarily by basing the computation of the factor numerators on the ratio of in-state aircraft departures, weighted by the cost and value of aircraft, to the total departures everywhere, similarly weighted. Some states have adopted the MTC approach, in whole or in part. Other states have adopted their own special formulas, such as formulas based on revenue miles or miles flown.
Property Factor. In general, the denominator of the property factor includes

the average value of all owned and rented real and tangible personal property used by the airline in its trade or business, and the numerator includes all owned and rented property used in the state. MTC Regulation IV.18(e) provides a special rule for sourcing aircraft ready for flight. Such aircraft are includible in a particular state’s numerator based on the ratio of in-state departures, weighted by the cost and value of aircraft, to the total departures everywhere, similarly weighted. Aircraft ready for flight are defined as aircraft owned or acquired through rental or lease that are in the possession of the taxpayer and are available for service on the taxpayer’s routes.

pensation paid everywhere by the airline, and the numerator is the total compensation paid in the state. MTC Regulation IV.18(e) provides a special rule for sourcing compensation paid to flight personnel. The payroll of such employees is includible in the state’s payroll factor numerator based on the ratio of in-state departures, weighted by the cost and value of aircraft, to the total departures everywhere, similarly weighted.
Sales Factor. Under MTC Regulation IV.18(e), the denominator of the sales factor includes all revenues that the airline derives from transactions and activities in the regular course of its trade or business, except for passive income and net gains or losses from the sale of aircraft. The numerator is the taxpayer’s total in-state revenue, which includes the sum of: (1) the total transportation revenue multiplied by the ratio of in-state departures, weighted by the cost and value of aircraft, to the total departures everywhere, similarly weighted; plus (2) any nonflight revenues directly attributable to the state. Recent Developments. Effective for tax years beginning on or after January

Payroll Factor. The denominator of the payroll factor includes all com-

1, 2012, an airline’s New Jersey sales factor is based on the ratio of revenue miles in New Jersey to revenue miles everywhere. However, if an airline is engaged in the transportation of passengers, the transportation of freight, or the rental of aircraft, the ratio will be determined by means of an average

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of a passenger revenue mile fraction, a freight revenue mile fraction, and a rental revenue mile fraction weighted to reflect the taxpayer’s relative gross receipts from passenger transportation, freight transportation, and rentals [S.B. 2753, April 28, 2011]. Under prior law, an airline’s New Jersey sales factor was based on departures, weighted by cost or value.
Railroads

Many states provide special apportionment formulas for railroads. MTC Regulation IV.18(f ), which the MTC adopted in 1981, addresses the apportionment of a multistate railroad’s business income. The manner in which the regulation modifies the standard equally-weighted three-factor property, payroll, and sales formula, is summarized below. Some states have adopted the MTC approach, in whole or in part. Other states have adopted their own special formulas, such as single-factor formulas based on revenue miles, or miles traveled.
Property Factor. In general, the denominator of the property factor includes

the average value of all owned and rented real and tangible personal property used by the railroad in its trade or business. Railroad cars owned by other railroads and temporarily used by the taxpayer for a per diem charge are not included in the property factor as rented property, whereas railroad cars owned by the taxpayer and temporarily used by other railroads for a per diem charge are included in the property factor. The numerator of the property factor includes all owned and rented property used in the state. Regulation IV.18(f ) provides a special rule for sourcing mobile property, such as passenger cars, freight cars, locomotives and freight containers, which are located within and without this state during the year. Such property is included in the property factor numerator based on the ratio of locomotivemiles or car-miles in the state to locomotive-miles or car-miles everywhere.

Payroll Factor. The denominator of the payroll factor includes all compensation

paid everywhere by the railroad, and the numerator is the total compensation paid in the state. Regulation IV.18(f) provides a special rule for sourcing compensation paid to enginemen and trainmen performing services on interstate trains. The payroll of such employees is included in the state’s payroll factor numerator based on the compensation required to be reported by such employees for purposes of determining their state personal income tax liabilities.

Sales Factor. Under MTC Regulation IV.18(f ), the denominator of the

sales factor includes all revenues derived by the railroad from transactions and activities in the regular course of its trade or business, except per diem and mileage charges. The numerator is the railroad’s total revenues in the state. The taxpayer in-state revenues from hauling freight, mail and express include the entire amount of the receipts from intrastate shipments (i.e., the

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shipment both originates and terminates within the state). In-state revenues also include a pro-rata portion of the receipts from interstate shipments (i.e., shipments passing through, into, or out of the state), determined by the ratio of the miles traveled by the shipment in the state to the total miles traveled by the shipment from its point of origin to its destination. Likewise, the taxpayer’s in-state revenues from hauling passengers includes the entire amount of the receipts from the intrastate transportation of passengers, and a pro-rata portion of the receipts from the interstate transportation of passengers, determined by the ratio of the revenue passenger miles in the state to the revenue passenger miles everywhere. The in-state portion of any revenues, other than revenue from hauling freight, passengers, mail and express, is determined under the standard UDITPA rules for sourcing sales.
Publishing Companies

Some states provide special apportionment formulas for taxpayers engaged in the publishing, sale, licensing or other distribution of books, newspapers, magazines, periodicals, trade journals or other printed material. MTC Regulation IV.18(j), which the MTC adopted in 1993, modifies the standard equally-weighted three-factor property, payroll, and sales formula, as summarized below.
Property Factor. In general, the denominator of the property factor includes

the average value of all owned and rented real and tangible personal property, including outer-jurisdictional (e.g., orbiting satellites and undersea transmission cables) used by the publisher in its trade or business. The numerator includes owned and rented property used in the state. Outer-jurisdictional property is pro-rated to a state based on the ratio of number of uplink and downlink transmissions in the state to the total number of uplink and downlink transmissions everywhere. If uplink and downlink information is not available, outer-jurisdictional property is pro-rata to the state based on the ratio of the amount of time the property was used to make transmissions in the state to the total amount of time the property was used for transmissions everywhere.

pensation paid everywhere by the taxpayer, and the numerator is the total compensation paid in the state, as determined under the standard UDITPA rules for sourcing payroll.

Payroll Factor. The denominator of the payroll factor includes all com-

factor includes all gross receipts derived by the taxpayer from transactions and activities in the regular course of its trade or business, and the numerator is the taxpayer’s gross receipts in the state. Gross receipts derived from the sale of printed materials are sourced to the state in which the material is delivered or shipped to the purchaser or subscriber. A throwback rule applies if the

Sales Factor. Under MTC Regulation IV.18(j), the denominator of the sales

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purchaser or subscriber is the U.S. government or the taxpayer is not taxable in a state in which the printed materials are shipped or delivered. Gross receipts derived from advertising and the sale or rental of the taxpayer’s customer lists are pro-rated to the state based on the taxpayer’s circulation factor. A separate circulation factor is computed for each publication of printed material, and equals the ratio of the in-state purchasers and subscribers to the purchasers and subscribers everywhere, as determined by reference to rating statistics.
Television and Radio broadcasters

Some states provide special apportionment formulas for television and radio broadcasters. MTC Regulation IV.18(h), which the MTC adopted in 1990 and amended in 1996, addresses the apportionment of a multistate television or radio broadcaster’s business income. The regulation covers taxpayers engaged in broadcasting over the public airwaves, by cable, satellite transmission, or by any other means of communication. The manner in which the regulation modifies the standard equally-weighted three-factor property, payroll, and sales formula, is summarized below.
Property Factor. In general, the denominator of the property factor includes

the average value of all owned and rented real and tangible personal property used by the broadcaster in its trade or business. However, outer-jurisdictional film and radio programming property are excluded from the property factor. Outer-jurisdictional property includes orbiting satellites, undersea transmission cables, and like property that is owned or rented by the taxpayer and used in its broadcasting business, but is not physically located in any particular state. Discs and similar medium containing film or radio programming and intended for sale or rental by the taxpayer for home viewing or listening are included in the property factor. The numerator of the property factor includes owned and rented property used in the state, as determined under the standard UDITPA rules for sourcing property.

Payroll Factor. The denominator of the payroll factor includes all compensa-

tion, including residual and profit participation payments, paid to employees, including that paid to directors, actors, newscasters and other talent in their status as employees. The numerator includes the total compensation paid in the state, as determined under the standard UDITPA rules for sourcing payroll. factor includes all gross receipts that the broadcaster derives from transactions and activities in the regular course of its trade or business, and the numerator is the broadcaster’s gross receipts in the state. Gross receipts, including advertising revenue, from television film or radio programming in release to or by television and radio stations is pro-rated to a state based on an audience factor, which equals the ratio of the broadcaster’s in-state viewing

Sales Factor. Under MTC Regulation IV.18(h), the denominator of the sales

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(listening) audience to its total viewing (listening) audience. A cable television system’s audience factor is the ratio of the system’s in-state subscribers to its total subscribers. Receipts from the sale, rental, or licensing of discs and similar media intended for home viewing or listening are sourced under the standard UDITPA rules for sourcing sales of tangible personal property.
Telecommunications Services

Some states provide special apportionment formulas for telecommunications service companies, and in 2008 the MTC has promulgated a Proposed Model Regulation for Apportionment of Income from the Sale of Telecommunications and Ancillary Services. For this purpose, the term telecommunications service means the electronic transmission of voice, data, audio, video, or any other information or signals, and includes a transmission, conveyance, or routing in which computer processing applications are used to act on the content for purposes of transmission, conveyance or routing without regard to whether such service is referred to as voice over Internet protocol services or is classified by the Federal Communications Commission as enhanced or value-added. Telecommunications services include, but are not limited to, the following: wireline, fixed wireless, mobile wireless, paging, prepaid calling, prepaid wireless calling, private communication, value-added non-voice data, coinoperated telephone and pay telephone services.
Property Factor. In general, the denominator of the property factor includes

the average value of all owned and rented real and tangible personal property used by the telecommunications service company in its trade or business. An exception applies to outer-jurisdictional property, which is excluded from the property factor. Outer-jurisdictional property includes orbiting satellites, undersea transmission cables, and like property that is owned or rented by the taxpayer and used in its telecommunications service business, but is not physically located in any particular state. The numerator of the property factor includes owned and rented property used in the state, as determined under the standard UDITPA rules for sourcing property.

Payroll Factor. The denominator of the payroll factor includes all compensation paid everywhere by the taxpayer, and the numerator is the total compensation paid in the state, as determined under the standard UDITPA rules for sourcing payroll. Sales Factor. The denominator of the sales factor includes all gross receipts that the taxpayer derives from transactions and activities in the regular course of its telecommunications service business, and the numerator includes all gross receipts of the taxpayer from sources within the state. The regulation provides numerous specialized sourcing rules for sales of telecommunications services.

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EXAMPLE
Gross receipts from the sale of mobile telecommunications services, other than airto-ground radiotelephone service and prepaid calling service, are attributed to the state when the customer’s place of primary use is in the state pursuant to the Mobile telecommunications Sourcing Act.

Financial Institutions

Some state impose special corporate franchise taxes on banks and other financial institutions, while other states subject financial institutions to the state’s standard corporate income tax. In addition, many states provide special apportionment formulas for financial institutions. In 1994, the MTC adopted a model statute for apportioning the income of a financial institution, which adopts the standard UDITPA equally-weighted three-factor apportionment formula. The manner in which model statute modifies the computation of the property, payroll, and sales factors is summarized below. Some states have adopted the MTC approach, in whole or in part. Other states have adopted their own special formulas, such as single-factor formulas based on gross receipts.
Property Factor. In general, the denominator of the property factor includes

the average value of all owned and rented real and tangible personal property used by the financial institution in its trade or business. The property factor also includes two intangible assets, loans and credit card receivables, which are valued at their average outstanding principal balance, without regard to any reserve for bad debts, but reduced by any amount written-off for Federal income tax purposes. The numerator of the property factor includes owned and rented real and tangible personal property that is physically located or used in the state. A loan is attributed to the state if it is properly assigned to a regular place of business of the taxpayer within the state. A loan is properly assigned to the place of business with which it has a preponderance of substantive contacts, as determined by such activities as the solicitation, investigation, negotiation, approval and administration of the loan. The location of credit card receivables is determined in the same manner as loans. pensation paid everywhere by the taxpayer, and the numerator is the total compensation paid in the state, as determined under the standard UDITPA rules for sourcing payroll.

Payroll Factor. The denominator of the payroll factor includes all com-

Sales Factor. The denominator of the sales factor includes all gross receipts

that the financial institution derives from transactions and activities in the regular course of its trade or business, and the numerator is the financial institution’s gross receipts in the state. Interest from loans secured by real property is attributed to the state in which the real property is located,

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whereas interest from loans not secured by real property is attributed to the state in which the borrower is located. Interest from credit card receivables and fees charged to card holders is attributed to the state in which the billing address of the card holder is located. Net gains from the sale of loans and loan servicing fees are sourced in the same manner as the loan interest. Likewise, net gains from the sale of credit card receivables are sourced in the same manner as the interest on the credit card receivables. Interest, dividends and net gains from investment and trading assets and activities are attributed to the state if such receipts are properly assigned to a regular place of business of the taxpayer within the state, based on where the day-to-day decisions regarding the assets or activities occur. Finally, under a throwback rule, all receipts which would be assigned to a state in which the taxpayer is not taxable are attributed to the state in which the financial institution has its commercial domicile.
Manufacturers

Some states provide specialized formulas for manufacturing companies. For example, Massachusetts generally requires corporations to apportion income using a three-factor property, payroll and sales formula that double weights the sales factor. However, a “manufacturing corporation” is allowed to use a single-factor sales formula. In Letter Ruling 11-8 [Mass. Dept. of Rev., Dec. 16, 2011], the Massachusetts Commissioner of Revenue addressed the issue of whether a global consumer products company that made extensive use of third-party contract manufacturers qualified as a manufacturing corporation. The taxpayer was engaged in the development, manufacture, and distribution of lubricants and cleaning products. The Commissioner ruled that, despite its extensive use of third-party contract manufacturers, the taxpayer qualified as a manufacturing corporation because it was integrally involved in the creation of its products from start to finish. The taxpayer invented the product formula and manufacturing processes for both blending concentrate and finishing, and also developed the specially-designed spray cans. The formula, processes, testing procedures, designs and manufacturing assets which the taxpayer provided to the contract manufacturers had direct physical application in the manufacturing process. The taxpayer also managed the overall manufacturing process and coordinated the collective manufacturing effort.
Insurance Companies

Many states do not subject insurance companies to the state’s standard corporate income tax. Those states that do impose a corporate income tax on insurance companies generally require insurance companies to apportion their income using a single-factor premiums formula. The MTC has not promulgated a special apportionment formula for insurance companies.

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STUDy QUESTIONS
5. For purposes of apportioning the income of an airline, MtC Reg. IV.18(e) provides that: a. the cost of aircraft ready for flight is includible in the numerator of a state’s property factor, based on the aircraft’s “predominant use.” b. the payroll of flight personnel is includible in the numerator of a state’s payroll factor, based on the ratio of in-state arrivals, to the total arrivals everywhere—both weighted by the cost and value of aircraft. c. the sales factor numerator equals the sum of the taxpayer’s in-state transportation revenues, plus any nonflight revenues directly attributable to the state. d. Airlines should use a single-factor revenue miles apportionment formula. 6. Which of the following statements is not true? a. MtC Reg. IV.18(h) provides special rules for apportioning the income of broadcasting companies, but only for companies that broadcast by cable. b. Some states have adopted their own special apportionment formulas for trucking companies, such as single-factor formulas based on revenue miles. c. under MtC Reg. IV.18(g), a trucking company is a business that primarily transports the tangible personal property of others by motor vehicle for compensation. d. those states that impose a corporate income tax on insurance companies generally require them to apportion their income using a single-factor premiums formula. 7. Which of the following statements is not true regarding MtC Reg. IV.18(j), which provides special rules for apportioning the income of publishing companies? a. For purposes of the property factor, the cost of outer-jurisdictional property (e.g., orbiting satellites) is pro-rated to a state based on the ratio of the amount of time the property was used to make transmissions in the state to the total time the property was used for transmissions everywhere. b. the payroll factor is determined based on the standard udItPA rules for sourcing payroll. c. With regards to the sales factor, a throwback rule applies if the purchaser or subscriber is the u.S. government, or if the taxpayer is not taxable in a state in which the printed materials are shipped or delivered. d. the regulation was adopted in 1993

RECENT DEvELOPMENTS
Arizona. In 2011, Arizona increased the weight on the sales factor in the optional enhanced sales factor apportionment formula to 85 percent for tax years beginning in 2014, 90 percent for tax years beginning in 2015, 95 percent for tax years beginning in 2016, and 100 percent for tax years beginning after 2016. [H.B. 2001, Feb. 17, 2011]

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businesses may participate in a program under which they contract with the Louisiana Department of Economic Development to use a sales-only formula for a period of 20 years (renewable for up to 20 additional years). [H.B. 729, May 31, 2012] Under prior law, a sales-only formula was available only if a business’s income was derived primarily from manufacturing or merchandising.
New jersey. For tax years beginning before 2012, New Jersey used a double-

Louisiana. Effective for tax years beginning after 2012, certain qualifying

weighted sales formula. In 2011, New Jersey enacted legislation to phase in a sales-only formula. The sales factor will be weighted 70 percent for tax years beginning in 2012, 90 percent for tax years beginning in 2013, and 100 percent for tax years beginning on or after January 1, 2014. [S.B. 2753, Apr. 28, 2011] Pennsylvania formula places a 90 percent weight on sales, and a 5 percent weight on both property and payroll. [H.B. 1531, Oct. 13, 2009] For tax years beginning after 2012, Pennsylvania uses a sales-only formula. [H.B. 761, July 2, 2012]

Pennsylvania. For tax years beginning after 2009 and before 2013, the

virginia. Effective for tax years beginning on or after July 1, 2011, but before

July 1, 2013, manufacturing companies may elect to use a triple-weighted sales apportionment formula. For tax years beginning on or after July 1, 2013, but before July 1, 2014, manufacturers may elect to use a quadrupleweighted sales formula. For tax years beginning on or after July 1, 2014, manufacturers may elect to use a sales-only formula. A manufacturer that makes this election is required to maintain certain employment and wage levels. [H.B. 2437, Apr. 14, 2009; and H.B. 460, Mar. 30, 2012] Effective for tax years beginning on or after July 1, 2015, retail companies are required to use a sales-only formula. For tax years beginning on or after July 1, 2012, but before July 1, 2014, retail companies are required to use a triple-weighted sales factor. For tax years beginning on or after July 1, 2014, but before July 1, 2015, retail companies are required to use a quadrupleweighted sales factor. [H.B. 154, Mar. 6, 2012]

STUDy QUESTION
8. Which of the following states increased the weight on the sales factor in the optional enhanced sales factor apportionment formula to 85 percent for tax years beginning in 2014? a. b. c. d. Pennsylvania new Jersey Louisiana Arizona

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ModuLe 1: CoRPoRAte InCoMe tAxAtIon — CHAPteR 2

Understanding the Property and Payroll Factors
LEARNING ObjECTIvES upon completion, you will be able to: Identify which assets are included in and excluded from the property factor explain how assets are valued for purposes of the property factor determine what compensation is included in and excluded from the payroll factor describe the rules for assigning employee compensation to a specific state

This chapter explains how the property and payroll factors of the apportionment formula are calculated.
FORMULARy APPORTIONMENT

A corporation that is taxable in more than one state has the constitutional right to have its income fairly apportioned among the taxing states. [Complete Auto Transit v. Brady, 430 U.S. 274 (1977)] A taxpayer apportions its income by computing the percentage of its business income that is taxable in each nexus state using the formulas provided by those states. To determine a state’s apportionment percentage, a ratio is established for each of the factors included in the state’s formula. Each ratio is calculated by comparing the level of a specific business activity within a state to the total corporate activity of that type. The ratios are then appropriately weighted and summed to determine the corporation’s apportionment percentage for each state. Apportionment does not necessarily provide a uniform division of a corporation’s income among the nexus states (i.e., a corporation’s apportionment percentages may not sum to 100 percent) because each state is free to choose the type and number of factors it will use as indicative of the amount of business activity conducted within its borders. Moreover, each state makes its own rules for computing the factors included in its apportionment formula. The lack of uniformity can result in either double taxation or “nowhere income.” In 1957, state tax officials promulgated the Uniform Division of Income for Tax Purposes Act (UDITPA), which is a model law for apportioning the income of a corporation that is taxable in two or more states. UDITPA provides for the use of an equally weighted three-factor formula that includes a sales factor, property factor, and payroll factor. In Moorman Manufacturing Co. v. Bair [437 U.S. 267 (1978)], the Supreme Court ruled that a three-factor formula is not constitutionally required, and that

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Iowa could use a sales-only apportionment formula. Consistent with its prior rulings, the Court stated that a state’s choice of apportionment formulas generally will be upheld unless a taxpayer can prove by clear and cogent evidence that the formula attributes income to the state that is out of all appropriate proportion to the business transacted by the taxpayer in that state. At present, about 10 states use a three-factor apportionment formula that equally weights sales, property, and payroll. Most states use either a formula that assigns more weight to the sales factor than to the property or payroll factor, or a formula that includes only a sales factor. The political appeal of an apportionment formula that weights the sales factor more heavily than the property and payroll factors is that it tends to reduce the tax liabilities of corporations that are based in the state, while potentially increasing the tax liabilities of out-of-state corporations. Specifically, placing more weight on the sales factor tends to apportion a larger percentage of an out-of-state corporation’s income to the state because the corporation’s major activity within the state—sales of its product—is weighted more heavily than its payroll and property activities. For corporations that are based in the state, however, placing more weight on the sales factor provides tax relief because those corporations generally own significantly more property and incur more payroll costs (factors that are given relatively less weight in the apportionment formula) within the state than do out-of-state corporations.
THE PROPERTy FACTOR

Despite the trend towards a single-factor sales-only apportionment formula, most states that impose a corporate income tax still employ a three-factor formula that includes a property factor. Under UDITPA Section 10, the property factor is computed as follows:
Average value of the taxpayer’s real and tangible personal property owned or rented and used in the state during the tax year Average value of all the taxpayer’s real and tangible personal property owned or rented and used during the tax year

Property Factor

=

Meaning of “Property”

The Multistate Tax Commission (MTC) has promulgated regulations interpreting UDITPA. Under these regulations, real and tangible personal property includes “land, buildings, machinery, stocks of goods, equipment, and other real and tangible personal property but does not include coin or currency.” [MTC Reg. IV.10.(a)] Leasehold improvements are treated as property owned by the taxpayer regardless of whether the taxpayer is entitled to remove the improvements or the improvements revert to the lessor at the end of the lease. [MTC Reg. IV.11.(b)(5)] Business assets other than

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real and tangible personal property, such as accounts receivable, marketable securities, patents, trademarks and other intangibles, are excluded from the property factor. business Use Requirement

Real and tangible personal property owned or rented by the taxpayer is included in the property factor only if it is “used during the tax period in the regular course of the trade or business.” [MTC Reg. IV.10.(a)] Property used to produce nonbusiness income is excluded from the property factor. Property used both in the regular course of the taxpayer’s trade or business and in the production of nonbusiness income is included in the property factor only to the extent that the property is used in the regular course of the taxpayer’s trade or business, based on the facts of each case. [MTC Reg. IV.10.(a)]
Idle property. The business use requirement is satisfied if the property is “ac-

tually used or is available for or capable of being used during the tax period in the regular course of the trade or business of the taxpayer.” [MTC Reg. IV.10.(b)] Thus, standby facilities, a plant that is temporarily idle, and raw material reserves not currently being processed are all includable in the factor.
EXAMPLE
If a taxpayer closes a manufacturing plant and puts the property up for sale, even if the property remains vacant until its sale one year later, the value of the manufacturing plant is included in the property factor until the plant is sold. [MtC Reg. IV.10.(b), example (i)]

Property used in the taxpayer’s trade or business is removed from the property factor, however, if its permanent withdrawal from service is established by an identifiable event, such as an extended period of time (normally, five years) during which the property is no longer held for use in the trade or business. [MTC Reg. IV.10.(b)]
EXAMPLE
If a chain of retail grocery stores closes one of its stores and remodels the space into three small retail stores (a dress shop, dry cleaner, and barber shop) that are leased to unrelated parties, the property is removed from the property factor on the date the taxpayer began to remodel the store. [MtC Reg. IV.10.(b), example (iv)]

Construction-in-progress. With the exception of inventoriable goods, prop-

erty or equipment that is under construction during the tax year is excluded from the property factor until the date on which the property is placed into

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service and actually used in the regular course of the taxpayer’s trade or business. If the property is partially used in the regular course of the taxpayer’s trade or business while under construction, the construction-in-progress (CIP) costs are included in the property factor to the extent the property is used. [MTC Reg. IV.10.(b)] In Technical Advice Memorandum 2011-1 [Cal. Fran. Tax Bd., Jan. 6, 2011], the California Franchise Tax Board ruled that a home builder’s or developer’s CIP is excluded from the California property factor, because it is not property owned or rented and used in California during the tax year. On the other hand, real property that has not yet become CIP or that is not CIP because it has been completed and is held for sale is includible in the property factor. Examples include: Undeveloped and partially developed land (regardless of whether development activities for that land are actual or planned Completed lots purchased prior to house construction Completed houses under sales contract Completed speculative houses Completed model houses (whether used as models or available for sale) Completed community improvements such as parks, libraries, clubhouses, community centers, and parkways
Examples

In Lockheed Martin Corporation v. State Tax Commission [142 Idaho 790 (Idaho Sup. Ct., 2006)], the Idaho Supreme Court ruled that the taxpayer was not required to include in its property factor the CIP costs associated with a building that the taxpayer was constructing to clean up nuclear and hazardous waste buried in a pit within Idaho, because the building was not being used in the regular course of the taxpayer’s trade or business. The construction of the building was only incidental to the primary remediation purpose of the taxpayer’s contract with the federal Department of Energy. Once the clean-up was completed, the contract required the taxpayer to remove its equipment and facilities from the site. Thus, the construction was not intended to be a permanent improvement to the real property. In Commissioner of Revenue v. New England Power Company [411 Mass. 418 (Mass. Sup. Jud. Ct., 1991)], the Massachusetts Supreme Judicial Court ruled that a public utility company properly included in the property factor the CIP costs associated with the construction of two nuclear power plants. The taxpayer’s construction of the power plants was a necessary function of its business, and the inclusion of the CIP costs in the federally set rate base indirectly generated income for the taxpayer. Therefore, although the power plants would not be producing income or be available for use until they were completed, the taxpayer was using the plants to meet its responsibilities as a public utility and the CIP costs were properly included in its property factor.

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Numerator of Property Factor

The numerator of the property factor is the value of the taxpayer’s property owned or rented and used in the state during the tax year. [UDITPA Sec. 10] Given that only real or tangible personal property are included in the property factor, the physical location of the property’s use is the controlling factor in determining the numerator of the property factor.
Mobile property. The value of mobile property, such as trucks, construc-

tion equipment, or leased electronic equipment, which is located both within and without this state during the tax year is included in the numerator of the property factor based on the total time the property is within the state during the tax year. [MTC Reg. IV.10.(d)] Generally, different rules apply to taxpayers in specialized industries. For example, under UDITPA Section 18, the MTC has promulgated special apportionment regulations for airlines (MTC Reg. IV.18(e)), railroads (MTC Reg. IV.18(f )), trucking companies (MTC Reg. IV.18(g)), construction contractors (MTC Reg. IV.18(d)), and television and radio broadcasters (MTC Reg. IV.18(h)).

Examples

An airline includes its aircraft in the numerator of a state’s property factor based on the ratio of in-state departures, weighted by the value of aircraft, to the total departures everywhere, similarly weighted. [MTC Reg. IV.18(e)] A trucking company includes its motor vehicles and trailers in the numerator of a state’s property factor based on the ratio of mobile property miles in the state to total mobile property miles. [MTC Reg. IV.18(g)] An automobile assigned to a traveling employee is included in the numerator of the property factor of the state to which the employee’s compensation is assigned for purposes of computing the payroll factor or in the numerator of the state in which the automobile is licensed. [MTC Reg. IV.10.(d)]
Property in transit. Property owned by the taxpayer and in transit between

locations of the taxpayer is included in the numerator of the destination state. Likewise, property in transit between a buyer and seller which is included by a taxpayer in the denominator of its property factor in accordance with its regular accounting practices is included in the numerator of the destination state. [MTC Reg. IV.10.(d)] In Appeal of Craig Corporation [87-SBE-013 (Cal. St. Bd. of Equalization, Mar. 3, 1987)], the California State Board of Equalization held that when inventory in transit is gathered, sorted, and inspected by the taxpayer at its facilities in California, following its importation from Asia but prior to its shipment to the taxpayer’s facilities in other states, the inventory is no longer

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considered to be “in transit” if the temporary stoppage is not the result of a lack of immediate transportation but is for the taxpayer’s own purposes. Accordingly, the inventory is included in the numerator of the California property factor even though the goods will be shipped to regional centers in other states after they are inspected and separated for shipment. Likewise, in Comptroller of the Treasury v. Mercedes-Benz of North America, Inc. [No. 8834940/CL88967 (Md. Cir. Ct. July 21, 1989)], a Maryland Circuit Court ruled that the taxpayer, which operated a vehicle preparation center in Maryland for vehicles imported from Europe, was required to include the value of vehicles in transit in the numerator of the state’s property factor. valuation of Owned Property

Property owned by the taxpayer is valued at its “original cost,” which generally equals the basis of the property for federal income tax purposes at the time of acquisition, adjusted by any subsequent capital additions or improvements or partial dispositions, but not reduced by federal depreciation deductions. [UDITPA Sec. 11, and MTC Reg. IV.11.(a)]
EXAMPLE
If a taxpayer purchased a factory building at a cost of $500,000, spent $100,000 for major remodeling of the building, and claimed $22,000 of depreciation deductions, the value of the building included in the property factor is $600,000. [MtC Reg. IV.11.(a), example (i)]

A special rule applies to capitalized intangible drilling and development costs, which are included in the property factor even if they are expensed for either federal or state tax purposes. [MTC Reg. IV.11(a)(1)] A few states require taxpayers to value property at its net book value (i.e., original cost less accumulated depreciation) rather than original cost.
Inventory. UDITPA does not specifically address the valuation of inventory.

However, the MTC regulations provide that inventory is included in the property factor “in accordance with the valuation method used for federal income tax purposes.” [MTC Reg. IV.11(a)(2)] Consistent with the MTC regulations, most states permit the use of the last-in, first-out (LIFO) method if the taxpayer has adopted LIFO for federal tax purposes. Likewise, if a state conforms to the inventory valuation for federal tax purposes, any overhead costs capitalized under the Code Section 263A uniform capitalization rules will be included in the state valuation of inventory.

Average value. Generally, the average value of property owned by the taxpayer is determined by averaging the values at the beginning and end of the tax year. The tax administrator may require or allow averaging by monthly values

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if that method of averaging is required to properly reflect the average value of the taxpayer’s property for the tax year. Averaging by monthly values is generally used if substantial fluctuations in the values of the property occur during the tax year or if property is acquired after the beginning of the tax year or disposed of before the end of the tax year. [UDITPA Sec. 12 and MTC Reg. IV.12] valuation of Rented Property

Property rented by the taxpayer is valued at “eight times the net annual rental rate.” [UDITPA Sec. 11] If property owned by others is used by the taxpayer at no charge or rented by the taxpayer for a nominal rate, the net annual rental rate for the property is based on a reasonable market rental rate for the property. [MTC Reg. IV.18.(b)(2)]
Annual rental rate. The annual rent includes any amount paid for the use of real or tangible personal property, whether the payment is a fixed sum or a percentage of sales or profits, as well as any amount paid in lieu of rents, such as interest, taxes, insurance or repairs, but not including amounts paid as service charges, such as utilities or janitor services. If property is rented for less than a 12-month period, the rent paid for the actual period of rental constitutes the “annual rental rate” for the tax year. However, if a taxpayer rents property for a 12-month period and the current tax period is a short year (due, for example, to a merger), the rent paid for the short tax year is annualized. [MTC Reg. IV.11.(b)(2) and (3)] Whether a payment constitutes “rent” can be uncertain.

Examples

In Nelson’s Office Supply Stores, Inc. v. Commissioner of Revenue [508 N.W.2d 776 (Minn. Sup. Ct., 1993)], the Minnesota Supreme Court ruled that, for purposes of computing the property factor for a retailer that rented space in several shopping centers, the capitalized rentals include the real property taxes, utilities, and common area expenses required to be paid under the lease. In Foodways National, Inc. v. Commissioner [232 Conn. 325 (Conn. Sup Ct., 1995)], the Connecticut Supreme Court ruled that, for purposes of computing the property factor for a frozen food manufacturer, storage fees paid to public warehouses were properly treated as rentals, rather than a fee for services. The product storage contracts at issue provided that a warehouse would supply the taxpayer with a specified amount of cubic storage space for a given quantity of frozen food products but did not designate a specific section of a warehouse to be set aside for the taxpayer’s use. Thus, the warehouse, rather than the taxpayer, determined the place within a warehouse where items would be stored.

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Subrents. Property rented by the taxpayer is valued at eight times the

“net” annual rental rate. If a taxpayer subleases the rented property, the net annual rental rate is the amount of annual rent paid by the taxpayer less the amount of annual subrents received by the taxpayer. [UDITPA Sec. 11] However, subrents do not reduce the net annual rental rate (or the value of the rented property) if the subrents constitute business income because the property that produces the subrents is used by the taxpayer in the regular course of a trade or business in producing such income. [MTC Reg. IV.11(b)(1)]

Examples

If a grocery store receives subrents from an in-store bakery concession, the subrents are business income and are not deducted from the rent paid by the taxpayer for the store. [MTC Reg. IV.11(b)(1), Example (i)] If a taxpayer rents a 20-story office building and uses the lower two stories for its corporate headquarters while subleasing the remaining 18 floors to others, the subrents are nonbusiness income that is deducted from the rent paid by the taxpayer because the rental of the 18 floors is separate from the operation of the taxpayer’s trade or business. [MTC Reg. IV.11(b) (1), Example (iii)] If nonbusiness subrents produce a negative or clearly inaccurate value for the rented property, the tax administrator may require or the taxpayer may request the use of another valuation method that will properly reflect the value of the rented property. In no case, however, can the value be less than an amount that bears the same ratio to the annual rental rate as the fair market value of that portion of the property used by the taxpayer bears to the total fair market value of the rented property. [MTC Reg. IV.18.(b)(1)]
EXAMPLE
If a taxpayer, who rents a 10-story building at an annual rental rate of $1 million, occupies two stories and sublets eight stories for $1 million a year, the net annual rental rate of the taxpayer must not be less than two-tenths of the taxpayer’s annual rental rate for the entire year, or $200,000. [MtC Reg. IV.18.(b)(1), example]

Payments for license agreements. In Meredith Corp. [No. 822396 (N.Y. Tax App. Trib., Mar. 10, 2011)], the Tax Appeals Tribunal ruled that the taxpayer could not treat amounts paid by the taxpayer’s TV stations under license agreements to broadcast TV programs as rental payments for the use of tangible personal property. The taxpayer argued that the payments were includible in the property factor because the programming

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was delivered by satellite transmission and backup tapes, which constituted tangible personal property. The Tribunal disagreed, concluding that the method of delivery was not dispositive of whether the payments for broadcast licenses could be included in the property factor. Under the license agreements, the stations acquired the exclusive rights to broadcast TV programs within a given market. The programming material was delivered to the stations for the sole purpose of enabling the stations to broadcast the material. The TV stations had no interest in or right to use the programming beyond the terms of the license agreements. The right to broadcast programs is equivalent to a copyright, which constitutes an intangible asset. Accordingly, the amounts paid for intangible broadcast rights could not be included in the property factor calculation, because they constituted intangible property.
Consistency in Reporting Requirement

If a taxpayer modifies the manner of excluding, including or valuing property in the property factor used in prior year returns, the taxpayer must disclose the nature of the modification in its current year return. In addition, if the state tax returns filed by the taxpayer are not uniform in the valuation of property and in the exclusion of property from or the inclusion of property in the property factor, the taxpayer must disclose the nature of the variance in its tax returns. [MTC Reg. IV.10.(c)]
STUDy QUESTIONS
1. According to udItPA and/or the MtC regulations, which of the following should be excluded from the property factor? a. b. c. d. 2. Property used in the production of business income Construction in progress Rented property Property that has been idle for six months

Which of the following statements is not true regarding the numerator of the property factor? a. An automobile assigned to a traveling employee is included in the numerator of the state in which the employee is a resident. b. Property in transit between states is considered located in the destination state. c. Special rules apply to certain industries. d. Mobile property, such as construction equipment, that is in more than one state during the tax year is assigned to the numerator on the basis of the time spent in the state.

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3.

Which of the following is not true regarding the valuation of inventory for purposes of computing the property factor? a. taxpayers generally use the same valuation method used for federal income tax purposes. b. States generally conform to the federal unICAP rules. c. no state permits the use of LIFo. d. udItPA does not specifically address the valuation of inventory.

PAyROLL FACTOR

Despite the trend towards a single-factor sales-only apportionment formula, most states that impose a corporate income tax still employ a three-factor formula that includes a payroll factor. Under UDITPA Section 13, the payroll factor is defined as follows: total amount paid in the state during the tax year by the taxpayer for compensation total compensation paid everywhere during the tax year

Property Factor

=

Denominator of Payroll Factor
Definition of compensation. The denominator of the payroll factor is the

total compensation paid everywhere during the tax year. For this purpose, “compensation means wages, salaries, commissions and any other form of remuneration paid to employees for personal services.” [UDITPA Sec. 1(c)] Consequently, payments made to independent contractors or any other person not properly classifiable as an “employee” are excluded from the payroll factor. The proper classification of a worker as an employee or an independent contractor can be uncertain.
EXAMPLE
In P.d. 03-24 [Mar. 24, 2003], the Virginia tax Commissioner ruled that the compensation of sales personnel was properly excluded from the payroll factor where the overall weight of the evidence suggested that the sales personnel should be classified as independent contractors.

California provides the following guidance for distinguishing employees from independent contractors. The term “employee” means (A) any officer of a corporation or (B) any individual who, under the usual common-law rules applicable in determining

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the employer-employee relationship, has the status of an employee. Generally, a person will be considered to be an employee if he is included by the taxpayer as an employee for purposes of the payroll taxes imposed by the Federal Insurance Contributions Act; except that, since certain individuals are included within the term “employees” in the Federal Insurance Contributions Act who would not be employees under the usual common-law rules, it may be established that a person who is included as an employee for purposes of the Federal Insurance Contributions Act is not an employee for purposes of this regulation. [Cal. Code of Regs. § 25132(a)(4)] In an attempt to make the state a more attractive location for a corporation’s headquarters office, a handful of states exclude compensation paid to executive officers from the payroll factor.
EXAMPLE
north Carolina excludes compensation paid to general executive officers, including the “chairman of the board, president, vice-presidents, secretary, treasurer, comptroller, and any other officer serving in similar capacities.” [n.C. Gen. Stat. § 105-130.4(k)(1)]

Only compensation paid by the taxpayer in the regular course of its trade or business is included in the payroll factor. Compensation that is related to the production of nonbusiness income is excluded from the payroll factor. [MTC Reg. 13.(a)]
EXAMPLE
If an employee’s only duty is managing a portfolio of securities that the employer holds as investments separate and apart from its trade or business, the employee’s salary is excluded from the payroll factor. [MtC Reg. 13.(a).(2), example (ii)]

Compensation that is treated as a capital expenditure is included in the payroll factor.
EXAMPLE
If the taxpayer treats as a capital expenditure the wages paid to employees who constructed a storage building that the taxpayer uses in its trade or business, those wages are still included in the payroll factor. [MtC Reg. 13.(a).(2), example (i)]

Method of accounting. The total amount of compensation “paid” to employees is determined based upon the taxpayer’s method of accounting. If the taxpayer uses the accrual method, all compensation that is properly accrued is deemed to have been paid. Regardless of the taxpayer’s overall method

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of accounting, if the taxpayer is required to use the cash method to report compensation for unemployment compensation purposes, the taxpayer may elect to use the cash method in determining the payroll factor. [MTC Reg. 13.(a).(2)]
Compensation paid on behalf of an affiliate. Salaries are generally included in

the payroll factor of the taxpayer for which the services were performed; in most cases, that would be the same corporation that is paying the employees. In Philip Morris, Inc. v. Director of Revenue [760 SW 2d 888 (Mo. Sup. Ct. Dec. 13, 1988)], however, the Missouri Supreme Court ruled that a Virginia parent corporation was required to include in the numerator of its Missouri payroll factor the salaries that the parent paid to the top executives of its wholly-owned Missouri subsidiary. The court reached this conclusion, even though the executives devoted all of their time to the subsidiary’s business and the subsidiary reimbursed the parent for the payroll costs. On the other hand, in Letter of Findings No. 01-0129 [July 1, 2002], the Indiana Department of Revenue ruled that an Indiana parent corporation that performed payroll functions for subsidiaries in Ohio and Michigan could not include the payroll expenses of the subsidiaries’ out-of-state employees in the denominator of the taxpayer’s Indiana payroll factor, because the taxpayer received a management fee from the subsidiaries for performing the payroll services.

Payroll in states in which the taxpayer is not taxable. The denominator of the payroll factor is the total compensation paid everywhere during the tax year. Accordingly, compensation paid to employees whose services are performed entirely in a state where the taxpayer is immune from taxation, for example, by Public Law 86-272, is included in the denominator of the payroll factor. [MTC Reg. 13.(b)]
EXAMPLE
If a corporation has employees in several states, including employees whose services are performed entirely in a state in which the corporation is immune from taxation under Public Law 86-272, the compensation of the latter employees is assigned to the state in which their services are performed even though the taxpayer is not taxable in that state. As a result, this payroll is included in the denominator but not the numerator of the payroll factor. [MtC Reg. 13.(b), example]

Numerator of Payroll Factor

The numerator of a state’s payroll factor is the total amount paid in this state during the tax year by the taxpayer for compensation. For this purpose, the entire amount of each individual employee’s compensation is assigned to a single state, based on a hierarchy of sourcing rules. Specifically, an employee’s

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compensation is “paid in this state” if any one of the following tests, applied consecutively, are met: The employee’s service is performed entirely within the state. The employee’s service is performed both within and without the state, but the service performed without the state is “incidental” (i.e., temporary or transitory in nature) to the employee’s service within the state. If the employee’s services are performed both within and without this state, the employee’s compensation is attributed to this state: If the employee’s “base of operations” (i.e., the more or less permanent place from which the employee starts work and customarily returns to receive instructions from the taxpayer, communicate with customers, replenish inventory, repair equipment, or perform other necessary business functions) is in this state; or If there is no base of operations in any state in which some part of the service is performed, but the “place from which the service is directed or controlled” by the taxpayer is in this state; or If the base of operations or the place from which the service is directed or controlled is not in any state in which some part of the service is performed, but the employee’s residence is in this state. [UDITPA Sec. 14 and MTC Reg. IV.14] The above tests for sourcing compensation are derived from the Model Unemployment Compensation Act. Accordingly, if compensation is included in the payroll factor based on the cash method of accounting or if the taxpayer is required to report compensation on a cash basis for unemployment compensation purposes, then it is presumed that the total wages reported by the taxpayer to this state for unemployment compensation purposes constitute compensation paid in this state for purposes of the payroll factor (except for compensation related to nonbusiness income). The presumption may be overcome by satisfactory evidence that an employee’s compensation is not properly reportable to this state for unemployment compensation purposes. [MTC Reg. 13.(c)] In Kentucky Revenue Cabinet v. Marquette Transportation Company, Inc. [No. 2006-CA-002639-MR (Ky. Ct. of App., Apr. 3, 2009)], the Kentucky Court of Appeals ruled that the compensation of company employees who operated towboats along the Mississippi River and Illinois River was not included in the numerator of the Kentucky payroll factor, because there was no evidence that the company’s towboat employees actually performed services in Kentucky. Although the company maintained its headquarters in Kentucky, it had no customers in Kentucky and its towboats never stopped in Kentucky. The company had about 35 employees who worked in the Kentucky headquarters office and 700 employees who worked on the towboats. Only the compensation paid to the towboat employees was in dispute. The fact that the company paid unemployment insurance tax for all of its employees to Kentucky was not

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relevant, because the Kentucky payroll factor statute does not mention unemployment taxes. In O.H. Materials Co. v. Commissioner [Ohio Ct. App., 3rd Dist., No. 5-89-2 (Nov. 26, 1990)], the Ohio Appeals Court ruled that wages paid by an Ohio company to employees working at two job sites in New Jersey were included in the numerator of the Ohio payroll factor, even though New Jersey also required inclusion of the wages in the numerator of its payroll factor. One project lasted 15 months and the other project lasted 10 months. New Jersey included the wages, because the services were performed in New Jersey, whereas Ohio included the wages because the employee’s “base of operations” was in Ohio.
Leased Employees

Employee leasing generally refers to a situation where a third-party company “employs” the taxpayer’s staff by taking over various legal responsibilities, including distributing paychecks, withholding and depositing personal income taxes, making FICA contributions, providing worker’s compensation insurance, and administering other employee benefits. In return for this service, the taxpayer pays the third-party company a cost-plus fee. In many cases, the taxpayer maintains significant control over the activities of a leased employee. As a consequence, a leased employee may be considered an employee of the service recipient under the common-law rules. UDITPA and the MTC regulations are silent regarding how the compensation costs associated with leased employees are properly treated for purposes of computing the payroll factor. One approach is to include a leased employee’s compensation in the payroll factor of the employee leasing company (the lessor) because that is the entity directly paying the individual in question. An alternative approach is to include a leased employee’s compensation in the payroll factor of the common-law employer, which could be either the employee leasing company or the entity for which the employees are providing services (the lessee). Some states provide specific guidance regarding the treatment of leased employees, but many states do not.
Examples

For purposes of computing the Massachusetts payroll factor, compensation paid for personal services rendered by leased employees is included in the payroll factor of the recipient of the services of the leased employee and is excluded from the payroll factor of the employee leasing company. [830 Mass. Code Regs. 63.38.1] For purposes of computing the New Mexico payroll factor, compensation paid for personal services rendered by leased employees is included in the payroll factor of the recipient of the services of the leased employee if the

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recipient is considered to be the employer or joint employer of the leased employee for payroll tax purposes. [N.M. Admin. Code tit. 3, § 5.14.8] In UPS Worldwide Forwarding, Inc. v. Commw. of Pennsylvania [Nos. 62-65 F.R. 2001 (Pa. Commw. Ct., Dec. 8, 2004)], UPS Worldwide Forwarding, Inc. (Taxpayer) and UPS Aviation Services, Inc. (UPS-AS) were wholly-owned subsidiaries of UPS-America. Taxpayer had no employees. Instead, all of Taxpayer’s services were performed by employees of affiliated companies and independent contractors. Taxpayer paid UPS-AS for the payroll costs it incurred for its employees who performed network planning and logistic functions for Taxpayer, and Taxpayer recorded these costs on its books as payroll expenses. The Pennsylvania Commonwealth Court ruled that the amounts Taxpayer paid UPS-AS did not constitute compensation expenses of the type includible in the Taxpayer’s payroll factor, because the individuals in question were not Taxpayer’s employees and there was no written agreement between Taxpayer and UPS-AS with respect to the individuals. The Pennsylvania Supreme Court affirmed the lower court’s decision. [No.1-4 MAP 2005 (Pa. Sup. Ct., Dec. 30, 2005)] In Plantation Pipeline Co. v. Department of Revenue [No. Corp. 05948 (Ala. Admin. Law Div., May 23, 2006)], Plantation Pipeline Company (Taxpayer) was an interstate oil pipeline company that conducted business in Alabama and numerous other states. Taxpayer was owned by an affiliate of ExxonMobil Pipeline Company (Exxon), Kinder Morgan Operating L.P. “D” (KMLP-D), and Kinder Morgan Operating L.P. “A.” In December 2000, Taxpayer entered into an agreement with Plantation Services, LLC (PS LLC), which required PS LLC to perform all of Taxpayer’s operational and administrative functions. PS LLC then subcontracted for KMLP-D to perform those functions for Taxpayer beginning in January 2001. PS LLC was owned by Exxon and KMLP-D. Pursuant to the agreement, Taxpayer transferred all of its employees to KMLP-D, effective January 1, 2001. These employees continued to perform the same services for Taxpayer as they had performed as direct employees of Taxpayer before 2001. The issue was whether the payments made by Taxpayer for the leased employees were properly included in Taxpayer’s Alabama payroll factor. The Alabama Administrative Law Division previously addressed the issue of whether payments for leased employees should be included in a taxpayer’s payroll factor in C&D Chemical Products, Inc. v. Department of Revenue. [No. 2000-288 (Ala. Admin. Law Div. Feb. 9, 2001)] In this case, the taxpayer was a partner in a partnership that operated in Alabama using leased employees provided by a related corporation. The partnership compensated the related corporation for the cost of the employees, and the taxpayer included the compensation paid for the leased employees in its Alabama payroll factor. The judge ruled that even though the employees in question were not direct employees of the partnership, a pro-rata share

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of the amounts paid for the leased employees was properly included in the corporate partner’s payroll factor because the applicable statute did not require that the compensation be paid to an employee. Consistent with the ruling in C&D Chemical Products, the judge in Plantation Pipeline Co. ruled that the compensation paid by Taxpayer to an affiliated corporation for the services performed by the transferred employees was properly included in Taxpayer’s Alabama payroll factor. The individuals who performed Taxpayer’s operational and administrative functions as employees of the affiliated corporation were the same individuals who performed those duties as direct employees of Taxpayer in prior years and contributed to Taxpayer’s production of business income to the same extent as they had in the prior years. Therefore, Taxpayer’s income producing activities were more accurately identified and attributed to Alabama if the compensation paid by Taxpayer for the transferred employees was included in its Alabama payroll factor.
STUDy QUESTIONS
4. Payments made to an independent contractor are always included in the payroll factor. True or False? a. true b. False 5. Which of the following statements is true? a. Some states provide specific guidance as to how to treat leased employees for purposes of computing the payroll factor. b. udItPA provides specific guidance as to how to treat leased employees for purposes of computing the payroll factor. c. the MtC regulations provide specific guidance as to how to treat leased employees for purposes of computing the payroll factor.

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Treatment of Nonbusiness Income
LEARNING ObjECTIvES upon completion of this chapter, the user will be able to: explain the role of the unitary business principle in determining nonbusiness income explain how udItPA defines business and nonbusiness income differentiate between the transactional and functional tests for determining whether an item is business income explain how nonbusiness income is allocated describe the treatment of expenses attributable to nonbusiness income

This chapter discusses how states tax a corporation’s nonbusiness income.
CONSTITUTIONAL RESTRICTIONS ON APPORTIONAbLE INCOME

The U.S. Constitution prohibits a state from taxing an out-of-state corporation on income derived from an unrelated activity that has nothing to do with the business activity of the corporation in the taxing state. This principle reflects the fundamental requirement of the Due Process and Commerce Clauses that there be “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” [Miller Bros. Co. v. Maryland, 347 U.S. 340, 1954] Under the unitary business principle, if a corporation’s interstate activities form a unitary business, a state need not isolate the corporation’s in-state activities from the rest of the business in determining the corporation’s taxable income. Instead, the state may tax an apportioned percentage of the income generated by the multistate unitary business. The unitary business principle was originally developed in the 19th century to address the issues that arose when states attempted to impose property taxes on interstate railroad and telegraph companies.
EXAMPLE
to determine the property tax value of the railroad track located within its borders, a state could apportion a share of the value of the entire multistate business to the state, rather than attempt to isolate and separately determine the value of the in-state property.

In Mobil Oil Corp. v. Commissioner of Taxes [445 U.S. 425 (1980)], the Supreme Court stated that “the linchpin of apportionability in the field of state income taxation is the unitary business principle.” Mobil was an

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integrated petroleum company that was incorporated and commercially domiciled in New York. Mobil challenged Vermont’s ability to tax dividends that the taxpayer received from its foreign subsidiaries. The essence of Mobil’s argument that Vermont could not constitutionally tax the foreign dividends was that the activities of the foreign subsidiaries were “unrelated” to Mobil’s activities in Vermont, which were limited to distributing petroleum products. The Supreme Court ruled that Vermont could tax an apportioned percentage of the dividends Mobil received from its foreign subsidiaries, because those subsidiaries were part of the same integrated petroleum enterprise as the business operations conducted in Vermont. In other words, the dividends were apportionable business income, because they were received from unitary subsidiaries. The Court also indicated that if the business activities of the foreign subsidiaries had “nothing to do with the activities of the recipient in the taxing state, due process considerations might well preclude apportionability, because there would be no underlying unitary business.” The two most recent Supreme Court decisions regarding apportionable business income are Allied-Signal and MeadWestvaco.
Allied-Signal. In Allied-Signal, Inc. v. Director, Division of Taxation [504

U.S. 768, 1992], the taxpayer was Bendix Corporation (Allied-Signal was the successor in interest to Bendix), a Delaware corporation that was commercially domiciled in Michigan and conducted business in all 50 states. In 1981, Bendix realized a $211.5 million gain from the sale of 20.6 percent of the stock of ASARCO, Inc. The Supreme Court ruled that the State of New Jersey was constitutionally prohibited from including the gain in the taxpayer’s apportionable business income, because none of the factors that would indicate that Bendix and ASARCO were engaged in a unitary business (e.g., functional integration, centralized management, or economies of scale) were present. As a result, the Court concluded that Bendix and ASARCO were “unrelated business enterprises each of whose activities had nothing to do with the other.” In addition, the ownership of ASARCO stock did not serve an operational function in Bendix’s business—”the mere fact that an intangible asset was acquired pursuant to a long-term corporate strategy of acquisitions and dispositions does not convert an otherwise passive investment into an integral operational one.” In arriving at its decision in Allied-Signal, the Supreme Court stated that “the payee and the payer need not be engaged in the same unitary business as a prerequisite to apportionment in all cases ... What is required instead is that the capital transaction serve an operational rather than an investment function.” As an example of an asset that serves an operational function, the Court mentions “interest earned on short-term deposits ... if that income forms part of the working capital of the corporation’s unitary business.” The Court’s reference to an operational function in this case was widely interpreted as modifying the unitary business principle and creating a second test for apportionable income. Under the alleged operational function test,

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even if no unitary business exists between the payee (taxpayer) and payer (asset), a state may still tax an apportioned percentage of the income from an intangible asset if that asset serves an operational function rather than an investment function in the taxpayer’s business.
MeadWestvaco. In MeadWestvaco Corporation v. Illinois Department of

Revenue [553 U.S. 16, 2008], the issue was whether Illinois was constitutionally prohibited from taxing an apportioned share of the $1 billion gain realized by Mead Corporation (Mead) in 1994 when it sold its investment in Lexis/Nexis (Lexis). MeadWestvaco is the successor in interest to Mead, which was an Ohio corporation. Lexis was one of Mead’s business divisions. The Illinois trial court concluded that although Mead and Lexis were not engaged in a unitary business, the gain nevertheless qualified as apportionable income, because Mead’s investment in Lexis served an operational purpose. The Illinois appeals court affirmed the trial court’s decision that Lexis served an “operational function” in Mead’s business, but did not address the issue of whether Mead and Lexis were engaged in a unitary business. The U.S. Supreme Court vacated the Illinois appeals court decision on the grounds that it misinterpreted the Court’s references to “operational function” in Allied-Signal as modifying the unitary business principle to add a new basis for apportionment. The Court explained that the operational function concept described in Allied-Signal merely recognizes the reality that an asset can be part of a taxpayer’s unitary business even if there is no unitary relationship between the payee (taxpayer) and payer (asset). The Court explained that its reference to “operational function” in Allied-Signal was “not intended to modify the unitary business principle by adding a new ground for apportionment.” Instead, “[t]he concept of operational function simply recognizes that an asset can be a part of a taxpayer’s unitary business even if what we may term a ‘unitary relationship’ does not exist between the ‘payor and payee.’” Thus, whether an asset serves an operational function in the taxpayer’s business is “merely instrumental to the constitutionally relevant conclusion that the asset was a unitary part of the business being conducted in the taxing State.” The Court illustrated this point using examples drawn from its earlier decisions. In Allied-Signal, the Supreme Court stated that apportionable income includes “interest earned on short-term deposits in a bank located in another State if that income forms part of the working capital of the corporation’s unitary business, notwithstanding the absence of a unitary relationship between the corporation and the bank.” The taxpayer is not unitary with the payer of the income (the bank), but the taxpayer’s deposits (working capital and thus operational assets) are clearly unitary with the taxpayer’s business. Likewise, in Container Corporation of America v. Franchise Tax Board [463 U.S. 159, 1983], the Supreme Court stated that “capital transactions can serve either an investment function or an operational function,” and noted that it had made this distinction with respect to a federal tax issue in

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Corn Products Refining Co. v. Commissioner. [350 U. S. 46, 1955] In Corn Products, a manufacturer purchased commodity futures to secure supplies of raw materials at an economical price. Thus, the taxpayer was not unitary with the payer of the income (the counterparty to the futures contracts), but the taxpayer’s futures contracts (hedges against the risk of a price increase for raw materials) were clearly unitary with the taxpayer’s business. Finally, the Supreme Court indicated that because the Illinois appeals court did not rule on whether Mead and Lexis formed a unitary business, the Illinois appeals court may take up that issue on remand.
STUDy QUESTIONS
1. Which statement regarding apportionable business income is not true? a. dividends that a u.S. parent corporation receives from a foreign subsidiary are business income if the u.S. parent and the foreign subsidiary are engaged in a unitary business. b. to qualify as business income, a capital transaction must serve an investment rather than an operational function. c. the linchpin of apportionability is the unitary business principle. d. A state may tax an apportioned percentage of the income generated by a unitary business. 2. Which of the following items of income is most likely nonbusiness income? a. Gain on the sale of a parcel of vacant land that has nothing to do with a manufacturing corporation’s business activities in the taxing state. b. dividends that a parent corporation receives from its unitary subsidiaries c. Interest income on bank deposits that are part of the taxpayer’s working capital

UDITPA DEFINITION OF bUSINESS INCOME

The Uniform Division of Income for Tax Purposes Act (UDITPA) is a model law for apportioning the income of a corporation. The apportionment laws of most states conform, to vary degrees, to UDITPA. Under UDITPA, “business income” is apportioned among the states in which the taxpayer has nexus, whereas the entire amount of an item of “nonbusiness income” is specifically allocated to a single state. Therefore, the principal consequence of classifying an item as nonbusiness income is that the income is excluded from the tax base of every nexus state except the state in which the nonbusiness income is taxable in full (e.g., the state of commercial domicile). Because the classification of an item as nonbusiness income effectively removes the income from the tax base of one or more states, the business versus nonbusiness income distinction has historically been an area of significant controversy.

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UDITPA Section 1(e) defines nonbusiness income as “all income other than business income.” According to UDITPA Section 1(a), business income is: [I]ncome arising from transactions and activity in the regular course of the taxpayer’s trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations. Therefore, under UDITPA, an item of income is classified as business income if it either arises from transactions and activity in the regular course of the taxpayer’s trade or business (transactional test) or from tangible and intangible property, if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations (functional test). [MTC Reg. IV.1.(a)(2)] Most frequently occurring transactions or activities will be in the regular course of the taxpayer’s trade or business, and therefore will satisfy the transactional test. Common examples include, but are not limited to, income from sales of inventory, services which are commonly sold by the trade or business, and income from the sale of property used in the production of business income of a kind that is sold and replaced with some regularity. Nevertheless, the transaction or activity need not be one that frequently occurs in the regular course of the taxpayer’s trade or business to satisfy the transactional test. Likewise, even if a taxpayer frequently or customarily engages in investment activities, if those activities are for the taxpayer’s mere financial betterment rather than for the operations of the trade or business, such activities do not satisfy the transactional test. [MTC Reg. IV.1.(a).(4).] Income need not be derived from transactions or activities that are in the regular course of the taxpayer’s trade or business in order to satisfy the functional test. Instead, the property from which the income is derived must be an integral, functional, or operative component used in the taxpayer’s trade or business, or otherwise materially contribute to the production of business income of the trade or business. Income that is derived from infrequently occurring transactions, including transactions made in liquidation of the business, is business income if the property is or was used in the taxpayer’s trade or business. Income from the licensing of an intangible asset (e.g., a patent) that was developed or acquired for use by the taxpayer in its trade or business constitutes business income. Likewise, income from intangible property that serves an operational function as opposed to solely an investment function also qualifies as business income. The functional test is not satisfied, however, where the holding of the property is limited to mere financial betterment of the taxpayer rather than for the operations of the trade or business. [MTC Reg. IV.1.(a).(5).]

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The MTC regulations provide examples of nonbusiness income that satisfies neither the transactional test nor the functional test, including the following:
EXAMPLE
the taxpayer operates a multistate chain of grocery stores. It owned an office building which it occupied as its corporate headquarters. Because of inadequate space, taxpayer acquired a new and larger building elsewhere for its corporate headquarters. the old building was rented to an investment company under a five-year lease. upon expiration of the lease, taxpayer sold the building at a gain. the net rental income received over the lease period is nonbusiness income and the gain on the sale of the building is nonbusiness income. [MtC Reg. IV.1.(c).(1), example (vii)]

EXAMPLE
In January, the taxpayer sold all of the stock of a subsidiary for $20,000,000. the funds are placed in an interest-bearing account pending a decision by management as to how the funds are to be utilized. the interest income is nonbusiness income. [MtC Reg. IV.1.(c). (3), example (vi)]

EXAMPLE the taxpayer is engaged in a multistate glass manufacturing business. It also holds a portfolio of stock and interest-bearing securities, the acquisition and holding of which are unrelated to the manufacturing business. the dividends and interest income received are nonbusiness income. [MtC Reg. IV.1.(c).(4)., example (vi)]

STATE DEFINITIONS OF bUSINESS INCOME

Most states conform, more or less, to the UDITPA definitions of business and nonbusiness income. However, each state is free to adopt its own definitions, subject to U.S. Constitutional constraints. This can result in the same item of income being treated differently in different states. Such inconsistent treatment can result in double taxation of the income in question.
EXAMPLE
When a grocery store chain sold its leasehold assets, the gain on the sale was held to be nonbusiness income in Kansas [In re Kroger Co., no. 93-15316-dt (Kan. B.t.A. Feb. 13, 1997)], but business income in Illinois [Kroger Co. v. Department of Revenue, nos. 1-951658, 1-95-2232 (Ill. App. Ct. Sept. 17, 1996)]. the Kansas court focused on the unusual nature of the transaction, whereas the Illinois court focused on the integral nature of the leasehold assets to the taxpayer’s trade or business.

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In Director of Revenue v. CNA Holdings. Inc., f/k/a Hoechst Celanese Corp. [No. 51, 2002 (Del. Sup. Ct. Mar. 21, 2003)], the Delaware Supreme Court ruled that Delaware could tax 100 percent of a corporation’s gain from the sale of a Delaware plant, even though other states also taxed an apportioned percentage of the gain. Because other states also taxed the transaction, the taxpayer was required to pay corporate income tax on 187 percent of its gain on the sale of the plant. Under Delaware law, the entire amount of the gain from the sale of business property is allocated to the state in which the asset is located. [30 Del. Code §1903(b)] Although the Delaware statute resulted in double taxation, the state’s highest court concluded that the statute was not unreasonable because, to the extent that Delaware may be taxing more than its share of a gain on the sale of property located in Delaware, it also was taxing less than its share of a gain on the sale of property located outside of Delaware. In Oracle Corporation v. Department of Revenue [No. TC-MD 070762C (Ore. Tax Ct., Feb. 11, 2010)], the taxpayer reported gains from the sale of stock as business income in California, its state of commercial domicile, but reported the same income as nonbusiness income on its Oregon return. The Oregon Department of Revenue argued that the taxpayer’s treatment violated a duty of uniform reporting of income under UDITPA, as codified in Oregon statutes. The Tax Court rejected this argument and agreed with the taxpayer that, because of differences in state law, its method of reporting the sale of stock under California law was not controlling for Oregon tax purposes. Instead, whether the gains were business or nonbusiness income for Oregon income tax purposes was an issue to be decided on the basis of Oregon law. In Oracle Corporation v. Department of Revenue [No. TC-MD 070762C (Ore. Tax Ct., Jan.19, 2012)], the Tax Court ruled that the gains from the sales of stock of subsidiaries were business income for Oregon tax purposes.
STUDy QUESTION
3. Which of the following is true of nonbusiness income? a. under udItPA, nonbusiness income is apportioned among the states in which the taxpayer has nexus b. under udItPA, nonbusiness income is specifically allocated to a single state. c. the definition of nonbusiness income is identical in all 50 states. d. udItPA defines nonbusiness income as all income other than income arising from routine business transactions.

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CONTROvERSy REGARDING FUNCTIONAL TEST

In determining whether an item of income is business or nonbusiness in nature, state courts have been divided on whether the UDITPA definition of business income includes both a transactional test (i.e., “income arising from transactions and activity in the regular course of the taxpayer’s trade or business”) and a functional test (i.e., “income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations”), or just a transactional test. The transactional test looks to the frequency and regularity of the income-producing transaction in relation to the taxpayer’s regular trade or business. The critical issue is whether the transaction is frequent in nature, as opposed to a rare and extraordinary event. In contrast, the functional test looks to the relationship between the underlying income-producing asset and the taxpayer’s regular trade or business. The critical issue is whether the asset is integral, as opposed to incidental, to the taxpayer’s business operations. State supreme courts in Alabama, Iowa, Kansas, Minnesota and Tennessee have ruled that the UDITPA definition of business income contains only a transactional test. In each case, the decision has been followed by a legislative change to broaden the statute to include a functional test. In 2003, the Multistate Tax Commission amended MTC Regulation IV.1(a) to provide that business income means income that meets either the transactional test or the functional test. Consequently, at present, the majority view is that the UDITPA definition of business income includes both a transactional test and a functional test, and that an item of income is properly classified as business in nature if either test is met.
Alabama. In Uniroyal Tire Co. v. State Department of Revenue [No.

1981928 (Ala. Aug. 4, 2000), the Alabama Supreme Court held that the Alabama statute (adopted verbatim from UDITPA) contained only a transactional test. In 1986, Uniroyal formed a 50-50 partnership with B.F. Goodrich, wherein Uniroyal transferred all of its business assets to the partnership and thereafter its only asset was the partnership interest. In 1990, Uniroyal sold its entire partnership interest at a gain. Despite the fact that the partnership interest produced business income prior to its sale, the Alabama Supreme Court held that the Alabama statute contained only a transactional test and that Uniroyal’s complete liquidation and cessation of business did not give rise to business income under the transactional test. In response to the decision in Uniroyal, the Alabama legislature broadened the statutory definition of business income to explicitly include a functional test. [Ala. H.B. 7 (Dec. 28, 2001)]

California. In Hoechst Celanese Corp. v. Franchise Tax Board [No. S085091 (Cal. May 14, 2001), cert. denied, No. 01-265 (U.S. Nov. 26, 2001)], the

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California Supreme Court analyzed the legislative history of the California definition of business income, as well as rulings in other states regarding the UDITPA definition, and concluded that the definition included both a transactional test and a functional test. The court then applied the two-part definition to the taxpayer’s $389 million of pension plan reversion income and ruled that, although the transactional test was not satisfied because the pension plan reversion was an extraordinary event rather than a normal trade or business activity, the functional test was satisfied, because the pension plan assets “materially contributed” to the production of business income and therefore were integral to the taxpayer’s trade or business. In Jim Beam Brands Co. v. Franchise Tax Board [No. A107209 (Cal. Ct. of App., Oct. 17, 2005)], the California Court of Appeal ruled that the gain from the sale of property arising from a partial liquidation transaction was business income under the functional test. The court concluded that there was no partial liquidation exception to the functional test and no independent requirement that the disposition of the property be an integral part of the corporation’s trade or business operations.
Georgia. In 2005, Georgia amended its apportionment statute to provide

that the state’s corporate income tax applies to a corporation’s income “to the extent permitted by the United States Constitution.” [H.B. 488, 2005]

Illinois. In a case involving the sale of a pipeline, Texaco-Cities Service Pipeline Co. v. McGaw [182 Ill. 2d 269 (1998)], the Illinois Supreme Court interpreted the applicable state statute (which was similar to the UDITPA definition) as including both a transactional test and a functional test. The taxpayer remained in the pipeline business after the sale, and the proceeds from the sale were immediately reinvested in the operations of the business rather than distributed as a dividend to the shareholders. Accordingly, the court ruled that the gain on the sale of pipeline assets was business in nature. On the other hand, in Blessing/White Inc. et al. v. Dept. of Revenue [No. 1 01 0733 (Ill. App. Ct. 1st Dist., Mar. 29, 2002)], the Illinois Appellate Court for the First District ruled that the gain realized from a complete liquidation was nonbusiness income, because the proceeds were distributed to the shareholders and not reinvested in the business. Likewise, in National Holdings, Inc. v. Zehnder [No. 4-06-0148 (Ill. App. Ct. 4th Dist., Jan. 19, 2007], the Illinois Appellate Court for the Fourth District joined the First District in recognizing a business-liquidation exception to the functional test, and the court concluded that the exception applied in this case. Thus, the court ruled that the gain was nonbusiness income, because all of the liquidation proceeds were distributed to the parent company and were not reinvested in the ongoing business. In 2004, Illinois broadened its definition of business income to include “all income that may be treated as apportionable business income under the

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Constitution of the United States.” [S.B. 2207, 2004] This legislation also requires the recapture of expenses related to an asset or activity if income previously classified as business income from that asset or activity is determined in a later year to be nonbusiness income.
Iowa. In Phillips Petroleum Co. v. Iowa Department of Revenue [511 N.W.2d 608 (Iowa 1993)], the taxpayer purchased a substantial amount of its outstanding stock to stave off a hostile takeover attempt. To retire the debt incurred for this purchase, the corporation sold at a gain a significant portion of its gas and oil-producing assets, none of which were located in Iowa. Even though the assets in question had been used in the taxpayer’s regular trade or business, the Iowa Supreme Court held that the gain was not business income. The court interpreted the applicable state statute (adopted verbatim from UDITPA) as “basically transactional” in nature, stating that the so-called functional test was “added to include transactions involving disposal of fixed assets by taxpayers who emphasize the trading of assets as an integral part of regular business.” Noting that the enormity of the disposition was “unprecedented” and “clearly a once-in-a-corporate-lifetime occurrence,” the court concluded that the gain failed the transactional test, and thus was nonbusiness income. In response to the decision in Phillips Petroleum, the Iowa legislature amended the Iowa statute to expressly include a functional test. [Iowa Code Ann. §422.32] Kentucky. In 2006, the Kentucky Department of Revenue adopted a regula-

tion which provides that the department will apply both the transactional test and the functional test in determining whether income is business income [Ky. Reg. 103 KAR 16:060E, Feb. 1, 2006].

Kansas. In 1994, the Kansas Supreme Court held that a gain on the sale of a subsidiary’s stock was nonbusiness income because the Kansas statute contained only a transactional test. [In re Chief Indus., Inc., No. 69972 (Kan. June 3, 1994)] In response to this decision, the Kansas legislature modified the state’s statute governing the treatment of nonbusiness income. In addition, to ensure that corporations that have their headquarters office (commercial domicile) in Kansas would not be at a disadvantage with regard to treatment of nonbusiness income, Kansas passed legislation that allows corporations to elect to have all income arising from the acquisition, management, use, or disposition of tangible or intangible property treated as business income. In 2008, Kansas broadened its definition of “business income” to include: Income arising from transactions and activity in the regular course of the taxpayer’s trade or business Income arising from transactions and activity involving tangible and intangible property or assets used in the operation of the taxpayer’s trade or business

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Income of the taxpayer that may be apportioned to this state under the provisions of the Constitution of the United States and laws thereof, except that a taxpayer may elect that all income constitutes business income. [H.B. 2434, May 22, 2008]
Minnesota. In Firstar Corp. v. Commissioner of Revenue [No. CX-97-600

(Minn. Mar. 12, 1998)], the Minnesota Supreme Court held that the gain realized by a Wisconsin-based bank on the sale of its headquarters office in Milwaukee was nonbusiness income. In making this determination, the court focused on two factors: 1. The frequency and regularity of similar transactions and the former business practices of the taxpayer 2. The subsequent use of the sale proceeds With respect to the first factor, the sale of the headquarters office was an isolated transaction in the bank’s history. In fact, prior to the sale of the headquarters office, Firstar had never sold a commercial office property. With respect to the second factor, the proceeds from the sale were not reinvested in the taxpayer’s ongoing business operations, but were instead used to retire the bonds secured by the headquarters office, pay the taxes on the gain from the sale, pay a dividend to shareholders, and redeploy the capital of Firstar into acquisitions of new banks. In response to the decision in Firstar, in 1999 the Minnesota legislature amended the statute to define nonbusiness income as “income of the trade or business that cannot be apportioned to this state because of the United States Constitution or the constitution of the state of Minnesota and includes income that cannot constitutionally be apportioned to this state because it is derived from a capital transaction that solely serves an investment function.” [Minn. Rev. Stat. §290.17]

Mississippi. In 2001, Mississippi amended its definition of business income

to include any income, other than income that fails both a transactional and a functional test. [A.B. 1695, 2001]

Montana. In Gannett Satellite Information Network, Inc. v. Montana

Department of Revenue [No. DA 08-0026 (Mt. Sup. Ct., Jan. 13, 2009)], the Montana Supreme Court ruled that the state’s definition of “business income,” which is based on UDITPA, contains both a transactional test and an independent functional test. As a result, the taxpayer’s $2.54 billion gain from the sale of its cable subsidiary was apportionable business income, because the income arose from the sale of property that was regularly used in the combined reporting group’s regular course of conducting its telecommunications business.

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provide that “100 percent of the nonoperational income of a taxpayer that has its principal place from which the trade or business of the taxpayer is directed or managed in this State shall be specifically assigned to this State to the extent permitted under the Constitution and statutes of the United States.” [A.B. 2501, 2002]
North Carolina. In Polaroid Corp. v. Offerman [No. 70PA98 (N.C. Oct. 12, 1998)], the North Carolina Supreme Court held that the North Carolina definition of business income includes both a transactional test and a functional test, and that “once a corporation’s assets are found to constitute integral parts of the corporation’s regular trade or business, income resulting from the acquisition, management, and/or disposition of those assets constitutes business income regardless of how that income is received.” Under this approach, the court treated damages that the taxpayer received in a patent infringement lawsuit as business income. In Union Carbide Corp. v. Offerman [No. 453A98-2 (N.C. Feb. 4, 2000)], the North Carolina Supreme Court ruled that income from a pension plan reversion did not meet the functional test because the taxpayer held only a contingent property right in the excess funds in the event of a plan termination and that contingent property right was not integral or essential to the taxpayer’s regular trade or business. Moreover, the assets of the pension plan were not used to generate income in the regular business operations, were not working capital, were not used as collateral in borrowing, and were not relied on to purchase equipment or support research and development. In Lenox, Inc. v. Offerman [No. 17A01 (N.C. July 20, 2001)], the North Carolina Supreme Court held that a consumer products company’s gain on the complete cessation and sale of a separate and distinct operating division (a fine jewelry business) and the distribution of the sale proceeds to the corporation’s parent company satisfied neither the transactional test nor the functional test, and therefore qualified as nonbusiness income. In effect, the court created an exception for dispositions of assets in a complete liquidation of a separate trade or business. Had the assets in question been disposed of under different circumstances, the sale would have given rise to business income because the assets were an integral part of the company’s business. In 2002, North Carolina broadened its definition of business income to include “all income that is apportionable under the U.S. Constitution.” [S.B. 1115, 2002] Ohio. In Kemppel v. Zaino [No. 00-358, Oh. Sup. Ct. May 23, 2001)], the Ohio Supreme Court ruled that gains realized by an S corporation on the liquidating sale of its assets were nonbusiness income, because the gains were not from a sale in the regular course of a trade or business, but rather from a liquidation of assets followed by a dissolution of the corporation.

New jersey. In 2002, New Jersey amended its apportionment statute to

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Oregon. In Williamette Industries, Inc. v. Oregon Department of Revenue

[331 Or. 311, 15 P.3d 18 (2000)], the Oregon Supreme Court held that the Oregon definition of business income included both a transactional test and a functional test. The court also ruled that the royalty income received by an Oregon lumber company from oil and gas drilling performed on land it owned in Louisiana and Arkansas was not business income under either test. The royalty income did not satisfy the transactional test because the taxpayer’s business was growing timber and making wood products, not producing oil and gas. In addition, the court refused to apply the functional test, stating that the test applies only to the sale or disposition of property, and the taxpayer had not disposed of the property in question. In Pennzoil Co. v. Department of Revenue [No. S47561 (Or. Oct. 4, 2001)], Pennzoil received a $3 billion settlement from Texaco in a lawsuit involving Texaco’s alleged interference with Pennzoil’s negotiations to purchase Getty Oil stock. Despite the extraordinary nature of the settlement, the Oregon Supreme Court ruled that the settlement proceeds were business income under the transactional test because the settlement arose from Pennzoil’s loss of a contract with Getty Oil and Pennzoil’s attempt to gain access to Getty Oil’s oil reserves was in the regular course of Pennzoil’s petroleum business. In 2004, the Oregon Department of Revenue adopted a regulation which provides that business income includes income of any type or class, and from any activity, that meets either the transactional test or the functional test. [OAR 150-314.610(1)-(A)(2)]

Pennsylvania. In Laurel Pipeline Co. v. Commonwealth [615 A.2d 841 (Pa.

1994)], the Pennsylvania Supreme Court interpreted the applicable state statute (adopted verbatim from UDITPA) as including both a transactional test and a functional test. In this case, the taxpayer realized a gain on the sale of a pipeline, the use of which was discontinued three years prior to the sale. The proceeds from the sale were distributed as a dividend to the corporation’s shareholders immediately after the sale. Both parties agreed that the gain on the sale of the pipeline failed the transactional test. In addition, because the taxpayer was not in the business of buying and selling pipelines and the pipeline was not an integral part of the taxpayer’s business at the time of its sale (its use had been discontinued three year earlier), the court held that the gain was nonbusiness income. [See also Ross-Araco Corp. v. Commonwealth, No. J-224-1995 (Pa. Apr. 18, 1996) (holding that the gain from the sale of undeveloped land from which the taxpayer never derived any rental or royalty income was nonbusiness income).] In 2001, Pennsylvania broadened its definition to include “all income which is apportionable under the Constitution of the United States” [H.B. 334, 2001].

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9203-CH-00045 (Tenn. Oct. 17, 1994)], the Tennessee Supreme Court ruled that a capital gain from the sale of a partnership interest that produced business income prior to its sale was nonbusiness income, because the sale was not a transaction in the regular course of the taxpayer’s trade or business. The Tennessee legislature later amended the statute to incorporate a functional test. [Tenn. Code Ann. §67-4-2004]
Utah. In 2008, the Utah Tax Commission changed its regulatory definition of “business income” to conform to the MTC regulations, which provide that “business income” means income that meets either the transactional test or the functional test. [Rule R865-6F-8, Utah Admin. Code, Sept. 9, 2008]

Tennessee. In Associated Partnership I, Inc. v. Huddleston [No. 01S01-

STUDy QUESTIONS
4. Which of the following best describes the functional test for business income? a. the income arises from transactions and activity in the regular course of the taxpayer’s trade or business. b. the income is derived from tangible or intangible property for which the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations. c. the income arises from a transaction that is frequent in nature, as opposed to a rare and extraordinary event. d. For federal tax purposes, the income is treated as ordinary income rather than as a capital gain. 5. the majority view is that the udItPA definition of business income includes both a transactional and functional test. True or False? a. true b. False 6. Which of the following states does not employ a functional test for business income? a. b. c. d. 7. Alabama Iowa tennessee none of the above

In which of the following cases did the state court determine that the functional test was met with respect to business assets distributed in a partial liquidation? a. b. c. d. Kemppel v. Zaino Phillips Petroleum Co. v. Iowa Department of Revenue Uniroyal Tire Co. v. State Department of Revenue Jim Beam Brands Co. v. Franchise Tax Board

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NONbUSINESS INCOME ALLOCATION RULES

UDITPA Sections 4 through 8 provide rules for allocating nonbusiness income to a specific state. The basic thrust of these rules is that nonbusiness income derived from real and tangible personal property is allocable to the state in which the property is physically located, whereas nonbusiness income derived from intangible property is allocable to the state of commercial domicile (except for royalties, which are allocable to the state where the intangible asset is used).
Rents, Royalties, and Gains from Realty. Nonbusiness rental, royalty, and

capital gain income derived from real property is generally allocable to the state in which the underlying property is located.

Rents and Gains from Tangible Personal Property. Nonbusiness rental and

capital gain income derived from tangible personal property is generally allocable to the state in which the underlying property is located if the income is taxable in that state. If the income is not taxable in the state in which the property is located, a throwback concept applies whereby the income is allocable to the state of commercial domicile. In addition, in the case of movable property, the income is allocated based on the proportionate days of use in each state.

Interest, Dividends, and Capital Gains from Intangibles. Nonbusiness capital gains from the sale of stocks, bonds, and other intangible assets are generally allocable to the state of commercial domicile. Likewise, nonbusiness interest and dividend income is generally allocable to the state of commercial domicile. Royalties from Patents and Copyrights. Nonbusiness royalty income derived from patents or copyrights is usually allocable to the state in which the intangible asset is used if the royalties are taxable in that state. If the royalties are not taxable in the state in which the intangible is used, a throwback concept applies whereby the income is allocable to the state of commercial domicile. For this purpose, a patent is considered used in a state to the extent that it is employed in production, fabrication, manufacturing, or other processing in the state, or to the extent a patented product is produced in the state. If the state in which the patent is used cannot be reasonably ascertained, the income is allocable to the state of commercial domicile. Commercial Domicile. UDITPA defines commercial domicile as “the prin-

cipal place from which the trade or business of the taxpayer is directed or managed.” [UDITPA Section 1(b)] The commercial domicile of a corporation may or may not be the same as the state of incorporation. The MTC comments to UDITPA state that the phrase “‘directed or managed’ is not

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intended to permit both the state where the board of directors meets and the state where the company is managed to claim the commercial domicile. Instead, the phrase ‘directed or managed’ is intended as two words serving the same end, not as two separate concepts.” The phrase commercial domicile was first used by the Supreme Court in Wheeling Steel Corp. v. Fox. [298 U.S. 193 (1936)] Wheeling was a Delaware corporation that challenged the constitutionality of a West Virginia property tax imposed on its intangible assets. The tax was upheld on the basis that the taxpayer’s “actual seat of corporate government” was located in West Virginia and that was where the “management functioned.” In the Matter of the Appeal of Downey Toy Company [No. 306793 (Cal. State Bd. of Equal., Jan. 31, 2008)], the California State Board of Equalization ruled that an investment holding company that was incorporated in Delaware and had no employees or operating assets was commercially domiciled in California, because that was the state from which the company “was managed and controlled and from which it received its greatest benefits and protections.” As a consequence, the corporation’s gain from the sale of a European company was subject to California corporate income tax. The taxpayer had argued that the company had a commercial domicile in Europe, because its only directors and shareholders (Chris Downey and his wife) traveled to Europe on the company’s behalf and managed and controlled the company during those trips.
EXPENSES ATTRIbUTAbLE TO NONbUSINESS INCOME

Generally, if a taxpayer treats an item as nonbusiness income, any interest expense or other expenses attributable to that nonbusiness income cannot be deducted against apportionable business income. In other words, expenses attributable to nonbusiness income may be offset only against the related nonbusiness income. In most cases, a deduction is related only to business income or to nonbusiness income. If a deduction is related to both business and nonbusiness income, it is prorated in a manner which fairly distributes the deduction between the two classes of income. [MTC Reg. IV.1.(d)] California historically required the use of the so-called interest-offset rule [Cal. Rev. & Tax. Code § 24344(b)] to compute the amount of a taxpayer’s interest expense that was attributable to nonbusiness income. In HuntWesson, Inc. v. Franchise Tax Board [120 S. Ct. 1022 (2000)], the Supreme Court ruled that California’s interest-offset rule was unconstitutional. Under California’s interest-offset rule, the amount of interest expense that an out-of-state corporation could deduct against apportionable business income equaled the amount by which the taxpayer’s total interest expense exceeded its nonbusiness interest and dividend income. The purpose of this rule was to prevent an out-of-state corporation from borrowing funds, making investments that generate nonbusiness income that is not subject

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to taxation in California, and then deducting the related interest expense against apportionable business income. The California interest-offset rule effectively assumed that any borrowings were used first to make investments that produce nonbusiness income, even if there was no evidence to support this assumption. The Court concluded that it was not reasonable to expect that a rule that attributed all borrowings first to investments that produce nonbusiness income would accurately reflect the amount of interest expense related to nonbusiness income. Because California’s offset provision was not a reasonable allocation of expense deductions to nonbusiness income, it effectively resulted in taxing the underlying nonbusiness income in violation of the Due Process Clause and Commerce Clause of the U.S. Constitution. California FTB Notice 2000-9 [Dec. 19, 2000] discusses the changes in California’s interest expense allocation policy in light of the Hunt-Wesson decision. In Kroger Co. [No. 69972 (Kan. Nov. 3, 2000)], the Kansas Supreme Court held that the interest expense incurred on a loan to defend against a hostile takeover was a nonbusiness expense and thus could not be deducted against apportionable business income. The taxpayer, an Ohio corporation operating grocery stores in Kansas, borrowed $4.1 billion to pay a special dividend to shareholders. The borrowing resulted in large amounts of interest expense, which the taxpayer deducted on its federal income tax return. Applying the transactional test (Kansas recognized only the transactional test during the years at issue, 1989-1992), the court determined that borrowing money to defend against a hostile takeover is not an expense in the regular course of business, but rather an extraordinary event. As a result, the interest expense was a nonbusiness expense allocable to Kroger’s state of commercial domicile, and not apportionable to Kansas. In American General Realty Investment Corp., Inc. [No. 156726 (Cal. St. Bd. of Equalization, June 25, 2003)], the California State Board of Equalization held that the taxpayer could not deduct interest expenses related to dividends that were not subject to the California corporation franchise tax.
RECENT DEvELOPMENTS
Alabama. In Kimberly-Clark Corporation v. Department of Revenue

[No. 1070925 (Ala. Sup. Ct., Feb. 26, 2010)], Kimberly-Clark (KC) was a manufacturer of paper-related consumer products. In 1962, KC purchased a pulp/paper mill and 375,000 acres of timberland located in Alabama (“Coosa properties”). Production from the Coosa properties constituted the majority of KC’s pulp production. In the early 1990s, KC changed its corporate strategy from being primarily a manufacturer of consumer-paper products to becoming a global consumer-products company. Consistent with its new strategy, KC sought to reduce its dependence on internally

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produced pulp. To further this goal, in 1998, KC sold the Coosa properties for $600 million. Based on its ruling in Uniroyal Tire Company v. State Department of Revenue [779 So.2d 227, 2000] that the state’s statutory definition of business income during the 1990s contained only a transactional test, the Supreme Court of Alabama ruled that KC’s sale of the Coosa properties was an extraordinary transaction that did not generate business income under the transactional test. The Supreme Court of Alabama reasoned that “[i]t is difficult to conceive how the sale of properties that had been operated by the company as part of its business for 34 years and were sold because of a new corporate strategy could be said to be in the ‘regular course of business’ for KC.”
California. In Appeal of Pacific Bell Telephone Co. & Affiliates [No. 521312 (Cal. State Bd. of Equal., Sept. 22, 2011)], the California State Board of Equalization ruled that dividend and capital gain income from the taxpayer’s foreign investments constituted nonbusiness income for California corporation franchise tax purposes, and, therefore, was wholly allocable to Texas, where the taxpayer was commercially domiciled. The Board agreed with the taxpayer’s argument that its foreign investments could not be part of its domestic telecommunications business due to its limited ownership, as well as regulatory, logistical, and technological roadblocks that made it virtually impossible for it to integrate these investments into its regular business operations. The taxpayer further argued that the investments did not allow it to expand or increase its customer base, service offerings, service volume, or operational revenues in any way. Louisiana. In BP Products North America, Inc. v. Bridges [No. 2010 CA 1860 (La. Ct. of App., Aug. 10, 2011)], the taxpayer was engaged in oil and gas exploration, production, transportation, refining and distribution. In 2000, as part of a larger strategic plan of examining all refineries owned by the taxpayer, parent, and other subsidiaries, the taxpayer sold its Louisiana refinery at a $496 million gain and treated the gain as apportionable income. The Department of Revenue argued that the gain was allocable income that was taxable in full in Louisiana, because the taxpayer was not in the business of buying and selling refineries for profit, and the transaction was a one-time asset divesture rather than a sale in the regular course of business. The appellate court rejected the Department’s argument, and held that the gain was apportionable income, because the sale was part of the company’s strategic plan to streamline its refining operations, and because this type of sale was a regular practice of the company. BP had bought and sold many refineries over the years, and neither the taxpayer nor its parent went out of business after this sale or similar sales. The gain from the sale was invested in other segments of the company’s business and was not distributed to shareholders.

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[No. 08-68-MT (Mich. Ct. of Cl., Aug. 16, 2010)], the Michigan Court of Claims held that a parent corporation’s capital gain on the sale of stock of a subsidiary was not includible in the Michigan single business tax base, because there was little evidence of functional integration, centralization of management, and economies of scale.
Pennsylvania. In Glatfelter Pulpwood Co. v. Commonwealth of Pennsylvania [No. 362 F.R. 2007, Pa. Commw. Ct., May 4, 2011], the Pennsylvania Commonwealth Court ruled that the taxpayer’s $55 million gain from the sale of timberland met the definition of business income. The taxpayer was in the business of procuring pulpwood from either company-owned timberland or from unrelated third parties. Based on a business decision, the taxpayer began selling off some of its company-owned timberland, reducing the percentage of pulpwood received from company timber from 25 percent to 5 percent. During the tax year in question, the taxpayer sold off some acres in Delaware and realized a net gain of $55 million. The taxpayer then distributed all of the proceeds from this sale to its parent who then used the funds to pay off debt and to pay dividends. The Delaware sale did not satisfy the transactional test, because it was a one-time event. The taxpayer argued that the sale also did not satisfy the functional test, because it constituted a partial liquidation of a unique aspect of its assets. The court concluded that the sale was not a partial liquidation but rather the disposition of property used in producing business income, in which case the functional test was satisfied.

Michigan. In Reynolds Metals Company LLC v. Department of Treasury

South Carolina. In Emerson Electric Co. v. South Carolina Department of Revenue [No. 27073 (S.C. Sup. Ct., Dec. 12, 2011)], the South Carolina Supreme Court ruled that the taxpayer could not deduct expenses related to dividends received from its subsidiary corporations. The taxpayer conducts much of its business through hundreds of wholly-owned foreign and domestic subsidiaries, from which it receives dividends. The taxpayer properly claimed a dividends received deduction for dividends received from its wholly-owned subsidiaries. Consequently, under the state’s “matching principle,” where income is not taxable in South Carolina, as is the case here, the expenses incurred in generating that income may are not deductible.
Tennessee. In Blue Bell Creameries v. Commissioner, Department of Revenue [No. M2009-00255-SCR11- CV, Jan. 24, 2011], the Tennessee Supreme Court ruled that a $120 million capital gain realized by a subsidiary from a stock redemption qualified as business income. The stock redemption did not satisfy the transactional test, because it was a one-time, extraordinary transaction. However, it did satisfy the functional test, because the acquisition and sale of the stock contributed materially to the production of business

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earnings. The taxpayer was in the business of producing and distributing ice cream, and the stock redemption was part of a reorganization of the business entities that constituted the ice cream business. The reorganization reduced expenses and removed one level of federal taxation on the earnings arising from the ice cream business. Taxation of the gain was also constitutional under the unitary business principle, because the reorganization served an operational function and both subsidiary and the parent derived their income from a single underlying activity.
STUDy QUESTIONS
8. Which of the following types of nonbusiness income is usually allocated to the state of commercial domicile? a. b. c. d. 9. Royalties from realty I Rents from realty Capital gains from intangible property Capital gains from real property

expenses related to nonbusiness income generally can be offset against business income. True or False? a. true b. False

10. under udItPA, nonbusiness royalty income derived from a patent is always allocable to the state of commercial domicile. True or False? a. true b. False

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ModuLe 1: CoRPoRAte InCoMe tAxAtIon — CHAPteR 4

State Treatment of Net Operating Losses
LEARNING ObjECTIvES upon completing this chapter, you should be able to: describe the reasons for differences between state and federal noL deductions explain the impact of mergers and acquisitions on federal and state noL deductions

This chapter explains how a corporation computes its state net operating loss (NOL) deduction. If a corporation has cyclical earnings, the effective tax rate on the corporation’s cumulative net earnings could significantly exceed the statutory tax rate if taxable income is determined on a strict annual basis, in which case losses from one year could not offset profits from another year. To prevent such inequities, Congress enacted Internal Revenue Code (Code) Sec. 172, which permits taxpayers to claim a net operating loss (NOL) deduction against current year taxable income in a carryover year. For federal tax purposes, NOLs can be carried back two years and forward 20 years. Code Sec. 172(b)(3) gives taxpayers the option to forgo the two-year carryback in favor of a carryforward.
FEDERAL vERSUS STATE NET OPERATING LOSS CARRyOvERS

Most states allow NOL deductions, but the specific rules vary from state to state. As a consequence, there is often a difference between the amount of the federal and state NOL deductions. These federal-state differences arise for a number of reasons, including: A corporation generally being required to be subject to tax and to file a state tax return in the year the NOL arises in order to carryover the loss No state provision for NOL carrybacks, and state carryforward periods that are shorter than the 20 year federal carryforward State statutory limitations on the dollar amount of the carryover allowed Different group filing methods for federal and state tax purposes The application of the state NOL deduction on a pre- versus postapportionment basis Depending in part on whether the state uses Line 28 or Line 30 of federal Form 1120 as the starting point for computing state taxable income, the

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requisite adjustments to convert a federal NOL deduction to the state deduction may take the form of an addition and/or subtraction modification.
Carryover Periods. Code Sec. 172 generally permits taxpayers to carry an NOL back two years and forward 20 years and claim as a deduction in the carryover year. Most states allow NOL deductions, but the specific rules vary from state to state. Many states do not permit a carryback, and a number of states have carryforward periods that are shorter than 20 years. These differences are due in large part to state budgetary constraints; in particular, the negative tax revenue consequences of having to pay tax refund claims associated with NOL carrybacks. In addition, as a revenue raising measure, some states have temporarily suspended the NOL deduction. During periods of economic recession, Congress has enacted enhanced carryback periods to infuse cash in the form of tax refunds into the economy. For example, the Job Creation and Worker Assistance Act of 2002 (Pub. L. No. 107-147) extended the carryback period to five years for NOLs arising in taxable years ending in 2001 and 2002. In addition, the American Recovery and Reinvestment Act of 2009 (Pub. L. No. 111-5, Feb. 17, 2009) permitted an eligible small business to elect up to a five-year carryback for an NOL sustained in a tax year beginning or ending in 2008. The Worker, Homeownership, and Business Assistance Act of 2009 (Pub. L. No. 11192, Nov. 06, 2009) significantly broadened the availability of the five-year carryback for NOLs arising in either 2008 or 2009. Federal law allows a taxpayer to forgo the automatic carryback period in favor of an NOL carryforward. [Code Sec. 172(b)(3)] Most states that allow a carryback also permit the election to forgo the state carryback, provided that the taxpayer has made the same election for federal purposes. If a loss corporation is a member of a federal consolidated group, different rules may apply.

EXAMPLE
If the current year’s loss is absorbed in the federal consolidated return, in certain separatecompany return states a state-only election to carry back or carry forward a state noL may be available.

Most states follow the federal rules for paying interest on carrybacks, i.e., no interest is paid if the refund is made within 45 days after the claim for refund is filed. Consequently, a refund claim associated with a state NOL carryback should be filed as soon as possible after the state return reporting the loss is filed.

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STUDy QUESTION
1. Which of the following is not a reason for federal-state differences in noL deductions? a. no federal provision for noL carrybacks b. State carryforward periods of less than 20 years c. different group filing methods for federal and state purposes Impact of Apportionment Percentage. Some

states require that the total NOL generated in a loss year be adjusted by the loss year’s apportionment percentage before it is applied in a carryover year, and then the apportioned NOL is offset against the amount of apportioned income in the carryover year. This is known as a post-apportionment NOL deduction. Other states require that the full amount of the loss year’s NOL be offset against the carryover year’s total apportionable income before applying the apportionment percentage for the carryover year to the net amount of apportionable income. This is known as a pre-apportionment NOL deduction. If there is a major change in the corporation’s state apportionment percentage between the loss year and the carryover year, the amount of the NOL deduction can vary significantly with the method (pre-versus post-apportionment) employed by the state.
EXAMPLE
Assume that in 20x1 Acme Corporation sustains a $100 noL and has a State x apportionment percentage of 50 percent. In 20x2, Acme has taxable income before the noL deduction of $300 and a State x apportionment percentage of 70 percent. If State x applies an noL on a pre-apportionment basis, Acme’s 20x2 taxable income is $140 ([$300 - $100] × 70%). on the other hand, if State x applies an noL on a post-apportionment basis, Acme’s 20x2 taxable income is $160 ([$300 × 70%] - $50]).

Impact of Addition and Subtraction Modifications. Regardless of whether Line 28 or Line 30 of the federal income tax return is used as the starting point in computing state taxable income, each state requires a number of addition and subtraction modifications. Generally, states require that the same modifications used in determining state taxable income be reflected in the computation of a state NOL. Some states have statutory or regulatory provisions mandating that the starting point (i.e., federal taxable income) before state modifications may not be smaller than zero unless an NOL is generated in that year. Therefore, in those states, if the state-specified addition modifications exceed the subtraction modifications in a year in which a federal NOL deduction is being used, the taxpayer may have state taxable income even though it has no federal taxable income for that year.

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Statutory Limitations. Some states impose flat dollar limitations on the amount

of an NOL carryback deduction.
EXAMPLE

utah limits carrybacks to $1 million, and Idaho limits carrybacks to $100,000. Some states impose flat dollar or percentage limitations on noL carryforward deductions.

EXAMPLE
For tax years beginning after 2009, Pennsylvania limits noL carryforward deductions to the greater of $3 million or 20 percent of Pennsylvania taxable income before the noL deduction.

Some states impose temporary limitations on NOL carryforward deductions in response to fiscal constraints.
EXAMPLE
Illinois suspended the noL carryforward deduction for tax years ending on or after January 1, 2011, and prior to december 31, 2012. For tax years ending on or after december 31, 2012, and prior to december 31, 2014, corporations may claim an noL deduction as long as it does not exceed $100,000 per tax year.

Some states permit an NOL deduction only to the extent that such a deduction is allowed in computing federal taxable income. The limitation is illustrated by the Oklahoma Supreme Court’s decision in Utica Bankshares Corp. v. Oklahoma Tax Commission. [892 P.2d 979 (Okla. 1994)] The court held that the federal NOL can be used only to offset federal taxable income in the carryover year and cannot offset state addition modifications in years in which Oklahoma taxable income was greater than federal taxable income. The computation of Oklahoma taxable income begins with federal taxable income, after the NOL deduction. Thus, a state NOL deduction is permissible only to the extent that a deduction is allowed for federal tax purposes.
STUDy QUESTION
2. If a corporation’s state apportionment percentage is higher in the carryforward year than the loss year, then the benefit of an noL carryforward deduction is greater if the state uses the pre-apportionment method rather than the post-apportionment method. True or False? a. true b. False

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Different Federal and State Consolidation Rules. In the case of an affiliated group of corporations filing a federal consolidated return, the computation of a state NOL deduction may be complicated by the use of different group filing methods for state tax purposes, such as separate-company returns, nexus consolidations, or combined unitary reporting. In such cases, the state NOL deduction may be determined on a federal pro forma basis, that is, what the allowable federal NOL carryover or deduction would be if only the separate company or the companies included in the state consolidated or combined return were included in the federal return. In Sovran Bank/D.C. National v. District of Columbia [731 A.2d 387 (D.C. Ct. of App. 1999)], the taxpayer successfully argued that because it was required to file a District of Columbia return on a separate-company basis, the appropriate construction of the District’s NOL provision was to determine NOL carrybacks as if the taxpayer had filed a separate federal return. [See also School Street Associates Limited Partnership et al. and Sovran Bank/D.C. National v. District of Columbia, 764 A.2d 798 (D.C. Ct. of App. Jan. 4, 2001)]. The District codified this decision by allowing NOLs to be computed on a separate-company basis, regardless of how the NOL is used on a federal consolidated return. [D.C. Code Ann. §47-1803.3(a)(14)(E)(ii)] States that permit the filing of a consolidated or combined return may impose restrictions on the use of a specific affiliate’s separate return year NOLs to reduce consolidated taxable income. For example, see Weyerhaeuser USA Subsidiaries v. Alabama Dept. of Revenue [No. CORP. 04-511 (Ala. Dept. of Revenue, Admin. Law Div., Mar. 11, 2005)]. In Golden West Financial Corp. v. Florida Department of Revenue [No. 1D07-0135, 975 (Fla. Dist. Ct., Feb. 19, 2008)], a Florida District Court of Appeal ruled that that a Florida regulation, which prohibited corporations that incurred losses when filing Florida returns on a separate-company basis to share those losses with members of their affiliated group when electing to file on a consolidated basis, was invalid because it impermissibly contravened the specific provisions of the enabling statutes. The Florida Department of Revenue subsequently deleted the invalid provision [Fla. Dept. of Rev., Regs. 12C-1.013, Apr. 14, 2009], and such corporations are now permitted to share Florida NOL carryovers on a consolidated return. North Carolina’s Net Economic Loss Approach.

For North Carolina tax purposes, an operating loss is deductible only if it is a “net economic loss,” rather than a net operating loss. A net economic loss is the amount by which allowable deductions, other than prior years’ losses, exceed income from all sources in the year, including nontaxable income. [N.C. Gen Stat. § 105-130.8].

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NET OPERATING LOSS CARRyOvERS: MERGERS AND ACQUISITIONS
Federal Tax Treatment

When the assets of a corporation that has NOL carryovers (a “loss corporation”) are acquired by another corporation, an important issue for the acquiring corporation is whether it can use the loss corporation’s preacquisition NOLs to offset the earnings from its other business activities. Over the years, Congress has enacted numerous restrictions to prevent the “trafficking in NOLs,” that is, profitable corporations acquiring corporations with NOL carryovers merely as a device to avoid taxes. The principal provisions governing the transfer of NOLs in such situations are Code Secs. 381 and 382. Section 381. Code Sec. 381 provides that an acquiring corporation succeeds to the NOL carryovers of a loss corporation when it acquires the assets of the loss corporation (or target) in one of the following transactions: Subsidiary liquidation under Section 332 Type A reorganization (statutory merger or consolidation) Type C reorganization (acquisition of substantially all of the target’s assets in exchange for the stock of the acquiring corporation) Nondivisive Type D reorganization (acquisition of substantially all of the target’s assets in exchange for stock, where the acquiring corporation distributes the stock it receives) Type F reorganization (change of identity, form, or place of organization) Type G reorganization (acquisition of substantially all of the target’s assets in a bankruptcy proceeding). Section 381 does not apply to: Partial liquidations (where the target remains intact and retains its tax attributes) Type B reorganizations (a stock-for-stock exchange in which the target becomes a subsidiary of the acquirer and retains its tax attributes) Divisive Type D reorganizations (where the tax attributes remain with the transferor in a spin-off, split-off or split-up) Type E reorganizations (recapitalizations, which involve a single corporation) Taxable asset acquisitions (where the tax attributes remain with the target) Taxable stock acquisitions where the new subsidiary is not liquidated (and the tax attributes remain with the target)
Section 382. For transactions in which the acquiring corporation succeeds to the NOL carryovers of the loss corporation (e.g., a statutory merger), Code Sec. 382 may limit the acquiring corporation’s use of the target’s preacquisition NOLs. Section 382 does not disallow an NOL deduction, but

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rather limits the amount of the deduction to the hypothetical future income that would be generated by the loss corporation’s business capital. Limiting the use of the NOLs to the amount that would have been deductible by the loss corporation reflects the policy of Section 382, which is that a change in ownership of the loss corporation’s assets should not make that corporation’s NOL carryovers more or less valuable. The restrictions of Section 382 apply when there has been a substantial change in the stock ownership of the loss corporation. More specifically, Section 382 applies when two requirements are met. First, there has either been a tax-free reorganization (other than a Type F, Type G, or divisive Type D), or a change in the stock ownership of persons owning 5 percent of more of the loss corporation’s stock. Second, the percentage of stock owned by one or more 5-percent shareholders increases by more than 50 percentage points (by value) during a three-year testing period. When the requisite change in stock ownership of the loss corporation has occurred, Section 382 limits the annual amount of NOL deductions available to the acquiring corporation to an amount equal to the fair market value of the loss corporation’s stock before the ownership change multiplied by the federal long-term tax-exempt rate. Thus, Section 382 limits the use of the loss corporation’s pre-acquisition NOLs to the hypothetical future income of the loss corporation, determined as if its stock were sold and the proceeds were reinvested in long-term tax-exempt securities. This federal long-term tax-exempt rate is published monthly by the Internal Revenue Service (IRS), and is computed specifically for the purpose of applying Section 382. Section 382 also imposes a continuity of business enterprise requirement. Specifically, if the acquiring corporation does not continue the business enterprise of the loss corporation at all times during the two-year period following the stock ownership change, no amount of the loss corporation’s pre-acquisition NOLs are deductible.
Other Statutory Restrictions. In addition to Section 382, Congress has enacted

various other restrictions on the carryover of tax attributes in mergers and acquisitions, including Code Secs. 269, 383, and 384. The regulations issued under Code Sec. 1502 also restrict the use of separate return limitation year NOLs in a consolidated tax return. Under Code Sec. 269, the IRS may disallow an NOL carryforward deduction if one corporation acquires another corporation and the principal purpose of the acquisition is to evade or avoid income tax by claiming the benefit of a deduction that would not otherwise be available. Section 269 is the Service’s oldest weapon (first enacted in 1943) against trafficking in NOLs. The primary defense against the Service’s use of Section 269 is to document a good business purpose for the acquisition.

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Code Sec. 383 extends restrictions similar to those found in Section 382 to other types of carryovers, including carryovers of capital losses, general business credits, minimum tax credits, and foreign tax credits. Code Sec. 384 prevents a corporation with unrealized built-in gains from acquiring a loss corporation in order to use the target’s pre-acquisition NOLs to offset its built-in gains. Section 384 provides that during a five-year postacquisition period, the loss corporation’s pre-acquisition NOLs may not offset the recognized built-in gains of the acquiring corporation. Section 384 also prevents an acquiring corporation from offsetting its pre-acquisition NOLs against the built-in gains of the target corporation. Finally, in the case of an affiliated group of corporations filing a consolidated tax return, if a member of the affiliated group acquires the stock of another corporation and the new affiliate joins in the filing of the consolidated return, the consolidated group’s use of the acquired corporation’s pre-acquisition NOLs to offset income generated by other members of the group is limited by the separate return limitation year rules of Treasury Reg. §1.1502-21. A separate return limitation year, or SRLY, generally is a tax year of a subsidiary during which the subsidiary was not a member of the group. Under the SRLY rules, the SRLY losses of one group member may be used to offset income of other group members only to the extent of the SRLY member’s aggregate contribution to the group’s consolidated taxable income.
STUDy QUESTION
3. Which Internal Revenue Code Section is the IRS’s oldest weapon against noL trafficking? a. b. c. d. Code Sec. 269 Code Sec. 382 Code Sec. 383 Code Sec. 384

State Tax Treatment

their tax laws by directly referencing the applicable federal provisions. Those states generally follow the limitations imposed by Code Secs. 381 and 382. Accordingly, if the acquiring corporation is not permitted to carry over the target corporation’s pre-acquisition NOLs for federal purposes, then those pre-acquisition NOLs may not be carried over for state tax purposes. States that use federal Form 1120, line 30 (i.e., federal taxable income net of all deductions, including the federal NOL deduction) as the starting point in computing state taxable income automatically accord a corporation the same NOL treatment for state and federal tax purposes, unless the

General Rules. A number of states incorporate the federal NOL provisions into

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state requires a modification for the federal NOL deduction. Some of the states that use Line 30 of the federal return as the starting point in computing state taxable income have no statutory provisions governing NOL deductions. In those states, an NOL deduction is allowable for state purposes to the extent that the NOL deduction is allowed in computing federal taxable income. By default, these states adopt the provisions of Code Secs. 381 and 382. Even if a state NOL deduction is determined based on the federal provisions or an amount reported on a federal return, the computation of the allowable state NOL deduction may be more complicated if state returns are filed on a separate-company basis or the consolidated or combined group for state tax purposes differs from the federal consolidated group. In either case, the state NOL deduction generally is determined on a pro forma federal basis, that is, the allowable federal NOL deduction determined as if only the corporation filing on a separate-company basis or the group of corporations included in the state consolidated or combined group were included in the federal return. Some states have created their own NOL provisions in lieu of adopting the federal provisions. These states generally permit an NOL to be carried forward in transactions involving tax-free reorganizations. Some of these states, however, have not adopted provisions similar to Code Secs. 381 and 382. In such states, it is possible that NOLs, which do not carry over for federal purposes, do carry over for state tax purposes.
Continuity of business Enterprise Requirement. Even if a state does not impose Section 382-type limitations, it may impose a continuity of business enterprise restriction on the use of pre-acquisition NOLs, in which case NOLs carry over only if the acquiring corporation continues the business enterprise of the loss corporation. In BellSouth Telecommunications, Inc. v. Department of Revenue (No. COA96-558 [N.C. Ct. App., June 3, 1997]), the North Carolina Court of Appeals ruled that a corporation could not deduct a premerger net economic loss of a former subsidiary, because the continuity of business enterprise requirement was not satisfied. Taxpayer in year of NOL Requirement.

Another common state restriction is that a corporation may claim an NOL deduction only if the corporation was doing business in the state in the year the NOL was incurred.
EXAMPLE
If a corporation incurs an noL in year one while doing business in State A, and during year two expands its business to State B, State B may not permit the corporation to deduct the noL carryover from year one.

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The proper application of this restriction to a merger may be uncertain.
EXAMPLE
If a loss corporation is merged into a profitable corporation in a nontaxable statutory merger, for federal tax purposes, the surviving corporation inherits the loss corporation’s pre-merger noLs. In a state that permits an noL carryforward deduction only if the corporation was doing business in the state in the year the noL was incurred, the taxpayer must determine whether this restriction means the surviving corporation was doing business in the state during the loss year or the merged corporation was doing business in the state during the loss year.

In American Home Products Corp. v. Tracy (No. 02AP-759 [Ohio Ct. of App., Mar. 27, 2003]), the Ohio Court of Appeals ruled that the successor corporation in a bankruptcy reorganization could not deduct an NOL carryforward generated by the predecessor corporation, because neither corporation was an Ohio taxpayer in the year the loss was generated.
Restricting NOL Deduction to Corporation That Incurred the Loss. Some states restrict the carryover of a pre-acquisition NOL to the specific corporation that actually generated the loss. In such cases, if a loss corporation is merged into a profitable corporation, the loss corporation’s NOLs may disappear for state tax purposes. In Richard’s Auto City, Inc. v. Division of Taxation (No. A-54 [N.J. Sup. Ct. June 21, 1995]), the New Jersey Supreme Court held that the Division of Taxation regulation limiting post-merger NOL carryovers to the same corporation that originally incurred the loss was valid. Thus, a corporate survivor of a merger could not deduct NOLs incurred by the merged corporation. See also A.H. Robins Company, Inc. v. Division of Taxation (No. A-96-2003 [N.J. Sup. Ct., Dec. 7, 2004]). Likewise, in Little Six Corp. v. Johnson (No. 01-A-01-9806-CH-00285 [Tenn. Ct. App., May 28, 1999]), the Tennessee Court of Appeals held that the surviving corporation in a statutory merger may not deduct NOLs incurred by the merged corporation because the use of such deductions was specifically prohibited by regulation, and an analysis of the applicable statute demonstrated the legislature’s intent that the corporation claiming the benefit of an NOL must be the same corporation that incurred the loss. See also AT&T Corp. v. Johnson (No. M2003-00148-COA-R3-CV [Tenn. Ct. App., Apr. 8, 2004]). In Macy’s East, Inc. v. Commissioner of Revenue (No. SJC-09194 [Mass. Sup. Jud. Ct. May 27, 2004]), the Massachusetts Supreme Judicial Court ruled that the surviving corporation in a merger may not deduct NOLs incurred by the merged corporation. Although the pre-merger

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NOLs carried over and were deductible by the surviving corporation for federal tax purposes, the state regulation that prohibited such carryovers was not unconstitutional.
STUDy QUESTION
4. In which of the following cases was the taxpayer denied an noL deduction because the continuity of business enterprise requirement was not met? a. b. c. d. American Home Products Corp. BellSouth Telecommunications, Inc. Richard’s Auto City, Inc. Little Six Corp. v. Johnson

NET OPERATING LOSS CARRyOvERS: COMbINED REPORTING AND CONSOLIDATED RETURNS
NOLs in a Federal Consolidated Return

Under Code Sec. 1501, an affiliated group of corporations may elect to file a federal consolidated income tax return. Thus, a federal consolidated return is not mandatory, and the members of an affiliated group have the option of filing federal returns on a separate-company basis. A federal affiliated group is defined as one or more chains of includible corporations connected through stock ownership with a common parent that is an includible corporation, provided that the common parent directly owns 80 percent or more of at least one of the other includible corporations, and stock meeting the 80 percent test in each includible corporation other than the common parent must be owned directly by one or more of the other includible corporations. [Code Sec. 1504(a)] An “includible corporation” is any corporation other than an exempt corporation, life insurance company, foreign corporation, Section 936 corporation, RIC, REIT, DISC or S corporation. [Code Sec. 1504(b)]
Offsetting losses of one affiliate against the profits of another. Under the statutory authority provided by Section 1502, the Treasury Department has issued voluminous regulations regarding how an affiliated group computes its consolidated federal income tax liability. These regulations generally adopt the single-entity approach to determining the tax of a consolidated group. Under this approach, the members of a consolidated group are treated as divisions of a single taxpayer. Thus, a major advantage of filing a federal consolidated return is that a net operating loss (NOL) sustained by one group member can offset income earned by other group members in computing consolidated taxable income. [Treas. Reg. §1.1502-11]

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Carryover of CNOL to consolidated return year. In computing its consolidated taxable income, a consolidated group may claim a deduction for the consolidated NOL (CNOL), which is the aggregate of the NOL carryovers to the consolidated return year, as determined under the principles of Section 172, and includes both any CNOLs of the consolidated group, as well as any NOLs of the members arising in separate return years. [Treas. Reg. §1.1502-21(a)] Carryover of CNOL to separate return year. The rules governing the carryover of a

CNOL to a separate return year are found in Treasury Reg. §1.1502-21(b). A CNOL that is attributable to a member may be carried back to a separate return year of that member. However, that same loss may not be carried back to a consolidated return year of the group. The portion of a CNOL that is attributable to a member is determined by a fraction, the numerator of which is the separate NOL of the member for the year of the loss and the denominator of which is the sum of the separate NOLs for that year of all members having such losses. If a corporation ceases to be a member during a consolidated return year, any portion of a CNOL carryforward attributable to the departing member which is not absorbed by the consolidated group in that year may be carried forward to the departing member’s first separate return year. However, that same loss may not be carried forward to a consolidated return year of the group.

Limitations on NOLs from separate return limitation years. If an acquired corporation

joins the acquiring corporation in the filing of a federal consolidated return, the use of the acquired corporation’s pre-acquisition NOLs to offset income generated by other members of the consolidated group is limited by both the separate return limitation year (SRLY) rules of Treasury Reg. §1.150221(c), and the Code Sec. 382 limitation. A SRLY is a tax year of a subsidiary during which the subsidiary was not a member of the consolidated group. Under Section 382, if a more than 50 percentage point change in stock ownership occurs with respect to a loss corporation, the use of the loss corporation’s NOL carryforwards is limited. The Section 382 limitation for a tax year of a loss corporation after an ownership change generally equals the fair market value of the corporation’s stock immediately before the ownership change multiplied by the long-term tax-exempt rate. To simplify the calculation of the loss limitations, Treasury Reg. §1.150221(g) contains an “overlap rule,” under which the Section 382 limitations, rather than the SRLY limitations, apply if certain requirements are met. If, after taking into account the overlap rule, the SRLY limitations apply, an acquired subsidiary’s SRLY losses may be deducted by the consolidated group only to the extent of that member’s cumulative contribution to the group’s consolidated taxable income.

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NOLs in State Combined Reporting and Consolidated Returns

States employ a variety of filing options for groups of commonly controlled corporations, including separate-company reporting, consolidated returns, and combined unitary reporting. Under separate-company reporting, each member of a commonly controlled group of corporations computes its income and files a return as if it were a separate economic entity. Some states permit or require affiliated corporations to file a state consolidated return if certain requirements are met. Combined unitary reporting is a methodology for apportioning the business income of a taxpayer member of a commonly controlled group of corporations that is engaged in a unitary business. In contrast to the federal single-entity approach to determining the tax of a consolidated group, some states treat each member of a combined reporting group (or each affiliate in a state consolidated return) that has nexus in the state as a separate taxpayer that must pay its own tax and file its own return.
EXAMPLE
under California’s combined reporting regime, each “taxpayer member” of the unitary business group (i.e., a member that has income tax nexus in California) generally must separately compute its own tax. Consistent with this separate-entity approach to combined reporting, a California-source noL incurred by one member of the combined reporting group cannot be used to offset the income of other group members in a subsequent tax year. [Calif. Code Regs. tit. 18 §25106.5-(e)]

Consistent with the federal tax regulations, some states have SRLY-type rules that restrict the use of an acquired subsidiary’s pre-acquisition NOLs.
EXAMPLE
oregon requires that if a consolidated oregon return is filed, the SRLY rules found in treasury Reg. §1.1502-1 must be followed. [ore. Reg. oAR 150-317.476(4)]

NET OPERATING LOSSES: RECENT DEvELOPMENTS
Arizona. Effective for tax years beginning on or after January 1, 2012, Arizona

extends its NOL carryforward period from five years to 20 years. [H.B. 2815, May 11, 2012] For tax years beginning in 2011 to 2013, the NOL deduction is limited to $250,000 per year. If the limitation prevents the use of any part of an NOL carryforward in a tax year, then all NOLs carried forward to such tax year may be carried forward one additional year for each tax year the restriction applies. Additionally, any portion of an NOL carryforward

Colorado.

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that cannot be used solely due to the limitation is increased by 3.25 percent per year until the loss is used. [H.B. 1199, Feb 24, 2010]
Illinois.

Illinois suspended the NOL carryforward deduction for tax years ending on or after January 1, 2011, and prior to December 31, 2012. The carryforward period for the suspended NOLs is extended by the number of years that the deduction is suspended. For tax years ending on or after December 31, 2012, and prior to December 31, 2014, corporations may claim an NOL deduction as long as it does not exceed $100,000 per tax year. [S.B. 2505, Jan. 13, 2011; and S.B. 397, Dec. 16, 2011]

Indiana.

Effective January 1, 2012, Indiana eliminated its two-year NOL carryback. [H.B. 1004, May 10, 2011]

New Hampshire. Effective for tax years ending on or after January 1, 2013, for New Hampshire business profits tax purposes, the NOL amount that can be carried forward cannot exceed $10 million. From July 1, 2005, through December 31, 2012, the NOL carryforward limitation was $1 million. [H.B. 242, May 23, 2012]

STUDy QUESTION
5. For California tax purposes, under what circumstances may an noL carryforward for one member of a combined reporting group be used to offset the income of another group member? a. b. c. d. the combined reporting group makes a timely election. the combined reporting group qualifies as a “small business.” the noL is not subject to the federal Section 382 limitation. none of the above

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State Tax Implications of Federal Section 338 Elections
LEARNING ObjECTIvES upon completion of this chapter, you will be able to: explain the federal income tax consequences of making a Section 338 election differentiate between the federal Section 338(g) and Section 338(h)(10) elections describe the state income tax consequences of Section 338(g) and Section 338(h) (10) elections

This chapter explains the state income tax consequences of making an Internal Revenue Code Sec. 338 election.
FEDERAL TAX TREATMENT

operations of another corporation (target) can be accomplished through the purchase of either the target corporation’s assets or the target corporation’s stock. If the acquisition is structured as a taxable asset purchase, the target recognizes gain or loss on the sale of its assets, and the acquirer takes a basis in the assets equal to the purchase price (i.e., market value). In other words, the basis of the acquired assets gets stepped-up or stepped-down to market value. On the other hand, the acquirer does not inherit the net operating loss (NOL) carryforwards, earnings and profits, and other tax attributes of the target corporation. These tax attributes remain with the target, which may use any of its NOL carryforwards to offset the gains from the asset sale. If the acquisition is structured as a taxable stock purchase, once the acquirer obtains a controlling interest in the stock of the target corporation, the acquirer may either continue to operate the target as a separate subsidiary or liquidate the target to obtain direct control of the target’s assets. In a stock purchase where the acquirer then continues to operate the target as a separate subsidiary, only the target shareholders recognize gain or loss. The target corporation does not recognize any gain or loss on the acquisition, there is no change in the basis of the target’s assets, and the target’s NOL carryforwards and other tax attributes remain with the target. If the acquirer liquidates the target, the subsidiary liquidation is generally nontaxable to both the acquirer and target under Internal Revenue Code (Code) Secs. 332 and 337, the target’s basis in its assets carries over to the acquirer (i.e., there

background. The acquisition by one corporation (acquirer) of the business

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is no step-up or step-down to market value), and the target’s tax attributes carry over to the acquirer. A corporation making a qualifying stock purchase also has the option to make a Section 338 election. If the acquirer makes a Section 338 election, the purchase of a controlling interest in the target’s stock is treated as if it were an asset purchase, which means the target recognizes gain or loss on the fictional asset sale, and the acquirer takes a basis in the target’s assets equal to the purchase price of the stock plus the liabilities assumed (i.e., market value). Section 338 reflects the judicial principle that the purchase of a target corporation’s stock in order to obtain the target’s assets should be treated as a single transaction involving the acquirer’s acquisition of the target’s assets (see, e.g., Kimbell-Diamond Milling Co. v. Commissioner, 187 F.2d 718 [CA-5, 1951]). In 1954, Congress codified this principle by enacting Code Sec. 334(b)(2), which in 1982 was replaced by Section 338.
Section 338(g) Election. Under Section 338(g), a corporation that makes a

qualifying stock purchase may elect to have the target corporation treated as if both of the following has occurred: On the stock acquisition date, the target sells all of its assets at fair market value in a single transaction. On the day after the stock acquisition date, the target is a new corporation that purchases all of the old target’s assets. Note that the acquirer acts alone in making a Section 338(g) election and the election has no effect on the seller of the target corporation stock. The acquirer is eligible to make a Section 338(g) election if, within a 12-month acquisition period, the acquirer obtains by purchase at least 80 percent of both the total voting power and total value of the stock of the target corporation. Stock acquired from a related party or stock acquired in a nontaxable transaction (e.g., a Code Sec. 351 transaction) is not taken into account in applying the 80 percent ownership test. The acquirer must make a Section 338(g) election no later than the fifteenth day of the ninth month beginning after the month in which the acquisition date occurs. The acquisition date is the first day during the 12-month acquisition period on which the 80 percent stock ownership requirement is satisfied. The election is made on federal Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases. In effect, a Section 338(g) election results in a hypothetical asset sale by the target corporation (“old target”) to a new corporation (“new target”). The old target must recognize gains and losses on the hypothetical asset sale, after which the old target no longer exists for federal income tax purposes and its tax attributes do not carry over to the new target, but instead expire. Thus, a Section 338 election triggers immediate gain recognition with respect to the target corporation’s appreciated assets. The target’s gains on the deemed

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asset sale are in addition to any gain recognized by the target’s shareholders on the actual sale of the target’s stock.
PLANNING POINTER
Because a Section 338 election triggers immediate gain recognition with respect to the target corporation’s appreciated assets, it is generally not beneficial to make a Section 338(g) election unless the target corporation has noL carryforwards that can be used to offset the gains triggered by the deemed asset sale.

Any gain or loss resulting from the deemed asset sale is included in the final tax return of the old target. That final return covers old target’s final tax year, which ends at the close of the stock acquisition date. When old target is a member of an affiliated group filing a consolidated return, absent a Section 338(h)(10) election (which is discussed in the next section), the old target is disaffiliated from that group immediately before its deemed sale of assets under Section 338(g) and must file a final return on a separate company basis that includes only the gain or loss from the deemed asset sale and certain carryforward items (Treas. Reg. §1.338-10(a)(2)). The separate final return is referred to as a “one-day return.” The new target is considered to be a newly formed corporation for federal income tax purposes, and the basis of the assets acquired from old target gets stepped-up or stepped-down to market value. The acquirer may choose to liquidate the target corporation, but a liquidation is not requirement of Section 338. If the new target is liquidated, the new target’s stepped-up or stepped-down basis in its assets carries over to the acquiring corporation. The price at which the old target is deemed to have sold all of its assets to the new target is referred to as the “aggregate deemed sales price” (Treas. Reg. §1.338-4), whereas the price at which the new target is deemed to have paid to purchase the old target’s assets is referred to as the “adjusted grossed-up basis” (Treas. Reg. §1.338-5). Both amounts are determined by reference to the acquiring corporation’s basis in the target’s stock and the liabilities of old target. To compute its gains and losses, old target allocates the deemed sales price among its assets under rules substantially similar to those applicable to purchase price allocations under Code Sec. 1060, which generally requires the use of the residual method to allocate the purchase price of applicable asset acquisitions among the individual assets purchased. The new target applies the same allocation principles to allocate the deemed sales price among the assets it acquired (Treas. Reg. §1.338-6). Under these principles, the deemed sales price is allocated among seven asset classes in priority order, starting with Class I assets (cash and cash equivalents), then Class II assets, then Class III assets, and so on, with any residual amount allocated to Class VII assets (goodwill and going concern value). The amount

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allocated to a specific asset, other than the Class VII assets, cannot exceed the asset’s fair market value. To report the basis allocation, both old target and new target must attach to their respective federal tax returns Form 8883 (Asset Allocation Statement Under Section 338).
Section 338(h)(10) Election. Section 338(h)(10) provides a special election

that is available when one corporation purchases the stock of another corporation that is either a member of an affiliated group of corporations or an S corporation. As with a Section 338(g) election, a Section 338(h)(10) election triggers a deemed sale of the target corporation’s assets that results in both gain or loss recognition and a step-up or step-down in the basis of the target’s assets. In contrast to a Section 338(g) election, however, the gain or loss on the actual sale of target’s stock is ignored. Therefore, a Section 338(h)(10) election results in a single level of taxation, rather than the two levels of taxation associated with a Section 338(g) election. For this reason, Section 338(h)(10) elections are more popular than Section 338(g) elections. A Section 338(h)(10) election may be made if the target corporation is a member of an affiliated group of corporations, regardless of whether the group members are filing a consolidated return or separate returns. If a Section 338(h)(10) election is made, the stock sale is treated as an asset sale by the old target, followed by the complete liquidation of the old target. In addition, any gain or loss recognized on the stock sale is ignored. The first part of the fiction created by a Section 338(h)(10) election is that the old target is deemed to have sold all of its assets to an unrelated person in a single transaction. If old target was a member of an affiliated group filing a consolidated return (i.e., a “selling consolidated group”), the asset sale is deemed to occur before the close of the acquisition date while old target is still a member of the selling consolidated group, and therefore the gain or loss is included in the selling consolidated group’s federal consolidated return (Treas. Reg. §1.338(h)(10)-1(d)(3)). If the old target was a member of an affiliated group filing separate returns, the gain or loss is included in old target’s separately filed final tax return. The basis of the assets that new target gets stepped-up or stepped-down to market value. The second part of the fiction created by a Section 338(h)(10) election is the deemed liquidation of the old target. After the deemed asset sale but before the close of the acquisition date, and while the old target is a member of the selling consolidated group (or owned by the selling affiliate), the old target is treated as having distributed the sales proceeds to the selling consolidated group or the selling affiliate as part of a complete liquidation to which Code Sec. 332 (nontaxable liquidation of subsidiary) applies, and the tax attributes of the old target carry over to the selling consolidated group or selling affiliate under Code Sec. 381 (Treas. Reg. §1.338(h)(10)-1(d)(4)). A Section 338(h)(10) election also may be made by S corporation shareholders when the stock of the S corporation is purchased by another

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corporation. The gain or loss from the deemed asset sale is included in old target’s separately filed final tax return. The target’s S corporation status continues in effect through the close of the acquisition date. Therefore, the S corporation shareholders take their pro rata share of the deemed sale tax consequences into account under Code Sec. 1366, and increase or decrease their basis in the target corporation’s stock under Code Sec. 1367 (Treas. Reg. §1.338(h)(10)-1(d)(5)). After the deemed asset sale but before the close of the acquisition date, the old target is treated as having transferred all of its assets to the S corporation shareholders as part of a complete liquidation to which Code Sec. 331 (taxable exchange of S corporation stock) applies. Note that unlike a Section 338(g) election, where any gains from the deemed asset sale are taxed to the stock purchaser, a Section 338(h)(10) election causes the stock seller to report and pay the tax on any gains from the deemed asset sale. As a consequence, a Section 338(h)(10) election must be made jointly on Form 8023 by both the seller and the purchaser (Treas. Reg. §1.338(h)(10)-1(c)(3)).
STUDy QUESTIONS
1. If an acquisition is structured as a taxable stock purchase, then: a. the acquirer may either continue to operate the target as a separate subsidiary or liquidate the target. b. target corporation steps up the basis of its assets to fair market value. c. the target’s noLs do not remain with the target, but instead carryover to the acquirer. d. the target recognizes gains or losses equal to the difference between the fair market value and adjusted basis of its assets. 2. Which of the following is a requirement for making a Section 338(g) election? a. Within a 12-month acquisition period, the acquirer must make a qualified purchase of at least 80 percent of the stock of the target corporation. b. the acquirer must make a Section 338(g) election no later than the 15th day of the third month beginning after the month in which the acquisition occurs. c. the election must be made on federal Form 8883. d. the target corporation must be a member of an affiliated group of corporations that file a consolidated return. 3. A Section 338(h)(10) election: a. Results in two levels of taxation b. Is not as popular as Section 338(g) elections c. Results in gain or loss recognition with respect to target’s assets, as well as a step-up or step-down in the basis of those assets d. Can only be made if the target is a C corporation

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STATE TAX TREATMENT

States generally conform to the federal income tax treatment of an election made under Section 338(g). See, for example, California Franchise Tax Board Legal Ruling 2006-03 [May 5, 2006]. Accordingly, for state income tax purposes, the selling corporation recognizes gain or loss on the stock sale, and the target’s deemed asset sale results in both gain or loss recognition and a step-up or step-down in the basis of the target’s assets. Most states also conform to the federal treatment of a Section 338(h) (10) election. As a consequence, for state income tax purposes, a Section 338(h)(10) election causes a deemed sale of the target corporation’s assets that results in both gain or loss recognition and a step-up or step-down in the basis of the target’s assets, whereas the seller’s gain or loss on the actual sale of the target’s stock is ignored.
Inclusion of Gain from Deemed Asset Sale in Apportionable Income. States generally treat the gains and losses resulting from a deemed asset sale under Section 338 as apportionable business income. However, courts in some states have ruled that such gains are specifically allocable nonbusiness income. In Canteen Corp. v. Commonwealth of Pennsylvania [854 A.2d 440 (Pa. Sup. Ct., 2004)], the Pennsylvania Supreme Court ruled that the gains triggered by a Section 338(h)(10) election made in 1994 were nonbusiness income, because the transaction met neither the transactional test nor the functional test for treatment as “business income.” Referring to the standards established in Laurel Pipe Line Comp. v. Board of Finance and Revenue [642 A.2d 472 (Pa. Sup. Ct. 1994)], the court noted that the transactional test was not met, because the “fictional liquidation” of assets stemming from the parent corporation’s Section 338 election is not a type of transaction in which the taxpayer regularly engages. The functional test also was not met because, as in Laurel Pipe, the taxpayer liquidated and distributed the proceeds to its shareholders. In 2001, the Pennsylvania legislature broadened the definition of business income to include “all income which is apportionable under the Constitution of the United States.” In Corporate Tax Statement of Policy 2004-01 [Nov. 9, 2004], the Pennsylvania Department of Revenue announced that due to the statutory amendments to the definition of “business income,” the taxable income generated as a result of a Section 338 election will be treated as business income. In ABB C-E Nuclear Power, Inc. v. Director of Revenue [No. SC87811 (Mo. Sup. Ct., Jan. 30, 2007)], the Missouri Supreme Court ruled that a $227 million gain from the sale and liquidation of a subsidiary in a Section 338(h)(10) transaction was nonbusiness income that was not apportionable to Missouri. The court concluded that the sale and liquidation was not a type of business transaction in which the subsidiary regularly engaged, nor was it a disposition of the sort that constituted an integral part of the subsidiary’s

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ordinary business. Therefore, the transaction was a one-time, extraordinary event that did not generate business income under either the transactional test or the functional test. In American States Insurance Co. v. Illinois Department of Revenue [No. 1-03-1646 (Ill. App. Ct., Aug. 27, 2004)]; appeal denied, No. 99589 [Ill. Jan. 26, 2005]), the Illinois Appellate Court ruled that the gains arising from a Section 338(h)(10) election made in 1997 were nonbusiness income, because the gains were related to the complete liquidation and cessation of business operations, and therefore, the functional test was not met. In Nicor v. Illinois Department of Revenue [No. 1-07-1359 & 1-07-1591 (Ill. App. Ct., Dec. 5, 2008)], the Illinois appellate court ruled that a Section 338(h) (10) election made in 1993 gave rise to nonbusiness income. Relying on the earlier ruling in American States Insurance, the appellate court held that the taxpayer’s sale must be treated as a complete liquidation and cessation of business resulting in nonbusiness income. The court also noted that in 2004, the Illinois Legislature broadened its definition of “business income” to include “all income that may be treated as apportionable business income under the Constitution of the United States.” [S.B. 2207, 2004] As a result, the functional test no longer exists and the arguments raised in this appeal are no longer relevant. In McKesson Water Products Company v. Division of Taxation [No. A-5423-06T3 (N.J. Super. Ct., July 16, 2009)], the New Jersey Superior Court ruled that a gain from the sale of a corporation’s stock that was part of a Section 338(h)(10) transaction was neither operational income nor investment income serving an operational function. As a consequence, the gain was not subject to New Jersey corporation income tax, but instead was non-operational income allocable to the taxpayer’s principal state of business, California. On the other hand, in General Mills, Inc. v. Commissioner of Revenue [440 Mass. 154, 795 N.E.2d 552 (Mass. Sup. Jud. Ct., 2003)], the taxpayer argued that the gains arising from a Section 338(h)(10) election were a federal tax fiction, and the reality of the transaction (i.e., a sale of stock) should be respected, in which case the gains were nonbusiness income. The Massachusetts Supreme Judicial Court rejected the taxpayer’s argument, and ruled that the gains from the deemed asset sale were properly included in the Massachusetts income tax base, consistent with the federal tax treatment of the transaction. Likewise, in S.C. Revenue Ruling No. 09-4 [Mar. 31, 2009], the South Carolina Department of Revenue ruled that if the target subsidiary uses the assets in its trade or business, the gains triggered by a Section 338(h)(10) election are apportionable business income. An exception applies to gains from the deemed sale of real property, which are allocated to South Carolina if the real property is located in South Carolina or to the extent of depreciation

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previously deducted in computing South Carolina taxable income. Also, in Newell Window Furnishing, Inc. v. Johnson [No. M200702176-COA-R3-CV (Tenn. Ct. of App., Dec. 9, 2008)], the Tennessee Court of Appeals ruled that where a corporation sold the stock of its subsidiary and the sale was treated as a sale of assets under Section 338(h)(10), the gain from the deemed asset sale is apportionable business income. In Centurytel, Inc. v. Department of Revenue [No. TC 4826 (Ore. Tax Ct., Aug. 9, 2010)], the Oregon Tax Court ruled that the gain from the sale of stock by a telecommunications company in a Section 338(h)(10) transaction was business income, because the proceeds were used to acquire additional telecommunications assets and to pay debts previously occurred in the business.
Inclusion of Income from Deemed Asset Sale in Sales Factor. Most states ap-

ply their standard apportionment rules to the target corporation’s deemed asset sale, and include either the gross receipts or net gains arising from the deemed asset sale in the target corporation’s sales factor.
EXAMPLE
In Ruling no. 2003-3 [July 14, 2003], the Connecticut department of Revenue ruled that gains arising from a Section 338(h)(10) election are reflected in the target corporation’s sales factor. Likewise, in S.C. Revenue Ruling no. 09-4 [Mar. 31, 2009], the South Carolina department of Revenue ruled that gains arising from a Section 338(h)(10) election are included in the sales factor, except for gains from real property which are treated as allocable income.

In Combustion Engineering, Inc. v. Commissioner of Revenue (No. F228740 [Mass. App. Tax Bd., Mar. 29, 2000]), the Massachusetts Appellate Tax Board ruled that a parent corporation’s gross receipts from the sale of a subsidiary’s stock were not includible in the parent’s sales factor, even though a federal Section 338(h)(10) election resulted in the stock sale being treated as a deemed asset sale, the gains from which were included in apportionable income. In 2004, however, the Massachusetts legislature enacted an amendment which clarifies that starting in 2005, if an acquiring corporation makes a Section 338 election, the target corporation will be treated as having sold its assets for Massachusetts apportionment purposes. [H.B. 4744, Aug. 9, 2004] This amendment effectively reversed the result in Combustion Engineering.
Special Apportionment Rule for Section 338(h)(10) Gains. New Jersey generally requires the gains from a deemed asset sale under Section 338(h)(10) to be allocated and sourced to New Jersey by multiplying the gains by a three-year average of the allocation factors used by a target corporation for

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its three tax return periods immediately prior to the sale. [N.J. Admin. Code 18:7-8.12(g), New Jersey Division of Taxation]
STUDy QUESTIONS
4. In which of the following cases did the state court rule that gains and losses from a deemed asset sale under Section 338 are allocable nonbusiness income? a. McKesson Water Products Company b. General Mills, Inc. c. Newell Window Furnishing, Inc. 5. Generally, the gross receipts or net gains arising from a deemed asset sale under Section 338 are included in the sales factor. True or False? a. true b. False

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Income from Foreign Subsidiaries
LEARNING ObjECTIvES upon completing this chapter, you will be able to: differentiate between water’s-edge and worldwide combined reporting explain how states tax Subpart F inclusions, Section 78 gross-up income, and dividends received from a foreign subsidiary describe the state tax treatment of foreign income taxes

This chapter explains how the states tax income derived from a foreign subsidiary corporation.
FEDERAL TAX TREATMENT
Domestic Consolidation and Deferral. The globalization of business has made state taxation of a domestic corporation’s foreign earnings an important issue. Federal tax law plays an important role in state taxation of a domestic corporation’s foreign earnings because states generally use federal taxable income (federal Form 1120, line 28 or 30) as the starting point for computing state taxable income. Under Internal Revenue Code (Code) Sec. 61, the federal government taxes the worldwide income of a domestic corporation, and allows a credit for the foreign income taxes imposed on foreign-source income. [Code Sec. 901] On the other hand, the federal government generally does not tax the undistributed foreignsource income of a foreign corporation, even if the foreign corporation is a wholly-owned subsidiary of a domestic corporation. [Code Secs. 881 and 882] Moreover, foreign corporations are not includible in a federal consolidated income tax return. [Code Sec. 1504] Consequently, if a domestic corporation operates abroad through foreign subsidiaries, the foreign earnings of those foreign corporations are generally not subject to U.S. taxation until the earnings are repatriated to the U.S. parent through a dividend distribution. This policy, which is known as deferral, is designed to allow U.S. companies to compete in foreign markets on a tax parity with foreign competitors.

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Dividends and Section 78 Gross-up Income. A U.S. parent corporation’s

receipt of a dividend distribution from a foreign subsidiary corporation generally represents the U.S. federal government’s first opportunity to tax the underlying foreign earnings. Therefore, the domestic corporation generally includes any foreign dividends in its federal taxable income [Code Sec. 61], and is not allowed an offsetting dividends-received deduction. [Code Sec. 243] A dividends-received deduction may be available, however, if a 10-percent-or-more-owned foreign corporation distributes a dividend out of earnings that are attributable to income derived from the conduct of a U.S. trade or business or dividends received from an 80-percent-or-more-owned domestic corporation. [Code Sec. 245] To mitigate double taxation of a foreign subsidiary’s earnings, upon receiving a dividend from a foreign subsidiary, a U.S. parent corporation may claim a deemed paid foreign tax credit for the foreign income taxes that a 10 percent-or-more-owned foreign corporation pays on its earnings. [Code Sec. 902] Because the amount of dividend income recognized by a U.S. parent corporation is net of any foreign income taxes paid by a foreign subsidiary, the domestic corporation is implicitly allowed a deduction for those foreign taxes. To prevent a double tax benefit, the domestic corporation must gross up its dividend income by the amount of the deemed paid foreign taxes, which offsets the implicit deduction. [Code Sec. 78] The domestic corporation reports its gross-up income as Dividends on Line 4 of Form 1120 (see Schedule C, Line 15).

Subpart F Inclusions. A policy of unrestricted deferral would create an op-

portunity to avoid U.S. taxes on portable income, such as passive investment income or inventory trading profits, that is easily shifted to a foreign corporation located in a tax haven country. In 1962, Congress attempted to close this loophole by enacting Subpart F (Code Secs. 951-965), which denies deferral to certain types of tainted income earned through a foreign corporation. Code Sec. 951 requires a U.S. shareholder of a controlled foreign corporation (CFC) to include in gross income its share of the CFC’s Subpart F income as well as its share of the CFC’s investment of earnings in U.S. property. A foreign corporation is a CFC if U.S. shareholders own more than 50 percent of the stock of the foreign corporation, by vote or value. [Code Sec. 957] Subpart F income is the sum of its foreign base company income and its insurance income. [Code Sec. 952] Under Code Sec. 954, foreign base company income is the sum of foreign personal holding company income, foreign base company sales income, foreign base company services income, and foreign base company oil related income. A Subpart F inclusion is reported as dividends on Line 4 of Form 1120 (see Schedule C, Line 14).

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STUDy QUESTION
1. Which of the following items of income derived by a domestic corporation would not be taxable for federal income tax purposes? a. dividend distributions received from a foreign corporation b. undistributed (non-Subpart F) foreign earnings of a wholly owned foreign subsidiary c. Section 78 gross-up income d. Foreign-source income from export sales

STATE TAX TREATMENT
Worldwide versus Water’s-Edge Combined Reporting

About 20 states require taxpayer members of a unitary business group to compute their taxable income on a combined basis. These states take one of two general approaches to dealing with unitary group members that are incorporated in a foreign country or conduct most of their business abroad:

1.

2.

Worldwide combination. The combined report includes all members of the unitary business group, regardless of the country in which the member is incorporated or the country in which the member conducts business. Water’s-edge combination. The combined report includes all members of the unitary business group, except for certain unitary group members that are incorporated in a foreign country or conduct most of their business abroad. A common approach is to exclude so-called 80/20 corporations. An 80/20 corporation is a corporation whose business activity outside the United States, as measured by some combination of apportionment factors, is 80 percent or more of the corporation’s total business activity.

Requiring the use of worldwide combined reporting is controversial for a number of reasons, including the following: 1) distortions in the property or payroll factors caused by significantly lower wage rates and/or property values in developing countries; 2) the difficulty of converting books and records maintained under foreign accounting principles and in a foreign currency into a form that is acceptable to the states; 3) the inability of states to readily access or audit records located in foreign countries; and 4) uncertainties about which affiliates are properly included in the unitary group. Despite the practical difficulties of apportioning income on a worldwide basis, the constitutionality of requiring a corporation to compute its state taxable income based on the combined income of a worldwide unitary

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group has been firmly established. In Container Corp. of America v. Franchise Tax Board [463 U.S. 159 (1983)], the Supreme Court held that California’s worldwide combined reporting method was constitutional with respect to a U.S.-based parent corporation and its foreign country subsidiaries. In Barclays Bank plc v. Franchise Tax Board [512 U.S. 298 (1994)], the Supreme Court held that California’s worldwide combined reporting method was also constitutional with respect to a foreign-based parent corporation and its U.S. subsidiaries. California repealed mandatory worldwide combined reporting in 1988 and permits a unitary group to make a water’s-edge election. Although a water’s-edge combination generally reduces the compliance burden, it may also increase the taxpayer member’s state tax liability if the unitary group’s U.S. operations are more profitable than its foreign operations. Although the inclusion of a foreign member’s profits increases the combined income of the group, the inclusion of the foreign member’s property, payroll, and/or sales in the denominators of the apportionment factors generally reduces the state’s apportionment percentage. The net effect can be a reduction in state taxable income if the group’s foreign operations are less profitable than its U.S. operations and an increase in state taxable income if the group’s foreign operations are more profitable than its U.S. operations.
Different state approaches. California, Idaho, Montana, and North Dakota generally require a worldwide combination, but give taxpayers the option to elect a water’s-edge combination. The District of Columbia, Massachusetts, Utah, and West Virginia generally require a water’s-edge combination, but give taxpayers the option to elect a worldwide combination. Alaska requires a water’s-edge combination, except for oil and gas companies, which must use worldwide combined reporting. The other mandatory combined reporting states, such as Illinois, Michigan, and Texas, require a water’s-edge combination. Regardless of whether a water’s-edge combination is mandatory or elective, a key issue is determining which members of the unitary group are excluded. One approach is to exclude any member that is incorporated in a foreign country.
EXAMPLE
oregon requires corporations that are engaged in a unitary business and file a federal consolidated return to file an oregon consolidated return. Because foreign corporations are not includible in a federal consolidated return, they are also not included in an oregon consolidated return. [ore. §317.710] Moreover, a domestic corporation is not excluded from the oregon consolidated return even if it conducts its business operations abroad.

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Another approach is to exclude any member of the unitary group, regardless of the country of incorporation, which qualifies as a so-called “80/20 corporation.” Under this approach, the water’s-edge group excludes a domestic corporation if its average property and payroll within the United States is 20 percent or less, and includes a foreign corporation if its average property and payroll within the United States is more than 20 percent.
EXAMPLE
A Colorado combined report excludes a member if 80 percent or more of its property and payroll are assigned to locations outside the united States. [Colo. §39-22-303]

Some states, such as Massachusetts, take a hybrid approach that looks at both the country of incorporation and the location of business activities. A Massachusetts’ water’s-edge group includes all domestic corporations, as well as any foreign corporation if the average of its property, payroll, and sales factors within the United States is 20 percent or more. [Mass. Ch. 63, §32B] Other variations on the concept of water’s-edge reporting include: Alaska, Montana and West Virginia require the inclusion of tax haven corporations. Montana and North Dakota require taxpayers that make a water’s-edge election to pay tax at a higher rate. Maine and New Mexico require foreign corporations to be included if they are required to file a federal income tax return (i.e., are engaged in a U.S. trade or business). To close a perceived loophole with water’s-edge reporting, Illinois requires a water’s-edge group to add back certain interest and royalty expenses paid to 80/20 corporations in computing its Illinois taxable income. Likewise, Oregon requires a unitary group to add back certain royalties and other intangible expenses paid to a related party that is excluded from the Oregon combined report, such as a domestic retailer paying royalties to a trademark holding company incorporated in Bermuda. [Ore. Reg. OAR §150-314.295] Minnesota requires a combined reporting group to add back interest and intangible expenses paid to a member of the unitary group that qualifies as a foreign operating corporation. [Minn. Stats. § 290.17(4)(i)]
California. If a member of the combined reporting group that is required to

file a California income tax return does not make a water’s-edge election, the California combined report includes the income and apportionment factors of all the members of the unitary business, including corporations organized in foreign countries. For members that are incorporated in a foreign country, the amount included in combined income is generally determined by preparing an income statement in the corporation’s functional currency, making

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adjustments to conform the income amount to U.S. GAAP and California tax accounting standards, and translating the income amount and the related apportionment factors into U.S. dollars. [Calif. Code of Regs. §25106.5-10] In lieu of a California combined report that includes all the members of the unitary business, taxpayer members have the option to make a water’sedge election, under which the income and apportionment factors of foreign (non-U.S.) corporations are generally, but not always, excluded from the combined report. To be eligible to make a water’s-edge election, a taxpayer member must consent to the taking of depositions from key employees or officers of the water’s-edge group and to the acceptance of subpoenas for producing documents. In addition, the taxpayer must agree to treat as apportionable business income any dividends received from (1) a corporation that is more than 50 percent owned by the unitary group and engaged in the same general line of business as the unitary group, and (2) any corporation that is either a significant source of supply for or a significant purchaser of the output of the members of the water’s-edge group, or that sells a significant part of its output or obtains a significant part of its raw materials or input from the unitary business. Significant means an amount equal to 15 percent or more of either input or output. [Cal. Rev. & Tax. Code §25110] A water’s-edge combined report includes the income and apportionment factors of only those members of the unitary group that meet one of the following criteria: 1. 2. 3. 4. 5. Any corporation incorporated in the United States (other than a Code Sec. 936 corporation) if more than 50 percent of its stock is controlled by the same interests; Any corporation, regardless of its country of incorporation, if the average of its property, payroll, and sales factors within the United States is 20 percent or more; Controlled foreign corporation, as defined in Code Sec. 957, but only to the extent of its Subpart F income and the apportionment factors related thereto; Domestic international sales corporation (DISC), foreign sales corporation (FSC), or export trade corporation, as defined in the Code; Any other corporation, but only to the extent of its U.S. located income and factors (e.g., a foreign corporation’s income effectively connected a U.S. trade or business). [Cal. Rev. & Tax. Code §25110]

A water’s-edge election may be terminated without the consent of the Franchise Tax Board (FTB) only after the election has been in effect for at least 84 months. An election may be terminated before the expiration of the 84-month period only with the consent of the FTB. [Cal. Rev. & Tax. Code §25113]

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unitary business group does not include any those members whose business activity outside the United States is 80 percent or more of the member’s total business activity, as measured by its property and payroll factors. [35 Ill. Comp. Stat. §1501(a)(27)] If a foreign (non-U.S.) corporation is not excluded from the unitary business group under the 80/20 rule, Code Sec. 882 limits the foreign corporation’s federal taxable income to the amount of its income effectively connected with a U.S. trade or business. As a consequence, using the foreign corporation’s worldwide apportionment factors to determine how much of its U.S. business income is apportioned to Illinois would not fairly represent that taxpayer’s business activities within Illinois. Accordingly, only the factors related to the foreign corporation’s U.S. business income are included in the numerators and denominators of the Illinois apportionment factors. [86 Ill. Adm. Code §100.3380(e)] A water’s-edge group must add-back certain interest and royalty payments made to 80/20 corporations in computing Illinois taxable income. [Ill. Comp. Stat. Ch. 35, § 203] Examples include interest or royalty payments made by a U.S. affiliate to an offshore financing subsidiary or intangible property company located in a foreign country.
Maine. Maine requires water’s-edge combined reporting. In Irving Pulp & Paper, Ltd. v. Maine State Tax Assessor [No. Ken-04-580 (Me. Sup. Jud. Ct., Aug. 9, 2005)], the Maine Supreme Judicial Court addressed the issue of whether statutory references to property, payroll and sales “everywhere” means a foreign corporation’s worldwide factors or only its factors within the United States. The court ruled that the taxpayer, a Canadian corporation, could not include its worldwide property, payroll, and sales in the denominators of the Maine apportionment factors, because Maine’s water’s-edge method of reporting looks only to a taxpayer’s U.S. activities in determining its taxable income and because Maine taxable income is based on federal taxable income. In the case of a foreign corporation, federal taxable income generally includes only the income effectively connected with the foreign corporation’s U.S. trade or business activities. Massachusetts. Massachusetts permits the taxable members of a combined

Illinois. For purposes of computing the Illinois corporate income tax, a

group (i.e., members that have income tax nexus in the state) to elect to determine their apportioned share of the taxable net income of the combined group on a worldwide reporting basis, which takes into account the income and apportionment factors of all the members includible in the combined group. The worldwide reporting election is binding for 10 years. If the taxable members do not elect worldwide reporting, they must determine their apportioned share of the taxable net income of the combined group on a water’s-edge basis. A Massachusetts’ water’s-edge group includes all domestic corporations, as well as any foreign corporation if the average of its property,

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payroll, and sales factors within the United States is 20 percent or more. [Mass. Ch. 63, §32B] However, an item of income of a foreign corporation is excluded from the income of a water’s-edge group if it is exempt from federal taxation under an income tax treaty. Moreover, a foreign corporation’s inclusion in a combined group is determined only with regard to any items of income that are not exempt, taking into account items of expense and apportionment factors associated with such items of nonexempt income to the extent provided by regulation. [S.B. 2582, Aug. 5, 2010]
Michigan. A Michigan combined report is limited to U.S. persons, as defined in Code Sec. 7701(a)(30). [Mich. Comp. Laws §208.1117] Foreign (non-U.S.) corporations are not includible in the unitary business group. [Mich. Comp. Laws §208.1511]A U.S. person that qualifies as a “foreign operating entity” is also not included in a unitary business group. [Mich. Comp. Laws §208.1117(6)]A “foreign operating entity” is a U.S. person (e.g., a corporation organized in the United States) that would otherwise be a part of a unitary business group but has substantial operations outside the United States, and at least 80 percent of its income is active foreign business income. [Mich. Comp. Laws §208.1109(5)]

conducts business outside the United States is excluded from a Texas combined report if 80 percent or more of its property and payroll are assigned to locations outside the United States. If either the property factor or the payroll factor is zero, the denominator is one. If a taxable entity that conducts business outside the United States has no property or payroll, the entity is excluded from the combined report if 80 percent or more of its gross receipts are assigned to locations outside the United States. [Tex. Tax Code §171.1014(a)]
West virginia. Water’s-edge combined reporting is the default method in West Virginia. Taxpayers have the option, however, to elect to file on a worldwide combined reporting basis. The election is binding for 10 years, and may be withdrawn only upon a written request to the Tax Commissioner for reasonable cause based on extraordinary hardship. [W. Va. Code §11.24]

Texas. For purposes of computing the Texas margin tax, a taxable entity that

STUDy QUESTION
2. Which of the following statements is true? a. Combined reporting states all require a worldwide combination. b. the u.S. Supreme Court has ruled that states may require worldwide combined reporting. c. Making a water’s-edge election always results in a lower state income tax liability. d. All states that impose corporate income taxes require combined reporting.

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Dividends from Foreign Subsidiaries

Most states do not permit worldwide combined reporting, in which case the foreign income of a foreign subsidiary is not included in the U.S. parent corporation’s state taxable income until those earnings are distributed as a dividend. Thus, consistent with the federal policy of deferral, a state’s first opportunity to tax the foreign income of a foreign subsidiary is generally when those earnings are repatriated by the U.S. parent corporation as a dividend.
Inclusion in Apportionable Income. Assuming either the activities of the foreign corporation or the stock of the foreign corporation is a unitary part of the business conducted by the U.S. parent in the states in which the parent has nexus, the dividend is included in the parent’s apportionable business income. [See MeadWestvaco Corporation v. Illinois Department of Revenue (553 U.S. 16, 2008), and Allied-Signal, Inc. v. Director, Division of Taxation (504 U.S. 768, 1992)] On the other hand, if the activities and the stock of the foreign corporation have nothing to do with the activities of the U.S. parent in the taxing state, then the dividend may be nonbusiness income that is allocable only to the U.S. parent’s state of commercial domicile. In Mobil Oil Corp. v. Commissioner of Taxes [445 U.S. 425 (1980)], the Supreme Court addressed the issue of whether dividends from foreign corporations are includible in a U.S. parent corporation’s apportionable business income. Mobil was a vertically integrated petroleum company that was commercially domiciled in New York. Mobil argued that Vermont could not constitutionally tax the dividends that Mobil received from its foreign subsidiaries, because the activities of the foreign subsidiaries were unrelated to Mobil’s activities in Vermont, which were limited to marketing petroleum products. Stating that “the linchpin of apportionability in the field of state income taxation is the unitary business principle,” the Supreme Court ruled that Vermont could tax an apportioned percentage of the dividends, because the foreign subsidiaries were part of the same integrated petroleum enterprise as the business operations conducted in Vermont. In other words, dividends received from unitary subsidiaries are business income. The Court also noted that if the business activities of the foreign subsidiaries had “nothing to do with the activities of the recipient in the taxing state, due process considerations might well preclude apportionability, because there would be no underlying unitary business.”

generally limits its dividends-received deduction to dividends received from domestic corporations, most states provide a deduction for dividends received from both domestic and foreign corporations. For example, consistent with how they treat domestic dividends, many states provide a

Dividends-Received Deductions. In sharp contrast with federal law, which

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100 percent deduction for dividends received from an 80-percent-or-moreowned foreign corporation. In Kraft General Foods, Inc. v. Department of Revenue [505 U.S. 71 (1992)], the Supreme Court ruled that an Iowa law that allowed taxpayers to claim a dividends-received deduction for dividends from domestic, but not foreign, subsidiary corporations was unconstitutional. During the years in question, Iowa conformed to the federal dividendsreceived deduction. As a consequence, Iowa did not tax dividends received from domestic corporations, but did tax dividends received from foreign corporations unless the dividend represented a distribution of U.S. earnings. The Court ruled that the Iowa provision which taxed only dividends paid by foreign corporations out of their foreign earnings facially discriminated against foreign commerce, in violation of the Commerce Clause. Since the Kraft decision, a number of state courts have also struck down dividends-received deduction provisions that favored dividends received from domestic corporations over dividends received from foreign corporations. In Dart Industries, Inc. v. Clark [657 A.2d 1062 (R.I. Sup. Ct., 1995)], the Rhode Island Supreme Court ruled the Rhode Island provision that allowed a deduction for dividends from domestic but not foreign subsidiaries was discriminatory in violation of the Commerce Clause. Likewise, in D.D.I Inc. v. North Dakota [657 N.W.2d 228 (N.D. Sup. Ct., 2003)], the North Dakota Supreme Court declared unconstitutional a North Dakota statute that permitted a dividends-received deduction, but only to the extent the dividend payer’s income was subject to North Dakota corporate income tax. In Hutchinson Technology, Inc. v. Commissioner of Revenue [698 N.W.2d 1 (Minn. Sup. Ct., 2005)], the Minnesota Supreme Court ruled that a state statute that excluded dividends paid by certain foreign sales corporations from the state’s dividends-received deduction was discriminatory in violation of the Commerce Clause. In Emerson Electric Co. v. Tracy [735 N.E.2d 445 (Ohio Sup. Ct., 2000)], the Ohio Supreme Court declared unconstitutional an Ohio statute that permitted a 100 percent deduction for dividends from domestic subsidiaries, but only an 85 percent deduction for dividends from foreign subsidiaries. In Conoco Inc. v. Taxation and Revenue Department [122 N.M. 736 (N.M. Sup. Ct., 1996)], the New Mexico Supreme Court ruled that the New Mexico scheme under which foreign but not domestic dividends were included in the tax base facially discriminated against foreign commerce, even through the state allowed a taxpayer to include a portion of the dividend-paying foreign subsidiaries’ property, payroll, and sales in the denominators of its apportionment factors, thereby reducing the state apportionment percentage.

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STUDy QUESTION
3. Which of the following is not true with respect to state dividends-received deductions? a. States generally allow dividends-received deductions for dividends received from foreign corporations. b. dividends from foreign corporations are always treated as nonbusiness income. c. In Kraft, the u.S. Supreme Court ruled that an Iowa law that allowed a dividends-received deduction for dividends from domestic corporations but not from foreign corporations was unconstitutional. d. In Emerson Electric Co. v. Tracy, the ohio Supreme Court ruled that an ohio statute that permitted a 100 percent deduction for dividends from domestic subsidiaries, but only an 85 percent deduction for dividends from foreign subsidiaries was unconstitutional.

Dividends-Received Deductions in a Water’s-Edge Combined Report. In foot-

note 23 of its decision in Kraft, the Supreme Court stated:

If one were to compare the aggregate tax imposed by Iowa on a unitary business which included a subsidiary doing business throughout the United States (including Iowa) with the aggregate tax imposed by Iowa on a unitary business which included a foreign subsidiary doing business abroad, it would be difficult to say that Iowa discriminates against the business with the foreign subsidiary. Iowa would tax an apportioned share of the domestic subsidiary’s entire earnings, but would tax only the amount of the foreign subsidiary’s earnings paid as a dividend to the parent. The state supreme courts in several water’s-edge combined reporting states have focused on this footnote and ruled that it is constitutionally acceptable to include dividends paid by foreign subsidiaries in the tax base, while excluding dividends paid by domestic subsidiaries that are included in the water’s-edge combined report. In Appeal of Morton Thiokol, Inc. [864 P.2d 1175 (Kan. Sup. Ct., 1993)], the Kansas Supreme Court noted that Kraft did not address the taxation of foreign dividends by water’s-edge combined reporting states (because Iowa is an elective consolidation state), and that “the aggregate tax imposed by Kansas on a unitary business with a domestic subsidiary would not be less burdensome than that imposed by Kansas on a unitary business with a foreign subsidiary because the income of the domestic subsidiary would be combined, apportioned, and taxed while only the dividend of the foreign subsidiary would be taxed.” Likewise, in E.I. Du Pont de Nemours & Co. v. State Tax Assessor [675 A.2d 82 (Maine Sup Ct., 1996)], the Maine Supreme

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Judicial Court held that Maine’s water’s-edge combined reporting method was distinguishable from the Iowa’s single-entity reporting method because the income of a domestic subsidiary is included in the Maine combined report. Therefore, taxing dividends paid by foreign but not domestic subsidiaries did not constitute the kind of facial discrimination found in the Iowa system. Finally, in General Electric Company, Inc. v. Department of Revenue Administration [No. 2005-668 (N.H. Sup. Ct., Dec. 5, 2006)], GE challenged the constitutionality of a New Hampshire statute that permits a U.S. parent corporation to claim a dividends-received deduction for dividends received from foreign subsidiaries only to the extent the foreign subsidiary has business activity and is subject to tax in New Hampshire. None of GE’s unitary foreign subsidiaries had business activities in New Hampshire during the tax years in question. Thus, it could not claim a dividends-received deduction for the dividends received from those foreign subsidiaries. The New Hampshire Supreme Court ruled that the New Hampshire tax scheme did not discriminate against foreign commerce because both a unitary business with foreign subsidiaries operating in New Hampshire and a unitary business with foreign subsidiaries not operating in New Hampshire are each taxed only one time. Thus, there was no differential treatment that benefits the former and burdens the latter.
Apportionment Factor Relief. The inclusion of dividends received from a

foreign subsidiary in the apportionable income of a U.S. parent corporation raises the issue of whether the parent’s apportionment factors should reflect the foreign subsidiary’s property, payroll, and sales. In his dissent in Mobil Oil Corp., Justice Stevens raised the issue of factor representation, noting that “[u]nless the sales, payroll, and property values connected with the production of income by the payor corporations are added to the denominator of the apportionment formula, the inclusion of earnings attributable to those corporations in the apportionable tax base will inevitably cause Mobil’s Vermont income to be overstated.” In NCR Corp. v. Taxation and Revenue Department [856 P.2d 982 (N.M. Ct. App. 1993), cert. denied, 512 U.S. 1245 (1994)], the New Mexico Court of Appeals rejected the taxpayer’s argument that the taxation of dividends received by a U.S. parent corporation from its foreign subsidiaries without factor representation resulted in constitutionally impermissible double taxation. Similar arguments made by NCR were also rejected by state supreme courts in Minnesota and South Carolina [NCR Corp. v. Commissioner of Revenue, 438 N.W.2d 86 (Minn. Sup. Ct., 1989), cert. denied, 493 U.S. 848 (1989); NCR Corp. v. Tax Commission, 439 S.E.2d 254 (S.C. Sup Ct., 1993), cert. denied, 512 U.S. 1245 (1994)]. Caterpillar, Inc. also litigated the issue of factor representation with respect to dividends received from foreign subsidiaries, and met with limited success. See, for example, Caterpillar, Inc. v. Commissioner of Revenue [568 N.W.2d

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695 (Minn. Sup Ct., 1997), cert. denied, 522 U.S. 1112 (1998)], and Caterpillar, Inc. v. Department of Revenue Administration [741 A.2d 56 (N.H. Sup Ct., 1999), cert. denied, 120 S. Ct. 1424 (2000)]. Finally, in Unisys Corp. v. Commonwealth of Pennsylvania [812 A.2d 448 (Pa. Sup. Ct., 2002)], the Pennsylvania Supreme Court ruled that factor representation was not constitutionally required because the taxpayer failed to prove that the state was unfairly taxing income earned outside its jurisdiction.
Section 78 Gross-up and Subpart F Inclusions

The rationale for including the Code Sec. 78 gross-up amount in federal taxable income does not apply for state tax purposes because no state allows a domestic corporation to claim a credit for the foreign income taxes paid by a foreign subsidiary. As a consequence, nearly all states provide a subtraction modification or dividends-received deduction for Section 78 gross-up income, in effect, excluding the federal gross-up amount from state taxation. In Amerada Hess Corp. v. North Dakota [704 N.W.2d 8 (N.D. Sup. Ct., 2005)], the North Dakota Supreme Court ruled that Section 78 gross-up amounts did not qualify as “foreign dividends” under the applicable North Dakota tax statute, and therefore did not qualify for the partial exclusion from income under North Dakota water’s-edge combined unitary reporting method of determining the state corporate income tax. Consistent with the notion that a Subpart F inclusion is a deemed dividend from a controlled foreign corporation, most states provide a dividends-received deduction or subtraction modification for income under Subpart F. California does not provide a dividends-received deduction for Subpart F income, but instead requires that the income and related apportionment factors of a controlled foreign corporation be included in a water’s-edge combined report to the extent of the controlled foreign corporation’s Subpart F income. [Cal. Rev. & Tax. Code §25110] In addition, some states provide only limited deductions for inclusions in gross income under Subpart F. For example, an Idaho water’s-edge group may claim only an 85 percent deduction [Idaho Code Ann. §63-3027C], and a Utah water’s-edge group may claim only a 50 percent deduction [Utah Code Ann. §59-7-106].
Check-the-box Foreign branches

If a domestic corporation operates abroad through an unincorporated foreign branch rather than a separately incorporated subsidiary, the foreignsource income of the foreign branch represents income earned directly by the domestic corporation. Historically, U.S. companies generally have not operated abroad through an unincorporated branch for many reasons, including the desire for limited liability or to have a local corporate presence. Since the check-the-box regulations [Treas. Reg. § 301.7701] took effect

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in 1997, however, it has been possible to organize a foreign entity that is recognized as a separate corporation for foreign tax purposes but is treated as a disregarded entity or partnership for U.S. tax purposes. States generally conform to the federal check-the-box rules for state income tax purposes. Thus, a foreign entity that is a corporation for foreign tax purposes but is a branch or partnership for U.S. federal tax purposes is generally treated as a branch or partnership for state income tax purposes. In Manpower Inc. v. Commissioner of Revenue [No. A06-468 (Minn. Sup. Ct., Dec. 7, 2006)], a domestic corporation owned 99 percent of Manpower France S.A.R.L (MPF), a French entity analogous to a U.S. limited liability company. In 1999, MPF made a federal check-the-box election, which caused the liquidation of a foreign corporation (MPF’s previous federal tax status) and a contribution of the distributed assets to a new partnership. For Minnesota tax purposes, income of “foreign corporations and other foreign entities” is not included in apportionable income. The Commissioner argued that when the French subsidiary elected to be classified as a partnership for federal tax purposes, a newly formed partnership was created under U.S. law. The taxpayer argued that, despite the federal check-the-box election, MPF still qualified as a “foreign entity” for Minnesota tax purposes, because it was created in France under French law and operated in France. The Minnesota Supreme Court agreed, ruling that the check-the-box election changed the French entity’s legal nature but not its nationality. The subsidiary was still a foreign entity, and the only effect of its check-the-box election was to convert it from a foreign corporation to a foreign partnership for federal income tax purposes.
Treatment of Foreign Income Taxes

For federal tax purposes, a domestic corporation may claim either a deduction or a credit for foreign income tax payments, but not both [Code Secs. 164, 275 and 901]. If the taxpayer elects to claim a foreign tax credit, the credit is limited to the portion of the domestic corporation’s pre-credit U.S. tax attributable to its foreign source taxable income [Code Sec. 904]. A domestic corporation that receives a dividend from a 10 percent-or-moreowned foreign corporation may also claim a deemed paid foreign tax credit for the portion of the foreign corporation’s foreign income taxes which are attributable to the dividend [Code Sec. 902]. When a domestic corporation claims a deemed paid foreign tax credit, it must gross up its dividend income by the amount of the deemed paid foreign income taxes [Code Sec. 78]. In contrast to federal law, no state allows a credit for foreign income taxes. However, some states allow a deduction for foreign income taxes, but generally only if a deduction is claimed for federal tax purposes. For federal tax purposes, taxpayers generally elect to claim a foreign tax credit under Code Sec. 901 rather than a deduction under Code Sec. 164, because a

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credit is usually more valuable than a deduction. A handful of states allow a deduction even if the taxpayer claims the credit for federal tax purposes. Many states, such as California, do not permit a deduction for foreign income taxes, regardless of whether a deduction or a credit is claimed for federal tax purposes [Cal. Rev. & Tax. Code §24345].
STUDy QUESTION
4. Which of the following statements is true? a. Some states permit a corporation to deduct foreign income taxes if a deduction is claimed for federal tax purposes. b. States generally do not conform to the federal check-the-box rules for income tax purposes. c. States generally allow a corporation to claim a deemed paid foreign tax credit when it receives a dividend from a foreign subsidiary.

CPE NOTE: When you have completed your study and review of chapters 1–6, which comprise Module 1, you may wish to take the Quizzer for this Module. Go to CCHGroup.com/PrintCPE to take this Quizzer online.

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Pre-Audit Strategies and Opportunities
LEARNING ObjECTIvES upon completion of this chapter, you will be able to: Identify the issues involved in scheduling an audit explain when and how to negotiate with an auditor determine how to control the information flow between the taxpayer and the auditor State the broad categories of exemptions; and utilize confirmation letters determine when a taxpayer should agree to a waiver of the statute of limitations explain how and why self-audits and reverse audits should be performed, and how they differ Identify the refund claim procedures and record retention issues determine how to respond to audit and nexus questionnaires utilize voluntary disclosure agreements and available amnesty programs

INITIAL AUDIT CONTACT AND THE AUDIT TONE
Overview

The initial contact in an audit is extremely important, as it sets the tone for the remainder of the audit. The challenge in the early stages of the audit is to take steps that will help a taxpayer gain a measure of control over the audit process. Although it is not possible to completely control the audit process, communicating to the auditor an intention to be cooperative and professional but also firm and knowledgeable can contribute to the success of the audit. State statutes confer broad authority on the state to audit a taxpayer’s records. In a system that relies heavily on voluntary compliance, the state must have substantial authority to audit taxpayers so that compliance can be verified. A weak state audit function would likely result in large-scale evasion.
PLANNING POINTER
Be sure to document key compliance positions and retain the documentation for use in future audits. Many taxpayers fail to adequately document their filing positions and over time forget significant issues that could be asserted upon audit in defense of the position.

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CAUTION
Auditors generally have administrative subpoena powers that give them the authority to compel taxpayers to produce information. However, this authority is rarely exercised. It is generally reserved for extremely uncooperative taxpayers.

Scheduling the Audit

Understanding the audit plan, as well as the time constraints that it places on an auditor, can have significant implications for the outcome of the audit. For example, delaying the discussion of a difficult topic until later in the auditor’s visit may result in less focus on sensitive details due to the auditor’s need to wrap up the audit to remain on schedule. Likewise, providing an auditor with a refund claim toward the end of an audit may result in a more limited review of the refund claim. Therefore, taxpayers should carefully consider the timing of the disclosure of important transactions or activities.
PLANNING POINTER
It is important to make the auditor aware early in the process that a refund claim is being prepared, so that they can build time into their schedule to review the refund documentation. However, there is no obligation to provide the auditor with the refund claim early in the field work.

Depending upon the taxpayer and the level of activity in a particular jurisdiction, an audit can take anywhere from a few days to several months, or even years to complete. Most auditors have a limited amount of time to complete the audit. Time limits are used to measure their efficiency. In addition, constraints related to travel can limit the amount of time an auditor has to spend on an audit.
EXAMPLE
States frequently purchase nonrefundable airline tickets for their auditors. this makes it difficult for an auditor to expand the scope of his or her review without returning for an additional period of time. If an additional period cannot be scheduled for several weeks or months, the audit will remain open the entire time. Consequently, auditors must evaluate whether there are sufficient issues to warrant another trip.

Of course, the scheduling issue is not a factor in every audit. Auditors often have great latitude in the scheduling and execution of their audit. Therefore, each audit must be evaluated early in the process and an appropriate decision made regarding the auditor’s time to complete the audit. As mentioned above,

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an audit can take anywhere from a few days to a few years to complete. Several factors that can affect the duration of an audit: Size of the taxpayer Relative operations in the state Scope of activities in the state
EXAMPLE
Auditing a large manufacturing operation will take considerably longer than auditing a sales office because of the significantly greater number of potentially taxable transactions that have to be reviewed and the complexity of the transactions.

The greatest amount of time will be spent from the point of sample selection and transaction review through the providing of a preliminary assessment. This portion of the audit is time consuming because it involves the manual review of the transactions on an individual basis and the negotiation of the final taxable amounts with the auditor. An auditor can question hundreds or even thousands of transactions. Each one must then be reviewed by the taxpayer and a determination made as to whether tax is due or an exemption applies.
PLANNING POINTER
Working with the auditor on sample size can have a significant impact on the workload of the audit. By trying to include as many transactions in the sample as possible, the level of detailed review can be reduced. of course, taxpayers need to make certain that the increases in the sample size do not jeopardize a favorable audit settlement.

PLANNING POINTER
When scheduling an audit, you must allow time to respond to the auditor’s requests for information and resolve open issues. It may not be prudent to schedule one audit immediately following another if you will not have the opportunity to resolve questions from the earlier audit.

Arguably, there is never a convenient time to undergo an audit. The intense scrutiny and the exposure to additional expense make the situation stressful under the best of circumstances. However, as an audit may not be delayed indefinitely, the issue is when it will be least disruptive to the taxpayer’s schedule. While auditors have a great deal of authority regarding the timing of an audit, taxpayers have rights to exert as well.

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EXAMPLE
A taxpayer who knows that the first quarter is the busiest time of year in the tax department can refrain from scheduling an audit during this time. A taxpayer who is fully scheduled with audits can suggest a later date that is more convenient.

Although there may be pressure to hastily schedule an audit, doing so can be unwise. Not being able to devote the necessary time to resolving audit issues can aggravate the auditor and adversely impact the final assessment. Delaying the start of an audit because of workload constraints may be preferable to impeding the auditor during the course of the audit.
PLANNING POINTER the following factors should be considered when scheduling an audit: Anticipated effort required to complete the audit Availability of personnel to work on the audit Workload of individuals who will be assigned to the audit Auditor’s schedule and anticipated length of stay Company position on the issuance of a waiver of the statute of limitations if the auditor requests one in exchange for a delay in the start of the audit Prior audit experience with the state

Additional factors can enter into a decision regarding the scheduling of an audit. A situation that can create urgency to schedule an audit is a visit by an auditor who rarely comes to a particular locale. Auditors sometimes visit an area for an open-ended period of time. In such a case, it is more difficult to refuse a request for audit scheduling or delay the commencement of an audit due to taxpayer inconvenience. The taxpayer’s convenience is generally subordinated to the state’s right to perform the audit because of the scheduling problem that would ensue if the auditor were unable to perform the audit while in the vicinity of the taxpayer. Therefore, in scheduling an audit with an out-of-state auditor, the taxpayer must determine whether the auditor is under this time constraint. If so, it may not be possible to refuse the audit appointment, unless the auditor’s request is unreasonable. The auditor will insist that he or she be allowed to perform the audit, unless it is absolutely impossible, which is generally not the case.
EXAMPLE
Contacting a taxpayer several months before year-end to request an audit appointment under most circumstances would appear to be a reasonable request, while contacting a taxpayer at thanksgiving to request an audit before year-end would not generally be considered a reasonable request.

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CAUTION
It is rarely impossible to accommodate a request for an audit, particularly if the request is made several weeks or months in advance. Since auditors possess the threat of a jeopardy assessment, taxpayers can be forced to schedule the audit, even if the timing is not optimal from their perspective.

To reduce the scope of the audit when time constraints exist, a taxpayer should use the following strategies:
Compress fieldwork through the use of assist reports and systems support.

Companies can often provide special reports to augment the auditor’s review or to assist the taxpayer in responding to requests. Forward records to the auditor after some preliminary review to allow the auditor to complete portions of the fieldwork at the office.
CAUTION
this approach can pose risks for the taxpayer by providing the auditor with unlimited time to review transactions and contact vendors, and it should only be used in areas where the taxpayer anticipates limited exposure.

Have the taxpayer perform some portion of the work, subject to auditor review.

In this approach, sometimes called a managed audit the taxpayer performs the more mundane tasks associated with the audit, typically in exchange for penalty and interest relief. The taxpayer and auditor agree to the areas of review after some preliminary analysis by the auditor. The taxpayer then reviews the transactions in areas identified by the auditor and prepares a summary of errors for the auditor. Once the errors have been agreed upon by both parties, an audit assessment is prepared.
CAUTION
taxpayers choosing approaches such as this need to be aware of the legal implications. Failure to identify transactions or areas of exposure in a voluntary program could have serious consequences.

In addition, many taxpayers have expressed concern about the additional workload that would be required for them, rather than the state auditor, to complete the audit. For these reasons, it appears that many companies are relying on the traditional approach and requiring the auditor to perform the fieldwork, despite any incentives that may be available from the state.

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Identify transactions that may be excluded from review for some reason and propose the exclusions to the auditor.

Very often, certain classes of transactions, such as those involving office supplies, shop supplies, or advertising materials, can be audited using alternative procedures because of the way the transactions are recorded on the books of the taxpayer. Eliminating the detailed review of these transactions by voucher and auditing by an allocation or distribution procedure or report can eliminate a substantial amount of work. For taxpayers that have special procedures in place to handle certain transactions, the risk of duplicate assessment is reduced by using these procedures. However, care must be exercised to exclude these transactions from the general voucher review to avoid doubling up on the assessment for those transactions.
Employ greater use of sampling to reduce the amount of transactional review.

If possible, suggest an alternative sampling methodology to the auditor that will reduce the effort required to complete the audit and still provide a valid result. One common criticism of state audit samples is that they oversample to obtain a result that the taxpayer will accept. A sample of several thousand transactions achieves the same audit result as a sample of several hundred transactions in a properly constructed sample. However, states are reluctant to reduce sample size for fear that the taxpayer will not accept the audit results. Note that some of the strategies discussed above may not apply in all situations. An auditor is likely to agree to alternative procedures only when the risk presented by unaudited transactions is minimal. The state may be unwilling to deviate from its established sampling techniques regardless of the reasons. In most cases, the states have only significantly altered sampling practices when current cases have forced the change. When a taxpayer’s only activity in the state is a sales office with few assets or other purchases, the auditor might be inclined to shorten the review time through the use of an alternative procedure.
Negotiations

The majority of negotiation activity occurs in the latter stages of the audit fieldwork, but taxpayers should be attuned to opportunities for negotiation in all phases of the audit.

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In the preaudit phase, taxpayers may have the opportunity to negotiate in the areas discussed below.
Audit Period

While the audit period is generally set by statute, taxpayers have decisions to make regarding the granting of a waiver of the statute of limitations.. Taxpayers need to be aware of their right to grant or not grant a waiver as they deem appropriate under the circumstances. Auditors sometimes assume that the taxpayer will automatically agree to grant a waiver. However, the taxpayer should always weigh an auditor’s request for a waiver carefully. If the taxpayer can provide a good reason for not granting the waiver, the auditor may drop the issue.
EXAMPLE
Many taxpayers refuse to grant waivers before the audit fieldwork has begun. As long as the taxpayer can schedule the audit within a reasonable time period, it is difficult for the auditor to force the taxpayer to sign the waiver, or for the auditor to issue a jeopardy assessment. taxpayers can always argue that the jurisdiction did not contact them soon enough to complete the audit within the statutory period.

Sampling Methodology

Auditors often seek agreement from the taxpayer on the sampling methodology to be used in the audit. This frequently begins during a preliminary telephone conversation with the taxpayer. These conversations are an opportunity for taxpayers to advance proposals that are in their interest. Auditors sometimes use these conversations as an opportunity to fulfill statutory requirements that an agreement be reached with the taxpayer on sampling. Therefore, taxpayers should be wary of making any quick, overthe-phone agreements on sampling. It is highly recommended that the auditor make all sampling proposals in writing, so that they can be studied before any firm agreement is reached. On the telephone, taxpayers should go no further than providing some assurances that a sample is an acceptable audit methodology, subject to a formal review of the state’s sampling technique.
CAUTION
Although some states, have statutes that require taxpayer approval or that attempt to obtain taxpayer approval of the sampling methodology, the majority of state statutes give the state broad authority to impose a sampling methodology on the taxpayer, whether the taxpayer agrees or not.

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PLANNING POINTER even though most states are not required to obtain taxpayer agreement on the sampling methodology, they do not want to contest sampling issues on appeal. therefore, the state may be willing to accommodate a taxpayer’s special sampling request as long as it does not compromise the overall audit and does not require any significant additional effort on the part of the state.

Scope of Review

In the early stages of an audit, the auditor is generally open to discussing issues involving the scope of the audit. Taxpayers should freely discourage the auditing of transactions that they feel may not be necessary. Although auditors may be skeptical of the taxpayer’s motives, they can sometimes be convinced to restrict the scope of certain reviews. Even if the auditor does not agree to forgo auditing certain transactions, he or she may be persuaded to modify the scope of the review, subject to further verification. Any time the audit fieldwork time is reduced, the taxpayer’s exposure is reduced as well.
EXAMPLE
If the taxpayer has a special accounting procedure for marketing materials, the auditor may agree to audit the distribution reporting procedure rather than the specific purchases of marketing materials, which may not be traceable to any state from the voucher records. this can save time for both the auditor and taxpayer.

STUDy QUESTIONS
1. Which of the following statements is true? a. taxpayers should never delay the discussion of a difficult topic until late in the auditor’s visit. b. An auditor can only question a limited number of transactions. c. An audit must always be completed within a year. d. A taxpayer that is fully scheduled with audits can suggest a later date for the audit that is more convenient. 2. to reduce the scope of the audit when time constraints exist, a taxpayer should generally do all of the following except: a. Compress fieldwork through the use of assist reports b. Forward records to the auditor after some preliminary review in areas where the taxpayer is concerned about exposure c. Perform a managed audit d. employ greater use of sampling

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ENTITIES SUbjECT TO AUDIT

Early in an audit, the auditor may be uncertain about which entities have nexus in the tax jurisdiction and should be included in the audit. If some of the taxpayer’s entities have nexus and others do not, the taxpayer should withhold the books or transactions of entities without nexus.
NOTE
the auditor’s authority to audit an entity is predicated upon that entity’s doing business in the state. If the entity does not have nexus, the state and the auditor have no authority to exert over that entity unless there is some unitary relationship.

CAUTION
Fraud or misrepresentation of the facts to an auditor can be criminal and is never an acceptable audit strategy, but taxpayers do have the right to highlight only those facts that support their position. they are not required to volunteer any information; the burden is on the auditor to ask the right questions to elicit the desired information.

EXAMPLE
If an auditor asks you to provide a list of all entities doing business in State x, without any additional qualifying terms, you can define “doing business” and provide the appropriate list of entities so engaged. However, if the auditor qualifies the question in a way that would include questionable entities, then you are obligated to provide the information requested.

Timing of the Audit

Taxpayers should be able to negotiate the timing of the audit with the auditor in the early stages of discussions. The taxpayer should not hesitate to suggest alternatives if the timing desired by the auditor does not fit the taxpayer’s schedule. Closing schedules, vacations, medical leaves for key employees, or special projects can hinder a taxpayer’s ability to conduct an audit. While rescheduling an audit for the taxpayer’s convenience may raise waiver questions, taxpayers should not let that deter them from negotiating a more appropriate time for the audit.
The Audit Contact Person

In the early stages of an audit, it is important to designate one or two individuals who will serve as the audit contact person(s). Maintaining control over the auditor’s contact with the taxpayer’s personnel provides several safeguards for the taxpayer.

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Many companies require the auditor to check in with the contact person upon arrival and departure for the day. This gives the company greater control over the auditor’s presence at its location. Check-in procedures also afford the contact person the opportunity to briefly discuss the progress of the audit with the auditor. Use of a contact person also assures continuity and consistency in providing data and responding to auditor requests.
CAUTION
However, logs of the data provided should be maintained for future reference in the event there is a dispute about the timeliness of the data provided or the data itself.

Other reasons for limiting the auditor’s contact with taxpayer personnel include the following: The taxpayer needs to know exactly what information has been provided to the auditor and what the auditor has been told about various positions taken by the taxpayer on its tax returns. As the number of individuals involved in the audit increases, it becomes virtually impossible to maintain consistency in responses to information requests and explanations of positions taken on the return. Auditors sometimes attempt to communicate with individuals who are readily available to answer their questions, such as clerical employees in accounts payable or purchasing. While this is understandable from the auditor’s viewpoint, it can have undesirable consequences for the taxpayer.
CAUTION
Most employees do not understand the complexity and delicate nature of tax positions. As a result, they may provide inaccurate, misleading, or unnecessary information that could seriously undermine a position taken by the taxpayer. Providing conflicting or inconsistent responses can damage the taxpayer’s credibility and the working relationship between the taxpayer and the auditor. this can manifest itself during the negotiation stage of the audit or at the conclusion of the audit, when the taxpayer is forced to provide additional evidence to support its positions.

Designating one contact person allows that individual to focus on audit issues and take ownership of the audit results. This should result in more thorough preparation and more successful negotiation during the audit.

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PLANNING POINTER the auditor may attempt to bypass the designated contact person. Some suggestions for keeping the auditor from doing so include the following: tell the auditor that you expect all questions to be addressed to the contact person. Locate the auditor in an area where there is little opportunity for contact with others, such as an office in the manufacturing department. Warn employees of the auditor’s visit and discourage them from responding to the auditor’s questions without prior approval. Regularly keep track of the auditor’s whereabouts with surprise visits and phone calls.

Written Communications

As early as possible in the audit, the taxpayer needs to stress to the auditor the importance of written communications. Generally, auditors only put communications that are important to the state in writing, unless the taxpayer requests written communications for all significant issues. Reasons to require written communications in an audit include the following: Establishes a written, formal record of the audit Documents questions that have been raised and responses that have been provided, so there can be no dispute about what was said Provides less likelihood of misunderstanding and misinterpretation Forces the questioner to be concise and reduces the likelihood of followup conversations; may also eliminate some questions because they will be forgotten or deemed not worth the effort required Taxpayers are obliged to respond to written questions in writing, but the extra effort may prove worthwhile by responding with only the necessary information. This forces the auditor to come back with yet another request if the expected answer was not received. Although auditors are often skilled questioners, they are not always skilled at writing questions. Written communication should be stressed throughout the audit, but the personal touch of verbal communication should not be overlooked. Taxpayers should not hesitate to verbally engage the auditor on minor issues or issues unrelated to the audit. Much insight about the auditor can be gained through casual conversation. Limits need to be placed on the use of written communication to avoid unnecessarily burdening the auditor or taxpayer. Generally, written communications are appropriate for questions that involve major issues or positions in the audit. They are also appropriate for outlining scope issues and audit procedures.

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Written communications are not appropriate if the auditor is requesting technical assistance about how to read a report or attempting to understand a company’s filing system. The more appropriate way to deal with questions of this nature is to meet regularly with the auditor to resolve these issues informally.
Controlling Information

Controlling the information provided to an auditor is critical to successful audit administration. Therefore, it is important to establish a detailed record or log to track what information has been provided to the auditor and how long the auditor has had it. Suggested data to retain in an information log includes: Description or copy of information provided Date the information was provided Date the information was returned Reference to the question in response to which the information was provided Indication of whether the auditor must return the information or may keep it The date the information was provided can be particularly critical if the taxpayer feels that the auditor should have completed his or her work with the information. Taxpayers should request that information be returned when it is no longer needed. This will both: Force the auditor to efficiently use data that has been provided and discourage him or her from “fishing” for something Assist the taxpayer in maintaining control over the records for use in other audits as required. When giving information to an auditor, the taxpayer should evaluate the auditor’s right to see the information and determine whether the auditor will be allowed to keep or copy it as part of a permanent audit file. Auditors have broad authority to examine taxpayer records, but they do not have carte blanche to examine everything. They must be able to show that the record requested relates to the audit.
CAUTION
Care should be exercised in disputing an auditor’s authority to examine certain records, as auditors have subpoena powers to compel a taxpayer to turn them over.

It is prudent for the taxpayer to require that as much information as possible be returned. Although auditors are required to treat taxpayer records

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with confidentiality, they generally should not be allowed to remove business records from the taxpayer’s premises. In addition to keeping a log, it is advisable to make copies, where feasible, of all data provided to the auditor. This assures that the taxpayer will have an exact duplicate of any information that the auditor has in his or her possession. Questions can arise as to whether the taxpayer provided certain data in a timely fashion or ever provided it at all. By maintaining a log of the information provided, the taxpayer will be in a stronger position to refute any accusations that the progress of the audit was impeded by slow responses to requests for data. An additional use of the data log is to assist the taxpayer in maintaining a log of the time spent on the audit by the auditor and the taxpayer. This information can be useful in the event questions about the taxpayer’s cooperation arise. It is also useful when making waiver or waiver extension decisions to have some objective measure of the time the auditor has spent on the audit.
STUDy QUESTIONS
3. Which of the following statements is true? a. taxpayers should make agreements on sampling over the phone if necessary. b. taxpayers should always grant a waiver if requested by the auditor. c. taxpayers should discourage the auditing of transactions they feel may be unnecessary. d. taxpayers should allow the auditor to audit the books or transactions of entities without nexus. 4. Ways to keep the auditor from bypassing the designated contact person include all of the following except: a. Locate the auditor in an area near as many employees as possible. b. discourage other employees from responding to the auditor’s questions without prior approval. c. Keep track of the auditor’s whereabouts. d. tell the auditor you expect questions to be addressed to the contact person.

CONFIRMATION LETTER FROM AUDITOR

In follow up to the initial contact and scheduling of an audit, the auditor will usually send the taxpayer a confirmation letter that outlines the audit and any agreements that have been made for its conduct. This boilerplate letter will also contain a broad delineation of records or information that the auditor may wish to have available on the first day of the audit. Confirmation letters generally contain a standard set of information and are more of a form letter than many taxpayers realize. The states use

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this boilerplate approach to assure that proper notification has been given to the taxpayer in the event that a subpoena of certain records is necessary. Confirmation letters usually contain the following information: The name(s) of the taxpayer(s) under audit and their appropriate identification numbers A statement regarding the period under review. If the taxpayer has agreed to provide a waiver of the statute of limitations, a request to complete the waiver will usually be included as part of the letter. The taxes that the auditor will be reviewing Dates of any fieldwork scheduled with the taxpayer A list of records, returns, and other documentation that the auditor may deem to be material in the course of the audit Items typically requested include copies of the sales and use tax returns for the entire audit period; supporting work papers and other data used to prepare the returns; general ledgers, supporting journals, and journal entries; copies of other tax returns, such as a federal income tax return, state income tax return, and property tax return; exemption certificates if exempt sales are made; purchase orders or other purchase contracts and lease agreements; accounts payable files; sales invoices and supporting documentation; listing of capital assets; and any other relevant information that the auditor may need during the conduct of the audit A statement documenting any agreements that have been reached regarding the scope or conduct of the audit. An example would be an agreement that has been reached to audit fixed assets in detail and to sample expense purchases using a block sample. The taxpayer usually will not have to respond to the letter, unless there is an error regarding the dates of the fieldwork or the conduct of the audit. If an error is discovered, the auditor should be notified as soon as possible. The auditor may submit a questionnaire for the taxpayer to complete and forward or have available on the first day of the audit fieldwork. These questionnaires frequently contain questions about nexus-creating events, and they may also contain requests for information about taxpayer operations in the state. Taxpayers should exercise care in responding to such requests, as they frequently serve as a basis for initiating expanded audit procedures. For example, the auditor may decide to expand the scope of the audit or audit a customer in the state if he or she believes important information can be gained about the nature of the taxpayer’s activities.
PLANNING POINTER taxpayers that provide written audit guidelines to the auditor might wish to respond to the confirmation letter by providing a copy of the guidelines. even if guidelines are provided in this manner, they should be reviewed with the auditor at the start of the audit.

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Another issue that these letters raise is whether the taxpayer must have all the information that the auditor has requested available on the first day of the audit. In general, this is not necessary. By listing all the information in the letter, the auditor is requesting everything that could possibly be needed, but this does not mean all the information will actually be needed or even used. And here lies an important point that taxpayers need to consider: Can the auditor achieve the desired results by reviewing some other document in lieu of the one requested? For example, rather than providing the auditor with copies of the general ledger, can the taxpayer satisfy the auditor’s need for verification of the data through the use of a specially created assist report that summarizes the information in a way that is useful to the auditor? Taxpayers must evaluate whether it is better to provide the auditor with the requested information or force the auditor to achieve the desired result through some other means.
EXAMPLE
the auditor may request copies of the taxpayer’s federal tax return to verify the sales that have been reported on the sales tax return. If the taxpayer has some other documentation available, such as a sales reconciliation that shows all the sales broken out by state, it might be preferable to provide that report rather than the federal income tax return. Similarly, it generally would be easier to provide a listing of fixed assets in the location than to provide copies of the property tax returns and attempt to reconcile the returns to the fixed-asset schedules.

STUDy QUESTION
5. In general, it is not necessary for the taxpayer to have all the information requested in the confirmation letter on the first day of the audit. True or False? a. true b. False

WAIvER OF STATUE OF LIMITATIONS

The agreement to extend the statute of limitations is referred to as a waiver of the statute of limitations, or waiver. A waiver means that the taxpayer and the tax jurisdiction have entered into an agreement to jointly waive, or set aside, their legal rights under the state’s statute and extend the period of assessment to some other date, which is generally three to six months beyond the expiration date.

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CAUTION the statute of limitations in all states is based on the filing of a return. If the taxpayer fails to file a return, the statute of limitations never begins to toll. therefore, taxpayers that are not filing returns are open as far back as the state can establish some business connection with the state.

PLANNING POINTER
Many taxpayers reduce their exposure for prior period taxes by entering into a Voluntary disclosure Agreement (VdA) with the state. under a VdA, the taxpayer comes forward voluntarily and agrees to pay tax for the open period under the statute of limitations and file on a going-forward basis as long as they have a filing obligation. In exchange for coming forward voluntarily, the state generally forgives any penalty that may be due and in some cases the interest that would otherwise be due. (For further discussion of VdAs, see the section later in this chapter on VdAs.

Deciding whether to grant the state a waiver is one of the more difficult issues that can arise in the early stages of an audit. It might seem that taxpayers would never want to grant the state a waiver, since it only prolongs the time period for the state to issue its assessment. However, under certain circumstances, a taxpayer may have no other choice.
PLANNING POINTER taxpayers should try to only issue waivers of the statute of limitations when it is to their advantage to do so. For example, near the end of the audit a taxpayer may need additional time to complete their review of questioned transactions. In such a circumstance, it would be beneficial for the taxpayer to grant a waiver so they have additional time to continue working on the audit.

Generally, if the audit is being delayed beyond the statutory assessment period for the taxpayer’s convenience or benefit, the taxpayer will be forced to issue a waiver to avoid a jeopardy assessment. The threat of a jeopardy assessment, and its related burden of proof, frequently forces a taxpayer to sign a waiver at the beginning of the audit. jeopardy Assessments

Jeopardy assessments are estimated assessments issued by a state when the taxpayer has failed to provide sufficient information for the state to make a reasonable determination of an audit deficiency.

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A key aspect of the jeopardy assessment is that the state can base the assessment on the best available information. This allows the state to become creative in the basis for its assessment.
EXAMPLE
the state might base a sales tax deficiency on typical assessments for similar taxpayers or on a limited amount of information that is provided to the auditor or is publicly available. the states tend to err on the high side when making assessments of this nature. once a jeopardy assessment is made, the burden of proof rests with the taxpayer. this means the taxpayer must demonstrate that the jeopardy assessment is not correct to receive relief. the taxpayer may have to do a detailed review of its records to support some other assessment amount.

Waiver Timing

Before granting a waiver at the beginning of an audit, the taxpayer should carefully evaluate the timing of the auditor’s request. Auditors frequently contact taxpayers just prior to the expiration of the statute of limitations and request an audit or a signed waiver that will allow them to audit the expired period at a later date.
EXAMPLE
An auditor might contact a taxpayer late in the year to request an audit appointment before the end of the year. For many taxpayers, an audit at this time of the year would be inconvenient, and they would be justified in refusing to grant the waiver. on the other hand, if the auditor contacted the taxpayer earlier in the year to request an appointment, the taxpayer might be forced to grant the waiver if the taxpayer could not accommodate the auditor’s schedule. Most states take the position that when an audit extension is granted for the convenience of the taxpayer, the taxpayer should be willing to sign a waiver to extend the expiring periods.

PLANNING POINTER
As a general rule, you should try to avoid extending a waiver beyond three months. extending the waiver for longer periods of time may provide too much time for both the taxpayer and auditor to complete their work on the audit.

There is frequently pressure to issue a waiver in the closing stages of an audit. Since audits are often done in the final year of the statute of limitations, the presence of unresolved issues in the latter stages of the audit can delay its completion beyond the statutory period for assessment.

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PLANNING POINTER
In circumstances where the taxpayer is working with the auditor on concluding issues that the taxpayer reasonably believes can be resolved through additional research of the law or facts or through negotiation, the taxpayer should grant the waiver to the auditor. Failing to grant the waiver in these circumstances will result in a greater assessment and the need to appeal the unresolved issues, which can be expensive and risky.

Taxpayers must also evaluate the impact that granting a waiver will have on any refunds they might request as part of the audit. While it might be logical to assume that any time the right of the state to issue an assessment is extended, the right of the taxpayer to request a refund of any overpaid tax is also automatically extended, that is not the case. Although some states grant the same extension to refunds and assessments, many others, do not. Taxpayers need to be aware of each state’s treatment and, if possible under the statute, modify the wording of the waiver so that it includes an extension of time for the filing of refund claims as well as the issuing of assessments. Modifying the waiver in some states will have no impact on a taxpayer’s ability to receive a refund after the statute has expired. In instances where the state bars refunds in the period under waiver, the doctrine of equitable recoupment, or equitable offset, allows a taxpayer to receive partial relief in the years under waiver. Under this doctrine, taxpayers may apply for refunds from that time period, otherwise statutorily barred, against any deficiency assessed for the period. In this way, taxpayers may recover some of their lost refunds.
NOTE
the taxpayer must still provide proof to establish the validity of the claim with the tax jurisdiction.

CAUTION
Most states require that the waiver be signed by the taxpayer or a corporate officer. An employee or representative of the taxpayer may not sign a valid waiver in most jurisdictions. In addition, the waiver must be executed by both the taxpayer and the state prior to the expiration date of the statute of limitations.

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STUDy QUESTION
6. In which of the following situations would a taxpayer be justified in not granting a waiver of the statute of limitations? a. the audit is being delayed for the taxpayer’s convenience. b. the auditor contacts the taxpayer to request an audit appointment late in the year that the statute of limitation ends. c. the taxpayer is working with the auditor to conclude issues that the taxpayer believes can be resolved through additional research.

PERFORMING SELF-AUDITS
Overview

All taxpayers that make taxable and exempt sales or purchases should have a regular self-audit program in place to detect errors and procedural breakdowns prior to an audit. Taxpayers that do not have an ongoing self-audit procedure in place should consider performing a self-audit prior to the commencement of the audit fieldwork. If there is not sufficient time or staffing to perform a complete self-audit prior to the auditor’s arrival, a limited review should be performed to identify obvious areas of exposure. These areas would include incomplete or missing exemption certificates and failure to self-assess use tax on capital or expense purchases. In a self-audit, the taxpayer identifies breakdowns in compliance procedures and filing practices that could result in underpayments of tax. In a reverse audit, the taxpayer identifies errors that result in an overpayment of tax. Thus, the self-audit seeks to identify and correct underpayment errors before the auditor reviews the books, while the reverse audit looks for overpayment errors that will generate a refund of tax.
Exemption Certificates

Exemption certificates are a common source of problems in sales and use tax audits. If the seller does not have an exemption certificate for each exempt sale, the auditor will assess the tax otherwise due against the seller. Therefore, having either a strong exemption certificate procedure or an exemption certificate self-audit procedure in place will reduce audit exposure. Most sellers will be missing at least some certificates at the time of an audit, which can translate into increased audit exposure, particularly when a sample is performed. Samples tend to increase exposure because of the projection of error over the entire audit period. However, depending on the

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sampling methodology to be used in the audit, the taxpayer may be able to secure many missing exemption certificates in advance, thereby reducing the audit exposure. If nonstatistical samples are to be used in the audit, the sample test period will generally be established during the initial contact with the auditor. The test period is established by selecting representative months from the audit period for review. Once the sample period has been selected, the taxpayer can begin to review for missing exemption certificates by focusing on the test periods. If a statistical sample is to be performed, the transactions tested will come from the entire period, and it will be more difficult to anticipate which transactions will be reviewed. A general review for missing exemption certificates would still be more appropriate in the case of a statistical sample. In a general review, the taxpayer would look for exemption certificates from major customers. Most internal accounting systems can provide sales by customer. Reports such as this can be used to screen for sales to exempt customers. Crosschecking exemption certificates against the report of exempt sales should provide an indication of missing certificates. If a specific sample period has been established for sales, a review can be performed to test the adequacy of exemption certificate files for exempt sales in the test period.
PLANNING POINTER
Customers should be contacted to request replacements for certificates that are missing or incomplete. Many states require that certificates be renewed at periodic intervals, typically from three to five years. therefore, even complete certificates must be refreshed regularly to remain in force.

Because the auditor is likely to ask that replacements for any missing, incomplete, or inaccurate certificates be obtained, requesting replacement certificates prior to the auditor’s arrival should not result in any wasted effort by the taxpayer. The effects on the audit of having complete certificates on file can be dramatic. If an auditor observes that many certificates are missing or incomplete, he or she might react by being very particular about any replacement certificates that are obtained. In addition, any decision made by an auditor that is documented in the work papers is subject to challenge by the auditor’s superiors or an audit review panel, so auditors are usually cautious about accepting replacement exemption certificates. On the other hand, if the taxpayer has obtained valid exemption certificates for virtually all the exempt sales in the test periods, the auditor is

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more likely to feel confident that the taxpayer has diligently complied with the tax laws. When only one or two certificates are missing or incomplete, the auditor might deem this an immaterial level of error that does not require an assessment. A decision must be made regarding the effective date of a replacement certificate obtained from a customer. If the customer signs and currently dates the certificate, the auditor may determine that the certificate is not valid for purchases prior to the date of signature. In this case, the taxpayer would need to obtain another certificate from the customer. Therefore, it is advisable to put a statement on the certificate that it is effective with the first day of the audit period or the date of first sale to the customer. That way, even if the customer signs with a current date, an argument can be made that the certificate is valid for all prior purchases that are part of the audit.
Missing Transactions

A major area of exposure that needs to be addressed in the self-audit process is taxable purchases on which the vendor failed to bill tax and/or no selfassessment was made. For many companies, this is the greatest area of exposure in an audit. Taxpayers have difficulty adequately monitoring purchases for the correct payment of tax because of the diversity and complexity of these transactions. Therefore, taxpayers should have a self-audit program in place to look for missed transactions and make the appropriate corrections before the auditor reviews the purchases. While the states have become sophisticated in their use of sampling to determine audit deficiencies, most states do not allow taxpayers to make selfassessments based on a sample determination without some prior agreement. Therefore, taxpayers must review all purchases in detail to properly determine their tax liability.
CAUTION
Self-assessment payments must be made within the audit period or on amended returns within the period. If payment is made outside the audit period, the auditor will assess the tax paid as a deficiency in the audit.

Once assist reports have been created, the process becomes an audit activity. The taxpayer reviews the selected purchases and determines whether tax has been properly paid. For a transaction in which the tax is underpaid, the taxpayer should self-assess and report the tax on its return. If the tax is overpaid, a refund claim should be filed.

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Taxpayers must decide whether to file an amended return to report any self-assessments. If a significant amount of tax is unpaid, the taxpayer should file an amended return to capture the appropriate amount of interest due with the underpayment. Taxpayers self-assessing on purchases that are older than three to six months would generally be expected to file an amended return.
CAUTION
the regular filing of amended returns may attract more audit scrutiny, so every effort should be made to incorporate self-assessments at the time the item is purchased.

For both assets and expenses, an evaluation of the item’s ultimate use must be made. Making an informed decision about the taxability of a purchase may require communication with operations personnel. If the item is used in a taxable manner and no tax has been paid or self-assessed, the taxpayer should voluntarily self-assess. The focus of a self-audit is on the individual transaction level. However, the taxpayer should also seek to identify broader procedural breakdowns.
EXAMPLE
the review may disclose that a particular buyer is incorrectly coding a taxable purchase as exempt. the buyer should be notified of the incorrect procedure so that it can be corrected. It is very important to create the feedback loop to make sure the error does not continue.

Once the review of all the transactions has been completed, the results of the review should be summarized and maintained for future reference. Adequate records must be retained for future reference. It does little good to go through all the effort to perform the self-audit and then neglect to retain the files necessary to prove which purchases have been self-assessed. Most state audit procedures require that the taxpayer prove the self-assessment was made on a particular transaction by showing the transaction on a report or listing and reconciling it to a summary schedule that can be traced to the return.
Sampling

While most states require that taxpayers perform the self-audit review in detail, some states allow taxpayers to estimate their tax liability through sampling, using state approved sampling procedures. Generally, arrangements must be made with the state to self-assess using sampling. The state will review the procedures used by the taxpayer to make certain that a sound basis exists for them.

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Of particular interest are the state’s procedures to avoid a duplicate assessment. When a self-assessment is made without the use of sampling, it is easy to relate the self-assessment to a particular transaction. However, when payments are made on the basis of a sample, the issue of which transactions were covered by the self-assessment can arise. Before a self-audit sample is performed, the taxpayer should reach an agreement with the state regarding how the results will be reflected in an audit. A common approach is to ignore the self-assessment at the individual transaction level and, instead, reflect the total amount paid against the entire amount of the audit deficiency and net the results as an overpayment or underpayment. If expenses have been sampled on a self-assessment basis, care must be exercised so that there is no duplication in the assessment. Particular note should be taken of the accounts that form the basis of the self-assessment or deficiency. For accounts that have been self-audited using a satisfactory sampling methodology, the focus of review should be the sampling methodology, not the individual transactions. If the sampling methodology used by the taxpayer has validity, all transactions that were sampled should be covered under the sample self-assessment. For the sample to have statistical validity, it must be conducted using a method of statistical sampling.
CAUTION
A nonstatistical sample, such as a block sample, does not have the same validity as a statistical sample and, therefore, would not be appropriate for this purpose.

STUDy QUESTIONS
7. Which of the following statements is true regarding missing exemption certificates? a. Sampling tends to decrease exposure. b. A replacement certificate should contain a statement that it is effective on the date it is signed. c. A general review for missing certificates would be more appropriate in the case of a statistical sample. d. Requesting replacement certificates before the auditor’s arrival is not advisable. 8. If a taxpayer determines that a significant amount of tax is unpaid due to a selfassessment, the taxpayer should not file an amended return because it will attract more audit scrutiny. True or False? a. true b. False

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REvERSE AUDITS AND REFUND REvIEWS
Overview

Taxpayers that are focused solely on the negotiation and analysis of vouchers and invoices selected for potential assessment by the auditor are missing substantial opportunities. In most self-assessment and tax payment models, taxpayers are as likely to make an overpayment as they are to make an underpayment. Therefore, taxpayers need to regularly review transactions for the overpayment of tax. Ideally, the reverse audit should be undertaken before commencement of the audit so the refund can be a part of the audit settlement. The object of a reverse audit is to recover tax incorrectly paid to the taxing jurisdiction. It is called a reverse audit because of its focus on generating a refund rather than an assessment. Taxpayers need to consider each state’s treatment of refund waivers when planning their reverse audit activity. Priority should be placed on completing reverse audits in states that refuse to grant extensions on refund claims. Most auditors concentrate on underpayment errors and only give cursory attention to overpayment errors. Taxpayers must seize the refund initiative for themselves by performing a reverse audit or hiring an outside firm to perform one. billing Errors

The nature of the relationship between the seller and purchaser is such that overpayment errors are usually quickly identified by the purchaser and corrected with a revised invoice or credit. However, billing errors may occur, and the focus of the sales review should be in these three principal areas: Incorrect tax status of purchaser or transaction Incorrect application of tax to items sold Incorrect tax rate applied to the items purchased
Tax Status of Purchaser or Transaction

The tax status of the purchaser should be reviewed to determine if tax was properly billed. Generally, a review of taxable invoices is performed by crosschecking the invoices against the exemption certificate files. In addition, a logic check may be performed against any taxable invoices billed to challenge whether the transaction is taxable. For example, a sale to a wholesaler or distributor or to a local government would typically not be subject to tax. After a preliminary review of sales, potentially exempt transactions should be segregated and the customers contacted to determine their status with regard to exemption.

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If any of the sales are subsequently determined to be tax exempt, a refund claim should be filed with the state.
PLANNING POINTER the filing of a refund claim is dependent upon who made the incorrect tax payment to the state. If the taxpayer made the payment in error on their return, the refund claim would be accomplished through the filing of an amended return. However, if there was a payment made in error to a vendor then refund can be claimed by the filing of a refund form with the vendor who made the original tax payment. the vendor would then have to file a refund claim with the state. As an alternative, some states have enacted statutes to allow the vendor to waive their rights to the refund so that the purchaser can file a refund claim directly with the state.

CAUTION
When a properly executed exemption certificate is received, the customer’s tax status should be corrected so the error is not perpetuated.

Improper Application of Tax

Correctly billing the sales tax requires that the seller properly classify the billing elements on the invoice and then apply the tax to the charges. Sellers frequently have difficulty doing this correctly, particularly in a multistate environment, which can result in an overpayment of tax. For example, if the tax jurisdiction does not charge tax on separately stated freight charges, and the seller unbundles the price, it is important to segregate those charges and not bill the tax. Sellers should periodically verify that the sales tax is being correctly charged on the taxable elements of their sales.
EXAMPLE
A number of states, including California, exempt the installation labor associated with tangible personal property if it is separately stated on the invoice. Sellers that bill in this manner need to review each state to verify that they have properly exempted the installation labor. If they have overcharged their customers, refund claims should be filed. Follow-up action may also be required to make certain that the billing error is corrected on future billings.

Incorrect Rate Applied

Many sellers have difficulty determining the proper local taxes to apply to a purchase. Therefore, the reverse audit procedure for sales should include a review of the rates applied to various invoices during the audit period.

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If it is determined that incorrect rates have been applied to certain sales invoices, a refund claim should be filed and procedures should be modified so the problem is avoided in the future. In some states, sales tax that is refunded to the seller must, by statute, be returned to the customer that ultimately paid the tax. While such statutes represent a well-intentioned attempt by the states to assure that all refunds are returned to the customers, they can serve as a barrier to refund claims on past sales. Sellers may adopt the attitude that they do not want to invest time and effort recovering tax that must be returned to the customer. In addition, sellers may be concerned about the potential fallout of admitting to customers that sales tax billing errors were made. Therefore, before undertaking a reverse audit of the sales area, taxpayers should determine what their refund policy will be.
PLANNING POINTER
In many states the vendor is required to refund any tax and interest that is returned by the state to its customers. So, the statutes must be carefully reviewed prior to filing the refund claim to determine if that is a requirement in the state where the overpayment occurred.

Overpayments on Purchases

The greatest opportunities for refunds are on purchases. The inherent complexity of state tax law, combined with the ever-changing nature of business operations, makes the purchase and capital addition reverse audit a fertile ground for refunds. Most purchasing and accounts payable systems are not designed to handle the complexities of sales and use tax law.
PLANNING POINTER
Particular attention should be given to manufacturing-related purchases in states that grant a manufacturing exemption as overpayments of tax are usually made as often as underpayments are made.

In addition, individuals who work in these areas are generally not motivated to learn basic tax concepts, as they are measured on other factors, such as cost savings and transaction processing speed. This lack of knowledge, combined with the tremendous volume of purchases in most companies, makes it difficult for taxpayers to designate the correct tax status of purchases. The steps to perform in a reverse audit of purchases include the following: Identify likely transactions for the incorrect payment of tax by reviewing charts of account, return work papers, and supporting schedules.

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Capture the activity in the identified accounts for the period under review, isolating transactions that are tax paid. Review applicable exclusions from tax and look for potential overpayment errors. Review exemptions from tax. In particular, look for purchases that are unique to the manufacturing process (in states that offer a manufacturing exemption) that may have been taxed in error. Review purchases shipped to other jurisdictions for misapplication of tax. Review any other transactions that may be eligible for special treatment under the statute.
PLANNING POINTER the key to success in reverse audits is to learn to assertively apply the tax laws to individual transactions in much the same way that an auditor applies the laws in an audit. For example, there might be a requirement in the manufacturing process to have temperature and humidity controls to protect the product from damage. the taxpayer could argue that these controls are required for manufacturing and not employee comfort, and the heating and air conditioning system is therefore exempt. Another example is the taxability of employee clothing such as gloves and gowns. Many states that otherwise tax these items will exempt them if it can be demonstrated that the clothing is required for product quality purposes.

Areas that may afford opportunities for assertive application of manufacturing tax exemptions by the taxpayer include the following: Identifying custom manufacturing activities that frequently take place outside the manufacturing departments and making sure they are treated as tax exempt in states with a manufacturing exemption Isolating the beginning and ending points in the manufacturing process to make sure that all eligible items are included in the manufacturing exemption Treating material handling throughout the manufacturing process as exempt if the state follows the integrated plant doctrine Applying the manufacturing exemption to items purchased for some unique aspect of the manufacturing process, such as clean rooms or worker apparel used to prevent contamination of the product Applying the manufacturing exemption to specialized temperature and humidity controls required for product quality Applying the manufacturing exemption to certain items used in the in-house print shop In addition to reviewing purchases for exemption from tax, it is important to look at exclusions from tax. An exclusion from tax refers to an item that the statute does not reach for imposition of tax. When reviewing exclusions,

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the focus should be on the manner in which the invoicing is executed and how that might impact the tax status of the purchase. As mentioned previously, there are a number of states that exclude tax on installation of tangible personal property when the installation charge is separately stated. A taxpayer reviewing transactions in such a state would look for purchases that were billed or self-assessed in this manner.
CAUTION
For multistate taxpayers, there can be confusion regarding which state’s tax to apply. this happens when vendors set up a single master account for all purchases. the account is generally identified for tax purposes to the main location of the taxpayer’s business. For purchases shipped to another state, the vendor’s invoicing system does not recognize that another state’s tax should be applied. the problem is compounded when the purchasing company’s accounts payable or purchasing system also does not recognize that some other tax rate should be applied. this situation can actually result in two errors: the wrong state’s tax has been paid A liability to the state of use has been underpaid. unfortunately, when tax is paid in error, there is no offset allowed for the correct amount of tax when it is paid. this can result in a duplicate payment of tax: once for the wrong state once as part of the audit assessment

To properly correct for this error a refund should be requested for the incorrect tax paid and a self-assessment should be made for the correct tax due. If the incorrect tax paid is offset against the tax legally due, the state will disallow the offset upon audit since the tax was not legally due under the statute.
Refund Claim Procedures

After identifying all the errors, the taxpayer must determine the correct way to proceed with the refund claim. If the overpayments have been made to a vendor, the taxpayer should either request a refund from the vendor, or request that the vendor sign an assignment of its rights to receive the refund so the taxpayer can request the refund directly from the state. Such assignments include provisions that prohibit the seller from claiming the refunds in the future. For very large taxpayers, this can be an attractive option, as it eliminates dealing with vendors on the details and reasons for the refund claims. This approach also removes the vendor as a middleman in the transaction and allows the taxpayer to deal directly with the state.

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CAUTION
Vendor refunds should not be claimed as an adjustment to the next month’s selfassessment or treated as a return offset to sales tax due. In virtually all states, netted refunds such as this will be disallowed by an auditor. If the statute of limitations has expired when the refunds are disallowed as offsets, the taxpayer will not be able to recover the lost adjustment.

NOTE
An erroneous overpayment of consumer’s use tax from a prior month can be an offset against consumer’s use tax due in a succeeding month.

If the taxpayer has merely over-assessed in error, the correct procedure is to take an offset against use tax due on a future return, unless the adjustment is substantial in amount. Once the data has been summarized and supporting documentation has been gathered to substantiate the refund claim, the next step in the reverse audit procedure is to file a refund claim or amended return with the appropriate state. The necessary supporting documentation for a refund claim is a copy of the invoice from the seller that includes the tax and some substantiation to show that the tax has been paid. This might include a copy of the check or voucher to show the amount of the payment. If the refund claim is field audited, it is reasonable to expect that the auditor will test some of these transactions to verify that the erroneous payments have been made. In addition to providing documentation supporting the refund claim, it will be necessary to explain why the transaction in question is not subject to tax. This may involve explaining the use of the item or indicating why the transaction falls under a particular statute or court case as exempt. Explanations for each category of purchase are generally provided in an attachment that accompanies the filing. States have varying administrative procedures for refund claims. Depending on the state, one of the following may be required: An amended return A special refund claim form Or a letter noting the issues in the refund claim may be required
CAUTION
Before filing a claim, be sure to check on the particular state’s filing requirements. Failure to properly file the claim can result in disallowance of some or all of the claim.

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When a taxpayer files a refund claim as part of an audit, special procedures may be required for the refund claim to be processed along with the assessment. Generally, these procedures require that the auditor promptly receive the refund claim so that it can be reviewed in conjunction with the audit.
PLANNING POINTER
A taxpayer under audit should notify the auditor that it intends to file a refund claim before the fieldwork is completed and request that the refund be processed as part of the overall audit settlement.

After determining the proper procedure to follow in requesting the refund, the taxpayer must decide on the content of the refund claim. Most state refund processing procedures require that a limited review in the form of an office audit occur before the refund claim is processed or denied. The purpose of the review is to substantiate the refund and review the taxpayer’s account for underpayments before the refund is issued. If the taxpayer is currently under audit, the office audit procedure will be modified to accommodate the field auditor’s review. Taxpayers should expect that processing a refund claim will take at least three months from the time it is filed. In many states, the goal is to process the refund claim and notify the taxpayer within one year. Other states are open-ended as to when they must respond to refund claim requests. Taxpayers filing refund claims should attach sufficient documentation to the claim so that the reviewer can determine the basis of the claim. For large refund claims involving many transactions, the state may grant the refund claim, contingent upon a subsequent field audit and review by the refund office staff. Taxpayers need to follow-up on the refund claim judiciously, as it is processed by the state department of revenue. Failure to keep track of the progress of the refund claim could result in a loss of important appeal rights. Each state has specific appeal procedures that provide taxpayers with certain statutorily set periods for appealing the denial or reduction of any refund claim.
CAUTION
Failure to meet an appeal deadline can result in denial of the claim. In addition, at the office review level, taxpayers are frequently given deadlines for responding to queries regarding the refund claim. Failure to respond or provide the additional documentation requested can result in a partial or complete disallowance of the refund claim.

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Using Outside Consultants

In recent years, the performance of reverse audits by outside consultants has been a growing trend. As corporations have downsized, the pressure on internal tax departments to do more with less has led to the outsourcing of a substantial amount of tax work. For companies that are faced with the prospect of not being able to recover any tax because they don’t have the personnel to perform a reverse audit, outsourcing is a logical solution. Taxpayers need to carefully evaluate the expertise of the firm proposing to perform the work, as not all outsourcing options are equal. Questions that should be addressed before retaining an outside firm to do refund recovery work include the following: Does the taxpayer have final veto over any refund claims filed? Who bears the cost of appeal or litigation expenses? Is the outsourcing firm willing to enter into a confidentiality agreement? Does the outsourcing firm require support personnel from the taxpayer?
Final veto

Outsourcing firms frequently encourage taxpayers to take extremely aggressive positions. It is advisable for taxpayers to have final authority over any refund claims submitted on their behalf to reduce the possibility of having a filing position jeopardized through an ill-advised refund claim.
Appeal or Litigation Expenses

A refund claim may be denied by the state if, in the state’s view, granting it could create an undesired precedent or undermine a position that the department of revenue is attempting to defend in court.
EXAMPLE
taxpayers and states with a manufacturing exemption have engaged in disputes over the scope of the exemption. If a state is litigating a particular issue, it would not be wise for the state to grant a refund claim based upon a lower court decision that is under appeal by the state.

Anytime a refund claim is filed, the possibility of litigation or appeal exists. This can be particularly true if the taxpayer is attempting an appeal based upon a recent court decision. In this situation, the issue of representation by the outsourcing firm must be addressed in any contract to perform reverse audit work. Many firms that engage in this type of work have attorneys, either on their staff or available on a retainer, to assist in any required appeal.

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Confidentiality Agreements

The confidentiality of taxpayer records is an important consideration whenever a taxpayer deals with outside organizations. While attorneys may always claim the client privilege to withhold documents, CPAs generally are not afforded this privilege.
EXAMPLE
A CPA who cannot claim return preparer status may be required to turn over documents in their file for a particular client if ordered by a court. A law firm representing the taxpayer, however, can assert “client-privilege communication” to avoid turning over such documents.

In addition, there is the possibility of disclosure to competitors or others that could be damaging or embarrassing to the taxpayer’s business or employees. Therefore, taxpayers should always insist that an outside consulting firm sign a confidentiality agreement stipulating that it will not disclose any information learned about the taxpayer during the course of its review. A confidentiality agreement provides an avenue for legal remedy in the event something is disclosed. In addition, most individuals will take their responsibility with respect to confidentiality more seriously if they are required to sign something attesting to that responsibility.
Support Personnel

Many outsourcing firms have a sufficient number of technical personnel, but they lack an adequate number of clerical personnel to complete the project in an efficient and timely manner. This can be particularly true for out-of-town engagements where the outsourcing firm is attempting to hold its costs down. The firm may look to the clerical personnel of the taxpayer to do photocopying, data entry, and other clerical tasks. Prior to the start of the engagement, an agreement should be reached on how these tasks will be done and who will bear the costs.
STUDy QUESTIONS
9. the sales review in a reverse audit may include all of the following activities except: a. A review of the rates applied to various invoices during the audit period b. A review of the tax status of purchasers c. Verification that the sales tax is being correctly charged on the taxable elements of sales d. Review of the payment terms offered

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10. Which of the following statements is not true? a. the greatest opportunities for refunds are on sales. b. When performing a reverse audit, the taxpayer should apply tax laws similar to the way in which an auditor applies the laws in an audit. c. State statutes that require sales tax refunds to be refunded by the seller to its customers can serve as a barrier to refund claims on past sales.

RECORD RETENTION ISSUES

Record retention and the timely destruction of unneeded records is an important facet of a company’s tax-planning strategy. The burden of proof that a transaction is nontaxable rests with the taxpayer and not the auditor in most states. Therefore, the taxpayer must maintain the necessary records to refute any assertions made by the auditor. In order to prove that a transaction is exempt, it may be necessary to review original source documents for explanations regarding the use of various items. Nothing is more frustrating in an audit than to know the correct answer but not be able to prove it to the auditor because of a lack of adequate records.
EXAMPLE
taxpayers are frequently unable to demonstrate that tax has been paid on a transaction because records may be missing from the flies or adequate notations regarding selfassessments were not retained. In such cases, the taxpayer should seek to provide alternative documentation to the auditor to establish that tax has been paid. For example, other invoices or self-assessments of like items from the same vendor may demonstrate the tax had been paid.

Conversely, unnecessary and out-of-date records should not be retained unless there are legal reasons for retaining them, such as a lawsuit that is either anticipated or in progress. Occasionally, having too much information can be costly to a taxpayer, while if nothing is available, an acceptable compromise may be worked out with the taxing jurisdiction. Before discarding any data, however, taxpayers need to verify that the information is not needed for IRS record retention agreements or for legal reasons.
PLANNING POINTER
If no valid reasons exist for retaining records, they should be discarded to avoid the additional storage expense and exposure that accompanies their retention.

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Increasing numbers of taxpayers are relying on personal computers as aids in the preparation of financial information and tax returns. Record retention policies need to encompass personal computer records as well as paper records. In many instances, there are no backups for this information since it exists at the workstations of individual employees. The lack of backup protection makes it all the more critical to address personal computer records in the record retention policy.
CAUTION
employees should be educated as to the importance of retaining records on the personal computer. Good habits include securing the integrity of information through passwords and regularly backing up data.

STUDy QUESTIONS
11. A taxpayer that accidentally over assesses an insubstantial amount of sales tax from a customer should do which of the following? a. take an offset against use tax due on a future return b. treat it as a return offset to sales tax due 12. Which of the following statements is true? a. the burden of proof that a transaction is taxable generally rests with the auditor. b. Some states and local jurisdictions have no specific period for processing refund claims. c. When a reverse audit is outsourced, the outsourcing firm should be given final authority for refund claims. d. Records should be retained indefinitely since it is always uncertain what the future will bring, even if there is no particular reason for doing so.

RESPONDING TO AUDIT AND NEXUS QUESTIONNAIRES

Nexus is the minimum threshold of activity that is necessary for a state to impose its tax upon a taxpayer. Nexus issues frequently become the focal point of audit activity as states seek to force taxpayers to pay tax. For sales and use tax, the current nexus standard was established by the U.S. Supreme Court in Quill Corp. v. North Dakota [504 US 298 (1992)]. In Quill, the Court established that a non-trivial physical presence is required for a state to impose its sales and use tax on a particular seller. Physical presence is generally created when a business has employees, property or other assets, or agents of the seller in the state.

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A federal statute, commonly known as Public Law 86-272, does not provide for any protected activities for sales and use tax purposes as it does for income tax purposes. Any physical presence greater than some de minimis presence creates nexus for the taxpayer and subjects the taxpayer to the state’s sales and use tax. Not surprisingly, the states aggressively enforce nexus provisions. Once a taxpayer is filing with a state, it generally continues to do so for some time. Therefore, the state’s reward for securing taxpayer compliance can be substantial. The states employ a variety of techniques to ferret out nonfilers. These techniques are important to understand, as they frequently form the basis for an audit. Some of the more common techniques employed include the following: Nexus questionnaires Nexus squads Information-sharing arrangements with other states Referrals from other taxpayer audits Targeting compliance of specific groups or classes of taxpayers
Nexus Questionnaires

Many states have developed questionnaires that are used to gather information necessary to determine whether a taxpayer has nexus in the jurisdiction. Taxpayers may receive a nexus questionnaire in a variety of situations. In the early stages of an audit, the auditor may request that the taxpayer complete a nexus questionnaire to assist the auditor in determining the scope of the audit.
CAUTION
Great care should be exercised in responding to nexus questionnaire questions. the questions are usually designed to elicit yes or no replies from the respondent. In some instances a yes or no answer may be sufficient, but further explanation is often needed to support the taxpayer’s position.

Prior to any preliminary audit contact, nexus questionnaires may be mailed to the taxpayer without being addressed to a specific person in the organization. Most tax advisors suggest that when this happens, the taxpayer should not respond to the initial inquiry. Mailings of this nature are often done with little or no follow-up on non-respondents, so failing to respond should not have adverse consequences. Nexus questionnaires that are mailed to a specific company officer or employee generally do require a reply, as follow-up is more likely to result from noncompliance. However, even in these instances, most advisors would recommend that taxpayers not rush to respond.

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CAUTION the taxpayer must evaluate the state’s intent in mailing the questionnaire. If it appears, based on information provided with the questionnaire, that the taxpayer has been targeted for specific reasons, the taxpayer should respond promptly. However, if it appears that the state does not have any particular information about the taxpayer, it might be prudent for the taxpayer to wait for follow-up from the state before responding. When it comes to responding to nexus questionnaires, taxpayers should always err on the side of caution.

Nexus questionnaires can also be provided to taxpayers as part of an audit investigation, in the preaudit phase or once the fieldwork begins, to determine whether the taxpayer is subject to a particular tax. In an audit, the taxpayer will usually have little alternative but to respond. Taxpayers should seek assistance if they have any uncertainty about how to respond to a nexus questionnaire. Given the seriousness of any audit-related inquiry, seeking advice from a SALT expert is always a good idea, even if the taxpayer is relatively well informed. In general, nexus questionnaires explore activities that, if undertaken, would support the state’s position that the taxpayer is subject to tax. Many questionnaires ask about specific activities that the courts have held create nexus for taxpayers.
CAUTION
A common mistake that taxpayers make with nexus questionnaires is having them completed by an individual who is not familiar with the tax implications of the questions. A nexus questionnaire should always be completed by an individual who understands state and local tax issues.

It can be extremely difficult, if not impossible, to retract a response, even if it was made in error. This is especially unfortunate if the statement could have been made in a way that would not create exposure for the taxpayer.
Nexus Squads

It has become common for a state to have a group of auditors that specialize in nexus reviews. These audit groups are sometimes called nexus squads. The role of the nexus squad is to engage in investigative work that is designed to identify taxpayers with undeclared nexus. An audit is often precipitated by the work of a nexus squad. Therefore, it is important to understand their methods of operation.

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In addition to using nexus questionnaires, nexus squads engage in the following activities to discover nonfiling taxpayers: Checking various taxpayer tax registrations for inconsistencies Reviewing advertising in local media and phone books to identify taxpayers with business activities in the state Contacting taxpayers suspected of engaging in nexus-creating activities
CAUTION
With the increased in use of databases, a nexus squad has much more information available with which to make its determination.

Checking various Taxpayer Tax Registrations for Inconsistencies

Taxpayers frequently register for one tax but ignore another tax obligation that might be expected to accompany it. For example, if a taxpayer is registered for payroll tax purposes, it might be logical to conclude that the taxpayer should also be registered for sales and use tax, as it would appear that the taxpayer has an employee working in the state. In many instances, there is a logical explanation for the seeming inconsistency. In the example cited, nexus would not be created for the employer if the employee merely lived in the state of withholding for personal reasons but worked for the taxpayer in another state.
CAUTION
As remote working becomes more commonplace, the states are starting to aggressively assert nexus in the states where the employees live and even occasionally work remotely.

Reviewing Advertising in Local Media and Phone books

Nexus squads can obtain leads from advertising by the taxpayer. Advertising is a primary means by which taxpayers reach potential customers and provide information to them. Such information can provide an audit trail that can be used against the taxpayer in a nexus review. Taxpayers need to anticipate whether the auditor has information of this nature at the start of the audit and, if so, take this into consideration when responding to questions from the auditor.
EXAMPLE
the provision of a local telephone number could be an indication that the taxpayer has a place of business in the state. the solicitation of sales through advertisement could be an indication that employees of the taxpayer are engaging in revenue-generating activities within the state.

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PLANNING POINTER
It is possible that, through planning, activities may be structured in a manner that reduces or eliminates the exposure for the taxpayer but still accomplishes the revenue-generating activity that the taxpayer is seeking. For example, it may not be necessary to provide a local phone number as a contact number. An out-of-state toll-free line may accomplish the same results without exposing the taxpayer to further nexus inquiries.

Tax planning may, however, interfere with business objectives. For example, a taxpayer may need a local contact for competitive reasons, despite the fact that it creates nexus and other tax consequences.
CONTRACTING TAXPAyERS SUSPECTED OF ENGAGING IN NEXUS-CREATING ACTIvITIES

As mentioned earlier, taxpayers frequently receive nexus questionnaires addressed to the company but to no particular individual. These questionnaires are often sent by a nexus squad. They may be a form of cold-calling by which the state is attempting to identify a new taxpayer through the answers provided, or they may be the result of the state having some additional information about the taxpayer’s activities. While it not likely that a substantial number of taxpayers are identified in this manner, the effort required for the state to generate periodic mailings of this nature is relatively low. Therefore, it seems likely that this type of activity will continue.
Information Sharing

A number of states engage in information-sharing agreements and compacts with other states. As a result, taxpayers should expect the auditor to have received advance information about their activities. The Great Lakes Regional Compact and the Southeastern States Compact are examples of information-sharing agreements between the states. The member states of these organizations assist each other by sharing information gathered during audits. Member states may request that taxpayers complete questionnaires similar to the nexus questionnaires discussed in the previous section. In addition to requesting information regarding the taxpayer’s activities in the state under audit, these questionnaires request information about the taxpayer’s activities in other states. The taxpayer’s responses are made available to the members of the compact.

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PLANNING POINTER taxpayers confronted with these questionnaires in an audit should be cautious about providing the information requested. As a general rule, states participating in information-sharing arrangements have little or no authority to compel the taxpayer to complete the questionnaire. In most instances, if the taxpayer refuses to provide the information, the auditor will not pursue the issue any further, although the auditor may note on the questionnaire that the taxpayer refused to complete it. In limited circumstances, the auditor may attempt to complete the questionnaire based upon his or her knowledge of the taxpayer’s operations. However, there is little motivation for the auditor to complete the questionnaire, as the information requested does not relate to the audit at hand.

The largest and most sophisticated of the information-sharing groups is the Multistate Tax Commission (MTC). A number of states rely on the MTC to perform some portion or all of their audit function. For taxpayers that are selected by the MTC for audit, this can be an overwhelming experience, as the auditor could be auditing on behalf of numerous states rather than just one. While the audit techniques are often the same, the assessment can be substantially greater due to the number of states engaging in the audit.
CAUTION
Although the extent of MtC audit work has diminished in recent years, taxpayers selected for MtC audit should be particularly cautious in dealing with the auditor or providing any nexus information in response to a request from the MtC.

In the course of completing an audit, auditors frequently gather evidence about the tax practices of other taxpayers. For example, in reviewing vouchered invoices for purchases from other companies, auditors observe what types of activities are being billed by the vendors, in addition to information about the billing practices of the seller. If the auditor sees something that does not appear to be correct or properly billed for tax purposes, a referral can be made for the state to audit the vendor. Also, if it appears that the seller is performing services in the state but has failed to register for sales and use tax, the auditor could make a referral based upon these observations.
CAUTION
Referral audits can result from any audit, so vendors always need to be cognizant of the tax positions that are reflected through their invoicing and other activities in a state. taxpayers need to be particularly aware of these issues when dealing with customers that are more frequent audit candidates. Generally, these would be the larger taxpayers in a state.

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Profiling

States frequently develop profiles of certain industries or types of businesses for auditors to use as a guide. For example, states know that taxpayers in the same trade or business tend to make similar purchases and, as a result, they can develop a profile of business purchases. Taxpayers can also benefit from such information if the state prepares a guideline that is published for taxpayer guidance on purchases. Some states have even used this information to develop a self-audit procedure for taxpayers to complete on their own. This allows the state to perform a quasi-audit without having to devote all the personnel that would be required to perform a field audit. In addition, states that engage in these industry self-audits can achieve a greater level of future compliance through the educational process that occurs as part of the overall review.
Harsh Consequences

For a taxpayer discovered through the nexus process, the consequences can be particularly harsh if the taxpayer has been operating in a state for several years. Since the statute of limitations in all states only begins to run with the filing of a return, a taxpayer that has never filed a return has not begun to toll the statute of limitations. The taxpayer is therefore open to assessment as far back as the state can establish a connection between the taxpayer and the state. This could be many years beyond what the statute of limitations would otherwise allow.
EXAMPLE
If a taxpayer has been operating in a state for 20 years without ever filing a return, upon audit a state could go back 20 years to determine their liability, despite the fact that the statute of limitations may only be four years.

In addition to the tax assessed for these open periods, the taxpayer would also owe various late filing penalties, late payment penalties, and potential negligence or gross negligence penalties. Some states provide additional penalty interest, over and above the normal interest, that is assessed in these situations. Such taxpayers, rather than waiting to be caught, may wish to proceed under a voluntary disclosure agreement with the state as a means of mitigating their exposure. voluntary Disclosure

A taxpayer that has a sound basis for not filing in a particular state may be able to negotiate a settlement with the state that minimizes the penalties

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and the number of years that the state goes back for assessment. Under a voluntary disclosure program, a taxpayer generally agrees to pay the tax due for the agreed upon years, generally tied to the statute of limitations in the state, plus interest and possibly penalties. In addition, the taxpayer agrees to begin filing going forward. Such agreements benefit both the taxpayer and the state. The taxpayer may begin filing without being liable for the entire period of noncompliance. The state derives an adjustment for the open years and has a compliant taxpayer going forward without much effort on their part. Taxpayers wishing to make a voluntary disclosure generally work through a third party to reach an agreement with the state before beginning to file. The states are not under any obligation to accept an offer, so premature disclosure by a taxpayer could have significant adverse consequences. Taxpayers may also wish to consider voluntary disclosure if there is little or no support for the position that they have taken. This could be the result of negligence or evasion on the taxpayer’s part or erosion of a position as a result of a court case or legislation. Generally, once the auditor has contacted the taxpayer and initiated the preliminary phases of a nexus review, the taxpayer will not be able to participate in a voluntary disclosure program. Therefore, it is important for taxpayers to anticipate these problems and stay ahead of the states’ nexus squads.
PLANNING POINTER taxpayers not wishing to be part of a voluntary disclosure program may also consider voluntarily complying on a prospective basis. However, many states require that taxpayers complete questionnaires about the extent of their prior business activities in the state. Responding to these questions truthfully can be difficult if the taxpayer has a lengthy history of noncompliance.

Amnesty Programs

Generally, states may offer amnesty under provisions enacted by their legislature. Such amnesty programs are usually offered for a limited period of time and provide a “no questions asked” opportunity for taxpayers to address past lapses in compliance. Amnesty for sales tax is also provided through the Streamlined Sales and Use Tax Agreement. A state that wishes to become a member of the Agreement must certify that its laws, rules, regulations, and policies are substantially in compliance with each of the requirements of the Agreement. The requirements of the Agreement include an amnesty for uncollected or unpaid tax for sellers that register to collect tax, provided they were not previously registered in the state.

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Taxpayers wishing to avail themselves of this amnesty must register within 12 months of a state’s participation in the Agreement. To obtain amnesty, taxpayers must agree to register in all full member states while registration in associate member states is optional. In addition, a member state may allow amnesty on terms and conditions more favorable to a seller than that required by the Streamlined Sales and Use Tax Agreement.
NOTE
Amnesty under the Agreement does not include use tax that may be due upon purchases.

STUDy QUESTIONS
13. If a nexus questionnaire is mailed to a taxpayer but not addressed to any particular person, and the mailing includes no indication that the taxpayer has been targeted for specific reasons, the taxpayer should do which of the following? a. b. c. d. Respond immediately Respond, but not immediately not respond, unless there is follow-up from the state not respond, even if there is follow-up from the state

14. Which of the following statements is true? a. A taxpayer that has never filed a return in open to assessment as far back as the state can establish a connection between the taxpayer and the state. b. under a voluntary disclosure program, a taxpayer generally agrees to pay tax due for the agreed-upon years, but pays no interest or penalties. c. the largest and most sophisticated of the information-sharing groups are nexus squads. d. the requirements of the Streamlined Sales and use tax Agreement include an amnesty for uncollected or un-paid tax for sellers that were previously registered in the state. 15. As a general rule, states participating in information-sharing arrangements have authority to compel the taxpayer to complete a questionnaire similar to a nexus questionnaire. True or False? a. true b. False

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Conducting the Sales and Use Tax Audit
LEARNING ObjECTIvES upon completing this chapter, you will be able to: Create and maintain an effective relationship with the auditor determine what should and should not be provided to the auditor outline the most common reasons for audit adjustments describe how to handle claims for refund List the different types of audits Clarify the advantages and disadvantages of statistical and nonstatistical sampling Conclude which audit issues should be challenged

INITIAL MEETING WITH AUDITOR ON FIRST DAy OF ENGAGEMENT

Establishing the proper tone for the audit begins with the preliminary contact by the auditor. It is also important to reinforce that tone during the initial meeting with the auditor on the first day of the engagement. Taxpayers who appear disorganized or uninformed about state laws or audit procedures at the initial meeting can create a negative impression that persists throughout the audit. This section discusses steps that a taxpayer can take to appear more knowledgeable and have a better working relationship with the auditor. These include: Establishing the proper demeanor with the auditor Using prepared audit guidelines Creating the proper work environment for the auditor Confirming the audit plan and beginning the fieldwork Responding to initial interview questions Disclosing refunds and self-reported adjustments
Face-to-Face Negotiations

Many taxpayers wonder how to deal with an auditor in face-to-face negotiations. Some individuals are overly intimidated while others are ready to battle over every, minor adjustment. Either extreme will most likely result in unsuccessful negotiations for the taxpayer. The best approach is to respect the auditor’s authority, while being willing to be firm with the auditor when it is appropriate to disagree. Knowledge of the state’s tax law can be an important element in the success of an audit. A little preparation can go a long way. Knowing the

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state’s tax law makes a favorable impression and helps the taxpayer frame his or her thoughts when responding to the auditor’s questions. Many taxpayers make the mistake of expecting the auditor to educate them about the tax law. Taxpayers who do so take two risks: 1. 2. The auditor may be misinformed about the law and its application. The auditor’s position, while representing the state’s position, may not reflect the most current case law (states are frequently slow to modify their position on an issue).
EXAMPLE
When a state department of revenue loses a court case that it can appeal, it frequently does not change its practices and policies in the matter until all appeals have been exhausted. And even then, at times it will issue a statement indicating that they will only apply the case in situations where the facts are exactly the same. therefore, relying upon the auditor for guidance may not reflect the most current judicial thinking on a particular issue.

Audit Guidelines

Most experienced auditors expect that taxpayers will have rules or guidelines for the auditor to follow during the course of the engagement. These guidelines generally deal with topics such as: Office hours Use of company telephones (not as critical an issue in the era of cell phones) Photocopy and record retrieval procedures Name, phone number, and address of contact person(s) Use of the cafeteria and other common areas Sign-in procedures Necessity for an escort in certain areas A copy of these guidelines should be given to the auditor at the initial meeting. Presenting guidelines in writing lends them greater credibility, assures uniform application from audit to audit, and eliminates the possibility that an important guideline will be forgotten. The taxpayer might also consider including directions and information about local lodging. Including such information in the guidelines affords the taxpayer the opportunity to send them to the auditor in response to the initial contact letter and makes the taxpayer appear less draconian and more helpful.
PLANNING POINTER
Regardless of whether the guidelines are mailed in advance, it is important to discuss them with the auditor at the initial meeting.

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Auditor’s Work Environment

There are two philosophies regarding the appropriate work environment for the auditor: 1. 2. Auditors should be provided with an uncomfortable work environment to make their stay as difficult as possible. Auditors should be provided a comfortable work environment that allows them to complete their audit without distraction.

Many auditors say that being subjected to a difficult work environment only stiffens their resolve to find a deficiency as a way of getting back at the taxpayer. Strive to provide the auditor with a good working environment. Denying auditors basic comforts during their fieldwork is never an acceptable audit strategy.
PLANNING POINTER
Find a location for the auditor that restricts his or her ability to engage in potentially damaging casual conversations with employees. For example, place the auditor in the Information Systems department rather than in Accounts Payable or General Accounting. even with these precautions, employees should be warned to not discuss the audit without proper authorization.

Preliminary Information

At the initial audit meeting, it is advisable to confirm the audit plan and discuss the timing of the review with the auditor. By the time the fieldwork commences, the taxpayer should have assembled the preliminary information that the auditor requested at the time the audit was scheduled. This information is generally provided to the auditor at the first meeting. If all the information is not available, the taxpayer needs to reach an agreement with the auditor as to when it will be available.
PLANNING POINTER
It is very important to confirm the sampling procedures in writing in an early phase of the audit. In addition, any concerns that you may have about the sampling methodology should be stated up front, early in the audit. A number of courts around the country have not looked kindly upon taxpayers that waited until the field work was completed to voice their concerns about sampling.

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PLANNING POINTER taxpayers sometimes wait for the auditor to request data a second time before providing it. By requiring a second request, taxpayers may avoid having to provide information that is not essential to the conduct of the audit. Auditors often lose interest in records that have only marginal audit potential. When the audit begins, the scope of review is generally broad, but it narrows as the audit continues.

Most auditors begin their fieldwork by reviewing return files and associated work papers. By reviewing this information, the auditor gains an understanding of the taxpayer’s reported transactions and begins to think about errors and potentially unreported transactions. After a day or so of reviewing the return files, the auditor usually formulates a final plan for the fieldwork.
PLANNING POINTER taxpayers may wish to maintain separate return correspondence files to avoid commingling damaging correspondence regarding filing positions with the return work papers. they should carefully review the return files to make certain that only essential information is turned over to the auditor.

Many return preparers have a habit of making extraneous comments on sticky notes and leaving them in the file. This information can generally be purged from the files without compromising their integrity. If more than one auditor is working on the engagement, it is likely that one auditor will begin to review fixed asset or expense purchases while another completes the review of the return files. When working with more than one auditor, taxpayers must be particularly careful in their conversations so that consistent responses are provided to both auditors.
PLANNING POINTER
At an early stage in the audit it is important to let the auditor know that you would prefer that all questions be in writing. this should be reinforced should the auditor attempt to start questioning you regarding the facts of certain transactions by informing the auditor that you would prefer that all questions be in writing. of course some discretion is required to make sure that you don’t make that requirement over-burdensome or unreasonable. For example, if the auditor is just requesting some assistance to understand your client’s recordkeeping procedures, such a request would generally not have to be in writing.

Initial Interview

At some point during the initial meeting, the auditor will interview the taxpayer to gain a fundamental understanding of the taxpayer’s business and operations in the state. The auditor will use this information to create

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an audit plan and identify potential lapses in compliance procedures or routines. It may be advisable for taxpayers to respond to basic questions about their operations in the state, but they may also wish to use this opportunity to reinforce the importance of written communications in the conduct of the audit.
CAUTION
taxpayers should not respond to questions they are uncertain about until further clarification is obtained. A spontaneous answer that provides too much information or is inaccurate may be difficult to retract or correct at a later date. For example, the dates of certain transactions may be critical in their impact upon the audit. It would not be prudent to speculate about those facts. the correct approach would be to advise the auditor that you will get back to him/her after you have checked into the matter.

Taxpayers may also wish to use this initial questioning period to reinforce positions taken on the return by highlighting facts that support the position and de-emphasizing facts that damage the position. However, taxpayers must not let their self-interests cloud the truthfulness of their answers.
CAUTION
Failure to be honest could place the individual involved in personal jeopardy for fraud or tax evasion.

REFUND CLAIMS AND SELF-REPORTED ADjUSTMENTS

If the taxpayer has refunds or other adjustments that could affect the audit results, he or she must decide when to provide the information to the auditor. Taxpayers are often advised not to provide a refund claim to the auditor too early in the fieldwork. Some auditors may view the refund claim as a benchmark for their assessment—i.e., they may feel an obligation to offset the refund if it is provided too early in the audit. If the taxpayer refrains from providing the refund claim until later in the fieldwork, he or she may wish to inform the auditor that a refund claim is in process and that the details of the claim will be provided before the fieldwork is concluded.
CAUTION
taxpayers should not wait until the last day of the review to give the auditor a refund claim. A reasonable period of time must be allowed for the auditor’s review of the documentation if the refund is to be processed as part of the audit.

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With regard to potential self-reported adjustments, taxpayers may wish to consider an early disclosure to the auditor, particularly if discovery of the error is likely to occur in the early phases of the fieldwork. By disclosing and self-reporting certain errors, taxpayers gain credibility with the auditor and may be in a better position to avoid penalties on the audit assessment. The following examples illustrate when disclosure might be appropriate.
EXAMPLE
An agreement was reached in the prior audit that certain transactions would be handled in a particular way and, for some reason, the taxpayer failed to implement the procedure. the taxpayer may wish to volunteer the adjustment early in the audit.

EXAMPLE the taxpayer agreed to improve compliance procedures on purchases and provided general assurance that it would attempt to do a more diligent job in meeting its use tax obligations. Just prior to the audit start date, the taxpayer discovers that no procedures were changed since the last audit. Because of the general nature of the commitment, it might be difficult to capture the unreported amounts without performing a complete audit. An effort of that magnitude would not be expected of the taxpayer. In this instance, the taxpayer might be better off waiting for the auditor to review the transactions as part of the audit.

STUDy QUESTIONS
1. Which of the following is recommended for taxpayers? a. b. c. d. 2. they should depend on the auditor to inform them of current tax law. they should present guidelines to the auditor in writing. they should subject the auditor to an uncomfortable work environment. they should provide all data immediately when requested by the auditor.

When is usually the best time to present a refund claim to the auditor? a. b. c. d. on the last day of the review early in the fieldwork Late in the fieldwork not during the audit

Reason for Audit

Understanding the reason for an audit can help the taxpayer gain greater insight into the direction the auditor will take with the review. By the beginning of the fieldwork, the taxpayer should have some idea of the reason for the audit.

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Audits are usually initiated for one of the following reasons: Recurring audit Response to amended return or refund claim Special industry audit Statutory change Referral from other taxpayers
Recurring Audit

Some taxpayers are targeted for audit simply because of their size. Businesses that have major operations in a state, such as Fortune 500 companies, can expect the state to audit them regularly. They need to be especially diligent with their compliance and document the positions taken on their returns. In most instances, the state will request that a waiver be completed so that no period of time is lost due to the tolling of the statute of limitations. States don’t want to lose any opportunity to audit because of the potential revenue that can be gained from a major taxpayer.
Response to Amended Return or Refund Claim

Many taxpayers believe that filing an amended return or refund claim will precipitate an audit. As a result, they often decide to make the correction or modification prospectively and forgo the refund claim. However, in many instances, filing a refund claim will not precipitate a field audit.
PLANNING POINTER of course, taxpayers should file for refunds if they are entitled to them. However, before filing for any refunds, taxpayers need to consider the potential exposure that filing a refund claim may bring. For example, it might not be prudent to file a refund claim for $5,000 in tax if the taxpayer has exposure on a related issue in some greater amount. In such a case, the taxpayer has more to lose than gain by filing a refund claim. nevertheless, taxpayers should expect that there will be some level of review applied to any amended return or refund claim. Generally, the review takes the form of an office audit, as opposed to a field audit.

In an office audit, a limited review of the refund claim will be performed. The purpose of the review is to determine if the amended return or refund claim is valid before payment is made to the taxpayer. The state reviews documentation that establishes the validity of the claim. At this level of review, the focus is more transactional than legal. The state’s interest is in ascertaining that the claim is valid, not in performing an audit of the taxpayer. After reviewing the documentation provided, the state will decide whether to approve some or all of the claim. Any amended return or refund claim that aggressively construes a statute beyond the state’s interpretation or policy

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will be rejected. If the claim is rejected, the taxpayer can proceed through the administrative appeal process and then into the court system.
PLANNING POINTER taxpayers filing amended returns or refund claims should assess their supporting documentation prior to filing the amended return or refund claim to verify that sufficient documentation exists to support the claim.

Taxpayers filing large refund claims or amended returns with substantial changes should expect an audit. States become concerned about the adequacy of compliance procedures in such situations and respond to those concerns by auditing the taxpayer. If there is validity to the claim, the taxpayer should not be deterred from filing it—unless other business reasons exist for not doing so.
EXAMPLE
A taxpayer may have a valid position on an issue that would result in a substantial refund of tax, but the state has publicly indicated that it does not agree with the position and will reject any claim filed using that position. the taxpayer is reluctant to litigate the issue for fear of exposing the position in other states or incurring litigation costs. In such a situation, the taxpayer’s interests may be better served by adopting the position prospectively and forgoing the refund opportunity.

CAUTION taxpayers should expect that a substantial portion of the audit will be devoted to a review of the basis for the amended return or refund claim.

Special Industry Audit

States often target specific industries or groups of taxpayers that may yield significant audit adjustments. A state will do this when it becomes aware that the tax implications of a common industry or business practice are being ignored by most taxpayers in that industry. Taxpayers generally do not know if they were selected for audit as part of such an enforcement action. Finding out whether this is the case may be beneficial to them in preparing for the audit. Indications that an auditor may be conducting a special industry audit include: The auditor has a prepared list of potential adjustments that appear to be tailored to the taxpayer’s specific activities. The auditor asks questions in a manner that leads the taxpayer to believe the auditor is expecting to make certain adjustments based on the taxpayer’s type of business.

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Many auditors have experience auditing specific categories of taxpayers, so it may be difficult to distinguish an auditor who is merely experienced from one who is conducting an industry audit. Taxpayers may also be alerted to special industry audits through trade associations, business groups, or tax professional groups.
Statutory Change

States often engage in targeted audits after a statutory change to ensure that taxpayers are complying with the new statute. Targeted audits will be performed, for example, if the state is concerned that the new law is too complex or difficult to administer. In addition, if the jurisdiction has revenue expectations under the revised statute that are currently not being met, it may target specific taxpayers that would be expected to yield substantial revenues subsequent to the change.
EXAMPLE
If a state legislature made repair labor associated with tangible personal property taxable, a state department of revenue may target repairers of tangible personal property for audit to make sure that the tax is being properly collected.

Taxpayers need to be alert to statutory changes and court decisions that affect their activities in a state. This can be particularly challenging when taxpayers are attempting to stay current in several states.
Referral from Other Taxpayers

States sometimes receive audit referrals from other taxpayers or the audits of other taxpayers. The source of the referral is often a disgruntled ex-employee or former spouse that decides to divulge information regarding the taxpayer’s compliance practices. Taxpayers can try to deter this type of activity by entering into confidentiality agreements with their employees, but for all practical purposes there is little they can do to prevent such disclosure. Vendors of the taxpayer can also be the subject of a referral audit.
EXAMPLE
In the course of reviewing accounts payable activity, the auditor notes that a vendor of the taxpayer has incorrectly billed sales tax on a portion of the sale. If the auditor suspects that the error is widespread, he or she could recommend the vendor for audit by the state. Another example that could result in a referral audit would be a situation in which a vendor is performing a service in the state, but that vendor does not appear to have a registration for sales tax. the auditor would make a referral to audit the service provider and determine whether a sales tax registration is required.

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Referrals of this nature occur regularly for vendors that deal with taxpayers that are frequently audited. Vendors need to realize that doing business with larger companies can be financially rewarding, but it also carries a higher risk of audit because of the possibility of referral. Such referrals underscore the importance of correctly handling sales taxes and properly reflecting the amounts on invoices. One way of recognizing a referral audit is that the auditor will have documentation from the other audit that highlights the problem he or she is investigating. This information, which may include copies of an invoice or voucher or other original source documentation, will usually be presented to the taxpayer early in the field audit so that a determination regarding the issue can be promptly made.
CAUTION
Because the auditor may not immediately share the information from the referral, taxpayers need to be especially cautious about responding to questions about billing practices or invoicing.

STUDy QUESTIONS
3. Which of the following statements is not true? a. Businesses that have major operations in a state can expect regular audits. b. Filing a refund claim will always trigger a field audit. c. taxpayers filing amended returns with significant changes will probably be audited. d. States often initiate targeted audits after a statutory change to ensure that taxpayers are complying with the new statute. 4. Vendors doing business with large companies carry a higher audit risk. True or False? a. true b. False

TRANSACTIONAL REvIEWS

The purpose of a sales and use tax audit is to review the sale and purchase activity of the taxpayer and determine whether the taxpayer has correctly reported all sales and use tax due. The operational framework for that review is discussed here and in the following sections. Most of the auditor’s fieldwork time will be devoted to development of the sampling and review of transactions. The auditor will closely examine sales made by the taxpayer to third parties to determine if sales tax has been properly charged and review purchases made by the taxpayer from vendors and suppliers to determine if the taxpayer has satisfied its use tax liabilities.

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PLANNING POINTER
In a typical audit, fixed asset purchases would be audited in detail, meaning that they would be 100 percent reviewed, while expense purchases would be sampled, using either a statistical or non-statistical sampling methodology. As a practical matter, the auditor will focus on identifying underpayments of tax. All the reviews and samples are designed to isolate such errors.

NOTE
In many instances, the auditors do not even examine transactions in accounts, or from tax-charging vendors, that might result in an overpayment error.

A state auditor’s procedures are not designed to identify overpayment errors. Taxpayers that fail to perform reverse audits to identify refunds should not count on auditors to identify refund opportunities for them. The review of sales and purchases will be performed with separate databases. Depending on the nature of a taxpayer’s activity in a state, the auditor may give greater attention to one of these elements of the review.
EXAMPLE
If the taxpayer has substantial sales but minimal purchases of fixed assets and expense items in a state, the auditor will focus on sales rather than purchases. Conversely, if the taxpayer has minimal sales but substantial purchases of fixed assets or expense items, the auditor will focus on purchases. If sales and purchases are both substantial, the auditor will focus on the area they believe will be the most productive in terms of isolating underpayment errors. Minimal sales and purchases would probably not result in an audit, as there would be little potential for an audit deficiency.

The auditor’s review of sales and purchases consists of the following procedures: Examine returns, supporting work papers, schedules, and calculations Tour manufacturing plant or other operations Perform sampling or detailed review of sales and purchases and review sales and purchases outside scope of review that may create taxpayer audit liability Provide taxpayer with a list of potential errors Review taxpayer’s reasons for not billing tax on sales or paying tax on certain purchases Finalize list of taxable transactions for assessment

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Document Examination

As an initial step, the auditor will review the returns, work papers, and supporting schedules. By reviewing the returns, the auditor develops an understanding of the taxpayer’s reporting practices and the types of transactions the taxpayer reports. The auditor also gets a general idea of whether there are unique or unusual transactions that might require special attention.
PLANNING POINTER
For very large taxpayers, providing copies of the returns for each month of the audit period, along with all supporting work papers and schedules, can be a burdensome task. Many auditors will agree to examine a sample of returns to reduce the effort required for a complete review. taxpayers should not hesitate to suggest this. In addition, many auditors now have access to electronic copies of the tax returns, eliminating the need to provide the paper copies.

CAUTION
Many taxpayers include internal notes about filing issues in the return file. this information can be particularly damaging if discovered by the auditor. therefore, taxpayers should separate return and correspondence files so that they do not have to turn over the correspondence unless specifically requested.

Auditors sometimes modify their audit plan after they have reviewed the taxpayer’s returns. In the course of the review, they often discover new areas or procedures that will require special attention. For example, they may discover a special routine for distribution of marketing or office supplies that will require some alternative audit procedure.
CAUTION
distribution items like marketing material or order forms. these distribution procedures may occur outside the normal accounts payable activity that is subject to the auditor’s review. therefore, care needs to be exercised so that duplicate assessment on those items is avoided. For example, if marketing supplies are shipped to a centralized storage point and then redistributed from there with an allocating journal entry, the transaction could be incorrectly taxed twice if the accounts payable activity is taxed and the special distribution journal entry is also taxed.

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When reviewing the return files, the auditor will look at the categories of transactions and individual transactions reported. However, the auditor will also look for transactions that were not reported. the auditor’s review is aimed at identifying underpayments, so the auditor will always be interested in activity that is unreported or underreported. For example, if the auditor discovers that the taxpayer does not self-assess on purchases from out-of-state vendors, that would be an obvious focal point of the audit. After completing the return review and finalizing the audit plan, the auditor is ready to begin the transaction review portion of the fieldwork. As part of this review process, the auditor may have questions about the preparation of the return or the supporting schedules. Inconsequential questions such as these may be answered verbally. note that forcing the auditor to put them in writing could strain the relationship early in the audit.

PLANNING POINTER
Some auditors may skip the return review step and immediately begin the transaction review, or they may begin the transaction review and perform the return review later in the fieldwork. For this reason, taxpayers should be prepared to explain their return preparation procedures when asked.

PLANT TOUR

The auditor may request a plant tour as a means of gaining a greater understanding of the manufacturing process and the company’s operations. Knowledge gained from a plant tour can be particularly useful to the auditor during the review of transactions or negotiations of potential adjustments with the taxpayer. Taxpayers should view plant tours with caution. Although plant tours sometimes benefit the taxpayer, they often create problems as well. In the plant tour environment, it is difficult for the taxpayer, or their advisor, to control the discussion and the scope of the auditor’s review. The following steps can help assure as positive a result as possible: Carefully plan the physical layout of the plant tour. Try to avoid controversial or high-exposure areas. Anticipate auditor issues and questions. Plan ahead to stress points that strengthen your position on issues. Explain objectives to tour guides. Coach tour guides on appropriate responses to anticipated questions. Ask tour guides to only respond to questions in your presence. Rehearse with tour guides. Do not offer auditor independent contact with plant personnel during or after the tour. Provide plant layout or other materials to auditor only if requested to do so.

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TRANSACTION REvIEW

The sample of expenses and detailed review of fixed assets are the most critical elements of the audit in terms of their impact on the audit results. Once the sample has been selected, the auditor will review all the transactions in the sample to determine if tax has been properly paid. For the sales portion of the review, the focus will be on exempt sales and the correct application of tax. A transaction that was improperly exempted becomes a potential adjustment. Most sales adjustments occur for one or more of the following reasons: An incorrect tax rate was applied to the sale. An exemption was granted to a taxpayer without a valid exemption certificate. The tax was not billed correctly on the various elements of the sale.
PLANNING POINTER
For most taxpayers, the principal area of audit exposure is in the area of use tax selfassessment. Many taxpayers do not have adequate procedures in place to properly selfassess use tax as part of their regular compliance procedures.

NOTE unreported use tax on purchases is the largest and most common sales and use tax audit adjustment for most taxpayers.

For the purchases portion of the audit, the focus will be on purchases for which no tax was paid to the vendor or self-assessed by the taxpayer. Because of the variety of vendors and purchases that a business can have, most taxpayers have a difficult time maintaining control over their use tax self-assessment procedures. Auditors are aware of the lapses that taxpayers have in this area and tend to focus on it in their audits. The most common use tax errors include: Failure to self-assess on purchases from unregistered or out-of-state vendors Overreaching on the application of exemptions, such as manufacturing machinery and equipment Failure to self-assess on inventory transfers for self-use or purchases from related entities Incorrect application of tax to purchases, i.e., an incorrect rate or incorrectly taxing or not taxing the components of the purchase

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PLANNING POINTER through self-audit and reverse audit activity on an ongoing basis, taxpayers should be able to maintain the integrity of their use tax compliance. In addition, regular training classes may assist key people in making the correct tax determination.

This phase of the audit can take anywhere from a few days to several months to complete. Taxpayers with larger and more complex operations should be prepared to have the auditor spend a significant amount of time reviewing transactions. Taxpayers should make sure they spend a sufficient amount of time reviewing transactions questioned by the auditor. Failure to do so will result in unnecessarily large audit assessments. After completing a review of sales and purchases, the auditor will focus on transactions outside the scope of this review. Special procedures must be used to audit these transactions. Alternative audit procedures include: Special sampling techniques designed for the specific transaction under review The creation of assist reports to allow the auditor to capture all the information that is necessary to review the transactions A detailed review of specific classes of transactions Examples of transactions that might require alternative audit procedures include: Inventory transfers from inventory to project expense accounts Distribution of marketing and advertising materials or office supplies Any such review of other transactions must be coordinated with the samples and detailed review of sales and purchases to avoid any duplicate assessments.
Potential Errors List

After completing a review of all transactions, the auditor will give the taxpayer a list of potentially taxable transactions. The number of questioned items on the list will vary with the size and complexity of the taxpayer’s operations in the state. For a large taxpayer with extensive operations in the state, it would not be surprising to have several thousand transactions on the list of potential adjustments. As a general rule, the auditor will list a transaction as taxable if it does not appear to have an obvious exemption or exclusion applicable to it.
CAUTION
In many instances, items that should be exempt are listed by the auditor as questionable. It is the taxpayer’s responsibility to go through the list and determine if any of the questioned transactions are exempt or nontaxable.

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PLANNING POINTER
Keep in mind that once an item has been listed on any audit schedules by the auditor, he/she may have to justify its removal to an audit reviewer. therefore, it is important to minimize the transactions that the auditor schedules.

In the unlikely event that the taxpayer agrees to all of the adjustments, the auditor will prepare an assessment from the list of taxable transactions. If the taxpayer does not agree to the preliminary list of transactions as taxable, the auditor will allow the taxpayer additional time to review the data before meeting to discuss the questioned adjustments. During this time, the taxpayer will seek explanations to present to the auditor that will allow the auditor to exclude the items from the assessment. The list is normally presented to the taxpayer at the completion of the fieldwork. However, the taxpayer may request that the auditor provide a list of potential adjustments as each section of the fieldwork is completed. In a large audit, this would afford the taxpayer additional time to work on that portion of the audit while the auditor continues to work on other portions. For audits that are being completed under waiver, this can help complete the audit sooner.
PLANNING POINTER
Reducing the overall time spent on an audit can also reduce the interest that would be due on the assessment.

Once the auditor has written up a potential adjustment, the removal of that adjustment from the taxpayer’s assessment is subject to challenge by the auditor’s supervisor or, in some states, an audit review committee. For this reason, auditors are frequently hesitant to remove transactions from the questioned list. This is sometimes referred to as the write-up and review dilemma. Because of this factor, taxpayers should try to persuade auditors not to schedule potential adjustments by convincing them that the transactions are not taxable during the transaction review process.
Review of Questioned Transactions

As indicated in the previous section, the auditor will give the taxpayer time to review the list of questioned transactions. Then the auditor will meet with the taxpayer to discuss the taxability of each transaction. The timing of the meetings depends on the size of the audit. The taxpayer will usually have a number of weeks to review the proposed adjustments.

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PLANNING POINTER
If the auditor is willing, it may be advantageous to resolve routine issues via correspondence. More important issues can then be discussed in the meetings with the auditor.

At the meetings with the auditor, the taxpayer will present evidence to support its position that the transactions should not be taxed. Frequently, the taxpayer will require the support of various departments within the organization to convince the auditor of a particular transaction’s exempt or nontaxable status. For example, the auditor may need to understand specifically where in the manufacturing process a particular machine is used in order for the machine to qualify under a manufacturing machinery and equipment exemption. Unfortunately, taxpayer representatives dealing with the auditor sometimes lack adequate knowledge of the manufacturing process to convince the auditor.
PLANNING POINTER the taxpayer should anticipate the resources that will be necessary to complete the review and present a defense to the auditor. If support from other departments will be required, the taxpayer should coordinate the reviews and ask the auditor for additional time to complete the review.

Final Adjustments List

After the taxpayer and auditor have completed their negotiations over the questioned transactions, the auditor will prepare a revised list of proposed adjustments for the taxpayer. This listing of transactions represents the final agreed-upon or “agree-to-disagree” adjustments proposed by the auditor. The taxpayer should carefully review the revised list of transactions to make certain that all adjustments that the auditor agreed to make are reflected. Frequently last-minute adjustments may be forgotten in the haste to finalize an audit. Therefore, the taxpayer should also make sure that all final adjustments are within the scope and period of the audit. Any discrepancies should be brought to the auditor’s attention. The finalized list will become the basis for the audit assessment. By the end of the audit, the taxpayer should understand the reasons for all adjustments proposed by the auditor and have copies of all audit work papers for future reference. Any sample projections should be verified as well. When the assessment billing notice is received, the taxpayer should carefully trace all calculations to the final worksheet of adjustments prepared by the auditor to make certain that all errors have been correctly reflected. Again, any discrepancies should be brought to the auditor’s attention.

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STUDy QUESTIONS
5. Which of the following steps should be taken to improve the possibility of a positive result from a plant tour? a. b. c. d. 6. Avoid high exposure areas, if possible. offer the auditor independent contact with plant personnel after the tour. offer the plant layout to the auditor. Refuse to allow a plant tour.

Which of the following statements is not true? a. Large taxpayers with extensive operations in a state may have several thousand potential adjustments. b. Frequently last-minute adjustments may be overlooked. c. taxpayers should depend on the auditor to discover overpayments of tax. d. If the taxpayer has substantial sales but minimal purchases of fixed assets and expense items in a state, the auditor will focus on sales.

SAMPLING

A key component of any sales and use tax audit is the methodology employed in sampling sales and purchases. Every state that performs sales and use tax audits uses some form of sampling to avoid reviewing the entire universe or population. Unfortunately, many states’ methods of sampling fall far short of any accepted standards. This is due in large part to the extensive use of nonstatistical sampling. Many taxpayers accept the unreliable audit results produced by this form of sampling. The purpose of this section is to make taxpayers aware of the issues involved when sampling is used.
CAUTION
taxpayers that are unfamiliar with sampling procedures should consult experienced professionals. Agreeing to an audit sampling proposal without fully understanding the implications can have a negative effect on the audit results.

The case law in most states is replete with examples of sampling challenges. As the use of sampling became more prevalent, many taxpayers challenged the state’s authority to use it when all the pertinent records were available to make the determination. The Marine Midland Bank case in New York is typical of these early challenges [New York State Tax Appeals Tribunal, DTA No. 807533 (May 13, 1993)]. In Marine Midland, the taxpayer maintained complete books and records for the entire audit period. Although the taxpayer never expressly objected to the use of sampling, the state never sought agreement from the

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taxpayer to use it. The court held that since the bank had complete books and records available from which to make an exact determination of the audit liability, the state could not use sampling to “estimate” the liability without the taxpayer’s express consent. Cases such as Marine Midland temporarily delayed the implementation of sampling in many states, but subsequently the states have been highly successful in modifying the statutes to give themselves the necessary authority to use it. In fact, many states, such as Wisconsin, went so far as to allow the state to perform the sample—whether the taxpayer consented or not. Other states, such as Ohio, require that the auditor attempt to reach some agreement with the taxpayer on sampling methodology. However, lack of agreement on some elements of the sample does not preclude Ohio from performing a sample. Florida law requires that a statistical sampling method be used, but, if the taxpayer consents, a nonstatistical sample may be used.
PLANNING POINTER
Frequently, the auditor will only propose a nonstatistical sample, so taxpayers should not agree to any sampling proposal without first checking state statutes and relevant case law.

Taxpayers should not assume that auditors intentionally perform inaccurate samples. However, it could be argued that using a sampling technique that is unverifiable or unreliable goes beyond the statutory authority for an audit to determine the correct amount of tax due. Therefore, it is questionable whether the state’s authority to audit extends to sampling methods that produce unverifiable results, as is the case with a nonstatistical sample. Taxpayers should never assume that the state has authority to perform the sample as outlined by the auditor.
PLANNING POINTER taxpayers should challenge the auditor’s authority to perform a sample by requiring that the auditor show them the statute that authorizes the state to perform a sample when adequate taxpayer records exist.

The taxpayer and the state both have ample reasons to rely on sampling for determination of an audit deficiency. A properly constructed sample can make a highly accurate determination of the deficiency in the universe or population at a fraction of the effort for both the taxpayer and the auditor. The problem is that the bulk of audits performed are nonstatistical and consequently not properly constructed from the taxpayer’s point of view. The remainder of this section will highlight the pitfalls that taxpayers should avoid and suggest strategies for more effective sampling.

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PLANNING POINTER
It is important to express sampling concerns to the auditor or sampling specialist early in the audit and in writing. By doing so, you preserve your appeal rights relative to sampling issues and put the state on notice that you have concerns about the methodologies chosen.

MECHANICS OF SAMPLING

Each state has its own approach to sampling, but there are similarities in the way the samples are created and executed. This section provides an overview of sampling methods.
Nonstatistical sampling

This type of sampling is far more common than statistical sampling, and it involves selection by the auditor of representative transactions throughout the audit period for the sample basis.
EXAMPLE
In a four-year audit, the auditor might select a quarter of a year’s transactions from each year in the sample. the auditor would use a different sampling period for each year, so year one would be sampled with the first quarter, year two with the second quarter, and so on. For the entire audit period, the auditor will have reviewed one complete year of transactions. By structuring nonstatistical samples in this manner, the states are responding to the criticism that nonstatistical samples tend to be arbitrary in nature.

Once the auditor has selected the sample and isolated the transactions that will be subject to audit, he or she will review the transactions in the sample. For accounts payable, the auditor will review the actual vouchers, vendor invoices, or sales invoices that are selected in the sample. The auditor will flag any transactions with questionable tax treatment for further review by the taxpayer. The list of questioned transactions is turned over to the taxpayer for review and explanation of the nontaxed transactions. The taxpayer will be allowed a period of time to perform the review and gather the necessary documentation. Once the taxpayer has reviewed the questioned transactions, the more formal negotiation stage of the audit begins. The taxpayer meets regularly with the auditor to go over the questioned transactions. This important phase of the audit can continue intermittently for several months until all questions have been resolved. When the list of errors has been finalized, the auditor submits the necessary worksheets through the state billing system to generate an

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assessment for the taxpayer. All states have administrative procedures that govern the process from this point forward.
Statistical sampling

With this method of sampling, the selection process is considerably different, but the review by the auditor and the negotiation process with the taxpayer are essentially the same. The audit generally begins with a review of the chart of accounts and departmental listings for the entity under audit. The auditor uses this information to target the transactions that will be the focus of the audit. Special databases are often compiled for the areas under audit, such as accounts payable and sales. Random sampling programs are then run to generate a potential list of transactions. The auditor will review the list to make certain that the appropriate transactions have been included in the sample. The auditor will often rerun the sample to gain better coverage throughout the audit period.
CAUTION
Although they may be hesitant to acknowledge the practice when constructing a statistical sample, auditors may run the listing of potentially taxable transactions multiple times and select the sample that maximizes the potential revenue for the state.

Once the final selection of transactions to audit has been completed, the review and negotiation phases commence. At the conclusion of the audit, the auditor will issue an assessment. The calculation of the assessment from the sample is an area of concern for taxpayers. The sample projection methodology can have a great impact on the tax deficiency. Taxpayers should discuss the projection methodology with the auditor at the time a sampling plan is formulated.
EXAMPLE
If five percent of the transactions in a particular stratum are reviewed, any errors would be multiplied by 20 to reflect the universe for that particular stratum. therefore, transactions can have a substantially greater impact on the audit deficiency, depending up the stratum and sampling rate for that stratum.

PLANNING POINTER taxpayers should carefully review the sample projection to make sure that the auditor follows the agreed-upon methodology in executing the projection.

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In a nonstatistical sample, the auditor will generally use one of two methods for the projection of error: 1. Multiply the amount of error times a factor that grosses up the error to an annual or audit-period basis. For example, if the audit period is four years and one quarter from each year is examined, each error would be multiplied by four. Relate the measure of tax error to the measure of all transactions analyzed. An error rate is then applied to the total amount of all transactions in the universe to determine an overall audit deficiency.
PLANNING POINTER
Whenever the percentage of error method of projection is used, the taxpayer should verify that the population includes the same classes of transactions as the sample. Auditors may incorrectly exclude transactions from the sample during the sample preparation stage of the review without revising the base for the projection. Applying the error rate to an inflated population base can overstate the audit liability. the taxpayer should verify all projection calculations before agreeing to any audit settlement.

2.

ADvANTAGES AND DISADvANTAGES OF SAMPLING Through the use of sampling, the state can conduct an audit in a fraction of the time it would otherwise take. If the sample is properly constructed, the results will be comparable to those obtained by auditing every transaction.
PLANNING POINTER
Many times a non-statistical sample will sample such a large number of transactions that its result will reflect the universe that the sample is attempting to model, even though there is no way to statistically prove that the sample is accurate.

For taxpayers, a quicker audit means less distraction from running their business. The use of sampling also allows a quick assessment of the audit potential in transactions, which also speeds along the audit process. Advantages of sampling include: Provides an accurate reflection of taxpayer’s tax deficiency if properly constructed Allows the state to complete the audit more efficiently Minimizes the audit burden for the taxpayer Provides quick insight into audit potential of transactions, eliminating the necessity for a complete review Reduces the number of personnel required to complete the audit for both the taxpayer and the state Provides a viable examination option for high-volume transactions

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While sampling has many advantages, it can also have significant disadvantages if not properly executed. The principal disadvantage of sampling is that most states use a nonstatistical method of sampling for the majority of audits. Although all states are capable of using statistical sampling with verifiable audit results, most reserve it for the largest taxpayers in the state, if they use it at all. Even then, the process is often compromised in ways that reduce the integrity of the sample. Many states accept a wide range of error, particularly when compared to scientific or other sampling applications where a three to five percent sampling error is more standard. As a practical matter, most states do not disclose information about sampling accuracy to taxpayers, so taxpayers agree to samples without knowing the accuracy of the results.
PLANNING POINTER taxpayers should request in writing that credit or negative transactions be reviewed as part of the sample and projected as offsets against the underpayments to get a more accurate picture of the taxpayer’s liability. Virtually no states have a practice of sampling and projecting credits or negative amounts as part of their overall audit procedures, but to ignore these transactions distorts the results of the audit.

As previously noted, the principal problem with using nonstatistical sampling is that the result is unverifiable. Neither the state nor the taxpayer knows whether the audit liability is a correct reflection of the true liability of the taxpayer. Nevertheless, states and taxpayers continue to rely upon nonstatistical sampling for the vast majority of audit settlements. Another disadvantage of sampling, whether statistical or nonstatistical, is that the state can influence the outcome of the sample by excluding certain transactions from the sample or by including a disproportionate amount of other transactions in the sample. This may result in an incorrect view of the population or universe sampled. When converted to an audit deficiency, the result can be seriously distorted.
PLANNING POINTER taxpayers should request in writing that credit or negative transactions be reviewed as part of the sample and projected as offsets against the underpayments to get a more accurate picture of the taxpayer’s liability. Virtually no states have a practice of sampling and projecting credits or negative amounts as part of their overall audit procedures, but to ignore these transactions distorts the results of the audit.

Disadvantages of sampling include: Most states do not use a verifiable sampling method in the majority of audits performed.

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Results can be biased and, therefore, not representative of the population or universe sampled. Most taxpayers have difficulty understanding sampling concepts, which makes them vulnerable to the state’s errors. Sampling is frequently applied to transactions that are not appropriate for sampling, such as large fixed-asset purchases. Sample sizes are not determined using any precise methods of calculation. States routinely over-sample transactions to get taxpayers to agree to the audit results, thus imposing additional effort on both the taxpayer and the state. block (Nonstatistical) Sampling Overview

Nonstatistical sampling is the mainstay of the states’ sampling methods. Its use is particularly prevalent for smaller taxpayers. This method is widely used because of its perceived ease of administration and execution. A number of states rely exclusively on nonstatistical sampling, including: Arizona Kentucky New Jersey New Mexico Oklahoma In a typical nonstatistical sample, an artificial distribution of transactions is used to create a sample from the population or universe to be sampled—such as sales invoices or vouchers. Nonstatistical samples are often based on a test of certain months or quarters during the year or an alphabetical sequence of vendors, invoices, or customers for some period of time. The sample is then analyzed and reviewed with the taxpayer. An error rate is established, and the resulting audit deficiency is calculated. For interest calculation purposes, the deficiency is usually spread over the audit period using sales or purchases as the allocation factor. Several common bases used to execute a nonstatistical sample include: Time-based sample, such as a month of sales or a quarter of purchases Alpha-based sample, such as all vendors with last names beginning A through H for first year of audit period, or all customers with last names beginning I through S for second year of audit period File drawer sample, i.e., if a year’s transactions are maintained in four standard business file drawers, the auditor selects one drawer from the four for each year of the audit Every nth item selected for sample, such as every 50th voucher Cluster sample, i.e., consecutive blocks of certain transactions are selected for review

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The use of a statistical sample provides greater assurance of the reliability of the result. Taxpayers should encourage the auditor to perform a statistical sample whenever possible.
Problems with Nonstatistical Samples

As noted in the previous section, the principal problem with a nonstatistical sample is the inability to verify the accuracy of the result. In addition, there is no way of knowing the proper sample size for a particular taxpayer. This could result in either over-sampling or undersampling of taxpayer records. When the auditor over-samples a taxpayer, the result may be a more accurate reflection of the taxpayer’s true audit liability, but unnecessary resources are expended by both the taxpayer and the state. When the auditor under-samples, the audit deficiency is based upon too few transactions to reach a reliable conclusion. This can be remedied by expanding the sample, but most auditors do not make the effort to do so unless the sample appears to be seriously flawed. Problems with nonstatistical sampling include: Inability to verify reliability of audit result Unscientific sample size, which may result in over-sampling and undersampling Arbitrary exclusion of a major category of transaction from the sample (i.e., many states exclude credits, which introduces an unnecessary bias into the sample) Haphazard selection, resulting in potential duplicate assessment on certain transactions (ex., if an alpha sample is used and Vendor A provides office supplies in year one while Vendor Z provides the same office supplies in year four, the audit result will be overstated if both vendors are selected in the sample.) Failure to take into account seasonal fluctuations in volume of business— the assumption is often made that activity is constant throughout the year Lack of stratification—all transactions are weighted equally regardless of their frequency of occurrence. Nonstatistical sampling does not distinguish between amounts when the sample error results are projected to the audit deficiency. For example, most businesses have substantially more small transactions (under $50) than large transactions (over $10,000). In a one-quarter sample, all errors would be multiplied by four to calculate a full year’s error, regardless of the frequency with which they occur when, in truth, the transaction may occur at more or less frequent intervals.

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PLANNING POINTER
If the auditor insists on performing a nonstatistical sample, the taxpayer should negotiate adjustments to the procedures that will minimize potential problems. For example, if there is duplication in review of certain transactions, purchases from those vendors should be audited in detail rather than projected. Likewise, if an unusually high dollar amount is selected in the sample, the auditor should be willing to audit those purchases in detail.

Statistical versus Nonstatistical Sampling

In addition to superior reliability, statistical sampling offers a number of other advantages when compared to nonstatistical sampling. As mentioned previously, states tend to reserve statistical sampling for larger taxpayers. Smaller taxpayers can usually request a statistical sample, though they may be required to demonstrate to the auditor that their computer system can support a statistical sample.
PLANNING POINTER taxpayers should be certain that they understand statistical sampling before requesting that a statistical sample be performed. A poorly done statistical sample is of little use to the taxpayer.

Strategies for More Effective Samples

To help ensure more effective audit samples, taxpayers should: Understand the state’s sampling techniques, especially as applied to their particular business. If necessary, they should seek professional assistance with regard to sampling. Participate in planning and executing the sampling plan. They should not hesitate to make suggestions to the auditor that will improve the sample or the sampling methodology. Assist the auditor in reviewing departments or charts of accounts for inclusion or exclusion from the sample. Consider whether the inclusion of capital assets in the sample would benefit them. The state may be willing to include lower dollar amount fixed assets in the sample to avoid the effort of reviewing these transactions in detail. Work with the auditor to reduce sample size and eliminate unnecessary effort. Encourage the auditor to use a statistical sampling method whenever possible. Request that the sample be drawn from all types of transactions, including credits. Provide for appropriately trained support to assist the auditor in executing the sample when, for example, a computer-assisted audit is performed.

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STUDy QUESTIONS
7. Which of the following is a disadvantage of using sampling? a. Most states use nonstatistical sampling instead of statistical sampling. b. Sampling increases the number of state personnel needed for the audit. c. Sampling increases the audit burden for the taxpayer. 8. Which of the following statements is true? a. In a nonstatistical sample, auditors usually use one of three methods for purposes of error projection. b. Sample projection methodology does not have much impact on the determination of tax deficiency. c. Nonstatistical sampling results in unverifiable results. 9. States do not necessarily have the authority to perform audit sampling as outlined by the auditor. True or False? a. true b. False

Overall Audit Strategies

Interpersonal skills can have a significant effect on audit results. Taxpayers must remain mindful of the importance of civil behavior when dealing with an auditor. This does not mean, however, that there may not be differences of opinion on significant issues. Taxpayers would be derelict in their duties if they did not raise legitimate concerns when appropriate. The key to successfully managing conflict in an audit is to avoid personalization of disagreements. Respectfully disagreeing with an auditor’s position based upon a thoughtful analysis of the statutes will benefit the taxpayer in terms of their creditability and overall dealings with the auditor. In addition, an auditor is more likely to side with the taxpayer when a judgment call is required if the taxpayer has worked with the auditor in a cooperative manner. Navigating a course of respectful disagreement, while avoiding personal conflict, is one of the most important skills that a taxpayer can develop. The following pointers should serve as a guide to appropriate taxpayer conduct during an audit: Be prompt to audit meetings. This creates the impression that the audit is a priority for you. Display a positive attitude at all times toward the auditor or the jurisdiction imposing the audit. Recognize that the auditor has a job to do, and be professional about your role in the process. Be ready with any data you agreed to provide.

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Do not impede the audit process. Delaying the release of information rarely has a positive effect on the audit’s outcome. Respond to requests for data promptly. Do not attempt to intimidate the auditor. Doing so often makes the auditor more determined to review additional areas. Provide the auditor with comfortable work accommodations. Cooperate with the auditor to complete the audit in a timely manner. Once you agree to a schedule for the audit, attempt to stay on that schedule, and regularly inform the auditor of your progress.
Negotiation Skills

Strong negotiation skills will serve a taxpayer well in an audit. While many issues, such as the statute of limitations or state policy on the taxation of certain transactions, may not be negotiable at the auditor level, the majority of issues relating to the application of tax to specific transactions are subject to negotiation. Like any other skill, negotiation requires practice. Following are tips for successful negotiation with an auditor: Accept the fact that the auditor will sometimes win. Understand the auditor’s ability to negotiate. Early on, test the auditor’s authority to negotiate. Auditors will often defer to their supervisor on certain issues. Never attempt to inappropriately influence the auditor or even hint at any inappropriate behavior. Maintain composure, and avoid losing your temper or exchanging harsh words with the auditor. Be willing to admit to error. This raises your credibility on other matters. Compromise, when appropriate, as audit issues are rarely “black and white.” Be honest and forthright in your dealings with the auditor. Never lie or attempt to deceive the auditor. Once you have identified a position as nonnegotiable, do not back down. Try to identify a middle ground, if appropriate, that provides most of what you want and gives the auditor something as well. Once you win your point, stop talking. Have multiple options available for critical positions with broader audit implications. Know your negotiation parameters and limitations. Defer to others on the facts when appropriate. Speculating or guessing on the facts generally creates more problems than it solves.

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STUDy QUESTION
10. Which of the following would most likely be subject to negotiation at the auditor level? a. b. c. d. the application of tax to a particular transaction the taxation of a type of transaction for which there is a state policy Issues concerning the statute of limitations the frequency of future audits

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Post-Audit Strategies
LEARNING ObjECTIvES upon completion of this chapter, you will be able to: List the different types of penalties that may be assessed explain common reasons for the imposition of penalties describe the reasons for meeting with the auditor’s supervisor List the different penalty defenses that may be used explain what should be considered when determining whether to file an appeal describe the current trends in sales and use tax audits

FINALIzING THE AUDIT

In the final phase of the audit, taxpayers have decisions to make regarding payment and appeal of the final results. Taxpayers who continuously assess the strength of their positions throughout the audit will be better prepared to make these decisions. The following actions should be taken in the final stages of an audit: Meet with auditor at a concluding conference, and verify the timetable and tasks to be completed to finalize the audit. Discuss the assessment process, and clarify your rights and responsibilities. Take particular note of your appeal rights and deadlines if you are planning to appeal. Confirm your appeal and payment rights through analysis of the state’s law. If the auditor provides you with copies of the audit workpapers, verify that all agreed-upon adjustments are reflected in the final workpapers. When the assessment is received, verify all amounts against the final worksheets provided by the auditor. Note deadlines for payment or appeal and plan accordingly so they are not missed. If an appeal or litigation is contemplated, discuss the probability of success with outside counsel. Verify that the interest calculation is correct. If the state allows partial payment on agreed-upon issues, consider paying that portion of the assessment to reduce interest costs during an appeal. Make sure the audit deficiency is properly accounted for on the company’s books. Promptly notify the auditor of any errors or discrepancies in the final audit workpapers or assessment.

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The Assessment

Before making any appeal or litigation decisions, taxpayers must verify that the assessment is correct. Prior to completion of the fieldwork, taxpayers should receive copies of all audit workpapers and schedules. These documents should be reviewed to verify that they properly reflect the agreements reached in the negotiations, particularly in the final stages of negotiations. Taxpayers should also verify that all dollar amounts have been correctly transferred from the worksheets to the assessment. Any errors in the assessment or discrepancies from the taxpayer’s final worksheets should be brought to the auditor’s attention immediately. Particular attention should be paid to any last-minute adjustments that were made in final negotiations to make sure they were carried forward to the auditor’s final worksheets. After all required adjustments have been made, some states will issue a preliminary assessment while others will issue a final assessment. An assessment is a formal request for payment that imposes certain obligations on the taxpayer for payment or appeal of the audit results.
CAUTION
With the issuance of an assessment, the state has the ability to place in motion a series of events that could culminate in the placing of a lien against assets of the taxpayer or the seizure of a taxpayer’s assets for failure to pay the assessment.

The issuance of either a preliminary or final assessment can take from four to 12 weeks after the fieldwork is completed. Most states issue their assessments six to eight weeks after the auditor turns in the necessary papers. Virtually all states engage in a review process that the audit must pass through before an assessment can be issued. This review process assures that the audit results are consistent from taxpayer to taxpayer and reflect the state’s current positions on key issues. Most states rely upon the auditor’s supervisor to perform the review; however, some states have a formal committee or department that reviews and processes all assessments. The level of review can vary with the amount of the assessment—larger assessments generally receive closer scrutiny. The issuing of a preliminary assessment affords the taxpayer an additional opportunity to review all the details before the final assessment is issued. Some states consider the auditor’s issuing of final copies of all worksheets a preliminary assessment and go directly to the final assessment. In either case, taxpayers should carefully review all data provided as part of an assessment. All dollar amounts from the assessment should be traced to the worksheets and schedules prepared by the auditor.

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CAUTION
Particular care should be observed regarding the deadline for any appeals. those dates are generally 30-90 days from the date of mailing or date on the notice. After the time has elapsed, the audit can no longer be appealed. So, taxpayers wishing to make an appeal of the results should make sure the appeal is filed no later than the deadline noted. In most states, the appeal must be postmarked by the deadline date, however, that, too, should be carefully reviewed to make sure that the correct date is observed.

States often allow the taxpayer to make a payment from the preliminary assessment to avoid incurring additional interest costs. If the audit is agreed upon, the taxpayer may wish to consider this alternative. In some states, if the audit is only partially agreed upon, the taxpayer may pay that portion to reduce interest costs on the overall settlement. Most states allow the taxpayer 30 or 60 days from the preliminary assessment notice to call attention to any errors that require correction before the final assessment is issued. In the event they find errors, taxpayers should promptly contact the auditor. Taxpayers should also verify the accuracy of any interest or penalty calculations that may be part of the preliminary assessment. Most states use simple interest, which makes the verification process relatively easy. If a penalty has been included in the assessment, taxpayers may wish to consider appeal of its imposition along with other issues. Taxpayers who receive a final assessment notice in lieu of a preliminary notice should follow the same general review procedures. Regardless of whether they receive a preliminary or final assessment notice, taxpayers need to take particular note of the deadline for appeal. The deadline is usually 30 to 90 days after the date the notice was mailed or received. If the taxpayer fails to file an appeal or protest by the deadline, the assessment becomes final and the results cannot be appealed.
PLANNING POINTER taxpayers should consider special mailing procedures for their payments or appeals, such as certified mail with a return receipt requested. Without proof that the payment or appeal was sent prior to the due date, taxpayers may be liable for additional interest or penalty expense. In addition, many states do not recognize overnight services, such as Fedex, until the return is received. So, care must be exercised in the use of such services.

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STUDy QUESTION
1. How much time from the preliminary assessment notice date do most states allow the taxpayer to report errors in the assessment? a. b. c. d. 90 or 120 days 30 or 60 days Six months Most states do not impose a time limitation for the reporting of errors.

PENALTy IMPOSITION

States use penalties as a means of obtaining greater taxpayer compliance. Because penalties are nondeductible for federal income tax purposes, the after-tax cost of a penalty is substantially greater than that of a fully deductible expense. The imposition of penalties also provides the state additional revenue. For example, a 25 percent penalty on a four percent tax base yields the equivalent of an additional one percent of tax. This does not take into account the additional income tax collections that result from the nondeductibility of the penalty expense. A contributing factor to the states’ increased use of penalties in recent years has been their efforts to make additional information available to taxpayers to assist them in compliance. In return, the states expect a higher level of compliance. In most states, the audit supervisor has the principal authority to impose a penalty, based upon the recommendation of the auditor. A few states impose automatic penalties on any assessment after the first audit assessment. Penalties can be imposed for a number of reasons—ranging from failure to self-assess use tax on purchases from out-of-state vendors, to committing fraud in filing a false return. Auditors are attuned to the potential for penalties in every audit they perform. They regularly amass the facts to determine if a penalty should be imposed. Taxpayers also need to be aware of the problems that could lead to the imposition of a penalty. Some of the more common reasons for imposition of a penalty include: Failure to file a return Failure to make payment of tax due Late filing or payment Failure to correct past errors in compliance Engaging in fraud or willful evasion of tax Most of these reasons are fairly obvious; however, one that is frequently overlooked by taxpayers is the failure to correct past compliance problems.

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EXAMPLE
Failure to self-assess on fixed asset purchases is a fairly common error in most audits. taxpayers who fail to initiate procedures to capture this information are setting themselves up for a penalty imposition in the next audit cycle with the state.

The states have an arsenal of penalties to fit various circumstances. The more serious the infraction, the greater the penalty. Following are the more common types of penalties: Ordinary negligence penalty Gross negligence penalty Fraud penalty Substantial understatement penalty
Ordinary Negligence

The penalty most commonly imposed is for ordinary negligence, which occurs when a taxpayer fails to exercise the degree of care that would be expected of a reasonable person in similar circumstances. Essentially, ordinary negligence means the taxpayer has not met its minimum responsibilities under the law. For example, if the taxpayer regularly makes purchases from vendors that do not charge tax, the taxpayer would be expected to have a self-assessment procedure in place. Failure to have such a procedure in place could result in the application of penalty to the amount of tax underpaid.
CAUTION
Many states have extended the ordinary care concept to include correction of similar errors identified in prior audits. therefore, taxpayers need to demonstrate improvement in compliance to avoid penalties in subsequent audits.

The rates for ordinary negligence penalties generally range from five percent to 15 percent of the amount of tax owed in the audit; the most common rate is 10 percent. In most states, ordinary penalties for late payment or late filing are imposed on a monthly basis up to a maximum rate or dollar amount per event. For example, the ordinary late return filing penalty might be five percent per month of the tax due up to a maximum of 25 percent of the tax due. A minimum dollar amount often applies to penalties of this nature.
Gross Negligence

Gross negligence occurs when the taxpayer demonstrates a careless or reckless disregard for the law. Such carelessness or disregard could be manifest in several ways, many of which are subject to interpretation by the states.

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For example, a careless or reckless disregard for the law could be demonstrated by a taxpayer’s failure to have adequate procedures in place to meet its tax responsibilities. Many states have also interpreted gross negligence to include failure to correct errors identified in prior audits.
CAUTION
Many states are going to additional lengths to point out errors to taxpayers in formal communications that are part of the audit. For example, a state might inform the taxpayer in a letter that it is expected to initiate procedures to capture the tax due on certain transactions. In doing this, the state is giving the taxpayer notice and setting the stage for a future gross negligence penalty if the taxpayer fails to address the problem. note that gross negligence penalties are most commonly imposed in a subsequent audit.

The rates for gross negligence penalties generally range from 20 to 30 percent; the most common rate is 25 percent. Many states impose additional, higher rates of interest to add to the impact of the penalty.
Fraud

Fraud occurs when the taxpayer willfully misleads or takes steps to conceal the truth about transactions as a way of evading the payment of tax. Largescale fraud can be a criminal offense. Fraud can include filing a false return or intentionally misleading an auditor.
CAUTION
Fraud can occur in compliance activities by willfully ignoring transactions that should be reported. It can also be alleged in an audit if the taxpayer either attempts to or does mislead the auditor with the intent of evading tax.

PLANNING POINTER
Written communications throughout the audit can help protect the taxpayer from possible accusations at a later time. By keeping a written transcript of exchanges with the auditor, a taxpayer can demonstrate that there was no attempt to willfully mislead the auditor on any matters.

In most jurisdictions, the penalty for fraud is generally 50 or 100 percent of the tax owed. Many jurisdictions also levy additional interest at a higher rate than otherwise might be assessed. The penalties for criminal fraud can include additional fines or imprisonment, depending on the nature and extent of the actions involved.

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PLANNING POINTER taxpayers who may have engaged in fraud or learn that others at their company may have been involved in fraud in the past should retain legal counsel to assist in their defense throughout the entire process.

Substantial Understatement

The substantial understatement penalty provisions give the state authority to expand the scope of an audit and /or impose additional financial sanctions. Under these provisions, the amount of tax voluntarily reported throughout the audit period is compared with the amount of tax that was subsequently found to be due as a result of the audit. If the difference exceeds a certain threshold, the state has the authority to expand the audit period into earlier years and impose additional penalties. The additional time period is usually between two and four years. The substantial understatement provisions also impose greater penalty and interest rates than would otherwise be applicable on the assessment. These rates are typically greater than those imposed for ordinary negligence and are closer to the gross negligence rates. Although the substantial underpayment provisions are most commonly employed in income tax audits, they can be applied in sales and use audits as well.
STUDy QUESTIONS
2. Which of the following is the most common penalty imposed as the result of a sales and use tax audit? a. b. c. d. 3. ordinary negligence penalty Gross negligence penalty Fraud penalty Substantial understatement penalty

What type of penalty would most likely be imposed if a taxpayer has shown a reckless disregard for the law? a. b. c. d. ordinary negligence penalty Gross negligence penalty Fraud penalty Substantial understatement penalty

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MEETING WITH THE AUDITOR’S SUPERvISOR

Near the end of the audit, the taxpayer needs to consider meeting with the auditor’s supervisor. The purpose of the meeting would be to advance the potential for a settlement on certain issues. In addition, the meeting could reveal the importance of the audit supervisor in the overall audit process. The supervisor’s role varies with the nature of the audit and the auditor’s level of experience. In a major audit, or if the auditor is inexperienced, the supervisor will play a more active role—at times directing the auditor through each stage of the review. Given the field audit background of most supervisors, the supervisor may have audited the taxpayer, so the supervisor’s knowledge of the taxpayer’s operations could be substantial. In a routine audit, or if the auditor is experienced, the supervisor will assume a background role and only become involved in the review process or at the request of either the taxpayer or the auditor. Occasionally, a supervisor will visit the taxpayer early in the audit process to assist the auditor in setting up certain aspects of the audit. For example, the supervisor may advise the auditor on sampling or areas to review, based on interviews with the taxpayer. Taxpayers may wish to inquire about the division of responsibility for various aspects of the audit while both parties are present to avoid confusion as the audit progresses. To avoid conflict with taxpayers, auditors often blame their supervisors for positions that are adverse to the taxpayer. The auditor might express support for the taxpayer’s position but say the supervisor insists on a different approach.
CAUTION
It may be difficult to determine who is directing the audit from the state’s perspective. In general, you should assume that the supervisor wields great influence on the direction of the audit, working in close concert with the auditor behind the scenes.

A taxpayer would request a meeting with the auditor’s supervisor for the following reasons: To negotiate trade-offs on certain issues To discuss the reasons for imposition of a penalty or the abatement of a penalty that has been imposed To gain additional insight into the position of the state To discuss problems relating to the auditor Each of these points is discussed on the following pages.

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Negotiation

In the latter stages of an audit, the taxpayer may have the opportunity to negotiate settlements on certain issues. Such opportunities are more likely to arise when there are few, if any, major areas of controversy. The state’s motivation may be to avoid conflict on certain issues or to achieve an agreedupon audit settlement. If the auditor lacks the authority to negotiate such settlements, a meeting with the auditor’s supervisor will be necessary. The taxpayer may not have to initiate the meeting, as the supervisor will often plan to meet with the taxpayer anyway to finalize open issues such as the imposition of penalty. The decision to “trade-off ” issues usually comes on the last planned day of negotiations and generally involves transactions with which there is some uncertainty regarding taxability. There will usually be one or more issues favoring the taxpayer and one or more issues favoring the state. Either the taxpayer or the state can suggest that the parties agree to trade-off the issues. The state passes on a transaction that it had hoped to tax in exchange for being allowed to tax some other transaction.
PLANNING POINTER taxpayers should prepare for the meeting by reviewing transactions that might be eligible for trade-off. Knowing the audit impact of transactions in advance can make for more fruitful negotiations. For example, if the supervisor proposes a trade-off that is overly advantageous to the state, the taxpayer might want to counter with an additional transaction to level out the impact.

States prefer to have an agreed-upon audit settlement, so the negotiation strength of the taxpayer is the greatest when the parties are close to settlement. If the audit process has been contentious, it is not as likely that the state will agree to any trade-offs with the taxpayer. While taxpayers should not refrain from raising legitimate issues of concern throughout the audit, they must also be realistic about the impact of doing so on other aspects of the audit.
EXAMPLE
States are generally less willing to engage in trade-offs at the field audit level if they know the audit will be protested since there is little incentive in such situations to reach an agreement.

Penalty Discussion

As previously discussed, the decision to impose a penalty is frequently made by the auditor’s supervisor with input from the auditor. Therefore, penalty issues are often the subject of discussions between a taxpayer and a supervisor.

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States assign the decision to the supervisor to achieve consistency in the application of penalty and to provide for as unbiased a decision as possible. However, the auditor can play a significant role in the decision by recommending an option to the supervisor. Therefore, taxpayers should not completely discount the auditor’s role in the process and should attempt to work through as many penalty issues as possible with the auditor.
PLANNING POINTER
Prior to meeting with the supervisor, the taxpayer should try to determine whether the state intends to impose a penalty in the audit. the taxpayer may wish to discuss the matter with the auditor. If the auditor is evasive or noncommittal, the taxpayer should be prepared for the possible imposition of a penalty.

The State’s Position

Taxpayers who are considering appeal of certain issues can obtain useful information regarding the strength of the state’s position from a meeting with the auditor’s supervisor. In many cases, substantive discussions of issues with auditors can be difficult, if not impossible. They will frequently reply that the issue is a matter of state policy or provide vague references to the statutes as their authority to impose tax on a transaction. To make an informed decision about an appeal or litigation, the taxpayer needs to know the strength of the state’s position and whether the state is willing to contest the issue. A meeting with the supervisor will often provide this insight. In addition, the meeting will help the taxpayer focus on the strengths and merits of its own position. Even if they do not intend to appeal or litigate, taxpayers may wish to approach the meeting with the supervisor as if they intended to do so. The supervisor may attempt to negotiate a settlement with the taxpayer to avoid a costly appeal or litigation. Taxpayers may have to file an appeal before substantive discussions with the supervisor or other Department of Revenue official can take place.
CAUTION
taxpayers need to present their argument in a comprehensive and convincing manner. Failure to do so could result in the state’s discounting the taxpayer’s position and being unwilling to negotiate a settlement to avoid the potential appeal or litigation. thus, the taxpayer’s position could actually worsen as a result of the meeting.

Problems with an Auditor

Serious problems with an auditor can occasionally occur in the course of an audit. When discussions with the auditor prove fruitless, the only recourse

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is to discuss the problems with the auditor’s supervisor. This is not an action that should be taken lightly, as supervisors tend to be skeptical of taxpayer claims in this regard. In addition, the taxpayer’s working relationship with the auditor can be irreparably harmed, particularly if the supervisor does not side with the taxpayer. Generally, taxpayers should only pursue a meeting with the supervisor to remove an auditor if the auditor has: Been extremely unreasonable Displayed bias in the audit Engaged in inappropriate conduct
EXAMPLE
If the auditor is auditing a minority-owned manufacturing company and makes statements displaying prejudice, the taxpayer would be justified in contacting the supervisor.

Before meeting with the supervisor, the taxpayer must thoroughly document the events that give rise to the concern. If the incident involves a verbal discussion, the taxpayer should carefully document whatever was said as soon as possible after the incident. Signed statements from individuals involved in the incident or incidents should also be obtained to provide further support for the taxpayer’s position. In most cases, the taxpayer should request a new auditor, but the taxpayer must recognize that the replacement auditor may be aware of what happened and, as a result, be biased against the taxpayer. Sometimes there are no easy solutions in these matters.
STUDy QUESTION
4. Which of the following is not a reason for a taxpayer to ask a supervisor to remove an auditor? a. b. c. d. the auditor has behaved inappropriately. the auditor is extremely unreasonable. the auditor is always late to meetings. the auditor is biased.

vERIFyING THE CALCULATION OF INTEREST

All states impose interest on deficiencies assessed as a result of an audit. The rates vary, usually ranging from 6 percent to 9 percent per year. Some states tie their underpayment interest rates to market interest rates. The objective of the higher rates is to prevent taxpayers from using the low interest costs of underpaying their taxes to finance other activities—a practice that was once common.

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Most states continue to assess simple interest, but there are several that apply compound interest rates to the underpayments. A few states tie their interest rates to the federal interest rates plus some additional factor, while a number of other states key off the prime interest rate. To verify the interest assessment: Determine what the state statute says regarding interest Estimate the amount of interest Compare the estimate to the interest assessed and, if there is a significant difference, notify the auditor. While the widespread use of computers has lessened the importance of the interest assessment review, it is still worthwhile to test the calculation along with the state’s allocation assumptions underlying the computation. In an income tax audit, the deficiency is usually more closely related to a particular point in time. However, in a sales and use tax audit, that is not necessarily the case. Because of the heavy reliance on sampling of expense purchases in sales and use tax audits, the audit deficiency may not be specifically assigned to each month under audit. In other words, the sample relates to the entire audit period, but not necessarily to any specific month within that period. In order to calculate interest, the sample must be allocated across the audit period on a monthly basis. The most common allocation bases used for this purpose are sales and cost of goods sold. These indices are utilized under the assumption that they reflect the volume of business for the taxpayer. For computational purposes, the auditor assumes that the deficiency determined by the sample was earned ratably over the audit period, and then allocates a portion of the deficiency to each month, using sales, cost of goods sold, or some other appropriate measure of business activity.
PLANNING POINTER
An allocation methodology that results in allocating the least amount of deficiency to the earlier years of the audit will reduce the overall interest expense. In many instances, the nature of sales volumes automatically has that effect. However, sales may not continue to increase across all audit periods. Where this is not the case, the taxpayer may wish to consider alternative methods of allocation that will result in a more equitable interest calculation (such as volume of purchases).

In addition to regular interest, some states have penalty interest that can be assessed. Penalty interest is calculated in the same manner as regular interest and may appear as just a higher rate of interest on some portion of the assessment or as a “surcharge” on the regular interest. The only additional review that would be required for penalty interest would be to verify the reason for the additional imposition.

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STUDy QUESTION
5. the use of computers has made the interest assessment review unnecessary. True or False? a. true b. False

SUCCESSFUL PENALTy APPEALS

Taxpayers would generally be expected to appeal a penalty because of the additional financial burden it imposes, particularly when its nondeductibility for federal income tax purposes is considered. Before taxpayers can make any decisions regarding the appeal of penalties, they must establish the basis for the state’s imposition of penalty. Obtaining a specific reason for imposition of penalty from the state can be a challenge. However, an attempt to secure an explanation is in order if the taxpayer intends to appeal. In order to refute the state’s position regarding a penalty, the taxpayer must understand the state’s reason for imposing it. Assuming the taxpayer obtains a satisfactory explanation for imposition of the penalty, the taxpayer must then present specific evidence to refute its imposition. However, since the reasons cited by the state for penalty imposition are often vague, taxpayers must also be prepared to provide broad evidence to convince the state to abate the penalty. If the state cites a specific transaction or group of transactions as giving rise to the penalty, the taxpayer will need to demonstrate that its actions with regard to the transaction(s) did not meet the penalty statute’s standard for imposition. If the state imposed a penalty because the taxpayer failed to exercise reasonable care in its self-assessments of tax on fixed assets, the taxpayer would want to introduce evidence to demonstrate that it had in fact exercised reasonable care. The taxpayer would want to: Explain its self-assessment procedure Cite the dollar amounts self-assessed and compare those amounts to the audit assessment amounts. List the number of transactions reviewed Identify any other material fact that supports its argument for abatement of penalty The taxpayer might also want to review department regulations, court cases, and department of revenue publications to determine if there are any guidelines that support its position.

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There is a good chance that the state will not be specific in its reasons for imposing a penalty. In many instances, the state will merely indicate that the taxpayer had made errors in prior audits with self-assessments and that similar errors were found in the current audit. Or the state may cite the amount of the assessment or the number of errors in the audit as being greater than in the previous audit. When the state provides general reasons for the imposition of penalty, the taxpayer must be prepared to respond in a broad manner. There are a number of general defenses to penalty imposition: Complexity in the administration of tax law Unsettled nature of issues Demonstrated level of self-compliance Tax voluntarily paid versus audit deficiency Prior audit history and compliance record (if favorable) Staffing issues Degree of cooperation with auditor These are discussed below.
Complex and Unsettled Issues

The first two defenses would not be appropriate in situations where the penalty has been imposed on uncontroversial transactions. They are more appropriate for issues that could be resolved as either taxable or nontaxable, depending on the way the facts are interpreted. The purpose of these defenses is to establish that the issue is unclear for compliance purposes and that a reasonable person could decide that the transactions were non-taxable, just as easily as they could determine that they were taxable.
Self-Compliance

The purpose of the self-compliance defense is to establish that the taxpayer was making a good-faith effort to comply with the law. To demonstrate self-compliance, the taxpayer must explain its self-assessment procedures highlighting the amounts assessed by category. voluntary Tax Payment

The reason for imposing a penalty can be diminished by comparing the amount of the deficiency with the amount of tax voluntarily paid during the audit period. For example, if the taxpayer had an audit deficiency of $50,000, but was able to show that over the entire audit period it had paid $500,000 in tax, the audit error would represent less than 10 percent of the amount of tax owed.

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If the taxpayer has information regarding the amount of sales tax paid to vendors, that can enhance the effectiveness impact of this defense. Unfortunately, many taxpayers are unable to obtain this information because their accounts payable systems do not capture the tax paid as a separate field. For most taxpayers, substantially more tax is paid to their vendor than self-assessed. So, making those comparisons is generally very favorable to the taxpayer.
Prior History

Discussing audit history can be an effective defense, if the taxpayer has a good record. For example, if the taxpayer has had only minimal audit assessments in the past, that would be an important fact to emphasize. If the taxpayer has a consistent record of timely compliance, that should also be emphasized.
Staffing Issues

Staff turnover and other personal issues can create compliance problems that are revealed in an audit. If this has occurred, it should be highlighted in the penalty discussion. This factor bears on the intent of the taxpayer—i.e., the taxpayer intended to comply but could not due to staffing problems.
CAUTION
understaffing of the tax function can also indicate a lack of emphasis on tax compliance by permanently understaffing the area. So care must be exercised before making this argument.

Degree of Cooperation

While it is unlikely that this defense alone will result in the abatement of penalty, it is worthwhile to raise in the appeal. Many taxpayers are uncooperative, so a cooperative taxpayer can create a favorable impression.
STUDy QUESTION
6. Which of the following defenses should be used to establish that the taxpayer has made a good-faith effort to comply with the tax law? a. b. c. d. Prior audit history Staffing issues degree of cooperation with the auditor Level of self-compliance

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Appeal and Litigation Decisions

In the final stages of the audit, taxpayers must decide whether to appeal the audit results. A number of considerations enter into a decision to appeal or litigate. These include: When to involve an attorney or a CPA Knowledge of local customs Estimate of the probability of success Performance of a cost-benefit analysis Assessment of the intangibles of litigation The impact of pending challenges from other taxpayers
When to Involve an Attorney or CPA

The taxpayer can engage an attorney or a CPA either during the audit, or at the end of the audit when the appeal decision must be made. It is generally wise to engage assistance as early as possible, so the advisor can participate in the taxpayer’s decision-making process regarding appeal.
CAUTION
delaying the involvement of an attorney or CPA may preclude the appeal of some procedural aspects of the audit if strategic mistakes are made that permanently block a specific course of action. For example, the failure to state concerns about sampling methodology in some states may preclude the taxpayer from successfully raising those issues later in the audit. therefore, competent advice needs to be secured early in the audit.

The taxpayer must decide whether it would be best to hire an attorney or a CPA. Generally, taxpayers should choose the representation that is appropriate to their appeal intentions and consistent with the representative’s scope, taking into consideration the representative’s knowledge and skill in the area.
PLANNING POINTER
Ideally the team should consist of both an attorney and a CPA since each brings a unique perspective to the issues.

If the taxpayer intends to litigate the issue, it might be wise to retain an attorney at the outset to provide representation throughout the appeal process. In some instances, a CPA will be able to provide equivalent services up to the point of litigation for a lower fee. The growth of state and local consulting services has led to the development of relationships between CPAs and attorneys that allow for

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cooperative efforts. It may be feasible to engage an accounting firm that has a close working relationship with a law firm that will be capable of handling the case if it goes beyond the administrative appeal level.
PLANNING POINTER taxpayers should determine an accounting firm’s ability to provide representation beyond the administrative appeal level. of particular concern would be any duplication of effort, and the resulting fee expense, that could result from involvement of an attorney in the case after some period of time. Ideally, the parties should be working in concert from the outset of the engagement. Choosing an accounting firm that has a professional relationship with a law firm or vice versa should address this issue.

Once the taxpayer decides to retain an outside advisor, the advisor must be duly authorized to act on the taxpayer’s behalf. The most commonly used form for this purpose is the power-of-attorney. Without the authorization provided by a power-of-attorney, most states will refuse to discuss any issues with a representative, unless the taxpayer is present to grant permission. Taxpayers should be able to obtain the necessary form from their state department of revenue. An attorney or CPA hired by a taxpayer must be familiar with local practice and procedure. There are rules, both written and unwritten, pertaining to the conduct of appeals and other administrative actions that can only be learned through experience. The personal credibility of the representative can also be an important factor. A hearing officer will be more likely to accept the interpretation of a representative who has a reputation as a knowledgeable tax professional.
The Probability of Success

Taxpayers should estimate the probability of success before proceeding with a costly appeal. Estimating the probability of success requires an understanding of the issue and the litigation environment in the state. Estimates are most often expressed as a percentage. For example, an advisor might indicate that in his or her opinion, there is a 60 percent chance of successfully winning the appeal at the first level and an 80 percent chance if the issue goes to the next level of appeal. Counsel’s estimate of the probability of success is a key factor in the decision to appeal. The greater the probability of success, the more likely the taxpayer will want to appeal the audit and vice versa. The estimate of success is also needed to perform the cost-benefit analysis discussed on the following page.

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Cost-benefit Analysis

Performing a cost-benefit analysis assures that the appeal, if unsuccessful, can be justified financially. In addition to counsel’s estimate of the probability of success, the taxpayer will need an estimate of the appeal costs or litigation expenses. The attorney or CPA selected for the appeal should be in the best position to provide this estimate. To perform the analysis, the taxpayer takes the amount that would be appealed, multiplies it by the factor for the probability of success, and compares that number to the cost of appeal. If the result is favorable, the taxpayer should proceed with the appeal. If it is unfavorable, the taxpayer may want to reconsider the appeal.
EXAMPLE
Assume that the issue to be appealed can have a $100,000 impact on the audit results. the CPA hired by the taxpayer estimates that it will cost $20,000 to mount an appeal, and the probability of success is 60 percent. the taxpayer would want to move forward with the appeal, since it shows a favorable cost benefit of $40,000 ($20,000 versus $60,000 (60 percent x $100,000)). If the fee increased or the probability of success decreased then the taxpayer might be forced to drop the appeal.

Assessment of Intangibles

If the cost-benefit analysis yields a favorable result, the intangibles of litigation must then be assessed. These include the following: How would the public disclosure of the taxpayer’s position affect the filing position in other states? Many taxpayers are uncomfortable with the public disclosure of information that could affect filing positions in other states. For example, if the taxpayer is following the same position in another state, the taxpayer could be seriously damaged if that information was publicly disclosed in a trial or hearing with a published and identified decision. The taxpayer may wish to limit its appeal options to nonpublished decisions to avoid problems in other states. Is the taxpayer prepared for public disclosure of its practices if the appeal goes to litigation in court? Many taxpayers are uncomfortable with disclosure of confidential tax information as part of an appeal. Taxpayers entering the appeal arena should be aware of the disclosures that will be necessary to successfully argue their position. Many taxpayers would prefer that suppliers, customers, employees, and others not have information about their tax-filing positions. Does management support the appeal decision and understand the potential hazards of litigation? An appeal is not wise unless it has management’s financial and moral support.

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Pending Challenges

One of the reasons for securing local advisors is to be able to draw upon their knowledge of pending cases. Taxpayers need to be aware of any cases that could affect their case, either favorably or unfavorably. Taxpayers may wish to assist other taxpayers that are attempting to appeal a particular issue. It is common for a group of taxpayers to select another taxpayer with “good facts” and use that taxpayer as the lead case on a particular issue. If the case is successful, the supporting taxpayers benefit from the precedent that is set. If the case is unsuccessful, the taxpayer may still mount an appeal based on its own facts.
STUDy QUESTION
7. A taxpayer is trying to determine whether to appeal an issue that can have a $70,000 impact on the audit results. the taxpayer’s CPA estimates that it will cost $20,000 to mount an appeal, and the probability of success is 70 percent. What would be the estimated cost benefit to the taxpayer? a. b. c. d. $29,000 $49,000 $50,000 none

PREPARING FOR THE NEXT AUDIT

At the conclusion of the audit, taxpayers should begin preparing for the next audit. By addressing issues promptly, taxpayers will be able to lessen their exposure to future sales and use tax deficiencies.
PLANNING POINTER
By demonstrating prompt attention to problem area identification in the audit, a taxpayer will be able to correct errors for the future and create a positive narrative for future penalty abatements.

Following are strategies to prepare for the next audit: Identify areas requiring improvement to avoid continuation of the problem. Hold training sessions and initiate procedural reviews. Document all activities and procedural changes for the next audit trail. Establish and maintain audit reserves for contested issues. Keep abreast of accounting system and other procedural changes that could impact compliance routines.

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Areas Requiring Improvement

Taxpayers often fail to correct errors that were identified in a prior audit. When a breakdown in a procedure or an error has occurred, an attempt to correct the problem for the future should be made. As mentioned earlier, a principal reason for the imposition of penalties is the failure of taxpayers to correct past problems. Depending on when the audit is completed, taxpayers may not be able to correct an error for all of the next audit period. However, they should be able to modify their procedures for at least a portion of the next audit period. Doing so should help the taxpayer if the penalty issue is raised in the next audit with respect to the error. Taxpayers should carefully note the completion dates of their audits. If they need to take corrective action, they should not be subject to penalties for errors that occurred prior to a final determination in the audit.
EXAMPLE
Assume that the taxpayer is under a four-year audit, with two years under waiver because the statute of limitations has expired. If the audit is completed in the third year of the next audit cycle, taxpayers should only be expected to demonstrate corrective action in years three and four of the next cycle. It is unlikely that the auditor will have any information to make this determination. therefore, taxpayers must be prepared to document the timing of the cycle and conclusion of the last audit.

Training Sessions and Procedural Reviews

Following an audit, training classes should be conducted for individuals or groups that may have committed errors that affected the audit results. Training must be done in a nonconfrontational manner. Employees should feel that they are an important part of the compliance team.
PLANNING POINTER
Given the nature of their duties, the purchasing and accounts payable departments often create problems in an audit. In many companies, these departments play a major role in the self-assessment and payment of sales and use tax. Making employees in these areas aware of the importance of sales and use tax compliance should be a priority.

Employees need to be educated about the multiplier effect that an audit can have on an error. For example, because of the sampling techniques used, the audit deficiency could be hundreds of times the amount of actual tax if the tax had been paid at the time it was due. And this does not include the interest and penalty amounts that are added to the audit deficiency.

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PLANNING POINTER one way to get operational department support for improved compliance procedures is to charge the deficiency from the identifiable audit errors back to the respective operating unit.

In addition to conducting training classes, taxpayers should review their compliance procedures. All tax departments or individuals responsible for tax compliance depend on other departments to provide them the information they need to comply with the tax-reporting requirements. It is important to review old assumptions and reports to make sure they are still reliable. The period following an audit is a good time to do this because the audit issues are still fresh in everyone’s mind.
Documentation

It is important to document all corrective action taken and any procedural changes made as a result of an audit. A written record of such action creates a strong defense if a negligence penalty is imposed in a subsequent audit. By initiating corrective action, the taxpayer is demonstrating concern about properly complying with the tax laws.
PLANNING POINTER
It is easy to forget that corrective actions were taken as a result of an audit. However, if the actions are thoroughly documented in a file they are less likely to be forgotten.

Audit Reserves

Financial accounting principles require that any material liabilities or potential asset impairment be recognized in financial statements. Therefore, if taxpayers have contested issues that are significant in amount, they should consider establishing audit reserves. For issues that may be appealed, the amount of potential liability, including interest and penalty, should be recorded on the books. If the issue may extend into future years, audit reserves based on estimated amounts should be established for those periods as well. Taxpayers with issues extending to several states may wish to consider providing for a reserve amount less than the entire liability, as it is unlikely that all the states will audit each year of exposure.
System Changes

Whenever an accounts payable, purchasing, fixed-asset, accounting, or other feeder system is replaced or modified, the tax implications of the change should be considered. Accounts payable and purchasing systems can have

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a significant impact on sales and use tax compliance because of the close relationship of the transactions in those systems to the compliance function. Taxpayers also need to be aware of changes to systems that provide the data they depend on for compliance. While the information may be reliable at the time it is first used, over time its integrity can deteriorate because of the differing uses made of it.
EXAMPLE
At the time the data is analyzed, it is determined that a particular computer field code represents purchases of delivery charges from vendors. the tax department therefore programs the accrual system to assess or not assess tax based upon that field code and each state’s particular treatment of that variable. over time, however, a new field code is added for certain transactions, but the tax department is not notified. Without an appropriate adjustment for the change, all purchases using the new code will be incorrectly self-assessed.

PLANNING POINTER one way for tax personnel to maintain contact with various systems is to review the systems update plan on a regular basis. Any questions that arise regarding the potential impact of a change should be directed to the individual or department initiating the change. Another effective technique for maintaining compliance routines is to develop a network of individuals in key areas and educate them on the importance of data integrity for tax compliance. When they become aware of changes that could affect compliance, they should contact someone in the tax department to discuss the modifications that are needed to remain in compliance.

STUDy QUESTION
8. If an audit is completed in the third year of the next four-year audit period, the taxpayer is responsible for demonstrating corrective action only in year four of that next cycle. True or False? a. true b. False

CORPORATE OFFICER AND RESPONSIbLE PERSON STATUTES

In certain circumstances, key tax personnel and corporate officers can be singled out for special penalties or held responsible personally for the tax liabilities of the corporation or other business entity. States use the responsible person statutes to gain greater taxpayer compliance.

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These statutes impose personal liability on a responsible person for improperly withholding or impeding the payment of tax on transactions. Some states also impose penalties on the responsible person for negligence or fraud. A responsible person is generally one who has control over compliance or the filing of returns, and who is in a position to influence payment. Individuals in this category include vice-presidents, controllers, tax directors, and tax managers. To a lesser extent, the responsible person statutes could also include the return preparers if they have substantial authority in the payment of tax. In order to avoid personal liability, individuals in positions of tax responsibility need to demonstrate that they have made reasonable efforts to comply with the requirements of the tax law. Advisors to responsible persons should make them aware of the sanctions that can be imposed.
STUDy QUESTION
9. Which of the following statements is not true? a. the amount of potential liability for issues that may be appealed should be recorded on the books. b. Being considered a responsible person under the tax statutes has no personal financial implications. c. taxpayers should not be subject to penalties for errors that occurred prior to a final audit determination.

AUDIT TRENDS
The Streamlined Sales Tax

There is little doubt that the Streamlined Sales Tax (SST) will dramatically simplify the audit process for vendors electing one of the technology models certified by the states. Vendors opting for the one of the models certified by the states will be relieved of much of the work associated with a traditional audit and, in some cases, will not be liable for errors resulting from use of a certified system. For sellers who do not opt to utilize one of the technology models certified by the states, the SST may still offer some relief in the form of uniform audit standards to be applied to both Certified Service Providers (CSP) and sellers. The uniform audit standards and procedures are as follows: Audits will be conducted by all participating states using statistical sampling techniques in accordance with generally accepted audit standards. States may conduct joint audits of CSP and sellers, although Model 3 sellers (those using a proprietary system that is certified by the states) with more complex tax systems and requirements may choose to be audited by individual states.

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When joint audits are conducted and errors identified, audit information will be provided to each participating state. Each state will then determine if an assessment or refund will be required. All states will issue the assessments or refunds within 90 days of completion of the audit. States will continue to follow their own statutes of limitations. Each participating state will provide a matrix of all definitions (uniform definitions and definitions specific to each state) of tangible personal property and services along with the taxability of CSP, and sellers will be held harmless from errors made by the state in its matrix. States will provide resources to answer questions of sellers and CSP on a timely basis.
Increasing Emphasis on Sales and Use Tax

Sales and use taxation has become a major source of revenue for state government. As a result, the states are likely to place greater emphasis on audits to maximize their revenues from these taxes. Public opinion polls identify sales and use as a popular form of taxation. This preference stems from taxpayers’ belief that they can control their level of taxation by controlling their expenditures. Due to this preference, emphasis on sales and use tax is likely to increase as states seek revenue sources for new and expanded services. More intense audit scrutiny is likely to follow. In addition, litigation could increase as the states and taxpayers attempt to resolve disputes in their favor.
Change Driven by Electronic Commerce

At this point in the development of electronic commerce, nobody can be sure how the structure of transactional taxes will have to be modified. While many commentators have suggested that the traditional sales tax model may be outmoded, it is too early to make that determination. However, it seems certain that if changes are not made, the states will face a significant erosion of revenue. Whether SST is able to bridge that divide remains to be seen. The nature of audits and the review process will have to change to accommodate the changes brought by electronic commerce. Taxpayers and tax jurisdictions cannot assume that the traditional audit trails and techniques will continue to be relevant in a paperless business environment.
EXAMPLE
the definition of tangible personal property has been expanded in recent years to cover digital products in many states as vendors and consumers have increased flexibility to download products electronically. For example, the downloading of music and movies is now treated as a sale of tangible personal property in most states.

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Greater Use of Sampling

As state resources become increasingly stretched and audits of taxpayers become even more complicated and time-consuming, sampling should continue to play a greater role. Reliable sampling is a viable option to increase the states’ efficiency in completing audits, even though there is much room for improvement in the states’ sampling procedures. Substantial efficiencies for both the taxpayer and the states could be achieved, for example, through the use of smaller and more scientifically determined sample sizes. The states also need to be more open to the possibility of taxpayers using sampling techniques to meet their compliance obligations. Many states are becoming more flexible with larger taxpayers in this regard, but more options need to be made available. Taxpayers should not have to spend thousands or, in some cases, hundreds of thousands of dollars just to comply with the tax laws by reviewing each purchase in detail. One option available in some states involves sampling similar to managed compliance approaches that would allow taxpayers to estimate their tax liability based on sampling and/or prior audit results. A follow-up audit would then be performed to determine the total amount of any tax due. Any potential amount due would be offset by the estimated payments that were made during the audit period. The resulting overpayment or underpayment would be the audit adjustment. Future estimates are then adjusted for audit results and changes in business operations. Under a system of estimated payment, the compliance burden on taxpayers is substantially lessened and the states would still receive their revenue.
Database Auditing

Greater use of database programs should increase efficiency for both the taxpayer and the state. When tax information is integrated into the database, the focus of the audit can shift from a detailed review of transactions to a verification of systems logic and a review of summarized data, based on variables established by the auditor. For example, if tax paid to vendors is a separate data field in the accounts payable computer records, a taxpayer or auditor could request a report of all tax-paid transactions by account, vendor, or some other variable. Conversely, a report of nontaxed transactions could also be prepared by account, vendor, or other appropriate sort field. Using these two reports could eliminate the detailed review of paper transactions, once both the auditor and the taxpayer are satisfied with system controls. The ability to correctly summarize the necessary information could reduce an audit of several weeks to a few days. In addition, the quality of work is elevated from the detailed and tedious review of paper documents to a more sophisticated systems analysis.

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More Audit Flexibility for Taxpayers

The states will continue to provide taxpayers options for streamlining the audit process, such as managed audit programs, which allow taxpayers to perform some of the routine audit work in exchange for reduced interest and penalties. Taxpayers considering this option should evaluate the resources they have to complete the audit. In addition, they must consider whether they are willing to highlight errors and reveal damaging information to the state. In light of these considerations, many taxpayers are choosing not to participate in such programs. Other states offer taxpayers the opportunity to perform the audit themselves, with state-provided guidelines for certain industries, and mail in the results of their self-review. Failure to respond or report common industry purchases can result in a field audit by the state.
Increasing Use of Penalties

States have learned that the use of penalties improves taxpayer compliance. Penalties also provide the state additional revenue. As a result, the use of penalties is likely to increase. However, the unreasonable use of penalties can serve as a disincentive for businesses to operate in the state. Therefore, states need to develop fair and objective criteria for the imposition of penalties.
STUDy QUESTION
10. Which of the following is one of the uniform audit standards that is required under the Streamlined Sales tax? a. Audits will be conducted by participating states using nonstatistical sampling. b. When join audits are conducted and errors identified, all states involved will issue assessments or refunds within 30 days of completion of the audit. c. each participating state will provide a matrix of all definitions of tangible personal property and services.

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Electronic Sales Tax Issues
LEARNING ObjECTIvES upon completing this chapter, you should be able to: describe the problems that may be encountered in determining sales and use tax liability when using prepaid phone cards and procurement cards explain the sales and use tax issues involved with electronic data transmission and telecommunications services describe the state taxability of canned and custom software explain how computer software and software licenses are treated for sales and use tax purposes understand the sales and use tax issues posed by cloud computing

PREPAID PHONE CARDS
Overview

Prepaid phone cards (PPCs) may be sold in units or dollars (i.e., $10 of long-distance service). A unit typically equals one minute of domestic phone service. With respect to international service, one minute of phone service may cost the user several units. Consumers typically redeem the phone cards through use of an 800 number and a validation code to access the service provider’s telecommunications equipment through which the call is routed and rated, and the call details are recorded. There are three types of PPCs: 1. 2.
Standard. The standard PPC generally is the type that is purchased Promotional. Promotional PPCs are customized and are typically given

from the local convenience store.

to the purchaser’s customers or are otherwise used for the purchasing entity’s own use.

EXAMPLE
Jack’s Hardware Store may have its name printed on PPCs that include $5 of domestic long-distance service and give the cards to customers who purchase more than $100 of merchandise.

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3.

of plastic rather than paper, and include a color picture of an item or person (i.e., an Elvis PPC). The charge for these cards generally is greater than the face value of the future phone service included on the card; the value of a collector card is substantially reduced if it is removed from the sealed wrapping (i.e., if it is used).

Collector. Collector cards typically have a limited issuance, are made

The use of most PPCs is subject to certain restrictions, such as they: May not be used to make 900 calls Are nonrefundable Expire if not used within a predetermined period of time Many PPCs may be recharged—that is, additional units may be ordered from the sponsor or wholesaler by calling an 800 number and charging the additional units to a credit card. PPCs raise a number of significant sales and use tax issues, including the following: Is the sale of PPCs taxed at the point of sale as a sale of tangible personal property (the card itself ), taxed as the telecommunications services are used by the consumer, or taxed both at the sale of the card and the use of the service? If the sale of the card is taxable as a telecommunications service: Is it taxable for calls originating in the customer’s state, calls terminating in the customer’s state, or calls that both originate and terminate in the customer’s state? Or does the answer depend on where the card is purchased? If the sale of the card is taxable as a telecommunications service, who is liable for remitting the tax: Retailer? Sponsor/wholesaler? Telecommunications services provider? If the sale of the card is taxable as a telecommunications service, is the tax base on which the sales or use tax is computed the monetary value of the services represented on the card or the retail cost of the card? What local sales tax rates apply to the sale of the cards or taxable telecommunications services? With respect to the issue of whether it is the sale of the PPC or the use of the service that is taxable, without legislation to carve out PPCs from the imposition of the telecommunications excise tax and then include PPCs in the sales and use tax definition of tangible personal property, most state laws would provide that sales and use tax is not imposed on the sale of the PPC itself. This is because the true object of what is being sold is the future long-distance service, rather than the card itself.

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From a state’s perspective, the advantages of taxing the PPC at the point of sale, rather than on use, include: Ease of administration by the states and retailers Avoidance of multiple taxes Imposition of the tax on the full sales price of the card, regardless of use (i.e., if taxed as the service is being used, unused portions of the PPCs are not subject to tax) Disadvantages of the taxation at the point of sale include: The creation of remote seller PPC companies located in Delaware or other states that do not impose sales and use tax could result in a significant loss of tax revenues for all states. Sales of PPCs outside the United States would not be subject to tax. Note that most foreign travel agencies recommend that travelers visiting the United States purchase PPCs to reduce the complexity and confusion when making calls from the United States. A significant problem could be created if the PPC is taxable on its purchase but then may be used to purchase both taxable and nontaxable goods. Many telecommunications service providers have already spent significant amounts of money on the development of elaborate systems to track and compute the telecommunications taxes on the use of PPCs. Over the past several years, a number of states have changed their laws to provide that PPCs are taxable at the point of sale rather than as the telecommunications services are being used.
CAUTION
Sellers of PPCs should exercise great care when dealing in a multistate environment because of the variation of treatment of these transactions from state to state. Some states treat the sale of a PPC as a sale of tangible personal property and assess tax at the point of sale. other states assess tax on the use of the PPC, when the call is placed using the card.

In recent years, a new dimension has been added to sales of PPCs. PPCs may now be sold through automated teller machines (ATMs). By inserting a PPC into the machine, the supply of available time can be replenished by an ATM charge to the customer’s bank account or credit card. This eliminates the need to repurchase a physical card when the time available on the PPC has expired, and provides the customer with more options and greater flexibility for recharging and using the PPC. Essentially rather than purchasing a replacement card, the customer is purchasing a new personal identification number (PIN) that allows reuse of the card. This further complicates the sales tax treatment of PPCs and raises new questions about the taxability of such transactions.

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STUDy QUESTION
1. Which of the following is an advantage to states of taxing PPCs at the point of sale? a. Sales of PPCs outside the united States would be subject to tax. b. Sales tax would be imposed on the total sales price of the card, regardless of use. c. the smart card concept would work well with the point-of-sale approach when it extends to PPCs. d. the PPC may be used to purchase both taxable and nontaxable goods.

PROCUREMENT CARDS
Overview

In an effort to reengineer the purchasing function for high-volume, lowcost goods and services, some companies use procurement cards. Generally, procurement cards are similar to credit cards issued to a designated corporate cardholder who is authorized to make specified purchases from a specific vendor or vendors. No purchase order is produced in a normal procurement card transaction. In addition, rather than receiving an invoice for each purchase, the cardholder receives a monthly statement with summary information about transactions that occurred during the monthly billing cycle. Only one check is drawn to cover all of the purchases included on the monthly statement. The simplification of the purchase and payment processes significantly reduces accounts payable processing costs. Although procurement cards streamline the purchasing and payment processes and, therefore, reduce costs, they may also create sales and use tax exposure issues because the paper trail is virtually eliminated. Specific transaction information, such as a description of items purchased and whether sales and use tax was charged at the time of purchase, is typically not reviewed by company personnel to determine whether sales and use tax was paid or should be accrued on the purchases. According to the procurement card white paper issued by the Steering Committee Task Force on Electronic Data Interchange (EDI) Audit and Legal Issues for Tax Administration in June 1997, the key issue for taxpayers and state tax administrators is: [w]hether the information provided to card users on the periodic statements from the card issuer regarding purchases made with procurement cards is sufficient to document that the correct amount of state and local sales or use tax was collected on the transaction at the time of sale.

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CAUTION
Failure to take active steps early in the planning phase of the procurement card start-up process may preclude a taxpayer from obtaining the necessary information for proper tax application later in the process.

Reducing Exposure Risk

To reduce potential audit exposure, a company may decide to do one or more of the following: purchases to either tax-exempt or taxable items to facilitate the decision to accrue use tax or to determine the measure on which such tax should be computed (or both). If the purchases are limited to a specific vendor, the vendor can be instructed to (or not to) collect tax on purchases made on the procurement card or by a specific purchaser.
Set up a liability account to accrue use tax on all procurement card purchases from out-of-state vendors. Although such action could result Limit procurement card transactions to purchases of certain goods or purchases from certain vendors. For example, the company could limit all

in an overpayment of tax, the extent of the overpayment may be less than the costs associated with more accurately determining the amount of tax that is due. Maintain supporting documentation. Supporting documentation could be a simple log that includes detailed descriptions of items purchased, their “shipped to” locations, and sales tax amounts. Unfortunately, such a procedure creates some of the same paperwork that the use of the procurement card was intended to eliminate.

Negotiate, and get in writing, an up-front compliance agreement with state authorities. If a taxpayer is concerned about the magnitude of

Work out a procedure with the card service to provide the necessary detail.

a potential sales and use tax assessment that may result when a state aggregates the procurement card purchases with other purchases and associated compliance ratios, the taxpayer should consider discussing with state officials, before an audit, the right to audit the two types of purchases separately.

Many card services have been working with their larger clients to minimize exposure in this area. In most instances, the information is available; it is just a matter of redesigning the statements to show the expanded information. For some taxpayers, remitting use tax on all purchases may be the safest option, but it could result in an overpayment of tax. Some procurement card issuers are developing the technology to capture documentation about sales tax collected on procurement card purchases, but it would require accurate data collection by vendors at the point of sale.

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Determining When the Sale Occurs

Another issue that arises in procurement card transactions is the point at which the transaction is deemed to have occurred. In the typical procurement card transaction, an order will be placed and the card charged on one day, the goods will be delivered at a later date, and the statement from the card issuer will be received anywhere from several days to more than 30 days after the order was placed and fulfilled. In general, taxpayers that owe more than a nominal amount of sales or use tax are required to file sales and use tax returns on a monthly basis.
EXAMPLE
For purchases made in January, the taxpayer must remit the applicable sales or use tax during February.

In the case of a normal 30-day procurement card billing cycle, the taxpayer may not receive the statement of its purchases until the sales and use tax return on the purchase is due. If the procurement card billing cycle is January 15 to February 13, the taxpayer will not receive the statement that includes purchases made on January 15 until after approximately February 16, yet the sales and use tax on purchases made during January may be due on February 20. If the state takes the position that the date the card is charged with the purchase is the date to be used in accruing the tax, the taxpayer most likely will not be in a position to timely pay the tax on such purchases.
PLANNING POINTER taxpayers involved in percentage or managed compliance agreements should carefully evaluate the nature and use of any procurement card purchases. For many taxpayers, special handling of these purchases may be required to attain more accurate reporting.

PLANNING POINTER taxpayers entering into agreements to utilize procurement cards should discuss the card service company’s ability to provide sufficient detail to resolve any questions in the event of a sales and use tax audit. If the card service company is unable to provide the required level of detail, other procurement card vendors should be evaluated, or transactions for the procurement card should be confined to tax-exempt purchases.

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CAUTION
In an effort to reduce the cost of the procurement function by using procurement cards, companies should not overlook the potential sales and use tax liabilities that such cards may create. the savings on the front end may be overshadowed by the possible compliance deficiencies.

STUDy QUESTION
2. to reduce potential audit exposure related to sales and use tax on procurement card purchases, companies should do all of the following except: a. b. c. d. destroy documentation Limit transactions to particular purchases Arrange with the card service to provide needed detail Maintain supporting documentation

ELECTRONIC DATA TRANSMISSION AND MISCELLANEOUS TELECOMMUNICATIONS SERvICES
Overview

Although the majority of states impose a sales and use tax or excise tax on the sale of certain telecommunications services, the proliferation of new and emerging services has made the distinction between taxable telecommunications services and non-telecommunications services unclear.
State Definitions
Telecommunication Services. The definition of telecommunications services

varies substantially among the states. For example, for Wisconsin sales and use tax purposes (Wisconsin Rule §Tax 11.66; Telecommunication & CATV Services), it is defined as: …electronically transmitting, conveying, or routing voice, data, audio, video, or other information or signals to a point or between or among points. Telecommunications services includes the transmission, conveyance, or routing of such information or signals in which computer processing applications are used to act on the content’s form, code, or protocol for transmission, conveyance, or routing purposes, regardless of whether the service is referred to as a voice over Internet protocol service or classified by the federal communications commissions as an enhanced or value-added nonvoice data service.

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Telecommunications services does not include any of the following: Data processing and information services that allow data to be generated, acquired, stored, processed, or retrieved and delivered to a purchaser by an electronic transmission, if the purchaser’s primary purpose for the underlying transaction is the processed data Installing or maintaining wiring or equipment on a customer’s premises Tangible personal property Advertising, including directory advertising Billing and collection services provided to third parties Internet access services Radio and television audio and video programming services, regardless of the medium in which the services are provided, including cable service, as defined in 47 USC 522(6), audio and video programming services delivered by commercial mobile radio service providers, as defined in 47 CFR 20.3, and the transmitting, conveying, or routing of such services by the programming service provider Ancillary services Digital products delivered electronically, including software, music, video, reading materials, or ringtones However, the following services are not subject to sales and use tax [Wisconsin Rule §Tax 11.66; Telecommunication & CATV Services]: Interstate or international telecommunications service if the service is sourced to a location outside Wisconsin Revenues collected under Wis. Stat. Sec. 256.35(3), the surcharge established by the public service commission under Wis. Stat. Sec. 256.35(3m)(f ), for customers of wireless providers as defined in Wis. Stat. Sec. 256.35(3m)(a)6., and the police and fire protection fees under Wis. Stat. Sec. 196.025(6) Transfers of telecommunications services to resellers who purchase, repackage, and resell the services to customers (The reseller is liable for sales tax on its final retail sales of those services.) Interstate 800 services Transfers of services, commonly called access services, to an interexchange carrier that permit the origination or termination of telephone messages between a customer in Wisconsin and one or more points in another telephone exchange, and that are resold by the interexchange carrier. The interexchange carrier is liable for sales tax on its final retail sales of those services. Detailed telecommunications billing services Although the components of taxable telecommunications services vary among the states, many states do exempt specific telecommunications services such as access services to 800 numbers and private line services.

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Internet Tax Freedom Act. The Internet Tax Freedom Act (ITFA) became

law on October 21, 1998. The Act provided a three-year state and local tax moratorium on certain Internet-related services and activities from October 1, 1998, to October 21, 2001 (subsequent legislation extended the moratorium to November 1, 2007). The ITFA also created an Advisory Commission that studied the federal, state and local, and international taxation and tariff treatment of transactions involving electronic commerce and Internet-related transactions. Although the Commission held several meetings and public hearings during its review period, it was unable to reach the required supermajority opinion on the substantive tax treatment of Internet sales. On October 31, 2007, President Bush signed the Internet Tax Freedom Act Amendments Act of 2007, extending the ban on Internet access and discriminatory taxes yet again to November 1, 2014 [Pub. L. No. 110-108 (H.R. 3678), Laws 2007, effective Nov. 1, 2007]. The 2007 Act added several provisions regarding grandfathering, and the definition of Internet access. The grandfather clause was extended but only to jurisdictions that have continued to tax Internet access without interruption. The definition of Internet access was expanded to include incidental services such as instant messaging, electronic mail, and personal electronic storage. The 2007 Act made it clear that it did not prohibit the inclusion of Internet access in the tax base of gross receipts taxes such as Washington’s business and occupation tax and the Ohio commercial activity tax. It also did not prohibit sales tax in states that imposed tax on Internet access charges before the IFTA became law.
PLANNING POINTER taxpayers often erroneously assume that the Internet tax Freedom Act protects them from taxation, even if they have traditional nexus with the taxing jurisdiction. this is not correct. If a taxpayer has nexus in a taxing jurisdiction the Internet tax Freedom Act provides no protection from the traditional forms of taxation. the Internet tax Freedom Act only provides protection from new or discriminatory forms of taxation. For example, if a state attempted to impose a tax only on an Internet transaction, that would violate the Internet tax Freedom Act.

Streamlined Sales Tax. may provide a more permanent solution to the taxation of remote sellers. The SST, which became operational on October 1, 2005, was developed by several states and state tax professional organizations with input from the private sector. The SST addresses the complexity in state sales taxation, which has often been cited as a hindrance to federal legislation requiring mail order, Internet, and other remote sellers to collect the tax on their sales. it provides detailed definitions in Section 314 of the Agreement for sourcing telecommunication

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and related services. The SST Agreement provides for the following sourcing of telecommunications and related services in member states.
Section 314: Telecommunication and Related Services Sourcing Rule 22.

A. Except for the defined telecommunication services in subsection (C), the sale of telecommunication service sold on a call-by-call basis shall be sourced to (i) each level of taxing jurisdiction where the call originates and terminates in that jurisdiction or (ii) each level of taxing jurisdiction where the call either originates or terminates and in which the service address is also located. B. Except for the defined telecommunication services in subsection (C), a sale of telecommunications services sold on a basis other than a callby-call basis, is sourced to the customer’s place of primary use. C. The sale of the following telecommunication services shall be sourced to each level of taxing jurisdiction as follows: 1. A sale of mobile telecommunications services other than air-toground radio-telephone service and prepaid calling service, is sourced to the customer’s place of primary use as required by the Mobile Telecommunications Sourcing Act. 2. A sale of post-paid calling service is sourced to the origination point of the telecommunications signal as first identified by either (i) the seller’s telecommunications system, or (ii) information received by the seller from its service provider, where the system used to transport such signals is not that of the seller. 3. A sale of prepaid calling service or a sale of a prepaid wireless calling service is sourced in accordance with Section 310. Provided however, in the case of a sale of prepaid wireless calling service, the rule provided in Section 310, subsection (A)(5) shall include as an option the location associated with the mobile telephone number. 4. A sale of a private communication service is sourced as follows: a. Service for a separate charge related to a customer channel termination point is sourced to each level of jurisdiction in which such customer channel termination point is located. b. Service where all customer termination points are located entirely within one jurisdiction or levels of jurisdiction is sourced in such jurisdiction in which the customer channel termination points are located. c. Service for segments of a channel between two customer channel termination points located in different jurisdictions and which segment of channel are separately charged is sourced 50 percent in each level of jurisdiction in which the customer channel termination points are located.

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d. Service for segments of a channel located in more than one jurisdiction or levels of jurisdiction and which segments are not separately billed is sourced in each jurisdiction based on the percentage determined by dividing the number of customer channel termination points in such jurisdiction by the total number of customer channel termination points. D. The sale of Internet access service is sourced to the customer’s place of primary use. E. The sale of an ancillary service is sourced to the customer’s place of primary use.
When Sales of Telecommunications Services Are Subject to Tax

The fact that a service is included in a state’s definition of telecommunications services does not mean that the service automatically is subject to sales and use tax. Although several states impose sales and use tax on intrastate, interstate, and international telecommunications services, many states impose tax only on intrastate services (i.e., services originating and terminating within the state). To determine the taxability of a telecommunications service: Ascertain whether the service involves an intrastate, interstate, or international service. Review the state’s statutes to determine the factors necessary for the state to impose sales and use tax on the service. Such factors generally include the locations (states) where the service originates and terminates, and the billing or service address to which the service is charged.
CAUTION
Because of the growth of Internet and wireless communications, the sales and use tax treatment of telecommunications services is likely to be a controversial issue in most states. Providers of telecommunications services should carefully monitor developments in this area.

CELL PHONES
Overview

As the use of cell phones continues to expand, the providers of cell phone service continue to offer new features and services to distinguish their service from that of other providers in hopes of gaining a competitive edge with consumers. While much of the competitive pressures are exerted through enhanced basic features (such as additional minutes of talk time, expanded coverage

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areas, and free minutes of talk or data time), an increasing number of cell phone service providers are offering new, add-on features to broaden their appeal. In addition to voice communications, most cell phone providers now offer Internet access and provide customers with the ability to download games and other features to their smart phones. This expansion of offerings provides more options for consumers, but it also increases the complexity of the taxation of cell phone usage and related charges.
PLANNING POINTER
Since most states now impose tax upon digital equivalents, the sale of music downloads, digital books, and other digital media is taxed in most states.

STUDy QUESTION
3. Which of the following is true based on SSt Agreement Section 314? a. A sale of post-paid calling service is sourced to the destination point of the telecommunications signal. b. Private communication service for segments of a channel between two customer channel termination points located in different jurisdictions and that are separately charged is sourced 50 percent in each level of these jurisdictions. c. Internet access service is sourced to each jurisdiction in which the customer uses the service based on percentage of usage.

COMPUTER SOFTWARE
Overview

Initially, software costs were not differentiated from computer hardware costs at the point of sale. Because the purchase price was for bundled property, these software sales received the same sales tax treatment as that associated with tangible property. In 1969 IBM segregated the costs of software from the costs of hardware, allowing for the separate tax treatment of software. In the same year, the Internal Revenue Service issued Revenue Procedure 69-21 [1969-2 C.B. 303 1], which provided for software sold in an unbundled form to be regarded as an intangible, thus denying the taxpayer the benefits of the investment tax credit or accelerated depreciation. These developments opened a veritable Pandora’s box for taxpayers and taxing jurisdictions alike, who found themselves forced to decide whether to classify computer software as tangible personal property subject to state sales and use tax or intangible intellectual property historically outside the

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scope of such taxes. In today’s state tax scheme, transactions involving computer software raise a variety of sales and use tax questions regarding the continuing dilemma of whether to impose tax on such transactions. Some of these questions include: What exactly is being purchased or sold? Is it an intangible right, or is it a service? Is the software canned or custom? Why does it matter? What if the software is not sold, but rather is licensed to a customer? What is the difference if the software is transmitted to a user electronically instead of by means of a disc?
Canned vs. Custom Software

Most of the states treat canned and custom software differently. Generally, canned software is taxable and custom software is not taxable. However, definitions of the two types of software can vary between the states. grams or other prewritten applications offered for general or repeated sale or lease. It is not created to the specifications of any particular user, but rather is designed for a wide range of users.
EXAMPLE
two of the more common examples of canned software used by most taxpayers are Microsoft Word and excel. Purchases of either product would be subject to tax.

Canned Software. Canned software is generally defined as computer pro-

The most pervasive example of canned software is the off-the-shelf or shrink-wrapped software created and standardized for multiple users. Absent extenuating circumstances provided for in certain states, canned software that is transferred via a disc or other tangible medium is subject to tax in every state imposing a sales or use tax.
CAUTION
Besides the shrink-wrapped, off-the-shelf version of canned software, many software vendors also sell their products as a digital file download. Such downloads of otherwise tangible items are generally taxable as digital equivalents in most states.

Custom Software. Most states do not impose tax on custom software because it is not considered tangible personal property. By definition, custom software generally embodies programs designed to the specification of a single user. Some states may further expand the definition of custom software

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to include computer programs that are modified to a particular user’s specifications, provided certain criteria or thresholds are met. Most states consider the purchase of true custom software to be the purchase of a service or intangible and, therefore, outside the imposition of sales and use tax in those states that do not tax services. In many instances, the taxability of software that is somewhere between canned and custom will turn on the distinction of how the state at issue defines custom software. Wisconsin Department of Revenue v. Menasha Corp. In a case that drew national attention, an integrated business application software system that had to be significantly modified before it could be used by the purchaser, Menasha Corp., was ruled not subject to Wisconsin sales and use tax as custom software by the Wisconsin Supreme Court [Wis. 754 N.W.2d 95, July 11, 2008]. application software that accommodates the special processing needs of the customer. At one time, the State of Wisconsin applied the following factors to the determination of whether a software program is a custom program. (While the factors are no longer formally used, they nevertheless provide an excellent guideline to utilize in making canned or prewritten versus custom software distinctions.) The extent to which the vendor or independent consultant engages in significant presale consultation and analysis of the user’s requirements and system Whether the program is loaded into the customer’s computer by the vendor and the extent to which the installed program must be tested against the program’s specifications The extent to which the use of the software requires substantial written documentation and training of the customer’s personnel The extent to which the enhancement and maintenance support by the vendor are needed for continued usefulness The rebuttable presumption that any program with a cost of $10,000 or less is not a custom program Custom programs do not include basic operational programs. If an existing program is selected for modification, there must be a significant modification of that program by the vendor so that it may be used in the customer’s specific hardware and software environment.
Custom Programs. A Wisconsin rule defines custom programs as utility and

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PLANNING POINTER
Custom programs generally involve a substantial commitment of programming effort to a particular user’s specific needs. In fact, the program, once created, generally has no value beyond the user for whom it was created.

prepared, held, or existing for general use normally for more than one customer, including programs developed for in-house use or custom program use that are subsequently held or offered for sale or lease. In Menasha, the purchaser bought a modular software system made up of standard software modules. The seller mass marketed this system to thousands of different businesses, and the system always had to be modified to fit a client’s particular business needs. The seller and various consultants made over 3,000 modifications to the purchaser’s software before the purchaser could use it as intended. The system was delivered to the purchaser on multiple CD-ROM disks. Implementation of the system on a subsidiary-by-subsidiary basis took almost seven years to complete. The core software system cost $5.2 million, but, with installation and modifications, the total cost of the system was more than $23 million. The Wisconsin Supreme Court held that the Wisconsin Tax Appeals Commission’s decision that the software was a custom program was reasonable. The commission had determined that it was custom software because the purchaser made significant investments in presale: Consultation and analysis Testing Training Written documentation Enhancement Maintenance support
PLANNING POINTER these factors tend to form a guideline that taxpayers can follow when trying to determine if software is canned or custom. If most or all of these factors are present, then it is likely that custom software has been purchased.

Prewritten Programs. Wisconsin also defines prewritten programs as programs

The significant cost of the system also weighed in favor of a finding that the software was custom software. The commission also determined, and the Supreme Court agreed, that the software system was not a prewritten program. The Supreme Court stated that a prewritten program is one that is ready to be used right off the shelf and does not require significant

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modifications in order for the purchaser to use the program. In this case, the software system was useless until it was modified. The modifications performed to make the software usable were time-consuming and expensive, and thus significant. The commission also determined, and the Supreme Court agreed, that the software system was not available for general use and, therefore, could not be considered prewritten software.
Cloud Computing. Cloud computing is one of the hottest topics in the information technology (IT) world and likely to become an equally hot topic in tax circles as well. Cloud computing has been defined as the offering of applications and services over the Internet. All that is needed to access the application or service is an Internet connection. Chances are you have visited a cloud computing site without even realizing it. For example, if you periodically visit a social networking site, you are using a cloud computing application. An online computer backup service is another common cloud computing service. But from a business perspective, cloud computing is much more than an opportunity to exchange pictures or catch up with old friends. Cloud computing offers the business community an opportunity to streamline its IT function and reduce costs without sacrificing service. To do that, cloud computing providers offer a wide variety to services over the Internet. The following are three of the more commonly used cloud computing services by businesses: Infrastructure-as-a-service—This is a service providing virtual servers with unique IP addresses and blocks of storage on demand. Platform-as-a-service—A set of software and product development tools are hosted on the provider’s infrastructure. Software-as-a-service—Vendors supply hardware infrastructure, software, and a front-end portal by which the user interacts with the provider.

Acquiring these services over the Internet as opposed to investing in the hardware and software for in-house systems provides the user with the necessary hardware, software, and technical tools without having to make the huge investment in equipment, software, and personnel to maintain them. However, in terms of the sales tax system, the question becomes whether the transaction has been sufficiently recharacterized to avoid tax imposition on otherwise taxable items, such as hardware and canned software. So, for businesses and individuals alike, cloud computing affords an opportunity to maintain their IT capabilities at a fraction of the cost. Businesses wishing to leverage their IT expenditures through cloud computing need to weigh these savings against the loss of control, data security issues, and so on, before making a final decision to source these services from a “cloud.”

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The tax issues associated with cloud computing are just starting to emerge. The key issue associated with cloud computing is whether the customer is purchasing tangible personal property or a service. If the customer is purchasing a service, then it depends upon whether the service is determined to be a taxable service or not. At present, many states appear to be taking the position that cloud computing is a service and therefore taxed only if it is enumerated in the statute. As the use of cloud computing expands and the offerings become broader in scope, it remains to be seen whether the states will continue this treatment. Of course, if cloud computing is deemed to be a taxable service, it opens up a number of issues for consideration, including: Where is the service performed—the customer’s location, service provider’s location, or server location where programs actually run? Is that service considered taxable in the state? Is it specifically enumerated in the statute or otherwise defined as taxable? Does the service provider have nexus in the customer’s state for other taxes beyond sales and use tax if it is in fact subject to sales and use taxes on the sale of these services?
Streamlined Sales Tax. It should also be noted that the SST contains uniform definitions for software and other common computer-related purchases. States opting to be part of SST would be required to adopt these definitions in lieu of their current statutes. Once adopted, however, a state could choose whether to tax or exempt any category adopted. Under the SST, prewritten computer software means computer software, including prewritten upgrades, that is not designed and developed by the author or other creator to the specifications of a specific purchaser. The combining of two or more prewritten computer software programs or prewritten portions thereof does not cause the combination to be other than prewritten computer software. Prewritten computer software includes software designed and developed by the author or other creator to the specifications of a specific purchaser when it is sold to a person other than the specific purchaser. Where a person modifies or enhances computer software of which the person is not the author or creator, the person shall be deemed to be the author or creator only of such person’s modifications or enhancements. Prewritten computer software or a prewritten portion thereof that is modified or enhanced to any degree, where such modification or enhancement is designed and developed to the specifications of a specific purchaser, remains prewritten computer software if there is a reasonable, separately stated charge or an invoice or other statement of the price given to the purchaser for such modification or enhancement. Otherwise, such modification or enhancement shall not constitute prewritten computer software.

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PLANNING POINTER
Care must be exercised in dealing with SSt states to make sure that key provisions of the SSt Agreement have been enacted and are in force in the state. this is particularly true if the state is an Associate Member State or in its first full year of membership as a Full Member State.

STUDy QUESTION
4. Most states exempt the sale of canned software from sales and use tax. True or False? a. true b. False

Licensing Agreements

The legal form of a software transaction may ultimately affect how the transaction is taxed in many states, irrespective of its similarity in substance to a transaction form that has a different sales tax consequence. A sale of software, where title passes to the purchaser, is generally subject to tax—unless the sale involves custom software, as noted above. Generally, a software licensing agreement is defined as the contractual right to use software written by another party. Under such an agreement, the title to the software does not pass to the licensee, and the licensee is typically subject to restrictions on the use or reproduction of the licensed software. Software licensing agreements are generally treated as taxable sales of tangible personal property, unless the licensed software is custom software.
EXAMPLE
Some of the more commonly licensed software includes Microsoft Windows, Microsoft office, and turbotax. the licensing of these products would be treated as a sale of tangible personal property in most states.

EXAMPLE
Most states provide that a distributor of computer products must pay use tax on a computer software license agreement under which the distributor is conveyed the right to use master copies of the licenser’s software.

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Electronic Transmission

One of the arguments advanced by states for the taxation of computer software is that the method of conveyance has traditionally been through tangible means, such as CDs, DVDs, discs, and magnetic tapes. As such, the transfer of the underlying software, transferred via CD, DVD, and so on, constitutes the sale of tangible personal property subject to tax. In the past, the taxability of the transaction could be impacted by eliminating the transfer of any tangible personal property. So, for example, downloading otherwise taxable software by electronic means in some states was not considered the transfer of tangible personal property and therefore was not subject to sales and use taxes, even if sale of the same software transferred by tangible means was taxable. As the use of downloads has expanded in recent years with the growth of Internet commerce, many states have adopted the so-called digital equivalent doctrine. The digital equivalent doctrine says that any downloaded item or transaction should be treated like its equivalent tangible item for sales tax application. So, for example, the purchasing of an e-book over the Internet should fundamentally be treated no differently than the sale of a hard-copy book at a shopping mall. However, not all states are necessarily adopting that policy. New York State recently ruled in TSB-M-11(5)S (NYS Dept of Taxation & Finance, April 7, 2011) that e-books meeting all the following conditions are nontaxable: The purchase cannot entitle the customer to additional goods and services from the vendor, and any revisions to the e-book are made solely to correct errors. The e-book must be provided as a single download. The product must be advertised or marketed as an e-book. If the intended use of the product requires that it be updated or revised, any updates or new editions cannot be issued more frequently than annually. The product must be designated only to work with software necessary to make the e-book readable.
Other Exemptions

Taxing jurisdictions may provide exemptions for otherwise taxable software under other exempt criteria. Several states, recognizing the emerging importance of software in operating sophisticated manufacturing machinery and equipment, have specifically enumerated certain types of software used in manufacturing production as exempt manufacturing machinery and equipment.

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Even in states where software is not specifically enumerated as manufacturing equipment, an argument to expand the exemption for manufacturing machinery and equipment to software involved in manufacturing may be available. Other states have provided specific exemptions for software used in research and development or in the production of additional software or related operating systems for resale. In any event, it is evident that otherwise taxable software used in special applications may well be exempt in certain jurisdictions. Accordingly, even canned software may not be subject to tax when used in specific applications, or by otherwise exempt entities.
PLANNING POINTER
While the distinction between canned or prewritten and custom software can be crucial in determining the incidence of sales and use taxation, many states provide scant guidelines to taxpayers seeking to make such a determination. Because of the variety of software and the diverse uses to which it can be put, consistently segregating it between canned and custom can be a daunting task. Although most states do not provide definitive guidelines, the following factors are generally applied in varying degrees to make the determination: degree of presale consultation and defining of user needs Amount of new base code language written for a specific program the relative cost and selling price of the program degree of modification to existing program Availability of software to other users through licensing or purchase agreements General business activity of software provider degree of support for installation, training, and maintenance of software using these factors as a guideline, taxpayers should be in a better position to evaluate the taxation of their software purchases.

Master Copies

It has become commonplace for a business to purchase a master copy of computer software, retain possession of it, and then distribute copies of it to offices around the country. The following questions then arise: Does this distribution create a taxable event and if so, in which state? Is the distribution taxable in the state where the copy is initiated, or is it taxable in the state where the copy is distributed, or both? Does the storage of the software before the distribution of the copies constitute a taxable event in the state of storage? If the software is determined to be taxable, at what value should the tax be imposed? Should it be taxed based on the pro rata value of the software distributed in the state, or is the entire purchase price of the master copy of the software subject to tax in the state?

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Depending upon the answer to these questions, there could be a significantly different tax liability on the transaction.
STUDy QUESTION
5. Which one of the following statements is true? a. Many states have adopted the so-called digital equivalent doctrine. b. there are a number of states where licensing software electronically for use over a limited period of time is not taxable if delivered by a tangible means. c. the SSt takes the position that electronic purchases are not the same as purchasing a tangible item. d. A sale of software, where title passes to the purchaser, is generally not taxable.

CPE NOTE: When you have completed your study and review of chapters 7–10, which comprise Module 2, you may wish to take the Quizzer for this Module. Go to CCHGroup.com/PrintCPE to take this Quizzer online.

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Answers to Study Questions
MODULE 1 — CHAPTER 1
1. a. Incorrect. Although the corporation is commercially domiciled in State A, the nonbusiness income is not allocated there. The income would be allocated to State A if it were nonbusiness income derived from the sale of intangible property. b. Correct. The gain is nonbusiness income because the sale is not in the taxpayer’s regular course of business and the land is not an integral part of the taxpayer’s regular business operations. Thus, the entire gain is allocated to State B because the real property is located in State B. c. Incorrect. The corporation is neither commercially domiciled in State C, nor is the real property located there. d. Incorrect. The income should be specifically allocated to a single state, rather than apportioned among the states, because it is nonbusiness, rather than business, income. 2. a. Incorrect. Since each state can choose the type and number of factors it will use to determine the amount of business activity conducted within its borders, a corporation’s apportionment percentages may not add up to 100 percent. In other words, there can be double taxation (i.e., the apportionment percentages sum to more than 100 percent) or nowhere income (i.e., the apportionment percentages sum to less than 100 percent). b. Incorrect. Allocation refers to the specific assignment of nonbusiness income to a particular state. Business income is apportioned among all of the states in which the taxpayer has nexus. c. Correct. A corporation that is doing business in more than one state uses state-mandated apportionment formulas to determine the percentage of its business income that is taxable in each nexus state. d. Incorrect. Since states use different apportionment formulas and different rules for computing apportionment factors, a corporation may be taxed on less than or more than 100 percent of its income. 3. a. Correct. When a corporation as a whole is profitable, but incurs a

loss in one state as determined by a separate geographic accounting, the use of an apportionment formula results in the corporation’s incurring an income tax liability in the state in which the loss occurs. b. Incorrect. Not all corporations are entitled to apportion their income. The requirements for being allowed to apportion income vary by state, but generally involve doing business or being taxable in another state. Some

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states allow apportionment only if the corporation actually files returns and pays tax in another state. c. Incorrect. UDITPA §18 allows taxpayers to petition for an alternative if the standard allocation and apportionment provisions do not fairly represent the extent of the taxpayer’s business activity in a state. However, UDITPA §18 also allows tax administrators to require an alternative method in these circumstances.
4. True. Correct. These industries are specifically exempted under UDITPA

§2. Many states provide special rules for computing apportionment percentages for financial organizations and public utilities because their in-state activity may not be fairly represented by the standard apportionment formula. b. False. Incorrect. Financial organizations and public utilities are specifically exempted under UDITPA §2 because the standard formula may not fairly apportion the income of these taxpayers.
5. a. Incorrect. MTC Reg. IV.18(e) provides that aircraft ready for flight are includible in the numerator of the property factor, based on the ratio of instate departures to the total departures everywhere (both weighted by the cost and value of aircraft). b. Incorrect. This calculation is correct, except it should be based on in-state departures rather than in-state arrivals. c. Correct. MTC Reg. IV.18(e) provides that an airline’s sales factor numerator includes the sum of (1) the total transportation revenue multiplied by the ratio of in-state departures to the total departures everywhere (both weighted by the cost and value of aircraft), and (2) any nonflight revenues directly attributable to the state. d. Incorrect. The MTC regulation does not require that airlines use a singlefactor formula, but instead modifies the standard three-factor formula, primarily by changing the computation of the factor numerators.

television or radio broadcaster’s business income, including broadcasting over the public airwaves by cable, as well as by satellite transmission or any other method of communication. b. Incorrect. This statement is true. Some states have adopted the MTC formula for trucking companies, while other states have adopted their own special formulas, such as formulas based solely on revenue miles. c. Incorrect. This statement is true. Under MTC Reg. IV.18(g), a trucking company is a motor common carrier, a motor contract carrier, or an express carrier that primarily transports others’ tangible personal property by motor vehicle for payment.

6. a. Correct. MTC Reg. IV.18(h) governs apportionment of a multistate

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d. Incorrect. This statement is true. The MTC has not promulgated a special

apportionment formula for insurance companies.

7. a. Correct. Outer-jurisdictional property is pro-rated to a state based on the ratio of uplink and downlink transmissions in the state to the total number of uplink and downlink transmissions everywhere. Only if that information is not available is outer-jurisdictional property prorated based on the ratio of the amount of time the property was used to make transmissions. b. Incorrect. This statement is true. The payroll factor is based on the normal UDITPA rules for sourcing payroll. The numerator of the payroll factor is the total compensation paid in the state, and the denominator includes all compensation paid everywhere by the taxpayer. c. Incorrect. This statement is true. Under MTC Reg. IV.18(j), a throwback rule applies if the purchaser is the U.S. government or if the taxpayer is not taxable in a state where the printed materials are delivered. d. Incorrect. This statement is true. The regulation modifies the standard UDITPA three-factor formula for taxpayers engaged in the publishing, sale, licensing or other distribution of books, newspapers, magazines, periodicals, trade journals or other printed material. 8. a. Incorrect. Pennsylvania uses a sales-only formula for tax years beginning after 2012. b. Incorrect. New Jersey’s sales factor will be weighted 70 percent for tax years beginning in 2012, 90 percent for tax years beginning in 2013, and 100 percent for tax years beginning on or after January 1, 2014. c. Incorrect. For tax years beginning after 2012, eligible businesses may contract with the state to use a single-factor sales formula for 20 years (renewable at the state’s discretion for up to 20 additional years). d. Correct. Arizona increased the weight on the sales factor in the optional formula to 85 percent for tax years beginning in 2014, 90 percent for tax years beginning in 2015, 95 percent for tax years beginning in 2016, and 100 percent for tax years beginning after 2016.

MODULE 1 — CHAPTER 2
1. a. Incorrect. Property used in the production of business income is included in the property factor; however, property used for the production of nonbusiness income is excluded. b. Correct. The MTC regulations require that construction in progress be excluded from the property factor until the property is placed into service and actually used in the taxpayer’s trade or business. c. Incorrect. Under UDITPA, the property factor includes real and tangible personal property owned or rented.

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d. Incorrect. Temporarily unused or idle property generally remains in the

property factor. However, the MTC regulations require that such property be removed from the property factor if its permanent withdrawal from service is established by an identifiable event, such as an extended period of time (normally, five years) during which the property is no longer held for use in the taxpayer’s trade or business.

2. a. Correct. This statement is false. An automobile assigned to a traveling employee is included in the numerator of the state to which the employee’s compensation is assigned for purposes of computing the payroll factor or in the numerator of the state in which the automobile is licensed. b. Incorrect. This statement is true. Property owned by a corporation that is in transit between states is considered to be located at its destination. c. Incorrect. This statement is true. Special rules apply to certain industries, such as airlines and trucking companies, for which specialized apportionment formulas have been adopted. d. Incorrect. This statement is true. Mobile property such as construction equipment, trucks, or leased electronic equipment that is located in more than one state during the tax year is included in the numerator of the property factor based on total time within the state during the tax year.

is included in the property factor using the same valuation method that is used for federal income tax purposes. b. Incorrect. This statement is true. If a state requires the inventory amount included in the property factor to be consistent with the federal income tax value, the UNICAP method applies by default. c. Correct. This statement is false. States generally permit the use of LIFO if the taxpayer has adopted LIFO for federal tax purposes. d. Incorrect. The MTC regulations specifically address the valuation of inventory but UDITPA does not mention the issue. payroll factor.

3. a. Incorrect. This statement is true. Under the MTC regulations, inventory

4. a. False. Incorrect. Only amounts paid to employees are included in the b. True. Correct. Payments made to an independent contractor are gener-

ally excluded from the payroll factor.

5. a. Correct. Some states provide this guidance, but many do not. b. Incorrect. UDITPA is silent regarding how payments for leased employees

should be treated for purposes of the payroll factor. c. Incorrect. The MTC regulations do not address how payments for leased employees should be treated for purposes of the payroll factor.

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MODULE 1 — CHAPTER 3
1. a. Incorrect. This statement is true. In Mobil Oil, the Supreme Court ruled that Vermont could tax an apportioned percentage of the dividends Mobil received from its foreign subsidiaries, because those subsidiaries were part of the same integrated petroleum enterprise as the business operations conducted in Vermont. b. Correct. This statement is not true. In Allied-Signal, the Supreme Court stated that in order to qualify as apportionable income, what is required is that the “capital transaction serve an operational rather than an investment function.” c. Incorrect. This statement is true. In Mobil Oil, the Supreme Court stated that “the linchpin of apportionability in the field of state income taxation is the unitary business principle.” d. Incorrect. This statement is true. Under the unitary business principle, if a corporation’s interstate activities form a unitary business, a state need not isolate the corporation’s in-state activities from the rest of the business in determining the corporation’s taxable income. Instead, the state may tax an apportioned percentage of the income generated by the multistate unitary business.

manufacturing activities of the taxpayer in the taxing state is the most likely candidate for treatment as nonbusiness income. b. Incorrect. In Mobil Oil, the Supreme Court ruled that a state could tax an apportioned percentage of dividends received by the taxpayer from its unitary subsidiaries. Thus, the dividends are probably business income. c. Incorrect. The interest is probably business income. In Allied-Signal, the Supreme Court stated that apportionable income includes “interest earned on short-term deposits in a bank . . . if that income forms part of the working capital of the corporation’s unitary business.”
3. a. Incorrect. This is true of business income, not nonbusiness income. b. Correct. Under UDITPA, business income is apportioned among the

2. a. Correct. The gain on the sale of land that has nothing to do with the

states in which the taxpayer has nexus, but nonbusiness income is exclusively allocated to a single state. c. Incorrect. Each state can adopt its own definition of nonbusiness income, subject to U.S. Constitutional limitations. This can result in inconsistent treatment and can cause double taxation of income. d. Incorrect. UDITPA defines nonbusiness income as “all income other than business income.” Business income is defined as income derived from transactions and activity in the regular course of the taxpayer’s trade or business (transactional test), or from tangible and intangible property, if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations (functional test).

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looks to the frequency and regularity of the income-producing transaction in relation to the taxpayer’s regular trade or business. d. Incorrect. The functional test is not based on the federal classification of the income as ordinary in nature. business income includes income that meets either the transactional test or the functional test. False. Incorrect. The majority view is that UDITPA’s definition of business income includes both a transactional test and a functional test, and that income is business in nature if either test is met.
6. a. Incorrect. In 2001, the Alabama Legislature added a functional test to the statutory definition of business income. b. Incorrect. In response to the Phillips Petroleum decision, the Iowa Legislature amended the Iowa statute to include a functional test. c. Incorrect. The Tennessee Legislature added a functional test to the business income statute after the Associated Partnership I case. d. Correct. All of the above states have added a functional test to their statutory definitions of business income. 5. True. Correct. In 2003 the MTC amended its Reg. IV.1(a) to state that

4. a. Incorrect. This describes the transactional test. b. Correct. This is a description of the functional test. c. Incorrect. This is a question asked in applying the transactional test, which

by an S corporation from the liquidating sale of its assets were nonbusiness income. b. Incorrect. In Phillips Petroleum Co., the Iowa Supreme Court determined that a taxpayer’s gain from a disposition of assets was nonbusiness income. c. Incorrect. In Uniroyal Tire Co. the Alabama Supreme Court held that a corporate partner’s gain from the sale of its entire interest in a partnership was nonbusiness income. d. Correct. In Jim Beam Brands, the California Court of Appeal ruled that the gain from the sale of property arising from a partial liquidation transaction was business income under the functional test.
8. a. Incorrect. Nonbusiness royalty income from real property is generally allocable to the state where the real property is located. b. Incorrect. Nonbusiness rental income from realty is usually allocable to the state where the rental property is located. c. Correct. Nonbusiness capital gains from the sale of intangible assets are generally allocable to the state of commercial domicile, as is nonbusiness interest and dividend income. d. Incorrect. Nonbusiness capital gain income from real property is generally allocable to the state where the property in question is located.

7. a. Incorrect. In Kemppel, the Ohio Supreme Court ruled that gains realized

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may be offset only against the related nonbusiness income. False. Correct. If an item is treated as nonbusiness income, any expenses attributable to that item generally cannot be deducted against apportionable business income.
10. True. Incorrect. Nonbusiness patent royalties are usually allocable to the state in which the patent is used, assuming the royalty income is taxable in that state. Under a throwback rule, royalties that are not taxable in the state in which the patent is used are allocable to the state of commercial domicile. False. Correct. UDITPA provides that nonbusiness patent royalties are allocable to the state in which the patent is used, unless the royalties are not taxable in that state, in which case the royalties are allocable to the state of commercial domicile.

9. True. Incorrect. Generally, expenses attributable to nonbusiness income

MODULE 1 — CHAPTER 4
1. a. Correct. Federal law permits a two-year carryback. A federal-state NOL difference may arise if the state has no provision for NOL carrybacks. b. Incorrect. The federal government allows a 20-year carryforward. Some states have shorter carryforward periods, which can result in a federal-state NOL deduction difference. c. Incorrect. If there are differences in federal and state group filing methods, this can create an NOL deduction difference. Other reasons for NOL deduction differences between federal and state returns include state statutory limitations on the dollar amount of the carryover, and the effect state apportionment may have on the state NOL deduction. 2. True. Correct. Under the pre-apportionment method, the full amount of the loss year’s NOL is offset against income in the carryforward year, and then the carryforward year apportionment percentage is applied to the net amount of apportionable income. Thus, if the apportionment percentage is higher in the carryforward year than in the loss year, the benefit of the NOL carryforward deduction is greater if the state uses the pre-apportionment method. False. Incorrect. The value of the NOL deduction is based on the carryforward year apportionment percentage if the pre-apportionment method is used, and the loss year apportionment percentage if the post-apportionment method is used. Thus, if the apportionment percentage is higher in the carryforward year, the NOL deduction is more valuable if the state uses the pre-apportionment method.

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NOL trafficking. It permits the IRS to disallow a carryforward NOL deduction if the principal purpose of acquiring another corporation is to claim the benefit of the deduction. b. Incorrect. Code Sec. 382 limits the amount of the deduction to the hypothetical future income that would be generated by the loss corporation, but it is not the IRS’s oldest weapon against NOL trafficking. c. Incorrect. Code Sec. 383 extends restrictions similar to those found in Code Sec. 382 to other types of carryovers, but it is not the IRS’s oldest weapon against NOL trafficking. d. Incorrect. Code Sec. 384 prevents a corporation with unrealized built-in gains from acquiring a loss corporation for the purpose of using that corporation’s pre-acquisition NOLs to offset its built-in gains, but Code Sec. 384 is not the IRS’s oldest weapon against NOL trafficking. state restriction that a surviving corporation may not claim an NOL deduction if the year in which the predecessor incurred the NOL was not a year in which the predecessor was an Ohio taxpayer. b. Correct. In BellSouth Telecommunications, Inc., the North Carolina Court of Appeals denied a deduction for a pre-merger net economic loss of a former subsidiary, because the continuity of business enterprise requirement was not met. c. Incorrect. In Richard’s Auto City, Inc., NOLs generated by a corporation, which had merged into a surviving corporation, were not deductible by the surviving corporation because it was not the same corporation that originally incurred the loss. d. Incorrect. In this Tennessee case, the Court of Appeals determined that the corporation surviving a statutory merger may not deduct NOLs incurred by the merged corporation. a combined reporting group to offset an NOL carryforward of one group member against the income of another group member. b. Incorrect. There is no small business exception to the general rule that an NOL incurred by one member of a combined reporting group cannot be used to offset the income of another group member. c. Incorrect. Regardless of whether the NOL is subject to a federal restriction, an NOL incurred by one member of a combined reporting group cannot be used to offset the income of another group member. d. Correct. Under California’s combined reporting regime, a Californiasource NOL incurred by one member of the combined reporting group cannot be used to offset the income of another group member.
5. a. Incorrect. California does not provide a special election which allows 4. a. Incorrect. The decision in American Home Products Corp. involved a

3. a. Correct. Code Sec. 269 is the IRS’s oldest weapon used to counter

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MODULE 1 — CHAPTER 5

acquirer attains a controlling interest in the target’s stock, the acquirer may either retain the target as a separate subsidiary or liquidate the target to acquire direct control of the target’s assets. b. Incorrect. In a stock purchase, there is no change in the basis of the target’s assets unless the acquirer makes a Section 338 election. c. Incorrect. If the acquisition is structured as a stock purchase, the target’s NOL carryforwards and other tax attributes remain with the target, which is now controlled by the acquirer. d. Incorrect. In a stock purchase, only the target shareholders recognize gain or loss. The target itself does not recognize any gain or loss on the acquisition.
2. a. Correct. This is a requirement for making a Section 338(g) election. The acquirer must obtain by purchase at least 80 percent of both the total voting power and total value of the stock of the target corporation. b. Incorrect. In order for an acquirer to be eligible for a Section 338(g) election, the acquirer must make the election no later than the 15th day of the ninth month beginning after the month in which the acquisition occurs. c. Incorrect. In order for an acquirer to be eligible for a Section 338(g) election, the acquirer must make the election on federal Form 8023. Form 8883 is required for allocating basis to the acquired assets. d. Incorrect. This is a requirement of a Section 338(h)(10) election, not a Section 338(g) election.

1. a. Correct. If the acquisition is structured as a stock purchase, once the

sale of the target’s stock is ignored. Therefore, a single level of taxation is created by a Section 338(h)(10) election. b. Incorrect. A Section 338(g) election results in two levels of taxation, whereas a Section 338(h)(10) election results in only a single level of taxation. Because of this, Section 338(h)(10) elections are more popular than Section 338(g) elections. c. Correct. A Section 338(h)(10) election causes a deemed sale of the target’s assets that results in both gain or loss recognition and a step-up or step-down in the basis of the target’s assets. d. Incorrect. A Section 338(h)(10) election can be made when the stock of an S corporation is purchased by another corporation.
4. a. Correct. In McKesson Water Products Company, the New Jersey Tax

3. a. Incorrect. In a Section 338(h)(10) election, the gain or loss on the actual

Court ruled that such a gain was non-operational income allocable to California. b. Incorrect. In General Mills, the Massachusetts Supreme Judicial Court ruled that such gains were properly included in Massachusetts apportionable income.

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c. Incorrect. In Newell Window Furnishing, the Tennessee Court of Appeals

ruled that where a corporation sold the stock of its subsidiary and the sale was treated as a sale of assets under Section 338(h)(10), the gain from the deemed asset sale was not allocable nonbusiness income, but apportionable business income. usually included in the target corporation’s sales factor.

5. True. Correct. Gross receipts or net gains from the deemed asset sale are False. Incorrect. Most states apply their standard apportionment rules to the

target corporation’s deemed asset sale. Thus, the gross receipts or net gains from the deemed asset sale are generally included in the target corporation’s sales factor.
MODULE 1 — CHAPTER 6

subsidiary are subject to U.S. taxation, with no offsetting dividends-received deduction. b. Correct. The federal government generally does not tax the undistributed foreign earnings of a foreign corporation, even if the foreign corporation is a wholly owned subsidiary of a domestic corporation. An exception applies if a controlled foreign corporation has any Subpart F income. c. Incorrect. Section 78 gross-up income is subject to federal taxation. To prevent a double tax benefit, Code Sec. 78 requires a domestic corporation that claims a deemed paid foreign tax credit to gross up its dividend income by the amount of the deemed paid foreign taxes. d. Incorrect. Under Code Sec. 61, a domestic corporation is subject to tax on its worldwide income.

1. a. Incorrect. Dividend distributions received by a U.S. parent from a foreign

water’s-edge combination. b. Correct. The constitutionality of requiring worldwide combined reporting was upheld by the U.S. Supreme Court in Container Corporation and Barclays Bank. c. Incorrect. Although a water’s-edge election generally reduces the compliance burden, it may also increase the taxpayer member’s state tax liability if the unitary group’s U.S. operations are more profitable than its foreign operations. d. Incorrect. Only about 20 states require a taxpayer member of a unitary business group to compute its taxable income on a combined basis.

2. a. Incorrect. Combined reporting states generally permit or require a

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generally extend their dividends-received deductions to dividends from foreign corporations. b. Correct. A dividend from a foreign corporation is included in the U.S. parent’s apportionable business income if the foreign subsidiary and U.S. parent are engaged in a unitary business. On the other hand, if the activities of the foreign corporation have nothing to do with the activities of the U.S. parent in the taxing state, then the dividend may be nonbusiness income. c. Incorrect. This statement is true. Since the Kraft decision, many states have amended their laws governing dividends-received deductions. d. Incorrect. This statement is true. The Ohio Supreme Court determined that the provision facially discriminated against foreign commerce in violation of the Foreign Commerce Clause of the U.S. Constitution.
4. a. Correct. Even though no state permits a corporation to claim a

3. a. Incorrect. This statement is true. Unlike the federal government, states

credit for foreign income taxes, some states allow corporations to claim a deduction. b. Incorrect. States generally do conform to federal check-the-box rules for income tax purposes. For example, a foreign entity that is a corporation for foreign tax purposes but is a branch for U.S. federal tax purposes is generally treated as a branch for state income tax purposes. c. Incorrect. None of the states permit a deemed paid credit for foreign income taxes.
MODULE 2 — CHAPTER 7

1. a. Incorrect. Delaying the discussion of a difficult topic until later in the auditor’s visit may result in less focus on sensitive details due to the auditor’s haste to wrap up the audit. b. Incorrect. An auditor can question hundreds or even thousands of transactions. c. Incorrect. An audit can take anywhere from a few days to years to complete. d. Correct. While auditors have a great deal of authority regarding the timing of an audit, taxpayers have rights to exert as well. A taxpayer who is fully scheduled with audits can suggest a later date that is more convenient. 2. a. Incorrect. Companies can often provide special reports to augment the auditor’s review or to assist the taxpayer in responding to requests to reduce the scope of the audit when time constraints exist. b. Correct. Forwarding records to the auditor after some preliminary review to allow the auditor to complete portions of the fieldwork at the office poses risks for the taxpayer by providing the auditor with

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unlimited time to review transactions and contact vendors, and should only be done in areas where the taxpayer anticipates limited exposure. c. Incorrect. This approach allows the taxpayer to perform some portion of the audit work, subject to auditor review. d. Incorrect. Employing a greater use of sampling can reduce the amount of transactional review. providing some assurances that a sample is an acceptable audit methodology, subject to a formal review of the state’s sampling technique. b. Incorrect. Taxpayers have the right to grant or not grant a waiver as they deem appropriate under the circumstances. However, not granting a waiver could lead to a jeopardy assessment. c. Correct. In the early stages of an audit, the auditor is generally open to discussing issues involving the scope of the audit. Taxpayers should freely discourage the auditing of transactions that they feel may not be necessary. d. Incorrect. If some of the taxpayer’s entities have nexus and others do not, the taxpayer should refuse to allow the auditor to audit the books or transactions of entities without nexus. If the entity does not have nexus, the state and the auditor have no authority to exert over that entity.
4. a. Correct. The auditor should be located in an area where there is little b. Incorrect. Employees should be warned of the auditor’s visit and discouraged 3. a. Incorrect. On the telephone, taxpayers should go no further than

opportunity for contact with others.

from responding to the auditor’s questions without prior approval. c. Incorrect. A taxpayer under audit should regularly keep track of the auditor’s whereabouts with surprise visits and phone calls. d. Incorrect. Designating one contact person allows that individual to focus on audit issues and take ownership of the audit results. The auditor should be told to address all questions to the contact person.
5. True. Correct. The auditor lists all information that could possibly be needed in the confirmation letter, but this does not mean all the information will actually be used. False. Incorrect. In general, it is not necessary for the taxpayer to have all the information requested on the first day of the audit. The auditor may be able to achieve the desired results by reviewing some other document in lieu of the one requested. 6. a. Incorrect. Generally, if the audit is being delayed beyond the statutory

assessment period for the taxpayer’s convenience or benefit, the taxpayer will be forced to issue a waiver to avoid a jeopardy assessment.

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inconvenient, and they would be justified in refusing to grant the waiver. c. Incorrect. In circumstances where the taxpayer is working with the auditor on concluding issues that the taxpayer reasonably believes can be resolved through additional research of the law or facts or through negotiation, the taxpayer should grant the waiver to the auditor. of error over the entire audit period. b. Incorrect. A statement should be on the exemption certificate noting that the certificate is effective with the first day of the audit period or the date of first sale to the customer. c. Correct. A general review, in which the taxpayer looks for exemption certificates from major customers, would be more appropriate in the case of a statistical sample. d. Incorrect. Because the auditor is likely to ask that replacements for any missing, incomplete, or inaccurate certificates be obtained, requesting replacement certificates prior to the auditor’s arrival should not result in any wasted effort by the taxpayer. Also, the effects on the audit of having complete certificates on file can be dramatic. three to six months old would generally be expected to file an amended return. However, the regular filing of amended returns may attract more audit scrutiny, so every effort should be made to incorporate self-assessments at the time the item is purchased. False. Correct. If a significant amount of tax is unpaid, the taxpayer should file an amended return to capture the appropriate amount of interest due with the under-payment. of the rates applied to various invoices during the audit period because it is often difficult to determine the proper local taxes to apply to a purchase. b. Incorrect. A review of taxable invoices should be performed by crosschecking the invoices against the exemption certificate files. A logic check may also be performed against any taxable invoices billed to challenge whether the transaction is taxable. c. Incorrect. Sellers frequently have difficulty properly classifying billing elements on an invoice, which can result in an overpayment of tax. d. Correct. The reverse audit looks for overpayment errors that will result in a tax refund. A review of payment terms is not an activity that would be included in a reverse audit.
9. a. Incorrect. The reverse audit procedure for sales should include a review 8. True. Incorrect. Taxpayers self-assessing on purchases that are more than 7. a. Incorrect. Samples tend to increase exposure because of the projection

b. Correct. For many taxpayers, an audit at this time of the year would be

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apply the tax laws to individual transactions in much the same way that an auditor applies the laws in an audit. c. Incorrect. When such a statute exists, a seller may not want to invest time and effort recovering tax that must be returned to the customer, or admit to the customer that it made billing errors. procedure is to take an offset against use tax due on a future return, unless the adjustment is substantial in amount. b. Incorrect. Vendor refunds should not be treated as a return offset to sales tax due. This would be disallowed by an auditor in virtually all states.
11. a. Correct. If the taxpayer has merely overassessed in error, the correct

10. a. Correct. The greatest opportunities for refunds are on purchases. b. Incorrect. The key to success in reverse audits is to learn to assertively

12. a. Incorrect. The burden of proof that a transaction is nontaxable rests with the taxpayer in most states. b. Correct. In many states, the goal is to process the refund claim and notify the taxpayer within one year. Other states and local jurisdictions are open-ended as to when they must respond to refund claim requests. c. Incorrect. It is advisable for taxpayers to have final authority over any refund claims submitted on their behalf to reduce the possibility of having a filing position jeopardized through an ill-advised refund claim. d. Incorrect. If no valid reasons exist for retaining records, such as an anticipated or pending lawsuit, they should be discarded to avoid additional storage expense and exposure.

questionnaire, that the taxpayer has been targeted for specific reasons, the taxpayer should respond promptly. b. Incorrect. Nexus questionnaires that are mailed to a specific company officer or employee generally require a reply. However, in these instances, most advisors would recommend that taxpayers not rush to respond. c. Correct. Most tax advisors suggest that when a nexus questionnaire is mailed to a taxpayer but not addressed to any particular person, the taxpayer should not respond to the initial inquiry. Mailings of this nature are often done with little or no follow-up on non-respondents, so failing to respond should not have adverse consequences. d. Incorrect. If there is follow-up from the state, the taxpayer should respond.
14. a. Correct. Since the statute of limitations in all states only begins to

13. a. Incorrect. If it appears, based on information provided with the

run with the filing of a return, a taxpayer that has never filed a return has not begun to toll the statute of limitations.

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b. Incorrect. Under a voluntary disclosure program, a taxpayer generally

agrees to pay tax due plus interest and possibly penalties. The taxpayer also agrees to file going forward. c. Incorrect. The largest and most sophisticated of the information-sharing groups is the Multistate Tax Commission. d. Incorrect. The requirements of the Streamlined Sales and Use Tax Agreement include an amnesty for uncollected or unpaid tax for sellers that register to collect tax, provided they were not previously registered in the state.
15. True. Incorrect. In most instances, if the taxpayer refuses to provide the False. Correct. States participating in information-sharing arrangements

information, the auditor will not pursue the issue any further.

generally have little or no authority to compel a taxpayer to complete such a questionnaire.

MODULE 2 — CHAPTER 8
1. a. Incorrect. Taxpayers should not expect the auditor to educate them in tax law because the auditor may be misinformed about the current law and its application. b. Correct. Providing written guidelines to the auditor gives the guidelines greater credibility, assures consistent application from audit to audit, and eliminates the possibility that a rule will be forgotten. c. Incorrect. Auditors should be provided a comfortable work environment that lets them complete their work without interruption. d. Incorrect. Taxpayers sometimes wait for the auditor to request data a second time before providing it to avoid having to provide information that is not essential to the audit. Auditors often lose interest in data that has little audit potential. The scope of review generally narrows as the audit continues.

must have time to review the documentation for the refund claim. b. Incorrect. Some auditors may feel obligated to offset the refund if it is provided too early in the audit. c. Correct. Informing the auditor that a refund claim is in process and will be provided before the fieldwork is concluded gives the auditor time to review the documentation and include the refund as part of the audit, but it does not cause the auditor to approach the audit looking for an offset to the refund. d. Incorrect. Refunds or other adjustments could affect the audit results so the refund claim should be presented to the auditor.

2. a. Incorrect. If the refund is to be included as part of the audit, the auditor

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Fortune 500 companies, can expect the state to audit them regularly, perhaps on an annual basis. b. Correct. In many instances, filing a refund claim will not result in a field audit. However, taxpayers should expect some level of review—probably an office audit prior to the state making payment of the refund. c. Incorrect. Taxpayers filing large refund claims or amended returns with considerable changes should expect an audit. d. Incorrect. Targeted audits may be performed, for example, if a new tax law is complex or if revenue targets for the tax change are falling short of estimates.
4. True. Correct. Although vendors may be financially rewarded by doing

3. a. Incorrect. Businesses that have major operations in a state, such as

business with larger companies, they subject themselves to a higher risk of audit because of the higher level of audit for larger companies and the possibility of referral. False. Incorrect. The possibility of referrals for audit is higher for large companies; therefore, there is a higher risk of audit for vendors who do business with them.
5. a. Correct. Taxpayers should try to avoid controversial or high-exposure areas during the tour. b. Incorrect. Taxpayers should not offer auditors independent contact with plant personnel during or after the tour. Additionally, tour guides should only respond to auditor questions in taxpayers’ presence. c. Incorrect. Taxpayers should provide plant layout or other materials to auditors only if the auditor requests them. d. Incorrect. Auditors should be allowed to tour the plant, but the taxpayer can undertake certain steps to improve the possibility of a positive result. 6. a. Incorrect. The number of questioned items on the auditor’s list of

potentially taxable transactions varies with the size and complexity of the taxpayer’s operations in the state. For a large taxpayer with extensive operations, it is not unusual to have several thousand transactions on the list. b. Incorrect. Auditors sometimes forget last-minute adjustments to the audit results. The taxpayer should make certain that all agreed-upon adjustments are included in the revised list of adjustments. c. Correct. Auditors focus on identifying underpayments of tax. Taxpayers should perform reverse audits to identify overpayments. d. Incorrect. This is true, and if the taxpayer has minimal sales but a lot of purchases of fixed assets or expense items, the auditor will focus on purchases.

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7. a. Correct. This is a disadvantage because statistical sampling provides b. Incorrect. An advantage of sampling is that it reduces the state and taxpayer c. Incorrect. An advantage of sampling is that it reduces the audit burden

a more accurate reflection of tax deficiency if properly done.

personnel needed to complete the audit.

for the taxpayer.

8. a. Incorrect. Sample projection methodology can have a large effect on the determination of tax deficiency. b. Correct. It may not be determined whether the audit liability calculated from using nonstatistical sampling accurately reflects the accurate liability of the taxpayer. 9. True. Correct. Taxpayers should challenge sampling methods that

produce unverifiable results, as is the case of a nonstatistical sample, and require that the auditor show them the statute that authorizes the state to perform a sample when adequate taxpayer records exist. False. Incorrect. Taxpayers should never assume that the state has authority to perform the sample as outlined by the auditor or agree to any sampling proposal without first checking state statutes and relevant case law.
10. a. Correct. Many issues relating to the application of tax to specific transactions are subject to negotiation. b. Incorrect. Some issues, such as the state policy on the taxation of certain transactions, may not be negotiable at the auditor level. c. Incorrect. Although many issues are negotiable at the auditor level, issues such as those related to the statute of limitations may not be. d. Incorrect. This is not an issue that the auditor would have the authority to negotiate.

MODULE 2 — CHAPTER 9
1. a. Incorrect. This is not the amount of time that most states allow the taxpayer to report errors. When reviewing for errors, taxpayers may also want to consider the appeal of any penalty included in the assessment. b. Correct. Most states allow 30 or 60 days to report errors that should be corrected before the final assessment is issued. Taxpayers should also verify that any interest or penalty calculations in the preliminary assessment are correct. c. Incorrect. Most states do not allow this much time. d. Incorrect. States impose a time limitation for the reporting of errors, although it varies. However, regardless of the time limitation, taxpayers should promptly contact the auditor when errors are found.

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commonly imposed as the result of a sales and use tax audit. Many states extend this penalty to errors that are similar to those found in previous audits. b. Incorrect. The gross negligence penalty is not the most common penalty imposed as the result of a sales and use tax audit. For those taxpayers who are assessed this penalty, the rate ranges from 20 to 30 percent. c. Incorrect. The fraud penalty is not the most common penalty as it is imposed when a taxpayer deliberately misleads the auditor or hides the truth. If the fraud is on a large enough scale, it can be a criminal offense. d. Incorrect. The substantial understatement penalty is not the most common penalty imposed as the result of a sales and use tax audit. This type of penalty is more commonly imposed in income tax audits.
3. a. Incorrect. When a taxpayer does not exercise the degree of care that would be expected of a reasonable person in similar circumstances that is considered to be ordinary negligence. This would not be as serious as a reckless disregard for the law. b. Correct. When a taxpayer exhibits a careless or reckless disregard for the law, which is considered gross negligence. This would include a taxpayer’s failure to have sufficient procedures in place to meet its tax responsibilities. c. Incorrect. A fraud penalty is the most serious penalty. It is imposed when a taxpayer intentionally misleads the auditor or conceals the truth about transactions to avoid paying tax. Most states impose either a 50 or 100-percent penalty for fraud. d. Incorrect. The substantial understatement penalty is imposed when the amount of tax voluntarily reported throughout the audit period is substantially less than the amount of tax that was subsequently found to be due as a result of the audit.

2. a. Correct. The ordinary negligence penalty is the penalty that is most

prejudice in a minority-owned firm, this would be a reason to request his or her removal. b. Incorrect. If an auditor has been extremely unreasonable, such as making demands that are extreme and unnecessary, and is unwilling to be flexible, a taxpayer may want to request his or her removal. c. Correct. Being late to meetings is an issue that should be handled by talking directly with the auditor and not involving the supervisor. Requesting a supervisor to remove an auditor can damage the working relationship with the state, so it should only be done for the reasons listed in a, b, and d. d. Incorrect. If an auditor has shown obvious bias against the taxpayer in the audit, this would be a reason to request his or her removal.

4. a. Incorrect. If an auditor has behaved inappropriately, such as displaying

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of the interest assessment review, taxpayers should still test the calculation for accuracy. False. Correct. The interest assessment should still be tested, including the state’s allocation assumptions that are used in the computation. out as an argument for leniency in the current period. However, this does not mean the taxpayer made a food-faith effort to comply with the tax law in the current period. b. Incorrect. Staffing issues should be brought up as a defense when the taxpayer was unable to comply with the tax law because of high staff turnover or other staffing problems. c. Incorrect. Just because the taxpayer cooperated with the auditor does not mean it made a good-faith effort to comply with the tax law. This defense is normally used in conjunction with other defenses. d. Correct. The taxpayer can establish that it was making a good-faith effort to comply with the tax law by demonstrating self-compliance through its self-assessment procedures.
7. a. Correct. There would be a favorable cost benefit of $29,000 ($20,000 b. Incorrect. This answer is incorrect because it does not consider the cost c. Incorrect. This answer is incorrect because it does not consider the d. Incorrect. This answer is incorrect because when the appropriate factors 6. a. Incorrect. If the taxpayer has a good audit history, this should be pointed

5. True. Incorrect. Although the use of computers has reduced the importance

versus $49,000 (70 percent x $70,000)).

of mounting an appeal.

probability of success.

are considered, there would be a cost benefit.

8. True. Correct. Taxpayers should not be subject to penalties for errors that occurred before a final audit determination. For this reason, taxpayers should carefully note the completion dates of their audits. False. Incorrect. Since the audit determination was not made until the midst of the third year of the next audit period, the taxpayer should not be subject to penalties for the same errors that occurred during the first three years of that period. 9. a. Incorrect. This statement is true. The amount of potential liability for

issues that may be appealed, including related interest and penalty, should be recorded on the books. If it is expected that the issue will extend into future years, estimated audit reserves should also be established for those years.

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b. Correct. Being considered a responsible person can have personal

financial consequences. State responsible person statutes impose personal liability on a responsible person if that person improperly withholds the payment of tax. Some states also impose negligence or fraud penalties on the responsible person. c. Incorrect. This statement is true. If the final audit determination does not occur until a later audit period, the taxpayer should not be subject to penalties for similar errors that have already occurred in that later audit period.
10. a. Incorrect. Participating states are required to use statistical sampling, not nonstatistical sampling. b. Incorrect. When joint audits are conducted and errors identified, the states involved must issue assessments or refunds within 90 days of completion of the audit. c. Correct. Each participating state must provide a matrix of all definitions of tangible personal property and services. Sellers will be held harmless due to errors made by the state in its matrix.

MODULE 2 — CHAPTER 10
1. a. Incorrect. If PPCs are taxed at the point of sale and are purchased in

foreign countries by travelers to the United States to be used in the United States, they would not be subject to tax in the United States. This would be a disadvantage to states. b. Correct. If PPCs are taxed at the point of sale, sales tax can be imposed on the entire price of the PPC. Whereas, if the sales tax were imposed as the service is being used, any part of the PPC that is not used would not be subject to sales tax. c. Incorrect. This could create a problem for states if the PPC is taxed when purchased but is then used to purchase taxable and nontaxable goods. d. Incorrect. This could create a significant problem. management. Destroying documentation could lead to a worse audit outcome. b. Incorrect. This would reduce potential audit exposure. The company could limit all purchases to either tax-exempt or taxable items, or limit purchases to a specific vendor who could be instructed to collect, or to not collect, tax on purchases. c. Incorrect. Statements can be redesigned to show the needed information. This would reduce potential audit exposure.
2. a. Correct. Supporting documentation is needed to have effective audit

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of items purchased, where they are shipped, and sales tax amounts, but this procedure creates some of the same paperwork that using the procurement card was supposed to eliminate.

d. Incorrect. This could be a recording of details that includes descriptions

3. a. Incorrect. This service is sourced to the origination point of the telecommunications signal as first identified by either the seller’s telecommunications system or, if using a service provider, information received by the seller from this service provider. b. Correct. Private communication service for segments of a channel between two customer channel termination points located in different jurisdictions and that are separately charged is sourced 50 percent in each level of these jurisdictions. c. Incorrect. Internet access service is sourced to the customer’s place of primary use.

of canned and custom software vary significantly among the states False. Incorrect. Most states tax canned software but not custom software.

4. True. Correct. Most states tax canned software. However, the definitions

5. a. Correct. As the use of downloads has expanded, many states have adopted the digital equivalent doctrine, which says that any downloaded item or transaction should be treated like its equivalent tangible item for sales tax purposes. b. Incorrect. There are still a number of states where licensing software electronically for use over a limited period of time is not taxable, but licensing software for use over a limited period of time and having it delivered by a tangible means is subject to tax c. Incorrect. Numerous states and the SST have enacted regulations or statutes that indicate that purchasing anything electronically is the same as purchasing it as a tangible item. d. Incorrect. This sale would be generally taxable unless the sale involves custom software.

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CPE Quizzer Instructions
This CPE Quizzer is divided into two Modules. To obtain CPE Credit, go to CCHGroup.com/PrintCPE to complete your Quizzers online for immediate results and no Express Grading fee. There is a grading fee for each Quizzer submission.
Processing Fee: $98.00 for Module 1 $112.00 for Module 2 $210.00 for all Modules CTEC Course Number: 1075-Ce-0142 for Module 1 1075-Ce-0143 for Module 2 Recommended CPE: 7 hours for Module 1 8 hours for Module 2 15 hours for all Modules CTEC California Hours: 7 hours for Module 1 8 hours for Module 2 15 hours for all Modules

Instructions for purchasing your CPE Tests and accessing them after purchase are provided on the CCHGroup.com/PrintCPE website. To mail or fax your Quizzer, send your completed Answer Sheet for each Quizzer Module to CCH Continuing Education Department, 4025 W. Peterson Ave., Chicago, IL 60646, or fax it to (773) 866-3084. Each Quizzer Answer Sheet will be graded and a CPE Certificate of Completion awarded for achieving a grade of 70 percent or greater. The Quizzer Answer Sheets are located at the back of this book.
Express Grading: Processing time for your mailed or faxed Answer Sheet is generally 8-12 business days. To use our Express Grading Service, at an additional $19 per Module, please check the “Express Grading” box on your Answer Sheet and provide your CCH account or credit card number and your fax number. CCH will fax your results and a Certificate of Completion (upon achieving a passing grade) to you by 5:00 p.m. the business day following our receipt of your Answer Sheet. If you mail your Answer Sheet for Express Grading, please write “ATTN: CPE OVERNIGHT” on the envelope. NOTE: CCH will not Federal Express Quizzer results under any circumstances.

If you mail or fax your Quizzer to CCH, the date of completion on your Certificate will be the date that you put on your Answer Sheet. However, you must submit your Answer Sheet to CCH for grading within two weeks of completing it.
Date of Completion:

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Recommended CPe credit is based on a 50-minute hour. Participants earning credits for states that require self-study to be based on a 100-minute hour will receive ½ the CPe credits for successful completion of this course. Because CPe requirements vary from state to state and among different licensing agencies, please contact your CPe governing body for information on your CPe requirements and the applicability of a particular course for your requirements.

Expiration Date: Evaluation:

December 31, 2014

To help us provide you with the best possible products, please take a moment to fill out the course Evaluation located after your Quizzer. A copy is also provided at the back of this course if you choose to mail or fax your Quizzer Answer Sheets.
CCH is registered with the national Association of State Boards of Accountancy (nASBA) as a sponsor of continuing professional education on the national Registry of CPe Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPe credit. Complaints regarding registered sponsors may be addressed to the national Registry of CPe Sponsors, 150 Fourth Avenue north, Suite 700, nashville, tn 37219-2417. Web site: www.nasba.org. CCH is registered with the national Association of State Boards of Accountancy (nASBA) as a Quality Assurance Service (QAS) sponsor of continuing professional education. State boards of accountancy have final authority on the acceptance of individual courses for CPe credit. Complaints regarding registered sponsors may be addressed to nASBA, 150 Fourth Avenue north, Suite 700, nashville, tn 37219-2417. Web site: www.nasba.org. CCH has been approved by the California tax education Council to offer courses that provide federal and state credit towards the annual “continuing education” requirement imposed by the State of California. A listing of additional requirements to register as a tax preparer may be obtained by contacting CteC at P.o. Box 2890, Sacramento, CA, 95812-2890, toll-free by phone at (877) 850-2832, or on the Internet at www.ctec.org.

one complimentary copy of this course is provided with certain copies of CCH publications. Additional copies of this course may be downloaded from CCHGroup.com/PrintCPE or ordered by calling 1-800-248-3248 (ask for product 9-4284-500).

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Quizzer Questions: Module 1
1.

How many states currently use the UDITPA equally weighted threefactor apportionment formula?
a. b. c. d.

None Fewer than 20 More than 20 but not all All

2.

A business is taxable in States A, B, and C. It is commercially domiciled in State A, but most of its facilities are located in State C. The business sells some intangible property at a gain. The sale is not in the regular course of the taxpayer’s trade or business, and the intangible property is not an integral part of the taxpayer’s regular business operations. Where should the income arising from the sale be allocated?
a. b. c. d.

State A only State C only States A and C States A, B, and C

3.

If a business is taxable in several states and the apportionment percentages for those states add up to 110 percent, then:
a. The apportionment percentages must have been calculated incorb. The taxpayer has nowhere income. c. There is double taxation of the taxpayer’s income. d. None of the above

rectly.

4.

UDITPA §18 provides that, if the allocation and apportionment provisions of UDITPA do not fairly represent the extent of the taxpayer’s business activity in a state, then ______ may seek to use an alternative formula.
a. b. c. d.

The taxpayer, but not the tax administrator The tax administrator, but not the taxpayer Either the taxpayer or the tax administrator Neither the taxpayer nor the administrator

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5.

Which of the following states will allow manufacturers to elect to use a quadruple-weighted sales formula for tax years beginning on or after July 1, 2013, but before July 1, 2014?
a. b. c. d.

Arizona New Jersey Pennsylvania Virginia

6.

The MTC has promulgated special apportionment regulations covering all of the following industries except:
a. b. c. d.

Radio broadcasters Publishing companies Trucking companies Professional sports franchises

7.

The MTC’s model regulations for apportioning telecommunications income provides that:
a. Outer-jurisdictional property is included in the property factor. b. The payroll factor is determined under the standard UDITPA rules c. The sales factor is determined under the standard UDITPA rules d. None of the above

for sourcing payroll. for sourcing sales.

8.

Which of the following statements is true?
a. All states impose special corporate franchise taxes on financial b. No state provides a special apportionment formula for financial c. The MTC’s model statute for financial institutions adopts a salesd. The MTC’s model statute for financial institutions adopts an equally

institutions. institutions.

only apportionment formula.

weighted three-factor apportionment formula.

9.

In Moorman Manufacturing Co., the U.S. Supreme Court ruled that:
a. A three-factor apportionment formula is constitutionally required. b. Iowa was not constitutionally prohibited from using a sales-only c. There are no restrictions on a state’s choice of apportionment formulas. d. None of the above

apportionment formula.

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10.

In FedEx Ground Package System, Inc., the Pennsylvania Supreme Court:
a. Upheld the lower court’s decision that the taxpayer could use its

average receipts per mile in Pennsylvania to calculate its revenue miles in Pennsylvania b. Reversed the lower court’s decision c. Determined that the method the taxpayer used to compute its revenue miles in Pennsylvania was inconsistent with the plain language of the statute d. None of the above
11.

Which one of the following is included in a taxpayer’s property factor?
a. b. c. d.

Property used for the production of nonbusiness income Intangible property Property that has been idle for 10 years None of the above

12.

The MTC regulations require that inventory be included in the property factor using which of the following valuation methods?
a. b. c. d.

Replacement cost Fair market value Same method as used for federal income tax purposes Average cost

13.

Property rented by the taxpayer is valued at ____ times the net annual rental rate.
a. b. c. d.

2 5 8 10

14. Which of the following statements is true? a. There are no MTC regulations which specifically address the inclu-

sion of leased employee compensation in the payroll factor. b. Compensation related to the production of nonbusiness income is included in the payroll factor. c. All states include compensation paid to executive officers in the payroll factor. d. Under the MTC regulations, compensation paid to employees whose services are performed entirely in a state where the taxpayer is immune from taxation is excluded from the denominator of the payroll factor.

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15. Which of the following statements is not true? a. The UDITPA Section 14 payroll sourcing rules are derived from b. If an employee performs services in two states, the employee’s com-

the Model Unemployment Compensation Act.

pensation is prorated between the payroll factor numerators of the two states. c. Compensation that is treated as a capital expenditure is included in the payroll factor. d. If an employee performs services exclusively within a single state, then that employee’s compensation is included in the numerator of that state.
16.

In MeadWestvaco, the Supreme Court stated that the operational function concept as described by the Court in Allied Signal:
a. Was properly applied by the Illinois courts b. Modifies the unitary business principle by adding a second test for c. Recognizes that an asset can be a part of a taxpayer’s unitary busi-

apportionable business income

ness, even if there is no unitary relationship between the payer and the payee d. None of the above
17.

If a corporation has nexus in two or more states, under the unitary business principle, a nexus state may tax:
a. b. c. d.

An apportioned percentage of the corporation’s business income All of the corporation’s business income All of the corporation’s business income and nonbusiness income None of the above

18.

The majority view of the UDITPA definition of business income is that it includes:
a. b. c. d.

A transactional test only functional test only either a transactional or functional test Both a transactional and a functional test

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19.

Which of the following statements is true of nonbusiness income?
a. It can be defined differently in different states, subject to U.S. b. It is apportioned among the states in which the taxpayer has nexus. c. It generally includes income derived from property that is an integral d. It includes income that meets both the transactional and the func-

constitutional restrictions.

part of the taxpayer’s regular trade or business operations tional test.

20. The functional test: a. Is not recognized by the MTC regulations b. Considers whether the income-producing property is integral, as c. Considers whether the transaction is frequent in nature, as opposed d. None of the above 21.

opposed to incidental, to the taxpayer’s business operations to a rare and extraordinary event

Which of the following states relies solely on the transactional test to determine whether income is business or nonbusiness in nature?
a. b. c. d.

California Illinois Pennsylvania None of the above

22. Which of the following items of nonbusiness income is generally

allocated to the state where the income-producing asset is physically located?
a. b. c. d.

Capital gains from the sale of stock Royalties from real property Interest Dividends

23. Which of the following statements is not true? a. Expenses related to nonbusiness income are generally deductible b. The commercial domicile of a corporation may be in a state other c. Nonbusiness patent royalties are generally allocated to the state in d. Nonbusiness income from intangible property is generally allocated

against business income.

than the state of incorporation. which the patent is used.

to the state of commercial domicile.

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24. In Allied Signal, the Supreme Court stated that: a. The payee and the payer need not be engaged in the same unitary b. To qualify as business income, what is required is that the capital

business as a prerequisite to apportionment in all cases

transaction serve an investment rather than an operational function c. Interest earned on short-term deposits that are part of a corporation’s working capital is nonbusiness income d. None of the above
25. In which of the following cases did the Supreme Court determine that

California’s interest-offset rule was unconstitutional?
a. b. c. d.

Kroger Co. Hunt-Wesson, Inc. Hoechst Celanese Corp. Downey Toy Company

26. Which of the following would be a reason for a difference between a

state and federal NOL deduction?

a. The state allows a carryback of two years. b. The state allows a carryforward of 20 years. c. The state requires the taxpayer to have nexus in the year the NOL d. None of the above 27.

is incurred.

Which of the following statements is not true?
a. State addition and subtraction modifications can cause a state NOL b. Even if there is a major change in a corporation’s state apportionment

to differ from the federal NOL.

percentage between the year of the loss and the carryover year, the benefit of the NOL deduction will be the same regardless of whether the state uses the pre-apportionment or post-apportionment method for determining the deduction. c. A corporation generally must be doing business in the state in the year of the loss to create a state NOL carryforward deduction. d. Some states impose flat dollar limitations on NOL carryovers.

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28. Code Sec. 381 does not apply to which of the following transactions? a. b. c. d. 29.

Type A reorganizations Type B reorganizations Type C reorganizations Type F reorganizations

Which of the following statements is true?
a. States that use federal Form 1120, Line 30, as the starting point

in determining state taxable income allow the same NOL deduction for state and federal tax purposes, unless the state requires a modification for NOLs. b. Most states do not permit NOL deductions. c. The NOL deduction in a state consolidated return is always identical to the NOL deduction in a federal consolidated return. d. None of the above
30. How many states allow NOL carrybacks? a. b. c. d. 31.

Only one Some All None

For federal tax purposes, if the acquirer makes a Section 338 election:
a. The purchase of a controlling interest in the target’s stock is treated b. The target recognizes no gain or loss on the deemed asset sale. c. The basis in target’s assets is stepped up or stepped down to market d. None of the above

as a stock purchase. value.

32. For federal tax purposes, under a Section 338(g) election: a. The basis of the old target’s assets carries over to the new target

corporation. b. The acquirer must formally liquidate the target corporation. c. Any gain or loss resulting from the deemed asset sale is included in the acquirer’s current year tax return. d. Target recognizes gains and losses arising from the deemed asset sale.

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33. For federal tax purposes, a Section A 338(h)(10) election: a. b. c. d.

Results in two levels of taxation Is made only by the target corporation, using federal Form 8023 May not be made by S Corporation shareholders None of the above

34. States generally treat gains and losses arising from a deemed asset sale

under Section 338 as:
a. b. c. d.

Allocable nonbusiness income Apportionable business income Nontaxable income None of the above

35. Which of the following statements is true? a. States generally conform to the federal treatment of a Section 338(g) b. Most states do not conform to the federal treatment of a Section c. All states treat the gains and losses resulting from a deemed asset d. All states apply special apportionment rules to the income arising

election.

338(h)(10) election.

sale under Section 338 as allocable nonbusiness income. from a deemed asset sale under Section 338.

36. Which of the following members of a unitary group is not included in

a California water’s-edge combined report?

a. A more than 50 percent owned domestic corporation b. A foreign corporation that has 20 percent or more of its property, c. A controlled foreign corporation, to the extent of its Subpart F d. All of the above are included in a California water’s-edge combined

payroll, and sales factors in the United States income and related apportionment factors report.

37.

A waters-edge combined report:
a. Includes members of the unitary group that are incorporated in a b. Includes all members of the unitary group, regardless of the country c. Is required by Illinois d. Is not permitted by Texas

foreign country and conduct all of their business abroad of incorporation or the location of business activities

QUIZZER QUESTIONS — Module X

249

38. In which of the following cases did the state supreme court determine

that factor representation is required for a foreign subsidiary’s property, payroll, and sales?
a. b. c. d.

NCR Corp. v. Minnesota Commissioner of Revenue NCR Corp. v. South Carolina Tax Commission Unisys Corp. v. Commonwealth of Pennsylvania None of the above

39. Which of the following statements is not true? a. Most states permit a dividends-received deduction or subtraction b. Most states allow a corporation to claim a credit for foreign income c. Most states conform to the federal check-the-box rules for state d. Most states allow a dividends-received deduction or subtraction

modification for Subpart F income. taxes.

income tax purposes.

modification for Section 78 gross-up income.

40. If a domestic corporation receives a dividend from a wholly owned

foreign corporation whose business activities are unitary with those of its domestic parent, then the dividend is treated as:

a. Business income that is apportioned among the states in which the

domestic parent does business b. Business income that is specifically allocated to the state in which the domestic parent is commercially domiciled c. Nonbusiness income that is specifically allocated to the state in which the domestic parent is commercially domiciled d. Nonbusiness income that is apportioned among the states in which the domestic parent does business

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Quizzer Questions: Module 2
41. When a jeopardy assessment is made: a. b. c. d.

The states tend to err on the low side when making assessments. The burden of proof rests with the state. The auditor and taxpayer must agree on the amount. The state can base the assessment on the best available information.

42. Which of the following statements is true of a self-audit? a. It is performed to identify and correct underpayment errors before b. It is performed to identify and correct overpayment errors before c. It is performed to find errors that will generate a refund. d. It is performed to correct inefficiencies. 43. If a taxpayer has never filed a return, which of the following is true? a. The taxpayer is open to assessment as far back as the state can b. The taxpayer is open to assessment for a maximum of 10 years. c. The taxpayer is only open to assessment until the state’s statute of d. None of the above

the auditor reviews the books. the auditor reviews the books.

establish a connection between the taxpayer and the state. limitations has run.

44. Which of the following is the object of a reverse audit? a. To identify and correct underpayment errors before the auditor

reviews the books b. To identify and correct underpayment errors when filing an amended return c. To recover tax incorrectly paid to a taxing jurisdiction or a vendor d. To make a tax payment just prior to the start of an audit
45. The greatest opportunities for refunds are related to: a. b. c. d.

Purchases by a taxpayer Incorrect tax status of a customer Incorrect tax status applied to items sold Errors made by the taxing jurisdiction

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46. Which of the following documentation should not be included with

a refund claim?

a. A copy of the invoice from the seller on which the tax was billed b. A copy of the check that shows that payment was made to the seller c. An explanation as to why the transaction in question is not subject d. None of the above 47.

to tax

A voluntary disclosure agreement benefits which of the following?
a. b. c. d.

Neither the taxpayer nor the state Both the taxpayer and the state The taxpayer only The state only

48. When should negotiations with the auditor take place? a. b. c. d.

Only in the latter stages of audit fieldwork Only in the beginning stages of audit fieldwork Only during the course of the audit fieldwork None of the above

49. Which of the following is true of sampling? a. Some states allow taxpayers to estimate their tax liability through b. Most states require the taxpayer to agree to the sampling methodolc. If a statistical sample is to be performed, the transactions tested will d. None of the above

sampling, using state-approved sampling procedures. ogy used by the auditor.

come from a specified test period.

50. When should records be discarded? a. b. c. d.

Immediately when the statute of limitations is reached Never Not as long as there are legal reasons for retaining them None of the above

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253

51.

Which one of the following statements is not true?
a. While auditors have a great deal of authority regarding the timing b. When scheduling an audit, prior audit experience with the state

of an adult, taxpayers have rights too.

should be considered. c. If attempting to reduce the scope of an audit when time constraints exist, a taxpayer should identify transactions that may be excluded from review and propose the exclusions to the auditor. d. In scheduling an audit with an out-of-state auditor, the taxpayer should not consider whether the auditor is under a time constraint.
52. A _____ audit refers to an approach where the taxpayer performs some

of the audit work, subject to auditor review.
a. b. c. d.

Field Sampling Managed None of the above

53. If a nexus questionnaire is mailed to a taxpayer and it appears that the

taxpayer has been targeted for specific reasons, the taxpayer should do which of the following?

a. Respond in writing to the request b. Attempt to contact the state via telephone to discuss the questionc. Not respond, unless there is follow-up from the state d. Not respond, even if there is follow-up from the state 54. Which of the following statements is not true? a. On the phone, taxpayers should go no further than providing some

naire before responding

assurances that a sample is an acceptable audit methodology, subject to a formal review of the state’s sampling techniques. b. To reduce the scope of the audit when time constraints exist, a taxpayer should use less sampling. c. Taxpayers should discourage the auditing of transactions they feel may be unnecessary. d. Taxpayers should refuse to allow the auditor to audit the books or transactions of entities without nexus.

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55. Audit confirmation letters usually contain all of the following information except: a. b. c. d.

The period under review Items to be included in the nexus questionnaire The taxes under review Any agreements previously reached regarding the scope of the audit

56. In which situation should the taxpayer probably not give disclosure to

the auditor?

a. The taxpayer failed to self-assess use tax for six months during the b. The taxpayer has several locations in the state that perform their c. The taxpayer has discovered an overpayment error and will probably d. None of the above 57.

audit period.

own tax compliance.

be filing a refund claim as part of the audit.

Which of the following statements is true?
a. Taxpayers should keep correspondence regarding filing positions b. Taxpayers should immediately respond to all auditor questions, c. Taxpayers should battle over every adjustment d. None of the above

in the same files as the return work papers.

even if they are not entirely certain of the correct answer.

58. Audits are usually initiated for all of the following reasons except: a. b. c. d.

Large size of the taxpayer Taxpayer filing large refund claim Referrals from other taxpayers Taxpayer purchase of a subsidiary

59. Which type of audit is likely if an auditor has a tailored list of possible

adjustments?
a. b. c. d.

Random selected audit Special industry audit Recurring audit Referral audit

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255

60. Which of the following is the cause of the largest use tax audit adjust-

ment for most taxpayers?
a. b. c. d.

Use tax was not self-assessed on inventory transfers for self-use. Inaccurate tax was applied to sales. Use tax on purchases was unreported. Exemptions were given to taxpayers without a valid exemption certificate.

61.

Why is nonstatistical sampling used more often than statistical sampling?
a. Because it considers seasonal fluctuations. b. Because the results are more reliable than when using statistical c. Because it is easier to use than statistical sampling. d. None of the above

sampling.

62. Which of the following is a disadvantage of nonstatistical sampling? a. b. c. d.

It uses stratification. There may be over-sampling and under-sampling. It is difficult to use. None of the above

63. Which of the following states exclusively uses statistical sampling? a. b. c. d.

Florida Georgia New York None of the above

64. State audit procedures are designed to find: a. b. c. d.

Overpayments but not underpayments of tax Underpayments but not overpayments of tax Both overpayments and underpayments of tax Neither overpayments nor underpayments of tax

65. Which of the following is an important and beneficial taxpayer skill? a. b. c. d.

Personalizing disagreements Respectfully disagreeing with the auditor Being fashionably late to meetings Attempting to intimidate the auditor

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66. The deadline for appeal of an assessment in most states is usually how

long after the notice was mailed or received?
a. b. c. d.

30 to 90 days 90 or 120 days Six months One year

67.

Which of the following is not a common reason for imposition of a penalty?
a. b. c. d.

Not filing a return Late filing Error in current return Late payment

68. Which type of penalty would most likely result if a taxpayer does not

pay tax to some vendors and does not have proper self-assessment procedures in place?
a. b. c. d.

Fraud Substantial understatement Gross negligence Ordinary negligence

69. When should discussions related to the trading off of issues occur? a. b. c. d.

At the beginning of negotiations with the auditor On the last planned day of negotiations with the auditor At the beginning of the audit After the assessment is issued

70. Which of the following statements is true? a. The rate of interest on deficiencies ranges from eight to 10 percent b. The use of computers has increased the importance of reviewing

in most states.

the interest assessment. c. Most states assess compound interest. d. A sample audit deficiency should be allocated across the audit period on a monthly basis to calculate interest.

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257

71.

Which of the following defenses should not be used when a penalty is imposed on an uncontroversial transaction?
a. b. c. d.

The taxpayer has a good audit history. The taxpayer has had significant staff turnover. The administration of the tax law is complex. The tax deficiency is low compared to the amount of tax voluntarily paid during the period.

72. Which of the following statements is not true? a. Most states will refuse to discuss issues with an outside advisor if b. If another taxpayer has been unsuccessful in appealing the same c. Intangibles of litigation, such as public disclosure, should be deterd. In order to properly estimate the probability of success of an appeal,

the advisor is not duly authorized to act on the taxpayer’s behalf.

issue, the taxpayer should not appeal, even if its facts are different. mined if the cost-benefit analysis yields a positive result.

the litigation environment in the state should be considered.

73. A taxpayer is under a four-year audit, with two years under waiver because

of expiration of the statute of limitations. The audit is completed in the second year of the next audit cycle. In which years of the next audit cycle should the taxpayer be required to demonstrate corrective action?
a. Years two through four b. Years three through four c. All four years, because the taxpayer has sufficient time to correct d. None of the years, because the audit cycle began before the audit

them before the next audit. was completed.

74.

If the tax law is not complied with, in some states a return preparer who has substantial authority for the payment of tax could:
a. Have a penalty imposed for negligence or fraud b. Not be allowed to prepare any future returns or perform any acc. Be subject to mandatory jail time even if they have made reasonable d. None of the above

counting work

efforts to comply with the requirements of the tax law

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75.

Which of the following is likely to occur in the near future?
a. Sampling will play a lesser role in sales and use tax audits. b. The use of penalties will decrease. c. The use of database programs in the performance of audits will

decrease. d. Taxpayers will have more opportunities to perform all or part of audits themselves.
76. Which one of the following statements is not true? a. A disadvantage of taxing PPCs at the point of sale is the difficulty b. More than a dozen states have recently changed their laws to tax c. Absent specific state legislation, most state laws would not impose

of administration for retailers and states. prepaid phone cards at the point of sale.

sales and use tax on the sale of prepaid phone cards because the true object of the sale is future long-distance service. d. A disadvantage of taxing PPCs at the point of sale is the possible difficulties encountered when using smartcards.
77.

Possible problems related to the use of procurement cards include all of the following except:
a. b. c. d.

Difficulty in determining when a sale occurs Receiving documentation too late to timely pay tax Overpaying use tax to avoid underpayments Increased administrative costs

78. Which of the following statements is true? a. The definition of telecommunications services is uniform among b. The Internet Tax Freedom Act does not forbid sales tax in states

the states.

that imposed tax on Internet access charges before the Act became law. c. The Streamlined Sales Tax agreement does not include definitions for sourcing telecommunication services. d. None of the above

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259

79. According to the Menasha Corp. decision, which of the following is

true in determining whether software is canned or custom? the users needs are custom programs.

a. Programs requiring significant presale consultation and analysis of b. Custom programs include basic operational programs. c. Any program costing $20,000 or less is a canned program. d. None of the above 80. Which of the following is true concerning cloud computing? a. If it is taxable as a service, it is easier to determine taxability issues b. It has many benefits but increases costs for businesses. c. Most states have determined that it should be taxed as tangible

than if it is taxed as tangible personal property.

personal property for sales tax purposes. d. None of the above

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(10014587-0002)

Module 1: Answer Sheet nAMe ________________________________________________________________________________ CoMPAnY nAMe ______________________________________________________________________ StReet _______________________________________________________________________________ CItY, StAte, & ZIP Code ________________________________________________________________ BuSIneSS PHone nuMBeR _____________________________________________________________ e-MAIL AddReSS _______________________________________________________________________ dAte oF CoMPLetIon _________________________________________________________________ CRtP Id (for CteC Credit only) _____________________________________________________

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