State Corporate Income Apportionment Key Fundamentals

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Presenting a live 110-minute teleconference with interactive Q&AState Corporate IncomeApportionment Key FundamentalsUnderstanding Trends and State Approaches to Factor Weighting,Service Revenue, Joyce vs. Finnigan and Other Apportionment ConceptsWEDNESDAY, MAY 15, 20131pm Eastern 12pm Central 11am Mountain 10am PacificToday’s faculty features:Richard Call, Attorney, Morrison & Foerster, New YorkKelly Brown, Director, State and Local Tax Group, PricewaterhouseCoopers, BostonMarianne Evans, Senior Manager, KPMG, Washington, D.C.For this program, attendees must listen to the audio over the telephone.Please refer to the instructions emailed to the registrant for the dial-in information.Attendees can still view the presentation slides online. If you have any questions, pleasecontact Customer Service at 1-800-926-7926 ext. 10.

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State Corporate Income ApportionmentKey Fundamentals SeminarMay 15, 2013Richard Call, Morrison & Foersterrcall@mofo.comMarianne Evans, KPMGmevans@kpmg.comKelly Brown, PricewaterhouseCooperskelly.brown@us.pwc.com

Today’s ProgramBusiness Vs. Non-Business Income[Richard Call]Slide 8 – Slide 10Apportionment Formula Key Concepts[Richard Call]Slide 11– Slide 14Sales Factor[Kelly Brown and Marianne Evans]Slide 15 – Slide 26Property Factor[Richard Call]Slide 27 – Slide 33Payroll Factor[Marianne Evans]Slide 34 – Slide 39Specific Industry Apportionment[Kelly Brown]Slide 40 – Slide 44Combined/Consolidated Return Issues[Richard Call]Slide 45 – Slide 50Latest Important Developments[Kelly Brown]Slide 51

NoticeANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BYTHE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANYOTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THATMAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING ORRECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.You (and your employees, representatives, or agents) may disclose to any and all persons,without limitation, the tax treatment or tax structure, or both, of any transactiondescribed in the associated materials we provide to you, including, but not limited to,any tax opinions, memoranda, or other tax analyses contained in those materials.The information contained herein is of a general nature and based on authorities that aresubject to change. Applicability of the information to specific situations should bedetermined through consultation with your tax adviser.

Richard Call, Morrison & FoersterBUSINESS VS. NON-BUSINESSINCOME

Apportionable V. Non-Apportionable Income Constitutional framework Apportionment formula may only apply to “apportionable” income. The U.S. Constitution prohibits a state from apportioning incomethat has no connection to the taxing state. Statutory framework Many states use a statutory term, “business income,” todetermine what income is apportioned to the state. Non-apportionable or non-business income can be specificallyallocated by statute.9

What Is Apportionable Income? Constitutional framework To be apportionable, income must come from a “unitary” business. Indicators of a unitary business are flows of value, which have beenexpressed as: Functional integrations Centralization of management Economies of scale Statutory framework Historically, “business income” was defined in UDITPA as “income arisingfrom transactions and activity in the regular course of the taxpayer’s trade orbusiness and includes income from tangible and intangible property if theacquisition, management, and disposition of the property constitute integralparts of the taxpayer’s regular trade or business operations.” Some states define “business income” as all income apportionable under theConstitution.10

Richard Call, Morrison & FoersterAPPORTIONMENT FORMULAKEY CONCEPTS

Apportionment U.S. Supreme Court precedent has interpreted the CommerceClause to require fair apportionment. What is fair apportionment? Do taxpayers have a right to apportion? If so, when? Apportionment formula must reasonably reflect how income isgenerated.This is MoFo.12

What Factors Are Used? This is MoFo.13

Weighting Of Factors This is MoFo.14

Kelly Brown, PricewaterhouseCoopersMarianne Evans, KPMGSALES FACTOR

NoticeANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDEDOR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED,BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THEPURPOSE OF (i) AVOIDINGPENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii)PROMOTING, MARKETING OR RECOMMENDING TO ANOTHERPARTY ANY MATTERS ADDRESSED HEREIN.You (and your employees, representatives, or agents) may disclose to any and all persons,without limitation, the tax treatment or tax structure, or both, of any transaction described inthe associated materials we provide to you, including, but not limited to, any tax opinions,memoranda, or other tax analyses contained in those materials.The information contained herein is of a general nature and based on authorities that aresubject to change. Applicability of the information to specific situations should be determinedthrough consultation with your tax adviser.16

Sales Factor: What Is Included?I. UDITPA refers to “total sales” but defines “sales” as “all grossreceipts of the taxpayer not allocated.”II. The MTC regulations specify that “sales” includes “all grossreceipts derived by the taxpayer from transactions andactivity in the regular course of the trade or business.”17

Sales Factor: What Is Excluded?I.MTC regulations exclude:A. Substantial amounts of gross receipts from the occasionalsale of fixed assets used in the taxpayer’s businessB. Insubstantial amounts that do not materially affect thefactorsC. Receipts on which the IPA cannot be localizedII. States have specific exclusions:A. Receipts other than receipts from the principal businessactivityB. Receipts from sale of certain assetsC. Receipts from income not included in the tax base18

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Sales Factor: Gross ReceiptsOr Net Gain?I. UDITPA and the MTC regulations refer to “gross receipts.”II. However, the MTC regulations were amended in 2001 and nowprovide that only the “overall net gain” from the sale,exchange or other disposition of “liquid assets” in a taxpayer’s“treasury function” are included.A. Only a few states have adopted this modification to theMTC regulations (e.g., HI, ID, UT).B. Other states have similar rules that allow inclusion of onlynet gains on sales of intangible property (e.g., IL).20

Sales Factor: Sourcing OfSales Of TPPI. UDITPAA. Sales of TPP are in this state if the property is delivered orshipped to a purchaser, other than the U.S. government,within this state.II. MTC regulationsA. Does not matter if the property is ordered from anotherlocationB. Does not matter if purchaser subsequently transfers theproperty to another stateC. Drop shipments: Sourced to where the ultimate recipientof the property is situated (your customer’s customer)21

Sales Factor Sourcing:Dock Pick-up SalesI. “ delivered or shipped to a purchaser within this state”A. Does “within this state” modify “delivered or shipped” or“purchaser”?II. If the purchaser picks up goods at seller’s dock and thentransports them to another state for use, to which state arethe sales sourced?A. Most state courts have held that such sales are sourced tothe state of ultimate destination.22

Sales Factor: ThrowbackI.UDITPAA. Sales of TPP are in this state if the property is shipped from anoffice, store, warehouse, factory or other place of storage in thisstate, and the taxpayer is not taxable in the state of thepurchaser.II. How do UDIPTA and/or the MTC regulations define “taxable in thestate of the purchaser”?A. Being subject to a net income tax, franchise tax for the privilegeof doing business, or a corporate stock tax in another stateB. Another state having the right to impose a net income tax, evenif it does not actually impose such a tax23

Sales Factor: SourcingOf Non-TPP SalesI. UDITPA 17A. Sales, other than sales of TPP, are in this state if:1. The income-producing activity (IPA) is performed inthis state, or2. The IPA is performed both in and outside this state,and a greater proportion of the IPA is performed in thisstate than in any other state based on costs ofperformance.24

Sales Factor: DefinitionsI. IPA - MTC Reg. IV.17.(2)A. IPA “applies to each separate item of income and meansthe transactions and activity directly engaged in by thetaxpayer in the regular course of its trade or business forthe ultimate purpose of obtaining gains or profits.”II. Costs of performance - MTC Reg. IV.17.(3)A. Direct costs determined in a manner consistent withgenerally accepted accounting principles and inaccordance with accepted conditions or practices in thetrade or business of the taxpayer25

Sales Factor:Market-Sourcing IssuesI. How do you determine where a service is received?II. How do you define the benefit of a service?III. How do you determine where the benefit is received?IV. When do you “look through” to the ultimate customer orultimate marketplace?V. What is a fixed or regular place of business?26

Richard Call, Morrison & FoersterPROPERTY FACTOR

Property Factor Uniform Division of Income for Tax Purposes Act (UDITPA) Owned and leased real and tangible personal property are includedin the factor. Owned property is valued at its original cost unless original cost isnot known; then, FMV at time of acquisition is used. Leased property is valued at 8 times the annual rental amount. The factor is determined by using an average of beginning- and endof-year values. Storage fees – Multistate Tax Commission Reg. IV.11(b)(3) “A taxpayer stores part of its inventory in a public warehouse. Thetotal charge for the year was 1,000 of which 700 was for the use ofstorage space and 300 for inventory insurance, handling andshipping charges, and C.O.D. collections. The annual rent is 700.”This is MoFo.28

Property Factor (Cont.)Movable property Multistate Tax Commission Reg. IV.10(d) “The value of mobile or movable property such as constructionequipment, trucks or leased electronic equipment which arelocated within and without this state during the tax period shall bedetermined for purposes of the numerator of the factor on thebasis of total time within the state during the tax period.” “An automobile assigned to a traveling employee shall beincluded in the numerator of the factor of the state to which theemployee's compensation is assigned under the payroll factor orin the numerator of the state in which the automobile is licensed.”This is MoFo.29

Property Factor (Cont.)In-transit property “Property in transit between locations of the taxpayer to which itbelongs shall be considered to be at the destination for purposes ofthe property factor.” Cal. Code Regs. tit. 18, 25129(d) Inventory in transit from one state to another is not included in thedenominator of the property factor. N.J. Admin. Code 18:7-8.4(c)(3) Maryland required inclusion of the value of automobiles on the highseas in the Maryland numerator, despite the fact that in-transitinventory was not addressed in the property factor statute.Mercedes Benz of N. Am., Inc. v. Comptroller of Treasury, Dkt. No.2813, (Md. Tax Ct. Oct. 7, 1988)This is MoFo.30

Property Factor For BanksLoans in property factor Minnesota - Minn. Stat. 290.191, Subd. 11 Secured loans are attributable to Minnesota if the security is inMinnesota. Unsecured consumer loans or consumer loans secured byintangibles are attributed to Minnesota if the loan was made to aresident of Minnesota. Unsecured commercial loan and installment obligations areattributable to Minnesota if the proceeds of the loan are to beapplied in Minnesota. Loans will generally include credit card receivables.This is MoFo.31

Property Factor For Banks (Cont.)Loans in property factor (Cont.) MTC A loan is considered to be located within this state if it is properlyassigned to a regular place of business of the taxpayer within this state. A loan is properly assigned to the regular place of business with which ithas a preponderance of substantive contacts. To determine the state in which the preponderance of substantivecontacts relating to a loan have occurred, the facts and circumstancesregarding the loan at issue shall be reviewed on a case-by-case basisand consideration shall be given to such activities as: Solicitation Investigation Negotiation Approval AdministrationThis is MoFo.32

Property FactorMeredith Corp. (N.Y. App. Div. 2012) Is programming delivered via satellite TPP includable in the propertyfactor? Policy change When litigation commenced, programming delivered via videotapewas considered TPP by the department. The department changed its policy via a TSB to excludeprogramming delivered by videotape. “This record establishes that programming on videotape had long beenconsidered by the Department as tangible property for purposes of theproperty factor, and there is no rational distinction for taxationpurposes between programming sent to a station on videotape andprogramming sent via satellite.”This is MoFo.33

Marianne Evans, KPMGPAYROLL FACTOR

NoticeANY TAX ADVICE IN THIS COMMUNICATION IS NOTINTENDED OR WRITTEN BY KPMG TO BE USED, ANDCANNOT BE USED, BY A CLIENT OR ANY OTHER PERSONOR ENTITY FOR THE PURPOSE OF (i) AVOIDINGPENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR(ii) PROMOTING, MARKETING OR RECOMMENDING TOANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.You (and your employees, representatives, or agents) may disclose to any and all persons,without limitation, the tax treatment or tax structure, or both, of any transaction described in theassociated materials we provide to you, including, but not limited to, any tax opinions,memoranda, or other tax analyses contained in those materials.The information contained herein is of a general nature and based on authorities that are subjectto change. Applicability of the information to specific situations should be determined throughconsultation with your tax adviser. 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member fi rms affiliated withKPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in the U.S.A.FOR INTERNAL USE ONLY. Not for distribution to clients unless the technical and policy review requirements of Tax Services Manual section 23.7 are satisfied.35

Payroll Factor: What Is Included? Total amount paid to employees for compensation Includes salaries, commissions, other taxable remuneration Per the taxpayer’s accounting method – accrual or cash Includes payroll capitalized as part of cost of asset, for book or taxpurposes May elect to use cash method if compensation reported under cashmethod for unemployment tax purposes Payroll related to production of non-business income is excluded Payroll paid to an employee in an “no-nexus”/P.L. 86-272 state isincluded in denominator 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member fi rms affiliated withKPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in the U.S.A.FOR INTERNAL USE ONLY. Not for distribution to clients unless the technical and policy review requirements of Tax Services Manual section 23.7 are satisfied.36

Payroll Factor: What Is Included? (Cont.) If the factor includes the total compensation paid to employees,who qualifies as employees? Officers? Independent contractors? “Leased employees”? Others? 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member fi rms affiliated withKPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in the U.S.A.FOR INTERNAL USE ONLY. Not for distribution to clients unless the technical and policy review requirements of Tax Services Manual section 23.7 are satisfied.37

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Hierarchy Of Payroll SourcingA. The state in which the employee’s services are wholly or substantiallyperformed, if services performed outside of that state are incidental(temporary or transitory) or rendered in connection with isolatedtransactionsB. The state in which the employee’s base of operations is located, ifsome part of the services are performed in that stateC. The state from which the employee is directed or controlled, if somepart of the services are performed in that stateD. The state in which the employee resides 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member fi rms affiliated withKPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in the U.S.A.FOR INTERNAL USE ONLY. Not for distribution to clients unless the technical and policy review requirements of Tax Services Manual section 23.7 are satisfied.39

Kelly Brown, PricewaterhouseCoopersSPECIFIC INDUSTRYAPPORTIONMENT

Special Industry Apportionment Three-factor formula works best for merchandising and manufacturingbusinesses. States allow other formulas, by statute and by taxpayerappeal. Construction: Include work in progress Athletes: Use duty-days Motion pictures: Use audience data Service providers: Use sales or payroll factors only Transportation: Use in-state miles, passenger-miles, train car-miles, tonmiles, time in-portPricewaterhouseCoopersSlide 41

Special Industry Apportionment (Cont.) Insurance companies: Use premium dollars written Mutual funds, banks: Use deposits, number of clients, number of cardsissued Communications: Use cable-miles, circulation, number of satellitestations on the groundPricewaterhouseCoopersSlide 42

Alternative Apportionment Method States may allow department to require, or taxpayer to request, use of analternative apportionment method. Usual goal is to prevent distortion or clearly reflect income in state.PricewaterhouseCoopersSlide 43

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Richard Call, Morrison & FoersterCOMBINED/CONSOLIDATEDRETURN ISSUES

Combination Combined report typically includes unitary members of the combinedgroup on either a worldwide or water’s edge basis. Inter-company transactions within the group may be eliminated, forapportionment purposes. Joyce/Finnigan Partnership factor flow-upThis is MoFo.46

Combination (Cont.)Appeal of Joyce (Cal. SBE 1966) SBE held that a company’s receipts from sales of TPP, shipped toCalifornia by a seller that was not taxable in California because ofP.L. 86-272 but was part of a unitary business conducted in California,could not be included in the California sales factor numerator. Joyce rule treats each combined group member as a separate entity, forapportionment purposes. Unless an entity has stand-alone nexus, its salesare not included in the sales factor numerator. Effects – Combined group members may have to throw back sales notsubject to tax in other states in which other combined group members aresubject to tax.This is MoFo.47

Combination (Cont.)Appeal of Finnigan (Cal. SBE 1990) SBE overruled Joyce and held that when a combined group memberhas sales to another state in which the combined group member isnot taxable, but in which other unitary combined group members aretaxable, the combined group member’s sales to that state are notsubject to throwback. Finnigan rule treats all combined group members as one entity, forapportionment purposes. Effects – All combined group members’ sales that are sourced toCalifornia are included in the numerator, regardless of whether theindividual combined group member is subject to tax in California.This is MoFo.48

Combination (Cont.)Partnership factor flow-up How does a state treat the apportionment factors of a partnership orLLC when income from those entities is included in the tax base? Are the factors of the partnership included in computing the tax? California Factors of the partnership flow up if the taxpayer and partnershipare engaged in a unitary business. Factors of the partnership do not flow up if the partnership is in adifferent line of business.This is MoFo.49

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Kelly Brown, PricewaterhouseCoopersLATEST IMPORTANTDEVELOPMENTS

Payroll Factor [Marianne Evans] Specific Industry Apportionment [Kelly Brown] Combined/Consolidated Return Issues [Richard Call] Latest Important Developments Slide 51 [Kelly Brown] Slide 8 - Slide 10 Slide 40 - Slide 44 Slide 45 - Slide 50 Slide 11-Slide 14 Slide 15 - Slide 26 Slide 27 - Slide 33 Slide 34 - Slide 39

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