Combined Reporting

1. Combined Reporting Cindy Avrette Revenue Laws Study Committee December 12, 2006

2. Combined Reporting • WHAT IS IT?It is a method of calculating the income of a group of affiliated corporations for tax purposes • HOW?It looks beyond the legal structure of separate incorporations to determine whether two or more affiliated corporations are engaged in a single unitary business • WHY?To ensure the income of a multiple entity unitary business computed and apportioned in the same manner as a single corporate business

3. Advantages of Combined Reporting • Comprehensive way to nullify income shifting strategies • Provides a more level playing field • Means to modernize state tax code to adapt to the growth of multi-state corporations – Recommended by Governor’s Commission to Modernize State Finances in 2002

4. What is Combined Reporting? • An accounting of the total income derived by a group of affiliated corporations from the operation of its unitary business. • A unitary business is a common enterprise engaged in by one or more members of a group of affiliated entities.

5. What is a Combined Report? • It is NOT a tax return. • It is an accounting document prepared on behalf of a group of affiliated corporations engaged in a unitary business. • Only those members of a unitary group that have nexus with NC pay corporate income tax to NC – Based on the combined group’s net income

6. Questions to Answer • Mandatory v. voluntary • Definitions • Affiliated corporations • Unitary business • Type of Combined Reporting • Worldwide • Water’s Edge • Method of Apportionment

7. Mandatory v. voluntary • Elective combined reporting would do nothing to reduce the tax planning opportunities – one of the primary benefits of combined reporting

8. Questions to Answer • Mandatory v. voluntary • Definitions • Affiliated corporations • Unitary business • Type of Combined Reporting • Worldwide • Water’s Edge • Method of Apportionment

9. Who must file a combined report? • Corporations • that are affiliated • and that are engaged in the same unitary business.

10. Corporations ... • All corporations that are subject to corporate income tax or would be subject to the tax if doing business in this State • Insurance companies – No. • Financial institutions. – Yes. • REITs and RICs. – Yes. • Non-US corporations. – Yes, if worldwide combined reporting

11. … that are affiliated … • More than 50% common stock ownership • Familiar rule with wide spread acceptance

12. and engaged in the same unitary business. • No universally accepted definition • Vertically or horizontally integrated • Established judicial tests • Unity of ownership, use, and operation • Contribution or dependency • Centralized management • Functional integration • Economies of scale • Flow of value

13. Multistate Tax Commission (MTC) A that is made up either single economic enterprise of separate parts of a single business entity or of a commonly controlled group of business entities that are sufficiently interdependent, integrated and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts.

14. Center for Policy Alternatives A group of corporations that are related through common ownership, and, by a preponderance of the evidence, are economically interdependent with one another as demonstrated by the following factors:a. Centralized management; b. Functional integration; andc. Economies of scale.

15. Alaska • A business is unitary if the entity or entities involved are owned, centrally managed, or controlled, directly or indirectly, under one common direction which can be formal or informal, direct or indirect, or if the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business outside the state.

16. California • Does not have a statutory definition. • Its Code of Regulations provides guidelines on what a unitary business is.

17. Colorado • Unique attempt to provide a bright-line test • Must find at least three of the following six factors are present for the current year and the two preceding tax years: • Intercompany sales or leases • Services provided by one for others • Long-term debt • Use of proprietary materials owned by another • Common corporate control • Common corporate management

18. Illinois • A group of persons related through common ownership whose business activities are integrated with, dependent upon and contribute to each other.

19. Hawaii • Business carried on by a group of entities that includes the taxpayer where there are flows of value among the entities resulting from (1) functional integration, (2) centralization of management, or (3) economies of scale.

20. Minnesota • Business activities or operations which result in a flow of value between them. … Flow of value is determined by reviewing the totality of facts and circumstances of business activities and operations.

21. Montana • The business operations conducted by the corporations in the affiliated group are interrelated or interdependent to the extent that the net income of one corporation cannot reasonably be determined without reference to the operation conducted by the other corporation.

22. Nebraska • A business that is conducted as a single economic unit by one or more corporations with common ownership and shall include all activities in different lines of business that contribute to the single economic unit.

23. New Hampshire and Vermont • One or more related business organizations engaged in business activity both within and without this state among which there exists a unity of ownership, operation, and use; or an interdependence in their functions.

24. Oregon • A corporation or group of corporations engaged in business activities that constitute a single trade or business. • A single trade or business is a business enterprise in which there exists directly or indirectly between the members … a sharing or exchange of values …

25. Utah • A group of corporations that are related through common ownership and by a preponderance of the evidence as determined by a court of competent jurisdiction or the commission, are economically interdependent with one another as demonstrated by the following factors: • Centralized management • Functional integration • Economies of scale

26. Definition of unitary business • Different definitions – Same concept • Proposal: Broad definition • Less opportunity for manipulation • Lower compliance costs

27. Questions to Answer • Mandatory v. voluntary • Definitions • Affiliated corporations • Unitary business • Type of Combined Reporting • Worldwide • Water’s Edge • Method of Apportionment

28. Worldwide v. Water’s Edge • Two general approaches on how to deal with a unitary group member that is incorporated in a foreign country • Prevailing position is worldwide combination with a water’s edge election

29. Worldwide combination • Consistent with concept that a unitary business should be taxed without regard to its organizational structure. • Constitutionality valid. • Controversial. • Distortions in property and payroll factors. • Difficulty of accounting and audit. • Business community does not favor it. • No major industrialized country requires it for income tax purposes.

30. Water’s edge combination • Exclude 80/20 corporations – A corporation whose business activity outside the US is 80% or more of the corporation’s total business activity. • Avoids the compliance burden of a worldwide combination.

31. Worldwide Combination with Water’s Edge Election • Water’s edge group includes: • U.S. corporations • Non-U.S corporations that do not meet the 80/20 test • Corporations doing business in tax-haven countries • Related intangible holding companies

32. Water’s Edge Election • Election must be in writing • Election binding for an initial period of time (MTC = 10 yrs) • Election automatically extended unless notice given of intent not to renew before the end of the last two years of the election period • If election terminated, cannot be renewed for minimum period of time

33. Questions to Answer • Mandatory v. voluntary • Definitions • Affiliated corporations • Unitary business • Type of Combined Reporting • Worldwide • Water’s Edge • Method of Apportionment

34. Apportionment Formula • Prevent income from being taxed twice • Three factor formula • Property in NC/Total property • Payroll in NC/Total payroll • Sales in NC/Total sales • Property + Payroll + 2(Sales)/4 = Apportionment Percentage

35. Apportionment of Income – Single entity reporting • Calculate apportionable taxable income under NC law • Calculate apportionment percentage using the apportionment formula(Property + Payroll + 2(Sales)/4) • Multiply apportionable taxable income by apportionment percentage to determine apportionable taxable income • Apportionable income + Nonapportionable income allocated to state = taxable income • Apply the tax rate to taxable income

36. Apportionment of Income – Combined Reporting • Calculate apportionable taxable income under NC law for entire combined group (subtracting income from inter-company transactions) • Calculate apportionment percentage by applying the apportionment formula using the aggregate factors of the combined group (payroll, property, sales) • Multiply apportionable taxable income for entire combined group by apportionment percentage to determine the State net income of the unitary business

37. Taxation of individual members of unitary group • Members calculate own apportionment percentage based upon their payroll, property, sales • Apply apportionment percentage to the combined group’s net taxable income = net taxable income of taxpayer from unitary business • Taxpayer’s NC taxable income = this amount + apportionable income derived from other business activities + nonapportionable income allocated to NC

38. Apportionment of Income – Combined Reporting • Calculate apportionment percentage by applying the apportionment formula using the aggregate factors of the combined group (payroll, property, sales) • Property in NC/Aggregate property • Payroll in NC/Aggregate payroll • Sales in NC/Aggregate sales X 2

39. Method of Apportionment:“… in North Carolina” • Finnigan: include the property, payroll, and sales of those members in the State, regardless of nexus • Prevents tax planning techniques for isolating sales in non-nexus affiliates • Constitutionality unclear/Litigation more likely • Joyce: include only the property, payroll, and sales of those members that have nexus with the State in the numerator • Most accepted method • Tax avoidance strategies exist

40. MTC Recommendation • Joyce method of apportionment • Adopt a throwback provision • Sales are sourced to the destination state • Throw-back causes the sales to be sourced to the state from which the property was shipped if the destination state does not impose income tax • Provision resolves some of the tax avoidance strategies

41. Proposal … • Mandatory combined returns • Definitions • Affiliated corporations – 50% • Unitary business – Broad • Type of Combined Reporting • Worldwide with Water’s Edge Election • Method of Apportionment • Joyce method • Throw-back provision