SALT Aspects of Acquisitions— A Colorado Perspective

SALT Aspects of Acquisitions—A Colorado Perspective Presentation by Peter Rose to the Tax Executives Institute Denver Chapter May 23, 2007

Colorado Taxes • Income tax • Sales and use tax • State imposed • State collected • Home-rule imposed and collected • Ad valorem (property) tax • Other taxes • Severance tax • Gasoline and special fuel tax • Tobacco tax

Colorado Income Tax • State-level only • Flat tax of 4.63% • No general capital gains or dividend preference • Certain long-term Colorado-source capital gains may be non-taxable • Individual exclusion for interest, dividends, and capital gain is currently suspended • Not a detailed code but supplemented by regulations and FYIs

Statutory Structure C.R.S. § 39-22-101 et seq. • Part 1—General rules and individual tax • Part 2—Partners and partnerships • Part 3—Corporations (C and S) • Part 5—Special Rules (mainly credits) • Part 6—Procedure and Administration

Conformity • “Moving conformity” • Taxable income generally computed from federal taxable income • Colorado income tax code is “synched” with federal tax code

Colorado Adjustments • General conformity bows to Colorado adjustments • Individual adjustments—C.R.S. § 39-22-104 • Corporate adjustments—C.R.S. § 39-22-304

Examples of Colorado Adjustments • Colorado NOL • Portion of federal NOL allocated to Colorado • Colorado corporate NOL cannot be carried back • Colorado-source Capital Gains Exclusion

Colorado Capital Gains Exclusion Eligible Property • Real or tangible property located in Colorado at time of sale • Interests in Colorado entities • 50% or more of property and payroll sourced to Colorado in every year of 5-year holding period • Does not apply to intangible personal property held outside of an entity

Colorado Capital Gains Exclusion Holding Period • Acquired after May 9, 1994 • Held for 5 years or more • Transfers in and out of FTEs may tack—see FYI Income 15 and DD-588 • Expanded holding period rules apply only if Colorado has a qualified surplus

FTEs and Disregarded Entities • Colorado follows federal treatment • Flow-through entities (FTEs) • Any federal tax partnership including partnerships and LLCs • S corporations • Disregarded entities • Not a taxable entity in Colorado

Colorado Income Tax Planning • In general federal tax planning will have similar Colorado consequences because of conformity • But always check Colorado adjustments

Example—Making a § 338 Election I.R.C. § 338 allows the purchaser of stock to treat the stock purchase as an asset purchase • OldCorp is deemed to have sold all its assets for fair market value • NewCorp is deemed to have purchased all of OldCorp’s assets for fair market value • OldCorp recognizes gain on sale and NewCorp has stepped-up basis • May be beneficial if OldCorp has historic NOLs or if target is an S corporation

Example—Making a § 338(g) Election Colorado Treatment • § 338 gain is included in federal taxable income and thus must be included in Colorado taxable income (DD-480) Colorado NOL Trap • Colorado NOL might not be same as federal NOL

Related Transactions • Colorado has not directly adopted substance-over-form or step-transaction doctrines • Conformity effectively piggybacks Colorado onto federal tax law regarding related transactions

Multistate Aspects Colorado taxable income is increased or decreased by: • Allocation of non-business income away from or to Colorado based on sourcing rules • Apportionment of business income away from or to Colorado based on multifactor tests

Business Income • Taxpayer position—gain on sale of out-of-state business is non-business income not taxable in Colorado • DOR position—“regular course” of business includes strategic acquisitions and divestment (DD-507) • Consider advantages of applying Colorado capital gains exception, if applicable

Colorado Income Tax Recap • Federal income tax planning generally has same effect at Colorado level • Be aware that Colorado adjustments may affect tax consequences • Colorado capital gains exclusion is a significant Colorado benefit • DOR’s broad definition of “business income” may create taxable gains in Colorado

Colorado Sales and Use Tax • State imposes and collects tax of 2.91% • State also collects on behalf of special districts • Statutory cities/towns/counties impose their own tax on the state tax base, but state collects their tax • Home rule cities impose and collect sales and use tax pursuant to their own ordinances • Use tax is a “soak-up” tax—imposing tax on purchases that escaped tax in the jurisdiction

Sources of Sales and Use Tax Law • C.R.S. § 39-26-101 et seq. • State regulations and FYIs • Municipal ordinances • Municipal regulations and FYIs • Departmental decisions • Case law

Taxable Sale • Sale is an exchange of property or services for consideration • Taxable sales are • Retail sales of tangible personal property not otherwise exempted or excluded • Retail sales of specified services

Non-Taxable Sale • Wholesale sale—sales for resale • Sale of intangible personal property

Sales of Stock • Stock sales are excluded from sales and use tax because stock is intangible personal property

Reorganizations • Reorganizations qualifying under I.R.C. § 368(a)(1) are generally excluded from definition of “sale” • Always check home rule ordinances • Denver does not exclude reorganizations per se • Other grounds for exclusion • B reorganizations should be excluded because transferred stock is intangible property • E and F reorganizations should be excluded because there is no exchange of tangible personal property

Sales of Partnership and LLC Interests • Transfers of partnership and LLC interests are excluded by state statute • Generally, home rule ordinances exclude transfers of partnership, but not LLC, interests • Are LLC interests excludible as intangible personal property? • Probably yes • Exclusions for partnerships are surplusage reflecting pre-RUPA view of partnership interests

Non-Corporate Mergers Mergers involving partnerships and LLCs pursuant to state law should be excluded • Transfer is of entity interests, which should not be tangible personal property • Assets transfer by operation of law pursuant to state law merger or “junction box” statute

Asset Sale • Colorado does not have a casual sale exemption • Asset sales are generally taxable to the extent that tangible personal property (not otherwise exempt or excluded) is transferred • In these respects, home rule jurisdictions generally are in accord with state treatment

Useful Exclusions or Exemptions from Sales and Use Tax • Real property • Inventory • Machinery and equipment

Real Property Exclusion • Real property is excluded because it is, by definition, not personal property • Personal property becomes real property when it is affixed to real property • Generally applicable to state and home rule jurisdictions

Inventory Exclusion • Applies only to property that is inventory in the hands of the seller and inventory in the hands of the buyer • Buyer should have a resale certificate to perfect exclusion • Generally applicable to state and home rule jurisdictions

Machinery and Equipment Exemption—C.R.S. § 39-26-709 Qualifying machinery • Used in Colorado • Directly and predominantly to manufacture tangible personal property for sale or profit • Cost more than $500 • Capitalized • Qualify as creditable property under I.R.C. § 38 • Tangible personal property with useful life of one year or more • $150,000 per year limit for used equipment

Machinery and Equipment Exemption—C.R.S. § 39-26-709 Scope of exemption is broadened in “Enterprise Zones” • Need not be capitalized • Construction or repair material is exempt • Mining equipment is eligible

Machinery and Equipment Exemption—Local Aspects • M&E exemption is an exception to the general rule that state tax base applies in statutory jurisdictions • Most statutory and home rule jurisdictions do not have an M&E exemption

Related Transactions • Colorado excludes certain transactions from the definition of a “sale”: • Certain corporate, partnership, and LLC formations • Certain corporate, partnership, and LLC liquidations • See C.R.S. § 39-26-102(10) (next slide) • These exclusions are not uniform across home rule jurisdictions

C.R.S. § 39-16-102(10) Exclusions (a) A division of partnership or limited liability company assets among the partners or limited liability company members according to their interests in the partnership or limited liability company; (b) The formation of a corporation by the owners of a business and the transfer of their business assets to the corporation in exchange for all the corporation's outstanding stock, except qualifying shares, in proportion to the assets contributed; (c) The transfer of assets of shareholders in the formation or dissolution of professional corporations; (d) The dissolution and the pro rata distribution of the corporation's assets to its stockholders; (e) The transfer of assets from a parent corporation to a subsidiary corporation or corporations which are owned at least eighty percent by the parent corporation, which transfer is solely in exchange for stock or securities of the subsidiary corporation; (f) The transfer of assets from a subsidiary corporation or corporations which are owned at least eighty percent by the parent corporation to a parent corporation or to another subsidiary which is owned at least eighty percent by the parent corporation, which transfer is solely in exchange for stock or securities of the parent corporation or the subsidiary which received the assets;

C.R.S. § 39-26-102(10) Exclusions (cont.) (g) A transfer of a limited liability company or partnership interest; (h) The transfer in a reorganization qualifying under section 368(a)(1) of the "Internal Revenue Code of 1986", as amended; (i) The formation of a limited liability company or partnership by the transfer of assets to the limited liability company or partnership or transfers to a limited liability company or partnership in exchange for proportionate interests in the limited liability company or partnership; (j) The repossession of personal property by a chattel mortgage holder or foreclosure by a lienholder; (k) The transfer of assets between parent and closely held subsidiary corporations, or between subsidiary corporations closely held by the same parent corporation, or between corporations which are owned by the same shareholders in identical percentage of stock ownership amounts, computed on a share-by-share basis, when a tax imposed by this article was paid by the transferor corporation at the time it acquired such assets, except to the extent provided by subsection (12) of this section. For the purposes of this paragraph (k), a closely held subsidiary corporation is one in which the parent corporation owns stock possessing at least eighty percent of the total combined voting power of all classes of stock entitled to vote and owns at least eighty percent of the total number of shares of all other classes of stock.

D.R.M.C. § 53-24(19) Exclusions • A division of partnership assets among the partners according to their interests in the partnership; • The transfer of assets of shareholders in the formation or dissolution of professional corporations if no consideration including, but not limited to, the assumption of a liability is paid for the transfer of assets; • The pro rata distribution of a corporation's assets to its stockholders upon dissolution of the corporation if no consideration including, but not limited to, the assumption of a liability is paid for the transfer of assets; • A transfer of a partnership interest; • The transfer of assets to a commencing or existing partnership if no consideration including, but not limited to, the assumption of a liability is paid for the transfer of assets; • The repossession of personal property by a chattel mortgage holder or foreclosure by a lienholder.

The Drop-Kick Transaction • The dropkick combines two excluded transactions: • Seller transfers assets to a newly formed partnership or LLC, an excluded transfer under C.R.S. § 39-26-106(10)(i). • Seller transfers the partnership or LLC interest to Buyer, an excluded transfer under C.R.S. § 39-26-106(10)(g). • Does this work?

International Paper v. Cohen126 P.3d 222 (Colo. App. 2006) • Seller and Buyer agreed to an asset purchase of Denver box plant • Seller transferred the box plant to an LLC in exchange for LLC interests • Seller sold the LLC interest to Buyer • Denver audited Seller and assessed sales tax on the transfer of the box plant’s tangible personal property to the LLC

International Paper v. Cohen • Denver Sales Tax Code does not exclude transfers to an LLC • Seller argued that transfer to the LLC was not for consideration and thus not a sale

International Paper v. Cohen Court of Appeals upheld Denver Assessment • Seller received consideration in the form of a membership interest for transferring the box plant to the LLC • The membership interest was valuable consideration since the Buyer immediately paid $16.5 million for the membership interest • The transfer to the LLC was thus an exchange for consideration and therefore a sale

International Paper v. Cohen • Key holding of International Paper is that third-party consideration can support a taxable sale • The Court did not explicitly invoke substance-over-form or step-transaction doctrines

Third-Party Consideration Colorado’s partnership contribution exclusion The formation of a limited liability company or partnership by the transfer of assets to the limited liability company or partnership or transfers to a limited liability company or partnership in exchange for proportionate interests in the limited liability company or partnership….(C.R.S. § 39-26-102(10)(i)) Denver’s partnership contribution exclusion The transfer of assets to a commencing or existing partnership if no consideration including, but not limited to, the assumption of a liability is paid for the transfer of assets…. (D.R.M.C. § 53-24(19)(e))

Third-Party Consideration • Denver may assert that a dropkick involving a partnership is a transfer for consideration based on International Paper’s third-party consideration holding • Outcome of a challenge is unpredictable • International Paper did not involve an explicit statutory exclusion • International Paper facts were favorable to Denver—will other fact patterns favor taxpayers? • State law does not qualify its exclusion with regard to consideration—third-party or otherwise—so International Paper is not directly pertinent to state sales tax

Step-Transaction Doctrine • Primarily an income tax concept • Sometimes applied to ad valorem taxes, for example, in California • Rarely applied in sales and use tax cases • Compare Hutton v. Johnson (Tenn. App. Ct. 1996) (applying step-transaction doctrine) with TJX Companies (N.Y. Div. Tax App. 1995) (refusing to apply step-transaction doctrine) • International Paper was not decided on step-transaction grounds • Denver and other jurisdictions will continue to press the issue in audits, hearings, and appeals

Sales Tax Liability—Entity Sale • Historic sales and use tax liability remains an entity liability • In general, no transactional sales tax liability should be incurred • Conventional for sales agreement to include • Covenants that sales and use taxes are paid and/or properly accrued • Indemnification extending past statute of limitations on assessment of sales tax for unpaid or unaccrued sales and use tax • Seller rights in an audit, hearing, or appeal

Sales Tax Liability—Asset Sale Historic and transactional sales tax liability attaches to assets transferred unless buyer complies with the procedure of C.R.S. § 39-26-117(d) and (e): • Buyer must withhold sufficient funds to cover sales tax liability of seller • Seller’s final return is due within 10 days • Buyer cannot release withheld funds without a clearance certificate from DOR • Home rule jurisdictions have similar provisions that must also be complied with

Sales Tax Liability—Asset Sale Clearance certificate procedure is rarely used by buyers and sellers. Instead, parties provide in agreement for: • Allocation of transactional sales taxes by contract—all to seller, all to buyer, or shared • Indemnification for historic tax liability of business

Sales Tax Liability—Asset Sale Allocations in sales agreement are not binding on DOR • Seller is liable if withholding/clearance certificate procedure is followed • Seller and buyer are liable if withholding/clearance certificate procedure is not followed • Buyer is potentially liable for use tax

Ad Valorem Tax Basics • Property is assessed on January 1 of the taxable year • Inchoate lien is created on the assessment date • Mill levy and thus actual tax is determined during the taxable year • Tax becomes due and payable on the subsequent January 1 • Tax is delinquent on June 16

Liability for Ad Valorem Tax Default rule—C.R.S. § 39-1-108 • Seller pays if conveyance is after June 30 • Buyer pays if conveyance is before July 1 • No allocation—default rule is all or nothing

SALT Aspects of Acquisitions— A Colorado Perspective