GHP Annual Tax Conference November 8, 2010 Multi-State Tax Update John LaBorde, Partner Grant Thornton LLP Houston, T

1. GHP Annual Tax ConferenceNovember 8, 2010Multi-State Tax UpdateJohn LaBorde, PartnerGrant Thornton LLPHouston, TX

2. Agenda State of the states State decoupling from the IRC Uncertain tax positions Economic substance Significant California tax development Tax amnesty programs Unitary business determinations

3. State of the states According to NCSL, 21 states have a budget gap (projected revenues less projected spending without any tax increases or spending reductions) of greater than $1 billion Total estimated budget gap for all states is $88.9 billion Many states also have current year deficits Federal stimulus funds used to balance state budgets in 2010 will be reduced in 2011 and eliminated in 2012 Revenues projected to increase slightly in 2011 Many states are expected to be late in passing their budgets or to require the scheduling of special legislative sessions to pass their budgets

4. State of the states State legislative response to economic environment 2009 was “a very trying year” for state legislatures due to economic environment States faced with the choice of cutting services or increasing revenue largely ended up cutting services and relying on stimulus funds in 2009 In 2010, the answer is likely to be “increasing revenue” through tax increases or state tax reforms “Will they or won’t they change the current tax system?” is likely to be replaced in 2010 by “how will they change the current tax system, and what will it mean for taxpayers?” 2009 was “a very trying year” for state legislatures due to economic environment States faced with the choice of cutting services or increasing revenue largely ended up cutting services and relying on stimulus funds in 2009 In 2010, the answer is likely to be “increasing revenue” through tax increases or state tax reforms “Will they or won’t they change the current tax system?” is likely to be replaced in 2010 by “how will they change the current tax system, and what will it mean for taxpayers?”

5. Latest on state conformity to federal tax provisions States still reacting to ARRA and newer federal tax provisions States are reducing budget gaps by decoupling from the federal income tax base Significant decoupling is occurring in the following areas: Bonus depreciation Net operating losses (NOLs) Deferral of cancellation of indebtedness income In light of the difficult environment, states are still reacting to ARRA (enacted on February 17, 2009) as well as newer federal tax provisions – and states are acting on their own to reduce budget gaps by decoupling from the federal income tax base States are acting on their own to reduce budget gaps by decoupling from the federal income tax base In light of the difficult environment, states are still reacting to ARRA (enacted on February 17, 2009) as well as newer federal tax provisions – and states are acting on their own to reduce budget gaps by decoupling from the federal income tax base States are acting on their own to reduce budget gaps by decoupling from the federal income tax base

6. State decoupling from bonus depreciation (IRC Sec. 168(k)) Many states have decoupled from bonus depreciation in 2009 and previous years Leads to difficulty in tracking numerous depreciation schedules from state to state States that have decoupled from bonus depreciation may allow a portion of the deduction in future years Taxpayers ultimately will get larger deductions for state depreciation than federal depreciation in later years – so decoupling generally acts to defer, but not deny benefits

7. State decoupling from NOL provisions (IRC Sec. 172) NOLs treated inconsistently by states: State NOL carryback and carryforward rules differ from federal two-year carryback and 20-year carryforward In general, most states do not allow NOL carrybacks, and many states provide for shorter carryforwards WHBAA provision allowing for limited five-year carrybacks will not be adopted by most states Indiana recently has decoupled Indiana recently has decoupled

8. State decoupling from NOL provisions (IRC Sec. 172) Some states place other significant limits on NOL deductions: In California, governor’s proposed budget for 2010-11 fiscal year includes a continued suspension of the NOL deduction. In addition, some states place other significant limits on NOL deductions, in an effort to maintain revenue: California – if taxable income was at least $500,000, NOL deduction was suspended for tax years beginning in 2008 or 2009 (could be extended) Colorado – legislation limits NOL deductions to $250,000 per year in 2011-2013, but allows taxpayer to add 3.25% annual interest to the deferred amount In California, governor’s proposed budget for 2010-11 fiscal year includes a continued suspension of the NOL deduction. In addition, some states place other significant limits on NOL deductions, in an effort to maintain revenue: California – if taxable income was at least $500,000, NOL deduction was suspended for tax years beginning in 2008 or 2009 (could be extended) Colorado – legislation limits NOL deductions to $250,000 per year in 2011-2013, but allows taxpayer to add 3.25% annual interest to the deferred amount

9. State decoupling from NOL provisions (IRC Sec. 172) Maine – NOL carryforward suspension in 2009, 2010 and 2011, and for the 2008 tax year, 10% addback of absolute value over $100,000 of any NOL that was being carried forward for federal income tax purposes to 2008 tax year Pennsylvania – Cap on net loss carryforwards (prior to 2009 tax year, the greater of $3 million or 12.5% of taxable income, percentage grows to 15% in 2009 tax year, and 20% after 2009 tax year) Other states considering this issue this year include Hawaii and Kentucky Maine – NOL carryforward suspension in 2009, 2010 and 2011, and for the 2008 tax year, 10% addback of absolute value over $100,000 of any NOL that was being carried forward for federal income tax purposes to 2008 tax year Pennsylvania – Cap on net loss carryforwards (prior to 2009 tax year, the greater of $3 million or 12.5% of taxable income, percentage grows to 15% in 2009 tax year, and 20% after 2009 tax year) Other states considering this issue this year include Hawaii and Kentucky

10. State decoupling from deferral of cancellation of indebtedness income (Sec. 108(i)) Many states will not conform to the ARRA deferral of income provision in Section 108(i), hampering taxpayers that are being incentivized to complete these transactions from a federal perspective Distinction between states that simply do not enact Section 108(i) because of a conformity date to the IRC that precedes enactment of ARRA, versus states that enact Section 108(i) but require an addback for the effect arising from the making of such election for federal purposes Many states will not conform to the ARRA deferral of income provision in Section 108(i), hampering taxpayers that are being incentivized to complete these transactions from a federal perspective There is a distinction between states that simply do not enact Section 108(i) because of a conformity date to the IRC that precedes enactment of ARRA, versus states that enact Section 108(i) but require an addback for the effect arising from the making of such election for federal purposes Many states will not conform to the ARRA deferral of income provision in Section 108(i), hampering taxpayers that are being incentivized to complete these transactions from a federal perspective There is a distinction between states that simply do not enact Section 108(i) because of a conformity date to the IRC that precedes enactment of ARRA, versus states that enact Section 108(i) but require an addback for the effect arising from the making of such election for federal purposes

11. Uncertain tax positions Potential action on IRS uncertain tax positions treatment In January, IRS announced that it is developing a new tax return schedule to require many business taxpayers to report “uncertain tax positions” on their returns State tax authorities may use the proposal as a springboard to creating their own state-specific disclosure requirements The format and content of a state disclosure form may substantially differ from the IRS disclosure form IRS may share information with states in a way that will trigger state tax audits

12. Economic substance Federal codification of economic substance doctrine On March 30, federal health care legislation was enacted that includes the first federal codification of the economic substance doctrine (adding a new IRC Section 7701(o)) Depending on federal conformity dates, some states may automatically adopt this new language Other states may adopt this language when they advance their federal conformity dates States may enact their own economic substance doctrine based on the federal law Last year, Wisconsin enacted its own economic substance law.Last year, Wisconsin enacted its own economic substance law.

13. Other issues of multistate importance Continuing shift from separate to mandatory unitary combined reporting – no adoptions this year to date Lack of uniformity in new combined reporting jurisdictions and difficulty in taking consistent positions in states Movement towards single sales factor apportionment and market-based sourcing of service income Last year, Wisconsin enacted its own economic substance law.Last year, Wisconsin enacted its own economic substance law.

14. Notable SALT developments – California California – for taxable years beginning on or after January 1, 2011, several changes are slated to take effect: Annual election to apportion using single sales factor Finnigan approach for apportioning sales to be readopted New rules on sourcing sales of items other than tangible personal property (replacing cost of performance) Definition of “doing business” amended to incorporate factor presence nexus standard Exclusions to definition of gross receipts

15. Notable SALT developments – California California – for tax years beginning on or after January 1, 2010, the IRC conformity date is updated from January 1, 2005 to January 1, 2009 Adopts some of the federal changes made after 2004 and before 2010 The apportionment regulation for sales of services has been amended (retroactive to tax years beginning on or after January 1, 2008) Definitions of “income-producing activity” and “costs of performance” expressly include services performed by agent or independent contractor on behalf of taxpayer

16. Notable SALT developments – District of Columbia The District of Columbia City Council has passed the following law: The Council shall pass legislation to require, for tax years beginning after December 31, 2010, that all corporations taxable in the District of Columbia shall determine the income apportionable or allocable to the District of Columbia by reference to the income and apportionment factors of all commonly controlled corporations organized within the United States with which they are engaged in a unitary business What exactly does this accomplish, and will combined reporting ultimately happen in the District?

17. Notable SALT developments – amnesty programs Amnesty has become very popular with the states in the last two years Examples of broad tax amnesties taking place in 2010 include MA, ME, NM, NV, PA and Philadelphia As state amnesties widely differ, it is important to look at the following components of amnesty agreements: Lookback period – Waiver of penalty / interest Right of appeal – Logistics of getting signoffs Type of tax

18. Other notable SALT developments in the courts Decisions in the courts have been focused on several areas: Sham / holding companies Unitary business determinations Business / nonbusiness determinations Procedural provisions

19. Sham / Holding Companies – Hormel Foods Corp. v. Wisconsin Department of Revenue  

20. Sham / Holding Companies – HMN Financial, Inc. v. Commissioner of Revenue  

21. Sham / Holding Companies – The Classics Chicago, Inc. v. Comptroller Maryland Court of Special Appeals held that intangible holding company subsidiary had sufficient nexus with Maryland to be subject to income tax because the holding company earned substantial revenue from the use of its intellectual property in the state Court rejected taxpayer’s contention that the subsidiary could only have nexus with Maryland if transaction with parent corporation in Maryland was a sham Look to economic reality of the transaction instead – the parent’s business in the taxing state produced the subsidiary’s income

22. Sham / Holding Companies – The Talbots, Inc. v. Commissioner of Revenue Massachusetts Appellate Tax Board determined that taxpayer’s royalty agreement with intangible holding company subsidiary was a sham Substantial evidence that transaction was motivated by tax avoidance Most royalties paid to subsidiary returned to parent Subsidiary had no discretion to invest royalties Parent protected and enforced trademarks Subsidiary did not license trademarks to third party Royalty payment was unilaterally increased by parent to increase its tax benefit

23. Unitary Business – R.R. Donnelley & Sons Co. v. Arizona Department of Revenue Arizona Court of Appeals held that two subsidiaries (a receivables factoring company and an investment company) were not unitary with the taxpayer However, a third subsidiary (a trademark licensing company) was unitary with the taxpayer and includable in the taxpayer’s combined return Use of “intermediate approach” to test of unity – distinction between “basic” and “accessory” functions where accessory functions “are not contained in the product or its delivery to the customer”

24. Nonbusiness Income – Kimberly-Clark Corp. v. Commissioner of Revenue Alabama Supreme Court determined that proceeds from the sale of substantial assets used in a business were treated as nonbusiness income allocable to Alabama Court followed narrow interpretation of business income definition in Alabama prior to 2002 change in legislation – concentrating on application of transactional test Court focused on non-core nature of assets being sold Sale not made in regular course of business because property held for 34 years, taxpayer had characterized sale as “extraordinary” in SEC reports, and sale was in conjunction with change in corporate strategy

25. Nonbusiness Income – Oracle Corp. v. Department of Revenue Oregon Tax Court interim order denying motion for partial summary judgment requested by Department of Revenue Taxpayer reported gain from asset sale as nonbusiness income in Oregon, and business income in California Department asserted duty of uniform reporting in UDITPA states, and disclosure of inconsistent positions Court agreed with taxpayer and refused to determine whether CA and OR had same conceptions of business / nonbusiness income, and noted that UDITPA adopts goal of uniformity, not requirement

26. Procedure – Miller v. Johnson Controls, Inc. The Kentucky Supreme Court held that taxpayers’ constitutional rights were not violated by a statutory amendment that retroactively eliminated the right of corporations to file combined returns and claim refunds for tax years prior to 1995 No set period beyond which legislation is impermissibly retroactive, and what is “modest” or acceptable for due process purposes depends on the facts of the case The issue is only whether the retroactive statute rationally furthers the legitimate governmental purpose preventing a significant and unanticipated revenue loss

27. Conclusion In order to generate revenue, we believe that states will continue to consider: Mandatory unitary combined reporting Decoupling from federal tax stimulus provisions Tax amnesty programs Single sales factor apportionment Market-based sourcing of service income More litigation as taxpayers and revenue departments become more aggressive

28. Contact Information John LaBorde, Partner, Grant Thornton LLP Houston, TX 832-476-3605john.laborde@gt.com