It's non- business: an open letter - of your

Dear State Tax Auditor:

This is in response to your request for copies of returns we have filed with other States. Your statement that my company is accountable for its allocation of non-business income to another state is incorrect. Such a statement assumes that all States have tax laws exactly like those of your state. While we wish that was true, unfortunately it is not.

Your State is a member of the Multistate Tax Commission (MTC) and has adopted both UDITPA and the MTC's Regulations. Yet about only 23 States have completely adopted UDITPA, and about only 32 States are members of the MTC. These facts alone suggest that there are probably differences between your State and those States that have not adopted UDITPA or are not MTC members. In point of fact, however, there are even significant differences between your State and your fellow MTC member States as well as between your State and States that have adopted UDITPA.

Let me give you some examples of differences between your State and other States:

1. Oklahoma has not adopted UDITPA and does not have the concept of business and non-business income. Those terms are not used anywhere in the Oklahoma statute or the Oklahoma Tax Commission's Rules. Instead, the Oklahoma statute contains a list of specific items of income which must be allocated. 68 O.S. [sections] 2358A(4) & (5).

2. Kansas -- a fellow member of the MTC that has adopted UDITPA -- does have the concept of business and non-business income, but does not use the functional test to distinguish between the two, as your State does. The Kansas Supreme Court made this clear in the In re Chief Industries, Inc., 875 P.2d 278 (Kan. 1994), and Western Natural Gas Co. v. McDonald, 202 Kan. 98, 446 P.2d 781 (1968) cases. Furthermore, Kansas allows taxpayers to elect to treat all income as apportionable. KSA [sections] 79-3271(a).

3. Missouri -- also a fellow member of the MTC, but one in which UDITPA is optional for taxpayers -- does not allow the filing of consolidated or combined returns by unitary groups, let alone require such filings as your State does. [sections] 143.431.3, RSMo 1986. The Missouri Supreme Court made this clear in The Williams Companies, Inc., v. Director of Revenue, 799 S.W.2d 607 (Mo. 1990).

4. Tennessee -- also a fellow member of the MTC that has adopted UDITPA -- did not have a functional test during some of the years under audit. The Tennessee Supreme Court confirmed this in General Care Corp. v. Olsen, 705 S.W.2d 642 (Tenn. 1986), Federated Stores Realty, Inc. v. Huddleston, 852 S.W.2d 206 (Tenn. 1992), and Union Carbide Corp. v. Huddleston, Tenn. Chancery Ct., No. 88-2526-I, June 10, 1991 (CCH [paragraph] 400-280).

5. Iowa, which has not adopted UDITPA, until 1995 had a functional test that was very different from your State's. Iowa's test was restricted to taxpayers engaged in trading assets as an integral part of their regular business. The Iowa Supreme Court addressed this issue in Phillips Petroleum Co. v. Iowa Department of Revenue & Finance, 511 N.W.2d 608 (Iowa 1993).

6. Massachusetts -- also a fellow member of the MTC, but whose adoption of UDITPA is different from your State's -- does not have a business/non-business income concept in its statute. Massachusetts's statute requires all income to be apportioned. G.L. c. 63, [subsections] 30, 38, & 38A.

This is but a short list of examples. Another point to consider is that, unlike your State, some MTC member States have only partially adopted the MTC Regulations. Other MTC member States have not adopted the MTC Regulations at all. And, of course, there are many States that are not members of the MTC.

Beyond the issue of distinguishing between business and non-business income, we have the related issue of how to apportion apportionable income. What factors are used and how are those factors determined? Here again numerous differences exist.

First, not all States have the same factors as your State and many weight the factors differently.

Second, although all States use a receipts or "sales" factor, it markedly varies among the States. Oklahoma, for example, uses a true "sales" factor that only includes sales and not other types of receipts, such as dividends, interest, rents, and royalties. 68 O.S. [sections] 2358A(5)(c) and Okla. Admin. Code 710:50-17-71(1)(A). In its receipts factor, Florida does not include interest and includes only certain rents and royalties. Fla. [sections] 220.15(5)(a). Your State includes net gains from asset sales in the receipts factor, yet Maryland (a fellow MTC member, but one that has not adopted UDITPA) only includes net capital gains in the receipts factor and not gains from sales of noncapital assets. Md. Regs. Code 03.04.03.08(C)(3).

A third example is throwback sales. While UDITPA contains a throwback rule, only 60 percent of the States that have an income-based tax have adopted a throwback rule. RIA All States Tax Guide [paragraph] 224. Your State has adopted a throwback rule. The trend, however, appears to be the repeal and elimination of throwback rules. Illinois (which has adopted UDITPA and is a former MTC member) on May 8 passed House Bill 585, repealing the Illinois throwback rule, by a unanimous vote in its Senate.

Going deeper into the issue of factors, we reach the issues raised by ownership of a partnership interest. Some States, such as Oklahoma, have the partnership do its own apportionment using its own factors, and then treat that apportioned income as allocable. 68 O.S. [sections] 2358A(4) and Okla. Admin. Code 710:50-17-51(15). Other States, such as California (a fellow MTC member that has adopted UDITPA), flow the partnership factors through into the combined return, just as if the partnership were a corporate member of the unitary group. Cal. Admin. Code. tit. 18, [sections] 25137-1(f). Still other States, such as Kentucky (which has partially adopted UDITPA), include a corporate partner's distributive share of partnership income in the receipts factors based on the partnership's stand-alone apportionment factor. Kentucky Revenue Cabinet Tax Policy 41P200 (1983).

This very short discussion just scratches the surface of the many differences that exist between the States, and even between MTC member States and States that have adopted UDITPA in the determination of apportioned income. For further information, you may wish to refer to the many materials published by Tax Management Inc., the Research Institute of America Inc., Panel Publishers Inc., and Tax Analysts. It would certainly make our life and yours as a tax administrator much simpler if the States all determined apportioned income the same. Regrettably, they do not. It is for this reason that what another State requires us to do is not relevant to how your State determines apportioned income and why we are not accountable to your State for the allocation or apportionment of income in another State's tax return.

What we are accountable for is to provide you with all relevant facts related to our items of income, to allow you to determine under the statute of your State and the guidelines set forth by the U.S. Supreme Court whether or not such item of income is allocable. Unfortunately, the methodology currently contained in your State's statute is suspect, because it contains the MTC's transactional and functional tests and not the operational and investment tests specified by the U.S. Supreme Court in the Allied Signal case.

Sincerely yours,

Tax Manager The Taxpayer Corp.

RELATED ARTICLE: State & Local Tax Course Draws Praise

I decided that the evaluation form for the State and Local Tax Course was inadequate and possibly a little unfair to the professionals who gave so unstintingly of their time. The course far exceeded my expectations; it was excellent, as was each and every presenter.

Had there been any doubt as to the extremely high value of the course (and there was none), it was removed when I returned to my office and found, at the top of the pile, an Income and License Tax assessment from a particular State. There was an issue of whether the sale of assets in another State (fortunately a partial liquidation and cessation of a line of business), resulted in business or nonbusiness income. There was a question of whether the pro rate formula used to disallow expenses allegedly attributable to nontaxable income accurately and fairly reflected the taxpayer's involvement in the production of that income. And, in the last year of the audit cycle, there was an issue whether we had sufficiently severed our nexus with the State in order to claim the protection of P.L. 86-272. (We did, having taken orders only out of state and used common carriers for deliveries; other connections were de minimis, see Wisconsin v. Wrigley.) No, Mr. Frankel, we did not pay, did not pay, did not pay. I could have written the protest using not much more than my notes from the course.

I have been in private practice and have done a fair amount of public speaking over the years. I know how much time it takes to prepare just a 50-minute presentation. Consequently, I very much appreciate the time and effort of the presenters and I am absolutely incredulous at several of the speakers having devoted days to help us. Please convey my thanks and admiration to the faulty and my thanks to TEI for making it happen.

James C. Heinhold BP America Inc. Member, Cleveland Chapter

David E. Wulf is Manager-State Tax for The Williams Companies, Inc., in Tulsa, Oklahoma. He is a member and former president of Tax Executives Institute's Oklahoma Chapter and currently serves on the Institute's State and Local Tax Committee. What follows is a open letter on state tax auditors concerning one of the vexing issues that confront state tax executives: the definition of business and non-business income.

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