Since Governor-Elect Murphy is set to take office later this month, we thought it would be instructive to offer up a brief primer and some additional thoughts on the new administration’s corporate tax plan for the Garden State. To be more specific, the Murphy team has repeatedly called for closing a “loophole” in the Corporation Business Tax (“CBT”) by adopting something called combined reporting.
The CBT is New Jersey’s form of a corporate income tax. The CBT is imposed on all corporations “doing business” or “deriving receipts” from New Jersey sources, though S corporations generally pay a flat tax that is based on gross receipts earned from New Jersey and pass their income through to shareholders who pay GIT on the S corporation income. A taxpayer’s Line 28 federal taxable income is the starting point for CBT with a host of New Jersey specific adjustments. That tax base is then apportioned to New Jersey by multiplying it by a ratio which is equal to New Jersey-source receipts divided by total gross receipts earned by the business from all locations.
Historically, the CBT has been imposed on a separate-entity reporting basis absent circumstances where the Division of Taxation determines that another reporting method is more appropriate. Separate entity reporting means that a corporation reports its income and apportionment factor (or allocation factor in the New Jersey CBT context) alone and does not combine these items with income and allocation factors of related or affiliated entities, even if one corporation owns 100 percent of another or both corporations are owned by the same parent company. This method of reporting is also considered to be the source of the “loophole” which the Governor-Elect has pledged to close.
Under a separate-entity reporting regime, a group of related companies may collectively work together to generate income and share costs. Often, there is an array of intercompany services provided between entities. The use of intercompany services, debt, or intangible property will often lead to a deduction for the paying entity and income for the entity receiving the payment for services or property. With careful planning, related companies could potentially exploit differences in state tax rules to ensure that entities in high-tax states operate with losses, while entities in low (or no) tax states show a considerable amount of income.
An example of one such planning technique is the use of a Delaware holding company. The ideal structure would be as follows: any valuable intellectual property such as, trademarks, patents, formulas and know-how are owned by a company based in Delaware. The valuable intellectual property is then licensed to related parties or affiliates doing business in other states. This results in the Delaware entity having intangible income, while the entities using the property should have deductions for the same amounts. The beauty of Delaware is that the state does not tax intangible holding companies. Accordingly, with the right planning, related entities can export the income to Delaware tax-free, while generating large deductions in the locations where actual business activity transpires.
Another effective state tax planning mechanism is the use of captive Real Estate Investment Trusts (“REIT”). Pursuant to federal income tax rules, a REIT does not pay tax on the dividends it pays out to investors. Consequently, some major retailers set up their own captive REITS to own the real estate locations where stores are based. The actual operating retail entity pays rent to the REIT which is deductible to the operating entity. And finally, the REIT pays the dividend out tax-free.
The key takeaway from these tax planning “loopholes” is that when a group of related companies operate with a single corporate purpose to benefit one another in a host of different ways, there are several opportunities for advantageous tax planning at the state level.
Now that we have described the “loophole,” let’s examine the proposed solution. Combined reporting is considered by many to be the silver bullet to state tax planning. In fact, 25 states and the District of Columbia have adopted combined reporting for corporate tax reporting purposes. In addition to Governor Elect’s promise to adopt the combined reporting regime, there are a few bills currently pending in the legislature that would enact the reporting method for CBT purposes.
Combined reporting combines all entities in a specifically-defined group for purposes of computing taxable income and apportionment in a combined tax report for the state in question. In addition, intercompany transactions are generally eliminated from the tax base and apportionment factor. Accordingly, combined reporting is considered to be an effective way to combat creative state tax planning which may export income to no or low-tax states, while reducing income of operating entities via intercompany deductions.
However, just like separate-entity reporting, the combined reporting regime has a host of complications to consider when adopting. The most basic question is what will be the definition or limitations pertaining to the combined group. Many states require unitary groups to report their income on a combined basis. Unitary is a constitutional concept which means a flow of value, goods or services and a level of interdependence between business lines or entities that warrants treating the different entities or businesses as one combined group for tax reporting purposes. The unitary analysis generally looks to the following factors: relationship between the parties and ultimate ownership; sharing of personnel, officers, resources or know-how; a substantial amount of intercompany transactions; economies of scale; and integration of the businesses to achieving a single corporate purpose.
Another way that states define the combined reporting group is by reference to federal income tax provisions concerning controlled corporations and related or affiliated entities under the Internal Revenue Code. Under this approach, the taxpayer would have the burden of demonstrating the lack of a unitary relationship where a particular level of control exists depending on the state.
In seeking to define the combined group, the different approaches laid out above present a host of complications. What should be done with pass-through entities or passive investments in other companies? What will be the interaction of the combined group and nexus, which means subjectivity or jurisdiction to tax? In other words, will all entities that are considered unitary or controlled by others be included in a combined report, even if certain entities do not independently have nexus with or a legal requirement to file in the state at issue? Will the combined report include foreign affiliates or will the group be limited to domestic entities?
Furthermore, the concept of a unitary business specifically in New Jersey has been a controversial one in the courts. There have been a number of cases in Tax Court and even the Appellate Division which have muddied these waters, turning on the specific and unique facts of each case. As such, it may be difficult to designate the regime as an efficient and taxpayer friendly reporting system without a clear set of guidelines.
Another complexity with combined reporting is the actual calculation of taxable income and apportionment. Some states include the aggregate taxable income and apportionment factors of all entities in the combined group, while other states limit the report to income and factors of entities with nexus. Another difficult issue that comes up is when a particular entity has a net operating loss carry forward, tax credit or other tax attribute which may or may not be applicable to the combined group’s calculation depending on the state.
Then there are the tax administration ramifications to weigh as well when considering this proposal. First, the New Jersey Division of Taxation, specifically audit personnel, has a long history of administering the CBT on a separate-entity basis. The Division has a well-developed set of regulations, guidance, and an audit manual and procedures which are geared towards a separate-company reporting regime. Changing this structure will require a great deal of training and a period of uncertainty as policies are developed and regulations are promulgated. Furthermore, what will the effect of such a change be on the Division’s policies regarding a taxpayer’s overpayment on the account, estimated payments, and safe harbor provisions for avoiding penalties?
There are also policy and general economic factors to consider as well. First, in a recent study of the effect of combined reporting in six states which have adopted the regime—Massachusetts, New Mexico, New York, Rhode Island, and Wisconsin, only New York met or exceeded corporate tax revenue projections in subsequent years following adoption. In addition, state corporate tax revenues even fell in the initial year after adoption.
Finally, there is one other element to think about here. What if I told you that New Jersey already has the appropriate tools in place to close such loopholes…
Dating back to the Business Tax Reform Act of 2002, New Jersey’s CBT incorporates a fairly broad economic nexus standard, as well as add-back rules for related party interest and intangible expenses. Under an economic nexus theory, any company which derives receipts from sources in the state should have a CBT filing obligation. Therefore, any company earning income from providing a service in the state or making sales into the state should not be able to avoid the CBT. Related party add-back rules guard against the income-stripping transactions described above by forcing a company to add back to taxable income any deduction for amounts paid to a related party for borrowing money or the use of intangible property, unless certain criteria can be satisfied.
Last but not least, the Division has another powerful tool referred to as Section 10 or N.J.S.A. 54:10A-10, which allows the Director to re-compute a taxpayer’s income in a host of different ways where the situation calls for this—often in the intercompany context. Under this provision, the Division can impute profits, interest or a higher price on goods or services where an arms-length standard is not satisfied. This means that if related parties are providing goods or services to another, the Division could adjust the income and/or deductions of either entity where there is some form of tax planning or some benefit conferred upon the companies via this arrangement.
Accordingly, in considering the tools New Jersey already has for closing the corporate tax loophole, the state may not need to do adopt a new reporting regime or make any statutory changes. However if the proposal is pursued by the new administration and legislature, careful steps must be taken to account for even more complexities than those discussed in this article, as well as what kind of changes need to be made to the current audit tools the state already has in collecting CBT. As any tax practitioner will tell you, regardless of whatever tax policy reforms are made, the state’s business community will require some degree of certainty and clear guidance if a major change is enacted.