Posted tagged ‘new jersey’

Recent Developments Regarding the “Throw Out Rule” by the New Jersey Tax Court and the Multistate Tax Commission

February 20, 2017

By Adam Koelsch

Recently, in Elan Pharm. v. Division of Taxation, the Tax Court of New Jersey issued a non-binding opinion that further limits the Division of Taxation’s enforcement of the controversial “throw out rule.”

Sometimes, when a multi-state taxpayer apportions its income, that taxpayer will source a receipt to a state in which the receipt is not subject to tax, either because the state has chosen not to tax it or because the state is not able to do so. One reason that a receipt may not be taxable, and a reason at issue in Elan Pharm., is P.L. 86-272 — a federal law that prohibits a state from taxing a business whose activities in that state are limited to the sale and/or the solicitation of sales of tangible personal property shipped from another state. This type of income sourcing creates “nowhere income,” that is, income that is not taxed by any jurisdiction.

In order to combat this, some states have employed a tactic known as a “throw out rule.” Under the rule, non-taxed receipts are ignored in calculating the state’s share of total receipts by subtracting the non-tax receipts from the apportionment denominator. As the Tax Court noted, “[b]y throwing out receipts from the denominator, the sales fraction always increases, causing the apportionment formula and the taxpayer’s resultant CBT [Corporation Business Tax] liability to New Jersey to increase.” The New Jersey throw out rule (former N.J. Stat. Ann. § 54:10A-6[B]), which was repealed by legislation in late 2008, continues to be enforced by the Division for the tax periods between January 1, 2002 and June 30, 2010.

Previously, in Whirlpool Properties, Inc. v. Director, Division of Taxation, 26 A.3d 446 (N.J. 2011), the New Jersey Supreme Court had held that, under the fair apportionment prong of the U.S. Supreme Court’s Complete Auto Transit test, application of the throw out rule to receipts sourced to states that simply choose not to impose a tax (as opposed to being unable constitutionally to impose a tax) is unconstitutional.

Recently, on February 7, 2017, the Multistate Tax Commission, in a staff comment regarding the operation of a proposed throw out rule in its Model Regulations, has suggested that the rule should apply only when a state cannot impose an income-based tax under the constitution or P.L. 86-272, and should not consider whether the state actually chooses to impose a tax.

In Elan Pharm., the taxpayer had filed income tax returns in six states, including New Jersey, for 2002. The taxpayer had received receipts from forty-four states in which it had claimed it was not taxable because the state lacked jurisdiction under P.L. 86-272. The taxpayer had property in thirty-nine states and payroll in forty-eight states. Nevertheless, the Division had included in the apportionment denominator only those receipts from the six states in which the taxpayer had filed, excluding the remainder of the receipts under the throw out rule.

The Tax Court, however, disagreed with the Division’s application of the rule. The Tax Court noted that several states in which the taxpayer conducted business (not just the six in which it had filed) had “throwback rules” — that is, a rule by which sales receipts are reassigned to the state from which goods are shipped when the purchaser’s state cannot impose an income or franchise under the constitution or P.L. 86-272. Thus, because certain receipts captured under the throwback rule could have been taxed by the shipping states, those receipts could not be excluded by application of the throw out rule by New Jersey.

In addition, the Court found that the presence of taxpayer’s property and/or payroll in many of the states from which excluded receipts had been sourced created sufficient nexus to render the receipts taxable in those states despite P.L. 86-272, and therefore could not be excluded using the throw out rule.

Despite its repeal, the throw out rule remains a subject of controversy which will continue to impact businesses operating in New Jersey. Indeed, understanding application of the rule is especially important to business entities that had never previously filed CBT returns in New Jersey — and therefore cannot benefit from the statute of limitations for the years that the rule was effective — because of their mistaken belief that their activities were insufficient to create nexus.

The New Jersey Tax Court opinion can be found here

Whirlpool Secures Partial Victory in New Jersey Supreme Court Case: “Throw-Out” Rule Unconstitutional When Applied to Sales in States without Income Tax

August 4, 2011

 By Paul Masters

The long-contested constitutional issue concerning the New Jersey throw-out rule has finally culminated in a New Jersey Supreme Court decision recognizing the general constitutionality of the rule, but for its application to sales receipts attributable to states that choose not to impose an income tax. But first, we summarize what this decision did not do. The decision did not address in any significant way the current challenges to nexus that the states confront. Rather, the decision reaffirmed existing federal law, 15 U.S.C.A. §§ 381-84 (commonly referred to as “P.L. 86-272”), and looked to well-grounded constitutional law by the United States Supreme Court. Cases regarding nexus continue to move forward, with KFC reaching an unfavorable decision at the Iowa Supreme Court, on petition for a writ of certiorari at the United States Supreme Court, and Texas also in that mix with the current Taco Bell litigation (examining whether Taco Bell has nexus with Texas by sending a third-party to inspect its Texas franchisees). However, the decision does push back against state attempts to expand its tax base, by placing a firm limit on expansion where a state is able to claim and tax revenue from another state because such state, such as Nevada, has elected not to impose an income tax on activities in which the constitutional nexus standard has been reached.

The throw-our rule that was challenged excluded certain income from the sales fraction’s denominator of the modified three-factor formula used by New Jersey, as provided for in New Jersey’s statutory scheme. N.J. Laws, L. 2002, c. 40, § 8.  The modified three-factor formula employed by this legislation weighed a taxpayer’s property, payroll and sales in the numerator, while the denominator was the taxpayer’s total taxed sales, as opposed to the general provision for taxpayers to use total sales. The non-taxed sales are thus “thrown out,” hence the name for the rule. The New Jersey legislature subsequently amended the statute to eliminate the throw-out rule, but only after the date of the operative facts in these cases. N.J. Laws, L. 2008, c. 120.

This decision is a partial affirmation of prior decisions by both the New Jersey Tax Court and the Appellate Division of the New Jersey Superior Court. In these prior decisions, both courts upheld the constitutionality of the throw-out rule. The courts looked to the constitutional standard provided in United States v. Salerno, 481 U.S. 739, 107 S. Ct. 2095, 95 L. Ed. 2d 697 (1987). Tax Court found three general circumstances where the throw-out rule operates constitutionally: (i) the income excluded from the denominator relates in whole or in part by activities in New Jersey, (ii) the application of the throw-out rule has no material effect on the sales fraction because the income in the non-taxing state is insignificant to the total income of the taxpayer, and (iii) the property and payroll fractions significantly temper the impact of the disputed sales fraction.

The Appellate Division agreed with the application of the Salerno standard, pointed to the lack of any case law in which an allocation formula was struck down as facially unconstitutional, and observed that it is unlikely that any person can actually demonstrate that “a given formula will yield allocations for most out-of-state taxpayers that are unconstitutionally disproportionate.” Because Whirlpool did not contest that it had nexus with New Jersey, and that sales to non-taxing states were not part of that business, the Appellate Division concluded the constitutional conditions were satisfied for application of the throw-out rule by New Jersey. The Appellate Division summarized that the throw-out rule does not result in double taxation, does not pressure taxpayers to increase their business activities in New Jersey at the expense of other states, and is thus facially constitutional.

The Supreme Court disagreed, in part. In doing so, the focus turned to four-prong approach used in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279, 97 S. Ct. 1076, 1079, 51 L. Ed. 2d 326, 331 (1977). This four-prong approach will sustain a state’s formula apportionment methodology for income tax when the tax: (i) is applied to an activity with a substantial nexus with the taxing state, (ii) is fairly apportioned, (iii) does not discriminate against interstate commerce, and (iv) is fairly related to the services provided by the state. Complete Auto, 430 U.S. at 279, 97 S. Ct. at 1079, 51 L. Ed. 2d at 331. The Whirlpool court focused on the second prong: fair apportionment.

Fair apportionment has two requirements: (i) internal consistency and (ii) external consistency. Internal consistency is where an application of the formula by every state would result in no more than all the taxpayer’s business income being taxed. Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159, 169, 103 S. Ct. 2933, 2942, 77 L. Ed. 2d 545, 556 (1983).  It is a hypothetical analysis of what the world would be like if every state had New Jersey’s throw-out rule. The second requirement is an actual analysis of whether the state’s reach goes beyond that portion of revenue that is fairly attributable to economic activity within the taxing state. Okla. Tax Comm’n v. Jefferson Lines, Inc., 514 U.S. 175, 185, 115 S. Ct. 1331, 1338, 131 L. Ed. 2d 261, 271-72 (1995). In other words, whether New Jersey’s throw-out rule reasonably reflects the activity within its jurisdiction.

Whirlpool argued that by including out-of-state receipts in New Jersey’s tax base, New Jersey taxed more than its “fair share.” The New Jersey Supreme Court divided these receipts into two parts: (i) receipts from states that could not impose an income tax due the lack of nexus in that state, and (ii) receipts from states that chose not to impose an income tax. As to the first, the Court ruled that the throw-out rule was constitutional, but as to the latter, the answer is “no.”

The reasoning as to the former is that another state’s decision tax, or not tax, its income would cause a change in New Jersey’s share of the income it is entitled to tax. Thus it is not externally consistent. The change is not reflected on the taxpayer’s activities (the economic activity in within the taxing state), but merely a reflection of another state’s legislature to impose tax. But as to the second, regardless of the other state’s choice regarding income tax, the amount that New Jersey would be able to tax via the throw-out rule remains the same. The only way the result would change is if the taxpayer alters its contacts with the other state.

Alabama Enacts Changes to Apportionment Provision Following Multistate Tax Compact, Including Throwout Rule

June 14, 2011

 By Paul Masters

Alabama House Bill 434, signed by Governor Robert Bentley, enacts three significant changes to Alabama’s apportionment provisions for tax years beginning on or after December 31, 2010:

* Double weight the sales factor for determining apportionment to 50%;

* Change from focusing on the location of income production for apportionment purposes to the taxpayer’s market for the sale for transactions other than tangible personal property; and

* Adoption of a “throwout” rule (similar to that recently rejected by New Jersey), by which a transaction that cannot be assigned to a particular state is removed from the denominator (thereby increasing the factor for apportionment to Alabama).

As to the change to the sales factor apportionment, this change reflects changes being considered by the Multistate Tax Compact. As of December 31, 2010, Alabama now apportions based on the following factors: (i) 25% for property, (ii) 25% for payroll, and 50% for sales.

Regarding the sourcing of sales, the prior version of the rule was more similar to that of Texas, in which one looks to source sales to where the income-producing activity takes place. Tex. Admin. Code § 3.591(e)(26). Alabama now sources services based on the taxpayer’s market for the sale, thus receipts from services are apportioned to Alabama if the service is delivered to Alabama, as adjusted for delivery to multiple locations. Similarly, where a person licenses intangible property for use in Alabama, such transaction would be Alabama-sourced. If the state cannot be fairly determined using the market-source rules, the taxpayer must reasonably approximate such sourcing.

Finally, if a taxpayer is unable to assign receipts based on the market-source rules, and they cannot be reasonably approximated, Alabama employs the so-called “throwout rule” by which the receipts are excluded from the denominator if the state of assignment cannot be determined or reasonably approximated. This was a controversial rule and challenged in New Jersey, as by artificially reducing the denominator it leaves the numerator unchanged, and the Alabama sales factor increases. One would expect for taxpayers to challenge the Alabama throwout rule based on the U.S. Constitution’s Commerce Clause, the Due Process Clause, the Supremacy Clause and the Equal Protection Clause. The New Jersey throwout rule has been challenged, for which New Jersey Supreme Court recently heard oral argument, with the lower courts in the cases of Whirlpool Properties, Inc. and Pfizer, Inc., in which the throwout rule was found to be constitutional.