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Many multistate businesses have organized themselves by separately incorporated entities within each state that nonetheless are part of a larger national affiliated group. States, in their continued search for cash, have targeted these multistate businesses as prime revenue sources. They have looked to different methods for taxing the income of these related groups of corporations. How each state identifies state taxable income makes a huge difference to the corporations’ final state tax bill. Basically, two approaches exist. One approach is known as “separate return filing,” where each individual incorporated entity that has sufficient contacts with the state must file a separate tax return. The other approach is “unitary combined reporting,” which generally requires related companies to file and pay tax as if they were a single corporation. The differences between separate return filing and combined reporting are profound. While the former treats each incorporated entity as a separate business, the latter basically ignores the “separateness” of legal entities and forces all related entities that share certain features to combine their income for purposes of filing one amalgamated tax return. Under combined reporting, any tax benefits or detriments associated with intercompany transactions are essentially eliminated. Thus, much tax planning is either rendered pointless or diminished in effectiveness when a state moves to combined reporting. Combined reporting is viewed by many corporate taxpayers as a tax increase. The District of Columbia and Maryland have entertained the notion of forcing companies to file on a combined basis. If either of these jurisdictions adopts this method of filing, many businesses in our area (and the lawyers who advise them) will need to address certain issues. WHAT IS UNITARY? What is a “unitary relationship” that might require companies to file on a combined basis? The definition of a unitary relationship is not, as the U.S. Supreme Court has acknowledged, unitary. In other words, courts have developed a number of alternative tests for determining the existence of a unitary relationship. One of the modern tests applied by the Supreme Court in Mobil Oil Corp. v. Commissioner of Taxes (1980) to establish a unitary relationship hinges on (1) centralized management, (2) functional integration, and (3) economies of scale among the related entities. This test of unity, as well as all the others, is difficult to apply to real companies and complex fact patterns. As a result, taxpayers and states invest significant resources in disputing the existence of a unitary relationship. States have adopted two distinct approaches to unitary combination: worldwide combined reporting and water’s-edge reporting. Worldwide combined reporting, which is now largely limited to oil companies in Alaska, requires that every related entity that maintains a unitary relationship (however defined) must join in the combined filing, regardless of location. In contrast, water’s-edge reporting requires only those related entities with a unitary relationship that are located within the United States to join in the combined report. It is notable that some corporations prefer filing on a combined reporting basis. For example, some taxpayers that own both subsidiaries that generate profits and subsidiaries that generate tax losses may prefer combined reporting because it allows them to offset the profits of one entity against the losses of others. But these taxpayers are in the minority, and taxpayers and taxpayer organizations generally resist state efforts to adopt combined reporting. THE MULTISTATE TAX COMMISSION The struggle associated with combined reporting has evolved. A number of states, including Maryland, Virginia, and the District, have enacted “expense disallowance” statutes that forbid taxpayers from taking tax deductions associated with certain related-party transactions. These anti-abuse type statutes are supported by some state tax commissioners for the same reasons that they support unitary combination. But the big story is the trend toward implementation or expansion of unitary combination regimes. It involves the reconsideration of worldwide combination as a potential panacea for perceived loopholes in corporate tax systems and shortfalls in state budgets. Factors influencing this trend include: states’ need for revenues; the attractiveness of out-of-state corporations as tax targets; and states’ efforts to combat perceived taxpayer abuses and control the tax ramifications of different corporate structures and of intercompany transactions involving offshore companies. The Multistate Tax Commission, an organization of state tax agencies that was created by an interstate compact, is the principal advocate for adoption of unitary combined reporting. The commission develops and recommends uniform laws and regulations and encourages business compliance. The latest focus of its uniformity efforts is a new model statute for combined reporting, which the Multistate Tax Commission intends to support with regulations addressing the many discrete issues arising in the context of a combined return. It is clear that the commission intends to play a leading role in the exploration and eventual implementation of more aggressive unitary combined filing regimes on a uniform multistate basis. Given the Multistate Tax Commission’s activism, this is the proper time to inquire whether the current environment is one in which combined reporting will replace separate return regimes. Whatever the landscape will be in another 30 years, today states are actively tinkering with their income tax filing regimes to sweep more members of the multinational corporate group into combined returns and to generate greater income tax revenues. PROBLEMS IN A DRAFT STATUTE The Multistate Tax Commission subcommittee circulated an issues list that guided its drafting of the model combined reporting statute. The issues list (available at www.mtc.gov) poses but does not try to answer a variety of questions concerning both theoretical and technical aspects of combined reporting. The draft Model Uniform Statute for Combined Reporting (issued most recently on Sept. 17) picks up where the issues list leaves off. It provides an early indication of the commission’s theoretical and political leanings. First, combination is the rule, rather than the exception, under this statute. Second, while the statute purports to offer water’s-edge reporting (as opposed to worldwide combined) as an elective filing method, the definition of jurisdictions falling within the “water’s edge” includes so-called “tax havens,” which are defined by reference to (1) determinations by the international Organization for Economic Cooperation and Development; (2) a set of “objective” criteria that include the ease of forming entities that lack physical presence or economic substance, as well as the lack of tax or merely nominal tax on the relevant income of such entities; and (3) each state revenue commissioner’s discretion, based on criteria that include but are not limited to the proportion of nontaxed “special purpose” entities in that jurisdiction. The multimillion-dollar question, from many affiliated groups’ perspectives, becomes: Does this “water’s-edge plus” filing method edge ever more closely toward mandatory worldwide combined reporting? The Multistate Tax Commission’s draft statute also outlines the determination of taxable income or loss in a combined report. It includes details on the entities that can be included in a water’s-edge elective return and prerequisites for the initiation and withdrawal of such a filing election. Another noteworthy feature of the draft statute is the extent to which it accords discretion to state tax commissioners to deviate from the strictly uniform provisions of the statute. Commissioners have discretion to define the scope of the filing group, by adding tax-haven jurisdictions to the water’s-edge return. They also may require combined filing even in the absence of a unitary relationship between an entity and an otherwise unitary group if certain conditions are met regarding separately reported income. Moreover, the commissioners may permit a unitary business with foreign operations to determine income based on the consolidated profit and loss statement prepared for filing with the Securities and Exchange Commission, if such a method will “reasonably approximate income” under the state revenue code. Although the last provision may provide some relief to taxpayers from the significant compliance burdens associated with combined reporting, the result of these exercises in discretion is to move away from the supposed virtues (and reduction in taxpayer burdens) that uniform legislation in this arena is alleged to effect. Seventeen states have implemented mandatory combined reporting for income tax purposes. There are 29 separate return or elective consolidated reporting states, plus the District. There have also been many efforts to implement combined reporting in separate return states during the last few years. BEST PRACTICES What this combined filing trend will ultimately mean to multistate and multinational businesses depends, of course, on such particularities as the relative profitability or loss status of foreign-incorporated entities. But there will continue to be certain opportunities, and pitfalls, associated with every state combined filing regime. Taxpayers should use certain best practices to manage the sweeping changes that will certainly continue to occur: 1. Take advantage of different filing options to minimize tax liability. Combined filing sometimes generates a greater tax liability, sometimes a lesser tax liability. Therefore, periodic reviews of the filing options available in each state may yield different strategies over time for a multi-entity business. 2. Maintain awareness of pending and recently decided combined filing decisions in state courts. These may serve as persuasive if not controlling authority in other jurisdictions if the facts or law are arguably similar. 3. Understand the prerequisites to water’s-edge elections and carefully review where the “water’s edge” actually lies for the purposes of each state. For instance, how does a state’s definition of a “tax haven” affect the definition of the water’s edge group? 4. Be aware of states’ legislative attempts to address taxpayer “abuses” in the form of tax minimization planning. If these and other best practices are adopted, even corporations facing the challenging issues of unitary combined filing systems will be well situated to optimize their state tax liability. Kendall L. Houghton and Jeffrey A. Friedman are partners in the tax practice in the D.C. office of Sutherland Asbill & Brennan, where they concentrate on state and local tax matters.

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