Tax Apportionment Shift Hits Multistate Companies

While some companies may benefit, the changes amount to a net loss for Corporate America.
David KatzMarch 31, 2011

For many finance executives and corporate tax directors, the biggest headache when it comes to state taxation is the issue of how income is apportioned among the various states. With many localities changing their rules in an attempt to replenish depleted revenue, such headaches are starting to throb.

In the most significant change, as many as 18 states have moved or are moving from a 54-year-old income-tax model based on a company’s sales, payroll, and property to a model based solely on sales. While that should benefit corporate taxpayers in their headquarters state, it represents an overall loss in deductibility for the many corporations that generate income in a number of states.

Further, as often happens in the crazy-quilt system of state tax regulation, the states are adopting apportionment changes in a plethora of ways. That spells compliance burdens and added costs for corporations. Take the example of a particular communications/media company with $500 million to $900 million in yearly revenue. The need to comply with “varying state apportionment factors” has resulted in the company having to pay taxes based on “more than 100% of income,” an official at the company says.

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The official was not alone in expressing such woes. Indeed, about 16% of the 151 tax directors and finance executives responding to the 2011 CFO Tax Survey said apportionment and related issues were their biggest worry in terms of state taxation. (See the upcoming April issue of CFO for survey results and coverage of other issues related to state tax.)

Most worrisome is the notion that so many states are breaking away from a stable and uniform system. At the July 1957 annual conference of the National Conference of Commissioners on Uniform State Laws, members enacted a model for the corporate allocation of income for state tax purposes that has dominated corporate income-tax assessment in the states. Up until recently, the model held sway in as many as 33 states.

Under that system, companies have been required to allot a portion of their total business income to a particular state for tax purposes based on a three-factor formula. The state’s take is calculated by multiplying the company’s total income by a fraction in which the denominator is three and the numerator is the sum of property, payroll, and sales factors.

The three factors are themselves fractions. For property, for example, the numerator is the average value of the taxpayer’s real and tangible personal property in the state and the denominator is the average value of all such property. A similar method is used to calculate the apportionment for payroll and sales.

Although far from perfect, the three-factor model has been “generally a fair way” to allocate corporations’ total taxable income across the states, says Geoffrey Christian, a senior tax specialist at Dow Lohnes Price Tax Consulting Group. But switching from three factors to a single factor — sales — removes needed balance from the system, he thinks.

While the sales-factor apportionment model can be a boon to in-state companies, it can hurt out-of-state companies that sell into the state, according to Christian. A switch to the single-factor model can cut an in-state company’s tax bill by eliminating the property and payroll factors, which tend to be relatively high for such companies.

Conversely, an out-of-state company that merely sells into a state would see its taxable income rise there. That’s because it would no longer receive a benefit for its employment and property ownership in another state.

About 18 states have moved or are moving to a single-factor system based on sales, with at least 3 more — California, New Jersey, and Pennsylvania — considering such a move, according to Dow Lohnes Price figures. (See chart below.)

Moreover, some three-factor states are reflecting the influence of the new system by doubling the sales factor in their calculations, notes Christian. Thus, instead of the three factors each being allotted 33%, property is assigned 25%, payroll 25%, and sales 50% of the total apportionment factor.

Overall, the states, not corporate taxpayers, stand to be net gainers. True, any state that switches to a single-factor model has in-state companies that will pay less tax. “But it will also have companies that reside in 49 other states that may do business in the state,” says Christian, “and it will get more revenues from them.”

Single-factor tax states