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As we head into the busy fall season, we want to caution practitioners about New Hampshire’s apportionment laws and rules and how they may affect your clients’ reporting obligations in light of the evolving nexus standards in New England and around the country. With cash-strapped state governments looking for additional revenue, especially from out-of-state businesses, it is increasingly important to be thoughtful about what pitfalls or opportunities might exist when businesses seek new markets for their products and services in neighboring states. In this Tax E-News, we will very briefly review the current apportionment and nexus standards governing New Hampshire businesses and identify some potential hazards as well as some potential planning opportunities.
Apportionment of Business Income
Every business organization conducting business activity both within and outside the State of New Hampshire that is subject to taxation (whether or not there exists any tax liability) in at least one additional state must apportion its income among those states for Business Profits Tax ("BPT") and Business Enterprise Tax ("BET") purposes. The income is apportioned for BPT purposes using the statutory sales, payroll and property factors and for BET purposes using the statutory compensation, interest and dividends factors.
If two or more related business organizations are engaged in what is considered a "unitary business" and a portion of such business activity is conducted in New Hampshire by at least one of the related business organizations, then the income apportioned to New Hampshire, for purposes of the BPT, is determined based on the apportionment factors of the combined unitary business group. A unitary business is defined as one or more related business organizations engaged in business activity, both within and outside the State of New Hampshire, among which there exists unity of ownership, operation, and use, or which have an interdependence in their functions. RSA 77-A:1, XIV. The use of combined reporting under the BPT is mandatory. Passive investments and distinct business operations may not be part of a unitary business.
Because each state has its own laws and rules regarding income apportionment, it is possible a business or unitary business group applying the apportionment factors to its income will end up with nowhere income, be double-taxed on a portion of its income or anywhere in between. While it is impossible to avoid these systemic uncertainties, knowing the applicable nexus and apportionment standards will allow you to navigate the uncertain waters of cross-border business activity with greater ease. The first and often most critical question that arises in the context of apportionment is whether or not the business or unitary business group is "subject to" taxation in another state so that it must apportion its income. The answer, in short, is that the business or unitary business group is subject to taxation in another state if it has sufficient "nexus" with that state, discussed further below.
NOTE: The United States Supreme Court characterized apportionment in Container Corp. v. Franchise Tax Bd., 463 U.S. 159 (1983) as an "imperfect proxy[ies] for an ideal which is not only difficult to achieve in practice but also difficult to describe in theory." If you are interested in learning more about nexus, apportionment or combined reporting, stay tuned to the Devine Millimet Tax Practice Group’s Seminars webpage as we will be offering four hour CPE courses on these topics in the spring.
Determining Whether Nexus Exists With Another State
The Due Process Clause and the Commerce Clause of the United States Constitution and related federal case law place limits on the states’ ability to tax the activity of out-of-state businesses occurring in their state. The law requires that a substantial relationship exist between the state and the activity which it seeks to tax, referred to as nexus. Determining whether nexus exists between the state and the activity to be taxed is relatively straightforward in many instances. For example, if the business or unitary business group has a storefront in another state and sells its products there, nexus clearly exists.
However, for the many New Hampshire businesses that do not have a physical location out-of-state and conduct only a small portion of their overall business activity out-of-state, determining whether nexus exists with another state can be difficult. Nexus is not based solely on having a physical location in a state, whether the business or unitary business group has registered to conduct business in the state or whether a tax return must be filed. In most states, there is no bright-line test but instead a somewhat ambiguous legal standard must be interpreted and applied. The legal standard in Connecticut, New Hampshire, Maine and Massachusetts, and which also appears to be the trend among states, is based on the economic presence of a business as opposed to physical presence in the state. Economic presence does not require that the business or unitary business group has any physical presence in the state and can be defined as the purposeful direction of business toward the state, based on the frequency, quantity and systematic nature of the business’ contact with the state. As the definition implies, this determination involves a fact-driven case-by-case analysis.
The shift among states from physical presence to economic presence represents an attempt by states to broaden their business tax base to include more out-of-state businesses, thus securing additional tax revenue without the politically divisive move of raising tax rates. Although some state revenue departments, such as the Connecticut Department of Revenue Services, have adopted bright-line tests in their regulations to determine if economic nexus exists, it is still unclear whether a bright-line nexus test would pass constitutional muster and whether the regulations exceed the department’s statutory authority.
Attempts have been made at the federal level to address the issue of nexus among the states in a more comprehensive and consistent manner but so far none have been successful. The most recent attempt, the Business Activity Tax Simplification Act ("BATSA"), has been pending in the U.S. House since last fall and would create a federal bright-line nexus standard that requires a physical presence in the state which is more than mere transient business activity. Federal legislation appears to be the best opportunity to remedy the varying and often contradictory state standards as state courts have unsurprisingly been sympathetic to state taxing authorities and the U.S. Supreme Court has declined to rule on any new nexus cases for some time.
Potential Issues and Opportunities
The first potential opportunity is one that is simple but may be overlooked. If a group of businesses in different states meet New Hampshire’s definition of a unitary business group, the group must use combined reporting and will offset gains and losses among the various entities. For example, assume that the owner-taxpayer, who is in the active business of rental property management, is the owner of three LLCs, one for each rental property the taxpayer owns. Two of the LLCs are domiciled in New Hampshire and one is domiciled in Massachusetts. The New Hampshire LLCs hold rental property located in New Hampshire and the Massachusetts LLC holds property located in Massachusetts. All are part of a unitary business group conducting rental activity. When completing New Hampshire tax returns for the New Hampshire entities, the owner-taxpayer should not use separate accounting for the Massachusetts LLC but should include the combined results of all three LLCs and apportion the income between the New Hampshire properties and the Massachusetts property.
Now instead assume that all three rental properties are located in New Hampshire and all three LLCs are domiciled in New Hampshire. One of the rental properties has significant losses and the other two are highly profitable. The owner-taxpayer is in the unfortunate position of having tax liability due on the two profitable LLCs without being able to offset those tax liabilities with the losses of the other LLC. If that taxpayer conducted a sufficient level of business activity outside of the state, such as renting a storage unit in Massachusetts to store the property maintenance equipment which is not currently being used or purchasing a new rental property in a state other than New Hampshire, the owner-taxpayer may have the ability to use the losses from the one LLC to offset the tax liabilities of the other profitable entities for New Hampshire tax purposes. Keep in mind it is the taxpayer’s burden to establish that its unitary business is subject to taxation in another jurisdiction.
Planning is key. Many times, the taxpayer does not consider nexus and apportionment until he receives an inquiry from an out-of-state taxing authority. Unless the taxpayer has filed returns with that state, the statute of limitations on any potential tax liability does not begin to run and thus all prior periods remain open. It can be especially painful for the taxpayer who is found to be taxable, including interest and penalties, and has missed the statute of limitations to file an amended return in the state in which he reported all of his income, resulting in the taxpayer being double-taxed on a portion of his income. Given that our neighbor to the south, Massachusetts, was ranked as one of the most aggressive states in asserting economic nexus over out-of-state businesses last year, it may be wise to perform a nexus and apportionment review annually. See Katz, "State Insecurity," CFO Magazine (April 2011), available online here.
Many states have also adopted a so-called throwback rule intended to ensure that all of the taxpayer’s business income is subject to tax somewhere by attributing the taxpayer’s business activity to the state of its origin if it is not taxed elsewhere. However, because these rules vary by state, the unsuspecting taxpayer may end up being double-taxed on a portion of income and the strategic taxpayer may end up with a portion of income remaining untaxed, also referred to as nowhere income. This is where careful planning comes into play. For example, assume the taxpayer is in the business of selling tangible personal property and has some sales nationwide but not enough to subject it to tax in any states other than New Hampshire and Massachusetts. The taxpayer has a warehouse in New Hampshire and a sales office in Massachusetts. Because New Hampshire’s throwback provision captures sales shipped from New Hampshire and Massachusetts’ throwback provision captures sales with a business premises or sales office in Massachusetts, the sales may be taxed by both states. If the taxpayer’s operation was reversed and the taxpayer had a sales office in New Hampshire and a warehouse in a state without a throwback rule, it is possible that this same business activity might escape taxation altogether.
Care must also be taken if a taxpayer employs a modified statutory apportionment method. The taxpayer can request, or the New Hampshire Department of Revenue Administration ("DRA") can require, use of a reasonable alternative method of apportionment. RSA 77-A:3, II(a); RSA 77-E:4, II. However, the use of any modified apportionment method without the prior written approval of the DRA will cause the tax return not to be considered filed for BPT and BET purposes and the statute of limitations will not begin to run.
Devine Millimet Can Help
If you are uncertain about whether nexus exists in any state where you have activities and are not currently filing tax returns or how to correctly interpret and apply New Hampshire’s apportionment laws and rules, please feel free to give a member of our Tax Practice Group a call or an email. With one of the largest and most diverse tax practices in New Hampshire, Devine Millimet is ready to assist you and your clients with all of your tax-planning and tax controversy representation needs.
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The Devine, Millimet & Branch Tax Group offers this free Monday E-Mail Alert service to provide information on recent developments in tax law. If you have any questions about this e-mail, or if you know of anyone else who may be interested in receiving these alerts, please send us an email at mgilbert@devinemillimet.com.
This is not a legal document nor is it intended to serve as legal advice or a legal opinion. Devine, Millimet & Branch, P.A. makes no representations that this is a complete or final description or procedure that would ensure legal compliance and does not intend that the reader should rely on it as such.
© Copyright 2012 Devine Millimet & Branch, Professional Association
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