On February 19, 2009, Wisconsin Governor Jim Doyle signed into law 2009 Wisconsin Act 2 (Act 2), which now requires, among other items, corporations to use combined reporting when computing their Wisconsin taxable income. The legislation was drafted in secret, introduced on February 17, 2009, passed by both houses of the Wisconsin Legislature without a public hearing on February 18, 2009 on strict party lines (no Republican in either house voted for the legislation), and sent to the governor, who signed it into law on February 19, 2009.
Combined reporting is complex. Given the lack of public input and retroactive effective date (January 1, 2009), the Wisconsin Department of Revenue (Department) will attempt to address this complexity administratively.1 As a result, there are many uncertainties.
Who Must File a Combined Report?
Previous to Act 2, each corporation was taxed separately and was not subject to state corporate franchise tax unless it was “doing business” in Wisconsin. Under Act 2, for tax years beginning on or after January 1, 2009,2 corporations that are not exempt by statute and are engaged in a unitary business with at least one other corporation must use combined reporting unless excluded by statute.3
Corporations excluded from combined reporting include (i) tax-option corporations such as S corporations,4 (ii) foreign corporations if 80 percent or more if their income is “active foreign business income” (as noted below under “Foreign Corporations”), and (iii) corporations that only have exempt income under state law.5 However, Act 2 also gives the Department authority to require a combined report to include “persons” not otherwise includable in a combined group (or exclude those that are) if the unitary business income is not otherwise properly apportioned or the inclusion (or exclusion) represents an avoidance or evasion of tax. This authority includes requiring combined reporting for “persons that are not corporations.”6 As of yet, the Department has not expanded on whether the definition of persons includes S corporations, foreign corporations that are normally excluded, or even individuals.
Most states that require combined reporting have adopted either the Joyce or Finnigan approach for determining whether to include the income and apportionment factors7 of a member who lacks nexus in that state. States that follow the Joyce approach, which is based upon a California State Board of Equalization (CSBE) decision, include the income and apportionment factors of all members of the combined group, including members who lack nexus in the state, but determine nexus separately for each member and, thus, do not tax those members who lack nexus.8 States that follow the Finnigan approach, which also is based on a CSBE decision, also include the income and apportionment factors of all members of the combined group, including members who lack nexus in the state, but provide that if any member of the combined group is doing business in the state, then all members of the combined group are considered doing business in the state, effectively taxing those members who lack nexus in the state.9 Wisconsin uses the Finnigan approach, which theoretically expands the members of the combined group, but may raise federal constitutional challenges.10
A foreign corporation is a corporation not (i) incorporated, organized, or created in the United States or under the laws of the United States or any state,11 or (ii) treated as a domestic (U.S.) corporation for purposes of filing a federal consolidated return. Foreign corporations are excluded from combined reporting if 80 percent or more if their income is active foreign business income — that is, foreign corporations are included in the combined group if more than 20 percent of their income is U.S.-source income (as provided in Internal Revenue Code §§ 861 through 865).
Generally, active foreign business income is income (i) derived from non-U.S. sources and (ii) attributable to the active conduct of a trade or business by a corporation (or its subsidiary) in a foreign country or possession of the United States.
As noted above, Act 2 requires all corporations engaged in a unitary business in Wisconsin to file a combined report. In general, a unitary business means two or more corporations that are (i) related to one another, as a single economic enterprise that is made up either of separate parts of a single business entity, multiple related entities (under Internal Revenue Code §§ 267 or 1563), or as a “commonly controlled group” of entities, and that are (ii) sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them, and a significant flow of value to the separate parts.12
Two or more entities are presumed unitary if the businesses have unity of ownership, operation, and use as indicated by the presence of one or more non-inclusive enumerated factors, including (i) centralized management or executive force, purchasing, advertising, or accounting; (ii) intercorporate sales or leases, services, debts, or use of proprietary materials; or (iii) interlocking directorates or corporate officers. In addition, Act 2 directs that the term unitary business to be broadly construed to the extent permitted by the U.S. Constitution.13
In general, a commonly controlled group is a parent corporation and any one or more corporations or chains of corporations that are connected to the parent corporation by direct or indirect ownership, if the parent corporation directly or cumulatively owns stock representing more than 50 percent of the voting power of at least one of the connected corporations. In addition, a commonly controlled group includes two or more corporations if a common owner, regardless of whether the owner is a corporate entity, directly or indirectly owns stock representing more than 50 percent of the voting power of the corporations or connected corporations.14
Historically, Wisconsin used physical presence when determining whether an organization was “doing business” in the state. By more recent statutory changes, doing business in Wisconsin is further defined to include: (i) issuing credit, debit, or travel and entertainment cards to customers in Wisconsin; (ii) owning, directly or indirectly, a general or limited partnership interest in a partnership that does business in Wisconsin, regardless of the percentage of ownership; and (iii) owning, directly or indirectly, an interest in a limited liability company that does business in Wisconsin, regardless of the percentage of ownership.
Act 2 greatly expands the definition of doing business to include several forms of “economic nexus,” which include (i) regularly selling products or services of any kind or nature to customers in Wisconsin that receive the product or service in Wisconsin; (ii) regularly soliciting business from potential customers in Wisconsin; (iii) regularly performing services outside Wisconsin if benefits are received in Wisconsin; (iv) regularly engaging in transactions with customers in Wisconsin that involve intangible property and result in receipts flowing to the taxpayer from within Wisconsin; and (v) holding loans secured by real or tangible personal property located in Wisconsin.15 Act 2 does not define “regularly” and the Department has yet to provide guidance on the meaning of this term. Many organizations will no doubt find this new definition of doing business quite onerous.
In addition, taxpayers may challenge this new definition of doing business, or economic nexus, on federal constitutional grounds. For instance, the new standards conflict with Public Law 86-272, 15 USC § 381, which prohibits a state from imposing an income tax on a business if the only business activity is mere solicitation — that is, the only business activity consists of solicitation of orders for sales of tangible personal property when the orders are approved or rejected outside the state and, if approved, are filled by shipment or delivery from a point outside the state. Act 2 not only clearly overruns that standard on its face, but the determination of tax liability for the combined group members causes additional problems. (See “Computing Taxable Income” below.) The Department has publicly stated, however, that it will address this issue administratively and perhaps legislatively in the near future.
Computing Taxable Income
The starting point and general rule for computing combined taxable income is the sum of the income, as computed for federal income tax purposes, subject to various provisions of the Internal Revenue Code that Wisconsin does not follow as well as special rules specific to Wisconsin, of all members of the combined group, regardless of whether a member has nexus with Wisconsin (i.e., using the Finnigan approach discussed above), provided that at least one member of the combined group is doing business in Wisconsin. If a unitary business includes income from a pass-through entity, the applicable member includes its allocable share from the pass-through entities that it owns.
In addition, Act 2 adds several modifications to the general rule, including (i) expanding the already existing dividends received deduction; (ii) rendering unnecessary the need to add back certain related party expenses incurred between members of the same combined group (see below under “Disallowable Deductions (or Addbacks)”), as income and expenses between such members generally cancel out when combined together; (iii) deferring intercompany gains or losses as provided under U.S. Treasury Regulation § 1.1502-13; and (iv) recomputing charitable contribution and capital loss limitations on a combined reporting basis.16 The result of this starting point is the unitary business income of the combined group.
The next step is to divide the unitary business income among the members of the combined group according to each member’s share of the combined group’s apportionment factors. Wisconsin generally uses single-factor sales apportionment. This means that a member’s share of unitary business income will generally be the product of (i) the unitary business income of the group multiplied by (ii) the “modified sales factor,” which is a fraction, the numerator of which is the member’s Wisconsin sales and the denominator of which is the total sales of the combined group. Each member’s share is then subject to taxation, and each member is responsible for its tax.17 Finally, the designated agent of the combined group is responsible for all estimated tax payments as a result (as noted below under “Estimated Taxes” and “Designated Agent”).
Throwback sales present an interesting quandary for Wisconsin combined reporting. Such sales occur when (i) a taxpayer delivers or ships a product from Wisconsin to a destination outside of Wisconsin, and (ii) the taxpayer lacks nexus with the destination state, and correspondingly is not subject to income tax in such state. Act 2 presumably did not change the longstanding rule that includes 50 percent of such sales in the numerator and 100 percent in the denominator of the modified sales factor.18 However, because Wisconsin uses economic nexus for combined reporting, and because one member’s nexus in a state creates nexus for all members of the combined group in that state, sales to a destination state appear to always create nexus in such state. Thus, by implementing economic nexus, Act 2 seemingly obliterates any possibility of throwback sales occurring for many taxpayers.
Industries that still use multiple-factor apportionment formulas such as interstate air carriers (one-third arrivals/departures, one-third revenue tons, and one-third originating revenue) and telecommunication companies (one-third property, one-third payroll, and one-third sales) must convert to a single sales factor under steps prescribed by Act 2.19
Joint and Several Tax Liability
Not only is each member responsible for its own tax (based on its share of unitary business income)20, but the members of a combined group are jointly and severally liable for taxes, costs, penalties, and interest associated with the combined report — that is, each member is responsible for every other member’s taxes and related costs as well as its own.21 This means that a corporation with no constitutional nexus in Wisconsin may be liable for Wisconsin taxes for other members in the group, and other members in the group with constitutional nexus in Wisconsin may be liable for Wisconsin taxes of those members who do not have constitutional nexus in Wisconsin. This exacerbates the federal constitutional problem noted above (under “Doing Business”) because even though the State of New York Court of Appeals upheld the Finnigan approach, under Public Law 86-272 challenge, it did so on the theory that the combined group had liability for the taxes, not the group’s specific members. In Disney Enterprises, Inc. v. Tax Appeals Tribunal of the State of New York, 10 N.Y.3d 392, 888 N.E.2d 1029 (N.Y. Court of Appeals, March 25, 2008), New York’s highest court held that including a member’s income in the combined group’s apportionment formula did not amount to a tax upon such member, but was rather an attempt “to best measure the combined group’s taxable in-state activities” (emphasis added). This additional facet of Act 2 raises serious doubt of its validity and viability.
Loss Carry-Forwards and Credits
Net operating losses of a member of the group, generated pre-combined reporting, can only be carried forward and used to offset taxable income of that member. However, members can generally carry forward combined reporting net operating losses and use them to offset the aggregate taxable income of the combined group. Illogically, and for unexplained reasons, only the member that generates a tax credit can use such tax credit, regardless of whether the credit is generated before or during combined reporting.22
For taxpayers required to use combined reporting, any estimated payments due less than 45 days after March 6, 2009 (on or before April 20), are not due until the next subsequent installment due date. For example, if a combined group’s taxable year begins on January 1, 2009, the first and second payments are due on June 15, 2009. On the other hand, if the taxable year begins on March 1, 2009, the first payment is due on May 15, 2009, and the second payment is due on August 15, 2009.23
Each combined group has one designated agent. The designated agent is normally the parent corporation of the combined group. If there is no parent corporation, the members can appoint the designated agent. If there is no a parent corporation and no member is appointed, the designated agent is the member that has the most significant operations in
Disallowable Deductions (or Addbacks)
2007 Wis. Act 226 retroactively disallowed, for tax years beginning in 2008, deductions for interest and rent expense paid or accrued to related entities, except in certain limited circumstances. (In general, a “related entity” means any person related to a taxpayer as provided under Internal Revenue Code §§ 267 or 1563 during all or a portion of the taxpayer’s taxable year as well as any real estate investment trust unless certain exceptions apply.) Act 2 expands the disallowance of expenses to include intangible expenses and management fees.24 Intangible expenses include, among other items, royalty, patent, technical, copyright, and licensing fees as well as similar expenses and costs.25 Management fees include, among other items, expenses and costs, not including interest expenses, pertaining to accounts receivable, accounts payable, employee benefit plans, insurance, legal matters, payroll, taxation, financial matters, securities, and accounting, to the extent that such amounts would otherwise be deductible in determining net income under the Internal Revenue Code as modified by Wisconsin law.26
Economic Substance Caveat
Act 2 provides the Department specific authority to disregard transactions lacking economic substance and creates a rebuttable presumption that transactions between members of a commonly controlled group lack economic substance. According to Act 2, a transaction has economic substance only if the taxpayer demonstrates both (i) the transaction changes the taxpayer’s economic position in a meaningful way, apart from tax effects, and (ii) the taxpayer has a substantial non-tax purpose for entering into the transaction and the transaction is a reasonable means of accomplishing that purpose. A transaction has a substantial non-tax purpose if it has substantial potential for profit, disregarding any tax effects.27 The Department has acknowledged that this standard has problems in practice such as whether the doctrine applies to an election to be treated as a tax-option corporation such as an S corporation.
According to the Wisconsin Legislative Fiscal Bureau, combined reporting, along with sourcing, tax administration, and related party transactions, which are other Act 2 provisions, will increase state income and franchise tax revenues by an estimated $27.7 million in 2008 – 2009, $75.6 million in 2009 –2010, and $111.7 million in 2010 –2011.28
Although the provisions of Act 2 regarding combined reporting are extensive, many questions remain unanswered. The Department has tentatively promised additional guidance with the first set of frequently asked questions to be provided in April 2009 (with continuous updates), drafts of combined reporting forms available for public comment in May 2009, a Wisconsin Guide to Combined Reporting available for public comment in August 2009, and finalized combined reporting forms and instructions available in November 2009.
1 In addition to Act 2 itself, portions of this article were drafted using Department materials from the designated combined reporting Web site, located at http://www.revenue.wi.gov/combrept/index.html.
2 Corporations with fiscal years beginning before January 1, 2009 are not required to use combined reporting until their first taxable year beginning after January 1, 2009. However, if other members of the corporation’s combined group have a calendar year or a different fiscal year beginning after January 1, 2009, those other members are required to use combined reporting. The Department has not provided any further information or instruction for such unique situations involving differing fiscal years.
11 Presumably, “under the laws of the United States or any state” would include the District of Columbia. Act 2 does not explicitly say this, however, for purposes of combined reporting, unlike other sections of Act 2. Compare Act 2 § 122, amending Wis. Stat. § 71.22(9g) to read: “For purposes of s. 71.25(9)(df), (dh), (dj), and (dk), ‘state’ means a state of the United States, [and] the District of Columbia . . . .” with Act 2 § 131, creating Wis. Stat. § 71.255(1)(h), which defines “domestic” to mean “incorporated, organized, or created in the United States or under the laws of the United States or any state” and creating Wis. Stat. § 71.255(1)(j), which defines “foreign” to mean “not incorporated, organized, or created in the United States or under the laws of the United States or any state.”
16 Act 2 § 131, creating Wis. Stat. § 71.255(4). Under separate entity reporting, charitable contribution and capital loss limitations are based on the taxpayer’s pro forma federal consolidated return. Since combined reporting causes a corporation’s income to be different from the pro form federal return, these limitations are recomputed on a combined reporting basis.
18 We understand the Department interprets Act 2 § 131, creating Wis. Stat. § 71.255(5)(a)1, as so providing, although newly created Wis. Stat. § 71.255(5)(a)1 does not expressly reference the 50 percent throwback rule.
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.
If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individuals:
Carl D. Fortner
Isaac J. Morris
Timothy L. Voigtman
Internal Revenue Service regulations generally require that, for purposes of avoiding United States federal tax penalties, a taxpayer may only rely on formal written opinions meeting specific requirements described in those regulations. This newsletter does not meet those requirements. To the extent this newsletter contains written information relating to United States federal tax issues, the written information is not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal tax penalties, and it was not written to support the promotion or marketing of any transaction or matter discussed in the newsletter.