SALT Blawg – State and Local Tax Blog
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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 § 54:10A-6[B]), which was repealed by legislation in late 2008, continues to be enforced by the Division for the tax periods between January 1, 2002 and June 30, 2010.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