Connecticut Corporation Business Tax

Presented by Department of Revenue ServicesOctober 2005

Connecticut Net Income

Federal taxable income+ Connecticut Additions- Connecticut Subtractions= Connecticut Net Income

ApportionmentWhen a corporation does business in more than

one state, Connecticut determines the percentage of business that should be “apportioned” to the state by creating a ratio:

Ratio: business within the statebusiness everywhere

Connecticut net income x ratio = Connecticut apportioned income.

Methods of ApportionmentConnecticut allows two basic methods of apportionment

depending upon the type of business:

1) Three factor apportionment: payroll factor, property factor and sales factor (double weighted) ÷ 4 = apportionment percentage. Applied to: most corporations.

2) Single factor apportionment: corporation’s in-state sales ÷ total sales = apportionment percentage. Applied to: financial service companies, manufacturers, and broadcasters.

If We Use 3 factorsThree factor: A manufacturer has the following:

Property factor = 50% Payroll factor = 50%Sales factor (30% x 2) = 60%

160 ÷ 4 = 40%Total Connecticut net income is $1M. $1M x 40% = $400,000$400,000 x 7.5% = $30,000

If We Use Single FactorSingle factor: A manufacturer derives 30% of

its sales from its business in Connecticut and 70% of its sales from business in Massachusetts and New York.

Total Connecticut net income is $1M. $1,000,000 x 30% = $300,000$300,000 x 7.5% tax rate = $22,500 tax due

[Compare $ 30,000 to $ 22,500 = 25% decrease]

Benefits of Single Factor Apportionment

Generally, lower effective tax rate;Eliminates a direct tax increase for creation of new jobs or plant expansion;Benefits in-state companies with large property and payroll that export products.

Effect of changes to the Apportionment Formula

CT companies that only operate in-state are not affected by changes in the apportionment formula;CT companies with significant property and payroll and large out-of-state sales benefit significantly when Connecticut uses single factor only;CT companies with small percentage of out-of-state sales realize little benefit from single factor only;

Apportionment changes (cont’d)Out-of-state corporations with small Connecticut property and payroll but a large percentage of Connecticut sales are big losers when Connecticut uses single factor only;Out-of-state corporations with a small percentage of Connecticut property, payroll and sales realize little change when Connecticut uses single factor only.

Changes to Apportionment Formula

Assume Connecticut net income of $1MThree Factor Single Factor(Sales x 2) (Sales Only)

T/P Prop Pay Sales Tax Due Tax Due % change

A 100 100 100 75,000 75,000 0%B 100 100 20 45,000 15,000 (67%)C 100 100 90 71,250 67,500 (5.3%)D 5 5 90 35,625 67,500 47%E 5 5 5 3,750 3,750 0%

Taxation of two or more related corporations

Two ways that states tax related corporations:1) Separate entity. Calculate the tax due from

each related entity that does business in the state on a separate company basis.

2) Combined calculation. Calculate the tax due from related entities that are in the same line of business as if they were one entity.

Connecticut Combined Return(not a combined calculation)

Calculates each corporation’s income and apportions that income separately and then adds the apportioned income or losses together to calculate the total taxable income.Includes only corporations that have “nexus” i.e., some physical connection to the state, such as property or payroll.

Connecticut calculation

Combined return with 2 CT nexus companies.Company A $1M income with 20% apportionment.Company B ($100,000) with 100% apportionment.

Company A’s apportioned income = $200,000Company B’s apportioned loss = ($100,000)Combined net income = $100,000 Tax due = $100,000 x 7.5% = $7,500 tax due.(This calculation does not take into account the preference tax.)

A tale about tax planning

It all began long ago with a giraffe named Geoffrey in the state of Delaware……

Delaware Holding CompaniesDHC

Delaware does not tax income on intangibles (royalty income, interest income).

Companies use DHCs to shift income to Delaware and reduce their income in separate entity states.

GeoffreyToys R Us created a DHC named Geoffrey. It transferred its trademark, Geoffrey the giraffe, to the newly created DHC.Geoffrey charged Toys R Us for the use of the trademark. Geoffrey consisted of rented office space in Delaware, with a part-time employee earning less than $2,000 per year. Geoffrey collected annual royalty income equal to 1% of sales or approximately $55M in 1990.

Circular Flow of Funds• Toys pays for use of the royalty;• Geoffrey has royalty income;• Royalty payment returns to Toys in form of loan

Carpenter GeoffreyToys

Deductions for Royalties

Dividends or Loans

Deductions for Interest

Connecticut Implications

Geoffrey does not have nexus with Connecticut.

Toys’ income subject to tax by Connecticut and other separate entity states is significantly reduced.

CalculationToys

No Intercompany Expense

Toys

$80M$20MCT Taxable Income

0$60MTotal Intercompany

Expenses

0$5MInterest Expense

0$55MRoyalty Expenses

$80M$80MNet Income

Deductions for Loans & Royalties

Carpenter GeoffreyToys

Federal taxationConnecticut -Separate Entity

Difference between federal tax and separate entity tax

Dividends or Loans

Connecticut’s Response to Trademark Holding CompaniesConn. Gen. Stat. §12-226a,

“If it appears to the Commissioner of Revenue Services that any agreement, understanding or arrangement exists between the taxpayer and any other corporation or any person or firm, whereby the activity, business, income or capital is not properly reflected, the Commissioner of Revenue Services is authorized or empowered, in his or her discretion, provided such discretion is not arbitrarily, capriciously or unreasonably exercised, and in such manner as he or she may determine, to adjust items of income, deductions and capital, and to eliminate assets in computing any apportionment percentage under this chapter….”

Department relied onsection 12-226a to argue:

no separate existence;no “substance” in the legal entity or in the transaction;no ability maintain a profit without the parent.

An uphill battle for the Department.

Legislative ResponseConn. Gen. Stat. §12-218c. Add-back of

intercompany intangible expenses and related interest expense.

Connecticut was only the second state in the nation to have such a provision.

11 additional states have attacked trademark holding companies through the use of an add back.

What came next?More Planning….

Many separate entitiesExpenses between the related entities, which shift income.Created expenses include: royalty expense, interest expense, management expense, manufacturing expense, etc.Estimated cost to the state $30 - $40 M

Nexus Isolation Retailer that separately incorporates each store. Individual stores pay the parent company for: -all the management services (at cost plus); -all the goods sold (at cost plus); -pay interest expense to the parent for

operating funds since the separate retail entities are not “profitable”.

Retailer isolates income of parent company and separately incorporated stores from CT tax.

Carve-upsA Connecticut taxpayer that had:

Connecticut net income $120M Connecticut apportioned income $40M average Connecticut tax $3M annually

Converted to: a tax refund with no liability in future years due to net operating losses.

After ReorganizationOne company reorganized into 5

separate entitiesParent

Holds trademarkProvides Management Services

MFG- CTManufactures for Operating

Pays for Management ServicesPays interest to parent

MFG - X MFG - Y

Operating CompanyR & D

Pays for contract manufacturingSells all products

Pays for trademarks

$ for Trademarks

$ for Mgt. Services

$ for Interest

$ for Mfg.

Tax Benefits of Reorganization

Parent – very large Connecticut apportionment factor, only small amount of wages outside. Net losses.

Operating Company - very small Connecticut apportionment factor, only inventory, small Connecticut wage and receipts; significant R & D tax credits.

MFG – Connecticut facility reports a large Connecticut apportionment factor but does not have significant income due to management fees, which offset income.

Calculations Pre and PostPost Reorg

Parent OP Mfg

($30M) $120M $15M97% 17% 79%

($29.1M) $20.4M $7.9M ($.8M)

$0

Pre ReorgOne Entity

$120M33%

$39.6Mn/a

$3 M

Taxpayers

CT net incomeApportionment

Taxable incomeCombined

incomeTotal tax due CT

Tax Credits25 Business Tax Credits that may be applied to the corporation business tax.

IP 2004(20), Guide to Connecticut Business Tax Credits.

Available on DRS web site: www.ct.gov/drs.

Tax Credit IssuesCredit percentages have not been

adjusted as tax rate has declined.

Many of the tax credits were enacted in the mid 90s when the effective tax rate was 13.5%.

Tax Credit IssuesInteraction of tax credits and

apportionment.

Credits available were not adjusted at the time that the state adopted single factor apportionment for financial service companies, manufacturers and broadcasters.

Lack of Definition/ClarityLitigation of flow through issue;Many credits do not adequately define what property qualifies/does not qualify;Many credits were drafted without tax issues in mind so they are difficult to administer;Difficulty enforcing credits that are administered by other agencies.

Incremental Tax CreditsIncremental credits are determined based on the increase

from the prior year’s expenses. Example:Year 1: $50,000 Credit based on $50,000Year 2: $75,000 Credit based on $25,000Year 3: $76,000 Credit based on $ 1,000

The tax credit statutes dealing with the incremental credits do not adequately deal with purchase of ongoing divisions, merger, spin-off and other reorganizations, resulting in base year issues.

Overlapping Tax CreditsA computer may qualify for either the machinery and equipment credit (§12-217o) or the fixed capital credit (§12-217w) and in addition qualifies for the EDP property tax credit (§12-217t) each year. For same type of equipment, the amount of the tax credit available depends on the credit selected.

Research and Development Credits

Connecticut has two major research and development (R & D) tax credits based on the same expenses.

Connecticut also allows qualifying taxpayers to exchange their R & D tax credits for a cash refund.

Research and Development Credits (cont’d)

The state R & D credits are based on Internal Revenue Code §174, a federal provision that treats research and development costs as deductible expenses vs. capital expenditures. Section 174 is very broad (unlike sec. 41 – the federal R & D credit). For federal purposes it does not matter if an expense is an R & D expense or a general deductible expense, because under federal law both expenses are a deduction from gross income.IRS does not expend significant time auditing section 174, because it is an expense, not a credit.

Research and Development Credits (cont’d)

IRS allows allocation methodologies for section 41 expenses (federal R & D credit) and these same methodologies are being applied to the much larger pool of section 174 expenses (including software) making the area very challenging to audit.Accounting firms have specialists that maximize R & D expenses for corporations.