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F I S C A L I M P A C T R E P O R T

SPONSOR Wirth

DATE TYPED 3-07-2005 HB 320/aHBIC

SHORT TITLE Mandate Combined Corporate Tax Returns

SB

ANALYST Taylor

REVENUE

Estimated Revenue

Subsequent

Years Impact

Recurring

or Non-Rec

Fund

Affected

FY05

FY06

$12,000.0

$24,000.0 Recurring

General Fund

(Parenthesis ( ) Indicate Revenue Decreases)

SOURCES OF INFORMATION

LFC Files

Taxation and Revenue Department (TRD)

SUMMARY

Synopsis of HBIC Amendments

The House Business and Industry committee amendments provide an exception to the require-

ment that all corporations file combined returns for unitary corporations whose principal busi-

ness activity is manufacturing. The amendments include a definition of manufacturing that ex-

cludes construction, farming, processing natural resources and “power generation, except for

electricity generation at a facility other than one for which both location approval and a certifi-

cate of convenience and necessity are required prior to commencing construction or operation of

the facility, pursuant to the Public Utility Act”.

Fiscal Impact of HBIC Amendments

The Taxation and Revenue Department reports that the exclusion provided for manufacturing

reduces the full-year fiscal impact from $30 million to $24 million.

Synopsis of Original Bill

House Bill 320 amends the corporate income and franchise tax act by requiring all corporations

subject to the act to file combined returns.

The provisions of the bill are applicable beginning January 1, 2006.

House Bill 320/aHBIC -- Page 2

FISCAL IMPLICATIONS

The Taxation and Revenue Department (TRD) estimates that requiring combined returns would

increase general fund revenues by $15 million in FY06 and by $30 million on a full year basis.

The fiscal impact estimate assumes that the change will increase corporate income tax revenues

by 15 percent as has been the case of some other states that have adopted this measure, according

to TRD.

The current forecast for Corporate Income Tax revenues in FY06 is $200 million. A 15 percent

increase implies revenues will grow by $30 million. The impact in FY06 is assumed to half of

this because of the applicability date, which falls in the middle of the fiscal year.

ADMINISTRATIVE IMPLICATIONS

TRD reports that the administrative impact of the proposed change would be modest.

TECHNICAL ISSUES

TRD submitted the following as a technical issue:

As a result of Conoco and Intel v. TRD (1997), the Department may not include foreign

dividends and subpart F income in the tax base for separate filers, but the Department can

and does include foreign dividends and subpart F income in the tax base for combined

and consolidated filers. (Subpart F income is income earned by controlled foreign corps

in tax haven countries. It is treated as a “deemed dividend” by the U.S. Internal Revenue

Code since it may never be formally repatriated.) There is no good economic reason for

the distinction between dividends received by separate and combined filers; it’s just a re-

sult of how that case was decided.

OTHER SUBSTANTIVE ISSUES

TRD provided the following background and discussion of policy issues related to the bill.

Current Practice and Probable Basis for the Proposed Legislation.

Under current law, each member of an affiliated group of corporations may file as a sepa-

rate entity in New Mexico. Only the entity with a taxable presence (“nexus”) must file a

return in the state. This filing method creates opportunities for controlled groups of cor-

porations to shift profits to their out-of-state affiliates by inflating inter-company charges

to the in-state entity. Because affiliated corporations almost always file a single “con-

solidated” return for federal purposes, the inter-company charges are not subject to fed-

eral audit scrutiny. Policing the legitimacy of these inter-company charges (for instance,

the proper amount of rent for an in-state store charged by a Delaware subsidiary) is very

difficult and time-consuming for state tax auditors. All other Western states with a corpo-

rate income tax currently mandate combined reporting, under which controlled groups of

“unitary” (interdependent) U.S.-based corporations must file a single composite return,

eliminating all inter-company charges. The states impose their apportioned tax on a lar-

ger tax base, likened by some to taxing a smaller share of a bigger pie. The Blue Ribbon

Tax Commission endorsed the concept of mandating combined filing in 2003.

House Bill 320/aHBIC -- Page 3

Eastern states have not generally adopted combined filing, although in response to some

well-publicized “tax planning” techniques, 13 Eastern states have recently adopted “add-

back” or “anti-PIC” legislation. These laws require taxpayers to disallow the amounts of

royalty and interest amounts paid to “intangible holding companies” based in low-tax

states like Delaware. New York allows its tax commissioner to “force” mandatory com-

bining to avoid income distortion. The discretionary powers necessary to properly im-

plement both the “add-back” provisions and the “forced combination” techniques have

generated significant litigation. Vermont has recently enacted mandatory combined fil-

ing, and other Eastern states are considering it in response to budget shortfalls. Pennsyl-

vania’s tax department recently estimated that adoption of combined filing in that state

would increase corporate income tax revenues by $120 million to $550 million per year.

Although there is some anecdotal evidence that the “federal consolidated” method has led

to some revenue losses from particular taxpayers with highly profitable in-state opera-

tions, use of the option gives both the states and the taxpayers absolute certainty as to

which entities must be included on a return, eliminating disputes as to whether two busi-

ness segments or separate entities are interdependent.

Eliminate Separate Corporate Entity Reporting: Arguments For and Against

Arguments in favor of eliminating separate corporate entity (SCE) reporting include:

1) Its elimination will reduce corporate tax planning that cost states corporate income tax

revenues

2) Elimination of SCE will make state corporate income tax practices more uniform than

they currently are

Arguments against the approach:

1) Eliminating SCE filing would discourage economic development by discouraging

firms from locating in a particular state

Eliminate Federal Consolidated Reporting: Arguments For and Against

The primary argument for eliminating consolidated reporting is based on a belief that

states lose substantial amounts of corporate income tax revenues by allowing the consoli-

dated filing method. The primary argument against eliminating consolidated filing is that

it is extremely easy to enforce by simply requiring firms to submit copies of their federal

tax returns when filing state corporate income tax returns.

Description of Reporting Methods

Current statutes allow groups of affiliated firms to file as "separate corporate entity"

(SCE), "unitary combined" and "federal consolidated group". This option is sometimes

referred to as "the ladder" because when moving from separate corporate entity to com-

bined, then federal consolidated reporting, firms include greater amounts of corporate in-

come in amounts of income reported. All three filing options require allocation and ap-

portionment under the Uniform Division of Income for Tax Purposes Act (UDITPA).

UDITPA and associated regulations provide rules whereby corporations or groups of

corporations operating in more than one state divide income and expenses among the

states in which they operate. It provides special rules, for example, for airlines, railroads,

construction contractors, trucking companies, broadcasters, and to firms in the publishing

and financial industries. In tax years following the first one in which corporations re-

port, they are allowed to employ a different filing method without permission from the

Department so long as they select a higher position on the "ladder". In other words, they

House Bill 320/aHBIC -- Page 4

are allowed to change from separate corporate entity to combined or consolidated without

permission from the Department. But they may not change from combined to separate

corporate entity without permission from the Department; and the Department does not

generally allow the election unless the proposed new reporting method is a better reflec-

tion of industry practices than the one the firm currently employs.

Unitary Businesses and Filing Methods

A unitary business is generally regarded to be one that operates as a unit; its branches are

so dependent on the business as a whole that their activities cannot be separated from

those of the main organization. A number of legal tests have been developed for deter-

mining whether a group of businesses constitutes a unitary business, yet the practical ef-

fect of the concept is that, once a group of businesses has been defined as a unitary group,

the only feasible approach to sourcing their incomes is via combining incomes from all

group members and subjecting them to formula apportionment. New Mexico statutes cur-

rently allow firms some freedom in defining the composition of their unitary businesses -

- i.e., in defining whether affiliated firms are part of a unitary business and filing taxes

accordingly. This discretion is contained in the three op-

tions allowed for filing returns. As illustrated in the fig-

ure below, the proportion of business activity subject to

apportionment increases as a firm moves from separate

corporate entity to combined and then federal consoli-

dated group reporting. New Mexico statutes allow firms

to move up the ladder, but not down without permission

of the Taxation and Revenue Department Secretary.

Differences in the three filing methods can be under-

stood with the aid of the figure. Assume, as illustrated in

the figure, that two affiliated firms -- firm A and firm B

-- operate in Colorado and New Mexico. Firm A oper-

ates partially within both states, but Firm B’s physical

presence is limited to Colorado. Firm B controls a num-

ber of subsidiaries -- three of which are in Colorado,

while one is located in New Mexico. The firms are, in

fact, related in some way -- via, for example, shared

trademarks, ownership, purchasing or other activities.

Under separate corporate entity reporting, Firm A is al-

lowed to report as if it were a separate entity totally un-

related to Firm B or the subsidiaries. That is, Firms A

and B are not considered unitary. Total income produced by firm A would be taxable, but

Firm A’s business income would be apportioned between Colorado and New Mexico us-

ing the three-factor apportionment formula.1 Income and apportionment factors of Firm

B and the various subsidiaries would be ignored. If Firm B is a subsidiary of A, Firms A

1

In formula apportionment, firms are allowed to allocate their “non-business” income, or income

that is not related to their normal business operations (e.g., dividend and interest income) to their

“state of commercial domicile” or state in which the corporate headquarters are located. Normal

business income is then apportioned among various states.

Firm B

Firm A

Colorado

New Mexico

Sub A

Sub C

Sub B

Sub D

House Bill 320/aHBIC -- Page 5

and B would each file separate returns based on the proportion of business conducted in

New Mexico by each firm. Under a combination of domestic unitary corporations report-

ing system, firms A and B would combine their income and report as if they were a single

firm. If subsidiaries of firm B are not considered part of the unitary business, their in-

comes would not be counted, nor would their activities be accounted for in the appor-

tionment factor. If federal consolidated group reporting is employed, all firms and sub-

sidiaries' incomes shown in the figure would be combined, including apportionment fac-

tors and incomes that are not considered part of the unitary businesses. Many intergroup

transactions would be eliminated, however, because they would not reflect total business

activity. Payroll, property and wages of all units would be accounted for in the appor-

tionment factor.

Effects on Tax Obligations

The movement from separate corporate entity to combined, then consolidated reporting

involves increasing taxable income from a group of business organizations attributable to

a single taxpayer -- a factor that tends to increase tax obligation. As each subsidiary’s in-

come is added to the group, however, data from its activities also flows into the appor-

tionment formula. To the extent that the subsidiary has no instate activities, it lowers the

apportionment percentage, thus decreasing tax obligations. Whether the firm’s total tax

obligation increases or decreases depends on whether the former effect exceeds the latter

one. Eliminating filing options is almost always expected to increase revenues, on the as-

sumption that firms choose the filing method that generates the lowest tax obligations. To

the extent that it causes firms to cease doing business in a particular state, it may have the

opposite effect, however.

Numbers of Filers by Filing Method

In tax year 2003, approximately 16,000 firms filed New Mexico corporate income tax re-

turns as separate corporate entities. Approximately 370 returns were filed as combined

unitary, while 866 firms filed federal consolidated returns. SCE filers paid approximately

46 percent of the tax; combined filers paid approximately 10 percent of the tax obliga-

tions, while federal consolidated return filers paid roughly 44 percent of New Mexico's

corporate income taxes. SCE filers tend to be relatively small firms, although they can be

quite large. Of the firms with New Mexico base income greater than zero, the average

tax liability among SCE filers was approximately $4,000, while combined filers averaged

approximately $36,000 per return and consolidated filers averaged roughly $62,000 per

return. Major SCE filers consisted primarily of firms in the mineral extraction, manufac-

turing and retail industry. Firms in mineral extraction industries are also heavily repre-

sented among combined and consolidated filers; the reason for this is probably that firms

in the mineral extraction industry currently pay a very high fraction of total corporate in-

come

taxes.

BT/rs:yr:lg