I. Introduction

Recently enacted chapter 262 of the Acts of 2004 makes certain changes that pertain to the allocation and apportionment of income of corporations, financial institutions, and other taxpayers that utilize or are affected by the corporate allocation and apportionment rules. The changes (1) provide for the allocation of certain "non-apportionable" income to Massachusetts when the income is realized by an in-state domiciliary corporation; (2) treat a deemed sale of assets pursuant to Internal Revenue Code § 338 as resulting in receipts from the sale of assets for purposes of the sales factor apportionment provision; and (3) restate and clarify existing law to the effect that in the case of the licensing of intangible property the "income-producing activity", for purposes of the sales factor apportionment provision, will be deemed to be performed in Massachusetts to the extent that the intangible property is used in Massachusetts.

The changes discussed by this TIR apply to domestic and foreign corporations that are subject to G.L. c. 63, § 30 et seq. and utility corporations that are subject to G.L. c. 63, § 52A, and also affect other taxpayers (e.g., corporate trusts, [1] and members of flow-through entities and non-residents taxable under G.L. c. 62) to the extent that the corporate allocation and apportionment rules of G.L. c. 63, § 38 are applicable. The changes regarding the allocation of certain non-apportionable income also apply to financial institutions that are subject to G.L. c. 63, § 2A.

To the extent that this TIR is inconsistent with public written statements applying prior law, this TIR supersedes those documents.

II. Allocation of Certain "Non-apportionable" Income

When a corporation does business in more than one state, the state in which the corporation has its commercial domicile is generally the only state that has authority under the U.S. Constitution to tax income that is not derived from a unitary business or from transactions serving an operational function. See generally Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768, 787 (1992); TIR 92-5.

Prior to the enactment of the recent legislation, Massachusetts law generally provided that in the case of a corporation that was a multistate business, i.e., it had income from business activity that was taxable both within and without the state, all of the corporation's net income was subject to apportionment. G.L. c. 63, § 38(c)-(m). As a result, when such a corporation had its commercial domicile in Massachusetts and derived income that non-domiciliary states were constitutionally prohibited from taxing (income not derived from a unitary business or from transactions serving an operational function), Massachusetts only taxed a portion of such income (determined under the income apportionment rules of G.L. c. 63, § 38(c)-(m)), and the balance of such income was not taxable by any state.

The recent legislation amends several provisions in chapter 63 to require that when an entity has its commercial domicile in Massachusetts, it must fully allocate to Massachusetts the income that other states are prohibited from taxing under the U.S. Constitution. Specifically, the legislation amends section 38(b) of chapter 63 to state: "Notwithstanding any other provision of this section or of section 52A, the portion of the taxable net income of a corporation that a non-domiciliary state is prohibited from taxing under the Constitution of the United States shall be allocated in full to the commonwealth if the commercial domicile of the corporation is in the commonwealth." St. 2004, c. 262, § 41. This provision applies to domestic and foreign corporations taxable under the provisions of G.L. c. 63, § 30 et seq., as well as to utility corporations taxable under the provisions of G.L. c. 63, § 52A. [2]

The recent legislation also amends the provisions of section 2A of chapter 63 to state: "Notwithstanding any other provision of this section, the portion of the net income of a financial institution that a nondomiciliary state is prohibited from taxing under the Constitution of the United States shall be allocated in full to the commonwealth if the commercial domicile of the institution is in the commonwealth." St. 2004, c. 262, § 35. Further, since the allocation and apportionment rules of G.L. c. 63, § 38 are also applicable to corporate trusts under G.L. c. 62, § 8, the recent legislation makes clear that the new rules concerning the allocation of income that other states are constitutionally prohibited from taxing also apply to corporate trusts. See St. 2004, c. 262, § 12 (the Massachusetts adjusted gross income of a corporate trust is "allocated or apportioned in accordance with section 38 of chapter 63"). See TIR 04-25. In addition, the amendment to section 38(b) of chapter 63 will also affect other taxpayers to the extent that the corporate allocation and apportionment rules of G.L. c. 63, § 38 are applicable (e.g., members of flow-through entities and non-residents taxable under G.L. c. 62).

As noted, the intention of the recent legislation is to allocate income to Massachusetts that cannot be taxed by any other state because of the application of the U.S. Constitution. [3] Consequently, the legislation provides that "[i]n the event that 1 or more states characterize as subject to apportionment income that the commissioner considers to be allocable in full to the commonwealth under this act, the commissioner shall use his best efforts in consultation with the state or states to avoid subjecting the income to multiple taxation." St. 2002, c. 262, § 62.

The provisions of §§ 35, 41 and 62 of chapter 262 of the Acts of 2004 all apply with respect to income that is recognized on or after July 1, 2004. St. 2004, c. 262, § 73. Section 12 of the Act, which applies to corporate trusts, is effective for taxable years beginning on or after January 1, 2004. St. 2004, c. 262, § 67.

III. Sales Factor Apportionment Treatment of Internal Revenue Code Section 338 Transactions

Section 338 of the Internal Revenue Code (IRC) permits an election in certain instances to treat the acquisition of stock of a corporation as an acquisition of the corporation's underlying assets. Such an election may result in the acquiring party taking as the basis for depreciation of the acquired assets a stepped-up basis that reflects the assets' fair market value. For example, in Combustion Engineering, Inc. v. Commissioner, the Appellate Tax Board evaluated a transaction in which a parent corporation sold all of the stock in a wholly-owned subsidiary to an unrelated purchaser and elected with the purchaser pursuant to IRC § 338(h)(10) to treat the transaction as if the subsidiary sold all of its assets directly to the purchaser. A.T.B. Docket No. F228740 (2000).

The Board in Combustion Engineering agreed with the parties that, by virtue of the IRC election, the transaction resulted in Massachusetts income to the subsidiary and not the parent since state law defines net income generally by reference to the Internal Revenue Code. See G.L. c. 63, § 30. See also General Mills, Inc. v. Comm'r, 440 Mass. 154, 169-171 (2003) (concluding that a deemed asset sale pursuant to IRC § 338(h)(10) results in income to the deemed seller of the assets). However, the Board concluded that, while the transaction resulted in income to the subsidiary pursuant to chapter 63, the receipts from the transaction for purposes of the sales factor were attributable to the parent as proceeds from the sale of stock.

The Board relied upon language in section 38(f) that states that "[a]s used in this subsection, sales means all gross receipts of the corporation except interest, dividends, and gross receipts from the maturity, redemption, sale, exchange or other disposition of securities." G.L. c. 63, § 38(f) (emphasis added). The Board reasoned that, although the transaction was a "deemed" sale of assets for purposes of determining taxable income and the impact of future depreciation deductions, this deemed sales treatment does not follow through for purposes of the sales factor apportionment provisions. Consequently, the Board determined that, because the "actual" receipts from the transaction were from the sale of securities, the sales factor receipts were attributable to the parent corporation and further were excluded from the parent's sales factor pursuant to the securities exception set forth in G.L. c. 63, § 38(f), supra. Subsequent to Combustion Engineering, the Commissioner announced his acquiescence in that decision, first in TIR 01-11 and then in 830 CMR 63.38.(9)(b)7.

The recent legislation amends the apportionment provisions set forth in c. 63, § 38 by adding subsection (n) to state that "in any case in which a purchasing corporation makes an election under section 338 of the Code, the target corporation shall be treated as having sold its assets for purposes of this section." St. 2004, c. 262, § 43. This provision is effective for tax years beginning on or after January 1, 2005. St. 2004, c. 262, § 72. Consequently, beginning with this period, the Commissioner will no longer follow the Board's decision in Combustion Engineering and will no longer adhere to the position stated in TIR 01-11 or that stated in 830 CMR 63.38.1(9)(b)7 as it pertains to a deemed sale of assets. TIR 01-11 is hereby revoked and the Commissioner serves notice that he will shortly amend the provisions of 830 CMR 63.38.1(9)(b)7 to reflect the change to section 38 of c. 63 that shows the legislative intent to match income with sales factor apportionment in IRC § 338 transactions.

The provisions of 830 CMR 63.38.1(9)(b)7 also now state that, as in the case of an IRC § 338(h)(10) election, "a payment of a dividend by a subsidiary corporation to its parent that is deemed to be a sale of assets by the subsidiary under Code § 311(b) is not included in the subsidiary's sales factor even if the transaction results in the subsidiary's recognition of taxable net income." This language was added to the regulation subsequent to the decision in Combustion Engineering to conform the regulation to the decision in that case. Because the Department will no longer follow the decision in Combustion Engineering, a deemed sale of assets under IRC § 311(b) will now be reflected in a subsidiary's sales factor when the transaction results in the recognition of taxable net income by the subsidiary. Therefore, the Commissioner serves notice that he will no longer follow the provisions of 830 CMR 63.38.1(9)(b)7 as they relate to IRC § 311(b), and intends to amend the regulation to effect this change. [4]

IV. Sales Factor Apportionment Treatment of Intangible Licensing Transactions

Pursuant to G.L. c. 63, § 38(f), "[t]he sales factor is a fraction, the numerator of which is the total sales of the corporation in this commonwealth during the taxable year, and the denominator of which is the total sales of the corporation everywhere during the taxable year." Specific rules determine when it is that sales of tangible personal property are "in the commonwealth". Further, "[s]ales, other than sales of tangible personal property, are in this commonwealth" based upon the location of the "income-producing activity." G.L. c. 63, § 38(f).

The recent legislation amends the provisions of section 38(f) to specify that "in the case of the licensing of intangible property, the income-producing activity will be deemed to be performed in the commonwealth to the extent that the intangible property is used in the commonwealth." St. 2004, c. 262, § 42. In applying the general language concerning "income-producing activity" as set forth in section 38(f) to a discrete set of transactions involving the licensing of intangibles, the amendment restates and clarifies existing law in a manner consistent with the Commissioner's prior interpretation and practice. See 830 CMR 63.38.1.9(d)3.c. Consequently, section 42 of chapter 262 of the Acts of 2004 became effective on passage.

/s/Alan LeBovidge

Alan LeBovidge,

Commissioner of Revenue

AL:LEM:mtf

181684

December 8, 2004

TIR 04-22


[1] The effect on corporate trusts of the changes regarding the allocation of certain non-apportionable income, in particular, is discussed in more detail in TIR 04-25.

[2] Expenses that are specifically and directly related to allocable income may first be deducted against allocable income. When a loss results from a transaction that would have given rise to allocable income under c. 63, § 38(b) and this TIR (if the transaction had in fact resulted in income rather than a loss), the loss is an allocable loss. Allocable losses may be offset first against allocable income and then against apportioned income.

Pursuant to G.L. c. 63, § 30, a foreign or domestic corporation may deduct certain net operating losses (NOLs) against its net income. Consequently, a foreign or domestic corporation can deduct allowable NOLs against either its allocated income or its apportioned income. However, because NOLs generally result from business activities, a multistate business must first deduct such losses against apportionable income.

[3] In some cases, a corporation's income is not taxable in another state because of the application of a federal statute, 15 U.S.C. § 381 et seq. Corporate income that is not taxed in another state due solely to the provisions of P.L. 86-272 is not allocable income within the meaning of this TIR.

[4] The legislative change relative to Combustion Engineering applies to corporate trusts, as (i) the recent legislation provides that "that for purposes of any determination involving sections 311, 312, 332 to 338, inclusive or 346 to 368, inclusive, of the Code, any corporate trust shall be treated as a corporation" (St. 2004, c. 262, § 12), and (ii) as discussed above in Part II of this TIR the corporate allocation and apportionment rules of G.L. c. 63, § 38 also apply to corporate trusts. In addition, this change as well as the change discussed in part IV of this TIR infra will apply to other corporations or any other taxpayers to the extent that they utilize the corporate allocation and apportionment rules (e.g., utility corporations, members of flow-through entities, and non-residents).