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F I S C A L I M P A C T R E P O R T
SPONSOR Wirth
ORIGINAL DATE
LAST UPDATED
1/18/06
1/25/06 HB 123
SHORT TITLE Corporate Income Tax Rates and Reporting
SB
ANALYST Francis
REVENUE (dollars in thousands)
Estimated Revenue
Recurring
or Non-Rec
Fund
Affected
FY06
FY07
FY08
20,000.0
40,000.0 Recurring General Fund
See narrative for detail
(Parenthesis ( ) Indicate Expenditure Decreases)
SOURCES OF INFORMATION
LFC Files
Taxation and Revenue Department (TRD)
Responses Received From
Taxation and Revenue Department (TRD)
SUMMARY
Synopsis of Bill
House Bill 123 amends the corporate income and franchise tax act (7-2A-5 NMSA 1978) by re-
quiring all unitary corporations to file a combined return with other unitary corporations as
though they were a single corporation. HB 123 also reduces the top corporate income tax rate
from 7.6 percent to 7.2 percent. The top rate applies to corporations with income greater than $1
million.
The provisions of the bill are applicable beginning January 1, 2007.
FISCAL IMPLICATIONS
The Taxation and Revenue Department (TRD) has estimated that requiring combined reporting
would increase general fund revenues by 20 percent. In FY06, that increase is $30 million and in
FY07 and beyond that increase is $60 million.
pg_0002
House Bill 123 – Page
2
Decreasing the top CIT rate from 7.6 percent to 7.2 percent will reduce CIT collections by $10
million in FY06 and $20 million in FY07 and beyond.
Table 1: Net Impact of HB 123 (Thousands of Dollars)
FY06 FY07 FY08
Mandatory Combined Reporting 30,000 60,000 60,000
Top CIT Rate Cut (10,000) (20,000) (20,000)
Total Impact 20,000 40,000 40,000
Corporate income tax collections are extremely volatile. Collections are currently estimated to
be $340 million in FY06 according to the Consensus Revenue Group, which is a high for CIT
collections. In FY05, CIT revenue was $250 million and before that as low as $120 million.
Most of the volatility comes from the oil and gas industry which has had a spectacular year.
Prices for oil and gas are at record highs and though they are expected to come down, they will
come down to a level that is still fairly high by historical standards.
Numbers of Filers by Filing Method
In tax year 2003, approximately 16,000 firms filed New Mexico corporate income tax returns as
separate corporate entities (SCE). 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 obligations, while federal con-
solidated 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 approxi-
mately $4,000, while combined filers averaged approximately $36,000 per return and consoli-
dated filers averaged roughly $62,000 per return. Major SCE filers consisted primarily of firms
in the mineral extraction, manufacturing and retail industry. Firms in mineral extraction indus-
tries are also heavily represented among combined and consolidated filers.
SIGNIFICANT ISSUES
Combined Reporting: Most corporations only do business in one state and so their CIT filing is
relatively straight-forward and combined reporting is not an issue for them. Where combined
reporting is an issue is where companies have significant operations in a state but very little in-
come when they file as separate entities, an option for NM CIT reporting. The use of subsidiar-
ies called “passive investment companies,” or PICs, has proliferated in the last decade which is
the primary reason states are moving towards requiring combined reporting. A PIC generally
has no economic activity other than the ownership of intangibles like trademarks, logos, copy-
rights and patents. The PIC is a subsidiary of the parent corporation so only the parent corpora-
tion benefits from the proceeds of the PIC.
For example, if two companies have competing retail operations in the state. Company A is lo-
cal and so all of their income is accounted for on their CIT return. Company B has a PIC in
Delaware (the host of many PICs since there is no corporate income tax) which owns the logo
and trademark that Company B uses to market its products. Company B leases the intangible
property from the PIC for an amount that roughly equals its net income. Company B now has a
competitive advantage over Company A because they have not paid any income tax in NM since
they shifted it to their PIC in a state where there is no income tax.
pg_0003
House Bill 123 – Page
3
Table 2: PIC Example
Company A Company B
Revenue
1,000,000
1,000,000
Operating Costs
500,000
500,000
Lease Costs for Intangibles (logos, trademarks)
0
350,000
Net Income in NM (@ 5.8%)
500,000
150,000
NM Income Tax
29,000
8,700
As Table 2 shows, Company A has a competitive disadvantage since it is paying three times the
corporate income tax as company B. This is a very simplistic example to demonstrate the prob-
lem. Actual corporate income tax filings are infinitely more complicated but the advent of man-
datory combined reporting occurred because of the aggressive tax planning multi-state corpora-
tions have engaged in. By combining the mandatory combined reporting with a decrease in the
corporate income tax rate, companies that will be impacted by the combined reporting require-
ment who have economically valid multi-state transactions will benefit from the lower corporate
income tax rate.
During testimony at the Revenue Stabilization and Tax Policy Interim Committee (RSTP), TRD
indicated that approximately 2 percent of corporations would be affected by requiring combined
reporting. Most corporations in New Mexico are single location companies who will not be af-
fected at all by combined reporting. These companies will to the extent that they have more than
$1 million in income will benefit from the decrease in the top CIT rate.
At the same RSTP meeting, representatives of the Association on Commerce and Industry (ACI)
indicated that the proposal unnecessarily complicates the tax system and would make New Mex-
ico uncompetitive in attracting economic development.
Sixteen states currently require combined reporting: Alaska, Arizona, California, Colorado, Ha-
waii, Idaho, Illinois, Kansas, Maine, Minnesota, Montana, Nebraska, New Hampshire, North
Dakota, Oregon, and Utah. Many of them are in the West and are New Mexico’s neighbors.
The only neighbors that do not require combined reporting are Oklahoma and Texas and Texas
does not have an income tax. Table 3 has the detail provided by TRD.
pg_0004
House Bill 123 – Page
4
TRD provided the following table – nearby states are in bold:
Table 3: Illustration: Corporate Income Tax Rates and Combined Filing Status Requirement
State
Tax Rates
Tax Brackets
# of Brackets
Mandatory Combined.
Alabama
6.5
----Flat Rate----
1
No
Alaska
1.0 - 9.4 10,000 90,000
10
Yes
Arizona
6.968 (b)
----Flat Rate----
1
Yes
Arkansas
1.0 - 6.5 3,000 100,000
6
No
California
8.84 (c)
----Flat Rate----
1
Yes
Colorado
4.63
----Flat Rate----
1
Yes
Connecticut
7.5 (d)
----Flat Rate----
1
No
Delaware
8.7
----Flat Rate----
1
No
Florida
5.5 (f)
----Flat Rate----
1
No
Georgia
6.0
----Flat Rate----
1
No
Hawaii
4.4 - 6.4 (g) 25,000 100,000
3
Yes
Idaho
7.6 (h)
----Flat Rate----
1
Yes
Illinois
7.3 (i)
----Flat Rate----
1
Yes
Indiana
8.5
----Flat Rate----
1
No
Iowa
6.0 - 12.0 25,000 250,000
4
No
Kansas
4.0 (l)
----Flat Rate----
1
Yes
Kentudky
4.0 - 8.25 25,000 250,000
5
No
Louisiana
4.0 - 8.0 25,000 200,000
5
No
Maine
3.5 - 8.93
(m) 25,000 250,000
4
Yes
Maryland
7.0
----Flat Rate----
1
No
Massachusetts
9.5 (n)
----Flat Rate----
1
No
Minnesota
9.8 (o)
----Flat Rate----
1
Yes
Misissippi
3.0 - 5.0 5,000 10,000
3
No
Missouri
6.25
----Flat Rate----
1
No
Montana
6.75 (p)
----Flat Rate----
1
Yes
Nebraska
5.58 - 7.81 50,000
2
Yes
New Hampshire
8.5 (q)
----Flat Rate----
1
Yes
New Jersey
9.0 (r)
----Flat Rate----
1
No
New Mexico
4.8 - 7.6 500,000 1 million
3
No
New York
7.5 (s)
----Flat Rate----
1
No
North Carolina
6.9 (t)
----Flat Rate----
1
No
North Dakota
2.6 - 7.0 3,000 30,000
5
Yes
Ohio
5.1 - 8.5 (u) 50,000
2
No
Oklahoma
6.0
----Flat Rate----
1
No
Oregon
6.6 (b)
----Flat Rate----
1
Yes
Pennsylvania
9.99
----Flat Rate----
1
No
Rhode Island
9.0 (b)
----Flat Rate----
1
No
South Carolina
5.0
----Flat Rate----
1
No
Tennessee
6.5
----Flat Rate----
1
No
Utah
5.0 (b)
----Flat Rate----
Yes
Vermont
7.0 - 9.75
(b) 10,000 250,000
4
No
Virginia
6.0
----Flat Rate----
1
Not a unitary state
Wst Virginia
9.0
----Flat Rate----
1
No
Wisconsin
7.9
----Flat Rate----
1
No
Information Sources: Federation of Tax Administrators web site; "2001 Multistate Corporate Tax Guide", Panel Publishers and "Setting the Re-
cord Straight on Combined Reporting" published by the Massachusetts Budget and Policy Center Notes: Wyoming, South Dakota, Nevada,
Washington ,Texas and Michigan do not impose corporate income taxes.
ADMINISTRATIVE IMPLICATIONS
TRD has reported that the administrative costs are expected to be relatively modest.
pg_0005
House Bill 123 – Page
5
TECHNICAL ISSUES
TRD: 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 consoli-
dated filers. (Subpart F income is income earned by controlled foreign corps in tax haven coun-
tries. It is treated as a “deemed dividend” by the U.S. Internal Revenue Code since it may never
be formally repatriated.)
OTHER SUBSTANTIVE ISSUES
Detailed TRD analysis of substantive issues:
Current Practice and Probable Basis for the Proposed Legislation.
Under current law, each member of an affiliated group of corporations may file as a separate
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 corporations 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 “consolidated” return for
federal purposes, the inter-company charges are not subject to federal audit scrutiny. Polic-
ing 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 corporate 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 larger 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.
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-Passive Investment Company” 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 combining to avoid income distortion. The discretionary powers necessary to
properly implement 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. 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 operations, 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 business segments or separate
entities are interdependent. As shown in the illustration below, about 16 states require com-
bined reporting..
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
pg_0006
House Bill 123 – Page
6
2) Eliminating 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 view that states
lose substantial corporate income tax revenue by allowing consolidated filing. 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 New Mexico statutes allow groups of affiliated firms to file as "separate corporate
entity" (SCE), "unitary combined" and "federal consolidated group". This option is some-
times referred to as "the ladder" because when moving from separate corporate entity to
combined, then federal consolidated reporting, firms include greater amounts of corporate in-
come in amounts of income reported. All three filing options require allocation and appor-
tionment under the Uniform Division of Income for Tax Purposes Act (UDITPA). UDITPA
and associated regulations provide rules whereby corporations or groups of corporations op-
erating in more than one state divide income and expenses among the states in which they
operate. It provides special rules, for exam-
ple, for airlines, railroads, construction con-
tractors, trucking companies, broadcasters,
and to firms in the publishing and financial
industries. In tax years following the first
one in which corporations report, they are al-
lowed 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 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 Depart-
ment; and the Department does not generally
allow the election unless the proposed new
reporting method is a better reflection of in-
dustry practices than the one the firm cur-
rently 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 determining whether a group of businesses constitutes a unitary
business, yet the practical effect of the concept is that, once a group of businesses has been
Firm B
Firm A
Colorado
New Mexico
Sub A
Sub C
Sub B
Sub D
pg_0007
House Bill 123 – Page
7
defined as a unitary group, the only feasible approach to sourcing their incomes is via com-
bining incomes from all group members and subjecting them to formula apportionment. New
Mexico statutes currently allow firms some freedom in defining the composition of their uni-
tary 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 options allowed for filing
returns. As illustrated in the figure below, the proportion of business activity subject to ap-
portionment increases as a firm moves from separate corporate entity to combined and then
federal consolidated group reporting. New Mexico statutes allow firms to move up the lad-
der, but not down without permission of the Taxation and Revenue Department Secretary.
Differences in the three filing methods can be understood with the aid of the figure. Assume,
as illustrated in the figure, that two affiliated firms -- firm A and firm B -- operate in Colo-
rado and New Mexico. Firm A operates partially within both states, but Firm B’s physical
presence is limited to Colorado. Firm B controls a number 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 allowed to report as if it were a separate
entity totally unrelated to Firm B or the subsidiaries. That is, Firms A and B are not consid-
ered unitary. Total income produced by firm A would be taxable, but Firm A’s business in-
come would be apportioned between Colorado and New Mexico using the three-factor appor-
tionment formula. Income and apportionment factors of Firm B and the various subsidiaries
would be ignored. If Firm B is a subsidiary of A, Firms A and B would each file separate re-
turns based on the proportion of business conducted in New Mexico by each firm. Under a
combination of domestic unitary corporations reporting system, firms A and B would com-
bine 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 incomes would not be counted, nor would their
activities be accounted for in the apportionment factor. If federal consolidated group report-
ing is employed, all firms and subsidiaries' incomes shown in the figure would be combined,
including apportionment factors and incomes that are not considered part of the unitary busi-
nesses. 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 apportionment factor.
Effects on Tax Obligations
The movement from separate corporate entity to combined, then consolidated reporting in-
volves 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 income
is added to the group, however, data from its activities also flows into the apportionment
formula. To the extent that the subsidiary has no instate activities, it lowers the apportion-
ment percentage, thus decreasing tax obligations. Whether the firm’s total tax obligation in-
creases or decreases depends on whether the former effect exceeds the latter one. Eliminat-
ing filing options is almost always expected to increase revenues, on the assumption 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.
pg_0008
House Bill 123 – Page
8
WHAT WILL BE THE CONSEQUENCES OF NOT ENACTING THIS BILL
Companies will still be able to shift incomes from NM to other states where there is no income
tax.
POSSIBLE QUESTIONS
What kind of transactions are valid between unitary corporations. In other words, what legiti-
mate business practices will be affected by making combined reporting mandatory.
NF/mt