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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

2/7/07

HB 535

SHORT TITLE Mandate Combined Income Tax Reporting

SB

ANALYST Francis

REVENUE (dollars in thousands)

Estimated Revenue

Recurring

or Non-Rec

Fund

Affected

FY07

FY08

FY09

6,000.0

20,000.0 Recurring General Fund

(Parenthesis ( ) Indicate Revenue Decreases)

SOURCES OF INFORMATION

LFC Files

Taxation and Revenue Department

Center for Budget and Policy Priorities

Responses Received From

Taxation and Revenue Department

SUMMARY

Synopsis of Bill

House Bill 535 lowers corporate income tax rates and makes combined reporting mandatory for

unitary corporations—corporations that are made up of two or more integrated corporations.

Under current law, the corporate income tax rates are:

Table 1: Current and Proposed Corporate Income Tax Rates

Current

Law HB535

Not over $500,000

4.8

4.0

$500,000 to $1,000,000

6.4

5.4

Over $1,000,000

7.6

6.4

Corporations currently can opt to file consolidated or combined reports. HB535 would require

corporations to file a return to show the income of the entire corporation

House Bill 535 – Page

2

The effective date is January 1, 2008.

FISCAL IMPLICATIONS

According to the Taxation and Revenue Department (TRD), making combined reporting manda-

tory will increase corporate income tax revenues by 20 percent or $80 million per year. Lower-

ing the tax rates will decrease corporate income tax revenues by about $60 million, making the

net impact $20 million.

TRD:

Because of the nature of corporate income tax filing, the fiscal impact estimates for this pro-

posal are more uncertain than those for most other legislative proposals. Among other things,

corporate tax collections fluctuate widely with the business cycle. Since we are now near the

top of a cycle in collections of this tax – due to unusually high oil and gas industry revenue –

the $20 million fiscal impact is higher than the average amount that would be generated in

most years.

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.

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-

House Bill 535 – Page

3

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.

TRD has provided additional information included as an appendix.

ADMINISTRATIVE IMPLICATIONS

TRD reports that the change in the tax rate will not be burdensome but the change to combined

reporting will require a new set of procedures.

TECHNICAL ISSUES

TRD:

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

dends 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 con-

solidated filers. (Subpart F income is income earned by controlled foreign corporations 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.)

NF/sb

House Bill 535 – Page

4

Appendix: Additional Information from Taxation and Revenue Department

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 en-

tity 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 prof-

its to their out-of-state affiliates by inflating inter-company charges to the in-state entity. Be-

cause affiliated corporations almost always file a single “consolidated" return for federal pur-

poses, the inter-company charges are not subject to federal audit scrutiny. Policing the legiti-

macy 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 filing, 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 ab-

solute 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 illustra-

tion below, about 16 states require combined reporting.

.1

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 costs states corporate income tax reve-

nues

2) Eliminating SCE will make state corporate income tax practices more uniform than they cur-

rently 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

1

Please see page 6 the Massachusetts Budget and policy Center report referenced earlier:

http://www.massbudget.org/recordoncr.pdf. See also "2001 Multistate Tax Guide", Volume 1, John Healy editor,

Panel Publishers, pp I-833-I-837. Note: minor discrepancies exist in the data provided by the two sources.

House Bill 535 – Page

5

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 en-

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

ferred to as "the ladder" because when moving from separate corporate entity to combined, then

federal consolidated reporting, firms include greater amounts of corporate income in amounts of

income reported. All three filing options require allocation and apportionment under the Uniform

Division of Income for Tax Purposes Act (UDITPA). UDITPA and associated regulations pro-

vide rules whereby corporations or groups of corporations operating in more than one state di-

vide 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 report, they are allowed to employ a different filing method without permission

from the Department so long as they select a higher po-

sition 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 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 sepa-

rated 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 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 unitary businesses --

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

ingly. 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 apportionment 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 ladder, 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 Colorado and

Firm B

Firm A

Colorado

New Mexico

Sub

A

Sub C

Sub B

Sub D

House Bill 535 – Page

6

New Mexico. Firm A operates partially within both states, but firm B’s physical presence is lim-

ited 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 exam-

ple, shared trademarks, ownership, purchasing or other activities.

Under separate corporate entity reporting, firm A is allowed to report as if it were a separate en-

tity totally unrelated to firm B or the subsidiaries. That is, firms A and B are not considered uni-

tary. Total income produced by firm A would be taxable, but firm A’s business income would be

apportioned between Colorado and New Mexico using the three-factor apportionment formula.

Three income and apportionment factors of Firm B and the various subsidiaries would be ig-

nored. If firm B is a subsidiary of A, firms A 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 reporting 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 busi-

ness, their incomes would not be counted, nor would their activities be accounted for in the ap-

portionment factor. If federal consolidated group reporting is employed, all firms and subsidiar-

ies' incomes shown in the figure would be combined, including apportionment factors and in-

comes that are not considered part of the unitary businesses. Many inter-group 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 involves

increasing taxable income from a group of business organizations attributable to a single tax-

payer -- 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 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 assumption that firms choose the filing method that gener-

ates the lowest tax obligations. To the extent that it causes firms to cease doing business in a par-

ticular 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 returns 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 obligations, 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 aver-

aged roughly $62,000 per return. Major SCE filers consisted primarily of firms in the mineral

extraction, manufacturing and retail industry. Firms in mineral extraction industries are also

heavily represented among combined and consolidated filers.