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The still-rising tide
Will investment managers be swept up in state income tax trends?
More and more states are looking to increase state income tax revenues by expanding their definition of nexus beyond physical presence to include “economic activity” in the state—a trend that has continued for several years.
This article by Gregory A. Bergmann and Keith Gray of Deloitte Tax LLP was originally published in the Journal of Taxation of Investments.
More states are moving from cost of performance to market-based sourcing for receipts from services and intangibles. The question thus arises: Do these new rules apply to investment funds and investment managers? If they do, the partners in the funds and fund managers may face new state tax liabilities as well as some sticky compliance and withholding rules.
Two state tax trends—economic nexus and market-based sourcing of the receipts factor—create challenges for investment funds and investment managers. Many in the industry are wondering just how far the states intend to go in taxing out-of-state businesses. Do these economic nexus and market-based sourcing rules apply to investment funds treated as partnerships for federal tax purposes and investment managers, or is investing not considered a business?1 In this article, we will discuss both trends and highlight some of the related issues that have arisen for investment managers.
The term “nexus” describes the degree of activity that an out-of-state business must have in a state before that state has the right to impose a tax or filing obligation on the business. Economic nexus is a recent concept where a state, through statute or administrative guidance, asserts that economic activity in the state other than physical presence in the state is sufficient to create nexus.
For example, in California a specified level of sales to customers in the state creates nexus,2 while in Michigan the “active solicit[ation] of customers in the state” (e.g., maintenance of an internet site over and through which customers may browse products/services and place orders)3 could create nexus.
Before discussing in greater detail the aspects of economic nexus and the implications for investment funds and investment managers, a review of general state income tax nexus concepts is worthwhile.
Overview of nexus
Nexus is measured by state statutes, case law, and the due process and commerce clauses of the US Constitution. In most, if not all states, nexus exists for state tax purposes when a business has a physical connection to the state, through either (1) owning or leasing property in the state or (2) employing personnel in the state, provided that such in-state activity is deemed to be greater than a “de minimis” level of activity.
Interpreting the due process clause, courts have held that the minimum connection standard is met if the business purposefully directs its activity into a jurisdiction.4
A more stringent connection standard exists under the commerce clause, which requires the business to have a “substantial presence” in the state before the requisite connection is established.5
Based on the US Supreme Court’s decision in Quill Corp. v. North Dakota,6 many commentators believe that in order to satisfy the commerce clause “substantial nexus” requirement, a business must have a “physical presence” in a state before the state may impose a net income tax on the entity. However, many state tax administrators contend that the physical presence standard identified in Quill is limited to sales and use taxes, and therefore a business need not have a physical presence in a state before the state can subject the business to a net income tax.
This has also been the trend in recent litigation, where state courts in various jurisdictions have held that a physical presence is not required to impose an income-based tax.7 Note that none of these cases involved investment funds or investment managers. While legislation has been introduced in Congress in recent years that would specifically apply the Quill standard to all state business activity taxes, including net income taxes, this legislation has generally not made it out of committee.8
Additionally, nexus can be created by using independent contractors to conduct business in a state. In Scripto, Inc. v. Carson,9 the US Supreme Court ruled that the use of independent brokers satisfied the due process requirement that there be a definite link or a minimum connection between a state and the person the state wants to tax. In
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1 For example, in Appeal of Bass, 89-SBE-004 (Jan. 25, 1989), available at https://www.boe.ca.gov/legal/pdf/89-sbe-004.pdf, the California State Board of Equalization held that a partnership that acquired, held, monitored, and disposed of corporate stock and other securities was engaged in investment activities that did not rise to the level of a trade or business.
2 California’s “doing business” statute also contains bright-line thresholds based on payroll and property in the state, which, if triggered, establish nexus through physical presence rather than through “economic activity.” We also note that the sales factor statutory threshold arguably serves as a proxy for a more holistic analysis of “economic activity” in the state. In this article, we focus on the “economic activity” implications of exceeding only the sales factor threshold where there is no physical presence and, thus, the term “economic nexus” is generally used throughout.
3 Mich. Comp. Laws § 206.621(1); Rev. Admin. Bull. 2013-9, available at http://www.michigan.gov/documents/taxes/RAB2013-9_423463_7.pdf.
4 See Nat’l Bellas Hess, Inc. v. Dep’t of Rev. of Illinois, 386 US 753 (1967).
5 See Complete Auto Transit, Inc. v. Brady, 430 US 274 (1977).
6 504 US 298 (1992). In Quill the US Supreme Court held that North Dakota could not require an out-of-state mail order retailer to collect use tax for sales to customers in the state because the retailer did not have physical presence in North Dakota.
7 See, e.g. MBNA Am. Bank, N.A. v. Indiana Dep’t of Rev., 895 NE2d 140 (In. Tax Ct.2008); KFC Corp. v. Iowa Dep’t of Rev., 792 NW2d 308 (Ia. 2010), cert. denied, 132 S. Ct. 97 (2011); Geoffrey, Inc. v. Comm’r, 899 NE2d 87 (Ma. 2009), cert. denied, 557 US 920 (2009); Lanco, Inc. v. Div. of Tax’n, 879 A2d 1234 (N.J. Super. Ct. App. Div. 2005), cert. denied, 551 US 1131 (2007); Geoffrey, Inc. v. South Carolina, 437 SE2d 13 (S.C. 1993), cert. denied, 510 US 992 (1993); Tax Comm’r of West Virginia v. MBNA Am. Bank, 640 SE2d 226 (W.Va. 2006), cert. denied, 551 US 1141 (2007); Secretary, Dep’t of Revenue v. Gap (Apparel), Inc., 886 So.2d 459 (La. Ct. App. 1st Cir. 2004); Couchot v. State Lottery Comm’n, 659 NE2d 1225 (Oh.), cert. denied, 519 US 810 (1996); Crutchfi eld Corp. v. Testa, 2016-Ohio-7760, 2016 Ohio LEXIS 2809 (Oh. 2016).
8 The “Business Activity Tax Simplifi cation Act” was introduced several times. See H.R.3220, 108th Cong. (2003); H.R. 1956, 109th Cong. (2006); H.R.1439, 112th Cong. (2011); H.R. 2992, 113th Cong. (2013); H.R. 2584, 114th Cong. (2015). On June 12, 2017, H.R. 2887, 115th Cong. (2017)—the No Regulation Without Representation Act of 2017—was introduced.
9 362 US 207 (1960).