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December 18, 2014

State Taxpayers: One Thing’s Consistent—There’s No Duty of Consistency

Taxpayers resisting audit requests for tax returns filed in other states, or requests for details about the treatment of an item in another state, now have another quill in their arsenal besides the 2010 Oregon Tax Court decision in Oracle Corp. v. Dep’t of Rev., 2010 Ore. Tax LEXIS 32 (Or. T.C. 2-11-10).  The New Jersey Tax Court recently issued a letter opinion in Elan Pharmaceuticals, Inc. v. Director, Division of Taxation, Tax Court Dkt. 010589-2010 (May 1, 2014), reiterating that a taxpayer is not required to treat an item in exactly the same way it treats it in another state.

Like OracleElan Pharmaceuticals involves the business/non-business distinction (called the operational/non-operational distinction in New Jersey vernacular).  Apparently, the company reported its gain from the sale of certain operations as business (i.e., “operational”) income on its California Franchise Tax Return, but reported the same gain as nonbusiness (i.e., “nonoperational”) income on its New Jersey Corporation Business Tax Return.  These facts largely mirror those in Oracle, except that the state involved was Oregon, not New Jersey.

During the Division of Taxation’s audit of the company, the gain was recharacterized as business income, which resulted in a substantial deficiency.  While the Division’s position was based on a number of factors, including its determination that the company never ceased conducting the line of business it purportedly disposed of, the Division was clearly influenced by the company’s treatment of the gain in California.  In fact, the Division asserted that because the company treated the gain as apportionable business income in California, it could not treat it as non-apportionable nonbusiness income elsewhere.

Like the Oregon Tax Court, the New Jersey Tax Court rejected such a purported duty of consistency.  The Court stated that a requirement of consistency, while “appealing under pure common sense, and in light of the purpose of the UDIPTA, . . . does not mean that [the company] is barred from seeking application of New Jersey law when challenging a New Jersey tax assessment.”  The Court continued:  “this court should be guided by N.J.S.A. 54:10A-6.1(a), New Jersey’s basis for taxing operational income, and the binding law construing that statute, not the consequent result of such treatment in another State.”

Ultimately, the Tax Court agreed with the Division of Taxation that the company’s gain was apportionable business income, relying largely on the unitary business principle (an aspect of the matter that appears not to have been fully developed on the record or addressed by the parties during briefing).  Still, the Court’s mandate that the actual treatment of an item in another state not be binding for New Jersey purposes is important.  It’s also entirely consistent with another recent Tax Court decision—Lorillard Licensing Co., LLC v. Director, Division of Taxation, N.J. Tax Ct. Dkt. A-2033-13T1 (Jan. 14, 2014), in which the Tax Court determined that whether or not another state actually imposes income tax on receipts is irrelevant for purposes of computing New Jersey’s now-defunct “throw out rule” so long as the other state would have had the authority to impose an income tax based on New Jersey’s own economic nexus standards.

How can decisions like OracleElan Pharmaceuticals, and even Lorillard, help taxpayers during audits and when establishing reserves for contingent positions?  As a practical matter, these are terrific cases to provide to auditors when the auditor asks how items are treated in other states.  For example, it is quite common for auditors to request a company’s 50-state apportionment worksheet.  Taxpayers often dread this request because it raises precisely the situation addressed in Oracle andElan Pharmaceutical—that a department of revenue will undermine any favorable positions taken by a taxpayer if the taxpayer took an apparently inconsistent position elsewhere, regardless of the legal or factual basis for the apparent inconsistency.  Of course, a reasonable response is refusal to provide the document on the basis that other states’ treatment of items is entirely irrelevant—and these cases support that defense.  Another approach is to complete the form as if every state imposed the same laws as the requesting state and administered them the same way, being sure to include a statement on the form indicating the approach used.  This method has been effective in a number of state audits.

The cases are also helpful to reference in tax reserve memos and opinions, both when inconsistent positions were actually taken in states and when a liability or benefit being booked relates to an inconsistent position.

OracleElan Pharmaceuticals, and Lorillard are good reminder that companies can—and should—explore all of their options before automatically treating items identically on returns filed throughout the country.  This is true, of course, with the business/non-business distinction as addressed inOracle and Elan Pharmaceuticals.  But it is also true with respect to other portions of a tax return, such as apportionment.  It is not unusual to find that a slight wording difference in a statute or regulation, or a department of revenue or state court’s interpretations of a statute, provide sufficient basis for taking seemingly contradictory favorable positions.

© 2014 McDermott Will & Emery

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In 1934 E.H. McDermott opened a law practice that focused exclusively on taxes. As chief counsel to the Joint Committee on Taxation of the United States Congress, McDermott observed firsthand how the rapidly expanding federal tax laws were affecting businesses and individuals. He recognized the need for a law firm to assist people and their businesses to understand and comply with their changing tax obligations.

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