Downstream Consequences Coming Into Focus A Year After Mississippi’s AT&T Dividend Decision
In October 2016, the Mississippi Supreme Court issued its long-awaited decision in Mississippi Department of Revenue v. AT&T Corporation, concluding the state’s dividend exclusion statute violated the Commerce Clause of the United States Constitution. The statute, Miss. Code Ann. Section 27-7-15(4)(i), unconstitutionally discriminated against interstate commerce by excluding from Mississippi gross income any dividends received from subsidiaries doing business and filing income tax returns in the state, while taxing identical dividends received from “non-nexus” subsidiaries having no Mississippi presence.
Following the AT&T decision, effectively no dividends remain taxable for Mississippi corporate income tax purposes. Longstanding Department of Revenue regulations classify dividends from foreign subsidiaries as non-business income, so the Court’s decision expanding the Section 27-7-15(4)(i) exclusion to encompass non-nexus dividends now renders virtually all domestic dividends exempt.
That practically universal dividend exclusion, however, has produced several important downstream consequences over the past year that could reduce the benefit from that decision, in many recent cases having resulted in material income and franchise tax audit adjustments.
Income Tax Apportionment – On its corporate audit schedules, the Department now routinely includes all dividends – domestic and foreign – in nonbusiness income. In computing the sales factor, all nonbusiness income is removed from gross receipts when calculating both the numerator and denominator of that ratio. Because very few multistate corporate taxpayers would have had any dividends sourced to Mississippi, this removal serves almost exclusively to reduce the denominator, thereby inflating the sales factor. In some egregious cases, this could double or even triple a company’s Mississippi sales factor. In a single sales factor scenario this could materially reduce the benefit received from the exclusion of those dividends from gross income.
Franchise Tax Apportionment – Several years ago, the Mississippi Legislature amended the franchise tax statutes to provide that the gross receipts for franchise tax apportionment purposes would be the same as those calculated for income tax. Mississippi’s franchise tax apportionment ratio consists of a modified two-factor formula that adds together the in-state tangible real and personal property (often narrower than the income tax property factor) to the Mississippi gross receipts, and then divides that total by the similarly computed worldwide combined factors. In other words, there is one combined numerator divided by a single combined denominator, rather than two separately calculated factors added together and divided by two. The removal of these “non-business” domestic dividends from the income tax sales denominator will have a similar – and often more material – impact on the franchise tax side. This can be a significant adjustment for companies having large amounts of passive income but not meeting the rigid statutory requirements of the franchise tax holding company exemption. Because the franchise tax statutes contain no direct alternative apportionment authority as do the income tax laws, defending this “flow-over” adjustment is often more challenging.
Interest Expense – Acquisition Debt. Mississippi does not permit the deduction of “interest upon indebtedness for the purchase of . . . stocks, the dividends from which are nontaxable under the provisions of this article.” Miss. Code Ann. Section 27-7-17(1)(b). There is no business purpose exception to this disallowance as there is for interest on debt used to purchase treasury stock or pay dividends. Since all dividends are now considered “nontaxable under the provisions of [the income tax] article” the Department recently has begun to look more closely at the origin of corporate obligations and has been aggressively disallowing the interest expense deduction if there is any reference within the company’s annual reports, press releases, or other sources to suggest third-party debt was used to purchase another corporation’s stock. It should be noted that acquisitions of entities other than corporations, such as partnerships and limited liability companies, do not appear to fall within this disallowance since those types of earnings are not statutorily exempt like dividends. This position is still in its infancy, and it is yet to be seen whether or to what extent the auditors will grant taxpayers any leeway in cases where debt was used for acquisitions as well multiple other non-acquisition purposes. There may be multiple ways, however, to address these issues depending on a company’s particular facts and circumstances.
Interest Expense – Nonbusiness Asset Ratio. Mississippi utilizes a “non-business asset ratio” to calculate that portion of a company’s overall interest expense purportedly attributable to the generation of non-business income, and the Department has been very aggressive on audit in using that formula to disallow otherwise ordinary and necessary interest deductions. Historically, investments in foreign subsidiaries have been included in the numerator of that ratio since the income tax regulations classify foreign dividends as nonbusiness income (queue a Foreign Commerce Clause challenge). Unitary domestic dividends, however, technically do not constitute nonbusiness income, so the investments in those domestic subsidiaries arguably should not enter that equation. The authors have seen domestic investments included in that formula on a few preliminary audit workpapers, so taxpayers should diligently review any proposed adjustments to determine if that inclusion is being made.
Could Some Dividends Remain Taxable? The Court relied on the internal consistency test from Maryland v. Wynne to isolate and quantify the discriminatory effect of the exclusion statute in double taxing a non-nexus subsidiary’s earnings. In theory, however, a subsidiary could earn 100% of its income in a state not imposing an income tax, in which case Mississippi’s taxation of those domestic dividends would not result in the double taxation of the non-nexus subsidiary’s earnings found offensive by the Court since no state would have taxed those earnings at the operational level. In that rare case, application of the statute may not produce an unconstitutional result, although it still would be constitutionally suspect under a facial discrimination analysis, which the Court did not reach in AT&T. The authors have not seen this hypothetical fact pattern arise in any cases so far, and are unaware of the Department making such inquiries on audit given the rarity of such a scenario.
The Department was very concerned about the fiscal impact of the AT&T decision, especially given Mississippi’s already dubious budget situation, and unsuccessful attempts were made earlier this year to amend the statute in a way that many taxpayers and observers feared was a surreptitious attempt to legislatively negate the ruling. It is equally clear that the Department intends to aggressively audit companies and assert these and potentially other novel positions in an attempt to minimize the impact of that newly expanded exemption to corporate taxpayers. Taxpayers should review closely their facts and circumstances in light of these new positions when preparing returns or defending an audit.