Snapshot: Corporate Income and Franchise Taxes in the USA

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How is taxable income determined in your state? To what extent is the state income tax base aligned with the federal income tax base?

Alabama levies a corporate income tax on business entities classified as taxable or “C” corporations that have nexus with the state and are not classified as “financial institutions” or insurance companies subject to a separate premium license tax; and it levies a FIET on business entities classified as financial institutions having nexus with the state. It also levies a relatively modest business privilege tax that is normally capped at $15,000 annually, although insurance companies and financial institutions are subject to a $3 million annual cap. See Ala. Code §40-14A-22. Until the U.S. Supreme Court’s landmark ruling in South Central Bell Tel. Co. v. State of Alabama, 526 U.S. 160 (1999), Alabama levied a debt- or net-worth based corporate franchise tax, the tax base of which depended on whether the corporation was incorporated under Alabama law or another state’s laws. That tax was ruled unconstitutional by the Supreme Court, so references to “franchise tax” today instead often mean the business privilege tax, which is based on a combination of apportioned net worth and taxable income.

For purposes of the corporate income tax, Alabama taxable income is based on federal taxable income, with a series of state-specific upward and downward adjustments and a separate set of rules for net operating loss carryovers. See Ala. Code §§40-18-33, -35.1. The individual income tax, which is relevant to non-corporate owners of pass-through entities operating in the state, is largely but not directly tied to federal adjusted gross income. See Ala. Code §40-18-1.1. In the latter tax scheme, federal Internal Revenue Code (“IRC”) sections are incorporated into the statute by specific reference (e.g., IRC or 26 USC section 162) so that a new IRC section enacted by the U.S. Congress (e.g., IRC section 199A, recently) is not automatically incorporated into the state’s individual income tax laws. Instead, the Alabama legislature must decide annually whether to conform, or in some cases, to de-couple from the IRC, as amended by Congress from time to time.

There are special rules for the state income taxation of S corporations and their shareholders. See Ala. Code §40-18-160 et seq.

The state follows the IRS’ so-called “check-the-box” regulations for business entity classification not only for income tax but sales/use/rental tax purposes as well. See ADOR Revenue Procedure 98-001 (Mar. 16, 1998).

How is in-state income apportioned for multi-state businesses? Does your state regulate transfer pricing?

Alabama utilizes a double-weighted sales apportionment factor, meaning that property and payroll factors are each counted once but sales are counted twice, creating a moderate incentive to manufacture goods in Alabama but export them to other states or internationally since the sales factor is based on the destination of the goods. Ala. Code §40-27-1. There are pending proposals to shift to a single sales factor apportionment formula, which appears to be the national trend. See Ala. HB 353 and SB 250 (March 2020) (described above).

The Alabama legislature in 2011 enacted so-called “market-based sourcing” for sales of services and other transactions not involving the sale of tangible personal property. See Ala. Code §40-27-1(IV)(17); Ala. Admin. Code r. 810-27-1-4-.17.01. Previously the state had followed the traditional “cost of performance” sourcing rule. Thus, if an engineering firm located in Birmingham, Alabama prepares design plans for a condominium development in Destin, Florida, the income from those services is now sourced to Florida rather than to Alabama.

Alabama regulates transfer pricing by statute and regulation, incorporating IRC section 482 principles by explicit reference. See Ala. Code §40-2A-17. In the authors’ experience, the ADOR is one of the more aggressive state taxing authorities in policing intercompany pricing as well as intercompany royalty and interest payments. See Ala. Code §§40-18-35(b), (c)(corporations) and -24(b) (pass-through entities), commonly known as the “add-back statute,” and Amy Hamilton and Andrea Muse, “States Aggressively Contracting With Transfer Pricing Experts,” Tax Notes Today (Apr. 1, 2020).

Nexus

How is nexus determined for corporate income tax purposes?

Until 2015, Alabama employed the “traditional” nexus tests, but in that year the state legislature enacted what was then the current version of the Multistate Tax Commission’s model factor presence nexus statute. See Ala. Code §40-18-31.2. For 2019 tax years, any company with sales in the state exceeding $538,000, property in the state exceeding $54,000, or payroll in the state exceeding $54,000, or if 25 per cent or more of its sales, property or payroll are apportionable to the state, then it is deemed to have nexus with Alabama and is therefore subject to corporate income tax, or in the case of financial institutions, the FIET. The company would also be subject to the business privilege tax. The application of this statute can in some cases lead to unfair or disproportionate results; the authors expect its validity to be challenged in court soon.

Is affiliate nexus recognized in your state? If so, to what extent? Has there been any notable case law in this area?

For the purposes of our corporate income tax, the ADOR may assert that an affiliated entity doing business in the state is an agent of the out-of-state-principal and the principal therefore has nexus with the state, or the ADOR may attempt to “collapse” or disregard certain affiliates as “shams,” lacking business purpose, thus achieving the same result, or in effect forcing combined reporting if the targeted entity and the collapsed affiliates are considered “unitary.” However, there is no statute that specifically authorizes this. On the other hand, Alabama indeed has two affiliates nexus statutes for sales and use tax purposes.

The Alabama Court of Civil Appeals rejected the Department’s position that the sales/use tax affiliate nexus provisions applied to the facts in ADOR v. Scholastic Book Clubs Inc., Case No. 2161077 (Ala. Civ. App. Sept. 7, 2018, cert. denied Ala. S. Ct. Nov. 9, 2018). Specifically, the court held that the ADOR could not force Scholastic Book Clubs Inc. to charge and remit sales or use taxes for prior years under (then) existing state law and that the teachers who take orders for their books are not their contractual agents. However, the court did not rule on how the U.S. Supreme Court’s June 2018 landmark ruling, Wayfair Inc. v. South Dakota, might apply to this or other pending Alabama tax cases. Scholastic Book Clubs Inc. was contesting an $815,000 seller’s use tax assessment for a six-year period ending March 31, 2013. Scholastic argued that Alabama could not require it to collect and remit sales and use tax because it had no physical presence in the state. The appeals court sided with Scholastic, expressly without considering any implications of Wayfair.

Rates

What are the applicable corporate income tax rates?

By state constitution and statute, Alabama levies a flat 6.5 per cent corporate income tax, and by statute a flat 6.5 per cent FIET. See Ala. Code §§40-18-31.1 and 40-16-4, respectively. However, Alabama is one of few states that allows a deduction for federal income taxes, which significantly reduces the effective tax rate, as discussed above.

Exemptions, deductions and credits

What exemptions, deductions, and credits are available?

Alabama taxable income for “C” corporations begins with federal taxable income, which is then modified by a series of upward and downward adjustments. See Ala. Code §§40-18-34 and -35, respectively. Additive adjustments include interest income that is exempt for federal income tax purposes but not for Alabama income tax purposes. A useful checklist can be found on Schedule A to the ADOR’s Form 20C. The “excise” tax levied on financial institutions was, as described above, substantially reformed in 2019 so that the tax base is now generally parallel to the corporate income tax, with certain unique or federally-mandated differences, while the apportionment formula is entirely different. See Ala. Code §40-16-1 et seq.; Legislator’s Guide to Alabama Taxes.

Filing requirements

What filing requirements and procedures apply? Are there special filing requirements for groups of company?

Alabama is known as a “separate return state,” meaning that corporations may file separate income tax returns rather than a consolidated or combined return, regardless of common ownership or the presence of a “unitary” relationship. However, a group of corporations filing a federal consolidated income tax return may elect to file an Alabama consolidated income tax return, but the filers are limited to those corporations having nexus with the state, and further, there is no intercompany netting of income or expenses. The Alabama election is therefore known as “bottom line consolidation.” See Ala. Code §40-18-39.

Alabama law prohibits the filing of a unitary combined return as well as the ADOR from forcing a unitary group of taxpayers to file such a return. Ala. Code §40-18-39(i).

Corporate franchise tax

Does your state impose a corporate franchise tax? If so, is it imposed in lieu of or in addition to corporate income tax?

No; as mentioned above, Alabama has not imposed a corporate franchise tax since 1999. It does, however, impose a relatively modest business privilege tax as a partial successor to the invalidated corporate franchise tax. The business privilege tax is based on a taxpayer’s net worth in Alabama. The rate varies from $0.25 to $1.75 per $1,000 of net worth, based on the taxpayer’s taxable income in the previous year. Net worth is allocated and apportioned to Alabama using the same three‚Äźfactor formula applicable for income tax. After allocation and apportionment, further deductions are available, generally related to certain specific investments in Alabama (e.g., pollution control facilities, air carriers with hubs in Alabama, and certain large manufacturing facilities). Most businesses will not pay more than the $15,000 maximum per year.

Republished with permission. This article, "Snapshot: Corporate Income and Franchise Taxes in the USA," was published by Lexology on September 30, 2020.