NEW JERSEY CHANGES ITS POLICY ON TREATMENT OF IRC SEC. 338(H)(10) TRANSACTIONS

By Jack Rothstein, CPA, Coopers & Lybrand L.L.P.

The New Jersey Division of Taxation (the Division) recently announced a significant change in its treatment of the sale of a business when an election is made under Federal IRC Sec. 338(h)(10). For transactions occurring on or after January 14, 1992, the state will follow the Federal treatment and will no longer require the seller to report gain or loss on the sale of a target corporation's stock (letter from the Division, dated March 13, 1995).

Federal Tax Treatment

For Federal income tax purposes, IRC Sec. 338(a) allows a corporation that purchases 80% or more of a target's stock to elect to have the acquisition treated as a purchase of the target's assets. Following the purchaser's election, the target is treated as if it sold all of its assets at a price determined by the purchasing corporation's basis in the target's stock. The result of the election is that the difference between the purchase price of a target's assets and its basis is recognized as gain or loss to the target, and the basis of the assets is stepped up or down, as the case may be.

If an IRC Sec. 338(a) election is made, a joint election may be made under IRC Sec. 338(h)(10) by the buyer and seller of the target's stock. Under this election, the gain or loss on the deemed asset sale is included in the consolidated tax return of the selling group, and no gain or loss is recognized on the sale of target's stock by members of that group.

Before January 11, 1992, an IRC Sec. 338(h)(10) election could be made only for a target that was a member of an affiliated group filing a consolidated Federal tax return. Recently, the IRS issued Treas. Reg. 1.338(h)(10), which expanded permissible IRC Sec. 338(h)(10) elections to include selling affiliated groups filing separate returns and S corporations. The new Federal regulation is effective for acquisitions occurring on or after January 14, 1992.

Policy Change

Historically, the Division's position, as stated in State Tax News articles and N.J.A.C. Sec. 18:7-11.15, has been to recognize two gains (assuming that the transaction results in gains rather than losses) in IRC Sec. 338(h)(30) transactions where both the seller and target are New Jersey taxpayers. One gain is recognized by the seller on the sale of a target's stock as required by N.J.A.C. Sec. 18:7-11.15(d); another gain is recognized by the target on the deemed sale of its assets in accordance with N.J.A.C: Sec. 18:7-11.15(e).

The Division's interpretation of IRC Sec. 338(h)(10) before the effective date of Treas. Reg. 1.338(h)(10) was that N.J.A.C. 518:7-11.15, which requires two levels of gains, is consistent with the Corporation Business Tax (CBT) act because one of the prerequisites for making the Federal election (a seller filing a consolidated return including the target) could never be attained under the CBT Act. The removal of this prerequisite has caused the Division to change its policy. For transactions occurring on or after January 14, 1992, the Division will no longer require inclusion of gain or loss arising from the sale of a target's stock provided that a valid Federal IRC Sec. 338(h)(10) election is made. The gain or loss on the deemed sale of the target's assets will continue to be reported on the target's New Jersey tax return.

Refund Opportunity

Taxpayers that previously reported the sale of a target's stock to New Jersey on IRC Sec. 338(h)(10) transactions occurring after the effective date of the Federal change should consider filing claims for refund. Further, the Federal change may provide refund or planning opportunities in other states, like New Jersey, that have historically treated IRC Sec. 338 (h)(10) transactions unfavorably. *

STATE SALES TAX ON INTERSTATE TRANSPORTATION SERVICE VALID

By Mark Dell'Isola, Esq., and Sara Ann Hull, Esq., Coopers & Lybrand L.L.P

The U.S. Supreme Court recently rendered a decision that could have significant impact on the manner in which states impose sales taxes on interstate services. In Oklahoma State Tax Commission v. Jefferson Lines, Inc. SCT. 63 USLW 4233 (4-3-95), the Court held that an Oklahoma tax on the sale of bus tickets for interstate transportation services was valid and did not violate the Commerce Clause of the U.S. Constitution.

Jefferson Lines involved a Minnesota bus company (hereinafter the "Taxpayer") engaged in the business of transporting persons from Oklahoma to points both within and without the state. Under Oklahoma law, sellers of transportation services (including bus, taxi, airplane, and railroad services) are required to collect and remit a 4.5% tax on the total cost of each ticket. The Taxpayer collected the tax on those bus tickets sold for intrastate transit; however, it did not collect the taxes on sales of bus tickets which involved transportation across state lines. When the Taxpayer filed for protection with the U.S. Bankruptcy Court, the Oklahoma Tax Commission filed a proof of claim for sales taxes not collected on sales of bus tickets for interstate transportation services. The Taxpayer challenged the claim, arguing that the tax violated the Commerce Clause since the State sought to tax the benefit of services rendered and received outside of Oklahoma. Further, the taxpayer claimed that the tax presented a danger of multiple taxation, since other states would be able to impose a mileage tax on the company for the use of their roads on that portion of the service passing through the state. Both the Bankruptcy Court and the U.S. Court of Appeals agreed with the Taxpayer, holding the tax failed the second prong of the constitutionality test established in Complete Auto Transit, Inc. v. Brady, [430 U.S. 653 (1977)], in that it was not fairly apportioned and reached beyond the portion of value of the service fairly attributable to the economic activity taking palace within the taxing state.

The U.S. Supreme Court reversed, however, finding that the tax met all four prongs set forth under Complete Auto Transit. In Complete Auto Transit, the U.S. Supreme Court held that in order for a tax on interstate transactions to be valid under the Commerce Clause, the tax must: 1) be applied to an activity with a substantial nexus to the state, 2) be fairly apportioned, 3) not discriminate against interstate commerce, and 4) be fairly related to the services provided within the state. The Court first determined that there was sufficient nexus with Oklahoma for the tax to be imposed, since the sales took place in Oklahoma and the Taxpayer was doing business in the State.

The court next addressed the primary issue in contention--whether the tax was fairly apportioned. "Fairly apportioned," requires that a tax be both internally and externally consistent. That means that if an identical tax was applied in every state, no multiple taxation would occur and the tax is not imposed on the value of services that are not attributable to economic activity within the taxing state.

The Court came to a number of striking conclusions in rendering its determination that the tax was constitutionally valid under this prong. First, in addressing the issue of whether there was a significant risk of multiple taxation, such that the tax should only be imposed on the value of services actually taking place in Oklahoma, the Court looked to whether a tax on sales had the same economic significance as a tax on gross receipts. In determining that it did not, the Court distinguished an earlier decision, Central Greyhound Lines v. Mealey, 334 US 653 (1948), which held that a gross receipts tax on transportation services must be apportioned based on the extent of the services conducted in each state. The court reasoned that a taxpayer earning income in a variety of states could be subject to an income tax in each state in which it had nexus. Since each state may validly tax a company's gross receipts earned from activities conducted in the state, when one state seeks to tax a company's gross receipts earned from an interstate service, multiple taxation occurs. However, a sales tax is imposed on the buyer, and may only be imposed by the state where the incidence of sale occurs. Thus, the sale of the service can thus only be taxed in a single state.

Second, in deciding that the Oklahoma sales tax was externally consistent and did not reach extraterritorial values, the Court noted that there is no difference between a sale of services and a sale of tangible goods. The Court viewed Oklahoma as taxing the in-state act of buying a bus ticket rather than taxing the interstate transportation the ticket represented. It held that a taxable sale is generally represented by agreement, payment, and delivery--all three of which took place within Oklahoma. As a result, the taxable event occurred within Oklahoma, regardless of whether a certain portion of the services took place in another state. Consequently, the Court concluded that, unlike a gross receipts tax, the sales tax needs not be apportioned.

Finally, the Court held that the final two prongs of the Complete Auto Transit test were met as well. It reasoned that the tax did not discriminate against interstate commerce, since interstate bus tickets were not subject to a higher rate of tax than those sold for in-state transit. Further, the Court found that the tax was fairly related to services performed within the state, since the taxable event--the sale of the bus ticket--took place in Oklahoma.

Observation

The Court's decision in Jefferson Lines holds significant implications for future sales taxes on interstate transportation services. Further, by distinguishing between gross receipts and sales taxes, the Court may have encouraged states to impose increased sales taxes on interstate services, rather than gross receipts taxes, since such a sales tax will provide states with a greater revenue base. As long as the state can identify a key event taking place in the state that ties that tax to that state, the entire value of the service may be taxed by that state, regardless of where the service is performed. This could have a significant impact on the information and telecommunications industries, whose services are frequently interstate in nature. Finally, as such issues become more numerous, taxpayers may want to seek out those states without a tax on interstate services and attempt to locate the incidence of sale in such states. *

MICHIGAN SINGLE BUSINESS TAX PREEMPTED BY ERISA

By Leonard DiMeglio, CPA, and John Hadjiparaskevas, Coopers & Lybrand L.L.P.

A Federal district court judge recently held that Sec. 514 of the Employee's Retirement Income Security Act of 1974 (ERISA) preempts that part of Michigan's Single Business Tax Act (SBTA) which requires entities subject to the tax to include within their adjusted tax bases contributions made to ERISA plans. (Akzo America, Inc. v. Revenue Division, Department of Treasury, State of Michigan, Case No. 4:93-CV-101, January 13, 1995).

Analysis of ERISA Section 514

Sec. 514 of ERISA generally provides that the ACT "supersede[s] any and all State laws insofar as they may now or hereafter relate to any employee benefit plan" covered by ERISA. Based on the U.S. Supreme Court's decision in Shaw v. Delta Air Lines Inc., 463 US 85 (1983), the Court found that a state law "relates to" an employee benefit plan if it either 1) has a connection with an ERISA plan, or 2) refers to an ERISA plan. While the court recognized that the Supreme Court has established an exception for state laws that affect employee benefit plans that are too tenuous, remote, or peripheral a manner, it concluded that this exception was only intended to apply when a state law has a "connection" with an ERISA plan. Consequently, the court held that the exception does not apply when a state law relates to an ERISA plan by virtue of its reference to the plan.

The Court relied upon District of Columbia v. the Greater Washington Board of Trade, 506 US. 121 L Ed. 2d 513 (1992), in which the court held that a provision, which specifically referred to ERISA plans, was preempted "on that basis alone." In the case, the Supreme Court stated that preemption does not occur "if the state law has only a 'tenuous, remote, or peripheral' connection with covered plans...." Accordingly, the Court concluded that Greater Washington limits the scope of the "tenuous, remote, or peripheral" exception to "connection with" situations by its failure to consider the exception with regard to state laws that make "reference to" ERISA plans. In reaching this conclusion, the court specifically disagreed with the earlier decision in Thiokol Corp. v. Roberts, 858 F Supp 674 (1994), in which the judge concluded that a state law does not necessarily "relate to" an ERISA plan merely because it refers to ERISA.

Specific Reference in Michigan SBT

For Michigan SBT purposes, the tax base is measured by "business income" subject to enumerated adjustments. One such adjustment required the addition of "compensation," the definition of which includes "payments to a pension retirement, or profit-sharing plan" [Mich. Comp. Law Section 2084.(3)]. The Court found that the specific reference of Sec. 2084(3) to plans regulated by ERISA was sufficient to preempt the Michigan SBT "on that basis alone." As a result, the court concluded that ERISA preempts Sec. 208.4(3) to the extent that it includes, within the meaning of "compensation," payments to ERISA plans.

Statute of Limitations

Although the Court found that ERISA preempts Sec. 208.4(3) of the Michigan SBT, it did not grant Akzo's request to invalidate Michigan's 90-day statute of limitations for refund claims. The 90-day statute of limitations applies to SBT tax refunds that are based on the validity of Federal or state tax laws. The court held that the 90-day provision does not violate ERISA's preemption clause since it does not specifically refer to ERISA plans. In addition, the court held that the 90-day provision could not be successfully challenged on constitutional grounds since the State of Michigan had a rational basis for its selection of an abbreviated limitations period.

Observation

In light of Thiokol's appeal of its own loss on this issue, the Michigan Department of Treasury has decided to continue holding all ERISA refund claims in abeyance pending the final resolution of these cases. Consequently, Akzo's victory in this case will not have any immediate impact on affected refund claims. However, this successful challenge highlights the need for companies to continue filing protective refund claims on this issue. *

NEW JERSEY GROSS INCOME TAX ADJUSTMENT FOR MEALS AND ENTERTAINMENT DEDUCTION

By Chaim Kofinas, CPA, David Berdon & Co. LLP

Subsequent to the submission of the article written by Lester Rosenbaum on this subject in the June 1995 issue of The CPA Journal, the State of New Jersey issued Technical Bulletin 37 (TB-37, April 6, 1995). In that bulletin, the State clarifies the ambiguity in prior filing instructions regarding S corporation deductibility of meals and entertainment expense and the correct pass-through to the S corporation shareholders.

In order for individuals to get the full deduction against S corporation income for meals and entertainment expense (passed through to them as shareholders), the bulletin instructs S corporations to insert the amount of disallowed meals and entertainment expense for Federal purposes on Form CBT­100S, Schedule K, Part II, line 4. This line is normally used for IRC Sec. 179 expense items. A rider should be attached to the return and to the shareholder's Form K-1 to identify this amount.

However, in computing the 2.35% corporation business tax, the Federal disallowance applies. Thus, the 50% of meals and entertainment expense disallowed should be reported on schedule C (line 5) as a book expense not deducted on the tax return. *

State and Local Editor:Kenneth T. Zemsky, CPA, Ernst & Young LLP

Interstate Editor:Marshall L. Fineman, CPA, David Berdon & Company LLP

Contributing Editors:Henry Goldwasser, CPA, M.R. Weiser & Co LLP

Alan J. Preis, CPA, Own Account

Leonard DiMeglio, CPA, Coopers & Lybrand L.L.P.

Jennifer Miles, CPA, KPMG Peat Marwick LLP

Steven M. Kaplan, CPA, Konigsberg Wolf & Co., PC