By Allison Gregory, Mike Herold
August 01, 2016
Financial institutions may have a “taxable, no tax due” presence in more states than meets the eye. While this may seem strange, the intricate complexity of multistate income tax nexus, apportionment, sourcing, and compliance can result in a favorable tax position.
Nexus is the term used to describe the connection between a state and a financial institution’s business activities that allows the state to impose tax on the financial institution’s income. The state nexus standards are not universal and do vary among states. Key factors in determining nexus are whether the financial institution has a physical presence (e.g., building or employee) or economic presence in the state. A question to ask is whether the financial institution is purposefully seeking customers from a state. If so, nexus has more than likely been created.
Nexus for financial institutions is dynamically evolving as many states broaden their nexus standards from physical to economic. While a physical presence standard is easily determined, the new trend of economic nexus is more nebulous. Economic nexus was created by the states as a method of capturing lost tax revenues as business transactions routinely cross state and national borders. Economic nexus can be triggered with the mere solicitation of loans. Other common economic nexus generating activities include but are not limited to: regularly soliciting business from state customers, engaging in transaction with customers involving intangible property, lending to a set number of customers, and soliciting loans secured by real or tangible personal property. Specific functions of lending may also generate economic nexus: solicitation, investigation, negotiation, approval and administration.
With the adoption of economic nexus rules, states have cast a wider net to generate out-state financial institution tax dollars.
Apportionment and Revenue Sourcing
A financial institution doing business in multiple states is required to attribute its business activity among states using an apportionment formula traditionally consisting of its property, payroll and revenue. As economic nexus is being adopted by states, this traditional formula has been altered to focus on how the revenue factor is sourced. The revenue factor includes but is not limited to:
Simply determining which state is entitled to this revenue is difficult. The complexity of properly sourcing revenue has intensified exponentially as states transition from the cost of performance rules to market-based sourcing rules. Understanding these rules can, at times, reduce taxes or prevent double taxation.
Voluntary Disclosure Agreements (VDA)
As you have read, remaining compliant with the changing state tax laws is difficult, and many taxpayers inadvertently find themselves tripped into a tax filing requirement. How does a financial institution resolve past delinquent tax filing requirements? One option is through a VDA. A VDA is a program that allows taxpayers to anonymously disclose prior year nexus and filing obligations where taxpayers were not compliant and proactivity seek limited relief from penalties and look-back periods. A financial institution with multistate nexus that is not compliant with its state tax filings and has not been notified by the taxing jurisdiction may find relief through the state’s VDA. The exposure to state income tax liabilities, potential interest and penalty burdens, and the statute of limitations risk can be exorbitant without a VDA.
Subject to Interpretation
A financial institution with income tax nexus will be subject to the applicable state income and franchise taxes. Depending on the state’s modified financial institution apportionment rules and the institution’s factors, the apportionment percentage could be zero. Thus, no state income and franchise tax liability. A financial institution with multistate nexus may actually lower the overall state income and franchise effective tax rate by apportioning income amongst other states.
Nexus determinations and apportionment calculations are fact specific and subject to interpretation. Contact your tax advisor if you are unsure whether your financial institution is subject to income tax in a particular jurisdiction.