What Are De Minimis and Zero Income Tax Apportionment Factors?
In World Acceptance Corp. & World Fin. Corp. of Kentucky v. Kentucky Dep’t of Revenue, Civil Action No. 14-CI-01193, (Ky. Franklin Cir. Ct. Nov. 10, 2015), the Franklin Circuit Court of Kentucky, on a motion to alter, amend, or vacate, affirmed the Kentucky Board of Tax Appeals, Final Order No. K-24682, File No. K13-R-18, dated August 29, 2014, and held that World Acceptance Corp. (WAC) and its subsidiary, World Finance Corporation of Kentucky (WFCKY), should not file a Kentucky mandatory nexus consolidated return under KRS 141.200(9) to (11), concluding that “WAC was not an ‘includable corporation’ because WAC’s payroll, property, and sales factors were either de minimis or zero.” World Acceptance is on appeal at the Court of Appeals.
Computing the Kentucky taxable income of WAC and WFCKY using the consolidated return method results in a refund. Not surprisingly, WAC and WFCKY were arguing that they should compute their income using the consolidated return method, and the Department took the opposite position.
The focus on World Acceptance has been on the construction and application of the mandatory nexus consolidated return rules. But, does World Acceptance have something to say about apportionment and nexus?
Kentucky’s Three-Factor Apportionment of Income for Tax Purposes
Kentucky apportions income using an apportionment factor comprised of the average of three ratios – the payroll factor, the property factor, and a double-weighted sales factor. KRS 141.120. Each factor is comprised of a numerator representing the in-state amount and a denominator representing the amount everywhere. KRS 141.120. In this regard, Kentucky apportions income consistent with the Uniform Division of Tax Purposes Act (UDITPA).
WAC’s Presence in Kentucky
Contrast WAC, the parent corporation, and WFCKY, WAC’s subsidiary. “WAC, a South Carolina corporation, had…one employee performing services in Kentucky.” World Acceptance, supra. “WFCKY is a corporation with over seventy storefronts in Kentucky which provide consumer loan and tax preparation services.” Id. Obviously, WFCKY has a substantial presence in Kentucky, and WAC has comparatively much less.
“[WAC’s] employee performed audit services and worked between 39 and 55 days in Kentucky…. This employee was a resident of Tennessee and she performed audit services for WAC in Tennessee as well. She received her assignments, schedules and payroll from the corporate headquarters in South Carolina.” Id. “This employee used a car and a laptop when she worked in Kentucky.” Id. “The only sales that WAC had in Kentucky…consisted of a management fee that WAC received from WFCKY each year to cover the cost of management, accounting, payroll and administrative activities that WAC performs for its subsidiaries…in South Carolina.” Id.
World Acceptance provides an opportunity to explore the edges of what de minimis or zero apportionment might be.
WAC’s Payroll Factor
The analysis in World Acceptance began with the payroll factor, likely because WAC’s primary contact with Kentucky was through just one employee. Payroll is assigned to the Kentucky numerator if:  the individual's service is performed entirely within Kentucky;  the individual's service is performed both within and without Kentucky, but the service performed without the state is incidental to the individual's service within Kentucky;  some of the service is performed in Kentucky and the base of operations is in Kentucky;  some of the service is performed in Kentucky and Kentucky is the place from which the service is directed or controlled; or,  some part of the service is performed, but the individual's residence is in this state. See KRS 141.120; 103 KAR 16:090.
Notice that the assignment of payroll to Kentucky (or not) is an all-or-nothing determination -- either all of an employee’s payroll is assigned to Kentucky or nothing is. The KBTA and the Franklin Circuit Court determined that “WAC’s payroll factor was zero” based on this test. The employee’s service was not performed entirely in Kentucky, was incidental to the Tennessee service (not to the Kentucky service), and was directed and controlled by a corporation based in South Carolina; and, she did not live in Kentucky. The base of operations test was not addressed but that test does not seem to be implicated from the operative facts.
So, despite the fact that WAC had an employee who worked in Kentucky between one and two months performing audit services, it was determined that WAC had a zero Kentucky payroll factor. What would have been the conclusion if there were two such employees? Ten such employees? A dozen? Dozens? Based on the Court’s logic, wouldn’t there still be zero payroll in each of these scenarios?
WAC’s Property Factor
The property that WAC had in Kentucky consisted of a car registered in Tennessee that the employee drove and a laptop that she used in Kentucky. In contrast to the payroll factor, the property factor numerator is comprised of “the average value of the corporation’s real and tangible personal property owned or rented and used in this state during the tax period….” KRS 141.120.
The World Acceptance Court concluded, “[S]ince . . . the employee's payroll must be assigned to Tennessee, and that the car is also registered in Tennessee, then the car cannot be included in the Kentucky property factor.” Although the property factor is generally determined based on an “average value”, this conclusion was based on 103 KAR 16:290, which provides, “An automobile assigned to a traveling employee shall be included in the numerator of the factor of the state to which the employee’s compensation is assigned under the payroll factor or in the numerator of the state in which the automobile is licensed.” Note that, again, as to the car, this results in a zero factor.
The general rule applies to the laptop. Under 103 KAR 16:290, “The value of mobile or movable property such as construction equipment, trucks or leased electronic equipment which is located within and without Kentucky during the taxable year shall be determined, for purposes of the numerator of the factor, on the basis of total time within the state during the taxable year.” So, applied by the World Acceptance Court, “[T]he laptop while it was used in Kentucky does not amount to more than a couple hundred dollars, if that.” This resulted in a Kentucky property factor of, at most, 0.0000064. The Court observed:
If sixty-four thousandth of one percent does not constitute a de minimis amount in any context outside of astronomy or molecular biology, then this Court is at a loss for what does. In fact, this number is so infinitesimally de minimis that it is essentially zero.
So, in the Court’s eyes, “essentially zero” is zero and is also de minimis, in the property apportionment factor context.
WAC’s Sales Factor
WAC received a management fee from WFCKY to cover the cost of activities that WAC performed for its subsidiary. “Sales, other than sales of tangible personal property, are in [Kentucky] if the income-producing activity is performed in this state; or the income-producing activity is performed in and outside [Kentucky] and a greater proportion of the income-producing activity is performed in [Kentucky] than in any other state, based on costs of performance.” KRS 141.120. See also 103 KAR 16:270.
The World Acceptance Court concluded that, “[T]he management fee did not exclusively cover the activities of WAC’s employees in Kentucky; it also covered accounting, payroll, management, and other administrative services performed by WAC employees at its headquarters in South Carolina for WFCKY.” So, it was “sourced to South Carolina rather than Kentucky since the income-producing activities were largely performed at WAC's headquarters in South Carolina….” Id. It would be interesting to see if the conclusion would have been different if there would have been a separately identifiable charge for the services performed in Kentucky. But, again, here the conclusion was that “WAC’s sales factor was zero.”
Effect of Either De Minimis or Zero Payroll, Property, and Sales on Application of Consolidated Return Rules
As to the consolidated return rules, although it directly owned the stock of an includable corporation, the World Acceptance Court adopted the Department’s view and applied the includable corporation exceptions in concluding that WAC was not a common parent. The potentially relevant exceptions here are: any corporation that realizes a net operating loss with de minimis property, payroll, and sales factors (“de minimis factor loss corporation”); and, any corporation for which the sum of its property, payroll, and sales factors is zero (“zero-factor corporation”). See KRS 141.200(9)(e)(7) & (8). Other corporations excepted include: foreign (i.e., non-U.S.) corporations; possessions corporations; REITs; RICs; and, DISCs. See KRS 141.200(9)(e)(2)-(6). So, despite having an employee ostensibly performing services in Kentucky, having property in Kentucky, and appearing to derive income from activities performed in Kentucky, the conclusion in World Acceptance has been that “WAC’s payroll, property, and sales factors were either de minimis or zero….” As such, WAC and WFCKY could not compute their Kentucky taxable income using the consolidated return method.
Potential Application to Nexus Rules
It is interesting that whether or not WAC was doing business in Kentucky, and thus has nexus with Kentucky, was not an issue in World Acceptance. A taxpayer is doing business in Kentucky when, among other things, the taxpayer: has one or more individuals performing services in Kentucky; owns or leases property in Kentucky; or, derives income from or attributable to sources within Kentucky. KRS 141.010. Doing business must be interpreted to not go beyond the limitations imposed by the United States Constitution.
So, is it arguable, that under World Acceptance, a taxpayer with an employee who simply travels occasionally into Kentucky is not doing business in Kentucky because such activity is de minimis and thus insufficient to constitute nexus under the Commerce Clause or the Due Process Clause of the United States Constitution? That a taxpayer having such an employee who only has an automobile and a laptop does not own or lease property in Kentucky? That a taxpayer deriving such income is not deriving income from Kentucky?
Does it matter since such a taxpayer has an apportionment factor of zero?
Can a taxpayer control the zero? Or, the de minimis?
The Court of Appeals is considering World Acceptance, on appeal. In addition to some insight on the consolidated return rules, will we get some additional guidance on nexus itself?
This is a modified version of Mark A. Loyd’s regular column, Tax in the Bluegrass, “What are de minimis and zero income tax apportionment factors?” which appeared in Issue 1, 2017 of the Kentucky CPA Journal.
March 29, 2017