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Corporate income tax change: single sales factor apportionment

In recent years, states have been slowly reducing corporate income taxes. States have been doing this not by reducing corporate income tax rates but rather by increasing the sales factor weighting in corporate income tax apportionment formulas.

What is apportionment of corporate income?
Apportionment of corporate income is an important issue for multi-state companies. Many decades ago, states agreed to use an evenly weighted three-factor apportionment formula based on a corporation's sales, property, and wages. Each factor was given a 33.3% weighting. This was intended to prevent overtaxation of a corporation's profits. For example, without apportionment, a company doing business in twenty states would have to pay 100% state corporate income tax if each state imposed a 5% corporate income tax rate.

Using the evenly weighted three factor formula, the corporation's income would be apportioned to each state where it did business. The following hypothetical example illustrates how this works

Percent of sales in
Other states: 99%
In-state: 1%

Percent of wages in
Other states: 1%
In-state 99%

Percent of property in
Other states: 1%
In-state: 99%

Other states = (99% + 1% + 1%) / 3 = 33.7%
In-state = (1% + 99% + 99%) / 3 = 66.3%

Why increase sales factor weighting?
States have been increasing the sales factor weighting from 33.3% in order to incentivize and encourage investment by high wage, export-oriented companies that have the option of locating in any state (or country for that matter). A semiconductor manufacturer, for example, pays high wages, brings money into the state by exporting products to other states, and can locate anywhere.

By increasing the sales factor to 100%, a company that employs Utahns and invests in Utah but exports all or most of its product to other states, would pay zero or little Utah corporate income tax (assuming the throwback rule were eliminated, which will talk about at a later time). Companies that produce and employ in other states but sell their products in Utah would not benefit from this change.

Using the above hypothetical example, the Utah-based exporter's apportionment to Utah would be 1% if single sales factor were used instead of 66.3% if evenly weighted three factor were used.

Currently, Utah uses a double-weighted (50%) sales apportionment formula. Only eight states use an evenly weighted formula for all corporations. Thirteen states allow or soon will be allowing some or all corporations to use single sales factor (100% weighting). In addition, three states (Nevada, South Dakota, and Wyoming) do not impose corporate income taxes at all.

What about repealing the state corporate income tax entirely?
Complete repeal of the Utah corporate income tax presents two problems. First, the fiscal impact would be huge. In FY2006, Utah's corporate income tax generated $380 million. (The amount generated each year varies dramatically depending on the state of the economy). Increasing the sales factor weighting would impact revenues by about $30 to $50 million per year.

Second, complete repeal of the state corporate income tax would allow local governments to begin taxing intangible property such as patents, trademarks, and goodwill. The Utah state constitution prevents the taxation of intangible property as long as corporate income tax is imposed ("If any intangible property is taxed under the property tax, the income from that property may not also be taxed." -- Utah Constitution, Article XIII, section 2, part (6))

For example, let's assume a company has a market value based on its stock price of $1 billion and tangible real and personal property of $100 million. Currently, local governments can impose property taxes on $100 million. If the state corporate income tax were repealed without changing the state constitution, then local governments would impose property taxes on $1 billion.

One additional thought:

It's a safe bet that most states will be using single sales factor or at least a very heavy weighting of sales factor by 2020 at the latest.

Tax reforms, cuts, and increases occur incrementally. If Utah does not continue to incrementally improve its tax system, it will find itself behind other states.

According to our analysis of data from the CCH 2007 State Tax Handbook, the average, unweighted sales weighting nationwide is 64% based on the following assumption/conditions:

- States without corporate income tax effectively have a 100% sales weighting.

- Some states have evenly weighted formulas in general but have heavier-weighted sales factors for certain industries (usually manufacturing or other high wage, export-oriented industries). The 64% calculation is based on the heavier-weighted option.

The "unweighted sales weighting" in the previous comment sounds awkward. It should have read "unweighted average of states' sales factor weighting". This means that the sales factor weightings of all states were averaged equally (treating California's weighting the same as Vermont's).

Also, the single sales factor would be electable, just like Utah's current double weighting is electable. That is, a corporation could choose between evenly weighted three-factor or single sales factor.

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