Combined Reporting Creates Compliance Challenges

By Carolyn Singh, MBA, Washington, D.C.

Editor: Annette B. Smith, CPA

State & Local Taxes

An increasing number of states have enacted or proposed combined reporting requirements for related entities involved in a unitary business. As of Jan. 1, 2012, 24 states and the District of Columbia require combined reporting as part of their corporate income tax regimes. States assert that combined reporting prevents tax avoidance and provides an appropriate source of revenue. The sometimes ambiguous and differing combined reporting provisions have created increased compliance burdens for taxpayers and administrative challenges for state tax agencies.

Different States, Different Rules

Taxpayers subject to combined reporting face a range of compliance challenges, including:

Defining “unity”: Whether a unitary business exists is dependent on state law. In states using the “three unities test,” the factors considered are unity of ownership, unity of operation (e.g., centralized purchasing), and unity of use (e.g., centralized executive function) (see Butler Bros. v. McColgan, 315 U.S. 501 (1942)). Other states base the determination on the three criteria of functional integration, centralization of management, and economies of scale (see Mobil Oil Corp. v. Commissioner of Taxes of Vt., 445 U.S. 425 (1980)). In addition, some states consider some other evidence of a sharing or exchange of value (see Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159 (1983)). A growing number of states provide a specific definition of unitary business in their statutes or regulations.

Who’s in and who’s out: While states generally set the combined reporting threshold at more-than-50% ownership, states differ on which members to include. For example, under a concept known as “instant unity,” some states allow newly acquired members to be included in the combined report. Another concern is the treatment of members subject to special apportionment provisions. While some states may require a combined report to include all members regardless of their apportionment methodology, other states require the exclusion of members subject to a special apportionment factor.

Still other states may require the use of a modified apportionment factor to account for differences between the individual members’ apportionment methods. Similarly, while some states exclude from the combined report any member subject to an alternative tax regime, such as an insurance company subject to gross premiums tax, other states include the member’s income and apportionment factors in the combined report.

Taxpayer or taxpayers: States differ as to whether they treat a combined group as a single taxpayer or a combination of individual taxpayers. The difference in treatment may affect the computation of the apportionment formula. For example, states that adopt a Finnigan approach (Appeal of Finnigan Corp., 88-SBE-022 (Cal. St. Bd. of Equal. 8/25/88)) treat all combined group members as a single taxpayer; hence, nexus by any one member in a taxing state results in nexus for all members in the state. In contrast, some states follow a Joyce approach (Appeal of Joyce, Inc., 66-SBE-070 (Cal. St. Bd. of Equal. 11/23/66)) and look to the activities of the individual member in determining nexus.

Tax attributes—Sharing or not: Tax attributes also create areas of complexity. For example, some states limit the use of net operating losses (NOLs) and income tax credits on a member-by-member basis. The entity-specific limits may apply regardless of whether the state views the combined group as a single taxpayer or a combination of individual taxpayers. The limits on NOLs and income tax credits may have a significant impact on deferred tax assets and liabilities, especially where a state moves to combined reporting after the tax attributes have been earned and accounted for. Some states and the District of Columbia have adopted an “ASC 740 fix” when enacting combined reporting legislation to limit the financial statement impact of combined reporting on deferred tax assets and liabilities.

Worldwide vs. water’s edge: States differ as to whether combined reports must be filed on a worldwide or “water’s-edge” basis. In general, worldwide filing includes all members of the unitary group, including foreign members. In contrast, water’s-edge filing excludes the income and apportionment factors of foreign entities with little or no presence in the United States. States that require either method may allow taxpayers to elect an alternative method, provided the taxpayer complies with election provisions. The election often is binding for an extended period and may require the taxpayer to comply with detailed terms and conditions. Taxpayers also should note that a growing number of states require that combined reports filed on a water’s-edge basis include members operating in a tax-haven jurisdiction.

Example: Combined Reporting Challenges in D.C.

The District of Columbia has adopted combined reporting, effective for tax years beginning after Dec. 31, 2010 (D.C. Code §47-1805.02a). In general, the District’s combined reporting statute conforms to the Multistate Tax Commission model combined reporting statute, with some notable differences. These include the use of water’s-edge combined reporting, absent an election to file on a worldwide basis.

Proposed regulations issued by the District in early 2012 seek to clarify some of the statutory provisions, such as the meaning of “unitary business,” which entities to include in a combined report, the treatment of entities subject to special apportionment, and the election to file reports on a worldwide rather than a water’s-edge basis (Prop. D.C. Mun. Regs. tit. 9, §156 et seq. (2012)). In addition, the regulations clarify statutory provisions that limit the use of tax credits and net operating losses on a member-by-member basis. While it is not directly addressed in the regulations, the District of Columbia Office of Tax and Revenue has stated that income is apportioned using a Joyce approach (Carroll, “D.C. Official Responds to Practitioners’ Combined Reporting Concerns,” 2012 STT 24-11 (Feb. 6, 2012)). Of note, the regulations do not speak to statutory provisions that allow the charitable deductions of one member to be used by the combined group (D.C. Code §47-1810.05(b)(7)(A)).

The proposed regulations specify that the entities in the combined group include any financial institution, utility company, transportation company, S corporation, real estate investment trust, and regulated investment company. Insurance companies are excluded from the combined group. In addition, the regulations provide that the common owner of the group does not need to be a part of the combined group, and they envision situations where a commonly controlled group may be engaged in multiple unitary businesses. Addressing the issue of instant unity, the regulations provide that newly formed corporations are presumed to be instantly unitary, while newly acquired corporations are not (however, either presumption may be rebutted).

The regulations also provide that a worldwide election, if made on an original, timely filed return, is effective for 10 years. If after the 10-year period the prior worldwide election is neither revoked nor renewed, the election will terminate for the subsequent tax year. In such a case, however, a new worldwide election may be made for any 10-year period thereafter.

The regulations also provide guidance on how to determine the apportioned income of a combined group that contains members required to use special apportionment formulas, including financial institutions and transportation companies.

Despite the draft regulations, open questions remain in a number of areas, including the workings of the “ASC 740 fix,” and tax treatment of qualified high-technology companies.


Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PwC.

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