State tax considerations for financial institutions

Editor: Kevin Anderson, CPA, J.D.

Financial institutions are often subject to unique state and local taxes based on income, net worth, or gross receipts due to the regulated nature of their business. This creates complexities with multistate compliance, as most states have varying definitions of “financial institution,” nexus standards, industry-specific apportionment rules, and filing methodologies. This item identifies key state and local tax considerations financial institutions should timely review to be compliant and avoid traps for the unwary.

Importance of definitions in state and local taxation

Companies providing financial or lending services need to pay particular attention to how state laws define “financial institutions.” The definition of a “bank,” “financial institution,” and similar terms will dictate whether the taxpayer is subject to a specific tax (i.e., if the entity will be subject to corporate income tax or a special tax imposed only on financial institutions). These definitions will also affect state separate-entity versus combined/consolidated reporting and the application of industry-specific apportionment rules.

The definition of “financial institution” (or any similar term) typically includes banks that are organized and/ or regulated under state or federal law. However, many business organizations are not registered banks but still conduct financial transactions that are similar or identical to those conducted by regulated banks. Examples include, but are not limited to, mortgage lenders and servicers, accounts receivable factoring organizations, savings and loan associations, and credit card processors. While these organizations are not technically banks — or may not be defined as banks for regulatory purposes — statespecific laws that apply to banks may also apply to such organizations.

For example, Connecticut defines a “financial service company” to include “[a]ny company which derives 50% or more of its gross income from an activity in which [a specified list of regulated banking organizations are] authorized to transact” (see Conn. Gen. Stat. §12-218b(a)(6)). Such an expanded definition is not uncommon among state taxing jurisdictions (see also Mass. Gen. Laws ch. 63, §1 (definition of “financial institution”) and N.H. Code Admin. R. Rev. §304.10(a)(7) (definition of “financial institution”)).

Certain states add even more complexities to the definition of a “financial institution.” In California, “financial corporation” is defined as “a corporation … which predominantly deals in money or moneyed capital in substantial competition with the business of national banks” (Cal. Code Regs. tit. 18, §23183(a)). Within this definition, “predominantly,” “deals in,” “money or moneyed capital,” and “substantial competition” are each defined terms that must be examined in determining whether a taxpayer is a “financial corporation” (see Cal. Code Regs. tit. 18, §§23183(b)(1)–(4)). And, because of how such terms are defined, some taxpayers, based on their facts, may qualify as a financial corporation in one tax year but not a subsequent year.

Another example is Illinois, which defines “financial organization” to encompass specific entities including a “small loan company,” “sales finance company,” and “investment company” (see 35 Ill. Comp. Stat. 5/1501(a)(8) (A)). Each of these terms has a specific, narrow definition (see Ill. Admin. Code tit. 86, §100.9710(d)). Taxpayers are advised to review such definitions, as they are more narrow than one may first believe.

What state tax is my organization subject to?

After a taxpayer determines that it is a “financial institution” (or another similar term, depending on the state), the taxpayer must then identify which state tax may apply to its operations.

Most U.S. states impose a net income tax on corporations doing business in the state. States may subject financial institutions to the general corporate net income tax (e.g., Arizona corporate income tax and New Jersey corporation business tax). However, depending on the state, a bank or financial organization may be subject to a separate or additional taxing regime. For example, in Pennsylvania, banks doing business in state are subject to the bank and trust company shares tax, imposed upon a taxpayer’s “taxable shares” (see 72 Pa. Stat. §7701). The same organizations are exempt from the Pennsylvania corporate net income tax because they are not a statutorily defined “corporation” (see 72 Pa. Stat. §7401(1)).

Other states may instead impose a specific tax on a “financial institution” or “financial organization,” measured by a tax base other than net income (e.g., net worth, capital, or book income). Ohio imposes the financial institutions tax based on a taxpayer’s “Ohio equity capital” (see Ohio Rev. Code §5726.04(A)). South Carolina imposes on every “bank engaged in business in [South Carolina]” a separate income tax with its own income and deduction provisions (see S.C. Code §§12-11-20 and 12-13-20).

Another example of a state’s specific bank tax is that of Georgia, which imposes an occupation tax on “each depository financial institution that conducts business or owns property in [Georgia]” (Ga. Code §48-6-95). However, such institutions are also subject to the Georgia corporate income and net worth tax. Despite the added tax obligation for applicable institutions, a dollar-for-dollar credit against the corporate income and net worth tax is available to depository institutions based on their occupation tax liability (see Ga. Code §48-7-29.7(a)).

Specific income tax considerations

If a financial institution is subject to a state’s corporate net income tax, other industry-specific rules may still apply to that taxpayer. For instance, if a taxpayer is a California financial corporation, that taxpayer is subject to corporate income tax at a different tax rate (10.84%, as opposed to 8.84%; see Cal. Rev. & Tax. Code §23186) and a different apportionment factor weighting (evenly weighted property/ payroll/sales factor, as opposed to single sales factor; see Cal. Rev. & Tax. Code §§25128(b) and (c)).

Financial institutions may also be subject to local taxes, such as the Philadelphia business income and receipts tax (BIRT). Generally, BIRT taxpayers are subject to both a net income and gross receipts tax. However, if a taxpayer qualifies as a “financial business” for BIRT purposes, it is subject to only the higher of the net income or gross receipts tax (see Philadelphia Department of Revenue, Form BIRTHJ, City of Philadelphia Business Income & Receipts Tax, Schedule H, (2022)).

Filing methodologies

Being defined as a financial institution may impact the institution’s required income tax return filing methodology. For example, Tennessee is generally a separate-company reporting state, where the individual entity doing business in Tennessee is subject to tax (see Tenn. Code §67-4-2007(a)). However, if the taxpayer is a “financial institution,” as defined under the applicable Tennessee statute, then for “financial institutions that form a unitary business, [taxable income] is defined as the combined net earnings or net loss … for all members of the unitary group” (see Tenn. Code §67-4-2006(a) (3)). Such a statute makes Tennessee a unitary combined reporting state for certain financial institutions.

Likewise, Indiana is generally a separate-company reporting state for corporate adjusted gross income tax purposes. However, financial institutions are subject instead to the financial institutions tax (see 45 Ind. Admin. Code r. 17-2-1). Under such a tax, combined reporting is mandatory if the taxpayer meets the Indiana regulatory definition of a “unitary group” (see 45 Ind. Admin. Code r. 17-3-2(b) and 17-3-5).

Apportionment

Additionally, financial institution taxpayers should pay particular attention to how their taxable income is apportioned. Many states have specific apportionment rules that apply to financial organizations. Such rules typically address the sourcing of receipts from financial services, sales of loans, and interest income. Where relevant, the apportionment rules may differ if the receipt is associated with a secured loan versus an unsecured loan. For states that do not have industry-specific apportionment rules, such receipts generally will be analyzed under the state’s sourcing rules applicable to sales of services or sales of other than tangible personal property. Such states source receipts based on either a cost-of-performance method (where the costs are incurred in generating the receipts) or a market-based-sourcing method (where the service is delivered or where the benefit is received).

What apportionment percentage applies to a financial institution may also further impact the taxpayer’s separate-company versus combined/ consolidated reporting profile. A state may preclude a financial institution from inclusion in a unitary combined reporting group with other nonfinancial institutions or may apply special apportionment rules to a unitary group that consists of a mix of financial and nonfinancial entities. When reviewing their combined filing obligations, taxpayers should evaluate the impact that using an industry-specific apportionment formula has on the combined group members. For example, Massachusetts provides that financial institutions may join a unitary combined group with other corporations. However, defined financial institutions are required to make specific adjustments to certain factors when included (see Mass. Regs. Code tit. 830, §63.32B.2(7)(h)). A financial institution in the group “shall adjust the numerator and denominator of its property factor so that the value of intangible property included in the factor is reduced by 80%” (Mass. Regs. Code tit. 830, §63.32B.2(7)(h)1).

Entity classification may also affect a financial institution’s apportionment methodology. A minority of states apportion income differently if the taxpayer is organized as a corporation versus a passthrough entity (e.g., partnership or S corporation). Such states include Michigan, New Jersey, New York, and Rhode Island. While the corporate net income tax apportionment provisions may have specific concepts applicable to financial institutions, the passthrough entity apportionment provisions may not.

Understanding potential nexus implications

Once taxpayers understand how states source receipts for financial institution/income tax purposes, they should evaluate their state and local tax nexus profile. Nexus is having sufficient constitutional connection to a taxing jurisdiction such that the jurisdiction may impose tax upon that taxpayer.

Since the early to mid-1990s, states have become more aggressive in asserting income tax jurisdiction over businesses having no physical presence in their jurisdiction. Often, state taxing jurisdictions have asserted that the presence of intangible property (e.g., loan or credit card receivables) is sufficient to constitute income tax nexus. More recently, states are increasingly asserting nexus when receipts sourced to the state exceed a certain threshold within a tax year (e.g., $500,000). Financial institution taxpayers that lack physical presence in a state but that may have significant deposits, loans (secured or unsecured), and/or credit card receivables assigned to the state should evaluate the state’s sales apportionment sourcing and economic nexus rules to determine whether they have a tax filing obligation.

Takeaways

The state and local tax rules applicable to financial institutions have numerous complexities. Companies engaged in providing financial services should review their state tax profiles annually to confirm if they may be classified as a financial institution subject to specific and perhaps unique state and local tax rules. Because the state tax rules related to apportionment and nexus continue to evolve, financial institutions must also keep up with developments affecting those rules. Further, a financial institution taxpayer’s state tax obligations may change year to year as its business activities change or grow within a state, even when the state’s tax authorities remain constant. As states continually seek to grow their tax bases targeting out-of-state businesses, financial services businesses should understand the mix of state tax concepts and avoid unwanted surprises.

Editor notes

Kevin Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.Contributors are members of or associated with BDO USA LLP. For additional information about these items, contact Anderson at 202-644-5413 or kdanderson@bdo.com.