United States

Colorado: Economic Nexus, Alternative Apportionment and More; Trial Court Addresses a Number of Corporate Income Tax Issues

Feb 13, 2017
From KPMG TaxWatch

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Recently, a Colorado district court addressed a number of issues with respect to the audit and assessment of an intangible holding company subsidiary of a multistate retailer. The subsidiary (the taxpayer) had no physical presence in Colorado and never filed Colorado returns.  In a lengthy 89-page decision, the court addressed the application of economic nexus (for tax years prior to Colorado adopting a factor-presence nexus test), whether the Department of Revenue could apply an alternative apportionment formula, whether an earlier audit of the group precluded the assessment for earlier tax years, and whether the Department’s delays in addressing the taxpayer’s protest should result in an interest abatement.  There were actually three audits at issue in the case―an audit in 2003, an MTC audit, and a second Department of Revenue audit. The 2003 audit was completed without the Department assessing the taxpayer. However, the MTC auditor had determined that the taxpayer, an 80/20 company, had nexus with Colorado and was subject to corporate income tax. The final departmental audit adopted the MTC rationale and concluded that the taxpayer had nexus with Colorado. This determination was then applied to tax years at issue in the 2003 audit.

The court first addressed the nexus issue and concluded that the taxpayer was “doing business” in Colorado for the tax years at issue- notably because it received “hundreds of millions of dollars in income related to the use of its IP in Colorado.” This determination did not violate the Commerce Clause, as the court concluded that the physical presence rule in Quill did not extend to income-based taxes. Having addressed the nexus question, the court turned to whether the Department had proven that the standard three-factor apportionment formula did not fairly reflect the taxpayer’s business activity in Colorado. Use of the standard three-factor formula that used an income―producing activity test for sourcing sales of other than tangible personal property resulted in no income being apportioned to Colorado. Therefore, the Department had applied an alternative, single-sales factor formula that utilized the taxpayer’s retail parent’s sales. The court concluded that the taxpayer’s situation―in that it had no property or payroll in Colorado and no sales sourced under the statutory method, but received hundreds of millions of dollars in royalties from Colorado―was an unusual fact situation in which the three-factor formula did not fairly represent the taxpayer’s activity in the state. However, because the taxpayer had substantial business activities in other places, the Department’s proposed formula―using the retail entity’s sales―was not reasonable and the court ordered the Department to include the taxpayer’s own property and payroll in the alternative formula.

Next, the court held that the Department could not assess the taxpayer for the years that pre-dated the 2003 audit. Although the taxpayer never filed standalone returns, the audit of the corporate group was in part an audit of the taxpayer and the court held that the statute of limitations was closed on those tax years. Finally, although the court declined to abate all interest and penalties, it did abate interest related to the MTC audit assessments because of delays in getting the matter to the Hearing Division. Please contact Mark Kaye at 303-382-7855 with questions on Target Brands, Inc. v. Colorado, Department of Revenue.

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.