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Jamie C. Yesnowitz
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On July 5, 2018, the Minnesota Supreme Court overturned a Tax Court decision and upheld the Commissioner of Revenue’s authority to require a financial institution to treat captive partnerships as financial institutions for apportionment factor purposes.1
The Supreme Court determined that the Commissioner had met her burden of proof when she showed that the regular apportionment formula did not fairly and correctly apportion the taxpayer’s income in Minnesota.
During the tax years at issue, Minnesota’s income tax law required financial institutions to apportion their income to Minnesota using special apportionment methods which included interest income from loans in the sales factor and the value of loans in the property factor. Business entities that were not financial institutions used the statutory three-factor apportionment formula (property, payroll and heavily-weighted sales) which excluded these items from the apportionment factors.2
During the 2007 and 2008 tax years, Associated Bank, N.A. (“Associated Bank”), a nationally chartered bank headquartered in Wisconsin and a wholly-owned subsidiary of Associated Banc-Corp, a bank holding company, filed a combined Minnesota corporation franchise tax return with certain affiliates using the special financial institution apportionment formula as required by law.
Associated Bank and certain affiliates are in the business of banking with locations in Wisconsin, Illinois and Minnesota. In September 2007, Associated Banc-Corp created two new limited liability companies under Wisconsin law: Associated MN Retail RE, LLC (“Retail LLC”) and Associated MN Commercial RE, LLC (“Commercial LLC”). Associated Bank and certain affiliates were the members of the newly created LLCs and they transferred portfolios of loans secured by Minnesota real estate to the newly created LLCs. The management of the transferred loans remained the same. Associated Bank remained the mortgagee on the loans and borrowers continued to make loan payments directly to Associated Bank as the collection agent for the LLCs. However, new reports were generated to track the portfolios. The newly created LLCs earned a significant amount of interest income on these loans.
Before the LLCs were created, Associated Banc-Corp explained to the federal Office of the Comptroller of Currency that the purpose for creating the two LLCs was to “minimize Associated’s Minnesota tax liability by reducing the Minnesota apportionment ratio.”
During the tax years at issue, Retail LLC and Commercial LLC each filed Minnesota partnership returns utilizing the general apportionment formula3
because as partnerships, they did not consider themselves to be financial institutions as defined in the Minnesota law.4
The general apportionment formula excluded interest income from the sales factor and intangible property (the value of the loans) from the property factor. As a result, the Minnesota apportionment factors for Retail LLC and Commercial LLC were zero.
The Minnesota Commissioner of Revenue issued a Notice of Change of Tax that applied an alternative apportionment method to Associated Bank’s 2007 and 2008 returns.5
The assessment substantially increased the apportionment ratio for Associated Bank by including the LLCs’ interest income and loan values in Associated Bank and certain affiliates’ apportionment factor in order to “fairly allocate taxable net income of the Minnesota unitary group to Minnesota.” The tax order assessed over $4.9 million in additional tax, plus interest. Associated Bank appealed the Commissioner’s tax order to the Minnesota Tax Court.
Tax Court relied on HMN Financial decision
In its decision issued on April 18, 2017, the Minnesota Tax Court held that the Commissioner improperly invoked the provisions of Minn. Stat. Sec. 290.20, subd. 1 to adjust the apportionment factors of Associated Bank and certain affiliates to reflect the transfer of the loans to the LLCs.6
The Commissioner argued that the general apportionment methods provided in Minn. Stat. Sec. 290.191 did not fairly reflect Associated Bank’s income apportionable to Minnesota and that it had authority to invoke an alternative apportionment method.7
While the Commissioner’s tax orders are “prima facie valid,”8
the statute providing the Commissioner with authority to use an alternative apportionment method presumes that the general apportionment methods are fair and correct.9
In HMN Financial, Inc. v. Commissioner of Revenue
, the Minnesota Supreme Court examined the provision authorizing the Commissioner to use an alternative apportionment method.10
The Supreme Court held that the plain meaning of Minn. Stat. Sec. 290.20 presumes “that a taxpayer has ‘fairly and correctly’ determined its Minnesota taxable income if that taxpayer used the reporting methods outlined in section 290.191.”11
Rather than asserting that Associated Bank “did not properly follow ‘the methods prescribed by section 290.191,’” the Commissioner asserted that she has broad statutory authority to disregard business entities structured to minimize tax liabilities. The Commissioner’s position was that the general apportionment method did not fairly capture Associated’s Minnesota income because: (1) substantial income was generated by loans secured by Minnesota property; (2) the “loans retained each and every aspect of their Minnesota character;” and (3) millions of dollars in revenue was sheltered from Minnesota tax.
Following HMN Financial’s
guidance, the Tax Court held that the Commissioner could not invoke her authority to use an alternative apportionment method to disregard the taxpayer’s lawfully created and organized corporate structure.
Supreme Court allows commissioner to use alternative apportionment
The Minnesota Supreme Court first reviewed and distinguished its prior decision in HMN Financial
. The Court explained that in HMN Financial
, the Commissioner relied on Section 290.20 for the general authority to impose additional tax based on the economics of the transaction. However, in this case, the Commissioner used Section 290.20 as specific authority to use an alternative apportionment method, because the regular apportionment formula did not “fairly reflect” the taxpayer’s Minnesota income.
The Supreme Court noted that Section 290.20 creates a presumption that the regular apportionment methods fairly and correctly determine the taxpayer’s income in Minnesota. As a result, the Commissioner had the burden to overcome this presumption. The Court found that the Commissioner had overcome the presumption supporting the regular apportionment formula when it presented substantial evidence that the regular apportionment formula failed to reflect any of the bank’s income that it received from the LLCs’ business activity in Minnesota. The loans were secured by Minnesota real estate, the bank remained the mortgagee of record, and the borrowers made their loan payments directly to the bank. The LLCs earned significant amounts of interest income from these loans. This allowed the Court to conclude that the regular apportionment method did not fairly reflect the bank’s Minnesota income, because under this method, the bank had no taxable income arising from the partnerships’ Minnesota contacts.
In reversing the Tax Court’s decision, the Supreme Court held that the alternative apportionment method used by the Commissioner was a fair reflection of the bank’s Minnesota income because it included each LLC member’s pro-rata share of the receipts and intangible property in the bank’s apportionment factors.
While the Minnesota Supreme Court did not use this decision to adopt a broad economic substance doctrine with respect to all types of tax matters, the decision is still a significant victory for the Commissioner since the Supreme Court allowed her to require the use of an apportionment formula which would fairly reflect the taxpayer’s Minnesota income that resulted from its activities in Minnesota. Based on this decision, the possibility exists for the Commissioner to utilize her powers of alternative apportionment more frequently.
However, the decision potentially may also be used by taxpayers that are seeking alternative apportionment. For example, taxpayers confronted with situations where significant sources of income (such as foreign source dividends) would typically not have apportionment factor representation in the current Minnesota single sales factor apportionment regime, may respond with alternative apportionment challenges of their own.
It should be noted that in 2017, as part of the Minnesota omnibus tax bill and as a reaction to the Tax Court’s decision in this matter, the definition of the term “financial institution” was changed to require partnerships and other entities that are owned more than 50% by a financial institution to use the financial institution apportionment method starting with the 2017 tax year. 12
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