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New Jersey adopts mandatory combined reporting, market-based sourcing

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On July 1, 2018, New Jersey enacted legislation overhauling a number of New Jersey tax laws in order to achieve a balanced budget for the 2019 fiscal year (which also began on July 1) and avoid a government shutdown.1 Gov. Phil Murphy and the legislature reached a last-minute agreement on legislation that makes significant changes to the state’s Corporation Business Tax (CBT). The legislation imposes a temporary surtax on corporations; decouples from certain Internal Revenue Code (IRC) provisions contained in H.R. 1, more commonly known as the Tax Cuts and Jobs Act (TCJA);2 and modifies New Jersey’s dividends received deduction (DRD) and net operating loss (NOL) deduction. Most notably, for tax years beginning in 2019 and thereafter, the legislation imposes mandatory unitary combined reporting and market-based sourcing for sales factor purposes.

Corporation business tax surtax An additional “surtax” is imposed on corporations subject to CBT for their next four tax years.3 Corporations with allocated net income in excess of $1 million will pay a surtax of 2.5% for tax years beginning in 2018 or 2019. For tax years beginning in 2020 or 2021, the surtax will be 1.5%. The surtax will be separately computed in addition to the current 9% CBT, effectively providing for a total CBT rate of 11.5% for tax years beginning in 2018 and 2019, and 10.5% for tax years beginning in 2020 and 2021. No credits are allowed against the surtax other than for prior period overpayments, estimated tax installments and extension payments.

IRC decoupling The legislation contains several provisions that address the TCJA. The New Jersey Division of Taxation previously had indicated that deemed repatriation dividends will be excluded from entire net income (ENI), as provided by the dividends received deduction (DRD).4 For tax years beginning in 2017 and thereafter, the legislation provides that New Jersey is not allowing any federal deduction, exemption or credit against deemed repatriation amounts under IRC Sec. 965 for purposes of computing ENI.5 For 2018 and subsequent tax years, New Jersey is decoupling from the 20% deduction for qualified business income allowed under IRC Sec. 199A.6 For New Jersey purposes, the federal interest deduction limitation contained in IRC Sec. 163(j) applies on a pro-rata basis to interest paid to both related and unrelated parties, regardless of whether the related parties are subject to addback requirements.7
 
Dividends received deduction For tax years ending on or before Dec. 31, 2016, New Jersey allowed a 100% dividends received deduction (DRD) for dividends paid by 80% or more owned subsidiaries.8 For subsequent tax years, the DRD is permanently reduced to 95% and covers both dividends paid and those “deemed paid.”9 For the tax year beginning after 2016, deemed dividends are specially allocated by either the three-year average of the taxpayer’s 2015- 17 allocation factors or 3.5%, whichever is lower.

The 50% deduction for dividends from subsidiaries 50% or more owned now applies to dividends paid and also to dividends that are deemed paid.10 In a tiered ownership structure, when a subsidiary pays tax on dividends from other subsidiaries and passes those same dividends up to a taxpayer, the taxpayer is allowed a DRD based on the subsidiary’s allocation factor.11

Net operating losses The computation and carryover of NOLs in New Jersey has changed significantly:

  1. The only NOL carryover deduction for losses incurred in tax years beginning prior to Jan. 1, 2018, is the prior net operating loss conversion carryover (PNOLCC) which recomputes NOLs from such earlier years on a post-allocation basis.12 This calculation is made by taking NOLs available for carryover from tax years beginning prior to Jan. 1, 2018, (referred to as the unabsorbed portion of net operating loss or UNOL) and multiplying those loss amounts by the taxpayer’s business allocation factor from its last tax year beginning prior to Jan. 1, 2018, (referred to as its “base year BAF”).

    The PNOLCC can be carried forward for up to 20 tax years following the tax year of the initial loss.13 It must be deducted from allocated ENI before the carryover of NOLs sustained in tax years following enactment.14

  2. For tax years beginning on or after Jan. 1, 2018, NOLs are computed on a post-allocation basis.&15 Also, the previous requirement that an NOL carryover be deducted before subtraction of any DRD has been eliminated. Under the new law, allocated NOLs are deducted from allocated ENI after the DRD.

Related member addbacks — ‘treaty’ exceptions New Jersey requires the addition of deductible interest and of intangible expenses paid, accrued or incurred to a related member.16 An exception is available for amounts paid to any related member in a foreign nation that has a comprehensive income tax treaty with the United States.17 For tax years beginning in 2018 and thereafter, the new law limits these treaty exceptions by requiring that the interest or intangible expenses be included in the related member’s tax base in a foreign nation and subject to an effective tax rate equal to or greater than 3% less than the tax rate applied by New Jersey.

Investment companies and REITs Under prior law, New Jersey taxed a strictly-defined “investment company” on 40% of its pre-allocation ENI and taxed a real estate investment trust (REIT) on 4% of its pre-allocation ENI.18 For tax years beginning in 2018 and thereafter, these entities are taxed on their “taxable net income” (allocated ENI less NOLs).

R&D credit For tax years beginning in 2018 and thereafter, the New Jersey research and development (R&D) credit is no longer refundable.19 Additionally, while the New Jersey credit is largely based on the federal research credit, the New Jersey credit will continue to be available even if IRC Sec. 41 (the credit for increasing research activities) is terminated.20

Market-based sourcing for sales of services For tax years beginning in 2019 and thereafter, receipts from sales of services will be allocated to New Jersey if the benefit of the service is received in New Jersey.21 Where the benefit of a service is received on a multistate basis, the portion of the receipts allocated to New Jersey will be based on the percentage of the total value of the benefit received in New Jersey or a “reasonable approximation” of the value.22 When the relative value of the benefit received in New Jersey cannot be determined for an individual customer, the benefit of the service is deemed to be received at the customer’s billing address.23 When the relative benefit received in New Jersey cannot be determined for a business customer, the benefit of the service is deemed to be received at the location from which the services were ordered.24 If that location cannot be determined, the benefit of the service is deemed to be received at the business customer’s billing address.25
 
Mandatory unitary combined reporting For tax years beginning in 2019 and thereafter, New Jersey is adopting mandatory combined filing for combined groups that have common ownership,26 conduct a unitary business,27 and have at least one member corporation subject to the CBT.28 A combined group will not include insurance companies (with the exception of combinable captive insurance companies as defined in the new statute) and gas or electric public utilities.29 The legislation eliminates the Director’s discretionary authority to require combination which was granted by New Jersey’s 2002 Business Tax Reform Act.30

Entire net income

Each taxable member of a combined group must determine its share of the ENI from the unitary business of the combined group.31 The unitary ENI of a combined group is the sum of the ENIs of both the taxable and nontaxable members of the group. For members incorporated in the United States, income included for the combined group is ENI as determined for CBT purposes.32 For foreign corporation members, income included in the ENI of the combined group starts with a profit and loss statement in their foreign currency adjusted to conform to U.S. GAAP and then further adjusted for any federal or state book/tax differences.33 This result (as well as relevant amounts for allocation purposes) are then translated into U.S. dollars.

When a member receives unitary income from a partnership, combined group ENI includes the member’s direct and indirect distributive share of the partnership’s unitary business income.34 A limited partner’s distributive share of income from a “qualified investment partnership” (more than 10 partners with no partner holding more than a 50% interest and that derives at least 90% of partnership gross income from dividends, interest and other securities transactions)35 is not considered part of unitary business income unless the limited partner and the general partner of the investment partnership have common ownership.36

All dividends paid between members of a combined group are eliminated from the income of the recipient.37 Business income from intercompany transactions is deferred in the same manner as for federal purposes.38

Net operating losses

A PNOLCC cannot be shared among the taxable members of a combined group.39 A PNOLCC can only be used to offset the portion of combined, allocated ENI of the member that created it. For tax years beginning in 2019 and thereafter, post-allocation NOLs of a combined group may be carried over and deducted by taxable members.40 A taxable member may share its NOL carryover with other taxable members that were members of the combined group in the year an NOL was incurred. A taxable member’s NOL carryover from a tax year when that member was not a member of the combined group may only be deducted by that member (or by other current group members that were part of the same combined group as the member in the loss year).
 
Credits and deductions

For tax years beginning in 2019 and thereafter, any New Jersey tax credit earned by a taxable member and any tax credit carryover of a taxable member may be shared by other taxable members of the combined group.41 Tax credit carryovers from tax years prior to the advent of combined reporting or from years when the taxable member earning the credit was not a member of the combined group may also be shared among the taxable members of a combined group.

Any expense of a member of a combined group that is directly or indirectly attributable to income which New Jersey is prohibited from taxing under federal law is disallowed as a deduction in computing the ENI of a combined group.42

A special deduction is provided for publicly traded companies affected by the new combined reporting requirements.43 The deduction is based on the aggregate increase to the net deferred tax liability of the members of a combined group or the aggregate decrease to their net deferred tax asset on account of New Jersey combined reporting.44

Allocation

Combined ENI is allocated to each taxable member according to its sales allocation factor.45 The numerator of the allocation factor for each taxable member is the amount of its receipts assignable to New Jersey while a taxable member’s denominator is the total combined allocable receipts of the entire combined group. Thus, the statute appears to follow the Joyce rule.46 Intercompany transactions between members of a combined group are eliminated from the sales allocation factor.47
  
Filing responsibility

The managerial member of a combined group may make a binding election (for the current plus five succeeding tax years) to have the group file on a worldwide basis or on an affiliated group basis.48 Absent any such election, combined groups will file their returns on a water’s-edge basis.

Water’s-edge group

A water’s-edge return will include only the ENI and allocation factors of the following members of the combined group:

  • Each member incorporated in the U.S., but excluding any U.S. members whose property and payroll during a tax year are 80% or more outside the U.S.;
  • Any member wherever incorporated whose property and payroll during a tax year are 20% or more within the U.S.;
  • Any member that earns more than 20% of its income directly or indirectly from intangible property or related services that are deductible by other members of the combined group; and
  • Any other member that has income for CBT purposes and has sufficient nexus with New Jersey for CBT purposes.49

Affiliated group election

Combined returns filed under an affiliated group election will include the ENI and allocation factors of all members of the affiliated group whether or not they are engaged in a unitary business with the taxable members of the group.50 An affiliated group is defined by reference to IRC Sec. 1504 except the group includes all domestic corporations that are commonly owned by any member of the group, without regard to whether the group includes: (i) corporations included in more than one federal consolidated return, (ii) corporations engaged in one or more unitary businesses, or (iii) corporations that are not engaged in a unitary business with any member of the group.51

Penalties and interest

A new statutory section in the legislation provides relief from penalties and interest for underpayment of tax on account of:

  • Provisions retroactive to tax years beginning on or after Jan. 1, 2017, if the tax due on account of those provisions is paid by Dec. 31, 2018.52
  • Provisions retroactive to tax years beginning on or after Jan. 1, 2018, if the tax due on account of those provisions is paid by the first estimated payment due after Jan. 1, 2019.
  • The change from separate returns to mandatory combined returns. Also, any overpayment by a member of the combined group from a prior tax year will be credited as an overpayment of the tax owed by the combined group, credited toward future estimated payments by the combined group.53

Commentary This legislation will have a dramatic impact on how taxpayers compute the CBT. Major changes such as market-based sourcing for services and mandatory unitary combined reporting are not effective until tax years beginning in 2019 and thereafter, but there are substantial changes that will affect the CBT prior to the 2019 tax year. As discussed below, there is a degree of uncertainty concerning the implementation of some of these changes.

The term “surtax” for the additional CBT rate imposed for tax years beginning in 2018 and thereafter technically is a misnomer, because this component of the tax is a separate additional tax. Due to the fact that the surtax is imposed on allocated net income rather than taxable net income, NOLs apparently are not taken into consideration. In addition, very few of the CBT credits may be taken against the new surtax. At this point, it is unclear how the surtax will be implemented in combined return years and where the surtax will be added to the New Jersey returns.

For tax years beginning in 2017 and thereafter, New Jersey is not allowing any federal deduction, exemption or credit against deemed repatriation amounts under IRC Sec. 965. However, the Division previously indicated that the deemed repatriated dividends will be excluded from ENI to the extent provided by the DRD. It is not clear how the provisions related to IRC Sec. 965 will be implemented on the CBT return, but presumably taxpayers that have already filed their 2017 returns will need to file amended returns. As discussed above, allocated NOLs are deducted from allocated ENI after the 95% DRD.

The change in the tax treatment of investment companies and REITs is significant and may substantially increase their tax liability. These entities previously were provided with favorable tax treatment, but they now are taxed on their allocated ENI less NOLs.

The adoption of market-based sourcing generally follows the state trend, but differs from many other states because it is limited to services. Thus, with the exception of services, market-based sourcing does not apply to sales other than sales of tangible personal property. As a result, the current regulations governing allocation of non-service, non-tangible personal property receipts remain in effect and the classification of revenue streams is vitally important.54

The implementation of mandatory unitary combined reporting for tax years beginning in 2019 and thereafter will affect most corporate business concerns. The expanded water’s-edge group is noteworthy because it excludes domestic “80/20” companies and includes foreign “20/80” companies. The affiliated group election apparently is not dependent on a unitary relationship and may be made by entities that meet the ownership requirement. The new statutory definition of “affiliated group” provides that the determination is made without regard to whether the group includes corporations that are engaged in a unitary business with other members of the group. Under the affiliated group election, the taxable members may take into account the entire net income or loss and allocation factors of all the group members, regardless of whether the members are engaged in a unitary business, that are subject to tax or would be subject to CBT if doing business in the state. Thus, an affiliated group combined return apparently is applied on a Finnigan55 basis, while water’s-edge and worldwide filers follow Joyce.
 

1 Ch. 48 (A.B. 4202), Laws 2018. For the full text of this legislation, see http://www.njleg.state.nj.us/2018/Bills/AL18/48_.PDF.
2 P.L. 115-97. For a discussion of this Act, see GT Alert: Tax Reform Law Transforming Business and Tax Planning.
3 N.J. REV. STAT. § 54:10A-5.41.
4 Notice: New Jersey’s Treatment of Repatriated Dividends Reported Pursuant to Internal Revenue Code (IRC) Section 965, New Jersey Division of Taxation, March 16, 2018. If a corporation does not meet the ownership thresholds, the deemed repatriation dividends will be included in ENI to the extent provided by New Jersey law. 
5 N.J. REV. STAT. § 54:10A-6.5.
6 N.J. REV. STAT. § 54:10A-4(k)(2)(J)(ii).
7 N.J. REV. STAT. § 54:10A-4(k)(2)(K).
8 N.J. REV. STAT. § 54:10A-4(k)(5)(A)(i).
9 N.J. REV. STAT. § 54:10A-4(k)(5)(A)(ii), (iii).
10 N.J. REV. STAT. § 54:10A-4(k)(5)(B).
11 N.J. REV. STAT. § 54:10A-4(k)(5)(C).
12 N.J. REV. STAT. § 54:10A-4(k)(6), (u).
13 N.J. REV. STAT. § 54:10A-4(u)(2)(B).
14 N.J. REV. STAT. § 54:10A-4(u)(2)(C).
15 N.J. REV. STAT. § 54:10A-4(v), (w).
16 N.J. REV. STAT. § 54:10A-4.4.5.b.
17 N.J. REV. STAT. § 54:10A-4.4.5.c.(1).
18 N.J. REV. STAT. § 54:10A-5(d).
19 N.J. REV. STAT. § 54:10A-5.24.b.
20 N.J. REV. STAT. § 54:10A-5.24.c.
21 N.J. REV. STAT. § 54:10A-6(B)(4)(i).
22 Id.
23 N.J. REV. STAT. § 54:10A-6(B)(4)(ii).
24 N.J. REV. STAT. § 54:10A-6(B)(4)(iii).
25 Id.
26 Common ownership means direct or indirect ownership of greater than 50% direct or indirect voting control of each member by a common owner or owners. N.J. REV. STAT. § 54:10A-4(aa).
27 A unitary business is a single economic business made up either of separate parts of a single business entity or of a group of business entities that are so interdependent, integrated, and interrelated as to provide a synergy and mutual benefit resulting in a significant flow of value among the separate parts of the business. It includes business conducted by a partnership if the partners are members of a combined group. “Unitary business” is construed as broadly as permissible under the U.S. Constitution. N.J. REV. STAT. § 54:10A-4(gg).
28 N.J. REV. STAT. §§ 54:10A-4(z); 54:10A-4.6.
29 N.J. REV. STAT. § 54:10A-4.6.k.
30 N.J. REV. STAT. § 54:10A-10(c).
31 N.J. REV. STAT. § 54:10A-4.6.
32 N.J. REV. STAT. § 54:10A-4.6.a.
33 N.J. REV. STAT. § 54:10A-4.6.b.
34 N.J. REV. STAT. § 54:10A-4.6.c.(1).
35 N.J. REV. STAT. § 54:10A-4(r).
36 N.J. REV. STAT. § 54:10A-4.6.c.(2).
37 N.J. REV. STAT. § 54:10A-4.6.d.
38 N.J. REV. STAT. § 54:10A-4.6.e.
39 N.J. REV. STAT. § 54:10A-4.6.g.
40 N.J. REV. STAT. § 54:10A-4.6.h.
41 N.J. REV. STAT. § 54:10A-4.6.i.
42 N.J. REV. STAT. § 54:10A-4.6.j.
43 N.J. REV. STAT. § 54:10A-4(k)(16). The total deferred tax deduction (DTD) is computed by taking the deferred tax impact of New Jersey combination, dividing it by the New Jersey tax rate and then further dividing this result by the unitary allocation factor of the combined group. One-tenth of the resulting DTD can be deducted by the combined group for 10 tax years beginning with its fifth tax year following the effective date for combined reporting.
44 A combined group with alternative minimum assessment (AMA) credits available can use them to reduce the increase in the combined group’s net deferred tax liability resulting from New Jersey’s transition to mandatory unitary combined reporting. N.J. REV. STAT. § 54:10A-4.9. Any remaining AMA credits can be used to reduce up to 50% of the combined group’s New Jersey tax liability.
45 N.J. REV. STAT. § 54:10A-4.7.
46 Many states, including states that have adopted the Uniform Division of Income for Tax Purposes Act follow the Joyce rule, a California State Board of Equalization decision, whereby sales made to the taxing state’s customers by a unitary group member that is not subject to tax in the state are not includible in the numerator of the group’s sales factor in the state, even though other members of the unitary group are subject to tax in the taxing state. Appeal of Joyce Inc., Dkt. No. 66-SBE-070 (Cal. State Bd. of Equal. Nov. 23, 1966).
47 N.J. REV. STAT. § 54:10A-4.7.c.
48 N.J. REV. STAT. § 54:10A-4.11. The “managerial member” of a combined group is responsible for the filing of a combined unitary tax return and payment of tax on behalf of the taxable members of the combined group and various other administrative tasks. N.J. REV. STAT. § 54:10A-4.8.a. The “privilege period” (taxable year) of the combined group is that of the managerial member. N.J. REV. STAT. § 54:10A-4.8.b. If the common parent corporation of a combined group is a taxable member of the group, it is the managerial member. N.J. REV. STAT. §§ 54:10A-4(cc); 54:10A-4.10.a. If the common parent is not a taxable member, the combined group shall make a binding 10-year election of the managerial member. At the discretion of the Director or if the combined group fails to select a managerial member, the Director will designate the managerial member of the combined group. 
49 N.J. REV. STAT. § 54:10A-4.11.a.
50 N.J. REV. STAT. § 54:10A-4.11.c.
51 N.J. REV. STAT. § 54:10A-4(x). Note that although the legislation makes a worldwide election available, it does not provide any additional detail regarding the composition of a worldwide combined group.
52 N.J. REV. STAT. § 54:10A-4.12.
53 Id.
54 For example, see N.J. ADMIN. CODE § 18:7-8.11.
55 Finnigan is a California SBE decision, currently followed by several states, that held sales made to a taxing state’s customers by a unitary group member that is not subject to tax in the state are includible in the numerator of the group’s sales factor in the state, as long as at least one member of the unitary group is subject to tax in the taxing state. Appeal of Finnigan, Dkt. No. 88-SBE-022 (Cal. State Bd. of Equal. Aug. 25, 1988).




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