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Kentucky amends corporate income tax regulations

Changes clarify apportionable income determination, alternative apportionment procedures

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The Kentucky Department of Revenue recently amended a variety of corporate income tax regulations.1 Some apportionment regulations are revised to reflect the major state tax reform legislation enacted last year, including the adoption of single sales factor apportionment.2 A regulation also is amended to provide taxpayers with procedures to request the use of alternative apportionment. Regulations that address topics such as apportionment of income reported under the completed contract method, related-party transactions and the nexus standard applicable to corporations and pass-through entities also have been amended.

Determination of apportionable income For taxable years beginning on or after Jan. 1, 2018, Kentucky is requiring most taxpayers to use a single sales factor apportionment formula.3 In line with model regulations adopted by the Multistate Tax Commission (MTC), the regulation updates the statutory terminology by replacing “business income” with “apportionable income” and “nonbusiness income” with “non-apportionable income.” Under the amended statute, apportionable income means income that is apportionable under the U.S. Constitution and is not allocated to Kentucky, including income arising from transactions and activity in the regular course of the taxpayer’s trade or business.4 Apportionable income also includes income arising from tangible and intangible property if the acquisition, management, employment, development or disposition of the property is or was related to the operation of the taxpayer’s trade or business.

Applicable to tax years beginning on or after Jan. 1, 2018, the apportionment regulation that covers income classification is extensively amended to reflect the tax reform legislation and new terminology.5 This regulation provides criteria for classifying corporate income into its apportionable and non-apportionable components, allocates expenses for non-apportionable income and clarifies that Kentucky follows both the transactional and functional tests. The regulation is amended to add a definition for “trade or business,”6 as well as update the definitions of the transactional7 and functional tests.8 Also, new examples are added to illustrate application of the functional test.9 The regulation also is expanded to include multiple examples of apportionable and non-apportionable income.10

The payroll and property factor regulations were amended to update statutory references and terminology. Most taxpayers use a single sales apportionment factor, but taxpayers such as providers of communications service, cable service and Internet access continue to use a three-factor formula.12

Alternative apportionment procedures The Kentucky tax reform legislation amended the alternative apportionment provisions and clarified the burden of proof required to utilize alternative apportionment.13 A regulation is amended to add alternative apportionment request procedures that apply to taxable years beginning on or after Jan. 1, 2018.14 Before a taxpayer files a return using alternative apportionment, the taxpayer must file a petition for the use of alternative apportionment with the Department. All petitions must be in written form and submitted to the attention of the Commissioner. The Department will notify the taxpayer, in writing, if the requested alternative method has been approved. If approved, the taxpayer may file an amended or original return using the approved alternative apportionment method. The regulation also addresses a taxpayer’s recourse if the Department denies the petition for alternative apportionment.15 Finally, the regulation clarifies that with respect to a request for separate accounting, the fact that taxable income is greater or lesser, or that the accounting records of the taxpayer reflect income by contracts or states is not sufficient to support such request.16

Completed contract method The regulation that explains how the apportionment factors are calculated when net income is reported on a completed contract basis is amended.17 The apportionment provisions are revised to reflect the adoption of single sales factor apportionment and omit the property and payroll factor provisions. Also, a definition is added for “gross contract price.”18

Related party transactions Kentucky law generally disallows intangible expenses, intangible interest expenses and management fees that are paid to related members or a foreign corporation.19 The corresponding regulation is amended to clarify that “arm’s length transaction” means a freely negotiated transaction between unrelated parties as provided under federal law.20

Nexus standard The regulation that addresses the nexus standard for corporations and pass-through entities is amended to provide that P.L. 86-272 does not afford immunity from the Kentucky limited liability entity tax.21 The existing regulation explains that under P.L. 86-272, Kentucky will not impose tax if the entity’s sole activity in the state is through representatives soliciting orders for the sale of tangible personal property and the orders are: (i) sent outside Kentucky for approval or rejection; and (ii) filled by shipment or delivery from a point outside Kentucky. The amendment clarifies that this provision applies regardless of the method of shipment or delivery.

Commentary Kentucky substantially amended the apportionment income classification regulation to reflect the major legislation enacted last year and provide further clarity to taxpayers. The state has adopted the terminology used by the MTC and distinguishes between apportionable and non-apportionable income. Many of the revisions to the regulation are drawn from the MTC’s Model General Allocation and Apportionment Regulations. In fact, the Kentucky regulation directly adopts the MTC’s functional test examples. The Kentucky regulation provides further guidance by adding multiple examples of apportionable and non-apportionable income. These amendments should assist taxpayers in determining the correct treatment of income. Furthermore, the new alternative apportionment provisions clarify the procedures that taxpayers should follow when requesting the use of an alternative apportionment methodology. As explained in the regulation, taxpayers must file a petition seeking the use of alternative apportionment prior to filing a return that employs this methodology. Kentucky is expected to amend additional regulations to address the major tax reform legislation enacted last year, including the implementation of rules governing mandatory unitary combined reporting, market-based sourcing for items other than tangible personal property, and the treatment of net operating losses.

 

1 103 KY. ADMIN. REGS. 16:060; 16:090; 16:230; 16:240; 16:290; 16:330; 16:340. The amendments are effective February 1, 2019, but some of the apportionment regulation amendments retroactively apply to tax years beginning on or after January 1, 2018.
2 Ch. 207 (H.B. 487), Laws 2018. For further information, see GT SALT Alert: Kentucky Enacts Tax Reform Including Mandatory Unitary Combined Reporting, Single Sales Factor Apportionment and Remote Seller Nexus. The legislation also adopted market-based sourcing for sales other than sales of tangible personal property but the amended regulations do not address this topic.
3 KY. REV. STAT. ANN. § 141.120(9). Previously, business income was apportioned to Kentucky using a three-factor formula consisting of a property, payroll and double-weighted sales factor. Former KY. REV. STAT. ANN. § 141.120(8).
4 KY. REV. STAT. ANN. § 141.120(1)(a).
5 103 KY. ADMIN. REGS. 16:060.
6 103 KY. ADMIN. REGS. 16:060.1(8). “Trade or business” as used in the definition of apportionable income means the taxpayer’s unitary business, part of which is conducted within Kentucky.
7 103 KY. ADMIN. REGS. 16:060.3. Under the transactional test, “[a]pportionable income includes income arising from transactions and activity in the regular course of the taxpayer’s trade or business.”
8 103 KY. ADMIN. REGS. 16:060.4. Under the functional test, “[a]pportionable income also includes income from tangible and intangible property, including any direct or indirect interest in, control over, or use in the property held directly, beneficially, by contract, or otherwise, that contributes to the production of apportionable income, if the acquisition, management, employment, development, or disposition of the property is or was related to the operation of the taxpayer’s trade or business.”
9 Id.
10 103 KY. ADMIN. REGS. 16:060.5. The examples include the following: (i) rental income from real and tangible personal property; (ii) gain or loss from the sale, exchange or other disposition of real, tangible or intangible property; (iii) interest income; and (iv) patent and copyright royalties.
11 103 KY. ADMIN. REGS. 16:090; 16:290.
12 KY. REV. STAT. ANN. § 141.121(1)(e), (3).
13 KY. REV. STAT. ANN. § 141.120(12). If the statutory allocation and apportionment provisions do not fairly represent the extent of the taxpayer’s business activity in Kentucky, a taxpayer may petition for, or the Department may require, in respect to all or any part of the taxpayer’s business activity, if reasonable: (i) separate accounting; (ii) the inclusion of one or more additional factors which will fairly represent the taxpayer’s business activity in the state; or (iii) the use of any other method to effectuate an equitable allocation and apportionment of the taxpayer’s income. The party petitioning for or the Department requiring the use of alternative apportionment must prove by clear and convincing evidence that: (i) the statutory allocation and apportionment provisions do not fairly represent the extent of the taxpayer’s business activity in Kentucky; and (ii) the alternative to the provisions is reasonable.
14 103 KY. ADMIN. REGS. 16:330.
15 Id. If a taxpayer disagrees with the denial of the petition, the taxpayer can: (i) pay the tax that is due under the Department’s interpretation and seek a refund which, if denied, can be protested; or (ii) file a return with the denied alternative apportionment method, which will result in an assessment being issued that the taxpayer can protest.
16 Id.
17 103 KY. ADMIN. REGS. 16:340.
18 Id. “Gross contract price” means the percentage of the entire contract that has been completed, from the commencement of the contract to the date of withdrawal, dissolution or cessation of the business.
19 KY. REV. STAT. ANN. § 141.205.
20 103 KY. ADMIN. REGS. 16:230. Specifically, the regulation adopts the definition as provided in 26 C.F.R. 1.482-1.
21 103 KY. ADMIN. REGS. 16:240.





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