The New Jersey throwout wins are more nationally relevant than ever, even though New Jersey repealed the throwout provision in its Corporation Business Tax Act nearly a decade ago. “Throwout” takes its name from the requirement that receipts be removed from (or “thrown out” of) a company’s sales factor denominator for income tax apportionment purposes if those receipts are not subject to tax in the state to which they are sourced. Throwing out receipts attributable to other states reduces the denominator of a company’s sales factor, resulting in an increase in the amount of the company’s income that is apportioned to and taxed by the state requiring throwout. Other states, blinded by the prospect of revenue, have not been as enlightened as the New Jersey Legislature, which understood that the right thing to do was to leave throwout in the state tax trash bin. Nonetheless, New Jersey courts have provided a framework for evaluating—and beating back—the constitutionality of other states’ throwout provisions.
Parameters Set by New Jersey Courts
New Jersey’s throwout provision made headlines twice with wins by our firm, Morrison & Foerster, in 2011 and 2014. The New Jersey Supreme Court agreed with us in 2011 and rejected the New Jersey Division of Taxation’s approach to throwout, which excluded all receipts from the sales factor denominator that were not actually taxed in another jurisdiction, even when nontaxation resulted from nothing more than the other jurisdiction’s policy choice. In Whirlpool Properties, Inc. v. Director, Division of Taxation, the New Jersey Supreme Court limited the application of throwout, ruling that it is constitutional only if it is limited to throwing out receipts that are not taxed by another state because either 1) the company lacks the requisite constitutional contacts with that state to be subject to tax there or 2) the company is protected from taxation due to congressional action, such as P.L. 86-272.1 The Whirlpool court held that New Jersey’s throwout provision is not constitutional if receipts are thrown out because the other state simply chooses not to impose an income tax.2 The court reasoned that “although a lack of jurisdiction is rationally related to how much business a taxpayer does in a state, a state’s legislative tax system is not. Whether another state chooses to tax a receipt has no bearing on how much income is attributable to New Jersey.”3
The Whirlpool court did not address whether another state’s constitutional jurisdiction to tax for throwout purposes should be based on that other state’s understanding of its constitutional jurisdiction to tax or based on New Jersey’s understanding. This question was particularly relevant because, in 2006, the New Jersey Supreme Court determined that New Jersey “constitutionally may apply the Corporation Business Tax notwithstanding a taxpayer’s lack of a physical presence in New Jersey.”4 The New Jersey Division of Taxation applied Whirlpool by asserting New Jersey’s own expansive view of its constitutional jurisdiction to tax a person, but also asserting that its own expansive view was not the relevant standard for determining whether another state had the constitutional jurisdiction to tax the same person for purposes of throwout. As one constitutional scholar noted, “[t]he court properly gave this response the summary dismissal it deserved.”5
In Lorillard Licensing Co. v. Director, Division of Taxation, the Tax Court of New Jersey agreed with us in 2014 and ruled that the Division’s interpretation of the throwout provision “tests the limits of [the Director’s] credibility” when the Division argued that the same presence that made a company constitutionally subjectable to tax in New Jersey did not also make that company constitutionally subjectable to tax in other states.6 The Tax Court of New Jersey and, on appeal, the Superior Court of New Jersey Appellate Division both soundly rejected the Division’s position.7 The courts held that, because there is only one U.S. Constitution, if a company is sufficiently present to be constitutionally subjectable to tax in New Jersey, that same presence must be sufficient in every other state.8 Accordingly, the courts held that New Jersey’s own nonphysical-presence nexus standard, which the courts found to be the same as the U.S. constitutional standard, is the standard that must be applied to determine whether a company was subject to tax in other states.9 Notably, it is irrelevant in which states the company actually paid tax.10 It is abundantly clear that taxability in another state has no bearing on the level of activity attributable to the taxing state.
These New Jersey wins have two clear takeaways. First, application of throwout is limited to receipts sourced to jurisdictions that either do not have constitutional jurisdiction to tax the company or jurisdictions that are barred from taxing the company due to actions of the U.S. Congress (e.g., P.L. 86-272). Second, when determining whether a company is subject to tax in another jurisdiction for purposes of throwout, the analysis uses the constitutional nexus standard of the state imposing throwout. If the state imposing throwout has a higher statutory nexus standard than the constitutional nexus standard, then the lower constitutional nexus standard applies. (A higher standard would simply be an exercise of one state’s tax policy that clearly has no effect on the level of activity attributable to another state.)
That said, like poisonous mushrooms popping up after a soaking rain, throwout has resurrected itself across the country. Based on the rationale of our New Jersey wins, these new throwout provisions should also be defeated.11
Other States’ Use of Throwout Should Be Defeated
States are increasingly adopting and invoking throwout rules, particularly as states move from traditional cost-of-performance sourcing to market-based sourcing. The traditional cost-of-performance method is origin-based and generally results in sourcing to a state where the company operates. Market-based sourcing is destination-based and generally results in sourcing to a state where the company’s customer is located. Therefore, market-based sourcing is more likely to result in receipts being sourced to a state where a company does not have a taxable presence (because a company is more likely to have a taxable presence in a state in which it operates than in a state where one of its customers is located).
We are seeing a disturbing trend resulting from the interplay of market-based sourcing and throwout whereby states require the exclusion of receipts from a company’s sales factor denominator when it cannot be determined how to source those receipts by applying that state’s market-based sourcing rules. In other words, if determining how to source a particular type of receipt under the state’s own market-based sourcing scheme is too difficult, states require that the receipt be thrown out of the sales factor.
Massachusetts and the Multistate Tax Commission
Massachusetts, for example, enacted a throwout provision when it adopted market-based sourcing.12 Massachusetts law states that “in the case of sales other than sales of tangible personal property if the taxpayer is not taxable in a state to which a sale is assigned, or if the state or states to which such sales should be assigned cannot be determined or reasonably approximated, such sale shall be excluded from the numerator and denominator of the sales factor.”13 The Massachusetts regulations follow the framework for constitutionality laid out by the courts in Whirlpool and Lorillard.
The regulations provide that, for purposes of the throwout provision, a company is taxable in another state if that state has jurisdiction to subject the company to a net income tax, regardless of whether that state actually imposes such a tax on the company (i.e., following the Whirlpool guidance).14 Furthermore, the regulations provide that another state has jurisdiction to subject the company to a tax if, under the Constitution and laws of the United States, “the taxpayer’s business activity could be taxed in Massachusetts under the same facts and circumstances that exist in the other state” (i.e., following the Lorillard guidance).15 Finally, the regulations provide that a state does not have jurisdiction to tax where the state is prohibited from imposing the tax by reason of the provisions of P.L. 86-272.16
However, the regulations create a presumption, when a company does not file returns in another state, that the company’s activities in that state are protected from that state’s jurisdiction to tax.17 Such a presumption is wrong, because how another state enforces its jurisdiction and tax collection is a matter of its own tax policy and has no bearing on the level of activity attributable to Massachusetts. The regulations continue that: “[a]ny taxpayer that claims to be subject to the tax jurisdiction of another state must furnish evidence to the Commissioner upon request to substantiate the claim.”18
The Massachusetts throwout provision mirrors the throwout provision the Multistate Tax Commission adopted when it amended the Multistate Tax Compact to include market-based sourcing.19 The throwout provision in the compact likewise applies only to sales other than sales of tangible personal property when, with respect to such sales, 1) the company is not taxable in the state in which the sale is assigned or 2) the state of assignment cannot be determined or reasonably approximated using the compact’s market-based sourcing rules.20 The Multistate Tax Compact defines “taxable in another State” in accordance with Whirlpool to mean that the other state “has jurisdiction to subject the taxpayer to a net income tax regardless of whether, in fact, the State does or does not do so.”21 Moreover, the model regulation states that “[j]urisdiction to tax is not present where the state is prohibited from imposing the tax by reason of the provision of Public Law 86-272.”22
Although the approach taken by Massachusetts and the Multistate Tax Commission complies somewhat with Whirlpool and Lorillard with respect to how throwout applies when a sale has been assigned to another state under the throwout state’s own sourcing regime, the Massachusetts and compact provisions provide for the throwout of another category of sales that the old New Jersey throwout provision did not attempt: sales where the state of assignment cannot be determined or reasonably approximated using market-based sourcing. Whirlpool explained that a sale could be constitutionally excluded from a company’s sales factor denominator only the exclusion of the sale is “rationally related to how much business a taxpayer does in a state.”23 However, the relative difficulty of applying market-based sourcing bears no rational relationship to how much business a company does in the states in which it operates. When the state of assignment of a sale cannot be determined or reasonably approximated using the market-based sourcing regime designed by that state, the proper approach is to use an alternative sourcing method, not to throw out the sale. In this respect, the Massachusetts and Multistate Tax Commission approach runs afoul of Whirlpool.
In Craigslist, Inc., the State Board of Equalization of California applied throwout to a company seeking alternative apportionment.24 For the year at issue in the case, California sourced sales other than sales of tangible personal property to the state with the greatest income-producing activity based on cost of performance.25 The company requested an alternative apportionment method by which it could source its advertising revenue using a market-based approach.26 The Franchise Tax Board (FTB) agreed that the company could file an amended return using market-based sourcing but also required that “gross receipts sourced to a location in which the taxpayer is not taxable, as defined in RTC [S]ection 25122, will be excluded from the sales factor calculation.”27 Under Section 25122 of the California Revenue and Tax Code, “taxable in another state” includes when “that state has jurisdiction to subject the taxpayer to a net income tax regardless of whether, in fact, the state does or does not.” Therefore, the FTB’s application of throwout appears to have complied with Whirlpool.
As in Lorillard, the question was, What constitutional subjectivity standard is relevant to the application of throwout? However, unlike in Lorillard, the competing subjectivity standards were not those of California and another state’s. Rather, the question was whether to apply California’s subjectivity standard during the relevant tax year or rather at the later time during which the FTB audited the company’s amended return.28 During the tax year at issue in the case, California’s subjectivity standard required a physical presence in the state.29 By the time the FTB audited the company’s amended return, California’s subjectivity standard no longer required a physical presence if a corporation had more than $500,000 of in-state receipts.30 The FTB took the position in the audit that the company must throw out receipts attributable to states in which it had no physical presence, even if it had more than $500,000 of receipts attributable to those states.31
The State Board of Equalization found that the California Legislature did not determine that a substantial economic presence met U.S. constitutional standards until after the tax year at issue and “decline[d] to require that the [FTB] retroactively apply an economic presence standard” for purposes of applying throwout to the company.32 However, as the Tax Court explained in Lorillard, “[t]here is only one Due Process Clause and only one Commerce Clause and those provisions mean the same thing in every jurisdiction to which they apply.”33 The meaning of the U.S. Constitution did not change between the tax year at issue in the case and the year that the company’s amended returns were audited. This example further highlights why throwout is such a poor tax policy: Although its application may not turn on other states’ tax policy decisions, it could turn on the throwout state’s evolving understanding of its own constitutional jurisdiction to tax, a factor that has nothing to do with the level of a company’s business activities in the taxing state.
For purposes of the Washington Business and Occupation Tax (B&O), any person earning apportionable income that is both subject to the B&O and taxable in another state must apportion to Washington “that portion of the person’s apportionable income derived from business activities performed within [Washington].”34 Washington defines “apportionable income” as “gross income of the business generated from engaging in apportionable activities,” inasmuch as the B&O is a tax imposed on receipts rather than on net income.35 Moreover, “apportionable activities” are defined to include only specifically enumerated activities (e.g., services) and do not include sales of tangible personal property.36
In computing the Washington receipts factor for purposes of apportionment, “[g]ross income of the business from engaging in an apportionable activity must be excluded from the denominator of the receipts factor if, in respect to such activity, at least some of the activity is performed in [Washington], and the gross income is attributable under [Washington’s market-based sourcing regime] to a state in which the taxpayer is not taxable.”37 Washington defines “a state in which the taxpayer is not taxable” as a state where “the taxpayer is not subject to a business activities tax . . . except that a taxpayer is taxable in a state in which it would be deemed to have a substantial nexus with that state under [Washington’s statutory nexus standard] regardless of whether that state imposes such a tax.”38 However, Washington’s statutory nexus provision does not expressly state that it constitutes the full extent of Washington’s jurisdiction to tax under the U.S. Constitution. (A state legislature, as a matter of policy, may decide to create a higher standard for nexus than the constitutional standard.) To the extent that Washington’s nexus standard constitutes a policy decision to create a higher standard for subjectivity than the constitutional standard, then the state’s use of its own statutory nexus standard for purposes of applying throwout conflicts with Whirlpool and Lorillard.
Moreover, a recent change to Washington’s subjectivity standard further demonstrates why throwout provisions are problematic. As of January 1, 2020, out-of-state business entities are determined to have a substantial nexus with Washington if they either 1) have more than $100,000 of cumulative gross receipts from Washington or 2) have “physical presence in [Washington], which need only be demonstrably more than a slightest presence.”39 Prior to January 1, 2020, out-of-state business entities had a substantial nexus with Washington if they had 1) more than $57,000 of property in Washington; 2) more than $57,000 of payroll in Washington; 3) more than $285,000 of receipts in Washington; or 4) at least twenty-five percent of their total property, total payroll, or total receipts in Washington.40 Therefore, under Washington’s pre-2020 subjectivity standard, far more receipts would qualify for throwout, because that standard required a far greater amount of in-state activity to create substantial nexus. A business entity could have the exact same level of activities in Washington in 2019 and in 2020, yet have significantly different apportionment percentages based only on Washington’s legislative changes with respect to B&O subjectivity. How can that be constitutional? It cannot be. This problem further demonstrates the flaws in using throwout to reasonably approximate how much business a company conducts in a state. Even attempts to apply throwout constitutionally can lead to unconstitutional results.
Throwout is bad tax policy and anti-business. It is also disingenuous to apply a throwout to market-based sourcing regulations that are too convoluted or difficult to apply through no fault of the taxpayer. How can a state say, in good faith, that if you cannot determine how to source a receipt under our own rules, then you must throw it out altogether? We defeated throwout previously and believe that it deserves to be defeated everywhere. The disturbing reemergence of throwout means that taxpayers must be prepared to fight back. Our victories in Whirlpool and Lorillard remain the leading precedents on the constitutionality of throwout, and these cases should continue to serve as the guideposts in interpreting and limiting the application of throwout provisions across the country.
Mitchell A. Newmark and Nicole L. Johnson are partners and Eugene J. Gibilaro is an associate in the New York City office of Morrison & Foerster LLP.
- 26 A.3d 446, 465 (N.J. 2011). Morrison & Foerster LLP represented Whirlpool Properties before the New Jersey Supreme Court.
- Id. at 463.
- Lanco, Inc. v. Dir., Div. of Taxation, 908 A.2d 176, 177 (N.J. 2006).
- Jerome R. Hellerstein et al., State Taxation, paragraph 9.18[c][ii] (3d ed. 2001 & Supp. 2019-3).
- 28 N.J. Tax 590, 605 (Tax Ct. 2014), aff’d, 29 N.J. Tax 275 (Super Ct. App. Div. 2015), certif. denied, 141 A.3d 297 (N.J. 2016). Morrison & Foerster LLP represented Lorillard Licensing Company LLC before the Tax Court of New Jersey.
- Lorillard, 28 N.J. Tax 590; Lorillard Licensing Co. v. Dir., Div. of Taxation, 29 N.J. Tax 275 (Super Ct. App. Div. 2015), certif. denied, 141 A.3d 297 (N.J. 2016). Morrison & Foerster LLP represented Lorillard Licensing Company LLC before the Superior Court of New Jersey Appellate Division and the New Jersey Supreme Court.
- Lorillard, 28 N.J. Tax at 605.
- Id. at 605-06.
- Id. In an unpublished decision, the Tax Court went one step further and held that receipts were not subject to throwout if they could have been subject to a throwback rule. Elan Pharm., Inc. v. Dir., Div. of Taxation, No. 010589-2010, 2017 N.J. Tax Unpub. LEXIS 12 (N.J. Tax Ct. February 6, 2017).
- After the enactment of the federal Tax Cuts and Jobs Act in December 2017, the Division attempted to resurrect throwout in New Jersey for purposes of allocating (New Jersey’s word for apportioning) global intangible low-taxed income (GILTI). Under the allocation method initially manufactured by the Division, GILTI was to be allocated using a factor “equal to the ratio of New Jersey’s gross domestic product (GDP) over the total GDP of every US state (and the District of Columbia) in which the taxpayer has economic nexus.” N.J. Div. of Taxation, TB-85(R), Tax Conformity to IRC Section 951A (GILTI) and IRC Section 250 (FDII) (December 24, 2018) (emphasis added). Therefore, the Division would have required taxpayers to exclude from the denominator of their GILTI allocation factor (i.e., “throw out”) the GDP of all states in which the taxpayer did not have (in the Division’s words) “economic nexus.” However, on August 20, 2019, throwout was defeated again in New Jersey when the Division withdrew its previous guidance and changed its policy for GILTI allocation, instead requiring companies to include net GILTI amounts “in the numerator (if applicable) and the denominator” of their allocation factors. N.J. Div. of Taxation, TB-92, Sourcing IRC Section 951A (GILTI) and IRC Section 250 (FDII) Replacing TB-85(R) (August 22, 2019), revised, TB-92(R) (October 31, 2019) (emphasis added).
- See Mass. Gen. Laws, Chapter 63, Section 38(f); 830 Mass. Code Regs.63.38.1(9)(d)(1)(f)(ii).
- Mass. Gen. Laws, Chapter 63, Section 38(f).
- 830 Mass. Code Regs. 63.38.1(5)(b).
- Id. at (5)(b)(1).
- Id. at (5)(b)(2).
- See Model Multistate Tax Compact, Article IV, Section 17 (Multistate Tax Comm’n 2015); Model Gen. Allocation & Apportionment Reg. IV.3.(c) (Multistate Tax Comm’n 2018).
- Model Multistate Tax Compact, Article IV, Section 17(c).
- Model Multistate Tax Compact, Article IV, Section 3.
- Model Reg. IV.3(c).
- 26 A.3d at 463.
- Nos. 725838, 843070, 2016 Cal. Tax LEXIS 40 (Cal. State Bd. of Equalization, March 29, 2016).
- Id. at *2.
- Id. at *2-3.
- Id. at *5.
- Id. at *4.
- Id. at *5.
- Id. at *4.
- Id. at *15–16.
- 28 N.J. Tax at 605.
- Wash. Rev. Code Section 82.04.460(1).
- Id. at (4)(a) (emphasis added).
- Wash. Rev. Code Section 82.04.462(3)(c).
- Wash. Rev. Code Section 82.04.067(1)(c).
- Wash. Rev. Code Section 82.04.067(1)(c), 5(a) (2019); Wash. Dep’t of Revenue, ETA 3195.2018, Economic Nexus Minimum Thresholds (December 20, 2018).