Under the New Markets Tax Credit (NMTC) program, Community Development Entities (CDEs) make qualified low-income community investments (QLICIs) into qualified active low-income community businesses (QALICBs). However, if a CDE makes a QLICI into a QALICB outside its commercial domicile, or the principal state in which it conducts business, it can face several state tax issues.
Nexus for State Tax Purposes
Nexus is the necessary connection between a state and a taxpayer that allows the state to impose a tax obligation on the taxpayer. Historically, nexus was dependent on physical presence in the state, such as the presence of a taxpayer’s office and employees in the state. More recently, nexus has more to do with economic than physical presence. Under this approach, a nexus may exist if a taxpayer has an economic presence in a state, even if the taxpayer has no physical presence. The move to economic rather than physical presence to establish nexus increases the probability that a CDE may need to file a state tax return in a state other than the one of its commercial domicile.
The definition of “economic presence” varies widely by state. For example, in some states, a certain dollar amount is necessary to trigger economic presence. Still, in other states, any amount of economic activity in the state is sufficient to establish nexus. In addition, some states have adopted multi-factor presence thresholds, which establish nexus based on certain quantitative measures, such as certain levels of property, payroll, or sales receipts within the state.
Factors that a CDE may wish to consider in determining whether it has nexus with a state based on economic presence may include:
- Whether the QLICI in the form of a loan made to the QALICB is secured;
- Whether the security is real or tangible personal property;
- Where the collateral is located;
- The QALICB’s geographical market; and
- If the QLICI is in the form of equity investment into a QALICB, where the QALICB has nexus and filing requirements.
Apportionment for State Tax Purposes
After establishing nexus and state tax filing requirements, CDEs must determine apportionment for state tax purposes. States most commonly use cost-of-performance or market-based sourcing approaches. However, some states have special apportionment rules for financial institutions; although CDEs may not necessarily be financial institutions in a traditional sense, some state laws may still define them as financial institutions based on their lending activities for apportionment.
Under the cost-of-performance sourcing approach, a taxpayer assigns receipts to the state in which it incurred the costs associated with the performance of that service. Therefore, in the case of a loan that a CDE made to a QALICB, the CDE would source the income to the state where the activities related to the negotiation, approval, and administration of the loan occurred. However, the cost-of-performance sourcing approach has become less popular recently for the same reason as nexus based on physical presence. States want to capture tax revenue from businesses that have an economic presence but do not necessarily have a physical location or employees in their states.
On the other hand, under the market-based sourcing approach, a taxpayer assigns receipts to the state where the customer benefited from its services. For example, if a CDE makes a loan to a QALICB, it will source the income to the state where the QALICB’s geographic market is located. Along with market-based sourcing, these states also are more likely to transition to single sales factor apportionment or apportionment based solely on sales receipts within the state in relation to total sales receipts. These states tend to reject apportionment based on certain levels of the traditional three factors of property, payroll, and sales receipts.
Complexities of Multi-State Filing Requirements
Since states have varying approaches to nexus and apportionment, CDEs may find themselves in situations where some income is not properly apportioned to any state or where some income is apportioned to more than one state, which can result in double taxation. These situations can lead to more complex determinations to determine the correct methods for claiming income on various state tax returns. Furthermore, as states’ filing requirements change over time, CDEs should review those requirements annually to determine if any changes have occurred that affect them.
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