Investment Income

Investment Income

April 01, 2005

INVESTMENT INCOME might be shifted to a low-tax state.

The Missouri Supreme Court barred the state in January from taxing a Missouri subsidiary on income it earned from investing its overnight cash balances because its parent company in another state did the investing.

The decision opens the door to tax planning. Income might be shifted to a state where there is no income tax by means of an investment agreement. The court said the “brain” of the operation — and hence where the income was earned — was not in Missouri.

Most states collect income or franchise taxes from companies doing business in them, but the taxes apply only to the share of a company’s income that comes from sources in the state. Most states make companies that are doing business in more than one state take their entire business income and apportion a share of it to the state. Many states do the apportionment using a three-factor formula. They look at the percentage of payroll, property and sales that a company has in the state. However, Missouri apportions based only on sales. Under the Missouri formula, a company multiplies its total income by a fraction. The denominator of the fraction is its total sales. The numerator is its Missouri sales plus half its sales that straddle Missouri and another state.

A Missouri subsidiary had an “investment agreement” with its parent company in Ohio. The parent invested the subsidiary’s overnight cash balances and paid the subsidiary 7.72% interest. The interest amounted to millions of dollars over the three tax years that were at issue in the case.

The Supreme Court said the subsidiary could exclude the interest from its total income to which it applied the apportionment fraction. The Missouri courts have historically let passive income that is earned from activity in another state escape any apportionment. In this case, the activity was in Ohio where the parent was located. The parent made the investment decisions.

The case is Medicine Shoppe International, Inc. v. Missouri Director of Revenue. The Supreme Court released its decision on January 25.

Keith Martin