NECESSITY, FUNCTION, AND CONFORMITY:
131.130(1) authorizes the
department to promulgate administrative regulations necessary to administer and
enforce Kentucky's tax laws.
141.120 contains provisions for assigning to
Kentucky the apportionable income and non-apportionable income of multistate
corporations. This administrative regulation establishes criteria for
classification of 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 examples used
throughout this administrative regulation are illustrative only and are limited
to the facts contained within.
"Acquisition" means the act of obtaining an interest in property.
(2) "Allocation" means non-apportionable
income specifically assigned or allocated to one (1) or more specific
income" is defined by
(4) "Apportionment" means apportionable
income divided among jurisdictions by use of the apportionment factor provided
(5) "Disposition" means the act or the power
to relinquish or transfer an interest in or control over property to another,
in whole or in part.
"Management" means the oversight, direction, or control, directly or by
delegation, of the property for the use or benefit of the trade or
income" is defined in
(8) "Trade or business" as used in the
definition of apportionable income and in the application of that definition
means the unitary business of the taxpayer, part of which is conducted within
Determination of Apportionable Income. In determining whether income is
appor-tionable income, the Department of Revenue shall apply both the
transactional test and the functional test as established in Sections 3 and 4
of this administrative regulation. The classification of income by the labels
occasionally used, such as manufacturing income, compensation for services,
sales income, interest, dividends, rents, royalties, gains, income derived from
accounts receivable, operating income, non-operating income, etc., is of no aid
in determining whether income is apportionable or non-apportionable
Test. Apportionable income includes income arising from transactions and
activity in the regular course of the taxpayer's trade or business in
accordance with this section.
(1) If the
transaction or activity is in the regular course of the taxpayer's trade or
business, part of which trade or business is conducted within Kentucky, the
resulting income of the transaction or activity is apportionable income for
Kentucky. Income may be apportionable income even though the actual transaction
or activity that gives rise to the income does not occur in Kentucky.
For a transaction or activity to be in
the regular course of the taxpayer's trade or business, the transaction or
activity is not required to frequently occur in the trade or business.
(a) Most, but not all, frequently occurring
transactions or activities will be in the regular course of that trade or
business and will, therefore, satisfy the transactional test.
It is sufficient to classify a
transaction or activity as being in the regular course of a trade or business,
if it is reasonable to conclude transactions of that type are:
1. Customary in the kind of trade or business
being conducted; or
2. Within the
scope of what that kind of trade or business does.
(c) If a taxpayer frequently or customarily
engages in investment activities, if those activities are for the taxpayer's
financial betterment rather than for the operations of the trade or business,
those activities shall not satisfy the transactional test.
The transactional test includes:
1. Income from sales of inventory, property
held for sale to customers, and services which are commonly sold by the trade
or business; and
2. Income from the
sale of property used in the production of apportionable income of a kind that
is sold and replaced with some regularity, even if replaced less frequently
than once a year.
(3) The corporation shall classify income as
apportionable or non-apportionable income on a consistent basis. If the
corporation is not consistent, it shall disclose in its Kentucky return the
nature and extent of the inconsistency.
Functional Test. Apportionable
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 appor-tionable 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.
Under the functional test, apportionable
income shall not be required to be derived from transactions or activities that
are in the regular course of the taxpayer's own particular trade or business.
(a) Except as provided in paragraph (b) of
this subsection, it shall be sufficient if the property from which the income
is derived is, or was a functional, operative component, or related to or used
in the taxpayer's trade or business operations, or otherwise materially
contributed to the production of apportionable income of the trade or business,
part of which trade or business is or was conducted within this
(b) Property that has been
converted to an investment purpose through the passage of a sufficiently
lengthy period of time (generally, five (5) years shall be sufficient) or that
has been removed as an operational asset and is instead held by the taxpayer's
trade or business exclusively for investment purposes, shall be deemed to have
lost its character as a business asset.
Property that was related to a part of
the trade or business shall not be considered converted to investment purposes
merely because it is placed for sale.
Example: Taxpayer purchases a chain of 100 retail stores for the purpose of
merging those store operations with its existing business. Five (5) of the
retail stores are redundant under the taxpayer's business plan and are sold six
(6) months after acquisition. Even though the five (5) stores were never
integrated into the taxpayer's trade or business, the income is appor-tionable
because the property's acquisition was related to the taxpayer's trade or
2. Example: Taxpayer is
in the business of developing adhesives for industrial and construction uses.
In the course of its business, it accidentally creates a weak but non-toxic
adhesive and patents the formula, awaiting future applications. Another
manufacturer uses the formula to create temporary body tattoos. Taxpayer wins a
patent infringement suit against the other manufacturer. The entire damages
award, including interest and punitive damages, constitutes apportionable
3. Example: Taxpayer is
engaged in the oil refining business and maintains a cash reserve for buying
and selling oil on the spot market as conditions warrant. The reserve is held
in overnight "repurchase agreement" accounts of U.S. treasuries with a local
bank. The interest on those amounts is apportionable income because the
reserves are necessary for the taxpayer's business operations. Over time, the
cash in the reserve account grows to the point that it exceeds any reasonably
expected requirement for acquisition of oil or other short-term capital needs
and is held pending subsequent business investment opportunities. The interest
received on the excess amount is non-apportionable income.
4. Example: A manufacturer decides to sell
one (1) of its redundant factories to a real estate developer and transfers the
ownership of the factory to a special purpose subsidiary, SaleCo as the
taxpayer, and immediately prior to its sale to the real estate developer. The
parties elect to treat the sale as a disposition of assets under IRC
338(h)(10), resulting in the taxpayer recognizing a capital gain on the sale.
The capital gain is apportionable income. Although the gain is apportionable,
application of the standard apportionment formula in
141.120 may not fairly reflect the taxpayer's
business presence in any state, necessitating a resort to equitable
apportionment pursuant to
(a) Income that is derived from isolated
sales, leases, assignments, licenses, and other infrequently occurring
dispositions, transfers, or transactions involving property, including
transactions made in the full or partial liquidation or the winding-up of any
portion of the trade or business, is apportionable income, if the property is
or was related to the taxpayer's trade or business operations, unless the
property has been converted to investment purposes.
(b) Income from the licensing of an
intangible asset, such as a patent, copyright, trademark, service mark,
know-how, trade secrets, or the like, that was developed or acquired for use by
the taxpayer in its trade or business, constitutes apportionable income whether
or not the licensing itself constituted the operation of a trade or business,
and whether or not the taxpayer remains in the same trade or business from or
for which the intangible asset was developed or acquired.
(3) Under the functional test, income from
intangible property is apportionable income when the intangible property serves
an operational function as opposed to solely an investment function. The
intangible property serves an operational function if it is or was held in
furtherance of the taxpayer's trade or business as evidenced by the objective
characteristics of the intangible property's use or acquisition and its
relation to the taxpayer and the taxpayer's activities. The functional test
shall not be satisfied if the holding of the property is limited to solely an
investment function for a period of five (5) years or more.
the acquisition, management, employment, development, or disposition of the
property is or was related to the operation of the taxpayer's trade or
business, then income from that property is apportionable income, even though
the actual transaction or activity involving that property that gives rise to
the income does not occur in Kentucky.
Example: A manufacturer purchases raw materials to be incorporated into the
product it offers for sale. The nature of the raw materials is such that the
purchase price is subject to extreme price volatility. To protect itself from
extreme price increases or decreases, the manufacturer enters into future
contracts pursuant to which the manufacturer may either purchase a set amount
of the raw materials for a fixed price, within a specified time period, or
resell the future contracts. Any gain on the sale of the future contracts would
be considered apportionable income, regardless of whether the contracts were
either made or resold in Kentucky.
Example: A national retailer produces
substantial revenue related to the operation of its trade or business. It
invests a large portion of the revenue in fixed income securities which are
divided into three (3) categories:
Short-term securities held pending use of the funds in the taxpayer's trade or
b. Short-term securities
held pending acquisition of other companies or favorable developments in the
long-term money market; and
Long- term securities held as an investment.
(b) Interest income on the short-term
securities held pending use of the funds in the taxpayer's trade or business
pursuant to clause a. of subsection 4(a) 2. of this section is apportiona-ble
because the funds represent working capital necessary to the operations of the
taxpayer's trade or business.
Interest income derived from the other investment securities pursuant to clause
b. and c. of subsection 4(a) 2. of this section is not apportionable as those
securities were not held in furtherance of the taxpayer's trade or
An item of property shall be presumed to
be related to the taxpayer's trade or business operations if the taxpayer:
1. Takes a deduction from income that is
apportioned to Kentucky; or
Includes the original cost in the property factor, if applicable.
(b) No presumption arises from the
absence of an action described in paragraph (a) of this subsection.
Application of the functional
test is generally unaffected by the form of the property (e.g., tangible or
intangible property, real or personal property).
(a) Income arising from an intangible
interest as, for example, corporate stock or other intangible interest in an
entity or a group of assets, is apportionable income when the intangible itself
or the property underlying or associated with the intangible is or was related
to the operation of the taxpayer's trade or business.
(b) While apportionment of income derived
from transactions involving intangible property may be supported by a finding
that the issuer of the intangible property and the taxpayer are engaged in the
same trade or business, establishment of a relationship is not the exclusive
basis for concluding that the income is subject to apportionment. It is
sufficient to support the finding of apportionable income if the holding of the
intangible interest served an operational rather than an investment
Examples of Apportionable and Non-apportionable Income.
Rents from real and tangible personal
property. Rental income from real and tangible property is apportionable income
if the property with respect to which the rental income was received is or was
used in the taxpayer's trade or business.
Example: The taxpayer operates a multistate car rental business. The income
from car rentals is apportionable income.
(b) Example: The taxpayer is engaged in the
heavy construction business in which it uses equipment such as cranes,
tractors, and earth-moving vehicles. The taxpayer makes short-term leases of
the equipment when particular pieces of equipment are not needed on any
particular project. The rental income is apportionable income.
(c) Example: The taxpayer operates a
multistate chain of men's clothing stores. The taxpayer purchases a five
(5)-story office building for use in connection with its trade or business. It
uses the street floor as one of its retail stores and the second and third
floors for its general corporate headquarters. The remaining two (2) floors are
held for future use in the trade or business and are leased to tenants on a
short-term basis in the meantime. The rental income is apportionable
(d) Example: The taxpayer
operates a multistate chain of grocery stores. It purchases as an investment an
office building in another state with surplus funds and leases the entire
building to others. The net rental income is not apportionable income of the
grocery store trade or business. Therefore, the net rental income is
Example: The taxpayer operates a multistate chain of men's clothing stores. The
taxpayer invests in a twenty (20)-story office building and uses the street
floor as one of its retail stores and the second floor for its general
corporate headquarters. The remaining eighteen (18) floors are leased to
others. The rental of the eighteen (18) floors is not done in furtherance of,
but rather is separate from, the operation of the taxpayer's trade or business.
The net rental income is not apportionable income of the clothing store trade
or business. Therefore, the net rental income is non-apportionable
(f) Example: The taxpayer
constructed a plant for use in its multistate manufacturing business and twenty
(20) years later the plant was closed and put up for sale. The plant was rented
for a temporary period from the time it was closed by the taxpayer until it was
sold eighteen (18) months later. The rental income is apportionable income and
the gain on the sale of the plant is apportionable income.
Gains or losses from sales of assets.
Gain or loss from the sale, exchange or other disposition of real property or
of tangible or intangible personal property constitutes apportionable income if
the property while owned by the taxpayer was related to the operation of the
taxpayer's trade or business.
(a) Example: In
conducting its multistate manufacturing business, the taxpayer systematically
replaces automobiles, machines, and other equipment used in the trade or
business. The gains or losses resulting from those sales constitute
The taxpayer constructed a plant for use in its multistate manufacturing
business and twenty (20) years later sold the property at a gain while it was
in operation by the taxpayer. The gain is apportionable income.
(c) Example: Same as paragraph (b) of this
subsection, except that the plant was closed and put up for sale but was not in
fact sold until a buyer was found eighteen (18) months later. The gain is
Same as paragraph (b) of this subsection, except that the plant was rented
while being held for sale. The rental income is apportionable income and the
gain on the sale of the plant is apportionable income.
Interest. Interest income is
apportionable income where the intangible with respect to which the interest
was received arose out of or was created in the regular course of the
taxpayer's trade or business, or the purpose of acquiring and holding the
intangible is related to the operation of the taxpayer's trade or business.
(a) Example: The taxpayer operates a
multistate chain of department stores, selling for cash and on credit. Service
charges, interest, or time-price differentials and the like are received with
respect to installment sales and revolving charge accounts. These amounts are
The taxpayer conducts a multistate manufacturing business. During the year the
taxpayer receives a federal income tax refund pertaining to the taxpayer's
trade or business and collects a judgment against a debtor of the business.
Both the tax refund and the judgment bear interest. The interest income is
The taxpayer is engaged in a multistate manufacturing and wholesaling business.
In connection with that business, the taxpayer maintains special accounts to
cover items such as workmen's compensation claims, rain and storm damage,
machinery replacement, etc. The funds in those accounts earned interest.
Similarly, the taxpayer temporarily invests funds intended for payment of
federal, state, and local tax obligations pertaining to the taxpayer's trade or
business. The interest income is apportionable income.
(d) Example: The taxpayer is engaged in a
multistate money order and traveler's check business. In addition to the fees
received in connection with the sale of the money orders and traveler's checks,
the taxpayer earns interest income by the investment of the funds pending their
redemption. The interest income is apportionable income.
(e) Example: The taxpayer is engaged in a
multistate manufacturing and selling business. The taxpayer usually has working
capital and extra cash totaling $200,000 which it regularly invests in
short-term interest bearing securities. The interest income is apportionable
(f) Example: In January,
the taxpayer sold all of the stock of a subsidiary for $20,000,000. The funds
are placed in an interest-bearing account pending a decision by management as
to how the funds are to be utilized. The funds are not pledged for use in the
business. The interest income for the entire period between the receipt of the
funds and their subsequent utilization or distribution to shareholders is
Patent and copyright royalties. Patent
and copyright royalties are apportionable income where the patent or copyright
with respect to which the royalties were received arose out of or was created
in the regular course of the taxpayer's trade or business, or where the
acquiring and holding the patent or copyright is or was related to the
operation of the taxpayer's trade or business, or contributes to the production
of apportionable income of the trade or business.
(a) Example: The taxpayer is engaged in the
multistate business of manufacturing and selling industrial chemicals. In
connection with that business, the taxpayer obtained patents on certain kinds
of its products. The taxpayer licensed the production of the chemicals in
foreign countries, in return for which the taxpayer receives royalties. The
royalties received by the taxpayer are apportionable income.
(b) Example: The taxpayer is engaged in the
music publishing trade or business and holds copyrights on numerous songs. The
taxpayer acquires the assets of a smaller publishing company, including music
copyrights. These acquired copyrights are thereafter used by the taxpayer in
its trade or business. Any royalties received on these copyrights are
Section 6. Relationship of Transactional and
Functional Tests to the U.S. Constitution. The Due Process Clause and the
Commerce Clause of the U.S. Constitution restrict states from apportioning
income that has no rational relationship with the taxing state. Satisfaction of
either the transactional test or the functional test complies with this
constitutional requirement, because each test requires that the transaction or
activity (in the case of the transactional test) or the property (in the case
of the functional test) be tied to the same trade or business that is being
conducted within this state.
Expenses Related to Non-apportionable or Nontaxable Income.
any deduction allowed under Chapter 1 of the Internal Revenue Code shall be
reduced by expenses directly or indirectly related to nontaxable or
non-apportionable income. If actual expenses, including interest, salaries,
general and administrative, and other stewardship expenses, is not related
directly to the income, one (1) of the following formulas shall be used:
(a) Ratio of non-apportionableandnontaxable
assets to total assets times interest expense. Interest expense shall represent
all expenses incurred in the stewardship or maintenance of non-apportionable or
nontaxable assets. Other expenses may be used which more fairly reflect
expenses attributable to the income or assets producing the
non-apportionableandnontaxable income. Assets shall be valued at cost, and the
investment account shall exclude equity;
(b) Ratio of non-apportionable andnontaxable
income to total gross receipts times interest expense, officers' salaries, and
general administrative expenses. The sum of these or any reasonable combination
of these expenses; or
(c) A flat
percentage, one (1) percent to 100 percent, of non-apportionable and nontaxable
income. The percentage used shall be reasonable and reflect the expenses
attributable to the stewardship or maintenance of the assets producing the
141.039(2)(c) requires a
corporation to relate expenses to non-apportionable and nontaxable income. The
formulas listed in subsection (1)(a) to (c) of this section for determining
related expenses shall be used by the corporation or assist the corporation in
developing a method more suitable to its particular
Proration of Deductions. Any allowable deduction that applies to both
apportion-able and non-apportionable income or to more than one (1) trade or
business shall be prorated to those classes of income or trades or businesses
by the formulas listed in Section 7 of this administrative regulation.
Section 9. The amendments to this
administrative regulation shall apply to tax periods beginning on or after
January 1, 2018.