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Stingers: The 2004 State Tax Survey

Tough times can make for tense relations between corporate tax executives and state tax authorities. Our survey suggests that even if economic conditions improve, the stage is set for more contentiousness than ever.

Tim Reason - CFO Magazine

January 1, 2004

It's been a rough three years. In September 2000, the California legislature was debating a tax-relief bill intended to lower its "unprecedented surpluses" by giving at least $50 back to every taxpayer. Since then, the state has plunged into fiscal chaos, and voters ousted former governor Gray Davis in favor of Arnold Schwarzenegger. The muscleman-turned-actor-turned-politician took office in November facing a year-end shortfall of $10.2 billion. His first move—delivering on his campaign promise to roll back his predecessor's despised car-tax hike—raised that shortfall to $13.4 billion.

While no state's plight has been illustrated quite as colorfully as California's, almost all the states are in desperate need of funds. At the same time, there's enormous reticence among politicians to raise taxes that directly affect voters—at least until after this year's elections. Add in the lingering disgust among voters over Corporate America's rash of scandals and, suddenly, business is openly in the crosshairs of state governments seeking revenue.

"A governor can say, 'I'm not raising taxes,' but go in and obliterate exemptions," says Brian Murphy, partner in charge of state and local taxation at Grant Thornton. Going after corporate taxpayers, he says, "is always more popular with voters." As one respondent to CFO magazine's latest state-tax survey noted, "We all know that the states need additional revenues, but the anticorporate rhetoric needs to be replaced by cooperation."

That's not likely. To be sure, states continue their competition with one another to woo businesses to their soil through tax incentives and abatements. But the long-running battle over when one state has the right to tax the income of a company in another has reached a turning point.

For years, states have tried to assert that right based on various degrees of physical or economic presence, while companies have planned around such nexus issues. Now, the states have lost enough fights—and are in sufficiently dire economic straits—that they are turning from the courts to the legislatures to short-circuit the nexus question. In the meantime, states continue to pursue revenues through aggressive corporate audits—and even clawbacks of incentives.

Dire States
No matter how irritating this is to corporate tax officials—and anger is a notable feature of our survey responses—no one denies the states need money. Current estimates peg combined state deficits for 2004 at about $80 billion—deeper, notes the liberal Center on Budget Priorities and Policies, than they have been at any time in the past 50 years. An overwhelming majority of survey respondents—81.3 percent—predicted that the state in which they work would be forced to raise taxes, regardless of additional collection or enforcement efforts.

Likely increases are not the only tax-related headache for businesses, however. For example, state tax forms generally mirror those of the Internal Revenue Service, but most states could not afford to follow Washington, D.C.'s lead in offering accelerated depreciation to businesses in 2002, forcing them to decouple their forms and tax codes, and adding to the corporate administrative burden. In Texas, tax refunds exceeding $250,000 can no longer be disbursed without legislative approval. And respondents complained bitterly about the amount of time they spend—or "waste," several said—with state auditors these days.

Yet even CFOs fighting what they see as unfair or unreasonable tactics by various states express some sympathy for the plight of their tormentors. "New York State is in a world of hurt, and I understand that," says Vince Holley, division controller of Wayland, New York-based Gunlocke Co., a division of Hon Industries. "But getting tough on clawback issues may burn them more."

"It is really scraping the [bottom of the] barrel," says Beverly, Massachusetts-based ZymeQuest Inc. CFO C. Evan Ballantyne of his state's efforts to suddenly deny his company an R&D credit it has claimed for seven years. "You start to think to yourself, 'These guys must be so desperate.'"

For states, financial desperation clearly has been coupled with frustration over corporate tax planning. Last July, the Multistate Tax Commission (MTC), an organization of 45 states, released a study claiming that 2001 state corporate-income-tax revenues of $35.4 billion would have been 35 percent higher but for corporate tax sheltering. "It is apparent," the study said, "that various corporations are increasingly taking advantage of structural weaknesses and loopholes in the state corporate tax systems."

The study drew a blistering response from the business-sponsored Council on State Taxation (COST), which argued that corporations pay an additional $358 billion in non-income taxes. But the MTC's broad definition of shelters—to which COST also hotly objected—at least accurately reflects the increasingly dim view that states take of tax planning.

Last year saw rulings in a number of high-profile nexus battles, all revolving around states' efforts to undermine tax-planning techniques involving Delaware holding companies. In most cases, the states lost, causing them to turn from the courts to their legislatures.