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State Insecurity

Faced with alarming budget shortfalls, states are pursuing corporate tax dollars in new and aggressive ways.
David M. Katz, CFO Magazine
April 1, 2011

Click here to download the complete results of the 2011 State Tax Survey.

When it comes to state-tax enforcement, it's getting scary out there for corporate taxpayers. Witness the Securities and Exchange Commission's entry into the state-tax fray with an apparently unprecedented action against Hudson Highland, a staffing firm based in New York.

The SEC charged that the company allowed its Hudson North America subsidiary to fail to collect state sales tax from its customers. Although such failures are typically regarded as state matters, the SEC charged that federal securities laws were also violated. While the $200,000 settlement was not a particularly harsh penalty for the $795 million company (which neither admitted nor denied the SEC findings), the case has sent shock waves through corporate tax departments.

Why the worry? This newfound federal interest in state-tax collection signals a significant intensification of corporate taxation efforts — efforts that were already on the fast track at the state and local level in the wake of the recession (see "The Tax Men Cometh," May 2009). Faced with huge budget deficits and public antipathy to tax hikes, states are aggressively trying to find new ways to raise revenue.

Many are attempting to expand the definition of what constitutes "nexus," a business connection to a given state that provides the state with a basis for collecting taxes — an issue that tax authorities, courts, and companies have debated for years. Others want to claw back the incentives they once happily provided to businesses in order to foster economic development.

The situation doesn't just frustrate companies — it infuriates them. In CFO's 2011 State Tax Survey, conducted in January with KPMG and yielding responses from 151 tax directors and other finance executives, one respondent complained, "The states are in a pure 'money grab' mode and don't care about policy, the law, or fairness."

The Budget Abyss
Driving the dash for cash is a plethora of persistently unbalanced state budgets. No fewer than 45 states are expecting 2012 shortfalls relative to their 2011 outlays, according to the Center on Budget and Policy Priorities, a think tank. (For most states, fiscal 2011 began in mid-2010.) Further, while most states have had budget deficits in the past two years, federal stimulus money helped them fill the gaps temporarily, notes Harley Duncan, managing director in the state and local tax group of KPMG's national tax practice. By the middle of this year, however, most of the stimulus money is likely to run out. "State bills are going to have to be paid with real money at some point," Duncan says.

One way states are attempting to raise revenue without tax hikes is through clawbacks of corporate tax incentives. Because of the recession, some companies have not performed as well as states expected when they provided tax sweeteners in exchange for corporate relocation or expansion. In such instances, the states can make a strong case, experts say. "The company is benefitting from the services and the infrastructure that the state provides…and the company is not paying its fair share of the costs," says Robert Willens, a tax accountant and CFO columnist. "That becomes a very persuasive argument to the courts." Indeed, survey respondents fear that California and Illinois, two of the most financially battered states, are among those "very likely to pursue clawbacks."

State tax officials are reportedly growing more litigious as well. State revenue departments "have moved from seeking the right outcome to using their power to maximize revenue from taxpayers by pushing (or threatening to push) every matter to litigation," says one survey respondent from a $5 billion communications company.

State courts, for their part, seem quite receptive to aggressive tax collection. In one 2010 decision in which it found against fast-food chain KFC, the Iowa Supreme Court noted that "state supreme courts are inherently more sympathetic to robust taxing powers of states than is the U.S. Supreme Court." Unfortunately for corporations, the high court has recently showed little interest in hearing such cases.

Nexus Nightmares
No issue involving corporate taxpayers is more contested than the matter of what constitutes nexus. Tax authorities appear to be growing bolder about pursuing companies on the basis of sales, rather than physical presence. New York, California, Massachusetts, New Jersey, and Michigan were ranked by survey respondents as the most aggressive states in terms of "asserting nexus positions for corporate income tax over corporations with only an economic presence in a state."

To assert so-called economic nexus is in itself an aggressive posture, since until quite recently states limited themselves to collecting sales taxes from companies that had established a physical presence in the state. But the Iowa Supreme Court, in the KFC case, and the Washington Supreme Court, in a case involving Lamtec, a Pennsylvania-based manufacturer of industrial materials, found in two separate recent decisions that there was no such necessity.


"In both cases, out-of-state corporations that had no physical presence in the host [state] were judged to be subject to tax nevertheless. I think that's a big problem," says Willens. Connecticut also implemented a broad version of the economic nexus standard in January 2010.

The basis for economic nexus may indeed be growing more tangential. The Iowa high court upheld the finding that KFC should be taxed on the basis that it licensed its trademark to independent franchise restaurants in Iowa and was collecting royalties as a result of its trademark. Most alarmingly, tax attorneys say, KFC will have to pay income taxes in Iowa. That represents a significantly more aggressive stance than previous assertions of nexus, which merely required companies to collect sales taxes from their customers.

This past January, the Washington Supreme Court chimed in on the nexus issue, ruling that Lamtec, which sells its wares via telephone, had nexus in the state. The court ruled that the company would be required to pay the state's business and occupation tax (a tax on the company's gross receipts, rather than its profits), interest, and penalties.

The court's reasoning: about two or three times a year, a few Lamtec sales employees visit customers in Washington to answer questions and provide information about the company's products. Willens calls such activity "a pretty tenuous connection" for establishing nexus.

Of special interest to state tax officials are out-of-state online retailers. Employing such notions as "click-through nexus," New York, North Carolina, Colorado, and Rhode Island have already enacted laws that incorporate the theory of economic nexus to enable them to tax companies like Amazon, requiring them to collect sales taxes from online shoppers. Says Walter Nagel, a partner at law firm Reed Smith in Washington D.C.: "More and more of the economy is online and electronic, and so the states are trying to tax as much of that revenue as possible."

Here Comes the Audit
Much of the quest for corporate tax payments, however, centers on good old-fashioned investigations and audits. But there are some new wrinkles there as well. In the District of Columbia, for instance, the revenue department has outsourced transfer-pricing audits on a contingency-fee basis to ACS, a Dallas-based provider of information-technology and business-process-outsourcing services. Since 2008, Chainbridge Software, an ACS subcontractor, has been using statistical analysis to dig up companies that seem likely to have been avoiding taxes in D.C. by shifting income among commonly controlled corporations.

In its work for the District, Chainbridge calculates a particular company's expected range of profit by comparing it with the estimated profit of comparable companies, according to Stephen M. Cordi, deputy CFO in D.C.'s Office of Tax and Revenue. If the income tax paid by the company is lower than Chainbridge's analysis indicates it should be, the firm does what it calls a "transfer-pricing analysis" to see what further taxation is needed to bring the company within the acceptable range, Cordi says.

For such reports, ACS collects a contingency fee of 16% of the tax revenue the District recovers as a result of its work, up to $30 million, and 14% of the revenue recovered in excess of $30 million. There is an overall cap of $9 million on ACS's fees.

Although D.C. has "collected nothing" as a result of the audits to date, it has a $3 million case in litigation and a number of cases to follow, says Cordi. If the District ends up collecting all the potential revenue identified by the audits to date, "you're talking $50 million and up," he adds.

For his part, Stephen Kranz, a lawyer with Sutherland, Asbill & Brennan who is representing the corporation currently in litigation with D.C., objects strenuously to at least one aspect of the District's approach. "The contingency-fee aspect of it is particularly offensive to many in the tax world," he says. "And we think that it very well may be developing into a trend." The presence of a contingency fee "creates an unnatural bias for the auditor to inflate the assessment," Kranz contends. "If the auditor gets paid on the size of the dollar figure they're going to deliver, they're going to be biased toward producing a larger number."

Room to Negotiate
With state and local governments pursuing corporate taxpayers so aggressively, what's a CFO to do? "I don't think there's a great deal you can do to plan for this," says Willens, reasoning that a corporation doing decent business in a state won't pull up stakes merely for tax reasons.

Still, there may be a faint silver lining in the fact that states are so anxious for revenue. Such eagerness offers corporate taxpayers an opportunity to settle for a fixed-dollar amount rather than pursuing the uncertainty of long-term litigation, according to Reed Smith's Nagel. In their current dire economic straits, states would rather get their money now than later.

David M. Katz is New York bureau chief and senior editor for accounting at CFO.


Methodology
This biannual survey, conducted since 1996 with the help of KPMG LLP, the audit, tax, and advisory firm, aims to capture tax executives' impressions about differing tax environments in each state in which they do business. The results presented here represent those opinions, rather than quantitative assessments of actual policies, tax rates, or other criteria.



2011 CFO State Tax Survey Results


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