Predictable Uncertainty in State and Local Taxes

While there is no cure for state and local tax uncertainty, CFOs and their tax heads need to be aware of states' discretionary authority.
Jr. and William M. BackstromOctober 22, 2013

Unfortunately, uncertainty is everywhere in the business world.  From a financial management and reporting perspective, uncertainty is never a welcome environment. Predictability is the desired environment. Corporate management and business owners live and die (and often are compensated) by the financial performance of the business. But CFOs and their companies can play a role in reigning in the uncertainty in the state and local tax (SALT) world that can arise from states’ use of discretionary authority provisions.

Analysis_Bug3One important element of the financial performance of a business is the effective tax rate.  Management wants to know with some degree of predictability the impact taxes have on the company’s financial statements.  Management also is interested in how the company’s effective tax rate stacks up against the effective tax rates of other businesses.  Investors and analysts also look a company’s financial statements and desire some level of predictability. The widespread desire for predictability in financial reporting falls squarely on the desk of the CFO.

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But when it comes to taxes, the CFO looks to the vice president of tax to help achieve desired levels of predictability. Everyone is happy when the actual impact of international, federal, state and local taxes is close to the predicted impact. Things get dicey, however, when the vice president of tax has to make the long walk down the hall to the CFO’s office to report a “tax issue” that could have an impact on the company’s financial reports.

Imagine this story, which although fictional, is based on real-life situations. Everywhere, Inc. operates on a multistate basis through various subsidiary entities.  The Everywhere consolidated group sells products and services on a worldwide basis. As is often the case, there are many intercompany transactions among Everywhere and its affiliates.

Everywhere and its subsidiaries file a federal consolidated income tax return.  In State A, the law requires that Everywhere and each of its subsidiaries with nexus in State A file separate corporate income tax returns. In State B, Everywhere and certain of its subsidiaries are required to file a state-level combined corporate income tax return.  State B apportions income within and without the state based on a single sales factor, the numerator of which is gross receipts from sources in State B and the denominator of which is gross receipts from all sources.

State B provides that income from the performance of services is sourced to State B based on the cost-of- performance method, which assigns income from an income-producing activity to the state where a majority of the services are performed. Following the cost-of-performance method, Everywhere reports no service income to State B because the majority of the costs of performing the services are provided outside State B.  Everywhere’s treasury department is responsible for Everywhere’s cash management system, including short-term investments of available funds.  Everywhere’s State B return includes the gross receipts from the treasury department security transactions in the denominator, but not the numerator, of the State B sales factor.

Everywhere’s vice president of taxes and her team feel confident in the fact that the State A and State B returns are filed precisely in accordance with the applicable laws. The tax provision for financial statement purposes is prepared based on the returns as filed. Confidence is high and executive management is pleased with what seems to be some predictability.

But, along come the state tax auditors. State A reviews the separate income tax returns of Everywhere and its affiliates. The auditors take a look at the voluminous intercompany transactions among Everywhere and its affiliates. Even though Everywhere has a study by a highly-reputable consulting firm confirming that the intercompany transactions are carried out on an arm’s-length basis, State A determines that the separate returns filed by Everywhere and its affiliates do not clearly reflect the income earned by the corporate group in State A and computes Everywhere’s State A taxable income based on a combined reporting methodology.  Exercising its discretionary authority and using this so-called “forced combination” methodology, State A issues a material assessment to Everywhere that includes a deficiency for additional tax, interest and penalties.

To add “SALT” to the wound inflicted by the State A assessment, the State B auditor makes two adjustments to the State B combined return.  First, the auditor agreed that the State B statutes provide that the gross receipts from the treasury department transactions should be included in the sales factor. The auditor, however, makes a determination that inclusion of the receipts distorts Everywhere’s State B income and, exercising its discretionary authority, excludes them entirely from the sales factor. This adjustment alone results in a substantial increase in the State B sales factor. Second, the auditor agrees that the State B statutes provide for sourcing of sales of services based on the cost-of-performance methodology. Again, however, the auditor determines that use of the cost of performance method distorts Everywhere’s State B income and, exercising its discretionary authority, re-determines State B income using the market-base sourcing method. This adjustment results in a substantial increase in the amount of service income assigned to State B. The State B tax assessment includes a very large tax deficiency, as well as interest and penalties.

The vice president of tax is now very unhappy and dismayed. The company filed the state tax returns precisely as required by applicable statutes and regulations. Relying on their discretionary authority, the states issue large assessments for additional taxes and interest.  The “knife in the back” is the assessment of penalties. The vice president of tax wonders, “How can we be penalized when we followed the statues?”  The team collectively sighs and begins preparing to deliver the bad news to the CFO. To make matters worse, quarterly reports are due and the tax team has to develop a strategy for accounting for the potential liabilities as a result of the assessments.  The “hit” to earnings will not be received well by any interested party. Also, having penalties assessed will not sit well with the executive management team.

This might sound like a script for a television show or a hypothetical case study on an exam. The scenario presented is based on several of many real-life cases that cause state and local tax professionals to lose sleep and become very adept at delivering bad news to CFOs. More importantly, they wreak havoc on predictability. Unfortunately, this environment seems to be more common in the business world today.

In a real life example, such as Equifax Inc. v. Mississippi Dep’t. of Revenue, No. 2010-CT-10857-SCT (Miss. 2013), the Mississippi Supreme Court upheld the use of an alternative apportionment formula by the Mississippi Tax Commission even though the taxpayers filed their returns exactly as required by applicable laws. The court also upheld the imposition of penalties against the taxpayer.

In Equifax, the taxpayers used the standard apportionment method (cost-of-performance) prescribed by the Commission’s own regulation to compute their Mississippi taxable income, which in both cases was zero.  The Commission audited the taxpayers’ returns, determined that the standard apportionment method did not fairly reflect the taxpayers’ business activities in Mississippi, and used an alternative apportionment method — market-based sourcing — to apportion the taxpayers’ income within Mississippi. The Commission relied on its discretionary authority to make the adjustments, which resulted in a substantial assessment of tax, interest and penalties.

The lower court held that the Commission bore the burden of proof to establish that the standard cost-of-performance method did not fairly reflect the taxpayers’ business activities in Mississippi and that the alternative method was reasonable.  The Mississippi Supreme Court reversed the lower court and held that the burden of proof essentially fell on the taxpayer to prove that the Commission’s alternative apportionment method was not reasonable.  The Court also upheld the substantial penalties imposed by the Commission even though the taxpayers had completely adhered to the applicable laws when filing their returns.

This is just an example of many cases in which taxpayers file their state tax returns in accordance with applicable laws, but the taxing authorities exercise their discretionary authority to make adjustments that are not addressed anywhere in the law, regulations or other administrative guidance.  Inevitably, without much if any warning, the taxpayer is blindsided with a material tax assessment. This is the world that SALT professionals are living in. It is one that by operation, at least, undermines the certainty and predictability that the business world desires.

At the very least, tax administrators who choose to rely on their discretionary authority to make audit adjustments should issue guidance as to when and how they will exercise their discretionary authority. Tax administrators may not be able to address every incident in which they will exercise their discretionary authority, but certainly there are many instances that can be addressed. In many cases, tax administrators should consider exercising their discretionary authority on a prospective basis only. But most importantly, tax administrators should exercise restraint in assessing penalties when a taxpayer filed a return in the only method permitted by law, but the tax administrator exercised his discretionary authority to make audit adjustments.

The judicial branch also can play a role by fully understanding the history, purpose and limitations with respect to discretionary authority provisions. More importantly, as most states laws provide, courts should require state tax administrators to bear the burden of proof when exercising discretionary authority to deviate from prescribed tax-reporting methods.

Thus, businesses should and do play a role in the legislative process by alerting elected officials of issues that wreak havoc on the desired world of predictability and assisting in addressing those issues. CFOs also need to be kind to the vice president of taxes when she delivers the bad news of the “tax issue” attributable to an unexpected audit adjustment by a tax administrator exercising discretionary authority. The mere fact that tax administrators are given the discretionary authority (and they also see other tax administrators using their discretionary authority) is certain to lead to uncertainty.

William M. Backstrom, Jr. is a partner and head of the tax and estates practice group at Jones Walker.

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