Taxing Issues

Discretionary authority, economic nexus, and the taxing of services loom large in the state tax landscape.
Edward TeachApril 7, 2014
Taxing Issues

The last time CFO magazine conducted its state tax survey, in 2011, the nation’s fiscal condition was very different. The Great Recession had depleted state coffers, and legislatures were looking to companies to pony up more tax dollars. “The states are in a pure ‘money grab’ mode,” one tax director complained at the time.

Today, the situation is brighter. Through the third quarter of 2013, total state tax revenues have grown for 15 consecutive quarters, according to the Nelson A. Rockefeller Institute of Government. Adjusted for inflation, the simple average quarterly growth rate over that period was 4.2%.

14Mar_StateTax_p30The return of fiscal stability set the stage in 2013 for attempts to enact comprehensive tax reform. Significant changes were proposed in a half-dozen or so states, including North Carolina, Ohio, Louisiana, Nebraska, and Minnesota, generally either reducing or repealing income taxes, both business and individual, and replacing them with sales taxes. For the most part, these efforts failed.

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But there is still a fair amount of aggressiveness among the states in collecting additional income tax revenues from corporations, say observers. One way of doing so is by asserting economic nexus — a threshold of business activity that makes an out-of-state company subject to income tax (as opposed to sales and use tax) even without a physical presence in a state. The most aggressive states in this regard are California and New York, according to the latest edition of CFO’s survey of corporate tax directors, followed by New Jersey, Michigan, and Massachusetts.

“They want to ensure that companies outside the state, whether they are making sales into the state or are conducting business in the state, are paying what they consider is their fair share of tax,” says Harley Duncan, managing director and state and local tax leader in KPMG’s Washington National Tax Practice. In California, for example, an out-of-state company triggers economic nexus if its sales in the state exceed the lesser of $500,000 or 25% of the company’s total sales. Other states continue to press out-of-state companies for income tax nexus in various ways.

Occasionally they overreach. In May 2012, for example, high courts in West Virginia and Oklahoma struck down those states’ attempts to extend economic nexus to Scioto Insurance and ConAgra Brands, respectively, neither of which had a physical presence in the state. (Scioto was licensing intellectual property to Wendy’s, the fast-food chain, while ConAgra was licensing the ability to use its brands to food distributors.)

Discretionary Matters
Some of the states’ aggressiveness can be seen in their growing use of discretionary authority, or alternative apportionment. “We’ve seen more and more states using discretionary authority, because they don’t like the answer they get when the rules as written in law are applied,” says Duncan.

“Almost every state has a provision that says if our standard apportionment factor doesn’t fairly reflect the extent of your business activity in our state, we can use our discretionary authority to adjust that,” says Lee Zoeller, partner and practice group leader of the state tax group at law firm Reed Smith in Chicago. In some instances states have used their discretionary authority to counter aggressive tax planning on the part of some companies, says Zoeller. But in others they have effectively undone what companies view as normal business transactions, because they produce less tax and are therefore considered distortive.

In recent cases involving subsidiaries of Wal-Mart and Delhaize America, North Carolina required the companies to file a consolidated return with the corporate parent to reflect their “true earnings” in the state. Appellate courts upheld these applications of discretionary authority. Following taxpayer and trade group discussions with the legislature, the state has since set some parameters for when it can use its discretionary authority, says Duncan.

14Mar_StateTax_p34More than 20 states use unitary reporting, automatically taxing the combined income of the out-of-state subsidiary, other subsidiaries, and the corporate parent if they are deemed to constitute a unitary business. In November the Alaska Supreme Court affirmed the right of Alaska to tax the worldwide income of Tesoro, a Texas-based petroleum company. Tesoro had argued that some segments, like its pipeline business, should not be taxed by the state.

Are They Being Served?
One of the biggest current issues in state taxation is sales-factor sourcing. Most states have moved away from three-factor apportionment — equally weighting sales, property, and payroll — to either using sales alone or weighting sales at 80% or 90%. “They are effectively exporting the tax to companies outside the home state,” says Zoeller. Doing so lightens the tax burden on in-state companies and takes into account the increase in online sales by companies with no bricks and mortar in a state. “The states were losing a little of their tax base,” says Zoeller, “so they had to try to balance it out.”

It isn’t difficult to determine whether the sale of goods or tangible personal property by an out-of-state business is an in-state sale. But how do you source income from the provision of services? “That’s the hard question everyone is wrestling with,” says Zoeller. The conventional method is cost of performance — where is the work done to make a service available? If most of the cost of performance of a service is incurred in a given state, all of the income from the performance of that service is apportioned to that state, no matter where the customers may be.

“There is a lot of litigation around cost of performance,” says Zoeller. “Courts have interpreted it differently. The telecom companies are involved in litigation all over the county to figure out where their costs are for phone calls.”

More than a dozen states have moved to a market-based, or customer-based, approach to sourcing service income, apportioning it to the state where the service is used or the benefits of the service are received. The problem is, with other states hewing to the older approach, companies can get whipsawed, says Duncan.

“If one state is using cost of performance and I have my cost of performance in that state, all of the income from the performance of that service goes to that state,” he explains. “If I sell 10% of my services into a second state using market-based sourcing, ultimately I’m going to end up with 110% of my service income being taxed between those two states.”

Adversarial Attitudes
CFO’s latest state tax survey was conducted in October and November in cooperation with KPMG, yielding responses from 78 tax directors and other finance executives. Some of the results were nothing if not consistent with previous surveys: for example, California, New York, New Jersey, Massachusetts, and Michigan typically rank as having among the least fair and predictable tax environments, and this time around was no exception.

Why do tax directors perennially give California and New York such low grades? Duncan says he can’t speak for them, but he says California’s “significant audit presence” may be unnerving to some taxpayers. “They delve into issues deeply,” he says. As for New York, its provision regarding combined reporting “is different than those in other states,” points out Duncan. “There is more flexibility in who gets combined and when they get combined, and I think that leads to a sense of unpredictability.”

Zoeller says there are “many reasons” why corporate tax directors might dislike California and New York, but adds that they can be summed up as a pervasive “adversarial attitude toward taxpayers.” A “no-holds-barred approach to tax administration” is a hallmark of both states, he says, with tax officials “doing everything they can to see that the state gets its last penny.”

But it doesn’t have to be that way, adds Zoeller. He says that in other states — and in pockets of California and New York as well — a different attitude can be discerned: “I work for your government, I’m here as your employee, and I’m trying to find the right answer and do the right thing.”