In practice, CFOs and other nontax executives often may not fully perceive the complexities surrounding management of state taxes and the impact those taxes have on other business functions and operations. State taxes typically play second fiddle to the federal income tax and other taxes. As a result, the real effect and importance of state taxes are overlooked until a controversy arises.
While the tax tail generally should never wag the business dog, nontax executives should better understand the materiality and importance of state taxes. The following is some information to help CFOs better appreciate the complexities surrounding state taxes.
• State taxes are likely more material than you think. When income, franchise, sales-and-use, property, licensing, transfer, telecommunication, and other industry-specific taxes are taken together — or even sometimes when they’re looked at individually — they result in very material dollar amounts. Although individual state tax rates are significantly lower in relation to the federal income tax rate, the same basic tax will often be assessed by multiple jurisdictions.
For example, a sales-and-use tax may be assessed at the state level and also at the county, city, and other municipal levels. As can be expected when multiple jurisdictions are involved, there is little or no consistency in reporting or calculating the various taxes, since each jurisdiction has its own set of rules.
That inconsistency leads to a greater risk of double taxation, which directly affects materiality. Not only are the amounts likely to be material, but any of the nonincome taxes also affect earnings before interest, taxes, depreciation, and amortization, since the non-GAAP metric excludes only income taxes. The inconsistency thus directly affects common accounting metrics used for business valuations and bonus determinations.
The administrative and other related costs associated with these taxes are also likely to be material, especially for larger, multistate companies. Such costs are driven mainly by the sheer number of state taxes that exist, but also as a result of the numerous jurisdictions and municipalities that require reporting — often on a monthly basis.
• State taxes are continuously affected by evolving business models. Through advances in technology, in particular those associated with the evolution of the Internet, businesses have access to larger markets and more customers. It’s also much easier to engage in targeted advertising with customers or potential customers, and that can translate into more sales than can be generated by traditional advertising.
Such technological advances have also made it much easier for businesses to store and access information, locate employees, and outsource certain functions. Businesses today are engaging in more commerce throughout the world economy. The various ways this is achieved have a direct impact on state taxes. In an effort to keep up with these changes, states have become far more creative and aggressive in finding ways to apply old taxing concepts to new business models, thus creating enormous uncertainty.
• Any departmental decision can have a state tax consequence. Human-resource decisions about relocating an employee to another state or allowing an employee to telecommute, technology decisions about where to locate servers, and advertising decisions about affiliate programs can all result in unexpected state tax consequences. Nontax executives should be aware of how decisions with seemingly little tax correlation can result in significant state tax risks and exposures, such as creating nexus (a sufficient connection that establishes a state’s authority to impose tax).
• State tax controversy can generate negative publicity. States seem more likely to play hardball in the press these days. Take, for example, all of the negative (and often inaccurate) publicity Amazon has been receiving about sales-and-use tax collection responsibilities. While there will be times when it is appropriate to fight the good fight, the costs of any related negative publicity must be weighed.
• There is seemingly little hope for uniformity among the various states. State tax laws and enforcement policies are changing at a much faster pace than federal tax laws. While some states are actually passing new laws to shrink budget deficits, many others are simply modifying interpretations and applications of existing laws to accomplish the same thing. Achieving uniformity among the states would take an extraordinary effort of compromise and cooperation, which is unlikely to happen. Federal intervention mandating uniformity is also unlikely for a variety of reasons, including a strong state’s-rights lobbying effort.
• Times may be a-changin’. Historically, there have been few transformative moments in the world of state taxation. However, we may be approaching one. Before 1959 and the U.S. Supreme Court’s decision in Northwestern States Portland Cement Co., there was a literal ban on the imposition of state income tax on “exclusively interstate commerce” (i.e., if you conducted your business from State A, State B could not tax you even if you sold to customers in State B). In the landmark Northwestern decision, the Supreme Court ruled that:
“net income from the interstate operations of a foreign operation may be subjected to state taxation provided the levy is not discriminatory and is properly apportioned to local activities within the taxing State forming sufficient nexus to support the same.”
Fearing that the states would use this decision to expand their reach of taxation, the business community urged the federal government to take action, and Congress enacted Public Law 86-272 as a temporary stop-gap measure. Still in effect today, the law precludes a state from imposing an income tax where the only in-state activity of a business is the solicitation of sales of tangible personal property.
In the early 1980s, the Supreme Court issued several opinions regarding a state’s ability to tax activities occurring outside its borders. Those decisions further developed the “unitary business principle” of income taxation of interstate enterprises.
In 1992 the Supreme Court issued its opinion in Quill, which precluded states from imposing sales-and-use tax collection responsibilities on a company with no in-state physical presence. In 1993, however, the South Carolina Supreme Court issued its ruling in Geoffrey, which permitted the state to impose an income tax on a company with only an “economic presence” rather than a “physical presence” in the state. Since the Geoffrey decision, many other state courts have upheld similar “economic presence” standards, thus allowing the states to expand their reach of taxation.
Separate pieces of legislation have recently been introduced in Congress to codify a physical-presence standard for imposing state income taxes and to expand sales tax collection responsibilities to companies without a physical presence. If such a bill were to be enacted, it would be only the second time Congress has exercised its powers under the U.S. Constitution to regulate taxation of interstate commerce.
The “Amazon” laws — referring to the alleged requirement that Amazon.com and other online retailers collect state sales taxes owed by their customers — currently being enacted in many states, and proposed federal legislation addressing same, could further change the landscape of state tax.
With the evolution of the Internet and advances in technology, there is very little about today’s business environment that has not changed. Each of these changes has added to the complexities in the imposition of and accounting for state tax liabilities. For example, can a presence on the Internet or in the cloud have an impact on the states in which a company has nexus? If a company can increase its penetration of a state’s market due to changes in technology, will a state view that company as perhaps having some type of “economic” presence? Can PL 86-272 be used to limit a state’s ability to tax a company, even though that company is selling a product that is less “tangible” than it once was? Nontax executives should stay tuned.
Kellie A. Lanford is a tax specialist and Marshal T. Kline is a member of Dow Lohnes Price Tax Consulting Group LLC.