State Taxation: 'Food For Thought'

My recent posts have contained some of my notes and questions I recorded from attending the Paul J. Hartman State and Local Tax Forum last week. This is my last post which lists 20 takeaways or 'food for thought.'

1. The Organisation for Economic Co-operation and Development (OECD) does not identify tax havens, so why are the states?
2. Discretionary Authority is no warning. It doesn't allow taxpayers to know what a state will do (i.e., using alternative apportionment or combined reporting to force a taxpayer to deviate from the standard apportionment formula; or modifying a costs-of-performance statute to get a market-based sourcing result).
3. International taxation is starting to use state tax concepts such as combined reporting and apportionment.
4. "Are 'bright-line' tests knee-jerk reactions?" - quote from one of the speakers
5. "Tax Haven legislation should be trashed. Tax haven legislation picks winners and losers." - quote from one of the speakers
6. The only way to fight retroactive legislation is to monitor it and lobby against it before it is enacted.
7. Should states be able to enact retroactive legislation to protect the state budget from financial loss?
8. Should judicial decisions only apply to the taxpayer involved in the litigation if it involves a refund?
9. Retroactive legislation should not be able to increase revenue.
10. Ask yourself, if a 'technical correction' is creating new law or changing the interpretation of the law from the original interpretation that has been followed by taxpayers for years. If the answer is yes, do something.
11. Should retroactive legislation be limited to a state's statute of limitations?
12. Prior legislatures can't bind future legislatures.
13. New legislatures can't determine, or know, the intent of prior legislatures. Shouldn't be able to unbind or unwind prior legislation.
14. "Retroactive legislation is telling you what the law was." - quote from one of the speakers
15. Are we moving from apportionment to allocation when we use single-sales factor apportionment and market-based sourcing?
16. Is single-sales factor apportionment 'fair apportionment'? Moves income to customer states, not to states where the activities occurred that generated the income. Income is not based solely on sales.
17. "Throwback and throwout rules are unconstitutional because they look beyond the borders of the state." - quote from one of the speakers
18. If alternative apportionment is wide open and anything goes, why have statutes?
19. "To gain true insight, read the entire case - don't just read the blurb. See what it says and what it doesn't say." - quote from one of the speakers. Get creative. See the case, the issue from a different perspective. Ask "why not."
20. Does common sense apply? If so, is your definition of 'common sense' the same as mine?

Obviously, I obtained all of the thoughts above from the Forum. Some are quotes from speakers, some are ideas paraphrased from a speaker's discussion, and others are personal reflections. 

LEGAL PRINCIPLES IN STATE TAXATION - DO YOU KNOW THEM?

Last week I attended the Treasures in the Attic-Tried and True Legal Principles in SALT session at the Paul J. Hartman State and Local Tax Forum presented by Janette Lohman and Brian Kirkell. I found the session very interesting and wondered if all state tax practitioners really know or understand how to use the legal principles that were discussed. Here is a list of the principles that were mentioned and can be used to defend your company or client.

1. Manifest Injustice
2. Equitable Estoppel
3. Statute of Limitations
4. Equitable Tolling
5. Equitable Recoupment
6. Collateral Estoppel
7. Statutory Rules of Construction (Canons of Construction)
8. Burden of Proof
9. Regulations Cannot Expand the Reach of a Statute
10. Retroactive Changes
11. Doctrine of Consistency
12. Laches
13. Conformity

State Taxation of The Sharing Economy - My Notes From the Paul J. Hartman SALT Forum

As I was sitting in the State Taxation of the Sharing Economy (i.e, Uber, Airbnb, etc.) session at the Paul J. Hartman State and Local Tax Forum presented by Jeremy Abrams, French Slaughter and Reid Okimoto last week, I took some notes. Here are a few of them:

1. How you characterize a charge (i.e., label it) and the contract language will most likely determine how the charge is taxed for sales tax purposes.
2. Will states 'back into' the characterization?
3. How do you source the sharing economy? By service address, billing address, or where the transaction starts or ends?
4. Does the Internet Tax Freedom Act pre-empt any sales taxation of the sharing economy?
5. Is physical presence 'nexus' MORE important, NOT less important due to technology advances and changes in how transactions occur?

CREDITS AND INCENTIVES - My Notes From the Paul J. Hartman SALT Forum

The following are some of my notes and thoughts from attending the Credits and Incentives session at the Paul J. Hartman State and Local Tax forum last week, presented by Chris Grissom, Robert Boehringer and Ron Rabkin.

1. All politics are local.
2. Taxpayers often obtain multiple letter rulings for credit and incentive deals due to the sophistication of the rules.
3. Credits and incentives are the opposite of simplification. Similar to market-based sourcing and single-sales factor apportionment, credits and incentives pick winners and losers - shifting the tax burden to out-of-state taxpayers and/or to other tax types such as property taxes and personal income taxes. How does this impact schools? Does the positive outweigh the negative?
4. Credits and incentives require so much knowledge of the deal, the incentive, the contacts at the jurisdiction, the procedure, etc. So many 'hoops' to jump through to obtain an incentive. Is it fair to have a system that requires so much investment of time, money, and energy? Those who are unwilling, or unable to invest the time, money and energy lose out. Is that fair? You could miss out on a great incentive package simply because you did not hire the right person to negotiate for you? Is that what it should take?
5. If a company makes an investment in a project before getting the credit and incentive, did the company actually need the credit and incentive?
6. Credits and incentives require companies to 'tell the story.'
7. Is everybody 'winning'?
8. What tool are you using to determine the type of credits and incentives that will benefit your company the most? A modeling tool or excel spreadsheet? Using the right tool will allow your company to negotiate with a state/city to get the right incentives package (i.e., incentives you can actually use).

Dot Foods & Washington: A Case Study on Intent, Interpretation and Retroactivity

Regardless of whether you have been following Dot Foods v. Washington Department of Revenue cases for the last several years, we need to pause and review.

According to the decision, Dot Foods 1  involved Dot Foods utilizing an exemption from the Washington Business & Occupation (B&O) tax for many years (note: the statute was originally enacted in 1983). Dot Foods facts changed from 1997 to 2000, but Dot Foods interpreted the exemption to still apply. In 1999, the state revised its interpretation of the statute to narrow the exemption, under which, Dot Foods would no longer qualify.

Washington later audited and assessed Dot Foods additional tax for the 2000 to 2004 tax years based on the state's revised interpretation. Dot Foods paid the tax, and filed a refund claim, eventually winning in the Washington Supreme Court in 2009. In simple terms, the court held the state's new interpretation was incorrect, and the state simply can't change it's long-standing interpretation of a statute without changing the legislation itself. The court said:

"The Department's argument for deference is a difficult one to accept, considering the Department's history interpreting the exemption. Initially, and shortly after the statutory enactment, the Department adopted an interpretation which is at odds with its current interpretation. One would think that the Department had some involvement or certainly awareness of the legislature's plans to enact this type of statute. As a general rule, where a statute has been left unchanged by the legislature for a significant period of time, the more appropriate method to change the interpretation or application of a statute is by amendment or revision of the statute, rather than a new agency interpretation."

 Dot Foods, Inc. v. Dep't of Revenue, No. 81022-2, SUPREME COURT OF WASHINGTON, 166 Wn.2d 912; 215 P.3d 185; 2009 Wash.

While Dot Foods 1 was going on, (2005 to 2009), Dot Foods paid tax under the state's new interpretation of the statute to avoid penalties and interest. When Dot Foods 1 was decided in 2009, Dot Foods filed a refund claim for the 2005 to 2009 tax years.

Washington amended the statute in 2010 after Dot Foods 1 was decided in 2009, and applied the amendment retroactive to when the statute was originally enacted in 1983. According to the Washington State Budget and Policy Center's report in May 2010,

"the legislature enacted technical corrections and clarifications to state tax laws that will prevent steep revenue losses in the current year and in future years. This includes the legislature’s response to a recent State Supreme Court case that greatly expanded an exemption originally intended only for companies such as Avon and Mary Kay that sell products solely through door-to-door salespersons (Dot Foods decision). Without legislative action, the state would have lost about $151 million in the current biennium due to refunds and new firms claiming the exemption."

Under the authority of the retroactive amendment to the statute, Washington denied Dot Food's 2005-2009 refund claim (note, some of these tax years have been settled). Dot Food's challenged the ability of Washington to change the statute retroactively (Dot Foods 2). The Washington Supreme Court ruled in the state's favor in March 2016 holding that the legislature's amendment which retroactively narrowed the exemption and prospectively repealed the exemption, did not violate a taxpayer's rights under the Due Process Clause of the U.S. Constitution, collateral estoppel, or separation of powers principles. The court said:

"Retroactive application of the amendment did not violate due process protections because the amendment served a legitimate legislative purpose and was rationally related to the legitimate legislative purpose. The amendment prevented large revenue losses and removed preferential tax treatment for out-of-state businesses. In addition, the requirements of collateral estoppel were not met because collateral estoppel does not apply to subsequent taxing periods that were not previously adjudicated. Finally, since the taxpayer could not point to any evidence that the legislature intended to affect or curtail a prior judgment in the case, retroactive amendment did not violate the separation of powers doctrine."

Dot Foods, Inc. v. Dep't of Revenue, No. 92398-1, SUPREME COURT OF WASHINGTON, 185 Wn.2d 239; 372 P.3d 747; 2016 Wash.

Dot Foods requested the U.S. Supreme Court to review the case. We are waiting to learn if the Court will. Here are links to briefs filed by various organizations in support of Dot Foods:

• TEI Brief
• COST Brief
• American College of Tax Counsel Brief

Note: I am working on a more in-depth article for my column in Tax Analysts State Tax Notes.

Stay tuned. 

Indiana Releases Combined Reporting and Transfer Pricing Studies

Indiana has released two separate studies, one on combined reporting and one on transfer pricing. The studies were a requirement of SB 323 that was amended on January 28, 2016 to study combined reporting instead of adopt combined reporting, as I reported earlier. 

Combined Reporting

The combined reporting study discusses all of the reasons why states adopt combined reporting - to stop base erosion from taxpayers using intellectual property holding companies, captive real estate investment trusts, captive insurance subsidiaries and overseas management affiliates, etc. However, the study also explains that combined reporting creates new problems that separate reporting states do not have to deal with, such as determining the unitary group, and additional administrative burdens during the transition to combined reporting. 

The study also asserts that the impact of combined reporting on state revenues is mixed, according to evidence from other states. Similar to most state tax laws, implementing combined reporting would provide additional revenue from some taxpayers and less revenue from other taxpayers. Consequently, the question remains as to what the overall revenue impact would be. The study suggests combined reporting would increase revenue in the short term, but be neutral in the long term.

Regardless of the revenue impact, the study confirmed that separate reporting does allow taxpayers with more opportunity to create favorable business structures and utilize intercompany transactions to shift income from affiliates based in high-tax states. Despite this fact, the study appears to be leaning towards a recommendation to not enact combined reporting.

Transfer Pricing

The transfer pricing study is a great report to review if you want to learn more about transfer pricing. The conclusion of the report explains the realities of related party transactions that exist due to complex business structures dominated by parent companies with affiliates in multiple states and countries. As a result, scrutinizing intercompany transactions is a necessity.

The study confirms that transfer pricing examinations and analysis are complex and expensive, and asserts that if a transfer pricing study is not conducted in an efficient and effective manner, it could be detrimental to the taxpayer. To reduce the amount of disputed transactions, Indiana requires the addback of deductions taken for royalties, intangible related-party expenses and intercompany interest. However, other states currently have broader addback provisions or have enacted combined reporting.

So What?

Indiana has had many cases and rulings that reflect the complexities and burdens of analyzing and resolving the proper treatment of intercompany transactions and transfer pricing studies. Consequently, Indiana and taxpayers have spent resources (time and money), which both the state and taxpayers do not have, to resolve these matters. Hence, in my opinion, Indiana should adopt combined reporting to reduce the amount of disputes involving intercompany transactions and transfer pricing studies. The whole question of whether an intercompany transaction is at arms-length doesn't matter when intercompany transactions are eliminated in a combined return. Albeit, there may be some entities that are not a part of the group and the issue could still occur. In addition, combined reporting will create new issues to deal with, such as what entities are part of the unitary group. However, I believe it is less of a burden for states and taxpayers to manage the issues related to combined reporting versus the issues related to transfer pricing studies and analyzing related party transactions.