Global Business and Technology Causes Overreaching Laws and Unintended Consequences

Now that the Organisation for Economic Co-operation and Development (OECD) has released its recommendations and actions under the Base Erosion and Profit-Shifting (BEPS) project, federal legislation and subsequent state law changes may occur causing companies to adapt.

The article by Deloitte entitled, "Global Business and State's Challenges to Taxable Income," reminds us of the various methods or tactics states have taken to reduce or eliminate a company's ability to plan around taxation by using intercompany transactions and out-of-state / off-shore entities.

For example, states have utilized Internal Revenue Code (IRC) Sec. 482 like powers to remove the income distortion created by intercompany transactions not completed at arms-length. States have also enacted combined reporting and various related-party expense addback provisions. The most recent method used by states to tax revenue earned outside their borders is tax haven legislation - look here for more info.

When states enact combined reporting, they usually require water's-edge reporting or allow taxpayers to make an election to use water's-edge reporting. Why don't states require worldwide combined reporting?  Worldwide combined reporting would address the tax haven issue so why don't states require it? The short answer, states may not get more revenue if they required worldwide combined reporting. The inclusion of foreign income and apportionment factor dilution can cause unexpected results. Thus, what seems like a great solution on the surface, may not be in practice. Other factors that come into play include currency, accounting methods, and international tax planning which can cause complications. For more info see, "Are Tax Havens Pushing States to Worldwide Combined Reporting." 

As a result, states that enact combined reporting continue to use other laws to selectively decide when and how a foreign entity is included in a combined group return. For example, states that require water's-edge reporting generally have foreign entity inclusion / exclusion rules. One such law provides that foreign operating companies (a U.S. corporation with substantial operations outside the U.S. and at least 80% of its income is active foreign business income) are generally excluded from combined groups (i.e., 80/20 rule). 

In spite of the 80/20 rule, taxpayers have successfully included foreign operating companies in a combined return. For example, in a recent Minnesota Tax Court case (Ashland Inc. and Affiliates vs. Commissioner of Revenue), the Court ruled that a foreign disregarded entity's income and apportionment factors could be included in a Minnesota combined return because the foreign entity was not a separate entity from it's owner. 

In general, court cases and rulings tell us that states have a variety of rules to capture revenue earned outside their borders. Court cases and rulings also tell us that taxpayers can navigate those rules to plan and effectively choose which foreign entities are included or excluded. 

As the business world becomes even more global, and technology erases the easily identifiable lines of where a transaction begins and ends, taxing authorities have a very complicated job to tax the 'right' amount of a taxpayer's income. 

As tax laws change in response to the OECD and BEPS, companies will continue to adapt in response to those changes. Consequently, if history tell us anything, there will always be laws that overreach, and unintended consequences (planning opportunities). Prepare accordingly.