AICPA Corporate Taxation Insider

Not Flat

Ron Tang — Thu, 26 Jun 2008 08:04:00 -0400

PL 86-272 provides that if the only in-state activities a business has is the solicitation of orders for tangible personal property that is approved and filled from outside the state, the state may not impose a net income tax on the business. States set the rules, within due process and commerce clause constraints of the U.S. Constitution, for businesses that sell services or intangibles.

States tend to take broad approaches. A 2007 Illinois Department of Revenue ruling notes that "as a general rule, the Department interprets the concept of nexus as broadly as possible (No. IT 07-0033 (PDF), September 2007)."

Below, we'll review recent income tax nexus rulings and proposals for improving guidance.

Selected Developments

In May 2008, the Oregon Department of Revenue (DOR) adopted Rule 151-317.010 (PDF) to clarify that a corporation can have substantial nexus in the state for corporate excise and income tax purposes without having a physical presence there. "Substantial nexus exists where a taxpayer regularly takes advantage of Oregon's economy to produce income for the taxpayer and may be established through the significant economic presence of a taxpayer in the state."

To determine if substantial nexus exists, the DOR may look at the regularity of contacts in the state, deliberateness of marketing to Oregon customers, and significant gross receipts from Oregon customers or from the use of intangible property in Oregon. Also relevant is whether the business is protected by Oregon laws, has court access, uses state roads, benefits from Oregon's educated workforce, or receives "police and fire protection for property in Oregon that displays taxpayer's intellectual or intangible property."

In Florida Technical Assistance Advisement 07C1-007 (October 2007), the DOR held that a financial services firm providing various services to retailers in Florida had substantial nexus for income tax purposes despite lack of a physical presence. For example, T, licensed with the Florida Department of Financial Services, has a number of authorized retailers in the state.

The DOR relied on Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444 (1940): the "simple but controlling question is whether the state has given anything for which it can ask return." Florida had provided T a license, access to Florida laws and courts, and "an orderly and regulated marketplace." T would not be able to operate in Florida without its retailers and made "purposeful direction towards the Florida market."

The DOR applied the tests of Complete Auto Transit, Inc., 430 U.S. 274 (1977) to determine that the commerce clause posed no problem.

The DOR relied on cases from other states that held that the physical presence standard of Quill (504 U.S. 298 (1992)) does not apply for income tax purposes. It also noted that the U.S. Supreme Court had declined to hear a state case on this issue. The DOR found these cases to be "persuasive, especially given the fact that the U.S. Supreme Court declined to hear the cases." While not mentioning the cases, the DOR was likely referring to MBNA, 640 SE2d 226 (2006) and Lanco, 188 NJ 380 (2006), cert. denied (June 2007). In these cases, the courts held that for commerce clause purposes, a "significant economic presence test" was appropriate to determine if a business had a substantial nexus in a state for income tax purposes (MBNA).

A 2008 ruling by the Virginia Department of Taxation (DOT) reminds us that nexus may not be a concern if the business has no income apportioned to the state. In Ruling No. 08-63 (May 2008), a credit card company headquartered outside of Virginia sought guidance on whether it had nexus for income tax purposes. The company had no property or employees in the state. From outside of the state, the company used mail, telephone and Internet ads to solicit credit card customers in Virginia.

Per the ruling, a corporation can have Virginia source income if it has sufficient business activity in-state such that the apportionment factor is positive. The ruling avoided the nexus issue by noting that even if the company has nexus, it is unlikely to have income apportioned to Virginia. With over 70 percent of the company's income derived from interest and credit card processing fees, it is a financial corporation which, under Virginia law, must apportion income using a cost of performance measure. Without property or employees in the state, the costs of performance occur elsewhere.

Similarly, a 2008 Nebraska ruling (24-08-1) stated that trucking companies without a business location in the state that use Nebraska roads are subject to income tax. However, if a company's Nebraska activities are de minimis, it need not apportion any income to the state and thus owes no income tax.

In Nebraska a trucking company must apportion income to the state if the company "owns or rents any real or personal property in this state, other than mobile property; makes any pick-ups or deliveries within this state; travels more than 25,000 mobile miles within this state or the total mobile miles within this state exceed three percent (3%) of the total mobile miles traveled in all states; or, makes more than 12 trips into this state."

Concerns

These rulings illustrate challenges some companies face in determining where they owe income taxes. Businesses not covered by PL 86-272 must review the law in every state in which they have customers, employees, agents or any activity. Where it has any physical presence, it must review the law to determine if it is enough (for example, how many miles its trucks drove in the state). Even without physical presence, it must determine if it derived some benefit in the state (for example, a sign displaying a trademark) or generated more than de minimis receipts.

If the company determines it has nexus, it must review the state's apportionment rules to determine if any income is taxable.

Lack of uniformity among states generates uncertainty and costs for businesses.

Solutions

S 1726 and HR 5267 (110th Congress) would expand PL 86-272 to apply also to services and intangibles. They require a physical presence for a business to be subject to income tax. The bills generally define physical presence as including employees, an exclusive agent or tangible property. Presence of less than 15 days or to conduct limited or transient business activity is ignored.

Congressman Rick Boucher (D-Va), a co-sponsor, suggests that this approach will "not diminish the ability of states and localities to collect tax revenue... [but instead] rationalizes and makes more predictable the process of doing so. (Cong. Rec. February 2008, E137 (PDF))" In February 2008, the House Small Business Committee held a hearing on tax and nexus issues small businesses face that "significantly inhibit their ability to engage in commerce."

On another front, National Conference of Commissioners on Uniform State Laws (NCCUSL) appointed a drafting committee to review the Uniform Division of Income for Tax Purposes Act (UDITPA). The committee's rewrite work could include nexus.

Uniformity among states will not be guaranteed through a UDITPA revision because states are not required to adopt the act, although Congress could provide some incentive for doing so. Federal legislation would provide uniformity, but agreement among legislators, states and businesses on what that uniformity should be remains elusive (see links).

Conclusion

Reaching a flat world in U.S. commerce depends on reaching appropriate nexus rules that enable businesses to easily engage in domestic commerce and for states to have the resources to serve the needs of citizens and businesses.

Gross Receipts Taxes

Ron Tang — Thu, 22 May 2008 10:34:00 -0400

In recent years, concern over declining corporate tax collections, aggressive tax planning and state revenue needs have led a few states to consider and even enact a gross receipts tax (GRT) on companies that do businesses within its borders. On the surface, a GRT is simple since it allows no deductions. The broad base allows for a very low rate that can make the tax more palatable. Further, all businesses are typically subject to the GRT, with the result that all businesses contribute something to state coffers.

Yet, many oppose the GRT because of its inherent flaws, one being that it is not tied to a business's ability to pay. Below, we'll look at reasons why some state tax reform discussions include the GRT and how the GRT stacks up against the principles of good tax policy. For more information see Gross Receipts Taxes (April 2008).

Rationale

The Multistate Tax Commission reports that in 1962 and 1980, corporate income taxes represented 6.4 percent and 9.7 percent of state tax receipts, respectively. In 2002, that percentage dropped to 4.9 percent (Federalism at Risk (PDF), 2003).

States have also seen corporations increasingly using a mix of tax provisions to optimize planning through the use of "nowhere income," holding companies, beneficial apportionment factors and state tax incentives. Budget deficits have led many states to reconsider their tax systems. The Center on Budget and Policy Priorities reports that a majority of states face budget problems for fiscal year 2009.

These concerns led to GRTs in Ohio (2006) and Michigan (2007). Ohio's GRT was part of a reform measure that also reduced the top personal income and sales tax rates and eliminated the corporate franchise and tangible personal property tax. Michigan's GRT arose from budget concerns and a desire to improve the business climate by encouraging jobs, investment and R&D (Michigan Dept. of Treasury and Governor's statement (PDF)).

These concerns also led Illinois Governor Blagojevich to propose a GRT in March 2007. He noted (PDF) that the average Illinois taxpayer paid $1,500 of state income taxes. However, an average of only $151 of corporate income tax was paid by 12,521 of the largest corporations in the state. He proposed (PDF) a "historic Tax Fairness Plan" to "replace the loophole riddled corporate income tax with a simple, fair" GRT.

However, his proposal had strong opposition. The Illinois Association of Realtors issued a report noting that the GRT would increase housing costs and result in a loss of about 14,000 construction jobs due to pyramiding (where tax is paid on a tax). In May 2007, the Illinois General Assembly voted unanimously to oppose the GRT (HR 402, May 2007).

An understanding of the pros and cons of a GRT helps explain how it can be so loved and hated.

Advantages and Disadvantages

Evaluation of a GRT within the context of the principles of good tax policy (PDF) follows.

Equity: A GRT is not based on a taxpayer's ability to pay and does not tie well to benefits received by the state. Profit margins vary by business and industry. A GRT is more favorable to a high-margin business than a low-margin one. A GRT can tend to favor a larger business that is (or can become) vertically integrated relative to a small business that must buy from other companies with GRT included in the prices.

A GRT often applies to all forms of businesses that can improve equity compared to having different tax systems for sole proprietors and corporations. A GRT can also be viewed as equitable in that every business pays something.

Certainty: While a GRT may be certain for an in-state business, it can be less certain for multistate businesses. For example, the guidance and protection of P.L. 86-272 does not apply since a GRT is not a net income tax, leaving taxpayers with less certainty as to where they may be subject to GRT.

Simplicity: Lack of deductions makes a GRT simpler to compute and audit relative to an income tax. However, GRTs tend to vary among jurisdictions as to the base, sourcing, nexus and apportionment rules, which increases complexity. Some states also address GRT problems, such as pyramiding, by allowing certain deductions or having different tax rates for different industries, which can also create complexities.

Neutrality: With no deductions or credits, a GRT is less likely to affect business decisions than a typical income tax. However, some GRTs do include deductions and credits.

The significant neutrality concern is pyramiding in which tax is paid on a tax. Because GRT is owed by each company providing services or goods along a production and distribution chain, it is built into prices charged, with GRT again paid by the purchaser. A 2002 study of Washington's Business & Occupation tax (a GRT) found that it pyramided an average of 2.5 times ranging from about 1.5 times for service businesses and over six times for some manufacturers. Pyramiding can affect business operational decisions such as encouraging provision of goods and services in-house or purchasing from firms not subject to the GRT (that might be out-of-state firms).

Michigan partially addresses pyramiding by allowing companies to deduct purchases from other firms from the GRT base. Some states use multiple rates. However, pyramiding is inherent in a GRT. States eager to reduce pyramiding should consider a value-added tax since it is structured to eliminate pyramiding.

Economic growth: A GRT can be harmful to start-ups that tend to operate at a loss. The pyramiding effect and any unintended consequence of a GRT encouraging firms to purchase from out-of-state firms can also harm economic growth.

Transparency: A GRT is not visible because typically businesses may not separately state it on sales invoices. Also, it is not obvious how much GRT is included in prices due to pyramiding.

Appropriate government revenues: A state may find that a GRT helps it achieve its revenue and economic development goals. However, if that result is achieved with a modified GRT with multiple rates and special deductions and credits, a net income tax could probably have been used instead. A GRT may increase sales tax revenues because the GRT is factored into prices charged. A state may prefer a GRT over an income tax because there is no need to consider whether it should conform to federal income tax changes. Finally, states may find that a tax based on gross receipts rather than net income is more stable.

Is It Worthwhile?

Despite the strong negative reaction to a GRT in Illinois, Ohio, Michigan and Texas enacted GRTs in the same time frame.

As states consider tax reform, they should start first by looking at their income taxes, since such levies can be modified to have a broader base and lower rates. States must also consider whether a GRT comports with their economic development goals and is consistent with what comparable states are doing.

If a GRT is created, it will certainly be more acceptable if it replaces other business taxes and addresses some of the concerns we discussed earlier in this article. States have a tremendous opportunity to learn from the states that recently enacted GRTs.

As states struggle to deal with budget problems, we are likely to see more consideration of GRTs despite the criticism against them. However, the exercise might lead states to more effectively consider how existing taxes can be improved.

Gross Receipts Taxes

Ron Tang — Thu, 24 Apr 2008 06:21:00 -0400

Recent tax reform efforts in Ohio, Texas and Michigan have led to an increase in the number of states imposing gross receipts taxes (GRT). Let's take a closer look at GRT and some important legal issues surrounding it.

Overview

The Multistate Tax Compact defines a GRT as "a tax, other than a sales tax, which is imposed on or measured by the gross volume of business, in terms of gross receipts or in other terms, and in the determination of which no deduction is allowed which would constitute the tax an income tax" (Article II (PDF)).

In 2005, Ohio enacted a GRT called the Commercial Activity Tax (CAT) that is now imposed on all types of business entities. The legislature described the CAT as a tax on the "privilege" of doing business in Ohio -- not specifically a sales tax. The rate is 0.26 percent of the business's annual receipts over $1 million. Businesses with receipts of $1 million or less pay a flat fee of $150 and business with receipts of $150,000 or less owe no tax at all. The rate can be adjusted based on tax collections. The Ohio CAT replaced the state's corporate franchise tax.

In contrast, the recently enacted Michigan GRT is a modified GRT imposed at a rate of 0.8 percent of gross receipts less purchases from other firms. Some jurisdictions with a GRT apply different rates to different industries.

Design and Legal Constraints

Is a GRT an income tax, a sales tax, a privilege tax or something else?

The Ohio CAT cannot be passed directly through to customers or shown separately on a customer invoice. Per a Q&A from Ohio's Department of Revenue, the CAT is not considered a sales tax, but is instead a tax on business activity. However, the CAT can be included in the overall costs of doing business and factored into the prices the business can charge.

Generally, the "true economic impact of a tax is what ultimately determines its nature" (In re: Advisory Opinion To The Governor, 509 So. 2d 292 (S. Ct. Fl 1987)). If a business has all of its sales subject to sales tax and is subject to a GRT on those sales receipts, its sales tax and GRT base would be the same. However, the GRT operates differently from a sales tax. Generally, a sales tax exempts sales made for resale while a GRT does not. Also, a sales tax is separately shown on sales invoices, while typically a GRT is not. In addition, when, for example, Taxpayer in State Y purchases from an out-of-state vendor, Taxpayer owes use tax to State Y. However, State Y won't necessarily collect GRT on the transaction.

The nature of a GRT is relevant in at least three situations.

State law prohibits or requires special treatment of a particular type of tax. In Ohio Grocers Association v. Wilkins (06CVH02-2278 (PDF), 8/24/07), the Ohio CAT was challenged as unconstitutionally imposed on food sales. The CAT was upheld as an excise tax on the privilege of doing business in Ohio rather than imposed on food sale transactions. In Volusia County Kennel Club v. Haggard, 73 So.2d 884 (S Ct. Fl 1954), cert denied 348 US 865 (1954), the court held that a GRT on gambling was a privilege tax rather than an income tax and therefore was not prohibited under Florida law.
Treatment of the tax by other states. For example, Wisconsin law does not allow a deduction for a GRT, but GRT paid might generate a credit for income taxes paid to another state.
Determining the appropriate nexus standard. Nexus guidance under P.L. 86-272 only applies to net income taxes and so does not apply to a GRT. Thus, businesses with customers, employees or property in a GRT state must review the state's law to determine if they owe GRT. Such laws pose constitutional issues if too broad in their reach.

Controversial Features

Some GRT features have generated or likely will generate legal challenges for some taxpayers and jurisdictions.

Nexus: The CAT nexus standard is modeled on the Multistate Tax Commission's factor presence standard (PDF). An out-of-state business is treated as having substantial nexus in Ohio and thus subject to the CAT if it meets any of the following criteria: (1) at least $500,000 in taxable gross receipts in Ohio, (2) at least $50,000 of property in Ohio, (3) at least $50,000 of payroll for work done in Ohio, or (4) at least 25 percent of its total property, payroll or sales in Ohio. This standard is different from what Ohio uses for its sales and franchise taxes.

In contrast, a business has nexus in Michigan if it has a physical presence there for more than one day during the tax year or it "actively solicits" (PDF) sales in Michigan and has unapportioned gross receipts of $350,000 or more sourced there.

Challenges are likely with new nexus standards and issues as to the nature of a GRT. Is a physical presence required? Can a modified GRT be considered a net income tax such that PL 86-272 applies?

Sourcing: Determining whether a business is subject to tax and if so, how much of its receipts are taxable, can raise apportionment issues and commerce clause issues.

Differences in sourcing rules stem from varying purposes that states have for their GRTs. Ohio does not tax export sales, indicating that the state is encouraging businesses to locate in state and have customers out of state. In contrast, Washington's GRT (called the Business & Occupations (B&O) tax) is imposed on businesses for engaging in commercial activities within the state (RCW 82.04.220). This design ties the tax to benefits received in the state (for doing business there). For a contrast of sourcing and apportionment approaches, compare Ohio (PDF) and Washington. For an example of a commerce clause concern on apportionment, see the amicus brief (PDF) of the Council on State Taxation and the National Association of Manufacturers in Ford Motor v. Seattle, 156 P3d 185 (2007), cert denied U.S. S. Ct Dkt. No. 07-623 (2/19/08).

Free speech: Kentucky's GRT prohibits sellers from directly collecting the tax from customers or stating the GRT separately on invoices. Despite this, at least one telecom service provider separately listed the GRT on customer bills. The provider did not want to factor the GRT into its basic charge because its national advertising indicated a fixed price for all customers. The provider challenged the requirement under the commerce clause and First Amendment of the US Constitution. The First Amendment challenge was upheld because the court found that the prohibition on separately listing the GRT prohibited more speech than was necessary to advance the government's interest in protecting its citizens from misleading information (AT&T v. Robbie Rudolph, 2007 U.S. Dist. LEXIS 13962 (ED KY 2007)).

Conclusion

No question, Gross Receipts Taxes are getting a great deal of attention today as policy makers wrestle with exactly what kind of a tax a GRT is -- or should be. In addition, issues exist for each individual state as lawmakers debate whether or not a GRT is a desirable way to tax businesses that operate within their jurisdictions.

The 50th Anniversary Of Public Law 86-272

Ron Tang — Thu, 27 Mar 2008 07:29:00 -0400

Public Law 86-272, addressing circumstances under which a multistate business may owe state income taxes, was enacted as a stopgap measure on September 14, 1959. For the past several years, efforts to reform this law have raised issues similar to those of 1959. This article provides a brief history and the issues surrounding PL 86-272 and poses the question -- when the 50th anniversary milestone is reached, will PL 86-272 be in its historic form or a new form (and what might that be)?

1959 Supreme Court Decision

In February 1959, the U.S. Supreme Court issued its opinion in Northwestern Cement v. Minn., 358 US 450 (1959). The Court upheld a state's power to tax income generated from interstate activities. Such a tax is valid if it does not discriminate against interstate commerce and is properly apportioned to activities within the state that create nexus. The Court ruled that such a tax was within the Due Process clause of the U.S. Constitution because fair apportionment led to only taxing income arising in the taxing state.

The Court referred to its earlier decision, Wisconsin v. J.C. Penney Co., 311 US 435, 444 (1940). The "'controlling question is whether the state has given anything for which it can ask return.' Since by 'the practical operation of [the] tax the state has exerted its power in relation to opportunities which it has given, to protection which it has afforded, to benefits which it has conferred.' it 'is free to pursue its own fiscal policies, unembarrassed by the Constitution.'"

Concerns

The decision raised many concerns for businesses and Congress. Most troubling was what the Senate described as the Court's "broad language" (Senate Rpt. No. 658 (8/11/59) to S. 2524).

Key concerns for businesses included:

Determining the quantity and nature of activities in a state that could cause a business to have sufficient nexus to be subject to income tax there.
How income of a multistate business should be fairly apportioned among states in which it has nexus.
The possibility that non-uniform rules among the states could cause a sale to be attributed to more than one state.
Dealing with the compliance burden and costs of computing taxable income under the differing rules of each state in which a business is subject to tax and applying the different apportionment rules of each state. Some businesses noted that the costs to comply might exceed the tax owed in some cases.

Some members of Congress observed that nexus uncertainty and compliance burdens could lead some businesses to limit their interstate activities. They noted that the situation was worse for small businesses for which the compliance costs were more problematic. Concerns were also expressed over the possibility that states would use the 1959 Court decision to assess taxes for past years.

PL 86-272

PL 86-272 was enacted within seven months of the Court's decision. Its aim was a more certain rule for when a multistate business is subject to income tax in any particular state. The Senate Report (Senate Rpt. No. 658 (8/11/59)) noted that the legislation "is not a permanent solution to the problem." Instead it was intended to "serve as an effective stopgap or temporary solution while further studies are made of the problem."

Senator Byrd of Virginia expressed the Senate's rationale for the rush in passing a law prior to further study of the issues. "Unless immediate action is taken at this time, it is feared that the States will amend their laws to further encroach upon interstate commerce." (Cong. Rec. 8/19/59, p. 16354).

Basically, PL 86-272 prohibits a state from imposing a net income tax if a company's only state activities are solicitation of orders for sales of tangible personal property which are sent outside the state for approval or rejection and are filled from outside the state. It also called for a study and report on state taxation by a congressional subcommittee.

Visit the author's website on PL 86-272 and its reform with links to proposals and analysis.

Current Issues

The "current" issue since 1959 is when temporary PL 86-272 will be replaced with permanent legislation. Prior to enactment, Senator Gore, who preferred further study before changing the law, noted that the legislation was permanent because no termination date was provided (Cong. Rec. 8/19/69, p. 16357).

While time has, in effect, made PL 86-272 permanent, in the past few years, there have been several proposals and hearings about its reform (for example, S. 1726 (110th Cong.), Senate Finance Committee hearing 7/25/06 and the Multistate Tax Commission's factor presence proposal (PDF)). These changes call for updating the law to cover more than net income taxes and tangible personal property.

Much of today's debate on PL 86-272 reform echoes the pro and con positions expressed in 1959 and the matters addressed in the post-1959 congressional study (often referred to as the "Willis report" (6/30/65) for the Congressman who headed up the project). These positions dealt with the tension between protecting businesses from uncertainty and multiple taxation and preserving state tax authority and revenues.

Today, many businesses sell services and intangibles, rather than tangible personal property. Also, some states have business taxes that are not income taxes, such as gross receipts taxes. When a business is not covered by the "protection" of PL 86-272, due process and commerce clause guidance governs whether a state may tax the income of a multistate business. Most states have provided nexus guidance either legislatively or administratively, but as was the situation decades ago, such guidance is not uniform among the states and rarely provides certainty to taxpayers.

When PL 86-272 does not apply, many businesses have relied on the physical presence nexus standard laid out by the Supreme Court in Quill (504 U.S. 298 (1992)). This case involved a state imposing sales tax collection responsibilities on a remote vendor. The Court held that the Commerce Clause required a physical presence for substantial nexus.

However, several court decisions have ruled that physical presence is only relevant for sales and use tax nexus (for example, Tax Comm'r. of the State of West Virginia v. MBNA, 640 SE2d 226 (2006), cert. denied, U.S. S.Ct., Dkt. No. 06-1228, 06/18/2007). Some of these cases have held that "economic presence" (such as customers and intangibles) can create nexus. The current state of affairs involving nexus determinations is reminiscent of 1959.

PL 86-272 Reform Considerations

Ways of doing business have changed dramatically since 1959. Businesses can operate with fewer physical locations, borders are not always important and many products and services are digitized. Congress, state governments and businesses must evaluate what nexus standards are appropriate today that also provide certainty and fairness to taxpayers and state governments. PL 86-272 focused on nexus rather than also apportionment. Reform efforts should consider how much guidance Congress should provide under its commerce clause authority to regulate interstate commerce. Congress must find the balance between the exercise of its authority and states' authority to define their tax systems.

As evidenced by a temporary law approaching its 50th anniversary, reform efforts will not be easy, but are clearly needed. The discussions are likely to continue right through PL 86-272's 50th anniversary.

Obstacles To Taxing Services -- Are They Insurmountable?

Ron Tang — Thu, 28 Feb 2008 14:40:00 -0500

State sales tax bases have traditionally included only tangible personal property. Often services are either ignored completely in describing the tax base, or a small number of services are specifically targeted as legally taxable. One reason for exclusion is historical. Tangible personal property was the main consumption item back in the 1930s when many states started imposing a sales tax. However, in the past two decades, consumption of services has become significant.

Since 1990, the Federation of Tax Administrators (FTA) has tracked the number and types of services taxed in each state. Of the 168 services tracked, Hawaii, New Mexico and South Dakota tax the greatest number (over 140 each), while most states tax less than 60 services.

To preserve or expand revenues, many states have pursued broadening their sales tax base to include more types of services. These efforts have not always been successful. States’ need to preserve their tax bases in light of changing consumption patterns, combined with their inherent need for revenue, makes it inevitable that states will continue to pursue expansion.

Below, we’ll look closer at reasons for taxing services, obstacles to doing so and possible solutions.

Famous Failures

Protests generated nationwide attention when two states attempted to expand their sales tax to services in the late 1980s. In 1987, Florida expanded its sales tax to include specified services, only to repeal it six months later. The legislature replaced the tax with a rate increase (New York Times). In 1990, Massachusetts expanded its sales tax to services only to repeal it before the effective date.

More recently, to generate needed revenue, Michigan enacted a use tax on 23 specified services including landscaping, party planning and packaging (HB 5198, October 2007 (PDF)). On the day the new tax went into effect, December 1, 2007, it was repealed and replaced with a business tax surcharge (HB 5408, December 2007).

Reasons for Including Services in the Sales Tax Base

Consumption Trends: Changes in lifestyles and technology have led to changes in consumption patterns. Busy families might hire a house cleaner, gardener and nanny. And it is not uncommon to hear of people hiring personal trainers and pet sitters.

From 1970 to 2001, consumption of tangible personal property minus groceries dropped from 39 percent of household consumption to 33 percent. From 1970 to 2001, consumption of services increased from 31 percent of household consumption to 44 percent (Mazerov, Expanding Sales Taxation of Services: Options and Issues, Center on Budget and Policy Priorities; also see Minnesota House Research).

Consumption trends also include greater consumption of digital goods. Reasons for expanding tax bases to include services also apply to digital goods, such as music and software downloads.

Tax policy and structure: Economically, there is no rationale for taxing some forms of consumption while exempting others. There is no reason to tax laundry detergent, but not dry cleaning services, or a lawn mower, but not gardening services.

Broadening the sales tax base to include more services can make the sales tax more equitable and can allow for a rate reduction (making the tax even more equitable). If needed, base broadening and a rate reduction can be combined to generate new revenues. States facing reduced sales tax collections due to a diminishing tax base might find it simpler to increase the tax rate, rather than expand the base. This approach though, ignores the underlying problem and creates others. Many services are more likely to be purchased by higher income individuals. Exempting that consumption while increasing the tax on tangible personal property makes the sales tax more regressive. Also, many states already have high sales tax rates and further increases may lead to competitive problems for businesses and greater tax evasion.

A broader base can also reduce volatility that can improve government budgeting. Base broadening can also help improve economic development decisions. For example, in some states, such as California, local governments are very dependent on sales tax revenues. Thus, they are “incentivized” to get retailers to locate within their jurisdiction rather than trying to attract businesses that offer nontaxable goods or services. A broader base enables governments to make better economic development decisions.

Issues and Analysis

Listed below are some of the reasons for the famous failures noted earlier, and suggestions for improvement.

Education: Predictably, adding a tax to something previously untaxed is not popular. A state should pursue education efforts to help consumers understand the sales tax and the benefits of base broadening. Once in place, taxpayers will also need information on when they owe use tax on services obtained from out-of-state.
Avoid pyramiding: Base broadening should be allocated to services that are not typically used by businesses so as to not worsen a state’s pyramiding problems. Pyramiding is the imposition of a tax on a tax. For example, if a business pays sales tax on its purchases, it will factor that cost into what it charges customers. When customers pay sales tax on purchases from that business, they pay a tax on a tax. Not taxing services primarily consumed by businesses should also be good for the state’s business climate. A sales tax on hair cuts won’t cause hair salons to leave the state, but a tax on information technology services may cause businesses to leave or to avoid locating in the state.
Legality: A state should review federal and state rulings for help in properly defining the expanded tax base. A 1987 Florida ruling provides insights on reducing the likelihood of legal challenges. Among other findings, the court noted that imposition of sales tax on legal services was permissible. Per the court, states have flexibility and discretion in selecting items to be taxed “provided that the classification is reasonable, non-arbitrary and rests on some ground of difference having a fair and substantial relation to the object of the legislation (In re Advisory Opinion to the Governor, 509 So 2d 292, 303 (FL 1987)).”

Case law should also be reviewed to aid in drafting rules on nexus and determining the tax on services performed and/or delivered to more than one state.
Transition: Implement the expansion gradually. The enacting statute should specify the items added to the base with effective dates spanning a future time period. This allows more time for the tax agency to help businesses that become subject to tax collection, and for consumers to adapt to the changes.
Compensation: Base expansion will cause more businesses to be subject to sales tax compliance. A state should provide a refundable tax credit to alleviate start-up costs for these businesses and ideally, provide compensation for all businesses that collect sales tax.
Rate reduction: The base should be expanded along with a rate reduction. This helps consumers to see justification for the base broadening beyond just generating revenue. A rate reduction might also alleviate other sales tax issues, particularly in states that already have a high rate.

Reality

Tax policy and revenue needs make it inevitable that states will continue to explore sales tax base broadening to include more services, as well as digital goods. Whether states will learn from the failed attempts remains to be seen. Working to avoid the obstacles though, such as in the ways noted above, should lead to improved tax systems and a manageable change process.

Corporate Tax Under the Microscope

Ron Tang — Thu, 24 Jan 2008 00:00:00 -0500

S corporations now account for two-thirds of U.S. corporate tax returns (see NTA report) and while designed for simplicity, they’ve become increasingly complex and harder for regulators to standardize and monitor.

As the number of small businesses has exploded, the number of S corporations formed has more than quadrupled since the last review (of 1984 returns) while the number with assets exceeding $10 million has increased 10-fold. Today’s S corporations are not necessarily small, and not necessarily easy to classify for tax reporting purposes.

In fact, the National Taxpayer Advocate’s (NTA) 2007 Annual Report to Congress (January 2008) identifies many problem areas for S corporations today and makes several strong recommendations for streamlining tax reporting and compliance in the future. Preceding this report, the IRS launched a review of 5,000 randomly selected S corporation returns in 2005 as part of its National Research Program (NRP).

The NTA report notes three problem areas for S corporations:

Insufficient data to aid the audit process. Despite the number and size of S corporations, the IRS classifies them into only three asset size groups, compared to 13 groups for C corporations. This limits the ability of the IRS to identify returns with the highest compliance risk. IRS audit techniques also make it difficult to find issues involving multiple levels of pass-through entities. The number of no-change audits in 2006 was 41 percent for field audits and 58 percent for correspondence audits indicating that current audit selection criteria are deficient.
Undue taxpayer burden caused by problems with the election process (Form 2553) and incorrect K-1 matching notices. In 2005 and 2006, about 15 percent of S corporation returns could not be posted because the Form 2553 had not been approved due to taxpayer or IRS errors. In 2004, the NTA suggested that the Form 2553 due date be the same as for the first Form 1120S (including extensions). The NTA notes that while Rev. Proc. 2007-63, allowing for late elections in certain circumstances will help alleviate some burden, the due date for Form 2553 should still be extended. The report suggests that better training of IRS employees could improve the K-1 matching program.
S corporations contributed almost $6 billion to the 2000 tax gap in the form of employment taxes from treating shareholder wages as distributions. Failure to pay compensation to S corporation shareholders who are officers or otherwise work for the corporation continues to be a problem. In 2005, almost 1 million S corporations with a sole shareholder failed to pay officer compensation. This longstanding issue is a time-consuming one for IRS examiners. The NTA suggests that the IRS send a “soft contact letter” to S corporations that report no officer compensation to get a sense of awareness of the issue and then check for future compliance.

Tax Gap

In its August 2007 report, Reducing the Federal Tax Gap (PDF), the IRS recommends electronic filing for all businesses required to file Schedule M-3. The IRS also recommends information reporting on payments made to corporations.

Corporate Tax Rate and Reforms

Several reports brought attention to the high federal and state U.S. corporate income tax rate of 39 percent relative to the 31 percent average for OECD (Organisation for Economic Co-operation and Development) countries, as well as some of the differences between U.S. business taxation and that of other countries.

Treasury Report of July 2007: A U.S. Treasury Department report noted problem areas in our corporate tax system including preferences that distort economic activity and add complexity. Treasury observed that elimination of tax preferences, such as the manufacturing deduction, research credit and others could allow the corporate rate to be reduced from 35 percent to 27 percent.

The report points out that relative to other countries, the U.S. derives a large percentage of its total business income from flow-through entities (about 27 million sole proprietors, S corporations and partnerships). In 1980, 83 percent of businesses were flow-through entities, rising to 93 percent by 2004. This makes the individual tax system important in considering business tax reforms. Treasury also highlighted distortions in the U.S. tax system such as rules favoring investment in owner-occupied housing, debt over equity, and investment in human capital over physical capital.

While the Treasury report made no recommendations, House Ways & Means Committee Chairman Charles Rangel introduced a tax reform bill (H.R. 3970) in October that eliminates or reduces several business tax preferences and drops the corporate rate from 35 percent to 30.5 percent. Arguably, this bill is an indication that business tax reform will also be discussed in Congress.

CRS Report of October 2007: A Congressional Research Service (CRS) report -- Corporate Tax Reform: Issues for Congress (PDF), questioned the validity of some of the claims about the benefits of reducing the corporate tax rate. According to this report, there is no evidence that a rate cut will lead to an increase in revenues. Also high U.S. rates will not necessarily create competition problems in the global economy. Competitiveness issues go beyond the statutory tax rate and can be affected by the mobility of capital, the interaction of individual and corporate rules, differing tax rules among countries and effective tax rates (taxes as a percentage of income). The report observes that the corporate rules do lead to some economic distortions, which if corrected, could support a lower rate and make the system more efficient.

Treasury Report of December 2007: As a follow-up to its July report, Treasury released Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century. This report also focuses on the need for a tax system that does not hinder the ability of U.S. businesses to compete in the global economy. Treasury lays out three possible reforms for further discussion, but makes no recommendation:

Replace business income taxes with a consumption tax.
Eliminate various tax preferences to allow for either a rate reduction or accelerated asset write-offs, along with adopting a territorial system for international taxation.
Address structural problems in the current income tax.

OECD Study: In November 2007, the Organization for Economic Co-operation and Development issued a study on fundamental corporate income tax reform in OECD countries. It covers trends, the reasons for a corporate income tax, types of reforms and policy considerations.

Revenue Projections

The Budget and Economic Outlook: An Update (PDF), issued by the Congressional Budget Office (CBO) in August 2007 reports that individual tax revenues are projected to increase from 2006 to 2017 at a much greater rate than corporate tax revenues, which are expected to decline as a percentage of GDP.

			2006 	2017 	Percentage change
Tax revenues (billions): 
Individual income tax 	$1,044 	$2,306 	120.8 percent 
Corporate income tax 	$354 	$415 	7.2 percent 
Social insurance taxes 	$838	$1,362 	62.5 percent 
As a  percent of GDP: 
Individual income tax 	8.0 	10.7   
Corporate income tax 	2.7 	1.9 
Social insurance taxes	6.4 	6.3

The growth in individual tax revenues is explained by expiring tax cuts, AMT, and an increase in the number of retired individuals.

Looking Ahead

The examination of corporate taxes in 2007 identified several topics needing further study before any decision can be made as to the best reforms for the U.S. business system. Efforts to enact changes will be complicated by the urgency of some individual tax issues, such as AMT and expiring tax breaks. The cost of individual reforms may require pursuing corporate and individual reforms as a package of reforms to the overall system. Congressman Rangel’s H.R. 3970 may be the vehicle for these discussions as it also calls for repeal of the individual AMT.

Policy Considerations of a Carbon Tax

adminn — Tue, 11 Dec 2007 15:46:00 -0500

Regardless of one’s view on the issue of climate change and how high priority it should be on national and international agendas, the topic, as well as ideas for reducing greenhouse gas (GHG) emissions, is getting much attention by legislators, governors, mayors and others. One idea that has been suggested for changing manufacturer’s behavior to reduce GHG emissions is a carbon tax (for more information on carbon taxes and examples of current proposals, see Warming Up to a Carbon Tax).

Energy Taxes -- Not a New Idea

Taxes on energy are not new. The federal gasoline excise tax has been around since 1932. State gas taxes are older, as Oregon has had one since 1919. By 1932, every state and the District of Columbia had followed Oregon’s lead. Since 1956, the federal tax has primarily been earmarked for highways and transit (Congressional Research Service report (PDF)).

Several times over the past few decades, proposals for higher gasoline taxes or other types of energy taxes have been considered, usually as a means of reducing budget deficits. The Congressional Budget Office (CBO) and other groups have devoted much time to analyzing different types of energy taxes, their likely impact on the economy, implementation issues, and pros and cons of various tax bases for an energy tax. For example, the CBO he CBO has studied the effects of a carbon tax to address global warming since 1990 (Carbon Charges as a Response to Global Warming: The Effects of Taxing Fossil Fuels (PDF)). Additional work continues to occur as the subject of energy taxes remains pertinent to deficit reduction as well as addressing climate change concerns.

Carbon taxes are a subset of energy taxes; they focus on the goal of reducing GHG emissions. Energy taxes can also reduce GHG emissions, but could also be more broadly based, such as on the heat content of fuels (BTUs) in which case they would even apply to sources of energy, such as renewables and nuclear, that do not generate GHG emissions.

Policy Considerations

Reasons for a new tax: Typically, energy taxes have been considered as a way to generate revenue while also having a favorable impact on reducing pollution, reducing reliance on foreign oil or encouraging energy efficiency. Carbon taxes specifically are proposed to not only raise revenue, but to also reduce GHG emissions and promote energy efficiency. If the goal is solely to raise revenue, a new tax is not needed as revenue can be generated from changes to existing taxes. To warrant a new tax, policymakers should be sure that the tax is designed to meet the non-revenue goals and that a tax is a more efficient way to reach those goals compared to alternatives.

Effects: The effect of a carbon tax on prices depends on many factors including the energy “content” of the goods or services, level of foreign competition and the ability of the affected parties to change their practices to reduce the amount of tax owed.

The 1990 CBO study on carbon charges concluded that while they can be effective in reducing GHG emissions generated from the burning of fossil fuels, “rapidly imposing large charges could be hazardous for the economy.” The CBO also noted that the costs of a tax “could be held to a loss of one percent to two percent of GNP annually during the first decade by phasing in the charges and taking offsetting actions to mitigate the contractionary effects of the charges (see report (PDF) p. xvi).”

The effects of a carbon tax will vary among industries and consumers. For industries or producers most reliant on coal to generate electricity, the impact is likely to be harsher given the carbon content and energy potential of this fuel relative to the burning of other fossil fuels. The effect on the economy will also vary depending on how the revenues generated from the tax will be used. If used to remove distortions in other taxes or provide tax reductions, the adverse economic effects of the tax might be diminished.

More recent CBO information notes that any effort to reduce GHG emissions would “produce long-term economic benefits by avoiding some future climate-related damage, and it would impose immediate economic costs by reducing the use of fossil fuels. Most analyses suggest that a carefully designed program to begin lowering CO2 emissions would produce greater benefits than costs.” (CBO testimony (PDF))

Non-tax alternatives: GHG emission reductions can also occur through regulation, investment in better technologies and to some extent, through education. Economic incentives are viewed as more cost effective than command-and-control laws and can also help to encourage better use of technology.

A commonly suggested market-based approach (besides a carbon tax) is a cap-and-trade system. Under such a system, emission targets are set and businesses are given tradable certificates that allow them to emit a specified level of GHG, with the amount decreasing regularly. Revenues could be generated through auction of the certificates.

Compared to a carbon tax, a cap-and-trade system would better enable the government to hit a specified emissions target. A tax would better enable prices to reflect the cost of the emissions. Economist Dr. Greg Mankiw observes that a cap-and-trade system is basically a tax on carbon emission with the revenue benefiting the GHG-emitting businesses. There is much debate today over which economic incentive is most efficient. The answer likely lies in system design and what other countries do to reduce their GHG emissions.

Tax alternatives: Consideration of tax approaches to reducing GHG emissions should also consider changes to existing tax rules. For example, provisions in the current income tax, such as tax-free employer-provided parking and incentives for the oil industry, could be removed. An increase in the existing gasoline tax could also be considered, although this fuel is not the only GHG generator.

Principles of good tax policy: Should policymakers decide that a carbon tax is an effective approach to reduce GHG emissions, principles of good tax policy (PDF) should be considered in designing the tax. These considerations include addressing the regressive nature of the tax, the varying effects on different regions of the country and industries, and reducing opportunities for evasion. Imposing the tax on producers rather than consumers can keep costs of collection (and evasion) low, but must be weighed against visibility of the tax. Minimizing economic distortions should also be considered to improve economic efficiency of the tax. Such consideration would include border adjustments and how to use the revenue generated.

Summary

Several lawmakers have proposed carbon taxes and other alternatives for reducing GHG emissions. Interesting and complex discussion and debates will continue with the next Congress and President.

Warming Up to a Carbon Tax

Ron Tang — Thu, 29 Nov 2007 00:00:00 -0500

Reports made by the United Nations and other groups over the past year have concluded that global warming is a certainty (United Nations Intergovernmental Panel on Climate Change, Pew Center on Global Climate Change and others). Greenhouse gases (GHG) trap heat in the atmosphere that slowly warms the earth. The primary greenhouse gas is carbon dioxide (CO2) generated from the burning of fossil fuels, such as oil, coal and natural gas.

The U.S. is the largest emitter of greenhouse gases (November 2007 report (PDF) from the Climate Change Science Program). Increased world attention to climate change will likely put pressure on the U.S. to reduce its GHG emissions. In addition, many state and local governments have taken actions to address global warming. They will also push for national remedies.

In January 2007, the Senate Committee on Energy and Natural Resources held a hearing on a proposed cap and trade system (a cap and trade system involves a government set limit on GHG emissions for particular industries. Companies are then issued certificates indicating how much they are allowed to emit, with allowances decreasing each year. If a company needs to emit more than allowed, it will need to either find a way to reduce its emissions or purchase certificates from others. This system employs market forces to encourage companies to determine their best reduction strategy.). In November 2007, the Senate Committee on Environment and Public Works held hearings on a climate security proposal (S. 2191).

In addition to discussions at both the federal and state levels on a cap and trade system to reduce GHG emissions, taxes have also been proposed by Congressmen Pete Stark (D-Calif.), John Dingell (D-Mich.) and others.

U.S. Budget and Tax Challenges

A $158 billion budget deficit is projected for 2007 (Congressional Budget Office, Budget and Economic Outlook (PDF), August 2007). If the 2001 and 2003 tax breaks are not renewed when they expire after 2010, a surplus is projected for future years. However, desire to extend all or most breaks and repeal the individual AMT will require new revenues and/or spending cuts. A possible source of revenue is a carbon tax imposed on certain activities that produce GHG emissions.

In addition, continued discussions on federal tax reform could include replacing a portion of the current income tax or payroll tax with an environmental tax, such as a carbon tax.

Carbon Tax Logic

The base of a carbon tax would be the carbon content of coal, oil and natural gas.

Benefits of a carbon tax include:

The increased cost of fossil fuels will lead many taxpayers to reduce usage and consider alternative energy sources.
The tax would cause the price of fossil fuels to include costs to society of pollution, GHG emissions and depletion of a natural resource that is associated with the burning of fossil fuels. If such a tax is designed to be visible to the end user, it would increase awareness of what activities cause global warming.
The rate could be increased regularly to encourage taxpayers to continue to reduce their use of fossil fuels.
Transitional rules could be included to provide time for people to find ways to reduce their use of fossil fuels. For example, utility companies will not be able to alter their energy sources overnight.
The revenue could be used to fund development of renewable energy, environmental clean-up, tax reductions and/or to improve the operation of other taxes.

Disadvantages of a carbon tax include:

For simplicity and effective administration, a carbon tax would likely be imposed on producers or retailers, rather than the final consumer. Thus, the tax may not be visible to the end-user and the intended behavioral change may not occur to the desired extent.
While a carbon tax can help cover costs of burning fossil fuels, it is unlikely to be effective in helping the government reach a specific GHG emission reduction target.
It may be difficult to determine how best to use the funds generated.

Design Issues and Proposals

Many design questions exist in the creation of a carbon tax. Who should the tax be imposed upon and at what level (extractor, refiner, distributor, retailer and/or consumer)? Should any taxpayers be exempt? What relief can and should be provided to address the regressivity of the tax? Should the tax be part of a larger federal tax reform effort?

While these questions have not been vetted in tax-writing committees, a few proposals have been introduced in the 110th Congress. In addition carbon tax examples exist because some countries, such as Sweden, have had them for several years and the City of Boulder, Colorado enacted one in 2006.

Congressman Dingell has proposed a $50 tax per ton of carbon content of coal, petroleum and natural gas to be phased in over five years. He would also increase the tax on gasoline and jet fuel by 50 cents per gallon. Congressman Stark proposes a tax of $10 per ton of carbon content of fossil fuels, increasing $10 each year until a specified level of GHG emissions is achieved (H.R. 2069).

Congressman John Larson (D-Conn.) proposes a $15 per ton of carbon content of fossil fuels (H.R. 3416). The funds collected would be used for research and a payroll tax refund. Use of a tax to reduce another tax is referred to as a “tax shift.” Congressman Larson describes his proposal as “an important move toward shifting taxes away from positive things, like labor, and onto negative things, like pollution” (August 2007 press release).

The carbon tax used in Boulder is added to utility bills. Most of the city’s electricity is generated from coal. The tax is estimated to be about $1.33 per household per month and almost four dollars per month for businesses (City of Boulder, 11/8/06).

Conclusion

A carbon tax would increase the cost of doing business for everyone given the pervasive use of fossil fuels in the U.S. While taxpayers seem to prefer a tax shift in order to recoup a portion of their carbon tax through another tax, given revenue needs, a carbon tax is likely to be used to prevent or reduce an income tax increase. A tax or other type of market-based remedy (such as cap and trade) is inevitable given the need to reduce GHG emissions. Businesses should consider working with their respective industry associations to encourage implementation of incentives along with any proposed carbon tax to assist in efforts to reduce reliance on fossil fuels. Such incentives might include rapid depreciation of renewable energy devices and tax credits.

The Future of the Corporate Income Tax

Cecille Isidro — Thu, 25 Oct 2007 15:33:00 -0400

Two great concerns leading to calls for tax reform are (1) that changes in the world economy are reducing the likelihood that the U.S. will be assured of a dominant role and (2) inordinate complexity that leads to disrespect for the tax system, economic inefficiencies and increased costs of tax compliance. Yet, despite numerous calls for tax reform, the major changes we have seen to the system recently have actually increased its complexity. Examples include the addition of Schedule M-3 for large corporations and the IRC §199 manufacturing deduction. Why? This article summarizes the primary reasons for tax reform discussion, some of the proposals and the obstacles.

President's Panel on Income Tax Reform

In 2005, President Bush's Advisory Panel on Federal Tax Reform noted the "unacceptable state of our current tax system" and that "America needs a better tax system." Big picture problems noted by the Panel included: Complexity and its costs, lack of integration of business and personal taxes, incentives that distort economic investment and are subsidized by higher taxes paid by those not entitled to the incentives, failure to recognize that the primary purpose of taxes is to raise revenue for the government and frequency of change resulting in increased volatility and economic distortion.

The Panel particularly criticized the numerous tax preferences in the law and their adverse effect on the economy. The panel further noted that tax preferences can lead taxpayers to make "inefficient choices" that "divert resources from their most productive use and reduce the productive capacity of our economy." Per the Panel, taxpayers help the economy best when they consider economics in making decisions rather than being swayed by tax preferences. Distorted decision-making can "waste economic resources, reduce productivity and, ultimately lower living standards for all" (see Final Report (PDF), page 36). These are strong statements that support the Panel's proposals to broaden the income tax base, eliminate tax credits and lower tax rates.

Panel examples of how the tax law distorts decision-making and hurts the economy include the following (see Panel's Final Report (PDF)):

Example 1: For federal income tax purposes, employer-provided health insurance is generally tax-free for employees yet deductible by the employer. This system is not only costly to the federal government, but results in increased cost of health care because the tax law has eliminated incentives for employees to control the costs of their health care. Higher health care costs result in increased insurance costs for individuals without employer-provided insurance and thus, many people not buying insurance.

Example 2: High technology companies often replace equipment within three years, yet a five-year recovery period is required for tax purposes. This life is based on that of government typewriters from the late 1970s. The tax law does not provide a mechanism for ensuring that the depreciable life assigned is appropriate given changes in technology.

Example 3: Double-taxation of corporate earnings results in a tax preference for debt over equity.

The Panel recommended two different plans to replace the current income tax: the "simplified income tax plan" and the "growth and investment tax plan." The simplified plan is based on our current income tax while the growth plan is closer to a consumption tax that would lessen the tax on savings. Both plans call for significant changes affecting both individuals and businesses. The details of each plan are too numerous to cover in this article (a summary and additional information on tax reform, including a link to a 2005 AICPA report, can be found at the author's tax reform Web site).

Significant provisions of the proposals include elimination of the AMT, expensing of some assets, movement to an integrated corporate and individual tax system, elimination of worldwide taxation and repeal of tax credits and several other tax preferences.

The Panel issued its report to the Treasury Department in November 2005. Specific proposals have not yet been issued by Treasury and little discussion has been generated by the Panel's report. The report's low profile is likely due to the significance of the proposed changes, particularly the elimination or reduction of popular tax preferences, such as the home mortgage deduction. A significant educational effort is needed to convince the public of the Panel's findings that a broader base and lower rates will improve economic efficiency and fairness and have a positive effect on taxpayers.

While not directly related to the Panel's report, in July 2007 the U.S. Treasury Department issued a background paper and held a conference entitled, Business Taxation and Global Competitiveness, discussed next.

Treasury Report

The Treasury report notes that our current tax system distorts many business and investment decisions to the overall detriment of the economy. Some tax provisions, such as those benefiting home ownership, tend to lead to over-investment in such assets and thus, under-investment in others. The report also questions whether current tax rules written many years ago that treat income from foreign and domestic investment similarly still make sense today when the U.S. no longer dominates the world marketplace.

Treasury estimates that if tax preferences, such as credits and the §199 deduction were eliminated, the top corporate tax rate could be lowered from 35 percent to 27 percent while at the same time raising the same amount of revenue and improving the economy.

Other tax law distortions noted in the report include double taxation of corporate income, failure to adjust depreciation deductions for inflation, favorable treatment of intangible assets relative to tangible assets and taxing human capital more favorably than physical capital.

Treasury also compared the U.S. tax system to that of our trading partners. The report notes that the combined federal and state income tax rate in the U.S. (39%) is the second highest among industrialized countries and other countries tend to be lowering their corporate rates.

The Treasury report does not make suggestions for reform. Treasury Secretary Paulson stated that Treasury's next steps would be to "develop specific follow-up steps in the coming months to build support for the need to improve our business tax system and ideas for doing just that."

Other Proposals

A variety of proposals have also been offered by legislators, think tanks and presidential candidates. These range from changes that would allow for repeal of the great revenue-generator -- the AMT, to flat rate systems that also reduce tax preferences. Proposals also include addition of a carbon tax, lower corporate tax rates, elimination of tax havens and replacement of most federal taxes with a national sales tax and even elimination of the IRS as it currently operates.

While there is little argument among policymakers that the federal income tax system is broken, reform seems elusive. Tax preferences add complexity, but each one has its band of supporters. The President's Panel, Treasury and many others have made strong cases for reform. However, until there is strong political will for major reform and broader public understanding of the problems and remedies, Form 1120 will continue to be a familiar document.

Nexus Confusion: Sales and Use Tax

Cecille Isidro — Fri, 05 Oct 2007 12:46:00 -0400

The best way for a business to simplify its nexus determination for sales tax purposes is to set up a sales office in the state in question. Then, it clearly has nexus and must collect sales tax there. But, this approach isn’t the business reality or plan for Internet-era businesses. Businesses without an obvious physical presence in a state, but with customers there, may be challenged to know if they should collect sales and use tax. This article looks at the reasons for uncertainty and what improvements might be made.

Sales and Use Tax Nexus

For a state to subject a vendor to sales and use tax (SUT) collection obligations, the vendor must have nexus with that state. Nexus is a connection between the vendor and state such that subjecting the vendor to the state’s laws is neither unfair to the vendor nor likely to harm interstate commerce -- requirements stemming from the due process and commerce clauses of the U.S. Constitution.

In the 1992 Quill Corp. v. North Dakota decision (504 U.S. 298), the Court ruled that due process and commerce clause nexus requirements were not the same because they were “animated by different constitutional concerns and policies.” Due process nexus requires “minimum contacts” with the jurisdiction. The Court found no due process concern where a vendor not physically present in a state purposefully availed itself of the benefits of an economic market in the state, such as Quill did, by sending catalogs into the state.

The Court held that the commerce clause required “substantial nexus” as indicated by physical presence. The Court noted the existence of over 6,000 state and local jurisdictions in the U.S. that imposed SUT without consistent rules. Requiring non-present vendors to collect SUT could harm interstate commerce.

Physical Presence Confusion

Since Quill, the challenge has been to determine how much and which type of physical presence is needed to have substantial nexus. The Court noted that the few floppy diskettes Quill sent to North Dakota customers did not satisfy substantial nexus.

The defining line between slightest and substantial presence varies from state to state. It is not unusual to see dissenting opinions and higher courts disagree with lower courts. A business with similar operations in two states might find that it is required to collect SUT in one but not the other.

An example of differing nexus interpretations involved online operations of booksellers that operated physical stores and expanded to online sales. Separate legal entities were formed for the online operations to reduce the number of physical locations of the entities, thereby reducing SUT obligations. The online entities (online) shared a name with the physical entities (physical) which also handled some returns for online customers.

Despite similar fact patterns, a 2007 Louisiana ruling (St. Tammany Parish Tax Collector v. BarnesandNoble.com (05-5695 ED La) concluded that online did not have nexus, while a 2005 California decision reached the opposite conclusion in Borders online, LLC v. BOE, 29 Cal Rptr 3d 176.

The Louisiana tax agency raised the nexus issue because online and physical had common membership and gift card programs, cross-promotional advertising and physical gave preferential product return treatment to online’s customers. The court found that activities physical performed for online did not rise to a level to indicate that physical marketed online’s products on behalf of online. Physical did not take orders for online and did not provide facilities for customers to place orders with online. The membership and gift card programs did not generate revenues for online. The court also found that the benefits online derived from physical’s advertising and returns did not impute physical’s presence to online. The court also noted prior cases holding that the physical presence of one corporate entity cannot be imputed to a related corporate entity (SFA Folio, (1991)).

In contrast, the California court found that physical’s activities for online made it a representative and promotional and return activities constituted “selling” thus creating SUT obligations for online (per California Revenue & Taxation §6203(c)).

Why Confusion Is a Problem

If a company believes it does not have nexus in a state and the state later finds that it does, the company will owe tax, interest and penalties. If a company errs on the side of caution and collects SUT, it may be incurring unnecessary compliance costs. Customers unaware they owe a use tax if they are not charged sales tax will find the company has higher prices than its competitors who are not collecting SUT.

Companies must spend significant time reviewing their operations and relationships and the law of every state in which they have customers to determine if they have SUT nexus, yet not achieve certainty. Confusion also results due to special state rules where some physical presence is ignored, such as certain trade show activity. But again, rules differ from state to state, are not always clear and interpretations continue to evolve.

Possible Solutions

States should take steps to make SUT nexus requirements as clear as possible. They could provide a checklist for businesses to allow them to determine if they have SUT nexus under state law and the Quill standards. If the checklist indicates a physical presence, the tax agency should help the vendor with its collection responsibilities. Simplified compliance approaches should be provided. For example, if the vendor only sells items online, the state should allow the vendor to have a link on its site such that when the customer’s credit card is charged for the goods purchased, it is also charged to the state tax collector for the SUT. This eliminates filing for vendors and reduces their compliance costs and credit card fees.

If the checklist indicates the vendor has no physical presence, the state should provide a safety mechanism to help ensure customers pay use tax. The state could ask non-present vendors to note on their Web site or catalog that they have no SUT collection obligation in State X, so State X customers must self-report use tax on the purchase. If vendors comply with this request, they could be relieved of liability should a later audit indicate that a non-fraudulent mistake was made on the checklist.

Several states have adopted the uniform SUT law created by the. The hope is that Congress will reverse Quill for these states to allow them to collect SUT from non-present vendors. However, not all states have adopted this law and some may not. Alternatively, Congress could exercise its authority under the commerce clause to provide uniform SUT nexus guidance.

Conclusion

The SUT nexus issue will not go away anytime soon and will continue to pose complexities and costs, particularly for e-commerce companies. States need to do more to reduce the uncertainty which should also improve their SUT collections.