Corporate Taxes

Workers And Managers Of The World, Unite!

Erin Drankoski — Mon, 07 Sep 2009 12:02:00 -0400

Why Insurance As We Know It Is Doomed

Erin Drankoski — Mon, 31 Aug 2009 06:28:00 -0400

Huntington's disease is unusually cruel. Symptoms tend to emerge in early middle age. One's cognitive functions waste away until dementia sets in, and victims are extremely vulnerable to heart disease, physical injury and suicidal depression. Indeed, according to one study, as many as 27% of sufferers attempt suicide. The condition is also highly predictable. If you have one parent with Huntington's disease, you have a 50% chance of inheriting it.

Closing Tax Gap

Cecille Isidro — Thu, 14 Aug 2008 16:26:00 -0400

Since the early 1980s, there has been a plethora of recommendations about how to reduce the tax gap. Many changes have been enacted, yet the gap grows. Proposals requiring additional information reporting or withholding are usually overlooked despite evidence that these techniques result in a low tax gap for wage earners. However, a significant information reporting rule was enacted in 2008. Its enactment though, seems to be more a result of its revenue potential than its role in a comprehensive tax gap reduction strategy.

Below, we'll review the tax gap and the recently enacted credit card information reporting provision, and explain reasons for the slow approach.

Tax Gap History

According to a 1994 GAO study, Tax Gap — Many Actions Taken, But a Cohesive Compliance Strategy Needed (GGD-94-123 (PDF)), the gross income tax gap for 1981 was $76 billion and $127 billion for 1992. By 2001, the tax gap had grown to $345 billion (IR-2006-28).

The 1994 GAO report noted: "Information returns are a proven way to promote compliance and help IRS find noncompliance." The GAO observed that Congress could do more to help improve compliance such as requiring: withholding on payments to independent contractors, 1099s for payments made to corporations, and basis reporting on 1099s for stock sales.

Many proposals have been made to reduce the tax gap. The 1994 GAO study lists 61 reports it issued from 1982 through 1993 on various aspects of the tax gap and compliance (Appendix II (PDF)). Proposals have also been made by the IRS, Treasury (PDF), the National Taxpayer Advocate, legislators, the AICPA and others.

The growing tax gap and need for revenue have led to greater focus on effective ways to reduce it. These activities include:

A conference by the AICPA, ABA, TEI, American Tax Policy Institute and American College of Tax Counsel held in June 2007 to discuss ideas to reduce the tax gap.

A tax compliance forum (PDF) held by the CBO, GAO and Joint Committee on Taxation in September 2007.

Sixteen tax compliance proposals are included in the President's 2009 revenue proposals (PDF). These measures include:

Proposal	10-Year Revenue Projection (millions)
1099s on payments to corporations	18.9
Basis reporting for security sales	16.9
Merchant payment card information reporting	13.8
Increase information return penalties	18.3

We have seen tax gap proposals included as revenue offsets to various tax bills. For example, Congressman Rangel's tax reform bill, HR 3970 (110th Congress) included basis reporting on 1099s for stock sales. This proposal was also included in a housing bill HR 5720 as well as a stand-alone bill, HR 878.

New Information Reporting Requirement

When a merchant allows a customer to pay with a credit or debit card, an entity, such as a bank, must process the transaction to enable the merchant to receive the funds. According to Treasury, the failure of some merchants to "accurately report their gross income, including income derived from payment card transactions, represents a significant part of the tax gap." (General Explanations of the Administration's Fiscal Year 2007 Revenue Proposals (PDF))

President Bush's budget proposals starting with FY2007 have included calling for regulations on information reporting of reimbursements made to merchants on credit cards, plus backup withholding. This information reporting idea finally made it into law via a statutory change. The Housing and Economic Recovery Act of 2008 (PL 110-289; July 2008) created IRC §6050W, Returns Relating to Payments Made in Settlement of Payment Card and Third Party Network Transactions. This rule requires payment settlement entities to file information returns with the IRS and the merchant. These returns are to include the merchant's name, address, taxpayer identification number (TIN), and the gross amount of the transactions the entity processed for the merchant. The provision covers credit and debit cards and third party payment networks, such as online payment systems.

As described in the Administration's FY2007 report (PDF), requiring the payment card issuers to file information returns should pose only a minimal burden because these issuers already provide the information to merchants. Backup withholding is viewed as leading to "material improvements in the compliance rates" of the merchants "without imposing a significant burden on the card issuers."

A de minimis exception provides that third party settlement organizations are only required to file returns regarding third party network transactions if the aggregate value of a merchant's transactions exceed $20,000 and the aggregate number of transactions exceeds 200.

Penalties are imposed for failure to file (IRC §6724). Backup withholding is required if a merchant does not provide a TIN (IRC §3406); effective for amounts paid after December 31, 2011. IRC §6050W is effective for calendar years beginning after December 31, 2010. For further details, see §6050W and the Joint Committee explanation (JCX-63-08 (PDF)).

Observations

Revenue reality: The Administration's FY2007 report (PDF) estimated that regulations calling for information reporting on payment cards would generate $225 million over 10 years. In the FY 2008 report (PDF), the estimate was up to $10.7 billion and for FY 2009 (PDF), $18.7 billion. The Joint Committee on Taxation (JCX-64-08 (PDF)) estimate for §6050W is $9.5 billion. This range of estimates likely reflects the challenges of measuring the tax gap, as well as the effect of a measure on compliance and enforcement.

Additional benefits: In testimony on the Administration's tax gap proposals, Treasury Assistant Secretary Eric Solomon made the following observations on additional benefits of credit card reporting (April 2007 testimony):

"[T]he proposed information reporting would assist the IRS by providing the merchant's overall volume of payment card sales in relation to expenses claimed and cash transactions reported. The reporting would also assist the IRS in analyzing the accuracy of reporting for payment card sales."

Complexities: In his 2007 testimony, Mr. Solomon also noted complexities in the credit card system due to the number of parties that can be involved in the reimbursement cycle. Refunds and cash back arrangements also pose problems. These issues should be addressed in regulations.

Small business concerns: In June 2008, the House Committee on Small Business held a hearing on electronic payment information reporting. Issues raised by those testifying included privacy, security, cost, the need for some entities to obtain new computer programming to comply, transaction complexity that will lead to inaccurate reporting or information that is not useful to verify gross receipts and not addressing unreported cash receipts instead.

Picking Up the Pace

Despite what appears to be increased concern over the tax gap, a comprehensive strategy for addressing it remains elusive. PAYGO (PDF) rules are the likely driver of piecemeal remedies. The information reporting provision that made it into the Housing Act had only weeks before being included as a revenue offset in an AMT relief bill (HR 6275).

A comprehensive approach to addressing the tax gap should yield a better result than the piecemeal, revenue targeting approach. Congress and Treasury could identify which measures would best address the most serious non-compliance problems. This approach likely would have led to enactment of measures to address non-reporting of cash transactions rather than credit card ones that already have audit trails. A comprehensive, strategic approach would likely have addressed causes of underreporting of payment card transactions. Many small businesses, particularly those that sometimes arise from online transactions, need guidance on recordkeeping and business reporting.

The piecemeal approach will likely remain for the 110th Congress as it works on AMT relief and extenders. The strategic approach will likely have to await tax reform activities in the 111th Congress.

California's Tax Loopholes That Aren't

Cecille Isidro — Fri, 11 Jul 2008 07:25:00 -0400

The package of six tax increases that passed in the Budget Conference Committee this week includes two described as loophole closers. Who can argue against closing a loophole? Unfortunately, the two provisions proposed to be changed aren't loopholes.

A loophole is the ability to use a rule in an unintended way. It may be due to poor wording or an incomplete definition in the law. For example, assume a state has a lower property tax rate for agricultural land to help farmers. However, the definition of agricultural land is so broad that the owner of a residence on 10 acres just needs to plant 20 fruit trees to qualify for the tax break. That's a loophole because a flaw in the law enables the rule to be used in unintended ways.

The two “loopholes” proposed to be corrected in the Budget Committee proposal are the net operating loss carryover for corporations and the $294 dependent credit for individuals. Neither are loopholes because each is being correctly used as intended.

A business has a net operating loss (usually called “NOL”) in any tax year in which its deductible expenses are greater than its revenue. A business may have a NOL due to a bad year, a business cycle that is longer than a tax year, or it could be a sign that the business is failing. It is not unusual for an income tax law to provide some relief by allowing the business owner to use the NOL against positive taxable income in prior or future years.

Does an income tax law have to allow for a NOL to be used to reduce income in a good year? No. Typically the rule is provided for equitable reasons because tax laws require annual tax returns. If tax returns were instead filed every two years, some businesses would not have a NOL.

The NOL carryover rules in California are being used as intended. Thus, changing the rule to suspend the use of NOLs for three years is not closing a loophole.

The other “loophole” closer is to reduce the $294 dependent credit for individuals with adjusted gross income above $150,000. The dependent credit is greater than the personal credit of $94. It was raised a few years back to provide a greater benefit to families. The Budget Committee hasn't stated that high-income individuals have found a way to claim the credit without actually having a dependent. Thus, it is not closing a loophole, it is just cutting back on this tax break.

So, why might the loophole language have been used?

Arguably, if you're going to get rid of a tax break, calling it a loophole should make it easier. But this approach distracts from the real changes that are needed to our tax system. There are many special deductions, credits and exclusions in our income tax law. Some of these serve an important purpose such as measuring ability to pay or encouraging charitable contributions. But some have outlived their usefulness, are overly generous or are poorly targeted such that they benefit taxpayers who don't need assistance.

Periodic review of these tax provisions would be useful in improving our tax system and state budget. Such a review would uncover tax breaks that could appropriately be cut back. It might even uncover some true loopholes.

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.

Throw Out the Tax Code

Ron Tang — Sun, 20 Apr 2008 07:25:00 -0400

Politicians don't like to talk about taxes except to brag about cutting them. But with California's widening budget deficit threatening deep cuts in education and other public services, it's difficult to avoid discussions about raising taxes.

Unfortunately, what's likely to be lost in the upcoming partisan melee over whether new taxes are needed to close the $16-billion gap is an equally important tax issue -- California's aging and often unfair tax system needs to be overhauled.

The goal of tax reform should be twofold. One is to generate a more reliable revenue stream. The other is to make the tax code more reflective of California's changing economy, which in turn could stimulate more growth.

Gov. Arnold Schwarzenegger has tentatively embraced the idea of tax reform. "If it is property tax, if it is personal income tax, if it is sales tax... if it is services, Internet," he said last week at a town hall meeting, "one has to look at all of those things together and say, let's bring it up to date, the system."

The major elements of the state's tax system were set in place during the Depression. The modern corporation and bank tax was enacted in 1929, the sales tax in 1933, the income tax (with a top rate of 15%) in 1935 and the statewide uniform vehicle license fee (the "car tax") in 1937. The big industries of that California -- agriculture, motion pictures, tourism -- relied on sunshine and produced mostly tangible goods, a lot of them sent to market in cans: peaches, sardines and movies.

The industries that drive today's state economy -- software, information services such as Google, high-tech, diversified manufacturing, movies, video games, professional and business services -- run on entrepreneurship, knowledge, creativity and technology. They produce more services and intangibles than hard goods. Operating in a global market, they face new competition from anywhere. And they can locate wherever there are fast broadband communications, good transportation, skilled workers and a high quality of life to attract and hold employees.

The state's tax system simply hasn't kept up with this transformation of its economy.

Although the overall state and local tax burden on California businesses is almost the national average -- and lower than in Florida and Texas, according to the Council on State Taxation, a nonprofit trade association -- the system, in general, treats new investment and new firms unfavorably. That doesn't promote economic growth.

How broken is the system? California is one of only four states that imposes sales taxes on manufacturing equipment. Because of Proposition 13, the property taxes of start-up companies that construct or buy their business facilities are assessed at current market value. That puts them at a disadvantage vis-à-vis longer-established competitors, whose property taxes are based on lower assessments from decades ago, regardless of the current value of the property in producing income for the firms. In a fiercely competitive global economy, none of this is very smart or strategic.

The sales tax paid by consumers is also out of step with changing economic reality. Today, consumers spend an increasing share of their income on such services as healthcare, gyms and gardeners as opposed to such tangible goods as clothes and furniture. But California, unlike most other states, still levies the sales tax on a relatively narrow range of tangible goods while exempting food, utilities and medicine. As a result, the dollars Californians spend yield about 30% less sales tax than they did in 1979. Even though California has among the highest sales tax rates in the country -- the combined state and local rate ranges from 7.25% to 8.75% -- the fact that it isn't levied on such things as amusements, repair services, car washing and limos causes revenues to lag behind the state's growth and the need for public services.

As a revenue raiser, California's income tax is a Swiss cheese. It incorporates most of the exclusions, exemptions and deductions in the federal tax code, including such biggies as the mortgage-interest deduction and the exclusion of employer-paid health insurance premiums. Then it adds more than two dozen holes of its own. Among them are a total exemption for Social Security benefits, which costs the state $1.8 billion a year; a credit for using rice straw in any other way than burning it; a credit for transporting donated farm products; and an exemption for state lottery winnings.

A smart tax system does its work of raising needed revenues while attempting to minimize economic harm and advancing certain social goals. California's system doesn't meet that standard. It taxes desirable activities -- work, through the income tax, saving and investment -- but not some undesirable ones, like pollution and the emission of carbon dioxide and other gases that contribute to global warming. And in defiance of all good economic sense, California has held down fuel taxes, which are a user fee, thereby shifting much of the burden of transportation funding toward the sales tax and bonds paid for with general taxes, and breaking the feedback loop between driving and paying for roads.

Such a system creates economic distortions and unfairness. You pay sales tax, meant to be a broad levy on personal consumption, when you buy a music CD but not on the same songs if you buy and download them online. If you wash your own clothes, you pay sales tax on your washer and laundry soap. If you can afford to send your laundry out, you pay no tax.

There's no good rationale for favoring iTunes customers over people who buy CDs at Wal-Mart, or the laundry customer over the home laundry. Playing favorites on different forms of consumption makes the economy less efficient. California's economy would be stronger if the sales and income taxes had a broader base but lower rates.

Some hard-line conservatives argue, as the headline of a recent Op-Ed article put it, that "no tax loopholes merit closing." That leaves the rest of us to wonder how Democrats, who have controlled the Legislature for most of the last 50 years, managed to get everything right about taxes except their overall level. Conservatives fear tax reform is only a cover for tax-raising. But even if the state doesn't choose to raise a dime more in revenue, there's potentially an enormous benefit in making the tax system better match California's fast-changing economy.

A smart and strategic tax-reform package would contain a mix of changes -- tax cuts and tax increases -- aimed at removing penalties on new investment and unfair treatment of different activities.

It might remove the sales tax on manufacturing and research equipment, exempt most businesses from paying property tax on tangible personal property -- computers, tables and stoves -- and reassess nonresidential commercial property at market rates. It might cut the overall sales tax rate while broadening its application to such consumer services as cable television, movie and sports admissions, golf courses, amusement parks and personal rentals (parking and mini-storage). And don't forget the purchase of digital equivalents of tangible goods -- e-books and music and movie downloads. A new tax code might begin imposing a carbon tax, helping California meet its global warming goals, and use the proceeds to lower the sales and income tax rate, helping the overall economy.

Unthinkable? No more unthinkable than a Democratic Congress and a Republican President Reagan agreeing on the landmark 1986 tax reform, which lowered tax rates while broadening the base. Reforming California's tax system will take more time than a budget cycle. But until the effort is undertaken, the state will continue to suffer from an unreliable revenue stream, and an economy whose rate of growth is hamstrung by an outdated tax system.

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.

Don't Link School Spending To Oil Companies' Profits

Ron Tang — Fri, 21 Mar 2008 08:33:00 -0400

Last week, a bill was proposed by a majority of Assemly Democrats to impose extra taxes on oil companies to help prevent pink slips for teachers. A March 12 vote, mostly along party lines, failed to garner the required two-thirds majority for passage of a tax increase.

But Assembly Speaker Fabian Núñez has said he does not plan to give up on the idea.

Despite the importance of not laying off teachers, failure to pass was a good result. The bill, ABX3 9, is not the solution for keeping teachers employed or solving California's budget problems.

Budget problems cannot be solved with taxes that are earmarked and unfair. More importantly, budget problems cannot be solved by ignoring budget and tax system weaknesses and how best to remedy them.

The bill proposed to create an oil severance tax of 6 percent on the value of each barrel of oil removed from the ground or water in California. It would also impose an extra tax on oil companies. This 2 percent tax would apply to taxable income in excess of $10 million. Finally, the bill directed that all revenue generated be appropriated to the superintendent of public instruction to alleviate the budget cuts leading to layoffs of school employees.

Three key problems plagued ABX3 9. First, it was designed more as an effort to highlight K-12 education cuts in light of oil company profits, rather than to address the underlying causes of California's budget problems. The bill attempted to draw a connection between oil company profits and education spending cuts, when no connection exists.

Second, the bill would not really help teachers or K-12 education funding. Education is a key function of state governments. Its funding should come from general tax revenues, not narrow, special taxes. What happens when oil company profits drop? Education should not take a hit. Funding for education should not be at the mercy of continued high profits of oil companies. Because there is no connection between oil profits and funds needed for education, it is not wise to earmark oil taxes for education.

Finally, the proposed taxes would create new problems. Equity calls for treating similarly situated taxpayers similarly. Singling out companies in one industry to pay an extra tax that other profitable companies do not have to pay is not equitable. Also, singling out an industry to pay a special tax makes the tax law more complex because special rules are needed to define that industry and the base the special tax applies to.

In changing tax rules, consideration should be given to where weaknesses exist and how best to address them. Should legislators find that corporate income tax rates are too low, they should address that. Should legislators find that a new source of revenue is needed, debate should focus on finding a new tax that would be equitable, simple, efficient and support other state policy goals. For example, given efforts to reduce carbon emissions, perhaps an oil severance tax that would increase the price of gas is appropriate. However, evaluation of several approaches should be considered rather than focusing on just one possibility.

No doubt, cuts to education funding in California call for intervention. Such intervention though should not single out one industry as the solution and should not earmark tax revenue. Such approaches will not lead to better tax and budget systems.

We need to find solutions that genuinely solve budget problems while not harming the tax system or education funding.