The network of state and local tax regulations is both widespread and ever-changing, meaning updates and opportunities are constantly arising for companies based in the United States. Below we’ve outlined some of the key changes happening now in state and local tax regulations and incentives.
Income and Franchise Tax Changes
Many states have moved to an economic nexus standard for income tax. In the recent case, Target Brands, Inc. v. Dept. of Revenue, No. 2015CV33831 (Colo. Dist. Ct., Jan. 27, 2017), the Quill physical presence requirement was rejected. The trend toward economic nexus began in South Carolina with other states following suit. Similarly, in the case, Capital One Auto Finance, Inc. v. Dept. of Revenue, T.C. 5197 (Ore. Tax Ct., Dec. 23, 2016), the court adopted a “significant economic presence test,” effectively fashioning their own nexus standard.
Factor Presence Nexus. The most recent development in the nexus world is the emergence of factor presence nexus. Under a factor presence nexus standard, a company is subject to state income tax if its in-state apportionment factors exceed the statutory threshold — otherwise known as a bright line test. So far, 10 states have adopted this standard. From a compliance standpoint, it’s important to regularly review apportionment factors as these rules are changing rapidly.
Trends in Income and Franchise Tax Apportionment
Market-Based Sourcing. Many states have adopted market-based sourcing for sales of services and intangibles. The move to market-based sourcing occurred for several reasons: (1) it creates an advantage for in-state businesses; (2) it is consistent with the sourcing rules for sales of tangible personal property; and (3) it is thought to be less complex. Depending on the state, pay close attention to the way market-based sourcing is defined, as the sourcing rules vary considerably among the states. Be sure to take a close look at special considerations including throw-out rules, look-thru rules, due diligence requirements and more. This is an especially complex area and the application of these rules may have a significant impact on state tax liabilities.
Single Sales Factor. Single sales factor (SSF) is used as an economic development tool to help in-state businesses. It’s also reflective of larger changes within the U.S. economy — as industries shift more from manufacturing-based to service-based. Recently, legislation in Utah and Massachusetts set requirements for certain industries to use SSF apportionment.
Alternative Apportionment. Alternative apportionment generally means that there is constitutional or statutory relief from the standard apportionment formula if the standard formula does not accurately reflect the in-state activity of a taxpayer. There are certain standards that must be met to obtain relief under alternative apportionment. Look to cases like Target Brands, Inc. v. Dept. of Revenue, No. 2015CV33831 (Colo. Dist. Ct., Jan. 27, 2017), Associated Bank, N.A. v. Comm’r of Revenue, No. 8851-R (Minn. Tax Ct., Apr. 18, 2017) or Rent-A-Center West Inc. v. Dept. of Revenue, No. 2012-208608 (S.C. Oct. 26, 2016) for examples of why a taxpayer or taxing authority may invoke alternative apportionment.
Growth of Unitary Combined Reporting
Mandatory unitary combined reporting has been used to attack passive investment company planning, effectively curtailing the benefits of separate company reporting. The use of combined reporting has increased significantly over the years. Today, 26 states mandate unitary combined reporting.
For unitary combined reporting, the “Joyce” and “Finnegan” rules refer to how the sales factor is calculated in combined reporting states. The rules established by two California court decisions, Joyce Finnegan, have been adopted by most combined reporting states. Accounting for these rules can sometimes result in errors, depending on which method the state adopts and the company’s fact pattern. One difference between Joyce and Finnegan is how a state’s sales-throwback rules are applied in the context of a unitary business group.
Waters-Edge Unitary Combined Reporting. The concept of tax havens often come up in discussions on unitary combined reporting. Most of the unitary combined reporting states require combined returns on a domestic entity basis only. There are exceptions in some waters-edge states called tax haven rules, and approaches to tax haven rules are different on a state-by-state basis. States with tax haven rules include: Alaska, Connecticut, DC, Montana, Oregon, Rhode Island and West Virginia.
Related Party Transactions, Intercompany Debt and Economic Substance Impact of the IRC § 385 Regulations. The 385 Regulations impose document regulations on intercompany debt issued by a covered member — or U.S. corporation — to another member of the covered members’ expanded group. If these requirements are not followed, debt is recast as stock and principal interest payments, and will be recast as dividends. In addition, how your state conforms to the IRC could cause the state’s treatment of the code to be different from the federal treatment.
Transfer Pricing and Related Party Expense Add-Back. In situations where there are intercompany transactions among related companies and the related companies are not included in the state’s combined or separate return, transfer issues come into play because the state wants to be sure that intercompany pricing is not being manipulated to create a more favorable taxing situation. This could be a source of audit challenges by the Department of Revenue.
Rather than deal with transfer pricing issues, many states require add-backs of certain intercompany transactions such as interest or royalty expense. Some states that have these types of provisions provide exceptions to the criteria.
State Income/Franchise Tax Base
Net Operating Losses. A limit is placed on the amount of the federal net operating loss carryforward used each year by a taxpayer over the remaining carryforward period of the net operating loss after the year of the ownership change. The annual limit is based on a calculation that uses the value of the company at the time of the change of ownership.
Federal Partnership Audit Rules. These rules represent potential state issues from the new budget rules relating to state conformity with assessing partnerships and potential conflicts with nonresident partner withholding obligations or partner composite returns. The Bipartisan Budget Act of 2015 introduced significant changes to federal partnership audit rules. Under the new audit rules, underpayments of tax are now assessed and collected from the partnership, and are subject to opt-out elections for partnerships with fewer than 100 partners. This is effective for taxable years beginning on or after January 1, 2018.
Credit & Incentive Changes
There have been two important developments impacting compliance for credits and incentives: GASB Statement #77 and FASB Topic 832. GASB Topic #77 may result in changes to reporting requirements related to local grants and incentives. On a similar front, FASB Topic 382 requires financial statement disclosure for incentives. This has been introduced to increase transparency, however privacy concerns have been raised related to this requirement.
When evaluating rules, credits and incentives, consider taking inventory of existing programs to see where gaps and opportunities may exist. It may also help to build a cross-functional team of stakeholders from HR staff to tax professionals, to ensure compliance on all fronts. Creating a process to identify and track your company’s compliance with incentive programs could be useful to stay organized, especially if there are multiple incentives in the works. Various software may be helpful while working on compliance reporting.
For all the talk of impending federal tax reform, myriad state and local changes are already underway, and businesses need to keep tabs on how these changes may affect their bottom line. For a more in-depth discussion on the latest shifting regulations and incentives that may impact your business, please contact MFA’s SALT team.