Other Business Activity Taxes: Cases and Trends

5/13/2015
COST Intermediate/Advanced State Income Tax School
Other Business Activity Taxes: Cases and Trends
May 20, 2015
William G. Nolan, Ernst & Young
John R. Trippier, Zaino Hall & Farrin LLC
Other Business Activity Taxes
• Commercial Activity Tax (CAT)
• Texas Franchise Tax (TFT)
• Washington Business and Occupations Tax (B&O)
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5/13/2015
CAT Topics
• Legislative Update
• Case Law Update
• Audit Activity & Issues
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CAT Legislative Update
• Very little activity during the last year • Budget Activity
– Governor’s plan – reduce personal income tax rates – pay for partly by increasing CAT rate from .0026 to .0032
– House completely overhauled Governor’s plan
– Budget has moved to the Senate
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5/13/2015
CAT Case Law Update
• L.L. Bean v. Levin, BTA Case No. 2010‐2853 (March 6, 2014)
– Initially was lead case in bright‐line nexus fight
– Ohio Board of Tax Appeals upheld assessment because BTA cannot rule on constitutional issues
– Case was appealed to Supreme Court of Ohio, subsequently remanded to BTA, and likely settled
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CAT Case Law Update
• Crutchfield v. Testa, BTA Case Nos. 2012‐926, 2012‐3068, 2013‐2021 (February 26, 2015)
– Now considered the lead case in bright‐line nexus fight
– Ohio Board of Tax Appeals upheld assessment because BTA cannot rule on constitutional issues
– No guidance again – not unexpected
– Case was appealed to Ohio Supreme Court
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5/13/2015
CAT Case Law Update
• Mason Companies, Inc. v. Testa, BTA Case Nos. 2012‐1169, 2012‐2806 (April 20, 2015)
– Bright‐line nexus fight
– Ohio Board of Tax Appeals upheld assessment because BTA cannot rule on constitutional issues
– No guidance again – not unexpected
– Will likely be appealed to Supreme Court of Ohio
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CAT Case Law Update
• Other CAT Nexus Cases at Supreme Court of Ohio
– Newegg, Inc. v. Testa 8
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5/13/2015
CAT Case Law Update
• Other CAT Nexus Cases at BTA
– Mason Companies, Inc. v. Testa
– Newegg, Inc. v. Testa
– Potpourri Group v. Testa
– Rubberlite, Inc. v. Testa
– The Swiss Colony, Inc. v. Testa
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CAT Case Law Update
• Final Determinations from Tax Appeals Division of Ohio Department of Taxation
– Lexmark International, Inc., July 15, 2014
• Appealed to BTA – scheduled to be heard 1/5/2016
– Moorehead Communications, Inc., November 28, 2014
• Appealed to BTA – scheduled to be heard 4/4/2016
– Motors Liquidation Company, October 8, 2014
• Appealed to BTA – scheduled to be heard 8/1/2016
– Nascar Holdings, Inc., January 5, 2015
• Appealed to BTA – scheduled to be heard 10/20/2015
– Quibids Holdings, LLC., February 25, 2015
• Appealed to BTA – hearing not requested brief due 1/4/2016
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5/13/2015
Audit Division Activity
• Trained more auditors
• Types of taxpayers
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50% – 60% Nexus
Registered v. unregistered
Combined v. consolidated
Private equity groups
• Managed CAT Audits
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CAT Audit Issues
• Ownership
• Gross Receipts
• Situsing
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5/13/2015
Ownership
And
v.
Or
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Ownership – Tale of the Tape
• Or
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–
• And
Statute: ORC 5751.011 & 5751.012
“value of ownership interest owned or
controlled, directly or constructively by common owners”
– Rule: OAC 5703‐29‐02
– “value of their ownership interest owned and
controlled by common owners”
– “In addition to an ownership interest, the higher‐tiered entity must have the ability through voting interests to control the operations…”
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5/13/2015
Ownership
• Which Provision should control?
– It seems obvious that the Statute should “control,” not the Rule.
• Query: Shouldn’t the taxpayer be able to rely on the Tax Commissioner’s Rule?
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Ownership
55%
C
A
G
100%
100%
D
E
60%
20%
B
40%
25%
F
JV
JV is controlled by Board made up of C, A and G. 66% of the vote is required to make decisions.
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5/13/2015
Audit Issues
• Retroactive Consolidation
– Audit ‐ NO
– CAT Division – Highly unlikely but possible based on facts
• Businesses with management companies, real property entities, purchasing entities, sales entities, manufacturing entities, etc.
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Audit Issues
• RC 5751.01(F) defines gross receipts:
– the total amount realized by a person,
– without deduction for the cost of goods sold or other expenses incurred, – that contributes to the production of gross income of the person, – including the fair market value of any property and any services received, and
– any debt transferred or forgiven as consideration.
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5/13/2015
Audit Issues
• Where do I start?
– Federal
– GAAP
– SEC
– Sales tax
– State income tax
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Audit Issues
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•
•
•
Agency
Interest (except on credit sales)
1221/1231 Property
Pass through
– Freight
– Co‐op advertising
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5/13/2015
Audit Issues
• Other common mistakes
– Sales tax exemptions do not equate to CAT exclusions
– Netting revenue in an expense account
– Negative expense accounts
– Miscellaneous income/expense accounts
– Intercompany is not excluded, intermember is
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Audit Issues
• Tangible Personal Property – RC 5751.033(E)
– “Ultimate destination”‐ the place at which such property is ultimately received after all transportation has been completed shall be considered the place where the purchaser receives the property.
– Income tax concept, not sales tax
– Know at the time of sale
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5/13/2015
Audit Issues
• Services – RC 5751.033(I)
– …shall be sitused to this state in the proportion that the purchaser’s benefit in this state with respect to what was purchased bears to the purchaser’s benefit everywhere with respect to what was purchased.
– Who, What and Where?
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Texas Franchise (“Margin”) Tax Overview
Lesser of
70% Total Revenue or
Total Revenue
(less cost of goods sold
or compensation)
or
Total Revenue ‐ $1 million
Tax Rate
1% or 0.5%
X
Receipts
Factor
X
Temporary Permissive Rates
.95% or .475%
(reports due after 12/31/14
and before 1/1/16)
Election to deduct COGS or compensation is annual and irrevocable
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5/13/2015
State of the state
• Texas House considering “Permanent” Franchise and Sales Tax Cuts
– Sales Tax (HB 31): 6.25% to 5.95%
– Franchise Tax (HB32): 25% rate reduction. (to 0.375% for retailers and wholesalers, and to 0.75% for all other businesses) • The proposed tax cuts are expected to create more jobs than the comparable increase in the homestead exemption over the next 5 years. – Sales Tax Cut: 10,000 more jobs; – Franchise Tax Cut: 70,370 more jobs in the next 5 years
State of the state (cont’d)
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Pre‐recession Texas employment peaked at 10,638,100 in August 2008; by February 2015 Texas added an additional 1,129,800 jobs across 11 major industries. By 2013, Texas’ read GDP grew by 3.7 percent. From January 2014 to January 2015 Texas unemployment fell 1.3%. Texas state sales tax receipts from March 2015 were 1.5% higher than for March 2014. Collections in fiscal year 2015 through March were up 8.3%. Franchise tax revenue, the second largest revenue producer (10.1% of total tax collections), is up 2%, although still under performing legislative estimates
Shifting economic drivers:
– Oil and gas is not as significant a portion of the state’s economy, despite the fact that the state’s rig count is close to all‐time highs (900 current collections have fallen 12.3% since 2014.
– Housing – A total of 7,731 building permits for single‐family homes, and 5,938 for multi‐family homes, were issued in February 2015. These figure have increased by 7.9% and 10.6%, respectively, since 2014. in January 2015, there were 17,986 sales of existing single‐family homes, 0.6% percent more than in February 2014. 13
5/13/2015
State of the state (cont’d)
• Tax Policy responds to 30,000 rulings per year (55% of which are sales tax questions)
– Upcoming changes: Declaratory rulings (technical and fact specific) will only be answered if:
• Taxpayer name is included
• No audit is ongoing
• Ruling request includes clearly defined facts and issues and supporting documentation is included (e.g., contracts, sales agreements, etc.)
• Economic nexus in Texas’ future? – Although Tax Policy thinks it is within statute, they will not pursue
– However, it has been discussed with the legislature as a way to increase revenue
• Apportionment: Sourcing the gain on the sale of a disregarded entity
– Is Texas changing their mind? • Past guidance indicated treating it as a sale of an intangible asset • Tax Policy said they are still reviewing this position
Comptroller rule update – franchise tax
• Rule 3.599 Qualified Research & Development Credit (eff. 04/05/2015)
– Conforms to, and implements statutory provisions related to eligibility, credit amounts, etc.
• Texas Register, Vol. 40, No. 13, March 27, 2015, Certification of average taxable price of gas and oil for February 2015
– Oil: $50.72 per barrel ($47.33 per barrel in January 2015); – Gas: $2.75 per MMus ($2.93 per MMus in January 2015)
• Decision No. 109,350, 12/12/2014 Flow‐Through Funds Exclusion
– This exclusion does not apply payments made by the taxpayer to businesses it subcontracted with to perform janitorial and cleaning services
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5/13/2015
Comptroller rule update – franchise tax (cont’d)
• Rule 3.584 Returns and Payments
– To be amended for:
• Allowance to elect COGS deduction or compensation deduction
• Rule 3.588 Cost of Goods Sold – To be amended for:
• Supervisor wages as nondeductible • Flow‐through entities’ ability to deduct depletion in COGS
Texas franchise tax
Conversations with Texas Tax Policy • Shortfall in projected revenues from franchise tax is believed by Comptroller to be attributable to unexpected increased COGS deductions, improper use of 0.5% tax rate, and increased use of small business exemption (revenues less than $1 million)
• Comptroller is not in favor of replacing Texas COGS with federal COGS as they do not want to audit federal COGS
• Texas has sent out information request letters (desk audits) to taxpayers requesting more information to determine if a business is eligible for COGS deduction, 0.5% tax rate, and income exclusions on EZ form
• Comptroller’s audit division auditing the largest 2,000 taxpayers filing combined returns
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5/13/2015
Policy change ‐ temporary credit for business loss carryforward
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On April 9, 2014, the Tax Policy Division issued a memo (20140487 8L) changing the criteria for determining when an entity “changes combined groups” for purposes of losing the right to the temporary credit for business loss carryforward
Under prior policy, the identify of the common owners was used to determine whether a member of a combined group changed combined groups and lost the credit
Under the new policy, the disallowance of the credit is determined on an entity‐
by‐entity basis with an entity being deemed to change combined groups in the following situations
– Entity leaves a combined group
– Entity joins an existing combined group
– When an entity’s acquisition results in the creation of a new combined group
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The change in criteria has immediate effect
If the Comptroller personnel previously revoked a taxable entity’s credit, a request that the credit be reinstated may be made by amending returns for years open under the statute of limitations
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Texas research and development incentives
• H.B. 800 reinstated the Research and Development Activities Credit • Texas companies may select either a Franchise Tax credit or a sales tax exemption on property purchased by persons engaged in qualifying activity
– R&D credit = 5% (current year QREs – 50%(3 prior years QREs/3)) limited to 50% of Franchise Tax due for period or 2.5% of current year QREs if there are one or more base years with no QREs (20 year carryforward for unused credit)
– Sales tax exemption on purchase of qualifying depreciable property
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Members of a combined group are considered one taxable entity
The Franchise Tax credit applies to reports due on or after January 1, 2014
The sales tax exemption was effective January 1, 2014
Both provisions are set to expire after 2026
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5/13/2015
Texas franchise tax audit activity
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Focus continues to be on combined filers, apportionment, deduction elections and COGS deductions
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For COGS, biggest contention relates to items that are “directly related” to the production of goods
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Also identified by the state as the “biggest mistakes” on returns
Typical audit duration for a COGS audit is one year
Supervisory labor
Transportation costs
Franchise tax audits are increasingly conducted by sales tax auditors as the state continues to cross‐train and attempt to cover all cases
– Comptroller using hourly paid contract auditors, not contingency fee based •
Comptroller’s budget cut by 10%; full time employees reduced to 300; hiring freeze in effect
– As much, Comptroller Glen Hegar admits the state to have upward $113 billion to spend this session; this figure is up more than 20% from the last legislative session ($92.6 billion in 2013)
Texas COGS deduction
Texas COGS ≠ federal COGS
•
Available ONLY to taxable entities that
– Produce or manufacture goods and/or – Sell real or tangible personal property in the ordinary course of business
– Also ‐‐ Lending institutions, certain leasing companies and companies in the construction industry can also take a COGS deduction
•
Three buckets of costs
1. Direct costs of acquiring or producing goods included entirely in COGS
2. Indirect or administrative overhead costs included at 4% of total in COGS
3. Costs not allowed to be included in COGS
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5/13/2015
Deductible costs for COGS
• The following costs are allowed to be included in COGS to the extent they are directly related to the production of goods
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Labor costs including W‐2 ages, temporary labor, payroll taxes, benefits
Cost of materials that are an integral part of specific property produced
Cost of materials that are consumed in the course of performing production activities
Handling costs, including costs attributable to processing, assembling, repackaging, and inbound transportation
Storage costs, including the costs of carrying, storing, or warehousing the property
Depreciation, depletion, or amortization reported on the federal income tax return
The cost of renting or leasing equipment, facilities, or real property, including pollution control equipment and intangible drilling and dry hole costs
The cost of repairing and maintaining equipment, facilities, or real property
Cost attributable to research, experimental, engineering, and design activities
Geological and geophysical costs incurred to identify and locate property that has the potential to produce minerals
Cost of utilities
Obsolescence, deterioration, and spoilage of goods
Cost of insurance on a plant or a facility, machinery, equipment, or materials
Cost of quality control
Nondeductible costs for COGS
• The following costs are not allowed to be included in COGS
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Costs related to pension and medical benefits for retired employees The cost of leasing or renting equipment, facilities, or real property that is not used for the production of goods
Payments to facility owners or event promotors under concession agreements for the right to sell food or beverages during events. (12/30/2014)
Selling costs
Distribution and outbound transportation costs
Idle facility expenses
Rehandling costs
Bidding costs
Income taxes
Interest expense
Strike expenses
Officer’s compensation
Cost of operating a facility owned or leased by federal government and used to house members of the Armed Forces
Compensation to undocumented workers
Costs funded by partnerships to the extent the extent the partnership took a COGS deduction
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5/13/2015
Statutory exceptions
• A taxable entity furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance of real property is considered to be an owner of the labor or materials and may include allowable costs in the computation of COGS
• A taxable entity whose principal business activity is film or television production or broadcasting or the sale of broadcast rights or the distribution of tangible personal property, or any combination of these activities, and who elects to use COGS to determine margin, may include as COGS:
– allowable costs related to the property – depreciation, amortization – and other expenses directly related to the right to broadcast or use the property
Unitary combined group
• Unitary combined reporting methodology
– Affiliated group members engaged in a unitary business (including partnerships and disregarded entities) are required to file a combined group report
• Credits: Texas provides a temporary tax credit for business loss carryforwards due before January 1, 2008; the right to claim the credit is lost if a member of the group changes combined groups after June 20, 2007.
– Includes one or more entities in which a controlling interest is owned by a common owner, either corporate or non‐corporate, or by one or more of the member entities
– Controlling interest (corporation)
• More than 50% of the combined voting power of all stock or • more than 50% of the beneficial ownership interest in voting stock • is owned directly or indirectly by common owner
– Controlling interest (other entities (including partnerships))
• More than 50% of the capital, profits, or beneficial ownership interest is owned directly or indirectly by common owner
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5/13/2015
Unitary combined group (cont’d)
• Unitary combined reporting methodology (cont’d)
– “Unitary business” defined as:
• “A single economic enterprise that is made up of separate parts of a single entity or of a commonly controlled group of entities that are sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts”
– Exclude foreign corporations (80/20 companies)
• Taxable entities that have 80% or more of their property and payroll outside the United States
• If no property or payroll, still excluded if 80% or more of its revenues are assigned to locations outside the United States
– Single uniform margin computation election for entire group
• Elect either cost of goods sold or compensation • All members must use same deduction
– Eliminate intercompany transactions
• Both tax base and combined apportionment factor Texas franchise tax apportionment factor
• Update on MTC election
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Texas Comptroller’s Tax Policy News (July 2010) – Texas Comptroller’s policy is that taxpayers may not elect to use the MTC 3‐factor apportionment formula instead of the single sales factor for franchise tax purposes (this policy was issued and adopted by Texas Comptroller on July 1, 2010 – see State Tax Automated Research System Accession No. 201007003L)
In numerous hearings since that time, the Comptroller has denied taxpayers’ franchise tax refund claims in which they elected the MTC 3‐factor apportionment formula. In the hearings, the Comptroller indicates that:
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Comptroller previously issued and adopted policy statement described above
Franchise tax is not an income tax for purposes of the election
Franchise tax law does not provide for alternative apportionment elections
House Research Organization’s Bill Analysis for H.B. 3 that implemented the franchise tax described the apportionment provisions as applying a single gross receipts factor, and no reference was made directly or indirectly to the 3‐factor formula under the MTC
• Comptroller’s interpretation as stated in both its rules and policy statements is consistent with the plain language of the franchise tax statutes and with the intent of the Legislature
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Graphics Packaging, Inc. v. Combs has now been filed in District Court with other taxpayers hoping to be held in abeyance at the District Court level
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5/13/2015
Recent franchise tax cases
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Gulf Chemical and Metallurgical Corp. v. Comptroller, Dkt. No. 0003‐12‐00772‐
CV, 03/26/2015
– Environmental disposal and recycling services for oil refineries can reduce its gross receipts for environmental service fee discounts. Newpark Resources, Inc v. Combs
– Oilfield services includes environmental costs in COGS deduction
– Comptroller has appealed
CGGVeritas Services, Inc v. Combs
– Geophysical services company includes certain costs in COGS
BASA Resources, Inc v. Combs
– Whether profits interest from oil lease constitutes real property
Nextera Energy Power Marketing, LLC v. Combs
– Costs related to generation/transmission of electricity are COGS and management fees qualify as revenue exclusion
Flint Energy Services, Inc v. Combs
– Oil and gas construction company can deduct per diems to employees in COGS
Washington Business & Occupation Tax (“B&O Tax”) – overview
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Washington does not have corporate or personal income taxes
Washington businesses are subject to three major taxes
– B&O Tax
– Retail sales/use tax
– Property Tax
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The B&O tax is based on gross receipts
Pyramiding tax structure by design (similar to Ohio CAT)
There are about 50 classifications for the B&O Tax based on type of business activity each having their own rates; the more common rates are as follows:
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Retailing ‐ .00471
Extracting/extracting for hire ‐ .00484
Manufacturing ‐ .00484
Wholesaling ‐ .00484
Service and other activities ‐ .018
Most businesses are subject to the B&O Tax at the entity level
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5/13/2015
Washington Business & Occupation Tax (“B&O Tax”) – overview
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Washington does not have corporate or personal income taxes
Washington businesses are subject to three major taxes
– B&O Tax
– Retail sales/use tax
– Property Tax
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The B&O tax is based on gross receipts
Pyramiding tax structure by design (similar to Ohio CAT)
There are about 50 classifications for the B&O Tax based on type of business activity each having their own rates; the more common rates are as follows:
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Retailing ‐ .00471
Extracting/extracting for hire ‐ .00484
Manufacturing ‐ .00484
Wholesaling ‐ .00484
Service and other activities ‐ .018
Most businesses are subject to the B&O Tax at the entity level
Washington is more dependent on sales taxes than the national average
22.9
US average
U.S.
Average
10.9
30.8
48.0
Washington
14.6
General sales taxes
0%
10%
20%
27.2
30%
Selective sales taxes
Selective Sales Taxes
40%
50%
8.2
27.3
Property
60%
70%
Income
80%
10.1
Other
90%
100%
Source: DOR Comparative State and Local Taxes, published 2010, based on US Census data for 2008
Sales tax and B&O tax is included in general sales taxes 22
5/13/2015
Economic nexus
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Replaces physical presence standard for service and royalty income and adopts a “factor presence” standard
– More than $50,000 in property located in Washington; or
• Does not include software or digital goods residing on servers in WA
– More than $50,000 in payroll located in Washington; or
• Payroll includes compensation paid to a non‐employee in WA
– More than $250,000 in receipts from Washington; or
– At least 25% of total property, total payroll or total receipts is located in Washington; or
– Domicile in Washington
•
These activities do not create nexus in Washington for an out‐of‐state seller:
– Ownership of software or digital good located on server in Washington
– Third‐party activities (e.g., marketplace services) conducted on seller’s behalf:
• Display of advertising
• Order taking
• Payment processing
Apportionment – from cost to receipts
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Cost of doing business (i.e., cost of performance) apportionment statute had been in place for more than 70 years
Effective June 1, 2010, cost of doing business method with a single receipts factor for most service activities
• For taxpayers engaging in service activities in more than one state that contribute to earning gross income taxable under the B&O tax, apportionment is constitutionally required ‐ Gwin, White & Prince, Inc. v. Henneford, 305 U.S. 434 (1939)
• A taxpayer’s right to apportion under the new law requires
– The taxpayer earn apportionable income, and
– The taxpayer is taxable in another state
• Washington state courts have said that there is no federal constitutional right to apportion selling taxes (i.e., retailing and wholesaling B&O taxes) – Ford Motor Company v. City of Seattle, 160 Wn.2d 32 (2007)
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5/13/2015
Key definitions
• Taxable in another state means a taxpayer is subject to a business activity tax by another state on income received from apportionable activities
• Business activity tax means a tax measured in whole or in part on net income, gross income, or receipts (doesn’t include a sales, use or similar transaction tax)
• State means a U.S. state, Puerto Rico, D.C., U.S. territories or possessions, or a foreign country or political subdivision of a foreign country
Single receipts factor (service classification)
• The receipts factor is a fraction as follows:
Gross income of the taxpayer from engaging in
an apportionable activity attributable to Washington
__________________________________________
Total gross income of the taxpayer from engaging in
an apportionable activity everywhere
• A separate factor is calculated for each apportionable activity
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5/13/2015
Numerator – income attributed to Washington
• Location of benefit of the service received or where the intangible is used (if in multiple states, then the place where the customer primarily received the benefit or used the intangible)
• If unable to determine, then the following apply (in order)
– Where the purchaser receives the benefit of the services
– If the benefit is received in multiple states, then where the benefit of the service is primarily received
– Then to where the service was ordered
– Then to where the bill is sent
– Then to where the customer sends the payment from
– Then to the customer’s address maintained in the seller’s records
– Then to the seller’s commercial domicile
Denominator – throw‐out rule
• Always the exception
• Gross income from engaging in an apportionable activity is excluded from the denominator of the receipts factor if both:
– The income is sourced to a state where the taxpayer is not subject to tax or does not have nexus
– At least some of the activity is performed in Washington
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5/13/2015
Intersection of state income tax planning and gross receipts taxes
• Businesses continue to look for ways to mitigate state and local income taxes through planning
• 3‐party (e.g., buy‐sell, etc.) structures are currently popular planning vehicles
• Do not forget to consider the potential impact of Ohio CAT or Washington B&O tax from any structures considered for implementation
Questions & Answers
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5/13/2015
Contact Information
William G. Nolan
John R. Trippier
Executive Director, State and Local Tax Services
Ernst & Young LLP
Centre Plaza, 50 South Main St., Suite 1200 Akron, Ohio 44308
Office: 330‐255‐5204
Mobile: 216‐570‐8233 william.nolan@ey.com Director, Multistate Taxes (non‐attorney professional)
Zaino Hall & Farrin LLC
41 S. High St., Suite 3600
Columbus, Ohio 43215
Office: 614‐349‐4815
Mobile: 614‐283‐0240
jtrippier@zhftaxlaw.com 53
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