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In-Depth Coverage of Issues Surrounding State and Local Tax
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Beleaguered D.C. Taxpayers Achieve Another Success in Ongoing Challenges to the Methodology Used in the District’s Transfer Pricing Audit Program

by , and | Nov 20, 2014 | , , , ,

On Friday, November 14, 2014, an administrative law judge (ALJ) issued three identical orders granting the taxpayer’s motion for summary judgment in Hess v. OTR, Shell v. OTR and ExxonMobil v. OTR.  In these orders, the ALJ determined that based on an early ruling that the challenged methodology was fatally flawed, the Office of Tax and Revenue was barred from re-litigating the issue in the current cases under the doctrine of non-mutual collateral estoppel.

Transfer Pricing Implications

The transfer pricing litigation in D.C. has been a frustrating road for taxpayers because the flaws in the methodology OTR applied have been apparent from the outset.  The first case to be litigated was Microsoft v. OTR, OAH Case. No. 2010-OTR-00012 (May 1, 2012).  In this case, an ALJ ruled that the methodology the District used was fatally flawed because the methodology  failed to (i) separate controlled from uncontrolled transactions and (ii) individually analyze different product lines and different functions.  As a result, the ALJ concluded that the analysis was flawed, arbitrary and unreasonable.  OTR initially appealed the Microsoft order to the D.C. Court of Appeals, only to withdraw shortly after by filing a motion to dismiss its own petition for review.

When Microsoft was decided in 2012, it appeared that the faulty transfer pricing methods used by the District had been permanently debunked.  Nevertheless, OTR renewed the contract for the business performing the transfer pricing audits and did not materially modify the assessment methods.  As a result, taxpayers continued receiving assessments from the OTR based on the same methodology previously ruled invalid in Microsoft.  At least 10 taxpayers have challenged these assessments post-Microsoft, and the orders issued Friday are the first of these challenges to be resolved by the Office of Administrative Hearings (OAH).

The taxpayers in the Hess/Shell/ExxonMobil cases all challenged the substantive validity of the assessment methodology and argued that the Microsoft decision should be controlling.  OTR asserted that the doctrine of non-mutual collateral estoppel did not apply to the government and, even if it did, the elements were not met in this case.  The ALJ disagreed with OTR’s analysis and found “the failure to apply [non-mutual collateral estoppel] would allow [DC] to keep issuing proposed assessments to taxpayers using the same flawed Chainbridge analysis, with the hope that some taxpayers won’t have the wherewithal to challenge the assessment and will find it economically advantageous to simply pay rather than fight.”

The three orders issued on Friday should provide a definitive signal to OTR that the method is flawed as a matter of law and cannot be validly used to assess D.C. taxpayers going forward.  These decisions are essentially decisions on the merits for the pending cases and, assuming no appeal is filed, D.C. should face sanctions if it continues to pursue assessments using the methodology at issue in these cases.

Broad Implications

Perhaps more importantly than the narrow (but important) transfer pricing issue in these decisions, OAH has made is clear that non-mutual collateral estoppel can be applied against OTR [...]

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Take Two: Massachusetts Department of Revenue Releases Revised Market-Based Sourcing Regulation

by | Nov 7, 2014 | , ,

Late last week, the Massachusetts Department of Revenue (the Department) released a revised draft regulation on Massachusetts’s new market-based sourcing law.  The changes made by the Department to purportedly address practitioner and taxpayer concerns were relatively modest.  The rules remain lengthy, complex and cumbersome.  There are still various assignment rules that apply to each of the following types of transactions: (1) in-person services, (2) professional services, and (3) services delivered to the customer, or through or on behalf of the customer (described in the new regulation as services delivered to the customer, on behalf of the customer, or delivered electronically through the customer, hereinafter “sales delivered to, by, or through a customer”).  For a more detailed discussion of these rules see our State Tax Notes article on market-based sourcing. 

The most noteworthy changes from the initial draft relate to the taxpayer’s ability to use a “reasonable approximation” method.  The initial draft regulation provided taxpayer’s with the ability to use a “reasonable approximation” when “the state or states of assignment” could not be determined.  The new regulation clarifies that a taxpayer must, in good faith, make a reasonable effort to apply the primary rule applicable to the sale (e.g., the specific assignment rules for in-person services, professional services, or sales to, by, or through a customer) before it may reasonably approximate.  Additionally, the regulation explicitly states that a method of reasonable approximation “must reflect an attempt to obtain the most accurate assignment of sales consistent with the regulatory standards set forth in [the regulation], rather than an attempt to lower the taxpayer’s tax liability.”  There is no guidance as to how a taxpayer would demonstrate that its reasonable approximation attempt was made to “obtain the most accurate assignment of sales.”  This raises a number of questions–for example, if a taxpayer determines that there are two equally reasonable methods by which it can reasonably approximate its Massachusetts sales, can it use the method that results in less tax?  Additionally, there does not seem to be any converse requirement that the Department make a similar demonstration (i.e., that any modifications to a taxpayer’s sourcing methodology not be an attempt to increase a taxpayer’s liability) when exercising its authority to adjust a taxpayer’s return (as discussed below).

In an attempt to make the regulation more even-handed, the Department’s revisions provide that neither a taxpayer nor the Department may adjust a “proper” method of assignment, including a method of reasonable approximation, unless it is to correct factual or calculation errors.  However, the revision isn’t all that meaningful because there are still a broad number of scenarios in which the Department can make changes, one of which is when a taxpayer uses a method of approximation and the Commissioner determines that the method of approximation employed by the taxpayer is not “reasonable.”  Additionally, when a taxpayer excludes a sale from both the numerator and denominator of its sales factor because it has determined that the assignment of the sale cannot be reasonably approximated, [...]

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New Jersey Tax Court Finds Two Pennsylvania Taxes Are Not Required To Be Added Back

by and | Oct 31, 2014 | , , ,

In a Corporation Business Tax (CBT) case, PPL Electric Utilities Corporation v. Director, Division of Taxation, Dkt. No. 000005-2011 (N.J. Tax. Ct. Oct. 2, 2014), the Tax Court of New Jersey found for the taxpayer and held that the Pennsylvania Gross Receipts Tax and Pennsylvania Capital Stock Tax were not required to be added back in computing New Jersey entire net income.

The case involves a 1993 amendment to the CBT statute regarding adding back taxes deducted in computing federal taxable income.  Prior to 1993, the New Jersey statutes required taxpayers to add-back only certain federal taxes and the CBT in computing New Jersey entire net income.  The amendment added a requirement that taxpayers add-back to federal taxable income taxes paid to states other than New Jersey “on or measured by profits or income, or business presence or business activity.”  N.J.S.A. 54:10A-4(k)(2)(C).  According to legislative history cited by the court, prior to the amendment “corporations which [did] business in several states [paid] a lower effective rate of tax on their New Jersey activities than [did] corporations which only [did] business in New Jersey.”  The court explained that the amendment corrected the inequity “by requiring multi-state taxpayers to add-back state taxes similar to that of the CBT.”

The Tax Court concluded that the Pennsylvania Gross Receipts Tax is not subject to the tax add-back, finding that the tax is:  (1) “based solely on the amount of electricity sold, regardless of whether income or profit is realized from such sales and not based upon the taxpayer’s business presence or business activity in Pennsylvania;” and (2) “passed through to the ultimate consumer of electricity.”  The court held that the Pennsylvania Capital Stock Tax was not subject to the tax add-back because it was in substance a property tax.

Interestingly, the Tax Court found that the New Jersey Division of Taxation’s (Division) interpretation of the tax add-back was not only incorrect but also discriminatory.

The 1993 amendment was passed because previously, solely New Jersey taxpayers were taxed on a higher tax basis than similarly situated multi-state taxpayers . . . .  Here, Taxation’s interpretation of the statute discriminates against multi-state taxpayers because they would be required to add-back the Pennsylvania Corporate Income Tax as well as other non-CBT-type taxes imposed by other states, such as the Pennsylvania Gross Receipts Tax and the Pennsylvania Capital Stock Tax, while solely New Jersey taxpayers are only required to add-back CBT-type taxes.  This court finds that the Legislature did not intend to cure one inequity by imposing another.

Given the number of different types of state taxes in existence, this case may have broad ramifications for multi-state taxpayers subject to the CBT.  We have seen the Division make similar adjustments to other companies on audit and this decision should be helpful in disputing those adjustments.  Additionally, multi-state taxpayers may have refund opportunities for similar taxes that they have previously added back.



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New Jersey Division of Taxation’s 2014 Tax Resolution Initiative – Not To Be Confused With An Amnesty

by and | Oct 30, 2014 | , , ,

The New Jersey Division of Taxation (Division) is trying to help taxpayers resolve unpaid tax liabilities for tax periods 2005 through 2013.  Through November 17, 2014, the Division is offering taxpayers that pay all tax and interest for the applicable periods a waiver of most penalties (but not penalties related to the 2009 amnesty) and any costs of collection or recovery fees.  Notably, this is not an amnesty like those conducted in 2002 and 2009.  It is not statutorily mandated and no penalties may be imposed for non‑participation.  Because the initiative is not statutorily mandated, the Division is not offering something it could not offer at any other time.  However, the Division’s offer to waive most penalties may be a good chance for many taxpayers to resolve issue and move on and is worth considering.



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A Very Scary Time of the Year: MTC Joint Audit Selection

by , and | Oct 23, 2014 | , , , , , , ,

With both Halloween and the Multistate Tax Commission (MTC) Income Tax Audit selection nearing, taxpayers should prepare themselves for the possibility of being spooked in the near future.  On Thursday, October 30, from 2-4 pm EST, the MTC Audit Committee—including representatives from the 22 states participating in the upcoming round of joint income tax audits—will be holding a teleconference that will begin with a public comment period.  Because of the inevitable disclosure of confidential taxpayer information, the bulk of this meeting—including selecting the various companies to audit—will take place during the second half of the agenda and be closed to the general public.  Just because a company has completed an audit in the past does not mean this season will be all treats.  The authors have noticed that companies previously audited by the MTC can remain on the list of targets and are often repeat selections.

Unique Complexities

The MTC audit process is not without its share of traps for the unwary.  First and foremost is the effort a taxpayer must expend in managing a multistate audit.  Issues such as differing statute of limitations, the effects of federal Revenue Agent’s Reports (RAR) and net operating loss (NOL) differences on limitations periods, timing of protests, and tax confidentiality become of heightened importance when one auditor is reviewing a taxpayer for multiple states.  Audited taxpayers should also keep in mind that the MTC does not issue the actual deficiency notices – these must come from the states.  As a result there may be certain areas such as credits or refunds that the MTC does not review and must be raised directly with a participating state.

On the substantive side, a primary area of inquiry of an MTC audit has been and is likely to continue to be inter-company transactions.  Historically MTC audits have taken a variety of approaches to disallow a taxpayer’s intercompany structure, including collapsing separate affiliates, applying the sham transaction doctrine, or using aggressive addback concepts.      Another similar concern for taxpayers audited by the MTC is the increased likelihood of transfer pricing issues being raised.  This comes in the wake of the creation of the MTC Arm’s-Length Adjustment Service (ALAS) this summer, led by former Montana Department of Revenue Director Dan Bucks.  The group recently held a transfer pricing summit at which it designed the MTC services to include third-party economic consultants at every stage.  The MTC transfer pricing services are expected to be implemented in mid-2015—just in time for companies selected for an MTC Income Tax Audit to be the test subjects.  Notably, of the nine states committing seed money to the development of a multistate transfer pricing audit service, five (Alabama, Hawaii, Kentucky, New Jersey and the District of Columbia) are participating in the MTC Income Tax Joint Audit Program.  It is not clear whether the two MTC-sponsored audit programs will be intertwined; however, the option was proposed this past summer and remains a possibility as we approach the upcoming audit selections.

Finally, it remains to [...]

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D.C. Bill Ostensibly Lowers Tax on Capital Gains from QHTC Investments… But How?

by , and | Oct 9, 2014 | , , , ,

On September 23, District of Columbia Council Chairman Mendelson introduced the Promoting Economic Growth and Job Creation Through Technology Act of 2014 (Bill 20-0945 , hereinafter the “Act”) at the request of Mayor Vincent Gray.  This marks the second time that the Council has considered the introduced language; it was originally included as part of the Technology Sector Enhancement Act of 2012 (Bill 19-747), but was deleted prior to enactment.  The Act would add a new provision to the D.C. Code (§ 47-1817.07a) to impose a lower tax rate on capital gains from the sale of an investment in a Qualified High Technology Company (QHTC) beginning in 2015.  The rate would be 3 percent as compared with the current rate of 9.975 percent for business taxpayers.  Notably the proposed provision is limited in scope and only applies when the following three elements are satisfied:

  1. The investment was held by the investor for at least 24 continuous months;
  2. The investment is in common or preferred stock or options of the QHTC Company; and
  3. During the taxable year, the investor disposed or exchanged of some or all of his or her investment in the QHTC.

As introduced, the proposed tax is explicitly applied “notwithstanding” any provision of the income tax statutes.

Good Thought, Poor Drafting

The intent of this legislation is clear, but the practical application is not.  As a threshold matter, the second element requires the investment to be “in common of preferred stock or options,” which by definition excludes partnerships and limited liability companies since only corporations can issue stock.  On its face, the language of the bill appears to be limited to investments in a QHTC organized as a corporation, despite the fact that other entities are eligible for QHTC status under D.C. law.  Therefore, limited partners and members investing in pass-through QHTC’s appear to fall outside the scope of the proposed legislation.

Second, by imposing a different rate on only a certain type of income and by taxing the gains notwithstanding any other provision of the income tax statute, the proposal fails to account for basic tax calculations necessary to arrive at taxable income in the District for a business taxpayer.  For example, the allocation and apportionment provisions would seem to be negated both practically and legally.   What part of a multistate taxpayer’s gain from a QHTC is subject to the 3 percent rate?  Is it all of the gain; an apportioned part of the gain – and if so, based on whose apportionment percentage?  What if the gain would have been categorized as non-business income and the taxpayer is a non-resident?  The answer is certainly not obvious from the legislation.  Similarly, how do a taxpayer’s losses, both in the current year and carried over, affect the amount of gain available to tax?  Can all of the losses be used against other types of income first?  Can the losses be used at all against the QHTC gain?

Third, how is a taxpayer [...]

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Multistate Taxpayers Take Note! Recap of the First Day of the MTC Pricing Summit

by and | Oct 7, 2014 | , ,

On October 6, 2014, the Multistate Tax Commission (MTC) held the first day of a two-day meeting intended to educate state revenue authorities on corporate income tax issues surrounding intercompany transactions, and further refine a path forward for states interested in collaborating on audit and compliance strategies.  This first day focused entirely on presentations by specialists in transfer pricing and related intercompany transaction issues.  Two important themes and one blatant omission regarding future enforcement emerged from the first day:  (1) suggestions for increased disclosure and substantiation requirements; (2) safe harbor options and (3) a lack of discussion of how to prevent the risk of double taxation.

Taxpayers should be particularly concerned with the stress placed by the specialists on increased disclosure and substantiation requirements.  Most of the specialists emphasized the importance of getting information into the hands of revenue authorities.  Several suggested adding questions to the tax return itself such as “does the taxpayer use intangible property owned by an affiliate?”  These questions would be used to identify potential audit targets and focus audit inquiries.  Separately – but in a similar vein – several specialists suggested that taxpayers be required to create contemporaneous documentation substantiating their intercompany pricing at the state level.  An example provided was the Organisation for Economic Co-operation and Development proposal that a taxpayer provide a country-by-country analysis.  This example provoked at least one attendee to compare it to the infamous “50-state spreadsheet.”  Some specialists even suggested that states create special penalties for failure to properly disclose or create the required substantiation.

As some commentators acknowledged, a substantial concern with both the disclosure and substantiation suggestions is the risk of a significant increase in the cost of compliance for taxpayers.  State authorities should carefully consider the risk/rewards of any such action.  Increased state disclosure requirements, such as modeling the federal uncertain tax position rule, have not yet widely caught on among the states despite spurts of activity.  This is partially because of the administrative burden on taxpayers and partially because states receive a great deal of information from the Internal Revenue Service.  It is clear, however, that the states continue to be frustrated with the perceived tax planning problem.  The specialists expressed near-unanimous agreement that states need more information to properly enforce intercompany transaction issues.

The second theme of the day was the concept of safe harbors.  This theme took different forms but could be something that both taxpayers and state revenue authorities would support.  For example, some specialists suggested that for low-value transactions, safe harbor rules be created to provide increased certainty to taxpayers.  This might include providing limits on the percentage profit that could be made from certain types of intercompany transactions.  Other commentators and some states suggested, however, that additional safe harbor protections are unnecessary because state add-back statutes effectively provide safe harbor protection.

In a glaring omission, specialists failed to recognize or address the need to avoid double taxation.  Although several specialists noted that in the international area, most of the action happens [...]

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Yes, Distortion is Enough: New York Tax Appeals Tribunal Clarifies Combined Reporting Requirements

by | Oct 6, 2014 | , ,

On September 18, 2014, the New York State Tax Appeals Tribunal released its first decision interpreting New York State’s post-2007 combined reporting laws and, in doing so, answered a question that has been lingering in the minds of taxpayers and the Department’s auditors—whether distortion alone can still justify combined reporting.  Reversing a June 2013 determination of a New York Division of Tax Appeals Administrative Law Judge, the Tribunal, in Matter of Knowledge Learning Corp. et al., DTA Nos. 823962; 823963 (N.Y. Tax App. Trib. Sept. 18, 2014), held that distortion, even in the absence of substantial intercorporate transactions, can provide the basis for combined reporting.

Before January 1, 2007, New York required combined reporting for companies that were linked by common ownership and engaged in a unitary business if separate filing would result in distortion of income.  Under prior law, distortion was presumed where taxpayers in a purported combined group engaged in substantial intercorporate transactions (SIT).  The 2007 amendment to the combined reporting statute converted the presumption arising from the presence of SIT into a rule of law, with taxpayers now required to file combined reports if SIT are present.  Unclear after the 2007 law change was whether taxpayers could be permitted or required to file on a combined basis if separate filing would distort the taxpayers’ New York incomes, even if the combined group did not engage in SIT.

The petitioners in Knowledge Learning Corporation filed a combined return for the tax year ending December 29, 2007 and argued (1) that the parent and subsidiaries included on the combined report engaged in SIT and (2) that, regardless of whether the SIT test was met, separate filing would result in distortion.  The ALJ declined to address the petitioners’ argument that there was actual distortion even if there were not SIT, stating that “distortion is not the proper analysis in light of the 2007 statutory amendment”—a conclusion with which many practitioners disagreed.  (See prior coverage here).  The Tribunal reversed, concluding that the amended law “allows combined reports to be filed, even in the absence of substantial intercorporate transactions, when combined filing is necessary to properly reflect income and avoid distortion.”  The Tribunal also overruled the ALJ’s conclusion that the petitioners did not engage in SIT and, after conducting a fact-intensive inquiry into the group’s operations, held that the leasing of employees to the subsidiaries by the parent and the parent’s payment of all of the subsidiaries’ expenses met the SIT test such that combination was required.

This decision is noteworthy for a number of reasons:  First, because the Tribunal found in favor of the taxpayer, the New York State Department of Taxation cannot appeal and the decision constitutes binding precedent.  Furthermore, although the Tribunal did not reach the issue of whether the petitioners had actually proved distortion, a wealth of New York case law discussing what is necessary to prove distortion (such as Matter of Autotote Limited, Matter of Heidelberg Eastern Inc. and Matter of Mohasco Corporation) exists, and [...]

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Did You Pay a Michigan Assessment After an MTC Audit? What the State’s Retroactive Compact Repeal May Mean

by and | Sep 30, 2014 | , , , , ,

On September 11, 2014, Michigan Governor Rick Snyder signed legislation (SB 156) retroactively repealing the Multistate Tax Compact (Compact, formerly codified at MCL § 205.581 et seq.) from the state statutes, effective January 1, 2008.  Among other things, the bill’s passage ostensibly supersedes the Michigan Supreme Court’s decision in Int’l Bus. Machines Corp. v. Dep’t of Treasury, 496 Mich. 642 (2014) (holding that (1) the enactment of a single sales factor under the Business Tax Act (codified at MCL § 208.1101 et seq.) did not repeal Compact by implication and (2) the state’s modified gross receipts tax fell within the scope of Compact’s definition of “income tax” which the taxpayer could calculate using Compact’s three-factor apportionment test) and relieves the Department of Treasury from having to pay an estimated $1.1. billion in refunds to taxpayers.  While many commentators have rightfully focused on the constitutional validity of retroactively repealing the Compact in Michigan in such a manner (including our own Mary Kay Martire in her recent blog post), we think it is equally as important to consider whether the repeal compromises the validity of prior interstate audit assessments authorized pursuant to the Compact.

Background

Article VIII of the Compact provides the specific rules governing participation in interstate audits conducted by the Multistate Tax Commission (MTC) via their Joint Audit Program (Program).  Unlike other provisions of the Compact, Article VIII is “in force only in those party states that specifically provide therefore by statute.”  Section 8 of the Compact provides this authority, simply stating “Article VIII [of the Compact] shall be in force in and with respect to this state.” See MCL § 205.588 (repealed by SB 156).  This threshold matter must be satisfied before the MTC is authorized to audit and assess businesses and review their books and records on behalf of any particular state.

The MTC and its participating audit states have taken the controversial position that membership and participation in the Program is independent from a state’s Compact status (e.g. Massachusetts, Nebraska, Tennessee, and Wisconsin have not adopted the Compact, yet participate in the Program).  Further, even when authorized, states have the discretion to elect not to participate in the Program by simply opting out for one or both of the taxes audited (income and franchise, or sales and use).

Minnesota offers an example of a state that may have withdrawn from the Compact correctly while maintaining the State’s ability to participate in MTC audits.  In May 2013, the legislature enacted legislation repealing the Compact (H.F. 677, repealing Minn. Stat. § 290.171) (this legislation does not appear to be retroactive).  In doing so, the legislature included a separate provision authorizing continued participation in audits performed by the MTC. See Minn. Stat. § 270C.03 subd. 1(9), amended by H.F. 677.  While Minnesota ultimately opted not to participate in these audits, they have statutory authority if they so choose (but as noted above, the Compact itself may not allow for this).

Implications

Unlike Minnesota, the recent repeal in Michigan failed to [...]

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MTC to Hold Transfer Pricing Group Meeting with Third-Party Contract Auditors

by and | Sep 23, 2014 | , , , , , , , , , , ,

On October 6 and 7, 2014, the Multistate Tax Commission (MTC) will hold an Arm’s-Length Adjustment Service (ALAS) Advisory Group Conference at the Atlanta Airport Marriott.  On the first day, third-party contract auditors will give presentations on transfer pricing issues.  An ALAS Advisory Group meeting will be held on the second day.

This past year, the MTC has been designing a joint transfer pricing program.  So far, nine members have committed money to the development of this program: Alabama, the District of Columbia, Florida, Georgia, Hawaii, Iowa, Kentucky, New Jersey and North Carolina.

Dan Bucks, former executive director of the MTC and former director of the Montana Department of Revenue, is the project facilitator.  In the lead-up to the event, he discussed arm’s-length issues with numerous third-party contract auditors.  On October 6, the contract auditors will explain how they believe a multistate transfer pricing program should work and how the MTC would best use their services to conduct transfer pricing audits on behalf of member states.

The list of contract auditors includes Chainbridge Software, Economics Analysis Group, Economists Incorporated, NERA, Peters Advisors, RoyaltyStat and WTP Advisors.  While project facilitator, Dan Bucks, has indicated that this meeting is not an audition for a procurement process, the discussion seems to be headed in that direction and the MTC has not ruled out utilizing third-party audit assistance in the transfer pricing program.

Businesses concerned with the overall direction of the ALAS Advisory Group, including the possibility of subjecting taxpayers to Chainbridge-style audits on a nationwide scale, should contact the authors.  For more information on the conference, please visit the MTC ALAS webpage.



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