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Nationwide Importance

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

by Diann Smith, Eric D. Carstens and Stephen P. Kranz | Oct 23, 2014 | Alabama, District of Columbia, Hawaii, Income Tax, Kentucky, Nationwide Importance, New Jersey, Transfer Pricing

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 Diann Smith, Eric D. Carstens and Stephen P. Kranz | Oct 9, 2014 | Allocation/Apportionment, District of Columbia, Income Tax, Nationwide Importance, Tax Base

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:

The investment was held by the investor for at least 24 continuous months;
The investment is in common or preferred stock or options of the QHTC Company; and
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 Diann Smith and Stephen P. Kranz | Oct 7, 2014 | Income Tax, Nationwide Importance, Transfer Pricing

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

by Diann Smith and Stephen P. Kranz | Sep 30, 2014 | Income Tax, Michigan, Minnesota, Nationwide Importance, Sales Tax, UDITPA

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 Diann Smith and Stephen P. Kranz | Sep 23, 2014 | Alabama, District of Columbia, Florida, Georgia, Hawaii, Income Tax, Iowa, Kentucky, Nationwide Importance, New Jersey, North Carolina, Transfer Pricing

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.

How Will Michigan Courts Analyze a Legal Challenge to the Michigan Legislature’s Retroactive Repeal of the Multistate Tax Compact?

by Mary Kay McCalla Martire | Sep 18, 2014 | Allocation/Apportionment, Income Tax, Michigan, Nationwide Importance, UDITPA

In recent days, the state tax world has focused on the State of Michigan’s retroactive repeal of the Multistate Tax Compact (Compact). Last week, the Michigan Legislature passed and Governor Snyder signed into law a bill (P.A. 282) that nullifies the effect of the state Supreme Court’s July 14, 2014 decision in International Business Machines v. Dep’t of Treasury, Dkt. No. 146440. In IBM, the state Supreme Court held that IBM may apportion its business income tax base and modified gross receipts tax base under the Michigan Business Tax (MBT) using the three-factor apportionment formula provided in the Compact, rather than the sales-factor apportionment formula provided by the MBT. Reflective of the urgency with which he views the situation, Michigan’s Governor Snyder signed the bill into law within twenty-four hours after its passage, with a statement that the state’s actions were an effort to ensure that “Michigan businesses are not penalized for investing in the State.” The Michigan Department of Treasury (MDOT) made no attempt to sugar coat its statements in language that would reflect support for Michigan business interests. Rather, it loudly proclaimed that the Legislature must act because the revenue impact to the State of the IBM decision was $1.1 billion.

The new law repeals L. 1969, P.A. 343, which enacted the Compact, retroactive to January 1, 2008, allegedly in order to express the original intent of the legislature regarding the application of M.C.L.A. §208.1403 of the MBT. (Section 208.1403 specifies that a multistate taxpayer must apportion its tax base to Michigan using the sales factor.) The law goes on to provide that the Legislature’s original “intended effect” of §208.1403 was to eliminate the ability for taxpayers to use the Compact’s three factor apportionment election provision in computing their MBT, and to “clarify” that the election provision included in the Compact is not available to the Michigan Income Tax Act, which replaced the MBT in 2012.

The actions of the state are perhaps not surprising, given MDOT’s revenue estimate and the number of related claims (more than 130) that are reported to be pending before MDOT and/or the Michigan courts on this issue. Earlier this week, the Michigan Court of Appeals issued an unpublished decision holding that the IBM ruling was dispositive on the issue of whether Lorillard Tobacco Company could elect to use a three-factor apportionment formula in computing its MBT for 2008 and 2009. Lorillard Tobacco Co. v. Dep’t of Treasury, No. 313256 (Sept. 16, 2014). Critics of the new law make strong arguments about the unfairness of the state’s recent actions, and tax pundits predict that the retroactivity of the law will soon be the subject of a court challenge. What do Michigan court’s prior rulings on retroactivity teach us about how the Michigan courts are likely to address this issue?

This is not the first time in recent memory that the state has acted to retroactively repeal legislation with the potential for large, negative implications to Michigan’s revenue stream. In General Motors Co. v. [...]

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State Revenue Departments Misapplying Federal Tax Law

by McDermott Will & Emery | Sep 9, 2014 | Audits, Federal Tax, Idaho, Income Tax, Maryland, Nationwide Importance, Procedure
State income tax laws generally build on federal tax law. The typical pattern is to begin the calculation of state taxable income with federal taxable income and then to modify it by adding or subtracting items where state tax policies differ from federal tax policies. As a result, a corporation’s state taxable income can be affected by the application of the federal Internal Revenue Code. State revenue departments generally do not consider themselves bound by Internal Revenue Service determinations respecting the application of federal tax law and believe that they are free to interpret the Internal Revenue Code as they see fit. Unfortunately, this has led to problems because state tax auditors often are not well trained in federal tax principles. We had an instance earlier this year in which an auditor claimed that the merger of a wholly-owned subsidiary into its corporate parent was taxable because there was an increase in the parent’s retained earnings. The merger was a plain vanilla tax-free liquidation under Sections 332 and 337 of the Internal Revenue Code (there was no intercompany debt and the subsidiary was clearly solvent), but sending copies of these provisions to the auditor left him unmoved. We finally got him to back down by showing that the parent’s increase in retained earnings was matched by a decrease in the subsidiary’s retained earnings so that there was no overall increase. As we explained to the client, a win is a win, even if for the wrong reasons. Nevertheless, if the auditor had been properly versed in the most basic federal corporate tax principles, this exercise would not have been necessary.

Two recent decisions illustrate misapplications of federal tax law by state revenue departments.

The Idaho Tax Commission recently held that a subsidiary’s net operating loss (NOL) carryovers did not pass to its parent in a merger of the subsidiary into the parent. The parent did not continue to operate the business of the merged subsidiary and the Commission held that “based on IRC §382, the Petitioner cannot carry the loss forward after the merger.” Idaho State Tax Commission Ruling No. 25749 (Apr. 17, 2014). The Commission’s statement of federal tax law is incorrect. Section 382 of the Internal Revenue Code does not apply to a merger of a wholly-owned subsidiary into its parent. Because of constructive ownership rules, no change in ownership is deemed to occur. Moreover, Section 382 does not prevent an NOL from passing to the surviving company in a merger; it simply limits the extent to which the NOL can be used. Although it is true that the limitation is zero for years in which the merged company’s business is discontinued, the NOL is not destroyed. If the parent later sells assets received from the subsidiary that had built-in gain at the time of the merger, the loss can be used to offset the gain.

Discussions that we have had with the Commission after the decision came out indicate that the Commission had [...]

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MTC’s Market-Based Sourcing Recommendations for UDITPA: Too Little, Too Late?

by Catherine A. Battin | Sep 3, 2014 | Allocation/Apportionment, Income Tax, Nationwide Importance, UDITPA
Member states of the Multistate Tax Commission (MTC) voted to adopt proposed amendments to Article IV of the Multistate Tax Compact during their annual meeting in late July. The proposed amendments likely to have the most widespread impact on taxpayers are the amendments to the Uniform Division of Income for Tax Purposes Act (UDITPA) Article IV section 17 sourcing rules that change the sales factor sourcing methodology for services and intangibles from a costs of performance (COP) method to a market-based sourcing method.

The MTC’s recommended market approach provides that sales of services and intangibles “are in [the] State if the taxpayer’s market for the sales is in [the] state.” In the case of services, a taxpayer’s market for sales is in the state “if and to the extent the service is delivered to a location in the state.” The proposed amendments also provide that if the state of delivery cannot be determined, taxpayers are permitted to use a reasonable approximation. At this point, there is no additional guidance from the MTC on the meaning of “delivered,” how to determine the location of delivery in the event that a service is delivered to multiple jurisdictions, or what constitutes a reasonable approximation.

While the proposed amendments may be touted by some as the death knell of COP sourcing, for these changes to take effect, they will still need to be adopted individually by legislatures in Compact member states or in any other states that may choose to adopt them. As we have seen over the last several years, many states have already forged their own paths in this area. (See our article discussing the wide variety of market-based sourcing rules.) Moreover, while many states have enacted market-based sourcing provisions with respect to the sale of services, certain states, unlike the MTC proposed amendments, have declined to convert to market-based sourcing for intangibles (e.g., Pennsylvania).

The proposed amendments leave taxpayers with many unanswered questions. For example, assume a corporate taxpayer (Corporation A) is in the business of offering a payroll processing service. Corporation A provides this service to Corporation B. Corporation B’s management of the contractual arrangement with Corporation A occurs in Massachusetts, which is also the location of Corporation B’s human resources function. Corporation B has 10,000 employees, 2,000 of whom are located in a jurisdiction that has adopted the MTC’s market-based sourcing recommendation (State X). What portion of Corporation A’s receipts from the performance of its payroll processing service for Corporation B should be sourced to State X?

One can reasonably argue that the service is delivered to Corporation B as a corporation (i.e., that the human resources function is the true beneficiary) and not individually to Corporation B’s employees—leaving State X with nothing. However, does the MTC’s language “if and to the extent the service is delivered” create an opportunity for State X to argue that it should receive 1/5 (2,000 employees/10,000 employees) of Corporation A’s receipts?

In late August, the MTC launched a project to [...]

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Connecticut Hires Chainbridge Software LLC for Transfer Pricing Training

by Diann Smith and Stephen P. Kranz | Aug 21, 2014 | Connecticut, Income Tax, Nationwide Importance, Tax Base, Transfer Pricing
On July 15, 2014, the Connecticut Department of Revenue Services awarded Chainbridge Software LLC a contract worth $50,000 for on-site and remotely supported training for transfer pricing audits. Chainbridge is infamous for being the contract auditor hired by the District of Columbia Office of Tax and Revenue to manufacture transfer pricing-based assessments. In 2012, the District of Columbia Office of Administrative Hearings denounced Chainbridge’s methodology in Microsoft Corp. v. Office of Tax and Revenue. Numerous other cases are in litigation following D.C.’s refusal to abide by that decision.

We have reviewed the Connecticut request for proposal drafted by the Department of Revenue Services. While we do not yet have access to the final contract, it will likely be similar to the request for proposal. The solicitation requests two to three days of training per week over the course of three months. According to the RFP, Chainbridge will teach the Department’s employees about transfer pricing principles and methodologies, taxpayer planning, economic analysis of transactions between related parties, pre- and post-audit planning, and other related topics.

In light of the Connecticut Department of Revenue Services’ expected contract with Chainbridge, we anticipate that the Department will become more active in evaluating transfer pricing. What is not certain is whether the analysis will follow the debunked method still being used in D.C.

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If At First You Don’t Succeed, Try, Try Again: Illinois General Assembly Sends Revised Version of Click-Through Nexus Law to the Governor for Signature

by Arthur R. Rosen and Mary Kay McCalla Martire | Jul 30, 2014 | Constitutional Issues, Illinois, Nationwide Importance, Nexus, Sales Tax, Transaction Taxes
In 2011, Illinois became one of the first states to follow New York’s lead by enacting “click-through nexus” legislation. The Illinois law created nexus for any out-of-state retailer that contracted with a person in Illinois who displayed a link on his, her or its website that had the ability to connect an Internet user to the remote retailer’s website, when those referrals generated over $10,000 per year in sales. Pub. Act 96-1544, §§5, 10 (eff. Mar. 10, 2011) (codified at 35 ILCS 105/2(1.1) and 35 ILCS 110/2(1.1) (West 2010). On October 13, 2013, the Illinois Supreme Court held that the click-through nexus law violated the Internet Tax Freedom Act (ITFA) by imposing a discriminatory tax on electronic commerce. Performance Marketing Ass’n v. Hamer, 2013 IL 114496. The court held that the statute unlawfully discriminated against Internet retailers by imposing a use tax collection obligation based only on Internet referrals but not on print or over-the-air broadcasting referrals. The court did not reach the question whether the law also violated the Commerce Clause of the United States Constitution (although the trial court had also rejected the law on this basis).

In its recently completed Spring 2014 legislative session, the Illinois General Assembly approved an amendment to the click-through law that was designed to correct the deficiencies found by the Illinois Supreme Court. SB0352 (the Bill). The Bill expands the definition of a “retailer maintaining a place of business in this State” under the Illinois Use Tax and Service Occupation Tax Acts (Acts) to include retailers who contract with Illinois persons who refer potential customers to the retailer by providing a promotional code or other mechanism that allows the retailer to track purchases referred by the person (referring activities). The referring activities can include an Internet link, a promotional code distributed through hand-delivered or mailed material or promotional codes distributed by persons through broadcast media. The Bill goes on to provide that retailers can rebut the presumption of nexus created by the use of promotional codes or other tracking mechanisms by submitting proof that the referring activities are not sufficient to meet the nexus standards of the United States Constitution. Presumably, under the principles of Scripto and Tyler, if a remote seller can demonstrate that the Illinois referrals are not “significantly associated” with its ability to “establish or maintain” the Illinois market, the presumption will be rebutted.

As amended, the Bill appears to address the ITFA concerns expressed by the Illinois Supreme Court by not singling out internet-type referrals. It also attempts to resolve any due process constitutional concerns by providing an opportunity for retailers to rebut the presumption of nexus created by their use of referring activities. The Bill was sent to the Illinois governor for signature on June 27. The Bill will take immediate effect upon becoming law.

At present, four other states (Georgia, Kansas, Maine and Missouri) have click-through nexus laws that expressly extend the presumption of nexus to non-Internet based referring activities. [...]

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