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Nationwide Importance

You Do the Math: Unclaimed Property Lawsuit Filed Against Kelmar

by Diann Smith, Eric D. Carstens and Stephen P. Kranz | Jun 9, 2014 | Constitutional Issues, Delaware, Nationwide Importance, Unclaimed Property

Mark McQuillen, president of Kelmar Associates, LLC, was misinformed when he was quoted as saying “I’ve never been sued” on May 26—less than one week after suit was filed against Kelmar and three Delaware state officials in a Delaware Federal District Court. See 72 State Tax Notes 455 (May 26, 2014). While the timing of this statement was an unfortunate – but likely honest – mistake, the lawsuit filed by Temple-Inland Inc. asserts the conduct of Kelmar in conducting an unclaimed property audit on behalf of the state of Delaware was anything but.

According to the complaint, Temple-Inland was initially asked to pay over $2 million to the state based on the “fatally flawed” extrapolation methodology used by Kelmar to calculate Temple-Inland’s liability (and Kelmar’s paycheck from Delaware). While the demand was reduced to $1.38 million after the plaintiff initiated administrative review, the result and details of how they got there remains alarming. Of note, Kelmar estimated that nearly $1 million was due to Delaware for the seven-year period of 1986 through 2003 after identifying a single unreported check for $147.30 during a subsequent six-year period (Complaint ¶ 84). The complaint contains countless examples of voided and reissued checks (even checks that escheated to other states) that were used in Kelmar’s extrapolation formula. Ultimately the result for Temple-Inland was a demand from Delaware alone of over $100,000 escheatable for prior year’s accounts payable, despite having only around $15,000 escheatable to all other states on these accounts for a five year period actually reviewed.

Based on these practices, Temple-Inland asserts that Kelmar and the state auditing officials have unconstitutionally applied the amendment to Delaware Escheat Law allowing for estimations of unclaimed property liability to years prior to its enactment in violation of the Ex Post Facto Clause. Along those same lines, the state penalized Temple-Inland for failing to maintain records for periods prior to 2010, when a substantive document retention requirement was imposed in the state (see S.B. 272 § 4). Nonetheless, Temple-Inland asserts that the methodology used by Kelmar violates federal common law, the Full Faith and Credit Clause, Commerce Clause and Takings Clause of the U.S. Constitution.

The opening brief filed on behalf of Temple-Inland is available here

Practice Note: While Delaware has settled every suit raising these questions and has an economic incentive to keep them from reaching what would likely be an adverse decision to the state’s (and Kelmar’s) financial interest, the discussion should not end there. Temple-Inland Inc. had a long history of solid compliance with the unclaimed property laws across several states, yet still was the target of a flawed and likely unconstitutional audit by Kelmar on behalf of the state of Delaware. The company was forced to hire counsel and litigate against Kelmar’s questionable practices. While two new Delaware bills have been introduced in an effort to eliminate unclaimed property contingent fee auditing practices (S.B. 215 and S.B. 228), holders should stand firm in opposition to Kelmar’s aggressive extrapolation methods and keep [...]

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One Thing’s Consistent—There’s No Duty of Consistency

by Emily Townsend | Jun 3, 2014 | Allocation/Apportionment, Nationwide Importance, New Jersey, UDITPA

Taxpayers resisting audit requests for tax returns filed in other states, or requests for details about the treatment of an item in another state, now have another quill in their arsenal besides the 2010 Oregon Tax Court decision in Oracle Corp. v. Dep’t of Rev., 2010 Ore. Tax LEXIS 32 (Or. T.C. 2-11-10). The New Jersey Tax Court recently issued a letter opinion in Elan Pharmaceuticals, Inc. v. Director, Division of Taxation, Tax Court Dkt. 010589-2010 (May 1, 2014), reiterating that a taxpayer is not required to treat an item in exactly the same way it treats it in another state.

Like Oracle, Elan Pharmaceuticals involves the business/non-business distinction (called the operational/non-operational distinction in New Jersey vernacular). Apparently, the company reported its gain from the sale of certain operations as business (i.e., “operational”) income on its California Franchise Tax Return, but reported the same gain as nonbusiness (i.e., “nonoperational”) income on its New Jersey Corporation Business Tax Return. These facts largely mirror those in Oracle, except that the state involved was Oregon, not New Jersey.

During the Division of Taxation’s audit of the company, the gain was recharacterized as business income, which resulted in a substantial deficiency. While the Division’s position was based on a number of factors, including its determination that the company never ceased conducting the line of business it purportedly disposed of, the Division was clearly influenced by the company’s treatment of the gain in California. In fact, the Division asserted that because the company treated the gain as apportionable business income in California, it could not treat it as non-apportionable nonbusiness income elsewhere.

Like the Oregon Tax Court, the New Jersey Tax Court rejected such a purported duty of consistency. The Court stated that a requirement of consistency, while “appealing under pure common sense, and in light of the purpose of the UDIPTA, . . . does not mean that [the company] is barred from seeking application of New Jersey law when challenging a New Jersey tax assessment.” The Court continued: “this court should be guided by N.J.S.A. 54:10A-6.1(a), New Jersey’s basis for taxing operational income, and the binding law construing that statute, not the consequent result of such treatment in another State.”

Ultimately, the Tax Court agreed with the Division of Taxation that the company’s gain was apportionable business income, relying largely on the unitary business principle (an aspect of the matter that appears not to have been fully developed on the record or addressed by the parties during briefing). Still, the Court’s mandate that the actual treatment of an item in another state not be binding for New Jersey purposes is important. It’s also entirely consistent with another recent Tax Court decision—Lorillard Licensing Co., LLC v. Director, Division of Taxation, N.J. Tax Ct. Dkt. A-2033-13T1 (Jan. 14, 2014), in which the Tax Court determined that whether or not another state actually imposes income tax on receipts is irrelevant for purposes of computing New Jersey’s now-defunct “throw out rule” so long as the other state [...]

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How to Negotiate a Settlement Agreement

by McDermott Will & Emery | May 22, 2014 | Nationwide Importance, Procedure

Settlements of tax audits are typically memorialized in closing agreements between the department of revenue and the taxpayer. Negotiating these agreements can be an important part of any settlement.

The department of revenue may have standard printed form closing agreements, and the taxpayer should determine the extent, if any, to which the standard form can and should be changed. If department representatives are reluctant to change the printed form, one possibility would be to add an appendix that elaborates on—and even contradicts—the provisions of the form.

The agreement should indicate whether it is effective with respect to similar issues in future years. Part of the settlement may be an agreement as to how certain items will be treated in future years; if so, this should be explicitly stated. On the other hand, if the intent is that the agreement will not govern the treatment of settled items in future years, this too should be explicitly stated. We have had cases in which this was not made clear, and, when the taxpayer in future years departed from the agreed treatment of certain items, the auditors said that the taxpayer was reneging on a deal. When the taxpayer pointed out that the agreement specifically said that the settlement was not to apply to future years and did not necessarily reflect the opinions of the parties as to the proper tax treatment of any item, the auditors backed down, but they were still somewhat resentful. The best approach is to pin down precisely the effect, if any, of the agreement on future years.

The department of revenue may want to provide that it can reopen the audit years if it discovers tax avoidance transactions. While the auditors are thinking about abusive tax shelters, their suggested language is often broad and can apply to routine business transactions where tax considerations have been taken into account. One government draft closing agreement that recently crossed our desks would have allowed the department to reopen the audit in the case of any “scheme, product, or transaction structured with the intent of evading or avoiding federal or state taxes.” This language could apply to the most routine business transactions where taxes were taken into account, such as a decision to sell a business in a tax-free reorganization as permitted by section 368 of the Internal Revenue Code (the Code) rather than in a taxable sale. Taxpayers should try to limit any such provisions to objectively determinable tax shelters such as “listed transactions” within the meaning of the Code or comparable state law. While the desire of state tax officials to be able to challenge abusive transactions is understandable, the typical closing agreement occurs only after an audit has gone on for some time and the taxpayer’s books have been carefully checked, so there is no reason why any significant transaction should not have come to light. The department should not be allowed to reopen an audit or address routine business transactions just because they [...]

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Retailers Should Examine Gift Card Practices in Light of a Recent Unclaimed Property False Claims Action

by Diann Smith | May 14, 2014 | Delaware, Nationwide Importance, Unclaimed Property

A complaint in the Superior Court of Delaware alleges that numerous retailers “schemed to deprive the State of Delaware of hundreds of millions of dollars due to the State under the Abandoned Property Law” (emphasis added). Delaware v. Card Compliant et al., Del. Sup. Ct (New Castle County), Case No. N13C-06-289 FS (6/2013). The complaint asserts that the retailers were all incorporated in Delaware and, under the second priority rule, unclaimed gift card funds should have been remitted to Delaware after five years of inactivity. According to the complaint, the defendants attempted to avoid this rule by setting up and using companies incorporated in states that exclude gift cards from the definition of unclaimed property for purposes of gift card issuance and management; however, the arrangements “are without substance as the value of all unredeemed gift cards remains within the possession, custody and control of the Delaware Defendants.”

The financial risk is considerable. A qui tam lawsuit such as this one allows for triple damages plus a per violation civil penalty of $5,500 to $11,000. The defendants included 15 retailers, primarily restaurants, a third party gift card company and its affiliates, and a trade association that allegedly promoted the gift card company business. As the action is under Delaware’s qui tam statute, it was filed under seal in June of 2013 and only recently became public. The defendants are only now becoming aware of the suit.

The complaint is definitely worth reading for anyone involved in gift card unclaimed property issues. There are several interesting points to note:

The original plaintiff bringing the suit (the relator) acted as controller and then vice president of client relations for the original gift card company offering the services to the defendants. The business was operated out of the relator’s basement. After the original gift card business was purchased by another company, the relator was a sales and support representative for the business. The relator appears to have kept records of the company’s business arrangements with the retail defendants and now uses those records to bring a law suit against his former employer’s clients.
One of the law firms representing the relator is a well-known political powerhouse in Delaware.
The relator has asked for jury trial of this case.

Important take-away issues: Any company involved in the use of gift cards should take a serious look at this complaint and initiate a review of gift card procedures. This review should include consideration of the following:

If using a gift card company, verify that there is economic substance to the structure. This applies both to the use of third party providers and captive gift card companies. While there are certainly legal arguments regarding the level of economic substance necessary, it is better safe than sorry. Furthermore, for any company relying on a captive gift card company, the risk of a piercing the corporate veil argument (or its equivalent) should be a consideration in how the relationship is structured.
Review and strengthen confidentiality [...]

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Revise Your Tax Matrix: Remote Access of Software Exempt in Michigan and Idaho

by Diann Smith and Stephen P. Kranz | May 6, 2014 | Idaho, Michigan, Nationwide Importance, Sales Tax, Tax Base, Transaction Taxes

A trend is developing in response to aggressive Department of Revenue/Treasury policymaking regarding cloud computing. The courts and legislatures are addressing the issue and concluding that the remote access to software should not be taxed. Here are two recent developments that illustrate the trend:

Michigan – Auto-Owners Insurance Company v. Department of Treasury

On March 20, 2014, the Michigan Court of Claims held in Auto-Owners Insurance Company v. Department of Treasury that certain cloud transactions were not subject to use tax because the transactions were nontaxable services. The State has appealed this decision.

Auto-Owners engaged in transactions with numerous vendors to provide services and products that Auto-Owners used to conduct its business. The court grouped Auto-Owners’ transactions into transactions with six categories of providers: (1) Insurance industry providers; (2) Marketing and advertising providers; (3) Technology and communications providers; (4) Information providers; (5) Payment remittance and processing support providers; and (6) Technology providers. The transactions all involved, on some level, Auto-Owners accessing software through the Internet. No software was downloaded by Auto-Owners.

The Michigan use tax is imposed on the privilege of using tangible personal property in the state. Tangible personal property includes prewritten, non-custom, software that is “delivered by any means.” Mich. Comp. Laws § 205.92b(o). The court held that the transactions were not subject to use tax under the plain language of Michigan’s statute.

First, the court held that use tax did not apply because the court interpreted the “delivered by any means” language from Michigan’s statute to apply to the electronic and physical delivery of software, not the remote access of a third-party provider’s technology infrastructure. Second, the court held that the software was not “used” by Auto-Owners. Auto-Owners did not have control over the software as it only had the “ability to control outcomes by inputting certain data to be analyzed.” Third, the court held that even if prewritten computer software was delivered and used, the use was “merely incidental to the services rendered by the third-party providers and would not subject the overall transactions to use tax.” Michigan case law provides that if a transaction includes the transfer of tangible personal property and non-taxable services, the transaction is not taxable if the transfer of property is incidental to the services.

Practice Note: This decision is encouraging in that the court said that the Department was ignoring the plain meaning of the statute and overreaching, and determined that the legislature must provide specific language extending the sales and use tax for such transactions to be taxable. It is important to note that the Michigan statute uses the phrase “delivered by any means,” and the court focused on the definition of deliver in reaching its decision. This decision will likely have implications for other streamlined sales tax (SST) member states. Auto-Owners Ins. Co. v. Dep’t of Treas., No. 12-000082-MT (Mich. Ct. Cl. Mar. 20, 2014).

Idaho – H.B. 598

On April 4, 2014, Governor Butch Otter signed into law Idaho [...]

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Multistate Tax Commission Appoints Keith Getschel as Director of Joint Audit Program

by Diann Smith and Stephen P. Kranz | May 6, 2014 | Audits, Income Tax, Nationwide Importance, Sales Tax

Beginning June 16, Keith Getschel will succeed Les Koenig as the Director of the Multistate Tax Commission (MTC) Joint Audit Program. Les Koenig is retiring as of July 31. Mr. Getschel comes from the Minnesota Department of Revenue, having held the position of Assistant Commissioner for Business Taxes since 2012. Mr. Getschel has worked in the Minnesota Department of Revenue for over 30 years, holding such positions as Director of Corporate Tax and Assistant Director in the Corporate and Sales Tax Division. He also has experience as a supervisor in the Tax Operations Division, a tax policy manager, a revenue tax specialist in the Amended Returns Unit, and an appeals officer in the Appeals and Legal Services Division.

The MTC Joint Audit Program performs audits on behalf of participating states. The program engages in audits of taxpayers simultaneously across multiple states, conserving state funds and time. Mr. Getschel’s reputation as a tax administrator in the Minnesota Department of Revenue makes him a great fit for this position. He has been viewed as taxpayer friendly and willing to work cooperatively with taxpayers to resolve issues. We hope he continues this trend at the MTC.

Oklahoma Supreme Court KOs the Constitution

by McDermott Will & Emery, Diann Smith and Stephen P. Kranz | May 5, 2014 | Constitutional Issues, Incentives, Income Tax, Nationwide Importance, Oklahoma, Tax Base

On April 22, the Supreme Court of Oklahoma released its opinion in CDR Systems Corp. v. Oklahoma Tax Commission. Case No. 109,886; 2014 OK 31. The Oklahoma Supreme Court, overturning the decision of the Court of Civil Appeals, held that an Oklahoma statute, which grants a deduction for income from gains that result from the sale of all or substantially all of the assets of an “Oklahoma company,” is constitutional under the Commerce Clause. “Oklahoma company” is defined as an entity that has had its primary headquarters in Oklahoma for at least three uninterrupted years prior to the date of the taxable transaction.

In a 5-4 decision, the Oklahoma Supreme Court determined that there was no discrimination against out-of-state commerce. Even if there was discrimination, the Oklahoma Supreme Court held that the statute does not facially discriminate against interstate commerce, does not have a discriminatory purpose and has no discriminatory effect on interstate commerce. The Oklahoma Supreme Court’s reasoning was based in part on the conclusion that the statute treated all taxpayers the same.

In his dissent, Justice Combs reached the opposite conclusion and wrote that the deduction is unconstitutional because the primary headquarters requirement is based upon the level of business a company conducts in Oklahoma, and therefore it discriminates against out-of-state taxpayers. The dissent concluded that the statute effectively creates a tax on taxpayers with an out-of-state headquarters.

Although the majority ably walked through the existing case precedent on these issues, it misunderstood the practical effect of the statute. First, the majority concluded that the statute did not discriminate against any particular market because all markets are treated the same. This conclusion ignores the fact that under the statute, in-state markets are treated differently than out-of-state markets. The majority stated that “[w]ithout any actual or prospective competition in a single market, there is no negative impact on interstate commerce that results from the application of this deduction and no discrimination against interstate commerce . . . .” (Majority Opinion, p. 14). However, there is competition between in-state companies and out-of-state companies, not just in a single market but in all markets.

In reaching this conclusion, the majority relied upon Gen. Motors Corp. v. Tracy, 519 U.S. 278 (1997), which upheld the constitutionality of a tax that discriminated across markets (in other words, the statute benefited an in-state entity not because the entity was in-state but because it was in a different market and sold different products than an out-of-state entity). The dissent specifically took exception to the majority’s reliance on Gen. Motors, for good reason. The Tracy case does not appear to be applicable here, because the in-state and out-of-state entities are competing in the same markets under the Oklahoma statute.

Second, the majority concluded that the statute did not facially discriminate against interstate commerce because “[t]he degree to which the entity generating the gains participated in out-of-state activity, i.e. interstate commerce, is not relevant to whether the entity qualifies for the deduction” (Majority Opinion, p. 17). The [...]

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Best Practices for State Engagement of Private Unclaimed Property Auditors

by Diann Smith and Stephen P. Kranz | Apr 29, 2014 | Delaware, Nationwide Importance, Unclaimed Property

The U.S. Chamber Institute for Legal Reform has released a report detailing current problems with states using private companies for unclaimed property audits and paying those auditors based on the amount recovered. The report begins with an example of what can go wrong when private auditors are paid on a contingent basis. The nightmare story of what many life insurance companies recently experienced is well worth the read by anyone who thinks that because their company has been diligently complying with unclaimed property laws, there can’t be any risk from an audit.

After reviewing the issues, the U.S. Chamber suggests several, eminently achievable, reforms. These reforms include:

Prohibiting contingency fees;
Requiring all state contracts for private audit services to be subject to an open, competitive bidding process;
Requiring all such contracts to be posted on the unclaimed property administrator’s website; and
No delegation of state authority to private contractor on substantive decision-making, such as legal theories.

The report also offers suggestions that states provide voluntary disclosure programs with certain protections for participating holders.

Practice Note: Over a decade ago, several attorneys with McDermott’s SALT practice, while working at the Counsel On State Taxation (COST), drafted a Holder’s Bill of Rights. While Delaware was one of the main proponents of the concept, it did not get any traction in other states. The current negative impression many holders have regarding third-party contingency fee unclaimed property auditors could have been limited, and perhaps prevented, if states had embraced this idea. It is probably time to consider this concept. If third-party auditors offered such a pledge to holders, audits would be far less adversarial and be completed much faster.

MTC State Transfer Pricing Program Looms on the Horizon

by McDermott Will & Emery, Diann Smith and Stephen P. Kranz | Apr 7, 2014 | Nationwide Importance, Transfer Pricing

More formal, rigorous, and perhaps more frequent, state transfer pricing audits appear to be looming on the horizon, as the Multistate Tax Commission (MTC) is set to launch a design and development project tasked with presenting a preliminary draft program by year’s end, with a final program recommendation due by the MTC’s annual meeting in July 2015. The intent would be to create a dedicated MTC program, including staff, that would assist, as well as train, member states (both combined and separate reporting states) in conducting state transfer pricing audits as an alternative to hiring contracted consultants.

Read the full article.

National Conference of State Legislatures to Tackle Key State Tax Policy Questions

by Arthur R. Rosen, Diann Smith, Jane Wells May and Stephen P. Kranz | Mar 7, 2013 | Constitutional Issues, Nationwide Importance, Procedure

The National Conference of State Legislatures’ (NCSL) Executive Committee Task Force on State and Local Taxation has expanded its scope to include all significant tax policy issues facing the states. As part of its expanded scope, the task force has met with industry representatives to identify tax policy topics that would benefit from the task force’s consideration. Companies with a multi-state presence and concern about state tax policy have found participation in task force meetings beneficial to assisting legislator understanding of complex tax issues.

Read the full article.

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