26th Annual Health Sciences Tax Conference

Transcription

1 26th Annual Health Sciences Tax Conference 2016 state tax developments and policy trends impacting health December 5, 2016

2 Disclaimer EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. This presentation is 2016 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are those of the speakers and do not necessarily represent the views of Ernst & Young LLP. This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Page 2

3 Presenters Dave Courtney Ardent Health Services Nashville, Tennessee Steven Wlodychak Ernst & Young LLP Washington, DC Jason Giompoletti Ernst & Young LLP Nashville, TN Page 3

4 Agenda Section 385 debt/equity regulations: state implications Tax the guy behind the tree: state tax haven legislation State transfer pricing developments State implications of federal partnership audit rules Federal pre-emption of certain non-income based state taxes Page 4

5 Section 385 debt/equity regulations: state implications Page 5

6 Key state income tax questions surrounding new rules Will the states conform to the final and temporary regulations? The documentation consolidated group exclusion in Reg (d)(2)(ii)(A)? The re-characterization consolidated group exception in Temp. Reg T(b)(1)? Will the states have powers independent of the IRS to police these rules? Can states make debt-equity determinations that are different from those made by the IRS? Page 6

7 State conformity to Section 385 itself and final regulations generally All states generally conform to Section 385, directly or indirectly, either: By using federal taxable income as the starting point for determining state taxable income (e.g., Illinois) Or By incorporating by specific reference sections of the Internal Revenue Code (e.g., California) Thus, determinations by the IRS under the statute and the final regulations will generally be baked into these states determination of state taxable income. Of course, these are broad generalizations with many variations among the states. Page 7

8 Consolidated group exception under proposed regulations Under the proposed regulations, the key state income tax issue was whether states would strictly conform to the consolidated group exception found in Prop. Reg (e), which reads as follows: Treatment of consolidated groups. For purposes of the regulations under Section 385, all members of a consolidated group (as defined in [Reg.] (h)) are treated as one corporation. This is applied for all purposes of the proposed regulations. The IRS described this as the one-corporation approach. Our State Income Tax practice had concluded, and some state tax officials had suggested, that the consolidated group exception may not have applied for state income tax purposes because: Most states don t follow the US federal consolidated return regulations at all. Even in states that did, the state income tax filing group sometimes doesn t match the federal consolidated group. Practically, related-party debt transactions that were not subject to the debt-equity rules for federal income tax purposes might still have had to comply with all of the Section 385 regulatory requirements for state income tax purposes. Page 8

9 Changes to consolidated group exception under final regulations In the final regulations, Treasury eliminated the consolidated group exception in Prop. Reg (e) but has retained the concept, although in different ways for both the Documentation Rule and the Recharacterization Rule. It hasn t solved the state tax problems. Documentation Rule consolidated group exclusion: Exclude from the crucial term applicable interest (defined in Reg (d)(2)(ii)(A) and which is a foundational element for whether an instrument is an expanded group instrument (EGI)... an intercompany obligation as defined in [Reg.] (g)(2)(ii) or an interest issued by a member of a consolidated group and held by another member of the same consolidated group, but only for the period during which both parties are members of the same consolidated group This means that intercompany debt between members of the same federal consolidated group continues to fall outside the scope of the Documentation Rule (same as before). But, for state income tax purposes: because certain states, whether requiring separate or combined filing methodologies, may not recognize that the definitional exclusion applies to applicable instruments. Page 9

10 Changes to consolidated group exception under temporary regulations Recharacterization Rule exception Modified and narrowly applies only to the Recharacterization Rule and is now set forth in Temp. Reg T. Temp. Reg T(b)(1) (applicable only to the Recharacterization Rule): All members of a consolidated group (as defined in [Reg.] (h)) that file (or that are required to file) a consolidated US federal income tax return are treated as one corporation [added language emphasized] In a preamble, Treasury said that this modification was made in response to a specific request by a commenter of the US state income tax implications of the proposed regulations: The comment suggested that this concern could be mitigated in states that adhere to the literal language of the section 385 regulations by modifying [Prop. Reg.] (e) to [add the new language]. The temporary regulations adopt this recommendation. We think there remains great uncertainty as to how US states will treat intercompany debt under these rules. Instruments excluded for US federal income tax purposes could still be subject to the rules for US state income tax purposes, particularly in states that: Don t align with the US federal consolidated filing group Or Don t follow the US federal consolidated return regulations Page 10

11 Taxpayer considerations in response to state income tax risks Impacted taxpayers should consider the following: No state taxing authority has yet issued any official guidance on how they intend to apply these debt-equity rules. It may be years before taxpayers find out, they may not know until they are audited or they may never know with any high degree of certainty. Still, states could simply conform to IRS Section 385 determinations for ease of administration. But states likely have authority and could attempt to apply these new rules independently because: State filing groups are different from the federal groups Or They find related-party debt arrangements troubling from a state perspective. Taxpayer s bottom line: State recharacterization of related-party stock as debt may not have the same exceptions or exclusions. Page 11

12 What should state taxpayers do? 1. Documentation Start the process of complying with Reg documentation requirements for all related-party instruments they want treated as debt even if excluded for federal tax purposes. For multistate businesses, to work to the lowest common denominator, consider the most aggressive state. 2. Tainted transactions Avoid all tainted transactions structures even if excluded because of consolidated group exception under the Recharacterization Rule. Assume Reg and Temp. Reg T and T apply. 3. Co-obligor (Even if they don t for federal income tax purposes) Make more domestic entities co-obligated on third-party debt to reduce reliance on intercompany debt (which, after all, is the primary focus of the Section 385 regs.). 4. Intercompany account cleanup Clean up intercompany balances among members of the federal consolidated group through properly structured and sequenced netting, contributions, distributions and payoffs. Page 12

13 State income tax implications of proposed regulations So what if the states don t conform to the consolidated group exception and enforce Section 385 regulations separately? What s the problem? 1. Main target denial of interest deductions for related-party debt But the states already do that: Separate return states require add-back of related-party interest expenses Combined reporting states forced combination, elimination of relatedparty interest expenses 2. Collateral damage disruption of subsidiary ownership interests 3. Collateral damage disparate state determinations of part debt/part equity of the same instrument! Result? Chaos in federal and state taxation of transactions Page 13

14 State income tax implications of proposed regulations Example Facts: Corp. Parent is publicly traded and files a consolidated federal income tax return with three corporate subsidiaries (100% owned). Corp. Sub 2 converts to a disregarded limited liability company (DRE). Relevant states follow the proposed regulations but do not follow the consolidated group exception (Reg (e)). Corp. Sub 3 fails to timely satisfy Section 385 documentation requirements on its intercompany loan to Corp. Sub 2. Results: Converts to a limited liability company Corp. Sub 1 Corp. Sub 2 Corp. Parent Corp. Sub 3 Intercompany loan For federal income tax purposes, the conversion transaction is tax-free under Sections 332 and 337. Why? Sec. 385 debt documentation not required consolidated group exception applies. For state income tax purposes: The intercompany loan is automatically re-characterized as stock in the hands of Corp. Sub 3 treated as 25% ownership interest in Corp. Sub 2. Corp. Sub 1 s ownership of Corp. Sub 2 falls below 80%; aggregate stock ownership rules of Treas. Reg don t apply. Limited liability company (LLC) conversion transaction does not qualify as tax-free subsidiary liquidation under Sections 332 and 337. Instead, it is treated as a taxable liquidation under Sections 331 and 336. Corp. Sub 2 is now a partnership (not a DRE) for state tax purposes only. Page 14

15 State income tax implications of proposed regulations Some of the consequences for lack of state conformity to IRS Section 385 determinations are: DREs become partnerships for state (but not federal). State dividends-received deductions (DRDs) might not apply. Tax-free ownership tests fail (below 80% ownership). States don t follow Treas. Reg aggregation rule. Fail Internal Revenue Code (IRC) tax-free provisions for state (but not federal) income tax purposes: 332 (sub-liquidations) 351 (contributions) 355 (spins) 368 (reorgs) Page 15

16 State income tax implications of proposed regulations Some of the consequences of lack of state conformity to IRS Section 385 determinations: They fail to qualify for exceptions to state s related-party interest expense add-back statute. Will states choose to use the blunt(er) Section 385 debt reclassification rules instead of the add-back statutes? Do the add-back statutes effectively become obsolete? States could come up with different determinations of part debt/part equity for related-party instruments. Federal 80/20 debt California we think it s 50/50 New Jersey no it s 30/70 and on, and on Every state s analysis will be different! (Gannett case in Maryland) Page 16

17 State income tax implications of proposed regulations Practical recommendation? Clint Eastwood as Dirty Harry This is a.44 caliber Magnum, the most powerful handgun in the world you have to ask yourself, Do I feel lucky? Failure to comply with Section 385 regulations is a powerful problem need to comply with the lowest common denominator most aggressive state Not that compliance is easy, but at least on documentation and compliance under Prop. Reg , perhaps applying same rigor of compliance to international transactions should be followed merely to satisfy a potential state problem. Regs likely to be challenged both legislatively and judicially. Maybe it s worth the wait? Do you feel lucky? Page 17

18 Tax the guy behind the tree: state tax haven legislation Page 18

19 State legislation targeting tax havens States requiring inclusion of tax haven subsidiaries in states combined reports Montana started the trend in 2004 First question: What s a tax haven? Two methods 1. Blacklist (derived from old Organisation for Economic Cooperation and Development (OECD) tax havens list) Examples: Montana, Oregon 2. Definitional Includes not only the usual suspects (e.g., Bermuda, Cayman Islands, Isle of Man, Luxembourg) but also Ireland, Switzerland, the Netherlands Jurisdiction s tax rate is lower than state s Examples: Alaska, Connecticut, District of Columbia (after repeal of blacklist), Rhode Island, West Virginia Page 19

20 Tax haven state enactment status, with recent proposals Enacted tax haven provisions Tax haven blacklist included or required in enacted legislation 2015 proposals WA OR ID MT WY ND SD MN WI MI NY VT NH CT ME MA RI CA NV UT CO NE KS IA MO IL IN OH KY WV PA MD VA CT NJ AK AZ NM TX OK AR LA MS TN AL GA NC SC DE DC HI FL Little-known fact: California considered tax haven legislation in 2010, but after much lobbying by the U.S. State Department and foreign ambassadors from affected countries (e.g., Ireland and the Netherlands), the effort was dropped. Page 20

21 Tax haven legislation: arguments for and against Arguments for tax haven legislation $20 billion in state tax revenue loss multinational corporations (MNCs) hide profits in island economies. Big business does not pay its fair share. Small business disadvantaged, unable to use tax haven loophole. Arguments against tax haven legislation Is it even constitutional? Japan Line, Ltd. v. County of Los Angeles US S. Ct. (1979) US must speak with one voice in international relations. Tax haven blacklisting is arbitrary. Can t prove its $20 billion in state tax losses. States are adopting a go-it-alone approach, which is out of sync with the rest of the international community. OECD Base Erosion and Profit Shifting (BEPS) rejects approach of naming tax havens which these states want to follow! Page 21

22 State transfer pricing developments Page 22

23 Multistate Tax Commission s (MTC) transfer pricing program Arm s-length Adjustment Services (ALAS) program Renamed State Intercompany Transaction Advisory Service Committee (SITASC) Originally, minimum commitment of 10 states required for economic viability Five states have formally committed (AL, IA, NJ, NC and PA). KY was in, and now it is out. Some states have expressed strong interest (GA, IN, KY, MN and OR). Early implementation steps: training, information exchange and case discussion Early activity steps can be taken without having to formally launch the program. Case discussion is an interstate discussion of pending taxpayers cases involving important arm s-length issues. Case discussions may help the states understand the challenges they face, different practices of each state and remedies employed by each state. Page 23

24 MTC ALAS timetable January June 2015 July 2015 June 2017 Developmental stage Recruiting states to join ALAS Further recruitment of states; finalizing service design; staff recruitment; information exchange; training; audits and voluntary disclosure period to occur during this period July 2017 June 2018 Full operational stage Prelaunch stage activities conducted on a regular and routine basis MTC revenue claims: $20 billion in state tax revenue lost annually to transfer pricing. MTC anticipates ALAS provides 14-to-1 return on investment for participating states. Page 24

25 Embedded intangibles and transfer pricing States are becoming more aggressive in asserting transfer pricing on embedded intangibles on intercompany transactions. CT, MA (on audit) Audit target is foreign-us supply chain structures. State position: Portion of price paid by US company to foreign affiliate in the supply chain structure is a royalty, subject to state add-back rules. States conduct their own transfer pricing studies. Typically, this is no more than aggregating information from across industries to determine the appropriate amount of royalty to be added back. Where could this go next? States with specific add-back provisions (e.g., GA, NC, NJ, VA) Page 25

26 What should taxpayers do about transfer pricing? Before the audit starts: Make sure transfer pricing is aligned with business Value drivers Substance Document arm s-length nature of transfer prices Create and follow intercompany agreements After the audit starts: If arm s-length nature of transfer prices is not already documented, do so! Evaluate whether proposed adjustment is based on transfer pricing principles Perform cost-benefit analysis on audit defense efforts Page 26

27 State implications of federal partnership audit rules Page 27

28 IRS partnership audit reform HR 1314 Bipartisan Budget Act of 2015 (P.L signed by President Obama on Nov. 2, 2015) Includes federal partnership audit reform Generally applies to partnership taxable years beginning after December 31, 2017 (2018 tax year first audits 2020(?)) Confusing, complex body of law imposing administrative burdens for the IRS and for taxpayers. Amendments are intended to streamline and simplify the partnership audit rules, and raise over $9.3b in revenue without raising tax rates. Why was this necessary? In 2012, the IRS audited 0.8% of large partnerships, but 27% of large C corporations. No change rate for audits closed in 2012: 42% for partnerships; 66.7% for large partnerships 29% for C corporations; 27.2% for large corporations Oh, and $9.3b of revenue (without raising taxes)! Page 28

29 IRS exam and adjustment rates by entity type Figure 5: Fiscal year 2012 examination and adjustment rates for different types of tax returns Source: U.S. Government Accountability Office, Partnerships and S corporations: IRS Needs to Improve Information to Address Tax Noncompliance (May 2014) (available on the Internet at (last accessed Mar. 22, 2016)) Page 29

30 IRS returns by entity type Figure 4: Number of returns by form of business, tax years 2002 to 2011 Source: U.S. Government Accountability Office, Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency (Sept. 2014) (GAO ) available on the internet at (last accessed Mar. 22, 2016)) Page 30

31 Growth of large partnerships Table 16: Number of large partnerships by industry group, tax years 2002 to 2011 Tax year Industry group Mining Manufacturing, transportation and warehousing Transportation and warehousing Finance and insurance Real estate, rental and leasing Professional, scientific and technical services ,799 2,195 2,715 3,190 4,731 5,707 5,530 6,124 5,955 7, ,081 1,275 1,486 1,401 1,287 1, Holding companies Other Source: GAO analysis of IRS data from the Enhanced Large Partnership Indicator (ELPI) File and Business Returns Transaction File, Compliance Data Warehouse. I GAO Page 31

32 IRS partnership audit reform Major changes IRS can collect tax and penalties and interest due at the entity level for all partnerships (unless an election to opt out of centralized system is made). Not just widely held partnerships like hedge funds and publicly traded partnerships unless the partnership is eligible and timely elects out Elections 1. Election out for partnerships with 100 or fewer partners and none of the partners are themselves partnerships, single member LLCs, trusts or tax-exempt organizations: Tiered partnerships can t opt out Although the IRS, by regulation, is authorized to allow S corporations and other pass-through entities to qualify as eligible partners for purposes of this opt-out election if certain additional information disclosures for the beneficial partners are provided. 2. Election to have any imputed underpayment assigned to each reviewed-year partner Must furnish a statement of the partner s share of the adjustments (similar to Schedule K-1) and each such reviewed year partner increases its tax for the year the statement is furnished In both cases, elections are the partnership s, not the partners. Page 32

33 IRS partnership audit reform Major changes So far, partners of opt-out partnerships will be audited at the partner level: Back to the future of the pre-tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) partnership audit rules/tefra rules repealed Designated tax matters partner (now known as the Partnership Representative ) has sole authority to bind the partnership, and any tax bill is responsibility of current year partners, unless push out election No joint and several liability for taxes (differs from prior proposals) Problems? But, may be for interest and penalties (perceived glitch in the law) Intergenerational partner problems because of default IRS assessment at partnership level Current partners paying for prior partners tax liability and tax-exempt partners paying for taxable partners liability. Somebody will not be happy with the Partnership Representative Expect significant revisions to partnership agreements and LLC management agreements, and technical corrections bill and, of course, new regulations Page 33

34 State conformity to IRS partnership audit reform So will the states conform? Not automatically: Most states conform to the IRC but only for the determination of taxable income, not for its administrative procedures: This bill primarily amends IRC Secs to 6241 (administrative procedures). States usually have their own administrative procedures independent of the IRC. Only one has published a partnership audit manual California FTB and that only addresses federal taxation of partnerships. Information sharing between IRS and states means potential for more state audits. But what will the states do with (and are they prepared to deal with) that information? Page 34

35 Procedural issues Statutes of limitation and notices to partners Start date of audit (as it relates to each partner) Adjustments that affect one partner Adjustments that affect multiple partners Adjustments that affect past years or future years Adjustments resulting in refunds Who represents the partnership with respect to appealing or settling issues Penalties and interest Collection of liabilities Page 35

36 State conformity to IRS partnership audit reform Questions for the states Do states even have statutory authority to audit (and would they want to audit) partnership returns based on presence of resident partner in state? Dilution of partnership income not only by number of partners but also because of apportionment makes collectible amounts really small. Will states change their composite return rules? Unfair treatment of nonresident taxpayers to benefit of resident taxpayers? What about completely opening up a discussion about state approaches to taxation of partnerships entirely? 50 states, 50 different rules variety of state approaches makes compliance, let alone auditing, extremely difficult. Page 36

37 Federal pre-emption of certain non-incomebased state taxes Page 37

38 What is federal pre-emption? Federal pre-emption federal law supersedes state law as a basic legal principle The Supremacy Clause of the U.S. Constitution provides that the Constitution and the laws of the United States are the supreme laws of the land, and the states shall be bound by them: U.S. Const. art. VI, cl. 2. Federal laws pre-empt state laws by express language in a Congressional enactment, by implication when the U.S. Congress dominated the legislative field, or by implication when there is a conflict between state and federal law: U.S. v. State of West Virginia 238 F. Supp. 2d 751 at 756 (4th Cir. 2002). Under the Supremacy Clause of the U.S. Constitution, a state law that interferes with or is contrary to federal law is without effect : Cipollone v. Liggett Group, Inc., 505 U.S. 504, 516 (1992). Page 38

39 Federal pre-emption from a tax perspective Federal Employees Health Benefits Act (FEHBA) The FEHB program provides health care for civilian employees of the federal government, their dependents and federal retirees. 5 U.S.C. 8909(f) provides the following: (1) no tax, fee, or other monetary payment may be imposed, directly or indirectly, on a carrier or an underwriting or plan administration subcontractor of an approved health benefits plan by any State or other governmental authority thereof, with respect to any payment made from the Fund. (2) except on net income or profit from business conducted under this chapter, if that tax, fee, or payment is applicable to a broad range of business activity. Page 39

40 Federal pre-emption from a tax perspective Civilian Health and Medical Program of the Uniformed Services (CHAMPUS)/TRICARE receipts TRICARE provides health care insurance for active and retired military personnel and their dependents. TRICARE is under the Department of Defense for administration purposes. Medicare Advantage and Medicare Part D receipts Medicare Advantage and Medicare Part D (prescription drug benefit under Medicare) are health care insurance programs where the federal government pays an insurance company to take over coverage for a Medicare-eligible individual. The insurance company provides coverage for the individual while stepping into the role of Medicare for health care coverage issues. Page 40

41 Federal pre-emption cases Federal and state court holdings in support of federal pre-emption: Travelers Ins. Co. v. Cuomo, 14 F.3d 708 (Second Cir. 1993) Health Maintenance Organization of New Jersey, Inc. v. Whitman, 72 F.3rd 1123 (Third Cir. 1995) HealthPartners, Inc. v. Commissioner of Revenue, 1999 Minn. Tax LEXIS 6 (Minn. T.C., 1999) Federal agency rulings OPM (Office of Personnel Management) carrier letters all favorable U.S. Court of Appeals Fourth Circuit against pre-emption: United States v. West Virginia, 339 F.3d 212, 218 (2003) Page 41

42 What does it mean? Federal pre-emption may create an opportunity to the extent that certain receipts from federal funds (e.g., FEHBA, TRICARE, Medicare Advantage and Medicare Part D) are subject to non-income-based state taxes. Provider taxes 49 states impose at least one type of provider tax. Provider taxes are imposed on for-profits and not-for-profits. Gross receipts taxes For example, Ohio Commercial Activity Tax (CAT), Washington Business and Occupation Tax (B&O) Other Page 42

43 Questions? Page 43

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