Broadband Tax Institute Annual Conference October 17, State Income Tax Controversy Breakout Session

Transcription

1 Broadband Tax Institute Annual Conference October 17, 2017 State Income Tax Controversy Breakout Session

2 Speaker Biographies Michele Borens, Partner, Eversheds Sutherland LLP Michele Borens is a partner in Eversheds Sutherland s Washington DC office. She is member of their state and local tax practice. Michele has over 20 years of experience in advising clients on state and local tax issues. Many of her client are impacted by taxation in the digital economy. She advises them on nexus issues, sales taxability, tax policy issues, legislative developments and financial statement reserve issues. She also defends them in litigation regarding state income and sales tax assessments. She speaks at numerous conferences and has published several articles on state and local tax matters. Before joining the firm, Michele practiced with PricewaterhouseCoopers LLP in their State and Local Tax Services group. Her practice included advising clients on state and local tax issues associated with corporate reorganization and restructuring, negotiating and securing state credits and incentives, and advising on state tax refund and planning opportunities. Her clients operated in numerous industries including construction, biotechnology, government contracting, health care, law and hospitality. 2

3 Speaker Biographies Brian Goldstein, Principal, PricewaterhouseCoopers LLP Brian Goldstein is a principal in PwC s State and Local Tax practice in New York. Brian has almost 30 years of broad tax experience helping emerging growth and Fortune 500 companies tackle their complex state and local tax issues by coupling technical knowledge with practical know-how. Brian is Lead Partner in charge of State and Local Tax services to the Communications Industry and was formerly PwC s National Leader of its US Indirect Tax practice. He assists clients with complex state and local tax issues, including nexus determinations, sourcing, compliance, planning, and controversy matters. Brian is a frequent speaker on tax issues affecting the Communications Industry, the evolution of new technology, the globalization of Indirect Taxation, the Internet Tax Freedom Act and the Marketplace Tax Fairness Act. 3

4 Speaker Biographies Kenneth Jewell, Partner, Deloitte LLP Ken Jewell is a Managing Director in the Washington National Tax practice of Deloitte Tax, LLP and is a member of the Firm s Technology, Media and Telecommunications Industry Practice. Based in Parsippany New Jersey, his practice includes advising companies on the state tax implications of corporate mergers, acquisitions, divestitures, and restructurings; the state tax implications of various business models and contractual relationships; matters of apportionment and filing methodologies; and providing audit representation. He also serves as co-leader of the firms New York Tax Desk program where he advises clients on the proper application of New York tax laws, as well as advising on controversy matters. Mr. Jewell is a co-author of BNA Portfolio #2205 New York State Corporate Income Taxes and has coauthored two recent articles for BNA addressing New York taxes: Proposed New York Tax Reform: Setting the Stage for New Legislation and New York State Corporate Tax Reform of Ken is a frequent speaker at multistate tax conferences including COST, TEI and the Multistate Tax Symposium. Ken holds a Masters of Laws (taxation) from the Boston University School of Law, a Juris Doctor for the DePaul College of Law, where he served as Editor-in-Chief of the DePaul Business Law Journal, and a Bachelors of Arts from the University of Hartford. Mr. Jewell is a member of the New York State Bar. 4

5 Speaker Biographies Mario Manniello, Executive Director, Verizon Communications Inc. Mario Manniello is an Executive Director of Income and Transaction Taxes at Verizon Communications Inc. He is responsible for managing all domestic audits in both the income and transaction tax areas. Mario received a Master s of Science Degree in Taxation from Seton Hall University and a Bachelor of Science Degree in Accounting from Rutgers University. Mario has over 20 years of experience in tax in both public accounting and private industry. He has over 10 years of experience in the telecommunications industry, working for AT&T before coming to Verizon. Additionally, he has spent a couple of years working in manufacturing for Pepsi Bottling Group Inc. He has spent a significant part of his career managing compliance, accounting for income tax, federal and state audits, and income and transaction tax planning. 5

6 Speaker Biographies Michael Wall, Vice President of Tax, Sprint Corporation Michael Wall is the Vice President of Tax at Sprint Corporation. He has overall responsibility for all of Sprint Corporation s tax matters. Michael received a Master s of Science Degree in Taxation and a Bachelor of Science Degree in Accountancy from DePaul University. Michael has over 28 years tax experience spanning diverse industries including telecommunications, industrial products, and public accounting. Michael has spent a significant part of his career managing global tax functions for large multinational corporations covering a variety of tax areas including direct and indirect tax compliance, U.S. and international tax planning, tax accounting, transfer pricing, audit defense, corporate restructurings, and tax lobbying. 6

7 Learning Objectives After attending this session, participants will be able to: Economic Nexus and Cost of Performance Apportionment Understand the differences between economic nexus for state income taxes and for sales and use taxes. Describe new developments in state tax nexus laws. Explain the use of the cost of performance method of apportionment, particularly with respect to taxpayers in the communications industry. Captive Structures Understand the Federal and state income tax requirements for captive insurance companies Describe state tax audit issues and current tax controversies for captive arrangements Explain the use of captive leasing companies and the sales and use tax implications 7

8 Learning Objectives After attending this session, participants will be able to: Current Audit Trends and Cases Understand the focus of state auditors in recent state income tax audits. Describe the states authority and theories for these positions and assertions. Describe how to best address or defend these issues Understand how these issues are being resolved or litigated by taxpayers. 8

9 Economic Nexus and Cost of Performance Apportionment 9

10 Economic Nexus - Overview For sales and use tax purposes, economic nexus is newly developing, as states grow increasingly frustrated with Quill. For state income/franchise taxes, economic nexus has been espoused by states for a long time. Several state courts have held that physical presence was not required for a state to impose income tax obligation on the taxpayer In Geoffrey, Inc., South Carolina Supreme Court upheld a tax upon corporation with no presence in State, whose sole connection was the licensing of intellectual property (the Toys R Us brand) to in-state affiliates. In MBNA America Bank, the Supreme Court of West Virginia held that taxpayer with no physical presence had substantial nexus with the State by way of licensing consumer credit cards to in-state users. 10

11 Economic Nexus Income/Franchise Tax Target Brands, Inc. v. Department of Revenue of the State of Colorado, District Court, City and County of Denver, No. 2015CV33831 (1/27/17) In January, 2017, a Colorado trial court found unreasonable an alternative apportionment formula imposed by the Department of Revenue, which required an intangible property company (which was determined to have nexus) to apportion its income based on the sales factor of its parent company. The trial court found that this alternative method was unreasonable because it failed to consider the significant contributions made by the intangible property company s payroll and property outside Colorado to the value the Department sought to tax. Accordingly, for the taxpayer in this case, the court found that any alternative apportionment formula must include the intangible property company s property and payroll. The ultimate decision did not arrive at an accepted apportionment formula for the company. This decision appears to be the first published court decision that affirms the imposition of Colorado s corporate income tax based on a taxpayer s economic nexus with the state. 11

12 Economic Nexus Ohio Commercial Activities Tax (CAT) Crutchfield Corp. v. Testa The Ohio Supreme Court held the state's commercial activity tax (CAT) economic threshold created substantial nexus for an online retailer. On appeal from a 2015 Board of Tax Appeals (BTA) decision, the Court ruled that physical presence is not a necessary condition for imposing the CAT because the statutory $500,000 sales-receipts threshold is an adequate quantitative standard that satisfies the dormant Commerce Clause s substantial nexus requirement. The Court also ruled that the burdens imposed by the CAT on interstate commerce are not clearly excessive in relation to fair taxation for both in-state and out-of-state sellers. Petition for certiorari to US Supreme Court is likely, and if granted, could be an avenue for the Court to consider overturning or abrogating Quill. 12

13 Economic Nexus Sales and Use Taxes In 1992 decision Quill Corp. v. North Dakota, the US Supreme Court held that a state can only impose a sales and use tax collection responsibility upon a business with physical presence within the state. States are increasingly frustrated with Quill. Several states have openly declared war with Quill, and have responded by establishing economic nexus standard for sales and use taxes. Alabama South Dakota Vermont States have taken different approaches, some by passing legislation (i.e., South Dakota), while others establish remote seller nexus via promulgating administrative regulations (i.e., Alabama, Tennessee). 13

14 Economic nexus sales and use tax WA OR MT ND MN VT NH ME ID WY SD WI MI NY MA CT RI CA NV UT CO NE KS IA MO IL IN OH KY WV PA VA NJ DE MD DC NC AZ NM OK AR TN SC AK MS AL GA TX LA HI FL Economic nexus enacted Economic nexus proposals in 2017 (TN carried over from 2016) No economic nexus threshold 14

15 Economic Nexus sales and use tax Alabama Remote sellers begin collecting in Alabama At a panel held August 4, 2016 for the Advanced State and Local Tax Institute at the Georgetown University Law Center, Alabama Revenue Commissioner Julie Magee said that 52 remote retailers, including Amazon.com Inc. and Overstock.com Inc., have joined the state's voluntary remittance program. The program imposes a flat 8% tax rate, however, vendors can keep 2% as compensation for collecting and remitting the tax. Magee reported that Alabama's new digital sales tax regime has pulled in approximately 80% of the state's online sales. 15

16 Economic Nexus sales and use tax Remote Seller Nexus Challenge - Alabama On June 8, 2016, an Internet retailer filed a notice of appeal with the Alabama tax tribunal, challenging the state s new economic nexus regulation. The retailer, Newegg Inc., does not have any physical presence in Alabama, nor does it make any sales within the state. All of Newegg's sales are interstate sales with orders received, processed, and filled from locations outside of Alabama. In the notice of appeal, Newegg argued that it does not have the necessary physical presence in Alabama required to satisfy the substantial nexus standard for sales and use taxes under the Commerce Clause of the US Constitution and the Department's attempt to apply the economic nexus regulation against Newegg is unconstitutional. Alabama filed an answer to the appeal on August 26, 2016, stating that Quill is no longer workable in today's national economy and has significant shortcomings in practice. The parties are currently involved in discovery proceedings before the Alabama Tax Tribunal. 16

17 Economic Nexus sales and use tax Tennessee The Tennessee Department of Revenue adopted an economic nexus regulation targeting outof-state retailers with substantial sales in the state. Effective January 1, 2017, the new regulation provides that substantial nexus will be established in Tennessee for out-of-state dealers who engage in regular or systematic solicitation of consumers in Tennessee through any means and who make sales exceeding $500,000 to consumers in Tennessee during the previous twelve-month period. Dealers who meet this threshold are required to register with the Department of Revenue by March 1, 2017, and to collect and remit sales and use tax by July 1, (Please note that this rule must be adopted as part of the omnibus bill in early 2017 for it to take effect.) In Feb. 2017, NetChoice and American Catalog Mailers Association filed an administrative challenge to Tennessee s regulation. 17

18 Allocation and Apportionment Nationwide Trends Apportionment Trends - Shift in factor weighting - Sales factor Gross versus net Market sourcing versus cost of performance approach - Use of discretionary authority to adjust formula (UDIPTA Sec. 18) 18

19 Cost of Performance Sourcing - The Historical Approach The General Rule: Sales, other than sales of tangible personal property, are in this State if: (a) the income-producing activity is performed in this State; or (b) the income-producing activity is performed both in and outside this State and a greater proportion of the income-producing activity is performed in this State than in any other State, based on costs of performance (UDITPA, Article IV, Section 17) Costs of Performance defined No bright line test Taxpayer s costs as determined in a manner consistent with GAAP or the taxpayer s trade or business Common costs include wages, taxes, interest, depreciation, costs of materials consumed, etc. Direct costs versus indirect costs 19

20 Market-based sourcing A number of states have changed their sales factor sourcing rules, shifting from a cost of performance approach to adopt market-based sourcing regimes for services and intangibles receipts. Rationale for the shift includes: The difficulty of sourcing receipts from non-tangible property; Administrative burden on all parties to determine cost of performance components; Aimed at attributing revenue to the state-based market (i.e., state) that contributes to taxpayer's income; and Market-based approach is typically favored by in-state business community, generally in connection with a statutory apportionment shift that emphasizes the state s sales factor. 20

21 Cost of Performance vs. Market-Based Sourcing WA OR*** ID MT*** WY ND SD MN WI MI NY VT NH MA CT ME RI CA* NV UT CO## NE KS IA IL IN OH KY WV PA# MD VA NJ DE DC AZ** NM OK AR TN NC SC AK MS AL GA HI TX LA FL Market-based state Cost of Performance state *Effective in 2011, for taxpayers that elect single sales factor only, but see Prop. 39 **Elective for deemed multistate service providers ***Oregon and Montana effective in taxpayers that elect single sales factor #service receipts only effective in 2014 ## intangible property receipts only 21

22 MTC Regulations Amendments to UDITPA On February 24, 2017, the Multistate Tax Commission voted to adopt a new receipts sourcing methodology to provide that receipts, other than receipts from the sales of tangible personal property, are sourced to a state if and to the extent the taxpayer s market for sales is in the state. Partially based on the Massachusetts market sourcing regulations, the MTC regulations establish uniform rules for: determining whether and to what extent the market for a sale is in the state; reasonably approximating the state or states of assignment when the state or states cannot be determined; and excluding receipts from the apportionment factor when the state or states of assignment cannot be determined or reasonably approximated or where the taxpayer is not taxable in the state to which the receipts are assigned. Approval of the Resolution represents the final step in the MTC s process to update the regulations to reflect amendments to Uniform Division of Income for Tax Purposes Act (UDITPA) in the Multistate Tax Compact (Compact) Article IV. Now that the MTC has adopted the Amendments, Compact member states may choose to adopt the amended regulations. 22

23 South Carolina Court of Appeals DIRECTV, Inc. & Subsidiaries v. South Carolina Department of Revenue (8/30/2017) South Carolina Court of Appeals affirmed the decision of Administrative Law Court, that the primary income-producing activity of a satellite video provider includes customer subscriptions and delivery of a signal into customers homes. As a result, all of the subscription receipts from South Carolina customers were sourced to the numerator of the gross receipts ratio. Taxpayer failed to show that incidental services such as collecting programming content and beaming signals to satellites influenced customer decisions to purchase its services. The court reaffirmed South Carolina s position that it does not adopt a cost-of-performance sourcing methodology. Rather, it applies a flexible income-producing activity standard. This decision continues a trend involving states with an income-producing activity or costof-performance sourcing statute arriving at a market-based conclusion by focusing on the final act provided to a customer and minimizing the impact of other substantial activities necessary to deliver the service. 23

24 Oregon Tax Court Apollo Education Group, Inc. and Subs. v. Ore. Dept. of Rev., No. TC-MD C (Ore. Tax Ct., Magistrate Div., Aug. 24, 2017). Apollo Education Group is parent company of University of Phoenix. The Oregon Tax Court upheld Department s assignment of revenue, holding that Apollo s receipts from online courses, for purposes of calculating the Oregon sales factor numerator, were calculated using only faculty cost data for the periods ending in 2009 and The Court found that, under the state's cost-of-performance sourcing method, the "incomeproducing activity" of providing online course sections was comprised of faculty, curriculum development and ecampus activities, but only faculty costs were "direct costs. The Tax Court concluded that the taxpayer s costs incurred in (1) developing and maintaining its software platform and (2) developing and reviewing course materials were not incremental direct costs incurred in providing educational services and, therefore, were not includable in the taxpayer s costs of performance calculation 24

25 Tennessee State Supreme Court Vodafone Americas Holdings, Inc. v. Roberts, Tenn. Sup. Court, No. M SC-R11-CV (3/23/16) On March 23, 2016, the Tennessee Supreme Court upheld the Tennessee Commissioner of Revenue s discretion to use an alternative method of apportionment based on the determination that the statutory cost of performance method did not fairly represent the extent of the taxpayer s business activity in the state. Additionally, the court held that the method employed by the Commissioner, which was similar to a market-based approach, satisfied regulatory standards for the imposition of alternative apportionment. 25

26 Indiana Letter of Findings No , Indiana Department of Revenue (11/30/2016) Indiana Department of Revenue ruled that an advertising service provider was entitled to apportion income received from delivering advertising to Indiana recipients on a cost of performance basis. Cost of performance is the default methodology used for apportionment of income, unless its results do not accurately reflect the division of income. Indiana statutes clarify that situations where cost of performance is not allowed will arise only in limited and unusual circumstances. The taxpayer disagreed with the audit's results, stating that the overwhelming cost of preparing advertising materials for delivery into Indiana occur in another state. The taxpayer did not believe that the results from the use of the cost of performance basis resulted in an unequitable division of income, nor were there any unusual circumstances that warranted a different apportionment methodology. The Department sustained the taxpayer s protest, summarily concluding that an apportionment of Indiana income based on the cost of rendering its mailing services fairly reflects that income. 26

27 Louisiana Court of Appeal Quest Diagnostics Clinical Laboratories, Inc. v. Barfield, La. 1st Cir. Ct of App., No CA 0926 (9/9/16) The Louisiana First Circuit Court of Appeal ruled a taxpayer that does not satisfy requirements for special apportionment as a service business nevertheless apportions service revenue based on the location of where the service was performed (which is consistent with service business apportionment) rather than to the location of the customer, as advocated by the Department. This decision remains relevant for tax years before Effective for tax years beginning on or after January 1, 2016, (1) single sales factor apportionment is applicable for most taxpayers, including service providers; and (2) service income is sourced to the state where the service is delivered. 27

28 Maryland Circuit Court Petition of Staples Inc. and Staples the Office Superstore, LLC, and the Decision of the Maryland Tax Court; Anne Arundel County Circuit Court, No. C-02-CV (12/30/16) The Circuit Court also upheld the tax court s decision allowing the Comptroller of Maryland to apply an alternative apportionment formula. The court found that out-of-state entities failed to carry their burden of proving that the Comptroller s non-statutory formula produced a tax liability out of all appropriate proportion to the business transacted in Maryland or led to a grossly distorted result. The method applied by the Comptroller is described as captur[ing] the royalty and interest expenses of [Maryland Affiliates] that simultaneously constituted the income of [Petitioners]. The Circuit Court reasoned that Petitioners offered little proof demonstrating that the Comptroller s formula which it had wide latitude to apply - produced a disproportionate, distorted, arbitrary, or unreasonable tax liability 28

29 Captive Structures 29

30 Captive Insurance Federal Income Tax Requirements Federal Income Tax Requirements State Insurance License Risk Shifting -- risk of loss transferred from the insured to the insurer Risk Distribution diversification (number of insured parties) Greater than 50% of the captives revenue must be insurance premiums Where these requirements are met, the payment of an insurance premium to the captive will generally generate a deduction per IRC section 162 and the captive will generally have income inclusion pre consolidation. Qualifying as an insurance company for federal income tax purposes should be viewed as foundational for state tax purposes due to general IRC conformity to define the starting point to compute state taxable income No state income tax modification to federal taxable income for payments to a captive that are not insurance premiums under the Internal Revenue Code 30

31 Captive Insurance State Tax Audit Issues Federal deduction for the premiums paid to the captive Recent Administrative law case in New York Inclusion of captives in a unitary combined return Loan-back of insurance premiums to insured (unsecured loans) Credit diversification or lack thereof Interest expense deduction on the loans from the captive Discretionary authority to adjust items of income and deduction State insurance law requirements and audits (adequate capitalization) State False Claims Act New York Pending case raises issues of ability to pay claims, transfer pricing and circular flow of funds Captive is alleged to have loaned back its premium revenue to the insured parties on an unsecured basis, generating a second deduction for interest paid 31

32 Captive Leasing (Sales and Use Tax) Legal form - choice of entity to mitigate income tax impacts Limited Liability Company s and Partnerships Business Substance (people, facilities, systems) Economic Substance (lease rate, residual value calculations) Transfer pricing Retailer/retailer engaged in business (profit element) Validity of resale exemption certificate issued to vendors Deferral vs principal tax reduction Wild card ASC 842 new lease accounting standard All leases will be recorded on the balance sheet Impact on audits of captive leasing structures 32

33 Current Audit Trends and Cases 33

34 Overview of State Audit Trends State Use of Transfer Pricing Authority o Historically, few states have actively utilized 482 equivalent authority. o States have limited experience with transfer pricing and few resources trained to apply transfer pricing rules as compared with the IRS or foreign taxing authorities. o Rather than engaging in a substantive pricing analysis, states are increasingly asserting unsupported adjustments. State Addback Adjustments o States are continuing to audit intercompany intangible and expense payments. o States are also disallowing intercompany charges for know-how, technology and software particularly when these charges are embedded with royalty payments. Nexus o States are continuing to audit nexus. o Challenging P.L and other no nexus positions. 34

35 MTC State Intercompany Transactions Advisory Service (SITAS) MTC Executive Committee approved the Final Program Design on May 7, 2015, although only five states formally committed: Alabama, Iowa, New Jersey, North Carolina, and Pennsylvania In December 2015, the MTC created an ALAS Committee to continue to gather support for, and refine the design of its ALAS initiative. Initially the ALAS Committee (now SITAS) decided to focus on information sharing and training relating to transfer pricing. Potential exists for state revenue agencies to be supported by external economic consulting firms in the following areas: - Training - Audit selection - Economic analysis - Litigation support PwC 35

36 Utah Reigning in Use of State Transfer Pricing Adjustments See s Candies, Inc. v. Auditing Div. of the Utah State Tax Comm n, No (Utah Dist. Ct. 2016) See s Candies deducted IP royalty payments made to an insurance company also owned by Berkshire-Hathaway. The Tax Commission argued that it could adjust See s income for the royalty payments based on the state s 482-style adjustment statute without reference to federal rules on related-company adjustments. The Utah District Court found that the Tax Commission abused its discretion by denying the entire intercompany royalty expenses when the Tax Commission failed to consider federal 482 guidance and failing to look at the taxpayer s transfer-pricing study. On appeal at the Utah Supreme Court. 36

37 District of Columbia Chainbridge Methodology Hess Corporation, et al. v. Office of Tax & Revenue, Nos OTR-00027, 2011-OTR-00047, OTR (D.C. Office of Admin. Hearings March 15, 2017) In 2012, in Microsoft, the Office of Administrative Hearings (OAH) held that the Office of Tax and Revenue s (OTR) reliance on the transfer pricing methodology employed by Chainbridge was arbitrary, capricious, and unreasonable and cannot form the basis for a determination to reallocate income between Microsoft and its affiliated businesses. The OAH found that the methodology improperly considered all of Microsoft s transactions, whether controlled or uncontrolled, in analyzing its profit-to-cost ratio and failed to compare specific types of Microsoft transactions to uncontrolled transactions. While Microsoft was pending, ExxonMobil Oil Corp., Hess Corp., and Shell Oil Co. were assessed additional corporate franchise tax by the OTR using the Chainbridge methodology. In 2014, the OAH granted summary judgment in favor of the taxpayers holding that the OTR was collaterally estopped from re-litigating the methodology. In 2016, the DC Court of Appeals held that the OAH abused its discretion and remanded the case to determine whether exceptional circumstances existed for collateral estoppel. On March 15, 2017, on remand, the OAH held that exceptional circumstances did not exist for collateral estoppel. Oral hearing on the merits of the case was held on September 14, The OTR recently retained Ednaldo Silva, one of the drafters of the IRC section 482 transfer pricing regulations, as an independent expert to support the jurisdiction in its dispute with three oil companies. 37

38 Virginia Subject to Tax Addback Kohl s Dep t Stores, Inc. v. Virginia Dep t of Taxation, No (Va. Aug. 31, 2017) The Virginia Supreme Court found that only the portion of royalties that are actually taxed by another state falls within its subject to tax exception to Virginia s addback statute for corporate income tax purposes. The Court acknowledged that the plain language of the statute is ambiguous and that both parties respective positions could be supported by the statute. The Court deferred to the Department s interpretation. The case has been remanded to the Circuit Court to determine the portion of the royalty payments actually taxed by another state. 38

39 New Jersey Satisfying the Unreasonable Exception BMC Software, Inc. v. Dir., Div. of Taxation, No (N.J. Tax Court May 24, 2017) The New Jersey Tax Court found that a subsidiary s intangible expenses paid to its parent qualified for the state s unreasonable addback exception because the payments were substantively equivalent to an unrelated party transaction. The court held that: 1) The unreasonable exception does not require showing that the related-party recipient paid Corporation Business Tax on the income. 2) Showing that the related-party transaction was substantively equivalent to an unrelated third party transaction is sufficient evidence for the addback is unreasonable. 39

40 Questions and Answers The content in this presentation is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 40