Corporate State Tax Reforms
State tax reforms — all creativity, no uniformity. What's in store for multistate corporations in 2008?
April 24, 2008
by Mary Bernard, CPA/MST
With at least 28 states trying to balance a deficit budget in the upcoming year, legislators are reaching out to explore areas previously untouched by income taxes. Traditional concepts of jurisdiction, tax measures and the assignment of tax bases are all being reconsidered within the context of increasing state revenues. The easiest target may be the out-of-state corporation doing business in a foreign state. Even legal and accounting services may be affected.
A trend began in the eastern states of the U.S. to require combined reporting for corporate income tax. The concept had been advocated by the Multistate Tax Commission (MTC) and the Center on Budget and Policy Priorities for years with very little success. Only Vermont and Texas had adopted combined reporting over the last 20 years. This trend changed in 2007 with new or expanded measures being adopted in West Virginia and Michigan, soon followed by New York. In some cases, the mere existence of inter-corporate transactions, regardless of transfer pricing, is sufficient to require combined reporting. States are divided on the issue of the amount of revenue actually generated by combined reporting. Some states are incorporating this concept into broader based tax scenarios.
Gross Receipts Taxes
Although it could be argued that an unusual, non-income tax-based tax may restrict competitiveness, Michigan was a trailblazer with its Single Business Tax, which was imposed for almost 30 years. The Single Business Tax was ultimately replaced by a hybrid tax — part modified gross receipts, part traditional income tax — effective this year. The intention was to adopt a tax "less burdensome and less costly to employers, more equitable, and more conducive to job creation and investment," according to the initiative petition approved by Michigan voters. In addition, both Ohio and Texas recently revised their tax structures to include gross receipts taxes. These taxes not only expand the definition of "taxpayer" to include individuals and pass-throughs, but are assessed on a combined basis.
There will be more activity in the area of nontraditional, gross receipts-type taxes before the year is over. Rhode Island implemented a gross receipts tax on medical imaging services last year, and proposed a similar gross receipts tax on legal and accounting services. In a recessionary economy, a gross receipts tax can be an unwelcome burden to a corporation with declining profits.
Gross receipts taxes are not for everyone. New Jersey's supplemental gross receipts based tax, the Alternative Minimum Assessment, enacted in 2002, was allowed to expire this year. The Limited Liability Entity tax in Kentucky, originally an alternative minimum calculation, may be repealed or significantly revised this year.
Among the many apportionment changes enacted this year to date, the largest amount of activity has been in the area of sourcing of service revenue. The majority of states traditionally used cost of performance measures to determine the situs of the income producing activity. The location in which the greatest cost of performance was incurred dictated the state in which the sale was apportioned.
Market-based sourcing, on the other hand, apportions service revenue to the state in which the benefit is received. This change in sourcing is quickly spreading among the states. It was rare in 1957, when the Uniform Division of Income for Tax Purposes Act (UDITPA) first proposed the income producing activity rules for sourcing service revenue, for a company to do business with an out-of-state service provider. In the intervening years, it has become rare for a company NOT to do business with out-of-state providers.
In order to correct the weakness (and complexity) of this sourcing rule, the market-based sourcing rule for service revenue attempts to attribute sales to the state of location of the recipient. This "benefit received" approach reduces the burden on service providers with in-state facilities and primarily out-of-state customers. It also creates an incentive for regional and national service providers to locate within the state's borders. Because of the proliferation of states still using the income-producing activity rule, a market-based sourcing rule could result in nowhere sales for service providers domiciled there. Currently, nine states are already using the market-based sourcing, which is much easier to track through sales journals. Usually, the billing address will be the state where the sale is apportioned.
The physical presence nexus standard has been easily discarded in some states in favor of the far-reaching economic nexus standard. Only three days after the Supreme Court refused to decide the issue generated by the West Virginia MBNA decision (Tax Commr. v. MBNA Americ Bank, N.A., W. Va. S. Ct. App., 640 SE2d 226) and the New Jersey Lanco decision, (Lanco, Inc. v. Director, Division of Taxation, N.J. S. Ct. (2006), 188 NJ 380) New Hampshire expanded its definition of "business activity" subject to its Business Profits Tax to include "a substantial economic presence evidenced by a purposeful direction of business toward the state examined in light of the frequency, quantity and systematic nature of a business organization's economic contacts with the state." Both Michigan and Ohio incorporated this concept in their revised tax systems. They attempted to also quantify the economic nexus standard by instituting dollar thresholds to establish nexus. This radical approach could quickly catch on in this year of budgetary constraints. New Hampshire maintains that this change alone will bring in between $10 million and $100 million in increased revenues.
As it is barely spring, we can expect much more activity in state tax legislation before the budgets are balanced.
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Mary F. Bernard, CPA/MST is a Tax Principal and Director of State and Local Tax Services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI.