Inside Deloitte Navigating state taxation in a global business environment · 2020-03-26 ·...

6
Inside Deloitte Navigating state taxation in a global business environment by Michael Paxton and J. Snowden Rives, Deloitte Tax LLP Spring 2015

Transcript of Inside Deloitte Navigating state taxation in a global business environment · 2020-03-26 ·...

Page 1: Inside Deloitte Navigating state taxation in a global business environment · 2020-03-26 · Navigating State Taxation in a Global Business Environment by Michael Paxton and J. Snowden

Inside Deloitte Navigating state taxation in a global business environment

by Michael Paxton and J. Snowden Rives, Deloitte Tax LLP

Spring 2015

Page 2: Inside Deloitte Navigating state taxation in a global business environment · 2020-03-26 · Navigating State Taxation in a Global Business Environment by Michael Paxton and J. Snowden

Navigating State Taxation in a Global Business Environment

by Michael Paxton and J. Snowden Rives

Thanks to technological change, commerce is virtuallyborderless. A modern business’s income may now resultfrom coordinated activities taking place in hundreds orthousands of national or subnational taxing jurisdictions.With that in mind, the theme of the National Multistate TaxSymposium on February 5 and 6 in Orlando, Florida —navigating state taxation in a global business environment— was chosen in light of governments’ focus on globalcompanies at the international, federal, and state levels.

As they struggle to keep pace with the change, govern-ments are exploring ways to allocate multijurisdictionalentities’ income. At the international level, there is a greatdeal of activity around the base erosion and profit-shiftingproject of the G-20 countries and the OECD, which ad-dresses both income tax and value added tax concernsarising from a global economy. At the federal income taxlevel, there are a number of U.S. House, Senate, and WhiteHouse proposals directed at multinational companies, bothinbound and outbound.

These initiatives have not been lost on the states, whichare not waiting for the results. As Bob Carleo of Deloitte Taxput it, states are ‘‘more attuned to international planning’’and ‘‘not waiting for the IRS to right a wrong that theyperceive.’’ Many states have been aggressively searching forways to increase revenue and shift the tax burden to out-of-state businesses through enforcement and legislative effortssuch as single sales factor, market sourcing, bright-line nexusstandards, and click-through/agency nexus.

As a result, taxpayers find themselves in an increasinglycomplex web of national and subnational tax consider-ations. And as Carrie Falkenhayn of Deloitte Tax added,‘‘the stakes are higher’’ for taxpayers now that tax reform hasa higher profile in the media.

I. State Takeaways From International Tax ReformThere is heated debate surrounding the G-20/OECD

BEPS project, which was undertaken to address govern-ments’ concerns that principles of national and interna-tional taxation were not keeping pace with the global natureof modern trading and business models. In particular, aperception among some governments is that existing rulesgive businesses too much opportunity for arbitraging taxrates and regimes. The BEPS project includes 15 topics(referred to as actions) that attempt to address those percep-tions.

The BEPS project will shape how some governmentscollect tax and how companies align their tax affairs andbusiness models. Although the action plan is designed tomultilaterally coordinate actions and partially reduce thepotential for international double taxation arising fromanti-BEPS legislation, change has already begun throughthe unilateral actions of some countries.

Bobby Burgner of General Electric Co. said that there aremany parallels between the topics of the BEPS project’s 15actions and issues that states have been addressing for years.For example, the plan’s action 4 to ‘‘limit base erosion viainterest deductions and other financial payments’’ reflectsan issue that many states have attempted to address usingintercompany interest addback statutes. The BEPS projectshows an international concern with interest expenses, butBurgner noted that action 4 would limit deductions, asopposed to the states’ disallowance of some deductions(while allowing safe harbors), which he said has more po-tential traps for taxpayers. Similarly, much like action 8reflects a BEPS concern with the use of intangibles, many

J. Snowden Rives

Michael Paxton

Michael Paxton is a manager and J.Snowden Rives is a senior consultantin Deloitte Tax LLP’s MultistateWashington National Tax practice. Ina new column, Inside Deloitte, theauthors use a recent Deloitte tax sym-posium as a platform to discuss howstate tax policy mirrors internationaltax reform and how it is implicated byfederal income tax proposals, state taxdevelopments directed at multina-tional companies, and some develop-ing areas of state nonconformity.

This article does not constitute tax,legal, or other advice from Deloitte,which assumes no responsibility re-garding assessing or advising thereader about tax, legal, or other conse-quences arising from the reader’s par-ticular situation.

The authors would like to thank Harrison Cohen, JeffKummer, Fred Paladino, Jon Almeras, and Michael DeHofffor their review of this article.

Copyright 2015 Deloitte Development LLC.All rights reserved.

INSIDE DELOITTEstate tax notes™

State Tax Notes, March 30, 2015 823

(C) T

ax Analysts 2015. A

ll rights reserved. Tax A

nalysts does not claim copyright in any public dom

ain or third party content.

Page 3: Inside Deloitte Navigating state taxation in a global business environment · 2020-03-26 · Navigating State Taxation in a Global Business Environment by Michael Paxton and J. Snowden

states disallow intangible expenses in the same manner asintercompany interest expenses.

Action 1, which would address the tax challenges of thedigital economy, echoes how states have struggled with lawsthat lag behind the digital economy. The Task Force on theDigital Economy, comprising participants from the G-20and OECD countries, was tasked with developing a reportto identify options to address digital economy issues. Oneoption the task force explored would require nonresidentsuppliers to register and account for value added taxes,which according to Burgner is like a click-through nexus orMarketplace Fairness Act-type provision, albeit one directedat value added taxes instead of sales taxes.

Some believe that state experiences can inform the inter-national discussion. Or as Doug Lindholm of the CouncilOn State Taxation put it, state and local tax experts may‘‘rule the world’’ because of their experience with what stateshave used to combat perceived BEPS.

Another BEPS project proposal that has attracted statetax administrators’ attention is the country-by-countrytransfer pricing documentation proposed in action 13,which would contain information on the global allocationof a multinational’s income and taxes paid together withindicators of the location of economic activity within themultinational group. As part of previous discussions of theMultistate Tax Commission’s Arm’s-Length AdjustmentService (ALAS) Advisory Group, state tax agency represen-tatives have questioned whether a similar state-focuseddocument taking those same factors but on a state-by-statebasis — or other disclosure requirements with penalty pro-visions — made sense.1

II. State Takeaways From Federal Tax ReformWhile the scope of federal tax reform proposals from the

Obama administration, the U.S. House, and the U.S. Sen-ate is quite broad,2 there are common themes, includinglowering the top corporate tax rate, modifying the currentsystem of the taxation of foreign income, and broadeningthe tax base by limiting or eliminating certain deductions,credits, and incentives.

Many state corporate income tax regimes are affected byfederal tax law changes because they piggyback off theInternal Revenue Code by either incorporating the IRC inwhole or in part, or by using federal taxable income as thestarting point. States with automatic or rolling conformitygenerally will adopt those changes unless there is legislation

to decouple from federal law. Other states adopt the IRC asof a specific date, do not adopt all the IRC provisions, orprovide modifications or exceptions to specific adoptedprovisions. A change in the top-line federal tax rate wouldnot automatically result in a change in state tax rates. On theother hand, base broadening (and inversion changes) couldimmediately and effectively raise taxes in those states thathave rolling conformity or use federal taxable income as astarting point. However, to the extent any reforms have alarge-scale impact, states may begin to reevaluate their tax-ing schemes.

One takeaway highlighted at the symposium is thatbecause many of the proposed federal income tax provisionswould affect repatriations, state tax practitioners shouldstart thinking now about advanced planning for repatria-tion. A related consideration is how a deemed repatriationtax, such as the one in the president’s budget, would bereflected in the state tax base. And to the extent that acompany physically repatriates or moves capital back intothe United States, another consideration would be that thecapital be repatriated to a tax-efficient jurisdiction from astate tax perspective.

III. State Tax Developments Directed atMultinational Companies

A. Tax Haven ProvisionsFormer MTC Executive Director Dan Bucks, who also

served a lengthy tenure as Montana’s revenue director, hasestimated that state losses from ‘‘international income shift-ing’’ could be as much as $20 billion a year.3 Rather thanwaiting for the federal government or other countries to act,states have responded to concerns over corporate tax baseerosion by exploring mechanisms to stop income frombeing shifted overseas.

For example, under typical tax haven legislation, anotherwise water’s-edge filing group is required to includethe income of any company incorporated or doing businessin a ‘‘tax haven.’’ Montana was the first state to enact taxhaven legislation, effective for tax years beginning afterDecember 31, 2003.4 It has since been joined by Alaska,Oregon, Rhode Island, West Virginia, and the District ofColumbia.5 The MTC has a model tax haven statute as well.

Tax haven provisions usually either specifically identifyjurisdictions considered to be tax havens or provide statu-tory criteria for determining whether a jurisdiction is a taxhaven. Oregon, for example, follows the first approach,requiring the taxable income or loss of a unitary member

1See Amy Hamilton, ‘‘OECD Guidance Could Shine Light onState Taxation of Foreign-Source Income,’’ State Tax Notes, Sept. 22,2014, p. 757.

2For example, the discussion draft of the Tax Reform Act of 2014 isjust shy of 1,000 pages of statutory text, with 700 pages of technicalexplanations from the Joint Committee on Taxation. It was incorpo-rated into the final bill (H.R. 1), introduced by then-U.S. House Waysand Means Committee Chair Dave Camp, Mich., without modifica-tion.

3Dan Bucks, ‘‘Preliminary Design for an MTC Arm’s-LengthAdjustment Service,’’ Dec. 2, 2014, p. 3.

4Mont. Code Ann. section 15-31-322(1) as added by 2003 Mont.Laws Ch. 521.

5Alaska Stat. section 43.20.145(a)(5); D.C. Code Ann. section47-1810.07(a)(2)(F)(i); Or. Rev. Stat. section 317.715(2); R.I. Gen.Laws section 44-11-4.1(d); W. Va. Code section 11-24-13f(a)(7).

Inside Deloitte

824 State Tax Notes, March 30, 2015

(C) T

ax Analysts 2015. A

ll rights reserved. Tax A

nalysts does not claim copyright in any public dom

ain or third party content.

Page 4: Inside Deloitte Navigating state taxation in a global business environment · 2020-03-26 · Navigating State Taxation in a Global Business Environment by Michael Paxton and J. Snowden

incorporated in any of the following jurisdictions to add tofederal consolidated taxable income: Andorra, Anguilla,Antigua and Barbuda, Aruba, the Bahamas, Bahrain, Bar-bados, Belize, Bermuda, the British Virgin Islands, theCayman Islands, the Cook Islands, Cyprus, Dominica, Gi-braltar, Grenada, Guernsey-Sark-Alderney, the Isle of Man,Jersey, Liberia, Liechtenstein, Luxembourg, Malta, the Mar-shall Islands, Mauritius, Monaco, Montserrat, Nauru, theNetherlands Antilles, Niue, Samoa, San Marino, Seychelles,St. Kitts and Nevis, St. Lucia, St. Vincent and the Grena-dines, the Turks and Caicos Islands, the U.S. Virgin Islands,and Vanuatu.6

The MTC model statute follows the second approach,defining a tax haven as a jurisdiction that:

has no or nominal effective tax on the relevant in-come; andi. has laws or practices that prevent effective exchangeof information . . . ;ii. has [a] tax regime which lacks transparency . . . ;iii. facilitates the establishment of foreign-owned en-tities without the need for a local substantive presenceor prohibits these entities from having any commer-cial impact on the local economy;

iv. explicitly or implicitly excludes the jurisdiction’sresident taxpayers from taking advantage of the taxregime’s benefits or prohibits enterprises that benefitfrom the regime from operating in the jurisdiction’sdomestic market; or

v. has created a tax regime which is favorable for taxavoidance, based upon an overall assessment of rel-evant factors, including whether the jurisdiction has asignificant untaxed offshore financial/other servicessector relative to its overall economy.7

Paul Buchman of Tyco International said that becausethe states with tax haven provisions are generally smaller, thelaws have been somewhat under the radar. But he added that‘‘some big states are starting to look at this,’’ includingMassachusetts, where two draft bills have been proposedthat follow the first approach.8 Similarly, lawmakers inAlabama, Florida, Kentucky, Maine, and New Hampshirehave introduced tax haven bills for this legislative session.9

Lindholm said that tax haven provisions have put statesback into the international lens. He calls the provisions a‘‘back door to worldwide combined reporting,’’ whichstalled in the 1980s at the threat of federal preemption. In adirect attempt to require worldwide combined filing, Mon-tana lawmakers have introduced a bill to eliminate thewater’s-edge election for corporate income tax return fil-ers.10

Lindholm also expressed concern about ‘‘what happenswhen tax commissioners declare our trading partners as taxhavens.’’ Foreign affairs ‘‘is not a skill of tax administrators,’’he said.

B. Factor-Presence NexusThough not directed at multinational — as opposed to

out-of-state — companies, expanded economic and bright-line statutory nexus thresholds are relevant for foreign enti-ties that lack physical presence in a state and whose onlyconnection is sales to customers in the state. When consid-ering whether a foreign entity has the requisite sales activitywithin a state to satisfy a bright-line threshold such asCalifornia’s and New York’s, one must take the state’sapportionment sourcing provisions into account, payingattention to: (1) jurisdictions using market-based sourcingfor services and intangible transactions, and (2) provisionsthat source tangible personal property sales to the ultimateshipping destination regardless of where title transfer occurs(unless that state extends P.L. 86-272 protection to foreignentities). In both sourcing situations, transactions that donot generate U.S.-source income for federal income taxpurposes may be considered sales sourced to a particularstate that applies a bright-line statutory nexus threshold.

Nearly a third of industry participants polled at thesymposium responded that economic nexus or bright-linenexus standards have caused their company to increasefinancial statement reserves or to begin filing in states wherethey previously believed nexus did not exist. Bob Vonick ofthe Walt Disney Co. suggested that in addition to commerceclause arguments, companies may want to consider dueprocess arguments when scrutinizing economic nexus andbright-line nexus standards, given some state courts’ in-creased focus in applying due process in the tax jurisdic-tional area.

C. State Transfer Pricing:Arm’s-Length Adjustment Service

State transfer pricing challenges have prompted theMTC to undertake an ALAS project. In December 2014 theMTC Executive Committee reviewed a preliminary designfor a transfer pricing audit program and passed a motion toformally solicit commitments from interested states forfunding such a program.11 While there is a domestic transfer

6Or. Rev. Stat. section 317.715(2)(b).7Recommended changes to ‘‘MTC Proposed Model Statute for

Combined Reporting,’’ section 1(I) (2011).8Massachusetts HD 1234 and SD 1699. See Neil Downing, ‘‘Mas-

sachusetts Lawmakers Propose Tax Haven Combined Reporting Bill,’’State Tax Notes, Mar. 2, 2015, p. 495.

9Alabama HB 142, Florida HB 1221, Kentucky HB 374, MaineLD 341, and New Hampshire HB 2 and 551. For news coverage of theMaine bill, see Douglas Rooks, ‘‘Lawmakers Considering Another TaxHavens Bill,’’ State Tax Notes, Feb. 16, 2015, p. 379. For news coverageof the New Hampshire bill, see Jennifer DePaul, ‘‘State LawmakersConsider Tax Haven Legislation,’’ State Tax Notes, Mar. 2, 2015, p.507.

10Montana SB 166.11See Hamilton, ‘‘States Could Recoup $25 Million Under MTC

Transfer Pricing Program,’’ State Tax Notes, Dec. 8, 2014, p. 527.

Inside Deloitte

State Tax Notes, March 30, 2015 825

(C) T

ax Analysts 2015. A

ll rights reserved. Tax A

nalysts does not claim copyright in any public dom

ain or third party content.

Page 5: Inside Deloitte Navigating state taxation in a global business environment · 2020-03-26 · Navigating State Taxation in a Global Business Environment by Michael Paxton and J. Snowden

pricing component to the project, past discussions indicatethat international transfer pricing issues are included.

Mike Bryan, then director of the New Jersey Division ofTaxation, provided some impetus for the MTC initiativewhen he requested at a May 9, 2013, Executive Committeemeeting that the commission evaluate a dedicated transferpricing audit program.12 At the symposium, Bryan ex-pounded on that request, saying he believes that ‘‘there issome abuse’’ of transfer pricing by taxpayers. But accordingto Bryan, states don’t have the resources to combat thoseabuses, nor can they pay senior economists enough to retaintheir knowledge.

States’ lack of transfer pricing expertise has resonatedthroughout the MTC meetings on the ALAS project. Mar-shall Stranburg, executive director of the Florida Depart-ment of Revenue, said states want this expertise to make andsupport audit determinations on whether a transaction ortransfer pricing study is appropriate. The knowledge couldalso ensure that if negotiations or litigation occurs, the statewould have its experts, just as many taxpayers have theirown PhD economists that provide transfer pricing studies,he added.

MTC Executive Director Joe Huddleston later said thathe was ‘‘hearing about lack of expertise’’ in transfer pricingfrom the state administrators. Huddleston noted that whilethe project is about spurring compliance, it ‘‘may result inlitigation.’’

The ALAS project’s outcome will depend on whether theMTC can secure commitments from the states. It has at leastone: Bryan noted that New Jersey has worked it into thefiscal 2016 budget.

Regardless of whether the project continues, the MTChas formal plans to include training on transfer pricingissues as part of its training program in 2015.13 With that inmind, taxpayers may wish to consider:

• developing state-relevant, exam-ready transfer pricingdocumentation to the extent such a study has not beenpreviously prepared; and

• reviewing any existing transfer pricing studies to deter-mine whether an update is advisable, given anychanges to the taxpayer’s business activities or whetherthose studies need to be adapted to take into accountstate laws.

IV. Developing Areas of State NonconformityTwo 2014 court decisions highlight the need for consid-

eration in areas in which state law doesn’t conform to theIRC. These decisions demonstrate that just because a stateincorporates the IRC by reference or starts its computation

with federal taxable income doesn’t mean that all federal taxconsequences, or even IRS determinations, will be followedat the state level.

A. Alaska Apportionment TrumpsIRC Dividend Exclusion

In Schlumberger Technology Corp. v. State, Department ofRevenue, the Alaska Supreme Court held that IRC section882(a)(1), which requires a foreign corporation to reportonly income effectively connected with the conduct of atrade or business within the United States, was not adoptedby reference because it is inconsistent with the formulaprovided by Alaska’s water’s-edge statute.14 The court heldthat the Alaska water’s-edge statute, which provides for theexclusion of 80 percent of dividends received by the taxpayerfrom foreign corporations, necessarily required the inclu-sion of 20 percent of dividends, even though they wereexcluded from the federal income tax computation underIRC section 882(a)(1).15 In other words, dividend incomeexcluded from the taxpayer’s federal income tax return hadto be included in its Alaska corporate income tax return.

Karl Frieden of COST said that this wasn’t necessarilythe end of the story in Alaska, as the taxpayer in this case didnot make a foreign commerce clause claim — leaving im-portant constitutional issues unanswered.

Despite the constitutional question, the takeaway is thattaxpayers may wish to consider whether taxing authorities inother states that do not expressly adopt the sourcing rules ofIRC section 882 or other limitations such as tax treaties maymake similar arguments to those presented in this decisionregarding corporations that satisfy nexus requirements orotherwise meet the requirements for inclusion in a water’s-edge group.

B. Massachusetts Not Bound by IRSClosing Agreement

Some states have challenged the characterization of inter-company debt, even those arrangements that otherwise passIRS scrutiny. Those transactions subject to IRS scrutinywould include international cross-border arrangements inwhich the IRS would have an interest in the proper treat-ment, as opposed to domestic transactions between entitiesfiling a consolidated U.S. income tax return in which thoseconsiderations would be less relevant. Massachusetts, forexample, has a line of cases in which the DOR has chal-lenged cross-border agreements.16 Sometimes these chal-lenges involve business purpose or economic substanceanalyses that do not follow federal law or apply those con-cepts to situations in which the IRS has not traditionallyapplied them.

12Bryan resigned from the New Jersey Division of Taxation onMarch 13 and has taken a position with Deloitte Tax MultistateWashington National Tax group effective March 23.

13Hamilton, ‘‘MTC Contracts With Economist Who Drafted U.S.Transfer Pricing Regs,’’ State Tax Notes, Mar. 9, 2015, p. 586.

14Schlumberger Tech. Corp. v. State, Dep’t of Revenue, 331 P.3d 334,335 (Alaska 2014).

15Id. at 336.16See, e.g., Kimberly-Clark Corp. v. Comm’r, 981 N.E.2d 208

(Mass. App. Ct. 2013).

Inside Deloitte

826 State Tax Notes, March 30, 2015

(C) T

ax Analysts 2015. A

ll rights reserved. Tax A

nalysts does not claim copyright in any public dom

ain or third party content.

Page 6: Inside Deloitte Navigating state taxation in a global business environment · 2020-03-26 · Navigating State Taxation in a Global Business Environment by Michael Paxton and J. Snowden

Most recently, in National Grid Holdings Inc. v. Commis-sioner, the Massachusetts Appellate Tax Board on June 4,2014, upheld assessments denying a domestic taxpayer’sinterest deductions for payments under deferred subscrip-tion agreements (DSAs) with foreign entities on the basisthat the DSAs did not qualify as true debt because theylacked an unconditional obligation to repay.17 The DSAswere instruments intended to be treated as debt for U.S.federal income tax purposes but not for U.K. tax purposes(that is, a hybrid debt arrangement).18 In subsequent litiga-tion, when the taxpayer presented the court with a post-audit closing agreement allowing a partial interest deduc-tion related to the DSAs for federal income tax purposes, thetax board held that neither Massachusetts statutes nor ap-plicable case law supports the conclusion that such anagreement would require the tax board to rule that pay-ments made under the DSAs were deductible interest forMassachusetts tax purposes.19

Carleo and Valerie Dickerson of Deloitte Tax highlightedthe importance the tax board placed on the fact that the

agreements were not ones that one would undertake with athird party. In other words, for related-party debt transac-tions, optics are important for surviving potential statechallenges.

Peter Faber of McDermott Will & Emery highlighted thepotential compliance headache that would result if morestates start to ‘‘go behind’’ IRS post-closing agreements. Hesaid it is a ‘‘waste of everybody’s time’’ for a state to ‘‘re-auditthe same issue’’ that the IRS audited, and he suggested thatgiven states’ concern over resources, it’s unproductive.

V. Conclusion

The ever-changing digital economy along with tax re-form proposals at the international and national levels maywell affect how taxes are collected and how companies dobusiness over the coming years, with the potential to signifi-cantly change state taxation. In the meantime, recent devel-opments show that the states are not waiting for nationalgovernments to act before taking their own administrativeor legislative action affecting multinational companies. Inthis environment, state taxes play an increasingly complexand important role, and taxpayers may wish to consider howthe evolving tax landscape may affect their existing businessstructures as well as any pending transactions. ✰

17National Grid Holdings Inc. v. Comm’r, No. ATB 2014-357,Mass. App. Tax Bd., at 411 (2014).

18Id. at 366.19National Grid USA Service Co. v. Comm’r, No. ATB 2014-630,

Mass. App. Tax Bd. (2014).

Inside Deloitte

State Tax Notes, March 30, 2015 827

(C) T

ax Analysts 2015. A

ll rights reserved. Tax A

nalysts does not claim copyright in any public dom

ain or third party content.