don't let uncertain state tax positions surprise your company or client

Uncertain state tax positions are everywhere. Your company or your clients likely have them. Have you identified them? Have you addressed them?

During ‘busy season’ or ‘tax season, state tax questions often arise or lay there quietly in the background while federal tax issues get all of the attention.

State tax issues or the state tax impact of an issue or transaction is generally considered after the federal tax impact is addressed.

Non-state tax experts are sometimes just too busy to give state tax issues adequate time before a deadline. In other situations, non-state tax experts may simply view a state tax issue as less complicated than it really is. Consequently, state tax issues may not get addressed before the original due date of the returns and may only get addressed in late summer or early fall prior to the extended due date. This often creates a time crunch for uncertain state tax positions to get adequately addressed. That's one of the problems.

The other problem is that most state tax issues are more complex than they appear. A high-level overview or two hours of research won't cut it, especially when you are trying to determine the state tax impact of a large transaction or adequately source the gain on a sale of a partnership interest to the right state or states.

What are these 'uncertain state tax positions'?

Where can they appear?

The following is a summary of some of the areas or items that create uncertain state tax positions on state income tax returns:

1. Structure - intangible holding companies; REIT / RIC; buy / sell companies, management / services companies; state-specific structures; captive insurance companies; finance companies; factoring companies; check-the-box entities; pass-through entities;

2. Transactions - mergers, acquisitions, divestitures; repatriation dividends; reorganizations; bankruptcy issues;

3. Nexus - P.L. 86-272; economic nexus; attribution of activities; forced combination; foreign company nexus despite no permanent establishment in U.S.;

4. Filing Options - separate, nexus combined, hybrid nexus combined, unitary combined (waters-edge, worldwide); consolidated;

5. Apportionment - ability to apportion income; choice of formula; throwback / throwout; joyce vs. finnegan; sales factor sourcing (destination, market-based sourcing, cost of performance, commercial domicile, location of payor);

6. Tax Base - business v.s nonbusiness income vs. separate accounting; Internal Revenue Code (IRC) conformity; related party addbacks; depreciation adjustments; dividends received deduction conformity; transfer pricing; foreign source income; state specific additions/subtractions;

7. Treatment of Partnerships - entity vs. aggregate theory; unitary (tax base / factor flow-up) vs non-unitary (allocation); sale of partnership interest;

8. Tax Attributes - NOLs (pre-apportioned vs. post-apportioned); IRC Sec. 382 limitations; survivor / non-survivor limitations; credits (claw-backs; compliance with agreements);

How do you ensure these items are addressed adequately?

• Get a state tax expert involved early.

How do you know when your client has any of these issues?

• Create a checklist that helps you identify clients or when your company may have these issues. That checklist may be based on the amount of sales a company has, the amount of taxable income, the number of states they file returns in (or the number of states they should file in), or if they have a specific structure or entered into a transaction that obviously needs reviewed.

There are multiple checklists you could create, the key is to make one that works for your company or firm that doesn't slow down the compliance process, but does allow you to reduce risk and adequately document a supportable, defendable or winnable position.

I hope you have a great tax season (now and in the fall). I hope all of your uncertain state tax positions achieve as much certainty as they can and are adequately addressed and documented.

Not All Intercompany Transactions Are Created Equal

For any group of affiliated entities, intercompany transactions, such as intercompany purchases, loans, licensing, services, and management, are a way of life. Even though those transactions are a part of normal business operations, they have created problems and opportunities in states that have not adopted combined reporting. States have sought to disallow the deduction of related-party expenses under the presumption that the transactions were not entered into with business purpose or economic substance, or that they distorted the true reflection of income earned in the state.

It could be argued that taxpayers abused the positive effect of ‘‘true’’ intercompany transactions by using special purpose entities such as sales companies, finance companies, and the infamous intangible holding company to shift income from one entity to another or from one state to another. The use of those types of entities and transactions exploded in the 1990s. Since then, states have worked to end that perceived abuse by enacting related-party expense addback legislation or adopting combined reporting. As a result, the ability to use intercompany transactions to shift income has become very difficult.

Taxpayers argue that economic substance and business purpose other than tax savings have always been integral parts of any state tax planning (even in the 1990s). However, taxpayers today approach state tax planning in terms of focusing on the business objective first, and then seeking to implement that objective in a tax-efficient manner. Some practitioners refer to that as business alignment planning. I like to describe it as not putting the cart before the horse.

To read more, check out my article from Tax Analysts State Tax Notes on October 28, 2013. 

Don't forget to sign up to attend the free Bloomberg BNA webinar tomorrow that I am co-presenting: "State Tax Planning for Related-Party Transactions." 

I hope you can join me to discuss:

• Triggers which create problems and opportunities (in regards to related-party transactions)
• Common inter-company transactions
• 6 ways states may respond to related-party transactions (including recent developments and how to analyze, defend and plan)

The Tightrope of Acceptable Intercompany Transactions

The following are excerpts from my January 6, 2014 article in Tax Analysts State Tax Notes. 

The Tightrope
An Indiana taxpayer paid factoring fees to a related entity that was not included in its Indiana income tax return. The taxpayer subcontracted the collection of its accounts receivable to the related entity by factoring the accounts to the entity. According to the taxpayer, the entity charged an arm’s-length rate based on a transfer pricing study prepared in accordance with IRC section 482 and related regulations. An independent third party prepared the study, and the factoring fees reported on the federal returns fell within the range of acceptable prices listed in the study. A portion of the receivable factoring expense that the taxpayer paid came back to it as dividends and loans from the related entity.

After an audit investigation, the Indiana Department of Revenue disallowed more than $57 million of the factoring fees the taxpayer paid to the related entity, which represented the portion of the fees paid to the entity that exceeded its expenses for providing the factoring services. The DOR argued that the taxpayer group, as an economic entity, did not achieve any business or operational advantage that it did not have before the taxpayer started factoring its receivables. The in-house factoring did not result in lower financing costs, the most common reason for factoring. The same departments, such as accounting, credit and collection, and customer service, that existed before the receivable factoring was put in place still existed.However, the functions became part of the operations of the related entity, which didn’t file in Indiana. Thus, the major benefit of the factoring operations was the minimization of state income tax. According to the DOR, that distorted the reported Indiana adjusted gross income without benefiting the whole organization. The factoring entity reported more income than all other entities in the consolidated group, including the taxpayer, which is supposed to be the most dominant entity.

In Indiana Letter of Findings 02-20120612, the DOR said corporate form will normally be respected unless the form is a sham or unreal. The DOR relied on the fact that courts have been consistent in holding that tax avoidance in and of itself is not a valid business purpose. It also relied on IC section 6-3-2-2(m) to distribute, apportion, or allocate income derived from sources in Indiana among organizations, trades, or businesses to fairly reflect income. According to the DOR, the regulations allow it to use any method to equitably allocate and apportion a taxpayer’s income.

Working Without a Net
The taxpayer argued that the independently prepared transfer pricing study provided enough support for the state to accept the intercompany transactions. However, the DOR stated in its letter of findings that the arm’s-length status of a transaction, considered in isolation, is not relevant to whether the substance of a taxpayer’s overall company structure, intercompany transactions, and consolidated group’s deductions fairly reflect a taxpayer’s consolidated group’s taxable Indiana income. According to the DOR, the problem was that the transfer pricing study was performed to analyze the arm’s-length status of the transactions for federal, not state, tax purposes. In fact, the transfer pricing study itself asserted it was not performed for state tax purposes and should not be used by the taxpayer as advice for state tax purposes.

Perhaps the most troublesome issue for the taxpayer was that a portion of the receivable factoring expense it paid came back to it as dividends and loans. The Indiana DOR has routinely provided guidance in letters of findings regarding the circular flow of funds between related parties, such as (i) when a taxpayer makes Intercompany payments and takes expenses for those payments but cannot explain the nature and substance of the underlying agreement and transactions; (ii) when the deduction of royalty and interest expenses are part of a continual circular flow of money between related entities—with the result of shifting taxable income to out-of-state entities that then return nontaxable income to the Indiana entities, calling into question the need for the transactions and resulting in an unfair reflection of the income earned from Indiana sources; and (iii) when the payment of royalties results in an intercompany circular flow of money that serves no commercial business purpose.

The taxpayer argued that its position should be sustained because the business purpose and substance of the related factoring entity were substantially similar to that of the factoring company described in Letter of Findings 02-20090805. However, the DOR argued that the taxpayers’ situations were not factually similar because there was no evidence that the other taxpayer had a circular flow of funds in the form of either loans or dividends. Letter of Findings 02-20090805 simply stated that the facts presented little to indicate that the factoring fees constituted an abusive tax avoidance scheme even though the claimed expenses significantly reduced the income subject to Indiana tax. In fact, the DOR held in Letter of Findings 02-20090805 that the related entity incurred legitimate and reasonable expenses associated with the collection of the factored Receivables. In this case, the DOR did request additional documentation regarding the circular flow of funds, but the taxpayer did not provide it. Thus, the DOR held it had legitimate concerns that the taxpayer exploited the company’s structure and the intercompany transactions to shift a substantial portion of its Indiana income outside the state.

Balancing Act
A related factoring entity can withstand audit scrutiny, but taxpayers should take proper steps to support the path to acceptance. Although each state differs, the lessons from the Indiana letters of findings can be used to substantiate the validity of the transactions. First, taxpayers should have a business or operational purpose for the creation of related entities when large intercompany transactions will occur. Second, taxpayers should realize some type of business benefit, such as liquidity or lower interest rates, for the whole organization as a result of the new entity or structure. Third, taxpayers should not rely on federal transfer pricing studies to substantiate state tax consequences of intercompany transactions. Lastly, taxpayers should avoid the circular flow of funds between related parties. Tax planning is each taxpayer’s right and obligation, but finding the balance between what is and isn’t acceptable is like walking a tightrope. As the Indiana letters of finding show, finding the balance is difficult, but not impossible.

Sidenote: Happy Valentine's Day!

State Tax Planning for Related-Party Transactions

I am pleased to be co-presenting a Bloomberg BNA Webinar this week, "State Tax Planning for Related-Party Transactions." I hope you can join me to discuss:

• Triggers which create problems and opportunities (in regards to related-party transactions)
• Common inter-company transactions
• 6 ways states may respond to related-party transactions (including recent developments and how to analyze, defend and plan)

Every affiliated group has related-party transactions. They are a necessity for business and legal reasons. However, the state tax impact is complex and controversial. All phases of the tax life-cycle are impacted by related-party transactions (provision, compliance, planning and controversy). The states have responded to perceived abuses with many justifiable tools. The states may or may not soon receive additional tools from the federal government. Regardless of a state's response, taxpayers must be proactive in defending legitimate expenses and be able to analyze and plan for audit assertions and adjustments.

YEAR-END TAX PLANNING: DON'T FORGET THE SALT

I have been swamped the past month with work and finishing our 6-month house renovation, so please forgive me for not posting as often. 2017 will be different. Looking to do great and different things in the world of state taxation next year. We are planning on moving-in this weekend (before Christmas - YES!). If you are considering renovating a house, feel free to contact me. I will give advice and my story. It may be helpful, or not.

In the midst of the chaos, I thought I would send out my annual year-end state tax planning list. Its strange, but predictable, that the list hasn't really changed from year-to-year. 

The following is a brief list of some actions you may want to take RIGHT NOW:

1. Nexus and FIN 48: At this time of year, it is a good time for companies to address their nexus position in advance of their FIN 48 analysis. Operations may also be able to be restructured. If your company or client utilizes telecommuting employees or independent contractors and hasn’t addressed their nexus position in a while, this may be a good time. Also, more states have adopted economic nexus standards and “bright line” nexus standards that may come into play.
2. Sales and Use Tax: It is also a good time to conduct a reverse sales tax audit to identify sales and use tax refund opportunities and potential exposure. If your client has purchased any software, SaaS or cloud computing recently, they may want to confirm there is no sales or use tax exposure. States are still playing 'catch-up' with cloud computing, but several states have issued rulings and guidance over the last year.
3. Income Tax: For C corporations, a reverse income tax audit could identify state income/franchise and gross receipts tax refund opportunities and potential exposure. Combined reporting and apportionment issues or opportunities may exist. Alternative apportionment and transfer pricing have become big (or bigger) issues in 2016.
4. Income Tax: For flow-through entities, a reverse income tax audit may be helpful on major states such as Texas, Michigan, Washington, Pennsylvania, etc.
5. Credits and Incentives: If your company or clients are entering into new states, hiring new employees, building new facilities, retaining employees, "going green," involved with renewable energy, etc. this is a good time to identify and capture credit and incentive opportunities.
6. Transaction Due Diligence: If your company or clients are entering into any acquisitions of other companies or assets, state and local tax issues should be reviewed to determine exposure, successor liability, and nexus impact.
7. Residency Issues: For individual tax clients that have changed their residency to another state or are considering such a change, guidance should be provided in regards to what records they need to maintain, etc.to support their residency or domicile.
8. Employee Misclassification: If your company or client utilizes a high volume of independent contractors, contracts should be reviewed to mitigate exposure of those independent contractors being reclassified as employees.

What do you think? What is a high priority for you? Comment or send me an e-mail.

Indiana Releases Combined Reporting and Transfer Pricing Studies

Indiana has released two separate studies, one on combined reporting and one on transfer pricing. The studies were a requirement of SB 323 that was amended on January 28, 2016 to study combined reporting instead of adopt combined reporting, as I reported earlier. 

Combined Reporting

The combined reporting study discusses all of the reasons why states adopt combined reporting - to stop base erosion from taxpayers using intellectual property holding companies, captive real estate investment trusts, captive insurance subsidiaries and overseas management affiliates, etc. However, the study also explains that combined reporting creates new problems that separate reporting states do not have to deal with, such as determining the unitary group, and additional administrative burdens during the transition to combined reporting. 

The study also asserts that the impact of combined reporting on state revenues is mixed, according to evidence from other states. Similar to most state tax laws, implementing combined reporting would provide additional revenue from some taxpayers and less revenue from other taxpayers. Consequently, the question remains as to what the overall revenue impact would be. The study suggests combined reporting would increase revenue in the short term, but be neutral in the long term.

Regardless of the revenue impact, the study confirmed that separate reporting does allow taxpayers with more opportunity to create favorable business structures and utilize intercompany transactions to shift income from affiliates based in high-tax states. Despite this fact, the study appears to be leaning towards a recommendation to not enact combined reporting.

Transfer Pricing

The transfer pricing study is a great report to review if you want to learn more about transfer pricing. The conclusion of the report explains the realities of related party transactions that exist due to complex business structures dominated by parent companies with affiliates in multiple states and countries. As a result, scrutinizing intercompany transactions is a necessity.

The study confirms that transfer pricing examinations and analysis are complex and expensive, and asserts that if a transfer pricing study is not conducted in an efficient and effective manner, it could be detrimental to the taxpayer. To reduce the amount of disputed transactions, Indiana requires the addback of deductions taken for royalties, intangible related-party expenses and intercompany interest. However, other states currently have broader addback provisions or have enacted combined reporting.

So What?

Indiana has had many cases and rulings that reflect the complexities and burdens of analyzing and resolving the proper treatment of intercompany transactions and transfer pricing studies. Consequently, Indiana and taxpayers have spent resources (time and money), which both the state and taxpayers do not have, to resolve these matters. Hence, in my opinion, Indiana should adopt combined reporting to reduce the amount of disputes involving intercompany transactions and transfer pricing studies. The whole question of whether an intercompany transaction is at arms-length doesn't matter when intercompany transactions are eliminated in a combined return. Albeit, there may be some entities that are not a part of the group and the issue could still occur. In addition, combined reporting will create new issues to deal with, such as what entities are part of the unitary group. However, I believe it is less of a burden for states and taxpayers to manage the issues related to combined reporting versus the issues related to transfer pricing studies and analyzing related party transactions.