State Tax Transfer Pricing - What's Next?

Recent media reports reflect that transfer pricing in the state tax area is gaining more scrutiny and attention due to international tax developments like OECD BEPS, but also the Multistate Tax Commission's Arms-Length Adjustment Service (ALAS) initiative, previous state litigation and growing interest in tax haven legislation. 

A nice presentation delivered by Michael Bryan, Karl Frieden, Jeff Friedman and Marshall Stranburg at the Federation of Tax Administrators Annual Meeting on June 13, 2016, provides good background information on the basics and importance of transfer pricing while describing the current environment.  

The presentation defines transfer pricing as "the pricing of transactions between related entities for goods, intangible assets, services, and loans." Transfer pricing is "designed to prevent tax avoidance among related entities by requiring pricing equivalent to prices available with an uncontrolled party:

• Transactions must (generally) be at arm’s length
• Non-arm’s length intercompany transactions can impact the clear reflection of income in states where income is reported on a separate or partial combination basis
• Tax evasion or avoidance generally not a pre-requisite for making a transfer pricing adjustment"

According to the presentation, the "key intercompany transactions subject to transfer pricing" are: 

• Transfer and licensing of intangible assets
• Providing and charging for common services
• Financing
• Factoring accounts receivables
• Sale of tangible goods that contain a trademark or other intangible
• Purchase and resale of tangible goods

WHAT'S NEXT?

The presentation ends with a question - "What's Next?" This is the most important question.

What should companies do now? How can companies plan? What path will states take to combat this perceived abuse? Will states piggyback off of BEPS? Will states get involved with the MTC initiative? Will states actually enact and enforce tax haven legislation? Or will states simply adopt worldwide combined reporting? Worldwide combined reporting seems to be a simpler approach. However, as I have noted before, making a simple general rule may not be beneficial to a state if applied to taxpayers across the board.

Consequently, it makes more sense for states to have discretionary authority and make case-by-case adjustments so they can better control the impact on revenue. Therefore, I think states will continue to use a combination of all of the tools that will allow them to retain discretionary authority and control. 

In the words of Dave Brunori, "when proving arm’s-length pricing, the side that can spend the most on good lawyers, accountants, and economists almost always wins." We shall see.

For more information, check out my previous post on the MTC ALAS program.

Should the Federal Government Pre-empt A State's Taxing Power?

I recently read an article by Shirley Sicilian from KPMG where she interviewed Greg Matson, the Executive Director of the Multistate Tax Commission. Good article. Recommended reading.

In the article, Ms. Sicilian asks Mr. Matson what he thinks will 'rock the tax world' in the next few years? Mr. Matson's response included the overturning of Quill, the ripple effect of BEPS on states, and states challenging congressional authority to pre-empt their taxing power.

With all of the court case challenges to Quill and the states trying to impose sales tax collection or reporting requirements on remote sellers, and the proposed federal legislation to reinforce Quill, I have been thinking about the battle between state sovereignty and federalism.

State sovereignty is the concept that states are in complete and exclusive control of all the people and property within their territory. State sovereignty also includes the idea that all states are equal as states.

Sovereignty is the power of a state to do everything necessary to govern itself, such as making, executing, and applying laws; imposing and collecting taxes; making war and peace; and forming treaties or engaging in commerce with foreign nations.

The individual states of the United States do not possess the powers of external sovereignty, such as the right to deport undesirable persons, but each does have certain attributes of internal sovereignty, such as the power to regulate the acquisition and transfer of property within its borders. The sovereignty of a state is determined with reference to the U.S. Constitution, which is the supreme law of the land.

I believe in state sovereignty and as much as I like uniformity and less complexity, I support a state's rights to make their own laws. However, when states overreach and attempt to enact unconstitutional taxes, that is when the federal government or the U.S. Supreme Court has to step in. 

When do you think the Federal government should step in?

Note: For more on federalism and state sovereignty, check out Federalism, State Sovereignty, and the Constitution: Basis and Limits of Congressional Power by Kenneth R. Thomas, Legislative Attorney.

NO REGULATION WITHOUT REPRESENTATION

The folks over at McDermott Will & Emery and the 'Inside SALT' blog made me aware of the "No Regulation Without Representation Act of 2016" (H.R. 5893). The bill was introduced by Congressman Jim Sensenbrenner (R-Wis.).   

The bill would require a person to have a physical presence in a state before the state can impose a sales or use tax collection or reporting requirement, an assessment, or treat the person as doing business (having 'nexus') in the state.

In essence, this bill is a glimmer of hope for remote sellers against the onslaught of state nexus expansion laws that have been enacted over the past few years, and the current litigation in South Dakota and Alabama where states are attempting to impose collection obligations on businesses without a physical presence.

The bill defines physical presence to include:

1. owning or holding a leasehold interest in, or maintaining real property such as a retail store, warehouse, distribution center, manufacturing operation or assembly facility;
2. leasing or owning tangible personal property (other than computer software) of more than de minimus value in the state;
3. having one or more employees, agents or independent contractors present in the state who engage in specific solicitations toward obtaining product or service orders from customers in that state, on behalf of the person;
4. having one or more employees or independent contractors present in the state who provide on-site design, installation, or repair services on behalf of the remote seller; 
5. maintaining an office in the state at which it regularly employs three or more employees for any purpose.

According to the bill, 'physical presence' does NOT include:

1. referral agreements with in-state persons who receive commissions for referring customers to the seller;
2. having a presence in the state for less than 15 days in a taxable year;
3. product delivery in-state by a third-party;
4. Internet advertising services not exclusively directed towards, or exclusively soliciting in-state customers.

If the Act gains traction and is actually enacted, it would apply to calendar quarters beginning on or after January 1, 2017.

It is too early to tell if this bill will actually go anywhere, but it is nice to see a bill like this get introduced.

GET THINGS DONE. MAKE THINGS HAPPEN.

You walk into a business, store, restaurant, service company, etc. You have a problem or need that requires help, a solution. If the problem is not straight forward or goes outside the 'normal operating procedure,' some employees would freeze. They would say they couldn't do it because 'the rules' tell them they can't or they don't have permission. Others may say, this isn't the norm, but let me see what I can do. A few minutes later, they have a solution, a work around, something that solves your problem without hurting the company. Something that will eventually help the company because the employee just showed me that common sense, ingenuity and the desire to help a customer trumps the 'way it must be done.' The personal ambition or motivation to actually do a good job, not just 'punch the clock.'

I call these people, 'get things done, make things happen' people. 

Any time I find these people, I shout for joy! They are my kind of people. Not working or living inside a box, but working to make the box bigger. Actually living each day with personal motivation to do the best, be the best and actually help others solve problems.

Today, I encourage you to be one of those people. 

GET THINGS DONE. MAKE THINGS HAPPEN.

STATE TAX LETTER RULINGS, OBTAINING CLARITY PART 1: THE PROCESS IN TENNESSEE

In our quest for clarity in the maze of continual multistate tax challenges and developments, we search our tax research databases, we contact colleagues, and yet, sometimes, we still don't know what to do. One option is to get a "letter ruling" or "private letter ruling." 

I want to provide you with information on each state's letter ruling process. Then we will explore 'how' to write a letter ruling.

Note: "When" to write a letter ruling is a judgment call based on the facts surrounding your case, and the specific state's process and other rulings the state has issued. 

I plan on writing about each state's letter ruling process in future blog posts. Today, I am focusing on Tennessee's letter ruling process since I recently moved to Tennessee. 

According to Tennessee law, a letter ruling is an interpretation and application of the tax law as it relates to a specific set of facts furnished to the Department by the taxpayer. Assuming the facts are correctly represented by the taxpayer requesting the letter ruling, the Department is bound to follow its decision with respect to that taxpayer. The taxpayer’s identity must be disclosed to the Department in its letter ruling request.

Revenue rulings are statements regarding the substantive application of law and statements of procedure that affect the rights and duties of taxpayers and other members of the public. Revenue rulings are advisory in nature and are not legally binding on the Department. The taxpayer’s identity is not required for a nonbinding revenue ruling.

When exceptional circumstances require immediate consideration of an issue, a taxpayer can request an expedited letter ruling or revenue ruling by expressly making such request in writing and submitting an expedited ruling fee of $10,000 with the request. When an expedited ruling is requested, the Commissioner of Revenue will either issue a ruling within sixty days from the date of the request or deny the request and return the fee to the requesting party within seven days from the date of the request.

Fees

The fee for the issuance of a letter ruling or revenue ruling is $500.
The fee for the issuance of an expedited ruling is $10,000.

To request a ruling, the taxpayer (or the taxpayer’s representative) should send a letter to the Commissioner of Revenue, 500 Deaderick Street, Nashville, TN 37242.

The letter should include the following:

• The taxpayer’s (or representative’s) contact information, including mailing address and telephone number;
• A check for the applicable fee;
• A fully completed Power of Attorney, if required (see below);
• The taxpayer’s question or questions;
• A description of all relevant facts;
• A copy of any pertinent sample invoices, contracts or the like (which may be provided in redacted form); and
• If appropriate, pictures of the equipment, products, or other items that are the subject of the ruling request.
• The letter may also include the taxpayer’s analysis of the law; however, this is not required.

Power of Attorney

The Department places extremely high importance on maintaining taxpayer confidentiality. In many cases, the taxpayer requesting a letter ruling wishes for the Department to communicate with its outside representative, such as a CPA or attorney. In such instances, the taxpayer must sign a Power of Attorney, which is available on the Department's website.

The Power of Attorney must list all outside representatives with whom the Department is permitted to communicate about the letter ruling request. A Power of Attorney is not required if the only people with whom the Department will communicate are the individual taxpayer, or the owners and employees of the taxpayer company.

The Process: From Request to Issued Ruling

Each ruling request is assigned to a Department attorney when received. The attorney will contact the taxpayer (or representative) to request any additional necessary information and to clarify any questions the attorney may have. The attorney works closely with the Department's General Counsel to research and prepare a preliminary draft of the ruling. When completed, the preliminary draft is sent to various divisions within the Department for review. The attorney may further revise the draft ruling, based upon comments received from the reviewers. Once the review and revision process is complete, the final version of the ruling is sent to the Commissioner's office. At least one Deputy Commissioner reviews the ruling before it is given to the Commissioner. In appropriate cases, the Commissioner will meet with the Deputy Commissioners and the Department's legal staff to discuss the ruling. After thorough consideration, the Commissioner will issue the ruling to the taxpayer.

Rulings on the Department of Revenue's Website

It is the policy of the Department that all letter rulings and revenue rulings that are instructive to other taxpayers, and that are not detrimental to the State’s Economic Development efforts, will be made available to the general public on the Department's Web site. All rulings will be redacted to remove identifying taxpayer information before being made public. The taxpayer will have the opportunity to review and comment on the proposed redacted version before it is made public. The Department will consider requests that rulings not be published based on a taxpayer's belief that confidentially cannot be accomplished in a redacted version of the ruling. Any request for non-publication, even in redacted form, should be made in the ruling request and must include a detailed explanation as to why the ruling should not be made public.

Duplicative Ruling Requests

If a tax ruling has been previously issued on a specific topic, the Department is not likely to issue another ruling on the same topic unless the taxpayer can show that its facts are materially different from the facts that serve as the basis for the issued ruling, or that there has been a substantive change in the law. If a taxpayer submits a ruling request that is duplicative of previously issued guidance, the Department will likely respond by informal letter and provide a copy of the applicable previously issued tax ruling, in addition to returning the taxpayer's ruling fee.

Revocation of a ruling

Rulings may be revoked or modified by the Commissioner at any time. The revocation or modification of a letter ruling will be effective retroactively unless the following conditions are met, in which case the revocation will be prospective only:

• The taxpayer must not have misstated or omitted material facts involved in the transaction;
• Facts that develop later must not be materially different from the facts upon which the ruling was based;
• The applicable law must not have been changed or amended;
• The ruling must have been issued originally with respect to a prospective or proposed transaction; and
• The taxpayer directly involved must have acted in good faith in relying upon the ruling and a retroactive revocation of the ruling must inure to his detriment.

Statutory Authority Tenn. Code Ann. Section 67-1-109 gives the Commissioner the power to issue revenue and letter rulings at his discretion.

Global Business and Technology Causes Overreaching Laws and Unintended Consequences

Now that the Organisation for Economic Co-operation and Development (OECD) has released its recommendations and actions under the Base Erosion and Profit-Shifting (BEPS) project, federal legislation and subsequent state law changes may occur causing companies to adapt.

The article by Deloitte entitled, "Global Business and State's Challenges to Taxable Income," reminds us of the various methods or tactics states have taken to reduce or eliminate a company's ability to plan around taxation by using intercompany transactions and out-of-state / off-shore entities.

For example, states have utilized Internal Revenue Code (IRC) Sec. 482 like powers to remove the income distortion created by intercompany transactions not completed at arms-length. States have also enacted combined reporting and various related-party expense addback provisions. The most recent method used by states to tax revenue earned outside their borders is tax haven legislation - look here for more info.

When states enact combined reporting, they usually require water's-edge reporting or allow taxpayers to make an election to use water's-edge reporting. Why don't states require worldwide combined reporting?  Worldwide combined reporting would address the tax haven issue so why don't states require it? The short answer, states may not get more revenue if they required worldwide combined reporting. The inclusion of foreign income and apportionment factor dilution can cause unexpected results. Thus, what seems like a great solution on the surface, may not be in practice. Other factors that come into play include currency, accounting methods, and international tax planning which can cause complications. For more info see, "Are Tax Havens Pushing States to Worldwide Combined Reporting." 

As a result, states that enact combined reporting continue to use other laws to selectively decide when and how a foreign entity is included in a combined group return. For example, states that require water's-edge reporting generally have foreign entity inclusion / exclusion rules. One such law provides that foreign operating companies (a U.S. corporation with substantial operations outside the U.S. and at least 80% of its income is active foreign business income) are generally excluded from combined groups (i.e., 80/20 rule). 

In spite of the 80/20 rule, taxpayers have successfully included foreign operating companies in a combined return. For example, in a recent Minnesota Tax Court case (Ashland Inc. and Affiliates vs. Commissioner of Revenue), the Court ruled that a foreign disregarded entity's income and apportionment factors could be included in a Minnesota combined return because the foreign entity was not a separate entity from it's owner. 

In general, court cases and rulings tell us that states have a variety of rules to capture revenue earned outside their borders. Court cases and rulings also tell us that taxpayers can navigate those rules to plan and effectively choose which foreign entities are included or excluded. 

As the business world becomes even more global, and technology erases the easily identifiable lines of where a transaction begins and ends, taxing authorities have a very complicated job to tax the 'right' amount of a taxpayer's income. 

As tax laws change in response to the OECD and BEPS, companies will continue to adapt in response to those changes. Consequently, if history tell us anything, there will always be laws that overreach, and unintended consequences (planning opportunities). Prepare accordingly.