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Looking ahead at the next five years, the legislative and regulatory trends we can expect include exporting of the tax burden, expanding the tax base, and closing perceived loopholes. How does this impact a business’ state tax department? What should your state tax department be thinking about in order to be proactive and get ahead of these trends and position their companies to deal with the impact in order to optimize the results for the business?
Exporting the tax burden
States are shifting the tax burden from in-state companies to out-of-state companies. Historically, a company needed property or employees in the state to be subject to tax. Today, businesses are relying less on physical presence in the form of manufacturing plants or brick and mortar stores to conduct commerce. Also, states are moving away from asserting jurisdiction over only those companies with a physical presence, and asserting nexus over companies based on an economic presence only. As business is conducted more in the “ether,” states are adjusting their jurisdictional reach to match the way commerce is conducted.
The result is that companies will be subject to tax in states where they have sales or other activities.
Another way states are exporting the tax burden is by altering the income tax apportionment formula. Historically, most states used a three factor formula to determine how much of a company’s income should be apportioned or attributed to a particular state: a ratio of equally weighted property, payroll and sales. Determining the amount of income sourced to a state was based on the property, payroll and sales into the state over total property, payroll and sales.
Today, most states have changed to a “single sales factor” to determine how much of a company’s income should be apportioned to a state. A single sales factor exports the tax burden because a taxpayer’s income sourced to the state is based solely on the sales made into the state. Companies are not penalized (i.e., taxed) by putting property and payroll in a state. Taxation is based purely on sales into the state. Thus, technically, a company can have all its people and property in a state and, if it has no sales in the state, no income tax liability.
How are sales sourced? Many states have moved to a market-based sourcing regime for sales of other than sales of tangible personal property. In general, this is how it works: A company’s sales of other than tangible personal property are attributed to a state in which its customers receive the benefit or where the services were delivered. There are many nuances to this determination and different states have different rules.
Expanding the tax base
States are broadening the types of transactions that are subject to sales and use tax. For example, services in many states have historically not been subject to sales and use tax. Today, more states are seeking to tax services.
Sales and use tax is generally imposed on sales of tangible, personal property. As the economy has changed, that’s expanded to include sales of intangibles, software and more recently, the sales tax base has expanded to include services.
States are also moving to combined unitary reporting, which is when all affiliated companies that operate the unitary business file as part of one tax return in a jurisdiction.
Companies will likely be filing in more states than in the past. The tax department will be required to work closely with their business units to understand in which states their companies are doing business so the tax department knows where to file. Companies that don’t have nexus may be brought into a combined return in that state and, therefore, be filing in more states than the past.
According to Peter Michalowski, national practice leader of PwC’s State and Local Tax (SALT) practice, “A lot of this is being driven by the fact that states are under pressure to raise revenue to address rising costs and to balance budgets. Many states have large, unfunded or underfunded pension liabilities. These states are faced with an ageing workforce, delayed infrastructure projects, and rising healthcare costs. The states have a lot of demands from a revenue perspective. Much of the legislation we’re talking about is designed to help address those budgetary demands the states are struggling to meet.”
Closing perceived loopholes
Legislation targeting activities in so-called tax havens and elimination of certain deductions are trends we’ve seen on the federal and international side and are now seeing at a local and state level.
Michalowski also noted that “In 2016, twelve states proposed legislation in an attempt to tax income earned offshore by U.S. companies in countries considered tax havens. States may have proposed their own tax haven legislation to try to tax this income because the states don’t believe the federal legislation has effectively stopped profit-shifting to these offshore jurisdictions.
“I think these rules are a far-reaching. These states have named certain countries as tax havens based on laws and tax rates in those countries, in some cases without regard to what level of business activities a company may have in that country. Under the states’ provisions, if you have entities that are operating in those countries, you’re required to include the income earned in those countries in the state tax base. I think tax haven legislation that’s been proposed and/or enacted by the states could be subject to litigation in the future. There are possible constitutional questions around it but time will tell,” says Michalowski.
An additional field that states are addressing as they try to close perceived loopholes is the credits and incentives area. States often offer companies attractive incentive packages to move jobs or open facilities. There has been more of a focus around the transparency and documentation that companies have to provide as to whether they’re meeting their obligations under those packages and many jurisdictions are including claw back provisions to recover benefits provided to companies if the business does not meet its obligations.
Michalowski explains, “State tax departments have to make sure they’re complying with the requirements set forth in the incentive agreements they negotiated with the state, or statutory credits they have claimed as both have significant documentation requirements that the states are reviewing closely. For companies to get the full benefit of those credits and incentives they need to make sure that they provide all requested documentation.”