On December 19, 2017, DC Councilmember Mary Cheh introduced the District Tax Independence Act of 2017 (Act), which would require the Chief Financial Officer (CFO) to submit a report outlining the steps and amendments necessary to decouple the District’s tax deduction laws from federal law. As introduced, the Act would require this report by no later than April 30, 2018. The Act was referred to the Committee on Finance and Revenue the same day it was introduced and has not been taken up by the committee, which has been dormant since and is not currently scheduled to meet again until the Council returns in late January. The legislation is co-sponsored by Councilmembers Allen, Evans, McDuffie, Bonds, Gray, Nadeau, R. White, Grosso, Silverman, T. White, and Chairman Mendelson. Notably, all members of the Committee on Finance and Revenue—including Chairman Evans—are co-sponsors. Practice Note The introduction of the Act signals the Council’s overwhelming disapproval of the federal tax reform enacted by Congress and signed by President Trump on December 22, 2017. This is a process that is likely to take place across the country as states begin to assess the revenue impact of the federal tax reform legislation on their state corporate income and franchise tax regime. The District currently conforms to many federal deductions on a rolling basis for purposes of the Franchise Tax, which is imposed on both corporations and unincorporated entities. See generally DC Code Ann. § 47-1803.03. As part of the decoupling process, the CFO and Council will need to determine which deductions to alter to avoid a significant revenue loss and what the DC treatment should be. Furthermore, the CFO and Council should consider which deductions are necessary to retain due to related increases to the federal tax base, which DC utilizes as the starting point for Franchise Tax purposes. The effective dates and relation to 2017 return deadlines will be critical to monitor as this process moves forward, as several portions of the federal tax reform are effective for the 2017 tax year—meaning the corresponding District changes (if any) will need to be retroactive since returns (absent extensions) are due before the CFO’s report to the Council is. DC taxpayers with specific questions on how this process may impact their Franchise Tax liability in 2017 and going forward are encouraged to contact the authors.
Yesterday, the application period opened for the limited-time MTC Marketplace Seller Voluntary Disclosure Initiative opened and it will close October 17, 2017. Since our last blog post on the topic detailing the initiatives terms, benefits and application procedure, six additional states (listed below) have signed on to participate in varying capacities. The lookback period being offered by each of the six states that joined this week is described below.
- District of Columbia: will consider granting shorter or no lookback period for applications received under this initiative on a case by case basis. DC’s standard lookback period is 3 years for sales/use and income/franchise tax.
- Massachusetts: requires compliance with its standard 3-year lookback period. This lookback period in a particular case may be less than 3 years, depending on when vendor nexus was created.
- Minnesota: will abide by customary lookback periods of 3 years for sales/use tax and 4 years (3 look-back years and 1 current year) for income/franchise tax. Minnesota will grant shorter lookback periods to the time when the marketplace seller created nexus.
- Missouri: prospective-only for sales/use and income/franchise tax.
- North Carolina: prospective-only for sales/use and income/franchise tax. North Carolina will consider applications even if the entity had prior contact concerning tax liability or potential tax liability.
- Tennessee: prospective-only for sales/use tax, business tax and franchise and excise tax.
The MTC marketplace seller initiative is now up to 24 participating states. It is targeting online marketplace sellers that use a marketplace provider (such as the Amazon FBA program or similar platform or program providing fulfillment services) to facilitate retail sales into the state. In order to qualify, marketplace sellers must not have any nexus-creating contacts in the state, other than: (1) inventory stored in a third-party warehouse or fulfillment center located in the state or (2) other nexus-creating activities performed by the marketplace provider on behalf of the online marketplace seller.
While Missouri, North Carolina and Tennessee have signed on to the attractive baseline terms (no lookback for sales/use and income/franchise tax), Minnesota and Massachusetts are requiring their standard lookback periods (i.e., 3+ years). Thus, these two states (similar to Wisconsin) are not likely to attract many marketplace sellers. The District of Columbia’s noncommittal case-by-case offer leaves a lot to be determined, and their ultimate offer at the end of the process could range from no lookback to the standard three years.
Last month, a bill (The False Claims Amendment Act of 2017, B22-0166) was introduced by District of Columbia Councilmember Mary Cheh that would allow tax-related false claims against large taxpayers. Co-sponsors of the bill include Chairman Jack Evans and Councilmember Anita Bonds. Specifically, the bill would amend the existing false claims statute to expressly authorize tax-related false claims actions against persons that reported net income, sales, or revenue totaling $1 million or more in the tax filing to which the claim pertained, and the damages pleaded in the action total $350,000 or more. The bill was referred to the Committee of the Whole upon introduction, but has not advanced or been taken up since then. Nearly identical bills were introduced by Councilmember Cheh in 2013 and 2016. Continue Reading DC Council Introduces False Claims Expansion – Taxpayers Beware!
Yesterday, the D.C. Council Committee of the Whole held an advocates-only hearing on the Universal Paid Leave Act of 2015 (Act), which was introduced on October 6, 2015 by a majority of councilmembers. As introduced, this bill establishes a paid leave system for all District of Columbia (District) residents and all workers employed in the District. It allows for up to 16 weeks of paid family and medical leave, which would more than double the amount of weeks (and dollar cap) of any U.S. state-sponsored paid-leave program. While other state paid family and medical leave programs are paid by the employees themselves, the benefits for employees of a “covered employer” (i.e., private companies in the District) would be funded by a one percent payroll tax on the employer. There has been talk of setting a minimum threshold of employees (i.e., 15-20 employee minimum) for an employer to be covered by the Act, although such a requirement does not exist in the current draft. Because the District cannot tax the federal government or employers outside its borders, District residents working for one of these entities are required to contribute to the fund individually. This would result in a strange dynamic that taxes District residents differently based on whether they work for a covered employer or not. Self-employed District residents have the ability to opt-out altogether (and not contribute to the fund or receive benefits) under the Act.
The definition of “covered employee” is drafted in such a way that temporary and transitory employees (i.e., “employed during some or all the 52 calendar weeks immediately preceding the qualifying event”) could claim the full 16 weeks of benefits and have no obligation to return to the job. The Act does exclude employees that spend more than 50 percent of their time working in a state other than District; however, this exclusion would not apply to employees that do not spend a majority of their time in any one state.
A qualifying individual is one who becomes unable to perform their job functions because of a serious health condition or to care for a family member with a serious health condition or a new child. Claims are filed with the District Government and the District must notify the employer within five business days of a claim being filed. Beneficiaries will receive 100 percent of their average weekly wages (up to $1,000 per week) plus 50 percent of their average weekly wages in excess, with a weekly cap of $3,000.
Advocates testifying yesterday expressed concerns that the proposed one percent rate (considered high by many) is unrealistic and would fall significantly short of funding the generous benefits—although no definitive data is available at this time. Aside from highlighting the unprecedented breadth of the benefits, many advocates also noted the significant loopholes in the current draft that could lead to unintended—and potentially unconstitutional—consequences, if passed. At this point, it appears that the Council has their work cut out for them to gain the support of the business community. One (or more) public hearings will also be held on the Act, with the first tentatively scheduled for January 2016. If the Act is passed next year, it will be interesting to see whether Congress will disapprove via joint resolution, as permitted by the Home Rule Act. Any such disapproval must be signed by the President, who has publicly expressed support of the Act. Stay tuned…
After being in effect for only a week, the Council of the District of Columbia (Council) unanimously enacted legislation today that will repeal the list of tax haven jurisdictions specifically enumerated in the D.C. Code. The legislation, titled the Fiscal Year 2016 Second Budget Support Clarification Emergency Amendment Act of 2015 (Act), was introduced on September 22, 2015, after the list created an uproar from singled-out countries and the business community alike. The tax haven list was passed on August 11, 2015, as part of the Fiscal Year 2016 Budget Support Act of 2015 (BSA), which became effective on October 22, 2015. The inclusion of the tax haven list in the BSA was as a supplement to the tax haven criteria that already existed in the D.C. Code.
As passed today, Section 6 of the Act repeals the tax haven list (and accompanying language) added by the BSA in August and restores the relevant D.C. Code provisions to their pre-BSA state. Thus, effective immediately, the tax haven standard established by D.C. Code § 47-1801.04(49), as amended, is as follows:
“(A) ‘Tax haven’ means a jurisdiction that:
(i) For a particular tax year in question has no, or nominal, effective tax on the relevant income and has laws or practices that prevent effective exchange of information for tax purposes with other governments regarding taxpayers benefitting from the tax regime;
(ii) Lacks transparency, which, for the purposes of this definition, means that the details of legislative, legal, or administrative provisions are not open to public scrutiny and apparent or are not consistently applied among similarly situated taxpayers;
(iii) Facilitates the establishment of foreign-owned entities without the need for a local substantive presence or prohibits these entities from having any commercial impact on the local economy;
(iv) Explicitly or implicitly excludes the jurisdiction’s resident taxpayers from taking advantage of the tax regime’s benefits or prohibits enterprises that benefit from the regime from operating in the jurisdiction’s domestic market; or
(v) Has created a tax regime that is favorable for tax avoidance, based upon an overall assessment of relevant factors, including whether the jurisdiction has a significant untaxed offshore financial or other services sector relative to its overall economy.
(B) For the purposes of this paragraph, the term “tax regime” means a set or system of rules, laws, regulations, or practices by which taxes are imposed on any person, corporation, or entity, or on any income, property, incident, indicia, or activity pursuant to governmental authority.”
Because only the tax haven list provisions—and not the historic tax haven criteria—were repealed today, the criteria will be the sole determiners of whether a jurisdiction is a tax haven for District Income and Franchise Tax purposes. The legislation enacted today was done on an emergency basis, with an identical temporary bill unanimously advancing for a third reading. This means that the repeal will be effective immediately, but will require subsequent permanent legislation to continue its effect beyond the 90 and 225 day (if the temporary bill is passed at a later date) periods of applicability permitted for emergency and temporary legislation, respectively.
Council Chairman Phil Mendelson has indicated his continued support for the tax haven list in a memorandum describing the enacted amendment, stating that “[t]he enumerated list improves enforcement, and is based on legislation adopted in two states . . . Repeal allows for additional time to evaluate what jurisdictions should qualify as a tax haven under existing law.” Stay tuned to see whether the Council ultimately embraces a tax haven list in the District or relies on their pre-existing regime.
The Fiscal Year 2016 Budget Support Act of 2015 (BSA), introduced by the Washington, D.C. Council at the request of Mayor Muriel Bowser on April 2, 2015, contains a subtitle (see Title VII, Subtitle G, page 66-67) that would give the Office and Tax and Revenue (OTR) complete discretion to indefinitely suspend the period of limitation on assessment and collection of all D.C. taxes—other than real property taxes, which contain a separate set of rules and procedures. The change to the statute of limitation provision would eliminate a fundamental taxpayer protection that exists today in all states. Those concerned should reach out to members of the D.C. Council to discourage adoption of this subtitle of the BSA.
Under current law, the amount of tax imposed must be assessed (in other words, a final assessment must be issued) within three (3) years of the taxpayer’s return being filed. See D.C. Code § 47-4301(a). Practically speaking, this requires the mayor to issue a notice of proposed assessment no later than two (2) years and 11 months after the return is filed—to allow the taxpayer the requisite 30 days to file a protest with the Office of Administrative Hearings (OAH). See D.C. Code § 47-4312(a). As the law reads today, the running of the period of limitation is suspended between the filing of a protest and the issuance of a final order by OAH, plus an additional 60 days thereafter. See D.C. Code § 47-4303. The District has 10 years after the final assessment to levy or begin a court proceeding for collections. See D.C. Code § 47-4302(a).
The BSA would extend the limitation period for assessment and collection, as follows:
- The BSA would add a new provision to statutorily require the chief financial officer (CFO, the executive branch official overseeing the OTR) to send a notice of proposed audit changes at least 30 days before the notice of proposed assessment is sent; and
- The BSA would toll the running of the statute of limitation on assessment and collection during the period after the CFO/OTR issues the aforementioned notice of proposed audit changes until the issuance of a final assessment or order by OAH.
The BSA does not indicate an applicable date for these changes. As a result, the provision likely would be applicable to any open tax period, effectively making the change retroactive to returns already filed.
By changing the law to toll the statute of limitation for the period after OTR issues a notice of proposed audit changes, the BSA would allow OTR to unilaterally control whether the three-year statute of limitation is running. The current statute requires that OTR issue its notice of proposed assessment before the expiration of the three-year statute—and gives taxpayers the ability to protest such notices before the OAH. By tolling the statute upon issuance of a notice of proposed audit changes, which is not subject to review by OAH, the BSA would strip taxpayers of the protection offered by a three-year statute of limitations closing the tax year. Instead, OTR would be able to indefinitely toll the statute by issuing a notice of proposed audit changes—an undefined document with no current statutory basis, which is not subject to judicial review. The end result for taxpayers will be indefinite audits and a disruption of the timely and efficient closing of tax years. We note that the approach is also inconsistent with the OTR’s own ‘Taxpayer Rights’ promise of “prompt treatment.”
In his recent article, “A Cursory Analysis of the Impact of Combined Reporting in the District”, Dr. Eric Cook claims that the District of Columbia’s (D.C. or the District) newly implemented combined reporting tax regime is an effective means of increasing tax revenue from corporate taxpayers, but it will have little overlap with D.C.’s ongoing federal-style section 482 tax enforcement. Dr. Cook is chief executive officer of Chainbridge Software LLC, whose company’s product and services have been utilized by the District to analyze corporations’ inter-company transactions and enforce arm’s length transfer pricing principles. Combined reporting, (i.e., formulary apportionment, as it is known in international tax circles) and the arm’s length standard, are effectively polar opposites in the treatment of inter-company taxation. It is inappropriate for the District (and other taxing jurisdictions) to simultaneously pursue both. To do so seriously risks overtaxing District business taxpayers and questions the coherence of the District’s tax regime.
Both combined reporting and 482 adjustments have had a renaissance in the past decade. Several tax jurisdictions, including the District, enacted new combined reporting requirements to increase tax revenue and combat perceived tax planning by businesses. At the same time, some tax jurisdictions, once again including the District, have stepped up audit changes based on use of transfer pricing adjustment authority. This change is due in part to new availability of third-party consultants and the interest in the issue by the Multistate Tax Commission (MTC). States have engaged consultants, such as Chainbridge, to augment state capabilities in the transfer pricing area. At the request of some states, the MTC is hoping to launch its Arm’s Length Audit Services (ALAS) program. States thus have increasing external resources available for transfer-pricing audits.
A similar discussion regarding how to address inter-company income shifting is occurring at the international level, but with a fundamentally important different conclusion. The national governments of the Organization for Economic Cooperation and Development (OECD) and the G-20 are preparing to complete (on a more or less consensual basis) their Base Erosion and Profit Shifting action plan. This plan will reject formulary apportionment as a means of evaluating and taxing inter-company transactions. Thus, in the international context, formulary apportionment and transfer pricing adjustment authority are not seen as complementary, but instead are seen as mutually exclusive alternatives. The history of formulary apportionment in international context sheds light on why states make a mistake when they seek to use both combined reporting and transfer pricing adjustments.
A combined reporting basis of taxation seeks to treat the members of a consolidated group as a single entity, consolidating financial accounts of the member entities and allocating a portion of the consolidated income to the taxing jurisdiction based on some formula or one or more apportionment factors. Under the arm’s length approach, individual entities of a consolidated group within a single jurisdiction are treated (generally) as stand-alone entities and taxed according to the arm’s length value (the value that would be realized by independent, third party entities) of their inter-company transactions.
National governments have for decades wrestled with the taxation of inter-company transactions amongst the largest corporations and the most complex transfer pricing arrangements. Going back to the earliest days of corporate income taxation, the “economic experts” to the League of Nations rejected formulary apportionment for cross-border taxation, having found, “the methodology has no fundamental basis in economic theory which is capable of easy application”.
Arguments in favor of combined reporting (formulary apportionment) generally center on simplicity of concept, administrative ease and reduced compliance burden, along with increased, comprehensive (and thereby, effective?) revenue collection. These arguments are generally from the perspective of the taxing authorities—who struggle with lack of resources, information and a complexity of rules and corporate structures.
And, yet, as is evident from the eight-part article authored by Michael Durst, former Director of the Internal Revenue Service (IRS) Advance Pricing Agreement program—devising and implementation of a formulary apportionment regime is anything but simple, or its results anything but certain or effective. Aside from the structural issues of determining the tax base (in terms of the inclusion of income categories and the disallowance of deductions, as well as inclusion/exemption of corporate members) and the selection of apportionment factors, there is the entire political issue of jurisdictional consensus. Then there are the economic issues, both theoretical and practical—in terms of tax incidence, incentives and economic substance, to name a few. In terms of today’s most vexing transfer pricing problem facing both state and national tax authorities—matching tax receipts with economic activity/value creation— combined reporting offers an imprecise and spurious solution.
States Should Make a Choice
Because transfer pricing adjustments and combined reporting are alternatives, not complements, states should choose which system to adopt. States that seek to utilize both lack a coherent tax imposition policy and create significant risk that their business taxpayers will be double taxed.
The international context explains why states with existing transfer pricing adjustment programs should reject adopting combined reporting. In the case of the District’s combined reporting regime, Dr. Cook’s claim that the program is both more effective (increases tax revenue) and efficient (non-overlapping) is both unlikely and one-sided. From the District’s standpoint, it may be true that they experienced an increase in tax revenue, but what is more likely that this is a “shift” (or more accurately, a double count) in tax liability from one jurisdiction to the next. One of the (other) problems with implementing combined reporting, especially on a unilateral basis, is defining the tax base and segmenting economic activity that originates in one jurisdiction and culminates in another, so as to ensure a single tax on the same unit of economic activity.
It is likely that the reported increased tax revenue cited by Dr. Cook is nothing more than an expanded reporting of revenue among entities established and operating outside of the District and selling into the District—that is, entities whose physical presence and economic talents (activity) are outside of the District but whose products are sold within or with nexus to the District. Unless the District’s program has some mechanism to identify (and inter-state agreement to credit) the increased tax liability associated with economic activity (value creation) in other tax jurisdiction(s), it will only be taxpayers that will realize a “real” increase in (double) tax.
Dr. Cook incorrectly asserts that combined reporting and transfer pricing should co-exist. The fact that additional revenue can be earned from imposing both regimes does not mean that both regimes should be implemented. He specifically notes that 30 taxpayers, or 10 percent of his sample, would have tax increases based partially on the effects of combined reporting and partially as a result of transfer pricing adjustments. This is an unacceptable overlap of competing tax regimes. Furthermore, Dr. Cook supports imposing both systems because most of the companies sampled did not have an increase in tax under the combined reporting regime but did under a transfer pricing analysis. This does not suggest that both regimes are necessary to properly calculate tax, but rather that both regimes are attractive to state revenue authorities because it increases their odds of finding new tax money. If someone asks us if we would like a cookie, a bowl of ice cream or both, we are always going to take both. This does not mean it is the appropriate thing to do.
Finally, while Dr. Cook does not directly address the issue, it is likely that any valid transfer pricing adjustment in a combined reporting regime is a result of international, rather than purely domestic, inter-company transactions. If this is true, this causes additional problems for Dr. Cook’s position. Many subnational tax jurisdictions, including the District, may not have the authority to make transfer pricing adjustments affecting international transactions if the IRS has declined to make such modifications. Furthermore, the taxation of international transactions on an arm’s length basis and domestic transactions on a formulary apportionment basis raise significant commerce clause issues for certain taxpayers. Thus, jurisdictions like the District that use these contrary regimes risk undermining the validity of their entire inter-company tax program.
 We love this acronym so much, we are thinking of getting T-shirts made.
 See Bloomberg BNA, “OECD’s Saint-Amans Says BEPS Debate Over Formulary Apportionment is Finished”, Transfer Pricing Report, April 3, 2014.
 See Wells, B. and C. Lowell, “Tax Base Erosion and Homeless Income: Collection at the Source is the Linchpin”, 65 Tax Law Review 535, University of Houston Public Law and Legal Theory Series, 2011 A-6, pg. 549
 See Michael Durst, “Starting the Conversation: A Formulary System For Dividing Income Among Taxing Jurisdictions,” 22 Transfer Pricing Report 98, 5/16/13; “Analysis for Dividing Income, Part II: Examining Current Formulary and Arm’s-Length Approaches,” 22 Transfer Pricing Report 270, 6/27/13; “Analysis of a of a Formulary System Formulary System for Dividing Income, Part III: Comparative Assessment of Formulary, Arm’s-Length Regimes,” 22 Transfer Pricing Report 653, 9/5/13; and “Analysis of a Formulary System, Part IV: Choosing a Tax Base,” 22 Transfer Pricing Report 771, 10/17/13, Analysis of a Formulary System, Part V: Apportionment using a Combined Tax Base,” 22 Transfer Pricing Report 972, 11/28/13, Analysis of a Formulary System, Part VI: Building the Formula,” 22 Transfer Pricing Report 1180, 1/23/14, Analysis of a Formulary System, Part VII: The Sales Factor,” 22 Transfer Pricing Report 1414, 3/20/14, Analysis of a Formulary System, Part VIII: Suggested Statutory, Regulatory Language for Implementing Formulary Apportionment,” 23 Transfer Pricing Report 70, 5/1/14.
 See Garry Stone and Elif Ekmekci-Taskiran, “Formulary Apportionment: The Case of Missing Income”, 22 Transfer Pricing Report 867, 11/14/2013.
On September 23, 2014, the District of Columbia Council enacted market-based sourcing provisions for sales of intangibles and services as part of the 2015 Budget Support Act (BSA), as we previously discussed in more detail here. Most notably the BSA adopts a single sales factor formula for the DC franchise tax, which is applicable for tax years beginning after December 31, 2014. But the market-based sourcing provisions in the BSA did not align with the rest of the tax legislation. Specifically, the BSA market-based sourcing provisions were made applicable as of October 1, 2014—creating instant tax implications on 2014 returns. Absent a legislative fix, this seemingly minor discrepancy will trigger a giant compliance burden that will require a part-year calculation for both taxpayers and the Office of Tax and Revenue (OTR) before the 2014 franchise return deadline on March 15. For example, taxpayers filing based on the new BSA provisions, as originally enacted in September, will have to use the cost-of-performance approach for the first nine months of the 2014 tax year and the new market-based sourcing approach for the remaining three.
Citing to the unintended compliance burden, the Council recently enacted emergency legislation to temporarily fix the unintended compliance burden. However they have not solved the problem going forward. On December 17, 2014, Finance and Revenue Committee Chairman Jack Evans introduced identical pieces of legislation that included both a temporary and emergency amendment to quickly fix on the problem (both pieces of legislation share the name “The Market-Based Sourcing Inter Alia Clarification Act of 2014”). These legislative amendments explicitly make the applicability of market-based sourcing provisions synonymous with the other provisions of the BSA, beginning for tax years after December 31, 2014. In DC, “emergency” legislation may be enacted without the typical 30-day congressional review period required of all other legislation, but is limited to an effective period of no longer than 90 days. Because the emergency market-based sourcing legislation was signed by Mayor Muriel Bowser on January 13, it will expire on April 13. Important to DC franchise taxpayers, this date is before the September 15 deadline for extended filers.
The second piece of legislation was introduced on a “temporary” basis. Unlike emergency legislation, temporary legislation simply bypasses assignment to a committee but must still undergo a second reading, mayoral review and the 30-day congressional review period. The review period is 30 days that Congress is in session (not 30 calendar days). Because the temporary Act is still awaiting Mayor Bowser’s approval at the moment, which is due by this Friday (February 6), it will not become effective until after the 2014 DC Franchise Tax regular filing deadline of March 15—even if it is approved by the Mayor and not subjected to a joint-resolution by Congress. Neither the House nor Senate is in session the week of February 15, which pushes the 30-day review period to roughly April 1 (assuming it is immediately submitted to Congress). However, once passed, temporary legislation in the District may remain in effect for up to 225 days.
Practice Note: Given the apparent intent of the Council to fix this problem, we are confident that a more permanent solution is on the way to correct the disconnect within the BSA provisions. The Council should act sooner rather than later to ensure taxpayers have a sense of clarity prior to the September filing deadline. While the Council appears to have their bases temporarily covered, any mishap in the passage of the temporary Act will leave DC taxpayers and the OTR with a significant compliance burden beginning on April 13. We are closely monitoring the temporary Act, the likely introduction of a permanent fix and the much-anticipated release of market-based sourcing regulations by the OTR (discussed below). We will update readers with any significant development in this area.
Additional Developments – Regulations Pending
Legislative mishap aside, OTR is nearing completion on a set of market-based sourcing regulations that are modeled off of the recently finalized Massachusetts guidance, but with fewer examples. The Multistate Tax Commission (MTC) Uniformity Committee is also working to develop model-market sourcing rules and is using the Massachusetts rules as its starting draft. As with similar uniformity efforts in the past, it will be interesting to see how uniform the DC regulations and MTC model regulations turn out to be. For example, if the final product in DC substantially conforms to the Massachusetts model, taxpayers may be able to cite to the extended examples provided in the Massachusetts or MTC regulations when taking a tax position. If history holds true, the one thing that is certain is that the uniformity effort won’t be entirely uniform.
Investors keeping a close eye on pending legislation (the Promoting Economic Growth and Job Creation Through Technology Act of 2014, Bill 20-0945) promoting investments in D.C. Qualified High Technology Companies (QHTC) will be happy to know it passed—but not without a serious caveat. While the bill was originally set to allow investors to cash in their investments after being held continuously for a 24-month period, the enrolled Act (D.C. Act 20-514) was amended to make the rate reduction applicable January 1, 2019 (at the earliest).
In September 2014, the D.C. Council began reviewing a proposal from Mayor Gray that would lower the tax rate to 3 percent for capital gains from the sale or exchange of eligible investments in QHTCs, as previously discussed by the authors here. As introduced, the bill was set to be applicable immediately; however, all that changed when an amendment was made on December 2 that restricts applicability of the Act to the latter of:
- January 1, 2019 to the extent it reduces revenues below the financial plan; or
- Upon implementation of the provisions in § 47-181(c)(17).
As noted in the engrossed amendment, this was done to “ensure that the tax cuts . . . codified by the 2015 Budget Support Act (BSA) take precedence.” These cuts, previously discussed by the authors here and here, include the implementation of a single sales factor, a reduction in the business franchise tax rate for both incorporated and unincorporated businesses, and switch from cost of performance sourcing to market-based sourcing for sale of intangibles and services.
The Act was quickly passed on December 22 with the amendment language included and a heavy dose of uncertainty regarding when the reduced rate will apply (if at all), since it is tied to the financial plan and BSA. Practically, this leaves potential investors with the green light to begin purchasing interests in QHTCs, since the Act is effective now, yet leaves these same investors with uncertainty about the applicability of the reduced rate.
Practical Questions Unresolved
The enrolled Act retains the same questionable provisions that were originally present upon its introduction, raised by the authors here. Specifically the language provides that the Act applies “notwithstanding any other provision” of the income tax statute and only to “investments in common or preferred stock.” The common or preferred stock provisions appear to arbitrarily exclude investments in pass-through entities, despite the fact that they are classified as QHTCs, disallowing investors that otherwise would be able to take advantage of the rate reduction. In addition, the Act lacks clarity regarding the practical application of basic tax calculations, such as allocation and apportionment. The Act seems to stand for the proposition that the investments should be set apart from the rest of the income of an investor, but to what extent? Absent regulations or guidance from the Office of Tax and Revenue (OTR), taxpayers taking advantage of the rate reduction in 2019 may fall into a Wild West-like situation and are encouraged to take advantage of the most favorable positions regarding categorization, allocation and apportionment, and losses.
Constitutional Limitation or Opportunity?
Because the favorable tax rate in this Act is imposed on investments in in-state companies only (since by definition a QHTC must be located in the District), serious constitutional questions are raised. The dormant Commerce Clause prohibits state taxation or regulation that discriminates against or unduly burdens interstate commerce and thereby ‘imped[es] free private trade in the national marketplace.’ ” Gen. Motors Corp. v. Tracy, 519 U.S. 278, 287 (1997). “No State, consistent with the Commerce Clause, may ‘impose a tax which discriminates against interstate commerce … by providing a direct commercial advantage to local business.” Boston Stock Exch. v. State Tax Comm’n, 429 U.S. 318, 329 (1977) (invalidating New York statute that reduced the transfer tax on securities sales if the sale of securities took place on an exchange within the state because the tax scheme “foreclos[ed] tax neutral decisions” and “creat[ed] both an advantage for the exchanges in New York and a discriminatory burden on commerce to its sister States.” Along the same lines, the Supreme Court found in Fulton Corp. v. Faulkner, 516 U.S. 325, 333 (1996), held that a North Carolina intangibles tax was impermissibly discriminatory because it “taxe[d] stock only to the degree that its issuing corporation participates in interstate commerce [and] favors domestic corporations over their foreign competitors in raising capital among North Carolina residents . . . discourag[ing] domestic corporations from plying their trades in interstate commerce.”
The QHTC rate reduction with “no doubt . . . facially discriminates against interstate commerce” like the Court found in Fulton and Boston Stock Exchange. Any investor in the District is impermissibly incentivized to keep their investments local (based on the favorable rates allowed on the basis of the company’s location) and not invest in the interstate market, where D.C. would tax their gains at an increased rate. This is a classic example of the economic protectionism the dormant Commerce Clause is aimed to prevent. While the violation is clear, the implications of this violation are not. There is a real possibility that far more companies will be able to take advantage of the rate reduction (e.g,. investments in otherwise QHTC-qualifying companies located outside the District). Because the QHTC qualifications are extremely broad, available here, there is a strong argument that OTR may be compelled to honor the lower rate for investments in companies outside the District.
The questionable constitutionality of in-state rate reductions is not specific to the QHTC or even the District. Taxing jurisdictions routinely adopt protectionist measures that run afoul of the commerce clause. For example, New York offers a reduced rate for “eligible qualified New York manufacturer” that similarly should be expanded beyond New York due to discrimination and economic protectionism. Oklahoma has a similar deduction that allows a taxpayer to adjust its Oklahoma taxable income for qualifying gains receiving capital treatment that result from the “sale of all or substantially all of the assets of an Oklahoma company,” which is defined as “an entity whose primary headquarters have been located in Oklahoma for at least three (3) uninterrupted years prior to the date of the transaction from which the net capital gains arise.” Just like the QHTC provision in the Act, these rate reductions based on an in-state interest are facially discriminatory and should be broadened—not struck down—so they fall outside the limitations of the dormant Commerce Clause. Taxing jurisdictions that adopt such constitutionally suspect measures put their taxpayers and fisc at risk. This is unfortunate, because it is not difficult to craft an effective incentive package that is also constitutional.
Practice Note: Any company that invests in a technology company should consider taking the stance that they are entitled to the reduced rates offered by the Act on capital gains. As noted, short-term investments do not qualify under the Act—they must be held for at least 24 months—and the applicability of the rate reduction will not begin until 2019 (or beyond).
The authors encourage any District taxpayer considering investing in or selling a businesses to contact the authors and explore the possibility of classifying the investment as a QHTC, regardless of whether the investment is in a D.C. company.
On Friday, November 14, 2014, an administrative law judge (ALJ) issued three identical orders granting the taxpayer’s motion for summary judgment in Hess v. OTR, Shell v. OTR and ExxonMobil v. OTR. In these orders, the ALJ determined that based on an early ruling that the challenged methodology was fatally flawed, the Office of Tax and Revenue was barred from re-litigating the issue in the current cases under the doctrine of non-mutual collateral estoppel.
Transfer Pricing Implications
The transfer pricing litigation in D.C. has been a frustrating road for taxpayers because the flaws in the methodology OTR applied have been apparent from the outset. The first case to be litigated was Microsoft v. OTR, OAH Case. No. 2010-OTR-00012 (May 1, 2012). In this case, an ALJ ruled that the methodology the District used was fatally flawed because the methodology failed to (i) separate controlled from uncontrolled transactions and (ii) individually analyze different product lines and different functions. As a result, the ALJ concluded that the analysis was flawed, arbitrary and unreasonable. OTR initially appealed the Microsoft order to the D.C. Court of Appeals, only to withdraw shortly after by filing a motion to dismiss its own petition for review.
When Microsoft was decided in 2012, it appeared that the faulty transfer pricing methods used by the District had been permanently debunked. Nevertheless, OTR renewed the contract for the business performing the transfer pricing audits and did not materially modify the assessment methods. As a result, taxpayers continued receiving assessments from the OTR based on the same methodology previously ruled invalid in Microsoft. At least 10 taxpayers have challenged these assessments post-Microsoft, and the orders issued Friday are the first of these challenges to be resolved by the Office of Administrative Hearings (OAH).
The taxpayers in the Hess/Shell/ExxonMobil cases all challenged the substantive validity of the assessment methodology and argued that the Microsoft decision should be controlling. OTR asserted that the doctrine of non-mutual collateral estoppel did not apply to the government and, even if it did, the elements were not met in this case. The ALJ disagreed with OTR’s analysis and found “the failure to apply [non-mutual collateral estoppel] would allow [DC] to keep issuing proposed assessments to taxpayers using the same flawed Chainbridge analysis, with the hope that some taxpayers won’t have the wherewithal to challenge the assessment and will find it economically advantageous to simply pay rather than fight.”
The three orders issued on Friday should provide a definitive signal to OTR that the method is flawed as a matter of law and cannot be validly used to assess D.C. taxpayers going forward. These decisions are essentially decisions on the merits for the pending cases and, assuming no appeal is filed, D.C. should face sanctions if it continues to pursue assessments using the methodology at issue in these cases.
Perhaps more importantly than the narrow (but important) transfer pricing issue in these decisions, OAH has made is clear that non-mutual collateral estoppel can be applied against OTR in any tax case as long as the elements of the doctrine are met. This gives real weight and importance to OAH as a venue for resolving complex tax questions.
The OTR has until December 15, 2014 to appeal to the D.C. Court of Appeals. In addition to the transfer pricing cases already resolved, five cases are still pending before the OAH challenging D.C.’s transfer pricing methods.