Virginia and Georgia are two of the latest states to pass laws responding to the federal tax reform passed in December 2017, known as the Tax Cuts and Jobs Act (TCJA). Both states updated their codes to conform to the current Internal Revenue Code (IRC) with some notable exceptions.

Virginia

On February 22, 2018, and February 23, 2018, the Virginia General Assembly enacted Chapter 14 (SB 230) and Chapter 15 (HB 154) of the 2018 Session Virginia Acts of Assembly, respectively. Before this legislation was enacted, the Virginia Code conformed to the IRC in effect as of December 31, 2016. While the new legislation conforms the Virginia Code to the IRC effective as of February 9, 2018, there are some very notable exceptions. The legislation explicitly provides that the Virginia Code does not conform to most provisions of the TCJA with an exception for “any… provision of the [TCJA] that affects the computation of federal adjusted gross income of individuals or federal taxable income of corporations for taxable years beginning after December 31, 2016 and before January 1, 2018…” Thus, despite Virginia’s update of its IRC conformity date, Virginia largely decouples from the TCJA. Continue Reading Southeast States Respond to Federal Tax Reform and NJ Senate Leader Talks Tax Surcharge to Limit Corporate “Windfall”

On August 9, 2017, the US Court of Appeals for the Third Circuit (Third Circuit), overruling the US District Court for the District of Delaware (District Court), allowed a claim by a holder seeking to prevent an unclaimed property audit by Delaware on due process grounds to proceed. See Plains All American Pipeline L.P. v. Cook et al., No. 16-3631 (3d Cir. Aug. 9, 2017).  The procedural due process claim challenges Delaware’s use of auditors that have a stake in the assessment. Consistent with the District Court decision, the Third Circuit held that challenges to Delaware’s estimation methodology were ruled not ripe. The case has been remanded to the District Court for further proceedings.

Continue Reading Resistance is not Always Futile: New Decision in Ongoing Delaware Unclaimed Property Audit Litigation

In a recent decision, the New Jersey Tax Court provided some long-awaited guidance on the “unreasonable” exception to the state’s related-party intangible expense add-back provision. In BMC Software, Inc v. Div. of Taxation, No 000403-2012 (2017), the Tax Court held that payments made by a subsidiary to its parent for a software distribution license were intangible expenses that were subject to the add-back provision, but that the statutory exception for “unreasonable” adjustments applied so that the subsidiary was able to deduct the expenses in computing its Corporation Business Tax (CBT). The court first determined that the expense was an intangible expense and not the sale of tangible personal property between the entities because the contract specifically called the fee a royalty, the parent reported the income as royalty income and the parent retained full ownership of the intellectual property rights indicating that no sale had taken place. Thus, the court determined that the intangible expense add-back provision did apply. The most interesting aspect of this case, however, was the court’s application of the “unreasonable” exception to the intangible expense add-back provision because that had not yet been addressed by the courts in New Jersey.

The Tax Court established two critical points with respect to the add-back of related-party intangible expenses: first, that the “unreasonable” exception does not require a showing that the related-party recipient paid CBT on the income from the taxpayer; and secondly, that a showing that the related-party transaction was “substantively equivalent” to a transaction with an unrelated party is sufficient evidence that the add-back is “unreasonable.” Continue Reading Favorable Guidance from the New Jersey Tax Court on the ‘Unreasonable’ Exception to the Related-Party Intangible Expense Add-back

This month the New Jersey Economic Development Authority (the Authority) provided businesses with guidance, in the form of Frequently Asked Questions, on how to elect to have their unpaid Business Employment Incentive Program (the Program or BEIP) grants converted into tax credits pursuant to N.J. Rev. Stat. § 34:1B-129.

Under the Program, New Jersey awarded qualifying businesses cash grants for hiring new employees in the state for a term of up to 10 years.  Since the Program’s inception in 1996, the Authority has executed 499 BEIP agreements valued at nearly $1.6 billion.  However, since 2013, the New Jersey legislature has not funded the Program, and thus many businesses have not received grant payments owed by the state.

In January, Governor Christie signed P.L. 2015, c. 194 into law, permitting the voluntary conversion of outstanding BEIP grants into tax credits. The option to convert a BEIP grant to a tax credit is New Jersey’s attempt to provide relief to those businesses that have been awarded grants but have not received grant payments. The law, unfortunately, was short on details.

Businesses that wish to take advantage of the grant conversion must elect to convert the grant into a tax credit by July 11, 2016. Once the election is made, it is irrevocable.

Because a business cannot predict with any certainty whether the New Jersey legislature will fund the Program in future years, a business has to decide whether to opt to convert its grant. If a business does not elect to convert its grant, it risks losing all of its unpaid BEIP grants. On the other hand, if a business makes the election and the Program is funded in future years, the business will have no choice but to receive tax credits even though a cash payment might be more valuable to the business.

If a business elects to convert its grant commitments to tax credits, the credits will be issued over a period of years as set forth in the statute.   This delayed payment means that the business will suffer an additional loss of money owed by New Jersey on account of the time value of money. The statute provides that the BEIP tax credit must be used in the designated years and may not be carried forward. The credit is a priority credit and should be applied before all other credits. Accordingly, it is important to consider whether the other credits claimed by a business are refundable when deciding whether to make the election and calculating the potential benefit of conversion.

In anticipation of the July 11, 2016, deadline for businesses to opt to convert their grant into a tax credit, the Authority has provided guidance on how to make the election. This guidance, as mentioned above, is informal and not a regulation. The guidance provides that to make the election, a business must submit an executed Amendment to Agreement. The form Amendments to Agreement for different tax types are available on the Authority’s website.  Once a business opts to convert its grant into a tax credit, New Jersey will issue an annual certificate for the tax credit, which the business will attach to its return for that year to substantiate the BEIP tax credit. If a business has no tax liability in a particular year (before taking other tax credits into account), New Jersey will issue a cash refund in the amount of the certificate.

Pursuant to the Authority’s guidance, a business that is not filing corporate business tax in New Jersey must elect by the same deadline of July 11, 2016, whether to receive a tax credit transfer certificate. Such a business may apply for a tax credit transfer certificate and sell the credit for at least 75 percent of face value before considering present value adjustments. The purchaser of the credit may not sell to a third party.

McDermott Will & Emery has released the December 2015 issue of Focus on Tax Controversy, which provides insight into the complex issues surrounding U.S. federal, international, and state and local tax controversies, including Internal Revenue Service audits and appeals, competent authority matters and trial and appellate litigation.

Mark Yopp authored an article entitled “Waiting for Relief from Retroactivity,” which discusses how courts are expanding the ability of state legislatures to retroactively change taxpayer liability going back many years.

View the full issue (PDF).

On May 18, the U.S. Supreme Court issued its decision in Comptroller of the Treasury of Maryland v. Wynne. In short, the Court, in a five-to-four decision written by Justice Alito, handed the taxpayer a victory by holding that the county income tax portion of Maryland’s personal income tax scheme violated the dormant U.S. Constitution’s Commerce Clause.

Specifically, the Court concluded that the county income tax imposed under Maryland law failed the internal consistency test under the dormant Commerce Clause, because it is imposed on both residents and non-residents with Maryland residents not getting a credit against that Maryland local tax for income taxes paid to other jurisdictions (residents are given a credit against the Maryland state income tax for taxes paid to other jurisdictions).

The Supreme Court emphatically held (as emphatically as the Court can be in a five-to-four decision) that the dormant Commerce Clause’s internal consistency test applies to individual income taxes. The Court’s holding does create a perilous situation for any state or local income taxes that either do not provide a credit for taxes paid to other jurisdictions or limit the scope of such a credit in some way.

The internal consistency test—one of the methods used by the Supreme Court to examine whether a state tax imposition discriminates against interstate commerce in violation of the dormant Commerce Clause—starts by assuming that every state has the same tax structure as the state with the tax at issue. If that hypothetical scenario places interstate commerce at a disadvantage compared to intrastate commerce by imposing a risk of multiple taxation, then the tax fails the internal consistency test and is unconstitutional.

Although the Wynne decision does not address the validity of other taxes beyond the Maryland county personal income tax, the decision does create significant doubt as to the validity of certain other state and local taxes such as the New York State personal income tax in the way it defines “resident.” New York State imposes its income tax on residents on all of their income and on non-residents on their income earned in the state; this is similar to the Maryland county income tax at issue in Wynne.

“Resident” is defined as either a domiciliary of New York or a person who is not a domiciliary of New York but has a permanent place of abode in New York and spends more than 183 days in New York during the tax year. N.Y. Tax Law § 605. (New York City has a comparable definition of resident.) N.Y.C. Administrative Code § 11-1705. Thus a person may be taxed as a statutory resident solely because they maintain living quarters in the state and spend more than 183 days in the state, even if those days have absolutely nothing to do with the living quarters; this category of non-domiciliary resident is commonly referred to a “statutory resident.” As such, under New York’s tax scheme, a person can be a resident of two states—where domiciled and where a statutory resident—and thus be subject to taxation on all of their income in both states.

Although New York State grants a credit to residents for taxes paid to another jurisdiction, that credit is only for taxes paid “upon income derived” from those other jurisdictions. N.Y. Tax Law § 620. As such, New York State does not grant a credit for taxes paid to another jurisdiction on income earned from intangible property, such as stocks, because income earned from intangible property is not ‘derived from’ any specific  jurisdiction.

To illustrate using an example, suppose an investment banker is unquestionably a domiciliary of New Jersey and has an apartment, i.e., permanent place of abode, in New York that he uses only occasionally. Further, suppose that the investment banker spends more than 183 days in New York during a tax year by going to his office in New York on most workdays. In such a case, the investment banker is a resident of both New Jersey and New York and subject to tax as a resident in both states on his entire worldwide income. New York does not give a credit for taxes paid to New Jersey on income derived from intangible property, and thus the investment banker pays tax on this income twice, once to New Jersey and once to New York, clearly disadvantaging interstate commerce and resulting in double taxation.

This is not some hypothetical example. This is actually the fact pattern in In the Matter of John Tamagni v. Tax Appeals Tribunal of the State of New York, 91 N.Y.2d 530 (1998). In that case, the New York Court of Appeals (New York State’s highest court) held that New York State’s taxing scheme did not violate the dormant Commerce Clause and did not fail the internal consistency test. The validity of the Court of Appeals’ decision is seriously called into question under the Wynne case.

The Court of Appeals, relying upon Goldberg v. Sweet, held that the dormant Commerce Clause did not apply to residency-based taxes because those taxes were not taxing commerce, but rather a person’s status as a resident. However, the U.S. Supreme Court’s decision in Wynne not only repudiates the very dicta from Goldberg v. Sweet cited by the New York Court of Appeals in Tamagni, but the U.S. Supreme Court also determined that even if a state has the power to impose tax on the full amount of a resident’s income, “the fact that a State has the jurisdictional power to impose a tax [under the Due Process clause of the Constitution] says nothing about whether that tax violates the Commerce Clause.” After Wynne, it is clear that the dormant Commerce Clause applies to residency-based personal income taxes.

The second reason that the vitality of the Tamagni decision is in question is its application of the internal consistency test. The Court of Appeals held that even if the dormant Commerce Clause applied, the internal consistency test was not violated because the tax at issue was imposed upon a purely local activity and thus could not violate the Complete Auto tests. However, as discussed above, New York State’s lack of a credit for taxes paid to other jurisdictions mirrors the lack of a credit under Maryland’s county income tax scheme.

New York State taxpayers should be cognizant of the Wynne decision and should consider filing refund claims if they have paid— or will pay—tax to New York State as a statutory resident (i.e., not as a New York domiciliary). One would expect the New York State Department of Taxation and Finance to be quite resistant to granting such refunds and likely to vigorously defend the existing taxing scheme.

It may be worthwhile to note that this problem of double taxation was acknowledged and addressed in an agreement executed in October 1996 by the heads of the revenue agencies of Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, and Vermont. Under that agreement, the “statutory resident” state would provide a credit for the taxes paid by the individual on his or her investment income to his/her state of domicile. Unfortunately, that agreement was never implemented through legislation— maybe now is the time for that to be done.

Finally, a word about New York City: New York City imposes a personal income tax on residents, allowing no credit for taxes paid to other jurisdictions. However, New York City does not impose a tax on non-residents, making its personal income tax different than the Maryland county income tax. Thus, the constitutionality of the New York City personal income tax is not specifically addressed by the U.S. Supreme Court’s decision. However, similar to the New York State definition of resident, a person can be a resident in two different jurisdictions under the New York City definition of resident. As such, New York City’s personal income tax could be imposed twice on a person if the person is a domiciliary of one state and a statutory resident in another. Thus, the tax potentially fails the internal consistency test.

The Supreme Court of New Jersey recently affirmed a decision that amnesty and late‑filing penalties did not apply to the taxpayers in United Parcel Serv. Gen. Servs. Co. v. Dir., Div. of Taxation, No. 072421 (N.J. Dec. 4, 2014).  In all, approximately $2 million in penalties and related interest were abated.

The primary substantive issue was imputation of interest related to United Parcel Service’s (UPS’s) cash management system, which hinged on whether the intercompany cash transfers were loans or dividends.  After an audit of the taxpayers’ Corporation Business Tax Returns for the years at issue, the New Jersey Division of Taxation assessed additional tax primarily resulting from the imputation of interest on the intercompany cash transfers, amnesty penalties related to the 1996 and 2002 amnesties, late-filing penalties and interest.  Following a trial, the Tax Court held against the taxpayer on the cash management issue, but noted that “[t]he case law discussed . . . could be interpreted to suggest that the cash management system utilized by the UPS Group may not have” resulted in the tax consequences advanced by the Division of Taxation.  The Tax Court found reasonable cause for the abatement of late-filing penalties and held that amnesty penalties did not apply to the taxpayers.  The Appellate Division affirmed the Tax Court’s decision.

With respect to the amnesty penalties related to the 1996 and 2002 tax amnesties, the statute imposed the amnesty penalties when taxpayers failed to pay liabilities “eligible to be satisfied” through the amnesty programs.  The Tax Court and Appellate Division found that the meaning of the phrase “eligible to be satisfied” was unclear.  Therefore, the lower courts looked to the legislative history for the amnesty programs, which included a statement by the New Jersey Treasurer that “the bill’s penalties will not be applied to deficiencies assessed pursuant to a question of law or fact uncovered through routine audits of taxpayers otherwise in compliance with filing and payment requirements of State taxes.”  The New Jersey Supreme Court looked to that same legislative history.  Noting that the taxpayers had timely filed returns and paid the tax shown as due on those returns, and that the Division of Taxation had uncovered issues of fact and law on audit of the tax returns, the court upheld the decision that the amnesty penalties did not apply.

With respect to the late-filing penalties, the taxpayers argued that reasonable cause existed for the abatement of penalties because the taxpayer had taken a good faith filing position with respect to the cash management system, and the imputation of interest on the cash transfers was an issue of first impression in New Jersey.   The New Jersey Supreme Court noted that the case involved genuine issues of fact and law, and there was “no directly pertinent legal authority then in existence” regarding the cash management system.   The court “therefore agree[d] with the Appellate Division and affirm[ed] the Tax Court’s finding that the Division did not exercise properly the discretion that the Legislature afforded to it . . . when it declined to waive late payment penalties imposed on plaintiffs.”

Many taxpayers should benefit from the amnesty victory.  Based on the statutory language, the Division of Taxation’s position has been that it has no authority to waive or abate amnesty penalties and that amnesty penalties automatically apply to all assessments for taxes related to tax periods covered by amnesty.  It should be noted that the taxpayers did not argue and the courts did not hold that the amnesty penalties were waived or abated.  Rather, the question was whether the penalties applied in the first instance.  Although several facts, including the nature of the substantive issues and the timing of the audit and of the issuance of the assessment, may have played a role in the decision that the taxes due were not liabilities to which the amnesty penalty applied, other taxpayers who have taken good faith filing positions that were adjusted on audit now have ammunition to challenge the Division of Taxation’s imposition of amnesty penalties.

Importantly, this decision may also affect taxpayers currently facing the 2009 amnesty penalty.   Because the statutory language implementing the 2009 amnesty is similar to that which was used in the 1996 and 2002 amnesties, the application of the amnesty penalties should be the same.

As far as late-payment penalties are concerned, taxpayers may look to this case to support penalty abatement or waiver arguments in states with a reasonable cause abatement or waiver standard.  This case supports that a revenue department’s discretion to waive or abate late-filing penalties is not unfettered.  We would argue that reasonable cause exists to waive or abate penalties imposed on tax assessments arising from good faith or genuine issues of fact or law.

In a Corporation Business Tax (CBT) case, PPL Electric Utilities Corporation v. Director, Division of Taxation, Dkt. No. 000005-2011 (N.J. Tax. Ct. Oct. 2, 2014), the Tax Court of New Jersey found for the taxpayer and held that the Pennsylvania Gross Receipts Tax and Pennsylvania Capital Stock Tax were not required to be added back in computing New Jersey entire net income.

The case involves a 1993 amendment to the CBT statute regarding adding back taxes deducted in computing federal taxable income.  Prior to 1993, the New Jersey statutes required taxpayers to add-back only certain federal taxes and the CBT in computing New Jersey entire net income.  The amendment added a requirement that taxpayers add-back to federal taxable income taxes paid to states other than New Jersey “on or measured by profits or income, or business presence or business activity.”  N.J.S.A. 54:10A-4(k)(2)(C).  According to legislative history cited by the court, prior to the amendment “corporations which [did] business in several states [paid] a lower effective rate of tax on their New Jersey activities than [did] corporations which only [did] business in New Jersey.”  The court explained that the amendment corrected the inequity “by requiring multi-state taxpayers to add-back state taxes similar to that of the CBT.”

The Tax Court concluded that the Pennsylvania Gross Receipts Tax is not subject to the tax add-back, finding that the tax is:  (1) “based solely on the amount of electricity sold, regardless of whether income or profit is realized from such sales and not based upon the taxpayer’s business presence or business activity in Pennsylvania;” and (2) “passed through to the ultimate consumer of electricity.”  The court held that the Pennsylvania Capital Stock Tax was not subject to the tax add-back because it was in substance a property tax.

Interestingly, the Tax Court found that the New Jersey Division of Taxation’s (Division) interpretation of the tax add-back was not only incorrect but also discriminatory.

The 1993 amendment was passed because previously, solely New Jersey taxpayers were taxed on a higher tax basis than similarly situated multi-state taxpayers . . . .  Here, Taxation’s interpretation of the statute discriminates against multi-state taxpayers because they would be required to add-back the Pennsylvania Corporate Income Tax as well as other non-CBT-type taxes imposed by other states, such as the Pennsylvania Gross Receipts Tax and the Pennsylvania Capital Stock Tax, while solely New Jersey taxpayers are only required to add-back CBT-type taxes.  This court finds that the Legislature did not intend to cure one inequity by imposing another.

Given the number of different types of state taxes in existence, this case may have broad ramifications for multi-state taxpayers subject to the CBT.  We have seen the Division make similar adjustments to other companies on audit and this decision should be helpful in disputing those adjustments.  Additionally, multi-state taxpayers may have refund opportunities for similar taxes that they have previously added back.

The New Jersey Division of Taxation (Division) is trying to help taxpayers resolve unpaid tax liabilities for tax periods 2005 through 2013.  Through November 17, 2014, the Division is offering taxpayers that pay all tax and interest for the applicable periods a waiver of most penalties (but not penalties related to the 2009 amnesty) and any costs of collection or recovery fees.  Notably, this is not an amnesty like those conducted in 2002 and 2009.  It is not statutorily mandated and no penalties may be imposed for non‑participation.  Because the initiative is not statutorily mandated, the Division is not offering something it could not offer at any other time.  However, the Division’s offer to waive most penalties may be a good chance for many taxpayers to resolve issue and move on and is worth considering.

With both Halloween and the Multistate Tax Commission (MTC) Income Tax Audit selection nearing, taxpayers should prepare themselves for the possibility of being spooked in the near future.  On Thursday, October 30, from 2-4 pm EST, the MTC Audit Committee—including representatives from the 22 states participating in the upcoming round of joint income tax audits—will be holding a teleconference that will begin with a public comment period.  Because of the inevitable disclosure of confidential taxpayer information, the bulk of this meeting—including selecting the various companies to audit—will take place during the second half of the agenda and be closed to the general public.  Just because a company has completed an audit in the past does not mean this season will be all treats.  The authors have noticed that companies previously audited by the MTC can remain on the list of targets and are often repeat selections.

Unique Complexities

The MTC audit process is not without its share of traps for the unwary.  First and foremost is the effort a taxpayer must expend in managing a multistate audit.  Issues such as differing statute of limitations, the effects of federal Revenue Agent’s Reports (RAR) and net operating loss (NOL) differences on limitations periods, timing of protests, and tax confidentiality become of heightened importance when one auditor is reviewing a taxpayer for multiple states.  Audited taxpayers should also keep in mind that the MTC does not issue the actual deficiency notices – these must come from the states.  As a result there may be certain areas such as credits or refunds that the MTC does not review and must be raised directly with a participating state.

On the substantive side, a primary area of inquiry of an MTC audit has been and is likely to continue to be inter-company transactions.  Historically MTC audits have taken a variety of approaches to disallow a taxpayer’s intercompany structure, including collapsing separate affiliates, applying the sham transaction doctrine, or using aggressive addback concepts.      Another similar concern for taxpayers audited by the MTC is the increased likelihood of transfer pricing issues being raised.  This comes in the wake of the creation of the MTC Arm’s-Length Adjustment Service (ALAS) this summer, led by former Montana Department of Revenue Director Dan Bucks.  The group recently held a transfer pricing summit at which it designed the MTC services to include third-party economic consultants at every stage.  The MTC transfer pricing services are expected to be implemented in mid-2015—just in time for companies selected for an MTC Income Tax Audit to be the test subjects.  Notably, of the nine states committing seed money to the development of a multistate transfer pricing audit service, five (Alabama, Hawaii, Kentucky, New Jersey and the District of Columbia) are participating in the MTC Income Tax Joint Audit Program.  It is not clear whether the two MTC-sponsored audit programs will be intertwined; however, the option was proposed this past summer and remains a possibility as we approach the upcoming audit selections.

Finally, it remains to be seen whether the MTC can audit for non-Compact states.  See Gillette Co. v. Franchise Tax Bd., 147 Cal. Rptr. 3d 603 (Cal. Ct. App. 2012) review granted and opinion superseded sub nom. Gillette v. Franchise Tax Bd., 291 P.3d 327 (Cal. 2013).  Audit authority stems from a provision in the compact giving the MTC authority to audit any “party state or subdivision thereof;” however, nowhere does the MTC define “party state.”  The bylaws of the MTC do distinguish between party states and mere member states—affording more rights to party states.  With this in mind, there appears to be a continued and unresolved argument to be made that non-Compact states (increasing by the day) are not “party states” and therefore have no authority to participate in the Joint Audit Program under the narrowly construed terms of the compact.

To participate in the public comment portion of the upcoming MTC Audit Committee meeting, dial (866) 546-3377, conference code 852212.   

Practice Note:  Taxpayers chosen as the subject of an MTC audit should carefully craft their audit strategy to address the unique issues raised by a multistate audit and by the MTC’s specific areas of focus.  Finally, while this post has focused on income tax issues, the MTC also audits for sales tax compliance.