The first New York meeting of McDermott’s Tax in the City® initiative in 2018 coincided with the June 21 issuance of the US Supreme Court’s (SCOTUS) highly anticipated Wayfair decision. Just before our meeting, SCOTUS issued its opinion determining that remote sellers that do not have a physical presence in a state can be required to collect sales tax on sales to customers in that state. McDermott SALT partner Diann Smith relayed the decision and its impact on online retailers to a captivated audience. Click here to read McDermott’s insight about the decision.

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Many provisions of the House and Senate tax reform proposals would affect state and local tax regimes. SALT practitioners should monitor the progress of this legislation and consider contacting their state tax administrators and legislative bodies to voice their opinions.

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Illinois Legislators have recently introduced three bills that would amend the Illinois False Claims Act (“Act”) to restrict the ability to bring tax-related claims. Senate Bill 9, the proposed “grand bargain” to resolve Illinois’ budget stalemate, includes language that would eliminate the ability to use the Act to bring tax claims.  In addition, Representative Frank Wheeler and Senator Pam Althoff have introduced House Bill 1814 and Senate Bill 1250, respectively, which are identical pieces of legislation that would significantly restrict a private citizen’s right to bring tax-related claims. Senate Bill 9, if adopted in its current form, would eliminate the ability to bring a tax-related claim under the Act.  Currently, the Act only excludes the right to bring income tax-related claims. 740 ILCS 175/3(c).  This would effectively conform the Act to the federal False Claims Act, which does not extend to tax claims.  Rather, tax-related claims are brought before the Internal Revenue Service’s Whistleblower Office as whistleblower claims. House Bill 1814 and Senate Bill 1250 (“Bills 1814/1250”) preserve the right to bring tax claims under the Act, and they maintain the prohibition against income tax claims.  However, in a significant improvement over current practice, the Bills would amend the Act to restrict the ability of a whistleblower or its counsel to control or profit from the filing of tax claims.  In addition, they enhance the role played by the Department of Revenue (“Department”) in determining whether a whistleblower’s tax claim should be pursued.  Effectively, the Bills make the filing of state tax-related whistleblower claims more like the procedure for bringing a federal tax violation before the IRS. Currently, the Act authorizes private citizens, termed “relators,” to initiate litigation to force payment of tax allegedly owed to the State.  740 ILCS 175/4(b).  Hundreds of such claims have been filed in Illinois by whistleblowers claiming a failure to collect and remit sales tax on internet sales.  Relators file a complaint under seal with the circuit court and serve the complaint on the State.  Id. 175/4(b)(2).  The Illinois Attorney General’s office then has the opportunity to review the allegations and decide whether to intervene in the litigation.  Id. 175/4(b)(2), (3).  The Department is not named as a Defendant and there is no requirement to involve the Department in the litigation.  If the Attorney General declines to proceed with the litigation, the relator may proceed with the lawsuit on its own and, if successful, is entitled to an award of 25 percent to 30 percent of the proceeds or settlement of the action, plus its attorneys’ fees and costs.  Id. 175/4(d)(2).  Even if the State intervenes and proceeds with the litigation, eliminating the relator’s day-to-day involvement, the relator is entitled to an award of 15 percent to 25 percent of the proceeds of settlement, plus attorneys’ fees and costs.  Id. 175/4(d)(1). In contrast, Bills 1814/1250 provide that only the Attorney General (“AG”) and the Department have the right to initiate claims under the Act for taxes administered by the Department.  Whistleblowers are required to report an alleged tax violation to the Department.  The Department must investigate the allegations and make a recommendation to the AG as to whether or not the AG should file suit based on the allegations.  Bills 1814/1250, 740 ILCS 175/4.5(b).  The AG can accept or reject the Department’s recommendation.  It can also bring suit in the absence of a Department recommendation.  Id.  If the AG initiates litigation based on a whistleblower’s allegations, the whistleblower is entitled to an award of 15 percent to 30 percent of the collected proceeds of the action and “related actions” or settlement, but no attorneys’ fees.  Id., 740 ILCS 175/4.5(d).  The whistleblower has no ability to proceed with litigation on its own if the Department or AG find the litigation unworthy.  These changes would significantly reduce the ability of a whistleblower or its counsel to profit from the filing of nuisance value claims. Bills 1814/1250 also provide that the Department has discretion to initiate an audit based on a whistleblower’s allegations and affirm that the audited entity has all the rights available to any other taxpayer to dispute any additional assessment of tax, interest and/or penalty charges.  Id., 740 ILCS 175/4.5(c).  Whistleblowers may not participate in or challenge the Department’s audit determination.  If the Department initiates an administrative action based on a whistleblower’s allegations, the whistleblower is entitled to an award of 10 percent to 15 percent of the collected proceeds of the action or settlement.  Id., 740 ILCS 175/4.5(d). Bills 1814/1250 also provide the much-needed ability to reduce the percentage award to a whistleblower under certain circumstances.  First, the Department has the discretion to reduce the percentage award to a whistleblower to 10 percent of the proceeds or settlement if it determines that the action (administrative or judicial) against a taxpayer is based primarily on disclosures from other sources.  Id., 740 ILCS 175/4.5(e).  (This provision is in the present version of the Act, but is a right afforded to the AG, not the Department.)  In addition, the Department has discretion to reduce the whistleblower’s award without limitation if it determines the whistleblower planned and initiated the violation of the Act.  Id., 740 ILCS 175/4.5(f).  The latter change should significantly reduce the ability of whistleblowers to profit from the repetitive filing of tax claims based on transactions initiated by the whistleblower. Bills 1814/1250 also would reduce the burden on the Circuit Courts with respect to these claims by requiring a whistleblower to file its claim with the Department, rather than the Court in the first instance, and by providing that Department award determinations are appealable exclusively to the Court of Claims.  Id., 740 ILCS 175/4.5(g), 705 ILCS 505/8(j). This is not the first time bills have been introduced to amend the Act.  Similar efforts over the past several years have been stymied when the legislature failed to consider the bills in Committee hearings. Hopefully, the Illinois General Assembly will take action to enact one of these much-needed legislative changes this year.

On April 4, 2016, without warning, the US Department of the Treasury proposed a new set of comprehensive regulations under section 385. There had been no advance indication that regulations were even under consideration. Although the Treasury indicated that the proposed regulations were issued in the context of addressing corporate inversions, their application went well beyond the inversion space and they apply to inter-corporate debt regardless of whether it occurs in an international context. The following is a discussion of the state and local tax consequences of the proposed regulations; for a detailed discussion of the proposed regulations themselves, see this previous article.

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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.

History

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)[1] program.  States thus have increasing external resources available for transfer-pricing audits.

International Context

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.[2]  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”.[3]

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.[4]  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.[5]  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.

[1] We love this acronym so much, we are thinking of getting T-shirts made.

[2] See Bloomberg BNA, “OECD’s Saint-Amans Says BEPS Debate Over Formulary Apportionment is Finished”, Transfer Pricing Report, April 3, 2014.

[3] 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

[4] 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.

[5] See Garry Stone and Elif Ekmekci-Taskiran, “Formulary Apportionment: The Case of Missing Income”, 22 Transfer Pricing Report 867, 11/14/2013.

On December 5, 2014, the New York Department of Taxation and Finance (Department) released TSB-M-14(5)C, (7)I, (17)S.  This (relatively short) bulletin sets forth the treatment of convertible virtual currency for sales, corporation and personal income tax purposes.  The bulletin follows on a notice released by the Internal Revenue Service (IRS) in March of this year, Notice 2014-21.

The IRS Notice indicates that, for federal tax purposes, the IRS will treat virtual currency as property, and will not treat it as currency for purposes of foreign currency gains or losses.  Taxpayers must convert virtual currency into U.S. dollars when determining whether there has been a gain or loss on transactions involving the currency.  When receiving virtual currency as payment, either for goods and services or as compensation, the virtual currency is converted into U.S. dollars (based on the fair market value of the virtual currency at the time of receipt) to determine the value of the payment.

The IRS Notice only relates to “convertible virtual currency.”  Virtual currency is defined as a “digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.”  Convertible virtual currency is virtual currency that “has an equivalent value in real currency, or that acts as a substitute for real currency.”

The Department’s bulletin also addresses only convertible virtual currency, and uses a definition identical to the IRS definition.  The Department indicates that it will follow the federal treatment of virtual currency for purposes of the corporation tax and personal income tax.

For sales and use tax purposes, the bulletin states that convertible virtual currency is intangible property and therefore not subject to tax.  Thus, the transfer of virtual currency itself is not subject to tax.  However, the exchange of virtual currency for products and services will be treated as a barter transaction, and the amount of tax due is calculated based on the fair market value of the virtual currency at the time of the exchange.

The Department should be applauded for issuing guidance on virtual currency.  It appears that these types of currencies will be used more and more in the future, and may present difficult tax issues.

However, the Department’s guidance is incomplete.  There are a couple of unanswered questions that taxpayers will still need to ponder.

First, the definition of convertible virtual currency is somewhat broad and unclear.  The Department and the IRS define “convertible” virtual currency as currency that has an “equivalent” value in real currency, but equivalent is not defined in either the IRS Notice or the bulletin.  Many digital products and services use virtual currency or points that cannot be legally exchanged for currency to reward users, and the IRS and the Department should be clearer about the tax treatment of those currencies.

Second, although the Department will follow the federal treatment for characterization and income recognition purposes, the bulletin does not discuss apportionment.  This is likely a very small issue at this point in time, but the Department will, some day, need to address how receipts from gains in the exchange of virtual convertible currencies are apportioned.

Virtual currencies will create issues not only in the tax world, but also in the unclaimed property world.  The Uniform Law Commission has begun its efforts to rewrite the Uniform Unclaimed Property Act, and the treatment of virtual currency will be an issue discussed during the rewrite.  Companies that use virtual currencies, convertible or not, should follow the rewriting process to make sure the drafters are informed of all of the issues these companies will face.