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Bloomberg Tax recently asked four prominent state and local tax thought leaders about changes they see on the horizon for 2018. Below are the responses from Ernst & Young LLP’s Joe Huddleston, PwC’s Scott L. Austin, KPMG LLP’s Harley Duncan, and Deloitte Tax LLP’s Valerie C. Dickerson.
Interview by Michael Murphree
Joe Huddleston is executive director of Ernst & Young LLP’s National Tax office Indirect Tax group in Washington, D.C. Scott L. Austin is a principal at PwC in Philadelphia. Harley Duncan is the managing director of the state and local tax group in KPMG LLP’s Washington National Tax practice. Valerie Dickerson is a partner at Deloitte Tax LLP, who leads Deloitte’s Washington National Tax-Multistate practice.
Interview by Michael Murphree
Looking ahead to 2018, what do you expect to be the top state and local tax trends that will emerge?
In 2018 there should be a number of significant state and local trends that develop or continue. I believe the issues surrounding Federal Partnership audit rules will play an increasingly important role, as states attempt to adjust and develop consistent treatments for partnerships. Beyond those questions we will continue to see battles over the impact of market sourcing and single sales factor apportionment. Many states have been moving in the direction of adding weight to the sales apportionment to enhance economic development and some have already moved all the way to a single sales factor. The Philip Morris issue currently working its way through the California administrative processes on a petition for alternate apportionment or the similar Indiana litigation could provide a format for a serious challenge to the 1978 Moorman Manufacturing case (Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978), which recognized a valid constitutional basis for single sales factor apportionment. Marijuana legislation seems to be spreading around the country and will only accelerate if states continue to see substantial new tax revenue. Additionally, I think an emerging, if short term, trend will be states reaction to federal tax reform. States will have to determine quickly whether to conform or decouple from the new IRC requirements as they determine the potential impact on state revenues.
Reaction to the enactment of federal tax reform looms over everything in the state tax world. State legislatures will have to act quickly to understand the impact of federal changes on state tax revenues and determine whether they will decouple from or conform to certain tax reform provisions, such as: mandatory deemed repatriation, a new measure taxing Global Intangible Low-Taxed Income, a new deduction for Foreign-Derived Intangible Income (FDII), a new Base Erosion Minimum Tax (BEMT), interest expense limitations, and full expensing of certain purchases.
Legislatively and administratively, states will continue to implement alternative methods to extend their income and sales tax nexus reach to taxpayers without traditional physical presence in their state, including:
Corporate tax departments will find increased value and enhanced efficiencies through incorporating data analytics and automation into their state tax function. State tax professionals will need to leverage technology to create and maintain support for state tax positions while managing the demand by internal and external stakeholders for more detaileess the state tax implications of federal tax reform.
I see two things dominating the discussion in state and local taxes in 2018. First, we will undoubtedly see a continuation of state legislative and administrative efforts to extend the tax collection obligations of remote sellers. I would expect these efforts to emphasize refining and amplifying the “extended physical presence” approach being put forth in Massachusetts and Ohio where the focus is on the use of in-state software as the physical presence hook over remote sellers. They will also focus on extending collection and/or reporting obligations to online marketplace providers as has been done in Washington State, Minnesota, Rhode Island and Pennsylvania. This is particularly true if the Pennsylvania, Washington and Rhode Island laws begin to promote collection by a range of marketplaces.
The second dominating theme and area to monitor closely is the state response to federal tax reform (presuming it makes its way to the President’s desk as seems likely now). The reform bill contains a number of dramatic changes in both personal income taxes and corporate income taxes that will affect states significantly and to which the states will have to respond in terms of conforming to the changes or not, or conforming in some modified form. There are substantial fiscal and policy challenges posed by the individual income tax changes, while the corporate changes also raise fiscal and compliance issues of considerable magnitude. In addition, the limitation on the federal deduction for state and local tax along with increased federal deficits raises fiscal challenges for states to deal with next year and in the longer run.
I have little doubt that it will be the impact of tax reform in the states. Most immediately is the need to evaluate the financial statement impact of tax reform including at the state tax level. For each quarter in the next 12 to 18 months, companies will need to be aware of and account for state decisions on IRC conformity, decoupling, and modifications related to the tax reform bill. Right now, states are inevitably evaluating the budgetary impact of federal tax reform and will soon be making decisions based on the expected revenue loss or gain (e.g., decoupling from 100% depreciation, amendments ensuring state-level personal exemptions continue to exist).
I’ve also been predicting a convergence in the technical issues between multistate and international tax for some time and this convergence can no longer be ignored. Exhibit A in this regard is the uncertainty around the state tax treatment of foreign income. The potential magnitude of deemed repatriation on the state tax level underscores the significance of conducting a detailed state by state analysis of tax base, apportionment and filing group options. The definition of what comprises the sales factor, already the subject of much attention for some states, also may become a stronger trend as these worlds converge.
What current state and local tax trends do you see going away in 2018?
Perhaps the most pronounced issues that states have been dealing with is the impact of remote sellers and how to tax nontraditional nexus internet sales. While I believe this will continue to be at the forefront of issues to be discussed, I think that we will see a marked decrease in its real significance. The methods that internet retailers use to carry on their business have continued to change over time and many of the larger sellers will find that they now have, more or less, traditional nexus. Most of the internet sellers that do not fall into this bucket will be the smaller sellers and many states may exempt them because of de minimis sales volume.
With the US Supreme Court’s denial of Gillette in October 2017, its June 2017 denial of Michigan’s Lorillard decision, and the Texas Supreme Court’s recent Graphic Packaging decision denying use of the compact election, taxpayer disputes around the Multistate Tax Compact election are likely to fade in 2018. Although the Oregon Health Net case is keeping the issue alive, we’re likely to see less activity around the Compact election.
With the need to focus on the state response to federal tax reform, I think we will see less emphasis on more state-oriented issues such as combined reporting and the transition to market-based sourcing. These movements have slowed a bit in recent years, and I think the federal focus will keep them on the back burner.
To the extent that companies decide to expand in the US in response to the new foreign income regime, I suspect many of the remaining 3-factor apportionment states may join the bandwagon and adopt sales factor-only apportionment provisions and/or application of market-based sourcing provisions for services in an attempt to encourage investment in their states.
What do you expect to be the most controversial issues that will emerge in 2018, and why?
Related party sales or transfer pricing issues will continue to be an area of controversy, but I think the focus will turn to issues related to imbedded royalties between domestic related parties and international entities. I think this may produce a growing area of controversy, as states, believing that they are leaving money on the table, increase their interest in closely examining such activities. This will especially be true in states participating in the Multistate Tax Commission’s State Intercompany Transaction Advisory Service Committee program.
How states choose to conform to or decouple from federal tax reform provisions will create complexity and controversy through 2018. States will be faced with significant policy decisions. States could potentially receive increased tax revenues due to the application of deemed repatriated income, GILTI income, and interest limitations. There may be considerable pressure from corporate taxpayers advocating for decoupling from certain federal tax reform provisions to avoid increased state tax liabilities. Will states selectively conform to provisions that increase tax revenues yet decouple from those that provide taxpayers with a decreased tax base?
States may also have to address the particular complexities that arise within certain tax reform provisions. For example, will states follow the federal deduction applicable to deemed repatriation? How will combined and consolidated filing states follow interest limitations applicable to ‘taxpayers’? Will full expensing bring with it the same compliance complexities as bonus depreciation? States will have to address these, and many more, questions that arise due to the application of federal tax reform provisions.
Additionally, states may engage in political efforts to react to perceived unfair treatment to their residents. For example, on January 3, 2018, in his State of the State address, New York Governor Andrew Cuomo announced that tax reform promotes double taxation, violates the principles of equal protection, and that he would challenge tax reform in court as unconstitutional. Governor Cuomo also said he would look to modify New York’s tax code, perhaps through the payroll tax. Similarly, California legislation may be introduced allowing citizens to make a donation to the state in lieu of income taxes.
As fiscally challenged states attempt to increase revenues, a few instances of troubling and controversial revenue-raising experiments have the potential to spread to other states in 2018. In what could create an acceleration of revenue, but no new revenue, Massachusetts introduced the concept of accelerated sales tax remittance. The Massachusetts Department of Revenue found that it would not be cost effective to implement an accelerated sales tax remittance system before June 1, 2018, putting the matter on hold, at least for now.
Extending nexus to taxpayers with questionable measureable presence may be another controversial trend in 2018. By regulation, Massachusetts provides that it will extend nexus to certain entities that that meet a sales and transaction threshold and use “in-state software (e.g., ‘apps’ and ancillary data (e.g., ‘cookies’).” This regulation already has been challenged (in a Virginia proceeding). Rhode Island, by statute, has a similar ‘cookie’ provision and the Connecticut Department of Revenue Services Commissioner is suggesting a similar rule.
Another trend that may continue involves states retroactively legislating away unfavorable decisions and interpretation of their laws. For example, Virginia reacted to administrative decisions favoring taxpayer interpretations of the state’s subject to tax exception to the addback rule by enacting a legislative change with a ten-year retroactive application. Another example involves Michigan addressing challenges to its adoption of the Multistate Tax Compact’s three-factor apportionment election by enacting a law retroactively repealing its adoption of the Compact.
I suspect that the state response to whether or not to conform to certain of the federal changes such as the passthrough deduction, the interest limitation and the international provisions will generate substantial controversy in some states. Also, deciding whether and how to adjust the state personal income tax to the federal changes such as the standard deduction, personal exemptions and itemized deductions and assessing the distributional effects of all the federal changes will generate a tremendous amount of debate in state legislatures.
States’ treatment of foreign income, as I mentioned before. We’ve been talking and thinking about it for several years as we’ve digested the BEPS initiative, but I think we will see a robust debate around the degree to which states can include foreign income in the tax base, at least in the same manner as the new federal rules. Companies that take the proactive approach of evaluating what is reasonable (as well as what may appear to be more technically sound), will be well positioned in the long run to react to state guidance (and potential litigation) in this regard.
What are the biggest challenges state revenue departments will face in the coming year?
Resources will once again be state revenue departments biggest challenges and headaches. Many states will face shortfalls from their revenue projections, which could result in budget reductions for all state departments including Revenue departments. It will continue to be difficult for state agencies to staff technical position such as auditors or attorneys. Additionally it may be almost impossible to keep pace with the IT systems requirements needed to adequately service the taxpaying public.
State Departments of Revenue will struggle with quickly understanding the implications of federal tax reform. Such understanding is critical as state legislatures may be looking to Departments for guidance in early 2018 legislative sessions regarding which elements of tax reform to conform to or decouple from.
I suspect they will continue to be asked to do more with less, so ensuring that they have up to date, secure technology and processing systems will be critical to ensure they can improve productivity and enhance taxpayer service. The same holds true for being able to apply new technologies such as data analytics, repetitive process automation (i.e., creating ‘bots’ to tax time out of processes). In addition, being able to provide state legislatures with quality, clear analysis of the impacts of the federal tax reforms on the state will be extremely important, but difficult in the short time available between now and the legislatures convening.
What’s old is new and everyone has retired. All kidding aside, this is an incredible time for engagement in state-level discussions regarding how to administer a newly revamped federal tax regime in the state context. The demand for sophisticated technical ability is high and revenue departments need to ramp up despite budget constraints and several years of “doing more with less.” Not unlike the challenges facing the private sector, needless to say.
What are the most important changes that states need to make to their tax regimes in 2018?
States should be conscious of the difficulty of compliance for multistate businesses. Many of these problems grow out of process issues rather than tax specific areas. Filing requirements and timing for changes related to federal audits have always produced difficult issues and the states should take more seriously problems that the lack of uniformity create for many industries.
Adoption of or decoupling from federal tax reform will be among the most important changes states will need to make with their tax regimes in 2018.
As states implement varying rules regarding how to tax transactions involving new technologies (e.g., cloud transactions or taxation of remote sellers) taxpayers are faced with complying with different rules across many jurisdictions. States should seek to modify their tax regimes to support conformity so taxpayers have more certainly in their state tax responsibilities.
I think it is the same old stand-bys. What is necessary to get to a diversified and stable revenue base that generates sufficient revenues to meet service needs, is in tune with the economy and its changes, and does not create economic distortion. That is no small task. In addition, dealing with the increasingly global economy with U.S. businesses doing business internationally and foreign firms increasingly being present in the U.S. will put strains on our traditional revenue sources.
State tax policymakers may decide they need to re-evaluate their IRC conformity philosophy. When the states automatically conform to essentially minor tweaks to the IRC, that is one thing. However, when automatic conformity pulls through fundamental shifts in how the federal government treats foreign income, that is quite another animal. Do state tax policies rely too much on the IRC to the detriment of state sovereignty? Consideration of non-income taxes (such as one based on gross receipts) in order to maintain a stable revenue base, always a risky political venture, may well be taken up by some legislatures and policy-makers depending on how budgets look when the tax reform dust settles.
Now that the U.S. Supreme Court agreed to hear the South Dakota Wayfair case, which seeks to overrule the 1992 ruling in Quill Corp. v. North Dakota as obsolete in the e-commerce era, how do you think the court might rule?
Given my surprise that they took this case, I might not be the best judge. Many believe that they would not have take this case unless they intend to overturn Quill, but clearly the Court has proven that they can go in any direction without much warning. It is possible that they could return this issue to the state for the facts to be presented or they could use the case to lay out rules for sales tax nexus. I can’t believe that they will want to go down the road of legislating for the states. They might simply want to make another statement about the legislative responsibility of the Congress. Given the lack of issues in dispute in this particular case my guess is that it is now “anybody’s guess” what this court might do.
It’s impossible to tell with certainty how the US Supreme Court will act. However, the Court’s granting of certiorari may be an indication that the justices may be willing to reconsider the continued viability of Quill.
There are two Supreme Court justices who have questioned Quill. In his 2015 concurrence in Direct Marketing Association v. Brohl (DMA), Justice Kennedy provided that, given changes in technology and consumer sophistication, “it is unwise to delay any longer a reconsideration of the Court’s holding in Quill.
Justice Gorsuch, who clerked for Justice Kennedy, sat on the Tenth Circuit Court of Appeals when DMA was before that court. In his concurrence in DMA, Justice Gorsuch provided that the physical presence rule may have “a sort of expiration date.”
Even if the US Supreme Court overturns the physical presence standard of Quill, will Congress intervene and provide a uniform nexus standard for all states?
I am still south of 50-50 that the Court will overturn Quill. Having said, albeit 25 years ago, that this was an issue that Congress could settle, that would still be a position the Court could take. I would also think the Court could be troubled by the route taken to get the case before the Court. Of course, I have been wrong pretty much all along the way on this one, so we’ll see.
Editor’s Note: The U.S. Supreme Court granted the petition to review the Wayfair case Jan. 12, and Valerie Dickerson was out of the country and unavailable to respond to this question in time for this publication.
The information in this article is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author only, and does not necessarily represent the views or professional advice of KPMG LLP.
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