State Tax Directors Focus on Fraud, Economic Substance and Closing Tax Gap

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By Michael Bologna  

March 7 — The duties of state tax directors won't get any easier during 2014 despite the improving economic climate and the availability of new tools supporting the missions of state revenue departments.

A series of interviews conducted by Bloomberg BNA in February with top revenue department officials from more than 25 states revealed that directors will see continuing uncertainty over resources available to administer and enforce state tax codes during 2014. Revenue directors will also face a steady stream of new demands from elected officials and interest groups seeking revisions to their tax codes, some of it driven by red state/blue state political agendas.

State tax directors will use new technologies and management strategies to close the tax gap but will see little relief from the patterns of fraud and noncompliance that leave billions of dollars uncollected each year.

State tax directors will use new technologies and management strategies to close the substantial gap between total tax obligations and the amount voluntarily submitted to the state. At the same time, state revenue directors will see little relief from the patterns of fraud and noncompliance that leave billions of dollars in tax obligations uncollected each year.

Illinois Revenue Director Brian Hamer, one of the longest-serving state revenue chiefs in the country, pointed to three critical challenges that will affect his ability to administer Illinois's tax code during the coming year—budgetary uncertainty, the loss of experienced revenue agents and auditors, and an accelerating pattern of demands from the state Legislature. Hamer said these challenges are specific to Illinois, but are familiar to tax directors throughout the country.

“There are more revenue bills introduced in the General Assembly each year than any other kind of bill,’’ Hamer, Illinois's revenue director since 2003, said Feb. 21. “It requires us to analyze and understand every one of those pieces of legislation and be prepared to comment on them and potentially implement them.’’

Economic Substance

In a separate set of interviews with Bloomberg BNA, practitioners and analysts monitoring state revenue agencies pointed to several important state and local tax themes to watch during 2014.

Jamie Yesnowitz, a principal and state and local tax practice leader in the Washington office of Grant Thornton LLP, said a key theme on the corporate tax side is a more aggressive focus on economic substance in audits as state revenue departments battle tax base erosion.

“I believe administrators have gotten more savvy over the years. They are investigating merger and acquisition transactions, restructurings and things like that. They are getting more savvy to make sure there is business purpose to these types of things, in line with the federal codification of the economic substance doctrine,’’ Yesnowitz said Feb. 21. “So that area is ripe for more cases.’’

Yesnowitz and other tax professionals pointed to several other state and local trends to watch during 2014, including:

  •  new efforts to close the “tax gap’’ with the help of emerging technologies and fraud detection strategies;
  •  additional states enacting “click-through nexus’’ laws;
  •  tax system revisions driven by red state/blue state political agendas;
  •  more defections from the Multistate Tax Compact;
  •  more states shifting to market-based sourcing and single sales factor apportionment;
  •  wider acceptance of state tax tribunals; and
  •  mounting pressure for corporate disclosures of state tax liabilities.
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    Closing the Tax Gap

    Several tax policy analysts and revenue directors told Bloomberg BNA that closing the tax gap remains a critical priority for the states, despite significant obstacles revenue directors face as they seek to boost the effectiveness of their collection systems.

    The Internal Revenue Service defines the tax gap as the difference between the total tax liability owed to a particular jurisdiction and the amount submitted voluntarily and on time by taxpayers. The IRS's most recent analysis, released in 2012 for tax year 2006, estimates an 83 percent federal compliance rate, leaving a gross tax gap of approximately 17 percent. While estimates vary among states, most analysts point to a similar 17 percent gap in terms of state tax revenues.

    Gale Garriott, executive director of the Federation of Tax Administrators, said even small degrees of success in closing state tax gaps add up to hundreds of millions of dollars, relieving governors and legislatures of some of the challenges associated with funding state services. Garriott said revenue directors continue to focus their tax gap energies on enforcement and fraud avoidance strategies with a mixed record for success.

    While much policy research asserts that revenue system investments in auditors and investigators trigger net gains for states, Garriott said not all states are making these investments. Several states lost enforcement personnel during the recession and staffing levels haven't fully rebounded.

    “The states are trying to get back to their prerecession employment levels, but I'm not sure all of them have,’’ Garriott said Jan. 31. “Some states took a really big hit.’’

    States Focusing on `Big Data.'

    In the absence of additional funding, Garriott said states are trying to use their limited investigation and enforcement resources more effectively. Those strategies include more efficient audit targeting and better identification of noncompliant taxpayers. Garriott said states are also leveraging “big data’’ strategies to identify and respond to patterns of noncompliance.

    “The states are trying to get back to their prerecession employment levels, but I'm not sure all of them have. Some states took a really big hit.’’Gale Garriott, Federation of Tax Administrators

    “States more and more are relying on data analytics, data metrics. At least half and perhaps more have built data warehouses where they can collect data from all sorts of different places and then match,’’ Garriott said. “So they can make inquiries against this data to find these areas of noncompliance. This is definitely an important direction for the states.’’

    In many cases, Garriott said states are teaming up with vendors to develop the data warehousing and analytical systems needed to accommodate these strategies.

    Data analytics company Teradata Corp., based in Dayton, Ohio, is a major player in this field, partnering with states to implement its Teradata Tax Compliance Solution. The system is built around a tax data warehouse, which interfaces with management information systems, analytical applications and business intelligence tools to boost a state revenue agency's performance.

    Psychology Behind Noncompliance

    Alex Lunsford, director of Teradata government systems, said Teradata econometricians and data scientists typically meet with revenue agencies early in an engagement to understand the issues driving noncompliance. The company then adapts various data analytic strategies to meet the specific needs of the state.

    The resulting systems help agencies quickly spot patterns of noncompliance, select targets for audit and prioritize collection activities, he said.

    “You have to ask the question: ‘What is the psychology behind the anomaly?’ You are deconstructing the behavior. You are figuring out, is it fraud, which is willful and implies malice aforethought; is it improper payments, so no malice aforethought, but it gets to compliance with the spirit of the law; and, is it waste, which is just human error or apathy,’’ Lunsford said. “If you want to close the tax gap, you have to get to all three of these at some point.’’

    Five States Collect $2.2 Billion

    Lunsford pointed to $2.2 billion in state tax revenues collected in five states that implemented Teradata solutions. Those dollars represent revenue the states previously had little hope of ever collecting, he said. In other words, each project contributed to the closure of some portion of the client state's tax gap.

    The success stories Lunsford cited include:

  •  The Texas Comptroller of Public Accounts implemented its Advanced Database System employing data from multiple sources, advanced data analytical capabilities, and faster querying and reporting. The initiative triggered $1.2 billion in additional revenue collections over 13 years.
  •  The Iowa Department of Revenue implemented an enterprise data warehouse system to enhance efficiencies and boost taxpayer compliance. The effort has produced $250 million in revenue over 12 years and continues to generate $14 million annually.
  •  The Missouri Department of Revenue improved its various operating systems to focus on accurate reporting, better case management and more effective audit targeting. Over seven years the strategy has netted 500,000 discovery leads and $375 million in additional revenue.
  •  The New Jersey Division of Taxation implemented an enterprise data warehouse and an enhanced tax compliance system to boost compliance and generate more useful audit leads. The effort has netted $350 million in revenue over six years.
  •  The Ohio Department of Revenue implemented an enterprise data warehouse with modules aimed at business intelligence, analytical case management and reporting. This strategy has collected $70 million over three years.
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    While some states have been using these strategies for several years, a Teradata official said state revenue systems are just beginning to tap into the terrific opportunities available through data analytics.

    `Early in the Evolution.'

    Leslie Arnold, senior solutions architect at Teradata, said states still haven't exploited data strategies that allow for real-time detection of tax program anomalies and new sources of data that could be used to detect noncompliance.

    Arnold said data analytic strategies could also be used to help revenue departments identify taxpayers employing “zappers,’’ electronic sales suppression systems that rob states of sales tax revenue.

    “We are fairly early in the evolution,’’ Arnold said. “Frankly we have only done a few different models. Many of the models have been, historically, around audit selection and collection prioritization.’’

    Stolen Identities

    Verenda Smith, deputy director of the FTA, said fraud may prove to be the biggest impediment to the states as they seek to close their tax gaps. While tax frauds take dozens of forms, she said the biggest current problem involves sophisticated criminal rings filing bogus returns and demanding refunds using stolen identities.

    Smith said the states are working aggressively to identify such frauds and halt refund checks before issuance. The states are also sharing information about active fraud rings and emerging fraud schemes. Smith conceded, however, that states are at a constant disadvantage because fraud patterns tend to evolve and evaporate quickly.

    “There are regular calls and meetings among the states on ways to attack this and adapt to the latest trends,’’ Smith said. “But this is definitely one of those problems that adapts itself like a virus; once you attack from one direction, it shifts in a new direction.’’

    Fraud “is definitely one of those problems that adapts itself like a virus; once you attack from one direction, it shifts in a new direction.’’ Verenda Smith, Federation of Tax Administrators

    Stephen Coggeshall, chief analytics and science officer at ID Analytics, a subsidiary of LifeLock Inc., said Feb. 6 that most state revenue departments haven't effectively responded to the significant threats posed by identity theft fraud. Most departments, he said, are still responding from a position of remediation instead of prevention.

    Behind the Curve on Fraud

    At a technical level, Coggeshall said revenue departments continue to operate “rules-based’’ and “filters-based’’ systems for detecting potentially fraudulent returns. Such systems screen tax returns and refund requests against various data sets and filters designed to highlight suspicious trends. The systems, however, operate several steps behind the most sophisticated fraud rings.

    Coggeshall said the states are also hampered by lack of resources for cutting-edge fraud detection systems.

    “In my opinion, they are really behind the curve,’’ Coggeshall said. “They are still applying old school systems and they really are not using the best available commercial solutions.” He said there are a lot of issues involving bureaucracy, funding and information technology sophistication affecting these tax authorities.

    “A lot of them are learning about identity fraud for the first time,” Coggeshall said. “They are fairly good at solving traditional tax fraud and the natural thing to do is to just apply those techniques to this new fraud. But as we discovered in the early 2000s, you really need a different technological approach aimed at this sophisticated identity fraud.’’

    Coggeshall said modern identity risk solutions, common in private industry, feature “machine learning artificial intelligence.’’ Such systems learn from the data coming into the organization and then adjust to risk patterns. He said these adaptive systems would permit state revenue departments to see identity fraud patterns quickly and respond to fraud on a real-time basis.

    Coggeshall said some revenue departments are beginning to implement these machine learning systems, but the transition could take several years.

    “I think they are just getting their act together because the problem has grown so quickly,’’ he said. “It is so politically sensitive, the funds are beginning to flow for them to put these more sophisticated commercial solutions in place.’’

    Red State/Blue State

    Several analysts pointed to potential changes in the structure of state tax codes during 2014, driven by red state/blue state political dynamics in those jurisdictions.

    Grant Thornton's Yesnowitz said 37 states are controlled completely by a single political party, the highest number in several decades. Of that group, 23 states are controlled by Republican governors and legislatures, and 14 states are controlled by Democrat governors and legislatures.

    On the red state side, Yesnowitz said several governors and legislative leaders are discussing reforms that would eliminate or roll back income taxes and make up the revenues through increases in the sales tax. Louisiana Gov. Bobby Jindal (R) made an unsuccessful play in that direction in 2013 and Wisconsin Gov. Scott Walker (R) expressed such preferences at the beginning of 2014. Yesnowitz said red states may also consider adjustments to their corporate income tax systems, seeking to stimulate business growth.

    Meanwhile, Yesnowitz said, blue states will consider revisions to make their tax codes more progressive. Such changes would likely boost taxes on high-income taxpayers and reduce burdens on low- and middle-income taxpayers through changes in rates, credits and exemptions. These themes were evident in the recommendations of the District of Columbia Tax Revision Commission, released Feb. 12.

    While these two paths may seem appealing to politicians, Yesnowitz said, the states will be constrained by economic reality in 2014. He said state revenues continue to recover but few states will have enough new revenues to permit their governors and legislatures to engage in broad experimentation with the tax code.

    Still, Yesnowitz predicted three red states would pursue broad reductions in their personal and corporate income tax rates during 2014. He said the potential list includes Wisconsin, Nebraska, North Dakota, Texas and Oklahoma. He also predicted three blue states would make targeted revisions benefiting low- and middle-income taxpayers. Likely players include the District of Columbia, Maryland and New York.

    Click-Through Nexus

    Yesnowitz predicted continued interest in “Amazon laws” or click-through nexus statutes despite an environment of political and legal uncertainty.

    With the federal Marketplace Fairness Act (S. 743, H.R. 684) stalled in the House and the Supreme Court's decision in late 2013 declining to review New York's click-through nexus law, Yesnowitz said some states would be emboldened to pass laws compelling remote sellers to collect state sales taxes. He said Tennessee and Indiana are actively interested in such statutes.

    At the same time, Yesnowitz said state efforts to tax electronic commerce are far from settled. In October 2013, the Illinois Supreme Court held that state's click-through nexus law was preempted by the federal Internet Tax Freedom Act (Performance Mktg. Ass'n Inc. v. Hamer, Ill., No. 114496, 2013 BL 290322 (10/18/13)).

    Similarly, Colorado's approach, which imposes use tax reporting requirements on retailers that don't collect sales tax on purchases by Colorado residents, was halted by a state court judge Feb. 18. The court granted the Direct Marketing Association's motion for a preliminary injunction, preventing the Colorado Department of Revenue from enforcing the law (Direct Mktg. Ass'n v. Brohl, Colo. Dist. Ct., No. 13CV34855 (2/18/14)).

    An Appetite for Litigation

    In this legal environment, Yesnowitz said states enacting click-through nexus statutes in 2014 must have an appetite for litigation.

    “You have New York, where the court ruled against the business taxpayers. Then you have Illinois where the court ruled in favor of business and the statute was unconstitutional. And then you have Colorado where all heck is breaking loose with respect to the use tax reporting requirement,’’ Yesnowitz said Feb. 21.

    “So you have several different conceptions of what the right policy should be. With that uncertainty, instead of 10 or 15 states deciding to adopt click-through nexus, you may see two, three or four states trying to adopt it and with a wary eye toward future litigation,’’ he said. “We've heard from New York, Illinois and Colorado, but we haven't heard the last of litigation in this area.’’

    Major remote sellers, including Amazon.com, are increasingly willing to collect state sales taxes in certain jurisdictions. “So there is less and less money on the table around the Marketplace Fairness Act,’’ said law professor Richard Pomp.

    Richard Pomp, a professor at the University of Connecticut School of Law who specializes in state and local tax issues, pointed to another dynamic that may cause states to forgo click-through statutes in 2014—major remote sellers, including Amazon.com, are increasingly willing to collect state sales taxes in certain jurisdictions.

    Pomp noted that large retailers including Walmart, Target and Staples already collect such taxes and Amazon in recent months has announced its intention to collect Wisconsin and North Carolina sales taxes, triggered by decisions to open distribution centers in those states. The company already collects sales tax from residents of Arizona, California, Connecticut, Georgia, Indiana, Kansas, Kentucky, Massachusetts, Nevada, New Jersey, New York, North Dakota, Pennsylvania, Tennessee, Texas, Virginia, Washington and West Virginia.

    “We are already seeing Amazon establishing more and more distribution centers, and voluntarily collecting in more and more states,’’ Pomp said.

    Corporate Income Taxes

    Tax professionals interviewed by Bloomberg BNA pointed to several important themes on the corporate tax front, including further erosion of the Multistate Tax Compact, raising questions about the agreement's viability.

    Yesnowitz said revenue directors and corporate taxpayers will be watching for the California Supreme Court's upcoming decision in Gillette Co. v. Cal. Franchise Tax Bd., Cal., No. S206587. The case involves the taxpayer's decision to avoid California's double-weighted sales factor apportionment formula and elect the three-factor formula specified in the compact. A state appeals court ruled that the election was available to allow taxpayers to apportion their in-state income using the compact's formula. The Gillette litigation caused the California Legislature to bow out of the multistate compact in June 2012.

    Yesnowitz pointed to similar interest in the Michigan Supreme Court's anticipated decision in Int'l Bus. Machs. Corp. v. Mich. Dep't of Treasury, Mich., No. 146440 (oral arguments 1/17/14). The court is expected to determine whether the Michigan Legislature intended to override the Multistate Tax Compact when it enacted the Michigan Business Tax Act, which includes a single sales factor apportionment formula, and whether the compact should take precedence over state law if multistate companies elect to use its three-factor apportionment formula.

    Four States May Leave the Compact

    Depending on the outcomes, Yesnowitz said the two cases and similar litigation in Texas, Oregon and Minnesota could lead to further problems for the compact. In 2013, the District of Columbia, Oregon, Utah, Minnesota and South Dakota enacted legislation repealing some or all of the compact. He predicted four more states would either sever their relationships with the compact in 2014, or cut themselves out of Article III and Article IV.

    “If they are severing Article III and Article IV, that's a big deal, that's a big part of the compact,’’ he said. “And, can a state really do that? Can a state really say, ‘we're part of the compact, but we're getting rid of the allocation and apportionment provisions,' which are at the heart of the compact?’’

    Such erosion of the compact certainly threatens its long-term viability, Yesnowitz said. He applauded the Multistate Tax Commission's (MTC) recent campaign to regain support from the states and taxpayers though its proposed model amending certain provisions of Article IV of the compact, which includes the Uniform Division of Income for Tax Purposes Act (UDITPA). The changes respond in part to criticisms of the compact and UDITPA over the treatment of the sourcing of income and apportionment of corporate income taxes.

    An important provision would give states the option to choose their own weighting of factors but include a recommendation that states double-weight the sales factor. Another provision would shift the compact from cost-of-performance to market-based sourcing for services and intangibles.

    Pomp Recommendations

    Yesnowitz also applauded the efforts of Pomp, who held a public hearing in 2013 on the model and issued a report recommending amendments to key provisions of Article IV. At the same time Yesnowitz predicted the commission's model would remain largely unchanged, particularly in the areas of market-based sourcing of services and alternative apportionment. In line with this view, he predicted the process would do little to attract interest from the states.

    “I think it is an excellent intellectual exercise for the MTC to do this and I think it is an excellent intellectual exercise to see Professor Pomp make comments in the hearing officer's report regarding what should be in Article IV and what should not be,’’ Yesnowitz said. “But is that going to have an effect on the states? I don't know that it motivates the states so much. I am pessimistic with respect to the compact provisions all of a sudden becoming something the states will want to adopt.’’

    Pomp said the business community is eagerly watching the MTC's uniformity committee to see if it will absorb his recommendations. The committee's response, expected in the next two to three months, will signal its willingness to modernize the compact and work with taxpayers. Pomp said corporate taxpayers will also be watching the MTC's choice of a new general counsel as an indicator of the commission's posture going forward.

    “I predict people will become disillusioned with market-based sourcing. They will realize all of the gray areas, all of the weaknesses, all of the foibles, and it will not prove to be the panacea they thought.’’Richard Pomp University of Connecticut School of Law

    “There is a great opportunity to reach out to the business community and bring them under the tent in a way that the MTC has not done before,’’ Pomp said. “So the question is whether it is going to be business as usual for the MTC or are they really going to seize an opportunity here to move the MTC to the next level and make them a key player for the next 10 or 20 years.’’

    `Equifax v. Mississippi.'

    Pomp offered several additional predictions on the corporate tax side, pointing first to more “equitable apportionment’’ strategies by states in the aftermath of the controversial Mississippi Supreme Court decision in Equifax Inc. v. Miss. Dep't of Revenue, Miss., No. 2010-CT-01857, 2013 BL 164432 (2013). While Equifax is seeking review by the U.S. Supreme Court, Pomp said the Mississippi decision has emboldened states to use alternative methods of apportionment when a state's prescribed method results in too much distortion of income.

    “We will see more equitable apportionment use by the states—more aggressive setting aside of the statutes, or in the case of Mississippi their own bloody regulations—and doing what the department thinks is right rather than what the legislature thought was right,’’ he said. “Tennessee and Mississippi are emboldened because they have won big cases.’’

    Pomp predicted more states would move toward the single-sales factor formula and pointed to a continued shift from the costs-of-performance method of apportionment to market-based sourcing. He noted that Pennsylvania and Massachusetts enacted market-based sourcing statutes in 2013. At the same time, Pomp said the states will begin to see flaws with market-based sourcing.

    “I predict people will become disillusioned with market-based sourcing,’’ he said. “They will realize all of the gray areas, all of the weaknesses, all of the foibles, and it will not prove to be the panacea they thought.’’

    Disclosure Legislation

    Finally, Pomp said corporate taxpayers should keep an eye on legislative proposals that would require corporate taxpayers to disclose their state tax liabilities.

    Illinois, for example, pursued legislation in 2013 that would have required all publicly traded corporations to file annual disclosure statements with the state describing various tax information, including the net corporate income taxes paid to the state. The state could then release the information to the general public after a two-year lag. The measure passed the state Senate but was never enacted.

    Pomp predicted limited success for these kinds of statutes in 2014. He suggested that advocates pushing these proposals should focus their attention on disclosures linked to state tax credits and business incentive programs rather than full tax liability transparency.

    Douglas Lindholm, president and executive director of the Council on State Taxation (COST), said his organization will be pushing state revenue departments and legislatures to make three changes important to its constituency of multijurisdictional corporate taxpayers. COST will use its resources to push for adoption of tax tribunals in more states, bans on the use of contingent fee auditors by state and local revenue departments, and prohibitions on qui tam actions brought against defendants alleged to have violated state and local tax codes.

    Tax Tribunals

    Lindholm noted that approximately half of the states have tax tribunals, which serve as independent appeals forums specifically dedicated to tax cases. Such states permit taxpayers to create a record for appeal before an independent adjudicative body staffed with judges specializing in tax law.

    According to the American Institute of CPAs, 32 states and the District of Columbia have some type of independent tax tribunal. Lindholm said COST will push for the remaining 18 states—Alabama, Arizona, California, Colorado, Florida, Maine, Nebraska, Nevada, New Mexico, North Dakota, Oklahoma, Pennsylvania, Rhode Island, South Dakota, Tennessee, Utah, Vermont and Virginia—to establish such structures.

    Lindholm said COST will also push for restrictions on revenue departments' use of third parties, working on a contingent fee basis, for tax audit and appeals services. Lindholm said such arrangements trigger incentives for auditors working outside of the objective goals of a government agency to distort the tax system for their own gain.

    “We see this as an inherent conflict of interest,’’ Lindholm said Feb. 4. “A contingent fee auditor has no interest other than to maximize the return. There is no consideration such as fairness or looking at issues that might bring refund. Their total effort is to maximize the assessment. These disputes should be handled by employees of the departments of revenue.’’

    Whistle-Blower Suits

    Lindholm also expressed concern about a litigation trend in which trial lawyers are using qui tam provisions in state and local false claims statutes as a basis for filing “whistle-blower’’ suits challenging taxpayers' returns. He said approximately half of the states have false claims laws, but only a handful of those laws specifically bar actions concerning alleged violations of the tax code.

    Lindholm said the suits can be expensive to defend and expensive to settle, due to requirements for civil penalties and treble damages. He also objected to patterns of litigation focusing on unsettled issues or tax law.

    Michael Wynne, a partner with Reed Smith LLP in Chicago, pointed to an example involving the imposition of Illinois sales taxes on shipping charges linked to online purchases. Wynne said more than 200 false claims suits have been filed in Cook County Circuit Court.

    Lindholm said such qui tam actions in the tax arena serve little purpose, especially when the litigation involves an unsettled area of state and local tax law. In line with that view, he said COST would lobby states such as Illinois to impose bars on qui tam litigation under the tax code.

    Finally, Lindholm said COST would be active in opposing state proposals that would require corporate taxpayers to disclose their state tax liabilities. He said such laws would do little more than “harass’’ corporate taxpayers, politicize issues around tax compliance and confuse the general public.

    “We are very concerned about the recent rash of statutes that purport to push for specific corporate tax return information. You saw that recently in Illinois. In essence, the only reason, in our view, that legislators would want to see this is for harassment purposes,’’ Lindholm said.


    To contact the reporter on this story: Michael Bologna in Chicago at mbologna@bna.com

    To contact the editor responsible for this story: Cheryl Saenz at csaenz@bna.com

    Text of the IRS tax gap report is at http://www.irs.gov/uac/IRS-Releases-New-Tax-Gap-Estimates;-Compliance-Rates-Remain-Statistically-Unchanged-From-Previous-Study.

    Text of the D.C. Tax Revision Commission's report is at http://media.wix.com/ugd/ddda66_a22fc7cb623d48c6acf639884047afcb.pdf.