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Bloomberg BNA recently asked three prominent state and local tax thought leaders about changes they see on the horizon for 2017. Below are the responses from EY's Joe Huddleston, KPMG's Harley Duncan and PwC's Peter Michalowski. For Duncan's responses, the author notes that this article represents the views of the author only, and does not necessarily represent the views or professional advice of KPMG LLP.
Interview by Michael Murphree
Joe Huddleston is executive director of Ernst & Young LLP's National Tax office Indirect Tax group in Washington, D.C.. Harley Duncan is a state and local tax managing director at KPMG's National Tax Office. Peter Michalowski is the National Practice Leader of PwC's State and Local Tax practice.
Looking ahead to 2017, what do you expect to be the top state and local tax trends that will emerge?
I think the top state and local tax trend that will emerge in 2017 will be the confusion created by the potential federal tax reform. States will be holding their breath waiting to see what fundamental changes to the federal tax code are enacted and whether the federal government finds the wherewithal to change the tax code for both domestic and international tax purposes.
I am going to be watching for three things in 2017 that you might consider trends. First, I think we should expect to see a fair amount of tax activity in 2017, with some part of it being to increase revenues. I say this because revenue growth has slowed significantly (approaching zero) over the last 12 months and a significant number of states are reporting shortfalls compared to budgeted amounts. In addition, overall state expenditures have been slowed in recent years, so the ability to squeeze more out of the spending side is somewhat constrained in my estimation. As a result, it seems to me that revenue actions may be necessary. Second, I am expecting several states to discuss some substantial tax reforms, generally with a view toward reducing income taxes (particularly corporate income taxes) and shifting to greater reliance on the sales tax. This could naturally lead to a discussion of how to extend the sales tax to a greater range of service transactions. Finally, I expect we will see an acceleration in efforts to collect tax through remote sellers by adopting economic nexus or related approaches, greater use tax reporting obligations, and (perhaps) an effort to impose a collection or reporting obligation on electronic marketplaces.
Until a federal legislative solution is enacted, the states will continue to act by enacting their own distinct solutions to the nexus issue. This exportation of tax goes hand-in-hand with a needed move toward a uniform standard of how states determine the market under a market-based sourcing apportionment methodology, as evidenced by the flurry of activities undertaken by the uniformity committee of the Multistate Tax Commission.
If we see federal tax reform enacted in 2017, the states will need to address an array of conformity issues, from how to treat deemed foreign repatriation to addressing a new pass-through business income tax system.
What current state and local tax trends do you see going away in 2017?
Depending on what happens at the federal level, we may see states' interest in international tax avoidance issues reduced.
Also, the tremendous appetite for credits and incentives at the state level seems to be on the decline but it is unlikely that state level credits will go away in totality since many states continue to use credits and incentives as a primary tool to attract new or expanding businesses.
I think the move toward “shoring up the corporate income tax” by moves such as economic nexus and combined reporting has pretty well played out. Many states have already done that, and those that have not seem to have decided they are satisfied with the structure they have now. Plus, some of the states are considering their ability to impose 482-type adjustments and other approaches to deal with intercompany transactions. I think we may also see a slow-down in the move to market-based sourcing of services. Here again, states seem to have reached an equilibrium and degree of satisfaction with what they have. But, there could be one more flurry of activity among a few states.
In light of the possibility of international tax reform, including a switch to a territorial system along with border adjustments for exports and imports, one must question whether we will see worldwide combined reporting go away. If a new pass-through business income tax system is implemented, will we see unincorporated business tax regimes, like those in New York City and DC, go away?
What do you expect to be the most controversial issues that will emerge in 2017, and why?
I think nexus will continue to be the most controversial issue in 2017, especially with the recent Ohio Supreme Court's rulings in Crutchfield [Corp. v. Testa , 2016 BL 382392, Ohio, No. 2016-Ohio-7760 (11/17/16)], Newegg [Inc. v. Testa , 2016 BL 382383, Ohio, No. 2016-Ohio-7762 (11/17/16)] and Mason Companies [Inc. v. Testa2016 BL 382389, Ohio, No. 2016-Ohio-7768 (11/17/16)] upholding Ohio's bright-line nexus standard under the commercial activity tax (CAT). These CAT nexus cases could lead the way to the U.S. Supreme Court's reconsideration of Quill [Corp. v. North Dakota , 504 U.S. 298 (1992)].
It seems to me that the continued push to overturn Quill by adopting economic nexus provisions or other questionable approaches to nexus are likely to be the most controversial. While they are aimed at obtaining an overturn by the U.S. Supreme Court or action in Congress, they place remote sellers in a very difficult position regarding whether they should comply with what is acknowledged to be an unconstitutional statute under current jurisprudence or risk unexpected liabilities should the decision ultimately be overturned.
Taxpayers must be able to rely on the law as it exists when business transactions take place. Since the Supreme Court held in [United States v.] Carlton [512 U.S. 26 (1994)] that retroactive legislation must be supported by a legitimate legislative purpose furthered by a rational means, a number of state cases have been decided that stretch the notion of Due Process beyond what many taxpayers believe is appropriate. The Supreme Court will face in 2017 a few opportunities to address the constitutionality of retroactive state laws, including Dot Foods [Inc. v. Wash. Dep't of Revenue] and a series of Michigan cases.
What are the biggest challenges state revenue departments will face in the coming year?
Revenue agencies will continue to see an increase in senior level retirements with an inability to replace that level of expertise, and they will continue to face funding problems with regard to critical technology systems upgrades.
I think state tax authorities face three major challenges: (a) dealing with the number or experienced and seasoned professionals that are at or near retirement age and being able to replace their institutional knowledge from the ranks of current employees; (b) the need to focus attention and resources on issues of data security and identity theft and what that does to the allocation of resources to policy guidance, taxpayer service and protest resolution; and (c) formulating responses to a number of substantial federal changes such as the IRC 385 regulations and the new partnership audit regime – not to mention potential federal tax reform.
Conforming to any comprehensive federal tax reform likely will be the greatest challenge faced by state revenue departments. Absent federal tax reform, the state revenue departments must tackle the new federal partnership audit and adjustment rules.
What are the most important changes that states need to make to their tax regimes in 2017?
States will need to consider and react to federal tax reform that will likely be enacted in 2017. Federal tax reform will be the primary driver in 2017 and beyond. And due to the ever-changing business environment (e.g., digital platforms, sharing services), state legislatures and revenue agencies will need to update their laws and policies to address these new ways of doing business.
In my estimation, the most pressing need from a structural standpoint is for the states to address the long-term structure and vitality of the retail sales tax. It is either the largest or 2nd largest revenue source in most states, but certain long-term trends – the growing role of services in the economy, the taxation of business inputs, remote sales, and an aging population – do not bode well. In addition, the increasing use of local sales taxes is making compliance exceedingly costly and complex. One more item of importance will be the possible/likely need to revisit state income tax structures if substantial federal tax reform is enacted.
Many states continue to face budget shortfalls. Will states continue to be caught short because of uncertain revenue streams or begin to think more comprehensively and long-term about tax reform?
To balance budgets, states should not look to traditional quick fixes, like cigarette taxes or tapping into rainy day funds, but rather to adopting fundamental tax reform that reduces revenue uncertainty by broadening the base, lowering the rate and providing clear and consistent application of the rules.
Do you think the Supreme Court will reconsider Quill and grant certiorari on a Quill challenge?
Yes, I do. I think the Ohio Supreme Court's ruling in the CAT nexus cases presents a unique opportunity for the U.S. Supreme Court to address substantial nexus under the Commerce Clause without their being hampered by the myriad of problems that face the sales tax nexus cases making their way through the court systems in Alabama and South Dakota.
Despite what we've heard from Justice [Anthony M.] Kennedy, I do not think the Court is looking for a Quill challenge. It seems to me that the majority in Quill paved the way for resolution of the issue when they said the settled expectations of the industry were important, but Congress can regulate and change the situation if they want. It seems to me to be incumbent on the states to undertake sufficient simplifications of the sales tax system to attract a Congressional majority to support an overturning of the decision in certain circumstances. If a state high court case from one of the states with an economic nexus standard is favorable to the state, then the chances that the U.S. Supreme Court would increase measurably.
There will be many opportunities for the Court to consider a Quill challenge, starting with DMA [Brohl v. Direct Mktg. Ass'n (certiorari was denied Dec. 12)]. If the Court does not grant certiorari on a Quill challenge and Congress continues to debate the nuances of a legislative solution rather than implement one, the states will continue to resort to state-specific solutions, such as we've seen in South Dakota and Alabama.
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