Weekly Round-Up: U.S. Supreme Court Cases, Federal Bills, Other Hot Issues Analyzed in Special Report

Aug. 22 — Leading state tax practitioners recently offered their candid thoughts and insights on major state tax developments at Bloomberg BNA's annual Roundtable event in Washington, D.C. A transcript of the proceedings along with background research, cites and summaries of specific developments is available in a special report.

Arthur R. Rosen, a partner in the law firm McDermott Will & Emery LLP and chairman of Bloomberg BNA's State Tax Advisory Board, moderated the discussion with state tax experts on topics including:

• the U.S. Supreme Court's grant and denial of certiorari in key state tax cases over the past year;
• general nexus considerations;
• federal legislation dealing with state taxes, including the Internet Tax Freedom Act (ITFA), Marketplace Fairness Act (MFA), the Digital Goods and Services Tax Fairness Act, the Business Activity Simplification Act (BATSA) and the Mobile Workforce State Income Tax Simplification Act;
• allocation, apportionment and sourcing trends;
• administrative and procedural considerations, such as qui tam lawsuits, independent tax tribunals and pay-to-play requirements;
• New York's sweeping business tax reforms; and
• developments in the unclaimed property arena.

U.S. Supreme Court's Grant and Denial of Cert.

This year, the Roundtable participants focused on the U.S. Supreme Court decision to hear two cases: Direct Marketing Association v. Brohl, No. 13-1032, and Maryland Comptroller of the Treasury v. Wynne, No. 13-485. In Brohl, the federal court found Colorado's so-called “Amazon law” that imposed notice and reporting obligations on out-of-state vendors that did not collect sales and use tax to be unconstitutional. On appeal, the U.S. Court of Appeals remanded the case to the district court and dismissed Direct Marketing Association's claims for lack of jurisdiction under the federal Tax Injunction Act.

Unlike Amazon-type laws in other states, Colorado's statute is more onerous and “that is why it is being challenged in the first place,” said Karl Frieden, vice president and general counsel at the Council On State Taxation (COST).

Despite the taxpayer's challenge of the statute, it seems unlikely that the U.S. Supreme Court will address the merits of the issue.

“I would be shocked if the U.S. Supreme Court addressed anything beyond [the procedural issues] and got into the substance of the Colorado law,” Rosen said. Instead, the court will likely focus on the principle of comity and whether third party, non-taxpayer plaintiffs have the right to challenge a state notice and reporting requirement in federal court. The court may also address the issue of the Tax Injunction Act, which prohibits a federal district court from enjoining, suspending or restraining “the assessment, levy or collection of any tax under State law where a plain, speedy and efficient remedy may be had in the courts of such State.” However, Rosen said, “the history of the court's recent decisions is somewhat akin to saying…the TIA itself is almost secondary, if not tertiary in importance.”

While the panelists disagreed as to whether the court will interpret the TIA as barring lawsuits that challenge state tax administration from reaching federal courts, ultimately, unless the U.S. Supreme Court decides the case is not barred from being heard in federal court by the TIA, the district court is unlikely to ever review the constitutionality of Colorado's actual statute.

Roundtable participants also discussed the Wynne case. In Wynne the owner of a Maryland-based S corporation argued that if Maryland's credit for taxes paid to other states is not also applied to the county component of Maryland's individual income tax, then the lack of a credit violates the commerce clause. While the taxpayer won at the state appellate level, Frieden expressed some concern that the court may reverse this decision.

“If the court were to rule in favor of Maryland and hold that the commerce clause only applies to the corporate net income tax and not to the personal income tax, you would have a dual tax system where the constitutional protections apply to certain types of interstate commerce (carried on by C corporations) and not to other types of interstate commerce (carried on by S corporations, partnerships and sole proprietorships),” Frieden said.

Concern Over Outcome

Shirley K. Sicilian, managing director with KPMG in Washington, D.C., also voiced her concern and said the court may see this case as being analogous to Moorman Manufacturing Co. v. Bair, 437 U.S. 267 (1978), where the court upheld Iowa's single sales factor formula, despite the fact that it was “out of step with the other states' three factor formulas.”

However, Rosen said it seemed doubtful that the U.S. Supreme Court would reverse the decision, noting an important distinction between Moorman and Wynne.

“What the U.S. Supreme Court said in Moorman is, everything is fine and dandy, as long as you apportion. We are saying the same thing here: it's not how you apportion or how you give a credit, but you must give a credit if you use a residence-based taxation approach,” Rosen said.

Finally, Roundtable participants discussed the U.S. Supreme Court's decision to decline to hear Equifax Inc. v. Mississippi Department of Revenue, 125 So. 3d 36 (Miss. 2013), cert. denied, No. 13-1006 (U.S. 2014), where a taxpayer who followed the state's statutorily mandated cost-of-performance approach to sourcing its receipts was hit with an assessment and penalties for not using a market-based method that better accounted for its in-state customers.

When it comes to sourcing receipts from services or intangibles, “there is a complete lack of certainty about what the outcome is going to be,” said Kendall Houghton, partner with Alston & Bird LLP. “Do you follow the statutory regime, the standard apportionment formula or do you seek an alternative apportionment method?”

Many of the participants echoed Hougton's concerns. However, Leah Robinson, partner with Sutherland, Asbill & Brennan LLP, said that taxpayers should “follow the statute when filing [their] return[s]…but [should] consider a reserve because of the Equifax case.” She also said that “…because many of us are so frustrated with the outcome of Equifax and the fact that there isn't going to be a review of the underlying issue, we're getting a better response in terms of states revisiting the process for discretionary adjustments…We already see legislatures reacting…”

Nexus Considerations

In the Internet-age, the bright-line physical presence rule for determining substantial nexus in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), has been blurred. Many states are successfully expanding their taxing jurisdiction through legislation and audit activity. Robinson said this seems to be occurring in three main ways: “the first is economic nexus…the next area is the move towards mandatory combined reporting, particularly with the Finniganapproach…[and] the third area is the general push towards market-sourcing.”

The Roundtable participants focused on the rise of economic nexus, as states take an increasingly aggressive view of what constitutes nexus.

“If you look at the annual Bloomberg BNA Surveys…the states answer questions about what position they might take if an out-of-state company just has data or software on a server in their state. A large number of states would say that this creates nexus and that this constitutes some sort of physical presence. I think that is a huge stretch,” Frieden said.

The participants also discussed the ramifications of the states' use of sales tax affiliate nexus and the unitary business concept to expand jurisdictional nexus. “…[T]he use of the unitary business concept into jurisdictional areas…blurs centuries-old legal traditions…of respecting separate legal persons,” Rosen said. He also said that is a “…slippery slope. I hope that some of the courts will recognize the sanctity of the idea that each legal person is a separate person under our law. Although they are hypothetical or fictional persons, we have an entire legal system based on respecting those fictions. Disregarding them could just lead to total chaos.”

Federal Legislation Regarding State Taxes

Of the federal legislation proposed in Congress that deals with state tax issues—the Marketplace Fairness Act (sales and use tax collection by remote sellers), the Digital Goods and Services Tax Fairness Act (equitable treatment of digital commerce), the Business Activities Tax Simplification Act (income tax nexus thresholds) and the Mobile Workforce State Income Tax Simplification Act (withholding thresholds for mobile employees)—the Internet Tax Freedom Act could be the most pivotal.

Unlike other bills, versions of the ITFA have passed in previous years. It imposes a moratorium on state and local taxation of Internet access and electronic commerce, and is back before Congress this year because it expires Nov. 1.

“I think if any other legislation is going to pass this year, it will need to be in conjunction with the Internet Tax Freedom Act,” Frieden said.
Rosen said the ITFA is likely to be extended or made permanent because it has the most political appeal, but its progress might be stunted by the other legislation.

“Everyone seems to want to attach something to it, so I'm wondering whether we are going to see a temporary extension because there is so much controversy surrounding the other bills people are interested in,” Rosen said.

Roundtable participants also said that the ITFA has importance beyond preventing states from imposing tax on Internet services—such as the ITFA's discrimination provision that the Illinois Supreme Court used to uphold the repeal of that state's click-through nexus law.

“We see the discrimination prong (of the ITFA) come into play a lot now in both sales tax and income tax cases, where taxpayers are arguing that what the state is trying to do is actually preempted by the discrimination prong in ITFA,” said Andrew Appleby, an attorney with Sutherland, Asbill & Brennan LLP.

Allocation, Apportionment and Sourcing

Right before the Roundtable met this year, the Multistate Tax Commission approved revisions to Article IV of the model compact, containing the Uniform Division of Income for Tax Purposes Act. The amendments change UDITPA's apportionment and sourcing provisions by:

• moving from cost-of-performance to market-based sourcing for services and intangibles;
• giving states the option to choose their own factor weighting, but including a recommendation that states double-weight the sales factor;
• expanding the definition and scope of “business income” to all income that is apportionable under the U.S. Constitution; and
• narrowing the definition of sales to exclude hedging transactions and treasury receipts from the sales factor.

One of the most important revisions the MTC made was the new model for market-based sourcing of the sales factor numerator for services and intangibles, Sicilian said.

“Legislatures are emphasizing the sales factor to remove the disincentive for locating property and payroll in the state,” Sicilian said. “But even a single sales factor does little good if the sales factor numerator is based on cost of performance, since costs of performance will generally reflect right back to property and payroll—and to a legislature, that represents investments and jobs.”

Frieden called the UDITPA rewrite “significant,”but said the question of the MTC recommendations' influence on the states will remain unanswered for some time because it will be up to the states to adopt the changes.

“One of the problems the MTC has been having in recent years is the adoption rate of many of their model statutes has been low,” Frieden said.
And at the same time, litigation is pending in five states regarding other parts of the MTC compact—namely, whether a compact state can jettison the election of Article III, which allows a taxpayer to elect the UDITPA apportionment formula in Article IV.

Administrative and Procedural Considerations

Three administrative or procedural issues that have grabbed state tax practitioners' attention this year are qui tam suits, independent tax tribunals and pay-to-play requirements.

Rountable participants sounded off against state tax qui tamsuits—those where whistle-blowers with inside knowledge file claims against individuals or corporations for allegedly fraudulent acts against the government. The state can decide to join the suit, and if the state wins, the defendant may pay higher damages and penalties than in a typical tax case.

“I am against putting any reference to tax into the False Claims Act since I think it would be very injurious to the existing tax enforcement system,” said Alan C. Levine, chief counsel of the Office of Tax and Revenue for the District of Columbia. Besides concerns that whistle-blower cases might lead to disproportionate tax enforcement, Levine said he is concerned about taxpayers' right to privacy when they are going through an audit.

On tax administration and pay-to-play, Appleby said several states, including Alabama, Georgia and Illinois, have gotten independent tax tribunals in recent years. Overall he said there are about 25 of them, which he called a great trend.

“You get to avoid the pay-to-play requirements that can be a barrier to legitimate tax challenges,” Appleby said.

Sicilian said it is also important to make sure commissioners retain a way to ensure quality control over department audits and that their regulatory policies are actually making sense as applied.

“Department quality control and independent tribunals together will lead to less litigation,” Sicilian said.

New York Corporate Tax Reform

In sweeping legislation this spring, New York overhauled its tax laws by switching to an economic nexus standard, eliminating its bank tax, creating new rules for mandatory combined reporting, substantially revising its tax base, shifting to market-based sourcing, changing to a new NOL regime and offering substantial incentives for manufacturers, among other provisions.

Through all of these changes, Robinson said she sees two issues that require serious attention from taxpayers: registration and estimated tax payment requirements for new New York taxpayers and new manufacturing benefits.

The registration and estimated tax payment requirements are important because for parties who are taxable in New York (for example, under the new economic nexus rules or because of the elimination of the fulfillment center exemptions), Robinson said there is no safe harbor for relief from the underpayment of estimated tax penalty for new filers.

The new manufacturing benefits are also huge, and Robinson called the list of companies that seem to qualify “shockingly broad.”

“In a nutshell, it is basically zero income tax,” Robinson said about the manufacturing benefits. But she said some of the benefits under the law might be unconstitutional, so taxpayers will have to consider whether they reserve if that turns out to be the case, or for those who do not qualify, whether they can book a benefit in the case that they are unconstitutional.

And on New York's nexus rules, Robinson said that those with physical presence in the state or those who have $1 million in sales assigned to New York based on the state's new sourcing rules will be taxable. Single entities, even when they do not meet the $1 million threshold, but that are part of a combined group that meets the threshold, will be combined.

“I think you have to look at the new rules to see how your receipts would be assigned and to see if you would meet the million dollar threshold, and because New York follows market sourcing, you probably will meet that threshold,” Robinson said.

Unclaimed Property

The small state of Delaware has out-sized influence in the unclaimed property arena. U.S. Supreme Court rules require that holders of unclaimed property who lack an owner's address must turn over the property to the state of incorporation, and many times a holder's state of incorporation is Delaware.

Delaware is strongly promoting its unclaimed property Voluntary Disclosure Agreement program, which limits taxpayers' look-back periods, and has been trying to get more taxpayers to participate with three months remaining to sign up, Houghton said.

She said the issues that come up in the unclaimed property area include whether estimation is constitutional or legally permissible and whether estimated liabilities are reasonable, among others.

“States have identified unclaimed property as a revenue generator,” Houghton said.

Meanwhile, the Uniform Law Commission is planning to rewrite the 1995 Uniform Unclaimed Property Act, and a draft of the 2016 Uniform Act may be available next year.

By Rebecca Helmes (@RebeccaHelmes) and Radha Mohan (@RMohan2014)