In an effort to enforce tax codes, state tax agencies must battle against increasingly sophisticated tax avoidance schemes, flat budgets, outdated laws, and a chilly relationship with legislatures, a panel of state tax department chiefs told attendees of the New York University Summer Institute.
Despite these obstacles, tax agencies often are the first to address important tax policy questions and provide guidance on how to comply with complex tax codes, the panelists said.
Several panelists said they worry about the long-term effects of having to constantly defend against aggressive tax avoidance schemes.
"There's not enough thought given by business leaders on the impact of continually pushing the envelope" on tax avoidance, said Brian Hamer, director of the Illinois Department of Revenue. If "so much brain power is behind tax avoidance," there won't be enough money for such things as schools and other public goods," he added.
A changing ethos among tax professionals is also a part of the problem, said R. Bruce Johnson, chairman of the Utah State Tax Commission.
"In the old days, the tax professionals were the guardians at the gate. In 1981, my friend said he would go to [American Bar Association] meetings and talk about what to do to protect clients from dubious tax planning. Fast forward and now they're talking about tax shelters," he said.
"I think we've moved away from strict parameters on things you could do on tax returns and contingent fees. At some point the tax function moved from compliance function into being a revenue raiser for clients where you sell accounting services in a way that will raise revenues," he said.
The prevalence of fairly sophisticated tax avoidance techniques "ups the pressure on the tax department to ramp up enforcement efforts," said Thomas Mattox, commissioner of the New York Department of Taxation and Finance. There are often huge differences between the amount that large companies report on their tax returns and the settlement amount they ultimately pay the state after an audit, he said.
Often, taxpayers who believe they would prevail on the merits of a dispute settle for practical reasons, noted Arthur R. Rosen, a partner with McDermott Will & Emery LLP in New York, who moderated the session. "Many times, taxpayers want [to] avoid the cost of hiring lawyers and finding old documents."
But the level of sophistication brought to many companies' financial activities belies claims of difficulties locating documents, Mattox said.
Perhaps many tax disputes would be avoided if there were a closer congruity between Securities and Exchange Commission reporting and the reporting of tax liabilities, Johnson said. "This would likely deter companies from overstating income in SEC filings and claiming undeserved losses in tax filings," he said.
"But that could only happen if you took public policy out of the tax code," Rosen added, noting that tax codes are shaped by a multitude of policy goals.
In waging the fight toward greater tax enforcement, several states seem constrained by limited budgets.
While the financial condition of states has begun to improve since the Great Recession, tax agency budgets remain relatively flat.
"They haven't raised my budget in 12 years," Johnson said.
The New Jersey Division of Taxation recently hired 330 new employees in the areas of information technology and tax collection, as well as attorneys. But these new hires are being outpaced by an expected wave of retirements, said Michael J. Bryan, the agency's director. "We may lose 5 to 10 percent of the agency. A lot of brain drain will occur in next 12 to 36 months," he said.
On a brighter note, after years of budget erosion, Connecticut was recently "able to staff up again and make up for past reversals," said Kevin B. Sullivan, commissioner of the state's Department of Revenue Services.
Utah deals with limited resources by relying on the Multistate Tax Commission for its efforts to enforce the states' corporate income tax. "We don't have resources to audit Bank of America or Wells Fargo," Johnson said. "Without participating in the MTC's audit program or nexus program, we'd be in trouble."
Technology based solutions such as electronic filing have also helped reduce the workload for state tax agencies. But these initiatives can bring additional problems as well. Someone in Asia can file 1,000 fraudulent Utah returns by pushing a button, Johnson said. To counter such activities, states are increasingly sharing information.
Despite the lack of resources, state tax agencies are on the front lines when it comes to making important policy determinations.
New technologies are quickly emerging, but many tax statutes have not been updated since the mid-1960s. As a result, tax agencies must often serve as the first responders to a wide array of important tax policy questions.
"We are running audits today. We're making calls this week. We don't have a choice but to make policy determinations in some cases," Mattox said. However, he added that "trying to shoehorn old laws to new transactions is not the way to go."
Ideally, tax policy on issues ranging from computer repairs to digital downloads should be established by the state legislature. But few legislatures take a broad policy view when working with their state's tax code, several panelists said.
Instead, the tendency is to amend the tax code to address anecdotal problems or to please powerful constituents, several panelists said. This piecemeal approach has created highly complex state tax codes with which compliance is often a struggle, even for the most well-intentioned taxpayers.
Sometimes tax legislation begins with good intentions, but ultimately creates another layer of complexity. Utah intended to enact a single-sales factor apportionment formula with the goal of making the state a more attractive place to do business. But the provision that was ultimately enacted only allows about half of all industries to use the apportionment method, Johnson said.
"Does this simplify things?
It looks like arbitrary decisions as to what apportionment factors are appropriate," he said.
Another problem is a growing distrust between state legislatures and tax agencies. In the past, lawmakers would consult with tax agency officials on tax policy matters, said Jerry Johnson, vice chairman of Oklahoma Tax Commission. "But now, many new legislators distrust us," he added.
He said term limits are partly to blame because they have made it more difficult for tax agency officials to form relationships with legislators and committee chairs.
"The fact that both the Oklahoma Legislature and the governor's office are controlled by the Republican Party hasn't lessened the distrust because the tax agency is not seen as being tied to [the] governor," he said.
Ultimately, state tax administrators have a constitutional duty to enforce the law, said Utah's Johnson. "To not tax a new type of transaction is a breach of duty if something meets the definition of 'tangible personal property,' " he said.
If the tax agency "gets it wrong, the legislature, governor, or courts can step in to correct it," Sullivan said.
"Part of the answer is not to surprise taxpayers. Announce the policy before implementing and apply it prospectively," Hamer added.
As tax agencies have taken on a larger role in shaping tax policies, taxpayers have pressured them to move toward greater transparency by issuing more guidance on compliance matters. But making too many documents publicly available can result in negative consequences, several panelists said.
"We've published private letter rulings for a long time, but the fact that they're out there even though they apply to one taxpayer causes issues," Hamer said. "Taxpayers read the letters out of context sometimes. They may have been written in a different era and different environment. This causes us to be somewhat gun shy about issuing private letter rulings," he said.
Oklahoma recently made its letter rulings available online, but did so after implementing procedures to ensure that the information is timely and supported by legal authority, Johnson said.
"There's always a tension that exists between getting taxpayers fast answers and taking the necessary time to do an adequate review," he added.
The District of Columbia, after voiding all private letter rulings about 10 years ago, recently launched its declaratory orders program, said Stephen M. Cordi, deputy chief financial officer for the District of Columbia's Office of Tax and Revenue. But the release of these documents has been slowed by the necessity of allowing the taxpayers involved in the ruling to redact trade secrets or other confidential information from the document.
Connecticut does not publish its private letter rulings, even though a great deal of tax policy is being implemented by those documents, said Connecticut's Sullivan.
And even after a tax agency has issued guidance, it is appropriate for the agency to change its policy in some cases, several of the panelists said. "Sometimes there's feeling that because things were done a certain way for a period time, the tax agency is required to do the same thing going forward," said New York's Mattox. "I've seen 25 year old documents purporting to lock the tax agency in a position. Agreements executed decades ago are subject to review going forward," he said.
Taxpayer deals struck with state economic development departments can be another source of unpleasant surprises upon audit, several of the panelists noted. "A major firm did a deal with Connecticut, but found out six months later that the services it performed were subject to sales tax," said Sullivan. To avoid unexpected tax liabilities, it is important to engage the state tax department in a dialogue about the tax risks of locating within their jurisdiction, he said.
"Don't presume that there's a communication between the economic development agency and the tax department," said New Jersey's Bryan. "If you feel we're not talking, it might be because we aren't."
Article by Steven Roll, Assistant Managing Editor, State Tax, Bloomberg BNA
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