JEFF SAVIANO is a Principal and leader of Ernst & Young LLP’s Americas Indirect & State/Local Tax practice. STEVE WLODYCHAK is a Principal and Ernst & Young LLP’s Center for State Tax Policy Leader. The views expressed are those of the authors and do not necessarily represent the views of Ernst & Young LLP or the global Ernst & Young organization.
In this first in a series from Ernst & Young LLP on today’s most Taxing Issues, Jeff Saviano and Steve Wlodychak tackle five key questions on a vital issue of state tax policy and practice.
Why isthere so much tax-based competitionamongthe states?
Jeff Saviano: Fundamentally, states are competing with one another to attract businesses. Meanwhile, there’s also a continuing struggle among states and companies: states want to maximize tax revenue; corporations want lower tax bills.
Understanding how this became so contested requires a bit of commercial history. A hundred years ago, companies operating in multiple states were often subjected to double taxation. A product might be manufactured in one state then sold to a buyer in a second state, but both states would claim all or a portion of the income from that sale for state income tax purposes. So the company would be taxed twice on the same income.
Steve Wlodychak: Apportionment of multistate income for individual state tax purposes remained contentious for many years. Then in 1965, Congress, at the behest of American industry, established the Willis Commission to study ways to harmonize interstate tax rules and practices.
The Commission’s proposal was to create a special division of state taxation in the U.S. Department of Treasury, the Federal State Income Tax Division (FSITD ). Instead of filing multiple state returns, multistate taxpayers would file a single form with the FSITD using federal taxable income as a starting point and applying uniform rules of apportionment to each state based on two factors: property and payroll.
In this way, all investment and income generated by each corporation nationwide would be accounted and apportioned to each state under uniform rules. There would be no opportunity by either the companies (to avoid taxation) or the states (to compete based on tax characterizations). Of course, each state would be free to adjust its tax rate on the income so apportioned, but not the rules for measuring property or payroll or for determining taxable income.
Saviano: But resistance to this idea was widespread. Many states were against new limits on their sovereignty. So-called “market” states realized that under a property/payroll formula, they would be unable to tax the income of out-of-state companies selling into their state if those companies did not have a local presence. Also, the fact that the proposed FSITD would act as the sole collection agent further diminished states’ control of their own revenues.
The states universally rejected this proposal but instead offered their own solution to the problem of multistate taxation. They created the Multistate Tax Commission (MTC) and the Uniform Division of Income for Tax Purposes Act (UDITPA), which essentially provided taxpayers with two options to report and apportion their income to the states:
One, a taxpayer could now elect to use a standard, three-factor apportionment formula. That is, in addition to property and payroll, there were also rules to evaluate revenues to determine income-serving to obviate the objections of market states.
Two, a taxpayer in any given state could simply elect to follow the state’s own apportionment rules. What all of this accomplished was that it began forcing more states to adopt more uniform practices. And by the late 1970’s, nearly all the states did just that.
So whydo problems and challenges still persist today?
Saviano: Today, we have states working incredibly hard to compete with one another to attract and retain businesses. So they’re engaging in economic development activity which includes all types of tax incentives-some more direct than others. For example, states can legislatively adopt a single sales factor approach and then tell companies: “Locate here, invest, employ and build and you won’t need to worry about your corporate income tax bill rising because of the property or employees located within our state.” Companies can pass on electing application of the standard three factor apportionment formula (option one above) and instead take option two, adopting an apportionment formula with a more heavily weighted sales factor. While this is good for the state and in-state company in question, it penalizes companies from out of state.
Another problem, 50 years ago, when today’s rules were being formulated, you could touch and feel the things we bought and sold, making it easier to determine where something was made and where the earnings should be taxed. No one had ever heard of software, or imagined that the bulk of a product’s value could be based on intellectual property (IP). Enormous growth in payments for things like royalties and service fees increase the likelihood that significant amounts of income will not be taxed at all.
Wlodychak: For a good illustration, think about the emergence of the Delaware Holding Company in the 1990s. Companies could set up a Delaware Holding Company that would perform services on behalf of other related companies operating outside of Delaware. They would also transfer a good portion of the company’s IP to this new entity, which could now charge royalties or fees for logistics, risk, intellectual property usage or insurance services to other companies which they deducted in computing their separate return taxable income. This increased profits in Delaware, reducing taxable income in other states.
But Delaware imposes no taxes on this income-part of the attraction of the structure. So for state tax purposes, this had the effect of creating non-taxed income. Ironically, we’ve moved from a focus on avoiding double taxation to now making sure that all income is subject to state tax-somewhere.
How are states dealing with these challenges? Click here to continue reading…Answers_to_Five_Questions_on_the_Continuing_Tax_Based_Competitive_Give_and_Take_Among_the_States__Jo