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State tax developments & trends: what to watch for in 2015: Nexus, market-sourcing, intercompany transactions, single-sales-factor apportionment expected to dominate state tax discussions this year.

Will the Republican Congress take up legislative measures of tremendous concern to TEI state tax law professionals, such as the Internet Tax Freedom Act and Mobile Workforce Act? It's too early to tell, but it bears watching.

Will the Republican domination of state legislatures lead to a panoply of business tax cut measures and other reforms (see box, page 30)? It's too early to know that answer as well, but what is clear is that, regardless of politics, at least four major, hot-button issues will be front and center in the state tax regulation landscape this year: nexus, market-sourcing, intercompany transaction, and single-sales-factor apportionment.

The "Nexus" Issue

One of the most important state tax developments and trends to monitor in 2015 involves the thorny issue of nexus: whether a state can tax the income of an out-of-state business person who makes sales to customers in the state and whether a state can impose a sales tax on other transaction-based taxes when the seller does not have a physical presence in the state.

While the issue of nexus is not new, this development will be increasingly significant this year as we continue to move at an almost breakneck speed to a more digitally based economy in which goods and services can be purchased remotely over the Internet.

As Jamie Fenwick, senior director of tax policy at Time Warner Cable explains, from both an income tax and sales tax perspective, states cannot tax certain companies and transactions based on traditional physical-presence nexus standards. In an attempt to tax these companies and transactions, lawmakers and tax administrators have developed alternative nexus standards--such as economic nexus, affiliate nexus, "click-through" nexus, and dollar-threshold nexus--to effectuate what might not be possible through traditional physical nexus, she notes. "It is still unclear whether or not these alternative nexus standards are permissible and whether the use of these alternative standards will likely create significant controversy or litigation in the future," Fenwick says.

States are struggling to figure out how to treat pass-through entities, agrees Steven N. J. Wlodychak, principal at Ernst & Young. For federal tax purposes, he notes, the "check the box" regulations simplified the process. Most states complied with the federal mandate, he explains. However, he adds, the complexity of withholding (nonresident withholding, how to treat corporate members, levying direct entity level taxes), apportionment (when should a corporation apportion partnership income at the partnership level, or when does it succeed to its distributive share of factors?), and non-income tax separate filing obligations for DREs come into play to make the lives of corporate tax directors exceedingly difficult.

In addition, Wlodychak notes, some states, such as Kansas and Ohio, view pass-throughs primarily as small businesses and want to continue growth through tax incentives. Kansas eliminated personal income tax on Sub K income entirely, he explains, while Ohio provides a special deduction.

States are becoming much more focused with respect to nexus issues, asserts Tov Haueisen, principal with PricewaterhouseCoopers LLP. "Whether it is traditional nexus, dollar-threshold nexus, agency nexus, or affiliate nexus, the states are becoming far more active," he explains. Haueisen has seen an increase in nexus cases moving through the state administrative levels and ending up in state courts. This trend is likely going to continue with the burgeoning interest among regulators in this area.

Nexus issues tend to linger longer than other state tax issues, notes Todd Lard, partner at Sutherland Asbill & Brennan. "Many states maintain that they have the authority to assess for a number of old years by treating the taxpayer as a notifier. They use that to their advantage," he explains.

Impact on Tax Practitioners

What does this development mean in a practical, everyday way for in-house corporate tax practitioners? Taxpayers have to determine whether they have the requisite nexus based on the nexus standards in the state. If they believe a states nexus standards are impermissible, they need to determine whether to file tax returns. These decisions can have a significant impact on a company's financial statements.

This development will be of continuing and increasing interest to taxpayers, Wlodychak agrees. Specifically, he notes, the intense interest on the part of taxpayers in the U.S. Supreme Court ruling in Wynne, expected in early 2015, is indicative of the importance of this issue (see TEI Roundtable Discussion, page 36).

Will the Feds Step In?

Speaking of developments at the federal level, in 2015 expect to see continued legislative efforts to resolve this controversy, predicts Fenwick. Potentially, this issue will continue to cause significant discussion or litigation until either Congress steps in to deal with the nexus standards issue or the U.S. Supreme Court grants cert to a nexus tax case, which could provide definitive, precedential guidance.

Market-Sourcing: Moving from Goods to Service Economy

Market sourcing is a key issue to watch for in 2015. This comes about when sales other than those of tangible personal property, such as services, are sourced to determine the sales factor in a state for apportionment purposes. As our economy moves from a more goods-based economy to a more service-based economy, determining the source of sales can have a significant impact on a states income tax revenues.

Effect on Tax Liability

The use of market sourcing versus cost of performance to source sales of services can have a significant impact on a taxpayer's tax liability in a state. If a taxpayer has a significant portion of his property and payroll in a state that sources sales based on cost of performance, but most of his customers in a market sourcing state, the taxpayer could end up in a situation where he pays tax on more than 100 percent of his income, explains Fenwick.

Lack of Consistency

What are the practical effects of market sourcing on in-house corporate tax practitioners? There is no consistency from state to state regarding what constitutes market sourcing, notes Fenwick. This can create confusion and additional work for tax practitioners. For example, she comments, "some states consider market sourcing to be based on the location of the customer, while other states base market sourcing on where the benefit is received." In addition, Fenwick notes, for mobile services or services sold over the Internet, the information to make market-sourcing determinations simply may not be available.

In recent years, Fenwick adds, the trend has been to couple market sourcing with a movement away from an apportionment factor based on property, payroll, and sales to either a more heavily weighted sales factor or single-sales-factor apportionment. "The result of these combined trends is to place all of the emphasis on the location of the customer or where the customer receives the benefit of the service, and the location where the service provider does the work is no longer relevant," she explains.

Here's Fenwicks overall take on this issue: "There are winners and losers when states move from cost-of-performance sourcing to market sourcing, and those results can be amplified when coupled with a movement to a more heavily weighted sales factor. Lawmakers should understand the ramifications to businesses in their state before they take action on this important issue."

PricewaterhouseCoopers LLP's Haueisen adds: "California and New York are among the states that have recently shifted to a market-based/ customer-based sourcing model from a costsof-performance basis for the sale of service, in addition to Massachusetts, which just published its guidelines in this area." This change is really impacting both in-state and out-of-state companies and has changed the landscape of sourcing, he explains. "It will be imperative that companies obtain granular-level detail and understand their streams of revenue to properly apportion or allocate their sales," Haueisen says. This change is really impacting both in-state and out-of-state companies and has changed the landscape of sourcing, he explains. "It will be imperative that companies seek to obtain granular-level detail and understand their streams of revenue to properly apportion or allocate their sales," Haueisen says.

A real issue for taxpayers will be whether states uniformly will define what constitutes the "market." Sutherland's Lard questions whether the Multistate Tax Commission (MTC) can foster uniformity as states continue to iron out the details of market sourcing. An MTC working group holds weekly calls to discuss how market sourcing should apply to specific facts, he notes. The end goal, Lard says, is to develop model regulations. "On each call, the number of participant states increases. Although there seems to be a consensus among states on some issues, widespread agreement on every factual issue has been elusive," he explains.

Auditing Intercompany Transactions: Key Concern of Administrators

Tax administrators have increasing concerns that taxpayers are using intercompany transactions to shift income from one taxing jurisdiction to another.

To combat this perceived abuse in the past, many states (particularly separate return states where intercompany transactions are not eliminated) enacted intercompany add-back provisions for specific types of transactions (usually involving intercompany interest or royalties). However, state tax administrators continue to have concerns regarding intercompany transactions and are spending more time scrutinizing these types of transactions when auditing companies.

From a practical perspective, intercompany transactions are initiated for economic, regulatory, or legal reasons and are unavoidable for large companies with multiple legal entities. If tax administrators attempt to unwind these intercompany transactions, it could have a significant impact on a taxpayer's tax liability and may not represent the economic realities, according to Fenwick.

What are the practical effects on in-house corporate tax practitioners? They must spend a significant amount of time and resources documenting intercompany transactions and supporting transfer pricing related to intercompany transactions, notes Fenwick. She points to a key state tax-related development that corporate tax professionals should monitor in 2015: The MTC has initiated a project to help states understand and better audit intercompany transactions. States likely will continue to spend a great deal of time and effort auditing intercompany transactions, Fenwick concludes.

Due Process Challenges to Single-Sales-Factor Apportionment: Keep a Close Eye on This Fairness Issue

Speaking of Wynne and apportionment, as more states shift to single-sales-factor apportionment, more out-of-state companies will be facing a larger share of the income tax burden. "The problem is fair apportionment," asserts Ernst & Young's Wlodychak.

With no physical presence, taxpayers should challenge the fairness of paying income taxes on limited activities in the state, he suggests. "The Supreme Court could take up where it left off in Moorman Manufacturing and elaborate on what it meant in the 'four-prong test' in Complete Auto Transit," a key case in the upcoming Wynne decision," he says.

The Multi-Billion Dollar Question: Will Tax Reform Happen This Year?

As TEI members can attest this question is asked almost incessantly with regard to federal tax, and the answer is almost always the same: probably not. But on the state level, the answer might be quite different.

Consider this: Not only do Republicans now control both houses of Congress, they also dominate state houses as well. In 2006, Democrats controlled 69 of the 99 state legislative chambers. (Nebraska has a unicameral legislature.) In 2014, Republicans controlled 60 of the chambers, including Nebraska's, which is technically nonpartisan but functionally controlled by Republicans (see Multistate's 2014 State Election Results, page 30).

What does that mean for possible tax reform and business tax cut measures? In the 2013-14 biennium, notes Joseph Crosby, principal at Multistate Associates, several states implemented significant reforms either through state legislatures, including those in Kansas, Minnesota, New York, and North Carolina, or at the ballot box, in the case of California. Many other states, such as Louisiana and Nebraska, proposed significant reforms that were ultimately abandoned due to insufficient political support.

With Republicans solidifying their hold on state governments, and with no current frontrunner for the 2016 Republican presidential nomination, the coming biennium is likely to be at least as active as the current one for tax legislation, asserts Crosby.

Crosby expects continued efforts by Republican governors and legislative leaders to reduce corporate and personal income tax rates. "The most recent proposals were fashioned on a revenue-neutral basis, but revenue-neutral tax reform rarely succeeds," he notes. "Conservative constituencies seek tax cuts, liberal constituencies seek additional services, and only tax policy types are invigorated by revenue-neutral reform," Crosby explains. As the economy continues to improve, and as state and local revenues maintain steady growth, expect Republican tax reform proposals to provide tax relief overall, he concludes.

Michael Levin-Epstein is a senior editor at The YGS Group. He can be reached at michael.levinepstein@

2014 State Election Results-Partisan Control (As of November 7,2014)


                    Republicans      Democrats   Undecided
Pre-election        29               21
Post-election       31               18 *        AK
Change (Pick-ups)   AR, IL, MD, MA   PA

Lieutenant Governors ****

                   Republicans          Democrats   Undecided/Vacant

Pre-election       27                   16          AR, MA (vacant)
Post-election      30                   14          AK (undecided)
Change (Pick-ups)  AR, IL, MD, MA, SC   PA

State Legislative Chambers **

                    Republicans                      Democrats

Pre-election        60 ***                           39

Post-election       69                               30

Change (Pick-ups)   CO Senate, ME Senate, MN House,
                    NV House, NV Senate, NH House,
                    NM House, WV House, WV Senate,
                    WA Senate, NY Senate

Attorneys General

                    Republicans   Democrats
Pre-election        24            26
Post-election       26            24
Change (Pick-ups)   NV, AR

* We include Vermont Gov. Shumlin (D) even though he did not
receive the majority of votes required under Vermont's Constitution
to declare him the outright winner. The actual election of the next
Governor will now be by the Democratic-controlled Legislature this

** Nebraska is legally nonpartisan, but legislators caucusing as
Republicans control the unicameral, thus we include it in this
chart as under Republican control.

*** Pre-election, Republicans controlled the New York and
Washington State Senates through "majority caucuses," even though
in both chambers Democrats had a numerical advantage. We count them
as being in Republican control pre-election, thus pre/post-election
totals may differ from other sources.

**** Five states do not have lieutenant governors; the position was
vacant going into the 2014 elections in Arkansas and Massachusetts.

Chart compiled by Multistate Associates Inc.
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Author:Levin-Epstein, Michael
Publication:Tax Executive
Date:Jan 1, 2015
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