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Tax strategies for weathering the economic storm.

Economic downturns spur the tax departments of both states and businesses to action. At the same time that states are searching for ways to supplement their declining tax revenues, businesses are formulating strategies to improve their profitability by reducing their tax liabilities.

Businesses often focus on sales and property taxes to reduce their overall tax payments, but in a poor economy companies also must prepare themselves to deal with states' more aggressive pursuit of sales tax revenues. On the positive side, many businesses--and not only manufacturers--can take advantage of external obsolescence caused by the economic crunch to reduce the assessed value of their property and, in turn, their property taxes.

State Efforts to Boost Sales Tax Revenues

With consumers saving more and spending less, most states have been stricken with depressed sales tax revenues. States in need of additional revenue sources generally take two approaches to replenish their coffers. A state might enact new or increased taxes upfront. In today's environment, this primarily takes the form of increased taxes on items that are considered recession-proof, like cigarettes and alcohol. States can also develop new interpretations of existing taxes, which they may or may not announce. A new interpretation typically renders taxable an activity or product that was previously not taxable. Thus, companies that have conducted business in a state for years suddenly find themselves subject to a new tax without any change in the actual (statutory) law.

Indiana, for example, issued a new information bulletin at the end of 2006 that significantly increased the number of extended warranties subject to sales tax. Previously, extended warranties were only taxable if there was a certainty the consumer would receive personal property under the warranty. For instance, an extended warranty for oil changes on a vehicle was taxable because the consumer would receive property like oil and filters; a general repair warranty was not taxable because it was possible that the consumer would not receive any property under the warranty. A consumer is deemed to receive property under a vehicle extended warranty for repairs if the vehicle requires a repair that includes parts. Under the new interpretation, which the state is strictly enforcing, an extended warranty is taxable if there is a reasonable expectation that the consumer will receive personal property under the warranty.

Similarly, Michigan is now taxing electronic information services--such as access to databases like LexisNexis--as though these services are tangible personal property. The state, however, has made no related announcement. Many affected companies learn of the tax only when the state's auditors appear to enforce it.

Michigan is one of a growing number of states targeting digital products, which the states assert resemble taxable tangible personal property more than nontaxable intangible information set vices. Banks, for instance, might find themselves subject to sales tax on loan origination or approval services that are delivered online. This past summer, Mississippi joined the ranks of states now imposing sales tax on products like digital movies, ringtones, and books. Many of these states are members of the Streamlined Sales Tax Project, a multistate effort to develop uniform standards for taxation. In 2007, the project adopted a specific definition of "digital products," along with procedures for taxing them.

These efforts can put companies between a rock and a hard place. If they fail to collect sales taxes from consumers, they could end up on the hook for the sums. But if they collect the taxes, they risk losing market share to competitors that do not collect taxes.

Minimizing Corporate Sales Taxes

With states expanding their sales tax nets, companies might benefit from restructuring their individual transactions or even their businesses. When sales are down, restructuring can have a substantial effect on profit margins. Companies can also take other steps to fight new taxes or interpretations of existing taxes.

Vendor contracts frequently provide ripe opportunities for restructuring transactions to be more tax-advantageous. Consider a company that has entered software maintenance contracts with a vendor that bills one lump sum for both telephone support and software updates. In many states, that lump sum is subject to sales tax in its entirety, even though telephone support is generally nontaxable. The company could bifurcate the transaction into separate contracts for the taxable software updates and the nontaxable phone support.

A company might also restructure its business. Consider a company that operates an internal fleet of trucks and delivery vehicles. Some states grant a sales tax exemption on trucks, tires, and fuel to companies that deliver other businesses' products; no such exemption is available to companies delivering their own products. By restructuring and creating a new entity, the company can isolate the delivery of its products and take advantage of the exemption.

In addition to restructuring, companies might take measures to avoid the expansion of their sales taxes liability. They can request formal rulings on state tax interpretations or operate on the edge of an interpretation. They also could fight legislation or an interpretation by lobbying their state representatives. If a company does not discover a new interpretation until the audit stage, it might obtain prospective treatment because it was not aware of the change, or at least negotiate a favorable settlement based on a pledge to collect the taxes going forward.

Finally, a company might be able to adjust its business to market products that are still exempt from sales tax. For example, a company that sells electronic information services might escape taxation by changing its model so that consumers cannot print anything tangible.

Interplay of External Obsolescence and Property Taxes

Even if a company sees increases in its sales taxes, it might be possible to offset that cost with reductions in property taxes due to external obsolescence (also known as economic obsolescence). External obsolescence occurs when external forces beyond a company's control--such as the economy--negatively influence property value. Because property taxes are based on the value of the property (that is, its price in its secondary market), a down market means greater property tax relief is available.

External obsolescence of real property can occur if a poor economy leads to increases in the number of comparable properties on the market or the level of local unemployment, or drops in occupancy or rental rates. Tangible personal property can suffer economic-related external obsolescence when a company is shackled with decreased demand and prices for its products or increased costs and competition. Potential buyers will not pay top dollar for the real or tangible personal property of companies in these positions.

Measuring External Obsolescence

It is generally not a question whether a company or industry is experiencing external obsolescence in today's economy. The only question is the extent of the obsolescence.

In a traditional brick-and-mortar business that manufactures goods, valuation experts have many tools for measuring external obsolescence. They likely will closely analyze historical benchmarks such as units sold, sales revenues, staffing levels, and net income to calculate the reduction in taxable property value.

But external obsolescence is not just for manufacturers. Companies that sell services or expertise also can claim external obsolescence, though it cannot be quantified using the same types of benchmarks. For these types of companies, valuators instead must use financial metrics derived from balance sheets, income statements, and other financial statements.

Comprehensive analysis of such metrics significantly slashed the property taxes of one client that was in a loss position. The client provided consulting services to pharmaceutical companies. The economy had reduced the demand for the client's services, and regulatory constraints had increased its cost of doing business and restricted its market. After an analysis of the relevant financial metrics, the client sliced 45 percent off of the value of its tangible personal property, leading to a tax savings of $260,000.

Regardless of whether a company sells widgets or services, it must present its external obsolescence analysis correctly to obtain a reduced assessment of property value. The tax assessor may contend that it has already accounted for obsolescence, but taxing authorities usually only consider physical obsolescence. When making the case for external obsolescence, a company cannot rely only on one measurement, such as units sold; the assessor will require more support. A company should present several different methods to quantify the percentage of value it hopes to remove. In particular, the company should look beyond its own metrics to also consider the industry perspective.

Companies claiming external obsolescence should heed an important caveat: External obsolescence fluctuates over time as circumstances change. As the economy improves, the value of a company's property can increase and, with it, the company's property taxes.

Tackling Tough Times

In a tight economy, companies with stagnant or declining revenues must be aware of the effects sales and property taxes are having on their profitability and act accordingly. Businesses can stay on top of sales tax developments through trade groups or by monitoring the actions of their state department of revenue. Sales tax reviews can help further by uncovering opportunities to obtain refunds and reduce taxes. Companies that can leverage external obsolescence to reduce their property taxes should also stay on their toes since obsolescence-related value adjustments generally must be claimed in the year they occur.

Scott M. Tyler is with Crowe Horwath LLP in the Tampa, Florida, office. He can be reached at 813.209.2455 or Jeffrey A. Greene is with Crowe Horwath LLP in the Indianapolis, Indiana, office. He can be reached at 317.706.2740 or Dean J. Uminski is a principal with Crowe Horwath LLP in the South Bend, Indiana, office. He can be reached at 574.239.7865 or
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Author:Tyler, Scott M.; Greene, Jeffrey A.; Uminski, Dean J.
Publication:Tax Executive
Date:Nov 1, 2009
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