Two Surprises in the District of Columbia: Combined Reporting with Use of Losses Severely Limited and a Remote Internet Sales Tax
Federal tax legislation is not the only important tax law being enacted in the District of Columbia (the “District”): the District government has enacted the Fiscal Year 2012 Budget Support Act of 2011 (the “2011 Act”). This alert focuses on two important legislative business tax changes: the adoption of mandatory combined reporting and a sales tax on remote Internet sellers. As well as summarizing other noteworthy legislative business tax changes, this article discusses a significant auditing initiative that the District commenced in 2010 and continued in 2011 involving intercompany transactions. The 2011 Act became effective on September 14, 2011, after the required 30-day congressional review period ended.
In the new combined reporting statute, the most significant surprise, and disappointment for taxpayers, is that a loss generated by one member will not be permitted to be used to offset the income of the combined group or any other member of the combined group in the year the loss arose. It is as if the District wants to mandate combined reporting to eliminate the effect of intercompany transactions, but not allow taxpayers any benefit by utilizing one member’s loss against another’s income. In response to this harsh rule, District taxpayers may want to restructure their operations, as discussed below.
The 2011 Act also authorizes the District to impose a sales tax on remote Internet sellers, even if they have no physical presence or other economic presence in the District. This is an aggressive move that goes well beyond recent state responses to untaxed cross-border sales.
Unitary combined reporting mandated for 2011
The District has adopted a mandatory combined reporting rule, which follows in large part the Multistate Tax Commission (MTC) model combined reporting statute, with certain modifications. The District’s CFO believes that combined reporting would add to the District’s coffers the amount of $492 million over the next five years. (By contrast, in neighboring Maryland, a recent study estimated that if combined reporting had been in effect in Maryland in 2008, the state would have collected $13 to $50 million less than under its current system).
Water’s edge default rule. Commencing with a tax year beginning after December 31, 2010, any corporation engaged in a unitary business with one or more other corporations that are part of a water’s edge combined group must file a combined report that includes the income and the allocation and apportionment factors and other required information. Thus, all U.S. unitary group members must be included in the group, not just those with District contacts. A water’s edge group generally means a unitary corporation that is incorporated in the United States or in any of its territories and possessions, and certain foreign corporate affiliates (including ones that have “subpart F” income under Section 952 of the Internal Revenue Code, and ones that conduct business in a “tax haven” country).
Since the legislation is now effective, combined reporting will be required for 2011, and estimated tax payments made in 2011 should therefore reflect the changes. The District, on its website, has announced that for calendar-year taxpayers, a fourth quarter “catch up” payment should be made, if needed. “For taxpayers required to use combined reporting, any estimated payments due before 45 days after September 14, 2011…are due the next subsequent installment due date. For example, if a combined group’s taxable year begins on January 1, 2011, the first, second, and third “catch up” payments are due on December 15, 2011, together with the fourth quarter payment under combined reporting.” See “Combined Reporting Transitional Rules for Estimated Tax Payments for Corporations and Unincorporated Business Entities,” Sept. 14, 2011, at www.cfo.dc.gov (click on Taxpayer Service Center, then on Tax Practitioner Service Center, and then on OTR News Room).
Worldwide election. While the default methodology is “water’s edge” (unlike the MTC model), group members can make a worldwide combined reporting election, after which the group must file a combined report that includes the income and factors of all corporations that are members of a unitary business. It is difficult to escape from a worldwide election once made, so taxpayers should be confident of its benefits prior to making the election. The election is binding for a period of ten years. It may be withdrawn prior to the ten-year period only upon written request for reasonable cause based on extraordinary hardship due to unforeseen changes in state tax statutes, law, or policy, and only with the written authorization of the mayor. If no withdrawal is made prior to the end of a ten-year term, the worldwide election will remain in place for an additional ten-year period, subject to the same conditions as applied to the original election. Withdrawal from the election must be made in writing within one year of the expiration of the election and such withdrawal is binding for ten years (unless the mayor grants a request to reinstate the election due to extraordinary hardship).
Composition of unitary group. A unitary group is not defined in terms of ownership of stock (such as an 80 percent stock threshold). Instead, it is defined as “a single economic enterprise that is made up either of separate parts of a single business entity or of a commonly controlled group of business entities that are sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts.”
Without objective standards, there will unavoidably be some uncertainty as to the composition of a combined group. The 2011 Act also provides the mayor with broad discretion, including the authority to require combination of additional taxpayers in order to reflect proper apportionment of income of the entire unitary business. Worldwide combined reporting may be mandated, for example, if it is determined that a person not included in the water’s edge group was availed of with a substantial objective of avoiding state income tax.
Calculation of income. The total income of the combined group is the sum of each member’s income determined under federal income tax laws, as adjusted for District purposes, but as if the members were not members of a federal consolidated return. From this total, any non-business income, expense, or loss of the combined group is removed. Each combined group member will be responsible for tax based on its taxable income or loss apportioned or allocated to the District, which includes the member’s apportioned share of business income of the combined group, where business income of the combined group is calculated as the sum of the individual net business incomes of all members of the combined group.
Reporting and separate liability. While each group member is responsible for tax based on its taxable income or loss apportioned to the District, the members of a combined group can annually designate one member to file a single return in lieu of filing their own respective returns, provided that the member so designated consents to act as a surety with respect to the tax liability of all other members properly included in the combined report and agrees to act as an agent of those members.
Significant limitation on net operating losses and credits. No net operating loss, other loss, or tax credit generated by a group member, not fully used by or allowed to that member on a post-apportionment basis, may be used by another group member or applied against the total income of the combined group. This is a very unfavorable taxpayer rule that runs counter to the single-entity approach adopted for federal income tax purposes and in many other states.
A post-apportionment deduction or credit carried over into a subsequent year as to the member that incurred it, and available as a deduction or credit to that member in a subsequent year, will be considered in the computation of the income of that member in the subsequent year regardless of the composition of that income as apportioned, allocated, or wholly within the District.
If the taxable income computed results in a loss for a member of the combined group, that member has a District net operating loss; the net operating loss will be applied as a deduction in a prior or subsequent year only if that taxpayer has District-source positive net income, whether or not the taxpayer is or was a member of a combined reporting group in the prior or subsequent year.
Taken together, the loss limitations described in the above three paragraphs are among the harshest in the country. The approaches are consistent with the MTC model, but other states that have relied on the MTC model (West Virginia and Wisconsin) have softened the loss limitation approach somewhat. Consistent with the underlying theory that is used to justify the combination of a unitary group’s income, combined reporting should allow net operating losses generated by a separate member to be used to offset the combined group’s income.
Companies with significant District operations should consider restructuring their operations to avoid the risk of one company suffering losses that may never be able to be utilized. Restructuring could be effected through tax-free intercompany mergers or liquidations.
Partnerships as part of a unitary business. Under the new regime, “any business conducted by a partnership shall be treated as conducted by its partners, whether directly held or indirectly held through a series of partnerships . . . .” Thus, a corporate partner’s share of income of a partnership that is part of a unitary business flows through and into the corporate partner’s combined report of income, regardless of the partner’s ownership interest. A business conducted directly or indirectly by one corporation through its direct or indirect interest in a partnership is unitary with that portion of a business conducted by one or more other corporations through their direct or indirect interest in a partnership if there is a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts, and the corporations are members of the same commonly controlled group. While income and other attributes of a partnership could flow into a combined return, it does not appear that a partnership would be treated as a member of a combined group.
Pass-through of apportionment factors. A corporate partner’s share of partnership apportionment factors flows through and into the corporate partner’s combined report of income, regardless of the partner’s ownership interest. The share is determined based on the percentage of the partnership’s total unitary income included in the combined group’s unitary income. (The District’s prior informal policy was not to permit the pass-through of apportionment factors).
Coordination with District Unincorporated Business Tax. The District imposes an unincorporated business tax (UBT) on pass-through entities such as partnerships and limited liability companies taxed as partnerships for federal income tax purposes. Under the previous regime, a corporate partner calculated its District corporation franchise tax by excluding its distributive share of any income subject to the UBT at the partnership level.
Under the new combined reporting rules, if a group member owns an unincorporated business entity that would be subject to the District’s UBT, the income and loss of such partnership or other unincorporated business will be apportioned to the District using the unincorporated business’ apportionment factors. The combined group member’s distributive share of the post-apportioned income will be added to the combined group member’s District taxable income. A group member’s share of an unincorporated business entity’s pre-apportionment income or loss is exempt from the UBT.
Joyce or Finnigan? The 2011 Act generally adopts the so-called “Joyce” approach, in which each member of a combined group is treated as a taxpayer, as opposed to the so-called “Finnigan” approach, in which the entire group is treated as the taxpayer. In Joyce states, only specific group members making the sale are included in the sales factor numerator; sales by a group member lacking nexus in the state are excluded from the combined report numerator. In Finnigan states, the group as a whole is treated as the taxpayer for apportionment purposes and all sales of members of the combined group are included in the sales factor numerator.
The 2011 Act does not address whether the District has adopted the Joyce or Finnigan approach to determine the sales factor of the combined group. However, the author has informally learned that the District expects to follow the Joyce rule in upcoming regulations, which are currently being drafted.
With respect to outbound sales, the District employs a “throwback rule,” which adds to the District’s sales numerator the sales of items where the buyer is the United States government or the taxpayer is not taxable in the buyer’s state. Different state approaches to Joyce and Finnigan can have dramatic results. A sale from a Joyce state with a throwback rule to a Finnigan state can be included in the sales factor numerator in both states, which can result in double-taxation. By contrast, a sale from a Finnigan state to a Joyce state can be excluded from both states’ sales factor numerators, which can result in no taxation.
Dividends-received issue. The 2011 Act provides as follows: “All dividends paid by one to another of the members of the combined group shall, to the extent those dividends are paid out of the earnings and profits of the unitary business included in the combined report, in the current or an earlier year, be eliminated from the income of the recipient.” This dividend-elimination rule is based on a California approach that is not as generous as it appears. It is intended to treat as income a dividend received by a group member that is paid out of earnings and profits arising prior to when the payor was a member of the combined group. Any dividends that fall outside this rule are at risk to be subject to District tax to the extent the dividend is not from a wholly-owned subsidiary; the District does not conform to the Internal Revenue Code on the treatment of dividends-received deductions, and for District franchise tax purposes corporations are entitled to deduct only dividends received from a wholly-owned subsidiary.
Federal consolidated return rules. While the deferred intercompany transaction rules of the federal consolidated return regulations are made applicable to transactions among and between members of the District combined group, and restoration into income rules similar to federal consolidated rules were adopted, the 2011 Act is silent with respect to stock basis adjustments of the members, earnings and profits calculations, and other combined report mechanics. These matters may be addressed in future District regulations.
Deferred tax liability deduction (FAS 109 deduction). If the District combined reporting requirements for a unitary business result in an increase to a combined group’s net deferred tax liability, the combined group will be entitled to a deduction. For the seven-year period beginning with the fifth year of the combined filing, a combined group will be entitled to a deduction equal to one-seventh of the net increase in the taxable temporary differences that caused the increase in the net deferred tax liability, as computed in accordance with GAAP or other international financial reporting standard. This provision was adopted as a resulted of an amendment promoted by taxpayer groups. The District is working on guidance on how to calculate this deduction, and the author was informed that the District is looking to adopt an approach somewhere in between similar FAS 109 deductions adopted in Michigan and Massachusetts.
Need for guidance. Given that combined reporting is effective for tax years commencing after December 31, 2010, and given the relative paucity of the statutory language, there is a real need for the Office of Tax and Revenue (OTR) to issue comprehensive regulations or other guidance quickly. However, OTR, chronically under-staffed, is not known for moving quickly.
Other corporate income tax law changes
Double-weighted sales factor. The 2011 Act has a number of other provisions in addition to the combined reporting rules. For tax years beginning after December 31, 2010, taxpayers subject to the District corporate franchise tax or the UBT must apportion their income to the District by multiplying the income by a fraction, the numerator of which is the property factor, the payroll factor, and the sales factor twice, and the denominator of which is four. (Under current law, total net income is apportioned to the District pursuant to the traditional three-factor approach.) This change may also affect a taxpayer’s 2011 estimated taxes.
Minimum tax increase. As of December 31, 2010, the minimum tax payable under the District’s corporate and unincorporated franchise tax has been increased to $250. If District gross receipts are greater than $1,000,000, the minimum tax payable is $1,000. Previously, the minimum tax was $100.
Estimated tax penalty safe harbor. For tax years beginning or after December 31, 2011, for corporations, financial institutions, and unincorporated businesses, an estimated payment is not considered an underpayment when it equals 25% of the lesser or (1) 90% of the tax shown on the entity’s return for the taxable year (or, if no return is filed, 100% of the tax for the taxable year), or (2) 110% (previously, 100%) of the tax shown on the entity’s return for the preceding taxable year if the entity filed a return for the preceding taxable year consisting of twelve months.
Withholding changes. For periods beginning on or after December 31, 2011, a taxpayer is entitled to additional withholding exemptions with respect to payment of wages equal to a number determined by dividing by $1,370 his or her estimated itemized deductions.
For periods beginning after December 31, 2011, if a resident receives an early distribution from a retirement plan or account and the payment is subject to mandatory withholding of federal income tax, the District tax must be withheld by the payor of that distribution at the highest District income tax rate as exists at the time of the receipt of that distribution.
Internet sales tax/remote-vendor sales
The 2011 Act contains some sales tax provisions, including a novel tax to be imposed on Internet sellers: new Chapter 39A, entitled “Internet Tax.” Within 120 days after the effective date of this chapter, the District must require every remote vendor not qualifying as an exempted vendor to collect and remit District sales tax on remote sales made via the Internet to a purchaser in the District. A “remote-vendor” means an Internet seller, whether or not it has a physical presence or other nexus in the District, selling property or rendering a service to a District purchaser. An “exempted vendor” means a remote-vendor that falls under a minimum threshold of gross receipts from Internet sales to purchasers in the District.
Prior to imposing this tax, the District must establish: (1) a registry with privacy and confidentiality controls where each remote-vendor must register; (2) appropriate protections for consumer privacy; (3) a means for a remote-vendor to determine current District sales and use tax rate and taxability; (4) a formula and procedure allowing a remote-vendor to deduct reasonable compensation for the administration, collection, and remittance of District remote sales taxes; (5) the date that the collection of remote sales taxes will commence; (6) a small-vendor exemption; (7) a list of the products and types of products that will be exempt from remote sales taxes; (8) rules for accounting for bad debts and rounding that address refunds and credits, and other specified topics; and (9) a plan to substantially reduce the administrative burdens associated with sales and use taxes, including remote sales taxes.
It appears that the provisions imposing an Internet tax on remote-vendors must be approved by Congress and signed by the President to become effective. While the Internet Tax provisions would be approved by Congress, the tax still must pass muster under the Commerce Clause of the U.S. Constitution. Because all District laws ultimately rely on congressional authority, it is expected that the District will argue, if the provision is enacted, that Congress has exercised its Commerce Clause powers to compel sales tax collection by non-nexus sellers. It is not clear if such a position would succeed in court.
This Internet tax legislation is a major development in the battle between states and localities and Internet sellers. It is an aggressive departure from the “Amazon” approach adopted by New York, where the seller must have an affiliated business relationship in the state, or the approach taken by some other states such as Colorado, which have relied on Internet retailers to notify their states’ customers of their use tax obligations.
Other sales tax law changes
Internet sales tax/nexus-vendor sales. Sales tax is imposed on any sales of tangible personal property or taxable services effected via Internet by a nexus-vendor. A nexus-vendor means a vendor that has a physical presence within the District, such as property or retail outlets, selling via the Internet property or rendering services to a District purchaser.
Online vendors of hotel rooms. The 2011 Act amends the sales tax provisions governing taxes on online vendors of hotel accommodations to provide that if the occupancy of rooms, lodgings, or accommodations is reserved, booked, or otherwise arranged for by a room remarketer, sales and use tax is determined based on the net charges and additional charges received by the room remarketer. A room remarketer is responsible for collecting the sales and use tax with respect to such additional charges. The room remarketer is responsible for collecting the sales and use tax with respect to net charges and has to remit the tax to the operator of the hotel, inn, tourist cabin, or any other place in which rooms, lodgings, or accommodations are regularly furnished to transients for a consideration.
Permanent sales tax rate change. The District’s 6% sales and use tax rate was scheduled to revert to 5.75% on September 30, 2012. The 2011 Act permanently sets the rate at 6%.
Certain security services taxed. The District sales tax now applies to charges for armored car service, private investigation service, and security service. An armored-car-services vendor can reasonably apportion any charges for any out-of-state delivery component, including the apportionment based on distance, time, or number of stops within and outside the District. The application of the sales and use tax to charges for security services is controlled by the delivery point of the services. The reimbursement of incidental expenses paid to a third party and incurred in connection with providing a taxable private detective service is not included in a retail sale. For further guidance, including government-related exemptions, see OTR Tax Notice 2011-03 (Sept. 1, 2011).
Sales tax year. The District is changing its sales tax year from a calendar year to its fiscal year ending September 30. The annual filing for 2011 will be for the period January 1, 2011 through September 30, 2011. Annual filing and payments will be due October 20, 2011, instead of January 20, 2012. Thereafter, the filing period will be October 1 through September 30, with a due date of October 20. See “New Sales and Use Tax Annual Filing and Payment Requirement,” Sept. 6, 2011, at www.cfo.dc.gov (click on Taxpayer Service Center, Tax Practitioner Service Center, and then OTR News Room).
Intercompany transaction proposed assessments
Based on public information
The OTR entered into a $9 million contract with ACS State and Local Solutions (formerly a division of Lockheed Martin) for the year 2010. According to the contract, ACS was to conduct research and analysis on transfer pricing—transactions between and among parent and subsidiary and related companies regarding the allocation of income and expenses. OTR was to use the reports to identify companies and generate proposed deficiencies against those that are deemed to violate transfer pricing rules.
The author learned that several corporate taxpayers have been issued multi-million proposed transfer pricing adjustments as a result of proposals by ACS to OTR. According to one source, ACS relied solely on publicly-available information, such as SEC filings, and OTR did not conduct any further review of the taxpayer’s actual records prior to issuing the proposed assessment. The author has further learned that additional assessments were sent out in the third quarter of 2011 arising from apparently a new 2011 ACS contract.
The first case to be filed in court arising from this initiative is BP Products North America, Inc. v. District of Columbia, in the Superior Court of the District, Tax Division. The complaint was filed on June 17, 2011, and alleges that ACS contracted with an organization named Chainbridge Partners to investigate and evaluate the intercompany transactions. Among the claims set forth in the complaint are that “No audit of the Taxpayer’s books and records was ever done and the only contact Chainbridge had with Taxpayer was through a Questionnaire that was sent to Taxpayer. The Reports fail to identify any controlled transaction that might be considered to be non-arm’s length.” The taxpayer in the case paid the tax, interest, and penalty and is seeking a refund in Superior Court.
The author was informed that a number of the taxpayers who received transfer-pricing assessments have settled their cases. Despite loud opposition to the auditing techniques, there is only one other reported opposition to this initiative, an appeal filed in the District’s Office of Administrative Hearings (OAH).
In 2011, ACS was acquired by another company, which apparently shut down ACS’s transfer pricing business. It is not clear if the District will continue this transfer pricing effort in 2012.
The District, by enacting combined reporting legislation, hopes to increase its corporate tax revenues. Certain provisions of the combined reporting rules are taxpayer unfriendly and may help the District achieve this goal, particularly the provision not permitting a loss generated by a combined group member to be utilized by the combined group in the year the loss is generated. However, it remains to be seen whether the District will reach its goal of increasing revenues.
The passage of the Internet Act, and the path for a tax to be imposed on remote Internet sellers, is a significant development in the battle between states and remote sellers. It further remains to be seen whether this aggressive approach will be upheld in the courts.