The 40th anniversary meeting of the Multistate Tax Commission (MTC), held in Minnesota last week, highlighted a significant number of state efforts dramatically to alter state taxation, particularly state income tax apportionment. The MTC announced its substantial effort to reshape the Uniform Division of Income for Tax Purposes Act (UDITPA), create (or re-create) special apportionment rules for the telecommunications and financial services industries, and attack perceived abuses associated with captive real estate investment trusts. Sutherland attended the entire meeting and reports on these developments further below.
Income Tax Subcommittee: Apportionment Dominates the Agenda
Several MTC activities discussed below highlight the MTC’s concern regarding state income tax apportionment, especially concerns associated with costs-of-performance (COP) sourcing. COP is used to determine the situs of sales from services and intagible income in calculating the sales factor. As discussed more fully below, the MTC is seeking to establish additional industry-specific regulations that will result in limiting the application of COP. Further, the MTC is seeking to limit or eliminate COP by devoting substantial resources to the effort to re-examine UDITPA led by the National Conference of Commissioners for Uniform State Laws (NCCUSL).
Telecommunications Apportionment Regulation
An ongoing, controversial, and important project undertaken by the MTC’s Income Tax Subcommittee is the drafting of special apportionment rules for telecommunications services. The MTC believes that costs of performance is an inappropriate standard for assigning the numerator of receipts from telecommunications services. A complex set of apportionment regulations has been drafted by the MTC staff.
While participants from the telecom industry once again provided comments at this Subcommittee meeting, the Subcommittee offered no discussion of, or reactions to, these comments, and the proposal was easily passed to the full Uniformity Committee. The full Uniformity Committee (made up of many of the same members as the Income Tax Subcommittee) similarly passed the proposal on to the Executive Committee.
Sutherland Observations: At the Executive Committee meeting, Sutherland testified in opposition to several elements of the proposed telecommunications regulation. Sutherland continued to highlight an overarching global problem – why single out telecommunications for special rules when the states have questions regarding the use of costs of performance for the entire service industry. Since NCCUSL (see below) is about to undertake a comprehensive review of UDITPA, including the section 17 rules for sourcing sales from services, it would be premature to adopt a special sourcing rule for one unique service industry currently covered by section 17. Further, the proposed telecom regulation adopts many of the definitions from the Streamlined Sales Tax Project. Those definitions were designed in order to create simplicity and understanding for the consumer of telecommunications services, not to properly source the income of the service provider itself. Furthermore, the telecommunications industry is really not a linear “industry” anymore – it is a communications industry which offers many different, non-traditional products (such as watching TV on one’s mobile phone) and includes “non-traditional” telecommunications providers that may not be covered by this proposal.
On the more specific issues, Sutherland notes that, as always, bundling is a problem. Whereas in the past, providers controlled the information and services being sold, today it is common for the customers to control the services they receive. This makes it difficult, and frequently impossible, for a telecom service provider to know which receipts in a transaction should be “telecom services” and subject to the MTC’s special sourcing rules, and which are instead subject to other apportionment rules.
The special – and absolutely unique – rule for wholesale sales of telecommunication services is particularly troubling. The regulations propose using a table prepared by the industry for FCC regulatory purposes, to apportion wholesale sales of telecommunications services. While the table purports to list carrier-to-carrier sales, it does so using very broad estimates which frequently have nothing to do with a particular company’s actual wholesale activity in any one state. The table also does not take into account the proper sourcing of foreign receipts. The problem the telecom industry is encountering in this regard, however, is that the industry has not offered a specific alternative to the MTC’s proposal for wholesale sales.
What is additionally troubling about the proposal for wholesale sales is that every industry – whether it is selling toilet paper or telecommunication services – has some level of wholesale sales. Historically, other industries have not had special rules for wholesale sales, and it is not clear why the telecom industry should. The MTC states appear to believe that the telecom industry is “getting away with something” because the wholesale sales are being sourced based on COP, which as an all-or-nothing standard, leaving some states feeling under-compensated. However, this problem arises in the case of every type of service provider and is not specific to telecom service providers.
While the Executive Committee listened attentively to Sutherland’s comments, and even agreed with some of the comments, the Executive Committee ultimately decided that the issues raised were better dealt with in the public hearing process. So, the apportionment regulations were passed out of the Executive Committee, and the MTC will conduct a public hearing on the proposal this fall. The Committee agreed that waiting for the NCCUSL process to finish would be a very long wait, and it was best to move forward now.
Sutherland Observations: During this meeting, the MTC asked the telecom industry to provide specific suggestions for improvements to its proposal, and not just complaints about what does not work. While more than five years’ of industry effort to educate the MTC on telecom sourcing concerns and to advocate reasonable approaches to various concerns would appear to have satisfied this request, the pressure to engage in specific drafting exercises will increase. Whereas certain technical issues, such as the inclusion of foreign receipts, will be taken care of in the MTC hearing process, the bigger debates, such as whether wholesale telecom sales should have a special rule at all, may require the industry and individual companies to offer real alternatives. It will be this time next year that the full Commission will likely vote on ultimately adopting the apportionment regulations as a uniformity provision.
Revisions to Financial Institutions Regulations
This new uniformity project is being aggressively pushed by the State of Oregon. The goal of the project is to revisit and revise the existing Financial Institution Apportionment Regulations, adopted in 1994 and widely used by many states. Oregon is concerned with how loans and credit card receivables are being sourced. An example of the alleged sourcing disconnect was provided by an MTC staff person; when he applied for a credit card over the phone, he learned that the fees, interest and other income to the credit card company from his use of the card would not be sourced to his location, but instead would be sourced to the location of the person who took his information, checked his credit, and authorized issuance of the card. This project and the proposal document (available on the MTC website) were apparently prepared as a result of MTC audits of several financial institutions and the issues that arose in those audits.
The specific items that the MTC has proposed revising include:
(a) Property Factor Issues: These relate to solicitation, investigation, negotiation, approval and administration (commonly referred to as the SINAA test). Currently, the regulations determine the sourcing of loans, which are included in the property factor, based on the types of contacts the loan has with a state. The relevant contacts include those listed in the SINAA test. The MTC is concerned that because institutions frequently sell loans soon after origination, such a test is no longer an accurate determination of the location of the loan. Further, the MTC wants more clarification on how each element of the SINAA test should be weighted. The concern is that many of the SINAA activities are being assigned to a taxpayer’s commercial domicile. The MTC is also particularly concerned with the effect of technology and e-commerce on the appropriate assignment of receipts from lending activities. Since many of these transactions are automated, the MTC is concerned that the money center states are being assigned an even larger share of the loans. The MTC would like to consider what other factors than SINAA should be taken into account in determining the property factor sourcing of loans.
(b) Receipts Factor Issues: The MTC notes that many types of receipts, other than loans and credit card receipts, are sourced under a costs of performance test (which the MTC abhors). The MTC would like to reconsider this approach.
(c) Entity Structure Issues: The MTC is concerned about the common practice of selling loans and receivables to related entities, such as a REMIC. The MTC sees the problem as a removal of the loans and the interest from the apportionment formula without a real change in the financial institution’s business.
Karen Boucher of Deloitte & Touche, speaking on behalf of the Financial Institutions State Tax (FIST) coalition, offered public and written comments. She reminded the group of the process taken in the early 1990’s to draft the original set of apportionment rules. This process was collaborative and included both the states (so-called “money center” and “market” states) and the affected businesses. FIST is extremely concerned that a similar process does not appear to be happening with respect to the newly proposed revisions. Surprisingly, and somewhat disturbingly, many MTC participants were unaware of the wealth of information (including seven volumes of notes, comments and drafts) that were available from the deliberations and discussions related to the existing financial institution apportionment regulations.
Sutherland Observations: Sutherland echoed FIST’s concern about the apparent lack of pre-consultation with the industry before the MTC’s process kicked off. Sutherland noted that the document distributed at the meeting as a “discussion” document not only identified the issues (which were only issues from certain states’ perspective), but also suggested possible solutions. This document was apparently never discussed or even provided to any representative of the financial industry prior to the MTC meeting. Sutherland noted that it can be much more difficult to move the process back to a collaborative process because certain positions have already been staked out. The Income Tax Uniformity Subcommittee apologized and emphasized that they did want to work with industry on this project.
Given the posture of this initiative, businesses involved in any type of lending, including credit card companies, should review the MTC’s proposals and quickly become engaged with the MTC process – either directly, through counsel, or through an active trade association. It is likely that there will be a MTC teleconference in the next two months on this issue. Unfortunately, the document pointing out the problems and the suggested solutions is already being used in MTC training of state attorneys. California, Oregon, possibly New York, and an unidentified small state will create a small group to start fleshing out the issues and the language with “concerned members of the public.” The industry should be prepared to discuss, in detail, their current practices, what type of information is available to the business, where and how their income is generated, and offer realistic proposals to the MTC as alternatives.
“On Behalf Of” Project
The “on behalf of” project was finally and formally completed. This project resulted in a change to the MTC’s uniformity provision regarding determining COP – the change from specifically excluding costs associated with activities done by third parties on behalf of the taxpayer to specifically including such costs. This change is broader than the California regulation adopted in the last year, which only includes activities performed by unitary affiliated entities in the COP analysis.
Another issue that has been percolating for some time at the Income Tax Subcommittee deals with the use of captive REITs as a tax sheltering device. The basic proposal would deny the dividends paid deduction for captive REITs. This proposal passed the Income Tax Subcommittee, the Uniformity Committee, and the Executive Committee. It will now be sent to public hearing.
KPMG has suggested that the MTC look at its existing RAR rules and consider adding additional uniformity suggestions to make compliance with state RAR reporting easier on large taxpayers with multiple filing entities. KPMG noted that state RAR reporting is still mostly a manual process. Some states require a full amended return while others allow a shortened reporting document. It is also labor intensive for the states. KPMG suggested simplifying and making the process more uniform.
MTC Forms Strategy to Influence NCCUSL’s Revision of UDITPA
As expected, NCCUSL recently unanimously approved the review and possible re-writing of UDITPA. The NCCUSL Drafting Committee has not yet been chosen but will likely include five to seven people. Importantly, the MTC announced that it will create and manage a parallel process (i.e., basically “staffing” NCCUSL). The MTC has formed two committees in keeping with this strategy. One committee is the MTC/NCCUSL Liaison Committee. The members of this committee are: Dan Bucks (MT); Ben Miller (CA); Elizabeth Harchenko (OR); and Bruce Johnson (UT). The other committee is the MTC UDITPA Drafting Subcommittee. It will be headed up by Ben Miller and will also include Joe Garrett (AL) and Ted Spangler (ID). MTC attorneys Shirley Sicilian (General Counsel) and Bruce Fort will be the staff members assigned to this subcommittee.
Sutherland Observations: Businesses that care about changes in UDITPA, particularly Section 17 (COP sourcing of receipts from sales of services and intangibles) and the other provisions of UDITPA in the MTC’s cross-hairs, see SAB Legal Alert dated May 16, 2007, should ensure that its interests are adequately represented in the NCCUSL process. The MTC will seek to have their work product form the basis for the NCCUSL drafting committee. The MTC member state participants in these committees are formidable state tax administrators with a wealth of “real-life” experience with the UDITPA provisions they seek to revise, and they will be aggressive advocates of the changes that the MTC has proposed. Taxpayers and their representatives must serve as an articulate counter-balance to the MTC through thoughtful advocacy of the positions that best reflect their views of fair apportionment and effective tax administration. Sutherland will be monitoring NCCUSL’s efforts and representing the interests of select industries.
Sales Tax Subcommittee: New Telecommunications Transaction Tax Project?
Several members of the telecommunications industry have suggested that the MTC commence a new project – using the Streamlined Sales Tax Project as a starting point – to bring more uniformity and less complexity to the area of telecommunication transaction taxes. Telecom industry representatives suggested three separate areas for consideration: (1) a model statute for some type of more centralized collection mechanism; (2) a uniform definition and rules (taking definitions from SSTP where they exist and are appropriate); and (3) protection from class action suits, similar to what has been adopted by SSTP (i.e., premised upon a seller’s reliance upon a state-posted database containing sales tax rates and boundaries). By way of background, the SSTP Agreement contains a robust set of telecommunications provisions, such as uniform definitions and sourcing rules. However, the Agreement is limited to sales and use taxation and, therefore, does not apply to the myriad of state and local telecommunications excise taxes.
The telecommunications industry’d pursuit of centralization of tax collection could take several different forms, depending on the state and the relation between the locals and the state. The next step is for the telecommunications industry to put together a detailed outline as to the scope of the suggested project. At the next meeting, a smaller group of states, together with industry representatives, will present the prepared scope document.
New MTC Officer Slate
Because Joan Wagnon, Secretary of the Kansas Department of Revenue, stepped down from her two-year role as Chair of the MTC, new officers were elected to comprise the MTC Executive Committee. The new Executive Committee will be headed by Jan Goodwin (New Mexico’s Secretary of Taxation and Revenue). Other members include Vice Chair Trish Vincent (Missouri Director of Revenue); Treasurer Thomas Surtees (Alabama Commissioner of Revenue); and At Large Officers Susan Combs (Texas Comptroller of Public Accounts), Dan Bucks (Director, Montana Department of Revenue), and Ward Einess (Commissioner, Minnesota Department of Revenue).
Sutherland Observation: The Executive Committee is comprised of energetic state advocates such as Commissioners Combs, Bucks and Einess; it is likely that the scope and number of the MTC’s projects will continue to grow.