In an unusual twist, the District of Columbia (the District) passed emergency legislation that adopts mandatory combined reporting and corrects existing statutory construction problems with the District’s related party expense disallowance provisions. Combined reporting was not seriously considered until it appeared as a proposal in the City’s budget legislation seeking to address the City’s budget deficit – which is estimated to be in the hundreds of millions. While combined reporting has been adopted by the District, there are no details included in the legislation as to how combined reporting will be applied. Sutherland will be working with the District to address these ambiguities.
I. Did it Really Happen?
After the City’s May revenue estimates were released it was apparent that the District would have a significant budget gap. The City Council introduced three bills to address the budget shortfall – an emergency act, a temporary act, and permanent legislation. Each of these bills included combined reporting language. Only emergency legislation was ultimately adopted (Bill # 18-409). It also includes a correction of the District’s related party expense disallowance provisions and several other tax changes. However, the emergency legislation expires after 90 days (on November 24, 2009). If permanent legislation is not adopted, the District’s combined reporting regime will sunset before it becomes effective in 2011. The City Council is scheduled to meet on September 22 to consider permanent legislation which would codify the combined reporting and expense disallowance language as permanent provisions of the law.
II. Combined Reporting - No Standard and No Guidance!!
District Bill #18-409 as enacted provides that “beginning after December 31, 2010, all corporations taxable in the District of Columbia shall determine their income apportionable or allocable to the District of Columbia by reference to the income and apportionment factors of all commonly controlled corporations organized within the United States with which they are engaged in a unitary business.” (emphasis added). Simply put, there is no other guidance or details in Bill #18-409 on combined reporting. There is no definition of what constitutes a unitary business, no explanation of how the combined report should mechanically be computed, and no explanation of how attributes will be treated in the combined report.
Sutherland Observation: While the District’s adoption of combined reporting will not go into effect until January 1, 2011, assuming permanent legislation is adopted, taxpayers must compute their deferred tax liabilities for financial statement purposes based on a calculated deferred income tax rate. Without clear guidance on how corporations will compute combined returns, it will be virtually impossible for taxpayers to predict their deferred effective income tax rate. There has been some discussion that the District of Columbia Office of Tax and Revenue (OTR) will attempt to finalize adoption of combined reporting via regulation. The validity and enforceability of such an approach would likely be challenged given the lack of statutory basis for the various calculation methodologies that would be required to file a combined return.
III. Related Party Expense Disallowance Fix
The validity of the District’s related party expense disallowance regime has come into question since their enactment in 2004. The first time the District enacted its related party expense disallowance provisions it codified them in the statutes applicable to individuals, estates and trusts, calling into question their applicability to corporate and unincorporated businesses. In 2006, the District corrected this problem but created another problem by moving the provisions to the statutory section addressing corporate deductions, but putting the expense disallowance provision in the subsection addressing “deductions allowed.” Specifically, the provision, as currently existing in the District’s tax code states: “The following deductions shall be allowed from gross income in computing net income of corporations…(19) Royalty payments. If the royalty payments are directly or indirectly paid, accrued, or incurred to a related member….”1
Bill #18-409 repeals D.C. Code Ann Sec. 47-1803(a)(19) and replaces it with more robust related party expense disallowance provisions under D.C. Code Ann Sec. 47-1803(d). The revised related party expense disallowance provisions are no longer limited to royalties and now include (1) interest; and (2) intangible expenses paid to a related entity. In addition, the District has expanded the exceptions and now provides for a (1) “conduit” exception; and (2) “subject to tax” exception that requires the related member to pay tax in another state or foreign country with a comprehensive treaty at an aggregate effective tax rate equal to or greater than 4.5%, without consideration of combined or consolidated filings. Both exceptions also require taxpayers to show business purpose (other than reducing state income tax) and arm’s length rates and terms. The legislation is retroactive – it is effective for taxable years beginning after December 31, 2008.
Sutherland Observation: Because the District’s existing related party expense disallowance provisions may not disallow such payments, taxpayers that have complied with these provisions for 2004 through 2008 may have potential refund claims. The related party expense disallowance corrections in Bill #18-409 would apply to tax years beginning on or after December 31, 2008.
Finally, the District now joins the increasing number of states that have adopted both combined reporting and related party expense disallowance provisions without addressing the interplay of how the two requirements work together. While the District’s combined reporting provisions will not go into effect until tax years beginning on or after January 1, 2011, it is unclear how the District intends to apply the expense disallowance provisions once combined reporting is in effect.
IV. Other Enacted Provisions
In addition to combined reporting and related party expense disallowance corrections, Bill #18-409 also provides for the enactment of:
- a tax amnesty program for tax periods ending prior to December 31, 2009;
- decoupling from the American Recovery and Reinvestment Tax Act of 2009 discharge of indebtedness income deferral provisions under IRC 108(i); and
- an increase in the sales tax rate from 5.75% to 6% effective October 1, 2009, through September 30, 2012.
V. What’s Next?
The City Council is set to meet again on September 22 to enact permanent legislation as the existing emergency legislation will expire in November if no further action is taken. It is not clear whether the City Council will adopt the language that appears in Bill #18-409 or whether it will return to the original placeholder language which expressed the Council’s intent to legislate combined reporting in a future legislative session. Once enacted by the City Council, any permanent legislation would be subject to a waiting period to allow for Congressional review. Congressional changes to the legislation are unlikely.