Stingers: The 2004 State Tax Survey

Tough times can make for tense relations between corporate tax executives and state tax authorities. Our survey suggests that even if economic conditions improve, the stage is set for more contentiousness than ever.

Yet even CFOs fighting what they see as unfair or unreasonable tactics by various states express some sympathy for the plight of their tormentors. “New York State is in a world of hurt, and I understand that,” says Vince Holley, division controller of Wayland, New York-based Gunlocke Co., a division of Hon Industries. “But getting tough on clawback issues may burn them more.”

“It is really scraping the [bottom of the] barrel,” says Beverly, Massachusetts-based ZymeQuest Inc. CFO C. Evan Ballantyne of his state’s efforts to suddenly deny his company an R&D credit it has claimed for seven years. “You start to think to yourself, ‘These guys must be so desperate.’”

For states, financial desperation clearly has been coupled with frustration over corporate tax planning. Last July, the Multistate Tax Commission (MTC), an organization of 45 states, released a study claiming that 2001 state corporate-income-tax revenues of $35.4 billion would have been 35 percent higher but for corporate tax sheltering. “It is apparent,” the study said, “that various corporations are increasingly taking advantage of structural weaknesses and loopholes in the state corporate tax systems.”

The study drew a blistering response from the business-sponsored Council on State Taxation (COST), which argued that corporations pay an additional $358 billion in non-income taxes. But the MTC’s broad definition of shelters—to which COST also hotly objected—at least accurately reflects the increasingly dim view that states take of tax planning.

Last year saw rulings in a number of high-profile nexus battles, all revolving around states’ efforts to undermine tax-planning techniques involving Delaware holding companies. In most cases, the states lost, causing them to turn from the courts to their legislatures.

Which Exit?

Most prominent among these cases was the decision in Lanco Inc. v. Director, Division of Taxation, a New Jersey ruling that our survey suggests is already as familiar to most corporate tax directors as 1992′s Quill Corp. v. North Dakota. In Quill, the U.S. Supreme Court ruled that “substantial nexus” was defined by a physical presence. Thus, North Dakota could not require Quill—an out-of-state office-supplies catalog vendor—to collect use taxes on sales within North Dakota.

The question in Lanco was whether physical presence was also necessary to levy income or franchise taxes. Quill has served as the basis for a decade of corporate tax planning. Typically, affiliated holding companies in tax-friendly states—usually Delaware—own and license intangibles such as trademarks and patents to the operating companies. Those operating companies can then deduct the payments to their affiliates.

In Lanco, New Jersey’s tax director had attempted to levy income tax on the Delaware holding company that licenses intangibles to clothing manufacturer Lane Bryant. And there was good reason for Lane Bryant officials to worry that New Jersey’s argument of “economic nexus” might prevail: the facts in the case were identical to those in 1993′s infamous Geoffrey Inc. v. South Carolina Tax Commission. In that case, the South Carolina Supreme Court ruled that Geoffrey, a Delaware holding company that licensed intangibles to Toys “R” Us, was subject to income tax even though it had no physical presence in the state.

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