Nexus End Run
A far more significant development, however, is the number of states that have grown tired of fighting and have simply changed the law. “There are two ways [for states] to attack” an out-of-state company, says Doug Lindholm, executive director of COST. “The first is to say it has economic presence. If that’s not going to work, because Lanco says you need a physical presence, [the state] can try to deny the deduction to the company that does have physical presence in the state.”
Today, nine states have legislation disallowing deductions taken by one company for payments—such as interest, or royalties on patents—to an affiliated company (see “Legislative Disallowance” later in this article). All but two have passed those laws since 2001. After losing the Sherwin-Williams case, Massachusetts simply changed the law last March to allow the tax commissioner to disallow any deduction that he considers a sham. New York passed tougher laws as well, despite winning its fight with Sherwin-Williams. “In 2003, the floodgates opened,” says the tax manager of one Fortune 500 company, who requested anonymity. Although only three states—New York, Massachusetts, and Arkansas—passed such laws last year, seven others considered similar proposals. Typically, these laws require the taxpayer to prove that the affiliated company has a legitimate business purpose.
“My prediction is that within the next three years, most separate-return states will have statutory limitations on related company expenses,” says COST legislative director Joe Crosby, “and they’ll be all over the board, capturing different types of items.”
That means more head-aches for corporations. The distinction between aggressive tax planning and improper tax sheltering is already a huge gray area. By disallowing certain types of intercompany transfers, the new laws potentially affect not just tax planning, but also such run-of-the-mill functions as treasury. Many of the new laws allow the company to justify to the tax commissioner why a particular transfer should be acceptable—but that is another compliance burden.
That complaint was already evident in our survey. Asked about the biggest headache for tax directors, one respondent wrote, “Inconsistent treatment of intercompany transactions—will the state disallow the expense, force combination, or declare affiliate nexus?” Said another: “New legislation that unreasonably denies deduction of intercompany payments.”
What’s most worrying about this new legislation, however, is not whether it’s reasonable, but that it isn’t likely to produce anywhere near enough money. “In the end,” says Michael Lippman, head of KPMG LLP’s state and local tax practice, “these income-tax expense-disallowance provisions are not going to be the cure for the states’ structural deficit problems, because they can’t raise sufficient revenue.” Despite the emphasis that corporate income tax often gets in the press and in state capitols, it typically makes up just 5 to 10 percent of state tax collections, says Lippman. The real dollars, he says, come from property tax, sales tax, and the individual income tax.