KJ - Let’s discuss multi-state tax issues that companies are faced with today. It is my understanding the states are going to be very busy. What are you encountering?

PP - Yes, the states are very busy overhauling the tax code because the majority of states are facing huge budget shortfalls. The usual suspects around us are the tax payers, and especially business taxpayers because they tend to have deeper pockets and states know where to find them.We are seeing a lot of royalty disallowance, disallowance of interest and a disallowance of other inter company charges. About twenty years ago, it was widespread practice for companies to put all of their intangible property into a special holding company that would then license the intangibles to the operating affiliates and in separate return states they would get a deduction for the royalty paid to the intangible holding company that would typically have nexus just in a combined state or maybe nexus only in Delaware or Nevada or some other location which did not tax it. A number of these cases were litigated and the states did not like the results because they only won roughly half of the cases. They then began to enact statutory disallowances of the deduction for the intangibles and in some cases for interest when it is paid to a related company. I think Ohio may have been the first state to do so and the practice spread like a virus. Now there may be approaching thirty states that have such statutory allowances. For companies there may be entirely non-tax motivated reasons to have intangibles in a separate company. Management may have an R&D function that it wants to keep separate and those companies actually end up being penalized as a result of the statutory disallowance. For instance, if they had their laboratory scientists or software engineers in the principle operating company then the payroll and the cost of facilities of those scientists and engineers would be deductible expenses This would reduce the taxable income of the principal operating company, part of which is a separate apportioned to separate return states. Further including payroll and property in the denominator would also reduce the apportionment factor in the separate return states. However, if it is in a separate company, then essentially the company is being penalized for the structure that it may be using for non-tax reasons. Companies are typically operating this way if they have set up an intangible holding company; however, companies are now migrating away from it because it can become quite costly to maintain that structure.


KJ- What are yout thoughts on R&D Tax Credits?

PP - In regards to R&D Tax Credits, many states give a credit for a portion of the cost of the R&D activities that are conducted in their state. Many states only allow the entity that earns the credit to utilize it on their tax return. If you have the R&D Credit in a separate company, in many states you are only able to reduce the tax burden of your group by the tax attributable to that separate company. California has legislatively changed its law now so that the company that earns the credit will be able to assign it to another member of the affiliated group of the combined group in future years.


KJ - Going forward, what should companies prepare for right now?

PP - This is a good question! One of the things that I am noticing now is the increased difficulty of audits and it has always been good to document your audit and make sure you understand what the auditors' objectives are and what their timeline is and what areas they plan on looking into. You need to establish ground rules for the auditors but lately I am seeing increased examples of where you will have an agreement with and auditor or you have agreed to a sampling or something else and then the auditor will renege on the commitment or the auditor is being pulled off. I just saw a couple of cases recently where the auditors really were not performing adequately from the states perspective and were then terminated or the audits were taken away from them. Often times, all I know is that the auditors were reassigned which I guess is the right way to say it. The result is that even after you have given the auditor the documentation that they have asked for , you end up with receiving a write up saying that this documentation was never furnished and then we have a very messy situation. It is very important to have clearly documented records of when you receive IDR’s and when you respond to them. It is important to make certain you put things down in writing and keep logs because you know the auditors are under a lot more pressure these days. In fact, the audit process is more frenzied than it used to be.One of the tax planning areas we are working a lot in right now has to do with different aspects of electronic commerce. In fact, many of our client’s business efforts are evolving as they are doing more delivery over the web and so increasingly we are handling nexus questions from an audit and tax planning perspective. This area is really evolving right now. One other area to mention is the unclaimed property area. In fact, a tax lawyer by the name of Kendall Houghton recently joined our practice in Washington DC. She is a leading expert in the unclaimed property area so our firms capacity she is really enhancing Baker's capacity in this area.


KJ - The word nexus frequently comes up in my conversations with tax professionals. What is nexus?

PP - Nexus is a conclusory word and it means the state has the jurisdiction to tax you; so nexus is really a conclusion as it is not an analytical tool but a conclusion. The analysis that you go through is do you have enough connection in the state, do you have people there; and the area that becomes really squishy is do you have relationships with related or unrelated persons that the state can characterize as an agency relationship sufficient to say that you are in the state and the state can assert tax jurisdiction over you. If the answer to any of these questions is affirmative then you have nexus in the state.What we have actually been doing a great deal of work on recently is this whole new agency issue for nexus because state courts have misused the word agency. I think that there are legal definitions and legal definitions and characteristics as a agent. The agent has the authority to bind a principle and so on. The states really do not use agency that way as what they really look to is somebody in the state doing something that helps you build and maintain a market in that state. They conclude that if they are then they are your agent for purposes of establishing nexus, so it is kind of a perversion of the term agency or agent. I think it becomes confusing certainly to new lawyers but to tax collectors and Judges as well . They do not realize when they use agency that they are not using it in a traditional legal sense.

KJ- Pat, thank you for taking the time to answer our questions. Your perspective is valuable to the Tax Intelligence Report readers around the world and we genuinely appreciate the time you gave to share your experiences.

Kathleen Jennings (KJ)
Editor, The Tax Intelligence Report
Kathleen@etsearch.com

J. Pat Powers (PP)
Tax Partner
Baker & McKenzie LLP - San Francisco / Palo Alto, California
Pat.Powers@BAKERNET.com