Cara Griffith and Jennifer Carr are legal editors and Amy Hamilton is a reporter with State Tax Notes.
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Founded by Tom Field, Tax Analysts was created to foster an open and informed debate about taxation. But Tax Analysts quickly realized that these activities required access to information -- information that federal tax authorities did not want disclosed. Tax Analysts has fought to obtain access to key documents in tax policy and administration, including private letter rulings and technical advice memoranda. But the need for openness does not end with federal tax law. State taxing authorities should be held to the same standards. Transparency is vital to a dynamic debate on tax issues.
This article is the first in a series that will examine transparency at the state tax level, showing where states are doing things right and where there is room for improvement. This first installment focuses on how states use their discretionary authority and how states provide guidance to taxpayers in circumstances in which states can use that discretionary authority. Later articles will address transparency in the legislative process and how states issue and make available private letter rulings.
Guidance and Discretionary Authority
Transparency, as it concerns state tax practice, covers a wide variety of situations and issues. The critical question in transparency debates is whether taxpayers, tax administrators, and lawmakers understand what the law is and how it will be enforced.
Several practitioners that spoke with Tax Analysts said that taxpayers crave certainty. They want to know both what the law is and how to follow it, and be comfortable that the law will be consistently enforced. Transparency ensures all three of those things. "Clarification is always desirable," said Todd Lard, general counsel for the Council On State Taxation. He added that he believes lack of guidance "is particularly rough on publicly traded companies," which need certainty not only to prepare accurate returns but also because they are required to properly disclose to shareholders an estimate of the potential tax, penalties, and interest for a tax position taken that could be successfully challenged.
Probably the biggest transparency issues arise when states provide insufficient guidance on how they administer or interpret their tax laws, particularly in situations in which there is broad discretionary authority. In general, state revenue officials are afforded some level of discretion to calculate a taxpayer's entire net income under alternative methods if they believe that calculation of a taxpayer's income under the state's tax code does not fairly represent the taxpayer's activity in the taxing state. Lard said it's one thing for taxpayers and their advisers to be unclear about a state tax agency's position on one discrete issue -- it's another thing altogether to be blindsided by a state tax agency's exercise of its broad discretionary powers to adjust the entire net income of taxpayers to reflect "true earnings" in the state.
"If a state routinely tries to exercise broad discretionary power, it almost has an obligation to publish guidance on that," Lard said, and yet that practice is neither routine nor required when it comes to a tax agency's exercise of its discretionary powers. Lard said that a tax agency might be forcing combined reporting, adding back related-party expenses, or making transfer pricing adjustments under IRC section 482-type authority -- and a corporate taxpayer won't have insight into the agency's position unless it hires someone who is privy to inside conversations to represent it on the matter.
North Carolina, New York City, and New Jersey provide case studies from the past year of the wide range of approaches taxpayers and their advisers encounter from tax agencies when it comes to sharing clear information on revenue officials' plans to apply their discretionary authority.
North Carolina Forced Combination
One extreme example of a tax agency's resistance to providing transparency in how it exercises its discretionary authority is well documented in Delhaize America, Inc. vs. Hinton, Secretary of Revenue of the State of North Carolina.1 In that case, the North Carolina Department of Revenue was alleged to have applied unpublished guidance to force the combination of affiliated corporations. Discovery in the case revealed troubling communications between DOR officials. For example, in one e-mail, a DOR official contends that issuing combination guidance "would be like handing a gun to the guy who is about to rob you."2 In another e-mail, a DOR employee offered to share some guidelines auditors had received on combination with a person outside the department provided the recipient promises to "not EVER divulge the source from whence it came" and "to not share the information with others" (emphasis in original).
The North Carolina DOR also went to great lengths to assert that any information that appeared to be guidance could not be relied on as guidance regarding when auditors would require combined reporting. Auditors were instructed that information should be considered "factors that go into our decision" that "in absolutely no circumstance should be . . . communicated to a taxpayer, in any way, for any reason."3 The DOR actually went so far as to refuse to provide guidance to auditors for fear that the guidelines would "eventually fall into the hands of the dreaded Jung Hoard (also know[n] as [taxpayers] and their representatives) and will be used against us."
The trial court, unsurprisingly, took issue with the department's behavior. "The opinion details how the DOR spent great efforts to avoid providing combination standards to taxpayers," said Lard. "Tax administration where no taxpayer really knows the rules is incredibly irritating to taxpayers who are expected to voluntarily comply." The trial court agreed. When analyzing the 25 percent negligence penalty assessed by the department, the court wrote that the "Secretary may not change the policy (which had been previously announced) while failing to issue guidelines on the new policy, and then assess a penalty on a return the taxpayer could not originally have filed and on a basis for which the Secretary refused to provide guidelines not only to taxpayers, but also to its own staff."4
After the egregious behavior was uncovered, the North Carolina General Assembly passed HB 619, which limits the secretary of revenue's authority to require combination.5 The bill provides that combination may be required or adjustments made only after it is found "as a fact that the corporation's intercompany transactions lack economic substance or are not at fair market value."6 HB 619 also provides specific definitions for economic substance and, by limiting the DOR's authority, provides protections for taxpayers. The threat of penalties is also removed by the bill for taxpayers that comply with combination orders on audit.7
NYC Proposed UBT Audit Position
Another example comes from New York City, where it's unclear whether the Department of Finance has already adopted a new unincorporated business tax (UBT) audit position that it has informed some taxpayers and practitioners it may be asserting against private investment funds.8 The only reason the state tax world knows the department may be considering adopting a new position on audits of investment fund managers that departs significantly from long-standing policy is that advisers from accounting firms first encountered the development during the audit process -- and then reported the department's informal advice in legal alerts to clients. The department is not required to make a public pronouncement of an audit position, and the city has not published guidance about the position change. The simple explanation might be that the department is in the process of considering that change and nothing has been finalized. But according to a PricewaterhouseCoopers client alert, tax officials claimed during the audit proceedings that Mayor Michael Bloomberg (I) has been briefed on the proposed change and has authorized the department to proceed with audits under the newly developed position.
When asked questions about the position, the department forwarded the following statement to Tax Analysts:
One of the areas of responsibility of the Finance Department's audit division is the issue of expense attribution among related parties. Whether the expense attribution is appropriate or not requires an analysis of the specific facts in a case. We are currently reviewing expense attribution for the investment partnership industry, as we have done for other industry sectors.
Although it's not at all clear from that e-mail, the department is allegedly preparing to assert a position that would shift expenses from the investment management entity in a private investment fund to the entity that receives carried interest. That shifting of expenses would increase the investment management entity's UBT liability because the entity would have fewer expenses to deduct. And because the carried interest entity is generally not subject to UBT, it does not benefit from having the expenses to deduct. The possible change is likely that the city is trying to avoid having to enact legislation that would subject carried interest to UBT, but would still glean some additional revenue from private investment funds.
PwC reported the city's position is that a portion of the expenses of the investment manager entity is attributable to earning the incentive allocation and should be reallocated to that general partnership. But the accounting firm says that the department has no specific section 482-type authority under the UBT to justify the proposed disallowance of expenses of the investment management entity. It's hard to debate this possibility when the department hasn't made public either its possible position change or the reasoning behind it. Though not required to make a public pronouncement before taking a new audit position, the department still may formally do so through a new position in a Statement of Audit Procedures. In the meantime, to date no taxpayers or taxpayers' advisers have reported the department issuing tax assessments under the possible new policy.
New Jersey Guidance on Transfer Pricing and APAs
The New Jersey Division of Taxation is an example of a revenue department attempting to make strides in the right direction by publishing guidance on how it plans to exercise its discretionary authority -- and provides an illustration of how such a move comes in fits and starts. In 2011 the division issued technical advice on intercompany transfer pricing that appears to be the first published guidance from a state explicitly addressing advance pricing agreements. In Technical Advice Memorandum 17, issued June 2011, the division stated it will consider -- but isn't bound by -- a taxpayer's APA with the IRS and may use other criteria to determine "fair and reasonable" tax due to New Jersey.9
TAM-17 set off a flurry of speculation among practitioners, many of whom took the technical advice to mean the state would disregard hard-won APAs in favor of the findings of controversial third-party auditors who help a state build support for IRC section 482 transfer pricing adjustments. In comments to Tax Analysts, however, Michael Bryan, director of the New Jersey Division of Taxation, clarified the intent behind the guidance. "It wasn't that we were leaving a window open to disregard APAs," he said. "It's that I wanted to publicly obligate my division to consider them because taxpayers spend a lot of time and money getting those agreements with the IRS. That is really the intent here."
Bryan was appointed director of the division in 2010. He started his career as an IRS revenue agent and most recently managed all tax controversy issues for Comcast Corp. as senior director for tax audits and international tax. Bryan said that since taking the helm at the division he'd had many discussions with practitioners about how the tax division approaches APAs. "There was a perception that the division is just taking APAs and ignoring them completely," Bryan said. "That's a conversation I've had pretty consistently with Big Four folks and other practitioners. I wanted to obligate us to give APAs credibility."
"We're not trying to broaden the statute; that wasn't the intent," Bryan said. "We're trying to make public what the expected behavior of the Division is in New Jersey."
When asked whether New Jersey has an issue with any transfer pricing method used by the IRS under section 482 -- such as the residual profit split method -- Bryan said, "No, we just weren't headed that way." He added that he understands how taxpayers and their advisers sometimes read more into published guidance than revenue directors intend, but TAM-17 was "more process-oriented." "We're not trying to broaden the statute; that wasn't the intent," Bryan said. "We're trying to make public what the expected behavior of the Division is in New Jersey."
Practitioners noted that publication of the technical advice provided indirect state recognition of an audit practice long believed to be occurring. "I think Director Bryan has essentially confirmed that there were a number of audits occurring where APAs were reviewed," said Jim Venere, a managing director in KPMG's State and Local Tax practice in Short Hills, New Jersey. He said that taxpayers and their advisers appreciate any guidance from tax departments generally and called Bryan's statements reassuring -- a "welcome comment" that the TAM was "intended to provide direction to the New Jersey Division of Taxation and to taxpayers in the community about how and in what manner it would consider and use APAs as part of the audit tool process."
Daniel De Jong, tax counsel for the Tax Executives Institute, agreed, saying that "it's good for taxpayers to know that this wasn't leaving the door open for massive disregard of APAs, and instead it was meant to reinforce the respect those agreements deserve." He added that it's a positive development generally that New Jersey issued the TAM: "These days it is very important for taxpayers to receive guidance as the tax codes of all states have become increasingly complex," De Jong said.
Venere and De Jong both said TAM-17 left some lingering uncertainty for taxpayers about what specific circumstances would cause the division to diverge from an IRS-approved APA. Perhaps responding to that uncertainty, the division decided to take a second stab at describing when it will honor an APA and when it will use its discretionary authority to adjust a taxpayer's entire net income. In February the division replaced TAM-17 with new technical advice that it intends to codify in a regulation. The new guidance specifies that "the Division will accept an APA or third-party pricing study between a taxpayer and the Internal Revenue Service as proper documentation and evidence in the evaluation of intercompany transfer pricing and the determination of 'fair and reasonable tax.'"10
On the application of APAs in an arm's-length analysis, the replacement technical advice says that "in most cases" the division will use IRC 482 standards in auditing and adjusting items above line 28 of Schedule A of the return -- and that in most circumstances, APAs and their content, including pricing methods, economic assumptions, and analysis and market valuations, will be respected by the division. The TAM still explains that the director has the authority to examine these agreements and challenge their underlying assumptions and interpretations in determining a taxpayer's entire net income if the "true earnings of the taxpayer on its business carried on in this state" are not reflected by the terms of the APA or advance pricing study at issue.
In the past few years, states have shown an increasing willingness to use their discretionary authority to adjust taxpayers' incomes. Although potentially worrisome for taxpayers, with proper transparency, this trend is less troubling. If taxpayers are provided adequate guidance on when revenue officials will use their discretionary authority, taxpayers are able to anticipate the consequences of a specific transaction or position. Taxpayers are also in a better position to challenge a state that may be abusing its discretionary authority. And, transparency and consistency benefits states by creating more efficient enforcement of tax laws. In the end, transparency creates a better tax system by creating the certainty that taxpayers crave and enabling a more informed debate about what constitutes fair tax administration.
1 Delhaize America Inc. v. Lay, No. 06 CVS 08416, N.C. Sup. Ct. (Jan. 12, 2011). (For the opinion, see Doc 2011-1227 or 2011 STT 14-22.)
2 E-mail from David Simmons, assistant director (interstate) of the Examinations Division, to interstate managers, Mar. 22, 2006.
3 Combination! What Do I Ask? June 2007, attached as Exhibit 4 in Plaintiff's memorandum in support of motion to amend complaint.
6 N.C. Gen. Stat. section 105-130.5A(b).
7 N.C. Gen. Stat. section 105-130.5A(k), 105-236(a)(5)(f).
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