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June 30, 2014
Where Is Delaware Headed on Unclaimed Property?
by Doug Sheppard

Full Text Published by Tax Analysts®

featuring Joe Crosby, Kendall Houghton, Stephen P. Kranz, and Diann
L. Smith interviewed by Doug Sheppard

Joseph Crosby, Kendall Houghton, Stephen P. Kranz, and Diann L. SmithRaising the Bar provides fresh, incisive analysis of breaking state and local tax issues from the perspective of four seasoned SALT veterans: Kendall Houghton of Alston & Bird LLP, Joe Crosby of MultiState Associates, and Stephen P. Kranz and Diann L. Smith of McDermott Will & Emery. All four are former Council On State Taxation staffers.

This column is taken from interviews by State Tax Notes legal editor Doug Sheppard.

* * * * *

Delaware unclaimed property collection legislation (SB 215) stemming from a recent contingent fee audit controversy is the focus of the first installment of Raising the Bar. The pending bill would prohibit paying auditors on a contingent fee basis and would require the rebidding of third-party auditing contracts a minimum of once every three years.

SB 215 was introduced to address the state's relationship with Kelmar Associates LLC, its third-party auditor. Private sector representatives have questioned not only the firm's aggressiveness, but the fact that former state escheator Mark Udinski took a position with Kelmar after leaving the state Department of Finance.

We pick up the discussion -- which also touched on current developments in the taxation of cloud computing -- there.

Joe Crosby: I am unclear at this point in time how far the legislation will go. Delaware doesn't really get active until now. But I am thrilled that someone in the Delaware legislature finally picked up on the fact that they're paying Kelmar so much money. When I was at COST, that was information we tried to obtain from the state but weren't able to. And the argument for contingent fee auditing has always been that the state could never develop the capability of effectively auditing holders and needed to rely on third parties. When I find out the state spent something like $116 million in the past three years, I'm reasonably certain that for a substantially smaller sum, they could have developed fairly capable auditors given that they're able to audit all kinds of taxes -- which are much more complicated than unclaimed property is.

Stephen P. Kranz: We agree that you should leave state government employee work to state government employees, not outsource it to third-party contingent fee auditors. Taxpayers are the ones paying for government service -- those payments should go to fund government, not private parties.

Crosby: Or if you are going to outsource some parts of it, I accept that there are instances where states need outside expertise they don't have on hand. And that makes perfect sense, whether it's implementing technology solutions or particular legal specialties -- but they should be paid on an hourly basis for limited work, rather than essentially turning over the police function of government to an outside party.

Kendall Houghton: Your reference to the delegation of a core government function, Joe, brings to mind the numerous challenges we've seen in the state tax arena where audits have been outsourced to private third parties. And the plaintiffs have alleged that either public policy or their due process rights have been violated, because of the delegation of the decision-making authority as well as the function.

It is apparent to me that Delaware has attempted to control the audit function and take the position that it has not abdicated its authority -- but that's always a question when you have, essentially, 100 percent of your audit activity conducted by a small and select number of contract firms.

Crosby: And when you have the former state escheator going to that firm, and other members of state government going to that firm, retiring at fairly young ages from state government employment, it creates certainly an appearance of impropriety. Whether there's any actual impropriety I couldn't say.

Diann L. Smith: Which seems to be called out in the legislation itself in the beginning of it that isn't part of the proposed statute, but the beginning of the legislation says something along the lines of pointing out the ethics rules in the state regarding going into a private company from the state.

Crosby: And if the law was not violated, certainly the spirit of it was bent significantly.

Doug Sheppard: So are contingent fee auditors, for lack of a better way of putting it, more effective than state auditors? Are they more sophisticated? Or is it a parallel effort?

Crosby: That's a good question, Doug. I would not suggest they're more effective. What I would suggest is they have a pecuniary interest in extracting as much money as possible -- whether we're talking about unclaimed property from the target, the holder, or the taxpayer -- regardless of whether that's the proper and correct amount that the state should collect. So their motivations are inherently different from what the state's motivations ought to be, which is to ensure that holders turn over property that is actually unclaimed property -- where the rightful owner is not known or cannot be located. And in the tax arena, to collect the proper tax due. When you pay someone on a contingent fee basis, you're essentially paying them to collect or extract as much as possible regardless of whether they should be collecting or extracting.

Sheppard: Is there any situation in which states could make a contingent fee audit work, in other words, be acceptable to the private sector and not run into any of those issues you've raised?

Kranz: People are generally less concerned about contingent fee collection work when the liability is known, certain, and already established by the state. Using a contingent fee collection agency to obtain those funds doesn't raise the same concerns as a contractor calculating the liability; anytime you're talking about determining the liability, paying someone to perform that function crosses the line.

Crosby: And I would go back to something that Kendall said about core government functions. I think there are lots of areas where state governments can and should use contingency fees or performance-based fees -- however you want to consider them. But those are areas that are not core functions. Technology is not a core function of state government. Collections are not a core function of state government. But determining the amount of tax that's owed or the amount of property that is unclaimed is certainly a core government function that shouldn't be outsourced on a contingent fee basis.

Smith: And I think states learn something from performing audits themselves in the type of scenarios where you're trying to decide how much is due. And to outsource that kind of learning function means that you're also outsourcing what underlies a lot of the policy decision-making.

Crosby: That's a great point, Diann. In many ways, you don't fully understand as a state what the third parties are doing, and so you don't really have any control over it. Which means that the third-party, outside company has more information -- and thus, as we know in any transaction, the party with less information, in this case the state, is on the losing end of it. The revelation of the amount paid to outside auditors appears to be, in part, what's motivated the sponsors of this legislation.

Smith: There are a few other states that have, particularly in the unclaimed property area, to some extent prohibited contingency fee contractors. Oddly enough, there are a couple states that have prohibited them for in-state companies but not for out-of-state companies.

Houghton: North Carolina enacted the contingent fee ban on audits, including with respect to unclaimed property audits, but with the exception of audits of life insurance proceeds and bearer bonds. And that carveout was very clearly lobbied by the Verus firm, which is auditing insurance companies and banks on behalf of more than 30 states with regard to both of those property types.

Kranz: Let's discuss the unveiled qui tam suit in Delaware [ Delaware ex rel. French v. Card Compliant ]; what is happening to corporate taxpayers in the qui tam world will be worse than what has been happening to them in the Kelmar, contingent fee audit world. We're essentially, again, outsourcing a core government function -- this time not to a firm that understands how to conduct contingent fee audits in any way, shape, or form, but to a law firm that is going to try to resolve potential liability through litigation, and do so under a statute that was never intended to apply to unclaimed property, in the same way that the Illinois qui tam statute is being used for sales tax purposes.

Smith: Where should these types of policy decisions be made?

Kranz: In the legislature or the courtroom? Unfortunately, it looks again like the courts will need to decide.

Cloud Computing

Kranz: In the world of cloud computing, there have been a number of developments over the past few months that we hope signal a trend in state legislatures and courtrooms around the country. Two decisions came out of Michigan: the most recent at the court of appeals, Thomson Reuters, and before that, there was Auto-Owners Insurance . The two of them together, we believe, spell an end to the Michigan Department of Treasury's view that software as a service, infrastructure as a service, and platform as a service should be taxable as the sale of tangible personal property. Thomson Reuters was more on the information side of the world than the earlier decision in Auto-Owners, which was clearly a software case. But that's a state that's taken an aggressive position, and two courts now have beaten them back.

In Idaho, the State Tax Commission had taken an aggressive position regarding software as a service, and the Legislature has now twice passed exemption bills carving out software as a service from the definition of tangible personal property -- leading to it being treated as exempt.

And these developments are occurring as state policymakers and judges react to aggressive positions by tax administrators. And hopefully it will cause tax administrators to pause as they decide what their state's position is going to be in the software as a service and cloud world.

Smith: There were a couple of unfortunate things that I saw the state doing in the Thomson Reuters case. The position, according to the opinion, was that this was prewritten software because the service was accessed over the Internet -- there was a small amount of JavaScript that was actually downloaded temporarily onto the user's computer so that they could access the database. The state took the position that because there was a small amount of JavaScript that entered the user's computer, that was the downloading of prewritten software that made the entire thing subject to sales tax. And I thought that that was a very extreme position.

Houghton: Are you seeing, Diann or Steve, the same or similarly aggressive interpretations in audits? Obviously, we're talking about decisions here, and it's always gratifying to see a court come out in what we would characterize as the right place or in the correct fashion on an issue like this, but I guess I'm a little less optimistic that a handful of decisions will forestall those sorts of positions being taken on audit in the majority of the states.

Kranz: You're exactly right, Kendall. The audits are percolating out there, and only after they reach maturity and people decide that they're going to fight the state's position and wind up in litigation will we have other authority to point to. I'm hopeful that we're at the beginning of a trend.

Houghton: And you can certainly help develop the trend if you have clients who are willing to litigate the issue.

Kranz: And you can, too. We are already handling a number of challenges to state tax positions on cloud computing and expect that the work will continue to grow. Trends like this take years to resolve so there will be work for all of us.

Houghton: Oh yes, of course!

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