United States: SALT Legislative Outlook, Trends And Predictions For 2011

Twelve months have passed since our release last January detailing what we thought would happen in the state and local tax world in 2010. Our global conclusion in the 2010 legislative outlook, trends and predictions alert was that many states that had cut services and used accounting measures to balance budgets in 2009 would be required to impose pure tax rate increases or significant state tax reform in 2010. In fact, 2010 featured more of the same. States dealing with the struggling economy combined with continuing budgetary distress for the most part found new and inventive ways to avoid tax increases and reforms, by relying on larger cuts to services and a continued pipeline of funds from the Federal stimulus program. States were insistent on not actually trying to change their tax structures, though there were a number of state tax reform commissions offering up suggestions on how to do it.

Throughout 2010, the states' budgetary situation became more precarious, and now as state legislatures open for business in 2011, the question is raised yet again – is it possible for the states to somehow manage to avoid fiscal catastrophe without fundamentally altering how they collect their revenues? This overhanging uncertainty continues to make predicting what will happen a challenge. But the crystal ball beckons again, and we offer up our analysis of how we did with last year's predictions, and what can be expected to happen in state and local tax this year.

How did we do with last year's predictions?

• Even if the economy improves, the states cannot avoid further budgetary pain. We predicted that at some point in 2010, the states would be forced to accept additional federal funding in order to fill a large portion of these historic gaps, and this funding would be subject to a variety of strict conditions tending to undermine state autonomy. While it is debatable as to whether the United States' economy appreciably improved in 2010, it became even clearer that many states are in serious trouble with respect to their budgets. A sampling of the states' budgetary woes by the Center on Budget and Policy Priorities (CBPP)¹ continues to show large-scale weakness in 2011 and beyond, with most of the states expecting budget shortfalls in excess of $1 billion for fiscal year 2012, generally comprising 10 percent or more of the general fund budget.² While the federal stimulus programs already in effect have assisted states in fiscal trouble, no broad-based federal bailouts have been offered to date. Proposals that might have been considered in the past couple of years, including federal relief for state-mandated Medicaid payments, and federal support for state pension obligations and education programs appear to be losing steam in light of the recent political shift in Congress. This shift may cause states to potentially consider more radical means of balancing state budgets, including debt restructuring and pension benefit reforms.
• The bigger the state, the more major the changes to the corporate tax system. Specifically, we predicted that: (i) New York would adopt at least some of the items contained in the Department of Taxation and Finance's corporate tax reform proposals in 2010, including the full adoption of mandatory unitary combined reporting; (ii) the California business net receipts tax (BNRT) would not be enacted, but the state would reevaluate the legislation scheduled to be enacted in 2011, including a prospective provision to elect single sales factor treatment; and (iii) Illinois would raise tax rates instead of enacting a gross receipts tax. Of the three predictions, the California prediction came closest to verifying, as the BNRT was not adopted, and a series of corporate income tax provisions scheduled to be enacted in 2011 were reevaluated, though a statewide referendum created to repeal the provisions ultimately failed.³ New York did not change its corporate tax system, though the Department's ideas remain under consideration in 2011. As for Illinois, we were off by less than two weeks, as substantial corporate and individual income tax rate hikes were just adopted and will be in effect for all of 2011.⁴
• Amnesty will not be going away. We predicted that as a means to maximize revenue, at least five states would adopt amnesty programs in 2010. This prediction easily verified, as the District of Columbia, Florida, Illinois, Kansas, Massachusetts, Maine, New Mexico and Nevada all enacted tax amnesty programs last year. Michigan and Washington also passed tax amnesty programs in 2010 that will be in effect during 2011.
• The current version of the model apportionment act will not be going away either. Likewise, our prediction that the Uniform Division of Income for Tax Purposes Act (UDITPA) revisions to be undertaken by the Multistate Tax Commission (MTC) would not gain significant traction in 2010 came true. The MTC did commence work on drafting a revision of UDITPA this year, including revisions to Section 17, dealing with the sourcing of sales of items other than tangible personal property. However, the draft has not been released to the public to date, and the passage of these changes at the MTC level, and then to state legislatures, is far from assured, and potentially several years away from reality. Instead, states that have not been happy with the traditional UDITPA treatment of sourcing sales from services and intangibles have been bucking uniformity by starting to amend these statutes on their own.
• Legislative sessions will lengthen to deal with revenue shortfalls. We had predicted that at least five state legislatures would call for special or extended sessions in an effort to resolve budget issues, and this occurred, as Arizona, California, Kentucky, Minnesota, New Mexico, New York and Washington all held special or extended sessions in an attempt to resolve their budgets. We also predicted that a majority of these sessions would result in broad-based corporate tax increases or reforms intended to increase corporate tax revenue. However, the only state in which significant corporate tax increases or reforms took place in special or extended sessions in 2010 was Washington's revision of the Business & Occupation Tax for service providers⁵ (Colorado's significant tax reforms were undertaken in regular session). It should be noted that Illinois' significant corporate income tax increase occurred in a lame duck session of its legislature less than two weeks after the new year began.
• More broad-based federal tax legislation down the road will again result in state decoupling. We had expected widespread affirmative or implicit decoupling from additional federal tax legislation, and two examples come to mind where this has occurred. The Patient Protection and Affordable Care Act⁶ and the Health Care and Education Reconciliation Act of 2010⁷ amended the Internal Revenue Code (IRC) to exclude from taxable income the value of employer-provided health insurance and reimbursements for an employee's child who has not attained age 27 by the end of the tax year.⁸ Many states have not fully conformed to this provision to date, which is likely to come as a surprise to employees that thought their health care benefits could not be subject to a state income tax. Further, the Small Business Jobs Act of 2010⁹ included several measures that affect state corporation income tax liability, including an extension of bonus depreciation to property placed in service in 2010¹⁰ and an increase in asset expensing limits,¹¹ among other items. Many states have decoupled or plan to decouple from the bonus depreciation and asset expensing provisions in the next few months.
• Amazon rule legislation sweeps forward as physical presence rule is side-stepped. We predicted that at least seven states would consider the Amazon rule in this year's legislative sessions, and at least three more states would adopt the Amazon rule.¹² The first half of the prediction verified easily, as ten states proposed legislation on the Amazon rule in the first four months of 2010. While many state legislatures presented legislation on the issue, none of these states ultimately enacted the Amazon rule, so the second half of the prediction did not come true. However, the issue has clearly not gone away, and has instead morphed into several different types of efforts to police sales and use tax collections. States have started to put forth legislation either requiring out-of-state retailers with in-state affiliates to register under the sales and use tax, or requiring out-of-state retailers with a threshold level of sales to engage in significant disclosure activities. Colorado, which initially proposed an Amazon rule in 2010, ultimately adopted affiliate nexus and disclosure methods instead.¹³ Of course, there is still the specter of potential Federal legislation in this area, as the Main Street Fairness Act, which would require remote sellers to collect sales /use taxes in Streamlined Sales Tax states, was introduced into Congress again in 2010.¹⁴ While this legislation could be introduced again in 2011, passage of the bill at this time is not particularly likely.
• Credits and incentives: A push to live up to jobs agreements. In the area of credits and incentives, we had thought that several state and local jurisdictions would publish guidance on the ability to use the clawback remedy in cases where businesses are unable to generate the number of jobs promised. While we did not see published action relating to this issue, it has been our experience that this issue is inviting a fair amount of scrutiny at the audit level, especially as the job market remains in flux while companies struggle to meet guarantees to states that were made in a much better economic environment. At the same time, states want to retain as many jobs as possible and have to balance that need against the desire to fully enforce the jobs agreements.
• Property tax issues loom as values continue to decline. We predicted that at least one state appellate or state supreme court case decided this year would address how intangible items should be excluded from property tax assessments. We did not see any published action at the appellate level this past year that dealt with this specific issue, but note that much like our comments in the credits and incentives area, the fight commonly continues on this front at the audit level.¹⁵ One development that we have seen is that the stagnation of property values has resulted in unique fiscal problems for some counties, which are starting to consider issuing bonds as a method to paying valid taxpayer refund claims.
• The U.S. Supreme Court will grant certiorari on a case relevant to state and local taxation. As much as we had thought this would be the case, we proved that it can be safer to bet against the U.S. Supreme Court taking substantive action on anything, particularly as the Court has reduced its case load in recent years to less than 100 cases annually. The Court did not take any state and local tax case with significant substantive merits in 2010.

Our 2011 Predictions

1. Decoupling from 100 percent expensing provision is very likely.

Much like the last several years, some of what the federal government is giving to taxpayers is being taken away by the states as a result of selective decoupling activities. On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010¹⁶ was enacted, and took bonus depreciation to a new level. The new law generally provided for the full expensing of property that would otherwise qualify for bonus depreciation, if placed in service after Sept. 8, 2010, and before Jan. 1, 2012.¹⁷ In addition, once the 100 percent expensing provision expires, the 50 percent bonus depreciation provisions will remain in effect for property placed in service during 2012.¹⁸ Due to the magnitude of the expensing provision, the number of conforming states could be less than the number of states that historically have conformed to the annual 50 percent bonus depreciation provisions (and approximately two-thirds of the states decoupled from the most recent 50 percent bonus depreciation provisions). Once legislatures have a full opportunity to consider the 100 percent expensing provision during the course of the year, we predict that at least three-quarters of the states ultimately will decouple from this provision.

2. Reevaluation of gross receipts taxes.

From a revenue-generation perspective, gross receipts taxes can be very appealing, in that such taxes can be imposed at a lower tax rate than a corporate income tax, and taxpayers are required to pay a gross receipts tax even if they are not profitable. Meanwhile, the large states that recently enacted gross receipts taxes, Michigan, Ohio and Texas, will be closely watching how actual revenues from their taxes compare to what they expected to get. So the debate this year looks to be a little bipolar. State tax reform commissions will continue to evaluate, and in some cases, endorse the shift to a gross receipts tax or a hybrid tax system, and some state legislatures might want to take the plunge based on the findings of these commissions, buttressed by a good revenue score. On the other hand, Michigan's newly elected Governor, Rick Snyder, campaigned on the promise to eliminate the Michigan Business Tax (MBT) as currently formulated, replacing it with a flat corporate income tax. With a potentially compliant legislature, the Governor has a pretty good chance of getting what he wants. We predict that one state will seriously consider a shift from a corporate income tax to a gross receipts tax, while Michigan will substantially modify or eliminate the modified gross receipts tax portion of the MBT.

3. A second year in a row without a move to combined reporting.

Many had expected that the watershed year of 2009, in which Massachusetts, West Virginia and Wisconsin adopted mandatory unitary combined reporting, would usher in an era where most of the remaining separate reporting states would shift to combination. But that did not happen in 2010, in part because the perceived revenue effect of shifting to combination became less attractive in an uncertain economy. There will be a few jurisdictions that undoubtedly will consider combined reporting in 2011, including Connecticut, Rhode Island, the District of Columbia and Maryland, especially to the extent that such provision is scored to bring in more revenue into these states. While the shift to combined reporting is by no means dead and will continue to be an issue in the future, we predict that no states will adopt mandatory unitary combined reporting this year.

4. Defeat of California tax hikes at the polls.

New Governor Jerry Brown will be trying to balance a frayed California budget through a variety of spending cuts and tax increases. The tax increases must first be adopted by a two-thirds vote in the state legislature, and then endorsed by a majority of voters in a statewide election, which likely would be held in the late spring or early summer time frame. We have seen in recent years how difficult it is for voters to approve to increase their own taxes, even when the result of rejecting these taxes is draconian cuts in state government. A good example of this occurred back in November when the state of Washington chose not to enact a personal income tax on high-income individuals, even though most voters would not have been subject to the tax.¹⁹ To the extent that Governor Brown succeeds in getting a two-thirds majority of the state legislature in this effort (which by itself will be difficult), we predict that the California electorate will vote down any tax increases.

5. Disclosure becoming the avenue of choice in policing the sales and use tax.

In what appears to be a developing sales and use tax trend, Colorado and Oklahoma recently enacted substantial notice requirements for out-of-state retailers that make sales in these states but are not required to collect sales and use tax.²⁰ In both states, out-of-state retailers must notify purchasers that they have an obligation to pay use tax. Colorado also requires that out-of-state retailers provide annual notices to purchasers and annual statements to the Colorado Department of Revenue listing the purchasers and the amount of their total purchases. In addition, the MTC is developing a model statute that closely follows the Colorado statutory approach.²¹ The expectation is that disclosure requirements will encourage more out-of-state retailers to register with a state, as well as ensure that in-state purchasers are properly reporting their use tax liability. We predict that at least five states will propose disclosure requirements for out-of-state retailers that are not currently subject to the sales and use tax in this year's legislative sessions, and at least one state will enact this requirement.

6. Sales taxes on a broad array of services will be examined by state legislatures.

Historically, the sales and use tax has been imposed on the retail sale of tangible personal property, and in some cases, selected services. As the national economy has shifted from a manufacturing to a service-oriented base, and from a brick-and-mortar to electronic environment, sales tax collections have stagnated. In light of the new economy, states largely believe that the taxation of services should not be the exception, but the rule. Efforts to tax a wider array of services, including professional services, have been ongoing over the past few years, and this may be the year in which the perfect storm of financial need and political will obviates a push toward a more modern sales tax that goes far beyond traditional sales of hard assets. Opponents of such legislation are likely to vigorously fight each bill that is introduced. We predict that at least seven states will introduce legislation this year proposing a broad-based sales tax on an array of services, and we expect that at least one state will move forward and enact the legislation.

7. Individual income tax rates will rise.

As the recent experience in Illinois has shown, states are desperate for revenue, and the individual income tax may be an area where states will consider pushing for that revenue in the coming year. The increases could be accomplished in two ways: (i) a broad-based tax increase for all individuals along the lines of what Illinois has recently done; or (ii) the enactment or extension of "millionaire" taxes targeting high-income taxpayers. One reason why this may be a particularly popular time to raise individual income tax rates across the board or at the very least, on high-income taxpayers, is that the increase in state tax will largely be offset in 2011 by the recently enacted one-year reduction in the federal payroll tax.²² We predict that at least three states (other than Illinois) will enact legislation in this year's legislative sessions increasing individual income tax rates for at least some subset of their taxpayers.

8. Enactment / modification of more state estate or inheritance taxes.

Less than half of the states currently have a state estate or inheritance tax. Of those that do, many of the state estate tax laws decouple from the federal estate tax by providing an exemption amount that is much smaller than the new federal exemption limit of $5 million applicable in 2011 and 2012. Accordingly, estate planners need to be mindful of the potential state tax ramifications of estates that will not trigger federal-level taxes. At the same time, in this economic environment, the possibility of a progressive revenue source that an estate or inheritance tax affords will be of interest to cash-strapped states. We predict that at least three states will enact new state estate or inheritance taxes, or substantially modify existing state estate or inheritance taxes in the coming year.

9. More emphasis on reportable and listed transactions.

In recent years, a number of states have adopted reportable and listed transaction rules loosely based on federal income tax provisions. Sometimes, this legislation allows a state tax authority to determine what will be classified as a state-specific listed transaction. The California Franchise Tax Board recently published a notice characterizing certain transactions between corporations and partnerships undertaken to improperly inflate the denominator of the California sales factor, and substantially similar transactions, as tax avoidance transactions that are classified as listed transactions.²³ We predict that in the coming year, at least two states will: (i) adopt new reportable and/or listed transaction statutes; (ii) provide further administrative guidance on what constitutes reportable and/or listed transactions; or (iii) adopt rules defining the economic substance standards for transactions.

10. The U.S. Supreme Court will grant certiorari on a case relevant to state and local taxation.

If this prediction sounds familiar, well, it is. We made the same prediction last year, and we are not giving up hope just yet. One case that could be ripe for U.S. Supreme Court consideration this year, if appealed, includes the recently released KFC²⁴ case, in which the Iowa Supreme Court held that an out-of-state intangible holding company that licensed trademarks to restaurant franchisees was subject to Iowa corporate income tax on revenue earned from the use of its trademarks within Iowa. The case is notable for its detailed explanation of how the Iowa Supreme Court believes that the U.S. Supreme Court would hold that a state can impose an income tax on a business without actual physical presence in such state. In addition, the area of retroactivity seems particularly relevant for U.S. Supreme Court review, and the Asworth²⁵ case dealing in part with the enactment of legislation retroactively denying interest on tax overpayments for very lengthy periods of time could be the type of case that garners the Court's attention. Accordingly, we predict, once again, that the U.S. Supreme Court will do something substantive this year on at least one state and local tax matter – and we will be there to cover it when it happens.

Footnotes

1 On its Web site (www.cbpp.org ), the CBPP is described as "one of the nation's premier policy organizations working at the federal and state levels on fiscal policy and public programs that affect low- and moderate-income families and individuals." The CBPP "conducts research and analysis to inform public debates over proposed budget and tax policies and to help ensure that the needs of low-income families and individuals are considered in these debates." With respect to state tax issues, the CBPP "analyzes state budget issues including multi-state trends, the adequacy and equity of tax policies, structural budget issues, and budget transparency."

2 For a full report on the budgetary stress facing the states, see the recent CBPP report written by Elizabeth McNichol, Phil Oliff, and Nicholas Johnson, "States Continue to Feel Recession's Impact," Dec. 16, 2010 (http://www.cbpp.org/cms/index.cfm?fa=view&id=711 ). The report predicts sharply constrained state budgets in 2011, no diminishment in state budget problems in 2012, and declining federal assistance as the stimulus program ends. The report notes that states have dealt with combined budget gaps of over $430 billion since the beginning of the recession.

3 Prop. 24, also known as the Repeal Corporate Tax Loopholes Act, failed to garnish a majority vote on November 2, 2010.

4 P.A. 96-1496 (S.B. 2505), Laws 2011.

5 WASH. REV. CODE §§ 82.04.066, 82.04.067, 82.04.460(4)(a), 82.04.462.

6 P.L. No. 111-148.

7 P.L. No. 111-152.

8 IRC § 105(b).

9 P.L. No. 111-240.

10 IRC § 168(k).

11 IRC § 179.

12 Under the Amazon rule, out-of-state vendors are faced with a rebuttable presumption of taxability arising from sales generated by referral agreements with in-state residents. New York was the first state to adopt this rule. N.Y. TAX LAW § 1101(b)(8)(vi). North Carolina and Rhode Island have also enacted this legislation. N.C. GEN. STAT. §§ 105-164.8(b), 105-164.3(33c); R.I. GEN. LAWS § 44-18-15(a)(2).

13 COLO. REV. STAT. §§ 39-26-102(3)(b)(II), 39-21-112.3.5(3). It should be noted that the Illinois legislature recently passed an Amazon rule, which is expected to be signed into law in the near future. H.B. 3659, passed by the Illinois House and Senate on Jan. 6, 2011.

14 H.R. 5660.

15 It should be noted that the development of the Oklahoma business activity tax (BAT) in 2010 was steeped in a court decision dealing with the property tax treatment of certain intangible property. In Southwestern Bell Telephone Co. v. Oklahoma State Board of Equalization, 231 P.3d 638 (Okla. 2009), the Oklahoma Supreme Court held that intangible personal property exempt from ad valorem taxation was limited to specifically listed intangible personal property set forth in the Oklahoma Constitution. Under this holding, such intangible property also was subject to local assessment. This decision subjected intangible personal property to tax that previously was not subject to tax, and effectively would have resulted in a large tax increase. In response to this decision, the BAT was created as a revenue-neutral solution. The BAT is being imposed in lieu of ad valorem taxes on the intangible property of most persons doing business in Oklahoma, in order to preserve the pre-Southwestern Bell status quo.

16 P.L. No. 111-312.

17 IRC § 168(k)(5).

18 IRC § 168(k)(2).

19 Initiative Measure 1098, rejected by Washington voters on Nov. 2, 2010.

20 COLO. REV. STAT. §§ 39-26-102(3)(b)(II), 39-21-112.3.5(3); OKLA. STAT. tit. 68, § 1406.1, et seq.

21 Multistate Tax Commission Sales & Use Tax Uniformity Subcommittee, Draft Model Sales & Use Tax Notice and Reporting Act, Sept. 20, 2010.

22 Pursuant to P.L. No. 111-312.

23 FTB Notice 2011-01, released Jan. 6, 2011.

24 KFC Corp. v. Iowa Department of Revenue, Iowa Supreme Court, No. 09-1032, Dec. 30, 2010.

25 Asworth, LLC v. Kentucky Department of Revenue, U.S. Supreme Court, Dkt. 10-662, petition for certiorari filed Nov. 16, 2010.

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