«Multistate Tax Commission Policy Statement 02-02 Amended October 17, 2002 02-02 Ensuring the Equity, Integrity and Viability of State Income Tax ...»
Multistate Tax Commission Policy Statement 02-02
Amended October 17, 2002
02-02 Ensuring the Equity, Integrity and Viability of State
Income Tax Systems
The right of a state to tax a fair share of interstate commerce that occurs
within its borders is an essential element of sovereignty guaranteed under
the U.S. Constitution. The exercise of that right by a state is fundamental to
the proper allocation of the costs of governmental services to those who
benefit from those services, which includes in-state residents and businesses and out-of-state enterprises engaging in business within the state.
Otherwise, in-state residents and businesses will be unfairly burdened by the cost of services attributable to economic activity of out-of-state enterprises.
A primary means by which states tax a share of interstate commerce is by taxing income earned within its borders. To be fair to all taxpayers income should be properly measured and divided among states in reasonable relationship to where the income was earned. Businesses earn income by engaging in activities of supply that meet customer demand. Engaging in either supply or demand activities beyond de minimis levels is evidence that the enterprise is doing business within a state, earning income within its borders and benefiting from the opportunities and services provided by that state.
Unfortunately, in recent years the increasing use of business tax sheltering methods has significantly undermined the proper accountability of income reporting by many multistate enterprises that are both willing and able to engage in aggressive tax avoidance. The extensive use of business tax shelters undermines the equity, integrity and viability of state income tax systems. Federal proposals to restrict state authority to impose business activity taxes will serve to legalize and expand tax shelter opportunities for a large segment of multistate businesses and further shift the tax burden unfairly to local citizens and businesses.
The recent rise in business tax sheltering compounds long-standing problems of ensuring proper accountability of income reporting from multinational corporations. In 1990, a congressional subcommittee estimated that the federal government lost $30 billion annually due to widespread international transfer pricing practices that shift income earned in the United States to tax haven locations. That $30 billion in lost federal revenue translates into approximately $6 billion of additional revenue lost at the state level. Federal efforts to solve the transfer pricing and other international income shifting problems have been ineffective.
Widespread international and domestic tax sheltering adversely affects the economy. Earning statements that are inflated by unproven tax shelters mislead investors as to the true value of a corporation’s actual business activity. Capital ismisallocated away from prudent enterprises that are diligent in their tax reporting obligations and toward corporations that engage in risky tax planning methods. Recent spectacular corporate bankruptcies underscore the fact that some companies that engage in aggressive tax planning methods only postpone the inevitable day of economic reckoning and, in the process, harm both investors and employees.
Beyond the problems of tax equity, improper reporting of income for tax purposes creates significant economic harm.
The Multistate Tax Compact charges the Commission with facilitating “the proper determination of the state and local tax liability of multistate taxpayers, including the equitable apportionment of tax bases...” The Compact was developed to preserve the sovereign authority of states to tax a fair share of interstate commerce occurring within their borders. Accordingly, the Commission by law and history is committed to advancing the full accountability of income reporting in reasonable relationship to where income is earned. A major portion of the activities of the Commission and its member states is devoted to this purpose. The Commission urges Congress and the Administration to support the states in achieving that purpose and, at a minimum, refrain from any actions that further undermine the equity, integrity and viability of state income tax systems.
2.2 Federal Support for Ensuring Full Accountability of Income Reporting
The Multistate Tax Commission strongly supports efforts by federal and state governments to enact legislation and regulations to insure full accountability in income reporting by individuals and business entities. The federal government asked the states to refrain from the use of worldwide combined reporting on the basis that the states should allow the federal government to handle international division of income issues. In exchange, the states were promised improved federal efforts to solve international income reporting problems and federal assistance in administering their corporate tax systems, including a federally-administered “domestic disclosure spreadsheet” to document the state income tax reporting practices of corporations. While the states honored the federal government’s request to refrain from using worldwide combined reporting, the federal support for the states has not been forthcoming. Moreover, the federal efforts to resolve the international income reporting problems remain inadequate because they are based on an “arms length” method of accounting that simply does not work in either theory or practice in the context of the modern global economy. The federal government should honor its earlier promises to the states of support for corporate income tax administration. The federal government should recognize as well the superiority of formula apportionment over arms length accounting and adopt methods of dividing international income pioneered and effectively applied by the states. Finally, the federal government should continue to upgrade its general efforts to counteract abusive tax shelter activity that undermines both federal and state income tax systems.
Specifically, Congress should undertake the following steps to ensure the
proper reporting of income:
• Enact legislation to undertake an orderly process of converting to formula apportionment on a worldwide basis employing the unitary business principle as the correct approach to properly dividing the income of multinational enterprises.
• Enact legislation that eliminates the tax benefits from “corporate inversions” under which U.S. corporations incorporate in off-shore tax havens to escape federal and state corporate income taxes while continuing to operate in the United States. Such legislation would be a transition measure until the federal government fully converts to a formula apportionment system applied on a worldwide basis.
• Enact legislation requiring multijurisdictional taxpayers to file with the IRS a domestic disclosure spreadsheet. Each spreadsheet would list the taxpayer’s liability in each state in which it operates and disclose the method of calculation used to reach the result. The IRS would review the spreadsheets for accuracy and would share information contained on the spreadsheets with the states. The information should be shared under exchange of information agreements that support cooperative work by the states through the Commission or other joint instrumentalities to ensure the proper reporting of income. This measure would strengthen the ability of states to ensure proper corporate income reporting. It would provide a basis for a stronger partnership between the federal government and the states in working to curb abusive tax shelter activity.
• Enact federal legislation to impose effective penalties on taxpayers for failure to properly report income and on investors in and promoters of transactions the primary purpose of which is tax avoidance. Such legislation will encourage the proper reporting of net income for both federal and state income tax purposes.
• Enact federal legislation that prohibits taxpayers from relying on opinions written by tax advisors who benefit from contingency fee arrangement in which the tax advisor receives a portion of the tax savings from the tax planning methods on which they offer advice.
This legislation is necessary and important to help restore integrity to the tax system.
• Study methods of bringing into closer alignment statements of book income and taxable income and then take action to implement the most promising methods. Sophisticated accounting methods are increasingly used to inflate book income and deflate taxable income.
Strengthening links between book income and taxable income will help restore integrity to accounting for both.
To improve coordination with the federal government on curtailing international and domestic tax shelter activities, the Commission commits itself to assisting the federal government in developing a system of formula apportionment at the international level. Further, the states should consider the development of a process that parallels the federal process of requiring those who engage in abusive tax shelters to disclose those tax shelters for review in advance of the normal audit process. Such a process would build on the federal process and would focus on domestic tax shelter activities that shift income away from where it was earned to tax haven locations or to being reported nowhere.
2.3 Opposing Federal Efforts to Restrict State Business Tax Authority
The Multistate Tax Commission strongly opposes federal legislation that infringes upon state authority to tax a fair share of interstate commerce.
Currently, legislation is pending in Congress that would impose a federal nexus standard of substantial physical presence for imposition of business activity taxes. The U.S. Supreme Court has upheld on numerous occasions that the nexus standard for business activity taxes is not based upon a concept of physical presence, but instead is based on the privilege of engaging in business in the state. Further, the Court has never ruled that a business must have “substantial physical presence” in a state before it can be subjected to state taxing jurisdiction. In addition, the proposed federal legislation not only would impose a general physical presence standard, it would also create a list of “tax haven activities” that would allow a company to avoid the jurisdiction of a state despite engaging in income-producing activity there.
Nexus standards for the imposition of business activity taxes based on physical presence will legalize and expand the use of abusive tax shelter activities that are already undermining the equity, integrity and viability of state business activity taxes. The list of “tax haven activities” offers a specific blueprint for shifting income away from where it is earned to tax favored locations. The physical presence standard and the list of “tax haven activities” will allow many out-of-state enterprises that earn income from within a state and benefit from the services the state provides to escape paying a fair share of the cost of those services. Imposition of new limits on state business activity taxing authority by requiring an untested level of physical contacts by a taxpayer will inevitably lead to lengthy and expensive litigation to determine the full meaning of such laws. Finally, physical presence nexus standards discourage the flow of investment across state boundaries, and subvert national economic growth and balanced economic development among all geographic regions of the nation.
Instead of undermining the proper operation of state business activity taxes, the Congress should undertake the measures outlined above that would establish a cooperative federal-state framework for ensuring the proper accountability of income.
2.4 Commission Support for Simple, Certain and Equitable Factor Presence Nexus Standard for Business Activity Taxes The Multistate Tax Commission and its member states devote extensive efforts to improving the accountability of income earned by multijurisdictional enterprises. The federal proposals for limiting state business taxes through a restrictive nexus standard run counter to those efforts. At the same time, the Commission recognizes the need to provide taxpayers with clear guidelines regarding the jurisdictional standards for business activity taxes that would serve to protect multijurisdictional businesses from the burden of filing taxes in states in which they have only minor activity.