5 SALT Policy Issues to Watch in 2020 and Beyond

Digital Taxes

Frustrated by the OECD’s progress on developing agreed-upon tax principles applicable to digital transactions, some European countries have imposed digital services taxes. For example, the French DST is imposed on revenues from specific digital services — such as online marketplace facilitation, online sales data analytics, and digital advertising services — at a rate of 3 percent. But the French DST is limited to companies that generate more than 750 million euros in digital revenues worldwide, of which at least 25 million euros are deemed to be generated in France. As a result of this structure, the United States has opposed these taxes because they discriminate against large U.S. businesses. And in some cases, the United States has proposed 100 percent tariffs on foreign goods in retaliation for DSTs,¹ but so far, such drastic action has been avoided.

Despite the federal government’s opposition, we expect a number of states to consider similar levies, including taxes on digital advertising services. Whether by expanding the sales tax base (as with the District of Columbia, New York, and Nebraska) or adopting an entirely new regime (as with Maryland’s and one of New York’s proposals), recent state proposals have differed in their approaches to taxing digital advertising services, arguably the most significant state and local tax policy issue so far this year. Whatever the approach, digital tax proposals may be met with serious legal challenges. Specifically, most of the 2020 proposals — especially Maryland’s digital advertising tax, which the General Assembly passed but Gov. Larry Hogan (R) vetoed — discriminate against electronic commerce in violation of the Internet Tax Freedom Act and thus violate the supremacy clause. Depending on the structure and incidence of a digital advertising tax, the proposal may be unconstitutional under the commerce or due process clauses and may implicate the First Amendment’s protection of commercial speech. These U.S. constitutional limitations on state taxes raise doubt about the projected revenue that can be raised from these impositions. State policymakers should evaluate the expected legal challenges when considering a digital tax regime.

Transfer Pricing Scrutiny

While not a new phenomenon in 2020, states are expected to engage in aggressive audits, assessments, and litigation generally. One area that will likely produce increased controversy relates to income tax transfer pricing. While the IRS has engaged in headline-grabbing litigation with corporate taxpayers, states have litigated only a handful of cases. For example, in the See’s Candies case, the Utah Supreme Court concluded that the State Tax Commission abused its discretion by denying the entire intercompany royalty without considering federal IRC section 482 guidance and the taxpayer’s transfer pricing study.² Some states — including Georgia, Indiana, North Carolina, and Rhode Island — have scrutinized taxpayers’ related-party transactions and questioned whether these transactions reflect arm’s-length pricing. And several other states — such as Connecticut, New Jersey, and Louisiana — and D.C. rely on contingency fee-based auditors who are motivated by the outcome of transfer pricing audits.

States’ increased scrutiny of transfer pricing raises multiple problems. First, state tax authorities may abuse their discretion by not following the IRC section 482 guidance, as was the case in See’s. Second, states may lack the technical knowledge to scrutinize transfer pricing studies, and assessments may result based on an unfortunate reliance on third-party consultants using questionable audit methods. Third, states’ unwillingness to accept taxpayers’ transfer pricing studies or IRS methods may make it harder for the parties to come to an agreement out of court. The complexity and involvement of transfer pricing may lead to unnecessary, costly litigation.

Teleworking and State Taxes

As teleworking becomes more prevalent, the COVID-19 pandemic will have a significant effect on how and where employees work. Mandatory work-from-home policies are being relaxed and states are opening up at varying rates. However, some employers will allow their employees to telework permanently — beyond the COVID-19 declarations of emergency. Employers should be aware that extending these policies may trigger new tax obligations in states or localities where their teleworkers are performing their job functions.

If an employee teleworks in a different state than his employer, state tax issues could arise. First, an out-of-state teleworking employee may cause the employer to have nexus for corporate income, sales/use, local business license, or other business activity taxes. A case demonstrating this point is Telebright v. Director, Division of Taxation.³ In Telebright, the Superior Court of New Jersey held that a Delaware corporation with offices in Maryland was subject to the corporation business tax because it had a single employee residing in New Jersey and telecommuting.⁴ The court explained that the one employee created sufficient minimum connection with New Jersey under the due process clause because the employee “produc[ed] a portion of the company’s web-based product [in New Jersey], and the company benefits from all of the protections New Jersey law afford[ed] this employee.”⁵

Second, remote workers may significantly affect an employer’s state withholding tax compliance obligations. Even though a number of states have agreed — for the moment — to hold employers harmless regarding these tax obligations during the COVID-19 declarations of emergency, that relief may expire when the declarations are lifted. Also, many states have not issued guidance in the first place. As a result, employers may face additional tax risks during and after the pandemic.

Recently introduced federal legislation — the Remote and Mobile Worker Relief Act of 2020 (S. 3995) — would go a long way in providing employers and tax administrators with much-needed certainty. Generally, the bill would adopt safe harbors and bright-line rules for state taxation of remote workers, business travelers, and their employers. As we move to the “new normal,” a federal solution to state tax issues related to teleworking is sound tax policy that would encourage productive and safe teleworking arrangements.

State Compacts to Limit Tax Incentives

A growing number of states are considering limiting the use of tax incentives through a multistate compact or agreement. This development was highlighted by a “truce” in 2019 between Kansas and Missouri, in which the governors signed a compact prohibiting the use of state incentives to lure companies from one side of the border to the other.

The “Corporate Welfare Prohibition Compact,” if adopted by states, would limit tax incentives across the country. States are moving to individually adopt this compact, but the proposed terms of these laws appear to vary. For example, implementing legislation in some states has provided judicial standing — the ability to sue — to individual residents of that state, while other states have left enforcement to a commission.

The compact has been introduced in Alabama, Arizona, Illinois, Missouri, New York, Rhode Island, and Utah — but so far no state has enacted it. Political opposition to tax incentives may provide some momentum to enactment of the compact by some states. However, policymakers should consider the consequences of disadvantaging their state, as inevitably, some states will not agree to restricted use of tax incentives.

Increased Local Tax Issues

Localities will look for ways to increase their tax revenues, either through increased enforcement of existing taxes or through the enactment of new taxes. Recently, there has been increased interest in gross receipts taxes. Localities in California, Missouri, Pennsylvania, and Virginia allow local gross receipt taxes. San Francisco and Seattle are considering various new taxes. The following are some of the recent proposals and enacted taxes:

• San Francisco has a November 2020 ballot initiative to implement a gross receipts tax and administrative office tax on San Francisco city and county companies whose executive pay ratio exceeds 100:1.

• Portland has had a similar tax since 2016, which imposes a 10 percent surcharge on the city’s existing business tax for a company that exceeds a 100:1 executive pay ratio, and a 25 percent surcharge is added if the pay ratio exceeds 250:1.

• King County, Washington has a proposed bill to impose a head tax, with progressive tax rates based on employee pay.

• Chicago’s amusement tax survived a challenge to the federal Internet Tax Freedom Act, and other Illinois municipalities, such as Evanston, are proposing similar amusement taxes. The Illinois League of Municipal Cities is also circulating a model ordinance.

• Seattle adopted an ordinance to impose a payroll expense tax on large employers, effective January 1, 2021. The ordinance exempts businesses with payroll expenses of less than $7 million in the most recent calendar year and independent contractors whose compensation is included in the payroll expense of another business. For those employers not exempt, the tax will be imposed under the following rate structure:

  • for businesses with payroll expenses up to $99,999,999.99, the tax will be 0.7 percent of the payroll expense of employees with annual compensation of $150,000 to $399,999.99 and 1.7 percent of the payroll expense of employees with annual compensation of $400,000 or more;

  • for businesses with compensation expenses of $100 to $999,999,999.99, the tax will be 0.7 percent of the payroll expense of employees with annual compensation of $150,000 to $399,999.99 and 1.9 percent of the payroll expense of employees with annual compensation of $400,000 or more; and

  • for businesses with compensation expenses of $1 billion or greater, the tax will be 1.4 percent of the payroll expense of employees with annual compensation of $150,000 to $399,999.99 and 2.4 percent of the payroll expense of employees with annual compensation of $400,000 or more.

These new taxes and their enforcement pose legal and policy questions, and once enforced, may pose compliance complexities for taxpayers. A new tax often comes with litigation on whether the local jurisdiction has the requisite state authority to impose it.

From a policy perspective, unlike income taxes, gross receipts taxes do not fluctuate based on the profitability — and the ability to pay — of the businesses subject to them. These taxes ultimately have a negative economic effect, particularly on start-ups. Also, local ordinances are often not comprehensive enough to address the many issues raised by multistate businesses. For instance, some local gross receipts taxes address neither when a taxpayer has nexus in the jurisdiction, nor how to apportion a taxpayer’s gross receipts from in-state and out-of-state sources. For example, there is pending litigation regarding fair apportionment of local taxes in Pennsylvania and Virginia. And some of these issues have been playing out among the state-level gross receipts taxes in Oregon, Ohio, Texas, and Nevada.

Conclusion

While the proposals discussed may offer some short-term revenue, states and localities should consider the larger impact of adopting and administering new taxes and policies, especially in the midst of a pandemic and recession. State and local policymakers may be better off evaluating broader tax reforms that could have a meaningful long-term impact.