NW Tax Wire What Is the Washington Business and Occupation Tax? - - PDF document

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The “three-legged-stool” model of state-tax systems holds that an ideal state-tax system will have a property tax, a net income tax, and a consumption (or sales) tax. The theory behind the model is that it allows a state to distribute the tax burden among as many different groups as possible. The Pacifi c North- west provides an interesting venue to study state-tax issues. Washington has property, gross receipts, and sales taxes but no income tax. Oregon has property and net income taxes, but no sales tax. Idaho has property, net income, and sales taxes. This means that a business

• perating in the tri-state area needs to

be relatively sophisticated with respect to the differences between these tax systems and plan its affairs accordingly. In the current era of state-tax law, the difference between a property tax and a net income tax is well accepted. Property taxes are generally ad valorem taxes based on the value of property in a

• location. Net income taxes are based on

a taxpayer’s income, minus expenses. Both property and net income taxes are occasioned by a status. A taxpayer incurs property taxes because the tax- payer owns property in a jurisdiction

• n the lien date. Similarly, a taxpayer

incurs a net income tax because the taxpayer is a resident of or has a taxable presence in a jurisdiction. Some states

• utside this region have franchise taxes.

These are also “status” taxes, since they are often based on a taxpayer’s capital

• attributes. Louisiana, for example, bases

its franchise tax on a taxpayer’s appor- tioned capital. Sales taxes, however, fall into the murky area of excise taxes. Excise taxes are broadly understood as taxes that are occasioned by specifi c events. They take a number of forms; the best- known excise taxes are sales taxes. For example, a taxpayer buys a television in Washington or Idaho. The vendor charges a sales tax on the event of the television purchase measured by the value of the television. Professor Hell- erstein notes that economists identify fi ve major types of general sales taxes: “(1) retail sales tax[es]; (2) single-stage excise [taxes] on sales by manufacturers

• r wholesalers; (3) multiple-stage ‘gross

sales’ or ‘turnover’ tax[es], applying to all sales by manufacturers, wholesalers, and retailers; (4) ‘gross income’ tax[es], applying not only to sales of tangible commodities but also to gross income from services; fi nally (5) the tax[es] on ‘value added’[, which] may be considered * * * general consumption, as well as * * * general business, tax[es].”1 When we discuss Washington’s tax regime, we typically compare the state’s business and occupation (“B&O”) tax regime to other states’ income taxes be- cause it is the primary state-level tax that most businesses pay and the incidence

• f taxation is on the business (meaning

that it cannot be passed directly through to the businesses’ customers).2 In fact, the B&O tax is an excise tax and is therefore more analogous to the state’s retail sales tax than to an income tax.3 Professor Hellerstein identifi es the B&O tax as a form of sales tax. It is a multistage tax that is imposed

• n a taxpayer’s revenues at each step
• f the supply chain. Because a single

taxpayer may perform multiple activi- ties giving rise to B&O tax in different categories, the legislature implemented the multiple-activities tax credit. This allows a taxpayer to take a credit and avoid paying B&O tax on different activities performed with respect to the same product.

(continued on page 5)

inside this issue

2 Who Watches the Watchmen? 4 Welcome to Washington . . .

What Is the Washington Business and Occupation Tax?

by Valerie Sasaki

valerie.sasaki@millernash.com

1 2 Jerome R. Hellerstein & Walter Hellerstein, State Taxation ¶ 12.01 (2010). 2 Nelson v. Appleway Chevrolet, Inc., 157 P3d 847 (Wash 2007). 3 2 Hellerstein, supra, ¶ 12.02, Table 12.1.

2 | miller nash llp | NW Tax Wire Oregon enjoys a reputation as a noncontroversial corporate income tax jurisdiction. The state requires a unitary combined fi ling method, so available separate company planning techniques have not been an issue. Two

• f the most dramatic changes in recent

years have been the Department of Rev- enue’s new rule on economic nexus and the legislature’s move to single-factor sales apportionment. Ho-hum . . . Every so often, however, a client’s unique facts will highlight an unusual point of law. That was the situation that gave rise to the Oregon State Bar Taxa- tion Section’s proposed 2011 legislation to address an odd quirk of Oregon statutory law. Section 316.032(2) of the Oregon Revised Statutes reads as follows: “Insofar as is practicable in the administration of this chapter, the department shall ap- ply and follow the administrative and judicial interpretations of the federal income tax law. When a provision of the federal income tax law is the subject of confl ict- ing opinions by two or more federal courts, the department shall follow the rule observed by the United States Commis- sioner of Internal Revenue until the confl ict is resolved. Nothing contained in this section limits the right or duty of the depart- ment to audit the return of any taxpayer or to determine any fact relating to the tax liability of any taxpayer.” The section was intended to direct taxpayers and the government to fed- eral pronouncements when Oregon law is silent on an issue. That makes sense, since the state adopts federal adjusted gross income as the starting point for its tax calculation. A recent case in the Oregon Tax Court, however, highlighted the pecu- liarity of the statute’s second sentence: “When a provision of the federal income tax law is the subject of confl icting

• pinions by two or more federal courts,

the department shall follow the rule

• bserved by the United States Com-

missioner of Internal Revenue until the confl ict is resolved.” Dep’t of Revenue v. Marks addressed the question whether the taxpayer’s property transaction met the require- ments for nonrecognition as a 1031 like-kind exchange.1 The Department

• f Revenue asserted that there were

confl icting federal

• pinions

about the treatment of this type of transac-

• tion. Thus, the Department asserted,

Oregon courts are bound to the posi- tion of the Commissioner of Internal

• Revenue. Judge Breithaupt determined

that there was no actual confl ict in the federal court opinions. Thus, he found that ORS 316.032(2) was not implicated. The issues that the Department’s argument raises are peculiar. First, one can easily foresee a situ- ation in which the Ninth Circuit Court

• f Appeals issues an opinion on an

issue and a second circuit (let’s say, for the sake of argument, the Fifth Circuit Court of Appeals) issues an opposite

• pinion on that same issue. Again,

for the sake of argument, let’s say the IRS Commissioner decides that the Fifth Circuit’s opinion is the correct

• answer. In that situation, did the Or-

egon legislature truly intend to have the Department of Revenue adhere to a po- sition of the Commissioner of Internal Revenue—and not to the holdings of its geographic circuit (the Ninth Circuit)? Second, in Marks, the Department asserted that the court—a component

• f the judicial branch of govern-

ment—was bound to the position of the federal government’s executive branch. Article III, Section 1, of the Oregon Constitution separates the authority of the legislative, executive, and judicial departments of government. Except in very specifi c and enumerated situ- ations, the executive branch does have authority over the judicial branch. Even

(continued on next page)

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1 Dep’t of Revenue v. Marks, No. 4797 (OTC Nov. 3, 2009).

| 3 then, it is the Oregon executive branch, not the federal executive branch. The Department cited a 1979 Or- egon Supreme Court opinion, Deblock

• v. Dep’t of Revenue, for the proposition

that where federal cases confl ict, the Department’s position (i.e., that of the Commissioner of Internal Revenue) is the correct rule according to ORS 316.032(2), so the Oregon courts should be bound to the Department’s (IRS’s) position.2 The Department asserts that in this situation, the only argument may be whether the Department cor- rectly interpreted the position of the Commissioner of Internal Revenue. The Department denies that the inquiry should be what the correct treatment of a tax item may actually be or what the Ninth Circuit’s view on the matter may be. Deblock involved the deductibility of job-related expenses when an individual taxpayer was away from home. In that case, the Oregon Supreme Court elected to defer to the Commissioner of Internal Rev- enue’s analysis and conclusions on the facts necessary to support (or refute) a deduction. Contrary to the Depart- ment’s interpretation, the Deblock court did not state that ORS 316.032(2) bound it to the position of the Commissioner

• f Internal Revenue.

It may prove instructive to review how other income tax jurisdictions han- dle a confl ict between federal courts. For this exercise, let’s consider Idaho and Iowa. Idaho is selected because it is geographically next to Oregon and, like Iowa and Oregon, adopts federal taxable income as its starting point for calculating Idaho taxable income. Iowa employs a single-factor sales analysis, and the Iowa Code was the original basis for the Oregon Revised Statutes. (California, perhaps an obvious geo- graphic choice, was rejected for this exercise because it does not technically start its income tax calculation with federal taxable income.) Idaho statutory law is silent as to the impact of a confl ict in federal law. The intent of the legislature in adopt- ing federal taxable income as a starting point is codifi ed as follows: “It is the intent of the legislature by the adoption

• f this act, insofar as possible to make

the provisions of the Idaho act identical to the provisions of the Federal Internal Revenue Code relating to the measure- ment of taxable income, to the end that the taxable income reported each tax- able year by a taxpayer to the [I]nternal [R]evenue [S]ervice shall be the identical sum reported to this state, subject only to modifi cations contained in the Idaho law . . . .”3 The statutory section that parallels ORS 316.032 merely states: “It shall be the duty of the state tax com- mission to administer the [tax laws].”

4

In contrast with Oregon, the Idaho State Tax Commission follows the in- terpretation of the Ninth Circuit Court

• f Appeals.5 Perhaps as a result of this

deference, we have been unable to lo- cate any Idaho tax opinion addressing a confl ict between the Ninth Circuit and the opinion of the Commissioner. Similarly, Iowa law requires the Iowa Department of Revenue to administer and enforce the Iowa tax laws.6 Iowa also explicitly authorizes the Director

• f its Department of Revenue to adopt

rules necessary to prevent confl ict with federal laws or regulations.7 But it does not bind the Director to the interpreta- tion espoused by a particular source. With these points in mind, the Oregon State Bar Taxation Section has proposed striking the second sentence of ORS 316.032(2). If passed, revised ORS 316.032(2) will read: “Insofar as is practicable in the admin- istration of this chapter, the department shall apply and follow the administra- tive and judicial interpretations

• f the federal income tax law.

Nothing contained in this sec- tion limits the right or duty of the department to audit the return of any taxpayer or to determine any fact relating to the tax liability of any taxpayer.” The proposed change is intended to help increase predictability in the administration of Oregon’s tax laws and cure a potential trap for taxpayers who might be unaware of this quirk in Or- egon law that can result in signifi cantly different taxable income for federal and Oregon purposes.

2 Deblock v. Dep’t of Revenue, 286 Or 735, 596 P2d 560 (1979). 3 Idaho Code § 63-3002. 4 Idaho Code § 63-2527(1). 5 See Idaho State Tax Commission, Ruling 7242 (June 22, 1994). 6 See, e.g., Iowa Code § 422.66. 7 Iowa Code § 421.17(27)(g).

“The Department denies that the inquiry should be what the correct treatment of a tax item may actually be or what the Ninth Circuit’s view on the matter may be.”

Who Watches the Watchmen? | Continued from page 2

NW Tax Wire | miller nash llp | 4 On April 23, 2010, Governor Chris- tine Gregoire of Washington signed Senate Bill 6143 (the “Tax Act”) into law, which is projected to raise $794 million for the state’s general fund. The Tax Act made two signifi cant changes to Washington’s Business and Occupation (“B&O”) tax statutes: First, the new B&O tax rules temporarily (through June 30, 2013) raise the tax on gross revenue from services from 1.5 percent to 1.8 per-

• cent. Second, and more signifi

cantly, Washington adopted a new “economic nexus” standard to determine whether a taxpayer has substantial nexus with the

• state. By eliminating the old physical-

presence requirement and establishing the new economic-presence threshold, Washington exposed many out-of-state service providers to B&O tax liability. What Is Economic Nexus? A state’s ability to tax nonresidents is limited by the U.S. Constitution’s Commerce and Due Process clauses. These clauses require a state wanting to tax a nonresident to demonstrate that the nonresident has substantial nexus,

• r a meaningful connection, with the

benefi ts provided to that nonresident.

Welcome to Washington: Expanded Nexus in an Age of Fiscal Uncertainty

(continued on page 6)

In the case of a sales tax, the U.S. Supreme Court held that a nonresident must have physical presence in order to have substantial nexus. Public Law 86-272 also creates a safe harbor for income taxes for a taxpayer whose ac- tivities are limited to sales solicitation. These protections do not extend to gross receipts or franchise taxes, such as Washington B&O tax. State revenue authorities all over the country are concerned that their ex- isting revenue laws are not responsive to recent changes in how businesses

• perate. A physical-presence standard

made sense when sales were conducted by “drummers” going from jurisdiction to jurisdiction with samples of goods to sell. Recently, various states began identifying activities that constitute a nonresident’s “purposeful availment”

• f a market and are suffi

cient to create an economic presence for the nonresi- dent in that jurisdiction. Refl ecting this trend, the Multistate Tax Commission (“MTC”) promulgated model “bright line” nexus standards. Several states, including Washington, have adopted some variation of the MTC standards. When Do You Have Nexus With Washington? Under the Tax Act, a service pro- vider’s B&O tax liability attaches if the provider has an economic presence in the state,1 without regard for whether any physical presence exists.2 Specifi

• cally, a nonresident taxpayer establishes

an economic nexus with Washington by having any of the following:

• More than $50,000 of real or

intangible property in the state;

• More than $50,000 of payroll

made to employees in the state;

• More than $250,000 of receipts

from Washington customers; or

• At least 25 percent of the busi-

ness’s total property, total payroll,

• r total receipts in the state.3

Once nexus is established, there is a rebuttable presumption that it lasts for the current and following tax years. This “trailing nexus” provision is an improvement from Washington’s prior

• law. Under the prior law, nexus was

presumed to last for four years follow- ing the year that nexus was conclusively

• established. In other words, an out-of-

state service provider that previously did not pay Washington taxes may now face tax liability if its business dealings are signifi cantly related to the state. Washington’s move to adopt an economic-nexus standard refl ects a recent trend in state tax law. Although the MTC standards articulated the framework for these new laws, the Supreme Court’s denial of certiorari in Tax Comm’r v. MBNA America Bank5

• pened the fl
• odgates for states to

adopt economic-nexus statutes. In that case, MBNA was incorporated in Dela- ware and had no physical presence in West Virginia.6 Instead, the bank’s only connection was issuing credit cards to West Virginia residents and servicing the cards.7 When the state assessed both franchise and corporate income taxes against MBNA, the bank sued be- cause it did not have a physical presence in West Virginia.8 In upholding the tax, the West Virginia high court ruled that the physical-presence requirement did not apply to business franchise or corporate income taxes.9 The MBNA court offered several points for limiting the physical-pres-

by Valerie Sasaki

valerie.sasaki@millernash.com

by Jesús Miguel Palomares

1 2009 Wash SB 6143, sec 104, at 3-4 (amending RCW ch 82.04). 2 2009 Wash SB 6143, sec 103, at 3 (amending RCW ch 82.04). 3 2009 Wash SB 6143, sec 104(1)(c), at 4 (amending RCW ch 82.04). 4 2009 Wash SB 6143, sec 102(2), at 3 (amending RCW ch 82.04.220). 5 640 SE2d 226 (W Va 2006). 6 MBNA, 640 SE2d at 227. 7 MBNA, 640 SE2d at 227-28. 8 Id. 9 MBNA, 640 SE2d at 232.

5 | miller nash llp | NW Tax Wire

tax team directory

Members of our team are available to help you with any questions you have. E-mail us at clientservices@millernash. com or call us toll-free at 877.220.5858. Jeneé Gifford Hilliard Merril A. Keane William S. Manne Ryan R. Nisle Valerie H. Sasaki Ronald A. Shellan . . . Business and Occupation Tax? | Continued from page 1 All types of tax require that a taxpay- er have nexus, or a connection, with the taxing jurisdiction. Constitutional law is well settled that an individual’s physi- cal presence on behalf of a taxpayer in a taxing jurisdiction will allow the state to tax that individual. In Quill Corp. v. North Dakota,4 the U.S. Supreme Court examined the situation in which an

• ffi

ce supply company had no physical presence in North Dakota other than some fl

• ppy disks. That state was at-

tempting to require the taxpayer to pay use tax on sales shipped into the state. The Court held that under the Com- merce Clause, a taxpayer must have “substantial nexus.” This is a higher standard than the “minimum contacts” that the Due Process Clause requires. The Court noted that in earlier cases, it had rejected a “slightest-presence” standard of constitutional nexus. Quill stands for the proposition that a taxpayer may have some minimum contacts but not have substantial nexus. Since the Court’s opinion, au- thorities have read Quill to require a taxpayer to have a physical presence in a jurisdiction. Most hold that Quill should be narrowly read and is limited in application to sales and use taxes, since a use tax was at issue in that case. Others argue that since the income and franchise taxes are based on the same constitutional provisions at issue in Quill, other taxes require a taxpayer to be physically present in order for a state to be able to subject the taxpayer to its tax laws. Nowhere has this debate been more contentious than in the recent discussions surrounding the theory of economic nexus. Economic nexus is the idea that a taxpayer’s efforts to develop and main- tain a market in a state—even from

• utside the borders of the state—will

create taxable presence in that state. Most recently, in Tax Comm’r of W. Va.

• v. MBNA Am. Bank, N.A.,5 the Supreme

Court of Appeals of West Virginia held that the Commerce Clause did not require a physical presence for purposes

• f the state’s corporate net income tax.

In that case, MBNA had no physical presence in West Virginia but derived $8 million in 1998 and $10 million in 1999 from customers located in West

• Virginia. The Supreme Court denied

MBNA’s petition for certiorari review

• f this decision. After that denial, many
• ther states adopted economic-nexus

standards. Most jurisdictions that are applying an economic-nexus standard are doing so with respect to taxes based on a taxpayer’s apportioned net income from that state.6 As a nod to Quill, states have not generally asserted economic nexus in the context of sales, use, or other excise taxes. The Washington Supreme Court is currently considering the limits of min- imum contacts and substantial nexus with Washington. In Lamtec Corp. v.

• Wash. Dep’t of Revenue,7 the taxpayer

manufactures vapor-retarding facings for insulation. For the periods at issue, it shipped products into Washington via common carrier. It also had sales repre- sentatives who would infrequently visit existing customers in the state. These visits were largely social and designed to provide the existing customers with information about the company and its

• products. The taxpayer is asserting that

those visits do not rise to the level of “es- tablishing and maintaining a market” in Washington. The state is asserting that, under Quill, physical presence in a state is suffi cient to subject that tax- payer’s sales to B&O tax. Interestingly, both the taxpayer and the state in Lamtec appear to agree with Professor Hellerstein that the B&O tax is most closely analogous to a sales

• tax. Although the taxpayer appeared to

confl ate B&O and net income taxes dur- ing oral argument (when talking about the possibility of double taxation), the taxpayer clearly would not be subject to tax based on these activities in a juris- diction that imposed a net income tax. Jurisdictions that impose a net income tax are subject to Public Law 86-272. This federal law prohibits states from imposing their net income taxes if a tax- payer’s only activities in the jurisdiction are the solicitation of sales of tangible personal property. As discussed elsewhere in this edi- tion of Northwest Tax Wire, Washington has recently adopted an economic-nexus

• standard. If a taxpayer with no physical

presence in Washington has more than $250,000 of receipts from Washington customers, Senate Bill 6143 would sub- ject the taxpayer to the state’s B&O tax. Given that all sides agree that the Wash- ington B&O tax is very much like a sales tax, it remains to be seen whether this new law will survive constitutional scru- tiny if, or rather when, it is challenged.

4 504 US 298, 12 S Ct 1904, 119 L Ed 2d 91 (1992). 5 No. 33049 (W Va Nov. 21, 2006). 6 Ohio has also adopted this standard for its commercial activity tax. A discussion of this tax is outside the scope of this analysis. 7 No. 83579-9 (Wash.).

NW Tax Wire™ is published by Miller Nash LLP. This newsletter should not be construed as legal opinion on any specifi c facts

• r circumstances. The articles are intended for general informational purposes only, and you are urged to consult a lawyer con-

cerning your own situation and any specifi c legal questions you may have. To be added to any of our newsletter or event mail- ing lists or to submit feedback, questions, address changes, and article ideas, contact Client Services at 503.205.2608 or at clientservices@millernash.com.

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Welcome to Washington . . . | Continued from page 4 ence requirement to sales and use taxes. Signifi cantly, the court distinguished sales and use taxes from income and franchise taxes, stating that the lat- ter’s regulation was simpler and thus enforcement did not place an undue burden on interstate commerce.10 Also, the court stated that a physical-presence requirement no longer made sense, given the modernization of today’s business world.11 Opponents of broader adoption of economic-nexus standards base their

• pposition on two main points: First,

adopting a substantial-nexus require- ment based on less than physical presence violates the Commerce Clause because earlier cases emphasized the need for separate Due Process and Commerce Clause analyses, and an economic-nexus test would look to eco- nomic connections for both. Second, an economic-nexus standard based solely

• n the economic benefi

ts derived from a state risks allowing taxation by mul- tiple states and thus would be an undue burden on interstate commerce. The adoption of an economic-nexus standard is attractive to state lawmak- ers because it expands a state’s tax base beyond the boundaries of the state to (nonvoting) nonresidents who do not have any physical connection with the

• state. As we have seen with other states,

in these economic times, state revenues are stagnant or declining, so there is a signifi cant incentive to tap new revenue

• sources. Washington’s budget defi

cit for the 2009-2011 biennium is expected to be at least $2.6 billion. The Tax Act’s economic-nexus provisions alone are expected to raise $260.9 million by the end of 2012, or about 10 percent of the projected shortfall.12

10 MBNA, 640 SE2d at 233-34. 11 MBNA, 640 SE2d at 234 (“we believe that the mechanical application of a physical-presence standard to franchise and income taxes is a poor measuring stick of an entity’s true nexus with a state”). 12 Washington State Offi ce of Financial Management Fiscal Note Summary for SB 6143 2ESSB AMC Conf H5847.5, at 10 (Apr. 19, 2010).