Recent trends in state and local income tax rules have led to increasing questions about how to treat them under Financial Accounting Standard (FAS) 109 and Financial Accounting Standards Board Interpretation (FIN) 48. This article explores some of these trends and discusses options for handling them in light of the FAS 109 and FIN 48 requirements.
Generally, accounting for income taxes is governed by FAS 109 (now Accounting Standards Codification 740 — ASC-740), which uses the liability method of accounting. ASC-740 applies to all taxes (federal, state, local and foreign) that are based on income; in contrast, FAS 5 (now ASC-450) applies to non-income-based taxes (such as sales and use tax). ASC-740 is applied at the entity level.
FIN 48 (now ASC 740-10) requires companies to analyze income tax positions (taken in a previously filed return or expected to be taken in a future return) that are less than certain. ASC-740-10 also governs decisions not to file returns, the characterization of income, and interest and penalties. Only benefits from positions that are “more likely than not” (i.e., greater than 50 percent likelihood) to be sustained can be recognized in a business’s financial statements.
Recent trends in state and local income tax rules may have profound impacts on the analysis of uncertain tax positions and on possible recognition of such positions under ASC-740-10.
Trends in State and Local Income Tax
Examples of recent trends in state and local income tax that may have an effect on a company’s ASC-740-10 process include:
- Economic nexus;
- Combined/consolidated reporting;
- Single sales factor;
- Tax rate increases and decreases;
- Net operating loss limitations; and
- Treatment of alternative taxes.
Economic nexus — About 10 jurisdictions have enacted or approved economic nexus standards since 2007. This adds to a myriad of states that had such standards prior to 2007. As we discussed in depth in 2011 Tax Advisor Weekly issues 7 () and 12 (), many states have recently expanded nexus standards to include so-called economic nexus. Such standards typically are based on some level of quantitative contact with the state (a certain level of sales, for example) instead of the historical qualitative standard of physical presence. As a result, taxpayers may find themselves required by various jurisdictions to file returns where they may not historically have filed. Analyzing such requirements under ASC-740-10 can be challenging, especially since the U.S. Supreme Court has consistently declined to hear economic nexus cases since its 1992 Quill decision (requiring a physical presence in order for a state to require sales and use tax collection). Further, the nexus issue is typically one of the largest that taxpayers face in performing ASC-740-10 analyses. If no filings are made, no statute of limitations is tolled; therefore, the potential liability grows each year (with no old years disappearing). This adverse effect on the financial statements continues until action is taken to resolve the issue.
Combined/consolidated reporting — Since 2004, about 10 jurisdictions have enacted rules requiring related groups of corporations to file combined or consolidated returns. The change from separate company reporting to combined/consolidated returns can profoundly change a taxpayer’s overall state income tax posture. Further, some combined/consolidated reporting is elective, and the choice of filing method in such states can have dramatic consequences. Analyzing the differences in results (especially relating to the realization of prior year deferred tax balances) creates complications under ASC-740-10.
Single sales factor — Over the last several years, many states have moved to a single sales factor method of apportionment, rather than the traditional property, payroll and sales factors method. Generally, such changes are phased in over a period of years. The shift to single sales factor reporting can result in large swings in taxpayer liabilities in various jurisdictions. Deferred tax balances should be re-evaluated in light of such changes, as well as particular state changes in benefit that would result from a different apportionment percentage into the state.
Increases and decreases in state tax rates — Recent shortages of state tax revenues have led to increased state income tax rates in various jurisdictions over the last few years. Further, some jurisdictions have actually lowered rates over the same time period. Technically, when such laws are enacted, these are discrete events that should be factored into the ASC-740-10 analysis of cumulative deferred balances based on the phase-in timeline of such law changes.
Net operating loss (NOL) limitations — Largely as a result of the above-mentioned shortfalls in state revenues, several states have enacted limitations (usually for a specific period) on the use of NOLs. In addition, many of these new rules also extend the carryforward period that NOLs can be used (theoretically to make up for the limitation on their use in current periods). Obviously, the unavailability of NOLs and subsequent extension of the carryforward periods will have an impact on the cumulative deferred tax balances.
Treatment of alternative taxes — Most state income tax rules do not allow a deduction for state taxes “based on net income.” Such taxes as the Texas Margin Tax, the Ohio Commercial Activity Tax and the Michigan Business Tax are not traditional income-based taxes but have portions that could be construed as income-based. In fact, different states have taken different positions on whether such taxes are income-based or not. The treatment of these taxes needs to be examined on a state-by-state basis to determine if there will be an impact on the ASC-740-10 analysis. Further, if classified as non-income taxes, such taxes will not fall under the purview of ASC-740-10 (which is limited to income taxes) but will instead be governed by ASC-450.
Identifying and Reporting Areas of Uncertainty in State Income Tax Positions
As stated above, ASC-740-10 requires an analysis of a taxpayer’s uncertain tax positions. In attempting to identify such positions, there are several areas where taxpayers are more likely to find uncertain tax positions.
Analyzing states where the company is not currently filing tax returns may surface nexus requirements. Examining the company’s filing options (combined, consolidated, etc.) may lead to a discovery of different choices (or requirements) than those currently used. Consideration of any significant state income tax planning structures (especially given the aggressive audit postures of many states) may uncover uncertain tax positions. Recent transaction activity (reorganization, merger, acquisition, etc.) may lead to changes in state income tax requirements. And, of course, an examination of significant state tax audits in process or recently resolved will almost certainly lead to the identification of uncertain tax positions.
Once identified, uncertain tax positions must be analyzed to determine if the related benefits taken are more likely than not to be realized. This analysis assumes that all positions will be examined by the taxing authorities and that such authorities will have all information pertaining to the position. The likelihood that a position will actually be audited and examined is not taken into account in performing the analysis. It is also assumed that the highest level of tax authorities will examine the position.
This can lead to some interesting dilemmas. For example, assume that a taxpayer has discovered that one of its entities has sales to a particular state in excess of that state’s threshold amount of sales and therefore is deemed to have economic nexus and a subsequent filing requirement in that state. The court of last resort (the highest authority) in this case is the U.S. Supreme Court, as nexus is a constitutional issue. Yet, the Court has consistently declined to hear such cases.
Must the taxpayer consider the likelihood that the Court will ultimately decide to hear such a case into its ASC-740-10 analysis? The answer is no — ASC-740-10 does not require an assessment of the likelihood that the Court will hear the issue. Instead, the taxpayer is required to “step into the shoes” of the Court and attempt to analyze, based on precedent, what the Court would rule if it took the case.
Similarly, in other areas, taxpayers must analyze what tax authorities with access to all information would do under current state income tax standards. Examples would be analyzing prior state income tax planning positions for economic substance and business purpose issues, or analyzing the likelihood that a state may require forced combination and/or the disregarding of entities.
The current climate in state and local tax presents taxpayers with many challenges, not the least of which is identifying and reporting uncertain tax positions under ASC-740 and ASC-740-10. Further, the qualitative nature of the analysis of such positions necessarily means that there may not be clear guidance as to their ultimate treatment. Taxpayers must remain vigilant in monitoring changes in state income tax statutes and regulations in order to properly comply with ASC-740 and ASC-740-10.
Alvarez & Marsal Taxand Says:
Although complying with ASC-740 and ASC-740-10 is challenging, the qualitative nature of the underlying analysis and lack of clear guidance in many areas of state income tax law provides taxpayers with some flexibility in determining whether it is more likely than not that a particular position will be sustained. Of course, this requires a thorough, well-reasoned approach to examining the likely treatment of positions by taxing authorities. Finally, it is unlikely that the pace of change in state and local income tax will decrease, which will mean greater challenges for taxpayers in identifying and analyzing uncertain tax positions.
We would like to hear from you.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the US., and serves the U.K. from its base in London.
Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in nearly 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.