Revised December 22, 2005
CLAIM THAT PROPOSED FEDERAL “BUSINESS ACTIVITY TAX NEXUS”
BILL WOULD HAVE A NEGLIGIBLE IMPACT ON STATE REVENUE IS
FALSE AND DISINGENUOUS
By Michael Mazerov
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Background and Summary
A bill under consideration in the U.S. House of Representatives would strip states of authority they currently have to tax a fair share of the profits of many corporations that are based out of state but do business within their borders. H.R. 1956, the “Business Activity Tax Simplification Act of 2005,” was introduced in April 2005 by Representatives Bob Goodlatte and Rick Boucher.[i] The bill was approved (with minor amendments) by the Subcommittee on Administrative and Commercial Law of the Judiciary Committee on December 13, 2005. The National Governors Association has estimated that states could lose $4.7 billion to $8.0 billion annually if this bill is enacted.[ii]
What the Bill Does
H.R. 1956 would impose what is usually referred to as a federally-mandated “nexus” threshold for state (and local) “business activity taxes” (BATs).[iii] State taxes on corporate profits are the most widely-levied state business activity taxes. The term also encompasses such broad-based business taxes as the Michigan Single Business Tax (a form of value-added tax) and the Washington Business and Occupations Tax (a state tax on a firm’s gross sales). The “nexus” threshold is the minimum amount of activity a business must conduct in a particular state to become subject to taxation in that state.
Nexus thresholds are defined in the first instance by state law. State laws governing business taxation will set forth the types of activities conducted by a business within the state that obligate the business to pay the tax. If a business engages in any of those activities within the state it is said to have “created” or “established” nexus with the state, and it therefore must pay the tax on its in-state activities. Federal statutes can override state nexus laws, however, and H.R. 1956 proposes to do so in four key ways:
- H.R. 1956 declares that a business must have a “physical presence” within a state before that jurisdiction may impose a BAT on the business. This provision would nullify many state laws that assert that a non-physically-present business establishes nexus with the state when it makes economically-significant sales to the state’s resident individuals and/or businesses. In establishing this true “physical presence” nexus threshold, H.R. 1956 proposes to resolve in favor of business a lingering question as to whether state laws declaring nexus to be created by sales alone are valid under the Commerce Clause of the U.S. Constitution.
- Under H.R. 1956, moreover, some businesses could have a substantial physical presence in a state without creating nexus. The bill would create a number of nexus “safe harbors.” These are categories and quantities of clear physical presence that a corporation or other business could have in a state that nonetheless would be deemed no longer sufficient to create BAT nexus for the business. For example, the bill allows a corporation to have an unlimited amount of employees and property in a state without creating nexus, so long as neither is present in the state for more than 21 days within a particular year.[iv]
H.R. 1956 substantially expands an existing nexus “safe harbor” enacted in 1959, federal Public Law 86-272. P.L. 86-272 provides that a corporation cannot be subjected to a state corporate income tax if its only activity within a state is “solicitation of orders” of tangible goods, followed by delivery of the goods from an out-of-state origination point. The protected “solicitation” may be conducted by advertising alone or through the use of traveling salespeople (including residents of the state who work out of home offices). H.R. 1956 would expand the coverage of P.L. 86-272 to the entire service sector of the economy and apply it to all types of BATs, not just income taxes.
- H.R. 1956 would impose new restrictions on the ability of a state to assert BAT nexus over an out-of-state corporation based on activities conducted within the state’s borders by a (non-employee) individual or other business acting on behalf of the out-of-state business.
Why the Claim of a “Negligible” State Revenue Loss Is False
A previously-issued Center on Budget and Policy Priorities report explains why and how these new restrictions on the authority of states to impose taxes on many out-of-state corporations would directly reduce state BAT revenues and open up broad new opportunities for corporations to avoid paying state taxes on a large share of their profits. (See: Michael Mazerov, Proposed "Business Activity Tax Nexus" Legislation Would Seriously Undermine State Taxes on Corporate Profits and Harm the Economy, May 9, 2005, www.cbpp.org/9-14-04sfp.htm. Hereafter referred to as “the Center analysis of H.R. 1956.”) As noted, the National Governors Association has estimated that the enactment of H.R. 1956 would lead to state revenue losses of between $4.7 billion and $8.0 billion annually.
Proponents of H.R. 1956 vehemently dispute these analyses. They claim that H.R. 1956 would not — and is not intended to — reduce the aggregate amount of business activity taxes corporations pay to the 50 states collectively.
Underlying the claim that the enactment of H.R. 1956 would have no more than a “negligible” revenue impact on the states are a number of more specific assertions. These have been laid out in the greatest detail by the “Coalition for Rational and Fair Taxation” (CRAFT), which has been organized to lobby for the enactment of federal BAT nexus legislation.[v] These assertions — and their rebuttals— are as follows:
Assertion: States will not lose any revenue from the bill’s imposition of a true “physical presence” nexus threshold, that is, its declaration that “no taxing authority of a State shall have the power to impose . . . a net income tax or other business activity tax on any person . . . unless such person has a physical presence in the State . . . .”[vi] Notwithstanding state laws that assert BAT nexus is created by in-state sales alone, states simply are not collecting revenue from corporations that truly have no employees or property within their borders because court decisions have made clear such laws are unconstitutional. Accordingly, merely codifying a “physical presence” nexus threshold in a federal statute would not have any adverse impact on existing state revenues.
Rebuttal: Although the state of the law is unclear, a number of state courts have held that “physical presence” is not required under the Constitution for a state to impose a BAT on an out-of-state company that is earning income by making sales to its residents. Accordingly, a company that chooses to flout state laws that impose BATs on non-physically-present sellers risks incurring substantial penalty and interest payments. For this reason — and backed by some concrete evidence from ongoing litigation in Massachusetts — it seems likely that certain kinds of businesses, such as banks and franchisors, do pay corporate income taxes to states in which they have no employees or physical property.[vii] In any case, this provision of H.R. 1956 is the least significant one with respect to its potential impact on state revenues, because Public Law 86-272 already effectively imposes a physical presence nexus threshold on the entire goods-producing and goods-selling sector of the U.S. economy.
- Assertion: Those corporations that would be protected from nexus in certain states by the “safe harbors” in H.R. 1956 declaring certain types of actual physical presence to be non-nexus-creating do not supply a “material amount of revenue” to such states. Therefore, enactment of the safe harbors would not result in a significant revenue loss.
Rebuttal: The “safe harbor” provisions in H.R. 1956 that declare that BAT nexus will not be created by certain categories of physical presence within a state represent a vast expansion of the safe harbors available under P.L. 86-272. Taken together, these new safe harbors will ensure that few corporations will be taxable in states in which they do not have a permanent, “brick and mortar” facility. (See the previously-cited Center analysis of H.R. 1956 for a detailed explanation of why this is the case.) Under current law, in contrast, numerous corporations now have BAT nexus in multiple states because they temporarily maintain property and/or employees in the states or hire other businesses to represent them. If a company makes substantial sales in a state it can have a large tax liability to that state notwithstanding the fact that its physical presence there is relatively limited. Indeed, in an increasing number of states, the level of sales in the state is the only factor that determines how much tax a corporation with nexus owes.[viii] By ensuring that temporary physical presence would rarely create BAT nexus, the enactment of H.R. 1956 would eliminate significant tax payments to numerous states made by out-of-state corporations lacking a permanent presence within their borders.
Assertion: The fact that particular corporations are protected from taxation in particular states by provisions of H.R. 1956 does not mean that these businesses’ profits go completely untaxed. The legislation simply results in those profits or sales being taxed by the “appropriate jurisdiction,” that is, the jurisdiction that has a legitimate right to tax the profits or sales based on public services it provides to the physically-present business.
Rebuttal: About half the states do have laws in effect that ensure that if a corporation earns profit in a state in which its level of activity is insufficient to put it across the nexus threshold, that profit effectively will be taxed in one or more states in which it does have nexus. But the business community vehemently opposes these so-called “throwback rules” and has been very successful in blocking additional states from enacting them. Opposition by business and procedural hurdles, such as legislative “supermajority” requirements for tax increases, would make it extremely difficult to enact these fallbacks. As a result of the continuing lack of throwback rules in a large number of states, a substantial share of the profit earned by corporations that states would no longer have the authority to tax under H.R. 1956 would be “nowhere income” not taxed by any state. Collectively, states would lose significant amounts of corporate tax revenues were H.R. 1956 to be enacted.
Assertion: Assuming for the sake of argument that the enactment of H.R. 1956 would create some new opportunities for corporations to shelter their profits from taxation by restructuring their operations, states have ample mechanisms available to them to nullify these “tax planning” opportunities.
Rebuttal: In addition to “throwback rules,” proponents of H.R. 1956 cite a variety of other tax policy reforms that states could adopt to nullify any “hypothetical” tax-avoidance opportunities that would be opened up by the enactment of the bill. Most often cited are corporate income tax policies known as “royalty addback” laws and “combined reporting.” As they are with respect to “throwback rules,” these claims are disingenuous. The same business interests that are pushing H.R. 1956 have largely blocked states from enacting these policies or made sure that they were enacted in a substantially watered-down form. For example, only 16 of 45 states with corporate income taxes use “combined reporting,” and business opposition blocked its enactment in 11 of the 12 states in which combined reporting bills were introduced in the last three years. Royalty addback laws only nullify one of the many tax-avoidance opportunities opened up by H.R. 1956, and they have been enacted by only a dozen or so states in any case. Other potential tools that states could use to nullify tax-sheltering opportunities opened up by H.R. 1956, such as legal challenges based on the “sham transaction doctrine,” have a high burden of proof and require substantial legal and accounting resources to litigate successfully; few states could afford to bring such cases. Moreover, well-advised companies would have little difficulty in giving their tax-shelter arrangements sufficient economic substance to avoid nullification under this doctrine.
H.R. 1956 is intended to — and would— block states from taxing the profits of many corporations they are now taxing. While in theory state laws could be rewritten both to ensure that these no-longer-taxable profits are taxed by other states and to nullify many of the various tax sheltering opportunities the bill would open up, the business community has an excellent track record in stopping state efforts to close corporate tax loopholes. There is little doubt that the overall effect of H.R. 1956 would be to reduce significantly the aggregate amount of business activity taxes that corporations pay to the states collectively.
[i] No Senate counterpart to H.R. 1956 has been introduced.
[ii] National Governors Association, Impact of H.R. 1956, Business Activity Tax Simplification Act of 2005, On States, September 26, 2005, www.nga.org/Files/pdf/0509BAT.PDF.
[iii] H.R. 1956 applies equally to BATs imposed by local governments. This paper generally refers to states alone, however, because most of the discussion in it is applicable to corporate income taxes. Corporate income taxes are not commonly imposed by local governments, with the prominent exceptions of New York City and the District of Columbia.
[iv] One of the amendments adopted in the subcommittee mark-up clarifies that the 21-day limit applies to employees and property combined. In other words, a corporation that had employees in a state on 15 days and property in the state on an additional 10 days would be outside the 21 day limit; a state would not be barred from asserting nexus over the company. As discussed in the previously-published Center analysis of H.R. 1956, however, such a provision is largely meaningless because a corporation that wished to have employees in a state for 15 days and property in the state for 10 more without establishing nexus could easily incorporate a separate subsidiary to be the nominal owner of the property. In that event, neither corporation would exceed the 21-day limit. The limit applies separately to each separately-incorporated subsidiary in a group of commonly-owned and commonly-controlled corporations.
[v] Letter dated September 27, 2005 from Arthur Rosen on behalf of the Coalition for Rational and Fair Taxation in support of H.R. 1956 to the Chairman of the Subcommittee on Commercial and Administrative Law, House Judiciary Committee. Hereafter referred to as the “CRAFT Statement.”
[vi] Proponents of H.R. 1956, including CRAFT, frequently characterize the entire bill as doing nothing more than establishing a “physical presence” nexus standard. That characterization is misleading. A physical presence nexus standard would mean that if a corporation had no physical presence in a state it would not be taxable there, and if it had a physical presence it would be taxable. In contrast, H.R. 1956 provides several new “safe harbors” that would allow a corporation to have substantial physical presence in a state without creating nexus, and it also preserves Public Law 86-272, which allows a corporation to have sales and delivery personnel in a state without creating nexus. Nonetheless, the quoted language is one provision of H.R. 1956, and — operating independently of the rest of the bill — it would establish a “physical presence” standard. That is why it is referred to in this section as the “true” physical presence threshold in the bill.
[vii] See: Affidavit of Thomas K. Condon, Massachusetts Department of Revenue, in the case of Prime Receivables Corporation v. Alan LeBovidge, dated December 3, 2003. This document indicates that a number of large multistate banks with customers in Massachusetts but no direct physical presence there dropped their challenges to the state’s bank income tax, which asserts that nexus is established if out-of-state financial institutions have a significant number of Massachusetts-resident customers. See the longer discussion on pp. 6-7 of this report.
[viii] See: Michael Mazerov, Federal "Business Activity Tax Nexus" Legislation: Half of A Two-Pronged Strategy To Gut State Corporate Income Taxes, Center on Budget and Policy Priorities, Revised November 30, 2005.