On-Demand: State & Local Tax Update
- Oct 21, 2020
- Gary Bingel
Our panelists discussed the current state tax nexus issues, as well as highlighted some of the pitfalls and opportunities that result from interest limitations at the federal level.
Lorie Daly:Good morning and welcome, everyone, my name is Lorie Daly, co-chair of TEI, New Jersey's state and local tax committee. We are happy and proud to have EisnerAmper sponsor today's event entitled, nexus and state 163(j) limits. Today's presentation is the second of a three-part series, being offered in October. If you have not already done so, there is still time to register for tomorrow's webcasts covering international tax issues.
Lorie Daly:Today's course will provide a Nexus overview, the impact of the Wayfair decision and an overview of the state treatment of federal interest limitations. Today's speakers are Gary Bingel and Bill Gentilesco, Gary Bingel is the partner in charge of the firm, State and Local Tax Group, with over 25 years’ experience. His expertise focuses on state and local income taxation and sales and use tax consulting. He has significant experience serving clients in the manufacturing, retail, pharmaceutical, biotechnology, technology, and service industries.
Bill Gentilesco is the director in the State and Local Tax Group, with over 25 years’ experience, his focus is on state and local income taxation and sales and use tax consulting. Bill has significant experience serving clients in the manufacturing, consumer products, retail, pharmaceutical, biotechnology and service industry. We, at TEI, want to thank everyone for joining us today and I'll pass the presentation over to Gary, thank you.
Gary Bingel:Great. Thanks, Lorie. Welcome, everybody, glad everybody could make it today. I'd say it's a pleasure to see you but I guess it's more a pleasure to feel your virtual presence, if you will. I've thought about a lot of slides here, I'm really going to skip over the first 15 or so, which are background on pre-Wayfair, which I think everybody's been through. Just going to highlight a couple of key points and then get into the current state of affairs.
I did include some of the prior slides just for some background information, for people to refer back to though, just in case they'd like to do that. First, I want to go over, well, why should people care about nexus and their nexus footprint and such? Just in case it's not obvious. If there's any transaction, obviously, it's one of the first things companies are looking at, especially since Wayfair. It's always been up there but Wayfair just seems to have heightened that, so there are a lot of due diligence issues.
Also, it's just a matter of making sure you're paying the right taxes, everywhere you should be. There's nothing worse, especially in sales tax, than having to pay a lot of back taxes in states you were unaware of. In sales tax, it's really a higher issue than, let's say, an income tax. In income tax, if you don't know you have nexus and you get caught, you're paying your own taxes versus in sales tax; you're possibly paying someone else's taxes, which no one likes to do.
It does impact all types of companies, that's something I really want to highlight for Wayfair and economic nexus. A lot of folks looked at it like it was purely a e-commerce issue and it does affect them, but it also affects IT companies, anybody selling any information service or SAS service companies, pretty much everybody. Typical issues we see, just around the whole gamut, especially today, remote employees, we're going to talk about that, especially in the COVID environment today and some of the state provisions on that.
Remote inventory continues to be an issue with so many people working with Fulfillment by Amazon, and there continues to be more and more agency, click-through issues. Also, government contracts, we still see something some companies are often unaware of or sometimes the tax department is the last one to know, that if you're doing business with any government agency or municipality or university, very often, it's a requirement, in order to do business with them, that you be registered in the state and that you're submitting taxes in the state. Sometimes you have to end up registering just in order to bid on contracts or just to sell into a state, which can often pull you in and sometimes the tax department is the last one to know about that. I do want to highlight that, if that's something your business is involved in.
Generally, in order to avoid pitfalls, you should be reviewing your company's activities, generally, just your business model, that changes over time. The sales by state, just some general things to keep track of, your payroll, especially today with remote employees, bigger and bigger issue where you have inventory. Your employee travel, we see a lot of companies that aren't properly tracking their employee travel, which can be an issue, and when they need to do so, it can be very cumbersome if they don't have the right processes in place. Affiliate agreements, what are those affiliate agreements? You need to know, with your marketing department, who they're with, what the purpose of them is, how they operate.
Whether you're currently registered with the secretary of state or other state agencies. Hopefully everybody knows, in their tax department, where they're filing taxes. But often they may not know other regulatory requirements or the regulatory registrations they have, so it does go way beyond the tax department, some of these issues that people need to be aware of.
Pre-Wayfair, these are all the ones I'm going to skip through here, it goes through Quill, due process clause, commerce clause, these are all the ones that we don't really need to get into today but we're including them for completeness sake.
Gary Bingel:Moving along and getting us a little bit more current here, pre-Wayfair, and this is something to take away. Everybody looks at Wayfair like it's an economic presence and an economic nexus provision, which it is, but economic nexus and economic presence has been around long before Wayfair. States really started chipping away back with the Jeffrey case, so that's just one thing to keep in mind. In some ways, a lot of people look at it like a new provision but it's really not, it's really been around for quite some time.
And states have been getting very, very aggressive, here's just some other things I've been looking at, Amazon provisions, click-through nexus and then they started getting into the bright-line and economics provision, economic nexus provisions. Many states looked at some of these Amazon and click-through nexus provisions very rigidly, they had set guides and so, again, there must be some written agreement, there has to be some compensation for these referrals or clicked-through. Each state was a little bit different and some states also have rebuttable presumptions for these click-through provisions.
These Amazon and click-through provisions have gotten a little bit less important, recently, because of the Wayfair provision, with every state enacting or almost every state enacting something along those lines. But you should be aware, they're still out there and they still may have applicability in certain circumstances, largely because, often, the thresholds that you see here are something like $10,000, which is much lower, obviously, than the Wayfair provisions.
Often, what they really said, these bright-line provisions, especially for income tax, and again, they were generally income tax only up until Wayfair. You had to have sales greater than $500,000, property greater than $50,000, payrolls greater than $50,000. Some states, one thing to point out is that these were safe harbors, and if you fell below that you didn't have nexus. In other states, these were just one of several tests so you could still have nexus, even if you fell below these. Just something to keep in mind, again, for the overall environment out there, it has been a process over time.
South Dakota's provision, you should know by now, it was really $100,000 or 200 transactions. It was an or test and the US Supreme Court said, "Yes," that it didn't strictly say it passes constitutional muster but it got over the substantial presence test, and really hasn't been challenged. So for all facts, for all practical purposes, this point, those are the thresholds. They could go lower at some point, right now that's what most states are using, that brings us up to current here.
Currently, about 44 states of the 46 that have a sales tax have imposed or enacted some economic nexus provision. You need to be aware; those are not all the same. Many of them, especially in the beginning, did mimic that South Dakota Wayfair provision of a $100,000 dollars or 200 transactions. What's happened, over time, as many states have changed and evolved their provisions, some states; it seemed like every few months they were changing it a bit. But some states use an, "And," as opposed to a, "Or," or you have to meet both the dollar threshold and the transaction threshold, at least for sales tax.
Also, many states realized that with that, especially if they had that transaction threshold, many states either got rid of that or did it in addition to, largely because they realized 200 transactions, depending upon what you were selling, if you were selling very small items, you could literally have nexus in a state based on that, with $2,000 in sales. And it was costing the states more to do the registrations and process the returns than they were getting in sales tax, I think. Many of them, over time, started increasing those dollar thresholds or getting rid of the transaction thresholds all together.
One thing to keep in mind with these, also, these are in addition to other tests like agency, click-through and really physical presence. And that's going to be important when we talk about the COVID test later, or some of the COVID provisions to keep that in mind that these are still out there and you need to be keeping an eye out for these, in addition to, not in replace of, the traditional other nexus provisions.
While Wayfair was a sales tax case, it does have applicability to other taxes like income tax, franchise, net worth tax. Really, what we're seeing now, slowly, but it is becoming a trend, many states have very, very broad doing-business nexus provisions. That really just said, "Look, if you're doing business here, deriving income from this state, you have nexus as long as it's permissible under the US constitution."
And so they were broad enough to encompass, essentially, Wayfair without actually having a Wayfair-specific threshold. And that's something to be aware of, especially in income tax, because there is a lot of gray areas in some of these other taxes, as far as how they're going to actually enact these. I think, as a general proposition, if you meet those Wayfair thresholds or have a $100,000 of sales in a state, you need to be looking at it, not just for sales tax but other states as well.
And, as noted before, many states already had economic nexus provisions for income tax, some states actually do have some provisions and some more guidance because they did enact specific thresholds, prior to Wayfair. And be aware, again, 86-272 is still a good law for sellers of tangible personal property. If all you're doing is soliciting sales in a state, you may be exempt from a net income tax in that state, despite the fact that you meet some of these economic nexus threshold. So you always have to keep that in mind as well and do that 86-272 analysis.
Current status, again, more and more states, really starting a little bit before Wayfair but we've really seen it pickup since then, are implementing some economic nexus provision for income and gross receipts or hybrid taxes. This is not an all-inclusive list by any means but it does give you a good flavor. California has had their economic nexus provisions in for a while, California is one that it does change annually, it is tied, somewhat, to inflation and that's why you have that funky $601,967 in receipts for income tax. And don't forget about their LLC fee, if you have LLCs doing business there, you may have 86-272 protection from income tax but potentially not that LLC fee.
Colorado and Massachusetts both have $500,000 thresholds for income tax. One thing to be aware of, from Massachusetts that includes unitary affiliates in that calculation. And so just like with the Wayfair provisions, where you need to know what those provisions are specifically, state by state, because some states use an "And," some states use an "Or," some states only look at sales of tactical, tangible, personal property. Other states may include resale or taxable services, and you really have to look at each state's specific provisions and it's the same thing for these income tax rules, you really need to look at each state.
Nevada, they've got a $4 million in gross receipts, some of the ones that we've seen catch people on, recently, obviously, Oregon is a relatively new one, just this year, $750,000 gross receipts and that is a commercial activity tax similar to Ohio. Tennessee has a $500,000 threshold for receipts for their business taxes or gross receipts tax, as well as their income tax. Very often, we do see people looking just the income tax and forgetting about that gross receipts tax, in Tennessee.
Texas, margins tax has been around for a while, they just recently implemented their threshold. And Washington has, obviously, had the B&O tax for a while, which is had an economic nexus threshold. They were one of the ones that it seemed like, every six months, they were changing their nexus provisions for the B&O and for retailers, which is wholesalers and sales tax. So that's one, if you get a notice or if you're looking at Washington, you really need to look at their history, of all the different provisions, to make sure they have nexus each time and don't just assume, "Oh, well, we have it now, we must have had it for the last couple of years," because that might not be the case.
Gary Bingel:That brings us up to where you set some background for things to be aware of now, with COVID-19 and nexus considerations. For the first several months of COVID, I had a least one conversation a day if not multiple, with clients, "What to do with our remote workforce." And now that's tailored down a little bit, although I'm having some of the same conversations with clients for a second round, as this has drag on a bit and they're getting a bigger and bigger remote workforce.
The general rule is, employees teleworking from a state where they otherwise don't have nexus is a nexus-creating activity, you have employees in the state, that's been the case for years. We've seen people hiring remote IT workers in the Midwest or wherever, because they can get them a lot cheaper than, let's say, in the Northeast, that's always been a nexus-creating activity.
It's just gotten a lot more heightened with COVID because if more and more employees are working remotely, employers are starting to look at this and consider, "Okay, well, we created nexus." As of October 7th, a couple of weeks ago, about 20 states, that's actually a typo it should say, "Have released guidance," not, "Have not," that, "Not," is typo, I apologize. Have released guidance on whether having any temporary employee will create nexus for income and, or sales tax purposes.
It's a little bit misleading because some of those states, when they released guidance, they really just said, "Well, our guidance hasn't changed, nexus created is the same," or, "We'll look at these things on a case-by-case basis so their, "Guidance," isn't really that helpful to some extent. What I have found is that this has really come down to a practical consideration, by many of the businesses. Some jurisdictions have expressly waived nexus for businesses with remote employees, during the pandemic or some official stay-at-home orders. So you're really need to look, again, state by state and see exactly what that means.
For income tax nexus, these jurisdictions, just a listing and this is, again, changing weekly by now, have waived nexus for businesses that have remote employees in their state due, solely, to the COVID. And so if you have remote employees in these states, they've said that will not, in and of itself, be a nexus-creating activity. One of the things to look out for, again, is always other specific provisions. When they say, "Solely due to COVID," is there a specific length of time? Does it mean just in that state? What if that state lifts its COVID, work from home restrictions but the state where the employee would normally be commuting to has not? You have issues like that.
I think that a lot of states may start using this and say, "While they worked from home solely due to COVID, that won't create nexus, but you had people working from home prior to COVID, every Friday you had an arrangement that employees were working from home," or what about these temporary employees that, all of a sudden, decide to continue to work from home after COVID? I highly doubt most businesses, I don't know of any, that really just flipped the switch and said, "Okay, Friday, nobody's coming to the office, Monday, everybody's coming into the office," most companies are phasing that in quite a bit.
And you need to be aware of some of the other ancillary issues like salary considerations, all of a sudden your people used to work in New York are now moving to Idaho, are you going to pay them the same amount? And you need to be looking at some of the things like withholding and unemployment charts. Income tax nexus, these states have come out and specifically said that having people work from home, during the pandemic, will create nexus. These are, obviously, states to watch out for, these 10.
Sales tax nexus, some states have said having remote employees may not create nexus for income tax, but will create it for sales tax or vice versa, so don't assume that just because the state has issued guidance, it applies across the board. Often, very often, this guidance is couched in terms of nexus for corporations, and they don't really address other types of pass-through entities. I think a state would have a hard time saying, "Well, we're just applying this to corps," and saying, "They don't have nexus but pass-through entities do," but that remains to be seen.
These states have waived sales tax nexus, as you can see, it's a much smaller list than the income tax list was. And also, be aware of economic nexus, remember these are due to solely working at home. Your only connection with the state is having remote employee due to COVID. Well, a few of the economic nexus anyway, under Wayfair, met their $100,000 threshold or whatever the threshold is, that's still going to give you nexus, you have not created nexus just because remote employee, you created because of their economic nexus provision. That is something else you want to be aware of, again, you have to look at all these different nuances.
Personal income tax, you need to, again, take a look and many companies are looking at their employees and saying, "Well, where do we need to be withholding personal income tax?" What I have seen, and we outlined a couple of states here, most states have really taken a more practical approach and said, "Look, just keep doing what you were doing pre-pandemic." I think most companies are doing that just because they don't want to change all their withholding and then have to change it back, in a few months or what was perceived as a few months and now, hopefully, it's perceived as just a few months more.
And companies are really handling this on a case by case basis because what happens is, we've seen companies get in, they say, "Well, okay, we can't just flip the switch to say everybody who used to be commuting to New York, we're going to flip the switch and we're just going to withhold in their state of residence." Which is maybe New Jersey or Connecticut, because then we have people who are not working from their apartment in New Jersey, they went to their in-laws in North Carolina. And this person went to their in-laws in Texas and this person went to Utah, and it becomes a real big morass as far as where do they need to register. And analyzing each specific state, it grows rather quickly so that also is forcing most companies to take a more practical approach and just say, "Hey, we're just going to keep things as they were and then when this pandemic's over and we get people back in the office, we'll handle those one-offs of people who have decided to work from home permanently."
Convenience of the employer tests, there are several states, New York being the biggest one, New Jersey has its own rule on it, Pennsylvania and Philadelphia have these convenience of the employer tests. New York is the most problematic, they're the most aggressive, they have not come out with any guidance as far as how to treat convenience of the employer test. Which says, "To the extent an employee is otherwise sourced to New York, all of their wages get sourced in New York unless it's for the necessity of the employer, that they're working somewhere else." I think that states would have or New York would have a difficult time enforcing that right now, under these circumstances, but it remains to be seen. And that's something to watch out for and something you need to take into consideration.
Apportionment, it's going affect your apportionment, having all these folks working from home to the extent you're using market sourcing, maybe your market hasn't changed but you might want to look, if you're selling to consumers or to business users who are now working from home. Maybe your market has changed, maybe instead of selling to a business and all the software is used in New York City, now maybe it's spread out around the country, that's something you may want to look at.
As far as cost of performance states, if you're using cost of performance, you're going to have to look at that as well, has their cost of performance shifted from New York to another state? The biggest place we see this is really, and the most applicable, is for the New York City UBT, that does use a sourcing of where the service is performed. Now you, obviously, don't have as many people performing that service in New York City. If they're all performing at New Jersey or somewhere else, there is some opportunity there to lower your portion of New York City, that's one of the more clear-cut ones.
Again, market sourcing, be aware of those. Generally, you have to look at the hierarchy here and sometimes, for reasonable approximation, these are just giving you some of the overviews and those things to consider. And, again, you're only going to want to go through this if you think it's going to really move the needle. You don't want to spend a lot of time looking at these apportionment issues, if it's going to have a minimal impact.
Just going through, again, remote employee implications and Pennsylvania, Philly and New Jersey have come out and said how to treat some of these apportionment of services and such. Most of them would just come out and say, "Keep the status quo, don't change anything as of yet." You may have a position to change if it's really going to give you a great answer though.
Unemployment insurance, that's, again, something you need to take into account. Has the employee's localization of services changed? Things like that. Again, most companies are saying, "Look, we're not going to change all of our unemployment insurance payments, just on a temporary basis. Also, we don't know where the employees, if they do get laid off, where they're going to end up filing. We don't want to end up creating issues where we change it for week one, we also change the withholding from state X to state. Y, we lay that person off and then all of a sudden they don't know what state to claim unemployment in."
And that was it, I know I flew through some of that pretty quickly, but there is a lot there. Really, I think the biggest issues with nexus is just to be aware it is an evolving state, still, especially with COVID. And very often you can look at a lot of the very technical rules and things, and companies are still falling back on the most practical application.
States are really overwhelmed, right now, with COVID and everything else themselves, and I think only time will tell. While we expect to see a lot more audits coming up in the future, as states get back to work and they're trying to close their budget deficits, nexus is going to be one of the areas they look at. But we really won't know for a while, how aggressive they're going to be and what stances they're going to have. With that, I'm going to turn it over to my co-presenter, Bill, to talk about state treatment of 163(j), Bill?
William Gentilesco:Thanks, Gary. Good morning, everybody. As Gary mentioned, I'll be covering state section 163(j) treatment for corporations. I'm going to start with a federal overview of 163(j) under both the Tax Cuts and Jobs Act, and then the more favorable CARES Act that was adopted in March of this year. As I mentioned, it'll be for corporations and lastly, I'm going to cover specific states and their 163(j) treatment. I'm going to cover 14 of the larger states where I see our clients filing corporate returns, that have higher apportionment. And I'm also going to cover New York city and Philadelphia.
Okay, federal changes to the interest limitations, prior to the Tax Cuts and JOBS Act, there was no cap or no percentage cap on the interest deduction a corporation would take. There were limitations under 163(j) but not a percentage cap. TCJA introduced a 30% limit of a corporation's adjusted taxable income, limited the amount of interest that could be deducted.
And then the CARES Act loosened that up and raised that to 50% of a taxpayer's ATI, and that was effective for tax years in 2019 and 2020. Also, under the CARES Act, a tax payer has the option, in 2020, to use either their 2020 or 2019 ATI. So that'll be an issue we'll need to focus on for 2020 tax returns as well as tax provisions, and whether or not other states adopt the CARES Act. In this case, we want the states to adopt the CARES Act for purposes of interest limitation, as it's more favorable.
State considerations, there's differences in federal and state law but the starting point is, how the state can influence the internal revenue code. Do they adopt the TCJA changes, which were effective beginning in 1/01/2018? Or do they allow the CARES Act a higher percentage limit, that I mentioned? And that usually breaks down as a starting point between rolling conformity states they adopt, the internal revenue code changes automatically as they occur. And some examples of that are New York, Illinois, Massachusetts, New Jersey, Tennessee, and Utah.
You'll see, in another slide, in a little bit, that some authors put New York and New Jersey under some type of a selective conformity, which is true that those states, they don't adopt the internal revenue code in their entirety but New Jersey and New York do start with federal taxable income, which has always been interpreted as the latest code. And there's a fixed conformity states or static conformity, they usually don't adopt the most recent internal revenue code although, in some cases, they do, they might be a year or so behind.
And those include quite a few states, Arizona, California, Florida, Georgia, et cetera, and I'll cover some of these larger states. And then there are selective conformity states that conform only to specific internal revenue code sections, which might be either static or rolling. In addition to the federal conformity issue, there's also, of course, the state filing method, whether it be separate, combined or consolidated. If you've got a separate filing state like Maryland or Pennsylvania or Florida, in most cases, I think in many cases you're going to need to do a standalone 163(j) computation for that a separate state filer.
But there's exceptions and we'll cover some of that. Combined, a question comes up, "Hey, if I'm filing combined in New Jersey, for example, and my New Jersey combined group matches my federal consolidated group, can I just use the federal 163(j) computation?" In some cases, yes, in many cases, the states are silent, so far. Oftentimes, state combined returns they don't necessarily adopt the federal consolidated return rules. My inclination is, if a state is silent, if a combined state is silent and your group matches, I'd probably use the federal limit and not do a standalone 163(j) count, for every member of my combined group. But you'll have to weigh whether you can get comfortable with that.
And then there's consolidator states, there's quite a few states that have a "Consolidated tax return," that might not necessarily be equivalent to a federal consolidated return. In that case, you have some of the same issues I mentioned, with the consolidating states. The federal 163(j) limitation is computed on a consolidated basis. And, lastly, you have state modifications that could complicate things. In particular, many states have related party interest add-back rules, that they've adopted many years ago. And that might conflict with the 163(j) calc, you have to add back twice. So far, at least two states, Pennsylvania and New Jersey, have said that there's a pro rata calculation that you do. And I think my last slide, I do an example of the pro rata calculation for Pennsylvania and how you handle that.
William Gentilesco:Moving on, I have here a chart that was put out by the council on state taxation, in April 2020. Every state may not be exactly correct but I think, based upon the states that I looked at, most of these haven't changed in the last several months. And this chart breaks it down into three different colors, I'm colorblind but I see there's the pink states, these are states that have decoupled from the federal 163(j) treatment. Then the blue states are rolling conformity that automatically adopt the code, as the federal internal revenue code changes, these states automatically follow.
And as I mentioned earlier, I would've put New Jersey in a blue and probably New York in blue but it could be technical, they don't necessarily adopt the entire internal revenue code but they do, at least for their starting point, New Jersey and New York, start with federal taxable income, including the CARES Act changes. And then there are static or selective conformity in green, these states adopt some internal revenue code provisions and decouple from others.
This chart as well as charts by CCH, RIA, Bloomberg, et cetera, I think they're a good starting point. They can give you a quick answer of whether a state follows TCJA or CARES Act, but they might not get into some of the nuances, states might release advisory rulings, regulations, et cetera. These charts, some do a better job than others, of capturing that. But, as I said, for quite a few of the larger states, I did that in preparing for this. I looked at tax return instructions and any state level guidance that was issued.
And I tried to group them similar to the way the cost chart did, and here's a handful of states that fell under the states that did not adopt or decoupled from 163(j). California corporations, they're still using the internal revenue code as of January, 2015, and that's prior to TCJA and prior to the CARES Act. So if you've got a big and unfavorable adjustment on your federal consolidated return for interest, you have a big limitation. Chances are, you will have a favorable California adjustment allowing a portion of that interest, they don't adopt either of the two limitations.
Kentucky is a static conformity state, they adopt the code as of December, 2019, thus, Kentucky follows the TCJA limit, not the CARES Act, Kentucky is unfavorable in that respect. Missouri is favorable, they enacted a statutory modification decoupling from 163(j), the tax years beginning on or after January, 2018. Tennessee is a little of both, they follow the CARES Act for 2019 and then for tax years beginning on or after January 1, 2020. Tennessee decoupled from the TCJA's changes, such that business interest expense will not be limited tax for 2020. Wisconsin adopts the internal revenue code as of January 31, 2017, but they did not adopt the TCJA or the CARES Act changes for section 163(j).
William Gentilesco:Okay, now we're into the rolling conformity states, Illinois, Massachusetts and Pennsylvania are rolling conformity plus, they follow the CARES Act changes to the internal revenue code. Pennsylvania issued fairly detailed, specific guidance on 163(j) and I'm going to cover that at a high level, in a later slide. Michigan is interesting; they give a corporate taxpayer the option of using the internal revenue code, as of January 1, 2018, or the internal revenue code in effect for the tax year. When I looked at the return and, in fact, that's what they say in their instructions, I didn't realize that before I looked at this. I think if you've got a lot of interest expense that might otherwise be limited, you're probably going to want to select current internal code and get the benefit of the CARES Act changes.
Also, another thing, Michigan issued a notice on June 8th, 2020, and they advised that combined groups cannot use the federal consolidated 163(j) calculate, each Michigan combined member must calculate 163(j) on a standalone basis. And I mentioned this earlier, in an earlier slide, that this could be an issue in combined returns. So far, Michigan is the only state that's come out saying you had to do this on a separate basis and, hopefully, it'll be the last one.
While New Jersey doesn't expressly adopt the internal revenue code, taxable income for corporation starts with federal taxable income, including the CARES Act changes. And New Jersey was, I think, the first state to issue a 163(j) guidance that I'm going to touch on later. Florida adopts the internal revenue code as of January 1, 2020, thus Florida follows the TCJA 163(j) changes so the 30%, but not the CARES Act, the 50%.
New York is a rolling conformity state in terms of their federal taxable income starting point, however, New York, especially decoupled from the CARES Act changes. For 2019 and 2020, you'll need to make an addition modification on your New York tax return, to the extent you benefited from the CARES Act and the same applies for New York City.
North Carolina adopts the code as of May 1, 2020, however, similar to New York, North Carolina has an addition modification for the increased federal interest deduction, attributable to the CARES Act, if any, if you have that. Virginia adopts the internal revenue code as of December 31, 2019, pre-CAERS Act. However, for tax years beginning on or after January 1, 2018, Virginia allows a deduction equal to 20% of the federal interest disallowed by the TCJA limitation.
And these are good examples of what we go through in state taxation, states just can't keep it simple, they all have different rules and different quirks on how to handle federal tax, the internal revenue code. Moving on to New Jersey, New Jersey issued a technical bill on April 12th, 2019, addressing interests under section 163(j) and how to handle that for New Jersey corporate tax purposes. And so this was pre-CARES Act but the bulletin really lays out overall guidelines on how to handle interest expense, and I think it can be applied equally to the CARES Act, they just shut out certain rules to follow, for New Jersey purposes.
First of all, the bulletin clarifies that any related party interest add-back must be applied after the federal 163(j) limitations. And that makes sense because the federal interest limit is already baked into your New Jersey starting point, and then if you have a related party interest add-back, then you'll need to do an addition modification for that or claim an exception, if applicable. And further, the bulletin advises that, if you have both, if you have a 163(j) limit and you also have an interest add-back interest paid to related parties, then you do a pro rata of the two.
Unfortunately, New Jersey didn't give an example of how to do that but Pennsylvania did, and it looks to me like Pennsylvania got it right and I would think that New Jersey would agree that the Pennsylvania method would also be accepted, acceptable for New Jersey. Now, another thing in the bulletin that they said was, if you're filing a consolidated federal return in a separate Jersey tax return, first of all, I don't know how many people would have that situation because New Jersey went to mandatory combination for unitary taxpayers, beginning in 2019. But you might have a situation where one or more taxpayers are not unitary with each other and they need to file separately, or whatever.
But New Jersey has said, based upon a court case, involving MCI Communications, that your starting point for New Jersey, line 28, if you will, you use your federal, that number from your federal consolidated return. So the federal consolidated return has a statement, usually statement one, that lists each affiliate and the revenue and expenses, and comes up with their own line 28. You use that, you don't need to do a standalone 163(j) calculation for New Jersey, even for a state filer that files a standalone New Jersey tax.
Moving on, when filing a New Jersey combined return, water's edge, worldwide or affiliated group, the section 163(j) limit and any related party interest are calculated on a consolidated basis, regardless of whether or not the federal consolidated return was filed, but I think that's favorable. And I mentioned this third bullet point, when filing a standalone, New Jersey CBT return, a separate filing taxpayer must use the 163(j) limit as calculated in the consolidated return.
Related party interest, to the extent you have that and you have, let's say, a sub paying interest to its parent and they're included in any New Jersey combined return, and if they're in the same combined return, that's eliminated, as related party interest add-back only applies to the extent interest is paid to a related party, that is not part of the combined return.
Pennsylvania issued a bulletin on April 29, 2019, a couple of weeks after New Jersey. And per the bulletin, by the way, Pennsylvania is a separate filing state, they have not adopted combined filing. And the state said they will not expect the corporate tax payer, that files a federal consolidated return, to limit their interest expense on their state return, unless the federal consolidated group reports a 163(j) limitation. If the federal group does report a 163(j) limit, then Pennsylvania wants each standalone corporate taxpayer to compute their own state level 163(j) limit, using the federal standalone rules.
Similar to New Jersey, the Pennsylvania bulletin says that if a taxpayer has an 163(j) limit as well as related party interest, the two are done on a pro rata basis and the next slide gets into that, my last slide. Philadelphia announced, in their own advisory notice on May 29, 2019, that, "The above PA guidance will be followed for the BIRT, Business Incoming Receipts Tax, method two filers." Method two, a taxpayer start with federal taxable income, Philadelphia is just saying, "We're going to follow these broad guidelines set out by Pennsylvania."
And also, the notice says that, "If you're a taxpayer that uses method two for BIRT". I'm sorry, "A method one for BIRT," which I don't see, I don't think I've ever seen that. Method 1 is, a taxpayer that uses their books and records and not their federal taxable income, as a starting point. If you do use method one, then Philadelphia says that you don't have to apply a 163(j) limitation, it's not applicable. But again, I don't see method one, I don't think I've ever seen it.
Okay, and here we have an example put out by Pennsylvania on how to handle both the 163(j) limit, as well as related party interest, that would be disallowed under the state's add-back provisions. And you'll see there's a 30% limitation on line two, this was issued when TCJA was in place but, similar to New Jersey, these are broad guidelines and I think they could be equally applied, under the CARES Act.
In 2018, taxpayer has adjusted taxable income of a million dollars, they have a 30% limit on their interest deduction, but they paid $350,000 of interest and, for federal, they were limited to $300,000. That's a 14% reduction, that's $50,000 that they lost, is 14% of the total. In addition, a taxpayer has $100,000 in their total $350,000; it's a $100,000 of related party interests that would be subject to the state add-back.
Pennsylvania says, "Well, since I already haircut you 14%, I'm not going to make you add that back because it's not being deducted, on your federal return." They reduced that a state level limitation to an $85,714 or 86% add-back, and they carry over the $14,286 limitation and for federal, the $50,000 that was limited is also carried over. Then in 2019, there's a $360,000 limit, the tax payer has a current interest expense of $350,000 and they're able to use, remember that they have $360,000 total limit, they're allowed $350,000 on their federal return plus another $10,000 out of the $50,000 that was carried over from the prior year, from federal, that's 20% of that $50,000, the $10,000 amount.
And so Pennsylvania says, "All right, you were able to use a 20% of your federal limitation but you also carry over a $14,000 related party add-back, for our Pennsylvania purposes. And that's embedded in that $10,000 that you were allowed for federal, so we're going to make you add back 20% of that." And that's how they get to the $2,857. I looked at this closely and it makes sense and, as I mentioned earlier, I believe New Jersey would allow a similar calculation, this pro rata type of a calculation. That's all I had in terms of the 163(j) slides, Lexi, did we get any questions?
Lexi D'Esposito:We did, there are a few questions in the Q&A widget.
William Gentilesco:Gary, I don't know how you want to handle this, should Lexi, read them?
Gary Bingel:I'll do them, I'll do my two. One was regarding nexus for foreign companies, by foreign; I assume we mean non-US companies. If they provide, let's say, sales into a state, whether through virtual events or something else, those economic nexus provisions and the nexus provisions apply equally to foreign companies as they do to US companies. You do need to be aware of those, if they're selling software or events or something into a state. And if it's a market sourcing state, which most states are now, that will be revenue source to that state and may then give you economic nexus there.
Now, depending upon the state, you may get relief from an income tax standpoint, if you don't have any permanent establishment here, such that you file a 1120-F protective return and your starting point is zero. And at most states, if they're starting with federal taxable income and you've got zero there, you essentially can file a zero return and may not have much exposure. Two issues, number one, if you're in a state that doesn't have a net income tax, they've got some gross receipts tax, you'll still be subject to that. Also, I haven't seen this happened yet but that starting point, for the states that might start with your 1120-F of zero, doesn't take into account any adjustments that may be applicable, so that's something else to watch out for, it does apply to them, although there may be some relief.
The other question was, to what extent are state income taxes a zero sum costs, in that a tax paid in one state is saved in another? Well, it really depends on the states in question and their tax regime. If they had the exact same apportionment formula and sourced everything the same way, and had the same tax rate, it'd be just taken out of one hand and given in the other. But a lot of states, you could get a benefit or it could be to your detriment, it just depends how those apportionment formulas work out, if one state has a higher tax rate than the other, et cetera.
You could be paying less tax in a 6% state and more tax in a 9% state, so you really need to go through and push the numbers to see whether it is a detriment or not. Here in the Northeast, we've gotten Jersey PA tests that have a lot of high income tax rates, on corporations. If we're going to end up filing in Florida, that has a 5% rate on it, it has 5.5%, something like that, you may actually get a benefit so it really depends, you have to go through and push the numbers up.
Gary Bingel:And then I think the other question was for Bill.
William Gentilesco Oh, I'm sorry.
Gary Bingel:No, go ahead.
William Gentilesco: I'll tak:e my two questions, one of them, just let me scroll down here. The first one was, if I file a federal consolidated return and a separate return for state, do I need to do a standalone 163(j) calc? I think, in many states, the answer is, yes, unless the state has come out with a guidance saying otherwise, which New Jersey did. New Jersey said that even if you file a standalone New Jersey return, you still use your federal taxable income on a standalone basis, from your federal consolidated return, you do not do a standalone calculation.
Pennsylvania said, "Well, if you have a 163(j) limit on your federal consolidated return, then you have to compute a standalone state 163(j) for any members of that return, that are filing separately in Pennsylvania. So between those two states, there were two different answers but for states that are silent, I would say, if it's a standalone state like Maryland or Florida, for most tests, I think you should be doing a standalone calculation unless the state says otherwise, by statute or some other guidance.
And lastly, there was a question about a small business exception for federal, under 163(j), and would the states follow it? I think the answer to that is, yes, because in most states they're adopting a version of the internal revenue code. So if it's a state that adopted the CARES Act and that small business limitation was there, or if it was in the TCJA Act and the state follows that version of the code then, yes, they should go along with the small business exception as well. Is that all my questions?
Gary Bingel:Yeah, I think that was yours then another one came in, which I'm not sure I understand it. Are there any sales tax programs available to capture the dollar amounts and number of transactions, for the vast amount of tax and jurisdictions, nationwide? I'm not really sure I understand the question, I'll say that there are programs out there like CCH and RAA and such, that you can go in and see what the various thresholds are.
If you're talking about tracking, actually internal tracking, generally most soft, most GL packages and such, you can get the number of transactions or run your invoices by state and your dollars by state. It's just a matter of finding out how to mine that information out. There's also software out there, I believe, that can help match those up, that they've got the economic nexus provision somewhat built in and it'll track it internally, in your system. They tend to be more geared towards e-commerce and such, and obviously, you have to have all your sales on one platform or have that software integrated with the different platforms or different piece systems that might be tracking different sales.
There are some programs out there that I know I've seen, none are really springing to mind, a lot of it is going to depend exactly on what you're using internally and such. And I think that is it and I know we're just a couple minutes over here.
William Gentilesco: I'll just comment, Gary, I cover 163(j), is that we'll probably need to look at this next year because I expect or hope that there'll be more states coming out with their guidance, and there might be some decoupling or following the internal revenue code or advancing their conformity, one year, for example, in Florida. So you'll need to revisit that, probably before you file your 2020 state tax returns.
Gary Bingel: Mm-hmm (affirmative). And just two final quick questions, looks like, just popped up. How does the state enforce economic nexus provisions of a foreign entity not included in the worldwide return? Well, the issue comes in, it's really, how do they enforce? Whether it's in a worldwide return or not, is somewhat irrelevant. That entity actually has nexus in its own right, if it meets economic nexus for a reason. So it doesn't need to be part a combined group. The issue can come into, how do they enforce it? And that can be an issue.
Now, it depends what the company is shipping into, if they have subsidiaries here or affiliates here that they may be able to go after. For shipping something in here, they may be able to stop it at the ports and enforce it that way or go after one of the affiliates here, through some affiliate nexus provision, so it's really going to depend on that. Enforcement can be an issue and I would say for some companies that are looking at that, if the extent they want to ignore, the issue becomes if you ever want to have a foreign subsidiary here, are you going to be able to open one if you've got judgements against you, for ignoring some economic nexus items.
We also had someone comment for sales tax purposes, Avalara does use a tracking where they'll track through AvaTax, where if you're using them and everything's integrated with them, they will track the dollar thresholds and the number of transactions. Be aware, though, it's only for sales tax, so they will not track it for income tax and such, I don't believe. And some of those income tax provisions are different than the sales tax provisions.
Also, you obviously have to have, again, all of your sales running through AvaTax. It's a lot of larger companies, especially when you use one platform for e-commerce and another platform for other types of sales, or have more than one platform. That's just something to be aware of, they do have something like that though. And I think that is it, I know we're gone over a few minutes here so I'll turn it back over to, I believe, Lexi, to bring us home.
Transcribed by Rev.com
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Gary Bingel, Partner-in-Charge of the National State and Local Tax Group, with expertise focuses on state and local income taxation, and sales and use tax consulting. He has significant experience serving clients in the manufacturing, retail, pharmaceutical, biotechnology, technology and service industries.
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