- CAT in the Cradle: Ohio Phasing Out Corporation Finance Tax in Favor of Gross Receipts Tax on Commercial Activities
- January 4, 2006 | Author: Lance S. Jacobs
- Law Firm: Pepper Hamilton LLP - Washington Office
In late June, the Governor of Ohio signed Ohio's biennial budget bill, which instituted sweeping changes to the Ohio tax regime. This article will discuss the mechanics of Ohio's new commercial activity tax (CAT) and the implications for taxpayers potentially subject to it.
The CAT is essentially a tax imposed at the rate of 2.6 mills on the "taxable gross receipts" of most taxpayers doing business in Ohio. The law calls for the CAT to be phased in between now and 2009. Taxpayers will be subject to a combination of the CAT and the corporate franchise tax between now and 2009, with the CAT portion increasing, and the corporate franchise tax decreasing, steadily until the CAT constitutes 100 percent of the tax due, as of March 31, 2009. The first CAT returns will be due on February 10, 2006.
The statute makes clear that the tax is not a transactional tax and that the tax cannot be billed or invoiced to another person; rather the statute explicitly states that the tax is an annual privilege tax imposed on the seller.
Taxpayers Subject to the CAT Generally
The CAT applies to most types of businesses, regardless of their form of organization. Thus, traditional pass-through or disregarded entities, such as partnerships, limited liability companies (single or multi-member) or qualified subchapter S subsidiaries are subject to the CAT.
Certain organizations and entities are excluded from the CAT, however, including nonprofit organizations, most governmental entities, some public utilities, those entities qualifying as dealers in intangibles (such as broker-dealers), financial institutions (and certain affiliates thereof) and insurance companies (and certain affiliates thereof). Most importantly, there is a minimum dollar threshold that a potential taxpayer must exceed before becoming subject to the tax; thus, any person with not more than $150,000 in "taxable gross receipts" (unless that person is part of a combined taxpayer or consolidated elected taxpayer group) is not subject to the tax. Essentially, stand-alone entities or individuals with less than $150,000 in Ohio-sourced gross receipts will not be subject to the tax.
Related entities are given the option of two filing methodologies. A group of two or more related entities can choose to be treated as "consolidated elected" taxpayers. Absent such an election, related entities are required to be treated as "combined taxpayers." Each option has its advantages and disadvantages.
Consolidated Elected Taxpayers
Related persons can choose to file the CAT on the consolidated elected basis and are thus treated as a single taxpayer under the statute. This option allows related entities to make some choices about the composition of the group. The group can choose between a 50 percent or 80 percent fair market value ownership threshold (i.e. owned or controlled by common owners included in the group) for inclusion in the group. A proposed rule clarifies that the rule is a vertical test and that the attribution rules contained in the Internal Revenue Code (such as those that would attribute ownership between husband and wife) would not apply. Additionally, the consolidated elected group is given an "all or nothing" election with respect to foreign members of the group; the group may include all foreign corporations that meet the ownership requirements, or it can include no foreign corporations that meet the ownership requirements.
The principal advantage to the consolidated election is that intercompany receipts between members of the consolidated group are eliminated in computing the CAT. The main disadvantage is that an individual member's Ohio-sourced gross receipts are included in the CAT calculation (and therefore subject to tax) without regard as to whether that member has substantial nexus with Ohio. Further, a draft rule dictates that a consolidated elected group will be subject to the minimum tax even if the group's taxable gross receipts are below the $150,000 threshold to be subject to the tax.
The election is binding on all of the members for the next eight quarters as long as at least two of the members continue to qualify. If the group does not notify the commissioner before the end of the eighth calendar quarter of its intent to cancel the election, it remains in effect for the next eight calendar quarters.
The default for entities having more than 50 percent common ownership (again, applying the vertical ownership principles contained in the draft rule) is the combined taxpayer election. Combined taxpayers, like consolidated elected taxpayers, also register, file returns and pay taxes as a single taxpayer. While combined taxpayers do not get to eliminate intercompany receipts in calculating the CAT, they presumably are not then required to include the receipts of non-nexus members in the CAT calculation. Further, a draft rule clarifies that if the combined group's taxable gross receipts are below the $150,000 threshold, the group is required neither to register nor to pay the minimum tax. A proposed rule would permit a member of a combined group to file separately under certain circumstances.
"Bright Line" Nexus Rules
The new statute (as well as one of the early information releases issued by the Ohio Department of Taxation with respect to the CAT) sets forth strict rules as to when a person will be considered to have substantial nexus with Ohio. A person will be considered to have substantial nexus if that person:
- owns or uses a part or all of its capital in Ohio
- is authorized to do business in Ohio
- has "bright line presence" in Ohio
- otherwise has taxable nexus within the confines of the Constitution.
"Bright line presence" is defined to include the following:
- property with an aggregate value of $50,000 in Ohio (property is valued at cost, and rented property is capitalized at eight times the annual rental charge)
- payroll of $50,000 within the state, including payroll subject to income tax withholding, and seemingly including payments to independent contractors
- $500,000 of taxable gross receipts (i.e., $500,000 of gross receipts sourced to Ohio under the sourcing rules)
- without an absolute dollar threshold, at least 25 percent of a person's total property, payroll or sales within Ohio.
Definition of Gross Receipts
Gross receipts are defined as the total amount received by a person, without deduction for cost of goods sold or other expenses incurred, that contributes to the gross income of the person, including the fair market value of any property and services received, and any debt transferred or forgiven as consideration. There are several items that are excluded from the definition, including: most interest income, corporate distributions, repayment of principal (on a loan or other debt security or in a repurchase agreement, for example), proceeds from the issuance of stock, other contributions to capital, sales and uses taxes collected as a vendor from a consumer and compensation received as an employee.
The CAT is not apportioned, per se; rather, the tax is imposed only on those gross receipts properly sourced to Ohio. Taxable gross receipts, which are multiplied by the tax rate to arrive at the tax due, are sourced to Ohio under statutorily codified sourcing provisions. Sales of tangible personal property are sourced to Ohio if the property is received in Ohio by the purchaser. Receipts from intellectual property are sourced to Ohio to the extent that the receipts are based upon the amount of intellectual property used in the state. Receipts from the sale of services are sourced to Ohio in the proportion that the purchaser's benefit in the state with respect to what was purchased bears to the purchaser's benefit everywhere. With regard to services, the statute provides that the physical location where the purchaser ultimately uses or receives the benefit of the service purchased is paramount. The Ohio Department of Taxation has recently issued the fourth draft of rule detailing the sourcing rules for particular services, with examples specific to those types of services. More details should be forthcoming.
The sourcing rules contain an interesting anti-abuse provision. If a seller arranges with a purchaser to take delivery outside the state in order to avoid the CAT, and the purchaser brings the property into Ohio within a year of the transaction, the purchaser will be subject to the CAT on the value of the property. The taxing authorities have issued a draft rule discussing the imposition of taxes on transfers of property into Ohio within this one-year period. The general presumption is that the transfer is not subject to tax, according to the rule; however, it reserves the Commissioner's right to include the value in taxable gross receipts on audit (however, the rule generally precludes the imposition of a penalty in this instance). It also reserves the Commissioner's right to post descriptions of abusive transfers of property into Ohio that would be subject to tax on its website (and a penalty for failure to report these items as gross receipts may be imposed). The taxpayer can file for a refund claim in this latter instance if it can show the transfer was not intended in whole or in part to avoid the CAT.
The new legislation contains provisions to address the potential loss of pre-CAT net operating losses (NOLs). The simplest option, and the one that will make the most sense for most taxpayers, is to use the existing NOLs to offset the corporate franchise tax during the phase-out period (until 2009). The value of these NOLs will shrink as the corporate franchise tax further phases out.
The second option is to convert the NOLs into a credit (NOL CAT Credit) that can be used to offset the first 50 percent of the CAT due until 2030. Practically speaking, this conversion is limited to those taxpayers who have Ohio NOLs of greater than $50 million, since the NOL CAT Credit calculation subtracts $50 million from existing NOLs.
The first installment of the CAT, covering the period from July 1 until December 31, 2005, will be due on February 10, 2006. For subsequent periods, returns will be due 40 days from the end of each calendar quarter for quarterly taxpayers (those with taxable gross receipts of at least $1 million during the calendar year); for annual taxpayers, returns will be due 40 days from the end of the calendar year. Persons are required to register for the CAT by November 15, 2005 if they have annual taxable gross receipts in excess of $150,000. Persons reaching this threshold after November 15, 2005 are required to register within 30 days of reaching $150,000 in taxable gross receipts.
The CAT provides some interesting challenges from a taxpayer's perspective. The first issue that most taxpayers will face is the "double-edged sword" of the consolidated versus combined taxpayer election. For those taxpayer groups whose intercompany transactions are minimal (or confined to loans between companies, since most interest income is excluded from the definition of gross receipts subject to the CAT), the combined election may appear to be the superior option, as this implicitly contains a nexus requirement in order to be subject to the CAT within the group. The CAT's aggressive nexus standards minimize the advantage of the combined election; however, because there is no guarantee that these aggressive nexus standards will hold up under the Constitution. Indeed, the CAT contains a provision that allows taxpayers to appeal directly to the Ohio Supreme Court if the Commissioner determines that the taxpayer has "bright-line nexus."
On the other hand, taxpayers with substantial intercompany activities may choose the consolidated election, as this will arguably eliminate the risk of double taxation on intercompany receipts. The drawback to this election is that any member of the group is then required to pay tax on their Ohio-sourced taxable gross receipts, whether they have nexus or not. This approach is reminiscent of the approach that the State of California (and other unitary states) took in requiring non-nexus companies to include California sales in the numerator of the sales factor under the so-called Finnigan1 approach.
The sourcing provisions for sales other than sales of tangible personal property are interesting as well. The sourcing for intellectual property licensing seemingly takes a Geoffrey2-type approach, looking to the underlying sales facilitated by the intellectual property in order to determine the sourcing on the royalty stream.
1 Appeal of Finnigan Corp., No. 88-SBE-022 (Cal. St. Bd. Equal. Aug. 25, 1988).
2 Geoffrey Inc. v. South Carolina Tax Commission, 437 S.E. 2d 13, cert. denied, 510 U.S. 992 (1993).