April 21, 2010
April 21, 2010
Washington State’s 2010 Tax Package
By Michele Radosevich, Garry Fujita, and Dirk Giseburt
Davis, Wright and Tremaine LLP
Every taxpayer in Washington will be directly or indirectly affected by massive changes to the Revenue Act of 1935, which is projected to raise close to $800 million in this biennium and over $1.6 billion in the next biennium.
The Washington State Legislature enacted the biggest set of changes to state tax law since 1993 – perhaps since 1935. Key was the final tax package, 2ESSB 6143, with major changes on many fronts.Some changes will affect nearly every taxpayer and others are discretely aimed at particular targets. The following are some examples:
* In the next twelve months, if you have a service business (there are few exception for hospitals and other service providers) you will likely see your B&O tax raised by 20% and in the aggregate, the service group will pay an additional $241 million dollars in new taxes.
* If your business sells cigarette or tobacco products, your industry will annually pay an additional $101.4 million in new taxes.
* If your business formerly used the direct seller exemption, your industry sector will pay $155 million in new taxes per year.
* A very controverisial change will tax and apportion certain businesses receipts under a new economic nexus standard, and that group will pay $84.7 million per year in new taxes. Instate services might find that they pay less tax and out-of-state business will most certainly pay more.
* If you are a CEO or CFO, then you now have personal liability for sales tax collected but not remitted to the state by your company. If you were the CEO or CFO when the error occurred, then you have persoal liability whether [you?] the person was at fault or whether [you?] the person knew or should have known of the error. There are two conditions before attaching the liability: (1) the company is insolvent, terminated, dissolved, or abandoned and (2) the state issues a warrant for collection of the unremitted sales tax. The state estimates this might be as much as $1 million per year.
The following description is at a very high level, and there is much detail omitted from this bulletin.
Final Tax Package
1. B&O Tax for Multistate Service and Royalty Businesses.
Minimum Nexus. The legislation enacts “economic” nexus standards for out-of-state service and intellectual-property businesses for B&O tax purposes. This affects businesses that do not sell tangible personal property; in other words, the affects businesses that sell services and other business activities (rate 1.5%; temporarily 1.8% beginning May, 1, 2010 and ending June 30, 2013) like financial services or the management and receipt of royalties.
Economic nexus is established with the state if the taxpayer has more than $250,000 of receipts from Washington customers. Nexus is also established if Washington payroll is more than $50,000 and the Washington property is more than $50,000. Nexus is also established if more than 25% of the taxpayer’s total property, total payroll and total sales are in Washington. There are allocation rules to determine whether the payroll, property or sales are treated as part of Washington’s domain. Once economic nexus is present, it lasts for the current and one subsequent tax year.
Single-Sales-Factor Apportionment. Except for financial institutions, the bill requires these taxpayers to use a single-sales-factor formula. The state is abandoning the Rule 194 cost-apportionment method; the Department of Revenue must establish apportionment for financial institutions by rule. This means that out-of-state businesses would pay B&O tax on 100% of income from services to Washington customers and of royalties paid by Washington customers. The corollary is that instate businesses selling services out of state would also use the single sales factor, allowing Washington services business to pay no B&O on their out-of-state sales. This is good news for the instate businesses and bad news for the out-of-state businesses.
The apportionment formula for service income is Washington sales divided by worldwide sales. Sales are sourced to Washington if the benefit can be attributed to Washington. Otherwise, there is a series of attribution rules that must be followed. This will be tricky because the formula is based on the current tax year, which is technically impossible to determine until the tax year has been completed. The law permits the use of the prior year’s formula but the taxpayer must make adjustments by October 31 following the close of the tax year. Any taxes due bear interest from the date the tax was due.
TIP: For an instate taxpayer, it will be important to understand quickly the attribution rules that determine if sales receipts are attributed to Washington. The rules are hierarchial and no one criterion will apply to all receipts. Rather, the hierarchy of criteria must be applied to each customer project. For an out-of-state taxpayer, it must first determine if it has met the substantial nexus tests, and then begin to determine when to atribute income to Washington.
Constitutionality Questions. An obvious question is whether these changes are constitutional on either the nexus principle or the apportionment formula for division of income. The bill recognizes the risk, providing that all nexus and apportionment sections of the bill are null and void if a court invalidates the law as to the nexus standard (but not the apportionment standard). It is not clear why this language is in bill unless the state will interpret null and void to mean that the law never existed, opening the door to taxing retroactively the businesses that benefitted from the single-sales-factor formula. (Effective June 1, 2010.)
2. “Tax Avoidance Transactions.” This part of the bill allows the Department of Revenue to disregard certain transactions that it believes lack economic substance and are used to avoid Washington excise taxes. The power to disregard applies to three identified transactions if they lack economic substance that include:
o Construction or development joint ventures organized so as to substitute payments for a contractor’s goods and services with the return of capital (a B&O and sales tax issue);
o setting up separate entities outside of Washington in order to move taxable income to another jurisdiction (a B&O tax issue); and
o the “drop kick” subsidiary that was used to eliminate sales or use tax on tangible personal property transfers between non-related parties (sales and use tax).
The Department is permitted to consider the following to determine if the transactions have economic substance:
Whether an arrangement or transaction changes in a meaningful way, apart from its tax effects, the economic positions of the participants in the arrangement when considered as a whole;
Whether substantial nontax reasons exist for entering into an arrangement or transaction;
Whether an arrangement or transaction is a reasonable means of accomplishing a substantial nontax purpose;
An entity’s relative contributions to the work that generates income;
The location where work is performed; and
Other relevant factors.
Previously, the Department of Revenue has generally not been allowed to use any of these principles to deny particular tax results, regardless of whether an auditor believed tax should be due or a taxpayer arguing that no tax should be due. As there is no Washington case law, use of these principles will likely be an adventure for both taxpayers and agency. For example, one test is whether the arrangement or transaction is a reasonable means of accomplishing a “nontax” purpose. Does this means that if a taxpayer solely engaged in a transaction to take advantage of a federal income tax provision, then will that be treated as a “nontax” purpose?
The bill also requires the Department to apply a 35% penalty when it determines that transaction or arrangement should be disregarded. Transactions or arrangements have immunity if the taxpayer reported its tax liability based on specific reporting instructions given by the Department, a determination published under RCW 82.32.410, or other instructions that the Department gave to the general public. (Effective date of the authority to disregard and penalty is retroactive to January 1, 2006; the immunity provision lasts only until May 1, 2010.)
TIP: If you discover that you have a prohibited arrangement or transaction, you can avoid the mandatory 35% penalty if you disclose the suspected arrangement or transaction to the Department of Revenue. Although you could apply the tests in the statute to determine for yourself if the arrangement or transaction has economic substance, remember that the Department of Revenue is not required to use the statutory tests and may use any other test that it deems appropriate. This makes predicting the outcome nearly impossible. With this type of discretion, taxpayer will be at the mercy of the Department of Revenue, making the more conservative approach to report, pay the tax and then seek to get it back.
The bill creates a temporary joint legislative review committee to monitor the Department’s implementation of this section of the bill and to study use of substance over form. Further, to the extent resources allow, the Department may study the taxing of intercompany transactions when tax applied is merely because of the form of the transaction and the economic substance is lacking. (Both expire on July 1, 2011.)
3. Real Estate Excise Tax Tightened Up. The bill also addresses a number of asserted gaps in the real estate excise tax.
Options to Acquire Entity Interests. The bill eliminates the use of options to acquire entity interests over time to avoid the real estate excise tax. Some parties had used binding options, requiring buyers to acquire not more than 50% of the real estate interest in each of three consecutive years, to avoid a transfer a taxable “controlling interest” in any of those years. Now, if an option is exercised, the “controlling interest” is deemed to have been acquired relating back to the execution of the option agreement. This can no longer be done to avoid the real estate excise tax. Evasion penalties will apply if the granting of such an option is not reported on annual reports to the Secretary of State, if the option is ultimately exercised and tax is due. (Effective May 1, 2010.)
Parent Liable for Dissolved Subsidiary’s Tax. The bill also eliminates the ability of the seller to avoid the real estate excise tax by use of entity created for the purpose of holding and then selling the real estate where the selling entity is dissolved without paying the tax before dissolution, by making the “parent corporation” liable as the “seller.” (Effective May 1, 2010.)
4. Limiting the First Mortgage Interest Deduction. This section clarifies the deduction that mortgage lenders take on the interest that they receive. It clarifies that interest, points and loan origination fees recognized over the life of the loan qualify for the deduction. A sample of what is excluded are receipts for documentation preparation, finder fees, brokerage fees, title examination fees, gains from the sale of servicing rights, and gains from the sale of loans. Loan servicers, who do not own the loan, are allowed the deduction only if (1) amounts received for servicing are determined by a percentage of the interest paid and are only received if interest payments are made, and (2) the servicer is the loan originator or acquired the loan originator through merger or acquisition. (Effective June 1, 2010.)
5. The Direct Seller Representative Exemption. This section eliminates a substantial part of the exemption for out-of-state sellers who sold goods exclusively through a statutorily defined agent. This section retroactively narrows the exemption to sales only done in home parties and door-to-door sales by limiting the exemption to (1) out-of-state taxpayers that sell only consumer products (taxpayer cannot sell both consumer and nonconsumer products) and (2) out-of-state taxpayers that use direct seller representatives who make retail sales in the home. (Effective retroactively for periods prior to May 1, 2010; the exemption is repealed beginning May 1, 2010.)
6. B&O Tax Preferences for Manufacturers of Products Derived from Certain Agricultural Products. Under the original statutory language, the preferential B&O tax rate for certain processing of meat products derived from animals extended beyond slaughterhouses and butchers. The bill prevents the processing of meat into food products (like chili con carne) from qualifying the lower B&O tax rate (.0138%). The provision also clarifies the special processing rate does not apply to fish. (Effective June 1, 2010.)
Similarly, the bill clarifies that the special rate (.0138%) applies to fruit and vegetable processing only as long as the final product is exclusively fruits, vegetables or any combination of the two. (Effective June 1, 2010.)
7. Suspending Sales and Use Tax Exemption for Livestock Nutrients etc. This section suspends the sales and use tax exemption for certain livestock nutrient management equipment and related labor and services. (Effective July 1, 2010 until June 30, 2013.)
8. B&O Tax Treatment on for Director Fees Received. There is no statutory exemption and this bill makes it clear that such director fees paid to a director must be reported as gross receipts for B&O tax purposes under the service rate (1.8% including the temporary service tax increase described below). Recognizing that some taxpayers have already paid this tax, the bill denies refunds to those who previously paid the tax on the basis that the tax was always due and to grant refunds would be a gift of public funds in violation of Article VIII, Section 5 of the state constitution. Consequently, there is a temporary, unwritten exemption — for those directors who received director fees but have not paid the tax — until the July 1, 2010 effective date of this section. (Effective July 1, 2010.)
9. Tax Debts. Under current law, if a taxpayer collects sales tax from its customers but does not pay it over to the state, then the “responsible party” who “willfully” failed to pay the state could be held personally liable for the collected but unremitted sales tax under some circumstances. This section will create strict and personal liability for the CEO and CFO of the collected but unremitted sales tax. Lack of knowledge (which means, apparently, even theft by an employee) is no defense. In order to trigger this personal liability, the Department of Revenue must (1) issue a warrant to the taxpayer and (2) the taxpayer must be insolvent, or the taxpayer must have been terminated, dissolved or abandoned. Noteworthy is that the personal liability attaches even though the CEO or CFO may not be employed at the time the warrant is issued and the taxpayer is insolvent, or has been terminated, dissolved or abandoned. The critical question is whether the CEO or CFO was employed in that capacity at the time the liability accrued. (Effective June 1, 2010.)
WARNING: Absent a constitutional argument, the CEO or CFO has no defense to the collection and failure to remit the sales tax to the state during the time he or she held the office. Consequently, a CEO or CFO could leave the taxpayer unaware of the error, when the firm was solvent. Four years later when the auditor discovers the error (e.g., an employee was embezzling and filing false returns), the firm might be insolvent, triggering the warrant, and making that officer liable for the collected but unremitted sales tax four, five, and maybe even ten years later after the error.
10. Repeal of the Sales and Use Tax Exemption for Bottled Water and Candy. Under this section, sales tax will now apply to bottled water and candy until July 1, 2013. “Candy” is defined as a product prepared with sugar, honey, or other natural or artificial sweeteners in combination with chocolate, fruits, nuts, or other ingredients or flavorings in the form of bars, drops, or pieces. It does not include preparations made with flour and does not require refrigeration. “Bottled water” is water that is bottled in a sealed container or package for human consumption. It is calorie free and does not contain sweeteners or other additives though it may contain antimicrobial agents, fluoride, carbonation, vitamins, minerals, electrolytes, oxygen, preservatives and flavors, extracts or essences derived from a spice or fruit. There are some exceptions that apply to prescriptions, bottled water that is the only source of water, and others. For candy manufacturers, there is a B&O credit for employees employed in Washington State. The Department of Revenue must compile a list of products that fall within and without the products on which the sales and use tax applies. (Effective June 1, 2010.)
11. PUD Privilege Tax Clarification. This section clarifies that any recurring charge billed to customers as a condition to receiving electric power is subject to the tax imposed under Chapter 54.28 RCW. (Effective May 1, 2010, applies prospectively.)
12. Temporary Increase of B&O Tax on Service; Increase of Small Business Credit. This section temporarily increases the B&O tax rate from 1.5% to 1. 8% beginning on May 1, 2010 and ending June 30, 2013. This increase does not apply to hospitals or companies performing research and development. The small business credit for the businesses affected by this temporary tax doubled from $35 to $70 per month. (Effective May 1, 2010.)
13. Property Management Salaries. Under current law, property management companies that assign employees to live on-site for property owners (owners of apartment houses) were allowed to deduct the wages paid to the assigned employees. This section will eliminate the deduction for for-profit property management companies. The exemption remains for (1) wages of employees employed by nonprofit management companies and (2) amounts paid by a housing authority to a property management company for on-site personnel. (Effective June 1, 2010.)
14. Temporarily Increasing Beer Taxes. Until June 30, 2013, this section imposes an additional tax of $15.50 on a thirty-one gallon barrel of beer. This section exempts the first 60,000 barrels of beer per year if the brewery is entitled to a reduced tax rate under 26 U.S.C. Sec. 5051 of the federal internal revenue code. (Effective June 1, 2010.)
15. Temporarily Imposing Tax on Carbonated Beverages. This section imposes a selling tax on the privilege of selling at wholesale or retail carbonated beverages at the rate of two cents per twelve ounces of carbonated beverages. There is an exemption for carbonated beverages if they were previously taxed under this section. There is also an exemption for the first ten million dollars of carbonated beverages sold in Washington. (Effective July 1, 2010 through June 30, 2013.)
16. Limiting Bad Debt Deduction. This section limits the bad debt deduction for sales tax that has been collected and paid to the state to the seller who collected, paid but did not fully recover the sales tax from the customer. It eliminates the ability to assign the right to the refund to a purchaser of the debt, preventing the assignee from taking the bad debt deduction. (Effective May 1, 2010.)
17. Data Centers. This section permits a sales and use tax exemption for eligible server equipment installed in an eligible computer data center. The scope includes equipment, labor and services to install the same as well as eligible power infrastructures. The applicant must apply in advance for a certificate to buy the goods and services without paying the sales or use tax. The benefit is tied to creating a certain number and type of jobs. As with other tax benefit programs, an annual report must be filed with the Department. (Effective May 1, 2010.)
18. Tobacco Taxes. Although contained in HB 2493, rather than the omnibus tax package, the final piece of the revenue package was an increase in cigarette and other tobacco product taxes.
Digital Products Revisited
Substitute House Bill 2620 was passed without controversy with the asserted purpose of correcting oversights and unintended consequences in the “digital products” bill passed in 2009, Engrossed Substitute House Bill 2075.
1. Remote Access Software and Data Processing. The 2009 bill imposed sales tax on the use of remote access software (“cloud computing”). Section 201 of SHB 2620 “clarifies” that this service includes remote access to perform “data processing,” which includes check, payroll, and claim processing and similar activities.
2. “Consumers” of Digital Products, Digital Codes, and Remote Access Software. Section 202 of SHB 2620 amends the definition of “consumer” to clarify that a purchaser or user of digital products, digital codes, or remote access software is not a “consumer” (and therefore subject to sales or use tax) if the digital product, digital code, or remote access software becomes a component of a new “product” – including digital products and remote access software services. A corresponding change was made in Sections 401 and 501, deleting the exemptions from sales and use tax under RCW 82.08.02082 and 82.12.02082 for the equivalent activity.
3. Exclusions from “Digital Automated Services.” The list of services excluded from “digital automated services” – and therefore from “digital products” – was expanded in Section 203 by specifying (a) “live presentations” accessed electronically or by telecommunications in which audience participation is feasible; (b) “advertising services” (described in the bill at length); (c) mere storage of software, digital products, and digital codes; and (d) “data processing services.”
4. Photographic Services as a “Digital Good.” Section 203 also specifies that photography is not among the personal and professional services excluded from “digital goods” when the photographs are transferred electronically to a consumer.
5. B&O Rates for Subscription TV and Radio Services. The 2009 legislation, by treating radio and television transmissions as a “digital good,” inadvertently converted such services to the “retailing” B&O classification from the “services” classification – reducing the B&O revenue stream by over 2/3s. This oversight is “corrected” in Sections 203 and 301 of the 2010 bill by providing new definitions of subscription radio and television services and specifying that these services are excluded from the digital products classification of RCW 82.04.257 and instead are taxable as services under 82.04.290(2).
6. Redefining “Internet Access” Again. After the 2009 bill amended Washington’s definition of “internet access” to match the federal definition under the Internet Tax Freedom Act, it was discovered that this had the effect of raising the B&O tax rate for those who provide telecommunications services to Internet access providers from the “retailing” rate to the “services” rate. The solution was not to create a specific B&O-classification solution (as for radio and tv subscription services) but, in Section 303 of the bill, to change “internet access” so that it no longer matches the federal standard – it now excludes telecommunications purchased, sold, or used to provide Internet access services.
7. Restricting Sales and Use Tax Exemption for Digital Products Distributed for Free. The sales and use tax exemptions under RCW 82.08.02082 and 82.2.02082 for digital products made available free of charge is now restricted to businesses and other organizations who make such products available free of charge to “the general public.” The exemption requires that the distributor have the legal right to engage in this distribution. Sections 401 and 501.
8. “Business Use” Exemption Expanded. The sales and use tax exemption under RCW 82.08. 02087 and 82.12.02087 for the acquisition of “standard digital information” for business purposes is expanded under Sections 402 and 502 of the bill to cover all digital goods and the installation, repair and improvement of digital goods.
9. Nexus Restriction Based on Software in the State. The 2009 bill excluded from the determination of whether a person is taxable in Washington under the Commerce Clause consideration of any digital good or digital codes owned by the person that reside in Washington. Section 701 of the 2010 bill treats software and master copies of software in the same way.
10. Effective Dates. Section 902 asserts that the bill has a retroactive effective date to July 26, 2009 – the effective date of the 2009 bill – except for the changes identified in paragraphs 2, 7, and 8 above (which are prospective only as of July 1, 2010).
Other Tax Bills
HB 1597 makes a number of small clarifications in tax law.
HB 2672 extends tax incentives for aluminum smelters.
HB 3014 retroactively narrows the applicability of the sales tax deferral program for distressed counties.
HB 3179 allows local governments to raise sales taxes with voter approval and eliminates non-supplant language to give local governments more flexibility. It also imposes a brokered natural gas use tax at the location where the gas is consumed or stored by the consumer.
SB 6169 broadens the use of Notice & Deliver lists used to collect tax warrants.
SB 6339 creates a sales tax exemption for materials used to create molds used in industrial processes.
SB 6712 extends the tax incentives for clean fuels & aircraft repair.
SB 6737 exempts air ambulances owned by non-profits from property tax.