A state government proposal that would change how revenue from services affects the corporate income tax of companies that do business in multiple states has drawn opposition from some heavy-hitting business and taxpayer groups.
The influential Americans for Tax Reform, a national tax advocacy group, says the proposed rules issued by the N.C Department of Revenue call for “an unsound approach” that would be akin to a tax increase.
“While North Carolina has been a national leader in tax reform in recent years,” Grover Norquist, the group’s president, wrote in a letter to legislators, “the Department of Revenue’s proposal … would be a step in the wrong direction that results in higher taxes” for businesses.
If the rules go into effect – which is far from automatic – North Carolina would become “one of the highest-taxing states on broadcasters in the country,” said Vans Stevenson, senior vice president of state government affairs for the Motion Picture Association of America. MPAA’s members include Disney, which owns broadcast network ABC and ESPN, and NBCUniversal, which includes NBC and Telemundo.
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The proposed rules delve into the arcane realm of apportioning, for state income tax purposes, the income of service companies that do business in multiple states – including, of course, North Carolina – regardless of where they have headquarters. The services at issue include: “in-person services” such as pest control, professional services such as legal and accounting services, and others such as advertising or a call center. In addition, income from intangibles, such as licensing fees and patent royalties, are covered.
Companies that don’t provide services, such as manufacturers, as well as service companies that do business only in North Carolina, wouldn’t be affected by the proposed rules.
The proposed rules were formulated and published in October as required under a law passed by legislators. A public hearing on the rules was held in October as well, followed by a public comment period that ended Jan. 3.
But because lawmakers dictated a departure from the typical rule-making process, the proposed rules won’t go into effect unless legislators act on them.
Tax attorney Bill Nelson of Raleigh law firm Smith Anderson, whose roster of clients includes MPAA, said the process gives legislators “another bite of the apple” after scrutinizing how the Revenue Department interpreted their mandate – and the business community’s reaction.
“I think it is healthy that we have moved slowly on this so that all involved can have a better understanding and so that if we move forward, helpful changes can be made,” Rep. Jason Saine, a Lincolnton Republican who chairs the House Finance Committee, wrote in an e-mail. “I know that the House Finance Committee intends to review this during the coming session and see if there is consensus on how to best proceed.”
Revenue Department spokesman Trevor Johnson had no comment on the proposed rules or the comments that were submitted. The rules were submitted by the administration of Gov. Pat McCrory, a Republican who lost his bid for re-election to Democrat Roy Cooper, who was sworn in Jan. 1. Cooper hasn’t yet nominated a new secretary of revenue.
Under current state law, income from services is apportioned to multi-state businesses under an “origin-based approach.”
That is, a key factor in determining the amount of income subject to N.C. tax is where the employees and property used to produce the service are located. So if an accounting firm’s Raleigh office does work for a customer in Washington, D.C., those receipts add to the accounting firm’s income subject to North Carolina income tax.
In addition to revenue, property and employee payroll figure into the state’s corporate income tax. But the state is transitioning to a system in which revenue will be the sole factor used to determine income tax, making the proposed rules especially important.
The proposed rules call for switching to “market-based sourcing,” so-called because the tax is based on where the customer receives the benefit of that service. So if an accounting firm’s Washington, D.C., office does work for a customer in Raleigh, those receipts would increase the amount of the firm’s income subject to North Carolina tax.
But figuring out where the service is received isn’t always straightforward. So the rules spell that out for various types of services.
“In the department’s defense,” Nelson said, “this is the whole reason why North Carolina and most states did not have market-based rules for services” historically. “It is very difficult to determine where a service is delivered or received.”
For example, MPAA objects that the proposed rules define the market for broadcasters as the “viewing audience.” The problem, said Stevenson, is that broadcasters don’t get their income from viewers.
“Our customer isn’t the viewer,” he said. “The customer is the cable operator or the advertiser.”
The conservative National Taxpayers Union also objects to the audience-based approach, calling it “outdated and unworkable.”
The Taxpayers Union’s comments on the rules note that there’s also a practical issue involved in taxing a content creator such as a broadcaster based on where the viewing audience is.
Content creators “do not have a direct relationship with the viewing audience,” the organization noted. “As a consequence, content creators do not have the requisite information – billing information, for instance – about the location of the consumer of the content in order to determine their tax liability.”
In addition, the N.C. Retail Merchants Association objects that the proposed rules give the state secretary of revenue broad discretion to adjust the income on a company’s tax return based on what is considered “reasonable.”
“Because Secretaries of Revenue change over time, so does the interpretation of what is a ‘reasonable’ adjustment,” Andy Ellen, the group’s president and general counsel, wrote in submitted comments. “What one secretary deems to be a reasonable adjustment may lead to a lengthy and costly audit” that a different secretary might not require.
That uncertainty, Ellen continued, flies in the face of one of the stated purposes of the legislation that mandated the rules: making North Carolina more attractive for service-oriented businesses.