Legal Alert: Ohio Enacts Substantial Tax Changes

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1 Legal Alert: Ohio Enacts Substantial Tax Changes Last Update: June 30, :25 p.m. On June 30, 2005, Ohio Governor Bob Taft signed legislation enacting one of the most significant tax reforms in Ohio history. The cornerstone of the Governor s reform is the phaseout of the corporate franchise (income) tax and a substantial restructuring of the personal property tax. To replace these two revenue streams, Ohio will impose a new.26% gross receipts tax on most business operations, entitled the Commercial Activity Tax (CAT). The Governor exercised his line-item veto power with respect to some of the bill s provisions; however, the core concepts of the original bill remain intact. This Legal Alert is intended to summarize the new gross receipts tax and property tax changes. The CAT becomes effective July 1, These tax changes may produce immediate significant financial statement considerations, especially for those companies facing a June 30, 2005 quarter close. Commercial Activity Tax Rate and Returns The Taft Tax Reform Plan ( Reform Act ) creates a new.26% Commercial Activity Tax ( CAT ) on Ohio gross receipts. Ohio Rev. Code The CAT becomes effective July 1, 2005 and will be phased-in according to the following schedule: 7/1/2005 3/31/ % of the tax otherwise due. 4/1/2006 3/31/ % of the tax otherwise due. 4/1/2007 3/31/ % of the tax otherwise due. 4/1/2008 3/31/ % of the tax otherwise due. After 3/31/ % of the tax due. This article is for informational purposes and is not intended to constitute legal advice. 1

2 Ohio Rev. Code The CAT is payable within 40 days after the close of each calendar quarter. Ohio Rev. Code The bill contains a mechanism that allows the statutory rate of.26% to be reconsidered every two years. Ohio Rev. Code SAB Observation Because the CAT is payable on a quarterly basis and is based on gross receipts rather than net income, it more closely resembles a sales tax than the franchise tax it replaces. However, see the discussion below on the Character and Incidence of the Tax. Taxable Entities The CAT is very broad-based and applies to business activity conducted in any form including corporations, sole proprietorships, partnerships, S corporations, LLCs (even if they are disregarded for federal income tax purposes), and clubs. However, the Reform Act specifically excludes some business types, including public utilities, financial institutions, insurance companies, and dealers in intangibles. In addition, the CAT was amended in conference committee to exclude nonprofits. All affected entities are required to register with the state no later than November 15, 2005, or when they have $150,000 of gross taxable receipts. Ohio Rev. Code (A), (E). SAB Observation Entities that are not currently subject to the franchise tax but will be subject to the CAT will have a new registration requirement. Gross Receipts Gross receipts are broadly defined to include the total amount realized, without deduction for the cost of goods sold or other expenses incurred, from activities that contribute to the production of gross income. Taxable gross receipts include proceeds from sales, services, or rentals. However, discounts, returns, and bad debts may be deducted from the gross proceeds. Ohio Rev. Code (F). The Reform Act provides for a number of exclusions from gross receipts. For example, the tax base only includes receipts from a trade or business, so interest and return of principal are excluded. Further, the Reform Act also excludes gross receipts from transactions that qualify as a capital gain for federal income tax purposes, dividends, and distributions. Capital contributions, proceeds from stock issuances, and damages are also excluded. Several industries obtained special exclusions, including real estate brokers, mortgage brokers, vehicle dealers, and professional employer organizations. Ohio Rev. Code (F). This article is for informational purposes and is not intended to constitute legal advice. 2

3 Bright-Line Nexus The Reform Act provides a special definition for substantial nexus with this state, which triggers a CAT obligation. Pursuant to the new law, a taxpayer has substantial nexus with Ohio if it: 1. Owns or uses part of its capital in Ohio; 2. Registers to do business in Ohio; 3. Has a bright-line presence in Ohio by having at any time during the year: a. $50,000 of property in Ohio; b. $50,000 of payroll in Ohio; c. $500,000 in Ohio gross receipts; d. 25% or more of its total property, payroll, or sales in Ohio; or e. a commercial domicile in Ohio; or 4. Otherwise has nexus in Ohio under a constitutional standard. Ohio Rev. Code (H). SAB Observation The bright-line presence test is similar to the MTC s factor presence nexus proposal, which purports to establish objective nexus thresholds based on a taxpayer s apportionment factors. Taxpayers are encouraged to challenge the imposition of this nexus test. The Reform Act contains an interesting provision that allows an aggrieved taxpayer to appeal directly to the Ohio Supreme Court any determination by the Commissioner that a taxpayer has bright-line presence in the state. Character and Incidence of Tax The Reform Act specifically states that the CAT is not subject to PL (which applies by its terms only to taxes imposed on, or measured by, net income). The Act states that the CAT is not a transaction tax and the incidence of the CAT falls on the person receiving the gross receipts. The Reform Act contains a specific provision that prevents the CAT from being invoiced or billed to another person. Ohio Rev. Code (H). The version of the Reform Act enacted by the legislature contained a provision allowing the CAT to be invoiced to another person if it was part of a legal contract. The Governor vetoed this provision stating that the CAT is not a tax on transactions. Sourcing (Situsing) of Receipts Unlike the existing Ohio franchise tax, the CAT is not apportioned. Rather, gross receipts are sourced according to the following specific rules: This article is for informational purposes and is not intended to constitute legal advice. 3

4 Gross receipts from the sale or rental of real property are sourced to Ohio if the property is located in Ohio. Ohio Rev. Code (A), (D). Rents and royalties from tangible personal property are sourced to Ohio if the property is located in Ohio. Ohio Rev. Code (B). Gross receipts from the sale of tangible personal property are sourced to Ohio if the property is received in Ohio by the purchaser. Ohio Rev. Code (E). Gross receipts from the sale or grant of the right to use a trademark, patent, or other similar intellectual property is sourced to Ohio based upon the amount of use of the property in Ohio, or the right to use the property in Ohio. Ohio Rev. Code (F). Gross receipts from the sale of most services are sourced to Ohio in the proportion that the purchaser s benefit in this state with respect to what was purchased bears to the purchaser s benefit everywhere with respect to what was purchased. The physical location where the purchaser ultimately uses or receives the benefit of what was purchased shall be paramount in determining the proportion of the benefit in this state to the benefit everywhere. Ohio Rev. Code (I) (emphasis added). The Reform Act also contains an anti-abuse provision contained within the definition of Gross Receipts discussed above. For instance, suppose a seller of tangible personal property was seeking to avoid the imposition of the CAT and therefore delivered the property to an Ohio purchaser outside the state. Under the sourcing rules described above, the sale would not be sourced to Ohio and therefore not lead to the imposition of the CAT. However, pursuant to the anti-abuse provision, if a taxpayer (e.g., the purchaser) transfers property into Ohio for its own use within a year after its purchase, the value of that property must be included in the taxpayer s gross receipts. So, based on the hypothetical situation posed above, if the seller delivers property to an Ohio purchaser outside the state, and the purchaser subsequently transports the purchased goods into Ohio, the purchaser will incur the CAT. The anti-abuse provision produces the very odd result of shifting the tax liability from the seller to the purchaser. These property transfers may be excluded from gross receipts if the commissioner determines that the transfer was not intended in whole or part to avoid the CAT. Ohio Rev. Code The Reform Act permits the commissioner to require, or the taxpayer to request, an alternative sourcing method if the statutory sourcing provisions do not fairly represent the extent of the taxpayer s activity in the state. However, the alternative sourcing option does not apply to the sourcing of services. Ohio Rev. Code (J). The version of the Reform Act enacted by the legislature contained a provision stating that existing franchise tax case law on how to source receipts for sales factor purposes should apply for situsing receipts for the CAT. The Governor vetoed this provision stating that franchise tax sourcing is not necessarily applicable to a new tax. Ohio Rev. Code This article is for informational purposes and is not intended to constitute legal advice. 4

5 SAB Observation The CAT sourcing rules vary greatly from the rules used to compute the existing franchise tax liability. Combination Options and Intercompany Transactions The Reform Act provides two different filing options for related taxpayers. The first option is to file as a combined taxpayer. All taxpayers who have more than 50% common ownership shall file as a combined taxpayer (if they do not file as a consolidated elected taxpayer, which is discussed below). Thus, combined filing is the default filing method for companies meeting the ownership requirement. A combined taxpayer registers and files as a single taxpayer. Presumably, only those taxpayers with substantial nexus (as defined in the Act and described above) with Ohio would be included in the combined return. One key aspect of a combined taxpayer is that intercompany transactions are not excluded from the computation of gross receipts. Thus, if a manufacturing entity sells a product to a related Ohio sales entity, which in turn sells the product to an Ohio customer, the proceeds from both sales should be included in gross receipts. Ohio Rev. Code The second option is to file as a consolidated elected taxpayer. As the name implies, related taxpayers may elect to file in this manner. If elected, the group will include all related parties even those without substantial nexus with Ohio. Unlike the combined taxpayer method, under the consolidated elected taxpayer option, intercompany transactions are excluded from the computation of gross receipts. The election is binding for 8 quarters. The taxpayer may also choose to include all foreign corporations in the group. A taxpayer may not choose which foreign corporations to include; the election requires that all foreign corporations or no foreign corporations must be included. Ohio Rev. Code Phase-Out of Corporate Franchise Tax The Reform Act eliminates the corporate franchise tax over five years for those taxpayers subject to the CAT. Ohio Rev. Code (g). The tax will be phased-out according to the following schedule: 2006 Tax Year 80% of the tax otherwise due Tax Year 60% of the tax otherwise due Tax Year 40% of the tax otherwise due Tax Year 20% of the tax otherwise due Tax Year and later No tax. This article is for informational purposes and is not intended to constitute legal advice. 5

6 Survival of Pre-CAT Net Operating Losses The Reform Act contains a very complex set of rules that address the survivability of NOL carryovers. This summary is intended to be a high-level review and does not discuss the numerous exceptions and special rules contained in the Reform Act. Taxpayers should carefully evaluate the application of the specific NOL provisions to their facts and circumstances. The Reform Act essentially provides two options to account for/utilize existing NOLs. The first option is to use existing NOLs against the phased-out corporate franchise tax over the next five years recognizing that as the corporate franchise tax decreases, the effective state rate used to value the NOLs also decreases. Ohio Rev. Code The second option is to convert the NOLs into a credit that can be used against the CAT, but this is only a practical consideration for taxpayers with Ohio NOLs in excess of $50 million (keeping in mind that combined and consolidated companies aggregate their losses). To calculate the credit, the Reform Act starts with a concept of a disallowed Ohio net operating loss carryforward ( DISNOL ). The DISNOL is the lesser of 1) the amount of Ohio NOL a taxpayer could have used during 2006 had the franchise tax survived intact minus $50,000,000, or 2) the amount of Ohio NOL the taxpayer used to calculate its deferred tax asset reflected on its books and records on the last day of 2004 minus any valuation allowance taken against the NOL minus $50,000,000. Once the DISNOL has been computed, the taxpayer then considers the concept of amortizable amount in computing the NOL credit against CAT. If a taxpayer has a positive Ohio deferred tax asset, the amortizable amount is equal to 8% (i.e., the former corporate franchise tax rate) of the sum of the DISNOL plus the deferred tax assets apportioned to Ohio. The amortizable amount becomes a cap for the credit. For each year before January 1, 2030, a taxpayer may use the amortizable amount to offset its CAT liability through the following formula: % of the amortizable amount % of the amortizable amount, less all amounts previously used; % of the amortizable amount, less all amounts previously used; % of the amortizable amount, less all amounts previously used; % of the amortizable amount, less all amounts previously used; % of the amortizable amount, less all amounts previously used; % of the amortizable amount, less all amounts previously used; This article is for informational purposes and is not intended to constitute legal advice. 6

7 % of the amortizable amount, less all amounts previously used; % of the amortizable amount, less all amounts previously used; 2019 through % of the amortizable amount, less all amounts previously used Any unutilized CAT credit becomes a refundable credit. The credit can only be used to offset the first 50% of the CAT, after the allowance for other credits that proceed the NOL in priority (i.e., jobs retention credit and R&D credits). NOTE: In order to use any amortizable amounts, a taxpayer must file a one-time report on June 30, 2006 that states the total amortizable amount. Ohio Rev. Code SAB Observation The NOL provision is somewhat limited because of the $50M floor. However, if a taxpayer exceeds the floor, the complex rules may allow for the use of some NOLs that would otherwise be lost with the repeal of the franchise tax. Property Tax Reform Under the Reform Act, personal property tax on new manufacturing machinery and equipment is exempt starting in The property tax on existing machinery and equipment, furniture and fixtures, and inventory is phased out starting in tax year 2006 and ending with no tax due in The property tax exemption will impact the municipalities. In order to ease the impact, the State will reimburse the school districts and local governments for the revenue lost by the reduction of the personal property tax base, using 2004 as a base year and patterning the process after the mechanism that was used for utility deregulation. From fiscal year 2012 through 2020, the reimbursements will be phased out. Ohio Rev. Code 5711 et seq. Please contact one of the following attorneys if you are interested in more information on these details. Jeff Friedman jeff.friedman@sablaw.com Kendall Houghton kendall.houghton@sablaw.com Scott Wright scott.wright@sablaw.com Todd Lard todd.lard@sablaw.com This article is for informational purposes and is not intended to constitute legal advice. 7