By Gary C. Bingel, CPA, JD
One of the hottest state tax topics today is the application of FASB Interpretation No. 48 (FIN 48). One reason for this is that the state tax arena historically has been one of high litigation and uncertainty, with relatively little guidance compared with federal tax. An area of uncertainty that is growing in importance relates to what would appear to be a basic FIN 48 question: what state and local taxes are "income taxes" for FIN 48 purposes?
FIN 48 is an interpretation of FASB Statement No. 109 (FAS 109), Accounting for Income Taxes, so the definition of "income tax" found in FAS 109 applies to FIN 48 as well. FAS 109 defines income tax as all "taxes based on income." This definition may be adequate at the federal level, but it has been subject to varying interpretations at the state and local tax levels. There are myriad taxes at the state and local level, some based on gross receipts, gross income, net worth, or combinations thereof. If "income" for FIN 48 purposes means net income, when do state addbacks become so material as to cross the line from a net income base to something else?
An example of this addback issue was the old Michigan Single Business Tax (SBT).1 While SBT calculations started with federal (net) taxable income, taxpayers would add to it all compensation and benefits, as well as depreciation, royalties paid, interest paid, among other items. For many taxpayers, these deductions were the majority of their expenses. As a result, companies with large book and tax losses would still have significant SBT liabilities.
The Pennsylvania Capital Stock and Franchise Tax (CSFT) poses another potential issue. The CSFT uses a five-year average of book income as one component of its tax base and net worth as the other. Is this considered to be a tax based on income? What portion, if any, of a company’s CSFT liability should be included in its FIN 48 analysis?
At the local level, a similar issue exists regarding local business privilege and gross receipts taxes. For instance, Philadelphia imposes a Business Privilege Tax (BPT) with two tax bases: net income and gross receipts. Taxpayers pay both. Should just the net income portion of the BPT be included in FIN 48 calculations?
The Michigan SBT, Pennsylvania CSFT, and Philadelphia BPT are only three examples of many where there is a lack of consistency and guidance. In a small, informal survey,2 various tax professionals were asked whether these taxes, among others, should be deemed "income tax" for FAS 109 and FIN 48. Majorities were achieved on most, but the only tax that had a unanimous decision was the Washington Business and Occupation Tax - 100 percent responded that it was not an income tax. Respondents thus far have been split - about 60 percent to 40 percent - against including the Michigan SBT in their FIN 48 and FAS 109 analysis. While a clear majority - about 85 percent - was against including the CSFT in FAS 109 analysis, there were still 15 percent who thought it was an income tax for these purposes. This author is aware of at least one instance where a major international accounting firm directed a client to include the CSFT in its FIN 48 analysis.
To illustrate the need for clear, consistent guidance, consider this example: one company is located in Philadelphia, the other is in Pennsylvania but outside Philadelphia. Both have similar revenue and net worth, and both have current year losses. If the Philadelphia business includes the CSFT and BPT in its FAS 109 calculations, and the other does not, the two could have materially different tax provisions and financial statements. Also, showing a loss but reflecting income taxes paid results in a negative effective tax rate. Due to these differences, investors may assume the Philadelphia business is not operating as efficiently as the other business, and base their investment decisions accordingly. This obviously does not meet the objective of FIN 48 to improve consistency and transparency of reporting for investors.
There is a clear need for a consistent interpretation of FAS 109 and FIN 48 regarding state taxes. There are several options for an analytical framework of deciding which state taxes are income taxes and which are not. One would be to link the definition of income tax for FIN 48 purposes to a definition used for other tax purposes, such as federal legislation P.L. 86-272.3 There is a fair amount of guidance on interpreting taxes in light of P.L. 86-272, but one problem with this approach is that P.L. 86-272 applies only to net income taxes. Despite this, it seems appropriate that there be some level of consistency between federal legislation, GAAP, and state legislation when it comes to defining income taxes. Unfortunately, until a proper analytical framework is devised, or appropriate guidance is issued, tax practitioners will have to make due with an "I know it when I see it" approach.
1 The "old" SBT was repealed, effective Dec. 31, 2007, and will be replaced by a new Michigan Business Tax (MBT), effective Jan. 1, 2008.
2 The results of this survey are still being compiled. Readers may access it and complete it electronically at www.smartgrp.com.
3 Public Law 86-272 is a federal statute that limits a state’s ability to impose a net income tax on businesses that limit their activities to solicitation of sales of tangible personal property.
Gary C. Bingel, CPA, JD, is managing director of tax services with SMART Business Advisory and Consulting LLC in New York. He can be reached at gbingel@smartgrp.com.
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