Big Tax Changes Introduced in Washington State
Last week, 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 12 months, if you have a service business (there are few exceptions for hospitals and other service providers) you will likely see your B&O tax raised by 20 percent 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 controversial change will tax and apportion certain business receipts under a new economic nexus standard, and that group will pay $84.7 million per year in new taxes. In-state 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, 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 personal liability whether you were at fault or whether you 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.
- Buyers and sellers of digital goods, online services and telecommunications will see numerous “corrections” and adjustments of the 2009 legislation on digital products through a separate bill, SHB 2620.
The following description is at a very high level, and there is much detail omitted from this advisory. Our goal is to provide an initial overview to help guide your next steps and further research.
THE FINAL TAX PACKAGE
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, businesses that sell services and other business activities (rate 1.5 percent; temporarily increasing to 1.8 percent beginning May, 1, 2010—see below), such as 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 or the Washington property is more than $50,000. Nexus is also established if more than 25 percent 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 could pay B&O tax on 100 percent of income from services to Washington customers and of royalties paid by Washington customers. The corollary is that in-state businesses selling services out of state would also use the single sales factor, potentially allowing Washington service businesses 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 Oct. 31 following the close of the tax year. Any additional taxes due bear interest from the date the tax was due.
Tip: For an in-state taxpayer, it will be important to understand quickly the attribution rules that determine if sales receipts are attributed to Washington. The rules are hierarchical, and no single criterion will apply to all receipts. Rather, the hierarchy of criteria must be applied to each customer project. Out-of-state taxpayers must first determine whether they have met the substantial nexus tests, and then begin to determine when to attribute 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 the 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 benefited from the single-sales-factor formula. (Effective June 1, 2010.)
“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, namely:
- 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);
- Setting up separate entities outside of Washington in order to move taxable income to another jurisdiction (a B&O tax issue); and
- The “drop kick” subsidiary that was used to eliminate sales or use tax on tangible personal property transfers between nonrelated parties (sales and use tax).
The Department of Revenue is permitted to consider the following to determine whether 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 the tax results of the form of the transaction, regardless of whether an auditor believed tax should be due or a taxpayer was arguing that no tax should be due. Because 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 mean that if a taxpayer engages in a transaction solely to take advantage of a federal income tax provision, the transaction will be treated as a “nontax” purpose?
The bill also requires the department to apply a 35 percent 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. (The effective date of the authority to disregard and of penalty is retroactive to Jan. 1, 2006; the immunity provision lasts only until May 1, 2010.)
|Tip: If you discover that you have a disregardable arrangement or transaction, you can avoid the mandatory 35 percent penalty if you disclose the 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, taxpayers will be at the mercy of the Department of Revenue, and therefore may choose 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 a tax is applied merely because of the form of the transaction and the economic substance is lacking. (Both provisions expire on July 1, 2011.)
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 percent of the real estate interest in each of three consecutive years, to avoid a transfer of 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 an 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.)
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. Some of the receipts excluded from the deduction include documentation preparation fees, 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.)
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 done only in home parties and door-to-door 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.)
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 for the lower B&O tax rate (0.0138 percent). 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 (0.0138 percent) 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.)
Suspending sales and use tax exemption for livestock nutrients, etc.
The act 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.)
B&O tax treatment of director fees specified
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 percent 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 that to grant refunds would be a gift of public funds in violation of Article VIII, Section 5 of the state constitution. Consequently, there may be 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.)
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. The act imposes strict and personal liability on the CEO and CFO for 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, (1) the Department of Revenue must 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 liability for 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 executive liable for the collected but unremitted sales tax years after the error.
Repeal of the sales and use tax exemption for bottled water and candy
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 categories to which the sales and use tax applies. (Effective June 1, 2010.)
PUD privilege tax clarification
The act 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.)
Temporary increase of B&O tax on services; increase of small business credit
The act temporarily increases the B&O tax rate from 1.5 percent to 1. 8 percent 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.)
Property management salaries
Under current law, property management companies that assign employees to live on-site for property owners (for example, owners of apartment houses) are allowed to deduct the wages paid to the assigned employees. The act eliminates 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.)
Temporarily increasing beer taxes
Until June 30, 2013, the act imposes an additional tax of $15.50 on a 31-gallon barrel of beer. The first 60,000 barrels of beer per year are exempt 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.)
Temporarily imposing tax on carbonated beverages
The act imposes a selling tax on the privilege of selling at wholesale or retail carbonated beverages at the rate of two cents per 12 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 $10 million of carbonated beverages sold in Washington. (Effective July 1, 2010, through June 30, 2013.)
Limiting bad debt deduction
The act limits the bad debt deduction for sales tax that has been collected and paid to the state to the seller who collected and 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.)
The act 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 of Revenue. (Effective May 1, 2010.)
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.
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.
“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 not 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.
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.”
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.
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 more than two-thirds. 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).
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.
Restricting sales and use tax exemptions for digital products distributed for free
The sales and use tax exemptions under RCW 82.08.02082 and 82.12.02082 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 the distribution. (Sections 401 and 501.)
“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.
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 goods or digital codes owned by the person that resides on a server in Washington. Section 701 of the 2010 bill treats software and master copies of software in the same way.
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 defining “consumers” of digital products, etc.; restricting the sales and use tax exemptions for digital products distributed for free; and expanding the exemption for “business” use” of digital goods described 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 nonsupplant 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 and aircraft repair.
- SB 6737 exempts air ambulances owned by nonprofits from property tax.