Editor: Mark Heroux, J.D.
Tax compliance in the United States and internationally is becoming more complex; simplification is still a pipe dream. Laws continue to change as governments pursue means to fill federal, state, and international coffers. Sweeping U.S. federal tax reform, state economic nexus law changes, and the anticipation of global taxation of the digital economy are great examples of new means to collect additional taxes, presumably in the jurisdictions where the revenue is perceived to be earned.
This item broadly summarizes the complexities of a digitalized economy (think activities, transactions, and interactions with electronic underpinnings) for U.S. multinational corporations or companies (or MNCs) and considers the multifaceted implications to U.S. MNCs with respect to financial statements and tax reporting.
Complexities of a digitalized economy for US MNCs
In late 2017, U.S. federal tax reform resulted in the enactment of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. This included an expanded international anti-deferral regime, the new global intangible low-taxed income (GILTI) provisions in Secs. 951A and 250. A U.S. MNC with net tested income in its controlled foreign corporations with income exceeding a 10% return on tangible depreciable assets has this income currently taxed as deemed dividend income. (Note that this is similar, but not identical to, Subpart F income in Sec. 951.)
Although U.S. MNCs may have opportunities for a 50% deduction for these GILTI inclusion amounts under Sec. 250 and the potential for an 80% foreign tax credit, the story plays out in that income previously determined to be nontaxable operating income may now be currently taxed in the United States as a return that is above and beyond a calculable return on the underlying tangible assets (i.e., an intangible income stream). Discussion around a high-tax exception to GILTI is potentially a fix but not without extensive considerations given to planning and the anticipated longevity of such planning.
Subsequently, on June 21, 2018, the U.S. Supreme Court overturned decades of precedent in its decision in South Dakota v. Wayfair Inc.,138 S. Ct. 2080 (2018). In Quill Corp. v. North Dakota,504 U.S. 298 (1992),the Court had previously required that a taxpayer have a physical presence in a U.S. state for the taxpayer to have nexus for sales-and-use-tax purposes with the state. In Wayfair, the Court upheld South Dakota's S.B. 106, which requires remote retailers that have $100,000 in sales or complete 200 transactions in the state to collect and remit sales taxes to the state, regardless of whether the retailers have a physical presence in South Dakota. Exceeding the economic nexus thresholds set by a state is now enough to legally require companies to collect and remit sales taxes. While the court did not define a remote retailer, it is assumed to apply to any seller of tangible goods and services.
Further, the lightning speed at which the Organisation for Economic Co-operation and Development (OECD) is pursuing its efforts to determine how to tax the digital economy, with a focus on producing a consensus solution in 2020, is almost unheard of in the tax world. Such efforts stem from the OECD's base-erosion and profit-shifting (BEPS) initiatives. Preliminary guidance is bifurcated into two pillars: Pillar one focuses on giving additional taxing rights to market jurisdictions (e.g., consideration of where a seller's users reside, where its marketing intangibles reside, and redefining the concept of "nexus" to be more amorphous than physical presence alone); and pillar two focuses on the concepts of a minimum tax and an anti-base-erosion tax. The OECD's overarching goal is to "shape policies that foster prosperity, equality, opportunity, and well-being for all" (OECD, "Discover the OECD" (May 2019)).
Multifaceted implications in financial statements and tax reporting
These developments with regard to the digital economy offer a glimpse into what U.S. MNCs are up against in the years ahead. The Wayfair decision, coupled with favorable economic conditions, has provided the perfect landscape for unreported tax matters to become material. Transactions involving acquisitions and divestitures are currently the norm and in connection with these transactions, particularly in the United States, unreported sales tax continues to be a key sticking point in pending sale or purchase transactions if a company has not ensured a proper plan for tax compliance. The consequences for lack of adequate planning include, but are not limited to, large escrows, purchase price adjustments, and possibly uncomfortable discussions about sales tax exposure during negotiations. Internal finance teams are responsible for ensuring these companies comply with the applicable laws. Along with their other responsibilities, having personnel with an appropriate skill set or available time may be an additional challenge.
As companies evaluate the impact of exposure for noncompliance with sales tax regulations, they should review FASB Accounting Standards Codification Topic 450, Contingencies, and IAS37, Provisions, Contingent Liabilities and Contingent Assets, as appropriate. These standards, which outline the accounting and disclosure requirements for loss and gain contingencies, cover the risk of loss for sales taxes. An estimated loss from a contingency is recognized only if available information indicates (1) it is probable an asset has been impaired or a liability has been incurred at the reporting date and (2) the amount of the loss can be reasonably estimated. Loss contingencies that do not meet both criteria for recognition may still need to be disclosed in the financial statements.
Further, it is important for companies to evaluate whether they have historical tax liabilities prior to registering in a state. If a company has sales tax nexus due to physical presence in a state and has not filed returns, the state can assert the filing responsibility retroactively because there is no statute of limitation. However, if nexus is due to recently enacted economic nexus standards, the liability is generally limited to the date from which the state enacted the new provisions. A key element of South Dakota's law that received approval from the Supreme Court was that it could not be retroactively applied.
All states that impose a sales tax have either enacted or promulgated economic nexus standards or are currently proposing to do so. The majority of states have two standards for determining economic nexus: gross sales and number of transactions. While some states limit these laws to sellers of tangible personal property only, several also impose it upon sellers of services. Sellers of custom software will most likely fall into the service category while sellers of prewritten software will most likely be considered to sell tangible personal property. Sales of software as a service (SaaS) may fall into either category depending on the state. While states have begun to address the sourcing of intangible revenue streams, most still provide little or no guidance.
The OECD's initiatives are anticipated to draw tax revenues to jurisdictions where income is "earned," and, as such, will entail a fundamental change to thinking about nexus. This change will require several levels of consensus, and there will be real and perceived winners and losers as to revenue streams. Each jurisdiction's approach to the digital economy, with unilateral action being undertaken at present, as well as the consensus solution being developed by the OECD, need to be monitored.
Given the multiple jurisdictions involved, this can be an exhaustive exercise, which requires a controlled process to keep up with the developments in individual jurisdictions and the OECD in order to alleviate double taxation where possible. From financial statements to tax compliance, U.S. MNCs will have to determine how to report taxable income by jurisdiction while also telling the whole story of the organization's overall taxable income. For U.S. MNCs, that effort will include filing IRS Form 8975, Country-by-Country Report.
Simplification is still a pipe dream
Proactive analysis of the various U.S. state sales tax laws, as well as monitoring of the impending digital economy guidance on a global basis, may require a U.S. MNC to crystallize internal controls and processes, including worldwide compliance functions. It is anticipated that such controls and processes will be evergreen and fluid and heavily monitored for impending changes.
Mark Heroux, J.D., is a principal with the Specialty Tax Services Group at Baker Tilly Virchow Krause LLP.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.