State & Local Taxes

Beware Ohio’s CAT

Public companies have been involved in interstate commerce for many years. The Internet has made such commerce more accessible to privately held smaller businesses, allowing them to expand their markets and increase sales. However, this increase in interstate commerce has had a negative effect on states that have an income tax system. Most of these tax systems are out-of-date and unable to bring in sufficient dollars to support ever-growing state budgets. This has caused some states to explore new tax systems, such as subjecting flowthrough entities to corporate franchise taxes or establishing a gross receipts tax.

A good example of this is Ohio. For the last several years, it has had a hard time collecting enough tax revenue to support its budget, causing budget and funding cuts. Ohio’s previous tax system placed most of the tax burden on manufacturers. The tax system was composed of a franchise/income tax levied on C corporations and a personal property tax levied on every business that held personal property used in a trade or business within the state. This tax system was adequate in the past, when most Ohio businesses were capital-intensive companies. However, the state has seen a shift from a manufacturing-based economy to one more focused on the service sector. This greatly reduced the tax dollars being collected, as service businesses are usually organized as flowthrough entities and are not capital-intensive.

In an effort to increase revenue, Ohio proposed an overhaul of its tax system that resulted in a gross receipts tax, entitled the commercial activity tax (CAT). The tax was enacted July 1, 2005 as part of the state’s biannual budget; see L. 2005, H66. The tax is a low-rate, broad-based tax levied on all Ohio taxable gross receipts. Its intent is to shift some of the tax burden from capital-intensive businesses to service-based ones, and also to out-of-state businesses that sell into Ohio. Additionally, the tax provides an incentive to Ohio businesses to sell their products and services outside the state; these gross receipts are not subject to the CAT.

Bright-Line Nexus

A component of the CAT is the bright-line nexus rule, OH Rev. Code (ORC) 5751.01(H)(3). Under P.L. 86-272, a state cannot tax a business for mere solicitation of sales in that state; a physical connection with that state is needed to establish nexus. However, P.L. 86-272 only governs income tax on interstate transactions. In the CAT, Ohio chose to enact an economic-nexus threshold, instead of a physical presence nexus standard; because the CAT is not an income tax, P.L. 86-272 does not apply. The effect of this approach is to subject a business to the CAT, even if its only connection to Ohio is the fact that it ships goods to in-state residents. Businesses no longer need a physical presence in Ohio to establish nexus.

Definition: Under the bright-line nexus standard, a person “has a substantial nexus with” Ohio if it has a bright-line presence in the state, defined by ORC 5751.01(I) as having at least:

• $50,000 worth of property in the state at any time during a calendar year;
   

• $50,000 of payroll in the state during a calendar year; or
   

• $500,000 of Ohio taxable gross receipts during a calendar year.

Alternatively, if a business employs 25% of its total property, payroll or gross receipts in Ohio during a calendar year, it will have nexus with the state and be subject to the CAT; see ORC 5751.01(I)(4).

This nexus standard enforces the idea that the state wants to shift the focus of taxation from businesses located in-state to those that do business within the state. In the past, Ohio has not been as aggressive as other states in finding businesses that have established nexus with the state and making them pay state tax. The bright-line nexus standard will hopefully help Ohio catch the out-of-state businesses that are selling products or services into the state.

CAT’s Details

The CAT is a tax on Ohio taxable gross receipts, which are calculated by starting with total gross receipts, excluding and deducting certain gross receipts, and then situsing the remaining gross receipts to Ohio. The deductions from gross receipts include cash discounts, returns and allowances, bad debts and certain sales of accounts receivable. The most common exclusions from gross receipts include interest, dividends, passthrough income from ownership of other businesses and capital gains; see Ohio Information Release (OIR) No. CAT 2005-17 (4/1/06).

Ohio has covered the situsing of gross receipts in great detail in OIR No. CAT 2005-06 (4/1/06). In general, the sale of tangible personal property will be sitused to the delivery point of the property, irrespective of where title transfers. Service gross receipts will be sitused to where the benefit of the service was received; the buyer’s physical location is paramount in determining where the benefit was received, under ORC 5751.033(I). For example, a New York engineering firm is working on the plans for an Ohio building, by performing all of the work in New York. The gross receipts would be sitused to Ohio, because the benefit of the service is received there.

A taxpayer is subject to the CAT if its Ohio taxable gross receipts exceed $150,000 (assuming it has bright-line nexus with the state). The tax is $150 annually for taxable gross receipts between $150,000 and $1 million. Gross receipts over $1 million will be taxed at a rate of 0.26% when the CAT is fully phased in by April 1, 2009. Taxpayers with gross receipts over $1 million are required to file electronic quarterly returns.

Pitfalls

When writing the CAT, Ohio lawmakers made sure that it was broad-based and somewhat vague, subjecting many businesses to the tax and also capturing many gross receipts. The CAT has also been written in such a way that the same gross receipts can be taxed more than once, in some circumstances.

Double tax: Several examples of this have come to light. Businesses that incur costs for their customers and then pass them through in the sales price of the goods or services are paying CAT on inflated gross receipts.

Example 1: An advertising agency places advertisements for a client with a local television station. The costs of placing the advertisement are billed through to the customer. The advertising agency pays the CAT on the gross amount billed to its customer. In addition, the local television station pays the CAT on its gross receipts, including the fees received from the advertising agency. In effect, the CAT has been collected twice on the same revenue. Had the advertising agency’s customer entered directly into a contract with the local television station and paid the costs of the media directly to the station, the CAT would have been collected only once, on the station’s gross billings. In these circumstances, the cost of doing business in Ohio has significantly increased, because the state does not provide a credit for CAT previously collected on the billed-through media costs.

This duplication will affect many types of businesses, including engineers, advertisers, lawyers, accountants and, particularly, the construction industry, where it is common to have layers of subcontractors and billed-through costs.

Exclusion: There is an exclusion from gross receipts under ORC 5751.01(F)(2)(l) for property, money and other amounts received by an agent on behalf of another in excess of the agent’s commission, that could be used to exclude some of these passthrough sales. However, OIR No. CAT 2006-03 (4/1/06) narrowly defines the principal-agent relationship and substantially reduces the use of this exclusion.

Related entities: Another instance in which gross receipts can be taxed twice is when a taxpayer’s related entities sell to each other. To eliminate intercompany sales, a group of related companies must elect to file as a consolidated entity for CAT purposes. To elect to file as a consolidated entity, the group members must have more than 50% common ownership by one common owner. Because there is no attribution under the CAT, there could be instances in which one related company sells to another related company located in Ohio which, in turn, sells to end-users in that state. The gross receipts from the sale of the product will be subject to the CAT twice.

Example 2: Individuals A, B and C each own 33% of X Corp. and Y Corp. For legal reasons, X manufactures products that it sells to Y, then Y sells the products to end-users. X and Y cannot be consolidated taxpayers, because no one owner owns more than 50% of both companies. Thus, the sales from X to Y would be subject to the CAT, and the sales from Y to Ohio customers would also be subject to the CAT. This results in double tax on the same gross receipts.

Conclusion

In establishing the CAT, Ohio has shown that it can adapt to the changing face of business, but time will tell if a gross receipts tax is a viable way for it to collect sufficient dollars in an interstate-commerce world to meet budget needs. The CAT’s success or failure will play a major role in the decisionmaking process for other states contemplating establishing a similar type of tax.

From Jennifer K. Tapia, CPA, Cohen & Company, Ltd., Cleveland, OH