State tax audit 1998 – Cover Story

Ian Springsteel

Despite sincere efforts at reform, certain state revenue departments keep companies tied up in knots.

For years, corporate tax departments and state tax administrators have been locked in an escalating battle of wits. The more aggressively tax collectors pursued corporations, the more vigorously corporations challenged the boundaries of tax law and enforcement. Aggressive state audits led to more court challenges, which led to more tax planning, which triggered more audits, and on and on.

So it was no surprise that the response was so fervent when CFO magazine first asked tax executives to rank state tax departments in 1996. Free to comment without fear of retribution, companies were sharply critical of their least-favorite states.

In truth, for the most sophisticated taxpayers, the situation has never been that dire. As a senior tax planner at one oil company explains, “Certain states are out-and-out aggressive. But in most, you can drive a Mack truck through the revenue department and no one will notice. They’re often clueless about how to question our tax planning strategies and techniques.”

But for smaller, less-aggressive taxpayers, the situation remains a struggle. “All the states treat income items differently, often favoring instate companies. And states often hit us with assessments they know won’t be material enough for us to pursue,” says a tax executive at a Silicon Valley technology firm. “As a result, we end up paying tax twice on 10 percent or more of our income, and struggle with the bureaucracy to do so.” Large or small, companies are genuinely afraid of retaliation if they openly criticize state tax departments. Of 26 corporate executives interviewed for this piece, only 15 agreed to go on record.

Yet, in the two years since the 1996 survey was published, efforts to reform state tax administration have gained steam. Revenue departments talk of “customer focus,” push forward reform packages, and hire consultants to improve their systems. “Many states are working hard to make themselves more taxpayer friendly,” says William McArthur, executive director of the Committee on State Taxation (COST), in Washington, D.C. “They are trying to reform their audit processes, deal directly with companies on serious questions, and make adjudication of disputes more impartial and fair.”

To assess what progress has been made, we decided to repeat the state tax survey and revisit the states that topped our “worst offenders” list in 1996. The toughest states – California, Louisiana, Kansas, Massachusetts, and Pennsylvania – have all taken steps to reform during the past two years. Nonetheless, three of them – Massachusetts, California, and Pennsylvania – topped the list again this year. Louisiana dropped to fourth place with New York, while Kansas dropped to a more moderate seventh place. (The explanation for this year’s results begins on page 30.)

As is clear from the following stories, tax-system reform is not simply a matter of charm school for auditors. In every state, cultural, economic, and historical factors weigh far more heavily than the good intentions of any governor. Serious reform will take new legislation, process redesign, and, most of all, time.


What Prop 13 Hath Wrought

In taxes as in much else, no state is more complex than California. Just consider the numbers. Nearly an eighth of the population of the United States call it home, as do three of the largest U.S. industries – defense/aerospace, computer technology, and entertainment. Its gross state product – $900 billion – exceeds that of Canada, Ireland, and Sweden combined. Its tax-collection apparatus, with 9,000 employees, is second only to the Internal Revenue Service in size and sophistication.

California also leads the way in setting tax-development policies designed to put the squeeze on evasive businesses and individuals. That’s all well and good for catching tax cheats. The problem, say taxpayers and their advocates, is that the agency’s leaders and attorneys have long used aggressive tax administration to create tax policy.

“The problem is that many of the staff believe that because their technical knowledge of tax is so great, they are higher authorities than the legislature and elected officials in creating tax policy,” says Lawrence McCarthy, president of the California Taxpayers’ Association, a lobbying group in Sacramento. “But that’s not their job; administration is.” He cites the agency’s stands on out-of-state contractors, minimal nexus conditions, the tax-raising Proposition 167, and various ongoing income tax issues, such as treatment of untaxed income from out-of-state sales.

But this isn’t the only issue. “California is a tough place to be a taxpayer, [in part] because California tax law is so complicated,” says tax litigator Eric Coffill of Morrison & Foerster LLP, which is based in San Francisco. “Plus, companies right here because the dollars at stake are usually considerable.” To take one notorious example, California’s unitary tax, which departs from the federal statute, has long troubled corporations with the imprecision of its rules defining a unitary group.

Who’s in Charge?

Then there’s California’s uniquely complex tax system, in which elected officials head two independent bureaucracies. One, the State Board of Equalization (BOE), is headed by four regionally elected representatives, as well as the elected state controller. It handles sales tax administration and all tax appeals. The other, the Franchise Tax Board (FTB), is headed by a three-member panel made up of the state controller, the elected chairman of the BOE, and a representative of the governor. This group administers all corporate franchise and personal income taxes.

For decades, the elected heads of the agencies let their staffs run things, and took little interest in directing tax policy. But no longer. The current leaders – Dean Andal, chairman of the BOE, and Kathleen Connell, the state controller and chairwoman of the FTB – are bent on reform. “There has been a lack of taxpayer accountability at the FTB,” says Andal, a conservative Republican and former state assemblyman. “The staff, while professional and talented, has been systematically aggressive and unfriendly toward taxpayers. But no one told them to do otherwise. Past boards didn’t do anything. They just rubberstamped the proposals put forward by the FTB staff. If we, as board members, do not assert any oversight or voter will on the process, what are we here for?”

Connell, a fiscally conservative Democrat, won the controllership in 1994 on a platform of improving government operations. At the FTB, she was initially stymied by Gov. Pete Wilson’s appointee and the former chairman of the BOE, neither of whom saw the need for the oversight board to direct reform. But since Andal’s arrival on the panel in January, Connell has had an ally willing to demand change.

“The oversight we are asserting over the Franchise Tax Board’s operations is completely appropriate,” says Connell. “Some disagree, saying this isn’t the way the other states or the IRS does things. But [unlike] the IRS, the FTB has elected board members who are accountable to the voters. As board members, we should step up to that responsibility.”

The two have adopted measures that require board approval for a host of decisions formerly handled directly by the staff. The list includes major initiatives on new regulations and legislation, significant expenditures, policy-level staff, the annual FTB budget, and all high-level appeals by the FTB to the state courts. In addition, Connell has initiated an independent audit of the FTB that will review internal processes, technology efficiencies, and staff structure.

The moves are controversial. Opponents argue that FTB executive director Gerald Goldberg has done a good job. They list such reforms as the audit and collections computerization program started in 1994 and the opening of the state’s settlement bureau, which allows taxpayers to bring questionable assessments to arbitration. Other critics argue that elected officials shouldn’t hold sway over agency staff. Chief among them is Governor Wilson’s delegate to the FTB, Robin Dezember. “The staff should not be asking mother-may-I to a bunch of part-time board members who have no continuity,” said Dezember at an FTB hearing on March 26. “None of the three members on the FTB may be here in a year, so we should not be directing tax policy or staff plans.”

That sentiment was echoed by Quentin Kopp, Democratic state senator. “Never has the staff of the FTB been held in higher repute,” said Kopp at FTB hearings in March. “I do not believe it is in the public interest for the board members to [intervene] in these issues. Policy should be set by the legislature and carried out by the staff.”

A Day in Court

Some reforms still require legislation. Companies especially want the legislature to create a tax court, which would take the appeals hearing process away from the BOE’s elected members. Critics complain that the BOE, despite its business-friendly leaders, almost always finds for the state. After paying the assessment, cases can enter the state court system. But the tax sophistication of the judges varies widely, resulting in numerous cases that contradict one another.

“A tax court would be very welcome over the current system,” says Michael Woo, tax director, the Americas, at Levi Strauss & Co., in San Francisco. “It would put taxpayers in an independent forum where the language is common, the concepts are known, and precedents are well considered. Over time, the state would get much better tax policy.”

So far, Andal and Connell have succeeded in initiating some reforms. They successfully blocked an attempt by FTB staff to raise taxes on the telecommunications industry. They have also resolved a number of “water’s edge” disputes stemming from the complexity of unitary taxation filing requirements. Of 149 companies with defective water’s edge elections in various states of appeal with the FTB, 129 will clear up their problems through new regulations.

Despite the additional friendliness toward taxpayers, the reformers have some private-sector detractors. “There is definitely an effort to be fair to taxpayers now. The FTB would rather settle than have a case go to the BOE on appeal,” says Gene Corrigan, senior manager of Ernst & Young LLP. “But I think it’s appalling that Andal and Connell are politicizing the tax administration system.”

Still, few practitioners or filers expect the FTB staff to roll over for corporations any time soon, and fewer still expect serious tax reform legislation any time soon.

Total FY97 taxes $62.7 billion

Amount from corporations(*) $5.8 billion (9.2%)

Hot buttons

* Internal struggle to direct tax policy

* Aggressive, sophisticated audit culture

* Dollars at stake

* Corporate income and privilege taxes only


Populist Tradition, Parish Authority

Like gumbo, Louisiana’s tax administration is a complex blend of colorful ingredients that have simmered for a good long time. Unfortunately, the result is not nearly as tasty as the state’s famous stew.

The central problem, practitioners and corporations say, is the ability of the state’s 64 parishes (basically, small counties) to assess and collect sales taxes on all manner of goods. In addition, one of the major industries in the state, oil and gas production and refining, is mostly run from out of state and garners little sympathy from voters and their representatives. As a result, politicians struggle to maintain taxes on that sector while not scaring away additional development and the jobs the energy sector provides.

Complicating matters are numerous and inconsistent exemptions in sales and use taxes. As Bill Backstrom, a tax specialist with Jones, Walker, et alia, in New Orleans, explains, “The other day, I needed to determine how certain food items are taxed in several locations. I have lived here and practiced tax law here all my life, but I didn’t know the answer. I had to look in three different guides, make five phone calls, and explain the matter several times, and even now, I’m not entirely confident in the answer. That’s typical in Louisiana.”

So it shocked few that in 1996, corporate tax executives ranked the state’s overall tax environment as the least fair and predictable in the United States and as one of the most aggressive on income tax audits. This year, although Louisiana improved, it still came out near the top of the list, at number 6.

Those scores, of course, reflect a long-running effort in the state to assert more tax on largely out-of-state companies, which in turn use more-complex planning techniques to minimize their taxes. For instance, a 1993 state law, Act 690, tried to reclassify income from dividends, interest, and capital gains as apportionable among states rather than allocable to a single state. But the law was overturned last year by the state’s Supreme Court. It seems the legislature didn’t follow a basic state law: The act was deemed a tax increase, and the state constitution forbids tax increases in odd-numbered years.

But that ill-fated attempt at legislation was more the exception than the rule. Generally, the legislature is loathe to act clearly on important tax policy issues, lest one interest group or another be seen as gaining an advantage in this largely populist state. Indeed, in the Act 690 overturn, the state Supreme Court declared the law void ab initio, meaning that it should be applied retroactively.

As a result, refunds are due to all taxpayers that paid additional tax under protest. Another 10,000, who simply paid the tax, are technically also owed refunds. In addition, about 215 taxpayers owe more tax than they paid in past years. An attempt abatement during a special session of the legislature last spring, led by Riverwood Industries Corp., quickly passed the state’s House but ground to a halt in the Senate. Accusations of favoritism and inequitable treatment flew, and the effort died, despite the proposal of compromise legislation that would have granted the Secretary of Revenue the ability to negotiate equitable abatements with all 215 taxpayers. The bills were to be reintroduced in the legislature’s regular session that started in late April, but progress was uncertain at press time.

John Kennedy, the Secretary of Revenue since 1996, is blunt about the situation. “I defended the law all the way to the Supreme Court because that’s my job,” he says. “But Act 690 was a disaster for the state. We hope all these issues can be resolved quickly, and I have some authority to handle the refunds and abatements. But we need to be sure we treat all taxpayers evenly and fairly in this situation, or we’ll do ourselves a disservice by harming the state’s reputation even more.”

Kennedy points out that in the past two years, he has led the department to implement changes that make tax compliance more efficient and less onerous for taxpayers, particularly individuals. “As our governor [Republican Murphy J. Foster Jr.] says, paying taxes is painful enough. We’re trying to make the process better, to get some government off people’s backs.” But the enthusiasm, he admits, has been slow to trickle down into clear regulation, especially in income tax rules. “You can never have enough clarity, because clarity is often sacrificed as part of the legislative process,” says Kennedy. “We’re trying to make it better by rewriting a lot of regulations and forms to be more up to date, but we have to be careful to get them right.”

The lack of urgency in this area is tolerated, it seems, because few local businesses or practitioners see fit to complain. In fact, it can work to their advantage. “Sometimes, the uncertainty is a good thing, because it allows you to negotiate and get quick interpretations that wouldn’t be possible in a more defined system,” says Rod Martinez, a partner with KPMG Peat Marwick LLP in New Orleans.

Yet the Department of Revenue has also taken advantage of loose interpretation to hit taxpayers between the eyes. A 1986 statute gives the Secretary of Revenue discretionary power to recalculate a corporation’s liability based on consolidated returns for its various entities, in order to “properly reflect income.” Taxpayers have no choice but to file separate returns for each legal entity, an inequity that chafes many.

The Winn-Dixie Audit

The department first asserted that power against Southern grocery-store giant Winn-Dixie Stores Inc. after an audit in 1994, filing suit against the Jacksonville, Florida-based company in 1995 for about $5 million in taxes. The first such challenge to reach the courts, the test case is scheduled to be tried later this year.

Winn-Dixie executives are still incensed at the assessment. “The Department of Revenue is so far off base with this. The statute gives them authority to adjust income if there is a distortion of income – if we had done something wrong – but that isn’t the case. They didn’t like the fact that we were using net operating losses [NOLs] to not pay tax in 1992 and 1993, so they just recalculated our income based on our consolidated return,” says Leon Calvert, director of taxes at Winn-Dixie. “If they’re right, there’s no way anyone can file an accurate tax return in Louisiana, ever, and that’s a little ridiculous to me.”

Kennedy asserts that the case is going to trial because there is “a legitimate difference of opinion about the degree of discretion allowed by the law,” he says. “I know they’re unhappy about it, but this is a good-faith conflict over an untested point of law. All other taxpayers will benefit once we know what the law is. And the way to find that out is in the courts.”

All of this boils down to a continued lack of certainty in the state that drives business taxpayers crazy, whether they are single proprietorships or multinationals. Not that the legislature has been completely unresponsive. In the special session ended in April, lawmakers passed a taxpayers’ bill of rights, a recodification and clarification of existing rights into a 20-point list to ensure tax fairness, and a tax amnesty program that will start in the fall. Both efforts were wholly supported by Kennedy.

But real reform would require the Louisiana legislature to take dramatic steps. It could unify the administration of, or abolish, the parish tax system. And the legislature could choose to become a unitary tax state like California. That would at least give the revenue department firm guidance. But, according to local observers, none of this is remotely close to occurring, because of the deeply ingrained parish tradition and the general lack of agreement on tax policy in the state assembly.

Kennedy admits that big changes will be hard to realize. “I’d love to organize a blue-ribbon committee to rewrite Louisiana’s tax laws. But with the political nature of such a move, that process would be very difficult, and subject to a lot of special-interest lobbying. The legislature could also clarify sales taxes and resolve the problem with local administration, but that’s very difficult,” says Kennedy. “Is there a better way? Yes, of course. Is it likely to pass? No. So I’ll spend my time working on things I think I can change, not those I can’t.”

Total FY97 taxes $5.1 billion

Amount from corporations(*) $624 million (12.2%)(**)

Hot buttons

* Too many local taxes

* Legislation untested in the courts

* Regulations outdated & incomplete

* Corporate income and privilege taxers only

** $1 billion (20.4%) with natural resource severance tax


The Perils of Reform

While California and Massachusetts have long been known for tough enforcement, Kansas hardly seems a likely venue for heated tax issues. But in the quiet, closed-door world of corporate taxation, Kansas developed a reputation as a tough nut, with a revenue department full of auditors and litigators who would go to the mat to collect taxes from companies, big or small. This reputation was reflected in the 1996 state tax survey. But while most states that fared badly in 1996 showed up in the same positions this year, Kansas improved significantly. Even more remarkable, the lightning rod for most of the complaints in 1996 – Secretary of Revenue John LaFaver – has been an active force in subsequent reform.

The arrival of LaFaver as secretary in January 1995 was a turning point in Kansas’s reputation as a tough tax state. Bill Graves, the then-newly elected Republican governor, hired LaFaver away from Maine’s revenue department to modernize the department and close the state’s tax gap – that is, taxes owed but not paid. LaFaver set to work in earnest, pushing auditors to pursue nonfilers and loophole users and encouraging litigators to take a hard line.

By later that year, he had also started implementing new technology in the department, with the help of American Management Systems Inc., the same group that works with California. He initiated “Project 2000,” which is designed to reshape the revenue collection process and technology.

“LaFaver was brought in by the governor to bring the revenue department up to date and get it ready for the next century,” says Bud Grant, a lobbyist with the Kansas Chamber of Commerce and Industry. “To find the financing for that, though, he started looking under every rock for more taxes, and it seems he looked under the wrong rocks, with the wrong methods. People here felt he was not going about things in an evenhanded manner.”

Nor did major out-of-state corporations like the new administration. “There was no single issue for us in Kansas; there were many,” says a senior tax executive at one of the largest corporations in the country. “There didn’t seem to be a willingness to discuss and resolve issues. We would have discussions, but they were never very fruitful.”

That dissatisfaction came through loud and clear in CFO’s 1996 survey, which named Kansas the most aggressive state in tax audits, and one of the most unpredictable. Kansas antitax groups and local papers picked up these results, amplifying the irritation felt by many taxpayers.

A political brushfire broke out. More-conservative Republicans and other antitax crusaders called for LaFaver’s departure. “I knew tax rates were an issue in Kansas, but I never knew tax administration could be such a heated issue,” says Governor Graves of that fall. “We had a problem here, and we needed to address it.”

Taxpayer Bill of Rights

The Kansas Chamber of Commerce and Industry jumped into the fray in the winter of 1997, and began working with legislators and LaFaver to craft a reform package of bills that would create a taxpayer bill of rights and direct the revenue department to change the way it handled appeals and assessments.

Responding to the heat, LaFaver embraced the proposals, and initiated a number of changes within the DOR without legislative directives. He insists he was already trying to take action within the department, albeit not so publicly. “Eighteen months ago, I never thought I’d say this, but the CFO survey and the local attention it generated were invaluable in helping to improve this department,” says LaFaver. “What it did was move the agenda for change straight to the top. As a result, we got some important changes made.”

Those changes started with the Kansas Taxpayer Equity and Fairness Act of 1997, passed that April. First, the law replaced the formal appeals process in the department with an informal hearing, and set a nine-month deadline for cases to be heard. The act also equalized interest owed by the state to taxpayers on refunds with that on underpayments and tied it to the IRS interest rate. And it established a “sunshine” rule requiring the Department of Revenue [DOR] to publish revenue regulations, private letter rulings, and other useful guidance regularly. To protect taxpayers from abusive behavior, the law sets out a bright-line test for the “good faith” standard for instances in which a taxpayer is being audited, and prohibits the DOR from promoting its staff on the basis of tax assessment or collection quotas.

Internally, LaFaver had the audit division establish a new process for issuing pre-assessment notices. “In the old system, auditors generally did their audit, wrote up their findings, then issued an assessment – end of discussion,” says LaFaver. The current process “creates a forum in which the two sides can discuss the findings before an official assessment is written up. Most disagreements in tax should take about nine minutes to resolve, not nine months or nine years.” That change has helped Kansas dramatically lower the number of assessment appeals made by taxpayers, from 554 in 1996 to just 212 in 1997, a 62 percent decrease.

The appeals-process changes have also been dramatic. Before, in the first level of appeals, a taxpayer had to make a formal legal case for the appeal. “Kansas had a terrible appeals process,” says Paul Frankel, co-head of the tax department at Morrison & Foerster.

Today, the hearing is informal and conducted by appeals officers who report directly to the secretary. In addition, there is a nine-month limit for appeals to be heard – any longer, and the taxpayer receives an automatic determination. “This way, we keep things moving. Without a time limit, you have no incentive to wrap things up. Now there is,” says LaFaver. The results, again, are impressive: Outstanding tax appeals in Kansas declined from 953 in January 1995 to just 266 at the start of December 1997.

Corporate taxpayers are noticing the difference. “The appeals process is better and fairer, and the people are a lot nicer to deal with,” notes Frankel.

Furthermore, “the Kansas DOR has [a better attitude] toward taxpayers. We’ve experienced faster responses to questions, and resolved outstanding appeals very quickly,” says one senior state tax attorney at a large consumer-goods company.

It’s not all wine and roses. “We’d heard there was a new attitude in Kansas. But we went there to dispute an assessment last year, and they were still tough and aggressive on their positions,” says the manager of state tax audits at a large industrial company.

But, says McArthur of COST, “Good tax administration is about impartiality and fairness, not softness. It’s about getting a fair hearing and getting an answer to the question: What should this number be?” he asserts. “In Kansas, they seem to have made some real improvements in that regard.”

Lafaver talks in terms of rethinking the relationship to taxpayers. “They are ‘customers,’ and we should view ourselves as a financial service provider, like a bank,” he says. “Taxpayers will not always agree with us, but there’s a way of dealing with people in an aboveboard, professional way. That’s what we’re striving for here.”

Total FY97 taxes $3.7 billion

Amount from corporations(*) $305 million (8.2 %)

Hot button

* Aggressive audit culture

* Corporate income and privilege taxes only


A Tradition Of Angry Taxpayers

Disagreement over taxes in Massachusetts dates back to the Boston Tea Party. And despite years of Republican governors and stabs at reform, the jab “Taxachusetts” retains its sting.

Indeed, after scoring as one of the most tax-offensive states two years ago, Massachusetts managed to make it to the very top in this year’s survey. Worse, reports from practitioners and former DOR employees indicate that the few reform efforts made over the past two years have had limited influence. Some have made the situation worse. To most in the state, former Governor William Weld and Acting Governor Paul Cellucci have given minimal attention to the issue, muddying their probusiness, antitax message as a result.

Pay to Play

The DOR’s bad reputation has several roots. For starters, audits are very rigid and the appeals process is onerous. Companies that are assessed extra taxes must pay them before they can appeal the assessment. This, in turn, has enabled an historically aggressive audit department to operate unchecked.

“The biggest single issue in Massachusetts is the lack of flexibility at the audit level, taken in combination with the requirement to pay all assessments before an appeal can be heard,” says Joe Donovan, a principal with Coopers & Lybrand LLP. “There’s been some very good intent at the senior levels within the department recently, but that message doesn’t always get to the auditors. In my view, it can’t change until the DOR gives auditors clear settlement authority [at the preliminary appeal and review stage] and takes away the pay-to-play requirement.”

The culture of the department is also a factor. “The department had a largely numbers-driven culture,” says Edward Liptak, a former DOR litigator now with the director of state and local tax service for Grant Thornton LLP in Boston. For years, the DOR has set out aggressive assessment goals for auditors and supervisors, despite a state law forbidding quotas in revenue collections, he says. The DOR’s own public reports show that audit assessment goals were set each year from 1994 to 1997, increasing 15 percent per year.

Some influential senior staffers – most notably, first deputy for administration Bernard Crowley and since-dismissed head of audit Enrique Barkey Jr. – have set a style of aggressive enforcement. But “people who worked at the department 25 years ago, when there was a corruption probe of the place – like Bernie Crowley – have had this incredibly aggressive, unyielding attitude ever since,” explains one former department employee. “As a result, auditors and litigators today are really reluctant to be reasonable and considerate with a taxpayer, because if it’s seen, there’s a witch-hunt. People are scared stiff of being investigated by Internal Audit, which Crowley headed until recently, so they pass everything upstream.”

Four years ago, the audit department got even stronger. Now it can veto decisions by the DOR’s litigators to settle a case. “While litigators had some authority to settle cases once they were on appeal at the Appellate Tax Board [ATB, the state’s tax court], you couldn’t do anything without audit’s approval. It was very demoralizing, and many litigators left the department as a result,” says Liptak.

Mitchell Adams, the commissioner of revenue since 1991, admits that he let some issues slide during his first years on the job. “My objective has been to collect the revenue owed the Commonwealth, but in a way that is fair and evenhanded. That hasn’t always been the case.”

The 1996 CFO survey, he says, served as a wake-up call. Most troubling, he says, was the perception that Massachusetts is capricious in applying its tax code. “I have no doubt that some survey respondents have had that kind of experience, but that is one area in which we are trying to improve.”

Adds Liptak: “I think the department has really taken some of the criticism to heart and moved to change the culture.”

Modest Reforms

Some reforms seem minor. One change has been to organize the audit staff to be more industry-specific. Another is to train more auditors in advance of industry audit waves, explains Fred Laskey, the appointed senior deputy commissioner. “Plus, we’re meeting with the practitioner and business communities to tell them what we are interested in and get feedback,” says Laskey.

Since 1996, the department has also offered more-specific written guidance on murky areas of tax law. For instance, it has issued 25 technical information releases.

The department also now requires a “predraft review” of more-formal regulations in the business community, to iron out conflicts before the proposed regulation enters the formal approval process. Although that initially slowed the process, Laskey says there are 17 new regulations in the pipeline.

But on the issues of asserting nexus and auditing aggressively, Laskey says, “we make no apologies. There’s some very aggressive tax planning by big, sophisticated corporations going on out there. As a shareholder of a company, that’s what I want. But in the revenue department, it’s our responsibility to be aggressive back and collect what’s due. That’s our job.”

Still, too many issues are created by auditors, and too few are resolved quickly. While the number of appeals to the ATB has declined over the past five years, practitioners say businesses are simply less likely to appeal than in the past, because many are more rational about assessments. “The attorneys’ fees required to take a case before the ATB are substantial, and companies have to pay the assessment anyway. So many do the math and just let the issue go,” says Peter Harris, a partner with KPMG Peat Marwick in Boston.

Some tax attorneys and accountants say reform has been uneven. In one instance, a large, out-of-state corporation was audited in 1997 and denied the dividend-received deduction for income paid to it by a wholly-owned domestic second-tier subsidiary. The reasoning was that the parent company owned the first-tier subsidiary that owned the payer, but not the stock of the payer itself. This novel theory was applied to the years being audited and resulted in an assessment in excess of $20 million.

The problem was that the company couldn’t pay. “The company had never thought of paying such taxes, because the theory behind the assessment was so absurd,” says one Boston tax attorney.

What happened next is instructive. Because the company was represented by a prominent attorney, its lawyer was able to speak directly to Laskey and to Donald Evans, the DOR’s general counsel. Its request to kill the issue before it reached appeal and review was granted.

“The way this was handled was terrible, but typical,” says the same attorney. “A supervisor should have been able to correct that mistake, but the company had to go all the way to the top to get the problem fixed. How many cases can Evans and Laskey review directly? It’s no way to run a department.”

Laskey defends his involvement in the matter, explaining that auditors made several assessments related to the dividends-received deduction. “People start calling me up, telling me audit was off freelancing,” Laskey says. “The problem was, audit was relying on guidance from litigation.”

With any luck, Massachusetts will rate a better score next time. Democratic Representative Peter Larkin, chairman of the state’s House Taxation Committee, has proposed two bills: one to rescind the pay-to-play requirement and the other to give the appeal and review hearing officers clear authority to negotiate settlements with taxpayers. Both bills have passed the House and are awaiting action by the Senate. And this year, both Cellucci and commissioner Adams endorsed the bills.

Nevertheless, there may be more criticism of the department before the year is over. The state’s House Post Audit and Oversight Bureau, a watchdog organization, is currently surveying tax practitioners and corporate tax executives on the competency and responsiveness of DOR auditors.

And in another twist of DOR personnel politics, the survey is being conducted by a former DOR litigation bureau chief, Thomas Hammond, the director and general counsel of the Oversight Bureau since 1992. DOR sources say Hammond was one of the more aggressive state litigators in the past, and has previously investigated the department for being too easy on taxpayers.

Today, he’s singing a different tune. “There’s been a lot of anecdotal evidence that the audit function is inconsistent and places a large burden on taxpayers,” says Hammond. Because of confidentiality laws, he explains, “we can’t just go in and audit the place as we do other departments. So we’re collecting the survey information to see what’s out there. And we’ll just go where the results lead us.”

Laskey says he welcomes the review because he’ll be able to compare it with surveys and post-audit review cards the department has already generated. Those results show little dissatisfaction with auditors. “We’re working hard to be friendly and fair to taxpayers and I think we’re doing a good job. Reputations change more slowly than reality, but eventually our reputation will change,” he says.

Total FY97 taxes $13 billion

Amount from corporations(*) %1.5 billion (11.5%)

Hot buttons

* Pay-to-play for appeals

* All-powerful auditors

* Corporate income and privilege taxes only


Friendly Persuasion

The challenges faced by taxpayers in Pennsylvania parallel many of those in other older industrial states – a confusing body of tax law and regulation, a revenue-department staff resistant to improvement, and a burdensome appeals process. In addition, until recently, legislators in Harrisburg had been among the most aggressive in the East, maintaining a sales tax, a corporate income tax, and a capital stock tax, all at relatively high rates. It’s a combination that pushed many corporate leaders to expand, and even relocate, outside Pennsylvania.

Says one tax executive at a major industrial corporation headquartered in the state, “We never look to expand here, and taxes are a major reason for that. It costs too much to operate here, and they take too much of the bottom line.”

A tax executive at another prominent Pennsylvania company explains, “I sit on our company’s site selection board, and increasingly, state taxes are a deciding factor in where we locate facilities, especially in our home state. The current [tax] system here has a negative economic development aspect to it,” he says. “The administration [of Pennsylvania’s Republican Governor, Tom Ridge] has tried to lessen the burden and improve the system, but too slowly.”

Little surprise then that the Quaker State ranked an unfriendly fourth in CFO’s overall state tax rankings in 1996, and ranked third this year.

For corporate taxpayers, problems start immediately on doing business in the state. The multiple taxes are backed by a crazy quilt of outdated, incomplete laws and regulations. As a result, auditors in Pennsylvania can create new interpretations of state tax law, often contradicting previous audits and settlements, which result in more court battles. “Part of the problem is that Pennsylvania tax law isn’t really codified,” says Joseph Bright, partner with Wolf, Block, Schorr and Solis-Cohen LLP, a Philadelphia law firm. “Another is that regulation and official guidance are pretty spotty.”

Even when the laws are clear, they are often tough on business. For instance, the income tax code does not allow NOL carry-forwards for more than $1 million. But in April, the governor’s proposal to extend the period from 3 years to 10 passed. Still, most taxpayers aren’t impressed. “That does very little for major corporations like us,” says Robert Hersh, state tax manager at Aluminum Company of America Inc., in Pittsburgh. “Plus, with that kind of limitation [of $1 million], why would anyone locate a start-up here?”

A Taxing Appeals Process

The appeals process is also onerous. “Taxpayers need to appeal three times in order to get a fair, impartial hearing,” says Morrison & Foerster’s Frankel. First, one appeals at the department level – but the hearing officers work directly with the auditors in the department. Then an appeal goes to the Board of Finance and Revenue, an elected and appointed panel. But that board is still heavily influenced by the state’s litigators, and rarely rules against the department. Finally, one can appeal to the Commonwealth Court, the general civil court, where overburdened Assistant Attorneys General try to settle most cases without going to trial. Those that don’t settle face judges with little tax background. Asserts Frankel, “It’s a terrible place to appeal a tax assessment.”

Secretary of Revenue Robert Judge Sr. has been trying to improve matters, although progress has been slow. Conceding there has been debate on the appeals process, he says, “We’re reviewing that process with the help of the business community.” Judge supported a recently approved reduction in the capital stock tax, from 12.75 percent to 11.99 percent, as a first move toward total repeal of the tax. And, Judge’s senior staff has gained a reputation for being open, responsive, and helpful in sorting out confusing regulations.

“I’d say the department has made tremendous strides in the past two years,” says Maura Donley, executive director of government affairs and counsel at the Pennsylvania Chamber of Business and Industry. “Judge and his senior staff have just been quiet about what they are doing, until the proposals being circulated are actually introduced,” says Donley.

More reform is in the works: The Uniform Tax Procedures Act, now in draft bill form, would require the state to accept corporate tax returns as filed, instead of allowing it 18 months to object or hold on to overpayments. Pennsylvania is the only state that does this. This bill would also take the auditor general (similar to a controller) out of the tax process completely.

Tax executives think more reform is needed. “There remains a problem with fairness in how the taxes are applied. That message should come from Judge,” says one tax executive.

Says another: “The senior people in the department have been doing some good things over the past few years, and they should be given credit for that. Unfortunately, the problems are bigger than the senior staff. The problems are in the system itself and in the bureaucracy of the department. If Ridge is reelected in November, Judge and his people still have a huge job in front of them.”

Total FY97 billion $17.3 billion

Amount from corporations(**) $3.9 billion (22.5%)

Hot buttons

* Three separate taxes

* High rates

* Biased and bewildering appeals process

* Does not incl. fuel taxes

** Corporate income and privilege taxes only


by Ian Springsteel, with assistance from Justin Bridge, DeAnn Christinat, and Ben Radlinski

In government, as in large corporations, change is often gradual. Little surprise, then, that most of the states identified as the toughest and the least predictable in CFO’s 1996 State Tax Survey returned to the rankings in nearly the same spots in 1998. This year, the five states ranked toughest on state taxes – based on an average of the following seven scores – were: Massachusetts and California, tied for first, and Pennsylvania, Illinois, and New York.

For 1998, we expanded the survey group from the 100 largest public U.S. companies to a random sample of 300 of the 1,000 largest U.S. public companies. We received responses from 91 tax directors or state tax managers, for a response rate of 30.3 percent.

How aggressively does the state assert economic presence nexus?

This question, which addresses the ability of a state to assert tax on income from intangible assets, is one of today’s hottest tax topics. South Carolina has the dubious distinction of ranking as the most aggressive state on this issue, thanks to its win in the landmark Geoffrey decision in 1994, which levied tax on royalty income paid to a Delaware holding company and set the stage for other states to follow. Close on its heels are California, Massachusetts, New Jersey, and Iowa. Worth watching are Florida and North Carolina, next on the list, both of which, say practitioners, have been taking tougher views on intangibles in recent audits.

How aggressive is the state in applying sales/use tax nexus?

On this area of tax law, California, Florida, and Massachusetts ranked first, second, and third, respectively, followed by Pennsylvania and New York. All of these states use a combination of active discovery efforts – such as computer file cross-referencing, questionnaires, and outside audit firms – and aggressive interpretations of nexus law to collect as much sales tax as possible.

How fair and predictable is the state tax environment?

Massachusetts tops the list of least fair and predictable, followed by California, Pennsylvania, Louisiana, and New York. Kansas, ranked 4th in the 1996 survey, dropped to 13th place, perhaps due to new regulations and processes there. But note that, as in the 1996 survey, the scores regarding fairness and predictability even out quickly, suggesting that most states are viewed as generally fair and predictable.

Which states are most aggressive in making assessments during income tax audits?

This ranking is based on a variety of common issues (forced combined and decombined filings, adjustment of apportioned income, and business/nonbusiness classification of income). Topping the list this year are California, New York, and Massachusetts, followed by Illinois and Kansas. In Louisiana, the overturn of Act 690 – which reclassified interest and dividend income as apportionable business earnings – by the state’s Supreme Court last year helped contain its aggressiveness in audits; Louisiana dropped from 3d place in 1996 to 31st pace this year.

How able are the states in negotiating gray areas?

Many audits result in differences of opinion. The first stop in resolving such conflicts is the audit department itself, where audit supervisors often have the ability to resolve gray areas of the law before they become official assessments. While most revenue departments are considered generally fair and able to negotiate such conflicts, Massachusetts and Pennsylvania stand out, followed by Louisiana, Maryland, and California.

How independent is the prestate court appeals process from its audit department?

As tax professionals know well, not all issues are negotiated successfully. The results were not very surprising: Topping the list are Massachusetts, Pennsylvania, and Illinois – all of which have initial appeals processes within their audit departments. Kansas, again, dropped because of changes to its appeals process, while North Carolina rose from 13th place to 4th place, because of more-aggressive leadership in the revenue department there, say tax executives.

How do tax policies and systems affect location and expansion decisions?

We found several changes in this area. Massachusetts again edged its way to the top of the heap, followed closely by Pennsylvania, California, and Louisiana – all understandable, because of the complexity, rates, and uncertainty of taxes in those states. New York is also in the top five, but at a more moderate score.

Ian Springsteel is an associate editor at CFO.

COPYRIGHT 1998 CFO Publishing Corp.

COPYRIGHT 2000 Gale Group

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