2010 Washington State Tax Legislation: What You Need to Know

On April 12, 2010 the Washington State Legislature resolved the budget impasse and adopted a $794 million tax package that the governor is expected to sign. The tax bill, 2ESSB 6143, contains a number of major changes to Washington's tax system. Because of the broad array of changes, the bill will likely affect virtually every company doing business in Washington. Many companies will also be impacted by other tax bills passed during the regular session. Below is an index and summary of key provisions.

TAX AVOIDANCE

Department to Disregard Certain "Tax Avoidance" Transactions The Demise of "Drop and Kick" New Treatment of Options to Purchase Entities Expanded Liability for Unpaid REET

BUSINESS & OCCUPATION ("B&O") TAX

Economic Nexus Replaces Physical Presence for Service and Royalty Income New Single-Factor, Receipts-Based Apportionment Formula Temporary Increase to Service B&O Tax Rate Corporate Directors Now Subject to Tax on Compensation Partial Repeal of Exemption for Certain Amounts Received by Property Managers Repeal of Direct Seller B&O Exemption New Requirements for Meat, Fruit and Vegetable Processing Classifications Changes to the First Mortgage Deduction

SALES TAX

Corporate Officers Strictly Liable for Unpaid Sales Tax Limiting the Bad Debt Deduction New Sales Tax on Bottled Water and Candy Nonresidents May Use Streamlined Exemption Certificate Temporary Repeal of Sales Tax Exemption for Livestock Nutrient Equipment Insurance Coverage of Sales Tax on Durable Medical Equipment Changes to Reseller Permits Sales Tax Base for Vending Machines Clarified

INCENTIVES

New Uniform Annual Surveys and Reports New Sales Tax Exemption for Rural Computer Data Centers Tax Incentives for Aluminum Smelters Extended Tax Incentives Extended for Certain Alternative Fuel Vehicles, Producers of Biofuels, and FAR Part 145 Repair Stations Changes to the Rural County Investment Incentive Program Certain Community Centers Exempt from Property Tax Changes to the Cost Recovery Incentives for Community Solar Programs

MISCELLANEOUS

Taxation of Digital Products Clarified Definition of "Use" With Respect to Brokered Natural Gas Amended Additional Protections to Taxpayer Confidentiality PUD Privilege Tax Imposed on Recurring Charges Direct Mail Sourced to Place of Delivery

OTHER REVENUE SOURCES

Increase in Cigarette Tax and Tobacco Products Tax Temporary Increase to Beer Taxes Temporary Tax on Carbonated Beverages

TAX AVOIDANCE

Department to Disregard Certain "Tax Avoidance" Transactions

The new legislation requires the Department of Revenue (the "Department") to disregard three expressly identified tax avoidance transactions or arrangements: (1) those that are, in form, a joint venture or similar arrangement between a construction contractor and the owner or developer that, in substance, provide substantially guaranteed payments for the purchase of construction services, (2) those through which a taxpayer avoids B&O tax by disguising income from third parties that would be taxable in Washington if they had not moved that income to another entity that was not taxable in Washington, or (3) those that avoid sales or use tax on property located in Washington that was transferred to or acquired by another entity, but the transferor effectively retains control over the property. 2ESSB 6143, §201.

In determining whether the Department must disregard a transaction or arrangement, the Department may consider:

Whether an arrangement or transaction changes the economic positions of the parties, apart from its tax effects; Whether substantial nontax reasons exist for the arrangement or transaction; Whether the arrangement or transaction is a reasonable means of accomplishing the nontax purpose; The entities' contributions to the work that generates income; The location where the work is performed; and Other "relevant" factors. It is noteworthy that past versions of the bill instructed the Department to consider judicial doctrines, as opposed to the statutory provisions listed above. By choosing to rely on statutory provisions, rather than judicial doctrines, federal and other state case law may provide little guidance on interpreting such provisions. This is unfortunate in some respects because case law generally imposes limitations not found in the statutory provisions listed above. For example, federal case law has found that minimizing foreign taxes is a business purpose; whether the statutory provision listed above will result in the same conclusion is unknown. Earlier versions of the bill also expressly required the Department to respect the form of a transaction. This language was regrettably removed from the final enacted version.

The Department may apply Section 201 retroactively to 2006, but it is precluded from doing so when the transaction or arrangement is initiated before May 1, 2010 and the taxpayer reported in conformance with specific written instructions by the Department, a published determination, or other publicly available document that is not materially different from the transaction or arrangement. In regards to this safe harbor, it is unclear when the transaction or arrangement is "initiated" in the context of a structure that results in ongoing avoidance of tax. In other words, if one structured an arrangement in 2000 that continues to avoid tax in 2011, does Section 201 apply?

The Department may also not apply Section 201 to any tax periods ending before May 1, 2010, which were included in a completed field audit conducted by the Department. There is no express date as to when that audit needs to have been completed, although one can speculate that the Department will assert that it must have been completed before May 1, 2010.

Taxpayers found to have engaged in a tax avoidance transaction will be assessed a 35% penalty in addition to other applicable penalties. Thus, tax avoidance, coupled with a substantial underpayment penalty and a delinquency penalty, can result in total penalties of 65%. The tax avoidance penalty will not be assessed, however, if a taxpayer discloses the transaction before the Department discovers it.

The legislation further calls for rulemaking and two studies: one study by the Department and one by a joint committee of the legislature. The Department is tasked with reviewing state policy with respect to the taxation of intercompany transactions. The report findings, or a status report, are scheduled for December 1, 2010, with a final report prepared no later than December 1, 2011. This report will include an analysis of potential alternatives to current policy. In addition, the joint legislative committee will monitor the Department's implementation of Section 201 and provide a report by December 31, 2010. The authorization for the joint legislative committee expires July 1, 2011.

The Demise of "Drop and Kick"

The legislation will effectively end the use of "drop-and-kick" structures to avoid sales and use tax on asset sales. 2ESSB 6173, sec. 206. The basic drop-and-kick strategy involved three steps: (1) the seller contributed assets to a newly created entity (the "drop"); (2) the seller sold the entity to the buyer (the "kick"); and (3) if desired, the buyer liquidated the entity and received the assets as a distribution. This strategy worked because the Department of Revenue respected the form of the transactions and none of the three steps, taken separately, triggered sales or use tax. Section 206 of the new legislation eliminates this planning opportunity by extending the use tax to property "acquired by the user in any manner."

Although Section 206 effectively ends the perceived abuses with drop-and-kick transactions, the new use tax provisions are not limited to the drop and kick or other tax avoidance situations. For example, a routine contribution of an asset by a parent to a subsidiary would appear to be subject to use tax as "property . . . acquired by the user in any manner." When this issue was brought to the Department's attention during the legislative session, the Department provided informal assurance that it did not interpret the new statutory language to provide such a sweeping expansion of the use tax. Although the legal basis for this assurance is unclear, it may rest on the theory that the parent is a "donor" and the property contributed is a "gift" on which sales or use tax was previously paid by the donor. Taxpayers should be very cautious regarding previously tax-free contributions and the distributions of assets between affiliated entities.

Section 206 also appears to do away with use tax on goods manufactured for commercial or industrial use. The new statutory language deletes from the laundry list of transactions subject to tax, property that is "produced or...

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