The Ohio commercial activity tax (CAT), a state-level tax imposed on certain gross receipts in lieu of a state income tax, presents its own set of intricacies and regulatory requirements. Ohio Rev. Code section 5751 provides guidance on the taxability or exempt nature of various types of revenue. Regardless, taxpayers often experience compliance challenges — whether caused by incorrect interpretation and execution of the regulations or simple misunderstanding of the requirements applicable to their industry. This item discusses three key considerations requiring attention during CAT return preparation, offering insight into methods for mitigating the unintended and disconcerting consequences of noncompliance.
First, state and local tax return preparation necessitates analysis of the taxpayer's sales apportionment data as relevant to the jurisdiction's current receipts-sourcing methodology. State taxing authorities may require sourcing based on where a majority of the performance costs were incurred (cost of performance), mandate apportionment according to the location where the customer receives a benefit (market-based sourcing), or impose a standard dependent upon whether the company sells tangible personal property or renders a service. Accurate tracing of revenue carries particular importance when applied to gross-receipts taxes, as improperly apportioned revenue may lead to unfavorable tax liability increases upon audit of the taxpayer's CAT fillings.
Second, with the continued proliferation of private-equity group investments and frequent portfolio modifications (i.e., mergers, acquisitions, and disposals), proper treatment of these transactions for purposes of the Ohio CAT becomes paramount to reducing the likelihood of later discovering additional tax liability. Considering the four-year statute of limitation on CAT filings, the presence of an improper filing structure may not derail a transaction entirely but could present an unpleasant blemish on the due-diligence report, prompting further discussion and a potential reduction in sales price.
Third, consistent with other state taxing authorities, Ohio provides taxpayers a research and development (R&D) credit for qualified activities conducted within the state. Often, these credits are claimed under the federal tax provisions, but taxpayers may neglect to realize the qualified activities entitle the organization to receive a benefit on their quarterly Ohio CAT return, too. Fortunately, Ohio's R&D credit system operates in a fairly straightforward manner and provides taxpayers a direct method for both realizing an immediate offset of CAT liability and reconciling prior periods within the statute of limitation.
Cumulatively, these three items — although not an all-inclusive summary of potential pitfalls surrounding the Ohio CAT — represent aspects of compliance commonly encountered by taxpayers and frequently scrutinized by examiners in the course of an audit. Methods exist to mitigate exposure by proactively managing the integrity of incoming data combined with application of the Ohio CAT regulations. Getting ahead of these issues can help reduce the prospect of undesirable tax consequences.
CAT receipts sourcing
The CAT applies to the gross receipts of sales sourced to the state (Ohio Rev. Code section 5751.01). Ohio calculates gross receipts as total consideration received, affording no deductions for cost of goods sold or related selling expenses. Although not discussed in this item, section 5751 provides for a select number of exceptions and exemptions — including the annual exclusion for the first $1 million of Ohio receipts — whereby the gross receipts are not subject to the CAT. Beyond taxability determinations, multistate businesses with complex income streams and/or multistate customers should examine their unique facts and circumstances to discern the proper sourcing methodology.
The imposition of tax requires a transaction and the proper sourcing of revenue within and outside the taxing jurisdiction. The market-based-sourcing methodology is used to determine which transaction(s) are subject to the CAT (Ohio Rev. Code section 5751.033). Market-based sourcing generally captures the seller's geographic market where sales conclude transit or customers realize the value of a rendered service. Market-based sourcing, for CAT purposes, is not restricted to sales of tangible personal property; service revenue where the taxpayer receives benefit in Ohio must be included in the CAT receipts base.
Applied to the CAT return, market-based sourcing generates gross receipts when shipping property to an end destination in Ohio (Ohio Rev. Code section 5751.033(E)). Similarly, performance of a service creates a taxable gross receipt when the customer receives a benefit at an Ohio location (Ohio Rev. Code section 5751.033(I)). Alternatively, tangible personal property initially shipped to an Ohio location and destined for transport outside of the state (e.g., distribution warehouse) or services rendered to an Ohio customer with multistate operations create the potential for a taxpayer to subject too many receipts to the CAT. Unless all facts regarding ultimate destination and/or usage of services are known before the transaction is completed, the entire receipt becomes subject to CAT. Consequently, taxpayers must understand their customers' shipping policies (i.e., not relying solely on the billing address) and inquire regarding the benefit received in multiple locations outside of Ohio to reduce the possibility of overstating Ohio CAT receipts.
PEGs and the Ohio CAT
Private-equity groups (PEGs) may unintentionally neglect the requirement to file combined or consolidated CAT returns on behalf of their portfolio companies. Ohio Rev. Code section 5751.011 dictates that taxable members possessing greater than 50 percent common ownership submit returns on a combined basis; however, a group of entities owned by a common owner may elect to be treated as a ‘consolidated elected taxpayer’ as long as the group restricts membership to companies with greater than 80 percent common ownership. These groups file a single consolidated return. PEGs must analyze their investments — particularly those with CAT nexus — and the sum of intercompany transactions subject to elimination before finalizing an election. Consolidated filings — not combined — permit the elimination of intercompany transactions when determining taxable Ohio receipts.
PEGs failing to identify and timely elect a combined Ohio CAT group may create exposure through improperly claiming multiple $1 million exclusions; generally, exposure arises when multiple portfolio companies simultaneously claim the exclusion for the same period. A combined group receives a single exclusion, taxed at a 0.0026 percent rate. If each member were to claim the exclusion, each erroneous claim produces an additional $2,600 tax liability before interest and penalties. PEGs invested in portfolio companies with Ohio-centric operations (e.g., company office or high sales volume in Ohio) must review prior filings for duplicate claims on separately filed returns. It is therefore prudent for taxpayers to examine the organization structure for qualified members omitted from the CAT group return — absent participants represent additional exposure for a taxpayer's total Ohio gross receipts amount.
Alternatively, PEGs seeking to maintain distinct financial records for each investment often favor filing each portfolio member on a separate basis. Ohio addresses the preference through Form CAT RTFS, Request to File Separately, permitting members of a controlled group to submit stand-alone CAT returns. Accordingly, each participant identifies the controlled group's reporting member, revoking both the claim to a $1 million exclusion and elimination of intercompany transactions. Consequently, PEGs must contemplate the associated compliance burden and potential added tax liability before requesting to file separately.
Ohio R&D credit
Federal, state, and local tax agencies incentivize the promotion of innovative thinking and endeavors to achieve advances in numerous industries through the provision of R&D credits. Frequently, state administrations promulgate regulations mirroring the federal R&D credit, providing guidance regarding qualified activities and the appropriate method for calculating and monetizing the credits. Absent the discretionary aspect present with other state and local tax credit programs — heavily publicized to induce new and continued economic development in the state — taxpayers often overlook the benefits of the R&D credit directly written into the state's regulations.
The Ohio Administrative Code provides a detailed calculation that guides taxpayers in determining their Ohio R&D credit (Ohio Admin. Code section 5703-29-22(C)(3)(a)). Effectively, Ohio requires that taxpayers determine the net increase of current-year expenditures over the average incurred during the preceding three years. Multiplying the result of this calculation by 7 percent (0.07) generates the amount of credit available for the current tax year. A net decrease indicates the absence of a credit, and the taxpayer must wait until the following year before repeating the process with a new three-year average.
Consistent with most jurisdictions' offers of tax credits, the Ohio Department of Taxation (DOT) may initiate a CAT audit upon receipt of the R&D credit claim. While conducting an audit, the DOT requests documentation substantiating the credit figure (e.g., IRS Form 6765, Credit for Increasing Research Activities, location, and description of qualified activities). Before claiming any R&D credit, taxpayers should inspect prior submissions to determine potential exposure for underreported receipts, absence of elections, or additional error(s) affecting the benefit derived from an R&D credit claim. Taxpayers may refer to Ohio Rev. Code sections 5751.01 through .04 for initial direction.
Ohio's CAT affects a wide range of taxpayers in or doing business through Ohio, imposing a broad tax base and an intricate set of requirements — including those addressing receipts sourcing, combinations, and incentives for R&D activities conducted within the state. However, these commonly encountered areas are only a few of those faced by both taxpayers and practitioners. Proactively managing the risks associated with these topics — in conjunction with overall CAT compliance — affords taxpayers an opportunity to get ahead of common CAT missteps.
Excerpted from the April 2018 issue of The Tax Adviser. Copyright © 2018 by the American Institute of Certified Public Accountants, Inc.