On February 12, 2013, the text of the Governor's budget proposal for the 2014-2015 biennium, announced on February 4, 2013, was made public as House Bill 59 ("HB 59"). The new HB 59 includes a state income tax deduction for owners of pass-through entities and reductions in the state's income, and sales and use tax rates. It replaces the revenue lost by these cuts principally by broadening the sales tax base to provide for the taxation of nearly all services and transfers of intangible property, including mortgages and digital products, and by revising the severance tax, including a new tax on horizontal drilling. The taxes on services would commence September 1, 2013. The Governor's intention in proposing these changes is to improve Ohio's competitive position and the efficiency of Ohio's tax system by decreasing reliance on income taxes, and increasing its reliance on consumption and resource-extraction taxes. Ohio businesses should act now to avoid adverse tax consequences of the language used in the proposed broad expansion of the sales and use tax base.

INCOME, SALES AND USE TAX REDUCTIONS

Under the proposal, owners of pass-through entities would be permitted a deduction of 50 percent of their annual pass-through business income up to $750,000, with each owner or investor taking a maximum deduction of $375,000 ($187,500 if married filing separately). This deduction would not apply to any pass-through income treated as wages. State income tax rates eventually would be cut by 20 percent for all brackets, resulting in a reduction of the top marginal rate from the current 5.925 percent to 4.47 percent, while the rate on incomes between $40,000 and $80,000 would drop from 4.109 percent to 3.287 percent. These cuts would be phased in over three tax years, from 2013 to 2015, with the cuts being an overall reduction of 7.5 percent in 2013, 15 percent in 2014, and the full 20 percent by 2015. Employers would reduce the corresponding Ohio withholding tax in September 2013, July 2014 and January 2015.

The state sales and use tax rate also would be reduced from 5.5 percent to 5.0 percent and the highest county rates of 1.5 percent would be reduced to a maximum of approximately 1.35 percent, while transit authorities would be reduced from a maximum .25 percent to approximately .20 percent. Actual reductions for any county or transit authority could be anywhere from an estimated 11-35 percent of its current rate, determined by a complex formula that allows for local revenue growth while preventing a windfall to local entities as a result of the broadening tax base. In order to protect against errors from incomplete data used to compute the rates, localities would be provided guaranteed payments until June 2015 and the maximum local rates under this formula would be adjusted in 2015 based on 2014 experience. Counties and transit authorities would be prohibited from imposing new sales and use taxes until July 2016.

EXPANDED SEVERANCE TAX

The existing severance tax is largely left in place for most conventional oil, natural gas and hydrocarbon wells, with an exemption from the tax added for small volume gas wells (those with production less than 10,000 MCF). [1] Conventional oil wells will continue to pay severance tax at the rate of 20 cents per barrel, with condensate taxed as oil and no tax imposed on natural gas liquids. The tax rate for conventional natural gas wells will be changed to the lesser of 3 cents per MCF or 1 percent of value from the current fixed rate of 3 cents per MCF.

For horizontal wells, the tax rates will depend on the product extracted: 1 percent for natural gas and 4 percent for oil, natural gas liquids or condensate, with a reduced 1.5 percent rate applicable for horizontal oil, natural gas liquid or condensate wells during the first year of production. According to one study cited in the Budget Reform Book, effective tax rates on wells producing dry natural gas and oil and wells producing dry natural gas and natural gas liquids would be lower than the average effective tax rates in Michigan, Pennsylvania, West Virginia, Arkansas, North Dakota, Oklahoma and Texas, depending on the type of well output.

SALES AND USE TAX ON SERVICES

In order to replace the lost revenue from the proposed reductions of the income tax rates and the state sales tax rate (from 5.5 percent to 5.0 percent), the sales tax base is to be expanded by adding numerous services. While current Ohio law imposes sales and use taxes on more services than many other states, most services are not taxed. The Governor's proposal, however, would subject all services to tax with certain limited exemptions. The services considered to be necessities that would remain exempt include: health care; education and tutoring; real estate construction services; rental of residential property; consumer insurance transactions; adult and child day care; social assistance services; residential trash services; funeral services and services by an employee to the employer.

Other services, especially services provided to business, will become taxable, including: accounting and bookkeeping; architecture; credit rating services; engineering services; intrastate courier services; packaging and crating; public relations; refuse collection (other than residential trash pick-up); investment counseling; loan brokerage; real estate agency; property management; real estate title abstracting; banking service fees; insurance services; legal services; marketing and advertising (except perhaps national radio and television advertising); telemarketing; telephone answering services; travel agent services; data mining services; software programming; digital books, movies, music and electronic goods; parking; court reporting and stenographic services. The list is not exhaustive.

We have been waiting for the dissemination of language of the bill to better understand the scope of the new taxes. The language of HB 59, however, does not answer many questions.

Surprisingly, the language is very spare considering the dramatic nature of the changes. The relevant portions of the bill, with new language underlined, read as follows:

(B) "Sale" and "selling" include all of the following transactions for a consideration in any manner, whether absolutely or conditionally, whether for a price or rental, in money or by exchange, and by any means whatsoever:

(3) All transactions by which: -- a service is or is to be provided:

(4) All transactions by which intangible property is or is to be transferred, or a license to use intangible property is or is to be granted [2];

(6) All transactions by which a specified digital product is provided for permanent use or less than permanent use, regardless of whether continued payment is required;

(X) "Service" means an act performed for another person for a fee, retainer, commission, or other consideration, including any fee or other amount charged for access to a physical fitness facility or recreation and sports club. "Service" does not include any of the following:

(1) Medical and health care services; [3]

(2) Educational services and tutoring services;

(3) Real property construction services;

(4) The lease or rental of a house, apartment, condominium, mobile home, or similar dwelling to a person, provided that the person occupies the dwelling for thirty or more consecutive days and that the dwelling is the person's primary residence;

(5) Transactions by which a consumer obtains insurance;

(6) Adult and child day care services;

(7) Social assistance services;

(8) Services used directly in producing tangible personal property by mining.

(9) Residential trash pick-up and disposal. As used in division (X)(9) of this section, "residential" means property improved with single-family, two-family, or three-family dwellings.

(10) Services rendered for an employer by the employer's employees within the employment relationship.

(11) Funeral services described in section 4717.01 of the Revised Code except to the extent that a sale of tangible personal property or services by the provider of services described in that section is a retail sale subject to the tax levied by section 5739.02 of the Revised Code under another division of this section and is not exempted under division (B) of section 5739.02 of the Revised Code. Division (X)(11) of this section does not affect the liability of a provider of funeral services for tax imposed under this chapter or Chapter 5741. of the Revised Code on the provider as a consumer of tangible personal property or services.

OBSERVATIONS

The Administration has used a comprehensive approach to taxing sales rather than an incremental approach. The new law automatically taxes all services unless those services squarely fit within the list of narrow exemptions. In one sense, this approach is simple and avoids the need to legislate many fine distinctions between taxable and non-taxable transactions. The comprehensive approach of broadly sweeping in new services, however, creates new challenges to taxpayers in complying with the law and the Tax Department in its administration. HB 59 does not confront these difficulties.

In particular, the proposed legislation does not address several significant concerns:

  • The statute imposes tax on the hiring of a lawyer to defend a taxpayer against a criminal charge or an accountant to prepare a state tax return. These are just two examples of situations in which many would find the state's decision to impose tax offensive. Not all services are equally desirable targets for sales and use tax but the comprehensive approach treats all services equally.
  • Most services not exempted under the bill are much more likely to be purchased by businesses. The Administration has published a table that describes the estimated tax liability by various categories of businesses, which is presented below. The increased liabilities are likely to be understated for several reasons including: (1) the data used for the chart is more than 10 years old; (2) the proposed tax is on such a broad base that meaningful data cannot be derived relevant to Ohio and elsewhere to project the costs; and (3) the chart observes in Note (d) that only the "first stage" effects are recognized, meaning that the table does not attempt to capture the pyramiding effect of taxing services.
  • The pyramiding of services in the business context, especially when basic resale exemptions are not made available, will mean that some industries will see the effect of the sales tax magnified by multiple layers of tax on services. That is, in contrast to a value added tax (VAT) in which input credits are given, each service used by a business in the process of producing the final service made available to the ultimate customer will be subject to tax and then will become part of the price to which more tax is added. This pyramiding raises serious tax policy implications. The Administration barely acknowledges the pyramiding, which is especially troubling in that this new tax follows on the heels of the 2005 enactment of the commercial activity tax, the defining feature of which is pyramiding of tax, albeit at a much lower rate than the new tax on services.
  • One particular type of pyramiding will occur when an affiliate of a company provides its sister company a service. HB 59 provides an inadequate exemption for services provided by affiliates.
  • Sourcing services according to benefit received is difficult and frequently devolves to sourcing to the place to which the bill is sent, which may have little relationship to the location of the service.
  • The Tax Department will not be able to administer the tax fairly because many vendors will not be required to collect the tax for lack of contacts with Ohio. Thus, in the case of individual purchases significant noncompliance is to be expected. For businesses, the Tax Department likely will increase compliance with aggressive purchase audits of Ohio businesses when suppliers do not collect the tax.
  • Competitive pressure will exist for some service providers to avoid the tax by providing the services from out-of-state locations and not collecting the tax although the customers are in Ohio. Nothing in the bill addresses this predictable effect of imposing these taxes.
  • The legislation fails to recognize the compliance problems that businesses will confront in dealing with the new tax base. An effective date of September 1, 2013 is not realistic.

The concerns expressed above are not theoretical. Problems inherent in taxing services broadly contributed to the conclusion by at least three states, Florida, Massachusetts and Michigan, that broad-based sales and use taxes on services could not be implemented successfully.

Moreover, in addition to taxing services, the new tax is imposed on intangibles and digital products, each of which is an important addition to the sales tax base. These additions are not mirrored in most other states. Businesses will pay a significant portion of the tax on these additions.

WHAT OHIO BUSINESSES NEED TO DO

Businesses in other states, which attempted to implement the broad-based sales and use taxes, learned that different industries were affected in different ways from the tax both on the services they sold and the services they bought. It will be important for Ohio businesses to participate in the legislative process to ensure that the tax on services will not be devastating to their respective businesses or industries. We expect the proposal will change dramatically during the consideration of HB 59 -- perhaps to limit the number of services that will be taxed. Even if the proposal to tax services is narrowed, businesses must stay involved and vigilant to prevent being selected for taxation in the same way in which employment agencies, landscapers and other industries were targeted for taxation in the past.

If you have any questions about how to be properly heard in the legislative process shaping this evolving proposal or about how to create a plan to address the potential consequences of the legislation to your business or industry, please give one of us a call.


[1] An MCF is one thousand cubic feet of gas.
[2] Intangible property is defined as follows: (QQQ) "Intangible property" means personal property that has value but that cannot be seen, weighed, measured, felt, or touched. "Intangible property" includes, but is not limited to, trademarks, copyrights, patents, franchises, and licenses. "Intangible property" does not include interest, gains, or dividends received from the sale or exchange of a financial instrument. "Financial instrument" is defined so as to exclude mortgages in proposed section 5739.01(RRR).
[3] The exemptions are defined elsewhere in the new law. The exemptions are defined narrowly.


Estimated Ohio purchases of services proposed to be taxed, and state & local sales tax paid on such services: Impact on selected industries

Calculations using U.S. data in 2002 Input-Output tables produced by U.S. Department of Commerce, Bureau of Economic Analysis. Ohio estimates are generated from national I-O amounts using Ohio/U.S. GDP shares by industry.

Note: Figures are in millions, and have not been projected beyond calendar year 2002.

(a) The Ohio figures shown in this table are rough estimates. They have not been adjusted to reflect potential compliance issues, exempt transactions, and other factors that are expected to dilute tax collections. Therefore, the figures shown here do not constitute final estimates of the expanded services sales tax base and revenue from that expanded tax base. Since the taxable purchases estimates have not been adjusted downward for exempt transactions or non-compliance, they probably overstate the impact of the sales tax base expansion on industry costs.

(b) Includes all depository and nondepository credit institutions, and other financial activities.

(c) For this table, purchases by hospitals are excluded from services proposed to be taxed. This is because the majority of such facilities are IRC Section 501(c)(3) entities whose purchases are exempt.

(d) This table reflects the potential "first-stage" effects from taxing business services, i.e., the sales tax charged to the purchaser.

Topics:  Local Taxes, Pass-Through Entities, Sales & Use Tax, Severance Tax, State Budgets, State Taxes, Tax Deductions, Tax Rates

Published In: Business Organization Updates, Elections & Politics Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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