Chasing Tax Revenue Across State Lines

Companies have long flocked to low-tax locales like Delaware and South Dakota. But those tax advantages may soon be in jeopardy. States, which collectively could face a $50 billion budget shortfall over the next two years, are scrambling for cash and may start hitting up companies for more money—even companies outside their borders. "The states are turning over every rock for money," says Richard D. Pomp, a professor at the University of Connecticut School of Law. "If they haven't been looking at the issue, they will."

Massachusetts officials just got the green light from the state's highest court to collect taxes from a multitude of companies headquartered elsewhere. Last year the state moved to collect more than $2 million in taxes from credit-card giant Capital One Financial (COF). The state claimed that Cap One made a sizable chunk of money from cardholders who reside there, and so the company had to fork over taxes on the income.

Cap One balked, taking the matter to the state's Appellate Tax Board. The company's argument: It didn't have a branch or an office in the state, the traditional standard for collecting corporate income tax. Cap One lost the case and a subsequent appeal to the Massachusetts Supreme Judicial Court in March. "The uncertainty and burden of trying to comply with state-by-state standards creates a significant hardship for businesses trying to navigate the economic consequences of their decisions," says Ryan Schneider, president of card services for Cap One.

Cap One is petitioning the U.S. Supreme Court to hear the case. If the nation's top court takes up the matter—and rules in the company's favor—it could halt the momentum nationwide to tax out-of-state companies. But the U.S. Supreme Court may not be sympathetic to Cap One. The justices refused to review a similar case in 2007 involving MBNA (BAC), now owned by Bank of America (BAC). Indiana courts decided the credit-card issuer owed taxes on fees and interest paid by local cardholders. Like Cap One, MBNA didn't have an office in the state. The differences between the two cases aren't meaningful, explains Washington (D.C.) attorney Donald M. Griswold, who represented MBNA in the matter. That's why, he says, "there's a snowball's chance in hell" the Supreme Court will hear Cap One's case.

The credit-card industry isn't the only one facing a bigger tax bill if more states follow Massachusetts' lead. Tax experts and lawyers figure states also may go after insurers, online retailers, software makers, and other companies that mainly operate in a single state but have customers across the U.S. Earlier this year the New York Supreme Court backed a state law that requires Amazon.com (AMZN) and other online retailers to charge sales tax on residents' purchases. "The big question here is whether you have to pay taxes where you don't have a physical presence," says Walter Hellerstein, a professor at the University of Georgia School of Law. "That's a huge dollar issue for companies.

How huge? Massachusetts tax officials estimate they will be able to collect an extra $20 million from companies following the Cap One ruling and another against Toys 'R' Us. That's a significant sum in the state, which collected $1 billion last year in corporate income taxes, according to a recent study by Ernst & Young. "This is an issue states should be paying attention to," says Kevin Brown, general counsel at the Massachusetts Revenue Dept. "There's a lot of money at stake."

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