Editorial note:
Following is a republication of three popular articles written by Gary M. Harden on the Ohio Commercial Activity Tax. Since its adoption in 2005 and resolution of state constitutional challenges, the CAT has earned its stripes, achieving its revenue goals, on a broad tax base with a nominal 0.26% rate, and substantially reduced administrative costs. Reliance upon the CAT enables substantially lower personal income tax rates and eliminates business franchise and personal property taxes. These articles, republished without update, still provide a good primer on the subject, that some have found to be an enjoyable read.
Ohio’s Commercial Activity Tax Bill (“Bill, the CAT”)
By Gary M. Harden and Kimberly A. Starr
Effective July, 1, 2005, there’s a new “CAT” in town. Buried in the thousands of pages of Ohio’s biennial budget bill (Amended Substitute House Bill 66, the “Bill”) is the state’s approach to financing operations for the next two years, and beyond. The tax, referred to as a commercial activity tax (CAT), is an excise tax on the privilege of doing business in Ohio. Differing from a franchise tax, the CAT nibbles at the first fruits of gross receipts (up to 0.26%); instead of taking a larger bite out of net worth or net income. A consumption tax, it resembles a sales tax, being based upon proceeds from the sales of business goods and services. Because of its reliance upon purchases, the state’s tax base is expected to stabilize from year-to-year swings, depending less upon items which disappear over time, like the book value of depreciable equipment and buildings. It was supported by the Ohio Society of Certified Public Accountants and the Ohio State Bar Association, with some reservations.
Its purposes include making Ohio more competitive with its neighbors, tax simplification and fairness.
To make way for the CAT, the Bill chases away some taxes and puts others on a diet. The Tangible Personal Property Tax leaves over the next four years with reduced listing percentages. The Corporate Franchise Tax takes a year longer, but leaves behind a net worth tax on financial institutions and their holding companies exempt from the CAT. Personal Income Tax rates are “skinnied up” over five years, reducing the maximum rate from 7.5% to 5.925%. So are sales taxes, with a 0.5% base rate reduction from 6% to 5.5%; although the state may expect to collect more sales taxes because the price of goods and services will be fattened by the CAT. Other changes in the income tax raise the floor for taxing individuals to $10,000, and make permanent the taxation of trusts. The additional Ohio estate tax (sponge tax) has left the neighborhood, leaving behind the basic Ohio estate tax, with a top rate of 7% for estates above $500,000. The 10% roll back for commercial and industrial real property tax is gone. The CAT touches or may touch many other taxes based upon studies of its performance.
Unsure of how business will feed the CAT, the legislature gave license to the Tax Commissioner to recalculate tax rates (currently, over three established periods) in order to satisfy budget goals. Businesses with under $150,000 of gross receipts are exempt. Those with between $150,000 and $1 million will pay a minimum tax of $150 and may elect to file and pay on a calendar year basis; all others are required to file and pay quarterly.
CAT rates don’t clamp down right away; it takes a while for their teeth to sink in. The initial rate of 0.06% is in effect now through the first quarter of 2006. For the following three quarters it is expected to be 0.104%. It will continue to adjust upward until the projected final rate is achieved. When combined with the Tax Commissioner’s authority to recalculate tax rates in order to satisfy Ohio’s budget, business may be faced with two bites from the CAT at once, one on the phase in and the other from a deficiency in budgetary performance.
In order to succeed at a low tax rate where the combination of other taxes has failed, the CAT reaches out to touch taxpayers, both inside and currently outside Ohio’s previous grasp. It touches individuals, trustees in bankruptcy, firms, companies, for profit corporations, estates, partnerships, limited liability companies, clubs, societies, S corporations and even entities disregarded for federal income tax purposes, like qualified subchapter S subsidiaries and single member limited liability companies. Activities previously off Ohio’s tax diet are now on the menu. Some commercial activities found to have substantial nexus with and gross receipts sitused in Ohio are fair game for the CAT, although until now they have been something Ohio could not get its paws on.
Instead of looking to nexus, businesses are in play if they have “substantial nexus” with Ohio. Under the Bill, the CAT reaches any person who:
• owns or uses any capital in Ohio,
• is authorized to do business in Ohio,
• has a “bright line presence” in Ohio, or
• can otherwise be reached by Ohio for taxation under the constitution of the United States. Each of these alternatives has an expansive view.
For example, under the bright line test, an out of state person crosses the bright line and has presence for Ohio’s CAT if the person has more than $500,000 in taxable Ohio gross receipts, has more than $50,000 in property in Ohio, spends more than $50,000 in payroll for work in Ohio, conducts more than 25% of its business activity in Ohio, or is otherwise domiciled in Ohio. A foreign person who merely holds a certificate from Ohio allowing it to do business in Ohio, regardless of activity, is within the CAT’s reach.
Alternative approaches within the Bill assure that the CAT will cross many a company’s path and not be avoided by creative uses of related entities, consolidated or affiliated groups. However for the wary, the Bill provides planning opportunities for some who elect to consolidate their reporting as a group.
After the table is set, the CAT can approach the gross receipts of persons with “situs” in Ohio under several alternative paths. Included are:
• rents and royalties from real and tangible personal property physically located in the state;
• proceeds from the sale of real property located in the state; and
• proceeds from the sale of tangible personal property received in the state by the purchaser (or received by the person upon delivery from a common carrier in interstate commerce within the state).
Also included, and less well understood are:
• gross receipts from the sale, exchange, disposition, or other grant of intellectual property (trademarks, trade names, patents, copyrights, etc.) based upon the amount of use within the state; and
• gross receipts from all other sales and services based upon the proportion of the purchaser’s benefit in this state compared to the purchaser’s benefit everywhere.
How the seller of a good or service will determine a purchaser’s proportionate benefit within Ohio under this approach is part of the mystery and CAT-like stealth of the enforcement scheme yet to be determined. How high an administrative burden will be extracted from businesses as they investigate and track the multitude of customers needed in low price large volume sellers of goods and services? Several approaches are already being discussed among industry and professional groups. Since the law applies to receipts before we can unravel this mystery, key everyday business processes are challenged, including tax compliance, cost accounting, pricing of goods and services, record keeping and remaining competitive on a level playing field in the presence of valid alternative interpretations under this new law.
These new and sometimes aggressive approaches appear poised for challenge by industry groups. Three of which, the “substantial nexus,” food tax and “purchaser’s benefit” approaches have already weighed in with the media for a CAT fight.
Consistency with the tax policy chosen has left certain taxpayers exempt, at least for now. The CAT ignores banks and other financial institutions, insurance companies, public utilities, the state and its political subdivisions. Also left unscathed are nonprofit organizations, since it touches only business activity, even though a nonprofit entity may generate business income unrelated to a federal tax exemption (UBI). UBI escaping the CAT appears, at least to this author, as an anomaly, a CAT and mouse game which may later fall prey to the state’s revenue scheme.
Over time, business owners and managers will learn to think of the CAT differently than they have its ancestors, and will adjust and plan accordingly. While the terrain appears familiar, the attack is focused differently. The CAT pounces on gross receipts, calculated in the same manner as for federal income tax purposes, i.e., accrual or cash basis; with a deduction for bad debts, cash discounts and sales returns and allowances. No deduction, however, is allowed for the cost of goods sold or other expenses (direct or overhead), although they contribute to the production of income. Examples include: the cost of sales; cost of services like wages, outside labor and professional fees; and rental.
The CAT won’t eat just anything; there’s a list of at least 26 items it won’t touch. Some receipts have been carved out, at least for now, like those from the sale of gasoline (a two year exemption). Also off the menu are employee compensation; dividends; capital gains and distributions; charitable contribution receipts; qualified retirement plan receipts; proceeds received from loans, stocks and bonds; and damages received from litigation.
For many businesses, the material reduction of tax rate may provide a welcome relief. If not, some may find that the trade off of a low rate CAT in place of a higher personal property tax on inventory and equipment will lessen their combined state tax burden. For others, applying it to gross receipts will be hard to swallow. Service providers which pay little or no personal property tax, will pay more. The focus on gross receipts as opposed to net income will redistribute the tax burden among businesses in changed proportion: the greater the operating cost, the greater the proportionate tax burden. One example of CAT slashed earnings is the wholesale and retail grocery supply industry. Although stores and retail chains have responded over time by adding complementary higher margin inventory, grocery’s low margin, high volume sellers now face paying 0.26% of gross receipts, on margins ranging from only 1% to 2%. When comparing this impact to that on 50% margin businesses, the relative fairness of a net income tax or a net worth franchise tax is apparent. In our example, the CAT devours about 17% of earnings, as opposed to 0.52% for others, which is about 33 times more (3300%). This impact can leave low margin businesses with an opinion more like Bill, the CAT, has hocked up a hairball, than provided fairness and equity. Perhaps low margin businesses will find legislative safe havens as the CAT takes larger and larger bites out of earnings as the rates phase in. Or, they may find that there is more than one way to skin a CAT. Until then, expect them to do their best to pass along this meal to consumers.
Business, as with any tax, will pass the CAT along in the cost of goods and services sold to customers. However, there is no such thing as just one CAT in a neighborhood. As it passes from suppliers to manufacturers, and to other intermediaries on its promiscuous way to the ultimate consumer of the good or service, the CAT will breed layer upon layer of additional tax. Although income, franchise, and personal property taxes work in a similar manner, none is as broad or potentially prolific as the CAT, so this inflationary effect can produce a rather fat result over time. When an entire industry operates on a large volume low margin approach, with a fair number of intermediaries along the way, the combined effect of this layering can be destructive. The ultimate consumer may not be willing to absorb the entire burden, or powerful intermediaries may refuse to absorb all or part of the CAT as an increase in price.
Sales tax, another consumption tax, provides a purchase for resale exemption which eliminates (or at least substantially reduces) this layering of tax, and also provides an exemption for sales of food items at retail because it is so regressive. That is, lower income consumers spend higher percentages of their disposable income on food, thus placing the tax burden on those least able to bear it. The CAT is not so kind. It provides neither the protection of a purchase for resale exemption nor the relief from tax to the retail consumer of food items. Whether business will be resilient enough to absorb or pass on the burden of the CAT in the short term remains to be seen. Focus on the issue now may permit business to respond while rates are still low, and minimize any damage.
As with any tax bill of this nature, there are penalties for failure to comply, regardless of how difficult it might be to understand its provisions. The first filing requirement is a mandatory CAT registration by all taxpayers, which has a deadline of November 15, 2005. This is a document which we or your tax return preparer would be pleased to assist you with filing. The first tax returns will be due in February, 2006.
With the new penalties, though, the legislature has provided a broad tax amnesty opportunity for noncomplying taxpayers to avoid penalties and half the interest obligation. It is available to taxpayers who have not been contacted by the Ohio Department of Taxation. It applies to all sales, use, corporate franchise, personal income and school district income, and personal property taxes unpaid as of May 15, 2005. Amnesty opens January 1, 2006 and closes 46 days later on February 15, 2006.
As we become more familiar with this new breed of CAT, and necessary refinements are provided to the Bill, we should be able to provide more than these general comments. Please contact Gary Harden as you have questions regarding the CAT, or if you would like to explore how it may affect your business.
Mr. Harden, a member of the Firm, focuses his practice on federal taxation, benefits and general business law. He has been listed in Best Lawyers in America for each of the last 10 years and Ohio Super Lawyers each year since its inception.
Ms. Starr, an associate of the Firm, concentrates her practice in the areas of corporate, estate and tax planning and probate administration.
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Disclaimer: This alert has been prepared for informational purposes only and should not be considered legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney/client relationship.
The “CAT” Goes on a Diet, Will It Starve?
Ohio Appeals Court Agrees with Grocers, Tax is Unconstitutional
by Gary M. Harden
Originally published September, 2008
On September 2, 2008, Ohio’s 10th District Court of Appeals ruled in favor of the Ohio Grocers Association that Ohio’s Commercial Activity Tax (CAT) is unconstitutional as applied to gross receipts from certain food sales (Ohio Grocers Assn. v. Wilkins).
The Grocers Association opposed the CAT from its conception on the grounds that the CAT is a disguised sales tax or other excise tax in violation of the Ohio Constitution. Certain June 8, 1976, amendments to the Constitution, in particular, Article XII, Sections 3 and 13, preclude any excise or other sales tax on food for human consumption off the premises where sold. Section 13 extends the prohibition up and down the food chain to wholesale sales of food and ingredients; sales and purchases of food and ingredients by manufacturers, processors, packagers, distributors and resellers; as well as to the packaging that contains the food and ingredients. On these grounds, the appellate court reversed a 2006 decision in favor of the Tax Commissioner, and entered judgment in favor of the Grocers Association. The case was remanded to the Franklin County Court of Common Pleas for further proceedings consistent with this opinion.
What does this mean?
First, some background. The CAT made law as part of Ohio’s 2005 biennial budget bill, worded as an “excise tax on the privilege of doing business in Ohio.” Its approach is simple and direct: gross receipts multiplied by a small percentage, applied to all business sales and service revenue generated within Ohio. Traditional income taxes, franchise taxes, personal property and sales taxes involve exclusions, deductions, credits, incentives, deferrals, graduated rates and other complexity driven by economic, political and in some instances, social engineering goals. The CAT is much less sensitive, aloof from motivations other than revenue. It’s indifferent to taxpayers’ margin, bottom line and other pedigree. The Ohio Legislature expected the CAT to make Ohio competitive with its neighbors, promoting tax simplification and fairness, and saving the state considerable administrative and enforcement expense. It was also supposed to stabilize Ohio’s tax base, making it less dependent upon employers’ reinvestment in depreciable equipment and less dependent on a net income base which could be reduced or eliminated when the local economy suffers.
Differing from the traditional taxes which it diminishes or eliminates over time, the CAT nibbles at the first fruits of gross receipts in very small bites. The first $150,000 of taxable receipts are exempt. There is a $150 tax on receipts up to $1 million, and beyond that there’s a flat rate on the balance phased in over five years, currently at 0.208% and capped at 0.26% next April. It applies to every sale, every resale. When added to the cost of goods sold each step of the way, it adds successive layers to the price in the process so that each bite is progressively larger. Its flat rate on gross receipts, adding layer upon layer until the final sale to a consumer, has a known regressive effect on consumers purchasing groceries, and upon grocers who operate on profit margins as thin as 1% – 2% of gross. As the food industry struggles to pass on to consumers some of the largest increases in costs experienced during the last 20 years, the CAT bite hurts even more. From conception to this delivery, a CAT fight has been brewing.
Since July 1, 2005, the CAT nibbled on every sale up and down the food chain. Repeal of the tax as applied to gross receipts from food sales would result in a crash diet and a state refund obligation of hundreds of millions of dollars to businesses that operate in Ohio. It could starve state government, as several other taxes have already been reduced or eliminated. From food retailers and wholesalers, Ohio collected $273.4 million in fiscal 2006 and $594.9 million in fiscal 2007, of which $416.4 million went to schools. Estimates of just the retail food industry’s deposit in the CAT revenue box are represented at a more modest $188 million. Fiscal 2008 revenue was budgeted to be even larger as the CAT rate tops out at 0.26% this year.
The CAT simply may not survive this and other challenges. Allowed only to dine out at restaurants (no carry out, please), the door has been opened to yet another challenge. It may not be able to drive; it will have to walk. The appellate court’s decision is based upon a legal conclusion that a tax on gross receipts is by its nature an excise tax, and such an excise tax is constitutionally prohibited regardless of any additional label assigned by the Ohio legislature such as that it is “on the business for the privilege of doing business in Ohio” and not “on the transaction of a sale to a consumer.”
A different CAT fight is already underway with Ohio’s fuel industry, as the CAT takes its bite out of gross receipts from the sale of motor vehicle fuels as well. Another constitutional provision, Article XII Section 5a, requires that excise taxes on fuel must be spent solely on highways, bridges, traffic law enforcement and hospitalization costs of indigent victims of motor vehicle accidents. The CAT tax is ear marked for schools and local government. So, if the latest appellate decision in Ohio Grocers Assn. v. Wilkins is upheld on grounds that the CAT is an excise tax, it would follow that CAT revenue from fuel sales must be redirected to highways and away from schools retroactive to the first dollar collected in 2005.
The September 3, 2008, Gongwer News Service Ohio Report estimates that weaning the CAT from food and fuel would eliminate 20% of total CAT revenue. So, it would appear that the Ohio Tax Commissioner must win his appeal to the Ohio Supreme Court on the specific grounds that a CAT on gross receipts is not a prohibited excise tax, asking the court to interpret the Ohio Constitutional amendments adopted in 1976 (food) and in 1947 (fuel) to exclude this kind of an excise tax, a distinction that does not appear in those sections of Constitution. Such a distinction may instead require a constitutional amendment, taking far more time and being equally unpredictable. The Tax Commissioner losing, or even wining on any other grounds, could leave the CAT $139 million short, roadkill along the highway after chasing cars.
We have every reason to believe that the Tax Commissioner will appeal the Ohio Grocers Association decision to the Ohio Supreme Court, and in the meantime, he will continue to collect the CAT until the tax is either sustained or these rulings on unconstitutionality become final. Reason would compel us to expect the Ohio legislature to explore backing another breed of CAT on a contingency plan.
For now, we are advising clients in the food industry that they will need to file and pay the CAT tax on all food related sales until the appellate decision becomes final or the law is changed. In order to support possible future amended tax returns, businesses should track and segregate these gross receipts from other sources, if this is not part of their regular tax accounting. As the tax first became effective July 1, 2005, businesses and their return preparers should watch applicable statutes of limitations. If appeals drag on too long, protective refund claims can and should be filed before expiration of these statutes of limitations in order to protect refund rights. Announcements from the Ohio Department of Taxation may be issued with an official position on these and other issues as the court’s decision is evaluated.
We will continue to monitor the situation and you should feel free to contact me directly if you have any questions.
Disclaimer: This alert has been prepared for informational purposes only and should not be considered legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney/client relationship.
“CAT” Bites Grocers, Not Groceries
Supreme Court Says It’s Constitutional
by Gary M. Harden
Originally published September 2009
On September 2, 2008, it looked like the Ohio Commercial Activity Tax or “CAT” would starve for lack of sufficient revenue when Ohio’s 10th District Court of Appeals ruled the CAT unconstitutional as applied to gross receipts from certain food sales. About 20% of the tax relates to revenue from sales of food and of highway fuel, the latter of which is subject to a similar constitutional challenge. By the time of this decision, more than $350 million in refunds and a potential $188 million budgetary shortfall were pending. One year and 15 days later, the Ohio Supreme Court has just saved the CAT’s kibble with this subtle but apparently sufficient distinction: the tax falls upon the “sellers of food” and not upon “the sale of food” (Ohio Grocers Association v. Levin). In so doing, the CAT takes a bite out of grocers but not the groceries.
Writing for the majority, Justice O’Connor relied upon the “strong presumption of constitutionality” and the grocers’ burden to prove unconstitutionality “beyond a reasonable doubt,” finding three approaches to support this distinction. First, the Court concluded the Constitution did not expressly prohibit the State from levying a tax on the privilege of doing business, and so it was permissible for gross receipts from the sale of food to be included in valuing that privilege. Second, the Court noted a long standing legal distinction between levying a tax upon a factor, and using that factor as a “measuring stick” for a tax. In a third but similar approach, the Court observed the privilege of doing business can be measured even by tax exempt factors, at least as compared to the corporate franchise tax, a tax which the CAT replaces.
Seemingly dissatisfied with its own justification, the majority strayed beyond the low standard that presumes constitutionality. Over the following 10 pages the Court took a swipe at the grocers’ position as “at best, . . . competing plausible reading” of the Constitution, and the Tax Commissioner’s position as “the correct reading of the provisions.”
When finished, the Court had clearly made its demeanor, if not the veracity of its distinctions, well understood. This demeanor does not bode well for other constitutional challenges, including those pending. To support the Tax Commissioner’s “correct reading of the provisions,” the Court relied on several distinctions, including the way it operates. It relied upon the historic treatment of dissimilar taxes, like the Ohio franchise tax which includes gross receipts from food included in net income from combined business operations which could be affected by losses, loss carryovers, apportionment and other factors. Some of these distinctions actually could convince the reader that the CAT really does get the groceries, through the grocer.
The majority concluded the CAT operates like a tax on a privilege and not on the sale of food items because:
• the state legislature said it was a franchise tax on a privilege (cannot be much more superficial than that);
• it is imposed upon the person enjoying the privilege (upon the grocer who remits the tax, although the consumer will pay the tax passed on in the cost of goods sold, and with a sales tax the grocer also remits the tax to the state and is personally liable if this does not happen);
• the statutory language prevents the privilege holder from passing the tax on to the consumer by a separate charge (the CAT will be passed on to the consumer in the cost of good sold);
• it is imposed based upon the filing of an annual return (as opposed to being reported on the basis of some other period, for example, monthly, like a sales tax return);
• it is imposed based upon results of an entire year, and not on a transaction by transaction basis (the CAT is on gross receipts, undiminished by losses or the effect of any other material influence of a year’s results, other than the additive effect of taxing each and every gross receipt); and finally
• “it is computed using a broad measure of market access that is rationally related to the enjoyment of the privilege of doing business.” (All gross receipts, including those from the sale of food for human consumption. The Court somehow appeared persuaded by the fact that the tax rate was low, which of course can be changed.)
In a spirited but singular dissent, Justice Pfeifer was not persuaded by the substance of the majority’s distinctions. Neither was he inclined to rely upon the presumption of constitutionality in the face of what otherwise appeared to him to be the specific intention of the Constitutional amendment that prohibited a tax on the sale of food, or on historic distinctions that were not germane to the instant tax. Quoting Holmes’ law review article “The Path of the Law” (Harvard Law Review, 1897): “It is revolting to have no better reason for a rule of law than that it was laid down in the time of Henry IV. It is still more revolting if the grounds upon which it was laid down have vanished long since, and the rule simply persists from blind imitation of the past.”
While the majority’s approach may be questioned, the result appears clear. The state of Ohio’s economy, potential refunds that could cripple state programs, budget deficits and the integrity of a tax system designed to improve collections, business and provide a more reliable source to fund education are important factors not to be discounted when weighing the substance of a constitutional challenge. The CAT became king of the urban tax jungle when it allowed the legislature to lower personal income tax rates, and to eliminate the state corporate franchise tax and personal property tax. Other constitutional challenges should expect scrutiny.
As a tax historian, one should question the will of the legislature. When tempted to raise additional revenue, will state law makers remain true to the new system of taxation, and adopt consistent adjustments to the CAT tax, or embark on a new adventure of “Bill the CAT” producing a changeling that fails to accomplish the worthy goals enacted? Will the legislature resurrect the franchise tax, personal property tax or perhaps increase the personal income tax rate to their former high levels? Such legislation already has been introduced into the State House (House Bill 284). Tax rates, especially income taxes, historically have been raised to their former levels directly, indirectly by broadening the base of tax or in combination. There are many examples. In the federal system the obvious example is the 1986 Federal Tax Code which lowered the top marginal rate to 28% and paid for it in a tax neutral act eliminating the investment tax credit (ITC) and broadening the tax base. The business incentive of lower rates was used to justify the elimination of ITC and broader tax base. The ITC still is gone, the tax base is broader than before and the top marginal rate has reached 39.6% with various claw back provisions that recoup for the Treasury the value of lower graduated marginal rates, the value of itemized deductions, alternative minimum tax on income that already has been spent on deductions not allowed for a different tax system and a host of similar provisions intent on increasing the effective rate by manipulating items other than the nominal rate. The current federal Congress is intent on more of the same. Do smoke and mirrors save face with the electorate?
One thing appears certain for now. The CAT, once appearing lean, is now free to nibble at its low rate on all the grocers’ food.
Disclaimer: This alert has been prepared for informational purposes only and should not be considered legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney/client relationship.