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By Kenneth T. Zemsky, JD, CPA, and Keith D. Eisenstein, JD, Arthur Andersen LLP

A recent administrative law judge determination paves the way for possible refunds with respect to the New York State personal income tax phase out of certain itemized deductions. Specifically at issue is New York's position on the Federal limitation of itemized deductions.

IRC section 68 limits the amount of itemized deductions that may be claimed by taxpayers whose adjusted gross income exceeds $100,000 (plus a cost-of-living adjustment). The total itemized deductions of such taxpayers (excluding deductions attributable to medical expenses, investment interest, and casualty or gambling losses) must be reduced by the lesser of 1) 3% of (AGI­$100,000) or 2) 80% of allowable itemized deductions.

N.Y. Reg. section 115.2(g) establishes an "ordering convention" for the application of the IRC section 68 limitation to New York itemized deductions. First, the IRC section 68 limitation on itemized deductions is used to reduce those itemized deductions which are allowable for New York State personal income tax purposes. Then, the limitation is used to reduce those deductions which are not allowable (i.e., state and local taxes deducted for Federal purposes) and, consequently, must be added back to Federal taxable income in determining New York taxable income. That is, the IRC section 68 limitation is only used to reduce the New York add-back modifications if the limitation was not fully utilized in reducing allowable New York itemized deductions.

In Matter of Shorter, DTA #813571 (1996), a New York State Administrative Law Judge ("ALJ") held that this ordering convention is invalid. The ALJ reasoned that the ordering convention resulted in a double disallowance of the taxpayer's itemized deduction for state and local income taxes because it required the add back of the entire amount of state and local taxes although the Federal deduction had already been limited by the IRC section 68 limitation. In other words, under the ordering convention, a taxpayer is required to add back a greater amount than was actually allowed as a deduction on the Federal return. As a result, the ALJ further held that the IRC section 68 limitation should be applied on a pro rata basis to all itemized deductions. Such a method limits the New York State add-back modification to the actual amount deducted for Federal income tax purposes.

Shorter represents a line of cases which indicate that New York tax law adheres to the tax benefit rule. An early case which clearly stated this principle was Hunt v. State Tax Comm'n, 65 N.Y.2d 13, 489 N.Y.S.2d 451, 478 N.E.2d 967 (1985). Implicit in Shorter, as well, is the continuing validity of the tax-benefit rule.

On the basis of the Shorter decision, a refund opportunity is available for all open years of New York State individual taxpayers who are subject to the IRC section 68 limitation. The refund claim would be in the amount of the difference between the add back modifications for itemized deductions required under the ordering convention and the modifications computed under the pro rata method. Such taxpayers may also adopt the pro rata method prospectively.

However, it must be noted that this refund opportunity and prospective filing position is tentative because ALJ determinations are not precedential. Further, the department has already filed an appeal of the ALJ's determination with the Tax Appeals Tribunal. Events should be
monitored as the case proceeds to the
tribunal. *


By Corinne L. Crawford and
Jeffrey M. Cobb

In January, the Office of Tax Policy of the New York State Department of Taxation and Finance released a report on the taxation of the telecommunications industry entitled "Improving New York State's Telecommunications Taxes." The report is one example of a wider national trend to clarify some of the complex tax issues facing businesses and government in the Information Age. The Department of Taxation and Finance has stated that New York State's economy relies on a healthy and growing telecommunications industry. The department believes the current tax structure has become increasingly outdated and cannot properly answer all the questions emanating from the new technologies and market forces. Legislation enacted in 1995 mandated the Department of Taxation and Finance to study telecommunications and recommend changes. The panel's study focused on three areas, corporate tax issues, general sales tax issues, and cellular telephone issues.

Summary of the Salient Recommendations Found in the Report

The panel recommends that the gross receipts method for taxing telecommunications companies be retained. Although, the Department of Taxation and Finance believes that a change to a tax based on net income is ultimately the desirable tax policy goal, the evolving nature of the regulatory reforms in this area makes switching to an income based tax premature at this time in the panel's view.

The panel recommends however, that the Article 9 taxes be revamped. The first recommendation is that the section 184 additional franchise tax imposed on local telephone businesses be eliminated. The second recommendation is that the section 186-a tax on the nontelecommunications income of Department of Public Service regulated companies be removed and a replacement tax under Section 183 be instituted. The third recommendation is that the Section 186-e tax rate be reduced. The panel believes that the changes to Article 9 would make the taxing structure more equitable, improve the competitive position of all telecommunications providers, and lower the costs of services to consumers of telecommunications services in the state.

The panel believes that Internet services are unenumerated services and should not be subject to sales tax. Further, the panel states as Internet services are not in the realm of telecommunications these receipts are beyond the scope of the Section 186-e gross receipts excise tax. The panel has mandated further collaborative study with industry in order to develop concise definitions and to distinguish these services from taxable information and entertainment services and from taxable telecommunications. The panel also reiterated New York State's position that nexus with the state is not created merely by having a non-New York company's advertising appear on a New York server or through a New York Internet provider.

The panel recommends that New York retain its policy of taxing prepaid phone cards when used. The legal defects in the options to tax the entire retail sales price of the cards when sold, either as telecommunications or as tangible personal property, make them difficult to recommend given New York's narrow sales tax base on telecommunications, in the panel's opinion. The panel believes the possibility of taxing calls not subject to sales tax (i.e., interstate and international calls) is too great to warrant a policy change at this time.

The panel believes New York's central office switching equipment exemption needs revision. The panel recommends that the current statute be updated to exempt all machinery and equipment used directly and predominately in initiating, switching, or receiving telecommunications at the destination. They believe the exemption should include equipment that processes and amplifies signals. This modification would extend the exemption beyond the current "central office switch." The panel states that at a later date, if fiscal constraints allow, the exemption could be broadened to include all network property and utility services used directly and predominately in telecommunications. The exemption would also include telephone lines, poles, and towers. As a third priority the panel would like to see a new sales tax exemption enacted for equipment used to provide television programming services.

The panel recommends using a service address concept based on the location of primary use to source cellular charges. The panel believes that the customer's billing address would work in most cases. However, the panel asserts that much work needs to be done to clarify the guidelines to administer this approach. Thus, the Department of Taxation and Finance invites the cellular industry to work with the department to develop these rules to ensure that they are clear and meet the needs of this rapidly changing technology.

Report Recommendations Accepted

In a Technical Services Bureau Memorandum,TSB-M-97(1)(S), issued shortly after the report was released, the department acted quickly on some recommendations affecting the electronic commerce industry. In its Technical Services Bureau Memorandum, the department expressly indicates that Internet access charges are not subject to either the New York State sales tax or the recently adopted excise tax on telecommunications imposed under Article 9, section 186-e of New York tax law. The department's new policy on Internet access charges became effective February 1, 1997. While the department indicates the new policy is available on a prospective basis only, this conclusion is not immune from legal challenge by those who have paid taxes on access charges prior to February 1, 1997. The department also indicates that nexus is not created for either sales tax or corporate franchise tax purposes merely by having advertising appear on a New York State server or through a New York State Internet service provider. The Technical Services Bureau Memorandum is silent, however, on whether nexus is created by content or services that exceed mere advertising.

Emerging Issues

The Department's report is part of a wider trend among many state tax officials and the Department of Treasury to clarify some of the complex and unique tax issues that have surfaced as the volume of electronic commerce has surged over the last three years. Like New York, several states including Florida, are currently studying the impact of state tax laws on electronic commerce. Currently, there is little uniformity in the application of state and local tax laws on electronic commerce and, unlike New York State, the results are not necessarily favorable for the taxpayer. For instance, in contrast to New York State, Connecticut has issued Connecticut Administrative Release, Ruling 95-2, that indicates that charges for access to an online information database are taxable as a computer and data processing service in Connecticut. Similarly, Florida has issued two Technical Assistance Advisement's, 95(A)-025R and 95(A)-044 which provide that commercial subscriber Internet access services are subject to a gross receipts tax.

Recently there has been some movement toward uniformity. The National Governors' Association voted on February 4 to endorse drafting a uniform statute for taxation of electronic commerce and/or clarification on nexus issues associated with use of the Internet. Moreover, several organizations, including the Multistate Tax Commission, have called for coordinated policies that promote fair taxation of the industry and uniformity.

The debate and complexity surrounding taxation of electronic commerce has not been limited to state and local officials. The Department of Treasury has recently issued a white paper entitled "Selected Tax Policy Implications of Global Electronic Commerce" that addresses the U.S. tax policy implications of electronic commerce from an international perspective. Moreover, the states' ability to establish new methods for taxing electronic commerce is not without critics. Sen. Wyden and Rep. Cox have introduced legislation in Congress, the Internet Tax Freedom Act, that would significantly restrict the states' ability to impose sales and use taxes on Internet services. The message of the legislation is clear. Congress can act to preempt state taxation if it so chooses. In the meantime, New York State's Technical Service Bureau Memorandum has clarified some of the department's tax policies. Although the department's report "Improving New York State's Telecommunications Taxes" is clearly meant to level the playing field between industry and government on a number of contentious issues facing the New York State electronic commerce industry. However, the debate in other states shows no sign of subsiding, absent a uniform approach to the state taxation of electronic commerce or congressional intervention. *

Corinne L. Crawford, CPA, and Jeffrey M. Cobb, JD, are principal consultants with Price Waterhouse LLP in its multistate tax consulting practice. Ms. Crawford specializes in the entertainment, media, and communications industries. Mr. Cobb specializes in the financial services industry.

State and Local Editor:
Marshall L. Fineman, CPA
David Berdon & Co. LLP

Interstate Editor:
Stuart A. Rosenblatt, CPA
Wiss & Company LLP

Contributing Editors:
Henry Goldwasser, CPA
M.R. Weiser & Co. LLP

Leonard DiMeglio, CPA
Coopers & Lybrand L.L.P.

Steven M. Kaplan, CPA
Konigsberg Wolf & Co., PC

John J. Fielding,CPA
Price Waterhouse LLP

Warren Weinstock, CPA
Paneth Haber & Zimmerman LLP

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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