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Multistate Tax Services Alert: Ohio Department of Taxation to establish Commercial Activity Tax liability for Private Equity Firms

At the 2012 Ohio Tax Conference, The Ohio Department of Taxation confirmed the Commercial Activity Tax (CAT) audit activity surrounding private equity firms. While not part of a specific audit program, the Department commented these taxpayers have become a common audit participant due to their ownership in portfolio companies. The Department said an auditor will generally identify a company to audit (which is unknowingly a portfolio company) and subsequently includes all companies associated with the private equity firm in the audit.

The Issue

Ohio law imposes the CAT on a combined group of persons (which includes the common owners) if they are commonly owned or controlled more than 50 percent. Unlike a Consolidated Elected Taxpayer (CET), only those persons having substantial nexus are forced into a combined group. The Department’s audit practice is to review a taxpayer’s organizational structure to determine a person (entity or individual) that is the common owner. Next, the Department determines all those persons owned or controlled more than 50 percent by a common owner. All of the persons who are owned or controlled more than 50 percent by a common owner are required by the Department to file CAT on a combined basis. A common owner could include an individual that controls the portfolio of companies.

In the example below, the Department would require all of the entities with Ohio nexus to file as one combined group since the private equity firm owns more than 50 percent of all the entities.

The Department has interpreted the law and rules to establish a private equity firm can be a common owner for all of its portfolio companies depending on the ownership structure. The Department has considered direct ownership and flow-through ownership (partnership, limited partnership, limited liability company, limited liability partnership, or other flow through entities), when making the determination of a common owner for private equity firms.

What is the audit impact?

The Department has indicated the impact under audit varies, but typically affects portfolio companies, as most common owners generally have not created substantial nexus for CAT purposes. Portfolio companies have been impacted in several ways:

  • Portfolio companies who previously filed a CET election, lose the election during the audit period. By eliminating the CET election, gross receipts between members of the group are not excluded, which can produce substantial additional CAT liability. In the example above, if A, B, and C had filed consolidated elected and excluded gross receipts among them, their election would be lost. They would be required to file in a combined group and the excluded gross receipts would now be taxable.
  • Unregistered portfolio companies with substantial nexus are required to file and pay CAT for all open years.
  • Portfolio companies who already registered (separately, combined or consolidated elected) and filed, lose the exclusion for the first $1 million in taxable gross receipts.

Audits of private equity firms or their portfolio companies can become quite complicated depending on various factors:

  • The scope of the audit as determined by the Department, including the types of documentation requested by the auditor.
  • The size of the private equity firm including the number of portfolio companies and their subsidiaries.
  • The type of ownership structure utilized (i.e., partnerships, LLCs, carried interests, etc.).
  • The determination of substantial nexus for CAT purposes for any person in the organizational structure.
  • The types of gross receipts to be sitused to Ohio.
  • The method chosen by the private equity firm to complete the audits of the portfolio companies.

What is the impact prospectively?

Taxpayers should also be concerned with the method of filing after the audit period is complete. Specific concerns may include:

  • Who will file the return on behalf of the combined group?
  • Who will file as part of a combined group?
  • Does the firm want to “opt-out” any of the portfolio companies from the combined group?
  • Should the firm make a request to file as a consolidated elected taxpayer?

These questions may be difficult to answer as some private equity firms will have certain hurdles when complying in the future:

  • Private equity firms often times do not have the staff to file CAT returns on behalf of their portfolio companies.
  • Portfolio companies often do not have interaction with each other.
  • Portfolio companies may not want to share financial data with other portfolio companies.

Does a private equity firm have to wait to be contacted by the Department?

No, private equity firms can be proactive in addressing this issue. First, firms should determine who is a common owner within their organizational structure. Second, determine which persons within their organizational structure have substantial nexus for CAT purposes. Third, determine if potential additional CAT liability exists. If compliance has been less than adequate, then firms can address the potential liability in three proactive ways:

  • General Amnesty — Firms could apply for general amnesty (May 1, 2012 through June 15, 2012, see Multistate Tax Services Alert:  Ohio General Tax Amnesty Program deadline approaches for more detail) and remit the tax liability for all open years plus one-half of the normal interest (no penalty would apply).
  • Voluntary Disclosure— Firms could apply for a voluntary disclosure agreement and remit the past three years plus full interest (no penalty would apply). We are experienced in assisting firms in determining whether Amnesty or Voluntary Disclosure is the better option.
  • Managed Audit— Firms could request a managed audit from the Department’s Audit Division and remit the tax liability plus full interest for the audit period, which is typically two years for registered taxpayers (no penalty would apply). While there is no formal managed audit program for CAT purposes, the Department may be willing to discuss this approach. This type of audit involves the Department and the firm planning the audit, allowing the firm to complete part of the actual work, which minimizes the involvement of the Department in the process. Firms are often more comfortable with this approach and feel more in control of the audit.

Our Multistate Tax professionals understand all aspects of the CAT and have defended against audits of private equity firms. We are experienced at ensuring accurate and fair audit results.

1R.C. 5751.01(A) defines person to include, but is not limited to individuals, combinations of individuals of any form, receivers, assignees, trustees in bankruptcy, firms, companies, joint-stock companies, business trusts, estates, partnerships, limited liability partnerships, limited liability companies, associations, joint ventures, clubs, societies, for-profit corporations, S corporations, qualified subchapter S subsidiaries, qualified subchapter S trusts, trusts, entities that are disregarded for federal income tax purposes, and any other entities.

If you would like to discuss this audit program or how McDonald Hopkins can help assist you with resolving in potential CAT liability, please contact:

John R. Trippier
(non-attorney professional)

Thomas M. Zaino
mailto: tzaino@mcdonaldhopkins.com

or any of our Multistate Tax Services Practice by clicking on the link below:

Multistate Tax Services

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© 2012 McDonald Hopkins LLC All Rights Reserved. This Alert is designed to provide current information for our clients, friends and their advisors regarding important legal developments. The foregoing discussion is general information rather than specific legal advice. Because it is necessary to apply legal principles to specific facts, always consult your legal advisor before using this discussion as a basis for a specific action.