The Ohio Supreme Court (Court) has ruled that the Commercial Activity Tax (CAT) can be imposed on an entity with substantial receipts from Ohio sources even if there is no physical connection to the State.¹ Investment advisors with receipts from customers located in Ohio should review their facts and consider whether the ruling in this case will affect them.

Overview

The CAT is an entity-level tax measured by taxable Ohio-sourced gross receipts from business activities.² The CAT is imposed on each "person," including unincorporated entities such as partnerships and limited liability companies, with substantial nexus to Ohio.³ Substantial nexus is created if a person has specified bright-line presence, including Ohio-sourced receipts of $500,000 or more, in the State.⁴ This means a company with no physical presence in Ohio is subject to the CAT if it has $500,000 of receipts from customers in the State. The current enacted tax rate is 0.26%.⁵

Economic nexus challenge

State taxing authorities continue to enact provisions that impose tax on companies with bright-line factor presence. Practitioners and taxpayers have speculated whether these statutes would withstand constitutional challenge. In this instance, the Court upheld the CAT's bright-line nexus standard. The Court determined that the State could impose tax on a company with no physical presence in Ohio, provided the company's economic connections to the State created substantial nexus as described by the US Supreme Court under its dormant Commerce Clause rulings. The Court concluded that, although setting a receipts threshold of $500,000 as a measuring stick may seem to be artificial and arbitrary, drawing such lines serves the justifiable purpose of defining legal obligations for the benefit of the taxpaying public. The threshold serves as "an adequate quantitative standard" confirming substantial nexus for the purpose of imposing the CAT.

The likelihood exists that the taxpayer will appeal the decision to the US Supreme Court. If that Court grants certiorari, it will likely take some time for the Court to hear the case and ultimately issue a ruling. In the meantime, the Ohio Department of Taxation (Department) will likely continue to assert economic nexus over out-of-state taxpayers.

The CAT is not an income tax, but it is reasonable to expect taxpayers in other states to continue to challenge their respective states' bright-line nexus taxing provisions. The effect this case will have on future legal challenges is debatable.

Implications

As a result of the Crutchfield decision, investment advisors may want to review their physical and economic connections to Ohio. Ohio has adopted market-based sourcing provisions that generally source receipts for services to the physical location where the customer uses or receives the benefit of a service. For example, receipts for the provision of investment management and advisory services to an individual Ohio resident would generally be considered Ohio-sourced receipts under this rule. The available guidance does not, however, address all business transactions, and the Department has interpreted the statute to allow the sourcing of receipts to the location of the customer and the location of the customer's customer. Therefore, in addition to capturing receipts directly received from customers physically located in Ohio, the sourcing rule may be broad enough to capture receipts indirectly received from customers in the state through their own direct customers that might not be located in the state.

An investment advisor that receives fees directly or indirectly from customers located in Ohio should consider the effects this ruling may have on its Ohio CAT filing obligations. It seems likely that fees directly received from Ohio residents (i.e., that exceed the $500,000 filing threshold) would trigger a filing requirement, barring the overturning of this ruling by the US Supreme Court. Persons receiving fees that can be attributed to investors in Ohio should review what, if any, ties there may be to Ohio and determine if any revisions to their existing filing position in Ohio are necessary.

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ENDNOTES

¹ Crutchfield, Corp. v. Testa, Slip Op. No. 2016-Ohio-7760 (Ohio S. Ct. Nov. 17, 2016). Newegg, Inc. v. Testa, Slip Op. No. 2016-Ohio-7762 (Ohio S. Ct. Nov. 17, 2016). Mason Companies, Inc. v. Testa, Slip Op. No. 2016-Ohio-7768 (Ohio S. Ct. Nov. 17, 2016). The cases were consolidated for purposes of litigation. We will use Crutchfield when referring to all three cases for purposes of this document.

² Items that are excluded from the taxable gross receipts include: interest income, dividend income and most receipts from assets described in Sections 1221 and 1231 of the Internal Revenue Code of 1986, as amended.

³ Related or affiliated entities that are taxpayers can be required to file a combined group return (or can elect to file on a consolidated basis). The existence of common ownership or control is sufficient to require a combined return. Common ownership or control will exist when a person directly or constructively has a more-than-50%-ownership interest in or control of another person.

⁴4 Persons with Ohio-sourced receipts over $150,000 are subject to a registration requirement and an annual minimum tax (AMT) of $150. See below.

⁵5 The tax rate applies to Ohio-sourced receipts over $1 million. The AMT also applies. For tax periods beginning on or after January 1, 2014, taxable persons are subject to a graduated AMT ranging from $150 to $2,600. The effect of the AMT is to gradually tax the first $1 million of Ohio-sourced receipts. For example, a person with Ohio receipts over $4 million would pay a minimum tax of $2,600, plus a tax of 0.26% on Ohio-sourced receipts over $1 million. AMT is based on prior year's receipts. The general tax rate of 0.26% has not been changed since enactment of the CAT in 2005.