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Georgia's New Withholding Rules

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    INTRODUCTION

    In the summer of 1993, Jerry Jackson, Deputy Commissioner, contacted the Taxation Section of the State Bar and the Atlanta Bar Tax Section requesting the Bars' participation in the formation of a new committee to solicit comment from tax professionals with respect to issues of importance. In response to this invitation, a committee, which has been designated as the Joint Liaison Committee jointly sponsored by the Atlanta and State Bar Tax Sections has been formed. Appointments from the Bar are made by the Chairs of the State Bar and Atlanta Bar Tax Sections respectively. In addition, invitations have been extended to and several members of the Georgia Society of CPAs have been included in this membership. The current membership of the Joint Liaison Committee from the private sector is: Charles R. Beaudrot, Jr., Bobby L. Burgner, Albert Caproni, Raymond P. Carpenter (Co-Chairman, State Bar), N. J. Citron, John L. Coalson (Co-Chairman, Atlanta Bar), Frank DeLuca, Peter Fishman, CPA, Stephen E. Forbes, Tim Gillis, Gary Hickman, Joann Jones, Patrick G. Jones, Richard M. Morgan, Linda W. Munden, James L. Underwood, CPA, Michael L. Wood, CPA.

    The formation of the Joint Liaison Committee represents an intelligent and laudable effort on the part of the Revenue Department to solicit comments and assistance with respect to proposed regulations and issues of concern to businesses and their tax advisors in Georgia.

    I. Withholding on Distributions to Nonresident Members of Partnerships, Subchapter S Corporations and Limited Liability Companies.

    A. Legal Background of Uncertainty to the Statute. The taxation of nonresident shareholders of S corporations and nonresident partners of partnerships has long been an extremely murky area. There is much lore and little law. Much of the "law" is little more than instructions to various tax forms and unwritten Revenue Department policies. For an excellent review of a number of salient issues with respect to taxation of nonresident partners and S corporation shareholders, see Patrick G. Jones, "Georgia Taxation: Partners and S Corporation Shareholders", The Atlanta Lawyer, Volume 40, No. 1, p. 14 et seq. (1973).

    B. Practical Problems. For some years the State of Georgia has had audit teams specifically assigned to the audit and assessment of Georgia income tax against nonresident partners and S corporation shareholders. Perhaps the most frequent pattern is that of the nonresident individual partner who has an interest in a syndicated Georgia partnership or entity. For a number of years the partnership would show a series of losses or small amounts of income until the year of the sale (or foreclosure) of the underlying assets. Frequently, the nonresident partner would report any income from the Georgia partnership on the tax return of the state of his domicile assuming, erroneously, that such income is analogous to dividend income from stocks, the income of which is generally taxable in the state of domicile of the holder of the interest. Similarly, such partners generally did not file any returns in Georgia.

    Under this scenario, the nonresident partner often found himself in the following unhappy position:

    1. The taxpayer has no statute of limitations protection (or perhaps a seven year statute of limitations under O.C.G.A. § 48-3-21) with respect to the Georgia income.
    2. The taxpayer owes tax, nondeductible interest and penalty (usually waived if reported to another state or otherwise innocently omitted).
    3. The taxpayer may have any claim for refund or credit in his home state barred by the applicable statute of limitations.
    4. The taxpayer ends up with substantial professional fees for the recomputation of his income in his home state, the filing of additional returns and negotiation with the Revenue Department to obtain waiver of penalties.

    The Revenue Department has similarly been frustrated by the practical inability of reaching nonresident partners and shareholders of S corporations, especially in those cases where the tax liability is modest and collection impractical.

    C. The Legislative Response. In response to these continuing difficulties, the Revenue Department sponsored and obtained the passage in the 1993 legislative session of a statute codified as O.C.G.A. §48-7-129.
    1. Basic Structure. The salient concepts of this withholding statute are the following:
      1. It imposes a 4% withholding on the entity as to distributions "paid or credited" to the nonresident. (See O.G.C.A. §48-7-100(2.1)).
      2. If the withholding is not made, a penalty is assessable against the entity and its members.
      3. The entity and its members have joint and several liability for the penalty. Thus, the statute represents an extremely important exception to the general rule of non-liability of shareholders and limited partners. It also has the effect of making residents guarantors of the nonresident taxpayer's liability.
      4. The statute then specifically sanctions, as an alternative to withholding, the filing of a composite return by the entity on behalf of the nonresident.
    2. Reconciliation. Nonresidents are to be given a reconciliation within thirty days of the close of the taxable year of the entity with respect to which the withholding payments were made.
    3. Exceptions to Withholding. The statute contains a number of important exceptions from withholding:
        The following questions are some of those frequently asked on LLCs. Many of these topics deserve an extensive discussion. The "answers" are included only to alert the practitioner to certain issues and to give him or her a start on the analysis.
      1. Partners as to which composite returns are filed.
      2. Distributions to a member of less than $1,000 per member per year.
      3. If the entity is an S corporation for federal tax purposes, but the election is not effective for Georgia tax purposes.
      4. Undue hardship.
      5. If the entity is a partnership, the partnership is a publicly traded partnership.
      6. Other exceptions created by regulation.
      7. Subsection 48-7-129(e)(2) contains an extremely important but confusing exception from withholding for income subject to withholding under other provisions of law or which "represent a return of such member's investment or return of capital." The regulations and forms add to this exception "previously taxed income." 560-7-8.35(3)(d).

    D. Problems of Interpretation of the Statute and Regulatory Response. The statute is replete with a variety of inherent ambiguities. The regulations adopted under this section appear at Reg. §560-7-8-.34 and attempt to clarify several issues. The regulations make substantial progress in this regard. By no means do they resolve all of the issues.
    1. Distributions to which Withholding Applies. A critical issue to the operation of the statute is the resolution of what are "distributions paid or credited" to which withholding applies. The definition adopted in Reg. §560-7-8-.34(1)(a) makes reasonably clear that a distribution means an actual distribution to a member or a segregation of funds for the benefit of the member. The withholding obligation is imposed only on such distributions, not on income. Also, the term as defined makes clear it does not apply to payments made to a member in a capacity other than as a member (e.g., as salary, rents or royalties).
    2. Guaranteed Payments. Although the issue was discussed at length with the Revenue Department and although the regulations are not as explicit on this point as they could be, it is clear that the Revenue Department interprets the regulations as applying the withholding obligation not only to "regular" partnership or S corporation distributions, but also to IRC §707(c) guaranteed payment to partners in capacities other than as partners.
    3. Crediting of Distributions. In addition to actual distributions which are subject to withholding, under Reg. §560-7-8-.34(2)(a), amounts credited in lieu of an actual distribution, for example, in the nature of an offset, are also subject to withholding. Reg. §560-7-8-.34(2)(a)(3). Although there is some uncertainty within the Revenue Department as to how this should be interpreted, it seems reasonably clear that the Revenue Department contends that withholding applies in the situation where funds are separately accounted for or set aside for a partner, something analogous to a "constructive receipt" test. It is reasonably clear that the Department would view a reinvestment plan or where funds are constructively received and reinvested as subject to withholding.
    4. Apportionment and Allocation. Reg. §560-7-8-.34(2)(b) is extremely important in that it formalizes that for partnerships and S corporations with income from both within and without the State of Georgia, that such income must be apportioned and allocated based upon O.C.G.A. §48-7-31(c) and (d). Presumably then, the withholding distribution is deemed to be proportional to such factors, although this is not as explicit in the regulation as one might wish. The regulation specifically permits use of the prior years' apportionment and allocation formulas as a safe harbor for purposes of making these determinations.
    5. Nonresident Corporate Limited Partners. Reg. §560-7-8-.34(c) has now codified the previously unclear rule that a nonresident corporate limited partner with no other contacts in Georgia is not subject to tax withholding on its distributions. The Revenue Department declined the invitation to extend this rule to members of limited liability companies.
    6. Distributions to Tax Exempt Entities. Distributions to tax exempt entities are subject to withholding only to the extent of unrelated taxable business income (Q&A - 2).
    7. Composite Returns. Reg. §560-7-8-.34(3) is extremely important in that it is the first explicit regulatory guidance on the composite return methodology. A copy of the approved form is attached at the end of this section. Several points are of interest.
      1. The return consists of a schedule of each of the nonresident member's computation. There are three options for the method of computation and these may be applied on a member by member basis.
      2. The schedule must include the name, address, social security number, and any amount distributed to any nonresident member not included in the composite return.
      3. If a nonresident member is not included in the composite return, the member is subject to withholding.
      4. The due date of the return is the same as for a calendar year individual. Note this will create some real practical difficulties for fiscal year entities.
      Importantly, a nonresident member which has income within Georgia from sources other than the entity may not be included in the composite return and is subject to withholding.
    8. Registration. The withholding statute requires a new and separate registration on Form CRF002. (A copy of the amended form is included with these materials).
    9. Payment of Withheld Taxes. Withheld taxes must be paid within thirty days of the close of the calendar month in which the distribution is paid or credited. These are to be remitted on Form G-6.
    10. Reporting to Recipients. The entity will have to provide a statement (Form G-2(A)) showing the amount of the distribution, the recipient's name, the address and tax identification number, and the amount of Georgia tax withheld, no later than thirty days following the close of the entities taxable year. Recipients will be required to include copies of two of the Form G-2(A) with their Georgia income tax return.
    11. Fiscal Years. The regulations give several illustrations of how the fiscal year partnerships and fiscal year entities are to integrate their withholding with the appropriate tax year.
    12. Undue Hardship. The regulations theoretically recognize the existence of undue hardship as an excuse for non compliance. However, the list of items which do not justify undue hardship is so exhaustive that it will be a rare case indeed where the withholding obligation will be excused. Apparently death of a general partner would be one such instance.
    13. Anti Avoidance Clause. Finally, Reg. §560-7-8.34(6) contains an extremely important anti avoidance clause. This clause which is patterned after Section 482 of the Internal Revenue Code, may well someday serve as a model for other regulations in other areas.

    E. Forms. Attached are copies of the statute and the regulations, as well as forms developed by the Revenue Department for implementation of the new statute.

    II. Withholding Tax on Sale or Transfer of Real Property and Associated Tangible Personal Property by Nonresidents.

    At the same time as the legislature was enacting the partnership and S corporation withholding rules, the legislature also enacted a new withholding tax with respect to transfers of real property by nonresidents. The new withholding tax on sale or transfer of real property by nonresidents is in a sense a "mini-FIRPTA" as far as Georgia is concerned. Withholding at 3% is imposed with respect to all sales or transfers by nonresidents unless they can meet the statutory definition of resident or deemed resident as contained in O.C.G.A. §48-7-128.

    A. Relief from Withholding. The transferor is permitted to avoid the withholding obligation upon receipt of an affidavit signed under oath swearing or affirming that the seller or transferor meets the following tests:
    1. The transferor has filed Georgia income tax returns or appropriate extensions for the two income tax years immediately preceding the year of sale;
    2. The seller or transferor is in business in Georgia and will continue substantially in the same business after the sale or the seller or transferor has real property remaining in the state at the time of closing of equal or greater value then the tax liability as measured by 100 percent property tax assessment of such remaining property;
    3. The seller or transferor will report the sale on Georgia income tax return for the current year and file it by its due date; and
    4. If the seller transferor is a corporation or limited partnership it is registered to do business in Georgia.

    B. Limitation of Withholding. In all other cases there is a 3% withholding obligation as to the purchase price paid. However, if the amount required to be withheld exceeds the net proceeds payable, the withholding is limited to the net proceeds actually payable. The Q&A indicate the common sense net proceeds means amounts paid to Seller. Alternatively, O.C.G.A. §48-7-128(c) specifically permits that by providing an appropriate affidavit computing the actual amount of gain withholding can be calculated at 3% of such amount. Under Reg. §560-7-8-.35(3)(a), in order to take advantage of this reduced withholding, a form IT-AFF2 must be used in such calculation. A copy of such form is attached. The Q&A's affirm that only taxable transactions are subject (Q&A - 9).

    C. Exceptions From Withholding. There are a number of important exceptions from withholding under O.C.G.A. §48-7-128(d) that solve some of the most chronic problems. These exceptions include:
    1. Sale or transfer of principal residences.
    2. Deeds in lieu of foreclosure.
    3. Transfers by an agency or authority of the United States of America, the State of Georgia, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation or the Government National Mortgage Association, or a private mortgage insurance company.
    4. By virtue of Reg. §560-7-8-.35(3)(b), for transactions where the purchase price is less than $20,000 or where the purchase price exceeds $20,000 but the tax liability is shown to be less than $600.
    O.C.G.A. §48-7-128(e)(1) also contains an exemption for transactions where the seller is a partnership or S corporation or other unincorporated organization which certifies to the buyer or transferee that a composite return is being filed on behalf of the nonresident members and that the transferor remits the tax on the gain on behalf of the nonresident members. It should only take a moment's reflection to see that the exemption of O.C.G.A. §48-7-128(e)(1) is not precisely congruent with the entity withholding statute. Perhaps one can assume that compliance with O.C.G.A. §48-7-129 as to composite returns will satisfy the O.C.G.A. §48-7-128 test, as this appears to be the intent. The Revenue Department has informally indicated this may be correct and is studying the issue.


    D. Definition of Residents and Nonresidents. The regulations go to some length to clarify unanswered questions as to the status of residents and nonresidents. For instance they make clear that joint tenants are to be tested separately. Reg. §560-7-8-.35(1)(a). Similarly, a trust administered outside of Georgia is a nonresident, presumably irrespective of the state of creation. Reg. §560-7-8-.35(a).

    E. Installment Obligations. The regulations specifically do not address the issue of how to deal with withholding on installment obligations. Presumably the 3% withholding, if it can be funded from the initial payment, will be due in full at closing. If not, the resolution is unclear. It is to be hoped the Department will agree to a procedure whereby the withholding can be collected ratably from the payments as made. The recent draft Q&A's take this position (Q&A - 11).

    F. Forms. The regulations are liberal as to use of forms and documentation. They specifically state that not only can the officially sanctioned forms be used, but any closing statement, transfer statement or other documents containing all of the requisite information can be used.

    G. Like Kind Exchanges. The regulations and forms are silent as to the tax treatment of like kind exchanges. It would appear, however, that as long as the exchange qualifies as a non-taxable exchange under O.C.G.A. §48-7-27(b)(6), then such withholding is excused provided that the appropriate IT-AFF2 gain affidavit is produced. To the extent of gain (i.e., boot), presumably this will be subject to withholding. Bear in mind, however, that exchanges for purposes of O.C.G.A. §48-7-27(b)(6) are considerably narrower than the federal test in that the replacement property must be located in Georgia. Also, the forms do not really address the issue. The Q&A's adopt this approach (Q&A - 7).

    H. Appendix. The statute, regulations developed by the Revenue Department and suggested forms developed by the Revenue Department for use under this new section are attached.

    III. Taxation of Computer Software for Ad Valorem Tax Purposes.

    A. Background on the Problem. An issue of continuing interest and concern for the high tech industry in Georgia has been the taxation of computer software for ad valorem tax purposes.

    Administratively, certain Georgia taxpayers had been assessed with respect to the book value of the capitalized costs of their software. Assessors in certain counties, mainly in Metro Atlanta, took the position that capitalized software constituted tangible personal property and was therefore subject to tax as personal property.

    Whether such software was taxable as "tangible personal property" for ad valorem tax purposes was highly debatable. Historically, the Revenue Department itself has drawn a distinction between a so-called "custom" or "canned or prewritten software" for purposes of whether such assets constitute tangible personal property for sales tax purposes. The Revenue Department's current position is that "canned" or "prewritten" software is taxable for sales tax purposes, but that "custom" software is not. What is "custom" as opposed to "canned" was and is less than clear.

    More generally, there was a fundamental question as to why software would not be properly categorized as an intangible. Specifically, pursuant to O.C.G.A. §48-6-21(9), even as it existed prior to the 1993 amendment described below, intangible personal property included a category of property including "patents, copyrights, franchises, and all other classes and kinds of intangible personal property not otherwise enumerated." There was no Georgia case law or interpretation with respect to whether the concept of intangible property should include software. It did not take a vast extension of existing case law to argue, however, that the physical embodiment of software in a tangible form, such as in a diskette, should no more make the underlying software taxable as tangible personal property than embodiment of Gone With the Wind in the covers of the book or in a videotape makes the copyright of Gone With the Wind (as distinguished from the book or videotape itself) taxable as tangible personal property. Cf. Turner Communications Corporation v. Chilivis, 239 Ga. 91, 236 S.E.2d. 251 (1971). [Videotapes are tangible personal property for sales tax purposes even though they consist of at least three different components: tangible medium, intangible contents and limited right to use the encoded program.]

    The Revenue Department had indicated, at least informally, that custom computer software should constitute intangibles and not be subject to the ad valorem regime. However, the Revenue Department also had indicated that the county administrative offices were free to examine the issue and would not preclude their efforts to assess taxpayers.

    Some commentators had urged that the line could be drawn between software inventoried physically in diskettes for sale, which would be subject to taxation based upon the rules applicable to inventory, versus the intangible residual inherent in the software as intellectual property. See Beaudrot, "Current Issues in State Taxation of Computer Software -- The Georgia Experience," The Atlanta Lawyer, Volume 40, No. 1 (1993).

    B. H.B. 350. The high tech industry in Georgia made a top priority for the 1993 legislative session an effort to obtain relief in this area. In this regard, the industry was most fortunate to enlist the support of Governor Miller. The result, H.B. 350, is codified in O.C.G.A. §48-1-8 and amendments to O.C.G.A. §48-6-21 and represents an interesting grafting of several concepts. First, computer software is defined in O.C.G.A. §48-1-8(a) for the first time as follows:
    1. As used in this Code section, the term "computer software" means any program or routine, or any set of one or more programs or routines, which are used or intended for use to cause one or more computers or pieces of computer related peripheral equipment, or any combination thereof, to perform a task or set of tasks. Without limiting the generality of the foregoing, the term "computer software" shall include operating and application programs and all related documentation.
      Second, computer software is defined to constitute personal property for ad valorem and intangible tax purposes only to the extent of the medium in which stored. O.C.G.A. §48-1-8(b) provides as follows:
    2. Except as otherwise provided in subsection (c) of this Code section, for the purposes of Chapters 5 and 6 of this title, computer software shall constitute personal property only to the extent of the value of the unmounted or uninstalled medium on or in which it is stored or transmitted.

    Finally, amendments to O.C.G.A. §48-6-21 classify computer software, as so defined, as an intangible, thus removing it from the domain of the county tax assessors.

    The net result is that software is valued only to the extent of the medium and is taxed as an intangible. This "double whammy" means that in most cases, little or no tax will ever be due with respect to software.

    C. Implications of H.B. 350 in Other Contexts. One of the most interesting aspects of O.C.G.A. §48-1-8(c) is the "inventory" exception to this rule.
    (c) Nothing herein shall be deemed to affect the taxation under Chapter 5 or Chapter 8 of this title of copies of computer software held as inventory in a tangible medium ready for sale at retail by one who is a dealer with respect to such property and the sale of which is subject to sales and use taxation.

    Such inventory is then subject to normal rules (i.e. implicitly subject to ad valorem and sales tax). This section raises interesting implications about the taxability for Georgia Sales and Use Tax of other "non inventory" software.

    IV. Use of Passive Investment Companies.

    Aaron Rents, Inc. v. Collins, Fulton County Superior Court, Case No. D096025 and Merck v. Collins, Fulton County Superior Court E-3677.

    Delaware permits companies which limit their instate activity to receipt of a passive investment income ("Passive Investment Companies" or "PICs") to pay no income tax on the earnings from these activities. Such passive income can include interest, dividends, and license and royalty fees with respect to patents, copyrights, trademarks, trade names, service marks or other intangible assets.

    A number of tax planners have actively marketed the establishment of Delaware PICs and the transfer of intangible assets to such holding companies in consideration for future payments of licenses or royalties. This can result in a reduction of Georgia taxable income to the Georgia company, thus substantially reducing tax.

    In the Aaron Rents case, Aaron Rents paid its PIC 2% of its gross sales as a royalty on the "Aaron Rents" trade name. According to the report contained in the pleadings, this resulted in 90% decrease in Georgia taxable income. The auditor disallowed the royalty deduction and assessed tax on Aaron Rents for additional taxes as if no royalty payment had been made.

    In Geoffrey, Inc. v. South Carolina Tax Commissioner, 437 S.E. 2d 13, (S. Ct. S.C., July 6, 1993), the South Carolina Supreme Court upheld the imposition of South Carolina income tax on payments to Geoffrey, Inc., a wholly owned second tier subsidiary of Toys R Us, Inc. with respect to payments made as royalties for use of the "Toys R Us" trade name and related marks against claims that such tax violated the due process and interstate commerce clause. The court concluded that the licensing of the trademarks alone created nexus in South Carolina. A petition for certiorari to the Supreme Court was denied on November 29, 1993 (114 S.Ct. 550, 62 USLW 3374).

    Aaron Rents was argued in March before Judge Eldridge who has referred the case to Roland Barnes as magistrate. A decision is expected at any time. Merck is still in discovery and negotiation of the stipulation of facts.

    V. Equitable Apportionment.

    Bechtel Power Corporation v. Collins, Fulton Superior Court No. D-81178.

    O.C.G.A. §48-7-31 provides for the methods of apportioning income as to companies doing business both within the state and outside of Georgia. As you know, the three factor method of sales, payroll and property is generally applicable to businesses selling tangible personal property. A single factor (gross receipts) is used for dealers in intangibles (including stock brokers). Companies which do not fit any of the foregoing fall under a third method that requires "equitable apportionment." Thus, businesses providing only services have no statutorily mandated methodology.

    As a policy matter, but with no regulatory sanction, the Revenue Department generally insists that service companies use a three factor formula and be done with it. However, some service companies would prefer to use only gross receipts.

    The state has consistently refused to adopt regulations which would resolve these issues. Apparently, the taxpayer in this case has taken the position that as long as the state does not write regulations, it can adopt any method which "equitably apportions" and, thus, that the gross receipts method is appropriate and permitted.

    The case was tried before Judge Long this spring and final post trial briefs submitted. A decision is awaited at any time.

    VI. Consolidated Returns.

    American Telephone & Telegraph Company, et al. v. Collins, Fulton County Superior Court, Case No. D-90621.

    O.C.G.A. §48-7-58 permits the Commissioner to require a unitary method of filing income tax returns by related corporations if other methods will result in distortion of income. On the other hand, the right to file a consolidated return is subject to consent by the Commissioner. The AT&T case raises the issue of whether the Commissioner abuses his discretion by refusing to permit a taxpayer to file on a consolidated basis if it is a unitary operation and if this will result in more accurate representation of business level activity and, incidentally this will also reduce Georgia tax.

    The case was tried before Judge Langham in September and briefed before Thanksgiving. A decision is expected at any time.