Although no study resolutions regarding taxation were approved by the 58th Legislative Assembly (2003), the Legislative Council assigned the Taxation Committee studies of corporate and personal income taxes, implementation and effect of the streamlined sales tax, and tax preferences for products, services, and entities.
Committee members were Senators Dwight Cook (Chairman), Ronald Nichols, Randy A. Schobinger, John O. Syverson, Harvey Tallackson, Ben Tollefson, Thomas L. Trenbeath, Herb Urlacher, and Rich Wardner and Representatives Larry Bellew, Wesley R. Belter, David Drovdal, Mike Grosz, C. B. Haas, Craig Headland, Ron Iverson, Frank Klein, Phillip Mueller, Kenton Onstad, Arlo E. Schmidt, Elwood Thorpe, Dave Weiler, Ray H. Wikenheiser, Dwight Wrangham, and Steven L. Zaiser.
The committee submitted this report to the Legislative Council at the biennial meeting of the Council in November 2004. The Council accepted the report for submission to the 59th Legislative Assembly.
In 1919 the state's first income tax law was enacted. Earned income and unearned income of individuals were taxed at different rates. In 1923 the individual income tax was revised to follow federal income tax law, the distinction between earned and unearned income was eliminated, and rates were adjusted to range from 1 to 6 percent of taxable income.
In 1933 individual income tax rates were increased, with a highest rate of 15 percent on taxable income over $15,000. In 1953 individual income tax rates were reduced, with rates set at 1 to 11 percent of taxable income. In 1973 the rates were again reduced, with a highest rate of 10 percent on taxable income over $8,000.
In 1978 state voters approved an initiated measure that reduced individual income tax rates and increased corporate income tax rates. The initiated measure adjusted the income brackets and set the highest individual income tax rate at 7.5 percent on taxable income in excess of $30,000. In 1980 the voters again approved an initiated measure, which included creation of an energy cost relief credit of up to $100 against state individual income tax liability.
In 1981 the Legislative Assembly created a simplified optional method of computing individual income taxes (the "short-form" method) which allowed most individual income taxpayers a substantial income tax liability reduction. The simplified method of computing individual income tax liability provided a tax of 7.5 percent of an individual's adjusted federal income tax liability. The preexisting method of determining income tax liability based on a percentage of federal taxable income ("long-form") was retained, and since that time taxpayers have had the option of filing under either of the two different methods.
In 1983 several enactments combined to increase individual income tax liability. The $100 energy cost relief was eliminated, the short-form return tax rate was increased from 7.5 to 10.5 percent, and equivalent increases on the long-form return brought the highest rate to 9 percent for taxable income in excess of $50,000.
In a 1986 special legislative session, legislation was passed to require mandatory state income tax withholding for all employees subject to federal income tax withholding, to increase the short-form tax rate from 10.5 to 14 percent of federal tax liability, and to increase long-form rates by a corresponding amount to provide a highest rate of 12 percent on income exceeding $50,000.
In 1987 a 10 percent surtax on state individual income tax liability was created to apply only for taxable year 1987.
In 1989 the Legislative Assembly increased the short-form income tax rate from 14 to 17 percent and increased long-form rates by corresponding amounts. The legislation imposing these rate increases was referred and defeated by the voters in the December 1989 special election.
In 2001 the Legislative Assembly, aware of the likelihood of federal income tax rate reductions and resulting impact on North Dakota income tax revenues, changed the basis for application of the "short-form" method. This change eliminated the reliance on federal income tax liability and substituted use of federal taxable income as the starting point to calculate North Dakota taxable income. This method was intended to be roughly equivalent to the previous method because it applied a set of graduated rates that were 14 percent of the 2001 federal tax rates and the rates were applied to five income brackets that mirrored federal brackets. To reflect the fact that the vast majority of taxpayers filed under the "short-form" method, the statutory reference to "optional" method of computing tax was moved from the "short-form" to the "long-form" return method. In addition, references to "short-form" and "long-form" were replaced by the Tax Commissioner with references to Form ND-1 (previously "short-form") and Form ND-2 (previously "long-form").
On May 23, 2003, Congress passed a major tax cut package (Jobs Growth Tax Relief Reconciliation Act of 2003) which reduced the tax rate for capital gains and dividends, accelerated marginal tax rate reductions, enhanced small business expensing, extended bonus depreciation, increased the child tax credit, provided temporary relief from alternative minimum tax, provided marriage penalty relief, expanded the 10 percent tax bracket, and made other changes. Because the North Dakota individual income tax was no longer tied to federal income tax liability, much of the income tax revenue reduction that would otherwise have occurred did not impact the state. However, the 2003 legislation did have an impact on North Dakota income tax revenues.
Corporate income taxes were first imposed in North Dakota in 1919, with a flat rate tax of 3 percent of net income. In 1937 a graduated corporate income tax rate structure was created with a highest rate of 6 percent. A 1978 initiated measure added a highest rate of 8.5 percent. In 1981 the highest corporate income tax rate was reduced to 7 percent for taxable income exceeding $50,000 per year. In 1983 corporate income tax rates were increased by 50 percent, with a highest rate of 10.5 percent.
Passage of House Bill No. 1471 (2003) eliminated the deduction for federal corporate income taxes paid and, except for water's edge filers, reduced corporate income tax rates beginning in 2004, with a highest tax rate of 7 percent for taxable income exceeding $30,000 per year. The 2003 changes added an additional tax of 3.5 percent of taxable income for water's edge filers, to be added to the normal rates, to take the place of the election under previous law requiring water's edge filers to give up the deduction for federal corporate income taxes paid. These changes were intended to reduce corporate income tax rates but to be approximately revenue-neutral to the state general fund.
The starting point for determination of North Dakota corporate income taxes is a corporation's federal taxable income. Corporate federal taxable income is gross income minus the wide range of deductions available under federal law. The North Dakota corporate income tax applies only to the portion of a corporation's taxable income that is derived from sources within North Dakota. A corporation that conducts business inside and outside North Dakota must apportion its federal taxable income to determine the portion that is attributable to sources within North Dakota. Because apportioning income among states is extremely complicated, apportionment factors have been developed for use among states. The apportionment factor for North Dakota is a percentage that is the average of North Dakota property, payroll, and sales compared to the corporation's total worldwide property, payroll, and sales. For a corporation electing to use the "water's edge" filing method, only the corporation's property, payroll, and sales in the fifty states, District of Columbia, and United States possessions are used in this comparison. Corporate income apportionment formulas are used by all states imposing corporate income taxes and have been adjusted by some states in efforts to encourage manufacturers to locate in those states.
A corporation that is part of a unitary business involving one or more affiliated corporations, including consideration of operations outside the United States, must file using the combined reporting method. A "unitary business" is a group of corporations carrying on activities that transfer value among themselves through unities of ownership, operation, and use. North Dakota is one of 23 states that have adopted the Uniform Division of Income Tax Act, which provides for apportionment of corporate income and contains detailed provisions relating to property, payroll, and sales factor computations.
A corporation required to file its North Dakota return using the combined reporting method but having income from operations outside the United States may elect to use the "water's edge" method. This election allows exclusion of consideration of most corporate income sourced outside the United States. The water's edge election must be made on the return as originally filed and is binding on the corporation for five consecutive tax years. If the election was made for taxable years before 2004, the corporation was required to give up the deduction for federal income taxes paid. If the election is made for taxable years after 2003, the corporation is subject to an additional tax of 3.5 percent of taxable income. A corporation electing to use the water's edge method must file with the Tax Commissioner a domestic disclosure spreadsheet to fully disclose income reported to each state, state tax liability, the method used to apportion or allocate income among states, other information required to determine the proper tax due to each state, and the identity of members of the water's edge group.
House Bill No. 1309 created a corporate income tax credit of 10 percent per year for five years for direct costs of equipment to retrofit an existing facility or to adapt a new facility to produce or to blend diesel fuel containing at least 2 percent biodiesel fuel by volume.
Senate Bill No. 2294 would have allowed a small business tax credit for amounts paid to the United States Small Business Administration as an annual guarantee fee to obtain Small Business Administration guaranteed financing. The bill failed to pass.
Senate Bill No. 2054 would have established a flat-rate corporate income tax of 6.84 percent and eliminated the federal income tax deduction. A higher rate of 9.9 percent would have applied for corporations filing under the water's edge method. The bill failed to pass.
Senate Bill No. 2374 would have reduced corporate income tax rates in all brackets, with a high rate of 7.2 percent. The bill would have eliminated the federal income tax deduction for corporations. The bill failed to pass.
Senate Bill No. 2314 would have eliminated personal and corporate income taxes and broadened the state's sales tax to offset the revenue effects. The bill was amended before being passed by the Senate to leave individual income taxes unchanged and to phase out corporate income taxes over a five-year period and offset a portion of revenue losses by a sales, use, and motor vehicle excise tax rate increase of one-fourth of 1 percentage point. The bill failed to pass in the House.
Corporate income tax collections have declined in recent years. The following table shows recent corporate income tax net collections:
| Fiscal Year | Net Collections |
|
1992 |
$36,778,251 |
|
1993 |
$42,525,921 |
|
1994 |
$50,727,400 |
|
1995 |
$44,027,738 |
|
1996 |
$49,047,417 |
|
1997 |
$50,300,520 |
| 1998 |
$65,543,025 |
|
1999 |
$57,877,194 |
|
2000 |
$47,528,001 |
|
2001 |
$51,606,853 |
|
2002 |
$41,374,297 |
| 2003 estimated | $42,861,000 |
The Tax Department estimates the combined impact of the federal Jobs Growth Tax Relief Reconciliation Act of 2003 on all state revenue sources is an expected reduction of $13.8 million in state general fund revenues for the 2003-05 biennium. It is anticipated that the federal Act will provide some stimulus to the North Dakota economy but the revenue estimate does not include consideration of any economic stimulus. The federal Act allocates federal funds to states to offset state income tax losses. It is anticipated that North Dakota will receive approximately $69 million in federal funds intended to offset state income tax revenue losses.
For calendar year 2002 individual income tax returns, 20.8 percent of filers had a net tax liability of zero and another 15.5 percent of filers had net tax liability of less than $100.
For Form ND-1, the most commonly used deductions for taxpayers in 2002 were the 30 percent long-term capital gain deduction, which provided a tax reduction of $5.8 million, and the deduction for interest on United States obligations, which provided a tax reduction of $1.6 million. These two deductions accounted for almost 80 percent of tax reductions from deductions on Form ND-1. For Form ND-2, the most significant deductions were for federal income taxes, state and local income taxes, medical expenses not allowed on the federal return, and interest on United States obligations.
The combined amount of income tax credits for Form ND-1 and Form ND-2 were less than $750,000 for taxable year 2002. The most significant credits were the renaissance zone credit, with a revenue cost of $255,858; long-term care insurance credit, with a revenue cost of $123,874; credit for unused federal credit for prior year minimum tax, with a revenue cost of $121,081; agricultural commodity processing facility investment credit, with a revenue cost of $107,608; and the seed capital investment credit, with a revenue cost of $98,448.
For taxable year 2002, only 2.3 percent of income tax returns were filed on Form ND-2. The committee discussed the possibility of eliminating Form ND-2 and attempted to gain an understanding of the rare instances in which a taxpayer benefits from filing Form ND-2. Lower-income taxpayers are more likely to benefit from filing Form ND-2. Others who might benefit from filing Form ND-2 include individuals with substantial amounts of medical expenses not allowed as deductions on the federal return; interest earnings on United States obligations; interest from North Dakota financial institutions; or retirement pay from military, civil service, firefighter, police, or Highway Patrol officer sources. The difference in tax savings by filing Form ND-2 rather than Form ND-1 is generally small. In a sample of returns examined by the Tax Department, the savings from using Form ND-1 ranged from less than $1 to $157. The Tax Department estimated that 64 percent of North Dakota income tax returns are prepared by professional tax preparers. Committee members pointed out that the cost of tax preparer preparation of Form ND-2 would likely exceed the savings from filing that form.
Eliminating the use of Form ND-2 would not result in a significant amount of savings for the Tax Department. There would be little change needed to Form ND-1 to make it more advantageous for the filers currently using Form ND-2, but the fiscal effect would be substantial because the changes would also benefit the 98 percent of filers already using Form ND-1. It appears the primary beneficiaries of the continued existence of Form ND-2 are low-income and older taxpayers. The committee makes no recommendation regarding the elimination of Form ND-2.
Under Senate Bill No. 2015 (2003), the Tax Commissioner conducted a tax amnesty program for four months ending January 31, 2004. The program resulted in collection of $6.9 million of overdue or underreported tax liability. The majority of the taxpayers participating in the amnesty program were individual income tax filers. Corporate income tax filers represented approximately 8 percent of taxpayers under the program. Interest on delinquent taxes is 12 percent by law and participants in the amnesty program received a reduced rate of 3 percent on delinquent taxes. The Tax Commissioner said the tax amnesty program was successful, but he would recommend that North Dakota not allow another amnesty program for 15 to 20 years because some states allow frequent amnesty programs, and that alters behavior of taxpayers who come to expect an amnesty program.
Interest earnings from state and local obligations are exempt from taxation at the federal level. In North Dakota interest earnings from out-of-state bonds are added back and taxed on Form ND-2 but there is no add-back for out-of-state bonds and obligations on Form ND-1, which is the primary filing method for most North Dakotans. Most states that impose income taxes do not grant favorable tax treatment except for earnings from bonds issued within their state. It was estimated that a bill draft to require add-back of out-of-state bond earnings would increase general fund revenue by approximately $1.5 million per biennium. The committee was concerned about the fairness of imposing taxes on income from bonds that have already been purchased with the expectation that income would not be taxed. To apply income taxes to out-of-state bond earnings for bonds purchased after 2005 would be approximately revenue neutral to the state.
The Servicemembers Civil Relief Act of 2003 prohibits a state from using active duty military pay of a nonresident servicemember to calculate income taxes on income that is taxable by the state. The most likely circumstance that would be impacted by this in North Dakota relates to income earned in the state by a nonresident civilian spouse of a nonresident servicemember stationed in North Dakota. To comply with the 2003 federal legislation, an adjustment must be made on Form ND-1 to exclude consideration of the servicemember's military income in determining the couple's tax obligation. The Tax Commissioner has made this adjustment by administrative action for taxable year 2003 and later. However, the Tax Commissioner believes that legislation is needed to recognize retroactive application for taxable years before 2003.
The committee considered a bill draft similar to Senate Bill No. 2314 (2003) to eliminate personal and corporate income taxes and broaden the state sales tax to offset the revenue effects. The bill draft was intended to mirror the South Dakota sales tax structure. The sales tax rate in the bill draft would be increased to 5.65 percent, including the tax rate for farm machinery and irrigation equipment. The most substantial broadening of sales taxes under the bill draft would be in applying sales taxes to services and to retail sales of food. These changes were suggested to enhance the business climate but it was noted they would make the tax structure more regressive and increase the possibility of severe negative impact on state revenues during an economic downturn. The committee makes no recommendation with respect to eliminating income taxes and broadening the sales tax base.
The committee examined reasons for the nationwide decline in corporate income tax revenues. One factor is slowing of the national economy in recent years. North Dakota corporate income tax collections are reduced because of recent federal corporate income tax reductions, including allowing accelerated depreciation and enhanced opportunities to carry back net operating losses. Corporations choose filing methods that will reduce overall tax liability, including electing to file under the water's edge filing method. In North Dakota the number of corporations choosing the water's edge filing election has increased from 30 to 276 in 13 years. In North Dakota numerous corporations have become eligible for taxation as a financial institution. Financial institution taxes are substantially equivalent in terms of tax liability but five-sevenths of financial institutions' taxes are distributed to counties, so there is a fiscal impact to the state general fund. A growing drain on corporate income tax revenues is the fact that businesses may organize in other business forms such as limited liability companies or partnerships, which allows an entity to avoid corporate income taxes. Another factor receiving nationwide scrutiny is the effect of corporate income tax shelters.
The Tax Department conducts audits on approximately 5 to 6 percent of corporate income tax returns. The focus of audit activity is generally on more complex returns of corporations doing business across state and national boundaries.
The committee examined detailed information on the effect of passthrough entities on corporate income tax revenues. Examples of passthrough entities include subchapter S corporations, partnerships, limited liability companies, limited liability partnerships, and master limited partnerships. The income or loss of these entities is passed through directly to owners of the entities and is not subject to corporate income taxes. There is a tax incentive to avoid corporate income taxes by choosing to do business as a passthrough entity rather than as a corporation. Over the past 10 years, passthrough entity filings in North Dakota have steadily increased while corporate filings have declined.
The Multistate Tax Commission has a working group considering issues relating to passthrough entities. The working group recommended legislation to states to require a passthrough entity to either file a composite income tax return or withhold income tax on the share of income of the entity distributed to each nonresident member. Nonresident members are subject to North Dakota income taxes on passthrough entity income earned in North Dakota, but there is a compliance problem under current law to identify nonresident members and collect taxes due.
The executive director of the Multistate Tax Commission addressed the committee regarding corporate income tax issues. It was stated that the creation and continued existence of state corporate income taxes is due to weaknesses of other tax types in addressing the corporate business form. A tax on income was viewed as fairer than other tax types because it taxes knowledge, patents, and other intangibles. It would be impractical to tax corporate earnings at the shareholder level because shareholders may reside in other states or countries or may be other corporations. The rationale for taxing corporate business activity is that states provide services to benefit businesses. The corporate income tax serves as a necessary companion to individual income taxes so income transfers to corporations cannot be used to avoid individual income taxes. Corporate income taxes are better suited than other tax types to fairly tax the new economy.
There are areas in which corporate income taxes are subject to criticism. The corporate income tax is a tax on production instead of consumption. The corporate income tax favors debt financing over equity and distorts business investment choices. Too many individuals and corporations are able to avoid corporate income taxes. The corporate income tax may be viewed as a double layer of taxation because income taxed at the corporate level is again subject to taxation at the individual level after distribution to shareholders.
It is important for states to observe principles to promote equity and make corporate income taxes work in practice. Income must be fully and fairly reported in reasonable relation to where that income is earned. The means of determining where multistate entity income is earned should be consistent among states.
States must recognize corporate income tax realities. Corporate income taxes have declined as a percentage of revenues for all states from approximately 9.7 percent in 1980 to 4.9 percent in 2002. Effective corporate income tax rates have declined from approximately 8.96 percent in the 1980s to 5.92 percent in 2001. A variety of factors have contributed to the decline in state corporate income tax revenues as a share of state tax collections. Changes in federal corporate income tax laws affect states due to the piggyback nature of state corporate income taxes on the federal corporate income tax structure. Federal preemption of state authority to tax some activities has caused some companies to restructure to take advantage of federal law protection. There has clearly been an increase in aggressive tax planning by corporations aimed at reducing state corporate income taxes. State policy choices on business incentives and economic development have reduced corporate income taxes for qualifying corporations. There has been a substantial shift to forms other than corporations for doing business, such as limited liability companies and similar business structures, including the creation of layers of corporate and noncorporate entities to reduce or avoid the impact of corporate income taxes.
The Multistate Tax Commission conducted a tax shelter study as an attempt to measure the degree to which income reporting for corporations does not reflect the place income was earned. One of the conclusions of the study was an estimate that states lost $8 billion to $12 billion in 2001 due to two or three categories of tax shelters. This represents a loss of approximately one-third of total state corporate income tax collections. It appears the primary method of sheltering corporate income is shifting income to a nontaxable location or tax haven or using other methods to avoid federal corporate income taxes.
It was recommended that combined reporting, including requiring information on tax haven activities, would improve corporate income tax administration. Montana enacted a 2003 law requiring that a water's edge report must include information on tax havens. It was recommended that states develop nexus rules on doing business which are consistent with how corporate income is apportioned. Uniformity among states would reduce incentives to shift income. A concerted effort should be made to curb tax sheltering and income shifting at the state and federal levels.
The Multistate Tax Commission working group also investigated the use of passthrough entities to avoid corporate income taxes. Traditional corporate forms of doing business which are subject to corporate income taxes are rapidly declining as a percentage of business organizations and as a percentage of business income. It has become clear that states need to take action to address growing use of passthrough entities. States need effective and simplified systems of ensuring proper reporting of passthrough entity income, which requires composite return and withholding requirements. It is necessary for state tax systems to address tax sheltering that employs layers of passthrough entities or single-member limited liability companies within corporations.
The committee reviewed a report prepared by a consultant for the Department of Commerce regarding the North Dakota business climate. The studies were conducted by comparing a 10-year tax analysis for Bismarck, North Dakota, with a similar analysis for 10 comparable cities in other states for location of a hypothetical manufacturing facility, an agricultural processing facility, and a technology-based business. The analysis evaluated property taxes, workers' compensation insurance, state and local sales taxes, unemployment insurance, and corporate income taxes. Tax incentives allowed in each community for businesses were included in the analysis. Of the communities compared in the studies, Bismarck was found to be the most advantageous location for a manufacturing facility or an agricultural processing facility. For technology-based business, Bismarck ranked fifth of the 11 communities compared.
A Department of Commerce representative informed the committee that the 2003 North Dakota corporate income tax rate reductions enhanced marketing for economic development because the tax rates reflect more favorably on the business climate in North Dakota.
The committee considered a bill draft, described under the individual income tax portion of this report, which would have eliminated personal and corporate income taxes and broadened the state sales tax to offset the revenue effects. The committee also considered a bill draft that would have eliminated the corporate income tax by reducing the tax rates by 10 percent per year for 10 years, at which point the tax would be repealed. The estimated fiscal impact of the bill draft to phase out the corporate income tax would be a loss of $1.3 million in general fund revenue for the 2003-05 biennium, a loss of $14.9 million in state general fund revenue in the 2005-07 biennium, and a loss of $31.6 million in the 2007-09 biennium. The committee makes no recommendation regarding the elimination of the corporate income tax.
The committee recommends House Bill No. 1040 to require adding back out-of-state bonds' interest earnings to individual taxable income on Form ND-1. The bill applies only to bonds purchased after December 31, 2005. It is anticipated that the bill will have little fiscal impact to the state general fund for the 2005-07 biennium.
The committee recommends House Bill No. 1041 to allow a claim of an individual income tax refund for taxable years 2001 and 2002 for a nonresident whose military income was used to determine the initial tax on North Dakota taxable income. The bill allows the refund claim to be filed until April 15, 2006. The estimated fiscal effect of the bill is a one-time loss of approximately $88,000 in general fund revenue.
The committee recommends Senate Bill No. 2045 to require passthrough entities, such as S corporations, partnerships, trusts, limited liability companies, and limited liability partnerships, to choose between the options of filing a combined report in North Dakota or withholding North Dakota income taxes on distributions to nonresident members of the passthrough entity. The estimated fiscal impact of the bill is an increase in general fund revenue of approximately $500,000 per biennium.
The committee recommends Senate Bill No. 2046 to require inclusion of corporations in a unitary relationship and incorporated in a tax haven as part of a water's edge corporate income tax filing election. The bill is patterned after 2003 Montana legislation and would allow the Tax Commissioner to require a taxpayer to include in a domestic disclosure spreadsheet any corporation in a unitary relationship with the taxpayer and incorporated in a tax haven. The bill also provides that income shifted to a tax haven, to the extent that it is taxable, is considered income subject to apportionment for income tax purposes. The estimated fiscal impact of the bill is an increase in general fund revenue of approximately $150,000 per biennium.
When a North Dakota resident makes a retail purchase from an out-of-state retailer by means of mail, telephone, or Internet and the purchased product is shipped to the purchaser in North Dakota, the purchaser has a tax obligation to North Dakota but the retailer has no obligation to collect North Dakota sales taxes on the purchase unless the retailer has nexus in the state of North Dakota. This situation results from interpretation of the commerce clause of the United States Constitution in a series of decisions of the United States Supreme Court, including the decision in Quill v. North Dakota.
In Quill the United States Supreme Court concluded that the commerce clause of the United States Constitution does not absolutely ban sales tax collection by out-of-state retailers but that states lack authority to require sales tax collection by remote retailers unless the United States Congress acts to give states that authority.
The sales tax is the primary state tax revenue source for most states. A growing portion of retail sales in the United States are escaping state sales taxes because mail order and Internet sales constitute a growing part of the retail economy. In addition, it is perceived as unfair competition to "main street" businesses, which must collect sales taxes and are placed at a competitive disadvantage against out-of-state retailers, who are not required to add sales taxes to the purchase price of products.
In the wake of the Quill decision, the National Governors Association, National Conference of State Legislatures, Multistate Tax Commission, and other groups urged a cooperative effort among sales tax states to promote nationwide uniformity in sales taxes. The most viable argument of Internet and mail order retailers against being required to collect sales taxes is that sales tax laws among states are impossible for retailers to deal with because of an incredible variety of differing provisions regarding sales tax exemptions, rates, caps, thresholds, and city and county sales taxes that differ from taxes imposed by states. To overcome these objections and gain authority from Congress to tax out-of-state retailers, states recognized that it was necessary to make their sales tax systems more uniform or "streamlined."
The Streamlined Sales Tax Project was initiated in March 2000 with meetings involving participation of 26 states, including North Dakota. By November 2002 the project had recommended a Streamlined Sales and Use Tax Agreement that participating states hoped could be implemented by 2006 to create uniform sales tax systems among states, with compatible sales tax exemptions and a limited number of sales tax rates to simplify sales tax collection by remote retailers. Participating states are hopeful that streamlining state tax systems will give states the leverage they need to convince Congress to authorize states to collect sales taxes from remote sellers. The Streamlined Sales Tax Project has received support from several large retailers engaged in mail order and Internet sales. A significant number of retailers have voluntarily agreed to register with states that have implemented the Streamlined Sales and Use Tax Agreement and to collect sales taxes on behalf of those states. For states, the stakes for success of the goals of the Streamlined Sales Tax Project are enormous. It is estimated that about $27 million per year in additional sales tax collections would result for North Dakota if purchases from out-of-state retailers were subject to North Dakota sales taxes.
The November 2002 Streamlined Sales and Use Tax Agreement was the basis for enactment in North Dakota of Senate Bill No. 2095 (2003) and Senate Bill No. 2096 (2003). The North Dakota complying legislation becomes effective January 1, 2006, as required by the agreement.
To date, 21 states have enacted legislation to comply with the Streamlined Sales and Use Tax Agreement. Almost an equal number of states are considering legislation to comply with the agreement. Upon adoption by states representing a sufficient percentage of United States population, a governing board of participating states will be established and North Dakota hopes to be one of the states represented on the governing board.
Tax Department staff pointed out several areas in which North Dakota law must be adjusted to be in compliance with the Streamlined Sales and Use Tax Agreement by the 2006 implementation date. The additional 1 percent lodging tax created in 2003 for Lewis and Clark Bicentennial funding is perceived as a provision not in compliance with the Streamlined Sales and Use Tax Agreement. It was suggested that converting the tax to a gross receipts tax would resolve the noncompliance problem.
It was pointed out that city and county home rule sales tax provisions are not in compliance with the Streamlined Sales and Use Tax Agreement to the extent that city and county sales taxes are generally limited to a maximum of $25 on a purchase. The North Dakota League of Cities supports the effort to streamline sales taxes but has concerns with placing cities in the position of having to go through the difficulty and expense of going to the voters to change provisions of local sales tax laws. It was suggested that a state legislative solution would be welcomed to bring home rule sales tax provisions into compliance with the Streamlined Sales and Use Tax Agreement. Some of these changes can be accomplished by changing nomenclature for taxes on farm machinery and alcoholic beverages from sales taxes to gross receipts taxes. Probably the most significant change relates to the maximum sales tax for a single purchase. Representatives of the Tax Department and League of Cities agreed that compliance with the Streamlined Sales and Use Tax Agreement could be achieved by requiring retailers to collect the full amount of sales tax on a purchase and to allow the purchaser to claim a refund from the Tax Commissioner for the difference between the amount paid and the amount that would have been due with the city or county cap in place. Tax Department representatives said no additional administrative cost is expected for the Tax Department to provide refunds in these situations.
Tax Department representatives identified for the committee additional areas for technical changes in sales and use tax provisions to bring the state into compliance with the Streamlined Sales and Use Tax Agreement. Representatives of the states participating in the Streamlined Sales and Use Tax Agreement reviewed the suggested North Dakota changes and concluded that these changes would bring North Dakota into full compliance with the Streamlined Sales and Use Tax Agreement if they become effective January 1, 2006.
The committee recommends House Bill No. 1042 to provide for North Dakota membership on the streamlined sales tax governing board. The Legislative Council chairman would appoint two members of the House of Representatives and two members of the Senate. The Tax Commissioner would designate a Tax Department staff person to accompany and advise the North Dakota members.
The committee recommends House Bill No. 1043 to bring North Dakota into compliance with the Streamlined Sales and Use Tax Agreement. The bill inserts appropriate statutory references to farm machinery and alcoholic beverage gross receipts taxes to allow those taxes to continue to be collected by cities and counties at the same rate as they are currently collected under the sales tax. The bill provides that any city or county home rule taxes on farm machinery, farm irrigation equipment, farm machinery repair parts, or alcoholic beverages become gross receipts taxes on January 1, 2006. The bill provides that a cap provided by city or county home rule for sales taxes on purchase of a single item will be replaced effective January 1, 2006, with a refund provision requiring the retailer to collect the full amount of city or county sales taxes and allowing the purchaser to claim a refund of the difference between the full amount paid and the amount that would have been paid if the cap were in place. These changes are made for all home rule cities and counties to avoid forcing cities and counties to each conduct an election for approval of these changes. The bill provides changes in sales and use tax definitions. The bill creates a section to provide that sales taxes will continue to apply to cigarettes, cigars, and other tobacco products, which was inadvertently eliminated by the 2003 legislation. The bill creates use tax imposition provisions for the farm machinery gross receipts tax and alcoholic beverage gross receipts tax which were created in 2003 but did not include use tax provisions. The bill changes the 1 percent lodging tax for Lewis and Clark Bicentennial funding into a gross receipts tax to satisfy the requirements of the Streamlined Sales and Use Tax Agreement. The revenue from the tax will still be used for the same purposes as were provided in the legislation that established the tax. The bill would become effective January 1, 2006, as required by the Streamlined Sales and Use Tax Agreement. The Tax Department estimates no fiscal effect from enactment of the bill.
Any tax exemption, deduction, credit, rate reduction, or other distinction allowing some taxpayers to pay less than would normally be paid under any tax type would be included within the study of tax preferences. Each tax governed by state law contains tax preferences and many contain numerous types of tax preferences. The committee focused its attention on sales, income, and property tax preferences.
The committee reviewed the year of enactment, coverage, and fiscal effect of each exemption allowed under sales and use taxes. The committee reviewed detailed information on services that are taxable or exempt under the North Dakota sales tax, including a comparison taxation of specific services in North Dakota and nine comparable states. Taxation of services was a significant part of the debate during consideration of 2003 legislation to broaden the sales tax and during consideration of a similar bill draft by the committee. It is estimated if all services now exempt from sales taxes were subjected to sales taxes, North Dakota general fund revenue would be increased by approximately $160 million. Elimination of all sales tax exemptions was estimated to increase state general fund revenues by approximately $470 million for a biennium. It was estimated that if all sales tax exemptions were eliminated, the sales tax rate could be reduced from 5 to 2.8 percent and it would generate the same revenue. However, removing sales tax exemptions for food, prescription drugs, health care supplies, medical services, and similar purchases would substantially increase the regressive nature of the sales tax and the greatest impact of the change would be felt by low-income persons and senior citizens.
The committee reviewed each income tax preference as described in the income tax study portion of this report.
Agricultural property receives preferential assessment for property tax purposes because it is valued under a productivity formula rather than being valued on the basis of market value. From 1993 through 2002, the percentage of total property taxes among all property owners in the state which has been paid by agricultural property owners has decreased by about four percentage points, residential property taxes paid have increased by about five percentage points, and commercial property taxes paid have remained within about one percentage point of the 1993 level. In 2003 legislative changes to the agricultural property valuation formula further decreased agricultural property valuations. Based on certain assumptions, the 2003 legislation is estimated to result in a shift of $879,000 in property taxes from agricultural property to residential and commercial property.
The committee gathered detailed information on agricultural property valuation under the valuation formula. The most significant change in 2003 legislation established a minimum capitalization rate for the productivity valuation formula of 9.5 percent. The capitalization rate that had been used in the formula for 2002 was 8.91 percent. The increase in the capitalization rate from 2002 to 2003 accounted for an average decrease in agricultural land values statewide of 6.2 percent. The increase in the cost of production index resulted in an additional 2.43 percent decrease. The two decrease factors were partially offset by increased productivity, resulting in an overall statewide agricultural property valuation decrease of 5.4 percent from 2002 to 2003. It is estimated that it will take at least five years for the capitalization rate to climb above the minimum value of 9.5 percent. Until that happens, it is expected that cropland values will remain steady to down 1 percent per year, noncropland values will decline 2 to 2.5 percent per year, and total agricultural land valuation will decline one-half of 1 percent to 1 percent per year. If interest rates rise to the point that the capitalization rate moves above the 9.5 percent minimum set by statute, the decline in agricultural land values will accelerate.
Before 1918 the Constitution of North Dakota did not allow exemption from property taxes for buildings. In November 1918 the voters approved an amendment to what is now Article X, Section 5, of the Constitution of North Dakota, which allowed the Legislative Assembly to classify buildings as personal property and thereby exempt selected buildings from property taxes.
The first property tax exemption for agricultural buildings in North Dakota was enacted by passage of Senate Bill No. 44 (1919). That bill simply provided exemption from property taxes for "all structures and improvements on agricultural lands." The bill contained no definition of the terms "structures and improvements" or "agricultural lands."
For a period of 50 years, the farm building exemption was changed very little, although a presumption was added that any parcel of property of less than five acres was not a farm. It appears that application of the exemption became more difficult as "nonfarmers" began moving to rural areas, and the 1971 Legislative Council report recommended a bill to increase the minimum qualifying size of a farm from 5 to 10 acres and to require that not less than 50 percent of total annual gross income of the farmer and the farmer's spouse must be derived from the farm. The report states that a problem existed in some areas when persons who were not farmers built houses in rural areas and claimed the houses were exempt under the farm structure exemption. The 42nd Legislative Assembly (1971) approved the bill recommended by the Legislative Council but deleted the requirement of 50 percent of the farmer's income coming from the farm.
In 1973 the Legislative Assembly restricted the application of the farm building exemption. This 1973 legislation introduced several new concepts, such as application of income limitations, activities limitations, and retirement considerations. The bill included a statement of intent of the Legislative Assembly that the exemption as applied to a residence was to be strictly construed and interpreted to exempt only a residence situated on a farm occupied or used by a person who is a farmer. The bill defined "farm" as agricultural land containing a minimum of 10 acres which normally provides a farmer, who is actually farming the land or engaged in the raising of livestock or other similar operations normally associated with farming and ranching, with not less than 50 percent of the individual's annual net income, and the bill defined "farmer" to mean an individual who normally devotes the major portion of the person's time to the activities of producing products of the soil, poultry, livestock, or dairy farming and who normally receives not less than 50 percent of the person's annual net income from these activities. The bill also defined "farmer" to include an individual who is retired because of illness or age and who at the time of retirement owned and occupied as a farmer the residence in which the person lives and for which the exemption is claimed.
In 1981 the farm building exemption was further restricted by defining income from farming activities, requiring that a husband and wife who reside in a residence claimed as exempt must receive not less than 50 percent of combined net income from farming activities and allowing the assessor to require the occupant of a residence who is claiming the agricultural building exemption to file a written statement regarding the income qualifications of the applicant and spouse.
In 1983 a limitation was added that the individual and spouse claiming the exemption could not qualify for the exemption if the individual and spouse had more than $20,000 of nonfarm income during each of the three preceding calendar years. This provision does not apply to an individual who is retired from farming and otherwise qualifies for the exemption. This annual nonfarm income limitation was increased from $20,000 to $30,000 per year for three preceding calendar years in 1985.
During the November 1991 special legislative session, a further limitation was added that any structure or improvement located on platted land within the corporate limits of a city or any structure or improvement located on railroad operating property is not exempt as a farm structure.
In 1995 the definition of livestock as used in the exemption was expanded to include nontraditional livestock.
In 1997 the requirement that a farm must normally provide the farmer with 50 percent or more of annual net income was replaced with a provision that disqualifies the farmer from the farm residence exemption if the farmer receives more than 50 percent of annual net income from nonfarm income during each of the three preceding calendar years. The limitation on nonfarm income was increased from $30,000 to $40,000 during each of the three preceding calendar years, which would disqualify a farmer from the farm residence exemption and an exclusion was added that a farmer operating a bed and breakfast facility would not be disqualified from the farm residence exemption because of income from operation of the bed and breakfast facility.
In 1999 the disqualification for earning 50 percent or more of annual net income from nonfarm income in each of the three preceding calendar years was replaced with a requirement that annual net income from farming activities must be 50 percent or more of annual net income during any of the three preceding calendar years. The 1999 changes also allowed a beginning farmer to qualify for the exemption by excluding consideration of that person's income history. In 1999 the farm building exemption was expanded to include feedlots and buildings used primarily, rather than exclusively, for farming purposes. In 1999 a provision was added to allow addition of depreciation expenses from farming activities to net farm income for purposes of qualifying for the farm residence exemption.
The committee received testimony from several county directors of tax equalization describing problems with the farm buildings property tax exemption. All of these tax officials described this exemption as the most difficult aspect of property tax administration in North Dakota.
A recent development that has raised questions regarding the farm residence exemption is corporate farm ownership, which has been addressed by two opinions of the Attorney General in 2004. The opinions concluded that a farm residence occupied by an individual receiving wages from a corporation would not qualify for the farm residence exemption but would be eligible for exemption as a farm building located on agricultural lands and used to provide housing for an employee. Because the income limitations for the farm residence exemption only apply to a residence, corporate ownership and classification of the residence as a farm building that is exempt means that the structure is exempt from property taxes regardless of the source of income or amount of income of the individual residing on the farm. As an example of the potential unfairness of this situation, a struggling farmer and spouse who earn slightly more nonfarm income than farm income per year are subject to property taxes on their farm residence while an incorporated farmer earning more than $100,000 annual nonfarm income and residing in a $300,000 residence on a farm owned by a corporation pays no property taxes on that home.
The income limitations in the farm residence exemption often have the most impact on struggling farmers. If farm income is low, any nonfarm income earned to keep the farm afloat could disqualify the owners from the exemption. The farmer whose residence is put on the tax rolls sees this as a double penalty because the farmer must take an outside job to keep the farm going and then is subjected to property taxes on the farmhouse because of the outside income.
The statutory provision allows assessors to require annual application for the farm residence exemption. In some counties applications are required every year in an attempt to be fair to all farmers. In some counties the county has suggested that applications should be required but in several townships the assessors refuse to require applications.
An example was given of a farmer whose spouse earned nonfarm income exceeding the limitations in the statute. The residence was subject to property taxes. The couple was divorced and the residence became exempt because there was no nonfarm income for one year. The farmer remarried and the new spouse also has more than $40,000 of nonfarm income but the residence in question remains exempt for three years because for one year there was no nonfarm income.
In several counties, problems were described with township application of the farm residence exemption. In some instances, it was alleged that residences that should be subjected to property taxes are exempt because of favoritism by the local assessor or the township board of supervisors. Instances were described in which a township assessor was fired for attempting to apply the law correctly but in opposition to the wishes of the board of township supervisors.
Eliminating the farm residence exemption has been suggested by some farmers who perceive unfairness in the current situation in which some residences are exempt and some are taxed. It was suggested that taxing all residences might result in lower overall taxes for some farmers when their neighbors' very expensive homes would be put on the tax rolls. County assessment officials pointed out the problem that it would take several years to assess all farm residences because existing assessment staff does not have extra time to complete these assessments.
It was suggested that using state-level assessors for farm residence assessments and application of exemptions would improve the uniformity of the system and address the problem that it is apparently becoming more difficult for counties and townships to get people to take the job of assessing farm property.
In discussion of problems with applying the farm residence exemption, no consensus of how to improve the existing situation could be achieved. The committee urged interested parties to continue discussion of these issues and seek a consensus recommendation for 2005 legislation that will improve the fairness and provide uniform application of the exemption.
The committee makes no recommendation regarding its tax preferences study.