Unclaimed Property – History, Audit Trends and Legislative Developments - Presentation delivered by Mike Stehly, Vice President, Tax, US Foods, Inc. at the marcus evans Tax Officers Summit Nov 13-15 2014, Las Vegas, NV

1. Unclaimed Property
Presented by
Mike Stehly, VP of Tax
US Foods, Inc.
FOOD. FOOD PEOPLE. EASY. 1

2. Objectives
• Overview of Unclaimed Property
• Key Concepts & Terms
• Types of Unclaimed Property
• State Jurisdiction – Priority Rules
• Differentiation from a Tax
• Audit Trends – Delaware Spotlight
• Unclaimed Property Feeding Frenzy
• Potential Audit Triggers
• Third Party Auditors
• Audit Process & Challenges
• Use of Extrapolation Methods
• Recent Legislation & Litigation in Delaware
FOOD. FOOD PEOPLE. EASY. 2

3. Overview of Unclaimed Property
• All 50 states, DC, Puerto Rico, the U.S. Virgin Islands & Guam
have unclaimed property laws
• There are four Uniform Act Versions: 1954, 1966, 1981 & 1995
• No two jurisdictions laws are exactly the same
•• Theoretically, states hold the property in custodial capacity until
the rightful owner claims
• Estimation of liability is allowed under most state unclaimed
property laws when records are not available
• There is no statute of limitations in most state laws
FOOD. FOOD PEOPLE. EASY. 3

4. Key Concepts & Terms
• What is Unclaimed Property?
Property held or owing in the ordinary course of business which has
not been claimed by the owner for a specific amount of time
• Key Terms:
• Holder
• Owner
•• Dormancy Period
• Due Diligence
• Escheat
FOOD. FOOD PEOPLE. EASY. 4

5. Types of Unclaimed Property
• Uncashed payroll & vendor checks
•• Unapplied accounts receivable credit balances
• Customer refunds and rebates
• Benefit plan payments
• Unredeemed gift certificates & gift cards
• Publicly traded securities
•• Dormant bank and brokerage accounts
• Life insurance policies
• Contents of safe deposit boxes
FOOD. FOOD PEOPLE. EASY. 5

6. State Jurisdiction – Priority Rules
ƒ Companies are required to report unclaimed property pursuant
to the jurisdictional priority rules established by the US
Supreme Court in Texas v. New Jersey (379 U.S. 674 (1965))
and its progeny cases.
ƒPriority Rules:
¾ First-Priority Rule: Property is reported to the state of the last
known address of the owner/payee/creditor as reflected on the
holder’’s books and records.
¾ Second Priority Rule: If owner is unknown, or if owner’s
address is unknown, or if the last-known address is in a state
that does not provide for the escheat of the property, property
is reported to the holder’s state of incorporation (domicile).
FOOD. FOOD PEOPLE. EASY. 6

7. Differentiation from a Tax
Taxes
• State holds direct Unclaimed Property
legal authority to
• States authority to collect, retain and spend tax revenue
• Nexus is required
• Independent receive and
retain is derived from the owner’s
rights and exists solely to protect
those rights in a custodial capacity.
Administrative Appeals
• – priority Process for Holders
• Statute of limitations
• Limited Nexus is not a factor rules
govern
• Independent administrative appeals
process typically unavailable – only
use of contract auditors
recourse is to sue in court
• Most states do not have a statute of
limitations
• Contract auditors conduct majority
of unclaimed property audits
Although unclaimed property is not a tax, corporate tax departments are often
tasked with compliance and audit responsibility
FOOD. FOOD PEOPLE. EASY. 7

8. Unclaimed Property Feeding Frenzy
• Unclaimed Property Generates Big Revenues for States
• Unclaimed property has become a revenue source for states
• States are prioritizing their bottom lines ahead of the historic goal of unclaimed
property which is to reunite property with the rightful owner
• Unclaimed property has been the third-largest source of revenue for Delaware for
fiscal year 2013 and 2014 bringing in $566.5M and $474.9M, respectively
• Delaware deposits all unclaimed property collections directly into the state’s
general fund
• Impact of Revenue Generation
• States are aggressive in their audit practices
• States are shortening the dormancy periods
• States are targeting new types of property (e.g., stored value cards, promotional
incentives)
If the purpose of the law is…to reunite owners with their lost or forgotten property, its
ultimate goal should little or all for the state ” v Chiang
be to generate no revenue at state.” Taylor v. Chiang,
No. Civ. S­01­2407
WBS GGH (E.D. Cal. June 1, 2007).
FOOD. FOOD PEOPLE. EASY. 8

9. What’s the Big Deal?
Company has been filing reports and believes it is in compliance,
BUT . . .
• Audits can go back as far as 1981
• Does the company have copies of the filed reports and supporting
documentation (down to the transaction detail) all the way back to 1981?
• No statute of limitations (in Delaware) for reports filed prior to 2002
• 3 year statute of limitations for reports filed after July 2002
• 6 year statute of limitations if “materially” under reported (25% or more)
• Use of extrapolation to estimate liability
• High penalty and interest
• Delaware has stepped up audit enforcement activities
• Began mailing out audit notices in February 2013
• Focus appears to be financial services industry, with retail, distribution,
entertainment and consumer products manufacturing industries also
targeted
FOOD. FOOD PEOPLE. EASY. 9

10. Potential Audit Triggers
• Holder is incorporated in the state or has presence in the state but
has not filed reports
• Gaps in reporting history
• Amounts reported by Holder appear small compared to the size of
the Holder
• There was no reach back on the initial reporting by the Holder
• Holder is large so as to draw attention from the state of
incorporation
• History of mergers, acquisitions, reorganizations, liquidations,
dissolutions, incorporations
• High volume of financial transactions (e.g., retailers or distributors)
• Failure to report some property types that are common to the
industry
FOOD. FOOD PEOPLE. EASY. 10

11. Third Party Auditors
• The number of states engaging contract audit firms has increased
drastically over just the past year
• from a handful to over 20
• while not all states currently use contract auditors, most have the statutory
authority to do so
• contract auditors perform virtually all of Delaware’s unclaimed property
audits
• Contract auditors are compensated by contingent fee which encourages
auditors to:
• be overly aggressive;
• interpret state laws to their own advantage;
• ignore holder errors that would result in lower assessment; and
• pick and choose audit targets
• A number of states may participate in the same audit
• focus state remains on Delaware as the lead state (of incorporation)
FOOD. FOOD PEOPLE. EASY. 11

12. Third Party Auditors (con’t)
• Extended “reach back” periods
• Delaware can audit as far back as 1981 (over 30 years!)
• Sampling and Extrapolations
• Delaware’s laws allow the state and its contract auditors to estimate a
holder’s liability where no records are available
• The Delaware statute offers no guidance on what estimation
method(s) to use
• Because no name and address information is available, the estimated
unclaimed property liability falls under the second-priority rule
(escheats to the state of incorporation)
FOOD. FOOD PEOPLE. EASY. 12

13. Unclaimed Property Headlines
• “Attorneys find ‘formidable’ opponent in Kelmar “ – Legal Newsline Legal
Journal 9/4/13
• “Delaware’s Unclaimed Property Racket: John Gotti Would be Proud” – The
American Spectator 5/16/13
•• “Are State’s Addicted to Revenue From Unclaimed Property?” – Forbes
10/18/13
• “Unclaimed Property Audit Lawsuit Filed Against Kelmar: You Do the Math” –
The National Law Review 6/9/14
• “Estimating Unclaimed Property Liability: The Wild West of Accounting” – Tax
Executives Institute, Inc. 11/15/2012
• “Once a Friendly Locale to Business, The Modern State of Delaware is a
Bully” – Forbes.com 5/19/2013
FOOD. FOOD PEOPLE. EASY. 13

14. Chronological Audit Components
1. Notice
2. Confidentiality & Non-Disclosure Agreement
3. Opening Meeting
4. Information/Document Requests
5. Sampling and Extrapolation
6. Remediation
7. Interim Status Report (ISR)
8. Report of Examination (ROE)
9. Statement of Findings and Request for Payment
10. Negotiation / Appeal
FOOD. FOOD PEOPLE. EASY. 14

15. Overview of Kelmar Audit Process
• Notice of intent to audit is received directly from the state(s) and
lists Kelmar as auditor
• Kelmar contacts the company:
• Complete a Confidentiality & Non-Disclosure Agreement (NDA)
• Limit to participating states
•• Have opening conference to kick off audit and complete the first
information request
•• Kelmar Uses a Four Phase Audit Approach
FOOD. FOOD PEOPLE. EASY. 15

16. Kelmar Four Phase Audit Process
• Phase I: Entity and Property Type Scoping
• Public Information
•Organizational Chart
• Federal Tax Return 1120 (state apportionment
schedules)
™™Kelmar identifies the entities to be the primary focus of the
examination – then requests general ledgers
• Analysis of General Ledgers (by In-Scope Entity)
™Kelmar identifies the GL accounts it believes may hold unclaimed
property and requests more detail on these particular accounts
FOOD. FOOD PEOPLE. EASY. 16

17. Kelmar Four Phase Audit Process
• Phase II: Quantification of Potential Unclaimed Property
• Kelmar Requests Source Data (bank account detail, A/R aged trial
balances, etc.)
• Transaction Level Detail (aged outstanding checks, A/R credit
write-offs, etc.)
Challenges for Holder to Respond
• Availability of records (record retention policies)
• Accounting system changes
• Staff changes
•• Mergers, acquisitions, reorganizations, liquidations, dissolutions,
incorporations
™ Kelmar uses the information to sample and extrapolate
FOOD. FOOD PEOPLE. EASY. 17

18. Kelmar Four Phase Audit Process
• Phase III: Research, Remediation and Due Diligence Adjustments
• Actuals Presented to Holder (provided by individual property category)
™Kelmar provides Holder with its initial findings of the populations of
presumptively due transactions
• Research, Remediation, Due Diligence (errors, filed, due diligence letters,
refunds, addresses)
• Holder performs research, due diligence to remediate the presumptively due
transactions asserted by Kelmar
• Remediation – Holder had burden to prove that the property is not abandoned
•• Phase IV: Unclaimed Property Reporting
• Report of Examination Findings
• Final Assessment
FOOD. FOOD PEOPLE. EASY. 18

19. Issues with Kelmar
• Long Drawn Out Audits
• Holder accounting system changes
• Data archived at summary level
• Request huge amounts of data/documents
• Request all reports filed in all states for all years (go back as far as furthest state – Delaware back to
1981)
• No statute of limitations (record retention policies often just 7 years)
•• Kelmar monthly TMR (Task Management Report) – track to show how many days requests are “past
due”
• Kelmar standard is to provide 30 days for responses – not reasonable considering amount of detail
being requested (ability to negotiate more time)
• Acquisitions – limited access or no access to software systems/records, but have liability
• Require all past reports, but Delaware says don’t have copies of all previous filings, holder
responsibility to retain copies
• Cost of external advisors
• Cost of internal staff hours to gather information
• Tie up internal personnel from multiple functional areas (treasury, accounts payable, accounts
receivable, payroll, shareholder services, tax, etc.)
• Failure by Kelmar to recognize some basic tax and recordkeeping principles (e.g., disregarded
entities)
• Estimation/Extrapolation techniques a huge issue
FOOD. FOOD PEOPLE. EASY. 19

20. Use of Extrapolation Methods
• Auditor selects base period covering several years for which records
are available
• Using the base period, auditor calculates an “escheat percentage”
(error rate)
• Example of an auditor’s extrapolation formula:
Escheat Percentage = [Determined Liability for Base Year(s) with Records]
[Revenue for Base Year(s)]
Projected Liability = [Escheat Percentage] x [Revenue for Years with
Insufficient or No Records]
FOOD. FOOD PEOPLE. EASY. 20

21. Use of Extrapolation Methods (con’t)
• Importantly, Determined Liability for Base Year(s) with Records
includes:
• All the unremediated items for the base year(s)
• All property escheated to any State during the base year(s)
• Items discovered during the audit and considered abandoned that are
reportable to any State and returned to the rightful owner
• Items that could be abandoned property reportable to any State, but
for an applicable exemption provided by the State to which the
property otherwise would be reportable.
• Impact of Extrapolation Can be Very Material!
• Interest/penalty can equal or exceed the amount of the actual liability
FOOD. FOOD PEOPLE. EASY. 21

22. Impact of Extrapolation Can be Material!
The Temple-Inland case highlights several of the weaknesses of the Kelmar
extrapolation methodology. The complaint lists several specific examples,
which practitioners have all seen before:
• Using a B2B check in a continuing relationship state as the basis for unclaimed
property, even though the check is not yet reportable to the state. A $1,312.72
check payable to a vendor in Tennessee turned into a Delaware assessment of
$101,463.27.
• A vendor check that was voided because it was issued in error and where no
liability exists turned the original $3,050.49 check issued in error into $144,028.97
under the extrapolation.
• A series of four vendor checks of $4,335.19 that were voided and reissued (and
subsequently cleared within the dormancy period) turned into $237,339.18 of
liability under the extrapolation.
FOOD. FOOD PEOPLE. EASY. 22

23. Impact of Extrapolation Can Be Material! (con’t)
Temple-Inland case examples of extrapolation methodology weaknesses
(con’t):
• A $100 uncashed check that was escheated to another state was used in the
extrapolation.
• A voided check that was issued to an employee for vacation time already
compensated was extrapolated to $87,386.75 in liability.
• Payroll checks that were reissued to employees in states other than Delaware for
$8,355.94 turned into $174,223.29 in the extrapolation.
• A check that was originally issued under payroll, then reissued under accounts
payable, turned $1,641.50 into $95,090.73.
FOOD. FOOD PEOPLE. EASY. 23

24. Key Recommendations
• Educate management team regarding Kelmar’s practices and what
is in store with the audit
• CFO, Controller, General Counsel
• Consider hiring outside assistance who has dealt extensively with
these audits
• Legal counsel (attorney-client privilege)
• Accountants if needed for the legwork (hire through legal counsel to
establish attorney client privilege)
• All communications and submissions to Kelmar should be done
through the legal counsel as the point contact
• Establish an internal mandate to not let anything out the door
without understanding what it is and what its ramifications may be.
• Anticipate resources needed – it will be more than you think!
FOOD. FOOD PEOPLE. EASY. 24

25. Recent Legislative Changes in Delaware
• Senate Bill 228 (signed 6/30/2014)
• Penalty for failing to file an unclaimed property report changed from 5% per month
to the lesser of 5% per month or $100 per day
• Maximum penalty for failing to file a report changed from 50% of the amount
required to be shown on the report to $5,000.
• Eliminated the assessment of interest on unpaid amounts
• Extended enrollment period for the Voluntary Disclosure Agreement (VDA)
program administered by the Secretary of State to September 30, 2014
• Senate Bill 215 (did not pass)
• Would have prohibited the state from paying contract auditors by commission and
require contracts with auditors to not extend beyond three years
• Bill also recited existing law restricting state employees from assisting any private
enterprise on any matter involving the State for a period of 2 years after
employment (directed at Delaware’s former State Escheator Mark Udinski who
joined Kelmar)
FOOD. FOOD PEOPLE. EASY. 25

26. Recent Litigation in Delaware
• Select Medical Corporation v. Cook, et. al. U.S. District Court, District of
Delaware No. 1:13-cv-00694, 1/21/2014)
• After Select Medical made a payment of more than $17,000 under a VDA,
Delaware performed an unclaimed property audit and issued an
assessment of $300,000
• Select Medical filed suit against Delaware arguing that Delaware’s
policies were improper based on the following:
• Delaware’s three year statute of limitations bars the assessment
• Delaware Section 1155 does not provide authority for retroactive estimation
techniques during the time period in question
• Texas v. New Jersey, 379 US 674 does not give common law authority for
estimation techniques since records were available during the time period in
question
• The estimation methodology was unconstitutional, violating the Commerce
Clause, Full Faith Clause, Credit Clause and the Takings and Substantive
Due Process Clause because it does not recognize exemptions, and was
y arbitrary and p
capricious
• The parties settled the case
FOOD. FOOD PEOPLE. EASY. 26

27. Recent Litigation in Delaware
• Temple-Inland v. Cook et. al., 1:14-cv-00654-SLR (D.Del. 5/21/14)
• Temple-Inland alleges that Delaware illegally estimated unclaimed checks
dating back to 1986, for years that the company could not produce records.
• A six-year audit of the books produced just a single $147.50 payroll check due to
Delaware for unreported unclaimed property liability
• The $147.50 in unreported payroll for the six-year period alone resulted in an
estimated $952,066.36 due to Delaware for the seven prior years without records
• Under Kelmar’s estimation and extrapolation methodology, Delaware assessed a
total liability of nearly $1.4M for the seven years without records
• Temple-Inland argues the calculation is flawed in several fundamental ways:
• There is no relationship between revenues and the amount of unreported property
• The adjustment of revenues by removing ACH payments from the denominator in
the escheat percentage calculation incorrectly inflates the final assessment
because no similar adjustment for ACH payments was made during the estimation
years.
• First case in which Kelmar Associates was directly named as a defendant
FOOD. FOOD PEOPLE. EASY. 27