Current State Income Tax
Developments
ELA Tax Executives Roundtable
June 9, 2004
Jeffrey Friedman
Partner, Washington National Tax
KPMG LLP
Washington, DC
(202) 533-3204
Brendon McKibbin
Partner
KPMG LLP
New York, NY
(212) 872-3559
KPMG
Legislative Update
KPMG
Legislative Update
„
The “state of the states” has not necessarily kept
pace with the upturn in the economy
„
“Loophole closers” and corporate tax reform
continue as the dominant legislative themes
for 2004
„
Historically anti-tax legislatures appear to be
more receptive to corporate tax measures
than in years past
KPMG
Legislative Update
„
Illinois - major tax reform proposal
–
–
–
–
–
–
„
Lockbox rule
Cost of performance
80/20 companies
Business/non-business income
Business software purchases
Tax planning transactions
Other states with major tax packages:
Kentucky (failed), Maryland, Virginia
KPMG
Legislative Update
„
Expense disallowance
–
–
–
–
–
District of Columbia
Maryland
Missouri
Tennessee
Virginia
„
Impact of California referendum
„
Texas special session
KPMG
Related Party
Expense Disallowance
KPMG
Related Party Challenges
Kevin Assoc. (LA)
Ind. L.O.F. 01-0132
Toys ‘R’ US (NYC)
Ind. L.O.F. 01-0063S
Ind. L.O.F. 00-0379
SYL (MD)
Crown Cork & Seal (MD)
Sherwin Williams (NY)
A&F (NC)
Lanco (NJ)
Cambridge Brands (MA)
Taxpayer Victory
Taxpayer Loss
Sherwin Williams (MA)
Indiana L.O.F. 95-0401
Indiana L.O.F. 01-0094
Syms (MA)
Gore/Acme Royalty (MO)
Kmart Properties (NM)
Burnham (1997, NY)
Geoffrey (1993, SC)
Aaron Rents (1994, GA)
Express (1995, NY)
1993 –
1995
1996 –
2000
2001
2002
2003
2004
KPMG
Related Party Challenges
„
Toys “R” Us - NYTEX (N.Y.C)
–
–
–
–
–
–
Forced combination rejected
First precedential ruling on this issue in NYC
Taxpayer’s arm’s-length evidence not rebutted
Business purpose/economic substance evidence
unnecessary
But see, New York State Sherwin Williams
And, impact limited by enactment of expense
disallowance
KPMG
Related Party Challenges
„
Cambridge Brands (Mass. ATB)
–
–
–
–
–
–
–
Taxpayer victory!
Licensing fees had business purpose
Based on comparisons to Sherwin Williams
and Syms
Taxpayer routinely segregated intellectual
property
Royalty was arm’s-length
Licensor assumed expenses
No circular flow of cash
KPMG
Expense Disallowance Update
Narrower
Broader
Royalties
North Carolina
Oregon
NEW
and
intangible related
interest
Connecticut
Mississippi
New York
and
other intercompany
interest
Alabama
Arkansas
Connecticut
Massachusetts
New Jersey
New York
Ohio
KPMG
Expense Disallowance Legislation
„
„
Measures enacted during 2003 in New York,
Massachusetts, Connecticut, Oregon, and
Arkansas
New York
–
„
Originally included royalties and interest;
subsequently amended to cover royalties only
Massachusetts
–
Retroactive to 2002
KPMG
Expense Disallowance Legislation
„
Connecticut
–
–
„
Existing royalty disallowance provision expanded
to include interest, as well
Unitary filing option created as an exception
Oregon regulation – why does a unitary state
need expense disallowance?
KPMG
Landscape: Before
No Income Tax
Unitary
Add Back of Royalty
States where Benefits
or Partial Benefits
May Remain
KPMG
Landscape: After
No Income Tax
Unitary
Economic Nexus
Add Back of Royalty
States Attacking
on Audit
States where Benefits
or Partial Benefits
May Remain
KPMG
California Disclosure
Legislation
KPMG
Disclosure Requirements
„
Disclosure by California taxpayers
–
–
–
–
„
Federal listed transactions entered into after
February 28, 2000
Other federal reportable transactions entered
into on or after January 1, 2003
California listed transactions entered into on or
after February 28, 2000
So far, two listed transactions
Registration and list maintenance
requirements for tax shelter organizers
KPMG
Penalties
„
„
„
„
„
„
Failure to disclose reportable or listed
transaction
Reportable transaction understatement
Non-economic substance transaction
understatement
IRC § 6662-based penalty
Increased interest
Statute of limitations doubled
KPMG
Voluntary Compliance Initiative
„
Began January 1, 2004; ended April 15, 2004
„
Applied to “abusive tax avoidance
transactions” for tax years beginning
before January 1, 2003
„
Penalty waiver in exchange for amended
return AND payment of tax
KPMG
Other States
„
New York
–
„
Legislation proposed (S.B. 6500)
Illinois
–
Mentioned in Governor’s budget address
KPMG
Nexus and Jurisdiction
KPMG
Nexus Proposals
„
Federal legislation
– ITFA moratorium expired Nov. 1, 2003
– Alternative resolutions pending on moratorium
– Additional proposals would:
z Codify Quill for BAT
z Overturn Quill for sales and use tax purposes
„
MTC factor-based BAT nexus proposal
– $50,000 property or payroll; $500,000 sales;
or 25 percent of any factor
– Computed on a unitary group basis
– Approved October 17, 2002
KPMG
Nexus – Intangibles
„
Lanco (N.J. Tax Ct. Oct. 21, 2003)
–
–
–
–
–
Physical presence required for income tax
purposes
Separate nexus standards for income and sales
and use taxes are “illogical”
Regulation provided that licensing trademarks
constituted doing business
Court stated legitimate tax planning permissible
But, impact limited by 2002 enactment of expense
disallowance
KPMG
Nexus - Intangibles
„
Louisiana
–
–
–
Kevin Associates reversed (La. Sup. Ct.)
z Delaware holding company was domiciled and
physically present in Louisiana through presence
of directors, officers
z Did not impose economic nexus
Autozone (La. Ct. App.)
z State could not reach through REIT to tax
out-of-state REIT holding company
z Footnote – Quill requires physical presence
But, several economic nexus suits pending,
including Geoffrey
KPMG
Nexus – Economic & Attributional
„
Annox (Ky. Bd. Tax App. Nov. 18, 2003)
–
–
–
–
Telecommunications reseller subject to tax
No presence, but interconnection agreements
Quill limited to sales/use tax
Nexus established by:
z Right to use in-state networks
z Certificate of Public Convenience
z Installation and repair by interconnection partners
z Congressional grant of authority?
KPMG
P.L. 86-272
„
Disney (N.Y. Div. of Tax App. Feb. 12, 2004)
–
–
–
–
–
Applied Finnigan rule
Protected subsidiaries required to source New York
destination sales to state on combined report
Significant cross-marketing
Alpharma (2002) same result; but Silver King
Broadcasting (1995) applied Joyce
None are precedential
KPMG
Apportionment Issues
„
Disney (N.Y. Div. Tax App.)
–
–
–
„
Royalties sourced to licensee address, not location
of manufacture (overseas)
No factor representation for intangibles licensed
to third parties
Film masters must be valued at cost, not market;
difference represented intangible copyright
UPS (Pa. Commw. Ct.)
–
Furnished employees did not create a payroll
factor for taxpayer
KPMG
Unitary Combined Reporting
„
Envirodyne (U.S. Ct. App. 7th Circ.)
–
–
–
–
Brother-sister not unitary; even though both
unitary with parent
Losses could not be brought into unitary group
“Spokes without a hub” theory
State level case law distinguished
KPMG
The information contained herein is general in
nature and based on authorities that are
subject to change. Applicability to specific
situations is to be determined through
consultation with your tax advisor.
KPMG
Current State Tax Developments
ELA Tax Executives Roundtable
June 9, 2004
Jeffrey Friedman
Partner, Washington National Tax
KPMG LLP
Washington, DC
2004 KPMG LLP
ALL RIGHTS RESERVED
Brendon McKibbin
Partner
KPMG LLP
New York, NY
CURRENT DEVELOPMENTS
A NATIONWIDE PERSPECTIVE
________________________________________________________________________
Table of Contents
I.
Legislative Roundup
II.
Jurisdiction to Tax
A.
B.
C.
III.
Substantial Nexus
Income Tax -- Economic Nexus
Income Tax -- U.S. Public Law No. 86-272 and Throwback
Corporate Income and Franchise Taxes
Page
2
4
4
11
14
Related Party Transactions and Arrangements
Tax Base and Credits
Allocation and Apportionment
Apportionment Issues
Filing Methods
Franchise and Net Worth Taxes
17
17
24
27
29
36
39
IV.
LLCs and Other Pass-Through Entities
41
V.
Sales and Transaction Taxes
43
A.
B.
C.
D.
E.
F.
Software, Telecommunications, and Digital Goods and Services
Exemptions
Resale
Other Taxability Issues
Sourcing
Drop Shipments
43
48
52
52
54
55
G.
Other Transaction Taxes
56
A.
B.
C.
D.
E.
F.
VI.
Property Taxes
57
VII.
Practice and Procedure
58
I.
Legislative Roundup
As the 2004 state legislative sessions progress, states continue to contend with
budget shortfalls. In addition, many states remain interested in enacting tax
reform and dealing with transactions perceived as loopholes. The following is a
summary of some of the recent legislative activity in select states. This summary
reflects legislative activity as of April 12, 2004.
A.
Alabama: A proposal to require combined reporting was expected to be
introduced during April.
B.
California: A voter referendum held March 2, 2004, approved the bond
financing plan and rejected a proposal to lower the supermajority
requirement for increasing taxes. As a result of these developments, taken
in concert, significant tax increases are not expected this year. Pending tax
legislation (all in early stages) includes several bills that would reinstate
the Manufacturer’s Investment Credit, legislation that would repeal the
water’s edge election, a proposal to include subpart F income in the
water’s edge group, and provisions that would allow the sale of unused
NOLs.
C.
District of Columbia: The Mayor included, as part of his budget
proposal, a related party expense addback provision. A similar measure
was introduced by the D.C. Council last year.
D.
Florida: Two bills, H.B. 735 and S.B. 2302 were still pending, toward the
end of the session, to repeal the substitute communications services tax.
The legislature was scheduled to adjourn on April 30, 2004.
E.
Illinois: The Governor’s budget address contained a sweeping tax reform
proposal that would change the Illinois “lockbox” rule and the cost of
performance sourcing rule; eliminate nonbusiness income; ensure no tax
benefits are available when intangible assets are transferred to tax havens;
enact straight-line depreciation; repeal the sales tax exemption for business
software purchases; and institute tax shelter legislation. Legislative
language is not yet available.
D.
Indiana: H.B. 1365, which was enacted on March 17, 2004, contains a
provision requiring out-of-state sellers to register for and collect sales and
use taxes if “closely related” to an entity that maintains a place of business
in Indiana or enters into a public contract with an Indiana agency. The
legislation also exempts separately states installation charges from sales
1
and use tax and clarifies the assignability of the sales and use tax bad debt
deduction. As originally introduced, the legislation contained an expense
disallowance provision that was deleted from the final version of the
legislation.
E.
Kentucky: The Governor had proposed a significant tax modernization
package. The legislature adjourned April 13, 2004, without passing the
Governor’s proposal or a budget bill.
F.
Louisiana: Legislation was enacted that: creates a phased-in exemption
for purchases of machinery and equipment by manufacturers; phases out
the borrowed capital component of the franchise tax; and provides for the
inclusion of related party debt that exceeds a certain threshold in the
franchise tax base.
G.
Maryland: On the last day of the session, April 12, 2004, the legislature
approved and sent to the Governor three bills, one containing related party
expense disallowance, another containing an amnesty provision with
respect to prior year related party expenses, and a bill imposing a
temporary corporate income tax surcharge. The Governor has threatened
to veto the surcharge bill and has announced that he has not decided
whether to sign either the expense disallowance or amnesty bills. The
Governor has until June 1, 2004 to sign the legislation.
H.
Massachusetts: Among the provisions included in the Governor’s budget
proposal, H.B. 1, are proposals to expand allocation of income of
domiciliary corporations, revise apportionment sourcing rules, address the
apportionment of income attributable to IRC § 338(h)(10) transactions,
and impose a sales/use tax collection obligation on certain drop shippers.
I.
Missouri: A related party expense disallowance provision containing safe
harbors, H.B. 969, which was supported by the business community,
passed the House and was sent to the Senate, where it was still pending as
of the middle of April. It is unclear whether the Governor, a strong
proponent of expense disallowance, would support the legislation with the
safe harbors included.
J.
New Jersey: The Governor has proposed extending the suspension of the
NOL deduction for 2004 and 2005.
K.
New York: The Governor has proposed single factor apportionment for
manufacturers. In addition, legislation has been introduced which would
require disclosure of certain tax planning transactions.
2
L.
Ohio: The budget that was passed during 2003 is a two-year provision.
The Governor has indicated that any major tax proposals would be
deferred until preparation of the 2005 budget. It is possible that a Housebased reform proposal will be introduced this year; but it is not anticipated
that any major tax reform will be enacted during 2004.
M.
Oregon: A voter referendum held on February 3, 2004, rejected a
proposed tax increase.
N.
Tennessee: Two expense disallowance bills have been introduced. One
applies only to royalties, while the other is broader.
O.
Texas: The Governor called the legislature into a special session to
address education financing, which began April 20, 2004. It was
anticipated that corporate limited partner nexus and related party expense
disallowance would be among the measures considered during the session.
P.
Virginia: A temporary budget bill, H.B. 5018 was approved by the House
on April 13, 2004 but, was drafted to “self destruct” on April 24, 2004, if a
2004-2004 biennial budget was not enacted by that date. H.B. 5018 was
scheduled for consideration by the Senate Finance Committee on April 16,
2004.
3
II.
Jurisdiction to Tax
A.
Substantial Nexus
1.
2.
Nexus Proposals
a.
Multistate: The Internet Tax Freedom Act moratorium
on discriminatory taxes and taxes on internet access
expired on November 1, 2003. Two bills, H.R. 49 and
S.150, were introduced during the latter part of 2003.
Two other measures have been introduced that would
set statutory nexus standards. H.R. 3184 would provide
for expanded collection authority for sales and use tax
purposes, essentially overturning the Quill physical
presence test. H.R. 3220 would codify the physical
presence test for business activity tax (BAT) nexus
purposes and expand the scope of U.S.P.L. 86-272.
H.R. 3220 does not address sales and use tax nexus.
b.
Multistate: The Multistate Tax Commission (MTC)
continues to support a BAT nexus proposal adopted in
October 2002 under which substantial nexus would be
established if a taxpayer had a threshold amount of
property, payroll, or sales in the state ($50,000 property
or payroll or $500,000 sales). Nexus would also be
established in any state in which at least 25 percent of
any of the three factors was concentrated. The proposal
would require the members of a unitary business group
to compute their nexus factors in the aggregate. If the
group as a whole met the nexus threshold, each member
of the group would be considered to have substantial
nexus in that state. Furthermore, the receipts factor
would include intercompany sales. The factors would
be computed according to the appropriate UDITPA
rules for the taxpayer. However, for receipts factor
purposes, the rule moves away from a cost of
performance standard toward a destination standard.
Intangible Licensing Activities, Other Holding Company Issues
a.
Louisiana: Reversing an appellate court decision, the
Louisiana Supreme Court has held that a Delaware
passive investment company was subject to Louisiana
corporate income and franchise taxes. The company
was part of a closely held group of corporations, and all
4
of its directors, except the Delaware-based nexus
provider, were Louisiana residents. Kevin Associates,
LLC v. Crawford, No. 03-C-0211 (Jan. 30, 2004). The
company earned dividends from subsidiaries located in
Louisiana and other states and received interest from an
intercompany loan to an affiliated Louisiana
corporation. The court held that the company was
commercially domiciled in Louisiana because it was
managed from Louisiana, and its Delaware presence
was merely a paper domicile. The court also concluded
that the company had a physical presence in Louisiana
because its principal place of business was in the state,
and it was managed from there. The appellate court had
held that the company did not have nexus, noting that
the company followed all the required formalities for
establishing and maintaining a DHC. Kevin Assoc. LLC
v. Crawford, 834 So.2d 465 (Nov. 8, 2002).
b.
Louisiana: A Louisiana appellate court has held that
the Department could not assert jurisdiction over an
out-of-state holding company, because the corporation’s
contacts with the state were not sufficient to satisfy the
nexus requirements of the Due Process Clause.
Bridges v. Autozone Properties, Inc., No. 2003 CA
0492 (La. App. 1 Cir. Jan. 5, 2004). (This decision was
issued before Kevin Associates). The Department
attempted to tax dividends received by a Nevada
corporation from a real estate investment trust (REIT)
that earned rental income from subsidiary retail stores,
some of which were located in Louisiana. The REIT
was subject to Louisiana tax but paid no tax as a result
of the dividends paid deduction, while the stores
received a deduction for rental expense. The court
examined Geoffrey, from a due process perspective
only. It concluded that, unlike the economic presence
created by the trademarks, which gave rise to the Due
Process nexus in Geoffrey, the holding company’s
dividends had no economic presence in Louisiana. Nor
could a Louisiana business situs be claimed for the
dividends that had no connection with the state other
than being paid by a REIT that earns part of its income
from Louisiana properties. While the Commerce
Clause was not at issue in Autozone, the court did state
in a footnote that Quill requires a physical presence to
establish Commerce Clause nexus. The court also
5
rejected an argument asserting that the holding
company and REIT were alter egos.
c.
Louisiana: A district court has denied motions filed by
two out-of-state trademark licensing companies to
dismiss suits filed by the state to recover income taxes.
Louisiana Dept. of Revenue v. Geoffrey, Inc., No.
502769; Louisiana Dept. of Revenue v. Gap (Apparel),
No. 501651 (Dec. 8, 2003). The court determined both
suits could proceed, despite the defendants’ claims that
they had no physical presence in the state; however, the
court did not actually rule on whether the companies
had established nexus in Louisiana.
d.
New Jersey: The New Jersey Tax Court has held that
an intangible holding company with no physical
presence in New Jersey, but which licensed trademarks
to an affiliated retailer in the state, was not subject to
the New Jersey Corporation Business (income) Tax
(CBT). Lanco, Inc. v. Director, Division of Taxation,
No. 005329-97 (N.J. Tax Ct. Oct. 23, 2003). The court
specifically ruled that the physical presence test upheld
by the U.S. Supreme Court in Quill Corp. v. North
Dakota, 504 U.S. 298 (1992), applies to income as well
as sales and use taxes. In so doing, the court appears to
have invalidated a 1996 Division of Taxation regulation
that defines doing business to include licensing
trademarks, if used in the state. The court explicitly
stated that there was no justification for imposing
different substantial nexus standards for sales and use
and income taxes. The court reasoned that, since an
obligation to collect use tax is not “more burdensome”
than an obligation to pay an income tax, it would be
“illogical” to require physical presence for use tax
nexus, while allowing income taxes to be imposed
under lesser circumstances. Although the decision is
taxpayer favorable, the impact is mitigated by New
Jersey’s 2002 enactment of statutory expense
disallowance provisions that require addback of certain
related party expenses, including royalties attributable
to licensing intangible property. Tax Court decisions
are not precedential.
6
3.
Attributional Nexus
a.
Indiana: Recently enacted legislation requires any
person that is “closely related” to another person that
maintains a place of business in Indiana, engages in the
regular or systematic soliciting of retail transactions
from potential customers in Indiana, or enters into a
public contract with a state agency to register and
collect sales and use tax. H.B. 1365 (Mar. 17, 2004).
The term, “closely related” is defined to include: use of
identical or substantially similar names, trademarks or
goodwill; persons that pay for each other’s services
under an arrangement that is contingent on sales volume
or value; and entities that share a common business
plan. The measure also expands the definition of a
retail merchant engaged in business in the state (for
sales and use tax collection purposes) to the boundaries
of the U.S. Constitution. The provision becomes
effective July 1, 2004.
b.
Kentucky: The Board of Tax Appeals has ruled that a
telecommunications reseller was subject to the Public
Service Corporation (PSC) property tax in a ruling with
both economic and attributional nexus elements.
Annox, Inc. v. Revenue Cabinet, No. K-19039 (Nov. 18,
2003). The reseller had no physical presence in the
state but did have interconnection agreements with two
in-state telephone companies entitling it to use their instate equipment to provide services to Kentucky
customers. Citing Scripto and Tyler Pipe, the Board
explained that the in-state interconnection partners
established and maintained a market for the reseller
through the activities of their employees, such as
performing installation and repair services for the
reseller’s Kentucky customers.
The Board also stated that Quill is only applicable for
sales and use tax purposes, and cited Geoffrey, despite
Geoffrey’s limited applicability to South Carolina. The
Board then explained that nexus was established
through the reseller’s absolute right to use the Kentucky
physical networks of two in-state telephone companies
(an intangible), as well as its Certificate of Public
Convenience issued by the Kentucky PSC. The Board
went so far as to state that the U.S. Congress granted
7
states nexus over all switchless resellers providing
services in their states when it specifically authorized
state commissions to approve interconnection
agreements (in the Telecommunications Act of 1996).
c.
New York An out-of-state non-profit membership
organization with no physical presence in New York
established nexus in the state through the activities of
two unrelated independent contractors in the state and
must collect sales and use tax on catalog and internet
sales made to New York purchasers. TSB-A-04(3)S
(N.Y. Dept. of Tax. and Fin. Feb. 24, 2004). The
organization, an association for boaters, provided
various services to its members, including marina
membership discounts, insurance, theft protection,
magazine subscription, and access to emergency towing
services. Four retail stores in New York owned by third
parties, but which bore the organization’s name, sold
memberships to the organization. The Department
ruled that the stores served as independent
representatives that established New York nexus for the
organization through the sale of memberships. The
Department found that nexus was also established
through the arrangement the organization had with local
towing companies for its members to receive
emergency towing services throughout the country.
d.
New York: An administrative ruling issued by the
New York Department of Taxation and Finance
provides that a remote vendor with an in-state retail
affiliate will not, generally, be required to collect use
tax on New York sales, as long as the entities do not
engage in certain activities or act as alter egos. TSB-A03(25)S (Jun. 11, 2003). However, the ruling also
listed a number of activities the Department would
consider as triggering a use tax collection obligation.
The Department noted that activities that would deem
an in-state retailer to be acting as a sales representative
for a remote vendor would subject the seller to use tax
collection. The ruling explained that an in-state seller
might be acting in a sales representative capacity if it
referred customers to a remote seller’s catalogs,
accepted returns of its merchandise, solicited customer
names for a remote vendor’s mailing lists, distributed
8
catalogs or coupons of the remote seller, or shared
common inventory or administrative staffs.
e.
4.
Virginia: A ruling issued by the Department of
Taxation clarifies the scope of recent legislation, and
essentially provides that sellers that wish to do business
with the state may be required to waive constitutional
nexus protections in order to obtain contracts with the
state. Ruling of Commissioner, P.D. 04-04 (Jan. 23,
2004). The legislation, enacted during 2003, prohibits
the state from purchasing goods or services from a
seller, if the seller or any of its affiliates is a “dealer”
under Virginia law and fails to collect and remit sales
and use taxes. The Department ruled that the state
could not enter into a contract with the taxpayer
because an affiliate of the taxpayer may have advertised
in the state. While advertising, alone, is not necessarily
sufficient to establish nexus under constitutional
standards, it does qualify a seller as a “dealer” under
Virginia law. Under the constitution, Virginia cannot
require a “dealer” to collect tax if it does not have nexus
with the state. However, the ruling explained that the
state may set its own conditions for vendors to do
business with state agencies.
In-State Representatives
a.
Connecticut: A Connecticut Superior Court has held
that a mail order computer seller did not establish nexus
for sales and use tax purposes by virtue of the in-state
activities of an unrelated company to which the seller
had outsourced a portion of its service contract repair
work. Dell Catalog Sales v. Commissioner of Revenue
Services, No. CV 00 0503146S (Jul. 10, 2003). Under
the contracts, telephone and online support services
were provided by the seller, while on-site services were
preformed by the repair company. On-site repair work
comprised only ten percent of the value of the services
performed under the contracts. The court focused on
the lack of evidence as to the actual number of repair
visits made to Connecticut. In the absence of actual
evidence, the court held that the fact that only ten
percent of the service contract revenue was attributable
to on-site work indicated that the repair company’s
presence was minimal and insufficient to establish
9
nexus for the seller. The court cited Appeal of
Intercard, 14 P.3d 1111 (Kans. 2000) (eleven
maintenance visits during an audit period did not
establish nexus).
b.
Michigan: On appeal, a Michigan court has ruled that
a lower court should have granted a summary judgment
motion against an out-of-state seller. The out-of-state
company was subjected to the single business tax (SBT)
based on the activities of two resident sales
representatives. Acco Brands, Inc. v. Department of
Treasury, No. 242430 (Mich. Ct. App. Nov. 20, 2003).
The representatives solicited orders in the state and sent
them to the company’s Illinois office for approval.
However, since it has been determined that the SBT is
not an income tax, the activities of the representatives
were not protected by P.L. 86-272. See Gillette Co v
Dep't of Treasury, 497 N.W.2d 595 (Mich. Ct.
App.1993. Revenue Administration Bulletin (RAB) 9801 provided that, effective for open tax years and going
forward, the presence of sales representatives in the
state is sufficient to establish SBT nexus for an out-ofstate entity if the representatives solicit sales or engage
in other activity in the state on behalf of the seller.
c.
New York: The Department of Taxation and Finance
has ruled that an out-of-state vendor established nexus
for use tax collection purposes through the in-state
activities of a commission-based independent
contractor. TSB-A-03(41)S (Nov. 19, 2003). The
independent contractor sold only one line of the
vendor’s products, and the majority of its sales were
attributable to participation in trade shows. Citing
Scripto, the Department ruled that the independent
contractor’s activities established New York nexus for
the vendor, and the vendor was required to collect New
York use tax on all sales (other than resales), including
online sales. Although nexus is often based on the
activities of independent contractors, the ruling failed to
analyze the volume or frequency of the contractor’s
activities, New York’s more than a slightest presence
standard (Matter of Orvis Co. Inc. v. Tax Appeals
Tribunal, 86 N.Y.2d 165 (1995)), or whether the
contractor satisfied the Scripto/Tyler Pipe marketmaking standard.
10
B.
Income Tax -- Economic Nexus
1.
State
Arizona
Arkansas
Colorado
Florida
Georgia
Hawaii
Indiana
Iowa
Kentucky
Louisiana
Maine
Maryland4
Massachusetts
Michigan
Minnesota
Missouri5
New Hampshire
New Jersey6
New Mexico
New York
North Carolina9
Ohio11
Oklahoma
Pennsylvania
South Carolina12
Tennessee13
Virginia
West Virginia
Reported and Known “Geoffrey Nexus” Positions By State
Statute
Rule
Yes
Audit Position
Yes
Yes1
Yes
Yes
Yes (Priv.Tax)
Yes 2
Yes (F/S)
Yes
Yes (F/S)
Yes
Yes (F/S)
Yes
Yes 3
Yes
Yes
Yes (F/S)
Yes
Yes
Yes7
Yes10
Yes
Yes
Yes
Yes
Yes
Yes
Yes8
Yes (Forced Comb.)
Yes
Yes
Yes
Yes (F/S)
Yes
Yes
Yes (F/S)
Yes
Yes
Yes (F/S)
Yes
“F/S” - Financial Services
1
The Colorado Department of Revenue indicated at a practitioner’s
liaison meeting that it will assert nexus in situations similar to
Geoffrey.
2
See Letter of Findings 95-0401 (Ind. Dept. Rev. Jul. 1, 2002), which
upheld an audit assessment against an intangible holding company
based on a Geoffrey nexus position.
11
3
Several suits are pending in which the Department of Revenue is
asserting economic nexus over intangible licensing companies, and
administrative guidance provides that an out-of-state intangible
licensing company would have nexus under certain circumstances.
Revenue Ruling 02-001 (La. Dept. of Rev. May 13, 2002). In addition,
the Louisiana Supreme Court has held that an out-of-state holding
company had nexus in Louisiana, although the decision was not based
directly on economic substance principles (company was held to be
domiciled in the state). Kevin Associates, LLC v. Crawford, No. 03-C0211 (Jan. 30, 2004).
4
Maryland’s highest court has reversed (on business
purpose/economic substance grounds), a group of decisions that had
held that Geoffrey was inapplicable in Maryland. See Comptroller of
the Treasury v. SYL, Inc., Comptroller v. Crown Cork & Seal
Company (Delaware), Inc. Nos. 76 & 80, (June 9, 2003). The U.S.
Supreme Court declined the taxpayers’ appeals in both decisions.
5
But see, Acme Royalty Co. v. Director of Revenue and Gore
Enterprise Holdings, Inc. v. Director of Revenue, Nos. SC84225,
SC84226 (Mo. Nov. 26, 2002), in which the Missouri Supreme Court
reversed two Administrative Hearing Commission orders and held, on
statutory grounds, that out-of-state companies licensing patents and
trademarks were not subject to Missouri income tax.
6
Legislation enacted during 2002 expands the New Jersey Corporation
Business Tax to corporations engaging in contacts within the state.
N.J. Stat. Ann. § 54:10A-2. However, a recent Tax Court decision
rejected the assertion of nexus in the absence of a physical presence.
Lanco, Inc. v. Director, Division of Taxation, No. 005329-97 (N.J. Tax
Ct. Oct. 23, 2003).
7
The New Mexico Court of Appeals has held that an out-of-state
company that licensed trademarks and tradenames to an in-state
affiliate was subject to New Mexico gross receipts and income taxes.
Kmart Properties, Inc. v. New Mexico Taxation and Revenue
Department, No. 21,140 (Nov. 27, 2001).
8
New Mexico imposes economic nexus requirements on franchisors
for purposes of its gross receipts tax.
9
See A&F Trademark, Inc. v. Secretary of Revenue, N.C Super. Ct.,
Wake Cty., (May 22, 2003), affirming Secretary of Revenue v. A&F
Trademark, Inc., Admin Decision No. 381 (May 7, 2002); contra
12
Educational Resources, Inc. v. Tolson, No. 00CVS14723-4 (Wake
Cty. Sup. Ct., Feb. 20, 2003).
10
A North Carolina statute, enacted during 2001, provides that
licensing intangibles for use in the state is considered to be doing
business in the state.
11
The Ohio Supreme Court upheld the taxation of a nonresident
individual’s Ohio lottery winnings. Couchot v. State Lottery Comm'n.,
659 N.E.2d 1225
12
Geoffrey Inc. v. South Carolina Tax Comm'n., 437 S.E.2d 13 (S.C.
1993), cert. denied, 510 U.S. 992 (1993).
13
Tennessee imposes economic nexus on financial institutions for
franchise/excise tax purposes. In J.C. Penney National Bank v.
Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999) cert. denied 121 S. Ct.
305 (2000), the imposition of tax on an out-of-state bank that issued
credit cards to Tennessee residents was rejected; however, in America
Online, Inc. v. Johnson, No. M2001-00927-COA-R3-CV (July 30,
2002), the Tennessee Court of Appeals clarified that J.C. Penney does
not impose a physical presence requirement for all taxes.
13
C.
Income Tax -- U.S. Public Law No. 86-272 and Throwback
1.
Massachusetts: The Massachusetts Supreme Judicial Court
has upheld an Appellate Tax Board (ATB) ruling that a
company’s in-state representatives exceeded U.S. P.L. 86-272
protection. Alcoa Building Products, Inc. v. Commissioner of
Revenue, SJC-08939 (Oct. 21, 2003). The taxpayer employed a
handful of sales managers that solicited sales of vinyl siding
and other building products from Massachusetts customers.
The ATB had ruled that the sales managers’ involvement in the
warranty claims process was sufficient to forfeit the company’s
P.L. 86-272 protection. The sales managers investigated sites
to evaluate the merit of warranty claims and assisted customers
in filling out as many as one-third of the claim forms filed with
the company. The court ruled that these activities had
independent business purposes, apart from solicitation,
including enhancing the taxpayer’s reputation and decreasing
the volume of traffic received by the taxpayer’s warranty
claims office. The court rejected the taxpayer’s claim that the
warranty activities consisted of merely passing inquiries and
complaints on to the home office, an activity that is explicitly
protected by regulation in Massachusetts (and consistent with
the MTC statement on P.L. 86-272). 830 Code Mass. Regs. §
63.39.1(5)(c)(4). The court explained that the warranty
activities were more akin to handling customer complaints, an
activity that the same regulation specifically provides exceeds
protection. The court also rejected the taxpayer’s attempt to
establish that the unprotected activities were de minimis, noting
that the sales managers participated in more than one-third of
the warranty claims filed by the taxpayer’s customers and
regularly visited warranty claim sites.
2.
New York: An administrative law judge (ALJ) with the New
York Division of Tax Appeals ruled that the New York
destination sales of certain members of a combined reporting
group must be sourced to New York, even though none of the
companies, themselves, engaged in any activities that exceeded
U.S Public Law 86-272 protection.
Matter of Disney
Enterprises, Inc., DTA No. 818378 (Feb. 12, 2004). The ALJ
ruled that the New York activities of the other members of the
group, including retail stores in the state, and substantial cross
marketing, was sufficient to require the non-nexus subsidiaries
to source their destination sales to the state. The ALJ
explained that these activities established that the companies’
business in New York was not merely limited to
14
remote/protected sales. This is the second ALJ ruling in the
last two years to employ the Finnigan approach in New York.
In 2002, a different ALJ also ruled that P.L. 86-272 protected
New York destination sales made by non-taxpayer corporations
of a New York combined reporting group must be included in
the numerator of the group's receipts factor. Matter of
Alpharma, Inc., DTA No. 817895 (2002). In contrast, in
Petition of Silver King Broadcasting of New Jersey, Inc., an
ALJ ruled that the Joyce approach should be applied. DTA No.
812589 (1995). None of these rulings are precedential.
3.
New York: Recent regulatory amendments provide that
participation in a trade show for no more than fourteen days, in
the aggregate, during a tax year qualifies for P.L. 86-272
protection from the franchise (i.e., income) tax. N.Y. Comp.
Codes R. & Regs. tit. 20, §§ 1-3.3, 1-3.4. (Jan. 22, 2004). In
order to qualify for the exception, no sales can be made at the
trade show, the person’s activity must be limited to displaying
goods and promoting services, and all orders must be sent
outside the state for acceptance. The regulation is effective
retroactively for taxable years beginning on or after January 1,
2002. A previously issued New York ruling provided that the
presence of employees at in-state trade shows and seminars an
average of ten days per year did not generate nexus for
corporation franchise tax purposes. N.Y. Dep’t of Tax. & Fin.,
TSB-A-97(6)C (Mar. 24, 1997). These changes are also
consistent with amendments made to New York City
regulations last year. Rules of the City of New York §§ 11-03,
11-04 (Jan. 2, 2003) were amended to include a fourteen-day
trade show safe harbor, effective January 1, 2002, as well.
4.
New York: The Department of Taxation and Finance has
issued an Advisory Opinion finding that an out-of-state food
seller was subject to New York corporation franchise tax.
TSB-A-03(13)C (Dec. 24, 2003). Although orders were sent
outside the state for approval and deliveries were made from
outside the state (in company owned trucks), the Department
concluded that the seller engaged in post-delivery activities that
exceeded P.L. 86-272 protection, including
picking up
damaged goods from customers and occasionally accepting
payments from customers for prior deliveries. The Department
found that these activities were unprotected under N.Y. Code
Regs. Reg. § 1-3.4(b)(9) - - replacing stale or damaged
products and collecting delinquent accounts. With regard to
the replacement of damaged products, however, the facts
15
indicate that the seller removed damaged products from
customers and issued credit, but do not indicate that any
replacements were delivered. Furthermore, the facts stated that
delivery persons occasionally accepted checks from customers
as an alternative to the customers mailing their payments.
There is no indication that these payments related to past due
accounts or that the delivery persons in any way solicited or
requested such payments. The Department also noted that the
seller was ineligible to claim a de minimis exception where
there was at least one damaged goods pickup per week.
16
III.
Corporate Income and Franchise Taxes
A.
Related Party Transactions and Arrangements
1.
Expense Disallowance Legislative Developments
a.
Connecticut: Legislation enacted during 2003 expands
the disallowance of related party interest expense under
the state’s expense disallowance provisions. H.B. 6806,
sec. 78 (Aug 16, 2003). The measure was enacted as a
substitute for legislation that would have imposed a
mandatory “alternate combined reporting” regime for
virtually all corporate taxpayers in Connecticut. The
legislation is effective for tax years beginning on or
after January 1, 2003. The legislation effectively
expands Connecticut’s expense disallowance to
intercompany financing (and other types of
intercompany interest payments). Under existing law,
taxpayers are already required to add back interest
expenses and costs related to intangible property under
Conn. Gen. Stat. § 12-218c. The legislation provides
five possible categories of exceptions to the
disallowance requirement, including the payment of tax
in another jurisdiction coupled with arm’s length terms
and a non-tax business purpose, as well as a treaty
exception. The addback may also be avoided if the
taxpayer agrees to file a unitary combined report.
Subsequently released information addresses the scope
of the addback exceptions. Form CT-1120AB and DRS
Commissioner Meeting Interest Add Back Issues (Dec.
3, 2003). The release specifies that a petition must be
filed with the Department in order to take advantage of
any of the statutory exceptions to addback, other than
the “three percent tax paid exception.” The release
clarifies that the three percent spread will be calculated
by comparing Connecticut’s maximum 7.5 percent
statutory rate to the income recipient’s effective tax rate
in any one state. The effective rate is calculated by
dividing actual tax paid by pre-apportionment taxable
income. Accordingly, the exception would not be
available to an income recipient in an NOL position in a
state in which it is subject to tax.
17
With regard to the new unitary election exception to
addback, the form imposes several conditions on the
unitary filing exception that are not required by the
legislation. The release states that the election is
water’s edge (although the legislation does not specify).
The release also explains that taxpayers may elect
unitary for Connecticut purposes if they file unitary in
another state but fails to address whether taxpayers that
do not file unitary in any other state may avail
themselves of the election. In addition, the form
specifies that no prior year NOLs or credits may be
utilized, and the entire unitary group is subject to the
twenty percent corporate tax surcharge. Furthermore,
the unitary group must be treated as a single taxpayer
for purposes of computing and using tax credits.
b.
Massachusetts: Related party expense disallowance
legislation was enacted during 2003. Subsequently
enacted legislation creates an additional treaty
exception. H.B. 3727 (Nov. 26, 2003). The legislation
provides that addback of interest or royalties is not
required if the expenses are paid, directly or indirectly,
to a related member that is a resident of a country which
has a comprehensive income tax treaty with the United
States (provided the company is not a controlled foreign
corporation under IRC § 957), the amounts are
deductible for federal tax purposes, the transaction
giving rise to the expenses has a valid non-tax business
purpose, and the terms of the transaction are arm’slength.
c.
New York: During 2003, legislation was enacted
imposing related party expense disallowance for both
New York state and city purposes. A.2106 (May 15,
2003). Subsequently enacted legislation amended the
scope of the disallowance provision. S.B. 5725
(October 21, 2003). A.2106 provided for disallowance
of related party royalty and interest expense deductions.
However, S.B. 5725 eliminated the addback of interest
expenses (other than interest related to intangible
assets).
S.B. 5725 also amended the expense
disallowance provision related to royalties, expanding
the definition of royalties to include payments related to
the use of patents and amending the exceptions
available from disallowance. Specifically, S.B. 5725
18
removes a provision contained in A.2106, which
provided an exception from addback if the related party
payments were made for a valid business purpose and
pursuant to a contract that reflected arm’s length
interest and terms. As amended, only two exceptions
are provided from royalty addback: 1) if the taxpayer
has a valid business purpose and the related member
pays the royalty to a non-related member during the tax
year pursuant to arm’s length terms; and 2) a new
exception is added where the royalty payments are paid
to a related member organized under the laws of a
country with a comprehensive income tax treaty with
the U.S. and the royalties are taxed in that country at a
tax rate at least equal to the rate imposed in New York.
d.
Ohio:
Recently enacted legislation revises the
discretionary authority of the Tax Commissioner to
adjust “sham transactions.” Am. Sub. H.B. 95 (Jun. 26,
2003). The legislation created new Ohio Rev. Code §
5703.56, which shifts the burden of proof
(preponderance of the evidence) from the
Commissioner to the taxpayer in cases where the
Commissioner disregards sham transactions between
members of a controlled group. The burden of proof
remains with the Commissioner with regard to sham
transactions involving unrelated taxpayers. A controlled
group is defined as direct/indirect control of over fifty
percent, based on ownership of common stock or other
equity with voting rights. The legislation repeals Ohio
Rev. Code § 5733.111 which granted the Commissioner
discretionary authority to use the equitable doctrines but
did not differentiate between related party and third
party transactions and imposed the burden on the
Commissioner. The legislation also doubles the statute
of limitations in situations in which the Commissioner
has disregarded a sham transaction. The legislation
became effective immediately.
e.
Oregon: A recently promulgated regulation imposes a
related party expense disallowance requirement for
Oregon tax purposes. Ore. Admin. Code § 150-314.295
(effective Dec. 31, 2003). While Oregon is a unitary
combined reporting state, the regulation targets royalty
payments to related parties excluded from the combined
report. An example contained in the regulation
19
specifically references trademarks licensed to an
Oregon taxpayer from a Bermuda subsidiary. The
requirement is triggered where both the owner and user
of the intangible asset are owned by the same interests,
as defined in Treas. Reg. §1.469-4T, and separation of
the ownership and use of the intangible asset has no
effect on the operations of the user other than the
payment of the royalty.
2.
Related Party Decisions and Administrative Developments
a.
Indiana: The Department of State Revenue has ruled
that out-of-state trademark licensing companies could
be required to file a unitary combined report with
affiliated Indiana taxpayer corporations. Letter of
Findings 00-0379 (Ind. Dept. of State Rev. Feb. 1,
2004). The Department upheld the auditor’s used of
forced combination but also noted that it would have
been equally appropriate to invoke the sham transaction
doctrine to disregard the in-state taxpayer’s deductions
for payments made to the intangible company. The
ruling noted that the transaction was solely motivated
by tax considerations, and the transfer of intangibles
and royalty payments were illusory because,
respectively, the trademarks had no value apart from the
taxpayer’s goodwill and the taxpayer was thus making
substantial payments for something with no value. The
ruling acknowledged the taxpayer’s right to structure its
business affairs as it sees fit; however, it also noted the
Department’s right to invoke substance over form.
Previously, in Letter of Findings 01-0132 (Oct. 1,
2003), the Department imposed forced combination,
notwithstanding the fact that the taxpayers obtained
valuation and transfer pricing studies. In contrast, the
Department has employed other approaches in previous
rulings. See Letter of Findings 95-0401 (Jun. 2002)
(economic nexus), Letter of Findings 01-0063S (Feb.
21, 2003) (expense disallowance).
b.
Maryland: The state’s highest court has held that
taxpayers’ trademark licensing subsidiaries were subject
to Maryland tax. Comptroller of the Treasury v. SYL,
Inc., Comptroller v. Crown Cork & Seal Company
(Delaware), Inc. Nos. 76 & 80, (June 9, 2003). The
decision overturned rulings by the Maryland Circuit
20
Court, which had found that jurisdiction could not be
exerted over an entity based on a unitary nexus theory if
the entity lacked a physical presence in Maryland unless
such entity was found to be a “phantom.” The lower
court had found the subsidiaries to be separate business
entities and not phantoms. On appeal, the court ruled
that the records demonstrated a lack of economic
substance. The court specifically found that the
subsidiaries were phantoms, and subjected them to tax
based on their parents’ apportionment factors. The
court failed to address physical presence issues, instead
simply collapsing the structure. Although the Court
discussed Geoffrey, and the New Mexico Kmart
Properties decision, it did not base its decision on these
cases or apply economic nexus. Thus the decision
could arguably be limited to “naked” intangible holding
company-type structures. The SYL decision involved
the same taxpayer and transactions as the Massachusetts
Syms decision. The U.S. Supreme Court has denied the
taxpayers’ writs of certiorari in both decisions.
c.
Massachusetts: The Massachusetts Supreme Judicial
Court affirmed an Appellate Tax Board decision that
permitted imposition of the step transaction doctrine to
negate a transfer of intangibles prior to the sale of a
subsidiary. General Mills, Inc. v. Commissioner of
Revenue, SJC-08935 (Sept. 15, 2003). The court held
that the pre-sale transaction lacked economic effect.
The subsidiary had transferred its trademarks to a newly
created Delaware holding company immediately prior
to the sale of the subsidiary to a third party.
Subsequently, the subsidiary and the DHC were sold to
a third party. The court held that the taxpayer could not
reduce its gain on the sale of the subsidiary by
transferring its valuable intangibles to a no-tax
jurisdiction. The court upheld the ATB’s reallocation
of the gain to the subsidiary, which was domiciled in
Massachusetts.
d.
Massachusetts: The Massachusetts Appellate Tax
Board has held that a taxpayer could deduct royalty
payments made to an affiliated entity for the use of
trademarks and similar intellectual property.
Cambridge Brands, Inc. v. Commissioner of Revenue,
No. C259013 (Jul. 16, 2003). The ruling involved an
21
asset purchase (from an unrelated party) of candy
trademarks and a factory. The purchaser initially held
the trademarks and later placed them in a subsidiary
that held all its intellectual property, while it placed the
factory in a newly formed manufacturing subsidiary
(i.e., the taxpayer). The manufacturer thereafter licensed
the trademarks from the parent company/subsidiary. In
allowing the royalty deductions, the Board determined
that the licensing arrangement had both a valid business
purpose and economic substance. The Board was
influenced by the fact that the deductions did not result
from a typical intangible holding company scenario.
The Board found that the separation in ownership
between the trademarks and the factory helped to
establish economic effect. The Board also cited a
number of other factors: the lack of a circular flow of
cash; the fact that both the taxpayer and the licensor
conducted active businesses; and the assumption of all
trademark related expenses by the licensor, rather than
the licensee.
e.
New York City: The New York City Tax Appeals
Tribunal has affirmed a 1999 administrative law judge
ruling which held that, for New York City general
corporation tax (GCT) purposes, the Geoffrey
trademark licensing company and two other affiliates
were not required to be combined with the Toys R Us
entities subject to the City tax. Matter of Toys “R” Us
– NYTEX, Inc., TAT (E) 93-1039 (GC) (N.Y.C. Tax
App. Trib. Jan. 14, 2004). The Tribunal found the
taxpayer had sufficiently established that the royalties
were priced at arm’s-length, and the City did not
adequately rebut this showing. Although the Tribunal
agreed that the taxpayer had satisfied the three
presumptive criteria for combination, the Tribunal also
agreed with the ALJ’s determination that the taxpayer
successfully rebutted the presumption by establishing
that the royalty rates were arm’s-length. The Tribunal
rejected the City’s attempt to inject a business
purpose/economic substance requirement into the
arm’s-length analysis. The ruling is favorable and is the
first City precedential ruling on this issue (the City
cannot appeal). However, the impact is limited by the
recent enactment of related party royalty expense
22
disallowance legislation, effective for tax years
beginning on or after January 1, 2003.
f.
New York: New York Tax Appeals Tribunal has
reversed an administrative law judge decision and, in
the first state level precedential decision of its kind in
New York, forcibly combined a taxpayer withy related
intangible holding companies. In the Matter of SherwinWilliams, DTA No. 816712 (June 5, 2003). This
decision involved the same taxpayer and transaction as
the Massachusetts Supreme Judicial Court decision of
the same name. The ALJ had held that the taxpayer and
its subsidiaries implemented licensing transactions for
valid business purposes and conducted such agreements
under arm’s-length terms. Relying on the two-prong
test set out in Frank Lyon Co. v. United States, 435 U.S.
561 (1978), the Tribunal held that the transactions
lacked economic substance and the subsidiaries were
not formed for valid business purposes. While the
Tribunal mentioned the Massachusetts decision
involving the same taxpayer and transactions, it did not
attempt to distinguish its conflicting conclusion
regarding business purpose. Rather, in examining the
business purposes set forth by the taxpayer, the Tribunal
found the ALJ erred in accepting them at face value,
finding that the business plan lacked plausibility and the
business purposes lacked independent merit (other than
tax avoidance). Similarly, the Tribunal felt the ALJ’s
reliance on expert testimony regarding the arm’s-length
nature of the transactions was in error.
g.
Virginia: An administrative ruling found that royalties
paid to a trademark licensing subsidiary lacked
economic substance and business purpose and did not
reflect arm’s-length rates. Ruling of Commissioner,
P.D. 03-73 (Oct. 15, 2003). The taxpayer was a major
retailer.
The Commissioner rejected the three
methodologies offered by the taxpayer to support arm’s
length pricing. Addressing the residual profit method,
the Commissioner concluded that the taxpayer’s higher
than industry average margin was due to various
economies of scale attributable to being one of the
leading retailers in the country, rather than to the
trademarks. The Commissioner noted that the royalty
rate used in a similar licensing agreement between the
23
taxpayer and an unrelated foreign corporation was onefifth the rate the taxpayer was paying to the trademark
licensing subsidiary.
The Commissioner also
determined that, even if the royalties reflected arm’slength rates, the deduction would not be sustainable.
The taxpayer used the intangibles as collateral for
outside financing, even after they were transferred to
the licensing subsidiary, and there were no standards in
place for quality control of the intangibles.
h.
B.
Virginia: The Department of Taxation has ruled that
an accounts receivable factoring company was properly
consolidated with related corporations for Virginia
corporate tax purposes. Rulings of Commissioner, P.D.
03-56, 03-57 (Aug. 8, 2003). The Department found
that the factoring transactions were not conducted in
accordance with arm’s-length terms and the factoring
company lacked economic substance. The Department
noted that the collection activities with respect to
outstanding receivables were performed by the taxpayer
even after transfer of the receivables to the factoring
company, and concluded that the $1,000 fee paid by the
factoring company to the taxpayer for collection and
administration services was inadequate to cover the
costs of collection. The Department also cited the lack
of arm’s length dealing in intercompany loans between
the taxpayer and the factoring company, such as the
lack of actual payments, the absence of nonpayment
penalties, and the fact that the loans were not
collateralized.
Tax Base and Credits
1.
Tax Base
a.
California: Legislation has been enacted that amends
Cal. Rev. & Tax. Code § 23051.5(e)(3) to provide that
federal elections made prior to becoming a California
taxpayer will be binding for California tax purposes and
that taxpayers cannot make a separate California
election unless the separate election is expressly
authorized under California law. S.B. 1065 (Sept. 22,
2003). Conversely, a taxpayer cannot make an election
for California purposes if it did not make the election
for federal purposes prior to becoming a California
24
taxpayer, unless the separate election is expressly
authorized under California law. The legislation does
not, however, eliminate the right of existing California
taxpayers to file separate elections with the Franchise
Tax Board (FTB) under Cal. Rev. & Tax. Code §
23051.5(e)(3)(A). Thus, the legislation appears to
preserve the right of taxpayers to opt in or out of federal
elections, such as IRC § 338(h)(10) and 338(g), without
regard to their federal tax treatment of the underlying
transactions. The legislation states that it codifies
existing FTB practice.
2.
Deductions
a.
California: The State Board of Equalization has
disallowed a portion of a taxpayer’s interest expense
deduction as attributable to nontaxable income under
Cal. Rev. & Tax Code § 24425. American General
Realty Investment Corp., No. 156726 (Jun. 25, 2003).
The income was the dividend from the taxpayer’s
insurance subsidiary (which was properly excluded
from the combined group). The SBE upheld the
disallowance of a portion of the unitary group’s total
interest expense based on the ratio that the nontaxable
insurance subsidiary dividend bore to the taxpayer’s
entire gross income. Following Appeal of Zenith
National Insurance Corp., 98-SBE-001, the SBE
applied federal Revenue Procedure 72-18, which
clarifies expense disallowance for IRC § 265 purposes.
The SBE noted that under Rev. Proc. 72-18, if a
taxpayer assumes debt and owns assets that generate
nontaxable income at the same time, there is an
inference that the purpose of the debt is, in part, to
generate nontaxable income because the taxpayer could
sell its nontaxable income bearing asset to fund its
business needs, rather than incurring debt for working
capital purposes. The SBE ruled that the taxpayer
failed to establish a non-tax business purpose sufficient
to rebut this presumption, concluding that it preferred to
incur debt rather than sell the insurance company stock.
b.
New York: An administrative law judge with the
Division of Tax Appeals has held that an adjustment to
a taxpayer’s net income also reduced its subsequent net
operating loss (NOL) carryfoward deductions. Petition
25
of New York Funeral Chapels, Inc., No. 818854 (Jul. 3,
2003). Under audit, the taxpayer had agreed to an
adjustment reducing its intercompany management fee
and interest expenses. This adjustment took the
taxpayer from an NOL position to a net income position
for the audit years, and its subsequent NOL
carryforward deductions were reduced accordingly.
The ALJ noted that even though the taxpayer agreed to
the adjustment, an $8 million adjustment indicated that
the taxpayer’s income was distorted and warranted
adjustment. The ALJ also rejected the taxpayer’s
argument that IRC § 172 must be applied for New York
tax purposes. N.Y. Tax Code § 208(9)(f) defines an
NOL to be “presumably” the same as a taxpayer’s NOL
under IRC § 172. The ALJ held that the auditor’s valid
exercise of its discretionary authority to adjust the
taxpayer’s expenses was sufficient to overcome the
presumption of conformity to the federal NOL.
3.
Credits
a.
Connecticut: A Connecticut Superior Court has ruled
that the corporate partners of a partnership operating in
Connecticut were entitled to utilize an income tax credit
that would have inured to the partnership if it had been
a taxable entity. Bell Atlantic NYNEX Mobile, Inc. v.
Commissioner of Revenue Services, No. CV 010511279S (Jul. 17, 2003). The credit was a corporation
business tax credit for personal property taxes paid on
certain types of electronic data processing equipment
(computers, printers, and similar property). The court
concluded that since business tax credits may be
separately stated items for federal tax purposes, the
Connecticut credit should maintain its identity and be
passed through to the corporate partners as a credit for
Connecticut corporation business tax purposes.
b.
New York: A recently issued ruling implies that outof-state manufacturing activities may be taken into
account in determining eligibility for a credit available
to manufacturers. TSB-A-03(6)C, (Jun. 11, 2003).
Under New York law, an industrial or manufacturing
business (IMB) may take a corporate income tax credit
for certain New York utility taxes paid by it, or passed
through to it, for the use of gas, electricity, steam,
26
water, or refrigeration in the state. The taxpayer was
headquartered in New York, but all its manufacturing
activity was located in Connecticut. The ruling stated
that the IMB determination is based on a corporation’s
entire business within and without New York.
c.
North Carolina: The Tax Review Board has ruled that
machinery and equipment placed into service at a
taxpayer’s North Carolina research and development
facility was eligible for a William S. Lee franchise tax
credit for manufacturing equipment. Admin. Decision
No. 410, N.C. Tax Review Board (Jul. 22, 2003). The
credit is applicable to machinery and equipment used in
manufacturing,
processing,
warehousing
and
distribution, or data processing. The ruling does not
explain why the credit was disallowed on audit,
although it appears to have been based on the use of the
property for R&D purposes, rather than the direct
manufacturing of the taxpayer’s goods. The ruling
concluded that the R&D activities conducted by the
taxpayer in North Carolina were necessary, inseparable,
and integral parts of the taxpayer’s primary business of
manufacturing. The ruling did not state whether actual
manufacturing was conducted in North Carolina or
another state(s); nor did it specify that in-state
manufacturing was required to claim a credit for R&D
equipment.
d.
Oregon:
Recently enacted legislation expands
eligibility for the income tax credit for qualified
research expenses and raises the maximum credit. H.B.
3183 (Aug. 29, 2003). Under existing law, a taxpayer
was only eligible for the credit if it was engaged in the
fields of advanced computing, advanced materials,
biotechnology,
electronic
device
technology,
environmental technology or straw utilization. The
statute was amended to delete all references to those
particular industries. Thus, the legislation removes the
restriction of the credit to high-tech businesses and
allows taxpayers engaged in other industries, such as
manufacturing, to claim the credit. In addition, the
legislation increases the maximum credit to $750,000
from $500,000. The amendment is effective for tax
years beginning on or after 2006.
27
C.
Allocation and Apportionment
1.
Indiana: A recent administrative ruling provided that, because
a limited partner is not permitted to exercise control over a
partnership in which it holds an interest, that interest could not
be considered operational for apportionment purposes. Letter
of Findings 00-0379 (Ind. Dept. of State Rev. Feb. 1, 2004).
Accordingly, pursuant to the rationale of the ruling, all gains
and losses held by limited partners should be considered
nonbusiness income. This ruling involved a loss incurred by a
limited partner; therefore the ruling was not favorable for this
particular taxpayer. However, if applied to non-Indiana-based
taxpayers with limited partnership interests, the ruling could
result in favorable allocation treatment of partnership income.
2.
Massachusetts: The Supreme Judicial Court has upheld an
Appellate Tax Board ruling that the gain realized by a
corporation on the sale of a subsidiary was not subject to tax.
The court also upheld the ATB’s imposition of the step
transaction doctrine to negate a transfer of intangibles prior to
the sale of a second subsidiary. General Mills, Inc. v.
Commissioner of Revenue, SJC-08935 (Sept. 15, 2003). In the
first transaction, the court held that the taxpayer, a food
products manufacturer, was not required to include the gain
from the sale of an apparel subsidiary in its apportionable tax
base because the subsidiary was not unitary with the taxpayer.
The court noted that there was no day-to-day management of
the subsidiary, despite some overlapping directors. The
taxpayer did provide limited administrative support with
respect to major capital funding decisions; however, this was
insufficient to establish centralized management. The court
also found that the subsidiary’s ability to borrow from the
taxpayer on demand did not establish a flow of value where all
intercompany transactions were conducted at arm’s-length.
3.
Massachusetts: The Massachusetts Court of Appeals has held
that capital gains earned by an out-of-state chemical
manufacturer from the sale of stock in several subsidiaries were
not subject to the corporate excise tax. W.R. Grace & Co. v.
Commissioner of Revenue, No.00-P-254 (Jul. 2, 2003). The
court’s ruling partially upholds a decision of the Appellate Tax
Board. W.R. Grace & Co. v. Commissioner of Revenue, Dkt.
No. F239586 (Nov. 19, 1999). The court ruled, under an AlliedSignal analysis, that the subsidiaries and the taxpayer were not
unitary. The subsidiaries and the taxpayer were engaged in
28
different lines of business, and the taxpayer did not exercise
actual managerial control over the subsidiaries, although it did
exercise supervisory oversight. The court held that the
taxpayer’s oversight did not establish centralized management
and did not exceed the supervision a corporation would exert
over an investment in a subsidiary. Furthermore, shared
services, including cash management, were provided under
arm’s length terms. However, the court held that intercompany
transactions undertaken at arm’s length do not result in a flow
of value sufficient to establish unity.
4.
Missouri: The Administrative Hearing Commission has ruled
that a taxpayer could exclude (i.e., allocate) intercompany
interest income from its Ohio-based parent in the calculation of
taxable income subject to apportionment. Medicine Shoppe
International, Inc. v. Director of Revenue, No. 02-1071 RI
(Dec. 23, 2003). The interest was attributable to an investment
agreement between the taxpayer and its parent corporation,
involving a daily sweep of the taxpayer’s cash accounts and
investment by the parent of funds that exceeded the taxpayer’s
business needs. The taxpayer had no control over the
investment of the funds, although it was entitled to draw down
on the investment account at any time (it never did). The
taxpayer reported its Missouri tax using the single-factor
method, in which the numerator of the factor is calculated as
the sum of the taxpayer’s Missouri sales plus fifty percent of its
sales partially within and partially without Missouri. Since the
taxpayer did not materially participate in the investment of the
funds and had no control over them, the Commission held that
the income was attributable to a passive investment with no
connection to Missouri. Despite the close relationship between
the taxpayer and the parent, the Commission rejected the
Director’s “attributional”/alter ego type argument that the
taxpayer should be deemed to have actively participated in the
investment of the funds. Citing to Acme Royalty Co. v.
Director of Revenue, 96 S.W.3d 72 (Mo. banc 2002), the
Commission stated that the companies were distinct business
entities, and the investment agreement had a legitimate
business purpose other than tax avoidance.
29
D.
Apportionment Issues
1.
Sales Factor Composition
a.
California: The Franchise Tax Board has issued a
legal ruling stating that dividends should be excluded
from a taxpayer’s sales factor unless it participates in
the management or operations of the distributing
company. Legal Ruling 2003-3 (Dec. 4, 2003). The
ruling addresses apportionable dividends distributed by
a non-member the taxpayer’s combined reporting
group.
The FTB cited California statutes and
regulations (which are based on UDITPA/MTC
regulations) which provide that: 1) the mere holding of
an intangible is not an income producing activity; and,
2) income not readily attributable to a specific income
producing activity is excluded from the numerator and
denominator of the sales factor. Although many states
have similar apportionment language, this “throwout”
rule is not commonly enforced in other states, in this
context. While some states exclude certain types of
passive income from the sales factor, many would
include business income dividends in the sales factor
and source the income to the recipient’s commercial
domicile. The ruling also specifies that exercising
voting rights, receipt or review of material normally
sent to stockholders, and accounting for the receipt of
dividend income would not be sufficient to establish
participation, whereas representation on the distributing
company’s board of directors or involvement in its
business decisions may suffice.
b.
Louisiana: The Department of Revenue has ruled that
the federal gasoline excise tax should be included in the
sales factor for income and franchise tax purposes.
Rev. Ruling No. 03-005 (Aug. 22, 2003). Unlike
UDITPA, where the sales factor is based on gross
receipts, the Louisiana sales factors are based on “net
sales.” Nevertheless, the Department ruled that the
incidence of the federal gasoline excise tax is on the
seller, rather than the purchaser and held that, if sellers
pass the tax on to consumers in separately stated
charges, the tax should be included in the sales factor
for both income and franchise tax purposes.
30
2.
c.
Ohio: Recently enacted legislation excludes certain
types of income from the sales factor and changes the
sourcing rules for Ohio franchise and corporate income
tax purposes. 2003 H.B. 127 (Dec. 11, 2003). H.B.
127 requires that receipts from and/or gains and losses
attributable to: (1) dividends and distributions; (2)
interest; (3) and other “excluded assets” must be
excluded from both the numerator and the denominator
of the sales factor. Excluded assets are defined as
capital assets or IRC §1231 assets (both of which were
already excluded from the sales factor for Ohio
apportionment purposes) as well as intangible property
other than trademarks, patents (and similar assets).
Thus intellectual property related receipts remain in the
Ohio sales factor. The legislation states that it is
effective immediately. According to Ohio case law, the
changes contained therein should not impact taxpayers
with taxable years ending prior to the date of enactment.
However, taxpayers with taxable years ending on or
after the date the legislation was signed, December 11,
2003, should apply the changes retroactively for the
entire taxable year.
d.
Wisconsin: Recently enacted legislation will phase in a
single sales factor apportionment formula over the next
five years. S.B. 197 (Jul. 31, 2003). Under current law,
Wisconsin employs a three-factor formula with a
double weighted sales factor. Under S.B. 197, the
apportionment formula will continue to be based on a
double weighted sales factor until tax years beginning
in 2006, at which point the sales factor will be weighted
at 60 percent. The sales factor will increase to 80
percent in 2007 and will be fully phased in for tax years
beginning on or after January 1, 2008.
Sales Factor Sourcing Issues
a.
New York: A recent administrative ruling rejected a
taxpayer’s attempt to source royalty income based on
the location where the licensees manufactured the
property that used the taxpayer’s intellectual property,
rather than the business address of the licensee. Matter
of Disney Enterprises, Inc., DTA No. 818378 (Feb. 12,
2004). Since much of that property was manufactured
outside the U.S., the position sought by the taxpayer
31
would have resulted in significant factor dilution. The
ALJ concluded that, since royalties were calculated
based on the licensees’ sales of products that used the
taxpayer’s intellectual property, the location of the
manufacturing activity was irrelevant to the taxpayer’s
income stream. The ALJ noted that, while the most
accurate method of sourcing would be based on the
location of the sales underlying the royalties, in the
absence of this information, the licensees’ business
addresses were a sufficient substitute.
b.
Ohio: Recently enacted legislation excludes certain
types of passive income from the sales factor and shifts
the state from a cost of performance approach to a
market state rule with regard to apportionment of
certain receipts. 2003 H.B. 127 (Dec. 11, 2003). Prior
to enactment of the legislation, sales other than sales of
tangible personal property were sourced based on the
location of the income producing activity, as measured
by the seller’s costs of performance. H.B. 127 repeals
the income producing activity/cost of performance rule
and replaces it with specific rules regarding the
sourcing of intangibles and services. Under the
legislation, receipts from intellectual property
(trademarks, tradenames, etc.) are sourced to Ohio to
the extent that the receipts are based on use of property
or the right to use the property in the state, and receipts
attributable to services will now be sourced to Ohio on
a pro rata basis, to the extent the services are used by
the purchaser in Ohio or the benefit of the services are
received by the purchaser in Ohio. The legislation
explicitly states that the physical location where the
purchaser uses or receives services shall be paramount
in determining the proportion of the benefit attributable
to Ohio. The legislation states that it is effective
immediately. According to Ohio case law, the changes
contained therein should not impact taxpayers with
taxable years ending prior to the date of enactment.
However, taxpayers with taxable years ending on or
after the date the legislation was signed, December 11,
2003, should apply the changes retroactively for the
entire taxable year.
c.
Virginia: The Department of Taxation has ruled that a
company commercially domiciled and headquartered in
32
Virginia was not required to include income from the
sale of manufacturing contracts sold in conjunction with
the sale of the taxpayer’s manufacturing division in the
numerator of its Virginia sales factor. Ruling of
Commissioner P.D. 03-78 (Nov. 3, 2003). Under
Virginia’s long-standing interpretation of the cost of
performance rule, income from intangibles and services
are sourced to the state when the costs of performance
in Virginia exceed the costs of performance outside
Virginia. The Department concluded that although
approval of the sale of the division occurred at the
taxpayer’s Virginia headquarters, the negotiation and
closing of the sale occurred in the purchaser’s state, and
the due diligence and accounting functions performed
in connection with the sale occurred in the state where
the facility was located. However, the ruling did
conclude that interest earned by the taxpayer’s divisions
located outside the state and patent royalties earned by
the manufacturing division were attributable to the
taxpayer’s Virginia domicile.
3.
“Gross Versus Net”
a.
California: The Sacramento County Superior Court
has ruled that a taxpayer could not include the return of
principal from investments in short-term securities in
the denominator of its California sales factor. Toy "R"
Us, Inc. v. Franchise Tax Board, No. 01AS04316 (Aug.
21, 2003). The court held that the receipts were not
derived from the “sale” of anything. The court
characterized the taxpayer’s short-term investment
activity as an ancillary service of loaning out
temporarily unneeded cash in return for interest. The
court also explained that the sales factor is designed to
reflect the market for a taxpayer’s goods or services.
As such, the court ruled that, because the return of
principal was not related to the taxpayer’s primary
function of selling toys, it should be excluded from the
sales factor. The also court noted that the inclusion of
the gross receipts in this instance would lead to
unreasonable and absurd results.
The court did
acknowledge that other state courts have held
differently. However, it noted that those states’
legislatures subsequently amended their sales factor
definitions to arrive at the same conclusion to be
rendered by the court in this case. Unlike many of the
33
previous California controversies involving this issue,
the instant case involved a taxpayer seeking a refund
rather than responding to an audit adjustment.
b.
4.
California: A California Superior Court has ruled that
a taxpayer may include gross receipts (rather than net
income) from the sale of marketable securities by its
Washington-based treasury department in the
denominator of its California sales factor. Microsoft
Corp. v. Franchise Tax Board, No. 400444 (Super. Ct.
of City and Cty of San Francisco, Sept. 9, 2003). The
court cited the plain language of Cal. Rev. & Tax Code
§§ 25134 and 25120, which indicate that “sales” for
purposes of the sales factor include gross receipts. The
court also noted that the FTB is currently seeking to
implement changes to the current law that would
require treasury function receipts to be included in the
sales factor on a net basis (i.e., modeled after the MTC
regulation). Based on the fact that the FTB was seeking
this change, the court concluded that existing law must
require the inclusion of Microsoft’s gross receipts from
treasury function investments. The court also held that
the FTB presented no evidence to support an alternative
apportionment formula under Cal. Rev. & Tax Code §
25137.
Property Factor
a.
New York: A recent administrative ruling addressed
the property factor treatment of film masters owned by
a taxpayer. Matter of Disney Enterprises, Inc., DTA
No. 818378 (Feb. 12, 2004). The taxpayer disputed the
valuation of its film masters at cost for property factor
purposes. The film masters, the original versions of the
taxpayer’s classic films, were worth billions of dollars.
However, the ruling concluded that the film masters
could not be included in the property factor at market
value, because the difference between the cost and
market values of the films was attributable to the right
to reproduce the films, which was a “copyright” - - - an
intangible asset which could not be included in the
property factor. The same ruling also provided that the
taxpayer was not entitled to property factor
representation for intangible property licensed to third
34
parties, which generated substantial revenue for the
taxpayer.
5.
Payroll Factor
a.
6.
Pennsylvania: The Commonwealth Court has held that
a taxpayer could not include a payroll factor in its
apportionment formula for corporate net income or
franchise tax purposes where all business of the
taxpayer was conducted by employees of affiliated
companies and independent contractors. UPS
Worldwide Forwarding, Inc. v. Commonwealth of
Pennsylvania, Nos. 62-65 F.R. 2001 (Pa. Commw. Ct.
Mar. 1, 2004). The taxpayer recorded payroll expenses
related to employees furnished by an affiliated
corporation; however, it had no written employment
agreement with the corporation. Furthermore, the
taxpayer had stipulated that it had “no employees.” The
court noted that “compensation” is defined for payroll
factor purposes as amounts paid to “employees.” Since
the taxpayer stipulated that it had no employees, it had
no compensation and thus had a zero payroll factor
denominator (i.e., no payroll factor).
The court
distinguished a Pennsylvania Supreme Court decision
with a similar fact pattern, in which furnished personnel
were found to be employees, there was a written
employment agreement between the affiliates, and the
taxpayer controlled the employees.
Other
a.
New York: A transaction treated by a taxpayer as a
financing arrangement was recast as an actual sale
requiring sales and property factor representation.
Petition of CS Integrated, LLC, LLC, DTA No. 17548
(Tax App. Trib. Nov. 20, 2003). The taxpayer operated
a warehouse in which food retailers stored their
inventory.
In order to assist a customer that
experienced financial difficulty, the taxpayer purchased
the customer’s inventory and resold it to the customer at
cost plus a carrying charge, rather than merely lending
money to the customer. An ALJ had ruled that the
transactions constituted a financing agreement, rather
than an actual purchase and sale of inventory. Since the
ALJ had found that the taxpayer did not actually
35
purchase the customer’s inventory, it was not required
to include it in its property factor. On appeal, the
Tribunal concluded that the transaction was an actual
sale, and thus must be reflected in both the sales and
property factors. The Tribunal noted that several
indicia of a sale were present: the taxpayer took legal
title and possession of the inventory and bore risk of
loss while it owned the inventory. The Tribunal also
ruled that the sales factor must include the gross
proceeds from the sale of the inventory rather than the
net income (i.e., the carrying charge). There is some
conflicting guidance on this issue in New York.
E.
Filing Methods
1.
Inclusion in the Unitary Business Group
a.
California: Recent legislation changes the water’sedge election, effective for taxable years beginning on
or after January 1, 2003, from a contractual election to
a statutory election. S.B. 1061 (Sept. 30, 2003). Under
new Cal. Rev. & Tax. Code § 25113, the water’s-edge
election will now be made by filing a timely return in
which tax is computed by including the income and
apportionment factors of the members of the water’sedge unitary combined reporting group and by using an
election form to be prescribed by the FTB. While the
election must still be made by all members of the
group, the failure of one or more members to make the
election will not forfeit the election for the entire
group, as long as the parent corporation includes the
non-electing members’ incomes and factors in its
combined report. The period of the water’s-edge
election remains eighty-four months. Taxpayers with
existing contractual elections will be “switched” to the
§ 25113 election procedures, although the start date of
their elections will be maintained for purposes of
computing the eighty-four month period. An election
under the new provisions may be terminated without
approval of the FTB at the end of eighty-four months
usage. Early termination may be obtained with the
consent of the FTB. Taxpayers that terminate their
elections (with or without the consent of the FTB)
cannot re-elect water’s-edge reporting for another
36
eighty-four months, although this restriction may be
waived by the FTB for good cause.
b.
California: The State Board of Equalization has ruled
that three U.S. members of a multinational
conglomerate were not unitary with their foreign
grandparent corporations, and granted the taxpayer’s
refund request. Appeal of Conopco, No. 129732 (Aug.
6, 2003). The ruling provided no analysis on the part of
the SBE, but did set forth the positions of both the
taxpayer and the FTB. The taxpayer’s arguments
against unity focused on the autonomous nature of the
U.S. subsidiaries, claiming that oversight by the foreign
parents was limited to stewardship activities, such as
appointing top managers and approving budgets. The
taxpayer also noted the absence of centralized
administrative functions (other than limited common
research activities), arm’s-length intercompany
transactions, minimal intercompany transfers of
personnel, and the production of defined brands and
products by the U.S. subsidiaries. The FTB claimed
that there was central policy-making coordination, an
extensive research and development network, shared
knowledge and expertise, and an integrated
management network aided by an organization-wide
management training college.
Apparently, the
taxpayer’s position was ultimately more persuasive.
c.
Illinois: The United States Court of Appeal for the
Seventh Circuit has held that a taxpayer must exclude
an affiliate that was engaged in a different line of
business from its unitary group. In re: Envirodyne
Industries, Inc., No. 02-1632 (Jan. 6, 2004). The matter
came to the court on appeal from a bankruptcy court
ruling. That ruling involved a claim filed by the Illinois
Department of Revenue for additional taxes assessed
after excluding the affiliated loss company from the
taxpayer’s Illinois unitary combined reporting group.
The in-state taxpayer and the loss company were
engaged in two different lines of manufacturing, food
packaging materials and steel, but both were owned by
the same parent corporation. The court depicted the
two entities as spokes of the same wheel without a rim
(i.e., the parent corporation). The court noted that the
parent was functionally integrated with each of the two
37
lines of business but that the two companies were not
integrated with each other. The court also stated that
the companies were not dependent on and did not
contribute to each other, even though the dependency
and contribution test was satisfied by each company
with respect to the parent. While the decision could
have favorable implications for some taxpayers, there is
existing, binding Illinois case law that may be seen as
inconsistent with this holding.
2.
Issues Involving 80/20 Companies
a.
3
Illinois: An Illinois appellate court has held that two
foreign intangible holding companies must be included
in a taxpayer’s Illinois combined report. Zebra
Technologies Corp. v. Topinka, No. 1-01-2861, 1-020386 (Ill. Ct. App. 1st Div. Aug. 11, 2003). The ruling
upheld a lower court decision that the taxpayer’s two
Bermuda subsidiaries, established to hold and license
the taxpayer’s trademarks and other intellectual
property, failed to qualify for the statutory “80/20”
exclusion from the Illinois combined reporting group.
All the subsidiaries’ property and their sole employee
were located in Bermuda. However, the court held that
less than 80 percent of the subsidiaries’ payroll was
located outside the U.S., because the taxpayer had
retained responsibility for the quality control of the
subsidiaries’ intellectual property and performed quality
control activities in Illinois, at no cost. The court
upheld the lower court’s imputation of the taxpayer’s
activities to the subsidiary to cause the subsidiaries to
fail the 80/20 test. Interestingly, the court agreed with
the lower court that the subsidiaries were formed for a
genuine economic purpose. Nevertheless, since the
80/20 exception was not otherwise satisfied, the
economic substance of the subsidiaries was not
determinative of the issue.
Special Industries
a.
New York: The Department of Taxation and Finance
has ruled that a bank subsidiary’s 1985 election to be
taxed under the corporation franchise tax article would
terminate if it reincorporated in another state in a
transaction that qualified for tax-free treatment under
38
IRC § 368(a)(1)(F). TSB-A-03(12)C (Nov. 6, 2003).
For New York tax purposes, corporations subject to the
bank tax under Article 32 were permitted to make a
one-time election for their 1984 taxable years if they
wished to continue paying tax under Article 9-A, the
general corporation franchise tax. The Department
ruled that reincorporation in another state would
terminate the taxpayer’s one-time election because the
transaction would cause the dissolution of the electing
taxpayer and the formation of a new corporation to
which the election would not carry over.
The
Department relied on IRC §368 and accompanying
regulations, which characterize “F reorganizations” as
involving two distinct corporations.
F.
Franchise and Net Worth Taxes
1
Louisiana: A Louisiana appellate court has held that payments
made by a taxpayer under numerous long-term lease
agreements did not constitute “borrowed capital” includable in
the franchise tax base. System Fuels, Inc. v. Dept. of Revenue,
No. CA 1723 (La. Ct. App. 1st Cir. Jun. 27, 2003). Borrowed
capital includes all long-term (greater than one year)
indebtedness of a corporation. The leases at issue involved
long-term rentals of fuel oil storage facilities and oil transport
vessels. The court held that the leases were true leases, rather
than financing leases, despite the inclusion of purchase options
in the contracts. The court noted that the purchase options
were based on fair market value rather than a bargain or
nominal price. The court declined to hold that all transactions
lacking a transfer of title of property should be excluded from
borrowed capital (in line with the lower court decision), but did
state that true leases that are not disguised credit sales would
not be considered borrowed capital. The court also rejected the
Department’s attempt to pull the leases into the franchise tax
base as “indebtedness,” based on the inclusion of unconditional
payment clauses in the rental contracts (hell or high water
clauses), explaining that the clauses were not truly
unconditional, because the lessor must still perform certain
obligations under the lease agreements.
2
Louisiana: An appellate court has held that lease obligations,
involving sale/leaseback arrangements, were not includable in
the franchise tax base. Entergy Louisiana, Inc. v. Dept. of
Revenue, 2003 CA 0166 (La. Ct. App. 1st Cir. Jul. 2, 2003).
39
The taxpayer sold a nuclear generating facility and leased it
back from the purchaser. The court held that the sale/leaseback
constituted a genuine lease, rather than a disguised credit sale.
The court noted that ownership was legally transferred and,
even though the taxpayer had a purchase option, it required the
taxpayer to pay the fair market value of the property. The
court’s rationale, while favorable to the taxpayer, contrasts with
the widely accepted treatment of sale/leaseback transactions in
other tax contexts. Whereas the court has held that the
sale/leaseback was not a disguised credit sale, most states that
have ruled on this issue have held that sales and use tax is not
due on sale/leaseback transactions, precisely because they are
financing vehicles rather than true leases.
3.
Missouri: The Missouri Supreme Court has held that three
investment holding companies could not apportion their
Missouri franchise tax bases because they employed no assets
outside the state. TSI Holding Co. v. Director of Revenue, Nos.
SC85179-81 (Nov. 4, 2003). The entities had no presence and
conducted no business activities outside Missouri.
For
Missouri franchise tax purposes, apportionment is based on the
percentage of a taxpayer’s accounts receivable, inventory, and
fixed assets employed in the state. The taxpayers, investment
companies, did not have any of the assets that are used to
determine franchise tax apportionment. Accordingly, the
taxpayers attempted to use an alternative apportionment
formula that apportioned their franchise tax bases according to
the location of their investments. Rejecting, the taxpayers’
apportionment methodology, the court explained that the right
to apportion is based on where a taxpayer’s assets are
employed, rather than where located. The court distinguished
Union Electric Co. v. Morris, 222 S.W.2d 767 (Mo. 1949), in
which a company's right to apportion was premised on
ownership of two Illinois subsidiaries. In Union Electric, the
court focused on the fact that the Illinois subsidiaries were
wholly owned and thus controlled by the taxpayer, leading to a
conclusion that the taxpayer conducted business (via the
subsidiaries) outside the state. The court’s decision, the first in
approximately forty years to address the issue of employment
of capital, upholds a Missouri Administrative Hearing
Commission ruling issued several months earlier. TSI Holding
Co. v. Director of Revenue, No. 01-1828 RV (Mar. 4, 2003).
40
IV. LLCs and Other Pass-Through Entities
A.
Conformity to the federal “check-the-box” regulations:
State
Alabama
Arizona
Arkansas
California
Connecticut
Delaware
District of Columbia
Florida
Georgia
Hawaii
Idaho
Illinois
Indiana
Iowa
Kentucky
Maine
Maryland
Massachusetts
Michigan
Minnesota
Mississippi
Missouri
Montana
Nebraska
New Hampshire
New Jersey
New York
North Carolina
North Dakota
Ohio
Oregon
Pennsylvania
South Carolina
Tennessee
Utah
Vermont
Virginia
Wisconsin
Conformity
X
X
X1
X
X
X
X2
X
X
X3
X
X
X
X
X
X
X
X
X
X4
X
X
X
X
Non-Conformity
Partial Conformity
X5
X
X
X
X
X
X
X
X
X6
X
X
X
X
41
1
Arkansas Code Ann. section 4-32-1313 was amended to provide that, for Arkansas
income tax purposes, an LLC will be taxed consistently with its federal tax
classification. H.B. 1959, signed March 31, 2003, effective for tax years beginning
on or after January 1, 2003.
2
An SMLLC is not subject to the unincorporated business franchise tax as long as it is
owned by an entity subject to D.C. tax.
3
Hawaii conforms to the federal “check-the-box” regulations, but does not adopt the
disregarded entity treatment of SMLLCs for the general excise tax. Hawaii Dep’t of
Tax., Tax Information Release No. 97-4 (Aug. 4, 1997). In addition, license and
registration requirements will still be applied at the entity level.
4
An election by a foreign (non-U.S.) single member eligible entity to be disregarded
will not be respected for Minnesota purposes because Minnesota law precludes the
inclusion of the apportionment factors and income of foreign entities in the Minnesota
unitary combined group. Minn. Dep’t of Revenue, Revenue Notice No. 98-08 (May
28, 1998).
5
An LLC’s federal classification under “check-the-box” will generally be respected;
however, single member LLCs are not disregarded for New Hampshire tax purposes.
N.H. Admin. Code R. 307.01. All LLCs remain subject to the New Hampshire
Business Profits Tax.
6
Legislation enacted during 1999 (H.B. 1676/S.B. 1806) broadened the Tennessee
excise and franchise tax to cover limited liability entities, including all LLCs, LLPs,
and LPs engaged in business in the state.
B.
Alabama: The Chief Administrative Law Judge for the Alabama
Department of Revenue has ruled that Alabama tax could not be
imposed on a nonresident individual that owned an interest in a limited
partnership conducting business in the state. Lanzi v. State of Alabama
Department of Revenue, No. 02-721 (Sept. 26, 2003). The ruling
involved tax years prior to 2001, the year in which Alabama began
imposing a nonresident withholding obligation on limited liability
entities (LLEs) doing business in the state. The ALJ’s decision was
based on Due Process considerations. Citing Alabama’s adoption of
the entity theory of partnerships, the ALJ held that the LP’s activities
and presence in the state could not be attributed to an out-of-state
investor. The ALJ distinguished the imposition of tax in this setting
from an International Harvester situation in which a withholding tax is
imposed on the in-state entity (which is consistent with Alabama’s
current LLE taxing scheme). The decision was not based on
Commerce Clause nexus. However, the ALJ did note that, while
previous Alabama administrative decisions (Cerro Copper and Dial
42
Bank) applied Quill’s physical presence test in the context of income
taxes, the ALJ noted his personal belief that he may have changed his
position on the issue of whether Quill applies outside of the sales and
use tax context.
C.
New York: An administrative law judge with the Division of Tax
Appeals has ruled that an S corporation shareholder was not required
to divide his capital gain from the sale by the S corporation of its assets
on a prorated basis between his periods of residency and nonresidency
for New York personal income tax purposes. Petition of Falberg, DTA
818960 (Oct. 9, 2003). The taxpayer changed his residency from New
York to Florida on July 20, 1997. The sale of the S corporation’s
assets occurred on July 31, 1997. Under New York law, residents are
subject to tax on their income in its entirety, while nonresidents are
only subject to tax on income from New York sources. A nonresident
S corporation shareholder sources the distributive share income based
on the S corporation's New York sourcing, as reported to the
shareholder. The audit division prorated the gain between the
taxpayer’s periods of residency and nonresidency, even though the gain
was generated during the period of nonresidency. Accordingly, the
prorated portion of the gain attributable to the period of residency
(January 1, 1997, through July 20, 1997) was taxed in full, rather than
subject to tax based on the taxpayer’s application of the S
corporation’s 10.4 percent business allocation percentage. The ALJ
ruled that the taxpayer has the option of prorating the income or
reporting it in accordance with its residency/nonresidency status on the
actual date of receipt. Since the taxpayer’s income was earned after
leaving the state, the ALJ ruled that the taxpayer could -- as had been
reported -- assign the entire gain to the period of nonresidency. It
appears that the ALJ departed from the "always-prorate" rule
enunciated by the TSB-M-00(1). However, the decision is not
precedential.
D.
New York: The state’s highest court, reversing an appellate decision,
has held that payments made to retired partners could not be deducted
for New York City unincorporated business tax purposes. Buchbinder
Tunick & Co. v. Tax Appeals Tribunal, No. 84 (Jun. 26, 2003). The
payments, which were made to extinguish the partners’ ownership
interests in the partnership, were calculated based on unrealized
receivables. Pursuant to New York City regulations, a partnership
cannot deduct payments to partners for services rendered. The court
ruled that the retirement payments were attributable to services
rendered, rejecting the lower court’s finding that the payments
represented a share of partnership revenue.
43
V.
Sales and Transaction Taxes
A.
Software, Telecommunications, and Digital Goods and
Services
1.
Massachusetts: A recent amendment to the computer industry
services and products regulation impacts resale exception
claims by computer service contract providers. 830 CMR
64H.1.3 (amended Dec. 19, 2003). The amended regulation
provides that a computer service contract provider that pays tax
on the purchase of tangible personal property but eventually
resells the property and collects tax from its customer must
present the vendor with a resale certificate and request refund
directly from the vendor (the vendor must then go to the state
for abatement of the tax remitted). Previously, a service
contract provider could claim a credit on a subsequent sales and
use tax return in order to recover the extra tax. This new policy
applies retroactively to sales or use taxes paid on or after
January 1, 2001.
2.
Minnesota: The Minnesota Tax Court has ruled that threedimensional images provided to customers via CD-ROM,
diskette, and videotape, were tangible personal property subject
to tax. Dynamic Digital Design, Inc. v. Commissioner of
Revenue, No. 7380-R (Jan. 14, 2004). The taxpayer developed
and designed interactive computer programs, animations, and
images that communicated technical information about its
customers’ products, designs or concepts. The court noted that
the boundaries of tangible personal property are still being
defined in Minnesota, with at least two cases involving this
issue currently pending before the Minnesota Supreme Court.
The court analyzed the taxability of the images by reference to
two existing Minnesota Supreme Court decisions, Fingerhut
Products Co. v. Commissioner of Revenue, 258 N.W.2d 606
(Minn. 1977) and Zip Sort, Inc. v. Commissioner of Revenue,
567 N.W.2d 34 (Minn. 1997), that distinguished customer lists
(intangibles) from labels, preprinted addresses and other items
(tangible), all transferred by tangible means. The court
concluded that the CD-ROMs, diskettes, and videotapes on
which the images were transmitted were usable devices, and
customers were paying for the form, in addition to purchasing
the images. The court did acknowledge that if the images had
been transferred electronically, they would not have been
subject to tax. Nevertheless, it rejected the taxpayer’s
44
argument that, because the images were capable of electronic
transmission, they were nontaxable intangible property.
3.
Missouri: The Department of Revenue has issued a notice
providing that load and leave transactions will be subject to
sales and use tax. Tax Policy Notice 16: Taxability of
Computer Software Load and Leave Transactions (Mo. Dept.
of Rev. Jan. 9, 2004). The notice explains that the change was
necessitated by the Missouri Supreme Court’s decision in
Kansas City Power and Light Co. v. Director of Revenue, 83
S.W.3d 548 (Mo. banc 2002), in which the court held that
transfer of title was not essential to qualify for a resale
exemption, if the right to use, store, or consume property was
transferred. The decision did not involve computer software,
but rather a utility company’s sales of electricity to a hotel.
The court found that the sales were sales for resale, because the
hotel customers paid tax on the electricity used in conjunction
with their rental of rooms and banquet halls. Based on the
rationale of Kansas City Power and Light, the Department
concluded that load and leave transactions, which involve a
transfer of a right to use property, rather than a transfer of title
to property should be considered “sales at retail.” Accordingly,
such sales are now taxable. The notice specifies that tax must
be collected regardless of whether the purchaser installs the
software and returns the tangible media to the seller or the
seller installs the software and leaves with the tangible media.
4.
Ohio: Ohio Am. Sub. H.B. 95, relaxes the taxation of
software. The legislation, which was designed to bring Ohio
into compliance with the Streamlined Sales and Use Tax
Agreement, and which became effective July 1, 2003, provides
that reasonable separately stated charges for modifications to
prewritten (i.e., canned) software are excluded from tax.
Nevertheless, Ohio Admin. Code § 5703-9-46(A)(7) provides
that charges for modifications to canned software are subject to
tax unless they constitute more than half of the price of the
sale. In response, the Ohio Department of Taxation has issued
guidance explaining that until the regulation is amended,
taxpayers should follow the provisions of H.B. 95, but should
remember that unless modification charges are separately
stated, they will be subject to tax as prewritten software.
Information Release ST 2003-06 (Jul. 2, 2003).
5.
Tennessee: The Tennessee Court of Appeals has held that a
provider of internet and other computer information services
45
was not performing taxable telecommunications services.
Prodigy Services Corp., Inc. v. Johnson, No. M2002-00918COA-R3-CV (Aug. 12, 2003). The company used modems to
provide internet access, e-mail, and other computer information
services to its customers. The term telecommunications
services is defined to include transmission by or through any
media, and contains a nonexclusive list of potentially taxable
services, none of which described the internet services at issue
in the controversy. In finding that the company’s services were
not included in the statute, the court relied on legislative intent,
specifically the 1993 deletion from the statute of “value added
networks” as a specifically identified example of
telecommunications services.
The court found that the
legislature’s action in this regard could be construed as
intended to clarify that electronic information services are not
subject to tax. The court was also influenced by the fact that
the company was not a regulated telecommunications service
provider under Tennessee or federal law. The Tennessee
Supreme Court subsequently declined to hear the Department’s
appeal in this decision.
In response to the court’s decision, the Department of Revenue
has
ordered
all
internet
service
providers and
telecommunications companies to stop collecting tax from
consumers on internet access. Sales and Use Tax Notice 04-03
(Jan. 30, 2004). The Notice explains that ISPs seeking refunds
of taxes collected from consumers on such services must show
that they refunded the tax to their retail customers. In addition,
an ISP must either provide documentation that it paid sales tax
on services originally purchased for resale or, alternatively,
reduce its own refund by the amount of sales taxes it would
have paid if it had not claimed a resale exception. However, an
ISP is not permitted to similarly reduce the refunds owed to its
retail customers for this amount.
6.
Virginia: The Department of Taxation has issued a ruling
addressing the taxability of certain programming, consulting,
travel, and administrative services provided in conjunction with
the sale and modification of software.
Ruling of
Commissioner, P.D. 03-61 (Aug. 19, 2003). Although the
outcome of the ruling was favorable for the taxpayer, the
approach taken by the Department may have broader negative
implications for other taxpayers. The taxpayer had entered into
two separate contracts with the same customer, one for the sale
of prewritten software, and the other a software modification
46
and services agreement. The taxpayer did not collect tax on the
second contract since the contract did not encompass the sale of
tangible personal property. However, citing to common law of
contracts, the Department ruled that the contracts could be
collapsed into a single contract for the sale of the prewritten
software (tangible personal property), because they were
executed on the same day, and the modifications were
necessary to render the software useful to the customer.
Despite the consolidation of the contracts, the Department
ultimately ruled that the services were eligible for a specific
exemption for separately stated charges for software
modification and services.
7.
Wisconsin: The Tax Appeals Commission has ruled that
global application software purchased by a company for use in
operation of its business was exempt custom software.
Menasha Corp. v. Wisconsin Dept. of Revenue, No. 01-S-72
(Dec. 1, 2003). The software cost several million dollars,
contained over seventy modules, and took several years to
implement. Wisconsin distinguishes prewritten and custom
software for sales and use tax purposes. A regulation contains
seven qualitative factors to be examined in characterizing
software that evaluate the complexity and nature of the
software. The Department’s policy has been to require all
seven conditions to be satisfied in order for software to qualify
as custom software, although the regulation does not explicitly
require that all criteria must be met. Prior to this decision,
neither the taxability of this type of software nor the
Department’s interpretation of the regulation had been
addressed in a judicial or administrative law setting, and the
Department traditionally subjected this type of software to tax.
However, the Commission ruled that the software did not need
to satisfy all seven elements of the regulation.
The
Commission weighed the various factors and concluded that,
based on the totality of the circumstances, the software was
custom, noting the cost of the software and the significant
training, testing, and maintenance required to implement the
software. The Commission also explained that the crucial issue
was the process required to implement the software not
whether the software purchased was part of a standard package.
47
B.
Exemptions
1.
Manufacturing
a.
California: Recent legislation places a ceiling on the
sales and use tax manufacturing credit. S.B. 1064
(Sept. 28, 2003). Cal. Rev. & Tax. Code § 6902.2
provided that in lieu of taking a manufacturer’s
investment credit (MIC) against personal or corporate
income taxes, an eligible taxpayer may file a sales and
use tax refund claim in an amount equal to the credit
that could be claimed for income tax purposes. This
provision has recently been the subject of SBE rulings
holding that the sales tax refund could be granted with
respect to unused MIC carryovers S.B. 1064 provides
that the amendments are declaratory of existing law but
are effective for refund claims filed on or after August
7, 2003 (the relevant SBE rulings were issued August 6,
2003). Therefore, the sales tax refund can now no
longer exceed the amount of MIC that would be
allowable for corporate income tax purposes after
application of all other credits. Note, the MIC expired
at the end of 2003.
b.
Louisiana: Recently enacted legislation creates a state
sales and use tax exemption for machinery and
equipment purchased by a manufacturer if used in a
plant facility predominantly and directly in the
manufacture of tangible personal property for sale to
another or manufacturing for agricultural purposes. The
exemption does not apply to the parish level tax. H.B.
2 (Mar. 23, 2004). The exemption will be phased in
over a seven-year period from 2005 through 2011.
Machinery and equipment is broadly defined and
expressly includes several categories of auxiliary
equipments, such as: computers and software that are
an integral part of machinery and equipment used in
manufacturing; pollution control equipment; and certain
testing equipment.
However, the legislation also
clarifies that structural property, HVAC, and property
used to transport or store property are ineligible, and
food preparation is not considered manufacturing. In
order to take advantage of the exemption, a purchaser
must obtain certification from the state that it qualifies
as a manufacturer. While the legislation ultimately
48
provides a benefit many Louisiana purchasers currently
enjoy similar sales and use tax benefits by virtue of
participating in the Louisiana enterprise zone program.
c.
New York: Reversing a previously issued advisory
opinion, the Division of Tax Appeals has ruled that
various pieces of equipment used on the premises of a
retail home improvement chain were eligible for the
production exemption. Matter of Lowe's Home Center,
Inc., DTA No. 819043 (Mar. 11, 2004). N.Y. Tax Law
§ 1115(a)(12) exempts from tax equipment used in the
manufacturing, processing or other production of
tangible personal property for sale. The equipment
involved machines used at the taxpayer’s retail facilities
to cut products to the desired size for customers - timber cutting saws, carpet/vinyl cutting equipment,
pipe threading/cutting equipment, glass cutting
machines, window trim machines and wire measuring
and coiling equipment. The ruling concluded that the
equipment was used to process the property purchased
by the taxpayer’s customers and rejected the Division’s
argument that the property was ineligible for exemption
because it had already entered the distribution phase by
being displayed on the sales floor.
d.
New York: The Department of Taxation and Finance
has issued an advisory opinion finding that purchases of
vacuum, hydrogen, nitrogen, and water cooling systems
were eligible for the manufacturing exemption even
though the various systems were used to treat (i.e., heat,
cool, etc.) the manufacturer’s products rather than
becoming components of the products themselves.
TSB-A-03(27)S (Jun. 24, 2003). Air, water, and gases
used in the systems were found to be used entirely in
manufacturing and integral to the manufacture of the
automotive electronics. Despite the fact that the exhaust
systems did not meet the statutory definition of
pollution control equipment, the systems were held to
be exempt from tax because the product itself would
have been harmed without the operation of the exhaust
system to remove noxious fumes and vapors produced
during the course of the manufacturing process.
Nevertheless, the ruling declined to extend the
exemption to the taxpayer’s HVAC equipment, finding
that it was present for the comfort of the taxpayer’s
49
factory employees rather
manufacturing process.
e.
2.
than
integral
to
the
Tennessee: The Tennessee Court of Appeals has ruled
that the industrial machinery exemption did not apply to
catalysts used by a chemical manufacturer in the
manufacturing process. Eastman Chemical Co. v.
Chumley, No. M2002-02114-COA-R3-CV (Jan. 12,
2004).
The exemption applies to “machinery,
apparatus, and equipment with all associated parts,
appurtenances and accessories.” The court rejected the
taxpayer’s claim that the catalysts were exempt
“apparatus.” The court explained that, taken together,
the terms machinery, apparatus, and equipment were
intended to apply the exemption to connected and
interrelated devices and parts used to carry out the
manufacturing process.
Accordingly, the court
determined that the catalysts at issue were not qualified
machinery, but rather were analogous to such
nontaxable items as fuel used to operate manufacturing
devices or substances use to cool those devices.
Research and Development
a.
New York: Reversing an administrative law judge
ruling, the Tax Appeals Tribunal has held that computer
equipment leased by a company for purposes of
developing a cancer specimen database was not eligible
for the research and development exemption. Petition of
Impath, Inc., DTA No. 818143 (N.Y. Tax App. Trib.
Jan. 8, 2004). The equipment was used to extract
information from data the taxpayer had gathered
through the performance of up to twenty tests each on
thousands of cancer specimens.
The tests were
performed for diagnostic purposes; however, the
taxpayer subsequently collated the information in order
to create a database that could form conclusions and
make predictions regarding future patient diagnoses and
pharmaceutical development. The Tribunal found that
the equipment did not qualify for exemption because
the taxpayer failed to use the equipment to develop a
new product or a new use for an existing product.
50
3.
Intercompany Transactions
a.
4.
Connecticut: Recently enacted legislation provides
that otherwise taxable services cannot be purchased
under a resale exemption, if they will be resold to an
affiliated purchaser. H.B. 6624 (Jul. 9, 2003).
Connecticut provides a statutory exemption for sales of
taxable services between certain related entities. Conn.
Gen. Stat. § 12-412(62). The legislation is designed to
ensure that an intermediary cannot makes a purchase
under a resale exemption of services that would be
exempt on resale under the intercompany exemption.
The legislation becomes effective October 1, 2003.
Other
a.
Florida: A recent ruling provides that gases used to
preserve fish and included in the container in which the
fish is sold qualified for the packaging material
exclusion from sales and use tax. Technical Assistance
Advisement 03A-028 (Jun. 10, 2003). Under Florida
law, sellers are not required to pay use tax on purchases
of packaging items accompanying the sale of their
products if delivery would be impracticable but for the
presence of the products, and there is no separate charge
for the products to the seller’s customers. Fla. Stat. §
2121.02(14)(c). A regulation lists numerous examples
of types of packaging materials that might qualify for
the exclusion.
Fla. Admin. Code § 12A-1.040.
However, the examples focus on types of containers,
rather than accompanying material. The Department’s
ruling demonstrates that the packaging material
exclusion may encompass a broader spectrum of
materials than merely containers, such as materials
placed inside the containers.
b.
Ohio: A recent Ohio Supreme Court decision provides
guidance on the taxability of employment services.
H.R. Options, Inc. v. Zaino, 800 N.E.2d 740 (Ohio Jan.
7, 2004). For Ohio sales and use tax purposes, the
provision of employment services are generally subject
to tax. However, an exclusion from taxation is
available for a contract of one-year or greater between a
service provider and a client, if the contract specifies
that the employees covered by the contract are assigned
51
to the client on a permanent basis. The decision
clarified that a contract between an employment
services provider and its client need not explicitly state
that the furnished employees’ assignments are
permanent. Rather, if an employment contract contains
no ending dates for the employees’ assignments, then
the assignments may be deemed permanent and eligible
for the exception. Nevertheless, the court noted that
even if a contract contains no ending date, the services
would not be eligible for the exception if the facts and
circumstances revealed that the employees were
provided for seasonal employment or to fill short-term
workload conditions. This decision applies only to
employees furnished by unrelated service providers. A
separate exception exists for employment services
between members of an affiliated group.
C.
Resale
1.
D.
Ohio: The Ohio Supreme Court has held that a company
that tested wheels for customers was not required to pay
sales or use tax on its purchases of tires and other
equipment used to test the tire rims, because the equipment
qualified for a resale exemption. Standards Testing
Laboratories, Inc. v. Zaino, No. 98-G-617 (Nov. 12, 2003).
The taxpayer purchased the equipment on behalf of its
customers and did bill them for it; however, the equipment
was, in most cases, not physically transferred to the
customers after use. The Ohio resale exemption requires a
transfer of title and/or possession of property. The court
noted that when the testing company took possession of the
tires and other equipment they were simultaneously
delivered to its customers, thus effecting a valid title
transfer for purposes of the resale exemption.
Other Taxability Issues
1.
Title Passage/Location of Sale
a.
Massachusetts: The Massachusetts Supreme Judicial
Court has ruled that a seller must collect sales tax on
items sold in its Massachusetts stores but picked up by
customers at its retail locations in New Hampshire
(which has no sales and use tax). Circuit City Stores,
Inc. v. Commissioner of Revenue, 790 N.E.2d 636 (Jun.
52
25, 2003). The items were paid for in full in
Massachusetts, and the sales were credited to the
Massachusetts stores and sales people, but the actual
items were “reserved” on the computer at the store
where the purchaser wished to take possession of the
merchandise. The court determined that since under the
Uniform Commercial Code and common law, title may
pass before a purchaser takes actual possession of
goods, title passed in Massachusetts. In contrast, in
Neiman Marcus Group, Inc. v. Commissioner of
Revenue, 26 Mass. App. Tax Bd. Rep. 316 (2001), the
Appellate Tax Board held that Massachusetts sales tax
was not due on sales made in Massachusetts retail
stores which the purchasers requested to be shipped to a
location in another state. The court dismissed the
Neiman Marcus decision as only superficially similar.
2.
Leasing Issues
a.
Florida: The Florida Department of Revenue has
issued a technical assistance advisement which
concludes that a dividend paid by a qualified S
corporation subsidiary (Q-Sub) to its sole shareholder
(S corporation) was actually a rental payment for use of
the S corporation’s building. As such, the dividend was
subject to Florida sales tax. TAA 03A-039 (Jul. 22,
2003). The taxpayer posed two alternatives to the
Department, one in which a lease agreement was
established for the use of the building but did not
require the payment of rent, and the other in which the
Q Sub would use the building without a lease. The
Department ruled that, under either scenario, a dividend
paid by the Q Sub to the S corporation would be taxed
as rent to the extent the dividend was actually paid to
the S corporation. The Department explained that,
because there was real consideration flowing from the
Q Sub to the S corporation, the dividend would be
considered rental compensation.
The Department
distinguished this situation from one in which the
dividend was merely an accounting entry with no actual
value flowing to the shareholder.
53
3.
Other
a.
E.
Maryland: The Maryland Tax Court has held that
federal law preempts the imposition of a use tax
collection obligation on a for-hire carrier that delivered
furniture in the state for a related out-of-state retailer.
Royal Transport, Inc. v. Comptroller of the Treasury,
Nos. 02-SU-OO-0298, 0299 (Oct. 22, 2003). The court
held that the imposition of a use tax obligation on the
delivery company would violate the Interstate
Commerce Act (Act), which prohibits states laws
“related to a price, route, or service of any motor
carrier.” Citing federal case law, the court concluded
that a tax collection obligation could place numerous
burdens on the carrier that could be construed as
additional services. Specifically, the court ruled that a
delivery company required to collect use tax would be
required to perform eleven additional services,
including determining whether tax was due,
determining whether tax had been previously collected,
computing tax, collecting tax, filling out tax forms, etc.
These additional services would violate the preemption
clause of the Act. The court also rejected the
Comptroller’s argument that the Act should not apply to
the delivery company because it was affiliated with the
furniture retailer. The court explained that the definition
of motor carriers includes any carrier for hire.
Sourcing
1.
Texas: Recently enacted legislation modifies the way in which
sales are sourced for local sales and use tax purposes. H.B.
2425 (Jun. 20, 2003). Currently, local sales and use taxes are
imposed on intrastate transactions using "origin based
sourcing" (i.e., order receipt location). Under H.B. 2425, sales
of taxable services will now be subject to destination based
sourcing. The legislation, however, does not change the local
jurisdiction's sourcing rules for tangible personal property.
Consequently, if a taxpayer purchases tangible personal
property and taxable services from the same vendor as part of a
single transaction (for example, the purchase of repair services
together with the related tangible property), it may be required
to source the tangible property to one locality and the services
to another. The sourcing rules become effective July 1, 2004.
54
F.
Drop Shipments
1.
Connecticut: The Department of Revenue Services has issued
a ruling exploring the relationship between the state’s drop
shipment rule and fulfillment house exemption. Ruling No.
2003-2 (May 30, 2003). Connecticut requires drop shippers
with nexus in the state to collect tax when a retailer does not
have a collection obligation. Conn. Gen. Stat. § 12407(a)(3)(A). The taxpayer was a distributor that used a third
party warehousing and delivery agent located in Connecticut to
house and transport its inventory. The taxpayer sold its
products to a mail order retailer, and the agent shipped directly
from the Connecticut warehouse to the retailer’s customers
throughout the country. In the absence of any relevant
exemption, the distributor would qualify under Connecticut law
as a deemed retailer obligated to collect tax from the out-ofstate (i.e., not physically present) retailer’s customers located in
Connecticut. The taxpayer/distributor argued that even though
it met the deemed drop shipper requirement, it should not be
required to collect tax under the fulfillment house exemption.
Conn. Gen. Stat. § 12-407(a)(15)(C). The Department ruled
that the scenario failed to meet the fulfillment exemption
because the products were shipped to the mail order retailer’s
customers, rather than the “purchaser’s” (i.e., distributor’s)
customers. In addition, the distributor would not be considered
to offer the products for sale, since it merely acted as a
wholesaler, selling them to the mail order retailer.
2.
Kansas: Legislation which became effective July 1, 2003,
imposes a sales and use tax collection obligation on certain
drop shippers. Kansas H.B. 2416. The Kansas Department of
Revenue recently released Notice 03-09, which clarifies the
new policy. (Jun. 25, 2003). The Notice explains that when a
manufacturer has nexus with Kansas but a retailer does not, the
manufacturer is required to collect Kansas sales or use tax
(depending on whether the shipment is made from within or
without the state) on the retail price of the item. The
manufacturer is considered to be a deemed retailer with respect
to the drop shipment. If the manufacturer does not know or
cannot reasonably determine the retail price of the goods, it is
required to collect Kansas sales or use tax from the retailer
based on the cost of the item. The Kansas Notice also explains
that where the manufacturer uses a drop shipper it is still
required to collect tax (if it has Kansas nexus) regardless of
whether that second-tier drop shipper is subject to Kansas tax.
55
However, if the manufacturer is not subject to tax in Kansas
and the second-tier drop shipper does have nexus, it would be
considered the deemed retailer.
G.
Other Transaction Taxes
1.
New York City: An administrative law judge from the New
York City Tax Appeals Tribunal has ruled that imposition of
the real property transfer tax (RPTT) on five out-of-state
corporations did not violate the Commerce Clause of the U.S.
Constitution. Matter of Corewood Enterprises, Inc., TAT(H)
00-39(RP) (Mar. 11, 2004). The ruling involved the concerted
sale of stock in five lower tier corporations that indirectly
owned a New York City hotel. The RPTT is imposed on the
sale of real property located in the City or of a controlling
economic interest in real property located in the City. The
Tribunal concluded that the RPTT could be imposed on the
corporations because in-state entities, including a company
hired to broker the sale of the hotel, acted as agents for the
corporations and thus engaged in activities in New York City
sufficient to establish nexus. The Tribunal cited Tyler Pipe for
the proposition that these entities engaged in market making
activities attributable to the corporations for nexus purposes.
The decision is not precedential.
56
VI. Property Taxes
A.
California: In an issue of first impression, a California court of appeal
has held that rotable spare parts used by a computer hardware seller to
service and repair its customers’ equipment were not exempt business
inventories for purposes of the personal property tax. Amdahl Corp. v.
County of Santa Clara, H025660 (Cal. Ct. App. 6th Dist. Mar. 3,
2004). The taxpayer’s customers could purchase flat fee extended
services contracts, which would cover the cost of unlimited
replacement parts. When spare parts were needed, the taxpayer took
possession of the damaged parts, repairing and reusing them, where
possible.
The statutory business inventory exemption is only
applicable to products sold or leased in the ordinary course of business.
The court found that the rotable spare parts were not sold because:
there was neither a charge nor other consideration for the replacement
parts; no tax was collected on their transfer; there was no inventory
reduction when a spare part was placed in service, since the taxpayer
took possession of the damaged part; and, the parts were capitalized
and depreciated for both income tax and book purposes.
Another aspect of the decision that may impact the computer services
industry dealt with the determination that the taxpayer was not a
“nonprofessional service provider” for property tax purposes.
Tangible personal property transferred by professional service
providers is subject to tax, while such property transferred by
nonprofessional service providers qualifies as exempt business
inventory. The court used the example of drycleaners versus attorneys
to illustrate the two categories. Noting that computer service providers
fall between these classifications, the court, nevertheless, held that the
their services were more accurately characterized as professional
services, thus making the spare parts taxable.
57
VII. Practice and Procedure
A.
California: The State Board of Equalization has ruled, in a nonprecedential decision, that a federal statute of limitations extension for
a taxpayer’s federal consolidated group did not extend the statute for
foreign affiliates of the taxpayer that were included in its worldwide
combined report but excluded from the federal consolidated return.
Appeal of Magnetek, Inc., No. 198051 (Jan. 27, 2004). The
instructions to the schedule (now R-7), on which members of a unitary
group can elect to file a single return currently, specify that a waiver of
the statute of limitations by the key corporation in a group will waive
the statute for all members of the group electing the single return
option. The SBE concluded that the instructions extending a waiver to
all members of the group only refer to a California waiver of
limitations by the key corporation and do not relate to a federal waiver.
B.
California: On October 2, 2003, legislation was signed in California
that imposes certain disclosure and reporting requirements on
taxpayers and tax advisors. A.B. 1601/S.B. 614. The legislation adopts
IRC §§ 6011, 6111, and 6112 and the accompanying Treasury
regulations for California tax purposes. The legislation imposes
significant penalties for failure to comply with the requirements of the
act. Under the legislation, taxpayers may voluntarily participate in a
compliance program, which began January 1, 2004 and ends April 15,
2004.
C.
Texas: Recently enacted legislation authorizes the state auditor to
audit any settlement, tax refund, credit, payment warrant, offset, or
check issued by the Comptroller’s office. H.B. 7C (Oct. 13, 2003).
The provision went into effect on February 1, 2004, and allows the
state auditor to examine such items prospectively from that date
forward, as well as retroactively for six years prior to the effective
date. The authority granted in the legislation is not restricted to any
particular type of tax. Nor does the legislation specify that the authority
granted to the state auditor does or does not allow the state auditor to
alter the terms of any settlement, refund, etc. However, the legislation
does specify that taxpayer confidentiality will be respected in
connection with these audit procedures.
The information contained herein is general in nature and based on authorities that are subject to change.
Applicability to specific situations is to be determined through consultation with your tax advisor.
58
Current State Tax Developments
ELA Tax Executives Roundtable
June 9, 2004
Jeffrey Friedman
Partner, Washington National Tax
KPMG LLP
Washington, DC
2004 KPMG LLP
ALL RIGHTS RESERVED
Brendon McKibbin
Partner
KPMG LLP
New York, NY
CURRENT DEVELOPMENTS
A NATIONWIDE PERSPECTIVE
________________________________________________________________________
Table of Contents
I.
Legislative Roundup
II.
Jurisdiction to Tax
A.
B.
C.
III.
Substantial Nexus
Income Tax -- Economic Nexus
Income Tax -- U.S. Public Law No. 86-272 and Throwback
Corporate Income and Franchise Taxes
Page
2
4
4
11
14
Related Party Transactions and Arrangements
Tax Base and Credits
Allocation and Apportionment
Apportionment Issues
Filing Methods
Franchise and Net Worth Taxes
17
17
24
27
29
36
39
IV.
LLCs and Other Pass-Through Entities
41
V.
Sales and Transaction Taxes
43
A.
B.
C.
D.
E.
F.
Software, Telecommunications, and Digital Goods and Services
Exemptions
Resale
Other Taxability Issues
Sourcing
Drop Shipments
43
48
52
52
54
55
G.
Other Transaction Taxes
56
A.
B.
C.
D.
E.
F.
VI.
Property Taxes
57
VII.
Practice and Procedure
58
I.
Legislative Roundup
As the 2004 state legislative sessions progress, states continue to contend with
budget shortfalls. In addition, many states remain interested in enacting tax
reform and dealing with transactions perceived as loopholes. The following is a
summary of some of the recent legislative activity in select states. This summary
reflects legislative activity as of April 12, 2004.
A.
Alabama: A proposal to require combined reporting was expected to be
introduced during April.
B.
California: A voter referendum held March 2, 2004, approved the bond
financing plan and rejected a proposal to lower the supermajority
requirement for increasing taxes. As a result of these developments, taken
in concert, significant tax increases are not expected this year. Pending tax
legislation (all in early stages) includes several bills that would reinstate
the Manufacturer’s Investment Credit, legislation that would repeal the
water’s edge election, a proposal to include subpart F income in the
water’s edge group, and provisions that would allow the sale of unused
NOLs.
C.
District of Columbia: The Mayor included, as part of his budget
proposal, a related party expense addback provision. A similar measure
was introduced by the D.C. Council last year.
D.
Florida: Two bills, H.B. 735 and S.B. 2302 were still pending, toward the
end of the session, to repeal the substitute communications services tax.
The legislature was scheduled to adjourn on April 30, 2004.
E.
Illinois: The Governor’s budget address contained a sweeping tax reform
proposal that would change the Illinois “lockbox” rule and the cost of
performance sourcing rule; eliminate nonbusiness income; ensure no tax
benefits are available when intangible assets are transferred to tax havens;
enact straight-line depreciation; repeal the sales tax exemption for business
software purchases; and institute tax shelter legislation. Legislative
language is not yet available.
D.
Indiana: H.B. 1365, which was enacted on March 17, 2004, contains a
provision requiring out-of-state sellers to register for and collect sales and
use taxes if “closely related” to an entity that maintains a place of business
in Indiana or enters into a public contract with an Indiana agency. The
legislation also exempts separately states installation charges from sales
1
and use tax and clarifies the assignability of the sales and use tax bad debt
deduction. As originally introduced, the legislation contained an expense
disallowance provision that was deleted from the final version of the
legislation.
E.
Kentucky: The Governor had proposed a significant tax modernization
package. The legislature adjourned April 13, 2004, without passing the
Governor’s proposal or a budget bill.
F.
Louisiana: Legislation was enacted that: creates a phased-in exemption
for purchases of machinery and equipment by manufacturers; phases out
the borrowed capital component of the franchise tax; and provides for the
inclusion of related party debt that exceeds a certain threshold in the
franchise tax base.
G.
Maryland: On the last day of the session, April 12, 2004, the legislature
approved and sent to the Governor three bills, one containing related party
expense disallowance, another containing an amnesty provision with
respect to prior year related party expenses, and a bill imposing a
temporary corporate income tax surcharge. The Governor has threatened
to veto the surcharge bill and has announced that he has not decided
whether to sign either the expense disallowance or amnesty bills. The
Governor has until June 1, 2004 to sign the legislation.
H.
Massachusetts: Among the provisions included in the Governor’s budget
proposal, H.B. 1, are proposals to expand allocation of income of
domiciliary corporations, revise apportionment sourcing rules, address the
apportionment of income attributable to IRC § 338(h)(10) transactions,
and impose a sales/use tax collection obligation on certain drop shippers.
I.
Missouri: A related party expense disallowance provision containing safe
harbors, H.B. 969, which was supported by the business community,
passed the House and was sent to the Senate, where it was still pending as
of the middle of April. It is unclear whether the Governor, a strong
proponent of expense disallowance, would support the legislation with the
safe harbors included.
J.
New Jersey: The Governor has proposed extending the suspension of the
NOL deduction for 2004 and 2005.
K.
New York: The Governor has proposed single factor apportionment for
manufacturers. In addition, legislation has been introduced which would
require disclosure of certain tax planning transactions.
2
L.
Ohio: The budget that was passed during 2003 is a two-year provision.
The Governor has indicated that any major tax proposals would be
deferred until preparation of the 2005 budget. It is possible that a Housebased reform proposal will be introduced this year; but it is not anticipated
that any major tax reform will be enacted during 2004.
M.
Oregon: A voter referendum held on February 3, 2004, rejected a
proposed tax increase.
N.
Tennessee: Two expense disallowance bills have been introduced. One
applies only to royalties, while the other is broader.
O.
Texas: The Governor called the legislature into a special session to
address education financing, which began April 20, 2004. It was
anticipated that corporate limited partner nexus and related party expense
disallowance would be among the measures considered during the session.
P.
Virginia: A temporary budget bill, H.B. 5018 was approved by the House
on April 13, 2004 but, was drafted to “self destruct” on April 24, 2004, if a
2004-2004 biennial budget was not enacted by that date. H.B. 5018 was
scheduled for consideration by the Senate Finance Committee on April 16,
2004.
3
II.
Jurisdiction to Tax
A.
Substantial Nexus
1.
2.
Nexus Proposals
a.
Multistate: The Internet Tax Freedom Act moratorium
on discriminatory taxes and taxes on internet access
expired on November 1, 2003. Two bills, H.R. 49 and
S.150, were introduced during the latter part of 2003.
Two other measures have been introduced that would
set statutory nexus standards. H.R. 3184 would provide
for expanded collection authority for sales and use tax
purposes, essentially overturning the Quill physical
presence test. H.R. 3220 would codify the physical
presence test for business activity tax (BAT) nexus
purposes and expand the scope of U.S.P.L. 86-272.
H.R. 3220 does not address sales and use tax nexus.
b.
Multistate: The Multistate Tax Commission (MTC)
continues to support a BAT nexus proposal adopted in
October 2002 under which substantial nexus would be
established if a taxpayer had a threshold amount of
property, payroll, or sales in the state ($50,000 property
or payroll or $500,000 sales). Nexus would also be
established in any state in which at least 25 percent of
any of the three factors was concentrated. The proposal
would require the members of a unitary business group
to compute their nexus factors in the aggregate. If the
group as a whole met the nexus threshold, each member
of the group would be considered to have substantial
nexus in that state. Furthermore, the receipts factor
would include intercompany sales. The factors would
be computed according to the appropriate UDITPA
rules for the taxpayer. However, for receipts factor
purposes, the rule moves away from a cost of
performance standard toward a destination standard.
Intangible Licensing Activities, Other Holding Company Issues
a.
Louisiana: Reversing an appellate court decision, the
Louisiana Supreme Court has held that a Delaware
passive investment company was subject to Louisiana
corporate income and franchise taxes. The company
was part of a closely held group of corporations, and all
4
of its directors, except the Delaware-based nexus
provider, were Louisiana residents. Kevin Associates,
LLC v. Crawford, No. 03-C-0211 (Jan. 30, 2004). The
company earned dividends from subsidiaries located in
Louisiana and other states and received interest from an
intercompany loan to an affiliated Louisiana
corporation. The court held that the company was
commercially domiciled in Louisiana because it was
managed from Louisiana, and its Delaware presence
was merely a paper domicile. The court also concluded
that the company had a physical presence in Louisiana
because its principal place of business was in the state,
and it was managed from there. The appellate court had
held that the company did not have nexus, noting that
the company followed all the required formalities for
establishing and maintaining a DHC. Kevin Assoc. LLC
v. Crawford, 834 So.2d 465 (Nov. 8, 2002).
b.
Louisiana: A Louisiana appellate court has held that
the Department could not assert jurisdiction over an
out-of-state holding company, because the corporation’s
contacts with the state were not sufficient to satisfy the
nexus requirements of the Due Process Clause.
Bridges v. Autozone Properties, Inc., No. 2003 CA
0492 (La. App. 1 Cir. Jan. 5, 2004). (This decision was
issued before Kevin Associates). The Department
attempted to tax dividends received by a Nevada
corporation from a real estate investment trust (REIT)
that earned rental income from subsidiary retail stores,
some of which were located in Louisiana. The REIT
was subject to Louisiana tax but paid no tax as a result
of the dividends paid deduction, while the stores
received a deduction for rental expense. The court
examined Geoffrey, from a due process perspective
only. It concluded that, unlike the economic presence
created by the trademarks, which gave rise to the Due
Process nexus in Geoffrey, the holding company’s
dividends had no economic presence in Louisiana. Nor
could a Louisiana business situs be claimed for the
dividends that had no connection with the state other
than being paid by a REIT that earns part of its income
from Louisiana properties. While the Commerce
Clause was not at issue in Autozone, the court did state
in a footnote that Quill requires a physical presence to
establish Commerce Clause nexus. The court also
5
rejected an argument asserting that the holding
company and REIT were alter egos.
c.
Louisiana: A district court has denied motions filed by
two out-of-state trademark licensing companies to
dismiss suits filed by the state to recover income taxes.
Louisiana Dept. of Revenue v. Geoffrey, Inc., No.
502769; Louisiana Dept. of Revenue v. Gap (Apparel),
No. 501651 (Dec. 8, 2003). The court determined both
suits could proceed, despite the defendants’ claims that
they had no physical presence in the state; however, the
court did not actually rule on whether the companies
had established nexus in Louisiana.
d.
New Jersey: The New Jersey Tax Court has held that
an intangible holding company with no physical
presence in New Jersey, but which licensed trademarks
to an affiliated retailer in the state, was not subject to
the New Jersey Corporation Business (income) Tax
(CBT). Lanco, Inc. v. Director, Division of Taxation,
No. 005329-97 (N.J. Tax Ct. Oct. 23, 2003). The court
specifically ruled that the physical presence test upheld
by the U.S. Supreme Court in Quill Corp. v. North
Dakota, 504 U.S. 298 (1992), applies to income as well
as sales and use taxes. In so doing, the court appears to
have invalidated a 1996 Division of Taxation regulation
that defines doing business to include licensing
trademarks, if used in the state. The court explicitly
stated that there was no justification for imposing
different substantial nexus standards for sales and use
and income taxes. The court reasoned that, since an
obligation to collect use tax is not “more burdensome”
than an obligation to pay an income tax, it would be
“illogical” to require physical presence for use tax
nexus, while allowing income taxes to be imposed
under lesser circumstances. Although the decision is
taxpayer favorable, the impact is mitigated by New
Jersey’s 2002 enactment of statutory expense
disallowance provisions that require addback of certain
related party expenses, including royalties attributable
to licensing intangible property. Tax Court decisions
are not precedential.
6
3.
Attributional Nexus
a.
Indiana: Recently enacted legislation requires any
person that is “closely related” to another person that
maintains a place of business in Indiana, engages in the
regular or systematic soliciting of retail transactions
from potential customers in Indiana, or enters into a
public contract with a state agency to register and
collect sales and use tax. H.B. 1365 (Mar. 17, 2004).
The term, “closely related” is defined to include: use of
identical or substantially similar names, trademarks or
goodwill; persons that pay for each other’s services
under an arrangement that is contingent on sales volume
or value; and entities that share a common business
plan. The measure also expands the definition of a
retail merchant engaged in business in the state (for
sales and use tax collection purposes) to the boundaries
of the U.S. Constitution. The provision becomes
effective July 1, 2004.
b.
Kentucky: The Board of Tax Appeals has ruled that a
telecommunications reseller was subject to the Public
Service Corporation (PSC) property tax in a ruling with
both economic and attributional nexus elements.
Annox, Inc. v. Revenue Cabinet, No. K-19039 (Nov. 18,
2003). The reseller had no physical presence in the
state but did have interconnection agreements with two
in-state telephone companies entitling it to use their instate equipment to provide services to Kentucky
customers. Citing Scripto and Tyler Pipe, the Board
explained that the in-state interconnection partners
established and maintained a market for the reseller
through the activities of their employees, such as
performing installation and repair services for the
reseller’s Kentucky customers.
The Board also stated that Quill is only applicable for
sales and use tax purposes, and cited Geoffrey, despite
Geoffrey’s limited applicability to South Carolina. The
Board then explained that nexus was established
through the reseller’s absolute right to use the Kentucky
physical networks of two in-state telephone companies
(an intangible), as well as its Certificate of Public
Convenience issued by the Kentucky PSC. The Board
went so far as to state that the U.S. Congress granted
7
states nexus over all switchless resellers providing
services in their states when it specifically authorized
state commissions to approve interconnection
agreements (in the Telecommunications Act of 1996).
c.
New York An out-of-state non-profit membership
organization with no physical presence in New York
established nexus in the state through the activities of
two unrelated independent contractors in the state and
must collect sales and use tax on catalog and internet
sales made to New York purchasers. TSB-A-04(3)S
(N.Y. Dept. of Tax. and Fin. Feb. 24, 2004). The
organization, an association for boaters, provided
various services to its members, including marina
membership discounts, insurance, theft protection,
magazine subscription, and access to emergency towing
services. Four retail stores in New York owned by third
parties, but which bore the organization’s name, sold
memberships to the organization. The Department
ruled that the stores served as independent
representatives that established New York nexus for the
organization through the sale of memberships. The
Department found that nexus was also established
through the arrangement the organization had with local
towing companies for its members to receive
emergency towing services throughout the country.
d.
New York: An administrative ruling issued by the
New York Department of Taxation and Finance
provides that a remote vendor with an in-state retail
affiliate will not, generally, be required to collect use
tax on New York sales, as long as the entities do not
engage in certain activities or act as alter egos. TSB-A03(25)S (Jun. 11, 2003). However, the ruling also
listed a number of activities the Department would
consider as triggering a use tax collection obligation.
The Department noted that activities that would deem
an in-state retailer to be acting as a sales representative
for a remote vendor would subject the seller to use tax
collection. The ruling explained that an in-state seller
might be acting in a sales representative capacity if it
referred customers to a remote seller’s catalogs,
accepted returns of its merchandise, solicited customer
names for a remote vendor’s mailing lists, distributed
8
catalogs or coupons of the remote seller, or shared
common inventory or administrative staffs.
e.
4.
Virginia: A ruling issued by the Department of
Taxation clarifies the scope of recent legislation, and
essentially provides that sellers that wish to do business
with the state may be required to waive constitutional
nexus protections in order to obtain contracts with the
state. Ruling of Commissioner, P.D. 04-04 (Jan. 23,
2004). The legislation, enacted during 2003, prohibits
the state from purchasing goods or services from a
seller, if the seller or any of its affiliates is a “dealer”
under Virginia law and fails to collect and remit sales
and use taxes. The Department ruled that the state
could not enter into a contract with the taxpayer
because an affiliate of the taxpayer may have advertised
in the state. While advertising, alone, is not necessarily
sufficient to establish nexus under constitutional
standards, it does qualify a seller as a “dealer” under
Virginia law. Under the constitution, Virginia cannot
require a “dealer” to collect tax if it does not have nexus
with the state. However, the ruling explained that the
state may set its own conditions for vendors to do
business with state agencies.
In-State Representatives
a.
Connecticut: A Connecticut Superior Court has held
that a mail order computer seller did not establish nexus
for sales and use tax purposes by virtue of the in-state
activities of an unrelated company to which the seller
had outsourced a portion of its service contract repair
work. Dell Catalog Sales v. Commissioner of Revenue
Services, No. CV 00 0503146S (Jul. 10, 2003). Under
the contracts, telephone and online support services
were provided by the seller, while on-site services were
preformed by the repair company. On-site repair work
comprised only ten percent of the value of the services
performed under the contracts. The court focused on
the lack of evidence as to the actual number of repair
visits made to Connecticut. In the absence of actual
evidence, the court held that the fact that only ten
percent of the service contract revenue was attributable
to on-site work indicated that the repair company’s
presence was minimal and insufficient to establish
9
nexus for the seller. The court cited Appeal of
Intercard, 14 P.3d 1111 (Kans. 2000) (eleven
maintenance visits during an audit period did not
establish nexus).
b.
Michigan: On appeal, a Michigan court has ruled that
a lower court should have granted a summary judgment
motion against an out-of-state seller. The out-of-state
company was subjected to the single business tax (SBT)
based on the activities of two resident sales
representatives. Acco Brands, Inc. v. Department of
Treasury, No. 242430 (Mich. Ct. App. Nov. 20, 2003).
The representatives solicited orders in the state and sent
them to the company’s Illinois office for approval.
However, since it has been determined that the SBT is
not an income tax, the activities of the representatives
were not protected by P.L. 86-272. See Gillette Co v
Dep't of Treasury, 497 N.W.2d 595 (Mich. Ct.
App.1993. Revenue Administration Bulletin (RAB) 9801 provided that, effective for open tax years and going
forward, the presence of sales representatives in the
state is sufficient to establish SBT nexus for an out-ofstate entity if the representatives solicit sales or engage
in other activity in the state on behalf of the seller.
c.
New York: The Department of Taxation and Finance
has ruled that an out-of-state vendor established nexus
for use tax collection purposes through the in-state
activities of a commission-based independent
contractor. TSB-A-03(41)S (Nov. 19, 2003). The
independent contractor sold only one line of the
vendor’s products, and the majority of its sales were
attributable to participation in trade shows. Citing
Scripto, the Department ruled that the independent
contractor’s activities established New York nexus for
the vendor, and the vendor was required to collect New
York use tax on all sales (other than resales), including
online sales. Although nexus is often based on the
activities of independent contractors, the ruling failed to
analyze the volume or frequency of the contractor’s
activities, New York’s more than a slightest presence
standard (Matter of Orvis Co. Inc. v. Tax Appeals
Tribunal, 86 N.Y.2d 165 (1995)), or whether the
contractor satisfied the Scripto/Tyler Pipe marketmaking standard.
10
B.
Income Tax -- Economic Nexus
1.
State
Arizona
Arkansas
Colorado
Florida
Georgia
Hawaii
Indiana
Iowa
Kentucky
Louisiana
Maine
Maryland4
Massachusetts
Michigan
Minnesota
Missouri5
New Hampshire
New Jersey6
New Mexico
New York
North Carolina9
Ohio11
Oklahoma
Pennsylvania
South Carolina12
Tennessee13
Virginia
West Virginia
Reported and Known “Geoffrey Nexus” Positions By State
Statute
Rule
Yes
Audit Position
Yes
Yes1
Yes
Yes
Yes (Priv.Tax)
Yes 2
Yes (F/S)
Yes
Yes (F/S)
Yes
Yes (F/S)
Yes
Yes 3
Yes
Yes
Yes (F/S)
Yes
Yes
Yes7
Yes10
Yes
Yes
Yes
Yes
Yes
Yes
Yes8
Yes (Forced Comb.)
Yes
Yes
Yes
Yes (F/S)
Yes
Yes
Yes (F/S)
Yes
Yes
Yes (F/S)
Yes
“F/S” - Financial Services
1
The Colorado Department of Revenue indicated at a practitioner’s
liaison meeting that it will assert nexus in situations similar to
Geoffrey.
2
See Letter of Findings 95-0401 (Ind. Dept. Rev. Jul. 1, 2002), which
upheld an audit assessment against an intangible holding company
based on a Geoffrey nexus position.
11
3
Several suits are pending in which the Department of Revenue is
asserting economic nexus over intangible licensing companies, and
administrative guidance provides that an out-of-state intangible
licensing company would have nexus under certain circumstances.
Revenue Ruling 02-001 (La. Dept. of Rev. May 13, 2002). In addition,
the Louisiana Supreme Court has held that an out-of-state holding
company had nexus in Louisiana, although the decision was not based
directly on economic substance principles (company was held to be
domiciled in the state). Kevin Associates, LLC v. Crawford, No. 03-C0211 (Jan. 30, 2004).
4
Maryland’s highest court has reversed (on business
purpose/economic substance grounds), a group of decisions that had
held that Geoffrey was inapplicable in Maryland. See Comptroller of
the Treasury v. SYL, Inc., Comptroller v. Crown Cork & Seal
Company (Delaware), Inc. Nos. 76 & 80, (June 9, 2003). The U.S.
Supreme Court declined the taxpayers’ appeals in both decisions.
5
But see, Acme Royalty Co. v. Director of Revenue and Gore
Enterprise Holdings, Inc. v. Director of Revenue, Nos. SC84225,
SC84226 (Mo. Nov. 26, 2002), in which the Missouri Supreme Court
reversed two Administrative Hearing Commission orders and held, on
statutory grounds, that out-of-state companies licensing patents and
trademarks were not subject to Missouri income tax.
6
Legislation enacted during 2002 expands the New Jersey Corporation
Business Tax to corporations engaging in contacts within the state.
N.J. Stat. Ann. § 54:10A-2. However, a recent Tax Court decision
rejected the assertion of nexus in the absence of a physical presence.
Lanco, Inc. v. Director, Division of Taxation, No. 005329-97 (N.J. Tax
Ct. Oct. 23, 2003).
7
The New Mexico Court of Appeals has held that an out-of-state
company that licensed trademarks and tradenames to an in-state
affiliate was subject to New Mexico gross receipts and income taxes.
Kmart Properties, Inc. v. New Mexico Taxation and Revenue
Department, No. 21,140 (Nov. 27, 2001).
8
New Mexico imposes economic nexus requirements on franchisors
for purposes of its gross receipts tax.
9
See A&F Trademark, Inc. v. Secretary of Revenue, N.C Super. Ct.,
Wake Cty., (May 22, 2003), affirming Secretary of Revenue v. A&F
Trademark, Inc., Admin Decision No. 381 (May 7, 2002); contra
12
Educational Resources, Inc. v. Tolson, No. 00CVS14723-4 (Wake
Cty. Sup. Ct., Feb. 20, 2003).
10
A North Carolina statute, enacted during 2001, provides that
licensing intangibles for use in the state is considered to be doing
business in the state.
11
The Ohio Supreme Court upheld the taxation of a nonresident
individual’s Ohio lottery winnings. Couchot v. State Lottery Comm'n.,
659 N.E.2d 1225
12
Geoffrey Inc. v. South Carolina Tax Comm'n., 437 S.E.2d 13 (S.C.
1993), cert. denied, 510 U.S. 992 (1993).
13
Tennessee imposes economic nexus on financial institutions for
franchise/excise tax purposes. In J.C. Penney National Bank v.
Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999) cert. denied 121 S. Ct.
305 (2000), the imposition of tax on an out-of-state bank that issued
credit cards to Tennessee residents was rejected; however, in America
Online, Inc. v. Johnson, No. M2001-00927-COA-R3-CV (July 30,
2002), the Tennessee Court of Appeals clarified that J.C. Penney does
not impose a physical presence requirement for all taxes.
13
C.
Income Tax -- U.S. Public Law No. 86-272 and Throwback
1.
Massachusetts: The Massachusetts Supreme Judicial Court
has upheld an Appellate Tax Board (ATB) ruling that a
company’s in-state representatives exceeded U.S. P.L. 86-272
protection. Alcoa Building Products, Inc. v. Commissioner of
Revenue, SJC-08939 (Oct. 21, 2003). The taxpayer employed a
handful of sales managers that solicited sales of vinyl siding
and other building products from Massachusetts customers.
The ATB had ruled that the sales managers’ involvement in the
warranty claims process was sufficient to forfeit the company’s
P.L. 86-272 protection. The sales managers investigated sites
to evaluate the merit of warranty claims and assisted customers
in filling out as many as one-third of the claim forms filed with
the company. The court ruled that these activities had
independent business purposes, apart from solicitation,
including enhancing the taxpayer’s reputation and decreasing
the volume of traffic received by the taxpayer’s warranty
claims office. The court rejected the taxpayer’s claim that the
warranty activities consisted of merely passing inquiries and
complaints on to the home office, an activity that is explicitly
protected by regulation in Massachusetts (and consistent with
the MTC statement on P.L. 86-272). 830 Code Mass. Regs. §
63.39.1(5)(c)(4). The court explained that the warranty
activities were more akin to handling customer complaints, an
activity that the same regulation specifically provides exceeds
protection. The court also rejected the taxpayer’s attempt to
establish that the unprotected activities were de minimis, noting
that the sales managers participated in more than one-third of
the warranty claims filed by the taxpayer’s customers and
regularly visited warranty claim sites.
2.
New York: An administrative law judge (ALJ) with the New
York Division of Tax Appeals ruled that the New York
destination sales of certain members of a combined reporting
group must be sourced to New York, even though none of the
companies, themselves, engaged in any activities that exceeded
U.S Public Law 86-272 protection.
Matter of Disney
Enterprises, Inc., DTA No. 818378 (Feb. 12, 2004). The ALJ
ruled that the New York activities of the other members of the
group, including retail stores in the state, and substantial cross
marketing, was sufficient to require the non-nexus subsidiaries
to source their destination sales to the state. The ALJ
explained that these activities established that the companies’
business in New York was not merely limited to
14
remote/protected sales. This is the second ALJ ruling in the
last two years to employ the Finnigan approach in New York.
In 2002, a different ALJ also ruled that P.L. 86-272 protected
New York destination sales made by non-taxpayer corporations
of a New York combined reporting group must be included in
the numerator of the group's receipts factor. Matter of
Alpharma, Inc., DTA No. 817895 (2002). In contrast, in
Petition of Silver King Broadcasting of New Jersey, Inc., an
ALJ ruled that the Joyce approach should be applied. DTA No.
812589 (1995). None of these rulings are precedential.
3.
New York: Recent regulatory amendments provide that
participation in a trade show for no more than fourteen days, in
the aggregate, during a tax year qualifies for P.L. 86-272
protection from the franchise (i.e., income) tax. N.Y. Comp.
Codes R. & Regs. tit. 20, §§ 1-3.3, 1-3.4. (Jan. 22, 2004). In
order to qualify for the exception, no sales can be made at the
trade show, the person’s activity must be limited to displaying
goods and promoting services, and all orders must be sent
outside the state for acceptance. The regulation is effective
retroactively for taxable years beginning on or after January 1,
2002. A previously issued New York ruling provided that the
presence of employees at in-state trade shows and seminars an
average of ten days per year did not generate nexus for
corporation franchise tax purposes. N.Y. Dep’t of Tax. & Fin.,
TSB-A-97(6)C (Mar. 24, 1997). These changes are also
consistent with amendments made to New York City
regulations last year. Rules of the City of New York §§ 11-03,
11-04 (Jan. 2, 2003) were amended to include a fourteen-day
trade show safe harbor, effective January 1, 2002, as well.
4.
New York: The Department of Taxation and Finance has
issued an Advisory Opinion finding that an out-of-state food
seller was subject to New York corporation franchise tax.
TSB-A-03(13)C (Dec. 24, 2003). Although orders were sent
outside the state for approval and deliveries were made from
outside the state (in company owned trucks), the Department
concluded that the seller engaged in post-delivery activities that
exceeded P.L. 86-272 protection, including
picking up
damaged goods from customers and occasionally accepting
payments from customers for prior deliveries. The Department
found that these activities were unprotected under N.Y. Code
Regs. Reg. § 1-3.4(b)(9) - - replacing stale or damaged
products and collecting delinquent accounts. With regard to
the replacement of damaged products, however, the facts
15
indicate that the seller removed damaged products from
customers and issued credit, but do not indicate that any
replacements were delivered. Furthermore, the facts stated that
delivery persons occasionally accepted checks from customers
as an alternative to the customers mailing their payments.
There is no indication that these payments related to past due
accounts or that the delivery persons in any way solicited or
requested such payments. The Department also noted that the
seller was ineligible to claim a de minimis exception where
there was at least one damaged goods pickup per week.
16
III.
Corporate Income and Franchise Taxes
A.
Related Party Transactions and Arrangements
1.
Expense Disallowance Legislative Developments
a.
Connecticut: Legislation enacted during 2003 expands
the disallowance of related party interest expense under
the state’s expense disallowance provisions. H.B. 6806,
sec. 78 (Aug 16, 2003). The measure was enacted as a
substitute for legislation that would have imposed a
mandatory “alternate combined reporting” regime for
virtually all corporate taxpayers in Connecticut. The
legislation is effective for tax years beginning on or
after January 1, 2003. The legislation effectively
expands Connecticut’s expense disallowance to
intercompany financing (and other types of
intercompany interest payments). Under existing law,
taxpayers are already required to add back interest
expenses and costs related to intangible property under
Conn. Gen. Stat. § 12-218c. The legislation provides
five possible categories of exceptions to the
disallowance requirement, including the payment of tax
in another jurisdiction coupled with arm’s length terms
and a non-tax business purpose, as well as a treaty
exception. The addback may also be avoided if the
taxpayer agrees to file a unitary combined report.
Subsequently released information addresses the scope
of the addback exceptions. Form CT-1120AB and DRS
Commissioner Meeting Interest Add Back Issues (Dec.
3, 2003). The release specifies that a petition must be
filed with the Department in order to take advantage of
any of the statutory exceptions to addback, other than
the “three percent tax paid exception.” The release
clarifies that the three percent spread will be calculated
by comparing Connecticut’s maximum 7.5 percent
statutory rate to the income recipient’s effective tax rate
in any one state. The effective rate is calculated by
dividing actual tax paid by pre-apportionment taxable
income. Accordingly, the exception would not be
available to an income recipient in an NOL position in a
state in which it is subject to tax.
17
With regard to the new unitary election exception to
addback, the form imposes several conditions on the
unitary filing exception that are not required by the
legislation. The release states that the election is
water’s edge (although the legislation does not specify).
The release also explains that taxpayers may elect
unitary for Connecticut purposes if they file unitary in
another state but fails to address whether taxpayers that
do not file unitary in any other state may avail
themselves of the election. In addition, the form
specifies that no prior year NOLs or credits may be
utilized, and the entire unitary group is subject to the
twenty percent corporate tax surcharge. Furthermore,
the unitary group must be treated as a single taxpayer
for purposes of computing and using tax credits.
b.
Massachusetts: Related party expense disallowance
legislation was enacted during 2003. Subsequently
enacted legislation creates an additional treaty
exception. H.B. 3727 (Nov. 26, 2003). The legislation
provides that addback of interest or royalties is not
required if the expenses are paid, directly or indirectly,
to a related member that is a resident of a country which
has a comprehensive income tax treaty with the United
States (provided the company is not a controlled foreign
corporation under IRC § 957), the amounts are
deductible for federal tax purposes, the transaction
giving rise to the expenses has a valid non-tax business
purpose, and the terms of the transaction are arm’slength.
c.
New York: During 2003, legislation was enacted
imposing related party expense disallowance for both
New York state and city purposes. A.2106 (May 15,
2003). Subsequently enacted legislation amended the
scope of the disallowance provision. S.B. 5725
(October 21, 2003). A.2106 provided for disallowance
of related party royalty and interest expense deductions.
However, S.B. 5725 eliminated the addback of interest
expenses (other than interest related to intangible
assets).
S.B. 5725 also amended the expense
disallowance provision related to royalties, expanding
the definition of royalties to include payments related to
the use of patents and amending the exceptions
available from disallowance. Specifically, S.B. 5725
18
removes a provision contained in A.2106, which
provided an exception from addback if the related party
payments were made for a valid business purpose and
pursuant to a contract that reflected arm’s length
interest and terms. As amended, only two exceptions
are provided from royalty addback: 1) if the taxpayer
has a valid business purpose and the related member
pays the royalty to a non-related member during the tax
year pursuant to arm’s length terms; and 2) a new
exception is added where the royalty payments are paid
to a related member organized under the laws of a
country with a comprehensive income tax treaty with
the U.S. and the royalties are taxed in that country at a
tax rate at least equal to the rate imposed in New York.
d.
Ohio:
Recently enacted legislation revises the
discretionary authority of the Tax Commissioner to
adjust “sham transactions.” Am. Sub. H.B. 95 (Jun. 26,
2003). The legislation created new Ohio Rev. Code §
5703.56, which shifts the burden of proof
(preponderance of the evidence) from the
Commissioner to the taxpayer in cases where the
Commissioner disregards sham transactions between
members of a controlled group. The burden of proof
remains with the Commissioner with regard to sham
transactions involving unrelated taxpayers. A controlled
group is defined as direct/indirect control of over fifty
percent, based on ownership of common stock or other
equity with voting rights. The legislation repeals Ohio
Rev. Code § 5733.111 which granted the Commissioner
discretionary authority to use the equitable doctrines but
did not differentiate between related party and third
party transactions and imposed the burden on the
Commissioner. The legislation also doubles the statute
of limitations in situations in which the Commissioner
has disregarded a sham transaction. The legislation
became effective immediately.
e.
Oregon: A recently promulgated regulation imposes a
related party expense disallowance requirement for
Oregon tax purposes. Ore. Admin. Code § 150-314.295
(effective Dec. 31, 2003). While Oregon is a unitary
combined reporting state, the regulation targets royalty
payments to related parties excluded from the combined
report. An example contained in the regulation
19
specifically references trademarks licensed to an
Oregon taxpayer from a Bermuda subsidiary. The
requirement is triggered where both the owner and user
of the intangible asset are owned by the same interests,
as defined in Treas. Reg. §1.469-4T, and separation of
the ownership and use of the intangible asset has no
effect on the operations of the user other than the
payment of the royalty.
2.
Related Party Decisions and Administrative Developments
a.
Indiana: The Department of State Revenue has ruled
that out-of-state trademark licensing companies could
be required to file a unitary combined report with
affiliated Indiana taxpayer corporations. Letter of
Findings 00-0379 (Ind. Dept. of State Rev. Feb. 1,
2004). The Department upheld the auditor’s used of
forced combination but also noted that it would have
been equally appropriate to invoke the sham transaction
doctrine to disregard the in-state taxpayer’s deductions
for payments made to the intangible company. The
ruling noted that the transaction was solely motivated
by tax considerations, and the transfer of intangibles
and royalty payments were illusory because,
respectively, the trademarks had no value apart from the
taxpayer’s goodwill and the taxpayer was thus making
substantial payments for something with no value. The
ruling acknowledged the taxpayer’s right to structure its
business affairs as it sees fit; however, it also noted the
Department’s right to invoke substance over form.
Previously, in Letter of Findings 01-0132 (Oct. 1,
2003), the Department imposed forced combination,
notwithstanding the fact that the taxpayers obtained
valuation and transfer pricing studies. In contrast, the
Department has employed other approaches in previous
rulings. See Letter of Findings 95-0401 (Jun. 2002)
(economic nexus), Letter of Findings 01-0063S (Feb.
21, 2003) (expense disallowance).
b.
Maryland: The state’s highest court has held that
taxpayers’ trademark licensing subsidiaries were subject
to Maryland tax. Comptroller of the Treasury v. SYL,
Inc., Comptroller v. Crown Cork & Seal Company
(Delaware), Inc. Nos. 76 & 80, (June 9, 2003). The
decision overturned rulings by the Maryland Circuit
20
Court, which had found that jurisdiction could not be
exerted over an entity based on a unitary nexus theory if
the entity lacked a physical presence in Maryland unless
such entity was found to be a “phantom.” The lower
court had found the subsidiaries to be separate business
entities and not phantoms. On appeal, the court ruled
that the records demonstrated a lack of economic
substance. The court specifically found that the
subsidiaries were phantoms, and subjected them to tax
based on their parents’ apportionment factors. The
court failed to address physical presence issues, instead
simply collapsing the structure. Although the Court
discussed Geoffrey, and the New Mexico Kmart
Properties decision, it did not base its decision on these
cases or apply economic nexus. Thus the decision
could arguably be limited to “naked” intangible holding
company-type structures. The SYL decision involved
the same taxpayer and transactions as the Massachusetts
Syms decision. The U.S. Supreme Court has denied the
taxpayers’ writs of certiorari in both decisions.
c.
Massachusetts: The Massachusetts Supreme Judicial
Court affirmed an Appellate Tax Board decision that
permitted imposition of the step transaction doctrine to
negate a transfer of intangibles prior to the sale of a
subsidiary. General Mills, Inc. v. Commissioner of
Revenue, SJC-08935 (Sept. 15, 2003). The court held
that the pre-sale transaction lacked economic effect.
The subsidiary had transferred its trademarks to a newly
created Delaware holding company immediately prior
to the sale of the subsidiary to a third party.
Subsequently, the subsidiary and the DHC were sold to
a third party. The court held that the taxpayer could not
reduce its gain on the sale of the subsidiary by
transferring its valuable intangibles to a no-tax
jurisdiction. The court upheld the ATB’s reallocation
of the gain to the subsidiary, which was domiciled in
Massachusetts.
d.
Massachusetts: The Massachusetts Appellate Tax
Board has held that a taxpayer could deduct royalty
payments made to an affiliated entity for the use of
trademarks and similar intellectual property.
Cambridge Brands, Inc. v. Commissioner of Revenue,
No. C259013 (Jul. 16, 2003). The ruling involved an
21
asset purchase (from an unrelated party) of candy
trademarks and a factory. The purchaser initially held
the trademarks and later placed them in a subsidiary
that held all its intellectual property, while it placed the
factory in a newly formed manufacturing subsidiary
(i.e., the taxpayer). The manufacturer thereafter licensed
the trademarks from the parent company/subsidiary. In
allowing the royalty deductions, the Board determined
that the licensing arrangement had both a valid business
purpose and economic substance. The Board was
influenced by the fact that the deductions did not result
from a typical intangible holding company scenario.
The Board found that the separation in ownership
between the trademarks and the factory helped to
establish economic effect. The Board also cited a
number of other factors: the lack of a circular flow of
cash; the fact that both the taxpayer and the licensor
conducted active businesses; and the assumption of all
trademark related expenses by the licensor, rather than
the licensee.
e.
New York City: The New York City Tax Appeals
Tribunal has affirmed a 1999 administrative law judge
ruling which held that, for New York City general
corporation tax (GCT) purposes, the Geoffrey
trademark licensing company and two other affiliates
were not required to be combined with the Toys R Us
entities subject to the City tax. Matter of Toys “R” Us
– NYTEX, Inc., TAT (E) 93-1039 (GC) (N.Y.C. Tax
App. Trib. Jan. 14, 2004). The Tribunal found the
taxpayer had sufficiently established that the royalties
were priced at arm’s-length, and the City did not
adequately rebut this showing. Although the Tribunal
agreed that the taxpayer had satisfied the three
presumptive criteria for combination, the Tribunal also
agreed with the ALJ’s determination that the taxpayer
successfully rebutted the presumption by establishing
that the royalty rates were arm’s-length. The Tribunal
rejected the City’s attempt to inject a business
purpose/economic substance requirement into the
arm’s-length analysis. The ruling is favorable and is the
first City precedential ruling on this issue (the City
cannot appeal). However, the impact is limited by the
recent enactment of related party royalty expense
22
disallowance legislation, effective for tax years
beginning on or after January 1, 2003.
f.
New York: New York Tax Appeals Tribunal has
reversed an administrative law judge decision and, in
the first state level precedential decision of its kind in
New York, forcibly combined a taxpayer withy related
intangible holding companies. In the Matter of SherwinWilliams, DTA No. 816712 (June 5, 2003). This
decision involved the same taxpayer and transaction as
the Massachusetts Supreme Judicial Court decision of
the same name. The ALJ had held that the taxpayer and
its subsidiaries implemented licensing transactions for
valid business purposes and conducted such agreements
under arm’s-length terms. Relying on the two-prong
test set out in Frank Lyon Co. v. United States, 435 U.S.
561 (1978), the Tribunal held that the transactions
lacked economic substance and the subsidiaries were
not formed for valid business purposes. While the
Tribunal mentioned the Massachusetts decision
involving the same taxpayer and transactions, it did not
attempt to distinguish its conflicting conclusion
regarding business purpose. Rather, in examining the
business purposes set forth by the taxpayer, the Tribunal
found the ALJ erred in accepting them at face value,
finding that the business plan lacked plausibility and the
business purposes lacked independent merit (other than
tax avoidance). Similarly, the Tribunal felt the ALJ’s
reliance on expert testimony regarding the arm’s-length
nature of the transactions was in error.
g.
Virginia: An administrative ruling found that royalties
paid to a trademark licensing subsidiary lacked
economic substance and business purpose and did not
reflect arm’s-length rates. Ruling of Commissioner,
P.D. 03-73 (Oct. 15, 2003). The taxpayer was a major
retailer.
The Commissioner rejected the three
methodologies offered by the taxpayer to support arm’s
length pricing. Addressing the residual profit method,
the Commissioner concluded that the taxpayer’s higher
than industry average margin was due to various
economies of scale attributable to being one of the
leading retailers in the country, rather than to the
trademarks. The Commissioner noted that the royalty
rate used in a similar licensing agreement between the
23
taxpayer and an unrelated foreign corporation was onefifth the rate the taxpayer was paying to the trademark
licensing subsidiary.
The Commissioner also
determined that, even if the royalties reflected arm’slength rates, the deduction would not be sustainable.
The taxpayer used the intangibles as collateral for
outside financing, even after they were transferred to
the licensing subsidiary, and there were no standards in
place for quality control of the intangibles.
h.
B.
Virginia: The Department of Taxation has ruled that
an accounts receivable factoring company was properly
consolidated with related corporations for Virginia
corporate tax purposes. Rulings of Commissioner, P.D.
03-56, 03-57 (Aug. 8, 2003). The Department found
that the factoring transactions were not conducted in
accordance with arm’s-length terms and the factoring
company lacked economic substance. The Department
noted that the collection activities with respect to
outstanding receivables were performed by the taxpayer
even after transfer of the receivables to the factoring
company, and concluded that the $1,000 fee paid by the
factoring company to the taxpayer for collection and
administration services was inadequate to cover the
costs of collection. The Department also cited the lack
of arm’s length dealing in intercompany loans between
the taxpayer and the factoring company, such as the
lack of actual payments, the absence of nonpayment
penalties, and the fact that the loans were not
collateralized.
Tax Base and Credits
1.
Tax Base
a.
California: Legislation has been enacted that amends
Cal. Rev. & Tax. Code § 23051.5(e)(3) to provide that
federal elections made prior to becoming a California
taxpayer will be binding for California tax purposes and
that taxpayers cannot make a separate California
election unless the separate election is expressly
authorized under California law. S.B. 1065 (Sept. 22,
2003). Conversely, a taxpayer cannot make an election
for California purposes if it did not make the election
for federal purposes prior to becoming a California
24
taxpayer, unless the separate election is expressly
authorized under California law. The legislation does
not, however, eliminate the right of existing California
taxpayers to file separate elections with the Franchise
Tax Board (FTB) under Cal. Rev. & Tax. Code §
23051.5(e)(3)(A). Thus, the legislation appears to
preserve the right of taxpayers to opt in or out of federal
elections, such as IRC § 338(h)(10) and 338(g), without
regard to their federal tax treatment of the underlying
transactions. The legislation states that it codifies
existing FTB practice.
2.
Deductions
a.
California: The State Board of Equalization has
disallowed a portion of a taxpayer’s interest expense
deduction as attributable to nontaxable income under
Cal. Rev. & Tax Code § 24425. American General
Realty Investment Corp., No. 156726 (Jun. 25, 2003).
The income was the dividend from the taxpayer’s
insurance subsidiary (which was properly excluded
from the combined group). The SBE upheld the
disallowance of a portion of the unitary group’s total
interest expense based on the ratio that the nontaxable
insurance subsidiary dividend bore to the taxpayer’s
entire gross income. Following Appeal of Zenith
National Insurance Corp., 98-SBE-001, the SBE
applied federal Revenue Procedure 72-18, which
clarifies expense disallowance for IRC § 265 purposes.
The SBE noted that under Rev. Proc. 72-18, if a
taxpayer assumes debt and owns assets that generate
nontaxable income at the same time, there is an
inference that the purpose of the debt is, in part, to
generate nontaxable income because the taxpayer could
sell its nontaxable income bearing asset to fund its
business needs, rather than incurring debt for working
capital purposes. The SBE ruled that the taxpayer
failed to establish a non-tax business purpose sufficient
to rebut this presumption, concluding that it preferred to
incur debt rather than sell the insurance company stock.
b.
New York: An administrative law judge with the
Division of Tax Appeals has held that an adjustment to
a taxpayer’s net income also reduced its subsequent net
operating loss (NOL) carryfoward deductions. Petition
25
of New York Funeral Chapels, Inc., No. 818854 (Jul. 3,
2003). Under audit, the taxpayer had agreed to an
adjustment reducing its intercompany management fee
and interest expenses. This adjustment took the
taxpayer from an NOL position to a net income position
for the audit years, and its subsequent NOL
carryforward deductions were reduced accordingly.
The ALJ noted that even though the taxpayer agreed to
the adjustment, an $8 million adjustment indicated that
the taxpayer’s income was distorted and warranted
adjustment. The ALJ also rejected the taxpayer’s
argument that IRC § 172 must be applied for New York
tax purposes. N.Y. Tax Code § 208(9)(f) defines an
NOL to be “presumably” the same as a taxpayer’s NOL
under IRC § 172. The ALJ held that the auditor’s valid
exercise of its discretionary authority to adjust the
taxpayer’s expenses was sufficient to overcome the
presumption of conformity to the federal NOL.
3.
Credits
a.
Connecticut: A Connecticut Superior Court has ruled
that the corporate partners of a partnership operating in
Connecticut were entitled to utilize an income tax credit
that would have inured to the partnership if it had been
a taxable entity. Bell Atlantic NYNEX Mobile, Inc. v.
Commissioner of Revenue Services, No. CV 010511279S (Jul. 17, 2003). The credit was a corporation
business tax credit for personal property taxes paid on
certain types of electronic data processing equipment
(computers, printers, and similar property). The court
concluded that since business tax credits may be
separately stated items for federal tax purposes, the
Connecticut credit should maintain its identity and be
passed through to the corporate partners as a credit for
Connecticut corporation business tax purposes.
b.
New York: A recently issued ruling implies that outof-state manufacturing activities may be taken into
account in determining eligibility for a credit available
to manufacturers. TSB-A-03(6)C, (Jun. 11, 2003).
Under New York law, an industrial or manufacturing
business (IMB) may take a corporate income tax credit
for certain New York utility taxes paid by it, or passed
through to it, for the use of gas, electricity, steam,
26
water, or refrigeration in the state. The taxpayer was
headquartered in New York, but all its manufacturing
activity was located in Connecticut. The ruling stated
that the IMB determination is based on a corporation’s
entire business within and without New York.
c.
North Carolina: The Tax Review Board has ruled that
machinery and equipment placed into service at a
taxpayer’s North Carolina research and development
facility was eligible for a William S. Lee franchise tax
credit for manufacturing equipment. Admin. Decision
No. 410, N.C. Tax Review Board (Jul. 22, 2003). The
credit is applicable to machinery and equipment used in
manufacturing,
processing,
warehousing
and
distribution, or data processing. The ruling does not
explain why the credit was disallowed on audit,
although it appears to have been based on the use of the
property for R&D purposes, rather than the direct
manufacturing of the taxpayer’s goods. The ruling
concluded that the R&D activities conducted by the
taxpayer in North Carolina were necessary, inseparable,
and integral parts of the taxpayer’s primary business of
manufacturing. The ruling did not state whether actual
manufacturing was conducted in North Carolina or
another state(s); nor did it specify that in-state
manufacturing was required to claim a credit for R&D
equipment.
d.
Oregon:
Recently enacted legislation expands
eligibility for the income tax credit for qualified
research expenses and raises the maximum credit. H.B.
3183 (Aug. 29, 2003). Under existing law, a taxpayer
was only eligible for the credit if it was engaged in the
fields of advanced computing, advanced materials,
biotechnology,
electronic
device
technology,
environmental technology or straw utilization. The
statute was amended to delete all references to those
particular industries. Thus, the legislation removes the
restriction of the credit to high-tech businesses and
allows taxpayers engaged in other industries, such as
manufacturing, to claim the credit. In addition, the
legislation increases the maximum credit to $750,000
from $500,000. The amendment is effective for tax
years beginning on or after 2006.
27
C.
Allocation and Apportionment
1.
Indiana: A recent administrative ruling provided that, because
a limited partner is not permitted to exercise control over a
partnership in which it holds an interest, that interest could not
be considered operational for apportionment purposes. Letter
of Findings 00-0379 (Ind. Dept. of State Rev. Feb. 1, 2004).
Accordingly, pursuant to the rationale of the ruling, all gains
and losses held by limited partners should be considered
nonbusiness income. This ruling involved a loss incurred by a
limited partner; therefore the ruling was not favorable for this
particular taxpayer. However, if applied to non-Indiana-based
taxpayers with limited partnership interests, the ruling could
result in favorable allocation treatment of partnership income.
2.
Massachusetts: The Supreme Judicial Court has upheld an
Appellate Tax Board ruling that the gain realized by a
corporation on the sale of a subsidiary was not subject to tax.
The court also upheld the ATB’s imposition of the step
transaction doctrine to negate a transfer of intangibles prior to
the sale of a second subsidiary. General Mills, Inc. v.
Commissioner of Revenue, SJC-08935 (Sept. 15, 2003). In the
first transaction, the court held that the taxpayer, a food
products manufacturer, was not required to include the gain
from the sale of an apparel subsidiary in its apportionable tax
base because the subsidiary was not unitary with the taxpayer.
The court noted that there was no day-to-day management of
the subsidiary, despite some overlapping directors. The
taxpayer did provide limited administrative support with
respect to major capital funding decisions; however, this was
insufficient to establish centralized management. The court
also found that the subsidiary’s ability to borrow from the
taxpayer on demand did not establish a flow of value where all
intercompany transactions were conducted at arm’s-length.
3.
Massachusetts: The Massachusetts Court of Appeals has held
that capital gains earned by an out-of-state chemical
manufacturer from the sale of stock in several subsidiaries were
not subject to the corporate excise tax. W.R. Grace & Co. v.
Commissioner of Revenue, No.00-P-254 (Jul. 2, 2003). The
court’s ruling partially upholds a decision of the Appellate Tax
Board. W.R. Grace & Co. v. Commissioner of Revenue, Dkt.
No. F239586 (Nov. 19, 1999). The court ruled, under an AlliedSignal analysis, that the subsidiaries and the taxpayer were not
unitary. The subsidiaries and the taxpayer were engaged in
28
different lines of business, and the taxpayer did not exercise
actual managerial control over the subsidiaries, although it did
exercise supervisory oversight. The court held that the
taxpayer’s oversight did not establish centralized management
and did not exceed the supervision a corporation would exert
over an investment in a subsidiary. Furthermore, shared
services, including cash management, were provided under
arm’s length terms. However, the court held that intercompany
transactions undertaken at arm’s length do not result in a flow
of value sufficient to establish unity.
4.
Missouri: The Administrative Hearing Commission has ruled
that a taxpayer could exclude (i.e., allocate) intercompany
interest income from its Ohio-based parent in the calculation of
taxable income subject to apportionment. Medicine Shoppe
International, Inc. v. Director of Revenue, No. 02-1071 RI
(Dec. 23, 2003). The interest was attributable to an investment
agreement between the taxpayer and its parent corporation,
involving a daily sweep of the taxpayer’s cash accounts and
investment by the parent of funds that exceeded the taxpayer’s
business needs. The taxpayer had no control over the
investment of the funds, although it was entitled to draw down
on the investment account at any time (it never did). The
taxpayer reported its Missouri tax using the single-factor
method, in which the numerator of the factor is calculated as
the sum of the taxpayer’s Missouri sales plus fifty percent of its
sales partially within and partially without Missouri. Since the
taxpayer did not materially participate in the investment of the
funds and had no control over them, the Commission held that
the income was attributable to a passive investment with no
connection to Missouri. Despite the close relationship between
the taxpayer and the parent, the Commission rejected the
Director’s “attributional”/alter ego type argument that the
taxpayer should be deemed to have actively participated in the
investment of the funds. Citing to Acme Royalty Co. v.
Director of Revenue, 96 S.W.3d 72 (Mo. banc 2002), the
Commission stated that the companies were distinct business
entities, and the investment agreement had a legitimate
business purpose other than tax avoidance.
29
D.
Apportionment Issues
1.
Sales Factor Composition
a.
California: The Franchise Tax Board has issued a
legal ruling stating that dividends should be excluded
from a taxpayer’s sales factor unless it participates in
the management or operations of the distributing
company. Legal Ruling 2003-3 (Dec. 4, 2003). The
ruling addresses apportionable dividends distributed by
a non-member the taxpayer’s combined reporting
group.
The FTB cited California statutes and
regulations (which are based on UDITPA/MTC
regulations) which provide that: 1) the mere holding of
an intangible is not an income producing activity; and,
2) income not readily attributable to a specific income
producing activity is excluded from the numerator and
denominator of the sales factor. Although many states
have similar apportionment language, this “throwout”
rule is not commonly enforced in other states, in this
context. While some states exclude certain types of
passive income from the sales factor, many would
include business income dividends in the sales factor
and source the income to the recipient’s commercial
domicile. The ruling also specifies that exercising
voting rights, receipt or review of material normally
sent to stockholders, and accounting for the receipt of
dividend income would not be sufficient to establish
participation, whereas representation on the distributing
company’s board of directors or involvement in its
business decisions may suffice.
b.
Louisiana: The Department of Revenue has ruled that
the federal gasoline excise tax should be included in the
sales factor for income and franchise tax purposes.
Rev. Ruling No. 03-005 (Aug. 22, 2003). Unlike
UDITPA, where the sales factor is based on gross
receipts, the Louisiana sales factors are based on “net
sales.” Nevertheless, the Department ruled that the
incidence of the federal gasoline excise tax is on the
seller, rather than the purchaser and held that, if sellers
pass the tax on to consumers in separately stated
charges, the tax should be included in the sales factor
for both income and franchise tax purposes.
30
2.
c.
Ohio: Recently enacted legislation excludes certain
types of income from the sales factor and changes the
sourcing rules for Ohio franchise and corporate income
tax purposes. 2003 H.B. 127 (Dec. 11, 2003). H.B.
127 requires that receipts from and/or gains and losses
attributable to: (1) dividends and distributions; (2)
interest; (3) and other “excluded assets” must be
excluded from both the numerator and the denominator
of the sales factor. Excluded assets are defined as
capital assets or IRC §1231 assets (both of which were
already excluded from the sales factor for Ohio
apportionment purposes) as well as intangible property
other than trademarks, patents (and similar assets).
Thus intellectual property related receipts remain in the
Ohio sales factor. The legislation states that it is
effective immediately. According to Ohio case law, the
changes contained therein should not impact taxpayers
with taxable years ending prior to the date of enactment.
However, taxpayers with taxable years ending on or
after the date the legislation was signed, December 11,
2003, should apply the changes retroactively for the
entire taxable year.
d.
Wisconsin: Recently enacted legislation will phase in a
single sales factor apportionment formula over the next
five years. S.B. 197 (Jul. 31, 2003). Under current law,
Wisconsin employs a three-factor formula with a
double weighted sales factor. Under S.B. 197, the
apportionment formula will continue to be based on a
double weighted sales factor until tax years beginning
in 2006, at which point the sales factor will be weighted
at 60 percent. The sales factor will increase to 80
percent in 2007 and will be fully phased in for tax years
beginning on or after January 1, 2008.
Sales Factor Sourcing Issues
a.
New York: A recent administrative ruling rejected a
taxpayer’s attempt to source royalty income based on
the location where the licensees manufactured the
property that used the taxpayer’s intellectual property,
rather than the business address of the licensee. Matter
of Disney Enterprises, Inc., DTA No. 818378 (Feb. 12,
2004). Since much of that property was manufactured
outside the U.S., the position sought by the taxpayer
31
would have resulted in significant factor dilution. The
ALJ concluded that, since royalties were calculated
based on the licensees’ sales of products that used the
taxpayer’s intellectual property, the location of the
manufacturing activity was irrelevant to the taxpayer’s
income stream. The ALJ noted that, while the most
accurate method of sourcing would be based on the
location of the sales underlying the royalties, in the
absence of this information, the licensees’ business
addresses were a sufficient substitute.
b.
Ohio: Recently enacted legislation excludes certain
types of passive income from the sales factor and shifts
the state from a cost of performance approach to a
market state rule with regard to apportionment of
certain receipts. 2003 H.B. 127 (Dec. 11, 2003). Prior
to enactment of the legislation, sales other than sales of
tangible personal property were sourced based on the
location of the income producing activity, as measured
by the seller’s costs of performance. H.B. 127 repeals
the income producing activity/cost of performance rule
and replaces it with specific rules regarding the
sourcing of intangibles and services. Under the
legislation, receipts from intellectual property
(trademarks, tradenames, etc.) are sourced to Ohio to
the extent that the receipts are based on use of property
or the right to use the property in the state, and receipts
attributable to services will now be sourced to Ohio on
a pro rata basis, to the extent the services are used by
the purchaser in Ohio or the benefit of the services are
received by the purchaser in Ohio. The legislation
explicitly states that the physical location where the
purchaser uses or receives services shall be paramount
in determining the proportion of the benefit attributable
to Ohio. The legislation states that it is effective
immediately. According to Ohio case law, the changes
contained therein should not impact taxpayers with
taxable years ending prior to the date of enactment.
However, taxpayers with taxable years ending on or
after the date the legislation was signed, December 11,
2003, should apply the changes retroactively for the
entire taxable year.
c.
Virginia: The Department of Taxation has ruled that a
company commercially domiciled and headquartered in
32
Virginia was not required to include income from the
sale of manufacturing contracts sold in conjunction with
the sale of the taxpayer’s manufacturing division in the
numerator of its Virginia sales factor. Ruling of
Commissioner P.D. 03-78 (Nov. 3, 2003). Under
Virginia’s long-standing interpretation of the cost of
performance rule, income from intangibles and services
are sourced to the state when the costs of performance
in Virginia exceed the costs of performance outside
Virginia. The Department concluded that although
approval of the sale of the division occurred at the
taxpayer’s Virginia headquarters, the negotiation and
closing of the sale occurred in the purchaser’s state, and
the due diligence and accounting functions performed
in connection with the sale occurred in the state where
the facility was located. However, the ruling did
conclude that interest earned by the taxpayer’s divisions
located outside the state and patent royalties earned by
the manufacturing division were attributable to the
taxpayer’s Virginia domicile.
3.
“Gross Versus Net”
a.
California: The Sacramento County Superior Court
has ruled that a taxpayer could not include the return of
principal from investments in short-term securities in
the denominator of its California sales factor. Toy "R"
Us, Inc. v. Franchise Tax Board, No. 01AS04316 (Aug.
21, 2003). The court held that the receipts were not
derived from the “sale” of anything. The court
characterized the taxpayer’s short-term investment
activity as an ancillary service of loaning out
temporarily unneeded cash in return for interest. The
court also explained that the sales factor is designed to
reflect the market for a taxpayer’s goods or services.
As such, the court ruled that, because the return of
principal was not related to the taxpayer’s primary
function of selling toys, it should be excluded from the
sales factor. The also court noted that the inclusion of
the gross receipts in this instance would lead to
unreasonable and absurd results.
The court did
acknowledge that other state courts have held
differently. However, it noted that those states’
legislatures subsequently amended their sales factor
definitions to arrive at the same conclusion to be
rendered by the court in this case. Unlike many of the
33
previous California controversies involving this issue,
the instant case involved a taxpayer seeking a refund
rather than responding to an audit adjustment.
b.
4.
California: A California Superior Court has ruled that
a taxpayer may include gross receipts (rather than net
income) from the sale of marketable securities by its
Washington-based treasury department in the
denominator of its California sales factor. Microsoft
Corp. v. Franchise Tax Board, No. 400444 (Super. Ct.
of City and Cty of San Francisco, Sept. 9, 2003). The
court cited the plain language of Cal. Rev. & Tax Code
§§ 25134 and 25120, which indicate that “sales” for
purposes of the sales factor include gross receipts. The
court also noted that the FTB is currently seeking to
implement changes to the current law that would
require treasury function receipts to be included in the
sales factor on a net basis (i.e., modeled after the MTC
regulation). Based on the fact that the FTB was seeking
this change, the court concluded that existing law must
require the inclusion of Microsoft’s gross receipts from
treasury function investments. The court also held that
the FTB presented no evidence to support an alternative
apportionment formula under Cal. Rev. & Tax Code §
25137.
Property Factor
a.
New York: A recent administrative ruling addressed
the property factor treatment of film masters owned by
a taxpayer. Matter of Disney Enterprises, Inc., DTA
No. 818378 (Feb. 12, 2004). The taxpayer disputed the
valuation of its film masters at cost for property factor
purposes. The film masters, the original versions of the
taxpayer’s classic films, were worth billions of dollars.
However, the ruling concluded that the film masters
could not be included in the property factor at market
value, because the difference between the cost and
market values of the films was attributable to the right
to reproduce the films, which was a “copyright” - - - an
intangible asset which could not be included in the
property factor. The same ruling also provided that the
taxpayer was not entitled to property factor
representation for intangible property licensed to third
34
parties, which generated substantial revenue for the
taxpayer.
5.
Payroll Factor
a.
6.
Pennsylvania: The Commonwealth Court has held that
a taxpayer could not include a payroll factor in its
apportionment formula for corporate net income or
franchise tax purposes where all business of the
taxpayer was conducted by employees of affiliated
companies and independent contractors. UPS
Worldwide Forwarding, Inc. v. Commonwealth of
Pennsylvania, Nos. 62-65 F.R. 2001 (Pa. Commw. Ct.
Mar. 1, 2004). The taxpayer recorded payroll expenses
related to employees furnished by an affiliated
corporation; however, it had no written employment
agreement with the corporation. Furthermore, the
taxpayer had stipulated that it had “no employees.” The
court noted that “compensation” is defined for payroll
factor purposes as amounts paid to “employees.” Since
the taxpayer stipulated that it had no employees, it had
no compensation and thus had a zero payroll factor
denominator (i.e., no payroll factor).
The court
distinguished a Pennsylvania Supreme Court decision
with a similar fact pattern, in which furnished personnel
were found to be employees, there was a written
employment agreement between the affiliates, and the
taxpayer controlled the employees.
Other
a.
New York: A transaction treated by a taxpayer as a
financing arrangement was recast as an actual sale
requiring sales and property factor representation.
Petition of CS Integrated, LLC, LLC, DTA No. 17548
(Tax App. Trib. Nov. 20, 2003). The taxpayer operated
a warehouse in which food retailers stored their
inventory.
In order to assist a customer that
experienced financial difficulty, the taxpayer purchased
the customer’s inventory and resold it to the customer at
cost plus a carrying charge, rather than merely lending
money to the customer. An ALJ had ruled that the
transactions constituted a financing agreement, rather
than an actual purchase and sale of inventory. Since the
ALJ had found that the taxpayer did not actually
35
purchase the customer’s inventory, it was not required
to include it in its property factor. On appeal, the
Tribunal concluded that the transaction was an actual
sale, and thus must be reflected in both the sales and
property factors. The Tribunal noted that several
indicia of a sale were present: the taxpayer took legal
title and possession of the inventory and bore risk of
loss while it owned the inventory. The Tribunal also
ruled that the sales factor must include the gross
proceeds from the sale of the inventory rather than the
net income (i.e., the carrying charge). There is some
conflicting guidance on this issue in New York.
E.
Filing Methods
1.
Inclusion in the Unitary Business Group
a.
California: Recent legislation changes the water’sedge election, effective for taxable years beginning on
or after January 1, 2003, from a contractual election to
a statutory election. S.B. 1061 (Sept. 30, 2003). Under
new Cal. Rev. & Tax. Code § 25113, the water’s-edge
election will now be made by filing a timely return in
which tax is computed by including the income and
apportionment factors of the members of the water’sedge unitary combined reporting group and by using an
election form to be prescribed by the FTB. While the
election must still be made by all members of the
group, the failure of one or more members to make the
election will not forfeit the election for the entire
group, as long as the parent corporation includes the
non-electing members’ incomes and factors in its
combined report. The period of the water’s-edge
election remains eighty-four months. Taxpayers with
existing contractual elections will be “switched” to the
§ 25113 election procedures, although the start date of
their elections will be maintained for purposes of
computing the eighty-four month period. An election
under the new provisions may be terminated without
approval of the FTB at the end of eighty-four months
usage. Early termination may be obtained with the
consent of the FTB. Taxpayers that terminate their
elections (with or without the consent of the FTB)
cannot re-elect water’s-edge reporting for another
36
eighty-four months, although this restriction may be
waived by the FTB for good cause.
b.
California: The State Board of Equalization has ruled
that three U.S. members of a multinational
conglomerate were not unitary with their foreign
grandparent corporations, and granted the taxpayer’s
refund request. Appeal of Conopco, No. 129732 (Aug.
6, 2003). The ruling provided no analysis on the part of
the SBE, but did set forth the positions of both the
taxpayer and the FTB. The taxpayer’s arguments
against unity focused on the autonomous nature of the
U.S. subsidiaries, claiming that oversight by the foreign
parents was limited to stewardship activities, such as
appointing top managers and approving budgets. The
taxpayer also noted the absence of centralized
administrative functions (other than limited common
research activities), arm’s-length intercompany
transactions, minimal intercompany transfers of
personnel, and the production of defined brands and
products by the U.S. subsidiaries. The FTB claimed
that there was central policy-making coordination, an
extensive research and development network, shared
knowledge and expertise, and an integrated
management network aided by an organization-wide
management training college.
Apparently, the
taxpayer’s position was ultimately more persuasive.
c.
Illinois: The United States Court of Appeal for the
Seventh Circuit has held that a taxpayer must exclude
an affiliate that was engaged in a different line of
business from its unitary group. In re: Envirodyne
Industries, Inc., No. 02-1632 (Jan. 6, 2004). The matter
came to the court on appeal from a bankruptcy court
ruling. That ruling involved a claim filed by the Illinois
Department of Revenue for additional taxes assessed
after excluding the affiliated loss company from the
taxpayer’s Illinois unitary combined reporting group.
The in-state taxpayer and the loss company were
engaged in two different lines of manufacturing, food
packaging materials and steel, but both were owned by
the same parent corporation. The court depicted the
two entities as spokes of the same wheel without a rim
(i.e., the parent corporation). The court noted that the
parent was functionally integrated with each of the two
37
lines of business but that the two companies were not
integrated with each other. The court also stated that
the companies were not dependent on and did not
contribute to each other, even though the dependency
and contribution test was satisfied by each company
with respect to the parent. While the decision could
have favorable implications for some taxpayers, there is
existing, binding Illinois case law that may be seen as
inconsistent with this holding.
2.
Issues Involving 80/20 Companies
a.
3
Illinois: An Illinois appellate court has held that two
foreign intangible holding companies must be included
in a taxpayer’s Illinois combined report. Zebra
Technologies Corp. v. Topinka, No. 1-01-2861, 1-020386 (Ill. Ct. App. 1st Div. Aug. 11, 2003). The ruling
upheld a lower court decision that the taxpayer’s two
Bermuda subsidiaries, established to hold and license
the taxpayer’s trademarks and other intellectual
property, failed to qualify for the statutory “80/20”
exclusion from the Illinois combined reporting group.
All the subsidiaries’ property and their sole employee
were located in Bermuda. However, the court held that
less than 80 percent of the subsidiaries’ payroll was
located outside the U.S., because the taxpayer had
retained responsibility for the quality control of the
subsidiaries’ intellectual property and performed quality
control activities in Illinois, at no cost. The court
upheld the lower court’s imputation of the taxpayer’s
activities to the subsidiary to cause the subsidiaries to
fail the 80/20 test. Interestingly, the court agreed with
the lower court that the subsidiaries were formed for a
genuine economic purpose. Nevertheless, since the
80/20 exception was not otherwise satisfied, the
economic substance of the subsidiaries was not
determinative of the issue.
Special Industries
a.
New York: The Department of Taxation and Finance
has ruled that a bank subsidiary’s 1985 election to be
taxed under the corporation franchise tax article would
terminate if it reincorporated in another state in a
transaction that qualified for tax-free treatment under
38
IRC § 368(a)(1)(F). TSB-A-03(12)C (Nov. 6, 2003).
For New York tax purposes, corporations subject to the
bank tax under Article 32 were permitted to make a
one-time election for their 1984 taxable years if they
wished to continue paying tax under Article 9-A, the
general corporation franchise tax. The Department
ruled that reincorporation in another state would
terminate the taxpayer’s one-time election because the
transaction would cause the dissolution of the electing
taxpayer and the formation of a new corporation to
which the election would not carry over.
The
Department relied on IRC §368 and accompanying
regulations, which characterize “F reorganizations” as
involving two distinct corporations.
F.
Franchise and Net Worth Taxes
1
Louisiana: A Louisiana appellate court has held that payments
made by a taxpayer under numerous long-term lease
agreements did not constitute “borrowed capital” includable in
the franchise tax base. System Fuels, Inc. v. Dept. of Revenue,
No. CA 1723 (La. Ct. App. 1st Cir. Jun. 27, 2003). Borrowed
capital includes all long-term (greater than one year)
indebtedness of a corporation. The leases at issue involved
long-term rentals of fuel oil storage facilities and oil transport
vessels. The court held that the leases were true leases, rather
than financing leases, despite the inclusion of purchase options
in the contracts. The court noted that the purchase options
were based on fair market value rather than a bargain or
nominal price. The court declined to hold that all transactions
lacking a transfer of title of property should be excluded from
borrowed capital (in line with the lower court decision), but did
state that true leases that are not disguised credit sales would
not be considered borrowed capital. The court also rejected the
Department’s attempt to pull the leases into the franchise tax
base as “indebtedness,” based on the inclusion of unconditional
payment clauses in the rental contracts (hell or high water
clauses), explaining that the clauses were not truly
unconditional, because the lessor must still perform certain
obligations under the lease agreements.
2
Louisiana: An appellate court has held that lease obligations,
involving sale/leaseback arrangements, were not includable in
the franchise tax base. Entergy Louisiana, Inc. v. Dept. of
Revenue, 2003 CA 0166 (La. Ct. App. 1st Cir. Jul. 2, 2003).
39
The taxpayer sold a nuclear generating facility and leased it
back from the purchaser. The court held that the sale/leaseback
constituted a genuine lease, rather than a disguised credit sale.
The court noted that ownership was legally transferred and,
even though the taxpayer had a purchase option, it required the
taxpayer to pay the fair market value of the property. The
court’s rationale, while favorable to the taxpayer, contrasts with
the widely accepted treatment of sale/leaseback transactions in
other tax contexts. Whereas the court has held that the
sale/leaseback was not a disguised credit sale, most states that
have ruled on this issue have held that sales and use tax is not
due on sale/leaseback transactions, precisely because they are
financing vehicles rather than true leases.
3.
Missouri: The Missouri Supreme Court has held that three
investment holding companies could not apportion their
Missouri franchise tax bases because they employed no assets
outside the state. TSI Holding Co. v. Director of Revenue, Nos.
SC85179-81 (Nov. 4, 2003). The entities had no presence and
conducted no business activities outside Missouri.
For
Missouri franchise tax purposes, apportionment is based on the
percentage of a taxpayer’s accounts receivable, inventory, and
fixed assets employed in the state. The taxpayers, investment
companies, did not have any of the assets that are used to
determine franchise tax apportionment. Accordingly, the
taxpayers attempted to use an alternative apportionment
formula that apportioned their franchise tax bases according to
the location of their investments. Rejecting, the taxpayers’
apportionment methodology, the court explained that the right
to apportion is based on where a taxpayer’s assets are
employed, rather than where located. The court distinguished
Union Electric Co. v. Morris, 222 S.W.2d 767 (Mo. 1949), in
which a company's right to apportion was premised on
ownership of two Illinois subsidiaries. In Union Electric, the
court focused on the fact that the Illinois subsidiaries were
wholly owned and thus controlled by the taxpayer, leading to a
conclusion that the taxpayer conducted business (via the
subsidiaries) outside the state. The court’s decision, the first in
approximately forty years to address the issue of employment
of capital, upholds a Missouri Administrative Hearing
Commission ruling issued several months earlier. TSI Holding
Co. v. Director of Revenue, No. 01-1828 RV (Mar. 4, 2003).
40
IV. LLCs and Other Pass-Through Entities
A.
Conformity to the federal “check-the-box” regulations:
State
Alabama
Arizona
Arkansas
California
Connecticut
Delaware
District of Columbia
Florida
Georgia
Hawaii
Idaho
Illinois
Indiana
Iowa
Kentucky
Maine
Maryland
Massachusetts
Michigan
Minnesota
Mississippi
Missouri
Montana
Nebraska
New Hampshire
New Jersey
New York
North Carolina
North Dakota
Ohio
Oregon
Pennsylvania
South Carolina
Tennessee
Utah
Vermont
Virginia
Wisconsin
Conformity
X
X
X1
X
X
X
X2
X
X
X3
X
X
X
X
X
X
X
X
X
X4
X
X
X
X
Non-Conformity
Partial Conformity
X5
X
X
X
X
X
X
X
X
X6
X
X
X
X
41
1
Arkansas Code Ann. section 4-32-1313 was amended to provide that, for Arkansas
income tax purposes, an LLC will be taxed consistently with its federal tax
classification. H.B. 1959, signed March 31, 2003, effective for tax years beginning
on or after January 1, 2003.
2
An SMLLC is not subject to the unincorporated business franchise tax as long as it is
owned by an entity subject to D.C. tax.
3
Hawaii conforms to the federal “check-the-box” regulations, but does not adopt the
disregarded entity treatment of SMLLCs for the general excise tax. Hawaii Dep’t of
Tax., Tax Information Release No. 97-4 (Aug. 4, 1997). In addition, license and
registration requirements will still be applied at the entity level.
4
An election by a foreign (non-U.S.) single member eligible entity to be disregarded
will not be respected for Minnesota purposes because Minnesota law precludes the
inclusion of the apportionment factors and income of foreign entities in the Minnesota
unitary combined group. Minn. Dep’t of Revenue, Revenue Notice No. 98-08 (May
28, 1998).
5
An LLC’s federal classification under “check-the-box” will generally be respected;
however, single member LLCs are not disregarded for New Hampshire tax purposes.
N.H. Admin. Code R. 307.01. All LLCs remain subject to the New Hampshire
Business Profits Tax.
6
Legislation enacted during 1999 (H.B. 1676/S.B. 1806) broadened the Tennessee
excise and franchise tax to cover limited liability entities, including all LLCs, LLPs,
and LPs engaged in business in the state.
B.
Alabama: The Chief Administrative Law Judge for the Alabama
Department of Revenue has ruled that Alabama tax could not be
imposed on a nonresident individual that owned an interest in a limited
partnership conducting business in the state. Lanzi v. State of Alabama
Department of Revenue, No. 02-721 (Sept. 26, 2003). The ruling
involved tax years prior to 2001, the year in which Alabama began
imposing a nonresident withholding obligation on limited liability
entities (LLEs) doing business in the state. The ALJ’s decision was
based on Due Process considerations. Citing Alabama’s adoption of
the entity theory of partnerships, the ALJ held that the LP’s activities
and presence in the state could not be attributed to an out-of-state
investor. The ALJ distinguished the imposition of tax in this setting
from an International Harvester situation in which a withholding tax is
imposed on the in-state entity (which is consistent with Alabama’s
current LLE taxing scheme). The decision was not based on
Commerce Clause nexus. However, the ALJ did note that, while
previous Alabama administrative decisions (Cerro Copper and Dial
42
Bank) applied Quill’s physical presence test in the context of income
taxes, the ALJ noted his personal belief that he may have changed his
position on the issue of whether Quill applies outside of the sales and
use tax context.
C.
New York: An administrative law judge with the Division of Tax
Appeals has ruled that an S corporation shareholder was not required
to divide his capital gain from the sale by the S corporation of its assets
on a prorated basis between his periods of residency and nonresidency
for New York personal income tax purposes. Petition of Falberg, DTA
818960 (Oct. 9, 2003). The taxpayer changed his residency from New
York to Florida on July 20, 1997. The sale of the S corporation’s
assets occurred on July 31, 1997. Under New York law, residents are
subject to tax on their income in its entirety, while nonresidents are
only subject to tax on income from New York sources. A nonresident
S corporation shareholder sources the distributive share income based
on the S corporation's New York sourcing, as reported to the
shareholder. The audit division prorated the gain between the
taxpayer’s periods of residency and nonresidency, even though the gain
was generated during the period of nonresidency. Accordingly, the
prorated portion of the gain attributable to the period of residency
(January 1, 1997, through July 20, 1997) was taxed in full, rather than
subject to tax based on the taxpayer’s application of the S
corporation’s 10.4 percent business allocation percentage. The ALJ
ruled that the taxpayer has the option of prorating the income or
reporting it in accordance with its residency/nonresidency status on the
actual date of receipt. Since the taxpayer’s income was earned after
leaving the state, the ALJ ruled that the taxpayer could -- as had been
reported -- assign the entire gain to the period of nonresidency. It
appears that the ALJ departed from the "always-prorate" rule
enunciated by the TSB-M-00(1). However, the decision is not
precedential.
D.
New York: The state’s highest court, reversing an appellate decision,
has held that payments made to retired partners could not be deducted
for New York City unincorporated business tax purposes. Buchbinder
Tunick & Co. v. Tax Appeals Tribunal, No. 84 (Jun. 26, 2003). The
payments, which were made to extinguish the partners’ ownership
interests in the partnership, were calculated based on unrealized
receivables. Pursuant to New York City regulations, a partnership
cannot deduct payments to partners for services rendered. The court
ruled that the retirement payments were attributable to services
rendered, rejecting the lower court’s finding that the payments
represented a share of partnership revenue.
43
V.
Sales and Transaction Taxes
A.
Software, Telecommunications, and Digital Goods and
Services
1.
Massachusetts: A recent amendment to the computer industry
services and products regulation impacts resale exception
claims by computer service contract providers. 830 CMR
64H.1.3 (amended Dec. 19, 2003). The amended regulation
provides that a computer service contract provider that pays tax
on the purchase of tangible personal property but eventually
resells the property and collects tax from its customer must
present the vendor with a resale certificate and request refund
directly from the vendor (the vendor must then go to the state
for abatement of the tax remitted). Previously, a service
contract provider could claim a credit on a subsequent sales and
use tax return in order to recover the extra tax. This new policy
applies retroactively to sales or use taxes paid on or after
January 1, 2001.
2.
Minnesota: The Minnesota Tax Court has ruled that threedimensional images provided to customers via CD-ROM,
diskette, and videotape, were tangible personal property subject
to tax. Dynamic Digital Design, Inc. v. Commissioner of
Revenue, No. 7380-R (Jan. 14, 2004). The taxpayer developed
and designed interactive computer programs, animations, and
images that communicated technical information about its
customers’ products, designs or concepts. The court noted that
the boundaries of tangible personal property are still being
defined in Minnesota, with at least two cases involving this
issue currently pending before the Minnesota Supreme Court.
The court analyzed the taxability of the images by reference to
two existing Minnesota Supreme Court decisions, Fingerhut
Products Co. v. Commissioner of Revenue, 258 N.W.2d 606
(Minn. 1977) and Zip Sort, Inc. v. Commissioner of Revenue,
567 N.W.2d 34 (Minn. 1997), that distinguished customer lists
(intangibles) from labels, preprinted addresses and other items
(tangible), all transferred by tangible means. The court
concluded that the CD-ROMs, diskettes, and videotapes on
which the images were transmitted were usable devices, and
customers were paying for the form, in addition to purchasing
the images. The court did acknowledge that if the images had
been transferred electronically, they would not have been
subject to tax. Nevertheless, it rejected the taxpayer’s
44
argument that, because the images were capable of electronic
transmission, they were nontaxable intangible property.
3.
Missouri: The Department of Revenue has issued a notice
providing that load and leave transactions will be subject to
sales and use tax. Tax Policy Notice 16: Taxability of
Computer Software Load and Leave Transactions (Mo. Dept.
of Rev. Jan. 9, 2004). The notice explains that the change was
necessitated by the Missouri Supreme Court’s decision in
Kansas City Power and Light Co. v. Director of Revenue, 83
S.W.3d 548 (Mo. banc 2002), in which the court held that
transfer of title was not essential to qualify for a resale
exemption, if the right to use, store, or consume property was
transferred. The decision did not involve computer software,
but rather a utility company’s sales of electricity to a hotel.
The court found that the sales were sales for resale, because the
hotel customers paid tax on the electricity used in conjunction
with their rental of rooms and banquet halls. Based on the
rationale of Kansas City Power and Light, the Department
concluded that load and leave transactions, which involve a
transfer of a right to use property, rather than a transfer of title
to property should be considered “sales at retail.” Accordingly,
such sales are now taxable. The notice specifies that tax must
be collected regardless of whether the purchaser installs the
software and returns the tangible media to the seller or the
seller installs the software and leaves with the tangible media.
4.
Ohio: Ohio Am. Sub. H.B. 95, relaxes the taxation of
software. The legislation, which was designed to bring Ohio
into compliance with the Streamlined Sales and Use Tax
Agreement, and which became effective July 1, 2003, provides
that reasonable separately stated charges for modifications to
prewritten (i.e., canned) software are excluded from tax.
Nevertheless, Ohio Admin. Code § 5703-9-46(A)(7) provides
that charges for modifications to canned software are subject to
tax unless they constitute more than half of the price of the
sale. In response, the Ohio Department of Taxation has issued
guidance explaining that until the regulation is amended,
taxpayers should follow the provisions of H.B. 95, but should
remember that unless modification charges are separately
stated, they will be subject to tax as prewritten software.
Information Release ST 2003-06 (Jul. 2, 2003).
5.
Tennessee: The Tennessee Court of Appeals has held that a
provider of internet and other computer information services
45
was not performing taxable telecommunications services.
Prodigy Services Corp., Inc. v. Johnson, No. M2002-00918COA-R3-CV (Aug. 12, 2003). The company used modems to
provide internet access, e-mail, and other computer information
services to its customers. The term telecommunications
services is defined to include transmission by or through any
media, and contains a nonexclusive list of potentially taxable
services, none of which described the internet services at issue
in the controversy. In finding that the company’s services were
not included in the statute, the court relied on legislative intent,
specifically the 1993 deletion from the statute of “value added
networks” as a specifically identified example of
telecommunications services.
The court found that the
legislature’s action in this regard could be construed as
intended to clarify that electronic information services are not
subject to tax. The court was also influenced by the fact that
the company was not a regulated telecommunications service
provider under Tennessee or federal law. The Tennessee
Supreme Court subsequently declined to hear the Department’s
appeal in this decision.
In response to the court’s decision, the Department of Revenue
has
ordered
all
internet
service
providers and
telecommunications companies to stop collecting tax from
consumers on internet access. Sales and Use Tax Notice 04-03
(Jan. 30, 2004). The Notice explains that ISPs seeking refunds
of taxes collected from consumers on such services must show
that they refunded the tax to their retail customers. In addition,
an ISP must either provide documentation that it paid sales tax
on services originally purchased for resale or, alternatively,
reduce its own refund by the amount of sales taxes it would
have paid if it had not claimed a resale exception. However, an
ISP is not permitted to similarly reduce the refunds owed to its
retail customers for this amount.
6.
Virginia: The Department of Taxation has issued a ruling
addressing the taxability of certain programming, consulting,
travel, and administrative services provided in conjunction with
the sale and modification of software.
Ruling of
Commissioner, P.D. 03-61 (Aug. 19, 2003). Although the
outcome of the ruling was favorable for the taxpayer, the
approach taken by the Department may have broader negative
implications for other taxpayers. The taxpayer had entered into
two separate contracts with the same customer, one for the sale
of prewritten software, and the other a software modification
46
and services agreement. The taxpayer did not collect tax on the
second contract since the contract did not encompass the sale of
tangible personal property. However, citing to common law of
contracts, the Department ruled that the contracts could be
collapsed into a single contract for the sale of the prewritten
software (tangible personal property), because they were
executed on the same day, and the modifications were
necessary to render the software useful to the customer.
Despite the consolidation of the contracts, the Department
ultimately ruled that the services were eligible for a specific
exemption for separately stated charges for software
modification and services.
7.
Wisconsin: The Tax Appeals Commission has ruled that
global application software purchased by a company for use in
operation of its business was exempt custom software.
Menasha Corp. v. Wisconsin Dept. of Revenue, No. 01-S-72
(Dec. 1, 2003). The software cost several million dollars,
contained over seventy modules, and took several years to
implement. Wisconsin distinguishes prewritten and custom
software for sales and use tax purposes. A regulation contains
seven qualitative factors to be examined in characterizing
software that evaluate the complexity and nature of the
software. The Department’s policy has been to require all
seven conditions to be satisfied in order for software to qualify
as custom software, although the regulation does not explicitly
require that all criteria must be met. Prior to this decision,
neither the taxability of this type of software nor the
Department’s interpretation of the regulation had been
addressed in a judicial or administrative law setting, and the
Department traditionally subjected this type of software to tax.
However, the Commission ruled that the software did not need
to satisfy all seven elements of the regulation.
The
Commission weighed the various factors and concluded that,
based on the totality of the circumstances, the software was
custom, noting the cost of the software and the significant
training, testing, and maintenance required to implement the
software. The Commission also explained that the crucial issue
was the process required to implement the software not
whether the software purchased was part of a standard package.
47
B.
Exemptions
1.
Manufacturing
a.
California: Recent legislation places a ceiling on the
sales and use tax manufacturing credit. S.B. 1064
(Sept. 28, 2003). Cal. Rev. & Tax. Code § 6902.2
provided that in lieu of taking a manufacturer’s
investment credit (MIC) against personal or corporate
income taxes, an eligible taxpayer may file a sales and
use tax refund claim in an amount equal to the credit
that could be claimed for income tax purposes. This
provision has recently been the subject of SBE rulings
holding that the sales tax refund could be granted with
respect to unused MIC carryovers S.B. 1064 provides
that the amendments are declaratory of existing law but
are effective for refund claims filed on or after August
7, 2003 (the relevant SBE rulings were issued August 6,
2003). Therefore, the sales tax refund can now no
longer exceed the amount of MIC that would be
allowable for corporate income tax purposes after
application of all other credits. Note, the MIC expired
at the end of 2003.
b.
Louisiana: Recently enacted legislation creates a state
sales and use tax exemption for machinery and
equipment purchased by a manufacturer if used in a
plant facility predominantly and directly in the
manufacture of tangible personal property for sale to
another or manufacturing for agricultural purposes. The
exemption does not apply to the parish level tax. H.B.
2 (Mar. 23, 2004). The exemption will be phased in
over a seven-year period from 2005 through 2011.
Machinery and equipment is broadly defined and
expressly includes several categories of auxiliary
equipments, such as: computers and software that are
an integral part of machinery and equipment used in
manufacturing; pollution control equipment; and certain
testing equipment.
However, the legislation also
clarifies that structural property, HVAC, and property
used to transport or store property are ineligible, and
food preparation is not considered manufacturing. In
order to take advantage of the exemption, a purchaser
must obtain certification from the state that it qualifies
as a manufacturer. While the legislation ultimately
48
provides a benefit many Louisiana purchasers currently
enjoy similar sales and use tax benefits by virtue of
participating in the Louisiana enterprise zone program.
c.
New York: Reversing a previously issued advisory
opinion, the Division of Tax Appeals has ruled that
various pieces of equipment used on the premises of a
retail home improvement chain were eligible for the
production exemption. Matter of Lowe's Home Center,
Inc., DTA No. 819043 (Mar. 11, 2004). N.Y. Tax Law
§ 1115(a)(12) exempts from tax equipment used in the
manufacturing, processing or other production of
tangible personal property for sale. The equipment
involved machines used at the taxpayer’s retail facilities
to cut products to the desired size for customers - timber cutting saws, carpet/vinyl cutting equipment,
pipe threading/cutting equipment, glass cutting
machines, window trim machines and wire measuring
and coiling equipment. The ruling concluded that the
equipment was used to process the property purchased
by the taxpayer’s customers and rejected the Division’s
argument that the property was ineligible for exemption
because it had already entered the distribution phase by
being displayed on the sales floor.
d.
New York: The Department of Taxation and Finance
has issued an advisory opinion finding that purchases of
vacuum, hydrogen, nitrogen, and water cooling systems
were eligible for the manufacturing exemption even
though the various systems were used to treat (i.e., heat,
cool, etc.) the manufacturer’s products rather than
becoming components of the products themselves.
TSB-A-03(27)S (Jun. 24, 2003). Air, water, and gases
used in the systems were found to be used entirely in
manufacturing and integral to the manufacture of the
automotive electronics. Despite the fact that the exhaust
systems did not meet the statutory definition of
pollution control equipment, the systems were held to
be exempt from tax because the product itself would
have been harmed without the operation of the exhaust
system to remove noxious fumes and vapors produced
during the course of the manufacturing process.
Nevertheless, the ruling declined to extend the
exemption to the taxpayer’s HVAC equipment, finding
that it was present for the comfort of the taxpayer’s
49
factory employees rather
manufacturing process.
e.
2.
than
integral
to
the
Tennessee: The Tennessee Court of Appeals has ruled
that the industrial machinery exemption did not apply to
catalysts used by a chemical manufacturer in the
manufacturing process. Eastman Chemical Co. v.
Chumley, No. M2002-02114-COA-R3-CV (Jan. 12,
2004).
The exemption applies to “machinery,
apparatus, and equipment with all associated parts,
appurtenances and accessories.” The court rejected the
taxpayer’s claim that the catalysts were exempt
“apparatus.” The court explained that, taken together,
the terms machinery, apparatus, and equipment were
intended to apply the exemption to connected and
interrelated devices and parts used to carry out the
manufacturing process.
Accordingly, the court
determined that the catalysts at issue were not qualified
machinery, but rather were analogous to such
nontaxable items as fuel used to operate manufacturing
devices or substances use to cool those devices.
Research and Development
a.
New York: Reversing an administrative law judge
ruling, the Tax Appeals Tribunal has held that computer
equipment leased by a company for purposes of
developing a cancer specimen database was not eligible
for the research and development exemption. Petition of
Impath, Inc., DTA No. 818143 (N.Y. Tax App. Trib.
Jan. 8, 2004). The equipment was used to extract
information from data the taxpayer had gathered
through the performance of up to twenty tests each on
thousands of cancer specimens.
The tests were
performed for diagnostic purposes; however, the
taxpayer subsequently collated the information in order
to create a database that could form conclusions and
make predictions regarding future patient diagnoses and
pharmaceutical development. The Tribunal found that
the equipment did not qualify for exemption because
the taxpayer failed to use the equipment to develop a
new product or a new use for an existing product.
50
3.
Intercompany Transactions
a.
4.
Connecticut: Recently enacted legislation provides
that otherwise taxable services cannot be purchased
under a resale exemption, if they will be resold to an
affiliated purchaser. H.B. 6624 (Jul. 9, 2003).
Connecticut provides a statutory exemption for sales of
taxable services between certain related entities. Conn.
Gen. Stat. § 12-412(62). The legislation is designed to
ensure that an intermediary cannot makes a purchase
under a resale exemption of services that would be
exempt on resale under the intercompany exemption.
The legislation becomes effective October 1, 2003.
Other
a.
Florida: A recent ruling provides that gases used to
preserve fish and included in the container in which the
fish is sold qualified for the packaging material
exclusion from sales and use tax. Technical Assistance
Advisement 03A-028 (Jun. 10, 2003). Under Florida
law, sellers are not required to pay use tax on purchases
of packaging items accompanying the sale of their
products if delivery would be impracticable but for the
presence of the products, and there is no separate charge
for the products to the seller’s customers. Fla. Stat. §
2121.02(14)(c). A regulation lists numerous examples
of types of packaging materials that might qualify for
the exclusion.
Fla. Admin. Code § 12A-1.040.
However, the examples focus on types of containers,
rather than accompanying material. The Department’s
ruling demonstrates that the packaging material
exclusion may encompass a broader spectrum of
materials than merely containers, such as materials
placed inside the containers.
b.
Ohio: A recent Ohio Supreme Court decision provides
guidance on the taxability of employment services.
H.R. Options, Inc. v. Zaino, 800 N.E.2d 740 (Ohio Jan.
7, 2004). For Ohio sales and use tax purposes, the
provision of employment services are generally subject
to tax. However, an exclusion from taxation is
available for a contract of one-year or greater between a
service provider and a client, if the contract specifies
that the employees covered by the contract are assigned
51
to the client on a permanent basis. The decision
clarified that a contract between an employment
services provider and its client need not explicitly state
that the furnished employees’ assignments are
permanent. Rather, if an employment contract contains
no ending dates for the employees’ assignments, then
the assignments may be deemed permanent and eligible
for the exception. Nevertheless, the court noted that
even if a contract contains no ending date, the services
would not be eligible for the exception if the facts and
circumstances revealed that the employees were
provided for seasonal employment or to fill short-term
workload conditions. This decision applies only to
employees furnished by unrelated service providers. A
separate exception exists for employment services
between members of an affiliated group.
C.
Resale
1.
D.
Ohio: The Ohio Supreme Court has held that a company
that tested wheels for customers was not required to pay
sales or use tax on its purchases of tires and other
equipment used to test the tire rims, because the equipment
qualified for a resale exemption. Standards Testing
Laboratories, Inc. v. Zaino, No. 98-G-617 (Nov. 12, 2003).
The taxpayer purchased the equipment on behalf of its
customers and did bill them for it; however, the equipment
was, in most cases, not physically transferred to the
customers after use. The Ohio resale exemption requires a
transfer of title and/or possession of property. The court
noted that when the testing company took possession of the
tires and other equipment they were simultaneously
delivered to its customers, thus effecting a valid title
transfer for purposes of the resale exemption.
Other Taxability Issues
1.
Title Passage/Location of Sale
a.
Massachusetts: The Massachusetts Supreme Judicial
Court has ruled that a seller must collect sales tax on
items sold in its Massachusetts stores but picked up by
customers at its retail locations in New Hampshire
(which has no sales and use tax). Circuit City Stores,
Inc. v. Commissioner of Revenue, 790 N.E.2d 636 (Jun.
52
25, 2003). The items were paid for in full in
Massachusetts, and the sales were credited to the
Massachusetts stores and sales people, but the actual
items were “reserved” on the computer at the store
where the purchaser wished to take possession of the
merchandise. The court determined that since under the
Uniform Commercial Code and common law, title may
pass before a purchaser takes actual possession of
goods, title passed in Massachusetts. In contrast, in
Neiman Marcus Group, Inc. v. Commissioner of
Revenue, 26 Mass. App. Tax Bd. Rep. 316 (2001), the
Appellate Tax Board held that Massachusetts sales tax
was not due on sales made in Massachusetts retail
stores which the purchasers requested to be shipped to a
location in another state. The court dismissed the
Neiman Marcus decision as only superficially similar.
2.
Leasing Issues
a.
Florida: The Florida Department of Revenue has
issued a technical assistance advisement which
concludes that a dividend paid by a qualified S
corporation subsidiary (Q-Sub) to its sole shareholder
(S corporation) was actually a rental payment for use of
the S corporation’s building. As such, the dividend was
subject to Florida sales tax. TAA 03A-039 (Jul. 22,
2003). The taxpayer posed two alternatives to the
Department, one in which a lease agreement was
established for the use of the building but did not
require the payment of rent, and the other in which the
Q Sub would use the building without a lease. The
Department ruled that, under either scenario, a dividend
paid by the Q Sub to the S corporation would be taxed
as rent to the extent the dividend was actually paid to
the S corporation. The Department explained that,
because there was real consideration flowing from the
Q Sub to the S corporation, the dividend would be
considered rental compensation.
The Department
distinguished this situation from one in which the
dividend was merely an accounting entry with no actual
value flowing to the shareholder.
53
3.
Other
a.
E.
Maryland: The Maryland Tax Court has held that
federal law preempts the imposition of a use tax
collection obligation on a for-hire carrier that delivered
furniture in the state for a related out-of-state retailer.
Royal Transport, Inc. v. Comptroller of the Treasury,
Nos. 02-SU-OO-0298, 0299 (Oct. 22, 2003). The court
held that the imposition of a use tax obligation on the
delivery company would violate the Interstate
Commerce Act (Act), which prohibits states laws
“related to a price, route, or service of any motor
carrier.” Citing federal case law, the court concluded
that a tax collection obligation could place numerous
burdens on the carrier that could be construed as
additional services. Specifically, the court ruled that a
delivery company required to collect use tax would be
required to perform eleven additional services,
including determining whether tax was due,
determining whether tax had been previously collected,
computing tax, collecting tax, filling out tax forms, etc.
These additional services would violate the preemption
clause of the Act. The court also rejected the
Comptroller’s argument that the Act should not apply to
the delivery company because it was affiliated with the
furniture retailer. The court explained that the definition
of motor carriers includes any carrier for hire.
Sourcing
1.
Texas: Recently enacted legislation modifies the way in which
sales are sourced for local sales and use tax purposes. H.B.
2425 (Jun. 20, 2003). Currently, local sales and use taxes are
imposed on intrastate transactions using "origin based
sourcing" (i.e., order receipt location). Under H.B. 2425, sales
of taxable services will now be subject to destination based
sourcing. The legislation, however, does not change the local
jurisdiction's sourcing rules for tangible personal property.
Consequently, if a taxpayer purchases tangible personal
property and taxable services from the same vendor as part of a
single transaction (for example, the purchase of repair services
together with the related tangible property), it may be required
to source the tangible property to one locality and the services
to another. The sourcing rules become effective July 1, 2004.
54
F.
Drop Shipments
1.
Connecticut: The Department of Revenue Services has issued
a ruling exploring the relationship between the state’s drop
shipment rule and fulfillment house exemption. Ruling No.
2003-2 (May 30, 2003). Connecticut requires drop shippers
with nexus in the state to collect tax when a retailer does not
have a collection obligation. Conn. Gen. Stat. § 12407(a)(3)(A). The taxpayer was a distributor that used a third
party warehousing and delivery agent located in Connecticut to
house and transport its inventory. The taxpayer sold its
products to a mail order retailer, and the agent shipped directly
from the Connecticut warehouse to the retailer’s customers
throughout the country. In the absence of any relevant
exemption, the distributor would qualify under Connecticut law
as a deemed retailer obligated to collect tax from the out-ofstate (i.e., not physically present) retailer’s customers located in
Connecticut. The taxpayer/distributor argued that even though
it met the deemed drop shipper requirement, it should not be
required to collect tax under the fulfillment house exemption.
Conn. Gen. Stat. § 12-407(a)(15)(C). The Department ruled
that the scenario failed to meet the fulfillment exemption
because the products were shipped to the mail order retailer’s
customers, rather than the “purchaser’s” (i.e., distributor’s)
customers. In addition, the distributor would not be considered
to offer the products for sale, since it merely acted as a
wholesaler, selling them to the mail order retailer.
2.
Kansas: Legislation which became effective July 1, 2003,
imposes a sales and use tax collection obligation on certain
drop shippers. Kansas H.B. 2416. The Kansas Department of
Revenue recently released Notice 03-09, which clarifies the
new policy. (Jun. 25, 2003). The Notice explains that when a
manufacturer has nexus with Kansas but a retailer does not, the
manufacturer is required to collect Kansas sales or use tax
(depending on whether the shipment is made from within or
without the state) on the retail price of the item. The
manufacturer is considered to be a deemed retailer with respect
to the drop shipment. If the manufacturer does not know or
cannot reasonably determine the retail price of the goods, it is
required to collect Kansas sales or use tax from the retailer
based on the cost of the item. The Kansas Notice also explains
that where the manufacturer uses a drop shipper it is still
required to collect tax (if it has Kansas nexus) regardless of
whether that second-tier drop shipper is subject to Kansas tax.
55
However, if the manufacturer is not subject to tax in Kansas
and the second-tier drop shipper does have nexus, it would be
considered the deemed retailer.
G.
Other Transaction Taxes
1.
New York City: An administrative law judge from the New
York City Tax Appeals Tribunal has ruled that imposition of
the real property transfer tax (RPTT) on five out-of-state
corporations did not violate the Commerce Clause of the U.S.
Constitution. Matter of Corewood Enterprises, Inc., TAT(H)
00-39(RP) (Mar. 11, 2004). The ruling involved the concerted
sale of stock in five lower tier corporations that indirectly
owned a New York City hotel. The RPTT is imposed on the
sale of real property located in the City or of a controlling
economic interest in real property located in the City. The
Tribunal concluded that the RPTT could be imposed on the
corporations because in-state entities, including a company
hired to broker the sale of the hotel, acted as agents for the
corporations and thus engaged in activities in New York City
sufficient to establish nexus. The Tribunal cited Tyler Pipe for
the proposition that these entities engaged in market making
activities attributable to the corporations for nexus purposes.
The decision is not precedential.
56
VI. Property Taxes
A.
California: In an issue of first impression, a California court of appeal
has held that rotable spare parts used by a computer hardware seller to
service and repair its customers’ equipment were not exempt business
inventories for purposes of the personal property tax. Amdahl Corp. v.
County of Santa Clara, H025660 (Cal. Ct. App. 6th Dist. Mar. 3,
2004). The taxpayer’s customers could purchase flat fee extended
services contracts, which would cover the cost of unlimited
replacement parts. When spare parts were needed, the taxpayer took
possession of the damaged parts, repairing and reusing them, where
possible.
The statutory business inventory exemption is only
applicable to products sold or leased in the ordinary course of business.
The court found that the rotable spare parts were not sold because:
there was neither a charge nor other consideration for the replacement
parts; no tax was collected on their transfer; there was no inventory
reduction when a spare part was placed in service, since the taxpayer
took possession of the damaged part; and, the parts were capitalized
and depreciated for both income tax and book purposes.
Another aspect of the decision that may impact the computer services
industry dealt with the determination that the taxpayer was not a
“nonprofessional service provider” for property tax purposes.
Tangible personal property transferred by professional service
providers is subject to tax, while such property transferred by
nonprofessional service providers qualifies as exempt business
inventory. The court used the example of drycleaners versus attorneys
to illustrate the two categories. Noting that computer service providers
fall between these classifications, the court, nevertheless, held that the
their services were more accurately characterized as professional
services, thus making the spare parts taxable.
57
VII. Practice and Procedure
A.
California: The State Board of Equalization has ruled, in a nonprecedential decision, that a federal statute of limitations extension for
a taxpayer’s federal consolidated group did not extend the statute for
foreign affiliates of the taxpayer that were included in its worldwide
combined report but excluded from the federal consolidated return.
Appeal of Magnetek, Inc., No. 198051 (Jan. 27, 2004). The
instructions to the schedule (now R-7), on which members of a unitary
group can elect to file a single return currently, specify that a waiver of
the statute of limitations by the key corporation in a group will waive
the statute for all members of the group electing the single return
option. The SBE concluded that the instructions extending a waiver to
all members of the group only refer to a California waiver of
limitations by the key corporation and do not relate to a federal waiver.
B.
California: On October 2, 2003, legislation was signed in California
that imposes certain disclosure and reporting requirements on
taxpayers and tax advisors. A.B. 1601/S.B. 614. The legislation adopts
IRC §§ 6011, 6111, and 6112 and the accompanying Treasury
regulations for California tax purposes. The legislation imposes
significant penalties for failure to comply with the requirements of the
act. Under the legislation, taxpayers may voluntarily participate in a
compliance program, which began January 1, 2004 and ends April 15,
2004.
C.
Texas: Recently enacted legislation authorizes the state auditor to
audit any settlement, tax refund, credit, payment warrant, offset, or
check issued by the Comptroller’s office. H.B. 7C (Oct. 13, 2003).
The provision went into effect on February 1, 2004, and allows the
state auditor to examine such items prospectively from that date
forward, as well as retroactively for six years prior to the effective
date. The authority granted in the legislation is not restricted to any
particular type of tax. Nor does the legislation specify that the authority
granted to the state auditor does or does not allow the state auditor to
alter the terms of any settlement, refund, etc. However, the legislation
does specify that taxpayer confidentiality will be respected in
connection with these audit procedures.
The information contained herein is general in nature and based on authorities that are subject to change.
Applicability to specific situations is to be determined through consultation with your tax advisor.
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