As part of the Tennessee Department of Revenue's (TDOR) annual "Technical Corrections Bill," the General Assembly has enacted provisions amending several areas of Tennessee's tax law. A summary of the relevant changes is set forth below.

  • FONCE No Longer Includes Industrial and Commercial Rent
  • Codifies F&E Exemption Filing Requirement
  • Revises Intangible Holding Company/Captive REIT Penalty Provisions
  • Modifies Job Tax Credit
  • Delays Effective Date of Remaining Streamlined Sales Tax Changes
  • Taxes Computer Software Warranty and Maintenance Contracts
  • Overturns TEKsystems
  • Exempts Preliminary Artwork and Advertising Services From Sales Tax
  • Centralizes Administration and Expands Scope of Local Business Tax

The Technical Corrections Bill passed the Senate on Friday, June 12, 2009, by a vote of 26-5, and passed the House with minor changes on Tuesday, June 16, 2009, by a vote of 53-43. The Bill will be sent to Governor Bredesen for his signature.

FONCE No Longer Includes Industrial and Commercial Rent

The FONCE exemption no longer applies to entities receiving rental income from industrial/commercial property and certain farm property. Entities receiving rental income from residential rental property will continue to qualify for the exemption, provided the residential rental property only includes property with four or fewer residential units. The effective date of the change is Oct. 1, 2009, but entities currently qualifying as a FONCE can elect unlimited liability and continue to be exempt as an obligated member entity, provided that the election is made prior to Oct. 1, 2009.

A related change establishes a phase-out of the rent that can be deducted by an affiliated lessee. Under the change, an affiliated lessee will be allowed to deduct monthly rent only up to 2 percent of the appraised property tax value of the property. As a result, for property with a value of $500,000 for property tax purposes, the lessee can deduct up to $10,000/month ($500,000 x 2 percent) for rent. Rent paid in excess of this cap is added back to the net earnings of the lessee. Notably, rent is not defined in the statute, making it unclear how the payment of maintenance expenses and insurance will be treated for purposes of the 2 percent rule. A plain reading of the statute would seem to suggest that those expenses can be deducted in addition to the rent threshold.

Codified F&E Exemption Filing Requirement

The franchise and excise tax exemptions are further amended to require both an application for exemption and an annual information return. The statute makes the applicable exemptions contingent upon filing these returns and further imposes a $1,000 penalty for the failure to either properly register or file the annual information return. Entities required to file the information returns include: family-owned non-corporate entities, farming/personal residence, affordable housing, venture capital funds, diversified investing funds, obligated member entities, asset-backed securitization entities (REMIC/FASIT), or other entities exempt as securing third-party indebtedness.

Revised Intangible Holding Company/Captive REIT Penalty Provisions

The penalty for failing to report intangible holding companies and captive REITs is amended to set a minimum penalty of $10,000. The alternative calculation is 50 percent of any required adjustments to the initial return filed. Under the prior law, the exemption was based on underpayments of tax and often resulted in a $0 penalty. The commissioner may waive the penalty for good and reasonable cause.

Job Tax Credit Modifications

The standard job tax credit is increased from $2,000 to $4,500. Under prior law the standard credit was $4,500 only for jobs created in economically distressed counties. Additionally, the legislation clarifies that the required capital investment includes investments in computer software. Also clarified in the Bill is that the required capital investment and creation of jobs must take place within 12 months of the effective date of the business plan which details the investment to be made and the jobs to be created.

Effective Date of Streamlined Sales Tax Changes Delayed

The Bill further extends the effective date of changes made as part of the Streamlined Sales Tax Project. The effective date of these changes is extended from July 1, 2009, to July 1, 2011.

Computer Software Warranty and Maintenance Contracts Taxable

The Bill extends the sales and use tax to computer software warranty and maintenance contracts. Thus, contracts to provide customers with future computer software updates or upgrades, or to provide support services, are subject to sales and use tax. The change is in response to certain taxpayers who where taking the position that software warranty contracts executed outside the state were not subject to Tennessee sales tax. Under the amendment, the sales tax will apply if (1) the maintenance contract is sold as part of the sale of computer software that is subject to the tax, (2) the contract applies to computer software installed on computers located in Tennessee, or (3) the location of the computer software is not known but the purchaser's address is in Tennessee. Additional charges made for actual repairs, modifications, updates or upgrades under the contract are also subject to the sales tax.

Legislature Overturns Teksystems

The Legislature also amended the exemption for software developed by a taxpayer for its own use. This is in response to a recent Tennessee Court of Appeals ruling – TEKsystems v. Chumley – in which the Court concluded that software developed by temporary, information technology professionals qualified for the "in-house" exemption because the professionals functioned as agents and not as independent contractors. The amendment limits the application of the exemption for future periods to software developed by a direct employee that receives a federal W-2 from the company for which the software is being developed.

Preliminary Artwork and Advertising Services Exempt

The Legislature also enacted provisions attempting to clarify the taxation of advertising agencies. Under the amendment, advertising services and preliminary artwork created by the advertising agency appear to be exempt from sales and use tax. Sales tax only applies to the sales price of the final artwork which is based on charges that are directly allocable to the production of the final artwork.

Under the amendment, "advertising materials" are also taxable. This includes tangible items or the digital equivalent produced to advertise a product, service, or idea, including brochures and catalogs. Notably, "advertising materials" specifically excludes sound recordings or video recordings produced by recording or television studios.

Centralized Administration of Local Business Tax

The Technical Corrections Bill also centralizes the administration of Tennessee's local business tax, which will be transitioned to the State over the next year. The tax continues to apply to the same privileges, and the rates, tax years, and return due dates also remain unchanged. Substantive changes include a 50 percent cap on tangible personal property tax credits and a requirement that general contractors obtain the business license of a subcontractor to qualify for the deduction for amounts paid to subcontractors. The Bill also changes the distinction between wholesalers and retailers such that businesses will now be classified as a wholesaler or retailer based on their predominant business activity.

Taxpayers must continue filing separate returns for each place of business, but the returns must now be sent to TDOR instead of the local jurisdiction. Also, taxpayers required to file sales and use tax returns electronically must also file business tax returns electronically. For a more detailed summary of the business tax changes, please see "Tennessee – Summary of Local Business Tax Changes."

Taxpayers should review their compliance with the business tax. The revenue estimates indicated that TDOR anticipates raising over $40 million from this change. The thinking is that TDOR will be able to match business tax records against sales tax records and IRS records better than city and county clerks, so taxpayers will likely see increased scrutiny on business tax filings. If a business has not paid or has underpaid business tax since Jan. 1, 2006, they should consider a Voluntary Disclosure Agreement (VDA), which should allow the taxpayer to anonymously offer to pay the tax and interest due and avoid the penalty. VDAs also limit the period of liability to three years.

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