United States: State And Local Tax Top Stories Of 2010

SALT Top Stories of 2010

While the "Great Recession" may have been declared over by the powers that be, the tepid recovery in 2010 did not help states gain a foothold on their budgets. In fact, many states will have to deal with multi-billion dollar budget gaps in 2011 and beyond, as structural deficits which can only be fixed by drastically raising taxes or cutting services are not being sufficiently addressed. From the tax perspective, pure tax increases have been difficult to adopt, in part because of political considerations, and even if such increases were adopted, there is no guarantee that such increases would guarantee significant revenue growth.

At the same time, the states' income tax, sales tax and property tax bases are not organically growing as they normally would in a strong economy. Both corporate and personal income tax collections have suffered in the recent economic environment. With the removal of many transactions to the Internet, many out-of-state vendors are not collecting and remitting sales tax, on the basis that they do not have physical presence in the state in which their customers are located. Property tax bases have stagnated in the past couple of years due to the retrenchment in housing prices. As states are still feeling the pain, it is not surprising to see new and distinctive methods by which states try to bridge their budget gaps, some of which challenge the bounds of constitutionality.

Now more than ever, states are looking at what the federal government is doing in the income tax area as a template for future activity. The federal adoption of statutory economic substance principles and uncertain tax position (UTP) reporting this year is sure to be copied in some form by the states, as a means to generate revenue without imposing pure income tax increases. On the other hand, states are continuing to decouple from the latest federal economic stimulus programs, which again address bonus depreciation and other items that reduce the federal income tax base when initially adopted, and likewise impact state income taxes.

The push to enact mandatory unitary combined reporting is still ongoing, and the threat of legislation remains real in a few states. States are also looking at economic nexus provisions, particularly rigid receipts thresholds, in an attempt to increase the number of filing taxpayers. The method of apportionment of service income is slowly changing, as states are focusing more on where a taxpayer's customer is receiving the benefit of the service, and less on where a taxpayer is incurring its own costs of performance. Again, this development is being driven in part because states believe that overall, apportionment factors will rise, particularly for out-of-state taxpayers, and revenue will grow accordingly.

On the sales tax front, states have begun to consider coercive forms of disclosure as a method by which they can persuade out-of-state retailers to register, collect and remit sales taxes from their customers. In an attempt to avoid increases in the nominal sales tax rate, states are considering how to broaden the sales tax base by trying to tax sales of services. And of course, the Streamlined Sales Tax (SST) effort continues onward, as nearly half of all states that have adopted a sales tax now conform to the agreement.

States are continuing to use broad tax amnesty programs as a means to supplement revenue. These programs continue to be diverse in scope, with some offering significant breaks on penalties and interest, and others not so forgiving. Many of these programs provide the "incentive" of participating, or being charged with post-amnesty penalties if a taxpayer is later assessed by the state tax authority. Further, the economic environment is putting pressure on state tax authorities to be especially rigid when it comes to penalty waivers at the audit level. Gone are the days where a boilerplate letter could informally eliminate a penalty imposed on a taxpayer for failure to file a return or make sufficient tax payments in a timely manner. Now, abatement of penalties has become a much more formalized process, and having reasonable cause is not always enough.

Having provided a broad background on the high-level issues driving state and local taxation this year, we present the top stories of 2010 as we see them:

1. Specter of economic substance and UTPs reverberate through the states

The federal developments relating to codification of economic substance and UTPs raise a variety of state tax issues that will need to be considered by taxpayers prospectively.

On March 30, 2010, President Obama signed into law the Health Care and Education Reconciliation Act of 2010 (HCERA).¹ As part of that legislation, Section 7701 of the Internal Revenue Code (IRC) was amended to "clarify" a long-standing federal tax common law doctrine regarding "economic substance."² The new statutory language specifies that "[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.³ This definition, which adopts a conjunctive test, effectively overrules the disjunctive test that some courts used in their interpretation of what qualifies under the economic substance doctrine. Along with the codification, Congress added new strict liability penalties that apply to underpayments attributable to transactions that lack economic substance.

The adoption of statutory economic substances raises several important state tax issues. The application of the economic substance and business purpose doctrines has always been a contentious issue in the state tax planning area. Arguably, the federal codification of the economic substance doctrine broadens the doctrine's application to state taxation in that: (1) state tax savings are no longer deemed to be a valid federal business purpose for a transaction; (2) certain issues which were previously determined by looking at the particular facts and circumstances of each transaction will need to be reviewed with an eye to new statutory definitions; and (3) the impact of this analysis on various federal penalty regimes has been codified.

The impact of this federal statutory modification on state taxes may be felt immediately in states that conform to the economic substance provisions contained in the current version of the IRC, and soon thereafter in states that do not necessarily incorporate these new provisions but are influenced by this legislation to adopt similar statutes or apply these standards on audit. It should be noted that questions will arise with respect to whether a state actually adopts IRC Section 7701(o), which is contained in the definitional section of the IRC. While many states explicitly or implicitly adopt the definitional sections of the IRC, not all do. And of course, states that conform to the IRC prior to March 30, 2010 will not conform to HCERA and hence, this provision, until the conformity date is advanced. One big issue that is likely to arise is whether a particular transaction is considered to be a transaction in which the economic substance doctrine is relevant.

In addition, a few states, like Massachusetts and Wisconsin, have already adopted statespecific economic substance statutes. Massachusetts' statute allows the state commissioner to disallow the asserted tax consequences of a transaction by asserting sham transaction or other related tax doctrines. If the commissioner made such an assertion, the taxpayer would have to prove by clear and convincing evidence that the transaction possessed the following elements: "(i) a valid, good-faith business purpose other than tax avoidance; and (ii) economic substance apart from the asserted tax benefit."⁴ Further, the taxpayer would also have the burden to prove by clear and convincing evidence that "the asserted nontax business purpose is commensurate with the tax benefit claimed."⁵

More recently, Wisconsin adopted an economic substance requirement.⁶ For tax years beginning on or after January 1, 2009, transactions considered to lack economic substance are statutorily disallowed. The Wisconsin statute essentially codified a two-prong test established over the years through federal jurisprudence.⁷ The first prong requires that the transaction change the taxpayer's economic position in a meaningful way, apart from federal, state, local and foreign tax effects.⁸ The second prong requires that the transaction has a substantial potential for profit, disregarding any tax effects, and the transaction is a reasonable means of accomplishing the substantial nontax purpose.⁹ Transactions between members of a controlled group¹⁰ are presumed not to have economic substance and the taxpayer must prove economic substance through clear and convincing evidence.¹¹

Finally, in addition to the federal and state-specific economic substance statutes, state courts have been wrestling with the economic substance issue. This year, in HMN Financial, Inc. and Affiliates v. Commissioner of Revenue,¹² the Minnesota Supreme Court declined the Commissioner's request to judicially adopt an economic substance requirement. In reversing a decision by the Minnesota Tax Court, the Supreme Court applied the relevant statutes and said that the Commissioner does not have "the authority to attribute income and assess taxes to a business that structured itself to comply with the letter of the relevant tax statutes" even though it was motivated to do so solely by tax avoidance. While declining the opportunity to judicially adopt an economic substance requirement, the Supreme Court said that it is up to the state legislature to adopt a change in the law.

As for UTPs, the Internal Revenue Service (IRS) provided final guidance to taxpayers on this issue in September,¹³ after previously providing draft guidance earlier in the year.¹⁴ Beginning with the 2010 tax year, C corporations that have total assets equal to or exceeding $100 million must file Schedule UTP.¹⁵ The total asset threshold is reduced to $50 million beginning with the 2012 tax year and is further reduced to $10 million beginning with the 2014 tax year. The IRS will require taxpayers to rank all of the reported tax positions based on the amount of the reserve recorded based on the position taken, and designate any position which constitutes 10 percent or more of all of the reserves reported on the schedule. The taxpayer will also be required to provide a concise description of the UTP itself.

It is unlikely that states will realize significant benefits from the disclosures contained in Schedule UTP, at least in the short term, because the disclosure requirements currently only apply to corporations of a certain size, and state UTPs like nexus exposure, apportionment issues, bonus depreciation adjustments and other state-specific items are not reported to the IRS.

In addition, companies that have historically recorded reserves for UTPs under FIN 48 are not required to disclose those "grandfathered" positions with the IRS. At the same time, the creation of Schedule UTP could result in a substantial compliance burden on multistate taxpayers, to the extent disclosures made on Schedule UTP ultimately result in a change in federal taxable income, since such change will require these taxpayers to file amended state returns based on revenue agents' reports. Further, many states are likely to see the effort by the IRS in developing Schedule UTP as an opportunity to attempt to create non-uniform state-specific disclosure forms, in an effort to raise additional revenue.

2. Federal legislation provides opportunities for states to decouple

The federal government continued to create economic stimulus programs in 2010 which changed provisions of the IRC, but are not being uniformly followed by the states in their conformity to the IRC. The Small Business Jobs Act of 2010 (SBJA),¹⁶ enacted on September 27, 2010, contains a retroactive extension of the 50 percent bonus depreciation provisions for property placed in service in 2010,¹⁷ an increase in the asset expensing limit¹⁸ for the 2010 and 2011 tax years to $500,000 and the phase-out threshold to $2 million,¹⁹ a nominal increase in the amount allowed as a deduction for start-up expenditures²⁰ and a reduction of built-in gains for S corporations.²¹

States continue to take a variety of approaches in determining whether to follow this federal legislation. Bonus depreciation and asset expensing are two areas in which a high incidence of decoupling by the states is likely to occur, which will complicate calculations and increase compliance costs for taxpayers. Some states have automatically conformed to the new federal provisions, while still other states have not indicated whether they will follow the SBJA provisions, and may not decide these issues until next spring, when a majority of state legislatures are in regular session. Due to budget shortfalls and the unexpected nature of this legislation, there will be pressure on these states to decouple from the SBJA provisions. A similar result is likely to occur with respect to the full expensing provision (a/k/a 100 percent bonus depreciation) contained in the Obama tax plan that has just been adopted.²²

3. Sales tax disclosure and affiliation rules complement, and may replace "Amazon rule" as means to enforce sales tax compliance

At the beginning of the year, it was expected that many states would follow the lead of New York, North Carolina and Rhode Island and adopt the "Amazon rule."²³ The "Amazon rule" typically targets an Internet retailer without physical presence in a particular jurisdiction that utilizes Web site owners residing in the jurisdiction to advertise for the Internet retailer, in return for a commission on sales resulting from the followed link. A presumption of taxability exists if the Internet retailer generated more than $10,000 through these referrals during the last four quarterly sales tax periods. The presumption may be rebutted if the Web site owner did not engage in any solicitation in New York that would result in a finding of nexus under constitutional standards.

In somewhat of a surprise, a wholesale adoption of the "Amazon rule" by states did not happen in 2010. Rather, states started to consider an alternative and far-reaching approach, ultimately endorsed by Colorado and Oklahoma -- coerce out-of-state retailers with substantial levels of gross receipts in the states to register for sales and use tax by imposing reporting requirements, and expand the reach of nexus through affiliates.

Effective March 1, 2010, Colorado extended the reach of its sales and use tax to certain out-of-state retailers. Pursuant to the legislation, an out-of-state retailer is presumed to be "doing business" in Colorado for purposes of the sales and use tax if such retailer is a member of a controlled group (using the IRC Section 1563 definition of the term) that has a member with a physical presence in the state of Colorado. However, the presumption of nexus may be rebutted by evidence that the member with a physical presence did not engage in sufficient solicitation on behalf of the out-of-state retailer.²⁴

In addition, retailers that do not have Colorado nexus will be required to follow three special notification and filing rules. The first rule requires the use of specific language on such retailers' invoices to Colorado-based customers stating that Colorado sales tax is due on all non-exempt purchases (retailers with less than $100,000 of prior year Colorado sales are exempt from this notice requirement).²⁵ The second rule requires notification to all Colorado purchasers by January 31 of each year showing amounts paid by the purchaser for Colorado purchases from the retailer in the previous year, along with other information as required by the Department.²⁶ This notification cannot be sent with any other shipments and must contain the words "Important Tax Document Enclosed."²⁷ The third rule requires the filing of an annual statement by March 1 of each year for each purchaser to the Department showing the total amount paid for Colorado purchases of such purchasers during the previous calendar year.²⁸ Penalties apply for failure to follow these rules.²⁹

Oklahoma also enacted legislation that made substantial changes to the sales and use tax, including an expansion of nexus standards for retailers.³⁰ Further, out-of-state retailers that currently do not have a use tax collection responsibility are required to provide notification that consumers are obligated to pay use tax on items used in Oklahoma, though such notification regime is not as complex as Colorado's incarnation. The legislation includes compliance initiatives that provide use tax amnesty for out-of-state retailers and consumers. The notification provisions in the statute became effective on September 17, 2010, the date that an administrative rule was promulgated and became effective.³¹

It is telling that the Multistate Tax Commission (MTC) is getting involved in the disclosure issue as well. In an effort to prevent states from taking completely different approaches in this area, the MTC is undertaking a project with a goal of developing a model statute that closely aligns with the language in the Colorado statute.³² Clearly, the rules adopted by Colorado and Oklahoma, particularly the disclosure initiatives, are designed to force outof- state retailers to become registered for sales and use tax purposes to avoid the burden of the disclosures. Whether that approach is constitutional is certainly subject to question, and undoubtedly will be the subject of future litigation.

Meanwhile, the "Amazon rule" that served as the genesis for the sales tax legislation is still being litigated in New York. The Appellate Division of the New York Supreme Court recently partially affirmed the dismissal of complaints filed by Amazon.com and Overstock.com challenging the constitutionality of the "Amazon rule."³³ The Appellate Division held that the Amazon rule did not violate the Due Process Clause, Commerce Clause or Equal Protection Clause on its face. However, the Appellate Division reinstated the cases to determine whether the statute violated the Due Process Clause and Commerce Clause as applied to Amazon and Overstock.

The resultant appeal of this decision to the top New York court, the Court of Appeals, followed by "as applied" litigation, virtually ensures that the ultimate result of the litigation will not be known for several years, and the breadth of the litigation will grow, as other adversely affected parties decide to litigate in states with an "Amazon rule." At the same time, the current state of play with respect to the litigation could result in encouraging more states to consider whether the adoption of an "Amazon rule" is appropriate.

4. A turning point for combined reporting? Maryland and other states say no for now, and the District is not so sure

While several jurisdictions considered the issue of mandatory unitary combined reporting throughout the year, none of these efforts were adopted. The biggest developments occurred in Maryland, a separate reporting state that has been considering the move to combined reporting for a long time, and the District of Columbia, whose legislative body, the City Council, presumably had intended to adopt combined reporting for 2011 and beyond, but has not acted on such authority to date.

In Maryland, legislation designed to measure the effect of combined reporting required corporate groups to report certain information to the state for their 2006-2010 tax years.³⁴ The legislation also created the Maryland Business Tax Reform Committee to analyze the combined reporting data collected by the Maryland Comptroller. While the 2006 and 2007 tax year data showed that combined reporting would result in significantly increased net revenue to the state, the 2008 tax year data resulted in a loss in net revenue (due to the slowing economy and the effect of combining gain and loss corporations). Accordingly, the Committee decided not to recommend the adoption of combined reporting to the Maryland legislature. While the failure to recommend immediate adoption of combined reporting is not binding on the legislature, it would appear unlikely at this juncture that the legislature will proceed with combined reporting in 2011 in light of these findings.

As for the District of Columbia, the City Council had previously passed a placeholder provision containing no specific details regarding how combined reporting will be implemented. The operative language simply stated that the City Council was directed to pass legislation to enact mandatory unitary combined reporting for tax years beginning after December 31, 2010."³⁵ The legislation apparently intimated that the City Council would pass further legislation that would implement combined reporting. While language was drafted by the District's Chief Counsel's Office for use by the City Council, the City Council has not acted on the legislation to date, making it very unlikely that a combined reporting regime will be in place beginning in 2011, as had been originally intended. Given Maryland's updated revenue estimate, the District may begin to reconsider whether its own revenue estimate is accurate, and whether combined reporting should be pursued.

5. States turn to economic nexus provisions with specific receipts thresholds

The ability of states to claim that corporate-level income taxes could be implicated through economic, rather than physical, presence has grown in recent years. The MTC has endorsed this position in its model legislation,³⁶ and states are beginning to adopt the standard. In 2010, the Colorado and Connecticut state tax authorities set specific receipts thresholds that would constitute nexus.³⁷ In Connecticut, economic nexus was statutorily enacted for tax years beginning on or after January 1, 2010, but the statute did not have a specific receipts threshold required to meet the economic nexus test.³⁸ The Connecticut Department of Revenue Services then issued guidance explaining its application of the new statutory economic nexus standard for corporate income tax.³⁹ The Department provided a de minimis rule as a method to determine whether economic nexus has been achieved, in the form of a bright-line test. The Department stated that an entity would not have economic nexus with Connecticut for a tax year if the frequency, quantity and systematic nature of its economic contacts with the state resulted in less than $500,000 attributable to Connecticut sources during the tax year.⁴⁰

In Colorado, the state's Department of Revenue adopted factor presence nexus standards without the benefit of a statute specifically authorizing such rules.⁴¹ Business organizations that are organized outside Colorado have substantial nexus with the state if they have property, payroll or sales that exceed specified thresholds during the tax period.⁴² For taxpayers organized outside Colorado, substantial nexus is established if any of the following thresholds is exceeded during the tax period: (1) $50,000 of property; (2) $50,000 of payroll; (3) $500,000 of sales; or (4) 25 percent of total property, total payroll or total sales.⁴³

The question to be raised in the future is whether the Connecticut and Colorado standards that were adopted by state tax authorities, as well as more general economic nexus standards created by state legislatures, will be upheld in the courts. It can be argued that the objective thresholds used to decide whether substantial nexus exists conflict with the judicial concept of determining substantial nexus on a case-by-case basis.

In Ohio, a state that has used statutorily adopted economic nexus thresholds for several years under the Commercial Activity Tax (CAT), litigation on this issue is pending. In September, the Ohio Tax Commissioner issued a final determination asserting that L.L. Bean, an out-of-state retailer which sold to a nationwide customer base, had substantial nexus with Ohio for purposes of the CAT because its level of gross receipts in the state (greater than $500,000) satisfied the bright-line presence test.⁴⁴ The retailer continuously and systematically engaged in solicitation of the Ohio economic marketplace through its catalogs, print and other advertising directed to Ohio residents.

The Commissioner rejected arguments by the retailer that imposition of the CAT would violate the Commerce Clause because the retailer lacked the "bright-line" physical presence in Ohio required by the U.S. Supreme Court in National Bellas Hess v. Illinois Revenue Department⁴⁵ and Quill Corp. v. North Dakota.⁴⁶ The Tax Commissioner noted that the Ohio Supreme Court found in Ohio Grocers Association v. Levin⁴⁷ that the CAT is not the functional equivalent of a sales tax, and the physical presence requirement in Quill was only applicable to a sales tax, and does not apply to the CAT.

Interestingly, the Commissioner stated that it was without jurisdiction to rule on the constitutionality of the substantial nexus provisions of the CAT, including the bright-line presence test, yet decided to discuss its take on the constitutional issue despite this limitation. Further, in a footnote, the Commissioner reserved the right to attack the petitioner's claim that it had no physical presence in Ohio if the Commissioner's ruling was ultimately overturned by a reviewing tribunal or court. Both of these assertions reflect the Commissioner's adamant and unwavering stance regarding these issues. A final resolution by the courts on this issue is likely to take several years.

6. The continuing wrangling over sourcing service revenue, and California's recent experience

States have struggled with how to source service income for purposes of apportionment. Some states have followed Section 17 of the Uniform Division for Income Tax Purposes Act (UDITPA), which sources sales, other than sales of tangible personal property (including services), by looking at the taxpayer's "costs of performance" (COP).⁴⁸ Generally, states that use COP use one of two methods to source service revenue: preponderance (all-or-nothing) sourcing to the state in which the most COP is located, which is endorsed by UDITPA, or proportionate (pro rata), sourcing to each of the states in which the COP is located.

Increasingly, however, states are looking to source services according to the location of the taxpayer's marketplace, or where the taxpayer's customer receives the benefit of the service, instead of COP. There are several reasons why states are moving away from the traditional COP rules and adopting market-based sourcing. Proponents of market-based sourcing claim that such method serves the purpose of the sales factor by balancing the origin-based property and payroll factors, and results in an increased level of certainty for taxpayers selling services and intangibles. Further, COP has been criticized as too difficult to determine, penalizes in-state companies, and is perceived as unfair when using an all-ornothing approach. In some cases, a state tax authority may so dislike the outcome of COP that it decides to utilize alternative apportionment, endorsed by UDITPA Section 18, as a means to more properly reflect a taxpayer's income.

The conflict between COP and market-based sourcing has been most apparent in California, which historically has followed preponderance COP principles.⁴⁹ California decided this year to incorporate both methods in apportioning service revenue starting in 2011. A market-based sourcing rule will be put into effect for taxpayers who elect to use a single sales factor apportionment formula when that election is available beginning in 2011.⁵⁰ Under this rule, sales from services will be sourced to California to the extent the purchaser of the service received the benefit of the service in California.⁵¹ Taxpayers who do not elect to use a single factor apportionment formula will continue to use the preponderance COP rule.⁵² The California Franchise Tax Board is in the process of promulgating a regulation that explains how to source services under the new market-based sourcing rule.⁵³

The draft regulation defines the term "benefit of a service is received" as the location where the taxpayer's customer has either directly or indirectly received value from delivery of that service.⁵⁴ In addition, the draft regulation provides a rebuttable presumption that for a taxpayer's individual customers, the location of the customer's billing address is where they have received the benefit, and for a taxpayer's corporate customers, there is a rebuttable presumption that the location designated by a contract or the taxpayer's books and records is the location of benefit.⁵⁵ Numerous examples are contained in the draft regulation to explain these concepts.⁵⁶ The final product, expected soon, could be the most complex regulation on this subject, and could be used by other states as a template through which they could reconsider their sourcing provisions.

7. Washington revamps B&O tax on service providers

The confluence of economic nexus provisions and sourcing services was found in the state of Washington this year, when significant changes were made to the Washington Business & Occupation (B&O) tax in 2010. As a result of these changes, many service providers with tangential presence in Washington may now be subject to the tax. Washington adopted a new economic nexus standard for taxpayers engaged in service and other enumerated "apportionable activities," based on achieving one of several Washington property, payroll or receipts thresholds.⁵⁷ In addition, the state imposed a 0.3 percent tax rate increase on service providers, bringing the rate to 1.8 percent, for the period May 1, 2010 through June 30, 2013.⁵⁸ The legislation also changed how income is apportioned for the B&O tax on services for both in-state and out-of-state businesses.⁵⁹ In lieu of historic cost apportionment, a seven-step cascading sourcing provision for receipts is now in effect, whereby the location where a taxpayer received the benefit of the services is paramount.⁶⁰ Special rules apply for determining where the customer's benefit may be located.⁶¹ Only if the location of benefit is not determinable does a customer's ordering or billing address potentially come into play for sourcing purposes.⁶² Similar rules are applicable to companies deriving income from royalties and intangible assets.⁶³

In conjunction with these changes, the Washington Department of Revenue sent out blanket notices to service providers throughout the United States, in an effort to require these businesses to affirmatively determine under the new guidelines whether or not they have B&O tax nexus, and if so, register with the state and calculate B&O tax liability. Service providers will need to determine whether they actually have nexus in Washington, through a consideration of whether it meets the bright-line economic nexus tests endorsed by the state.

8. Fallout from Kmart and implication of retroactivity issues

In 2009, the Michigan Court of Appeals held in Kmart Property Services, LLC v. Department of Treasury⁶⁴ that a single-member limited liability company (SMLLC) that was disregarded for federal tax purposes must file a return separate from its owner. The Court determined that under a single business tax (SBT) statute, the taxpayer was required to file an SBT return, regardless of its classification as a disregarded entity for federal tax purposes.⁶⁵ This decision was contrary to a historic position taken by the Michigan Department of Treasury in Revenue Administrative Bulletin (RAB) 1999-9⁶⁶ that a taxpayer was restricted to the same entity filing status under the SBT that it had used for federal tax purposes for the same tax period.

Following the decision in Kmart, the Treasury released a notice⁶⁷ concluding that for purposes of the SBT, Kmart would be applied to all open tax years, invalidating the portions of RAB 1999-9 and RAB 2000-5⁶⁸ to the extent such RABs were inconsistent with Kmart. Under the SBT notice, the Treasury allowed taxpayers that would benefit from the application of the Kmart case to file for refund claims, but limited this benefit to all open tax years instead of all tax years beginning on or after January 1, 1997, the date on which RAB 1999-9 was originally effective. In contrast, taxpayers owing taxes as a result of the application of the Kmart case were required to file SBT returns back to tax years beginning on or after January 1, 1997.

In response to the SBT notice issued in the aftermath of the Kmart decision, Michigan enacted what it termed to be "curative" legislation earlier this year.⁶⁹ The legislation prevents the Department from: (i) assessing a taxpayer an additional tax or reducing an overpayment because the taxpayer originally included a disregarded entity on its SBT return; and (ii) requiring the disregarded entity to file a separate return. In addition, the legislation bars a taxpayer that filed an SBT return which included an entity disregarded for federal income tax purposes from claiming a refund based on the disregarded entity filing a separate return as a distinct taxpayer.⁷⁰ As a result of the legislation, the Treasury rescinded the SBT notice discussing the effect of Kmart.⁷¹

Undeterred by this action, the Treasury later issued a second notice addressing how taxpayers should treat federally disregarded business entities for purposes of the Michigan Business Tax (MBT).⁷² The MBT notice requires taxpayers with federally disregarded entities to treat these entities as separate filers under the MBT, consistent with the Treasury's posture on prior SBT filings, or file as a member of a unitary business group to the extent the disregarded entity is part of a unitary group. The new policy in the MBT notice contrasts with current MBT form instructions, and taxpayers affected by the change in policy will be required to file and amend MBT returns for current and prior tax years by June 30, 2011 or risk failure to file penalties, even if the change does not result in a change in MBT liability.

The back-and-forth between the courts, Treasury and the legislature clearly is causing significant confusion in how to report the ownership of disregarded entities, and could lead to a compliance nightmare for taxpayers if the legislature does not act to change the MBT interpretation by the Treasury. But the larger, and in many respects, more controversial issue here is that of the tacit approval of retroactivity, by both the legislature and the Treasury. The legislation concerning the SBT treatment of disregarded entities expressly provides that taxpayers no longer will be able to claim refunds based on a disregarded entity filing a separate return as a distinct taxpayer, voiding potential refunds which were applied for pursuant to the SBT notice. Likewise, the MBT notice retroactively requires taxpayers to file in a certain manner, and pay interest on additional MBT liabilities that have suddenly appeared as a result in a change in the Treasury's policy.

These retroactive provisions could be subject to challenge, and taxpayers across the country are facing this issue. Two of these cases recently were adjudicated in Kentucky. In Miller v. Johnson Controls, Inc.,⁷³ the Kentucky Supreme Court upheld the constitutionality of certain amendments to corporate income tax statutes that barred the filing of combined tax returns under the unitary business concept and related tax refunds for tax years prior to 1995. According to the Court, the amendments did not violate due process or other constitutional requirements because they were rationally related to the legitimate governmental purpose of regulating revenue. The U.S. Supreme Court recently denied certiorari in this case.⁷⁴ In the second Kentucky case, Revenue Cabinet v. Asworth Corp.,⁷⁵ the Kentucky Court of Appeals ruled that legislation that retroactively delayed the computation of interest on tax refunds and reduced the interest rate was constitutional, again satisfying the "rational relationship" test. The case, which was denied review by the Kentucky Supreme Court, has been appealed to the U.S. Supreme Court, where a decision on certiorari may be made in the next few months.⁷⁶

9. The Kimberly-Clark business / nonbusiness income controversy

Early this year, the Alabama Supreme Court determined that the proceeds from the sale of substantial assets (timberland and a mill) that had been used in a business were required to be treated as nonbusiness income allocable entirely to Alabama.⁷⁷ As a result, the Court upheld an Alabama Department of Revenue assessment on two related taxpayers of nearly $21 million.

Originally, the taxpayers reported gross receipts from the sale of the property as apportioned business income. However, the taxpayers excluded the receipts from the calculation of the Alabama sales factor as substantial amounts of gross receipts arising from an incidental or occasional sale of a fixed asset used in the regular course of the taxpayers' trade or business.⁷⁸ This exclusion served to lower the taxpayers' Alabama corporation income tax liability.

The Department originally agreed with the taxpayers' business income classification, but disputed the exclusion of the gross receipts from the Alabama sales factor, resulting in a reduction of a tax refund due to the parent taxpayer of approximately $150,000, and an assessment on the subsidiary taxpayer of approximately $3.4 million. The taxpayers did not agree with the Department's actions and filed petitions for review. In their petitions, the taxpayers advanced an alternative argument stating that the receipts constituted nonbusiness income allocable to Texas, the taxpayers' state of commercial domicile. The Department responded by accepting the taxpayers' nonbusiness income position, and turning it on its head by claiming that all the receipts were allocable to Alabama, the location of the sold properties.⁷⁹ This position resulted in an assessment on the parent taxpayer of approximately $7.4 million, and on the subsidiary taxpayer of approximately $13.6 million.

In finding for the Department, the Alabama Supreme Court noted that under the state's historic conception of UDITPA, in determining whether a transaction results in business or nonbusiness income, one must look at the nature of the particular transaction giving rise to the income, and consider the frequency and regularity of similar transactions, along with former practices of the business.⁸⁰ In concluding that the sale of the properties resulted in nonbusiness income, the Supreme Court focused on the non-core nature of the property that was sold, concluding that the property was not essential to the taxpayers' business operations, and the sales were part of the parent taxpayer's strategy to shed businesses other than its consumer products business. The Court noted the fact that the sale of the properties could not have been made in the regular course of business because such properties were part of the parent taxpayer's business for 34 years. The extraordinary nature of the sale resulted in nonbusiness income, and by implication, the Court accepted the Department's argument that the receipts from the sale of the property would be allocated entirely to Alabama.

The result in this case should serve as a cautionary tale to taxpayers that are considering apportionment positions based on the exclusion of gross receipts, as well as the decision to classify receipts from a transaction as business or nonbusiness income. Though most states now allow for business income treatment in cases where either the transactional or functional test is met, the ramifications of this decision still could extend to other states that follow the UDITPA apportionment laws and regulations.

10. SST developments

This year, the SST Governing Board finally resolved some thorny issues on vendor compensation and the small seller exception from collection of tax on remote sales in states belonging to the SST Agreement. With respect to vendor compensation, member states will need to pay compensation to all vendors in an amount that is at least 0.5 percent of the state's total sales and use tax collections. The compensation amount that would need to be paid to all vendors will be at least 0.75 percent of the state's total sales and use tax collections if the state requires sellers to report local taxes. A "new remote seller" with gross national remote sales of less than $5 million annually is entitled to receive additional "bonus" compensation in the first six months that it collects a member state's tax, in order to cover compliance costs. As for the small seller exception, sellers with less than $500,000 in annual gross national remote sales will initially be exempt from the SST collection requirements if the federal SST bill passes, though such threshold may drop in future years. A registration requirement will remain for sellers with remote sales between $100,000 and $500,000, though collection will not be necessary by those sellers.

On the federal SST legislation front, the Main Street Fairness Act was introduced into Congress again this summer.⁸¹ The bill, if enacted, would allow any SST member state to be able to require a remote seller that has no physical presence in the state to which a particular sale is sourced, to collect that state's sales or use tax on such sales.⁸² An exception from this requirement would be made for small sellers.⁸³ This federal legislation would go into effect on the first day of a calendar quarter that is at least six months after the date the SST Governing Board makes a determination that its member states are in compliance with the provisions of the federal bill.⁸⁴ To be in compliance, the federal bill lists a total of 19 minimum simplification requirements that must be met by member states to the SST Agreement.⁸⁵

One state, Georgia, did adopt most of the SST conforming legislation during 2010 and it will become an associate member state on January 1, 2011. An open question for 2011: will any other states adopt SST conforming legislation?

As the SST Agreement continues to become more complex, it becomes increasingly difficult for states to uniformly comply with the agreement. This is particularly going to be an issue as the SST Governing Board tries to make the SST Agreement more palatable for prospective members. At the most recent SST meeting, six states were found out of compliance in the annual recertification process. Though these states will not be sanctioned for their noncompliance at the current time, the SST Governing Board will have to wrestle with a tough choice: either enforce the SST Agreement and threaten sanctions for noncompliance, which may be enough for a state involved in SST to leave the agreement; or be lenient with noncompliance issues and live with a certain level of nonconformity among the existing SST members.

Two other issues to note: the SST Governing Board is aware of sales tax nexus legislation that was adopted in New York, Colorado and Oklahoma (discussed above), and continued adoption of these types of rules could act to spoil the SST effort through its nonconforming approaches. In addition, the SST Governing Board is considering test litigation as a possible method to overturn the physical presence standard that was adopted in the Quill case, based on the argument that the burden on out-of-state vendors complying with registration requirements in a particular state conforming to the SST Agreement has been now sufficiently reduced in order to allow such states to require these vendors to collect and remit the sales tax.

Footnotes

1 P.L. 111-152.

2 The language clarifying the federal economic substance doctrine is codified as IRC § 7701(o).

3 IRC § 7701(o)(1). In addition, "[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted." IRC § 7701(o)(5)(C). It should be noted that "any State or local income tax effect which is related to a Federal income tax effect shall be treated in the same manner as a Federal income tax effect. IRC § 7701(o)(3).

4 MASS. GEN. LAWS ch. 62C, § 3A.

5 Id.

6 WIS. STAT. §§ 71.10(1m), 71.30(2m), as added by Act 2 (S.B. 62), Laws 2009, §§ 111 and 158.

7 Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985), although some federal circuits have refused to apply the rigid two-step analysis to the economic sham inquiry as laid out in Rice. Rather, they viewed the steps as related factors. Both affect the analysis of whether the transaction, apart from its tax consequences, has sufficient substance to merit respect. See also, Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 781-82 (5th Cir. 2001).

8 WIS. STAT. § 71.30(2m)(b). See also, ACM Partnership v. Commissioner, 157 F.3d 231 (3rd Cir. 1998).

9 Id.

10 As defined in IRC § 267(f)(1).

11 WIS. STAT. §§ 71.10(1m)(c), 71.30(2m)(c), 71.80(1m)(c).

12 No. A09-1164, filed May 20, 2010.

13 IRS Announcement 2010-75, issued Sep. 24, 2010.

14 IRS Announcement 2010-9, issued Jan. 26, 2010; IRS Announcement 2010-30, issued Apr. 19, 2010.

15 Thus, all C corporations with less than $100 million in assets, as well as all partnerships, limited liability companies, and S corporations are not required to file Schedule UTP (although uncertain tax positions in such entities that are reflected in the federal income tax returns filed by their owners or members who are subject to the filing requirement may be subject to scrutiny).

16 P.L. 111-240.

17 IRC § 168(k).

18 IRC § 179.

19 Prior to amendment, the expensing limit was $250,000 for tax years beginning in 2010 and $25,000 for tax years beginning in 2011. The phase-out threshold was $800,000 for tax years beginning in 2010 and $200,000 for tax years beginning in 2011.

20 IRC § 195.

21 IRC § 1374(d).

22 H.R. 4853, which amends IRC § 168(k).

23 N.Y. TAX LAW § 1101(b)(8)(vi); TSB-M-08(3)S, New York State Department of Taxation and Finance, May 8, 2008; TSB-M-08(3.1)S, New York State Department of Taxation and Finance, June 30, 2008.

24 COLO. REV. STAT. § 39-26-102(3)(b)(II).

25 1 COLO. CODE REGS. § 39-21-112.3.5(3).

26 COLO. REV. STAT. § 39-21-112(3.5)(d)(I)(A).

27 COLO. REV. STAT. § 39-21-112(3.5)(d)(I)(B).

28 COLO. REV. STAT. § 39-21-112(3.5)(d)(II)(A).

29 COLO. REV. STAT. § 39-21-112(3.5)(c), (d)(III).

30 OKLA. STAT. tit. 68, § 1401.9.

31 OKLA. STAT. tit. 68, §§ 1406.1.B, 1406.2; OKLA. ADMIN. CODE § 710:65-21-8.

32 Multistate Tax Commission Sales & Use Tax Uniformity Subcommittee, Draft Model Sales & Use Tax Notice and Reporting Act, July 15, 2010.

33 Amazon.com, LLC v. New York State Department of Taxation and Finance, New York Supreme Court, Appellate Division, No. 601247/08, Nov. 4, 2010; Overstock.com v. New York State Department of Taxation and Finance, No. 107581/08, Nov. 4, 2010.

34 H.B. 664 and S.B. 444, enacted April 24, 2008.

35 The legislation was enacted as the "Combined Reporting Reform Authorization Emergency Act of 2009," § 7231.

36 See Multistate Tax Commission, "Factor Presence Nexus Standard for Business Activity Taxes."

37 Last year, California enacted a factor presence nexus standard for its corporation franchise tax that is effective for tax years beginning on or after January 1, 2011. CAL. REV. & TAX CODE § 23101. Oklahoma also adopted an economic nexus threshold for its newly adopted business activity tax. OKLA. STAT. tit. 68, § 1218(H). The Washington economic nexus thresholds that were adopted in 2010 are discussed below.

38 The statute reads as follows: "Any company that derives income from sources within this state, or that has a substantial economic presence within this state, evidenced by a purposeful direction of business toward this state, examined in light of the frequency, quantity and systematic nature of a company's economic contacts with this state, without regard to physical presence, and to the extent permitted by the Constitution of the United States, shall be liable for the tax imposed under chapter 208 of the general statutes. Such company shall apportion its net income under the provisions of said chapter 208." According to the Connecticut Legislature's Public Acts to General Statutes Conversion Tables, § 90 is being codified as CONN. GEN. STAT. § 12-216a.

39 Informational Publication 2010(29), Connecticut Department of Revenue Services, Sep. 23, 2010.

40 For pass-through entities, the determination of whether such an entity satisfies the bright-line test is made at the entity level.

41 1 COLO. CODE REGS. § 39-22-301.1.

42 1 COLO. CODE REGS. § 39-22-301.1(2)(a)(ii).

43 1 COLO. CODE REGS. § 39-22-301.1(2)(b).

44 In re L.L. Bean, Inc., Ohio Department of Taxation, Aug. 10, 2010.

45 386 U.S. 753 (1967).

46 504 U.S. 298 (1992).

47 916 N.E.2d 446 (Ohio 2009).

48 UDITPA § 17.

49 CAL. REV. & TAX. CODE § 25136(a).

50 CAL. REV. & TAX. CODE § 25136(b)(5). It should be noted that on November 2, 2010, California voters rejected an initiative, Proposition 24, the Repeal Corporate Tax Loopholes Act, which would have repealed the single sales factor election, and would have caused the sourcing of services to revert to the COP rule for all taxpayers.

51 CAL. REV. & TAX. CODE § 25136(b)(1)-(4).

52 CAL. REV. & TAX. CODE § 25136(a).

53 CAL. CODE REGS. tit. 18, § 25136 (draft).

54 CAL. CODE REGS. tit. 18, § 25136(b)(1) (draft).

55 CAL. CODE REGS. tit. 18, § 25136(c)(1), (2) (draft).

56 CAL. CODE REGS. tit. 18, § 25136)(c)(1)(D), (2)(E) (draft).

57 WASH. REV. CODE §§ 82.04.066, 82.04.067, 82.04.460(4)(a); WASH. ADMIN. CODE § 458-20-19401.

58 WASH. REV. CODE §§ 82.04.290; 82.04.29002. Contests of chance of $50,000 or more also are subject to an existing additional tax. As a result, these taxpayers are taxed at a rate of 1.93 percent. An exemption is provided for hospitals and scientific research and development activities. Businesses subject to this increased rate may be entitled to a small business credit not to exceed $70 per month.

59 WASH. REV. CODE § 82.04.462.

60 See WASH. REV. CODE § 82.04.460; WASH. ADMIN. CODE § 458-20-194.

61 WASH. ADMIN. CODE § 458-20-19402(5)(a)(i).

62 WASH. REV. CODE § 82.04.462(3)(b).

63 Id.

64 770 N.W.2d 915 (Mich. App. 2009).

65 See former MICH. COMP. LAWS §§ 208.6 and 208.31.

66 Revenue Administrative Bulletin 1999-9, Michigan Department of Treasury, Nov. 29, 1999. This RAB was effective January 1, 1997 and covered the effect of a federal entity classification election on Michigan taxes.

67 Notice to Taxpayers Regarding Kmart Michigan Property Services LLC v. Dep't. of Treasury, the Single Business Tax, RAB 1999-9, and RAB 2000-5, Michigan Department of Treasury, Feb. 5, 2010.

68 Revenue Administrative Bulletin 2000-5, Michigan Department of Treasury, June 19, 2000. This RAB concerned the Michigan tax treatment of the federal qualified Subchapter S subsidiary (QSub) election and was effective for SBT returns filed in tax years beginning on or after July 14, 1999.

69 Act 38 (H.B. 5937), Laws 2010, effective March 31, 2010.

70 Id.

71 Rescinded: Notice to Taxpayers Regarding Kmart Michigan Property Services LLC v. Dep't. of Treasury, the Single Business Tax, RAB 1999-9, and RAB 2000-5, Michigan Department of Treasury, April 12, 2010.

72 Notice to Taxpayers Regarding Federally Disregarded Entities and the Michigan Business Tax, Michigan Department of Treasury, Nov. 29, 2010.

73 296 S.W.3d 392 (Ky. 2009).

74 Johnson Controls, Inc. v. Miller, U.S. Supreme Court, Dkt. 09-981, petition for certiorari denied May 24, 2010.

75 Revenue Cabinet v. Asworth Corp., Kentucky Court of Appeals, Nos. 2007-CA-002549-MR, 2008-CA-000023- MR, Nov. 20, 2009.

76 Asworth, LLC v. Kentucky Department of Revenue, U.S. Supreme Court, Dkt. 10-662, petition for certiorari filed November 16, 2010.

77 Kimberly-Clark Corp. v. Alabama Department of Revenue, Alabama Supreme Court, No. 1070925 (Feb. 26, 2010).

78 ALA. ADMIN. CODE r. 810-27-1-4.18(3)(a).

79 ALA. CODE § 40-27-1, Art. IV.6.(a). It is uncertain as to how the taxpayers came to the assertion that the sale should have been sourced to its commercial domicile. Under the applicable statute, capital gains and losses may be sourced to a taxpayer's commercial domicile only when such gains and losses arise from sales of: (i) tangible personal property with a situs in a jurisdiction in which a taxpayer is not taxable; or (ii) intangible personal property. ALA. CODE § 40-27-1, Art. IV.6.(b), (c).

80 Ex parte Uniroyal Tire Co., 779 So. 2d 227 (Ala. 2000).

81 H.R. 5660.

82 H.R. 5660, §§ 4(a)(1); 10(5), (6).

83 H.R. 5660, § 7(a)(17).

84 H.R. 5660, § 4(c)(2).

85 H.R. 5660, § 7(a)(1)-(19).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.