United States: State + Local Tax Insights: Winter 2013

Sales Tax Nexus Developments in California and Beyond: A Year in Review1

The battlelines have shifted once again in the disputes over sales tax nexus and we bring you this installment to cover the major developments in these issues over the past year. Our previous articles analyzed Amazon's and other online retailers' attempts to challenge the requirements for remote (largely Internet-based) sellers to collect the states' sales taxes.2 In our last installment, we reported on Amazon's efforts to take California's affiliate nexus law to the voters, which the company ultimately abandoned after reaching an agreement with the State to delay the effective date for one year, permitting Amazon time to lobby for federal legislation on the subject.3 Now, the one-year grace period has come and gone, federal legislation is still pending and California's new sales tax nexus statutes have gone into effect, as of September 15, 2012. In addition, Amazon is planning to build two large distribution centers in California and several in other states in order to shorten its shipping times.

In this article, we review the requirements of California's new law and analyze the proposed regulations recently issued by the State Board of Equalization ("SBE"), as well as bring you up to date on other sales tax nexus developments around the country. In addition, we provide an update on the status of pending federal legislation on this issue. Finally, we offer a few thoughts on the new direction this battle over sales tax nexus seems to be taking and the implications it might have for states and taxpayers.


California's statute, as amended last year, expands the definition of a "retailer engaged in business in this state" to include both: (i) any retailer that is a member of a commonly controlled group, of which another member "pursuant to an agreement with or in cooperation with the retailer, performs services in this state in connection with tangible personal property to be sold by the retailer;" and (ii) any retailer that has an affiliate in the state, that is, the retailer has entered into "an agreement or agreements under which a person or persons in this state, for a commission or other consideration, directly or indirectly refer[s] potential purchasers of tangible personal property to the retailer, whether by an Internet based link or an Internet Web site, or otherwise," if minimum thresholds are met for sales based on referrals from the agreement (i.e., $10,000) and for total sales by the retailer (i.e., $1 million).4 The statute expressly provides that advertising, whether on television, on radio, in print or on the Internet, does not trigger nexus, unless the compensation for the advertising service is by commissions based on the sale of tangible personal property.5 With respect to Internet advertisements, nexus is not triggered unless the person displaying the advertisement "also directly or indirectly solicits potential customers in this state through use of flyers, newsletters, telephone calls, electronic mail, blogs, microblogs, social networking sites, or other means of direct or indirect solicitation . . . ."6

The SBE's proposed regulations track the new statutory provisions, define a few key terms and provide examples that interpret the new statute in a manner that creates a safe harbor for certain types of Internet advertising relationships. First, the regulations expand on the term "commission or other consideration" by noting that this means any "consideration that is based upon completed sales of tangible personal property, whether referred to as a commission, fee for advertising services, or otherwise . . . ."7 Thus, "commission" does not, apparently, extend to fees paid to an advertiser based on the number of times viewers "click" on the advertisement or based on the number of times customers complete a sale through an affiliate referral.

Second, the regulations define "advertisement" as "a written, verbal, pictorial, graphic, etc. announcement of goods or services for sale, employing purchased space or time in print or electronic media, which is given to communicate such information to the general public."8 In addition, the regulations specifically address Internet advertising, noting that "[o]nline advertising generated as a result of generic algorithmic functions that is anonymous and passive in nature, such as ads tied to Internet search engines, banner ads, click-through ads, Cost Per Action ads, links to retailers' websites, and similar online advertising services, are advertisements and not solicitations."9 "Solicitation," on the other hand, is defined as "a direct or indirect communication to a specific person or specific persons done in a manner that is intended to and calculated to incite the person or persons to purchase tangible personal property from a specific retailer or retailers."10 In addition to these definitions, the SBE clarifies that much standard Internet advertising will not trigger nexus under the statute. For example, the proposed regulations specifically mention "Cost Per Action ads," which are advertisements for which the advertiser is paid a fee based on the number of specified actions by the viewer of the advertisement, e.g., clicks on the ad or sales made after clicking through the ad to the retailer's website. One could certainly interpret the SBE's definition of "solicitation" to extend to this type of advertisement. Indeed, if the "Cost Per Action" compensation arrangement were to trigger nexus under the statute, it would presumably bring much of the Internet advertising within the framework of affiliate nexus. However, the SBE is apparently not inclined to take that draconian approach and has, instead, created a safe harbor for a certain segment of the Internet advertising industry.

The regulations' examples confirm that the SBE does not consider click through advertisements paid based on commissions for sales to trigger nexus under the new statute. In one example, the regulations describe a remote seller that has an agreement with an in-state entity to place click-through advertisements or links on the in-state entity's website.11 The remote seller pays the in-state entity "commissions based upon the retailers' completed sales made to customers who click-through the ads or links . . . ."12 In addition, the in-state website posts reviews of the products sold by the remote-seller. However, the example notes that the in-state entity "does not engage in any solicitation activities in California that refer potential customers to the retailer . . . ."13 According to the example, nexus is not triggered for the remote seller by this relationship with the in-state website.14

In addition, the proposed regulations adopt New York's model for administration by specifying that a remote seller can establish that it does not have nexus based on its affiliate relationships by including certain terms in its contracts with in-state affiliates and obtaining an annual certification from those affiliates.15 In particular, the contract with the affiliate should prohibit the affiliate from "engaging in any solicitation activities in California that refer potential customers to the retailer including, but not limited to, distributing flyers, coupons, newsletters and other printed promotional materials or electronic equivalents, verbal soliciting (e.g., in-person referrals), initiating telephone calls, and sending e-mails . . . ."16 In addition, the affiliate's annual certification should provide that the affiliate has not engaged in any of the prohibited solicitation in California and must be signed under penalty of perjury.17 The retailer must accept the certification in good faith and have no "reason to know that the certification . . . [is] false or fraudulent."18

Assuming the proposed regulatory definitions of advertising and solicitation, along with the examples, are adopted, Internet sellers will be able to enter into contracts for quite a broad variety of online advertising without concern that those contracts will create nexus for the seller in California. This is consistent with our long standing view that basic advertising should not be enough contact with a state to trigger nexus.19 However, the California regulations take this a step further by expressly permitting online advertising with click-through ads that is compensated based on commissions for sales. We are encouraged by this indication that California apparently intends to adopt a measured approach in its new statutory definition of nexus.

We had previously noted our concern that California's new statute was broader in scope than other states, based on the fact that it bases nexus on agreements with any "persons" in the state, whereas other statutes are limited to agreements with "residents."20 Indeed, the SBE staff rejected requests made by interested parties during the rulemaking process to define "person" for this purpose as "an individual that is a California resident or a business legal entity that is commercially domiciled or headquartered in California."21 The SBE noted that "person" is broadly defined in the statute and that "an individual does not need to be a resident of California and a legal entity does not need to be headquartered or domiciled in California in order to perform services in this state."22

In addition, the proposed regulations specifically provide that the only activities of an affiliate that matter for the purpose of determining whether those activities create nexus for the remote seller are the activities that the affiliate undertakes in California.23 The SBE expressly noted that the affiliate nexus provisions apply only "when an individual solicits potential customers under the retailer's agreement while the individual is physically present within the boundaries of California . . . ."24 This resolves our concern that the statutory language could be construed more broadly to create nexus based on an agreement with an affiliate that has presence in California but did not necessarily conduct the marketing activities on behalf of the out-of-state seller in California.25

In sum, the SBE's proposed regulations on California's new sales tax nexus statutes seem to take a relatively moderate approach to reaching online retailers. As mentioned above, Amazon has begun collecting sales tax on its California sales. Overstock.com, by contrast, terminated its agreements with California affiliates to avoid its collection obligation, citing its position that California's law is unconstitutional.26 However, given the safe harbor set up in the proposed regulations, Overstock.com might well be able to reinstate its affiliate contracts- at least in some form-assuming the regulations are adopted.

Developments in Other States

There have been several interesting developments in litigation, legislation and settlements across the country since we last reported on these issues.

Let's first take a look at the major litigation matters: Amazon's lawsuit against New York's trail-blazing affiliate nexus statute is now on appeal before that State's highest court, the Court of Appeals.27 The appeal relates to a decision by the intermediate appellate court (i.e., the Appellate Division) that rejected Amazon's facial constitutional challenges to the statute, concluding that Amazon was unable to establish that there was "no set of circumstances" in which the law could be validly applied.28 However, the Appellate Division also concluded that the record was insufficient to determine whether the law might be unconstitutional as applied to Amazon's facts and sent the case back to the trial court for a determination of the merits of the asapplied challenges.29 After engaging in discovery for over a year, Amazon has now dropped its as-applied challenges in order to bring the facial challenge before the State's highest court.30

The cases brought by two marketing trade organizations met with initial successes. As we have previously reported, the Direct Marketing Association sued Colorado over its law that would have required out-of-state sellers to comply with certain notification and reporting requirements, including sending the State an annual list of Colorado customers and their purchases on which sales tax was not collected.31 The trial court issued a preliminary injunction and has now made the injunction permanent.32 The State has appealed the decision.33 Another trade organization, the Performance Marketing Association, sued Illinois over its affiliate nexus law and won in the trial court, which held that the law "fails the ۆsubstantial nexus' requirement for state use tax collection and reporting obligations under the Commerce Clause . . . ."34 The State is appealing directly to the Illinois Supreme Court on the grounds that the judgment declares the State statute invalid.35

The state legislatures have slowed a bit in introducing new affiliate nexus laws. For example, Minnesota's legislature introduced a new nexus statute, but it failed to pass before the conclusion of the legislative session and, therefore, is effectively dead.36 This is the second year in a row in which a new nexus law was introduced, but not passed, in Minnesota.

Most of the recent legislative developments have involved agreements by the states to extend the effective date of new nexus provisions in exchange for Amazon's development of new distribution centers in those states. Amazon brokered the first of these agreements with Tennessee and South Carolina. Since then, Amazon has reached similar agreements with New Jersey, Texas, Nevada, Arizona, Indiana, Virginia, Pennsylvania and, of course, California, although the grace period under that agreement has already expired, as described above. Amazon's agreements with Texas and Arizona also settled assessments of back taxes by those States (for $269 million and $53 million, respectively).37 As of the time of this writing, the press is reporting that Amazon has recently agreed to collect sales tax in Massachusetts beginning on November 1, 2013.38

National Legislation

Concurrent with its effort to negotiate with individual states regarding the terms on which it will begin to collect sales tax, Amazon has been lobbying for a uniform, national solution. There are currently three bills pending in Congress on this issue.39 Each piece of legislation proposes a slightly different approach, but all three would authorize states to require out-ofstate sellers to collect use taxes, even absent physical presence in the state, and effectively overrule the twenty-year old U.S. Supreme Court decision in Quill.40

The Main Street Fairness Act would require states to conform to the Streamlined Sales and Use Tax Agreement in order to obtain authorization to require use tax collection.41

The Marketplace Equity Act would give states collection authority with fewer simplification requirements and, thus, satisfy large states such as California.42 If enacted, this bill would require states to have remote sellers file only one sales and use tax return per state. The bill would also give remote sellers the option of collecting sales tax based on one blended rate per state (rather than differing rates for each relevant locality), the maximum state rate imposed, or the rate in the locality into which the product is sold. The proposal would exempt from the collection requirement vendors with less than $1 million in annual remote sales or less than $100,000 in annual remote sales into any one state.

The third bill, the Marketplace Fairness Act, adopts a system of rules for sourcing transactions and also contemplates a system of consolidated certified service providers that will assume responsibility for sales and use tax collection and filing responsibilities for remote sellers on an aggregated basis.43

Reflections on the Shifting Battlelines

Notwithstanding victories in the lower courts in Illinois and Colorado, in challenges to those states' efforts to impose obligations on out-of-state sellers, the trend over the past several months has clearly been toward increased sales tax collection by online retailers, in particular, Amazon. Of course, Amazon's agreement to collect state sales and use taxes has been coupled with its increased physical presence in those states by way of many new distribution facilities. At least in California, Amazon has attempted to extract even more value from this change of strategy by negotiating agreements with the cities in which the new distribution centers will be located to obtain rebates of a portion of the sales tax revenue that will be generated by the cities as a result of those centers.44 Amazon may get as much as 75-80% of the sales tax revenue for Patterson and San Bernardino for the first few years during which the distribution centers are operational.45

Although Amazon has apparently determined to work for uniform national collection responsibilities, other online retailers continue to oppose the federal legislative efforts. Notably, eBay and Overstock.com are lobbying against the recent legislation as part of the group NetChoice. This organization, along with another lobbying group of over 1,000 smaller companies called WE R HERE ("Web Enabled Retailers Helping Expand Retail Employment"), is focused on raising the annual sales threshold so that smaller retailers would be exempt from the collection requirements.46

Thus, there now appears to be a divide over the Quill holding not only between Internet and brick and mortar sellers but also in the Internet seller community itself. In the face of these developments, one might well wonder whether Quill's physical presence requirement for constitutional nexus can survive. Moreover, it seems that the online retail industry (represented, voluntarily or not, by Amazon) and states are now negotiating agreements in which remote sellers will collect sales and use taxes under certain circumstances typically following a physical expansion into the state combined with a safe harbor period to come into compliance. On the bright side, California's proposed regulations may be a harbinger of a new era in which the concept of solicitation that creates attributional nexus is clarified such that states will seek to force remote sellers to collect tax only when the in-state affiliates are truly soliciting sales. Only time will tell. In the meantime, the initial results indicate that online shoppers have not curbed their spending due to the new addition of that sales tax charge to the bill.47


1 The authors would like to thank Lauren Volkmann for her assistance with this article.

2 Thomas H. Steele and Kirsten Wolff, Reflections on the Current State of "Attributional Nexus": When May a State Use the Presence of an In-State Entity to Claim Jurisdiction Over an Out-of-State Seller, in University of Southern California Gould School of Law 61st Tax Institute - Major Tax Planning 2009 (Matthew Bender 2009); Thomas H. Steele and Kirsten Wolff, Battle California! Sales Tax Nexus Gets Even More Interesting, 61 State Tax Notes 699, (Sept. 12, 2011); Thomas H. Steele, Andres Vallejo and Kirsten Wolff, No Solicitations: The "Amazon" Laws and the Perils of Affiliate Advertising, 59 State Tax Notes 939 (Mar. 28, 2011).

3 Thomas H. Steele and Kirsten Wolff, Battle California! Sales Tax Nexus Gets Even More Interesting, 61 State Tax Notes 699 (Sept. 12, 2011).

4 Cal. Rev. & Tax. Code § 6203(c)(4), (c)(5)(A).

5 Id. § 6203(c)(5)(B).

6 Id. § 6203(c)(5)(C).

7 Collection of Use Tax by Retailers, Cal. Code Regs. tit. 18 § 1684(c)(3) (proposed Apr. 6, 2012).

8 Id. § 1684(c)(8)(A).

9 Id.

10 Id. § 1684(c)(8)(E).

11 Id. § 1684(c)(9)(A).

12 Id.

13 Id.

14 Id.

15 Id. § 1684(c)(7)(B).

16 Id. § 1684(c)(7)(A)(i).

17 Id. § 1684(c)(7)(B).

18 Id. § 1684(c)(7)(C).

19 Thomas H. Steele and Kirsten Wolff, Reflections on the Current State of "Attributional Nexus": When May a State Use the Presence of an In-State Entity to Claim Jurisdiction Over an Out-of-State Seller, in University of Southern California Gould School of Law 61st Tax Institute - Major Tax Planning 2009 (Matthew Bender 2009); Thomas H. Steele and Kirsten Wolff, Battle California! Sales Tax Nexus Gets Even More Interesting, 61 State Tax Notes 699 (Sept. 12, 2011); Thomas H. Steele, Andres Vallejo and Kirsten Wolff, No Solicitations: The "Amazon" Laws and the Perils of Affiliate Advertising, 59 State Tax Notes 939 (Mar. 28, 2011).

20 Thomas H. Steele and Kirsten Wolff, Battle California! Sales Tax Nexus Gets Even More Interesting, 61 State Tax Notes 699, 702 (Sept. 12, 2011).

21 Cal. State Bd. of Equalization, Initial Statement of Reasons for Adoption of Proposed Amendments to California Code of Regulations, Title 18, Section 1684, Collection of Use Tax by Retailers, at 17 (Apr. 6, 2012).

22 Id.; see Cal. Rev. & Tax. Code § 6005.

23 Collection of Use Tax by Retailers, Cal. Code Regs. tit. 18 § 1684(c)(3) (proposed Apr. 6, 2012).

24 Cal. State Bd. of Equalization, Initial Statement of Reasons for Adoption of Proposed Amendments to California Code of Regulations, Title 18, Section 1684, Collection of Use Tax by Retailers, at 20 (Apr. 6, 2012) (emphasis added).

25 Thomas H. Steele and Kirsten Wolff, Battle California! Sales Tax Nexus Gets Even More Interesting, 61 State Tax Notes 609, 703 (Sept. 12, 2011).

26 Aarti Shahani, California Online Sales Tax Faces Enforcement Hurdle, National Public Radio (Sept. 14, 2012), http://www.npr. org/2012/09/14/161083090/california-online-alestax- faces-enforcement-hurdle .

27 Amazon.com, LLC v. N.Y. State Dep't of Taxation & Fin., 81 A.D.3d 183 (N.Y. App. Div. 2010), appeal filed (N.Y. Feb. 2012).

28 Amazon.com, LLC v. N.Y. State Dep't of Taxation & Fin., 81 A.D.3d 183, 194 (N.Y. App. Div. 2010) (discussing the standard for facial challenges in United States v. Salerno, 481 U.S. 739, 745 (1987)).

29 Amazon.com, LLC, 81 A.D.3d at 207.

30 Amazon.com, LLC v. N.Y. State Dep't of Taxation & Fin., 81 A.D.3d 183 (N.Y. App. Div. 2010), appeal filed (N.Y. Feb. 2012).

31 Direct Mktg. Ass'n v. Huber, No. 10-cv-01546- REB-CBS (D. Colo. Mar. 30, 2012).

32 Id.

33 Direct Mktg. Ass'n v. Huber, No. 10-cv-01546-REBCBS (D. Colo. Mar. 30, 2012), appeal docketed, No. 12-1175 (10th Cir. Apr. 30, 2012).

34 Performance Mktg. Ass'n, Inc. v. Hamer, No. 2011 CH 26333 (Ill. Cir. Ct. May 7, 2012).

35 Ill. Sup. Ct., R. 302(a); Performance Mktg. Ass'n, Inc. v. Hamer, No. 2011 CH 26333 (Ill. Cir. Ct. May 7, 2012), cert. granted, No. 114496 (Ill. June 22, 2012).

36 S.F. 2391, 2011-2012 Leg., 87th Sess. (Minn. 2012); H.F. 1849, 2011-2012 Leg., 87th Sess. (Minn. 2012).

37 See Amazon.com, Inc. Form 10-Q, filed Oct. 27, 2012; Amazon.com, Inc. Form 10-Q, filed April 27, 2012.

38 Greg Bensinger, Amazon, Massachusetts Strike Deal for Residents on Sales Tax, The Wall Street Journal, Dec. 11, 2012, http://online.wsj.com/article/SB100014241278873243392045781738824 10132440.html .

39 The Main Street Fairness Act, S. 1452, 112th Congress (2011), H.R. 2701, 112th Congress (2011); The Marketplace Equity Act, H.R. 3179, 112th Congress (2011); The Marketplace Fairness Act, S. 1832, 112th Congress (2011).

40 Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

41 S. 1452, 112th Congress (2011); H.R. 2701, 112th Congress (2011).

42 H.R. 3179, 112th Congress (2011).

43 S. 1832, 112th Congress (2011).

44 Marc Lifsher, Amazon poised to get a cut of California sales taxes, Los Angeles Times (May 19, 2012), http://articles.latimes.com/2012/may/19/business/lafi- amazon-sales-taxes-20120520 .

45 Id.

46 Paul Demery, Small e-retailers mobilize to lobby against online sales tax collection, Internet Retailer (Sept. 14, 2012), http://www.internetretailer.com/2012/09/14/small-e-retailers-mobilize-lobbyagainst-online-sales-tax .

47 Greg Bensinger, The Sales-Tax Effect on Amazon: Nada, The Wall Street Journal (Sept. 17, 2012), http://blogs.wsj.com/digits/2012/09/17/the-salestax- effect-on-amazon-nada/ .

Recent MoFo State + Local Taxpayer Victories

The State + Local Tax Group diligently works throughout the year to favorably resolve our clients' tax disputes. Although we resolve the vast majority of matters before going to trial, the following are some of our recent published taxpayer victories:

1. EchoStar Satellite Corporation v. New York State Tax Appeals Tribunal

The New York Court of Appeals ruled that when a satellite television provider purchases equipment that is subsequently leased to its customers for a separately stated fee on which it collected and remitted sales tax, that purchase is exempt from the State's sales and use taxes. Read the decision here.

2. Reynolds Metals Co. v. Michigan Dep't of Treasury

The Michigan Court of Appeals agreed that the unitary business principle applies to the Single Business Tax and that a corporation's gain from the sale of its interest in a foreign joint venture was not includable in the tax base since none of the elements of a unitary business were present between the corporation and the joint venture. Read the decision here.

3. Scioto Insurance Co. v. Oklahoma Tax Comm'n

The Oklahoma Supreme Court decisively held that a company was not subject to Oklahoma's corporate net income tax as a result of receiving payments under a licensing contract that was not made in the State of Oklahoma and no part of which was to be performed in Oklahoma. Read the decision here.

4. GMRI, Inc. v. California

The California State Board of Equalization determined that sales tax is not due on gratuities that are included on checks of parties of eight or more when customers of Red Lobster and Olive Garden restaurants changed the gratuity from the amount suggested on the menu. See the decision here.

5. Powerex Corp. v. Oregon Dep't of Revenue

The Oregon Tax Court granted victory to the taxpayer and held that a corporation's sales of electricity were sales other than sales of tangible personal property. Accordingly, the revenue from the sales of electricity could not be sourced to Oregon for purposes of the corporation's Oregon sales factor. Read the decision here.

6. E.I. du Pont de Nemours & Co. v. Michigan Dep't of Treasury

The Michigan Court of Appeals held that a corporation was not required to include the capital gains from the sale of its interest in a partnership in its Single Business Tax base because the corporation did not operate a unitary business with the joint venture. The court also held that the corporation was entitled to include receipts from foreign exchange contracts in the denominator of its sales factor. Read the decision here.

7. IGT v. Director, New Jersey Div. of Taxation

The New Jersey Tax Court rejected the Division of Taxation's attempt to deprive the taxpayer of nearly four years of interest. The court held that as N.J.S.A. 54:49-14a barred taxpayers from filing refund claims once an assessment has been challenged and, but for the Throw-Out issue, the corporation was otherwise due a refund, the refund interest runs from the date the protest was filed and not the date of the final determination. Read the decision here.

8. NIHC, Inc. v. Maryland Comptroller of the Treasury

The Maryland Circuit Court again granted victory to this corporation. The case involved a reportable gain under IRC Section 311(b), which the corporation was initially required to defer for federal tax purposes. The Circuit Court held that the deferred gain when reported on the federal consolidated return is not included in the Maryland income tax return because, under Maryland's separate company reporting regime, each member of a consolidated group reports its separate company income without regard to consolidation. Read the decision here.

9. Meredith Corporation v. New York State Tax Appeals Tribunal

The New York Appellate Division, Third Department, granted the corporation's request for refund of corporate franchise taxes. The court held that regardless of its mode of delivery-by satellite or via tangible media-certain programming acquired for broadcast at the corporation's television stations was tangible personal property for purposes of the property factor of the business allocation percentage. Read the decision here.

10. Wendy's Int'l, Inc. v. Virginia Dep't of Taxation

A Virginia Circuit Court held that a corporation was entitled to a refund of corporate income tax paid with respect to the addback of intangible expenses as Wendy's qualified for one of the "safe-harbor" exceptions to the addback. The Virginia Supreme Court refused the Department of Taxation's petition for appeal. Read the decision here.

Exploring the Subject to Tax Exception to Addback Statutes

By Craig B. Fields and Richard C. Call

Statutes requiring taxpayers to add back royalties or interest paid to related members have been around for two decades and have now been adopted by over 20 states. Audit issues with respect to addback statutes are common, but only a few courts have addressed these statutes despite their long existence. However, we are aware of several addback cases working their way through state administrative and judicial systems, including a recent taxpayer victory in Virginia.1 Given this heightened activity, a discussion of addback statutes is appropriate.

Many of the states with addback statutes have some form of a "subject to tax" exception (i.e., if the exception is applicable, the addback is not required). The basic premise of such an exception is that the related member recipient's taxability in a jurisdiction may justify the claiming of the interest or royalty expense deduction by the taxpayer that pays the expense. Beyond this simple premise, however, the states' laws and the applications and interpretations of such laws are varied. Questions raised by such exceptions include: (1) whether payments of tax to certain states qualify for the exception; (2) what rate of tax the recipient must pay to a jurisdiction to qualify for the exception; and (3) how net operating losses affect the subject to tax exception. This article examines some of the states' approaches and suggests ways to successfully claim the subject to tax exception.


Many states have codified the subject to tax exception.2 Other states have adopted the subject to tax exception by regulation.3 Importantly, a state's subject to tax exception may not apply to both interest and royalty addbacks or the exception may be applied differently by state taxing authorities depending on whether interest or royalties are involved.4 Furthermore, although we will not address such issues in this article, taxpayers should be aware that some states incorporate a business purpose or economic substance requirement into their subject to tax exceptions.5 Additionally, taxpayers that do not qualify for a state's subject to tax exception may qualify for other exceptions to addback statutes that are not addressed in this article.

What Jurisdictions Count?

Variations exist among the states as to which states count for the subject to tax exception. Some state laws or state taxing agencies allow the subject to tax exception only when the expense is paid to a related member that is a taxpayer in that state or is a taxpayer in a "separate entity" state as described below.

Same State

The New Jersey Division of Taxation's regulations and forms provide that the subject to tax exception for royalty payments is permitted if the related member recipient of the income is subject to tax in New Jersey (assuming certain tax rate requirements are met).6 However, the exception is not granted for payments to other states.7 By contrast, the New Jersey statutes permit the subject to tax exception for interest when the related member recipient is subject to tax in other states (as long as other conditions are also met).8 As discussed below, the Division of Taxation's position that allows the subject to tax exception for royalty payments only when the related member is subject to tax in New Jersey may be facially discriminatory and should be extended to apply to the extent that related members are subject to tax in foreign jurisdictions or in states other than New Jersey.

Separate Entity v. Combined Reporting

Some states or state taxing agencies have taken the position that the subject to tax exception is not available when the related member is subject to tax in a combined reporting state.9 Some state taxing authorities justify this approach by reasoning that the net effect of combined reporting purportedly results in a wash for tax purposes.10 Such reasoning is flawed and combined reporting states should not be excluded from the states for which a state's subject to tax exception may apply. Consider, for example, a taxpayer that successfully claims the subject to tax exception in State Y for royalty payments made to a related member that was subject to tax in Massachusetts in 2008 when Massachusetts was a separate entity state. The taxpayer's and related member's operations did not change from 2008 through 2009. However, Massachusetts adopted combined reporting for 2009. The taxpayer would be unable to claim the deduction for the royalty payments for 2009 even though everything but the Massachusetts law remained unchanged.


Granting the subject to tax exception based on subjectivity to tax in one state but not in another state or jurisdiction raises Constitutional questions. The Commerce Clause of the U.S. Constitution prohibits state taxes that discriminate against interstate commerce by favoring activities conducted in some, but not all, other states. In New Energy Co. of Indiana v. Limbach, the U.S. Supreme Court struck down an Ohio tax statute that provided a tax credit for ethanol produced in some states but not in other states.11 Specifically, the Ohio statute gave tax credits for ethanol produced in states that taxed ethanol in the same manner as Ohio (i.e., granting tax credits for ethanol production). However, no credit was given to an ethanol producer that was located in a state that provided benefits to the ethanol industry through subsidies instead of through tax credits. Therefore, the credit mechanism discriminated against interstate commerce. Similarly, granting the subject to tax exception for activity conducted in states with a certain type of taxing regime (i.e., separate entity) but not for the same activity conducted in other states (i.e., combined reporting) discriminates against interstate commerce.

Statutory v. Effective Tax Rate Comparisons

Some states' subject to tax exceptions require that the related member pay tax at or above a certain rate of tax or tax rate as compared to the taxpayer's rate of tax or tax rate to satisfy the subject to tax exception.12 Differing approaches exist as to how these comparisons are to be computed. The following paragraphs contrast two State taxing authorities' methods-New Jersey and Massachusetts-for making this comparison. Importantly, taxpayers may have avenues for claiming the subject to tax exception other than the methods described below.

New Jersey - Effective Tax Rate Compared to Effective Tax Rate

The New Jersey statutes allow the subject to tax exception for interest payments made to a related member when the related member is subject to tax in a state, the interest is included in the related member's measure of tax and "the rate of tax applied to the interest received by the related member is equal to or greater than a rate three percentage points less than the rate of tax applied to taxable interest by this State."13 In Beneficial New Jersey, Inc. v. Director, Division of Taxation, the dispute was whether the phrase "rate of tax" means the statutory or effective tax rate (i.e., whether the subject to tax exception was based on comparing the statutory tax rates of the taxpayer and the related member or the effective tax rates of the taxpayer and the related member).14 The judge held that the exception was based on an effective tax rate comparison, which was the position adopted by the Division of Taxation ("Division") by regulation and in the mechanics of New Jersey's Schedule G-2.

Under an effective tax rate to effective tax rate comparison method, a taxpayer that has a high apportionment factor in New Jersey may have increased difficulty claiming the subject to tax exception because it would have a high New Jersey effective tax rate. By contrast, a taxpayer that has a low apportionment factor may be able to more easily qualify for the subject to tax exception. When a taxpayer's New Jersey apportionment factor is less than approximately 33.33%, any payment of tax by the related member recipient of the interest in another separate entity state should qualify for the subject to tax exception because the taxpayer's effective tax rate would be below 3% (33.33% apportionment factor * 9% tax rate = 3% effective tax rate). Therefore, any effective tax rate above 0% would be within three percentage points of the taxpayer's effective tax rate. Another interesting result of the Division's method is that if a related member recipient of the income is subject to tax in New Jersey at the same apportionment percentage as the taxpayer then the taxpayer should be permitted a full exception.

Massachusetts - Statutory Tax Rate Compared to Effective Tax Rate

The Massachusetts Department of Revenue ("Department") takes an approach different from the New Jersey Division. The Department promulgated a regulation applying both full and partial exceptions to the intangible and interest expense addback when the taxpayer establishes that the related member is taxed on the corresponding income.15 A full exception (i.e., full deduction of royalties paid) is allowed when the related member is taxed on the corresponding income at "an aggregate effective rate of tax that is within three percentage points of the taxpayer's statutory rate of tax" (i.e., based on a comparison of the related member's effective tax rate and the taxpayer's statutory tax rate).16 If a taxpayer is unable to satisfy the requirement for the full exception, a partial exception may be available. The partial exception to the addback is allowed to the extent that the interest or intangible expense is paid to a related member that is subject to tax.17

Under the Department's approach, if the related member recipient of the income was also a taxpayer in Massachusetts and had the same apportionment percentage as the payor, the payor would not be granted a full exception as a result of the related member's payment of tax to Massachusetts (unless, for example, the two entities' Massachusetts apportionment percentages were 100%).18 This result seems illogical inasmuch as Massachusetts would not be deprived of any of the tax it would have received had the payor never paid the expense.

Net Operating Losses

Some state taxing authorities have taken the position that the subject to tax exception does not apply when a related member is subject to tax but is in a loss position for the tax year. For example, under the Connecticut statutes the subject to tax exception applies when:

[T]he related member was subject to tax on its net income in [Connecticut] or another state or possession of the United States or a foreign nation; (ii) a measure of said tax included the interest received from the corporation; and (iii) the rate of tax applied to the interest received by the related member is no less than the statutory rate of tax applied to the corporation under [the Connecticut statutes], minus three percentage points . . . .19

The Connecticut Department of Revenue Services has taken the position that this statute means a taxpayer may not claim this exception when the related party has a net operating loss.20 However, the plain language of Connecticut's statute is silent with respect to net operating losses. Moreover, such an approach is improper because it bases the tax consequences of one taxpayer on the profitability of another, albeit related, corporation. Consider, for example, a taxpayer that successfully claims the subject to tax exception for royalties paid to a related member that is not in a loss position for years one through four. The taxpayer's operations do not materially change from years one through five. However, in year five the related member is in a loss position. Failing to grant the subject to tax exception would mean that the taxpayer's tax consequences change year to year despite the fact that its operations have not changed.

The "Reverse" Subject to Tax Exception

We have discussed above exceptions that allow a taxpayer to claim a deduction for amounts paid to a related member. Some states permit what might be termed the "reverse" subject to tax exception. In this scenario, the payor is required to add back the expense (i.e., it does not ultimately deduct the payment) and the related member recipient of the income excludes the royalties received from the payor under certain circumstances. For instance, Maryland allows a royalty recipient to claim a deduction if the royalty payor added back the royalties in any state or foreign jurisdiction (if certain other conditions including a comparison of "aggregate effective tax rates" are satisfied).21

In some cases, the exclusion is allowed only when the royalty payor is subject to tax in the state in which the recipient seeks to exclude the income. For example, Connecticut now has an economic nexus statute the Department of Revenue Services may use to assert that a company deriving receipts from licensing in Connecticut is subject to tax in Connecticut.22 However, in administrative guidance, the Department of Revenue Services has provided that a corporation with economic nexus is not required to include in its income those amounts added back for Connecticut tax purposes by a related member payor.23

Another interesting statute is the New York statute which provides that "a taxpayer shall be allowed to deduct royalty payments directly or indirectly received from a related member during the taxable year to the extent included in the taxpayer's federal taxable income unless such royalty payments would not be required to be added back under [the New York Tax Law]."24 Presumably, this exception would allow related member recipients that are subject to tax in New York to deduct royalties received from related members that are New York taxpayers. Additionally, the statute's use of the phrase "would not be required to be added back" leaves open the possibility that a royalty recipient could deduct royalties received from a non-New York taxpayer so long as the payor would be required to add back the royalties if it were subject to tax in New York.25


Many variations exist in the statutes and regulations that implement the subject to tax exception to addbacks as well as the state taxing agencies' application of such laws. We have discussed above some of those variations. In our experience, each state's subject to tax exception presents different challenges and avenues for successfully claiming the subject to tax exception that taxpayers should consider in preparing returns and defending their positions on audit and in appeals.


1 In Wendy's Int'l, Inc. v. Virginia Dep't of Taxation, No. CL09-3757 (Va. Cir. Ct. Mar. 29, 2012), the court held that the taxpayer was entitled to a refund of corporate income tax paid with respect to the addback of royalties. Morrison & Foerster LLP represented Wendy's in this matter.

2 See, e.g., Conn. Gen. Stat. § 12-218d(c) (only applies to interest addback); Ind. Code § 6-3-2-20(c)(2); Ohio Rev. Code Ann. § 5733.055; Va. Code Ann. § 58.1-402(B)(8)(a)(1).

3 See, e.g., 830 Mass. Code Regs. § 63.31.1(4) (Massachusetts' rules provide the subject to tax exception under the "unreasonable" exception contained in Massachusetts General Laws chapter 63, Sections 31I(c) and 31J(a)); N.J. Admin. Code § 18:7-5.18(b)(3) (adopting a subject to tax exception for interest and royalties).

4 Connecticut's subject to tax exception is available for interest but not royalties. Conn. Gen. Stat. § 12-218c (intangible addback); id. § 12-218d(c) (relating to the interest addback).

5 See, e.g., id. § 12-218d(c); N.J. Stat. Ann. § 54:10A-4(k)(2)(I)(i).

6 N.J. Admin. Code § 18:7-5.18(b)(3).

7 Id.

8 N.J. Stat. Ann. § 54:10A-4(k)(2)(I)(iii).

9 See, e.g., N.J. Admin. Code § 18:7-5.18(a)(5), Example 5; Ohio Rev. Code Ann. § 5733.055(A)(2).

10 See, e.g., N.J. Admin. Code § 18:7-5.18(a)(5), Example 5.

11 New Energy Co. v. Limbach, 486 U.S. 269 (1988).

12 See, e.g., Mass. Gen. Laws ch. 63, § 31J(b)(iii)(c); N.J. Stat. Ann. § 54:10A-4(k)(2)(I); Wis. Stat. § 71.80(23)(a)(2).

13 N.J. Stat. Ann. § 54:10A-4(k)(2)(I) (emphasis added).

14 Beneficial N.J., Inc. v. Director, Div. of Taxation, No. 009886-2007 (N.J. Tax Ct. 2010) (not approved for publication).

15 830 Mass. Code Regs. § 63.31.1(4) (promulgated June 16, 2006).

16 Id. § 63.31.1(4)(a)(1).

17 Id. § 63.31.1(4)(b)(1).

18 The taxpayer may be able to deduct additional amounts paid to a related member as a result of the related member being subject to tax in other states in addition to Massachusetts.

19 Conn. Gen. Stat. § 12-218d(c). The statute also contains other requirements for the exception such as that "the interest is paid pursuant to a contract that reflects an arm's length rate of interest . . . ." Id.

20 Form CT-1120AB, p. 2 (Conn. Dep't of Revenue Servs., 2010). Connecticut also does not allow a subject to tax exception for combined returns.

21 Md. Code Ann., Tax-Gen. § 10-306.1(f).

22 Conn. Gen. Stat. § 12-216a; Info. Pub. 2010(29.1) (Conn. Dep't of Revenue Servs., Dec. 28, 2010).

23 Info. Pub. 2010(29.1) (Conn. Dep't of Revenue Servs., Dec. 28, 2010).

24 N.Y. Tax Law § 208(9)(iii)(o)(3).

25 Id. (emphasis added).

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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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