United States: Kentucky Enacts Legislation Amending Intercompany Management Fee Addback, Imposing Remote Seller Notification Requirement

On April 4, Kentucky Governor Steve Beshear signed legislation that makes several changes to income tax law as well as sales and use tax law.¹ Specifically, the legislation amends income tax provisions including the intercompany management fee addback requirement and personal and dependent credit amounts. Also, the legislation includes sales and use tax provisions such as enacting a remote seller use tax notice requirement, amending vendor compensation reimbursements, repealing the residential telecommunications services exemption and changing the farm machinery definition. The income tax amendments are effective for tax years beginning on or after January 1, 2014 and the sales and use tax amendments are effective July 1, 2013.

Corporate and Personal Income Tax

Intercompany Management Fees

Under current law, a taxpayer subject to Kentucky corporate income tax is required to add back management fees directly or indirectly paid, accrued or incurred to, or in connection with a transaction with related members, foreign corporations or an entity that would be included in the affiliated group based upon ownership interest if it were a corporation.² Management fees are defined to include, but are not limited to, expenses paid for services related to accounts receivable, accounts payable, employee benefit plans, insurance, payroll, legal, data processing, procurement, tax, accounting, and reporting and compliance services.³ However, the addback of management fees does not apply if: (i) the taxpayer and recipient are both included in the same Kentucky corporation income tax return; (ii) the taxpayer makes a disclosure and proves that the transaction was made at a commercially reasonable rate and at terms comparable to an arm's length transaction; or (iii) the taxpayer and the Kentucky Department of Revenue agree in writing to the use of an alternative apportionment method.⁴

For tax years beginning on or after January 1, 2014, intercompany management fees will be subject to the same addback provisions as intercompany intangible expenses and intangible interest expenses as provided under current law.⁵ Generally, an entity subject to the Kentucky corporate income tax is not allowed to deduct an intangible expense, intangible interest expense, and now management fees, paid to a related member, a foreign corporation, or to an entity that based upon ownership interest, would be included in the affiliated group if it were a corporation.⁶ The definition of what constitutes a management fee has not changed.

In order to deduct management fees under the new legislation, a taxpayer will have to show that one of the following four conditions has been met:

1) The taxpayer and the recipient are both included in the same consolidated Kentucky corporation income tax return; or

2) The entity makes a disclosure, and establishes by a preponderance of the evidence that:

3) The taxpayer makes a disclosure, and establishes by a preponderance of the evidence that the recipient regularly engages in transactions with one or more unrelated parties on terms identical to that of the subject transaction; or

4) The taxpayer and the Department agree in writing to the use of an alternative method of apportionment.⁸

Personal and Dependent Credits

The legislation reduces some of the personal and dependent credit amounts that may be taken in computing income tax when a personal exemption deduction is not claimed.⁹ For taxable years beginning on or after January 1, 2014, the credit is decreased from $20 to $10 for: (i) unmarried individuals; (ii) dependents; and (iii) estates.¹⁰ Also, the credit is $10 (currently, $20) for a married individual filing a separate return and an additional $10 (currently, $20) for the taxpayer's spouse if a separate return is made by the taxpayer and if the spouse has no Kentucky gross income and is not the dependent of another taxpayer.¹¹ Finally, the credit for married persons filing a joint return, provided neither spouse is a dependent of another taxpayer, is reduced from $40 to $20.¹² The other credit amounts are not changed.

Sales and Use Tax

Remote Sellers Use Tax Notice Requirement

Under existing law, a presumption is made that tangible personal property shipped or brought to Kentucky by the purchaser was purchased from a retailer for storage, use or other consumption in Kentucky.¹³ This provision is amended to require retailers to provide notice that the purchaser must report and pay use tax directly to the Department on purchases of nonexempt tangible personal property. Note that any retailer that made total gross sales of less than $100,000 to Kentucky residents or businesses located in Kentucky, and that reasonably expects its Kentucky sales in the current calendar year will be less than $100,000, is exempt from the notice requirements.¹⁴

The use tax notices must be easily visible and contain the following exact language:

• The retailer is not required to and does not collect Kentucky sales or use tax;
• The purchase may be subject to Kentucky use tax unless the purchase is exempt from taxation in Kentucky;
• The purchase is not exempt merely because it is made over the Internet, by catalog, or by other remote means; and
• The Commonwealth of Kentucky requires Kentucky purchasers to report all purchases of tangible personal property or digital property that are not taxed by the retailer and pay use tax on those purchases unless exempt under Kentucky law. The tax may be reported and paid on the Kentucky individual income tax return or by filing a consumer use tax return with the Kentucky Department of Revenue. These forms and corresponding instructions may be found on the Kentucky Department of Revenue's Internet Web site.¹⁵

The use tax notification must be included on the retailer's Web site, retail catalog and invoices provided to the purchaser.¹⁶ Specifically, the notice must be provided on the: (i) Internet Web site page necessary to facilitate an online sales transaction; (ii) electronic order confirmation or, if an electronic order confirmation is not issued, the notice must be included on the purchase order, invoice, bill, receipt, sales slip, order form or packing statement; and (iii) catalog order form, purchase order, invoice, bill, receipt, sales slip or packing statement.¹⁷ Also, the notice requirement generally applies to online auction Web sites.¹⁸

Vendor Compensation Reimbursement

The legislation amends the amount that vendors are entitled to deduct as reimbursement for the cost of collecting and remitting sales and use tax in Kentucky.¹⁹ While the legislation increases the deduction that a seller can take on tax due in excess of $1,000 from 1 percent to 1.5 percent, the legislation reduces the maximum reimbursement allowed for each seller in any reporting period from $1,500 to just $50.²⁰

Residential Telecommunications Services

The sales and use tax exemption is repealed for any rate increase for school taxes and any other charges or surcharges added to the total amount of residential telecommunications service.²¹ For purposes of this exemption, the telecommunications service was required to be provided to: (i) an individual for personal use at a residential address, including an individual dwelling unit; or (ii) an individual resident in an institution such as a school or nursing home if the service was paid by the individual resident.

Farm Machinery

The legislation clarifies the exemption for "farm machinery."²² Currently, farm machinery is defined as machinery used exclusively and directly in the occupation of tilling the soil for the productions of crops as a business, or in the occupation of raising and feeding livestock or poultry or of producing milk for sale. The legislation amends this provision to expand the definition of "farm machinery" to include combine header trailers, combine header wagons, and any other implements specifically designed and used to move or transport a combine head. Automobiles, trucks, trailers, and truck-trailer combinations will still not qualify as exempt farm machinery.

Commentary

While many states require taxpayers to add back intangible expenses and interest expenses, Kentucky is one of a small minority of states to require taxpayers to add back management fees.²³ Because the management fee addback will follow the same tests for deductibility as intangible expenses and intangible interest expenses for tax years beginning after 2013, some taxpayers with management fees will face a stricter standard to meet an exception to the addback requirement. As before, taxpayers are not required to add back management fees if they file consolidated returns with the recipient or agree with the Department to use an alternative apportionment methodology. Also, management fees are exempt from the addback requirement if the taxpayer discloses that the recipient regularly engages in transactions with unrelated parties under identical terms. However, taxpayers that want to use the exception for transactions made at a reasonable rate and at terms comparable to an arm's length transaction now must also prove that the payment was subject to tax in the recipient's commercial domicile²⁴and the recipient was engaged in substantial business activities unrelated to intangibles or financing related members. Thus, the requirements for meeting this exception are becoming more difficult to satisfy.²⁵

The remote seller use tax notification requirements are somewhat controversial. Several other states, including Colorado,²⁶ Oklahoma,²⁷ South Dakota²⁸ and Vermont,²⁹ have passed similar legislation requiring remote sellers to provide notification to purchasers that they must submit and pay use tax to the state. In Colorado, the U.S. District Court intervened and issued a permanent injunction barring the legislation from being implemented.³⁰ However, Colorado's notice statute was much more extensive than the legislation enacted by Kentucky and the other states because it also required that: (i) an annual purchase summary be provided to each customer in the state; and (ii) an annual statement for each purchaser be filed with the Department of Revenue. Taxpayers could challenge Kentucky's notice requirement, but the likelihood of success is less certain due to Kentucky's less onerous requirements.

Footnotes

^{1 Ch. 119 (H.B. 440), Laws 2013.}

^{2 KY. REV. STAT. ANN. § 141.205(4).}

^{3 KY. REV. STAT. ANN. § 141.205(1)(d).}

^{4 KY. REV. STAT. ANN. § 141.205(5).}

^{5 KY. REV. STAT. ANN. § 141.205(2).}

^{6 Note that this applies to both direct and indirect transactions.}

^{7 If the recipient is a foreign corporation, the foreign country must have in force a comprehensive income tax treaty with the U.S.}

^{8 KY. REV. STAT. ANN. § 141.205(3) (emphasis added).}

^{9 KY. REV. STAT. ANN. § 141.020(3).}

^{10 KY. REV. STAT. ANN. § 141.020(3)(b)(1)(a), (c), (i).}

^{11 KY. REV. STAT. ANN. § 141.020(3)(b)(1)(b).}

^{12 Id.}

^{13 KY. REV. STAT. ANN. § 139.450.}

^{14 KY. REV. STAT. ANN. § 139.450(8).}

^{15 KY. REV. STAT. ANN. § 139.450(3).}

^{16 KY. REV. STAT. ANN. § 139.450(2).}

^{17 KY. REV. STAT. ANN. § 139.450(4).}

^{18 KY. REV. STAT. ANN. § 139.450(7). An "online auction Web site" means a collection of Internet Web pages that allows persons to display tangible personal property or digital property for sale that is purchased through a competitive process where participants place bids with the highest bidder purchasing the item when the bidding period ends.}

^{19 KY. REV. STAT. ANN. § 139.570.}

^{20 KY. REV. STAT. ANN. § 139.570(1)(b). For the first $1,000 of tax due, the deduction remains 1.75 percent.}

^{21 KY. REV. STAT. ANN. § 139.470(9).}

^{22 KY. REV. STAT. ANN. § 139.480(11).}

^{23 Wisconsin also requires the addback of management fees. WIS. STAT. § 71.26(2)(a).}

^{24 If the recipient is a foreign corporation, the foreign nation must have in force a comprehensive income tax treaty with the U.S.}

^{25 See GT SALT Alert: Kentucky Requires Filing of Disclosure Schedule for Related-Party Costs for further commentary on related-party transactions.}

^{26 COLO. REV. STAT. § 39-21-112(3.5)(d).}

^{27 OKLA. STAT. tit. 68, § 1406.1; OKLA. ADMIN. CODE § 710:65-21-8.}

^{28 S.B. 146, LAWS 2011.}

^{29 VT. STAT. ANN. tit. 32, § 9783.}

^{30 Direct Marketing Association v. Huber, U.S. District Court, D. Colorado, No. 10-cv-01546-REBCBS, March 30, 2012.}

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