United States: Massachusetts Tax Developments: A Reed Smith Quarterly Update (3rd Quarter 2013)

Welcome to the Reed Smith Massachusetts State Tax Quarterly Update for the 3rd Quarter of 2013. This update includes coverage of the repeal of the short-lived software services tax and pending litigation on other software-related services, as well as a number of corporate excise tax developments, including: (1) newly enacted apportionment legislation, which imposes market sourcing for many types of receipts and institutes a throwout rule; (2) the Department's attempt to narrow the application of the operational approach to cost of performance sourcing; and (3) pending cases at the Appellate Tax Board involving transfer pricing, embedded royalties, and interest/royalty add-back.

Sales and Use Tax

Massachusetts revokes software services tax; additional taxpayers challenge whether SaaS, ASP and cloud computing services are subject to sales tax

The Massachusetts Legislature and Governor Patrick responded to overwhelming opposition and revoked the software services tax, retroactive to the date it was imposed; refund headache ahead for vendors that have been collecting the tax.

Less than two months after it was enacted, Governor Patrick signed a law repealing Massachusetts' controversial software services tax, retroactive to its intended effective date.

While Massachusetts businesses should be happy to see the unpopular tax repealed, one lingering headache will remain for some vendors—customer refunds. The tax was repealed before any vendor was required to remit collected tax on sales of software services to the Department of Revenue (the "Department"), but many vendors seeking to comply with the law during the two months it was in effect did collect the tax from their customers. Those vendors are now required to make "reasonable efforts" to return the collected tax to their customers.1

While the "software services tax" is no more, Massachusetts still attempts to tax many software-related services. The Department reclassifies many purchases of software as a service ("SaaS") and cloud computing services as purchases of "software" subject to sales and use tax. Taxpayers continue to challenge this position, as well as the Department's authority to tax sales of access to software located outside of Massachusetts.

In a recent teleseminar, we discussed pending litigation at the Appellate Tax Board in which a vendor is challenging the Department's assessment of tax on the vendor's SaaS offering. (If you were unable to attend our teleseminar, click here for the slide deck and audio recording.)

Another quarter brings another challenge to the Department's expansive view of what constitutes taxable computer software. This time, in a case pending at the Appellate Tax Board, a vendor is challenging the Department's view—expressed in a recent letter ruling2—that when (1) a vendor sells access to software hosted on the vendor's servers and (2) that software permits purchasers (or third parties) to remotely access their (the purchaser's) own computers; then the sale of access to the vendor's software constitutes a sale of software subject to tax in Massachusetts.

In the pending case, the vendor maintains control of all software on its own servers, with the exception of a free applet that is sometimes transferred to the customer. Purchasers access the vendor's software over the Internet and use the software as a conduit to connect to their own computers in other locations.

As in other appeals involving sales tax imposed on remotely accessed software, the vendor is arguing (1) that sales of remote access to software is not taxable in Massachusetts because a taxable transfer of software has not occurred; and (2) that the object of the transaction is a non-taxable service.

Takeaways:

  • With yet another appeal filed on this issue, vendors and purchasers of remotely accessed software, as well SaaS, ASP, and cloud computing services, should keep a close eye on these cases as they develop. If a decision were issued in the vendor's favor in any of these pending cases, it could call into question much of the Department's guidance regarding the taxability of remotely accessed software, as well as mixed software and service transactions.
  • Purchasers that have paid Massachusetts sales tax on remotely accessed software, as well as on SaaS, ASP, or cloud computing services with similar fact patterns, should consider working with their vendors to file protective refund claims.

For more information and updates on the pending cases discussed above, contact Michael Jacobs at mjacobs@reedsmith.com.

Corporate Tax

Legislature Enacts Market Sourcing and Throwout – Beginning in 2014

Market sourcing is coming to Massachusetts in 2014. In addition, as part of the switch to market sourcing, Massachusetts has adopted a throwout rule for certain sales.

Massachusetts enacted legislation replacing its current cost of performance sourcing regime for sales other than sales of tangible personal property, with a market-based sourcing rule for tax years starting on or after January 1, 2014. The legislation also implements a throwout rule for sales other than sales of tangible personal property in situations where the taxpayer is not taxable in the state to which the sale is assigned, or if the state to which the sale is assigned cannot be determined or reasonably approximated.3

In August, Reed Smith hosted a teleseminar on these changes as well as issues remaining under the cost of performance approach. If you were unable to attend, click here for the slide deck and audio.

  • Guidance forthcoming: The Department is currently working on regulations interpreting the new statute. While we expect a draft to be released in early 2014 for public comments, taxpayers with specific issues may want to consider reaching out to the Department now. The Department typically is willing to receive and consider taxpayer comments throughout the regulation drafting process.
  • Licenses to Software Sourced to Server Location: The new sourcing rules are unambiguous regarding the treatment of receipts from licenses to use tangible personal property—the sale is sourced to the location of the property. The Department's existing regulations state that software is considered tangible personal property for income tax purposes.4 As a result, the application of the new market sourcing rules to receipts from software licenses may produce surprising results. For example, a vendor that sells a license to use software hosted on the vendor's server and accessed remotely by the taxpayer would presumably source the receipts from that license to the location of the vendor's server. At the same time, if a vendor sells a license to use software to a customer and the software is downloaded onto the customer's server, and the software is then remotely accessed by the customer's employees throughout the country, then the receipts from the license should be sourced to the location of the customer's server, regardless of the location of the customer's employees who access the software.

The Department formalizes its policy to narrowly apply the Appellate Tax Board decision in AT&T to other cost of performance appeals

On August 20, the Department issued Technical Information Release 13-12, formally announcing what had already been clear from its litigation posture in numerous other cases: the Department views the taxpayer victory in AT&T,5 which upheld the use of an operational approach to cost of performance sourcing, as limited to the specific facts presented by AT&T. In other words, the Department will continue to challenge taxpayer attempts to apply an operational approach to source receipts outside of Massachusetts on an "all or nothing basis."

Despite the Department's attempts to limit the effect of the AT&T decision, taxpayers continue to bring appeals applying both the operational and transactional approaches to source receipts from sales other than sales of tangible personal property. More information regarding pending and recently resolved cost of performance cases is available in our last Quarterly Update, as well as our recent  teleseminar on the subject of sales factor sourcing in Massachusetts.

Can Department change the add-back exception computation without a change in statute?

In 2006, without any statutory change, the Department changed the form taxpayers use to compute the interest add-back exception. The method used to compute the exception on the revised form was less taxpayer friendly than on the prior version of the form. Should taxpayers still be permitted to use the method outlined on the prior version of the form?

In 2006, three years after the enactment of the related-party interest add-back provision, the Department changed the portion of Schedule ABI used to calculate the partial interest add-back exception for payments to related members subject to tax on the interest income ("Exception #2") in a way that significantly reduced the available exception for many taxpayers. The change produced particularly harsh results if the affiliated entity receiving the interest payment was subject to tax in Massachusetts.6 To illustrate the potential effect, here's an example of a hypothetical taxpayer's interest add-back exception computation before and after the Department changed the form:7

Description

Prior to 2006 

 2006

 Taxpayer interest paid to Affiliate A

 $1,000

 $1,000

 Taxpayer's Massachusetts apportionment %

 5%

 5%

 Affiliate A's Massachusetts apportionment %

 5%

 5%

 Affiliate A's apportionment % in combined/unitary states

 95%

 95%

 Massachusetts tax rate for Taxpayer and Affiliate A

 9.5%

 9.5%

Taxpayer interest add-back exception per schedule ABI "Exception #2"

 $1,000

 $50

This change to Schedule ABI "Exception #2" was made in the absence of any change to the statute governing the interest add-back. The Department promulgated regulations in 2006 regarding the interest add-back exceptions. However, these regulations do not, on their face, differ materially from the Department's guidance in Technical Information Release 03-19, issued near the time the interest add-back was enacted. This raises the question: shouldn't the prior, taxpayer friendly, method for computing Exception #2 still be valid?

Given the lack of statutory or explicit changes to the Department's published interpretations of the statute, we see no reason why taxpayers should be prevented from computing their exception under the more favorable formula. Since the Department instructs its auditors to refer to TIR 03-19 to determine whether a taxpayer is eligible for the interest add-back exception, it is not clear why the forms issued at the same time as that guidance should not still be applicable as well.8 Furthermore, taxpayers that would benefit from the prior formula should keep their eye on pending litigation involving a similar change to Schedule ABIE (for royalty add-back exceptions), where a taxpayer is alleging that there was no legal basis for the Department's 2006 charges to the Schedule.

Takeaway

  • Potential Audit Offset (especially 2006 – 2008): With the adoption of unitary combined reporting in 2009, the interest expense add-back provision affects fewer taxpayers than it did previously. However, any taxpayer under audit for tax years from 2006 - 2008 that did not claim the full add-back exception should consider whether they would benefit from recomputing their exception under the prior "Exception #2" method. If the prior method results in an increased exception to add-back, the taxpayer should consider (1) requesting that the auditor apply that method under add-back Exception #3 (exception based on a supporting statement), pointing the auditor to the audit manual citing to TIR 03-19 for support that the method is still valid; and (2) raising this issue in any assessment appeal while litigation regarding the 2006 changes is pending.

Taxpayers continue to challenge Department of Revenue embedded royalty/transfer pricing adjustments

Department auditors continue to deny business expense deductions for the full amount of payments made to affiliated taxpayers. Pending cases challenge the Department's authority to disallow deductions for intercompany payments supported by third-party transfer pricing studies; the Department's attempts to reclassify intercompany payments as embedded royalties are also under challenge.

The Department continues to challenge taxpayer deductions for payments to affiliated entities by disregarding the taxpayer's transfer pricing study and/or reclassifying a portion of the payment as an "embedded royalty." Of course, Department auditors are also issuing assessments based on the theory that an affiliate should have charged more for the sale of goods to an affiliate. In pending or recently resolved cases, the Department has been arguing for:

  • The reclassification of payments made by a distribution company for purchases of products from its affiliate as embedded royalties;
  • The disallowance of any deduction for amounts paid to an affiliate for various services;
  • The increase of a taxpayer's net income from sales of pharmaceuticals to an affiliated retailer, using general industry financial ratios as the basis for the increase; and
  • the increase of a taxpayer's net income from sales of various retail products to affiliates despite two third-party transfer pricing studies supporting taxpayer's sales price.

Takeaways

  • Department's methodology: Thus far, the Department appears to be making transfer pricing adjustments on a case-by-case basis, without relying on any consistent method. As cases proceed through the appeal process, the Department will likely be required to put into writing standards and justifications for its adjustments. Taxpayers should keep a close eye on briefs and other Department filings in which the Department sets forth standards for determining fair intercompany pricing. For example, briefs in pending cases in which the Department is arguing that intercompany prices should have been higher may include language that proves useful for taxpayers challenging adjustments in which the Department is reducing an expense deduction for a payment to an affiliate.
  • Embedded royalties—transfer pricing by another name: Taxpayers facing assessments denying a portion of the deduction for payments to an affiliate on the basis that the payment included an "embedded royalty" should consider whether the Department's adjustments met the transfer pricing adjustment standards of I.R.C. § 482. Several taxpayers have pending appeals challenging "embedded royalty" adjustments on the basis that they are, in fact, transfer pricing adjustments, and the auditor failed to apply I.R.C. § 482 standards in making the adjustments.

Footnotes

1.H.B. 3662.

2.Letter Ruling 12-10 (September 25, 2012).

3.Ch. 46, Acts of 2013.

4.See 830 CMR 63.38.1(9)(e).

5.AT&T Corp. v. Commissioner, Mass. Appellate Tax Board, Docket No. C293831 (June 8, 2011) aff'd Mass. App. Ct., Docket No. 11-P-1462 (July 13, 2012).

6.Compare Schedule ABI, Exceptions to the Add Back of Interest Expenses, "Exception 2" version 2005 and 2006.

7.Example assumes that the net income for the tax year of the affiliate receiving the interest payment is greater than the interest income it receives from Taxpayer and that affiliate receiving the interest payment does not receive interest from other affiliated entities.

8.See Auditing Net Income—Step #9, Massachusetts Field Audit Manual (Rev. 2009).

9.National Grid Holdings, Inc., et al. v. Commissioner, Appellate Tax Board Docket Nos. C292287-89, (Decision issued March 28, 2013, Findings of Fact and Report forthcoming).  

This article is presented for informational purposes only and is not intended to constitute legal advice.

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