United States: SALT Top Stories Of 2013

For the second consecutive year, the two dominant stories in state and local taxation (SALT) related to the challenges surrounding an apportionment election contained in the Multistate Tax Compact, and the sales and use tax treatment of remote sellers.

Interestingly, the California Supreme Court did not decide The Gillette Co. v. Franchise Tax Board,1 the California Court of Appeal case which inspired widespread action on the Compact in the state courts, administrative branches, legislatures and even the Multistate Tax Commission (MTC) in 2013. The interest level of apparent bystanders to the outcome in Gillette is staggering due to the potential revenue effect in impacted states if refund claims on the Compact's three-factor election are allowed. While numerous events this year demonstrated how states are preparing for life with an altered Compact, or perhaps no Compact at all, the activity in this area may pale in comparison to what happens next year, when Gillette is expected to be addressed by California's high court.

Interest in the Compact expands beyond the availability of the three-factor election. Specifically, growth in the use of market-based sourcing of sales of items other than tangible personal property, as well as the expanded use of alternative apportionment, both touch upon provisions contained in the Compact.

On the sales tax side of the ledger, the Marketplace Fairness Act of 2013 (MFA) became the second SALT bill in two years to pass one chamber of Congress, but not the other. The relative progress of the MFA did not stop states from continuing to push click-through nexus and related legislation designed to resolve the remote seller issue, and defend such legislation from constitutional attacks.

In addition to the Compact and the MFA, continuing economic pressures faced by many states and localities still recovering from the Great Recession led to several other important developments. The stagnation of the sales tax from a revenue perspective forced states to at least reconsider the structure and purpose of the sales tax, with taxation of a broader swath of service-based transactions threatened in many instances, and achieved in a few. The "worst-case scenario" of financial disaster occurred in the city of Detroit, where the failure to determine how to balance budgets and pay for future obligations to which the city is committed is resulting in the largest municipal bankruptcy case in U.S. history. On the opposite end of the fiscal spectrum, the state of Texas afforded businesses significant corporate and sales tax breaks, showing that an abundance of highly valued natural resources can protect against fiscal distress.

In our annual end-of-year alert, we summarize the ten stories which in our view constituted the most material SALT developments of the year:

  • The multi-faceted issues surrounding the Multistate Tax Compact
  • Market-based sourcing incrementally progresses
  • Equifax and alternative apportionment challenges
  • Allied Domecq and the application of the "sham transaction" doctrine in restructurings
  • The Texas budget legislation offers expansive tax relief
  • Detroit's bankruptcy filing
  • Marketplace Fairness Act takes center stage on the Senate floor
  • Sales tax click-through nexus and notice litigation: The legal, the illegal, and the uncertain
  • Broadening the sales tax base and raising the tax rate
  • Property tax and the treatment of intangibles

1. The multi-faceted issues surrounding the Multistate Tax Compact

If 2012 could be considered the year of Gillette, 2013 may best be remembered as the year in which state courts, legislatures and taxpayers began to respond to Gillette, in preparation for the California Supreme Court's decision in the case expected early next year.

On the litigation front, activity in Michigan illustrated that two courts in one state could come to different conclusions. In 2012, the Michigan Court of Appeals held in International Business Machines Corp. v. Department of Treasury2 that a taxpayer was not allowed to elect to use the Compact's three-factor apportionment formula for purposes of the Michigan Business Tax (MBT). The Court concluded that the MBT apportionment statute repealed by implication the apportionment election provision found in the Compact. The Court also held that the Compact is not a binding contract that prevents the state from enacting modifications to the state tax base and apportionment statutes. The IBM case was accepted by the Michigan Supreme Court for review this year, with oral arguments to be presented in the coming weeks, and a decision expected soon thereafter.3

The Michigan Court of Claims came to a starkly different result this year in Anheuser-Busch, Inc. v. Michigan Department of Treasury,4 holding that the Compact was a binding compact on Michigan that could not be repealed by a conflicting state statute. While the Court agreed with the taxpayer that for purposes of the MBT the election could be made to apportion the business income tax (BIT) component of the MBT, the Court also held that the MGRT component of the MBT was not an "income tax" under the Compact, and therefore, the election was inapplicable to the MGRT. The result in Anheuser-Busch has been appealed to the Michigan Court of Appeals, which now faces the task of reconciling its opinion in IBM with the Court of Claims' Anheuser-Busch analysis.5 One senses that the ultimate determination in IBM could inform the Court of Appeals' approach in Anheuser- Busch, and it will be interesting to see whether the eventual decision in Gillette has any effect on both Michigan cases.

In Texas, a series of letter rulings issued by the Comptroller has made it clear that a position to elect three-factor apportionment under the Compact for purposes of the Revised Texas Franchise Tax (RTFT) will not be accepted by the Comptroller at any time in the near future.6 In fact, one of the rulings expressly rejected a taxpayer's reference to the Gillette decision by the California Court of Appeals as not being citable because the California Supreme Court granted review of the case.7 It should be noted that the first challenge on the subject to reach the Texas judicial system is presently under consideration by a state trial court, with a decision expected soon.8

In response to the potential results a taxpayer-favorable decision in Gillette could bring, state legislatures spent a significant amount of time and energy attempting to protect themselves from refund claims and prospective tax benefits by removing themselves from the Compact, or at the very least legislating out of Articles III and IV of the Compact. Following California's lead in 2012,9 the District of Columbia,10 Minnesota,11 Oregon,12 South Dakota,13 and Utah14 all enacted legislation in 2013 repealing all or certain portions of the Compact. Of course, due to the Gillette litigation and other cases, it is still uncertain as to whether states can effectively insulate themselves from litigation concerning the three-factor apportionment election by repealing certain provisions of the Compact.

Finally, the MTC's effort to amend the Uniform Division of Income for Tax Purposes Act (UDITPA), along with the recommendations contained in the Report of the Hearing Officer which analyzes proposals and makes recommendations for amending key provisions of Article IV of the Compact,15 has potential implications on the ongoing vitality of the Compact. The Compact currently provides for a three-factor apportionment formula consisting of equally-weighted property, payroll and sales factors.16 However, many states have moved away from this standard formula and require that multistate taxpayers apportion income using a single sales factor or a three-factor formula with a double-weighted sales factor. One of the MTC Uniformity Committee's recommendations was for the Compact to be amended to recommend a double-weighted sales factor to Compact states, but ultimately allow these states to define their own factor weighting. This amendment would allow states to essentially reset the Compact from the equally-weighted three-factor formula to a formula including a more heavily-weighted sales factor so that the MTC election (which would remain under the Uniformity Committee's recommendation) would no longer provide taxpayers with an obvious apportionment formula benefit. The Hearing Officer's Report noted that the "proposal to allow states to define the factor weighting fraction is a concession to reality" and that "[t]he recommendation of double weighting is unlikely to have much effect."17

2. Market-based sourcing incrementally progresses

States are continuing to shift from the cost of performance (COP) method of sourcing sales of services for purposes of income tax apportionment to the market-based sourcing method. In 2013, Massachusetts and Pennsylvania took steps to adopt market-based sourcing in the near future, though the states differ somewhat in how to determine the marketplace. As judged by the Massachusetts and Pennsylvania enactments, sourcing via the location of the benefit of the customer appears to be going out of vogue, while the location where the service is delivered is becoming more popular.

In Massachusetts, the change will become effective for tax years beginning on or after January 1, 2014.18 The legislation requires sourcing of sales of items other than sales of tangible personal property to Massachusetts if the corporation's market for the sale is in Massachusetts.19 In the case of the sale of services, such items are sourced to Massachusetts if the services are delivered to a location in the state.20 Five other market-based sourcing rules are provided to source items other than the sale of services:

  • The sale, rental, lease or license of real property is sourced to the location of such property.
  • The rental, lease or license of tangible personal property is sourced to the location of the property.
  • The lease or license of intangible property, as well as a sale or exchange of such property where the receipts from such sale or exchange derive from payments contingent on the productivity, use or disposition of the property are sourced to the location where the property is used.
  • With respect to other sales of intangible property, contract rights, government licenses or similar intangible property authorizing the holder to conduct a business activity in a specific geographic area are sourced to the location of use or other association.
  • Other sales of intangible property not addressed in these provisions are excluded from the sales factor calculation.21

If the sourcing provisions for sales of items other than tangible personal property are inconclusive, such sourcing must be reasonably approximated.22 If a reasonable approximation cannot be made, or if the taxpayer is not taxable in the state of assignment, such sale is excluded from the sales factor calculation.23

As for Pennsylvania, Act 5224 enacted several tax reforms, including the move to market-based sourcing for many, but not all types of sales. Currently, the COP rule is applicable to sales of all items other than tangible personal property.25 Effective for tax years beginning on or after January 1, 2014, four sourcing rules will come into play:

  • Sales or leases arising from real property are sourced to Pennsylvania if the property is located in Pennsylvania;
  • Sales of tangible personal property are sourced to Pennsylvania if the customer first takes possession in Pennsylvania, but if the customer subsequently takes it out of Pennsylvania, it is sourced to Pennsylvania to the extent usage occurs in the Commonwealth;
  • Services are sourced to Pennsylvania to the extent delivered in Pennsylvania (or, if the state of delivery is indeterminable, the customer has a Pennsylvania billing address); and
  • Income from intangibles continues to be sourced based upon the "old" greater COP rules.26

Clearly, while market-based sourcing is the hot trend in sales factor apportionment, the lack of consistency in how states are adopting it is somewhat remarkable. In contrast to Massachusetts, Pennsylvania appears to have bucked the general trend toward market-based sourcing to the extent that the historic COP rule was left alone with respect to the sourcing of sales from intangibles. Both states will need to develop regulations in the coming year to further explain how the market-based sourcing concepts will apply to businesses.

As for other developments in market-based sourcing, the latest state to develop regulations in this area, Alabama, was tasked with interpreting a "service delivery" sourcing statute for tax years beginning on or after December 31, 2010.27 In the corresponding regulation, the Alabama Department of Revenue created a distinction between the sourcing of sales derived from services rendered to individuals versus services rendered to unrelated business customers.28 The New Jersey Division of Taxation spent much of 2013 drafting a regulation which, if finalized, would implement market-based sourcing even though the state has a pro rata COP statute.29 Finally, the MTC's endorsement of a market-based sourcing concept in UDITPA has been called into question by the Hearing Officer's Report. Rather than endorsing market-based sourcing, the Hearing Office recommended revising the COP method by replacing the "all-or-nothing" method under the current COP standard with a proportionate approach, more clearly defining the term "direct costs" for purposes of COP, and extending the COP calculation to include costs of independent contractors. However, the Hearing Officer did acknowledge that "COP is incompatible with the economic development considerations that led to single-factor apportionment," and so states that have adopted single sales factor apportionment would be unlikely to adopt COP.

3. Equifax and alternative apportionment challenges

Given the desire by many states to endorse market-based sourcing, tax authorities in states that have not enacted market-based sourcing have become more aggressive with utilizing alternative apportionment to get to that result instead of COP sourcing, particularly in situations where the sourcing of items other than tangible personal property yield results that in the authority's view do not clearly reflect income. In Equifax v. Department of Revenue,30 the Mississippi Supreme Court endorsed the Mississippi Department of Revenue's approach, providing a cautionary tale for taxpayers relying upon the plain reading of a statute to apportion income.

The taxpayer in Equifax engaged in a credit reporting business throughout the United States, and had a fairly significant number of Mississippi-based customers. In contrast, the taxpayer had minimal physical presence in Mississippi as transactions were normally performed on an electronic basis. Applying the proportional COP method of apportionment for service companies,31 the taxpayer concluded that it had no income subject to tax in Mississippi, arguing that none of its income-producing activity occurred in Mississippi. The Department determined that the standard apportionment method used by the taxpayer did not reflect the extent of its business in the state, as the taxpayer's customers received the taxpayer's service in Mississippi. Accordingly, the Department used an alternative apportionment method consisting of market-based sourcing to issue a substantial assessment.

The Mississippi Supreme Court held that the Mississippi Chancery Court (the trial court) correctly placed the burden of proof on the taxpayer to show by a preponderance of evidence that the alternative apportionment method imposed by the Department was arbitrary and capricious or violated its constitutional rights. In addition, the Court rejected the taxpayer's argument that alternative apportionment resulted in an illegal promulgation of a rule, as the taxpayer failed to prove that the Department was applying this type of alternative apportionment for all service companies. The Court determined that the Department was simply applying Mississippi's regulation (modeled after a UDITPA provision) that allows the Department to use an alternative apportionment formula.32 The Court also upheld the imposition of penalties on the taxpayer, even though the taxpayer utilized the statutory method of apportionment. The taxpayer's motion for rehearing by the Court has been denied.33

This decision could be used as support for state tax authorities to further rely on alternative apportionment theories in cases where the sourcing of income from sales of services is at issue. By the same token, the decision could embolden some taxpayers to reconsider traditionally iron-clad methods of statutory apportionment through alternative apportionment challenges when such approach is beneficial. In any event, it is likely that these types of disputes will continue to be litigated around the country as taxpayers and state tax authorities look to use their preferred sourcing methodology, regardless of what the general statute and interpretive regulations say.

Finally, it is not surprising to see that the issues highlighted in Equifax have been front and center in the recent debate surrounding the MTC's proposed changes to UDITPA, particularly in the recently released Hearing Officer's Report. The Report advocated that with respect to the burden of proof issue, which is not currently addressed in UDITPA, the party utilizing alternative apportionment should have the burden of proof. Further, the Report noted that to the extent alternative apportionment is mandated by the tax administrator, penalties should not be imposed if the taxpayer reasonably relied on the general apportionment provisions. Finally, a taxpayer permitted to use an alternative apportionment method may not have such permission revoked for transactions that have already occurred unless there has been a material change in, or a material misrepresentation of, the facts provided by the taxpayer. It remains to be seen whether the MTC will endorse the proposals contained in the Report.

4. Allied Domecq and the application of the "sham transaction" doctrine in restructurings

Corporate restructurings that are undertaken for a variety of business reasons often face the charge that such transactions are driven by federal or state income tax savings. The Massachusetts Appellate Tax Board issued a strident caution to taxpayers that are engaged in these types of transactions in Allied Domecq Spirits and Wines USA, Inc. v. Commissioner of Revenue.34 The taxpayer in Allied engaged in a restructuring in which the parent company with no Massachusetts payroll or property obtained a taxable presence so that the parent (and its large net operating loss) could be included in the subsidiary company's Massachusetts nexus combined return.35 The parent achieved the taxable presence in Massachusetts through a transfer of some tax, insurance and internal audit employees from the subsidiary to the parent, as well as rent payments by the parent to the subsidiary. The subsidiary also paid the parent an administrative service fee. The parent's large net operating loss served to reduce the taxpayer's Massachusetts corporation income tax liability. The restructuring plan faced a number of implementation obstacles, including some of the parent's "new" employees continuing to be paid by the subsidiary, and the payment of an intercompany fee by the parent so that the subsidiary could make payments to these employees. Also, the rental agreement did not provide for the lease of office space for all of the parent's employees, and the lease agreement expired after two years without renewal.

The Massachusetts Commissioner of Revenue was unimpressed with the effect of the restructuring, issuing a $20.6 million assessment on the assertion that the restructuring was a sham transaction, and the Board agreed. The Board disregarded the transfers of the nexus-creating payroll and property from the taxpayer to the taxpayer's corporate parent so that the parent's losses could be used in the Massachusetts return. The Board disregarded the transfers of the employees and the lease of the office space because, in its opinion, these transactions did not address any business concerns and had no business purpose or economic effect other than tax avoidance.

The Board "found that there were no legitimate non-tax concerns for transferring the tax, insurance and internal audit functions" from one related company to another. In fact, the Board found ample evidence that the subsidiary's tax department designed the 'state tax planning project' specifically to have "no economic effect." The Board concluded by stating that it "found no indication on this record that the appellant had any business concerns which were addressed by purportedly transferring its tax, insurance and internal audit departments from [the subsidiary] to [the parent], or that the tax-planning project had any economic effect beyond the creation of tax benefits." The Board also contended that "centralization of the tax, insurance and internal audit functions was not a legitimate business purpose for the transfer of such functions to [the parent] and the resulting intercompany charges and deductions." The Board did not explain why it believed that a business cannot transfer functions in order to enhance its business. The Board also attacked the taxpayer's efforts to document the restructuring as proof that the restructuring was designed solely to save state income tax.

The Board's decision raises concerns that businesses could be targeted by state tax authorities for any type of tax planning, including common, run-of-the-mill restructurings that result in some form of state tax savings. In response, businesses considering major (and even minor) changes in their structure that are both driven by operational need and potential state tax savings must be careful in how they document these changes, noting that contemporaneous documentation is still a best practice. Further, a business that undertakes a restructuring must fully commit to and implement the business changes comprising the restructuring.

5. The Texas budget legislation offers expansive tax relief

A series of budget bills adopted by Texas in 2013 contained significant RTFT and sales tax relief for businesses.36 The RTFT rate will be reduced for RTFT reports due in 2014 from 1.0 percent to 0.975 percent for taxpayers other than retailers and wholesalers, and from 0.5 percent to 0.4875 percent for taxpayers that are retailers or wholesalers.37 If certain revenue estimates are met, for RTFT reports due in 2015, the RTFT rates will fall to 0.95 percent for taxpayers other than retailers and wholesalers, and 0.475 percent for taxpayers that are retailers or wholesalers.38 In addition, a provision makes permanent the exemption from the RTFT for taxpayers with a taxable margin of $1 million or less.39 Effective September 1, 2013, certain businesses are allowed to deduct certain relocation costs from the business's apportioned margin in relocating the company's main office or principal place of business from outside Texas to within the state (if the taxpayer or an affiliate of the taxpayer did not do business in Texas before relocating to the state).40 A number of provisions are designed to provide targeted RTFT relief to specific industries.41

Texas also enacted a series of sales tax refund and exemption provisions effective September 1, 2013, again targeted to specific industries. Providers of cable television, internet access, or telecommunications services or their affiliates are now able to obtain a refund of state sales and use tax paid on the purchase, lease, or rental of tangible personal property directly used or consumed in providing these services.42 In addition, an owner, operator and/or occupant of a data center being specifically constructed or refurbished in Texas to be used primarily to house servers and related equipment for processing, storage, or distribution of data may apply to the Comptroller for certification as a qualifying data center that can claim a state sales and use tax exemption for certain taxable items.43

Finally, a new provision designed to spur research and development activities in the state provides a unique and unparalleled choice for taxpayers. Taxpayers with certain research and development activity in Texas may make an annual election either to deduct such expenses from their sales and use tax returns or to take a credit against their RTFT liability.44 Beginning January 1, 2014, taxpayers may claim an exemption from sales and use tax for the sale, storage, or use of depreciable tangible personal property45 directly used in qualified research46 if the property is sold, leased, or rented to, or stored or used by a person engaged in qualified research.47 Alternatively, beginning January 1, 2014, taxpayers can claim a RTFT credit equal to 5 percent of the difference between the qualified research expenses incurred during the period on which the report is based and 50 percent of the average amount of qualified research expenses incurred during the three preceding report periods.48 Qualified research expenses are defined under IRC Section 41, with the exception that expenses must be for research conducted in Texas.49 The credit is limited to 50 percent of the franchise tax due for the report before any other applicable tax credits are applied50 and can be carried forward for a maximum of 20 consecutive reports.51 The credit may not be conveyed, assigned or transferred to another taxpayer unless all assets of the taxpayer are conveyed, assigned or transferred in the same transaction.52 Both the sales tax exemption and the RTFT credit are available through December 31, 2026.53

6. Detroit's bankruptcy filing

The story of the year in municipal finance undoubtedly was the bankruptcy filing entered into by the city of Detroit under Chapter 9 of the U.S. Bankruptcy Code.54 The filing followed years of fiscal distress, population declines, excessive and exponentially increasing pension costs, and economic blight in the city. The city's property tax base has significantly declined as companies and individuals have departed for other jurisdictions, abandoning buildings and impacting adjoining areas. Detroit's revenues from city-level taxes (including the income tax and the utility user's tax) have suffered as well, furthering the city's financial woes.

Faced with the plain fact that Detroit was out of money and could not pay debts as they came due, Michigan Governor Rick Snyder permitted Detroit's emergency manager (which had been appointed by the Governor earlier in the year) to enter into the Chapter 9 bankruptcy filing on July 18. Numerous parties, including pension funds, city unions and retirees, challenged the filing on a number of grounds, arguing that the state of Michigan did not allow cities to file for bankruptcy, and that the city of Detroit did not negotiate in good faith with its creditors.

Following a bankruptcy eligibility trial, on December 3, U.S. Bankruptcy Judge Steven Rhodes decided that the bankruptcy filing could proceed, and that cuts to existing pension programs would be allowed. The judge also raised the specter of raising one-time funds through asset sales, though such sales would not singlehandedly help the city regain its financial footing. The city is required to develop a plan for restructuring and paying its debts in a timely manner. Undeterred, the parties opposed to bankruptcy have filed appeals, which will be heard while the Chapter 9 process begins unless a higher court orders a stay to the proceedings.

Based on how the Detroit Chapter 9 filing proceeds, it is certainly within the realm of possibility that other distressed Michigan municipalities will be forced to go the bankruptcy route. In considering how the bankruptcy will impact the Detroit tax system, it will be interesting to see how Detroit deals with taxpayers that file refund claims while the city is in bankruptcy, and whether the city becomes more aggressive in its efforts to audit taxpayers and collect from noncompliant businesses. Of course, it is possible that city tax rate increases may be a part of the long-term solution to exit bankruptcy.

7. Marketplace Fairness Act takes center stage on the Senate floor

The Marketplace Fairness Act of 2013 (MFA) is the latest in a long line of Congressional attempts to allow states to require remote (out-of-state) sellers to collect and remit sales and use tax on sales to in-state residents, even if the retailer has no physical presence in the state.55 In its previous iterations, the MFA had not garnered significant attention in Congress. That changed in 2013 as the U.S. Senate found itself with an unexpected gap in its agenda and fast-tracked the MFA, spending a full afternoon debating the merits of the bill. Regardless of how one felt about the issue being debated, it was a watershed moment for many SALT practitioners that took a fair amount of pride in watching senators argue whether the Quill56 physical presence standard should be repealed.

On May 6, soon after the debate, the Senate passed the MFA with a significant 69–27 majority. Under the MFA, a member state of the Streamlined Sales and Use Tax Agreement (SSUTA) would be able to require the collection of tax beginning 180 days after it publishes notice of its intent to exercise its authority.57 In order for states that currently are not members of the SSUTA to secure collection and remittance authorization, such states would need to adopt and implement several minimum sales tax simplification requirements.58 The MFA would exempt remote sellers with $1 million or less in annual sales, and would require that an adopting state provide free software to remote sellers to calculate and file sales and use tax returns.59

The Senate bill was sent to the House Judiciary Committee of the House of Representatives. Rep. Bob Goodlatte, R-Va., the chair of the Committee, considered the bill and instead of openly endorsing the MFA, issued a press release setting forth a series of seven basic principles that an act covering the remote sales tax should meet:

  • Tax Relief – Using the Internet should not create new or discriminatory taxes not faced in the offline world. Nor should any fresh precedent be created for other areas of interstate taxation by States.
  • Tech Neutrality – Brick & Mortar, Exclusively Online, and Brick & Click businesses should all be on equal footing. The sales tax compliance burden on online Internet sellers should not be less, but neither should it be greater than that on similarly situated offline businesses.
  • No Regulation Without Representation – Those who would bear state taxation, regulation and compliance burdens should have direct recourse to protest unfair, unwise or discriminatory rates and enforcement.
  • Simplicity – Governments should not stifle businesses by shifting onerous compliance requirements onto them; laws should be so simple and compliance so inexpensive and reliable as to render a small business exemption unnecessary.
  • Tax Competition – Governments should be encouraged to compete with one another to keep tax rates low and American businesses should not be disadvantaged vis-a-vis their foreign competitors.
  • States' Rights – States should be sovereign within their physical boundaries. In addition, the federal government should not mandate that States impose any sales tax compliance burdens.
  • Privacy Rights – Sensitive customer data must be protected.60

The issuance of the press release has not resulted in a House bill to date, although a House bill based on the seven principles may be drafted in the next several months. It remains to be seen whether such a bill would be similar to the MFA, and if so whether the bill would garner a similar amount of bipartisan support to match that achieved in the Senate. Assuredly, large brick-and-mortar retailers and many "Main Street" businesses will continue to argue in favor of the MFA or similar bill requiring remote sellers to collect sales tax on purchases in states in which they have no physical presence. Likewise, many internet retailers will continue to argue that the MFA or similar bill would hamper one of the fastest growing segments of the economy, burden small online retailers, and unfairly allow states to target businesses outside their borders. As 2013 closes, the fate of the bill rests in the House, with public consciousness of the issue raised to unprecedented levels.

8. Sales tax click-through nexus and notice litigation: The legal, the illegal, and the uncertain

Given the lack of Congressional action on the sales and use tax treatment of remote sellers, states have been active in creating sales tax click-through nexus, affiliate nexus and notice requirements over the past five years. Three high-profile decisions arriving at three different conclusions gave impacted businesses little hope that a universal solution could be fashioned by the judicial system regarding what is permissible from a constitutional perspective.

In the long-awaited decisions in Amazon.com and Overstock.com,61 the New York Court of Appeals found that the state's click-through nexus statute (the nation's first62) did not facially violate the Commerce Clause and Due Process Clause of the Constitution. The Court determined that for Commerce Clause purposes, the click-through nexus statute did not impose an undue burden on interstate commerce.63 As for the Due Process Clause, the Court held that the statute reasonably allowed for collection of the sales tax because the businesses satisfied the "minimum contacts" standard and purposefully directed its activities toward New York. The businesses appealed the decision to the U.S. Supreme Court, but on December 2, the Court denied certiorari, effectively upholding the Court of Appeals' decision.64

The Illinois courts came to a completely different conclusion, albeit on different grounds than New York. In Performance Marketing Association, Inc. v. Hamer,65 the Illinois Supreme Court affirmed a circuit court holding that Illinois' click-through nexus law is preempted under the Supremacy Clause of the U.S. Constitution due to the federal prohibition against discriminatory state taxes on electronic commerce contained in the Internet Tax Freedom Act. The decision upheld the circuit court's granting of summary judgment in the underlying case.66 In doing so, the Illinois Supreme Court explained that the click-through nexus law implicitly targeted collection requirements on online marketing efforts broadcast to a worldwide audience, in contrast to offline marketing on which the collection requirement only applied to marketing directed to Illinois consumers.

While the U.S. Supreme Court was unwilling to enter the fray in the New York litigation, and may not do so in the Illinois litigation, another federal court did weigh in on the validity of sales and use tax notice and reporting requirements in the past year. In Direct Marketing Association v. Brohl,67 the U.S. Court of Appeals for the Tenth Circuit ordered a U.S. District Court to dismiss a case in which a permanent injunction had been granted against the Colorado Department of Revenue that prevented the Department from enforcing Colorado's sales and use tax notice and reporting requirements for out-of-state (remote) retailers. After determining that the federal Tax Injunction Act68 deprived the U.S. District Court of jurisdiction to enjoin Colorado's tax collection effort, the Tenth Circuit remanded the case to the District Court to dismiss the Commerce Clause claims raised by the remote retailers. Previously, the U.S. District Court had determined that Colorado's notice and reporting requirements violated the Commerce Clause of the U.S. Constitution.69 In remanding the case, the U.S. Court of Appeals did not consider the merit of the constitutional arguments. On remand, the District Court followed the order of the Tenth Circuit70 and the plaintiff is likely to pursue its claims in the Colorado state courts.

9. Broadening the sales tax base and raising the tax rate

Several states attempted to either replace planned individual and/or corporate income tax rate cuts with higher sales tax rates, and/or broadened sales tax bases, with varying levels of success. Proposals to greatly expand the reach of the sales tax to numerous services, including professional services, generally did not materialize, though some level of base-broadening was achieved.

Minnesota's budgetary plan resulted in omnibus tax legislation intended to raise $2.1 billion in taxes.71 The legislation expanded the sales and use tax to include services purchased by businesses after June 30, 2013 to repair and maintain several items, including: commercial and industrial machinery and equipment; electronic and precision equipment; computer hardware; office equipment; scientific instruments; and medical equipment.72 In addition, businesses that purchase warehousing or storage services for tangible personal property will be required to pay sales or use tax on these services after March 31, 2014 (with limited exemptions).73 Effective July 1, 2013, Minnesota eliminated a sales tax exemption for the purchase of telecommunication equipment including ancillary machinery and equipment along with repair and replacement parts.74 Also effective July 1, 2013, sales and use tax is imposed on the purchase of digital books, digital movies, digital music and audio works, digital greeting cards, online video or electronic games that are transferred electronically to a customer.75

Ohio enacted a $62 billion budget bill for Ohio fiscal years 2014 and 201576 that increased the state sales tax rate from 5.5 to 5.75 percent on September 1, 2013.77 The budget also broadened the sales tax base, as for the first time, downloaded digital products are subject to Ohio sales tax, including digital audiovisual and audio works as well as books delivered electronically (cable service and video programming are exempt).78 Additionally, the exemption previously provided for magazine subscriptions has been repealed.79 The provisions affecting digital products and magazine subscriptions will take effect January 1, 2014.

In North Carolina, the Tax Simplification and Reduction Act of 201380 expanded the state's sales tax base to include certain service contracts under which a seller agrees to maintain or repair tangible personal property. Service contracts including warranty agreements, maintenance agreements, repair contracts, and similar agreements or contracts are now subject to tax at the general rate.81 However, an exemption is allowed for a service contract for tangible personal property that is provided for: (i) an item that is exempt for sales tax; and (ii) a transmission, distribution or other network asset contained on utility-owned land, right-of-way or easement.82 Also, an exemption is provided for an item used to maintain or repair tangible personal property under a service contract if the purchaser of the contract is not charged for the item.83

The subject of sales tax base broadening would not be complete without a brief discussion of the Massachusetts experience. Effective July 31, 2013, the state briefly implemented a new sales and use tax on computer and software services, including computer system design services and the modification, integration, enhancement, installation or configuration of standardized software, as a means to fill a budget gap in its transportation financing bill.84 Due to significant outcry from the business community and other groups, however, the new tax lasted a little more than one month and was retroactively repealed.85 The Massachusetts experience shows how difficult in practice it may be to actually impose a new sales tax that broadly impacts business services, even if the political will to pass a bill exists.

10. Property tax and the treatment of intangibles

Finally, a recent California Supreme Court decision highlights the distinctive nature of intangible items and how they may impact property tax valuations. In Elk Hills Power, LLC v. Bd. of Equalization,86 the Court held that intangible property cannot be taxed directly for property tax purposes, clarifying that intangible assets must be excluded from the computation of real property values. However, earnings derived from intangible assets can be considered if the value of the property is enhanced by their presence. This decision represents the first attempt by the Court in many years to address the longstanding uncertainty regarding inclusion of intangible assets in computing fair market value for property tax purposes, and has far-reaching implications in how property with intangible components is valued in California, and perhaps beyond.

The taxpayer in Elk Hills owned and operated a California independent electric power plant. In order to obtain environmental authorization to construct the power plant and to operate it at certain air-pollutant emission levels, Elk Hills purchased emission reduction credits (ERCs), which were considered to be intangible rights. The issue in dispute was whether the ERCs could be taken into account for purposes of determining the California property tax base pursuant to either the replacement cost approach or the income capitalization approach. In considering the issue, the Court had to take into account the fact that California property tax law specifically prohibits the direct taxation of certain intangible assets and rights,87 but allows the assumption of the "presence of intangible assets or rights necessary to put the taxable property to beneficial or productive use."88

The Court concluded that the Board directly and improperly taxed intangible assets by adding their replacement cost to a property's taxable value when applying the replacement cost method of valuation. However, the Board was not required to deduct a value attributable to the intangible assets in computing the property valuation using an income capitalization approach, noting that under an income stream approach, not all intangible rights have a quantifiable fair market value that must be deducted. The Court distinguished between intangible assets which are enterprise-related and directly enhance the income stream derived from taxable property (such as the goodwill of a business, customer base, and favorable franchise terms or operating contracts) and those which contribute only indirectly to the income stream of a company (such as the ERCs at issue in this instance).89 The Court, in noting that the sole purpose of the ERCs is to enable the taxable property in question to function and produce income as a power plant, held that the Board simply "assumed their presence" in order to tax the property in question as a fully functioning power plant. The decision is essential reading for entities that hold non-enterprise intangible assets with respect to real property in California and potentially other states, and could lead to challenges of assessments derived by the cost approach that took the intangible assets into account.

Footnotes

1 California Court of Appeal, First District, No. A130803, Oct. 2, 2012.

2 Michigan Court of Appeals, No. 306618, Nov. 20, 2012 (unpublished).

3 International Business Machines Corp. v. Department of Treasury, Michigan Supreme Court, No. 146440, leave to appeal granted, July 3, 2013. Note that the Michigan Supreme Court instructed the parties to brief the following issues: (i) whether the taxpayer could elect to use the apportionment formula provided by the Compact in calculating its 2008 tax liability or whether it was required to use the apportionment formula provided by the MBT Act; (ii) whether the MBT repealed by implication Article III(1) of the Compact; (iii) whether the Compact constitutes a contract that cannot be unilaterally altered or amended by a member state; and (iv) whether the modified gross receipts tax (MGRT) component of the MBT constitutes an income tax under the Compact.

4 Michigan Court of Claims, No. 11-85-MT, June 6, 2013.

5 Michigan Court of Appeals, No. 316743, filed June 12, 2013.

6 Decision, Hearing Nos. 107,937, 107,938, 107,939, and 107,940, Texas Comptroller of Public Accounts, June 7, 2013; Decision, Hearing Nos. 108,223, 108,284, 108,285, Texas Comptroller of Public Accounts, May 2, 2013; Decision, Hearing Nos. 107,323 and 107,324, Texas Comptroller of Public Accounts, April 9, 2013.

7 Decision, Hearing Nos. 108,223, 108,284, 108,285, Texas Comptroller of Public Accounts, May 2, 2013.

8 Graphic Packaging Corp. v. Combs, Dist. Court of Travis County, 353rd Jud. Dist., No. D-1-GN-12- 003038

9 Ch. 37 (S.B. 1015), Laws 2012.

10 D.C. CODE ANN. § 47-441.

11 Ch. 143 (H.F. 677), Laws 2013.

12 Ch. 407 (S.B. 307), Laws 2013.

13 S.B. 239, Laws 2013.

14 Ch. 462 (S.B. 247), Laws 2013.

15 Report of the Hearing Officer, Multistate Tax Compact Article IV (UDITPA) Proposed Amendments, Oct. 25, 2013. The report was generated in response to a public hearing on the subject after the MTC's proposed changes to UDITPA late in 2012. The Hearing Officer's Report is available at http://www.mtc.gov.

16 Multistate Tax Compact Art. IV.9.

17 Report of the Hearing Officer, Multistate Tax Compact Article IV (UDITPA) Proposed Amendments, Oct. 25, 2013.

18 Ch. 46 (H.B. 3535), Laws 2013, §§ 37, 84.

19 MASS. GEN. LAWS ch. 63, § 38(f).

20 Id.

21 Id.

22 Id.

23 Id.

24 Act 52 (H.B. 465), Laws 2013.

25 72 PA. STAT. § 7401(3)2(a)(17); Commonwealth v. Gilmour Manufacturing, Inc., 822 A.2d 676 (Pa. 2003).

26 H.B. 465, §§ 19; 42(2)(xiii), adding 72 PA. STAT. § 7401(3)2(a)(16.1).

27 H.B. 434, Laws 2011.

28 ALA. ADMIN. CODE r. 810-27-1-4-.17.01.

29 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A (proposed).

30 Equifax, Inc. v. Department of Revenue, Mississippi Supreme Court, No. 2010-CT-01857-SCT, June 20, 2013.

31 CODE MISS. R. 35-III-8.06:402.09.

32 CODE MISS. R. 35-III-8.06:402.10. This is based on UDITPA § 18.

33 Equifax, Inc. v. Department of Revenue, Mississippi Supreme Court, No. 2010-CT-01857-SCT, motion for rehearing denied, November 21, 2013.

34 Allied Domecq Spirits and Wines USA, Inc. v. Commissioner of Revenue, Massachusetts Appellate Tax Board, Docket Nos. C282807, C293684, C297779, May 22, 2013.

35 As allowed by former MASS. GEN. LAWS ch. 63, § 32B, repealed for tax years beginning on and after Jan. 1, 2009. Massachusetts adopted mandatory combined reporting beginning with the 2009 tax return.MASS. GEN. LAWS ch. 63, § 32B.

36 H.B. 500, 800, 1133, 1223, Laws 2013, Regular Session.

37 TEX. TAX CODE ANN. § 171.0022(a), (b).

38 TEX. TAX CODE ANN. § 171.0023(a), (b). If the revenue target is not met, the tax rates will revert to 1.0 percent and 0.5 percent for RTFT reports due in 2015.TEX. TAX CODE ANN. § 171.0023(d).

39 See TEX. TAX CODE ANN. § 171.002(d).

40 TEX. TAX CODE ANN. § 171.109(a)(1), (b)(1), (2). Presumably, if a taxpayer has previously filed a franchise tax return and subsequently relocates its main office to Texas, it is ineligible for the deduction.

41 H.B. 500, § 20. Note that this legislation generally applies only to a report originally due on or after January 1, 2014.

42 TEX. TAX CODE ANN. § 151.3186.

43 TEX. TAX CODE ANN. § 151.359.

44 TEX. TAX CODE ANN. §§ 151.3182; 171.651-171.665.

45 "Depreciable tangible personal property" means tangible personal property that: (1) has a useful life that exceeds one year; and (2) is subject to depreciation under generally accepted accounting principles (GAAP) or IRC Sections 167 or 168. TEX. TAX CODE ANN. § 151.3182(a)(1).

46 The definition of "qualified research" is adopted from IRC Section 41. TEX. TAX CODE ANN. § 151.3182(a)(3).

47 TEX. TAX CODE ANN. § 151.3182(b). Note that this provision expires on December 31, 2026. See TEX. TAX CODE ANN. § 151.3182(f).

48 TEX. TAX CODE ANN. § 171.654(c). If a taxpayer does not have qualified research expenditures during any of the three preceding periods, the credit will be equal to 2.5 percent of all qualified research expenses incurred during the report period. TEX. TAX CODE ANN. § 171.654(c). If a taxpayer contracts with at least one public or private institution of higher education to perform qualified research in Texas, the credit percentage increases to 6.25 percent if the taxpayer has three years of research expenses and 3.125 percent if it does not. TEX. TAX CODE ANN. § 171.654(b) and (d).

49 TEX. TAX CODE ANN. § 171.651(3).

50 TEX. TAX CODE ANN. § 171.658.

51 TEX. TAX CODE ANN. § 171.659.

52 TEX. TAX CODE ANN. §§ 171.655; 171.660.

53 TEX. TAX CODE ANN. §§ 171.665; 151.3182(f).

54 See 11 U.S.C. § 901 et seq. Notably, states are precluded from claiming bankruptcy under Chapter 9 or any other provision.

55 S.743, as passed by the Senate on May 6, 2013. Note that this Bill was originally introduced as S.336 on February 14, 2013. Also, an identical corresponding Bill, H.R. 684, was introduced in the U.S. House of Representatives on February 14, 2013. The Senate's legislation was amended prior to passage.

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

57 S.743, § 2(a).

58 S.743, § 2(b). For a non-member SSUTA state, the enacting legislation must specify: (i) the taxes to which the state's authority to impose a collection and remittance requirement upon remote sellers will apply; and (ii) the products and services otherwise subject to these taxes to which the state's authority to impose a collection requirement upon remote sellers will not apply. S.743, § 2(b)(1).

59 S.743, §§ 2(c); 2(b)(2)(D)(ii).

60 House Judiciary Committee Press Release, "House Judiciary Committee Releases Principles on Internet Sales Tax," September 18, 2013.

61 Overstock.com, Inc. v. New York State Department of Taxation and Finance, 987 N.E.2d 621 (N.Y. 2013). Note that the Amazon.com and Overstock.com cases were combined on appeal. Because Amazon and Overstock decided to forgo their challenges "as applied" to their businesses, the Court of Appeals only considered the facial challenges.

62 N.Y. TAX LAW § 1101(b)(8)(vi). Specifically, the definition of "vendor" was amended in 2008 to include Internet retailers that actively encourage Web site owners residing in New York 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. The New York State Department of Taxation and Finance has released administrative guidance on the click-through nexus statute. 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.

63 Citing Matter of Orvis Co. v. Tax Appeals Tribunal, 654 N.E.2d 954 (N.Y. 1995), cert. denied 516 U.S. 989 (1995).

64 U.S. Supreme Court, Dkt. 13-252, 13-259.

65 Illinois Supreme Court, Doc. No. 114496, Oct. 18, 2013.

66 Performance Marketing Association, Inc. v. Hamer, Circuit Court, First Judicial Circuit, No. 2011 CH 26333, Order Granting Plaintiff's Motion for Summary Judgment entered on May 7, 2012.

67 U.S. Court of Appeals, 10th Circuit, No. 12-1175, Aug. 20, 2013.

68 28 U.S.C. § 1341.

69 The Direct Marketing Association v. Huber, U.S. District Court, D. Colorado, No. 10-cv-01546-REBCBS, Jan. 26, 2011 (Order Granting Motion for Preliminary Injunction).

70 The Direct Marketing Association v. Huber, U.S. District Court for the District of Colorado, Dkt. No. 10-cv-01546-REB-DBS, December 10, 2013.

71 Ch. 143 (H.F. 677), enacted on May 23, 2013.

72 MINN. STAT. § 297A.61(3)(m)(1), (2).

73 MINN. STAT. § 297A.61(3)(m)(3).

74 MINN. STAT. § 297A.68(35).

75 MINN. STAT. §§ 297A.61 (3)(l), (10), (50)-(56). The purchase of a digital code providing the purchaser with the right to obtain a digital product will also be subject to tax. These digital products are subject to tax if the purchaser has the right to use the product on a temporary or permanent basis, and even if the purchaser is required to make continued payments for the right to use the product.

76 H.B. 59, Laws 2013; Release, Ohio Department of Taxation, July 1, 2013.

77 OHIO REV. CODE ANN. § 5739.02(A)(1). The enacted budget did not affect the local option rate that can be imposed by cities and counties, which can range from 0.75 percent to 1.25 percent.

78 OHIO REV. CODE ANN. § 5739.01(B)(12), (QQQ).

79 OHIO REV. CODE ANN. § 5739.02(B)(4).

80 Ch. 316 (H.B. 998), Laws 2013.

81 N.C. GEN. STAT. §§ 105-164.3(38b); 105-164.4(a)(11).

82 N.C. GEN. STAT. § 105-164.13(61).

83 N.C. GEN. STAT. § 105-164.13(62).

84 CH. 46 (H.B. 3535), Laws 2013.

85 CH. 95 (H.B. 3662), Laws 2013.

86 Elk Hills Power, LLC v. Bd. Of Equalization, Cal. Sup. Ct., No. D056943, August 12, 2013.

87 CAL. REV. & TAX. CODE § 212(c), 110(d).

88 CAL. REV. & TAX. CODE § 110(e).

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