United States: Massachusetts Tax Developments 14th October, 2014

Welcome to the latest Reed Smith Massachusetts State Tax Quarterly Update. In this update, we'll look back to the developments from the first half of 2014, and look ahead to market-based sourcing and other issues on the horizon for the fourth quarter of 2014 and beyond.

Corporate Tax

Department of Revenue released first draft of market-based sourcing and throwout regulations On March 25, 2014, the Department released a working draft of a revised apportionment regulation. The revisions would implement legislation (effective for tax years beginning on or after January 1, 2014) enacting market-based sourcing for sales other than the sale of tangible personal property. The Department accepted public comments on the draft regulations through May 19, 2014, and our understanding is that numerous taxpayers submitted comments.

The Department is expected to issue revised proposed regulations in the upcoming months, and will likely schedule public hearings for the revised proposal.

The proposed regulations are complex, with a mix of detailed examples for certain types of sales, and broad and ambiguous rules for receipts from a large variety of other types of sales. In this alert, we'll highlight some of the more interesting provisions in the current proposal. For a more detailed analysis of the legislation and the proposed regulations, check out our prior  alert and teleseminar.

Takeaways

  • Department attempts to bar certain refund claims? One of the most surprising provisions in the regulation is a rule that would bar taxpayers that use a "reasonable method of approximation" to source their receipts on their original return, from later filing amended returns to change their sourcing method (with limited exceptions for "factual" or "calculation" errors).

    This rule is bad policy, and if the Department were to promulgate a final regulation including this rule, it would be ripe for challenge as beyond the scope of the Department's authority under the statute. The Legislature has long granted taxpayers three years to file amended returns and seek a refund for tax overpayments. Nothing in the market sourcing statute changes this statutory refund right granted by the Legislature; thus, this attempt to narrow the refund provisions of the statute is clearly beyond the Department's authority, and should be removed from the final regulation. In addition, the proposed regulations appear to prevent taxpayers from filing amended returns that would change the "reasonable method of approximation" used to source receipts on the taxpayer's original return, even if the change would result in an increase to the taxpayer's Massachusetts apportionment. Suppose a taxpayer undertakes a nationwide analysis of its sales factor sourcing and, as a result, decides to file amended returns in all market sourcing states, changing its method of sourcing certain receipts from the sale of services. This change in sourcing method has the effect of decreasing the taxpayer's tax burden in some states, but has the effect of increasing the taxpayer's tax burden in Massachusetts. Under the proposed regulation, the taxpayer would be barred from amending its Massachusetts return. If the taxpayer was later audited, and the Department were to issue an assessment changing the taxpayer's method of sourcing receipts, the Department's authority to include interest or penalties in the assessment might be called into question.
  • Special Industry Apportionment Regulations Still Valid? The proposed regulations state that nothing in the new regulations supersedes or affects the validity of existing special industry apportionment regulations. Our view is that the passage of market sourcing by the Legislature already caused the previously promulgated special industry apportionment regulations to become invalid.

    The Department has promulgated several special apportionment regulations for industries such as airlines, telecommunications, and the electricity industry under the authority granted by G.L. c. 63, § 38(j). However, section 38(j) permits the Department to promulgate alternative apportionment rules for specific industries only if the statutory apportionment rules "are not reasonably adapted to approximate the net income" of a particular industry in Massachusetts. The previously promulgated industry-specific regulations are arguably valid for years beginning before January 1, 2014, because the Department has already determined that the statutory apportionment rules in effect for those years, including the cost of performance sourcing rule, did not meet the "reasonable approximation" standard. However, now that market sourcing has become effective for tax years beginning on or after January 1, 2014, any prior findings by the Department became moot. Absent the promulgation of new regulations finding that statutory apportionment—including the new market sourcing rule—is not reasonably adapted to approximate the net income of a particular industry, the special industry rules should have no effect. Given that the Department specifically cited the distortion resulting from the cost of performance sourcing rule as the basis for promulgating several of the existing special industry regulations, our view is that the Department would have difficulty finding a new basis for re-promulgating its existing special industry regulations in the current form. This should be good news for taxpayers. In our view, any taxpayer that would qualify for special industry apportionment now has a choice of either applying the current statutory market sourcing apportionment rules, or applying the special industry apportionment regulations. Of course, the Department could always attempt to re-promulgate the special industry apportionment regulations or issue a statement that the special industry apportionment regulations are no longer valid, but this issue is one that affected taxpayers should watch closely.

Appeals Court upholds application of sham transaction to intercompany employee transfers; Supreme Judicial Court declines review As we previously reported, the Appellate Tax Board last year issued a decision expanding the application of the sham transaction doctrine (as codified in G.L. c. 62C, § 3A) to transactions intended to transfer Massachusetts payroll and property to a corporation that otherwise lacked nexus with Massachusetts.1 The case, Allied Domecq, involved the unusual scenario where the Department was disputing a taxpayer's claim that an affiliated parent corporation ("ADNAC") had nexus with Massachusetts. The Department took this position in order to prevent the taxpayer from including ADNAC in its combined Massachusetts return and claiming the benefit of an apportioned share of ADNAC's losses.

After asking difficult questions of both sides during oral argument, the Massachusetts Appeals Court issued an opinion affirming the decision of the Appellate Tax Board on June 18, 2014. The Supreme Judicial Court has declined to review the decision of the Appeals Court.

Appellate Tax Board publishes decision denying true debt treatment for deferred subscription arrangements As we reported in September of last year, the Appellate Tax Board decided against the taxpayer in the National Grid case. While the Board's order was issued March 28, 2013, the actual written decision and order was not published until June 4, 2014.2 (This delay is understandable, given the two weeks of trial testimony and hundreds of pages of briefs the Board had to sift through in reaching its decision.)

National Grid represents the latest in a series of decisions by the Board in favor of the Department on the issue of whether a taxpayer's obligation to an affiliated entity constitutes "true debt." In National Grid, as in the prior cases, the Department has successfully argued that transfers of funds between affiliated entities should be classified as "capital transactions" rather than "loans" for corporate excise tax purposes. In these cases, the Department has reclassified any repayments as a return on capital (rather than a repayment of principal and/or interest) and has denied an interest deduction to the payor. National Grid has not sought further review of the Board's decision.

In a separate appeal, the Board found that National Grid could not challenge the Department's denial of interest deductions for payments on the instruments that the Department had reclassified, notwithstanding the fact that a portion of the payments were treated as deductible interest payments in National Grid's closing agreement with the IRS.3

For more information on the specifics of the National Grid case, check out our previous alert.

Takeaway

  • While Massachusetts adopted an add-back statute in 2003, the Department continues to successfully argue that taxpayers must first show that an intercompany payment constitutes true debt before determining if the payment qualifies for an exception to add back. Interest deductions related to common intercompany arrangements, such as cash management systems or centralized third-party financing entities that may be respected in other jurisdictions, are often denied in Massachusetts.

    While this issue should be of lesser concern for tax years beginning on or after January 1, 2009, when Massachusetts adopted mandatory unitary combined reporting, taxpayers participating in cash management arrangements that include entities outside of the Massachusetts combined return—and taxpayers still under audit for years prior to mandatory unitary combined filing that have significant interest deductions for payments made to an affiliated entity—should be aware that auditors continue to look very closely at this issue. Auditors also continue to reclassify intercompany obligations as capital transactions, rather than as "true debt", for purposes of the net-worth-based portion of the corporate excise tax, which continues to be computed on a separate company basis.

Research and development credit expanded On August 13, 2014, Governor Patrick signed an $80 million economic development bill into law. The law includes an expansion of the research and development credit. For calendar years 2015, 2016, and 2017, taxpayers may now elect to take a credit equal to 5% of their qualified research expenses that exceed 50% of the taxpayer's average qualified research expenses for the previous three years.

The credit will be increased to 7.5% for 2018, 2019, and 2020; and then increased to 10% for years thereafter. If a taxpayer does not have qualified research expenses in any one of the three taxable years preceding the year for which the credit is claimed, the credit will be 5% of the taxpayer's qualified research expenses for the year for which the credit is claimed. For purposes of the credit, the term "qualified research expense" is defined in the same manner as for purposes of the federal research credit under IRC section 41, but is limited to expenses incurred in Massachusetts.

Sales Tax

Department issues rulings holding that the object of mixed software/services transactions is a non-taxable service When determining whether a transaction involving mixed software and services constitutes a purchase of taxable canned software, or non-taxable services, the Department applies an "object of the transaction" analysis to determine whether the sale is taxable. Recent rulings indicate that the Department's application of this test may be evolving in a more taxpayer-friendly direction.

In the year since the ill-fated software services tax was revoked, the Department has now issued three letter rulings applying its object of the transaction analysis to mixed software/services transactions, and in each case it has found that the object of the transaction was a non-taxable service.

  • Cloud-Computing and Remote Storage Services (Letter Ruling 12-8—revised and reissued): The Department took the unusual step of revising an earlier ruling holding that the object of certain cloud-computing transactions was taxable software. The Department reversed its previous holding and found that (among other factors), if underlying operating software accessed by cloud-computing customers was not sublicensed to the customer and there was no separately stated charge for the software, the object of the transaction was a non-taxable service.4
  • Subscription to Online Database (Letter Ruling 14-1): The Department held that sales of access to a database providing information on suppliers and purchasers of goods and services constituted a non-taxable service. The heavy use of software by the seller to compile and organize the data, and the customer's use of that software for a variety of purposes beyond simply accessing the data, was found to be incidental to the services provided.5
  • Online Training Services (Letter Ruling 14-4): Sales of training programs focused on corporate ethics and compliance were deemed to be sales of non-taxable services. The customer's use of software to access the training programs was found to be incidental to the services provided.6

Takeaways

  • Taxpayers should review taxability determinations regarding cloud-computing, SaaS, and similar software/services transactions: From 2010 through 2012, the Department issued a series of letter rulings regarding the taxability of cloud-computing and software as a service (SaaS) transactions, many of them finding that the object of the transaction was taxable software. In February 2013, the Department issued a working draft directive summarizing the principles governing those rulings.

    Now that the Department has reversed itself on one of the letter rulings that served as the basis for the draft directive, and has issued two more rulings finding that mixed software/services transactions are purchases of non-taxable services, taxpayers should revisit taxability determinations that relied on prior Department guidance. This is especially the case for vendors and purchasers of cloud-computing services.
  • Pending litigation challenges the Department's existing guidance. While the Department's recent guidance regarding mixed software/services transactions is encouraging, pending (and recently settled) litigation demonstrates that the Department's application of the object of the transaction test is subject to further challenges. For example, in one case pending at the Appellate Tax Board, a vendor is challenging the taxability of mixed software/services transactions, where a software applet is being provided to customers as part of the transaction.

Footnotes

1. Allied Domecq Spirits and Wines USA, Inc. v. Commissioner, Mass. Appellate Tax Board, Dckt Nos. C282807, C293684, and C297779 (May 27, 2013); see also Brief for Appellant, Mass. App. Ct. Dckt No. 2013-P-0984 at page 16.

2. National Grid Holdings, Inc. v. Commissioner, Mass. Appellate Tax Board Dckt Nos. C292287, C292288, C292289 (June 4, 2014).

3. National Grid USA Service v. Commissioner, Dckt No. C314926 (Sept. 19, 2014).

4. Massachusetts Letter Ruling 12-8 (Revised and Reissued) (Nov. 8, 2013).

5. Massachusetts Letter Ruling 14-1 (Feb. 10, 2014).

6. Massachusetts Letter Ruling 14-4 (May 29, 2014).

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

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