Tennessee Enacts Major Legislation Expanding Nexus, Adopting Market-Based Sourcing - Sales Taxes: VAT, GST

On May 20, Tennessee Governor Bill Haslam approved legislation, termed the Revenue Modernization Act, which enacts major amendments concerning excise and franchise taxes, business tax and sales and use taxes.¹The Tennessee excise and franchise taxes are amended by adopting a new substantial nexus standard that includes bright-line nexus, a triple-weighted sales factor, market-based sourcing, special sourcing provisions for security dealers and telecommunication companies, and an apportionment election for taxpayers with large distribution sales. Also, the related-party intangible expense provisions are amended. The business tax similarly is amended to adopt a new bright-line nexus standard. Sales and use tax provisions are amended to adopt click-through nexus and impose tax on cloud computing and video game digital products. Unless otherwise noted, the legislation is effective for tax years beginning on or after January 1, 2016.

Excise and Franchise Taxes

Tennessee has a unique system for taxing businesses. The excise and franchise taxes are imposed on the privilege of doing business in Tennessee.² Although these are two separate taxes, they are treated as part of the same taxing system. The excise tax is based on net earnings or income for the tax year. The franchise tax is based on the greater of net worth or the book value of real or tangible personal property owned or used in Tennessee. In contrast, the state business tax, which is discussed below, is imposed on the privilege of engaging in certain listed vocations, occupations, businesses or business activities.³ A taxpayer's dominant business activity is taxed, but the tax rate and base vary according to the type of activity. In addition to the state business tax, local governments are authorized to impose a municipal business tax. State and municipal business taxes are administered by the Tennessee Department of Revenue, but taxpayers located in a municipality that has approved a business tax must file two separate returns. If a taxpayer engages in a listed activity in Tennessee without establishing a physical location,⁴ it is subject to the state business tax but is not subject to a municipal business tax.

Bright-Line Nexus

The legislation provides that Tennessee excise and franchise taxes are imposed on persons "doing business in this state and having a substantial nexus in this state."⁵ The addition of the words "having a substantial nexus in this state" is intended to include any connection to Tennessee sufficient under the U.S. Constitution to require the taxpayer to remit tax.⁶ The connection includes, but is not limited to, the following: (i) the taxpayer is organized or commercially domiciled in Tennessee; (ii) the taxpayer owns or uses its capital in Tennessee; (iii) the taxpayer has systematic and continuous business activity in Tennessee that has produced gross receipts attributable to customers in Tennessee; (iv) the taxpayer licenses intangible property for use by another party in Tennessee and derives income from that use in Tennessee; or (v) the taxpayer has bright-line presence in Tennessee. A person has bright-line presence in Tennessee if any of the following applies:

The taxpayer's total receipts in Tennessee during the tax period exceed the lesser of $500,000 or 25 percent of total receipts everywhere during the tax period;
The average value of the taxpayer's real and tangible personal property owned or rented and used in Tennessee during the tax period exceeds $50,000 or 25 percent of the average value of the taxpayer's total real and tangible personal property; or
The total amount the taxpayer pays in Tennessee during the tax period for compensation exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.⁷

A company treated as a foreign corporation under the Internal Revenue Code (IRC) and that has no income effectively connected with a U.S. trade or business is not considered to have "substantial nexus in this state."⁸ To the extent a company that is treated as a foreign corporation under the IRC has income effectively connected with a U.S. trade or business, the company's net earnings and net worth are its net earnings and net worth connected with its U.S. trade or business. Only property used in, payroll attributable to, and receipts effectively connected with the company's U.S. trade or business are considered in calculating the apportionment fraction.

Triple-Weighted Sales Factor

For tax years beginning on or after July 1, 2016, all net earnings are apportioned to Tennessee for excise tax purposes by using a triple-weighted sales factor.⁹ For previous tax years, Tennessee uses a double-weighted sales factor.¹⁰ Corresponding changes are made for apportioning the net earnings of a captive real estate investment trust (REIT) affiliated group¹¹ and for apportioning net worth for franchise tax purposes.¹²

Market-Based Sourcing

For tax years beginning on or after July 1, 2016, Tennessee replaces the cost of performance (COP) method for sourcing sales other than sales of tangible personal property with a market-based sourcing method.¹³ Specifically, these sales are sourced to the location of the taxpayer's market for the sale:¹⁴

The sale of a service is sourced to Tennessee to the extent the service is delivered to a location in Tennessee.¹⁵
The sale, rental, lease or license of real property is sourced to Tennessee to the extent the property is located in Tennessee.¹⁶
The rental, lease or license of tangible personal property is sourced to Tennessee to the extent the property is located in the state.¹⁷
The rental, lease or license of intangible property generally is sourced to Tennessee to the extent it is used in the state.¹⁸
The sale of intangible property generally is sourced to Tennessee to the extent the property is used in the state.¹⁹

If the state or states of assignment cannot be determined using the above methods, a reasonable approximation must be made.²⁰ If the state or states of assignment cannot be reasonably approximated, the sale must be excluded from the sales factor.²¹ If the application of market-based sourcing to a tax year results in a lower apportionment factor than under the COP method, a taxpayer may elect to apply the COP method.²² However, the election must result in a higher apportionment factor for the tax year, and the taxpayer must have net earnings, rather than a net loss, for that tax year.

Sourcing for Security Dealers

For tax years beginning on or after July 1, 2016, the legislation adds special sourcing provisions for security dealers.²³ Receipts equal to the net gain or income from the sale of a security made by a security dealer²⁴ are sourced to Tennessee if the customer is located in Tennessee. A customer that is an individual, trust or estate is in Tennessee if it is a resident of the state. Other customers with a Tennessee commercial domicile are also treated as being located in Tennessee. Unless the dealer has actual knowledge of the customer's residence or commercial domicile during the tax year, the customer is deemed to be located in Tennessee if its billing address, as shown in the dealer's records, is in the state.

Sourcing for Telecommunications Companies

For tax years beginning on or after July 1, 2016, a special sourcing provision applies to certain qualified telecommunications companies that are members of a qualified group.²⁵ Specifically, total receipts in Tennessee equal the receipts from all sales of tangible personal property sourced to the state under the standard apportionment provisions plus the average of the receipts from all sales other than tangible personal property that are in Tennessee determined under each of the following alternative methods: (i) all sales sourced to Tennessee under the new market-based sourcing provisions; and (ii) all sales sourced to Tennessee based on COP.²⁶

This special provision applies to a qualified group member that is principally engaged in the sale of telecommunications, mobile telecommunications service, Internet access service, video programming service, direct-to-home satellite television programming service, or a combination of services, as each term is used or defined for sales and use tax purposes.²⁷ "Qualified group" means an affiliated group that meets both of the following criteria: (i) one or more of the members of the group is a qualified member; and (ii) the members of the group either (a) incur aggregate, qualified expenditures²⁸ exceeding $150 million; or (b) make sales that are subject to sales and use tax in excess of $150 million.²⁹

Apportionment Election for Taxpayers with Large Distribution Sales

A special apportionment election is available for major taxpayers that move large amounts of goods through distribution centers in Tennessee.³⁰ If the election is made, the taxpayer apportions net earnings and net worth in the standard manner, but the total amount from certified distribution sales³¹ is excluded from the numerator of the receipts factor.³² In exchange for this benefit, the taxpayer must pay an annual excise tax on the total amount of excluded certified distribution sales.³³ Depending on the amount of excluded sales, the tax rate varies from 0.5 percent if no more than $2 billion in sales are excluded to 0.125 percent if more than $4 billion in sales are excluded.³⁴ To qualify for the election, the taxpayer must have: (i) more than $1 billion of sales of tangible personal property in Tennessee to all distributors; and (ii) a receipts factor over 10 percent.

Related-Party Intangible Expenses

Tennessee law generally provides that an intangible expense paid, accrued or incurred in connection with a transaction with one or more affiliates must be added to a taxpayer's net earnings or losses when computing excise tax liability.³⁵ Under current law, any related-party intangible expense may be subtracted if the Revenue Commissioner determines, upon application by the taxpayer, that the expense did not have the avoidance of tax as its principal purpose.³⁶ As amended, for tax years beginning on or after July 1, 2016, any related-party intangible expense may be subtracted if the expense has been disclosed and either of the following conditions is met: (i) the related party is registered for and paying excise tax; or (ii) the expense was paid to an affiliate in a foreign nation that is a signatory to a comprehensive tax treaty with the U.S. or to an affiliate that is otherwise not required to be registered for or to pay excise tax.³⁷ Under the legislation, taxpayers must disclose related-party expenses on a form prescribed by the Commissioner.³⁸ Any taxpayer that fails to disclose the intangible expenses or fails to add the expenses is subject to a negligence penalty.

Business Tax

Similar to the excise and franchise tax nexus standards, nexus for purposes of the business tax is expanded to include all persons with a substantial nexus in the state.³⁹ Also, similar to the provisions added to the excise and franchise taxes, a new provision is added to the business tax that defines "substantial nexus in this state" and includes bright-line presence.⁴⁰ However, unlike the definition for excise and franchise taxes, the definition does not include a taxpayer that licenses intangible property for use by another party in the state and derives income from that use of intangible property in the state.⁴¹ Also, a deduction is provided for the sale of any service that is delivered outside the state.⁴²

Sales and Use Tax

Click-Through Nexus

Effective July 1, 2015, Tennessee enacts a rebuttable click-through nexus provision. Specifically, a dealer is presumed to have substantial nexus with Tennessee if the dealer enters into an agreement with one or more persons located in the state under which the person, for a commission or other consideration, directly or indirectly refers potential customers to the dealer, whether by a link on an Internet Web site or any other means.⁴³ The dealer's cumulative gross receipts from these transactions in the state must exceed $10,000 during the preceding 12 months. Also, effective May 20, 2015, a new statute provides it is the legislative intent to impose sales and use tax to the fullest extent allowed under the U.S. and Tennessee Constitutions.⁴⁴

Computer Software

Under current law, the retail sale, lease, licensing or use of computer software in Tennessee is subject to sales and use tax.⁴⁵ Effective July 1, 2015, "use of computer software" includes the access and use of software that remains in the possession of the dealer who provides the software or in the possession of a third party on behalf of the dealer.⁴⁶ An exemption currently is provided for the fabrication of software by a person or direct employee for a person's own use or consumption.⁴⁷ The exemption is expanded to include the access and use of software that remains in the possession of the dealer who provides the software or in the possession of a third party on behalf of the dealer, where the access and use of the software is solely by the person or direct employee for the exclusive purpose of fabricating software that is both: (i) owned by that person; and (ii) for that person's own use and consumption.⁴⁸ Also, current law exempts the use of computer software that is developed and fabricated by an affiliated company.⁴⁹ This exemption now is provided regardless of how the software is accessed, used or delivered.

Video Game Digital Products Subject to Tax

Effective July 1, 2015, video game digital products are subject to sales and use tax.⁵⁰ "Video game digital product" means the right to access and use computer software that facilitates human interaction with a user interface to generate visual feedback for amusement purposes, when possession of the computer software is maintained by the seller or a third party, regardless of whether the charge for the service is on a per use, per user, per license, subscription or some other basis.⁵¹

Commentary

This legislation is significant and contains a variety of nexus and apportionment provisions. Tennessee is the latest state to adopt a bright-line presence test that may be used to determine nexus for purposes of a corporate tax in lieu of physical presence.⁵² The new bright-line presence test in the Tennessee statutes is similar to the Multistate Tax Commission's factor presence nexus standard model statute that was approved in 2002. This standard has been approved in administrative decisions in Ohio⁵³ and Washington,⁵⁴ but still has not been considered by higher-level courts. Interestingly, special provisions apply to foreign corporations, and the determination of whether such corporations have effectively connected income for federal income tax purposes takes on added importance for Tennessee. To the extent that such corporations ultimately have excise or franchise tax nexus in Tennessee, the lack of an ability to include all of their worldwide property, payroll and receipts in their apportionment factor denominators could unexpectedly raise their overall apportionment factor percentages and increase potential excise and franchise tax liability. Also, click-through nexus has been adopted for sales and use tax purposes. Under these nexus provisions, out-of-state taxpayers may suddenly have a new tax obligation to Tennessee. Note that the bright-line nexus provisions are effective for tax years beginning on or after January 1, 2016, but most of the other excise and franchise tax provisions are effective for tax years beginning on or after July 1, 2016.

The legislation also includes important income apportionment provisions. Tennessee is the latest state to follow the trend of adopting market-based sourcing for sales other than sales of tangible personal property.⁵⁵ This is particularly interesting because the Revenue Commissioner has been issuing variances requiring the use of market-based sourcing rather than the statutory COP method.⁵⁶ Thus, the Commissioner seemed to have unofficially adopted market-based sourcing for certain types of taxpayers. This legislation clarifies that Tennessee is a market-based sourcing state. The Tennessee market-based sourcing provisions differ from the statutes in other states because they allow taxpayers to elect to use the COP method if it results in a higher apportionment factor than market-based sourcing. Also, the double-weighted sales factor is changing to a triple-weighted sales factor. Some of the apportionment provisions such as the sourcing for certain telecommunications companies and the election for taxpayers with large distribution sales in the state appear to be incentives targeted at a very limited number of taxpayers.

The related-party expense provisions have been amended to allow a subtraction if the taxpayer makes a disclosure and meets certain other requirements. Thus, taxpayers are no longer required to apply to the Commissioner for a subtraction. However, the situations where the taxpayer is allowed the subtraction are narrower than under previous law. For example, the subtraction is no longer allowed when the affiliate has paid a portion of the expenses to an entity this is not an affiliate.

It also is noteworthy that sales and use tax now applies to the use of computer software retained by the dealer (cloud computing services) as well as video game digital products.

Footnotes

1 H.B. 644, Laws 2015.

2 TENN. CODE ANN. §§ 67-4-2001 et seq; 67-4-2101 et seq. See Franchise and Excise Tax Guide, Tennessee Department of Revenue, Nov. 2014.

3 TENN. CODE ANN. §§ 67-4-701 et seq. See Tennessee Business Tax Guide, Tennessee Department of Revenue, Jan. 2015. 4 As discussed below, this is expanded to include taxpayers that have substantial nexus with Tennessee.

5 TENN. CODE ANN. §§ 67-4-2007(a); 67-4-2105(a).

6 TENN. CODE ANN. § 67-4-2004.

7 Id.

8 Id.

9 TENN. CODE ANN. § 67-4-2012(a)(2). 10 TENN. CODE ANN. § 67-4-2012(a)(1).

11 TENN. CODE ANN. § 67-4-2013(d).

12 TENN. CODE ANN. § 67-4-2111(a).

13 TENN. CODE ANN. §§ 67-4-2012(i); 67-4-2111(i).

14 TENN. CODE ANN. §§ 67-4-2012(i)(1); 67-4-2111(i)(1).

15 TENN. CODE ANN. §§ 67-4-2012(i)(1)(C); 67-4-2111(i)(1)(C).

16 TENN. CODE ANN. §§ 67-4-2012(i)(1)(A); 67-4-2111(i)(1)(A).

17 TENN. CODE ANN. §§ 67-4-2012(i)(1)(B); 67-4-2111(i)(1)(B).

18 TENN. CODE ANN. §§ 67-4-2012(i)(1)(D)(i); 67-4-2111(i)(1)(D)(i). Intangible property used in marketing a good or service to a consumer is considered to be used in Tennessee if that good or service is purchased by a consumer who is in the state.

19 TENN. CODE ANN. §§ 67-4-2012(i)(1)(D)(ii); 67-4-2111(i)(1)(D)(ii). A contract right, government license or similar intangible property that authorizes the holder to conduct a business activity in a specific geographic area is considered to be used in Tennessee if the geographic area includes all or a part of the state. Receipts from intangible property sales that are contingent on the productivity, use or disposition of the property are treated as receipts from the rental, lease or licensing of the property. All other receipts are excluded from the receipts factor.

20 TENN. CODE ANN. §§ 67-4-2012(i)(2); 67-4-2111(i)(2).

21 TENN. CODE ANN. §§ 67-4-2012(i)(3); 67-4-2111(i)(3).

22 TENN. CODE ANN. §§ 67-4-2012(i)(4); 67-4-2111(i)(4). Note that there appears to be a technical defect in the legislation. Market-based sourcing is effective for tax years beginning on or after July 1, 2016, but the election provision specifically mentions the apportionment method that was in effect prior to January 1, 2016. 23 TENN. CODE ANN. §§ 67-4-2013(b)(3)(H); 67-4-2118(c)(8).

24 As defined by IRC § 475.

25 TENN. CODE ANN. §§ 67-4-2012(j); 67-4-2111(j).

26 TENN. CODE ANN. §§ 67-4-2012(j)(1); 67-4-2111(j)(1).

27 TENN. CODE ANN. §§ 67-4-2012(j)(2)(C); 67-4-2111(j)(2)(C).

28 These are outside expenditures for the following: (i) purchasing tangible personal property placed in service in Tennessee by a member of the qualified group; and (ii) payroll for employees employed by a member of the qualified group in Tennessee. TENN. CODE ANN. §§ 67-4-2012(j)(2)(A); 67-4- 2111(j)(2)(A).

29 TENN. CODE ANN. §§ 67-4-2012(j)(2)(B); 67-4-2111(j)(2)(B). 30 H.B. 644, § 14.

31 These are sales of tangible personal property made in Tennessee by the taxpayer to any distributor, whether or not affiliated with the taxpayer, which is resold for ultimate use or consumption outside the state. The distributor must certify that the property has been resold for ultimate use or consumption outside Tennessee. H.B. 644, § 14(b)(3).

32 H.B. 644, § 14(c)(1).

33 H.B. 644, § 14(c)(2).

34 For taxpayers excluding more than $2 billion but no more than $3 billion of certified distribution sales, the amount of tax is 0.375 percent of sales in excess of $2 billion plus $10 million. For taxpayers excluding more than $3 billion but no more than $4 billion of certified distribution sales, the amount of tax is 0.25 percent of sales in excess of $3 billion plus $13,750,000. For taxpayers excluding more than $4 billion of certified distribution sales, the amount of tax is 0.125 percent of sales in excess of $4 billion plus $16,250,000.

35 TENN. CODE ANN. § 67-4-2006(b)(1)(K).

36 TENN. CODE ANN. § 67-4-2006(b)(2)(N).

37 Id.

38 TENN. CODE ANN. § 67-4-2006(d). 39 TENN. CODE ANN. § 67-4-717(a)(1).

40 TENN. CODE ANN. § 67-4-702(a).

41 Id.

42 TENN. CODE ANN. § 67-4-711(a)(6). Prior to amendment, the deduction was for sales of services that are received by customers located outside the state.

43 H.B. 644, § 27.

44 H.B. 644, § 26.

45 TENN. CODE ANN. § 67-6-231(a)(1).

46 TENN. CODE ANN. § 67-6-231(a)(2).

47 TENN. CODE ANN. § 67-6-387(a).

48 TENN. CODE ANN. § 67-6-387(b). 49 TENN. CODE ANN. § 67-6-395(a).

50 TENN. CODE ANN. § 67-6-233.

51 TENN. CODE ANN. § 67-6-102.

52 Several states now apply bright-line presence nexus standards for purposes of corporate-level taxes. For example, Ohio uses a bright-line presence standard for purposes of the commercial activity tax (CAT). OHIO REV. CODE ANN. § 5751.01. In 2009, California enacted a bright-line presence standard for its corporation franchise tax that is effective for tax years beginning on or after January 1, 2011. CAL. REV. & TAX CODE § 23101. In 2010, bright-line nexus standards were adopted for Colorado's corporate income tax (1 COLO. CODE REGS. § 39-22-301.1) and Washington's business and occupation (B&O) tax for purposes of service and royalty income (WASH. REV. CODE §§ 82.04.066; 82.04.067). In 2014, New York enacted an economic nexus standard for purposes of the corporation franchise tax and the metropolitan tax (MTA) surcharge for tax years beginning on or after January 1, 2015 (N.Y. TAX LAW §§ 209.1(b); 209-B.1(a)).

53 Newegg, Inc. v. Testa, Ohio Board of Tax Appeals, No. 2012-234, Feb. 26, 2015; Crutchfield, Inc. v. Testa, Ohio Board of Tax Appeals, Nos. 2012-926, 2012-3068, 2013-2021, Feb. 26, 2015. For a discussion of these decisions, see GT SALT Alert: Ohio Board of Tax Appeals Holds Out-of-StateRetailers with Significant Gross Receipts Have Substantial Nexus for CAT.

54 Determination No. 14-0342, Washington Department of Revenue, Oct. 30, 2014 (released Apr. 30, 2015). For a discussion of this decision, see GT SALT Alert: Washington Department of Revenue Rules on Application of Economic Nexus to B&O Tax.

55 For example, the following jurisdictions have adopted market-based sourcing fairly recently: Alabama, California, District of Columbia, Illinois, Maine, Massachusetts, Michigan, Nebraska, New York, Oklahoma, Pennsylvania, Rhode Island, Utah and Wisconsin.

56 See Vodafone Americas Holdings Inc. v. Roberts, Tennessee Court of Appeals, No. M2013-00947- COA-R3-CV, June 23, 2014; leave to appeal granted, Tennessee Supreme Court, Nov. 20, 2014. For a discussion of this case, see GT SALT: Tennessee Court of Appeals Affirms Variance Requiring Telecommunications Company to Use Market-Based Sourcing.

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