Current State Income Tax Developments ELA Tax Executives Roundtable June 9, 2004 Jeffrey Friedman Partner, Washington National Tax KPMG LLP Washington, DC (202) 533-3204

Brendon McKibbin Partner KPMG LLP New York, NY (212) 872-3559

KPMG

Legislative Update

KPMG

Legislative Update „

The “state of the states” has not necessarily kept pace with the upturn in the economy

„

“Loophole closers” and corporate tax reform continue as the dominant legislative themes for 2004

„

Historically anti-tax legislatures appear to be more receptive to corporate tax measures than in years past KPMG

Legislative Update „

Illinois - major tax reform proposal – – – – – –

„

Lockbox rule Cost of performance 80/20 companies Business/non-business income Business software purchases Tax planning transactions

Other states with major tax packages: Kentucky (failed), Maryland, Virginia KPMG

Legislative Update „

Expense disallowance – – – – –

District of Columbia Maryland Missouri Tennessee Virginia

„

Impact of California referendum

„

Texas special session KPMG

Related Party Expense Disallowance

KPMG

Related Party Challenges Kevin Assoc. (LA) Ind. L.O.F. 01-0132 Toys ‘R’ US (NYC) Ind. L.O.F. 01-0063S Ind. L.O.F. 00-0379 SYL (MD) Crown Cork & Seal (MD) Sherwin Williams (NY) A&F (NC) Lanco (NJ) Cambridge Brands (MA)

Taxpayer Victory Taxpayer Loss

Sherwin Williams (MA) Indiana L.O.F. 95-0401 Indiana L.O.F. 01-0094 Syms (MA) Gore/Acme Royalty (MO) Kmart Properties (NM)

Burnham (1997, NY) Geoffrey (1993, SC) Aaron Rents (1994, GA) Express (1995, NY)

1993 – 1995

1996 – 2000

2001

2002

2003

2004

KPMG

Related Party Challenges „

Toys “R” Us - NYTEX (N.Y.C) – – – –

– –

Forced combination rejected First precedential ruling on this issue in NYC Taxpayer’s arm’s-length evidence not rebutted Business purpose/economic substance evidence unnecessary But see, New York State Sherwin Williams And, impact limited by enactment of expense disallowance KPMG

Related Party Challenges „

Cambridge Brands (Mass. ATB) – – –

–

– – –

Taxpayer victory! Licensing fees had business purpose Based on comparisons to Sherwin Williams and Syms Taxpayer routinely segregated intellectual property Royalty was arm’s-length Licensor assumed expenses No circular flow of cash KPMG

Expense Disallowance Update Narrower

Broader

Royalties

North Carolina Oregon NEW

and intangible related interest

Connecticut Mississippi New York

and other intercompany interest Alabama Arkansas Connecticut Massachusetts New Jersey New York Ohio KPMG

Expense Disallowance Legislation „

„

Measures enacted during 2003 in New York, Massachusetts, Connecticut, Oregon, and Arkansas New York –

„

Originally included royalties and interest; subsequently amended to cover royalties only

Massachusetts –

Retroactive to 2002 KPMG

Expense Disallowance Legislation „

Connecticut –

–

„

Existing royalty disallowance provision expanded to include interest, as well Unitary filing option created as an exception

Oregon regulation – why does a unitary state need expense disallowance?

KPMG

Landscape: Before

No Income Tax Unitary Add Back of Royalty States where Benefits or Partial Benefits May Remain

KPMG

Landscape: After

No Income Tax Unitary Economic Nexus Add Back of Royalty States Attacking on Audit States where Benefits or Partial Benefits May Remain

KPMG

California Disclosure Legislation

KPMG

Disclosure Requirements „

Disclosure by California taxpayers – – – –

„

Federal listed transactions entered into after February 28, 2000 Other federal reportable transactions entered into on or after January 1, 2003 California listed transactions entered into on or after February 28, 2000 So far, two listed transactions

Registration and list maintenance requirements for tax shelter organizers KPMG

Penalties „ „ „ „ „ „

Failure to disclose reportable or listed transaction Reportable transaction understatement Non-economic substance transaction understatement IRC § 6662-based penalty Increased interest Statute of limitations doubled KPMG

Voluntary Compliance Initiative „

Began January 1, 2004; ended April 15, 2004

„

Applied to “abusive tax avoidance transactions” for tax years beginning before January 1, 2003

„

Penalty waiver in exchange for amended return AND payment of tax

KPMG

Other States „

New York –

„

Legislation proposed (S.B. 6500)

Illinois –

Mentioned in Governor’s budget address

KPMG

Nexus and Jurisdiction

KPMG

Nexus Proposals „

Federal legislation – ITFA moratorium expired Nov. 1, 2003 – Alternative resolutions pending on moratorium – Additional proposals would: z Codify Quill for BAT z Overturn Quill for sales and use tax purposes

„

MTC factor-based BAT nexus proposal – $50,000 property or payroll; $500,000 sales; or 25 percent of any factor – Computed on a unitary group basis – Approved October 17, 2002 KPMG

Nexus – Intangibles „

Lanco (N.J. Tax Ct. Oct. 21, 2003) – – – – –

Physical presence required for income tax purposes Separate nexus standards for income and sales and use taxes are “illogical” Regulation provided that licensing trademarks constituted doing business Court stated legitimate tax planning permissible But, impact limited by 2002 enactment of expense disallowance KPMG

Nexus - Intangibles „

Louisiana –

–

–

Kevin Associates reversed (La. Sup. Ct.) z Delaware holding company was domiciled and physically present in Louisiana through presence of directors, officers z Did not impose economic nexus Autozone (La. Ct. App.) z State could not reach through REIT to tax out-of-state REIT holding company z Footnote – Quill requires physical presence But, several economic nexus suits pending, including Geoffrey

KPMG

Nexus – Economic & Attributional „

Annox (Ky. Bd. Tax App. Nov. 18, 2003) – – – –

Telecommunications reseller subject to tax No presence, but interconnection agreements Quill limited to sales/use tax Nexus established by: z Right to use in-state networks z Certificate of Public Convenience z Installation and repair by interconnection partners z Congressional grant of authority? KPMG

P.L. 86-272 „

Disney (N.Y. Div. of Tax App. Feb. 12, 2004) – – – – –

Applied Finnigan rule Protected subsidiaries required to source New York destination sales to state on combined report Significant cross-marketing Alpharma (2002) same result; but Silver King Broadcasting (1995) applied Joyce None are precedential

KPMG

Apportionment Issues „

Disney (N.Y. Div. Tax App.) – – –

„

Royalties sourced to licensee address, not location of manufacture (overseas) No factor representation for intangibles licensed to third parties Film masters must be valued at cost, not market; difference represented intangible copyright

UPS (Pa. Commw. Ct.) –

Furnished employees did not create a payroll factor for taxpayer KPMG

Unitary Combined Reporting „

Envirodyne (U.S. Ct. App. 7th Circ.) – – – –

Brother-sister not unitary; even though both unitary with parent Losses could not be brought into unitary group “Spokes without a hub” theory State level case law distinguished

KPMG

The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax advisor.

KPMG

Current State Tax Developments

ELA Tax Executives Roundtable June 9, 2004

Jeffrey Friedman Partner, Washington National Tax KPMG LLP Washington, DC

2004 KPMG LLP ALL RIGHTS RESERVED

Brendon McKibbin Partner KPMG LLP New York, NY

CURRENT DEVELOPMENTS A NATIONWIDE PERSPECTIVE ________________________________________________________________________

Table of Contents

I.

Legislative Roundup

II.

Jurisdiction to Tax A. B. C.

III.

Substantial Nexus Income Tax -- Economic Nexus Income Tax -- U.S. Public Law No. 86-272 and Throwback

Corporate Income and Franchise Taxes

Page 2 4 4 11 14

Related Party Transactions and Arrangements Tax Base and Credits Allocation and Apportionment Apportionment Issues Filing Methods Franchise and Net Worth Taxes

17 17 24 27 29 36 39

IV.

LLCs and Other Pass-Through Entities

41

V.

Sales and Transaction Taxes

43

A. B. C. D. E. F.

Software, Telecommunications, and Digital Goods and Services Exemptions Resale Other Taxability Issues Sourcing Drop Shipments

43 48 52 52 54 55

G.

Other Transaction Taxes

56

A. B. C. D. E. F.

VI.

Property Taxes

57

VII.

Practice and Procedure

58

I.

Legislative Roundup As the 2004 state legislative sessions progress, states continue to contend with budget shortfalls. In addition, many states remain interested in enacting tax reform and dealing with transactions perceived as loopholes. The following is a summary of some of the recent legislative activity in select states. This summary reflects legislative activity as of April 12, 2004. A.

Alabama: A proposal to require combined reporting was expected to be introduced during April.

B.

California: A voter referendum held March 2, 2004, approved the bond financing plan and rejected a proposal to lower the supermajority requirement for increasing taxes. As a result of these developments, taken in concert, significant tax increases are not expected this year. Pending tax legislation (all in early stages) includes several bills that would reinstate the Manufacturer’s Investment Credit, legislation that would repeal the water’s edge election, a proposal to include subpart F income in the water’s edge group, and provisions that would allow the sale of unused NOLs.

C.

District of Columbia: The Mayor included, as part of his budget proposal, a related party expense addback provision. A similar measure was introduced by the D.C. Council last year.

D.

Florida: Two bills, H.B. 735 and S.B. 2302 were still pending, toward the end of the session, to repeal the substitute communications services tax. The legislature was scheduled to adjourn on April 30, 2004.

E.

Illinois: The Governor’s budget address contained a sweeping tax reform proposal that would change the Illinois “lockbox” rule and the cost of performance sourcing rule; eliminate nonbusiness income; ensure no tax benefits are available when intangible assets are transferred to tax havens; enact straight-line depreciation; repeal the sales tax exemption for business software purchases; and institute tax shelter legislation. Legislative language is not yet available.

D.

Indiana: H.B. 1365, which was enacted on March 17, 2004, contains a provision requiring out-of-state sellers to register for and collect sales and use taxes if “closely related” to an entity that maintains a place of business in Indiana or enters into a public contract with an Indiana agency. The legislation also exempts separately states installation charges from sales

1

and use tax and clarifies the assignability of the sales and use tax bad debt deduction. As originally introduced, the legislation contained an expense disallowance provision that was deleted from the final version of the legislation. E.

Kentucky: The Governor had proposed a significant tax modernization package. The legislature adjourned April 13, 2004, without passing the Governor’s proposal or a budget bill.

F.

Louisiana: Legislation was enacted that: creates a phased-in exemption for purchases of machinery and equipment by manufacturers; phases out the borrowed capital component of the franchise tax; and provides for the inclusion of related party debt that exceeds a certain threshold in the franchise tax base.

G.

Maryland: On the last day of the session, April 12, 2004, the legislature approved and sent to the Governor three bills, one containing related party expense disallowance, another containing an amnesty provision with respect to prior year related party expenses, and a bill imposing a temporary corporate income tax surcharge. The Governor has threatened to veto the surcharge bill and has announced that he has not decided whether to sign either the expense disallowance or amnesty bills. The Governor has until June 1, 2004 to sign the legislation.

H.

Massachusetts: Among the provisions included in the Governor’s budget proposal, H.B. 1, are proposals to expand allocation of income of domiciliary corporations, revise apportionment sourcing rules, address the apportionment of income attributable to IRC § 338(h)(10) transactions, and impose a sales/use tax collection obligation on certain drop shippers.

I.

Missouri: A related party expense disallowance provision containing safe harbors, H.B. 969, which was supported by the business community, passed the House and was sent to the Senate, where it was still pending as of the middle of April. It is unclear whether the Governor, a strong proponent of expense disallowance, would support the legislation with the safe harbors included.

J.

New Jersey: The Governor has proposed extending the suspension of the NOL deduction for 2004 and 2005.

K.

New York: The Governor has proposed single factor apportionment for manufacturers. In addition, legislation has been introduced which would require disclosure of certain tax planning transactions.

2

L.

Ohio: The budget that was passed during 2003 is a two-year provision. The Governor has indicated that any major tax proposals would be deferred until preparation of the 2005 budget. It is possible that a Housebased reform proposal will be introduced this year; but it is not anticipated that any major tax reform will be enacted during 2004.

M.

Oregon: A voter referendum held on February 3, 2004, rejected a proposed tax increase.

N.

Tennessee: Two expense disallowance bills have been introduced. One applies only to royalties, while the other is broader.

O.

Texas: The Governor called the legislature into a special session to address education financing, which began April 20, 2004. It was anticipated that corporate limited partner nexus and related party expense disallowance would be among the measures considered during the session.

P.

Virginia: A temporary budget bill, H.B. 5018 was approved by the House on April 13, 2004 but, was drafted to “self destruct” on April 24, 2004, if a 2004-2004 biennial budget was not enacted by that date. H.B. 5018 was scheduled for consideration by the Senate Finance Committee on April 16, 2004.

3

II.

Jurisdiction to Tax A.

Substantial Nexus 1.

2.

Nexus Proposals a.

Multistate: The Internet Tax Freedom Act moratorium on discriminatory taxes and taxes on internet access expired on November 1, 2003. Two bills, H.R. 49 and S.150, were introduced during the latter part of 2003. Two other measures have been introduced that would set statutory nexus standards. H.R. 3184 would provide for expanded collection authority for sales and use tax purposes, essentially overturning the Quill physical presence test. H.R. 3220 would codify the physical presence test for business activity tax (BAT) nexus purposes and expand the scope of U.S.P.L. 86-272. H.R. 3220 does not address sales and use tax nexus.

b.

Multistate: The Multistate Tax Commission (MTC) continues to support a BAT nexus proposal adopted in October 2002 under which substantial nexus would be established if a taxpayer had a threshold amount of property, payroll, or sales in the state ($50,000 property or payroll or $500,000 sales). Nexus would also be established in any state in which at least 25 percent of any of the three factors was concentrated. The proposal would require the members of a unitary business group to compute their nexus factors in the aggregate. If the group as a whole met the nexus threshold, each member of the group would be considered to have substantial nexus in that state. Furthermore, the receipts factor would include intercompany sales. The factors would be computed according to the appropriate UDITPA rules for the taxpayer. However, for receipts factor purposes, the rule moves away from a cost of performance standard toward a destination standard.

Intangible Licensing Activities, Other Holding Company Issues a.

Louisiana: Reversing an appellate court decision, the Louisiana Supreme Court has held that a Delaware passive investment company was subject to Louisiana corporate income and franchise taxes. The company was part of a closely held group of corporations, and all 4

of its directors, except the Delaware-based nexus provider, were Louisiana residents. Kevin Associates, LLC v. Crawford, No. 03-C-0211 (Jan. 30, 2004). The company earned dividends from subsidiaries located in Louisiana and other states and received interest from an intercompany loan to an affiliated Louisiana corporation. The court held that the company was commercially domiciled in Louisiana because it was managed from Louisiana, and its Delaware presence was merely a paper domicile. The court also concluded that the company had a physical presence in Louisiana because its principal place of business was in the state, and it was managed from there. The appellate court had held that the company did not have nexus, noting that the company followed all the required formalities for establishing and maintaining a DHC. Kevin Assoc. LLC v. Crawford, 834 So.2d 465 (Nov. 8, 2002). b.

Louisiana: A Louisiana appellate court has held that the Department could not assert jurisdiction over an out-of-state holding company, because the corporation’s contacts with the state were not sufficient to satisfy the nexus requirements of the Due Process Clause. Bridges v. Autozone Properties, Inc., No. 2003 CA 0492 (La. App. 1 Cir. Jan. 5, 2004). (This decision was issued before Kevin Associates). The Department attempted to tax dividends received by a Nevada corporation from a real estate investment trust (REIT) that earned rental income from subsidiary retail stores, some of which were located in Louisiana. The REIT was subject to Louisiana tax but paid no tax as a result of the dividends paid deduction, while the stores received a deduction for rental expense. The court examined Geoffrey, from a due process perspective only. It concluded that, unlike the economic presence created by the trademarks, which gave rise to the Due Process nexus in Geoffrey, the holding company’s dividends had no economic presence in Louisiana. Nor could a Louisiana business situs be claimed for the dividends that had no connection with the state other than being paid by a REIT that earns part of its income from Louisiana properties. While the Commerce Clause was not at issue in Autozone, the court did state in a footnote that Quill requires a physical presence to establish Commerce Clause nexus. The court also

5

rejected an argument asserting that the holding company and REIT were alter egos. c.

Louisiana: A district court has denied motions filed by two out-of-state trademark licensing companies to dismiss suits filed by the state to recover income taxes. Louisiana Dept. of Revenue v. Geoffrey, Inc., No. 502769; Louisiana Dept. of Revenue v. Gap (Apparel), No. 501651 (Dec. 8, 2003). The court determined both suits could proceed, despite the defendants’ claims that they had no physical presence in the state; however, the court did not actually rule on whether the companies had established nexus in Louisiana.

d.

New Jersey: The New Jersey Tax Court has held that an intangible holding company with no physical presence in New Jersey, but which licensed trademarks to an affiliated retailer in the state, was not subject to the New Jersey Corporation Business (income) Tax (CBT). Lanco, Inc. v. Director, Division of Taxation, No. 005329-97 (N.J. Tax Ct. Oct. 23, 2003). The court specifically ruled that the physical presence test upheld by the U.S. Supreme Court in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), applies to income as well as sales and use taxes. In so doing, the court appears to have invalidated a 1996 Division of Taxation regulation that defines doing business to include licensing trademarks, if used in the state. The court explicitly stated that there was no justification for imposing different substantial nexus standards for sales and use and income taxes. The court reasoned that, since an obligation to collect use tax is not “more burdensome” than an obligation to pay an income tax, it would be “illogical” to require physical presence for use tax nexus, while allowing income taxes to be imposed under lesser circumstances. Although the decision is taxpayer favorable, the impact is mitigated by New Jersey’s 2002 enactment of statutory expense disallowance provisions that require addback of certain related party expenses, including royalties attributable to licensing intangible property. Tax Court decisions are not precedential.

6

3.

Attributional Nexus a.

Indiana: Recently enacted legislation requires any person that is “closely related” to another person that maintains a place of business in Indiana, engages in the regular or systematic soliciting of retail transactions from potential customers in Indiana, or enters into a public contract with a state agency to register and collect sales and use tax. H.B. 1365 (Mar. 17, 2004). The term, “closely related” is defined to include: use of identical or substantially similar names, trademarks or goodwill; persons that pay for each other’s services under an arrangement that is contingent on sales volume or value; and entities that share a common business plan. The measure also expands the definition of a retail merchant engaged in business in the state (for sales and use tax collection purposes) to the boundaries of the U.S. Constitution. The provision becomes effective July 1, 2004.

b.

Kentucky: The Board of Tax Appeals has ruled that a telecommunications reseller was subject to the Public Service Corporation (PSC) property tax in a ruling with both economic and attributional nexus elements. Annox, Inc. v. Revenue Cabinet, No. K-19039 (Nov. 18, 2003). The reseller had no physical presence in the state but did have interconnection agreements with two in-state telephone companies entitling it to use their instate equipment to provide services to Kentucky customers. Citing Scripto and Tyler Pipe, the Board explained that the in-state interconnection partners established and maintained a market for the reseller through the activities of their employees, such as performing installation and repair services for the reseller’s Kentucky customers. The Board also stated that Quill is only applicable for sales and use tax purposes, and cited Geoffrey, despite Geoffrey’s limited applicability to South Carolina. The Board then explained that nexus was established through the reseller’s absolute right to use the Kentucky physical networks of two in-state telephone companies (an intangible), as well as its Certificate of Public Convenience issued by the Kentucky PSC. The Board went so far as to state that the U.S. Congress granted

7

states nexus over all switchless resellers providing services in their states when it specifically authorized state commissions to approve interconnection agreements (in the Telecommunications Act of 1996). c.

New York An out-of-state non-profit membership organization with no physical presence in New York established nexus in the state through the activities of two unrelated independent contractors in the state and must collect sales and use tax on catalog and internet sales made to New York purchasers. TSB-A-04(3)S (N.Y. Dept. of Tax. and Fin. Feb. 24, 2004). The organization, an association for boaters, provided various services to its members, including marina membership discounts, insurance, theft protection, magazine subscription, and access to emergency towing services. Four retail stores in New York owned by third parties, but which bore the organization’s name, sold memberships to the organization. The Department ruled that the stores served as independent representatives that established New York nexus for the organization through the sale of memberships. The Department found that nexus was also established through the arrangement the organization had with local towing companies for its members to receive emergency towing services throughout the country.

d.

New York: An administrative ruling issued by the New York Department of Taxation and Finance provides that a remote vendor with an in-state retail affiliate will not, generally, be required to collect use tax on New York sales, as long as the entities do not engage in certain activities or act as alter egos. TSB-A03(25)S (Jun. 11, 2003). However, the ruling also listed a number of activities the Department would consider as triggering a use tax collection obligation. The Department noted that activities that would deem an in-state retailer to be acting as a sales representative for a remote vendor would subject the seller to use tax collection. The ruling explained that an in-state seller might be acting in a sales representative capacity if it referred customers to a remote seller’s catalogs, accepted returns of its merchandise, solicited customer names for a remote vendor’s mailing lists, distributed

8

catalogs or coupons of the remote seller, or shared common inventory or administrative staffs. e.

4.

Virginia: A ruling issued by the Department of Taxation clarifies the scope of recent legislation, and essentially provides that sellers that wish to do business with the state may be required to waive constitutional nexus protections in order to obtain contracts with the state. Ruling of Commissioner, P.D. 04-04 (Jan. 23, 2004). The legislation, enacted during 2003, prohibits the state from purchasing goods or services from a seller, if the seller or any of its affiliates is a “dealer” under Virginia law and fails to collect and remit sales and use taxes. The Department ruled that the state could not enter into a contract with the taxpayer because an affiliate of the taxpayer may have advertised in the state. While advertising, alone, is not necessarily sufficient to establish nexus under constitutional standards, it does qualify a seller as a “dealer” under Virginia law. Under the constitution, Virginia cannot require a “dealer” to collect tax if it does not have nexus with the state. However, the ruling explained that the state may set its own conditions for vendors to do business with state agencies.

In-State Representatives a.

Connecticut: A Connecticut Superior Court has held that a mail order computer seller did not establish nexus for sales and use tax purposes by virtue of the in-state activities of an unrelated company to which the seller had outsourced a portion of its service contract repair work. Dell Catalog Sales v. Commissioner of Revenue Services, No. CV 00 0503146S (Jul. 10, 2003). Under the contracts, telephone and online support services were provided by the seller, while on-site services were preformed by the repair company. On-site repair work comprised only ten percent of the value of the services performed under the contracts. The court focused on the lack of evidence as to the actual number of repair visits made to Connecticut. In the absence of actual evidence, the court held that the fact that only ten percent of the service contract revenue was attributable to on-site work indicated that the repair company’s presence was minimal and insufficient to establish

9

nexus for the seller. The court cited Appeal of Intercard, 14 P.3d 1111 (Kans. 2000) (eleven maintenance visits during an audit period did not establish nexus). b.

Michigan: On appeal, a Michigan court has ruled that a lower court should have granted a summary judgment motion against an out-of-state seller. The out-of-state company was subjected to the single business tax (SBT) based on the activities of two resident sales representatives. Acco Brands, Inc. v. Department of Treasury, No. 242430 (Mich. Ct. App. Nov. 20, 2003). The representatives solicited orders in the state and sent them to the company’s Illinois office for approval. However, since it has been determined that the SBT is not an income tax, the activities of the representatives were not protected by P.L. 86-272. See Gillette Co v Dep't of Treasury, 497 N.W.2d 595 (Mich. Ct. App.1993. Revenue Administration Bulletin (RAB) 9801 provided that, effective for open tax years and going forward, the presence of sales representatives in the state is sufficient to establish SBT nexus for an out-ofstate entity if the representatives solicit sales or engage in other activity in the state on behalf of the seller.

c.

New York: The Department of Taxation and Finance has ruled that an out-of-state vendor established nexus for use tax collection purposes through the in-state activities of a commission-based independent contractor. TSB-A-03(41)S (Nov. 19, 2003). The independent contractor sold only one line of the vendor’s products, and the majority of its sales were attributable to participation in trade shows. Citing Scripto, the Department ruled that the independent contractor’s activities established New York nexus for the vendor, and the vendor was required to collect New York use tax on all sales (other than resales), including online sales. Although nexus is often based on the activities of independent contractors, the ruling failed to analyze the volume or frequency of the contractor’s activities, New York’s more than a slightest presence standard (Matter of Orvis Co. Inc. v. Tax Appeals Tribunal, 86 N.Y.2d 165 (1995)), or whether the contractor satisfied the Scripto/Tyler Pipe marketmaking standard.

10

B.

Income Tax -- Economic Nexus 1.

State Arizona Arkansas Colorado Florida Georgia Hawaii Indiana Iowa Kentucky Louisiana Maine Maryland4 Massachusetts Michigan Minnesota Missouri5 New Hampshire New Jersey6 New Mexico New York North Carolina9 Ohio11 Oklahoma Pennsylvania South Carolina12 Tennessee13 Virginia West Virginia

Reported and Known “Geoffrey Nexus” Positions By State Statute

Rule Yes

Audit Position Yes Yes1

Yes Yes Yes (Priv.Tax) Yes 2

Yes (F/S) Yes Yes (F/S)

Yes

Yes (F/S)

Yes

Yes 3 Yes Yes

Yes (F/S) Yes

Yes Yes7

Yes10

Yes

Yes Yes Yes Yes Yes Yes8 Yes (Forced Comb.) Yes Yes

Yes Yes (F/S)

Yes Yes

Yes (F/S)

Yes Yes

Yes (F/S)

Yes

“F/S” - Financial Services 1

The Colorado Department of Revenue indicated at a practitioner’s liaison meeting that it will assert nexus in situations similar to Geoffrey. 2

See Letter of Findings 95-0401 (Ind. Dept. Rev. Jul. 1, 2002), which upheld an audit assessment against an intangible holding company based on a Geoffrey nexus position.

11

3

Several suits are pending in which the Department of Revenue is asserting economic nexus over intangible licensing companies, and administrative guidance provides that an out-of-state intangible licensing company would have nexus under certain circumstances. Revenue Ruling 02-001 (La. Dept. of Rev. May 13, 2002). In addition, the Louisiana Supreme Court has held that an out-of-state holding company had nexus in Louisiana, although the decision was not based directly on economic substance principles (company was held to be domiciled in the state). Kevin Associates, LLC v. Crawford, No. 03-C0211 (Jan. 30, 2004). 4

Maryland’s highest court has reversed (on business purpose/economic substance grounds), a group of decisions that had held that Geoffrey was inapplicable in Maryland. See Comptroller of the Treasury v. SYL, Inc., Comptroller v. Crown Cork & Seal Company (Delaware), Inc. Nos. 76 & 80, (June 9, 2003). The U.S. Supreme Court declined the taxpayers’ appeals in both decisions. 5

But see, Acme Royalty Co. v. Director of Revenue and Gore Enterprise Holdings, Inc. v. Director of Revenue, Nos. SC84225, SC84226 (Mo. Nov. 26, 2002), in which the Missouri Supreme Court reversed two Administrative Hearing Commission orders and held, on statutory grounds, that out-of-state companies licensing patents and trademarks were not subject to Missouri income tax. 6

Legislation enacted during 2002 expands the New Jersey Corporation Business Tax to corporations engaging in contacts within the state. N.J. Stat. Ann. § 54:10A-2. However, a recent Tax Court decision rejected the assertion of nexus in the absence of a physical presence. Lanco, Inc. v. Director, Division of Taxation, No. 005329-97 (N.J. Tax Ct. Oct. 23, 2003). 7

The New Mexico Court of Appeals has held that an out-of-state company that licensed trademarks and tradenames to an in-state affiliate was subject to New Mexico gross receipts and income taxes. Kmart Properties, Inc. v. New Mexico Taxation and Revenue Department, No. 21,140 (Nov. 27, 2001).

8

New Mexico imposes economic nexus requirements on franchisors for purposes of its gross receipts tax. 9

See A&F Trademark, Inc. v. Secretary of Revenue, N.C Super. Ct., Wake Cty., (May 22, 2003), affirming Secretary of Revenue v. A&F Trademark, Inc., Admin Decision No. 381 (May 7, 2002); contra

12

Educational Resources, Inc. v. Tolson, No. 00CVS14723-4 (Wake Cty. Sup. Ct., Feb. 20, 2003). 10

A North Carolina statute, enacted during 2001, provides that licensing intangibles for use in the state is considered to be doing business in the state. 11

The Ohio Supreme Court upheld the taxation of a nonresident individual’s Ohio lottery winnings. Couchot v. State Lottery Comm'n., 659 N.E.2d 1225 12

Geoffrey Inc. v. South Carolina Tax Comm'n., 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993). 13

Tennessee imposes economic nexus on financial institutions for franchise/excise tax purposes. In J.C. Penney National Bank v. Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999) cert. denied 121 S. Ct. 305 (2000), the imposition of tax on an out-of-state bank that issued credit cards to Tennessee residents was rejected; however, in America Online, Inc. v. Johnson, No. M2001-00927-COA-R3-CV (July 30, 2002), the Tennessee Court of Appeals clarified that J.C. Penney does not impose a physical presence requirement for all taxes.

13

C.

Income Tax -- U.S. Public Law No. 86-272 and Throwback 1.

Massachusetts: The Massachusetts Supreme Judicial Court has upheld an Appellate Tax Board (ATB) ruling that a company’s in-state representatives exceeded U.S. P.L. 86-272 protection. Alcoa Building Products, Inc. v. Commissioner of Revenue, SJC-08939 (Oct. 21, 2003). The taxpayer employed a handful of sales managers that solicited sales of vinyl siding and other building products from Massachusetts customers. The ATB had ruled that the sales managers’ involvement in the warranty claims process was sufficient to forfeit the company’s P.L. 86-272 protection. The sales managers investigated sites to evaluate the merit of warranty claims and assisted customers in filling out as many as one-third of the claim forms filed with the company. The court ruled that these activities had independent business purposes, apart from solicitation, including enhancing the taxpayer’s reputation and decreasing the volume of traffic received by the taxpayer’s warranty claims office. The court rejected the taxpayer’s claim that the warranty activities consisted of merely passing inquiries and complaints on to the home office, an activity that is explicitly protected by regulation in Massachusetts (and consistent with the MTC statement on P.L. 86-272). 830 Code Mass. Regs. § 63.39.1(5)(c)(4). The court explained that the warranty activities were more akin to handling customer complaints, an activity that the same regulation specifically provides exceeds protection. The court also rejected the taxpayer’s attempt to establish that the unprotected activities were de minimis, noting that the sales managers participated in more than one-third of the warranty claims filed by the taxpayer’s customers and regularly visited warranty claim sites.

2.

New York: An administrative law judge (ALJ) with the New York Division of Tax Appeals ruled that the New York destination sales of certain members of a combined reporting group must be sourced to New York, even though none of the companies, themselves, engaged in any activities that exceeded U.S Public Law 86-272 protection. Matter of Disney Enterprises, Inc., DTA No. 818378 (Feb. 12, 2004). The ALJ ruled that the New York activities of the other members of the group, including retail stores in the state, and substantial cross marketing, was sufficient to require the non-nexus subsidiaries to source their destination sales to the state. The ALJ explained that these activities established that the companies’ business in New York was not merely limited to

14

remote/protected sales. This is the second ALJ ruling in the last two years to employ the Finnigan approach in New York. In 2002, a different ALJ also ruled that P.L. 86-272 protected New York destination sales made by non-taxpayer corporations of a New York combined reporting group must be included in the numerator of the group's receipts factor. Matter of Alpharma, Inc., DTA No. 817895 (2002). In contrast, in Petition of Silver King Broadcasting of New Jersey, Inc., an ALJ ruled that the Joyce approach should be applied. DTA No. 812589 (1995). None of these rulings are precedential. 3.

New York: Recent regulatory amendments provide that participation in a trade show for no more than fourteen days, in the aggregate, during a tax year qualifies for P.L. 86-272 protection from the franchise (i.e., income) tax. N.Y. Comp. Codes R. & Regs. tit. 20, §§ 1-3.3, 1-3.4. (Jan. 22, 2004). In order to qualify for the exception, no sales can be made at the trade show, the person’s activity must be limited to displaying goods and promoting services, and all orders must be sent outside the state for acceptance. The regulation is effective retroactively for taxable years beginning on or after January 1, 2002. A previously issued New York ruling provided that the presence of employees at in-state trade shows and seminars an average of ten days per year did not generate nexus for corporation franchise tax purposes. N.Y. Dep’t of Tax. & Fin., TSB-A-97(6)C (Mar. 24, 1997). These changes are also consistent with amendments made to New York City regulations last year. Rules of the City of New York §§ 11-03, 11-04 (Jan. 2, 2003) were amended to include a fourteen-day trade show safe harbor, effective January 1, 2002, as well.

4.

New York: The Department of Taxation and Finance has issued an Advisory Opinion finding that an out-of-state food seller was subject to New York corporation franchise tax. TSB-A-03(13)C (Dec. 24, 2003). Although orders were sent outside the state for approval and deliveries were made from outside the state (in company owned trucks), the Department concluded that the seller engaged in post-delivery activities that exceeded P.L. 86-272 protection, including picking up damaged goods from customers and occasionally accepting payments from customers for prior deliveries. The Department found that these activities were unprotected under N.Y. Code Regs. Reg. § 1-3.4(b)(9) - - replacing stale or damaged products and collecting delinquent accounts. With regard to the replacement of damaged products, however, the facts

15

indicate that the seller removed damaged products from customers and issued credit, but do not indicate that any replacements were delivered. Furthermore, the facts stated that delivery persons occasionally accepted checks from customers as an alternative to the customers mailing their payments. There is no indication that these payments related to past due accounts or that the delivery persons in any way solicited or requested such payments. The Department also noted that the seller was ineligible to claim a de minimis exception where there was at least one damaged goods pickup per week.

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III.

Corporate Income and Franchise Taxes A.

Related Party Transactions and Arrangements 1.

Expense Disallowance Legislative Developments a.

Connecticut: Legislation enacted during 2003 expands the disallowance of related party interest expense under the state’s expense disallowance provisions. H.B. 6806, sec. 78 (Aug 16, 2003). The measure was enacted as a substitute for legislation that would have imposed a mandatory “alternate combined reporting” regime for virtually all corporate taxpayers in Connecticut. The legislation is effective for tax years beginning on or after January 1, 2003. The legislation effectively expands Connecticut’s expense disallowance to intercompany financing (and other types of intercompany interest payments). Under existing law, taxpayers are already required to add back interest expenses and costs related to intangible property under Conn. Gen. Stat. § 12-218c. The legislation provides five possible categories of exceptions to the disallowance requirement, including the payment of tax in another jurisdiction coupled with arm’s length terms and a non-tax business purpose, as well as a treaty exception. The addback may also be avoided if the taxpayer agrees to file a unitary combined report. Subsequently released information addresses the scope of the addback exceptions. Form CT-1120AB and DRS Commissioner Meeting Interest Add Back Issues (Dec. 3, 2003). The release specifies that a petition must be filed with the Department in order to take advantage of any of the statutory exceptions to addback, other than the “three percent tax paid exception.” The release clarifies that the three percent spread will be calculated by comparing Connecticut’s maximum 7.5 percent statutory rate to the income recipient’s effective tax rate in any one state. The effective rate is calculated by dividing actual tax paid by pre-apportionment taxable income. Accordingly, the exception would not be available to an income recipient in an NOL position in a state in which it is subject to tax.

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With regard to the new unitary election exception to addback, the form imposes several conditions on the unitary filing exception that are not required by the legislation. The release states that the election is water’s edge (although the legislation does not specify). The release also explains that taxpayers may elect unitary for Connecticut purposes if they file unitary in another state but fails to address whether taxpayers that do not file unitary in any other state may avail themselves of the election. In addition, the form specifies that no prior year NOLs or credits may be utilized, and the entire unitary group is subject to the twenty percent corporate tax surcharge. Furthermore, the unitary group must be treated as a single taxpayer for purposes of computing and using tax credits. b.

Massachusetts: Related party expense disallowance legislation was enacted during 2003. Subsequently enacted legislation creates an additional treaty exception. H.B. 3727 (Nov. 26, 2003). The legislation provides that addback of interest or royalties is not required if the expenses are paid, directly or indirectly, to a related member that is a resident of a country which has a comprehensive income tax treaty with the United States (provided the company is not a controlled foreign corporation under IRC § 957), the amounts are deductible for federal tax purposes, the transaction giving rise to the expenses has a valid non-tax business purpose, and the terms of the transaction are arm’slength.

c.

New York: During 2003, legislation was enacted imposing related party expense disallowance for both New York state and city purposes. A.2106 (May 15, 2003). Subsequently enacted legislation amended the scope of the disallowance provision. S.B. 5725 (October 21, 2003). A.2106 provided for disallowance of related party royalty and interest expense deductions. However, S.B. 5725 eliminated the addback of interest expenses (other than interest related to intangible assets). S.B. 5725 also amended the expense disallowance provision related to royalties, expanding the definition of royalties to include payments related to the use of patents and amending the exceptions available from disallowance. Specifically, S.B. 5725

18

removes a provision contained in A.2106, which provided an exception from addback if the related party payments were made for a valid business purpose and pursuant to a contract that reflected arm’s length interest and terms. As amended, only two exceptions are provided from royalty addback: 1) if the taxpayer has a valid business purpose and the related member pays the royalty to a non-related member during the tax year pursuant to arm’s length terms; and 2) a new exception is added where the royalty payments are paid to a related member organized under the laws of a country with a comprehensive income tax treaty with the U.S. and the royalties are taxed in that country at a tax rate at least equal to the rate imposed in New York. d.

Ohio: Recently enacted legislation revises the discretionary authority of the Tax Commissioner to adjust “sham transactions.” Am. Sub. H.B. 95 (Jun. 26, 2003). The legislation created new Ohio Rev. Code § 5703.56, which shifts the burden of proof (preponderance of the evidence) from the Commissioner to the taxpayer in cases where the Commissioner disregards sham transactions between members of a controlled group. The burden of proof remains with the Commissioner with regard to sham transactions involving unrelated taxpayers. A controlled group is defined as direct/indirect control of over fifty percent, based on ownership of common stock or other equity with voting rights. The legislation repeals Ohio Rev. Code § 5733.111 which granted the Commissioner discretionary authority to use the equitable doctrines but did not differentiate between related party and third party transactions and imposed the burden on the Commissioner. The legislation also doubles the statute of limitations in situations in which the Commissioner has disregarded a sham transaction. The legislation became effective immediately.

e.

Oregon: A recently promulgated regulation imposes a related party expense disallowance requirement for Oregon tax purposes. Ore. Admin. Code § 150-314.295 (effective Dec. 31, 2003). While Oregon is a unitary combined reporting state, the regulation targets royalty payments to related parties excluded from the combined report. An example contained in the regulation

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specifically references trademarks licensed to an Oregon taxpayer from a Bermuda subsidiary. The requirement is triggered where both the owner and user of the intangible asset are owned by the same interests, as defined in Treas. Reg. §1.469-4T, and separation of the ownership and use of the intangible asset has no effect on the operations of the user other than the payment of the royalty. 2.

Related Party Decisions and Administrative Developments a.

Indiana: The Department of State Revenue has ruled that out-of-state trademark licensing companies could be required to file a unitary combined report with affiliated Indiana taxpayer corporations. Letter of Findings 00-0379 (Ind. Dept. of State Rev. Feb. 1, 2004). The Department upheld the auditor’s used of forced combination but also noted that it would have been equally appropriate to invoke the sham transaction doctrine to disregard the in-state taxpayer’s deductions for payments made to the intangible company. The ruling noted that the transaction was solely motivated by tax considerations, and the transfer of intangibles and royalty payments were illusory because, respectively, the trademarks had no value apart from the taxpayer’s goodwill and the taxpayer was thus making substantial payments for something with no value. The ruling acknowledged the taxpayer’s right to structure its business affairs as it sees fit; however, it also noted the Department’s right to invoke substance over form. Previously, in Letter of Findings 01-0132 (Oct. 1, 2003), the Department imposed forced combination, notwithstanding the fact that the taxpayers obtained valuation and transfer pricing studies. In contrast, the Department has employed other approaches in previous rulings. See Letter of Findings 95-0401 (Jun. 2002) (economic nexus), Letter of Findings 01-0063S (Feb. 21, 2003) (expense disallowance).

b.

Maryland: The state’s highest court has held that taxpayers’ trademark licensing subsidiaries were subject to Maryland tax. Comptroller of the Treasury v. SYL, Inc., Comptroller v. Crown Cork & Seal Company (Delaware), Inc. Nos. 76 & 80, (June 9, 2003). The decision overturned rulings by the Maryland Circuit

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Court, which had found that jurisdiction could not be exerted over an entity based on a unitary nexus theory if the entity lacked a physical presence in Maryland unless such entity was found to be a “phantom.” The lower court had found the subsidiaries to be separate business entities and not phantoms. On appeal, the court ruled that the records demonstrated a lack of economic substance. The court specifically found that the subsidiaries were phantoms, and subjected them to tax based on their parents’ apportionment factors. The court failed to address physical presence issues, instead simply collapsing the structure. Although the Court discussed Geoffrey, and the New Mexico Kmart Properties decision, it did not base its decision on these cases or apply economic nexus. Thus the decision could arguably be limited to “naked” intangible holding company-type structures. The SYL decision involved the same taxpayer and transactions as the Massachusetts Syms decision. The U.S. Supreme Court has denied the taxpayers’ writs of certiorari in both decisions. c.

Massachusetts: The Massachusetts Supreme Judicial Court affirmed an Appellate Tax Board decision that permitted imposition of the step transaction doctrine to negate a transfer of intangibles prior to the sale of a subsidiary. General Mills, Inc. v. Commissioner of Revenue, SJC-08935 (Sept. 15, 2003). The court held that the pre-sale transaction lacked economic effect. The subsidiary had transferred its trademarks to a newly created Delaware holding company immediately prior to the sale of the subsidiary to a third party. Subsequently, the subsidiary and the DHC were sold to a third party. The court held that the taxpayer could not reduce its gain on the sale of the subsidiary by transferring its valuable intangibles to a no-tax jurisdiction. The court upheld the ATB’s reallocation of the gain to the subsidiary, which was domiciled in Massachusetts.

d.

Massachusetts: The Massachusetts Appellate Tax Board has held that a taxpayer could deduct royalty payments made to an affiliated entity for the use of trademarks and similar intellectual property. Cambridge Brands, Inc. v. Commissioner of Revenue, No. C259013 (Jul. 16, 2003). The ruling involved an

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asset purchase (from an unrelated party) of candy trademarks and a factory. The purchaser initially held the trademarks and later placed them in a subsidiary that held all its intellectual property, while it placed the factory in a newly formed manufacturing subsidiary (i.e., the taxpayer). The manufacturer thereafter licensed the trademarks from the parent company/subsidiary. In allowing the royalty deductions, the Board determined that the licensing arrangement had both a valid business purpose and economic substance. The Board was influenced by the fact that the deductions did not result from a typical intangible holding company scenario. The Board found that the separation in ownership between the trademarks and the factory helped to establish economic effect. The Board also cited a number of other factors: the lack of a circular flow of cash; the fact that both the taxpayer and the licensor conducted active businesses; and the assumption of all trademark related expenses by the licensor, rather than the licensee. e.

New York City: The New York City Tax Appeals Tribunal has affirmed a 1999 administrative law judge ruling which held that, for New York City general corporation tax (GCT) purposes, the Geoffrey trademark licensing company and two other affiliates were not required to be combined with the Toys R Us entities subject to the City tax. Matter of Toys “R” Us – NYTEX, Inc., TAT (E) 93-1039 (GC) (N.Y.C. Tax App. Trib. Jan. 14, 2004). The Tribunal found the taxpayer had sufficiently established that the royalties were priced at arm’s-length, and the City did not adequately rebut this showing. Although the Tribunal agreed that the taxpayer had satisfied the three presumptive criteria for combination, the Tribunal also agreed with the ALJ’s determination that the taxpayer successfully rebutted the presumption by establishing that the royalty rates were arm’s-length. The Tribunal rejected the City’s attempt to inject a business purpose/economic substance requirement into the arm’s-length analysis. The ruling is favorable and is the first City precedential ruling on this issue (the City cannot appeal). However, the impact is limited by the recent enactment of related party royalty expense

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disallowance legislation, effective for tax years beginning on or after January 1, 2003. f.

New York: New York Tax Appeals Tribunal has reversed an administrative law judge decision and, in the first state level precedential decision of its kind in New York, forcibly combined a taxpayer withy related intangible holding companies. In the Matter of SherwinWilliams, DTA No. 816712 (June 5, 2003). This decision involved the same taxpayer and transaction as the Massachusetts Supreme Judicial Court decision of the same name. The ALJ had held that the taxpayer and its subsidiaries implemented licensing transactions for valid business purposes and conducted such agreements under arm’s-length terms. Relying on the two-prong test set out in Frank Lyon Co. v. United States, 435 U.S. 561 (1978), the Tribunal held that the transactions lacked economic substance and the subsidiaries were not formed for valid business purposes. While the Tribunal mentioned the Massachusetts decision involving the same taxpayer and transactions, it did not attempt to distinguish its conflicting conclusion regarding business purpose. Rather, in examining the business purposes set forth by the taxpayer, the Tribunal found the ALJ erred in accepting them at face value, finding that the business plan lacked plausibility and the business purposes lacked independent merit (other than tax avoidance). Similarly, the Tribunal felt the ALJ’s reliance on expert testimony regarding the arm’s-length nature of the transactions was in error.

g.

Virginia: An administrative ruling found that royalties paid to a trademark licensing subsidiary lacked economic substance and business purpose and did not reflect arm’s-length rates. Ruling of Commissioner, P.D. 03-73 (Oct. 15, 2003). The taxpayer was a major retailer. The Commissioner rejected the three methodologies offered by the taxpayer to support arm’s length pricing. Addressing the residual profit method, the Commissioner concluded that the taxpayer’s higher than industry average margin was due to various economies of scale attributable to being one of the leading retailers in the country, rather than to the trademarks. The Commissioner noted that the royalty rate used in a similar licensing agreement between the

23

taxpayer and an unrelated foreign corporation was onefifth the rate the taxpayer was paying to the trademark licensing subsidiary. The Commissioner also determined that, even if the royalties reflected arm’slength rates, the deduction would not be sustainable. The taxpayer used the intangibles as collateral for outside financing, even after they were transferred to the licensing subsidiary, and there were no standards in place for quality control of the intangibles. h.

B.

Virginia: The Department of Taxation has ruled that an accounts receivable factoring company was properly consolidated with related corporations for Virginia corporate tax purposes. Rulings of Commissioner, P.D. 03-56, 03-57 (Aug. 8, 2003). The Department found that the factoring transactions were not conducted in accordance with arm’s-length terms and the factoring company lacked economic substance. The Department noted that the collection activities with respect to outstanding receivables were performed by the taxpayer even after transfer of the receivables to the factoring company, and concluded that the $1,000 fee paid by the factoring company to the taxpayer for collection and administration services was inadequate to cover the costs of collection. The Department also cited the lack of arm’s length dealing in intercompany loans between the taxpayer and the factoring company, such as the lack of actual payments, the absence of nonpayment penalties, and the fact that the loans were not collateralized.

Tax Base and Credits 1.

Tax Base a.

California: Legislation has been enacted that amends Cal. Rev. & Tax. Code § 23051.5(e)(3) to provide that federal elections made prior to becoming a California taxpayer will be binding for California tax purposes and that taxpayers cannot make a separate California election unless the separate election is expressly authorized under California law. S.B. 1065 (Sept. 22, 2003). Conversely, a taxpayer cannot make an election for California purposes if it did not make the election for federal purposes prior to becoming a California

24

taxpayer, unless the separate election is expressly authorized under California law. The legislation does not, however, eliminate the right of existing California taxpayers to file separate elections with the Franchise Tax Board (FTB) under Cal. Rev. & Tax. Code § 23051.5(e)(3)(A). Thus, the legislation appears to preserve the right of taxpayers to opt in or out of federal elections, such as IRC § 338(h)(10) and 338(g), without regard to their federal tax treatment of the underlying transactions. The legislation states that it codifies existing FTB practice. 2.

Deductions a.

California: The State Board of Equalization has disallowed a portion of a taxpayer’s interest expense deduction as attributable to nontaxable income under Cal. Rev. & Tax Code § 24425. American General Realty Investment Corp., No. 156726 (Jun. 25, 2003). The income was the dividend from the taxpayer’s insurance subsidiary (which was properly excluded from the combined group). The SBE upheld the disallowance of a portion of the unitary group’s total interest expense based on the ratio that the nontaxable insurance subsidiary dividend bore to the taxpayer’s entire gross income. Following Appeal of Zenith National Insurance Corp., 98-SBE-001, the SBE applied federal Revenue Procedure 72-18, which clarifies expense disallowance for IRC § 265 purposes. The SBE noted that under Rev. Proc. 72-18, if a taxpayer assumes debt and owns assets that generate nontaxable income at the same time, there is an inference that the purpose of the debt is, in part, to generate nontaxable income because the taxpayer could sell its nontaxable income bearing asset to fund its business needs, rather than incurring debt for working capital purposes. The SBE ruled that the taxpayer failed to establish a non-tax business purpose sufficient to rebut this presumption, concluding that it preferred to incur debt rather than sell the insurance company stock.

b.

New York: An administrative law judge with the Division of Tax Appeals has held that an adjustment to a taxpayer’s net income also reduced its subsequent net operating loss (NOL) carryfoward deductions. Petition

25

of New York Funeral Chapels, Inc., No. 818854 (Jul. 3, 2003). Under audit, the taxpayer had agreed to an adjustment reducing its intercompany management fee and interest expenses. This adjustment took the taxpayer from an NOL position to a net income position for the audit years, and its subsequent NOL carryforward deductions were reduced accordingly. The ALJ noted that even though the taxpayer agreed to the adjustment, an $8 million adjustment indicated that the taxpayer’s income was distorted and warranted adjustment. The ALJ also rejected the taxpayer’s argument that IRC § 172 must be applied for New York tax purposes. N.Y. Tax Code § 208(9)(f) defines an NOL to be “presumably” the same as a taxpayer’s NOL under IRC § 172. The ALJ held that the auditor’s valid exercise of its discretionary authority to adjust the taxpayer’s expenses was sufficient to overcome the presumption of conformity to the federal NOL. 3.

Credits a.

Connecticut: A Connecticut Superior Court has ruled that the corporate partners of a partnership operating in Connecticut were entitled to utilize an income tax credit that would have inured to the partnership if it had been a taxable entity. Bell Atlantic NYNEX Mobile, Inc. v. Commissioner of Revenue Services, No. CV 010511279S (Jul. 17, 2003). The credit was a corporation business tax credit for personal property taxes paid on certain types of electronic data processing equipment (computers, printers, and similar property). The court concluded that since business tax credits may be separately stated items for federal tax purposes, the Connecticut credit should maintain its identity and be passed through to the corporate partners as a credit for Connecticut corporation business tax purposes.

b.

New York: A recently issued ruling implies that outof-state manufacturing activities may be taken into account in determining eligibility for a credit available to manufacturers. TSB-A-03(6)C, (Jun. 11, 2003). Under New York law, an industrial or manufacturing business (IMB) may take a corporate income tax credit for certain New York utility taxes paid by it, or passed through to it, for the use of gas, electricity, steam,

26

water, or refrigeration in the state. The taxpayer was headquartered in New York, but all its manufacturing activity was located in Connecticut. The ruling stated that the IMB determination is based on a corporation’s entire business within and without New York. c.

North Carolina: The Tax Review Board has ruled that machinery and equipment placed into service at a taxpayer’s North Carolina research and development facility was eligible for a William S. Lee franchise tax credit for manufacturing equipment. Admin. Decision No. 410, N.C. Tax Review Board (Jul. 22, 2003). The credit is applicable to machinery and equipment used in manufacturing, processing, warehousing and distribution, or data processing. The ruling does not explain why the credit was disallowed on audit, although it appears to have been based on the use of the property for R&D purposes, rather than the direct manufacturing of the taxpayer’s goods. The ruling concluded that the R&D activities conducted by the taxpayer in North Carolina were necessary, inseparable, and integral parts of the taxpayer’s primary business of manufacturing. The ruling did not state whether actual manufacturing was conducted in North Carolina or another state(s); nor did it specify that in-state manufacturing was required to claim a credit for R&D equipment.

d.

Oregon: Recently enacted legislation expands eligibility for the income tax credit for qualified research expenses and raises the maximum credit. H.B. 3183 (Aug. 29, 2003). Under existing law, a taxpayer was only eligible for the credit if it was engaged in the fields of advanced computing, advanced materials, biotechnology, electronic device technology, environmental technology or straw utilization. The statute was amended to delete all references to those particular industries. Thus, the legislation removes the restriction of the credit to high-tech businesses and allows taxpayers engaged in other industries, such as manufacturing, to claim the credit. In addition, the legislation increases the maximum credit to $750,000 from $500,000. The amendment is effective for tax years beginning on or after 2006.

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C.

Allocation and Apportionment 1.

Indiana: A recent administrative ruling provided that, because a limited partner is not permitted to exercise control over a partnership in which it holds an interest, that interest could not be considered operational for apportionment purposes. Letter of Findings 00-0379 (Ind. Dept. of State Rev. Feb. 1, 2004). Accordingly, pursuant to the rationale of the ruling, all gains and losses held by limited partners should be considered nonbusiness income. This ruling involved a loss incurred by a limited partner; therefore the ruling was not favorable for this particular taxpayer. However, if applied to non-Indiana-based taxpayers with limited partnership interests, the ruling could result in favorable allocation treatment of partnership income.

2.

Massachusetts: The Supreme Judicial Court has upheld an Appellate Tax Board ruling that the gain realized by a corporation on the sale of a subsidiary was not subject to tax. The court also upheld the ATB’s imposition of the step transaction doctrine to negate a transfer of intangibles prior to the sale of a second subsidiary. General Mills, Inc. v. Commissioner of Revenue, SJC-08935 (Sept. 15, 2003). In the first transaction, the court held that the taxpayer, a food products manufacturer, was not required to include the gain from the sale of an apparel subsidiary in its apportionable tax base because the subsidiary was not unitary with the taxpayer. The court noted that there was no day-to-day management of the subsidiary, despite some overlapping directors. The taxpayer did provide limited administrative support with respect to major capital funding decisions; however, this was insufficient to establish centralized management. The court also found that the subsidiary’s ability to borrow from the taxpayer on demand did not establish a flow of value where all intercompany transactions were conducted at arm’s-length.

3.

Massachusetts: The Massachusetts Court of Appeals has held that capital gains earned by an out-of-state chemical manufacturer from the sale of stock in several subsidiaries were not subject to the corporate excise tax. W.R. Grace & Co. v. Commissioner of Revenue, No.00-P-254 (Jul. 2, 2003). The court’s ruling partially upholds a decision of the Appellate Tax Board. W.R. Grace & Co. v. Commissioner of Revenue, Dkt. No. F239586 (Nov. 19, 1999). The court ruled, under an AlliedSignal analysis, that the subsidiaries and the taxpayer were not unitary. The subsidiaries and the taxpayer were engaged in

28

different lines of business, and the taxpayer did not exercise actual managerial control over the subsidiaries, although it did exercise supervisory oversight. The court held that the taxpayer’s oversight did not establish centralized management and did not exceed the supervision a corporation would exert over an investment in a subsidiary. Furthermore, shared services, including cash management, were provided under arm’s length terms. However, the court held that intercompany transactions undertaken at arm’s length do not result in a flow of value sufficient to establish unity. 4.

Missouri: The Administrative Hearing Commission has ruled that a taxpayer could exclude (i.e., allocate) intercompany interest income from its Ohio-based parent in the calculation of taxable income subject to apportionment. Medicine Shoppe International, Inc. v. Director of Revenue, No. 02-1071 RI (Dec. 23, 2003). The interest was attributable to an investment agreement between the taxpayer and its parent corporation, involving a daily sweep of the taxpayer’s cash accounts and investment by the parent of funds that exceeded the taxpayer’s business needs. The taxpayer had no control over the investment of the funds, although it was entitled to draw down on the investment account at any time (it never did). The taxpayer reported its Missouri tax using the single-factor method, in which the numerator of the factor is calculated as the sum of the taxpayer’s Missouri sales plus fifty percent of its sales partially within and partially without Missouri. Since the taxpayer did not materially participate in the investment of the funds and had no control over them, the Commission held that the income was attributable to a passive investment with no connection to Missouri. Despite the close relationship between the taxpayer and the parent, the Commission rejected the Director’s “attributional”/alter ego type argument that the taxpayer should be deemed to have actively participated in the investment of the funds. Citing to Acme Royalty Co. v. Director of Revenue, 96 S.W.3d 72 (Mo. banc 2002), the Commission stated that the companies were distinct business entities, and the investment agreement had a legitimate business purpose other than tax avoidance.

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D.

Apportionment Issues 1.

Sales Factor Composition a.

California: The Franchise Tax Board has issued a legal ruling stating that dividends should be excluded from a taxpayer’s sales factor unless it participates in the management or operations of the distributing company. Legal Ruling 2003-3 (Dec. 4, 2003). The ruling addresses apportionable dividends distributed by a non-member the taxpayer’s combined reporting group. The FTB cited California statutes and regulations (which are based on UDITPA/MTC regulations) which provide that: 1) the mere holding of an intangible is not an income producing activity; and, 2) income not readily attributable to a specific income producing activity is excluded from the numerator and denominator of the sales factor. Although many states have similar apportionment language, this “throwout” rule is not commonly enforced in other states, in this context. While some states exclude certain types of passive income from the sales factor, many would include business income dividends in the sales factor and source the income to the recipient’s commercial domicile. The ruling also specifies that exercising voting rights, receipt or review of material normally sent to stockholders, and accounting for the receipt of dividend income would not be sufficient to establish participation, whereas representation on the distributing company’s board of directors or involvement in its business decisions may suffice.

b.

Louisiana: The Department of Revenue has ruled that the federal gasoline excise tax should be included in the sales factor for income and franchise tax purposes. Rev. Ruling No. 03-005 (Aug. 22, 2003). Unlike UDITPA, where the sales factor is based on gross receipts, the Louisiana sales factors are based on “net sales.” Nevertheless, the Department ruled that the incidence of the federal gasoline excise tax is on the seller, rather than the purchaser and held that, if sellers pass the tax on to consumers in separately stated charges, the tax should be included in the sales factor for both income and franchise tax purposes.

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2.

c.

Ohio: Recently enacted legislation excludes certain types of income from the sales factor and changes the sourcing rules for Ohio franchise and corporate income tax purposes. 2003 H.B. 127 (Dec. 11, 2003). H.B. 127 requires that receipts from and/or gains and losses attributable to: (1) dividends and distributions; (2) interest; (3) and other “excluded assets” must be excluded from both the numerator and the denominator of the sales factor. Excluded assets are defined as capital assets or IRC §1231 assets (both of which were already excluded from the sales factor for Ohio apportionment purposes) as well as intangible property other than trademarks, patents (and similar assets). Thus intellectual property related receipts remain in the Ohio sales factor. The legislation states that it is effective immediately. According to Ohio case law, the changes contained therein should not impact taxpayers with taxable years ending prior to the date of enactment. However, taxpayers with taxable years ending on or after the date the legislation was signed, December 11, 2003, should apply the changes retroactively for the entire taxable year.

d.

Wisconsin: Recently enacted legislation will phase in a single sales factor apportionment formula over the next five years. S.B. 197 (Jul. 31, 2003). Under current law, Wisconsin employs a three-factor formula with a double weighted sales factor. Under S.B. 197, the apportionment formula will continue to be based on a double weighted sales factor until tax years beginning in 2006, at which point the sales factor will be weighted at 60 percent. The sales factor will increase to 80 percent in 2007 and will be fully phased in for tax years beginning on or after January 1, 2008.

Sales Factor Sourcing Issues a.

New York: A recent administrative ruling rejected a taxpayer’s attempt to source royalty income based on the location where the licensees manufactured the property that used the taxpayer’s intellectual property, rather than the business address of the licensee. Matter of Disney Enterprises, Inc., DTA No. 818378 (Feb. 12, 2004). Since much of that property was manufactured outside the U.S., the position sought by the taxpayer

31

would have resulted in significant factor dilution. The ALJ concluded that, since royalties were calculated based on the licensees’ sales of products that used the taxpayer’s intellectual property, the location of the manufacturing activity was irrelevant to the taxpayer’s income stream. The ALJ noted that, while the most accurate method of sourcing would be based on the location of the sales underlying the royalties, in the absence of this information, the licensees’ business addresses were a sufficient substitute. b.

Ohio: Recently enacted legislation excludes certain types of passive income from the sales factor and shifts the state from a cost of performance approach to a market state rule with regard to apportionment of certain receipts. 2003 H.B. 127 (Dec. 11, 2003). Prior to enactment of the legislation, sales other than sales of tangible personal property were sourced based on the location of the income producing activity, as measured by the seller’s costs of performance. H.B. 127 repeals the income producing activity/cost of performance rule and replaces it with specific rules regarding the sourcing of intangibles and services. Under the legislation, receipts from intellectual property (trademarks, tradenames, etc.) are sourced to Ohio to the extent that the receipts are based on use of property or the right to use the property in the state, and receipts attributable to services will now be sourced to Ohio on a pro rata basis, to the extent the services are used by the purchaser in Ohio or the benefit of the services are received by the purchaser in Ohio. The legislation explicitly states that the physical location where the purchaser uses or receives services shall be paramount in determining the proportion of the benefit attributable to Ohio. The legislation states that it is effective immediately. According to Ohio case law, the changes contained therein should not impact taxpayers with taxable years ending prior to the date of enactment. However, taxpayers with taxable years ending on or after the date the legislation was signed, December 11, 2003, should apply the changes retroactively for the entire taxable year.

c.

Virginia: The Department of Taxation has ruled that a company commercially domiciled and headquartered in

32

Virginia was not required to include income from the sale of manufacturing contracts sold in conjunction with the sale of the taxpayer’s manufacturing division in the numerator of its Virginia sales factor. Ruling of Commissioner P.D. 03-78 (Nov. 3, 2003). Under Virginia’s long-standing interpretation of the cost of performance rule, income from intangibles and services are sourced to the state when the costs of performance in Virginia exceed the costs of performance outside Virginia. The Department concluded that although approval of the sale of the division occurred at the taxpayer’s Virginia headquarters, the negotiation and closing of the sale occurred in the purchaser’s state, and the due diligence and accounting functions performed in connection with the sale occurred in the state where the facility was located. However, the ruling did conclude that interest earned by the taxpayer’s divisions located outside the state and patent royalties earned by the manufacturing division were attributable to the taxpayer’s Virginia domicile. 3.

“Gross Versus Net” a.

California: The Sacramento County Superior Court has ruled that a taxpayer could not include the return of principal from investments in short-term securities in the denominator of its California sales factor. Toy "R" Us, Inc. v. Franchise Tax Board, No. 01AS04316 (Aug. 21, 2003). The court held that the receipts were not derived from the “sale” of anything. The court characterized the taxpayer’s short-term investment activity as an ancillary service of loaning out temporarily unneeded cash in return for interest. The court also explained that the sales factor is designed to reflect the market for a taxpayer’s goods or services. As such, the court ruled that, because the return of principal was not related to the taxpayer’s primary function of selling toys, it should be excluded from the sales factor. The also court noted that the inclusion of the gross receipts in this instance would lead to unreasonable and absurd results. The court did acknowledge that other state courts have held differently. However, it noted that those states’ legislatures subsequently amended their sales factor definitions to arrive at the same conclusion to be rendered by the court in this case. Unlike many of the 33

previous California controversies involving this issue, the instant case involved a taxpayer seeking a refund rather than responding to an audit adjustment. b.

4.

California: A California Superior Court has ruled that a taxpayer may include gross receipts (rather than net income) from the sale of marketable securities by its Washington-based treasury department in the denominator of its California sales factor. Microsoft Corp. v. Franchise Tax Board, No. 400444 (Super. Ct. of City and Cty of San Francisco, Sept. 9, 2003). The court cited the plain language of Cal. Rev. & Tax Code §§ 25134 and 25120, which indicate that “sales” for purposes of the sales factor include gross receipts. The court also noted that the FTB is currently seeking to implement changes to the current law that would require treasury function receipts to be included in the sales factor on a net basis (i.e., modeled after the MTC regulation). Based on the fact that the FTB was seeking this change, the court concluded that existing law must require the inclusion of Microsoft’s gross receipts from treasury function investments. The court also held that the FTB presented no evidence to support an alternative apportionment formula under Cal. Rev. & Tax Code § 25137.

Property Factor a.

New York: A recent administrative ruling addressed the property factor treatment of film masters owned by a taxpayer. Matter of Disney Enterprises, Inc., DTA No. 818378 (Feb. 12, 2004). The taxpayer disputed the valuation of its film masters at cost for property factor purposes. The film masters, the original versions of the taxpayer’s classic films, were worth billions of dollars. However, the ruling concluded that the film masters could not be included in the property factor at market value, because the difference between the cost and market values of the films was attributable to the right to reproduce the films, which was a “copyright” - - - an intangible asset which could not be included in the property factor. The same ruling also provided that the taxpayer was not entitled to property factor representation for intangible property licensed to third

34

parties, which generated substantial revenue for the taxpayer. 5.

Payroll Factor a.

6.

Pennsylvania: The Commonwealth Court has held that a taxpayer could not include a payroll factor in its apportionment formula for corporate net income or franchise tax purposes where all business of the taxpayer was conducted by employees of affiliated companies and independent contractors. UPS Worldwide Forwarding, Inc. v. Commonwealth of Pennsylvania, Nos. 62-65 F.R. 2001 (Pa. Commw. Ct. Mar. 1, 2004). The taxpayer recorded payroll expenses related to employees furnished by an affiliated corporation; however, it had no written employment agreement with the corporation. Furthermore, the taxpayer had stipulated that it had “no employees.” The court noted that “compensation” is defined for payroll factor purposes as amounts paid to “employees.” Since the taxpayer stipulated that it had no employees, it had no compensation and thus had a zero payroll factor denominator (i.e., no payroll factor). The court distinguished a Pennsylvania Supreme Court decision with a similar fact pattern, in which furnished personnel were found to be employees, there was a written employment agreement between the affiliates, and the taxpayer controlled the employees.

Other a.

New York: A transaction treated by a taxpayer as a financing arrangement was recast as an actual sale requiring sales and property factor representation. Petition of CS Integrated, LLC, LLC, DTA No. 17548 (Tax App. Trib. Nov. 20, 2003). The taxpayer operated a warehouse in which food retailers stored their inventory. In order to assist a customer that experienced financial difficulty, the taxpayer purchased the customer’s inventory and resold it to the customer at cost plus a carrying charge, rather than merely lending money to the customer. An ALJ had ruled that the transactions constituted a financing agreement, rather than an actual purchase and sale of inventory. Since the ALJ had found that the taxpayer did not actually

35

purchase the customer’s inventory, it was not required to include it in its property factor. On appeal, the Tribunal concluded that the transaction was an actual sale, and thus must be reflected in both the sales and property factors. The Tribunal noted that several indicia of a sale were present: the taxpayer took legal title and possession of the inventory and bore risk of loss while it owned the inventory. The Tribunal also ruled that the sales factor must include the gross proceeds from the sale of the inventory rather than the net income (i.e., the carrying charge). There is some conflicting guidance on this issue in New York.

E.

Filing Methods 1.

Inclusion in the Unitary Business Group a.

California: Recent legislation changes the water’sedge election, effective for taxable years beginning on or after January 1, 2003, from a contractual election to a statutory election. S.B. 1061 (Sept. 30, 2003). Under new Cal. Rev. & Tax. Code § 25113, the water’s-edge election will now be made by filing a timely return in which tax is computed by including the income and apportionment factors of the members of the water’sedge unitary combined reporting group and by using an election form to be prescribed by the FTB. While the election must still be made by all members of the group, the failure of one or more members to make the election will not forfeit the election for the entire group, as long as the parent corporation includes the non-electing members’ incomes and factors in its combined report. The period of the water’s-edge election remains eighty-four months. Taxpayers with existing contractual elections will be “switched” to the § 25113 election procedures, although the start date of their elections will be maintained for purposes of computing the eighty-four month period. An election under the new provisions may be terminated without approval of the FTB at the end of eighty-four months usage. Early termination may be obtained with the consent of the FTB. Taxpayers that terminate their elections (with or without the consent of the FTB) cannot re-elect water’s-edge reporting for another

36

eighty-four months, although this restriction may be waived by the FTB for good cause. b.

California: The State Board of Equalization has ruled that three U.S. members of a multinational conglomerate were not unitary with their foreign grandparent corporations, and granted the taxpayer’s refund request. Appeal of Conopco, No. 129732 (Aug. 6, 2003). The ruling provided no analysis on the part of the SBE, but did set forth the positions of both the taxpayer and the FTB. The taxpayer’s arguments against unity focused on the autonomous nature of the U.S. subsidiaries, claiming that oversight by the foreign parents was limited to stewardship activities, such as appointing top managers and approving budgets. The taxpayer also noted the absence of centralized administrative functions (other than limited common research activities), arm’s-length intercompany transactions, minimal intercompany transfers of personnel, and the production of defined brands and products by the U.S. subsidiaries. The FTB claimed that there was central policy-making coordination, an extensive research and development network, shared knowledge and expertise, and an integrated management network aided by an organization-wide management training college. Apparently, the taxpayer’s position was ultimately more persuasive.

c.

Illinois: The United States Court of Appeal for the Seventh Circuit has held that a taxpayer must exclude an affiliate that was engaged in a different line of business from its unitary group. In re: Envirodyne Industries, Inc., No. 02-1632 (Jan. 6, 2004). The matter came to the court on appeal from a bankruptcy court ruling. That ruling involved a claim filed by the Illinois Department of Revenue for additional taxes assessed after excluding the affiliated loss company from the taxpayer’s Illinois unitary combined reporting group. The in-state taxpayer and the loss company were engaged in two different lines of manufacturing, food packaging materials and steel, but both were owned by the same parent corporation. The court depicted the two entities as spokes of the same wheel without a rim (i.e., the parent corporation). The court noted that the parent was functionally integrated with each of the two

37

lines of business but that the two companies were not integrated with each other. The court also stated that the companies were not dependent on and did not contribute to each other, even though the dependency and contribution test was satisfied by each company with respect to the parent. While the decision could have favorable implications for some taxpayers, there is existing, binding Illinois case law that may be seen as inconsistent with this holding. 2.

Issues Involving 80/20 Companies a.

3

Illinois: An Illinois appellate court has held that two foreign intangible holding companies must be included in a taxpayer’s Illinois combined report. Zebra Technologies Corp. v. Topinka, No. 1-01-2861, 1-020386 (Ill. Ct. App. 1st Div. Aug. 11, 2003). The ruling upheld a lower court decision that the taxpayer’s two Bermuda subsidiaries, established to hold and license the taxpayer’s trademarks and other intellectual property, failed to qualify for the statutory “80/20” exclusion from the Illinois combined reporting group. All the subsidiaries’ property and their sole employee were located in Bermuda. However, the court held that less than 80 percent of the subsidiaries’ payroll was located outside the U.S., because the taxpayer had retained responsibility for the quality control of the subsidiaries’ intellectual property and performed quality control activities in Illinois, at no cost. The court upheld the lower court’s imputation of the taxpayer’s activities to the subsidiary to cause the subsidiaries to fail the 80/20 test. Interestingly, the court agreed with the lower court that the subsidiaries were formed for a genuine economic purpose. Nevertheless, since the 80/20 exception was not otherwise satisfied, the economic substance of the subsidiaries was not determinative of the issue.

Special Industries a.

New York: The Department of Taxation and Finance has ruled that a bank subsidiary’s 1985 election to be taxed under the corporation franchise tax article would terminate if it reincorporated in another state in a transaction that qualified for tax-free treatment under

38

IRC § 368(a)(1)(F). TSB-A-03(12)C (Nov. 6, 2003). For New York tax purposes, corporations subject to the bank tax under Article 32 were permitted to make a one-time election for their 1984 taxable years if they wished to continue paying tax under Article 9-A, the general corporation franchise tax. The Department ruled that reincorporation in another state would terminate the taxpayer’s one-time election because the transaction would cause the dissolution of the electing taxpayer and the formation of a new corporation to which the election would not carry over. The Department relied on IRC §368 and accompanying regulations, which characterize “F reorganizations” as involving two distinct corporations.

F.

Franchise and Net Worth Taxes 1

Louisiana: A Louisiana appellate court has held that payments made by a taxpayer under numerous long-term lease agreements did not constitute “borrowed capital” includable in the franchise tax base. System Fuels, Inc. v. Dept. of Revenue, No. CA 1723 (La. Ct. App. 1st Cir. Jun. 27, 2003). Borrowed capital includes all long-term (greater than one year) indebtedness of a corporation. The leases at issue involved long-term rentals of fuel oil storage facilities and oil transport vessels. The court held that the leases were true leases, rather than financing leases, despite the inclusion of purchase options in the contracts. The court noted that the purchase options were based on fair market value rather than a bargain or nominal price. The court declined to hold that all transactions lacking a transfer of title of property should be excluded from borrowed capital (in line with the lower court decision), but did state that true leases that are not disguised credit sales would not be considered borrowed capital. The court also rejected the Department’s attempt to pull the leases into the franchise tax base as “indebtedness,” based on the inclusion of unconditional payment clauses in the rental contracts (hell or high water clauses), explaining that the clauses were not truly unconditional, because the lessor must still perform certain obligations under the lease agreements.

2

Louisiana: An appellate court has held that lease obligations, involving sale/leaseback arrangements, were not includable in the franchise tax base. Entergy Louisiana, Inc. v. Dept. of Revenue, 2003 CA 0166 (La. Ct. App. 1st Cir. Jul. 2, 2003). 39

The taxpayer sold a nuclear generating facility and leased it back from the purchaser. The court held that the sale/leaseback constituted a genuine lease, rather than a disguised credit sale. The court noted that ownership was legally transferred and, even though the taxpayer had a purchase option, it required the taxpayer to pay the fair market value of the property. The court’s rationale, while favorable to the taxpayer, contrasts with the widely accepted treatment of sale/leaseback transactions in other tax contexts. Whereas the court has held that the sale/leaseback was not a disguised credit sale, most states that have ruled on this issue have held that sales and use tax is not due on sale/leaseback transactions, precisely because they are financing vehicles rather than true leases. 3.

Missouri: The Missouri Supreme Court has held that three investment holding companies could not apportion their Missouri franchise tax bases because they employed no assets outside the state. TSI Holding Co. v. Director of Revenue, Nos. SC85179-81 (Nov. 4, 2003). The entities had no presence and conducted no business activities outside Missouri. For Missouri franchise tax purposes, apportionment is based on the percentage of a taxpayer’s accounts receivable, inventory, and fixed assets employed in the state. The taxpayers, investment companies, did not have any of the assets that are used to determine franchise tax apportionment. Accordingly, the taxpayers attempted to use an alternative apportionment formula that apportioned their franchise tax bases according to the location of their investments. Rejecting, the taxpayers’ apportionment methodology, the court explained that the right to apportion is based on where a taxpayer’s assets are employed, rather than where located. The court distinguished Union Electric Co. v. Morris, 222 S.W.2d 767 (Mo. 1949), in which a company's right to apportion was premised on ownership of two Illinois subsidiaries. In Union Electric, the court focused on the fact that the Illinois subsidiaries were wholly owned and thus controlled by the taxpayer, leading to a conclusion that the taxpayer conducted business (via the subsidiaries) outside the state. The court’s decision, the first in approximately forty years to address the issue of employment of capital, upholds a Missouri Administrative Hearing Commission ruling issued several months earlier. TSI Holding Co. v. Director of Revenue, No. 01-1828 RV (Mar. 4, 2003).

40

IV. LLCs and Other Pass-Through Entities A.

Conformity to the federal “check-the-box” regulations:

State Alabama Arizona Arkansas California Connecticut Delaware District of Columbia Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kentucky Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska New Hampshire New Jersey New York North Carolina North Dakota Ohio Oregon Pennsylvania South Carolina Tennessee Utah Vermont Virginia Wisconsin

Conformity X X X1 X X X X2 X X X3 X X X X X X X X X X4 X X X X

Non-Conformity

Partial Conformity

X5

X X X X X X X X

X6

X X X X

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1

Arkansas Code Ann. section 4-32-1313 was amended to provide that, for Arkansas income tax purposes, an LLC will be taxed consistently with its federal tax classification. H.B. 1959, signed March 31, 2003, effective for tax years beginning on or after January 1, 2003.

2

An SMLLC is not subject to the unincorporated business franchise tax as long as it is owned by an entity subject to D.C. tax.

3

Hawaii conforms to the federal “check-the-box” regulations, but does not adopt the disregarded entity treatment of SMLLCs for the general excise tax. Hawaii Dep’t of Tax., Tax Information Release No. 97-4 (Aug. 4, 1997). In addition, license and registration requirements will still be applied at the entity level.

4

An election by a foreign (non-U.S.) single member eligible entity to be disregarded will not be respected for Minnesota purposes because Minnesota law precludes the inclusion of the apportionment factors and income of foreign entities in the Minnesota unitary combined group. Minn. Dep’t of Revenue, Revenue Notice No. 98-08 (May 28, 1998).

5

An LLC’s federal classification under “check-the-box” will generally be respected; however, single member LLCs are not disregarded for New Hampshire tax purposes. N.H. Admin. Code R. 307.01. All LLCs remain subject to the New Hampshire Business Profits Tax.

6

Legislation enacted during 1999 (H.B. 1676/S.B. 1806) broadened the Tennessee excise and franchise tax to cover limited liability entities, including all LLCs, LLPs, and LPs engaged in business in the state. B.

Alabama: The Chief Administrative Law Judge for the Alabama Department of Revenue has ruled that Alabama tax could not be imposed on a nonresident individual that owned an interest in a limited partnership conducting business in the state. Lanzi v. State of Alabama Department of Revenue, No. 02-721 (Sept. 26, 2003). The ruling involved tax years prior to 2001, the year in which Alabama began imposing a nonresident withholding obligation on limited liability entities (LLEs) doing business in the state. The ALJ’s decision was based on Due Process considerations. Citing Alabama’s adoption of the entity theory of partnerships, the ALJ held that the LP’s activities and presence in the state could not be attributed to an out-of-state investor. The ALJ distinguished the imposition of tax in this setting from an International Harvester situation in which a withholding tax is imposed on the in-state entity (which is consistent with Alabama’s current LLE taxing scheme). The decision was not based on Commerce Clause nexus. However, the ALJ did note that, while previous Alabama administrative decisions (Cerro Copper and Dial

42

Bank) applied Quill’s physical presence test in the context of income taxes, the ALJ noted his personal belief that he may have changed his position on the issue of whether Quill applies outside of the sales and use tax context. C.

New York: An administrative law judge with the Division of Tax Appeals has ruled that an S corporation shareholder was not required to divide his capital gain from the sale by the S corporation of its assets on a prorated basis between his periods of residency and nonresidency for New York personal income tax purposes. Petition of Falberg, DTA 818960 (Oct. 9, 2003). The taxpayer changed his residency from New York to Florida on July 20, 1997. The sale of the S corporation’s assets occurred on July 31, 1997. Under New York law, residents are subject to tax on their income in its entirety, while nonresidents are only subject to tax on income from New York sources. A nonresident S corporation shareholder sources the distributive share income based on the S corporation's New York sourcing, as reported to the shareholder. The audit division prorated the gain between the taxpayer’s periods of residency and nonresidency, even though the gain was generated during the period of nonresidency. Accordingly, the prorated portion of the gain attributable to the period of residency (January 1, 1997, through July 20, 1997) was taxed in full, rather than subject to tax based on the taxpayer’s application of the S corporation’s 10.4 percent business allocation percentage. The ALJ ruled that the taxpayer has the option of prorating the income or reporting it in accordance with its residency/nonresidency status on the actual date of receipt. Since the taxpayer’s income was earned after leaving the state, the ALJ ruled that the taxpayer could -- as had been reported -- assign the entire gain to the period of nonresidency. It appears that the ALJ departed from the "always-prorate" rule enunciated by the TSB-M-00(1). However, the decision is not precedential.

D.

New York: The state’s highest court, reversing an appellate decision, has held that payments made to retired partners could not be deducted for New York City unincorporated business tax purposes. Buchbinder Tunick & Co. v. Tax Appeals Tribunal, No. 84 (Jun. 26, 2003). The payments, which were made to extinguish the partners’ ownership interests in the partnership, were calculated based on unrealized receivables. Pursuant to New York City regulations, a partnership cannot deduct payments to partners for services rendered. The court ruled that the retirement payments were attributable to services rendered, rejecting the lower court’s finding that the payments represented a share of partnership revenue.

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V.

Sales and Transaction Taxes A.

Software, Telecommunications, and Digital Goods and Services 1.

Massachusetts: A recent amendment to the computer industry services and products regulation impacts resale exception claims by computer service contract providers. 830 CMR 64H.1.3 (amended Dec. 19, 2003). The amended regulation provides that a computer service contract provider that pays tax on the purchase of tangible personal property but eventually resells the property and collects tax from its customer must present the vendor with a resale certificate and request refund directly from the vendor (the vendor must then go to the state for abatement of the tax remitted). Previously, a service contract provider could claim a credit on a subsequent sales and use tax return in order to recover the extra tax. This new policy applies retroactively to sales or use taxes paid on or after January 1, 2001.

2.

Minnesota: The Minnesota Tax Court has ruled that threedimensional images provided to customers via CD-ROM, diskette, and videotape, were tangible personal property subject to tax. Dynamic Digital Design, Inc. v. Commissioner of Revenue, No. 7380-R (Jan. 14, 2004). The taxpayer developed and designed interactive computer programs, animations, and images that communicated technical information about its customers’ products, designs or concepts. The court noted that the boundaries of tangible personal property are still being defined in Minnesota, with at least two cases involving this issue currently pending before the Minnesota Supreme Court. The court analyzed the taxability of the images by reference to two existing Minnesota Supreme Court decisions, Fingerhut Products Co. v. Commissioner of Revenue, 258 N.W.2d 606 (Minn. 1977) and Zip Sort, Inc. v. Commissioner of Revenue, 567 N.W.2d 34 (Minn. 1997), that distinguished customer lists (intangibles) from labels, preprinted addresses and other items (tangible), all transferred by tangible means. The court concluded that the CD-ROMs, diskettes, and videotapes on which the images were transmitted were usable devices, and customers were paying for the form, in addition to purchasing the images. The court did acknowledge that if the images had been transferred electronically, they would not have been subject to tax. Nevertheless, it rejected the taxpayer’s

44

argument that, because the images were capable of electronic transmission, they were nontaxable intangible property. 3.

Missouri: The Department of Revenue has issued a notice providing that load and leave transactions will be subject to sales and use tax. Tax Policy Notice 16: Taxability of Computer Software Load and Leave Transactions (Mo. Dept. of Rev. Jan. 9, 2004). The notice explains that the change was necessitated by the Missouri Supreme Court’s decision in Kansas City Power and Light Co. v. Director of Revenue, 83 S.W.3d 548 (Mo. banc 2002), in which the court held that transfer of title was not essential to qualify for a resale exemption, if the right to use, store, or consume property was transferred. The decision did not involve computer software, but rather a utility company’s sales of electricity to a hotel. The court found that the sales were sales for resale, because the hotel customers paid tax on the electricity used in conjunction with their rental of rooms and banquet halls. Based on the rationale of Kansas City Power and Light, the Department concluded that load and leave transactions, which involve a transfer of a right to use property, rather than a transfer of title to property should be considered “sales at retail.” Accordingly, such sales are now taxable. The notice specifies that tax must be collected regardless of whether the purchaser installs the software and returns the tangible media to the seller or the seller installs the software and leaves with the tangible media.

4.

Ohio: Ohio Am. Sub. H.B. 95, relaxes the taxation of software. The legislation, which was designed to bring Ohio into compliance with the Streamlined Sales and Use Tax Agreement, and which became effective July 1, 2003, provides that reasonable separately stated charges for modifications to prewritten (i.e., canned) software are excluded from tax. Nevertheless, Ohio Admin. Code § 5703-9-46(A)(7) provides that charges for modifications to canned software are subject to tax unless they constitute more than half of the price of the sale. In response, the Ohio Department of Taxation has issued guidance explaining that until the regulation is amended, taxpayers should follow the provisions of H.B. 95, but should remember that unless modification charges are separately stated, they will be subject to tax as prewritten software. Information Release ST 2003-06 (Jul. 2, 2003).

5.

Tennessee: The Tennessee Court of Appeals has held that a provider of internet and other computer information services

45

was not performing taxable telecommunications services. Prodigy Services Corp., Inc. v. Johnson, No. M2002-00918COA-R3-CV (Aug. 12, 2003). The company used modems to provide internet access, e-mail, and other computer information services to its customers. The term telecommunications services is defined to include transmission by or through any media, and contains a nonexclusive list of potentially taxable services, none of which described the internet services at issue in the controversy. In finding that the company’s services were not included in the statute, the court relied on legislative intent, specifically the 1993 deletion from the statute of “value added networks” as a specifically identified example of telecommunications services. The court found that the legislature’s action in this regard could be construed as intended to clarify that electronic information services are not subject to tax. The court was also influenced by the fact that the company was not a regulated telecommunications service provider under Tennessee or federal law. The Tennessee Supreme Court subsequently declined to hear the Department’s appeal in this decision. In response to the court’s decision, the Department of Revenue has ordered all internet service providers and telecommunications companies to stop collecting tax from consumers on internet access. Sales and Use Tax Notice 04-03 (Jan. 30, 2004). The Notice explains that ISPs seeking refunds of taxes collected from consumers on such services must show that they refunded the tax to their retail customers. In addition, an ISP must either provide documentation that it paid sales tax on services originally purchased for resale or, alternatively, reduce its own refund by the amount of sales taxes it would have paid if it had not claimed a resale exception. However, an ISP is not permitted to similarly reduce the refunds owed to its retail customers for this amount. 6.

Virginia: The Department of Taxation has issued a ruling addressing the taxability of certain programming, consulting, travel, and administrative services provided in conjunction with the sale and modification of software. Ruling of Commissioner, P.D. 03-61 (Aug. 19, 2003). Although the outcome of the ruling was favorable for the taxpayer, the approach taken by the Department may have broader negative implications for other taxpayers. The taxpayer had entered into two separate contracts with the same customer, one for the sale of prewritten software, and the other a software modification

46

and services agreement. The taxpayer did not collect tax on the second contract since the contract did not encompass the sale of tangible personal property. However, citing to common law of contracts, the Department ruled that the contracts could be collapsed into a single contract for the sale of the prewritten software (tangible personal property), because they were executed on the same day, and the modifications were necessary to render the software useful to the customer. Despite the consolidation of the contracts, the Department ultimately ruled that the services were eligible for a specific exemption for separately stated charges for software modification and services. 7.

Wisconsin: The Tax Appeals Commission has ruled that global application software purchased by a company for use in operation of its business was exempt custom software. Menasha Corp. v. Wisconsin Dept. of Revenue, No. 01-S-72 (Dec. 1, 2003). The software cost several million dollars, contained over seventy modules, and took several years to implement. Wisconsin distinguishes prewritten and custom software for sales and use tax purposes. A regulation contains seven qualitative factors to be examined in characterizing software that evaluate the complexity and nature of the software. The Department’s policy has been to require all seven conditions to be satisfied in order for software to qualify as custom software, although the regulation does not explicitly require that all criteria must be met. Prior to this decision, neither the taxability of this type of software nor the Department’s interpretation of the regulation had been addressed in a judicial or administrative law setting, and the Department traditionally subjected this type of software to tax. However, the Commission ruled that the software did not need to satisfy all seven elements of the regulation. The Commission weighed the various factors and concluded that, based on the totality of the circumstances, the software was custom, noting the cost of the software and the significant training, testing, and maintenance required to implement the software. The Commission also explained that the crucial issue was the process required to implement the software not whether the software purchased was part of a standard package.

47

B.

Exemptions 1.

Manufacturing a.

California: Recent legislation places a ceiling on the sales and use tax manufacturing credit. S.B. 1064 (Sept. 28, 2003). Cal. Rev. & Tax. Code § 6902.2 provided that in lieu of taking a manufacturer’s investment credit (MIC) against personal or corporate income taxes, an eligible taxpayer may file a sales and use tax refund claim in an amount equal to the credit that could be claimed for income tax purposes. This provision has recently been the subject of SBE rulings holding that the sales tax refund could be granted with respect to unused MIC carryovers S.B. 1064 provides that the amendments are declaratory of existing law but are effective for refund claims filed on or after August 7, 2003 (the relevant SBE rulings were issued August 6, 2003). Therefore, the sales tax refund can now no longer exceed the amount of MIC that would be allowable for corporate income tax purposes after application of all other credits. Note, the MIC expired at the end of 2003.

b.

Louisiana: Recently enacted legislation creates a state sales and use tax exemption for machinery and equipment purchased by a manufacturer if used in a plant facility predominantly and directly in the manufacture of tangible personal property for sale to another or manufacturing for agricultural purposes. The exemption does not apply to the parish level tax. H.B. 2 (Mar. 23, 2004). The exemption will be phased in over a seven-year period from 2005 through 2011. Machinery and equipment is broadly defined and expressly includes several categories of auxiliary equipments, such as: computers and software that are an integral part of machinery and equipment used in manufacturing; pollution control equipment; and certain testing equipment. However, the legislation also clarifies that structural property, HVAC, and property used to transport or store property are ineligible, and food preparation is not considered manufacturing. In order to take advantage of the exemption, a purchaser must obtain certification from the state that it qualifies as a manufacturer. While the legislation ultimately 48

provides a benefit many Louisiana purchasers currently enjoy similar sales and use tax benefits by virtue of participating in the Louisiana enterprise zone program. c.

New York: Reversing a previously issued advisory opinion, the Division of Tax Appeals has ruled that various pieces of equipment used on the premises of a retail home improvement chain were eligible for the production exemption. Matter of Lowe's Home Center, Inc., DTA No. 819043 (Mar. 11, 2004). N.Y. Tax Law § 1115(a)(12) exempts from tax equipment used in the manufacturing, processing or other production of tangible personal property for sale. The equipment involved machines used at the taxpayer’s retail facilities to cut products to the desired size for customers - timber cutting saws, carpet/vinyl cutting equipment, pipe threading/cutting equipment, glass cutting machines, window trim machines and wire measuring and coiling equipment. The ruling concluded that the equipment was used to process the property purchased by the taxpayer’s customers and rejected the Division’s argument that the property was ineligible for exemption because it had already entered the distribution phase by being displayed on the sales floor.

d.

New York: The Department of Taxation and Finance has issued an advisory opinion finding that purchases of vacuum, hydrogen, nitrogen, and water cooling systems were eligible for the manufacturing exemption even though the various systems were used to treat (i.e., heat, cool, etc.) the manufacturer’s products rather than becoming components of the products themselves. TSB-A-03(27)S (Jun. 24, 2003). Air, water, and gases used in the systems were found to be used entirely in manufacturing and integral to the manufacture of the automotive electronics. Despite the fact that the exhaust systems did not meet the statutory definition of pollution control equipment, the systems were held to be exempt from tax because the product itself would have been harmed without the operation of the exhaust system to remove noxious fumes and vapors produced during the course of the manufacturing process. Nevertheless, the ruling declined to extend the exemption to the taxpayer’s HVAC equipment, finding that it was present for the comfort of the taxpayer’s

49

factory employees rather manufacturing process. e.

2.

than

integral

to

the

Tennessee: The Tennessee Court of Appeals has ruled that the industrial machinery exemption did not apply to catalysts used by a chemical manufacturer in the manufacturing process. Eastman Chemical Co. v. Chumley, No. M2002-02114-COA-R3-CV (Jan. 12, 2004). The exemption applies to “machinery, apparatus, and equipment with all associated parts, appurtenances and accessories.” The court rejected the taxpayer’s claim that the catalysts were exempt “apparatus.” The court explained that, taken together, the terms machinery, apparatus, and equipment were intended to apply the exemption to connected and interrelated devices and parts used to carry out the manufacturing process. Accordingly, the court determined that the catalysts at issue were not qualified machinery, but rather were analogous to such nontaxable items as fuel used to operate manufacturing devices or substances use to cool those devices.

Research and Development a.

New York: Reversing an administrative law judge ruling, the Tax Appeals Tribunal has held that computer equipment leased by a company for purposes of developing a cancer specimen database was not eligible for the research and development exemption. Petition of Impath, Inc., DTA No. 818143 (N.Y. Tax App. Trib. Jan. 8, 2004). The equipment was used to extract information from data the taxpayer had gathered through the performance of up to twenty tests each on thousands of cancer specimens. The tests were performed for diagnostic purposes; however, the taxpayer subsequently collated the information in order to create a database that could form conclusions and make predictions regarding future patient diagnoses and pharmaceutical development. The Tribunal found that the equipment did not qualify for exemption because the taxpayer failed to use the equipment to develop a new product or a new use for an existing product.

50

3.

Intercompany Transactions a.

4.

Connecticut: Recently enacted legislation provides that otherwise taxable services cannot be purchased under a resale exemption, if they will be resold to an affiliated purchaser. H.B. 6624 (Jul. 9, 2003). Connecticut provides a statutory exemption for sales of taxable services between certain related entities. Conn. Gen. Stat. § 12-412(62). The legislation is designed to ensure that an intermediary cannot makes a purchase under a resale exemption of services that would be exempt on resale under the intercompany exemption. The legislation becomes effective October 1, 2003.

Other a.

Florida: A recent ruling provides that gases used to preserve fish and included in the container in which the fish is sold qualified for the packaging material exclusion from sales and use tax. Technical Assistance Advisement 03A-028 (Jun. 10, 2003). Under Florida law, sellers are not required to pay use tax on purchases of packaging items accompanying the sale of their products if delivery would be impracticable but for the presence of the products, and there is no separate charge for the products to the seller’s customers. Fla. Stat. § 2121.02(14)(c). A regulation lists numerous examples of types of packaging materials that might qualify for the exclusion. Fla. Admin. Code § 12A-1.040. However, the examples focus on types of containers, rather than accompanying material. The Department’s ruling demonstrates that the packaging material exclusion may encompass a broader spectrum of materials than merely containers, such as materials placed inside the containers.

b.

Ohio: A recent Ohio Supreme Court decision provides guidance on the taxability of employment services. H.R. Options, Inc. v. Zaino, 800 N.E.2d 740 (Ohio Jan. 7, 2004). For Ohio sales and use tax purposes, the provision of employment services are generally subject to tax. However, an exclusion from taxation is available for a contract of one-year or greater between a service provider and a client, if the contract specifies that the employees covered by the contract are assigned

51

to the client on a permanent basis. The decision clarified that a contract between an employment services provider and its client need not explicitly state that the furnished employees’ assignments are permanent. Rather, if an employment contract contains no ending dates for the employees’ assignments, then the assignments may be deemed permanent and eligible for the exception. Nevertheless, the court noted that even if a contract contains no ending date, the services would not be eligible for the exception if the facts and circumstances revealed that the employees were provided for seasonal employment or to fill short-term workload conditions. This decision applies only to employees furnished by unrelated service providers. A separate exception exists for employment services between members of an affiliated group.

C.

Resale 1.

D.

Ohio: The Ohio Supreme Court has held that a company that tested wheels for customers was not required to pay sales or use tax on its purchases of tires and other equipment used to test the tire rims, because the equipment qualified for a resale exemption. Standards Testing Laboratories, Inc. v. Zaino, No. 98-G-617 (Nov. 12, 2003). The taxpayer purchased the equipment on behalf of its customers and did bill them for it; however, the equipment was, in most cases, not physically transferred to the customers after use. The Ohio resale exemption requires a transfer of title and/or possession of property. The court noted that when the testing company took possession of the tires and other equipment they were simultaneously delivered to its customers, thus effecting a valid title transfer for purposes of the resale exemption.

Other Taxability Issues 1.

Title Passage/Location of Sale a.

Massachusetts: The Massachusetts Supreme Judicial Court has ruled that a seller must collect sales tax on items sold in its Massachusetts stores but picked up by customers at its retail locations in New Hampshire (which has no sales and use tax). Circuit City Stores, Inc. v. Commissioner of Revenue, 790 N.E.2d 636 (Jun. 52

25, 2003). The items were paid for in full in Massachusetts, and the sales were credited to the Massachusetts stores and sales people, but the actual items were “reserved” on the computer at the store where the purchaser wished to take possession of the merchandise. The court determined that since under the Uniform Commercial Code and common law, title may pass before a purchaser takes actual possession of goods, title passed in Massachusetts. In contrast, in Neiman Marcus Group, Inc. v. Commissioner of Revenue, 26 Mass. App. Tax Bd. Rep. 316 (2001), the Appellate Tax Board held that Massachusetts sales tax was not due on sales made in Massachusetts retail stores which the purchasers requested to be shipped to a location in another state. The court dismissed the Neiman Marcus decision as only superficially similar. 2.

Leasing Issues a.

Florida: The Florida Department of Revenue has issued a technical assistance advisement which concludes that a dividend paid by a qualified S corporation subsidiary (Q-Sub) to its sole shareholder (S corporation) was actually a rental payment for use of the S corporation’s building. As such, the dividend was subject to Florida sales tax. TAA 03A-039 (Jul. 22, 2003). The taxpayer posed two alternatives to the Department, one in which a lease agreement was established for the use of the building but did not require the payment of rent, and the other in which the Q Sub would use the building without a lease. The Department ruled that, under either scenario, a dividend paid by the Q Sub to the S corporation would be taxed as rent to the extent the dividend was actually paid to the S corporation. The Department explained that, because there was real consideration flowing from the Q Sub to the S corporation, the dividend would be considered rental compensation. The Department distinguished this situation from one in which the dividend was merely an accounting entry with no actual value flowing to the shareholder.

53

3.

Other a.

E.

Maryland: The Maryland Tax Court has held that federal law preempts the imposition of a use tax collection obligation on a for-hire carrier that delivered furniture in the state for a related out-of-state retailer. Royal Transport, Inc. v. Comptroller of the Treasury, Nos. 02-SU-OO-0298, 0299 (Oct. 22, 2003). The court held that the imposition of a use tax obligation on the delivery company would violate the Interstate Commerce Act (Act), which prohibits states laws “related to a price, route, or service of any motor carrier.” Citing federal case law, the court concluded that a tax collection obligation could place numerous burdens on the carrier that could be construed as additional services. Specifically, the court ruled that a delivery company required to collect use tax would be required to perform eleven additional services, including determining whether tax was due, determining whether tax had been previously collected, computing tax, collecting tax, filling out tax forms, etc. These additional services would violate the preemption clause of the Act. The court also rejected the Comptroller’s argument that the Act should not apply to the delivery company because it was affiliated with the furniture retailer. The court explained that the definition of motor carriers includes any carrier for hire.

Sourcing 1.

Texas: Recently enacted legislation modifies the way in which sales are sourced for local sales and use tax purposes. H.B. 2425 (Jun. 20, 2003). Currently, local sales and use taxes are imposed on intrastate transactions using "origin based sourcing" (i.e., order receipt location). Under H.B. 2425, sales of taxable services will now be subject to destination based sourcing. The legislation, however, does not change the local jurisdiction's sourcing rules for tangible personal property. Consequently, if a taxpayer purchases tangible personal property and taxable services from the same vendor as part of a single transaction (for example, the purchase of repair services together with the related tangible property), it may be required to source the tangible property to one locality and the services to another. The sourcing rules become effective July 1, 2004.

54

F.

Drop Shipments 1.

Connecticut: The Department of Revenue Services has issued a ruling exploring the relationship between the state’s drop shipment rule and fulfillment house exemption. Ruling No. 2003-2 (May 30, 2003). Connecticut requires drop shippers with nexus in the state to collect tax when a retailer does not have a collection obligation. Conn. Gen. Stat. § 12407(a)(3)(A). The taxpayer was a distributor that used a third party warehousing and delivery agent located in Connecticut to house and transport its inventory. The taxpayer sold its products to a mail order retailer, and the agent shipped directly from the Connecticut warehouse to the retailer’s customers throughout the country. In the absence of any relevant exemption, the distributor would qualify under Connecticut law as a deemed retailer obligated to collect tax from the out-ofstate (i.e., not physically present) retailer’s customers located in Connecticut. The taxpayer/distributor argued that even though it met the deemed drop shipper requirement, it should not be required to collect tax under the fulfillment house exemption. Conn. Gen. Stat. § 12-407(a)(15)(C). The Department ruled that the scenario failed to meet the fulfillment exemption because the products were shipped to the mail order retailer’s customers, rather than the “purchaser’s” (i.e., distributor’s) customers. In addition, the distributor would not be considered to offer the products for sale, since it merely acted as a wholesaler, selling them to the mail order retailer.

2.

Kansas: Legislation which became effective July 1, 2003, imposes a sales and use tax collection obligation on certain drop shippers. Kansas H.B. 2416. The Kansas Department of Revenue recently released Notice 03-09, which clarifies the new policy. (Jun. 25, 2003). The Notice explains that when a manufacturer has nexus with Kansas but a retailer does not, the manufacturer is required to collect Kansas sales or use tax (depending on whether the shipment is made from within or without the state) on the retail price of the item. The manufacturer is considered to be a deemed retailer with respect to the drop shipment. If the manufacturer does not know or cannot reasonably determine the retail price of the goods, it is required to collect Kansas sales or use tax from the retailer based on the cost of the item. The Kansas Notice also explains that where the manufacturer uses a drop shipper it is still required to collect tax (if it has Kansas nexus) regardless of whether that second-tier drop shipper is subject to Kansas tax.

55

However, if the manufacturer is not subject to tax in Kansas and the second-tier drop shipper does have nexus, it would be considered the deemed retailer.

G.

Other Transaction Taxes 1.

New York City: An administrative law judge from the New York City Tax Appeals Tribunal has ruled that imposition of the real property transfer tax (RPTT) on five out-of-state corporations did not violate the Commerce Clause of the U.S. Constitution. Matter of Corewood Enterprises, Inc., TAT(H) 00-39(RP) (Mar. 11, 2004). The ruling involved the concerted sale of stock in five lower tier corporations that indirectly owned a New York City hotel. The RPTT is imposed on the sale of real property located in the City or of a controlling economic interest in real property located in the City. The Tribunal concluded that the RPTT could be imposed on the corporations because in-state entities, including a company hired to broker the sale of the hotel, acted as agents for the corporations and thus engaged in activities in New York City sufficient to establish nexus. The Tribunal cited Tyler Pipe for the proposition that these entities engaged in market making activities attributable to the corporations for nexus purposes. The decision is not precedential.

56

VI. Property Taxes A.

California: In an issue of first impression, a California court of appeal has held that rotable spare parts used by a computer hardware seller to service and repair its customers’ equipment were not exempt business inventories for purposes of the personal property tax. Amdahl Corp. v. County of Santa Clara, H025660 (Cal. Ct. App. 6th Dist. Mar. 3, 2004). The taxpayer’s customers could purchase flat fee extended services contracts, which would cover the cost of unlimited replacement parts. When spare parts were needed, the taxpayer took possession of the damaged parts, repairing and reusing them, where possible. The statutory business inventory exemption is only applicable to products sold or leased in the ordinary course of business. The court found that the rotable spare parts were not sold because: there was neither a charge nor other consideration for the replacement parts; no tax was collected on their transfer; there was no inventory reduction when a spare part was placed in service, since the taxpayer took possession of the damaged part; and, the parts were capitalized and depreciated for both income tax and book purposes. Another aspect of the decision that may impact the computer services industry dealt with the determination that the taxpayer was not a “nonprofessional service provider” for property tax purposes. Tangible personal property transferred by professional service providers is subject to tax, while such property transferred by nonprofessional service providers qualifies as exempt business inventory. The court used the example of drycleaners versus attorneys to illustrate the two categories. Noting that computer service providers fall between these classifications, the court, nevertheless, held that the their services were more accurately characterized as professional services, thus making the spare parts taxable.

57

VII. Practice and Procedure A.

California: The State Board of Equalization has ruled, in a nonprecedential decision, that a federal statute of limitations extension for a taxpayer’s federal consolidated group did not extend the statute for foreign affiliates of the taxpayer that were included in its worldwide combined report but excluded from the federal consolidated return. Appeal of Magnetek, Inc., No. 198051 (Jan. 27, 2004). The instructions to the schedule (now R-7), on which members of a unitary group can elect to file a single return currently, specify that a waiver of the statute of limitations by the key corporation in a group will waive the statute for all members of the group electing the single return option. The SBE concluded that the instructions extending a waiver to all members of the group only refer to a California waiver of limitations by the key corporation and do not relate to a federal waiver.

B.

California: On October 2, 2003, legislation was signed in California that imposes certain disclosure and reporting requirements on taxpayers and tax advisors. A.B. 1601/S.B. 614. The legislation adopts IRC §§ 6011, 6111, and 6112 and the accompanying Treasury regulations for California tax purposes. The legislation imposes significant penalties for failure to comply with the requirements of the act. Under the legislation, taxpayers may voluntarily participate in a compliance program, which began January 1, 2004 and ends April 15, 2004.

C.

Texas: Recently enacted legislation authorizes the state auditor to audit any settlement, tax refund, credit, payment warrant, offset, or check issued by the Comptroller’s office. H.B. 7C (Oct. 13, 2003). The provision went into effect on February 1, 2004, and allows the state auditor to examine such items prospectively from that date forward, as well as retroactively for six years prior to the effective date. The authority granted in the legislation is not restricted to any particular type of tax. Nor does the legislation specify that the authority granted to the state auditor does or does not allow the state auditor to alter the terms of any settlement, refund, etc. However, the legislation does specify that taxpayer confidentiality will be respected in connection with these audit procedures.

The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax advisor.

58

Current State Tax Developments

ELA Tax Executives Roundtable June 9, 2004

Jeffrey Friedman Partner, Washington National Tax KPMG LLP Washington, DC

2004 KPMG LLP ALL RIGHTS RESERVED

Brendon McKibbin Partner KPMG LLP New York, NY

CURRENT DEVELOPMENTS A NATIONWIDE PERSPECTIVE ________________________________________________________________________

Table of Contents

I.

Legislative Roundup

II.

Jurisdiction to Tax A. B. C.

III.

Substantial Nexus Income Tax -- Economic Nexus Income Tax -- U.S. Public Law No. 86-272 and Throwback

Corporate Income and Franchise Taxes

Page 2 4 4 11 14

Related Party Transactions and Arrangements Tax Base and Credits Allocation and Apportionment Apportionment Issues Filing Methods Franchise and Net Worth Taxes

17 17 24 27 29 36 39

IV.

LLCs and Other Pass-Through Entities

41

V.

Sales and Transaction Taxes

43

A. B. C. D. E. F.

Software, Telecommunications, and Digital Goods and Services Exemptions Resale Other Taxability Issues Sourcing Drop Shipments

43 48 52 52 54 55

G.

Other Transaction Taxes

56

A. B. C. D. E. F.

VI.

Property Taxes

57

VII.

Practice and Procedure

58

I.

Legislative Roundup As the 2004 state legislative sessions progress, states continue to contend with budget shortfalls. In addition, many states remain interested in enacting tax reform and dealing with transactions perceived as loopholes. The following is a summary of some of the recent legislative activity in select states. This summary reflects legislative activity as of April 12, 2004. A.

Alabama: A proposal to require combined reporting was expected to be introduced during April.

B.

California: A voter referendum held March 2, 2004, approved the bond financing plan and rejected a proposal to lower the supermajority requirement for increasing taxes. As a result of these developments, taken in concert, significant tax increases are not expected this year. Pending tax legislation (all in early stages) includes several bills that would reinstate the Manufacturer’s Investment Credit, legislation that would repeal the water’s edge election, a proposal to include subpart F income in the water’s edge group, and provisions that would allow the sale of unused NOLs.

C.

District of Columbia: The Mayor included, as part of his budget proposal, a related party expense addback provision. A similar measure was introduced by the D.C. Council last year.

D.

Florida: Two bills, H.B. 735 and S.B. 2302 were still pending, toward the end of the session, to repeal the substitute communications services tax. The legislature was scheduled to adjourn on April 30, 2004.

E.

Illinois: The Governor’s budget address contained a sweeping tax reform proposal that would change the Illinois “lockbox” rule and the cost of performance sourcing rule; eliminate nonbusiness income; ensure no tax benefits are available when intangible assets are transferred to tax havens; enact straight-line depreciation; repeal the sales tax exemption for business software purchases; and institute tax shelter legislation. Legislative language is not yet available.

D.

Indiana: H.B. 1365, which was enacted on March 17, 2004, contains a provision requiring out-of-state sellers to register for and collect sales and use taxes if “closely related” to an entity that maintains a place of business in Indiana or enters into a public contract with an Indiana agency. The legislation also exempts separately states installation charges from sales

1

and use tax and clarifies the assignability of the sales and use tax bad debt deduction. As originally introduced, the legislation contained an expense disallowance provision that was deleted from the final version of the legislation. E.

Kentucky: The Governor had proposed a significant tax modernization package. The legislature adjourned April 13, 2004, without passing the Governor’s proposal or a budget bill.

F.

Louisiana: Legislation was enacted that: creates a phased-in exemption for purchases of machinery and equipment by manufacturers; phases out the borrowed capital component of the franchise tax; and provides for the inclusion of related party debt that exceeds a certain threshold in the franchise tax base.

G.

Maryland: On the last day of the session, April 12, 2004, the legislature approved and sent to the Governor three bills, one containing related party expense disallowance, another containing an amnesty provision with respect to prior year related party expenses, and a bill imposing a temporary corporate income tax surcharge. The Governor has threatened to veto the surcharge bill and has announced that he has not decided whether to sign either the expense disallowance or amnesty bills. The Governor has until June 1, 2004 to sign the legislation.

H.

Massachusetts: Among the provisions included in the Governor’s budget proposal, H.B. 1, are proposals to expand allocation of income of domiciliary corporations, revise apportionment sourcing rules, address the apportionment of income attributable to IRC § 338(h)(10) transactions, and impose a sales/use tax collection obligation on certain drop shippers.

I.

Missouri: A related party expense disallowance provision containing safe harbors, H.B. 969, which was supported by the business community, passed the House and was sent to the Senate, where it was still pending as of the middle of April. It is unclear whether the Governor, a strong proponent of expense disallowance, would support the legislation with the safe harbors included.

J.

New Jersey: The Governor has proposed extending the suspension of the NOL deduction for 2004 and 2005.

K.

New York: The Governor has proposed single factor apportionment for manufacturers. In addition, legislation has been introduced which would require disclosure of certain tax planning transactions.

2

L.

Ohio: The budget that was passed during 2003 is a two-year provision. The Governor has indicated that any major tax proposals would be deferred until preparation of the 2005 budget. It is possible that a Housebased reform proposal will be introduced this year; but it is not anticipated that any major tax reform will be enacted during 2004.

M.

Oregon: A voter referendum held on February 3, 2004, rejected a proposed tax increase.

N.

Tennessee: Two expense disallowance bills have been introduced. One applies only to royalties, while the other is broader.

O.

Texas: The Governor called the legislature into a special session to address education financing, which began April 20, 2004. It was anticipated that corporate limited partner nexus and related party expense disallowance would be among the measures considered during the session.

P.

Virginia: A temporary budget bill, H.B. 5018 was approved by the House on April 13, 2004 but, was drafted to “self destruct” on April 24, 2004, if a 2004-2004 biennial budget was not enacted by that date. H.B. 5018 was scheduled for consideration by the Senate Finance Committee on April 16, 2004.

3

II.

Jurisdiction to Tax A.

Substantial Nexus 1.

2.

Nexus Proposals a.

Multistate: The Internet Tax Freedom Act moratorium on discriminatory taxes and taxes on internet access expired on November 1, 2003. Two bills, H.R. 49 and S.150, were introduced during the latter part of 2003. Two other measures have been introduced that would set statutory nexus standards. H.R. 3184 would provide for expanded collection authority for sales and use tax purposes, essentially overturning the Quill physical presence test. H.R. 3220 would codify the physical presence test for business activity tax (BAT) nexus purposes and expand the scope of U.S.P.L. 86-272. H.R. 3220 does not address sales and use tax nexus.

b.

Multistate: The Multistate Tax Commission (MTC) continues to support a BAT nexus proposal adopted in October 2002 under which substantial nexus would be established if a taxpayer had a threshold amount of property, payroll, or sales in the state ($50,000 property or payroll or $500,000 sales). Nexus would also be established in any state in which at least 25 percent of any of the three factors was concentrated. The proposal would require the members of a unitary business group to compute their nexus factors in the aggregate. If the group as a whole met the nexus threshold, each member of the group would be considered to have substantial nexus in that state. Furthermore, the receipts factor would include intercompany sales. The factors would be computed according to the appropriate UDITPA rules for the taxpayer. However, for receipts factor purposes, the rule moves away from a cost of performance standard toward a destination standard.

Intangible Licensing Activities, Other Holding Company Issues a.

Louisiana: Reversing an appellate court decision, the Louisiana Supreme Court has held that a Delaware passive investment company was subject to Louisiana corporate income and franchise taxes. The company was part of a closely held group of corporations, and all 4

of its directors, except the Delaware-based nexus provider, were Louisiana residents. Kevin Associates, LLC v. Crawford, No. 03-C-0211 (Jan. 30, 2004). The company earned dividends from subsidiaries located in Louisiana and other states and received interest from an intercompany loan to an affiliated Louisiana corporation. The court held that the company was commercially domiciled in Louisiana because it was managed from Louisiana, and its Delaware presence was merely a paper domicile. The court also concluded that the company had a physical presence in Louisiana because its principal place of business was in the state, and it was managed from there. The appellate court had held that the company did not have nexus, noting that the company followed all the required formalities for establishing and maintaining a DHC. Kevin Assoc. LLC v. Crawford, 834 So.2d 465 (Nov. 8, 2002). b.

Louisiana: A Louisiana appellate court has held that the Department could not assert jurisdiction over an out-of-state holding company, because the corporation’s contacts with the state were not sufficient to satisfy the nexus requirements of the Due Process Clause. Bridges v. Autozone Properties, Inc., No. 2003 CA 0492 (La. App. 1 Cir. Jan. 5, 2004). (This decision was issued before Kevin Associates). The Department attempted to tax dividends received by a Nevada corporation from a real estate investment trust (REIT) that earned rental income from subsidiary retail stores, some of which were located in Louisiana. The REIT was subject to Louisiana tax but paid no tax as a result of the dividends paid deduction, while the stores received a deduction for rental expense. The court examined Geoffrey, from a due process perspective only. It concluded that, unlike the economic presence created by the trademarks, which gave rise to the Due Process nexus in Geoffrey, the holding company’s dividends had no economic presence in Louisiana. Nor could a Louisiana business situs be claimed for the dividends that had no connection with the state other than being paid by a REIT that earns part of its income from Louisiana properties. While the Commerce Clause was not at issue in Autozone, the court did state in a footnote that Quill requires a physical presence to establish Commerce Clause nexus. The court also

5

rejected an argument asserting that the holding company and REIT were alter egos. c.

Louisiana: A district court has denied motions filed by two out-of-state trademark licensing companies to dismiss suits filed by the state to recover income taxes. Louisiana Dept. of Revenue v. Geoffrey, Inc., No. 502769; Louisiana Dept. of Revenue v. Gap (Apparel), No. 501651 (Dec. 8, 2003). The court determined both suits could proceed, despite the defendants’ claims that they had no physical presence in the state; however, the court did not actually rule on whether the companies had established nexus in Louisiana.

d.

New Jersey: The New Jersey Tax Court has held that an intangible holding company with no physical presence in New Jersey, but which licensed trademarks to an affiliated retailer in the state, was not subject to the New Jersey Corporation Business (income) Tax (CBT). Lanco, Inc. v. Director, Division of Taxation, No. 005329-97 (N.J. Tax Ct. Oct. 23, 2003). The court specifically ruled that the physical presence test upheld by the U.S. Supreme Court in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), applies to income as well as sales and use taxes. In so doing, the court appears to have invalidated a 1996 Division of Taxation regulation that defines doing business to include licensing trademarks, if used in the state. The court explicitly stated that there was no justification for imposing different substantial nexus standards for sales and use and income taxes. The court reasoned that, since an obligation to collect use tax is not “more burdensome” than an obligation to pay an income tax, it would be “illogical” to require physical presence for use tax nexus, while allowing income taxes to be imposed under lesser circumstances. Although the decision is taxpayer favorable, the impact is mitigated by New Jersey’s 2002 enactment of statutory expense disallowance provisions that require addback of certain related party expenses, including royalties attributable to licensing intangible property. Tax Court decisions are not precedential.

6

3.

Attributional Nexus a.

Indiana: Recently enacted legislation requires any person that is “closely related” to another person that maintains a place of business in Indiana, engages in the regular or systematic soliciting of retail transactions from potential customers in Indiana, or enters into a public contract with a state agency to register and collect sales and use tax. H.B. 1365 (Mar. 17, 2004). The term, “closely related” is defined to include: use of identical or substantially similar names, trademarks or goodwill; persons that pay for each other’s services under an arrangement that is contingent on sales volume or value; and entities that share a common business plan. The measure also expands the definition of a retail merchant engaged in business in the state (for sales and use tax collection purposes) to the boundaries of the U.S. Constitution. The provision becomes effective July 1, 2004.

b.

Kentucky: The Board of Tax Appeals has ruled that a telecommunications reseller was subject to the Public Service Corporation (PSC) property tax in a ruling with both economic and attributional nexus elements. Annox, Inc. v. Revenue Cabinet, No. K-19039 (Nov. 18, 2003). The reseller had no physical presence in the state but did have interconnection agreements with two in-state telephone companies entitling it to use their instate equipment to provide services to Kentucky customers. Citing Scripto and Tyler Pipe, the Board explained that the in-state interconnection partners established and maintained a market for the reseller through the activities of their employees, such as performing installation and repair services for the reseller’s Kentucky customers. The Board also stated that Quill is only applicable for sales and use tax purposes, and cited Geoffrey, despite Geoffrey’s limited applicability to South Carolina. The Board then explained that nexus was established through the reseller’s absolute right to use the Kentucky physical networks of two in-state telephone companies (an intangible), as well as its Certificate of Public Convenience issued by the Kentucky PSC. The Board went so far as to state that the U.S. Congress granted

7

states nexus over all switchless resellers providing services in their states when it specifically authorized state commissions to approve interconnection agreements (in the Telecommunications Act of 1996). c.

New York An out-of-state non-profit membership organization with no physical presence in New York established nexus in the state through the activities of two unrelated independent contractors in the state and must collect sales and use tax on catalog and internet sales made to New York purchasers. TSB-A-04(3)S (N.Y. Dept. of Tax. and Fin. Feb. 24, 2004). The organization, an association for boaters, provided various services to its members, including marina membership discounts, insurance, theft protection, magazine subscription, and access to emergency towing services. Four retail stores in New York owned by third parties, but which bore the organization’s name, sold memberships to the organization. The Department ruled that the stores served as independent representatives that established New York nexus for the organization through the sale of memberships. The Department found that nexus was also established through the arrangement the organization had with local towing companies for its members to receive emergency towing services throughout the country.

d.

New York: An administrative ruling issued by the New York Department of Taxation and Finance provides that a remote vendor with an in-state retail affiliate will not, generally, be required to collect use tax on New York sales, as long as the entities do not engage in certain activities or act as alter egos. TSB-A03(25)S (Jun. 11, 2003). However, the ruling also listed a number of activities the Department would consider as triggering a use tax collection obligation. The Department noted that activities that would deem an in-state retailer to be acting as a sales representative for a remote vendor would subject the seller to use tax collection. The ruling explained that an in-state seller might be acting in a sales representative capacity if it referred customers to a remote seller’s catalogs, accepted returns of its merchandise, solicited customer names for a remote vendor’s mailing lists, distributed

8

catalogs or coupons of the remote seller, or shared common inventory or administrative staffs. e.

4.

Virginia: A ruling issued by the Department of Taxation clarifies the scope of recent legislation, and essentially provides that sellers that wish to do business with the state may be required to waive constitutional nexus protections in order to obtain contracts with the state. Ruling of Commissioner, P.D. 04-04 (Jan. 23, 2004). The legislation, enacted during 2003, prohibits the state from purchasing goods or services from a seller, if the seller or any of its affiliates is a “dealer” under Virginia law and fails to collect and remit sales and use taxes. The Department ruled that the state could not enter into a contract with the taxpayer because an affiliate of the taxpayer may have advertised in the state. While advertising, alone, is not necessarily sufficient to establish nexus under constitutional standards, it does qualify a seller as a “dealer” under Virginia law. Under the constitution, Virginia cannot require a “dealer” to collect tax if it does not have nexus with the state. However, the ruling explained that the state may set its own conditions for vendors to do business with state agencies.

In-State Representatives a.

Connecticut: A Connecticut Superior Court has held that a mail order computer seller did not establish nexus for sales and use tax purposes by virtue of the in-state activities of an unrelated company to which the seller had outsourced a portion of its service contract repair work. Dell Catalog Sales v. Commissioner of Revenue Services, No. CV 00 0503146S (Jul. 10, 2003). Under the contracts, telephone and online support services were provided by the seller, while on-site services were preformed by the repair company. On-site repair work comprised only ten percent of the value of the services performed under the contracts. The court focused on the lack of evidence as to the actual number of repair visits made to Connecticut. In the absence of actual evidence, the court held that the fact that only ten percent of the service contract revenue was attributable to on-site work indicated that the repair company’s presence was minimal and insufficient to establish

9

nexus for the seller. The court cited Appeal of Intercard, 14 P.3d 1111 (Kans. 2000) (eleven maintenance visits during an audit period did not establish nexus). b.

Michigan: On appeal, a Michigan court has ruled that a lower court should have granted a summary judgment motion against an out-of-state seller. The out-of-state company was subjected to the single business tax (SBT) based on the activities of two resident sales representatives. Acco Brands, Inc. v. Department of Treasury, No. 242430 (Mich. Ct. App. Nov. 20, 2003). The representatives solicited orders in the state and sent them to the company’s Illinois office for approval. However, since it has been determined that the SBT is not an income tax, the activities of the representatives were not protected by P.L. 86-272. See Gillette Co v Dep't of Treasury, 497 N.W.2d 595 (Mich. Ct. App.1993. Revenue Administration Bulletin (RAB) 9801 provided that, effective for open tax years and going forward, the presence of sales representatives in the state is sufficient to establish SBT nexus for an out-ofstate entity if the representatives solicit sales or engage in other activity in the state on behalf of the seller.

c.

New York: The Department of Taxation and Finance has ruled that an out-of-state vendor established nexus for use tax collection purposes through the in-state activities of a commission-based independent contractor. TSB-A-03(41)S (Nov. 19, 2003). The independent contractor sold only one line of the vendor’s products, and the majority of its sales were attributable to participation in trade shows. Citing Scripto, the Department ruled that the independent contractor’s activities established New York nexus for the vendor, and the vendor was required to collect New York use tax on all sales (other than resales), including online sales. Although nexus is often based on the activities of independent contractors, the ruling failed to analyze the volume or frequency of the contractor’s activities, New York’s more than a slightest presence standard (Matter of Orvis Co. Inc. v. Tax Appeals Tribunal, 86 N.Y.2d 165 (1995)), or whether the contractor satisfied the Scripto/Tyler Pipe marketmaking standard.

10

B.

Income Tax -- Economic Nexus 1.

State Arizona Arkansas Colorado Florida Georgia Hawaii Indiana Iowa Kentucky Louisiana Maine Maryland4 Massachusetts Michigan Minnesota Missouri5 New Hampshire New Jersey6 New Mexico New York North Carolina9 Ohio11 Oklahoma Pennsylvania South Carolina12 Tennessee13 Virginia West Virginia

Reported and Known “Geoffrey Nexus” Positions By State Statute

Rule Yes

Audit Position Yes Yes1

Yes Yes Yes (Priv.Tax) Yes 2

Yes (F/S) Yes Yes (F/S)

Yes

Yes (F/S)

Yes

Yes 3 Yes Yes

Yes (F/S) Yes

Yes Yes7

Yes10

Yes

Yes Yes Yes Yes Yes Yes8 Yes (Forced Comb.) Yes Yes

Yes Yes (F/S)

Yes Yes

Yes (F/S)

Yes Yes

Yes (F/S)

Yes

“F/S” - Financial Services 1

The Colorado Department of Revenue indicated at a practitioner’s liaison meeting that it will assert nexus in situations similar to Geoffrey. 2

See Letter of Findings 95-0401 (Ind. Dept. Rev. Jul. 1, 2002), which upheld an audit assessment against an intangible holding company based on a Geoffrey nexus position.

11

3

Several suits are pending in which the Department of Revenue is asserting economic nexus over intangible licensing companies, and administrative guidance provides that an out-of-state intangible licensing company would have nexus under certain circumstances. Revenue Ruling 02-001 (La. Dept. of Rev. May 13, 2002). In addition, the Louisiana Supreme Court has held that an out-of-state holding company had nexus in Louisiana, although the decision was not based directly on economic substance principles (company was held to be domiciled in the state). Kevin Associates, LLC v. Crawford, No. 03-C0211 (Jan. 30, 2004). 4

Maryland’s highest court has reversed (on business purpose/economic substance grounds), a group of decisions that had held that Geoffrey was inapplicable in Maryland. See Comptroller of the Treasury v. SYL, Inc., Comptroller v. Crown Cork & Seal Company (Delaware), Inc. Nos. 76 & 80, (June 9, 2003). The U.S. Supreme Court declined the taxpayers’ appeals in both decisions. 5

But see, Acme Royalty Co. v. Director of Revenue and Gore Enterprise Holdings, Inc. v. Director of Revenue, Nos. SC84225, SC84226 (Mo. Nov. 26, 2002), in which the Missouri Supreme Court reversed two Administrative Hearing Commission orders and held, on statutory grounds, that out-of-state companies licensing patents and trademarks were not subject to Missouri income tax. 6

Legislation enacted during 2002 expands the New Jersey Corporation Business Tax to corporations engaging in contacts within the state. N.J. Stat. Ann. § 54:10A-2. However, a recent Tax Court decision rejected the assertion of nexus in the absence of a physical presence. Lanco, Inc. v. Director, Division of Taxation, No. 005329-97 (N.J. Tax Ct. Oct. 23, 2003). 7

The New Mexico Court of Appeals has held that an out-of-state company that licensed trademarks and tradenames to an in-state affiliate was subject to New Mexico gross receipts and income taxes. Kmart Properties, Inc. v. New Mexico Taxation and Revenue Department, No. 21,140 (Nov. 27, 2001).

8

New Mexico imposes economic nexus requirements on franchisors for purposes of its gross receipts tax. 9

See A&F Trademark, Inc. v. Secretary of Revenue, N.C Super. Ct., Wake Cty., (May 22, 2003), affirming Secretary of Revenue v. A&F Trademark, Inc., Admin Decision No. 381 (May 7, 2002); contra

12

Educational Resources, Inc. v. Tolson, No. 00CVS14723-4 (Wake Cty. Sup. Ct., Feb. 20, 2003). 10

A North Carolina statute, enacted during 2001, provides that licensing intangibles for use in the state is considered to be doing business in the state. 11

The Ohio Supreme Court upheld the taxation of a nonresident individual’s Ohio lottery winnings. Couchot v. State Lottery Comm'n., 659 N.E.2d 1225 12

Geoffrey Inc. v. South Carolina Tax Comm'n., 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993). 13

Tennessee imposes economic nexus on financial institutions for franchise/excise tax purposes. In J.C. Penney National Bank v. Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999) cert. denied 121 S. Ct. 305 (2000), the imposition of tax on an out-of-state bank that issued credit cards to Tennessee residents was rejected; however, in America Online, Inc. v. Johnson, No. M2001-00927-COA-R3-CV (July 30, 2002), the Tennessee Court of Appeals clarified that J.C. Penney does not impose a physical presence requirement for all taxes.

13

C.

Income Tax -- U.S. Public Law No. 86-272 and Throwback 1.

Massachusetts: The Massachusetts Supreme Judicial Court has upheld an Appellate Tax Board (ATB) ruling that a company’s in-state representatives exceeded U.S. P.L. 86-272 protection. Alcoa Building Products, Inc. v. Commissioner of Revenue, SJC-08939 (Oct. 21, 2003). The taxpayer employed a handful of sales managers that solicited sales of vinyl siding and other building products from Massachusetts customers. The ATB had ruled that the sales managers’ involvement in the warranty claims process was sufficient to forfeit the company’s P.L. 86-272 protection. The sales managers investigated sites to evaluate the merit of warranty claims and assisted customers in filling out as many as one-third of the claim forms filed with the company. The court ruled that these activities had independent business purposes, apart from solicitation, including enhancing the taxpayer’s reputation and decreasing the volume of traffic received by the taxpayer’s warranty claims office. The court rejected the taxpayer’s claim that the warranty activities consisted of merely passing inquiries and complaints on to the home office, an activity that is explicitly protected by regulation in Massachusetts (and consistent with the MTC statement on P.L. 86-272). 830 Code Mass. Regs. § 63.39.1(5)(c)(4). The court explained that the warranty activities were more akin to handling customer complaints, an activity that the same regulation specifically provides exceeds protection. The court also rejected the taxpayer’s attempt to establish that the unprotected activities were de minimis, noting that the sales managers participated in more than one-third of the warranty claims filed by the taxpayer’s customers and regularly visited warranty claim sites.

2.

New York: An administrative law judge (ALJ) with the New York Division of Tax Appeals ruled that the New York destination sales of certain members of a combined reporting group must be sourced to New York, even though none of the companies, themselves, engaged in any activities that exceeded U.S Public Law 86-272 protection. Matter of Disney Enterprises, Inc., DTA No. 818378 (Feb. 12, 2004). The ALJ ruled that the New York activities of the other members of the group, including retail stores in the state, and substantial cross marketing, was sufficient to require the non-nexus subsidiaries to source their destination sales to the state. The ALJ explained that these activities established that the companies’ business in New York was not merely limited to

14

remote/protected sales. This is the second ALJ ruling in the last two years to employ the Finnigan approach in New York. In 2002, a different ALJ also ruled that P.L. 86-272 protected New York destination sales made by non-taxpayer corporations of a New York combined reporting group must be included in the numerator of the group's receipts factor. Matter of Alpharma, Inc., DTA No. 817895 (2002). In contrast, in Petition of Silver King Broadcasting of New Jersey, Inc., an ALJ ruled that the Joyce approach should be applied. DTA No. 812589 (1995). None of these rulings are precedential. 3.

New York: Recent regulatory amendments provide that participation in a trade show for no more than fourteen days, in the aggregate, during a tax year qualifies for P.L. 86-272 protection from the franchise (i.e., income) tax. N.Y. Comp. Codes R. & Regs. tit. 20, §§ 1-3.3, 1-3.4. (Jan. 22, 2004). In order to qualify for the exception, no sales can be made at the trade show, the person’s activity must be limited to displaying goods and promoting services, and all orders must be sent outside the state for acceptance. The regulation is effective retroactively for taxable years beginning on or after January 1, 2002. A previously issued New York ruling provided that the presence of employees at in-state trade shows and seminars an average of ten days per year did not generate nexus for corporation franchise tax purposes. N.Y. Dep’t of Tax. & Fin., TSB-A-97(6)C (Mar. 24, 1997). These changes are also consistent with amendments made to New York City regulations last year. Rules of the City of New York §§ 11-03, 11-04 (Jan. 2, 2003) were amended to include a fourteen-day trade show safe harbor, effective January 1, 2002, as well.

4.

New York: The Department of Taxation and Finance has issued an Advisory Opinion finding that an out-of-state food seller was subject to New York corporation franchise tax. TSB-A-03(13)C (Dec. 24, 2003). Although orders were sent outside the state for approval and deliveries were made from outside the state (in company owned trucks), the Department concluded that the seller engaged in post-delivery activities that exceeded P.L. 86-272 protection, including picking up damaged goods from customers and occasionally accepting payments from customers for prior deliveries. The Department found that these activities were unprotected under N.Y. Code Regs. Reg. § 1-3.4(b)(9) - - replacing stale or damaged products and collecting delinquent accounts. With regard to the replacement of damaged products, however, the facts

15

indicate that the seller removed damaged products from customers and issued credit, but do not indicate that any replacements were delivered. Furthermore, the facts stated that delivery persons occasionally accepted checks from customers as an alternative to the customers mailing their payments. There is no indication that these payments related to past due accounts or that the delivery persons in any way solicited or requested such payments. The Department also noted that the seller was ineligible to claim a de minimis exception where there was at least one damaged goods pickup per week.

16

III.

Corporate Income and Franchise Taxes A.

Related Party Transactions and Arrangements 1.

Expense Disallowance Legislative Developments a.

Connecticut: Legislation enacted during 2003 expands the disallowance of related party interest expense under the state’s expense disallowance provisions. H.B. 6806, sec. 78 (Aug 16, 2003). The measure was enacted as a substitute for legislation that would have imposed a mandatory “alternate combined reporting” regime for virtually all corporate taxpayers in Connecticut. The legislation is effective for tax years beginning on or after January 1, 2003. The legislation effectively expands Connecticut’s expense disallowance to intercompany financing (and other types of intercompany interest payments). Under existing law, taxpayers are already required to add back interest expenses and costs related to intangible property under Conn. Gen. Stat. § 12-218c. The legislation provides five possible categories of exceptions to the disallowance requirement, including the payment of tax in another jurisdiction coupled with arm’s length terms and a non-tax business purpose, as well as a treaty exception. The addback may also be avoided if the taxpayer agrees to file a unitary combined report. Subsequently released information addresses the scope of the addback exceptions. Form CT-1120AB and DRS Commissioner Meeting Interest Add Back Issues (Dec. 3, 2003). The release specifies that a petition must be filed with the Department in order to take advantage of any of the statutory exceptions to addback, other than the “three percent tax paid exception.” The release clarifies that the three percent spread will be calculated by comparing Connecticut’s maximum 7.5 percent statutory rate to the income recipient’s effective tax rate in any one state. The effective rate is calculated by dividing actual tax paid by pre-apportionment taxable income. Accordingly, the exception would not be available to an income recipient in an NOL position in a state in which it is subject to tax.

17

With regard to the new unitary election exception to addback, the form imposes several conditions on the unitary filing exception that are not required by the legislation. The release states that the election is water’s edge (although the legislation does not specify). The release also explains that taxpayers may elect unitary for Connecticut purposes if they file unitary in another state but fails to address whether taxpayers that do not file unitary in any other state may avail themselves of the election. In addition, the form specifies that no prior year NOLs or credits may be utilized, and the entire unitary group is subject to the twenty percent corporate tax surcharge. Furthermore, the unitary group must be treated as a single taxpayer for purposes of computing and using tax credits. b.

Massachusetts: Related party expense disallowance legislation was enacted during 2003. Subsequently enacted legislation creates an additional treaty exception. H.B. 3727 (Nov. 26, 2003). The legislation provides that addback of interest or royalties is not required if the expenses are paid, directly or indirectly, to a related member that is a resident of a country which has a comprehensive income tax treaty with the United States (provided the company is not a controlled foreign corporation under IRC § 957), the amounts are deductible for federal tax purposes, the transaction giving rise to the expenses has a valid non-tax business purpose, and the terms of the transaction are arm’slength.

c.

New York: During 2003, legislation was enacted imposing related party expense disallowance for both New York state and city purposes. A.2106 (May 15, 2003). Subsequently enacted legislation amended the scope of the disallowance provision. S.B. 5725 (October 21, 2003). A.2106 provided for disallowance of related party royalty and interest expense deductions. However, S.B. 5725 eliminated the addback of interest expenses (other than interest related to intangible assets). S.B. 5725 also amended the expense disallowance provision related to royalties, expanding the definition of royalties to include payments related to the use of patents and amending the exceptions available from disallowance. Specifically, S.B. 5725

18

removes a provision contained in A.2106, which provided an exception from addback if the related party payments were made for a valid business purpose and pursuant to a contract that reflected arm’s length interest and terms. As amended, only two exceptions are provided from royalty addback: 1) if the taxpayer has a valid business purpose and the related member pays the royalty to a non-related member during the tax year pursuant to arm’s length terms; and 2) a new exception is added where the royalty payments are paid to a related member organized under the laws of a country with a comprehensive income tax treaty with the U.S. and the royalties are taxed in that country at a tax rate at least equal to the rate imposed in New York. d.

Ohio: Recently enacted legislation revises the discretionary authority of the Tax Commissioner to adjust “sham transactions.” Am. Sub. H.B. 95 (Jun. 26, 2003). The legislation created new Ohio Rev. Code § 5703.56, which shifts the burden of proof (preponderance of the evidence) from the Commissioner to the taxpayer in cases where the Commissioner disregards sham transactions between members of a controlled group. The burden of proof remains with the Commissioner with regard to sham transactions involving unrelated taxpayers. A controlled group is defined as direct/indirect control of over fifty percent, based on ownership of common stock or other equity with voting rights. The legislation repeals Ohio Rev. Code § 5733.111 which granted the Commissioner discretionary authority to use the equitable doctrines but did not differentiate between related party and third party transactions and imposed the burden on the Commissioner. The legislation also doubles the statute of limitations in situations in which the Commissioner has disregarded a sham transaction. The legislation became effective immediately.

e.

Oregon: A recently promulgated regulation imposes a related party expense disallowance requirement for Oregon tax purposes. Ore. Admin. Code § 150-314.295 (effective Dec. 31, 2003). While Oregon is a unitary combined reporting state, the regulation targets royalty payments to related parties excluded from the combined report. An example contained in the regulation

19

specifically references trademarks licensed to an Oregon taxpayer from a Bermuda subsidiary. The requirement is triggered where both the owner and user of the intangible asset are owned by the same interests, as defined in Treas. Reg. §1.469-4T, and separation of the ownership and use of the intangible asset has no effect on the operations of the user other than the payment of the royalty. 2.

Related Party Decisions and Administrative Developments a.

Indiana: The Department of State Revenue has ruled that out-of-state trademark licensing companies could be required to file a unitary combined report with affiliated Indiana taxpayer corporations. Letter of Findings 00-0379 (Ind. Dept. of State Rev. Feb. 1, 2004). The Department upheld the auditor’s used of forced combination but also noted that it would have been equally appropriate to invoke the sham transaction doctrine to disregard the in-state taxpayer’s deductions for payments made to the intangible company. The ruling noted that the transaction was solely motivated by tax considerations, and the transfer of intangibles and royalty payments were illusory because, respectively, the trademarks had no value apart from the taxpayer’s goodwill and the taxpayer was thus making substantial payments for something with no value. The ruling acknowledged the taxpayer’s right to structure its business affairs as it sees fit; however, it also noted the Department’s right to invoke substance over form. Previously, in Letter of Findings 01-0132 (Oct. 1, 2003), the Department imposed forced combination, notwithstanding the fact that the taxpayers obtained valuation and transfer pricing studies. In contrast, the Department has employed other approaches in previous rulings. See Letter of Findings 95-0401 (Jun. 2002) (economic nexus), Letter of Findings 01-0063S (Feb. 21, 2003) (expense disallowance).

b.

Maryland: The state’s highest court has held that taxpayers’ trademark licensing subsidiaries were subject to Maryland tax. Comptroller of the Treasury v. SYL, Inc., Comptroller v. Crown Cork & Seal Company (Delaware), Inc. Nos. 76 & 80, (June 9, 2003). The decision overturned rulings by the Maryland Circuit

20

Court, which had found that jurisdiction could not be exerted over an entity based on a unitary nexus theory if the entity lacked a physical presence in Maryland unless such entity was found to be a “phantom.” The lower court had found the subsidiaries to be separate business entities and not phantoms. On appeal, the court ruled that the records demonstrated a lack of economic substance. The court specifically found that the subsidiaries were phantoms, and subjected them to tax based on their parents’ apportionment factors. The court failed to address physical presence issues, instead simply collapsing the structure. Although the Court discussed Geoffrey, and the New Mexico Kmart Properties decision, it did not base its decision on these cases or apply economic nexus. Thus the decision could arguably be limited to “naked” intangible holding company-type structures. The SYL decision involved the same taxpayer and transactions as the Massachusetts Syms decision. The U.S. Supreme Court has denied the taxpayers’ writs of certiorari in both decisions. c.

Massachusetts: The Massachusetts Supreme Judicial Court affirmed an Appellate Tax Board decision that permitted imposition of the step transaction doctrine to negate a transfer of intangibles prior to the sale of a subsidiary. General Mills, Inc. v. Commissioner of Revenue, SJC-08935 (Sept. 15, 2003). The court held that the pre-sale transaction lacked economic effect. The subsidiary had transferred its trademarks to a newly created Delaware holding company immediately prior to the sale of the subsidiary to a third party. Subsequently, the subsidiary and the DHC were sold to a third party. The court held that the taxpayer could not reduce its gain on the sale of the subsidiary by transferring its valuable intangibles to a no-tax jurisdiction. The court upheld the ATB’s reallocation of the gain to the subsidiary, which was domiciled in Massachusetts.

d.

Massachusetts: The Massachusetts Appellate Tax Board has held that a taxpayer could deduct royalty payments made to an affiliated entity for the use of trademarks and similar intellectual property. Cambridge Brands, Inc. v. Commissioner of Revenue, No. C259013 (Jul. 16, 2003). The ruling involved an

21

asset purchase (from an unrelated party) of candy trademarks and a factory. The purchaser initially held the trademarks and later placed them in a subsidiary that held all its intellectual property, while it placed the factory in a newly formed manufacturing subsidiary (i.e., the taxpayer). The manufacturer thereafter licensed the trademarks from the parent company/subsidiary. In allowing the royalty deductions, the Board determined that the licensing arrangement had both a valid business purpose and economic substance. The Board was influenced by the fact that the deductions did not result from a typical intangible holding company scenario. The Board found that the separation in ownership between the trademarks and the factory helped to establish economic effect. The Board also cited a number of other factors: the lack of a circular flow of cash; the fact that both the taxpayer and the licensor conducted active businesses; and the assumption of all trademark related expenses by the licensor, rather than the licensee. e.

New York City: The New York City Tax Appeals Tribunal has affirmed a 1999 administrative law judge ruling which held that, for New York City general corporation tax (GCT) purposes, the Geoffrey trademark licensing company and two other affiliates were not required to be combined with the Toys R Us entities subject to the City tax. Matter of Toys “R” Us – NYTEX, Inc., TAT (E) 93-1039 (GC) (N.Y.C. Tax App. Trib. Jan. 14, 2004). The Tribunal found the taxpayer had sufficiently established that the royalties were priced at arm’s-length, and the City did not adequately rebut this showing. Although the Tribunal agreed that the taxpayer had satisfied the three presumptive criteria for combination, the Tribunal also agreed with the ALJ’s determination that the taxpayer successfully rebutted the presumption by establishing that the royalty rates were arm’s-length. The Tribunal rejected the City’s attempt to inject a business purpose/economic substance requirement into the arm’s-length analysis. The ruling is favorable and is the first City precedential ruling on this issue (the City cannot appeal). However, the impact is limited by the recent enactment of related party royalty expense

22

disallowance legislation, effective for tax years beginning on or after January 1, 2003. f.

New York: New York Tax Appeals Tribunal has reversed an administrative law judge decision and, in the first state level precedential decision of its kind in New York, forcibly combined a taxpayer withy related intangible holding companies. In the Matter of SherwinWilliams, DTA No. 816712 (June 5, 2003). This decision involved the same taxpayer and transaction as the Massachusetts Supreme Judicial Court decision of the same name. The ALJ had held that the taxpayer and its subsidiaries implemented licensing transactions for valid business purposes and conducted such agreements under arm’s-length terms. Relying on the two-prong test set out in Frank Lyon Co. v. United States, 435 U.S. 561 (1978), the Tribunal held that the transactions lacked economic substance and the subsidiaries were not formed for valid business purposes. While the Tribunal mentioned the Massachusetts decision involving the same taxpayer and transactions, it did not attempt to distinguish its conflicting conclusion regarding business purpose. Rather, in examining the business purposes set forth by the taxpayer, the Tribunal found the ALJ erred in accepting them at face value, finding that the business plan lacked plausibility and the business purposes lacked independent merit (other than tax avoidance). Similarly, the Tribunal felt the ALJ’s reliance on expert testimony regarding the arm’s-length nature of the transactions was in error.

g.

Virginia: An administrative ruling found that royalties paid to a trademark licensing subsidiary lacked economic substance and business purpose and did not reflect arm’s-length rates. Ruling of Commissioner, P.D. 03-73 (Oct. 15, 2003). The taxpayer was a major retailer. The Commissioner rejected the three methodologies offered by the taxpayer to support arm’s length pricing. Addressing the residual profit method, the Commissioner concluded that the taxpayer’s higher than industry average margin was due to various economies of scale attributable to being one of the leading retailers in the country, rather than to the trademarks. The Commissioner noted that the royalty rate used in a similar licensing agreement between the

23

taxpayer and an unrelated foreign corporation was onefifth the rate the taxpayer was paying to the trademark licensing subsidiary. The Commissioner also determined that, even if the royalties reflected arm’slength rates, the deduction would not be sustainable. The taxpayer used the intangibles as collateral for outside financing, even after they were transferred to the licensing subsidiary, and there were no standards in place for quality control of the intangibles. h.

B.

Virginia: The Department of Taxation has ruled that an accounts receivable factoring company was properly consolidated with related corporations for Virginia corporate tax purposes. Rulings of Commissioner, P.D. 03-56, 03-57 (Aug. 8, 2003). The Department found that the factoring transactions were not conducted in accordance with arm’s-length terms and the factoring company lacked economic substance. The Department noted that the collection activities with respect to outstanding receivables were performed by the taxpayer even after transfer of the receivables to the factoring company, and concluded that the $1,000 fee paid by the factoring company to the taxpayer for collection and administration services was inadequate to cover the costs of collection. The Department also cited the lack of arm’s length dealing in intercompany loans between the taxpayer and the factoring company, such as the lack of actual payments, the absence of nonpayment penalties, and the fact that the loans were not collateralized.

Tax Base and Credits 1.

Tax Base a.

California: Legislation has been enacted that amends Cal. Rev. & Tax. Code § 23051.5(e)(3) to provide that federal elections made prior to becoming a California taxpayer will be binding for California tax purposes and that taxpayers cannot make a separate California election unless the separate election is expressly authorized under California law. S.B. 1065 (Sept. 22, 2003). Conversely, a taxpayer cannot make an election for California purposes if it did not make the election for federal purposes prior to becoming a California

24

taxpayer, unless the separate election is expressly authorized under California law. The legislation does not, however, eliminate the right of existing California taxpayers to file separate elections with the Franchise Tax Board (FTB) under Cal. Rev. & Tax. Code § 23051.5(e)(3)(A). Thus, the legislation appears to preserve the right of taxpayers to opt in or out of federal elections, such as IRC § 338(h)(10) and 338(g), without regard to their federal tax treatment of the underlying transactions. The legislation states that it codifies existing FTB practice. 2.

Deductions a.

California: The State Board of Equalization has disallowed a portion of a taxpayer’s interest expense deduction as attributable to nontaxable income under Cal. Rev. & Tax Code § 24425. American General Realty Investment Corp., No. 156726 (Jun. 25, 2003). The income was the dividend from the taxpayer’s insurance subsidiary (which was properly excluded from the combined group). The SBE upheld the disallowance of a portion of the unitary group’s total interest expense based on the ratio that the nontaxable insurance subsidiary dividend bore to the taxpayer’s entire gross income. Following Appeal of Zenith National Insurance Corp., 98-SBE-001, the SBE applied federal Revenue Procedure 72-18, which clarifies expense disallowance for IRC § 265 purposes. The SBE noted that under Rev. Proc. 72-18, if a taxpayer assumes debt and owns assets that generate nontaxable income at the same time, there is an inference that the purpose of the debt is, in part, to generate nontaxable income because the taxpayer could sell its nontaxable income bearing asset to fund its business needs, rather than incurring debt for working capital purposes. The SBE ruled that the taxpayer failed to establish a non-tax business purpose sufficient to rebut this presumption, concluding that it preferred to incur debt rather than sell the insurance company stock.

b.

New York: An administrative law judge with the Division of Tax Appeals has held that an adjustment to a taxpayer’s net income also reduced its subsequent net operating loss (NOL) carryfoward deductions. Petition

25

of New York Funeral Chapels, Inc., No. 818854 (Jul. 3, 2003). Under audit, the taxpayer had agreed to an adjustment reducing its intercompany management fee and interest expenses. This adjustment took the taxpayer from an NOL position to a net income position for the audit years, and its subsequent NOL carryforward deductions were reduced accordingly. The ALJ noted that even though the taxpayer agreed to the adjustment, an $8 million adjustment indicated that the taxpayer’s income was distorted and warranted adjustment. The ALJ also rejected the taxpayer’s argument that IRC § 172 must be applied for New York tax purposes. N.Y. Tax Code § 208(9)(f) defines an NOL to be “presumably” the same as a taxpayer’s NOL under IRC § 172. The ALJ held that the auditor’s valid exercise of its discretionary authority to adjust the taxpayer’s expenses was sufficient to overcome the presumption of conformity to the federal NOL. 3.

Credits a.

Connecticut: A Connecticut Superior Court has ruled that the corporate partners of a partnership operating in Connecticut were entitled to utilize an income tax credit that would have inured to the partnership if it had been a taxable entity. Bell Atlantic NYNEX Mobile, Inc. v. Commissioner of Revenue Services, No. CV 010511279S (Jul. 17, 2003). The credit was a corporation business tax credit for personal property taxes paid on certain types of electronic data processing equipment (computers, printers, and similar property). The court concluded that since business tax credits may be separately stated items for federal tax purposes, the Connecticut credit should maintain its identity and be passed through to the corporate partners as a credit for Connecticut corporation business tax purposes.

b.

New York: A recently issued ruling implies that outof-state manufacturing activities may be taken into account in determining eligibility for a credit available to manufacturers. TSB-A-03(6)C, (Jun. 11, 2003). Under New York law, an industrial or manufacturing business (IMB) may take a corporate income tax credit for certain New York utility taxes paid by it, or passed through to it, for the use of gas, electricity, steam,

26

water, or refrigeration in the state. The taxpayer was headquartered in New York, but all its manufacturing activity was located in Connecticut. The ruling stated that the IMB determination is based on a corporation’s entire business within and without New York. c.

North Carolina: The Tax Review Board has ruled that machinery and equipment placed into service at a taxpayer’s North Carolina research and development facility was eligible for a William S. Lee franchise tax credit for manufacturing equipment. Admin. Decision No. 410, N.C. Tax Review Board (Jul. 22, 2003). The credit is applicable to machinery and equipment used in manufacturing, processing, warehousing and distribution, or data processing. The ruling does not explain why the credit was disallowed on audit, although it appears to have been based on the use of the property for R&D purposes, rather than the direct manufacturing of the taxpayer’s goods. The ruling concluded that the R&D activities conducted by the taxpayer in North Carolina were necessary, inseparable, and integral parts of the taxpayer’s primary business of manufacturing. The ruling did not state whether actual manufacturing was conducted in North Carolina or another state(s); nor did it specify that in-state manufacturing was required to claim a credit for R&D equipment.

d.

Oregon: Recently enacted legislation expands eligibility for the income tax credit for qualified research expenses and raises the maximum credit. H.B. 3183 (Aug. 29, 2003). Under existing law, a taxpayer was only eligible for the credit if it was engaged in the fields of advanced computing, advanced materials, biotechnology, electronic device technology, environmental technology or straw utilization. The statute was amended to delete all references to those particular industries. Thus, the legislation removes the restriction of the credit to high-tech businesses and allows taxpayers engaged in other industries, such as manufacturing, to claim the credit. In addition, the legislation increases the maximum credit to $750,000 from $500,000. The amendment is effective for tax years beginning on or after 2006.

27

C.

Allocation and Apportionment 1.

Indiana: A recent administrative ruling provided that, because a limited partner is not permitted to exercise control over a partnership in which it holds an interest, that interest could not be considered operational for apportionment purposes. Letter of Findings 00-0379 (Ind. Dept. of State Rev. Feb. 1, 2004). Accordingly, pursuant to the rationale of the ruling, all gains and losses held by limited partners should be considered nonbusiness income. This ruling involved a loss incurred by a limited partner; therefore the ruling was not favorable for this particular taxpayer. However, if applied to non-Indiana-based taxpayers with limited partnership interests, the ruling could result in favorable allocation treatment of partnership income.

2.

Massachusetts: The Supreme Judicial Court has upheld an Appellate Tax Board ruling that the gain realized by a corporation on the sale of a subsidiary was not subject to tax. The court also upheld the ATB’s imposition of the step transaction doctrine to negate a transfer of intangibles prior to the sale of a second subsidiary. General Mills, Inc. v. Commissioner of Revenue, SJC-08935 (Sept. 15, 2003). In the first transaction, the court held that the taxpayer, a food products manufacturer, was not required to include the gain from the sale of an apparel subsidiary in its apportionable tax base because the subsidiary was not unitary with the taxpayer. The court noted that there was no day-to-day management of the subsidiary, despite some overlapping directors. The taxpayer did provide limited administrative support with respect to major capital funding decisions; however, this was insufficient to establish centralized management. The court also found that the subsidiary’s ability to borrow from the taxpayer on demand did not establish a flow of value where all intercompany transactions were conducted at arm’s-length.

3.

Massachusetts: The Massachusetts Court of Appeals has held that capital gains earned by an out-of-state chemical manufacturer from the sale of stock in several subsidiaries were not subject to the corporate excise tax. W.R. Grace & Co. v. Commissioner of Revenue, No.00-P-254 (Jul. 2, 2003). The court’s ruling partially upholds a decision of the Appellate Tax Board. W.R. Grace & Co. v. Commissioner of Revenue, Dkt. No. F239586 (Nov. 19, 1999). The court ruled, under an AlliedSignal analysis, that the subsidiaries and the taxpayer were not unitary. The subsidiaries and the taxpayer were engaged in

28

different lines of business, and the taxpayer did not exercise actual managerial control over the subsidiaries, although it did exercise supervisory oversight. The court held that the taxpayer’s oversight did not establish centralized management and did not exceed the supervision a corporation would exert over an investment in a subsidiary. Furthermore, shared services, including cash management, were provided under arm’s length terms. However, the court held that intercompany transactions undertaken at arm’s length do not result in a flow of value sufficient to establish unity. 4.

Missouri: The Administrative Hearing Commission has ruled that a taxpayer could exclude (i.e., allocate) intercompany interest income from its Ohio-based parent in the calculation of taxable income subject to apportionment. Medicine Shoppe International, Inc. v. Director of Revenue, No. 02-1071 RI (Dec. 23, 2003). The interest was attributable to an investment agreement between the taxpayer and its parent corporation, involving a daily sweep of the taxpayer’s cash accounts and investment by the parent of funds that exceeded the taxpayer’s business needs. The taxpayer had no control over the investment of the funds, although it was entitled to draw down on the investment account at any time (it never did). The taxpayer reported its Missouri tax using the single-factor method, in which the numerator of the factor is calculated as the sum of the taxpayer’s Missouri sales plus fifty percent of its sales partially within and partially without Missouri. Since the taxpayer did not materially participate in the investment of the funds and had no control over them, the Commission held that the income was attributable to a passive investment with no connection to Missouri. Despite the close relationship between the taxpayer and the parent, the Commission rejected the Director’s “attributional”/alter ego type argument that the taxpayer should be deemed to have actively participated in the investment of the funds. Citing to Acme Royalty Co. v. Director of Revenue, 96 S.W.3d 72 (Mo. banc 2002), the Commission stated that the companies were distinct business entities, and the investment agreement had a legitimate business purpose other than tax avoidance.

29

D.

Apportionment Issues 1.

Sales Factor Composition a.

California: The Franchise Tax Board has issued a legal ruling stating that dividends should be excluded from a taxpayer’s sales factor unless it participates in the management or operations of the distributing company. Legal Ruling 2003-3 (Dec. 4, 2003). The ruling addresses apportionable dividends distributed by a non-member the taxpayer’s combined reporting group. The FTB cited California statutes and regulations (which are based on UDITPA/MTC regulations) which provide that: 1) the mere holding of an intangible is not an income producing activity; and, 2) income not readily attributable to a specific income producing activity is excluded from the numerator and denominator of the sales factor. Although many states have similar apportionment language, this “throwout” rule is not commonly enforced in other states, in this context. While some states exclude certain types of passive income from the sales factor, many would include business income dividends in the sales factor and source the income to the recipient’s commercial domicile. The ruling also specifies that exercising voting rights, receipt or review of material normally sent to stockholders, and accounting for the receipt of dividend income would not be sufficient to establish participation, whereas representation on the distributing company’s board of directors or involvement in its business decisions may suffice.

b.

Louisiana: The Department of Revenue has ruled that the federal gasoline excise tax should be included in the sales factor for income and franchise tax purposes. Rev. Ruling No. 03-005 (Aug. 22, 2003). Unlike UDITPA, where the sales factor is based on gross receipts, the Louisiana sales factors are based on “net sales.” Nevertheless, the Department ruled that the incidence of the federal gasoline excise tax is on the seller, rather than the purchaser and held that, if sellers pass the tax on to consumers in separately stated charges, the tax should be included in the sales factor for both income and franchise tax purposes.

30

2.

c.

Ohio: Recently enacted legislation excludes certain types of income from the sales factor and changes the sourcing rules for Ohio franchise and corporate income tax purposes. 2003 H.B. 127 (Dec. 11, 2003). H.B. 127 requires that receipts from and/or gains and losses attributable to: (1) dividends and distributions; (2) interest; (3) and other “excluded assets” must be excluded from both the numerator and the denominator of the sales factor. Excluded assets are defined as capital assets or IRC §1231 assets (both of which were already excluded from the sales factor for Ohio apportionment purposes) as well as intangible property other than trademarks, patents (and similar assets). Thus intellectual property related receipts remain in the Ohio sales factor. The legislation states that it is effective immediately. According to Ohio case law, the changes contained therein should not impact taxpayers with taxable years ending prior to the date of enactment. However, taxpayers with taxable years ending on or after the date the legislation was signed, December 11, 2003, should apply the changes retroactively for the entire taxable year.

d.

Wisconsin: Recently enacted legislation will phase in a single sales factor apportionment formula over the next five years. S.B. 197 (Jul. 31, 2003). Under current law, Wisconsin employs a three-factor formula with a double weighted sales factor. Under S.B. 197, the apportionment formula will continue to be based on a double weighted sales factor until tax years beginning in 2006, at which point the sales factor will be weighted at 60 percent. The sales factor will increase to 80 percent in 2007 and will be fully phased in for tax years beginning on or after January 1, 2008.

Sales Factor Sourcing Issues a.

New York: A recent administrative ruling rejected a taxpayer’s attempt to source royalty income based on the location where the licensees manufactured the property that used the taxpayer’s intellectual property, rather than the business address of the licensee. Matter of Disney Enterprises, Inc., DTA No. 818378 (Feb. 12, 2004). Since much of that property was manufactured outside the U.S., the position sought by the taxpayer

31

would have resulted in significant factor dilution. The ALJ concluded that, since royalties were calculated based on the licensees’ sales of products that used the taxpayer’s intellectual property, the location of the manufacturing activity was irrelevant to the taxpayer’s income stream. The ALJ noted that, while the most accurate method of sourcing would be based on the location of the sales underlying the royalties, in the absence of this information, the licensees’ business addresses were a sufficient substitute. b.

Ohio: Recently enacted legislation excludes certain types of passive income from the sales factor and shifts the state from a cost of performance approach to a market state rule with regard to apportionment of certain receipts. 2003 H.B. 127 (Dec. 11, 2003). Prior to enactment of the legislation, sales other than sales of tangible personal property were sourced based on the location of the income producing activity, as measured by the seller’s costs of performance. H.B. 127 repeals the income producing activity/cost of performance rule and replaces it with specific rules regarding the sourcing of intangibles and services. Under the legislation, receipts from intellectual property (trademarks, tradenames, etc.) are sourced to Ohio to the extent that the receipts are based on use of property or the right to use the property in the state, and receipts attributable to services will now be sourced to Ohio on a pro rata basis, to the extent the services are used by the purchaser in Ohio or the benefit of the services are received by the purchaser in Ohio. The legislation explicitly states that the physical location where the purchaser uses or receives services shall be paramount in determining the proportion of the benefit attributable to Ohio. The legislation states that it is effective immediately. According to Ohio case law, the changes contained therein should not impact taxpayers with taxable years ending prior to the date of enactment. However, taxpayers with taxable years ending on or after the date the legislation was signed, December 11, 2003, should apply the changes retroactively for the entire taxable year.

c.

Virginia: The Department of Taxation has ruled that a company commercially domiciled and headquartered in

32

Virginia was not required to include income from the sale of manufacturing contracts sold in conjunction with the sale of the taxpayer’s manufacturing division in the numerator of its Virginia sales factor. Ruling of Commissioner P.D. 03-78 (Nov. 3, 2003). Under Virginia’s long-standing interpretation of the cost of performance rule, income from intangibles and services are sourced to the state when the costs of performance in Virginia exceed the costs of performance outside Virginia. The Department concluded that although approval of the sale of the division occurred at the taxpayer’s Virginia headquarters, the negotiation and closing of the sale occurred in the purchaser’s state, and the due diligence and accounting functions performed in connection with the sale occurred in the state where the facility was located. However, the ruling did conclude that interest earned by the taxpayer’s divisions located outside the state and patent royalties earned by the manufacturing division were attributable to the taxpayer’s Virginia domicile. 3.

“Gross Versus Net” a.

California: The Sacramento County Superior Court has ruled that a taxpayer could not include the return of principal from investments in short-term securities in the denominator of its California sales factor. Toy "R" Us, Inc. v. Franchise Tax Board, No. 01AS04316 (Aug. 21, 2003). The court held that the receipts were not derived from the “sale” of anything. The court characterized the taxpayer’s short-term investment activity as an ancillary service of loaning out temporarily unneeded cash in return for interest. The court also explained that the sales factor is designed to reflect the market for a taxpayer’s goods or services. As such, the court ruled that, because the return of principal was not related to the taxpayer’s primary function of selling toys, it should be excluded from the sales factor. The also court noted that the inclusion of the gross receipts in this instance would lead to unreasonable and absurd results. The court did acknowledge that other state courts have held differently. However, it noted that those states’ legislatures subsequently amended their sales factor definitions to arrive at the same conclusion to be rendered by the court in this case. Unlike many of the 33

previous California controversies involving this issue, the instant case involved a taxpayer seeking a refund rather than responding to an audit adjustment. b.

4.

California: A California Superior Court has ruled that a taxpayer may include gross receipts (rather than net income) from the sale of marketable securities by its Washington-based treasury department in the denominator of its California sales factor. Microsoft Corp. v. Franchise Tax Board, No. 400444 (Super. Ct. of City and Cty of San Francisco, Sept. 9, 2003). The court cited the plain language of Cal. Rev. & Tax Code §§ 25134 and 25120, which indicate that “sales” for purposes of the sales factor include gross receipts. The court also noted that the FTB is currently seeking to implement changes to the current law that would require treasury function receipts to be included in the sales factor on a net basis (i.e., modeled after the MTC regulation). Based on the fact that the FTB was seeking this change, the court concluded that existing law must require the inclusion of Microsoft’s gross receipts from treasury function investments. The court also held that the FTB presented no evidence to support an alternative apportionment formula under Cal. Rev. & Tax Code § 25137.

Property Factor a.

New York: A recent administrative ruling addressed the property factor treatment of film masters owned by a taxpayer. Matter of Disney Enterprises, Inc., DTA No. 818378 (Feb. 12, 2004). The taxpayer disputed the valuation of its film masters at cost for property factor purposes. The film masters, the original versions of the taxpayer’s classic films, were worth billions of dollars. However, the ruling concluded that the film masters could not be included in the property factor at market value, because the difference between the cost and market values of the films was attributable to the right to reproduce the films, which was a “copyright” - - - an intangible asset which could not be included in the property factor. The same ruling also provided that the taxpayer was not entitled to property factor representation for intangible property licensed to third

34

parties, which generated substantial revenue for the taxpayer. 5.

Payroll Factor a.

6.

Pennsylvania: The Commonwealth Court has held that a taxpayer could not include a payroll factor in its apportionment formula for corporate net income or franchise tax purposes where all business of the taxpayer was conducted by employees of affiliated companies and independent contractors. UPS Worldwide Forwarding, Inc. v. Commonwealth of Pennsylvania, Nos. 62-65 F.R. 2001 (Pa. Commw. Ct. Mar. 1, 2004). The taxpayer recorded payroll expenses related to employees furnished by an affiliated corporation; however, it had no written employment agreement with the corporation. Furthermore, the taxpayer had stipulated that it had “no employees.” The court noted that “compensation” is defined for payroll factor purposes as amounts paid to “employees.” Since the taxpayer stipulated that it had no employees, it had no compensation and thus had a zero payroll factor denominator (i.e., no payroll factor). The court distinguished a Pennsylvania Supreme Court decision with a similar fact pattern, in which furnished personnel were found to be employees, there was a written employment agreement between the affiliates, and the taxpayer controlled the employees.

Other a.

New York: A transaction treated by a taxpayer as a financing arrangement was recast as an actual sale requiring sales and property factor representation. Petition of CS Integrated, LLC, LLC, DTA No. 17548 (Tax App. Trib. Nov. 20, 2003). The taxpayer operated a warehouse in which food retailers stored their inventory. In order to assist a customer that experienced financial difficulty, the taxpayer purchased the customer’s inventory and resold it to the customer at cost plus a carrying charge, rather than merely lending money to the customer. An ALJ had ruled that the transactions constituted a financing agreement, rather than an actual purchase and sale of inventory. Since the ALJ had found that the taxpayer did not actually

35

purchase the customer’s inventory, it was not required to include it in its property factor. On appeal, the Tribunal concluded that the transaction was an actual sale, and thus must be reflected in both the sales and property factors. The Tribunal noted that several indicia of a sale were present: the taxpayer took legal title and possession of the inventory and bore risk of loss while it owned the inventory. The Tribunal also ruled that the sales factor must include the gross proceeds from the sale of the inventory rather than the net income (i.e., the carrying charge). There is some conflicting guidance on this issue in New York.

E.

Filing Methods 1.

Inclusion in the Unitary Business Group a.

California: Recent legislation changes the water’sedge election, effective for taxable years beginning on or after January 1, 2003, from a contractual election to a statutory election. S.B. 1061 (Sept. 30, 2003). Under new Cal. Rev. & Tax. Code § 25113, the water’s-edge election will now be made by filing a timely return in which tax is computed by including the income and apportionment factors of the members of the water’sedge unitary combined reporting group and by using an election form to be prescribed by the FTB. While the election must still be made by all members of the group, the failure of one or more members to make the election will not forfeit the election for the entire group, as long as the parent corporation includes the non-electing members’ incomes and factors in its combined report. The period of the water’s-edge election remains eighty-four months. Taxpayers with existing contractual elections will be “switched” to the § 25113 election procedures, although the start date of their elections will be maintained for purposes of computing the eighty-four month period. An election under the new provisions may be terminated without approval of the FTB at the end of eighty-four months usage. Early termination may be obtained with the consent of the FTB. Taxpayers that terminate their elections (with or without the consent of the FTB) cannot re-elect water’s-edge reporting for another

36

eighty-four months, although this restriction may be waived by the FTB for good cause. b.

California: The State Board of Equalization has ruled that three U.S. members of a multinational conglomerate were not unitary with their foreign grandparent corporations, and granted the taxpayer’s refund request. Appeal of Conopco, No. 129732 (Aug. 6, 2003). The ruling provided no analysis on the part of the SBE, but did set forth the positions of both the taxpayer and the FTB. The taxpayer’s arguments against unity focused on the autonomous nature of the U.S. subsidiaries, claiming that oversight by the foreign parents was limited to stewardship activities, such as appointing top managers and approving budgets. The taxpayer also noted the absence of centralized administrative functions (other than limited common research activities), arm’s-length intercompany transactions, minimal intercompany transfers of personnel, and the production of defined brands and products by the U.S. subsidiaries. The FTB claimed that there was central policy-making coordination, an extensive research and development network, shared knowledge and expertise, and an integrated management network aided by an organization-wide management training college. Apparently, the taxpayer’s position was ultimately more persuasive.

c.

Illinois: The United States Court of Appeal for the Seventh Circuit has held that a taxpayer must exclude an affiliate that was engaged in a different line of business from its unitary group. In re: Envirodyne Industries, Inc., No. 02-1632 (Jan. 6, 2004). The matter came to the court on appeal from a bankruptcy court ruling. That ruling involved a claim filed by the Illinois Department of Revenue for additional taxes assessed after excluding the affiliated loss company from the taxpayer’s Illinois unitary combined reporting group. The in-state taxpayer and the loss company were engaged in two different lines of manufacturing, food packaging materials and steel, but both were owned by the same parent corporation. The court depicted the two entities as spokes of the same wheel without a rim (i.e., the parent corporation). The court noted that the parent was functionally integrated with each of the two

37

lines of business but that the two companies were not integrated with each other. The court also stated that the companies were not dependent on and did not contribute to each other, even though the dependency and contribution test was satisfied by each company with respect to the parent. While the decision could have favorable implications for some taxpayers, there is existing, binding Illinois case law that may be seen as inconsistent with this holding. 2.

Issues Involving 80/20 Companies a.

3

Illinois: An Illinois appellate court has held that two foreign intangible holding companies must be included in a taxpayer’s Illinois combined report. Zebra Technologies Corp. v. Topinka, No. 1-01-2861, 1-020386 (Ill. Ct. App. 1st Div. Aug. 11, 2003). The ruling upheld a lower court decision that the taxpayer’s two Bermuda subsidiaries, established to hold and license the taxpayer’s trademarks and other intellectual property, failed to qualify for the statutory “80/20” exclusion from the Illinois combined reporting group. All the subsidiaries’ property and their sole employee were located in Bermuda. However, the court held that less than 80 percent of the subsidiaries’ payroll was located outside the U.S., because the taxpayer had retained responsibility for the quality control of the subsidiaries’ intellectual property and performed quality control activities in Illinois, at no cost. The court upheld the lower court’s imputation of the taxpayer’s activities to the subsidiary to cause the subsidiaries to fail the 80/20 test. Interestingly, the court agreed with the lower court that the subsidiaries were formed for a genuine economic purpose. Nevertheless, since the 80/20 exception was not otherwise satisfied, the economic substance of the subsidiaries was not determinative of the issue.

Special Industries a.

New York: The Department of Taxation and Finance has ruled that a bank subsidiary’s 1985 election to be taxed under the corporation franchise tax article would terminate if it reincorporated in another state in a transaction that qualified for tax-free treatment under

38

IRC § 368(a)(1)(F). TSB-A-03(12)C (Nov. 6, 2003). For New York tax purposes, corporations subject to the bank tax under Article 32 were permitted to make a one-time election for their 1984 taxable years if they wished to continue paying tax under Article 9-A, the general corporation franchise tax. The Department ruled that reincorporation in another state would terminate the taxpayer’s one-time election because the transaction would cause the dissolution of the electing taxpayer and the formation of a new corporation to which the election would not carry over. The Department relied on IRC §368 and accompanying regulations, which characterize “F reorganizations” as involving two distinct corporations.

F.

Franchise and Net Worth Taxes 1

Louisiana: A Louisiana appellate court has held that payments made by a taxpayer under numerous long-term lease agreements did not constitute “borrowed capital” includable in the franchise tax base. System Fuels, Inc. v. Dept. of Revenue, No. CA 1723 (La. Ct. App. 1st Cir. Jun. 27, 2003). Borrowed capital includes all long-term (greater than one year) indebtedness of a corporation. The leases at issue involved long-term rentals of fuel oil storage facilities and oil transport vessels. The court held that the leases were true leases, rather than financing leases, despite the inclusion of purchase options in the contracts. The court noted that the purchase options were based on fair market value rather than a bargain or nominal price. The court declined to hold that all transactions lacking a transfer of title of property should be excluded from borrowed capital (in line with the lower court decision), but did state that true leases that are not disguised credit sales would not be considered borrowed capital. The court also rejected the Department’s attempt to pull the leases into the franchise tax base as “indebtedness,” based on the inclusion of unconditional payment clauses in the rental contracts (hell or high water clauses), explaining that the clauses were not truly unconditional, because the lessor must still perform certain obligations under the lease agreements.

2

Louisiana: An appellate court has held that lease obligations, involving sale/leaseback arrangements, were not includable in the franchise tax base. Entergy Louisiana, Inc. v. Dept. of Revenue, 2003 CA 0166 (La. Ct. App. 1st Cir. Jul. 2, 2003). 39

The taxpayer sold a nuclear generating facility and leased it back from the purchaser. The court held that the sale/leaseback constituted a genuine lease, rather than a disguised credit sale. The court noted that ownership was legally transferred and, even though the taxpayer had a purchase option, it required the taxpayer to pay the fair market value of the property. The court’s rationale, while favorable to the taxpayer, contrasts with the widely accepted treatment of sale/leaseback transactions in other tax contexts. Whereas the court has held that the sale/leaseback was not a disguised credit sale, most states that have ruled on this issue have held that sales and use tax is not due on sale/leaseback transactions, precisely because they are financing vehicles rather than true leases. 3.

Missouri: The Missouri Supreme Court has held that three investment holding companies could not apportion their Missouri franchise tax bases because they employed no assets outside the state. TSI Holding Co. v. Director of Revenue, Nos. SC85179-81 (Nov. 4, 2003). The entities had no presence and conducted no business activities outside Missouri. For Missouri franchise tax purposes, apportionment is based on the percentage of a taxpayer’s accounts receivable, inventory, and fixed assets employed in the state. The taxpayers, investment companies, did not have any of the assets that are used to determine franchise tax apportionment. Accordingly, the taxpayers attempted to use an alternative apportionment formula that apportioned their franchise tax bases according to the location of their investments. Rejecting, the taxpayers’ apportionment methodology, the court explained that the right to apportion is based on where a taxpayer’s assets are employed, rather than where located. The court distinguished Union Electric Co. v. Morris, 222 S.W.2d 767 (Mo. 1949), in which a company's right to apportion was premised on ownership of two Illinois subsidiaries. In Union Electric, the court focused on the fact that the Illinois subsidiaries were wholly owned and thus controlled by the taxpayer, leading to a conclusion that the taxpayer conducted business (via the subsidiaries) outside the state. The court’s decision, the first in approximately forty years to address the issue of employment of capital, upholds a Missouri Administrative Hearing Commission ruling issued several months earlier. TSI Holding Co. v. Director of Revenue, No. 01-1828 RV (Mar. 4, 2003).

40

IV. LLCs and Other Pass-Through Entities A.

Conformity to the federal “check-the-box” regulations:

State Alabama Arizona Arkansas California Connecticut Delaware District of Columbia Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kentucky Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska New Hampshire New Jersey New York North Carolina North Dakota Ohio Oregon Pennsylvania South Carolina Tennessee Utah Vermont Virginia Wisconsin

Conformity X X X1 X X X X2 X X X3 X X X X X X X X X X4 X X X X

Non-Conformity

Partial Conformity

X5

X X X X X X X X

X6

X X X X

41

1

Arkansas Code Ann. section 4-32-1313 was amended to provide that, for Arkansas income tax purposes, an LLC will be taxed consistently with its federal tax classification. H.B. 1959, signed March 31, 2003, effective for tax years beginning on or after January 1, 2003.

2

An SMLLC is not subject to the unincorporated business franchise tax as long as it is owned by an entity subject to D.C. tax.

3

Hawaii conforms to the federal “check-the-box” regulations, but does not adopt the disregarded entity treatment of SMLLCs for the general excise tax. Hawaii Dep’t of Tax., Tax Information Release No. 97-4 (Aug. 4, 1997). In addition, license and registration requirements will still be applied at the entity level.

4

An election by a foreign (non-U.S.) single member eligible entity to be disregarded will not be respected for Minnesota purposes because Minnesota law precludes the inclusion of the apportionment factors and income of foreign entities in the Minnesota unitary combined group. Minn. Dep’t of Revenue, Revenue Notice No. 98-08 (May 28, 1998).

5

An LLC’s federal classification under “check-the-box” will generally be respected; however, single member LLCs are not disregarded for New Hampshire tax purposes. N.H. Admin. Code R. 307.01. All LLCs remain subject to the New Hampshire Business Profits Tax.

6

Legislation enacted during 1999 (H.B. 1676/S.B. 1806) broadened the Tennessee excise and franchise tax to cover limited liability entities, including all LLCs, LLPs, and LPs engaged in business in the state. B.

Alabama: The Chief Administrative Law Judge for the Alabama Department of Revenue has ruled that Alabama tax could not be imposed on a nonresident individual that owned an interest in a limited partnership conducting business in the state. Lanzi v. State of Alabama Department of Revenue, No. 02-721 (Sept. 26, 2003). The ruling involved tax years prior to 2001, the year in which Alabama began imposing a nonresident withholding obligation on limited liability entities (LLEs) doing business in the state. The ALJ’s decision was based on Due Process considerations. Citing Alabama’s adoption of the entity theory of partnerships, the ALJ held that the LP’s activities and presence in the state could not be attributed to an out-of-state investor. The ALJ distinguished the imposition of tax in this setting from an International Harvester situation in which a withholding tax is imposed on the in-state entity (which is consistent with Alabama’s current LLE taxing scheme). The decision was not based on Commerce Clause nexus. However, the ALJ did note that, while previous Alabama administrative decisions (Cerro Copper and Dial

42

Bank) applied Quill’s physical presence test in the context of income taxes, the ALJ noted his personal belief that he may have changed his position on the issue of whether Quill applies outside of the sales and use tax context. C.

New York: An administrative law judge with the Division of Tax Appeals has ruled that an S corporation shareholder was not required to divide his capital gain from the sale by the S corporation of its assets on a prorated basis between his periods of residency and nonresidency for New York personal income tax purposes. Petition of Falberg, DTA 818960 (Oct. 9, 2003). The taxpayer changed his residency from New York to Florida on July 20, 1997. The sale of the S corporation’s assets occurred on July 31, 1997. Under New York law, residents are subject to tax on their income in its entirety, while nonresidents are only subject to tax on income from New York sources. A nonresident S corporation shareholder sources the distributive share income based on the S corporation's New York sourcing, as reported to the shareholder. The audit division prorated the gain between the taxpayer’s periods of residency and nonresidency, even though the gain was generated during the period of nonresidency. Accordingly, the prorated portion of the gain attributable to the period of residency (January 1, 1997, through July 20, 1997) was taxed in full, rather than subject to tax based on the taxpayer’s application of the S corporation’s 10.4 percent business allocation percentage. The ALJ ruled that the taxpayer has the option of prorating the income or reporting it in accordance with its residency/nonresidency status on the actual date of receipt. Since the taxpayer’s income was earned after leaving the state, the ALJ ruled that the taxpayer could -- as had been reported -- assign the entire gain to the period of nonresidency. It appears that the ALJ departed from the "always-prorate" rule enunciated by the TSB-M-00(1). However, the decision is not precedential.

D.

New York: The state’s highest court, reversing an appellate decision, has held that payments made to retired partners could not be deducted for New York City unincorporated business tax purposes. Buchbinder Tunick & Co. v. Tax Appeals Tribunal, No. 84 (Jun. 26, 2003). The payments, which were made to extinguish the partners’ ownership interests in the partnership, were calculated based on unrealized receivables. Pursuant to New York City regulations, a partnership cannot deduct payments to partners for services rendered. The court ruled that the retirement payments were attributable to services rendered, rejecting the lower court’s finding that the payments represented a share of partnership revenue.

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V.

Sales and Transaction Taxes A.

Software, Telecommunications, and Digital Goods and Services 1.

Massachusetts: A recent amendment to the computer industry services and products regulation impacts resale exception claims by computer service contract providers. 830 CMR 64H.1.3 (amended Dec. 19, 2003). The amended regulation provides that a computer service contract provider that pays tax on the purchase of tangible personal property but eventually resells the property and collects tax from its customer must present the vendor with a resale certificate and request refund directly from the vendor (the vendor must then go to the state for abatement of the tax remitted). Previously, a service contract provider could claim a credit on a subsequent sales and use tax return in order to recover the extra tax. This new policy applies retroactively to sales or use taxes paid on or after January 1, 2001.

2.

Minnesota: The Minnesota Tax Court has ruled that threedimensional images provided to customers via CD-ROM, diskette, and videotape, were tangible personal property subject to tax. Dynamic Digital Design, Inc. v. Commissioner of Revenue, No. 7380-R (Jan. 14, 2004). The taxpayer developed and designed interactive computer programs, animations, and images that communicated technical information about its customers’ products, designs or concepts. The court noted that the boundaries of tangible personal property are still being defined in Minnesota, with at least two cases involving this issue currently pending before the Minnesota Supreme Court. The court analyzed the taxability of the images by reference to two existing Minnesota Supreme Court decisions, Fingerhut Products Co. v. Commissioner of Revenue, 258 N.W.2d 606 (Minn. 1977) and Zip Sort, Inc. v. Commissioner of Revenue, 567 N.W.2d 34 (Minn. 1997), that distinguished customer lists (intangibles) from labels, preprinted addresses and other items (tangible), all transferred by tangible means. The court concluded that the CD-ROMs, diskettes, and videotapes on which the images were transmitted were usable devices, and customers were paying for the form, in addition to purchasing the images. The court did acknowledge that if the images had been transferred electronically, they would not have been subject to tax. Nevertheless, it rejected the taxpayer’s

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argument that, because the images were capable of electronic transmission, they were nontaxable intangible property. 3.

Missouri: The Department of Revenue has issued a notice providing that load and leave transactions will be subject to sales and use tax. Tax Policy Notice 16: Taxability of Computer Software Load and Leave Transactions (Mo. Dept. of Rev. Jan. 9, 2004). The notice explains that the change was necessitated by the Missouri Supreme Court’s decision in Kansas City Power and Light Co. v. Director of Revenue, 83 S.W.3d 548 (Mo. banc 2002), in which the court held that transfer of title was not essential to qualify for a resale exemption, if the right to use, store, or consume property was transferred. The decision did not involve computer software, but rather a utility company’s sales of electricity to a hotel. The court found that the sales were sales for resale, because the hotel customers paid tax on the electricity used in conjunction with their rental of rooms and banquet halls. Based on the rationale of Kansas City Power and Light, the Department concluded that load and leave transactions, which involve a transfer of a right to use property, rather than a transfer of title to property should be considered “sales at retail.” Accordingly, such sales are now taxable. The notice specifies that tax must be collected regardless of whether the purchaser installs the software and returns the tangible media to the seller or the seller installs the software and leaves with the tangible media.

4.

Ohio: Ohio Am. Sub. H.B. 95, relaxes the taxation of software. The legislation, which was designed to bring Ohio into compliance with the Streamlined Sales and Use Tax Agreement, and which became effective July 1, 2003, provides that reasonable separately stated charges for modifications to prewritten (i.e., canned) software are excluded from tax. Nevertheless, Ohio Admin. Code § 5703-9-46(A)(7) provides that charges for modifications to canned software are subject to tax unless they constitute more than half of the price of the sale. In response, the Ohio Department of Taxation has issued guidance explaining that until the regulation is amended, taxpayers should follow the provisions of H.B. 95, but should remember that unless modification charges are separately stated, they will be subject to tax as prewritten software. Information Release ST 2003-06 (Jul. 2, 2003).

5.

Tennessee: The Tennessee Court of Appeals has held that a provider of internet and other computer information services

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was not performing taxable telecommunications services. Prodigy Services Corp., Inc. v. Johnson, No. M2002-00918COA-R3-CV (Aug. 12, 2003). The company used modems to provide internet access, e-mail, and other computer information services to its customers. The term telecommunications services is defined to include transmission by or through any media, and contains a nonexclusive list of potentially taxable services, none of which described the internet services at issue in the controversy. In finding that the company’s services were not included in the statute, the court relied on legislative intent, specifically the 1993 deletion from the statute of “value added networks” as a specifically identified example of telecommunications services. The court found that the legislature’s action in this regard could be construed as intended to clarify that electronic information services are not subject to tax. The court was also influenced by the fact that the company was not a regulated telecommunications service provider under Tennessee or federal law. The Tennessee Supreme Court subsequently declined to hear the Department’s appeal in this decision. In response to the court’s decision, the Department of Revenue has ordered all internet service providers and telecommunications companies to stop collecting tax from consumers on internet access. Sales and Use Tax Notice 04-03 (Jan. 30, 2004). The Notice explains that ISPs seeking refunds of taxes collected from consumers on such services must show that they refunded the tax to their retail customers. In addition, an ISP must either provide documentation that it paid sales tax on services originally purchased for resale or, alternatively, reduce its own refund by the amount of sales taxes it would have paid if it had not claimed a resale exception. However, an ISP is not permitted to similarly reduce the refunds owed to its retail customers for this amount. 6.

Virginia: The Department of Taxation has issued a ruling addressing the taxability of certain programming, consulting, travel, and administrative services provided in conjunction with the sale and modification of software. Ruling of Commissioner, P.D. 03-61 (Aug. 19, 2003). Although the outcome of the ruling was favorable for the taxpayer, the approach taken by the Department may have broader negative implications for other taxpayers. The taxpayer had entered into two separate contracts with the same customer, one for the sale of prewritten software, and the other a software modification

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and services agreement. The taxpayer did not collect tax on the second contract since the contract did not encompass the sale of tangible personal property. However, citing to common law of contracts, the Department ruled that the contracts could be collapsed into a single contract for the sale of the prewritten software (tangible personal property), because they were executed on the same day, and the modifications were necessary to render the software useful to the customer. Despite the consolidation of the contracts, the Department ultimately ruled that the services were eligible for a specific exemption for separately stated charges for software modification and services. 7.

Wisconsin: The Tax Appeals Commission has ruled that global application software purchased by a company for use in operation of its business was exempt custom software. Menasha Corp. v. Wisconsin Dept. of Revenue, No. 01-S-72 (Dec. 1, 2003). The software cost several million dollars, contained over seventy modules, and took several years to implement. Wisconsin distinguishes prewritten and custom software for sales and use tax purposes. A regulation contains seven qualitative factors to be examined in characterizing software that evaluate the complexity and nature of the software. The Department’s policy has been to require all seven conditions to be satisfied in order for software to qualify as custom software, although the regulation does not explicitly require that all criteria must be met. Prior to this decision, neither the taxability of this type of software nor the Department’s interpretation of the regulation had been addressed in a judicial or administrative law setting, and the Department traditionally subjected this type of software to tax. However, the Commission ruled that the software did not need to satisfy all seven elements of the regulation. The Commission weighed the various factors and concluded that, based on the totality of the circumstances, the software was custom, noting the cost of the software and the significant training, testing, and maintenance required to implement the software. The Commission also explained that the crucial issue was the process required to implement the software not whether the software purchased was part of a standard package.

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B.

Exemptions 1.

Manufacturing a.

California: Recent legislation places a ceiling on the sales and use tax manufacturing credit. S.B. 1064 (Sept. 28, 2003). Cal. Rev. & Tax. Code § 6902.2 provided that in lieu of taking a manufacturer’s investment credit (MIC) against personal or corporate income taxes, an eligible taxpayer may file a sales and use tax refund claim in an amount equal to the credit that could be claimed for income tax purposes. This provision has recently been the subject of SBE rulings holding that the sales tax refund could be granted with respect to unused MIC carryovers S.B. 1064 provides that the amendments are declaratory of existing law but are effective for refund claims filed on or after August 7, 2003 (the relevant SBE rulings were issued August 6, 2003). Therefore, the sales tax refund can now no longer exceed the amount of MIC that would be allowable for corporate income tax purposes after application of all other credits. Note, the MIC expired at the end of 2003.

b.

Louisiana: Recently enacted legislation creates a state sales and use tax exemption for machinery and equipment purchased by a manufacturer if used in a plant facility predominantly and directly in the manufacture of tangible personal property for sale to another or manufacturing for agricultural purposes. The exemption does not apply to the parish level tax. H.B. 2 (Mar. 23, 2004). The exemption will be phased in over a seven-year period from 2005 through 2011. Machinery and equipment is broadly defined and expressly includes several categories of auxiliary equipments, such as: computers and software that are an integral part of machinery and equipment used in manufacturing; pollution control equipment; and certain testing equipment. However, the legislation also clarifies that structural property, HVAC, and property used to transport or store property are ineligible, and food preparation is not considered manufacturing. In order to take advantage of the exemption, a purchaser must obtain certification from the state that it qualifies as a manufacturer. While the legislation ultimately 48

provides a benefit many Louisiana purchasers currently enjoy similar sales and use tax benefits by virtue of participating in the Louisiana enterprise zone program. c.

New York: Reversing a previously issued advisory opinion, the Division of Tax Appeals has ruled that various pieces of equipment used on the premises of a retail home improvement chain were eligible for the production exemption. Matter of Lowe's Home Center, Inc., DTA No. 819043 (Mar. 11, 2004). N.Y. Tax Law § 1115(a)(12) exempts from tax equipment used in the manufacturing, processing or other production of tangible personal property for sale. The equipment involved machines used at the taxpayer’s retail facilities to cut products to the desired size for customers - timber cutting saws, carpet/vinyl cutting equipment, pipe threading/cutting equipment, glass cutting machines, window trim machines and wire measuring and coiling equipment. The ruling concluded that the equipment was used to process the property purchased by the taxpayer’s customers and rejected the Division’s argument that the property was ineligible for exemption because it had already entered the distribution phase by being displayed on the sales floor.

d.

New York: The Department of Taxation and Finance has issued an advisory opinion finding that purchases of vacuum, hydrogen, nitrogen, and water cooling systems were eligible for the manufacturing exemption even though the various systems were used to treat (i.e., heat, cool, etc.) the manufacturer’s products rather than becoming components of the products themselves. TSB-A-03(27)S (Jun. 24, 2003). Air, water, and gases used in the systems were found to be used entirely in manufacturing and integral to the manufacture of the automotive electronics. Despite the fact that the exhaust systems did not meet the statutory definition of pollution control equipment, the systems were held to be exempt from tax because the product itself would have been harmed without the operation of the exhaust system to remove noxious fumes and vapors produced during the course of the manufacturing process. Nevertheless, the ruling declined to extend the exemption to the taxpayer’s HVAC equipment, finding that it was present for the comfort of the taxpayer’s

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factory employees rather manufacturing process. e.

2.

than

integral

to

the

Tennessee: The Tennessee Court of Appeals has ruled that the industrial machinery exemption did not apply to catalysts used by a chemical manufacturer in the manufacturing process. Eastman Chemical Co. v. Chumley, No. M2002-02114-COA-R3-CV (Jan. 12, 2004). The exemption applies to “machinery, apparatus, and equipment with all associated parts, appurtenances and accessories.” The court rejected the taxpayer’s claim that the catalysts were exempt “apparatus.” The court explained that, taken together, the terms machinery, apparatus, and equipment were intended to apply the exemption to connected and interrelated devices and parts used to carry out the manufacturing process. Accordingly, the court determined that the catalysts at issue were not qualified machinery, but rather were analogous to such nontaxable items as fuel used to operate manufacturing devices or substances use to cool those devices.

Research and Development a.

New York: Reversing an administrative law judge ruling, the Tax Appeals Tribunal has held that computer equipment leased by a company for purposes of developing a cancer specimen database was not eligible for the research and development exemption. Petition of Impath, Inc., DTA No. 818143 (N.Y. Tax App. Trib. Jan. 8, 2004). The equipment was used to extract information from data the taxpayer had gathered through the performance of up to twenty tests each on thousands of cancer specimens. The tests were performed for diagnostic purposes; however, the taxpayer subsequently collated the information in order to create a database that could form conclusions and make predictions regarding future patient diagnoses and pharmaceutical development. The Tribunal found that the equipment did not qualify for exemption because the taxpayer failed to use the equipment to develop a new product or a new use for an existing product.

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3.

Intercompany Transactions a.

4.

Connecticut: Recently enacted legislation provides that otherwise taxable services cannot be purchased under a resale exemption, if they will be resold to an affiliated purchaser. H.B. 6624 (Jul. 9, 2003). Connecticut provides a statutory exemption for sales of taxable services between certain related entities. Conn. Gen. Stat. § 12-412(62). The legislation is designed to ensure that an intermediary cannot makes a purchase under a resale exemption of services that would be exempt on resale under the intercompany exemption. The legislation becomes effective October 1, 2003.

Other a.

Florida: A recent ruling provides that gases used to preserve fish and included in the container in which the fish is sold qualified for the packaging material exclusion from sales and use tax. Technical Assistance Advisement 03A-028 (Jun. 10, 2003). Under Florida law, sellers are not required to pay use tax on purchases of packaging items accompanying the sale of their products if delivery would be impracticable but for the presence of the products, and there is no separate charge for the products to the seller’s customers. Fla. Stat. § 2121.02(14)(c). A regulation lists numerous examples of types of packaging materials that might qualify for the exclusion. Fla. Admin. Code § 12A-1.040. However, the examples focus on types of containers, rather than accompanying material. The Department’s ruling demonstrates that the packaging material exclusion may encompass a broader spectrum of materials than merely containers, such as materials placed inside the containers.

b.

Ohio: A recent Ohio Supreme Court decision provides guidance on the taxability of employment services. H.R. Options, Inc. v. Zaino, 800 N.E.2d 740 (Ohio Jan. 7, 2004). For Ohio sales and use tax purposes, the provision of employment services are generally subject to tax. However, an exclusion from taxation is available for a contract of one-year or greater between a service provider and a client, if the contract specifies that the employees covered by the contract are assigned

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to the client on a permanent basis. The decision clarified that a contract between an employment services provider and its client need not explicitly state that the furnished employees’ assignments are permanent. Rather, if an employment contract contains no ending dates for the employees’ assignments, then the assignments may be deemed permanent and eligible for the exception. Nevertheless, the court noted that even if a contract contains no ending date, the services would not be eligible for the exception if the facts and circumstances revealed that the employees were provided for seasonal employment or to fill short-term workload conditions. This decision applies only to employees furnished by unrelated service providers. A separate exception exists for employment services between members of an affiliated group.

C.

Resale 1.

D.

Ohio: The Ohio Supreme Court has held that a company that tested wheels for customers was not required to pay sales or use tax on its purchases of tires and other equipment used to test the tire rims, because the equipment qualified for a resale exemption. Standards Testing Laboratories, Inc. v. Zaino, No. 98-G-617 (Nov. 12, 2003). The taxpayer purchased the equipment on behalf of its customers and did bill them for it; however, the equipment was, in most cases, not physically transferred to the customers after use. The Ohio resale exemption requires a transfer of title and/or possession of property. The court noted that when the testing company took possession of the tires and other equipment they were simultaneously delivered to its customers, thus effecting a valid title transfer for purposes of the resale exemption.

Other Taxability Issues 1.

Title Passage/Location of Sale a.

Massachusetts: The Massachusetts Supreme Judicial Court has ruled that a seller must collect sales tax on items sold in its Massachusetts stores but picked up by customers at its retail locations in New Hampshire (which has no sales and use tax). Circuit City Stores, Inc. v. Commissioner of Revenue, 790 N.E.2d 636 (Jun. 52

25, 2003). The items were paid for in full in Massachusetts, and the sales were credited to the Massachusetts stores and sales people, but the actual items were “reserved” on the computer at the store where the purchaser wished to take possession of the merchandise. The court determined that since under the Uniform Commercial Code and common law, title may pass before a purchaser takes actual possession of goods, title passed in Massachusetts. In contrast, in Neiman Marcus Group, Inc. v. Commissioner of Revenue, 26 Mass. App. Tax Bd. Rep. 316 (2001), the Appellate Tax Board held that Massachusetts sales tax was not due on sales made in Massachusetts retail stores which the purchasers requested to be shipped to a location in another state. The court dismissed the Neiman Marcus decision as only superficially similar. 2.

Leasing Issues a.

Florida: The Florida Department of Revenue has issued a technical assistance advisement which concludes that a dividend paid by a qualified S corporation subsidiary (Q-Sub) to its sole shareholder (S corporation) was actually a rental payment for use of the S corporation’s building. As such, the dividend was subject to Florida sales tax. TAA 03A-039 (Jul. 22, 2003). The taxpayer posed two alternatives to the Department, one in which a lease agreement was established for the use of the building but did not require the payment of rent, and the other in which the Q Sub would use the building without a lease. The Department ruled that, under either scenario, a dividend paid by the Q Sub to the S corporation would be taxed as rent to the extent the dividend was actually paid to the S corporation. The Department explained that, because there was real consideration flowing from the Q Sub to the S corporation, the dividend would be considered rental compensation. The Department distinguished this situation from one in which the dividend was merely an accounting entry with no actual value flowing to the shareholder.

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3.

Other a.

E.

Maryland: The Maryland Tax Court has held that federal law preempts the imposition of a use tax collection obligation on a for-hire carrier that delivered furniture in the state for a related out-of-state retailer. Royal Transport, Inc. v. Comptroller of the Treasury, Nos. 02-SU-OO-0298, 0299 (Oct. 22, 2003). The court held that the imposition of a use tax obligation on the delivery company would violate the Interstate Commerce Act (Act), which prohibits states laws “related to a price, route, or service of any motor carrier.” Citing federal case law, the court concluded that a tax collection obligation could place numerous burdens on the carrier that could be construed as additional services. Specifically, the court ruled that a delivery company required to collect use tax would be required to perform eleven additional services, including determining whether tax was due, determining whether tax had been previously collected, computing tax, collecting tax, filling out tax forms, etc. These additional services would violate the preemption clause of the Act. The court also rejected the Comptroller’s argument that the Act should not apply to the delivery company because it was affiliated with the furniture retailer. The court explained that the definition of motor carriers includes any carrier for hire.

Sourcing 1.

Texas: Recently enacted legislation modifies the way in which sales are sourced for local sales and use tax purposes. H.B. 2425 (Jun. 20, 2003). Currently, local sales and use taxes are imposed on intrastate transactions using "origin based sourcing" (i.e., order receipt location). Under H.B. 2425, sales of taxable services will now be subject to destination based sourcing. The legislation, however, does not change the local jurisdiction's sourcing rules for tangible personal property. Consequently, if a taxpayer purchases tangible personal property and taxable services from the same vendor as part of a single transaction (for example, the purchase of repair services together with the related tangible property), it may be required to source the tangible property to one locality and the services to another. The sourcing rules become effective July 1, 2004.

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F.

Drop Shipments 1.

Connecticut: The Department of Revenue Services has issued a ruling exploring the relationship between the state’s drop shipment rule and fulfillment house exemption. Ruling No. 2003-2 (May 30, 2003). Connecticut requires drop shippers with nexus in the state to collect tax when a retailer does not have a collection obligation. Conn. Gen. Stat. § 12407(a)(3)(A). The taxpayer was a distributor that used a third party warehousing and delivery agent located in Connecticut to house and transport its inventory. The taxpayer sold its products to a mail order retailer, and the agent shipped directly from the Connecticut warehouse to the retailer’s customers throughout the country. In the absence of any relevant exemption, the distributor would qualify under Connecticut law as a deemed retailer obligated to collect tax from the out-ofstate (i.e., not physically present) retailer’s customers located in Connecticut. The taxpayer/distributor argued that even though it met the deemed drop shipper requirement, it should not be required to collect tax under the fulfillment house exemption. Conn. Gen. Stat. § 12-407(a)(15)(C). The Department ruled that the scenario failed to meet the fulfillment exemption because the products were shipped to the mail order retailer’s customers, rather than the “purchaser’s” (i.e., distributor’s) customers. In addition, the distributor would not be considered to offer the products for sale, since it merely acted as a wholesaler, selling them to the mail order retailer.

2.

Kansas: Legislation which became effective July 1, 2003, imposes a sales and use tax collection obligation on certain drop shippers. Kansas H.B. 2416. The Kansas Department of Revenue recently released Notice 03-09, which clarifies the new policy. (Jun. 25, 2003). The Notice explains that when a manufacturer has nexus with Kansas but a retailer does not, the manufacturer is required to collect Kansas sales or use tax (depending on whether the shipment is made from within or without the state) on the retail price of the item. The manufacturer is considered to be a deemed retailer with respect to the drop shipment. If the manufacturer does not know or cannot reasonably determine the retail price of the goods, it is required to collect Kansas sales or use tax from the retailer based on the cost of the item. The Kansas Notice also explains that where the manufacturer uses a drop shipper it is still required to collect tax (if it has Kansas nexus) regardless of whether that second-tier drop shipper is subject to Kansas tax.

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However, if the manufacturer is not subject to tax in Kansas and the second-tier drop shipper does have nexus, it would be considered the deemed retailer.

G.

Other Transaction Taxes 1.

New York City: An administrative law judge from the New York City Tax Appeals Tribunal has ruled that imposition of the real property transfer tax (RPTT) on five out-of-state corporations did not violate the Commerce Clause of the U.S. Constitution. Matter of Corewood Enterprises, Inc., TAT(H) 00-39(RP) (Mar. 11, 2004). The ruling involved the concerted sale of stock in five lower tier corporations that indirectly owned a New York City hotel. The RPTT is imposed on the sale of real property located in the City or of a controlling economic interest in real property located in the City. The Tribunal concluded that the RPTT could be imposed on the corporations because in-state entities, including a company hired to broker the sale of the hotel, acted as agents for the corporations and thus engaged in activities in New York City sufficient to establish nexus. The Tribunal cited Tyler Pipe for the proposition that these entities engaged in market making activities attributable to the corporations for nexus purposes. The decision is not precedential.

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VI. Property Taxes A.

California: In an issue of first impression, a California court of appeal has held that rotable spare parts used by a computer hardware seller to service and repair its customers’ equipment were not exempt business inventories for purposes of the personal property tax. Amdahl Corp. v. County of Santa Clara, H025660 (Cal. Ct. App. 6th Dist. Mar. 3, 2004). The taxpayer’s customers could purchase flat fee extended services contracts, which would cover the cost of unlimited replacement parts. When spare parts were needed, the taxpayer took possession of the damaged parts, repairing and reusing them, where possible. The statutory business inventory exemption is only applicable to products sold or leased in the ordinary course of business. The court found that the rotable spare parts were not sold because: there was neither a charge nor other consideration for the replacement parts; no tax was collected on their transfer; there was no inventory reduction when a spare part was placed in service, since the taxpayer took possession of the damaged part; and, the parts were capitalized and depreciated for both income tax and book purposes. Another aspect of the decision that may impact the computer services industry dealt with the determination that the taxpayer was not a “nonprofessional service provider” for property tax purposes. Tangible personal property transferred by professional service providers is subject to tax, while such property transferred by nonprofessional service providers qualifies as exempt business inventory. The court used the example of drycleaners versus attorneys to illustrate the two categories. Noting that computer service providers fall between these classifications, the court, nevertheless, held that the their services were more accurately characterized as professional services, thus making the spare parts taxable.

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VII. Practice and Procedure A.

California: The State Board of Equalization has ruled, in a nonprecedential decision, that a federal statute of limitations extension for a taxpayer’s federal consolidated group did not extend the statute for foreign affiliates of the taxpayer that were included in its worldwide combined report but excluded from the federal consolidated return. Appeal of Magnetek, Inc., No. 198051 (Jan. 27, 2004). The instructions to the schedule (now R-7), on which members of a unitary group can elect to file a single return currently, specify that a waiver of the statute of limitations by the key corporation in a group will waive the statute for all members of the group electing the single return option. The SBE concluded that the instructions extending a waiver to all members of the group only refer to a California waiver of limitations by the key corporation and do not relate to a federal waiver.

B.

California: On October 2, 2003, legislation was signed in California that imposes certain disclosure and reporting requirements on taxpayers and tax advisors. A.B. 1601/S.B. 614. The legislation adopts IRC §§ 6011, 6111, and 6112 and the accompanying Treasury regulations for California tax purposes. The legislation imposes significant penalties for failure to comply with the requirements of the act. Under the legislation, taxpayers may voluntarily participate in a compliance program, which began January 1, 2004 and ends April 15, 2004.

C.

Texas: Recently enacted legislation authorizes the state auditor to audit any settlement, tax refund, credit, payment warrant, offset, or check issued by the Comptroller’s office. H.B. 7C (Oct. 13, 2003). The provision went into effect on February 1, 2004, and allows the state auditor to examine such items prospectively from that date forward, as well as retroactively for six years prior to the effective date. The authority granted in the legislation is not restricted to any particular type of tax. Nor does the legislation specify that the authority granted to the state auditor does or does not allow the state auditor to alter the terms of any settlement, refund, etc. However, the legislation does specify that taxpayer confidentiality will be respected in connection with these audit procedures.

The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax advisor.

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