By Stephen Burroughs

The Kentucky Board of Tax Appeals (Board) has held that Netflix’s digital streaming service is not subject to the state’s telecommunications taxes.

Kentucky’s telecommunications tax regime is comprised of three distinct taxes, each imposed on the provision of “multichannel video programming service” (MVPS). The taxes consist of a gross revenues tax, an excise tax, and a utility gross receipts license tax, all amounting to a 6.7% tax on MVPS. Kentucky defines MVPS as programming that is “generally considered comparable to programming provided by a television broadcast station.” The statutory definition also includes cable service.

The Kentucky Department of Revenue (Department) argued that the similarities between the digital content Netflix offers through its streaming service and traditional television programing justified subjecting Netflix to the tax. The Department analogized Netflix’s service to cable television’s video-on-demand. Netflix distinguished its service from the array of “linear” programming options offered by cable and broadcast television providers.

The Board focused on the dictionary definitions of “programming” and “comparable” to conclude that Netflix was not similar enough to broadcast television to justify the imposition of tax on the streaming service. The Board noted that while both Netflix and broadcast television allow consumers to watch television shows and movies, Netflix does not offer live programming, sports or news. The Board determined that on-demand television, while similar to the presentation of Netflix programming, was “only an incidental part of the broadcast and cable TV services programming” and insufficient to draw a significant comparison with Netflix’s customer interface.

Two related issues will be worth watching as this case progresses through Kentucky’s appellate system (if it is appealed). First, Kentucky’s telecommunications tax regime preempts Kentucky local governments from imposing local franchise fees on certain MVPS providers. Kentucky cities, along with the Kentucky League of Cities, have challenged the constitutionality of this local tax prohibition under the Kentucky Constitution. The Department and the Kentucky Cable Television Association argued to uphold this preemption, but an unpublished decision of the Kentucky Court of Appeals struck it down. See City of Florence, Kentucky, et al v. Flanery, No. 2013-CA-001112-MR, Nov. 7, 2014, modified by No. 11-CI-01418 (Ky. Ct. App. filed March 13, 2015) (unpub). That case now awaits a hearing date before the Kentucky Supreme Court.

Second, although Kentucky’s definition of MVPS closely tracks a similar federal regulatory definition, the Board refused to consider the federal regulatory treatment of digital streaming services. For more than a year, the Federal Communications Commission (FCC) has grappled with similar issues as it seeks to determine whether digital streaming video providers are properly classified as multichannel video programming distributors for regulatory purposes. An FCC order on the issue is expected this fall. Netflix, Inc. v. Kentucky Finance & Admin. Cabinet, Order No. K-24900 (Ky. Bd. Tax App. Sept. 23, 2015).

By Evan Hamme and Tim Gustafson

In a rare Chief Counsel Ruling (the first of 2015), the California Franchise Tax Board (FTB) held that the sale of an entire line of business qualified as an “occasional sale” for corporate franchise tax purposes, thus requiring the selling taxpayer to exclude the resulting gross receipts from its California sales factor. The taxpayer operated two lines of business and, through the transaction at issue, sold one to an unrelated party in order to focus on the other. California Code of Regulations, title 18, section 25137(c)(1)(A) requires taxpayers to exclude from the sales factor gross receipts resulting from a transaction that is both: (1) “substantial” (i.e., a 5% or greater decrease to the sales factor denominator would result from excluding the gross receipts); and (2) “occasional” (i.e., “is outside the taxpayer’s normal course of business and occurs infrequently”). The FTB found the transaction was “substantial” because excluding the gross receipts decreased the taxpayer’s denominator by approximately 33%. Adopting and applying an analysis from case law interpreting California’s transactional test for business income, the FTB also found the transaction was “occasional” because (1) the taxpayer’s disposition of an entire line of business was “an extraordinary corporate occurrence” that did not occur in the taxpayer’s regular course of business; and (2) the sale was infrequent since this was the only time the taxpayer had disposed of an entire line of business. Cal. FTB Chief Counsel Ruling No. 2015-01 (Jul. 31, 2015).

By Mike Kerman and Madison Barnett

The Indiana Tax Court granted summary judgment to Rent-A-Center East, Inc. (RAC), finding that the Department of Revenue’s determination that RAC and two affiliates should have filed a combined return was improper. This case was on remand from a prior Indiana Supreme Court ruling (please see our prior coverage). RAC engaged an independent accounting firm to conduct a transfer pricing study to determine arm’s-length pricing for royalty payments to one affiliate and for management fee payments to the other affiliate. While separate filing is the default method in Indiana, the Department may require a taxpayer to use an alternative apportionment method, including filing a combined return, if the standard sourcing rules do not fairly reflect the taxpayer’s income. However, the court rejected the Department’s argument that the mere fact that RAC and the affiliates operate a unitary business required a combined return regardless of a possibility of distortion. Similarly, the court also rejected the Department’s long-standing position that transfer pricing studies are not relevant to whether a separate return fairly reflects Indiana source income because Indiana Code § 6-3-2-2(m) mirrors the language in I.R.C. § 482. Additionally, the court concluded that the Department failed to introduce any evidence to show that RAC’s royalty and management fee payments lacked a business purpose or economic substance, or were made to avoid taxes. Finally, the court found that reductions in year-to-year Indiana taxable income do not establish per se that RAC’s Indiana sourced income was not properly reflected on its returns. Thus, the Department should not have required RAC to file a combined return. Rent-A-Center East, Inc. v. Dep’t of Revenue, No. 49T10-0612-TA-00106 (Ind. Tax Ct. Sept. 10, 2015).

In his State of the State address at the beginning of the year, Texas Governor Greg Abbott tasked the Legislature with enacting meaningful business tax relief. The Legislature responded by reducing the franchise (also called the margin) tax rate and creating new exemptions and incentives for sales tax. At the same time, however, the Legislature cut funding for several economic incentive programs and added an additional layer of review by creating an Economic Incentive Oversight Board. 

In their article for State Tax Notes, Sutherland attorneys Leah Robinson and Olga Jane Goldberg discuss recent tax changes in Texas and conclude that the Legislature at least partially fulfilled the governor’s request to cut taxes.

View the full article reprinted from the August 31, 2015, issue of State Tax Notes.

By Michael Penza and Timothy Gustafson

The Virginia Tax Commissioner upheld an upward adjustment to a taxpayer’s payroll factor attributing to Virginia all compensation that the taxpayer had reported to the Virginia Employment Commission (VEC) for purposes of the state’s unemployment insurance tax. The taxpayer, a Virginia-based contractor providing security services for the United States government, reported to the VEC compensation paid to employees working exclusively in foreign countries as an administrative convenience, even when the compensation was not properly reportable. In its Virginia payroll numerator, though, the taxpayer included only compensation that was subject to Virginia income tax withholding, despite the state’s regulatory presumption that compensation reported to the VEC equals compensation attributable to Virginia for purposes of the payroll factor. The taxpayer argued that including this information was a better reflection of compensation paid or accrued in Virginia given the location of its employees. The Commissioner rejected the taxpayer’s argument and upheld the adjustment because: (1) compensation subject to Virginia income tax withholding does not necessarily equal compensation attributable to Virginia for purposes of the payroll factor; and (2) the taxpayer did not provide sufficient evidence showing that the compensation reported to the VEC actually included compensation paid to employees working exclusively outside of Virginia. However, the Commissioner sent the matter back to the audit staff to consider any additional evidence the taxpayer might present to show which employees worked solely outside of Virginia. Va. Pub. Doc. No. 15-166 (Aug. 18, 2015).

By Mike Kerman and Open Weaver Banks

The Washington Court of Appeals held that for local business and occupation (B&O) tax purposes, a securities broker with employees in its Seattle office must source to Seattle the receipts from commissions for services performed by the employees via phone and Internet. Under the city ordinance implementing the state’s required apportionment formula for local B&O tax, service income is sourced to Seattle if: (i) the customer is located in the city; or (ii) the greater proportion of the service income-producing activity is performed in the city than in any other location, based on costs of performance, and the taxpayer is not taxable at the customer location; or (iii) the service income-producing activity is performed within the city, and the taxpayer is not taxable at the customer location. For several years, the city has interpreted “customer location” to be the place where the majority of physical contacts with customers occur. In this case, because the taxpayer’s services were provided by phone and Internet, it had no physical contacts with customers. Therefore, the court held that the taxpayer must source all of its receipts from commissions earned from services provided by employees in its Seattle office to Seattle, where the majority of its income-producing activities occurred, rather than only commissions earned from services provided to customers located in Seattle. Although the court recognized that some of the taxpayer’s activities occurred outside of the Seattle area, it found that the taxpayer failed to provide any documentation or support for its non-Seattle activities. Wedbush Sec., Inc. v. City of Seattle, No. 71932-7-I (Wash. Ct. App. Aug. 10, 2015). 

By Michael Penza and Amy Nogid 

The U.S. Court of Appeals for the Eleventh Circuit invalidated Florida’s rental tax imposed on the Seminole Tribe of Florida’s (the Tribe) leases of tribal land to non-Indian corporations, but upheld Florida’s utility tax collected from the Tribe. 

The Tribe operated casinos on two of its reservations; non-Indian corporations entered into leases with the Tribe to operate food courts at the casinos. The court affirmed the district court and held that the Indian Reorganization Act (IRA), which prohibits states from taxing lands held in trust by the United States on behalf of Indian tribes, preempts application of Florida’s rental tax on the non-Indian corporations’ lease payments to the Tribe. Relying on the U.S. Supreme Court’s decision in Mescalero Apache Tribe v. Jones, 411 U.S. 145 (1973), the Eleventh Circuit held that the ability to lease property is a fundamental privilege of property ownership, and that a tax on that privilege, such as Florida’s rental tax, amounted to a tax on the land itself, thereby violating the IRA. The court rejected Florida’s argument that the rental tax was a transactional tax rather than a tax on the land.

However, the court reversed the district court and upheld Florida’s utility tax collected from the Tribe related to utility services provided on the Tribe’s reservations. The court’s ruling hinged on determining the legal incidence of the utility tax. States are categorically barred from taxing Indian activity on reservations, but may tax non-Indian activity on reservations if not otherwise prohibited by federal law. The district court had found that the legal incidence of the utility tax was on consumers, likening it to a sales tax, and that an explicit pass-through provision of the tax to consumers was not required. The Eleventh Circuit, on the other hand, found that the legal incidence of the utility tax fell on the utility companies, and the utility companies were not legally required to pass the tax on to their customers. The court also found that unlike the rental tax, the utility tax was not preempted by federal law, even though electricity was essential to tribal activities, because there was no demonstrated Congressional intent to regulate utility use on tribal lands. Seminole Tribe of Florida v. Stranburg, No. 14-14524 (11th Cir. Aug. 26, 2015), aff’g in part and rev’g in part (S.D. Fla. Sept. 5, 2014). 

The long saga of Michigan’s Multistate Tax Compact election continued on Wednesday with oral argument before the Michigan Court of Appeals. A packed courtroom witnessed a 1.5 hour proceeding before an active three-judge panel. The arguments focused primarily on: (1) whether legislation can retroactively repeal the state’s adoption of the Multistate Tax Compact; (2) whether a retroactive repeal violates due process; (3) whether the contractual terms of the Compact require only prospective repeal; and (4) whether the legislation violated separation of powers.

View the full Legal Alert.
Read our August 2015 posts on stateandlocaltax.com or read each article by clicking on the title. For the latest coverage and commentary on state and local tax developments delivered directly to your phone, download the latest version of the Sutherland SALT Shaker mobile app.
  • SALT Pet of the Month: Zander
    Meet Zander, the seven-year-old Great Pyrenees belonging to Sutherland SALT Associate Madison Barnett and his family.

 

From September 1, 2015, through October 30, 2015, the Comptroller of Maryland will administer a Tax Amnesty Program for tax periods beginning before December 31, 2014. Eligible taxpayers that participate in the Program will receive a waiver of certain civil penalties and a reduction of 50% of the interest associated with certain delinquent taxes.

View the full Legal Alert.