By Nicole Boutros and Andrew Appleby

The New Jersey Supreme Court held that the New Jersey Division of Taxation improperly exercised its discretion when it refused to waive its imposition of $1.8 million in late payment penalties and tax amnesty penalties. The taxpayers, five subsidiaries of United Parcel Service of America (collectively, UPS), used a cash management system for intercompany transfers but did not report New Jersey corporation business tax (CBT) related to the transfers. The State assessed the CBT, imposed the two types of penalties at issue, and assessed interest, asserting that the intercompany transfers were actually loans upon which the State could impute interest income. The New Jersey Superior Court, Appellate Division, upheld the lower court’s determination that the State abused its discretion by imposing the penalties, explaining that UPS had reasonable cause to waive penalties because the taxability of the intercompany transfers was an issue of first impression. The New Jersey Supreme Court agreed and further explained that a taxpayer’s “honest misunderstanding of fact or law that is reasonable in light of the experience, knowledge and education of the taxpayer” supported a finding of reasonable cause to waive late payment penalties. Additionally, the court held that the imposition of tax amnesty penalties, which apply to taxpayers that fail to pay any state tax, did not apply to taxpayers that timely filed returns and paid their tax liabilities, but whom the State assessed on audit. The court emphasized that the legislative history of the tax amnesty penalties supported its determination that the State could not impose such penalties on deficiencies discovered through an audit of UPS’s timely filed returns. United Parcel Serv. Gen. Servs. Co. v. Dir., Div. of Taxation, No. 072421 (N.J. Dec. 4, 2014).

Read our November 2014 posts on stateandlocaltax.com or read each article by clicking on the title. To read our commentary on the latest state and local tax developments as they are published, be sure to download the Sutherland SALT Shaker mobile app.

By Evan Hamme and Timothy Gustafson
A California Superior Court held that passive membership in a limited liability company (LLC) is insufficient to meet California’s statutory “doing business” standard. In Swart Enterprises, Inc. v. California Franchise Tax Board, an Iowa corporation with no business activities or physical presence in California invested in a fund organized as a California LLC. Despite its previous Technical Advice Memorandum (TAM) finding that passive investment in an LLC did not create nexus with California, the Franchise Tax Board (FTB) asserted that Swart Enterprises, Inc. was “doing business” in the state by virtue of having previously purchased an interest in the fund two years prior to the tax year in question. Because the LLC had elected under federal and California law to be treated as a partnership for tax purposes, the FTB argued that “partnership” must be interpreted to mean a general partnership, and that each LLC member, like a general partner in a partnership, would presumptively have control over the management of the business. The court disagreed. Under California law, the fund was organized as a “manager-managed LLC” rather than a “member-managed LLC”; thus, Swart had no control over the management of the fund. Nor did Swart have a sufficient percentage interest to indirectly control its management, because Swart’s investment gave it only 0.2% ownership of the fund. Accordingly, the court held that Swart was not doing business in California. Notably, while the litigation was pending, the FTB issued a TAM effectively changing the position espoused in its earlier TAM and asserting that passive LLC members were subject to tax in California. After analyzing the California case law relating to limited partnership interests, the court stated there was “no legal authority” for the conclusions drawn by the FTB under the new the TAM. The court did not reach Swart’s contentions that subjecting Swart to California’s corporate franchise tax would violate the due process clauses of the California and United States Constitutions. Also, the court did not address the FTB’s constitutional and standing arguments. Swart Enterprises, Inc. v. California Franchise Tax Board, Case No. 13CECG02171 (Cal. Super. Ct. Nov. 13, 2014).

By Evan Hamme and Timothy Gustafson

A California Superior Court held that passive membership in a limited liability company (LLC) is insufficient to meet California’s statutory “doing business” standard. In Swart Enterprises, Inc. v. California Franchise Tax Board, an Iowa corporation with no business activities or physical presence in California invested in a fund organized as a California LLC. Despite its previous Technical Advice Memorandum (TAM) finding that passive investment in an LLC did not create nexus with California, the Franchise Tax Board (FTB) asserted that Swart Enterprises, Inc. was “doing business” in the state by virtue of having previously purchased an interest in the fund two years prior to the tax year in question. Because the LLC had elected under federal and California law to be treated as a partnership for tax purposes, the FTB argued that “partnership” must be interpreted to mean a general partnership, and that each LLC member, like a general partner in a partnership, would presumptively have control over the management of the business. The court disagreed. Under California law, the fund was organized as a “manager-managed LLC” rather than a “member-managed LLC”; thus, Swart had no control over the management of the fund. Nor did Swart have a sufficient percentage interest to indirectly control its management, because Swart’s investment gave it only 0.2% ownership of the fund. Accordingly, the court held that Swart was not doing business in California. Notably, while the litigation was pending, the FTB issued a TAM effectively changing the position espoused in its earlier TAM and asserting that passive LLC members were subject to tax in California. After analyzing the California case law relating to limited partnership interests, the court stated there was “no legal authority” for the conclusions drawn by the FTB under the new the TAM. The court did not reach Swart’s contentions that subjecting Swart to California’s corporate franchise tax would violate the due process clauses of the California and United States Constitutions. Also, the court did not address the FTB’s constitutional and standing arguments. Swart Enterprises, Inc. v. California Franchise Tax Board, Case No. 13CECG02171 (Cal. Super. Ct. Nov. 13, 2014).

By Jessica Kerner and Charlie Kearns
In what appears to be the latest in a series of conflicting rulings issued to the same company from at least seven other states, Tennessee and South Carolina have rendered their own opinions addressing the application of sales tax to cloud collaboration service. (See prior coverage ¬here: [link to https://www.stateandlocaltax.com/southeast/cloud-based-services-not-subject-to-georgia-sales-and-use-tax/]). 
The company at issue maintains and operates hardware and software on servers located outside of the states issuing the tax rulings. The hardware and software is used to support its customers’ telecommunications equipment, including voice, video, messaging, presence, audio, web conferencing and mobile capabilities. The company’s customers provide their own telephone equipment and access the company’s cloud applications through the customers’ existing telecommunications, Internet or network connections obtained through third parties. 
In the Tennessee ruling, the Department of Revenue explained that sales tax would apply if the cloud collaboration service constituted tangible personal property or an enumerated taxable service (i.e., telecommunications service or ancillary service). The Department characterized all components of the service as taxable telecommunications services, except messaging and conferencing, which constituted taxable ancillary services. Consistent with prior guidance, the Department stated that the cloud collaboration service did not involve the transfer of title, possession, or control of any tangible personal property (e.g., hardware or prewritten computer software) or computer software. See, e.g., Tenn. Letter Ruling No. 11-58, Oct. 10, 2011; Tenn. Letter Ruling No. 13-12, Sept. 12, 2013. However, the Department explained in a footnote that unlike other cloud computing services, the company’s service was not exempt data processing or information services because the primary purpose was not to merely access the data and information contained on out-of-state servers. The Department further classified the telecommunications components of the service as intrastate telecommunications, which are subject to a higher local tax rate. The Department reached this conclusion by focusing only on the “last mile” portion of the service performed at the customers’ premises and not considering how or from where the company provided the service. 
The South Carolina Department of Revenue also concluded that the company’s cloud collaboration service constituted a taxable communications service. South Carolina imposes sales tax on the “gross proceeds accruing or proceeding from the charges for the ways or means for the transmission of the voice or messages.” Historically, the Department has broadly applied this provision to remote access software or cloud-based services, where the software or service routes (or sends) a signal of voice or messages. Because the Department determined that the company’s cloud collaboration service processes and routes telephone calls (as well as voice, video and voicemail messages, and also supports audio conferencing, video conferencing and mobility services), the Department concluded that the services were taxable communications services. 
Tenn. Letter Ruling 14-05 (Aug. 25, 2014, released Oct. 6, 2014).
S.C. Private Letter Ruling No. 14-4 (Nov. 4, 2014, released Nov. 18, 2014).

By Jessica Kerner and Charlie Kearns

In what appears to be the latest in a series of conflicting rulings issued to the same company from at least seven other states, Tennessee and South Carolina have rendered their own opinions addressing the application of sales tax to cloud collaboration service. See prior coverage here. 

The company at issue maintains and operates hardware and software on servers located outside of the states issuing the tax rulings. The hardware and software is used to support its customers’ telecommunications equipment, including voice, video, messaging, presence, audio, web conferencing and mobile capabilities. The company’s customers provide their own telephone equipment and access the company’s cloud applications through the customers’ existing telecommunications, Internet or network connections obtained through third parties. 

In the Tennessee ruling, the Department of Revenue explained that sales tax would apply if the cloud collaboration service constituted tangible personal property or an enumerated taxable service (i.e., telecommunications service or ancillary service). The Department characterized all components of the service as taxable telecommunications services, except messaging and conferencing, which constituted taxable ancillary services. Consistent with prior guidance, the Department stated that the cloud collaboration service did not involve the transfer of title, possession, or control of any tangible personal property (e.g., hardware or prewritten computer software) or computer software. See, e.g., Tenn. Letter Ruling No. 11-58, Oct. 10, 2011; Tenn. Letter Ruling No. 13-12, Sept. 12, 2013. However, the Department explained in a footnote that unlike other cloud computing services, the company’s service was not exempt data processing or information services because the primary purpose was not to merely access the data and information contained on out-of-state servers. The Department further classified the telecommunications components of the service as intrastate telecommunications, which are subject to a higher local tax rate. The Department reached this conclusion by focusing only on the “last mile” portion of the service performed at the customers’ premises and not considering how or from where the company provided the service. 

The South Carolina Department of Revenue also concluded that the company’s cloud collaboration service constituted a taxable communications service. South Carolina imposes sales tax on the “gross proceeds accruing or proceeding from the charges for the ways or means for the transmission of the voice or messages.” Historically, the Department has broadly applied this provision to remote access software or cloud-based services, where the software or service routes (or sends) a signal of voice or messages. Because the Department determined that the company’s cloud collaboration service processes and routes telephone calls (as well as voice, video and voicemail messages, and also supports audio conferencing, video conferencing and mobility services), the Department concluded that the services were taxable communications services. Tenn. Letter Ruling 14-05 (Aug. 25, 2014, released Oct. 6, 2014). S.C. Private Letter Ruling No. 14-4 (Nov. 4, 2014, released Nov. 18, 2014).

By Sahang-Hee Hahn and Prentiss Willson
The Florida Department of Revenue permitted a taxpayer to discontinue filing Florida consolidated corporate income tax returns because the taxpayer established that its affiliated group’s business focus had changed significantly since making its election. In Florida, a parent corporation may elect to file a consolidated corporate income tax return. If the parent makes this election, however, it must continue filing on a consolidated basis absent limited exceptions unless the Executive Director permits the filing of separate returns. Pursuant to Florida Regulation 12c-1.0131(3)(b)(2)(a), the Executive Director will authorize a taxpayer’s affiliated group to discontinue filing a consolidated return if there is good cause for doing so, including changes to the group that do not affect income tax liability. In this case, the taxpayer established that its affiliated group had undergone several significant changes since making its election, including significant growth; expanded activities conducted by the taxpayer and its product line; and a change in the nature of the group’s overall business. The Department ruled that the taxpayer’s overall business focus and its substantial growth, taken together, provided a sufficient basis for granting the taxpayer’s request for deconsolidation. Fla. TAA 14C1-009 (08/11/2014).

By Sahang-Hee Hahn and Prentiss Willson

The Florida Department of Revenue permitted a taxpayer to discontinue filing Florida consolidated corporate income tax returns because the taxpayer established that its affiliated group’s business focus had changed significantly since making its election. In Florida, a parent corporation may elect to file a consolidated corporate income tax return. If the parent makes this election, however, it must continue filing on a consolidated basis absent limited exceptions unless the Executive Director permits the filing of separate returns. Pursuant to Florida Regulation 12c-1.0131(3)(b)(2)(a), the Executive Director will authorize a taxpayer’s affiliated group to discontinue filing a consolidated return if there is good cause for doing so, including changes to the group that do not affect income tax liability. In this case, the taxpayer established that its affiliated group had undergone several significant changes since making its election, including significant growth; expanded activities conducted by the taxpayer and its product line; and a change in the nature of the group’s overall business. The Department ruled that the taxpayer’s overall business focus and its substantial growth, taken together, provided a sufficient basis for granting the taxpayer’s request for deconsolidation. Fla. TAA 14C1-009 (08/11/2014).

By Nicole Boutros and Pilar Mata

The Illinois Cook County Circuit Court held that an Illinois law firm (the Relator) that filed a qui tam lawsuit against a taxpayer failed to meet its burden to prove the taxpayer knowingly failed to collect and remit Illinois use tax, as required under the Illinois False Claims Act. The taxpayer sold furniture, equipment and supplies to Illinois customers through representatives, by telephone, through a catalog and over its website. The taxpayer collected use tax on the sale of its goods by catalog and over the Internet but did not collect tax on the shipping and handling charges associated with such sales. The Relator alleged the taxpayer knowingly failed to collect and remit such tax and sought treble damages and mandatory penalties on each alleged false claim. The court held that the Relator failed to prove the taxpayer had actual knowledge that it had to pay tax on shipping and handling charges, acted in deliberate ignorance, or acted with reckless disregard when it did not collect and remit tax on such charges. In so doing, the court adopted the standard for “reckless disregard” issued under federal False Claims Act cases, finding that the Relator had to prove the taxpayer failed to conduct a reasonable or prudent inquiry, or that the taxpayer knew or had reason to know of the facts that would lead a reasonable person to believe harm was likely to result. The court also emphasized that the Illinois False Claims Act was not intended to penalize “frank differences of opinion or innocent errors made despite the exercise of reasonable care” and “does not encompass innocent mistakes or negligence.” The fact that the Illinois Department of Revenue had conducted a use tax audit of the taxpayer but had not assessed additional tax for shipping and handling charges was central to the court’s holding that the Relator failed to meet its burden of proof. This is the second Illinois case holding that the Relator did not meet its burden of proof when the taxpayer relied upon the results of the Department’s audit of the taxpayer’s books and records in which the Department did not assess use tax on shipping and handling charges. The court’s holding in this case and explanation of the standard to demonstrate a “knowing” act is likely to impact numerous other Illinois False Claims Act cases filed by the Relator as a whistleblower in Illinois. State of Illinois ex rel. Schad Diamond & Shedden v. National Business Furniture, LLC, No. 2012 L 000084 (Ill. Cir. Ct. Oct. 23, 2014); see also State of Illinois Ex Rel. Schad Diamond and Shedden v. FansEdge Inc., No. No. 11 L 9550 (Ill. Cir. Ct. Jun. 5, 2014).

Meet Hades, the mischievous Husky-Corgi mix belonging to Sutherland SALT’s newest member, Robert Merten III and his wife, Whitney. Twelve-year-old Hades may be mature in age, but he is definitely a puppy at heart. Quite the accomplished escape artist, Hades has led Robert and Whitney on hour-long neighborhood chases on more than one occasion. 
For the first nine years of his life, Hades had the house to himself and enjoyed all the perks of being a spoiled only child. He was doted on by his parents and loved sharing their bed. He’s had to make some major life adjustments over the last three years with the arrival of Robert and Whitney’s two sons, Lex (3) and Leo (1). He may be a little crankier with kids in the picture, but Hades has gotten used to sharing mom and dad’s attention and loves his “brothers,” especially when they so willingly share their food! Hades is honored to be November’s Pet of the Month!

Hades.jpgMeet Hades, the mischievous Husky-Corgi mix belonging to Sutherland SALT’s newest member, Robert Merten III and his wife, Whitney. Twelve-year-old Hades may be mature in age, but he is definitely a puppy at heart. Quite the accomplished escape artist, Hades has led Robert and Whitney on hour-long neighborhood chases on more than one occasion. 

Dad w- Hades and newborn Lex.jpgFor the first nine years of his life, Hades had the house to himself and enjoyed all the perks of being a spoiled only child. He was doted on by his parents and loved sharing their bed. He’s had to make some major life adjustments over the last three years with the arrival of Robert and Whitney’s two sons, Lex (3) and Leo (1). He may be a little crankier with kids in the picture, but Hades has gotten used to sharing mom and dad’s attention and loves his “brothers,” especially when they so willingly share their food! Hades is honored to be November’s Pet of the Month!

By Evan Hamme and Timothy Gustafson

The Colorado Department of Revenue issued guidance to a taxpayer operating a colocation and hosting facility, which provided customers a place to securely store computer servers, on whether certain charges imposed by the taxpayer were subject to sales and use tax. Specifically, the taxpayer requested guidance on the applicability of sales and use tax to charges for: (1) providing cross connects (i.e., cables) for customer use; (2) private lines purchased from telecommunications providers and passed on to customers at a marked-up rate; and (3) licenses to use the taxpayer’s remote access software programs. The Department declined to make any specific determinations, but stated that whether the taxpayer was providing a service or renting cables depended on the true object of the transaction and that when addressing computer software and related hardware the Department considers a number of factors, including the degree of control exercised by the customer over the property. The Department also noted if the taxpayer’s customers used the private lines to make intrastate telephone calls or telegraphs, the taxpayer must collect sales tax on the entire charge, including the mark-up. Finally, the Department observed that software licenses for application service provider (ASP) software are not taxable; the taxpayer, however, had provided insufficient information for the Department to determine whether the taxpayer’s software was ASP software. Colo. Gen. Inf. Ltr. GIL-14-018, 07/28/2014 (released 10/07/2014).

A New York Tax Appeals Tribunal Administrative Law Judge (ALJ) recently determined that a federal savings and loan association was not required to include a subsidiary, which was formed as a Connecticut passive investment company, in its combined New York City bank tax return. In the Matter of the Petition of Astoria Financial Corporation & Affiliates, TAT(H) 10-35(BT) (Oct. 29, 2014, released Nov. 7, 2014). While it appears that the New York City Department of Finance audit focused on the three statutory criteria for requiring a combined return, it also raised a fourth criterion—whether the subsidiary or the savings and loan association’s transactions with the subsidiary were a “sham.”

View the full Legal Alert. 

On Wednesday, November 12, 2014 the United States Supreme Court heard oral arguments in Comptroller of Maryland v. Wynne.  The case turns on whether Maryland’s personal income tax system violates the dormant Commerce Clause of the United States Constitution because of Maryland’s failure to provide a credit for taxes paid to other states.  The case has far-reaching implications and the US Supreme Court justices engaged in a lively dialogue with counsel regarding the constitutional limitations of state taxation.
In their article for Law360, Sutherland tax attorneys Jeffrey Friedman and Jonathan Maddison discuss the arguments raised in the briefing and describe how resolving the debate about whether states of residence can tax all of the income of their residents may have far reaching outcomes.
Read the full article.

On November 12, the U.S. Supreme Court heard oral arguments in Comptroller of Maryland v. Wynne. The case turns on whether Maryland’s personal income tax system violates the dormant Commerce Clause of the United States Constitution because of Maryland’s failure to provide a credit for taxes paid to other states. The U.S. Supreme Court justices engaged in a lively dialogue with counsel regarding the constitutional limitations of state taxation.

In their article for Law360, Sutherland tax attorneys discuss the arguments raised in the briefing and describe how resolving the debate about whether states of residence can tax all of the income of their residents may have a far-reaching effect.

Read the full article.