Lily1.jpgMeet Lily, the adorable six-month-old Beagle/Basset Hound mix belonging to Sutherland SALT’s Jonathan Maddison and his fiancée, Molly. Lily is a rescue dog and was found in a Lily2.jpgtrailer in Alabama. Jon and Molly adopted her at seven weeks old, so they have enjoyed seeing her grow up! Lily enjoys chewing on everything (especially her parents’ shoes), playing with her friends at the dog park, rolling around in mud, watching hockey with her dad, keeping a lookout from her watch tower and falling asleep on her parents.

On July 30, the Multistate Tax Commission (MTC) approved amendments to the Multistate Tax Compact’s (1) definition of nonbusiness income, (2) definition of “sales,” (3) factor-weighting, (4) alternative apportionment, and (5) sourcing of service and intangible revenue. With the approval, the amendments officially become a model act of the MTC, and taxpayers should expect legislation to be introduced in several states when their legislatures convene for next year’s sessions.

The most significant amendment adopted was the change to Section 17 of the Compact, which is identical to the Uniform Division of Income for Tax Purposes Act (UDITPA). Section 17 applies to the sourcing of sales, other than the sale of tangible personal property. The amendment switches the sourcing methodology from the traditional costs-of-performance method to a market-based sourcing method for services and intangibles.

As to the factor-weighting amendment, the current version of Section 9 of the Compact provides for an equally weighted apportionment formula consisting of the sum of a taxpayer’s property, payroll and sales factors divided by three. The amendment provides that member states are able to define their own factor weighting fraction. However, a double-weighted sales factor is “recommended.”

The amendment to Section 1(a) of the Compact replaces the concept of business income with the phrase “apportionable income.” The phrase essentially applies a constitutional standard with additional guidance. The definition—among other revisions—exchanges the language “constitute integral parts of” for “is or was related to the operation of,” and also removes the word “regular” in describing what income arises from tangible and intangible property in the taxpayer’s trade or business.

The Section 1(g) amendment narrows the definition of what constitutes “sales” for purposes of the sales factor. The amendment expressly excludes treasury and hedging activities from the sales factor.

Lastly, the MTC amended Section 18, which contains the MTC’s alternative apportionment provision. The amendment allows for an administrator to adopt regulations under Section 18 that must be applied to all similar taxpayers. Arguably, the amendment broadens a state’s current authority, which usually results in regulations targeted at unique industries. The amendment provides the administrator the authority to draft regulations to target a “particular transaction or activity.”

The adoption of these amendments marks the end of a Compact revision process that started in August 2007. While the amendments are now officially part of the MTC’s uniform law collection, many of the changes will require regulations to be enacted before they can be applied. The question now is whether states will move to enact the new amendments, or perhaps defer enactment until the MTC pulls together effective regulations.

By Derek Takehara and Andrew Appleby

The Texas Comptroller determined that a semiconductor manufacturer’s purchases of computer software-related services were subject to sales and use tax because the taxpayer failed to prove that such purchases qualified for the multistate benefit exemption. Taxable services performed for use in Texas are generally subject to tax. Because some services are performed for use both in and outside of Texas, legislation was created to provide an exemption—the multistate benefit exemption—for the portion of the taxable services performed for use outside of Texas. The Comptroller clarified such exemption applies only to services that became taxable after September 1, 1987, and a taxpayer must prove by clear and convincing evidence that it operates in more than one state and that the service supports a separate, identifiable segment of the business rather than the general administration or operation of the business. In 1984, Texas began to impose tax on repair, maintenance and restoration services of tangible personal property, including canned computer software. Texas did not include custom computer programs in the definition of tangible personal property until October 1, 1987. Given this timeline, only a small portion of the taxpayer’s purchases were even eligible for the multistate benefit exemption: purchases for repair, maintenance and restoration services of custom computer software. However, a 2007 Texas Comptroller’s Decision provided that such services constitute part of the original sale of the software when performed by the original vendor, and the taxpayer was further required to prove that the services it purchased were stand-alone services in order to claim the exemption. Based on the evidence proffered, the Comptroller determined that the taxpayer failed to meet its burdens and denied the taxpayer’s claim for refund. Tex. Comp. Decision 105,855 (Apr. 24, 2014).

By Stephen Burroughs and Andrew Appleby

Former Chicago Bears linebacker Hunter Hillenmeyer and former Indianapolis Colts center Jeff Saturday challenged the City of Cleveland’s application of the “games-played” apportionment method to their football salaries before the Ohio Board of Tax Appeals. During their careers, both players were nonresidents whose respective NFL teams traveled to the city to play the Browns. Cleveland ordinance provides a specific apportionment formula for professional athletes: (Games in Cleveland / Total Games) x Total Income earned in the taxable year. The players argued this formula taxes income earned from out-of-state services, in violation of Ohio law and the U.S. Constitution. Hillenmeyer’s contract required him to participate in the Bears’ official mandatory mini-camp(s), official preseason training camp, all Bears meetings and practice sessions. The games-played method excludes players’ non-game services from the apportionment calculation, which for Hillenmeyer, resulted in a 400% increase in income subject to tax in Cleveland (over the standard “duty days” method). The City argued that the result is correct under the apportionment ordinance because NFL players only receive a paycheck for each game played (and not throughout the year). Saturday’s contract contained similar language, but he was injured during the tax period in question and did not travel to the city. Cleveland’s apportionment ordinance specifically includes games “the athlete was excused from playing because of injury or illness.” Therefore, a portion of Saturday’s income was still subject to tax. In each case, the Board of Tax Appeals ruled in favor of the City, stating that the City’s adherence to the games-played ordinance was reasonable but acknowledged that the Board did not have authority to decide the players’ Commerce Clause and Equal Protection Clause constitutional challenges. Like many Browns opponents, the NFL players may have a fourth-quarter comeback left in them—Hillenmeyer recently sought review from the Ohio Supreme Court. Hillenmeyer v. City of Cleveland Bd. of Review, Case No. 14-0235.

By Mary Alexander and Timothy Gustafson

The Colorado Department of Revenue determined that a mail-order seller was required to collect state and local sales tax on orders shipped to localities where it had established nexus and state use tax (and any applicable special district use tax) on all other sales shipped to customers in Colorado. According to the Department, the obligation to collect state sales or use tax requires (1) nexus with Colorado and (2) a taxable event. The out-of-state seller had a sales representative who both lived and rented an office in Colorado. The representative solicited new business and maintained customer relationships from the in-state office; thus, the Department concluded that the seller had nexus with Colorado for purposes of sales and use taxes. Furthermore, the Department explained that a taxable event occurs in Colorado when property is sold to a customer in Colorado because “[a] sale generally takes place when and where the retailer delivers goods to the buyer.” Consequently, when the seller delivered goods by common carrier to a buyer in Colorado, the Department determined that a sale took place within the state. In addition, Colorado cities, counties and special districts can also levy sales and use taxes, but a seller only has an obligation to collect such sales taxes (or use taxes) for state-administered local tax jurisdictions if it has nexus with them. Accordingly, when the seller shipped products to a customer located in the same local jurisdictions where its “direct or indirect location” was located, the seller was required to collect local sales taxes. However, when the seller shipped products to a customer located in a local jurisdiction in which it did not have a “direct or indirect location,” it was required to collect state use tax and, if the customer was located within a special district that levied a use tax, any applicable special district use tax. Col. Gen. Info. Ltr. GIL-14-005 (Apr. 28, 2014).

By Madison Barnett

The Alaska Supreme Court held that a foreign member of a water’s edge unitary group must include its foreign dividend income in the Alaska apportionable tax base, regardless of whether the income is “effectively connected income” (ECI) for federal income tax purposes. Alaska law incorporates the Internal Revenue Code, including the ECI rules, “unless excepted to or modified” by state law. The taxpayer argued that because the foreign-source dividends were not ECI for federal income tax purposes and were not included in federal taxable income, the income should not be included in the Alaska tax base. The court, however, held that the federal ECI rules are “sourcing rules” that are “fundamentally inconsistent with the formula apportionment required by the Multistate Tax Compact.” The court then compared the federal ECI rules’ treatment of foreign dividends with the state’s 80% dividends received deduction and concluded that the “two formulas are simply inconsistent.” One could question whether the Multistate Tax Compact, which is concerned with apportioning the tax base among various states, is truly inconsistent with a provision of the Internal Revenue Code used to determine the apportionable tax base to begin with. Schlumberger Technology Corp. & Subs. v. State of Alaska, Dep’t of Revenue, Op. No. 6924 (Alaska July 18, 2014).

On July 28, the Multistate Tax Commission (MTC) Uniformity Committee tabled two projects in order to focus on apportionment regulations in anticipation that the Commission will amend several key UDITPA sourcing rules on Wednesday.
View the full Legal Alert.

On July 28, the Multistate Tax Commission (MTC) Uniformity Committee tabled two projects in order to focus on apportionment regulations in anticipation that the Commission will amend several key UDITPA sourcing rules on Wednesday.

View the full Legal Alert.

 

On July 28, the Arm’s Length Adjustment Services Advisory Group (Group) of the Multistate Tax Commission (MTC) met for the third time at the MTC Annual Conference in Albuquerque, New Mexico. The Group began this effort on June 2 and met again on June 25 in furtherance of a Summer 2015 deadline to implement its transfer pricing model.

            The Group established the following projected milestones:

  • November 2014 – Group will complete draft of Preliminary Design
  • December 2014 – Present draft to Executive Committee
  • March 2015 – Target for completion of the Final Design
  • July / August 2015 – Target for implementation

Using External Economists

Consistent with the Group’s prior two meetings, the discussion focused primarily on increasing the ability of states and the MTC to analyze intercompany transactions. While taxpayers typically engage economists to ensure accurate intercompany pricing, states have not traditionally done the same when conducting audits. Dan Bucks, project facilitator, engaged several firms specializing in transfer pricing economics to determine how—and at what cost—the MTC could utilize these firms when conducting transfer pricing audits. As was predicted, the cost of hiring these firms is high—and perhaps prohibitively so.

The Group plans to meet in Atlanta on October 6 with up to seven firms to explore engaging them. Some firms have indicated that their expertise could be leveraged to eventually increase the capacity of states to conduct economic analysis without the assistance of outside firms. Others, however, have resisted that transference of expertise to the states and thus envision their role as full-service audit assistance.

The Group is continuing to consider the ability of the MTC to hire an internal economic expert to work in tandem with an outside firm. While there was no clear consensus about the appropriate level of involvement by an outside firm, there was a clear sense of anticipation among the Group’s members that these issues should be resolved at the October 6 meeting.

Developing In-House Skills

Beyond hiring an outside firm (or firms) to assist with the audit process, the Group discussed to what extent states can implement their own internal procedures to increase their ability to conduct transfer pricing audits. For instance, the Group considered training state auditors to request the proper documents from the taxpayer at the beginning of the audit process. At this point, the District of Columbia reiterated its purported success in preemptively identifying taxpayers for transfer pricing audits. An additional component of increasing the states’ ability to conduct transfer pricing audits is establishing a robust information sharing program. One recommendation was to hire an MTC employee to coordinate the sharing of taxpayer-provided information among the states. The Group conceded that this is likely a sensitive issue for taxpayers.

The MTC also envisions providing comprehensive training for state employees. Similar to its “nexus school,” the MTC proposes to provide detailed transfer pricing training to state auditors. Because transfer pricing is a recent focus of the MTC, the training classes would likely begin at a fairly rudimentary level, with the hope of increased sophistication over time. The MTC would provide additional training for litigating transfer pricing issues.

Incorporating Transfer Pricing Audits into Existing MTC Audit Structure?

The Group again broached the controversial issue of how the MTC may incorporate transfer pricing into its audit process. The topic was discussed at both prior meetings, with little consensus being reached. Bucks indicated that there are three options for conducting transfer pricing audits: (1) joint audits solely for transfer pricing issues; (2) a comprehensive audit program that incorporates transfer pricing issues operating parallel to the current MTC audit program; or (3) incorporating transfer pricing into the existing MTC audit program. Not only is there disagreement about the need for an MTC-directed audit for transfer pricing issues (Florida, for example, has repeatedly indicated it would not participate in a joint audit), but there is also disagreement over how the audit process would work. Five states indicated that the audit service would potentially be utilized, and four indicated that such a service is not a priority. Bucks indicated that his preference is to incorporate the transfer pricing audits into the existing MTC audit program. The continued debate over the audit process makes it the controversial component of the Group’s mission.

Next Steps     

With the self-imposed November deadline to complete its preliminary draft, the Group has set the following meetings for the coming months:

  • August / September 2014 – Bucks will conduct interviews with states involved in the project
  • Week of September 22, 2014 – Meeting via teleconference
  • October 6, 2014 – Meeting with economics consulting firms in Atlanta
  • October 7, 2014 – Meeting to discuss meeting with firms in Atlanta

All meetings are open to the public, and interested parties are encouraged to participate in the public comment portion of each meeting.

By Stephanie Do and Pilar Mata

The Colorado Department of Revenue determined that an out-of-state S corporation was not subject to Colorado income taxes and was not required to register with the Department. The S corporation provided information technology consulting services and designed accounting software systems. One of the S corporation’s clients was located in Colorado; however, the S corporation performed its work for that client from outside the state and accessed the client’s system through a virtual private network. Neither the S corporation nor its subcontractor traveled to Colorado to perform services on behalf on the client. The Department applied its factor presence nexus rule to determine whether the S corporation had nexus with the state, which provides that nexus is established when a business organized outside of Colorado has more than: (1) $50,000 of property; (2) $50,000 of payroll; (3) $500,000 of sales; or (4) 25% of the total property, total payroll or total sales in the state. The S corporation represented that it had no payroll or property in Colorado and did not have any apportioned sales to Colorado (presumably under a cost of performance sourcing methodology). Because the S corporation did not exceed any of these economic nexus thresholds, the Department held that the S corporation was not obligated to file a Colorado income tax return. Colo. Dep’t of Revenue, Gen. Info. Letter GIL-14-011 (Apr. 28, 2014).