By Stephanie Do and Andrew Appleby

The Texas Comptroller determined that an integrated circuit manufacturer’s purchases of software tools used to design and test the software code embedded in its semiconductor chips did not qualify for the manufacturing exemption for sales and use tax purposes. For Texas’s manufacturing exemption, software manufacturing begins with software design or code writing, and includes software testing and demonstration. The taxpayer contended that its purchases of software tools qualified for the manufacturing exemption because such tools were used to test the functional logic of the software code that was ultimately embedded into its semiconductor chips. The Comptroller, however, determined that the software code embedded into the semiconductor chips functioned as hardware, not software, and ruled that the manufacturing exemption for software manufacturing was not applicable to the taxpayer’s purchases. The Comptroller also determined that the software tools were not incorporated into the semiconductor chips and rejected the taxpayer’s alternative argument that the software tools were exempt as sales for resale. Tex. Comp. Decision 102,151 (Feb. 5, 2014). 

On May 8, the Multistate Tax Commission’s Executive Committee voted to advance its amendments to the Multistate Tax Compact’s definition of nonbusiness income, definition of “sales,” factor weighting, and the sourcing of service and intangible revenue. The Committee essentially embraced the MTC’s original proposed amendments and failed to incorporate any of the comments and observations of its Hearing Officer, Professor Richard Pomp.

View our full Legal Alert for more details.

On Thursday, May 8, the Multistate Tax Commission’s Executive Committee met in Washington, DC. During the meeting the Committee voted to advance its amendments to the Multistate Tax Compact’s definition of nonbusiness income, definition of “sales,” factor weighting, and the sourcing of service and intangible revenue. The next step in the Compact’s amendment process—which is identical to the Uniform Division of Income for Tax Purposes Act (UDITPA)—is a “Bylaw VII” survey by the MTC member states. The Committee essentially embraced the MTC’s original proposed amendments and failed to incorporate any of the comments and observations of its Hearing Officer, Professor Richard Pomp.

Read the full Legal Alert here.

By Sahang-Hee Hahn and Timothy Gustafson

The New York State Tax Appeals Tribunal ruled the New York State Department of Taxation and Finance could not decombine taxpayers’ New York combined filing group for tax years 2002-2004. The Tribunal’s ruling upholds the ALJ’s determination that there was a sufficient flow of value between entities engaged in related lines of businesses and that reimbursements to the taxpayers’ parent holding company for key services performed on taxpayers’ behalf were made at cost. The taxpayers were wholesale/retail distributors that formed part of the U.S. branch of an Italian clothing business that sold luxury Italian clothing and apparel in New York. The taxpayers’ remaining group member, the domestic parent holding company, performed the management and related support services necessary for the taxpayers’ day-to-day business operations. The parent provided these services at cost to its subsidiaries. No intercompany agreements memorialized the group’s transactions, and the group made and received intercompany payments using a common cash management system during the years at issue. On these facts, the Tribunal held that the taxpayers could file a combined report because the criteria for filing a combined New York return were met: the ownership requirement, the unitary business requirements, and the “distortion” requirement pursuant to Section 211(4)(a)(4) of the New York Tax Law and Section 6-2.2(a)-(b) of the New York Codes, Rules and Regulations, Title 20. Focusing on the latter two criteria, the Tribunal first determined that the taxpayers met the standard for a unitary business because they were engaged in the same or related lines of business: the taxpayers sold Italian clothing, and their parent serviced and managed businesses that sold Italian clothing. The Tribunal also determined there was a sufficient flow of value between and among the three entities to satisfy the federal constitutional standard for a unitary business, due to their common president, centralized management and administrative support, and common cash management system. Regarding the “distortion” requirement, the Tribunal found dispositive the fact that the parent provided key services to the taxpayers “at cost” during the years at issue and held this resulted in distortion. The Tribunal also disagreed with the ALJ’s finding that the taxpayers had never made payments for management services provided by the parent because no actual payments had occurred, holding instead that such transactions were deemed “paid for purposes of determining distortion” because taxpayers had memorialized these transactions among their books and records, consolidated financial statements, and pro forma tax returns. The Department is not permitted to appeal the Tribunal’s decision. By providing an example of taxpayer facts that satisfy the “distortion” requirement, this case is relevant for business taxpayers who seek to defend their New York combined filing group as well as for those who face forced combination by the Department. In the Matter of IT USA, Inc., DTA Nos. 823780; 823781 (N.Y. Tax App. Trib. Apr. 16, 2014).

By Sahang-Hee Hahn and Timothy Gustafson
The New York State Tax Appeals Tribunal ruled the New York State Department of Taxation and Finance could not decombine taxpayers’ New York combined filing group for tax years 2002-2004. The Tribunal’s ruling upholds the ALJ’s determination that there was a sufficient flow of value between entities engaged in related lines of businesses and that reimbursements to the taxpayers’ parent holding company for key services performed on taxpayers’ behalf were made at cost. The taxpayers were wholesale/retail distributors that formed part of the U.S. branch of an Italian clothing business that sold luxury Italian clothing and apparel in New York. The taxpayers’ remaining group member, the domestic parent holding company, performed the management and related support services necessary for the taxpayers’ day-to-day business operations. The parent provided these services at cost to its subsidiaries.  No intercompany agreements memorialized the group’s transactions, and the group made and received intercompany payments using a common cash management system during the years at issue. On these facts, the Tribunal held that the taxpayers could file a combined report because the criteria for filing a combined New York return were met: the ownership requirement, the unitary business requirements, and the “distortion” requirement pursuant to Section 211(4)(a)(4) of the New York Tax Law and Section 6-2.2(a)-(b) of the New York Codes, Rules and Regulations, Title 20. Focusing on the latter two criteria, the Tribunal first determined that the taxpayers met the standard for a unitary business because they were engaged in the same or related lines of business: the taxpayers sold Italian clothing, and their parent serviced and managed businesses that sold Italian clothing. The Tribunal also determined there was a sufficient flow of value between and among the three entities to satisfy the federal constitutional standard for a unitary business, due to their common president, centralized management and administrative support, and common cash management system. Regarding the “distortion” requirement, the Tribunal found dispositive the fact that the parent provided key services to the taxpayers “at cost” during the years at issue and held this resulted in distortion. The Tribunal also disagreed with the ALJ’s finding that the taxpayers had never made payments for management services provided by the parent because no actual payments had occurred, holding instead that such transactions were deemed “paid for purposes of determining distortion” because taxpayers had memorialized these transactions among their books and records, consolidated financial statements, and pro forma tax returns. The Department is not permitted to appeal the Tribunal’s decision. By providing an example of taxpayer facts that satisfy the “distortion” requirement, this case is relevant for business taxpayers who seek to defend their New York combined filing group as well as for those who face forced combination by the Department. In the Matter of IT USA, Inc., DTA Nos. 823780; 823781 (N.Y. Tax App. Trib. Apr. 16, 2014).

Click here to read our April 2014 posts or read each article by clicking on the title. A printable PDF is also available here. 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.

Thumbnail image for Filion Pets.jpgFilion Cats.jpgMeet Jethro and George, the feline companions of Kathy Filion, an executive assistant at Tyco, who answered our recent call for feline pets. Both Jethro and George are rescue kitties and die-hard Green Bay Packers fans (seen drowning their sorrows in food at the end of football season with the Filions’ dog, Gracie, who already had her 15-minutes of fame). George has an adventurous side and once went on a six-week “walk-about.” A kind family called to let the Filions know he was hanging Filion Pet 1.jpgout at their house seven miles away! The Filions were thrilled to have him back. He came home to Gracie and a new little brother, Jethro.  George and Jethro have been buddies ever since. When the boys aren’t reading up on the latest SALT news, they are busy stalking and chasing each other, and then napping from all the hard work they have done. Jethro and George say thanks for choosing them as Pets of the Month…and GO PACK GO!

By Derek Takehara and Andrew Appleby

The Virginia Tax Commissioner issued a taxpayer-favorable ruling addressing Virginia sales and use tax on (1) computer software sold to manufacturers and (2) cloud computing services. The Commissioner determined that Virginia’s manufacturing exemption can apply to sales of computer software if the software is used directly in the manufacturer’s production process (i.e., as an indispensable and immediate part of the actual production process). As an example, the Commissioner distinguished between software used to direct or control production operations (exempt) and software used only to monitor such operations (taxable). If potentially exempt software is used in both taxable and exempt production activities, a preponderance of use test is used to determine whether the exemption applies on an all-or-nothing basis. The Commissioner reminded the taxpayer that sales of computer software could also be exempt as sales of prewritten software modifications or custom software, irrespective of whether the purchaser is engaged in manufacturing. If the taxpayer relies on the manufacturing exemption, the Commissioner cautioned the taxpayer to collect an exemption certificate from manufacturers at the time of sale to avoid later audit scrutiny. Finally, the Commissioner determined that cloud computing services were exempt from sales and use tax because they do not involve tangible medium and qualify as a nontaxable service under Virginia’s exemption for electronic transfers of software. Va. Pub. Doc. Rul. No. 14-42 (Mar. 20, 2014).

By Kathryn Pittman and Timothy Gustafson

The Oklahoma Supreme Court held Oklahoma’s deduction for capital gains arising from the sale of a company headquartered in the state for three or more years does not violate the dormant commerce clause of the U.S. Constitution. The taxpayer, a California company with its headquarters in Florida, sold a manufacturing facility in Oklahoma and claimed the Oklahoma capital gains deduction. The Oklahoma Tax Commission denied the taxpayer’s deduction because it was not headquartered in Oklahoma for three years prior to the sale, and the taxpayer challenged the denial on constitutional grounds. The Oklahoma Supreme Court, an elected body, held that the application of the deduction had no negative impact on interstate commerce because the deduction was available to a qualified entity participating in any market or industry, regardless of whether it participated in intrastate or interstate commerce, and concluded that the dormant commerce clause did not apply. Even if the dormant commerce clause applied, the court held that the deduction on its face does not penalize the out-of-state activities of corporations doing business in Oklahoma; serves the non-discriminatory purpose of enticing out-of-state companies to locate in Oklahoma; and does not preclude tax-neutral decision-making or otherwise have a discriminatory effect on interstate commerce. CDR Sys. Corp. v. Oklahoma Tax Commission, Case No. 109886 (Okla. 2014). This decision raises an issue similar to that in DaimlerChrysler Corp. v. Cuno, 547 U.S. 332 (2006), a case ultimately dismissed on standing grounds. If appealed and granted review, the Oklahoma decision would give the U.S. Supreme Court the opportunity to revisit the constitutionality of tax incentives.

By Jessica Kerner and Pilar Mata

The Michigan Court of Claims held that cloud computing, or software as a service (SaaS), is a nontaxable service rather than a taxable use of prewritten software. The taxpayer, an insurance company, entered into various transactions that provided the taxpayer with remote access to third parties’ software. The Michigan Department of Treasury asserted that the insurance company was liable for use tax because the transactions at issue involved the “use” of prewritten computer software “delivered by any means.” The court disagreed, reasoning the software was not “delivered” because the third-party providers did not surrender possession or control of the software to the taxpayer, nor did the third parties actually transfer to the taxpayer the software needed to process and produce the outcomes. Moreover, the court found that the legislature could not have intended the term “delivered” to include remotely accessing a third-party provider’s technology infrastructure because such remote access was unheard of at the time the statute was enacted. The court further determined that even if the software was deemed to be “delivered,” the taxpayer had not made the requisite “use” of the software because there was no evidence that the taxpayer exercised a right or power incident to ownership in the underlying software. The court’s decision acknowledged the “complexity associated with the computer environment” and the “changing nature of computer-based technology and business models.” There are currently two bills pending in Michigan, Senate Bill 142 and Senate Bill 143, which would codify the decision in this case. These bills would make it clear that for both sales and use tax purposes, the right to access prewritten computer software on another person’s server is a nontaxable sale of service. Auto-Owners Insurance Company v. Department of Treasury, Case No. 12-000082-MT (Mich. Ct. Cl. 2014).

By Zachary Atkins and Pilar Mata

A California Court of Appeal held that a mobile telecommunications service provider could pursue refund actions against local taxing authorities in California without first having to refund the disputed taxes to its customers. Pursuant to a settlement agreement, New Cingular, the provider, filed refund claims against 132 California cities and two counties on behalf of its customers for taxes erroneously charged on sales of Internet access services. The local taxing authorities argued that New Cingular did not have standing to bring refund suits on its customers’ behalf because New Cingular failed to refund the amounts in question to customers before filing refund claims in accordance with local ordinances. The court disagreed and held that local “refund first” ordinances are preempted by the state Government Claims Act to the extent they purport to create additional preconditions on the filing of refund claims for local taxes and that New Cingular’s claims substantially complied with the requirements of the Government Claims Act. The court also held that New Cingular had standing because it had a direct interest in seeking the refunds as a result of the settlement agreement—an enforceable contract that required New Cingular to seek the refunds on behalf of its customers—and there was no possibility that New Cingular would be unjustly enriched. Allowing New Cingular to proceed with its refund suit also ensured that the local taxing authorities would not be unjustly enriched with erroneously collected sales taxes. The court’s opinion is consistent with the New Jersey Tax Court’s recent opinion in New Cingular Wireless PCS, LLC v. Director, Div. of Taxation, No. 000003-2012, 2014 WL 714769 (N.J. Tax Ct. Feb. 21, 2014), which Sutherland covered here. Sipple v. City of Hayward (Apr. 8, 2014, B242893) ___ Cal.App.4th ___ [2014 Cal. App. LEXIS 313].