By Christopher Chang and Timothy Gustafson

The Massachusetts Department of Revenue issued a Letter Ruling stating that, for purposes of determining common control with regard to a combined report, the Department looks to actual voting control as opposed to voting power, which is the test for federal consolidated reporting. Under the Massachusetts combined reporting rules, common ownership means that more than 50% of the voting control of each member in the combined group is held by a common owner, either directly or indirectly. The applicant in this instance requested a determination regarding whether Corporations X and Y, which had a common shareholder (Shareholder), met the Massachusetts common ownership requirement. Corporations X and Y had the same capital and governance structure. The board of directors for each corporation consisted of 10 total members who were elected, in non-cumulative voting, by two classes of common stock. The first common stock class elected three board members, while a combined vote of both common stock classes elected the remaining seven board members. Shareholder held 23.13% of Corporation Y common stock and 53.74% of Corporation Y total votes. Shareholder also held 21.77% of Corporation X common stock prior to May 3, 2012 and 13.90% after, and 61.92% of Corporation X total votes prior to May 3, 2012 and 56.72% after. Using the federal voting power test, Shareholder held 51.56% of Corporation Y’s voting power and 49.88% of Corporation X’s voting power. However, the Department considered Shareholder’s actual voting control in the non-cumulative voting context and determined that Shareholder could elect seven board members, giving Shareholder more than 50% voting control in both Corporations X and Y. The Department noted that the federal voting power test specifically looks to “stock possessing” the required voting power, as opposed to Massachusetts statutory language that looks to “voting control.” Mass. Ltr. Rul. No. 13-7 (September 20, 2013).

By Suzanne Palms and Timothy Gustafon

The Illinois House of Representatives recently held a contentious hearing on legislation introduced earlier this year that would require publicly traded corporations, and those that are at least 50% owned by a publicly traded company, “doing business” in Illinois to disclose certain tax information in an annual statement filed with the Secretary of State. Under House Bill (HB) 3627’s broad definition of “doing business,” corporations making sales of tangible personal property to Illinois customers, earning income from intangible personal property with a situs in Illinois, or performing services for customers located in Illinois would be subject to the disclosure requirements even if not subject to the corporate income tax. The annual statements would be public records and would include items such as a corporation’s base income, Illinois apportionment factor, business income apportioned to the state, nonbusiness income allocated to the state, net operating loss deduction or credits claimed, and Illinois tax liability before and after credits.

In lieu of the statement described above, a corporation doing business in Illinois but not required to file an Illinois corporate income tax return could elect to file a statement explaining why the corporation is not required to file a corporate income tax return and designating the corporation’s total gross receipts from sales to purchasers in Illinois. The annual statements would be available to the public two years after the initial disclosure on a searchable Internet database created by the Illinois Secretary of State. Corporations that failed to file an annual statement or those that provided inaccurate information could be subject to a civil penalty of up to $100 per statement per day. A similar measure, SB 282, was approved by the Illinois Senate in November 2012 but died in the House Revenue and Finance Committee. The current bill sits in the House Rules Committee, and no vote on the bill is currently scheduled. HB 3627, “Illinois Corporate Responsibility and Tax Disclosure Act,” as introduced in the Illinois House of Representatives on May 2, 2013.

By Saabir Kapoor and Andrew Appleby

After the U.S. Court of Appeals for the Tenth Circuit denied an en banc rehearing on October 1, 2013, the Direct Marketing Association (DMA) is expected to bring suit in Colorado District Court to challenge the constitutionality of the Colorado law that requires out-of-state retailers without a physical presence in Colorado to notify their customers of their use tax responsibilities. The DMA initially filed a complaint for declaratory and injunctive relief in U.S. District Court to enjoin enforcement of Colorado’s reporting requirements, which were scheduled to take effect on January 31, 2011, asserting that: (1) the regime discriminates impermissibly against out-of-state retailers; and (2) the regime imposes undue burdens on interstate commerce. On March 30, 2012, the U.S. District Court permanently enjoined the enforcement of the reporting requirements, finding that the law “patently discriminates” against interstate commerce in violation of the Commerce Clause by imposing a unique burden on out-of-state retailers with no physical presence in the state. With respect to the DMA’s second claim, the court held that the reporting requirements violate the U.S. Supreme Court’s holding in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), which prohibits a state from imposing use tax on out-of-state retailers with no physical presence in the state. However, the U.S. Court of Appeals for the Tenth Circuit ordered that the permanent injunction be dissolved because the federal Tax Injunction Act (TIA) prevented the court from maintaining jurisdiction to enjoin Colorado’s reporting requirements. The TIA prohibits federal courts from interfering with state tax administration that would “inhibit state tax assessment, levy, or collection.” Based on this premise, the court concluded that the DMA’s challenge sought to restrain the collection of sales and use tax in Colorado because the reporting requirements were a substitute for requiring out-of-state retailers to collect sales and use tax. Notably, the court did not reach a decision on the merits of the case. The DMA is expected to challenge the law in state court, and may file a petition for writ of certiorari in the U.S. Supreme Court. Direct Marketing Ass’n v. Brohl, Appellate Case No. 12-1175 (10th Cir. Aug. 20, 2013), reh’g denied (10th Cir. Oct. 1, 2013).

By Madison Barnett and Prentiss Willson

The Indiana Department of Revenue determined in a Letter of Finding that an out-of-state information service provider must apportion its receipts from sales to Indiana customers to Indiana in a market-sourcing-like manner, even though the majority of its costs were incurred outside Indiana. The taxpayer provided information services electronically to customers in Indiana and around the country. Its direct costs of providing the services—wages of editors, researchers, analysts and database managers, as well as computer and software development costs—were incurred outside Indiana. The taxpayer applied Indiana’s statutory cost of performance (COP) sourcing method and sourced its service receipts to the location where the majority of its costs were incurred, i.e., outside Indiana. Under a strained interpretation of its COP statute, the Department upheld an audit assessment against the taxpayer, determining that the taxpayer’s “income-producing activity” occurred entirely within Indiana, and therefore the COP sourcing methodology was inapplicable. The Department reasoned that the relevant “income-producing activity” was the actual “Indiana sales transactions” rather than the taxpayer’s development, aggregation and analysis of the information being sold. While a small handful of courts in other states have accepted similarly narrow interpretations of the term “income-producing activity,” others have properly rejected it for what it is—an attempt to administratively convert statutory COP sourcing rules to market sourcing. Indiana Dept. of Rev. Letter of Finding No. 02-20130238 (Sept. 25, 2013).

By Scott Booth and Andrew Appleby

Although states continue to challenge the validity of captive insurance companies, Wendy’s has notched several taxpayer victories. In a win involving Scioto Insurance Company (Scioto), Wendy’s captive insurance company, the Illinois Appellate Court held that Scioto constituted a bona fide insurance company that was properly excluded from Wendy’s combined report. To meet the capitalization requirements under Vermont insurance law, Scioto acquired Oldemark, a Wendy’s affiliate that held trademarks valued at more than $900 million that Oldemark licensed to Wendy’s. The IRS did not challenge Scioto’s status as an insurance company for federal income tax purposes. Even so, the Illinois Department of Revenue concluded that Scioto was not a true insurance company because: (1) there was not actual risk shifting and risk distribution; (2) the majority of Scioto’s income was derived from intercompany royalty income; and (3) it was not regulated in all states in which it wrote premiums. The court gave the Department’s arguments a frosty reception by rejecting them all, holding that the character of Scioto’s business was insurance, and that Scioto engaged in the necessary risk shifting and risk distribution. The court noted that Scioto generated its own business income separate from Oldemark’s intercompany royalty income. Although Scioto’s royalty and interest income dwarfed its insurance premium income, the court recognized that “it is not any percentage of income that determines whether a company is taxable as an insurance company but rather the character of the business actually done by the company.” Wendy’s Int’l v. Hamer, Dkt. No. 4-11-0678 (Ill. App. Ct. Oct. 7, 2013).

By Zachary Atkins and Douglas Mo

A Florida trial court ruled that imposing different tax rates on cable and satellite television services did not violate the Commerce Clause or the Equal Protection Clause of the U.S. Constitution. The statute in question imposes a statewide communications services tax at a higher rate on satellite service than on cable service. Rejecting the satellite industry’s contention that the differential tax treatment discriminates against interstate commerce, the court concluded that the challenged statute is facially neutral as to intrastate and interstate commerce because the tax applies whether the cable or satellite provider is located in or outside Florida or whether the service originated in or outside the state. The court also noted the statute does not reward in-state companies or activities at the expense of out-of-state companies or out-of-state activities. The court further held that there was a rational basis for classifying cable and satellite service differently because they are, in fact, different: they are organized differently; have different modes of operation; use different technologies and have different capabilities. The fact that satellite service is exempt from the local communications services tax that applies to cable service was also noted by the court. Although satellite service bears a higher rate under the challenged statute, the court held that the statute is part of a larger, comprehensive taxing scheme that treats cable and satellite service roughly the same. Summ. Final J. for Defs., DIRECTV, Inc. v. State of Fla., Dep’t of Revenue, Case Nos. 05-CA-1037 & 05-CA-1354 (Fla. 2d Jud. Cir. Ct. Oct. 9, 2013).

By Shane Lord and Timothy Gustafson

The Tennessee Court of Appeals held that a taxpayer’s wholesale service of converting end-user information into Internet protocol was an “enhanced” service for which the true object or primary purpose was to provide the non-taxable service of “Internet access” and not the taxable service of “telecommunications.” Adopting definitions set forth by the Federal Communications Commission, the court described taxable telecommunication services as “basic” services that offer “pure transmission capability….” In contrast, the court defined “enhanced” services as non-taxable services that combine basic service with “computer processing applications to act on the format, content, code, protocol or similar aspects of the subscriber’s transmitted information, or provide the subscriber additional, different or restructured information, or involve subscriber interaction with stored information.” The court held that the taxpayer offered “enhanced” services to Internet service providers and large corporations because the services converted end-user data into Internet protocol, the language of computers, and only then used the communications infrastructure to transmit the converted Internet protocol to the appropriate location on the Internet. The court held that despite the fact that the taxpayer’s service allowed end-users to communicate over telecommunication lines, the ultimate purpose and true object was to enable an end-user to access the Internet. Level 3 Communications, LLC v. Richard Roberts, Comm’r of Revenue, No. M2012-01085-COA-R3-CV (Tenn. Ct. App. Sept. 20, 2013). 

Click here to read our September 2013 posts on stateandlocaltax.com or read each article by clicking on the title. A printable PDF is also available here.

By Jessica Kerner and Andrew Appleby

The Virginia Tax Commissioner concluded that a taxpayer was not permitted to deduct a portion of the royalties it had paid to an affiliate by narrowly construing the “subject to tax” exception to the state’s addback statute. This exception provides that the deduction will be permitted if the “corresponding item of income received by the related member is subject to a tax based on or measured by net income or capital imposed by Virginia, [or] another state…” The Commissioner interpreted this exception to apply only to the portion of the intangible expense payment that was actually subject to tax in another state, as evidenced by the amount of the affiliate’s income that was apportioned to the other state. The fact that the taxpayer’s affiliate filed income tax returns in the other state that reflected the gross amount of income from the royalty payment was determined to be insufficient. Instead, the Commissioner concluded that the deduction for the royalty payment is only permitted to the extent the related income was apportioned to the other state. The Commissioner did permit the taxpayer to take the deductions for royalties paid to two other affiliates because these payments qualified for the state’s addback exception that applies when the related party also licenses intangible property to unrelated third parties. Virginia Rulings of the Tax Commissioner, Document No. 13-165 (Aug. 23, 2013).

By Zachary Atkins and Douglas Mo

The California Supreme Court held that the State Board of Equalization (SBOE) violated the state’s Administrative Procedures Act (APA) when it promulgated Cal. Code Regs., tit. 18, § 474 (Rule 474). Rule 474, a specialized property tax rule relating to the assessment of petroleum refineries, creates a rebuttable presumption that the land, improvements, fixtures, and machinery and equipment are to be assessed as a single appraisal unit. The significance of Rule 474 is that increases in the value of the land and improvements of a refinery, to the extent they exceed the 2% per year ceiling established by Proposition 13, can be used to offset depreciation otherwise attributable to fixtures and machinery and equipment. This offset has the effect of diminishing the value of fixture depreciation each year. The Western States Petroleum Association, a trade association, attacked Rule 474 on both substantive and procedural grounds. The California Supreme Court invalidated Rule 474 on procedural grounds. Unfortunately for business, however, the Court signaled that the rule would have been valid but for the SBOE’s failure to substantially comply with the APA. The SBOE has already initiated the rulemaking process to readopt Rule 474. This new rulemaking process could have a broader impact on the business community if the SBOE conforms Rule 461(e)—the general property tax rule that provides that fixtures and equipment are to be considered a separate appraisal unit—to Rule 474. W. States Petroleum Ass’n v. Bd. of Equalization (Aug. 5, 2013, S200475) __ Cal.4th __.