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 __.

By Kathryn Pittman and Andrew Appleby

A Washington Superior Court held that using leased specialized railroad cars to transport products in Washington did not rise to the level of “substantial nexus.” The taxpayer, a California company, sold food products into the state by transferring its products into specially leased railroad cars that traveled to Washington. The Washington Board of Tax Appeals overturned the Department of Revenue’s business and occupation (B&O) tax assessment against the taxpayer, determining that the taxpayer lacked the substantial nexus with the state required to impose tax. On appeal, the Superior Court recognized that a taxpayer must take action to establish and maintain a market in the state in order to create nexus. The court held that the use of the leased railroad cars in the state was not sufficient to create nexus, particularly in this case where there was no evidence that the taxpayer was attempting to maintain a business in Washington. Dep’t of Revenue v. Sage V Foods, LLC, Dkt. No. 12-2-01893-3 (Wash. Super. Ct. 2013), nonprecedential order.

Skip and Zack 1.pngMeet Skip, the five-month-old Welsh Terrier of Sutherland State and Local Tax Associate Zack Atkins and his fiancé, Emily. Skip hails from a small country town in western Tennessee, but he is quickly becoming an Atlantan. Don’t let his small size fool you; Skip thinks he is the king of the Piedmont Dog Park. He likes to run with the big dogs, but most of theSkip 2.JPG time the big dogs chase him!

Between the hours of 6:00 a.m. and 8:00 p.m., Skip likes to get into mischief. Whether it is biting holes in clothing (especially socks), discovering new areas of the house, or barking at the dishwasher and dryer, Skip keeps his owners busy. After 8:00 p.m., however, Skip is a completely different puppy. He likes to lay on the couch (preferably between the cushions) and either watch television with Zack and Emily or sleep.

By Mary Alexander and Andrew Appleby

The Indiana Department of Revenue disallowed a taxpayer’s deduction for interest expenses accrued to a subsidiary because the Department considered the loan a sham. Unless eligible for an exemption under Ind. Code § 6-3-2-20(c), a taxpayer that is subject to Indiana’s adjusted gross income tax is required to add back its federal deductions relating to interest expenses paid or accrued to a member of the same affiliated group. The Department determined that the taxpayer did not meet any of the add-back exceptions and that the loan fell within the definition of a “sham transaction” because it lacked “economic substance.” While the form of the transaction was a loan, the Department determined that the substance “could be treated as a capital contribution or some relevant account of money, but the form of the loan is a ‘sham.’”  The subsidiary did not have any employees, and its only activity was to hold a master note for a line of credit between the taxpayer and the subsidiary. The Department also noted that although the taxpayer made substantial profits from its operations in Indiana, the income apportioned to Indiana was “severely distorted” by the interest deduction. The Department concluded that the loan was “motivated by nothing other than” the taxpayer’s “desire to secure the attached tax benefit.” The Department also addressed the characterization of the taxpayer’s income from the sale of a specialized industry subsidiary and determined the income was appropriately re-characterized as business income under Indiana’s functional test. Letter of Findings No. 02-20120140, Ind. Dep’t of Revenue (Aug. 28, 2013).

By Madison Barnett and Timothy Gustafson

In a case involving the exclusion of captive insurance companies from combined reporting groups, the Indiana Tax Court held that a captive must be physically present in Indiana to be “subject to” the insurance premiums tax and therefore exempt from the corporate income tax. The Tax Court initially had ruled that two foreign captive reinsurers were “subject to” the premiums tax, although they did not actually pay the tax, based on the plain meaning of the phrase “subject to.” After the Indiana Supreme Court reversed this ruling, the Tax Court on remand had to determine whether the foreign reinsurers were doing business in Indiana so as to be “subject to” premiums tax. The Tax Court ruled that while the captives received premiums on insurance policies covering risks within Indiana, a physical presence rather than economic presence standard applies to the premiums tax and thus the captives were not doing business in Indiana. The Tax Court also rejected a Commerce Clause challenge to the outcome—taxing domestic reinsurers under the premiums tax but foreign reinsurers under the corporate income tax—finding that state taxes on insurance are “immune from Commerce Clause challenges” under the federal McCarran-Ferguson Act. United Parcel Service, Inc. v. Ind. Dep’t of Revenue, Case No. 49T10-0704-TA-24 (Ind. Tax Ct. Sept. 16, 2013), on remand from Ind. Dep’t of Revenue v. United Parcel Service, Inc., 969 N.E.2d 596 (Ind. 2012), rev’g United Parcel Service, Inc. v. Ind. Dep’t of Revenue, 940 N.E.2d 870 (Ind. Tax Ct. 2010).