By Jessica Kerner and Timothy Gustafson 

The Tennessee Department of Revenue determined in a Letter Ruling that a taxpayer’s sale of remote storage services and virtual computing services are not subject to Tennessee sales or use tax where the data centers and servers used to provide such services are located outside the state. The Department determined neither service was subject to Tennessee sales and use tax because there was no sale, transfer or electronic delivery of tangible personal property or computer software in Tennessee in connection with the furnishing of these services. The Department noted that the taxpayer prohibited customers from downloading any part of its remote storage interface or its virtual computing software. Further, the Department concluded that the services are not specifically enumerated taxable services in the state and ruled that both services were excluded from the state’s definition of telecommunications services based upon the primary purpose of each service. The Department determined that the primary purpose of the remote storage service was the remote storage of digital data, applications and information, and the primary purpose of the virtual computing service was to access processed data or information stored on the taxpayer’s servers located outside the state. Accordingly, the Department categorized both services as data processing and information services, which are specifically excluded from the definition of telecommunications services. Tennessee Letter Ruling 13-12 (Sept. 12, 2013).

By Mary Alexander and Andrew Appleby

The Tennessee Court of Appeals held a wide area network (WAN) service provided by IBM was not taxable because the true object of the service was not a “telecommunications service.” IBM’s WAN service was a technological infrastructure that enabled remote access to information by linking geographically separated computers. The users of the WAN service could retrieve information related to the customer’s business but were not able to use the WAN service to communicate with other users. The WAN service did not include any messaging capabilities (e.g., email or voice). The Commissioner of Revenue argued that the WAN service was taxable as a communications service because “IBM did not create the content that it transmitted to its customers.” Quoting Qualcomm Inc. v. Chumley, 2007 WL 2827513 (Tenn. Ct. App. Sept. 26, 2007), the court stated that a distinction based upon the creator of the content did not trump inquiry into the true object of a potentially taxable service. The true object test that the court applied was “whether communication between users of the service was the primary purpose of the service.” Because the true object of IBM’s service was to allow users to access information stored on geographically separated computers, and the service did not allow users to communicate with one another, the court determined that IBM’s WAN service was not taxable as a telecommunications service. IBM Corp. v. Farr, No. M2012-0714-COA-R3-CV (Tenn. Ct. App. Sept. 24, 2013).

In a 6-1 decision, the Illinois Supreme Court affirmed an Illinois Circuit Court holding that Illinois Public Act 96-1544 (The Click-Through Nexus Act), requiring out-of-state retailers to collect and remit use tax, violates the Internet Tax Freedom Act. Performance Marketing Ass’n v. Hamer, Docket No. 114496 (Oct. 18, 2013).

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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).