Anna and Vic 1_smaller.jpgMeet Anna—the adventurous Husky/Chesapeake bay retriever mix (a “love child” from a farm in Wisconsin) who is in charge of the home of good Sutherland SALT friend, Victor Ledesma (Kimberly-Clark Corporation) and his lovely wife, Jackie. During Anna’s seven years with the Ledesmas, she has earned a variety of nicknames as a result of her antics, including “The Boss,” “The Beast,” “The Queen,” “The Girl,” and, of course, “Honey” (one nickname has been omitted to protect Anna’s reputation).

Anna loves to hike with her bright red backpack, swim, jump in snow drifts, and chase the local squirrels and rabbits from her yard. After repeating puppy school twice, Anna has mastered a few commands—but “Come!” is unfortunately still not one of them. During one of her walks, Anna took off to chase eight deer for over a half mile, charging through a ravine and out of sight, only to be found an hour and a half later. In another adventure, Anna strutted out onto a (nearly) frozen pond and fell through the ice. Anna_smaller.jpgLoaded down by the water bottles and dog treats in her backpack, she was unable to climb out herself and had to be rescued by her brave hero—Vic—who bravely pulled her to safety while grasping a hanging tree branch. The two emerged soaked, frozen, and muddy—making it a day they will never forget.

Along with all of her drama, Anna also offers the Ledesmas her unconditional love and companionship. When inside the house, she is by their side constantly—greeting them at the door with genuine excitement and loyally following them from room to room, even if it interrupts her slumber. And despite her energy, she has a true gentleness about her. To quote Vic, she will take celery from your fingertips “softer than a lazy winter snowfall.” All of these qualities, found in one striking puppy package, makes us proud to coin Anna’s new nickname—Sutherland SALT’s Miss December.

The National Conference of State Legislatures’ Task Force on State and Local Taxation of Communications and Interstate Commerce commissioned Drs. Bill Fox and LeAnn Luna, economists with the University of Tennessee, to study the current economic realties of mandatory unitary combined reporting. The report, entitled Combined Reporting with the Corporate Income Tax: Issues of State Legislatures (Nov. 17, 2010), is intended “to explain the features of combined reporting and to analyze the key issues that states should consider when determining corporate tax structures, and specifically the relative merits of separate and combined reporting.”

Of its various findings, the Fox Report most notably concluded that combined reporting should not be used as a revenue raiser to close states’ budget holes, stating “[c]ombined reporting has no direct effect on state tax revenues.” Rather, if a state’s goal is an immediate increase in corporate income tax revenue, adoption or expansion of the use of intercompany expense addback statutes is a much more effective means of achieving this goal than adoption of combined reporting.

The Fox Report further advises, “[l]awmakers considering a move to combined reporting should consider the immense complexity the reporting regime will introduce” and such “complexity comes with a great amount of uncertainty.” Indeed, such advice is generally echoed by the multistate tax community and supported by similar recommendations made by the Maryland Business Tax Reform Commission and Virginia’s Joint Legislative Audit and Review Commission to their respective state legislatures.

The Washington Department of Revenue has developed a decision tree that illustrates the analysis necessary to determine how an electronically transferred product is taxed. Excise Tax Advisory 9003.2010 (Nov. 30, 2010) summarizes the process by which taxpayers can determine whether a given item is taxable as a digital product (a digital good or a digitally automated service) or remote access software. The decision tree section is intended to “highlight key considerations in the analysis process.”

The decision tree  is a five-step process: 

  1. Determine whether the transaction involves the electronic transfer of a product or service according to the definition of digital products found in RCW 82.04.192; 
  2. Determine whether any exclusions from the definition of digital products or remote access software apply (also found in RCW 82.04.192). For instance, payment processing, online educational programs, live presentations, data processing and other products are excluded from the tax imposition statute; 
  3. Apply Washington’s sourcing rules to determine whether the transaction is sourced to Washington; 
  4. Determine whether any exemption from retail sales or use tax applies; 
  5. Determine whether any other issues, such as amnesty, nexus, or royalties, are involved. For instance, Washington provides a nexus “safe harbor” for digital products and software on servers in the state (RCW 82.32.532). Then, repeat as necessary.

In IDC Research, Inc. v. Comm’r of Revenue, No. 09-P-1533 (Nov. 30, 2010), the Appeals Court of Massachusetts held that the transfer of International Data Group’s (IDG) logo licensing business to a Delaware subsidiary was a sham. The court affirmed the Appellate Tax Board’s decision and reallocated the Delaware subsidiary’s royalty income from foreign affiliates to IDG. 

The court found that IDG never actually transferred ownership of the logo licensing business because it:

  1. Failed to adhere to multiple corporate formalities; 
  2. Continued to identify itself as the owner of the logo; 
  3. Continued to treat the logo as its own after the transfer; and 
  4. Retained the benefits and burdens of ownership – as evidenced by its withdrawal of millions of dollars from the Delaware subsidiary’s account.

IDG asserted that the withdrawals were loans; however, there was no loan documentation and minimal repayment to the subsidiary. While IDG claimed that its business purpose for the structure was decentralization, the court held this was inconsistent with IDG’s retention of control over the subsidiary and the logo. 

In addition to the lack of business purpose, the court found that the Delaware subsidiary lacked economic substance. Its only activities consisted of the receipt of royalty income, the automatic investment of such income, and the leasing of office space in Delaware for $250 a month. Furthermore, all of the Delaware subsidiary’s licensing agreements were with affiliated entities. Finally,  the court agreed with the Appellate Tax Board’s conclusion that the Delaware subsidiary was a “passive vessel” used to divert royalty income from IDG.

The South Carolina Tax Realignment Commission (TRAC) has released its Final Report, which includes proposed draft legislation to achieve its recommendations. As expected, the recommendations include the expansion of the sales tax base to include “data processing, software delivered over the Internet, and digital products.” In addition, the recommendations include language to expand sales tax collection obligations with a New York-style click-through nexus provision and an affiliate nexus provision. Although word on the street is that the South Carolina legislature is unlikely to enact the majority of the recommendations contained in this Final Report, current economic conditions require careful monitoring of these and other tax hikes.

The TRAC proposes to achieve the tax base expansion in a curious fashion—by adding data processing, computer software, and digital products to the list of “intangibles” included in the definition of “tangible personal property.” Thus, in the topsy-turvy world of state sales tax, intangible property can indeed be taxed as tangible property.  The suggested language is as follows:

“Tangible Personal Property” means personal property which may be seen, weighed, measured, touched, or which is in any manner perceptible to the senses.  It also includes services . . . and intangibles, including data processing, computer software, digital products, communications, laundry and related services, furnishing of accommodations and sales of electricity, the sale or use of which is subject to tax under this chapter and does not include stocks, notes, bonds, mortgages or other evidences of debt. 

The draft legislation includes a broad definition of “digital products” that includes, but is not limited to, the Streamlined Sales Tax-like definitions of “digital audio-visual works,” “digital audio works,” and “digital books.” Digital products is expansively defined to mean, “electronically transferred goods obtained by the purchaser by means other than tangible storage media.” 

Likewise, “data processing” is broadly defined in the proposed statute as “the manipulation of information furnished by a customer through all or part of a series of operations involving an interaction of procedures, processes, methods, personnel, and computers. It also means the electronic transfer of or access to that information.  Examples of the processing include, with-out limitation, summarizing, computing, extracting, storing, retrieving, sorting, sequencing, and the use of computers.” 

These proposed definitions are so amorphous that they provide the state with the authority to tax practically any service, data, information, or digital good, so long as it is transferred electronically. This legislation could be interpreted to include information services, cloud computing, and other electronically delivered services far beyond what are specifically enumerated as taxable services in South Carolina statutes. It is precisely this type of unclear and expansive digital imposition that creates uncertainty for businesses and can act as a damper on business development and job creation within the state.

On the nexus front, TRAC recommends a two-pronged attack to compel out-of-state companies to collect sales tax. If adopted, a retailer will be “presumed to be liable for the sales tax . . . if the retailer enters into an agreement with a resident of this State under which the resident, for a commission or other consideration, directly or indirectly refers potential customers, whether by a link on an Internet Web site or otherwise, to the retailer.” The recommendations also contain a provision that establishes nexus by expanding the definition of a “retailer maintaining a place of business” in South Carolina to include an out-of-state company if an in-state affiliated entity has a presence in the state and the affiliated entity does any of the following: use “substantially similar name, tradename, trademark, or goodwill, to develop, promote, or maintain sales”; “pay for each other’s services in whole or in part”; “share a common business plan or substantially coordinate their business plans”; or the in-state company “provides services to or on behalf of, or that inure to the benefit of, the out-of-state retailer.” Adding the TRAC nexus provisions to its long-standing economic income tax nexus regime, the TRAC nexus proposal would make South Carolina one of the most aggressive nexus jurisdictions in
the country.

Despite the overwhelming business opposition to “throwout” sales factor apportionment rules and New Jersey’s recent repeal of its “throwout” rule, Maine is now bucking the trend and adopting a new “throwout” rule. Effective for 2010 and subsequent years, Maine adopted the Finnigan methodology for computing the sales factor for a combined return and to replace its “throwback” rule with the “throwout” rule.

Under the new Finnigan methodology of Code Me. R. 810 for determining the numerator of the sales factor in a combined report, “total sales of the taxpayer” in Maine now includes sales of the taxpayer and sales of any other entity included in a combined return, regardless of whether those entities themselves have nexus with Maine. The adoption of Finnigan applies to both unitary groups that have elected to file a single combined return and those that file separate returns utilizing combined apportionment. If separate returns are filed, each taxpayer’s  return will include in the numerator of the sales factor its own Maine sourced sales as well as a portion of the Maine sourced sales of those entities in the unitary group that do not have nexus with Maine.

Continue Reading Throw Out the Throwback: Maine Replaces “Throwback” with “Throwout” and Adopts Finnigan

On November 18, 2010, the New York Division of Tax Appeals held that Dann Ocean Towing (Dann), a Florida corporation with no employees or property in New York State, was liable for New York’s petroleum business tax. In re Dann Ocean Towing, Inc., Determination DTA No. 822683 (Nov. 18, 2010).

Dann owned 12 tugboats, seven of which were used to perform towing, icebreaking and other operations in New York State on behalf of third-party charter companies. The agreements between Dann and the charter companies were drafted as “service” agreements. However, the tugs were owned by Dann, and Dann’s employees operated the tugs and performed services on behalf of the charter companies.

The New York Division of Tax Appeals held that the tugboats’ operations in New York waters, which included towing and discharging cement and performing ice-breaking operations, constituted substantial nexus with the state. By operating its vessels in New York waters, Dann engaged in business in the state and was liable for the petroleum business tax. 

Dann also argued that the charter companies had control over the tugboats, and therefore, they should be responsible for the tax. Dann pointed to the charter agreement provisions requiring the charterers to reimburse Dann for fuel purchased for the tugboat. The Division of Tax Appeals con-cluded that Dann exercised significant control over the tugboats and, therefore, was liable for the tax.

The Michigan Court of Appeals ruled that two in-state visits per year by representatives of an out-of-state taxpayer could create nexus sufficient to impose the Single Business Tax (SBT). Barr Labs., Inc. v. Dep’t of Treasury, 2010 Mich. App. LEXIS 2033 (Oct. 21, 2010).  At trial, the taxpayer offered an affidavit by its vice president of taxation stating that its employees did not solicit sales during their infrequent trips to Michigan, but rather visited to “gather information.” The Department of Treasury, however, introduced the nexus questionnaires completed by Barr Labs indicating that its employees entered Michigan between two and nine times a year to solicit sales. The trial court found the affidavit to be the most credible evidence and held that Barr Labs’ contacts with Michigan were insufficient to establish the requisite substantial nexus under the Commerce Clause and granted summary judgment in favor of the taxpayer.

Continue Reading Taxpayer’s Solicitation Activities Could Establish Michigan SBT Nexus

A taxpayer has filed a petition for certiorari, asking the U.S. Supreme Court to rule on whether an out-of-state corporation has nexus with Kentucky by virtue of its ownership interest in a limited partnership that does business in the state. Asworth LLC (f/k/a Asworth Corp) v. Kentucky Dep’t of Revenue, Docket No. 10-662 (Nov. 16, 2010). 

Asworth and its affiliates are out-of-state corporations that manage investments of various legal entities. None of the corporations has any property, employees, or payroll in Kentucky. Asworth owns a limited partnership interest in a partnership that conducts business in Kentucky. The Department of Revenue assessed Asworth for corporate income taxes on its distributive share of partnership income. Asworth challenged the assessment arguing that it was not subject to the corporate income tax because it did not have nexus with the state.

The Kentucky Court of Appeals reversed the decision of the Circuit Court and upheld the Department’s finding that Asworth had nexus with the state through its distributive share of partnership income. Revenue Cabinet v. Asworth Corp., 2009 Ky. App. LEXIS 229 (Ky. Ct. App. 2009). Asworth’s argument  that the assessment violated the dormant Commerce Clause’s physical presence nexus requirement was rejected because the corporation owned an interest (up to 99% at various times) in a partnership that conducted business in Kentucky. The court observed that it still remains unclear whether the bright-line physical presence standard articulated in Quill v. North Dakota, 504 U.S. 298 (1992), for sales and use taxes applies to income taxes.

The time has come for the Court to accept a nexus case. Time will tell whether Asworth is the appropriate vehicle for the Court to provide further nexus guidance.

In In re Appeal of Imperial, Inc., Case Nos. 472648; 477927 (July 13, 2010), the California State Board of Equalization (SBE) ruled that gain from the sale of stock sold pursuant to an IRC § 338(h)(10) election constituted business income. Imperial, Inc., a Wisconsin S corporation, entered into an acquisition agreement with an unrelated buyer, whereby Imperial’s shareholders received cash for their shares. The stock sale was treated as an asset sale for income tax purposes as a result of the IRC § 338(h)(10) election, and as a consequence, the sale was deemed to trigger gain on the sale of goodwill.

Imperial argued that the gain on goodwill constituted nonbusiness income and should be allocated to Wisconsin, where Imperial was headquartered, whereas the Franchise Tax Board argued that the gain was business income under the business income functional test.

Under California law, gains realized upon the termination of a business are treated as business income if: 

  1. The taxpayer has sufficient control over the income-producing property; and 
  2. The taxpayer’s control and use of the property is integral to the taxpayer’s regular trade or business operations.

The SBE noted that Imperial’s goodwill was an asset that was created, managed and disposed of by Imperial in the day-to-day operations of its business from 1959 until the sale in 2003, and that more than 50% of the goodwill’s value was attributable to Imperial’s customer base, trade names and internally developed software. The SBE concluded that Imperial’s goodwill represented the residual value of Imperial’s business operations as a going concern after its “hard” assets were valued. The SBE also determined that the goodwill was essential to the viable conduct of its business. For these reasons, the SBE found that both prongs of the functional test were satisfied. 

The SBE next addressed whether the gross receipts from the sale were excludable from the company’s California sales factor under the incidental or occasional sale exception pursuant to California Regulation 25137(c)(1)(A). The taxpayer sought to include the receipts from the sale of goodwill because it would have reduced its California sales factor. The SBE held that excluding the amount associated with the sale of goodwill was justified because the sale created a substantial amount of gross receipts (more than 60%) relative to the taxpayer’s total gross receipts for the year.

The Imperial decision is consistent with the Oregon Tax Court’s analysis of an IRC § 338(h)(10) sale in Centurytel, Inc. v. Dep’t of Revenue, No. TC 4826 (Or. T.C. August 9, 2010) (see SALT Shaker, Vol. 1, No. 9, pp. 2-3). In each of these cases, the tribunal analyzed the character of the transaction based upon the deemed asset sale created by the federal income tax election.