Chaos resulting from the California budget crisis reached a crescendo in recent weeks because of a new budget agreement, a bevy of voter referendums addressing tax legislation, and new regulations addressing corporate income tax apportionment issues. In the aftermath of the chaos, California has again significantly modified its corporate income tax apportionment provisions, for the second time in the last two years. 

The first major event occurred on October 8, when the California Legislature approved a set of budget bills that were signed by Governor Schwarzenegger. The budget bills included SB 858, which made two significant changes to California’s corporate income tax regime: 

  1. Enacted modifications to California’s sales apportionment factor sourcing provisions; and 
  2. Imposed a two-year suspension on utilization of Net Operating Losses (NOL) for the 2010 and 2011 tax years. 

By way of background, California’s costs-of-performance methodology had been repealed (and replaced with market type sourcing provisions) through legislation passed in February 2009; however, the repeal was not set to become effective until January 1, 2011. This change from costs-of-performance to market-based apportionment was made along with the enactment of an election available to most taxpayers to annually choose to use a single sales factor (rather than a formula comprised of property, payroll, and double-weighted sales). SB 858 changes this regime and provides that effective January 1, 2011:

  • Taxpayers that do not elect single sales factor apportionment (either because the election is not available or the election is not made) are required to use California’s costs-of-performance methodology to source receipts from “other than sales of tangible personal property” (e.g., receipts from intangibles and services). 
  • Taxpayers that elect to apportion income via a single sales factor apportionment formula are required to source receipts from “other than tangible personal property” via California’s market sourcing provisions. 

At the time of enactment of SB 858, the fate of California’s single sales factor election—which was not set to become effective until January 1, 2011—was left to California voters through Proposition 24, which would have repealed the election. Proposition 24 was defeated, and therefore the annual single sales factor election survives.     

At the same time that California’s legislature enacted legislation that modified California’s corporate income tax sourcing regime, the California Franchise Tax Board (FTB) issued new proposed regulations for applying its market-based apportionment rules to the sourcing “of sales other than sales of tangible personal property in the state.” Under the FTB’s proposed Regulation Section 25136, sales of services are generally assigned to California “to the extent the customer of the taxpayer receives the benefit of the service” in the state. However, the proposed regulations provide for a cascading set of rules that considers other differing factors for individual customers and business customers to the extent the location where the “benefit of the service” is received is not determinable. The other factors are more complex rules for business customers.  For receipts from intangible property, Reg. 25136 provides for varying rules depending on the type of intangible generating receipts, whether there is a complete transfer of the rights in the intangible, and whether there is exclusive use of the intangible in California or use in multiple states. These receipts may be sourced to California if any of the criteria are satisfied under a tiered methodology.

In an unfortunate misapplication of the constitutional nexus rules, the New York Tax Appeals Tribunal has found that two corporations had franchise tax nexus with New York solely because the corporations received income from ownership interests in a seven-plus tier entity structure culminating in a pass-through entity that was doing business and earning income in the State. Matter of Shell Gas Gathering Corp. No. 2 et al., DTA Nos. 821569 and 821570 (Sept. 23, 2010). The taxpayers, Shell Gas Gathering Corp. No. 2 and Shell Gas Pipeline Corp. No. 2, were both holding companies that were not themselves doing business in New York. To make a really long story short, the taxpayers, through approximately seven tiers of various ownership interests in various types of pass-through entities, had an indirect interest in an entity, Coral Energy Resources LP, that did business in New York. Coral Energy was a seller and marketer of natural resources and conducted business, owned property, and made sales in New York. A distributive share of the income from Coral Energy’s business was ultimately passed-through to the taxpayers.

Continue Reading New York Tax Appeals Tribunal Confuses Nexus Rules With Income Sourcing Rules–Constitutional Mashup Ensues

It is no secret that states need money, and many are turning to unclaimed property audits to get it. These audits are low-hanging fruit as they cost the states little to administer because many third-party audit firms work on a 10%-12% contingency arrangement, which can produce fees in the tens of millions of dollars. The only real losers here are the companies placed under audit. Unclaimed property audits frequently are demanding and aggressive.

So, assuming a company has been able to dodge the unclaimed property bullet so far, here are some “red flags” that may increase the risk of a third-party unclaimed property audit. 

  1. Everybody Knows Your Name: A Sutherland lawyer was once on a bus at a conference with a bunch of state unclaimed property administrators, and as the bus passed a famous landmark with a large company’s name on it, the administrators started asking whether that company had been audited yet! A large company with a well-known name or a manufacturer of a common household product is or will be on an audit list. 
  2. People Come, People Go:  Companies with a transient work force or a significant number of employees who are paid hourly are often targets. This is one of many reasons why retail is a favorite target. There tends to be a great deal of turnover, which may lead to unclaimed property issues associated with uncashed payroll checks. Employees who are paid hourly tend to have significantly more “reissued” checks because of errors with hours, vacation time accrued, double-time, lost checks, etc. Due to the potential replication of these types of errors, the amount of unclaimed property exposure can be substantial. 
  3. It Is So Obvious: Another common red flag for audits is if “obvious” property types are missing from a report.  Based on a company’s particular industry, there are certain property types that are expected to be reported. For example, a health care provider should always have some patient credit balances to report as unclaimed property and excluding them will serve as an indication that the provider is not compliant. Spending a few minutes to brainstorm the types of industry-specific unclaimed property issues a company should be reporting (and comparing those categories to what is reported) could stave off a thorny unclaimed property audit.
  4. Nothing In This World Is Free:  Before claiming unclaimed property from a state, consider whether the company is (or should be) reporting unclaimed property to the state. Sutherland lawyers have received several calls from companies’ personnel excited to have found unclaimed property being held by a state only to realize that the same company is not in compliance with the state.  
  5. You Are Being Watched:  States benchmark unclaimed property reports and audit the results of various industries.  As a result, if a state notes that a particular company within a specific industry is remitting significantly less than other companies in the same industry, an audit is likely. States also tend to “move” through certain industries. For example, about three years ago, oil and gas companies were audit targets. Currently, insurance companies are under attack, and a wave of audits are underway.
  6. Your State of Incorporation Is (Almost) Everything:  Under the jurisdictional rules of unclaimed property, if the last known address of a payee  is unknown or incomplete, the property is reportable to the holder’s (company’s) state of incorporation. Since the majority of public companies are incorporated in Delaware, well…we think you get the idea. Many companies are considering Delaware’s and other states’ unclaimed property laws (and the aggressiveness of those states’ audit practices) when considering incorporating new or existing businesses. 
  7. If You Have Nothing to Say, Don’t Say Anything:  One of the biggest and most obvious audit triggers is underreporting unclaimed property when it is obvious that the company has more significant unclaimed property owing to the state. Many companies decide they need to “get in compliance” so they just file negative or zero reports with all the states. After all, “There is no way people don’t cash their checks!” (If Sutherland had a dime for every time a business unit manager said this, Sutherland would have a lot of dimes). Taking this route routinely produces an unclaimed property audit. 

Last Words: A study published in the Medical Journal of Australia on December 16, 2009, reported that on a pain scale of 1 to 10 (with 10 the “worst pain imaginable”), students who had a bandage ripped of their arms quickly had an average pain score of 0.92 while those who had the bandage removed slowly experienced an average rating of 1.58. Coming into compliance with unclaimed property laws may result in much higher average pain scales than having a bandage ripped off an arm, but coming into compliance quickly (through comprehensive internal audits and voluntary disclosure agreements) will still be less painful than taking the slow approach (waiting for state audits). All states, with the exception of California, allow companies to enter into some type of voluntary disclosure agreement, which reduces or eliminates penalties and interest, and shortens the “look-back” period.

The New Jersey Supreme Court granted leave to appeal in the Whirlpool Properties Inc., and Pfizer Inc. cases to determine whether the New Jersey “Throwout Rule” is facially unconstitutional. Whirlpool Properties, Inc. v. Div. of Taxation and Pfizer, Inc. v. Div. of Taxation, Dockets A-1180-08T2 and A-1182-08T2 (N.J. Super. Ct. App. Div., July 12, 2010) (leave to appeal granted Oct. 21, 2010). The New Jersey Appellate Division affirmed the New Jersey Tax Court’s decision in the consolidated decision holding that the Throwout Rule did not, on its face, violate the Due Process, Commerce, or Supremacy Clauses of the United States Constitution because the statute could operate constitutionally in some instances. 

The New Jersey Throwout Rule required taxpayers to exclude (or “throwout”) receipts from the denominator of their sales apportionment factor if the sales are assigned to a state where the taxpayer is not subject to tax. The Throwout Rule was effective for tax periods beginning on or after January 1, 2002, and before July 1, 2010. 

Many taxpayers have a vested interest in the Whirlpool and Pfizer cases because of pending appeals and potential refund claims. In addition, many taxpayers and practitioners are interested in the outcome of the case because the Throwout Rule represents the clearest example of extraterritorial taxation on state and local tax. Although New Jersey no longer imposes the Throwout Rule, other states, including Maine and West Virginia, continue to employ similar apportionment rules. If the taxpayers’ facial claims ultimately are unsuccessful, the taxpayers likely will pursue challenging the Throwout Rule on an “as applied” basis.

In what was beginning to seem like an unlikely event, the Michigan Legislature finally passed a nearly year-old bill that will allow for a limited amnesty period, from May 15, 2011, to June 30, 2011. While the Senate passed the original amnesty bill in 2009, there was no further movement of the bill until September 2010, when the House and Senate finally agreed that the bill could help close Michigan’s $484 million budget gap—without raising taxes. Governor Jennifer Granholm approved Senate Bill 884 on October 5. The amnesty program is projected to bring in $61.8 million of additional revenue.

Unlike other recent amnesty programs, Michigan’s program is relatively simple. Taxpayers that participate in the program will receive a waiver of all penalties (civil and criminal) for taxes paid through the program. The Bill does not state whether taxpayers will be required to waive their right to seek a refund of liabilities paid under the program. Nor does it indicate whether post-amnesty penalties will apply to taxpayers who do not participate in the program. In order to qualify for Michigan’s amnesty program, taxpayers must file a written request for a waiver on a form provided by the Department, and meet the following requirements:

  • Have an outstanding Michigan tax liability (except for taxes due after the close of the 2009 calendar year). The Bill does not specify the types of taxes eligible for the amnesty program;
  • File any unfiled or amended returns; and
  • Pay all outstanding tax and interest.

Additionally, some taxpayers are ineligible to participate, such as:

  • Those eligible to enter into a voluntary disclosure agreement under § 30c for the tax at issue.  Under § 205.30c of Act 122 of 1941, a non-filer who either: (1) has a filing responsibility under nexus standards issued by the department after December 31, 1997; or (2) has a reasonable basis to contest liability, as determined by the state treasurer, for a tax or fee, is eligible to enter into a voluntary disclosure agreement.
  • Those whose tax is attributable to income derived from a criminal act, if the taxpayer is under criminal investigation or involved in a civil action or criminal prosecution for that tax, or if the taxpayer has been convicted of a felony under this act (Act 198 of 2010) or the Internal Revenue Code of 1986.

The Department of Treasury is expected to provide further details on Michigan’s amnesty program as the amnesty period approaches. In addition, the Department is required to provide “reasonable notice” to taxpayers who might be eligible to participate in the program at least 30 days prior to the start of the amnesty period. Thus, as 2011 moves into full swing, taxpayers with outstanding Michigan tax liabilities may be receiving notice of their eligibility to participate in the amnesty program.

The Connecticut Department of Revenue recently issued an Informational Publication (Publication) on September 23, 2010, to provide guidance on its new “economic nexus” standard, effective for tax years beginning on or after January 1, 2010. Connecticut’s new economic nexus standard states that:

Any company that derives income from sources within this state, or that has a substantial economic presence within this state, evidenced by a purposeful direction of business toward this state, examined in light of the frequency, quantity and systematic nature of a company’s economic contacts with this state, without regard to physical presence…shall be liable for the tax… Conn. Stat. L. 2009 § 90 (emphasis added).

The Publication:

  • Sets forth those activities that will constitute “substantial economic presence” and will result in a corporation being subject to Connecticut corporate income tax.
  • Provides that the substantial economic presence in Connecticut must be attributable to the purposeful direction of business activities toward the state, and those activities are evaluated “based on the frequency, quantity, and systematic nature of the business’s economic contacts in Connecticut.”
  • Provides a bright-line test for determining when these activities will result in substantial economic presence: when the company has receipts from business activities of $500,000 or more attributable to Connecticut sources during a taxable year. Even if a company has less than $500,000 in receipts, the Commissioner may still assert that a company has a filing and tax payment obligation if it has nexus with the state through some other means. 
  • Addresses when the use of an intangible in the state will result in a Connecticut tax liability pursuant to the new economic nexus standard.  The use of an intangible will result in Connecticut tax liability if:
  1.  
    1. The intangible property generates, or is otherwise a source of, gross receipts within the state for the corporation, including through a license or franchise;
    2. The activity through which the corporation obtains such gross receipts from its intangible property is purposeful (e.g., a contract with an in-state company); and
    3. The corporation’s presence within the state, as indicated by its intangible property and its activities with respect to that property, result in it having $500,000 or more of receipts attributable to Connecticut sources during a taxable year To determine if a taxpayer has $500,000 or more of receipts from the use or sale of intangibles in the state, Connecticut’s existing market-sourcing rules must be used. Under these rules, receipts from intangibles are sourced to Connecticut if the receipts are from: rentals and royalties from properties situated within the state; royalties from the use of patents or copyrights within the state; net gains from the sale or other disposition of intangible assets managed or controlled within the state; and all other receipts earned within the state.
  • The Publication further provides that passive investment income derived from Connecticut is not considered in subjecting a company to economic nexus.   

“Factor presence” tests—like Connecticut’s—have been growing in popularity since the Multistate Tax Commission approved a model regulation on October 17, 2002, which provides for such a standard. Washington state enacted a similar factor presence test earlier this year with respect to its Business & Occupation Tax, and a similar standard in California for corporate income tax purposes becomes effective January 1, 2011. However, the factor presence nexus standard is not without controversy, and legal challenges to these standards likely are on the horizon.

The New Jersey Division of Taxation is revisiting a proposed regulation that would provide new rules governing the sale of software and related services. While the draft regulation has not been formally published for public comment, the Division is working with interested parties to accept comments prior to the draft’s publication.

The draft would amend existing definitions and add new definitions to N.J. Admin. Code §18:24-25.1, and replace the existing §18:24-25.6, entitled “Treatment of maintenance contracts and software-related services,” with new §18:24-25.6, entitled “Treatment of software-related services and software maintenance contracts.” These changes are significant because New Jersey taxes the enumerated services of installation and services to tangible personal property; but does not tax downloaded prewritten computer software when sold to a business user. New Jersey’s position is that these services are taxable, even when performed on electronically delivered, prewritten computer software.

Although New Jersey amended its definition of tangible personal property to include prewritten computer software on October 1, 2005, to conform to the Streamlined Sales and Use Tax Agreement (SSUTA), businesses presumed that because the State had also adopted a statutory exemption for prewritten computer software when sold to a business user, that all associated services (e.g., installation, configuration, and customization) would continue to be exempt. However, the Division’s policy is that because prewritten computer software is expressly included in the definition of tangible personal property, the Division can tax the services performed on the software, regardless of how it was delivered. Taxpayers who receive electronic delivery of software in New Jersey should evaluate the regulation’s implications for those purchases.

West Virginians (and hungry road-trippers passing through the state) may soon face a new tax on their drive-through purchases. The West Virginia Department of Transportation has proposed charging an additional five percent tax on food and beverages purchased at drive-through windows, in addition to the six percent customers already pay.

The proposal is one of many suggestions by the state’s transportation department to bring in money for the state road fund. Advocates say the tax is necessary to repair and maintain miles of neglected roads although the connection between drive-through food and road repair is tenuous at best. Other suggestions include levying a one percent surcharge on car insurance premiums. The Department of Highways estimates that the drive-through tax could bring in $50 million a year, and proponents argue that it would encourage healthier eating habits.

There is no indication, however, that the Legislature will support the idea. Customers and business owners are likely to oppose it as well – customers because of the higher prices (and general antipathy toward “sin” taxes), and business owners because of the potential hit to their sales. For instance, customers who would otherwise have made a quick stop for a cup of coffee on the road might be discouraged by the higher price. Moreover, some critics have pointed out that most of the revenue for the state road fund comes from gas taxes – which drive-through customers are already paying.

For his part, West Virginia Governor Joe Manchin is not on board. He released a statement on September 14 saying, “I want to be clear that these are suggestions that I strongly oppose and do not in any way support as a means to generate revenue for the state road fund.”

The U.S. Court of Appeals for the District of Columbia, sitting en banc on September 29, raised serious questions in a suit seeking refund of telephone excise taxes paid to the Internal Revenue Service (IRS). A decision on the arguments raised could have far-reaching consequences for the IRS, potentially requiring it to conform to the Administrative Procedure Act (APA) when issuing guidance.

The case involves 26 U.S.C. § 4251, a three percent excise tax on long-distance phone calls for which the charges varied based only on transmission time, which five circuit courts declared invalid in 2005 and 2006. In May 2006, the IRS declared that it would no longer impose the tax and would allow taxpayers to claim refunds for excise taxes. The guidelines for claiming the refund, which were outlined in Notice 2006-50, required taxpayers to affirmatively request the refund on their 2006 federal tax return and precluded other administrative remedies.

A number of taxpayers filed suit to overturn the Notice, claiming that it represented final agency action that “arbitrarily, unreasonably, and unlawfully limits restitution of the funds unlawfully exacted.” In re Long-Distance Tel. Serv. Fed. Excise Tax Refund Litig., 501 F.Supp.2d 34, 38-39 (D.D.C. 2007). Taxpayers protested the fact that they were not allowed to seek refunds in any other manner than that set forth in the Notice. This, they argued, constituted “final agency action” subject to judicial review under the APA, and that the Notice was laden with mandatory language and created new obligations for taxpayers in violation of the rules of administrative procedure.

The IRS argued in Cohen v. United States, No. 08-5088 (D.C. Cir. Aug. 7, 2009), that the decision of whether or not to process refund requests was entirely up to the IRS’s discretion and that its methods were unreviewable under the APA. The IRS also insisted that the guidelines set forth in the Notice did not preclude other administrative action. The Court disagreed, noting that the taxpayers had no other remedy at law than to challenge the Notice on the grounds that it violated the APA. In response to the government’s contention that the Anti-Injunction Act (AIA) precluded the suit, taxpayers said the statute was inapplicable because the IRS had already collected the tax. The AIA only affects lawsuits while the agency is in the process of assessing or collecting a tax.

Gilbert Rothenberg, acting deputy assistant attorney general to the Justice Department Tax Division, pointed out during the en banc hearing that Congress had established procedures taxpayers must follow to obtain a refund—procedures the taxpayers had ignored in this case—and that the statute of limitations was in fact still open. It would be unprecedented, he said, for a court to find that it had jurisdiction to hear a case challenging compliance with the APA when a taxpayer had not first used the appropriate refund process. But the judges questioned how the IRS could be immune from the APA and criticized the terms of the Notice.

If the court finds that the IRS failed to adequately adhere to the APA in constructing the procedures in the Notice, the consequences could be significant. A ruling for the taxpayers could require the IRS to follow formal notice-and-comment procedures when formulating guidance—such as Revenue Rulings, Revenue Procedures, and Notices—that have the effect or force of law.

On September 28, 2010, the United States Supreme Court granted certiorari in two important Due Process Clause cases dealing with the assertion of personal jurisdiction against foreign corporations:

  • In Goodyear Luxembourg Tires v. Brown, the Court will consider “whether a foreign corporation is subject to general personal jurisdiction, on causes of action not arising out of or related to any contacts between it and the forum state, merely because other entities distribute in the forum state products placed in the stream of commerce by the defendant.”
  • In J. McIntyre Machinery Ltd. v. Nicastro, the Court will consider a related  question: whether a state may be permitted to exercise specific jurisdiction over a foreign manufacturer under the stream-of-commerce theory “solely because the manufacturer targets the United States market for the sale of its product and the product is purchased by a forum state consumer.”

Although there are no direct state tax implications in these two cases, they will raise issues among corporations engaging in electronic commerce and are concerned about being subject to tax in every state. If the Court rules that jurisdiction was properly asserted in either of these cases, businesses, and particularly those engaged in electronic commerce, will be faced with the daunting prospect of being haled into court anywhere in the United States with no connection to the forum state beyond selling items on a third-party website. So much for purposeful availment!

Continue Reading Supreme Court Grants Cert in Two Jurisdiction Cases – Will the Long Arm Get Longer?