On December 22, 2022, the Massachusetts Supreme Judicial Court held that a taxpayer’s use of computer cookies did not constitute substantial nexus with the state for periods prior to the United States Supreme Court’s decision in South Dakota v. Wayfair, Inc. The taxpayer sold auto parts entirely online and utilized cookies to track customers that visited its website. Effective October 1, 2017, the Massachusetts Department of Revenue promulgated a regulation that required nondomiciliary vendors that employed apps, cookies, or content delivery networks (“CDNs”) in connection with its sale of goods or services in the state to register, collect, and remit Massachusetts sales or use tax if during the preceding 12 months it also met certain transaction value and volume thresholds. This regulation applied to periods prior to the Wayfair Court’s abrogation of the physical presence nexus rule. Nevertheless, the Department assessed the taxpayer based on its electronic contacts with Massachusetts. The taxpayer protested the Department’s use tax assessment for October 1, 2017 to October 31, 2017.

The Massachusetts Supreme Judicial Court held for the taxpayer. The court refused to apply Wayfair’s holding retroactively because “the regulation, by its own terms, limited its reach to nondomiciliary Internet vendors that satisfied the physical presence test set forth in Quill.” The court also admonished the Department for ignoring its position (contained in an amicus brief filed with the US Supreme Court) that it would not apply the Wayfair Court’s holding retroactively. Thus, the pre-Wayfair physical presence standard applied for the tax period at issue. Under that standard, the use of apps, cookies, and CDNs did not constitute physical presence in the state.  

U.S. Auto Parts Network, Inc. v. Commissioner of Revenue, 199 N.E.3d 840 (Mass. 2022).

State and local tax (SALT) issues may arise from mergers, acquisitions, or dispositions. Eversheds Sutherland Partner Todd Betor presented on Unique State Tax Issues at Tax Executives Institute’s 2023 Mergers & Acquisitions Seminar last week in Nashville, TN.

In addition to the need for SALT advisors to get involved at the outset of a deal, the following are three key takeaways from Todd’s panel presentation.

  1. States (and some localities) divert from the federal tax treatment of certain transactions;
  2. SALT deal considerations go beyond how states view a transaction; and
  3. Considering SALT issues as part of a plan can result in meaningful tax savings.

States Do Not Always Follow Federal Tax Rules or Results

As a general rule, states are not bound to conform to the federal tax treatment of a transaction. Indeed, the myriad of state responses to the 2017 Tax Cuts and Jobs Act and, more recently, the 2020 CARES Act demonstrates how very real the disconnect between federal tax provisions and state conformity therewith can be.

A prime example of this disconnect is illustrated by states’ varying levels of conformity to Internal Revenue Code (IRC) Section 381, which governs preservation/carryover of tax attributes,1 including net operating losses (NOLs) of the target company.

While a majority of states generally conform to IRC Section 381, a fair number do not. Massachusetts, for instance, decouples from the federal provision with respect to NOLs via regulation – 830 CMR § 63.30.2(9)(a). That regulation provides in the case of a merger of two or more corporations where there is a single surviving/successor entity, the NOLs of the corporation merged out of existence are eliminated. In other words, the surviving/successor entity only succeeds to, or more appropriately, carries forward the NOLs that a surviving corporation incurred prior to the merger. An unexpected result may occur where two or more existing corporations consolidate into a new corporation. In that situation, Massachusetts regulations provide that the new corporation has no NOLs—any NOLs of the consolidated entities are lost.

Massachusetts’ deviation from IRC Section 381 is but the tip of the state tax iceberg that companies and practitioners must navigate in evaluating and implementing a merger, acquisition, or divestiture, among other transactions. And this example merely serves to highlight the complexity state tax brings to a deal.

SALT Deal Considerations Go Beyond How States View a Transaction

How states ultimately view a transaction and the implications stemming therefrom is but one piece of the SALT considerations that go into a deal. Two examples of other major SALT considerations are discussed below.

A significant SALT consideration is the “track record” of the target company/business, e.g., historic tax positions, filing methodologies, audit history, etc., which the buyer should consider in moving forward with a transaction. This issue relates to successor liability of the buyer for SALT exposures inherent in stock and asset deals.

What a target’s SALT track record looks like, and how it looks through the lens of a buyer, can have a significant impact on a deal, including pricing. More often than not, a SALT risk is identified—typically in the diligence process, either proactively by the seller or raised by the buyer—that cannot otherwise be overcome by the buyer through negotiations (for example, the seller getting the buyer comfortable with the target’s position on the taxability of a service offering). When this occurs, the parties commonly seek to address the risk through seller indemnification, seller escrow (i.e., placing a portion of the purchase price in escrow pending a triggering point for use/release), and/or a purchase price reduction.

How a SALT risk is handled in the transaction agreement (e.g., indemnification, escrow, purchase price adjustment) is generally dependent on the scope of the risk, the risk appetite of the buyer, and advice of SALT advisors. On this last point, it is often that the parties will have differing positions on the historic tax position of the target—typically with respect to sales and use taxes. SALT advisors can add value by substantiating a position or otherwise providing context and support for a target’s position. And the advice may support the elimination or narrowing of an indemnification provision, escrow amount, or purchase price adjustment.

On the other side of the table, a SALT advisor’s role is to advise the buyer on the financial exposure related to pre-transaction tax liabilities of the target. This role is all the more important if a buyer is planning on, and/or the transaction agreement contemplates, the pursuing voluntary disclosure agreements (VDAs) to preemptively address SALT risks.

From the buy-side, another significant SALT consideration is what the post-transaction tax picture may look like. Though the implications are post-transaction, this analysis and planning should be contemporaneous with the steps leading up to close.

At a high-level, this generally involves a review of a target’s nexus footprint with a focus not just on current filing states, but also evaluating a target’s profile based on employee location (payroll), property location, and source of receipts (sales), and comparing that footprint to the buyer’s existing SALT filing profile. Hand-in-hand with the nexus evaluation is how the target will be viewed from an income tax filing perspective, particularly whether there will be “instant unity” of the target with the buyer’s existing business such that target would be included in the buyer’s existing state income tax reporting groups.

Consideration of SALT Issues as Part of a Plan Can Have Meaningful Tax Savings

Considering SALT issues as part of a plan can result in meaningful tax savings. For example, the use of equity consideration can lead to a significant state franchise (or net worth) tax exposure. These taxes are privilege taxes—taxes imposed for doing business in a state—that are generally based on a taxpayer’s total equity value.

A prime example is the Illinois Franchise Tax, administered by the Illinois Secretary of State as opposed to the state’s Department of Revenue, which utilizes “paid-in capital” as the base for the tax (as imposed on corporations) and is imposed on a separate company basis.2 The term is broadly defined to include – 

the sum of the cash and other consideration received, less expenses, including commissions, paid or incurred by the corporation, in connection with the issuance of shares, plus any cash and other consideration contributed to the corporation by or on behalf of its shareholders, plus amounts added or transferred to paid-in capital by action of the board of directors or shareholders pursuant to a share dividend, share split, or otherwise, minus reductions . . .. 3

The franchise tax implications of using equity consideration, specifically issuance of additional equity, are illustrated in the 2004 case of USX Corp. v. White.4 In that case, USX Corp. (USX) had issued additional shares of its stock (133,184,470 shares), which was used as consideration in a reverse subsidiary merger with Texas Oil and Gas Corporation. For purposes of its Franchise Tax, USX reported $2.99 billion as the entire consideration received for issuing the new USX stock—a $2.99 billion increase in paid-in capital. The case ultimately dealt with the application of an exclusion Illinois affords to vertical mergers—which the court found did not apply to USX’s fact pattern.

The above highlights the need for careful planning as to transaction consideration and its impact on a company’s franchise tax liability. Post-transaction debt restructuring can also have a significantly similar tax impact. All too often, though, SALT advisors are called upon to address the tax impact after the fact; further enforcing the need for SALT advisors to get involved at the outset of a deal.

_______

1 Putting aside limitations on tax attributes under IRC Sections 382, 383, and 384, and states’ conformity therewith. 

2 805 ILCS §§ 5/15.25, 15.40, 15.55, 15.70.

3 805 ILCS § 5/1.80(j).

4 352 Ill. App. 3d 709 (Ill. App. Ct. 2004).

The pending precedential Office of Tax Appeal’s (OTA) decision of Appeal of L. Smith, OTA Case No. 20036033 (Dec. 7, 2022) concerned whether California could impose income tax on a nonresident’s distributive share of gain from the sale of an interest in a timeshare developer operating in California as a limited liability company (Timeshare). This turned on two issues. 

The first issue was whether a nonresident’s distributive share of gain on a sale of an interest in a pass-through entity must be sourced using the statute for sourcing gain from the sale of intangibles, Cal. Rev. & Tax. Code § 17952, or FTB’s regulation for sourcing partnership income from a trade, business or profession, Cal. Code Regs., tit. 18, § (“Regulation”) 17951-4.  Following the Court of Appeal’s decision in The 2009 Metropoulos Family Trust, et al. v. Franchise Tax Bd. (2022) 79 Cal.App.5th 245, 266 (see our prior coverage here), the OTA found that it must apply FTB’s regulation. Although Metropoulos concerned an S Corporation, OTA found that its holding applies equally to partnerships and limited liability companies taxed as partnerships.

The second issue arose in the course of applying Regulation 17951-4:  whether the parent limited liability company (Holding Co) that sold the interest in Timeshare was engaged in a unitary business with Timeshare. If it was, then the apportionment factors of Timeshare would flow up to Holding Co, resulting in nearly 42 percent of the gain from the sale being sourced to California, as opposed to none. OTA found that Timeshare and Holding Co were engaged in a unitary business. Notably, OTA rejected FTB’s argument that a special unitary test applied to holding companies. It also explained that majority ownership is not required to be unitary in the partnership context because unlike “a corporate shareholder, only the partner’s ownership interest in the partnership’s income and apportionment factors may be combined.” The OTA’s analysis highlighted California’s alternative test for unity — the “three unities test” and “dependency or contribution test” — but focused on the latter because that is what FTB based its assessment on and the taxpayer failed to rebut FTB’s position. Critical factors that OTA relied on in reaching its decision were an integrated executive force, intercompany financing, and a covenant not to compete.

The decision is available here.

Calling all trivia fans! Don’t miss out on a chance to show off your SALT knowledge!

We will award prizes for the smartest (and fastest) participants.

This week’s question: The Texas Comptroller of Public Accounts recently made amendments to its franchise tax apportionment rule in light of which case?

E-mail your response to SALTonline@eversheds-sutherland.com.

The prize for the first response to today’s question is a $25 UBER Eats gift card. This week’s answer will be posted on Saturday in our SALT Shaker Weekly Digest. Be sure to check back then!

A recent report issued by the New Jersey Division of Taxation includes a suggestion that state lawmakers consider a cloud computing tax. The report titled, “Studying the Impact of the Digital Economy” recommends adopting a sales and use tax model that differentiates between physical good and services and digital goods and services. The report notes that New Jersey law does not specifically address cloud computing services and thus sales tax does not apply to software as a service (SaaS) or platform as a service (PaaS). The report suggests that a review of tax policy regarding cloud computing services should be undertaken as the volume of transactions increases, but adds that “[t]o effectively tax cloud computing services, nexus and sourcing issues will also have to be addressed.”

New Jersey Division of Taxation, “Studying the Impact of the Digital Economy.” (2023)

The New York Tax Appeals Tribunal ruled that a semiconductor manufacturer was eligible to use the carryover refund from both the Empire Zone investment tax credit (EZ-ITC) for new businesses and the qualified investment project (QUIP)/significant investment project (SCIP) tax credit in the same year, resulting in a $152.3 million refund for the 2014 tax year. 

In 1986, the Legislature created the Economic Development Zone Act to stimulate private investment and job creation in specific economically challenged areas of the state (the areas were later renamed Empire Zones). Among the tax incentives, the EZ-ITC allowed taxpayers a refund of 50% of its EZ-ITC carryover as a new business, and a 50% refund of its EZ-ITC carryover as the owner of a QUIP or SCIP. 

GlobalFoundries, as an operator of a manufacturing facility in a designated Empire Zone, filed a refund claim for 2014 on the basis that it was entitled to combine the new business credit carryover refund and the QUIP/SCIP credit carryover refund, which together effectively provided a 100% refund of its EZ-ITC credit carryover. The Division of Tax Appeals rejected GlobalFoundries’s refund claim, ruling that the two credit carryovers are mutually exclusive, and that GlobalFoundries was only entitled to the original 50% refund. 

On appeal, the Tax Appeals Tribunal overturned the ALJ’s decision, refraining from deferring to the Divisions requested deference to its interpretation and concluding that the new business credit and the QUIP/SCIP credit could be taken together. The Tribunal pointed to the unambiguous plain language of the statute, which “expressly provides” that a new business is entitled to a 50% refund of its EZ-ITC carryover, and the statute “also expressly provides that, in addition, any taxpayer that is approved as the owner of a QUIP or SCIP may elect to treat 50% of its EZ-ITC carryover as an overpayment of tax to be credited or refunded.” The Tribunal held that a natural reading of the language allows a taxpayer that qualifies for both benefits to receive both benefits. 

Matter of the Petition of GlobalFoundries U.S. Inc., DTA No. 829184 (Tax App. Trib., Jan. 19, 2023).

Calling all trivia fans! Don’t miss out on a chance to show off your SALT knowledge!

We will award prizes for the smartest (and fastest) participants.

This week’s question: The Supreme Court of Virginia recently upheld a decision invalidating which county’s plan to claw back tax refunds?

E-mail your response to SALTonline@eversheds-sutherland.com.

The prize for the first response to today’s question is a $25 UBER Eats gift card. This week’s answer will be posted on Saturday in our SALT Shaker Weekly Digest. Be sure to check back then!

To kick off the SALT Shaker Podcast for 2023, Eversheds Sutherland Associate and host Jeremy Gove welcomes Maria Koklanaris, Senior Tax Correspondent for Law360, to the show. Together, they tackle state tax legislation and litigation that should be on your radar this year.

Jeremy and Maria begin with an overview of state tax legislation season, including: two diverging trends, some states increasing taxes on people deemed “high earners” versus other states moving to cut taxes or simplifying their tax codes; and states’ continued attempts to tax the digital economy. 

Beyond legislation, they also discuss cases to watch this year, which includes two U.S. Supreme Court cases dealing with unclaimed property, and a non-tax California ballot initiative case which has the potential to inform the application of “Pike Balancing” under the Commerce Clause. They also address the pending case before the Ohio Supreme Court confronting the tax impacts of remote work.

You can read Maria’s articles they referenced here:

To conclude, Jeremy picks his first overrated/underrated question of the year – how do you feel about hot chocolate?

Questions or comments? Email SALTonline@eversheds-sutherland.com. You can also subscribe to receive our regular updates hosted on the SALT Shaker blog.

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