In June of 2015, Connecticut passed legislation that implements combined reporting for tax years beginning on, or after January 1, 2016. Part of the new regime, which is codified by Conn. Gen. Stat. P.A. 15-5, § 144 (2015), requires water’s-edge combined groups to include entities incorporated in tax havens in the combined group. Just before the holidays, the Connecticut General Assembly passed legislation that narrowed the definition of a “tax haven” from the originally adopted definition.

Under the originally passed combined reporting law, the determination of whether a jurisdiction was a “tax haven” was made using five different definitions. If any one definition was satisfied, the jurisdiction was a “tax haven.” None of the five definitions is entirely clear and each generally required an analysis of facts related to the jurisdiction’s government rather than the activities of a taxpayer in the jurisdiction. The original definition of tax haven was similar, but not identical to the Multistate Tax Commission Proposed Model Statute for Combined Reporting. The new law required the commissioner of revenue to publish a list of jurisdictions determined to be tax havens by September 30, 2016.

In December, the Connecticut General Assembly convened a special session and passed Public Act 15-1, which amends the newly enacted tax haven law in section 37. As amended, the Connecticut statute still contains the five different definitions. However, the amended law excludes from the definition of a tax haven “a jurisdiction that has entered into a comprehensive income tax treaty with the United States” and which meets certain other requirements. Additionally, the December legislation also repealed the requirement for the commissioner to publish a list of tax havens. In sum, the limiting amendment to the tax haven law should provide taxpayers with some clarity, although that will be somewhat offset by the lack of a formal list.

Connecticut is one of four New England states that considered and/or passed legislation adding tax haven provisions to their combined reporting regimes. Tax haven legislation passed in Rhode Island in 2015, as part of Rhode Island’s adoption of combined reporting effective for tax years beginning on or after January 1, 2015. The Maine and Massachusetts legislatures considered tax haven provisions, but ultimately did not pass such laws in 2015.

After refusing to back down on the issue for years, the Michigan Department of Treasury (Department) issued guidance last week to taxpayers announcing a change in its policy on the sales and use taxation of remotely accessed prewritten computer software.  This comes after years of litigating the issue in the Michigan courts, most recently with the precedential taxpayer victory in Auto-Owners Ins. Co. v. Dep’t of Treasury, No. 321505 (Mich. Ct. App. Oct. 27, 2015), in which the Michigan Court of Appeals held that remote access to software did not constitute delivery of tangible personal property.  See our prior coverage here.  The Department has announced it will apply Auto-Owners (and the numerous other favorable decisions) retroactively and thus allow for refunds for all open tax years.  This is a huge victory for taxpayers; however, those that paid the tax (both purchasers and providers alike) must act promptly to coordinate and request a refund prior to the period of limitations expiring.

Implications

In issuing this guidance, the Department specifically adopts the Michigan Court of Appeals interpretation of “delivered by any means” (as required to be considered taxable prewritten computer software).  Going forward, the “mere transfer of information and data that was processed using the software of the third-party businesses does not constitute ‘delivery by any means’” and is not prewritten software subject to sales and use tax.  See Auto-Owners, at 7.  Not only has the Department admitted defeat with respect to the delivery definition, but it also appears to have acquiesced to taxpayers’ arguments with respect to the true object test (or “incidental to services” test in Michigan).  This test was first announced by the Michigan Supreme Court in Catalina Marketing, and provides that a court must objectively analyze the entire transaction using six factors and determine whether the transaction is “principally” the transfer of tangible personal property or the transfer of services with a transfer of tangible personal property that is incidental to the service.[1]  In last week’s guidance, the Department states that if only a portion of a software program is electronically delivered to a customer, the “incidental to service” test will be applied to determine whether the transaction constitutes the rendition of a nontaxable service rather than the sale of tangible personal property.  However, if a software program is electronically downloaded in its entirety, it remains taxable.  This guidance comes in the wake of Department and the taxpayer in Thomson Reuters, Inc. v. Dep’t of Treasury stipulating to the dismissal of a Supreme Court case involving the same issues that had been appealed by the Department.  In light of these developments, it appears that the Department has given up all ongoing litigation over cloud services.

Immediate Action Required for Refunds

Taxpayers who paid sales or use tax on cloud based services are entitled to receive a refund for all open periods.  In Michigan, the period of limitations for filing a refund is four (4) years after the filing deadline of the original return (including extensions).  See Mich. Comp. Laws Ann. § 205.30 (citing Mich. Comp. Laws Ann. § 205.27a).  Because sales and use tax returns are filed periodically, typically monthly, taxpayers should act quickly to avoid missing out on a portion of their refund.[2]  The Department states that a taxpayer seeking a refund of taxes paid for a product falling within the Auto-Owners opinion should file a written refund request with the Department, which should include any necessary supporting documentation.  The guidance sets forth the requirements and procedure for filing a refund claim, including the address to send the claim to and return requirements.

Vendors who collected the tax from customers will need to carefully review the requirements in Michigan about customer reimbursement to determine what must be done (such as notify customers, etc.) to satisfy the state refund procedures.  Customers who paid tax to vendors on these purchases must notify the vendors (not the Department) that they are owed a refund from the vendor.  Specifically, Michigan statutorily provides that a cause of action against a seller for overcollected sales or use taxes does not accrue until a purchaser has provided written notice, including sufficient information to determine the validity of the request, to a seller and has given the seller 60 days to respond.  See Mich. Comp. Laws Ann. §§ 205.60(2), 205.101(3).  This statutory requirement will force purchasers of cloud-based services to dig deep in their records—as far back as 2012—for documentation that sales tax was paid on the transactions (and collected and paid to the state by whom) and require vendors to promptly respond to customer requests.

Practice Note

While this guidance represents a monumental victory in Michigan, we are wary that the Department may pursue alternative avenues to tax remotely accessed software in the future, such as through the Legislature.  With Michigan starting its 2016 session yesterday, companion exemption bills that were introduced (but not passed) in 2015 will be carried over and are likely to be reconsidered.  There have been discussions that the Department may seek an imposition through the Legislature, so vendors should monitor the 2016 session carefully.

[1] See Catalina Marketing Sales Corp. v. Dept. of Treasury.  678 N.W.2d 619 (Mich. 2004) (identifying six factors to consider when making this determination that include: (1) what the buyer sought as the object of the transaction; (2) what the seller or service provider is in the business of doing; (3) whether the goods were provided as a retail enterprise with a profit-making motive; (4) whether the tangible goods were available for sale without the service; (5) the extent to which intangible services have contributed to the value of the physical item that is transferred; and (6) any other factors relevant to the particular transaction).

[2] In Michigan, taxpayers with annual sales, use and withholding tax due of less than $750 file annually; taxpayers with between $750 and $3,600 annual tax due for the year of the same taxes file quarterly; and taxpayers with over $3,600 annual tax due for the same taxes file monthly—with the return due on the 20^th of the following month.

Last week, the California Supreme Court denied the State Board of Equalization’s (BOE’s) petition for review in Lucent Technologies, Inc. v. State Bd. of Equalization, No. S230657 (petition for review denied Jan. 20, 2016). This comes just months after the California Court of Appeals held against the BOE and ordered it to pay Lucent’s $25 million sales tax refund. As explained in more detail below, the denial finalizes the favorable precedent of the Court of Appeals in Nortel Networks Inc. v. State Bd. of Equalization, 191 Cal. App. 4th 1259, 119 Cal. Rptr. 3d 905 (2011)—representing a monumental victory for a broad range of taxpayers in California and opening the door for significant refund opportunities. Moreover, the California Supreme Court’s denial affirms the Court of Appeals decision that the BOE’s position was not substantially justified and the taxpayer was entitled to reasonable litigation costs of over $2.6 million.

Background

Lucent and AT&T (collectively Lucent) are and were global suppliers of products and services supporting, among other things, landline and wireless telephone services, the internet, and other public and private data, voice and multimedia communications networks using terrestrial and wireless technologies. Lucent manufactured and sold switching equipment (switches) to their telephone customers, which allowed the customers to provide telephone calling and other services to the end customers. The switches required software, provided on storage media, to operate. Lucent designed the software (both switch-specific and generic) that runs the switches they sell, which was copyrighted because it is an original work of authorship that has been fixed onto tapes. The software also embodies, implements and enables at least one of 18 different patents held by Lucent.

Between January 1, 1995, and September 30, 2000, Lucent entered into contracts with nine different telephone companies to: (1) sell them one or more switches; (2) provide the instructions on how to install and run those switches; (3) develop and produce a copy of the software necessary to operate those switches; and (4) grant the companies the right to copy the software onto their switch’s hard drive and thereafter to use the software (which necessarily results in the software being copied into the switch’s operating memory). Lucent gave the telephone companies the software by sending them magnetic tapes or CDs containing the software. Lucent’s placement of the software onto the tapes or discs, like the addition of any data to such physical media, physically altered those media. The telephone companies paid Lucent over $300 million for a copy of the software and for the licenses to copy and use that software on their switches.

The BOE assessed sales tax on the full amount of the licensing fees paid under the contracts between Lucent and its telephone company customers. Lucent paid the assessment and sued the BOE for a sales tax refund attributable to the software and licenses to copy and use that software at the trial court. The parties filed cross-motions for summary judgment on Lucent’s refund claims, and the Los Angeles County Superior Court issued a 15-page ruling granting Lucent’s motions in 2013. The court concluded that the contracts between Lucent and the telephone companies were technology transfer agreement’s (TTA’s) within the meaning of the California exemption statute. See Cal. Rev. & Tax. Code §§ 6011(c)(10); 6012(c)(10) (exempting the amount charged for intangible personal property transferred with tangible personal property in any TTA from the definition of “sales price” and “gross receipts”). According to the California statute, a TTA is “any agreement under which a person holding a patent or copyright interest assigns or licenses to another person the right to make and sell a product or to use a process that is subject to the patent or copyright interest.” As a result, Lucent was obligated to pay sales taxes on the tangible portion of the sale (the switches, the instructions, and the tapes and CDs used to transmit the software), but not required to pay tax on the intangible portion (the software and licenses). Because of this, the court ordered the BOE to refund the sales taxes paid on the software and licensing fees—totaling more than $24.5 million. The court also awarded court costs and “reasonable litigation costs” of more than $2.6 million after finding the BOE’s position in the litigation was not “substantially justified.”  The BOE appealed to the California Court of Appeals.

Court of Appeals Decision

On October 8, 2015, the California Court of Appeals for the Second Appellate District affirmed the Superior Court ruling granting Lucent’s motion for summary judgment and ordering the BOE to pay Lucent’s refund and costs (including attorneys’ fees). Once again, the BOE argued that copying the software to a CD or tape, rather than transferring it over the internet, transformed the software or the rights to use it into tangible personal property (i.e., subject to sales tax). The appellate court rejected this argument, citing to the 2011 Nortel case involving nearly the exact same facts. Consistent with Nortel, the court determined that that the BOE’s sales tax assessment was erroneous. In so concluding, the court held that: (1) the manufacturer’s decision to give the telephone companies copies of the software on tapes and CDs (rather than over the internet) does not turn the software itself or the rights to use it into tangible personal property subject to the sales tax; (2) a TTA, which exempts from the sales tax the intangible portions of a transaction involving both tangible and intangible property, can exist when the only intangible right transferred is the right to copy software onto tangible equipment; and (3) a TTA can exist as long as the grantee of copyright or patent rights under the agreement thereafter copies or incorporates a copy of the copyrighted work into its product or uses the patented process, and any of these acts is enough to render the resulting product or process “subject to” the copyright or patent interest. Procedurally, the court held that the BOE’s trenchant opposition to the manufacturer’s refund action in this case was all but foreclosed by Nortel and other binding decisional and statutory law, making the BOE’s position not “substantially justified” and the trial court did not abuse its discretion in awarding the manufacturer its “reasonable litigation costs.”

Impact of the Decisions

The Lucent denial by the California Supreme Court could have a significant impact. Although both Lucent and Nortel were factually based on telecommunications equipment in interpreting the TTA, there is nothing in either decision to suggest that their scope is limited to telecommunication equipment. The decisions involve the sales and use tax statutes and broadly apply to any mixed or bundled transaction where the driving cost behind the transaction is an intangible, including software. Any business selling or buying software should consider whether refund opportunities exist for open years. In the sales tax context for California, the period of limitations to file a refund is generally “three years from the last day of the month following the close of the quarterly period for which the overpayment was made.” See Cal. Rev. & Tax. Code § 6902(a)(1).

As the refund madness plays out over the coming months (any beyond), it will be interesting to see if the BOE once again attempts to retroactively mitigate the effects of the courts’ precedent. Specifically, in June 2013, BOE officials, working with Governor Jerry Brown, made an eleventh-hour attempt to insert language into a budget trailer bill that would have retroactively overturned the effects of Nortel and curtailed the ability of other taxpayers to claim refunds of taxes on software qualifying for exclusion under the TTA laws. California lawmakers ultimately rejected the inclusion of the provision in the budget trailer on procedural grounds, but left the door open for future legislation on the substance. The language would have broadened the definition of “storage media” such that prepackaged software sold on storage media is always tangible property subject to sales tax. Whether the BOE pursues legislation or not, the fight over the scope of the TTA exemption will likely continue despite the recent precedential victory and slap on the wrist by the appellate courts.

Last month, a much-anticipated bill drafted by the Alabama Department of Revenue (Department) was introduced in the Alabama Senate that would have expanded the definition of tangible personal property to include “digital goods.”  See Senate Bill 242 (introduced February 16, 2016).  Fortunately, the Senate Finance and Taxation Education Committee (Committee) rejected the bill on March 9, 2016, after hearing testimony from Assistant Department Counsel Christy Edwards and extensively questioning her on the bill’s content and motives.  Notably, the Department continues to take aggressive positions in an effort to tax digital goods and services, without the requisite statutory or legislative approval to back it up.

Background

On February 28 2015, the Department proposed an amendment to Regulation 810-6-5-.09, which would have amended the rental tax on tangible personal property to include “digital transmissions” (broadly defined to include digital content such as streamed audio and video).  After significant opposition from industry representatives, the Joint Legislative Council (composed of leadership from both chambers) wrote a letter to Commissioner Julie Magee in April 2015 requesting that the proposed regulation be withdrawn.  It cited to the fact that the proposal was overly expansive and would in effect be the imposition of a new tax, a determination that rests with the legislature.  See our prior coverage here.  With hesitation and only after continued pushback from the Legislative Council, the Department withdrew the rental tax regulation amendment on July 7, 2015.

In response to the rejection of the proposed regulation, the Department went through its historic revenue rulings and revoked a number of technology rulings in January 2016, noting they will continue attempting to apply the rental tax to streaming services.  Commissioner Magee cited the revocations as a mere “clarification” that did not change the law.  In her comments to the revocations, Commissioner Magee noted that all taxpayers will be collecting and remitting tax in the future “[e]ither legislatively through a digital goods bill or through audits and assessments.”

Senate Bill 242

The digital goods bill arrived just a few weeks later, sponsored by Senator Trip Pittman.  As introduced, the bill would define “tangible personal property” to include “digital goods.”  For these purposes, digital goods include “[s]ounds, images, data, facts, or information, or any combination thereof, transferred electronically, including, but not limited to, specified digital products and any other service transferred electronically that uses one or more software applications.”  As is readily apparent, this language is extremely broad and arguably includes every service delivered over the internet.  The definition also raised concerns because it borrows from Streamlined language (“transferred electronically”; “specified digital products”), but Alabama is not a Streamlined state and does not define those terms elsewhere in the legislation or Code.  As drafted, the bill would have become effective immediately upon passage.

After cancelling a scheduled Committee hearing earlier this month, citing the need for revisions, the sponsor and Department entered the March 9 public hearing with a substitute bill.  Instead of defining “digital goods” as tangible personal property, the substitute provided that the “digital equivalent of tangible personal property” is now also tangible personal property.

Christy Edwards testified at the hearing in favor of the bill.  Consistent with the Department’s position over the past year, she consistently framed the bill as a “clarification” of existing law.  Several senators questioned this notion, noting that there would be no need for legislation if digital goods and equivalents are already taxed to the extent suggested in the bill.  Many senators also pushed back on the lack of clarity in the bill, asking Ms. Edwards to explain with specificity what is taxable and not taxable based on the bill’s language—which she largely could not do aside from a continued reference to digital photographs.  In apparent frustration, one senator specifically requested a chart from the Department listing goods and services that would be taxable (or not) based on this bill to provide to her constituents.

Committee discussion of the bill concluded with a vote on a motion by the sponsor to favorably recommend SB 242 to the Senate as a whole.  The Committee emphatically rejected the motion by a two-thirds majority, refusing to advance the bill 8-4.

Companion Exemption Bills

After Senate Bill 242 was introduced, companion exemption bills were introduced in both chambers of the Alabama Legislature that would specifically exempt “products transferred electronically acquired with less than the right of permanent use granted by the seller or use which is conditioned upon continued payment from the purchaser” from the sales, use and rental taxes.  See House Bill 349 and Senate Bill 345.  This exemption language captures streaming audio, video and games (and any other subscription-based digital good or service to which perpetual use rights are not acquired by the purchaser).  While these bills would undercut the efforts of the Department to expand the current statutory imposition to these items, their outlook is unclear.  On March 16, 2016, the House bill was passed out of committee and is now being considered by the House as a whole.  Last Friday, the exemption bill was endorsed by the Business Council of Alabama after hearing from a number of business groups concerned with the recent efforts of the Department.  The exemption legislation is one to closely monitor in the coming weeks.

Last Friday, the Alabama Court of Civil Appeals handed the Department of Revenue (Department) a significant loss in their continued attempt to tax non-enumerated services and tangible property provided in conjunction with those services under the sales tax.  See State Dep’t of Revenue v. Omni Studio, LLC, No. 2140889 (Ala. Civ. App. Apr. 29, 2016).  Specifically, the appellate court affirmed the taxpayer’s motion for summary judgment granted by the trial court, which set aside the Department’s assessment on the basis that photographs provided by a photography studio are merely incidental to the nontaxable photography services provided by the studio.  While the prospective effect of the holding in the photography context is unclear due to recent amendments to the photography regulation (effective January 4, 2016), the case is significant in that it strengthens the “incidental to service” (or “true object”) precedent in Alabama and should be seen as a rebuke to the Department for ignoring judicial precedent in favor of their own administrative practices and guidance.

This decision is important in analyzing the taxability of mixed/bundled sales to Alabamans (i.e., where services and some degree of tangible personal property are provided as part of the same transaction).  As with any decision, taxpayers should consider potential refund claims.

Facts

Omni Studio, LLC (Omni) is a photography studio in Birmingham, Alabama that provides photography services to a variety of customers ranging from advertising and marketing firms to wedding parties.  During the audit period, Omni had not remitted any sales tax on the photographs and services provided as part of its business and charged clients based on the time and resources spent to provide the services offered (as opposed to the number, size or type of photo produced).  In June 2013, the Department audited Omni for a six-year period from 2007-2013.  At the conclusion of the audit, the Department determined that Omni owed sales tax for “headshots, flat-rate photography sessions, digital studio photography, portraits, weddings and reception events” and issued a final assessment to the tune of over $27,000—which included interest and penalties.  Omni appealed the final assessment to the Jefferson County Circuit Court and the parties each filed motions for summary judgment.  The trial court denied the Department’s motion and granted Omni’s—setting aside the Department’s final assessment.  The Department appealed.

Taxpayer’s Argument

Omni cited a number of Alabama cases standing for the notion that some transfers of tangible personal property are merely incidental to the nontaxable sale of services and, therefore, are not themselves taxable under a true object analysis.  For example, they highlighted an Alabama Supreme Court decision finding that the transfer of dentures and other prosthetic devices from a dentist to patient is not a sale, but a mere incident to the professional treatment rendered by dentists.  See Haden v. McCarty, 275 Ala. 76, 78, 152 So.2d 141, 142 (1963).  Omni noted that the court has expanded this notion beyond the “learned professional” context and directed the court to two decisions finding catalogues and brochures provided by an advertising agency and portraits provided by an artist to be merely incidental to the sale of the services provided.  See State v. Harrison, 386 So.2d 460, 461 (Ala. Civ. App. 1980) (public relations services); see also State v. Kennington, 679 So.2d 1059 (Ala. Civ. App. 1995) (artistic services).  Omni argued that there is no meaningful distinction between the services and personal property Harrison and Kennington provided to their clients and the services and property Omni provides.

While the taxpayer initially argued at the trial court level that the license to use the images it provides is not a transfer of ownership (and not a sale), it backed away from this argument during the appellate court proceedings and the issue was not addressed.

Department’s Argument

The Department asserted that Alabama has long rejected the argument that a photographer renders a nontaxable professional service and took the position that the sale of photographs are taxable retail sales under Alabama law.  In making this argument, they did not point to any decisions of the Court of Civil Appeals or Alabama Supreme Court, but instead relied on three administrative law division decisions.

Holding

The appellate court affirmed the trial court decision granting Omni’s motion for summary judgment, agreeing with Omni that there is no meaningful distinction between the photos provided by Omni and the various items of tangible personal property provided in Harrison and Kennington.  The court pointed out that at least one of the administrative law division decisions relies on the administrative decision in Kennington, which has since been abrogated.  The court found that although the interpretation of the statute by an administrative agency charged with its enforcement is persuasive, that interpretation is not binding on the court.  Citing stare decisis, the court concluded that they were not asked to revisit their various holdings finding transfers of tangible personal property to be merely incidental to nontaxable services, and refused to overrule the controlling precedent cited by the taxpayer.

Practice Note

This decision transcends the photography context and may provide a basis for refund claims for providers of other services that collect on the tangible personal property they provide in Alabama.  Photography businesses should be careful not to overlook the Department’s amended photography regulation.  However, this regulation is not applicable to other service-based taxpayers and photographers doing business in Alabama before this year.  At a minimum, this case provides a reminder of the binding “incidental to service” test and the persuasive effect of any Department guidance to the contrary.

It should be noted that this Department loss comes just a month after the Department made an unsuccessful push to legislatively expand the definition of tangible personal property to include “digital goods.”  See our prior coverage on the rejection of this proposal by the Alabama Legislature.  The competing exemption bill on the topic (House Bill 349) has yet to advance in the Senate after being passed in the House on April 12, 2016.  Last week, Commissioner Julie Magee circulated a letter to state legislators opposing the bill and restating the position of the Department that there is no difference between digital and non-digital transactions.  Similar to the Department’s position on photography services in Omni, the basis for this position is tied to administrative decisions and practices—which the Court of Appeals emphasized is not binding.  In light of the lack of a legislative solution this year, the Commissioner’s letter indicated that the Department will not initiate any new audits on the issue and will hold in suspense any preliminary assessments of taxpayers interpreting digital transactions as nontaxable.

The Commissioner’s letter and Omni signify additional ammunition in the ongoing battle over the taxation of digital goods and services in Alabama—a battle that is likely to continue into 2017 with a legislative solution looking unlikely this year.

Yesterday, a legislative conference committee was appointed to approve an already agreed-upon $1.3 billion revenue package, which was immediately approved by both the House (116-75) and Senate (28-22) and sent to Governor Wolf for approval.  The governor subsequently issued a press release confirming that he “will sign this revenue package.”  A copy of the conference committee report (in full) that passed is available here.

The final revenue package includes (among a host of other revenue raising changes) a new tax on digital content and services, as described in more detail below.  Specifically, the expansion captures most (if not all) digital goods within the sales and use tax imposition by defining them as tangible personal property.  A number of digital services are also captured in the broadly defined language. 

The Approved Language

The language passed by the General Assembly today (as contained on pages 8-9 of the report) specifically provides that tangible personal property “shall include the following, whether electronically or digitally delivered, streamed or accessed and whether purchased singly, by subscription or in any other manner, including maintenance, updates and support:

1. video;
2. photographs;
3. books;
4. any other otherwise taxable printed matter;
5. applications, commonly known as apps;
6. games;
7. music;
8. any other audio, including satellite radio service;
9. canned software, notwithstanding the function performed; or
10. any other otherwise taxable tangible personal property electronically or digitally delivered, streamed or accessed.”

If the revenue package is approved by the governor as promised, this provision will take effect August 1, 2016. 

Taxability Changes

While this proposal (derived from the governor’s first budget proposal in 2015) has been around over a year, there were a few modifications to the language contained in prior iterations.  See, e.g., S.B. 117 (2015).  Notably the expansion (as passed) expressly includes streamed content, “maintenance, updates and support” charges and satellite radio services.  Notable omissions from the list include magazines, newspapers and mailing lists.  Because there is still a catch-all provision for “any otherwise taxable printed matter”, the digital versions of these items are captured only to the extent the print version is taxable.  Because print newspapers and subscriptions to periodicals (such as magazines) are exempt, their digital counterparts are not captured by the base expansion.

Unfortunately, the vast majority of digital goods and services are captured by the new tax.  Digital goods/products such as movies, music and books delivered electronically (i.e., downloaded) will be taxable going forward.  Streamed audio and video services, whether offered by subscription or otherwise will also be taxed.  Because the mere access to these items is considered tangible personal property under the revised definition of tangible personal property, online video game play and remote access to canned software and apps is also captured by the new digital imposition.

Practice Note

Vendors of digital content and services should carefully evaluate the imposition language to determine whether products and services are covered.  Unfortunately, compliance determinations must be made and implemented within only two weeks to meet the August 1, 2016 effective date.

After the highly publicized administrative lease transaction and amusement tax expansions in Chicago last year, more cities around the country are taking steps to impose transaction taxes on the sale or rental of digital content. Unlike tax expansion efforts at the state level (such as the law recently passed in Pennsylvania), which have almost all been tackled legislatively, the local governments are addressing the issue without clear legislative authority by issuing administrative guidance and taking aggressive positions on audit. As the local tax threat facing digital providers turns from an isolated incident to a nationwide trend, we wanted to highlight some of the more significant local tax developments currently on our radar.

California

This summer, a coalition of approximately 40 California cities hired a law firm to draft an administrative ruling that would expand their Utility Users Tax (UUT) on video programming services (i.e., basic and premium cable services, audio services, video games, pay-per-view services and on-demand programming) provided by “video service suppliers” to include subscription video services provided over the top (OTT) by companies that are not video service suppliers.

By way of background, the UUT is an excise tax imposed by California municipalities on the consumption of utility services, including cable television. Like a sales tax, the UUT is collected from the consumer and remitted to the local jurisdiction by the service provider. However, unlike the sales tax, which is remitted to the state (and subsequently distributed to localities), the UUT is not imposed at the state level and therefore, businesses required to collect must remit tax on a city-by-city basis. There are about 150 local jurisdictions with UUT ordinances, but only about half of them include the video programming services imposition language that the draft ruling seeks to interpret. Of those, roughly half of the local jurisdictions are part of the coalition that requested the draft ruling expanding the imposition to OTT content.

If adopted, this ruling would expand the UUT to require both cable (video service suppliers) and non-cable service providers to begin collecting and remitting UUT for their subscription and one-time service fees charged for “video services” to customers residing in the California locality. The draft ruling even goes so far as to provide a list of popular companies and products (see Attachment A of the draft ruling) that will likely be captured by the UUT expansion. Strangely, the ruling does not have a clear effective date, but instead simply provides that “this Ruling shall be implemented by no later than January 1, 2017.” (emphasis added) While only two cities have adopted the ruling so far (Benicia and Indio), the unclear effective date is included in both. We have sought guidance from each city on whether the rulings took effect upon adoption in late August or will take effect on some later date, prior to January 1, 2017. As of the drafting of this blog, we have not heard back from either jurisdiction.

Because the original imposition of tax on video programming services appears intended to govern only video service suppliers providing one or more channels of video programming (and not streaming or OTT video content), it does not appear that California local tax administrators have the authority to expand the UUT as the draft ruling proposes.

Just a few weeks ago, a memo to the Pasadena City Manager was issued that resulted in several members of the City Council questioning and pushing back on this effort. Ultimately the ruling was never adopted. This development, paired with the feedback on compliance concerns raised by OTT representatives throughout the process has resulted in the coalition of cities delaying further adoption and implementation until representatives from the OTT industry are given the chance to offer input. Based on this temporary delay, the implementation of the rulings is expected to be pushed back to March or April 2017, as opposed to January 1, 2017 (as included in the rulings adopted in Benicia and Indio). The most recent version of the ruling is available here.

Practice Note:

The California UUT video programming services ruling is not the only example of a recent local grab in the digital context.

A number of vendors have indicated that third-party contract auditors working for Colorado cities have begun taking the position on audit that the local sales tax imposition on “tangible personal property” (defined a corporeal personal property) applies to streaming and other OTT content because the transactions take up some space (albeit temporary) on hardware devices sitting in Colorado.

In Alabama, representatives of local government groups are actively participating in a legislative working group to define the scope of the digital tax expansion effort expected during the 2017 session.

As with most transaction tax trends we expect to see many more cities evaluate whether they can administratively or legislatively impose tax on OTT digital content in 2017. In cases where such taxes are imposed outside the traditional sales tax context, we expect it will be difficult, if not impossible, for companies to comply with such regimes.

On Saturday, January 14, the National Conference of State Legislatures (NCSL) Task Force on State and Local Taxation (Task Force) met in Scottsdale, Arizona to discuss many of the key legislative issues that are likely to be considered by states in 2017. The Task Force consists of state legislators and staff from 33 states and serves as an open forum to discuss tax policy issues and trends with legislators and staff from other states, tax practitioners and industry representatives.

Below is a short summary of the key sessions and takeaways from the first Task Force meeting of 2017. PowerPoints from all sessions are available on the Task Force website.

Nexus Expansion Legislation Expected to Continue

With lawsuits pending in South Dakota and Alabama over actions taken by states in 2016, MultiState Associate’s Joe Crosby provided an overview of 2016 nexus expansion legislation (as well as legislation introduced thus far in 2017), with NCSL’s Max Behlke pointing out that he expects a lot of states to act on this trend this year.

In particular, it was pointed out that the US Supreme Court’s denial of cert in DMA v. Brohl (upholding the decision of the 10th Circuit) should give states confidence about their ability to constitutionally adopt similar notice and reporting laws. Last month, Alabama Revenue Commissioner Julie Magee publicly stated that Alabama plans to introduce notice and reporting legislation similar to Colorado, along with at least two other states.

Economic nexus laws directly challenging Quill, similar to South Dakota SB 106 passed last year, are also expected to be prevalent in 2017—with five states (Mississippi, Nebraska, New Mexico, Utah and Wyoming) already introducing bills or formal bill requests that include an economic nexus threshold for sales and use tax purposes. Notably, the Wyoming bill (HB 19) has already advanced through the House Revenue Committee and its first reading by the Committee of the Whole and is expected to receive a final vote in the House this week. The Nebraska bill (LB 44) takes a unique approach in that it would impose Colorado-style notice and reporting requirements on remote sellers that refuse to comply with the economic nexus standard.

Behlke pointed out that he doesn’t see Congress acting on the remote sales tax issue in early 2017 due to other priorities—including federal tax reform. With a final resolution of the kill-Quill efforts by the US Supreme Court most likely not possible until late 2017 (or later), state legislatures are likely to feel the need to take matters into their own hands. From an industry perspective, this presents a host of compliance concerns and requires companies currently not collecting based on Quill to closely monitor state legislation. This is especially true given the fact that many of the bills take effect immediately upon adoption.

Need for States to Conform to Federal Partnership Audit and Adjustment Rules

In a session co-hosted by COST’s Fred Nicely and Nikki Dobay, TEI’s Pilar Mata and the MTC’s Tom Skimkim, the speakers encouraged states to adopt uniform legislation for reporting federal tax and audit changes in light of the new partnership rules adopted as part of the Bipartisan Budget Act of 2015 that will be applicable for tax years after Dec. 31, 2017. The MTC’s Partnership Work Group is currently in the process of considering this important issue.

Proposed legislative solutions offered as part of drafting the model act include: (1) revising the definition of “final determination” to be consistent; (2) allowing reporting of changes on a streamlined report in lieu of amended returns; (3) incorporating a de minimis exception (for tax changes amounting to $250 or less) that would allow for a less-burdensome administrative process for reporting minor changes; (4) clarifying the statute of limitations for failure to file amended returns; and (5) allow for the filing of an estimated payment to toll interest accrual on adjustments.

Federal Tax Reform Coming –State Tax Implications

The Tax Foundation’s Kyle Pomerleau gave an insightful summary and outlook of the two current federal tax reform proposals (Trump’s campaign plan and the House GOP “Better Way” plan), which are expected to be but have not been formally put into legislation yet.

This session was followed by an overview of the potential state tax implications of the Better Way plan by COST’s Karl Friedan, Turner SALT’s Greg Turner, MultiState Associate’s Joe Crosby, and CBPP’s Michael Mazerov. The speakers highlighted that simply conforming to the forthcoming federal tax reform has the potential to generate more revenue than many of the other high profile state tax issues being discussed—such as remote sales tax collection. More specifically, the broader base and lower rates included as part of the proposal will likely increase the revenue to states—which only conform to the federal tax base (not rates). Therefore, the 14 states that automatically conform to the federal tax base might see a significant increase in revenue generated without taking any affirmative action. Others would need to adopt legislation conforming as of a specific date to achieve the same results. Regardless of the method of conformity, states that do conform are likely to see a windfall of revenue based on the increased federal tax base, without affirmatively reducing rates consistent with the federal reform. The speakers pointed out that there are a number of issues that states need to carefully consider before blindly conforming to the federal tax reform, including potential violations under the foreign Commerce Clause based on the changes in treatment of foreign profits. This is an issue to closely watch that will require further evaluation as one or more federal tax reform proposals become available in more detail in the coming months.

Digital Taxation and Augmented Reality

McDermott’s Steve Kranz and Entertainment Software Association’s Tom Foulkes gave an update on the state and local approach to taxing the world of digital content and services and provided an overview of issues likely to come before legislators in the coming year—including virtual and augmented reality. A copy of the presentation is available here.

Final Tax Expenditure Best Practices Adopted

In concluding the day, the Task Force adopted a final version of best practices regarding tax expenditure budgets and reports, which is available here.

In a recent decision, the New Jersey Tax Court provided some long-awaited guidance on the “unreasonable” exception to the state’s related-party intangible expense add-back provision. In BMC Software, Inc v. Div. of Taxation, No 000403-2012 (2017), the Tax Court held that payments made by a subsidiary to its parent for a software distribution license were intangible expenses that were subject to the add-back provision, but that the statutory exception for “unreasonable” adjustments applied so that the subsidiary was able to deduct the expenses in computing its Corporation Business Tax (CBT). The court first determined that the expense was an intangible expense and not the sale of tangible personal property between the entities because the contract specifically called the fee a royalty, the parent reported the income as royalty income and the parent retained full ownership of the intellectual property rights indicating that no sale had taken place. Thus, the court determined that the intangible expense add-back provision did apply. The most interesting aspect of this case, however, was the court’s application of the “unreasonable” exception to the intangible expense add-back provision because that had not yet been addressed by the courts in New Jersey.

The Tax Court established two critical points with respect to the add-back of related-party intangible expenses: first, that the “unreasonable” exception does not require a showing that the related-party recipient paid CBT on the income from the taxpayer; and secondly, that a showing that the related-party transaction was “substantively equivalent” to a transaction with an unrelated party is sufficient evidence that the add-back is “unreasonable.”

The “unreasonable” exception to the CBT add-back provision does not require that the related-recipient pay CBT on the income.

With respect to the first point, the Tax Court partially relied on its decision in Morgan Stanley & Co. Inc. v. Director, Div. of Taxation, 28 N.UJ. Tax 197 (2014) that a similarly worded unreasonable exception applied even if the affiliate recipient of the payment had not paid CBT on such payment. While Morgan Stanley involved the interest add-back provision, not the intangible expense add-back, the Tax Court in BCM Software relied on Morgan Stanley because both add-back provisions contained similarly worded “unreasonable” exceptions. The court held that its conclusion that the “unreasonable” exception applied regardless of whether CBT had been paid by the recipient on the payment was consistent with the Legislature’s intent—the add-back was adopted to ensure that the related-party income was captured in taxable income and was subject to tax, not that CBT was actually paid on the income, so that it was not necessary that the recipient pay CBT on the income (rather than use net operating losses (NOLs) to offset the income) for an exception to apply.

In BCM Software, the affiliate recipient was subject to the CBT but did not pay the CBT on the income because it had NOLs. The court did not opine on whether the “unreasonable” exception could apply when the related-party recipient is not subject to the CBT.

A showing that the related-party transaction was “substantively equivalent” to a transaction with an unrelated party is sufficient evidence that the add-back is “unreasonable.”

Again relying on Morgan Stanley, the Tax Court determined that while it was not necessary that the recipient pay CBT on the payment for the “unreasonable” exception to apply, the “unreasonable” exception required more than a mere showing that the related-party transaction had a non-tax motive and economic purpose. The court held that the taxpayer’s evidence that the terms of the related-party transactions were “substantively equivalent” to transactions with unrelated third parties was sufficient for the “unreasonable” exception. In this case there was evidence of third-party license transactions between the parent and third parties and the taxpayer and third parties. In comparing such transactions to the related-party transactions at issue, the court noted that the terms of the agreements with unrelated parties were “barely different” from the agreements between the parent and the taxpayer—for example, in both the licenses were non-exclusive and non-transferable and both gave the licensor the right to audit the licensee’s records. Although the related-party royalty payments to the parent were computed by use of one rate for all income streams, while the payments to third parties were computed using a tiered system where different rates applied to different income streams, the court was unpersuaded that this distinction was material because the subject of the contracts were the same and the lump sum computation resulted in a comparable expense to the expense computed using the tiered rates.

What does this mean for the intangible add-back in New Jersey?

This case is a published Tax Court case and, thus, is precedential and may significantly narrow the applicability of the add-back for related-party intangible expenses in New Jersey. The decision (particularly the court’s interpretation of the add-back statute’s legislative history) provides favorable authority for taxpayers that make payments to related parties that have NOLs and, therefore, are subject to (but do not pay) the CBT.  However, arguably this case may even permit taxpayers that pay an intangible fee to a related party that does not have nexus with New Jersey to deduct the related-party expense if the transaction is “substantively equivalent” to an unrelated-party transaction. Furthermore, while the taxpayer in BMC Software presented contracts with third parties as evidence that its related-party transactions were “substantial equivalents” to transactions with unrelated parties, it is possible that even transfer pricing studies or the terms of comparable transactions to which neither the taxpayer nor the recipient is a party could be evidence that the transaction is “substantively equivalent” to transactions with unrelated parties.

On August 31, 2017, in a 4-3 split decision, the Virginia Supreme Court (Court) affirmed a circuit court’s ruling that in order for income to qualify for the “subject-to-tax” exception to its addback statute, the income must actually be taxed by another state. Kohl’s Dep’t Stores, Inc. v. Va. Dep’t of Taxation, no. 160681 (Va. Aug. 31, 2017). A copy of the Opinion (Op) is available here. The Court, however, did find for the taxpayer on its alternative argument, concluding that the determination of where income was “actually taxed” includes combined return and addback states, in addition to separate return states, and includes income subject to tax in the hands of the payor, not just the recipient. For our prior coverage of the subject-to-tax exception, see here.

The issue here was whether Kohl’s Department Stores, Inc. (Kohl’s), which operates retail stores throughout the United States (including Virginia), was required to “add back” to its income royalties it paid to a related party for the use of intellectual property owned by that party. Kohl’s deducted the royalty payments as ordinary and necessary business expenses in the computation of its federal income, and the recipient related party included the royalty income in its taxable income calculations in the states in which it filed returns, including both separate and combined reporting states. The Court considered whether the royalty payments paid by Kohl’s must be “added backed” to Kohl’s taxable income under Virginia law, or whether the royalties fell within Virginia’s “subject-to-tax” exception.

Virginia law, like the law of other states, requires taxpayers to add to their state taxable income the amount of intangible expenses and costs paid to a related party to the extent the expenses and costs were deducted in computing federal taxable income. Va. Code Ann. § 58.1-402(B)(8)(a). But Virginia’s addback statute (like those of other states) has a “subject-to-tax” exception under which taxpayers are not required to addback intangible expenses if “[t]he corresponding item of income received by the [recipient] related member is subject to a tax based on or measured by net income or capital imposed by Virginia, another state, or a foreign government that has entered into a comprehensive tax treaty with the United States government.” Id. § 58.1-402(B)(8)(a)(1).

In determining whether the royalties paid by Kohl’s to a related party fell within Virginia’s subject-to-tax exception, the City of Richmond Circuit Court, on the parties’ cross motions for summary judgment, granted the Department of Taxation’s (Department) motion and held that the intangible expenses paid must be “actually taxed in another state” to qualify for the subject-to-tax exception. See Kohl’s Dep’t Stores, Inc. v. Va. Dep’t of Taxation, 91 Va. Cir. 499 (Va. Cir. Ct. Feb. 3, 2016). In reaching this result, the circuit court purported to rely on the plain language of the subject-to-tax exception and the legislature’s intent in enacting the state’s addback statute, which the court determined was “to close a corporate tax loophole and ensure that income attributable to Virginia is taxed.” Id. Kohl’s petitioned for certiorari, which was granted.

On appeal, the Supreme Court affirmed the circuit court’s conclusion that in order for a taxpayer to qualify for the “subject-to-tax” exception, the corresponding income received by a related party must be “actually taxed by another state” (Op. at 11) but for different reasons. First, unlike the circuit court, the Supreme Court found the plain language of the exception ambiguous. See Op. at 8 (“Because the royalties were included in Kohl’s Illinois’s taxable income, they were, to a certain extent, ‘subject to’ the income taxes of other states. At the same time, a substantial amount of the royalties was not apportioned to, and thereby not legally ‘subject to’ the income tax of, any state in which Kohl’s Illinois filed a return.”). Yet in analyzing the plain language of “subject to tax,” the Court also relied on US Supreme Court precedent holding that “only the amount of a corporation’s income that is fairly apportionable to a given state is legally subject to that state’s income tax.” Op. at 7 (citation omitted). Second, the Court relied on legislative intent indicating that the State enacted the addback statute to raise tax revenue, and reasoned that to accept Kohl’s interpretation that “subject-to-tax” means inclusion in the taxable income computation “would effectively negate the add back statute’s intended operation and undermine this expected revenue.” Op. at 10. Third, the Court relied on case law for the notion that courts should look to the administering agency’s interpretation when a statute is ambiguous. See Op. at 10-11 (“Moreover, we have repeatedly held that when a statute’s language is of doubtful import, the construction given to it by a state official charged with its administration may be considered. … The construction of this exception which [the Department] advocates, and which we apply, is reasonable.”) (citations omitted).

At the circuit court level, Kohl’s argued that in the alternative, even if the subject-to-tax exception meant that tax must actually be imposed on the corresponding income, the Department’s method for calculating this amount erroneously excluded income that was actually taxed in states other than separate return states or taxed to the payor by required addback statutes of other states. The circuit court did not rule on Kohl’s alternative argument. On appeal, the Supreme Court found for Kohl’s on this issue, holding that: “To the extent that the royalties were actually taxed by the Separate Return States, Combined Return States, or Addback States, they fall within the subject-to-tax exception regardless of which entity paid the tax.” Op. at 12. In reaching this conclusion, the court rejected the Department’s argument that royalty income was “actually taxed” in only states in which the recipient related party filed a separate return. Rather, the court agreed with Kohl’s that in addition to separate return states, a determination of the amount of corresponding income that was “actually taxed” must be made by examining those amounts in combined return states and states where the income was added back to the payor. Relatedly, the court also concluded that the subject-to-tax exception “does not require that [] the [recipient] related member be the entity that pays the tax” on the corresponding income. Op. at 12.

A strongly-worded dissent took issue with the majority’s conclusion that “subject to” tax means “actually taxed.” The dissent chided the majority for reading into the (in its view unambiguous) plain language of the subject-to-tax exception, a requirement that the exception apply only to income on a state tax return to which a state’s apportionment formula has been applied, which results in a portion of the income being taxed in that state (post-apportionment basis). Further, the dissent observed that on several occasions, the Virginia General Assembly failed to enact legislation limiting the exception’s application to a post-apportionment basis. Notably, even after the enactment of budget bills that purported to be retroactive and “apply only to the portion of such income received by the related member, which portion is attributed to a state or foreign government in which the related member has sufficient nexus to be subject to such taxes[,]” addback would not be required in states in which the related party has nexus. See Op. at 15 (quoting 2014 & 2016 budget bills).

Practice Note: In light of this ruling, Virginia taxpayers must reexamine tax treatment in the state(s) where the corresponding income is sourced or added-back. Additionally, this ruling exacerbates the inherent problem of addback statutes taxing income earned in other states by narrowing categories of income that can be excluded from the statute.

The White House and Republican congressional leadership released an outline this week to guide forthcoming legislation on federal tax reform. The states conform to the federal tax laws to varying degrees and the extent to which they will adopt any federal changes is uncertain. This memorandum outlines some of the key areas—individual taxation, general business taxation and international taxation— with which the states will be concerned as details continue to unfold.

Continue reading.

Determining financial statement impact from the state flow through of federal tax reform will be complicated by changes in state tax policy expected to be adopted. In our latest Tax Takes video, McDermott’s Steve Kranz and Diann Smith discuss the issues with Joe Henchman, Executive Vice President of the Tax Foundation. The group suggests options for companies to protect against negative policy changes.

The 2017 federal tax reform bill, known as the Tax Cuts and Jobs Act (Act), made a number of significant changes to the law, particularly to the international tax provisions of the Internal Revenue Code (IRC). Last month, Illinois joined the growing number of states responding to the Act by proposing legislation purporting to add-back the new federal deduction for foreign-derived intangible income (FDII). The FDII deduction, enacted in sub-part (a)(1)(A) of new IRC section 250, allows US corporate taxpayers a deduction in the amount of 37.5 percent of income earned from the sale of property to a person outside of the US for use outside of the US or the provision of services to a person outside of the US or with respect to property not located in the US. (For tax years beginning 2026, the deduction is reduced to 21.875 percent.)

Senate Bill (SB) 3152 (linked here) proposes an amendment to Section 203(b)(2) of the Illinois Income Tax Act (IITA) that would add back to taxable income the amount of a corporate taxpayer’s FDII deduction allowed under the IRC. Absent this amendment, the FDII deduction likely automatically would be included in Illinois’ corporate tax base: Illinois is a “rolling” conformity state (IITA section 1501(a)(11)), and the FDII deduction is a “special deduction” under the IRC which is incorporated in Illinois’ starting point for taxable income (IITA section 203(b)(1), (e) (For corporations IITA imposed on “taxable income” as defined under the IRC); IRC section 63 (“taxable income” includes “special deductions”)).

SB 3152 has been assigned to the Senate Revenue committee for review. It remains to be seen how, if at all, Illinois will respond to other changes enacted by the federal Act, particularly with respect to the other new international tax provisions, including those related to the deferred foreign earnings transition tax and global intangible low-taxed income, which include both additions and deductions at the federal level.

States are moving to advance different solutions in their efforts to address federal tax reform. Illinois recently introduced legislation to addback the new deduction for foreign-derived intangible income (a topic we’ve previously covered), and its Department of Revenue has issued its position on other aspects of federal reform. Oregon, after resolving a controversy between its senate and house, is about to pass legislation addressing deemed repatriation income and repealing its tax haven inclusion provisions.

Illinois Issues Guidance on Federal Tax Reform

On March 1, the Illinois Department of Revenue (Department) issued guidance explaining its position with respect to how various law changes made in the 2017 federal tax reform bill, known as the Tax Cuts and Jobs Act (Act), will impact taxpayers in Illinois.

While, for the most part, the pronouncement provides a cursory analysis of the provisions of the Act and a conclusory statement as to whether each provision will result in an increase or decrease in a taxpayer’s adjusted gross income (for individuals) or federal taxable income (for corporations), there are a few items that do warrant some specific mention.

With respect to Illinois’ treatment of the Act’s new international tax provisions, the Department provides some insight into treatment of deemed repatriated foreign earnings and global intangible low-taxed income (GILTI). For purposes of both the deemed repatriated foreign earnings and the GILTI, the Act provides that a taxpayer computes its taxable income by including an amount in income and taking a corresponding deduction to partially offset the inclusion. The Illinois guidance indicates that the inclusion in Illinois will be net, with both the income inclusion and the deduction taken into account in determining a taxpayer’s tax base. This is consistent with the provisions of the Illinois corporate income tax that provide that the Illinois tax base is a corporation’s “taxable income,” which is defined as the amount of “taxable income properly reportable for federal income tax purposes for the taxable year under the provisions of the Internal Revenue Code.” 35 ILCS 5/203(b)(1), (e).

Mitigating the tax impact of these provisions, the Department also takes the position that the amount included as deemed repatriated foreign earnings or as GILTI will be treated as a foreign dividend eligible for Illinois’ 100 percent dividend-received deduction. See 35 ILCS 5/203(b)(2)(O), (b)(2)(G). This rationale is in accordance with the provisions in the Illinois statute that provide a dividend-received deduction for dividends received or deemed received under Internal Revenue Code sections 951 through 965. Thus, because the deemed repatriated foreign earnings are included pursuant to section 965 and the new GILTI is included pursuant to section 951A, those amounts should both be dividends eligible for the dividend-received deduction.

In addition, the Department has specified that the new provision limiting the use of federal net operating losses (NOLs) in an amount equal to 80 percent of the taxpayer’s taxable income is a change that could provide an increased tax base or increased tax revenue to Illinois. Corporate taxpayers should not get confused, however. Illinois allows use of the federal NOL only for individuals. Corporate taxpayers, however, have to add back any federal NOL and then compute a separate NOL for purposes of the Illinois corporate income tax. Thus, neither the 80 percent limitation nor the change to unlimited carryforwards will impact the ability of a corporate taxpayer to use its NOL for purposes of the Illinois corporate income tax.

Nail Biting Success in Oregon on Tax Haven Repeal Following Federal Tax Reform

While drama surrounded Oregon’s legislation addressing aspects of federal tax reform, the end result provides clarity and relief for taxpayers with international affiliates. Oregon has now addressed the repatriation provisions of federal tax reform and is in the process of repealing its (hated) tax haven inclusion provision.

Oregon Senate Bill 1529-A addresses several elements of how the state will conform to federal tax reform. Oregon decided it needed to address reform rapidly because of the risk of a perceived windfall to taxpayers if the state did not change its existing dividend-received deduction statute. Absent the legislation, Oregon would have included both the repatriation addition and the deduction in its tax base and allowed its 80 percent dividend-received deduction against the gross, not the net. The adopted legislation changes this calculation. The legislation requires that amounts deducted for income repatriated under section 965 must be added back in calculating Oregon taxable income. This provision is added to ORS 317.267, the provision decoupling from the federal dividend-received deduction. The tax on the remaining amount would be due in year one, as there is no provision in the bill similar to the federal 8-year payment allowance. It is estimated that the state will receive approximately $160 million from the one-time deemed repatriation. Absent the change, the state would have lost $100 million.

The legislation provides additional relief from the tax on repatriated income. Oregon is one of the states that had adopted tax haven legislation, requiring income of the taxpayer’s affiliates incorporated in certain listed countries to be included in the taxpayer’s taxable income. ORS 317.716. As a result, Oregon may have already taxed some of the income now deemed repatriated. To alleviate any double taxation, new Section 33 in the bill allows a credit for taxes attributable to this income. The credit is limited to the lesser of the tax attributed to the repatriated income or the tax on the income included under ORS 317.716. Unused credits may be carried over five years.

The drama over passage of the bill revolved around a provision that repealed the tax haven inclusion provisions of ORS 317.716. The bill that passed the senate unanimously included the repeal of the tax haven provision. When it reached the house, however, Amendment –A9 removed the repeal. A hearing on the bill included testimony both for and against the repeal. Proponents argued that it was too soon to determine whether repeal was necessary and the tax haven provision should be maintained until the Department of Revenue completed a study to determine whether there was truly overlap between the tax haven inclusion and the GILTI provisions. McDermott provided written comments explaining why maintaining the tax haven provision was duplicative of the policy behind the new GILTI provision and would require complex computations to avoid double taxation when a taxpayer was subject to both GILTI and the tax haven inclusion. COST and the Tax Foundation also provided comments supporting the bill as passed by the senate that included the tax haven repeal language. The house ultimately passed a bill repealing the tax haven provisions, and the senate agreed in conference. The bill is awaiting the governor’s signature.

Under amendments to the bill, the Department of Revenue will have an opportunity to evaluate the efficacy of GILTI, but it is not clear whether the pending budget bill will provide funding for this study.

Please contact us to join McDermott’s multi-state coalition, the STAR Partnership, which will address state business tax ramifications raised by federal tax reform. Further information is available here.

Virginia and Georgia are two of the latest states to pass laws responding to the federal tax reform passed in December 2017, known as the Tax Cuts and Jobs Act (TCJA). Both states updated their codes to conform to the current Internal Revenue Code (IRC) with some notable exceptions.

Virginia

On February 22, 2018, and February 23, 2018, the Virginia General Assembly enacted Chapter 14 (SB 230) and Chapter 15 (HB 154) of the 2018 Session Virginia Acts of Assembly, respectively. Before this legislation was enacted, the Virginia Code conformed to the IRC in effect as of December 31, 2016. While the new legislation conforms the Virginia Code to the IRC effective as of February 9, 2018, there are some very notable exceptions. The legislation explicitly provides that the Virginia Code does not conform to most provisions of the TCJA with an exception for “any… provision of the [TCJA] that affects the computation of federal adjusted gross income of individuals or federal taxable income of corporations for taxable years beginning after December 31, 2016 and before January 1, 2018…” Thus, despite Virginia’s update of its IRC conformity date, Virginia largely decouples from the TCJA.

One major exception to Virginia’s decoupling from most of the provisions of the TCJA concerns the deemed repatriation of foreign earnings under IRC § 965, with such amount clearly affecting the computation of federal adjusted gross income of individuals and the federal taxable income of corporations for tax years beginning before January 1, 2018.

Georgia

On March 2, 2018, Georgia Governor Nathan Deal signed into law a tax bill (HB 918) that specifically addresses Georgia’s treatment of many of the provisions of the TCJA.

As a preliminary matter, the Georgia bill provides conformity to the IRC as of February 9, 2018, with certain exceptions. Before the bill’s enactment, the Georgia Code had conformed to the IRC as of January 1, 2017, and, in turn, did not conform to the TCJA.

The new legislation contains numerous exceptions to Georgia’s conformity with the current IRC. For example, the tax bill explicitly provides that Georgia will decouple from the new interest expense limitations in IRC § 163(j) and also from the new provisions in IRC § 118 that provide inclusion in gross income of certain capital contributions.

With respect to the international provisions of the TCJA, Georgia specifically provides that its dividends-received deduction for dividends received from foreign corporations does not apply to the global intangible low taxed income (GILTI) required to be included in the federal tax base under IRC § 951A. This is not surprising; we expected that some states would determine that the GILTI should not be treated as a dividend for purposes of state dividends-received deductions. The bill does provide, however, that the GILTI deduction in IRC § 250 (which is used to facilitate the reduced effective federal tax rate on GILTI) will apply to the extent that the GILTI is included in Georgia taxable income. Thus, effectively Georgia includes the net GILTI amount in the state tax base in the same manner as it is included in federal taxable income.

While the bill does not specifically state that deemed repatriated foreign earnings under IRC § 965 are eligible for Georgia’s deduction for dividends received from foreign corporations, such income should be eligible for such deduction because even prior to the new legislation the deduction applied to “amounts treated as dividends and income deemed to have been received under provisions of the Internal Revenue Code…” and has specifically included “Subpart F income.” Ga. Code § 48-7-21(b)(8)(A). Furthermore, the bill specifically excludes GILTI but not deemed repatriated foreign earnings from the foreign dividend-received deduction, thus implying that the deemed repatriated foreign earnings are eligible for Georgia’s dividends-received deduction. The bill also prevents taxpayers from being able to get a potential double benefit by specifying that the IRC § 965(c) deduction cannot be used to the extent that the IRC § 965(a) income has been removed from the state tax base by the dividends-received deduction.

Finally, the Georgia bill provides that the new federal net operating loss (NOL) provisions (including the restriction that the NOL cannot exceed 80 percent of taxable income and the new federal carryback and carryforward provisions) apply for purposes of computing the Georgia net operating loss deduction with the specification that the 80 percent limitation is computed based on Georgia taxable net income (not federal taxable income).

New Jersey

New Jersey continues its flirtation with tax surcharges. State Senate President Stephen Sweeney announced that he was supporting a 3 percent tax surcharge on corporate income in excess of $1 million. His reasoning is that corporations received a windfall as a result of federal tax reform. At a press conference on Tuesday, he is reported as saying “This is money they never had. They didn’t work for it. They didn’t earn it. They didn’t sell one more product for it. They did nothing for it.” To say the least, this is an interesting characterization of a decrease in corporate income tax rates, which are based on what a company earns. This surcharge is seen as a substitute for the governor’s proposal to increase taxes on high income individuals. Sweeney believes that following federal tax reform, increasing taxes on individuals is unfair because of the limitation on the state tax deduction. The surcharge is estimated to raise $657 million. Under the surcharge, affected corporations would have a tax rate of 12 percent, a rate tied for the highest rate in the country. Democrats control both houses of the legislature as well as the governor’s office.

Please contact us to join McDermott’s multi-state coalition, the STAR Partnership, which will address state business tax ramifications raised by federal tax reform. Further information is available here.

It’s been nearly three months since the federal tax reform bill (commonly referred to as the Tax Cuts and Jobs Act, or “TCJA”) was enacted and states continue to respond to the various provisions of the TCJA. Recently, there have been notable legislative efforts in New York, Idaho, Iowa and Minnesota.

New York

Starting with the release of the Governor’s Budget Bill in January 2018, the 30-day amendments to that Bill on February 15, and the amendments to the Assembly Bill and Senate Bill this month, there has been much action this legislative session concerning the potential response to federal tax reform. The proposed response in the two latest bills—the Assembly Bill (AB 9509) and the Senate Bill (SB 7509)—is discussed below.

Repatriated Earnings: Both the Assembly and the Senate Bills contain the changes originally suggested in the 30-day amendments to the Governor’s Budget Bill with respect to the deemed repatriated earnings under IRC § 965. This language provides that the deemed repatriated earnings will be considered “exempt CFC income” with the result that any amount included in the federal tax base under the repatriation transition provisions will be excluded from the taxable income base, even if such amounts were received from a non-unitary subsidiary. This proposed exclusion for amounts deemed received from non-unitary subsidiaries is an expansion of New York’s usual policy, which only considered exempt CFC income to include income from unitary subsidiaries.

Both Bills also make clear that the federal deduction permitted under IRC § 965(c) (which facilitates a reduction of the effective federal tax rate on the deemed repatriated foreign earnings) would not be allowed in computing New York taxable income. We expected New York would make this proposed change because disallowing the § 965(c) deduction from New York taxable income would be consistent with excluding the deemed repatriation from taxable income.

GILTI: The Senate Bill now attempts to extend similar treatment to global intangible low-taxed income (GILTI) that may be included in a taxpayer’s income under IRC § 951A, with the result that GILTI would be “exempt CFC income” excluded from taxable income. As with the deemed repatriated earnings, this treatment would extend to GILTI attributable to non-unitary subsidiaries.

Technical adjustments may need to be made to the language in the Senate Bill to implement the treatment intended by the Senate because the current language provides for an exclusion for “income required to be included in the taxpayer’s federal gross income pursuant to subsection (A) of Section 951 of the Internal Revenue Code, without regard to the deduction under Section 250 of the Internal Revenue Code . . . ” The proper reference, however, should be to IRC § 951A, not IRC § 951(A).

In addition, as with the deduction that is intended to provide a reduced federal rate on the deemed repatriated foreign earnings, the Senate Bill also provides that the GILTI deduction would not be excluded in determining taxpayers’ income tax bases.

Interest Limitation. The Senate Bill also provides that New York State would decouple from the interest limitations under IRC § 163(j). However, it is not certain that the language used in the Senate Bill will be effective in completely decoupling from IRC § 163(j). The language provides that a taxpayer’s entire net income for New York State purposes will be computed “without the exclusion, deduction or credit of . . . the amount disallowed as a deduction pursuant to” IRC § 163(j)(1). However, IRC § 163(j)(1) does not exclude, deduct or credit the interest disallowance in computing federal taxable income; IRC 163(j)(1) includes such amount. Therefore, the statutory language should be enacted, consistent with other statutory add-back modifications in New York’s Tax Law, to provide that entire net income shall not “include” the IRC §163(j)(1) disallowance.

FDII: Under the Senate Bill, the Foreign-Derived Intangible Income (FDII) deduction allowed by IRC § 250 would be allowed in computing the income tax base of the New York corporate franchise tax.

FDIC Premiums: The Senate Bill provides that New York State would decouple from the provision disallowing the deduction of Federal Deposit Insurance Corporation (FDIC) premiums.

Surcharge: The Assembly Bill, but not the Senate Bill, also includes the imposition of a 3 percent tax surcharge on the franchise tax liability of most corporations. This is designed to tax the “windfall” that corporations have been touted to have received under the TCJA.

New York City Conformity: The Assembly Bill and the Senate Bill both extend their proposed statutory adjustments in response to the TCJA to the New York City Administrative Code, thus retaining conformity between the New York State and the New York City corporate franchise taxes.

Idaho

On February 9, 2018, Idaho Governor Otter signed into law HB 355. Under this legislation, the Idaho Code adopted the deemed repatriated foreign earnings provisions in IRC § 965. Because the starting point for computing the Idaho state tax base is federal taxable income, under this Idaho legislation the foreign earnings deemed repatriated under IRC § 965 should be included in the Idaho state tax base for tax years beginning on or after January 1, 2017. However, the legislation explicitly disallows the deduction under IRC § 965(c) which is used to facilitate the reduced federal tax rate on the deemed repatriated foreign earnings. Idaho law currently has an 85 percent dividend-received deduction that applies for water’s-edge taxpayers to amounts included  in income by reference to Subpart F income; this deduction should apply to the foreign earnings deemed repatriated under IRC § 965(a) of Subpart F. Accordingly, under current law only 15 percent of the foreign earnings deemed repatriated should be included in state taxable income for water’s-edge taxpayers.

On March 12, 2018, the governor signed into law HB 463. This legislation provides that for tax years beginning on or after January 1, 2018, Idaho conforms to the IRC as in effect on January 1, 2018, including the provisions of the TCJA. Thus, GILTI included in federal taxable income under IRC § 951A should be included in the Idaho state tax base beginning in 2018. As with the disallowance of the deduction for deemed repatriated foreign earnings under HB 355, HB 463 explicitly disallows the IRC § 250 deduction for 50 percent of the GILTI, which at the federal level facilitates the reduced effective tax rate on the GILTI. However, the state’s 85 percent dividend-received deduction for Subpart F income should apply to GILTI since IRC § 951A is included under Subpart F of the IRC. Accordingly, under current law only 15 percent of GILTI should be included in state taxable income for water’s-edge taxpayers. This legislation also disallows the deduction for IRC § 78 gross-up amounts related to GILTI and the federal deduction for 37.5 percent of FDII, both provided for in IRC § 250.

There is proposed legislation in Idaho that would change one of the recently enacted provisions by removing the state’s addback of deductions under IRC § 965(c) (but not IRC § 250). HB 684. This bill was heard and passed out of the House Revenue and Taxation Committee earlier this week.

Iowa

Iowa SF 2383 would provide rolling conformity with the IRC beginning on January 1, 2019. The bill would also change Iowa’s net operating loss regime for tax years beginning on or after January 1, 2019, to specifically conform to the federal regime. Currently, the starting point for computing the Iowa tax base is federal taxable income before the federal net operating loss deduction and then Iowa provides a net operating loss deduction to the extent apportioned Iowa taxable income results in a net operating loss. The bill would change the starting point for determining the corporate state tax base to federal taxable income including the federal net operating loss deduction and remove the Iowa net operating loss deduction. To address carryforwards, the bill would provide that federal net operating losses carried forward from a year beginning before January 1, 2019, should be added back to the state tax base and, instead, the Iowa net operating loss deduction as computed under the current law would be permitted with respect to loss carryforwards from a year beginning before January 1, 2019.

The bill does not specifically address Iowa’s treatment of any of the TCJA provisions. Since the rolling IRC conformity would apply to tax years beginning on or after January 1, 2019, the foreign earnings deemed repatriated under IRC § 965 would not impact the computation of a taxpayer’s Iowa corporate income tax. With respect to the GILTI included in the federal tax base under IRC § 951A, that income would be included in the Iowa state tax base under the bill, along with the 50 percent deduction of such income provided in IRC § 250. Iowa does provide a deduction for “the amount of foreign dividend income, including subpart F income as defined in section 952 of the Internal Revenue Code, based upon the percentage of ownership as set forth in section 243 of the Internal Revenue Code” (Iowa Code § 422.35.21); however, that deduction would only apply to the extent that GILTI is considered a dividend because GILTI is not subpart F income as defined in section 952. While uncertain, it is unlikely that GILTI will be considered a dividend.  Assuming the GILTI is not a dividend, GILTI, net of the 50 percent deduction in IRC § 250, would be included in the Iowa state tax base under the bill. The deduction for the Section 78 GILTI gross-up and the deduction related to FDII would also be allowed under the Iowa bill.

The bill would also decouple from federal expensing provisions in IRC § 168(k), as amended by the TCJA for tax years beginning on or after January 1, 2019.

Minnesota

Minnesota HF 3656 would provide conformity to the IRC as of December 23, 2017, but not for corporate filers (for which conformity with the IRC remains December 16, 2016). Thus, the bill would not adopt the provisions of the TCJA for corporate filers.

This bill was introduced in the House of Representatives on March 12, 2018.

Please contact us to join McDermott’s multi-state coalition, the STAR Partnership, which will address state business tax ramifications raised by federal tax reform. Further information is available here.

This morning, Indiana Governor Eric Holcomb signed a bill into law that will exempt cloud-based software transactions from State Gross Retail and Use Taxes, effective July 1, 2018. The signing took place at the headquarters of Indiana-based cloud service provider DemandJump, Inc.

Specifically, Senate Enrolled Act No. 257 (which was unanimously passed by both chambers of the General Assembly) will add a new section to the Indiana Code chapter on retail transactions that specifically provides that “[a] transaction in which an end user purchases, rents, leases, or licenses the right to remotely access prewritten computer software over the Internet, over private or public networks, or through wireless media: (1) is not considered to be a transaction in which prewritten computer software is delivered electronically; and (2) does not constitute a retail transaction.” The new law will also clarify that the sale, rental, lease or license of prewritten computer software “delivered electronically” (i.e., downloaded software) is subject to the Gross Retail and Use Taxes.

Practice Note

Governor Holcomb and the Indiana General Assembly both made it a priority to provide cloud software providers with much-needed clarity regarding their Indiana collection obligation. This comes after years of increasingly convoluted and complex rulings on various subsets of cloud-based software and services by the Indiana Department of Revenue (DOR), which took the position that “constructive possession” of software through remote means was a taxable transaction. Despite the DOR’s enforcement efforts in this area, the fiscal estimates for this legislation assumed that the DOR is collecting on only 40 percent of remotely accessed software transactions, creating a lack of parity for similarly situated software providers. Indiana businesses had identified this concern to the Indiana Chamber, which advocated for this exemption and clarification effort throughout the legislative process.

We commend Governor Holcomb, the General Assembly and the Indiana Chamber for their efforts to acknowledge this area of need and create a clear, workable solution that will increase compliance and decrease controversy in Indiana going forward. Consistent with the Cloud Based Services Principles adopted by the National Conference of State Legislators, legislators and executive officials should consider whether their state is imposing its transaction tax on cloud based services via administrative action alone, and if so, take action to ensure the state’s position is clear and statutory. Notably, a minority of states (less than 10, including Indiana) have a specific statutory cloud software exemption or imposition.

Indiana is not alone in its desire to legislatively exempt cloud-based services and provide clarity in this largely silent area of the law. In Arizona, an ad hoc legislative interim committee was formed in 2017 to review the taxation of digital goods and services. This initiative has since developed into comprehensive digital goods and services legislation (SB 1392 and HB 2479). This legislation would provide much-needed certainty to Arizona taxpayers that for years have been attempting to reconcile dated state and municipal Transaction Privilege Tax (TPT) laws with no clear direction in the area of remote software services, Arizona Department of Revenue and local enforcement efforts and rulings taking the position that various cloud-based services are subject to tax, and class action risk. The legislation pending now would put an end to this, and exclude the gross proceeds from the sale, lease or licensing of digital services (including cloud-based software services) and digital goods that are remotely accessed by customers from the state and municipal TPT, as well as the use tax. The legislation also specifies that downloaded prewritten computer software—regardless of delivery method and digital goods transferred electronically—are taxed under the retail classification of TPT or the use tax. The comprehensive digital goods and services legislation has passed the House and is pending a final vote in the Senate. Stay tuned!

On Wednesday, the Illinois Department of Revenue (Department) issued additional guidance concerning its treatment of the new deemed repatriated foreign earnings provisions found in Internal Revenue Code Section 965, enacted in the federal tax reform bill (known as the Tax Cuts and Jobs Act, or “TCJA”).  The Department confirmed key aspects of Illinois’ treatment of the repatriation provisions, including:

• Both the income inclusion and deduction provided for in the deemed repatriated foreign earnings provisions will be taken into account in determining a taxpayer’s tax base, so that the inclusion in Illinois will be net. The Department’s guidance references the new federal IRC 965 Transition Tax Statement, which a taxpayer must file with its 2017 federal return when reporting deemed repatriated foreign earnings; that statement includes both income under IRC 965(a) and the corresponding participation deduction under IRC 965(c).
• Additionally, the Department’s guidance also confirms that the net amount included as deemed repatriated foreign earnings will be treated as a foreign dividend eligible for Illinois’ dividend-received deduction, which can be a 70 percent, 80 percent or 100 percent deduction depending on a taxpayer’s percentage share of ownership of the foreign subsidiary subject to the repatriation provisions. See 35 ILCS 5/203(b)(2)(O). (For tax periods beginning on or after January 1, 2018, 80 percent is reduced to 65 percent and 70 percent is reduced to 50 percent because this provision incorporates the federal dividend-received deduction rates found in IRC 243, which was amended as such by the TCJA.)

• The Department recently revised the instructions to its corporate income return and to Schedule M (reporting additions and subtractions) and Schedule J (Foreign Dividends) of the return to reflect that Illinois will take into account net deemed repatriated foreign earnings plus any amount eligible for the dividend-received deduction. On Schedule J, the Department specifically instructs taxpayers to report deemed repatriated foreign earnings amounts eligible for the dividend-received deduction on lines 7–9.
• Not surprisingly, the Department’s guidance provides that any tax liability resulting from the deemed repatriated foreign earnings provisions is due in 2017 and confirms that Illinois does not conform to the federal election (IRC 965(h)) to pay the tax liability resulting from the deemed repatriated foreign earnings provisions over eight years.
• The Department confirms that reporting and payment related to the repatriation provisions is subject to Illinois’ penalties and interest provisions.

Please contact us to join McDermott’s multi-state coalition, the STAR Partnership, which will address state business tax ramifications raised by federal tax reform. Further information is available here.