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In-Depth Coverage of Issues Surrounding State and Local Tax
INSIDE SALT
In-Depth Coverage of Issues Surrounding State and Local Tax
Allocation/Apportionment
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California Legislatively Overturns Recent Office of Tax Appeals Taxpayer Win

by , and | Jul 3, 2024 | , , , , ,

The California State Legislature overturned Microsoft’s recent win at the Office of Tax Appeals, which held that the gross amount of dividends received from foreign affiliates outside its water’s-edge group should be included in its sales factor denominator, regardless of the application of a dividends-received deduction excluding 75% of such dividends from its taxable base.

The legislation declares that FTB Legal Ruling 2006-1 “shall apply with respect to apportionment factors attributable to income exempt from income tax under the Corporation Tax Law,” and it claims that the declaration “does not constitute a change in, but is declaratory of, existing law.” Consistent with the FTB’s position in the Microsoft case, Legal Ruling 2006-1 would limit the sales factor denominator to the net dividends included in the tax base.



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California Legislator Considers Digital Advertising Tax

by , , and | Mar 29, 2024 | , , , , , ,

Senator Steven Glazer, chair of the California State Senate Revenue and Tax Committee, is treating data like the next gold rush and taking bold steps to mine this new vein of wealth with his proposed “Digital Data Extraction Tax Law.” While couched as a tax on “data extraction,” the base for the tax is digital advertising revenue. The draft proposal contains several gaps, including the tax rate and effective date, and we understand that Senator Glazer is not certain he will file it.

Senator Glazer modeled his proposed tax on Maryland’s digital advertising gross receipts (DAGR) tax approach but with a twist, aligning it with Tennessee’s digital barter tax proposal (House Bill 2234/Senate Bill 2065). While California’s bill attempts to cure the numerous legal infirmities present in Maryland’s DAGR tax, it suffers from many of the same fatal weaknesses.

LEGISLATIVE BACKGROUND

The bill’s stated intent is to tap into the supposedly “enormous economic rents” that the “largest” internet companies generate from the personal data they “extract” from their users. The draft bill would introduce a new tax on gross receipts from the sale of digital advertising services (digital ad tax). The digital ad tax would be imposed on persons engaged in “digital data extraction transactions,” defined as transactions where:

(i) a person sells advertisers information about or access to users of the person’s services, [and]

(ii) the person engages in a digital barter by providing services to a user in full or partial exchange for displaying advertisements to the user or collects data about the user.

Under the bill, persons with digital advertising revenue above a certain level would be deemed engaged in taxable activity. Additionally, the digital ad tax would only apply to persons with advertising revenue above a certain (currently unspecified) level but would provide a carve-out for news media entities. Revenue from the tax would be earmarked for a fund that supports local newspapers.

A troubling feature of the draft bill is its sourcing regime. The bill would require that those subject to the digital ad tax use personally identifiable information about those to whom the ads are served to source revenue from the advertising to either California or somewhere else. Specifically, the bill requires that sellers of digital advertising services capture and retain information, such as users’ GPS locations or IP addresses. A seller would be required to produce this information to tax authorities on audit. These requirements raise profound privacy issues.

Perhaps recognizing the myriad of legal challenges faced by Maryland’s DAGR tax, California’s bill attempts to limit its application to entities based on their revenue derived in the state. It also attempts to ward off challenges that the digital ad tax is a discriminatory tax on electronic commerce barred by the Internet Tax Freedom Act (ITFA) by adding a bare statement that the “Legislature finds and declares . . . . [t]hat digital advertising is not substantially similar to traditional print [...]

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Microsoft Scores Massive Win in California, Opens the Door for Others Nationwide

by , and | Mar 15, 2024 | , , , , ,

The Office of Tax Appeals (OTA) handed Microsoft an enormous win in its controversy with the California Franchise Tax Board (FTB) over the inclusion of qualifying dividends in the sales factor denominator for which it also claimed a dividends received deduction (DRD).

Microsoft filed a water’s-edge combined report for the years at issue and deducted 75% of qualifying dividends received from foreign affiliates outside its water’s-edge group. Initially, Microsoft only included the 25% net amount of dividends received in its sales factor denominator. Subsequently, Microsoft filed a refund claim asserting that the gross amount of dividends received should be included in the sales factor denominator, which would have resulted in a nearly $100 million refund.

The FTB argued that its own legal ruling (Ruling 2006-01) limiting the denominator to net dividends was dispositive of the issue. In its opinion, qualifying dividends should be excluded like eliminated intercompany dividends that were previously reported as income. The FTB also argued that a “matching principle” should apply to exclude the dividends like other items expressly excluded for allegedly not contributing to the tax base.

However, the OTA did not defer to FTB’s legal ruling because it was not a formal regulation. It was interpreting a statute, and its interpretation was inconsistent with the law. The OTA also disagreed with the comparison to eliminated intercompany dividends as there is no similar express exclusion in the DRD statute. Furthermore, the OTA found that “the legislative history” did not support the FTB’s “matching principle” because if the legislature intended the list of exclusions to be non-exhaustive, it would have used language like “such as” or “and other similar transactions.”

In its petition for rehearing, the FTB raised new arguments that the legislative history supported its interpretation and that qualifying dividends should be excluded from the denominator because they are qualitatively different from Microsoft’s main line of business. The OTA again rejected “the same or similar arguments that were considered and rejected in the Opinion” and stated that “new theories that could have been raised, but were not, is not one of the causes that permits a new hearing.” Accordingly, the OTA found that Microsoft was entitled to the nearly $100 million refund.

*          *          *

Corporate taxpayers should consider this decision as the basis for similar claims both in California and nationwide. While the Microsoft case involved dividends resulting from the Section 965 inclusion regime, it should apply to any type of dividend. The position is not conceptually different from including the factors of a unitary business entity that is in a loss while simultaneously using the loss for a net operating loss deduction. Therefore, in states where taxpayers are including only dividends in the denominator to the extent included in the base, there may be a position to instead include all dividends – even those subject to a deduction from the base. Depending on the statutory language in any given state, this could be true even if 100% of the dividends are deducted. [...]

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Massachusetts Adopts Single-Sales-Factor Apportionment; Manufacturing Classification Becomes Less Controversial

by , and | Oct 11, 2023 | ,

On October 4, 2023, Massachusetts Governor Maura Healey signed House Bill 4104 into law. The most significant change it introduces is the adoption of single-sales-factor apportionment (SSF) for all corporate taxpayers, not just manufacturers and mutual fund service corporations. Massachusetts joins more than 30 other states that have adopted either mandatory or elective SSF. The law applies to tax years beginning on or after January 1, 2025.

In addition to the anticipated reduction in taxes for corporations with a relatively large Massachusetts property and payroll base, the change will end the relevance of the manufacturing and mutual fund service corporation classifications.

During the 20th century, Massachusetts was synonymous with three-factor apportionment. In fact, many called three-factor apportionment the “Massachusetts formula,” especially in the context of manufacturing. Then, in the 1990s, the state adopted SSF for manufacturers and mutual fund service corporations.

Generally speaking, under SSF, companies with a relatively large out-of-state presence had a lower apportionment percentage if they were not considered manufacturers. By contrast, companies with a large in-state presence generally had a lower apportionment percentage if they were manufacturers. Naturally, there were years of audits and litigation regarding these classifications. A company’s classification could even change from year to year depending on what ratio of its business fell within a classification. Thus, “winning” in one year did not mean that the issue would not be reexamined during the next audit cycle.

The broad adoption of SSF means that these classifications will no longer be relevant in this context, although the classifications still matter for other aspects of corporate income tax (like credits), as well as property and sales tax.



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At the 10-Yard Line: New York Formally Proposes Corporate Tax Reform Regulations

by , , and | Aug 11, 2023 | , , , , , ,

On August 9, 2023, the New York State Department of Taxation and Finance (Department) released 417 pages of proposed regulations, an important step toward concluding a now almost decade-long process to implement corporate tax reform.

The journey began in 2014 with the enactment of legislation modernizing the state’s corporate tax law. Thereafter, the Department released several versions of draft regulations while warning taxpayers that the drafts were “not final and should not be relied upon.” Even though the Department announced last spring that it intended to formally propose and adopt such regulations in fall 2022, taxpayers had to wait another year.

Comments on the proposed regulations must be provided to the Department by October 10, and the regulations will be finalized thereafter. In this article, we’re taking a closer look at a few of the items included in the proposed regulations.

ADOPTION OF THE MULTISTATE TAX COMMISSION’S INTERPRETATION OF P.L. 86-272

Consistent with the Department’s final version of the draft regulations, the proposed regulations contain rules based on model regulations adopted by the Multistate Tax Commission, which narrowly interpret P.L. 86-272. Under the proposed regulations, “interacting with customers or potential customers through the corporation’s website or computer application” exceeds P.L. 86-272 protection. By contrast, “a corporation will not be made taxable solely by presenting static text or images on its website.” This sweeping change remains surprising because P.L. 86-272 is a federal law, the scope of which is not addressed by the state’s corporate tax reform.

THE ELIMINATION OF THE “UNUSUAL EVENTS” RULE

The proposed regulations omit the “unusual events” rule contained in the 2016 draft regulations. Generally consistent with Department regulations long predating the state’s corporate tax reform legislation, the 2016 draft stated that “business receipts from sales of real, personal, or intangible property that arose from unusual events” were not included in the business apportionment factor. For example, a consulting firm that sold its office building for a gain would not have included the gain in its apportionment factor because the sale was considered to be from an unusual event. The Department claims to have abandoned the rule “because Tax Reform provided significantly more detailed sourcing rules, including guidelines for those transactions that might have been excluded under pre-reform policy.”

SAFE HARBOR SOURCING FOR DIGITAL PRODUCTS AND SERVICES

Post-reform corporate tax law sources receipts from digital products and digital services to New York if the location the customers derive value from is in New York as determined by a complicated hierarchy of methods. The proposed regulations provide a simplified safe harbor in applying this sourcing rule, where “if the corporation has more than 250 business customers purchasing substantially similar digital products or digital services as purchased by the particular customer . . . and no more than 5% of receipts from such digital products or digital services are from that particular customer, then the primary use location of the digital product or digital service is [...]

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As Minnesota Moves Toward GILTI Taxation, New Jersey May Be Moving Away from It

by , and | May 23, 2023 | , , , , , , ,

We previously reported that the Minnesota Legislature was considering imposing mandatory worldwide combined reporting through an omnibus tax bill. Subsequent to our report and in the face of numerous criticisms, Minnesota Senate leaders backed away from the proposal. But ominously, those same leaders said they would examine other tax increases to make up for the (potentially hypothetical) revenue left on the table by moving away from mandatory worldwide combined reporting.

After a series of negotiations, an updated omnibus tax bill (HF 1938) emerged from the Minnesota Legislature conference committee over the weekend, which has already been passed by both the Minnesota House and Senate. Most notably for corporate taxpayers, the legislation:

  • Recouples Minnesota with the Internal Revenue Code provision providing for the inclusion of global intangible low-taxed income (GILTI) (under IRC § 951A) in the corporate tax base while providing a 50% dividends received deduction (but no deduction under IRC § 250)
  • Reduces the dividends received deduction from 80% to 50% for corporations in which the recipient owns 20% or more of the stock and from 70% to 40% for corporations in which the recipient owns less than 20% of the stock and
  • Decreases a corporation’s maximum net operating loss deduction from 80% to 70% of taxable net income each year.

As no prior bills proposing these tax increases had been introduced in the Minnesota Legislature, these tax increases have been passed without any public hearing or public testimony. The rush to put these proposals together may explain why the legislation fails to address how income from GILTI must be accounted for in determining a taxpayer’s apportionment factor.

Minnesota’s move toward GILTI taxation is out of step with legislation introduced in New Jersey, which would increase the state’s GILTI deduction to 95% from 50%. The proposal, which is part of a broader legislative compromise package negotiated by New Jersey government officials and businesses, has the support of the chair of the New Jersey Senate Budget and Appropriations Committee and has been publicly called “win-win” legislation by a New Jersey Division of Taxation representative.

As litigation addressing the constitutionality of taxing GILTI is already percolating through administrative appeals in numerous states, it is likely that New Jersey’s potential move away from GILTI taxation will prove to be the more fiscally prudent way to go.



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New Mexico Proposes Regulations Addressing Gross Receipts Tax Treatment of Digital Advertising Services

by , , , and | Aug 11, 2022 | , , , , , , ,

On August 9, 2022, the New Mexico Taxation and Revenue Department published proposed regulations addressing the gross receipts tax (New Mexico’s version of a sales tax) treatment of digital advertising services. The Department states the proposed regulations do not reflect a change in policy but instead ensure the rules are consistent for all advertising platforms.

While the proposed regulations provide some clarity regarding the taxation of digital advertising services under preexisting rules, they introduce several inconsistencies and other gaps, particularly with respect to the finer details of the sourcing provisions. For example, we believe the proposed regulations leave ambiguity regarding whether gross receipts from the provision of digital advertising services should be sourced to:

  1. The purchaser’s address
  2. The server’s location
  3. The viewer’s location

Separately, the proposed regulations would allow a deduction for gross receipts from national or regional advertising. However, the deduction is not allowed if the purchaser is incorporated in or has its principal place of business in New Mexico. While this significantly narrows the base for the tax, it injects complexity by requiring that the seller know the state in which its purchaser is incorporated or has its principal place of business, information not likely available in the context of internet-based advertising platforms.

Collectively, these inconsistencies and lack of clarity could lead to future compliance issues, which we hope will be mitigated as part of the Department’s regulatory approval process.

The Department scheduled a public hearing on the proposed rules for September 8, 2022, at 10:00 am MDT, which also is the due date for submission of written comments. The proposed regulations would be effective upon publication in the New Mexico Register, which could happen as soon as October 11, 2022 (or thereabout).

Please contact the McDermott Will & Emery State & Local Tax team if you have any questions about the potential impact of these proposed regulations on your company. In the meantime, we will be monitoring the regulation approval process and participating in next month’s public hearing.



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Washington Department of Revenue Announces LendingTree Decision Does Not Prevent Sourcing of Services to Customer’s Customer Location

by | Aug 17, 2020 | , ,

The Washington State Department of Revenue (the “Department”) recently announced its interpretation of the Washington Court of Appeals’ March 30, 2020, adverse ruling in LendingTree, LLC v. Dep’t of Revenue, no. 80637-8-I (Wash. App. Ct. Mar. 30, 2020). See here for our prior analysis of the LendingTree opinion. In its interpretation, the Department takes the view that the LendingTree opinion “does not represent a new legal framework,” but rather that the court simply followed the applicable business and occupation tax apportionment rules in sourcing service receipts to the customer’s location and rejecting the Department’s methodology sourcing to the customers’ customers’ location.

The Department’s response suggests that it intends to narrowly apply LendingTree‘s holding. The Department admits that the court agreed with LendingTree in designating the service at issue to be LendingTree’s referral services (lenders pay a fee to receive referrals of potential borrowers) and rejected the Department’s characterization of the service as marketing and outreach to potential borrowers. Under this characterization, the Department observes, in accordance with a Washington regulation sourcing services to where the customer’s related business activity occurs, the referral services are sourced to the lender’s location, where lenders evaluate the referrals received by LendingTree.

The response goes on to emphasize, however, that there are circumstances where the Department will continue to source service receipts to a customer’s customers’ location. The Department announced that one such circumstance would be for taxpayers who have revenues from the sale of marketing or advertising services to a customer engaged in the business of selling.

Taxpayers should be forewarned that despite the LendingTree ruling, they may still have to battle Department efforts to source service receipts based on the location of their customers’ customers (particularly if they are engaged in the sale of marketing or advertising services), despite a Washington statute requiring service receipts to be sourced to the customer and federal constitutional principles requiring that an apportionment method reflect a taxpayer’s in-state activity. (See: e.g., Oklahoma Tax Commission v. Jefferson Lines, 514 U.S. 175 (1995); Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983).) Unfortunately, it appears that “look through” sourcing disputes between taxpayers and the Department will continue.



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Washington Appellate Court Rejects Department’s B&O Tax Apportionment Method

by | Apr 17, 2020 | ,

In a recently issued taxpayer-favorable opinion, the Washington Appellate Court rejected the apportionment methodology used by the Department of Revenue, which sourced service receipts to the location of a taxpayer’s customers’ customers. The Court then affirmed the taxpayer’s methodology, which sourced the receipts to the location of its customers. LendingTree, LLC v. State of Wash. Dep’t of Revenue, no. 80637-8-I (Wash. App. Ct. Mar. 30, 2020) (“LendingTree Op.”).

The dispute concerned the receipts LendingTree, LLC (“LendingTree”) earned from operating its online loan marketplace for purposes of Washington’s Business and Occupation Tax. LendingTree’s business sought to match prospective borrowers and lenders though its website. Prospective borrowers provided LendingTree with requested financial information for no charge, and LendingTree analyzed this data to make referrals to lenders. Lenders paid fees to LendingTree related to its referral services. On audit, the Washington Department of Revenue (“Department”) took the position that LendingTree should have apportioned its service receipts based on the location of potential borrowers rather than its lenders’ locations. Both the Administrative Review and Hearings Division and trial court found for the Department, and LendingTree appealed.

Washington law, like the law of other states, requires multi-state taxpayers earning income from the performance of services to apportion the income to Washington if a customer receives the benefit of the taxpayer’s services in Washington (see Wash. Rev. Code § 82.04.462(3)(b)(i)). A related Washington regulation clarifies where a customer engaged in business receives the benefit of a taxpayer’s service: If the service relates to a customer’s business activities (and the service does not relate to real or tangible property), then the benefit is received where the customer’s related business activities occur. See Wash. Admin. Code 458-20-19402(303)(c). Citing this regulation, the Appellate Court concluded that “taxes are attributed to the state where the lenders conduct their business activity that most closely or directly relates to the services performed by LendingTree” (LendingTree Op. at 5).

The Appellate Court went on to conclude that the services at issue were LendingTree’s referrals of prospective borrowers to lenders, and that the lenders’ related business activities were their receipt and evaluation of the referrals at lender business locations. The Court rejected the Department’s argument that lenders received the benefit of LendingTree’s services where the borrowers (LendingTree’s customers’ customers) were located, reasoning that lenders received no benefit from LendingTree’s services until LendingTree made referrals to lenders identifying prospective borrowers. In support of its conclusion, the Court noted that lenders did not even know the identity of potential borrowers at the onset of the referral evaluation process. (LendingTree Op. at 7).

In reaching its conclusion that service receipts must be apportioned based on where the customers received the benefit of the taxpayer’s services, rather than where the customers’ customers were located, the court relied on its recently published opinion in ARUP Laboratories, Inc. v. State of Washington Department of Revenue, no. 52349-3-II (Wash. App. Ct. Feb. 11, 2020) (“ARUP Op.”). Interpreting the same rules at issue in [...]

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New State Digital Ad Taxes? Will Maryland’s Take Effect? Which States Will Follow? Litigation Guaranteed!

by and | Mar 25, 2020 | , , , , ,

On March 18, 2020, Maryland legislature sent a massive new tax on digital advertising services to Governor Hogan for consideration. The tax imposes a rate of up to 10% on annual gross revenue in the state derived from digital advertising services. This tax is on a sliding scale based on companies’ global revenues and would take effect with tax year 2021. There are many legal problems with the legislation, including the violations of the Internet Tax Freedom Act, the Commerce Clause and the First Amendment. Other states have considered and are considering similar proposals. It is imperative that companies know how broadly this new tax will apply.

Click below to watch our recent webinar on this new tax. We discuss the legal challenges that can be made and how to protect your company from the unlawful reach of such laws.



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