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Delaware Court Denies Most of Defendants’ Motion to Dismiss Unclaimed Property Gift Card False Claims Action

Two years ago, a former employee of Card Fact, LLC (subsequently purchased by Card Compliant), a company providing gift card issuance and management services to retailers, filed a false claims action in Delaware alleging that his former company and its retailer clients concocted a scheme to avoid remitting unclaimed gift card funds to Delaware. Last week, the judge in the case issued a memorandum opinion on the defendants’ Motion to DismissState of Delaware ex rel. French v. Card Compliant LLC, et al., C.A. No.: N13C-06-289 FSS [CCLD] (Del Sup. Ct. Nov. 23, 2015). While the opinion is likely disappointing to most of the defendants, it should not be read as a final victory for the state. There is still much to be decided in the case, as this was just a motion to dismiss and not a decision as to whether the plaintiffs will ultimately prevail.

The judge did however make several legal conclusions that are of import to Delaware companies. First, the judge determined that as to gift card liability that was initially incurred by the retailers but subsequently transferred to Card Fact (and its affiliates), the retailers remained the debtors with respect to the card owners, unless the customers consented to the delegation of debt. The judge found that the contractual agreements between the retailers and the Card Fact companies were not controlling. However, the judge did not specifically rule on gift card liabilities that were never transferred from the retailers to Card Fact, but instead were incurred directly by Card Fact after its relationship with the retailers began.

Second, the judge found that for defendants that were not C corporations, the second priority rule was to be applied based on the state of formation, not the principal place of business. This is contrary to most state laws and sets up a direct conflict between the states.

Finally, the judge found that because one of the retailers had previously been audited by Delaware (through Kelmar), it could not be a defendant in this false claims action. The judge dismissed this defendant entirely, even for claims that arose subsequent to the audit conclusion. The judge noted that “[i]f the auditor has given [the retailer] a bye, that is between the escheater and the auditor.” This is very good news for any company that has previously been audited by the state regarding the risk of a false claims action.

Practice Notes

  1. For companies that have been audited by Delaware, the risk of a false claims action has likely been significantly reduced if not eliminated;
  2. Unincorporated entities should investigate the indemnification provisions between their state of formation and state of principal place of business to determine the risk of choosing which state to remit to;
  3. Companies using gift card entities or other liability allocation arrangements should review their disclosures and agreements with customers to verify appropriate consent and understanding regarding which entity holds the actual liability.



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Happy Holidays from McDermott’s SALT Practice

In our holiday tradition, as a thank you to all of our Inside SALT readers and subscribers, we are pleased to present our annual Inside SALT Crossword Puzzle Contest. We hope you’ll enjoy this little diversion that tests your knowledge of key state and local tax developments this year. To enter, please download and print the puzzle by clicking on the image below. After you complete the puzzle, please send it as a PDF file to skranz@mwe.com no later than December 31, 2015, at 11:59 pm EST. The first eligible entrant to submit a complete and correct puzzle wins a $200 Amazon gift card. The contest is open to registered Inside SALT email subscribers from the United States and District of Columbia who are age of majority or older. (To become a subscriber, please enter your email address in the box on the right side of your screen.) Contest ends at 11:59 pm EST on December 31, 2015. Participation is subject to the Official Rules. For complete details, click here to view the Official Rules.) This contest is void outside the U.S. and D.C. and where prohibited, restricted or taxed. Please also share your feedback about what topics you would like to hear more about in the comments section below. We look forward to hearing from you and to bringing you timely SALT updates and analysis in the coming year! Click puzzle to enlarge and download.




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A Steep Slope — Vermont Supreme Court Finds AIG Not Unitary With a Ski Resort Based On a Clear and Cogent Evidence Burden of Proof

In the first Vermont Supreme Court decision addressing combined unitary reporting since Vermont’s combined reporting regime became effective in 2006, the court affirmed a lower court’s decision that AIG, the multinational insurance company, was not unitary with a ski resort operated by a subsidiary in Vermont; accordingly, a combined report covering the two businesses was not required. The decision is important because it lays the foundation for future unitary cases in Vermont.

The court agreed with AIG that there were no economies of scale between the operations of AIG and the ski resort. “Because [the entity] is a ski resort and therefore its business type is not similar to AIG’s insurance and financial service business, there is no opportunity for common centralized distribution or sales, and no economy of scale realized by their operations.” On centralization of management, the court noted that although AIG controlled the appointments to the ski resort’s board and management, this did not translate into “actual control” over the ski resort’s operations. Lastly, the Vermont Department of Taxes attempted to argue functional integration based primarily on AIG’s influx of working capital to the ski resort. The court rejected this assertion stating the funding “served an investment rather than operational function. The financing was not part of an AIG operational goal to grow part of its business. Further, there is no operational integration between AIG’s insurance and financial businesses and the ski resort operated by [the resort].”

The case is interesting because it involved whether an instate entity was unitary with its parent. For the year at issue, Vermont had a three factor apportionment formula with a double-weighted sales factor. Presumably, the ski resort had a high Vermont apportionment factor and relatively little income, so including AIG in the combined group increased AIG’s Vermont apportionment factor without significantly  diluting its income.

Interestingly, the court addressed AIG’s burden of proof on the unitary issue. The taxpayer argued that a preponderance of the evidence standard should apply. The Vermont Supreme Court disagreed. Looking to the United States Supreme Court’s decision in Container Corp. as well as to decisions of other states, the taxpayer has the burden of proving by “clear and cogent” evidence that its operations are not unitary.  Interestingly, the court suggested that one California court decision that applied a preponderance of the evidence standard to a unitary question was distinguishable because that case involved a taxpayer claiming that unity existed — and AIG was claiming that unity did not exist. This disparate burden depending on the direction of the unitary argument may prove important to taxpayers seeking to bring entities or operations into a combined report in Vermont.

State tax professionals may react to this decision in a manner similar to the way many reacted when the Court of Appeals of Arizona decided Talley Industries and Woolworth. Those decisions engendered substantial hope that courts — and, ultimately, state revenue agencies — would analyze unitariness not on the basis of a “checklist” or as a knee-jerk reaction to [...]

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Precedential Cloud Victory in Michigan Court of Appeals

On Tuesday, a three-judge panel sitting for the Michigan Court of Appeals unanimously affirmed a lower court decision finding that the use of cloud-based services in Michigan is not subject to use tax in Auto-Owners Ins. Co. v. Dep’t of Treasury, No. 321505 (Mich. Ct. App. Oct. 27, 2015). While there have been a number of cloud-based use tax victories in the Michigan courts over the past year and a half, this decision marks the first published Court of Appeals opinion (i.e., it has precedential effect under the rule of stare decisis). See Mich. Ct. R. 7.215(C)(2). Therefore, the trial courts and Michigan Court of Appeals are obligated to follow the holdings in this case when presented with similar facts, until the Michigan Supreme Court or Court of Appeals say otherwise. While the ultimate outcome (i.e., not taxable) of the lower court decision was affirmed, the analysis used by the Court of Appeals to get there was slightly different and the court took the time to analyze over a dozen different contracts, as discussed below. Given the fact that a petition for review is currently pending in another Court of Appeals case (Thomson Reuters) decided on similar issues in 2014, it will be interesting to see if this development increases the Michigan Supreme Court’s appetite to hear a use tax case on cloud-based services. The Department of Treasury (Department) has approximately 40 days to request that the Auto-Owners decision be reviewed by the Michigan Supreme Court.

Facts

Auto-Owners is an insurance company based out of Michigan that entered into a variety of contracts with third-parties to provide cloud-based services. These contracts were grouped into six basic categories for purposes of this case: (1) insurance industry specific contracts, (2) technology and communications contracts, (3) online research contracts, (4) payment remittance and processing support contracts, (5) equipment maintenance and software customer support contracts and (6) marketing and advertising contracts.  The contracts all involved, at some level, software accessed through the internet. Michigan audited Auto-Owners and ultimately issued a use tax deficiency assessment based on the cloud-based service contracts it utilized.  In doing so, the Department cited the Michigan use tax statute, which like many states, provides that tax is imposed on the privilege of using tangible personal property in the state. See generally Mich. Comp. Laws Ann. § 205.93. The Department took the position that the software used in Michigan by Auto-Owners was “tangible personal property,” which is defined to include prewritten, non-custom, software that is “delivered by any means” under Michigan law. See Mich. Comp. Laws Ann. § 205.92b(o). The taxpayer paid the tax under protest and filed a refund claim, which was the focus of the Court of Claims decision being appealed.

Procedural History

At the trial court level, the Court of Claims determined that the application of use tax to the software used in Michigan by Auto-Owners would be improper. In doing so, the court issued three separate holdings—all in favor of the taxpayer. First, the court held that use tax [...]

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Taking a Stand Against Retroactive State Legislation

Changing the past: Serious scientists, talented fantasists, regretful Ashley Madison members and many other segments of humanity have considered, and even longed for, the ability to rewrite history. One group has apparently succeeded – state legislatures that backdate tax law changes.

Such success may be short lived, however, as experts identify significant legal and policy faults with retroactively changing tax obligations.  Two recent articles in State Tax Today explain why retroactive tax laws should not be passed and if they are, should be invalidated by the courts – and invalidated retroactively. In “Retroactive Tax Laws Are Just Wrong” David Brunori (Deputy Publisher, State Tax Today) describes the fairness problem with retroactive tax legislation.  In a second article, the monthly interview column “Raising the Bar,” McDermott’s Steve Kranz and Diann L. Smith, Joe Crosby (MultiState Associates) and Kendall Houghton (Alston & Bird LLP) provide details on recent cases addressing retroactive tax changes.

The Council On State Taxation (COST) is also offering a discussion of this issue at its 46th Annual Meeting/Fall Audit Session in Chicago, Illinois (October 20-23, 2015).   McDermott’s Diann L. Smith, Catie Oryl (COST) and Scott Brandman (Baker & McKenzie) will discuss “Retroactive Legislation: Just a ‘Clarification’?”  If you are interested in receiving a copy of the COST outline following the event, please contact Diann at dlsmith@mwe.com.




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Post-DMA, Federal Court of Appeals Broadly Interprets Jurisdictional Limitations of Anti-Injunction Act

Earlier this month, the United States Court of Appeals for the D.C. Circuit held in Florida Bankers Ass’n v. U.S. Dep’t of the Treasury, No. 14-5036 (D.C. Cir. Aug. 14, 2015) that the Anti-Injunction Act (AIA, codified at 26 U.S.C. § 7421(a)) barred two state banking associations from challenging Treasury regulations that: (1) required banks to annually report interest paid to certain foreign account-holders, and (2) imposed a penalty on banks that fail to do so.  Notwithstanding attempts to reconcile the holding with recent precedent, the majority’s decision directly conflicts with the recent unanimous Supreme Court decision in Direct Mktg. Ass’n v. Brohl, 135 S. Ct. 1124 (March 3, 2015) (DMA), which found that the Tax Injunction Act (TIA, codified at 28 U.S.C. § 1341) did not bar a retail association’s challenge to comparable Colorado notice and reporting requirements (and accompanying penalty) imposed on out-of-state retailers.  The TIA is modeled off of, and has consistently been interpreted to apply in the same fashion as its federal companion, the AIA. Given the striking similarities between the two cases, it is hard to reconcile the expansive application of the AIA in Florida Bankers with the narrow analysis of the TIA in DMA.

Majority Opinion

The majority opinion begins by highlighting the fact that the penalty imposed on the banks is technically a “tax” for purposes of the AIA because it is found in a specific section of the Internal Revenue Code (IRC, Ch. 68, Subchapter B) that states as much. See 26 U.S.C. § 6671(a). The majority emphasized that the Supreme Court recently confirmed that these types of penalties are treated as taxes when analyzing the application of the AIA, citing to the Nat’l Fed. of Indep. Bus. v. Sebelius decision. The majority distinguishes DMA on the basis that, unlike the tax-penalty in Chapter 68B of the IRC, the Colorado penalty imposed on out of state retailers that failed to report was not—or at least the parties never argued or suggested that it was—itself a tax. The majority was clear that “[i]f the penalty here were not itself a tax, the Anti-Injunction Act would not bar this suit.” Because the penalty was a “tax”, a favorable ruling for the plaintiffs “would invalidate the reporting requirement and restrain (indeed eliminate) the assessment and collection of the tax paid for not complying with the reporting requirement.”  Because of this, the majority held that the banking associations’ challenge to the reporting requirements was barred by the AIA.

Practice Note: The majority relies heavily on the technical tax-penalty distinction in reaching their holding that the AIA applied. In making this distinction, the majority suggests that the label given to a penalty is controlling in determining whether the AIA and TIA apply to shut the door to federal district court. While at first glance it would appear that the holding is limited in scope to federal tax issues, it has the potential to spill over into the state tax world since many states have specifically conformed to [...]

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Should Companies Adjust Their Incentive Strategies in Light of New Governmental Accounting Disclosure Requirements?

Earlier this month, the Governmental Accounting Standards Board (GASB) approved Statement No. 77, Tax Abatement Disclosures, which requires state and local governments to report on foregone revenue from tax abatement agreements. This will significantly increase scrutiny of negotiated tax incentives, particularly at the local level. Businesses need to consider how this may change their local incentive strategies.

To summarize, Statement 77 requires state and local governments to disclose basic information about their current incentive agreements, or other agreements, that reduce tax revenue:

  • Dollar amounts by which the government’s tax revenues were reduced as a result of tax abatement agreements;
  • The name and purpose of each tax abatement program;
  • The specific taxes being abated;
  • The authority under which the tax abatement agreements are entered into;
  • The criteria that make the recipient eligible to receive a tax abatement;
  • The mechanism by which the taxes are abated;
  • The provisions for recapturing abated taxes (e., clawbacks);
  • The types of commitments made by tax abatement recipients; and
  • Any other commitments made by the government as part of the agreements.

For tax abatements where a government has reduced its own revenue, disclosed information should be organized by each major tax incentive program. For incentives where one government’s revenue has been reduced by a different government’s abatement (e.g. a municipal property tax incentive reducing a school district’s revenue), disclosed information is based on the government that entered into the abatement agreement and the type of tax being abated.

Statement 77 permits the reporting government to decide whether to report the required information individually or in the aggregate. If agreements are disclosed individually, the government must establish a quantitative threshold to determine which agreements to disclose—it cannot disclose selectively. A reporting government is permitted to omit specific information if it is legally prohibited from disclosures, such as via state confidentiality laws or a confidentiality provision in the agreement itself.

The disclosure provisions of Statement 77 apply only to tax abatement agreements, which are negotiated agreements where a government agrees to forego tax in exchange for some benefit. Tax incentives that do not require an agreement are not affected. Negotiated grants or other non-tax incentives are also not affected.

Practice Note

Statement 77 will significantly change the world of incentives, particularly at the local level where negotiated agreements reducing property or sales taxes are common. The disclosures of the amounts of forgone revenue associated with tax abatement programs will provide ammunition to groups criticizing incentives, and gone are the days that The New York Times has to spend 10 months gathering state and local incentive data, as they did in 2012. Businesses should expect increased scrutiny during the approval process as governments become more sensitive to whether they are getting a “good deal.” Companies with existing agreements should also be concerned: local governments may seek to renege on their commitments as the costs become more apparent, particularly when new politicians come into office who were not part of the original deal.

One consideration in negotiating incentives [...]

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Tax on Tax Credits: U.S. Tax Court Addresses Federal Taxation of Refundable State Credits in Maines

As more and more states offer refundable tax credits to induce economic development, it is critical for businesses weighing incentive offers to take into consideration the federal income tax implications of an award. While a payment may be called a “credit” and claimed on a state tax return, that payment might nonetheless constitute taxable income for federal tax purposes. Imposition of federal income tax on incentive payments can materially reduce their value and should be considered when weighing the potential benefit of an award. A recent United States Tax Court decision, Maines v. Commissioner, demonstrates that risk.

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Uniform Law Commission Completes First Reading of the Revised Uniform Unclaimed Property Act

On Tuesday, July 14, 2015, at their Annual Meeting the Uniform Law Commission (ULC) completed their first reading of the Revised Uniform Unclaimed Property Act (RUUPA or the Act). While over half of the sections comprising the current draft of the Act were passed over due to strict time constraints imposed by the ULC President Harriet Lansing, the RUUPA Drafting Committee (Committee) did their best to focus the time they did have on sections they felt were most in need of feedback from the ULC Commissioners (Commissioners) as a whole. The Committee even went so far as to invite discussion by allowing American Bar Association (ABA) Advisors and National Association of Unclaimed Property Administrators (NAUPA) to explain their stances on hot button issues such as the derivative rights doctrine, life insurance provisions and the inclusion of a business-to-business exemption. Despite this attempt, Commissioner feedback was sparse (to non-existent) for a majority of the reading and was often technical in nature when provided. While over 250 of the 400 Commissioners were present at the Annual Meeting, only about half of those present attended the morning session of the RUUPA reading. After a lunch break, the afternoon session of the reading was even more sparsely attended, with less than 100 Commissioners present. While the turnout and participation was not ideal, the Committee provided some guidance to the Commissioners that may be useful to interested parties going forward.

Highlights

  • Committee Co-Chair Rex Blackburn made it clear that they would be considering the application of the derivative right doctrine, which generally stands for the proposition that state unclaimed property administrators cannot receive greater rights than those of the true owner, on a property-type basis (as opposed to a blanket inclusion or exclusion). Aside from the short ABA-NAUPA debate on the issue, there was no substantive discussion of the derivate rights doctrine.
  • A return to the 1981 Act’s 10-year statute of repose was discussed. Commissioner Raymond Pepe noted that the Committee reverted back to this based on the widespread abuse of statistical sampling. Several Commissioners were supportive of this change, and even encouraged the Committee to shorten this period further since the statute does not begin running until after the report was due. Nebraska Commissioner Harvey Perlman suggested that the Committee simply limit the use of abusive statistical sampling instead of establishing a statute of repose. The Committee responded that a bright-line rule is necessary here to provide certainty.
  • The Committee confessed that the current section on the conduct of audits (Section 20) needs to be broken out into four distinct sections in the next draft. A majority of the discussion in this area was on the use of contingent fee contract auditors—which is permitted in the current draft with numerous protections that seek to enhance the transparency of this process. Connecticut Commissioner David Biklen suggested that his state would not be able to audit holders without the use of contract auditors and expressed concern [...]

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How Far Back Can a Back Tax Go? Petition for Certiorari in Hambleton Asks Supreme Court to Right Unjust Retroactivity

Retroactivity is an endemic problem in the state tax world.  In this year alone, we have seen retroactive repeal of the Multistate Tax Compact (MTC) in Michigan, as well as significant retroactivity issues in New York, New Jersey and Virginia.  But after decades of states changing the rules on taxpayers after-the-fact, relief may be on the way if the Supreme Court of the United States grants certiorari in a Washington estate tax case, Hambleton v. Washington, with retroactivity that makes you say “What the heck?”.

The taxpayers filed a petition for certiorari on June 5, 2015.  The Court requested a response, which is now due by September 9, 2015.  The Tax Executives Institute filed an amicus brief on July 6, 2015.

The case involves two widows’ estates.  As stated in the petition:

Helen Hambleton died in 2006, and Jessie Macbride died in 2007.  Each was the passive lifetime beneficiary of a trust established in her deceased husband’s estate, and neither possessed a power under the trust instrument to dispose of the trust assets.  Under the Washington estate tax law at the time of their deaths, the tax did not apply to the value of those trust assets.  In 2013, however, the Washington Legislature amended the estate tax statutes retroactively back to 2005, exposing their estates to nearly two million dollars of back taxes.

In 2005, Washington state enacted an estate tax that was intended to operate on a standalone basis, separate from the federal estate tax.  In interpreting the new law, the Department of Revenue issued regulations that the transfer of property from the petitioners’ husbands to the petitioners through a Qualified Terminable Interest Property (QTIP) trust was not subject to the Washington estate tax.  The Department then reversed its position and assessed tax.  Petitioners, along with other estates, challenged the Department’s position and won in Washington Supreme Court (In re Estate of Bracken, 290 P.3d 99 (Wash. 2012)).  Then in 2013, the Washington legislature amended the estate tax to retroactively adopt the Department’s position, going back to 2005.  The petitioners challenged this law up to the Washington Supreme Court, which held in favor of the Department and concluded that the retroactive change satisfied the due process clause under a rational basis standard.

The petition urges the Supreme Court to take the case to resolve the uncertainty as to “how long is too long” when it comes to retroactive taxes, citing multiple examples of past and ongoing litigation in which lower courts have taken divergent approaches to the length of retroactivity that is permissible.  Of particular interest, one of the cases cited is International Business Machines Corp. v. Michigan Department of Treasury, 852 N.W.2d 865 (Mich. 2014).  The retroactive repeal of the MTC election in Michigan is a central issue in that ongoing litigation. If the Supreme Court takes Hambleton, its decision would likely impact the Michigan MTC litigation. The recent decision by the New York Court of Appeals, allowing [...]

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