Jeffrey A. Friedman, Partner Michele Borens, Partner Leah Robinson, Partner TEI/IPT SALT Day December 9, 2014

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1 Jeffrey A. Friedman, Partner Michele Borens, Partner Leah Robinson, Partner TEI/IPT SALT Day December 9, 2014 State Tax Litigation and Controversy Update

2 Agenda Apportionment Income Tax Nexus Dormant Commerce Clause Unitary Business False Claims and Class Actions U.S. Supreme Court Cases Sales and Use Tax 2

3 Apportionment 3

4 Apportionment (MTC Election) IBM Corp. v. Dep t of Treasury, Docket No (Mich. 2014) On July 14, 2014, the Michigan Supreme Court overturned the court of appeals and held that: the state s modified gross receipts tax is an income tax for purposes of the Multistate Tax Compact; and IBM was entitled to use the compact s elective three-factor apportionment formula to calculate its state taxes On September 11, 2014, the Governor signed legislation that retroactively repealed the Multistate Tax Compact from Michigan s code, so that the state could avoid paying an estimated $1 billion in tax refunds to corporations following the decision The Compact repeal is effective January 1, 2008 Motion for rehearing denied. 4

5 Apportionment (MTC Election) Cases have been filed challenging Michigan s retroactive legislation. On October 16, 2014, Arby's Restaurant Group Inc. filed a complaint in the Michigan Court of Claims challenging the state's retroactive repeal of the Multistate Tax Compact on the grounds that the repeal violates the compact, the tax title clause of the state constitution, the separation of powers doctrine, and the First Amendment and due process clause. See Arby's Restaurant Group Inc. v. Dep't of Treasury; No MT. In addition, the retroactive legislation has been raised in other pending refund cases. In a supplemental reply brief requested by the Michigan Court of Appeals, Anheuser-Busch Inc. argues that Michigan's retroactive repeal of the Multistate Tax Compact is neither constitutional nor applicable to the pending Anheuser-Busch Inc. v. Dep't of Treasury case. See Anheuser-Busch Inc. v. Dep't of Treasury; Nos ; , Michigan Court of Appeals. 5

6 Apportionment (MTC Election) Graphic Packaging Corporation v. Combs, Dkt. No. D-1-GN (353rd Jud. Distr. Ct. Jan. 15, 2014) Texas Trial court denied the taxpayer s claim that it was entitled to the MTC s three-factor formula election for purposes of the Texas Margins Tax The court left some questions open: The decision did not address whether the election was actually available Nor did the decision address whether the Texas Margins Tax meets the definition of an income tax for purposes of the MTC Compact Two claims remain outstanding: An as-applied constitutional challenge to the single-sales factor apportionment method, and A challenge to the imposition of penalties and interest on the taxpayer The taxpayer has appealed the decision to the Texas Third Court of Appeals 6

7 Apportionment (Throwout Rule) Lorillard Licensing Co. v. Director, Div. of Taxation, No. A T1 (N.J. Tax Ct. Jan. 14, 2014) The New Jersey Tax Court issued a written amplification of its August 9, 2013 bench decision ruling that the Division may not apply dual nexus standards for throwout purposes The Tax Court held that, because New Jersey successfully asserted an economic nexus standard for Corporation Business Tax Constitutional subjectivity purposes, in applying throwout that same standard must also apply for other States subjectivity The Division appealed the decision on December 30,

8 Apportionment Vodafone Americas Holdings, Inc. v. Roberts, No. M COA-R3-CV (Tenn. Ct. App. 2014) Vodafone (based in California) held a 45% interest in a partnership (Cello) that operated Verizon Wireless Vodafone calculated its apportionment formula by using a pay-peruse or primary-place of use methodology Filed a refund claim and argued that it was not subject to Tennessee franchise tax Amended complaint argued that a COP analysis should be used instead resulted in 89% reduction in tax liability Court of Appeals determined the Commissioner properly required Vodafone to apportion sales using market-based sourcing instead of the statutory cost of performance method Tennessee Supreme Court held on November 20, 2014 that it will hear the appeal. 8

9 Other Noteworthy Cases

10 Income Tax Nexus Gore Enterprise Holdings, Inc. v. Comptroller of the Treasury, Md. Ct. App., Dkt. No. 36 (Mar. 24, 2014) The Maryland Court of Appeals held that two out-of-state intangible holding companies were a unitary business, but held that the unitary business principle could not be used to establish nexus for the subsidiaries Sufficient nexus was established because the subsidiaries lacked substance apart from the parent; The court also upheld the use of the parent s apportionment factor for the subsidiaries rather than the statutorily provided method for intangible income This decision is inconsistent for a variety of reasons: It treated the subsidiaries as lacking substance for nexus purposes, but treated them as separate companies for assessment purposes Muddled Maryland s nexus standard even further 10

11 Dormant Commerce Clause CDR Systems Corporation v. Oklahoma Tax Commission, Dkt. No (Okla. Apr. 22, 2014) Taxpayer was headquartered in Florida, but sold a manufacturing facility in Oklahoma and tried to claim Oklahoma s headquarters deduction, which requires a company to be headquartered in Oklahoma for three or more years The Oklahoma Supreme Court upheld the deduction as constitutional indicating that dormant commerce clause did not apply since deduction was available to qualified entities regardless of participation in interstate or intrastate commerce The court further held that the deduction withstood a facial challenge under the dormant commerce clause because: The deduction does not penalize the out-of-state activities of corporations doing business in Oklahoma; Serves a non-discriminatory purpose in attracting out-of-state development; Does not preclude tax neutral decision making or otherwise affect interstate commerce On May 12, 2014, the Taxpayer filed a petition for a rehearing with the Oklahoma Supreme Court, asking the court to reconsider the facts and find that the requirements violate the dormant commerce clause 11

12 Unitary Business Rent-A-Center, Inc. v. Department of Revenue, Dkt. No. TC-MD D (Or. T.C. May 12, 2014) Tax Court determined that Rent-A-Center was and its wholly owned franchising subsidiary were not unitary, while it was unitary with its captive insurance subsidiary The court determined that the presence of all three unitary factors (i.e., flows of value evidenced by centralized management, economies of scale, and functional integration) were required to find a unitary business The franchising subsidiary only exhibited centralized management with Rent-A-Center, but found that the captive insurance subsidiary exhibited all three unitary factors The court specifically focused on functional integration and found that providing insurance to Rent-A-Center s unitary relieved the subsidiaries of the burden of finding their own insurance and resulted in a financial benefit to the entire group The Department has appealed this decision to the Regular Division of the Oregon Tax Court, and the parties are scheduled for oral argument on December 2,

13 False Claims and Class Actions

14 False Claims New York Danon v. Vanguard Group, Inc., N.Y. Sup. Ct. (filed 2013) Alleges that Vanguard illegally evaded more than $1 billion in federal and state taxes over the past decade Danon was previously an in-house attorney at Vanguard Group Inc. Unsealed by Danon in 2014 after the New York Attorney General's Office chose not to prosecute Vanguard Danon may continue the case as a civil lawsuit Seeking a court judgment against Vanguard equal to three times the amount of damages the state has sustained, plus a civil penalty of $6,000 to $12,000 for each action in violation of the FCA Requesting 15 to 30 percent of the money recovered by state and local governments 14

15 Litigation: False Claims Illinois State of Illinois v. Fansedge Inc., Cook County Circuit Court, No. 11 L 9550 (June 5, 2014). The court did not need to rule on whether sales tax actually applied to shipping charges Issue whether the taxpayer intentionally, knowingly, or recklessly concealed from the Illinois Department of Revenue that it was not collecting tax on its shipping charges Taxpayer endured two Illinois DOR audits Taxpayer s employees gave very effective testimony about the audits and the issue Judge found the testimony credible, and in ruling for the taxpayer chided the IDOR: As an aside to this opinion and not part of it, one cannot but wonder why this case is authorized by the State of Illinois and brought under these facts Brian Hamer, IL Rev. Director, states that IL has nearly 400 of these cases 15

16 Litigation: False Claims Illinois It has been reported that the Chicago law firm that has filed hundreds of questionable qui tam actions under the Illinois False Claims Act has found a new tax-related area to pursue. Illinois courts are starting to unseal the first of about 50 new suits filed in August by Stephen B. Diamond PC. The new round of litigation targets out-of-state liquor merchants that sell and ship alcoholic beverages to customers in Illinois who make the purchases over the Internet. In one of the unsealed suits, State of Illinois ex rel. Stephen B. Diamond PC v. Garnet Wines & Liquors Inc., Diamond alleges that the company made illegal website sales to Illinois customers. Diamond also alleges that the company fraudulently failed to collect use and liquor excise taxes on those sales, as well as tax on the shipping and handling charges. In the complaint, Diamond notes that the Illinois False Claims Act says demonstrating that a person has knowingly violated the law requires "no specific proof of intent to defraud." One of Diamond's arguments appear to be that registration requirements under Illinois liquor laws create nexus for sales tax purposes. 16

17 Litigation: Class Action Schojan v. Papa John s International, Inc., No. 8:14-cv T33MAP (M.D. Fla. 2014) Three Florida men filed a class action lawsuit against Papa John s claiming the pizza chain charges customers sales tax on delivery fees in violation of Florida law Papa John s removed the case to the U.S. District Court on May 22, 2014 On July 23, 2014, the U.S. District Court denied Papa John s motion to dismiss, and ordered Papa John s to respond to the complaint by July 30, 2014 Tucker v. Papa John s International, Inc., No. 3:14-cv NJR-PMF (S.D. Ill. 2014) Zachary Tucker filed a class action lawsuit against Papa John s claiming that it charged unlawful sales taxes on delivery orders Papa John s removed the case to the U.S. District Court on May 16, 2014 On July 11, 2014, Papa John s filed a motion to dismiss 17

18 U.S. Supreme Court

19 U.S. Supreme Court Direct Marketing Assoc. v. Colorado Dep t of Rev., Case No. 13CV34855 (Denver Dist. Ct. Feb. 18, 2014) A Colorado state district court issued a preliminary injunction preventing the Colorado Department of Revenue from enforcing Colorado s out-of-state seller use tax reporting statutes and related regulations Previously, the Tenth Circuit Court of Appeals dismissed a federal district court s grant of a permanent injunction against the Colorado Department of Revenue that prevented the Department from enforcing Colorado s use tax notice and reporting requirements Direct Mktg. Ass'n v. Brohl, 2013 U.S. App. LEXIS (10th Cir. Aug. 20, 2013) Certiorari was granted by the U.S. Supreme Court on July 1,

20 U.S. Supreme Court Maryland State Comptroller of the Treasury v. Brian Wynne, Dkt. No. 107, September Term 2011 (Md. Jan. 28, 2013) Maryland allowed taxpayers to claim a credit against their state income taxes for taxes paid to other states. However, a similar credit was not allowed against a resident s county income tax. The Court of Appeals held that Maryland s scheme for allowing credits violated the dormant Commerce Clause Was not fairly apportioned, as taxpayers earning income outside the state would be taxed at higher rates due to multiple taxation Discriminated against interstate commerce because taxpayer pays higher rate of tax on income earned out-of-state Certiorari was granted by the U.S. Supreme Court on May 27,

21 Sales and Use Tax

22 Sales Tax Ohio Valley Aluminum Company LLC v. Dep't of Revenue; No CA MR, KY. Ct. of Appeals (Sept. 12, 2014) At issue was a provision in Kentucky's sales and school tax regime exempting from the tax energy purchases exceeding 3 percent of a processing company's total costs of production The taxpayer argued that because it had set up a subsidiary to own the raw materials that were processed and because that subsidiary entered into a tolling contract with the processor, the value of the processed aluminum should not be included in the taxpayer's costs of production However, the court held that the statutes at issue must be expansively interpreted to encompass all costs of production -- including raw materials -- and that the taxpayer did not demonstrate that it was a truly separate and complete operation from its subsidiary Because the two companies were dependent on one another to produce a finished product, both companies' inputs are part of the total costs of production The court also held that because the subsidiary company did not have any of its own employees, was wholly owned, had the taxpayer as its only aluminum processor, and commingled its assets in the same bank account as the taxpayer, the substance over form doctrine applies to deny the taxpayer from avoiding taxes by using a paper-only company The court cited no statutory basis for extending the substance over form doctrine 22

23 Sales Tax LumiData Inc. v. Commissioner of Revenue, A , Minn. Sup. Ct. (Sept. 10, 2014) LumiData sold a software program called "SOLYS" to retail suppliers. SOLYS organizes and analyzes information about sales at retailers' cash registers. Each time LumiData sold a license for SOLYS, it customized SOLYS to meet the supplier's needs Based on the audit, the Commissioner concluded that SOLYS is a prewritten computer software under Minn. Stat. 297A.61, subd. 17 (2012). Because LumiData had not separately stated in its invoice the charges for customizing SOLYS, the Commissioner concluded that all of LumiData's SOLYS sales for the period at issue were subject to sales tax LumiData argued that each SOLYS sale was "a unique package specifically tailored to the needs of each individual" customer. Because customers refused to purchase SOLYS without customization, LumiData contends it did not sell taxable, prewritten computer software The Minnesota Supreme Court held that the point-of-sale software sales were subject to the state sales and use tax as prewritten computer software because, while the software was a combination of custom and prewritten software, any customization charges were not separately stated on invoices 23

24 Sales Tax Auto Owners Insurance Company v. Dep t of Treasury, MT, 03/20/14 Access to third party software hosted remotely was properly characterized as a nontaxable service as opposed to the sale of prewritten computer software Taxpayer did not take delivery of the software Although computer software was involved in the transactions, the taxpayer did not obtain the requisite level of control required to satisfy the definition of use of the software Even if software was delivered to the taxpayer, the software was in fact simply an incidental component of the principal transactions for the various services 24

25 Sales Tax Thomson Reuters Inc. v. Dep t of Treasury, No , LC No MT Mich. Ct. of App. (May 13, 2014) The Michigan Court of Appeals held that Thomson Reuters sale of Checkpoint was the sale of a nontaxable information service and not tangible personal property The Michigan Department of Treasury argued Checkpoint was tangible personal property because it constituted the sale of prewritten computer software subject to tax when plaintiff s Michigan customers used and controlled the computer code that resided on the web browser interface and on the server side. Applying Michigan s incidental to service test, however, the Court of Appeals found Checkpoint customers sought access to information, not the underlying computer code that constituted less than one percent of the transaction 25

26 Sales Tax Rehmann Robson & Co. v. Dep t of Treasury, Case No MT Mich. Ct. of Claims. (Nov. 26, 2014) The Michigan Court of Claims held that Rehmann Robson s, an accounting firm, purchases of Checkpoint subscription services are not subject to Michigan use tax. The Michigan Department of Treasury argued Checkpoint was tangible personal property because it constituted the sale of prewritten computer software subject to tax. The Court held that the software was not taxable tangible personal property because the software was not delivered to the customer. Additionally, the Court held that the software used to produce the results that Rehmann obtained from Checkpoint was not handed over, left, or transferred. The Court disagreed with the Department's argument that mere "access" to Checkpoint's computer servers equates with "use." Applying Michigan s incidental to service test, the Court of Claims found Checkpoint customers sought access to information, not the underlying computer code. 26

27 Sales Tax Appeal of Sungard Securities Finance, LLC, N.Y. Div. of Tax App., No , Feb. 6, 2014 Web-based program that tracks the execution of customers securities transactions does not constitute a taxable license to prewritten software Customers simply outsource their back office tracking functions to the taxpayer, so the taxpayer s activity constitutes information services Since reports furnished as a result of the services are personal or individual in nature, the services constitute nontaxable information services 27

28 Questions? Jeffrey A. Friedman Michele Borens Leah Robinson

29 Connect with us! The Sutherland SALT Shaker mobile app is now available. Download today from the: Windows Phone Store itunes App Store Google Play Amazon Appstore for Android Visit us at Sutherland SALT Group 29

Jeff Friedman, Partner Michele Borens, Partner TEI Richmond Chapter March 19, 2014

Jeff Friedman, Partner Michele Borens, Partner TEI Richmond Chapter March 19, 2014 State Tax Controversy Update Agenda MTC Compact Election Filing Methodologies Insurance Companies 2 MTC Compact Litigation