State and Local Tax: Ten Cases to Watch

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1 Prentiss Willson, Of Counsel Sutherland Asbill & Brennan LLP Tax Executive Institute Houston Chapter State and Local Tax May 9, 2014 State and Local Tax: Ten Cases to Watch 1

2 Due Process and Commerce Clauses Collide Maryland State Comptroller of Treasury v. Wynne, 431 Md. 147 (2013). Maryland law allows individuals to apply for a tax credit for income taxes paid to other states against their state income taxes, but not against the county income tax. Maryland Court of Appeals held that the law violated the Commerce Clause because it was not fairly apportioned and it discriminated against interstate commerce. Maryland AG filed for writ of certiorari with the U.S. Supreme Court on October 15, 2013 (Sup. Ct. Dkt. No ). On January 13, 2014, the U.S. Supreme Court asked the U.S. Solicitor General to file a brief. On April 4, 2014, the U.S. Solicitor General filed an amicus brief disagreeing with the Maryland Court of Appeals and urging the U.S. Supreme Court to grant writ. 2

3 Sales and Use Tax Nexus Direct Marketing Assoc. v. Huber, No. 10-cv-1546, 2012 WL (U.S. Dist. Ct. Colo. Mar. 30, 2012), reversed, No (10th Cir. 2013), remanded to 10-cv (U.S. Dist. Ct. Colo. 2013). Colorado law required vendors to provide additional information to the state concerning in-state purchases, including information regarding the purchasers, when they are not collecting sales/use tax on such purchases The U.S. District Court granted the Direct Marketing Association s (DMA) motion for a preliminary injunction preventing Colorado from enforcing its sales tax notice and reporting regime because: The impact of the regime is felt only by out-of-state retailers, because in-state retailers are already required under other laws to collect and remit taxes There are other, non-discriminatory methods to achieve the legislature s goal of collecting tax on sales by out-of-state retailers, specifically the alternative method of having taxpayers remit use tax on personal income tax returns [B]urdens imposed by the Act and the Regulations are inextricably related in kind and purpose to the burdens condemned in Quill Tenth Circuit held that federal courts lacked subject matter jurisdiction under the federal Tax Injunction Act. On remand, the federal district judge dismissed DMA s Commerce Clause claims and dissolved the permanent injunction entered against the state. DMA filed a petition for writ with the U.S. Supreme Court on February 25,

4 Sales and Use Tax Nexus Direct Marketing Assoc. v. Colorado Dep t of Revenue, Case No. 13CV34855 (Denver Dist. Ct. Feb. 18, 2014). DMA filed its case in Colorado state court after being denied rehearing with the U.S. Court of Appeals for the Tenth Circuit and argued for a temporary restraining order against the law. The 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. The court determined there was a reasonable probability that DMA would succeed on the merits of its Commerce Clause challenge before the state court that the reporting requirements are facially discriminatory. 4

5 Allocation and Apportionment: Multistate Tax Compact Litigation (Michigan) IBM Corp. v. Dep t of Treas., No , 2012 Mich. App. LEXIS 2293 (Mich. Ct. App. Nov. 20, 2012) Michigan Court of Appeals held that the Compact election was impliedly repealed with the enactment of the more specific Michigan Business Tax Act The federal interstate compact law relied on by the Gillette court was largely ignored The court summarily dismissed the idea that the Compact was a binding contract, noting that it was not expressly identified as such Taxpayer made Compact election on originally filed tax return in lieu of the single-receipts factor formula required under the Michigan Business Tax (MBT) Act Three-factor formula used for both components of MBT(Business Income Tax and Gross Receipts Tax) Michigan Supreme Court granted review of the IBM decision on July 3, Oral arguments were held January 15,

6 Allocation and Apportionment: Multistate Tax Compact Litigation (Michigan) Anheuser-Busch, Inc. v. Michigan Dep t of Treas., Dkt. No MT (Mich. Ct. Cl. June 6, 2013) Michigan Court of Claims held that the Compact was a binding contract that could not be repealed by enacting a conflicting statute Thus, the Compact controlled and functioned as an exception to the MBT provisions Taxpayer made Compact election on originally filed tax returns for both the modified gross receipts tax (MGRT) and business income tax (BIT) portions of the Michigan Business Tax (MBT) The court held that the taxpayer could make the election in computing BIT liability, but could not make the election for MGRT purposes The MGRT is not an income tax under the Compact definition The Michigan Supreme Court has agreed to review the IBM case, but declined to review Anheuser Busch directly 6

7 Unitary Group Credits Mississippi Dep t of Rev. v. Isle of Capri Casinos, Inc., Dkt. No CA SCT (Feb. 13, 2014) Whether credits should be available to all members of a unitary group or just the member doing the activity generating the credit. Taxpayer was an affiliated group filing on a combined basis Four of the affiliates had gaming licenses for which they paid fees, and the combined group used such fees as a credit to offset its combined income tax liability. The Department argued that the credit could only offset the liability attributable to the group members that generated the credit (i.e., that affiliates that held the licenses) The court permitted sharing of the credit because the combined group taxpayers were jointly and severally liable under MS law Thought experiment: wider application for other types of credits within landscape of unitary theory? 7

8 Allocation and Apportionment: Alternative Apportionment Equifax, Inc. v. Mississippi Dep t of Revenue, 2012 WL (Miss. App. May 1, 2012) Court reversed trial court for improperly imposing burden on the taxpayer and remanded case for determination on merits Court held the state bears burden to prove two things: The statutory formula does not fairly represent the taxpayer s business activity in the state; and The state s proffered alternative method is reasonable In dicta, court opined that state s ad hoc application of alternative apportionment did not constitute rulemaking subject to the Mississippi Administrative Procedures Act 8

9 Allocation and Apportionment: Alternative Apportionment Equifax, Inc. v. Miss. Dep t of Revenue, 125 So.3d 36 (Miss. June 20, 2013) Mississippi Supreme Court reversed Court found that the taxpayer not the Department has the burden to prove that it is entitled to the relief requested Court relied on the Mississippi Administrative Procedures Act (APA) to determine that the Chancery Court must give deference to holdings of the Mississippi State Tax Commission Equifax failed to prove that, by applying alternative apportionment, the Department promulgated a new rule in violation of the Mississippi APA 9

10 Allocation and Apportionment: Alternative Apportionment Equifax, Inc. v. Miss. Dep t of Revenue, 125 So.3d 36 (Miss. June 20, 2013) (cont.) Equifax s motion for rehearing was denied on November 21, Mississippi State Senate Finance Chair Joey Fillingane introduced SB 2487 on January 23, 2014 in response to the decision. Would bar the Department from requiring a combined return that includes one or more corporations not subject to the state income tax until regulations have been promulgated. Good-faith challenge to the constitutionality or legality of a law would preclude the Department from assessing penalties arising from forced combinations. Equifax filed a petition for writ of certiorari on February 21, 2014 with the U.S. Supreme Court arguing that the Mississippi Department of Revenue violated due process by rejecting the company s use of a the statutory apportionment formula and assessing interest and penalties under an alternative formula. 10

11 Qui Tam Actions New York v. Sprint Nextel Corp., et. al., (N.Y. Sup. Ct. June 27, 2013). New York amended its False Claims Act (FCA) to allow whistleblowers to bring qui tam actions against taxpayers for false claims under the N.Y. Tax Law. A New York State trial court denied Sprint s motion to dismiss a claim brought by Empire State Ventures, LLC, under the FCA alleging the company knowingly filed false tax returns and underpaid New York State sales taxes on fixed-rate monthly wireless telephone plans sold to New York customers. 11

12 Qui Tam Actions New York v. Sprint Nextel Corp., et. al., (N.Y. Sup. Ct. June 27, 2013) (cont.) The court rejected Sprint s argument that it reasonably interpreted the law when it determined that N.Y. Tax Law 1105(b) allowed it to exclude from sales tax the portion of its fixed monthly charges attributable to interstate voice services. The court similarly rejected Sprint s arguments under the Mobile Telecommunications Sourcing Act and the Ex Post Facto Clause of the U.S. Constitution. On February 27, 2014, the N.Y. Supreme Court, Appellate Division affirmed the state court s decision to deny Sprint s motion to dismiss the complaint in its entirety. California: Hobbs v. Verizon California Inc., No. B (Cal. Ct. App. Feb. 26, 2014). Dismissed for lack of jurisdiction since relevant transactions were already in the public domain and plaintiff could not prove he was the original source of the underlying allegations. 12

13 State Taxation of Insurance Companies Wendy s Int l, Inc. v. Hamer, No , 2013 IL App (4th) (Ill. App. Ct. Oct. 7, 2013) Illinois Appellate Court determined that state must treat the Wendy s captive insurance company as an insurance company for income tax purposes. Thus, taxpayer properly excluded the captive from its unitary group. The court looked to the character of the business actually done by the company. The captive s sole business was to insure its affiliates and its ownership of a disregarded LLC. Receipt of royalty income as a result of that ownership, did not alter that conclusion. Additionally, the captive met the definition of insurance company under federal law and, for the purposes of consistency and conformity, was properly recognized as such under state law: Majority of captive s income derived from insurance business activities Formed for purpose of shifting and distributing risk 13

14 Nexus: Sham Transaction Doctrine Allied Domecq Spirits & Wines USA, Inc. v. Comm r of Revenue, Dkt. Nos. C282807, C293684, & C (Mass. App. Tax Bd. May 22, 2013) The Massachusetts Appellate Tax Board held that activities undertaken to establish nexus for a foreign parent were disregarded under the sham transaction doctrine Canadian-based parent of a U.S. subsidiary group transferred employees of certain Massachusetts subsidiaries to its payroll, and leased office space at an affiliate s Massachusetts location to house the transferred employees After the transfers, the Parent was included in taxpayer s Massachusetts combined group and the Parent s losses were used to offset the group s income In reaching its decision, the Board heavily relied on internal communications indicating that the reorganization was intended to reduce Massachusetts tax liability Also, Board found it significant that there was no change in overall management or for the purportedly transferred employees 14

15 Nexus: Physical Presence Ind. Dep t of Revenue v. United Parcel Service, Inc., 969 N.E.2d 596 (Ind. June 21, 2012) The Indiana Supreme Court held that income from UPS s out-of-state captives was not exempt from the state s corporate income tax because reinsurance transactions taking place out of state did not subject the affiliates to the state s premium tax. If the captives had nexus in Indiana, they would be subject to the premium tax and their income could not be included in the UPS combined corporate income tax return. United Parcel Service, Inc. v. Indiana Department of State Revenue, No. 49T TA-24 (Ind. Tax Ct. Sept. 16, 2013) On remand, the Indiana Tax Court determined that captive insurance companies must be physically present in the state to be doing business and thus be subject to the premium tax (and to qualify for a corporate income tax exemption). The court stated that both the state s premiums tax and corporate income tax utilize a physical presence standard 15

16 Tax Base: Expense Disallowance Kimberly-Clark Corp. v. Mass. Comm r of Revenue, 83 Mass App. Ct. 65, 981 N.E.2d 208 (Mass. App. Ct. 2013) The Appeals Court of Massachusetts upheld an Appellate Tax Board decision addressing the deductibility of certain intercompany interest and royalty expenses in tax years both before and after Massachusetts adopted a related-party expense disallowance statute Interest deducted in years prior to the addback statute was not related to bona fide debt and was required to be added back Loan agreements had no security provisions and there was no evidence that the loans had been, or were intended to be, repaid Intercompany payments made after the addback statute did not qualify for the unreasonable exception because interest was not related to bona fide debt and the taxpayer failed to establish that tax avoidance was not a principal purpose of the structure that resulted in the royalty payments 16

17 Tax Base CDR Sys. Corp. vs. Okla. Tax Comm n, Dtk. No. 109,886 (Okla. App. June 12, 2013) The Oklahoma Court of Appeals, Division II granted a Tax Commission request for rehearing and issued a substitute opinion on June 12, 2013 Oklahoma Statute 2358(D) was facially discriminatory because it allowed a capital gain exclusion only for Oklahomaheadquartered corporations State did not prove that the law advanced a legitimate local purpose that could not be served through reasonable nondiscriminatory alternatives The court clarified that because the issue was constitutional in nature, the decision would apply retroactively and therefore CDR Systems would be entitled to relief on past periods Petition for certiorari has been granted by the Oklahoma Supreme Court. 17

18 Sales & Use Tax: Taxability Lucent Technologies Inc., et. al. v. State Bd. of Equal., Dkt. No. BC (Sept. 27, 2013) The Superior Court of California for Los Angeles County recently ruled that Lucent s agreements governing the use of software to operate telephone switching equipment were technology transfer agreements (TTA) and were exempt from sales tax. Lucent manufactured and sold switches to their customers for processing telephone calls and operating hundreds of features; the switches required software to perform their desired functions. Lucent entered into licensing agreements with their customers, giving them the right to use Lucent s software programs in the switches. In reaching its decision, the Court noted that the California Court of Appeal s decision in Nortel Networks Inc. v. Board of Equalization is directly on point and controlling. Thus, Lucent s licensing agreements were exempt from tax under the TTA statutes because they (1) were copyrighted, (2) contained patented processes, and (3) enabled the licensee to copy the software, and to make and sell products embodying the copyright. The State Board of Equalization (SBE) presented expert testimony in support of its argument that computer code, when stored on a physical medium, was tangible personal property and therefore taxable. The Court rejected that argument as it was doubtful that the testimony would have made any difference either in the decision of the trial court or the Court of Appeal. 18

19 Business Income/Unity ComCon Production Services I, Inc. v. California Franchise Tax Bd., Los Angeles Superior Ct Case No. BC Comcast and MediaOne entered into a merger agreement whereby MediaOne would pay Comcast a $1.5 billion termination fee if MediaOne accepted a competing proposal. MediaOne accepted a proposal from AT&T and paid the termination fee to Comcast. Comcast and QVC entered into a program agreement in which Comcast received QVC stock and commission in exchange for broadcasting QVC programming. Comcast ultimately acquired 57% of QVC and the issue became whether the two companies were unitary and subject to combined reporting. 19

20 Business Income/Unity Did the termination fee from MediaOne constitute business or nonbusiness income? Transactional test: whether the transaction or activity that gave rise to the income arose in the regular course of the taxpayer's trade or business Comcast argued that the termination fee was a product of a merger agreement that was a one-in-a-lifetime transaction. FTB argued that Comcast grew through acquisition. Functional test: whether the acquisition, management, and disposition of the property were "integral parts" of the taxpayer's regular trade or business operations. Comcast argued that it never even acquired property from which business income could arise because the merger was not consummated and the time frame between the decision to merge and the termination was minimal. FTB argued that the property that generated the termination fee was the contractual right to receive the termination fee and that right was an integral part of Comcast's efforts to expand its cable television business. 20

21 Business Income/Unity Were Comcast and QVC a single unitary business subject to combined reporting? Comcast argued, inter alia, that the companies were not subject to combined reporting because the companies had separate staff and management, and they each maintained distinct businesses which operated at arm s length. Trial held in early Fall 2013, decision on March 6, The trial court held: Termination fee constituted business income. Comcast and QVC were not single unitary business. 21

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