State Income Tax Litigation You Need to Know About

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1 Michele Borens, Partner Amy Nogid, Counsel TEI New York State and Local Tax Seminar November 9, 2016 State Income Tax Litigation You Need to Know About All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland and the recipient.

2 Apportionment Cost of Performance (COP) Dish DBS Corp. v. S.C. Dep t of Revenue, Dkt. 14-ALJ CC (S.C. Admin. Law Ct. May 20, 2016) Administrative Law Court said that South Carolina is not a COP state but an income-producing activity (IPA) state; the statute provides a flexible standard based upon the income-producing activity for a given industry. Court agreed with Department that Dish had one IPA: the delivery of the signal to the customer premises. Advertising as an IPA 2

3 Apportionment Bank of Am.Consumer Card Holdings v. Dir., Div. of Taxation, N.J. Tax (N.J. Tax Ct. Oct. 6, 2016) The court held that the taxpayers must source 50% of their credit card service fees (e.g., late fees, return check fees, over the limit fees, non-sufficient fund fees, and annual fees) to NJ based on NJ s regulatory 25/50/25 rule. - 25% to where the service originates, - 50% to where the service is performed, and - 25% to where the service terminates Interest and interchange fees should be sourced to NJ if generated by NJ cardholders. The court s opinion conflicts with NJ s statutory rules because NJ has not adopted market-based sourcing. The statute looks to the location of performance. Rejected Division s attempt to apply throwout. 3

4 Apportionment Powerex Corp. v. Oregon Dep t of Revenue, TC 4800, 2016 WL (Or. Tax Ct. Aug. 1, 2016) Tax Court ruled that receipts from sales of electricity to California purchasers cannot be sourced to Oregon. The only sales includible in the Oregon sales factor numerator were those that both parties agreed were sales to purchasers in Oregon. 4

5 Apportionment In re Gerson Lehrman Group, Inc., TAT(H) 08-79(GC), 12-38(GC) & 12-39(GC) (N.Y.C. Div. of Tax App. Oct. 4, 2016) Addressed whether the services constituted consulting services the receipts from which would be sourced based on where the services were performed or where the services were rendered by the salespeople who sold the subscription agreements for such services, which would be sourced to the office locations of the salespeople. ALJ concluded that taxpayer was providing expert knowledge, analysis and views; the fact that clients pay for the service via subscription agreements is not relevant in determining what the service is and where the service is performed. 5

6 Alternative Apportionment Vodafone Americas Holdings, Inc. v. Roberts, 486 S.W.3d 496 (Tenn. 2016) Pursuant to its alternative apportionment authority, the Department required Vodafone to apportion sales using market-based (PPU) sourcing rather than the statutory COP sourcing method. Tennessee Supreme Court found no abuse of discretion: COP did not fairly reflect the extent of Vodafone s in-state business. The importance of optics in COP-based refund cases 6

7 Alternative Apportionment Rent-A-Center West Inc. v. South Carolina Dep t of Rev., App. Case. No (Oct. 26, 2016) Under the statutory method, the numerator of R-A-C West s receipts factor was comprised of the SC receipts from licensing IP and the denominator included all revenue from retail stores and licensing activities. The DOR argued that including the retail sales in the denominator diluted the receipts factor. The DOR s expert opined that including both royalty and retail receipts in the denominator was like putting apples in the numerator and apples and oranges in the denominator. R-A-C West s expert countered that this is exactly how an apportionment formula is supposed to work. The DOR failed to satisfy its burden of showing that the statutory formula did not fairly represent R-A-C West s business activity in SC. 7

8 Discretionary Adjustment Canon Financial Services, Inc. v. Dir., Div. of Taxation, Dkt. No (N.J. Tax Ct. Oct. 13, 2016) (unpublished) NJ applied 100% apportionment because the taxpayer did not have a regular place of business outside of NJ. The three-factor formula would have resulted in approximately 30% apportionment. The court found the three-factor formula was distortive because most of Canon s receipts were outside of NJ. The court remanded for the Division to fashion some form of apportionment relief (which will have to be somewhere between 30% and 100%). 8

9 Throwout Lorillard Licensing Co., LLC v. Dir, Div. of Taxation, 29 N.J.Tax 275 (App. Div., Dec. 4, 2015) An intangible holding company was not required to throw out any of its nowhere receipts from an affiliate in computing the denominator of its receipts factor. New Jersey s economic nexus standard under Lanco must be applied to determine whether a corporation is subject to tax in other jurisdictions. The New Jersey Supreme Court denied certification on June 17,

10 Transfer Pricing Rent-A-Center East Inc., v. Indiana Dep't of State Revenue, 42 N.E.3d 1043 (Ind. T.C. 2015) The Indiana Tax Court rejected combination as an alternative apportionment methodology. The court rejected the Department's claim that R-A-C s income would be distorted unless it filed a combined return with two affiliates. The court relied in part on an IRC 482 transfer pricing study and the parties stipulation of valid business purposes. The Indiana Supreme Court denied review on March 2,

11 Transfer Pricing Columbia Sportswear USA Corp., v. Ind. Dep t of Revenue, No. 49T TA (Ind. Tax Ct. Dec. 18, 2015) Indiana Tax Court concluded that because Columbia s transfer pricing studies demonstrated that its intercompany transactions were conducted at arm s length rates, its Indiana income was fairly reflected for purposes of Indiana s transfer pricing statute. 11

12 Debt Versus Equity Mass. Mutual Life Ins. Co. v. Comm r of Revenue, Dkt. Nos. C305276, C (Mass. App. Tax Bd. June 12, 2015) - ATB held intercompany loans between parent and subsidiaries were bona fide debt. - Applying a 16-factor test, the ATB concluded that interest paid on the debt was not required to be added back. Nat l Grid Holdings, Inc. v. Comm'r of Revenue, 89 Mass. App. Ct. 506 (2016) - Deferred subscription arrangements among related entities to sell and repurchase shares of stock; designed to look like debt for U.S. purposes and equity for U.K. purposes. - Massachusetts Appeals Court agreed that the DSAs did not constitute debt because the company failed to prove that there was an unqualified obligation to repurchase shares (and thus repay the funds). 12

13 Royalty Addback Exception Kohl s Dep t Stores, Inc. v. Va. Dep t of Taxation, No. CL (Va. 13 th Jud. Cir. Ct. Feb. 3, 2016, review granted, No (Va. Sup. Ct. Oct. 31, 2016) Royalties paid to related members must be added back to a taxpayer s federal taxable income unless such payments are subject to a tax based on or measured by net income or capital. Virginia trial court said that even where royalties are reported by related members to other states, royalty payments do not qualify for the addback exception unless those other states actually tax them. 13

14 Interest Addback Exception Kraft Foods Global, Inc. v. Div n of Tax n, 29 N.J.Tax 224 (Apr. 25, 2016) Parent corporation took on third-party debt and allocated it to the operating company, Kraft Foods Global. The Division asserted that the interest payments made to the parent were subject to addback. Kraft Foods Global countered that the debt issued by its parent was essentially Kraft Foods Global s debt and that the interest payments were a legitimate business expense. The New Jersey Tax Court determined that the Division correctly required the taxpayer to add back related party interest payments, holding that the taxpayer did not prove by clear and convincing evidence that addback was unreasonable. 14

15 Interest Addback/Throwback/NOLs Indiana Letter of Findings No (Ind. Dep t of Revenue Sept. 28, 2016) Rejected taxpayer s argument that interest on intercompany debt was properly deductible. - Taxpayer argued that the intercompany debt was attributable to its parent s external debt used to acquire the taxpayer and taxpayer s assets collateralized the debt. - Department relied on the discretionary adjustment provision to disallow the interest deduction for years prior to enactment of addback legislation and relied on the addback legislation for post-addback years. - Reduced NOLs in years barred by SOL for assessment. Concluded that throwback was appropriate because the taxpayer was protected by P.L and therefore was not subject to tax in the states in question. Upheld negligence penalty. 15

16 Unclaimed Property Temple-Inland v. Cook, Civ. No GMS (Del. Dist. Ct. June 28, 2016) - Concluded that Delaware engaged in a game of gotcha that shocks the conscience in administering its unclaimed property law. - Held that Delaware s audit methods violated Temple-Inland s substantive due process rights. This communication cannot be used for the purpose of avoiding any penalties that may be imposed under federal, state or local tax law. 16

17 Questions? Michele Borens Sutherland Asbill & Brennan LLP Amy Nogid Sutherland Asbill & Brennan LLP

18 Connect with us! Download the Sutherland SALT Shaker app today: Apple App Store Google Play Windows Phone Store Amazon Sutherland SALT Group This communication cannot be used for the purpose of avoiding any penalties that may be imposed under federal, state or local tax law. 18