Portfolio Media. Inc. 111 West 19 th Street, 5th Floor New York, NY 10011 www.law360.com Phone: +1 646 783 7100 Fax: +1 646 783 7161 customerservice@law360.com The Most Important State And Local Tax Cases Of 2017 By Jeffrey Friedman and Stephanie Do December 21, 2017, 10:55 AM EST There has been no shortage of state tax controversies this year. States and taxpayers looked to state courts seeking guidance on some of the most contentious state tax issues. In anticipation of the new year, we look back at some of the most interesting decisions of 2017, which highlight critical developments all taxpayers should watch out for, especially attacks on the physical presence nexus requirement, aggressive application of economic nexus principles and continued uncertainty around the applicability of related party addback exceptions and retroactive tax legislation. South Dakota v. Wayfair Inc. Jeffrey Friedman A significant portion of this year s controversies has been devoted to nexus, especially the continued viability of Quill Corp. v. North Dakota s[1] physical presence requirement for sales and use tax purposes. States continue to express frustration and concern with the physical presence requirement as a barrier to forcing out-of-state retailers to collect their sales and use taxes. Several states enacted sales tax collection requirements directly contrary to Quill. On March 22, 2016, South Dakota enacted Senate Bill 106, asserting a sales tax collection and remittance obligation on out-of-state retailers without a physical presence in the state if they have at least $100,000 gross revenue or 200 separate transactions involving delivery into the state. Stephanie Do Using a fast-track litigation strategy, South Dakota expedited state court proceedings to address the constitutionality of its collection requirement, which runs afoul of Quill s physical presence standard. On Sept. 13, 2017, in South Dakota v. Wayfair Inc.,[2] the South Dakota Supreme Court found that the remote seller collection requirement is unconstitutional because it violates Quill. On Oct. 2, 2017, South Dakota petitioned the U.S. Supreme Court for writ of certiorari and requested the court to reverse its Quill decision. The earliest the court could consider reviewing South Dakota s petition is January 2018.
A similar case with a few twists to watch out for in the new year is Crutchfield Corp. v. Harding.[3] Rather than adopting a statute, the Massachusetts Department of Revenue adopted a remote seller regulation. Effective Oct. 1, 2017, the regulation requires an internet vendor with a principal place of business outside of Massachusetts to register, collect and remit sales and use tax if the vendor has: (1) more than $500,000 in sales to Massachusetts customers completed over the Internet; and (2) 100 or more transactions resulting in a delivery into Massachusetts during the previous 12 months.[4] Unlike other recent remote seller statutes and regulations, Massachusetts regulation concludes that certain internet activities such as use of in-state software (e.g., apps) and ancillary data (e.g., cookies) distributed to or stored on in-state customers electronic devices create an in-state physical presence. Instead of filing suit in a Massachusetts court, electronics retailer Crutchfield Corporation (Crutchfield) filed suit in Albemarle County Circuit Court in Virginia, where it is headquartered, to challenge the validity of the regulation. Crutchfield is challenging the Massachusetts regulation in Virginia courts by using a special Virginia jurisdictional provision enacted in 2004 that allows a Virginia business to challenge a sales or use tax nexus assertion by another state.[5] Although the lawsuit is about whether Crutchfield has a physical presence in Massachusetts, the outcome of this lawsuit may also impact the validity of internet nexus theories. Similar lawsuits may arise with some states recently expanding sales tax collection requirements to marketplace providers that provide their platforms to retailers to sell their goods.[6] Myria Holdings Inc. v. Iowa Department of Revenue Although attempts to kill Quill have garnered the most attention this year, economic nexus principles continue to extend to income taxes. In a case in which the taxpayer argued it had nexus, the Iowa Supreme Court determined, in Myria Holdings Inc. v. Iowa Department of Revenue, that certain headquarter-type activities do not create nexus with Iowa.[7] The court held that an out-of-state parent company could not be included in an Iowa consolidated income tax return because it lacked nexus with the state. The court found that the parent company s activities with its subsidiaries doing business in Iowa were activities of ownership and control, which are not considered doing business in the state. The court also disagreed with the taxpayer s position that the parent company had nexus in Iowa because it owned intangible property (shares of stock and money) with a situs in Iowa. The Iowa Court of Appeals subsequently relied upon Myria a few weeks later. In Romantix Holdings Inc. v. Iowa Department of Revenue,[8] the Iowa Court of Appeals upheld the Iowa Department of Revenue s determination excluding an out-of-state parent holding company from an Iowa consolidated income tax return due to lack of nexus, even though it held intangible property that was used in Iowa by its subsidiaries doing business in Iowa. Citing Myria, the court reasoned that the in-state subsidiaries use of its parent holding company s intangible property, including a business trademark, is not enough to establish a taxable nexus with Iowa.[9] Unlike the Iowa state courts, which declined to apply economic nexus principles in Myria and Romantix, a Colorado district court embraced the Colorado Department of Revenue s economic nexus arguments in Target Brands Inc. v. Department of Revenue.[10] The district court found that Target Corporation s
(Target) wholly owned subsidiary, Target Brands Inc. (TBI) which managed Target s brands had substantial nexus in Colorado because its intellectual property (IP) licenses were used in Colorado. The court found that TBI was doing business in the state by: (1) choosing to license its IP for use by Target in Colorado; (2) directing the use of its IP in Colorado; and (3) receiving compensation for use of its IP in Colorado. These cases cannot be reconciled with cases from other states holding that the use of an intangible by a related party in the state creates nexus.[11] State courts will continue to confront economic nexus arguments, which will likely lead to inconsistent state court decisions. Kohl's Department Stores Inc. v. Virginia Department of Taxation Addback statutes which require taxpayers to forego deducting intangible payments and interest payments made to related parties generate litigation associated with the interpretation of exceptions, as highlighted by Kohl's Department Stores Inc. v. Virginia Department of Taxation.[12] Like several other states, Virginia law requires corporations to add back intangible expenses that are otherwise deductible if the expenses are directly or indirectly paid, accrued or incurred to a related member.[13] However, Virginia provides a subject to tax exception. Under the exception, a taxpayer is not required to add back intangible expenses to the extent the income received by the related party was subject to a tax based on or measured by net income or capital imposed by Virginia, another state, or a foreign government that has entered into a comprehensive tax treaty with the United States government. [14] For the tax years at issue, Kohl s Department Stores Inc. (Kohl s) paid royalties to an affiliated company, Kohl s Illinois Inc. (Kohl s Illinois), for the use of IP owned, managed and licensed by Kohl s Illinois. Kohl s Illinois included in its state corporate income tax returns the royalties it received from Kohl s. However, Kohl s Illinois paid state tax on only a portion of the royalties because each state taxed a fraction of Kohl s Illinois s taxable income. The Virginia Department of Taxation audited Kohl s Virginia corporation income tax returns and issued assessments based on a recalculation of Kohl s Virginia taxable income to include a partial addback of the royalties Kohl s paid to Kohl s Illinois. The Department of Taxation allowed only a partial exception to the addback requirement related to the royalties that were actually subject to tax by other states. The court acknowledged that the plain language of the subject to tax exception is ambiguous and interpreted the subject to tax standard as an actual taxation standard. The court, however, agreed with the taxpayer s alternative argument and found that to the extent the royalties were actually taxed by states including those that require separate company tax returns or combined returns they should qualify for the subject to tax exception. Kohl s sets a worrisome example of the continued uncertainty and litigation expected from addback exceptions. Dot Foods Inc. v. Washington Department of Revenue State legislatures have been able to effectively reverse a court s decision by retroactively changing the
law. Several taxpayers have challenged the validity of retroactive state tax changes by arguing that the retroactive laws violate the U.S. Constitution s Due Process Clause, which requires that no state may deprive any person of life, liberty, or property without due process of law. The U.S. Supreme Court last addressed the constitutionality of retroactive tax legislation in 1994 in United States v. Carlton.[15] In Carlton, the court upheld retroactive federal tax legislation because the legislation was enacted for a legitimate legislative purpose furthered by rational means and the legislature acted promptly and established only a modest period of retroactivity. In Carlton, the legislation retroactively applied back one year. The standard provided in Carlton, however, does not give clear guidance on a constitutionally acceptable length of time for retroactive tax changes and what is considered a modest period of retroactivity. On May 22, 2017, the U.S. Supreme Court declined two opportunities to clarify what is an acceptable length of time: (1) Dot Foods Inc. v. Washington Department of Revenue,[16] where the taxpayer challenged Washington s retroactive application of tax law changes going back 27 years; and (2) six cases, including Gillette Commercial Operations North America v. Michigan Department of Revenue,[17] challenging Michigan s retroactive repeal of an alternative apportionment method going back six years. Both cases involve decisions upholding a statutory amendment applied retroactively after the statute had been reviewed by the states supreme courts in favor of the taxpayers. In absence of additional guidance by the U.S. Supreme Court, victorious taxpayers may find their hardfought successful litigation undone by a retroactively applied tax law. Conclusion This upcoming year will continue to challenge the development of state and local tax. Taxpayers should be wary of assertions of nexus for sales and use tax and income tax purposes. State courts will also continue to be confronted with challenging applications of addback exceptions, while use of retroactive tax law legislation will make reliance on existing state tax laws difficult for taxpayers. Jeffrey A. Friedman is a partner and Stephanie T. Do is an associate at Eversheds Sutherland LLP in Washington, D.C. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] 504 US 298 (1992). [2] 901 N.W.2d 754 (S.D. 2017). [3] Complaint for Declaratory Judgment, Crutchfield Corp. v. Harding, No. CL17001145-00 (Va. Cir. Ct. Oct. 24, 2017). [4] 830 CMR 64H.1.7.
[5] Va. Code Ann. 8.01-184.1. [6] H.B. 2163, 3rd Sp. Sess. (Wash. 2017); H.F. 1, 1st Sp. Sess. (Minn. 2017); H.B. 5175, Reg. Sess. (R.I. 2017); H.B. 542, Reg. Sess. (Pa. 2017). [7] 892 N.W.2d 343 (Iowa 2017). [8] 901 N.W.2d 838 (Iowa Ct. App. 2017). [9] The court s decision does not discuss whether there was compensation for use of the intangible property, which makes distinction from the Iowa Supreme Court s decision in KFC Corp. v. Iowa Department of Revenue, 792 N.W.2d 308 (Iowa 2010) unclear. [10] No. 2015CV33831 (Colo. 2nd Dist. Ct. 2017). [11] See e.g., Lanco Inc. v. Dir., Div. of Taxation, 908 A.2d 176 (N.J. 2006); A&F Trademark Inc. v. Tolson, 605 S.E.2d 187 (N.C. App. 2004); Geoffrey Inc. v. Oklahoma Tax Comm'n, 132 P.3d 632 (Okla. Civ. App. 2005). [12] 803 S.E.2d 336 (Va. 2017). [13] Va. Code Ann. 58.1-402(B)(8)(a). [14] Va. Code Ann. 58.1-402(B)(8)(a)(1). [15] 512 U.S. 26 (1994). [16] 372 P.3d 747 (Wash. 2016). [17] 878 N.W.2d 891 (Mich. Ct. App. 2015), denying appeal, 880 N.W.2d 230 (Mich. 2016).