Ernst & Young's State and Local Tax Weekly newsletter for February 12 is now available. Prepared by Ernst & Young's State and Local Taxation group, this weekly update summarizes important news, cases, and other developments in U.S. state and local taxation.

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Top Stories

US Congress passes permanent Internet Tax Freedom Act, including a 2020 sunset date for taxes imposed by grandfathered states

On Feb. 11, 2016, the US Congress approved the Trade Facilitation and Trade Enforcement Act of 2015 (HR 644) (the Act), provisions of which make the Internet Tax Freedom Act (ITFA) permanent, and place a four-year sunset on the ITFA "grandfathering" provisions, discussed below which allowed a few states to continue to impose taxes on certain Internet services. The current version of ITFA, passed in December 2015, had been set to expire on Oct. 1, 2016. The Act will now be sent to the President, who is expected to sign the measure within the next two weeks.

Originally enacted in 1998, ITFA bars federal, state and local governments from taxing Internet access and from imposing "multiple and discriminatory taxes on electronic commerce," but provides an exception for those states that imposed a tax on Internet access prior to Oct. 1, 1998 (the so-called grandfathered states — Hawaii, New Mexico, North Dakota, Ohio, South Dakota, Texas and Wisconsin). The current provision contained in the Act will allow the grandfathered states to continue to tax Internet access for an additional four-and-a-half years (through June 30, 2020), at which point the prohibition on such taxes imposed by the Act would apply and these states that were imposing taxes on Internet access services will no longer be allowed to do so.

Over the past few years, opponents of barring the ability of the states to impose Internet access taxes estimated that prohibiting and eliminating these taxes could cost these grandfathered states more than $500 million per year in lost tax revenues. Accordingly, taxpayers in the grandfathered states should prepare for tax law changes and/or cuts in services to make up for the anticipated revenue shortfalls beginning in 2020.

One other outcome of enactment of the Act is that taxpayers should monitor Congressional activity with respect to legislating a national nexus standard for sales and use tax purposes, such as progress on the Marketplace Fairness Act (MFA) and other similar legislation. Some US Senators blocked the progress of the Act because they believed progress on the bills like the MFA should be tied to the extension of the ITFA provision. Apparently, as part of the compromise to allow the Act to move forward with the ITFA permanency provision included, Senate Majority Leader McConnell indicated that the Senate would take up the national nexus standard provision at some point in 2016 placating the concerns of those Senators threatening to block action on the Act. For additional information on this development, see Tax Alert 2016-299.

Colorado district court excludes holding company with no property or payroll from group's combined return, finds DOR not required to follow check-the-box designation

In Agilent Technologies Inc., a Colorado District Court (court) held that the Colorado Department of Revenue (Department) erred in requiring a holding company with no property or payroll of its own to be included in an affiliate corporation's Colorado combined return because the holding company does not meet the definition of an "includable C corporation" under C.R.S. Section 39-22-303(12)(c). Notably, the court also held that the Department, for Colorado income tax purposes, is not required to treat the holding company and its foreign subsidiaries as a single C corporation merely because they elected to be treated as disregarded entities for federal income tax purposes. Agilent Technologies, Inc. v. Colorado Department of Revenue, No. 2014CV393 (Colo. Dist. Ct., Denver Cnty., Jan. 20, 2016).

It is likely the Department will appeal this decision, and there is also said to be another similar case currently before the court. As it may take years for this issue to makes its way through the judicial process, taxpayers filing a Colorado combined report with holding company subsidiaries with no payroll or property of their own should consider their procedural options (e.g., filing amended returns to exclude such corporations from their Colorado combined reporting groups).

The court's ruling that federal entity classifications do not apply when testing the status of an 80-20 company was surprising, and could have implications beyond the facts of this case. While the case specifically dealt with 80-20 company testing in the context of disregarded foreign entities, the court's rationale could extend to all determinations made with respect to Colorado's combined reporting rules. For example, when considering whether corporations meet the three of six unity tests, the court's rationale suggests that testing should be applied without consideration of federal entity classification rules (e.g., tests applied between and among corporations and disregarded entities as single entities). In yet another example, the court's rationale could be read to suggest that, when a corporation forms or acquires a disregarded domestic single member LLC, that LLC would be separately removed from the Colorado combined return under the "two-year rule." For more on this development, see Tax Alert 2016-298.

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Income/Franchise

Alabama: Proposed bill (SB 202) wouldadopt mandatory unitary combined reporting, effective for all tax years beginning after Dec. 31, 2014. The combined report would include all members of the unitary group doing business in the US. A unitary business would mean "a single economic enterprise that is made up either of separate parts or a single business entity or a commonly controlled group of business entities that are sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts." Taxpayers would be allowed to make a water's edge election to determine their apportioned shares of net business income or loss of the combined group. The entire income and apportionment factors of any group member doing business in a tax haven would be included in the water's edge calculation. In addition, taxpayers would be allowed to make an affiliated group election to treat as its combined group all corporations that are members of its affiliated group. The tax commissioner would be tasked with promulgating implementation regulations. SB 202 was introduced on Feb. 11, 2016.

Idaho: New law (HB 425) updates Idaho's date of conformity to the IRC to Jan. 1, 2016 (formerly Jan. 1, 2015), retroactively effective to Jan. 1, 2016. In addition, the provisions of HB 425 make clear that for purposes of Idaho's income tax, the state will recognize marriages recognized and permitted by the US Supreme Court and the 9th Circuit Court of Appeals. Idaho Laws 2016, Ch. 1 (HB 425), signed by the governor on Feb. 9, 2016.

Maryland: Proposed bills (HB 1419 and SB 34) would adopt mandatory unitary combined reporting with a water's edge election, effective for taxable years beginning after Dec. 31, 2016. Under the water's edge method, the unitary group only would include the following affiliated entities: (1) corporations that are incorporated in the US, excluding corporations making an election pursuant to IRC §§931 to 936; (2) DISCs and FSCs; (3) any corporation, other than a bank, regardless of the place where it is incorporated if the average of its property, payroll and sales factors within the US is 20% or more; (4) export trade corporations; (5) a foreign corporation deriving gain or loss from the disposition of an interest in real property in the US to the extent recognized under IRC §897; and (6) other corporations not previously described that are specified in regulations adopted by the comptroller. The regulations adopted by the comptroller would have to be consistent with the Multistate Tax Commission's regulation (Reg. IV.1.(B)) "Principles for Determining the Existence of a Unitary Business". HB 1419 was introduced on Feb. 12, 2016 and SB 34 was introduced on Jan. 13, 2016. Similar bills have been considered in prior legislative sessions, but have not passed.

New Jersey: Proposed bill (SB 61) would adopt mandatory combined reporting provisions, which would take effect immediately and apply to privilege periods ending after the bill's date of enactment. SB 61 was introduced on Jan. 12, 2016. A similar bill was considered in prior legislative session but was not enacted.

South Dakota: New law (HB 1049) updates South Dakota's date of conformity with the IRC to the IRC as amended and in effect on Jan. 1, 2016, for purposes of the income tax imposed on financial corporations. S.D. Laws 2016, HB 1049, enacted on Feb. 12, 2016.

Virginia: A Virginia circuit court ruled against a multistate retailer and found that it is required to add-back royalties paid to an out-of-state related entity (Illinois entity) because these payments do not qualify for the "subject to tax" safe harbor exception to Virginia's inter-company add-back provisions. Under Virginia law, a taxpayer is required to add-back to federal taxable income the amount of any intangible expenses and costs directly or indirectly paid, accrued or incurred to, or in connection directly or indirectly with one or more transactions with one or more related members, unless an exception applies. At issue in this case is the exception for being subject to tax in another state found in Va. Code Ann. §58.1-402(B)(a), which provides that add-back is not required if: "[t]he corresponding item of income received by the related member is 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 ... " The retailer argued that under the plain meaning of this provision, income is taxable in another state if the income is included in the computation of a corporation's taxable income in another state. The retailer further argued that under this interpretation, it meets the "taxable in other states" exception because the Illinois entity included the royalty payments it received from this retailer in its income tax filing in other states, even if those amounts were not actually taxed in those states. The circuit court rejected the retailer's interpretation of the add-back exception provision, holding that under the plain language of the statute, in order to meet the exception, the intangible expense paid to a related member: (1) must be subject to tax in another state, and (2) tax must actually be imposed. Kohl's Dept. Stores Inc. v. Virginia Dept. of Taxn., No. CL12-1774 (Va. Cir. Ct., City of Richmond, Feb. 3, 2016).

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Sales & Use

Louisiana: A manufacturer's purchases of certain chemicals and other raw materials for use in its manufacturing process are excluded from Louisiana's sales and use tax under the "further processing exclusion"; the exemption does not apply to repulpable tape and professional services. In affirming the trial court, the Louisiana Court of Appeal (Court) cited the standard established in International Paper v. Bridges, which held that raw materials "further processed" into end products are excluded from sales and use tax when: (1) the raw materials become recognizable and identifiable components of the end products; (2) the raw materials are beneficial to the end products; and (3) the raw materials are material for further processing, and as such, are purchased with the purpose, but not necessarily the primary purpose, of inclusion in the end products. The Court found that Bridges soundly rejected the "primary purpose" test distilled from Traigle and Vulcan, and noted that the pertinent inquiry is whether the chemicals were purchased for the purpose of incorporation or inclusion into the end product, not whether they were purchased for the purpose of achieving some specific benefit in the end product. In addition, the Court did not find manifest error in the trial court's denial of the manufacture's claim that it is due a refund for sales and use taxes attributable to repulpable tape, because the manufacturer failed to present enough evidence that the repulpable tape met the Bridges test. Finally, the Court declined to apply the divisible sales approach in a matter involving the further processing exclusion. Graphic Packaging Itnl., Inc. v. Lewis et al., No. 50,371-CA (La. App. Ct., 2d Cir., Feb. 3, 2016).

Michigan: The Michigan Department of Treasury (Department) issued guidance on how to determine if property is tangible personal property or real property for sales and use tax purposes. The Department explained that Michigan applies a three-factor test to determine whether property remains personal property or becomes part of realty (i.e., becomes a fixture). These factors to determine whether property becomes affixed to and part of the realty, as articulated by the Michigan Supreme Court in Sequist v. Fabiano are: (1) annexation to the real estate, either actual or constructive; (2) adaptation or application to the use or purpose of the real estate; and (3) intention to make the article a permanent accession to the real estate. In regards to annexation, an object may acquire the status of fixture by constructive annexation even if an object is not physically affixed to the realty, and whatever is affixed to a building by an owner to complement, to facilitate its use and occupation in general, becomes a part of the realty, even though it is capable of removal without injury to the building. For adaptation, an object that is introduced onto the realty may become a fixture if it is a necessary or at least a useful adjunct to the realty, considering the purpose to which it is involved. Finally, in regards to intention to make an object a fixture, the intention that controls is that manifested by the objective, visible facts (rather than the annexor's subjective intent), and the intent can be inferred from the nature of the article affixed, the purpose for which it was affixed, and the manner of annexation. The Department noted, that the "permanence required is not equated with perpetuity." The Department provided examples of how specific items are characterized, as well as detailed examples of how specific cases are characterized by applying the three-factor analysis. Mich. Dept. of Treas., RAB 2016-4 (Feb. 1, 2016).

Rhode Island: Proposed bill (HB 7375) would adopt an economic nexus standard for sales and use tax purposes, stating that the "general assembly recognizes that the United States Supreme Court has held that a person or entity must have a physical presence in the taxing state in order to find that a substantial nexus for sales and use tax collection purposes exists. The general assembly finds that this reasoning no longer applies for the reasons [stated in the bill]" (e.g., availability of sales and use tax collection software, no longer an undue burden to require remote sellers to collect and remit tax). The bill defines "doing business in the state" to include various activities, including: (1) maintaining within the state, directly or indirectly, an office, distribution facility, salesroom, warehouse, storage place or other similar place of business; (2) engaging in, either directly or indirectly through a marketplace provider, referrer or other third party, direct response marketing targeted at this state; (3) entering into one or more agreements under which a person(s) that has nexus with Rhode Island directly or indirectly refer potential purchasers of products to the seller for a commission or other consideration, whether by internet link, website or otherwise. A seller also would be doing business in the state if any part of its sales process occurs in the state, regardless of whether that part of the process has been subcontracted to an affiliate or third party. A seller would be presumed to be doing business in the state if the total cumulative sales price of products sold to purchasers in Rhode Island exceeds $10,000 in the immediately preceding calendar year and the seller either has a physical presence in or is registered to collect and remit sales and use tax in a state that is a member of the streamlined sales and use tax agreement. Further, a person would be presumed to be doing business in Rhode Island if that person is related to a person that has nexus with the state and meets certain criteria (e.g., sells under the same or similar business name, maintains an office or facility in the state, uses the in-state related person's trademarks/tradenames in Rhode Island, performs various delivery/installation services, shares management). Provisions of HB 7375 also require a marketplace provider doing business in the state to collect and remit sales and use tax on any sales it facilitated to customers in the state, unless a retailer or marketplace seller is responsible for collecting and remitting the tax. Lastly, HB 7375 establishes registration requirements for a person who contracts or otherwise agrees with a retailer to list multiple items of tangible personal property or services for sale and the sales price for these goods and services in any forum, including a catalog or internet website and meets other criteria. If enacted, these provisions would apply to taxable years beginning on or after Jan. 1, 2017. HB 7375 was introduced on Jan. 28, 2016.

South Dakota: Proposed bill (SB 106) would establish an economic nexus provision for sales and use tax. Specifically, a seller selling tangible personal property, products transferred electronically or services (collectively goods) for delivery into South Dakota would be required to follow all applicable sales and use tax collections and remittance procedures as if the seller had a physical presence in the state, if: (1) the seller's gross revenue from delivery of such goods into South Dakota exceed $100,000; or (2) the seller sold such goods for delivery into South Dakota in 200 or more separate transactions. Provisions of the bill include appeal process and procedures (e.g., enjoin the state from enforcing the provisions) and lists the legislature's reasoning for enacting these provisions. Such reasons include the state's inability to effectively collect sales or use tax from remote retailers, the revenue losses to the state from this inability, the structural advantages of remote sellers, remote sellers benefit from the state's market (economic and infrastructure), decrease in the costs of collection due to modern computer software, Justice Kennedy's concurring opinion in DMA, and the urgent need for the U.S. Supreme Court to reconsider the physical presence requirement. If enacted, these provisions would be in full force and effect on the first day of the month that is at least 15 calendar days from the date this bill is signed by the governor. SB 106 was introduced on Jan. 27, 2016 and passed the S.D. Senate State Affairs committee on Feb. 17, 2016.

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Business Incentives

Florida: The Florida Department of Revenue (Department) announced that the application process for the Florida research and development (R&D) credit will begin on Sunday, March 20, 2016 at 12:00 a.m. (ET) and end on Saturday, March 26, 2016 at 11:59 p.m. (ET). Qualified target industry businesses may apply using the online application. The Department noted that the state has not yet updated its date of conformity to the IRC and that the legislature is currently considering whether to adopt the changes made to the federal R&D credit included in the federal Protecting Americans from Tax Hikes (PATH) Act of 2015 signed by the President in December 2015. As a result, the Department said that it cannot approve any allocations of the R&D credit until the state's updated conformity to the IRC becomes law. Thus, businesses applying for the credit may need to obtain an extension to file their 2015 Florida corporate income tax return. The Department also reminded businesses that before they can apply for the R&D credit, they must obtain a certification letter from the Florida Department of Economic Opportunity (DEO) confirming that the business is a qualified target industry business. The DEO will begin accepting certification requests on Tuesday, March 1, 2016. Fla. Dept. of Rev., TIP No. 16C01-01 (Feb. 5, 2016).

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Property tax

Arkansas: The University of Arkansas's property at issue in this case is immune from ad valorem taxation based on sovereign immunity, because the University is an instrumentality of the state. In support of this finding, the Arkansas Supreme Court (Court) reasoned that the Arkansas Constitution (Constitution) lacks language articulating that property owned by the state is "subject to" taxation. Moreover, the Constitution delegates the power to enact laws regarding taxation and the record demonstrates that the state legislature has neither enacted a law subjecting property owned by the state to ad valorem taxation nor has it delegated the power to tax to subordinate political or municipal corporations. The Court also rejected the state's argument that the Constitution employs a use analysis in determining whether state property is exempt from tax, requiring use exclusively for public purposes. Washington Cnty. et al. v. Univ. of Ark. Bd. of Trustees, No. CV-15-357 (Ark. S. Ct. Feb. 4, 2016).

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Compliance & Reporting

Rhode Island: The Rhode Island Division of Taxation (Division) issued guidance on filing requirements for entities registered with the Rhode Island Secretary of State, including entities that may not have conducted business in the state for a particular year. For tax years beginning on or after Jan. 1, 2016, a $450 minimum business corporation tax is imposed on an entity treated as a C corporation, an S corporation, an LLC not treated as a corporation for federal income tax purposes (including a SMLLC and any LLC treated as a disregarded entity for federal income tax purposes), and a partnership (including LLPs and LPs). The guidance includes information on the forms these entities are required to file. R.I. Div. Taxn., Notice 2016-01 (Feb. 5, 2016).

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Controversy

California: Amendments to Cal. Code Regs. tit. 18, §§ 5218, 5235, 5237 and 5267 incorporate the prior delegation by the California State Board of Equalization's (Board) of authority to Board staff to grant or deny appeals and refund, credit, or cancel amounts in excess of $100,000 without the Board's approval. Under the amended procedures, however, the Board's Deputy Directors will make determinations regarding whether to approve their staff's recommendations to refund, credit, or cancel amounts in excess of $100,000 or cancel a fraud or evasion penalty in any amount. The amended regulations also provide taxpayers the opportunity to request an appeals conference or Board hearing to further appeal a Deputy Director's determination if it is less favorable than the Deputy Director's staff's recommendation. The amended regulations take effect March 1, 2016. Cal. State Bd. of Equal., Cal. Codes Regs. tit. 18, §§ 5218, 5235, 5237, and 5267 (approved Feb. 3, 2016).

Michigan: The Michigan Department of Treasury (Department) issued a new acquiescence policy regarding non-binding, adverse judicial decisions that is similar to the policy adopted by the IRS. Starting with its next quarterly newsletter (to be issued in May 2016), the Department will publish a list of final (unappealed), non-binding, adverse decisions and announce its acquiescence or non-acquiescence with respect to each decision. If the Department acquiesces, it accepts the ruling of the court and it will follow the ruling in similar cases with the same controlling facts. Mich. Dept. of Treas., Treasury Update Vol.1, issue 2 (Feb. 1, 2016).

* Tax alerts are available in the EY Client Portal. If you are not a subscriber to EY Client Portal and would like to subscribe to EY Client Portal and receive our Tax Alerts via email, please contact your local state tax professional.

Because the matters covered herein are complicated, State and Local Tax Weekly should not be regarded as offering a complete explanation and should not be used for making decisions. Any decision concerning matters covered herein should be reviewed with a qualified tax advisor.