Ernst & Young's State and Local Tax Weekly newsletter for April 15 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

New York enacts budget legislation including substantive and technical changes to NYS and NYC corporate tax reform

On April 13, 2016, New York State Governor Andrew Cuomo signed the FY 2016-17 revenue-related budget bill, A9009-C / S6409-C, (hereinafter, Final Bill) that includes substantive and technical amendments to New York State and New York City corporate tax reform as previously enacted in 2014 and 2015. The most significant corporate tax related provisions in the Final Bill include: conformity to the new federal tax filing dates, extension of the tax shelter reporting requirements until July 1, 2019, amendments to the definition of Qualified Financial Instrument (QFI), and amendments to the special bank subtractions.

Many of the legislative changes in the Final Bill have retroactive effect and, as such, apply to tax years beginning on or after Jan. 1, 2015. Some of these changes are not merely technical/corrective in nature but do change the result of tax reform enacted in 2014 and 2015. For additional information on the Final Bill, see Tax Alert 2016-714.

New York tax appeals tribunal requires bank to apply its NOL against entire net income in a year it measured liability on alternative non-income base

The New York Tax Appeals Tribunal (the Tribunal), in reversing a determination of an administrative law judge (ALJ), held that a bank should reduce its 2006 entire net income by approximately $3.7 million because its New York NOL deduction was not limited by the measure of franchise tax liability on an alternative non-income base. In reaching this conclusion, the Tribunal analyzed the plain language and legislative history of former §1453(k-1) of the New York Tax Law consistent with former Article 9-A §208(9)(f), to highlight the principle of federal conformity in determining the New York NOL deduction.

Former Section 1453(k-1) provides that "a NOL deduction shall be allowed which shall be presumably the same as the NOL deduction allowed under" IRC §172, subject to certain limitations as listed by statute.Therefore, although the federal NOL deduction is the starting point for the computation of the New York NOL, Section 1453(k-1)(1) through (4) requires certain specific adjustments that may cause the New York NOL deduction to deviate from the federal NOL. Most significantly, the Tribunal noted that the New York NOL deduction was limited to the amount of the federal NOL deduction for the same year. The Tribunal also highlighted New York's conformity to the federal deduction through the application of the federal ordering rules as provided in IRC §172(b)(2). These rules require a taxpayer to carry any available New York NOL to the earliest of the tax years to which it may be carried and to use it as a deduction for that year to the maximum extent possible. As a result, the Tribunal relied on this principle to demonstrate that the amount of the bank's federal NOL deduction should be applied against its New York entire net income for the tax year 2006, regardless of the bank's use of an alternative non-income tax base.

Finally, the Tribunal focused on the language of the statute to demonstrate that there is no provision in former §1453(k-1) to support the bank's position that New York does not require an offset of entire net income if entire net income plays no role in determining its tax liability. It also noted that corporate tax reform legislation enacted in 2014 supported the statutory interpretation of this provision by the New York Department of Taxation and Finance (Department). Under corporate tax reform, a New York NOL deduction reduces a taxpayer's tax on allocated business income to the higher of the tax on the capital base or the fixed dollar minimum (i.e., New York State does not require reducing entire net income beyond the point to which a taxpayer is subject to tax on an alternative tax base). The Tribunal viewed this change to the New York State statute as support for the Department's position that prior law lacked any limitation regarding the use of the New York NOL deduction as related to the payment of tax on an alternative basis. Therefore, the Tribunal ultimately found that the Department's interpretation of the New York NOL provision was reasonable, and that the bank had not met its burden to establish entitlement to its claimed NOL deductions. In the Matter of the Petition of TD Holdings II, Inc., DTA No. 825329 (N.Y. Tax App. Trib. April 7, 2016). For more on this development, see Tax Alert 2016-715.

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Income/Franchise

New York: The retroactive application of 2010 statutory amendments to New York State's tax treatment of IRC §338(h)(10) to a transaction that was negotiated and completed between 2007 and 2008 is not unconstitutional under the Due Process Clauses of the US and New York constitutions, because it is not harsh and oppressive. In reversing the Administrative Law Judge, the New York Tax Appeals Tribunal (Tribunal) applied the Replan balancing-of-the-equities test that considers three factors: (1) the taxpayer's forewarning of a change in legislation and the reasonableness of reliance on the old law, (2) the length of the retroactive period, and (3) the public purpose for the retroactive application. In applying these factors and citing its 2015 decision in Caprio, the Tribunal first found that the taxpayer — a nonresident 100% shareholder of an S corporation that sold his stock in the S corporation to a buyer in 2008 and made an election under IRC §338(h)(10) to treat the sale as a deemed asset sale — did not reasonably rely on provisions excluding the proceeds from New York tax and should have been aware at the time of the negotiation and sale of the S corporation of the longstanding policies of the New York Division of Taxation (tax division) requiring taxpayers to pay proportionate state income taxes on deemed asset sale gains. In addition, although there is no bright line test delineating when a taxing statute retroactivity period becomes unconstitutional, this two-and-one-half to three-year retroactivity period is not unreasonable because, per Caprio, the 2010 amendments were curative or corrective in nature, and applied only to open tax years. Finally, citing Caprio and Matter of Baum, the Tribunal found that the curative, rational public purpose of the statutory amendments — corrective legislation meant to clarify New York's policy regarding federal conformity as it relates to IRC §338(h)(10) following a decision of the Tribunal and a determination of the Division of Tax Appeals that overturned the longstanding policies of the tax division — are compelling and support upholding the retroactive application of the statute. In the Matter of the Petition of Luizza, No. 824932 (N.Y. Tax App. Trib. March 29, 2016).

Texas: A landman company was not entitled to exclude from total revenue flow-through funds for payments mandated to be distributed to its subcontractors because none of the services it performed during the tax years at issue (2009 through 2012) encompassed statutorily excluded services. Under Texas franchise tax law, the landman company must exclude from its total revenue the flow-through funds that are mandated by contract to be distributed to other entities for subcontracting payments handled by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling or repair of improvements on real property or the location of the boundaries of real property. The Administrative Law Judge found that the landman company failed to show that any of the amounts it excluded from revenue as flow-through funds were related to such contracts. Moreover, none of the services the landman company performed during the report years in question encompassed the services described by statute. Accordingly, the landman company failed to demonstrate that any of its subcontracting payments qualified for the exclusion from total revenue. Note that for franchise tax due on or after Jan. 1, 2014, Texas enacted a law change that allows taxable entities engaged primarily in the business of performing landman services to exclude from total revenue subcontracting payments made to nonemployees for the performances of landman services on behalf of the taxable entity. Tex. Comp. of Pub. Accts., Decision Nos. 111,668, 11,669, 111,670, and 111,671 (Nov. 6, 2015)(released April 2016).

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Sales & Use

Massachusetts: Certain deliveries by an out-of-state wholesale distributor (wholesaler) that had nexus with Massachusetts to Massachusetts customers are subject to the state's sale tax, because under the state's drop shipment rule, Massachusetts treats the party that supplied the product and ultimately affected its delivery into the state as the vendor who sold the products to the ultimate consumer. In reaching this conclusion, the Massachusetts Appellate Tax Board (Board) rejected the wholesaler's burden-shifting argument that before the drop shipment rule can be applied to a wholesaler, the Massachusetts Commissioner of Revenue (Commissioner) must make a preliminary determination that a retailer is not actually engaged in business in the state. Rather, the Board found that the wholesaler's argument "misses the mark," noting that the wholesaler failed to cite any ambiguity in the rule that would shift the burden to the Commissioner, and that the drop shipment rule is consistently and unambiguously applied. Accordingly, the wholesaler has the burden to prove facts that would prevent application of the drop shipment rule. In addition, the Board rejected the wholesaler's double taxation argument — consumer obligation to report and remit use tax and wholesaler remitting sales tax under the drop shipper rule — explaining that use tax does not apply because under the drop shipment rule, a wholesaler with Massachusetts nexus is treated as the vendor making a retail sale in the state for sales tax purposes. Thus, the transaction is subject to sales tax and exempt from use tax. Lastly, the Board ruled that the drop shipment rule does not discriminate against interstate commerce because scenarios involving in-state and out-of-state vendors are equally subject to tax and there is no greater burden on the transaction using an out-of-state vendor. D&H Distributing Co. v. Mass. Comr. of Rev., No. C314566 (Mass. App. Tax Bd. April 4, 2016).

Missouri: A computer software company is not entitled to a refund of use tax it remitted on sales of hardware and software to an national credit card company that the credit card company used in processing credit and debit card transactions. In reaching this conclusion, the Missouri Supreme Court (Court) noted that while it "has held that the production of intangible products such as computer data may be 'manufacturing,' it has rejected the idea that every use of a computer to aid a business or transmit information is 'manufacturing.' Such an interpretation of the term … would be at odds with the fundamental principle … that exemptions are to be construed narrowly against the taxpayer." Moreover, the Court rejected the software company's argument that under Bell I and Bell II the Court should broaden the manufacturing exemption to include the transmission of computer data itself, which would allow it to treat the transmission and analysis of credit information as a form of exempt manufacturing. IBM Corp. v. Dir. of Revenue, No. SC94999 (Mo. S. Ct. April 5, 2016).

Missouri: An out-of-state multistate retailer is entitled to a refund of use tax paid on catalogs that it printed and mailed outside Missouri to customers in Missouri, because the retailer's activities do not constitute a "use" of the catalogs in the states as required by the use tax statute. The Missouri Supreme Court (Court) determined that the retailer does not exercise any right or power over tangible personal property incident to the ownership or control of that property in Missouri. The Court rejected the revenue department's argument that by causing the catalogs it had printed to be delivered to Missouri residents, the retailer "used" those materials in the state and is liable for use tax, noting that this argument would have the Court broadly construe the word "use" beyond the concept of "control" set forth in the statute. Thus, the mere shipment of a product from another state into Missouri does not constitute an in-state exercise of right or power or control over the property as required by the use tax statute. Office Depot Inc. v. Dir. of Revenue, No. SC950029 (Mo. S. Ct. April 5, 2016).

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Business Incentives

Alabama: New law (HB 34) creates two new economic development tax credits — the port credit and the Growing Alabama Credit (GAC). The port credit provides tax credits for increased use of the state's port facilities (including inland ports), and is awarded based on the port user's cargo volume or base cargo volume. The credit cannot offset the taxpayer's income tax below zero, and unused credits can be carried forward for up to five years. Applications for the credit will solicit whatever information the Renewal of Alabama Commission (Commission) deems important to its determination of whether granting a port credit will create new, high paying jobs in the state, bring substantial capital to the state, increase the usage of a port facility, promote the development of clusters of businesses in the state, or promote Alabama's economic development efforts. Awards cannot exceed $5 million in a fiscal year and $12 million for the life of the program. The GAC provides an income tax credit for those who agree to make a cash contribution to a local economic development organization approved by the Commission. The GAC cannot reduce the taxpayer's tax liability by more than 50%. Unused GACs can be carried forward for up to five years. GACs are not permitted in excess of $5 million for fiscal year 2016, and are not permitted in excess of $10 million per year for fiscal years 2017 through 2020. To the extent a taxpayer uses a GAC, the taxpayer may not take any deduction that would have otherwise been allowed for the taxpayer's contribution. The GAC can only be claimed by the donating individual or entity and it is non-assignable and nontransferable. A taxpayer also may not claim a credit for a donation made by any other entity, including an entity taxed under subchapter S or subchapter K of which the taxpayer is an owner, shareholder, partner, or member. Ala. Laws 2016, Act 2016-102 (HB 34), signed by the governor on April 4, 2016.

Iowa: New law (SF 2300) creates a renewable chemical production tax credit program for renewable chemicals produced in Iowa from biomass feedstock. The credit can be claimed against personal net income tax or corporate business tax in an amount equal to the product of $0.05 multiplied by the number of pounds of renewable chemicals produced in Iowa from biomass feedstock by the eligible business during the calendar year in excess of the eligible business' pre-eligibility production threshold. The credit is refundable; alternatively, taxpayers may apply excess credits to the subsequent tax year's liability. The maximum credit is $1 million for eligible businesses that has been in operation in Iowa for five years or less upon credit application, and $500,000 for eligible businesses that have been in operation in Iowa for more than five years at the time of application. Eligible businesses cannot receive more than five tax credits under the program. The renewable chemical production tax credit is not available for any renewable chemical produced before the 2017 calendar year and after the 2026 calendar year. In addition, provisions of SF 2300 cap the high quality jobs program tax credits at $105 million for each fiscal year of the fiscal period beginning July 1, 2016 and ending June 30, 2021, with an extension available if an award threshold is met. Iowa Laws 2016, SF 2300, signed by the governor on April 6, 2016.

Oregon: New law (HB 4084) authorizes certain local governments to adopt an ordinance or resolution providing for programs that offer ad valorem property tax brownfield incentive benefits. The incentives can be for special assessment of any land that constitutes a brownfield and/ or an exemption (or partial exemption) of improvements and personal property on land that constitutes a brownfield, each for a period up to 10 years with the possibility of a five-year extension based upon certain local criteria. The incentive program benefits are available until either the expiration of the 10- or 15-year period of eligibility, or the date on which the dollar amount of the benefit equals the eligible costs for the property. Such an ordinance or resolution does not become effective unless the tax rates of the taxing district located within the local jurisdiction, when combined with the tax rate of the local jurisdiction that adopted the ordinance or resolution, equal 75% or more of the total combined tax rate within the local territory. HB 4084 discusses eligibility requirements and what qualifies as eligible costs, and provides claw back provisions by which local governments can disqualify a property from the incentive programs and collect additional taxes. These provisions are repealed on Jan. 2, 2027, however, property that has been granted an incentive under this program before the repeal date will continue to receive the benefit for the period of time for which it was granted. Or. Laws 2016, Ch. 96 (HB 4084), signed by the governor on April 4, 2016.

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Property tax

North Carolina: In reversing the North Carolina Property Tax Commission, the North Carolina Court of Appeals (Court) held that prototype, and conformance production, airplane tires are excluded from North Carolina personal property tax because they are finished goods that fall within the definition of "inventories owned by manufacturers." The parties did not contest that the taxpayer is a manufacturer, and they agreed that the tires are "finished goods" because they have completed the manufacturing process. The county assessor, however, argued that the statutory phrase "consumed in manufacturing or processing or that accompany and become part of the sale of the property being sold" modifies "finished goods," making the tires subject to tax. The Court disagreed, interpreting "inventory" definitions going back to 1985 through 2008 to find that "finished goods" is not modified by materials or supplies consumed in manufacturing. In the Matter of the Appeal of Michelin North America, Inc., No. COA 15-415 (N.C. Ct. App. April 5, 2016).

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Controversy

Kentucky: New law (SB 129) permits the Kentucky Department of Revenue to publish tax forms and form instructions without promulgating an administrative regulation and amends various other provisions related to Kentucky's administrative regulation process. The amendments require that the review of an administrative regulation include the entire administrative regulation and all attachments filed with the administrative regulation, and the review of amendments to existing administrative regulations must not be limited to only the changes proposed by the promulgating administrative body. The provisions also amend requirements related to the basic information proposed regulations should include, certain contact information for parties who can provide insight into particular regulations, filing requirements for after-comments versions of regulations, and requirements aimed at maintaining clarity and ease of understanding how regulations are being amended (such as by avoiding ambiguous words and sufficiently describing material incorporated by reference in sufficient detail that a person reading the summary would know the differences between the material previously incorporated by reference and the new material). Ky. Laws 2016, SB 129, signed the governor on April 9, 2016.

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Miscellaneous Tax

Federal: On Tuesday, April 26, 2016, from 1:00-2:00 p.m. EDT New York; 10:00-11:00 a.m. PDT Los Angeles EY's Credits & Incentives practice will launch a four-part webcast series that will explore and discuss recent extensions under the PATH Act of certain federal tax credits and incentives and the opportunities they may provide. Panelists on the inaugural webcast will review the PATH Act's changes to the federal Work Opportunity Tax Credits, New Markets Tax Credits, and Renewable Energy Tax Credits, and will discuss the potential opportunities and implications for companies and investors. Future topics in the series include: (1) Seminar #2 — Work Opportunity Tax Credits (May 2016); (2) Seminar #3 — New Markets Tax Credits (June 2016); (3) Seminar #4 — Renewable Energy Tax Credits and Sustainability (July 2016). To register for this event, go to Federal tax credits and incentives.

All States: On Wednesday, May 4, 2016, from 2:00-3:00 p.m. EDT New York; 1:00-2:00 p.m. CDT Chicago; noon-1:00 p.m. MDT Denver; 11:00-noon PDT Los Angeles, join EY for its sales tax seminar series. Our second webinar in this series will address the sales and use tax consequences of legal entity structuring. The panelists will discuss sales tax matters relating to legal entity classification risks and the importance of business purpose and economic substance in entering into any transaction. Topics will include: whether the structure or entity has a purpose or utility apart from the anticipated tax consequences; and whether there are objective indicators of the practical effects of a transaction, independent of taxes. The webinar will also cover some of the challenges businesses face when evaluating the sales tax and the sales tax impact of changing business structures or purchasing processes, such those due to supply chain realignments, centralization of business functions, mergers, acquisitions and divestitures. Click here to register for this event.

International: On Wednesday, April 27, 2016, from 1:00-2:15 p.m. EDT New York/Toronto; 10:00-11:15 a.m. PDT Los Angeles/Vancouver, EY will hold a webcast highlighting the impact of transfer pricing on income taxes and customs. Multinational enterprises (MNEs) participating in cross border transactions should understand the complexities of transfer pricing and customs issues, as well as how these different "valuation" regimes intersect. These issues are becoming increasingly important as convergence efforts and the Base Erosion and Profit Shifting (BEPS) initiative of the Organization for Economic Co-operation and Development continue to evolve and change the legal landscape across the globe. Join our EY panel as we discuss how these issues can influence your business, with an emphasis on: (1) the tension between transfer pricing and customs, (2) the current US approach to the use of transfer pricing in determining customs valuation, (3) global transfer pricing and customs convergence efforts, and (4) BEPS implications for customs. The panel will also discuss how changes to the customs laws in the European Union (EU) illustrate how the effects of the BEPS initiative are already affecting customs laws in various jurisdictions. To register for this event, go to BorderCrossings.

* 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.