Ernst & Young's State and Local Tax Weekly newsletter for June 10 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

Connecticut enacts budget bill that includes market-based sourcing, single sales factor apportionment for individuals

On June 2, 2016, Governor Dannel Malloy signed SB 502, the state's 2016-17 budget implementer bill (the Bill) that includes various tax law changes. The most notable tax law changes contained in the Bill are the establishment of market-based sourcing for sales of non-tangible property and services for corporate and individual income tax purposes and the use of single-sales factor apportionment for individual income tax purposes.

Effective for tax years beginning on or after Jan. 1, 2016, gross receipts, for corporate income tax purposes, are sourced as follows:

— Gross receipts from sales of tangible personal property are assignable to Connecticut if the property is delivered or shipped to a purchaser within the state (unless election made to be treated like a DISC), regardless of the FOB point or other conditions of the sale.

— Gross receipts from services are assignable to Connecticut if the market for services is in Connecticut, which occurs if and to the extent the service is used in a location in Connecticut (note, this is a departure from the former origin-based sourcing method).

— Gross receipts from the rental, lease or license of real or tangible personal property are assignable to Connecticut to the extent the property is situated within Connecticut.

— Gross receipts from the rental, lease or license of intangible property are assignable to Connecticut if and to the extent the property is used in Connecticut.

— Gross receipts from interest managed or controlled within Connecticut are assignable to Connecticut. Gross receipts from the sale or other disposition of real property, tangible personal property or intangible property are excluded from the apportionment fraction calculation if the property is not held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business.

— Gross receipts not specifically enumerated above are assignable to Connecticut to the extent the taxpayer's market for the sales is in the state.

The market based sourcing provisions for personal income tax purposes (including nonresident non-corporate pass-through entity owners), are similar but with some differences and applicable to income years beginning on or after Jan. 1, 2017. Under both the corporate and personal income tax provisions, if a taxpayer cannot reasonably determine the assignment of its receipts in accordance with the new sourcing provisions, the taxpayer may petition the commissioner to use a methodology that reasonably approximates the assignment of the receipts.

Effective for and applicable to income years beginning on and after Jan. 1, 2017, SB 502 implements single sales factor apportionment for personal income tax purposes. The portion of a nonresident partner's distributive share of partnership income, a nonresident shareholder's pro rata share of S corporation income, and a nonresident beneficiary's share of trust or estate income that is derived from or connected with sources within Connecticut is determined under the amended market-based sourcing provisions. For additional information on these developments, see Tax Alert 2016-1025.

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Income/Franchise

Arkansas: The Office of Hearings and Appeals of the Arkansas Department of Finance and Administration upheld the Department's denial of a corporate income tax refund claim based on amended returns using the standard apportionment formula for sourcing receipts from services. The taxpayer filed its 2009 and 2011 Arkansas corporate income tax returns using market-based sourcing (based on customer location) related to its sales of management services. The taxpayer did not, however, request a deviation from the standard apportionment formula as required by Ark. Code Ann. §26-51-718. In reviewing its tax returns, the taxpayer concluded that it had erroneously filed the 2009 and 2011 returns since it did not use the prescribed apportionment method nor did it request a deviation as required by law. The taxpayer then filed amended 2009 and 2011 returns based on the standard apportionment formula, which resulted in a claim for refund. The Department denied the refund claim. In so doing, it concluded that the taxpayer's proposed change in the sales factor did not fairly reflect its Arkansas business activity and that the market-based methodology used on the original filings effectuated a more equitable apportionment method. In the Department's view, sourcing based on customer location provided a "known quantity of the actual revenue" received from Arkansas' sources versus the apportionment of those services based on a somewhat attenuated segment of the taxpayer's business (i.e., sale of goods). On appeal, the ALJ determined that the Department did not abuse its discretion in denying the refund claim as the cost-of-performance methodology, though otherwise prescribed by Arkansas law, did not fairly reflect the taxpayer's Arkansas activity and the market-based methodology used on the originally filed returns fairly reflected that activity. The ALJ noted that the fact that the taxpayer used market-based sourcing on its original returns suggested that it was not an unreasonable methodology, and essentially concluded that the taxpayer did not meet its burden of demonstrating that it was entitled to the refund. Ark. Dept. of Rev., Dkt. Nos. 16-202 and 16-213 (Admin. Hearing Decision May 27, 2016). For additional information on this development, see Tax Alert 2016-1006.

Massachusetts: A multinational electricity and gas utility company's closing agreement with the IRS, which allowed a federal deduction for a portion of the amount claimed by the company as interest on deferred subscription arrangements (DSAs), is not binding on the revenue commissioner as to the deductions allowed for Massachusetts corporate excise tax purposes. In reaching this conclusion, the Massachusetts Supreme Judicial Court agreed with the revenue department's argument that since Massachusetts deductions are determined by reference to the IRC, the closing agreement by permitting only a portion of the claimed federal interest deductions for the DSA payments (and not all), did not establish that the DSA payments qualified as interest. National Grid USA Service Company, Inc. v. Commissioner of Revenue, No. 14-P-1861 (Mass. S. Judicial Ct. June 8, 2016).

Massachusetts: A multinational electricity and gas utility company's deferred subscription arrangements (DSAs) did not qualify as bona fide debt for Massachusetts tax purposes because the DSAs did not require payments to satisfy the obligations. As a result, the company subscribing for shares could neither deduct the interest expense component of its payments pursuant to the DSAs in determining its taxable net income nor deduct as liabilities the book value of the DSAs in determining its taxable net worth. National Grid USA Service Company, Inc. v. Commissioner of Revenue, No. 14-P-1662 (Mass. S. Judicial Ct. June 8, 2016).

New York City: In affirming an administrative law judge's decision, the New York City Tax Appeals Tribunal (Tribunal) held that a federal savings and loan association and its affiliates (collectively, the corporation) were not required to include an out-of-state wholly owned passive investment company subsidiary (subsidiary) that held its non-New York mortgages, in their combined New York City (NYC) bank tax return because the subsidiary was not a sham corporation and had economic substance, and the intercompany transactions were at arm's-length. The Tribunal determined that the record did not support a finding that there was any agreement, understanding, or arrangement between the subsidiary and the corporation that resulted in the improper reflection of the activity, business, income, or assets of the corporation requiring the inclusion of the subsidiary in the corporation's bank tax returns for the applicable tax years. The Tribunal found that the organization of the subsidiary as a passive investment company to acquire the assets of a REIT and to continue its operations had sufficient business purpose apart from the tax benefits, because although the tax purposes were substantial, separating non-New York loans from the corporation was a sufficient non-tax business purpose to support the transactions. In addition, the movement of assets from the REIT to the subsidiary was not an artificial transaction created to generate a tax benefit — it was a bona fide transaction undertaken to avoid the adverse consequences of leaving the assets in a New Jersey REIT while retaining the structure that enabled the corporation to maintain an important favorable business-related rating. In the Matter of the Petition of Astoria Financial Corp. & Affiliates, No. TAT(E)10-35(BT) (NYC Tax. App. Trib. May 19, 2016).

South Carolina: In Dish DBS Corporation, a South Carolina Administrative Law Judge (ALJ) ruled that South Carolina is not a cost-of-performance state or a market-based sourcing state. Instead, South Carolina statutes provide an apportionment standard based on where the "income-producing activity" takes place. South Carolina's apportionment statute states that receipts from the sale of services are sourced to South Carolina if the income-producing activity is performed in South Carolina. If the income-producing activity is performed partly within and partly outside South Carolina, sales are attributable to South Carolina to the extent the income-producing activity is performed within South Carolina. The ALJ noted two distinct differences between the method described by South Carolina statute and the cost-of-performance method provided in Section 17 of the Uniform Division of Income for Tax Purposes Act (UDITPA). First, South Carolina chose not to include the phrase "cost of performance" in its statute. Second, the statute does not include language indicating that the sourcing of receipts to South Carolina is determined on an "all-or-nothing" basis as it appears to be in UDITPA, in which revenues from sales of other than tangible personal property are sourced solely to the state in which the greatest proportion of the income-producing activity is performed. As such, the ALJ concluded that South Carolina is not a strict "cost-of-performance" state. Additionally, the South Carolina statute does not reference a proxy (e.g., costs of performance) to measure the income-producing activity. Therefore, the ALJ further concluded that South Carolina is not a pro rata cost-of-performance state. The ALJ also found that South Carolina is not a "market share" or "audience" state. Instead, the South Carolina statute focuses solely on the extent the "income-producing activity" is performed in South Carolina. The ALJ ultimately agreed with the Department's position that the income-producing activity is the delivery of a signal into the customer's home and onto the customer's television. The ALJ noted that preparatory activities identified by the digital television service provider contribute to the delivery of its signal to subscribers, but they are not activities that customers would pay for separately without access to service provider's programming on their television sets. Because the South Carolina subscription receipts are directly tied to the income-producing activity and most accurately reflect service provider's proportion of business carried on within South Carolina, all of the income-producing activity — the delivery of service provider's signal into South Carolina subscribers' homes and onto their television sets — occurs within South Carolina. Therefore, 100% of the service provider's South Carolina subscription receipts are sourced to South Carolina. Dish DBS Corp, f/k/a/ EchoStar DBS Corp., and Affiliates v. South Carolina Department of Revenue, South Carolina, Administrative Law Judge Division, No. 14-ALJ-17-0285-CC (S.C. Admin. Law Ct. May 20, 2016). For more on this development, see Tax Alert 2016-946.

Virginia: Royalties paid as part of a joint venture's distributive share to a participating out-of-state corporation qualified for the foreign source income subtraction because the royalties were received for the use of intellectual property by foreign business entities operating overseas, and were properly excluded from the taxpayer's sales factor denominator. Generally, royalty income from licensing intellectual property is included in the sales factor, but Virginia law permits the taxpayer to subtract foreign source income (which includes royalties such as those here) from federal taxable income (FTI) to the extent it is included and not otherwise subtracted from FTI. Va. Dept. of Taxn., Ruling of the Tax Commissioner No. 16-51 (April 11, 2016).

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Sales & Use

All States: In the second of four installments of Ernst & Young LLP's (EY) sales tax quarterly webcast seminar series, EY panelists from the National Indirect Tax Practice discussed common business structures and transactions from a sales tax perspective, the complicated issues that must be considered around legal entity classification risk, and the importance of business purpose and economic substance. For more on this development, see Tax Alert 2016-953.

Florida: An in-state florist that sold flowers, gift baskets and other goods via its online website is liable for sales tax on all its sales, including sales to out-of-state customers for out-of-state deliveries, as the imposition of tax does not violate the dormant Commerce Clause or the Due Process Clause of the US Constitution. Under Florida law (Fla. Stat. §212/05(1)(l)), in-state florist are liable for sale tax on sales to retail customers regardless of where or by whom the items are delivered, but are not liable for tax on payments received from other florist for items delivered to in-state customers. The florist argued that the statute violates the dormant Commerce Clause as applied to its on-line sales. The Florida Supreme Court (court) disagreed, finding the tax did not run afoul of the Complete Auto four part test. The court concluded that: (1) the substantial nexus requirement is met in that the florist had more than a slight presence in Florida as its economic activities and transactions transpired from its principal place of business in Florida; (2) the tax is fairly apportioned — it is internally consistent because if all states taxed only the entity initially receiving the flower order, and not the florist to whom the order and delivery is referred, then no florist would be taxed twice on the same transaction, and it is externally consistent as the statute taxes the transaction that occurs in Florida by the entity engaged in business in the state and not on items sold or activities occurring out of state; (3) the tax does not discriminate against interstate commerce as the statute does not contain a provision that affords preferential treatment or any commercial advantage to a Florida business over an out-of-state business; and (4) the tax is fairly related to the services provided by the state because the florist benefits from the state's resources and services. Lastly, the court found that due to the florist in-state business location it meets the Due Process Clause's minimum connection requirement. Florida Department of Revenue v. American Business USA Corp., No. SC14-2404 (Fla. S. Ct. May 26, 2016).

Illinois: A steroid-releasing sinus implant qualifies as a medicine or drug and is eligible for Illinois' reduced sales tax rate of 1% plus any applicable local taxes because the product provides a sustained release of a drug via a bioabsorbable sinus implant. Items subject to the lower 1% rate include prescription and nonprescription medicines, drugs, medical appliances, among other items, for human use. Ill. Dept. of Rev., Private Letter Ruling No. ST 16-0002-PLR (March 15, 2016).

Louisiana: In Bridges v. Nelson Industrial Steam Co., the Louisiana Supreme Court (court) reversed a lower court ruling, and held that a power plant operator's limestone purchases are excluded from sales and use tax under the "further processing exclusion" because the use of limestone in the power generation process creates ash as a by-product that is sold at retail. The Louisiana Department of Revenue (Department), however, has filed a petition asking the court to reconsider its decision, arguing that the court's adoption of a "dual or multiple purpose test" for the exclusion will give taxpayers the opportunity to seek to exempt their entire purchases from taxation by "claiming innovative, miniscule residual purposes" for their purchases. It should be noted that the Louisiana Governor has called for a second special session beginning on June 6, 2016. Included in the Governor's summary of the call for the second special session was a bullet point to "Address the 'primary use test' as applied to Louisiana's 'further processing' exclusion." For additional information on this development, see Tax Alert 2016-981.

Missouri: The Missouri General Assembly passed a bill (SB 823) that would temporarily prohibit the Missouri Department of Revenue (Department) from issuing sales and use tax assessments based on the recent Missouri Supreme Court (court) ruling in IBM. The bill was sent to Governor Jay Nixon on May 25, 2016. He has 45 days to act on the measure. In IBM, the court found that the taxpayer was not entitled to a use tax exemption for hardware and software sold to a large credit card company because the credit card company's use of the materials for processing credit and debit card transactions did not qualify as "manufacturing of any product" under the statute. This ruling potentially overturns a quarter century of precedent supporting the position that organizing information constitutes manufacturing. An earlier version of SB 823 would have effectively reversed the Court's ruling in IBM by expanding the exemption to include the activity at issue in the case. This language, however, was removed during conference committee and replaced with a provision prohibiting the Department from sending notice to any taxpayer regarding taxability of transactions under IBM before Aug. 28, 2017. Under legislation enacted in 2015, such notification is required before the Department can issue a new assessment based on the change in law. For additional information on this development, see Tax Alert 2016-1027.

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Business Incentives

Maryland: New law (SB 843) changes Maryland's tax credits evaluation process and requires the state Comptroller to adopt procedures to improve the accuracy and collection of tax data necessary to more effectively evaluate the state's tax incentive programs. Specifically, SB 843 eliminates the requirement that a credit be evaluated in the year preceding its termination date, and requires: (1) job creation tax credits be reviewed by July 1, 2017; (2) research and development and biotechnology investment credits be reviewed by July 1, 2018; and (3) certain Regional Institution Strategic Enterprise Zone credits and cybersecurity investment credits be evaluated by July 1, 2019. In addition, SB 843 delays to November 15 (from October 31) the date by which the Department of Legislative Services must publish a credit evaluation, and delays the date to December 31 (from December 14) by which the evaluation committee must hold a public hearing on an evaluation report. The evaluation report must discuss: (1) the purpose for which the tax credit was established; (2) whether the original intent of the tax credit is still appropriate; (3) whether the tax credit is meeting its objectives; (4) whether the purposes of the tax credit could be more efficiently and effectively carried out through alternative methods; and (5) the costs of providing the tax credit. Finally, a tax credit designated for evaluation under the Tax Credit Evaluation Act is subject to reevaluation seven years (previously five years) after the initial evaluation. SB 843 took effect June 1, 2016. Md. Laws 2016, Ch. 582 (SB 843), signed by the governor on May 19, 2016.

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Property tax

Michigan: Reversing the lower court, the Michigan Court of Appeals (court) held that the Michigan Tax Tribunal (Tribunal) erred when it rejected the cost-less-depreciation valuation approach for a "big-box" store and adopted a sales-comparison approach that failed to fully account for the effect on the market of comparable properties' deed restrictions. Citing Clark, the court found that the strict application of the sales-comparison approach would undervalue the property, and the cost-less-depreciation approach is more appropriate, when: (1) the highest and best use (HBU) of the property is its existing use; and (2) when because the property is built to suit there would be little to no secondary market for the property where it would still be used at its HBU. Like the industrial plan in Clark, the court found it would not be appropriate to value the subject property significantly less than its replacement costs simply because owner-occupied freestanding retail spaces are rarely bought or sold for use as owner-occupied freestanding retail spaces on the open market. In addition, the big-box store is well suited for its current use and would be so considered by a hypothetical buyer who wished to own a freestanding retail building in accordance with the subject's capabilities; therefore, the property must be valued as if there were such a potential buyer, even if no such buyer actually exists. Requiring the taxing unit to prove an actual market for the property's existing use would lead to absurd under-valuations. The court also found that the big-box store's and the Tribunal's reliance on the functional obsolescence concept to discredit using the cost-less-depreciation approach is misplaced because there is no evidence of any deficiency in the premises that would inhibit its ability to properly function as an owner-occupied freestanding rental building. The court remanded the case back to the Tribunal with instructions that it take additional evidence with regard to the market effect of the deed restrictions. Menard, Inc. v. City of Escanaba, Mich., No. 325718 (Mich. App. Ct. May 26, 2016).

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Compliance & Reporting

Maryland: New law (HB 484) amends the date by which corporations must file a corporate income tax return to April 15 (formerly March 15). If filing on a fiscal year basis, the return is due on or before the 15th day of the fourth (formerly third) month after the end of that year. HB 484 takes effect July 1, 2016, and is applicable to all taxable years beginning after Dec. 31, 2015. Md. Laws 2016, Ch. 548 (HB 484), signed by the governor on May 19, 2016.

Michigan: New law (HB 5131) removes the statutory requirement that flow-through entities withhold tax on the distributive share of taxable income of individual nonresident members or the distributive share of business income of members that are corporations or other flow-through entities. Instead, members of flow-through entities will be expected to calculate and remit their own quarterly estimated tax payments. The changes are effective for tax years beginning on or after July 1, 2016. Mich. Laws 2016, PA 158'16 (HB 5131), signed by the governor on June 8, 2016. For additional information on this development, see Tax Alert 2016-1004.

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Controversy

Maryland: New law (HB 1054) reduces the maximum penalty that may be imposed on a person that fails to pay income tax to 10% (from 25%), effective on, and applicable to all income tax penalties assessed on or after, July 1, 2016. Md. Laws 2016, Ch. 642 (HB 1054), signed by the governor on May 19, 2016.

Maryland: New law (SB 843) requires the Comptroller to adopt procedures and protocols related to the administration of Maryland's tax system to implement a private letter ruling process for tax guidance. Md. Laws 2016, Ch. 582 (SB 843), signed by the governor on May 19, 2016.

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Miscellaneous Tax

All States: On Tuesday, June 28, 2016 from 1:00 - 2:30 p.m. EDT (10:00 - 11:30 a.m. PDT), EY will host a webcast on current developments in state and local tax audits. The following topics will be discussed on the upcoming webcast: (1) states' applications of old nexus and sourcing laws to new ways of doing business; (2) how some states are applying their own interpretation of the Internal Revenue Code; (3) states that are stretching income and sales tax nexus in audits and the double-edged sword this creates; (4) how retail loyalty points programs precipitate qui tam and class action lawsuits; and (5) other timely audit issues affecting state and local taxation. Click here to register for this webcast.

Alabama: An insurance company improperly claimed the dividends received deduction (DRD) and net operating loss (NOL) deduction for Alabama business privilege tax purposes because both are deducted in arriving at federal taxable income, and the clear intent of the regulation at issue (Ala. Reg. 810-2-8-.01(g)) is to remove those deductions from Alabama's business privilege tax computation. The regulation provides that "federal taxable income shall be taxable income less the [DRD] and the [NOL] deduction." At issue in this case is how "less" should be interpreted. The Alabama Tax Tribunal (Tribunal) agreed that the use of the word "less" is awkward, but the clear intent of the phrase is that federal taxable income should be total income "without" the DRD or NOL. The Tribunal further stated that the only reason to address the DRD or the NOL in the regulation is to modify the taxable income from federal Form 1120-PC (filed by the insurance company) to remove the two deductions for purposes of business privilege tax computation. Attorneys Ins. Mutual of the South, Inc., Risk Retention Group v. Ala. Dept. of Rev., No. BPT 15-860 (Ala. Tax Trib. May 10, 2016).

Nevada: After defeats in Nevada's courts, proponents of a ballot initiative to repeal the Nevada Commerce Tax, which was enacted in 2015, have apparently abandoned their attempt to repeal the gross receipts tax this year. At the same time, the Nevada Department of Taxation (Department) has issued final regulations (LCB File No. R123-15) and draft filing forms. The Department has yet to issue a final draft of the return or return instructions, but draft forms are available to public. As these forms are not final, taxpayers should not rely on them and they should be used only for general guidance. The Department also has created several forms to assist taxpayers in the registration process. The Department also issued a nexus questionnaire to assist companies in determining whether their in-state activities give rise to nexus for Commerce Tax purposes. In a recently published FAQ, the Department stated that a "minimum connection" with Nevada is necessary for a business to be subject to the Commerce Tax under Section 16 of the adopted regulations. This nexus questionnaire is informational in nature and does not need to be filed with the state. The Department has made clear that taxpayers that have nexus with Nevada are still obligated to file returns even if they do not have Nevada gross receipts that exceed the $4 million threshold over which tax is due. Companies doing business in Nevada and subject to the tax are reminded that their first annual return is due Aug. 15, 2016. For additional information on this development, see Tax Alert 2016-1026.

Pennsylvania: A freight broker's charges are not excepted from local business privilege tax under the "public utility" exception of the Local Tax Enabling Act (LTEA) because the rates of the carriers with whom the freight broker does business are not fixed and regulated by the Pennsylvania Public Utility Commission (PUC), and, thus, the entire exception is inapplicable. In reaching this conclusion, the Pennsylvania Supreme Court rejected the freight broker's argument that the Pennsylvania Commonwealth Court's tax authority-favorable holding contains an implicit assertion that the "public utility" exception to the LTEA has been repealed as a result of deregulation. Nothing in the LTEA suggests that a person or company whose rates were once regulated by the PUC is forever shielded from local taxation. Only persons or companies whose rates are fixed and regulated by the PUC are excepted from local taxation, along with the services of such public utility and the transactions and privileges involving such public utility services. S&H Transport, Inc. v. City of York, No. 17 MAP 2015 (Pa. S. Ct. May 25, 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.