08 July 2016 State and Local Tax Weekly for July 1 Ernst & Young's State and Local Tax Weekly newsletter for July 1 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. Federal district court rules Delaware's estimation method used to audit and assess unclaimed property violates substantive due process On June 28, 2016, the US District Court for the District of Delaware (Court) issued its opinion in Temple-Inland, Inc. holding Delaware's executive action of auditing and assessing a multistate corporation's unclaimed property violated substantive due process because the state's actions, when taken together, "shocks the conscience." Temple-Inland, Inc. v. Thomas Cook et al., Civ. No. 14-654-GMS (D. Del. June 28, 2016). According to the Court, an executive action — in this case Delaware's audit and assessment of Temple-Inland's unclaimed property liability — will violate substantive due process protection under the US Constitution when it "shocks the conscience," the meaning of which varies based on factual context. While the Court found a lack of clear precedent addressing whether a state's executive action with respect to unclaimed property reporting and compliance shocks the conscience, the Court "found several aspects of [Delaware's] actions troubling." Most notably, the state waiting 22 years to conduct an audit, avoiding the otherwise applicable statute of limitations, failing to notify holders that they would need to retain unclaimed property records for an unspecified amount of time in order to defend against unclaimed property audits, applying Del. Code. tit. 12, Section 1155 for a prolonged retroactive period "for no obvious purpose other than to raise revenue," and failing to follow the fundamental principles of estimation when the characteristics of the sample are extrapolated across the whole, which puts Temple-Inland at risk for liability on the same property among multiple states. The Court found that these executive actions, when considered in combination, shock the conscience. The Court's ruling in Temple-Inland, if it stands, will significantly affect unclaimed property audits and Voluntary Disclosure Agreements (VDAs). Key takeaways from this decision include the following: — Change in the estimation calculation: Estimation as calculated historically by Delaware or other states, inclusive in part of all escheatable property regardless of addressable state or exempt status, will not continue "as-is" and the calculation itself will change. Clarity on what the future calculation model will look like is forthcoming, given the Court's lack of finite guidance on what constitutes a "reasonable" estimation and reliance on Delaware to determine the way forward. At this time, it doesn't appear that the theory of estimation is entirely off the table for holders. — Potential effect on other states: The effect on other states with similar calculation models (i.e. New York and New Jersey) may include the ability to change those models and introduce the possibility of multi-state extrapolation, which is similar to apportionment within state and local tax and will have ramifications related to the prior Texas cases of the US Supreme Court which have established the priority system of assigning unclaimed property authority among the various states. All organizations or holders should consider the effect of this ruling on their own unclaimed property footprint and strategy, as it will significantly affect those currently working through exposure related to Delaware unclaimed property audits or VDAs as well as in other states and their annual compliance efforts. For additional information on this development, see Tax Alert 2016-1158. New York: The New York Department of Taxation issued an opinion regarding the applicability of the insurance company franchise tax on foreign surplus lines insurance corporations unauthorized to transact business in New York under a certificate of authority. These corporations are unauthorized non-life insurance corporations (unauthorized insurers) and, therefore, must calculate their franchise tax under N.Y. Tax Law §1502, not §1502-a (which applies only to authorized non-life insurance corporations), and must pay the tax on the highest of four tax bases, plus a tax on subsidiary capital without statutory limitation (N.Y. Tax Law §1505(a)). Because the unauthorized insurers are taxable on allocated income, allocated capital base, or their allocated income and salaries, not on their premium, they are not subject to double taxation. N.Y. Dept. of Taxn. and Fin., TSB-A-16(4)C (June 10, 2016). Oregon: The Oregon Supreme Court has scheduled oral arguments for September 19, 2016 in the appeal of the Health Net Inc. decision of the Oregon Tax Court (Tax Court). The taxpayer, a multistate corporation, is appealing the Tax Court's ruling that it was not entitled to a refund of corporate excise tax based on making an election to use the Multistate Tax Compact's three-factor apportionment formula because the state's enactment of a statute requiring the use of a single sales factor apportionment formula by "disabling" the Compact election was valid. Health Net Inc. v. Ore. Dept. of Rev., No. TC 5127 (Ore. Tax Ct. Sept. 9, 2015), cert. granted (Ore. S. Ct., arguments scheduled for Sept. 19, 2016). Texas: The Texas Comptroller of Public Accounts (Comptroller), responding to the decisions in Titan Transportation and Newpark Resources, Inc., revised its policy regarding payments eligible for exclusion under Tex. Tax Code §171.1011(g) and qualifying activities for the cost of goods sold (COGS) deduction under Tex. Tax Code §171.1012(i). Section 171.1011(g) provides that a taxable entity shall exclude from its total revenue only the flow-through funds that are mandated by contract to be distributed to other entities. Under the Comptroller's revised policy, a payment is mandated by contract to be distributed to other entities and qualifies as flow-through funds if the taxable entity has a contract with its customer providing that a subcontractor may be used and requiring payment to the subcontractor, or by a written contract between the taxable entity and the subcontractor where the payment is based on the funds paid to the taxable entity by the taxable entity's customers. The Comptroller noted that the timing of the payment does not determine if it qualifies as a flow-through fund. Further, payments that qualify as flow-through funds and have a reasonable nexus to the actual or proposed design, construction, remodeling or repair of improvements on real property or the location of boundaries of real property, may be excluded from revenue under §171.1011(g)(3). In regard to the COGS deduction, the revised policy expands the Comptroller's interpretation of what is considered to be furnishing labor or materials to a project for the construction, improvement, remodeling, repair or industrial maintenance of real property. The Comptroller has revised its policy to expand its interpretation of what is considered to be "furnishing labor or materials to a project … " and will no longer require an entity to actually physically touch the property or make a change to the property in order to qualify for the COGS deduction. The Comptroller further stated that costs that are "too far removed" from the construction, remodeling or repair or industrial maintenance of real property do not qualify for either an exclusion from revenue or a COGS deduction. Examples of such services include legal and accounting services. Lastly, the Comptroller stated that the change in policy does not alter the treatment of taxable entities renting or leasing equipment to others for use in or during such projects. These changes took immediate effect and apply to open tax years. Tex. Comp. of Pub. Accts., Memo 201606856L (June 30, 2016) (supersedes Memo 201406920L issued June 10, 2014). Georgia: Sales of bundled products at a single price for both electronically delivered software and software-related services by a provider of messaging security software products are not subject to Georgia's sales and use tax because the software is not tangible personal property and the service is not a specifically enumerated taxable service. Tax, however, would apply if the customer receives the software in a tangible medium and receives the right to the software in a tangible medium. Customers' invoices or supporting documentation must indicate that the software was delivered to the customer exclusively in an electronic format to maintain nontaxable status. Software-related services that are not subject to tax include implementation, installation, upgrades, updates, and technical support, but the provider is liable for tax on all tangible personal property used to provide its software-related services. Ga. Dept. of Rev., LR SUT-2016-09 (March 30, 2016). Illinois: An Illinois state court has ruled that online travel companies are not subject to local hotel occupancy tax when municipal ordinances (such as those promulgated by the Illinois Villages of Arlington Heights, Bedford Park, Oak Lawn, Orland Hills, Orland Park, Schaumburg, and Tinley Park) place all hotel occupancy tax collection and remittance duties on owners, operators, or managers of hotel accommodations. Since online travel companies are not hotel owners, operators, or managers, the court reasoned these taxes don't apply. Online travel companies, however, are subject to local hotel occupancy tax when municipal ordinances (such as those promulgated by the Cities of Des Plaines, Rockford, and Warrenville, and the Village of Willowbrook) levy tax on engaging in the business of renting, leasing, or letting of motel or hotel rooms. Village of Bedford Park, Ill. v. Expedia Inc., No. 13 C 5633 (U.S. Dist. Ct., N.D. Ill. June 20, 2016). Indiana: A company's sales of bottled water and fruit juice from vending machines, as well as certain sales of cafeteria food for immediate consumption, are subject to Indiana's sales tax. In reaching this conclusion, the Indiana Tax Court (Court) held that all sales from vending machines, regardless of item type, are taxable, and the company misread the sales tax clarification notice regarding a change in the taxability of bottled water and soft drinks and, therefore, was not entitled to relief via estoppel or penalty waiver. The Court, citing J&J Vending, also found that taxing vending machine food sales and not grocery/convenience store food sales does not violate the Indiana Equal Privileges and Immunities Clause and the US Constitution's Equal Protection Clause as the disparate tax treatment is reasonably related to differences inherent in the nature of the two types of food sales. The Court did find, however, that the company's provision of free and discounted bottled water and fruit juice to exempt customers are not subject to sales tax and must be removed from the proposed assessments. Lastly, the Court held that the sale of cafeteria food sold for immediate consumption occurring in a premises not owned by the company is taxable because the plain meaning of the regulatory language "premises of the seller" does not imply the premises must be owned by the seller, and instead refers to the place of business of an enterprise. RDM Sales and Service Inc. v. Ind. Dept. of Rev., No. 82T10-1001-TA-00003 (Ind. Tax Ct. June 23, 2016). New York: The New York Department of Taxation and Finance concluded in an advisory opinion that the following charges by a restaurant franchisor (franchisor) to its franchisees are not subject to sales tax: charges for faxes and online orders (reimbursement fees not subject to tax); initial software installation (nontaxable service); loyalty rewards hosting (unenumerated service exempt from sales tax); and franchise fees and royalty fees (intangible rights with which incidental tangible objects such as operations manuals were conveyed). However, the following charges by a franchisor to a franchisee are taxable: charges associated with miscellaneous hardware and hardware to support an internet connection (sales of tangible personal property with entire charge included in the receipt); initial hardware installation (installation of this tangible personal property is a taxable service); ongoing IT support (maintaining, servicing, or repairing tangible personal property is taxable); and charges for marketing fees (tangible point-of-purchase materials included in the marketing fees are not an insignificant element of the marketing fees, and the tangible personal property and nontaxable fees were not itemized). Shipping charges are subject to sales tax if the item being shipped is being sold in a taxable transaction. N.Y. Dept. of Taxn. and Fin., TSB-A-16(21)S (May 27, 2016). New York: A technology provider's electronic gatekeeper services (portal and trusted identity framework) are subject to New York's sales and use tax as protective services and are sourced based on the location where the protected data resides. The services provide a protective service in New York to the extent the data being protected resides on servers in New York, and if the protected data is located both inside New York and outside New York, the provider should collect tax only with respect to data located in New York. In determining where the protective services are being provided, the technology provider may rely on a signed letter from the customer indicating the jurisdiction(s) where the protected data is located (note: the letter must contain other information, be kept for three years, and the customer must update it if there is a change in where the services are being provided). The technology provider's charges for messaging and supplier connection services are not subject to sales or use tax because they are nontaxable bridging services, and its charges for mapping services are not taxable as this activity constitutes data processing. N.Y. Dept. of Taxn. and Fin., TSB-A-16(20)S (May 27, 2016). Texas: An oil and gas exploration and production company's purchases of casing, tubing, other well equipment, and associated services are not eligible for the statutory exemption from sales tax for "property used in manufacturing" because the equipment did not directly cause a physical change in petroleum brought to the surface from underground. The relevant portions of the exemption statute in question, Tex. Tax Code §111.104, specifically require as a condition to the exemption that the property consumed in the manufacturing process have such an effect on the product being manufactured, or any intermediate or preliminary product that will become an ingredient or component part of the finished product. In reaching its conclusion, the Texas Supreme Court (Court) found that "direct" cause implies a close link with no intervening causes, and the direct cause of the petroleum's physical change is the change in pressure and/or temperature. The equipment, the Court explained, is merely an indirect cause of the physical changes. Southwest Royalties, Inc. v. Hegar, No. 14-0743 (Texas S. Ct. June 17, 2016). Louisiana: New law (SB 10) prohibits certain manufacturers, and all related parties, affiliates, subsidiaries, parent companies, or owners of such manufacturers that claim the industrial property tax exemption from claiming a refund of the inventory tax credit in the same year. SB 10 does not apply to amended returns for original returns filed before July 1, 2016, upon which the credits were properly claimed. La. Laws 2016 (2nd Special Session), Act 5 (SB 10), signed by the governor on June 28, 2016. Louisiana: New law (SB 6) changes the refundable treatment of inventory tax credits, effective for any return filed on or after July 1, 2016. Provisions of SB 6 create three categories of taxpayers based on the amount of credits claimed and require that all taxpayers included in one consolidated federal income tax return be treated as a single taxpayer for purposes of determining the inventory tax credit limitation. The three categories of taxpayers are as follows: (1) taxpayers with eligible credit of zero to $500,000 will be refunded the entire amount of the excess credit, (2) taxpayers with eligible credit more than $500,000 but less than or equal to $1 million will be refunded 75% of the excess credit and the remaining 25% will be carried forward for five years, and (3) taxpayers with eligible credit of more than $1 million will be refunded 75% of the first $1 million of excess credit and the remaining amount of the credit will be carried forward for five years. SB 6 allows a taxpayer to claim the credit on its separately filed income or corporate franchise tax return but limits the application of the refundability by treating all taxpayers included in one consolidated federal income tax return as a single taxpayer when determining the credit limitation. The Secretary of the Louisiana Department of Revenue must promulgate rules to ensure that taxpayers affiliated with or related to any other entity through common ownership by the same interests or as parent or subsidiary will be considered one taxpayer for the purpose of the limitations on refunds provided in SB 6. La. Laws 2016 (2nd Special Session), Act 4 (SB 6), signed by the governor on June 28, 2016. Illinois: A law granting preferential property tax treatment to a fixed base operator (FBO) at one municipal airport in Illinois, but not offering the same incentives to other FBOs at other public airports, is unconstitutional because it discriminates in favor of one FBO and there is no reasonable basis for limiting tax incentives to this particular business when others are similarly situated. In reaching this conclusion, the Illinois Supreme Court (Court) affirmed that the law violates the special legislation clause of the Illinois Constitution. The law was designed to provide a financial incentive to a particular company to expand its operations at the Metropolitan Airport Authority's facilities in Rock Island County, Illinois rather than its operations in Des Moines, Iowa, which were not subject to property tax. However, Illinois has many municipal airport authorities and numerous FBOs, including FBOs similar to the tax-favored FBO in this case, that operate near other states with a more favorable tax environment, and they, too, would stand to benefit from tax incentives. Moline School District No. 40 Board of Ed. v. Quinn, 2016 IL 119704 (Ill. S. Ct. June 16, 2016). Texas: Adopted amended regulation (34 Texas Admin. Code § 3.582) clarifies that an entity with no federal gross income does not qualify as a passive entity. In addition, passive entities that are registered or are required to be registered with either the Texas Secretary of State (Secretary) or the Texas Comptroller of Public Accounts (Comptroller) must file a No Tax Due Report to affirm that the entity qualifies as passive for a period upon which the tax is based, effective for franchise tax reports originally due on or after Jan. 1, 2011. The former policy did not require subsequent filing of a franchise tax report as long as the entity qualified as passive — this provision has been removed. Entities that qualify as passive are not required to file a Public Information or an Ownership Information Report, but a limited partnership that qualifies as passive may be required to file with the Secretary. An unregistered entity that no longer qualifies as passive must register with the Comptroller and begin filing annual franchise tax reports. The amended regulation took effect June 28, 2016. Texas Comp. of Pub. Accts., 34 Texas Admin. Code § 3.582 (Texas Register, adopted June 24, 2016). Federal: On July 12, 2016 from 1:00-2:00 p.m. EDT (10:00-11:00 a.m. PDT), Ernst & Young LLP will hold the last of our four-part webcast series on federal credits and incentives extended under the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act). During the webcast, tax professionals from EY's Credits and Incentives practice will discuss the Investment Tax Credit and Production Tax Credit extensions, other provisions promoting energy efficiency and what the extensions mean for corporate sustainability officers, tax directors, investors and developers of renewable energy facilities. Topics to be covered include: (1) Renewable energy landscape, particularly the positive changes to the market in light of the tax credit extensions provided by the PATH Act; (2) Options for procuring electricity through a Power Purchase Agreement from a renewable energy facility; and (3) Options for reducing federal tax liability by investing in renewable energy facilities for allocations of either the Investment Tax Credit or Production Tax Credit. Click here to register for the event. All States: On Tuesday, July 26, 2016 from 2:00 - 3:30 p.m. EDT New York (11:00 a.m. - 12:30 p.m. PDT), EY will host a webcast during which panelists will share highlights and insights from the results of the EY/Bloomberg BNA 2015 multistate payroll withholding survey and examine key areas of risk that are frequently overlooked. Specific topics of focus will include: (1) 2015 survey results — key compliance trends; (2) 2015 survey results — trends in technology, knowledge and data gathering; (3) 2015 survey results — governmental audit trends; (4) developments affecting income tax withholding for US business travelers; (5) the top 15 withholding tax audit flags; (6) data necessary for withholding and reporting and how it might be gathered; (7) the records necessary in compliance and audit defense; and (8) inside a New York withholding tax audit. Click here to register for this event. (Note: 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. Document ID: 2016-1193 |
