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

Ruling that Delaware's estimation method used to audit and assess unclaimed property violates substantive due process to stand as parties reach settlement

On Aug. 5, 2016, Delaware and the unclaimed property holder (holder) in Temple-Inland, Inc. filed a joint motion to dismiss the case with prejudice, after reaching a settlement agreement. The voluntary settlement agreement "fully and finally resolves all claims" in the case. Therefore, the case will not be appealed to the US Third Circuit Court of Appeals by either party, as originally anticipated. At the end of June, in a long-awaited and highly anticipated decision, the US District Court for the District of Delaware (Court) held that Delaware's executive action of auditing and assessing a multistate corporation's unclaimed property violated substantive due process because the state's action, when taken together, "shocks the conscience." Most notably, the Court held that the state's use of the existence of unclaimed property in the base year to infer the existence of unclaimed property in the reach back year without replicating the characteristics and qualities of the property within the sample, creates significantly misleading results.

Although the terms are unknown, this settlement leaves in place the Court's June ruling. The Court's assertion that Delaware's estimation process violates substantive due process creates an historic, landmark turning point in the area of unclaimed property, requiring immediate attention by the holder community. Delaware's settlement of this suit, without addressing the need for remedies proposed by the Judge, will create further uncertainty for holders as they consider critical issues that remain unanswered. These significant, uncertain questions include: (1) how to determine a reasonable estimation calculation, (2) what is the appropriate look back period, and (3) how long must a holder retain records.

Delaware is likely to communicate that the findings in the Judge's initial decision apply only to that holder's specific set of facts and has no bearing on on-going or future audits and voluntary disclosure agreements (even though the estimation calculation and look back period described in the Temple-Inland opinion are commonly and widely utilized to conduct examinations). As a result, more litigation challenging Delaware's unclaimed property audit methods are likely to surface. Temple-Inland, together with additional significant administrative, judicial and legislative changes to the unclaimed property laws, (such as a new proposed Uniform Unclaimed Property Act and the case filed by 21 states against Delaware heading to the US Supreme Court to revisit long-standing priority rules), creates a significant opportunity for holders to: (1) closely monitor unclaimed property developments throughout the US for new litigation and legislative changes; (2) immediately examine the holders' unclaimed property footprint and current reporting processes to ensure 50-state compliance, allowing the organization to be well-poised for impending changes; and (3) discuss and examine the appropriate course of action associated with any settlements proposed by states of incorporation under that priority rule, whether currently contemplated or planned for the future. For more on this development, see Tax Alert 2016-1378.

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Income/Franchise

Alabama: The Alabama Department of Revenue repealed Ala. Reg. 810-3-35-.01, Deductions Allowed Corporations, and replaced it with Ala. Reg. 810-3-35-.01, Federal Income Tax (FIT) Deduction, "to provide simplification of the [FIT] and to allow Alternative Minimum Tax (AMT) to be deducted as well based on an ALJ ruling." The FIT attributable to Alabama may be deducted in the year paid or accrued, according to the accounting method used in computing taxable income. Cash basis taxpayers deduct FIT in the year paid. Accrual basis taxpayers deduct FIT either: (1) in the year for which the tax was imposed if the tax is not contested; or (2) if the tax is contested, the FIT is accrued and subsequently paid and deducted during the year in which the liability becomes fixed and certain (but in no case later than the date it was actually paid). For purposes of the regulation, FIT is the amount of federal income taxes paid or accrued and subsequently paid by the taxpayer for a tax period, including adjustments for refundable and nonrefundable credits, special deductions, net operating loss deduction, alternative minimum tax (AMT) and minimum tax credit (MTC), and similar adjustments, with special allocation provisions for the AMT and the MTC for taxpayers that file as part of a federal consolidated group. The regulation enumerates how FIT is attributable to Alabama for: (1) accrual basis taxpayers that do not file as a member of a federal consolidated income tax return group and that apportion/allocate income within and outside Alabama, (2) accrual basis taxpayers that file as a member of a federal consolidated income tax return group, and (3) cash basis taxpayers. The former regulation is repealed as of, and the new regulation takes effect on, Aug. 29, 2016. Ala. Dept. of Rev., Regs. 810-3-35-.01 (filed July 15, 2016).

California: In response to a ruling request, the Franchise Tax Board (FTB) advised a multistate company, which designs, markets and distributes name brand goods, that it: (1) must aggregate the proceeds from sales of tangible personal property with royalties received to determine whether it has nexus with California, and (2) should not throwback to its California sales factor the sales of tangible personal property from states where it has nexus and its activities exceed the protections of P.L. 86-272. Under California law, a taxpayer is doing business in the state if its sales exceed the threshold under the factor presence nexus standard (in 2014, $529,562 or 25% of the taxpayer's total sales, amount adjusted annually for inflation). The definition of sales means all gross receipts of the taxpayer not allocated under CR&TC §§25123 to 25127. Gross receipts is defined as gross amounts realized from the sale or exchange of property or use of property or capital, including royalties, in a transaction that produces business income, in which the income, gain or loss is recognized. Accordingly, the gross amounts realized by the company from its sales of tangible personal property and from royalties are gross receipts that must be aggregated to determine whether the company is doing business in California under the factor presence nexus standard. Because the company's aggregated sales exceeded the threshold amount, the FTB determined that the company was doing business in the state. The FTB also determined that the company should not throwback to its California sales factor numerator sales of tangible personal property shipped from California to another state. The company had a substantial nexus with these states and its royalty income derived from the licensee's use of its licensed marks, which created royalty income, is an activity not protected by P.L. 86-272, as the company availed itself of the market in these states and retained control over the use of its licensed marks. Further, deriving royalty income from the licensee's use of the company's licensed marks is not a de minimis in-state activity. The company's purposeful targeting of these states and the licensing of its marks and their use by the licensee was a nontrivial additional connection for purposes of P.L. 86-272. Cal. FTB, Chief Counsel Ruling 2016-03 (July 5, 2016).

District of Columbia: New emergency law (B21-812) makes various changes to the District of Columbia corporate and unincorporated business tax. Provisions of the bill delay when a combined group whose net deferred tax liability was increased as a result of the enactment of the combined reporting provisions can deduct a portion of the net increase. Under the amended provisions, the deduction may be claimed by an eligible taxpayer for a seven-year period, beginning with the tenth year (formerly fifth year) of the combined filing. For taxpayers who took the deduction into account when making estimated 2015 payments and an underpayment results, the estimated tax interest resulting from such underpayment, upon application, will be waived. These provisions took effect upon enactment. B21-812 also includes provisions that have been previously enacted as emergency or temporary law, including the repeal of tax haven country blacklist and reinstatement of the tax haven factor/criteria language, and adds 9.2% to the list of possible corporate and unincorporated business tax rates (this rate was part of the tax relief package enacted in 2015, but not included in the list of possible corporate and unincorporated tax rates). D.C. Laws 2016, Act 21-462 (B21-812), enacted July 20, 2016 and expires on Oct. 18, 2016. A bill (B21-669) to enact these changes on a permanent basis is awaiting the mayor's approval and then will be sent to Congress for a mandatory 30-in session day review period.

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Sales & use

Arkansas: A company in the business of manufacturing and distributing certain industrial, medical, and specialty gases that is contemplating the sale of its business to another company would be entitled to use the isolated sale exemption on the one-time sale of the furniture and fixtures (of non-inventory assets) because the company is not engaged in the business of selling plant equipment, supplies, tools, and furniture. The company, however, would not be entitled to use the isolated sale exemption for the sale of: (1) real property as the isolated sales exemption does not apply to the collection of the real property transfer tax; (2) motor vehicles and/or trailers because they are specifically excluded by the isolated sales exemption rule; and (3) inventory since the company is in the business of selling its inventory. The Arkansas Department of Finance and Administration noted that the sale of inventory could be exempt if another exemption applies, such as the sale for resale exemption, and the company maintained exemption certificates in its sales records. Finally, the company would not be responsible for collecting gross receipts tax on the sale of any motor vehicles or trailers, because the purchaser would pay the tax due at the time of registration and application for certification of title. Ark. Dept. of Fin. and Admin., Rev. Legal Counsel Opinion No. 20160604: Gross Receipts Tax-Isolated Sales Tax Exemption (July 29, 2016).

Arkansas: A manufacturer's purchase of machinery used to manufacture material used in another step of the manufacturing process (and not used to handle raw material before the production process) does not qualify for the manufacturing machinery and equipment exemption from use tax because the machinery is not "directly" involved in production of an article of commerce. The Administrative Law Judge (ALJ), citing Weiss v. Bryce Co., LLC, explained that tangible personal property may be exempt manufacturing equipment if the items: (1) possess some degree of complexity; (2) possess continuing utility; and (3) are used directly in the manufacturing process by causing "a recognizable and measurable mechanical, chemical, electrical, or electronic action to take place as a necessary and integral part of manufacturing, the absence of which would cause the manufacturing operation to cease." The function of the machinery at issue is to reprocess excess materials trimmed from the manufacturer's finished products so that the excess material may be recycled and reused. Because the machinery is not being directly used in the manufacturing process of a good that will be placed on the market for retail sale, it does not qualify for the machinery and equipment exemption. Ark. Dept. of Fin. and Admin., Dkt. No. 16-327 (Ark. Dept. of Fin. & Admin, Off. of Hearing & App., July 29, 2016).

Washington: An out-of-state company (company) that sells nutritional supplements at wholesale and retail to Washington customers has nexus with the state for sales and use tax purposes because its activities within Washington are sufficient to create a substantial physical presence in the state. In reaching this conclusion, the Washington Court of Appeals (Court) cited Complete Auto's substantial nexus requirement, which exists if the corporation has a presence in the taxing state, and noted that the case's other three tests of fair apportionment, discrimination against interstate commerce, and fair relation to state-provided services were not at issue. Nexus creating activities the company engaged in within Washington included having $5 million in retail sales; participating in various marketing activities such as new item presentation, category review, promotional planning, and educating sales staff and trade show exhibitions; and engaging in a wide variety of activities with its wholesale customers. The Court rejected the company's argument that it could "dissociate" its retail activities from its wholesale activities to avoid nexus with the state. Irwin Naturals v. Wash. Dept. of Rev., No. 73966-2-I (Wash. Ct. App., Div. 1, July 25, 2016).

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Compliance & reporting

District of Columbia: New emergency law (B21-812) changes the filing due date of franchise tax returns for corporations and financial institutions. Effective for tax years beginning after Dec. 31, 2015, returns for calendar year taxpayers are due on or before April 15 (formerly March 15), while returns for fiscal year filers is on or before the fifteenth day of the fourth month following the close of the fiscal year (formerly the fifteenth day of the third month). D.C. Laws 2016, Act 21-462 (B21-812), enacted July 20, 2016 and expires on Oct. 18, 2016. A bill (B21-669) to enact these changes on a permanent basis is awaiting the mayor's approval and then will be sent to Congress for a mandatory 30-in session day review period.

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Controversy

Alabama: Reminder: The Alabama tax amnesty program ends Aug. 30, 2016. Amnesty applies to taxes due before Jan. 1, 2015 or taxes for taxable periods that began prior to Jan. 1, 2015. The amnesty program applies to all taxes administered by the Alabama Department of Revenue (Department), including sales/use, corporate and individual income, withholding, pass-through entity income, business privilege, financial institution excise, oil & gas severance, mobile telecommunications service, utility gross receipts, and various tobacco taxes. Amnesty does not apply to motor fuel taxes. In exchange for participating in, and fully complying with the terms of, the amnesty program, the Department will apply a three-year look-back period (i.e., the last three full years of delinquent returns) and waive penalties and one-half of interest. Taxpayers eligible to participate in the program include those who have not been contacted by the Department regarding the tax types included in the amnesty application within the last five years. Taxpayers that have been contacted by the Department within the last five years or who have been party to any criminal investigation or criminal litigation in any US or Alabama court cannot participate in the amnesty program. Taxpayers that participate in but fail to fully comply with the terms of the amnesty program may be subject to a negligence penalty. Click here for additional information on Alabama's amnesty program.

Illinois: New law (HB 5527) establishes new oversight provisions for state income tax preparers, including the requirement for the preparer to include his/her Preparer Tax Identification Number (PTIN) on returns he/she prepares and files for others as well as income tax refund claims under the Illinois Income Tax Act. The State Tax Preparer Oversight Act also requires the Illinois Department of Revenue (Department) to develop and implement a program using the PTIN as an oversight mechanism to assess returns, identify high error rates, patterns of suspected fraud, and unsubstantiated basis for tax positions by income tax return preparers. The Department also must establish formal and regular communication protocols with the IRS Commissioner to share and exchange PTIN information on income tax return preparers suspected of fraud, disciplined, or barred from filing tax returns with the Department or IRS. The Department also may establish additional communication protocols with other states to exchange similar enforcement or discipline information. In addition, the new law discusses enforcement procedures. These new requirements are effective for taxable years beginning on or after Jan. 1, 2017. Ill. Laws 2016, P.A. 99-0641 (HB 5527), signed by the governor on July 28, 2016.

New Hampshire: New rules (2910.01 - 2910.07) implement New Hampshire's voluntary disclosure program (VDP), which allows eligible taxpayers to self-disclose a tax liability to the New Hampshire Department of Revenue Administration (Department) in exchange for waiver of otherwise applicable penalties and settlement and compromise the taxes and interest due for the look-back period (i.e., the three most recently completed full tax years and the incomplete current tax year). Taxpayers that want to participate in the VDP need to make a written request to the Department. The written request should include the following: (1) the name and contact information of the taxpayer or the taxpayer's representative (taxpayers can come forward anonymously through a representative); (2) a description of the taxpayer's New Hampshire activities and whether the taxpayer is an affiliate of another entity or a member of a unitary business; (3) the taxpayer's tax year end; (4) the tax type(s) the taxpayer is requesting to voluntary disclose; (5) the reason for the taxpayer's failure to pay its tax liability; (6) the taxpayer's estimated tax liability for each tax type for the look-back period; and (7) a statement declaring that the taxpayer is not ineligible to participate in the program. A taxpayer is not eligible to participate in the VDP if the taxpayer has been contacted by the Department regarding the taxpayer's tax liability, or whether the taxpayer is subject to and has a collection responsibility, for any tax administered by the Department; the taxpayer collected but failed to remit any tax administered by the Department; the taxpayer filed a return in a previous taxable period for the specific tax; or the taxpayer's estimated tax liability for a specific tax, for the look-back period, is less than $500. An ineligible taxpayer, however, may voluntarily disclose its tax liability to the Department, anonymously through a representative, and request the Department settle and compromise the taxes, interest, and penalties for good cause shown. The rules set forth factors the Department will consider in determining whether to allow the taxpayer to participate in the VDP, information that must be included in the voluntary disclosure agreement (VDA), and actions that will cause the VDA to become null and void. N.H. Dept. of Rev. Admin., Rules 2910.01 through 2910.07, adopted July 21, 2016.

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Miscellaneous tax

New York City: The transfer of a property through a series of integrated transactions that were executed on the same day (Dec. 22, 2010) is subject to New York City's Real Property Transfer Tax (RPTT) because the transfer did not qualify for an exemption as either a mere change of form of ownership or as a transfer of a non-controlling economic interest in property. On Dec. 22, 2010, all of the essential documents for a property sale were executed through a series of transactions whereby a limited liability company (LLC1) conveyed its tenant-in-common property interest to a second limited liability company (LLC2) in exchange for cash and relief from liability under a mortgage loan. The New York City Tax Appeals Tribunal (Tribunal) determined that the step-transaction doctrine applied to treat these transactions as steps in a single transaction not exempt from the RPTT either as a mere change of form of ownership or as a transfer of non-controlling economic interest in property. In reaching this conclusion, the Tribunal reasoned that the one step in the series of events essential to the tax consequences sought by LLC1 had no substance, because LLC1's ownership interest in LLC2 was too transient to be given effect so as to qualify LLC1's contribution of its tenant-in-common interest in the property to LLC2 for the "mere change" exemption. The Tribunal noted that the mere change exemption would have applied to actions taken on Dec. 22, 2010, if the pivotal step — the receipt by LLC1 of an interest in LLC2 — withstood scrutiny as a transaction having substance and independent significance. However, LLC1's receipt of a transitory interest in LLC2 had the fewest indicia of substance or independent significance of any steps in the transaction, and the parties failed to specify with any detail their respective interests in profits, losses, or cash flow. Lastly, the Tribunal rejected the taxpayer's assertion that the New York courts have not sanctioned the use of the step transaction doctrine in RPTT cases or in cases under the state's real estate transfer tax, noting that it has the authority to issue a decision that has precedential effect provided there is no contrary state precedent. In the Matter of GKK 2 Herald LLC, No. TAT (E) 13-25 (RP) (N.Y. City Tax App. Trib. July 15, 2016).

Washington: An out-of-state company (company) that sells nutritional supplements at wholesale and retail in Washington has sufficient nexus with Washington for Business and Occupation (B&O) tax purposes because the company's in state activities helped it establish and maintain a marketplace for its retail sales within the state. In reaching this conclusion, the Washington Court of Appeals (Court) found that Tyler Pipe controls the analysis of whether a substantial nexus exists for B&O tax purposes. The retailer's wholesale and retail sales each involved nutritional products, and similar to sales representatives in Tyler Pipe, the retailer gathered virtually all its information regarding the Washington market through its extensive wholesale marketing and sales apparatus, including the retailer's participation in new item presentation, category review, promotional planning, educating sales staff and trade show exhibitions, and engaging four marketing firms to aid in marketing products in Washington to complete a wide variety of activities on the retailer's behalf. In addition, phone calls resulting from wholesale sales generally supported the retailer's ability to establish and maintain a market for its goods in Washington. The retailer's argument that its retail sales did not have a transactional nexus with Washington, while acknowledging that its wholesale activities did, failed. Irwin Naturals v. Wash. Dept. of Rev., No. 73966-2-I (Wash. Ct. App., Div. 1, July 25, 2016).

(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.