Ernst & Young's State and Local Tax Weekly newsletter for November 4 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

Mississippi Supreme Court holds dividend exclusion rule violates the internal consistency test under the dormant Commerce Clause

The Supreme Court of Mississippi (Court) in AT&T Corp., held that Mississippi's dividend received exemption under Miss. Code Ann. §27-7-15(4)(i) which limited the Mississippi dividends received deduction to the distributing corporation's apportionment to Mississippi violates the dormant Commerce Clause of the US Constitution. The Court further held that the appropriate remedy was to strike the unconstitutional provisions from the Mississippi statute; thus, eliminating the taxpayer's Mississippi corporate income tax assessment for the years at issue. Mississippi Dept. of Rev. v. AT&T Corp., No. 2015-CA-00600-SCT (MS S. Ct. Oct. 27, 2016).

It is unknown at this time whether the Mississippi Department of Revenue will seek review of the Court's decision by the United States Supreme Court. The ruling by the Court likely has implications for other taxpayers that have been denied the exemption for dividends received from affiliates that did not do business or file a tax return in Mississippi. These taxpayers should consider potential refund claims. Miss. Code Ann. §27-7-313 prescribes a three-year statute of limitations on refund claims running at the due date of the return including extensions. For additional information on this development, see Tax Alert 2016-1880.

South Carolina appeals court rules state revenue department failed to meet its burden of proof in asserting alternative apportionment

In Rent-A-Center West, Inc., the South Carolina Court of Appeals (Court) reversed an Administrative Law Court's (ALC) decision and found that the South Carolina Department of Revenue (DOR) had not met its burden of proof in asserting an alternative apportionment method to assess corporate tax liability. The DOR asserted that the statutory filing method was unrepresentative of the company's business activities in South Carolina.

Providing a similar outcome as in CarMax, the Court ruled in favor of the company after concluding that the DOR did not present sufficient evidence showing that the company's use of the gross receipts method does not fairly reflect its business activity in South Carolina, stating that "substantial evidence does not support the ALC's finding the DOR met its burden." Because the DOR did not meet its burden, the Court did not address whether the DOR's alternative method was reasonable. Rent-A-Center West Inc. v. South Carolina Dept. of Rev., No. 2012-208608 (S.C. Ct. App. Oct. 26, 2016). For more on this development, see Tax Alert 2016-1848.

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Income/Franchise

California: Following the US Supreme Court's (USSC) denial of certiorari in Gillette Co. v. Franchise Tax Board (Gillette), the lead Multistate Tax Compact (Compact) apportionment election case, the California Franchise Tax Board (FTB) on Nov. 1, 2016, issued Notice 2016-03 (Notice) in which it advised taxpayers and their representatives of its intended course of action in processing Compact election cases. In the Notice, the FTB advised taxpayers and their representatives "to comply with all applicable laws and procedures to protect their rights and interest, and should not rely on any information in this notice that may result in any activity contrary to statutes or regulations." In February 2016, the FTB announced that it had paused action on any refund claims while the Gillette case was pending before the USSC. Since the Gillette case has been finally resolved by the USSC's denial of certiorari, the FTB in its Notice said that it will take the following actions on these claims: (1) refund claims containing a Compact election will be processed in the normal course of business, with formal notices in response to the refund claims being sent over the next several months; (2) administrative protests that include Compact election issues will be placed into active status and work on these cases will resume (the FTB will work with the California State Board of Equalization (SBOE) to have administrative appeals containing Compact election issues placed on active status before the SBOE); (3) audits involving Compact election issues will be processed by the FTB in the normal course of business; taxpayers should consult with assigned auditors regarding the timeline of their particular case; (4) to stop the accrual of interest on deficiency notices, taxpayers should make tax deposits or pay the proposed deficiency assessment; and (5) penalties will be assessed on a case-by-case basis. For additional information on this development, see Tax Alert 2016-1881.

Illinois: New regulation (86 Ill. Admin. Code §100.2465) permits a taxpayer to subtract from federal taxable income or adjusted gross income (AGI) an amount equal to the deduction used to compute the federal income tax credit for restoration of substantial amounts held under claim of right for the taxable year under IRC §1341 or of any itemized deduction taken from AGI in computing taxable income for restoration of substantial amounts held under claim of right for the taxable year. For federal income tax purposes, if a taxpayer is required to include a receipt in taxable income under the claim of right principle because the taxpayer had an unrestricted right to the item when received, and is subsequently required to repay the item, the taxpayer must deduct the repayment in the year of repayment, rather than exclude the receipt from income. IRC §1341 allows some taxpayers to claim a credit against their federal income tax liability in the year of repayment, in lieu of taking a deduction. To avoid taxing income received under a claim of right that is subsequently repaid, Illinois allows a taxpayer that claimed a credit under IRC §1341 for a taxable year to subtract an amount equal to the repayment that would otherwise have been deductible in that taxable year. For individuals, the deduction allowed for repayment of claim of right income is an itemized deduction taken from AGI. The subtraction is allowed for any taxable year, subject to the statute of limitations for claims for refund. The regulation took effect Oct. 12, 2016. 86 Ill. Admin. Code §100.2465 (adopted Oct. 12, 2016).

Indiana: A manufacturer of wire and wire products (manufacturer) is not entitled to an interest expense deduction because the interest expense is subject to the state's add-back rule and does not qualify for an exception from add-back as the manufacturer's loan agreement and promissory note both show that the interest rate was not an "arm's length transaction" and that there was no intention to pay back the principal amount of the loan when the manufacturer did not make any payments to the parent company. In addition, the Indiana Department of Revenue's (Department) throw-back of out-of-state sales is proper because the manufacturer did not establish that it had any presence in the throw back states. The Department reasoned that the presence of spools and reels in other states did not contribute to the manufacturer's ability to maintain sales in throwback states and, despite maintaining ownership of the spools, the manufacturer did not provide evidence that it refilled them or maintained a plant or office in those states. Further, the manufacturer failed to show that its spool deposit program is not merely ancillary to requesting orders or de minimis. Lastly, the Department's adjustment to the manufacturer's net operating losses that were generated in closed years but carried forward to the years under audit is proper because the adjustment is based on the disallowance of the interest expense deduction. Ind. Dept. of Rev., Letter of Finding 02-20150384 (Oct. 24, 2016).

Virginia: The Virginia Supreme Court will review a circuit court's ruling against a multistate retailer in which the circuit court found that the retailer is required to add-back royalties paid to an out-of-state related entity (Illinois entity) because these payments do not qualify for the "subject to tax" safe harbor exception to Virginia's inter-company add-back provisions. Kohl's Dept. Stores Inc. v. Virginia Dept. of Taxn., No. CL12-1774 (Va. Cir. Ct., City of Richmond, Feb. 3, 2016), review granted (Va. S. Ct. Oct. 31, 2016).

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Sales & Use

Indiana: An out of state technology solutions company's (company) "cloud collaboration service offering" product is not subject to Indiana's sales and use tax because it is a statutorily enumerated non-taxable service, and not a taxable telecommunication service. In reaching this conclusion, the Indiana Department of Revenue (Department) applied the statutory service-person test, and determined that the company's cloud services offering satisfies all of the requirements for finding that these services (e.g., software applications that support a customer's own voice, video, messaging, presence, audio/web conferencing, and mobile capabilities) are non-taxable. The Department reasoned that: (1) the company is primarily in the business of providing telecommunication supporting services, not selling tangible personal property; (2) the software and hardware is for the purpose of supporting telecommunication functions incident to the company's telecommunication supporting services; (3) the company does not charge for the software or hardware and as such it would be considered inconsequential compared to the overall service fee; and (4) the company paid Illinois sales or use tax for the software or hardware it uses. The Department also found that the cloud services are a "service" and not a sale, lease, license or other transfer of software or other tangible personal property, and that the hardware and software purchased, leased, or licensed by the company is for its own consumption incident to this service and not for resale. Ind. Dept. of Rev., Rev. Ruling No. 2013-01ST (Oct. 4, 2016).

Missouri: Frozen dinners sold to airline customers are taxed at 4% and do not qualify for the reduced 1% rate, because the dinners are not food for home consumption. Citing Wehrenberg as controlling, the Missouri Supreme Court (Court) explained that the context of transactions must be considered in determining whether the reduced rate applies, and the determining factor for a transaction is whether the items are intended for home consumption. Here, the frozen meals sold to customers were expected and intended to be eaten exclusively on the aircraft. In addition, the Court ruled that this finding does not violate the Missouri Constitution's uniformity clause because the state reasonably distinguished between food that is sold "for home consumption" and food that is not. The Court noted that this finding is not limited to prospective application because it was not "unexpected" as a reasonable person would have expected the decision based on prior law, previous policy or regulation of the revenue department. Gate Gourmet, Inc. v. Mo. Dir. of Rev., No. SC95388 (Mo. S. Ct. Oct. 4, 2016).

New Jersey: An information technology solutions business's (business) receipts for 2004 and the first three quarters of 2005 are not subject to sales tax regardless of a lack of breakdown of the invoices for taxable versus non-taxable services, because at that time the tangible personal property being sold was prewritten computer software, and the law deeming prewritten computer software to be taxable tangible personal property did not take effect until October 1, 2005. For the remaining tax periods through 2010, the New Jersey Tax Court (Court) found that the business's accountant's recomputation of the auditor's figures to distinguish between taxable and non-taxable goods and services did not overcome the presumptive correctness of the New Jersey Division of Taxation's (Division) final determination. The Court reasoned that the accountant's allocations were not supported by "any ascertainable facts" and "there were no supporting invoices or certifications from [the business's] members or … clients." Moreover, contracts provided as evidence showed there was no breakdown or itemization of the services being billed. The Court also rejected the business's challenge of the use tax assessment for purchase of assets and for expenses, finding that since most of the invoices examined did not include a description of a markup, the accountant's methodology of reducing the taxable purchases by applying a modified markup to the cost of goods sold computation cannot be sustained. Premier Netcomm Solutions, LLC v. NJ Div. of Taxn., No. 016307-2012 (NJ Tax Ct. Oct. 25, 2016) (Unpublished).

New York: A retail supermarket chain's (supermarket) purchases of fuel and utilities (collectively, fuel) to power a fuel cell used in certain production activities (e.g., baking, cutting and packaging meat, slicing deli meats and cheeses to order) are exempt from sales tax to the extent the fuel is used directly and exclusively in the production process. The fuel cell meets the "directly" requirement if it creates the energy used to power equipment used in production activities, and it meets the "predominantly" requirement if more than 50% of its use provides the energy used to power production equipment. The supermarket must use a method, such as an engineering study, to allocate the portion of energy used in production processes, and that method is subject to review by the New York Department of Taxation and Finance. The portion of the supermarket's utility purchases that are not used or consumed in an exempt manner are subject to sales tax. N.Y. Dept. of Taxn. and Fin., TSB-A-16(25)S (Aug. 29, 2016).

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Property tax

California: The California State Board of Equalization issued a letter to county assessors highlighting principles related to the valuation and appeal of new construction in progress discussed in Ellis v. County of Calaveras. The principles clarified in Ellis include: (1) the value of construction in progress on the lien date is a base year value; (2) construction in progress is appraised at its full value each lien date until construction is complete; (3) appeals challenging an assessor's valuation of construction in progress are appeals of base year values, and taxpayers may file such applications in the year of the assessment or in any of the three succeeding years; and (4) a taxpayer who successfully appeals a base year value on construction in progress is entitled to a refund of taxes only if the appeal was filed in the same year the base year value was established. The appeal must be filed in the same year the base year value was established since California law limits refunds to the year in which the appeal was filed and in succeeding tax years. If the appeal is filed within the statutory deadline but in a year subsequent to the establishment of the base year value, a refund cannot be granted since it would be for a year prior to the filing of the application for appeal. A refund is available only for the year in which the base year value on construction in progress was established because that base year value is valid only for that year. New base year values are established for subsequent lien dates on which the construction is still in progress. Cal. SBOE, Letter to County Assessors No. 2016/042 (Oct. 26, 2016).

Louisiana: Governor John Bel Edwards issued an executive order outlining amended and restated conditions to participate in Louisiana's Industrial Tax Exemption Program from ad valorem tax. The Governor will only consider contracts accompanied by advance notifications (applications for miscellaneous capital additions or for tax exemptions for maintenance capital, required environmental capital upgrades, and new replacements for existing machinery will not be approved). In addition, the Governor will not approve contracts unless the Louisiana Board of Commerce and Industry has specifically determined that the establishment meets the constitutional definition of manufacturing. The Governor favors exemption contracts for new manufacturing plants or establishments, but does not favor exemption contracts for additions to any existing plant or establishment unless they provide for new jobs or present compelling reasons for the retention of existing jobs. The executive order outlines the documents that must be submitted for consideration for the Industrial Tax Exemption, and states the conditions under which a contract will be approved for an initial term or renewed. The executive order took effect Oct. 21, 2016, for all pending contractual applications for which no advance notification is required under the rules of the Board of Commerce and Industry (Rules), except for contracts that provide for new jobs at the completed manufacturing plants or establishments. For all contracts for which advance notification is required under the Rules, the executive order is effective for advance notifications filed after June 24, 2016. The executive order's requirements do not apply to industrial tax exemptions approved before June 24, 2016, or the renewal of those contracts, but nothing in the executive order relieves any Industrial Tax Exemption Program participants from their contractual obligations. La. Gov., Exec. Order No. JBE 2016-73 (Oct. 21, 2016).

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Miscellaneous Tax

All States: Ernst & Young LLP's (EY) third installment of its Quarterly webcast series: a focus on state tax matters is now available for on-demand replay on the EY Thought Center website. In the webcast, EY provides information on notable 2016 statewide ballot initiatives involving state business taxes, an update on sales tax nexus expansion efforts by the states, a recap of 2016 state tax legislation and major judicial and administrative developments affecting state and local taxation. For a summary of the webcast, see Tax Alert 2016-1870.

All States: On November 16, 2016 from 2:00-3:00 p.m. EST, EY will host its fourth webcast in its sales tax seminar webcast series. The webcast will address issues related to the systems and processes used by companies to effectively manage sales and use taxes. Panelists will discuss the strategic and operational challenges and risks that taxpayers face when evaluating current business requirements and identifying existing systems and process gaps. Panelists will also discuss ways to improve the effectiveness of the tax function and the implementation of tax processes and software. Click here to register for this webcast.

All States: On Wednesday, Nov. 30, 2016, from 2:00 - 3:30 p.m. EST New York; 11:00 - 12:30 p.m. PST Los Angeles, EY will host its 2016 payroll tax year in review webcast. The following are the topics included in this year's webcast: (1) ACA information reporting — what's new this year?, (2) ACA information reporting — meeting the challenges, (3) 2016 and 2017 rates and limits, (4) Form W-2 reporting and due date changes, (5) mandatory and recommended employee notices, (6) Form W-2 frequently asked questions, (7) common payroll reporting errors, (8) 2016 unemployment insurance trends and developments, (9) other state and local payroll tax developments in 2016, (10) legislative and regulatory outlook for 2016 and 2017, and (11) the payroll year-end checklist. Click here to register for this event.

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.