Ernst & Young's State and Local Tax Weekly newsletter for January 27 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

California appeals court rules out-of-state corporation not doing business in state when its only connection is a limited investment

In Swart Enterprises, a California Court of Appeal (Court) upheld a lower court's ruling that a corporation was not doing business under California's prior doing business standard and was not subject to the state's annual minimum franchise tax where its sole connection with California was passively holding a 0.2% ownership interest, with no right of control over the business affairs of an LLC that was doing business in California and was treated as a partnership for federal and California income tax purposes. Swart Enterprises, Inc. v. California Franchise Tax Board, No. F070922 (Cal. Ct. App., 5th Dist., Jan. 12, 2017).

The California Attorney General (AG) echoed the arguments of the California Franchise Tax Board (FTB) that Swart was doing business in California and subject to the minimum tax because the LLC elected to be treated as a partnership for federal income tax purposes and since the LLC was doing business in California, so was Swart. The Court disagreed, finding Swart's passively held 0.2% interest in the manager-managed LLC to "closely resemble that of a limited, rather than general, partnership," reasoning that Swart did not have the right to act on behalf of or bind, or participate in the management and control of, the LLC. Citing the California State Board of Equalization's (SBE) decision in Appeals of Amman & Schmid Finanz AG, the Court held that "[b]ecause the business activities of a partnership cannot be attributed to limited partners … ., Swart cannot be deemed to be 'doing business' in California solely by virtue of its ownership interest in [the] LLC."

The AG further argued that if the LLC elected to be treated as a partnership for federal income tax purposes, then the LLC's taxation election automatically transmutes Swart as a member of the LLC into a general partner of the LLC and, therefore, can be imputed with "doing business" in California since the LLC was "doing business" in the state. The Court found no legal authority to support this argument, finding the AG's reliance on IRC §702(b) to "make the point" that "wherever the partnership does business, the activities of the partnership are attributed to each partner, whether general or limited, with the consequence that in locations where the partnership is doing business, the partners are also doing business" is "flawed" for two key reasons: (1) a taxation election "may not control for all taxation purposes in all circumstances," and (2) it does not distinguish between general and limited partnership interests.

Further, the Court concluded that Swart "was a quintessential passive investor." Under the operating agreement, Swart was expressly prohibited from taking part in the management and control of the LLC. Moreover, Swart had no interest in the specific property of the LLC, it could not act on behalf of or bind the LLC, and it was not personally liable for the LLC's obligations.

Lastly, the Court rejected the AG's argument that Swart itself, as a member of the LLC, is doing business in the state by virtue of its ownership interest in the LLC. The AG's contention is based on Legal Ruling 2014-01 (issued during the pendency of the Swart litigation) in which the FTB formalized its position that LLC members are 'doing business' in California if the LLC is doing business in the state, regardless of whether they are members of a member-managed LLC or a manager-managed LLC. In the legal ruling, the FTB took the position that even a member of a 'manager-managed' LLC is 'doing business' in California "because the distinction between manager-managed LLCs and member-managed LLCs is not relevant for purposes of determining whether members of an LLC, which is 'doing business' in California and is classified as a partnership for tax purposes, is 'doing business' [in California] within the meaning of [Cal. Rev. & Tax. Code] Section 23101." The FTB (and the AG) asserted that members of a manager-managed LLC have the right to exercise some control over the LLC because they relinquish control over the LLC to the manager and the members have the right to remove the manager. The Court, however, disagreed, holding that Swart could not have exercised any right of control by relinquishing control of the LLC to a manger, because "[Swart] never had this right to begin with." The LLC was established as manager-managed two years before Swart invested in it. Moreover, given Swart's 0.2% investment interest, it can be reasonably inferred that Swart would not have been able to exercise influence over the decision to designate the LLC as manager-managed; Swart could not even remove the manager on its own, as such action required a majority vote.

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Income/Franchise

California: On Jan. 20, 2017, the California Franchise Tax Board held its first Interested Parties Meeting for the next round of proposed amendments to its market-based sourcing rules under California Code of Regulations (CCR) tit. 18, § 25136-2. Topics discussed during the meeting included: (1) asset management fee issues, (2) sourcing dividends and interest, (3) reasonably approximated/reasonable approximation method, (4) benefit of the service received, (5) freight forwarder examples, and (6) marketing intangibles. The forthcoming proposed amendments will affect asset managers, government contractors and other industries. For additional information on this development, see Tax Alert 2017-148.

Massachusetts: A biotechnology corporation (corporation) is required by statute to apportion its income under the single sales factor formula because it qualified as a "manufacturing corporation" for all tax years at issue when more than 25% of its gross receipts were derived from the sale of its manufactured goods. In reaching this conclusion, the Massachusetts Supreme Judicial Court (Court) found that "gross receipts" are statutorily limited to receipts relating to business income received by the corporation — insofar as investment income is concerned, interest, dividends, and capital gains. The inclusion of short-term investments in gross receipts would distort the self-described biotechnology company with substantial revenue derived from sales of its specialty drugs into essentially an investment business. The Court also found that the single sales factor apportionment formula does not violate the commerce clause because it does not discriminate against interstate commerce on its face or as applied to the corporation. The formula treats the income from every sales transaction involving manufactured goods exactly the same, no matter where the corporation's manufacturing operations may be located. The Court found that the purpose of the formula change was designed to encourage manufacturers to increase the level of their investment in manufacturing operations in Massachusetts by removing a tax "disincentive" created by the three-factor formula, and the US Supreme Court has recognized this type of business investment encouragement as a constitutionally appropriate goal. Finally, the unavailability of the investment tax credit or the research and development credit to the manufacturing corporation, which conducts its manufacturing operations and performs research and development activities outside Massachusetts, does not change this result, because the credits existed long before the statute was amended to add the single-sales factor formula for manufacturing corporations; they are available to a variety of corporations in addition to manufacturing corporations; and are clearly designed to encourage companies to locate operations in Massachusetts and thereby invest in the state's economy. Genentech, Inc. v. Mass. Comr. of Rev., No. SJC-12083 (Mass. S. Jud. Ct. Jan. 12, 2017).

New York: In In the Matter of the Petitions of Checkfree Services Corp., the New York Division of Tax Appeals held, under prior law, that receipts for electronic bill payment and presentment services are properly classified as receipts derived from the performance of services (rather than "other business receipts") and could not be allocated to New York because the services were not performed in the state. For additional information on this development, see Tax Alert 2017-186.

North Carolina: The North Carolina Department of Revenue adopted and submitted to the Rules Review Commission (RRC) rules regarding market-based sourcing provisions for sales of non-tangible personal property and services (17 NCAC 05G.0101). These provisions establish uniform rules for: (1) determining the extent the market for a sale is in North Carolina, (2) reasonably approximating the state(s) of assignment where the state(s) cannot be determined, (3) excluding receipts from the sale of intangible property from both the numerator and denominator of the sales factor pursuant to N.C. Gen. Stat. §105-130.4(l), and (4) excluding receipts from the sales factor denominator where the state(s) of assignment cannot be determined or reasonably approximated. Topics addressed by the rules include the following: (1) assignment of sales of non-tangible personal property; (2) rules of reasonable approximation — generally, approximation based upon unknown sales, related entity transactions; (3) exclusion of receipts from the sales factor — allocated gross receipts, unassignable gross receipts; (4) changes in methodology — alternative apportionment, original return, Secretary of Revenue's (Secretary) authority to adjust a taxpayer's return, taxpayer's and Secretary's authority to change a method of assignment on a prospective basis; (5) sales of services; (6) sales of in-person services — in general, assignment of receipts from sale of in-person services, reasonable approximation; (7) services delivered to a customer on behalf of the customer, or delivered electronically through the customer — in general, assignment of receipts from such services, delivery to or on behalf of an individual or business customer by physical means, delivery to customers by electronic transmission, services delivered electronically through or on behalf of an individual or business customer; (8) professional services — in general, overlap with other categories of services, assignment of receipts, professional services other than architectural or engineering services, architectural or engineering services with respect to real or tangible personal property, related entity transactions; (9) licensing or leasing of intangible property — in general, license of marketing intangible, license of a production intangible, license of a mixed intangible, license of intangible property when substance of the transaction resembles a sale of goods or services; (10) sales of intangible property — assignment of receipts; (11) special rules — software transactions, sales or license of digital goods and services, telecommunications companies. The rules were adopted on Jan. 4, 2017, submitted to the RRC on Jan. 18, 2017, and scheduled for review by the RRC on Feb. 16, 2017.

North Dakota: Beginning with the 2016 tax year, a C corporation that conducts its business both inside and outside North Dakota may elect to use an apportionment formula that more heavily weights the sales factor, phased in as follows: (1) for the 2016 and 2017 tax years, the weighting is: 25% property, 25% payroll, and 50% sales; (2) for the 2018 tax year, the weighting is: 12.5% property, 12.5% payroll, and 75% sales; and (3) for tax years 2019 and after, the weighing is: 100% sales. The following conditions apply to the election to use the alternative apportionment formula: (1) it must be made on a timely filed original corporation income tax return (Form 40); (2) it applies to all C corporations in a unitary group and for all C corporations filing a consolidated North Dakota corporation income tax return; (3) it is binding for five tax years, after which it automatically lapses; (4) after a five-year election period lapses, a new election must be made to continue using the alternative apportionment formula (the election must be made on a timely filed original corporation income tax return filed for the tax year following the last year of the lapsed period); and (5) if a new election is not made as required, the equally weighted three-factor apportionment formula must be used for the next three tax years, after which the election to use the alternative apportionment formula may be made again. Taxpayers that use special industry apportionment provisions can make a sales factor weighting election. If a corporation's apportionment factors include amounts attributable to a passthrough entity, the election applies to the calculation of the corporation's apportionment factors, as adjusted to include the passthrough entity amounts. It should be noted that a passthrough entity itself cannot make this election. N.D. Tax Comr., Income Tax Newsletter (January 2017).

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Sales & Use

All States: The EY Sales and Use Tax Quarterly Update provides a summary of the major legislative, administrative and judicial sales and use tax developments. Highlights of this edition, include: (1) an overview of the Ohio Supreme Court's recent ruling Crutchfield, which may serve as the vehicle for a US Supreme Court hearing to reverse Quill; (2) an update on the litigation challenging Philadelphia's new "Soda Tax"; and (3) an overview of recent sales and use tax developments related to technology, transactions, tax base, exemptions and compliance. Click here for a copy of the newsletter.

Indiana: A warehouse's purchases of electricity and certain freezer equipment it used to freeze its customers' food products were not exempt from Indiana sales tax because the warehouse was not engaged in the production of other tangible personal property and did not use the electricity and freezer equipment as an essential and integral part of its integrated production process. In reaching this conclusion, the Indiana Tax Court found that the warehouse's freezing services do not culminate in the production of new, distinct, marketable goods when it preserves goods through freezing. In addition, both the consumption and equipment exemptions employ the "double direct" standard, which requires the taxpayer who purchased the electricity or equipment in question to use the purchased equipment and electricity as part of its own process to produce other tangible personal property, not as part of an alleged process of another taxpayer. Merchandise Warehouse Co., Inc. v. Ind. Dept. of Rev., No. 49T10-1302-TA-00009 (Ind. Tax Ct. Jan. 11, 2017).

Iowa: An on-line retailer's sales of memberships to its prime services (Prime) to Iowa customers is subject to sales and use tax because it is a bundle of goods, services, and other benefits sold for one nonitemized price, and the presence of at least one separately taxable item — here, on demand streaming video (Prime Video) — makes the entire bundled transaction subject to tax. The Iowa Department of Revenue (Department) determined that Prime Video service fits within the common-sense understanding of the statutory term "pay television" and the defining administrative rule because it shares traits with traditional television services, such as cable and satellite. The Department noted that under its long-standing administrative rule, the taxability of Prime does not depend on owning or initiating the internet communication through which the pay television itself is distributed; the controlling fact is that the taxpayer sells pay television service in Iowa and, therefore, Prime Video is subject to Iowa sales and use tax as pay television service. In addition, the Department determined that a free 30-day trial of Prime to Iowa customers is not subject to Iowa sales and use tax. In the Matter of Amazon Services LLC, No. 2017-240-2-0000 (Iowa Dept. of Rev. Dec. 28, 2016).

Tennessee: A web-based document management and compliance solutions provider's (provider) basic product and add-on component are not subject to sales and use tax because although both involve the use of software, the true object of both products is the provision of nontaxable data storage services. The Tennessee Department of Revenue (Department) determined that clients purchase the basic product for cloud-based data storage services rather than to access the web-based portal, and the web-based portal is merely a tool to view the end result of the services that the clients purchase through the basic product. In addition, through the add-on component, the clients purchase enhanced storage services that allows for centralized document review and the creation of additional reports to track items. Therefore, the true object of the add-on component is the additional data storage functionality rather than the client's use of the web-based software. Only specifically enumerated services are subject to sales and use tax in Tennessee, and data storage services are not specifically enumerated as taxable by statute. Tenn. Dept. of Rev., Letter Ruling No. 16-12 (Dec. 16, 2016).

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Business Incentives

Arkansas: A qualified steel manufacturer may carry forward for a period of 14 years any Recycling Tax Credits granted under the authority of the Arkansas Department of Environmental Quality. In addition, for any year in which both the Job Creation Credits and the Recycling Tax Credits are available, the manufacturer may first apply Job Creation Credits to offset 50% of its tax liability, and then may apply Recycling Tax Credits to offset the remainder of its state income tax liability to the extent these credits are available. Ark. Dept. of Fin. and Admin., Rev. Legal Counsel Opinion No. 20160904 (Dec. 16, 2016).

California: The California Film Commission (Commission) announced that the next application window for the California Film and TV Tax Credit Program 2.0's TV Projects: Non-transferable tax credit is Feb. 10-17, 2017. Applications are ranked within categories (such as TV Projects versus other TV Projects, relocating TV series v. other relocating TV) based on their "jobs ratio" score. The Commission provides a jobs ratio calculator online to help applicants in preparing details for their applications. Applicants must have a completed and tagged budget in order to fill out the application. The Commission will notify the top 200% (double the number of projects for which funding is available) by Feb. 21, 2017 to submit Phase II documents. Credit allocation letters will be issued March 20, 2017, and no costs qualify prior to that date. If an applicant's application is selected, the applicant will have three days to prepare and provide the materials listed in the Commission's online checklist. Cal. Film Comn., Production Alert (Jan. 16, 2017).

Illinois: New law (SB 513) extends the Economic Development for a Growing Economy (EDGE) Tax Credit Act through April 30, 2017. The credit was scheduled to sunset on Dec. 31, 2016. Ill. Laws 2016, Pub. Act 99-925 (SB 513), signed by the governor on Jan. 20, 2017.

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Property tax

Oregon: Proposed bill (HB 2407), introduced in response to an ongoing property tax valuation dispute, would require a percentage of interest be paid if additional tax, or a refund of tax, is due upon finale resolution. If a refund is ordered upon final resolution of the appeal to which a deferred billing credit relates, the amount of interest payable would be reduced to one-third of 1% per month or fraction of a month for the period beginning on the later of the payment date or due date and ending on the date of refund, on: (1) the amount refunded that is affirmed by order upon final resolution of the appeal, and (2) the amount by which the refund exceeds the deferred billing credit. Further, under current law if additional taxes are due upon final resolution of the appeal, such taxes are payable without interest and after application of the 3% discount. If HB 2047 is enacted, additional tax would be paid without application of the 3% discount and interest would be payable at the rate of one-third of 1% per month or fraction of a month, within 45 days following the date on which the county assessor mails the required notice. The bill would apply to billing credits ordered on or after Jan. 1, 2017. HB 2407 was introduced on Jan. 9, 2017.

Texas: Holders of mineral interests leases that authorized pooling but prohibited cross-conveyance of interests, never owned an interest in pooled minerals located in San Augustine County (County) (rather, the interests were located in Shelby County) and, therefore, have no obligation to pay that County's property tax. In reaching this conclusion, a Texas Court of Appeals found that whether pooling resulted in cross-conveyance, and whether the minerals that the San Augustine County Appraisal District sought to tax were within or outside the boundaries of the County, depended on the construction of the language of the leases. The parties did not dispute that the units include land not covered by the leaseholders' leases, and the leases specified that such units "shall not have the effect of exchanging or transferring any interest under" the leases. Lease language specifying that the formation of a unit including land not covered by the lease does not have the effect of exchanging or transferring any interest under the lease is a specific rejection of the cross-conveyance of interests. Chambers et al. v. San Augustine Appraisal Dist., No. 12-15-00201-CV (Tex. App. Ct., 12th Dist., Jan. 18, 2017).

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Compliance & Reporting

Wisconsin: The Wisconsin Department of Revenue issued a publication explaining how to obtain extensions for filing returns and reports for individual income tax, corporate franchise or income tax, homestead and farmland preservation credit claims, sales and use tax returns, partnership returns, fiduciary income tax returns, withholding reports, and information returns. The publication provides the following information: the various forms for each tax type; their original due dates; extension periods (if permitted); and extension forms to use for Wisconsin extension. The publication also provides information pertinent to each particular type of tax, including: how federal extensions apply for Wisconsin purposes; more information about available federal extensions; obtaining a Wisconsin only extension; and how extensions affect tax payments. Wis. Dept. of Rev., Pub. 401: Extensions of Time to File (January 2017).

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Controversy

Kentucky: The Kentucky Department of Revenue (Department) must, under the Kentucky Open Records Act, produce for inspection suitably redacted copies of its final rulings in tax administration cases, including final rulings that have not been appealed. The Kentucky Court of Appeals (Court) affirmed the Franklin Circuit Court, finding that the rulings contain great bodies of information related to the reasoning and analysis of the Department with respect to its administration of Kentucky's tax laws, and they can be made available without jeopardizing the privacy and interests of individual taxpayers protected by statutory provisions. Ky. Dept. of Rev. v. Sommer, No. 2015-CA-001128-MR (Ky. App. Ct. Jan. 13, 2017).

Washington: The Washington Department of Revenue (Department) provided guidance on tax preference transparency requirements, enacted in 2013. Under the 2013 law, new tax preferences automatically expire in 10 years unless an express expiration date applies, and the amount of a new tax preference claimed by a taxpayer may be publicly disclosed 24 months after the preference is claimed, exceptions apply. A tax preference is an exemption, exclusion, deduction, credit, deferral, or preferential rate, for a tax administered by the Department. Disclosure requirements do not apply to: (1) property tax exemptions, (2) tax preferences required by constitutional law, (3) tax preferences where the amount claimed by the taxpayer is less than $10,000 per year, (4) taxpayers that are annual filers, and (5) taxpayers with a good cause waiver. In addition, for taxpayers that do not have to electronically file any documents with the Department, the disclosure requirement does not apply to tax preferences not listed on the combined excise tax return. Taxpayers applying for a good cause waiver must explain in detail how their businesses will suffer economic harm if their tax preference amounts are publicly disclosed. A good cause waiver is available for certain preferences, including paymaster services business and occupation (B&O) tax deduction, cooperative finance organizations B&O tax deductions, investment data for investment firms sales and use tax exemptions, and large private airplane sales and use tax exemptions. Wash. Dept. of Rev., Tax Topics: Tax preference transparency (Jan. 12, 2017).

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Miscellaneous Tax

New York City: Certain charges by a communications provider (provider), such as recoupment of taxes and fees attributed to the costs of providing long-distance service and billed as a percentage of the charge of long-distance calls, are exempt from New York City's utility tax as they qualify as exempt revenues associated with long-distance telephone calls. In reaching this conclusion, an Administrative Law Judge (ALJ) for the New York City Tax Appeals Tribunal found that the tax under the applicable law (General City Law Sec. 20-b) does not reach a long-distance telephone call even if some part of the call occurs within the City, because the law prohibits utility tax from being imposed on a "transaction originating or consummated outside the [City's] territorial limits." Specifically, the ALJ found the following charges are exempt from the utility tax: (1) access fees based on usage (these fees are exempt with respect to the long-distance phone calls because the charge is related exclusively to those calls); and (2) purely long-distance telephone calls, such as ATM service, frame service, and feature charges all correspond to the provider's long-distance service. Charges that are subject to the utility tax include: (1) charges for sale and installation of equipment to a customer to provide long-distance service; (2) billing fees (these fees are related to long-distance service but are independent of the transactions); and (3) voicemail (the provider failed to demonstrate that voicemail was a long-distance transaction because it can exist apart from a long-distance call). Finally, the utility tax may not be imposed on the local DSL fees because such tax is barred by the Internet Tax Freedom Act. In the Matter of the Petitions of U.S. Sprint Comm. Co., LP, Nos. TAT(H)14-12(UT) and TAT(H)14-13(UT) (NYC Tax App. Trib. Dec. 29, 2016).

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.