Ernst & Young's State and Local Tax Weekly newsletter for February 17 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

Maryland circuit court affirms nexus for out-of-state corporations and Comptroller's use of an alternative apportionment formula, vacates waiver of penalties and interest

A Maryland circuit court (circuit court) issued its decision in Staples, Inc. and affirmed the Maryland Tax Court's (tax court) ruling that "enterprise dependency" existed and that the out-of-state corporations were not separate business entities from in-state affiliated companies, were part of a unitary business, and thus, had nexus with Maryland. The circuit court also affirmed the tax court's approval of the Comptroller of Treasury's (Comptroller) attribution of the affiliates' apportionment factor to the out-of-state affiliated corporations that received the interest and royalties. The circuit court, however, vacated the tax court's waiver of penalties and interest assessed against the corporations, and remanded this issue back to the tax court for an evidentiary hearing on whether the penalties and interest should be waived. Petition of Staples, Inc. and Staples the Office Superstore, Inc., Case No. C-02-CV-15-002009 (Md. Cir. Ct., Anne Arundel Cnty., Dec. 30, 2016).

This case is the result of a 2008 Comptroller audit for tax years 1999 through 2004. It should be noted that the audit period is prior to the 2004 enactment of the Maryland intercompany add back for intangibles. The Comptroller assessed $14,392,364 of additional income taxes (including interest and penalties) against two out-of-state corporations that have affiliated retail stores in Maryland owned and operated by their affiliates. The out-of-state corporations appealed the assessment to the tax court, which considered three issues: (1) whether the out-of-state corporations had real economic substance as separate business entities; (2) whether the Comptroller fairly apportioned their income; and (3) whether waiver of interest and penalties for reasonable cause should be granted. The tax court ruled in favor of the Comptroller on the economic substance and apportionment issues, but abated penalties and interest.

On appeal, the circuit court found no fault in the tax court's determination that the out-of-state corporations, through their affiliates, "realized taxable income, subject to taxation by Maryland" from: (1) franchise fees paid to them by affiliates, and (2) affiliates' use of their intellectual property in Maryland. The circuit court noted the tax court's findings that: (1) the activities of the out-of-state corporations, in reality, permeate the activities of each other and the affiliates; (2) the out-of-state corporations "could not operate independently;" (3) "enterprise dependency existed between [the out-of-state corporations] and the [affiliates];" and (4) the out-of-state corporations were not separate business entities, are part of a unitary business enterprise and, therefore, have nexus with Maryland.

The circuit court also rejected the out-of-state corporations' argument that the Comptroller was required to use a three-factor apportionment formula to determine its Maryland taxable income, and that the Comptroller's use of a non-statutory formula "attributed income to Maryland out of proportion to the business [they] transacted in the State." The out-of-state corporations had the burden of proving that the Comptroller's use of a non-statutory formula led to "a grossly distorted result;" however, the circuit court determined that the evidence the out-of-state corporations presented failed to demonstrate distortion. Rather, the evidence presented was "tailored" to the statutory three-factor formula.

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Income/Franchise

Alabama: Under Alabama law, a real estate investment trust (REIT) can also be a corporation, and vice versa; thus, a bank that received dividends from an Alabama corporate REIT subsidiary (subsidiary) is entitled to a dividends received deduction (DRD) for financial institution excise tax (FEIT) purposes. In so holding, the Alabama Tax Tribunal (Tribunal) made clear that the dividend deduction applies "if the entity that pays the dividends … is a corporation organized and existing under Alabama law. If that criteria is satisfied, the deduction must be allowed." Here, the subsidiary was organized under Alabama law and existing under Alabama law during the years at issue. The Tribunal found it irrelevant that the subsidiary elected to operate and be taxed as a REIT for federal and Alabama tax purposes, because both federal and Alabama law clearly envision that a REIT also can be a corporation. In addition, the Tribunal rejected the Alabama Department of Revenue's (Department) argument the subsidiary was a bank that is statutorily prohibited from being a corporate REIT, finding instead that since the subsidiary did not receive deposits during the years in issue, it did not qualify as a bank. The Tribunal also rejected the Department's argument that if the subsidiary is allowed to take a dividends paid deduction and the bank is allowed to take a DRD, the subsidiary's income will escape taxation and the presumption should be that the legislature did not intend for this result. Citing Ex Parte Sonat, the Tribunal reasoned that the subsidiary was undoubtedly incorporated as a REIT because of favorable tax advantages afforded REITs by federal and Alabama law, and the incorporators were well within their rights to do so because a taxpayer is entitled to arrange or organize its business affairs so as to take advantage of all legal means of reducing its tax liability. Moreover, the Legislature must be presumed to be aware that for FIET purposes, a financial institution can deduct dividends received from corporations organized and existing under Alabama law, and that its law defined a REIT to include corporations. The Tribunal noted that it is the Alabama Legislature's role to amend statutes not the courts. Ameris Bank f/k/a Southland Bank v. Ala. Dept. of Rev., No. BIT 16-255 (Ala. Tax Trib. Feb. 9, 2017).

Florida: An out-of-state reinsurer does not have nexus with Florida and is not required to file a Florida corporate income tax return because it is not an approved reinsurer, it is not registered with the Florida Office of Insurance Regulation, and the reinsurer's ceding companies (affiliates that perform certain activities) are not domiciled or commercially domiciled in Florida. In addition, none of the ceding companies have a regional home office in Florida or are resident in Florida. Further, although the ceding companies perform various activities in Florida (e.g., selling insurance, approving or rejecting coverage, issuing insurance, and acting as a service center for policy holders) that are the same as many of the activities that would occur in a regional home office, the Florida Department of Revenue determined that none of the ceding companies have a regional home office in Florida or are resident in Florida. In addition, less than 5% of the ceding insurer's underwritings are located in Florida, which is under the 25% threshold to be deemed a commercially domiciled insurer within Florida. Fla. Dept. of Rev., Technical Assistance Advisement No. 17C1-001 (Jan. 13, 2017).

Idaho: New law (HB 26) updates Idaho's date of conformity to the IRC to Jan. 1, 2017 (formerly Jan. 1, 2016), retroactively effective to Jan. 1, 2017. Idaho Laws 2017, Ch. 5 (HB 26), signed by the governor on Feb. 13, 2017.

North Carolina: On Feb. 16, 2017, the North Carolina rules review committee approved the revenue department's proposed market-based sourcing rules for non-tangible personal property and services. The review committee will notify the legislature of its approval of the rules. The legislature then needs to enact market-based sourcing rules and once this legislation is enacted, the rules will be submitted for publication in the North Carolina register and become final.

Ohio: A trust's capital gains on the sale of shares in a pass-through entity constituted a "qualifying trust amount" that can properly be allocated in part to Ohio because the trust qualifies as a pass-through shareholder for the business, bears the income tax consequences of the operation of the business, and enjoys the statutory right to access corporate information. In reaching this conclusion, the Ohio Supreme Court (Court) also held that because the income is a "qualifying trust amount," it is neither "modified business income" nor "modified nonbusiness income." The Court further found that the trust had a legal basis for seeking a reduced Ohio allocation — the state used the wrong method in allocating the gain to Ohio — and remanded this cause for determination of proper allocation. After the Court determined that the trust should be taxed as a nonresident trust, the Court found that the assessment does not violate the trust's due process rights because although the trust grantor deliberately set up a Delaware trust, the trust grantor was an Ohio resident who conducted his business in significant part in Ohio through the corporate form, and disposed of his business and corporate interest not by a personal sale but by means of a trust that he created to accomplish his objectives for himself and his family. Finally, the assessment does not violate the trust's equal protection rights because differential treatment between corporate entities and pass-through entities is rational; corporations that are themselves taxpayers are differently situated with respect to state tax law than are pass-through corporations and, by extension, shareholders who have elected to carry the corporation's income on their own tax returns are differently situated from those who have not. T. Ryan Legg Irrevocable Trust v. Testa, No. 2016-Ohio-8418 (Ohio S. Ct. Dec. 28, 2016).

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Sales & use

Pennsylvania: All support services of canned computer software are subject to state sales and use tax when transferred in a sale at retail or made use of after being obtained in a purchase at retail. The Pennsylvania Department of Revenue (Department) finds that the legislature's recent amendment to the definition of tangible personal property to add "canned software" and "maintenance, updates and support" renders all such services to canned computer software as being subject to tax. The Department considers any support that involves the access to, use of, or alteration of the software itself as constituting a taxable component of the transaction, including electronic or remote access as well as direct physical access to the software, and any updates, upgrades, enhancements, patches, modules, and/or other modifications to canned software, whether provided and billed separately, or in conjunction with such support. The guidance provides examples. Pa. Dept. of Rev., No. SUT-17-001 (Feb. 9, 2017).

Pennsylvania: The Pennsylvania Supreme Court declined to grant Extraordinary Relief to immediately hear the appeal of the Philadelphia Court of Common Pleas' decision upholding Philadelphia's sugar-sweetened beverage tax (Soda Tax), which took effect Jan. 1, 2017. Accordingly, the appeal remains with the Pennsylvania Commonwealth Court.

Tennessee: The Nashville Metropolitan Government of Davidson County imposes a 0.25% Central Business Improvement District (CBID) fee on retailers on the sales price of certain tangible personal property and services subject to state sales tax. Beginning with the February 2017 return (due March 20), CBID retailers must report and pay CBID fees on a separate Schedule D on their sales and use tax return, rather than electronically filing a separate CBID return as previously required. The CBID fee is imposed on retailers in a specifically defined district, and is administered in the same manner as the state sales tax. Certain sales are not subject to the CBID fee, including sales exempt from tax (e.g., out-of-state sales, sales of professional services, sales for resale, sales to non-profits) and specified sales subject to state sales tax (e.g., transient lodging, publications). CBID retailers may, but are not required to, collect the fee from their customers by separately itemizing it on their customers' invoices or receipts; the fee should not be included in the sales price for sales tax purposes or in other taxable gross receipts for business tax purposes. Tenn. Dept. of Rev., Notice No. 17-02 (February 2017).

Utah: A vendor's sales, leases, or rentals (including monthly service fees and commissions) of a mobile point of sale (POS) device system (i.e., computer tablets) to a restaurant for use at its tables is subject to sales and use tax as the sale, lease, or rental of tangible personal property. Alternatively, this treatment would not change if the restaurant (instead of the vendor) owned the POS system. In this situation, payments for the use of the vendor's software for the POS system are subject to tax as a sale of the use of prewritten computer software, which is considered tangible personal property. The Utah State Tax Commission found that the essence or primary object of the agreement between the vendor and the restaurant is for the use of taxable software, not for the nontaxable services of the vendor's personnel. If the vendor does not collect Utah sales tax on the payments, the restaurant must pay Utah use tax on the payments. Collection and remittance requirements cannot be transferred between the vendor and the restaurant by their own agreement. In addition, sales by the restaurant to its customers for access to premium content on the tablets (including a fee for unlimited access to games, current events, and social media), are exempt from sales and use tax as the sale of the right to use an unassisted amusement device for amusement, entertainment or recreation. Utah State Tax Comn., PLR No. 15-007 (July 29, 2016) (released February 2017).

Utah: A multi-level marketing company's renewal fee for Utah distributors of nutritional, dietary, and skin care products is subject to sales tax as a bundled transaction because the transaction included taxable and nontaxable items sold for one non-itemized price. In addition, the company's optional fee for a distributor dashboard and personal website is subject to sales tax as a bundled transaction because the transaction included taxable and nontaxable items sold for one non-itemized price. The Utah State Tax Commission (Commission) noted that if the dashboard and personal website were sold separately, the dashboard would not be taxable because the essence of a separate distributor dashboard sale is more convenient access to the marketing company's information. A separate sale of the personal website would be taxable because the primary object of this sale is the use of a standard website that distributors can customize in limited ways. In both situations, if the company sufficiently identifies the nontaxable and taxable portion of the transaction from its records by reasonable and verifiable standards in its regular course of business, only the sales of the taxable items would be subject to tax. Utah State Tax Comn., PLR No. 15-008 (July 20, 2016) (released February 2017).

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Business incentives

New Jersey: New law (SB 2477) authorizes the payment of refunds for certain unused portions of insurance premiums tax credit issued to businesses under the Business Employment Incentive Program (BEIP). It also provides business with unused portions of corporation business tax or insurance premiums tax credits issued under BEIP the option of receiving a tax credit transfer certificate instead of a refund for the portion of the credit that cannot be used to reduce a tax liability. Both of these are effective retroactive to Jan. 11, 2016. In addition, provisions of SB 2477 exempt certain purchasers of business development incentives from specified notification requirements under the sales and use tax and the bulk sale law that are used to ensure payment of state tax liabilities. The notification provisions do not apply to the sale, transfer, or assignment of a grant, tax credit, or tax credit transfer certificate awarded, issued, or otherwise made available to a person required to collect tax in connection with a state or local business assistance or incentive program or activity authorized by law. This portion of the law took effect Feb. 6, 2017. N.J. Laws 2017, ch. 12 (SB 2477), signed by the governor on Feb. 6, 2017.

North Dakota: The North Dakota Attorney General (AG) issued a letter opining that the North Dakota Department of Commerce's (Department) program guidelines for the Renaissance Zone Program do not have the force and effect of law; consequently, the Department must manage the program according to the program's governing statutes. The program guidelines and application form requiring a letter of approval from the county and school district affected by the Renaissance Zone do not have the force and effect of law because the corresponding statute does not include this requirement, and the requirement is not included in a properly promulgated administrative rule. The Department, however, may alter its interpretation of what is meant by "community support" from that stated in its Renaissance Zone guidelines and application, in accordance with the applicable statutes. N.D. Atty. Gen., Letter Opinion No. 2017-L-01 (Feb. 3, 2017).

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Compliance & reporting

Delaware: The Delaware Division of Revenue (DOR) is granting all C corporations required to file a Form 1100 for a tax year beginning after Jan. 1, 2016 and before Jan. 1 2017, an automatic extension of time to file their Delaware corporate income tax returns to the due date of the taxpayer's federal return, without regard to extensions, which with federal holidays, will be April 18, 2017. To file past the original due date, taxpayers must submit extension form 1100-EXT to the DOR. The DOR noted that the due date for filing the first installment of estimated tax has not been modified, and remains April 1, 2017 (or the first day of the fourth month after the end of the corporation's fiscal year). In regard to partnerships and S corporations, the DOR said the return due dates for these entities have not changed. Accordingly, for calendar year taxpayers, the partnership return is due April 30 (for fiscal year taxpayers the due date is the 30th day of the fourth month following the close of the taxable period), and the S corporation return due date is March 30 (for fiscal year taxpayers the due date is the 30th day of the third month following the close of the taxable period). Del. Div. of Rev., Tech. Info. Memo. 2017-01 (Feb. 13, 2017); New Release "New Business Tax Return Due Dates For Partnerships and Corporations" (Feb. 14, 2017).

Montana: New law (HB 42) amends the partnership return filing deadline to align with the federal filing deadline. Under the revised provisions, a partnership that has Montana source income is required to file an information return on or before the fifteenth day of the third month following the close of its annual accounting period (formerly fourth month). This change took immediate effect and applies retroactively to tax years beginning after Dec. 31, 2016. Mont. Laws 2017, Ch. 6 (HB 42), signed by the governor on Feb. 13, 2017.

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Controversy

Texas: The Texas Comptroller of Public Accounts advised that a $50 late-filing penalty is assessed on taxpayers on each report filed after the report due date for the following taxes and fees: (1) franchise tax; (2) sales and use tax (including direct pay); (3) 9-1-1 prepaid wireless emergency service fee; (4) hotel occupancy tax; (5) maquiladora export tax; (6) mixed beverage gross receipts tax; (7) mixed beverage sales tax; (8) motor fuels tax; (9) motor vehicle gross rental receipts tax; (10) motor vehicle seller financed sales tax; (11) fireworks tax (repealed effective Sept. 1, 2015); and (12) off-road, heavy-duty diesel equipment surcharge. The penalty is assessed regardless of whether any taxes or fees are due for the late filed report period, and it is in addition to any other penalties assessed for the reporting period. Tex. Comp. of Pub. Accts., Pub. 98-918 (January 2017).

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.