Ernst & Young's State and Local Tax Weekly newsletter for March 24 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

Texas Court of Appeals rules car dealership's auto repair labor costs are not includible in cost of goods sold calculation for Texas franchise tax purposes

The Texas Court of Appeals (court) has reversed a trial court's ruling in favor of a Texas car dealership, holding that the dealership cannot include auto repair labor costs incurred as part of repair work to install automotive parts on customer-owned vehicles in its cost of goods sold (COGS) calculation. In reaching this conclusion, the court determined that, based on plain statutory language, repair labor costs are costs of services rather than tangible personal property, and that the relevant statutory language in Tex. Tax Code § 171.1012 is not subject to multiple understandings, so it is not ambiguous. Hegar v. Autohaus LP, LLP, No. 03-15-00427-CV (Tex. App. Ct., 3d Dist., Feb. 24, 2017).

An automotive dealership on its 2009 Texas franchise tax return calculated its taxable margin by subtracting its COGS from its total revenues. As part of its COGS, the dealership included labor cost incurred as part of repair work (repair labor costs) to install automotive parts on customer-owned vehicles. Following an audit, the Comptroller of Public Accounts (Comptroller) disallowed the repair labor costs, which resulted in an additional assessment of franchise tax. The dealership challenged the assessment, a trial court ruled in its favor, and the Comptroller appealed.

As a threshold matter, both parties disagreed on the issue of whether the relevant parts of Tex. Tax Code § 171.1012 are ambiguous. The Comptroller argued that the statute is ambiguous in regard to mixed transactions and as to the use of the term "installation," specifically in the context of "production." Accordingly, the Comptroller asserted that Rule 3.588(b)(7) should be given deference.

In contrast, the dealership asserted that the statute is not ambiguous and that the plain meaning of "installation" supported its position that its repair labor costs at issue are properly subtracted as COGS. The court agreed with the dealership that the statutory language is not ambiguous as it is not subject to multiple interpretations, but rejected its argument that the statute supports inclusion of repair labor costs in its COGS.

The court reasoned that, in the context of the statutory scheme, "installation" is listed with "production" activities, such as "construction" and "manufacturing." These listed activities address the direct costs of "producing the goods" (making or completing goods) as compared with the cost of "acquiring" goods for resale. A taxable entity must own the "good" to include its costs under COGS, and there are specific references to "production," "produced," and "acquiring or producing" in the enumerated categories of direct costs. Ultimately, the court determined that the dealership's repair labor costs were not properly included as COGS because it did not, in any way, modify, make or complete the automotive part to "produce" it based on the plain language of the statute. For additional information on this development, see Tax Alert 2017-514.

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Income/Franchise

Arkansas: New law (HB 1562) requires partnerships that have income from within and without Arkansas to apportion income to the state under the Uniform Division of Income for Tax Purposes Act (UDITPA) as adopted in Arkansas. Current UDITPA provisions (enacted under Ark. Stat. § 26-51-701 et seq) require that income be apportioned to the state using a three-factor apportionment formula with a double weighted sales factor. If the apportionment does not fairly reflect the extent of the partnership's business activity in the state, the partnership may petition for, or the Arkansas Department of Finance and Administration may require, with respect to all or a part of the taxpayer's business activity, the use of an alternative apportionment formula. Alternatives include: (1) separate accounting, (2) exclusion of one or more factors, (3) inclusion of one or more additional factors, or (4) employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer's partnership income. These provisions are effective for tax years beginning on and after Jan. 1, 2018. Ark. Laws 2017, Act 482 (HB 1562), signed by the governor on March 14, 2017. For additional information on this development, see Tax Alert 2017-549.

California: The California Franchise Tax Board (FTB) recently issued guidance on the California Other State Tax Credit (OSTC) and allowable credits or deductions for purposes of taxes paid to other states. In the legal ruling, the FTB explains general OSTC principles, the state and local tax deduction rules, and the FTB's process for determining whether an OSTC or a deduction applies to a particular state or local tax paid directly or indirectly by a California resident to another state. The FTB's characterization of a tax as a net income tax applies universally for all taxpayers, and such characterization is based on the entire potential tax base and not on a particular taxpayer's tax base. The guidance also walks through various examples, including whether a taxpayer may claim an OSTC or deduction for the Texas Margin Tax, the Tennessee franchise and excise taxes, and the New York City Metropolitan Commuter Transportation Mobility Tax, among others. The ruling applies retroactively to taxable years beginning on or after Jan. 1, 2016. Cal. FTB, Legal Ruling 2017-01 (Feb. 22, 2017).

Georgia: New law (HB 283) updates Georgia's date of conformity to the IRC as amended and in effect on or before Jan. 1, 2017 (from Jan. 1, 2016), effective for taxable years beginning on or after Jan. 1, 2016. The state continues to decouple from bonus depreciation, the IRC §199 production deduction and various other provisions. Ga. Laws 2017, Act 10 (HB 283), signed by the governor on March 21, 2017.

Indiana: A parent company and its three wholly owned subsidiaries that consented to file on a consolidated basis for federal income tax purposes and on a nexus consolidated basis for Indiana income tax purposes were liable for additional Indiana income tax because they were not entitled to deduct gains recognized from intercompany transactions (as deferred taxable income) incurred before they made an Indiana nexus consolidated return election for the audit years at issue. In this instance, the parent company and each of its subsidiaries chose to file separate Indiana corporate returns for the prior non-audit years and, in doing so, each claimed its respective deductions, credits and exemptions separately when filing their Indiana corporate tax returns. The Indiana Department of Revenue found that the federal rules regarding consolidated groups apply, including Treas. Reg. Section 1.1502-13, and do not apply in reverse to allow parent's desired result — deferred income in reverse. Ind. Dept. Rev., Letter of Findings No. 02-20150326 (Feb. 22, 2017).

Indiana: A manufacturer was not entitled to an interest expense deduction for an intercompany loan because the interest rate was not determined in an arm's-length transaction and the manufacturer did not intend to repay the loan principal because no principal payments had been made. In addition, the manufacturer's sales from Indiana locations to customers in foreign states in which the manufacturer did not establish that it was subject to an income or franchise tax were subject to Indiana throwback. Citing Tyler Pipe, the Indiana Department of Revenue (Department) found that the presence of the manufacturer's spools and reels in those states did not contribute to its ability to maintain sales in there. Additionally, citing Wrigley, the manufacturer did not show that its spool deposit program was not merely ancillary to requesting orders or de minimis. Finally, the Department properly disallowed NOLs arising from losses attributable to interest expenses in prior years and carried forward to years under audit since the manufacturer's protest was denied. Ind. Dept. Rev., Letter of Findings No. 02-20150384 (Feb. 22, 2017).

Indiana: An out-of-state tobacco manufacturer was not entitled to use an alternative apportionment formula because Indiana's statutory single sales factor apportionment formula fairly represents the tobacco manufacturer's Indiana-source income. In making this determination, the Indiana Department of State Revenue cited Moorman Manufacturing, stating that Indiana has wide latitude in choosing apportionment formulas. Ind. Dept. Rev., Letter of Findings No. 02-20160014 (Feb. 22, 2017).

Indiana: The Indiana Department of Revenue (Department) has ruled that an individual Indiana resident could not claim a credit against local income taxes for state income taxes paid to Illinois because Indiana's tax structure does not violate the dormant Commerce Clause. Under Indiana law, state income tax credits are allowed only for out-of-state income taxes paid, and local income tax credits are allowed for out-of-state local income taxes paid. Distinguishing the U.S. Supreme Court's decision in Wynne, the Department applied the internal consistency principle and found that if every state adopted a tax structure identical to Indiana's, then every state would impose state and county taxes, and taxpayers in every state would be entitled to claim credits for both state and county taxes paid on income earned out of state. Ind. Dept. Rev., Letter of Findings Nos. 01-20160515 and 01-20160515R (Feb. 22, 2017).

New Jersey: The New Jersey Division of Taxation issued guidance on other states' taxes that a taxpayer must add back to its federal taxable income for purposes of determining its corporate business tax (CBT) liability. The types of taxes that should be added back include taxes measured based on profits or income; taxes based on business presence or business activity that are not property taxes, excise taxes, payroll taxes or sales taxes; and taxes similar to the CBT. Types of taxes that should not be added back include gross receipts taxes that are imposed based on receipts, but not profits (similar in nature to the New Jersey Petroleum Gross Receipts Tax); taxes imposed on capital stock that measure a taxpayer's assets; excise taxes; sales taxes; property taxes; and payroll taxes. The categorization of the tax is based on how it operates, not on how it is named. The guidance provides examples of taxes that are and are not required to be added back. N.J. Div. Taxn. TB-80 (March 15, 2017).

New York City: The New York City Department of Finance (Department) issued guidance on calculating liabilities attributable to categories of business capital for the alternative tax on capital (capital base) of the city's recently enacted Business Corporation Tax (BCT). The BCT carries over the income, capital and receipts tax bases of the historic General Corporation Tax (GCT), with some modifications. For example, the Department is applying a new 0.075% tax rate to the portion of total business capital directly attributable to stock in a subsidiary that: (A) would be taxed as a utility within the meaning of the New York City Utility Tax, or (B) would have been taxed as an insurance corporation under the former New York City Insurance Corporation Tax. Having a new tax rate, however, means the Department must attribute liabilities between utility and insurance capital and general business capital to determine the amount of net business capital taxable in each tax rate. The Department will extend the methodology that applies to attributing liabilities between particular items of investment capital both directly and indirectly, and the guidance includes a worksheet with a framework for taxpayers. If the value of all liabilities attributable to business capital exceeds the value of such capital for the year, net business capital is zero for purposes of the capital base, and no attribution between tax rate categories is necessary. Other significant modifications to the capital base include: (1) excluding net investment capital from tax, and making net business capital the entire base for tax; (2) limiting the definition of investment capital, which expands the scope of business capital; and (3) reducing all tax calculations by $10,000 and capping them at $10 million. The historic 0.15% tax rate still applies to net business capital other than net insurance and utility capital, and cooperative housing corporations still use a 0.04% tax rate for the entire capital base, consistent with the GCT. N.Y.C. Dept. of Fin., Finance Memorandum No. 17-2 (March 2, 2017).

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Sales & use

North Carolina: In response to a private letter ruling request, the North Carolina Department of Revenue (Department) determined that a processed biomass fuel manufacturer's (manufacturer) production process substantially changes raw materials into a "finished product of manufacture." Therefore, the manufacturer's purchases of mill machinery, mill machinery parts and accessories used in the production phase of industrial or manufacturing operations qualify for the lower 1% privilege tax rate instead of the higher state (4.75%) and local (2.25%) sales and use tax rates. The Department cautioned that the manufacturer should not treat as one article two or more articles that make a functional unit when joined together, such as connected or unconnected conveyor sections. N.C. Dept. of Rev., Private Letter Ruling No. MEPLR 2017-0001 (Jan. 10, 2017).

Tennessee: Fees a management services company (company) charged to its clients for transcription services are not subject to Tennessee sales and use tax because the company is providing non-taxable services. The Tennessee Department of Revenue (Department) reasoned that even though clients download a software component to their computers, the client's use of the component is incidental to the true object of the company's service — the provision of storage services and transmission of transcriptions. Report fees the company pays to a third-party software provider, however, are subject to sales and use tax as the charges relate to software transferred to the company, and downloaded onto its servers, in Tennessee. The Department noted that the transaction does not qualify as a sale for resale because the company uses and consumes the purchased software to provide its services. Tenn. Dept. of Rev., Letter Ruling No. 17-01 (Feb. 9, 2017).

Texas: Amended regulations (Amended 34 Tex. Admin. Code § 3.335) have been adopted by the Texas Comptroller of Public Accounts (Comptroller) related to a temporary sales and use tax exemption for certain property used in a qualifying data center, implementing HB 2712 (enacted in 2015). The definitions section is amended to apply to both qualifying data centers and qualifying large data center projects. The amendments clarify the definition of "qualifying job," add new definitions of "qualifying large data center project" and "shared employment responsibilities," and amend "capital investment" to exclude property purchased before Sept. 1, 2013 for qualifying data centers, or property purchased before May 1, 2015 for qualifying large data center projects. The amended regulations also cover the eligibility for certification as a qualifying large data center project, the application process, dates for when the temporary exemption begins and ends, requirements for exemption certificates, and exemption revocation information. The exemption for qualified data centers only applies to state sales and use tax, while the exemption for qualifying large data center projects applies to state and local sales and use tax. Finally, entities that qualify for the exemption as a qualifying data center or qualifying large data center project cannot receive a limitation on appraised value of property for ad valorem tax purposes. The amended regulations took effect March 19, 2017. Tex. Comp. of Pub. Accts., amended 34 Tex. Admin. Code §3.335 (42 TexReg 1117 March 10, 2017).

Texas: A company's charge for tracking and monitoring insurance coverage is not subject to the state's sales and use tax because it is a charge for a nontaxable service, and not a charge for taxable data processing and insurance services. Although the company provides data processing services when it manages certain information, along with its professional knowledge, these services are ancillary to the professional services the company provides. The tracking and monitoring services are not data processing because that definition specifically excludes providers of other professional services who use a computer to facilitate the service performance. In addition, while the company provides services related to insurance, these services do not fall within the definition of taxable insurance. Tex. Comp. of Pub. Accts., No. 201701013L (Jan. 31, 2017).

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Business incentives

Louisiana: The Louisiana Department of Revenue (Department) issued guidance on claiming a transferable tax credit on a tax return. Under state law, a taxpayer may only claim a tax credit on a tax return by doing at least one of the following: (1) purchasing tax credits with an effective date of transfer on or before the return's date, without regard to a grant of any extensions; or (2) executing Form R-6111, which provides evidence of a binding agreement to transfer a tax credit, on or before the due date of the return, without regard to a grant of any extensions. For purposes of executing Form R-6111, there is no requirement that the specific project from which the credits subject to the binding agreement are identified or certified at the time of the execution, or that the specific type of transferable credit or the exact amount of credits to be transferred are identified at the time of execution of the binding agreement. Failure to subsequently transfer credits certified from the named transferor to the named transferee under the terms of the binding agreement, however, will result in assessment of penalties and interest from the return's due date. These provisions apply to income tax periods beginning Jan. 1, 2016 and corporation franchise tax periods beginning Jan. 1, 2017, and apply unless otherwise provided by the statute granting the credit. La. Dept. of Rev., Rev. Info. Bulletin No. 17-008 (March 6, 2017).

New Mexico: A New Mexico administrative law judge (ALJ) has ruled that a bank that purchased five energy-producing facilities could not claim the renewable energy production tax credit (the energy credit) at any time after the facilities began producing qualified energy after its initial application package was approved. Instead, the bank would only be able to claim the energy credit in the tax year in which the New Mexico Energy, Minerals and Natural Resources Department (Energy Department) issued certificates of eligibility. The ALJ explained that in order to claim the credit, New Mexico statutory law requires taxpayers to have a certification of eligibility from the Energy Department, and it does not allow a taxpayer to reach back to the initial application approval date to claim the energy credit. The application approval is a preliminary step that merely guarantees the bank's priority over others claiming the energy credit. The ALJ rejected the bank's arguments that it should be permitted to take the credit because it submitted its application packages in the same year that it began producing qualified energy, and that if it were not allowed to do so it may not receive the full benefit of the energy credit for the 10 years permitted by law. The ALJ noted that the credit is not open-ended, unrestricted, or unconditional, and that a taxpayer may claim the energy credit for 10 consecutive years beginning on the date of initial production. Thus, even though the bank could not claim the credit for the 2011 tax year as requested, it is eligible to claim the credit for the 2021 tax year. In the Matter of the Protest of Wells Fargo Equipment Finance, No. 17-09 (N.M. Admin. Hearings Ofc. Feb. 23, 2017).

Puerto Rico: Puerto Rico's Financial Advisory Authority and Fiscal Agency (better known as AAFAF by its Spanish name) issued Administrative Order (AO) 2017-01, which provides for the suspension of the granting of new tax credits under various laws. Credit programs include: Investment Capital Fund Act, Conservation Easement Act, Revitalization of Urban Centers Act, Economic Incentives for the Development of Puerto Rico, Economic Incentives for the Film Industry Act, Tax Incentives for the Investment in Facilities for the Reduction, Disposal and Treatment of Solid Waste. AO 2017-01 establishes the Authorization Committee for Disbursements and Tax Credits, which has been granted the authority to take various actions with respect to the tax credits under the previously listed laws. AO 2017-01 also requires Puerto Rico's Treasury Secretary to create an inventory of the tax credits granted. Tax credit holders must report the amount of credits they hold. If the tax credit holders cannot provide proof that they have complied with the reporting requirement, they will not be able to claim the credits. For additional information on this development, see Tax Alert 2017-532.

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Property tax

Georgia: The Georgia Supreme Court has held that a company that is authorized to operate a liquid natural gas (LNG) transfer station (i.e., it receives LNG owned by others into its facility, converts it to natural gas, and places that natural gas into pipelines owned by others for distribution), is authorized to act as a "transportation company," and does not meet the definition of a "gas company" or "natural gas company." Consequently, the court declined to compel the Georgia Revenue Commissioner to recognize the company as a "public utility" and accept its ad valorem tax returns. In so holding, the court distinguished the facts of the case from those in Colonial Pipeline, finding that the transportation company's certificate of incorporation authorizes it to only act as a "transportation company, or common carrier." In addition, distinguishing the case from the rulings in Southland Steamship and Colonial Pipeline, the court considered other statutory or regulatory provisions that limit the transportation company's "power … to engage in such business," and found that it is not a "gas company" because it is not "certificated … to construct or operate any pipeline or distribution system, or any extension thereof, for the transportation, distribution, or sale of natural or manufactured gas." It also is not a "natural-gas company" under federal law as it is not "engaged in the transportation of natural gas in interstate commerce, or the sale in interstate commerce of such gas for resale." Riley v. Southern LNG, Inc., No. S16A1659 (Ga. S. Ct. March 6, 2017).

Tennessee: Property that was used for three outdoor youth program events in seven months did not qualify for a property tax exemption for religious, scientific, charitable, or educational institutions because the use was sporadic and did not rise to the level of active, regular use required by regulation and administrative precedent. Once regular use of the property began, however, the property owner successfully demonstrated qualifying use of almost all of the subject property. In addition, the Administrative Law Judge of the Tennessee State Board of Equalization found sufficient evidence to justify the exemption of additional acres of land beyond the statutory limit of 100 acres of land "not necessary to support exempt structures or site improvements associated with exempt structures," as these addition acres were necessary to support exempt improvements. In re Remote Area Medical, Inc., Nos. 93646, 93649 through 93699, 96580 and 108630 (Tenn. State Bd. of Equal. March 2, 2017).

Virginia: The Virginia Supreme Court (court) affirmed a circuit court ruling that a cable company's (company) television set top boxes/converters are not subject to local property tax because the statute specifically classifies personal property used in cable television businesses as intangible personal property not subject to local taxation unless it falls within any enumerated exceptions, which in this case it does not. In reaching this conclusion, the court determined that the legislative intent of the Virginia General Assembly was to remove converters from the list of property subject to taxation, based on the creation of a separate statutory subsection for cable television services in which "tuners" and "converters" were removed from the list of property subject to local taxation. The court rejected the tax commissioner's argument that the "tuners" and "converters" were "machines" subject to local taxation as tangible personal property because the General Assembly's amendment of "machinery and tools" to "machines and tools" broadened the scope of property subject to local taxation to include these items. In addition, the court reversed the circuit court's determination that the company was not entitled to refunds for the 2008 and 2009 tax years because it failed to timely file its refund claims for those years. The question of the timeliness of the company's refund claims for 2008 and 2009 was not argued previously and, therefore, it could not be raised for the first time in judicial review proceedings by the circuit court. Accordingly, the company is entitled to refunds for these years. Verizon Online LLC v. Horbel, No. 151955 and Horbal v. Verizon Online LLC, No. 151956 (Va. S. Ct. March 2, 2017).

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Compliance & reporting

South Dakota: New law (SB 36) revises the time to file certain tax returns and remit certain taxes. Generally, persons who remit tax by electronic transfer to the state must file the return on or before the 20th day of the month (previously, 23rd day) following each period and must remit the tax on or before the 25th day of the month (previously due the second to the last day) following each period. Affected taxes include: (1) the retail sales and service tax; (2) gross receipts tax on visitor-related business; (3) use tax; (4) realty improvement contractors' excise tax; (5) alternate realty improvement contractor's excise tax; (6) excise tax on farm machinery, farm attachments units, and irrigation equipment; (7) uniform municipal non-ad valorem tax; (8) municipal gross receipts tax; (9) taxation of telecommunications companies; (10) taxation of intermediate care facilities for persons with mental retardation; and (11) emergency reporting telephone service. The provisions also change due dates for several fuel tax returns and reports to the 20th day of each month (previously, 23rd day). For those taxes for which the Secretary of Revenue (Secretary) can authorize a taxpayer to file a return or pay tax due on a basis other than monthly, the return and remittance is due the 20th day of the month (previously, the last day of the month) following the reporting period, or at a time the Secretary otherwise requires. Until July 1, 2018, South Dakota will not impose late filing penalties on taxpayers who fail to file electronically as required by the 20th day of each month but file no later than the 23rd day of each month, and will not impose late payment penalties for electronic payments not made by the 25th day of the month as required but made no later than the second-to-the-last business day of that month. S.D. Laws 2017, SB 36, signed by the governor on March 8, 2017.

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Miscellaneous tax

Oregon: An online vacation rental company (company) could be liable for the City of Portland's transient lodging tax collections as a transient lodging intermediary, but it is not liable for the transient lodging tax as a booking agent or the hotel operator tax as a managing agent. In reaching these conclusions, a U.S. District Court (court) found that Portland made sufficient allegations to claim that the company is a transient lodging intermediary, and thus a transient lodging tax collector, because it charges a service fee to patrons based on the price of the short-term rental and is the only entity that determines the total price that customers eventually pay. The court further held that the company is not a booking agent under Portland's home rule status or other provisions in the city charter because neither the home rule status nor the city charter authorizes Portland to tax the company as a booking agent. In so holding, the court noted that "the City does not have the inherent power to tax without limitation." In addition, the company is not a managing agent under the hotel operator tax because Portland failed to show that the company exercises judgment and discretion over several significant proprietary functions, such as providing access and services for rental properties, setting the occupancy price, and accepting or rejecting reservation requests. The court determined that in order to qualify as a managing agent, an entity must perform all or nearly all of the functions of a hotel operator. City of Portland v. Homeaway.com, Inc., No. 3:15-cv-01984-MO (D. Or. March 9, 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.