April 16, 2018 Kentucky legislature overrides veto on tax reform legislation, sends governor more sweeping tax changes, including combined reporting On April 13, 2018 the Kentucky legislature overrode Governor Matt Bevin's veto of HB 366, adopting significant changes to Kentucky's tax code. During the interim period between the veto and the veto override a number of concerns were identified with regard to HB 366, in particular the impact on manufacturers of expanding the Kentucky sale and use tax to the installation and repair of tangible personal property. To address this, and other concerns, the legislature on April 14, 2018, passed and sent HB 487 to Governor Bevin. In a surprising move, the legislature, as part of HB 487, adopted mandatory combined reporting, which would, if enacted, apply to tax years beginning on or after January 1, 2019. Governor Bevin has 10 days in which to sign or veto HB 487. If the Governor vetoes all or any part of HB 487 via his line-item veto power, the changes adopted by HB 366 would stand as is, but the changes adopted by HB 487 (including the "fixes" and combined reporting) would not become law. A veto could result in the necessity of a special legislative session that would have to occur before June 30, 2018. The major tax changes enacted by HB 366 are discussed next, followed by a discussion of the changes that would be adopted by HB 487 should Governor Bevin sign the legislation into law. Corporate income tax — HB 366 changes HB 366 makes major changes to the corporate tax structure in Kentucky. One of the most notable changes is a shift from the three-factor (property, payroll, and double weighted sales) formulary apportionment formula to a single sales factor. The second switches Kentucky from a cost-of-performance sales factor sourcing state to a market-based sourcing state for sales of non-tangible property (e.g., intangibles, services). In line with the market-based sourcing rules in other states, Kentucky excludes sales of intangible property/services from the factor if the sourcing cannot be reasonably estimated. Moreover, HB 366 excludes all receipts from treasury functions from the definition of gross receipts and, hence, the sales factor. This is a significant change from current law as Kentucky allows the net gains from certain treasury functions to be included in the determination of the sale factor. These changes are effective for tax years beginning on or after January 1, 2018. In addition, HB 366 updates Kentucky's conformity to the Internal Revenue Code (IRC) as of December 31, 2017, for tax years beginning on or after January 1, 2018. Kentucky will continue to decouple from bonus depreciation (IRC Section 168(k)) and the expanded IRC Section 179 expensing consistent with current Kentucky law. In conjunction with the IRC conformity update, HB 366 adopts a rate reduction, decreasing the corporate tax rate to a flat 5% and also removes the Kentucky Domestic Production Activities Deduction to conform to the elimination of that provision (IRC Section 199 (repealed)) by the Tax Cut and Jobs Act (P.L. 115-97) (TCJA). These changes are effective for tax years beginning on or after January 1, 2018. Individual income tax — HB 366 changes HB 366 also makes changes to Kentucky's individual income tax code. Similar to the corporate changes, the legislation updates the IRC conformity date for Kentucky's individual income tax regime to December 31, 2017. As a result of the updated conformity, most itemized deductions, including deductions for medical expenses, taxes paid (that already weren't required to be added back) and casualty and theft losses, are no longer deductible for Kentucky individual income tax purposes. As under the TCJA, charitable donations and the mortgage interest deductions are preserved for Kentucky individual income tax purposes. Additionally, HB 366 adopts a 5% flat rate for all individuals, eliminating the current tax brackets that range from 2% to 6% depending upon income levels. The legislation also decreases the amount of the pension income exclusion from $41,110 to $31,110. Sales tax — HB 366 changes Other major changes in HB 366 include an expansion of Kentucky's sales tax base. Receipts from services such as landscaping, janitorial, fitness and recreation sports centers, and extended warranties will be subject to sales tax. Furthermore, the base expansion includes charges for labor or services rendered in installing or applying tangible personal property, digital property, or service sold. These changes apply to transactions occurring on or after July 1, 2018. HB 366 also readies Kentucky in the event the physical presence nexus standard formally enunciated in Quill Corp. v. North Dakota1 is overturned by the US Supreme Court in South Dakota v. Wayfair,2 which will be heard by the Court on April 17, 2018, with a decision expected by the end of June 2018. In the event Quill is overturned, the legislation will require a remote retailer of tangible personal property or digital property making sales to Kentucky residents to collect and remit sales tax if the remote retailer had 200 or more separate transactions or gross receipts that exceeds $100,000 in either the previous or current year. Credits and incentives — HB 366 changes HB 366 makes changes to a number of credits and incentives Kentucky currently provides, including and most notably the motion picture credit. Kentucky currently provides a refundable motion picture credit for sales and use taxes paid on purchases made in conjunction with the filming or producing of motion pictures in Kentucky. Under HB 366, all applications for the refundable sales tax credit currently allowed are suspended until July 1, 2022. Additional credits currently allowed that are also suspended until July 1, 2022, include the Industrial Revitalization Tax Credit, Investment Fund Tax Credit, and Angel Investor Tax Credit. Administrative items — HB 366 changes Finally, HB 366 provides additional taxpayer protections regarding appeals and assessments. HB 366 increases the current protest period from 45 days to 60 days for assessments issued on or after July 1, 2018, and extends the period from 30 days to 90 days to notify the Kentucky Department of Revenue of a final Revenue Agents Report in the event of a federal audit. Changes adopted by HB 487 awaiting Governor's action As noted, the legislature was made aware of certain concerns with HB 366 and took up HB 487 to address these concerns; some of these concerns, such as the Limited Liability Entity Tax, were not addressed. Nevertheless, if HB 487 is signed into law, it would enact even more sweeping changes to Kentucky's tax code. These potential changes are discussed next. Corporate income taxes — potential HB 487 changes The most significant, and surprising, change provided in HB 487 is the adoption of mandatory water's-edge combined reporting for unitary groups of corporations for tax years beginning on or after January 1, 2019. This would be a radical departure from Kentucky's current nexus consolidated regime. If HB 487 is enacted, the water's-edge combined group would include members that are not 80/20 companies or that are doing business in certain tax havens. It appears that the combined group would apportion its receipts from tangible personal property using a Finnigan approach (Kentucky does not have a throw-back rule for outbound sales of tangible personal property). Kentucky's net operating loss deduction would conform to the new combined/consolidated methodology. HB 487 also would permit an eight-year election to make a consolidated filing in accordance with IRC 1502 principles in lieu of filing the combined report. Taxpayers not qualifying to file combined or consolidated returns would file on a separate-entity basis. HB 487 also would carve out providers of communication, cable or internet access services from single sales factor and market-based sourcing as otherwise adopted in HB 366. These providers would continue to use the current three-factor apportionment formula and the cost-of-performance method for sourcing its receipts. Individual income taxes — potential H.B. 487 changes HB 487 would decouple from the TCJA provisions relating to the 20% deduction for pass-through income. Sales and use taxes — potential HB 487 changes One of the concerns identified with HB 366's expansion of the sales and use tax base is the application of tax to repair and installation services performed with regard to manufacturing property. HB 487 would modify Kentucky's manufacturing exemption, as modified by HB 366, to exempt installation and repair labor relating to manufacturing equipment for transactions occurring on or after July 1, 2018. Credits and incentives — potential HB 487 changes HB 487 would limit the suspension of the Investment Fund Tax Credit and the Angel Investor Tax Credit for two years with new caps set at $3 million annually beginning January 1, 2021. HB 487 also would retain the Kentucky Industrial Revitalization Tax Credit with informational reporting required from the Kentucky Departments of Revenue and Economic Development by May 1, 2019. Administrative items — potential HB 487 changes HB 487 would further extend the period to notify the Kentucky Department of Revenue of a final Revenue Agents Report in the event of a federal audit from 90 days, as enacted in H.B. 366, to 180 days. Implications HB 366 is now enacted law and, in its own right, adopts sweeping changes to the Kentucky corporate, individual and sales tax regimes. Most notably, by updating the IRC conformity date to December 31, 2017, Kentucky conforms to many of the provisions of the TCJA, with the exception of the bonus depreciation and expanded IRC Section 179 expensing provisions, which would result in a broader Kentucky state corporate tax base. The adoption of market-based sourcing may also encourage economic development in Kentucky. However, the impact of the expansion of the sales and use tax base adopted in HB 366 would appear to adversely affect manufacturers. HB 487 addresses some of the concerns identified in HB 366, particularly providing that repair and installation labor performed with regard to manufacturing machinery and equipment would not be subject to sales and use tax. More significantly, HB 487 would dramatically shift Kentucky away from its current nexus consolidated corporate income tax regime to combined reporting starting for tax years ending on or after January 1, 2019. At this time, it is unknown whether Governor Bevin will sign HB 487 or veto it. If vetoed, a special legislative session may be required to address these concerns. EY will continue to monitor developments in this area. ———————————————
——————————————— 1 Quill Corp. v. North Dakota, 504 U.S. 298 (1992). 2 South Dakota v. Wayfair, Inc. et al, 2017 S.D. 56 (S.D. S. Ct. Sept. 13, 2017), petition for cert. granted, Dkt. No. 17-494 (U.S. S. Ct. Jan. 12, 2018). | |||||||||
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