April 27, 2018 Kentucky governor does not veto additional tax reform legislation that includes combined reporting, sales tax fix As discussed in Tax Alert 2018-0819, the Kentucky legislature passed a tax reform bill (HB 487) on April 14, 2018. HB 487 was intended to address concerns with the tax reform provisions contained in another bill, HB 366, which was enacted into law after the legislature voted to override Governor Matt Bevin's veto on April 13, 2018. Governor Bevin did not veto HB 487 and thus, as of April 27, 2018, under Kentucky's constitution, HB 487 became law. Accordingly, enactment of HB 487 will result in dramatic changes to Kentucky's corporate income tax regime. Moreover, some of these changes apply to tax years beginning on or after January 1, 2018, while the new combined reporting requirements apply to tax years beginning on or after January 1, 2019. We discuss below the major Kentucky tax law changes brought about by these two new laws. Corporate income tax HB 366 updates Kentucky's conformity date to the Internal Revenue Code (IRC) as of December 31, 2017, for tax years beginning on or after January 1, 2018. In considering IRC conformity, however, Kentucky will continue to decouple from the federal bonus depreciation rules set forth in IRC Section 168(k) and the expanded IRC Section 179 expensing consistent with Kentucky's past approach. In addition, the new law reduces the corporate income tax rate to a flat 5% and also eliminates the Kentucky Domestic Production Activities Deduction, consistent with the federal elimination of a similar provision (IRC Section 199 (repealed)) brought about through enactment of the federal Tax Cuts and Jobs Act (P.L. 115-97) (TCJA). HB 366, as modified by HB 487, also makes significant changes to Kentucky's apportionment and allocation rules. First, Kentucky has adopted a single sales factor for determining apportionment for tax years beginning on or after January 1, 2018. Previously, Kentucky required the use of a three-factor (property, payroll, and double weighted sales) apportionment formula. Second, following a recent model rule proposal of the Multistate Tax Commission, HB 366 substitutes the definitions of "business" and "non-business" income with "apportionable income" and "non-apportionable income," respectively. Following approaches in other states, Kentucky has adopted market-based sourcing for purposes of assigning sales of non-tangible property (e.g., intangibles, services) to the states for apportionment purposes but also includes a throw-out rule if the taxpayer is not subject to tax in the state to which the receipt would otherwise be assigned or if the sourcing cannot be reasonably estimated. Excluded from these HB 487 provisions, however, will be providers of communications, cable or internet access services, which will continue to use three-factor apportionment and cost-of-performance sourcing. The sales factor excludes all receipts from treasury functions, which is a significant change from prior law that allowed net gains from certain treasury functions to be included in the sales factor. Kentucky had been one of the few remaining states to significantly limit combined reporting. HB 487 changes that. For tax years beginning on or after January 1, 2019, Kentucky taxpayers engaged in a unitary business will be required to file their returns on a mandatory water's-edge combined reporting method. Thus, the 2018 tax year will mark the last year of Kentucky's current nexus consolidated regime. Under the new Kentucky rule, the water's-edge combined group will include any member earning more than 20% of its income from intangible property or service-related activities from other members of the combined group and includes members that are doing business in tax havens. No required ownership percentage is expressly specified in the new law. Moreover, a unitary combined group cannot opt to file on a worldwide combined basis, either by election or otherwise, as is common in other jurisdictions requiring water's-edge combined reporting. Each taxpayer member will be responsible for tax based on its own taxable income or loss apportioned or allocated to Kentucky. A combined group may, however, designate a taxpayer member to file a single return in the form and manner to be described by the Kentucky Department of Revenue. Accordingly, it appears that Kentucky will adopt a Joyce approach to include in the sales factor numerator only those Kentucky-sourced sales from members with Kentucky nexus. Moreover, the new combined reporting regime significantly alters Kentucky's treatment of net operating losses (NOLs). Under the prior nexus consolidated law, Kentucky NOLs were computed on a pre-apportionment basis and could be shared among members of the nexus consolidated group, subject to the 50% income limitation. Under the new law, NOLs will be computed on a post-apportionment basis with no sharing among members of the combined group. There are no transition rules in HB 487 as written that provide guidance as to how NOL carryforwards under the old nexus consolidated regime will be carried forward to the new combined reporting regime. In lieu of combined reporting, the new law permits a group of taxpayers to make an eight-year election to file on a consolidated basis in accordance with IRC Section 1502 principles, similar to what was available to Kentucky corporate taxpayers before 2005. Taxpayers not qualifying to file combined or consolidated returns must file on a separate-entity basis. Individual income tax HB 366 also updates Kentucky's IRC conformity date for purposes of its individual income tax to the IRC as of December 31, 2017. As a result, 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 either no longer deductible or subject to significant limitations for Kentucky individual income tax purposes. As under the TCJA, deductions for charitable donations and mortgage interest are preserved for Kentucky individual income tax purposes, subject to certain limitations. Owners of pass-through entities, however, are not eligible for the 20% deduction for Kentucky purposes (which is allowed under the TCJA — IRC Section 199A). HB 366 substitutes a flat 5% rate for all individuals for the current progressive tax brackets ranging from 2% to 6%, depending upon income levels. Lastly, HB 366 decreases the amount of the pension income exclusion from $41,110 to $31,110. These individual income tax changes are effective for tax years beginning on or after January 1, 2018. Sales tax HB 366 also expands 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 services sold. HB 487 modifies Kentucky's manufacturing exemption to exempt installation and repair labor relating to manufacturing equipment. These changes apply to transactions occurring on or after July 1, 2018. Kentucky provides an exemption to manufacturers for energy and energy-producing fuels, to the extent that they exceed 3% of the cost of production in manufacturing. HB 487 makes changes with regard to the cost of production definitions for tolling arrangements. Historically, tollers were able to exclude the raw materials they were processing from their costs of production since they never owned the raw materials, resulting in more of their energy cost being exempt. HB 487 appears to require an allocated share of raw materials costs, based on a proportion of all manufacturing or industrial processing operations at the facility, to be included in the cost of production computation, thus increasing the 3% threshold and the sales/use tax paid on energy. The language is unclear as to whether the 3% test applies to the production activities of the contract manufacturer across multiple contracts collectively or to measure and allocate production costs proportionally as they apply to each individual production contract. Provisions of HB 366 also ready Kentucky in the event the physical presence nexus standard formally enunciated in Quill Corp. v. North Dakota is overturned by the U.S. Supreme Court in South Dakota v. Wayfair, which was heard by the Court on April 17, 2018 and is expected to be decided 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 had Kentucky gross receipts exceeding $100,000 in either the previous or current year. Credits and incentives HB 366 suspends all applications for the refundable motion picture credit for sales and use taxes paid on purchases made in conjunction with the filming or production of motion pictures in Kentucky until July 1, 2022. In addition, HB 487 (which modifies suspension provisions for certain other credits enacted under HB 366) suspends both 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. The Kentucky Industrial Revitalization Tax Credit will be retained. Administrative items HB 366 and HB 487 provide additional taxpayer protections regarding appeals and assessments. Under HB 366, the protest period is increased from 45 days to 60 days for assessments issued on or after July 1, 2018. HB 487 extends the period from 30 days to 180 days (up from the 90 days provided for in HB 366) to notify the Kentucky Department of Revenue of a final Revenue Agents Report in the event of a federal audit. Implications HB 366, as modified by HB 487, is now enacted law. The legislation adopts sweeping changes to Kentucky's corporate, individual and sales tax regimes. By updating the IRC conformity date to December 31, 2017, Kentucky conforms to many of the TCJA's provisions with the exceptions of bonus depreciation, the expanded IRC Section 179 expensing provisions and the 20% deduction for individuals for pass-through entity income. The adoption of a single sales factor apportionment rules, along with market-based sourcing, may encourage economic development in Kentucky. The shift from nexus-consolidated to a mandatory water's-edge combined reporting filing regime (for tax years beginning on or after January 1, 2019) is another dramatic change. Given the uncertainty around some of these hastily-added provision (e.g., combined reporting, sales/use tax changes applicable to tollers), it is anticipated that additional technical corrections legislation will be needed. It is possible that this could occur in a special legislative session before June 30, 2018, but it appears more likely to occur in the next legislative session in early 2019. EY will continue to monitor developments in this area. ———————————————
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