The Latest & Greatest State Tax Litigation

Council On State Taxation Mid-Atlantic Regional State Tax Seminar

Provided by:

Robert P. Harrill Todd A. LardBlank Rome LLP Council on State TaxationPhiladelphia, PA Washington, DC

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AgendaAgenda

Income Tax Issues– Nexus– Municipal Bond Interest – Add-Back of Deductions– Apportionment– Business/Nonbusiness income

Taxation of Pass-Through EntitiesSales Tax Issues

– Nexus– Standing

Credits & Incentives

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Nexus Issues Nexus Issues –– Virginia and AlabamaVirginia and Alabama

Virginia Public Document Ruling No. 06-114, October 11, 2006.– The Commissioner concluded that a taxpayer’s collection activities of

calling and writing debtors to collect receivables performed out-of-state were not sufficient to create nexus for corporate net income tax purposes.

Lanzi v. Department of Revenue, Alabama Court of Appeals, Dkt. No. 2040298, June 30, 2006.– The Appellate Court held that a mere investment in a limited

partnership did not meet the minimum contacts standard of the Due Process Clause notwithstanding case law and statutory law that permit the state to tax income of a nonresident if the taxpayer has established a commercial domicile in the state or if a business intangible has a situs in the state.

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Municipal Bond Income Municipal Bond Income ---- KentuckyKentucky

Davis v. Department of Revenue, 197 S.W.3d 557 (Ky. App. 2006)– Kentucky Court of Appeals held that Kentucky’s taxation of income from other states’

bonds, but exempting income from Kentucky bonds, discriminated against interstate commerce in violation of the Commerce Clause.

– The court placed little weight on the Ohio Court of Appeals decision in Shaper v. Tracy 647 N.E. 2d 550 (Ohio Ct. App. 1994) that had sustained a similar Ohio scheme stating that the court failed to fully analyze the issue.

– The court also distinguished the U.S. Supreme Court decision in Bonaparte v. Tax Court, 104 U.S. 592 (1881) because it did not involve a challenge under the dormant Commerce Clause.

– Court rejected the argument that the taxing scheme was not discriminatory because of the market participant doctrine.

– The U.S. Supreme Court has granted certiorari.Other Cases

– The Superior Court has certified a class of North Carolina taxpayers, who paid tax on income earned from out-of-state obligations. Dunn v. Cook, 635 S.E.2d 604 (N.C. App. 2006).

– Similar statutes are being challenged in Arizona and Louisiana.

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Royalty Expense Royalty Expense AddbackAddback ---- AlabamaAlabama

VFJ Ventures, Inc. v. Surtees, No. CV-03-3172 (Ala. Cir. Ct. Montgomery County Jan. 24, 2007)– In a decision that marks the first time a court has examined an

intangible “addback” statute, an Alabama Circuit Court found that a taxpayer is entitled to an “unreasonableness” exception.

– The court found that royalty payments made to affiliated entities had economic substance and business purpose and were not abusive.

– While the court provided some discussion and evaluation of the “subject-to-tax” exception, the court ultimately did not rule on this exception.

– Approximately 17 states have addback statutes similar to Alabama.

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AddbackAddback of Dividend Received of Dividend Received Deduction Deduction ---- MississippiMississippi

AT&T Corporation v. Mississippi Tax Commission, Chancery Court of Hinds, Docket No. G-2000-31S/Z, May 26, 2006 (Appeal Pending)– The district court held a statutory scheme that allows a

deduction for dividends received only from corporations that do business in Mississippi was unconstitutional on the grounds that it was facially discriminatory.

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CostCost--ofof--Performance Performance –– CaliforniaCalifornia

California Legal Ruling 2006-06 (Cal. FTB May 3, 2006)– The California Franchise Tax Board (“FTB”) ruled that activities

performed by a member of the taxpayer’s unitary combined reporting group on behalf of the taxpayer are considered income producing activities directly engaged in by the taxpayer for purposes of calculating the sales factor for sales other than tangible personal property sourced by costs-of-performance.

– Expenses paid to third party independent contractors that perform services on behalf of the taxpayers who are not members of the taxpayer’s unitary combined reporting group will continue to be disregarded for purposes of identifying taxpayer’s income producing activities.

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CostCost--ofof--Performance Performance –– VirginiaVirginia

General Motors Corp. v. Virginia, 602 S.E.2d 123 (Va. 2004)– The Virginia Supreme Court held that a regulation concerning

the apportionment of financial institution’s income defined costs-of-performance in a manner inconsistent with the Virginia statute.

– The regulation defined cost of performance to exclude activitiesperformed on behalf of a taxpayer by a third party.

– The court found that nothing in the statute limited costs of performance to direct costs of the taxpayer or implied that the Department could exclude costs incurred on behalf of the taxpayer by a third party.

Recent MTC Efforts Regarding “Direct Costs”

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CostCost--ofof--Performance Performance –– IllinoisIllinois

Illinois General Information Letter 05-0046 (October 26, 2005).– Taxpayer, a California corporation, requested a ruling that its sales factor

numerator should be zero because in applying the costs of performance to its income producing activities, a greater proportion of its costs are performed outside of Illinois than in Illinois.

– The Taxpayer totaled up all of its costs related to its performance of advertising services for the year and found that a greater proportion of its costs were performed outside of Illinois than in Illinois.

– The Department responded that the COP method must be applied on a sale-by-sale basis, not by using the total activity related to all sales in a given taxable year.

– The Department concluded that the taxpayer did not provide enough information for it to determine the numerator of the Taxpayer’s sales factor under the costs of performance method.

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Sales Factor Apportionment Sales Factor Apportionment --CaliforniaCalifornia

The Limited Stores, Inc. v. Franchise Tax Board, Docket No. A102915, California Court of Appeal, First District, June 8, 2007.– On remand, the court held that the FTB properly adjusted the

sales factor to include merely the net income received when short-term financial instruments matured rather than return of principal, plus interest or dividends, as Limited had reported on its return.

– The court reasoned that the UDITPA includes relief provisions that permit the FTB to use an alternate method of apportionment to effectuate equitable apportionment of a taxpayer’s income if the regular apportionment provisions do not fairly represent the extent of the taxpayer’s business in the state and if reasonable.

– Applying the two prong Microsoft Test the court found that the inclusion of investment receipts from the redemptions caused a quantitative distortion.

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Business/Business/NonbusinessNonbusiness –– CaliforniaCalifornia

Jim Beam v. Franchise Tax Bd., 133 Cal. App. 4th 514 (Cal. Ct. App. 2005).– Taxpayer appealed the FTB ruling that a gain from the sale of a

subsidiary's stock constitutes apportionable business income because the subsidiary was part of the taxpayer's unitary business. The FTB recharacterized the gain as apportionable business income

– The taxpayer argued that the stock sale fell within an exception to the functional test, which, as explained in Lenox Inc. v. Offerman, 538 S.E. 2d 203 (N.C. Ct. App. 2000), treats partial liquidations asnonbusiness income even if the liquidated assets were part of the taxpayer's unitary business

– The court rejected that argument, noting that the Lenox decisionconflicts with prior California precedent (Hoechst Celanese) and held that the stock sale satisfied the functional test

– On January 4, 2006, the California Supreme Court denied review.

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Business/Business/NonbusinessNonbusiness –– IllinoisIllinois

Shakkour v. Bower, 368 Ill. App. 3d 627 (Ill. Appt. Ct. 2006)– Nonresident partner’s distributive share of a partnership’s income

realized from the partnership’s sale of certain software technology was non-business income.

– Department asserted that sale of the software technology was business income because it was an integral part of the regular business operations and qualified as business income .

– Court applied Blessing/White business liquidation exception which provides that income from disposition of business assets in a one-time event that results in cessation of the business activities is nonbusiness income.

– 2004 modification to statute likely trumps decision.• Statute defines business income to include all income that may

constitutionally be apportioned.– On January 24, 2007, the Supreme Court of Illinois denied review.

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Business/Business/NonbusinessNonbusiness –– IllinoisIllinois

National Holdings, Inc. v. Zehnder, 369 Ill. App. 3d 977 (Ill. Appt. Ct. 2007)– Gains recognized on the a sale of assets were properly characterized as non-business

income because the transaction resulted in a cessation of business and the proceeds were distributed to the shareholders.

The Mead Corporation v. Bower, 861 NE2d 1131 (Ill. Appt. Ct. 2007)– Gain recognized on a sale of assets was properly characterized as business income

because the transaction did not result in a distribution of sale proceeds but rather use the proceeds to buy back stock

Private Letter Ruling, IT 07-0001-PLR, March 23, 2007.– Taxpayer was permitted to elect to treat gain from the sale of stock as business income

and exclude the gain from the numerator and denominator of the sales factor.Nicor, Inc. v. Department, No. 05 L 01306 (Cir. Ct. of Cook County, April 19, 2007).

– Circuit Court held that gain recognized on a § 338(h)(10) transaction must be recognized as non-business income because there is a cessation of business and there is a distribution of the proceeds to the shareholders.

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Business/Business/NonbusinessNonbusiness –– IndianaIndiana

Letter of Findings #06-0187, April 18, 2007.– The Department concluded that, under the circumstances, an IRC

§ 338(h)(10) asset liquidation gain should be classified as apportionable business income rather than allocable nonbusinessincome because:

• The company for which the election was made was part of the ultimate parent’s overall business and the company’s assets were business property and remained business property even when ultimately sold; and

• The business was sold as part of the ultimate parent’s overall business plan and, therefore, constituted an integral part of the taxpayer’s business operations under the state’s functional test.

– The Department so concluded even though the sale did not meet the requirements of the state’s transactional

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Business/Business/NonbusinessNonbusiness –– MissouriMissouri

ABB C-E Nuclear Power, Inc. v. Director of Revenue, No. WD65820(Mo. Ct. Appt. June 30, 2006), aff’d, 215 S.W.3d 85 (Mo. 2007).– The Administrative Hearing Commission (“AHC”) held that the

Petitioner’s gain from a deemed sale of its assets under IRC § 338(h)(10) was non-business income and not apportionable to Missouri because the Petitioner was deemed to have liquidated its assets--a disposition that was not in the regular course of its trade or business nor an integral part of its trade or business--the deemed gain was non-business income even though the successor entity may have continued the Petitioner’s line of business

– The case was ultimately transferred to the Missouri Supreme Court which held that the AHC correctly determined that the proceeds from the sale did not constitute business income under either test because it was the sale and liquidation was a “one-time, extraordinary event”

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Business/Business/NonbusinessNonbusiness –– TennesseeTennessee

Siegel-Robert Inc. v. Commissioner, No. 00- 3763-III (Tenn. Ch. Ct. Aug. 17, 2006)– Court held that investment income earned on a corporation’s

excess capital was nonbusiness income– Taxpayer was a manufacturer of automobile parts and also earned

interest income on treasury securities – Court found that interest income was earned on surplus funds in

excess of operational and working capital needs– Funds were used to implement taxpayer’s diversification strategy

by acquiring other businesses and were not used for capital expansion or day-to-day operations

– Court indicated that the income must have some link and minimum connection to Tennessee and because the investment and manufacturing businesses were conducted separately and distinctly there was no unitary relationship

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Business/Business/NonbusinessNonbusiness –– UtahUtah

Chambers v. Utah State Tax Commission, No. 050402915 TX (Utah Dist. Ct. Jan. 29, 2007)– Utah District Court held that gain realized on the complete sale of

a corporation in an IRC Sec. 338(h)(10) transaction was nonbusiness income for Utah corporate income tax purposes because the transaction was not integral to the corporation's regular trade or business operations.

– Looking to the decisions of other states, the court held that, under the functional test, the disposition of property in this case was not integral to the corporation's regular trade or business operations, because it did not benefit the corporation's regular trade or business. Rather, the disposition benefited only the shareholders of the corporation, while resulting in the complete cessation of the corporation's operations.

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Business/Business/NonbusinessNonbusiness –– North North CarolinaCarolina

Secretary of Revenue Decision #2006-111, April 19, 2007.– Proceeds received from a lawsuit settlement agreement that were

intended to compensate the recipient for lost profits resulting from the opposing party’s breach of contract constituted apportionablebusiness income under the functional test and the transactional test.

– Under the transactional test, the creation and negotiation of the underlying contract took place as part of the recipient’s regular business.

– Under the functional test, the underlying contract was negotiated for the recipient’s growing business and the fact that the income from the contract was received via legal settlement rather than market sales is irrelevant.

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Taxation of PassTaxation of Pass--Through Entities Through Entities --CaliforniaCalifornia

Northwest Energetic Services LLC v. Franchise Tax Board, Superior Court for San Francisco County, No. CGC 05-437721, April 13, 2006 (Appeal Pending).– The Superior Court held that the California LLC fee scheme,

which is a “fee” based upon un-apportioned gross income from all sources, is an unfairly apportioned tax in violation ofboth the Due Process and Commerce Clauses. In so holding, the court concluded that:

• The “fee” was tax that raised general fund revenues and not a regulatory fee

• The “fee” failed both the internal and external consistency tests of Complete Auto

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Sales and Use Taxes Sales and Use Taxes –– MaineMaine

DaimlerChrysler Corp. v. Maine Revenue Services, Maine Supreme Judicial Court, No. Ken-06-503, May 22, 2007 – Automobile manufacturer was not entitled to a refund of sales tax

that it had reimbursed its customers under the Maine Lemon Law.– The manufacturer was not a "taxpayer" that was entitled to a

refund because it had not collected and paid over Maine sales taxes. Instead, its customers had paid the state the taxes.

– In addition, the manufacturer was not a "taxpayer's successor ininterest" that was entitled to a refund because its customers had not paid sales taxes more than once and had not been subjected to sales taxes illegally or erroneously.

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Sales and Use Taxes Sales and Use Taxes –– MaineMaine

Flippo v. L.L. Bean, Inc., 898 A2d 942 (Me. 2006)– The Maine Supreme Court held that retailer L.L. Bean properly charged

Maine sales tax on the gross purchase price of merchandise and rejected a class action claim that the sales tax should only have been charged on the net price after subtracting the value of the coupons.

– The lead plaintiff had made a purchase from L.L. Bean using a $5 coupon that she had obtained when she signed up for an L.L. Bean MBNA credit card. She claimed L.L. Bean wrongly overcharged her 27 cents of sales tax by applying Maine’s then 5.5% sales tax rate to the gross purchase price, including the $5 coupon.

– The Court held that the value of the coupons at issue in this case were part of the sales price and not a discount because the royalty payments that MBNA paid to L.L. Bean when L.L. Bean MBNA credit cards were opened and used by customers were intended to reimburse L.L. Bean for the value of the coupons.

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Sales and Use Taxes Sales and Use Taxes –– North CarolinaNorth Carolina

DirecTV, Inc. v. Department of Rev., 632 S.E.2d 543 (N.C. App. 2006 )– The North Carolina Court of Appeals held that imposing sales tax

on satellite television service but not on cable television service does not violate the Commerce Clause

– The Satellite industry argued that taxing satellite television services violated the Commerce and Equal Protection Clauses because it discriminated against interstate commerce

– The court held that whether a company is subjected to the sales and use tax statute at issue depends only upon how companies deliver television programming services to its subscribers, and not whether the delivery of the programming services occurs inside or outside the state of North Carolina. Consequently, the distinction was permissible under the Commerce Clause because it was not based on the location of the taxpayer.

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Sales and Use Taxes Sales and Use Taxes –– MissouriMissouri

Ronnoco Coffee Co., Inc. v. Director of Rev., 185 S.W.3d 676 (Mo. 2006)– The Supreme Court of Missouri ruled that a coffee bean wholesaler could

purchase coffee equipment for its customers’ use tax-free for resale, as all the elements of a sale were evident

– The wholesaler provided the equipment to the customer without a separate charge, but factored the cost of the equipment into the price it charged for coffee. The wholesaler retained legal title to the equipment and the customer was required to return the equipment upon termination of the contract

– The Court followed previous decisions, and held that when a business does not charge separately for goods, but instead factors the cost of the goods into the price of all items sold to the customers, those goods are exempt from the use tax

– It was not relevant whether the customer agreements constituted loans, leases or rentals, because the customer had the right to use, store, and consume the equipment even though it was required to return the equipment.

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PassPass--Through of Transactional TaxesThrough of Transactional Taxes

Sprint Spectrum, L.P. v. Seattle Dept. of Exec. Admin., 127 P.3d 755 (Wash. Ct. App. 2006), rev. denied, 149 P.3d 377 (Wash. 2006)– Court ruled that Sprint must include the amount of Seattle telephone business

tax (voluntarily) passed through to its customers in calculating its gross income subject to utility tax.

AT&T Corp. v. Rudolph, CA No. 06-16 (E.D.K.Y. February 27, 2007)– Court ruled unconstitutional (on First Amendment grounds) a provision of

Kentucky law which prohibited AT&T from collecting the costs of the gross revenues tax directly from purchasers by separately stating the tax on the bill to the purchasers.

Sprint – Texas Controversy– On February 5, 2007, the Texas Attorney General filed a petition claiming that

Sprint is improperly seeking reimbursement of the Texas Margin Fee (which is not effective until 2008) from customers in violation of the Texas Deceptive Trade Practices – Consumer Protection Act.

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Sales and Use Taxes Sales and Use Taxes –– LouisianaLouisiana

State v. Dell Int’l, Inc. 922 So.2d 1257 (La. App. 2006) – At issue was Dell's liability for use tax for its sales of computers to Louisiana

customers. Dell had no offices, stores, or property in Louisiana. Dell solicited orders from outside the state and shipped computers into Louisiana using common carrier.

– Dell contracted with BancTec, to provide the onsite services for its products in Louisiana. In addition to its contracts with Dell, BancTec performed onsite computer repair services for other companies.

– The court, in ruling against Dell, found the contractual relationship between Dell and BancTec enhanced Dells’ ability to establish and maintain a market in Louisiana. Dell had control over significant aspects of the services BancTec performed, and Dell guaranteed those services to its customers. The court held that contractual tags, labels, or words used to describe the service relationship could not be used to negate the evidence that the repair company was acting on the taxpayer's behalf

– Request for rehearing was denied.

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Sales and Use Taxes Sales and Use Taxes –– CaliforniaCalifornia

In the Matter of Reynolds, Cal. SBE, May 31, 2007).– An out-of-state partnership that shipped unassembled product to an affiliate

in California where the affiliate then completed assembly and effected delivery to California purchasers was considered engaged in business in California for use tax collection purposes on the completed items sold to the California purchasers.

– The State Board of Equalization found three bases under which Reynolds was required to collect and remit the use tax:

• Reynolds had a business location in California because the storage of finished goods pending sale to the California purchasers constituted a storage place for stock of Reynolds’ goods.

• Reynolds was a retailer engaged in business in California by the in-state affiliate acted under Reynolds’ authority as its California representative to assemble and deliver tangible personal property.

• Reynolds’ held a California seller’s permit, which requires its holder to collect and remit use tax.

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Sales and Use Taxes Sales and Use Taxes –– KansasKansas

Final Determination No. 06-0121 through 0133, Kansas Department of Revenue, Office of Administrative Appeals (Nov. 27, 2006).– In a final determination letter, the Kansas Department of

Revenue, Office of Administrative Appeals ruled that out-of-state Internet and catalog companies had nexus for purposes of state use tax collection on items sold to in-state customers as a result of the activities of an affiliated in-state retail brick-and-mortar store that promoted and facilitated sales of the Internet and catalog companies.

– The Department reasoned that the affiliates satisfied the definition of retailers doing business in this state under Kansas Statutes Annotated section 79-3702(h)(2).

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Sales and Use Taxes Sales and Use Taxes –– VirginiaVirginia

Ruling of Commissioner, P.D. #07-24, March 27, 2007.– An out-of-state retailer who enters into an arm’s length

contract with multiple affiliated entities to perform distribution center functions, where the distribution center maintains title to the product but ships the product at the direction of the retailer, would not be considered to have sales/use tax nexus because the out-of-state retailer does not control the work to be done by the distribution center, and, therefore, no agency relationship has been established.

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Sales and Use Taxes Sales and Use Taxes –– AlabamaAlabama

Crown Housing Group, Inc. v. Alabama Dept. of Rev., No. S. 06-399 (Ala. DOR ALJ July 26, 2007) – Retailer with neither a physical location nor salespersons in a

particular locality was not responsible for collecting and remitting local sales taxes on sales made into the locality.

– The taxpayer sold mobile homes, which were delivered throughout the state of Alabama by using independent contractors. The taxpayer collected and remitted state sales tax but not local sales taxes where taxpayer had no offices.

– In ruling for the taxpayer, the ALJ determined that it was bound by the precedent of Yelverton’s, Inc. v. Jefferson County, Alabama, 742 So.2d 1216 (Ala. Civ. App. 1997), which concluded that under Alabama statute a remote retailer must have either a physical location or a salesperson in a locality before the locality can require the retailer to collect and remits tax on sales into thejurisdiction.

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Sales and Use Taxes Sales and Use Taxes –– New YorkNew York

Apple Computer, Inc., TSB-A-07(14)S, May 17, 2007).– Music distributed digitally over the Internet was not subject

to state sales/use tax because the downloaded music files constituted nontaxable intangibles regardless of whether a physical medium (such as a paper certificate of plastic card) was used to transmit the alphanumeric codes to customers to download purchased files at a later date.

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Sales and Use Taxes Sales and Use Taxes –– AlabamaAlabama

Boyd Brothers Transportation, Inc. v. State Department of Revenue, Civil Court of Appeals, Docket No. 2050675, 06/22/2007).– The Alabama Court of Civil Appeals held that trucks and trailers

first used in Ohio (and other states) for an average of 400 daysprior to being used in Alabama were not subject to use tax.

– In so holding, the Court of Civil Appeals agreed with Boyd’s arguments that:

• If no Alabama sales tax is due on a transaction that occurs in Alabama, then no use tax is due on a similar transaction that occurs outside Alabama; and

• The use tax statute requires that the property be purchased for use in Alabama and there was no evidence Boyd intended to use the trucks and trailers in Alabama at the time of purchase.

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PostPost--CunoCuno LitigationLitigation

Cuno– Return to state court

Wisconsin Airline “Hub Facilities” Incentives – Northwest Airlines, Inc. v. Wisconsin Dep’t of Revenue, 717

N.W.2d 280 (Wis. 2006).North Carolina Incentives for Dell Computer

– Blinson v. State of North Carolina, 05 CVS 8378 (Wake Co. Super Ct., May 12, 2006), discretionary review denied, 645 S.E.2d 376 (N.C. 2007)

Minnesota, Oklahoma, Nebraska litigation