This Week in State Tax

A California Superior Court held that a taxpayer was liable for $6.6 million in use tax on repair parts incorporated into medical equipment that was repaired in California and shipped out of state for subsequent use. The taxpayer sold medical equipment and offered optional maintenance contracts under which out of state customers shipped equipment to the taxpayer’s national service center in California for repair. The taxpayer performed the repairs, including replacement of parts when needed, then shipped the equipment back to the out of state customers. Customers paid a lump-sum fee covering all repairs and parts, rather than paying for individual repair work.

The central issue was whether the taxpayer was exempt from California use tax on the repair parts it incorporated into the equipment that was subsequently returned to customers outside California. Under California sales and use tax law, the terms “storage” and “use” exclude any property kept or retained in California solely for subsequent transport and use outside the state, or for the purpose of being processed, fabricated, or manufactured into, attached to or incorporated into other property to be transported and used solely outside California. Additionally, California provides that when repairs are performed pursuant to a lump-sum maintenance contract that includes parts, materials, and labor, the person making the repair is deemed the consumer of parts and materials furnished.

The taxpayer argued that its use of repair parts was exempt because they were “incorporated into” equipment that was shipped and used exclusively outside California. The Department of Tax and Fee Administration (CDTFA) disagreed, asserting that the parts were consumed in California during the repair process, and the equipment was present in-state for functional purposes and not merely for storage or transit. The court agreed with the CDTFA, emphasizing that the exemption applies only when property has no functional use in California beyond transit. The court rejected the taxpayer’s reliance on statutory language referencing property “processed, fabricated, or manufactured into” other property,” clarifying that this language does not create a broad manufacturing exemption. Rather, it protects property in California solely for transit from being taxed due to its attachment to something else while in California.

The court also concluded that the CDTFA properly assessed a negligence penalty in this matter. In three prior audits, the CDTFA had assessed use tax against the taxpayer based on the same issue. The court found that the taxpayer knew, or should have known, the transactions were taxable. For more information on Olympus Am. Inc. v. Cal. Dep’t of Tax & Fee Admin., contact Jim Kuhl. 

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After 10 years of waiting, the California legislature has approved a bill to update the state’s general date of conformity to the Internal Revenue Code (IRC) for income and franchise tax purposes from January 1, 2015 to January 1, 2025, effective for tax years beginning on or after that date. The bill is before the Governor for signature. Due to the 2015 conformity date, California generally did not conform to the IRC changes in the Tax Cuts and Jobs Act of 2017 and numerous subsequent federal changes, unless the state specifically provided for conformity under California law. In total, there were reportedly over 1,000 differences between the IRC and California law, prior to the adoption of the update.

While the conformity update should simplify matters for taxpayers, the state will still determine those changes in the IRC to which it will conform, and it will not be conforming automatically to the provisions of the One Big Beautiful Bill Act enacted in July 2025. In keeping with California’s historical selective conformity approach, the conformity update bill would modify, or otherwise decouple from, certain specific IRC provisions. Some of the notable such provisions include: (1)  conformity to the Alternative Simplified Credit but with reduced credit percentages and decouple from the Alternative Incremental Research Credit under IRC section 41; (2) decouple from IRC section 163(j) - the interest expense limitation; (3) continue to decouple from IRC section 174 - the capitalization and amortization of research and experimental expenditures; (4) continue to decouple from IRC section 168(k) - federal bonus depreciation; (5) partially decouple from the American Rescue Plan Act limitations on deductions for executive pay under IRC section 162(m); and (6) continue to decouple from FDII and GILTI deductions under IRC sections 250 and 951A.

Separately, the California legislature also approved a bill that would address the California treatment of the gross income exclusion provided under IRC sections 6417 and 6418. Under IRC section 6417, eligible entities may elect to receive direct payments from the federal government for certain credits they generate. Under IRC section 6418, eligible entities may elect to sell all or a portion of certain eligible credits that they generate to unrelated taxpayers. Under IRC sections 6417 and 6418, the refund amount and gain recognized on the sale of  credits is excluded from gross income. The bill would specifically exclude from gross income payments made pursuant to IRC sections 6417 and 6418. In line with IRC section 6418, the bill would also disallow any deduction for amounts paid in consideration of a transfer of the eligible credits. The bill would apply for taxable years beginning on or after January 1, 2026 and before January 1, 2031.

Both bills are currently awaiting a signature from Governor Newsom, and if signed, the legislation will go into effect immediately. Please contact Candace Axline, Oksana Jaffe, or Geoffrey Way with questions about S.B. 711 and S.B. 302. 

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The Washington Department of Revenue recently published several new Interim Guidance Statements to assist taxpayers in implementing Engrossed Substitute Senate Bill 5814 enacted earlier this year. ESSB 5814 expands the definition of “retail sale” to include certain business activities and services not previously subject to sales tax, effective October 1, 2025. The Department indicates the purpose of the interim statements is to provide guidance and direction on which taxpayers can rely in complying with the new provisions until permanent guidance is issued.

The Interim Guidance Statements released to date address the following topics:

• Advertising Services
• Custom Website Development
• DAS Exclusions
• Existing Contracts
• IT Services
• Live Presentations
• Security Services
• Temporary Staffing

For each topic, the Department outlines the new provisions of law and provides examples and explanations designed to clarify common questions, such as sourcing rules, multiple points of use exemptions, stated exclusions, transactions between affiliated entities, “resale” transactions, the appropriate sales tax rate, and the business and occupation (B&O) tax base for the taxable sales.

As of this writing, the Department is still finalizing interim guidance for “Custom Software”. KPMG will continue to monitor developments and provide updates when released. Stay tuned for a KPMG SALT Alert! which will address each Interim Guidance Statement more fully. For additional information regarding the changes in ESSB 5814 and related legislation, please see  our TWIST of May 25, 2025 or contact Michel Baisler or Alex Low.

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Recently, three states released guidance on the state treatment of certain provisions amended under the One Big Beautiful Bill Act (OB3) enacted in July, and others have reported on the budget impacts of OB3 on state revenues.

The Alabama Department of Revenue has issued a notice providing guidance to corporate taxpayers on the state treatment of research and experimental (R&E) expenditures. Under the Tax Cuts and Jobs Act (TCJA), IRC section 174 requires taxpayers to amortize R&E expenses over either a 5 or 15-year period, depending on whether the costs are domestic or foreign or domestic, beginning in tax year 2022. Beginning in tax year 2024, Alabama decoupled from these provisions and allowed taxpayers the option of currently deducting such expenses or following the federal treatment prior to 2022. OB3 permits taxpayers to fully expense domestic R&E expenditures starting in 2025 and permits taxpayers to elect to expense previously capitalized and unamortized amounts in full or ratably over two years (2025 and 2026) (accelerate expensing). The guidance provides that if the taxpayer chooses to deduct the unamortized amounts fully or ratably under the new OB3 provisions, the amounts deducted must be added back to the Alabama taxable income to the extent they were previously deducted on an Alabama tax return. The guidance also provides form-specific instructions for both corporations and financial institutions adding back amounts to the Alabama income tax returns. For questions on the Notice on Research and Experimental Expenditures please contact Gregory Aughenbaugh.

The Rhode Island state budget adopted earlier this year decoupled from the treatment of domestic R&E expenses under OB3.  The R.I. Division of Taxation issued guidance pointing out that in addition to indicating that Rhode Island will decouple from the OB3 changes in IRC section 174 generally, the state will also decouple from the federal election for eligible small businesses (through federal amended returns or accounting methods change) to accelerate expensing of domestic R&E expenses that were capitalized and amortized for Tax Year 2022 through 2024. If the taxpayer chooses to amend its federal returns for such tax years to avail itself of the change in law, Rhode Island amended returns will also be required. In addition, Rhode Island also decouples from the federal election to accelerate expensing for unamortized amounts, incurred in Tax Years 2022 through 2024, in full or ratably over two years. For tax year 2025, the guidance also states that state corporate taxpayers must amortize domestic R&E expenditures, even when fully expensed at the federal level. The guidance includes instructions on additional new schedules that must be filed to address the state and federal difference relating to domestic R&E treatment. The guidance also notes that the state will be issuing additional guidance regarding other provisions of OB3 later in the month. For questions on Rhode Island Advisory Notice 2025-18 please contact Jamie Posterro.

In Maryland, the Maryland Bureau of Revenue Estimates recently released a report providing that the state is expecting a loss of approximately $190 million over the next two years due to federal tax changes resulting from the passage of OB3. Based on Maryland’s unique conformity statute, because conforming to OB3 amendments to IRC sections 174 and 174A (R&E expense deduction), IRC section 168(n) (Bonus depreciation for qualified production property), and IRC section 163(j) (Business interest deduction limitation) will each individually impact Maryland revenue by greater than $5 million, Maryland will decouple from these provisions beginning with tax year 2025 and any prior tax year. However, Maryland will conform to the OB3 amendments to IRC in these sections beginning tax year 2026 unless the state legislature enacts decoupling provisions. Maryland will immediately conform to the amendments to IRC sections 179 Expensing, as well as GILTI, and FDII. For questions on the One Big Beautiful Bill 60-Day Report please contact Diana Smith.

In Nebraska and Virginia, the states have issued reports detailing the estimated impact of the OB3 changes on state income tax revenues. Nebraska, which conforms to taxable income for corporate purposes and adjusted gross income for individuals, anticipates a revenue loss of about $102 million in FY 2026 and $115 million in FY 2027. The largest effects are from increased depreciation allowances for capital assets and non-residential structures, as well as the state and local tax deduction and R&E expensing.

In Virginia, the Commonwealth “paused” its rolling conformity to the IRC for most federal tax changes enacted in 2025 and 2026, including most OB3 provisions. The Department of Taxation recently presented an estimate to the General Assembly of the impact of OB3 on state revenues should the state return to rolling conformity. The state anticipates a revenue impact of about $575 million in FY 2026 and $250 million in subsequent years from OB3. For questions on the Nebraska and the Virginia reports, contact Kara Hernandez (Nebraska) and Diana Smith (Virginia). 

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