This Week in State Tax

The Illinois Department of Revenue recently published Private Letter Ruling ST 25-0008-PLR, addressing the exemption from Retailers’ Occupation Tax (ROT) for machinery and equipment used in the manufacturing process. The company at issue develops and operates landfill-based waste-to-renewable energy projects. The company captures raw landfill gas (methane), cleans and refines it to pipeline-quality renewable natural gas, and then injects the renewable gas into local natural gas pipelines for transportation. The company requested the Department rule on whether this process qualifies as manufacturing under Illinois law, and if so, whether the machinery and consumables used in the process are exempt from ROT.

Illinois statutes define the manufacturing process as the production of tangible personal property by procedures commonly regarded as manufacturing, processing, fabricating, or refining, which substantially changes some existing material into a material with a different form, use, or name. Importantly, the exemption specifically excludes machinery and equipment used in the generation or treatment of natural or artificial gas for wholesale or retail sale that is delivered to customers through pipes, pipelines, or mains.

The Department concluded that the company’s process for cleaning and treating methane gas to produce renewable gas mirrors the process of treating fossil natural gas. Each step of the company’s process aligns with the treatment of natural gas under a plain reading of the statutory exception to the manufacturing exemption. Furthermore, since the company injects the renewable gas into pipeline for transportation, the process satisfies the second prong of the exception to the manufacturing exemption. As a result, the Department determined that the machinery used by the company in the process of capturing, treating and refining methane to pipeline-quality renewable natural gas does not qualify for the Illinois manufacturing exemption. For further questions on the Illinois manufacturing exemption, please contact Drew Olson.

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In a recently published decision, a New York appeals court has ruled that a taxpayer’s fees charged to clients for a license to access its vendor management software (VMS) are taxable as sales of prewritten software. The taxpayer in this case uses its proprietary technology platform to match clients with suppliers of contingent and temporary labor, then provides additional services associated with the management, retention, and invoicing of such labor to its clients. In 2016, the Department of Taxation and Finance audited and assessed the taxpayer for unpaid sales and uses taxes based on a finding that the fees charged its clients are for a license to access the taxpayer’s prewritten software, a taxable transaction under New York law.

The taxpayer petitioned to the Division of Tax Appeals (DTA) for redetermination, arguing that the VMS is not prewritten software, and even if it was so found, the “true object” of the taxpayer’s business is not the selling software. Instead, the taxpayer is providing the service of matching buyers and sellers of contingent and temporary labor. The DTA upheld the department, stating that the taxpayer was selling licenses to prewritten software and that the licenses were not incidental to the taxpayer’s business. The taxpayer appealed to the Tax Appeals Tribunal, which affirmed the DTA findings, holding that selling licenses to the VMS, a prewritten computer software, is a “core element” of the taxpayer’s business. The taxpayer then pursued the matter in the appellate court.

Throughout the proceedings, the taxpayer’s central argument was that it does not sell prewritten software, but instead, provides nontaxable services through the use of its VMS platform. In evaluating the tribunal determination, the appeals court referenced sample client agreements furnished by the taxpayer which included provisions stating that the taxpayer granted its clients a “limited, nonexclusive, nontransferable license to use and access the [taxpayer’s] VMS solutions”. Based on this language, and similar wording found on the taxpayer’s website, the appeals court found that the tribunal determination that the taxpayer had made retail sales of tangible personal property by selling a software license was supported by substantial evidence. The taxpayer also unsuccessfully argued that its VMS is not prewritten software because it is tailored to each client. The appeals court agreed with the tribunal, however, that this tailoring was purely aesthetic and did not require amendments to the VMS source code.

Finally, the taxpayer argued that New York law requires application of the primary function or true object test when the sale of tangible personal property is bundled with nontaxable services. While noting that New York typically applies the true object test to transactions which involve multiple services, the appeals court found that the tribunal engaged in the functional equivalent to the true object test by finding that the licenses sold by the taxpayer were not incidental to the services rendered. Instead, it found that the software was central to the taxpayer’s transactions, as it was the primary means for clients to request labor, select candidates, and bill for labor. The court also examined other subsidiary arguments, and on all counts, upheld the determination that the taxpayer’s sales of VMS licenses were taxable as a sale of tangible personal property. Please contact Judy Cheng or Jennifer White with questions on Beeline.com v. Tax Appeals Tribunal.

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As state legislative sessions begin to pick up the pace, several governors have used their budget proposals (or veto pen) to weigh in on conformity to the One Big, Beautiful Bill Act (OB3).

• Arizona: Governor Hobbs vetoed a bill that would update Arizona’s Internal Revenue Code (IRC) static conformity date to January 1, 2026 (effectively conforming to the entirety OB3). The Governor criticized the business provisions of OB3 as “tax breaks for special interests” and called for further negotiations over conformity in her veto message. The governor has proposed an alternative bill that would incorporate many of the individual income tax provisions of OB3 (including the enhanced deduction for seniors and deductions for tip and overtime income) but not the business provisions. Contact Alexander Townsend with questions about ongoing conformity developments in Arizona.
• Massachusetts: Governor Healey has proposed a bill that would temporarily delay conformity to many OB3 business provisions as a means of moderating the state budget impact. The bill would disallow the full expensing of domestic research and experimental (R&E) expenditures under IRC § 174A for the taxable year beginning in 2025, but allow such expensing beginning in tax year 2026. The bill would also postpone the implementation of the OB3 version of IRC § 168(n) (bonus depreciation for qualified production property), IRC § 179 (immediate expensing of certain property), and IRC § 163(j) (business interest expense limitation) until taxable years beginning in 2027. In addition, the bill would expand the pass-through entity tax (PTET) to include income subject to the 4 percent individual income surtax (i.e., income over $1 million) which was enacted after initial passage of the PTET in 2021. Currently, the PTET applies only to income subject to the 5 percent state income tax. Finally, the governor is proposing a measure that would delay adoption of future federal changes to which the state would automatically conform for one year if the estimated state revenue impact exceeds $20 million. Contact Nikhil Sequeira with questions about House Bill 4975.
• Maryland: Governor Moore’s budget proposal calls for conformity to several of the business provisions of OB3, including the full expensing of domestic R&E expenditures under IRC § 174A and the modified limitation on the deduction of business interest under IRC § 163(j). However, the proposal calls for decoupling from the special depreciation allowance for qualified production property under IRC § 168(n) and modifying depreciation allowances for capital investments for certain corporations. Contact Diana Smith with questions about continuing budget developments in Maryland.
• New York: Governor Hochul’s budget proposal calls for decoupling from the full of expensing of domestic R&E expenditures under IRC § 174A and the deduction for qualified production property under IRC § 168(n). She did propose, however, adopting the deduction of tip income by certain taxpayers. Contact Aaron Balken with questions about ongoing budget developments in New York.

In addition, the Pennsylvania Department of Revenue issued new guidance clarifying that, under the conformity bill passed in November, taxpayers will be required to add back deductions taken federally for foreign and domestic R&E expenditures, and then take a subtraction to deduct such R&E expenses at the rate of 20 percent per taxable year until the full amount of the original expense is deducted. The guidance explains that taxpayers electing for federal purposes to accelerate unamortized domestic R&E from tax years 2022 to 2024 cannot make this election for Pennsylvania purposes; they must instead amortize those expenses at the rate of 20 percent per year. As it relates to IRC § 168(n) (bonus depreciation for qualified production property), the Commonwealth will require an addback of amounts deducted for federal purposes, and then allow depreciation deductions for that property using the normal depreciation rules found in IRC §§ 167 and 168. The deduction of business interest expense under IRC § 163(j) remains tied to the IRC as of December 31, 2024 for Pennsylvania purposes. Contact Robert Weyman with questions about H.B. 416 (November bill) and the department guidance.

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In response to the federal phase-out of the penny, states are continuing to provide guidance for taxpayers on handling the application of sales tax to transactions that require rounding because of the inability to make exact change. We will continue to track these through TWIST, providing a list of the states as well as links to where you can find the direct guidance.

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