TWIST - This Week in State Tax

Welcome to TWIST for the week of July 25th, featuring Sarah McGahan from the Washington National Tax State and Local Tax practice.

In a recent ruling, the Tennessee Department of Revenue addressed the taxability of certain fees charged by a delivery network company that had elected to collect sales and use tax as a marketplace facilitator. The marketplace charged the fees to third party sellers and service providers for the service of connecting these entities with purchasers and for processing payments. Both the sellers and service providers were also provided access to the marketplace’s web-based interface and app, which enabled them to list products and obtain leads, among other things. The Department concluded that neither fee was subject to sales and use tax because the marketplace’s nontaxable lead generation and payment processing services were the true object of the transactions at issue, not the access to the web-based interface or app.

In a lengthy decision, an ALJ for the New York Division of Tax Appeals addressed whether a taxpayer could remove deferred IRC section 311(b) gain from its New York combined returns for the tax years at issue and whether the taxpayer was entitled to a bad debt deduction.  Holding for the Division, the ALJ first determined that the taxpayer was required to use the same accounting method for New York purposes as it did for federal purposes and therefore the deferred section 311(b) gain was properly reported on the taxpayer’s New York combined report for the years at issue. With respect whether the federal bad debt deduction was allowed for New York purposes, the ALJ ruled in the taxpayer’s favor. Because the IRS had audited the specific bad debt deduction for federal purposes and approved of the relevant entity taking the deduction, the ALJ concluded that the taxpayer had met its burden of proof that it was entitled to the deduction. 

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New York: ALJ Addresses Deferral of IRC §311(b) Gain, Bad Debt Deductions

In a lengthy decision, an Administrative Law Judge (ALJ) for the New York Division of Tax Appeals addressed whether a taxpayer could remove IRC section 311(b) gain from its New York combined returns and whether the taxpayer was entitled to take a bad debt deduction. The taxpayer, a fashion specialty retailer engaged in business in multiple states, filed combined New York returns for the tax years at issue. For federal purposes, the taxpayer filed consolidated returns.  The first issue before the ALJ was whether the Division erred when it denied the taxpayer’s request to remove deferred IRC section 311(b) gain from its New York returns for relevant tax years. For federal purposes, because the parties involved in the transaction that gave rise to the gain were included in the same federal consolidated group, the section 311(b) gain was deferred over a 15-year period. Had the parties not been included in the same federal consolidated group, the entire gain would have been reported in the year of the transaction (1999). The taxpayer initially included 1/15th of the gain on its New York state returns for the tax periods at issue. Later, the taxpayer argued that the gain should be eliminated from the computation of entire net income.  The taxpayer’s position centered around New York regulations that require a member of a New York combined group to compute federal taxable income “as if” each member of the group had filed its federal income tax returns on a separate basis. The taxpayer argued that if it had filed its federal returns on a separate basis, the entire gain from the intercompany transaction would have been reported in 1999, which was a year when the entity required to report the gain was not a New York taxpayer.  The ALJ observed that the “as if separate” language must be read in conjunction with all the provisions of Article 9-A and the applicable regulations. The Division’s regulations stated that generally the method of accounting used in computing federal taxable income will be used in computing entire net income, unless the Commissioner determines that a different method should be used to properly reflect entire net income. The inclusion of the deferred income in the New York returns over fifteen years was consistent with the taxpayer’s federal method of accounting, and the ALJ concluded that the Division did not err when it held that the income was correctly included in computing entire net income. The Division had also argued that the taxpayer was required to report the gain consistent with how it was reported in closing agreements related to prior audits (i.e., over 15 years) and that the taxpayer had made a material misrepresentation of fact in those prior closing agreements when it agreed to the deferred reporting. The ALJ noted that the earlier closing agreements do not extend to other tax periods and that the taxpayer’s later revising its legal argument around the reporting of the gain was not a material misrepresentation of fact.

The ALJ next addressed whether the Division properly disallowed the taxpayer’s federal bad debt deduction for the tax years at issue. The Division did not challenge the amount of the deduction; instead, it asserted that the deduction should have been claimed by an entity not included in the New York combined group. However, the IRS had audited the specific bad debt deduction for federal purposes and approved of the relevant entity taking the deduction.  The ALJ concluded that by virtue of the federal audit, the taxpayer had met its burden of proof that it was entitled to the deduction. In fact, in the ALJ’s view, the taxpayer also met its burden of proof on the bad deduction issue even if the federal audit was disregarded.   Please contact Russ Levitt at 212-872-6717 with questions on Matter of Nordstrom’s Inc. and Combined Affiliates.

Tennessee: Fees Charged by a Marketplace not Subject to Sales and Use Tax

In Revenue Ruling 22-02, the Tennessee Department of Revenue addressed the taxability of certain fees charged by a delivery network company that had elected to collect sales and use tax as a marketplace facilitator. The fees at issue were referred to as selling fees and service fees. The selling fees were charged by the marketplace to third party sellers for the service of connecting the sellers to purchasers and for processing the payment for the purchase of the seller’s items. The fee, which was charged only if a purchaser bought an item from the seller, was computed based on a percentage of the payments made by purchasers to sellers. Similar service fees were charged to service providers for the service of connecting them with a purchaser seeking delivery of items purchased from sellers and processing payment for a delivery service. It is important to note that this ruling did not address fees that might be charged to purchasers of products over the marketplace. Both sellers and service providers were provided access to the marketplace’s web-based interface and app, which enabled them to list products and obtain leads, among other things. Access to the web interface and app was not offered as a separate product, and no separate fee was charged for this access. Rather than billing the sellers and service providers separately for these fees, the marketplace simply retained the fees from the amount collected from the purchasers before a net amount was paid over to the sellers and service providers. The marketplace requested a ruling as to whether these fees were subject to sales and use tax.

Under Tennessee law, the true object test applies to determine if a transaction involving both taxable and non-taxable components is taxable. If the true object of the transaction is subject to sales tax, the entire transaction is subject to sales tax. The Department concluded that neither fee was subject to sales and use tax because the marketplace’s lead generation and payment processing services, which were nontaxable services under Tennessee law, were the true object of the transactions at issue.  Although access to the taxable web-based interface and app was subject to Tennessee sales and use tax as remotely accessed software, in the Department’s view, the software merely facilitated lead generation and payment processing. Without connecting to purchasers who pay for items and have them delivered, the software would be of little to no use to the sellers and service providers. The limited functionality of the software supported the notion that the software was a merely incidental mechanism for delivering lead generation and payment processing services. Please contact Justin Stringfield with questions on Revenue Ruling 22-02.