TWIST - This Week in State Tax

California: Factors Related to Deductible Income Cannot be Excluded from Apportionment Formula

The California Office of Tax Appeals or OTA recently addressed whether property, payroll and sales associated with deductible income are excluded from the apportionment formula.  The taxpayer, an agricultural cooperative corporation headquartered in Minnesota, manufactured sugar, and sugar by products from beets grown by its farmer members. The taxpayer owned a for-profit sugar manufacturer the acquisition of which was funded with third-party debt. The two entities were engaged in a unitary business and filed a combined California return. In computing its separate net income (the first step in determining the combined group’s California liability), the taxpayer deducted member income under R&TC section 24404, as well as interest expense on debt used to acquire the sugar subsidiary, and depreciation expense related to assets that were used to produce deductible member income.  On audit, the FTB excluded all the taxpayer’s property, payroll, and sales attributable to its deductible member income on the basis that only activities giving rise to net business income were included in the apportionment formula.  The FTB also disallowed the taxpayer’s interest and depreciation deductions that were related to deductible member income.  The taxpayer protested and the matter eventually came before the OTA.

Under California law, agricultural cooperatives are permitted to deduct all income (1) resulting from or arising out of business activities for or with their members and (2) from activities done on a nonprofit basis for or with nonmembers. The issue before the OTA was whether property, payroll, and sales associated with deductible member income were includible in the taxpayer’s apportionment formula. The OTA concluded that there was no language in UDITPA or in California’s statutes or regulations supporting the FTB’s assertions that activities related to deductible income should be excluded from the apportionment formula. Further, the OTA declined the FTB’s request to defer to Legal Ruling 2006-01, in which it concluded that activities related to income that is partially or completely excluded from the measure of tax should be excluded from both the numerator and denominator of the property, payroll, and sales factors. The OTA distinguished the situations addressed in Legal Ruling 2006-01, including one addressing the FTB’s position that when 75 percent of a foreign dividend is excluded from the tax base only 25 percent of the dividend is includible in the U.S. dividend recipient’s sales factor denominator. In the OTA’s view, cooperative member income “deducted” under R&TC section 24404 should not be equated with income that has been “exempted,” “excluded,” or “not recognized,” as such items generally do not enter into gross income to begin with and are not included in net income.  The OTA next addressed and sustained the FTB’s denial of the interest and depreciation deductions against the taxpayer’s nonmember income. This decision is “pending precedential.”   Please contact Oksana Jaffe with questions on Appeal of Southern Minnesota Beet Sugar Cooperative.

Michigan: Treasury Issues New RAB on Taxability of Software and Digital Goods

The Michigan Department of Treasury recently issued a comprehensive Revenue Administrative Bulletin (RAB 2023-10) addressing the taxation of computer software, computer software service contracts, and digital goods. The new RAB replaces RAB 1999-5 and is retroactive to all tax periods open under the statute of limitations. Generally, prewritten computer software is subject to Michigan sales or use tax as a sale or use of tangible personal property. The RAB notes that although some products can be easily identified as prewritten computer software, other types of products (particularly those characterized as cloud computing) often require a fact-intensive review of the product and how that product is delivered to the consumer to determine whether it qualifies as “prewritten computer software.”  Characterizations such as IaaS, PaaS, and SaaS are not dispositive as to the taxation of a product; the product will need to be evaluated under applicable statutory provisions and legal principles developed from Michigan case law. The RAB sets forth an analysis that the Department of Treasury will follow when examining software delivery models to determine whether computer software will be taxable. Notably, the Department will examine whether there is some delivery of the software in Michigan and, if so, will apply the incidental to services test to determine whether the transaction is taxable. The RAB also addresses the taxation of digital goods, including NFTs, and micro-transactions, which are commonly referred to as “in app” or “in-game” purchases. Generally, to the extent that an item or product constitutes a “digital good” that does not fall within the definition of “prewritten computer software,” it is not subject to sales tax or use tax regardless of whether it is downloaded, streamed, or accessed through a subscription service. However, there are products that may appear to be “digital goods” but actually constitute taxable “prewritten computer software.”  These products include certain applications and video games downloaded or otherwise installed onto electronic devices such as smartphones, tablets, and game consoles.    The RAB provides numerous examples of taxable and nontaxable transactions. Please contact Ryan Hohenthaner with questions on RAB 2023-10.

Michigan: Alternative Apportionment Denied and Use of Statutory Apportionment Formula was Constitutional

Recently, the Michigan Supreme Court issued a decision in seemingly never-ending litigation addressing whether and how amounts from the sale of a business should be included in the Michigan sales factor.  This case has a long and complicated procedural history. The taxpayer, an S-corporation headquartered in Minnesota, was engaged in the business of constructing, maintaining, and repairing oil and gas pipelines.  The taxpayer operated in 24 states, including periodically in Michigan, but never maintained a permanent business location or retained permanent employees in Michigan, which had historically resulted in relatively low Michigan sales.  In the same year in which the taxpayer was cleaning up a catastrophic oil spill in Michigan (resulting in a significant increase in the taxpayer’s Michigan sales), the taxpayer’s shareholders sold all of their stock and elected under IRC § 338(h)(10) to treat the sale of stock as the taxpayer’s sale of all of its assets.  In computing its now-repealed Michigan Business Tax (MBT) liability on a short year return for the year of the sale, the taxpayer included the sale in its business income tax base; it also included the sale proceeds in the denominator of its sales factor. The proceeds were not included in the Michigan sales factor numerator.  On audit, the Michigan Department of Treasury determined that the sale was not includable in the sales factor denominator under Michigan’s statutory definition of “sales.” This resulted in increasing the taxpayer’s apportionment from about 15 percent to almost 70 percent because of its large project in Michigan during the tax year of the sale.

The taxpayer subsequently filed a complaint with the Court of Claims on multiple grounds, including arguing that it was entitled to use an alternative apportionment formula because to include the sale as business income while also excluding the asset sale from the sales factor would disproportionally attribute long-term gain to Michigan. The taxpayer also alleged that excluding the sale violated the Commerce and Due Process Clauses. The Court of Claims originally analyzed and decided the issue in favor of the Department. However, the appeals court reversed, holding that applying the statutory formula violated the Commerce Clause and an alternative should be applied. The Michigan Supreme Court vacated the Court of Appeals decision and remanded the matter back to the appeals court to determine the proper method of calculating MBT liability under the statutory apportionment formula. The Court of Appeals then remanded the matter to the Court of Claims, which ruled in Treasury’s favor holding that that the sale of the taxpayer’s business was not includable in the sales factor under the narrow statutory definition of a “sale.” An appeal was filed, and the Court of Appeals agreed with the lower court that the amount was not included in the sales factor under the statutory definitions. However, the appeals court again held that the application of the statutory formula violated the constitution, and an alternative formula should be applied. The matter then went back up to the Michigan Supreme Court.

On appeal, the court considered two questions: (1) whether income from the sale should be included in the tax base; and (2) whether application of the statutory formula (excluding the sale from the sales factor denominator) would result in tax that was disproportionate to the taxpayer’s business activities in Michigan.

The majority held that income from the sale was properly included in the apportionable tax base because the taxpayer was a member of a unitary business with Michigan nexus, the gain from the sale of all the taxpayer’s assets was business income as defined in the statute, and the income was not unrelated to business activities in Michigan (which the majority identified as the relevant constitutional standard.) The majority also responded to an argument by the dissent that income from the sale could not be taxed in Michigan because it was attributable to assets held primarily outside of Michigan and goodwill accumulated primarily outside of Michigan; in the majority’s view, although these assets had been historically used primarily outside of Michigan, there was no reason to believe that they would not be used in Michigan in the future.

The majority next addressed the taxpayer’s argument that the application of the statutory apportionment formula, which excluded the sale from the sales factor denominator, resulted in attributing income to Michigan that was all out of proportion to the business transacted in the state. The taxpayer’s argument appeared to focus on the fact that historically, it had significantly less Michigan activity. The court rejected the taxpayer’s position and determined that the application of the statutory apportionment formula was constitutional under the Commerce Clause as applied to the taxpayer. The formula was internally consistent because application of the same rules by all states would result in tax on no more than 100 percent of the taxpayer’s income. The majority also held that the formula was externally consistent. The taxpayer had not shown “by clear and cogent evidence” that the application of the statutory formula resulted in taxation of income that was out of all proportion to the taxpayer’s business transacted in the state. In reaching this decision, the court pointed out that three-factor and single-factor methods often result in radically different apportionment ratios, and that states are nonetheless permitted to choose between them. It further observed that the statutory formula resulted in an outcome that accurately reflected the taxpayer’s business activities within Michigan and that Michigan had no obligation to consider historical tax information when determining liability in the current year.

It is not known at this time whether the taxpayer will file a motion for reconsideration or rehearing with the Michigan Supreme Court or will seek an appeal to the U.S. Supreme Court. For questions on Vectren Infrastructure Services Corp (Vectron II) please contact Dan De Jong.

New Hampshire: Legislation Decouples from Federal Interest Expense Limitations

On July 28, 2023, Senate Bill 189, which decouples from the business interest expense limitation under IRC section 163(j), was signed into law. Specifically, effective for tax years beginning on or after January 1, 2024, a deduction will be allowed for any interest expense disallowed under IRC section 163(j). Conversely, an addition will be required for an IRC section 163(j) carryforward generated in tax years commencing after January 1, 2024. Any carryforward of disallowed business interest under IRC section 163(j) as of the tax year ending before January 1, 2024 can be deducted in three equal parts over three consecutive years, beginning with the first tax year commencing on or after January 1, 2024. Please contact Jennifer Bates with questions on New Hampshire Senate Bill 189.

Ohio: Fracking Equipment Qualifies for Oil and Gas Production Exemption

The Ohio Supreme Court recently issued its first decision addressing the expanded sales and use tax exemption for oil and gas production. The case focused on whether certain pieces of equipment used in fracking were exempt from sales and use tax. To qualify for the exemption, the purchaser’s purpose must be “to use or consume the thing transferred directly” in the production of crude oil and natural gas for sale. In the midst of the dispute, a retroactive amendment to the statue adopted a non-exhaustive list of items that qualified as “things transferred” and things that did not qualify as “things transferred.” Applying the revised law, the BTA determined that the items at issue were not “things transferred” because certain pieces of equipment were used for storage and another item was a motor vehicle. The taxpayer appealed.

Under the revised statute, tangible personal property used in hydraulic fracking was a “thing transferred,” but property used for storage or delivery purposes generally was not. In this instance, each piece of equipment served multiple purposes and potentially implicated both the thing-transferred and the not-a-thing-transferred categories. Importantly, all of the equipment was undoubtedly used in hydraulic fracturing but also had a storage or delivery function. The court reviewed each of the BTA’s determinations and concluded that almost all of the equipment was a “thing transferred” because it was directly used in hydraulic fracking, even if it had an ancillary purpose (e.g., storage).  The exception was the taxpayer’s data van; a “thing transferred” specifically excluded motor vehicles. The court next addressed the Commissioner’s argument that even if the items were “things transferred” they were not used to send material directly into the well and therefore did not qualify for the exemption. The court rejected the Commissioner’s narrow interpretation of the amended statute and noted that under his reading of the new statute, the only impact of the statutory amendment would be to restrict the items that qualified as tax exempt.  The court was not “inclined to believe that the legislature chose to engage in such a pointless exercise.”

In an important sidenote, the court explicitly repudiated the traditional rule that statutes granting tax exemptions must be strictly construed against the taxpayer. In its view, this rule was an impermissible exercise of tax policymaking on the part of the judiciary, and that tax statutes should instead be construed using the same methods of construction used for any other statute. Please contact Dave Perry with questions on Stingray Pressure Pumping LLC v. Harris.