TWIST - This Week in State Tax

As part of a comprehensive bill designed to prevent minors from being exposed to and becoming addicted to pornography, Alabama House Bill 164 imposes an additional tax on the gross receipts of businesses selling material harmful to minors. Specifically, a new 10 percent tax is imposed on the gross receipts of any commercial entity operating an adult website for all sales, distributions, memberships, subscriptions, performances, and all other content amounting to material harmful to minors that is produced, sold, filmed, generated, or otherwise based in Alabama. An “adult website” is a website, application, or digital or virtual platform that uses the Internet to facilitate the dissemination of pictures, videos, or other content, a substantial portion of which is sexual material harmful to minors. The term “harmful to minors” is defined with reference to the criminal code and means that (1) the average person, applying contemporary community standards, would find that the material, taken as a whole, appeals to the prurient interest of minors;  and (2) the material depicts or describes sexual conduct, breast nudity or genital nudity, in a way which is patently offensive to prevailing standards in the adult community with respect to what is suitable for minors, and (3) a reasonable person would find that the material, taken as a whole, lacks serious literary, artistic, political or scientific value for minors.

Effective September 1, 2025, the additional tax will be collected by the Alabama Department of Revenue at the same time and in the same manner as state sales and use taxes are collected. Revenue generated from the tax will be spent for the care and treatment of individuals with behavioral health needs, including prevention, treatment, and recovery services and supports. Please contact Sarah McGahan with questions on Alabama House Bill 164. 

Netflix and the Colorado Department of Revenue have had a long-running dispute over whether Netflix’s streaming service falls within the definition of “tangible personal property” for state sales tax purposes. In May 2020, the Department sought to address this issue by proposing an amendment to a rule that clarified that sales tax applied to tangible personal property regardless of the “method of delivery,” and included an example providing that streaming service subscriptions are subject to tax. The proposed rule became effective in 2021. Later that year, the Colorado legislature enacted a Digital Goods Law that purported to codify the Department’s treatment of digital goods, as reflected in its rule. The Digital Goods Law stated that “tangible personal property” included “digital goods,” which is defined as “any item of tangible personal property that is delivered or stored by digital means,” and that “the method of delivery does not impact the taxability of a sale of tangible personal property.”

Following enactment of the Digital Goods Law, Netflix periodically remitted sales tax to Colorado for sales of its streaming service, but later submitted a refund claim for the tax that was remitted, which the Department denied. Netflix appealed the denial of its refund claim to the Colorado district court, and as part of that action filed a motion for summary judgment.

Netflix made three arguments. First, it asserted that the streaming service was not a physical object, and therefore was not subject to tax as tangible personal property; second, that the terms of use with its subscribers did not grant anything that could be construed as tangible personal property; and third, because its streaming service was billed monthly, it did not constitute a “sale.” The court agreed with Netflix that its streaming service was not a sale of tangible personal property, so the court did not address the last two arguments.

As part of its analysis, the court noted that Colorado’s sales tax law was originally enacted in 1935 and imposed sales tax on tangible personal property.  The law defines “tangible personal property” as “corporeal personal property,” and to find a definition of “corporeal personal property” that was contemporaneous with enactment of the Colorado tax, both parties turned to the 1933 edition of Black’s Law Dictionary. There, the term “corporeal property” was defined as “such as affects the senses, and may be seen and handled, as opposed to incorporeal property, which cannot be seen or handled, and exists only in contemplation.” (Emphasis added). The notes to the definition also provided that “in modern law, all things which may be perceived by any of the bodily senses are termed corporeal, although a common definition of the word includes merely that which can be touched and seen.” In reviewing this definition and other contemporaneous regulations, the court stated that it found “little evidence to support the Department’s argument that the clear import of the 1935 tax code was to tax items that have no physical body and cannot be touched.”

The court also rejected the Department hearing officer’s reliance on State v. Jones, an Arizona Supreme Court case from 1943 that has recently been cited by the Arizona Court of Appeals in finding that a SaaS application constituted the sale of tangible personal property subject to transaction privilege tax. The Jones case involved a taxpayer’s revenues earned from jukeboxes, and the Arizona Supreme Court held that the “playing of a record is perceptible to the sense of hearing, and hence, constitutes what the statute terms tangible personal property.” The Colorado court found that the Jones case was of limited value, however, because the definition of “tangible personal property” in the Arizona statute was broader than the Colorado statute, and included “property which may be seen, weighed, measured, felt, touched, or is in any other manner perceptible to the senses.”

The court reviewed several other court cases cited by the Department but found them unpersuasive. The court also considered the state’s taxation of electricity and telecommunications but noted that these items are taxable under separate provisions of the tax code rather than as sales of “tangible personal property.” Finally, the court noted that software in Colorado is taxable only if a purchaser obtains possession of the software via a tangible medium, such as a CD, and that software hosted over the internet is not subject to tax.

In conclusion, the court held that it could not find that in 1935 the Colorado legislature intended to tax something “as ephemeral” as streaming services, and that its use of the term “corporeal” to define “tangible personal property” instead showed that the legislature intended to limit the scope of taxation to items that could be seen and touched. Because the Netflix streaming service can be seen, but is not capable of being touched, the court held that it was not subject to tax. For questions on Netflix v. Department of Revenue, please contact Steve Metz.

Two states recently addressed the taxability of certain types of entertainment. In Watertoys, LLC. v. South Carolina, the Administrative Law Court was asked to resolve a dispute between a taxpayer and the Department of Revenue over the taxability of the taxpayer’s parasailing rides. Under South Carolina law, an admissions tax is imposed on amounts paid to enter places of amusement. The parties agreed that parasailing was an amusement- the dispute was over whether a statutory exemption for admissions to boats which charge a fee for pleasure fishing, excursions, sightseeing, and private charter applied. The taxpayer argued that parasailing fell within the language of the exemption as an “excursion, sight-seeing or private charter.” In an earlier Revenue Ruling, the Department had reiterated that “fees for boat, carriage, helicopter, plane or bus rides for touring, charter, fishing, or excursion” are not subject to admissions taxes. However, in that same Revenue Ruling, the Department stated that “para sail rides” are subject to admissions taxes. The court concluded that the statutory language was ambiguous as to whether parasailing is an “excursion, sight-seeing and private charter.”  Further, the issue involved whether a tax exemption applied and therefore the statutes were to be construed strictly against the claimed exemption. The court concluded that because the language of the exemption statute did not specifically include parasailing and the Department’s long-standing published statement was entitled to deference, the parasailing rides were subject to admissions tax as a matter of law.

In Arkansas, Legal Counsel Opinion No. 20211202 was issued addressing whether sightseeing tours provided by aircraft were subject to sales tax. The taxpayer, noting that federal law prohibits the imposition of sales tax on the transportation of a passenger traveling in air commerce, asked whether it should stop charging sales tax. The Department noted that the prohibition did not apply when, as in the instant case, the flight took off and landed in the same state. As such, the Legal Counsel concluded that the taxpayer’s sightseeing flights were subject to sales tax. These rulings highlight the nuances involved when analyzing the taxability of amusements, admissions, and activities. Please contact Sarah McGahan with questions. 

On Thursday April 25, 2024, the Tennessee House and Senate adopted the Conference Committee Report on House Bill No. 1893 / Senate Bill No. 2103, which revises the state’s franchise tax structure and, more importantly, authorizes refunds for taxpayers that paid franchise tax on the value of their real and tangible personal property owned or used in Tennessee. Governor Bill Lee is expected to sign the legislation. Additional details on the changes and the process for filing refunds are below.

Background: Historically, the Tennessee franchise tax was imposed on the greater of apportioned net worth, or the actual value of real and tangible personal property owned or used in Tennessee. Due to pending lawsuits in Tennessee over the constitutionality of the property measure, it was recommended that the property measure be repealed, and refunds be issued to taxpayers. The Governor’s proposed budget earmarked approximately $1.5 billion for refunds. As the session progressed, the House and Senate disagreed on key details related to payment of the refunds. A conference committee was convened to work out the differences with just days left before the Legislature was to adjourn.

Conference Committee Report: Effective for tax years ending on or after January 1, 2024, Tenn. Code Ann. section 67-4-2108, which sets forth the alternative franchise tax measure based on real and tangible personal property, is repealed.  A new section of law sets forth the process for granting refunds to taxpayers that previously paid on the property measure. Specifically, the Commissioner is required to issue refunds in the amount of franchise tax actually paid minus the tax that would have otherwise been due under the net worth base. “Tax actually paid” includes any credits applied on the return, which will be reinstated but not refunded. 

Franchise tax refunds will be paid for taxes reported to the Department on returns filed on or after January 1, 2021 covering tax periods that ended on or after March 31, 2020. In general, refunds will be available for a three-year period. Importantly, claims for refund under the new legislation must be filed between May 15, 2024 and November 30, 2024. Upon acceptance of a refund, taxpayers must agree to waive the right to file a lawsuit alleging that the franchise tax is unconstitutional because it fails the internal consistency test.  Further, any lawsuits filed alleging that the franchise tax fails the internal consistency test must be filed on or before November 30, 2024.

During the negotiations, the House was adamant that the names of taxpayers that are ultimately issued refunds be publicly disclosed. As a result, the final legislation requires that, during the period from May 31, 2025 and June 30, 2025, the Department must publish the names of each taxpayer issued a refund and the dollar range of the refund on its website. The applicable ranges are: $750 or less; more than $750 but less than or equal to $10,000; and more than $10,000. Attorneys’ fees will not be added to the refund amount. All refunds are required to be paid through a fund established by the Commissioner of Finance and Administration. The section of the Act governing refunds takes effect upon enactment.

Contacts and Next Steps: The Department of Revenue will be issuing further guidance on the procedures for filing refund claims and the timing of when refunds will be processed. Further, the conference committee report requires the Office of the Attorney General to review and approve the Department's process for reviewing refund claims before the Department will be able to review and approve such claims. Because the repeal of the alternative franchise tax measure based on real and tangible personal property was repealed retroactively to January 1, 2024, taxpayers should take that into account when determining their estimated tax payments for 2024. Please contact John Harper or Taylor Sorrells with questions.

The Virginia Department of Taxation recently issued two policy documents (P.D. 24-18 and P.D. 24-26) addressing the state’s related party expense disallowance rules. Both rulings discussed the application of the “subject-to-tax” exception taking into account the litigation in the Kohl’s case.  In both rulings, the Department of Taxation, on audit, reduced the claimed exception amount on the basis that the exception should be limited to the portion of the intangible expense payments that correspond to the portion of the taxpayers’ affiliates' income subjected to tax in other states. The taxpayers contended that the plain language of the statute entitled them to exclude 100 percent of the royalties because all the royalty income was included in the affiliates’ taxable income in another state. The Department disagreed and reminded the taxpayers that in the Kohl’s case, the Virginia Supreme Court held that the subject-to-tax exception applies to the portion of royalties actually taxed by another state. In other words, the exception is calculated based on post-apportionment income, rather than pre-apportionment income. The Kohl’s court also held that at the “statute only requires that the ‘item of income received by the related member’ . . . be taxed by another state. It does not require that the related member be the entity that pays the tax on that ‘item of income.” Further, in a subsequent court case also involving Kohl’s, the Department of Taxation successfully argued that the subject-to-tax exception does not apply when royalty payments are eliminated as intercompany transactions in combined or consolidated reporting states. P.D. 24-26 also addressed the impact of New Jersey's "throw-out" rule on the calculation of the addback exception. The Department determined that when a state has a "throwout" or "throwback" rule, the amount of income eligible for the subject-to-tax exception must include all intercompany intangible income taxed in the state, including any additional income apportioned to, and taxed by, such state by operation of the throwout or throwback rule.

P.D. 24-18 also addressed a second important issue—whether certain types of expenses – merchandise buyer service fees and systems license fees – were subject to addback. Pursuant to Virginia Code § 58.1-302, five categories of expenses qualify as intangible expenses and costs. The first category ties the expense to the definition of “intangible property.”  The fourth category specifically lists licensing fees without regard to whether the fee is paid for intangible property. The Department concluded that the merchandise buyer fees were not a type of expense that was captured by the addback statute. However, the license fee, which was calculated based on a percentage of the taxpayer’s sales, was paid to an affiliate for the use of certain trade secrets and other intangible property, including unique computer software application systems. In addition to use of the software, the taxpayer asserted that the fees were also paid for the service of maintaining and operating the systems. The Department disagreed, noting that a sample license agreement provided by the taxpayer stated that the affiliates employees developed and maintained the software. Further, the licensing fee structure was similar to those normally associated with intellectual assets specifically identified under the definition of intangible property under Virginia Code § 58.1-302. The Department concluded that the systems license fee expenses were subject to addback and would be eligible for the subject-to-tax exception. Please contact Diana Smith with questions.