After the highly publicized administrative lease transaction and amusement tax expansions in Chicago last year, more cities around the country are taking steps to impose transaction taxes on the sale or rental of digital content. Unlike tax expansion efforts at the state level (such as the law recently passed in Pennsylvania), which have almost all been tackled legislatively, the local governments are addressing the issue without clear legislative authority by issuing administrative guidance and taking aggressive positions on audit. As the local tax threat facing digital providers turns from an isolated incident to a nationwide trend, we wanted to highlight some of the more significant local tax developments currently on our radar.
On Monday, October 17, the Illinois Appellate Court issued another taxpayer-friendly opinion in an Illinois False Claims Act case alleging a failure to collect and remit sales tax on internet and catalog sales to customers in Illinois (People ex. rel. Beeler, Schad & Diamond, P.C. v. Relax the Back Corp., 2016 IL App. (1st) 151580)). The opinion, partially overturned a Circuit Court trial verdict in favor of the Relator, Beeler, Schad & Diamond, PC (currently named Stephen B. Diamond, PC).
The Supreme Court of the United States has been asked to hear an appeal in a case involving the circumstances in which retroactive tax legislation will be constitutional.
In Dot Foods, Inc. v. State of Washington Department of Revenue, 372 P.3d 747 (Wash. 2016), the Washington State Supreme Court upheld legislation retroactively removing a corporate income tax exemption. Although the legislature, in justifying its action, said that the retroactive legislation was intended to reflect the legislature’s initial intent, the facts did not bear that out. The exemption was consciously adopted by the legislature and, indeed, upheld by the Washington Supreme Court when the Department of Revenue attacked Dot Foods’ use of it in an earlier case. Continue Reading
Another federal judge slams Delaware’s unclaimed property audit methodology but rejects the holder’s reliance on the priority rules as a defense to the audit demands. See Marathon Petroleum Corp. et al. v. Cook et al., No. 1:16-cv-00080-LPS (D. Del., Sept. 23, 2016). The court recognized the unjustness of Delaware’s audit approach, but followed a previous case finding the priority rules can only be raised by states with competing claims.
Moments ago, the United States House of Representatives (House) passed the Mobile Workforce State Income Tax Simplification Act of 2015 (H.R. 2315) Mobile Workforce State Income Tax Simplification Act of 2015 (H.R. 2315) by voice vote. The Act will now be delivered to the United States Senate (Senate) for introduction and referral to committee for consideration. While the Senate Committee on Finance has not advanced a companion bill (S. 386) introduced by Senators John Thune (R-SD) and Sherrod Brown (D-OH) in February 2015, the bill currently touts 45 co-sponsors.
The Mobile Workforce Act that passed today was introduced in May 2015 by Representatives Mike Bishop (R-MI) and Hank Johnson (D-GA). As highlighted in our prior coverage, the bill advanced out of the House Judiciary Committee in June 2015 by a vote 23-4. This legislation has been introduced in the House by each Congress since it was first introduced in 2006 by the 109th. While the legislation has seen some degree of success in the House, it has yet to advance beyond the Senate Committee on Finance. Notably, in May 2012, a prior version of the Act was passed in the House, but the Senate Committee on Finance did not take it up for consideration.
The Mobile Workforce Act
While the Mobile Workforce Act has been tweaked over the years, its underlying objective has largely remained the same—to providing a workable, national framework for the administration of, and compliance with, the states’ incongruent withholding and nonresident income tax payment laws. The version of the Act passed by the House today establishes a thirty-day safe harbor for traveling employees from nonresident state personal income taxes, and greatly reduces and simplifies the withholding and reporting burdens and related costs to their employers. Specifically, an employee working in a nonresident state for thirty or fewer days would not pay personal income tax to the nonresident state. Instead, the employee would remain fully taxable in its resident state on these earnings.
Under the Act, employers would not be required to withhold taxes in the nonresident state for employees whose travel falls at or below the thirty-day threshold in the state. In making this determination, the Act allows employers to rely on an employee’s annual determination of the time they will spend working in a state, absent fraud or collusion by the employee. The definition of “employee” has the same meaning given to it by the state in which the employment duties are performed, subject to only a few exceptions (including professional athletes, professional entertainers, and public figures who are persons of prominence who perform services for wages or other remuneration on a per-event basis).
As passed today, the “Act shall take effect on January 1 of the [second] year that begins after the date of the enactment of this Act” and retroactive application is expressly prohibited. Practically speaking, this means that the absolute earliest the Act could take effect is January 1, 2018 (assuming the Senate passes and President approves the Act this year), and would apply to tax obligations that accrue beginning then.
If recent history is any indication, the outlook in the Senate remains somewhat bleak. Looking at the glass half full, the Senate companion bill does enjoys 45 co-sponsors this time around—a figure that has been much less in the past. With elections and a lame-duck session right around the corner, it will be interesting to see if the Senate has an appetite to advance the Act this year.
The two other state tax bills advanced by the House Judiciary Committee last summer (i.e., the Digital Goods and Services Tax Fairness Act of 2015 and the Business Activity Tax Simplification Act of 2015) were not included on this week’s House suspension calendar for consideration.
More significantly in the eyes of many, the House Judiciary Committee has yet to formally consider one of the widely discussed online sales tax bills. This inaction comes amidst legislative and judicial turmoil as states continue to challenge the continued viability of the Quill physical presence standard.
The situation is only expected to get worse, as we understand several states are preparing to introduce South Dakota-style legislation (i.e., similar to S.B. 106) during their upcoming 2017 legislative sessions. As more states follow the lead of aggressive states likes South Dakota and Alabama, the desperation for a Congressional solution will continue to increase. While we applaud the passage of the Mobile Workforce Act, Congress continues to leave the most important issue on the table.
On August 30, 2016, following a one day bench trial, Cook County Circuit Judge Thomas Mulroy ruled in favor of Treasury Wine Estates (“TWE”) in Illinois False Claims Act (“Act”) litigation filed by the law firm of Stephen B. Diamond, PC (“Relator”). Relator alleged that TWE had violated the FCA by knowingly failing to collect and remit Illinois use tax on the shipping and handling charges associated with its internet sales of wine shipped to Illinois customers. State of Ill. ex rel. Stephen B. Diamond, P.C. v. Treasury Wine Estates Americas Company, d/b/a Treasury Wine Estates, No. 14 L 7563 (Cir. Ct. of Cook County, Ill. Aug. 30, 2016) (“Order”). The Court held that Relator failed to prove that TWE knowingly violated the FCA or that it acted in reckless disregard of any Illinois tax collection obligation.
The Court confirmed that an “extreme version of ordinary negligence” standard applies to prove that a defendant “knowingly” violated the FCA by acting in “reckless disregard” of an obligation to pay or transmit money to the State. The Order describes “[t]his standard … [as] meant to reach defendants who intentionally close their eyes, hide their heads in the proverbial sand, and do not make simple inquires which would inform them that false claims are being made.” Order at 14. The Court’s interpretation of the “reckless disregard” standard is consistent with the standard recently established by the Illinois Appellate Court in State of Illinois ex rel. Schad, Diamond & Shedden, P.C. v. National Business Furniture, LLC, 2016 IL App (1st) 150526, ¶ 39 (Aug. 1, 2016) and is very favorable for defendants defending against FCA claims. (“Significantly more than an error, mistake, or ordinary negligence is required … to demonstrate reckless disregard in the context of a False Claims Act violation. Relator … needed to prove that defendant ignored obvious warning signs, buried its head in the sand, and refused to learn information from which its duty to pay money to the State would have been obvious.”), aff’g, No. 12 L 84 (Cir. Ct. of Cook County, Ill. Oct. 23, 2014) (citations omitted).
Analyzing the evidence produced at trial, the Court held that it was reasonable for TWE to rely on third party tax consultants to prepare and file its Illinois tax returns, even though TWE did not review the returns before they were filed. The Order states:
Defendant relied on its consultants to do the job for which they were hired, to do the right thing and to be acquainted with Illinois sales tax law.Defendant relied on its preparers’ expertise, experience in the field and representations to ensure its ST-1 forms were accurate. Defendant was faced with the task of filing hundreds of tax returns in many states which have different and conflicting laws. Defendant did what a prudent business would do: it asked for help with navigating the murky waters of Illinois tax law and the challenging task of correctly preparing an Illinois sales tax return. Defendant did not intend to defraud Illinois; it intended to do what Illinois law required and sought expert help to do it. Defendant was not required to check the work of its consultants by seeking advice from other professionals. Defendant was prudent when it sought and paid for advice from companies experienced in its industry and experienced in state tax preparation work.
Order at 15.
The Court also held that the fact that TWE’s tax returns specifically disclosed that TWE was not collecting tax on its shipping charges further supported the conclusion that TWE did not knowingly violate the tax laws.
The Court rejected Relator’s argument that TWE and its advisors acted recklessly based on TWE’s participation in a voluntary disclosure application with respect to time periods prior to time periods at issue in this lawsuit, in which it paid tax on shipping charges. Evidence presented at trial established that the VDA payment was made for administrative convenience; no professional ever told Defendant that tax was due on shipping charges. Evidence was also presented that after the lawsuit was filed, the Department of Revenue advised both TWE and its third party consultant, in separate consultations, that tax was not owed on separately stated shipping charges.
Taxpayers who rely on qualified third party consultants for the preparation of their tax returns, particularly those who expressly disclose their filing practice on their returns, can take comfort from the Court’s conclusion that TWE did not violate the FCA.
The Diamond firm will have 30 days from the date of entry of the Circuit Court’s Order to either seek reconsideration or appeal from the trial court’s ruling.
Today, the Chairman of the House Judiciary Committee, Rep. Goodlatte from Virginia, released the long-anticipated discussion draft of the Online Sales Simplification Act of 2016. Highlights of the bill include:
- The bill implements the Chairman’s much-discussed ‘hybrid-origin’ approach.
- The bill removes the Quill physical presence requirements for sales tax collection obligations under certain circumstances.
- States may impose sales tax on remote sales IF the state is the origin state and it participates in a statutory clearinghouse AND the tax uses the origin state base and the destination state rate for participating states (the origin state rate is used if the destination state does not participate in the clearinghouse).
- A remote seller will only have to remit the tax to its origin state for all remote sales.
- A destination state may only have one statewide rate for remote sales.
- Only the origin state may audit a seller for remote sales.
- States that do not participate in the clearinghouse have significant restrictions on the ability to extract the tax from the remote seller.
Below is a more in-depth discussion of the intricacies of the bill.
The court case challenging Delaware’s unclaimed property audit methodologies has settled following an opinion brutalizing Delaware’s position. This settlement leaves the US District Court for the District of Delaware (District Court) holding as precedent, but the issue of what methods Delaware must jettison remains open.
Last Friday, Temple-Inland and Delaware filed a joint motion to dismiss with prejudice in the District Court after the parties agreed to settle the dispute. While the settlement agreement was not publicly disclosed, we understand that Delaware agreed to withdraw its entire assessment (totaling $2,128,834.13) and pay Temple-Inland’s attorneys’ fees and costs, including expert witness reports. The settlement avoids an affirmation by the US Court of Appeals for the Third Circuit that Delaware’s audit practices and estimation techniques collectively “shock the conscience,” but remains a significant holder victory given that the Temple-Inland District Court opinion, which is detailed in our prior blog, can now be cited as binding (and finally resolved) precedent by similarly situated holders under audit by the State. Continue Reading
On August 4, 2016, representatives of the Texas Comptroller of Public Accounts held a limited-invite roundtable to discuss the proposed amendments to 34 Tex. Admin. Code 3.584, relating to the reduced rate available under the Texas Franchise Tax for retailers and wholesalers. As previously reported, these proposed revisions were published in the Texas Register on May 20, 2016 and have the potential to double the tax rate for a substantial number of businesses – namely those in the information technology and pharmaceutical industries.
Members of the Comptroller’s office present included Karey Barton, Associate Deputy Comptroller for Tax, Theresa Bostick, Manager of Tax Policy, William Hammer, Special Counsel for Tax and Jennifer Burleson, Assistant General Counsel. Several representatives of businesses and trade groups, along with legal and accounting professionals, were also present.
Ms. Bostick opened the meeting by reiterating the language of the statute and the proposed regulation, and clarifying the application of the proposed regulation’s language. To briefly summarize, the proposed rule provides that a retailer is considered to produce the products it sells (and therefore may be disqualified from the lower Franchise Tax rate available for retailers) if it “acquires the product and makes modifications to the product that increase the sales price of the product by more than 10 percent.” See proposed Rule 3.584(b)(2)(C)(i). A business will also be considered a producer if it “manufactures, develops, or creates tangible personal property that is incorporated into, installed in, or becomes a component part of the product that it sells.” See proposed Rule 3.584(b)(2)(C)(ii). The proposed Rule offers two examples of businesses that will now be considered “producers” rather than retailers: (1) a business that produces a computer program, such as an application or operating system, that is installed in a device that is manufactured by a third party; and (2) a business that produces the active ingredient in a drug that is manufactured by an unrelated party. These proposals represent substantial changes to both the current version of Rule 3.584 and prior Comptroller interpretations of the retailer/producer distinction, and are not supported by the language of the statute that the Rule purports to interpret.
Ms. Bostick explained that the Comptroller had received several comments on the 10 percent rule (some of which were reiterated at the roundtable, including comments that the 10 percent rule should be interpreted as a safe harbor rather than a ceiling and that it should be applied to both modification and development), and that the Comptroller will consider how to define “modification” in the context of Rule 3.584(b)(2)(C)(i) (such language was not provided at the roundtable). She then focused on Rule 3.584(b)(2)(C)(ii) and the examples provided thereunder, explaining that these provisions are meant to convey that if a taxable entity produces (with “development” being equivalent to “production” in this context) tangible personal property that is incorporated into, installed in, or becomes a component part of a product it sells, that business is considered a producer of the product. Because the Comptroller’s representatives view software as being tangible personal property under Texas tax law (apparently for all purposes, despite its inconsistent treatment as tangible or intangible property under different parts of the Texas Tax Code), it is their continued position that businesses that both develop software and sell devices onto which the software is installed are producers of the devices, even if all physical manufacturing of the device is performed by an unrelated party. This stands in contrast to the Comptroller’s treatment of prototypes that do not contain software; a business may in fact develop a prototype and provide that prototype to a third party for manufacturing without being considered the producer of the resultant product.
The Comptroller’s office then heard several comments by roundtable attendees. In a noteworthy exchange, Patrick Reynolds of the Council on State Taxation (COST) pushed the Comptroller’s representatives on its apparently arbitrary inconsistent treatment of prototype development versus software development. Mr. Reynolds provided the example of a surfboard, the value of which is substantially increased by the addition of a patented rudder that is developed by the company selling the surfboard. Mr. Barton, Mr. Hamner and Ms. Bostick engaged in a question and answer exchange and all ultimately agreed that if the company develops the rudder, creates a prototype of the rudder, and provides that prototype to a third party contract manufacturer who then incorporates the rudder into the manufacture of the surfboard for sale by the company, the company will not be considered the producer of the surfboard. However, if the company developed a software application that could inform surfboard users of optimal surf conditions, that company would be considered the surfboard’s producer even if the process used to produce the surfboard was exactly the same (i.e., development of the software, creation of a software source code, provision of the software code to a third party manufacturer for incorporation into the surfboard manufactured by that third party) and even if the software increased the value of the surfboard by a miniscule amount (as compared to the substantial value increase resulting from the rudder). Mark Nebergall of the Software Finance and Tax Executives Council (SofTec) added that in this case, the party replicating the software—not the designer thereof—should be considered the producer; the Comptroller’s representatives predictably disagreed.
These arbitrary distinctions are not supported by Texas statute or good public policy. Another attendee, Sarah Matz of the Computing Technology Industry Association (CompTIA), pointed out that the Comptroller’s continued targeting of IT development can and will have a stifling effect on this important Texas industry. The Comptroller’s representatives did not respond to this point outright.
The Comptroller’s representatives have promised to consider the comments raised at the roundtable and circulate an update which will include any changes to the proposed regulation within thirty days.
Yesterday, Congressman Jim Sensenbrenner (R-WI) introduced the No Regulation Without Representation Act of 2016 (H.R. 5893) in the US House of Representatives (House). The bill would codify the physical presence requirement established by the US Supreme Court in Quill. The bill would specifically define physical presence, creating a de minimis threshold, and would significantly affect existing state efforts to expand the definition of physical presence and overturn Quill.
Not only would the bill preempt the ‘nexus expansion’ laws, such as click-through nexus provisions, affiliate nexus provisions, reporting requirements and marketplace collection bills, but it would likely halt the South Dakota and Alabama (and other state litigation) specifically designed to overturn Quill. It would also move all future litigation on this issue to federal courts.
The bill would be effective as of January 1, 2017. The bill was referred to the House Committee on the Judiciary, which Rep. Sensenbrenner is a sitting member of (and former Chairman).
The bill defines “seller”, and provides that states and localities may not: (1) obligate a person to collect a sales, use or similar tax; (2) obligate a person to report sales; (3) assess a tax on a person; or (4) treat the person as doing business in a state or locality for purposes of such tax unless the person has a physical presence in the jurisdiction during the calendar quarter that the obligation or assessment is imposed.
Persons have a physical presence only if during the calendar year the person: (1) owns or leases real or tangible personal property in the state; (2) has one or more employees, agents or independent contractors in the state specifically soliciting product or service orders from customers in the state or providing design, installation or repair services there; or (3) maintains an office in-state with three or more employees for any purpose.