BREAKING NEWS: Discussion Draft of Online Sales Simplification Act of 2016 Released

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.

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Settlement Reached in Temple-Inland; Delaware Internally Reviewing Unclaimed Property Audit Practices

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

Texas Comptroller’s Office Holds Roundtable on Proposed Regulation Targeting IT, Pharmaceutical Industries

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.

Breaking News: Physical Presence Requirement Bill Introduced in Congress

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).

Summary

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.

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Pennsylvania General Assembly Passes Revenue Package with Significant Digital Tax Expansion

Yesterday, a legislative conference committee was appointed to approve an already agreed-upon $1.3 billion revenue package, which was immediately approved by both the House (116-75) and Senate (28-22) and sent to Governor Wolf for approval.  The governor subsequently issued a press release confirming that he “will sign this revenue package.”  A copy of the conference committee report (in full) that passed is available here.

The final revenue package includes (among a host of other revenue raising changes) a new tax on digital content and services, as described in more detail below.  Specifically, the expansion captures most (if not all) digital goods within the sales and use tax imposition by defining them as tangible personal property.  A number of digital services are also captured in the broadly defined language.  Continue Reading

Breaking News: Federal Court Finds Delaware’s Unclaimed Property Enforcement “Shocks the Conscience”

On June 28, 2016, the much-anticipated memorandum opinion of the US District Court for the District of Delaware in Temple-Inland, Inc. v. Cook et al., No. 14-654-GMS was released on the parties’ cross-motions for summary judgment, finding Delaware’s extrapolation methodology and audit techniques collectively violate substantive due process.  According to Judge Gregory M. Sleet, “[t]o put the matter gently, [Delaware has] engaged in a game of ‘gotcha’ that shocks the conscience.”  The opinion also specifically called third-party auditor Kelmar Associates LLC’s formula used for estimation into question, noting that the use of a holder’s calendar sales as the denominator in the ratio used to estimate liability raises questions given the lack of connection between abandoned property and the economy.  In sum, this opinion is a “must read” for any unclaimed property advisor or holder going through a Delaware audit and is likely to have a drastic impact on both on-going and future unclaimed property audits.  Holders should contact their unclaimed property advisors immediately to begin discussing how to proceed based on this groundbreaking development.

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Breaking News: Tennessee Submits Proposed Economic Nexus Regulation for Publication

Earlier today, the Tennessee Department of Revenue (DOR) submitted a new sales and use tax regulation for publication titled “Out-of-State Dealers” (Rule 1320-06-01-.129) that would administratively create an economic nexus threshold. With the submission, Tennessee becomes the most recent addition to the growing list of states seeking to directly attack the Quill physical presence standard.  As detailed in our prior blog, both Alabama and South Dakota are already litigating whether their economic nexus standards are sufficient to satisfy the dormant commerce clause substantial nexus requirement.  Additionally, at least 11 different bills in eight different states have been introduced in state legislatures so far in 2016.  With states continuing to attack Quill from all angles, remote sellers are scrambling to keep up with the increasingly volatile nexus landscape. Continue Reading

Washington ALJ Upholds B&O Assessment on German Company’s Royalty Income

On May 31, 2016, the Washington Department of Revenue (DOR) Appeals Division released a Determination (No. 15-0251, 35 WTD 230) denying a German pharmaceutical company’s business and occupation tax (B&O) protest. The administrative law judge (ALJ) ruled that while the nondiscrimination provisions contained in Article 24 of the US-Germany Income tax Treaty (Treaty) “may apply,” the B&O does not discriminate against non-US businesses because it is imposed on any business deriving royalty income from Washington sources and applies equally to foreign and US companies. The ALJ also found that the company could avoid double taxation of the royalty income by excluding income taxed by Washington from its German tax base. While the company also challenged the constitutionality of the 2010 B&O economic nexus law, the ALJ declined to entertain it—citing a lack of authority to rule on the constitutionality of Washington statutes.

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Alabama Issues Remote Sellers Use Tax Assessments, Newegg Inc. Appeals

Ever since Alabama’s new economic nexus regulation went into effect, litigation over its constitutionality has been expected given that Alabama Commissioner Julie Magee and Governor Bentley said as much when announcing it (Rule 810-6-2-.90.03, effective January 1, 2016).  It appears that they finally got their wish. On June 8, 2016, Newegg Inc. (Newegg) filed a Notice of Appeal in the Alabama Tax Tribunal challenging the Alabama Department of Revenue (DOR) Notice of Final Assessment of Sellers Use Tax (Assessment) that was entered on May 12, 2016. The Assessment is for seller’s use tax, interest and penalties for the months of January and February 2016 (the Assessment Period), which represent the first two months the new regulation was in effect.

The Alabama litigation comes on the heels of the litigation in South Dakota, which also involves Newegg and other retailers. Although the critical issue in both is whether economic nexus is constitutional, given that the Alabama imposition is through a regulation and not a statute, the arguments in each state’s litigation may not be parallel.

DOR Explanation of the Assessment

The DOR asserts that under the new regulation Newegg has a “substantial economic presence” in Alabama.  According to Newegg, the DOR “has offered no basis for its determination” that the regulation’s requirements were satisfied during the Assessment Period. Specifically, Newegg notes that the DOR “conclusion appears to be based solely upon the fact that Newegg had ‘significant sales into Alabama,’ i.e., more than $250,000 of retail sales to Alabama customers.”

Newegg’s Grounds for Appeal

Newegg requests that the Tax Tribunal cancel the Assessment, citing the following grounds as the primary basis:

  1. The application of the new regulation to Newegg (and the Assessment) are unconstitutional because Newegg did not (and does not) have the necessary physical presence required to satisfy the “substantial nexus” standard for sales and use taxes under the Commerce Clause, as described by the US Supreme Court in Quill.
  2. The new regulation is invalid because retailers must “lack an Alabama physical presence” for it to apply. Therefore, it conflicts with both the Alabama sales and use tax statutes and the US Constitution, each of which requires a physical presence in the state by (or on behalf of) the retailer.
  3. The application of the new regulation to an internet retailer with no physical presence in Alabama is inconsistent with the authorizing seller’s use tax statute. Specifically, none of the provisions of the sales and use tax statutes (or any other provision in the Alabama Code) authorize the DOR to impose seller’s use tax collection obligations on internet retailers with no physical presence in the state.

The State of Nexus in Other States

The Alabama litigation represents the third prominent nexus case that involves Newegg.  Not only is the company involved in South Dakota (see our prior coverage of the South Dakota lawsuits here), but it is also one of the three taxpayers involved in the Ohio Commercial Activity Tax (CAT) litigation (see our prior coverage of the Ohio lawsuits here). All three cases involve the imposition of nexus on a company without physical presence in the taxing state, one with respect to a gross receipts tax (the Ohio CAT), and the others with respect to sales and use taxes.

On May 25, 2016, the fast-tracked lawsuit filed by South Dakota was (at least temporarily) slowed down when defendants filed a Notice of Removal (Notice) in the US District Court for the District of South Dakota. Under the Federal Rules of Civil Procedure, the plaintiff (South Dakota here) has 30 days (i.e., until June 24, 2016) to file a motion to remand based on a defect in the removal procedure. However, a claim based on lack of subject matter jurisdiction can be raised at any time. According to the Notice and accompanying documentation, the basis for removal is federal question jurisdiction. Because the defendants notified the state court, the state court is likely deprived of jurisdiction to act unless the federal court remands the case back to state court. If South Dakota proceeds with the litigation in federal court, it will lose the benefits of the expedited state court appeal process enacted by Senate Bill 106. Only time will tell how the case proceeds.

Practice Note

As judicial challenges to the continued viability of Quill move further along (with Alabama now joining South Dakota as a state with potential Quill litigation pending), the impact on the status of federal legislation remains to be seen. Speaking before the Federation of Tax Administrators (FTA) yesterday, Commissioner Magee pointed out that 41 remote sellers have signed up for Alabama’s Simplified Sellers Use Tax Program, which allows them to avoid the application of the new economic nexus regulation. The Commissioner proudly touted revenue raised in excess of $1 million in the first calendar quarter of 2016 alone. Although we only know of the Newegg case at this point, it’s likely that there are many other assessments and suits to come in Alabama.

During yesterday’s FTA panel presentation on the topic (by Commissioner Magee, South Dakota Secretary Andy Gerlach, COST’s Fred Nicely and Steve Kranz) and conversations that followed, tax administrators in a number of states expressed a willingness to accept prospective voluntary disclosure agreements (VDA’s) from remote retailers. See our prior article explaining why taxpayers should say no to standard VDA lookback periods. In states where a risk of retroactive application exists (or where the taxpayer is going to begin filing anyway) it makes sense to explore the possibility of a prospective arrangement and ensure the state does not seek backward-looking compliance with their new law or position. It should be noted that, unlike South Dakota, the Alabama regulation does not contain any provisions regarding retroactivity.  The regulation took effect as of January 1, 2016, and, ostensibly, liability for retailers not collecting and remitting is accumulating. Retailers should review their positions regarding Alabama and determine the potential liability.  Retroactivity was a significant issue in the Quill case and, unlike South Dakota, there is no statute limiting the effect of a judicial decision to a prospective basis. How this will affect the litigation remains to be seen.

Unclaimed Property Hunger Games: States Seek Supreme Court Review in ‘Official Check’ Dispute

Background

As detailed in our blog last month, MoneyGram Payment Systems, Inc. (MoneyGram) is stuck in between a rock and a hard place as states continue to duel with Delaware over the proper classification of (and priority rules applicable to) MoneyGram’s escheat liability for uncashed “official checks.”  The dispute hinges on whether the official checks are properly classified as third-party bank checks (as Delaware directed MoneyGram to remit them as) or are more similar to “money orders” (as alleged by Pennsylvania, Wisconsin and numerous other states participating in a recent audit of the official checks by third-party auditor TSG). If classified as third-party bank checks, the official checks would be subject to the federal common law priority rules set forth in Texas v. New Jersey, 379 U.S. 674 (1965) and escheat to MoneyGram’s state of incorporation (Delaware) since the company’s books and records do not indicate the apparent owner’s last known address under the first priority rule. However, if the official checks are classified as more akin to money orders under the federal Disposition of Abandoned Money Orders and Traveler’s Checks Act of 1974 (Act), as determined by TSG and demanded by Pennsylvania, Wisconsin and the other states, they would be subject to the special statutory priority rules enacted by Congress in response the Supreme Court of the United States’ Pennsylvania v. New York decision and escheat to the state where they were purchased. See 12 U.S.C. § 2503(1) (providing that where any sum is payable on a money order on which a business association is directly liable, the state in which the money order was purchased shall be entitled exclusively to escheat or take custody of the sum payable on such instrument).

In addition to the suit filed by the Pennsylvania Treasury Department seeking more than $10 million from Delaware covered in our prior blog, the Wisconsin Department of Revenue recently filed a similar complaint in federal district court in Wisconsin, alleging Delaware owes the state in excess of $13 million. Other states participating in the TSG audit (such as Arkansas, Colorado and Texas) also recently made demands to MoneyGram and Delaware.

It is interesting to note that in 2015, Minnesota (MoneyGram’s former state of incorporation) turned over in excess of $200,000 to Pennsylvania upon its demand for amounts previously remitted to Minnesota for MoneyGram official checks. Apparently not only do the states in which the transaction occurred disagree with but even a former state of incorporation took the majority path.   Continue Reading

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