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California Legislator Considers Digital Advertising Tax

by Stephen P. Kranz, Michael J. Hilkin, Mark Nebergall and Jonathan C. Hague | Mar 29, 2024 | Allocation/Apportionment, California, Constitutional Issues, Nationwide Importance, Sales Tax, Tax Base, Transaction Taxes

Senator Steven Glazer, chair of the California State Senate Revenue and Tax Committee, is treating data like the next gold rush and taking bold steps to mine this new vein of wealth with his proposed “Digital Data Extraction Tax Law.” While couched as a tax on “data extraction,” the base for the tax is digital advertising revenue. The draft proposal contains several gaps, including the tax rate and effective date, and we understand that Senator Glazer is not certain he will file it.

Senator Glazer modeled his proposed tax on Maryland’s digital advertising gross receipts (DAGR) tax approach but with a twist, aligning it with Tennessee’s digital barter tax proposal (House Bill 2234/Senate Bill 2065). While California’s bill attempts to cure the numerous legal infirmities present in Maryland’s DAGR tax, it suffers from many of the same fatal weaknesses.

LEGISLATIVE BACKGROUND

The bill’s stated intent is to tap into the supposedly “enormous economic rents” that the “largest” internet companies generate from the personal data they “extract” from their users. The draft bill would introduce a new tax on gross receipts from the sale of digital advertising services (digital ad tax). The digital ad tax would be imposed on persons engaged in “digital data extraction transactions,” defined as transactions where:

(i) a person sells advertisers information about or access to users of the person’s services, [and]

(ii) the person engages in a digital barter by providing services to a user in full or partial exchange for displaying advertisements to the user or collects data about the user.

Under the bill, persons with digital advertising revenue above a certain level would be deemed engaged in taxable activity. Additionally, the digital ad tax would only apply to persons with advertising revenue above a certain (currently unspecified) level but would provide a carve-out for news media entities. Revenue from the tax would be earmarked for a fund that supports local newspapers.

A troubling feature of the draft bill is its sourcing regime. The bill would require that those subject to the digital ad tax use personally identifiable information about those to whom the ads are served to source revenue from the advertising to either California or somewhere else. Specifically, the bill requires that sellers of digital advertising services capture and retain information, such as users’ GPS locations or IP addresses. A seller would be required to produce this information to tax authorities on audit. These requirements raise profound privacy issues.

Perhaps recognizing the myriad of legal challenges faced by Maryland’s DAGR tax, California’s bill attempts to limit its application to entities based on their revenue derived in the state. It also attempts to ward off challenges that the digital ad tax is a discriminatory tax on electronic commerce barred by the Internet Tax Freedom Act (ITFA) by adding a bare statement that the “Legislature finds and declares . . . . [t]hat digital advertising is not substantially similar to traditional print [...]

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Microsoft Scores Massive Win in California, Opens the Door for Others Nationwide

by Stephen P. Kranz, Diann Smith and David Jasphy | Mar 15, 2024 | Allocation/Apportionment, California, Federal Tax, Income Tax, Nationwide Importance, Tax Base

The Office of Tax Appeals (OTA) handed Microsoft an enormous win in its controversy with the California Franchise Tax Board (FTB) over the inclusion of qualifying dividends in the sales factor denominator for which it also claimed a dividends received deduction (DRD).

Microsoft filed a water’s-edge combined report for the years at issue and deducted 75% of qualifying dividends received from foreign affiliates outside its water’s-edge group. Initially, Microsoft only included the 25% net amount of dividends received in its sales factor denominator. Subsequently, Microsoft filed a refund claim asserting that the gross amount of dividends received should be included in the sales factor denominator, which would have resulted in a nearly $100 million refund.

The FTB argued that its own legal ruling (Ruling 2006-01) limiting the denominator to net dividends was dispositive of the issue. In its opinion, qualifying dividends should be excluded like eliminated intercompany dividends that were previously reported as income. The FTB also argued that a “matching principle” should apply to exclude the dividends like other items expressly excluded for allegedly not contributing to the tax base.

However, the OTA did not defer to FTB’s legal ruling because it was not a formal regulation. It was interpreting a statute, and its interpretation was inconsistent with the law. The OTA also disagreed with the comparison to eliminated intercompany dividends as there is no similar express exclusion in the DRD statute. Furthermore, the OTA found that “the legislative history” did not support the FTB’s “matching principle” because if the legislature intended the list of exclusions to be non-exhaustive, it would have used language like “such as” or “and other similar transactions.”

In its petition for rehearing, the FTB raised new arguments that the legislative history supported its interpretation and that qualifying dividends should be excluded from the denominator because they are qualitatively different from Microsoft’s main line of business. The OTA again rejected “the same or similar arguments that were considered and rejected in the Opinion” and stated that “new theories that could have been raised, but were not, is not one of the causes that permits a new hearing.” Accordingly, the OTA found that Microsoft was entitled to the nearly $100 million refund.

* * *

Corporate taxpayers should consider this decision as the basis for similar claims both in California and nationwide. While the Microsoft case involved dividends resulting from the Section 965 inclusion regime, it should apply to any type of dividend. The position is not conceptually different from including the factors of a unitary business entity that is in a loss while simultaneously using the loss for a net operating loss deduction. Therefore, in states where taxpayers are including only dividends in the denominator to the extent included in the base, there may be a position to instead include all dividends – even those subject to a deduction from the base. Depending on the statutory language in any given state, this could be true even if 100% of the dividends are deducted. [...]

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OTA Finds CDTFA’s Audit Methodology Arbitrary

by Charles Moll, III, Troy M. Van Dongen, Marcy Jo Mandel and Elle Kaiser | Jul 24, 2023 | Audits, California, Sales Tax

In Appeal of Colambaarchchi (OTA Case No. 21017152; 2023-OTA-302), a California-based retailer was audited by the California Department of Tax and Fee Administration (CDTFA) for years 2016 through 2019. Upon audit, CDTFA determined that taxable sales went unreported. In calculating the extent of the underreporting, CDTFA used various indirect methods for different periods in the audit years and applied a method to each period that maximized the amount of tax due. The Office of Tax Appeals (OTA) found that this methodology was utilized simply to create the largest underreporting, was inconsistent and lacked the required minimum rational and reasonable basis.

Colambaarchchi operated two perfume retail stores. During its audit, CDTFA performed various sales tests that suggested unreported sales. To compute the taxable measure, CDTFA used a combination of the federal income tax returns (FITR) method and the bank deposits method. Specifically, CDTFA used the bank deposits method for 2016, switched to the FITR method for 2017, then switched back to the bank method for 2018 and Q1 2019. In the audit work papers, CDTFA noted that the “[a]uditor used the higher of FITR or bank deposit difference to arrive at audited taxable sales.” In other words, CDTFA alternated between the two methodologies simply to maximize the tax liability.

CDTFA subsequently issued a notice of determination, which the company timely appealed. At the prehearing conference, OTA placed the parties on notice that, in deciding the appeal, the OTA may consider “[w]hether respondent was justified in selecting the bank deposit method for 2016, 2018 and the first quarter of 2019 and gross receipts from the [FITR] for 2017.” Accordingly, bearing the initial burden of showing that its decision to switch between two methods was reasonable and rational, CDTFA argued that it “selected the FITR method for 2017 because ‘the bank deposits may not have all cash deposited into the bank’ in 2017, and that it may have selected the bank deposits method for 2016, 2018 and 1Q19 because the income tax returns ‘may not be accurate because obviously there are additional [bank] deposits in addition to what they reported on their income tax returns.’”

OTA rejected this argument because it found “no support in the record for CDTFA’s assumption that the bank deposits method is less accurate in 2017 than in the other periods such that it would be reasonable and rational for CDTFA to switch to the FITR method in 2017.” According to OTA, CDTFA “cannot assume that one indirect audit method is more accurate in one period than another just because it produces a higher result.” OTA further stated that “this arbitrary selection made solely to increase unreported taxable sales is not reasonable and rational. Where CDTFA alternates between indirect audit methods because one method produces a higher result, CDTFA is no longer attempting to estimate the correct measure of tax but instead is arbitrarily increasing the tax measure.” Consequently, OTA held that CDTFA failed to meet its burden of proof, and CDTFA was ordered to utilize the bank deposits [...]

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Buehler Doesn’t Get a Day Off from Double Taxation

by Charles Moll, III and Michael J. Hilkin | May 12, 2023 | California, Constitutional Issues, Income Tax, Massachusetts, State Tax, Unitary Business

The California Office of Tax Appeals (OTA) recently held that a California resident’s income tax paid to Massachusetts from the sale of his membership interest in a limited liability company (LLC) doing business in Massachusetts was not eligible for California’s other state tax credit. The OTA reached this conclusion while acknowledging that it “will result in the income” from the sale of the membership interest “being double taxed.”

The taxpayer in the case, Mr. Buehler, was one of three managing members of an LLC that had an office in Massachusetts and provided portfolio management services for pooled investment vehicles. Buehler “was actively involved in” the LLC’s management and operations. After selling his membership interest in the LLC, Buehler filed a Massachusetts nonresident tax return and reported and paid tax on a share of the net gain from the sale of the membership interest, using the LLC’s Massachusetts apportionment factors.

The OTA’s decision did not question whether Buehler properly determined, under Massachusetts law, the tax owed to Massachusetts from the sale of his LLC membership interest. At that time, the Massachusetts Department of Revenue took the position that such sales of pass-through entity interests were taxable in Massachusetts where the entity conducted business regardless of whether the seller was “unitary” with the entity. (See, e.g., VAS Holdings & Investments LLC v. Comm’r of Revenue, 489 Mass. 669 (2022).) Instead, the OTA focused on the language of California’s other state tax credit, which applies to income taxes paid to another state on “income derived from sources within that state.” As stated by the OTA, “in order for a California taxpayer to be entitled” to a credit, “income taxes paid to the nonresident state (here, Massachusetts) must be based on income sourced to that nonresident state using California’s nonresident sourcing rules.” (Emphasis in original).

The OTA determined that under Cal. Rev. & Tax. Code § 17952, the LLC interest was not sourced to Massachusetts because Buehler’s LLC membership interest had not acquired a “business situs” in Massachusetts. According to the OTA, Buehler’s activities as a managing member of the LLC did not cause the “membership interest itself” to be “integrated into the business activities” of the LLC “in Massachusetts.” (Emphasis in original). In other words, while Buehler’s “services for” the LLC “as one of its three managing partners may connect him with” the LLC’s “Massachusetts business activities, that fact alone does not show that [Buehler’s] membership interest was localized in Massachusetts.”

The OTA also rejected Buehler’s alternative argument that his active involvement in the LLC caused him to “become unitary” with the LLC’s business, allowing for combination and apportionment under California Tax Regulation § 17951-4(d). The OTA explained that Buehler did not establish that he was “operating a sole proprietorship or any kind of business activity” separate and apart from the LLC “that could be considered unitary with” the LLC.

The OTA acknowledged that its decision would lead to double taxation of income from the sale of the LLC membership interest but concluded [...]

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California Supreme Court Lets It Stand That CDTFA Can Decide Who Is and Is Not a Retailer

by Charles Moll, III, Troy M. Van Dongen and Elle Kaiser | Apr 28, 2023 | California, Local Tax, Nationwide Importance, Sales Tax

On April 26, 2023, the Supreme Court of California declined to review the Second District Court of Appeal’s decision in Grosz v. California Dep’t of Tax & Fee Admin. In the underlying case, Stanley Grosz, a business owner based in Fresno, California, filed suit seeking a declaration that the California Department of Tax and Fee Administration (CDTFA) has a mandatory duty to collect sales and use tax from an internet retailer for sales that were made by third-party merchants on the retailer’s website, but fulfilled by the retailer. Grosz also sought an injunction requiring the CDTFA to collect the sales and use tax.

The internet retailer’s service allows third-party merchants to outsource their order fulfillment to the retailer. As part of the service, the internet retailer stores the merchants’ products at one of its fulfillment centers. According to Grosz, the provision of these services necessarily defined the internet retailer as a “consignment retailer” responsible for remitting sales tax on transactions facilitated through its website. (18 CCR § 1569.) The CDTFA disagreed and counter-argued that the determination of who constitutes a “retailer” under California sales and use tax law is a decision that is within its sole discretion to make.

The Second District Court of Appeal, in analyzing the statutory definition of “retailer” contained in Section 6015(a) of the Revenue and Taxation Code, concluded that it was “clear” that both the internet retailer and the third-party merchants could be regarded as retailers for purposes of transactions conducted under the service. The Court then agreed that the CDTFA has broad discretion to determine who constitutes a “retailer” under California’s sales and use tax laws.

It is important to note that the facts in this case occurred before the enactment of California’s Marketplace Facilitator Act (MFA). Under current law, marketplace facilitators generally are responsible for collecting, reporting and paying the tax on retail sales made through their marketplace for delivery to California customers. Thus, the current statutory scheme has greater clarity concerning the sales tax collection and reporting requirements for marketplace facilitators and sellers. Nevertheless, this case highlights the exposure some sellers may have for sales made before the MFA went into effect if tax was not properly collected and remitted.

Is California Picking the Pockets of Other States?

by Charles Moll, III, Elle Kaiser, Michael J. Hilkin and Marcy Jo Mandel | Oct 21, 2022 | California, Local Tax, Nationwide Importance, Sales Tax, Transaction Taxes

In Matter of Body Wise International LLC (OTA Case No. 19125567; 2022 – OTA – 340P), a California-based retailer collected amounts designated as “tax” related to jurisdictions where it was not registered to collect tax. The California Office of Tax Appeals (OTA) held that the retailer must remit those amounts to California, even though the sales were not taxable in California, because the retailer did not actually pay the “tax” amounts it collected to the other states nor did it refund those amounts to its customers.

Body Wise International, LLC sold weight loss supplements to customers across the country and shipped the products directly to customers via common carrier from its warehouse in California. During the periods at issue, Body Wise’s tax software program charged a “Tax Amount” on all sales to customers located in various states based upon the respective tax rates in those other states. In states where Body Wise had not registered to charge or collect tax, Body Wise did not remit the “tax” collected to those states.

On audit, the California Department of Tax and Fee Administration (CDTFA) determined that the “Tax Amounts” Body Wise collected in those other states constituted excess sales tax reimbursements under California Revenue & Taxation Code (R&TC) section 6901.5, which provides that a retailer who collects a sales tax reimbursement exceeding the amount of the sales tax liability imposed upon the sale must remit the excess to the customer or to the state. CDTFA concluded that those amounts collected but not paid over to the other states must either be returned to the customer or remitted to California.

Upon appeal, the OTA agreed with CDTFA. OTA first observed, “it is not necessary for a sale, purchase, or any other type of transfer for consideration to be subject to California’s sales tax in order for the excess tax reimbursement provisions of R&TC section 6901.5 to apply.” Rather, OTA then stated, the requirement to remit or refund excess sales tax reimbursement to CDTFA applied to Body Wise even where the underlying transaction was nontaxable or exempt in California. Based upon this, OTA concluded that Body Wise must remit those amounts collected to California. OTA supported its conclusion by observing that Body Wise was not registered to collect sales tax in some or all of the other states.

However, logically, the excess tax reimbursement covered by the statute must be excess California tax reimbursement in the first instance. Indeed, the statute by its own terms expressly applies to “taxes due under this part [the California Sales and Use Tax Law].” (Cal. Rev. & Tax. Code § 6901.5.) Because these were not taxes due to California but ostensibly to the other states, California’s attempt to abscond with revenues belonging to another state would appear to be unconstitutional as violating the sovereignty of that other state.

The OTA’s conclusion would seem to be at odds with the important maxim of statutory construction to avoid an interpretation of the statute that would render it [...]

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More than Tax Compliance: California Legislation Requires Marketplace Facilitators to Track “High-Volume” Seller Information

by Charles Moll, III, Michael J. Hilkin and Elle Kaiser | Oct 7, 2022 | California, Local Tax, Sales Tax, Transaction Taxes

The responsibilities of marketplace facilitators operating in California are expanding under legislation recently signed by Governor Gavin Newsom. Starting on July 1, 2023, an “online marketplace” will be required to collect and maintain specified contact and financial information related to its “high-volume third-party sellers.” The legislation is intended to “provide greater tools for law enforcement to identify stolen items” being resold through online marketplaces.

Under the legislation, a “high-volume third-party seller” is defined as any seller who, in any continuous 12‑month period during the previous 24 months, has entered into 200 or more transactions through an online marketplace for the sale of consumer products to buyers located in California, resulting in a total of $5,000 or more in gross revenues. While the legislation includes its own definition of an “online marketplace,” the definition will likely reach most (if not all) businesses classified as “marketplace facilitators” for California sales tax purposes.

An online marketplace will be required to collect information about any high-volume third-party seller on its platform, including the seller’s name, tax ID number and bank account number (presuming the seller has a bank account), along with certain government-issued records or tax documents if the seller is not an individual. For those sellers making at least 200 sales totaling at least $20,000 in gross revenues to buyers in California, an online marketplace must collect additional information, disclose certain contact information to consumers and provide a means to allow users “to have direct and unhindered communication with the seller.”

Information collected about sellers must be verified within 10 days and be maintained for at least two years, and the online marketplace must suspend sales activities of a high-volume third-party seller out of compliance with the requirements of the legislation. An online marketplace not in compliance with the legislation will be subject to a penalty of up to $10,000 for each violation.

Businesses impacted by this legislative development or with questions about marketplace facilitators are encouraged to contact the authors of this article.

CDTFA Proposes Significant Revisions to Chapters 4 and 13 of the Sales Tax Audit Manual

by Charles Moll, III, Troy M. Van Dongen, Marcy Jo Mandel and Elle Kaiser | Feb 10, 2022 | Audits, California, Local Tax, Nationwide Importance, Sales Tax

On February 2, 2022, the California Department of Tax and Fee Administration (CDTFA) held an interested parties meeting (IPM) to discuss proposed amendments to sales tax audit manual (AM) Chapter 13, “Statistical Sampling,” and Chapter 4, “General Audit.”

Prior to the IPM, the CDTFA released a lengthy discussion paper outlining the extensive proposed changes to the AM, which includes:

1. Removing the three error rule. The current text of AM 1308.05 explains that when a sample produces only one or two errors, the auditor must evaluate whether these errors are representative or whether it is possible they indicate problems in certain areas that could be examined separately. Under the proposed amendment, the same evaluation standards would still be in place without the minimum error requirement. According to the CDTFA, the proposed removal of the three error rule is because of the fact that “the number of errors identified in a sample does not give any indication whether the sample is representative or not…If the combined evaluation evaluates within Department [CDTFA] standards, it is justified to project the results even if one or two errors are found.”

2. Requiring 300 minimum sample items per stratum unless the auditor obtained approval from CAS to select fewer than 300. Currently, the “minimum sample size of at least 300 items of interest is to be used in all tests, except where the auditor can support a smaller sample size and it evaluates well.” (AM 1303.05) Under the new subsection titled “Materiality,” a minimum of 300 sample items per test stratum is recommended. Computer Audit Specialist (CAS) approval is required for selecting less than 300 sample items per test stratum.

3. Refunding Populations: A minimum of 100 sample items per stratum is required. In the section addressing sampling refund populations (AM 1305.10), the proposed amendment would permit auditors to select as few as 100 sample items per test stratum without CAS approval, provided the expected error rate is sufficiently high (greater than 20%). No such rule exists under the current text of Chapter 13.

4. Contacting CAS when the prior audit had 300 hours charged to it is now mandatory. In contrast, under the current rule, it is mandatory that CAS be contacted when the prior audit expended 400 or more hours or if CAS was involved in the prior audit.

5. Replacing Credit Methods 1, 2 and 3 with one recommended approach to handling credits in a statistical sample. The subsection (AM 1303.25) currently lists three types of credit methods that can be used for a statistical sample. The CDTFA now only recommends one credit method for use in a stratified statistical sample, which is referred to as “Method 1” in the current AM text. When auditors review electronic data, attempts should be made to match credit invoices to original invoices (including partially) if it is certain that the credit invoices are related to the original invoice. For all credit memos that are not matched to original invoices, those credits will be removed from [...]

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Illinois Enacts Pass-Through Entity Tax to Help Partners and S Corporation Shareholders Avoid the $10,000 SALT Cap

by Fred M. Ackerson | Sep 3, 2021 | California, Illinois, Income Tax, New York

Illinois enacted a pass-through entity tax (PTE Tax) that may be elected by partnerships and S corporations to permit a federal deduction of state income taxes that otherwise are limited to $10,000 per year from 2018 to 2025 by the Tax Cuts and Jobs Act of 2017 (TCJA). State income taxes paid by individuals, whether attributable to pass-through entity income or other income, are subject to the TCJA’s $10,000 “SALT Cap.”

In Internal Revenue Service (IRS) Notice 2020-75, the IRS announced its approval of the federal deduction of state PTE Taxes paid by the entity in circumstances where the partner or shareholder receives a state tax credit, and the PTE Tax essentially is paid in lieu of the state income tax otherwise imposed upon the partner or S corporation shareholder.

The new Illinois PTE Tax was signed into law by Governor JB Pritzker on August 27, 2021 (Public Act 102-658) and applies to taxable years ending on or after December 31, 2021, and prior to January 1, 2026. Eighteen other states have also enacted PTE Taxes and 14 of those (including Illinois) are effective for 2021.

TAX AT ENTITY LEVEL

The Illinois PTE Tax is imposed on electing partnerships and S corporations at a rate of 4.95%, the flat income tax rate applicable to individuals. The tax is imposed upon the Illinois net income of the partnership or S corporation, which is equal to Illinois base income after apportionment or allocation. As discussed below, partners and S corporation shareholders may claim a refundable Illinois credit equal to their distributive share of the Illinois PTE Tax paid by the partnership or S corporation. Illinois base income of a partnership or S corporation for purposes of the PTE Tax is computed without deduction of Illinois net loss carryovers or the standard exemption. It’s also computed after addback of the partnership subtraction modification for reasonable compensation of partners (including guaranteed payments to partners) and the subtraction modification for income allocable to partners or shareholders subject to the Illinois “replacement tax.” The PTE Tax does not affect the replacement tax computation.

The Illinois PTE Tax is paid by the partnership or S corporation on all of its Illinois net income after apportionment or allocation. As a result, any tax exempt owner of a partnership or S corporation may be required to file Illinois refund claims in order to recoup PTE Taxes paid at the entity level (including as estimated payments). In some cases, this may be avoided by forming an upper-tier partnership for partners that are not tax exempt. Other states have avoided this problem by permitting the PTE Tax to be elected on a partner-by-partner basis rather than for the entity as a whole (e.g., California) or by imposing the PTE Tax only upon income that is allocable to partners subject to the state’s personal income tax (e.g., New York State).

TIERED PARTNERSHIPS

In the case of tiered partnerships, if a lower-tier partnership makes the PTE Tax election, the upper-tier [...]

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Governor Newsom Announces New Relief for Remitting California Sales Tax

by Charles Moll, III, Troy M. Van Dongen, Marcy Jo Mandel and Elle Kaiser | Dec 1, 2020 | California, Interest and Penalties, Nationwide Importance, Sales Tax

On Monday, November 30, 2020, Governor Gavin Newsom announced that California will provide temporary tax relief for eligible businesses impacted by restrictions imposed to control the COVID-19 pandemic.

The announcement indicates that the Governor will direct the California Department of Tax and Fee Administration (CDTFA) to:

Provide an automatic three-month extension for taxpayers filing less than $1 million in sales tax on the return and extend the availability of existing interest- and penalty-free payment agreements to companies with up to $5 million in taxable sales;
Broaden opportunities for more businesses to enter into interest-free payment arrangements; and
Expand interest-free payment options for larger businesses particularly affected by significant restrictions on operations based on COVID-19 transmissions.

No information was provided as to how the CDTFA will expand interest-free payment options for larger businesses, or what constitutes “significant restrictions” on a business’ operations for purposes of this temporary tax relief. Nevertheless, we applaud the governor’s move to initiate this relief for California’s taxpayers, and we will keep readers up to date as additional details are revealed for this program.

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