It’s been nearly three months since the federal tax reform bill (commonly referred to as the Tax Cuts and Jobs Act, or “TCJA”) was enacted and states continue to respond to the various provisions of the TCJA. Recently, there have been notable legislative efforts in New York, Idaho, Iowa and Minnesota.

New York

Starting with the release of the Governor’s Budget Bill in January 2018, the 30-day amendments to that Bill on February 15, and the amendments to the Assembly Bill and Senate Bill this month, there has been much action this legislative session concerning the potential response to federal tax reform. The proposed response in the two latest bills—the Assembly Bill (AB 9509) and the Senate Bill (SB 7509)—is discussed below. Continue Reading More States Respond to Federal Tax Reform

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

In a curious decision out of Arizona, an Administrative Law Judge (ALJ) found an out-of-state provider of online research services was properly assessed transaction privilege tax (TPT, Arizona’s substitute for a sales tax) based on the logic that the provider was renting tangible personal property to in-state customers.  The Office of Administrative Hearings (OAH) decision, No. 14C-201400197S-REV, available here, should be unsettling for all remote providers of subscription-based services with customers in Arizona.  This decision offers an example of the continued push by states to administratively expand the tax base to include nontaxable digital services.  Many states, like Arizona, do so by considering remote access to digital goods and services to be tangible personal property, as defined by statutes that are decades old.

Facts

The taxpayer was an out-of-state IT research firm offering internally-produced proprietary research and data compilation content remotely.  The taxpayer’s headquarters, offices, servers and platform were all located outside Arizona.  Customers accessed the research material via usernames and passwords received as part of a subscription.  The Arizona Department of Revenue (the Department) determined that the subscription income was subject to the TPT because it was income from the leasing of tangible personal property.  The taxpayer filed a protest with the Department, arguing that the online research services provided make it a service provider—not a lessor of tangible personal property.  The taxpayer noted “at most, [they are] providing clients with a simultaneous license to use.”

Department’s Argument

The Department argued that the taxpayer was leasing tangible personal property (research and data content) through the subscriptions they provide to customers.  Because they had exclusive access and use to the digital content (via username and password), the customers were able to perceive tangible personal property through their sense of sight. Therefore, the taxpayer’s receipts from subscriptions to its research and data content are taxable rental activities subject to the personal property rental classification.

Holding

The ALJ held the taxpayer did not meet its burden of proof of showing the Department misapplied the tax laws.  The decision dismissed all of the taxpayer’s arguments that it is not engaged in leasing tangible personal property.  At the outset, the ALJ found that the inability to control or modify the digital content was not enough to consider the customers to be lacking “exclusive control.”  This is important because the Arizona Supreme Court has made it clear that the scope and application of the personal property rental classification (and its predecessor) hinges on the degree of control over the property in question that is ceded to its putative “lessee” or “renter.” In sum, because the access and use of the proprietary research and data content was offered for a periodic subscription (consideration), such activity is the leasing of tangible personal property, and the assessment by the Department was appropriate.

Analysis

As a threshold matter, it is unclear whether the Department has authority to consider remote access to digital content to be tangible property merely because the content may be viewed on a computer or mobile device.  For purposes of this statute, the definition of tangible personal property was enacted in 1989.  See Taxation—Corrections Bill, 1989 Ariz. Legis. Serv. 132.  The Internet as we know it today did not exist, with the World Wide Web not even established until 1991.  By interpreting the definition as such, the Department is imposing a new tax—something that is the province of the legislature.  The proprietary research and data available electronically is more properly characterized as an intangible or service.  By purchasing a subscription, customers are really paying for access to the proprietary data and research, the creation of which is unquestionably a service.  This information service is the “true object” of the subscription transaction, and any tangible personal property (i.e., the ability to access it via the Internet) is a mere inconsequential element.

Second, even if the classification as tangible personal property is proper, we seriously doubt whether the exclusive use and control requirement is met in this case.  In State Tax Commission v. Peck, 106 Ariz. 394, 476 P.2d 849 (1970), the court determined that customers of a coin-operated laundry “have an exclusive use of the equipment for a fixed period of time and for payment of a fixed amount of money . . . [and] exclusively control all manual operations necessary to run the machines.” Id. at 396, 476 P.2d at 851.  Over 30 years later, the Arizona Court of Appeals found customers at a tanning salon do not “themselves exclusively control all manual operations necessary to run” the tanning beds in question. The court held that while customers could select within a five-minute window when the tanning session begins and terminate it early, the question of whether a tanning session may be commenced at all, and how long it could last, were exclusively controlled by the taxpayer’s tanning technician.  Further, the question of the appropriate tanning device was also significantly within the technician’s control. In sum, the “exclusive use and control by the customer that Peck determined to be the essence of “renting” taxing statute [was] not present” in the tanning salon context.  See Energy Squared, Inc. v. Arizona Dep’t of Revenue, 203 Ariz. 507, 510, 56 P.3d 686, 689 (Ct. App. 2002).

Here, like the tanning salon in Energy Squared, the taxpayer’s customers do not have “exclusive use or control” of the research and data.  The ability to open and access the content is limited by the subscription level, and customers are only permitted one copy (limitations that someone with exclusive use or control would not receive).  Because the information is proprietary in nature, customers are further restricted by the fact that they may not use the research as their own and may only summarize, excerpt or quote it.  Further (and perhaps most importantly), the content is at all times housed on the server of the taxpayer, who may add or subtract to the content available to customers at any time.  Because the property in question (however it may be classified) is ultimately controlled by the taxpayer, it is not exclusively used or controlled by the customer.  This common law requirement is a prerequisite to the application of the TPT personal property rental classification, upon which the Department and ALJ decision relies.

Beyond Arizona

The Arizona Department is not the first revenue department to proffer this logic to tax subscriptions to digital services.  Within the past year, the authors are aware of two other state tax agencies that have attempted to tax remote providers—both resulting in legislative action opposing the agency’s actions.

  • Alabama: On February 28, 2015, the Alabama Department of Revenue proposed an amended regulation ( Admin. Code r. 810-6-5-.09, available here) that sought to impose rental tax on remote providers of streamed music and video to in-state customers.  Similar to Arizona’s tactic here, the proposed regulation would have imposed tax by considering streamed music and movies to be tangible personal property.  After significant feedback from industry representatives, the Joint Legislative Council (composed of the state legislative leaders from both chambers) wrote the Commissioner requesting the proposed regulation be withdrawn.  The letter cited to the fact that the proposal was overly expansive and would in effect be the imposition of a new tax, a determination that rests with the legislature.
  • Idaho: In October 2014, the Idaho State Tax Commission issued a notice of proposed rulemaking for a regulation that would have taxed the sale, lease or rental of digital products (defined as tangible personal property under Idaho law) if the user had the right to stream or download them.  See Idaho State Tax Comm’n, Notice of Proposed Rulemaking Dkt. 35-0102-1401 (Oct. 2014).  In response, the legislature passed a bill in March 2015 (House Bill 209, available here) that modifies the statute to require digital products be purchased with a permanent right to use to be taxable as tangible personal property, effective April 1, 2015.  Notably, the bill states that a permanent right to use does not exist when the right to use is conditioned upon continued payment.

Practice Note:  While the OAH decision is appealable, the 30-day period to request review has run.  It is unclear whether the taxpayer in this case has requested review, appealed directly to the Board of Tax Appeals or accepted defeat.  Taxpayers providing subscriptions to digital goods and services (including streaming audio and video) should be aware of the Arizona decision and be prepared to defend their service offerings from the states apparent position.

State income tax laws generally build on federal tax law.  The typical pattern is to begin the calculation of state taxable income with federal taxable income and then to modify it by adding or subtracting items where state tax policies differ from federal tax policies.  As a result, a corporation’s state taxable income can be affected by the application of the federal Internal Revenue Code.  State revenue departments generally do not consider themselves bound by Internal Revenue Service determinations respecting the application of federal tax law and believe that they are free to interpret the Internal Revenue Code as they see fit.  Unfortunately, this has led to problems because state tax auditors often are not well trained in federal tax principles.  We had an instance earlier this year in which an auditor claimed that the merger of a wholly-owned subsidiary into its corporate parent was taxable because there was an increase in the parent’s retained earnings.  The merger was a plain vanilla tax-free liquidation under Sections 332 and 337 of the Internal Revenue Code (there was no intercompany debt and the subsidiary was clearly solvent), but sending copies of these provisions to the auditor left him unmoved.  We finally got him to back down by showing that the parent’s increase in retained earnings was matched by a decrease in the subsidiary’s retained earnings so that there was no overall increase.  As we explained to the client, a win is a win, even if for the wrong reasons.  Nevertheless, if the auditor had been properly versed in the most basic federal corporate tax principles, this exercise would not have been necessary.

Two recent decisions illustrate misapplications of federal tax law by state revenue departments.

The Idaho Tax Commission recently held that a subsidiary’s net operating loss (NOL) carryovers did not pass to its parent in a merger of the subsidiary into the parent.  The parent did not continue to operate the business of the merged subsidiary and the Commission held that “based on IRC §382, the Petitioner cannot carry the loss forward after the merger.”  Idaho State Tax Commission Ruling No. 25749 (Apr. 17, 2014).  The Commission’s statement of federal tax law is incorrect.  Section 382 of the Internal Revenue Code does not apply to a merger of a wholly-owned subsidiary into its parent.  Because of constructive ownership rules, no change in ownership is deemed to occur.  Moreover, Section 382 does not prevent an NOL from passing to the surviving company in a merger; it simply limits the extent to which the NOL can be used.  Although it is true that the limitation is zero for years in which the merged company’s business is discontinued, the NOL is not destroyed.  If the parent later sells assets received from the subsidiary that had built-in gain at the time of the merger, the loss can be used to offset the gain.

Discussions that we have had with the Commission after the decision came out indicate that the Commission had concluded that there was real doubt as to whether the subsidiary’s losses were valid in the first place.  Nevertheless, its explanation of the reasons for preventing the loss from passing to the parent are incorrect as a matter of law and may be a problem to taxpayers if Commission auditors take the Commission’s language at face value in the future.

NIHC, Inc. v. Comptroller of the Treasury (Docket 63, Court of Appeals of Maryland) (August 18, 2014) involved corporations that were filing consolidated federal income tax returns but separate Maryland income tax returns.  A subsidiary distributed appreciated property to its parent in a transaction in which, had they been filing separate federal income tax returns, a gain would have been taxed to the subsidiary under Section 311(b) of the Internal Revenue Code.  Under the federal consolidated return regulations, however, the subsidiary’s gain was “recognized” but “deferred.”  This means that the gain was not immediately taxed but would have been taxed in later years upon the occurrence of certain events (e.g., a breakup of the consolidated return group, the transfer of the appreciated property by the parent outside the group, or the depreciation or amortization of the transferred property by the parent).  Under the federal consolidated return regulations, the subsidiary recognized income gradually over the next 15 years as the parent amortized the appreciated property.  Thus, the subsidiary reported income in later years but not in the year of the distribution.

In the litigation, the subsidiary took the position that it should have recognized the gain for Maryland income tax purposes in the year of the distribution because the corporations were filing separate Maryland income tax returns.  In other words, the taxpayer argued that the deferral principles of the federal consolidated return regulations, which were predicated upon the filing of consolidated returns by the corporations, should not apply for Maryland tax purposes because the corporations were filing separate Maryland tax returns.  The statute of limitations for assessing deficiencies for a taxable year of the distribution had expired.  The court, without discussing the applicable principles, held that the subsidiary made its bed and should lie in it and should not profit by the mistake that it claimed to have made in filing its tax returns for the year of the distribution.  The court failed to analyze the federal tax principles and their relationship with Maryland tax principles.

This may have been a classic case of bad facts making bad law.  The subsidiary had been established as an intangible holding company and the court made it clear that it disapproved of the taxpayer’s alleged attempt to divert income from Maryland through the intangible holding company device.  Nevertheless, the court clearly misapplied federal tax principles.

The takeaway here is that practitioners should not assume that state tax auditors will understand and correctly apply federal tax principles.  It may be necessary to call upon a company’s federal tax advisors to explain these principles to the auditors in simple terms.  It may also be necessary to talk to senior people in the department of revenue, who are more likely to be knowledgeable about federal tax rules than are the auditors.

The Idaho Sales Tax Rules Committee is currently revising Rule 027, Computer Equipment, Software, and Data Services, in response to the passage of H.B. 598.  The Committee met for the last time on July 24 to discuss the draft rule prior to the promulgation of the proposed rule.

As previously discussed in Inside SALT, the passage of Idaho H.B. 598 has resulted in the exclusion from the definition of tangible personal property of “computer software that is delivered electronically; remotely accessed software; and computer software that is delivered by the load and leave method where the vendor or its agent loads the software at the user’s location but does not transfer any tangible personal property containing the software to the user.”  However, “computer software that constitutes digital music, digital books, digital videos and digital games” is included within the definition of tangible personal property.

The discussion draft of Rule 027, released prior to the meeting, added new definitions for ‘canned software,’ ‘computer program,’ ‘computer software,’ ‘custom software,’ ‘digital product,’ ‘information stored in an electronic medium,’ ‘load and leave method’ and ‘remotely accessed computer software.’  As of the July 24 meeting, the definition of ‘delivered electronically’ was still under discussion.

The draft rule interprets H.B. 598 to assist taxpayers in identifying transactions subject to Idaho sales tax.  Following are items addressed by the draft rule:

  • The draft identifies streaming digital music, books and videos as subject to Idaho sales tax.
  • The draft explains that if canned software is loaded onto a user’s computer but has minimal or no functionality without connecting to the provider’s servers, it may be taxable based upon the delivery method of the canned software.
  • Online or remote data storage on storage media owned and controlled by another party is a nontaxable service.
  • Where the seller purchases raw data, expends time and resources to “clean up” the raw data into a usable format and charges customers for the right to use the data for a specified period of time, and the customers only have access to the full data over the internet, the charges are not taxable.
  • Digital games are treated by the draft rule as tangible personal property, and thus taxable, regardless of the method of access or delivery and regardless of whether the digital game requires the internet for some or all of its functionality.
  • Periodic charges to play games that require a constant connection over the internet to a remote server and periodic charges for a gaming service that enables certain functionality are taxable.
  • While the rule imposes sales tax on the purchase of virtual currency that enables additional content or progress in a digital game, it will not address the purchase of virtual currency used to purchase digital products such as video games, digital videos or apps.
  • The draft rule addresses the taxability of maintenance contracts.  The original rule is revised to impose tax on mandatory maintenance contracts only if the software to which the contract applies is subject to tax.  Sales tax is imposed on fees for upgrades from optional maintenance contracts only where the upgrades are delivered on storage media.  Where an optional software maintenance contract provides for software updates to be delivered electronically but also allows a customer to receive software updates on storage media, no portion of the contract is taxable unless the customer actually receives software updates on storage media.
  • The draft rule also addresses the taxability of digital subscriptions.  Digital subscriptions granting access to a database of digital music, books or videos are taxable regardless of the method of access or delivery.  However, subscription charges to digital newspapers, magazines or other periodicals, or to online research databases are not taxable.

We have received reports that the July 24 rule-making meeting did not result in any significant changes to the state’s draft taxability matrix.  It is expected that there will not be any further rule-making meetings, that the Committee will finalize the proposed rule by August 29 and publish it in the October Administrative Bulletin.  The proposed rule will then be subject to a three-week comment period.  The effective date of the final rule will likely be in March or April 2015.

A trend is developing in response to aggressive Department of Revenue/Treasury policymaking regarding cloud computing.  The courts and legislatures are addressing the issue and concluding that the remote access to software should not be taxed.  Here are two recent developments that illustrate the trend:

Michigan – Auto-Owners Insurance Company v. Department of Treasury

On March 20, 2014, the Michigan Court of Claims held in Auto-Owners Insurance Company v. Department of Treasury that certain cloud transactions were not subject to use tax because the transactions were nontaxable services.  The State has appealed this decision.

Auto-Owners engaged in transactions with numerous vendors to provide services and products that Auto-Owners used to conduct its business.  The court grouped Auto-Owners’ transactions into transactions with six categories of providers: (1) Insurance industry providers; (2) Marketing and advertising providers; (3) Technology and communications providers; (4) Information providers; (5) Payment remittance and processing support providers; and (6) Technology providers.  The transactions all involved, on some level, Auto-Owners accessing software through the Internet.  No software was downloaded by Auto-Owners.

The Michigan use tax is imposed on the privilege of using tangible personal property in the state.  Tangible personal property includes prewritten, non-custom, software that is “delivered by any means.”  Mich. Comp. Laws § 205.92b(o).  The court held that the transactions were not subject to use tax under the plain language of Michigan’s statute.

First, the court held that use tax did not apply because the court interpreted the “delivered by any means” language from Michigan’s statute to apply to the electronic and physical delivery of software, not the remote access of a third-party provider’s technology infrastructure.  Second, the court held that the software was not “used” by Auto-Owners.  Auto-Owners did not have control over the software as it only had the “ability to control outcomes by inputting certain data to be analyzed.”  Third, the court held that even if prewritten computer software was delivered and used, the use was “merely incidental to the services rendered by the third-party providers and would not subject the overall transactions to use tax.”  Michigan case law provides that if a transaction includes the transfer of tangible personal property and non-taxable services, the transaction is not taxable if the transfer of property is incidental to the services.

Practice Note:  This decision is encouraging in that the court said that the Department was ignoring the plain meaning of the statute and overreaching, and determined that the legislature must provide specific language extending the sales and use tax for such transactions to be taxable.  It is important to note that the Michigan statute uses the phrase “delivered by any means,” and the court focused on the definition of deliver in reaching its decision.  This decision will likely have implications for other streamlined sales tax (SST) member states.  Auto-Owners Ins. Co. v. Dep’t of Treas., No. 12-000082-MT (Mich. Ct. Cl. Mar. 20, 2014).

Idaho – H.B. 598

On April 4, 2014, Governor Butch Otter signed into law Idaho H.B. 598.  Idaho subjects sales of tangible personal property to sales tax.  Idaho Code Ann. § 63-3616.  H.B. 598 excludes from the definition of “tangible personal property” “computer software that is delivered electronically; remotely accessed computer software; and computer software that is delivered by the load and leave method where the vendor or its agent loads the software at the user’s location but does not transfer any tangible personal property containing the software to the user.”  However, the bill does not exempt “computer software that constitutes digital music, digital books, digital videos and digital games” – leaving them subject to tax as tangible personal property.  This language was pushed by the Idaho State Tax Commission to codify its existing administrative position that such items are already taxable.

Practice Note:  The legislation takes effect on July 1, 2014, though an argument exists that some cloud based software was previously exempt by legislation that passed in 2013.  We expect rulemaking on H.B. 598 to happen quickly.