INSIDE SALT

Colorado Changes Rules for Determining Members of Combined Filing Group

by Stephen P. Kranz, Michael J. Hilkin and David Jasphy | May 20, 2024 | Colorado, Income Tax, Tax Base, Unitary Business

Colorado Governor Jared Polis has signed legislation that would replace Colorado’s unique “3 of 6” rule for determining the members of a unitary group for combined reporting purposes and instead adopt what Legislative Council Staff has called “the Multistate Tax Commission’s standard” for determining the members of a combined filing group.

Under current law, a combined report may only contain those members of an affiliated group of corporations as to which three of the following six facts have been in existence in the tax return year and the two preceding years:

Sales or leases between one affiliate and another constitute 50% or more of the gross operating receipts or cost of goods sold of the entity making the sales/leases
Certain back-office services are provided by one affiliate for the benefit of another
Twenty percent or more of the long-term debt of one affiliate is owed to or guaranteed by another affiliate
One affiliate substantially uses certain intellectual property of another affiliate
Fifty percent or more of the board of one affiliate are members of the board or are corporate officers of another affiliate
Twenty-five percent or more of the 20 highest ranking officers of an affiliate are members of the board or are corporate officers of another affiliate.

Under the new law all members of a “unitary business” will be required to file a combined report. A “unitary business” is defined as an affiliated group of entities “that are sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts.”

The new law keeps Colorado’s water’s-edge rule in place, but it’s notable that said rule provides an exception for any entity “incorporated in a foreign jurisdiction for the purpose of tax avoidance” while identifying a list of nations where a corporation will be presumed to be incorporated for tax avoidance purposes (including the Cayman Islands, Luxembourg, Monaco, etc.).

Presuming Colorado voters don’t file a referendum petition and get the legislation overturned in November, the new standard would go into effect for tax years beginning on or after January 1, 2026.

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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ALJ Rules That a Taxpayer Is a Qualified New York Manufacturer Even Though Qualifying Property Was Operated by a Third Party

by Stephen P. Kranz, Michael J. Hilkin and David Jasphy | Mar 4, 2024 | Incentives, Income Tax, New York

The New York State Division of Tax Appeals determined that E. & J. Gallo Winery is a qualified New York manufacturer (QNYM) even though its only property in New York that could allow it to qualify for QNYM classification – a vineyard – was operated by a third-party contractor and Gallo did not have any of its own employees involved in the operation of the vineyard.

Gallo is a multinational manufacturer of table wines that acquired a vineyard in New York and hired a third-party contractor to maintain and farm the vineyard “so as to produce the quantity and quality of grapes” that Gallo’s significant winemaking operations needed. “The service agreement [between Gallo and the third-party contractor] was not a lease,” but instead gave the contractor the responsibility of the “full and complete management, supervision and control of the development and operation of the . . . vineyard.” In this role, the contractor was required to hire employees and subcontractors. The service agreement with Gallo confirmed that the contractor was to be treated “in all respects [as] the sole employer of such persons, employer of such persons, employees, duly licensed contractors, or firms.”

Gallo claimed it was a QNYM during the years at issue (2016 to 2019) under New York Tax Law §§ 210(1)(a)(vi) and 210-B(1)(b)(i)(A), which the administrative law judge (ALJ) summarized as requiring a taxpayer or combined group to have:

Been “principally engaged” (derived more than 50% of its gross receipts) in the production of goods by manufacturing, processing, assembling, refining, mining, extracting, farming, agriculture, horticulture, floriculture, viticulture or commercial fishing
Owned property in New York that had an adjusted basis of at least $1 million at the close of each taxable year or had all of its real and personal property located in New York
[Whereby] such property is principally used by the taxpayer in the production of goods by the same list of activities noted above, including manufacturing and viticulture.

The New York State Department of Taxation and Finance agreed that Gallo satisfied the first two requirements, but claimed, pursuant to TSB-M-15(3)C, that Gallo failed to meet the third requirement because it did not have any employees related to the vineyard and, therefore, it did not actually use the relevant New York-located property in the production of goods.

The ALJ, however, pointed out that “TSB-Ms are informational statements of the Division of Taxation’s policies” and “do not have legal force or effect.” And because the QNYM statute is a rate reduction and not an exemption, “it is to be construed most strongly against the government and in favor of the taxpayer.”

In analyzing the statute, the ALJ found that there was no “employee requirement” like that in the alternative test (i.e., having 2,500 manufacturing employees and $100 million of manufacturing property in New York) to be considered a QNYM. Therefore, the ALJ stated, “there is no basis to import the requirements from one test to the other when the Legislature could have easily done [...]

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New Jersey Governor Flip-Flops on Corporate Business Tax Surtax Expiration

by Stephen P. Kranz, Michael J. Hilkin and David Jasphy | Feb 27, 2024 | Income Tax, New Jersey

After months of insisting that he would not allow New Jersey’s 2.5% corporate business tax surtax to be extended – and previously having allowed it to lapse for tax years beginning on January 1, 2024 – New Jersey Governor Phil Murphy is now proposing that the surtax be revived for companies earning profits that exceed $10 million a year (up from the prior threshold of $1 million). The proposal appears to apply retroactively to January 1, 2024.

This will cause New Jersey to once again have the highest corporate income tax rate in the nation at 11.5%. According to the New York Times, Governor Murphy is selling the revival of the surtax as a “corporate transit fee” because the extra revenue will be earmarked for New Jersey Transit.

The governor’s proposed flip-flop is expected to receive significant pushback from the business community. The New Jersey Chamber of Commerce, which has already called the governor’s proposal a “nightmare scenario for New Jersey,” has indicated that it will be meeting with the Murphy administration and legislative leaders to voice their opposition.