Multistate Tax Compact
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How Far Back Can a Back Tax Go? Petition for Certiorari in Hambleton Asks Supreme Court to Right Unjust Retroactivity

Retroactivity is an endemic problem in the state tax world.  In this year alone, we have seen retroactive repeal of the Multistate Tax Compact (MTC) in Michigan, as well as significant retroactivity issues in New York, New Jersey and Virginia.  But after decades of states changing the rules on taxpayers after-the-fact, relief may be on the way if the Supreme Court of the United States grants certiorari in a Washington estate tax case, Hambleton v. Washington, with retroactivity that makes you say “What the heck?”.

The taxpayers filed a petition for certiorari on June 5, 2015.  The Court requested a response, which is now due by September 9, 2015.  The Tax Executives Institute filed an amicus brief on July 6, 2015.

The case involves two widows’ estates.  As stated in the petition:

Helen Hambleton died in 2006, and Jessie Macbride died in 2007.  Each was the passive lifetime beneficiary of a trust established in her deceased husband’s estate, and neither possessed a power under the trust instrument to dispose of the trust assets.  Under the Washington estate tax law at the time of their deaths, the tax did not apply to the value of those trust assets.  In 2013, however, the Washington Legislature amended the estate tax statutes retroactively back to 2005, exposing their estates to nearly two million dollars of back taxes.

In 2005, Washington state enacted an estate tax that was intended to operate on a standalone basis, separate from the federal estate tax.  In interpreting the new law, the Department of Revenue issued regulations that the transfer of property from the petitioners’ husbands to the petitioners through a Qualified Terminable Interest Property (QTIP) trust was not subject to the Washington estate tax.  The Department then reversed its position and assessed tax.  Petitioners, along with other estates, challenged the Department’s position and won in Washington Supreme Court (In re Estate of Bracken, 290 P.3d 99 (Wash. 2012)).  Then in 2013, the Washington legislature amended the estate tax to retroactively adopt the Department’s position, going back to 2005.  The petitioners challenged this law up to the Washington Supreme Court, which held in favor of the Department and concluded that the retroactive change satisfied the due process clause under a rational basis standard.

The petition urges the Supreme Court to take the case to resolve the uncertainty as to “how long is too long” when it comes to retroactive taxes, citing multiple examples of past and ongoing litigation in which lower courts have taken divergent approaches to the length of retroactivity that is permissible.  Of particular interest, one of the cases cited is International Business Machines Corp. v. Michigan Department of Treasury, 852 N.W.2d 865 (Mich. 2014).  The retroactive repeal of the MTC election in Michigan is a central issue in that ongoing litigation. If the Supreme Court takes Hambleton, its decision would likely impact the Michigan MTC litigation. The recent decision by the New York Court of Appeals, allowing [...]

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Pennsylvania Unwraps Final Market-Sourcing Guidance

The Pennsylvania Department of Revenue (the Department) recently finalized its Information Notice on sourcing of services for purposes of determining the appropriate net income and capital franchise tax apportionment factors.  The guidance also addresses the Department’s views on the sourcing of intangibles under the income producing activity test.  Since Pennsylvania is not a member of the Multistate Tax Compact, it is no surprise that the Department did not wait for the Multistate Tax Commission to complete its model market sourcing regulation before it issued its guidance.

Under the Pennsylvania statute (72 Pa. Stat. Ann. § 7401(3)(2)(a)(16.1)(C)), for tax years beginning after December 31, 2013, receipts from services are to be sourced according to the location where the service is delivered.  If the service is delivered both to a location in and outside Pennsylvania, the sale is sourced to Pennsylvania based upon the percentage of the total value of services delivered to a location in Pennsylvania.  In the case of customers who are individuals (other than sole proprietors), if the state or states of delivery cannot be determined for the customer, the service is deemed to be delivered at the customer’s billing address.  In the case of customers who are not individuals or who are sole proprietors, if the state or states of delivery cannot be determined for the customer, the service is deemed to be delivered at the location from which the service was ordered in the customer’s regular course of operations.  If the location from which the service was ordered in the customer’s regular course of operations cannot be determined, the service is deemed to be delivered at the customer’s billing address.

The statute generated more questions than it answered.  Key terms such as “delivered” and “location” were not defined.  The Department’s Information Notice provides answers to many of taxpayers’ questions.  However, unlike the draft Information Notice released in June 2014, the final Information Notice shies away from providing a succinct definition of “delivery” and resorts to defining the term through various examples.  (For our coverage of the Department’s draft Information Notice, click here.)  However, the Information Notice does define “location” stating that “location” generally means the location of the customer and, thus, delivery to a location not representative of where the customer for the service is located does not represent completed delivery of the service.

The Information Notice is chock full of examples to guide taxpayers.  The Department’s views relating to various scenarios when services are performed remotely on tangible personal property owned by customers are of interest.  If a customer ships a damaged cell phone to a repair facility that repairs and returns it, the Department deems the service to be delivered at the address of the customer.  Contrast that with a situation when a customer drops a car off for repair at a garage and later returns to pick it up.  One may conclude that the service should also be deemed to be delivered at the address of [...]

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Did You Pay a Michigan Assessment After an MTC Audit? What the State’s Retroactive Compact Repeal May Mean

On September 11, 2014, Michigan Governor Rick Snyder signed legislation (SB 156) retroactively repealing the Multistate Tax Compact (Compact, formerly codified at MCL § 205.581 et seq.) from the state statutes, effective January 1, 2008.  Among other things, the bill’s passage ostensibly supersedes the Michigan Supreme Court’s decision in Int’l Bus. Machines Corp. v. Dep’t of Treasury, 496 Mich. 642 (2014) (holding that (1) the enactment of a single sales factor under the Business Tax Act (codified at MCL § 208.1101 et seq.) did not repeal Compact by implication and (2) the state’s modified gross receipts tax fell within the scope of Compact’s definition of “income tax” which the taxpayer could calculate using Compact’s three-factor apportionment test) and relieves the Department of Treasury from having to pay an estimated $1.1. billion in refunds to taxpayers.  While many commentators have rightfully focused on the constitutional validity of retroactively repealing the Compact in Michigan in such a manner (including our own Mary Kay Martire in her recent blog post), we think it is equally as important to consider whether the repeal compromises the validity of prior interstate audit assessments authorized pursuant to the Compact.

Background

Article VIII of the Compact provides the specific rules governing participation in interstate audits conducted by the Multistate Tax Commission (MTC) via their Joint Audit Program (Program).  Unlike other provisions of the Compact, Article VIII is “in force only in those party states that specifically provide therefore by statute.”  Section 8 of the Compact provides this authority, simply stating “Article VIII [of the Compact] shall be in force in and with respect to this state.” See MCL § 205.588 (repealed by SB 156).  This threshold matter must be satisfied before the MTC is authorized to audit and assess businesses and review their books and records on behalf of any particular state.

The MTC and its participating audit states have taken the controversial position that membership and participation in the Program is independent from a state’s Compact status (e.g. Massachusetts, Nebraska, Tennessee, and Wisconsin have not adopted the Compact, yet participate in the Program).  Further, even when authorized, states have the discretion to elect not to participate in the Program by simply opting out for one or both of the taxes audited (income and franchise, or sales and use).

Minnesota offers an example of a state that may have withdrawn from the Compact correctly while maintaining the State’s ability to participate in MTC audits.  In May 2013, the legislature enacted legislation repealing the Compact (H.F. 677, repealing Minn. Stat. § 290.171) (this legislation does not appear to be retroactive).  In doing so, the legislature included a separate provision authorizing continued participation in audits performed by the MTC. See Minn. Stat. § 270C.03 subd. 1(9), amended by H.F. 677.  While Minnesota ultimately opted not to participate in these audits, they have statutory authority if they so choose (but as noted above, the Compact itself may not allow for this).

Implications

Unlike Minnesota, the recent repeal in Michigan failed to [...]

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How Will Michigan Courts Analyze a Legal Challenge to the Michigan Legislature’s Retroactive Repeal of the Multistate Tax Compact?

In recent days, the state tax world has focused on the State of Michigan’s retroactive repeal of the Multistate Tax Compact (Compact).  Last week, the Michigan Legislature passed and Governor Snyder signed into law a bill (P.A. 282) that nullifies the effect of the state Supreme Court’s July 14, 2014 decision in International Business Machines v. Dep’t of Treasury, Dkt.  No. 146440.  In IBM, the state Supreme Court held that IBM may apportion its business income tax base and modified gross receipts tax base under the Michigan Business Tax (MBT) using the three-factor apportionment formula provided in the Compact, rather than the sales-factor apportionment formula provided by the MBT. Reflective of the urgency with which he views the situation, Michigan’s Governor Snyder signed the bill into law within twenty-four hours after its passage, with a statement that the state’s actions were an effort to ensure that “Michigan businesses are not penalized for investing in the State.”  The Michigan Department of Treasury (MDOT) made no attempt to sugar coat its statements in language that would reflect support for Michigan business interests.  Rather, it loudly proclaimed that the Legislature must act because the revenue impact to the State of the IBM decision was $1.1 billion.

The new law repeals L. 1969, P.A. 343, which enacted the Compact, retroactive to January 1, 2008, allegedly in order to express the original intent of the legislature regarding the application of M.C.L.A. §208.1403 of the MBT.  (Section 208.1403 specifies that a multistate taxpayer must apportion its tax base to Michigan using the sales factor.)  The law goes on to provide that the Legislature’s original “intended effect” of §208.1403 was to eliminate the ability for taxpayers to use the  Compact’s three factor apportionment election provision in computing their MBT, and to “clarify” that the election provision included in the Compact is not available to the Michigan Income Tax Act, which replaced the MBT in 2012.

The actions of the state are perhaps not surprising, given MDOT’s revenue estimate and the number of related claims (more than 130) that are reported to be pending before MDOT and/or the Michigan courts on this issue.  Earlier this week, the Michigan Court of Appeals issued an unpublished decision holding that the IBM ruling was dispositive on the issue of whether Lorillard Tobacco Company could elect to use a three-factor apportionment formula in computing its MBT for 2008 and 2009.  Lorillard Tobacco Co. v. Dep’t of Treasury, No. 313256 (Sept. 16, 2014).  Critics of the new law make strong arguments about the unfairness of the state’s recent actions, and tax pundits predict that the retroactivity of the law will soon be the subject of a court challenge.  What do Michigan court’s prior rulings on retroactivity teach us about how the Michigan courts are likely to address this issue?

This is not the first time in recent memory that the state has acted to retroactively repeal legislation with the potential for large, negative implications to Michigan’s revenue stream.  In General Motors Co. v. [...]

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MTC’s Market-Based Sourcing Recommendations for UDITPA: Too Little, Too Late?

Member states of the Multistate Tax Commission (MTC) voted to adopt proposed amendments to Article IV of the Multistate Tax Compact during their annual meeting in late July.  The proposed amendments likely to have the most widespread impact on taxpayers are the amendments to the Uniform Division of Income for Tax Purposes Act (UDITPA) Article IV section 17 sourcing rules that change the sales factor sourcing methodology for services and intangibles from a costs of performance (COP) method to a market-based sourcing method. 

The MTC’s recommended market approach provides that sales of services and intangibles “are in [the] State if the taxpayer’s market for the sales is in [the] state.”  In the case of services, a taxpayer’s market for sales is in the state “if and to the extent the service is delivered to a location in the state.”  The proposed amendments also provide that if the state of delivery cannot be determined, taxpayers are permitted to use a reasonable approximation.  At this point, there is no additional guidance from the MTC on the meaning of “delivered,” how to determine the location of delivery in the event that a service is delivered to multiple jurisdictions, or what constitutes a reasonable approximation.

While the proposed amendments may be touted by some as the death knell of COP sourcing, for these changes to take effect, they will still need to be adopted individually by legislatures in Compact member states or in any other states that may choose to adopt them.  As we have seen over the last several years, many states have already forged their own paths in this area.  (See our article discussing the wide variety of market-based sourcing rules.)  Moreover, while many states have enacted market-based sourcing provisions with respect to the sale of services, certain states, unlike the MTC proposed amendments, have declined to convert to market-based sourcing for intangibles (e.g., Pennsylvania).

The proposed amendments leave taxpayers with many unanswered questions.  For example, assume a corporate taxpayer (Corporation A) is in the business of offering a payroll processing service.  Corporation A provides this service to Corporation B.  Corporation B’s management of the contractual arrangement with Corporation A occurs in Massachusetts, which is also the location of Corporation B’s human resources function.  Corporation B has 10,000 employees, 2,000 of whom are located in a jurisdiction that has adopted the MTC’s market-based sourcing recommendation (State X).  What portion of Corporation A’s receipts from the performance of its payroll processing service for Corporation B should be sourced to State X?

One can reasonably argue that the service is delivered to Corporation B as a corporation (i.e., that the human resources function is the true beneficiary) and not individually to Corporation B’s employees—leaving State X with nothing.  However, does the MTC’s language “if and to the extent the service is delivered” create an opportunity for State X to argue that it should receive 1/5 (2,000 employees/10,000 employees) of Corporation A’s receipts?

In late August, the MTC launched a project to [...]

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Is 2015 the Beginning of Mandatory Single Sales Factor Apportionment for D.C. Taxpayers?

On July 14, 2014, the Fiscal Year 2015 Budget Support Emergency Act of 2014 (2015 BSEA) was enacted after the D.C. Council voted to override Mayor Vincent Gray’s veto.  The act includes a tax relief package recommended by the D.C. Tax Revision Commission, and includes a change to D.C.’s apportionment formula, moving the city to single sales factor apportionment.

Since January 1, 2011, D.C. has required taxpayers to apportion their business income by the property-payroll double-weighted sales factor formula.  D.C. Code Ann. § 47-1810.02(d-1).  Among the provisions enacted in the 2015 BSEA, the District will require the apportionment of business income via a single sales factor formula, starting with tax years beginning after December 31, 2014.  D.C. Act 20-0377, § 7012(c)(10) (2014).  While the 2015 BSEA has only a temporary effect and expires on October 12, 2014, it serves as a stopgap until the process of enacting the permanent version, the Fiscal Year 2015 Budget Support Act of 2014 (2015 BSA) is completed.  (See the single sales factor apportionment provision at D.C. Bill 20-0750, § 7012(a)(10) (2014).)  The 2015 BSA has not yet been enrolled and transmitted to the mayor.  After the mayor signs the 2015 BSA or the D.C. Council overrides his veto, the 2015 BSA will be sent to Congress for review.  If Congress and the President do not enact a joint resolution disapproving of the 2015 BSA, the 2015 BSA will become law, and the switch to single sales factor apportionment will be effective as of January 1, 2015. 

Even with this legislative change, D.C. taxpayers may have an argument for apportioning their business income under the three-factor apportionment formula.  In 1981, the District adopted the Multistate Tax Compact (Compact) as 1981 D.C. Law 4-17.  The Compact provides for the use of the evenly weighted three-factor sales-property-payroll formula.  Multistate Tax Compact, art. IV, sec. 9.  The Compact permits the taxpayer to elect to apportion his business income under the city’s apportionment formula or under the Compact’s three-factor formula.  Multistate Tax Compact, art. III, sec. 1.  In 2013, D.C. repealed and reenacted the statute codifying the Compact, D.C. Code § 47-441.  However, D.C. did not re-enact Article III, Elements of Income Tax Laws, and Article IV, Division of Income.  The repeal of the two articles was effective as of July 30, 2013.  D.C. Act 20-130, §§ 7342(a), (b) (2013); D.C. Act 20-204, §§ 7342(a), (b) (2013); D.C. Law 20-61, §§ 7342(a), (b) (2013).

D.C. repealed and reenacted the Compact in reaction to litigation involving taxpayers that elected to use the three-factor apportionment formula under the Compact instead of the state-mandated apportionment formulas.  See Gillette Co. et al. v. Franchise Tax Bd., 209 Cal.App. 4th 938 (2012); Int’l Bus. Mach. Corp. v. Dep’t of Treasury, No. 146440 (Mich. Jul. 14, 2014); Health Net, Inc. v. Dep’t of Revenue, No. TC 5127 (Or. T.C. 2014).  The California Court of Appeal and Michigan Supreme Court have upheld the taxpayers’ use of the Compact election.

Following the theories being advanced in [...]

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