August’s SALT developments included a healthy mix of guidance released by state and local tax authorities, along with binding decisions from tax tribunals, and courts. The Colorado Department of Revenue issued guidance on procedures for making retroactive pass-through entity tax elections. Portland, Ore., released guidance on the application of Public Law 86-272 protection for purposes of local income taxes.

Also, there were some noteworthy tax litigation developments. The California Office of Tax Appeals determined that deductible income should be included in the sales factor and decided not to follow the Franchise Tax Board’s historical position. Finally, the Ohio Supreme Court decided that certain equipment used in fracking operations is exempt from use tax.

On the legislative front, Massachusetts enacted legislation to implement the “millionaires’ tax” approved by voters at the November 2022 general election. Learn more about these developments in our summary of SALT news for August 2023. 

California OTA holds deductible income must be included in sales factor

In August 2023, the California Office of Tax Appeals (OTA), in Southern Minnesota Beet Sugar Cooperative, released a decision holding that deductible income received from a unitary group member must be included in the sales factor calculation. The OTA declined to follow a 2006 legal ruling issued by the California Franchise Tax Board (FTB) holding that certain deductible items that do not factor into taxable net income should be excluded from the sales factor. The case was decided in March 2023 and its status is “pending precedential.”  

The taxpayer, an agricultural cooperative headquartered in Minnesota owned by farmer shareholders, earned most of its income from business activities for or with its member shareholders. Under a California statute providing a deduction to farm cooperatives for certain income from business activities with their members, the taxpayer was permitted to deduct most of its business income, which greatly reduced its net income subject to California tax. The taxpayer also earned a relatively small amount of income that did not qualify for the deduction. In addition, the taxpayer acquired a for-profit corporation that was not entitled to the farm cooperative deduction. Collectively, the taxpayer and its acquired subsidiary engaged in a unitary business manufacturing sugar and sugar byproducts. The subsidiary earned substantial net income subject to California tax during the 2008-2011 tax years at issue in this matter.

As a unitary business, the taxpayer and its subsidiary filed a two-member California combined report, in which the taxpayer and subsidiary were each required to compute their separate net income before allocation and apportionment. In computing its separate net income, the taxpayer deducted its member income, as well as interest expenses incurred on debt used to acquire the subsidiary and depreciation expense from assets used to produce its deductible income. After aggregating their separate income, the taxpayer and its subsidiary multiplied the combined amount by the group’s California apportionment percentage, determined via the state’s historic three-factor apportionment formula with a double-weighted sales factor. Because all its property and payroll were outside California and a small portion of its sales was located in California, the taxpayer’s inclusion of activities attributable to its member income resulted in a significant reduction of the taxpayer’s overall California apportionment percentage.

The FTB examined the taxpayer’s 2008-2011 tax returns and proposed three adjustments. First, the FTB excluded all the taxpayer’s property, payroll and sales attributable to its deductible member income from the group’s apportionment percentage. Second, the FTB determined the taxpayer’s interest expenses from acquiring the subsidiary could not be deducted from its gross income because it was related to the taxpayer’s deductible member income. Third, the FTB disallowed the taxpayer’s depreciation expense deductions.

The OTA held that the taxpayer properly included in its combined reporting group’s California apportionment percentage its property, payroll and sales related to business income that could be deducted by agricultural cooperatives. According to the OTA, the Uniform Division of Income for Tax Purposes Act (UDITPA) provisions adopted by California do not exclude factors related to deductible agricultural cooperative income. Nothing in the plain language of UDITPA provides that the factors used to generate deductible member income are excluded from the apportionment formula. Similarly, there is nothing in the FTB’s regulations interpreting UDITPA that indicates activities related to deductible member income are excluded from the apportionment formula. The FTB cited only one case, Chase Brass & Copper Co. v. Franchise Tax Board, to support its adjustments. The OTA held that this case, decided by the California Court of Appeals in 1977, was distinguishable and did not support the FTB’s position.

The FTB unsuccessfully argued that the OTA should provide deference to its 2006 legal ruling, which reflected the FTB’s historical position that income excluded from the measure of tax should not be reflected in the apportionment formula. In rejecting the FTB’s argument, the OTA explained that the “FTB’s position does not persuasively explain how the relevant statutes or regulations might be interpreted in the manner it proposes, which would result in excluding unitary business activities that contribute to the production of apportionable business income from the apportionment formula without support in the UDITPA and its regulations and without a showing of distortion.” Importantly, the OTA declined to follow the FTB’s approach in its legal ruling and distinguished income that is exempted or excluded from taxation from amounts that are includible in gross income but subject to a special business deduction.

The OTA agreed with the FTB with respect to its other adjustments. The OTA held that the taxpayer could not deduct the interest expense incurred to acquire the unitary subsidiary against its taxable nonmember income. Because the OTA was unable to determine the taxpayer’s dominant purpose for incurring the debt, and the acquisition of the subsidiary produced both taxable and nontaxable income for the combined group, California case law provides that an allocation formula must be used. The OTA held that the taxpayer was not entitled to deduct its interest expense because it failed to clearly offer a reasonable allocation formula supported by the evidence. Finally, the OTA held that the taxpayer could not deduct the depreciation expense incurred from assets used to produce deductible income under the agricultural cooperative provision against its taxable nonmember income.

Colorado issues guidance on retroactive pass-through entity tax elections

On Aug. 14, 2023, the Colorado Department of Revenue released revised guidance on making retroactive pass-through entity (PTE) tax elections. Colorado enacted legislation in 2021, termed the SALT Parity Act, allowing partnerships and S corporations to make an annual election to be subject to state income tax at the entity level for tax years beginning in 2022 and thereafter. In May 2022, Colorado enacted additional legislation permitting entities to retroactively make the election for tax years beginning in the 2018-2021 tax years.

The Department’s guidance explains that PTEs must file a composite amended return online to make the election for one or more of the 2018-2021 tax years. The composite amended return, which must include all tax years during this four-year period for which the election is made, must report the tax calculated for the electing PTE, any required qualified business income addback for each partner or shareholder, and each partner’s or shareholder’s share of the tax paid. Each partner’s or shareholder’s share of the tax paid, less any additional tax they owe for a qualified business income addback, will be refunded to them.

The guidance is intended to assist PTEs in the preparation of composite amended returns filed to make the election. In calculating the tax, the PTE must report each partner’s or shareholder’s income, gain, loss, deductions, and modifications for the year of the election. The guidance provides separate instructions for determining the income, gain, loss, deductions, and modifications for resident and nonresident owners of PTEs.

Any PTE that files a composite amended return to make the election must provide information for each partner or shareholder, except any C corporation that is unitary with the partnership making the election. The electing PTE must provide identifying information for each partner and or shareholder that will be used to issue refunds. 

Massachusetts enacts legislation to implement millionaires’ tax   

At the November 2022 general election, Massachusetts voters approved a constitutional amendment to impose an additional 4% tax on income over $1 million, with proceeds from the tax designated for education, roads and bridges, and public transportation. This income level will be adjusted annually for inflation, and the tax applies to tax years beginning on or after Jan. 1, 2023. On Aug. 9, 2023, Massachusetts enacted budget legislation, Ch. 28 (H.B. 4040), which includes provisions to implement this new tax and which may affect resident and nonresident individual estimated tax payments to be made for the 2023 tax year.

Under existing law, Massachusetts divides gross income into three different categories. Part A income consists of interest, dividends and capital gains income. Part B income is income that is not included in Parts A or C, including wages, pensions, business activities and rents. Finally, Part C income consists of capital gains income from the sale or exchange of capital assets held for more than one year. Most income is generally taxed at a 5% rate, though certain Part A income, including short-term capital gains, is subject to a 12% tax rate. The new statute provides that where the sum of Part A taxable income, Part B taxable income, and Part C taxable income exceeds $1 million, the portion of taxable income over $1 million is taxed at the rate for each category, plus an additional 4%. In determining the amount that may be subject to the additional 4% tax, any negative amount or loss in any part of taxable income is not applied to reduce the income in any other part or otherwise applied to reduce such amount. The Massachusetts Department of Revenue is authorized to promulgate regulations or issue other guidance necessary to implement this legislation. Taxpayers should watch for future information from the Department that may clarify computation of the new tax. 

Ohio Supreme Court holds fracking equipment exempt from sales and use tax

On Aug. 2, 2023, in Stingray Pressure Pumping, L.L.C. v. Harris, the Ohio Supreme Court held that most of the equipment that the taxpayer used in fracking operations was exempt from sales and use tax because it satisfied the statutory exemption for items used directly in oil and gas production. In reaching its decision, the court considered amendments enacted in 2018 that were made to the statutory provisions exempting items used directly in the production of oil and natural gas.

The taxpayer was engaged in the fracking business, in which a pressurized mixture of water, chemicals, and sand is pumped deep into the earth to fracture and prop open rock formations and extract oil and gas. The taxpayer did not pay use tax on the fracking equipment that it purchased in 2012 and claimed that it was exempt. At the time the equipment was purchased, Ohio law provided an exemption “where the purpose of the purchaser” was “to use or consume the thing transferred directly” in producing crude oil and natural gas. The Ohio Tax Commissioner determined that the equipment was exempt only if it was directly used in injecting the high-pressure fracking fluid into the well. Under this standard, the commissioner concluded that the pumps used to inject the hydraulic mixture into the well and the manifolds used in conjunction with the pump were exempt. However, the commissioner determined that other items of equipment were taxable because they were primarily used before the insertion of the hydraulic mixture into the well. The taxpayer appealed the assessments to the Ohio Board of Tax Appeals (BTA). After the BTA affirmed the assessments, the taxpayer appealed to the Ohio Court of Appeals.

While the appeal was pending, in 2018, the Ohio legislature amended the tax exemption for items directly used in oil and gas production to add a non-exhaustive list of equipment that constitutes a “thing transferred” as well as a non-exhaustive list of equipment that does not constitute a “thing transferred.” The court of appeals concluded that the amendment applied retrospectively and remanded the case to the BTA for application of the new statute to the taxpayer’s equipment. On remand, the BTA concluded that all of the equipment at issue remained taxable under the new statutory language. In applying the new statutory categories, the BTA determined that each piece of equipment was not a “thing transferred” exempt from tax. The taxpayer appealed this decision to the Ohio Supreme Court.

On appeal, the Ohio Supreme Court determined that most of the disputed equipment was exempt from tax. The court reviewed the statutory lists of items that do or do not constitute a “thing transferred” for purposes of the exemption. The taxpayer argued that its equipment qualified as a “thing transferred” because the statute includes in relevant part tangible personal property directly used in hydraulic fracturing. The Department argued that most of the equipment did not qualify for the exemption because the statute provides that “thing transferred” does not include tangible personal property used primarily in storing, holding or delivering solutions or chemicals used in well stimulation. The court reviewed the specific types of equipment and determined that most of it was exempt as a “thing transferred” that was directly used in hydraulic fracturing. Although some of the equipment provided a storage holding function, the court determined that this was not the equipment’s primary use. However, the court held that a data van that the taxpayer used at its command center at the fracking sites was not exempt as a “thing transferred” because it was a motor vehicle that was not used directly in the fracking process.

The court also rejected the commissioner’s argument that even if the equipment at issue constituted a “thing transferred,” it was not exempt because the equipment was not used “directly in production of crude oil and natural gas for sale.” In disagreeing with the commissioner, the court noted that such a narrow reading of the statutory amendments would render the new statute’s list of items qualifying as a “thing transferred” to be meaningless. The court explained that the legislature intended that the items listed as a “thing transferred” must, at least in some circumstances, qualify for the exemption. Other than the data van, the court concluded that the equipment was used directly in the production of oil and gas. Accordingly, the court affirmed the BTA’s determination that the data van was not tax exempt, but reversed the BTA’s determination that the other items were taxable. One justice filed a dissent which would have held that some of the equipment did not constitute a “thing transferred” because it was used primarily in storing or holding solutions or chemicals. 

Portland, Ore. changes policy on local P.L. 86-272 protection

The City of Portland, Ore.’s issuance of a Tax Administration Policy reflects an interpretive change concerning the application of Public Law 86-272 (P.L. 86-272) for purposes of the city’s business license tax, Multnomah County business income tax, and the Metro Supportive Housing Services (SHS) business income tax. P.L. 86-272 limits the state and local taxation of income from sales of tangible personal property if the taxpayer’s only business activities in the state are the solicitation of orders that are approved and shipped from outside the state. A taxpayer is protected from state and local taxes when its activities are limited to the solicitation of sales (or activities entirely ancillary to the solicitation of sales) of tangible personal property.  

The guidance, finalized in April 2023, explains that for tax years beginning before 2023, the collective Portland-area local tax jurisdictions apply P.L. 86-272 on an intrastate basis. Under this interpretation, P.L. 86-272 protection applies to a business unless its activities within the local tax jurisdiction exceed solicitation of sales or activities entirely ancillary to solicitation of sales. However, for tax years beginning in 2023 and beyond, the application of P.L. 86-272 will be done on an interstate basis. This means that P.L. 86-272 protection will only apply to a business when its activities in Oregon do not exceed solicitation of sales or activities entirely ancillary to solicitation of sales. A business with nexus in the local tax jurisdictions whose activities exceed solicitation of sales or activities entirely ancillary to solicitation of sales of tangible personal property anywhere within Oregon will not be protected by P.L. 86-272 in the local tax jurisdictions.

According to the guidance, the change in policy is an outgrowth of Oregon’s adoption of market-based sourcing for state apportionment purposes in 2018, which was followed by the Portland-area local tax jurisdictions for their income-based taxes in 2023. The interstate application of P.L. 86-272 was endorsed as a means to implement market-based sourcing to its fullest extent.

The guidance provides four examples explaining the application of the city’s new policy, including the potential effect of throwback rules, for tax years beginning in 2023 and thereafter. Taxpayers should consider this guidance and the examples in determining whether P.L. 86-272 protection applies and the proper apportionment treatment for the local tax jurisdictions.