State and local tax news for September 2023

In the past month, California promulgated a long-awaited permanent sales tax regulation with relevance for marketplace sales and facilitators. In addition, a series of state tax controversies tackled SALT hot topics such as the extent of Public Law 86-272 protection, the scope of royalty addback exceptions, limits on the use of statutory apportionment, and the proper sourcing method for sales of products stored in a state for a limited period of time. A California Superior Court denied a motion for summary judgment for a challenge of the state’s guidance on the application of Public Law 86-272 protection to internet transactions.

In a royalty addback case, the New Jersey Tax Court applied a regulation as amended in 2020 to prior tax years to prevent constitutional violations. A New York administrative law judge determined that the application of the statutory apportionment method to investment receipts under the previous tax regime resulted in impermissible distortion. Finally, the Ohio Board of Tax Appeals held that receipts from products stored in the state should not be sourced to Ohio for Commercial Activity Tax purposes because they ultimately were shipped to customers outside the state. These developments are covered in our summary of SALT news for September 2023. 

California issues permanent marketplace sales regulation  

Effective Aug. 28, 2023, the California Department of Tax and Fee Administration (CDTFA) promulgated a permanent sales tax regulation to provide guidance for marketplace sales. California enacted legislation in 2019 that established sales tax collection and remittance requirements for marketplace facilitators that became effective on Oct. 1, 2019. A marketplace facilitator is considered to be a seller and retailer for each sale facilitated through its marketplace for purposes of determining whether it has a sales tax filing obligation in California. As such, marketplace facilitators are subject to the state’s $500,000 sales threshold for purposes of determining whether they have economic nexus with California.

The CDTFA issued an emergency regulation that became operative on June 29, 2020, to implement the marketplace provisions. The emergency regulation included the following: (i) definitions of terms and phrases; (ii) clarification of registration requirements for marketplace facilitators and sellers; (iii) an explanation of when a marketplace facilitator is the seller and retailer for purposes of the sale of tangible merchandise facilitated for a marketplace seller; (iv) procedures for a delivery network company to elect to be a marketplace facilitator; and (v) examples illustrating how its provisions were applied. The emergency regulation remained in effect for two years. The CDFTA received public comment prior to releasing the permanent regulation.

The permanent regulation generally retains the language of the emergency regulation, though there are some noteworthy changes. While the broad definition of “marketplace facilitator” is included in the permanent regulation, new definitions are added for “fulfillment or storage services,” “order taking,” and “providing customer service or accepting or assisting with returns or exchanges.”

The definition of “facilitate” is amended to clarify that it applies to activities that make it possible (previously, “easy”) or easier for the marketplace seller to sell its products through the marketplace. Also, the facilitation activities are expanded to include listing products for sale. The provisions under the “facilitate” definition that excluded a person who operates a newspaper or internet website that advertises tangible personal property without participating further in the sale have been expanded and moved to a separate “advertising” section. Also, examples have been added to clarify the treatment of persons engaging in advertising.

Several other definitions, such as “branding sales as those of the marketplace facilitator,” “listing products for sale,” and “payment processing services” also have been amended and expanded. New examples have been added to the “marketplace” definition. For purposes of determining whether a marketplace seller is a retailer engaged in business in California because its sales of property for delivery in the state exceed $500,000, the regulation is amended to clarify that all sales of tangible personal property for delivery in the state are considered, regardless of whether the sales are taxable. 

California court denies summary judgment in P.L. 86-272 challenge

On Aug. 24, 2023, in American Catalog Mailers Association v. Franchise Tax Board, the California Superior Court for San Francisco County denied a motion for summary judgment in a challenge of the guidance released by the California Franchise Tax Board (FTB) on Public Law 86-272 (P.L. 86-272) protection. The court determined that the American Catalog Mailers Association (ACMA) failed to show that the FTB’s guidance concerning internet transactions contradicted P.L. 86-272 on its face.

P.L. 86-272, a federal law enacted in 1959, 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. In 2021, the Multistate Tax Commission (MTC) adopted a revised statement interpreting P.L. 86-272 as it applies to the modern economy and internet business activities. In 2022, the FTB released guidance, Technical Advice Memorandum (TAM) No. 2022-01, and revised FTB Publication 1050 to address the application of P.L. 86-272 to companies with internet transactions. The FTB’s guidance does not explicitly adopt or reference the MTC’s revised statement, but the guidance generally is consistent with the positions set forth in the statement by addressing the same internet activities that are outlined in the MTC’s statement and reaching the same conclusions.

ACMA is a non-profit trade association advocating on behalf of catalog, online, direct mail, and other remote retailers and their suppliers. The association has approximately 120 to 140 members across the country, and as a trade association, it does not sell tangible products or pay income tax (though its members do). In its original complaint seeking a declaratory judgment, ACMA alleged that the FTB’s guidance is invalid because it contradicts P.L. 86-272 and the U.S. Constitution, the FTB failed to comply with rulemaking under the Administrative Procedure Act (APA); and is substantively invalid (or alternatively should have limited application prospectively). ACMA moved for summary judgment on the first count seeking a declaration that the guidance is invalid because it contradicts P.L. 86-272 and the U.S. Constitution, but it did not seek a ruling on the other two counts. ACMA specifically challenged the two hypotheticals in the guidance indicating that P.L. 86-272 protection is lost if a company provides live chat and email through its website, or places internet “cookies” onto the computers or other electronic devices of California customers that are used to gather customer information.

The FTB raised several technical and procedural objections to ACMA’s claim that were rejected by the court. First, the FTB unsuccessfully argued that the California Constitution’s requirement that a taxpayer “pay first” before beginning a legal action prevented this suit. According to the court, this provision did not bar the suit because the FTB failed to show that there were any ACMA members with pending tax assessments. The court also determined that ACMA had standing to bring and maintain this action. Specifically, ACMA had “associational standing” because its members would have standing in their own right to pursue this litigation. The court explained that this action fit within ACMA’s purpose of advocating for the interests of remote merchants and did not require the participation of individual ACMA members. The court also determined that ACMA had standing because at least one of its members was an “interested person” operating a type of business described in the guidance that did not receive P.L. 86-272 protection.

ACMA also successfully argued that its action was ripe for review because it is concrete, presents a pure question of law, and withholding a judicial determination would result in a hardship to ACMA’s members because they were at significant risk of penalties, interest, and double tax. The court explained that although ACMA members have yet to be assessed California income tax, the state of the law for out-of-state businesses that allow California consumers to place orders through websites or use cookies on their websites is uncertain due to the FTB’s guidance. The court also agreed with ACMA that the guidance constitutes “regulations” that are subject to challenge because they are generally applicable and describe the manner in which the FTB will apply P.L. 86-272 to out-of-state businesses engaged in interstate commerce over the internet. The FTB conceded that the guidance was not promulgated as a regulation, but ACMA did not move for summary judgment on the count that the guidance is invalid as an “underground regulation” adopted in violation of the APA.

Ultimately however, the court rejected ACMA’s motion for summary judgment because it did not meet its burden of showing that the guidance contradicted P.L. 86-272 on its face. The court noted that ACMA’s challenge was based on two hypotheticals in which P.L. 86-272 protection did not apply. The conclusions for each hypothetical fact pattern in the guidance were tied to P.L. 86-272 and the U.S. Supreme Court cases considering the “solicitation of orders.” The court acknowledged that “[a]lthough some of the FTB’s analysis may be flawed,” the court could not conclude that the TAM and FTB Publication 1050 are invalid in their entirety. Furthermore, the court explained that the determination of whether the businesses in the hypothetical fact patterns are engaging in activities that would forfeit P.L. 86-272 protection would be better considered with a developed factual record.

In conclusion, the court explained that ACMA relied upon the use of general fact patterns in the guidance to seek summary judgment without adequate supporting facts or substantive argument regarding post-sales assistance and internet cookies. Although the guidance raises significant concerns on the FTB’s application of P.L. 86-272, the court could not conclude as a matter of law that the use of generic hypotheticals contradicts P.L. 86-272 on its face such that the entire TAM and FTB Publication 1050 are invalid. Because this was a summary judgment action, it is very likely that a court will consider the scope of the FTB’s guidance when there is a developed factual record. Given that this litigation concerns how states may be able to implement the interpretive guidance provided by the MTC with respect to the reach of P.L. 86-272, the arc of this case will continue to garner national interest.

New Jersey court applies 2020 version of addback regulation retroactively  

On Sept. 13, 2023, in Lorillard Tobacco Co. v. Director, Division of Taxation, the New Jersey Tax Court retroactively applied the royalty addback regulation as amended in 2020 to prior tax years to prevent a violation of the federal dormant Commerce Clause. The court determined that the portion of the regulation providing an addback exception in effect prior to 2020 violated the fair apportionment prong of the dormant Commerce Clause due to its geographic limitation for proving that the same income was taxed outside New Jersey. However, this constitutional violation was eliminated in 2020 because the regulation now includes five scenarios that satisfy the unreasonableness exception to the addback requirement. The court applied the 2020 version of the regulation to the 2002-2005 and 2007-2010 tax years at issue as the most sensible interpretation of the royalty addback statute.  

The taxpayer claimed a 100% exception to the addback of New Jersey allocated royalties it paid to its wholly owned subsidiary. The New Jersey Division of Taxation granted a partial exception because the subsidiary’s New Jersey apportionment factor was lower than the taxpayer’s apportionment factor. As a result, the subsidiary’s corporation business tax (CBT) payment on the royalties from the taxpayer was less than the taxpayer’s CBT due to the royalty addback. In a prior decision, the New Jersey Tax Court agreed with the taxpayer that not permitting a full deduction when the subsidiary had filed returns and paid CBT on its portion of New Jersey income was an unreasonable exercise of the Division’s discretion. The Tax Court did not address the taxpayer’s constitutional arguments.

Following an appeal by both parties, the Appellate Division reversed the Tax Court and held that the Division’s decision to limit the exception to the extent of the New Jersey taxes paid by the subsidiary was reasonable. The taxpayer cross-appealed that the addback regulation and Schedule G-2 of the CBT return, “Claim for Exceptions to Disallowed Interest and Intangible Expenses and Cost,” were unconstitutional because they: (i) were discriminatory; (ii) indirectly taxed the subsidiary’s out-of-state activities; and (iii) resulted in gross distortion of the taxpayer’s allocable income. The Appellate Division held that the constitutional issues required consideration by the Tax Court and noted that the amendments made to the regulation in 2020 could moot the taxpayer’s constitutional argument. Prior to the instant case, both parties agreed that the 2020 amendments were not retroactive.

A New Jersey statute requires an entity doing business in the state to add back otherwise deductible royalties paid to a related member in computing its allocable entire net income. However, the addback does not apply if the taxpayer proves that the addback is unreasonable. Prior to 2020, the contested regulation provided a “deduction shall be permitted . . . [i]f the taxpayer establishes that the adjustments are unreasonable by showing the extent that the payee pays tax to New Jersey on the income stream.” This was the only stated option to provide an exception under the unreasonableness exception. Schedule G-2 provides for the computation of the deductible amount.

In 2020, during the appeal of this case, the addback regulation was amended to add five scenarios for claiming that a disallowed royalty is unreasonable. The amended regulation provides that a deduction may be allowed if the adjustment is unreasonable and one of the following circumstances applies: (i) unfair duplicate taxation; (ii) technical failure to qualify the transactions under the statutory exceptions; (iii) inability or impediment to the meet the requirement due to legal or financial constraints; (iv) unconstitutional result; or (v) transaction is equivalent to an unrelated loan transaction. However, the Division did not change Schedule G-2. The payor’s deduction continues to be limited to the CBT paid by the payee on the royalty addback amount.

The taxpayer argued that the pre-2020 version of the regulation was unconstitutional because it limited the unreasonableness exception to the CBT paid by the payee, which in turn is dependent on the payee’s New Jersey allocation factor. The Tax Court explained that the taxpayer’s challenge was focused on the dormant Commerce Clause prongs of: (i) discrimination; and (ii) the external consistency part of the “fair apportionment” prong which requires the tax at issues be internally and externally consistent. The court found no facial discrimination in the pre-2020 version of the regulation. In applying the unreasonableness exception, the domestic entities were not treated more favorably than the foreign entities. However, the court held that the pre-2020 version of the regulation violated the external consistency test by denying the taxpayer a deduction of the amount of royalties paid to its subsidiary without considering whether these amounts were reported or taxed outside the state.

The Tax Court decided on its own accord to apply the 2020 version of the regulation to the taxpayer as a means to address the constitutional issue. As explained by the court, the 2020 version is constitutional because the taxpayer can prove unfair double or multiple taxation by showing taxes paid on the subsidiary’s New Jersey-based royalty income outside the state. In deciding to apply the regulation retroactively, the court explained that “elimination of the geographic limitation ... and incorporation of the illustrative examples retains the original regulatory intent of unfair duplicative taxation but avoids an unconstitutional result.” The court addressed the taxpayer’s argument that constitutional concerns remain because Schedule G-2 continues to limit the deduction to the amount of CBT paid by the payee. According to the court, Schedule G-2 is constitutional because it allows taxpayers an opportunity to seek additional deductions on a separate claim form.

Because New Jersey has adopted unitary combined reporting, the related party expense addback is no longer required. However, this case remains relevant to New Jersey taxpayers with royalty addback exception issues and may be relevant to taxpayers in other states that continue to have similar royalty addback exception statutes. 

New York ALJ holds state improperly sourced investment receipts 

On Aug. 31, 2023, an administrative law judge (ALJ) with the New York Division of Tax Appeals held in Jefferies Group LLC that the Division of Taxation used an apportionment sourcing methodology that resulted in an unconstitutional distortion of the taxpayer’s income that did not accurately reflect how the income was generated. The ALJ determined that the Division improperly sourced the receipts based on the location of the institutional intermediaries rather than the underlying investors that were responsible for the taxpayer’s receipts. The taxpayer also challenged the Division’s denial of the taxpayer’s election to treat the net income from its securities borrowing and securities lending transactions, interest rate swap transactions, and cash on deposit as investment capital as well as the Division’s disallowance of a substantial portion of the taxpayer’s investment tax credits and employment incentive credits, but this summary focuses on the apportionment issue.

During the 1997-2007 tax years at issue, the taxpayer was the parent of a combined group of subsidiary corporations that operated as a full-service investment bank and institutional securities firm focused on growth and middle-market companies and their investors. The two subsidiaries considered in the decision were registered securities broker-dealers headquartered in New York City. Both subsidiaries derived commissions from executing brokerage transactions in equity securities at the direction of institutional intermediaries such as registered investment advisors, pension funds, hedge funds, mutual funds, registered securities brokers or dealers, and similar financial intermediaries and collective investment vehicles. The parties stipulated that the underlying investors were comprised of investors in mutual funds, hedge funds and similar collective investment vehicles, and the beneficiaries of pension and retirement plans, including collective investment vehicles managed by registered and non-registered investment advisors. The subsidiaries had underlying investors located throughout the country.

For the tax years at issue, New York corporate taxpayers reported their tax liability based on their computation of the highest of four income bases. A corporation’s entire net income base was computed by calculating its entire net income, generally consisting of its investment income and its business income. The corporation’s investment income and business income were allocated to New York based on the corporation’s investment allocation percentage and business allocation percentage (BAP), with the resulting amounts totaled to arrive at the corporation’s entire net income. For registered securities dealers, New York law provided customer-based sourcing rules for certain categories of receipts, including brokerage commissions, margin interest, gross income including any accrued interest from principal transactions, certain underwriting revenue, interest on loans to affiliates, account maintenance fees, and fees for management and advisory services.

For the 2003-2007 tax years, the taxpayer filed amended returns reporting reduced BAP resulting from a reduced receipts factor, taking the position that its brokerage commissions, gross income from principal transactions including accrued interest, margin interest, clearing fees and management fees should be sourced based on the locations of the underlying investors of the institutional intermediaries rather than the location of the institutional intermediaries themselves. The Division sourced these receipts based upon the location of the institutional intermediaries listed in the taxpayer’s books and records. New York law applicable to the relevant tax periods generally required that a registered broker-dealer source revenue based upon the addresses of the customers responsible for paying this revenue. The dispute concerned who was the “customer responsible for paying” the revenues and how those revenues should be sourced in the receipts factor.

The taxpayer asserted that the sourcing of brokerage commissions earned through its relationships with institutional intermediaries was the largest component of the disputed brokerage commissions at issue. Because most of the subsidiaries’ security trades were made at the request of registered investment advisors on behalf of their institutional intermediary clients, most of their commissions were generated by security trades on behalf of the underlying investors in those institutional intermediaries. Furthermore, the taxpayer argued that the subsidiaries’ institutional intermediary clients were not the customers responsible for paying the brokerage commissions. The institutional intermediaries were acting on behalf of their underlying investors. The taxpayer similarly sourced the subsidiaries’ margin interest, management fees, and clearing fees based upon an approximation of the locations of the underlying investors, but the Division sourced these receipts to the institutional intermediaries. The ALJ determined that the Division followed the law by sourcing the receipts to the institutional investors because the law did not permit the sourcing of receipts based upon an approximation of the location of the underlying investors.

Although it was determined that the law did not permit the taxpayer to source its receipts based on the location of its underlying investors, the taxpayer argued that the Division should be required to apply its discretionary authority to source the receipts on this basis. The Division calculated the subsidiaries’ receipts factor at approximately 20-22% during the relevant tax years based on the location of their institutional intermediaries. However, using U.S. census data to approximate the location of the underlying investors would result in only 6.48% of the income being sourced to New York. The ALJ determined that the use of New York’s share of the U.S. census was the appropriate sourcing method in this case. According to the ALJ, the Division’s allocation method was very distortive because its receipts allocation factor grossly overstated, by a factor of three or four times, the results reached using an allocation method that reasonably approximates the location of the underlying investors. This resulted in an unconstitutional distortion of the taxpayer’s income that did not accurately reflect how the income was generated.

This case concerned tax years prior to the major tax reform that New York enacted beginning with the 2015 tax year. Under current law, brokerage commissions are deemed to be generated within the state if the mailing address in the records of the taxpayer of the customer who is responsible for paying such commissions is within the state. Because the statutory language continues to reference the customer who is responsible for paying the commission, this decision could have relevance to sourcing brokerage commissions under current law. Also, this case is relevant in a broader, multistate context because it is an instance in which the use of the statutory apportionment methodology results in an unconstitutional distortion of receipts sourced to a state. The Division may decide to appeal this decision.  

Ohio BTA holds no CAT on items ultimately delivered outside state  

On Sept. 13, 2023, in VVF Intervest LLC v. Harris, the Ohio Board of Tax Appeals (BTA) held that a taxpayer that manufactured soap in Kansas that was transported to its customer’s distribution center in Ohio was not subject to Ohio Commercial Activity Tax (CAT) for the soap that ultimately was delivered outside Ohio.

The taxpayer, VVF Intervest, manufactured bar soap and other personal care items in Kansas and did not have any property or employees in Ohio. At the end of the manufacturing and packaging process, VVF knew the intermediate destination of the soap, but had limited information about where the soap was ultimately destined. VVF’s largest customer, High Ridge Brands (HRB), contracted with third-party trucking companies to transport the soap from VVF’s manufacturing facility to its distribution centers in Ohio, Missouri, and California. HRB held approximately two months of inventory in the Ohio distribution center. From this Ohio facility, HRB contracted to transport the goods to destinations outside Ohio based on its customer needs. HRB did not own the trucks or distribution centers and no changes were made to the soap or its packaging at the distribution centers. VVF filed an application seeking a refund of CAT paid on bar soap receipts from 2010 through 2014. After the Ohio Tax Commissioner denied the refund claim, VVF appealed to the OTA.

Under the CAT, gross receipts from the sale of tangible personal property occur in Ohio if the property is received in the state by the purchaser. In the case of delivery of tangible personal property by motor carrier, the place at which such property is ultimately received after all transportation has been completed is considered the place where the purchaser receives the property. In interpreting this provision, the BTA considered several cases addressing the relevant CAT sourcing statute, and a similar sourcing statute in effect when Ohio previously imposed a corporate franchise tax. In the cases addressing the CAT sourcing statute, the BTA determined that the taxpayers failed to show that Ohio was merely a stop in the transportation process and not the place where the goods were ultimately delivered after all transportation had been completed. However, the BTA noted in these decisions that the taxpayers could have prevailed if they had been able to show that the transportation ended outside Ohio.

VVF argued that the soap should not be sourced to Ohio because the Ohio distribution center was an interim stop in the distribution chain and not the location where the soap was ultimately received. As a result, VVF argued that 96.84% of its HRB receipts should not be sourced to Ohio, and 52% of its receipts to another customer, Dollar General, should not be sourced to the state. The Commissioner argued that the trip from Kansas to Ohio should be treated as a taxable event separate from the trip from Ohio to another state. The Commissioner placed great emphasis on VVF’s records and subjective knowledge at the time the soap left Kansas. Because those documents indicated the soap bars were destined for Ohio, the Commissioner argued that the receipts should be sourced to Ohio.

The OTA determined that VVF’s subjective knowledge at the initial shipping point was probative but not dispositive. Neither the statute nor the case law imposes a requirement of contemporaneous knowledge of the ultimate destination at the time of transportation. The OTA held that VVF carried its burden of proof for the HRB receipts for bars that were ultimately delivered outside Ohio. VVF presented sufficient evidence that the soap was not ultimately delivered to its customer in Ohio. The OTA agreed with the Commissioner that the sale of goods to HRB could be viewed as a transaction separate from the subsequent sale of those goods from HRB to its customers. However, the OTA determined that the ultimate delivery to HRB was not to the Ohio distribution center. From the Ohio facility, HRB again contracted to transport the goods outside Ohio based on customer needs. Although VVF met its burden for the HRB receipts, it did not meet its burden regarding the Dollar General receipts because its evidence was speculative. The OTA clarified that its analysis was confined to VVF’s receipts and that it made no findings concerning the receipts of HRB, the trucking companies, or the warehouse.

One of the members of the three-member OTA panel filed a dissent and disagreed that the soap ultimately delivered outside Ohio should not be sourced to the state. Contrary to the majority’s finding, the dissent interpreted the relevant statute to require taxable gross receipts to be sourced where ultimately received by the purchaser in the sale generating the gross receipts, not where received by the ultimate purchaser. The decision, which may be appealed by the state, should be of interest to manufacturers and other businesses that sell their products to Ohio distributors and source these sales for CAT purposes as Ohio sales, but have proof that such distributors resell those products to a national market.