State and local tax news for April 2024

The April 2024 summary of SALT news discusses several developments from state legislatures addressing tax matters, along with decisions concerning ever-popular apportionment issues. First, the California Office of Tax Appeals (OTA) officially released the long-awaited Microsoft decision and the subsequent decision rejecting a motion for rehearing that were favorable for taxpayers, but both decisions were designated as nonprecedential. The California OTA also released a decision considering unitary business and business income issues related to gains from the sale of a joint venture interest.

Kentucky became one of the first states to enact significant budget legislation that amended many areas of tax law. Minnesota enacted legislation correcting the effective date of legislation enacted last year that reduced the net operating loss limitation. Finally, the New Jersey Tax Court decided a taxpayer could use market-based sourcing for service revenue in tax years prior to the state’s enactment of this sourcing methodology. 

California OTA designates Microsoft decisions as nonprecedential

On April 2, 2024, the California OTA formally posted the Microsoft decisions on its website and designated the decisions as “nonprecedential.” The OTA originally decided the Microsoft case on July 27, 2023, holding that a water’s-edge group could include the gross amount of repatriated dividends in the denominator of its sales factor without taking the 75% qualifying dividend deduction. Because the California Franchise Tax Board (FTB) challenged this holding by filing a petition for rehearing, the decision was not posted by the OTA in 2023.

A separate panel of the OTA confirmed the original decision on Feb. 14, 2024, and denied the FTB’s petition for rehearing. Both opinions were unofficially disseminated to the public in February 2024. The OTA released both opinions in early April 2024 as nonprecedential decisions. As a result, these decisions are not binding on the FTB, OTA, or taxpayers. Future taxpayers that would benefit from the rationale in Microsoft are likely to cite to these opinions as persuasive authority, but the FTB and OTA are not required to follow it. Note there is a possibility that a request with the OTA may be filed in an attempt to designate these decisions as precedential. 

California OTA makes unitary business and business income determination  

In Alvaco Trading Company, Inc., the OTA released a decision on April 2, 2024 (originally decided on Jan. 23, 2024), that addressed unitary business and business income issues arising from gain on the sale of a joint venture interest. In another opinion designated as nonprecedential, the OTA determined that the taxpayer and the joint venture were engaged in a unitary business and the gain from the sale constituted business income.

Alvaco Trading Company (Alvaco) was an S corporation based in Florida that was the largest independent contact lens distributor in the U.S. In 2007, Alvaco and Con-Cise LLC (Con-Cise), the second largest contact lens distributor, contributed substantially all of their operating assets to form a joint venture limited liability company, ABB. Alvaco owned 55% of ABB and Con-Cise owned the remaining 45%. ABB became the largest contact lens distributor in the U.S. and was doing business in California during 2012. In October 2012, Alvaco disposed of most of its interest in ABB, retaining a 13.46% stake at year’s end. According to the California FTB, Alvaco reported that it was unitary with ABB on its tax returns for the 2007 through 2012 tax years. For 2012, Alvaco reported gain from its sale of ABB as nonbusiness income. Other than its interest in ABB, Alvaco had no sales, payroll, or property sourced to California. Following protest proceedings, the FTB determined that Alvaco and ABB were part of the same unitary business and that the gain from the sale was business income. Alvaco appealed this determination to the OTA.

On appeal, the OTA agreed with the FTB that Alvaco and ABB were engaged in a unitary business and that Alvaco’s gain from selling its interest in ABB was business income. As a preliminary matter, the OTA noted that a determination of whether an item is business income is independent of whether the entities are engaged in a unitary business. In this case, because Alvaco did not have California activity of its own, Alvaco only would have California tax liability if it were determined to be unitary with ABB. As explained by the OTA, since this appeal involved an S corporation, a former operating company which later became an entity holding only the ABB membership interest, the law required a more nuanced approach to determine if the entities were unitary.

The OTA concluded that the stock ownership requirement for C corporations was met because Alvaco owned 55% of ABB. Furthermore, the traditional unitary tests were satisfied. The OTA explained that there was a flow of value because Alvaco supplied ABB with the operational assets, intellectual property and management to become the largest contact lens distributor. There was functional integration between the entities and the sharing of senior executives satisfied the centralized management requirement. In addition, the OTA noted that mutual interdependence and flow of value existed as ABB was dependent on Alvaco’s assets and executive expertise as much as Alvaco was dependent on ABB’s revenue stream after contributing all its operating assets to ABB. The OTA determined that the FTB’s determination of unity was reasonable and rational and that Alvaco failed to meet its burden of establishing that it was not in a unitary business with ABB.

In deciding that the gain constituted business income, the OTA explained that California courts have established two tests to make this determination. Under the transactional test, income constitutes business income if the relevant transaction and activity occurred in the regular course of trade or business. Under the functional test, income is business income if the taxpayer’s acquisition, control, and use of the property contribute materially to the taxpayer’s production of business income. The parties agreed that the transactional test did not apply, but they disputed whether Alvaco’s sale of its interest in ABB generated business income under the functional test. The FTB successfully argued that the functional test was met because ABB was integral to Alvaco’s regular business operations. Alvaco argued that it did not have sufficient control over ABB to satisfy the functional test, but the OTA determined that Alvaco managed and controlled its membership interest in ABB. The OTA also held that the FTB correctly determined that Alvaco’s shareholders were taxable by California on their pro rata share of Alvaco’s unitary business income apportioned to California.

Kentucky enacts budget legislation containing variety of changes

In April 2024, Kentucky enacted budget legislation, H.B. 8, which amended multiple areas of Kentucky tax law. On April 9, 2024, Kentucky Gov. Andy Beshear line-item vetoed provisions concerning a sales tax exemption for currency and bullion as well as an unfunded mandate for a tax amnesty program. The legislature voted to override these vetoes on April 12, 2024. According to the legislature’s website, the legislation became law on April 10, 2024, without the governor’s signature. The most significant provisions of the budget legislation are discussed below.   

The legislation advances the Internal Revenue Code (IRC) conformity date for income tax purposes, and amends a provision originally enacted to provide relief to certain combined groups that suffered adverse tax impact from the shift from separate to combined reporting. For tax years beginning on or after Jan. 1, 2024, Kentucky generally adopts the IRC in effect on Dec. 31, 2023. Kentucky previously had adopted the IRC as in effect on Dec. 31, 2022. Under existing law, for 10 years starting with a combined group’s first tax year beginning on or after Jan. 1, 2024, a combined group is entitled to a deduction from the group’s entire net income equal to 10% of the amount necessary to offset the increase in the net deferred tax liability, decrease in the net deferred tax asset, or aggregate change from a net deferred tax asset to a net deferred tax liability due to the imposition of combined reporting. The recent budget legislation delays the start of the 10-year deferred tax deduction period to tax years beginning on or after Jan. 1, 2026.

The legislation also expands a provision that allows for sellers of de minimis levels of a variety of prescribed taxable services to remain exempt from the Kentucky sales and use tax during the first year in which they sell these types of services. When Kentucky expanded the scope of the sales and use tax to numerous services in 2019, it provided for an exemption for sellers that sold a minimal amount of these services during the first year in which they sold these services. The threshold for taxability for these persons was initially set at $6,000 in gross receipts in 2019 or future tax years. To the extent the person sold more than $6,000 in services, all gross receipts over this amount were taxable in the calendar year. Further, all gross receipts became subject to tax in subsequent calendar years. The list of services that became subject to sales tax and was covered by this exemption was expanded in 2023. The enacted legislation raises the threshold for taxability from $6,000 to $12,000 in 2025 or future tax years, with the same condition that such exemption only applies for the first year in which the seller sells these services. 

In addition to the change to the de minimis exemption, the legislation also creates a sales and use tax exemption for the sale, use, storage or consumption of currency and bullion. A new provision defines “bullion” to include bars, ingots, or coins made of gold, silver, platinum, palladium or a combination of these metals.

For tax years beginning after 2024 and before 2029, the legislation creates a qualified broadband investment tax credit to provide for the expansion of broadband services in Kentucky. The income tax credit equals 50% of the sales and use tax paid on a qualified broadband investment in Kentucky reduced by the amount of seller reimbursement, but is limited to a total of $5 million for all tax credits in each year. The credit is nonrefundable, nontransferable, and allowed against corporation income tax, individual income tax, and limited liability entity tax.

Finally, tax amnesty is provided for a 60-day period beginning on Oct. 1, 2024, and ending on Nov. 29, 2024. The amnesty broadly applies to taxes, penalties, fees, and interest administered by the Kentucky Department of Revenue, with the exception of property taxes and certain penalties.     

Minnesota corrects effective date of NOL limitation reduction  

In 2023, Minnesota enacted legislation limiting the amount of the corporate income tax net operating loss (NOL) deduction to 70% (previously, 80%) of taxable net income in a single tax year. As originally enacted, this change was effective for tax years beginning in 2023 and thereafter. However, there was an indication when the original legislation was adopted that the effective date did not represent the true intent of the Minnesota legislature. In response, on April 8, 2024, Minnesota enacted legislation, H.F. 3769, which remedies this issue by retroactively amending the effective date of the NOL limitation reduction to tax years beginning in 2024 and thereafter.  

As explained on the Minnesota Department of Revenue’s website, for tax years beginning in 2018 through 2023, the NOL deduction is limited to 80% of the corporation’s taxable income. For tax years beginning in 2024 and beyond, the NOL deduction is limited to 70% of the corporation’s taxable income. Minnesota law does not distinguish between NOL carryovers generated before or after the law change. If taxpayers filed their 2023 Corporation Franchise Tax Return before this law change, they may need to file an amended return to claim the additional NOL deduction.    

New Jersey Tax Court allows market-based sourcing prior to enactment             

On April 11, 2024, in Solix Inc. v. Director, Division of Taxation, the New Jersey Tax Court held that the taxpayer could use market-based sourcing (MBS) to apportion its service revenue in tax years prior to the state’s adoption of MBS. The taxpayer sought a refund for the 2011 and 2012 tax years after filing amended corporation business tax (CBT) returns using MBS. In granting the refund requests, the court determined that New Jersey law did not prohibit the use of MBS prior to 2019 and found that MBS most accurately reflected the economic realities of the taxpayer’s business activities.

Before 2019, the New Jersey apportionment statute was silent on how the numerator of the sales factor should be calculated if services were performed both within and outside the state. However, a regulation provided that the numerator of the sales factor should include receipts from services based on costs of performance (COP), the amount of time spent in performing the services, or by some other reasonable method reflecting economic realities. COP was defined as all direct costs incurred in performing the services, including direct costs of subcontractors. A separate regulation provided a 25-50-25 method for “certain service fees” where 25% of the fees were sourced to the state of origin, 50% to the state where the service is performed, and 25% to the state in which the transaction terminates. For tax years ending on or after July 31, 2019, the New Jersey apportionment statute was amended to adopt MBS to source services based on where the customers are located. The regulations were amended in 2020 to adopt MBS and eliminate the 25-50-25 method. 

The taxpayer, a Delaware corporation based in New Jersey, had 900 employees, with roughly 300 located in New Jersey. For the relevant tax years, the taxpayer provided web-based business solutions to its customers, which included the creation or customization of its proprietary software that was designed and developed in New Jersey. The main computer servers were in New Jersey and all executive functions were performed in the state. The taxpayer primarily acted as the third-party administrator for out-of-state governmental entities in operating and managing governmental subsidy programs for the benefit of the residents of those states. Nearly all its customers were located outside New Jersey and a majority of its employees performed their duties outside the state. The taxpayer apportioned 90% of its payroll to New Jersey, but 70% of its workforce was located outside New Jersey and performed services for 99% of the taxpayer’s out-of-state customers.

On its CBT returns for the 2011 and 2012 tax years, the taxpayer sourced approximately 82% of its services to New Jersey. In 2016, the taxpayer amended its returns using the COP method so that it could add payroll and subcontractor payments as direct costs. Because this lowered the sales factor, the taxpayer filed refund requests. In reply to the New Jersey Division of Taxation’s request for further information, the taxpayer filed a second set of amended returns using MBS because it was “more reflective of the economic realities of its business.” This further reduced the taxpayer’s sales factor numerator. The taxpayer argued that while it had used the 25-50-25 method for the 2010 tax year, MBS was more appropriate for the 2011 and 2012 tax years. In rejecting refunds based on MBS, the Division determined that COP was the appropriate method for sourcing the taxpayer’s service receipts. The taxpayer appealed this determination to the New Jersey Tax Court.