State and local tax news for November/December 2023

While we expected the pace of state and local tax developments to slow in the waning weeks of 2023, several noteworthy events have unfolded, primarily in the courts. In California, an appellate court affirmed a 2012 ballot measure requiring single sales factor apportionment. Also, California issued new regulations providing procedures to file petitions requesting alternative apportionment. The high courts in three states issued significant tax decisions. The Maine Supreme Judicial Court decided an apportionment case concerning the sourcing of receipts from prescription benefit management services. Also, the Minnesota Supreme Court released an opinion on the apportionment of gain from the sale of goodwill. The Missouri Supreme Court held that a company’s purchases of equipment that were sold to subsidiaries qualified for the resale exemption against Missouri use tax. Finally, the Michigan Tax Tribunal decided a unitary business matter and the Wisconsin legislature enacted legislation advancing its Internal Revenue Code (IRC) conformity date. These developments are covered in our final summary of SALT news for 2023. 

California court upholds proposition requiring single sales factor apportionment    

On Oct. 23, 2023, in One Technologies, LLC v. Franchise Tax Board, the California Court of Appeal upheld a proposition approved by voters that required multistate businesses to use single-sales factor apportionment. The court held that Proposition 39, enacted by voters in 2012, which eliminated the option to apportion income using a three-factor formula, was valid and did not violate the California Constitution’s single-subject rule.

Prior to the enactment of Proposition 39, taxpayers generally could choose between two apportionment methods: (i) a three-factor formula using property, payroll, and sales; or (ii) a single sales factor formula. The three-factor method sourced sales other than sales of tangible personal property based on income-producing activity and the single-sales factor method uses market-based sourcing. Proposition 39 was designed to increase tax revenue by requiring the use of single sales factor apportionment. Part of this increased revenue was intended to support a Clean Energy Job Creation Fund. However, qualified cable companies that spent $250 million or more in California on certain expenditures could reduce their California taxable income by treating 50% of their in-state sales as out-of-state sales.

The California Constitution provides that ballot initiatives may not contain more than one subject. As explained by the court, the single-subject rule is intended to minimize the risk of voter confusion and deception. In applying a presumption that an initiative is valid, the California Supreme Court has identified two tests for determining compliance with the single-subject rule. The first test provides that an initiative does not violate the single-subject requirement if all its parts are “reasonably germane” to each other and to the general purpose or object of the initiative. Under the second test, an initiative complies with the single-subject rule if its provisions are “functionally related.”      

In 2017, the taxpayer, a Texas-based provider of credit score and credit reporting services, paid tax to California under the single-factor apportionment method. The taxpayer subsequently filed a refund claim with the FTB, alleging it was entitled to choose three-factor apportionment because Proposition 39 violated the single-subject rule for ballot initiatives. According to the taxpayer, the proposition consisted of three components (the Clean Energy Job Creation Fund, the elimination of three-factor apportionment, and the provision reducing tax liability for cable companies) which were not united by a single subject, object, or purpose. The taxpayer argued that the initiative was invalid under the single-subject rule because the special tax treatment for cable companies had no reasonable connection to the proposition’s purpose of funding the creation of clean energy jobs. After the trial court rejected the taxpayer’s argument, the taxpayer appealed the case to the California Court of Appeal.

In affirming the trial court’s holding that the proposition did not violate the single-subject rule, the appellate court explained that the purpose of the proposition was to fund a clean energy job creation program by raising taxes on some multistate businesses. The provisions were “reasonably germane” to this purpose, because they provided the mechanisms to raise tax revenues and direct them to clean energy job creation. Also, the provisions were “functionally related” because the changes to multistate business taxation funded the clean energy jobs program. The court noted that Proposition 39 was discussed in four and a half pages in the voter information guide, a reasonable length in the court’s view, and the analysis specifically addressed the favorable rules for certain large cable companies. Accordingly, the court concluded that the proposition was neither deceptive nor confusing and did not raise a constitutional concern.

The court also rejected the taxpayer’s argument that the inclusion of the special treatment for cable companies with the more popular provision of supporting clean energy job creation was a “classic example of logrolling.” The California Supreme Court has held that logrolling is not a separate basis to invalidate an initiative. In fact, the Supreme Court has explained that the single-subject rule is designed to prevent logrolling (which occurs when several minority groups of voters that constitute a majority approve a measure that lacks popular support but secures the benefit of one favored, isolated and severable provision). Calling the favorable treatment for cable companies “logrolling” did not alter the court’s conclusion that Proposition 39 was constitutional. Furthermore, the single-subject rule does not require a showing that each of a measure’s provisions would receive voter approval independently of each other. This ruling clarifies that Proposition 39 was valid and taxpayers are required to use single sales factor apportionment.  

California provides alternative apportionment procedures 

Effective Nov. 3, 2023, the California regulation for requesting alternative apportionment methods has been amended to provide more formal and defined procedures for filing petitions. The amendments add rules, conditions, and deadlines for filing petitions with the California Franchise Tax Board (FTB), clarify the briefing process and specify the procedures related to hearings on the petitions, as well as address the application of the ex parte communication rule.

The regulation continues to provide that in cases deemed appropriate by the FTB, it may elect to hear and decide alternative apportionment provisions instead of having this function performed by the FTB staff. As amended, the regulation provides extensive procedural rules for petitions that are publicly heard by the three-member FTB, itself, rather than its staff. Historically, this was the second step in the process after an alternative apportionment committee comprised of FTB staff had either recommended that the taxpayer’s petition be denied, or the state’s alternative apportionment method be granted. Taxpayers are directed to file their petitions with the Chief Counsel of the FTB explaining why their requested alternative apportionment methodology is appropriate or why the alternative apportionment imposed by the FTB staff is not appropriate. The regulation provides deadlines for filing the petitions. For example, a petition must be filed within 60 calendar days of a written adverse variance action determination by the FTB staff. In general, within 60 calendar days of receiving a taxpayer’s petition, the Chief Counsel will notify the taxpayer of the receipt of the petition in writing, which will include a briefing schedule.

The regulation includes instructions for filing and drafting briefs. Taxpayers must submit their opening brief to the Chief Counsel within 60 calendar days of the document notifying the taxpayer of the receipt of its petition. After the taxpayers have submitted their opening brief, the FTB staff has 30 calendar days to submit its opening brief. Taxpayers then have 30 calendar days to submit a reply brief. The regulation includes length limitations and formatting rules for the opening briefs and reply briefs.

After the briefing is complete, the FTB may schedule a hearing during an open session at a regularly scheduled meeting to consider the taxpayer’s petition. The regulation includes procedures for conducting the hearing. The FTB must render its decision on the taxpayer’s petition during an open session at a regularly scheduled meeting. In general, the regulation prohibits any ex parte communication regarding any substantive issue in the petition without notice and opportunity for all parties to participate in the communication. Taxpayers seeking the use of an alternative apportionment methodology in California should review these new detailed procedures.  

Maine court rules on sourcing prescription benefit management services   

On Nov. 7, 2023, the Maine Supreme Judicial Court held in Express Scripts Inc. v. State Tax Assessor that a taxpayer must source its receipts from providing prescription benefit management (PBM) services to where the individuals fill their prescriptions at retail pharmacies. The court determined that the receipts at issue were derived from the performance of claims processing services that were received by individuals at retail pharmacies in Maine.

During the 2011–2013 tax years at issue, the taxpayer sold prescription drugs by mail order delivery and provided infusion services throughout the U.S., including Maine. Also, the taxpayer sold claims adjudication and other PBM services across the country. The taxpayer generated revenue primarily from the delivery of prescription drugs through its contracted network of retail pharmacies, from home delivery of prescription drugs, from specialty pharmacy services, and from services in its non-PBM business segments. Nearly all the taxpayer’s revenue was received from the delivery of prescription drugs to its members. The taxpayer’s “clients” included health insurers, maintenance organizations, employers, governmental health programs, and union-sponsored benefit plans. The clients’ “members” were the primary recipients of the taxpayer’s services. If a client was a health insurer, the insured individuals were the “members.” If a client was an employer, the employees covered by the employer’s health plan were the “members.”

The taxpayer filed its 2011 Maine corporate income tax return and calculated its sales factor for receipts from PBM services based on the location of the retail pharmacies where the members filled prescriptions (“market member method”). For the 2012 tax year, the taxpayer sourced the PBM receipts based on the location of the clients’ commercial and administrative headquarters (“market client method”). The taxpayer made this change even though its business operations and the applicable Maine statutes and rules had not changed. For the 2013 tax year, the taxpayer continued to source the PBM receipts using the market client basis. Beginning in 2015, Maine Revenue Services (MRS) conducted an audit of the taxpayer’s corporate income tax returns for 2011-2013. The taxpayer filed an amended 2011 Maine return seeking a refund. MRS denied the refund claim and issued a notice of assessment for back taxes and interest based on its determination that the receipts from the PBM services should be sourced using the market member method. MRS denied the taxpayer’s request for reconsideration. In response to the taxpayer’s appeal, the Maine Board of Tax Appeals upheld the MRS’s reconsideration decision. The taxpayer subsequently filed a petition for review and de novo determination with a trial court. In September 2022, the trial court granted the State Tax Assessor’s motion for summary judgment. 

In affirming the trial court, the Maine Supreme Judicial Court agreed that the market member method should be used to source the PBM receipts. Under Maine law, receipts from the performance of services are sourced to the state where the services are received. The main issue concerned where the services were received and whether the market member or market client method should be used. The Tax Assessor successfully argued that the market member method should be used because the individual members receive the services when they fill prescriptions at retail pharmacies and the taxpayer provides the PBM services. The taxpayer unsuccessfully argued that because it contracts with its clients, rather than the individual members, the ultimate recipient of its services is the client, even if it is the member who initiates the claim at the retail pharmacy. According to the taxpayer, the services are received at the commercial and administrative headquarters of the client, not the retail pharmacy. The court held that the receipts should be sourced using the market member method because the claims-processing services were received by members at retail pharmacies in Maine, and the receipts at issue were derived from these claims processing services. Accordingly, the court affirmed the lower court’s decision to grant the Assessor’s motion for summary judgment because there was no genuine issue of material fact. 

Michigan Tax Tribunal holds subsidiary not part of unitary business group

On Oct. 17, 2023, the Michigan Tax Tribunal held in TTI Inc. v. Michigan Department of Treasury that a wholly-owned subsidiary was not a member of the taxpayer’s unitary business group (UBG). The Tribunal determined the alternate relationship tests necessary to establish a UBG were not satisfied.

For the relevant 2013-2016 tax years, the taxpayer and its wholly-owned subsidiary both sold electronic components. However, their operations generally were conducted separately. The taxpayer filed original Michigan corporate income tax returns that included the subsidiary as a member of the taxpayer’s UBG. In September 2018, the taxpayer amended its returns to exclude the subsidiary from the group. Because the removal of the subsidiary from the amended returns resulted in overpayments for each tax year, the taxpayer requested refunds. The Michigan Department of Treasury issued the refunds and subsequently audited of the taxpayer’s returns for the amended tax years. After determining that the subsidiary was a member of the UBG, the Department issued bills for tax due. The Department granted the taxpayer’s request for an informal conference and upheld each of the bills. The taxpayer appealed to the Michigan Tax Tribunal.  

Michigan law requires a UBG to file a combined return that includes each unitary U.S. entity. A statute defines a UBG as a group of corporations: (i) in which one owns or controls, directly or indirectly, more than 50% of the ownership interest (“control test”) of the other members; and (ii) that has business activities or operations which result in a flow of value between or among members of the UBG (“flow of value test”) or has business activities or operations that are integrated with, dependent upon, or contribute to each other (“contribution/dependency test”). The Department has interpreted the UBG statutory definition to require satisfaction of a control test and one of the relationship tests: (i) flow of value test; or (ii) contribution/dependency test. To explain these tests, the Department has issued administrative guidance, Revenue Administrative Bulletin 2018-12. The determination of whether a unitary relationship exists requires an examination of the totality of the facts and circumstances related to the business activities and operations of the entities at issue.

After determining that the control test clearly was satisfied because the taxpayer owned 100% of the subsidiary’s stock, the Tribunal conducted a thorough review of the alternate relationship tests. The responses in the taxpayer’s unitary questionnaire were considered in determining the relationship between the taxpayer and the subsidiary.

After a detailed analysis, the Tribunal determined the flow of value test was not satisfied. This test required the Tribunal to consider functional integration, centralization of management, and economies of scale. The taxpayer argued there was no functional integration because the subsidiary had autonomy over its general business strategy, operations, personnel, accounting, and financing. The Department maintained there was functional integration based on intercompany sales, common marketing, and sharing of competitive intelligence. In determining that there was no functional integration, the Tribunal concluded that the transfer of value between these companies did not significantly affect their operations. These transfers did not generate income and were only done when they could not obtain the products from their manufacturer. There was little shared marketing information, and the companies had separate purchasing, operations, and distribution systems. Also, there was no evidence of other shared intangibles such as patents, trademarks, or copyrights.

The Tribunal also determined there was no centralized management or economies of scale. The taxpayer successfully argued that there was no centralization of management because the subsidiary operated as a distinct business enterprise subject only to occasional oversight by the taxpayer to the extent that a parent company would give its investment in a subsidiary. The Department replied there was evidence of common officers and decision making by one entity on behalf of another. After considering the U.S. Supreme Court’s decision in Woolworth Co. v. Taxation Department from 1982, the Tribunal quoted the Court in determining that the independence of operations and management in this case were “not interrelated with those of its subsidiaries so that one’s ‘stable’ operation is important to the other’s ‘full utilization’ of capacity.” In addition, the conclusion that there was no centralization of management was supported by the responses in the unitary questionnaire indicating that the entities had separate critical business functions. As the last part of the flow of value test, the Tribunal decided that economies of scale did not operate to significantly decrease the cost of operations or administration functions because the entities had many separate key business operations.

According to the Tribunal, the alternate contribution/dependency relationship test also was not satisfied. The Tribunal concluded that the taxpayer and subsidiary were not integrated with each other because they had separate business functions. Furthermore, the Tribunal determined the companies were not dependent upon, or contribute to, each other. The taxpayer again successfully argued that there was a “distinct nature of the two businesses,” with separate headquarters, sales, warehouses, and distribution.

The Tribunal’s decision is instructive because it contains a detailed and thorough analysis of the factors that must be considered in making unitary determinations for UBG purposes. In performing this analysis, all the facts and circumstances of the business activities and operations must be considered. Although unitary determinations are very fact specific, taxpayers arguing against unity could cite to this decision to support their argument.  

Minnesota Supreme Court considers apportionment of gain from goodwill 

In a 4-2 decision, the Minnesota Supreme Court issued an opinion on Nov. 22, 2023, holding that a nonresident owner’s gain from the sale of goodwill was apportionable business income. In Cities Management, Inc. v. Commissioner of Revenue, after determining the relevant language in the apportionment statute was ambiguous, the court considered legislative history and intent to interpret the statute.  

The taxpayer, a Minnesota S corporation that managed community associations in Wisconsin and Minnesota, was partially owned by a nonresident. Following the sale of the taxpayer to another business in 2015, the taxpayer and its nonresident owner filed Minnesota tax returns, characterizing the gain on the sale of goodwill as nonbusiness income that was subject to allocation under Minn. Stat. Sec. 290.17. The taxpayer relied on the Minnesota Tax Court’s interpretation of this statute in its 2006 decision in Nadler v. Commissioner of Revenue. In this case, the Tax Court determined that income generated by the sale of goodwill constituted nonbusiness income that was subject to allocation under the statute. While the Tax Commissioner never appealed the Nadler decision, the Minnesota Department of Revenue began internally taking the position in 2007 that it did not acquiesce to Nadler. The Tax Commissioner did not make the Department’s disagreement with Nadler publicly known until its issuance of Revenue Notice 17-02 in July 2017.

In September 2018, following an audit of the taxpayer’s return, the Commissioner determined the taxpayer had applied the incorrect allocation rule to the income from the sale. According to the Commissioner, the income was business income subject to apportionment. The Commissioner issued an assessment for nonresident withholding tax, plus interest and an understatement penalty. Following the taxpayer’s administrative appeal, the Commissioner affirmed the assessment but removed the substantial understatement penalty because the taxpayer reasonably relied on Nadler. The taxpayer appealed this decision to the Tax Court, which affirmed the assessment. Relying on the Minnesota Supreme Court’s 2020 decision in YAM Special Holdings, Inc. v. Commissioner of Revenue, the Tax Court determined that the taxpayer’s income from the sale of its goodwill was business income of a unitary business. The Tax Court rejected the taxpayer’s argument that the Department was bound by Nadler, noting that the intervening Tax Court cases had cast doubt on Nadler’s applicability to cases involving the unitary business principle. The taxpayer appealed this decision to the Minnesota Supreme Court.

On appeal, the Minnesota Supreme Court affirmed the Tax Court and held that the gain from goodwill was business income subject to apportionment. The court first considered the taxpayer’s argument that the Commissioner must follow Nadler because the Commissioner never appealed the decision. The court was “troubled by the Commissioner’s conduct that this case has brought to light.” Rather than appealing the Tax Court’s decision in Nadler, the Commissioner decided internally that it would not follow the Tax Court’s interpretation of the law. However, the court explained that it was not required to decide whether the Commissioner was bound by Nadler to resolve this case. The validity of the Commissioner’s assessment depended on the Minnesota Supreme Court’s interpretation of Minn. Stat. Sec. 290.17. As a result, the court declined to announce a bright-line rule on the binding nature of Tax Court decisions that were not appealed.

The Minnesota Supreme Court was required to interpret the meaning of Minn. Stat. Sec. 290.17 in determining whether the gain on the sale of goodwill was subject to apportionment. The taxpayer argued that the allocation rules in the statute applied because the gain on the sale of goodwill is income that was “not derived from the conduct of a trade of a business.” The Commissioner argued that the taxpayer’s income was subject to apportionment under the statute because it was business income derived from a unitary asset. After thoroughly considering the statutory language, the court concluded that the treatment of gain on the sale of goodwill under Minn. Stat. Sec. 290.17 is ambiguous.

The court considered “other interpretative tools” to determine the legislature’s intent regarding the taxation of gain from the sale of goodwill. Specifically, the court examined contemporaneous legislative history in interpreting the statute. In 1999, the following language was added to the statute: “[a]ll income of a trade or business is subject to apportionment except nonbusiness income.” Contemporaneously, provisions concerning nonbusiness income were extensively changed. The legislation’s author described the provisions amending Minn. Stat. Sec. 290.17 as a response to the Minnesota Supreme Court’s 1998 decisions in Firstar Corp. v. Commissioner of Revenue and Hercules Inc. v. Commissioner of Revenue. In both cases, the court reversed decisions holding that the income was subject to apportionment. The legislative history reflected an intent to expand the state’s ability to tax multistate businesses’ income through apportionment by adopting a purely constitutional distinction between business and nonbusiness income. Ultimately, the Minnesota Supreme Court held that the taxpayer’s income, which derived from a unitary asset, could be constitutionally apportioned as business income. As a result, the allocation rules in Minn. Stat. Sec. 290.17 did not apply and the business income was subject to apportionment.

Two justices filed a dissent that would reverse the tax assessment due to the Commissioner’s decision to reject Nadler for 10 years before informing the public. The dissent supported the adoption of an equitable rule that the Commissioner is bound by Tax Court decisions that are not appealed unless the Department provides public notice of its disagreement with the decision. Under this equitable rule, the Commissioner would be required to follow the Tax Court’s interpretation of the statute in Nadler.

The Minnesota Supreme Court’s decision interprets ambiguous statutory language concerning apportionment and provides some clarity to taxpayers. The court is taking a more expansive approach in requiring the apportionment of income. However, as noted by the dissent, it seems inequitable to impose the assessment on a taxpayer that was following the Tax Court’s interpretation of the apportionment statute and had no way of knowing that the Commissioner had decided to reject this approach. In this case, the taxpayer filed its tax returns before the Commissioner provided public notice of its position.   

Missouri Supreme Court holds subsidiary entitled to resale exemption

On Nov. 9, 2023, in Walmart Starco LLC v. Director of Revenue, the Missouri Supreme Court determined that a Walmart subsidiary’s purchases of electronic equipment that were sold to other Walmart and Sam’s Club subsidiaries for store operations qualified for the resale exemption against Missouri use tax. The equipment consisted of electronic price scanners, credit card readers, computers, and servers. Some of the equipment needed additional software or hardware to meet the purchasers’ specifications. The subsidiary, Starco, loaded the necessary software or hardware on the equipment, tested it, and repackaged it for resale. Starco paid for delivery and charged the cost of the items plus a fixed-percentage mark-up. The purchasers remitted use tax to the jurisdictions where the equipment was delivered. Following an audit, the Missouri Director of Revenue assessed use tax against Starco for all equipment purchased prior to Feb. 1, 2013, and for all subsequent purchases of equipment sold and delivered to out-of-state purchasers. On appeal, the Missouri Administrative Hearing Commission concluded Starco’s use of the equipment was exempt from use tax under the resale exemption.

In affirming the Commission, the Missouri Supreme Court agreed the use tax resale exemption applied to Starco. The court rejected the Director’s argument that Starco’s installation of software and hardware, testing, and repackaging for delivery indicated that Starco did not hold the equipment solely for resale. The undisputed facts showed Starco exchanged ownership of the equipment in exchange for consideration. Accordingly, the court concluded that these transactions qualified as a “sale” under Missouri law and, therefore, as a “resale” for purposes of the resale tax exemption. The court reasoned that because Starco purchased the equipment with the intent to resell it to stores throughout the country, at a markup, and the purchasers remitted use tax to the appropriate jurisdictions, the transactions should not be taxed again.

The court also rejected the Director’s argument that the Commission erred in applying the resale exemption to Starco’s use of equipment prior to Feb. 1, 2013, when Starco was classified as a disregarded entity for federal income tax purposes. The Director previously argued before the Commission that Starco was a separate entity from the corporate siblings that purchased the equipment. However, the Director argued before the Missouri Supreme Court that Starco could not “resell” the equipment because it was not separate from its corporate owner that purchased some of the equipment. Because the Director did not timely raise this issue during the administrative proceedings, the court did not consider this argument. 

Wisconsin updates IRC conformity    

On Oct. 25, 2023, Wisconsin enacted legislation, A.B. 406, advancing its adoption of the Internal Revenue Code (IRC) for purposes of the state’s corporate income and franchise taxes and individual income tax to conform to most federal tax provisions that were enacted in 2021 and 2022. For taxable years beginning after Dec. 31, 2022, Wisconsin retroactively adopts the IRC as amended to Dec. 31, 2022. However, there continue to be many exceptions to conformity for federal legislation enacted prior to 2021. For taxable years beginning in 2021 and 2022, Wisconsin continues to adopt the IRC as amended to Dec. 31, 2020.

Wisconsin specifically adopts IRC Sec. 1202 related to the exclusion of sales of qualified small business stock from taxable income, retroactive to the 2019 tax year, and including any future changes to this provision. However, the legislation does not adopt the provisions under the American Rescue Plan Act of 2021 (ARPA) (P.L. 117-2) that create an income tax exclusion for certain forgiven student loans, nor does it include certain federal provisions relating to the tax treatment of health savings accounts and high-deductible health plans that were enacted in 2021 or 2022.   

The state continues to expressly decouple from certain provisions of the Tax Cuts and Jobs Act (TCJA) (P.L. 115-97) that were enacted in 2017, including the amendments to IRC Sec. 163(j) concerning the business interest expense limitation and IRC Sec. 174 addressing research and experimental expenditures. Furthermore, Wisconsin expressly decouples from the federal treatment of global intangible low-taxed income (GILTI) and foreign-derived intangible income (FDII).