State and local tax news for August 2024

The SALT developments during the waning days of summer cover a wide variety of income tax, franchise tax, and sales tax issues. In California, litigation has been filed challenging the legislation that California enacted in June 2024 that effectively overrules the Microsoft apportionment decision. Illinois enacted sales tax legislation requiring certain retailers to collect sales tax at the destination tax rate. The Kansas Department of Revenue issued guidance to clarify the procedures that taxpayers should use to claim income tax refunds for disallowed interest expense under legislation that was enacted earlier this year. Not surprisingly, a New York administrative law judge required a nonresident employee of a New York business to pay the state’s individual income tax for the days that he worked at home during the COVID-19 pandemic. Finally, a Texas district court held that franchise tax is not imposed on the revenue that an airline receives from passenger tickets, baggage fees, and transportation charges because it is pre-empted by federal law. 

Litigation filed challenging California Microsoft law  

Two separate lawsuits were filed during August 2024 challenging a provision in recent California legislation, S.B. 167, which effectively reverses a California Office of Tax Appeals (OTA) decision in Microsoft Corp. holding that a water’s-edge filer could include the gross amount of repatriated dividends in the sales factor. Both lawsuits challenge the constitutionality of the legislative provision due to its retroactive nature.

S.B. 167 enacted a new statute, Cal. Rev. & Tax. Code Sec. 25128.9, which effectively overrules the California OTA’s Microsoft decision 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. In Microsoft, the OTA rejected Legal Ruling 2006-01 issued by the California Franchise Tax Board (FTB) providing that the sales factor includes only the net dividends after applying the qualifying dividend deduction. The new statute, which applies “to taxable years beginning before, on, or after the effective date of the act adding this section [June 27, 2024],” expressly provides that Legal Ruling 2006-01 applies to apportionment factors attributable to corporate taxpayers. This statute is intended to prevent a negative revenue impact to California of up to $1.3 billion over multiple years based on similar filings from past tax years, and an estimated $200 million in potential refund claims generated in each tax year on a prospective basis.

The National Taxpayers Union filed litigation on Aug. 14, 2024, in the Superior Court of California, Sacramento County, arguing that the statute is contrary to the OTA’s holdings in Microsoft and Southern Minnesota Beet Sugar Cooperative, and its retroactive application will violate the Due Process Clauses of the U.S. and California Constitutions. Furthermore, the complaint alleges that the new statute contradicts California’s existing apportionment statutes and violates the Due Process Clause of the U.S. Constitution as being vague. The complaint requests that the FTB be prevented from applying the statute either in its entirely in violation of the U.S. Constitution or retroactively in violation of the U.S. and California Constitutions.

On Aug. 15, 2024, the California Taxpayers Association (CalTax) filed litigation in the Superior Court of California, Fresno County, also challenging the constitutionality of the new statute. As explained in its complaint, the statute was claimed to be a clarification of the Uniform Division of Income for Tax Purposes Act (UDITPA) which was enacted by California in 1966. The complaint alleges that Cal. Rev. & Tax. Code Sec. 25128.9 is inconsistent with California judicial and administrative decisions since 1966 that clarified the meaning of UDITPA. As a result, the complaint argues that describing the statute as a nonretroactive clarification conflicts with prior case law in violation of the separation of powers doctrine. Also, according to CalTax, the statute is a retroactive change to a statute enacted in 1966. The complaint alleges that this “unprecedented and unreasonable period of retroactivity” violates the taxpayers’ due process rights under the U.S. Constitution.

The legislation overruling Microsoft is controversial and has garnered considerable attention. As noted above, the Microsoft decision was expected to result in reduced tax liability and substantial refunds for certain taxpayers in the future. Taxpayers should monitor this litigation to see whether the courts decide to invalidate the statute reversing Microsoft or limit its applicability.  

Illinois enacts legislation changing sales tax sourcing provisions

Although Illinois enacted its most significant tax legislation for 2024 in June, the state also enacted some noteworthy sales and use tax legislation in the past month. Illinois enacted legislation, S.B. 3362, on Aug. 9, 2024, that addresses sales tax sourcing by adding provisions for a “retailer maintaining a place of business in this state.” On the same day, S.B. 3282 was enacted to require holders of direct pay permits to review their purchase activities. On Aug. 5, 2024, the state enacted legislation, H.B. 3144, which eliminates the state’s 1% sales and use tax on groceries.   

S.B. 3362 addresses an issue concerning the Leveling the Playing Field Act that became effective on Jan. 1, 2021, and whether the destination or origin sales tax rate should be used by certain Illinois retailers. Under the legislation, beginning Jan. 1, 2025, a retailer maintaining a place of business in Illinois that makes retail sales of tangible personal property to Illinois from locations outside the state is engaged in the occupation of selling at retail. Those retailers are liable for all applicable state and locally imposed sales taxes administered by the Illinois Department of Revenue on retail sales made by those retailers to Illinois customers from locations outside the state. Furthermore, for sales that would otherwise be sourced outside the state, a retailer maintaining a place of business in Illinois that makes retail sales of tangible personal property from outside Illinois is engaged in the business of selling at the location to which the tangible personal property is shipped or delivered or at which possession is taken by the purchaser. Thus, the destination sales tax rate, rather than the origin sales tax rate, will apply to Illinois retailers for items shipped from outside the state to Illinois customers. This may require some Illinois retailers to make changes to their tax software systems.   

By March 31, 2025, and by March 31 of each following year, S.B. 3282 requires holders of a direct pay permit to review their purchase activity to verify that the purchases made during the 12-month period ending on Dec. 31 of the immediately preceding calendar year were sourced correctly and that the correct tax rate was applied. If the holder of the permit discovers an error in sourcing or the tax rate during the review process, the holder must file an amended return to correct the error by April 20 of the year in which the review occurs. Direct permit holders that fail to verify the purchase activity and correct any errors may be subject to a penalty.

Beginning Jan. 1, 2026, H.B. 3144 generally exempts food for human consumption that is to be consumed off the premises from the 1% sales tax imposed by the state. However, counties and non-home rule municipalities are allowed to impose a 1% tax on groceries beginning Jan. 1, 2026.  

Kansas allows refunds for disallowed interest expense 

Earlier this year, Kansas enacted legislation, Ch. 81 (S.B. 410), which provides an income tax refund opportunity for Kansas taxpayers for the 2021 tax year pertaining to disallowed interest expense under Internal Revenue Code (IRC) Sec. 163(j) in the 2018-2020 tax years. On Aug. 7, 2024, the Kansas Department of Revenue released guidance, Notice 24-16, discussing the legislation and providing information concerning the refund procedures. Taxpayers will need to amend their 2021 Kansas income tax return to claim the deduction for the cumulative disallowed interest for these three tax years.

The Tax Cuts and Jobs Act (TCJA), enacted in late 2017, amended IRC Sec. 163(j) to limit the deduction for net business interest expense in excess of business interest income to 30% of adjusted taxable income for tax years beginning after Dec. 31, 2017. In 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act temporarily increased the limitation to 50% for tax years beginning in 2019 and 2020.  

Under existing law, Kansas conformed to IRC Sec. 163(j) for the 2018-2020 tax years, thereby limiting the deductibility of interest expense in each of those years consistent with the federal limitation under the TCJA and the CARES Act. Beginning with the 2021 tax year, the state decoupled from IRC Sec. 163(j) by creating two modifications: (i) a subtraction modification for any current year interest expense limitation under IRC Sec. 163(j); and (ii) an addition modification for any current year federal utilization of IRC Sec. 163(j) disallowed interest carryforwards.

Given the way that the statutory language was adopted, this created an issue whereby any interest disallowed in the 2018-2020 tax years would be effectively “double taxed” because it would have to be added back to Kansas taxable income when utilized for federal purposes in 2021 and beyond even though it was never deducted for Kansas income tax purposes. To correct this issue, Kansas recently amended its tax law to allow for a one-time subtraction of any disallowed interest in the 2018-2020 tax years to be deducted on the 2021 Kansas return.

Taxpayers must file an amended 2021 Kansas income tax return within the three-year statute of limitations to claim the deduction. In Notice 2024-16, the Department directs taxpayers to include a copy of federal Form 8990, Limitation on Business Interest Expense Under Section 163(j), that was filed for each of the 2018-2021 tax years. Also, taxpayers should include a worksheet that shows the computation of the amount of interest expense being claimed for each of the four tax years.

New York ALJ holds nonresident’s income subject to tax            

On Aug. 8, 2024, a New York administrative law judge (ALJ) ruled in Matter of Struckle that a taxpayer employed in New York was subject to the state’s individual income tax during the period that he worked from his Pennsylvania home in 2020 due to the COVID-19 pandemic. The taxpayer was taxable under New York’s “convenience of the employer” test because he did not establish that he worked at his Pennsylvania home due to a requirement by his employer to do so.

During the 2020 tax year, the taxpayer was a resident of Pennsylvania who was employed by a company located in New York City. The taxpayer worked at his employer’s office for 66 days but worked remotely from his home in Pennsylvania for 196 days due to the pandemic. The employer’s office was closed from March to September 2020, and then again in December 2020. Accordingly, employees were granted permission to work from their home offices from March to December 2020. The employer withheld New York income tax from the taxpayer’s wages for all the days he worked in 2020.

The taxpayer filed a New York State nonresident and part-year resident income tax return for the 2020 tax year and claimed a refund for the wages withheld for the days that he worked from his residence in Pennsylvania. The New York State Department of Taxation and Finance proceeded to audit the refund claim, and sent the taxpayer a request for information letter and an income allocation questionnaire. The Department reviewed the taxpayer’s responses and determined that he owed New York State income tax on income earned while telecommuting. According to the Department, the taxpayer did not show that he had an assigned primary work location outside New York or that his employer had established a bona fide office at his telecommuting location. The Department recomputed the taxpayer’s return by allocating most of his income to New York and substantially reducing the taxpayer’s refund. The taxpayer appealed the refund disallowance to a New York ALJ.

Under N.Y. Tax Law Sec. 631(a)(1), the state may tax a nonresident only on income that is “derived from or connected with New York sources.” A regulation, N.Y. Comp. Codes R. & Regs. tit. 20, Sec. 132.18(a), provides if a nonresident employee performs services both within and outside New York, the portion of the employee’s income derived from New York sources is the ratio of total days worked in New York to total days worked both within and outside the state. This regulation limits the allocation of days outside the state with the “convenience of the employer” test, which provides that “any allowance claimed for days worked outside New York State must be based upon the performance of services which of necessity, as distinguished from convenience, obligate the employee to out-of-state duties in the service of his employer.”

The taxpayer argued before the ALJ that the Department unfairly applied the convenience of the employer test. In 2020, the pandemic forced the taxpayer’s employer to close his office, which prevented him from reporting to his normal New York City workplace. Given the exceptional circumstances, the taxpayer claimed that he properly allocated his workdays between New York and Pennsylvania, and that it was unfair to allocate all his wage income to New York as his employer closed its New York office. Disagreeing with the taxpayer, the ALJ accepted the application of the convenience of the employer test in this instance, noting that New York courts have repeatedly upheld this test and rejected constitutional challenges to it. In affirming the assessment, the ALJ concluded that the taxpayer did not work remotely out of his employer’s necessity because he failed to establish that his employer required him to work from his Pennsylvania home. 

This decision is consistent with the New York ALJ’s decision in Matter of Zelinsky from November 2023 concerning the application of the convenience of employer test to work performed remotely due to the pandemic. One would expect to see additional challenges to the convenience of the employer test be considered by the New York State administrative and judicial authorities, as the Department is actively auditing taxpayers that had a change in work circumstances in 2020 as a result of the pandemic.

Texas franchise tax not imposed on air transportation revenue   

On Aug. 2, 2024, in American Airlines, Inc. v. Hegar, the district court in Travis County, Texas held that a major airline’s revenue from passenger ticket sales, baggage fees, and freight transportation is not subject to the Texas franchise tax because it is preempted by federal law. The court explained that the federal Anti-Head Tax Act (AHTA) prohibits states from imposing any tax on gross receipts from air commerce or air transportation. Accordingly, an airline may exclude this air transportation revenue when calculating its franchise tax liability.   

The airline, which is based in Texas, computed its Texas franchise tax liability by: (i) taking its total revenue and multiplying the amount by 70%; (ii) determining the amount of its total revenue apportioned to its Texas business; and (iii) multiplying that amount by the franchise tax rate. There were no deductions or exclusions from the airline’s revenue from passenger ticket sales, baggage fees, or freight transportation. The airline paid franchise tax on 70% of the gross receipts from these sources that were apportioned to Texas. This case concerned the 2015 franchise tax report year.

For the 2009-2014 franchise tax report years, the Texas Comptroller of Public Accounts agreed with the airline that the AHTA preempted the state’s ability to tax the airline’s revenue from passenger ticket sales, baggage fees, and freight transportation. The Comptroller later changed his position and informed the airline that he no longer agreed with the preemption argument. However, the Comptroller subsequently refunded the Texas franchise tax paid on this revenue for report year 2014. The Comptroller requested an opinion in early 2014 from the U.S. Department of Transportation (DOT), the federal agency responsible for administering the AHTA, that the AHTA did not preempt the Texas franchise tax as applied to revenue received from air commerce or transportation. The DOT rejected the Comptroller’s position.

The airline disputed its payment of franchise tax on its gross receipts from air commerce or transportation for the 2015 report year. After paying over $107,000 in franchise tax on baggage fees under protest, the airline timely filed suit in the district court to obtain a final confirmation that the Comptroller is prohibited by the AHTA from imposing franchise tax on gross receipts from air commerce or transportation, and obtain a refund of the amount of franchise tax it overpaid for the 2015 report year. 

The district court agreed with the airline that Texas was preempted by federal law from imposing franchise tax on passenger ticket sales, baggage fees, and freight transportation. The AHTA prohibits states from taxing gross receipts from air commerce or air transportation. The court held that the airline properly excluded passenger, baggage, and freight revenue, pursuant to the AHTA, from its total revenue when re-calculating its franchise tax liability for the 2015 report year. As a result, the airline was entitled to a refund of the franchise tax at issue, together with statutory interest and court costs. Based on this decision, other airlines may want to consider filing Texas franchise tax refund claims if they paid tax on similar revenue from air commerce or air transportation.