State and local tax news for January 2024


There were some noteworthy decisions by courts and revenue departments during the final weeks of 2023 and the first weeks of 2024.


In Illinois, an appellate court held that sales of medical equipment to managed care organizations were not exempt as sales to a governmental body. The Michigan Court of Appeals revisited the issue of whether a passive investment company has nexus for purposes of the Detroit income tax. In a property tax case, the Oregon Tax Court rejected a taxpayer’s request to lower its store’s real market value by considering the value of vacant properties. The Pennsylvania Commonwealth Court struck down the facility tax that Pittsburgh imposes on nonresident athletes and entertainers because it violates the Uniformity Clause of the Pennsylvania Constitution. In Texas, the Court of Appeals rejected a taxpayer’s argument that an apportionment rule was inconsistent with the underlying apportionment statute. Finally, the Washington Department of Revenue released Business & Occupation tax decisions addressing application of the tax to pharmacy benefit management services and whether the subsidiary of a national retailer had nexus with the state.


Our first summary of SALT developments for 2024 discusses these developments.




Illinois court holds sales to managed care organizations not exempt 


On Dec. 26, 2023, the Illinois Court of Appeals in Midwest Medical Equipment Solutions, Inc. v. Illinois Department of Revenue held that the Retailer’s Occupation Tax (ROT) exemption for sales to a governmental body did not apply to sales of medical equipment to managed care organizations (MCOs). Because the exemption is limited to sales made directly to the government, sales to MCOs did not qualify for the exemption.


Midwest Medical Equipment Solutions, Inc. (Midwest) was a licensed provider of durable medical equipment (DME) that provided breast pumps and nebulizers to individuals enrolled in Medicaid. Historically, the Illinois Department of Healthcare and Family Services (DHFS) directly paid providers for DME. Because Midwest’s sales of DME were made directly to DHFS, they were covered by the governmental body exemption to the ROT. In 2011, Illinois expanded its use of MCOs, which are a form of health maintenance organization (HMO) that establish a network of covered providers that serve individuals enrolled in the MCOs’ plans. Midwest is now reimbursed by MCOs rather than the DHFS in a majority of the transactions. Claiming the governmental body exemption, Midwest did not pay taxes for which it was directly reimbursed by MCOs.


The Illinois Department of Revenue audited Midwest for the failure to pay ROT for three periods between June 2012 and April 2020 and issued three tax notices. Midwest subsequently filed petitions in the Illinois Tax Tribunal that challenged each notice of tax liability. According to Midwest, the sales were exempt under the governmental body exemption because Midwest made those sales to MCOs, which were paid by DHFS, a governmental body. Midwest moved for summary judgment and argued that the governmental body exemption excused it from paying the taxes, that the MCOs were agents of DHFS, and that the substance-over-form doctrine dictated that DHFS was the true purchaser of the DME. In its cross-motion for summary judgment, the Department contended that the exemption did not apply. The Tax Tribunal granted the Department’s motion for summary judgment and found that the MCOs were not governmental bodies but merely private companies that contracted with the government. The MCOs were not DHFS’s agents and had separate contractual relationships with both DHFS and the providers.


Before the Illinois Court of Appeals, Midwest argued that it was entitled to the governmental body exemption to the ROT. The court began its analysis by reviewing the governmental body exemption and quoting the statutory language that the exemption applies to “[g]ross receipts from proceeds from the sale of . . . [p]ersonal property sold to a governmental body.” The court previously held in Lombard Public Facilities Corp. v. Department of Revenue in 2008 that “governmental body,” as used in the statute, does not include “agents or instrumentalities thereof.” The 2008 decision explained that the exemption “applies to the actual purchaser and not to a future beneficiary of the purchases.” Furthermore, an Illinois regulation provides that an exemption identification number must be presented to receive the governmental body exemption. This requirement could not be met in this case because MCOs do not have exemption identification numbers. The court also rejected Midwest’s argument that limiting the exemption to actual governmental bodies would cause a financial hardship. The court held that the disputed sales were not covered by the governmental body exemption to the ROT because it was undisputed that Midwest’s sales were made to MCOs rather than a governmental body.


The court also rejected Midwest’s argument that the substance-over-form argument dictates that DHFS was the true purchaser of the DME. Under this doctrine, a transaction’s tax consequences are governed by the underlying substance of the transaction and not its legal form. The court disagreed with Midwest’s claim that DHFS was in substance the purchaser of the DME because the product Midwest sells to the MCOs is different from the product that the MCOs sell to DHFS. Midwest also argued that the substance of DHFS’s relationship with the MCOs indicated that they were agents that could act on DHFS’s behalf. In rejecting the argument, the court noted that, as discussed above, a “governmental body” does not include an agent. In addition, the court determined Midwest could not have possessed a good faith belief that the MCOs were agents of DHFS. Finally, the court affirmed the Tax Tribunal’s decision to uphold the tax penalties assessed against Midwest. 




Passive investment company had Detroit income tax nexus  


On Jan. 4, 2024, the Michigan Court of Appeals held in Apex Laboratories International, Inc. v. City of Detroit that the taxpayer had nexus with Detroit for purposes of the City of Detroit Income Tax (CDIT). In reversing the Michigan Tax Tribunal, the court held that although the taxpayer did not have any employees or property in Detroit, the taxpayer had officers and agents in Detroit that took many actions to establish substantial nexus.


This case has a very long and complex procedural history. The original dispute involves a private equity firm which created a fund to invest in Labstat International, ULC (Labstat), a Canadian tobacco testing company. The taxpayer, Apex Laboratories International Inc. (Apex), was created in 2006 during the acquisition process to function as a passive holding company for the fund’s investment in Labstat. Apex is a Delaware corporation that maintains a mailing address in Delaware. To satisfy the minimum corporate governance requirements, Apex had a few officers and members of the board of directors that were employed by the private equity firm and located in a Detroit office. These employees did not regularly perform activities for Apex, but they were considered to be Apex’s agents. The Detroit office was listed in Apex’s annual report as its principal place of business and was used to receive mail associated with tax returns and annual reporting.


The dispute concerned the imposition of CDIT on the dividend income that Apex received from Labstat in 2010 and the capital gains that Apex received from selling its Labstat shares in 2012. In March 2015, Detroit issued a proposed assessment to Apex indicating that it had nexus with the city and thus owed an additional 1% of CDIT, interest, and penalties for 2010 and 2012 resulting from dividends and capital gains received. Arguing that it did not conduct business in the city, Apex filed for a refund of CDIT paid. Detroit denied the refund claim and Apex filed an appeal with the Michigan Tax Tribunal. On May 1, 2017, the Tribunal granted Apex’s motion for summary disposition and held that it did not have the requisite nexus with Detroit for purposes of the CDIT, based on Apex’s lack of physical presence in Detroit.


The Tribunal’s decision was upheld by the Michigan Court of Appeals in 2018 and appealed to the Michigan Supreme Court. While the case was pending in the Michigan Supreme Court, the U.S. Supreme Court decided South Dakota v. Wayfair, Inc. In this 2018 decision, the Court overruled the long-standing physical presence requirement that was necessary to establish substantial nexus for sales tax purposes. The Michigan Supreme Court vacated the earlier Apex decision and remanded the case to the Court of Appeals for reconsideration in light of Wayfair. The Court of Appeals subsequently vacated the Tax Tribunal’s decision and remanded the case “to allow the parties to focus their arguments concerning Wayfair, Quill, and the Due Process and Commerce Clauses, and to allow the Tribunal to make a ruling in the first instance.”


In 2022, the Tax Tribunal granted summary disposition in favor of Apex because its physical presence in Detroit was de minimis and did not meet the substantial nexus requirement of Wayfair. Furthermore, even if Apex had nexus with Detroit, no tax was imposed because Apex had no business activities in Detroit. The instant decision concerns Detroit’s appeal of this 2022 decision.


The Court of Appeals reversed the Tax Tribunal’s decision to grant summary disposition in favor of Apex and remanded the case for further proceedings. In determining that Apex had nexus with Detroit, the court reviewed the Wayfair decision. The U.S. Supreme Court explained that substantial nexus is “established when the taxpayer . . . avails itself of the substantial privilege of carrying on business in that jurisdiction.” After considering Wayfair, the court noted that although Apex is a Delaware corporation, it listed in its Delaware filings that Detroit was its principal place of business. While Apex had no employees and owned no property in Detroit, the court concluded that Apex’s officers and agents were located in Detroit.  These representatives took many actions on behalf of Apex concerning the sale of the Labstat stock, demonstrating that Apex had nexus with Detroit. On that basis, the Court of Appeals concluded that the Tax Tribunal erred when it granted Apex’s motion for summary disposition on this issue.


After deciding the nexus issue, the Court of Appeals acknowledged that it previously reached a different conclusion on this nexus issue. However, the court explained that it did not apply the correct legal standard when ruling on a motion for summary disposition in the prior decision, in part because it did not truly conduct a de novo review.


The court next considered the city’s argument that the Tax Tribunal erroneously allocated none of Apex’s income to Detroit. In general, a “business allocation percentage method” consisting of property, payroll and revenue factors is used to allocate income for CDIT purposes. The Tax Tribunal ruled that no income should be allocated to Detroit because Apex had no property, payroll or revenue in the city. Detroit argued that an alternative method should be used since none of the three factors was present in this case. The court disagreed with the Tax Tribunal’s ruling that an alternative method was inapplicable due to the “very minimal presence and activities” conducted by Apex’s agents in Detroit. Specifically, the court did not agree that Apex’s presence in Detroit or its activities could be deemed “minimal.” Because Apex had business activities other than sales of goods and services, an alternative allocation method must be used. The court concluded that the Tax Tribunal erred in granting Apex’s motion for summary disposition on the allocation issue. The case was remanded for the Tax Tribunal to consider the use of an alternate allocation method.  


One judge filed a dissent disagreeing with the majority’s conclusion that as a matter of law there was substantial nexus between Apex’s net profit and Detroit. The dissent would vacate the Tax Tribunal’s decision and remand the case for an evidentiary hearing to make a nexus determination.


It is interesting that the Court of Appeals originally determined Apex did not have nexus with Detroit but changed its conclusion and now holds that there is nexus. The change in the court’s nexus conclusion seems to be based on its application of the substantial nexus standard from Wayfair. In light of this case’s lengthy history, it is likely that there will be further developments concerning this litigation. Taxpayers should monitor what the Michigan Tax Tribunal does with this case on remand. 




Oregon Tax Court rejects lower valuation based on vacant property


In a property tax case decided on Dec. 22, 2023, the Oregon Tax Court denied a grocery store owner’s attempt in Albertsons Cos. v. Clackamas County Assessor to lower an occupied store’s real market value by considering comparable properties that were vacant or “dark stores.”  


This case concerned the 2020-21 real market value of a grocery store and its underlying land located in a suburb of Portland, Oregon. The subject property was a separately owned lot containing a 47,512 square foot building that was operated as a Safeway grocery store. As part of a portfolio sale involving multiple properties, Safeway sold the property to a third party in January 2018 for nearly $9 million and leased it back to the taxpayer which was a related entity. The third party sold the property to investors in May 2018 for nearly $11 million. Both the portfolio sale and the subsequent resale to the investor were arm’s-length transactions. The board of property tax appeals upheld the $11.5 million real market value placed on the 2020-21 assessment and tax roll by the county assessor. On appeal to the Oregon Tax Court, the taxpayer requested that the property’s real market value be reduced to $7,750,000, while the assessor requested a valuation of $11,250,000.


The Oregon Tax Court noted that the taxpayer has the burden of proving a lower market value than the county’s valuation. As explained by the court, the “parties’ appraisals reflect striking differences in choices of comparable sales and leases.” The taxpayer’s appraiser disfavored sales of leased properties because they failed to show the “fee simple” interest. The county’s appraiser relied entirely on sales and leases of properties spun off from a portfolio of sale-leaseback of grocery stores, but the taxpayer’s appraiser largely rejected this property in favor of vacant properties and former supermarket buildings repurposed for new uses. The court opined that the differences in choice of comparable properties reflect different views of the property interest being valued.


In considering what property interest is valued, the court analyzed an Oregon Supreme Court case, Swan Lake Moulding Co. v. Department of Revenue, from 1970. The taxpayer in this case argued that certain long-term commercial leases reduced its property’s income potential and its value, but the county argued that the leases had no effect on value. The court held for the county and disregarded the existing leases. Applying this decision, the Tax Court concluded that even a commercial property with a long-term, below-market lease should be valued for assessment purposes as if its rent were at the market rate. A property with an existing above-market lease should be treated the same way. 


In Powell Street I, LLC v. Multnomah County Assessor, decided in 2019, the Oregon Supreme Court restated the rule of Swan Lake using the term “fee simple” to describe the interest being valued in a property assessment. The Powell court explained that when property is subject to leases, the value for property tax purposes may differ from the price that the owner may receive for the property. As stated in Powell, this difference is “because the property tax is assessed on the fee simple interest in the property, which is the value of all interests in the property, including those of the owner (ordinarily the lessor) and any lessees.” The Tax Court noted that the “fee simple” language in Powell is potentially ambiguous because lawyers and appraisers use the term differently. The legal definition of “fee simple” is the broadest property interest allowed by law, but appraisers use “fee simple” to distinguish unencumbered property from “leased fee” property. The Powell court adopted the meaning used by appraisers by explaining that when a fee simple interest is valued, there is a presumption that the property is available to be leased at market rates.


Based on this case law, the Tax Court concluded that a property must be valued as if it were being put to its highest and best use. In the case of rental property, the best use includes generating market rent from a lessee. Applying the sales comparison approach does not require appraisers to avoid “leased fee” comparables for commercial buildings. Sales of commercial properties leased at market rates are better indicators of market value than vacant buildings that meet an appraiser’s definition of “fee simple.”


The Tax Court reviewed the methods used by both appraisers. In considering the approach advanced by the taxpayer, the court noted that his sales comparison approach relied heavily on vacant property, which comprised half of the comparable sales. The court noted that the taxpayer’s appraisal was not a sufficiently reliable indicator of the property’s real market value for the following reasons: (i) it primarily relied on a Safeway lease that was set in a mediation process designed to reach a nonmarket rent; (ii) it rejected the property’s own lease and sale while accepting a similarly situated Safeway’s lease and sale; and (iii) its extensive reliance on vacant sales and second-generation leases even though the property remains viable as a first-generation supermarket. Therefore, the taxpayer failed to meet its burden of proof.


According to the court, the county appraiser’s valuation was more plausible because he identified property with physical characteristics “exceptionally similar” to the taxpayer’s property. Although there were some uncertainties caused by the appraiser’s reliance on spinoff sales from a portfolio sale-leaseback, they involved similar properties and market participants operating at arm’s length.




Pennsylvania court strikes down facility tax on nonresident athletes  


On Jan. 10, 2024, in National Hockey League Players Association v. City of Pittsburgh, the Pennsylvania Commonwealth Court held that a city’s facility tax (commonly termed the “jock tax”) that was imposed on nonresident athletes and entertainers violated the Pennsylvania Constitution’s Uniformity Clause. In affirming the trial court, the Commonwealth Court agreed that the city failed to provide a justification for treating residents and nonresidents as distinguishable classes that may be subjected to different tax burdens. Also, the Commonwealth Court affirmed the trial court’s determination that the ordinance could not be corrected by removing the invalid language. 


The Uniformity Clause of the Pennsylvania Constitution provides that “[a]ll taxes shall be uniform, upon the same class of subjects, within the territorial limits of the authority levying the tax, and shall be levied and collected under general laws.” Pennsylvania law allows cities such as Pittsburgh that have a publicly funded sports stadium or arena (facility) to impose a facility tax “upon those nonresident individuals who use [a facility] to engage in an athletic event or otherwise render a performance for which they receive remuneration.” Individuals liable for the facility tax are exempt from any earned income tax (EIT) imposed by the city. Under this statutory authority, Pittsburgh imposes a 3% facility tax on nonresidents who earn income at one of the city’s facilities. Residents who earn income at a facility do not pay the facility tax but pay a 1% EIT and a 2% school tax. Nonresidents who do not earn income at a facility pay a 1% EIT but no school tax.


Three major professional sports associations filed a civil complaint against Pittsburgh alleging the facility tax is facially discriminatory under the U.S. and Pennsylvania Constitutions. The complaint sought an injunction that would prevent the city from imposing and collecting the tax. The trial court granted a motion for summary judgment and held that the facility tax violates the Uniformity Clause of the Pennsylvania Constitution. According to the trial court, the facility tax makes a facial distinction between residents and nonresidents because only nonresidents are subject to the tax. Also, the trial court rejected the city’s argument that the unconstitutional language in the ordinance should be severed by removing the “nonresident” language. This change would have the effect of imposing the facility tax on residents, which the enabling legislation does not contemplate. The enabling statute provides that if a court invalidates the facility tax, the nonresidents would no longer be exempt from the EIT. The trial court declared the facility tax unconstitutional and enjoined Pittsburgh from further assessing, imposing, or collecting the tax.


On appeal to the Pennsylvania Commonwealth Court, the city argued that the trial court erred in concluding that the facility tax violates the Uniformity Clause. The city alternatively argued that if the court concluded the facility tax is unconstitutional, the trial court erred by not severing the problematic language from the ordinance and deciding to issue an injunction.


The Commonwealth Court first considered the requirements of the Uniformity Clause. In challenging the constitutionality of a tax under the Uniformity Clause, a taxpayer must show that the tax results in some form of classification which is unreasonable and not rationally related to a legitimate state purpose. As explained by the Pennsylvania Supreme Court in Clifton v. Allegheny County in 2009, the Uniformity Clause is violated when the method or formula for computing the tax “produce[s] arbitrary, unjust, or unreasonably discriminatory results.” A law is facially unconstitutional only where no set of circumstances exists under which the law would be valid.


The city unsuccessfully argued that the facility tax did not violate the Uniformity Clause because the overall tax burden on both residents and nonresidents is 3% (residents pay a 1% EIT and a 2% school tax while nonresidents pay a 3% facility tax). In rejecting the city’s argument, the court explained that the facility tax burdened nonresidents with an additional 2% tax on earned income that is not assessed on residents. The court determined the 2% school tax paid by residents was not relevant to its analysis because the school district is prohibited from imposing school taxes on nonresidents. If the 2% school tax is not considered, the city effectively is imposing a 3% EIT on nonresidents and a 1% EIT on residents deriving income from the facilities. The court concluded that the city failed to provide the necessary justification for treating residents and nonresidents as distinguishable classes that may be subjected to different tax burdens. Therefore, the court concluded that the facility tax violates the Uniformity Clause.


The Commonwealth Court also agreed with the trial court that the invalid language could not be severed from the ordinance. The city’s suggestion that the ordinance imposing the facility tax could be corrected by replacing “nonresident” with “individual” was rejected because the tax cannot be imposed on residents. Furthermore, the statute authorizing the facility tax provides that the exemption from the EIT for nonresidents who pay the facility tax no longer applies if the facility tax is struck down. The court concluded that the statutory language indicated that the legislature preferred that an ordinance imposing a facility tax that is found to be unconstitutional should be entirely stricken rather than expanded to include residents.


One justice filed a dissent and would hold the facility tax to be constitutional because nonresidents and residents both ultimately paid a 3% total local tax on income attributable to their work at a facility. The dissent contended that the overall tax burden should be considered and the ultimate destination of the tax revenue to either the city’s general fund or to a school district should not change the result. Also, the dissent would reject the associations’ argument that the creation of a separate class of athletes and entertainers that are subject to the facility tax violates the Uniformity Clause because there are legitimate reasons for making this distinction. 




Texas court upholds apportionment sourcing rule     


On Dec. 21, 2023, in NuStar Energy, L.P. v. Hegar, the Texas Court of Appeals rejected the taxpayer's argument that an administrative rule for apportioning gross receipts for franchise tax purposes was invalid because it contradicted the state’s apportionment statute. The rule was a valid construction of the underlying apportionment statute because they both use a “place of delivery” approach to source sales of tangible personal property that does not consider the buyer’s location.


The taxpayer challenged the apportionment of its gross receipts to Texas for the 2011-2013 tax years. A Texas statute provides in relevant part that the following gross receipts are counted as business done within Texas: receipts from “each sale of tangible personal property if the property is delivered or shipped to a buyer in this state.” The Texas Comptroller of Public Accounts has adopted rules governing the sourcing of a taxpayer’s gross receipts in a variety of commercial contexts. The taxpayer challenged the following provisions in the rule sourcing sales to Texas: (i) the sale of tangible personal property that is delivered in Texas to a purchaser: (ii) the sale and delivery in Texas of tangible personal property that is loaded in a conveyance that the purchaser of the property leases and controls or owns; (iii) the drop shipment of tangible personal property in Texas; and (iv) revenues from transactions that occur in Texas waters.  


After paying the disputed franchise tax relating to the sales, the taxpayer filed a refund suit against the Comptroller, seeking a declaratory judgment that the disputed subsections of the rule were facially invalid under the Administrative Procedure Act (APA). The parties filed cross motions for partial summary judgment on the issue of the rule’s facial validity. After concluding that the rule is facially valid, the trial court granted the Comptroller’s cross motion for partial summary judgment and denied the taxpayer’s motion. The taxpayer appealed to the Texas Court of Appeals.


The Texas Court of Appeals explained that the sole issue on appeal was the challenge of the apportionment rule’s validity. In this type of case, the challenging party must show that the rule: (i) contravenes specific statutory language; (ii) runs counter to the general objectives of the statute; or (iii) imposes additional burdens, conditions, or restriction in excess of or inconsistent with the relevant statutory provisions. In this case, the determination of whether the rule was facially valid depended on the construction of the apportionment statute and the contested provisions of the rule.  


The taxpayer argued on appeal that the subsections of the apportionment rule are facially invalid because they are contrary to the apportionment statute. According to the taxpayer, the statute applies the franchise tax on the sale of personal property only when the buyer is located in Texas (sometimes called a “place of market,” “location of buyer,” or “ultimate destination” approach), but the challenged portions of the rule apply the franchise tax on transactions where the seller ships or delivers the property to the buyer in Texas, regardless of whether the buyer is located within or outside the state (sometimes called a “place of transfer” or “location of delivery” approach). The Comptroller argued that the statute sources receipts using a “place of transfer” approach, and therefore the rule is consistent with the apportionment statute.


The court concluded that the statutory language sourcing sales of tangible personal property to Texas “if the property is delivered or shipped to a buyer in this state” is not ambiguous. Under the plain meaning of this language, whether a receipt is sourced to Texas depends on where the buyer receives the property, not where the buyer is ultimately located when it plans to use or sell the property. The court rejected the taxpayer’s application of the “last antecedent” canon of statutory construction to support an argument that the phrase “in this state” only modifies “buyer.” According to the court, the canon only may be applied if the statutory language is ambiguous. Furthermore, use of this canon would make the phrase “if the property is delivered or shipped” superfluous.


Because the apportionment statute was derived from the model language in the Uniform Division of Income for Tax Purposes Act (UDITPA) and the 1967 Multistate Tax Compact, the taxpayer argued that the court should consider cases from other states that have interpreted the statutory language. The court agreed that the Texas apportionment statute was based on the model language, but it declined to follow the interpretations of other courts. As noted by the court, states have followed different approaches in their apportionment statutes and regulations. Because each state has amended or modified the Compact’s model language, there are no uniform statutory apportionment statutes. States are not bound by the Compact and may enact their own apportionment methods.


The court concluded that the only reasonable construction of the statutory language is the place of delivery controls for apportionment purposes even if the buyer is located outside the state. The taxpayer unsuccessfully argued that the contested subsections of the apportionment rule were contrary to the apportionment statute because they applied a “place of delivery” approach to apportioning gross receipts. The court determined that the “place of delivery” construction in the rules was consistent with the statutory language. Therefore, the taxpayer failed to overcome the presumption that the subsections of the rule were facially valid and constitutional. The Court of Appeals affirmed the trial court’s decision to grant the Comptroller’s motion for partial summary judgment.


This is a significant decision that may assist taxpayers in interpreting the statutory language in the apportionment statute relating to the sourcing of sales of tangible personal property. As explained by the court, the Texas apportionment statute and rules follow a “place of delivery” approach that does not consider the buyer’s location.




Washington ruling clarifies B&O tax treatment of PBM services    


On Dec. 22, 2023, the Administrative Review and Hearings Division of the Washington Department of Revenue released a ruling, Determination No. 21-0153, explaining the application of Business & Occupation (B&O) tax to pharmacy benefit management (PBM) services. Specifically, payments that a taxpayer performing PBM services receives from its customers to compensate for payments to associated pharmacies were properly included in the taxpayer’s gross income. Also, rebates paid by pharmaceutical manufacturers to taxpayers engaging in PBM services did not qualify as bona fide discounts that may be deducted from gross income.


The taxpayer provided PBM services to its customers, including health insurers, employers, union-sponsored benefit plans, workers’ compensation plans and government health programs. These customers offered healthcare insurance coverage to their healthcare plan members. After conducting an audit of the taxpayer’s business activities in Washington from 2015 to 2019, the Washington Department of Revenue determined that the taxpayer failed to report payments that the taxpayer received from customers to compensate for payments to pharmacies, and rebates from pharmaceutical manufacturers, as gross income. The Department subsequently issued a notice of assessment and the taxpayer timely petitioned for administrative review.


The Hearings Division held that the payments the taxpayer received from its customers were for its PBM services and were part of its gross income subject to B&O tax. Under Washington law, the B&O tax is imposed on every person “for the act or privilege of engaging in business activities” and applies to the gross income of the business. For B&O tax purposes “business” includes “all activities engaged in with the object of gain, benefit, or advantage to the taxpayer or to another person or class, directly or indirectly.” A B&O tax statute broadly defines “gross income of the business” to include “the value proceeding or accruing by reason of the transaction of the business engaged in” and includes a list of taxable activities, but there is no deduction for associated costs or expenses.


In this case, the taxpayer was contractually obligated to pay pharmacies established prices for drugs that were dispensed to members. Customers were required by their contract to pay the taxpayer corresponding amounts to compensate for these payments to pharmacies. Accordingly, the Hearings Division concluded that the taxpayer’s PBM services included issuing payments to pharmacies for the cost of drugs dispensed to members and that the payments received from customers were compensation for the services. The Hearings Division determined that the payments the taxpayer received from its customers were properly included in the taxpayer’s gross income.


The taxpayer unsuccessfully argued that the payments it received from customers should be excluded from gross income as reimbursements that the taxpayer received as an agent of the pharmacies. A B&O tax regulation permits a taxpayer to exclude from gross income certain advances and reimbursements that a taxpayer receives solely in its capacity as an agent. The Hearings Division noted that this regulation requires the existence of a true agency relationship. As determined by the Hearings Division, the taxpayer failed to meet its burden of establishing an agency relationship with its customers and that its liability to pay the pharmacies was solely in its capacity as the customers’ agent.


The Hearings Division concluded that the rebates the taxpayer received from pharmaceutical manufacturers did not qualify as bona fide discounts that could be deducted from gross income. A B&O tax statute provides that “[i]n computing tax there may be deducted from the measure of tax the amount of cash discount actually taken by the purchaser.” A regulation clarifies that a “bona fide discount” has terms that are contemplated at the time of sale and applies at the time of sale or within a time determined by the parties. As explained in a prior ruling, the discount must be part of a single transaction. To receive the rebates from pharmaceutical manufacturers, the taxpayer in this case was required to submit claims data to the manufacturers to confirm that it exceeded the established thresholds. The Hearings Division rejected the taxpayer’s argument that the payments were bona fide discounts because the taxpayer’s payments for pharmacy services and the receipt of rebate payments were separate transactions.


The Hearings Division disagreed with the taxpayer’s claim that the rebate payments that it passed on to pharmacies should be excluded as pass-through income. The taxpayer failed to establish the requisite agency relationship with the pharmacies. Finally, the Hearings Division determined that the taxpayer did not establish that its failure to apportion its receipts to Washington and timely file annual reconciliations of its apportionable income was due to circumstances beyond its control. As a result, the taxpayer was not eligible for a waiver of delinquent penalties.     




Application of B&O tax nexus explained in Washington ruling 


The Administrative Review and Hearings Division of the Washington Department of Revenue released Determination No. 21-0083 on Dec. 22, 2023, holding that a subsidiary of a national retailer with stores in Washington had substantial nexus with the state for Business & Occupation (B&O) tax purposes. The Hearings Division also held that transfers between the subsidiary and national retailer following a merger of the entities were not subject to B&O tax because they no longer were separate entities.


The taxpayer was a distributor of tangible personal property that was based outside Washington. A national retailer (parent company) purchased the taxpayer and operated it as a subsidiary. During the relevant tax years, the entities subsequently merged and the taxpayer operated as a division of the parent company. The taxpayer primarily made wholesale sales of tangible personal property but also made some retail sales. Prior to the merger, the taxpayer’s primary sales method was through a catalog containing the logos of both the taxpayer and the parent company. The taxpayer did not have property, employees, or independent contractors in Washington prior to the merger. Customers would go to the parent company’s retail stores in Washington and a sales associate would initiate purchases on a store computer that would track the order as a special-order purchase by the parent company from the taxpayer. The taxpayer contended that it did not have substantial nexus with Washington prior to the merger.  


The Department conducted an audit of the taxpayer for tax periods both before and after the merger. For the post-merger period, the Department assessed B&O tax on transfers between the taxpayer and the parent company as separate entities because the accounting records and consolidated returns continued to use the taxpayer’s federal tax identification number (FEIN). The taxpayer explained that its old FEIN continued to be used to track its activities and transactions in the parent company’s accounting software. According to the taxpayer, the failure to change the FEIN was done as a matter of convenience and did not indicate that the taxpayer continued to exist as a separate entity after the merger. The taxpayer also argued that some wholesale sales were improperly classified as retail sales. Following the audit, the Department issued separate tax assessments for the pre-merger and post-merger periods. The taxpayer timely filed petitions for review contesting both assessments, which were consolidated for review by the Hearings Division.   


The Hearings Division determined that the taxpayer established substantial nexus for pre-merger periods based on its relationship with and use of the parent company’s Washington retail locations. Washington law provides statutory substantial nexus standards that apply to persons engaging in business. Any activity performed by an employee, agent, or other representative on behalf of a seller that is significantly associated with establishing or maintaining a market in the state, is sufficient to establish nexus. Courts have held that the activities of an affiliated company with nexus that support the market for an out-of-state affiliate may establish nexus for the out-of-state affiliate.


The question considered by the Hearings Division in this matter was whether the activities of the parent company, in marketing the taxpayer’s products and accepting and placing orders for the taxpayer, were sufficient to establish substantial nexus with Washington. In determining that there was substantial nexus, the Hearings Division noted that the taxpayer’s logo and brand name were present on a variety of the parent company’s catalogs, as well as other marketing and promotional materials. Significantly, the parent company promoted the taxpayer’s products and allowed customers to directly place orders for the taxpayer’s products at the parent company’s retail locations in Washington.


While the taxpayer’s petition that it lacked substantial nexus with Washington prior to the merger was rejected, the taxpayer successfully argued that transactions with its parent company following the merger were not subject to B&O tax. Generally, transactions between affiliated companies are subject to B&O tax, and so transactions between the taxpayer and its parent company were taxable prior to the merger because they were separate entities. As a result of the merger, the taxpayer ceased to exist as a separate entity and became a division of the parent company. The Hearings Division rejected the Department’s argument that the taxpayer’s continued use of its FEIN after the merger indicated that it continued to be a separate entity.


The Hearings Division also considered the taxpayer’s argument that the Department improperly classified some of its wholesale sales as retail sales. Unless a seller has a reseller permit from a buyer, the burden of proving that a sale is a wholesale sale is upon the person who made it. Because the taxpayer failed to present records supporting its argument that some of the retail sales should be classified as wholesale sales, the Hearings Division rejected the taxpayer’s petition on this issue. However, if the taxpayer can provide additional records to support classifying certain retail sales as wholesale sales, the taxpayer would be eligible to pay the tax and file a petition for refund.  




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Dana Lance

Dana Lance is the Tax Practice Leader for the Greater Bay Area and the SALT Practice Leader for the West Region. Dana is based in San Jose, California.

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