State and local tax news for November 2024

As the recent federal and state elections have garnered sizable attention, there have been some significant SALT developments outside the world of politics that should also be considered. The Illinois Department of Revenue issued a private letter ruling and general information letter that address the proper sourcing of sales revenue for apportionment purposes. North Carolina provided some welcome relief to corporate taxpayers by lengthening the automatic extended filing deadline one month past the federal extended deadline. Taxpayers are reminded that they have until Nov. 30 to file Tennessee franchise tax refund claims in response to legislation enacted earlier this year which eliminated the property measure for computing the tax. The Washington Supreme Court issued an opinion that considers the availability of the deduction for investment income for business and occupation tax purposes. Finally, the Virginia Court of Appeals held that the income a taxpayer received from its minority ownership in a nonunitary business should not be subject to apportionment. November’s State and Local Thinking discusses all these developments.  

Illinois clarifies sourcing of sales for apportionment purposes  

In November 2024, the Illinois Department of Revenue released a private letter ruling (PLR) and a general information letter (GIL) that clarify the sourcing of sales for apportionment purposes and application of the destination rule. In the PLR, IT-24-0001-PLR (dated Aug. 22, 2024), the Department held that sales of products that are temporarily located in a third-party’s distribution center in Illinois are not sourced to Illinois or subject to the throwback rule. In the GIL, IT-24-0008-GIL (dated Sept. 17, 2024), the Department determined that sales should be sourced to Illinois if the products are delivered and sold to third-party distributor warehouses in the state, regardless of whether the third-party distributor subsequently moves the products to locations outside the state.   

The taxpayer requesting the PLR is a leading global games company with headquarters and manufacturing facilities located outside Illinois. The taxpayer files an Illinois combined corporate income tax return that includes all members of its federal consolidated group, including a member designated as “Company 2” in the PLR. The company, which supplies game content and gaming machines to licensed gaming entities, ships its products from its manufacturing and assembly facilities located outside Illinois. Company 2 has offices in Illinois, but all contract negotiations and final contracts are approved by employees located outside the state. None of the inventory is stored at or shipped from the Illinois office and no manufacturing or assembly is performed in the state.

Company 2 began using a centrally located distribution center in Illinois that is owned and operated by an unrelated third party. The distribution center is used solely to accommodate further shipping and the products are not modified, changed or otherwise altered at the location. Products generally are located at the distribution center for as little as a few hours and for up to seven days (on average, the products remain at the distribution center for two or three days). The taxpayer requested a ruling that sales of Company 2’s products that pass through the Illinois distribution center and are destined for another state or country are not includible in the numerator of Company 2’s Illinois sales factor.

To compute the sales factor for sales of tangible personal property, Illinois law provides that sales are sourced to the state and included in the numerator if: (i) the property is delivered or shipped to a purchaser, other than the U.S. government, within Illinois regardless of f.o.b. point or other conditions of the sale; or (ii) the property is shipped from an office, store, warehouse, factory or other place of storage in Illinois and either the purchaser is the U.S. government, or the person is not taxable in the state of the purchaser (termed the throwback rule). A regulation explains that property is delivered or shipped to a purchaser within Illinois if the shipment terminates in the state, even though the property is subsequently transferred by the purchaser to another state.    

The Department agreed with the taxpayer’s argument that the sales of Company 2’s products that pass through the Illinois distribution center intended for destinations in other states and countries are not sales within Illinois. In reaching its decision, the Department noted that the products are not altered in Illinois, and the products only remain at the Illinois distribution center for a short time. On that basis, the Department concluded that shipment of the products does not terminate in Illinois. The products are shipped to Illinois merely to accommodate further shipping to a predetermined destination outside the state, and the taxpayer is not engaged in a warehouse function in the state. Furthermore, the Department determined that a “temporary interruption” in Illinois of shipments from another state to other states or a foreign country in which the taxpayer is not subject to tax will not cause the sale to be thrown back to Illinois.

In the GIL, the Department considered the same statutory and regulatory language as discussed above for the PLR. However, the facts considered in the GIL differed from the facts in the PLR because ownership of the products is transferred at the time of delivery to the third-party warehouses or storerooms. For purposes of the GIL, the original seller is not involved in the future distribution of the product, the third party is responsible for the future shipment, and the seller does not know the subsequent destination of the products. The Department determined that delivery of products to distributor warehouses within Illinois terminates in and constitutes sales in Illinois, regardless of whether the distributor subsequently moves the products to locations outside the state. Conversely, delivery of products to distributor warehouses located outside Illinois terminates outside the state and does not constitute sales in Illinois, regardless of whether the distributor later moves the products to locations inside the state.

North Carolina lengthens filing extension for corporations

The North Carolina Rules Review Commission approved amendments to an administrative rule on Oct. 30, 2024, which lengthens the automatic filing extension for corporate franchise and income tax returns from six months to seven months after the original due date of the return. This change applies to tax years beginning on or after Jan. 1, 2025. Under the amended rule, a corporation will receive the extension if it: (i) receives an automatic extension to file a federal income tax return; or (ii) timely files Form CD-419, Application for Extension for Corporate Franchise and Income Tax, on or before the original due date of the return. This should benefit corporate taxpayers in North Carolina by providing them with one month after filing their extended federal income tax return to file their extended North Carolina income tax return. Previously, the extended North Carolina corporate income tax returns were due the same day as the extended federal corporate income tax returns.  The amended rule follows a continuing trend of lengthening the extended state income tax filing deadline beyond the extended deadline for filing federal income tax returns. This development is welcomed by taxpayers concerned about having enough time to address state-specific matters on state income tax returns.

Tennessee franchise tax refund deadline approaching

As previously reported, Tennessee enacted legislation, S.B. 2103, in May 2024 which eliminated the property measure for computing the Tennessee Business Privilege Tax (franchise tax) for tax years ending on or after Jan. 1, 2024. Prior to amendment, the franchise tax was based on the greater of Tennessee apportioned: (i) net worth (assets less liabilities) computed on Schedule F of the franchise tax return; or (ii) the book value (cost less accumulated depreciation) of real and tangible property owned or used in Tennessee computed on Schedule G of the return.

The legislation enacted earlier this year allows taxpayers that were required to use the property measure to file tax refund claims for the three prior tax years. Specifically, taxpayers who paid franchise tax based on the property measure may request a refund of franchise tax for tax years ending on or after March 31, 2020, for which a return was filed with the Tennessee Department of Revenue on or after Jan. 1, 2021. Taxpayers seeking a refund are reminded that claims must be filed by Nov. 30, 2024, though the Tennessee Department of Revenue has stated that since the Nov. 30 date falls on a Saturday, claims may be filed until Dec. 2, 2024.  

Potential refunds should be considered by taxpayers that computed their Tennessee franchise tax during the past three years using the property measure on Schedule G. These taxpayers typically would have a relatively large amount of real and tangible property in the state that exceeds their net worth. For example, taxpayers that could benefit from this legislation include entities engaged in real estate, retail, transportation, and manufacturing. The tax is broadly imposed on corporations, limited partnerships, limited liability companies, and business trusts chartered, qualified, or registered in Tennessee or doing business in the state. Franchise and Excise Tax Notice #24-05, released by the Department in May 2024, provides specific refund procedures.

Virginia court considers apportionment of income from nonunitary business        

In Commonwealth of Virginia, Department of Taxation v. FJ Management, Inc., the Virginia Court of Appeals held on Nov. 12, 2024, that a taxpayer was not required to apportion income that it earned from its minority interest in an LLC because its enterprise was not considered a unitary business. The Virginia Department of Taxation’s application of the statutory apportionment method to the income earned from the LLC violated the Due Process and Commerce Clauses of the U.S. Constitution.

The taxpayer, FJ Management, Inc. (FJM), was a corporation based in Utah that was qualified to do business in Virginia. Prior to filing for Chapter 11 bankruptcy in 2008, FJM’s primary business was the operation of 220 interstate travel centers in the U.S. and Canada, which provided various services to long-distance truckers. In addition, FJM owned entities that operated oil refineries in California and Utah, an oil pipeline in Texas, and a bank that provided services to truck drivers. During the bankruptcy, FJM sold all its travel centers and received cash and a minority interest in the acquiring entity, Pilot Travel Centers, LLC (PTC). FJM also entered into an agreement to sell fuel to PTC from its Utah oil refinery for 20 years. Upon exiting bankruptcy in 2010, FJM retained only its Utah oil refinery, the bank, and a minority interest in PTC. Following these transactions, PTC owned approximately 550 travel centers operating in multiple states, including Virginia. During the tax years at issue in this matter, FJM’s interest in PTC was approximately 17%, and FJM only had the ability to appoint two members to the PTC’s management board, which consisted of nine to eleven members.

FJM timely filed its Virginia corporate income tax returns for the 2013 through 2015 tax years at issue. On its original tax returns, FJM reported its distributive share of income earned from PTC as income subject to Virginia statutory apportionment. The returns combined PTC’s apportionment factor with FJM’s apportionment factors to determine FJM’s taxable income apportioned to Virginia. In August 2017, FJM filed amended tax returns and claimed that it had incorrectly reported its income from PTC as apportionable income. FJM removed PTC’s apportionment factors and treated the income from PTC as allocable nonunitary business income. The Department denied FJM’s amended tax returns, concluding that FJM’s ownership interest was not limited enough to permit FJM to remove PTC’s apportionment factors. Following FJM’s request for review, the Tax Commissioner upheld the Department’s decision. FJM subsequently appealed to the trial court.

Before the trial court, FJM argued that it did not form a unitary business with PTC and the Department’s application of the Virginia statutory apportionment method to FJM’s income earned from PTC was unconstitutional as applied. The trial court found for the taxpayer and concluded that the income FJM received from PTC could not constitutionally be apportioned as part of FJM’s apportionable business income because FJM was not operating as a unitary business with PTC. The Department appealed this decision to the Virginia Court of Appeals.

In affirming the trial court, the Virginia Court of Appeals held that FJM and PTC did not form a unitary business and the Department’s application of PTC’s apportionment factors to FJM under the statutory method violated the U.S. Constitution. First, the court concluded that FJM and PTC did not form a unitary business because the evidence sufficiently established that the three unitary business factors of functional integration, centralized management, and economies of scale did not exist between the entities. The court determined that FJM and PTC were not functionally integrated companies but instead were engaged in discrete lines of business. Also, there was no centralized management because FJM only had a 17% ownership interest, with a limit on appointing two of PTC’s board of managers. Finally, the economies of scale test was not satisfied because the entities did not have any cost advantages or efficiencies through their relationship. PTC did not receive any special discounts on the fuel that it purchased from FJM under the fuel supply agreement.

Because FJM and PTC did not form a unitary business, the court held that the inclusion of PTC’s apportionment factors violated the Due Process and Commerce Clauses of the U.S. Constitution because the apportioned taxable income had no rational relationship between the tax and the values connected with the taxing state, and FJM was subjected to unfairly apportioned taxation. The court also rejected the Department’s argument that FJM failed to follow the statutory procedures for requesting alternative apportionment, in part due to the fact that the Department failed to make this argument at the trial court. The court disagreed that the Department could treat FJM and PTC as a unitary business for apportionment purposes because FJM’s ownership interest was not passive and FJM took an operational role in PTC’s management. Finally, the court rejected the Department’s argument that a Virginia statute that imputes the characterization of a pass-through entity’s income, gain, loss or deduction to its owners creates a presumption that the pass-through entity and its owner are engaged in a unitary business. The court reiterated that FJM presented sufficient evidence demonstrating that it was not unitary with PTC. 

Washington Supreme Court limits investment income deduction  

On Oct. 24, 2024, the Washington Supreme Court held in Antio, LLC v. Washington State Department of Revenue that the business and occupation (B&O) tax deduction for investment income is limited. Washington law allows a taxpayer to deduct amounts derived from investments, but a prior Washington Supreme Court decision from 1986 defined “investments” to mean “incidental investments of surplus funds.” Despite subsequent legislation that amended the statute, the court determined that its earlier definition limiting the deduction remains in effect. 

The taxpayers, a group of 16 related limited liability company (LLC) investment entities, buy and sell distressed debt instruments such as credit card debt. All of their income is derived from owning or trading in these investments. In 2019, the taxpayers paid B&O tax on their income and then applied for a refund for the previous several years. They claimed that 100% of their income was deductible under Washington law because it was all “investment income.” The relevant statute provides that “amounts derived from investments” may be deducted, but the statute does not define “investments.” The Washington Department of Revenue conducted an audit and denied the taxpayers’ refund claim. The taxpayers challenged this decision before a superior court.

In granting the Department’s motion for summary judgment, the superior court held that the legislature did not amend the Washington Supreme Court’s definition of “investment” from its 1986 decision in O’Leary v. Department of Revenue, which limited the term to incidental investment of surplus funds, when it amended the relevant statute in 2002. The taxpayers appealed this decision.

The Washington Court of Appeals affirmed the superior court, finding that the Washington Supreme Court in O’Leary had previously defined “investments” in the statute to refer only to “incidental investments.” Although the legislature amended the statute in 2002, the court found no evidence that this amendment superseded O’Leary. Because the taxpayers’ income did not meet O’Leary’s definition of investments, the Court of Appeals found the taxpayers were not entitled to the deduction. The Washington Supreme Court granted the taxpayers’ petition for review.

The Washington Supreme Court affirmed the lower courts, holding that O’Leary’s interpretation of “investment” to mean “incidental investments” remained valid. The court’s opinion provided a robust history of the investment income deduction. From 1970 through 2002, the statute provided in relevant part: “In computing tax there may be deducted from the measure of tax amounts derived from persons, other than those engaging in banking, loan, security, or other financial businesses, from investments.” As discussed above, in 1986, the Washington Supreme Court in O’Leary limited the definition of “investments” under the statute. In 2000, the court held in Simpson Investment Co. v. Department of Revenue that a holding company that provided administrative and managerial services to its subsidiaries was an “other financial business” and therefore ineligible for the deduction. Because this decision further restricted what types of entities could claim the deduction, the business community reacted strongly to Simpson. In 2002, the legislature amended the statutory language to provide a deduction for amounts derived from investments with an exception for amounts received by a banking, lending, or security business. The amended statute eliminated the phrase “other financial businesses.”

The taxpayers unsuccessfully argued that when the legislature amended the investment income statute it also made the court’s definition of investments in O’Leary obsolete. They contended that any business that is not a banking, lending, or security business can deduct income from investments, even if the investment is not incidental to the entity’s main purpose. The court held that the legislature did not abrogate O’Leary’s definition of investments when it amended the statute. In considering the stated legislative intent, the court noted that the amendment was solely in response to Simpson and intended to reduce the “uncertainty” caused by the vague phrase “other financial businesses” in the statute. The court explained that there was no clear legislative intent to abrogate O’Leary’s definition of “investments.” The legislature did not amend the statute to define “investments” or indicate in the intent section that it was dissatisfied with the court’s definition.

The court held that O’Leary’s definition of investments remains in effect because the legislature did not express a clear intent to invalidate O’Leary. Businesses can claim the deduction only for investments that are incidental to the main purpose of a business. As a result, the taxpayers could not deduct income generated by their main business activities. Taxpayers that primarily derive their income from investments and historically have taken the deduction should seriously consider how this decision may adversely impact this position.

Two of the court’s justices joined in a lengthy dissent contending that the court must determine the meaning of a current statute using its current language, not from a court decision interpreting a prior version of the statute. As explained by the dissent, the current statute creates a broadly accessible deduction for all investment income and a narrow list of entities barred from claiming the deduction. Because the current statute eliminates the exception for “other financial businesses,” it undermines the basis for O’Leary’s incidental investment exception. Furthermore, the dissent noted the explicit legislative intent to expand the availability of the investment income deduction.