State and local tax news for October 2024

 

During the past several weeks, there have been some significant court decisions concerning SALT issues, including two state supreme court cases.

  • The Nebraska Supreme Court and Oregon Tax Court both considered the state income tax treatment of repatriated income in the wake of the U.S. Supreme Court’s recent decision in Moore v. United States that upheld the constitutionality of IRC Section 965.
  • The Pennsylvania Supreme Court held that the federal deferral of income in like-kind exchanges under IRC Section 1031 does not apply to Pennsylvania personal income tax for years beginning before 2023.
  • In Colorado, the Department of Revenue issued a private letter ruling concerning the sourcing of sales to the U.S. government.
  • Finally, the Massachusetts Appellate Tax Board held that taxpayers may take a research credit against the financial institution excise tax. 

 

 

Colorado explains sourcing of sales to federal government  

 

On Aug. 21, 2024, the Colorado Department of Revenue issued a private letter ruling, PLR 24-003, holding that receipts from sales of property to the U.S. government that is manufactured in Colorado and stored in the state prior to delivery are not sourced to Colorado because final delivery is completed at a location outside the state.

 

The taxpayer, a Delaware corporation headquartered in Colorado, manufactures items in Colorado and sells them to the U.S. government, with ultimate delivery to locations outside the state. After the manufacturing is completed, the government performs a “final inspection” and then an “unconditional acceptance” in Colorado. However, because the U.S. government facilities are often not ready to receive the items, the contract requires the taxpayer to store the items in Colorado until the U.S. government is ready for them. The U.S. government pays the taxpayer to store and service the items in Colorado until they are delivered by the company to the U.S. government location outside the state. The taxpayer is taxable in every state in which it delivers the items to the government.

 

The Department explained in its ruling that receipts from sales of tangible personal property are sourced to Colorado if the “property is delivered or shipped to a purchaser in Colorado regardless of the f.o.b. point or other conditions of the sale.” Under Colorado law, receipts from the sales at issue are not sourced to Colorado because the items are not delivered or shipped to the U.S. government in Colorado. The taxpayer represented that the U.S. government does not take possession of the items at any time prior to delivery of the items to locations outside the state. The physical location of the items at the time of “final inspection” and “unconditional acceptance” does not determine the state to which the sales are sourced. Although federal regulations relate to the conditions of sales to the U.S. government, such as final inspection, acceptance, and delivery, sales to the government are sourced under Colorado law like sales to any other purchaser. Furthermore, the Department noted that the taxpayer’s storage of items for the government after “final inspection” and “unconditional acceptance” does not determine the state to which the sales are sourced. In this case, the U.S. government does not take delivery of the items in Colorado, even though the taxpayer stores the items in Colorado after the government’s “final inspection” and “unconditional acceptance.”

 

It should be noted that prior to 2019, Colorado followed an origin-sourcing rule with respect to sales to the U.S. government, which would have changed the outcome of this ruling had the rule still been in place. While the Department’s ruling concerns sales to the U.S. government, it also may be instructive with respect to sourcing sales to non-governmental entities that inspect and accept items, or require storage of such items, in Colorado prior to shipment and delivery outside the state. Finally, this ruling also may be considered by taxpayers located in other states who sell items to the U.S. government and do not apply an origin-sourcing rule to these sales. 

 

 

 

Massachusetts allows financial institution to take research credit

 

On Aug. 15, 2024, in State Street Corp. v. Commissioner of Revenue, the Massachusetts Appellate Tax Board held that a bank holding company that filed a combined report was entitled to claim a research credit against the financial institution excise tax. The board explained that Massachusetts law does not limit eligibility for the Massachusetts research credit to business corporations taxed under the corporate excise tax. Business corporations are permitted to claim the Massachusetts research credit, with no specified distinctions for eligibility based on the type of business corporation.

 

The taxpayer was registered with the Federal Reserve as a bank holding company and filed a consolidated federal income tax return. For federal income tax purposes, the taxpayer and its subsidiaries were classified as corporations. The taxpayer and two of its subsidiaries were included within the Massachusetts statutory definition of a financial institution and were subject to the financial institution excise tax. For each of the tax years ending Dec. 31, 2016, through Dec. 31, 2018, the taxpayer filed a combined Massachusetts report that included the two financial institution subsidiaries, both of which generated Massachusetts research credits. One of the subsidiaries had research credits for the 2016 and 2017 tax years which were carried forward because the group had losses for these years. Both subsidiaries also had research credits for the 2018 tax year. Including the carried-over amounts, the taxpayer claimed nearly $14 million in Massachusetts research credits on its combined report for the 2018 tax year at issue.

 

Following an audit, the Massachusetts Department of Revenue disallowed the research credits under the rationale that these credits are not available to financial institutions. The Department issued a notice of intent to assess the tax, interest and penalties for a total assessment of nearly $18 million. After the Department denied the taxpayer’s application to abate the tax, the taxpayer filed a petition with the Board.

 

In granting the taxpayer’s motion for summary judgment, the Board determined that Massachusetts law does not limit eligibility for the research credit to business corporations subject to the corporate excise tax. The Board explained that Massachusetts law generally provides a research credit to business corporations subject to excise tax. Also, a business corporation is defined in relevant part as an entity that is classified for the tax year as a corporation for federal income tax purposes. The parties did not dispute that the taxpayer and its subsidiaries satisfied the definition of “business corporation” during the research credit tax years at issue. The Board concluded that under the unambiguous statutory language, the taxpayer and its subsidiaries were business corporations entitled to receive the Massachusetts research credits. The Department argued that the taxpayer’s position conflicted with its research credit regulation, but the Board noted that the regulation had not been updated to address amendments that were made to the relevant statutes in 2008. As a result, the Board declined to give the regulation any deference for the tax years at issue.

 

Based on this decision, financial institutions that have incurred research and development expenses in Massachusetts should consider filing amended excise tax returns as a means to claim the Massachusetts research credit.

 

 

 

Nebraska Supreme Court denies deduction for foreign retained earnings 

 

In Precision Castparts Corp. v. Nebraska Department of Revenue, the Nebraska Supreme Court held on Aug. 30, 2024, that income, which represented retained earnings of the taxpayer's foreign subsidiaries that were included on its 2017 federal income tax return under Internal Revenue Code (IRC) Sec. 965, could not be deducted from Nebraska income as dividends deemed to be received under state law. 

 

The federal Tax Cuts and Jobs Act (TCJA), which was enacted in 2017, included an overhaul of the federal taxation of U.S. corporations that earn international income. IRC Sec. 965 created a one-time tax for the 2017 tax year in which taxpayers’ subpart F income from controlled foreign corporations (CFCs) was effectively increased by the accumulated post-1986 deferred foreign income of the CFCs. Nebraska law historically has provided a deduction from taxable income for “dividends received or deemed to be received from corporations which are not subject to the Internal Revenue Code,” and such law did not change in any way when the TCJA was enacted to provide for the one-time tax under IRC Sec. 965.

 

The taxpayer, an Oregon-based corporation that sold its products in Nebraska, was subject to Nebraska income tax. For the 2017 tax year, the taxpayer included the IRC Sec. 965 income on its federal income tax return. The taxpayer did not include its IRC Sec. 965 income in the tax base in its original Nebraska corporation income tax return it filed for 2017, but it amended its return in December 2021 to include it. In March 2022, the taxpayer filed a request with the Nebraska Department of Revenue seeking a declaratory order authorizing it to amend its 2017 Nebraska return to deduct the IRC Sec. 965 income pursuant to the Nebraska dividends received deduction (DRD). The Nebraska Tax Commissioner issued a declaratory order denying the request on the basis that the DRD did not apply to IRC Sec. 965 inclusion income. As determined by the Tax Commissioner, the IRC Sec. 965 income was a “deemed inclusion,” rather than a “deemed dividend” that could have been deducted under Nebraska law. 

 

In affirming the declaratory order, a district court agreed with the Tax Commissioner’s conclusion that the IRC Sec. 965 inclusions are income, but they do not qualify as dividends deemed to be received for purposes of the Nebraska DRD. The taxpayer appealed the district court’s order to the Nebraska Supreme Court.  

 

On appeal, the Nebraska Supreme Court affirmed the district court's order denying the taxpayer's request to amend its 2017 Nebraska corporate income tax return to claim the deduction. The court explained that the case concerned whether IRC Sec. 965 income qualified as dividends deemed to be received under Nebraska law. In affirming the order, the court agreed with the district court’s observation and the Tax Commissioner’s argument that the language of IRC Sec. 965 does not explicitly deem the income inclusion to be dividends. The court considered the U.S. Supreme Court’s recent decision in Moore v. United States that involved a challenge to the constitutionality of IRC Sec. 965. In rejecting the constitutional challenge, the Court’s conception of IRC Sec. 965 indicated that the statute does not operate by deeming shareholders to have received a distribution of retained earnings from CFCs. Instead, IRC Sec. 965 employs a pass-through treatment that does not require a distribution of earnings to shareholders. The U.S. Supreme Court determined that IRC Sec. 965 attributes earnings realized by CFCs to shareholders without regard to whether the earnings are distributed.

 

The Nebraska Supreme Court concluded that, based on the language of IRC Sec. 965 and the U.S. Supreme Court's characterization of IRC Sec. 965's operation in Moore, the income included and taxed under IRC Sec. 965 does not qualify for the Nebraska DRD. This case is noteworthy, particularly for businesses with significant inclusions from international operations, because a state’s top court has now applied the U.S. Supreme Court’s recent analysis in Moore in determining the operation of IRC Sec. 965 and its application to a state deduction. It also highlights the fact that states which taxed IRC Sec. 965 inclusions in the 2017 tax year and now tax global intangible low-taxed income (GILTI) amounts have not been entirely consistent with respect to how such amounts should be treated for purposes of corporation income taxes, both from a tax base and sales factor sourcing perspective. 

 

 

 

Oregon Tax Court holds portion of repatriated income included in sales factor        

 

On Aug. 29, 2024, the Oregon Tax Court considered the state tax apportionment treatment of repatriated “deemed dividends” arising under IRC Sec. 965 in Microsoft Corp. v. Department of Revenue. The court held that the 20% repatriated income remaining after the state’s DRD must be “reincluded” in the sales factor denominator for the water’s edge group. However, the court determined that the taxpayer could not use alternative apportionment to include additional amounts that were excluded from the tax base as a DRD in the sales factor denominator.

 

As in the Nebraska Precision Castparts decision, the court in Microsoft considered IRC Sec. 965, as interpreted by the U.S. Supreme Court in Moore v. United States. The repatriation requirement automatically was incorporated into Oregon law. However, CFC shareholders that are corporations holding at least 20% of the stock of a CFC historically were allowed to take a DRD allowing them to subtract 80% of the federal repatriation amount in computing Oregon taxable income. The court referred to the remaining repatriated income as the “20% repatriation amount.”

 

The taxpayer, a Washington headquartered corporation, along with its numerous domestic and foreign subsidiaries (the worldwide group) were a unitary group conducting a major unitary software business. Members of the group consisting of the taxpayer and its domestic subsidiaries (the water’s edge group) own foreign subsidiaries, including CFCs that license, manufacture and distribute taxpayer-branded software products outside the U.S. The taxpayer had a large federal repatriation amount during the year at issue, the fiscal and tax year ending on June 30, 2018.

 

Applying the Oregon Department of Revenue’s guidance on the TCJA, the water’s edge group completed its corporate excise tax return by including the 20% repatriation amount in its income, but did not include any portion of the federal repatriation amount in either the numerator or the denominator of its sales factor. The taxpayer paid the tax but immediately filed an amended return based on the use of alternative apportionment, claiming a partial tax refund. In computing the refund claim, the taxpayer added the 20% repatriation amount to the sales factor denominator. The Department denied the refund and followed its published position that no amount of the repatriated income could be included in the sales factor. The taxpayer appealed the Department’s refund denial to the Oregon Tax Court.

 

The court accepted the taxpayer’s first argument that a deemed dividend constituting the 20% repatriation amount must be reincluded in the sales factor denominator for the water's edge group because the deemed payor was a CFC engaged in a unitary business with the taxpayer, and the taxpayer's primary business activity is the same as that of the CFC. The taxpayer based its argument on the Oregon Tax Court’s 2021 decision in Oracle Corp. v. Department of Revenue that concerned the statutory definition of “sales” that was effective for tax years beginning before 2018. The definition excluded deemed dividends under subpart F because they arise from the holding of intangible assets, but an exception treated these amounts as sales if they were derived from the taxpayer’s primary business activity. In Oracle, the court determined that subpart F amounts are sales under the exception if: (i) the CFC and the companies are engaged in a single unitary business; and (ii) the CFC’s earnings and profits constituting the subpart F amounts are from a single primary business activity. Oracle concerned subpart F income prior to the TCJA, but the court applied the holding to repatriated income. In partially granting the taxpayer’s motion for summary judgment, the court concluded the 20% repatriation amount must be reincluded in the sales factor for the water’s edge group, which resulted in a refund to the taxpayer.    

 

With respect to the taxpayer’s request to apply alternative apportionment, the court disagreed that the assessment failed to fairly represent the extent of its business activity in the state or that the assessment produced unconstitutional results. The court applied the test from the Oregon Supreme Court’s Twentieth Century-Fox v. Department of Revenue decision from 1985 in making this determination. In this prior case, the court announced that in the context of the Uniform Division of Income for Tax Purposes Act (UDITPA), reasonableness has at least three components: (i) the division of income fairly represents business activity and if applied uniformly would result in taxation of no more or no less than 100% of the taxpayer’s income; (ii) the division of income does not create or foster lack of uniformity among UDITPA jurisdictions; and (iii) the division of income reflects the economic reality of the business activity engaged in by the taxpayer in Oregon. In the instant case, the court concluded that the taxpayer did not prove that the assessment was inaccurate, or that it failed to reflect the economic reality of the water’s edge group’s activities in Oregon. Also, the court held that the taxpayer did not prove that the degree of factor representation under Oregon law — with or without reinclusion of the 20% repatriation amount in the denominator of the sales factor — was insufficient.  

 

As an alternative to the statutory “fairly represent” test, the taxpayer requested factor relief to “remedy unconstitutional results.” The taxpayer argued that the assessment violated the Commerce Clause, the additional requirements of the Foreign Commerce Clause, and the Due Process Clause. The court applied the four-part test for making Commerce Clause determinations from the U.S. Supreme Court’s decision in Complete Auto Transit, Inc. v. Brady requiring that the state tax: (i) be applied to an activity with a substantial nexus with the taxing state; (ii) be fairly apportioned; (iii) not discriminate against interstate commerce; and (iv) be fairly related to the services provided by the state. After a thorough analysis, the court determined that these tests were satisfied. The court also concluded that the assessment did not violate the multiple international taxation prohibition under the Foreign Commerce Clause. In rejecting the taxpayer’s Due Process Clause argument, the court held that a minimum connection existed between the state and the water’s edge group and the repatriation amount and the group. Finally, the portion of the federal repatriated amount that was included in Oregon taxable income was rationally related to values connected with Oregon. The court denied the taxpayer’s motion for summary judgment as it pertained to alternative apportionment. 

 

 

 

Pennsylvania Supreme Court considers like-kind exchanges

 

On Sept. 26, 2024, the Pennsylvania Supreme Court held in Pearlstein v. Commonwealth that Pennsylvania does not follow the federal deferral of gains from like-kind exchanges of real property for personal income tax purposes for tax years beginning prior to 2023. For the 2013 and 2014 tax years at issue, the court held that Pennsylvania taxed net gains on like-kind exchanges at the time of the exchange.

 

The IRC generally requires that the gain or loss from a sale of property be recognized upon the sale or exchange of the property. However, the IRC provides an exception to the general rule by deferring the reporting of the gain or loss for like-kind exchanges under IRC Sec. 1031 until the property is ultimately sold. Prior to legislation enacted in 2022, Pennsylvania law did not explicitly address like-kind exchanges, nor did it reference IRC Sec. 1031 or the federal income tax deferral rule.

 

In 2006, the Pennsylvania Department of Revenue issued guidance, Personal Income Tax Bulletin, 2006-07, recognizing that Pennsylvania personal income tax does not contain an analogous provision to IRC Sec. 1031. However, the bulletin noted that “the Department has determined that gain or loss on like-kind exchanges does not have to be recognized at the time of the exchange if a taxpayer’s method of accounting permits the deferral of gain from a like-kind exchange.” A Pennsylvania regulation provides that tax bulletins are considered “revenue information material,” which the Department issues “for informational purposes only and should not be relied upon or used in tax appeals.” Legislation was enacted in 2022 that defers the recognition of gain from like-kind exchanges for Pennsylvania personal income tax purposes beginning with the 2023 tax year, consistent with the federal provision.

 

The taxpayers in this case completed like-kind exchanges of real property in 2007 and 2008 and deferred the gains on both their federal and Pennsylvania income tax returns. For the 2013 and 2014 tax years, the taxpayers filed their Pennsylvania personal income tax returns, which deferred recognition of the gains. After reviewing the tax returns, the Department determined that the deferral of the gains was inconsistent with Pennsylvania law and issued notices of assessment. The taxpayers protested the assessments at the Pennsylvania Board of Appeals and claimed that deferral of the gains was permitted under Bulletin 2006-07. After the Board denied their claim, the taxpayers appealed to the Pennsylvania Board of Finance and Review. The taxpayers argued that the deferral of gains was supported by their use of the federal income tax (FIT) method of accounting. In December 2017, after the Board denied the taxpayers’ appeal, the Department posted a revised bulletin that eliminated the sentence allowing the deferral of gain if permitted by the taxpayer’s method of accounting and explained that IRC Sec. 1031 cannot be used as a basis to defer gain from the exchange of properties for Pennsylvania income tax purposes.

 

In response to a petition of review filed by the taxpayers, the Pennsylvania Commonwealth Court affirmed the assessments because deferring the reporting of gains from like-kind exchanges violated the requirement under Pennsylvania personal income tax law that any accounting method used must “clearly reflect income.” The court determined that the FIT method of accounting could not be used to defer gains on like-kind exchanges, and rejected the argument that the taxpayers’ method of accounting satisfied Pennsylvania law and complied with Bulletin 2006-07. The taxpayers appealed to the Pennsylvania Supreme Court.

 

Applying the principles of statutory construction, a majority of the Pennsylvania Supreme Court affirmed the assessment because Pennsylvania personal income tax law did not explicitly establish an exception or deferral principle for net gains from like-kind exchanges for the tax years at issue. The court acknowledged that the deferral principles of IRC Sec. 1031 have become firmly entrenched in federal law and the laws of many states.

 

Pennsylvania ultimately enacted legislation to incorporate IRC Sec. 1031 in 2022 for the 2023 tax year and beyond, but this law did not apply to the 2013 and 2014 tax years. Also, the court agreed with the Department’s position that every taxpayer initially uses the FIT accounting method for purposes of filing federal income tax returns. The court noted that treating the FIT method as an accepted accounting principle would allow taxpayers to incorporate all IRC provisions into Pennsylvania law. Also, Bulletin 2006-07 did not convince the court that the taxpayers could defer the gain. The Department successfully argued that Bulletin 2006-07 was limited to situations in which the Generally Accepted Accounting Principles (GAAP) method of accounting is used, and even under GAAP, the Department contended that such scenarios are exceedingly rare. Based on its statutory interpretation, the court agreed with the Department that Bulletin 2006-07 did not establish an exception for like-kind exchanges.

 

A concurring opinion agreed with much of the majority’s opinion, but disagreed with the majority’s “apparent dismissal of Bulletin 2006-07 as mere nonbinding revenue information.” The concurring opinion believed that taxpayers should be entitled to rely on the Department’s interpretations contained in its own publications. A dissenting opinion joined by two justices would hold that the option to defer gains from like-kind exchanges was available to taxpayers under the Department’s regulation that permits taxpayers to use an accounting method that clearly reflects income. Under this regulation and Bulletin 2006-07, the taxpayers should have been able to use the FIT method of accounting to defer the gains on the like-kind exchanges. 

 
 

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