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Kentucky enacts major tax reform legislation

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On April 27, 2018, Kentucky enacted major tax reform legislation, H.B. 487, without the signature of Gov. Matt Bevin.1 This legislation supersedes similar tax reform legislation, H.B. 366, which had been enacted over the governor’s veto earlier in April.2 H.B. 487 updates the Internal Revenue Code (IRC) conformity date, imposes a flat tax rate, adopts mandatory unitary combined reporting, enacts single sales factor apportionment for most taxpayers, and adopts market-based sourcing for sales other than sales of tangible personal property. Furthermore, the legislation includes major sales and use tax provisions that expand the tax base to include a variety of services and enact a bright-line nexus standard for remote sellers.

General income tax provisions IRC conformity advanced

For taxable years beginning on or after Jan. 1, 2018, Kentucky updates its IRC conformity date from Dec. 31, 2015, to Dec. 31, 2017.3 As a result, Kentucky generally conforms to the federal tax reform provisions contained in H.R. 1, commonly referred to as the Tax Cuts and Jobs Act (TCJA).4 However, Kentucky continues to decouple from the federal bonus depreciation and asset expensing provisions.5 Thus, Kentucky does not adopt federal income tax changes that allow for a 100 % bonus depreciation deduction for assets placed in service after Sept. 27, 2017, and before Jan. 1, 2023, or the $1 million and $2 million investment phase-out limitations for the asset expense deduction under IRC Sec. 179. For taxpayers that are not corporations, the legislation requires adding back the amount of the IRC Sec. 199A deduction enacted by the TCJA for the qualified business income of pass-through entities.6

Flat income tax rate enacted for corporations and individuals

For tax years beginning on or after Jan. 1, 2018, Kentucky is imposing corporate and individual income taxes at a flat rate of 5%.7 Prior to amendment, corporations paid income tax at graduated rates ranging from 4% to 6% and individuals at graduated rates ranging from 2% to 6%.

Certain deductions limited

For taxable years beginning on or after Jan. 1, 2018, a statute is enacted to provide a limitation on deductions to income directly or indirectly subject to Kentucky tax.8 A deduction directly or indirectly allocable to tax-exempt income, and double deductions of the same item are not allowed.9

Income tax credit for property tax paid on inventory

In an effort to phase out Kentucky’s property tax on inventory, H.B. 487 enacts a non-refundable credit against corporate and individual income tax of 25% of the property taxes timely paid on inventory for 2018.10 The credit amount is increased annually until a 100% credit is available for property taxes paid on business inventory beginning with the 2021 tax year.11

Corporate income tax Combined reporting requirement for members of a unitary business group

Unlike H.B. 366, H.B. 487 requires combined reporting for members of a unitary business group, effective for tax years beginning on or after Jan. 1, 2019.12 Groups may, however, elect to file a consolidated return with all members of the affiliated group.13

If an election is made to file a consolidated return, the return must include all corporations that are members of the federal affiliated group as defined under IRC Sec. 1504(a).14 An affiliated group may file a Kentucky consolidated return regardless of whether it filed a federal consolidated return.15 For affiliated groups that make the election, the group is treated as a single corporation for corporate income tax purposes, with eliminations for intercompany transactions.16 The consolidated return election is binding on both the Department of Revenue and the affiliated group for eight years.17

If the consolidated election is not made, a taxpayer engaged in a unitary business with one or more other corporations must file a combined report on a water’s edge basis that includes the income and the apportionment fraction of all corporations that are members of the unitary business.18 Each taxpayer member is responsible for tax based on its taxable income or loss apportioned or allocated to Kentucky.19 The statute lists the items of income that must be included, and there are restrictions on the sharing of tax credits and post-apportionment deductions among members of the group.20

The taxpayer’s share of the combined group’s business income apportionable to Kentucky is the combined group’s apportionable income multiplied by the taxpayer member’s apportionment fraction.21 The combined group’s apportionable income is determined by taking each member’s federal taxable income, as adjusted for Kentucky purposes, as if each member were not consolidated for federal purposes, and then, from the combined group’s total income, subtract any income and add any expense or loss, other than the apportionable income, expense or loss of the combined group.22

The combined group’s total income includes the following:

  • The entire income and apportionment percentage of any member incorporated in the U.S. or formed under the laws of any state, the District of Columbia, or any territory or possession of the U.S.;
  • Any member that earns more than 20% of its income from intangible property or service-related activities that are deductible against the apportionable income of other group members, to the extent of that income and the apportionment factor related to that income; and
  • The entire income and apportionment factor of any member that is doing business in a tax haven.23

Special rules apply to determine income from a pass-through entity, the treatment of deferred intercompany transactions, and income arising from sales of capital assets.24 Additionally, as a result of the change in filing methodology, a provision was included in H.B. 487 to limit utilization of net operating loss deduction carry-forwards prior to the imposition of combined reporting.25

Single sales factor apportionment

Prior to the enactment of H.B. 487, business income was apportioned to Kentucky using a three-factor formula consisting of a property, payroll and double-weighted sales factor.26 For taxable years beginning on or after Jan. 1, 2018, Kentucky is using a single sales factor formula to determine apportionable income.27 Apportionable income includes income that is apportionable under the U.S. Constitution and is not allocated to Kentucky.28 Additionally, the sales factor no longer includes income derived from hedging and other treasury transactions.29 Finally, communication, cable, or Internet service providers continue to use Kentucky’s historic three-factor formula.30

Market-based sourcing

Under prior law, receipts from sales of other than tangible personal property were sourced based on costs of performance.31 For taxable years beginning on or after Jan. 1, 2018, sales are sourced to Kentucky if the taxpayer’s market for the sales is in the state.32 The statute includes provisions for determining whether a taxpayer’s market for sales is deemed to be in Kentucky. Dispositions of real property and rentals, leases and licenses of tangible personal property are sourced to Kentucky if the property is located in the state.33 A service is sourced to Kentucky if and to the extent it is delivered to a location in the state.34 Sales of intangible property are sourced to Kentucky to the extent the intangible property is used in the state.35 If the state of assignment cannot be determined, it may be reasonably approximated.36 The legislation includes a “throw-out” rule providing that if the taxpayer is not taxable in a state to which a receipt is assigned, or the state of assignment cannot be determined or reasonably approximated, that receipt must be eliminated from the denominator of the receipts factor.37

Individual income tax For tax years beginning on or after Jan. 1, 2018, the enacted legislation repeals the $10 personal credit that had previously been available to individual taxpayers.38 Also, individual retirement (pension) income in excess of $31,110 (a reduction from the previous allowable exclusion of $41,110) cannot be subtracted from a Kentucky taxpayer’s federal income tax base.39 Finally, individuals who itemize deductions for Kentucky purposes are not permitted to subtract certain deductions itemized for federal purposes, including investment interest, casualty or theft losses, medical care expenses, moving expenses and miscellaneous deductions.40

Sales and use tax Services subject to tax expanded

For transactions occurring on or after July 1, 2018, the sales tax base is expanded to include a number of services such as landscaping services, janitorial services, veterinary and pet care services, industrial and non-coin operated laundry services, linen supply services, indoor tanning services, non-medical diet and weight reducing services, limousine services, and extended warranty services.41 Receipts from these services will be taxed at the standard sales tax rate of 6%.

Economic nexus provision for remote retailers

For transactions occurring on or after July 1, 2018, a “retailer engaged in business in this state” is expanded to include any remote retailer42 selling tangible personal property or digital property delivered or transferred electronically to a purchaser in Kentucky if:

  • The remote retailer sold tangible personal property or digital property delivered or transferred electronically to a purchaser in Kentucky in 200 or more separate transactions in the previous or current calendar year; or
  • The remote retailer’s gross receipts from the sale of tangible personal property or digital property delivered or transferred electronically to a purchaser in Kentucky in the previous or current calendar year exceeds $100,000.43

Kentucky also adopts several definitions relevant to online marketplaces, include the terms “marketplace,”44 “marketplace facilitator,”45 “marketplace retailer”46 and “referrer.”47 However, the legislation does not impose a sales tax collection requirement on these entities.

Manufacturing exemptions

For transactions occurring on or after July 1, 2018, the computation of the sales tax exemption for energy costs uses in manufacturing is amended.48 Under existing law, an exemption is provided for energy used in the course of manufacturing, processing or mining to the extent the cost exceeds 3% of the cost of production. As amended, the cost of production is computed on the basis of a plant facility, which includes all operations within the continuous, unbroken, integrated manufacturing or industrial processing process that ends with a product packaged and ready for sale. Also, existing law provides an exemption for the purchase of machinery for new and expanded industry.49 The definition of “machinery for new and expanded industry” is amended to mean machinery directly used in the manufacturing or industrial processing process.50 As a result of these changes, new definitions have been added for “directly used in the manufacturing or industrial processing process”51 and “industrial processing.”52

Taxation of certain admissions and lodging

Admission to racetracks, historical sites, and a portion of admissions to county fairs are now exempt from sales tax in Kentucky.53 However, certain admissions to bowling centers, golf course, and recreational sports centers are now subject to sales tax.54 Also, campsites, campgrounds and recreational vehicle parks are considered to be short-term lodging subject to the 6% sales tax.55

Repeal of exemption for pollution control facilities

The sales and use tax exemption available to certified pollution control facilities has been eliminated.56

Credits and Incentives H.B. 487 impacts several existing tax credit programs available to businesses in Kentucky. The suspension of the Kentucky Industrial Revitalization Tax Credit and the repeal of the Kentucky Jobs Retention Act Tax Credit under H.B. 366 are both reversed, allowing companies to continue to file applications for program benefits.57 Also, a new incentive reporting requirement is imposed for the Industrial Revitalization Act which requires the Department of Revenue to prospectively submit the amount of approved costs for the tax credit to the Interim Joint Committee on Appropriations and Revenue.58 Finally, the Angel Investor Credit and the Investment Fund Credit will be suspended throughout 2019 and 2020, with a new limitation enacted for each program.59 For all years prior to 2021, a $40 million cap is put in place for each program, and each credit is limited to $3 million per year in 2021 and thereafter.

Commentary The sweeping Kentucky tax reform legislation followed weeks of intense legislative activity and conflict between the legislature and the governor. On April 13, 2018, the Kentucky legislature voted to override the governor’s veto of previous tax reform legislation, H.B. 366. On April 14, 2018, the legislature passed similar tax reform legislation, H.B. 487, which contains many of the provisions of H.B. 366 but also adopts mandatory unitary combined reporting. Because the governor did not take action by the statutory deadline, H.B. 487 became law without the governor’s signature, and supersedes H.B. 366.

This legislation combines federal conformity provisions with state-specific income and sales tax reforms that recently have been adopted by many states. The move to a single sales factor apportionment formula and the imposition of mandatory combined reporting for businesses unitary groups could result in many taxpayers seeing an increase in their Kentucky corporate income tax liability. Furthermore, the adoption of market-based sourcing of receipts for services and income from intangibles, as well as the potential “throw-out” of some intangible receipts, without immediate guidance on how to implement these provisions, could be problematic. Many of these changes have effect for the 2018 tax year and will cause immediate changes to the ASC 740 provision.

From a sales tax perspective, the state’s adoption of an economic nexus statute to collect tax from remote sellers is very similar to the South Dakota statute that currently is being considered by the U.S. Supreme Court in Wayfair.60 Thus, the constitutionality of this statute will not be known until the Court soon issues its decision. The marketplace definitions have been added to Kentucky law, but there currently is no collection obligation associated with these definitions. Presumably, the enactment of the definitions is the first step in implementing a collection and remittance requirement for marketplace sales. These Kentucky changes, along with the expansion of services subject to sales tax, could represent a longer-term emphasis on taxes based on consumption rather than on income.

 

1 Ch. 207 (H.B. 487), Laws 2018.
2 Ch. 171 (H.B. 366), Laws 2018 (superseded).
3 KY. REV. STAT. ANN. § 141.010(14).
4 P.L. 115-97. For a discussion of this Act, see GT Alert: Tax Reform Law Transforming Business and Tax Planning.
5 H.B. 487, § 55 (new provision, KY. REV. STAT. ANN. ch. 141).
6 Id.
7 KY. REV. STAT. ANN. §§ 141.020(2); 141.040(2).
8 H.B. 487, § 54 (new provision, KY. REV. STAT. ANN. ch. 141).
9 Id.
10 N.Y.C. ADMIN. CODE § 11-652(5-a)(b). Specifically, the provision applies to corporations subject to Chapter 6 City Business Taxes, Subchapter 3-A Corporate Tax of 2015.
11 Id.
12 H.B. 487, § 119 (new provision, KY. REV. STAT. ANN. ch. 141). A “unitary business” is a single economic enterprise that is made up either of separate parts of a single corporation or of a commonly controlled group of corporations that are sufficiently interdependent, integrated and interrelated through their activities to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts. The term “unitary business” must be broadly construed to the extent permitted by the U.S. Constitution. H.B. 487, § 120 (new provision, KY. REV. STAT. ANN. ch. 141).
13 Id.
14 Id.
15 Id.
16 Id.
17 Id.
18 H.B. 487, § 120 (new provision, KY. REV. STAT. ANN. ch. 141). The Department may require the combination of unitary corporations that are not members of the combined group if necessary to properly reflect the taxpayer’s business activity in Kentucky or to prevent tax avoidance or evasion.
19 Id.
20 Id.
21 Id.
22 Id.
23 Id. “Tax haven” means a jurisdiction that has no or nominal effective tax on the relevant income during the taxable year and: (i) has laws or practices that prevent the effective exchange of information for tax purposes with other governments on taxpayers benefiting from the tax regime; (ii) has a tax regime which lacks transparency; (iii) facilitates the establishment of foreign-owned entities without the need for a local substantive presence or prohibits these entities from having any commercial impact on the local economy; (iv) explicitly or implicitly excludes the jurisdiction’s resident taxpayers from taking advantage of the tax regime’s benefits or prohibits enterprises that benefit from the regime from operating in the jurisdiction’s domestic market; or (v) has created a tax regime which is favorable for tax avoidance, based on an overall assessment of relevant factors, including whether the jurisdiction has a significant untaxed offshore financial or other services sector relative to its overall economy.
24 Id.
25 KY. REV. STAT. ANN. § 141.011(5).
26 Former KY. REV. STAT. ANN. § 141.120(8).
27 KY. REV. STAT. ANN. § 141.120(9). The legislation replaces the historic “business income” terminology with “apportionable income.”
28 KY. REV. STAT. ANN. § 141.120(1)(a).
29 KY. REV. STAT. ANN. § 141.120(1)(e).
30 KY. REV. STAT. ANN. § 141.1210(1)(e), (3).
31 Former KY. REV. STAT. ANN. § 141.120(8)(c).3.
32 KY. REV. STAT. ANN. § 141.120(11)(a).
33 KY. REV. STAT. ANN. § 141.120(11)(a).1, 2.
34 KY. REV. STAT. ANN. § 141.120(11)(a).3.
35 KY. REV. STAT. ANN. § 141.120(11)(a).4.
36 KY. REV. STAT. ANN. § 141.120(11)(b).
37 KY. REV. STAT. ANN. § 141.120(11)(c).
38 KY. REV. STAT. ANN. § 141.020(3)(a).
39 H.B. 487, § 55 (new provision, KY. REV. STAT. ANN. ch. 141).
40 Id.
41 KY. REV. STAT. ANN. § 139.200(2)(g)-(q). As part of the expansion of the sales tax, the “amount charged for labor or services rendered in installing or applying the tangible personal property, digital property, or service sold” is now includable under the definitions of “gross receipts” and “sales price.” KY. REV. STAT. ANN. § 139.010(15)(a).6. Previously, this amount was excluded provided it was separately stated on the invoice, bill of sale, or similar document provided to the purchaser. Former KY. REV. STAT. ANN. § 139.010(15)(c).4. Businesses providing “extended warranty services” are now considered to be retailers engaged in business in Kentucky. KY. REV. STAT. ANN. § 139.340(2)(b), (c), (e). “Extended warranty services” are services provided through a service contract agreement between the contract provider and the purchaser where the purchaser agrees to pay compensation for the contract and the provider agrees to repair, replace, support or maintain tangible personal property or digital property according to the terms of the contract if: (i) the service contract agreement is sold or purchased on or after July 1, 2018, and (ii) the tangible personal property or digital property for which the service agreement is provided is subject to sales tax. KY. REV. STAT. ANN. § 139.010(13).
42 A “remote retailer” is a retailer with no physical presence in Kentucky, but the term does not include a marketplace facilitator or a referrer. KY. REV. STAT. ANN. § 139.010(34).
43 KY. REV. STAT. ANN. § 139.340(2)(g).
44 A “marketplace” is any physical or electronic means through which one or more retailers may advertise and sell or lease tangible personal property or digital property, such as a catalog, Internet Web site, or television or radio broadcast, regardless of whether the tangible personal property, digital property or retailer is physically present in Kentucky. KY. REV. STAT. ANN. § 139.010(21).
45 A “marketplace facilitator” is a person that facilitates the retail sale of tangible personal property or digital property by listing or advertising the tangible personal property for sale at retail and either directly or indirectly through agreements or arrangements with third parties, collects the payment from the purchaser, and transmits the payment to the seller of the property. KY. REV. STAT. ANN. § 139.010(22).
46 A “marketplace retailer” is a person that has an agreement with a marketplace facilitator and makes retail sales of tangible personal property or digital property through a marketplace. KY. REV. STAT. ANN. § 139.010(23).
47 A “referrer” is a person that: (i) contracts with a retailer or retailer’s representative to advertise or list tangible personal property or digital property for sale or lease; (ii) makes referrals by connecting a person to the retailer or the retailer’s representative, but not acting as a marketplace facilitator; and (iii) received in the prior calendar year or the current calendar year, in the aggregate, at least $10,000 in consideration from remote retailers, marketplace retailers, or representatives of remote retailers or marketplace retailers for referrals on retail sales to purchasers in Kentucky. KY. REV. STAT. ANN. § 139.010(33).
48 KY. REV. STAT. ANN. § 139.480(3).
49 KY. REV. STAT. ANN. § 139.480(10).
50 KY. REV. STAT. ANN. § 139.010(19).
51 “Directly used in the manufacturing or industrial processing process” means the process within a plant facility that commences with the movement of raw materials from storage into a continuous, unbroken, integrated process and ends when the finished product is packaged and ready for sale. KY. REV. STAT. ANN. § 139.010(12).
52 “Industrial processing” includes (i) refining; (ii) extraction of minerals, ores, coal, clay, stone, petroleum or natural gas; (iii) mining, quarrying, fabricating, and industrial assembling; (iv) the processing and packaging of raw materials, in-process materials, and finished products; and (v) the processing and packaging of farm and dairy products for sale. KY. REV. STAT. ANN. § 139.010(17).
53 KY. REV. STAT. ANN. § 139.200(2)(c).
54 KY. REV. STAT. ANN. § 139.010(1).
55 KY. REV. STAT. ANN. § 139.200(2)(a).
56 Former KY. REV. STAT. ANN. § 139.480(12).
57 H.B. 487, § 149.
58 H.B. 487, § 95 (new provision, KY. REV. STAT. ANN. ch. 154). The report must be submitted by July 1, 2019, and by each subsequent July 1.
59 KY. REV. STAT. ANN. §§ 154.20-236; 154.20-255.
60 South Dakota v. Wayfair, Inc., No. 17-494 (U.S. 2018). See GT SALT Alert: Supreme Court Considers Landmark Wayfair Case.




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