Read "Applying False Claims Acts in State Taxation," reprinted with permission from the May 7, 2012 issue of State Tax Notes.

Read Sutherland SALT's Legal Alert, "Transfer Pricing Assessment Invalidated by DC ALJ" for more details.

Sutherland SALT's Marc Simonetti poses with his catch of the day, an 8-foot-5-inch, 250-pound hammerhead shark.

Uniloy Milacron USA, Inc. (Uniloy), a manufacturer of molds used in blow-molding machines, entered into a distributor agreement with an affiliated corporation to purchase for resale and market Uniloy’s products. The affiliate did not obtain physical possession of the products. Instead, Uniloy packaged, loaded, and shipped the products directly to the affiliate’s customers.

The Michigan Department of Treasury (Department) argued that all of Uniloy’s sales should be sourced to Michigan for purposes of the Single Business Tax (SBT) sales apportionment factor because Uniloy’s products were “delivered” to the affiliate in Michigan before ultimately being sold/shipped to the affiliate’s customers.

Under Michigan’s repealed SBT regime, a sale of tangible personal property is sourced to Michigan if the product is shipped or delivered to a customer within Michigan. The Court disagreed with the Department and reasoned that just because Uniloy sold its products to its affiliate does not necessarily mean that Uniloy “delivered” the products to the affiliate corporation. Rather, the products were packaged by Uniloy and shipped by Uniloy directly to the affiliate’s customers, the vast majority of whom were located outside of Michigan, and there was no documentary evidence to demonstrate otherwise. The terms “shipped” and “delivered” were not defined for SBT purposes, but the Court had no trouble concluding that they referred to the location to which the products were “carried and turned over,” “handed over,” “surrendered,” “sent away,” or “transported” to a customer within Michigan.

Other state courts have taken a view contrary to that of the Michigan Court of Appeals with regard to the sourcing of “dock sales” receipts (sourcing sales of tangible personal property). For example, in Stryker Corp. v. Director, Division of Taxation, 168 N.J. 138 (June 14, 2001), the New Jersey Supreme Court held that a Michigan-based corporation’s receipts from sales of manufactured products at its New Jersey facility, sold to its wholly owned New Jersey subsidiary at the same facility, and drop-shipped directly to the subsidiary’s out-of-state customers constituted New Jersey receipts includable in the New Jersey sales factor numerator because the receipts were earned in New Jersey.

Sutherland SALT's Eric Tresh pauses for a photo op with Mary Vickers and Stephenie Schwarzmann from Cox Enterprises and Jill Wood from Home Depot at the 24th Annual Hearts with Hope Gala benefiting the Partnership Against Domestic Violence.

The Iowa Department of Revenue (IDOR) looked to the state’s statutory authority and acknowledged that the taxability of “cloud computing has not been expressly addressed by the Iowa Code.” Nonetheless, the IDOR determined that the sale of hosted software is not taxable because the Iowa Code provides that a “taxable ‘sale’ of tangible personal property does not occur if the substance of the transaction is delivered to the purchaser digitally, electronically, or by utilizing cable, radio waves, microwaves, satellites, or fiber optics.” I.C. § 423.3(67). Likewise, the IDOR considered web-based training to be nontaxable because “software training” is not an enumerated service under the Iowa Code.

The Kansas Department of Revenue (KDOR) made a distinction between the treatment of such an arrangement depending on the specific contractual terms agreed upon, for purposes of determining the proper sales and use tax treatment. While the KDOR maintains that the charges for using “someone else’s software” on a remote computer are not subject to tax (commonly referred to as Software as a Service), it has advised that when an in-state or out-of-state business leases space on a remote server located in Kansas and buys prewritten software that is installed on that server, both the software purchase and the charge for leasing space on the Kansas server (commonly referred to as Infrastructure as a Service) are subject to Kansas tax.

The KDOR described a “hosted software” transaction as one that “obligates a service subscriber to pay a fee to gain Internet access to, and the use of, the service provider’s software and servers and to the data the subscriber inputs and stores on those servers.” The ruling further provides that charges for hosted software services are not taxable “because the software that is installed on a remote server isn’t delivered to subscribers or installed on their computers” and “[t]he service provider has title and possession of the software.” But the KDOR further qualifies this position by stating that “[s]uch software is not taxable as a sale of prewritten software so long as the software is not billed to subscriber as a separate line item charge.”

Also important to note is the sourcing implication of this guidance: Kansas considers the location of the server, rather than the customer/user, to be the proper taxing jurisdiction for hosted software applications. Since the majority of states that tax cloud-based software services source the sale to the end user location, the KDOR effort to tax at the server location could lead to multiple taxation.

Under Massachusetts Law, a “manufacturing corporation” that has income from business activity that is taxable both in Massachusetts and outside the state is required to apportion its net income to Massachusetts using a single sales factor. There are two requirements to be a “manufacturing corporation.” First, the corporation must be engaged in manufacturing during the year, and second, the manufacturing activity must be substantial. A corporation’s manufacturing activities are substantial if the corporation meets one of the five statutorily enumerated tests. The first test is that the corporation derives 25% or more of its receipts for the taxable year from the sale of manufactured goods that it manufactures.

The taxpayer was engaged in the development, manufacture, and distribution of lubricants and cleaning products. Approximately 70% of the taxpayer’s revenue was attributable to the manufacture and sale of a specified lubricant. Although the taxpayer’s internal production did not generate 25% of its receipts, the Department concluded that the taxpayer met the statutory test.

The Department explained that when products are produced through an outsourcing arrangement, “the issue is whether the Company’s activities are essential and integral to the overall manufacturing process such that its activities constitute manufacturing.” The Department determined that the taxpayer was integrally involved in the creation of the product from start to finish. The taxpayer invented the product formula, manufacturing processes, and testing procedures. The Department also found that the taxpayer controlled the overall manufacturing process. As a result, the Department ruled that the Company was engaged in manufacturing that was substantial and, therefore, was permitted to use a single sales factor to apportion its net taxable income to Massachusetts.

Companies filing in Massachusetts that are considering outsourcing their manufacturing activities, and those that have already done so, should evaluate whether their own activities are “essential and integral” to the overall manufacturing of their product such that they could be permitted or required to source their receipts using a single sales factor.

Last year, Governor Brewer vetoed similar market sourcing legislation because it was viewed as conflicting with the temporary voter-approved increase to Arizona’s sales tax rate.  This time around, legislators cured the conflict between tax hikes and cuts by delaying the effective date of the marketing sourcing election until 2014, after the sales tax increase expires, and by adopting a unique phase-in that will delay full market sourcing for qualified taxpayers until 2017. 

The first year of the phase-in will allow multistate service providers to include 85% of market sourced sales along with 15% of costs-of-performance sourced sales in the numerator.  Similar to when states phase-in a single sales factor formula by still accounting for the property and payroll factors at a reduced weight, this phase-in requires taxpayers to source sales using both sourcing methods and to include the respective percentage of those sales in the numerator of the sales factor during the phase-in period.

Under the new market sourcing rules, receipts are included in the numerator of a taxpayer’s sales factor based on where a purchaser receives the benefit of the service.  However, there is no elaboration on how to determine where the benefit of a service is received.  This lack of clarity may present difficulties for taxpayers in trying to implement the new sourcing rules.  However, because of the delayed effective date, the Arizona Department of Revenue will have an opportunity to issue regulations or guidance to help taxpayers interpret the provisions.

Read "Demystifying Accountant-Client Privileges in State Tax Litigation," reprinted with permission from the April 2, 2012 issue of State Tax Notes.

To calculate the SBT tax base (now two tax regimes ago), “royalties” were subtracted from federal taxable income.  Pfizer calculated its royalty income based on the “profit split methodology” under  Internal Revenue Code § 482 regulations, which treat 50% of a subsidiary’s profits as “intangible property income” to the parent. Pfizer subtracted these “royalty” amounts to compute its SBT tax base.

The Department disallowed the royalty deduction, claiming that “intangible property income” was not synonymous with the term “royalties” as defined by the Michigan Supreme Court in Mobil Oil Corp. v. Dep’t of Treas., 373 N.W.2d 730, 736 (1985): “payment received by the transferor in patent . . . transactions[.]”  The Department claimed that the definition of “royalties” in Mobil is narrower than the term “intangible property income,” as used in IRC § 936(h)(3)(B), and thus items that may be included in “intangible property income” may not necessarily be considered “royalties” for SBT purposes. 

However, the court dismissed the Department’s theoretical arguments because Pfizer met its burden of proof through uncontroverted affidavits that all of the relevant income related to the subsidiary’s use of Pfizer’s patents. The court placed great weight on the Department’s failure to produce any evidence that Pfizer’s royalty payments were for anything other than the use of its patents.