TWIST - This Week in State Tax

Welcome to TWIST for the week of January 24th, featuring Sarah McGahan from the Washington National Tax State and Local Tax practice.

First up today is a corporate franchise tax development from North Carolina. Recently, the North Carolina Office of Administrative Hearings addressed the constitutionality of a franchise tax statute that allowed a deduction from the corporate franchise tax base only for receivables owed to the taxpayer by related corporations doing business in the state. The OAH first determined that it had the authority to decide the taxpayer’s as-applied constitutional challenge and that the taxpayer could proceed with a claim that the statute was unconstitutional as applied to it without having to first establish that the statute was capable of constitutional applications. Next, the OAH noted that the statute at issue denied the taxpayer a deduction for certain of its affiliate receivables, while a corporation that loaned only to affiliates that do business in North Carolina was permitted to deduct all its affiliate receivables. The OAH concluded that this “differential treatment” based on the location of the debtor’s business was clearly discriminatory.

In Connecticut, the Department of Revenue Services ruled that NOLs generated in years when corporations filed a unitary combined return remained available to the group after two of the unitary group members merged into a third. In the Department’s view, by allowing the surviving entity to utilize the NOLs allocated the merged corporations or to share such NOLs with the other corporate member, the income against which the NOLs will be applied will be generated by substantially the same businesses that incurred the losses.

In sales and use tax news, the Michigan Court of Appeals held that a taxpayer was making retail sales and was required to pay sales and use tax on its delivery charges. In reaching this conclusion, the court rejected various arguments made by the taxpayer that it was not making retail sales of tangible personal property, including that it was providing a delivery service or was acting as a purchasing agent for its customers.

In other sales tax news, the Virginia Department of Taxation ruled that an artist that painted a mural for a subway station was selling tangible personal property because the mural was painted on canvasses before being installed. In the Department’s view, the "true object" of the transaction between the artist and the train station customer was to obtain the canvasses, as the work would be of no value to the customer without the transfer of the canvasses. Therefore, the entire charge for the mural, including the services rendered in creating the art, was subject to Virginia retail sales and use tax.

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Connecticut: Combined Group NOLs Survive Merger

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The Connecticut Department of Revenue Services recently addressed the availability of NOLs following a merger. A Connecticut unitary combined group consisting of four related corporations generated NOLs for two of the tax years at issue.  For the tax year ending in 2020, two of the corporations merged into a third member of the group. Following the merger, the unitary group consisted of the surviving entity and the other corporate group member. The taxpayer requested guidance as to whether the NOLs allocated to the corporations that were merged into the surviving entity remained available to the new combined group.

The Department concluded that when taxable members are allocated a portion of a combined unitary group’s NOLs, and one or more of the taxable members merges with another taxable member of the combined unitary group, those NOLs may continue to be shared and utilized by the surviving taxable members.  Notably, following the mergers, the business activities of the surviving entity were comprised of the collective business activities of the merged corporations. Moreover, the remaining corporations continued to file combined unitary tax returns together. Thus, the business activities subject to combined unitary tax remained the same both before and after the mergers. By allowing the surviving entity to utilize the NOLs allocated the merged corporations or to share such NOLs with the other corporate member, the income against which the NOLs will be applied will be generated by substantially the same businesses which incurred the losses. Please contact Sarah McGahan with questions on Ruling 2022-1.

Michigan: Taxpayer was Making Sales of Aggregate and Owed Tax on Delivery Charges

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The Court of Appeals of Michigan recently affirmed a lower court decision holding that a taxpayer was making retail sales of tangible personal property and was liable for sales tax on its delivery charges. The taxpayer at issue transported aggregate materials, such as sand or gravel, in bulk for customers’ construction projects. When it purchased the materials, the taxpayer provided a resale certificate. Customers were billed one lump-sum for materials, delivery charges, and tax. However, the taxpayer calculated sales tax only on the materials and did not remit tax on the delivery charges. On audit, Treasury determined there was a deficiency related to the delivery charges. The taxpayer protested. After the court of claims ruled in Treasury’s favor, the taxpayer appealed.

Under Michigan law, the sales tax base for "all persons engaged in the business of making sales at retail" includes "delivery charges," so long as such charges are incurred "before the completion of the transfer of ownership of tangible personal property ... from the seller to the purchaser." The taxpayer’s position centered around various arguments that it was not making sales at retail. The taxpayer first asserted it was not making sales at retail but was acting as a “purchasing agent” for its customers. However, the court noted that even in the broadest definition of “agent,” the principal must control the activities of the agent. Here, there was no evidence that the customers had any control over where aggregate was purchased, or the delivery routes used to deliver the materials. Further, the taxpayer’s use of an exemption certificate to purchase the aggregate indicated it considered itself a retailer. The taxpayer next tried to argue because its primary business activity was not making retail sales it was not subject to sales tax on delivery charges. The court firmly rejected this position, noting that the Michigan sales tax law contains no requirement that a person be primarily engaged in the business of retail sales to be subject to tax. Finally, the taxpayer asserted that its primary business was a service (the procurement and delivery of aggregate), and it was not subject to sales tax under the incidental-to-services test of Catalina Marketing Sales Corp v Dep't of Treasury.   In the court’s view, the Catalina Marketing case was inapplicable because the Legislature had expressly mandated that delivery services related to sales of tangible personal property were subject to sales tax. Please contact Dave Perry with questions on Brusky v. Department of Treasury. 

North Carolina: Franchise Tax Deduction for only North Carolina Affiliates was Discriminatory

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Recently, the North Carolina Office of Administrative Hearings (OAH) addressed the constitutionality of statute that allowed a deduction from the corporate franchise tax base only for receivables owed to the taxpayer by related corporations doing business in the state. The North Carolina franchise tax is imposed on C corporations, and liability is computed on a separate entity basis. During the years at issue, the franchise tax was calculated as a percentage of the greater of 1) a corporation’s capital stock base; 2) 55 percent of the assessed value of the corporation’s assets located in North Carolina; and 3) the value of the corporation’s investment in tangible property in North Carolina. The capital stock base is calculated by reference to the taxpayer’s books and records, with certain required adjustments.  Two adjustments were at issue in the dispute. The first adjustment required a taxpayer to add back to the capital stock base amounts owed to affiliate corporations. The other adjustment required a corporation to deduct from the capital stock base amounts owed to it by affiliate corporations to the extent that the receivables were not included in the affiliate debtor’s capital stock base under the first adjustment. For practical purposes, this meant that the addback was required when the debtor affiliate was not doing business in North Carolina and was not subject to franchise tax.  The taxpayer claimed that the second limitation— denying corporations a deduction for affiliate receivables owed by corporations not doing business in North Carolina— constituted discrimination against interstate commerce prohibited by the Commerce Clause of the U.S. Constitution.

The first issue before the OAH was whether it had jurisdiction over the constitutional challenge. The OAH is permitted to consider a constitutional challenge if it is an “as applied” challenge, as opposed to a facial challenge. The Department argued that a taxpayer must first establish that the subject statute is not facially unconstitutional before an as applied challenge may be considered by the OAH. It further argued that the taxpayer had not established, or even or asserted that the statute was facially constitutional. Reviewing prior North Carolina cases, the OAH concluded that the taxpayer could proceed with a claim that the statute was unconstitutional as applied to it without first having to establish that the statute was capable of constitutional applications. Next turning to the taxpayer’s claim that the statute was discriminatory, the OAH noted that the statute at issue denied the taxpayer a deduction for certain of its affiliate receivables, while a corporation that loaned only to affiliates that do business in North Carolina was permitted to deduct all its affiliate receivables. The OAH concluded that this “differential treatment” based on the location of the debtor’s business (in-state vs. out-of-state) was clearly discrimination. The fact that a debtor was not subject to North Carolina’s franchise tax, the OAH noted, was no reason to deny a taxpayer a deduction that applied to all corporations that lend to North Carolina affiliates. Please contact Nikki Emanuel-Jarrell with questions on Philip Morris USA, Inc. v N.C. Department of Revenue.

Virginia: Mural Installed in Subway was Subject to Sales Tax

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The Virginia Department of Taxation recently addressed whether a mural painted by an artist (the taxpayer) for a subway station was subject to sales and use tax. The mural at issue was painted on three separate canvasses before it was installed into the subframe of the subway station. The issue before the Department was whether the artist was selling tangible personal property or providing a service. In a transaction involving both the sale of property and the provision of a service, the Commonwealth applies the true object test. If the true object of a transaction is to secure a service and the tangible personal property which is transferred to the customer is not critical to the transaction, then the transaction is an exempt service. However, if the object of the transaction is to secure the property produced by the service, then the entire charge, including the charge for any services provided, is taxable. In the Department’s view, the "true object" of the transaction between the artist and the train station customer was to obtain the canvasses.  The mural work would be of no value to the customer without the transfer of the canvasses installed in the subframe. Therefore, the entire charge for the mural, including the services rendered in creating the work, were subject to Virginia retail sales and use tax. Please contact Jeremy Jester with questions on Policy Document 21-157.