TWIST - This Week in State Tax

Welcome to TWIST for the week of March 21th, featuring Sarah McGahan from the Washington National Tax State and Local Tax practice.

First up today, the Ohio Supreme Court recently addressed whether a taxpayer’s purchases of certain computer services were exempt from sales and use tax as nontaxable accounting or customized software services.  The court concluded that the services were not professional or personal services. They were not performed by individuals and the service provider did not have the legal authority to provide professional accounting services. The case was remanded back to the Board to apply the “true object” test to determine whether taxpayer’s true object was to purchase taxable automatic data processing and electronic information services or to obtain software customization.

In New York, the Tax Appeals Tribunal concluded that a taxpayer purchased one-half of a Picasso painting for resale when it was purchased and leased to the individual who owned the other half of the painting. The Administrative Law Judge for the New York Division of Tax Appeals had previously determined that although there was a valid lease in place, the taxpayer was not entitled to the resale exemption because its acquisition of the painting served two purposes: adding to the taxpayer’s art collection and potentially being available to lease to others. The Tribunal disagreed. In its view, the taxpayer had established that at the time of the purchase, its only intent was to resell or lease the painting. Importantly, the lease was entered into on the day the taxpayer acquired its half interest in the painting and had been extended multiple times.

Lastly, the California Office of Tax Appeals (OTA) recently addressed whether a taxpayer’s installment gain should be accelerated. Under California law, future installment payments are accelerated when the entire income from a sale has not been reported before dissolution or cessation of a business. The company argued that although the S corporation dissolved, the business continued California operations as a C corporation and thus, should not be subject to accelerated reporting. Agreeing with the Franchise Tax Board (FTB), the OTA noted that, when an election under IRC section 338(h)(10) is made, the corporation is treated as if it sold its assets, liquidated, and ceased to exist.  As a result, the company also ceased to exist for purposes of the accelerated future payment requirement under California law. 

Thank you for listening to TWIST and stay well!

California: Contingent Installment Sale Gain Accelerated

Download PDF

Recently, the California Office of Tax Appeals (OTA) addressed whether a taxpayer’s installment gain should be accelerated. In 2013, an S corporation (Company) and its shareholders entered into a transaction to sell the stock of Company and make an election under IRC section 338(h)(10) to treat the transaction as a sale of Company’s assets.  The agreement provided for Company’s shareholders to receive an initial fixed payment, along with deferred payments contingent on earnings in the years following the exchange, totaling up to $50M. On its 2013 California tax return, which it indicated was its final California return, Company included the gain in taxable income, computed without taking into account any of the contingent amounts that could be received in subsequent years. The company included over $100 million attributable to the fixed payment in the “everywhere” sales factor and assigned $22,395 to California. 

On appeal, the California Franchise Tax Board (FTB) asserted that gain attributable to the future installment payments should have been accelerated and included in taxable income in the year of the sale. Under California law, future installment payments are accelerated when the entire income from a sale has not been reported before dissolution or cessation of a business. The company argued that although the S corporation dissolved, the business continued California operations as a C corporation and thus, should not be subject to accelerated reporting. Agreeing with the FTB, the OTA noted that, when an election under IRC section 338(h)(10) is made, the corporation is treated as if it sold its assets, liquidated, and ceased to exist.  As a result, Company also ceased to exist for purposes of the accelerated future payment requirement under California law. “While a taxpayer is free to organize its affairs as it chooses, nevertheless, once having done so, it must accept the tax consequences of its choice, whether contemplated or not, and may not enjoy the benefit of some other route it might have chosen to follow but did not.”

The OTA next concluded that the amount to be included was equal to the fair market value of the contingent fees contract less the basis of the installment obligation and that the taxpayer had the burden of proving that the fair market value was less than the face amount of the obligation.  Finding that the taxpayer failed to present evidence to establish the fair market value of the contingent obligation, the OTA accepted the FTB’s determination of the value of the obligation, which was based on amounts subsequently paid. The OTA finally concluded that the portion of the gain from the deemed asset sale related to intangibles such as goodwill was business income that was excluded from the sales factor as a receipt arising from a substantial and occasional sale. Please contact Candace Axline or Scot Grierson with questions on Matter of Appeal of Amarr Co.

New York: Painting Leased to Co- owner was Purchased for Resale

Download PDF

The New York Tax Appeals Tribunal recently reversed a previous determination of the New York Division of Tax Appeals. In doing so, the Tribunal concluded that a taxpayer’s purchase of a one-half interest in a Picasso painting was exempt from sales tax as a purchase for resale. The taxpayer, an LLC whose two members were family trusts, collected artwork and occasionally leased pieces of art to others. The taxpayer purchased a one-half interest in Picasso’s “Femme a la Robe Verte;” the other half was purchased by the father of the two sons who were named in the family trusts. Sales tax was paid on the purchase by both parties. The trust subsequently leased the painting to the father for a year-long period; the lease was extended twice. The lease payments included sales tax, which was remitted to the Department of Taxation and Finance. The taxpayer (the LLC) subsequently filed a claim for refund of the sales tax paid on its half of the painting on the basis that the half of the painting was purchased for resale. After the claim was denied, the taxpayer appealed to the Division of Tax Appeals.  

Under New York law, failure to provide a resale certificate does not automatically bar a taxpayer from claiming the resale exemption, but the taxpayer must demonstrate that the sole purpose at the time of the purchase was for resale. The Administrative Law Judge (ALJ) for the New York Division of Tax Appeals concluded that although there was a valid lease in place, the taxpayer was not entitled to the resale exemption because its acquisition of the painting served two purposes: adding to the taxpayer’s art collection and potentially being available to lease to others.  The Tribunal disagreed. In its view, the taxpayer had established that at the time of the purchase, its only intent was to resell or lease the painting. Importantly, the lease was entered into on the day the taxpayer acquired its half interest in the painting and the lease had been in place at least three years after the purchase. Although the taxpayer might, at some point, divert a leased piece of art into its own collection, the Tribunal noted that possibility was not evidence of the taxpayer’s intent at the time of purchase. Furthermore, should such possibility come to fruition, a remedy was already provided under New York tax law: the taxpayer would be required to pay use tax. Noting that this case indicates that a resale exclusion is properly allowed when there is evidence of interest to resell and no evidence of taxable use, the Tribunal concluded that the taxpayer was entitled to a refund of the sales tax paid on the purchase of the half interest in the painting. For more information on In re Matter of Objet LLC please contact Judy Cheng at (212) 872-3530.

Ohio: Bank’s Refund on Purchases of Computerized Services Denied

Download PDF

The Ohio Supreme Court recently held that sales tax applies to transactions that involve automatic data processing, electronic information services, or computer services when the true object of the transaction is receiving such services. In the years at issue, the taxpayer –a bank– purchased computerized account-processing services that entailed collecting electronic data from the taxpayer and the taxpayer’s customers, processing and making the data available to the taxpayer, and maintaining the taxpayer’s general ledger. The taxpayer filed a refund claim for sales tax paid on these transactions.  The Department rejected the taxpayer’s claim, which was based on its position that it purchased nontaxable accounting services, or alternatively, nontaxable customized software services. On appeal to the Board of Tax Appeals (BTA), the BTA treated the matter as the taxpayer making a claim for a tax exemption and found in favor of the Department because in “doubtful” cases, the exemption must be denied. The taxpayer subsequently appealed to the Ohio Supreme Court.

The Ohio Supreme Court noted at the outset that the BTA erred when it viewed the service of software customization as an exemption from the tax imposed on the services of automatic data processing (ADP) and electronic information services (EIS). In the court’s view, ADP and EIS were distinct services that were separate and apart from personal and professional services, which were often performed by individuals. Furthermore, when nontaxable services and ADP or EIS were provided together in a single mixed transaction, the “true-object” test applied to determine whether the transaction was taxable. In this case, the taxpayer bank purchased both ADP and EIS from the service provider and needed the provider’s software customized for its own use. In the court’s view, the BTA should have determined the true object of the transactions by examining whether specific charges related to transactions in which obtaining software customization was the true object of the transaction as opposed to receiving ADP and/or EIS. The court concluded that the case should be remanded to the BTA for it to apply the true object test to determine whether the taxpayer was entitled to a refund. Next, the court affirmed the BTA’s conclusion that the taxpayer was not purchasing personal or professional accounting services because the services at issue were solely performed by computer software and did not involve accounting-related services performed by individuals. Furthermore, the service provider did not have legal authority to provide professional accounting services, which requires licensure. For questions on Cincinnati Federal Savings & Loan Co. please contact Dave Perry.