Welcome to TWIST for the week of April 4th, featuring Sarah McGahan from the Washington National Tax State and Local Tax practice.
First up today, Kentucky House Bill 8 has passed both chambers of the legislature and has been delivered to Governor Beshear. If signed into law, the bill would make significant changes to Kentucky’s tax laws. The most impactful change is likely the gradual, potential reduction—and possible elimination—of the state’s current 5 percent individual income tax rate. Most other tax measures in the bill are designed to raise revenues to help fund the individual income tax cut. House Bill 8 would impose sales tax on 35 new enumerated services effective January 1, 2023 and adopts a new 6 percent excise tax for the privilege of providing a motor vehicle for sharing or for rent, with or without a driver. Another new tax would apply to entities operating electric vehicle charging stations, and electric vehicle owners would be subject to new fees. In corporate tax news, House Bill 8 would advance the Commonwealth’s conformity to the Internal Revenue Code to the Code as in effect on December 31, 2021. Finally, a tax amnesty program would be held from October 1, 2022 through November 29, 2022.
In Arkansas, an ALJ addressed whether a taxpayer had nexus and receipts apportioned to the state for the 2014-2016 tax years under a Multistate Tax Commission audit. The ALJ first determined that the taxpayer had nexus under the “significant economic presence test” first articulated in West Virginia v. MBNA, which Arkansas had adopted. With respect to whether the taxpayer had receipts sourced to the state, the ALJ declined to specifically adopt the Department’s interpretation of the income-producing activity test but agreed that the situation warranted the application of an alternative apportionment method.
Finally, the Oregon Tax Court recently addressed an issue stemming from tax years when receipts were sourced to the state under the income-producing activity test. The issue was whether certain activities performed by payment acquirers were costs that were counted in determining the taxpayer’s costs of performance. Third-party activity was considered income-producing activity if the activity was of the type directly engaged in by the taxpayer in its regular profit-seeking business and the activity was performed “on behalf of” the taxpayer. Although the first criteria was met, the tax court concluded that the payment acquirers were not acting “on behalf” of the taxpayer.
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Recently, an Administrative Law Judge (ALJ) for the Arkansas Department of Finance and Administration Office of Hearings and Appeals addressed whether a taxpayer had nexus and receipts apportioned to the state for the tax years under a Multistate Tax Commission (MTC) audit (2014-2016). The taxpayer, an out of state corporation with no physical presence in Arkansas, asserted it did not have Arkansas nexus because it did not deploy capital/resources in the state during the audit period. The taxpayer also argued that – even if it had nexus – its sales would be sourced outside of Arkansas under the statutory costs of performance methodology.
The ALJ first determined that the taxpayer had nexus under the “significant economic presence test” first articulated in West Virginia v. MBNA, which the Department stated Arkansas had adopted. This test looks at the frequency, quantity, and systematic nature of the entity’s economic contacts with the state. Trivial, infrequent, and inconsequential contacts are de minimis in nature and will not cause taxpayers to meet the substantial economic presence test. The ALJ concluded that the taxpayer’s economic contacts with Arkansas customers were not trivial, infrequent, or inconsequential; therefore, the taxpayer had Arkansas nexus during the audit period. The ALJ next addressed the issue of how the taxpayer’s revenue from sales of digital products should be sourced. The taxpayer asserted that the receipts were not Arkansas receipts because all the activities performed by the taxpayer occurred outside of Arkansas. The Department argued that the revenues should be apportioned to the location where the end consumers accessed and purchased the items sold, or alternatively, that the Department should be allowed to apply an alternative apportionment method to reach this result. The ALJ determined that even if it accepted (but did not approve of) the Department’s proposed interpretation of the costs of performance sourcing statute, the alternative apportionment position was persuasive. The taxpayer had business activity within the state and its revenue was determined by reference to individuals located within the state. The ALJ held that “[a]pportionment of the sales commissions based on the end customers’ locations is a reasonable method” and that Arkansas law “does not require [the Department to use] a perfect methodology.” In the absence of capricious, arbitrary or fraudulent conduct, the ALJ determined that the Department’s apportionment method must be respected. Having found none of these conditions existed, the ALJ sustained the alternative apportionment “even if [it] contradicted the statutory method.” Please contact Jennifer Knickel with questions on this administrative decision.
On March 30, 2022, House Bill 8 was delivered to Kentucky Governor Andy Beshear. If signed into law, the bill would make significant changes to Kentucky’s tax laws. The most significant change is likely the gradual, potential reduction (and possible elimination) of the state’s current 5 percent individual income tax rate. If the Department of Revenue determines that the “reduction” conditions specified in the bill (based on balances in the state treasury and the cost of a rate reduction) exist at the end of the current fiscal year, the rate will drop by 0.5 percent for the tax year beginning on January 1, 2023. A similar exercise would repeat in future years until the tax is fully phased out.
Most other tax measures in the bill are designed to raise revenues to help fund the individual income tax cut. Currently, Kentucky imposes sales and use tax on 17 specifically enumerated services. House Bill 8 would add 35 new services to the list, including but not limited to, marketing, lobbying, website design and development, web hosting services, numerous personal services (e.g., cosmetic surgery, personal training and fitness, body modification), and prewritten computer software access services. These services would become subject to the state’s 6 percent sales (excise) tax on January 1, 2023. House Bill 8 would also impose a new 6 percent excise tax for the privilege of providing a motor vehicle for sharing or for rent, with or without a driver. This tax would be imposed on receipts derived from rentals of vehicles by peer-to-peer car sharing companies, rentals of vehicles by car rental companies, and sales of taxi, limousine, and Transportation Network Company services. Electric vehicles are also addressed in the bill. A new tax (initially set at $.03 per kilowatt hour) would apply to entities operating electric vehicle charging stations, and electric vehicle owners would be subject to new fees. The bill would also expand the types of accommodations subject to state and local transient accommodations tax and confirm that “rent” includes amounts charged by persons facilitating the rental of accommodations. In corporate tax news, House Bill 8 would advance the Commonwealth’s conformity to the Internal Revenue Code to the Code as in effect on December 31, 2021. The updated conformity date would apply for tax years beginning on or after January 1, 2022. Finally, House Bill 8 would authorize a tax amnesty program to be held from October 1, 2022 through November 29, 2022. It is unclear whether Governor Beshear will sign the legislation. Please stay tuned to TWIST for future updates.
Recently, the Oregon Tax Court, Magistrate Division considered whether two payment processing companies acted “on behalf of” a taxpayer so that their services were counted in measuring where the taxpayer’s income producing activities occurred. The taxpayer contracted with several telecommunication companies for payment processing and fraud prevention services. The telecoms offered prepaid wireless services to their customers who were able to purchase of additional time and data increments via credit card, debit card or electronic payment. Purchases for additional time were typically made in “card-not-present” transactions, which are more susceptible to fraud. The taxpayer ‘s business was to assess risk of fraud, approve or reject requests to purchase additional time, and assume liability for all chargebacks due to unauthorized card use. The contracts with the telecoms stipulated that the taxpayer was responsible for payment, irrespective of future chargebacks.
To perform its contractual duties, the taxpayer entered arrangements with two payment acquirers to process the payment transactions. On its 2010 and 2011 tax returns, the taxpayer counted the amounts paid to the payment acquirers in determining where its direct costs of performance occurred. As a result, the taxpayer’s fees earned from its telecom customers were sourced outside of Oregon. On audit, the Department disagreed that the payments to the acquirers were direct costs of the taxpayer. The disallowance increased the taxpayer’s Oregon apportionment factor and taxable income for the tax years in question. The taxpayer appealed the audit adjustment.
Under Oregon law in effect for the tax years at issue, sales other than sales of tangible property were included in the Oregon sales factor if a greater proportion of the income-producing activity was performed in Oregon than in any other state, based on costs of performance. Income-producing activity was defined as activity “directly engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of obtaining gains or profit” and included “transactions and activities performed on behalf of a taxpayer, such as those conducted on its behalf by an independent contractor.” Third-party activity was considered income-producing activity if the following criteria were met: the activity had to be of the kind directly engaged in by the taxpayer in its regular profit-seeking business and the activity was required to be performed “on behalf of” the taxpayer.
The tax court determined that the payment acquirers’ activities met the first criteria. The taxpayer’s income-producing activity included managing the entire credit card transaction for each telecom customer. The court noted that a “taxpayer’s inability to perform a given task alone does not imply that task is not part of its income-producing activity.” However, the tax court found that the payment acquirers’ activities did not meet the second criterion: an independent contractor does not act “on behalf of” a taxpayer if its contract with the taxpayer does not determine the nature of its activity. In the case at bar, the payment acquirers did not change the nature of their activities to suit the taxpayer, and the contracts between the parties were largely boilerplate in nature. Relying heavily on the analysis in AT&T Corp. v. Department of Revenue, the tax court concluded that the payment acquirers did not act “on behalf of” the taxpayer. Please contact Rob Passmore with questions on Vesta Corporation v. Department of Revenue.