TWIST - This Week in State Tax

Welcome to TWIST for the week of August 1st ,2022. This is Sarah McGahan from the KPMG Washington National Tax State and local tax practice.

In the Texas Register published on July 29, 2022, the Comptroller of Public Accounts adopted amendments the rule that addresses the franchise tax research and development activities tax credit. In 2021, the Comptroller finalized extensive amendments to the rule that in many instances limited a taxpayer’s ability to qualify for credits. The most recent amendments are more taxpayer favorable. One of the key changes is that the revised rule addresses the disconnect between federal and state law that exists because Texas defines the Internal Revenue Code for purposes of the research and development activities tax credit as the Code in effect on December 31, 2011.   Under the revised rule, a federal regulation adopted after December 31, 2011 is applicable if a taxable entity could have applied the regulation to the 2011 tax year.  The revised rule also addresses credit carryforwards when the membership of a combined group changes.

In other news, the Michigan Court of Appeals recently held that sales of container-recycling machines and repair parts did not qualify for a sales and use tax exemption that applies to sales of tangible personal property that are used to perform an industrial processing activity. The Court concluded that the container-recycling machines did not perform any specifically enumerated industrial processing activity.

Thank you for listening to TWIST and stay well!

Texas: Comptroller Adopts Changes to R&D Regulations

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In the July 29, 2022 version of the Texas Register, the Comptroller of Public Accounts adopted amendments to 34 TAC §3.599, which addresses the franchise tax research and development activities tax credit. Under Texas law, taxpayers may claim either a sales tax exemption or a franchise tax credit for qualifying research expenses that occur in Texas.  In 2021, the Comptroller finalized extensive amendments to 34 TAC §3.599 that in many instances limited a taxpayer’s ability to qualify for credits. The most recent amendments are more taxpayer-favorable. One of the key changes is that the revised rule addresses the disconnect between federal and state law that exists because Texas defines the Internal Revenue Code for purposes of the research and development activities tax credit as the Code in effect on December 31, 2011.   Before the amendments, federal regulations adopted after December 31, 2011 were included in the definition of Internal Revenue Code only to the extent that the federal regulation was made to apply to the 2011 federal tax year. Under the revised rule, a federal regulation adopted after December 31, 2011 is applicable if a taxable entity could have applied the regulation to the 2011 tax year. In other words, regulations that were not finalized in 2011 may be applied if Treasury allowed the taxpayer to apply the regulation to the 2011 tax year. Newly added examples of regulations that are now included in the definition of Internal Revenue Code are Treasury regulations §§ 1.174-2 and 1.41-4, except for paragraph (c)(6) addressing internal use software. Taxable entities may elect to follow two different versions of paragraph (c)(6).

The amended rule also addresses credit carryforwards when the membership of a combined group changes. Under the prior version of 34 TAC §3.599, generally, if there was a change in membership of the combined group, the resulting combined group was not entitled to a credit carryforward. However, there were certain instances, such as when two members merge, that were not considered changes in membership of a combined group.

Under the amended rule, the credit carryforward attributable to a member of a combined group for each prior report year is determined by multiplying the total credit carryforward available for that report year by a fraction, the numerator of which is the qualified research expenses paid or incurred by the member during that report year, and the denominator of which is the total qualified research expenses paid or incurred by the combined group during that report year. When the membership of a combined group changes, the credit carryforward will be determined under the regulation as follows.  If a combined group loses a member, the credit carryforward will be attributed to each member of the combined group that was included on the report for the report year to which the carryforward relates. Each member of the combined group that has a carryforward attributed to it, including the member that leaves the combined group, may continue to use that carryforward on its future franchise tax reports. If a taxable entity that was not part of a combined group when it created a credit carryforward later joins a combined group, any credit carryforward it had previously established may be claimed on the combined group's future franchise tax reports. If a taxable entity, including a member of a combined group, is a non-surviving entity in a merger transaction, any credit carryforward established by the non-surviving entity may be claimed on the surviving entity's future franchise tax reports. Unless the above statement applies, if a taxable entity, including a member of a combined group, is terminated, dissolved, or otherwise loses its status as a legal entity, the credit carryforward attributable to that taxable entity may not be claimed on any future franchise tax report. Generally, a combined group may only use a credit carryforward attributable to a member under these new provisions if that member was part of the combined group on the last day of the accounting period on which that report is based.

While the effective date of the revised rule is August 4, 2022, the changes are expected to apply retroactively, as well as prospectively. Please contact Jeff Benson, (214) 840-6911 or Karey Barton, (512) 501-5324.

Michigan: Container-Recycling Machines Did Not Perform Industrial Processing

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The Michigan Court of Appeals recently addressed whether sales of container-recycling machines and repair parts qualified for a sales and use tax exemption for industrial processing. The case at issue had a complex procedural history that resulted in the consolidation of three different appeals. The outcome of the case hinged on whether the container-recycling machines performed an industrial processing activity. The taxpayer sold and leased container-recycling machines that accepted and sorted aluminum cans, plastic bottles, and glass bottles, which were then either compacted or stored before being sold to manufacturers for remanufacture into other products. The taxpayer argued that the machines at issue performed multiple industrial processing activities listed in the exemption statute including testing, remanufacturing, recycling for sale at retail or reuse, production material handling, and storage of in-process materials.

Under Michigan law, a sales and use tax exemption applies to sales of tangible personal property that are used to perform an industrial processing activity for or on behalf of an industrial processor. The statute includes a non-exhaustive list of the activities that are considered “industrial processing” including “inspection, qualify control, or testing, to determine whether particular units of materials or products or processes conform to specified parameters at any time before materials or products first come to rest in finished goods inventory storage.” The court determined that while the machines clearly assessed various qualities of the containers, which could be considered “testing,” the testing was not of “materials or products” that would ultimately come to rest in finished goods inventory. The containers, the court observed, were more akin to raw materials, as opposed to finished goods and therefore were not “materials or products” as intended by the statute.

The court further determined that neither did the machine’s activities not qualify as remanufacturing, recycling of used materials for ultimate sales at retail or reuse, production material handling, or storage of in-process materials. In an underlying appeal, the Michigan Supreme Court established that the machines at issue simply facilitate the collection of raw materials—an inherently passive activity—that would not fit the meaning of manufacturing and by extension remanufacturing. For similar reasons, the court at hand determined that the distinction between “raw materials” and “materials” means that the machines did not perform the downstream activities of production material handling or storage of in-process materials. Additionally, the court reasoned that because the sorted containers were subsequently destroyed or used as raw materials for other products as opposed to being sold or reused, such activities would not be considered recycling of used materials for ultimate sale at retail or reuse.

The court concluded that the sale of the machines and repair parts did not qualify for the exemption because they did not perform a specifically enumerated “industrial processing” activity. Please contact Ryan Hohenthaner with questions on TOMRA of North America Inc. v. Treasury.