Welcome to TWIST for the week of August 8, 2022. This is Sarah McGahan from the KPMG Washington National Tax State and local tax practice.
First up today, in corporate income tax news, the Alaska Supreme Court concluded that a lower court did not err when it upheld the constitutionality of a statute requiring certain foreign corporations doing business or incorporated in no or low tax jurisdictions to be included in the Alaska combined report. However, the Alaska Supreme Court determined that the lower court erred when it ruled that the statute requiring the inclusion of entities doing business or incorporated in low or no tax jurisdictions was void for vagueness.
In another corporate income tax development, the Alabama Tax Tribunal held that a taxpayer was not required to add back interest paid to an Irish affiliate because it qualified for the subject to tax exception to the state’s related party addback rules. The Department had tried to argue that because the foreign entity receiving the income was able to reduce its tax base by deducting interest paid to an affiliate, the subject to tax exception should not apply. However, the Tribunal concluded that interest income that the foreign affiliate received from the taxpayer was considered subject to a tax even if no actual taxes were paid on such item of income in the taxing jurisdiction by reason of deductions or otherwise.
Finally, the Idaho Tax Commission has issued draft regulations addressing the state’s revised sourcing laws. The draft regulations largely incorporate the MTC’s model rules for sourcing service and intangible receipts, but also provide guidance on the annual election to use an evenly weighted three factor formula that is available to electronical corporations, telephone corporations, communications companies, and taxpayers subject to a special industry apportionment rule under Idaho Rule 580.
On the sales and use tax side, the Colorado Department of Revenue has issued additional FAQs on the $0.27 retail delivery fee that retailers were required to begin collecting the fee on July 1, 2022. The fee applies to every retail sale of taxable tangible personal property that is delivered by a motor vehicle to a purchaser in Colorado. The FAQs confirm that the fee is not included in the tax base at the state level; however, the FAQs note that the fee may be subject to sales tax in self-collecting home rule jurisdictions. At least one city, Denver, is taking steps to revise its municipal code to exclude the retail delivery fee (and certain bag fees) from the city tax base.
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On August 5, 2022, the Alaska Supreme Court addressed a taxpayer’s challenge to the constitutionality of a law requiring certain tax haven entities to be included in the combined group. Generally, Alaska corporate taxpayers are required to file a water’s edge combined report. However, affiliated foreign corporations incorporated in or doing business in countries that do not impose an income tax or that impose an income tax with a rate lower than 90 percent of the U.S. income tax rate are required to be included in the Alaska combined group. The taxpayer at issue filed returns for the 2007 through 2010 tax years but excluded certain foreign unitary affiliates from its combined report. On audit, the Department included the foreign entities in the group, which resulted in a deficiency assessment. After a trial court upheld the constitutionality of the inclusion statute but ruled in the taxpayer’s favor that the statute was void for vagueness, both parties appealed.
The state supreme court first addressed the superior court’s conclusion that the statute requiring inclusion of low tax jurisdiction entities was void for vagueness. The statute mandated that entities incorporated or engaged in business in low tax jurisdictions be included in the combined group if two conditions were met. There was, however, no conjunction between the two subparts setting forth the conditions, making it not clear as to whether the parts should be read conjunctively with an implied “and” between them, or disjunctively, with an implied “or” between them. The superior court had noted that a disjunctive “or” made the most sense but was “not the only logical reading.” After concluding that a civil statute is subject to a more lenient vagueness standard, the court determined that the statute could be interpreted through the adjudication process and therefore the missing conjunction did not render the statute void for vagueness. Thus, on this point, the state supreme court overturned the superior court.
The taxpayer next claimed that the superior court erred when it assessed the potential discriminatory effect of the statute in determining whether it discriminated against foreign commerce. In the taxpayer’s view, the statute was facially discriminatory because of its specific geographic references, and therefore it should have been struck down without further inquiry. The state supreme court did not agree that the lower court erred when it evaluated the discriminatory effect and the resulting burdens in concluding the statute was not facially discriminatory. In its analysis, the superior court found, and the supreme court concurred, that the only effect of the statute was to cause a taxpayer to file an additional tax return, which is not itself a significant burden constituting discrimination against foreign commerce. Any effect on a company’s tax liability resulting from the return depended on applying the apportionment formula. After determining that the statute’s ”effects on interstate commerce are only incidental,” the supreme court next upheld the superior court conclusion that the taxpayer did not establish the statute violated the Commerce Clause under the Pike balancing test. Please contact Jon Edmonds with questions on Department of Revenue v. Nabors.
The Alabama Tax Tribunal recently addressed whether a taxpayer qualified for the subject to tax exception to the state’s related party addback rules. Under Alabama law, otherwise deductible intangible and interest expenses paid to related parties are required to be added back unless one of several specified exceptions applies. One exception is if the recipient is subject to a tax based on or measured by the related member's net income by a foreign nation that has in force an income tax treaty with the United States. “Subject to a tax based on or measured by the related member's net income” means that the payment is reported and included in income for purposes of a tax on net income, and not offset or eliminated in a combined or consolidated return which includes the payor. An item of income is considered subject to a tax even if no actual taxes are paid on such item in the taxing jurisdiction by reason of deductions or otherwise.
The taxpayer at issue paid interest to a related member in Ireland. The Ireland related member reported the interest income on its 2012 Ireland return, but on that same return deducted interest paid to a Luxembourg affiliate. This essentially netted out the interest income. Before the Tribunal, the Department asserted that the interest expense paid to the Ireland entity was not subject to a tax measured by the entity’s net income due to the deduction. The Tribunal, however, determined that the taxpayer’s situation fit the express wording of the subject to tax exception. Specifically, the interest income that the Irish affiliate received from the taxpayer was considered subject to a tax even if no actual taxes were paid on such item of income in the taxing jurisdiction by reason of deductions or otherwise. Please contact Kati Amajuwon with questions on Pfizer, Inc. v. State of Alabama.
Earlier this year, Idaho House Bill 563 made significant changes to the state income tax apportionment rules effective January 1, 2022. Generally, the bill adopted single-sales factor apportionment and market-based sourcing rules for service and intangible receipts. However, there are some notable exceptions in the revised law. Certain types of corporations—electrical corporations, telephone and communications companies, and companies using special industry apportionment—are allowed to elect to continue using a three-factor formula. A “communications company,” as defined, may also elect to continue using the income-producing activity test to source sales other than sales of tangible personal property.
Recently, the Idaho Tax Commission issued draft regulations largely incorporating the MTC model rules for sourcing service and intangible receipts. However, the draft regulations also provide guidance on the annual election to use an evenly weighted three factor formula that is available to electrical corporations, telephone corporations, communications companies, and taxpayers subject to a special industry apportionment rule under Idaho Rule 580. The draft regulations confirm that the three-factor election is to be made on an original return and may not be changed after the return has been filed absent permission from the Tax Commission. Further, the election applies at the entity level and not to the entire combined group. If any MTC special industry regulation adopted by Idaho includes a property and payroll factor, by default, those provisions will be ignored, and the taxpayer will use only the sales factor provisions to calculate an apportionment percentage. However, a taxpayer subject to special industry regulations may elect to use the property, payroll, and sales factors, if the special industry regulation applicable to that taxpayer provides for a property and/or payroll factor. The draft regulations also update the state’s adoption of the MTC’s financial institution apportionment rule to the rule as adopted by the MTC as of July 29, 2015. Currently, Idaho adopts the MTC rule as in effect on November 17, 1994. Please stay tuned to TWIST for additional apportionment updates.
Legislation enacted in 2021 established new sources of funding for Colorado’s transportation system, including the imposition of a retail delivery fee that is made up of various components. From July 2022 to June 2023, the total retail delivery fee is $0.27 per delivery, and retailers were required to begin collecting the fee on July 1, 2022. The fee applies to every retail sale of taxable tangible personal property that is delivered by a motor vehicle to a purchaser in Colorado. The Colorado Department of Revenue recently clarified in FAQs that USPS deliveries by motor vehicle will be subject to the fee. The FAQs also addressed whether the delivery fee is included in the underlying sales tax base. Per the FAQs, it is not included in the tax base at the state level; however, the FAQs further note that the fee may be subject to sales tax in self-collecting home rule jurisdictions. As such, the Department recommended that retailers contact the local jurisdiction directly or utilize the Colorado Sales Tax Lookup and select the “retail delivery fee” from the searchable product and services list. The Colorado Municipal League has drafted model legislation for home rule cities to adopt to exempt the retail delivery fee from the local sales tax base and at least one City, Denver, is taking steps to do so. The Denver City Council Finance and Governance Committee recently approved an amendment to the City’s municipal code that would exempt the retail delivery fee from the city sales tax, as well as the carryout and disposable bag fees. The proposal must next be approved by the City Council as a whole. Please Stay tuned to TWIST for additional updates on the Colorado retail delivery fee.