TWIST - This Week in State Tax

California: Franchise Fees Included in the Sales Tax Base

In a nonprecedential decision, the California Office of Tax Appeals recently addressed whether initial franchise fees paid under a franchise agreement were subject to sales and use tax. The taxpayer entered into franchise agreements that purportedly gave its franchisees the legal right to operate one of the taxpayer’s ATMs in California and to use the taxpayer’s trademarks.  In exchange for an initial franchise fee, the franchisee also received an ATM and training on the use of the ATMs, which was a mandatory prerequisite to operating the ATMs. The issue before the OTA was whether the entire initial franchise fee was subject to sales tax, or just the portion of the fee related to the transfer of tangible personal property. Under California law, when transactions involve both taxable and nontaxable components, the application of sales tax depends on whether the transaction is a bundled or mixed transaction. The test for whether a transaction is a bundled transaction is whether the tangible personal property is inextricably intertwined in a single transaction with nontaxable intangibles and/or services. The OTA determined that the initial franchise fee was payable in connection with, at a minimum, a bundled transaction for the sale of the ATM and cash cassette, and the provision of the mandatory training service. Applying the true object test, the OTA concluded that a purchaser’s true object of this bundled transaction was the ATM (tangible personal property) and not the provision of the mandatory training. The OTA noted that if the true object was to obtain the training, it would not have to be structured as a mandatory prerequisite to operating one of the taxpayer’s ATMs.  

The OTA next addressed the taxpayer’s argument that a significant element of the franchise agreement was the right to operate an ATM franchise using the taxpayer’s marks. Although the agreement did not specifically allocate any value to the intangibles or specifically state that any intangible rights were provided in consideration for payment of the initial franchise fee, the OTA assumed so for purposes of the analysis.  The OTA noted that California views sales of tangible personal property bundled with intangibles differently than it treats bundles of tangible personal property and services. While the true object test is applied to determine the taxability of a transaction that includes services and tangible personal property, the state’s current position (as expressed in case law) on bundled transactions involving tangible personal property and intangibles is that generally the true object test does not apply. However, at a minimum, tax would apply to a bundled transaction involving tangible personal property and intangibles if it passed either the physically useful test (i.e., the tangible property transferred was physically useful to the purchaser), or the true object test. However, the California Supreme Court has indicated that tax may apply even if the transaction does not meet either of these two tests. The OTA determined that the transfer of the ATM and the right to operate the ATM constituted a bundled transaction for intangibles and tangible personal property. The OTA further found that because the ATM is physically useful, if not essential, to the operation of a trademarked ATM business, the entire initial franchise fee was taxable, without deduction on account of the intangible elements, or the training services, transferred under the franchise agreement. Please contact Jim Kuhl with questions on Appeal of ACFN Franchised, Inc.

Louisiana: Sales Tax Applies to Sales of Electricity at EV Charging Stations

In a recent ruling, the Department of Revenue determined that the sale of electricity at an electric vehicle charging station was a taxable retail sale of tangible personal property. Although the Louisiana Constitution excludes from sales and use tax the sale of utilities furnished to single, private residences, the electricity sold through charging stations was not being purchased for residential use. In addition, although purchases of electricity for business use are subject to a lower sales tax rate, the electricity sold at charging stations was not being purchased for business use.  Moreover, the taxability of the transaction did not depend on whether the price charged was based on the amount of electricity consumed or the time spent using the charging station. The Department did conclude, however, that fees charged to vehicle owners for “idle time” (periods during which a vehicle is fully charged but has not been unplugged from the charging station) were not subject to sales tax, provided such fees are separately stated. Owners of charging stations may purchase the electricity sold through the station as a nontaxable sale for resale. 

Michigan: 163(j) Legislation Passes; Guidance Issued on Computing Pro Forma Federal Taxable Income

Legislation (Senate Bill 195), which has passed both chambers of the legislature, would address how the 163(j) limitation is computed for Michigan corporate income tax purposes retroactively for tax years beginning on and after January 1, 2022. Under the legislation, a person or a person that is included in a unitary business group that files a federal consolidated return would not have a Michigan business interest expense limitation if the person (1) does not have a federal 163(j) limitation for the tax year, (2) is exempt from the business interest limitation under IRC section 163(j)(3), or is (3) engaged in a trade or business that is excepted under IRC section 163(j)(7).  if a corporation is a member of a federal consolidated group that does not have a federal 163(j) limitation for the tax year, that corporation would not have a Michigan business interest expense limitation for that year. The bill would also provide guidance on the tax treatment of any excess business interest, including rules for sharing excess business interest among members of the same unitary business group. It remains to be seen whether Governor Whitmer will sign the legislation.

In other corporate tax news, the Michigan Department of Treasury recently released an 8-page Revenue Administrative Bulletin (RAB 2022-23) addressing the calculation of pro-forma federal taxable income for members of a unitary business group (UBG).  For Michigan Corporate Income Tax (CIT) purposes, C corporations engaged in a unitary business file a combined return that is based on a 50 percent common ownership requirement.  Federal affiliated groups can make a binding election to file as a Michigan UBG. The election is irrevocable for a 10-year period.   Under Michigan law, each UBG member (regardless of whether the state affiliated election is made) is treated as a single person and all the components of a federal return are separately computed to arrive at a UBG member’s pro-forma federal taxable income.  Each member’s separately computed pro-forma federal taxable income is then summed together to determine the UBG’s federal taxable income.

The RAB stresses that the composition of a federal consolidated group and a Michigan UBG may differ, even if the affiliated group election is made. For federal purposes, a direct 80 percent or more ownership test applies for inclusion in a federal consolidated return; however, the definitions of “unitary business group” and “affiliated group” in the CIT include persons that are more than 50 percent owned, directly or indirectly, by another member.  Also, certain corporations excluded from a federal consolidated return are not excluded from the Michigan return (e.g., REITs). In contrast, foreign operating entities may be included in a federal consolidated return, but are specifically excluded from the definition of UBG. The RAB notes several statutory adjustments are required to be made to pro-forma federal taxable income and the federal consolidated return regulations are not followed for purposes of computing pro-forma federal taxable income under the Michigan CIT.  This results in differences between federal taxable income for federal and Michigan CIT purposes, even when the members of a federal consolidated group and the UBG are the same.  The RAB includes examples to illustrate both the difference in composition between a consolidated group and a UBG as well as adjustments that must be made in computing each member’s federal taxable income under the CIT. Interestingly, in a footnote to the RAB, the Department refers to the potential law change around the computation of the 163(j) limitation and reminds taxpayers that the amount of interest deducted at the federal level under IRC section 163(j) and under the CIT may be different. The footnote references the Department’s Notice Corporate Income Tax Treatment of the IRC 163(j) Business Interest Limitation and notes that the Notice is subject to revision pending statutory codification of the IRC 163(j) adjustments required under the CIT that may diverge from current interpretation discussed in the Notice. Please contact Dan De Jong with questions on RAB 2022-23.

Missouri: Department Rules on Drop Shipments; Marketplace Facilitator FAQs Issued

The Missouri Department of Revenue recently addressed the sales tax treatment of drop shipments by a vendor that did not have nexus in Missouri.  In a letter ruling request (LR 8214), the taxpayer explained that it was an out-of-state vendor that sold a manufacturer’s products in Missouri by having the products directly drop shipped from the manufacturer to customers within Missouri. The taxpayer also stated that it did not have physical or economic nexus in Missouri. In its response, the Department determined that the taxpayer was not exempt from collecting and remitting Missouri sales tax for its drop shipment transactions. In the Department’s view, title to the products first transferred from the manufacturer to the taxpayer upon delivery to customers in Missouri. The title to the products then transferred from the taxpayer to its customers. Therefore, the Department concluded that the taxpayer was required to collect and remit sales tax for sales that were drop shipped by the third-party supplier to customers in Missouri.

The Missouri Department of Revenue has issued FAQs on the state’s economic nexus law that becomes effective next month. Specifically, effective January 1, 2023, a remote seller or a marketplace facilitator whose gross receipts from taxable sales of tangible personal property exceed $100,000 in the previous or current calendar year is required to register and collect vendor’s use tax. The FAQs outline the two options for registering with the Department as a marketplace facilitator and address how marketplace sales should be reported on a separate line of the vendor’s use tax return under a separate item code. If marketplace sales are subject to other taxes (e.g., food tax), the FAQs provide the applicable codes for reporting such taxes.  Please contact John Griesedieck with questions on Missouri’s sales and use tax.

New York Qualified Emerging Technology Company (QETC) Determination Does Not Apply at Combined Group Level

An Administrative Law Judge (ALJ) for the New York Division of Tax Appeals recently addressed whether certain taxpayers were “qualified emerging technology companies” or QETCs so that they were able to use the 6.5 percent corporate rate applicable to Qualified New York Manufacturers for the 2012-2014 tax years at issue. The taxpayer, an affiliated group of companies providing video, high-speed data, and digital voice services to both residential and business customers, filed its New York combined returns using the 6.5 percent rate applicable to QETCs. After an audit, the Division determined that the group was not a QETC and applied the regular 7.1 percent rate.   

Under New York law for the tax years at issue, a “qualified emerging technology company” was a “qualified New York manufacturer” eligible for the reduced tax rates. There were two separate methods by which a party could be classified as a “qualified New York manufacturer.”  The first (“Method One”), specifically measured a combined group’s activities; the second method (“Method Two”), which was applicable to QETCs, did not specifically state that the combined group’s attributes should be considered together. The taxpayer argued that the attributes of combined group members should be aggregated and considered together to meet the criteria of being a QETC. Not doing so, the taxpayer argued, was antithetical to the concept of combined reporting, which treats a unitary business as a single taxpayer.

ALJ Decision

After first determining that the statutory provision at issue in this case was to be construed most strongly against the government and in favor of the taxpayer, the ALJ noted that the matter was governed by the rules of statutory construction. Notably, the two methods utilized to classify a taxpayer as a “qualified New York manufacturer” were in the same section of the tax law. The statutory text for Method One clearly and unambiguously articulated that a combined group may qualify as a “qualified New York manufacturer” and the test for that method was applied based on the combined group’s entire gross income aggregated across all members of the group. In contrast, the Method Two language did not articulate that a combined group’s attributes, in particular all of its various component entity physical locations, should be used to meet the required criteria. Instead, the location of each individual entity needed to be considered. In the ALJ’s view, the legislature’s failure to include language similar to that in Method One in the statutory section describing Method Two was deliberate. Furthermore, the ALJ noted that other statutes addressing the criteria in Method Two referred to a singular “company” for the proper application of the QETC test and likewise did not articulate that a combined group’s characteristics should be used to meet the qualifications of that test. Having reached this conclusion, the ALJ rejected the taxpayer’s alternative argument that if the combined group did not qualify as a QETC, then the Division should be required to calculate the application of the QETC beneficial rate for the individual entities of petitioners’ combined group that separately qualify as a QETC and provide the taxpayers the amount of those benefits. In the ALJ’s view, separately breaking out individual component companies of a combined taxpayer would appear to create distortion.

Next Steps and Contacts

As a ALJ determination, this decision is not precedential. However, an exception to the determination may be filed with the Tax Appeals Tribunal and the outcome of that appeal would be precedential.  Please contact Russ Levitt or Aaron Balken with questions on Matter of the Petition of Charter Communications, Inc. and Combined Affiliates, F/K/A Time Warner Cable, Inc. and Combined Affiliates (N.Y. Div. of Tax Appeals, Dkt. No. 829691, Dec. 1, 2022).