TWIST - This Week in State Tax

Kentucky: State High Court Holds that Purchases are Exempt Supplies, Not Taxable Replacement Parts

The Kentucky Supreme Court recently addressed the distinction between exempt supplies and taxable repair parts. Under Kentucky law, “supplies” purchased by a manufacturer for use in the manufacturing process are tax exempt, but “repair, replacement, or spare parts” are not. To be classified as a “supply” an item must be tangible personal property, be consumed in manufacturing or industrial processing, be used directly in manufacturing or industrial processing, and have a useful life of less than one year. “Repair, replacement or spare parts” are tangible personal property used to maintain, restore, mend, or repair machinery or equipment.  The Kentucky Supreme Court recently concluded that an aluminum manufacturer’s purchases qualified as exempt supplies. In the court’s view, the plain language of the definition of repair, replacement and spare parts restricted the part’s use to maintaining, restoring, mending or repairing the actual manufacturing machinery or equipment. As such, tangible personal property that maintained the “manufacturing process,” but did not actually replace an existing part of the permanent machinery, did not fit within the definition of a taxable repair part.  The court concluded that the question as to whether tangible personal property is a tax-exempt supply or a taxable part, if all the other characteristics of a tax-exempt supply are met, may be resolved by whether the tangible personal property has the characteristics of being consumed in the manufacturing process and having a useful life of less than one year. “With the conclusion that specific tangible personal property is a supply, its defining characteristics exclude it from being categorized as a repair, replacement or spare part, and the statute cannot be construed in an absurd, inconsistent manner to allow the same tangible personal property to be viewed also as a part.” Please contact Greg Ruud or Dave Perry with questions on Century Aluminum of Kentucky, GP v. Dep’t of Revenue.

Massachusetts: Cookies Not Sufficient to Establish Physical Presence Nexus

On December 22, 2022, the Massachusetts Supreme Judicial Court affirmed an Appellate Tax Board decision holding that for tax periods prior to Wayfair, the Commissioner could not impose a use tax collection and remittance responsibility an out-of-state online retailer whose presence in Massachusetts was limited to the placement of “cookies” and “apps” on the computers and portable devices of its Massachusetts customers. Recall, under a regulation promulgated by the Commissioner effective October 1, 2017, a taxpayer with more than $500,000 in Massachusetts sales from 100 or more online transactions with Massachusetts customers, coupled with the placement of cookies on customer devices and the use of content delivery networks, was deemed to have sufficient contacts with the Commonwealth to be required to register, collect and remit Massachusetts use tax.

The court first rejected the Commissioner’s position that the Wayfair decision could be applied retroactively—regardless of whether the presence of apps and cookies constituted a physical presence in the Commonwealth. In Harper v. Virginia, the U.S. Supreme Court stated that decisions on issues of federal law "must be given full retroactive effect in all cases still open on direct review and as to all events, regardless of whether such events predate or postdate [the Court's] announcement of the rule." Although the Commissioner asserted this meant that the Wayfair holding applied retroactively, the Massachusetts court disagreed on the basis that the Commissioner’s own regulation limited its reach to vendors that satisfied the physical presence test in Quill. In other words, regardless of whether Supreme Court decisions applied retroactively, the regulation itself required a physical presence. The court also noted that the Supreme Court in Wayfair identified the South Dakota statutory prohibition on applying a favorable decision retroactively as contributing to its determination to abrogate the Quill physical presence rule. It further noted that Massachusetts was part of a coalition of states filing an amicus brief in Wayfair arguing that “there was no reason to expect” retroactive application of Wayfair by states because of regulations and processes that would bar imposition of a new rule on retailers on retailers meeting the terms of the Quill rule.

The court then moved on to affirm the Board’s conclusion that the use of cookies, apps, and content delivery network servers did not constitute sufficient physical presence under Quill. In the court’s view, it was clear the Wayfair Court did not view the “physical aspects” of modern technology (e.g., cookies, apps, and use of in-state servers) as satisfying the physical presence rule under Quill. The court concluded that it would defer to the Board’s “reasonable conclusion” that use of apps, cookies and content delivery networks did not create in-state physical presence. Please contact Ryanne Tannenbaum or Jon Benson with questions on U.S. Auto Parts Network, Inc. v. Commissioner of Revenue.

North Carolina: Court Rejects U.S. Supreme Court Holding Addressing Distinction Between Sales and Use Tax

On December 16, 2022, the North Carolina Supreme Court ruled in favor of the state in Quad Graphics, Inc. v. N.C. Dep’t of Revenue. In an earlier decision, the state’s Business Court concluded that North Carolina lacked sufficient nexus to impose a sales tax collection obligation on Quad Graphics in light of the U.S. Supreme Court’s 1944 decision in McLeod v. Dilworth. In Dilworth, the U.S. Supreme Court determined Arkansas had no authority under the Commerce Clause to impose a tax on the sale of machinery or mill supplies purchased from Tennessee corporations when title passed upon delivery to a common carrier within Tennessee before the goods were ultimately brought into Arkansas for delivery. In the Dilworth Court’s view, these sales were consummated in Tennessee and were not subject to Arkansas sales tax.  Similar to the sales at issue in Dilworth, title passed to Quad Graphics’ customers outside of North Carolina. As such, it was the taxpayer’s position (with which the North Carolina Business Court agreed) that the Department of Revenue could not assess sales tax on those sales. On appeal, the North Carolina Supreme Court concluded that although Dilworth was never explicitly overturned, the formalism doctrine established in Dilworth had not survived more recent U.S. Supreme Court decisions in Complete Auto and Wayfair, and therefore the imposition of North Carolina sales tax as opposed to use tax passed constitutional scrutiny. This decision has implications outside the sales and use tax context, as there are cases holding that only the U.S. Supreme Court, rather than lower federal courts or state courts, can overrule its prior holdings. It is not yet clear whether Quad Graphics will file a petition for certiorari with the U.S. Supreme Court. Please stay tuned to TWIST for future updates on this case.

Pennsylvania: Refund Ordered in NOL Cap Case

Recently, the Pennsylvania Commonwealth Court issued the latest decision addressing the state’s unconstitutional flat dollar NOL cap, which was struck down in the 2017 Nextel decision. In light of the Pennsylvania Supreme Court’s conclusion in a different case (General Motors II) that the Nextel decision applied retroactively, the Commonwealth Court revised its original panel decision and held in an en banc decision that the only remedy available to equalize the tax positions between favored and non-favored taxpayers was to issue the taxpayer a refund.  Although the taxpayer calculated its tax liability for the tax year applying the valid percentage cap, the court noted that the taxpayer was disadvantaged when compared to small corporate taxpayers that utilized the flat dollar NOL cap and paid no taxes.  To equalize the actual tax positions and provide “meaningful backward-looking relief” as required to remedy the due process violation, McKesson Corp. requires that either the favored taxpayers be assessed additional taxes or the unfavored taxpayer be refunded the taxes it paid. Because the statute of limitations precluded Pennsylvania from assessing the favored taxpayers, the Commonwealth Court concluded that the only remedy available to cure the Uniformity Clause violation was to issue the taxpayer a refund of the taxes paid after it applied the percentage cap. It is not yet known whether the decision will be appealed. Please contact Mark Achord with questions on Alcatel-Lucent USA Inc. v. Commonwealth of Pennsylvania.

Multistate: Recently Enacted State Tax Bills of Note

In legislative news, Michigan Governor Whitmer vetoed Senate Bill 195, which would have revised the computation of the 163(j) limitation for Michigan corporate income tax purposes retroactively for tax years beginning on and after January 1, 2022. 

In New Jersey, legislation was signed that ends the extended statute of limitations on assessments. As background, on March 9, 2020, Governor Murphy of New Jersey declared both a Public Health Emergency and a State of Emergency. The Legislature subsequently enacted the “COVID-19 Fiscal Mitigation Act” extending the original tax assessment period and consent period by an additional 90 days after the New Jersey State of Emergency had ended. In other words, if the normal three- or four-year statute of limitations period would have expired during the emergency period, it was extended until 90 days after the State of Emergency declaration was lifted. The Division of Taxation normally pays interest on refunds that are issued more than six months after the date the refund claim was filed, the tax was paid, or the due date of the return, whichever is later (the original interest payment period). The 2020 legislation also extended the original interest payment period by an additional six months after the State of Emergency ended.

The New Jersey State of Emergency Declaration has remained in effect, even after the Public Health Emergency was lifted on June 4, 2021. On December 22, 2022, Governor Murphy signed Assembly Bill 4295 which, as of the bill’s enactment date, ends the extended statute of limitations and the six-month extension on the payment of interest. Any assessment of tax related to the COVID extension that was made after the December 22, 2022 enactment date must be voided. Assembly Bill 4295 also adopts the new federal partnership audit regime and eliminates the requirement to affirmatively elect New Jersey S Corporation status.

Finally, House Bill 223 was signed into law in Ohio. This bill allows vendors to deduct bad debts written off as uncollectible by certain third-party lenders. Under existing law, only vendors or certified service providers that generated a bad debt and charged that debt off as uncollectable may claim the bad debt deduction. As amended, a vendor is allowed to deduct bad debt held by a third party through a “private label credit account” that is associated with a sale that the vendor reported on a previous return. A private label credit account is defined as an account with a lender (typically a bank) that “carries, refers to, or is branded with” the name of the vendor and which is used to finance sales on credit by the vendor’s customers. Unlike situations in which the vendor held the debt directly, the vendor will not be permitted obtain a refund from the deduction of third-party debt, but unused third-party bad debt may be carried forward indefinitely and used to offset future taxable receipts. A vendor taking a deduction under this section is required to maintain books and records verifying the transaction. Please stay tuned to TWIST for additional legislative updates.