TWIST - This Week in State Tax

California: Appeals Court Rejects Suit Seeking to Invalidate Single-Sales Factor Apportionment

In 2017, a Texas-based company called One Technologies filed a complaint alleging that The Clean Energy Jobs Act or Proposition 39, which was approved by California voters in November 2012, should be invalidated as violating the state constitutional single-subject rule for initiative measures. Proposition 39 mandated that most corporate taxpayers use single-sales factor apportionment and the corresponding market-based sourcing rules. It also created a special apportionment rule for cable companies and created a fund for clean energy projects. Prior to Proposition 39, taxpayers could elect between a single sales factor formula with market-based sourcing, or a three factor double-weighted sales formula with costs of performance sourcing.  The complaint alleged that the three components of Proposition 39 were not unified under a common subject, object, or purpose, which rendered it invalid under the California Constitution. Specifically, the taxpayer asserted that the special tax break for cable companies had no reasonable connection to the Proposition’s overall purpose of funding the creation of clean energy jobs. If instead the purpose of the proposition was to modify the tax scheme for multistate businesses, the taxpayer claimed the Job Creation Fund was unrelated to that purpose. The taxpayer requested a refund of corporate income tax on the basis that it should have been permitted to file using three-factor double weighted apportionment and costs of performance sourcing. After a Los Angeles County Superior Court judge dismissed the complaint on the basis that the company failed to state a valid cause of action, the taxpayer appealed.

The single-subject rule arises under the California Constitution, which provides, “an initiative measure embracing more than one subject may not be submitted to the electors or have any effect.” The rule was, in part, adopted to minimize the risk of voter confusion and deception. On appeal, the court held that Proposition 39 did not violate the single-subject rule. The purpose of Proposition 39 was to fund a clean energy job creation program by raising taxes on some multistate businesses and the provisions of the proposition were both reasonably germane and functionally related to that purpose. Notably, the provisions established a funding mechanism and the means of directing that funding to clean energy job creation.  In the court’s view, the special rule for cable companies reflected a determination by the drafters that some businesses should bear the funding burden more than others. The court further rejected the taxpayer’s contentions that Proposition constituted “logrolling” because it combined a likely unpopular change (cable company tax break) with a popular change (job creation). Relying on an earlier California case, the court determined that “logrolling” was not a separate basis (apart from the single-subject rule) to invalidate an initiative.  Please contact Oksana Jaffe with questions on One Technologies, LLC v.  Franchise Tax Board.

Kansas: Department of Revenue Clarifies Corporate Rate Reduction

The Kansas Department of Revenue recently issued a notice (Notice 23-10) addressing the change to the corporate income tax rate that was announced in September. Recall, the Secretary of the Department of Revenue filed a notice in the Kansas Register announcing that the normal corporate income tax rate is reduced from 4 percent to 3.5 percent effective January 1, 2024. The rate reduction stems from the APEX legislation enacted in Kansas in 2022. Under this law, the corporate income tax rate is reduced by 0.5 percent for all businesses upon the commencement of a qualifying APEX Project in the state. It was unclear initially whether the rate reduction would need to be blended for fiscal year taxpayers. The Department’s notice appears to confirm that the rate reduction to 3.5 percent applies effective for tax years beginning in 2024. It should be noted that the 3 percent corporate surtax rate is unchanged. Please contact Derek Love with questions.

New York: Party Supply Store Selling Exempt Clothing

Recently, an Administrative Law Judge for the New York Division of Tax Appeals issued a lengthy decision addressing whether a party supply retailer properly collected and remitted sales tax on certain sales. The taxpayer sold party supplies, accessories, and costumes both at retail stores and online.  Under New York law, items of clothing under $110 per article are exempt from sales and use tax, but they are subject to local sales tax in jurisdictions that do not conform to the state exemption. By statute, “clothing” does not include costumes. The party supply retailer did not collect the full amount (state and local) of sales tax on sales of certain items. On audit, the Division asserted that numerous items should have been taxed at the full state and local amount because they were intended to be part of a costume based on how the taxpayer marketed and presented the items in its retail stores and online. Using the SKUs assigned to the items, the auditor also determined that the items were listed on the taxpayer’s website as a costume or a costume accessory.  For certain other items, the auditor could not verify what the  intended use was from the taxpayer’s website and argued the full sales tax rate applied to these items as well.

The ALJ determined that the auditor’s reliance on how the taxpayer marketed its items to determine their taxability was unreasonable. Whether an item qualifies for the clothing exemption is determined at the time of the sale. The sales receipt provided to the customer at the time an item is purchased is what should be used to determine the taxability of the item. The taxpayer’s sales receipts provided to customers at the time of sale included the item’s SKU number and a description of the item purchased. Many of the SKU descriptions listed on the taxpayer’s receipts included identifiers of items that were considered exempt under the Division’s guidance in TB-ST-350, such as hats, shirts, dresses, jackets, and robes.  Some of the SKU descriptions, such as tutu, petticoat, skirt, tunic, jumpsuit, capelet and vest, were not specifically enumerated in TB-ST-350 as exempt. However, in the ALJ’s view, these items constituted articles of clothing worn by human beings.  In sum, the ALJ concluded that the auditor erroneously relied on the taxpayer’s sales reports and should not have tried to verify the characterization of items from the taxpayer’s website. The taxpayer’s sales receipts included the SKU numbers, and those numbers and descriptions were adequate for determining the taxable status of each item. The ALJ concluded that almost all the disputed items were exempt as clothing. Having found in the taxpayer’s favor on this issue, the ALJ next rejected as “meritless” the taxpayer’s claim that the Division unevenly applied the exemption to similarly situated retailers selling both clothing and costumes in violation of the Equal Protection Clause of the United States Constitution. Please contact Judy Cheng with questions on Matter of Party City Corporation.

Utah: Streaming Service Taxable as Part of Bundled Transaction

Recently, an ALJ for the Utah State Tax Commission addressed whether a taxpayer owed sales tax on subscription fees charged to customers for access to streaming services. The taxpayer, a multinational provider of licensed and original entertainment programming, offered customers various subscriptions to its streaming services platform for a monthly fee. During the audit period, the taxpayer included online streaming, as well as the ability to download programming for viewing offline through the streaming platform. Per the taxpayer, 99 percent or more of its content was viewed by the subscribers through the online-streaming feature.  The taxpayer had stopped collecting and remitting sales tax on its subscription fees after legislation specifically imposing sales tax on streaming services was repealed in 2019. However, on audit the Business Taxes and Discovery Division of the Commission took the position that the taxpayer’s subscription fees were taxable as “products transferred electronically” or that they were taxable as part of a bundled transaction. The taxpayer protested, and the matter came before an ALJ with the Utah State Tax Commission.

The ALJ first rejected the Division’s position that online streaming services were subject to Utah sales tax as a product transferred electronically. Importantly, this conclusion would have directly contradicted several previous Private Letter Rulings issued by the Commission concluding that streaming services were not products transferred electronically and were not taxable. The ALJ next addressed the Division’s position that the services were taxable because they were part of a bundled transaction. Under Utah law, which incorporates the Streamlined Sales and Use Tax Agreement, a bundled transaction is the sale of two or more items of tangible personal property, products, or services if the tangible personal property, products, or services are:(i) distinct and identifiable; and (ii) sold for one nonitemized price. “Distinct and identifiable” does not include a product that is provided free of charge with the purchase of another product or a service. The taxpayer argued that the ability to download content for viewing offline was not a not “distinct and identifiable” product because the offline download feature was provided for no extra change with the purchase of online streaming. The ALJ, however, determined that the taxpayer had not established that the offline download feature was provided “free of charge.” Although there was a press release noting that the download option was being added to subscriptions for “no extra cost,” the ALJ noted that there were no statements, invoices, press releases or other documentation supporting the taxpayer’s assertion that the offline download feature was offered “free of charge.” Rather, the taxpayer’s price list showed that the download benefit increased with the more costly subscription packages. As such, the ALJ concluded that the that the subscription fees were “bundled transactions.” Because one product in the bundle was subject to tax the entire bundled transaction was subject to taxation. Please contact Mike Larkin with questions.