State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP

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1 State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP Major Nexus Developments of 2010 Examined; States Follow Trend of Adopting Bright-Line Nexus Standards During 2010, states continued to follow the trend of revising nexus standards to broaden the scope of out-of-state companies that are subject to their tax. Perhaps the most significant nexus development in 2010 was the adoption of factor presence (bright-line) nexus standards by several states with corporation income taxes. Prior to 2009, this approach had been limited to states such as Michigan and Ohio that do not impose traditional corporate income taxes. In the area of sales tax nexus, a New York appellate court held that the controversial Amazon rule was constitutional on its face, but may be challenged as applied. Finally, Oklahoma broadened its sales tax nexus standards by greatly expanding the definition of retailer. Because most states desperately are searching for additional tax revenue, these trends probably will continue in Factor Presence (Bright-Line) Nexus Under a factor presence or bright-line nexus standard, an out-of-state entity has nexus with a state if it meets minimum dollar thresholds for property, payroll or sales in the state. This approach was first recommended by the Multistate Tax Commission (MTC). On October 17, 2002, the MTC approved a model statute entitled the Factor Presence Nexus Standard for Business Activity Taxes. 1 This model statute provides clear standards for determining whether a taxpayer has nexus with a state. Under the model statute, a taxpayer has substantial nexus with a state if any of the following thresholds is exceeded during the tax period: Release date February 3, 2011 States All Issue/Topic Nexus Contact details Giles Sutton Charlotte T E Jamie C. Yesnowitz Washington, DC T E Chuck Jones Chicago T E (1) $50,000 of property; (2) $50,000 of payroll; (3) $500,000 of sales; or (4) 25 percent of total property, payroll or sales. 1 The MTC explains that [a] working group of states formulated the proposal over several months through public teleconferences and the Commission held four public hearings covering the technical, policy and constitutional aspects of the proposed provision. According to the MTC, [t]his factor presence nexus standard is intended to represent a simple, certain and equitable standard for the collection of state business activity taxes.

2 Grant Thornton LLP - 2 Although states originally were slow in adopting this approach, 2 several states adopted a factor presence nexus standard in Due to this trend, the factor presence nexus standard has become increasingly important. During 2010, a factor presence nexus standard was adopted by Colorado, Connecticut, Oklahoma and Washington. Legislatures in Oklahoma and Washington adopted the standard by amending statutes. The standard was adopted by Colorado and Connecticut by administrative regulation or release. Also, the Ohio Department of Taxation ruled on a high-profile matter concerning the bright-line nexus standards of the commercial activity tax (CAT). Colorado Effective April 30, 2010, the Colorado Department of Revenue amended the corporate income tax regulation that defines doing business in Colorado to adopt a factor presence nexus standard. 3 Under Colorado law, the corporate income tax is imposed on corporations that are doing business in the state. 4 The statute does not define doing business. The regulation provides that a corporation is doing business in Colorado whenever the minimum standards of Public Law are exceeded and the corporation has substantial nexus with the state. Business organizations that are organized outside Colorado have substantial nexus with the state if they have property, payroll or sales that exceed the same thresholds that are specified in the MTC s model statute during the tax period. Connecticut Effective for tax years beginning after 2009, a Connecticut statute applies an economic nexus standard. 5 To the extent constitutionally allowed, a company having a substantial economic presence or deriving income from sources within Connecticut is subject to corporate income tax. The term substantial economic presence is defined as purposely directing business toward Connecticut, by looking at the frequency, quantity and systematic nature of the company s contact with Connecticut. On September 23, 2010, 2 Prior to 2010, three states adopted a factor presence nexus standard. In 2009, California enacted a factor presence nexus standard for its corporation franchise tax that is effective for tax years beginning after The definition of doing business adopts thresholds similar to those found in the MTC s proposed model statute. Ohio adopted a factor presence nexus standard for purposes of its CAT, which began in The Michigan business tax, which applies to tax years beginning on or after January 1, 2008, uses a different factor presence nexus standard. A taxpayer has substantial nexus with Michigan if (1) the taxpayer has a physical presence in Michigan for more than one day during the tax year or (2) the taxpayer actively solicits in the state and has gross receipts of at least $350,000 sourced to Michigan. 3 1 COLO. CODE REGS Prior to the amendment, a corporation was considered to be doing business in Colorado whenever the minimum standards of Public Law were exceeded. 4 COLO REV. STAT CONN. GEN. STAT a.

3 Grant Thornton LLP - 3 the Connecticut Department of Revenue Services implemented a bright-line nexus standard, under which an entity has economic nexus with Connecticut for a tax year if the frequency, quantity, and systematic nature of its economic contacts with the state result in at least $500,000 attributable to Connecticut sources during the tax year. 6 Oklahoma In 2010, Oklahoma enacted a new Business Activity Tax (BAT) that is effective for the 2010 through 2012 tax years, and effectively replaces the state s franchise tax for these years. 7 For purposes of this tax, a taxpayer is doing business in Oklahoma if it satisfies the same nexus standards proposed by the MTC or otherwise has nexus with Oklahoma to an extent that the person can be required to remit the tax under the U.S. Constitution. 8 This nexus standard differs from the current nexus standard applied for purposes of Oklahoma income tax. 9 Washington Effective June 1, 2010, Washington adopted a factor presence nexus standard for purposes of the Business and Occupation (B&O) tax. 10 An out-of-state business is subject to Washington s B&O tax on service and royalty income if the business meets at least one of the four criteria of the MTC s model statute discussed above. 11 Note that the new nexus standard only applies to out-of-state entities that make sales to Washington customers classified as service or royalty income. The physical presence nexus standard continues to be required for retailing, wholesaling, and any other classification of business that is not subject to the single-factor apportionment formula. Washington also has a new trailing nexus provision for the B&O tax that was effective June 1, An entity that stops the business activity that created nexus in Washington continues to have nexus for the remainder of that calendar year, plus one additional calendar year Informational Publication 2010(29), Connecticut Department of Revenue Services, Sept. 23, S.J.R. 61, Laws The Oklahoma legislature placed a moratorium on the franchise tax for the taxable periods beginning on or after July 1, 2010 and ending before July 1, The BAT is in lieu of ad valorem taxes on intangible property of all persons doing business in Oklahoma, except public service corporations, air carriers and railroads. Despite the scheduled expiration and the current intention of the Oklahoma legislature, a framework is in place to modify and continue the imposition of the BAT for tax years beginning after Dec. 31, OKLA. STAT. tit. 68, 1218(H). 9 OKLA. ADMIN. CODE 710: WASH. REV. CODE , Historically, a person was required to have physical presence in the state to have nexus for purposes of the B&O tax. 11 Id. 12 WASH. REV. CODE ; Special Notice, Washington State Department of Revenue, Sept. 10, 2010.

4 Grant Thornton LLP - 4 Ohio Bright-Line Nexus Affirmed Ohio adopted a factor presence nexus standard for purposes of its CAT, which began in For purposes of the CAT, several different factors, including a bright-line presence, cause a taxpayer to have nexus with the state. 13 The definition of bright-line presence includes the threshold factors contained in the MTC s proposed model statute. Specifically, a taxpayer has bright-line presence in Ohio if the taxpayer: (1) has property in the state with a value of at least $50,000; (2) has payroll in Ohio of at least $50,000; (3) has taxable gross receipts of at least $500,000; (4) has at least 25 percent of its total property, payroll or gross receipts in the state; or (5) is domiciled in Ohio. 14 In 2010, the Ohio Tax Commissioner held in a final determination that an out-of-state retailer had substantial nexus with Ohio for purposes of the CAT because its gross receipts in the state satisfied the bright-line presence test. 15 The Tax Commissioner found that the retailer satisfied the substantial nexus requirement of the Commerce Clause by its continuous, systematic and significant solicitation and exploitation of the economic marketplace in Ohio. The retailer s level of activity in Ohio was substantial because its total gross receipts in the state for the relevant years exceeded $100 million. According to the Tax Commissioner, a physical presence test does not apply to the CAT. The decision of the Tax Commissioner is likely to be litigated in the Ohio courts over the next several years. Interaction with Public Law A federal law, commonly called Public Law , prohibits states from imposing taxes based on or measured by net income, when an entity s only in-state activity is restricted to mere solicitation of orders of tangible personal property. 16 Orders received must be sent outside the state for approval and, if approved, must be shipped or delivered from outside the state. Orders may be solicited by employees or representatives. If there is an activity that exceeds solicitation, the immunity from taxation is lost. An out-of-state company potentially may be subject to a state s income tax under a factor presence nexus standard, but be protected from taxation by P.L For example, an out-of-state company may have $550,000 of sales of tangible personal property in a state 13 OHIO REV. CODE ANN (H). 14 OHIO REV. CODE ANN (I). 15 In re L.L. Bean, Inc., Ohio Department of Taxation, Aug. 10, U.S.C. 381 to 384.

5 Grant Thornton LLP - 5 during the year. If the company s only activity in the state is solicitation of orders of tangible personal property, P.L would prevent the company from being taxed. Thus, an out-of-state company should consider the applicability of P.L before it pays tax to a state under a factor presence nexus statute. Constitutional and Other Considerations Out-of-state of companies that previously were not subject to tax in a state may find that they suddenly are subject to tax under a factor presence nexus standard. For instance, a company that otherwise only has a slight connection with a state will be subject to tax if it exceeds any of the factor presence nexus factors. Note that the revenue threshold may be crossed even if the taxpayer is not trying to make a market in the state. Although the factor presence nexus standard is recommended by the MTC, the constitutionality of this approach is questionable. The adoption of objective standards to determine whether substantial nexus exists in a state may conflict with the judicial concept of substantial nexus in Complete Auto Transit v. Brady 17 and subsequent cases. Courts intended that the substantial nexus test would be based on a case-by-case analysis of whether a taxpayer had enough presence in a state to be subject to tax. Under the judicial approach, many factors beyond the level of a company s property, payroll and sales should be considered in making a nexus determination. By basing a nexus decision only on these three factors, out-of-state companies are being deprived of a thorough nexus analysis. Due to the uncertain constitutionality of the factor presence nexus approach, taxpayers should seriously consider whether they should file income tax returns only on the basis that they exceed one of the factor presence nexus thresholds. In Colorado and Connecticut, the states revenue departments each adopted a factor presence nexus standard to more specifically define the concept of economic nexus. However, it is noteworthy that the factor presence nexus standard was adopted by the revenue departments rather than the legislatures. Typically, a change in a state s nexus standard is made by a state s legislature pursuant to statute, and the MTC s model enactment was intended to be statutory in nature. Therefore, aggrieved companies may argue that the revenue departments in Colorado and Connecticut do not have the necessary authority to adopt specific nexus standards that attempt to describe the concept of substantial nexus. Sales Tax Nexus Developments The controversial Amazon rule that applies to sales and use tax has received a great of deal of publicity. This continued in 2010 when a New York appellate court considered the constitutionality of the Amazon rule. Further, Oklahoma greatly expanded its sales tax nexus standards for retailers U.S. 274 (1977).

6 Grant Thornton LLP - 6 Amazon Rule In 2008, New York enacted a sales tax nexus provision for Internet retailers that is commonly called the Amazon rule. 18 The definition of vendor was amended to include Internet retailers that actively encourage Web site owners residing in New York to advertise for the Internet retailer in return for a commission on sales resulting from the followed link. A presumption of taxability exists if the Internet retailer generated more than $10,000 through these referrals during the last four quarterly sales tax periods. The presumption may be rebutted if the Web site owner did not engage in any solicitation in New York that would result in a finding of nexus under constitutional standards. In November, the Appellate Division of the New York Supreme Court partially affirmed the dismissal of complaints filed by Amazon.com and Overstock.com challenging the constitutionality of the Amazon rule. 19 The Appellate Division held that the Amazon rule does not violate the Due Process Clause, Commerce Clause or Equal Protection Clause on its face. However, the Appellate Division reinstated the cases to determine whether the statute violates the Due Process Clause and Commerce Clause as applied to Amazon and Overstock. The Amazon litigation in New York is being closely watched because other states have either enacted their own Amazon rule or are considering this type of legislation. 20 The fact that an appellate court has determined that the statute is constitutional on its face is significant, although it is likely that the litigation will be considered by the New York Court of Appeals, the state s highest court. The fact that the constitutionality of the statute has been upheld may further encourage other states to enact this type of legislation in 2011, even though it is likely that this particular litigation ultimately will take several years to resolve. 18 N.Y. TAX LAW 1101(b)(8)(vi); TSB-M-08(3)S, New York State Department of Taxation and Finance, May 8, 2008; TSB-M-08(3.1)S, New York State Department of Taxation and Finance, June 30, This provision is referred to as the Amazon rule by many tax professionals because the provision appears to target companies like Amazon.com and other online retailers outside New York that pay New York advertisers commissions for sales generated from advertisements that link to online retailers Web sites. 19 Amazon.com, LLC v. New York State Department of Taxation and Finance, New York Supreme Court, Appellate Division, No /08, Nov. 4, 2010; Overstock.com v. New York State Department of Taxation and Finance, No /08, Nov. 4, Amazon legislation has been enacted in North Carolina (N.C. GEN. STAT (b); N.C. GEN. STAT (33c)) and Rhode Island (R.I. GEN. LAWS (a)(2)). Also, the Illinois legislature approved the Amazon rule in January H.B. 3659, passed by the Illinois House and Senate on Jan. 6, 2011.

7 Grant Thornton LLP - 7 Oklahoma s Expansion of Nexus In 2010, Oklahoma enacted legislation adding new provisions that greatly expand the definition of retailer for purposes of Oklahoma sales and use tax. 21 The new standards are based on a substantial ownership interest, controlled groups and contracts to perform installation or maintenance services. Under the legislation, there are two instances in which the existence of a substantial ownership interest may result in an out-of-state retailer being engaged in the business of selling tangible personal property for use in Oklahoma. The first situation applies where an out-of-state retailer holds a substantial ownership interest in, or is owned in whole or in substantial part by, a retailer maintaining a place of business within Oklahoma. 22 The second situation applies when an out-of-state retailer holds a substantial ownership interest in, or is owned in whole or in substantial part by, a business that maintains a distribution house or warehouse in Oklahoma that delivers property sold by the retailer to consumers. 23 The legislation also provides that an out-of-state retailer is presumed to be engaged in business in Oklahoma if it is part of a controlled group of corporations that has a component member that is a retailer engaged in business in Oklahoma. 24 This presumption may be rebutted by evidence that during the calendar year the component member that is a retailer engaged in business in Oklahoma did not engage in any of the activities described in the provision dealing with substantial ownership interests on behalf of the retailer. The statute adopts the federal definitions of controlled group of corporations 25 and component member. 26 Because this statute adopts federal income tax definitions, sales and use tax practitioners will need to become familiar with this aspect of federal income tax law. Finally, any retailer making sales of tangible personal property to purchasers in Oklahoma by mail, telephone, the Internet or other media that has a contractual relationship with an 21 OKLA. STAT. tit. 68, OKLA. STAT. tit. 68, b(1)(b). In this situation, if the out-of-state retailer sells the same or a substantially similar line of products as the related Oklahoma retailer under the same or a substantially similar business name, or the Oklahoma facilities or employees of the related Oklahoma retailer are used to advertise, promote or facilitate sales by the out-of-state retailer, the out-of-state retailer will be deemed to be engaged in the business of selling tangible personal property for use in Oklahoma. 23 OKLA. STAT. tit. 68, b(2). In this situation, the out-of-state retailer is deemed to be engaged in the business of selling tangible personal property for use in Oklahoma, without any other conditions. 24 OKLA. STAT. tit. 68, d. 25 IRC 1563(a). 26 IRC 1563(b).

8 Grant Thornton LLP - 8 entity to provide and perform installation or maintenance services for the retailer s purchasers within Oklahoma are included within the definition of retailer. 27 Out-of-state retailers that have ownership affiliations or other relationships with in-state retailers or businesses will need to consider the new provisions and determine whether they now have nexus with Oklahoma for sales and use tax purposes. The new Oklahoma nexus standards governing out-of-state retailers with related parties located in Oklahoma are intricately designed in many cases to require registration by retailers that do not have actual physical presence in the state. Note that Oklahoma s expanded nexus standards are accompanied by new disclosure and notification requirements. 28 In addition, Colorado enacted expanded affiliate nexus and out-of-state retailer notification requirements in 2010 that are broader than and distinct from the Oklahoma requirements. 29 Further, New York previously adopted affiliate nexus standards in In light of this growing trend, other states may consider adopting a similar nexus approach in States have taken different approaches to taxing sales from out-of-state retailers that do not have nexus with the state under a traditional physical presence nexus standard. States such as New York, North Carolina and Rhode Island have enacted Amazon legislation to subject these sales to tax. A second approach, used by Colorado, New York and Oklahoma, is to impose tax on out-of-state retailers through affiliate or related-party nexus. This method either outlines presumptions of nexus which can be rebutted in certain circumstances, or automatically results in an irreversible finding of nexus. A third approach, adopted by Colorado in 2010 but currently inoperative due to a preliminary injunction recently issued by a federal district court, 31 imposes notification requirements on out-of-state retailers with a certain level of sales within the state. This approach is related to the sales and use tax nexus issue because the burdens imposed on out-of-state retailers by this approach tends to encourage voluntary registration with the state, akin to the forcing of an admission of nexus. All three of these approaches are controversial and have been subject to criticism. However, states desperately need to increase tax revenue. In 2011, it will be interesting to see which states adopt or reject these approaches. The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant 27 OKLA. STAT. tit. 68, e. 28 OKLA. STAT. tit. 68, ; OKLA. ADMIN. CODE 710: COLO. REV. STAT (3)(b)(II), (3). 30 N.Y. TAX LAW 1101(b)(8)(i)(I), (v)(b). 31 The Direct Marketing Association v. Roxy Huber, Civil Case No. 10-cv REB-CBS, Order Granting Motion for Preliminary Injunction (U.S. Dist. Ct. Colorado, Jan. 26, 2011).

9 Grant Thornton LLP - 9 Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. Tax professional standards statement This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circumstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed. To the extent this document may be considered written tax advice, in accordance with applicable professional regulations, unless expressly stated otherwise, any written advice contained in, forwarded with, or attached to this document is not intended or written by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code.

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