The Administration introduced the “Revenue Modernization Act” on February 11 in the Senate Finance Committee, and the proposal includes numerous modifications to all Tennessee’s major taxes, including economic nexus, click-thru nexus, market sourcing, sales tax on remotely accessed computer software, and expansion of the business tax.

Governor Bill Haslam announced during the annual state-of-the-state address in Tennessee on February 10 that the Administration would introduce a “Revenue Modernization Act” during the current legislative session to address revenue shortfalls experienced in the FY2014 budget. This is motivated in large part to balance the budget and account for new spending proposals set forth by the Governor in the FY2016 budget.

The Governor was careful to point out during his address that significant efforts have been made to reduce expenditures, but new revenue sources were needed to balance the budget. In particular, Governor Haslam noted the following tax updates in his address:

After presenting our budget last year, there was a sharp decline in revenue collections, and we weren’t able to do some of the things we initially proposed in the budget. Most of the drop was in our business tax collections. We’ve spent a lot of time working internally and with outside experts to analyze what happened.

Some of it is a result of the natural volatility of business taxes in general. Some of it was due to over-collections in which reimbursements weren’t accounted for in the budgeting process. And some of it is that companies outside of Tennessee, but that do business in Tennessee, aren’t always required to pay the same taxes that our in-state and homegrown companies do. Through the analysis, we found that Tennessee has fallen behind other states in protecting our in-state businesses from unfair competition from out-of-state companies.

To remedy that, we will file the Revenue Modernization Act, which aims to level the playing field in terms of sales tax and business taxes. The bill also capitalizes on trends that we’re seeing in product distribution by creating an incentive for companies to use Tennessee’s distribution industry, which maximizes our state’s strengths.

We are committed to Tennessee remaining a low tax state. This proposal simply brings us in line to better compete with other states and to not put our in-state businesses at a disadvantage, which we are doing today.

On the heels of the address, Commissioner of Finance and Administration, Larry Martin, presented the budget to the Senate Finance Ways and Means Committee on Tuesday, which included the introduction of SB603/HB644 (Norris/McCormick), which includes many significant changes to Tennessee’s franchise and excise tax, sales and use tax, and business tax.

Economic Nexus

Among the changes are proposals to adopt economic nexus standards for the franchise and excise tax and business tax, as well as click-thru nexus for sales and use tax. For the franchise and excise tax, these proposals mark a departure from existing law in Tennessee dating back to J.C. Penney National Bank v. Johnson, which requires an actual physical presence in Tennessee for the franchise and excise tax to apply. The threshold for economic nexus is established as the lesser of $500,000 or 25 percent of a taxpayer’s total receipts everywhere, which is consistent with measures adopted in states that have departed from the physical presence requirement.

Click-Thru Nexus

For the click-thru nexus provisions to apply, the dealer’s cumulative gross sales made from in-state referrals need only exceed $10,000 to establish the presumption that the dealer is soliciting sales in Tennessee and subject to the state’s jurisdiction to collect the sales and use tax. Again, this threshold is consistent with many states that have adopted click-thru nexus, although Georgia has a $50,000 threshold.

Market Sourcing for Services and Intangibles

The bill also proposes the adoption of market sourcing of receipts from sales other than sales of tangible personal property. This change would put an end to the debate that is currently being litigated in Vodafone Americas Holding v. Roberts regarding the cost of performance rules and the authority the Commissioner possesses to adopt alternative apportionment methodologies. In Vodafone, the Commissioner has attempted to impose market sourcing on an out-of-state company despite there being no statutory basis for such a methodology. The taxpayer has argued that market sourcing is a decision that should be left to the legislature. Although Vodafone is awaiting oral argument before the Tennessee Supreme Court, the Department of Revenue seems to be taking the taxpayer’s advice and pursuing a legislative resolution of the issue for future tax periods. Market sourcing is often viewed as favorable for Tennessee-domiciled service providers, and it would likely increase the apportionment factor and the taxes of companies either domiciled or headquartered outside Tennessee.

Sales Tax on Remotely Accessed Software

The bill also expands the scope of Tennessee’s taxation of computer software. Under current law, software is taxable only if it is downloaded to a computer or server in Tennessee as part of the sale. The tax does not apply to software that is maintained on remote servers or is accessed via the Internet. This would change if the bill is passed, and businesses with locations in Tennessee would be required to pay sales and use tax on software used in Tennessee regardless of whether the software is actually downloaded to a computer or server in Tennessee. In addition, ancillary services related to the sale of remotely accessed software would ostensibly be brought into the tax base with this change.

The tax will be based on the primary address of the customer, but to the extent that there are multiple users located both within and without the state, the proposal would allow the dealer to allocate only a portion of the sale to the state. This provision will likely have a negative impact on Tennessee businesses that use remote providers for technology solutions, which is inconsistent with other provisions of the bill that are focused on out-of-state businesses.

Expansion of Business Tax

The bill expands the business tax to all out-of-state businesses making sales of tangible goods and services in the state, provided the business meets the economic nexus standards of having sales of at least $500,000 in Tennessee. This continues the trend in recent years of expanding Tennessee’s gross receipts tax.

The tax was originally a local tax that only applied to taxpayers with business locations in the state, but changes made from 2010 to 2013 amended the business tax to include a state component and expanded the tax to certain out-of-state companies. This appears to be the next step in the evolution of this tax and confirms concerns expressed in prior legislative sessions that the Department was attempting to convert Tennessee’s locally imposed-business tax into Tennessee’s version of the Ohio Commercial Activity Tax, the Texas Margins Tax, and the Michigan Business Tax.

Apportionment of Sales through Tennessee Distribution Centers

In what appears to be a proposal unique to Tennessee, the bill would allow taxpayers using Tennessee distribution centers to use an alternative apportionment calculation for excise tax purposes. This is an effort to address recent defections of distribution centers, such as McKesson that relocated to Mississippi in 2010, and might also be an effort to reduce the tax burden caused by Amazon’s recent expansion of distributions in the state. It is unclear, however, how many taxpayers may benefit from this provision, as it is limited to taxpayers with gross sales in this state that exceed $1 billion. Even more interesting in this provision is a gross receipts tax that would apply to receipts removed from the apportionment factor, which would might offset the reduction in franchise and excise tax in some cases.

Intangible Expenses Paid to Affiliates

The bill also includes a modification to the intangible holding company expense deduction application process. The process to claim deductions for intangible expenses paid to affiliates remains unchanged, but under the proposals in the bill, a taxpayer must prove by clear and convincing evidence that the Commissioner’s determination to deny an application was incorrect. This would further heighten the standard currently in place to claim intangible expense deductions paid to affiliates and make it more difficult for taxpayers to maintain these positions.

This proposal will be debated in the Senate and House Finance committees over the coming weeks. The schedule for those committee meetings has not yet been set, but the schedule of the hearings will likely be a topic of discussion during the next Senate Finance Committee meeting on February 17, 2015, at 8:30.

The attorneys of Bradley Arant Boult Cummings will be closely monitoring these tax provisions. Please contact Brett Carter, Nathan Ridley, or other members of BABC’s Tennessee state and local tax practice with any questions you might have about the Revenue Modernization Act.