The Tennessee General Assembly has adopted the "Revenue Modernization Act" and sent it for signature by the Governor. Once enacted, the Act will impose a number of sweeping changes to Tennessee's tax laws, the vast majority of which will significantly increase the State's tax revenue, mostly by imposing an increased tax burden on companies with little to no physical presence in the State. For example, the Act adopts a market-based sourcing regime and triple-weighted sales factor apportionment formula for calculating the percentage of a company's net worth and net earnings subject to Tennessee's franchise and excise taxes. The Act also imposes a new sales tax on any transaction that allows a customer to access an online video game.
While these new provisions may be troubling for their own reasons, the more problematic aspect of the Revenue Modernization Act is that a number of its most prominent provisions are contrary to current Tennessee law or are so ambiguous that they are open for interpretation and debate by the Department of Revenue's auditors and taxpayers alike. This ambiguity is made worse by the fact that the Department has not provided any proposed regulations or guidance regarding the Act's new provisions. In particular, there are at least three components of the Revenue Modernization Act that practically guarantee litigation in the years to come: (1) expanded "economic" nexus for all taxes, (2) adoption of market-based sourcing for sales of services, and (3) imposition of a sales tax on cloud computing services.
Expanded Nexus Provisions
The Revenue Modernization Act adopts new nexus standards for each of the State's major taxes. With regard to the State's sales and use taxes, the Act adopts click-through nexus, under which an out of state seller will be presumed to have nexus with the State if the seller receives at least $10,000 from Tennessee residents as a result of referral relationships within the State.
For purposes of the franchise and excise taxes, as well as the gross receipts business tax, the Act adopts an economic nexus standard, with brightline factor presence thresholds. According to those thresholds, a company is deemed to have nexus with the State if it has over $500,000 in receipts attributable to the State or if more than 25% of its total receipts are attributable to Tennessee. Even if these thresholds are not met, the Act provides a more nebulous standard that would allow the State to claim a company has nexus for franchise and excise tax purposes whenever the company "has systematic and continuous business activity in this state that has produced gross receipts attributable to customers in this state."
It is difficult to understand how the General Assembly reconciles the adoption of these economic nexus provisions in light of the decision from the Tennessee Court of Appeals in J. C. Penney National Bank v. Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999). In that case, the Court specifically held that the Commerce Clause of the United States Constitution requires a company to have a physical presence in Tennessee before the State can impose the franchise and excise tax on the company. In other words, just 15 years ago, the Tennessee Court of Appeals rejected as unconstitutional exactly the kind of economic nexus standard that has now been adopted by the General Assembly.
With regard to this part of the Act, it is not a question of whether a company will file litigation to challenge the economic nexus standard but which company will get to the courthouse first. A constitutional challenge on this point is a virtual certainty. Likewise, given the controversy surrounding the adoption of click-through nexus standards for sales taxes across the country, it seems likely that those aspects of the Act will be challenged on constitutional grounds as well. As a result, and even though the Act purports to adopt broader nexus standards, the real impact of those provisions – and whether any expansion of nexus has really occurred in Tennessee – will be determined in the courts of Tennessee over the next several years.
Adoption of Market-Based Sourcing (Sort of)
The Revenue Modernization Act adopted market-based sourcing for purposes of determining a taxpayer's Tennessee franchise and excise tax sales factor with regard to sales of services and all sales other than tangible personal property. This change was made with the intent of shifting the tax burden to out of state companies and, purportedly, to simplify the calculation of the sales factor by replacing the cost of performance standard with the theoretically easier to apply market-based sourcing provisions. In reality, the shift to market-based sourcing has likely only changed the nature of the debate, rather than reducing the amount of debate on this issue. For certain taxpayers, the Act has actually exacerbated the difficulty of calculating the sales factor for sales of services.
The market-based sourcing standard adopted in the Act is misleadingly simple on its surface. Under that standard, a sale will be attributed to Tennessee "if the taxpayer's market for the sale is in this state." As always, the devil is in the details. For instance, the statute provides that sales of services are attributed to Tennessee "if and to the extent the service is delivered to a location" in Tennessee. That standard might be easy to apply when sourcing sales of personal services or other services that are physically provided to a specific location, but then again, the cost of performance standard was also easy to apply in those circumstances. In the current digital economy, services are more frequently provided from a distance through the use of the internet, remotely located software, or other electronic means. For many of those services, there is no "place of delivery" because a customer can use or receive the benefit of the service wherever she happens to be located at the time. In these fairly standard circumstances, the new market-based sourcing provisions are just as open for debate as the previous cost of performance provisions, and there will almost certainly be litigation in an attempt to define the edges of these rules.
The Act does attempt to prevent these kind of disputes by providing that, if the market state cannot be determined under the specific rules provided in the statute, "the state or states of assignment shall be reasonably approximated." The statute then goes on to provide that, if the state or states of assignment cannot be reasonably approximated, the sales shall be excluded from the denominator and numerator of the sales factor altogether. These attempts to clarify this issue actually raise more questions than they resolve. Specifically, what test will be used to determine when the primary rules cannot be used and "reasonable approximation" is required? Who is authorized to make the determination that reasonable approximation is required – the taxpayer, the Department, or both? What standard will be used to determine whether an approximation is reasonable? Who has authority to decide whether an approximation is reasonable? Using a "reasonable approximation" approach, when – if ever – would it be permissible or required to source receipts from a single sale to more than one state? Will a determination that reasonable approximation is required or the method of approximation be subject to review and, if so, what is the standard of review? Each of these questions is currently up for debate and will need to be addressed through regulations or litigation in the coming years.
Finally, it is important to note that the Act did not actually eliminate cost of performance sourcing for sales of services altogether. "Qualified members" of a "qualified group" – defined as taxpayers making a threshold investment in the State and primarily engaged in telecommunications, internet, satellite television, or cable television businesses – are required to calculate their sales factors by using both the cost of performance methodology and the market-based sourcing methodology and then averaging those two figures together. As a result, for these taxpayers, sourcing sales of their services for purposes of calculating their Tennessee sales factors is even more complex under the Act than under the prior cost of performance methodology. Obviously, increased complexity means increased room for dispute, and given the disputes that have taken place in states across the country with regard to applying the cost of performance methodology to the very businesses required to use the hybrid sourcing approach under the Act, the new sourcing regime seems certain to result in additional litigation on this issue as well.
Sales Tax on Cloud Computing
The one provision in the Revenue Modernization Act that will impact Tennessee businesses at least as significantly as out of state businesses is the new imposition of sales and use tax on cloud computing services. Under the Act, taxable use of computer software is expanded to include "access and use of software that remains in the possession of the dealer who provides the software or in the possession of a third party on behalf of such dealer." For emphasis, the Act explains that, if a customer accesses software from a location in Tennessee "as indicated by the residential street address or the primary business address of the customer," such access "shall be deemed equivalent to the sale or licensing of the software and electronic delivery of the software for use in this state."
While this language appears to bring cloud computing services – sometimes referred to as software as a service – within the scope of Tennessee’s sales and use taxes, the Department has consistently stated that it does not intend to impose a new tax on any services that were previously not subject to Tennessee sales or use tax. In fact, the Act expressly states that nothing in this provision "shall be construed to impose a tax on any services that are not currently subject to tax" and identifies several services – such as "information or data processing services," "payment or transaction processing services," and "billing and collection services" – as examples of nontaxable services. Notably, however, the General Assembly did not include the broader concepts of software as a service or cloud computing in the list of nontaxable services. This seems odd at best considering the Department’s repeated rulings that such services are not taxable under the prior law. See Tenn. Rev. Ruling 07-35;accord Tenn. Rev. Ruling 11-21; Tenn. Rev. Ruling 11-58.
The failure to include cloud computing in the list of nontaxable services forecasts the disputes that are likely to exist on this issue for years to come. Obviously, most cloud computing services rely on software to provide their services to customers. As a result, whether the transaction is taxable under the Act will depend on how the service is characterized. If the service is characterized as a customer acquiring access to software held at a remote location, the transaction will be subject to the tax as long as the customer is located in Tennessee. On the other hand, if the transaction is characterized as the provision of a service, it will not be subject to tax. It is pretty easy to predict which characterization the Department will adopt and which characterization taxpayers will adopt in the vast majority of cases. As a result, this provision in the Act appears to set the stage for repeated disputes and litigation on the proper characterization of each cloud computing transaction.
In this way, the new tax on cloud computing services resembles Tennessee's struggles with the tax on "telecommunications" services, which has resulted in at least seven cases before the Tennessee Court of Appeals focused on whether the primary purpose of the specific service at issue is taxable telecommunications or not. Unless they are willing to simply concede to the Department's position on this issue, providers of cloud computing services can expect similar disputes and the possibility of litigation in Tennessee regarding the imposition of taxes on "the cloud" under the Revenue Modernization Act.