Welcome to the latest Reed Smith Massachusetts State Tax Quarterly Update. In this update, we’ll look at the most recent developments in Massachusetts corporate tax, sales and use tax, and tax administration; and discuss some hot topics for 2015.
Market sourcing takes shape: Department of Revenue releases final market sourcing regulations On January 2, 2015, the Department of Revenue (“Department”) released final revised apportionment regulations implementing Massachusetts’ new market sourcing and throwout rules that apply to sales, other than sales of tangible personal property.1 The regulations are effective for tax years beginning on or after January 1, 2014. The final regulations closely resemble the working draft issued by the Department for practitioner comment last spring, and the proposed regulations issued October 30, 2014. The Department also reissued or revised six special industry apportionment regulations.
Overall, the final regulations are complex, highly technical, and thoughtfully drafted with numerous examples covering a variety of business receipts. Substantial changes from the proposed draft to the final regulation include: (1) reductions to the thresholds taxpayers must meet to qualify for safe harbors that permit the sourcing of receipts based on the customer’s billing address; (2) expansion of certain safe harbors to apply to professional services; (3) addition of specific bases for the commissioner to audit and adjust a taxpayer’s sourcing methodology; and (4) substantial revisions to the sourcing rules for transportation receipts.
For more details on the regulations and the general sourcing rules under the new regulations, click the following links for slides and recordings from Reed Smith’s teleseminars on the final regulations and the working draft. Additional reading on market sourcing can be found here and here.
Reed Smith Comments
Are professional services really so different? One interesting aspect of the regulations is that the Department has determined that, unlike all other service receipts, receipts from sales of professional services must be sourced in the first instance using rules of reasonable approximation.
This is a major deviation from the statute, which requires taxpayers to first source sales of services to the location of delivery. Rules of reasonable approximation are only supposed to apply if the location of delivery cannot be determined.2
Denying taxpayers the ability to source receipts based on the location of delivery can dramatically alter the sourcing of some receipts. Take brokerage services, for example. Under the current regulations, brokerage services are treated as a professional service, and brokerage fees are sourced to the purchaser location under rules of reasonable approximation. Assuming an individual customer is located in Massachusetts, the brokerage fees are 100% sourced to Massachusetts.3
But what if the taxpayer were permitted to follow the statutory language and source the brokerage fees to the location of delivery instead? Brokerage services would appear to be analogous to services delivered “on behalf” of a customer.4 To determine the “delivery” location of services delivered on behalf of a customer, the regulations ignore customer location. Instead, delivery occurs at the location where the taxpayer actually delivers the service. For example, if a New York broadcaster sells advertising placement to be shown only in the New York City market to a Massachusetts customer, the broadcaster ignores the fact the customer is located in Massachusetts, and the service is deemed to be delivered in New York City, where the advertisement is broadcast to an audience “on behalf” of the customer.5 In the same way, a broker that executes a trade on an exchange located in New York delivers its service “on behalf” of its Massachusetts customer at the location of the exchange, and should be able to source the sale to New York—not Massachusetts. Thus, under a “location of delivery” rule, the sourcing of brokerage fees could produce a completely different result from that produced under the regulation.
Our view is that the Department’s determination regarding professional services is contrary to the intent of the Legislature to source receipts to delivery location, and some taxpayers providing professional services will have a strong argument that they should be entitled to source their receipts using a method other than that outlined in the regulations.
Throwout? What throwout? While the Legislature included a throwout rule for sales sourced to a state where the taxpayer is not “subject to taxation,” Massachusetts has defined “subject to taxation” very broadly, and few, if any, taxpayers should end up throwing out receipts from sales of services or intangibles on the basis that the receipts are sourced to a state where they are not subject to taxation.
Even if a corporation does not pay income tax in a particular state or foreign jurisdiction, before applying throwout to sales into that state, it should consider:
(1) whether that jurisdiction could impose tax on the corporation’s income based on economic nexus principles, even if the jurisdiction has not actually adopted an economic nexus standard;
(2) whether the corporation would be included in a unitary combined group in the jurisdiction, even if the state has not adopted unitary combined reporting; or
(3) whether the corporation would be subject to tax on its income in the jurisdiction if the state applied Massachusetts law.
If the answer to any of these questions is yes, then the corporation should not have to throwout any receipts sourced to that jurisdiction on the basis that it is not subject to tax.
One change we didn’t see: Despite repeated taxpayer comments in opposition, the Department ultimately chose to keep a provision that limits taxpayers’ ability to file amended returns and applications for abatement changing their sourcing methodology.6 Under the final regulations, if a taxpayer “properly” assigns sales to a particular state, that taxpayer cannot later file an amended return or application for abatement changing its sourcing methodology, except to correct “factual” or “calculation” errors.
How the Department applies this provision going forward will be an issue to watch. However, when the Massachusetts Legislature adopted market-based sourcing rules, it did not amend the statute governing applications for abatement. Therefore, our continued view is that the Department has exceeded its statutory authority by including this provision in the regulations, and that taxpayers seeking to change their sourcing methodology through an amended return remain entitled to do so.
Supreme Judicial Court upholds sourcing of securitization entity’s loans to commercial domicile Upholding a determination of the Appellate Tax Board (“ATB”), the Massachusetts Supreme Judicial Court held that a securitization entity was required to source 100 percent of the value of its loan portfolio to its commercial domicile for purposes of computing its property apportionment factor.7
For financial institutions, a loan is included in the property factor and sourced to the regular place of business where the preponderance of the corporation’s "SINAA"8 activities occur with respect to the loan. Gate Holdings (“Gate”) purchased and securitized education loans, but did not originate or service any of the loans in its portfolio. The court upheld the ATB’s determination that because Gate did not originate or service the loans, it had no SINAA factors. Therefore, all of the loans were sourced to Gate’s commercial domicile—Massachusetts.
Reed Smith Comment
Opportunity for out-of-state taxpayers? Because Gate was commercially domiciled in Massachusetts, the ATB decision led to a particularly harsh result—a 100 percent property factor. However, the decision could be a positive development for similar taxpayers commercially domiciled outside Massachusetts.
Consider an entity similar to Gate that purchases and securitizes loans originated by an affiliated entity. The entity has a third party or another affiliate service the loans. Under the holding in First Marblehead, the entity would have no SINAA factors. If the entity is included in a Massachusetts combined group, the entity could arguably include the value of the loans in the computation of the group’s property factor denominator, but none of the value of the loans would be included in the entity’s numerator.
For more detail on the First Marblehead decision, including additional issues considered by the ATB but not argued on appeal, please see our prior update.
ATB finds nexus for biotechnology company owning drugs being studied in Massachusetts On November 17, 2014, the ATB promulgated its Findings of Fact and Report in Genentech, Inc. v. Commissioner9, in which the ATB held that a corporation doing business in Massachusetts was not entitled to claim the protection of P.L. 86-272 because it owned property in the commonwealth and, therefore, was subject to Massachusetts’ corporate excise tax. The corporation was a biotechnology company headquartered in California that developed and sold therapeutic drugs.
The corporation appealed an assessment of corporate excise tax, arguing that its activities in Massachusetts were limited to the solicitation of sales and, thus, were protected by P.L. 86-272. The ATB found that, for the years at issue, the corporation (1) shipped large quantities of drugs to a third-party manufacturer in Massachusetts that encapsulated the drugs and sent them back to the corporation ready for commercial sale; (2) sent drugs to third-party clinical researchers in Massachusetts, who conducted clinical trials in Massachusetts on the corporation’s behalf; and (3) owned machinery and equipment located in Massachusetts. The corporation retained title to the drugs throughout these research and manufacturing activities. The ATB found that, based on the continuous presence of the property owned by the corporation in Massachusetts, the corporation was subject to corporate excise tax in Massachusetts.
Reed Smith Comments
Clinical Trials, Detailing & Implications for P.L. 86-272: With respect to the clinical trials, the ATB did not attribute the activities of the third-party clinical researchers to Genentech—it focused only on Genentech’s ownership of the drugs used by the researchers. Further, the ATB did not view Genentech’s detailing activities as going beyond the protections of P.L. 86-272.
Thus, the decision suggests that a corporation can engage in detailing and engage third parties to conduct clinical trials in Massachusetts without losing P.L. 86-272 protection, as long as these activities can be structured in a way that does not involve the corporation holding title to inventory or other property in the commonwealth.
Additional Coverage: The appeal involved several issues; for more information on the case, please see our prior update.
Corporate tax amnesty to occur before June 30, 2015 On February 13, 2015, Gov. Charlie Baker signed legislation (House Bill 52), which is intended to close the projected budget deficit for the 2015 fiscal year. In addition to some spending cuts, the bill authorizes a corporate tax amnesty program, which would run during a two-month period ending on or prior to June 30, 2015.
The amnesty program would allow taxpayers to settle past-due tax liabilities within the two-month amnesty period, while automatically waiving certain penalties. The bill grants the commissioner the authority to determine the taxes to be included in the amnesty, but the corporate excise tax is required to be among the eligible taxes. This new amnesty program follows an amnesty program administered last fall for sales and use taxes, meals tax, income withholding, pass-through entity withholding, and some other tax types.
Reed Smith Comment
Limited Relief: Similar to the amnesty program enacted last fall, the corporate excise tax amnesty program will provide penalty relief only. While certain taxpayers will benefit from the penalty relief, the legislature passed on the opportunity to create a more robust, expansive amnesty program that would benefit and appeal to a greater number of taxpayers. Given the limited nature of the amnesty, it remains to be seen whether it will exceed the revenue estimates, in a manner similar to last fall’s amnesty.
Department issues directive 14-4, denying deductions to corporate taxpayers On December 16, 2014, the Department released Directive 14-4, which states that if a taxpayer elects to take a credit instead of a deduction for purposes of computing its federal tax liability, the taxpayer is prohibited from claiming that deduction for purposes of computing its Massachusetts tax liability.
The commonwealth defines “net income” as “gross income less the deductions, but not credits, allowable under the provisions of the Federal Internal Revenue Code.” In issuing the directive, the Department interpreted “net income” as being computed based on the exact deductions claimed for federal income tax purposes on a federal consolidated return, even if different deductions could have been elected on a separate company federal return.
Reed Smith Comments
Is the Department’s Position Consistent with Massachusetts’ Statutory Definition of “Net Income”? Massachusetts law provides that “net income” of a corporation is its gross income, less deductions “allowable under the provisions of the Federal Internal Revenue Code.”10 The deductions that the Department is disallowing with this directive are “allowable” deductions. The fact that they were not actually claimed on a federal income tax return does not cause them to not be “allowable” deductions.
Is the Department’s Position Consistent with the Statutory Provisions Governing the Massachusetts Research Credit?The directive also ignores the statute governing the Massachusetts research credit. This statute includes a provision stating that the Internal Revenue Code provision that disallows deductions for qualified research expenses when those expenses are used to claim a federal research credit does not apply in computing net income for Massachusetts purposes. See G.L. c. 63, § 38M(c).
Appellate Tax Board update: Are eFax emails taxable telecommunications services? Taxpayers continue to file appeals with the ATB on issues relating to the scope of Massachusetts sales tax on telecommunications services. (See here for our update on appeals involving the taxability of early termination fees.) The trend continues with a recent ATB petition alleging that, on audit, the Department has taken the position that the scope of taxable telecommunications services includes “eFax” services.
The appeal involves a vendor that receives faxes intended for its customers. The vendor converts each fax into a computer file and sends an email to the intended recipient of the fax with a copy of the file. The intended recipient can then view the file wherever they can access their email. In its petition to the ATB, the vendor alleges that the Department auditor classified these eFax services as taxable telecommunications services, and estimated the portion of the services to be sourced to Massachusetts based on the percentage of population in Massachusetts to the population through the United States as a whole.
The taxpayer is challenging the assessment on a variety of grounds, including (1) whether the eFax services provided by the vendor are non-taxable data processing or information services; (2) whether the assessment of sales tax on the eFax services violates the Internet Tax Freedom Act; and (3) whether the assessment is contrary to the Department’s own published guidance.
Reed Smith Comments
Effect on similar service providers? This appeal should be closely tracked by any company doing business in Massachusetts that provides any service whereby an electronic communication—fax, voicemail, video, etc.—is converted to a file format that the customer can access by email.
What about the sourcing? Even if eFax services are considered taxable telecommunications services, it is unclear whether the sourcing methodology used by the Department to compute the assessment meets the “two-out-of-three” test required by Goldberg v. Sweet to satisfy external consistency for fair apportionment under the Commerce Clause.11 InGoldberg, the U.S. Supreme Court upheld an Illinois tax on telecommunications services on the basis that the tax was imposed on telephone calls that (1) were charged to a service address in Illinois; and (2) either originated or terminated in Illinois. Massachusetts applies a similar test to determine which receipts from telecommunications services are sourced to Massachusetts (although Massachusetts captures some additional receipts by defaulting the sourcing of certain services to the customer billing address).
Determining the actual origination or termination location of an eFax service would likely be impossible for the vendor. (The Department allegedly approximated the portion of the eFax transmissions sourced to Massachusetts based on U.S. population data.) The impossibility of applying the sourcing required under Goldberg to this service would seem to indicate that the Legislature didn’t intend to include eFax services in the scope of the tax on telecommunications.
Massachusetts’ aggressive use tax policy on vehicles purchased out-of-state upheld by ATB in Regency Transportation On December 4, 2014, the ATB issued its Findings of Fact and Report in Regency Transportation, Inc. v. Commissioner12, in which the ATB held that the taxpayer – an interstate freight transportation company – was subject to Massachusetts use tax on vehicles purchased outside of Massachusetts, because those vehicles were stored and used in Massachusetts. The vehicles in question had all been purchased in states that either did not impose a sales tax or did not impose a sales tax on vehicles engaged in interstate commerce.
The taxpayer had argued that the vehicles were exempt from tax because they were engaged in interstate commerce (the taxpayer’s transportation business covered the entire Eastern United States), and that the imposition of the tax on the taxpayer failed to satisfy all four prongs of the test set forth by the United States Supreme Court in Complete Auto Transit, Inc. v. Brady.13 The taxpayer argued that the tax must be apportioned among all states in which the vehicles were used, because subjecting the entire purchase price of the vehicles to Massachusetts use tax resulted in the vehicles being taxed twice. The ATB rejected that argument, holding that the use tax need not be apportioned because the Massachusetts use tax scheme prevented double taxation by allowing a credit against the use tax for sales tax paid to other states.
Reed Smith Comment
ATB Abates Penalties for Reliance on Department Guidance: On the issue of penalties, the ATB ruled in the taxpayer’s favor. It held that the penalties assessed against the taxpayer should be waived because the taxpayer had relied on a letter ruling14 issued by the Department in 1980, which provided an exemption from use tax for certain purchases of vehicles bought outside of Massachusetts that entered the commonwealth for the first time while engaged in interstate commerce. The ATB noted that the letter ruling was based on regulations that ceased to be in effect in 1996, but held that the taxpayer’s reliance on the ruling was reasonable in light of the fact that the Department had continued to publish the outdated ruling. However, this reliance was not sufficient to defeat the Department’s assessment of tax.
ATB finds orthopedic braces are exempt from sales and use tax On October 24, 2014, the ATB issued its Findings of Fact and Report in Excel Orthopedic Specialists, Inc. v. Commissioner15, holding that orthopedic braces were exempt from sales and use tax. The ATB concluded that the braces were “individually designed, constructed or altered” to be used as a brace for a “particular crippled person” within the meaning of G.L. c. 64H, § 6(l).
The ATB ruled for the taxpayer, finding that each brace had a unique function and was individually fitted to each patient by a certified orthotics fitter. The fit was made by following a detailed set of instructions written by the prescribing physician, which set forth the type of brace required, the desired range of motion, the patient’s injury history, and the patient’s physical attributes. Accordingly, the ATB found the braces indistinguishable from the orthopedic foot braces the commissioner ruled were exempt in Letter Ruling 98-8. See here for prior coverage from www.MassachusettsSALT.com, including a copy of the decision.
Department issues directive governing the sale and use of direct mail promotional advertising materials Sales of direct promotional advertising materials distributed to residents of the commonwealth are exempt from sales and use tax. On October 20, 2014, the Department issued Directive 14-3 that provides guidance on that exemption.
Directive 14-3 provides that materials are exempt if they meet the following criteria:
- The materials contain discount coupons
- The materials are no longer than six pages
- The materials qualify as direct mail
- The materials are distributed by U.S. mail or common carrier
- The materials are distributed at no charge to the mailing recipient
- The materials are not mixed-use publications
The directive defines “direct mail” as material mailed directly to a specific or prospective customer that is listed in the sender’s mailing lists or database. “Coupon” is defined as a printed piece of paper, scan card, code, or other identifier that, upon presentation to a vendor, entitles a retail customer to receive a service or product for free or at a lower price.
Taxpayers take advantage of Department’s expedited settlement process The Department has recently stated that more than 70 taxpayers have applied to participate in the Department’s expedited settlement process. Taxpayers large and small have entered the program, including seven appeals with more than $1 million in dispute. The Department offers its expedited settlement process at the Office of Appeals. (Note: the Office of Appeals reserves the right to determine that a case is not appropriate for expedited settlement).
Reed Smith Comments
Timing is Everything: Taxpayers appealing an assessment to the Office of Appeals must request expedited settlement at the time they file their appeal. This is done by checking a box on the appeal form (Form DR-1). In addition, to be eligible for expedited settlement, a taxpayer must include the following with the Form DR-1: (1) a complete explanation of the facts and issues in dispute; (2) a specific proposal for settlement; and (3) all documentation necessary to support the settlement proposal. For pre-assessment appeals, taxpayers also must submit Form B-37 (Special Consent Extending the Time for Assessment of Taxes).16
Settlement Authority is Required: Taxpayers who request expedited settlement (or their representative) must be prepared to participate in a conference or hearing on an expedited basis, and must have binding authority to settle the dispute at the time of any conference or hearing.
Improving Process: In our experience, both the expedited settlement program and the Department’s early mediation program (see here for more information) are efficient and practical options for resolving disputes, including those that involve complex issues and large amounts in controversy. We view the adoption of these programs as a positive development in streamlining the appeal process for certain taxpayers. For additional information on these programs, or to discuss our experience, contact the authors of this update or see our prior alert here.
More things you should know:
Non-filer Amnesty Proposed: As part of his budget proposal for fiscal year 2016, Gov. Baker announced his intention to enact legislation authorizing a tax amnesty program for nonfilers to run throughout the entire 2016 fiscal year (July 1, 2015 through June 30, 2017). Businesses and individuals with Massachusetts tax liabilities that have not previously filed Massachusetts returns – regardless of whether they are known or unknown to the commonwealth – would be eligible to participate, as long as they have not yet received an assessment.
Commissioner Pitter to Step Down: On January 6, 2015, Amy Pitter announced that she would be resigning her position as Commissioner of Revenue. Commissioner Pitter remains in office, pending the appointment of a new commissioner by Gov. Baker, and has indicated that she will stay on for a period to assist with the transition of her successor.