The Tennessee Department of Revenue recently released several Letter Rulings analyzing various Tennessee tax issues, including the application of sales and use taxes to cloud collaboration services and software consulting services, the application of the Hall income tax to cash distributions received by an employee shareholder, and the availability of the franchise and excise tax industrial machinery credit. An analysis of these rulings and practice point comments are set forth below.
Cloud Collaboration Service Subject to Sales Tax
Ltr. Rul. 14-05 (Tenn. Dep’t of Revenue Aug. 25, 2014) – Posted Oct. 6, 2014
Facts: The taxpayer is a provider of comprehensive and integrated technology solutions that involve transfers of hardware, software, and value-added services. One of those services is a “cloud collaboration service,” which supplements and supports the operation of its customer’s telecommunications equipment. The cloud collaboration service facilitates the processing and routing of telephone calls and augments voice, video, messaging, presence, audio/web conferencing, and mobile capabilities. The use of these cloud-based applications eliminates the need for the customers to maintain hardware and software for the internal processing and routing of calls they receive.
The customers obtain their own telephone equipment and network connections for voice and Internet access from telephone and Internet access providers. The taxpayer owns and leases or licenses the hardware and software needed to facilitate the cloud collaboration service. The hardware is maintained by the taxpayer at its locations, and the software is not downloaded by the customer. The taxpayer remotely monitors performance and provides updates and troubleshooting.
The taxpayer charges a monthly fee under a customer service contract, which includes charges for hardware, software, virtual server instances, required storage, rack space, power and cooling, monitoring and management, and upgrades. Customers may also purchase add-on services, which are charged separately. The ruling addresses whether the cloud collaboration service is subject to Tennessee sales tax and, if so, how it is sourced.
Summary of Ruling:
- The taxpayer’s cloud collaboration service is subject to Tennessee sales tax as the sale of intrastate telecommunications and ancillary services.
- Where a sale of cloud collaboration service is made to a Tennessee customer, the sale is sourced to Tennessee if the customer primarily uses the service at a street address located in Tennessee.
- The taxpayer’s purchases, leases, and licenses of hardware and software are not sales for resale, because the taxpayer is considered the end user and consumer of the hardware and software in providing its services.
Discussion: The Department explains that the taxpayer’s cloud collaboration service is different from cloud computing services that are accessed by Tennessee consumers on servers located outside the state and are excluded from the definition of telecommunications services as “data processing and information services.” See Ltr. Rul. 13-12 (Tenn. Dep’t of Revenue Sept. 12, 2013). The distinction the Department relies on is based on the primary purpose of the cloud computing service, which is to access data and information stored on servers located outside the state; whereas, the primary purpose of the cloud collaboration service is to process and route telephone calls at the customer’s place of primary use.
Practice Point: The ruling is a reminder to companies that provide technology solutions for their customers that the Department routinely classifies and taxes emerging technologies under the telecommunications tax. There is a series of tax disputes in Tennessee involving the scope of the telecommunications tax, including cases involving check verification and Internet access. Technology businesses should carefully evaluate the services provided to determine whether the telecommunications tax applies. Taxing technology solutions through the telecommunications tax allows the Department to impose the tax based on the more favorable sourcing provisions to the State of using the location of the customer instead of where the underlying technology is downloaded.
Software Consulting Services Provided as Stand-Alone Services Generally Not Subject to Sales Tax
Ltr. Rul. 14-10 (Tenn. Dep’t of Revenue Oct. 13, 2014) – Posted Nov. 3, 2014
Facts: The taxpayer is a Tennessee-based consulting firm that is a reseller and certified service provider of software systems that integrate internal management information across an organization, including finance and accounting, manufacturing, sales and service, customer relationship, and other components. Software publishers develop, write, and distribute the software, with software maintenance contracts and licenses entered into directly between the taxpayer’s clients and the software publishers.
The taxpayer also offers a variety of consulting services to its clients, such as training, configuration, project management, client correspondence, data conversion, documentation, testing, and report writing. If a client purchases the software system as well as individualized consulting services, the taxpayer provides separate software and consulting service proposals and separate invoices. Consulting services are billed on an hourly basis.
Summary of Ruling:
The taxpayer’s consulting services, which generally are provided on a stand-alone basis, are not subject to Tennessee sales tax with the exception of the report-writing service that involves coding or programming. If, however, the consulting services are required to be included in the sales price of a taxable item or service, the consulting services may be subject to sales tax.
Discussion: The Department analyzes each type of consulting service provided by the taxpayer concluding that each of those services is not taxable on a stand-alone basis, with the possible exception of report writing. Where the transaction involves a combination of services, the totality of circumstances must be examined as to each client contract. For example, if one or more of the consulting services is “crucial,” “essential,” “necessary,” “consequential,” or “integral” to providing the taxable service – the sale of the software system – the consulting service would be taxable even if the fee for that service is separately stated. If, on the other hand, any of the consulting services are optional services that the client may purchase, they would not be taxable as part of the entire transaction.
Practice Point: This ruling is consistent with numerous rulings issued by the Department that focus on the relationship between nontaxable services and the taxable sale of computer software. To the extent the consulting or other related services are inseparable from the development of software, those services are bundled and taxed with the computer software. As the ruling illustrates, this is a fact-dependent analysis and the taxability of a transaction will hinge on various factors including the underlying contracts, course of dealings, invoicing of the sale, and the location of the download of computer software. Taxpayers should carefully review these factors and determine early on whether the transaction is taxable so that sales tax can be collected from its customers.
Cash Distributions Are Dividends Subject to Hall Income Tax
Ltr. Rul. 14-09 (Tenn. Dep’t of Revenue Oct. 6, 2014) – Posted Nov. 3, 2014
Facts: The taxpayer is described as a Tennessee resident who accepted an offer of employment with a corporation. As part of the employment agreement, the corporation provided the taxpayer with stock options vesting over time. The employee exercised his options and acquired shares in the corporation.
The corporation formed a subsidiary limited liability company and subsequently sold 25% of it to a third party. The corporation made cash distributions to its shareholders of the proceeds from the partial sale of the subsidiary limited liability company. The distributions did not reduce the number of the taxpayer’s shares or proportionate interest in the corporation. The corporation remains a going concern.
The question presented is whether the cash distributions are characterized as dividends for purposes of the Tennessee individual income (or Hall) tax and whether any portion of the distributions are properly considered return of capital and exempt from taxation.
Summary of Rulings:
- The cash distributions from the sale of the subsidiary limited liability company are properly characterized as dividends subject to Tennessee’s Hall income tax.
- No portion of the distributions is a return of capital that is exempt from the Hall income tax.
Discussion: The Department notes that while the Tennessee individual income tax provisions do not define the term “dividend,” the Tennessee Supreme Court has held that for purposes of the Hall income tax, “dividend” means the “recurrent return upon stock paid to stockholders by a going corporation in the ordinary course of business which does not reduce their stock holdings and leaves them in a position to enjoy future returns upon the same stock.” Dobson v. Huddleston, 863 S.W.2d 392, 396 (Tenn. 1993).
The Department further explains that the distributions are not exempt from the Hall income tax as return of capital. To qualify as exempt returns of capital, the value of the property invested by the shareholders must be the sole remaining value of the corporation. Cherry v. Farr, 2014 WL 1512811, at *4 (Tenn. Ct. App. April 15, 2014), perm. app. denied, (Tenn. Aug. 26, 2014). To the extent a corporation can continue to conduct business and has sufficient funds to make distributions without returning capital, the distribution does not reduce the value of the corporation below the value contributed by the shareholders.
Practice Point: This ruling relies on the recent Court of Appeals' decision in Cherry, which highlights the narrow construction of the exemption for return of capital. The treatment of distributions for federal income tax purposes is not controlling, and a taxpayer must show that a part of the shareholder’s investment is being returned and that the company’s capital is reduced as a result of the distribution. Taxpayers may want to consider structuring distributions as liquidations or partial liquidation, as such distributions generally are not subject to the Hall income tax. See Gallagher v. Butler, 378 S.W.2d 161 (Tenn. 1964).
Industrial Machinery Credit Not Available for Equipment Acquired Through Sale of Stock Treated as Sale of Assets
Ltr. Rul. 14-06 (Tenn. Dep’t of Revenue Aug. 25, 2014) – Posted Oct. 6, 2014
Facts: A parent corporation sold 100% of the stock of the taxpayer to the buyer. At the time of the sale, the taxpayer owned manufacturing assets that qualified as industrial machinery for Tennessee tax purposes. The buyer and seller elected to treat the stock sale as a sale of assets for federal income tax purposes under I.R.C. § 338(h)(10).
The question presented is whether the taxpayer can claim the industrial machinery credit for tax periods following the sale for Tennessee franchise and excise tax purposes with respect to the assets that the taxpayer was deemed to have acquired through the I.R.C. § 338(h)(10) election.
Summary of Ruling:
The taxpayer cannot claim the Tennessee franchise and excise tax industrial machinery credit with respect to the assets that the taxpayer was deemed to have acquired through the I.R.C. § 338(h)(10) election.
Discussion: The Department explained that in order for the taxpayer to qualify for the industrial machinery credit with respect to the assets acquired through an I.R.C. § 338(h)(10) election, the following requirements must be met: (1) the taxpayer must have purchased the assets during the tax period in which the credit was claimed; (2) the assets must be industrial machinery; and (3) the assets must be located in Tennessee. The Department concluded that the first requirement for the industrial machinery credit was not met under these facts because the taxpayer did not, for Tennessee tax purposes, purchase the assets as a result of the sale.
Practice Point: This is a reminder that Tennessee franchise and excise tax laws are not controlled by federal income tax laws, regulations, and elections. SeeOak Ridge Land Co. v. Roberts, 2012 WL 5962002, *3 (Tenn. Ct. App. Nov. 29, 2012), perm. app. denied, (Tenn. April 9, 2013); Little Six Corp. v. Johnson, 1999 WL 336308, at *3 (Tenn. Ct. App. May 28, 1999). Accordingly, taxpayers should carefully consider state and local tax issues in structuring transactions to maximize the availability of tax attributes.