Source: https://www.reedsmith.com/en/perspectives/2017/08/massachusetts-state-tax-developments
Timestamp: 2019-04-21 04:06:42+00:00

Document:
Welcome to the latest Reed Smith update on recent developments in Massachusetts state tax.
The latest in Massachusetts tax controversy.
The Department defines software as “tangible personal property”; can taxpayers include the value of software in property factor for corporate excise tax purposes?
The draft nexus regulations issued by the Department generated significant coverage for sales tax purposes (see alert here and additional coverage below), but there are potential implications for the corporate excise tax as well. For example, the Department’s reasoning could impact the treatment of software for purposes of computing a taxpayer’s property factor.
When computing their property factor, taxpayers are required to include the value of their real and tangible personal property.1 While the statute does not indicate whether software is included in the definition of “tangible personal property,” the Department’s nexus analysis would support the conclusion that software is tangible personal property, and the value of software is included in the factor.
If software is considered tangible personal property at common law, this certainly raises a question of legislative intent behind the current version of the apportionment statute (G.L. c. 63, § 38). When interpreting technical words and phrases in a statute, the Legislature is presumed to intend to use the specific legal meaning those words and phrases may have acquired.4 If tangible personal property is commonly understood to include software, the fact that the Legislature did not exclude software from the definition of tangible personal property would indicate that it intended for taxpayers to include the value of software in the property factor.
Including software in the property factor raises interesting questions regarding both sourcing and valuation. Taxpayers with significant internally developed or purchased software should review whether the value of its software has been included in their property factor, and if not, the potential impact.
Is the Department’s market-based sourcing regulation treatment of software valid? Another question raised by the Department’s assertion that software constitutes tangible personal property is its treatment of software for sales factor purposes.
As with the property factor, the sales factor apportionment statute does not indicate whether “tangible personal property” includes software. However, the Department’s market-based sourcing regulations take the position that electronically delivered software should be treated as an intangible or a service.
If software is commonly understood to be tangible personal property, this would call into question the validity of the Department’s interpretation of the sales factor statute in the regulation.
Sourcing software as tangible personal property would create significant refund opportunities for certain taxpayers that license hosted software to third-parties and other software providers. It would also impact whether those taxpayers are subject to the throwout rules that apply for services and intangibles, or the throwback rules that apply to sales of tangible personal property.
REMIC Excess Inclusion Income - Is It Included in Net Income?
Corporations and financial institutions that hold REMIC residual interests may have a Massachusetts corporate excise tax refund opportunity.
REMICs are essentially pools of mortgages that are taxed on a pass-through basis for federal income tax purposes. Interests in REMICs fall into two general categories: regular interests and residual interests. Typically, the holders of the REMIC residual interests are not entitled to any payments with respect to their interests until the regular interests have been fully satisfied. However, under the federal income tax rules governing REMICs, residual interest holders may still be required to recognize income in years in which they receive no payments with respect to their interests. This “phantom” income recognition is referred to as “excess inclusion income”.
Mechanically, excess inclusion income is reported as an annual “true up” to the federal taxable income of a residual interest holder. Thus, REMIC residual interest holders are instructed that the taxable income they report on Line 30 of their federal income tax return (Form 1120) for each year must be no less than the excess inclusion amount.
Many residual holders assume that excess inclusion income must also be included in net income for Massachusetts corporate income tax purposes. However, it is not clear that this treatment is correct.
Second, the Massachusetts courts have long viewed the authorization for the imposition of an income tax in Article 44 of the Amendments to the Massachusetts Constitution as limited to taxes imposed on “true” income. Thus, in several cases, the Supreme Judicial Court (“SJC”) has found taxes to be invalid to the extent imposed on “fictional” or “paper” income.8 Excess inclusion income would seem to fall squarely within the scope of fictional income—because it can be recognized by a residual interest holder independent of any distribution, disposition or other realization event.
Net worth deductions for obligations to any affiliate that is classified as debt on the company’s books and records.
A recently resolved appeal at the Appellate Tax Board highlights the issues facing taxpayers with obligations to foreign affiliates. In this appeal, members of the affiliated group borrowed funds from a Hungarian affiliate and deducted interest paid to the affiliate in computing the group’s combined income. The group claimed an exception to addback on interest paid to the Hungarian affiliate because Hungary has a comprehensive tax treaty with the United States; the Hungarian affiliate was not a controlled foreign corporation; and the interest was deductible for federal income tax purposes. The taxpayer alleged that there was valid business purpose, and the loan terms were at arm’s length. The debtor entity also deducted the value of the loan to the affiliate when computing net worth.
At audit, the Department challenged the treatment of the intercompany debt. First, the Department argued that the intercompany loan from the Hungarian affiliate was not “true debt.” As a result, no deduction was allowed for the interest paid to the Hungarian affiliate for purposes of computing the group’s combined income, and the obligation was not treated as a liability for purposes of computing net worth. Second, the Department asserted that even if the loan constituted “true debt,” the interest was not deductible because the interest did not qualify for an exception to Massachusetts’ addback for interest paid to related entities.
While this case was eventually resolved before trial, the taxpayer was first required to appeal the adjustments relating to its intercompany debt all the way to the Appellate Tax Board. The case illustrates that even taxpayers with seemingly strong facts supporting an addback exception and deduction for net worth related to intercompany interest should expect pushback at audit, and therefore, should be sure to maintain sufficient documentation to show that an intercompany obligation is true debt, and that any interest paid to a foreign affiliate is eligible for an addback exception.
Can a Department auditor reduce a taxpayer’s deduction for a net operating loss (“NOL”) carryforward, even if the NOL was generated in a tax year that is closed under the statute of limitations? This question is the subject of an appeal currently pending at the ATB.
The appeal involves a telecommunications company that was audited for the 2007 – 2009 tax years. The taxpayer had an NOL carryforward that it applied to reduce Massachusetts taxable income for years during the audit period. As part of the audit, the Department disallowed the taxpayer’s deductions for interest paid to affiliates under a cash management system, increasing the taxpayer’s income subject to tax. But the Department then went a step further. According to the taxpayer’s petition, the Department also reviewed the taxpayer’s interest deductions for the years in which the taxpayer generated the NOL carryforward deducted in the years included in the audit period. The Department disallowed the interest deductions claimed for payments to affiliates under the cash management system for these otherwise closed years, resulting in a reduction to the taxpayer’s claimed deduction for NOL carryforwards during the years included in the audit. In effect, the Department conducted an audit of a year that would otherwise have been closed by statute, in order to make adjustments that could be carried forward to open tax years.
The taxpayer is arguing that the adjustments to its NOL carryforwards are invalid, in part, because the Department does not have the authority to revise its net income (or loss) for years that are otherwise closed by the statute of limitations.
Opportunity for taxpayers: This case should serve as a reminder to taxpayers under audit or filing a refund claim to consider whether they have additional issues that could create or increase an NOL in a prior year, which could then be carried forward and used in the year that is the subject of the audit or refund claim, even if the prior year would otherwise be outside the statute of limitations.
For example, suppose a taxpayer faces an audit adjustment for the 2012 tax year. However, for the 2008 tax year (a year for which the limitations period for filing a refund claim has closed), the taxpayer erroneously added back interest paid to an affiliate for which an exception to add back was available. If the exception had been claimed, the interest deduction would have resulted in an NOL that would have been available for carryforward to the 2012 tax year. When appealing the 2012 tax year assessment, the taxpayer should consider both challenging the audit adjustment for the 2012 tax year and arguing for an increase in its NOL carryforward from the 2008 tax year as an offset issue.
Closing agreements can address NOL carryovers: This case should also serve as a reminder to taxpayers settling an audit or appeal through a closing agreement to carefully review how NOL carryforwards are addressed in the agreement.
In many cases, a closing agreement can address NOLs that are carried forward to years beyond those covered by the agreement (especially for unitary combined filing tax years, where the various members of a unitary group may have “siloed” NOLs). Our experience is that the Department, in some cases, is open to including a provision in a closing agreement that specifies the amount of NOLs available for carryforward out of the years covered by the closing agreement on an entity-by-entity basis. This type of agreement provides certainty to both the Department and the taxpayer regarding the total amount of net operating losses that can be carried forward.
Taxpayers should consider their NOL situation carefully before entering into a closing agreement, and consider whether it is beneficial to request an agreement that specifies the amount of NOL carryforwards or that is silent on the issue.
In a recent appeal at the ATB, a taxpayer challenged the Department’s assertion that the creation and sale of intangible property is a qualified manufacturing activity subjecting the taxpayer to single-factor apportionment. The taxpayer alleged the Department’s policy has been to require that the new product produced by a manufacturing corporation be “tangible” property. Thus, because the taxpayer only creates intangible property for sale, it argued that it cannot be a manufacturing corporation.
The case is particularly interesting because it involved an audit adjustment to the apportionment of a corporation that, by itself, did not create any tangible or intangible property. The tax years at issue were after the adoption of combined reporting. The combined reporting regulations promulgated in 2009 include special rules for determining whether members of a combined group are classified as manufacturing corporations, when the members are involved in intercompany transactions with other group members. If a member of the combined group purchases property or services from an affiliated member for resale to a third-party, that sales company determines whether it is classified as a manufacturing corporation by looking to both its own activities and those of the affiliated member. This rule can have a significant impact if a corporation acting as a sales company for affiliated member engaged in manufacturing has a Massachusetts payroll and/or property factor that differs significantly from its Massachusetts sales factor.
Refund opportunity for resale of intangibles: This appeal illustrates the broad scope of the manufacturing classification in Massachusetts—including its application to corporations producing intangibles. Any Massachusetts-based corporation that creates intangible property should consider whether it is eligible to apportion its income as a manufacturer if that would benefit the company—regardless of whether the intangible property created by the corporation is sold to an affiliate or a third-party.
Regulatory overreach? The appeal also raises the question of whether the Department had the authority to promulgate its special manufacturing rules for combined groups. The Department has indicated that its regulations allowing a business corporation to be classified as a manufacturing corporation based, in part, on the activities of its affiliated member are intended to prevent “distortion.” 830 CMR 63.32B.2(7)(g)(2). This would seem to be an exercise of the Department’s alternative apportionment authority under G.L. c. 63 § 38(j). That authority is limited to situations where the standard apportionment rules result in the apportionment of income in a manner not “reasonably adapted to approximate the net income derived from business carried on within this commonwealth.” Given that the statutory apportionment formula for business corporations that are not classified as manufacturers is a three-factor formula with a double-weighted sales factor, it would seem that the alternative formula adopted by the Department—requiring the single sales factor applied to manufacturers—would be more likely to result in distortion if the standard statutory apportionment formula is viewed as the benchmark.
Several sales tax refund appeals involving multiple points of use sourcing for software have been filed at the ATB over the past year. Each of the appeals involve purchases of software billed or delivered to a purchaser’s Massachusetts address. In each case, the vendor charged Massachusetts sales tax on the full sales price and remitted the tax to Massachusetts. The software, however, was ultimately accessed and used by employees of the purchaser located outside of Massachusetts. In each case, the vendors are requesting refunds on behalf of the purchasers for sales tax paid on the portion of the purchase price attributable to the out-of-state users.
These cases follow two related appeals involving multiple points of use sourcing that were recently decided by the ATB. In the recently-decided appeals, the taxpayer challenged the Department’s authority to deny refund claims based on multiple points of use by requiring taxpayers to submit any multiple points of use exemption certificates at the time of purchase. On May 22, 2017, the ATB issued decisions in favor of the Department in these cases. Findings of Fact and Report were requested but have not yet been published.
Further details regarding the issue can be found in our previous updates here and here.
Refund opportunity: These cases highlight a continued refund opportunity for taxpayers that have purchased software that was billed to a Massachusetts address and paid Massachusetts sales tax on the full purchase price.
If the software is used, even in part, by employees located outside of Massachusetts, the taxpayer may be entitled to a refund of a portion of the Massachusetts sales tax paid—even if the software is located in Massachusetts and remotely accessed by out-of-state customers.
Preserving additional issues: In addition to raising the multiple points of use issue, taxpayers should closely review the nature of the software transaction to determine whether additional issues may apply.
For example, taxpayers purchasing software as a service or cloud computing products may be able to argue that their purchases are properly classified as the purchase of service—not software—and that the purchase is exempt from tax regardless of the location of use.
And if the software is remotely accessed, there is recently settled and ongoing litigation on whether a variety of software products that are remotely accessed over the internet can be subject to tax. For more information on these appeals, see our prior alert here.
Massachusetts is the latest state seeking to impose sales tax collection obligations on remote sellers lacking the in-state contacts that have traditionally been viewed as constituting a “physical presence.” However, the Massachusetts approach differs significantly from the “Kill Quill” bills that have been passed in South Dakota and other states around the country. The Department of Revenue believes that most remote internet vendors already have sufficient contacts with Massachusetts to satisfy the physical presence requirement under Quill, and are obligated to collect Massachusetts sales tax regardless of whether Quill is overturned.
In our view, by arguing that most remote internet vendors already have contacts with the Commonwealth that satisfy the physical presence requirement of Quill, the Massachusetts’ approach potentially poses an even greater threat to remote sellers than the “Kill Quill” statutes because (1) its effectiveness is not contingent on the U.S. Supreme Court actually granting certiorari in a nexus case and deciding it in a manner that would overturn Quill; and (2) it could mire any vendor seeking to challenge constitutionality of the regulation “as applied” in extensive discovery and litigation without resulting in an outcome that would provide meaningful guidance for other vendors.
Provision of additional services beyond delivery.
The internet vendor completed 100 or more transactions that were delivered to Massachusetts.
Broader Reach than Directive 17-1?: The proposed regulation appears have a slightly broader scope than the Directive. The Directive asserted that “ownership and use” of software in Massachusetts constituted physical presence in Massachusetts. In contrast, the proposed regulation seems to go further by asserting that a vendor could have Massachusetts nexus based merely on having a “property interest” or “use” of software in Massachusetts.
interest in software (including cookies) located on a computer in Massachusetts, it could still have nexus with Massachusetts as a result of its use of software owned by others on a computer located in Commonwealth.
For further discussion regarding the constitutional implications of the proposed regulation, including potential challenges under the Internet Tax Freedom Act, see our prior alert here.
The Department has released an updated version of its Audit Manual that includes a revised section that reflect changes to the amended return and abatement process. Specifically, the updated version reflects that Form CA-6, Application for Abatement/Amended Return, is no longer in use as of October 31, 2016. Taxpayers seeking to challenge a deficiency or penalty assessment must now use Form ABT. Taxpayers seeking to a refund are now required to follow the same procedures as filing original tax returns.
The Department adopted a revised alternative apportionment regulation, 830 CMR 63.42.1, on February 24, 2017.
Under the new regulation, a taxpayer must file a request for alternative apportionment when it files its tax return. However, even if a timely request for alternative apportionment is submitted, the taxpayer must still pay tax computed based on the statutory apportionment rules. If the Department grants the taxpayer’s request for alternative apportionment, then the taxpayer must file a refund claim using the approved alternative apportionment method.
The alternative apportionment regulation sets a higher bar for a taxpayer than for the Commissioner in asserting the need for alternative apportionment. A taxpayer seeking to use an alternative apportionment method must show by “clear and cogent evidence that the income attributed to Massachusetts using statutory apportionment does not fairly represent the extent of the [taxpayer’s Massachusetts business activity].” On the other hand, the regulation provides the Department may assert the need to use an alternative apportionment method based on the “Commissioner’s judgment.” There may be an opportunity to challenge the validity of these standards. The alternative apportionment statute, G.L. c. 63 § 42, does not contemplate different standards for the taxpayer and Commissioner. As such, the regulation may be invalid as contrary to Massachusetts statute.
If you believe your business is entitled to use an alternative apportionment method, or if the Department asserts the need to use an alternative apportionment as part of an audit of your business’ returns, Reed Smith’s team of lawyers is available to discuss potential challenges to the new regulation.
On July 18, 2017, Massachusetts Governor Charlie Baker announced he would be appointing Commissioner of Revenue Michael Heffernan as Secretary of Administration and Finance, effective August 14. The Secretary of Administration and Finance is a cabinet-level position that supervises the Department, among other agencies. At the time of his appointment as Secretary of Administration and Finance, Mr. Heffernan had been Commissioner for fifteen months. Chris Harding, who had been serving as Mr. Heffernan’s Chief of Staff, succeeded him as Commissioner. Mr. Harding joined the Department in 2016 from a leadership position in private industry. Mr. Harding is the third Commissioner to lead the Department in the last two years.
During the 2018 general election, Massachusetts taxpayers will have the opportunity to vote on a ballot measure to impose a four percent surtax on individuals with annual incomes over $1 million—the so-called “millionaires’ tax”. Supporters argue it would raise an additional $1.9 billion per year to be spent on public education and transportation infrastructure. If the measure passes, Massachusetts would join California, New York, and the District of Columbia in imposing a higher tax rate on individuals with annual incomes of over $1 million.
Effective for tax years beginning after December 31, 2015, the due date for filing federal tax returns for C corporations and partnerships were revised. As shown in the table below, C Corporations now have an additional month—until April 15—to file their federal returns, whereas partnerships now have one month less to file their federal returns, which are now due March 15.
Subsequently, the Massachusetts Legislature enacted conforming legislation to change the due dates of Massachusetts returns to match the new federal due dates.17 However, the Massachusetts conformity legislation is only effective for tax returns due on or after January 1, 2018 (determined without regard to extensions), which creates a gap from the time the federal changes first take effect. Taxpayers with Massachusetts corporate excise tax returns due during this gap period will be required to file their Massachusetts returns before their corresponding federal income tax returns are due.
To help taxpayers with Massachusetts corporate excise tax returns due during this gap period, the Department has issued guidance agreeing to waive penalties assessed against any taxpayer with a corporate excise tax return during the gap period (i.e., a return for a tax year beginning after December 31, 2015 that is due on or before December 31, 2017), so long as the taxpayer files its corporate excise tax return within one month of the statutory due date or the statutory due date on extension. See Technical Information Release (“TIR”) 17-3 (March 2, 2017) and TIR 17-5 (May 31, 2017).
Two other cases involving corporate taxpayers are of note: one currently before the Supreme Judicial Court (“SJC”) on direct appellate review from the ATB; a second decided by the SJC in July.
Dental Service of Massachusetts, Inc. v. Commissioner of Revenue, Docket No. SJC-12346 involves a taxpayer’s challenge to the application of Massachusetts 2.28% excise tax on gross premiums received with respect to preferred provider arrangements.18 Dental Services is a non-profit dental services company located in Boston, and a member of Delta Dental Plans Association, a nationwide provider of dental insurance coverage. Dental Services contracted exclusively with employers headquartered in Massachusetts to provide insurance for their employees. However, the coverage provided by Dental Services extended to employees of these Massachusetts employers who were not Massachusetts residents.
The premium excise tax imposed on preferred provider arrangements is based on “gross premiums received during the preceding calendar year for covered persons residing in the commonwealth.” Dental Services is arguing the emphasized phrase includes individual plan subscribers (employees) who are residents of Massachusetts. Conversely, the Department is arguing that the phrase is limited to employers based in Massachusetts that contract to offer coverage to their employees. The ATB agreed with Dental Services’ interpretation of the scope of gross premiums subject to the tax.
If the SJC affirms the decision of the ATB, taxpayers subject to the preferred provider premiums excise tax may have a refund opportunity to the extent that they have been remitting tax based on premiums paid with respect to covered employees who are not Massachusetts residents.
In D&H Distributing Co. v. Commissioner of Revenue, Docket No. SJC-12260a, the SJC considered whether the taxpayer, a distributor located outside of Massachusetts, bore the burden of proving that a drop shipment to a Massachusetts customer was a “sale at retail” upon which the distributor had an obligation to collect Massachusetts sales or use tax. The transactions at issue were drop shipments where a Massachusetts customer purchased products from an out-of-state retailer, which then directed D&H Distributing (“D&H”) to package, label, and ship products to the Massachusetts customer. D&H had nexus with Massachusetts, but did not have warehouses in the Commonwealth. D&H collected sales tax on transactions where the retailer making a purchase on behalf of a customer had a Massachusetts billing address and the vendor did not provide D&H with a resale certificate.
The Department’s auditor identified drop-shipment transactions with a ship-to address in Massachusetts, but a bill-to address outside of Massachusetts, on which D&H had not collected Massachusetts sales tax. The auditor then eliminated those transactions where the order was placed with D&H by a retailer that D&H knew to have a presence in Massachusetts. The Department assessed Massachusetts sales and use tax on the remaining transactions.
See Directive 17-1: Requirement that Out-of-State Internet Vendors with Significant Massachusetts Sales Must Collect Sales or Use Tax (April 3, 2017, revoked).
Notice of Public Hearing, August 24, 2017, regarding 830 CMR 64H.1.7: Vendors Making Internet Sales.
G.L. c. 4, § 6, Third.
G.L. c. 63, §§ 1, 30.
See 2016 Instructions for Form 1120, U.S. Corporation Income Tax Return, p. 15.
See, e.g., 2016 Massachusetts Corporate Excise Return, Form 355, Instructions, p. 12.
See, e.g., Bill DeLuca Enterprises, Inc. v. Commissioner, 431 Mass. 314 (2000).
Directive 17-1 (Apr. 3, 2017); Directive 17-2 (June 28, 2017). Following the publication of Directive 17-1, a suit was brought by the American Catalog Mailers Association and NetChoice in the Superior Court of Suffolk County alleging, among other things, that the Directive violated the Massachusetts Administrative Procedure Act (“Massachusetts APA”) as a regulation issued without the required notice and comment period. On June 28, 2017, the same day that Directive 17-1 was withdrawn, the Superior Court issued a memorandum of decision and order granting summary judgment on the plaintiffs claim that Directive 17-1 was promulgated in a manner that violated the Massachusetts APA. American Catalog Mailers Association and NetChoice v. Heffernan, Superior Court Civil Action No. 2017-1772 BLS1 (June 28, 2017).
See Notice of Public Hearing, August 24, 2017, regarding 830 CMR 64H.1.7: Vendors Making Internet Sales, available here.
St. 2017, c. 5, §§ 11-14.
G.L. c. 176I, § 11.
G.L. c. 64H, § 1.
D&H Distributing Company v. C.I.R., 477 Mass. 538 (2017) (“we conclude that the commissioner and the board correctly determined that D & H was responsible as the vendor for collecting and remitting the sales tax due on products it sold to the out-of-State retailers and then delivered to consumers where it failed to meet its burden of proving that the retailers were engaged in business in Massachusetts.”).

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