New Illinois and Chicago tax rules pose challenges.
On a separate Illinois tax matter, some businesses may fall within the scope of the City of Chicago's personal property lease transaction tax and amusement tax. New safe-harbor revenue thresholds for these city taxes go into effect July 1, 2021.
This item discusses these recent tax developments in Illinois and Chicago.
Illinois ROT: New economic nexus rules
On Jan. 1 of this year, new ROT provisions took effect that govern economic nexus, marketplace facilitator responsibility, and sourcing (Leveling the Playing Field for Illinois Retail Act, Ill. Public Act 101-0031 and Ill. Public Act 101-0604). These changes significantly affect remote retailers' sales into the state.
Under the economic nexus provisions, remote retailers are subject to state and local ROT remittance responsibilities if, during the previous 12-month period, they either (1) had gross receipts from the sale of tangible personal property to Illinois purchasers of $100,000 or more; or (2) entered into 200 or more separate transactions for the sale of tangible personal property to purchasers in Illinois (35 Ill. Comp. Stat. 120/2(b)). Remote retailers were already responsible for collecting and remitting state use tax when exceeding either threshold.
To determine whether remote retailers meet either nexus threshold, sales of services are not included. Additionally, certain sales of tangible personal property are also excluded, including (1) sales of tangible personal property made through a marketplace facilitator; (2) sales for resale; and (3) sales of titled property (e.g., motor vehicles, watercraft) (Ill. Admin. Code tit. 86, [section]131.120(b)). Importantly, sales of exempt items are included for purposes of calculating the thresholds (id.).
Such a broad swath of exclusions is uncommon among state economic nexus provisions. Texas and New York both require remote sellers to include facilitated sales and sales for resale when evaluating nexus thresholds. California also requires the inclusion of facilitated sales but does not require remote retailers making only sales for resale into California to register for use tax collection, though a single retail sale will trigger the addition of the sales for resale back into the nexus determination.
Marketplace facilitators: When marketplace facilitators perform the required computation to determine whether they are subject to the Illinois economic nexus threshold, they must combine gross receipts from both their own sales and facilitated sales, and also must count individual transactions for both. If a marketplace facilitator has economic nexus, it is the retailer of facilitated sales of tangible personal property to Illinois purchasers and is responsible for reporting and paying ROT for those sales (35 Ill. Comp. Stat. 120/2(c)).
Importantly, affiliates of a marketplace facilitator are not marketplace sellers. They must register with the Illinois Department of Revenue (DOR) and collect and remit tax on sales facilitated by the affiliated marketplace facilitator (Ill. Admin. Code tit. 86, [section]131.130(e)). An affiliate is (1) an entity with direct or indirect ownership of more than 5% in the other person; or (2) related to the other person because a third person, or a group of third persons who are affiliated with each other, holds a direct or indirect ownership interest of more than 5% in the related person (id. at [section]131.105).
Certified service providers: Remote retailers may, instead of registering with the DOR, enter into a tax remittance agreement with a certified service provider (CSP). The CSP registers, as agent, for the remote retailer, files returns, and makes tax payments (Ill. Admin. Code tit. 86, [section]131.125(a)). If the DOR assesses a CSP for failure to remit the correct amount of tax and the CSP demonstrates that its failure to correctly remit tax resulted from a good-faith reliance on incorrect or insufficient information provided by a remote retailer, the DOR instead will assess the remote retailer (id. at [section]131.160(d)).
Sourcing: Retailers face several sourcing scenarios under the new regulations. The general rule is that when the selling activities are performed in Illinois, state and local ROT is due at that location (i.e., origin sourcing).
Starting on Jan. 1, 2021, if the retailer does not have a physical presence in the state, but it exceeds the state's economic nexus threshold, then it is responsible to report and pay state and local ROT at the rate in effect at the destination (i.e., destination sourcing). However, if the inventory is held and the selling activities are performed outside Illinois, but the retailer has a physical presence in the state, such as employees going into the state to service equipment, then the retailer is subject to the 6.25% state use tax.
Marketplace facilitators simply owe ROT at the destination location for facilitated sales, if the marketplace seller is identified to purchasers in the marketplace as the party on whose behalf the tangible personal property is being sold.
For a marketplace facilitator's own sales and for sales by an unidentified marketplace seller, a marketplace facilitator may owe ROT at destination or at origin. For sales fulfilled from within Illinois, the marketplace facilitator will report and pay state and local ROT at the rate in effect at the fulfillment location. For sales fulfilled from outside Illinois, the marketplace facilitator will collect state and local ROT at the rate in effect at the delivery location.
Potential legal challenges: A potential legal challenge may be mounted against the rule requiring remote retailers to pay ROT at the destination of the sale, while retailers with a physical presence in Illinois are required to pay ROT or use tax at the origin.
One basis for a challenge to the state's new remote retailer rule could be that the lower tax burden (remitting only the 6.25% state use tax) on the remote sales of retailers with an in-state presence, compared with a remote retailer that also must remit local ROT (combined rates can reach 11%) is unconstitutional. Specifically, the rule arguably is a violation of the Uniformity Clause of the Illinois Constitution, which requires that, with respect to "any law classifying the subjects or objects of non-property taxes or fees, the classes shall be reasonable and the subjects and objects within each class shall be taxed uniformly" (emphasis added) (Ill. Const. Art. IX, [section]2).
In 1967, the service occupation tax (SOT), previously imposed only on the cost of tangible personal property transferred incident to the sale of a service, was expanded to also be imposed on the sale of services by four categories of "servicemen," including those repairing tangible personal property and selling pharmaceuticals as a registered pharmacist. Affected servicemen filed suit, and the Illinois Supreme Court held that with regard to the state Uniformity Clause, any "classifications must be based upon real and substantial differences between persons taxed and those not taxed" (Fiorito v. Jones, 39 Ill. 2d 531, 535-36 (1968)). The court found that the majority of servicemen excluded from the new tax base appeared to possess the same relevant attributes as those subject to the expanded SOT: They rendered a service that involved the incidental transfer of tangible personal property. Therefore, the court found no "real or reasonable difference between the classes subject to taxation and those excluded" and held the expansion was unconstitutional (id. at 540). Because a remote retailer collecting state and local ROT at destination and an in-state retailer collecting state use tax are identical in all respects other than their physical presence, a court may conclude the additional burden placed on remote retailers violates the Illinois Constitution.
Chicago's PPLTT and amusement tax
In addition to changes at the state level described above, Chicago's Department of Finance (DOF) issued an informational bulletin, effective July 1, 2021, that establishes safe-harbor revenue thresholds for the city's personal property lease transaction tax (PPLTT) and its amusement tax, incorporating Wayfair-type principles.
The PPLTT is imposed on (1) the lease or rental in the city of personal property; and (2) the privilege of using in the city personal property that is leased or rented outside the city (Chicago Mun. Code [section]3-32-030(A)). Notably, a "lease" includes "nonpossessory computer leases" in which a person obtains access to a provider's computer and uses the computer and its software to input, modify, or retrieve data or information (id., [section]3-32-020(K)). This results in an array of cloud computing, software as a service, and other cloud-based infrastructure-type services being subject to the tax.
The amusement tax is imposed on charges paid by patrons of every amusement in the city, including exhibitions and performances for entertainment purposes; recreational activity, such as carnivals and bowling; and paid television programming (Chicago Mun. Code [section]4-156-020(A)). After a 2015 ruling, the amusement tax is also applied to electronically delivered amusements, such as streamed or rented movies, shows, music, and games (City of Chicago Dep't of Fin., Amusement Tax Ruling (June 9, 2015)). The tax is not imposed on permanently downloaded content or content delivered via radio or satellite television, and it has faced (and so far withstood) legal challenges on grounds relating to the federal Internet Tax Freedom Act, P.L. 105-277, the Uniformity Clause of the Illinois Constitution, and Chicago's exceeding its home rule authority by taxing services occurring outside the city.
The new safe harbor, intended to relieve compliance burdens and give nexus certainty with respect to these Chicago taxes, is available to out-of-state entities that received less than $100,000 in revenue from Chicago customers during the most recent consecutive four calendar quarters. Entities that do not exceed the threshold will not be expected to collect either PPLTT or the amusement tax. To qualify for the safe harbor, an entity also must not have other "significant contacts" with Chicago, such as advertising directed at Chicago customers and activities performed by employees in Chicago.
If an out-of-state business initially qualified for the safe harbor but now no longer qualifies, it must (1) register with the Chicago DOF within 60 days; (2) begin collecting taxes within 90 days; and (3) continue collecting Chicago taxes for at least 12 months. The DOF's informational bulletin clarifies that the safe harbor only addresses whether a provider must collect the taxes from its customers, not whether a customer has a duty to pay the taxes, and that whether a taxpayer has "significant contacts" that would make it ineligible for the safe harbor is analyzed on a case-by-case basis. From Allen Storm, CPA, Dallas, and John Griesedieck, J.D., LL.M., Chicago
New Mexico's gross receipts tax: Round 2 of changes
On April 4, 2019, New Mexico Gov. Michelle Lujan Grisham signed House Bill (H.B.) 6, enacting major changes in the state's corporate income tax and gross receipts tax (GRT) regimes. The changes to the GRT came primarily in response to the U.S. Supreme Court decision in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018), in which the Court overturned its decades-old physical-presence nexus rule. This paved the way for states to enact economic nexus laws requiring out-of-state businesses to collect sales and use tax from in-state customers even if the businesses have no physical presence in the state. Under H.B. 6, New Mexico's own economic nexus threshold for the GRT took effect on July 1, 2019.
H.B. 6 also contained a second set of significant GRT changes that will go into effect on July 1, 2021. Potentially affecting more businesses than the nexus provisions, this second set of changes implements a regime of substantially uniform GRT and compensating taxes for both in-state and out-of-state businesses. Any sellers that transact business with New Mexico consumers should take note of these changes and understand the impact to their New Mexico tax obligations.
This discussion summarizes both sets of changes to New Mexico's GRT and compensating tax regime, including economic nexus for remote sellers and marketplace facilitators, a comprehensive system of local compensating taxes, changes in the state's sourcing rules, and expansion of the tax base to include services performed out of state and certain digital goods.
Basic structure of New Mexico's GRT and compensating tax
New Mexico's GRT is a unique state tax that resembles the retail sales tax (RST) imposed by most other states, but it differs from the RST in several ways. While an RST is a transaction tax imposed on the sale of tangible personal property and certain enumerated services, the GRT is imposed on the privilege of doing business in New Mexico. The tax base for the GRT is generally broader than an RST and applies to the sale of tangible personal property as well as generally to all receipts from services performed in New Mexico, the leasing or licensing of property in New Mexico, and the granting of a right to use a franchise employed in New Mexico.
Businesses subject to the GRT are not required to collect GRT from their customers, but in practice, they nearly always do. Similar to states with an RST, New Mexico also imposes a complementary compensating tax, which is an excise tax imposed on persons using property or services in New Mexico; as with a use tax, it is intended to protect New Mexico businesses from out-of-state businesses that are not subject to the GRT.
For in-state businesses, the GRT can be seen as easier to apply than an RST. Nearly all sales are subject to the GRT, meaning taxability determinations are likely less complicated than under an RST. In addition, the GRT rate is based on the seller's business location rather than the buyer's location. The rate includes a combination of state and local GRTs, if applicable. Because the GRT is currently origin-based rather than destination-based, many in-state sellers are subject to the GRT at only one rate that applies at their business location. As discussed below, H.B. 6 will require a shift in sourcing the GRT on July 1, 2021.
Economic nexus and marketplace providers
Prior to July 1, 2019, a business was subject to the GRT only if it had a physical presence in New Mexico. With the enactment of H.B. 6, however, a remote seller or a marketplace provider lacking a physical presence in New Mexico is now considered to be engaged in business in the state and will incur a GRT obligation if, during the previous calendar year, it had at least $100,000 in total taxable gross receipts from New Mexico consumers.
Under these new rules, a marketplace provider is responsible for GRT on its receipts derived from facilitating New Mexico sales, leases, and licenses, regardless of whether the marketplace seller is "engaged in business" in New Mexico.
To qualify as a marketplace provider, one must list or advertise items for sale, lease, or license and, directly or indirectly, collect and transmit the payment from the end customer to the marketplace seller. A marketplace seller is eligible for a GRT deduction if the provider pays the GRT, because the GRT obligation is imposed on the marketplace provider.
Following the trend of other states, H.B. 6 also imposes tax on specified digital goods sold to or accessed by instate residents. As of July 1, 2019, New Mexico redefined the term "property" to include digital goods and defined the term "digital good" to mean a digital product delivered electronically, including software, music, photography, videos, reading material, applications, and ringtones.
Additional changes to the GRT regime will take effect July 1, 2021, when New Mexico moves to destination-based sourcing and a comprehensive system of local compensating taxes. This is discussed in more detail in the next two subsections.
Sourcing rule changes
Currently, New Mexico applies origin-based rules for sourcing GRT transactions, meaning that most sales of tangible personal property and services are sourced to the business location of the seller. Under these rules, a seller has an obligation to collect or pay state and local GRT if a delivery originates from a New Mexico jurisdiction in which the seller has a physical or business presence. For out-of-state sellers that satisfy the state's economic nexus threshold, a collection obligation applies for the statewide GRT (unless an exemption is available) but not for the GRT imposed by local jurisdictions.
Effective July 1, 2021, New Mexico will move to a destination-based sourcing regime for both sales of tangible personal property and certain services. Under the new regime, gross receipts (and deductions) from the sale or lease of tangible personal property, certain licenses, and most services will be sourced to the destination of the goods or services. In other words, items and services delivered to a customer will begin to be sourced to the location of the delivery rather than to the seller's business location.
There will be certain exceptions. In-person or "over-the-counter" retail sales will not be affected by this change. Sourcing for professional services will continue to be the seller's place of business. In addition, construction and real estate services will be sourced to the location of the construction project or real estate sold.
Both in-state and out-of-state sellers that make sales throughout the state will need to prepare to collect and report GRT at new rates based on the location of their customers. Pursuant to H.B. 6, the New Mexico Taxation and Revenue Department (TRD) must develop a database of tax rates to assist businesses and individuals in determining the correct rate of tax owed; sellers who rely on the database will not be held liable if the database somehow provides an incorrect rate.
Local compensating tax
In addition to the move to destination-based sourcing, New Mexico will also begin a comprehensive local compensating tax regime on July 1, 2021. Under the existing regime, there is no compensating tax in New Mexico on a municipal and county level--only a statewide compensating tax--even though local governments can levy a local GRT at varying rates. Deliveries from out of state are subject to a single state-level tax, while an in-state delivery is subject to the state tax plus any local GRT.
Pursuant to H.B. 6, the state will adopt a statewide system of municipal and county compensating taxes that will apply in each jurisdiction at a rate equal to the combined municipal and county GRTs imposed under current law. The new compensating taxes will apply to sales of tangible personal property, services, licenses, and franchises that are used in the municipality or county. The tax will also apply to tangible personal property, services, licenses, and franchises that are acquired inside or outside New Mexico as the result of a transaction with a person located outside New Mexico that would have been subject to the state GRT had the property, services, licenses, or franchises been acquired from a person with nexus with New Mexico.
Sourcing for the local compensating taxes will follow the new destination-based rules. The combination of the new sourcing rules and local compensating taxes means that most transactions that are subject to GRT or compensating taxes will be on a destination basis, and the tax will apply at the combined state and local rate in the destination jurisdiction, regardless of whether the seller was located in state or outside of New Mexico. The TRD will be charged with enforcing the collection of the local compensating taxes in the same manner as the statewide GRT and compensating tax.
The move to a local compensating tax regime will primarily affect persons that purchase goods, services, or licenses from out-of-state sellers. If an out-of-state seller does not collect GRT, perhaps because the seller does not satisfy New Mexico's economic nexus threshold, the New Mexico purchaser will be subject to an increased compensating tax obligation that is on par with the GRT that would have applied had the seller been located within New Mexico.
Tax changes for out-of-state sellers of services
Another upcoming change under H.B. 6 will primarily affect businesses that perform services outside of New Mexico for customers in New Mexico, because more services of this type will be subject to the GRT. Currently, New Mexico provides an exemption from GRT for certain "receipts from selling services performed outside New Mexico the product of which is initially used in New Mexico." Effective July 1, 2021, however, the exemption for services performed outside the state will no longer apply to most services. Instead, only "research and development services performed outside New Mexico the product of which is initially used in New Mexico" will be exempt (under certain circumstances). Moreover, the imposition of the compensating tax will be amended so that services performed outside the state are taxable if those services would have been subject to GRT if they were performed by a person with a GRT obligation. As a result, many out-of-state service providers selling to New Mexico customers will be required to collect GRT, and some in-state businesses may be required to accrue and remit compensating tax if GRT was not collected by the service provider.
There is one gray area for the sourcing of sales of services by out-of-state sellers that should be addressed by the TRD or the Legislature. As previously noted, some in-state professional services will continue to be sourced to the seller's place of business rather than the customer's location. But for out-of-state professional service providers, H.B. 6 is unclear on whether their services will be sourced on a destination basis or whether they will be subject to a single out-of-state rate. Based on draft regulations proposed by the TRD, it appears that out-of-state sellers of professional services, the product of which is delivered to a New Mexico customer for initial use in the state, will collect or pay only the state-level GRT.
Beyond the initial changes affecting economic nexus, marketplaces, and digital goods, H.B. 6 will soon bring additional substantial changes to the New Mexico GRT and compensating tax regime. To be ready for the changes taking effect on July 1, 2021, both New Mexico-based and out-of-state businesses should work to update their compliance processes and systems to ensure proper payment of New Mexico's GRT and compensating tax. These businesses need to ensure that their gross receipts are being appropriately sourced based on the new destination-based sourcing rules. Further, with the new local compensating taxes, businesses may also be required to remit compensating tax at an increased rate.
From Jeff Cook, J.D., Washington, D.C.; Jasmine Gandhi, J.D., Washington, D.C.; and Carolyn Owens, CMI, Dallas
State proposals to tax digital ads are popping up everywhere
Last year, certain jurisdictions introduced bills that would have imposed new taxes on revenues from digital advertising or expanded the state sales tax base to include sales of digital advertising. This year, similar bills, as well as new proposals aimed at sales of personal data and social media providers, are popping up across the country.
Maryland recently became the first state to enact such a tax when on Feb. 12, 2021, the Maryland Senate joined the House of Delegates and voted to override Gov. Larry Hogan's veto of H.B. 732. Effective for tax years beginning after Dec. 31, 2020, H.B. 732 imposes a tax on a person's annual gross revenues derived from digital advertising services in Maryland. Legal challenges have already been filed alleging that the new tax violates the federal Internet Tax Freedom Act, P.L. 105-277, and the U.S. Constitution's Commerce Clause. States considering similar legislation are likely following the litigation closely. As of this writing, there was legislation pending that would push the effective date of Maryland's digital advertising tax to tax years beginning after Dec. 31, 2021.
Digital advertising services taxes
Certain states have pending proposals similar to the new Maryland law that would impose tax on persons deriving revenue from digital advertising services.
In other states, proposals are targeted to digital advertising revenues earned by social media providers. One state, New York, has proposed bills that would expand the state's sales and use tax to sales of digital advertising.
In the social media space, a bill has been introduced in Connecticut (H.B. 5645) that would impose tax on a social media provider's apportioned annual gross revenue derived from social media advertising services in the state. Revenue from the tax would be dedicated, in part, to funding online bullying prevention efforts and training for social isolation and suicide prevention. Two other Connecticut bills, S.B. 821 and H.B. 6187, propose to raise a number of taxes generally and would also adopt a new 10% tax on the annual gross revenues derived from digital advertising services in the state for any business with annual worldwide gross revenues exceeding $10 billion. At this point, these are purely intent bills that do not include any language on the tax rate, apportionment, or other details on the proposed taxes.
Indiana H.B. 1312 would adopt a new social media surcharge tax imposed on social media providers that have annual gross revenues from social media advertising services in Indiana of at least $1 million and have more than 1 million active account holders in Indiana. The surcharge would be equal to (1) the annual gross revenue derived from social media advertising services in Indiana in a calendar year multiplied by 7%, plus (2) the total number of the social media provider's active Indiana account holders in a calendar year multiplied by $1.
To determine the amount of annual gross revenue derived from social media advertising services in Indiana, a taxpayer would apportion its revenue, using a formula that looks at Indiana social media advertising revenues over annual gross revenues from social media advertising services in the United States. There is no guidance in the bill on how to determine when revenue from social media advertising services is attributable to Indiana. Revenues from the surcharge tax would be contributed to a new fund called the "online bullying, social isolation, and suicide prevention fund."
In New York, A.B. 734 and S.B. 302 would extend the state's sales and use tax to sales of digital advertising, except sales for resale. The definition of "digital advertising services" includes "banner advertising, search engine advertising, interstitial advertising, and other comparable advertising services which markets or promotes a particular good, service, political candidate or message." The revenues from the sales tax would be used to provide zero-interest refinancing of eligible student loans, and the tax would be repealed after five years. New York S.B. 1124, which is nearly identical to the Maryland legislation, would impose tax on the annual gross revenues derived from providing digital advertising services in New York.
Similarly, Montana H.B. 363 would impose a 10% tax on annual gross revenue derived from digital advertising services in Montana. The tax would apply only to persons with at least $25 million in worldwide annual gross revenue from digital advertising services and with some receipts from Montana advertising services.
Finally, there are several proposals in Massachusetts. House Docket 3210 would impose tax on a taxpayer with at least $50 million in annual gross revenues and $100,000 in revenues derived from Massachusetts digital advertising services, with a rate ranging from 5% to 15%, depending on the taxpayer's annual gross revenues. Digital advertising services would be sourced to Massachusetts if they appear on a user's device with an IP address located in Massachusetts, or if the user is known or reasonably presumed to be using the device in the state.
Massachusetts House Docket 3601 would impose a 5% excise tax on the annual revenue from digital advertising services in Massachusetts for companies with revenue exceeding $25 million from those services. Again, a digital advertising service would be deemed to be provided in Massachusetts if it is received on a user's device with an IP address located in Massachusetts. House Docket 3558, in contrast, would establish a special commission to conduct a comprehensive study relative to generating revenue from digital advertising that is displayed inside of Massachusetts by companies that generate over $100 million a year in global revenue. The commission would be required to file its report not later than Feb. 15, 2022. House Docket 3522 and House Docket 3812 purport to impose new taxes on online or digital advertising, but the draft legislation has not yet been released for either bill.
Bills imposing taxes on sales of personal information
Other proposals focus on taxing revenues from sales of personal data. In Washington, H.B. 1303, if enacted, would extend the business and occupation tax to "every person engaging within this state in the business of making sales of personal data or exchanging personal data for consideration."The tax would be "equal to the gross income of the business multiplied by the rate of 1.8 percent." Gross income from the sale of personal information attributable to Washington state would be calculated using a ratio "expressed as a percentage, that the number of Washington addresses in the personal information bears to all addresses in the personal information," provided that only personal information used to generate income of the business is considered in the calculation. If the taxpayer is unable to attribute the gross income of the business using this method, a population method or some other reasonable method must be used to allocate receipts to Washington.
In Oregon, a state that does not impose a sales and use tax, proposed H.B. 2392 would impose a 5% gross receipts tax on the privilege of engaging in the business of selling taxable personal information at retail in Oregon. The tax base would include consideration from other than cash and cash equivalents and is based on receipts generated from selling personal information of individuals with an Oregon IP address. Personal information is defined to include information that "identifies, relates to, describes or is capable of being associated with an individual," not to include photographs.
New York A.B. 946 and S.B. 3790 would impose a 5% tax on the gross income of any corporation that derives income from the data that individuals of the state of New York share with the corporation. The funds from this tax are to be directed to a new "data fund" intended to eventually be distributed back to New York taxpayers so that they might "share in the wealth that is created from their data" (as the justification memo for a predecessor proposal, S.B. 6102, put it). The bills provide no substantive guidance on how the tax would be implemented.
In Indiana, proposed H.B. 1572 is unique in that it imposes an annual registration fee on social media providers that derive economic benefit from personal data that individual subscribers share with the providers. Only social media providers that maintain a public social media platform, derive some economic benefit from the data of Indiana individuals, and have more than 1 million active Indiana account holders would be subject to the fee.
"Social media platform" is defined to mean "a website or Internet medium that allows account holders to create, share, and view user-generated content through an account or profile; and primarily serves as a medium for users to interact with content generated by other third party users of the medium." However, social media platforms do not include email or online newspapers. An "Indiana account holder" is defined to include account holders who used an IP address located in Indiana to establish their account or with information that indicates a current residence in the state. The fee would be calculated by multiplying the number of the social media provider's active Indiana account holders in a calendar year by $5.
Interestingly, the bill does not define the term "active" or "active account holder," nor does it provide that the number of active account holders used in the fee calculation will be limited to those account holders from which the taxpayer actually derives economic benefit. In other words, it is conceivable that a taxpayer could derive economic benefit from only a small number of Indiana account holders but have over 1 million Indiana "active account holders" and still be subject to a fee of at least $5 million.
Whether any of these bills will be enacted is yet to be determined, but the sheer number of proposals this year indicates that they have captured the attention of state legislators. The states that are proposing taxes very similar to Maryland's will likely be watching closely as the litigation unfolds. The states that are considering taxes on revenues from the sales of personal information should be thinking about whether those taxes would face similar legal challenges.
From Jessi Vice, J.D., LL.M., Washington, D.C., and Sarah McGahan, J.D., LL.M., Houston
In Texas, the rules of the game have changed for sourcing of receipts
Texas is the consummate football state. From peewee to NFL games, Texans are well accustomed to seeing flags thrown and penalties called midgame. At times, these calls can and do change the outcome of the game. Preparing tax returns is not as fun as watching a good football game, but in neither situation do taxpayers expect the rules to change at halftime.
This is somewhat like what happened when the Texas Comptroller's Office published the final version of revised Administrative Rule Section 3.591, Margin: Apportionment, in the Texas Register. As amended, this regulation significantly revises the rules for sourcing receipts to Texas, and almost all taxpayers, particularly those engaged in service industries, will be affected by the rule changes. The explanatory text in the register provides that many of the additions or revisions are expositions of existing comptroller policy. An example of this: The revised general rule for sourcing service receipts "is an exposition of the Comptroller's current interpretation of the sourcing statute, which has been endorsed in part by the [Texas] Court of Appeals opinion in the Sirius XM Radio litigation." Because the rule is applied both prospectively and retroactively, taxpayers must reassess past plays and think about upcoming audits.
The receipts-producing, end-product act
Perhaps the most significant change is the revised general rule for sourcing service receipts, which is applied if the service is not specifically addressed elsewhere (there are special rules for certain types of receipts, e.g., advertising services, internet hosting services, loan servicing activities). Texas law apportions receipts from providing services to the location where the services are performed. If services are performed both inside and outside of Texas, then the receipts are attributed to Texas in proportion to the fair value of the services that are rendered in Texas. The final regulation adds guidance on interpreting the location where a service is considered performed. Under the revised rule, a service will generally be performed at the location of the receipts-producing, end-product act or acts.
This new test, so to speak, aligns with language adopted by the Texas Court of Appeals in Hegar v. Sirius XM Radio, Inc., 604 S.W.3d 125 (Tex. Ct. App. 2020). In that case, the court held that the receipts-producing, end-product act associated with the provision of satellite radio service is the taxpayer's activating a customer's chip set in a satellite-enabled radio. This occurs where the customer's radio is located, which is likely in the customer's residence or car. Sirius XM is not yet final; the taxpayer's petition for review before the Texas Supreme Court is pending.
Additionally, if there is a receipts-producing, end-product act, the rule will not consider the location of other acts, even if those acts are essential to the performance of the receipts-producing, end-product act. This result is also consistent with Sirius XM, as the Appeals Court held that producing programming content for satellite radio stations was a non-receipt-producing act, albeit an essential one.
The revised rule provides scant guidance on how a taxpayer should determine the receipts-producing, end-product act associated with a service. If there is no receipts-producing, end-product act associated with the service (and again, it is not clear in the rule when this would be the case), then the locations of all essential acts may be considered in determining where a service is performed. However, beyond directing the taxpayer to consider all essential acts to determine the location where a service is performed (assuming there is no receipts-producing, end-product act), the rule provides no examples or guidance on how to measure those essential acts and make a conclusion as to the ultimate location where the service is performed.
Taxpayers that perform certain types of services (e.g., tax preparation or legal services) may question whether their services have receipt-producing, end-product acts or whether the services are considered to be performed in more than one state so that fair-value analysis is required. It can be argued the receipts-producing, end-product act of a tax return preparation service for a Texas taxpayer is the delivery of the return to the taxpayer, even though parts of the return may be prepared in multiple states. Similarly, pretrial legal work might be part of the receipts-producing, end-product act of a trial. Applying the test, receipts from preparing the return would likely be sourced to Texas, which is the location of the customer receiving the tax return, and receipts related to the trial would be sourced to the location where the trial is held. The finalized rule, however, provides an example of a law firm charging clients for work performed both inside and outside of Texas and requires a fair-value analysis. Ultimately, the Comptroller is the deciding referee in this game and will control which way the ball goes when determining if a service produces an end-product act or not.
Internet hosting services
One other change in the rule that might catch players off guard is a new definition of "internet hosting services." Since 2014, by statute, receipts from internet hosting services have been sourced to the customer's location. The revised rule now defines internet hosting services to include real-time or on-demand access to several computer services including, but not limited to, data storage and retrieval, videogaming, database search services, entertainment streaming, data processing, and marketplace provider services. Internet hosting excludes telecommunication services and cable television services, along with internet connectivity services, internet advertising, and internet access to download digital content only. The preamble to the revised rule acknowledges that some of these services extend beyond what might ordinarily be considered internet hosting services.
Receipts from internet hosting are generally considered Texas gross receipts if the customer is located in Texas. The customer location is determined by the physical location where the purchaser or the purchaser's designee consumes the service. The location should be determined in good faith, using the most reasonable method under the circumstances, considering the information reasonably available. Receipts from some services may be sourced to multiple customer locations or to multiple customers. Locations that may be reasonable under the circumstances include the customer's principal place of business, the customer's business unit that is using the computer services, the delivery addresses for individual units of service provided to the customer, the primary place or places of consumption by the customer, the customer's service address, the customer's billing address, or a combination of methods. Numerous examples illustrate these provisions.
While internet hosting receipts have been sourced to the customer location since 2014, it is arguable that taxpayers providing data processing services or streaming services may not have known those services were considered internet hosting services until the revised rule was released. These taxpayers may have used the general rule for sourcing service receipts, which looks to the location where the service was performed, rather than the customer's location.
Capital assets and investments
The final regulation also revises the rules around capital assets and investments and clarifies that only the net gain from the sale of a capital asset is included in gross receipts. A net loss from the sale of a capital asset or investment is not included in gross receipts. For reports originally due before Jan. 1, 2021, a taxable entity may add the net gains and losses from sales of investments and capital assets to determine the total gross receipts from the transaction. For other reports, going forward, the net gain or loss is determined separately for each sale of a capital asset or investment. Although the rules determine net gains and losses on a sale-by-sale basis, there is some uncertainty as to whether that sale-by-sale basis is based on a total transaction-by-transaction approach or an asset-by-asset approach.
The underlying question is this: If a taxpayer sells multiple capital assets in one transaction, is the net gain or loss determined to be the total net gain or loss of that one transaction or will the taxpayer have to look at each individual asset in the transaction to determine each asset's net gain or loss? As an additional interesting inquiry, if it is the latter, will the taxpayer be able to prepare for that if an audit were to arise?
Additional definitions and sourcing rules
The final rule also includes new and revised definitions and provisions addressing the sourcing of certain types of receipts and services, including, but not limited to, advertising receipts, loan servicing activities, computer software services, interest receipts, and receipts from the sale of an interest in a single-member limited liability company (SMLLC).
A new provision consolidates the sourcing rules for advertising receipts across all media. "Advertising receipts," as defined, are sourced to the location of the advertising audience, which can be determined, in good faith, by the physical locations of the advertising considering the information reasonably available. Reasonable locations can include the recorded locations of the advertising audience and the locations listed in published rating statistics. If the locations of nationwide advertising audiences cannot otherwise be reasonably determined, then 8.7% of the gross receipts are sourced to Texas. For reports originally due before Jan. 1, 2021, advertising receipts attributable to a radio or television station transmitter in Texas may be sourced to Texas.
The guidance on sourcing "loan servicing" fees has been updated to provide that gross receipts from servicing loans that are not secured by real property are sourced under the general rule addressing services.
The current rule that addresses "computer software services and programs" has been replaced with guidance on sourcing receipts from "computer hardware and digital property." Ostensibly to aid in applying these rules, the finalized regulation includes several new examples.
The revised regulation also makes minor changes to the rules for sourcing interest, which continues to be sourced to the location of the payer. Now interest received from a national bank is a Texas gross receipt if the banks principal place of business is in Texas or the bank is organized under the Texas Banking Code. Interest on federal obligations that is excluded from total revenue and interest exempt from federal income tax is excluded from gross receipts entirely.
Additionally, the final regulation provides guidance on the sourcing of the sale of an interest in an SMLLC. The sale is considered a sale of an interest in an intangible asset and should be sourced to the location of the payer.
Lastly, the comptroller adopted amendments to Administrative Rule Section 3.586, Margin: Nexus, to address the U.S. Supreme Court's decision in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018). Although the changes were fairly minor, they do improve certain language and phrases. An example of this improvement is an amendment changing the phrase "is not doing business" to "does not have physical presence." The amendments also update the economic nexus subsection to emphasize certain subsections of Section 3.591 and to include a definition of Texas gross receipts. To conclude the updates, the comptroller outlines the key dates foreign (i.e., non-Texas organized) entities established Texas nexus:
* Prior to Jan. 1, 2019, a foreign taxable entity begins doing business in Texas on the date the entity has physical presence.
* On or after Jan. 1, 2019, a foreign taxable entity's beginning date is outlined as the earliest of the date the foreign taxable entity has physical presence, the date when the foreign taxable entity obtains a Texas use tax permit, or the first day of the federal income tax accounting period ending in 2019 or later in which the entity had gross receipts from business done in Texas of $500,000 or more.
The revisions to Administrative Rule Section 3.591, especially to the extent the rules apply retroactively, may have nexus implications for taxpayers meeting the gross receipts threshold in Texas after applying the revised regulation. Taxpayers should carefully consider the effect of the rule on their future footprint, as well as their prior filing positions.
From Sarah McGahan, J.D., LL.M., and Lori Wright, CPA, Houston
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
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|Author:||McGahan, Sarah; Wright, Lori|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2021|
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