Back to School: What Tennessee Taxpayers Can Learn from Recent Multistate Tax Decisions

It’s back to school time in Tennessee. My two daughters are starting new schools, and my little man is going into 2nd grade at the same school, hoping to be in the same class with all his hoodlum buddies. After a summer of fun in the sun, they appear to be ready to get back to learning, which should last for about a week.

For Tennessee tax gurus, it’s time to bottle up that new school-year excitement and go to school ourselves on some recent multistate tax decisions and consider whether those cases may have an impact on Tennessee tax compliance. While we often focus on changes for legislation, caselaw, rulings and other guidance from the Department of Revenue on how to tailor Tennessee tax compliance, we cannot overlook cases from other states and how those issues may inform tax positions that we take in Tennessee.

Below is a sample of some of the more recent multistate decisions that Tennessee taxpayers should consider.

South Dakota – Economic Nexus Case Headed to South Dakota Supreme Court

Tennessee is in the middle of a regulatory challenge to the newly-promulgated regulation imposing economic nexus on out-of-state / remote sellers for Tennessee sales and use tax purposes. Despite this posture, Tennessee’s case is well behind the lead case in the country which is in the South Dakota courts. The South Dakota case (South Dakota v. Wayfair, Inc.), which notably involves a statute and not a regulation, has already been decided by the South Dakota trial courts and is now set for oral argument before the South Dakota Supreme Court on August 29. A decision is expected by some by October.

The decision in Wayfair will likely have a direct bearing on the Tennessee case, which is just getting heated up in the Tennessee trial courts. In Wayfair, the trial court concluded that the economic nexus statute was unconstitutional based on the U.S. Supreme Court precedent in Quill – not a surprising result considering the binding nature of that authority. It has always been the intent of the states that they were attempting to force a case to the U.S. Supreme Court on this constitutional issue, which would inevitably require some losses along the way.

The Tennessee case (American Catalog Mailers Association v. Gerregano) was filed in March and is still in the discovery stage to the extent that any discovery needs to be completed. Notably, the parties are in a discovery dispute related to the Plaintiff’s objections to discovery served by the state. Once discovery is completed, this case should proceed to cross motions for summary judgment quickly.

Because the Tennessee case involves a regulation and not a statute, it will be interesting to monitor whether the taxpayer will push the procedural issues related to the promulgation of the regulation or whether those issues will take a back seat to the constitutional challenge.

Practice Pointer: Tennessee, and other states such as Mississippi, who are unable to muster sufficient legislative support for economic nexus to pass a statute have opted instead to attempt to use a regulation to adopt economic nexus. What is interesting about this approach is that even if the constitutionality of economic nexus is ultimately upheld, taxpayers will be able to challenge the effectiveness of the regulation on separate grounds, setting up the possibility that all this effort to get a case to the Supreme Court, as Governor Haslam has touted, would be just a big waste of time. If you are delaying, you are probably winning.

In the interim, Tennessee taxpayers should pay close attention to South Dakota and Wayfair, so we can learn as much as we can from that state’s lawsuit and how it may inform the treatment of remote sellers in Tennessee.

Massachusetts - Drop Shipment Case Serves as Reminder to Tennessee Wholesalers

Tennessee’s drop shipment law is set forth in a 1998 Sales and Use Tax Notice that requires out-of-state retailers to register and collect Tennessee sales tax on transactions drop-shipped to customers in Tennessee. If the retailer does not register in Tennessee and provide a Tennessee resale certificate to the in-state wholesaler, the wholesaler is left holding the bag and must collect the Tennessee sales tax on the wholesale price of the product.

It’s rare that you see drop shipment cases go to court, but that is exactly what happened in Massachusetts in D&H Distributing Co. v. Commissioner. Neither the wholesaler nor the retailer collected tax on transactions in Massachusetts, and the Massachusetts DOR assessed the wholesaler, rather than the out-of-state retailer for the tax. Under Massachusetts law, like in Tennessee, the wholesaler would have been required to collect the use tax if the out-of-state retailer was not doing business in Massachusetts.

The case was ultimately litigated on the issue of who had the burden of proving whether the out-of-state retailer had nexus with Massachusetts. The taxpayer argued that it was the burden of the state to prove that the out-of-state retailer was not doing business in Massachusetts, while the Massachusetts DOR took the position that the wholesaler must prove that the out-of-state company was doing business in the state.

The Court ultimately ruled in favor of the state, stating that “the department established a factual basis for the validity of its assessment, which D&H failed to rebut.” The state relied on D&H Distributing’s business practice of requiring its retailer/customers to provide proof that they didn’t have a Massachusetts presence. Per the decision, D&H never provided evidence showing the retailer to have nexus with Massachusetts.

This is a difficult result for the wholesaler and is a case study in how important it is for wholesalers to get the appropriate documentation for their wholesale transactions. States differ on what the appropriate documentation is. Some states allow out-of-state resale certificates of resale, but many states, like Tennessee, require a Tennessee resale certificate. Other states require in-state resale certificates and require the wholesaler to collect on the retail rate if the appropriate documentation is not obtained.

While the Massachusetts DOR only collected sales tax on the wholesaler’s sales price, the decision does not provide explicit guidance that this position would be accepted on audit in the future.

Minnesota - Alternative Apportionment Struck Down

Alternative apportionment, or “variances” as we call them in Tennessee, have spelled doom for Taxpayers in Tennessee in recent years with decisions in Vodafone and Bellsouth Advertising going against taxpayers in cases involving cost of performance and market sourcing.

With that history, it is always noteworthy to see when a taxpayer is on the winning side of an alternative apportionment case, like the taxpayer in Associated Bank N.A. v. Commissioner, a case recently decided in Minnesota. In Associated Bank, the trial court concluded that the Minnesota DOR improperly invoked alternative apportionment in a case involving the restructuring of a financial institution to use partnership entities as part of its operations.

Under Minnesota law, partnerships are not included in the definition of financial institutions. Accordingly, the partnerships could use standard apportionment which excludes interest and intangibles from the apportionment formula. The Minnesota Court acknowledged that the taxpayer was “taking advantage of a tax loophole” to minimize the Minnesota tax but concluded that it was “up to the legislature to close tax loopholes – not the Commissioner or the Courts” -  a refreshing perspective, considering the Tennessee Court’s willingness to allow the Commissioner in Tennessee to resort to self-help under the variance statutes when the results from the statute are not to his liking.

A significant difference between this case and the Tennessee cases is that Minnesota was attempting to disregard properly formed business transactions and was not merely adopting a different apportionment regime. Moreover, the Minnesota Court cited HMN Financial, Inc. v. Commissioner as precedent for not allowing the Commissioner to use alternative apportionment “to look through or disregard the taxpayer’s corporate structure.”

This case is worth filing away as a potential approach to the Tennessee DOR if they aggressively pursue a Department-imposed variance outside of the cost of performance framework.

Nevada - Supreme Court Decision Highlights Constitutional Issue of Tax Incentives

Is it also true that what happens in Nevada, stays in Nevada? With respect to the recent decision in Southern California Edison v. Dept. of Taxation, maybe we’ll see. There were some interesting issues that bubbled up related to the constitutionality of certain tax incentives in this case, providing some food for thought for certain businesses that may be left on the outside looking in to certain tax incentives provided to Tennessee-based companies.

In the Southern California Edison, the taxpayer had filed refund claims of upwards of $100 million related to a state statute that provided an exemption from the use tax for minerals mined in-state. The trial court in this case declared that the exemption was unconstitutional under the dormant commerce clause because it did not exempt minerals mined in other states, citing Sierra Pacific Power Co. v. Dept. of Taxation. However, the trial court concluded that the taxpayer was not entitled to a refund because it had no competitors that benefited from the discriminatory tax.

The Nevada Supreme Court did not address the constitutional issue, focusing instead on the secondary conclusion of the trial court and stating that the company was not entitled to a refund because it had “not demonstrated the existence of substantially similar competitors that were advantaged by the unconstitutional tax.”

This case highlights an important issue for taxpayers to consider with respect to their multistate activities that venture into Tennessee. Like Nevada, Tennessee has several tax provisions - the benefits of which are limited to in-state companies. Most notably on that list is the recent enactment of single sales factor for the F&E tax, which is only available for Tennessee manufacturers. Some out-of-state companies may benefit from single sales factor but not be able to qualify as “Tennessee” manufacturers. Faced with this predicament, it may be worth a visit to the dormant commerce clause to see whether there is some basis for which the taxpayer might also obtain the benefits of the incentive.

In the future, we will continue to monitor out-of-state decisions to see what we can learn about the proper application of Tennessee’s tax code to taxpayers doing business in Tennessee.

If You Build It, They Will (Stay or) Come: Tennessee Adopts Single Sales Factor for "Tennessee" Manufacturers

Kevin Costner’s character in Field of Dreams, Ray Kinsella, heard voices from a field in Iowa that convinced him to mount a tractor and convert a corn field into a baseball diamond fit for baseball’s late and great stars. They came, and tourists still flock to Dyersville, Iowa where the Field of Dreams stands to this day. Tennessee channeled its Inner-Field of Dreams this legislative session with the passage of single sales factor for manufacturers, succumbing to years of lobbying from the Tennessee Chamber and other trade associations. And now … Tennessee is expecting Tennessee manufacturers to stay and for more to come.

              The characters in Tennessee’s Field of Dreams?

Ray Kinsella – Governor Haslam. He kind of looks like Costner

Terence Mann – It’s probably House Ways and Means Committee Chair, Charles Sargent. He has a pretty memorable voice like James Earl Jones, and like Terry Mann, Rep. Sargent finally came around after years of holding back on his full support for single sales factor.

Shoeless Joe Jackson – Ray Liota’s character, the benefactor of the Field? -Insert tax director from any major Tennessee manufacturer here:_____________ & a tax director from an out-of-state company, relocating to Tennessee here: _____________!

The Voice from the Corn? – No doubt it is Bradley Jackson who championed the change for years and continued to remind legislators throughout the 2017 session that this was something that manufacturers really wanted. “If you build it, They Will Come!” (In Bradley’s best whispering voice.)

And the Law...

One of the cornerstone’s to the Governor’s IMPROVE Act, Tennessee’s single sales factor apportionment law is elective and is effective for tax years beginning on or after January 1, 2017. The key determination that taxpayers will need to consider is whether the principal business in Tennessee is that of a manufacturer, which is defined as a taxpayer with revenue from its Tennessee activities of 50% or more from fabricating or processing tangible personal property for resale and consumption off the premises.

Practice Point: The definition of manufacturing is a familiar one for Tennessee manufacturers as it is used for the sales tax, industrial machinery exemption but with the key difference being that the determination of whether a taxpayer is a manufacturer for purposes of F&E apportionment is based on a statewide calculation and not on a location-by-location basis, which is the case with the sales tax. The location-specific determination under the sales tax code oftentimes leaves certain facilities in Tennessee out, and they do not qualify as manufacturing facilities for purposes of the sales tax exemption.  Based on this distinction, manufacturers should carefully evaluate whether they meet the 50% test under this change.

A late addition to the new law was the exclusion of “passive income” from the calculation of the 50% test. So, passive income from dividends, interest, sales of securities, and income from licensing or sale of intellectual property is excluded from the taxpayer’s revenue for purposes of calculating the 50% threshold.

Single sales factor apportionment is elective, but once a taxpayer elects in, it is bound by the election for five years. Another point to focus on for taxpayers is the proper application of single sales factor to combined franchise tax filers, as the election only applies to group members that qualify as manufacturers. Out-of-state manufacturers who might want to use single sales factor will likely be left out in the cold unless they want to mount a constitutional challenge to the limitation of single sales factor to just Tennessee manufacturers...

Will it Work?

Massachusetts is another state that adopted single sales factor for manufacturers with the hope that it would maintain or boost manufacturing jobs in the state. The reality, however, has been different than anticipated with Massachusetts now having 40% fewer manufacturing jobs than when single sales factor was enacted.

Based on those results, it remains to be seen whether Tennessee manufacturers will stay or come, but in the interim, Taxpayers should pay close attention to this provision to see whether they qualify for the benefits of the single sales factor.