Tennessee Issues Franchise/Excise Tax Ruling on RMA's Substantial Nexus Standard

Tennessee’s franchise and excise tax economic nexus provisions were adopted in the Revenue Modernization Act (RMA) in 2015. This change ushered in a series of questions regarding the proper application of Tennessee nexus laws for tax years beginning on or after January 1, 2016. Those returns are now coming due, and with the Department’s issuance of Letter Ruling 17-08, we are starting to get a peek behind the door on how the Department plans to enforce these changes … And it’s not looking good for out-of-state businesses!

Back in 2015, the Tennessee General Assembly, at the urging of the Governor and Department of Revenue, enacted economic nexus legislation under Tennessee's franchise/excise taxes and the Tennessee business tax, breaking from years of posturing by the Department that the existing statutes provided sufficient authority for the State to pursue out-of-state businesses for payment of Tennessee taxes. At the time, the enactment was championed as bringing Tennessee in line with other states that had previously enacted economic nexus statutes. The argument was that Tennessee had fallen behind and needed to catch up with other states.

Under prior law, taxpayers doing business in Tennessee were subject to the franchise and excise tax, and doing business was defined as,

any activity purposefully engaged in within Tennessee, by a person with the object of gain, benefit or advantage, consistent with the intent of the general assembly to subject such persons to the Tennessee franchise/excise tax to the extent permitted by the United States Constitution and the Constitution of Tennessee.

Tenn. Code Ann. §67-4-2004(14)(A) (2014).

Fast forward to the RMA, and Tennessee adopted an amendment that added an additional threshold before a taxpayer is subject to Tennessee’s franchise and excise taxes. Under the amended law, an entity had to be both “doing business in [Tennessee]” and have “substantial nexus in” the state. The definition of substantial nexus includes “any direct or indirect connection of the taxpayer to this state such that the taxpayer can be required under the Constitution of the United States to remit” franchise and excise taxes. This definition goes on to set forth specific examples of what connections qualify as “substantial nexus,” including:

-          The taxpayer is organized or commercially domiciled in this state;

-          The taxpayer owns or uses its capital in this state;

-          The taxpayer has systematic and continuous business activity in this state that has produced gross receipts attributable to customers in this state;

-          The taxpayer licenses intangible property for use by another party in this state and derives income from that use of intangible property in this state; or

-          The taxpayer has bright-line presence in this state. A person has bright-line presence in this state for a tax period if any of the following applies:

o   The taxpayer's total receipts in this state during the tax period, exceed the lesser of five hundred thousand dollars ($500,000) or twenty-five percent (25%) of the taxpayer's total receipts everywhere during the tax period;

o   The average value of the taxpayer's real and tangible personal property owned or rented and used in this state during the tax period, as determined under § 67-4-2012, exceeds the lesser of fifty thousand dollars ($50,000) or twenty-five percent (25%) of the average value of all the taxpayer's total real and tangible personal property; or

o   The total amount paid in this state during the tax period by the taxpayer for compensation, determined under § 67-4-2012, exceeds the lesser of fifty thousand dollars ($50,000) or twenty-five percent (25%) of the total compensation paid by the taxpayer;

Tenn. Code Ann. §67-4-2004(49)(A).

Following this enactment, questions swirled about how this amendment squared with the Tennessee Court of Appeals’ decision in J.C. Penney National Bank v. Johnson, which approved physical presence as the constitutional standard in Tennessee for the franchise and excise taxes. Would Tennessee’s adoption of what amounts to economic nexus withstand judicial scrutiny in Tennessee with well-established judicial precedent that a physical presence is required? While taxpayers have not fared particularly well in other states, there is no better state than Tennessee to mount the last stand for physical presence considering J.C. Penney is still the law. It is likely just a matter of time before that lawsuit is filed.

For taxpayers not itching for a fight in the courts, there were also questions regarding the differences between the “doing business” and “substantial nexus” standards and how the amended law requires both thresholds to be met before an out-of-state entity would be subject to tax in Tennessee. Are those standards the same or is there some difference between what constitutes “doing business” and what constitutes “substantial nexus?”

The “bright-line presence” standards of the RMA appeared to establish certain minimum thresholds of receipts, property and payroll that had to be exceeded before the tax would apply. However, in a recent ruling, the Department noted that “it is not required that a taxpayer have bright-line presence to have substantial nexus with Tennessee. A taxpayer may have substantial nexus with Tennessee with lesser amounts of property, payroll, and receipts in Tennessee if it has any connection with the state that requires it to remit tax under the United States Constitution.” Tenn. Ltr. Rul. 17-08.

In Letter Ruling 17-08, which was just released, the Department addressed the application of the “substantial nexus” provisions to an interstate motor carrier and concluded that the motor carrier would have “substantial nexus” with Tennessee if the carrier has trips that (1) both begin and end in Tennessee, (2) delivers goods into Tennessee that originate in another state, or (3) makes pickups of goods from Tennessee for delivery into another state. Despite the carrier not meeting any of the “bright-line presence” standards, the Ruling still concludes that the activities listed above were sufficient to establish substantial nexus.

The ruling also addresses “doing business,” but in part seems to confuse the analysis between “doing business” and “substantial nexus” using those terms interchangeably in the analysis. That is not surprising considering the close relationship between the standards, but taxpayers should pay careful attention to those differences, as there could be fact patterns where a taxpayer may not be doing business or may not have “substantial nexus.” It remains to be seen whether there is a meaningful difference between those two requirements.

Practice Point: For taxpayers with no other contacts with Tennessee, it appears that the Department is conceding that these minimum thresholds could serve as a carve out for taxability, but they would appear to have limited applicability. For example, if a taxpayer only has one employee who lives in the state but the employee conducts no sales or other activity in the state on behalf of his employer, the payroll threshold might provide a basis for avoiding a franchise/excise tax filing. The $50,000 threshold is problematic, however, as more than one employee would likely blow that limit.

Practice Point #2: Tennessee has made a habit of attacking in-state businesses on their claim of multistate business activities and apportionment and applying Tennessee’s “doing business” standard to determine whether activity in the other state would be considered “doing business” in Tennessee. This is a constitutionally suspect provision that is currently being challenged in the Courts, but that may be one reason that Tennessee made a distinction between “doing business” and “substantial nexus.” Because “doing business” is the standard for apportionment, the minimum thresholds of “substantial nexus” do not appear to serve as the basis for an in-state business arguing that it is entitled to apportion.

These changes were only effective for tax years beginning on or after January 1, 2016, so we are just now seeing some activity related to the application of these changes, and we expect that is more to come, so stay tuned.