Tennessee: Franchise, excise, business and sales and use taxation

Franchise, excise, business and sales and use taxation

Both houses of the Tennessee legislature have passed the Revenue Modernization Act (House Bill 644), thus sending the bill to the governor for action.

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Governor Bill Haslam touted the revenue modernization plan in his “state of the state” address earlier this year, and is expected to sign the legislation.

The legislation, if enacted, would make changes to Tennessee’s franchise and excise, business, and sales and use tax laws.

Factor-presence nexus standards

The legislation would adopt factor-presence nexus standards for excise (income), franchise, and state business tax purposes.*

*The Tennessee Business Tax is a state and local tax assessed for the privilege of conducting business within the state and certain counties and/or incorporated municipalities.

Specifically, taxpayers that are doing business in Tennessee and have a substantial nexus in the state would be subject to excise, franchise and business taxes effective for all tax years beginning on or after January 1, 2016.

“Substantial nexus” in Tennessee means that a person has any direct or indirect connections to Tennessee so that it could be required under the U.S. Constitution to remit the taxes owed. Examples of substantial nexus include, but are not limited to:

  • The taxpayer is organized or commercially domiciled in Tennessee.
  • The taxpayer owns or uses its capital in Tennessee.
  • The taxpayer has systematic and continuous business activity in Tennessee that has produced gross receipts attributable to Tennessee customers.
  • The taxpayer has a bright-line presence in Tennessee, which means the taxpayer’s total receipts attributed to the state under Tennessee’s sourcing rules (that also are revised under the bill) exceed the lesser of $500,000 or 25% of the taxpayer’s total receipts during the tax period, or the taxpayer’s real and tangible property or compensation attributed to Tennessee exceeds the lesser of $50,000 or 25% of the taxpayer’s total property or compensation.

The legislation would clarify that a company treated as a foreign corporation under the Internal Revenue Code that has no income effectively connected with a U.S. trade or business (as determined under the Code) would not be considered to have a substantial nexus in Tennessee. For excise and franchise tax purposes, if a foreign corporation has effectively connected income, then only the corporation’s net earnings and net worth connected with the U.S. trade or business would be taxable and only property, payroll and receipts connected with the U.S. trade or business would be considered in determining the corporation’s apportionment factor.

Related-party expense disallowance rules

Under current law in Tennessee, a taxpayer must apply to the Commissioner of Revenue before it may deduct intangible expenses paid, accrued, or incurred in connection with a transaction with one or more affiliates. In general, the expense will be deductible if the Commissioner determines the principal purpose of the underlying transaction is not the avoidance of tax. There are certain circumstances or “safe-harbors” under which the Commissioner is required to approve an application to deduct intangible expenses.

The bill would eliminate the application process and would require taxpayers to disclose relevant intangible expenses.

In addition, the legislation seems to narrow the circumstances under which intangible expenses paid to related parties could be deducted by eliminating the safe harbors involving payments to an affiliate that are passed through to an unaffiliated entity (commonly referred to as the “conduit exception”), and payments that are subject to tax in certain other states that the Commissioner, under current law, is required to allow.

Under the bill, an intangible expense paid, accrued or incurred in a transaction with one or more affiliates could be deducted for excise tax purposes only if the intangible expense has been disclosed (in a manner prescribed by the Commissioner) and one of two conditions are met.

  • The first condition is that the affiliate to whom the expense has been paid, accrued, or incurred is registered and paying Tennessee excise tax. Ostensibly, under the new factor-presence nexus rules, entities deriving income from licensing intangibles to Tennessee affiliates would now be subject to Tennessee tax.
  • The second condition is that the intangible expense was paid to an affiliate in a foreign nation that is a signatory to a comprehensive tax treaty with the United States or to an affiliate that is not required to register or pay Tennessee excise tax.

It appears that these are the only circumstances under which intangible expenses paid, accrued, or incurred in a transaction with one or more affiliates would be deducted. Taxpayers that fail to disclose intangible expenses or to add the expenses back to net earnings would be subject to a negligence penalty. These changes would apply to tax years beginning on or after July 1, 2016.

Increased sales factor weight

Under current law, taxpayers apportion their tax base to Tennessee for franchise and excise tax using a three-factor double-weighted sales formula.

The legislation provides that for tax years beginning on or after July 1, 2016, net earnings and net worth would be apportioned to Tennessee using a three- factor formula with triple-weighed sales, i.e., the sales factor will account for 60% of the overall apportionment factor.

Market-based sourcing

Under current Tennessee law, receipts from sales other than sales of tangible personal property are sourced to Tennessee if a greater proportion of the earnings-producing activity is performed in Tennessee than in any other state, based on costs of performance.

Under the bill, effective for tax years beginning on or after July 1, 2016, sales, other than sales of tangible personal property, would be sourced to Tennessee if the taxpayer’s market for the sale is in Tennessee. Specific rules would apply in determining whether the market for certain types of sales will be deemed to be in Tennessee:

  • In the case of a sale, rental, lease or license of real property, the sale would be attributed to Tennessee if and to the extent the property is located in Tennessee.
  • In the case of a rental, lease or license of tangible personal property, the sale would be attributed to Tennessee if and to the extent the tangible property is located in Tennessee.
  • In the case of a sale of services, the sale would be attributed to Tennessee if and to the extent the service is delivered to a location in Tennessee.
  • In the case of a rental, lease or license of intangible property, including a sale or exchange of such property when the receipts from the sale or exchange result from payments that are contingent on the productivity, use, or disposition of the property, the sale would be attributed to Tennessee if and to the extent the intangible property is used in Tennessee.
  • In the case of a sale of intangible property, other than as referenced above, when the property sold is a contract right, government license, or similar intangible property that authorizes the holder to conduct a business activity in a specific geographic area, the sale would be attributed to Tennessee if and to the extent that the intangible property is used in Tennessee.

Any receipts from a sale of intangible property not specifically described in the statute would be excluded from the numerator and the denominator of the sales factor entirely (i.e., a throw-out rule would apply to such receipts). If a taxpayer cannot source any type of receipt using the rules discussed above, the legislation allows taxpayers to reasonably approximate the state or states to which the receipts are to be assigned. If the location of the sale cannot be determined or reasonably approximated, the receipts would be excluded from both the numerator and the denominator of the sales factor.

The new market-sourcing rules would also be used for excise (income) tax and Tennessee franchise tax purposes. The bill also includes a provision stating that if the application of the market-sourcing provisions results in a lower apportionment factor than current law rules, taxpayers could elect to use the rules in effect prior to the law change if this results in higher apportionment for that year and if the taxpayer had positive net earnings for the tax year, rather than a net loss.

KPMG observation

This rather odd election presumably may allow some taxpayers to achieve a more rapid utilization of accumulated net losses being carried forward.

New special rule for receipts from sales of securities

Effective for tax years beginning on or after July 1, 2016, a new apportionment rule would apply to receipts equal to the net gain or income from the sale of a security made by a person who is a dealer in securities under IRC section 475. Such receipts would be attributed to Tennessee if such person’s customer is located in Tennessee and such receipt is not otherwise attributed to Tennessee under the rule that applies to receipts from the sale of an intangible or tangible asset.

A customer is considered to be in Tennessee if the customer is an individual, trust or estate that is a resident of Tennessee or if the customer’s commercial domicile is in Tennessee. Unless the dealer has actual knowledge of the customer’s residence or commercial domicile, the customer will be deemed to be a Tennessee customer if the billing address is in Tennessee.

Special rule for certain communications companies

The bill would require certain “qualified members” of certain “qualified groups” in the communications industry to use a special apportionment formula. Under this formula, total receipts in Tennessee (i.e., the numerator of the sales factor) equals the receipts from all sales of tangible personal property attributed to Tennessee under the sourcing rules for tangible personal property plus the arithmetical average of receipts from all sales of other than tangible personal property that are in Tennessee as determined under (1) the new market-sourcing rules, and (2) the historical earnings producing activity test.

A “qualified member” is a person principally engaged in the sale of telecommunications services, mobile telecommunications services, internet access services, video programming services, direct–to-home satellite television programming services, or some combination thereof. A qualified group is an affiliated group that meets these two criteria: (1) one or more members of the group is a qualified member; and (2) the members of the group, during the tax period, incur “qualified expenditures” of greater than $150 million or make sales subject to Tennessee sales and use tax of greater than $150 million.

“Qualified expenditures” are expenditures incurred in transactions with persons who are not members of the qualified group for: (1) tangible personal property placed in service in Tennessee by a member of the qualified group; and (2) payroll for employees employed by a member of the qualified group at a facility in Tennessee.

Election for taxpayers with sales to distribution centers

Effective for tax years beginning on or after January 1, 2016, the legislation contains an election specific to taxpayers that: (1) make sales of tangible personal property to Tennessee distributors exceeding $1 billion during the tax year; and (2) have a Tennessee receipts factor that exceeds 10% under the application of the normal sourcing rules and before the exclusion. Such taxpayers may elect to exclude from the sales factor numerator the total amount derived from “certified distribution sales.”

“Certified distribution sales” are sales made to a Tennessee distributor (regardless of whether such distributor is related to the taxpayer) that are certified as being resold for use or consumption outside of Tennessee. Taxpayers electing to exclude such receipts are required to pay an annual excise tax on the excluded certified distribution sales. The amount of excise tax is based on the amount of certified distribution sales excluded.

Click-through nexus

Effective July 1, 2015, the legislation adopts click-through nexus provisions for sales and use tax purposes. Specifically, a dealer is presumed to have substantial nexus with Tennessee if it enters into an agreement with one or more persons in Tennessee who, for consideration, refer prospective customers, directly or indirectly, to the dealer via a link on their website or other means if cumulative gross receipts from retail sales in the state created through such affiliation exceed $10,000 in the preceding 12-month period.

The presumption that nexus exists may be rebutted “…by clear and convincing evidence that the person with whom the dealer has an agreement or contract did not conduct any activities in this state that would substantially contribute to the dealer’s ability to establish and maintain a market in this state.”

Taxation of access to software

Under current law, the sale of computer software is subject to Tennessee sales and use tax “regardless of whether the software is delivered electronically, delivered by use of tangible storage media, loaded or programmed into a computer, created on the premises of the consumer, or otherwise provided.”**TENN. CODE ANN. § 67-6-231(A).

Effective July 1, 2015, the legislation adopts a definition of “use of computer software” that includes the access and use of remotely hosted software that remains in the possession of a dealer or a third party on behalf of such dealer.

If a customer accesses the software from a location in Tennessee as evidenced by a residential street address or the primary business address of the customer, such access would be deemed equivalent to the sale or license and electronic delivery of the software in Tennessee.

When the sales price includes users located both in and outside Tennessee, the sales price would be allocated for tax purposes based on the users in Tennessee. The legislation specifies that the provision is not to be construed as imposing tax on any services that are not currently subject to Tennessee sales and use tax, including but to limited to, information services or data processing.

The general rules regarding purchases for resale will apply to dealers that purchase access to computer software for resale. However, a qualified data center that purchases software for use by an affiliated company would not be eligible for a resale exemption. In that situation, the data center would be considered the end- user of the software and would be eligible for the industrial machinery exemption for such purchases.

The existing sales and use tax exemption for the use of computer software developed and fabricated by an affiliated company would remain in effect but modified to address the taxability of software accessed remotely. In addition, the existing sales and use tax exemption for the fabrication of computer software by a person, or its direct employee, for such person's own use and consumption, would be expanded. The expanded exemption applies to the access and use of software that remains in the possession of a dealer or third party when such access and use of the software is solely by a person or that person’s direct employee for the exclusive purpose of fabricating other software that is both: (1) owned by that person; and (2) for that person’s own use and consumption.

Video game digital products

In addition to expanding the sales tax to access of hosted software, the legislation expands the types of digital goods subject to sales and use tax to include online gaming, effective July 1, 2015. Currently, Tennessee taxes “specified digital products,” which includes electronically transferred digital audio-visual works, digital audio works and digital books.*

*TENN. CODE ANN. § 67-6-102(88).

Under the legislation, “specified digital products or video game digital products” are subject to sales and use tax. “Video game digital products” means “the right to access and use computer software that facilitates human interaction with a user interface to generate visual feedback for amusement purposes, when possession of the computer software is maintained by the seller or a third party….”

Attorney General weighs in

The Tennessee Attorney General (AG) issued Opinion No. 15-37 (April 22, 2015) addressing a number of aspects of the legislation, including whether the factor-presence nexus standards would run afoul of the Commerce Clause and the Tennessee J.C. Penney case.

In the J.C. Penney case, the Tennessee Court of Appeals held that “physical presence is required in order to satisfy the substantial nexus requirement of Complete Auto.” The AG observed that courts in other states have frequently rejected the reasoning in J.C. Penney and, in his view, the factor presence standards incorporated into the legislation would be “defensible under the United States Constitution.”

 

For information, contact a KPMG State and Local Tax professional:

Loren Chumley | +1 (615) 248-5565 | lchumley@kpmg.com

Blair Norman | +1 (615) 248-5544 | blairnorman@kpmg.com

Justin Stringfield | +1 (615) 248-5510 | jstringfield@kpmg.com

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