Welcome to the latest Massachusetts Quarterly Update from Reed Smith. This update for the 2nd Quarter of 2013 includes coverage of a number of corporate excise tax developments, in particular: (i) pending apportionment legislation on Beacon Hill that would impose market sourcing for many types of receipts and institute a throwout rule; and (ii) some recent decisions from the Appellate Tax Board ("ATB") regarding the taxation of securitization entities, SINAA sourcing, and the sham transaction doctrine.
This update also covers a number of sales tax issues, including: (i) pending litigation that could impact the taxation of software as a service (SaaS) and cloud computing services; (ii) recent letter rulings regarding SaaS and cloud computing transactions; (iii) pending legislation expanding the sales tax to certain computer services; and (iv) some recently decided cases involving (a) class action sales tax lawsuits; and (b) bad debt refund claims by vendors in third-party financing transactions.
Market sourcing and throwout likely on the way—in 2014
Pending legislation would bring market sourcing to Massachusetts for the 2014 tax year and include a throwout rule when sourcing receipts from sales other than sales of tangible personal property.
The House and Senate have passed legislation replacing Massachusetts’ current cost of performance sourcing regime for sales other than sales of tangible personal property with a market-based sourcing rule for tax years starting on or after January 1, 2014. The legislation would also implement a throwout rule for sales other than sales of tangible personal property.1
Governor Patrick has returned the bill to the Legislature and recommended amendments, not because of any objection to the apportionment changes, but because it lacked certain additional revenue provisions (most importantly a provision to increase the gas tax to offset potential lost highway toll revenue). The Democratic legislative leadership has recommended that its members reject the gas tax provision; however, the initial legislation passed with enough votes to override the Governor’s veto. As a result, there is still a strong chance the apportionment changes could be enacted in their current form, notwithstanding a potential veto by the Governor.
- Effect on Alternative Industry Apportionment Rules: It is unclear how the legislation will affect existing alternative apportionment rules for industries such as airlines and delivery companies. The authority of the Massachusetts Department of Revenue (the "Department") to promulgate alternative apportionment rules for special industries is triggered only if the statutory apportionment rules "are not reasonably adapted to approximate the net income" of a particular industry in Massachusetts. The current industry-specific regulations were arguably permissible because the Department had determined that the statutory apportionment rules, including the cost of performance sourcing rule, did not meet the "reasonable approximation" standard. However, it is less clear that the Department will be able to continue to meet this burden in the case of all industries with alternative apportionment regimes once the statutory apportionment rules are amended to adopt market-based sourcing.
- Guidance to Follow: While the legislation does not take effect until 2014, we expect the Department to issue guidance implementing the apportionment changes shortly after the legislation is enacted.
The Department continues to challenge taxpayer use of the "operational approach" in applying the cost of performance sourcing rule—except in situations where the majority of the taxpayer’s operations are in Massachusetts.
At a recent meeting of the Boston Bar Association, David Davenport (Deputy Commissioner and Senior Policy Counsel for the Department) stated that he did not believe that the 2011 ATB decision in AT&T,2 which applied an operational approach to cost of performance sourcing, was broadly applicable. This indicates that the Department will continue to challenge taxpayer attempts to apply an operational approach to source receipts outside of Massachusetts on an "all or nothing basis." Mr. Davenport made clear that his comments were his own and not an official statement of the Department of Revenue, but with more than a dozen cost of performance cases currently pending at the ATB, it is clear that the Department views AT&T as a decision with limited applicability to other out-of-state service providers.
Of course, when the application of an operational approach benefits Massachusetts (e.g., in the case of taxpayers that have a majority of their operations in Massachusetts), we expect the Department to continue to employ an operational approach in applying the cost of performance sourcing rule, citing AT&T, as well as the ATB decisions in Boston Bruins and Interface Group.3 The Department is currently taking this position in several cases pending at the ATB.
- Out-of-state taxpayers that have taken the operational approach to applying the cost of performance sourcing rule should keep a close eye on the cost of performance cases pending at the ATB. Taxpayers that have not yet employed this approach to applying the cost of performance sourcing rule still have time to file refund claims for tax years before the effective date of the pending legislation.
- Masschusetts-based service providers should consider whether they can apply the Department’s own arguments in support of sourcing receipts using a transactional approach to support a position that a portion of their receipts can be sourced outside of Massachusetts—even if the majority of the costs of performance associated with their overall operations are incurred in Massachusetts.
- Taxpayers interested in receiving updates on the cost of performance cases pending at the ATB should contact Michael Jacobs at
Securitization entity qualifies as a financial institution
The ATB held that a corporation formed in connection with a typical securitization transaction qualified as a financial institution rather than a business corporation for corporate excise tax purposes. The ATB found that purchasing and holding loans qualified as "lending activity," and that these lending activities, as well as the securitization transactions, were activities that were in "substantial competition" with other financial institutions.
In a recent decision, the ATB provided some insight into the corporate excise tax treatment of some of the bankruptcy remote entities that are typically formed as part of a securitization transaction.4 The appeal involved a corporation formed to own beneficial interests in trusts holding securitized student loans initially issued by third party.
Based on the facts in First Marblehead/Gate Holdings, the Board found:
- Purchasing loans is a "lending activity": A taxpayer qualifies as a financial institution for corporate excise tax purposes if, among other activities, it is engaged in a "lending activity" that is in "substantial competition" with other financial institutions. While the taxpayer in this case (Gate Holdings) and the trusts in which it held beneficial interests did not issue loans to the public, the ATB found that Gate Holdings was engaged in a lending activity because the trusts it owned purchased and held student loans.
- Expansive definition of "substantial competition": In interpreting the "substantial competition" requirement, the ATB found that banks also engaged in similar transactions involving the securitization of loans, and that such transactions facilitated lending by the banks. Further, the ATB noted that the purchase and securitization of loans by Gate Holdings and its affiliates reduced the investment opportunities available to other banks and financial institutions. Thus, the ATB determined that Gate Holdings and its affiliates were in substantial competition with other financial institutions. The ATB rejected the Department’s argument that the "substantial competition" prong was satisfied only if the taxpayer directly competed with other financial institutions to purchase the specific loans in its portfolio.
The taxpayer has appealed the decision of the ATB to the Massachusetts Appeals Court. The taxpayer’s first brief is due July 22.
- Department Believes Merely Purchasing Loans Insufficient to Qualify as a Financial Institution? Taxpayers that have previously qualified as "financial institutions" solely on the basis of purchasing, rather than issuing, loans should keep a close eye on this litigation as it proceeds through the courts. While we think the Department’s position is unsupported by the statute, a Department victory would mean that taxpayers that merely purchase loans issued by others would be taxed as business corporations, absent other activities that would qualify the taxpayer as a financial institution. Taxpayers that would benefit from such a change in classification should consider protective refund claims.
- ATB provides support for business purpose and economic substance of securitization entities? Some Department auditors have been challenging the transfer of loan portfolios to affiliated out-of-state bankruptcy remote securitization entities under the sham transaction doctrine. While the ATB’s decision in First Marblehead/Gate Holdings involved the securitization of third-party loans, it provides substantial analysis supporting the business purpose and economic substance of securitization transactions in general. This analysis should provide support for taxpayers that have engaged in similar intercompany transactions as part of a securitization of receivables when defending against sham transaction attacks by the Department.
Financial institution’s purchase of loans made by a lender to borrowers located outside of Massachusetts causes institution to be engaged in business in the states where the borrowers were located and eligible for apportionment under Massachusetts’ economic nexus standard; however, purchased loans treated as Massachusetts property for apportionment purposes
The First Marblehead/Gate Holdings decision also provided guidance regarding a financial institution’s eligibility for apportionment and the sourcing of the institution’s loan portfolio for property factor purposes. Significantly, the ATB held:
- Financial institution entitled to use economic nexus standard to determine whether "taxable" in another jurisdiction: Gate Holdings had no payroll or receipts, and no property other than the student loans it purchased. Nonetheless, the ATB held that Gate Holdings was entitled to apportion its income because it held loans made to borrowers in all 50 states, and the presence of those borrowers would permit those other states to impose tax on Gate Holdings – presumably under Massachusetts’ economic nexus standard.
- Third-party activities not considered in sourcing loan for property factor purposes: For financial institutions, a loan is included in the property factor and sourced to the regular place of business where the preponderance of the "SINAA"5 activities occur with respect to the loan. Gate Holdings argued that in determining where the SINAA activities occurred with respect to its loans, it should be permitted to take into account the location of activities conducted by the third-party loan servicers under contract with Gate Holdings. The ATB rejected this argument, because it did not consider the loan servicers to be agents of Gate Holdings. Instead, the ATB concluded that Gate Holdings did not have a regular place of business, either inside or outside of Massachusetts, and instead sourced the loans to Gate Holding’s commercial domicile in Massachusetts.
- Third-party activity insufficient to establish nexus: Non-Massachusetts taxpayers will breathe a sigh of relief that the ATB rejected the Gate Holding’s argument that the activities of the third-party loan servicers paid by Gate Holdings were sufficient to cause Gate Holdings to be subject to tax in states other than Massachusetts. The ATB rejected this argument on the basis that no agency or other relationship existed between Gate Holdings and the third parties sufficient to attribute the activities of the servicers to Gate Holdings. If the ATB had not rejected this argument, the Department could have used the same theory to assert that out-of-state taxpayers were similarly "taxable" in Massachusetts based on the Massachusetts activities of unrelated third parties, based merely on the fact that those third parties were paid by the taxpayers.
As stated above, the First Marblehead/Gate Holdings decision has been appealed by the taxpayer to the Massachusetts Appeals Court, so taxpayers with similar apportionment issues should continue to follow this case.
Department applies sham transaction doctrine to deny taxpayer nexus
In an odd twist, the ATB issued a decision this quarter in a case in which the Department was successful in contesting a taxpayer’s claim of nexus with Massachusetts. In Allied Domecq Spirits and Wines USA, Inc., the ATB held that Massachusetts could apply the sham transaction doctrine to disregard the transactions that would have otherwise caused a taxpayer to have nexus with Massachusetts.6
Prior to the tax years at issue in the Allied Domecq case, the taxpayer was the principal reporting corporation in a combined group filing Massachusetts corporate excise tax returns. The taxpayer reported net income apportioned to Massachusetts on these returns. The taxpayer was a subsidiary of another corporation ("Parent"). Parent did not have sufficient nexus with Massachusetts to be included in the Massachusetts combined group with the taxpayer. Parent generated substantial losses each year. In order to make Parent’s losses available to offset the income of the Massachusetts combined group, the taxpayer caused certain Massachusetts employees to be transferred to Parent, and subleased, through a subsidiary, office space to Parent. As a result of these arrangements, the taxpayer treated Parent as having nexus with Massachusetts and included Parent in the Massachusetts combined group. This allowed the taxpayer to offset its taxable income with the losses generated by Parent. In a further expansion of the sham transaction doctrine in Massachusetts, the ATB agreed with the Department’s determination that the employee transfer and lease arrangement to Parent was a sham and thus, upheld Parent’s exclusion from the Massachusetts combined group.
The ATB determined that the employee transfer was a sham, in part, because the employee transfer had no valid, non-tax business purpose. In reaching this conclusion, the ATB focused on an internal memorandum indicating: (i) that state tax savings was the purpose of the transfer, and (ii) that the employee transfer could be accomplished with no effect on the business.
The taxpayer has appealed this decision to the Massachusetts Appeals Court and taxpayer’s brief is due August 5, 2013.
Sales and Use Tax
The Department continues to issue guidance on the taxability of mixed transactions that involve the provision of both software and services. At the same time, in a case pending at the ATB, a taxpayer is challenging the Department’s position that SaaS and cloud computing software are subject to sales tax.
Department determines cloud computing software to be true object of bundled transaction.
In a recent ruling, the Department concluded that subscriptions paid for bundled sales of cloud computing products were taxable, because the use of prewritten software was the true object of the transactions.7 The primary product offering of the taxpayer requesting the ruling was an automated system embedded into a customer’s website that collected, organized and displayed customer ratings, questions, answers and stories on the customer’s website or Facebook page. The Taxpayer also offered a service in which its employees monitored and filtered the data, and provided the customer with advice on how to maximize their social media exposure.
The Department concluded that the primary offering was taxable prewritten software because it operated automatically, without interaction from the customer. Any additional services would be non-taxable services if not bundled with the primary offering. However, the Department concluded that any additional services, like the moderation services, would be taxable if bundled with the primary offering.
The Department determines that a subscription charge for a product that allows purchaser to arrange virtual conferences and events is a purchase of prewritten computer software, subject to tax.
The Department has issued a letter ruling in which it concluded that the subscription charges that customers paid for the ability to set up a virtual conference or event center were subject were taxable charges for the use of prewritten computer software under the true object test.8 The taxpayer that requested the ruling offered a product that allowed its customers to set up a virtual conference center housed on the taxpayer’s server. This virtual conference center could be customized by the taxpayer, and could be accessed by the customer through the customer’s own Internet connection. The taxpayer provided each customer with an explicit license to use the software used to create and customize the virtual conference center.
The Department concluded that the taxpayer’s sales of subscriptions were taxable, whether sold alone or bundled with additional services, because the object of a customer in purchasing a subscription was to use the software to create a customized online event. Moreover, customers were explicitly given a license to use the software. These licenses constituted a taxable transfer of tangible personal property.
Pending litigation at ATB challenges the Department’s view that sales of SaaS and cloud computing software are taxable.
In a case pending at the ATB, a taxpayer is challenging the Department’s assessment of sales tax on sales of SaaS. While this case is still in the early stages of development, a taxpayer victory could call into question much of the Department’s guidance treating sales of SaaS and cloud computing software as subject to Massachusetts sales tax.
Businesses interested in updates regarding this case should contact Michael Jacobs at
Pending legislation would impose Massachusetts sales tax on specified software services, with an effective date of July 1, 2013
The Legislature has passed a bill expanding the coverage of the sales tax to a variety of software-related services, and "computer system design services." The Governor has returned the legislation with recommended amendments because the legislation does not include unrelated revenue increases. However, the Legislature should have enough votes to override a threatened veto.
The Legislature has passed legislation imposing sales and use tax on:
- "Computer system design services," defined as planning, consulting, or designing computer systems that "integrate computer hardware, software, or communication technologies"
- Modification, integration, enhancement, installation, or configuration of standardized software9
As currently drafted, the legislation could be interpreted as imposing sales tax on services relating to the customization of software, since both "modification" and "enhancement" of standardized software are taxable under the legislation. In addition, the definition of "computer system design services" in the legislation is extremely vague.
- Taxpayers need to watch the effective date closely: The version of the legislation passed by both houses of the Legislature and vetoed by Governor Patrick had a July 1, 2013 effective date for the sales tax changes. Governor Patrick has proposed for the sales tax changes to be effective seven days after the legislation is signed into law, which would at least provide taxpayers a minimal amount of time to implement the changes necessary to collect the new tax. If the Legislature overrides Governor Patrick’s veto, however, businesses will be forced to deal with a retroactive effective date of July 1, 2013.
- Department guidance expected shortly after implementation: If the sales tax changes are enacted, notwithstanding Governor Patrick’s recommended amendments, the Department will likely issue near immediate guidance interpreting the new provisions. The Department typically invites taxpayer comments at all stages of its policy-making process, but in this case, the need for immediate guidance may limit the period available for the Department to consider taxpayer input. As a result, taxpayers with particular concerns should consider reaching out to the Department as soon as possible.
Sellers beware: waivers may not protect vendors from class actions for improper sales tax collection
The Supreme Judicial Court reaffirmed a Superior Court holding that waivers, which compel individual arbitration claims for improper sales tax collection by vendors, rather than pursuit of such claims through class actions, may be invalid.10
The case involved optional service contracts that Dell sold to purchasers of its hardware. Dell collected sales tax on the purchase price paid for these optional service contracts. Customers brought suit against Dell, alleging that Dell made them pay for a tax that was not authorized by any Massachusetts taxing authority, and sought relief through a class action under a consumer protection law. Dell moved to compel individual arbitration based on the class action waiver included in the standard Terms and Conditions that accompanied each sale.
The court revisited a decision it issued in 200911 in favor of the class in light of a United States Supreme Court decision that held that class action waivers are presumptively valid under freedom of contract and the Federal Arbitration Act’s policy of promoting arbitration.12
The Supreme Judicial Court’s holding in Feeney II was based on different grounds than its decision in Feeney I. Instead of relying on the consumer protection law, the court held that the class action waiver was invalid where a plaintiff can show that the enforcement of the waiver would effectively bar the plaintiff from pursuing a claim against a defendant, making the claim nonremediable.
The court held that the plaintiffs had sufficiently showed that their sales tax claims would be nonremediable if the class action waiver were enforced. The court determined that each individual customer’s claim against Dell was so small that no individual customer could efficiently enforce his or her rights in arbitration. Thus, the court noted that enforcing the class action waiver would effectively immunize Dell from civil liability for the alleged injuries resulting from its sales tax collection practices. Therefore, the court invalidated the waiver and allowed the case to proceed on the merits as a class action.13
Taxpayers claiming bad debt refunds still have no remedy
Massachusetts courts continue to interpret the bad debt deduction in a manner that effectively makes the deduction inapplicable to tax remitted on transactions financed by third parties.
In our Quarterly Update for the 4th Quarter of 2012, we reported on the Catch-22 facing taxpayers that used third-party lenders to extend credit to customers when the customer accounts later proved uncollectible. In Sears, Roebuck & Co. v. Commissioner,14 the Appeals Court upheld the ATB’s decision that vendors are not permitted to claim a bad debt deduction for sales tax remitted by third-party finance companies.
If you have questions about any of the items discussed in this update, please contact the authors of this alert, or the Reed Smith lawyer with whom you usually work. For more information on Reed Smith's Massachusetts tax practice, visit www.reedsmith.com/matax.
2. AT&T Corp. v. Commissioner, Mass. Appellate Tax Board, Docket No. C293831 (June 8, 2011) aff’d Mass. App. Ct., Docket No. 11-P-1462 (July 13, 2012).
3. Boston Prof’l Hockey Ass’n, Inc. v. Commissioner, 820 N.E.2d 792 (Mass 2005); Interface Group v. Commissioner, Mass. App. Ct., Docket No. 08-P-1861 (December 8, 2009).
4. First Marblehead Corp. & Gate Holdings, Inc. v. Commissioner, Mass. Appellate Tax Board, Docket Nos. C293487, C305217, C305240, C305241 (April 17, 2013).
5. The SINAA activities with respect to a loan are solicitation, investigation, negotiation, approval, and administration. See G.L. c. 63, §2A(e)(vi)(3)(C).
6. Allied Domecq Spirits and Wines USA, Inc. v. Commissioner, Mass. Appellate Tax Board, Docket Nos. C282807, C293684, and C297779 (May 27, 2013).
7. Letter Ruling 13-2 (March 11, 2013).
8. Letter Ruling 13-5 (June 4, 2013).
9. H. 3535.
10. Feeney v. Dell, Inc., 465 Mass. 470 (2013) ("Feeney II").
11. Feeney v. Dell, Inc., 908 N.E.2d 753 (2009) ("Feeney I").
12. AT&T Mobility LLC v. Concepcion, 131 S.Ct. 1740 (2011).
13. The plaintiffs still face a daunting task to prevail on the merits. Based on the Supreme Judicial Court’s holding in Feeney I, the plaintiffs, in order to prevail, must prove Dell was collecting a facially valid tax improperly as part of a scheme to shift the burden of repairs from Dell to the consumer, thereby increasing Dell’s profits on the service contracts.
14. Sears, Roebuck & Co. v. Commissioner, Mass. App. Ct., Docket No. 12-P-547 (June 19, 2013).
Client Alert 2013-199