Reed Smith Client Alert

Welcome to the first of a new series of quarterly updates from Reed Smith on state tax developments in Massachusetts. Every three months we will be updating you on the key cases and administrative releases, as well as providing you with some insight on new issues that taxpayers are facing in audits and cases pending before the Appellate Tax Board ("ATB").

For more information on any of the issues discussed below, contact Michael Jacobs or Robert Weyman in Reed Smith’s State Tax Group.1

Corporate Excise Taxes

Cash Management Company Interest Payments Not True Debt, Subject to Add-Back

The Court of Appeals has upheld a decision of the ATB denying deductions for interest paid under a cash management system, because taxpayer could not establish the interest payments were for true debt. Other taxpayers that have been denied deductions for cash management interest should still consider appeal if they have strong facts indicating the existence of true debt, such as evidence of actual repayment of principal at or before the deadline set in the loan documentation.

Last week, the Massachusetts Appeals Court upheld the ATB’s decision denying Kimberly-Clark interest deductions for interest payments attributable to a cash management system.2 The appeal involved interest deductions for a three year period; including a tax year (2001) before the adoption of the statutory add-back for related-party interest, and two tax years (2002-2003) after the adoption of the statutory interest add-back.3

Prior to the enactment of the statutory interest add-back, taxpayers had to establish by the preponderance of the evidence that their interest payments were for obligations deemed to be "true debt." Kimberly-Clark provided the following evidence:

  • A sample executed loan agreement with one of its subsidiaries
  • Sample promissory notes
  • Proof that the interest rate paid was considered "arm’s length" for purposes of I.R.C. § 1274(d)

For the 2001 tax year, the court found that the preponderance of the evidence did not support Kimberly-Clark’s contention, relying on the following facts:

  • The loan agreement and promissory notes did not require security or collateral, and did not have a provision covering the effect of default by one of the parties
  • Kimberly-Clark never repaid the principal on the loans, despite the fact that the expiration date had passed for the promissory notes provided as evidence
  • Kimberly-Clark used the same interest rate for all subsidiaries. Simply using the "arm’s length" rate provided by I.R.C. § 1274(d) for every entity was insufficient to overcome other factors.

The court, therefore, disallowed Kimberly-Clark’s interest deductions attributable to its cash management system for the 2001 tax year.

For the 2002-2003 tax years, Massachusetts’ add-back statute was in effect. For those years, the court held that there was no change in Kimberly-Clark’s facts, and that the "true debt" standard still applied. The only difference was the legal standard. Under the add-back statute, taxpayers have an even greater evidentiary burden, specifically that they must establish that the debt is true debt through "clear and convincing evidence," rather than the previous standard: "preponderance of the evidence."4 Since Kimberly-Clark did not meet the lower standard in effect before add-back, it could not meet the higher standard for the add-back years.

Numerous cases involving this same issue are still pending at the Appellate Tax Board and the Appeals Court. The pending cases involve tax years before and after enactment of Massachusetts’ statutory add-back for interest paid to affiliated entities.


  • Cash management cases are very fact-specific, and a loss by Kimberly-Clark does not necessarily mean that all interest paid under all cash management systems will be subject to add-back.
  • While the Commonwealth’s recent victories on this issue have strengthened its position, the Department continues to settle cases with taxpayers that have facts supporting the treatment of their cash management balances as "true debt." 
  • The court declined to provide further guidance on the distinction between its previous requirement that the "preponderance of the evidence" establish that a debt is "true debt," and the new standard that taxpayers must provide "clear and convincing evidence." Since the court reasoned that Kimberly-Clark lost under either standard, it remains to be seen if the courts will impose a significantly stricter analysis under the clear and convincing standard.

Taxpayer Need Not Conduct its Manufacturing 'In House' to be a Manufacturing Corporation

The ATB has confirmed that a company that outsources manufacturing to a third party can still be classified as a manufacturing corporation and be required to apportion income using a single-sales factor. The broad definition of manufacturing adopted by the ATB may create refund opportunities for in-state companies that outsource manufacturing operations, and create exposure for out-of-state companies.

Massachusetts requires corporations classified as manufacturing corporations to use a single-sales-factor apportionment formula, rather than the standard three-factor apportionment formula that is applied to most other corporations.5 While this apportionment provision tends to benefit manufacturers with substantial amounts of payroll and property in Massachusetts, being classified as a manufacturing corporation often punishes out-of-state manufacturers that would otherwise benefit from the inclusion of their low Massachusetts payroll and property factors in their apportionment formula.6

Many taxpayers are surprised by the broad interpretation that the Department of Revenue and the Appellate Tax Board have given to the manufacturing corporation classification. The breadth of the classification was illustrated in a recent ATB decision confirming that a taxpayer can be a manufacturer, even if a third party actually produces the product that it sells to customers.7

The decision involved Random House, a book publisher. Random House worked closely with independent authors to create a final draft of a book to be published, and then worked with a third party to design and format the book layout. The design and format were completed electronically and then transmitted to a third-party printer. While the tangible books had to be printed to Random House’s specifications, the actual printing of the tangible books was done by the third-party printer.

Following prior decisions for similar taxpayers, the ATB held that Random House was a manufacturer—even though the third-party printer produced the physical books.8 While the statutory definition of "manufacturing corporation" requires that a taxpayer be engaged in transforming physical materials into a new product, the ATB followed its prior case law to determine that there is no requirement that the manufacturing company itself must actually transform the physical materials. Designing a product and setting the specifications for it to be produced, and then directing a third-party to transform materials into the specified product, is sufficient for a corporation to be classified as a manufacturer.


  • Taxpayers that outsource manufacturing activities to third parties should be aware that they may still qualify as a manufacturing corporation in Massachusetts. This may create refund opportunities for Massachusetts-based corporations that use contract manufacturers to handle the physical production of their goods.
  • A taxpayer’s input and approval over the final product produced by a third party can be sufficient to cause the taxpayer to be classified as a manufacturing corporation.

Tax Credit Based Solely on Investment in Massachusetts Property Does Not Violate Commerce or Due Process Clauses

In addition to the single-sales-factor apportionment formula, the Commonwealth offers manufacturing corporations an investment tax credit equal to 3 percent of the cost or other basis of eligible property situated in and used in Massachusetts.

In the Random House decision discussed above, the taxpayer argued that basing the investment tax credit solely on the cost of eligible property located in Massachusetts results in an unfair competitive advantage for Massachusetts’ businesses, and violates the Commerce and Due Process clauses of the United States Constitution.

The ATB dismissed this argument, finding that the credit was available to both domestic and foreign corporations, and thus did not discriminate based on domicile.

Taxpayers Continue to Bring 'Operational Test' Cost of Performance Appeals—Argument Even Stronger in Light of AT&T Decision

The Department continues to challenge out-of-state service providers that have sourced receipts outside of Massachusetts under the all-or-nothing cost-of-performance rule. These challenges typically involve an attempt by the Department to narrow the scope of the income-producing activity to which the cost-of-performance analysis is applied. The ATB and the courts have rejected a number of these challenges by applying a broad, operational approach to defining a taxpayer’s income-producing activity. Service providers that have not been applying an operational approach and sourcing their service receipts outside of Massachusetts may have refund opportunities.

Corporations that derive receipts from the provision of services both inside and outside of Massachusetts are required to source their service receipts for Massachusetts apportionment purposes based on the location of the costs of performance associated with the services. If more of the taxpayer’s costs of performing its income-producing activity are incurred in any state other than Massachusetts, then none of the taxpayer’s receipts from that income-producing activity are sourced to Massachusetts.9

Massachusetts’ courts and the Appellate Tax Board have consistently applied an "operational approach" to determine the taxpayer’s income-producing activity.10 That is, the courts have ruled that a taxpayer’s income-producing activity is the entire operation that produced the service, including all of the subsidiary activities that cannot be associated with any single customer transaction. Under the operational approach, if the taxpayer incurred more costs in the overall provision of a service in a state other than Massachusetts than in Massachusetts, then all receipts from the service are excluded from the taxpayer’s sales-factor numerator. The AT&T decision issued by the Massachusetts Appeals Court in July illustrates the potential breadth of the operational approach.11 The Massachusetts Appeals Court found that AT&T’s "income-producing activity" was the provision of an integrated long-distance telecommunications network to its customers located in Massachusetts and other states. While AT&T may have incurred more costs in Massachusetts to process particular telephone calls, the court, when looking at its operation as a whole, determined that more of AT&T’s costs of operating and maintaining the long-distance network needed to service all customers were incurred in New Jersey than in Massachusetts. As a consequence, the court affirmed the decision of the ATB that all of AT&T’s receipts from long distance calls were excluded from its Massachusetts sales factor numerator.

Taxpayers continue to file appeals arguing for the application of the operational approach to the sourcing of service receipts in a variety of business contexts. Some examples of pending cases at the ATB include: 

  • Franchise Fees: An international fast food franchisor is arguing that franchise fees received from fast food franchises located in Massachusetts should be excluded from its sales-factor numerator because more costs of franchisor’s business are incurred in a state other than Massachusetts.
  • Wholesale Electricity Sales: Electricity sales made by an electricity wholesaler on the basis that primary cost is the purchase of electricity, and more of those costs are incurred in a state other than Massachusetts.
  • Delivery Company Receipts: An international package delivery company is arguing that its receipts from delivering packages and documents to customers—including receipts for delivering packages to Massachusetts customers—must be excluded from its sales-factor numerator because more of it costs of providing its delivery services are incurred in a state other than Massachusetts.

Although the Department continues to argue for the application of the transactional approach in most cases, we understand that the Department has also been settling cases where the taxpayer presents facts that demonstrate the taxpayer’s services are provided through an integrated operation that extends outside of Massachusetts.


  • Taxpayers that derive receipts from providing a service to customers in Massachusetts and other states where the services provided through an integrated multistate operation and the greater proportion of the costs of that operation are incurred in a state other than Massachusetts, may have a refund opportunity if they have been sourcing any of their service receipts to Massachusetts.

Sales and Use Taxes

'Catch-22' Bad Debt Appeal Oral Argument Scheduled for January 17

Under current law, neither the vendor nor the third-party financing company can claim a bad-debt deduction for Massachusetts sales tax purposes, when the purchase price was financed by the third-party finance company, and the purchaser defaults prior to making full payment. This treatment creates a windfall for the Commonwealth. The Appeals Court is scheduled to hear argument in an appeal of an ATB decision that involves the right of a vendor to claim the bad-debt deduction when its receivables have been sold to a third-party finance company.

The Appeals Court has scheduled oral argument for January 17, 2013, in a case involving Sears. Sears is arguing that it is entitled to a bad-debt deduction for financed transactions where the customer ultimately did not pay the full sales price for a purchased item. Sears is requesting that the court overturn an ATB decision that seems to make it impossible for either the retailer/ vendor or the finance company to treat a retail sale involving third-party financing as resulting in a bad debt for sales tax purposes.

The ATB held that when Sears made sales at retail to customers, received full payment for those sales from a finance company, and remitted sales tax to the Commonwealth for those transactions, it was not eligible to take a bad-debt deduction when the customer ultimately did not pay the financing company.12 In this situation, the ATB found that the financing company recorded the bad debts on its books and it, rather than Sears, ultimately wrote them off. Therefore, the ATB concluded that vendor was not entitled to claim a bad-debt deduction for sales tax purposes. As a result of this holding, under current Massachusetts case law, in the typical retail sale involving third-party financing, neither the vendor nor the financing company would be eligible to claim a bad debt deduction for sales tax purposes.13


If the court upholds the ATB’s decision, it will create a Catch-22 that ensures that the Commonwealth receives a sales tax windfall on any retail sale with third-party financing where the customer does not ultimately pay the full purchase price.

Massachusetts currently permits certain taxpayers to take a bad-debt deduction for sales tax previously remitted to the Commonwealth if the customer ultimately defaults on amounts due and the vendor writes off the bad debt. The current appeal involving Sears addresses whether the "vendor" is eligible for that bad-debt deduction if a third party financed the sale. The ATB found that it was not. Standing alone, the decision of the ATB might seem reasonable. After all, the vendor receives full payment from the financing company at the time of purchase and it is the financing company—not the vendor—that bears the loss if the customer ultimately defaults. But, when combined with prior case law, which restricts the bad-debt deduction to the "vendor" and denies the third-party financer a right to the deduction, the ultimate result is a Catch-22 where neither the vendor nor the finance company is eligible to claim a bad-debt deduction.

Thus, we’re left with the following situation: if a vendor extends credit to a customer, and that customer ultimately defaults, there is no question that the vendor is entitled to a bad-debt refund because it is both the vendor and the party that extended credit. However, in a situation that is identical, except for the fact that a third-party extended the credit, the Commonwealth keeps the sales tax because neither the vendor nor the finance company has a means to claim a refund.

From a policy perspective, if the court does not find for the vendor in this appeal, one hopes the Legislature will step in to correct an obviously flawed result. Financing companies expand the public’s access to credit, spread the risk among a larger population of customers, and thereby can generally offer lower interest rates than an individual vendor would on its own. As it currently stands, Massachusetts’ courts have interpreted the sales tax statute in a manner that increases the cost of using third-party financing, and will, ultimately, reduce the availability of such financing for Massachusetts customers. Further, Massachusetts is getting a windfall by retaining sales tax remitted by vendors with respect to amounts that customers never actually paid—an obviously unfair result.

Taxability of Web-Hosted Software, SaaS, and Cloud Computing Addressed by Department

Over the past few months, the Department has issued rulings providing additional guidance on the sales tax treatment of software in several different contexts. Taxpayers that have paid Massachusetts sales or use tax on data transfer services or software used in states other than Massachusetts, may have refund opportunities.

Web-Accessed Software Found Taxable. In two separate rulings, the Department determined that sales of access and use of software stored on vendors’ servers constituted a taxable purchase of prewritten software. The Department ruled that the true object of the transaction was the software because the customer’s involvement with, and use of, the software was essential to meeting the customer’s objectives.14

Web-Access Software Accessed as Part of Data Back-Up and Restoration Services Not Taxable: The Department determined that remotely accessed data back-up and restoration ("B&R") services were not taxable where the service gave customers access to their data stored on the taxpayer’s servers through a free download program that served merely as a portal. The Department reasoned that the software program had no functionality without a subscription to the B&R service; therefore, the true object of the purchase was the B&R service. Because the B&R services were found to be non-taxable, the software was not taxable as well.15


  • Data Transfer Services — Still Taxable? In a letter ruling issued earlier this year, the Department found that separately stated fees for data transmission services provided over the Internet constituted taxable telecommunication services.16 Yet, in the more recently issued LR 12-11, the vendor also transmitted data over the Internet to customers, and the transmission services were found to be part of a non-taxable service. While the Department did not clarify why different treatment applied in LR 12-11, one possibility is that the fees for data transmission were separately stated in the previous letter ruling, while they were provided as part of one bundled service in LR 12-11.
  • Web-Hosted Services: The Department continues to apply a "true object" test to distinguish whether sales that include web-accessed software are taxable sales of pre-written software, or non-taxable sales of services. Recent guidance focuses on the amount of services the vendor must provide—other than maintaining the online software. The greater the day-to-day involvement by the vendor in providing services as part of the sale, the more likely the service is to be treated as non-taxable.
  • Sourcing: Department guidance continues to presume that the sales of software are sourced entirely to Massachusetts when there is a delivery of a physical disk in Massachusetts. However, Massachusetts has adopted multiple points-of-use sourcing.17 As a consequence, multi-state taxpayers may be able to source a portion of the sale outside of Massachusetts if the software is going to be used, in part, outside of Massachusetts. For example, a recent letter ruling involved software typically used by IT Departments to log into the computers of their co-workers to resolve software issues.18 The Department found the sale/license of the software taxable, presumably because the software was delivered to the customer’s IT department in Massachusetts. However, if an employee of the customer located outside Massachusetts was to use the software, then the software would be partially used outside Massachusetts and a portion of the sale price should not be subject to Massachusetts tax.

Amazon and Gov. Patrick Reach Agreement

Massachusetts Gov. Deval Patrick and Amazon announced that Amazon will collect and remit sales tax in Massachusetts starting November 1, 2013. The details of this agreement have yet to be made public. Tax Analysts has already filed a Massachusetts Public Records Request regarding the agreement. Although Tax Analysts’ request was denied, we expect that there will be further efforts to make the agreement public.

Administrative Updates

Mediation Pilot Program Unveiled

Taxpayers under audit and facing an assessment in excess of $1 million may be able to participate in mediation to expedite resolution of their case as part of a new Department pilot program. The timeframe for requesting to participate in the mediation program is limited, so taxpayers should be prepared to make the request prior to their exit conference.

Responding to taxpayer concerns that the appeal process in Massachusetts can take several years, the Department finalized guidance regarding its new administrative early mediation program. The pilot program is intended to resolve disputes within four months after the finalization of an audit through the use of mediation.

In order for a case to head to mediation, both the taxpayer and the Department must agree that mediation is appropriate—otherwise, standard appeal rules apply. While the administrative guidance lays out broad guidelines for the types of cases that the Department will deem appropriate for mediation, how they will be applied in practice remains to be seen. Our view is that the program could be extremely popular with taxpayers if the Department is open to considering a wide variety of cases for mediation.


  • Mediation must be agreed to prior to the issuance of the Notice of Intent to Assess by the Department
  • The exit interview is probably the best time to make the request
  • Mediation must be complete within four months absent unusual circumstances
  • Mediation must resolve all issues in the assessment; taxpayers cannot request mediation for only some issues in the assessment and appeal the rest
  • The program is available for proposed assessments in excess of $1 million where the issues and facts are fully developed
  • The Department’s goal is for the pilot program to include six to ten cases. Our understanding is that slots are still available in the pilot program.
  • If mediation is unsuccessful, the Department has put protections in place to prevent taxpayer’s (and the Department’s) submissions to the mediator from becoming discoverable in later litigation

DirecTV - Excise Tax Exclusively Imposed on Satellite-Providers Upheld; Taxpayer Skips ATB Appeal Process by Seeking Declaratory Judgment

As part of their national litigation challenging state sales and excise taxes imposed on satellite TV providers—but not on their cable competitors—DirecTV and Dish Network brought an appeal claiming that Massachusetts’ 5 percent excise tax on satellite TV providers, enacted in 2009, violated the Due Process and Commerce Clauses. The satellite TV providers filed a complaint directly with the Massachusetts Superior Court seeking a declaratory judgment on whether the excise tax violated various provisions of the United States and Massachusetts Constitutions.

The Superior Court denied the satellite TV providers’ declaratory judgment action on cross-motions for summary judgment.19 While the court followed the reasoning of other courts around the country in granting the Department’s summary judgment motion on this issue, other taxpayers may find the appeal route chosen by the satellite TV providers interesting. Rather than challenging the excise tax through a standard refund or assessment appeal, the providers immediately sought a declaratory judgment from the Superior Court.

For taxpayers challenging tax amounts based strictly on constitutional issues, this alternative route may be appealing because it should result in a much quicker decision, bypassing the large backlog of cases at the Appellate Tax Board.

Underpayment Penalty Directive Issued

The Department has finalized its directive regarding the 20 percent penalty for underpayment of tax required to be shown on a return (the "35A Penalty").20 The penalty applies in cases when a taxpayer substantially understates its tax liability or underpays because of negligence or disregard of Massachusetts tax law. In determining whether there is a substantial understatement for purposes of the 35A Penalty, tax items are not taken into account if (i) the taxpayer had substantial authority for its treatment of the item, or (ii) there was a reasonable basis for the treatment of the item and it was adequately disclosed on the return. The directive indicates that Massachusetts will largely follow the Treasury Regulations promulgated under I.R.C. § 6662 with regard to determining whether there is substantial authority for the taxpayer’s treatment of an item (taking into account Massachusetts-specific authorities where applicable). In addition, the Department can waive the 35A Penalty if it determines that a taxpayer had reasonable cause for the understatement and that the taxpayer acted in good faith.


While the directive highlights several safe harbors for taxpayers, one issue that is not directly addressed is whether the 35A Penalty can be applied by the Department in situations where the understatement of tax results from the Department’s application of its authority to make transfer pricing adjustments or to adjust taxable income under general anti-tax avoidance doctrines, such as the sham transaction doctrine.

For example, in recent audits covering tax years prior to Massachusetts’ adoption of unitary combined reporting, the Department has been aggressively asserting the sham transaction doctrine as a basis to disregard the separate existence of investment management subsidiaries. As a consequence, when auditing the parent corporations of these subsidiaries, the Department has, in effect, been combining the income of the subsidiaries with that of the parent corporations. Auditors have been assessing 35A Penalties against the parent corporations as part of these audits.

The new directive was a missed opportunity for the Department to limit the application of 35A Penalties to understatements in these types of situations. It is unreasonable for the Department to apply 35A Penalties to a taxpayer who files a return where the only understatement results from the Department’s decision (often unpredictable) to deviate from the specific rules set forth in the Department’s own published guidance.

Should 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

  1. The authors thank Brent Beissel, an associate in Reed Smith’s Philadelphia office, for his many contributions to this update.
  2. Kimberly-Clark v. Commissioner, 2013 WL 119778 (Mass. App. Ct. 2013).
  3. The Appeals Court also denied Kimberly-Clark’s royalty deductions for payments to an affiliate intangible holding company, as well as rebate payments to the affiliate that were deemed embedded royalties.
  4. Mass. Gen. Law c. 63, § 31J(a)(1).
  5. Mass. Gen. Law c. 63, § 38(l).
  6. An out-of-state manufacturing corporation has already unsuccessfully challenged the single-sales-factor apportionment formula for manufacturing as being facially discriminatory and, thus, a violation of the Commerce Clause of the U.S. Constitution. Advanced Logic Research, Inc. v. Commissioner, ATB Docket Nos. C271740 and C271871 (January 10, 2008), upheld 906 N.E.2d 1031 (Mass App. Ct. 2009)(unpublished).
  7. Random House, Inc. v. Commissioner, ATB Docket No. C303502 (Mass App. Tx. Bd. 2012).
  8. Id.
  9. Mass Gen. Law c. 63 § 38.
  10. See Boston Professional Hockey Association, Inc. v. Commissioner, 820 N.E.2d 792 (Mass. 2005); The Interface Group v. Commissioner, ATB Docket Nos. C266670 – 76 & C266680 (Mass App. Tx. Bd. 2008).
  11. Commissioner v. AT&T Corp., 970 N.E.2d 814 (Mass. App. Ct. 2012) review denied by 979 N.E.2d 224 (Mass. 2012).
  12. Sears, Roebuck & Co. v. Commissioner, ATB Docket No. C293755, (Mass. App. Tx. Bd. 2012).
  13. Household Retail Services v. Commissioner, 859 N.E.2d 837 (Mass. 2007).
  14. Letter Ruling 12-10 (September 25, 2012) and Letter Ruling 12-13 (November 9, 2012).
  15. Letter Ruling 12-11 (September 25, 2012).
  16. Letter Ruling 12-8 (July 16, 2012).
  17. See 830 CMR 64H.1.3(15).
  18. Letter Ruling 12-10 (September 25, 2012).
  19. DirecTV, LLC and Dish Network, L.L.C. v. Commonwealth of Massachusetts, Department of Revenue, Docket No. 10-0324-BLS1 (Mass. Sup. Ct. 2012).
  20. DOR Directive No. 12-7 (December 19, 2012).



Client Alert 2013-013