Reed Smith Client Alert

Welcome to the latest Reed Smith Massachusetts State Tax Quarterly Update. In this update, we’ll take a look back to the developments from the last quarter of 2013, and look ahead to some percolating issues at the Appellate Tax Board ("ATB").

Sales Tax

Mobile telecommunications company challenges sales tax assessment on early termination fees

In a petition filed recently with the ATB, a mobile telecommunications company is contesting a sales tax assessment by the Massachusetts Department of Revenue ("the Department"). The assessment resulted from the Department asserting that the sales tax on telecommunications services applies to "early termination fees."

For sales tax purposes, taxable telecommunications services are defined as the "transmission of messages or information by electronic or similar means."1 At audit, the Department adopted an expansive view of this definition and issued an assessment against the Petitioner for failure to collect sales tax on receipts from "early termination fees" that the Petitioner charged when a customer with a contract cancelled the contract prior to its expiration date. To add insult to injury, the Department’s assessment—according to the Petitioner—included tax on early termination fees that were waived and, thus, never collected from customers.

In its ATB petition, the telecommunication company is arguing, rightfully in our view, that the early termination fees received were not charges for the transmission of messages and information. Indeed, the fees in question were charged because the customer informed the vendor that it did not want the vendor to "transmit" any messages.


  • Broader Implications? If this case is litigated and the taxpayer prevails, the decision could provide taxpayers with ammunition for excluding other telecommunications charges from the sales tax base by claiming that they are not charges for message transmission. For example, a taxpayer victory would weaken the current Department position that installation and activation charges—charges for services that occur before the vendor ever transmits a message—are charges for taxable telecommunications.
  • Impact on Sales Factor Sourcing: A taxpayer victory in the sales tax context could also support a position that early termination fees and other similar charges are not receipts from telecommunications services (or ancillary services) for corporate excise tax purposes, permitting taxpayers to use the cost of performance sourcing rule to source such receipts for tax years beginning prior to January 1, 2014.

    The Department has promulgated special industry apportionment rules for telecommunications companies. However, these special rules only apply to the receipts identified by the special apportionment regulation. Receipts of telecommunications companies from sales other than sales of tangible personal property continue to be sourced under the statutory cost of performance sourcing rule, if not covered by the special apportionment regulation. Applying the "all or nothing" cost of performance rule, taxpayers will be able to exclude such receipts from the sales factor numerator if their costs of performance are incurred predominantly outside the commonwealth.

After further review . . . vendor’s cloud computing services are not taxable

The Department revised and reissued Letter Ruling No. 12-8 regarding the taxability of a vendor’s cloud computing services, finding that the services are not subject to Massachusetts sales tax.

In Letter Ruling 12-8, the vendor sold cloud computing products that gave customers access to the vendor’s computer infrastructure and operating system, allowing the customer to use the vendor’s computer resources and storage space to perform various activities.

Customers needed an operating system that would enable them to use the vendor’s cloud computing products. They had three options: (1) provide their own operating system; (2) use an open-source system; or (3) use an operating system the vendor licenses from a third party. The vendor charged its customers by the hour, and imposed a higher hourly rate for customers that used a third-party operating system.

In the original version of the ruling, the Department found that charges associated with the third option were subject to tax, because the customer’s object in choosing that option was to obtain the right to use software—not the vendor’s cloud computing services. (The Department previously found that when customers chose the other two options, the vendor’s charges were not subject to tax.) In its revision, the Department reversed course, finding that the vendor’s services were not subject to tax, regardless of the operating system option selected by the customer.

The Department also found that the vendor’s remote storage services were not subject to tax.


  • It’s not all good news for cloud computing vendors… Tucked away in the ruling is a Department comment that the vendor is required to pay use tax on the "apportioned cost of prewritten operating system software that it consumes in the provision of the nontaxable services to customers in Massachusetts." This appears to be an expansion of the Department’s policy regarding the taxability of remotely accessed software. As we’ve previously written, taxpayers are challenging whether a vendor must charge sales tax on sales of remotely accessed software to customers located in Massachusetts. Here, the Department seems to be taking things a step further. It is taking the position that a vendor is "using" software in Massachusetts—and must pay Massachusetts use tax on such software—if the vendor’s Massachusetts customers access the software as part of a non-taxable sale of services.
  • Refund opportunity for software located in Massachusetts? On the flip side, the revised ruling creates an opportunity for taxpayers that purchase software located on a server in Massachusetts that is used by their customers outside of Massachusetts. Take the example of a company that purchases software and integrates it into its corporate website, which is accessed for no charge by its customers in Massachusetts and around the country. Based on the Department’s comment in the revised ruling, the purchaser could argue that since it consumed the software in providing a free service to its customers (the offering of a free website), it should be able to apportion the purchase price and pay Massachusetts use tax based only on the percentage of use attributable to Massachusetts customers.

    Of course, if a purchaser did not provide a multiple points of use (MPU) certificate to its vendor at the time it purchased the software, the purchaser should, before filing a refund claim, be aware of pending litigation involving MPU certificates. In ongoing cases, the Department appears to be taking the position that a vendor is barred from claiming a refund if it failed to provide an MPU certificate at the time of purchase. See here for more details.
  • Revised Software Directive to Come? Last February, the Department released a Draft Directive addressing the taxability of mixed sales of software and services (click here for more details).2 As we previously reported, the Directive indicated that there was a presumption that sales of certain cloud computing services were subject to tax, including those discussed in Letter Ruling 12-8. The revision of the Ruling indicates that the Department may need to make significant revisions to the Draft Directive as well, prior to releasing a final version.

Corporate Tax

ATB Update—Taxpayers continue to file petitions challenging Department positions regarding cost of performance sourcing and transfer pricing

Cost of Performance Sourcing: While market sourcing is in effect for tax years beginning on or after January 1, 2014, the application of the cost of performance sourcing rules for earlier tax years continues to be a major source of controversy at the ATB. Dozens of recently settled or pending appeals involve situations in which either the taxpayer or the Department is arguing for "all or nothing" cost of performance sourcing (click here and here for our prior alerts on this issue). This quarter sees two new sets of filings challenging the Department’s position regarding cost of performance sourcing:

  • A film and television distribution company is arguing that cost of performance sourcing applies to its receipts from distribution fees charged to title holding companies.
  • A national telecommunications company has filed multiple claims requesting that its services receipts be sourced following cost of performance principles.

Transfer Pricing and Embedded Royalties: The Department continues to aggressively challenge intercompany payments between affiliated entities at audit—especially in audits involving tax years before mandatory combined filing went into effect. In a typical appeal scenario, a company claims a business expense deduction for goods and/or services purchased from an affiliated entity. The affiliated entity providing the goods and/or services typically either does not have Massachusetts nexus, or has Massachusetts apportionment factors that are smaller than the purchasing entity. When presented with such situations, the Department is often making two separate adjustments to the purchasing entity’s taxable income. First, the Department reduces the taxpayer’s deduction for amounts paid to the affiliated entity on the basis that the payment exceeds an arm’s-length charge, and second, the Department then disallows a portion of the reduced deduction by characterizing it as an "embedded royalty," subject to the intangible expense add-back provision. The Department’s approach can be illustrated by a recent appeal filed with the ATB.

The appeal was filed by a national restaurant chain. The chain has a centralized purchasing/ distribution entity that handles just-in-time purchasing for food, as well as centralized purchasing for other products used at the chain’s restaurant locations around the country. Separate legal entities operate the chain’s restaurant locations. These entities purchase food and other products from the purchasing/distribution company.

In this case, the auditor first asserted that the purchase price charged by the purchasing/ distribution company was greater than an arm’s-length price and, thus, limited the deductions claimed by the restaurant entities for the cost of their purchases, pursuant to the Department’s authority under M.G.L. ch. 63 § 39A.

The auditor then made a second adjustment, further reducing the cost-of-goods-sold deduction for the restaurant entities, by treating a portion of the purchase price paid as an "embedded royalty" that was not deductible under intangible expense add-back provision.
Taxpayers are understandably reluctant to pursue litigation on transfer pricing issues because of the potential for protracted discovery—a tactic often threatened by the Department’s Litigation Bureau. Nevertheless, as numerous cases on these issues are currently pending at the ATB, the potential for a written decision providing some guidance in this area increases.

Budget Season Is Here

Governor releases proposed budget, while Speaker positions himself in opposition to any new taxes

After the major tax overhauls (and subsequent reversals) that animated the budget process for year 2014, the governor’s 2015 budget proposal contains more modest tax goals. Governor Patrick’s proposal includes provisions that would:

  1. Impose room occupancy tax on the total amount that online hotel room resellers charge to their customers for a room (currently many retailers exclude their service fees from the tax base when charging sales tax)
  2. Eliminate the special classification for securities corporations
  3. Eliminate the sales tax exemption for soda and candy
  4. Delay the implementation of the FAS 109 deduction for yet another year
  5. Tax disregarded entities as business corporations if they are (1) subsidiaries of insurance companies; and (2) earn income from activities unrelated to the provision of insurance

The governor’s proposals, however, were quickly met by a statement from Speaker of the House Robert DeLeo, who indicated that the House intended to pass a budget with no new taxes or fees in the upcoming year. Given this quick reaction, it appears that even the governor’s modest proposals may be dead on arrival.

Administrative Updates

Department officially makes mediation program permanent

The Department of Revenue has now officially made its early mediation program permanent and expanded the program to include audits with $250,000 or more at issue (the previous threshold was set at $1 million by Administrative Procedure 635).

The early mediation program was introduced last fall as a pilot program for taxpayers with fully developed audit issues who had requested to participate in the program before they had received a Notice of Intent to Assess.

The Department will only consider mediating an issue under the program in situations where (1) the issue and facts have been fully developed during the course of the audit; (2) the taxpayer has stated in writing its disagreement with the handling of the issue in the audit; and (3) the parties are genuinely willing to resolve all disputed issues through the mediation.

The results from the program have been encouraging so far. As of early December, six of the first seven mediations had resulted in a settlement. Furthermore, those mediations produced settlements in 3-1/2 to 5 months, a far cry from the years that it might have otherwise taken to resolve the same issues at the Office of Appeals or the Appellate Tax Board.

Reed Smith Massachusetts Tax Team Update

Reed Smith launches Massachusetts SALT blog

As part of our efforts to bring you the latest updates in Massachusetts state tax, Reed Smith has launched a blog covering Massachusetts state tax— The goal of the blog is to provide updates and insights into the latest developments in Massachusetts state tax law.

If you have questions about any of the items discussed in this update, please contact the authors, or the Reed Smith lawyer with whom you usually work.

Reed Smith’s Massachusetts tax practice is built on more than 15 years of experience in Massachusetts state tax planning and controversy matters, focusing on income and sales and use taxes. The Massachusetts tax team writes and speaks frequently on Massachusetts tax issues, and handles significant Massachusetts tax appeals for some of the nation’s largest companies. For more information, visit

1. M.G.L. ch. 64, § 1.
2. Working Draft Directive 13-XX: Criteria for Determining Whether a Transaction is a Taxable Sale of Pre-written Software or a Non-taxable Service, released February 7, 2013.




Client Alert 2014-044