Governor’s proposed FY 2020 budget includes new and renewed tax provisions

On January 23, 2019, Governor Charlie Baker introduced House Bill 1, with his proposals for the Commonwealth’s fiscal year (FY) 2020 budget.  The Governor’s budget proposals included several tax-related measures—including marketplace seller provisions, a tax on opioids, and new accelerated sales tax remittance procedures to require certain third-party processors (e.g., credit card companies) to remit sales tax collected more frequently.

• Marketplace sellers.  The Governor’s Budget would require online marketplace facilitators to collect and remit Massachusetts sales and use tax on behalf of vendors who sell their goods on the marketplace.  The rules would only apply to a marketplace with sales into the Commonwealth that exceed a threshold set by the Massachusetts Department of Revenue (the Department).
• Opioid tax.  The Governor’s budget would impose a new excise tax on opioid products.  The Tax would be imposed on all opioid manufacturers that maintain a place of business in Massachusetts or make sales of opioid products for distribution in Massachusetts in excess of $25,000 during a quarterly reporting period.  The tax would be 15% of gross receipts from opioids dispensed in Massachusetts pursuant to a valid prescription.
• Accelerated sales tax remittance.  The Governor’s budget would authorize the Department to require certain vendors to remit sales tax collections on a more frequent basis.  The vendors would be required to remit the collected tax within a period prescribed by the Department but prior to the monthly returns being due.  The proposal would not apply to vendors that remitted less than $100,000 in sales or use tax for the preceding 12 months.  The proposal would also impose a 5% underpayment penalty.

Next, the House Ways and Means Committee will consider the Governor’s budget and will introduce a new bill with the House’s budget proposals.

Additional Reed Smith comments

• A stepping stone to real-time remittance?  The Governor’s proposal to require more frequent remittance of sales and use tax is the most recent iteration in a series of such proposals.  Governor Baker first proposed more frequent sales and use tax remittances as part of his FY 2018 budget proposal.  The FY 2018 budget proposal would have required third-party payment processors to remit collected tax on an “accelerated” basis.  The legislature adopted part of the proposal and incorporated it into the final enacted budget, but left it to the Department to fill the gaps regarding frequency and feasibility.  If the Department determined that accelerated sales tax remittances was not cost-effective to accomplish within FY 2018 , the law provided that the Department could ignore the mandate to implement accelerated sales tax remittance.  After soliciting comments from businesses, industry groups, and practitioners, the Department determined that compliance with the law was not cost-effective and that accelerated sales tax remittance should not be enforced for FY2018.

A similar proposal was included in the Governor’s budget proposal for FY 2019, but was not enacted.  The latest proposal from the Governor would again grant considerable discretion to the Department because the Department is instructed to determine what period for remitting collected tax would be practical for vendors.  Vendors that would be affected by this proposal should watch closely to see if these changes are sufficient for the law to pass and go into effect.

• Opioid tax follows national trend.  An excise tax on opioids was first introduced in the Massachusetts legislature in 2017.  The Governor’s proposal to tax opioids follows an approach that has been taken by other states in recent years.  Since 2015, at least seven states have introduced legislation to tax opioids.  As of this writing, New York is the only state to have enacted a tax on opioids, which took effect on July 1, 2018.  The New York law was challenged in Court almost immediately.

Massachusetts legislature introduces bill that would allow elective single sales factor apportionment

 On January 22, 2019, Representative Elizabeth Poirier introduced, House Bill 2607, which would allow all business corporations and financial institutions to elect an alternative apportionment method to compute their corporate excise tax.  As proposed, the bill would allow corporations to elect a different apportionment method for tax years beginning on or after January 1, 2015, in accordance with a sliding scale moving toward single sales factor apportionment (see chart below).  For tax years beginning on or after January 1, 2019, business corporations and financial institutions could elect to apportion their corporate excise tax using the sales factor (receipts factor) only.

As proposed, the bill would appear to apply retroactively.  However, it seems likely that the bill was originally drafted for consideration prior to January 1, 2015, and it was not updated by the sponsors to reflect the appropriate effective dates.  Thus, the sponsors probably intended for the election to go into effect for tax years beginning on or after January 1, 2019, with the sliding scale toward single sales factor apportionment applying for tax years beginning on or after January 1, 2015 and before January 1, 2023.

ATB characterizes remote-desktop access services as the taxable use of software

On November 8, 2018, the Appellate Tax Board (ATB) released its Findings of Fact and Report in Citrix Systems, Inc. v. Commissioner, in which the ATB held that sales of remote-desktop access services were sales of computer software subject to sales and use tax.  Massachusetts characterizes prewritten computer software, regardless of the method of delivery, as tangible personal property that is generally subject to sales and use tax.  In 2012, the Department issued several letter rulings extending the tax to reach software as a service or cloud computing transactions where the true object of the transaction was the use of prewritten software.¹  Accordingly, the Department’s authority to tax software as a service, application service providers, and computing transactions depends on the transaction’s characterization as the use of prewritten software, which may be taxable as tangible personal property, or as a service transaction, which would generally not be taxable (unless it were a telecommunications service).

Citrix’s remote-desktop access products provide customers the ability to establish a remote-access connection to a host computer.  The ATB concluded that the true object of Citrix customers was the use of prewritten software and therefore, the transactions were transfers of tangible personal property subject to tax.  This case has been appealed to the Court of Appeals, where an application was filed to transfer the case to the Supreme Judicial Court (SJC) on direct review.

Additional Reed Smith comments

• ATB adopts position of prior letter ruling. The ATB’s Findings of Fact and Report confirm that the same services analyzed by the ATB in this case were also the subject of the Department’s Letter Ruling 12-10.  In that ruling, the Department concluded the “true object” of such a service was the use of remote desktop access software that established the secure connection.  The ATB has now explicitly adopted the Department’s true-object analysis and policy.  However, now that the ATB has confirmed that Letter Ruling 12-10 involved Citrix and published additional factual detail, taxpayers with facts that differ materially from Citrix’s may want to consider arguing that the Department’s “true object” analysis in Letter Ruling 12-10 is limited in its application.

U.S. Supreme Court’s decision in Wayfair fails to bring litigation over “cookie” nexus to an end

The U.S. Supreme Court is credited with “Killing Quill” when it issued its Wayfair decision on June 21, 2018.  But eight months earlier the Department promulgated regulations asserting that for all practical purposes, Quill was already dead for internet retailers.  Specifically, on October 1, 2017, the Department-promulgated regulation, 830 CMR 64H.1.7, which imposed sales tax collection obligations on certain remote sellers, went into effect. The regulation, sometimes referred to as the “cookie nexus regulation”, requires “internet vendors” to collect and remit sales tax on sales to customers in Massachusetts.

While every other jurisdiction that has published guidance on the subject has limited the application of Wayfair to remote sellers to periods after the decision was issued, Massachusetts is taking a different approach.  On September 17, 2018, the Department issued Technical Information Release (“TIR”) 18-8 stating that it would enforce the regulation as of the original effective date, October 1, 2017.  The “cookie nexus” regulation has triggered two sets of litigation.  A summary of the cases and recent developments are recapped below.

Crutchfield Corp. v. Harding, Albemarle Circuit Court Docket No. CL17001145-00.

On October 24, 2017, Crutchfield filed an action for declaratory judgment seeking to stop the enforcement of the cookie-nexus regulation against Crutchfield.  Crutchfield brought this case in the Circuit Court for Albemarle County, Virginia. In its complaint, Crutchfield argued that the regulation was barred by the U.S. Supreme Court’s determination in Quill, violated the Due Process and Commerce Clauses of the U.S. Constitution as well as the Internet Tax Freedom Act.

Crutchfield has asserted that Virginia has jurisdiction to hear the appeal under Virginia Code § 8.01-184.1, which provides Virginia Circuit courts with original jurisdiction over civil actions seeking declaratory judgment where: (1) the party seeking relief is a business organized under the laws of, or qualified to do business in, Virginia, and (2) the responding party is a government official of another state who asserts that the business is or was in the past obligated to collect sales or use tax based on the business’s conduct occurring wholly or partially in Virginia.

While the Wayfair decision may have made Crutchfield’s Commerce and Due Process Clause challenges to the regulation more difficult, questions remain as to whether the regulation violates the Internet Tax Freedom Act.  The Crutchfield case is currently in the discovery phase.

Additional Reed Smith comments

• This litigation could be in jeopardy after the U.S. Supreme Court granted certiorari in California Franchise Tax Board v. Hyatt, a case that will decide whether the U.S. Constitution bars lawsuits against states in the courts of other states.   Massachusetts joined 43 other states filing an amicus brief in support of California’s petition for certiorari in the Hyatt case.

Blue Nile LLC et al. v. Commissioner, Massachusetts Superior Court, Suffolk County, Docket No. 1884CV03934-BLS1.

On December 21, 2018, a group of Internet retailers filed an action for declaratory judgment against the Commissioner alleging that the Commissioner’s decision to enforce the cookie nexus regulation back to October 1, 2017, was an impermissible retroactive application of Wayfair.  The retailers argue that the Supreme Court’s language in Wayfair, which emphasized that South Dakota’s collection statute was prospective-only, was an essential element of the statute and thus formed part of the legal basis for the Court’s decision to uphold the law.  Unlike the law at issue in South Dakota, the retailers allege that Massachusetts’ law is imposing collection requirements that exceed Quill’s limitations to transactions occurring before the Supreme Court’s decision in Wayfair.

On February 22, the Commissioner responded by filing a motion to dismiss the case.  The motion to dismiss argues that the Department’s cookie nexus regulation was valid because the presence of cookies on the computer of a customer located in Massachusetts constitutes physical presence in Massachusetts in compliance with Quill, and therefore, the Supreme Court’s decision in Wayfair was not a basis for the collection and remittance provisions in the cookie nexus regulation.  The motion to dismiss also raised the threshold issue of whether the retailers have exhausted their administrative remedies prior to filing the case in court.

Tax Reform updates

Department guidance on deemed repatriation provides relief; raises questions

The federal Tax Cuts and Jobs Act (TCJA), among other provisions, included a new Internal Revenue Code (IRC) § 965, which imposes a one-time tax on the post-1986 foreign earnings of certain U.S.-owned foreign subsidiaries not yet repatriated to, or taxed by, the U.S.  The deemed repatriation under IRC § 965 requires taxpayers to include these untaxed earnings in federal gross income (as a subpart F inclusion) in their last tax year beginning before January 1, 2018.  Deemed repatriation income under IRC § 965 is included in Massachusetts taxable income, subject to Massachusetts’s 95% dividends received deduction (DRD).

Massachusetts issued two TIRs providing relief to taxpayers.

• On May 5, 2018, Massachusetts issued TIR 18-4 providing that the Department will not impose estimated tax penalties to the extent the underpayment of estimated tax is due to an increased tax liability resulting from deemed repatriation income under IRC § 965.  Given the complexities involved in calculating deemed repatriation income and the materiality of the inclusion, the TIR is welcome news to large taxpayers.
• On September 11, 2018, the Department issued emergency regulation 830 CMR 58.2.1 providing that deemed repatriated income under IRC § 965 (and income related to another TCJA provision, global intangible low-tax income (GILTI) under IRC § 951A) will not be considered in qualification as a “manufacturing corporation” entitled to special tax benefits (e.g., certain property and sales and use tax exemptions).  The emergency regulation provides that taxpayers will not lose their status as manufacturing corporations simply because of the deemed repatriation (or GILTI) inclusions.

The Department also released a TIR that raises questions as to the ability of taxpayers to seek alternative apportionment for deemed repatriation (and GILTI) income.

• On October 4, 2018, the Department issued TIR 18-11 concluding that deemed repatriation income is included in the Massachusetts tax base, subject to a 95% DRD. The TIR also suggests that taxpayers cannot claim alternative apportionment for dividends, subpart F inclusions, deemed repatriation income, and GILTI.  We disagree with that suggestion.

The TIR concludes that the deemed repatriation amount is not included in the sales factor because the deemed repatriation “does not implicate” a taxpayer’s apportionment.  The Department reasons that the 5% portion of the deemed repatriation not covered by the Massachusetts DRD is intended as an expense disallowance and, in general, an expense disallowance does not implicate apportionment.  Rather than supporting the Department’s conclusion, the TIR relies on statutory authority that supports the opposite conclusion.  G.L. c. 63, § 30.4 states that the inclusion is “in lieu of”—i.e., is not—an expense disallowance.  Under this view, a taxpayer should not be foreclosed from petitioning the Department for alternative apportionment if the deemed repatriation (or GILTI) results in distortion.

For more on alternative apportionment, see our prior Massachusetts State Tax Developments client alert discussing the Department’s alternative apportionment regulations.

The foreign tax credit gross-up: should taxpayers deduct 100%?

Massachusetts is one of the few states that imposes tax on the federal foreign tax credit gross-up.  Although this has always been the case, the tax imposed on the gross-up may be more significant for some taxpayers as a result of the magnitude of the deemed repatriation and GILTI.  In our view, taxpayers may be able to take the position that the Massachusetts Constitution prohibits taxing the gross-up because the gross-up is fictional or phantom income.

Taxpayers are allowed a federal foreign tax credit to the extent they paid foreign taxes on subpart F income, deemed repatriation income, or GILTI included in federal gross income.²  If a taxpayer elects to claim a foreign tax credit, the taxpayer is subject to a special rule: the taxpayer is required to include the amount of foreign taxes paid on that subpart F income, deemed repatriation income, or GILTI in its federal gross income.  This fictional inclusion is referred to as the foreign tax credit “gross-up”, and is required solely to calculate the federal limitation on the foreign tax credit.  Massachusetts does not provide a foreign tax credit, but still taxes 5% of the gross-up.

We would argue that the taxation of any portion of the gross-up by Massachusetts would violate the Massachusetts Constitution because it is not a tax on “income.”  The SJC has interpreted Article 44 of the Massachusetts Constitution, which allows the Commonwealth to “levy a tax on income”, as a limitation on the Commonwealth’s taxing power.  In Bill DeLuca Enterprises, Inc. v. Commissioner of Revenue,³  the SJC held that “the term ‘income’ must be rationally construed and not stretched to include purely theoretical as distinguished from practical conceptions.  Income as a subject to taxation imports an actual gain.”⁴  Because the gross-up is not actual income earned by a foreign corporation and is included in federal taxable income solely for the purpose of computing the federal tax credit, the gross-up arguably does not import “an actual gain” that can be taxed by the Commonwealth.

The SJC has already considered the gross-up and concluded it is “a fictional Federal addition to gross income designed to help the Federal foreign tax credit.”⁵  But that conclusion was reached in a case where the constitutional issue was not before the Court.  Taxpayers should reconsider whether 100% of the gross-up should properly be excluded from Massachusetts income.

An equitable answer to interest expense limitation:  treat it like the charitable deduction limitation

The TCJA included a new version of IRC § 163(j) that generally limits a corporation’s deductible interest to business interest income plus 30 percent of adjusted taxable income (ATI) (generally, taxable income before NOL, interest, and depreciation).⁶  Interest that cannot be deducted because of the limitation is carried forward to future years.⁷  Although the Department has not yet provided guidance on how the federal interest expense limitation will apply in the context of the corporate excise tax, the limitation should apply in computing taxable income for purposes of the tax.  This is because taxable income for purposes of the tax is defined as federal gross income minus federal deductions, and the new IRC § 163(j) limitation acts to reduce the federal interest expense deduction.⁸

The two most pressing questions facing taxpayers are: (1) whether a corporation filing as part of a Massachusetts combined return must calculate the IRC § 163(j) limitation on a separate company or combined group basis for corporate excise tax purposes; and (2) whether the IRC § 163(j) limitation is applied before or after adding back interest under the Commonwealth’s comprehensive interest addback scheme.

Separate company or combined group.  Massachusetts statute and regulations suggest that a corporation filing as part of a Massachusetts combined return must apply the interest expense limitation on a separate company basis.  This is because the taxable income of a Massachusetts combined group is “the sum of the incomes, separately determined, of each member of the combined group.”⁹  However, applying the IRC §163(j) limitation separately to each corporation in a combined return would likely result in more interest expense overall being disallowed, and would be administratively burdensome for the taxpayers and the Department.  The better answer would be to apply the limitation on a combined group basis.  Luckily, there is Massachusetts precedent that would support such an approach.

The existing federal limitation on the deductibility of charitable contributions is similar to the new IRC § 163(j) limitation on the deductibility of interest expense—both limitations are based on a taxpayer’s income.  The Department’s regulations provide that a corporation filing as part of a combined group must calculate the charitable contribution limitation at the combined group level.¹⁰  The regulations also provide that a corporation filing as part of a combined group may carry over any excess contributions to subsequent years, and provide rules for allocating a portion of the deduction to each member of the combined group.  These regulations provide a framework the Department could follow in applying the IRC § 163(j) interest expense limitation in the combined group context.

Apply limitation before or after addback. Applying the addback for interest paid to related entities before the IRC § 163(j) interest expense limitation will generally produce a more favorable result for taxpayers.

The statute does not provide a clear answer as to whether the addback for interest paid to related entities applies before the IRC § 163(j) interest expense limitation and the Department has not yet issued guidance.  Interestingly, if the Department adopts a rule that simply requires the interest expense limitation to apply on a combined group basis, the addback for interest paid to related parties would automatically apply before the IRC § 163(j) interest expense limitation.  This is because the related party interest addback would remain a separate company calculation that is performed before the calculation of the combined group’s net income.¹¹

Applying the interest expense limitation on a combined group basis would produce a more equitable result for taxpayers, similar to the more equitable result produced by applying the charitable deduction limitation on a combined group basis.¹²

Massachusetts follows federal qualified opportunity zone benefits

The TCJA created new incentives to invest in areas identified as economically distressed or low-income.  To claim a benefit, a taxpayer must invest in a “qualified opportunity fund.”¹³  A qualified opportunity fund is an investment vehicle organized to hold assets in areas designated by the Treasury as “qualified opportunity zones.”¹⁴  As of this writing, there were 138 designated zones across the Commonwealth.¹⁵

The new rules provide investors the opportunity to defer or, in some cases, permanently exclude, certain capital gains.  For example, a taxpayer may be able to defer capital gains by investing the proceeds in a qualified opportunity fund.  Recognition of the gain would be deferred until the taxpayer sells its investment in the qualified opportunity fund.  Moreover, any appreciation in an interest in a qualified opportunity fund may be excluded from income when the interest is ultimately sold.¹⁶

Massachusetts conforms to the IRC provisions allowing for the deferral and reduction of capital gains recognized on interests in qualified investment funds for corporate excise tax purposes.  This is because the benefits of investing in qualified investment funds are reflected via adjustments to a taxpayer’s “gross income”, and the Massachusetts Corporate Excise Tax base starts with federal gross income.¹⁷

Other updates

Legislature enacts law extending room occupancy excise tax to short term rentals

On December 28, 2018, Governor Baker signed into law Chapter 337 of the Acts of 2018, which extends the state and local room occupancy excise tax to short term rentals.  The law, which takes effect on July 1, 2019, applies to an occupied property that is not a hotel, motel, lodging house, or bed and breakfast establishment where at least one room is rented out by an operator for 31 or fewer consecutive days using advance reservations.  The law requires operators of such facilities to collect and remit the room occupancy tax, but in some cases, obligates intermediaries acting on behalf of the operators to collect and remit the tax in place of the operators.  On February 4, 2019, the Department issued a working draft of a TIR interpreting the new law.

Legislature creates permanent annual sales tax holiday

On June 28, 2018, Governor Baker signed Chapter 121 of the Acts of 2018 into law which created an annual sales tax holiday—a period of time during which non-business consumers can purchase goods without owing sales tax.  The holiday will occur during one weekend in August each year.  By June 15 of each year, the legislature must pass a resolution establishing the tax-free weekend, but if it fails to do so, the law requires the Department to establish the dates for the tax-free weekend no later than July 1.

Governor Baker proposes deeds excise tax increase to fund climate change projects

So far, in 2019, Governor Baker has unveiled a number of tax proposals, both as part of the proposed budget and otherwise.  One proposal, introduced on January 18, would increase the deeds excise tax rate by 0.2%.  The deeds excise tax is a transfer tax paid at the time a deed for real property is transferred.  The proposal would allocate the funds raised from the tax increase—expected to be $1 billion over the next 10 years—to projects designed to mitigate the effect of climate change.  According to the Governor, these projects will invest in communities, infrastructure, and preserve property values.

“Millionaire’s tax” reintroduced

Two Senators reintroduced a proposed constitutional amendment to impose a 4% surtax on taxable income over $1 million.  Unlike the citizen-initiated amendment that was struck down by the SJC last year for addressing two or more unrelated subjects, this proposal is a legislator-initiated amendment.  As such, it is permissible for the proposed amendment to address multiple subjects.  However, before appearing on the ballot, the proposal must get a majority vote in two successive legislature sessions.

Upcoming webinar: Massachusetts' net worth based tax - not as simple as it appears

Massachusetts’ corporate excise tax is not just based on income. The tax also has a net worth-based component. For many corporations, this component has gone from an after-thought to a multi-million dollar expense. This teleseminar will explain how the net worth-based tax is computed, some common taxpayer pitfalls in computing the tax, refund opportunities, and challenges to Department audit positions.

This webinar will be held at 2 p.m. on Tuesday, April 23, 2019.  Register through Webinar Requests.

1. See, e.g., Letter Ruling 12-10 (Sep. 25, 2012).
2. IRC § 960.
3. 431 Mass. 314 (2000).
4. Id. (internal quotations omitted).
5. Dow Chemical Co. v. Comm’r of Revenue, 378 Mass. 254, 257–58 (1979).
6. The new limitation is effective for tax years beginning after Dec. 31, 2017, and does not apply to all taxpayers (e.g., businesses with average gross receipts less than $25 million over the prior three years). IRC § 163(j)(3).  For tax years beginning after December 31, 2021, ATI is generally taxable income before NOL and interest.  IRC § 163(j)(8).
7. IRC § 163(j)(2).
8. Mass. Gen. Laws c. 63, § 1 (“Net income”).
9. 830 CMR § 63.32B.2(6)(c)(2) (emphasis added); see also Mass. Gen. Laws c. 63, § 32B(d)(3).  FMR Corporation v. Commissioner of Revenue, 441 Mass. 810 (2004) (“the plain language of G.L. c. 63, § 32B . . . requires net income to be calculated on an individual-entity basis.”) (obsoleted in part by amendments to Mass. Gen. Laws 63 § 32B and 830 CMR § 63.32B.2(6)(c)(6)).
10. 830 CMR § 63.32B.2(6)(c)(6).
11. Mass. Gen. Laws 63 c, § 31I(b) (“For purposes of computing its net income under this chapter, a taxpayer shall addback otherwise deductible interest expenses . . . directly or indirectly paid, accrued or incurred to. . . one or more related members.”); Mass. Gen. Laws 63 c, §§ 31J, 31K; 830 CMR. § 63.32B.2(6)(c)1. (“the total income of the combined group is the sum of the incomes, separately determined, of each member of the combined group.”).
12. We note that some other states have taken an alternative position that taxpayers must apply IRC § 163(j) first, then treat a prorated portion of allowed interest as related-party for purposes of applying the state’s addback statute.
13. IRC § 1400Z-1.
14. IRC § 1400Z-2(d).
15. The IRS designation of qualified opportunity zones is available at cdfifund.gov.
16. IRC § 1400Z-2.
17. IRC § 1400Z-2(a)(1), (b); Mass. Gen. Laws 63 c, § 1.

Client Alert 2019-079