Tax Practice
State and Local Tax Report
April 2011
In This Issue
On January 26, 2011, in Wirtz v. Quinn, Ill. App. Ct. Dckt. Nos. 1-09-3163 and 1-10-0344, an Illinois Appellate Court struck down legislation representing the basis for a multibillion dollar Illinois public works project. The court determined that the legislation violated the “Single Subject Rule” of the Illinois Constitution.
The principal legislation invalidated by the court’s decision, Illinois Public Act 96-34, was originally introduced into the Illinois General Assembly as a five-page bill addressing the narrow subject of amending the Illinois estate and generation-skipping transfer tax. The original provisions of this legislation were subsequently removed from the bill, which was then amended to add provisions creating the Video Gaming Act, the Capital Spending Accountability Law, and amendments to the Illinois Lottery Law, State Finance Act, the Use Tax Act, the Service Use Tax Act, the Service Occupation Tax Act, the Retailer’s Occupation Tax Act, the Motor Fuel Tax Law, the University of Illinois Act, the Riverboat Gambling Act, the Liquor Control Act, the Environmental Protection Act, the Vehicle Code, and the Criminal Code. The legislation, as enacted, totaled 280 pages. Its multitude of revenue provisions, as signed into law by Governor Quinn in 2009, were designed to generate revenue that would be used to fund a $31 billion Illinois capital spending program on roads, bridges, high speed rail, other transportation, and education projects -- Illinois’ first capital spending plan in over a decade.
The court found that the “Single Subject Rule,” contained in Article IV, Section 8(d) of the Illinois Constitution, required that bills “be confined to one subject.” The court held that this rule was designed to preclude the legislative practice of “logrolling,” which the court defined as the “bundling less popular legislation with more palatable bills so that the well received bills would carry the unpopular ones to passage.” The court further held that the rule was designed to insure that “the legislature addresses the difficult decisions it faces directly and subject to public scrutiny” by limiting a bill to a single subject, and therefore permitting legislators to “better understand and more intelligently debate the issues presented by a bill.”
The court determined in applying the “Single Subject Rule” that while the term “subject” generally is construed liberally by courts in favor of the constitutionality of legislation, Public Act 96-34, nonetheless, clearly violated the rule. The court ruled that the wide range of topics in the legislation did not constitute a single subject because they did not have a “natural and logical connection.” The court found unconvincing the state’s argument that the varied provisions of the act fit within the broad category of “revenue.” In reaching this conclusion, the court relied on a previous Illinois Supreme Court decision in which that court had ruled that the “use of such a sweeping and vague category to unite unrelated measures would essentially eliminate the single subject rule as a meaningful check on the legislature’s actions.”
The Illinois Supreme Court in early March granted the State of Illinois’ petition for leave to appeal the appellate court’s decision, as well as the state’s motion for an accelerated docket. The briefing schedule for this case before the Illinois Supreme Court is set to run from March through May 2, 2011, with the parties to be notified of a date thereafter for oral argument.
In a January 18, 2011 decision, the California Court of Appeal in Nortel Networks, Inc. v. State Board of Equalization, (2011) 191 Cal. App. 4th 1259, held that the license of prewritten software by Nortel Networks, Inc. (“Nortel”) to Pacific Bell Telephone Company (“Pacific Bell”), used to operate switching equipment sold by Nortel to Pacific Bell, was exempt from sales tax because it was a Technology Transfer Agreement (“TTA”).
Under California law, a licensing agreement is exempt from sales tax if it is a TTA. A TTA is defined as “any agreement under which a person who holds a patent or copyright interest assigns or licenses to another person the right to make and sell a product or to use a process that is subject to the patent or copyright interest.” (Cal. Rev. & Tax. Code § 6011(c)(10)(D), 6012(c)(10)(D).) Thus, under California law, not every software program qualifies as a TTA for sales tax purposes. Only the transfer of a program that is subject to a patent or copyright is a TTA. But an agreement does not need to expressly reference a patent or copyright in order to be a TTA. (Nortel, 191 Cal. App.4th at 1276.)
The State Board of Equalization (“Board”) also adopted Regulation 1507 defining a TTA and, importantly, describing what a TTA is not. Regulation 1507(a)(1) states, in part, that a TTA “does not mean an agreement for the transfer of prewritten software…” (Cal. Code Regs., tit. 18, § 1507(a)(1).)
In Nortel, the taxpayer manufactured and sold telecommunication hardware to Pacific Bell that processed telephone calls, and handled features such as conference calling, call waiting, and voice mail. As part of the transaction, the parties entered into licensing agreements giving Pacific Bell the right to use Nortel’s copyrighted software programs in the hardware, which implemented processes that were subject to Nortel’s patents. Pacific Bell used these patented processes to create and sell a product – telephone communications for consumers.
The California Court of Appeal in Nortel considered, among other things, whether Nortel’s license of prewritten software to Pacific Bell is subject to sales tax. The court held that Nortel’s license of prewritten software was a TTA and thus exempt from sales tax because it was (1) copyrighted, (2) contained patented processes, and (3) enabled the licensee to copy the software, and to make and sell products. (Nortel, 191 Cal. App.4th at 1265.)
The Board argued that, pursuant to Regulation 1507(a)(1), Nortel’s license of prewritten software was not a TTA. The court disagreed, holding that the Board’s regulation was invalid. The court reasoned that “the TTA statutes do not restrict agreements transferring an interest in prewritten software. Instead, they apply to ‘any agreement’.” (Id. at 1277.) Because the Board in its regulation “exclud[ed] prewritten software that is subject to a copyright or patent” it “thereby creat[ed] an exception that the Legislature did not see fit to make” and thus was outside the scope of its authority. (Id.) The court held the regulation was, therefore, invalid.
As a result of the Nortel case, the Board may no longer be able to tax many prewritten software programs. Instead, the Board will now have to look at the transfer of a prewritten software program on a case-by-case basis to determine if it constitutes a TTA. Companies or individuals licensing, assigning, or selling software that is subject to a copyright or patent should consider the Nortel decision and the application of the TTA statutes when determining their sales tax reporting obligations.
The Board has filed a petition for review with the California Supreme Court.
C. States Adopting Broader Nexus Standards
- $50,000 of property;
- $50,000 of payroll;
- $500,000 of sales; or
- 25% of total property, payroll, or sales.
- The taxpayer is organized or commercially domiciled in California;
- Sales exceed the lesser of $500,000 or 25% of the taxpayer’s total sales;
- Real and tangible personal property of the taxpayer in California exceed the lesser of $50,000 or 25% of the taxpayer’s total real and tangible personal property;
- The taxpayer’s payroll in California exceeds the lesser of $50,000 or 25% of total payroll.
In the last year, many states have revised the nexus standards for their corporate income tax and sales tax frameworks. By adopting these types of revisions, states broaden the scope of out-of-state companies that are subject to taxation and generate more revenue.
Several states with corporate income tax schemes have adopted the “factor presence (bright-line) nexus” standard. Under this standard, which was first recommended by the Multistate Tax Commission (“MTC”) in 2002, an out-of-state entity has nexus with a state if it meets minimum dollar thresholds for property, payroll, or sales in the state. The MTC’s model statute sets forth that a taxpayer has substantial nexus with a state if any of the following thresholds is exceeded during the tax period:
Four states — Colorado, Connecticut, Oklahoma, and Washington — adopted the factor presence nexus standard in 2010. Three states, including California, had adopted the factor presence nexus standard in 2009.
In California, the factor presence nexus standard for its corporation franchise tax became effective on January 1, 2011. This new law, California Revenue and Taxation Code section 23101 (“Section 23101”), states that a taxpayer is “doing business in California” if it actively engages in any transaction for the purpose of financial or pecuniary gain or profit in California or if any of the following conditions are satisfied:
(Cal. Rev. and Tax. Code § 23101.) The new law affects out-of-state corporations and pass-through entities (partnerships, S corporations, LLCs treated as partnerships) and their partners/shareholders/members that have property, payroll, or sales in California. Furthermore, even if the out-of-state taxpayer has less than the threshold amounts of property, payroll, and sales in California, it may still be considered “doing business in California” if the taxpayer actively engages in any transaction for the purpose of financial or pecuniary gain in California. Section 23101, therefore, greatly expands the nexus standard and increases the number of out-of-state businesses which are subject to California’s corporation franchise tax.
Also in the last year, the “Amazon tax,” which applies to sales and use tax, has received a great deal of publicity. As discussed in the December 2010 State and Local Tax Report, a New York appellate court recently upheld the constitutionality of the Amazon tax, which provides for a statutory presumption of nexus for New York sales tax law purposes. Based on agency nexus principles, the Amazon tax amended the definition of a “vendor” and created a presumption that an out-of-state seller solicits business in New York State through independent contractors or other representatives. More specifically, an out-of-state seller is required to collect sales tax on sales within New York if: (1) the seller enters into an agreement with a resident of New York; (2) under that agreement, the New York resident, for a commission or other consideration; (3) directly or indirectly refers potential customers to the seller by a link on an internet website or otherwise; and (iv) gross receipts from sales by the seller to customers in New York that were referred to the seller through the agreement exceed $10,000 during the preceding four quarters. By implementing this “Amazon tax,” New York is able to find nexus and tax the sales of internet retailers that have a New York resident “agent” who is soliciting business on the seller’s behalf. This practice also increases the reach of New York’s sales and use tax.
Other states are following suit and adopting similar rules to tax the sales made by online retailers. Just this month, Illinois Governor Pat Quinn signed into law the Main Street Fairness Act, which amends and expands the Illinois Use Tax Act’s statutory definition of an online retailer (e.g. Amazon.com) that maintains a place of business in Illinois. (See Illinois House Bill 3659.) The amendment requires out-of-state retailers to collect Illinois sales tax for internet sales based on the premise that affiliate marketers create nexus in Illinois. In other words, any sort of physical presence within Illinois, including maintaining a relationship with “affiliate” companies located in Illinois, such as deal and coupon website operators which earn commissions for directing shopping traffic to the internet retailer, will require the internet retailer to collect taxes on the Illinois sales. The Illinois amendment takes effect July 1, 2011. By expanding the nexus standard, the Illinois legislature hopes to collect the state’s 6.25 percent sales tax on all purchases made by Illinois residents, as well as level the playing field for Illinois retailers with out-of-state online competitors. In response to the new law, however, Amazon has sent out letters which terminate its relationship with Illinois affiliates, so the ultimate fiscal impact of the Main Street Fairness Act is yet to be determined.
Nevertheless, these nexus developments are a trend in state taxation, and they will likely be adopted by more states as states continue to seek additional tax revenue.
D. Taxes v. Fees: Not a Watertight Distinction in California
On January 31, 2011, the California Supreme Court finally issued its decision in California Farm Bureau Federation v. State Water Resources Control Board. While the decision was long-awaited, it did little to clarify the distinction between a tax and a fee, one of the more challenging areas of state and local tax law.
In 2003, the California Legislature passed amendments to the Water Code to provide funding for the Water Rights Division, which administers the water rights program. There are three primary types of water rights: (1) riparian, pueblo or other appropriative rights acquired before 1914; (2) federally held water rights; and, (3) licensed and permitted water rights. Of these, the State Water Resources Control Board and its Water Rights Division only have authority over the licensed and permitted water rights, which account for approximately 40 percent of all of the water subject to water rights.
In 2003, by a 53 percent majority vote, the Legislature passed Senate Bill No. 1049, which repealed and enacted various sections in the Water Code. In sum, the effect of SB 1049 and the regulations subsequently enacted under it, was to impose a fee for operating the Water Rights Division entirely upon the 40 percent of water users holding licenses and permits. This meant that the majority of water interests held by riparian, pueblo, and other appropriative rights acquired before 1914, as well as federally held rights, would pay essentially nothing.
The California Farm Bureau Federation and others challenged this as an illegal tax because, among other things, it did not meet the definition of a fee and thus violated Proposition 13. California Constitution, article XIII A, section 3 requires that “any changes in state taxes enacted for the purpose of increasing revenues” be approved by a two-thirds majority of the Legislature. Thus, if the assessment was a tax, it was not passed by the requisite super-majority of legislators, and was therefore invalid.
The Supreme Court, citing its former decision, Sinclair Paint v. State Board of Equalization (1997) 15 Cal.4th 866, 874, again held that “‘tax’ has no fixed meaning, and that the distinction between taxes and fees is frequently ‘blurred,’ taking on different meanings in different contexts.” Holding that “permissible fees must be related to the overall cost of the governmental regulation,” and that “[t]hey need not be finely calibrated to the precise benefit each individual fee payor might derive,” the Court went on to remand the matter to the trial court to make detailed findings focusing on whether the associated costs of the regulatory fee were reasonably related to the fees assessed on the payors. A request for rehearing has been made, but not yet ruled upon. Unfortunately, assuming the decision for rehearing is not granted and the case is remanded, there does not appear to be a clear standard for the trial court to apply.
During the course of the litigation, the State Water Resources Control Board claimed that 95 percent of its time and expenses are directed toward servicing and regulating those licensees and permittees against whom the challenged fees were assessed. The record below, however, does not contain ample findings to support that allegation. What would the trial court do if less than 50 percent of time were actually devoted to licensee and permittee issues? Hopefully whatever decision is made not only makes sense, but holds water.
Regardless of how the trial court rules, this decision is likely just a prelude to other legal challenges in the months and years ahead. That is because Proposition 26, which was recently passed by California voters, explicitly requires a two-thirds legislative vote for fees whose funds are not used to directly regulate the payee.
E. Washington Supreme Court Finds Sending Employees into State Establishes Substantial Nexus
Tax practitioners holding out hope for establishment of a physical presence test to determine nexus for purposes of income taxation suffered another setback with the recent decision from the Washington Supreme Court. In Lamtec Corp. v. Dept. of Revenue, 170 Wash. 2d 838 (2011), the state’s high court examined how much instate activity was necessary to establish nexus for purposes of Washington’s business and occupancy (“B&O”) tax (which imposes a gross receipts tax for the act or privilege of engaging in business activities in the state) and concluded that the taxpayer’s practice of regularly sending sales representatives into the state to maintain its market satisfied the nexus requirement.
In Lamtec, the taxpayer sold products to Washington state customers from its facility in New Jersey. All orders were placed by telephone, and although Lamtec had no permanent facilities, office address, telephone number, or employees in Washington, it did send three employees into the state two or three times a year. Those employees did not solicit sales directly during their visits, but they did answer questions and provide product information to the extent that the Department of Revenue (“Department”) determined Lamtec had substantial nexus with the state of Washington. Thus, when the Department discovered this activity was taking place, it issued an assessment for back taxes, penalties, and interest.
Lamtec paid the assessment under protest and filed a refund claim in superior court, which was dismissed pursuant to the Department’s motion for summary judgment. The Court of Appeals affirmed the lower court’s action, so Lamtec appealed to the state’s Supreme Court, arguing that it had insufficient nexus with Washington to be subject to the B&O tax.
In its analysis of the commerce clause argument raised by Lamtec, the court started with the test set forth in Complete Auto Transit v. Brady, 430 U.S. 274 (1977) for imposing tax on out of state corporations, and narrowed its focus to the question of whether the employee visits were enough to satisfy the substantial nexus prong. Lamtec contended that in order to have substantial nexus, the taxpayer must have a physical presence, and that such physical presence requires a small sales force, plant, or office in the taxing state. Thus Lamtec urged the court to adopt the same “bright-line” physical presence test generally required for the collection of sales and use taxes.
Although the court noted that there is some appeal to a bright-line test for business taxation, it ultimately rejected Lamtec’s arguments. In particular, the court concluded that to the extent there is a physical presence requirement, it can be satisfied merely by the presence of activities within the state. According to the court, nexus does not require a “presence” in the sense of having a brick and mortar address within the state. Indeed, the court found no material difference between activities that are performed by a staff permanently employed within the state, by independent agents contracted to perform the activity within the state, or by persons who travel into the state from other jurisdictions. According to the court, the crucial factor governing nexus is whether the subject activities are significantly associated with the taxpayer’s ability to establish and maintain a market within the state. Here, the court found that the contacts by Lamtec’s sales representatives were designed to maintain its relationships with its customers and to maintain its market within Washington State. Because the activities were neither slight nor incidental to some other purpose or activity, the court held that although Lamtec did not have a permanent presence within the state, by regularly sending sales representatives into the state to maintain its market, Lamtec satisfied the nexus requirement. Thus the court affirmed the Court of Appeals’ decision, and held that the Department had authority under the commerce clause to impose the B&O tax on Lamtec.
F. Recent Winston & Strawn Tax News and Publications
- State and Local Tax Group leader Charles J. Moll III was again named as a Northern California Superlawyer in 2011.
- Winston & Strawn tax attorney Bradley R. Marsh was recently named as a “Northern California Rising Star” by SuperLawyers. Mr. Marsh had previously been recognized by SuperLawyers in the Southern California edition.
- Charles J. Moll III was a speaker at the Institute for Property Tax Professionals meeting in New Orleans on March 24, 2011. He spoke on the panel “Value in Use v. Value in Exchange: Do the Courts Know the Difference?” Joining him on the panel were Elliott Pollack from Polman and Comley LLP and John VanSanten from Huron Consulting Group.
- On January 6, 2011, Winston & Strawn tax attorney Bradley R. Marsh spoke at the State Bar of California’s Cyber Institute. Mr. Marsh spoke on the topic of “California Residency and the Franchise Tax Board-A Primer,” which discussed the basics of California residency law, as well as audits, appeals, and current developments. The discussion also included tips for and pointers relating to strategy and appeals processes as they relate to residency issues.
G. Upcoming Winston & Strawn Tax News and Publications
- Charles J. Moll III will be speaking at the 2011 NYU Summer Institute of Taxation in July, 2011.
- On September 1, 2011, Winston & Strawn tax attorney Bradley R. Marsh will be speaking at a CalCPA meeting in San Jose, CA. Mr. Marsh will present on “Property Tax Assessments and Appeals” which will provide a general overview of: commonly litigated issues in property tax, how to handle those issues at an assessment appeals hearings, and best practices for those unfamiliar with property tax appeals. He will be joined by Shannon N. Cogan, who is counsel to the Santa Clara County Assessment Appeals Board.
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If you have any questions regarding the contents of this newsletter, please contact the following attorneys in the firm’s State and Local Tax Practice Group:
| Chicago (312) 558-5600 | San Francisco (415) 591-1000 |
| Charles J. Moll III | |
| Alan Lindquist | Troy M. Van Dongen |
| Bradley R. Marsh |
| Jocelyn M. Wang |
| Dina M. Bronshtein |
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