Tennessee Enacts Tax Reform Measures (article)
In May 2015, Tennessee Governor Bill Haslam signed into law Tennessee H.B. 644, known as the Revenue Modernization Act (“RMA”). The RMA makes sweeping changes to the Tennessee franchise and excise tax regimes, in many instances subjecting more out-of-state businesses to taxation in Tennessee or otherwise increasing their Tennessee tax burden. While many of the provisions do not go into effect until next year, some sales and use tax provisions went into effect on July 1.
The RMA includes the following changes to Tennessee law:
- Adopts economic/bright-line nexus thresholds for the business tax and the franchise and excise tax;
- Addresses the treatment of foreign corporations;
- Implements market-based sourcing for sales other than the sale of tangible personal property;
- Modifies the related-party intangible expense deduction for expenses paid to an affiliate;
- Adopts a triple-weighted sales factor replacing the existing apportionment double-weighted sales factor for calculating the franchise and excise tax;
- Adds an alternative apportionment election for high-volume sellers with distribution centers in Tennessee;
- Implements a presumption of “click-through” nexus for sales and use tax; and
- Expands sales tax to include certain cloud computing transactions.
Economic/Bright-Line Nexus Thresholds
Effective for tax years beginning on or after January 1, 2016, the RMA expands the definition of “substantial nexus in this state” for both business and franchise and excise tax purposes and implements a “bright-line presence” threshold. Substantial nexus would include:
- A taxpayer being organized or commercially domiciled in Tennessee;
- A taxpayer owning or using its capital in Tennessee;
- A taxpayer having systematic and continuous business activity in the state that produces gross receipts attributable to customers in Tennessee;
- A taxpayer licensing of intangible property for use by another in Tennessee and deriving income from the use of that intangible property; or
- A taxpayer having a bright-line presence in Tennessee.
“Bright-line” presence occurs if any one of the following apply:
- The taxpayer’s total receipts in Tennessee during the tax period exceed the lesser of $500,000 or 25 percent of total receipts from all jurisdictions;
- The average value of the taxpayer’s real and tangible personal property owned or rented and used in Tennessee during the tax period exceeds $50,000 or 25 percent of the average value of all the taxpayer’s real and tangible personal property; or
- The total amount the taxpayer pays in Tennessee during the tax period for compensation exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.
For business tax purposes, a taxpayer must have substantial nexus with Tennessee and be engaged in certain activities in the state. The RMA expands the definition of activities to include any delivery of tangible property to a location in Tennessee and the sale of a service delivered to a Tennessee location.
Foreign Corporations with/without Effectively Connected Income
Effective for tax years beginning on or after January 1, 2016, foreign corporations that have no effectively connected income for federal tax purposes, shall not be considered to have substantial nexus for Tennessee income and franchise tax purposes. If a company treated as a foreign corporation for federal tax purposes has effectively connected income, then the RMA provides that the company’s net earnings and net worth for Tennessee purposes shall be its net earnings and net worth connected with its U.S. trade or business. Likewise, its apportionment factors for Tennessee shall be the property, payroll and receipts effectively connected to its U.S. trade or business.
Effective for tax years beginning on or after July 1, 2016, the RMA provides for market-based sourcing for excise and franchise tax purposes, replacing the current cost-of-performance method for sourcing sales other than the sale of tangible personal property. These sales are sourced to the location of the taxpayer’s market for the sale:
- The sale of a service is sourced to Tennessee to the extent the service is delivered to a location in Tennessee.
- The sale, rental, lease or license of real property is sourced to Tennessee to the extent the property is located in Tennessee.
- The rental, lease or license of tangible personal property is sourced to Tennessee to the extent the property is located in the state.
- The rental, lease, license, or sale of intangible property generally is sourced to Tennessee to the extent the property is used in the state.
If the state of assignment cannot be made pursuant to the above methods, then the state of assignment shall be reasonably approximated. If the state of assignment cannot be reasonably approximated, the sale must be thrown out of the sales factor. A taxpayer may make an annual election to use the cost-of-performance method if that method will result in a higher overall apportionment factor for the tax year. A taxpayer must have net earnings, rather than a net loss, for the tax year that the election is made.
Sourcing for Security Dealers
Receipts equal to the net gain or income from the sale of a security made by a security dealer are sourced to Tennessee if the customer is located in Tennessee (market sourcing). To determine whether a customer is located in the state, the dealer may default to the customer’s billing address unless the dealer has actual knowledge of the customer’s residence or commercial domicile.
Sourcing for Telecommunication Companies
Cost-of-performance treatment continues to apply to ‘qualified members’ of a ‘qualified group,’ which includes taxpayers with qualifying expenditures or taxable sales in excess of $150 million in the state and that are primarily engaged in telecommunications, internet, video programming, satellite television services or some combination of these services. Total receipts in Tennessee equal the receipts from all sales of tangible personal property sourced to the state under the standard apportionment provisions plus the average of the receipts from all sales other than tangible personal property that are in Tennessee determined using both the cost-of-performance method and the market-based sourcing method.
Intangible Expenses Paid to an Affiliate
Tennessee currently allows a taxpayer to deduct an intangible expense that is paid, accrued or incurred in connection with certain transactions with an affiliate if the Commissioner of the Department of Revenue determines, upon application, that tax avoidance is not the primary purpose of the expense. The RMA eliminates the application process. Effective for tax years beginning on or after July 1, 2016, any related-party intangible expense may be subtracted if the expense has been disclosed and either of the following conditions is met:
- The related party is registered for and paying excise tax; or
- The expense was paid to an affiliate in a foreign nation that is a signatory to a comprehensive tax treaty with the U.S. or to an affiliate that is otherwise not required to be registered for or to pay excise tax.
Taxpayers failing to disclose or add back related party intangible expenses are subject to negligence penalties.
Excise and Franchise Tax Triple Weighted Sales Factor Apportionment Formula
Effective for tax years beginning on or after July 1, 2016, all net earnings and net worth are apportioned to Tennessee for excise and franchise tax purposes by using a triple-weighted sales factor. For previous tax years, Tennessee uses a double-weighted sales factor. Corresponding changes are made for apportioning the net earnings of a captive real estate investment trust (REIT) affiliated group.
High-Volume Sellers with Distribution Centers in Tennessee
Effective for tax years beginning on or after January 1, 2016, a special apportionment election is available for franchise and excise tax purposes for high-volume sellers who choose to use distribution centers located in Tennessee. The election allows a taxpayer to elect to exclude from the numerator of its receipts factor, and instead pay a separate excise tax at a dramatically reduced rate on, sales made to a distributor (for resale outside Tennessee). The taxpayer must have a Tennessee receipts factor that exceeds 10 percent and sales of tangible personal property to Tennessee distributors that exceed $1 billion. If elected, the separate Excise Tax ranges from 0.125 percent to 0.5 percent, depending on the amount of certified distribution sales.
Click-Through Nexus for Sales and Use Tax Purposes
Effective July 1, 2015, for purposes of sales and use tax, Tennessee enacts a rebuttable click-through nexus provision. Under the RMA, a dealer is presumed to have substantial nexus with Tennessee if:
- The dealer enters into an agreement with one or persons located in Tennessee under which the person, for a commission or other consideration, directly or indirectly refers potential customers to the dealer whether by an Internet link, website, or other means; and
- The dealer’s cumulative gross receipts from these transactions in the state must exceed $10,000 during the preceding 12 months.
A seller may rebut this presumption by proving that the seller did not conduct any activities in Tennessee that would substantially contribute to the seller’s ability to establish and maintain a market in the state during the preceding 12 months.
Expansion of Sales and Use Tax to Include Remotely Accessed Software (Cloud Computing)
Under previous law, the retail sale, lease, licensing or use of computer software in Tennessee was subject to sales and use tax. Effective July 1, 2015, “use of computer software” includes the access and use of software that remains in the possession of the dealer who provides the software or in the possession of a third party on behalf of the dealer. If the customer accesses the software from a location in the state, the access would be deemed the equivalent to the sale or licensing of the software and electronic delivery of the software for use in this state. The law change exempts dealers who purchase computer software only for reselling access and use of the software and also exempts software developed by an affiliate. Additionally, the RMA allows for multiple points of use sourcing based on the percentage of users located inside and outside of Tennessee. The legislation also expands the existing provisions regarding the taxation of ‘specified digital products’ to include ‘video game digital products.’
All taxpayers with a financial presence in Tennessee should review the effects the new Tennessee law will have on their tax reporting and financial statements. The new law appears to generally benefit Tennessee-based businesses while placing a greater burden on out-of-state businesses. The adoption of bright-line nexus thresholds and click-through nexus will create Tennessee tax filing obligations for taxpayers who previously did not have nexus due to a lack of physical presence in the state. As we have seen in other states that adopt bright-line nexus thresholds, however, Tennessee taxpayers will likely have a stronger argument for the right to apportionment as they can now base their claim on exceeding the sales threshold in other states rather than having a physical presence in other states.
Further, the shift to a market-based sourcing approach coupled with the adoption of a more sales-emphasized apportionment formula will likely have the effect of raising the Tennessee franchise and excise tax burden of out-of-state businesses, especially service enterprises, which have significant sales into Tennessee but minimal property and payroll in the state. Conversely, the shift will favor Tennessee businesses that have significant Tennessee property and payroll but also have significant sales to customers in other states. Lastly, businesses should be aware that Tennessee has expanded the taxability of software to include applications utilizing the cloud such as software as a service or other web-based applications.
If you have any questions regarding tax law changes in Tennessee, please contact your CBIZ MHM tax advisor.
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