The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.
By Dolores W. Gregory and J.P. Finet
Dolores W. Gregory is a staff editor with BNA; J.P. Finet is a legal editor with BNA.
Despite an abundance of petitions on pressing state tax issues, the U.S. Supreme Court began its 2009 term Oct. 5 with no state tax cases on its docket.
Rather, the court chose to grant review of only two cases that are even tangentially related to state taxes:
• Bilski v. Kappos (formerly, Bilski v. Doll (08-964), which deals with patenting business practices and, thus, could have implications for tax planning patents; and
• Hemi Group LLC v. New York City (08-969), which deals with whether the city had standing bring a civil RICO action against online sellers to recover uncollected city tobacco taxes. The decision could have implications for any state considering a similar strategy.
So far, only one other tax case of interest to states appears to have a fighting chance this term: Missouri Gas Energy v. Schmidt (08-1458), a commerce clause and due process challenge to an Oklahoma county's ad valorem tax on gas in temporary storage. On Oct. 5, the court issued an order inviting the U.S. Solicitor General to file a brief expressing the views of the United States in the case.
The Federal Energy Regulatory Commission (FERC) regulates natural gas in interstate commerce, and that fact may account for the court's invitation to the Solicitor General, said Walter Hellerstein, professor of law at the University of Georgia School of Law. But that does not guarantee that the court will grant review.
“Whatever the Solicitor General says is very, very important,” Hellerstein said. “If the Solicitor General says, ‘yes, this is a problem the court ought to look at,' very likely the court will look at it. If the Solicitor General says ‘this is not a problem, and certainly not a problem that concerns the United States,' that will detract substantially from the prospect that the court will grant. It's a lot better than cert. denied, let's put it that way, but it doesn't mean the court is going to take the case.”
Otherwise, the 2009 term is shaping up to be remarkable more for the state tax cases the court declined than the case it has accepted.
Among those cases the court passed up: Capitol One Bank v. Massachusetts Comr. of Rev. (08-1169) and Geoffrey Inc. v. Massachusetts Comr. of Rev. (08-1207), two Massachusetts Supreme Court decisions affirming the state's economic nexus doctrine; Dell Marketing v. New Mexico Taxn. and Rev. Dept. (08-770), dealing with affiliate nexus; VFJ Ventures v. Surtees, (08-916), addressing the constitutionality of Alabama's add-back statute; Ventas Finance I LCC v. California Franchise Tax Board (08-1022), a due process challenge to the state's refusal to refund the full amount paid under a tax later found to be unconstitutional; Ford Motor Co. v. Delaware (08-1409), dealing with apportionment of gross receipts taxes that are not transactional in nature; and Pooh Bah Enterprises Inc. v. Cook County, Ill. (09-83), challenging, on First Amendment grounds, the denial of small venue exemptions to adult entertainment establishments.
Another petition for cert. is still pending: Levin v. Commerce Energy Inc. (09-223), in which the Ohio tax commissioner seeks clarity from the court on the scope of the Tax Injunction Act following its ruling in Hibbs v. Winn. The case has not yet been scheduled for conference.
This article reviews the tax-related cases before the court, as well as several of the significant cases that the court declined to review.
MISSOURI GAS ENERGY
Missouri Gas Energy v. Schmidt concerns a property tax imposed by Woods County, Okla., on natural gas held in a FERC-regulated storage facility in the county. Missouri Gas Energy (MGE), a local gas distribution company based in Kansas City, Mo., purchased gas from suppliers in Texas, Missouri, and Oklahoma and contracted with Panhandle Eastern Pipeline company to transport the gas to Missouri.
MGE sold no gas in Oklahoma and maintained neither property nor employees in that state; however, some of the gas that MGE purchased was placed in storage in Panhandle Eastern's facility in Woods County.
In 2001, the Woods County assessor obtained from the pipeline company a list of the shippers storing gas in the county and allocated to each a portion of the gas stored at Panhandle Eastern's facility. Based on this allocation, the assessor levied a tax for a three-year period; MGE protested the levy.
In its petition to the U.S. Supreme Court, MGE maintained that the assessor had used a “fictional ownership allocation calculated by considering all the gas stored on the interstate pipeline system—not just the gas physically stored in Oklahoma on the date of assessment.”
The result, MGE said, was that Woods County “attributed large quantities of gas in storage to MEG for tax purposes, when, as a matter of physics, most, if not all, of that gas could not have belonged to MGE.”
No ‘Situs' in Oklahoma
At trial, an Oklahoma district court found for the taxpayer and ordered a refund of taxes and accrued interest. The trial court found that natural gas held in storage in the county could not acquire a tax situs in Oklahoma because it was “in transit in interstate commerce.”
The Oklahoma Supreme Court reversed the trial court's decision. While gas might be “in transit” for federal regulatory purposes, the court said, “large volumes of gas are stored in Woods County for a substantial part of the year”—long enough “to satisfy the dictates of due process.”
As for the commerce clause challenge, the state supreme court noted that there is no “blanket prohibition” against state taxation of interstate commerce. Rather, the four-part test of Complete Auto Transit Inc. v. Brady (430 U.S. 274 (1977) governs, the court said, finding that the Woods County tax met all four tests.
Reliance on Older Authorities
Hellerstein told BNA he believes the Oklahoma Supreme Court ruled correctly on the constitutionality of the tax with respect to the “in transit” issue, but was not certain about the allocation issue, which was not the focus of the state supreme court's opinion.
But an interesting element of the cert. petition, he said, is the degree to which the taxpayer relies on cases that predate Complete Auto by decades, and thus, relies on the “old notion that there is immunity of interstate commerce from taxation.”
A century ago, Hellerstein said, if a state had tried to tax gas or oil moving through a pipeline, the tax would have been struck down.
“The U.S. Supreme Court had read the commerce clause to immunize interstate commerce from state taxation,” he said. “Stuff moving through the states was interstate commerce. It was pretty simple. You can't tax things in transit.”
But that is no longer the case.
Under Complete Auto—and as articulated in D.H. Holmes v. McNamara, 486 U.S. 24 (1988), a subsequent case involving use tax on catalogues—whether something is in transit is “irrelevant” to a commerce clause analysis.
“Why should it be irrelevant for a tax on catalogues but relevant for a tax on gas?” Hellerstein said.
“Are they arguing for a rule that creates kind of an immunity here, rather than a rule that says we should only pay our fair share?”
Further, he asked, why should the U.S. Supreme Court be interested in the case if the fundamental issue is really a technical one—whether a county tax is properly calculated? The fact that natural gas is an important source of energy, regulated by the federal government, may account for the court's interest, he suggested, even if there is no clear constitutional issue.
“It seems to me one of the reasons the court may have asked the Solicitor General is that they want to know if there is anything in Federal Energy Regulatory Commission regulations or policy that might be frustrated by this kind of tax,” he said.
The taxpayer and amici raise concerns about the risk of multiple taxation, he added, but that alone is hardly anything unusual; such risks always exist.
“The court might be much more concerned about these risks in this context, particularly where there is federal regulation,” he added. “That's what must make this case different, and cert. worthy.
BILSKI V. KAPPOS
The supreme court case that is probably garnering the most discussion among tax practitioners is the appeal of the U.S. Circuit Court for the Federal Circuit's en banc ruling in Bilski v. Kappos—formerly captioned Bilski v. Doll (No. 08-964).
Several attorneys who have been following the case told BNA the high court's decision to hear a challenge to the “machine-or-transformation” test for evaluating the patentability of business methods is a significant development that could have an impact in the tax strategy patent area.
In Bilski v. Doll, the Federal Circuit found a business method was eligible for a patent if it was either tied to a particular machine or apparatus or it transformed a particular article into a different state. The October 2008 ruling rejected the test the Federal Circuit had adopted in State Street Bank & Trust Co. v. Signature Financial Group Inc., in which it found that methods are patentable.
Richard Gruner, a professor and director of the Center for Intellectual Property Law at John Marshall Law School, told BNA in June that the Federal Circuit's ruling left open the idea that a tax method patent might survive if a computer was involved in some of the steps. He added that most tax strategies involve at least some steps performed by a computer.
“Confirmation of the Bilski ‘machine or transformation' test for process patents, or something similar, would make tax strategy claims that are not required to be implemented by computer patent-ineligible,” wrote Linda Beale, a Wayne State University Law School professor and author of the ataxingmatter blog, in a June e-mail to BNA. “That's an appropriate result, from my perspective, because of the many policy concerns about tax strategy patents.”
Former Treasury Tax Legislative Counsel Michael Desmond, now with McKee Nelson LLP in New York, told BNA in June that the Supreme Court's ruling in Bilski could have far-ranging consequences for tax strategy patents, as well as for anyone else who is seeking patent protection for a business method or business idea that does not have a mechanical component.
“This is a very important issue, and not just in the tax area,” Desmond said. “The Federal Circuit's decision restricted significantly the ability of people to seek patents for business methods.”
Gruner noted that the financial services industry has sought a broad range of patents on its financial methods, some of which provide tax advantages for clients. While not tax strategy patents per se, he said, there are often close parallels.
“The Court hasn't spoken on patent eligibility in some time, and Bilski provides an opportunity for the court to address the explosion of business method patents in areas of dubious applicability,” said Beale. “Though it is difficult to forecast, the acceptance of cert. may indicate that the Court is ready to delineate new boundaries for patent eligibility.”
HEMI GROUP LLC
The other tax-related case currently on the high court's docket is Hemi Group LLC v. New York, N.Y. (No. 08-969). The case is an appeal of the Second Circuit's September 2008 consolidated ruling in New York, N.Y. v. Smokes-Spirits.com Inc., which held that New York City has standing to assert civil claims under the Racketeer Influenced and Corrupt Organizations Act against out-of-state vendors who allegedly sold cigarettes to city residents over the internet without reporting those sales to the state for tax purposes, as required by the Jenkins Act.
In its Smokes-Spirits.com ruling, the Second Circuit found that the tax loss injury flowing from the alleged predicate acts of mail and wire fraud linked to a Jenkins Act violation was sufficiently direct to satisfy RICO causation requirements and that the lost taxes were an injury to the city's “business or property” for RICO purposes.
The Jenkins Act requires out-of-state cigarette sellers to file a report with the tobacco tax administrator of each state into which the seller ships cigarettes to nondistributors, identifying the name, address, and quantity of cigarettes purchased by the nondistributor state residents.
The Second Circuit's decision overturned a district court finding that the structure of the alleged primary enterprises was legally viable but the alleged RICO persons (employees and/or officers of the businesses) did not have individual duties to file Jenkins Act reports, and thus could not have committed the alleged predicate racketeering act.
According to a brief filed by the Hemi Group LLC—one of the defendants in Smokes-Spirits.com—there is a distinct split among the circuits as to whether state and local governments can use RICO in federal district courts to collect taxes and similar noncommercial losses. Additionally, the group claimed the Second Circuit's ruling conflicted with Supreme Court precedent requiring a party to suffer direct injury to have RICO standing.
The Second Circuit found that the tax loss injury flowing from alleged predicate acts of mail and wire fraud ... were an injury to a city's “business or property” for RICO purposes.
Hemi Group said the Second and Seventh Circuits have held that state and local governments have standing to recover loss of tax revenue. However, it noted that the Ninth and Sixth Circuits have ruled that state and local governments lack the requisite RICO standing to recover noncommercial losses.
OTHER ISSUES OF CONCERN TO STATES
Protection of Tax Accrual Work Papers
Practitioners are also eyeing the progress of another federal tax case, United States v. Textron, in which the First Circuit refused to give work product protection to tax accrual work papers sought by the Internal Revenue Service. The deadline for appealing the case to the Supreme Court is Nov. 11.
This is another case that, while not directly involving state taxes, could have implications for the states if the U.S. Supreme Court were to grant cert.
In Textron, the First Circuit refused to give work product protection to tax accrual work papers sought by IRS in an administrative summons. The summons was issued as part of an audit conducted during an investigation into the company's alleged use of a tax shelter. The 3-2 en banc ruling came nearly five months after the First Circuit vacated a three-judge panel's initial 2-1 decision in the case that found the firm's disclosure of the documents to its auditor was not a waiver of work product immunity.
“To sum up, the work product privilege is aimed at protecting work done for litigation, not in preparing financial statements,” concluded Judge Michael Boudin. “Textron's work papers were prepared to support financial filings and gain auditor approval; the compulsion of the securities laws and auditing requirements assure that they will be carefully prepared, in their present form, even though not protected; and IRS access serves the legitimate, and important, function of detecting and disallowing abusive tax shelters.”
In so ruling, the First Circuit reaffirmed its 2002 decision in Maine v. Department of the Interior. Maine implemented a so-called “because of” test that asked whether, in light of the nature of the document and the factual situation in the particular case, the document can be fairly said to have been prepared or obtained because of the prospect of litigation.
The Textron decision conflicts with the Fifth Circuit's 1982 ruling in United States v. El Paso Co.. Boudin explained that, in El Paso, the Fifth Circuit denied protection for work papers because the court recognized that the company in question was conducting the relevant analysis because of a need to bring its financial books into conformity with generally accepted auditing principles. He noted that the Fifth Circuit employed a so-called “primary purpose” test and found the sole function of the work papers was to back up financial statements.
“[Textron] holds that tax accrual work papers are not only not work product in the traditional sense, but goes beyond that in departing from the majority ‘because of test' and arguably creating a new test—the ‘for use in litigation' test,” Lawrence Hill, chair of Dewey & LeBoeuf's Tax Controversy and Litigation Group, told BNA in August. “The court found that tax accrual work papers have no use in litigation and that any experienced litigator would consider them tax documents not litigation documents. The IRS's policy of restraint is likely to be loosened and the decision has implications to tax documents beyond tax accrual work papers.”
Hill added that the Textron ruling is representative of a growing trend among the courts to undercut privilege protection and to embrace disclosure as the “emissary of truth.”
Susan Hackett, senior vice president and general counsel for the Association of Corporate Counsel, told BNA in August that the First Circuit's Textron ruling was “devastating” for all corporate counsel. She explained that her association filed an amicus brief in the case that supported Textron's position because the issues it presents reach beyond corporate tax departments.
“For the in-house community, this is a devastating decision and it sends all of the wrong messages,” Hackett said. “If there's one thing we have learned in the post-Enron, post Sarbanes-Oxley world, it is that you want attorneys discussing these things with your accountant. This decision is going the wrong way.”
CASES DENIED REVIEW
This year, as in past years, the court declined to hear a number of cases presenting issues of particular concern to state tax practitioners.
Ford Motor Co.
Among them was the May appeal of the Delaware Supreme Court's ruling in Ford Motor Co. v. Delaware Director of Revenue. In Ford, the state supreme court found Delaware's imposition of an unapportioned wholesaler's tax on Ford's in-state motor vehicle sales to independent dealerships did not violate the Commerce Clause of the U.S. Constitution.
The ruling upheld a superior court decision finding a state director of revenue determination that an unapportioned tax on Ford's receipts may be lawfully imposed. Between 1999 and 2002, Ford paid a state wholesaler's tax of $3.6 million on sales of products shipped to locations in the state. Ford applied for a refund of the tax paid, which was denied by the appellate director of revenue.
In its appeal to the Delaware Supreme Court, Ford contended the wholesaler's tax, as applied to the proceeds of its sales where title to the product passes outside Delaware before being physically delivered to dealers in the state, violates the Commerce Clause. Specifically, the company contended the tax violates the negative or dormant aspect of the Commerce Clause that denies states the power to exact more than their fair share from interstate commerce than would be commensurate with the burden imposed by that activity.
Ford claimed the superior court erred in holding the wholesalers' tax permits taxation of receipts from sales of its vehicles physically delivered outside of Delaware. It argued that none of its vehicles were physically delivered to the state because they were sent by common carrier to a “mixing center” in Ohio, where the vehicles are sorted.
According to Hellerstein, the court's decline of cert. in the case was not a surprise, given that it had declined review of a “substantially similar” case, Ford Motor Co. v. Seattle, in 2008.
Capitol One a ‘Surprise'
The court's refusal to hear Capital One, however, did come as “a bit of surprise” to Todd Lard, general counsel with the Council On State Taxation (COST). Along with the National Association of Manufacturers and the National Marine Manufacturers Association, COST had filed an amicus brief in both Capital One v. Massachusetts and Geoffrey v. Massachusetts.
Lard said he considered Capital One to be a good candidate for review because Virginia and South Dakota had also filed an amicus brief urging the court to take the case.
“Both states laid out a compelling argument because they are concerned about uncertainty in revenues,” Lard said. “But the court didn't seem interested.”
In both cases, the Massachusetts Supreme Court ruled that the physical presence standard laid out by the U.S. Supreme Court in Quill Corp. v. North Dakota was limited to sales and use taxes.
In Capital One, the court held that the imposition of the Massachusetts financial institutions excise tax on banks that lacked a physical presence in the state met the substantial nexus requirement of the U.S. Constitution's Commerce Clause because the banks issued credit cards used by state residents.
Ruling on Geoffrey, the court said the state's imposition of a corporate excise tax satisfied the substantial nexus test because the firm's trademark licensing exclusively to Toys “R” Us-Mass Inc. and Baby Superstore generated continued business and substantial annual royalty income from stores in the state.
Virginia and South Dakota urged the U.S. Supreme Court to grant review because “[s]tates that do not presently rely on the economic-nexus approach need this Court's guidance to gain an accurate and reliable understanding of what is and is not constitutionally permissible. The states need that guidance before deciding to venture down that road and run the risk of subsequent invalidation, with all of the attendant disruption to revenues and services that this would entail.”
Physical Presence Issue Left Unresolved
Paul Frankel, partner in Morrison & Foerster, which represented Geoffrey, told BNA the court's denial of cert. for Geoffrey and Capital One leaves the economic nexus question still open in most states.
“The great unresolved issue in our field is whether you can impose a tax without physical presence. Any tax,” Frankel said. “We know they can't do it in sales and use tax because of Quill and Bellas Hess.”
There are about 35 states which have not dealt with the question of economic nexus for other taxes, Frankel noted.
“We have cases moving up in other states,” he said. “I am convinced they will take this issue at some point. It may be next year or it may be five years out, but they will take it; they will resolve this.”
Meanwhile, Lard said, the Supreme Court's refusal to take either of the Massachusetts cases means that some states may take the economic presence standard even further than they have so far.
Lard described economic nexus as a standard that has been applied in “waves.”
The first wave was an effort by states to challenge intangible holding companies. The second wave was an effort to impose income or business taxes on out-of-state banks based on activities of in-state credit card customers.
The “third wave” is exemplified by a recent case in which New Jersey assessed the corporation business tax against a Colorado computer company based on its having licensed software in the state.
In that case, the taxpayer prevailed at the New Jersey Tax Court, Lard said, “but it's an example of where states are going.”
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