Massachusetts SJC Reaffirms Decision Sourcing 100% of Taxpayer’s Loans to Massachusetts — Confirms Opportunity for Out-of-State Financial Institutions

On Friday, August 12, the Massachusetts Supreme Judicial Court (the “SJC”) reaffirmed its decision in First Marblehead—that a financial institution that is commercially domiciled in Massachusetts can be required to source 100% of its loans to Massachusetts for purposes of computing its property factor numerator.  See The First Marblehead Corp. v. Commissioner, Supreme Judicial Court Docket No. SJC-11609 (August 12, 2016).  While this decision produced a harsh result for the taxpayer in First Marblehead, a financial institution commercially domiciled in Massachusetts, the decision confirms an opportunity for many financial institutions domiciled outside Massachusetts that purchase loans from affiliates and third parties.

By way of background, First Marblehead involved the sourcing of securitized loans for property factor purposes under Massachusetts’ rules for financial institutions.  In contrast to most Massachusetts corporate taxpayers, financial institutions are permitted to include loans in their property factor. For property factor purposes, financial institutions source their loans based on the location of five factors, referred to as the SINAA factors (solicitation, investigation, negotiation, approval and administration).  However, in First Marblehead, the Massachusetts Department of Revenue (the “Department”) determined that the taxpayer, which was an entity formed specifically to hold securitized loans, had no SINAA factors because the taxpayer did not originate or service its loans (as is typical of a securitization entity).  The Department argued that because the taxpayer had no SINAA factors, the statute required that all of its loans be sourced to the location of the taxpayer’s commercial domicile—Massachusetts.  This resulted in a 100% Massachusetts property factor for the taxpayer, even though the overwhelming majority of the borrowers with respect to its loans were located outside Massachusetts.

Last January, the SJC upheld an Appellate Tax Board decision affirming the Department’s assessment.  See The First Marblehead Corp. v. Commissioner, 470 Mass. 497 (2015).  The taxpayer requested cert from the United States Supreme Court.  Last October, the Supreme Court issued an order vacating the SJC’s decision and remanding the case to the SJC for further consideration in light of its decision in Comptroller of Treasury of Md. v. Wynne, 135 S.Ct. 1787 (2015).  See The First Marblehead Corp. v. Mass. Comm’r of Revenue, 136 S. Ct. 317 (2015).

The SJC has now reconsidered its earlier opinion and reached the same result—upholding the inclusion of 100% of the value of the taxpayer’s loan portfolio in its property factor numerator, despite the fact that most of the borrowers under the loans are located outside Massachusetts and all the loan administration is conducted outside Massachusetts.  The SJC’s reasoning in its new decision, however, is arguably consistent with Wynne. In its prior determination, the SJC only looked to see if the Department’s method actually resulted in more than 100% apportionment. Because the taxpayer only filed returns in Massachusetts and Florida, its combined apportionment factors were considerably less than 100%.  Wynne, however, made clear that the internal consistency analysis required under the Commerce Clause required considering the outcome if every state were to apply the same sourcing rules as Massachusetts.  The SJC found that if every state applied Massachusetts’ rule, all the loans would be sourced to Massachusetts, and no other state, for purposes of the property factor.  Thus, the SJC concluded there was no risk of double taxation.

Opportunity for Financial Institutions Commercially Domiciled Outside of Massachusetts:  Although today’s decision produced a harsh result for the taxpayer, it confirms a corporate excise tax refund opportunity for other financial institutions that are:

  • Commercially domiciled outside Massachusetts; and
  • Purchasers of loans from affiliates or third parties

Taxpayers that satisfy these criteria can, in most cases, include their purchased loans in their property factor denominator without including any of the loans in their property factor numerator—even if some or all of the borrowers under the loans are located in Massachusetts. Any taxpayer that satisfies these criteria and that has been including loans it has purchased in its Massachusetts property factor numerator may have a Massachusetts refund opportunity.  For questions about the refund opportunities created by the First Marblehead decision, and the impact that further SJC review of that decision could have on other Massachusetts taxpayers, contact the authors of this Alert or another member of the Reed Smith State Tax Group.

Tom Brady’s suspension reinstated, so what are the potential Massachusetts tax consequences?

Deflategate and the NFL’s suspension of quarterback Tom Brady for 4 games has been the NFL’s biggest news story of the past two years. On Monday, the United States Court of Appeals for the Second Circuit ruled in favor of the NFL, overturning a lower judge decision to vacate Patriots quarterback Tom Brady’s four-game Deflategate suspension. Under the Second Circuit ruling, Brady will miss the first 4 games of the 2016 season.

Obviously, the biggest focus for Patriots fans is the impact that Brady’s suspension could have on the team’s fortunes this season. However, for Brady and his tax advisors, the suspension could also have interesting tax implications.

While Brady has so far made every attempt to have the suspension overturned, he has, at the same time, prepared well for the financial impact of the suspension. During this past offseason, Brady restructured his contract with the Patriots and converted a $9 million base salary for 2016 into a signing bonus and a $1 million base salary. Suspensions only result in the loss of base salary, so Brady will only forfeit $235  thousand if suspended for 4 games this year rather than the $2.11 million he’d miss out on if the deal had not been altered.

While restructuring the deal may have saved Brady money, the Commonwealth may have lost income tax revenue based on the new contract terms. If Brady files as a non-resident of Massachusetts, he may not be subject to the “Jock Tax” in Massachusetts on his signing bonus.

As a consequence, if Brady files as a Massachusetts non-resident, the Commonwealth may have lost the ability to tax the $8 million that was shifted from base salary to signing bonus. Assuming that Brady would have spent approximately 85% of duty days during the 2016 season in Massachusetts, this shift will have reduced Brady’s Massachusetts income tax bill by approximately $340,000 .

Now, given Brady’s Brookline estate, one might assume that Brady files as a Massachusetts’ resident.  But for high-wealth individuals like Brady that have homes in multiple states, simply owning a home in a state does not necessarily mean they are a “resident” for tax purposes.   If Brady is not a resident of Massachusetts, he would still pay Massachusetts income tax on a portion of his base salary under Massachusetts’ Jock Tax on non-resident athletes.

Under the Massachusetts Jock Tax, an athlete’s compensation for services rendered as a member of an athletic team during the taxable year is included in the athlete’s income and then apportioned to Massachusetts using the ratio of duty days spent within Massachusetts rendering services for the team during the taxable year by the total number of duty days spent both within and without Massachusetts during the taxable year.  830 CMR 62.5A.2(2).  Remuneration paid for signing a contract is not subject to Massachusetts’ taxation of income received by non-resident professional team athletes if all of the following conditions are met: (a) the payment for the signing bonus is not conditional upon the signee playing any games for the team; (b) the signing bonus is payable separately from the salary and any other compensation; and (c) the signing bonus is nonrefundable.  830 CMR 62.5A.3.

Typically, a duty day is defined as any day in which an athlete does some form of work for their team such as a game, team practice, or media appearance. However, a day for which an athlete is not compensated and is not rendering services for the team in any manner, including a day spent suspended without pay, is not treated as a duty day.  See 830 CMR 62.5A.2(3).

Mark Nunnelly Leaving Position as DOR Commissioner – DOR Now Seeking 3rd Commissioner in Less Than 2 years

Governor Charlie Baker’s office announced in a press release today that Mark Nunnelly has accepted a new role as Executive Director of MassIT, the state technology office, beginning April 4.  In that role, Mr. Nunnelly is expected to lead an effort to “revamp and improve” the way that people interact online with government on matters ranging from licensing, health services, and tax filing.  Mr. Nunnelly will report directly to Governor Baker in this new role.

While it was not mentioned in the press release from the Governor’s office, it was subsequently reported by State House News Service (subscription required) that Mr. Nunnelly will be leaving his position as Commissioner of Revenue when he accepts his new role on April 4.  As to the Department of Revenue that Mr. Nunnelly leaves behind, the DOR will now be looking for its third Commissioner in less than two years.  (Last spring, we reported on the appointment of Mr. Nunnelly following the resignation of former Commissioner Amy Pitter).

Massachusetts Net Worth “True Debt” Litigation Moves Forward—Oral Argument Held, Awaiting Decision

With oral argument and briefing complete, the Massachusetts Department of Revenue’s authority to increase the net worth component of a taxpayer’s corporate excise using its “true debt” analysis is under review by the Appeals Court in National Grid Holdings, Inc. et. al. v. Commissioner.  The appeal should be of particular interest to taxpayers because, in addition to reviewing whether the taxpayers are entitled to interest deductions from the income tax base, it would be the first Appellate Court decision that involves a true debt attack on a taxpayer’s net worth tax base since Overnite Trans. Co. v. Commissioner, 54 Mass.App.Ct. 180 (2002).  

By way of background, the Department has been issuing assessments that increase a taxpayer’s net worth subject to the corporate excise by denying a deduction for intercompany debt.  The Department asserts that the intercompany obligation is not “true debt”, and therefore, cannot be deducted as a liability from the taxpayer’s net worth leading to an assessment.  This can lead to substantial assessments for taxpayers.  In some cases, the Department makes the adjustment even though the obligation is treated as debt for purposes of the taxpayer’s financial reporting and debt treatment has been respected at the federal level and all other state jurisdictions.   

Whether the Department has the authority to make these “true debt” adjustments for purposes of computing the net worth tax base is now before the Appeals Court.  The taxpayer is arguing that under Massachusetts statutes and case law interpreting the net worth statute, a taxpayer’s accounting treatment of the obligation on its books and records is controlling.  If the obligation is treated as a liability in the taxpayer’s books and records, it is deductible, regardless of whether it is “true debt” for income tax purposes.  At oral argument, the taxpayer particularly emphasized the importance of the obligation’s characterization for financial reporting purposes, highlighting that its obligations were treated as liabilities in financial reports made to the Securities and Exchange Commission on several occasions.  In its brief, the taxpayer argued that its analysis is consistent with Appellate Tax Board rulings in other net worth tax cases that indicate that following a taxpayer’s accounting treatment in its books and records ensures that taxpayers are not unnecessarily forced to keep “two separate sets of books, one for financial accounting purposes and one for tax accounting purposes”. 

The fact pattern is a particularly complex international debt arrangement that required hundreds of pages of briefing and weeks of testimony at the Appellate Tax Board, it may take the Appeals Court some time to issue a decision (a longer discussion of National Grid’s fact pattern is discussed in greater detail here).  But given the number of pending appeals on the issue, the decision will be eagerly anticipated by many.  It is our hope that the Appeals Court takes the opportunity to reverse the Appellate Tax Board and stops what we consider to be an example of Departmental overreach.  If it does not, taxpayer’s may still want to preserve their appeals.  True debt appeals are fact intensive and there have been some rumblings from the Legislature of adopting retroactive legislation to cure this issue.  You can read more about that legislation here

Massachusetts Department of Revenue Launches Pilot Program for Settling Uncertain Tax Issues—Lack of Anonymity in Settlement Process a Concern

Continuing its efforts to improve the process for resolving tax disputes in Massachusetts, the Massachusetts Department of Revenue has released final AP 637 Voluntary Disclosure Program for Settlement of Uncertain Tax Issues (Click Here) outlining a new pilot program for settling “uncertain tax issues” through its voluntary disclosure program.  (Click Here for a redline showing the modest changes from the draft guidance released in January).  The program contemplates permitting taxpayers to disclose and request settlement of uncertain tax, including those that would otherwise require a taxpayer to book a reserve under ASC 740.

We applaud the Department for launching a cutting edge program that has the potential to dramatically improve the audit and appeal process in Massachusetts.  However, we are concerned that one aspect of the program will significantly reduce interest in the program and, therefore, its ultimate success—the lack of anonymity during settlement discussions.

The current pilot program only applies to uncertain tax issues for which the tax liability, exclusive of interest and penalty, exceeds $100,000, and requires taxpayers to disclose their identity before settlement discussions can begin.  While the Department offers participants in the program the carrot of penalty waiver for any tax associated with uncertain tax issues disclosed under the program regardless of whether a settlement is reached (in most cases), many taxpayers will still be rightfully reluctant to identify themselves and highlight an uncertain position to the Department without knowing whether a settlement of the underlying tax can actually be reached.  For tax positions supported by a reasonable, good-faith interpretation of the law, taxpayers are already entitled to a penalty waiver under Massachusetts law.  As a consequence, for many taxpayers the prime attraction of the program won’t be the penalty waiver, but instead will be the ability to resolve uncertain tax positions quickly for financial accounting purposes. We expect that the risks of self-identification will outweigh this benefit for many taxpayers and suppress taxpayer involvement.

While we understand that the Department is likely concerned about the need to verify facts and calculations before entering into a binding agreement regarding an uncertain tax position, these concerns could be met by allowing the parties to enter into an agreement in principle prior to the taxpayer revealing its identity. The Department would then have the option to audit the taxpayer after its identity was revealed to ensure that the taxpayer’s representations were accurate.

Overall, when combined with the highly successful Early Mediation and Expedited Settlement Programs, this is yet another signal to taxpayers that the Department is willing to think outside-the-box to improve its audit and appeal process.    It is our hope that as the program goes forward, the Department recognizes that they could greatly increase taxpayer participation through the simple change of allowing taxpayer to reach tentative agreements under the program while remaining anonymous.

Supreme Judicial Court Rules Against Taxpayer in Regency Transportation

On January 6, the Massachusetts Supreme Judicial Court (“SJC”) issued its decision in Regency Transportation v. Commonwealth, finding against the taxpayer.  The taxpayer in Regency was a trucking company that purchased vehicles in states that did not charge sales tax on the purchases.  Regency used the vehicles more than half the time outside of Massachusetts as part of its trucking business.  Regency challenged the Department of Revenue’s assessment of use tax on the full purchase price of the vehicles.  Prior coverage of this case can be found here, here, and here.

Regency had argued that the Department’s use tax assessment was excessive because the vehicles were being used in interstate commerce and the use tax as applied to the vehicles by the Department violated the four-pronged Complete Auto Transit test.  In particular, Regency argued that the Department’s application of the use tax violated the Commerce Clause, because the tax was not fairly apportioned and, thus, discriminated against purchasers of vehicles engaged in interstate commerce.

The SJC, disagreed, and ruled that Massachusetts’s imposition of use tax was fairly apportioned, being both internally and externally consistent.  In addition, the SJC leaned on the catch-all exemption for taxes paid to any other state to support its conclusion that the imposition of the tax would not result in impermissible double taxation.  Thus, the SJC upheld Massachusetts’s assessment of use tax against Regency.

Massachusetts Joint Committee Hears Testimony Yesterday on Bill to Ban Use of Contingent Fee Auditors

Yesterday, the Massachusetts Legislature’s Joint Committee on State Administration and Regulatory Oversight heard testimony on Senate Bill 1710, a bill that would prohibit the use of contingent fee auditors by state agencies, including the Massachusetts Department of Revenue (the “Department”). As the name suggests, such auditors get paid a fee which is contingent on the amount of tax (or unclaimed/abandoned property) collected based on their audits.

The Associated Industries of Massachusetts (“AIM”), represented by Brad MacDougall, offered testimony at yesterday’s hearing in strong support of Senate Bill 1710, The testimony provided important background on Massachusetts’ efforts to reform and improve its unclaimed property laws, and how a ban on contingent fee auditors would be consistent with those reform efforts. AIM provided numerous examples of the problems created by the use of contingent fee auditors by Massachusetts and other states during abandoned property audits, and how those issues create the impression that states that use contingent fee auditors are not business friendly.

AIM also noted that the use of contingent fee auditors is simply bad public policy, noting that when an auditor is being compensated based the collections he or she generates, the “risk of abuse creates a perception of unfairness that colors taxpayers’ relationships with administrators and creates an atmosphere of mistrust that hinders compliance.” Such a conflict runs contrary to public policy goal of fair and impartial application of the tax laws.

The use of contingent fee auditors by states and localities has been a controversial issue in recent years. Many of our clients report that the use of contingent fee auditors in areas such as transfer pricing and unclaimed property have resulted in audits that are more burdensome, more costly to defend, and assessments based on overly aggressive positions. Recent decisions in favor of taxpayers involving contingent fee audits in Washington D.C. (transfer pricing) and litigation in Delaware and California (unclaimed property) have highlighted the potential for overreach in contingent fee audits.

We applaud AIM’s testimony and its efforts to inform Legislature regarding the benefits of this legislation. A PDF with AIM’s testimony can be found here: AIM Testimony.

 

Supreme Judicial Court hears Oral Argument in Regency

Today, the Massachusetts Supreme Judicial Court (“SJC”) heard oral argument in Regency Transportation v. Commonwealth, a case in which the taxpayer is challenging the Department of Revenue’s assessment of use tax on the full purchase price of vehicles that it purchased outside of Massachusetts and used more than half the time outside of Massachusetts as part of its transportation services.  Prior coverage of this case can be found here and here.

A hot bench peppered the taxpayer’s representative with questions throughout his argument regarding the taxpayer’s contention that the Department’s assessment was barred on internal and external consistency grounds.  The Department faced fewer questions, though in one interesting exchange, Justice Cordy asked a series of hypotheticals regarding the application of Massachusetts’ credit provisions.  For example, Justice Cordy asked whether Massachusetts would assess use tax in a situation where a taxpayer first used property in Massachusetts for a period of time, but then later brought the property into New Jersey for use and then later accrued and remitted New Jersey use tax.  The Commissioner’s representative indicated that in such a circumstance, the Department would honor the credit provisions in the use tax statute and not assess use tax even though the first use of property was in Massachusetts and tax would otherwise have been due.

After today’s oral argument, and the recent United States Supreme Court decision to vacate and remand the SJC’s decision in First Marblehead for further internal consistency analysis in light of the recent decision in Comptroller of Treasury of Md. v. Wynne, 576 U. S. ____ (2015), the SJC should be issuing some important decisions involving internal and external consistency in the near future.

U.S. Supreme Court Vacates Decision in First Marblehead; Remands to Massachusetts Supreme Judicial Court

On October 13, the United States Supreme Court granted a request for review in the case of First Marblehead Corporation v. Massachusetts Commissioner of Revenue, and summarily vacated the decision issued January 28, 2015, by the Supreme Judicial Court of Massachusetts. The case has been remanded to the Supreme Judicial Court for further consideration in light of the U.S. Supreme Court’s decision earlier this year in Comptroller of Treasury of Md. v. Wynne, 576 U. S. ____ (2015).

The U.S. Supreme Court’s decision in Wynne held that Maryland’s personal income tax scheme (which allowed a credit against the state tax, but not the local tax, for taxes paid to another state) violated the Dormant Commerce Clause.  In Wynne, the Court held in a 5-4 decision that the Dormant Commerce Clause precluded Maryland from imposing a tax that discriminates against interstate commerce by favoring intrastate over interstate economic activity, or that might lead to double-taxation of out-of-state income.  The Supreme Court’s decision affirmed the use of the internal consistency test as the measuring stick for Dormant Commerce Clause violations resulting in double-taxation.

The Massachusetts Supreme Judicial Court (“SJC”) is now tasked with applying the internal consistency test to First Marblehead’s facts. First Marblehead involves Massachusetts’ rules for the sourcing of loans by financial institutions for property factor purposes. For property factor purposes, Massachusetts sources loans of financial institutions to the regular place of business of the financial institution where the preponderance of substantive contact with respect to the loan occur.  The location where the preponderance of substantive contacts with respect to a loan occur is determined based on the location of five factors, referred to as the SINAA factors (solicitation, investigation, negotiation, approval and administration).  However, in First Marblehead, the taxpayer purchased loans originated by third-party banks and contracted with an unaffiliated servicing company to handle administration of the loans.  Based on these facts, the Massachusetts Appellate Tax Board (“ATB”) found that the taxpayer had no SINAA factors, and sourced all of the taxpayer’s loans to its commercial domicile in Massachusetts.

In its vacated decision, the SJC affirmed the ATB’s holding, which resulted in a 100% Massachusetts property factor for the taxpayer.  It is that result that now must be scrutinized by the SJC under the internal consistency test.

Massachusetts Denies ‘True Debt’ Treatment for Cash Management Obligations

The Massachusetts Appellate Tax Board (“ATB”) has once again issued a Findings of Fact and Report upholding a Department assessment on the basis that a taxpayer’s intercompany obligations under a cash management system were not bona fide debt.  The most recent decision, issued September 4, 2015, is Staples, Inc. and Staples Contract and Commercial, Inc. v. Commissioner.  (Click here for a copy of the decision).  As with other recent true debt cases, a Department audit resulted in two related assessment issues: (1) a denial of an interest deduction for interest obligations accruing under the cash management system for purposes of the income measure of the corporate excise tax; and (2) the elimination of the liability under the cash management system, resulting in an increase in net worth for purposes of the non-income measure of the corporate excise tax.

Importantly, the ATB’s decision to uphold the assessment for purposes of the non-income measure of the corporate excise means that the “true debt” issue continues to be relevant for companies with cash management systems (and other intercompany obligations), even for years after combined reporting was adopted in Massachusetts.

For more details regarding the Staples case, Legislative efforts to correct this issue, and additional analysis, see our prior quarterly update.

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