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Tennessee Enacts Significant Business Tax Changes

On May 20, 2015, Tennessee Governor Haslem signed into law HB 644, which is known as the Revenue Modernization Act.  Earlier in the legislative session, Governor Haslem stated the intent of the Act is to “level the playing field in terms of sales tax and business taxes.”   The “leveling” refers to the tax burden on in-state and out-of-state companies doing business in Tennessee.

The Act institutes a myriad of changes including factor nexus and market sourcing for franchise and excise tax purposes, click-through nexus for sales tax, the inclusion of SaaS as taxable computer software, and an alternative tax for taxpayers that sell massive quantities of product to distributors located in Tennessee.   Following is a brief summary of the key provisions of the Act. 
Factor Nexus

The Act provides for a bright-line factor nexus standard modeled after the UDITPA provision for both the excise (business income) tax and the franchise tax.  In this case, $500,000 of sales to Tennessee customers is sufficient to create a “substantial nexus in [Tennessee]” and subject the business to both the excise and franchise taxes regardless of any physical presence.
The Act does not address the application of P.L. 86-272.  However, the federal protection against state income tax for taxpayers whose activity is limited to the mere solicitation of tangible personal property should still apply to the excise tax, but no similar protection is afforded for franchise tax purposes.
This change is applicable to tax years starting on or after January 1, 2016. 
Deduction for Related Party Intangible Expense

Related party intangible expenses are generally required to be added back to Tennessee taxable income, after which Tennessee permits a deduction if certain requirements are satisfied such as “substantial business purpose” and “tax avoidance” is not its principal purpose.  The Act amends the deduction provision to require the taxpayer to show “clear and convincing evidence” the Commissioner’s denial of the deduction was incorrect.  This clarification of the taxpayer’s burden of proof decreases the taxpayer’s ability to justify the deduction.
This change is applicable to tax years starting on or after January 1, 2016. 

Market-Based Sourcing

The Act shifts the construction of the sales factor numerator from “costs of performance” to “market” for sales “other than sales of tangible personal property.”  Service revenue will be sourced to the state in which the service is delivered.  Intangible receipts will generally be sourced to the state in which the intangible is used.  If the “state of assignment” for both service and intangible revenue cannot be determined or reasonably approximated then the receipts are to be excluded from both the sales factor numerator and denominator. 

This change is applicable to tax years starting on or after January 1, 2016.
Alternative Additional Tax for Large Sellers of Goods to Distributors in Tennessee 

Presumably as a response to pending litigation by companies in the pharmaceutical industry, Tennessee has enacted an alternative tax for taxpayers that have sales in excess of $1 billion to Tennessee distributors in which the Tennessee distributor will attest that the product’s ultimate destination is outside Tennessee.  The alternative tax is a gross receipts tax upon “Certified Distribution Sales.”  The alternative tax has a graduate rate that starts at 0.5% for Certified Distribution Sales of $2B and less, and then is incrementally reduced to 0.125% for sales in excess of $4 billion.
The alternative tax is elective by the taxpayer, but is also in addition to the traditional franchise and excise taxes.  Taxpayers that elect to use the alternative tax are permitted to exclude Certified Distribution Sales from the numerator of the sales factor for franchise and excise tax apportionment purposes.  Therefore, taxpayers that may have Tennessee sales approaching $1B should evaluate the impact of electing into the new alternative tax to determine if electing into the new alternative tax creates a more favorable tax result.  The evaluation should also include the taxpayer’s ability to use tax attributes it may have such as depreciation, credits and NOLs.

Sales Tax Click-Through Nexus

As part of the rapid trend across many states, the Act institutes click-through nexus for sales tax purposes.  A taxpayer that engages a third party located in the state to “directly or indirectly” refer potential customers to the taxpayer and the taxpayer’s sales from this referral activity exceeds $10,000 annually is assumed to have nexus for sales tax purposes.  The assumption may be rebutted but only by “clear and convincing” evidence. 

This change is applicable to transactions starting on or after July 1, 2015.  

Expanded Sales Tax on Computer Software

The Act has extended the tax on computer software to include software that is accessed remotely in a similar manner as software that is delivered in tangible form or electronically.  The definition of use of computer software has been expanded to include “the right to access and use software that remains in the possession of the dealer …” If the software is accessed by a user located in Tennessee then it may be subject to Tennessee sales tax as if the software was electronically delivered.  If the purchaser has users located both in and out of Tennessee that will access the software then the tax can be allocated based upon the proportion of the software accessed by users in Tennessee.

It is important to note that the Act does not subject all services that may be considered software as a service (“SaaS”) to sales tax.  Specially, the new provision states its intent is not to impose a tax on otherwise exempt services “such as information services, payment processing services, internet access, or the mere storage of digital products, digital codes, or computer software.”  Thus, all transactions should be reviewed to identify the true object of the transaction to determine if it is a non-taxable service or the remote access of taxable software.
This change is applicable to transactions starting on or after July 1, 2015.  Considering the effective date for this provision creates some complication for contracts that started prior to July 1 but continue after July 1.  The new provision does not provide any guidance on how to handle contracts that straddle the effective date.        

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