Companies and state tax authorities are embroiled in court cases that could have a major impact on how states handle taxes on digital advertising, online sales and transfer pricing.
Some cases involve the scope of the Internet Tax Freedom Act, including digital advertising tax cases in Maryland and Texas involving Apple. The iPhone maker
"The Maryland digital ad tax cases are coming together," said Clark Calhoun, a state and local tax partner at the law firm Alston & Bird. "It may be later in the year before we see anything in terms of a ruling. They've got a refund claim and a case in court. That case is going to involve threshold questions like 'Does the tax apply?' And then probably the more interesting question is, 'Does the Internet Tax Freedom Act prohibit Maryland from imposing a tax on digital advertising?' I think the answer is going to be yes. We've already seen one court answer that question and say yes. That was overturned on procedural grounds. To me, it's a pretty clear violation of the ITFA and I expect the taxpayers to win those cases."
Apple has also been embroiled in a tax dispute with the State of Texas over a claim for a $4.7 million refund on taxes paid on sales of its iCloud and iTunes Match services, arguing that the Internet Tax Freedom Act applies. The 1998 law preempts state and local governments from levying taxes on internet access and multiple or discriminatory taxes on e-commerce. However, the Supreme Court's decision in 2018 in the case South Dakota v. Wayfair gave states more ability to impose taxes on out-of-state sellers such as e-commerce providers even if they don't have a physical presence in the state.
"Another wrinkle on the ITFA issue is Apple has another case in Texas that I understand is going to go to trial at some point in 2024 on the application of Texas' tax on data processing services to Apple iCloud storage services and to Apple's iTunes Match," said Calhoun. "Apple's arguing there's not a similar nondigital service that Texas would tax, and so the discrimination prong of the ITFA bars Texas from tax. Texas, interestingly, is responding and saying the ITFA doesn't bar the application of the tax, but even if it does, they say that the law is a violation of the anti-commandeering principle."
He compared the case to the Supreme Court's 2018 decision in the case of Murphy v. National Collegiate Athletics Association, which paved the way for state-sanctioned sports gambling.
"Texas is saying the same thing should apply to the ITFA — that the federal government can't have this law that prohibits states from exercising their taxing authority," said Calhoun. "That will be an interesting aspect of that challenge: What is the scope of the ITFA, and is there any implication with the anti-commandeering principle?"
Wayfair repercussions
Other cases are challenging home-rule tax schemes in Louisiana and Colorado involving sales taxes in the aftermath of the Supreme Court's Wayfair decision. Halstead Bead, an online jewelry supply company based in Arizona, filed suit against Louisiana's parish-by-parish sales and use tax system, saying it's difficult to comply with, as there are over 50 sales tax authorities in the state.
"With Louisiana, Halstead Bead is challenging Louisiana's Wayfair law, in particular the 200-transaction prong, and that was really obviated by Louisiana getting rid of that 200-transaction prong," said Calhoun. "They've got a partial system aimed at satisfying the requirements of Wayfair, where you've got to avoid retroactivity. There were a few components that the Supreme Court looked at with the South Dakota law to find a constitutional lack of retroactivity. They also looked into simplifying the scope of the tax for state and local administration, and just minimizing the burdens on out-of-state businesses in trying to comply with the tax. Louisiana and Colorado are the principal examples of these states that haven't done a good job of minimizing those burdens. They still have a lot of non-centralized administration where taxpayers have to go get a license or go register and file specific returns with cities and counties and parishes all over the state. Louisiana has made some efforts toward central administration for remote sellers, but for anybody that has a physical presence there, they're still stuck with this parish-by-parish registration and filing requirement."
Wayfair itself — the company, not the court decision — has challenged Colorado's system on a similar basis. "They have been assessed by a city called Lakewood, and both Lakewood and the Colorado Department of Revenue asserted that Colorado's system is not meeting those requirements of Wayfair, and they have been stuck waiting for a motion to dismiss to be ruled on," said Calhoun. "The department argued that it should be dismissed from the case. In many ways to me that really proves Wayfair's point. If it still has to litigate and file returns and be audited by and litigate against every city or county that disagrees with Wayfair's tax filing, that is far short of the centralized administration and easing of burdens that the Supreme Court required. I think Colorado's system is just blatantly deficient under [the Wayfair decision], and they just continue to have this bifurcated system where you've got a little bit of central administration. The department administers some cities and counties, but then a bunch of cities and counties have not opted into that system and they still want their separate filing of returns."
Transfer pricing disputes
Other state tax cases involve income taxes for businesses dealing with state rules on transfer pricing and intercompany adjustment matters in states like South Carolina, Georgia and Louisiana. They face issues not unlike multinational corporations that use transfer pricing strategies to minimize taxes across their subsidiaries in different countries.
"The separate reporting states have been learning and trying to come up with processes for auditing and adjusting intercompany transactions for probably 10 or 15 years," said Calhoun. "They did quite a bit of assessing taxpayers before they really engaged in any resources or really understood the purpose of these intercompany transfer pricing adjustments and the actual methods and how the numbers are derived. You see states take different approaches, most of them just adjusting and denying quite a bit of intercompany payments and asking taxpayers to prove their entitlement to those. The taxpayers have been fairly successful in demonstrating that there is a lot of support for the structures of their intercompany payments."
Some states like North Carolina have operated formal programs for the taxpayers to come together on an appropriate adjustment on the taxes, he noted, but others have been less willing to compromise.
"Then you have South Carolina take a unique approach where they say, 'We don't really care about your transfer pricing study. We don't care what the number ought to be. We're just going to force combinations among all the unitary businesses in the group,' said Calhoun.
In one
"It ruled for the state and said that we don't think the taxpayer in this case has demonstrated that its reporting was a fair representation of its own activities in the state," said Calhoun. "But I think the outcome in that case is going to make it really hard for the state to run that same playbook because they didn't make any effort to show what the intercompany transactions or any intercompany services should have been worth. They just demonstrated that there wasn't a fair representation based on the amounts that were reported."
The court affirmed the assessment, but more litigation is likely in this case as well as others in South Carolina.
"I don't think the court is going to allow the department to continue coming into court and not offering any evidence of what that intercompany price should have been," said Calhoun. "My expectation is that more of these cases are going to start settling out. The department is going to have to recognize that there is a right number for the value of these intercompany services or these cases ought to settle, or some taxpayers are going to win because the department doesn't put forth any [transfer pricing] evidence or input for the number that is at least partly supportive of what the taxpayer reported."
In Georgia, a number of administrative assessments of transfer pricing strategies are working their way through the system. "Georgia has been using less external support than other states in both reaching its assessments and in resolving them," said Calhoun. "I'm hopeful that as we move into 2024 and future years, they're going to employ a more supportable approach, rather than actually getting some external support and being able to respond to and review what the taxpayers have filed."
Louisiana has what Calhoun calls a "bombshell case" in the transfer pricing area involving ConocoPhillips, a multinational oil and gas exploration and production company.
"The department has gone in and sued ConocoPhillips for, in their view, improper transfer pricing and income shifting," said Calhoun. "We'll see how that plays out. Certainly Louisiana has used a little more external support than a state like Georgia, but I still don't know that they have a real strong basis for any of their conclusions. I guess it remains to be seen how much support there is for their position or if that suit was just about shock value."
