Court of Appeals Holds Non-Resident Companies' Passive Investments in Flow-Through Entities Constitutes Tax Nexus
In Revenue Cabinet v. Asworth Corporation, et al., Nos. 2007-CA-002549 & 2008-CA-000023 (Ky. App. Nov. 20, 2009), motion for discretionary review pending, No. 2009-SC-000816 (Ky. Dec. 21, 2009), the Kentucky Court of Appeals (“Court of Appeals”) held that Asworth Corporation (n/k/a Asworth, LLC) (“Asworth”), HT-Forum, Inc. (n/k/a HTF, LLC) (“HTF”) and D Aviation Services, Inc. (n/k/a D Aviation Services, LLC) (“D Aviation”) (collectively, the “Companies”), all non-Kentucky corporations, had income tax nexus with Kentucky based on their passive investments in flow-through entities, even though they did not own or lease property in Kentucky and had no employees in Kentucky. The Court of Appeals also held that the single-factor apportionment method used by the Kentucky Department of Revenue (“Department”) was proper.
The Companies were created under the laws of Nevada and Delaware and had their principal places of business in Illinois. They were not domiciled in Kentucky and did not have any property, employees or payroll in Kentucky during the tax years at issue. Their sole connection with Kentucky was through their ownership of passive investments and receipt of distributive shares of flow-through entity income received from the profits of variously named and organized partnerships doing business in Kentucky.
For the taxable periods involved, the Companies filed Kentucky corporation income tax returns and paid Kentucky corporation income tax calculated by using the standard UDITPA modeled three-factor apportionment formula of KRS 141.120. The Companies also filed Kentucky corporation license tax returns and paid the tax pursuant to KRS 136.070 using the same methodology.
The Department audited Asworth and concluded that it was not required to file a corporation license tax return because it had no “physical presence in Kentucky and so no nexus,” but it owed additional corporation income taxes, plus interest and penalties. The Department applied a single-factor apportionment formula based on sales and excluded the factors of all of the involved partnerships calculating the amount of tax due. Asworth paid the taxes as assessed by the Department and then filed amended returns, requesting refunds for the taxes it paid in relation to its original returns as well as the amount paid following the audit. The Department did not audit or issue assessments to HTF or D Aviation.
During the tax years at issue, KRS 141.040 had a “physical presence” nexus test, and imposed corporation income tax only on those foreign corporations owning or leasing property in Kentucky or having one or more employees receiving compensation in Kentucky. Kentucky did not impose corporation income tax on flow-through entities such as partnerships, but imposed tax on partners’ distributive share of income from these entities.
On appeal to the Kentucky Board of Tax Appeals (“KBTA”), the Companies argued that because they had no property or payroll in Kentucky, they were not subject to Kentucky corporation income tax based on the clear language of KRS 141.040. They also argued that KRS 141.206 did not impose tax on them but merely provided filing mechanics once a non-resident corporate partner itself was determined to have nexus and thus was subject to tax under KRS 141.040. The Companies contended that even if the KBTA held that they had nexus on statutory grounds, they had no nexus under the Commerce Clause because they had no physical presence in Kentucky as required by Quill Corp. v. North Dakota, 504 U.S. 298 (1992). The Companies also argued that they had no nexus under the Due Process Clause.
The Department countered that KRS 141.206 was a tax imposition statute and that KRS 141.040 was not applicable to non-resident corporate partners, such as the Companies. The Department also argued that physical presence was not required for Kentucky to impose the corporation income tax on the Companies, and that the Companies’ receipt of income from partnerships doing business in Kentucky satisfied the Due Process and Commerce Clause’s nexus tests. The Department further argued that the Companies were required to use the single-factor apportionment method of KRS 141.206.
The KBTA held in favor of the Companies, finding that because they had no physical presence in Kentucky, they had no nexus with Kentucky pursuant to KRS 141.040. A full refund of tax, interest and penalties paid to date was ordered, along with interest thereon calculated under KRS 131.183. The KBTA did not reach the constitutional or apportionment issues.
The Department appealed to the Franklin Circuit Court (“Circuit Court”), which held that the KBTA’s determination that the Companies did not have nexus with Kentucky pursuant to KRS 141.040 ignored the existence of KRS 141.206. The Circuit Court held that if a corporation has no property or payroll in Kentucky, but is a partner in a partnership doing business in Kentucky, KRS 141.206 controls and imposes corporation income tax on the non-resident partner. The Circuit Court therefore held that the Companies had statutory tax nexus with Kentucky and were subject to Kentucky corporation income tax.
The Circuit Court then reviewed the Companies’ constitutional claims and held that their receipt of income from partnership interests in partnerships doing business within and without Kentucky satisfied the Commerce Clause’s substantial nexus requirement. The Circuit Court also held that the minimum connection required by the Due Process Clause was present due to the Companies’ interests in partnerships that were doing business both within and without Kentucky.
The Circuit Court, citing Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), then held that the three-factor apportionment formula of KRS 141.120 applied to the Companies because they were multi-state corporations based outside of Kentucky. The Circuit Court also granted the Companies’ Motion requesting immediate payment of the tax refunds, and ordered that the Department must pay refunds within 15 days of entry of the Order.
The Department appealed the decision to the Court of Appeals on the apportionment issue, and the Companies filed a cross-appeal on the nexus issue and the KBTA’s failure to consider expert testimony on apportionment. In addressing whether the Companies were subject to taxation under Kentucky’s corporation income tax statutory scheme, the Court of Appeals ignored KRS 141.040(1), which provides that “every foreign corporation owning or leasing property located in this state or having one (1) or more individuals receiving compensation as defined in KRS 141.120(8)(b) in this state” shall pay tax on its taxable net income, and held that the Companies were subject to taxation pursuant to KRS 141.206(5) even though they had no Kentucky property or payroll. The Court of Appeals relied solely on KRS 141.206(5), which provides that “Nonresident individuals and corporations which are partners in a partnership or shareholders in an S corporation which does business within and without Kentucky are taxable on their proportionate share of the distributive income passed through the partnership or S corporation attributable to business done in Kentucky;” to impose tax liability upon the Companies. The Court of Appeals then addressed the Companies’ alternative argument that if KRS 141.206 is looked to, it was void due to its vagueness and lack of essential terms. The Court of Appeals concluded, with no analysis, that “the legislative will expressed in KRS 141.206(5) is intelligible.”
The Court of Appeals cited Complete Auto Transit v. Brady, 430 U.S. 274 (1977) and distinguished Quill Corp. v. North Dakota, 504 U.S. 298 (1992), stating that it was “unclear” whether Quill, which involved sales and use taxes, applied in this income tax case. With no analysis of the issue, the Court of Appeals simply stated that if Quill’s physical presence test did apply here, the Companies would nonetheless meet that test.
The Court of Appeals then addressed apportionment and held that because it determined that the Companies were subject to taxation under KRS 141.206(5), single-factor apportionment was applicable and three-factor apportionment under KRS 141.120 was not applicable.
The Court of Appeals then addressed at length the Companies’ argument that two recent legislative acts, House Bills 704 and 216 (“Bills”), were invalid because they unconstitutionally and retroactively deprived the Companies of interest on their tax refunds. The Bills changed the law to provide that for tax refunds issued after a certain date, interest would begin to accrue from the date of filing an amended return and at a rate of “prime” minus 2%. The Bills, each enacted after the underlying refunds were awarded to the Companies applied “retroactively on all outstanding refund claims for taxable years ending before December 31, 1995 and shall apply to all claims for such taxable years pending in any judicial or administrative forum.”
In its analysis, the Court of Appeals determined that taxpayers have “no vested right in the Internal Revenue Code,” and framed the issue as whether retroactive application of the Bills rationally furthers the legitimate governmental purpose of raising revenue to prevent a significant and unanticipated revenue loss. While recognizing that the legislative fiscal notes to both Bills indicate that the Bills have no fiscal impact on the Commonwealth, the Court of Appeals nonetheless stated that this was not dispositive of whether the Bills actually further the purpose of raising revenue. The Court of Appeals also held that United States v. Carlton, 512 U.S. 26 (1994) did not establish or impose a “modesty requirement,” but rather, a modesty consideration, and held that the retroactive period related to the Bills did not violate Due Process.
The Companies filed a Motion for Discretionary Review with the Supreme Court on December 21, 2009. The authors’ law firm represents the Companies in this case.
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