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Nexus Statute Trumps Consolidated Return Statute Court Rules

10.03.2008

We represent AT&T in this case. The holding discussed below creates an opportunity for December year end taxpayers coming up on filing deadlines. We would be happy to talk with you regarding potential or protective refund claims as well as other strategies and opportunities that may result from the Circuit Court’s decision discussed below.

In AT&T Corporation v. Department of Revenue, No. 08-CI-01272 (Jefferson Cir. Ct. Sept. 9, 2008), the Jefferson Circuit Court (“Court”) held in an appeal from the Kentucky Board of Tax Appeals (“KBTA”) that the elective consolidated corporation income tax return statute [KRS 141.200 as in effect for tax years and elections made prior to 2005] did not trump the nexus provisions of KRS 141.040.

In so holding, the Court found that KRS 141.200 was ambiguous because it both referenced KRS 141.040, which included exemptions, and simultaneously discounted KRS 141.040 by stating that all members of an affiliated group shall be treated as one corporation. The Court also held that 103 KAR 16:200, the Administrative Regulation concerning the consolidated income tax return method, was invalid and that KRS 141.200 violated the Commerce Clause of the United States Constitution. Additionally, it held that the Department of Revenue’s (“Revenue”) interpretation of KRS 141.200 violated the Due Process Clause of the United States Constitution. In so holding, the Court reversed the KBTA which had held in favor of Revenue and ordered Revenue to pay AT&T’s refunds computed by not including AT&T’s non-Kentucky subsidiaries in its Kentucky consolidated returns.

AT&T is a publicly-traded corporation organized under the laws of New York and has hundreds of subsidiaries across the nation which were also organized under the laws of states other than Kentucky. Approximately twenty of those subsidiaries had a physical presence in Kentucky during the tax periods at issue and one subsidiary was an insurance company. The other subsidiaries had no physical presence in Kentucky.

In setting forth the facts, the Court observed that this case involved specific provisions of two of Kentucky’s income tax statutes: KRS 141.040 and KRS 141.200. By way of context, the 2005 General Assembly made substantial amendments to both. For taxable periods prior to 2005, however, Kentucky imposed its corporation income tax on domestic corporations and foreign corporations with a “physical presence” in Kentucky, but the General Assembly changed Kentucky’s bright-line physical presence nexus standard to a broader, more nebulous, “doing business” standard.

Amended in 1996, KRS 141.200 established an elective procedure for filing a Kentucky consolidated return. For corporations electing Kentucky consolidated income tax return methodology of KRS 141.200 as in effect during tax years ending on or after 1995 through 2004, KRS 141.200 defined a consolidated return to include all corporations except those exempt from taxation under KRS 141.040, and treated an affiliated group electing to file a Kentucky consolidated return as “single corporation.” But, notably, the 2005 General Assembly also made substantial amendments to KRS 141.200. It retained the elective consolidated return provisions for those elections in effect, and established what some practitioners refer to as a mandatory nexus consolidated return filing methodology.

Ultimately, for the taxable years at issue, 1995, 1996 and 1997 (the initial three tax years for which the elective consolidated return method was available), AT&T elected to file Kentucky consolidated income tax returns. In those returns, AT&T included all of its subsidiaries with property and/or payroll in Kentucky, but did not include its subsidiaries without any physical presence in Kentucky. AT&T’s returns requested refunds which Revenue denied.

The Court observed that the Kentucky Board of Tax Appeals found for Revenue, but determined that the income of American Ridge was exempt from income tax pursuant to KRS 141.040(1)(f) as it as an insurance company. The Board concluded that a consolidated return filed pursuant to KRS 141.200(3) was not limited to a nexus consolidated return, but to all members of the affiliated group other than those “exempt” corporations specifically listed under KRS 141.040(1)(a) through (i). The Board further found that AT&T, by making the consolidation election pursuant to KRS 141.200(3), elected to be treated as a single corporation for all purposes under Chapter 141 and therefore, had a physical presence in Kentucky. The Board did not address any of AT&T’s constitutional arguments.

The Court stated that the primary issue before it was whether AT&T’s foreign subsidiaries may be taxed under KRS 141.040 using the consolidated return method provided in KRS 141.200. It also observed that this was an issue of first impression.

In commencing with its analysis, the Court stated that, “the seminal statue regarding corporate income tax is KRS 141.040(1).” This statute imposes tax on corporations “except those corporations listed in paragraphs (a) to (i).” KRS 141.040(1)(i) provides an exception for corporations whose only owned or leased property located in Kentucky is located at the premises of a printer with which it has contracted for printing. The Court agreed with AT&T unlike the KBTA, that KRS 141.040(1)(i) was in issue because AT&T contended that its out-of-state subsidiaries fell under this exception.

Appling the principles of affording the words of a statute their plain meaning and literally interpreting an unambiguous statute, the Court held that “KRS 141.040(1)(i) provides that the most property a corporation can have within the state of Kentucky and still be excluded from KRS 141.040 is the printed product at a printer’s premises.” It also held that AT&T’s foreign subsidiaries could be considered outside the scope of KRS 141.040(1) entirely. Accordingly, the Court held that the subsidiaries with no physical presence whatsoever in Kentucky “fell squarely with the exclusionary parameters set by KRS 141.040(1)(i).”

The Court held that KRS 141.200 was ambiguous because KRS 141.200(1)(b) which states that “corporations exempt from taxation under KRS 141.040 shall not be included in the return” is contrary to the mandates of Subsection (3)(a) which states that “an affiliated group, whether or not filing a consolidated return, may elect to file a consolidated return which includes all members of the affiliated group.” The Court noted that statutes are to be read as a whole and that any doubts regarding this tax statute’s construction should be resolved in favor or the taxpayer.

Further, the Court highlighted the conflicting position taken by Revenue (and accepted by the KBTA) which agreed to remove the insurance company from the “affiliated group” pursuant to KRS 141.040(1)(f), while not affording such treatment to the other out-of-state subsidiaries. Instead, Revenue lumped the remaining out-of-state subsidiaries together and treated them as a single corporation. The Court admonished that Revenue could not both acknowledge the exemptions by removing the insurance company and deny them at the same time by lumping the remaining out-of-state subsidiaries together.

And, very importantly, the Court struck down the Administrative Regulation concerning consolidated returns [103 KAR 16:200] as violating KRS Chapter 13A which governs the promulgation of an Administrative Regulation by a government agency such as Revenue. It held that the Regulation was invalid as it did not contain all of the exemptions listed under KRS 141.040.

In sum, the Court held KRS 141.200 to be ambiguous. And then, moved from its analysis of the involved statutes to the constitutional issues which the Board did not address.

The Court held the KRS 141.200 violated the four-prong Complete Auto test for determining whether a tax withstands Commerce Clause scrutiny.[1] Specifically, the Court said that (1) the activities of the out-of-state subsidiaries lacked substantial nexus with the taxing state because a great majority of AT&T’s subsidiaries have nothing to do with the state of Kentucky; and (2) the KRS 141.200 discriminates against interstate commerce because out-of-state corporation which invest in certain printed material within Kentucky may be excluded from a consolidated return, thus establishing a preference for in-state corporations and investors.

Finally, the Court held that Revenue’s interpretation of KRS 141.200 violated the Due Process Clause because of lack of nexus between the state and entity it seeks to tax. Therefore, the Court reasoned, Kentucky could not constitutionally tax affiliated group members over which it had no jurisdiction, and the Court rejected the notion that a corporation may waive its constitutional rights by filing a tax return that the Revenue broadly interprets due to ambiguities and inconsistencies inherent in the text of the involved statute.



[1] Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977) (A statute withstands Commerce Clause scrutiny when the tax imposed (1) is applied to an activity with a substantial nexus with the taxing state; (2) is fairly apportioned; (3) does not discriminate against interstate commerce; and (4) is fairly related to the services provided by the State.)

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