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Taxpayers Petition U.S. Supreme Court to Review Decision Imposing Income Tax on Out-of-State Corporate Partner Based on Holding of Passive Investment Interests in In-State Entities

12.01.2010

On November 16, the taxpayers in Revenue Cabinet v. Asworth Corporation, et al., Nos. 2007-CA-002549 & 2008-CA-000023 (Ky. App. Nov. 20, 2009), review denied, No. 2009-SC-000816 (Ky. Aug. 18, 2010), petition for cert. filed (U.S. Nov. 16, 2010) (“Asworth”), petitioned the U.S. Supreme Court for a writ of certiorari to review the Kentucky Court of Appeals’ decision which held that income of an out-of-state corporate partner holding passive investment interests in entities with in-state business operations satisfied the Commerce Clause’s substantial nexus requirement and that tax legislation retroactively denying interest on overpayments for up to 17 years was valid.  

Asworth, LLC (f/k/a Asworth Corporation), HTF, LLC (f/k/a HT-Forum, Inc.), and D Aviation Services, LLC (f/k/a D Aviation Services, Inc.) (collectively “Companies”) were not Kentucky corporations nor did they have commercial domiciles in Kentucky.  Asworth, LLC was a Nevada corporation and HTF, LLC and D Aviation Services, LLC were Delaware corporations; each maintained its principal place of business in Chicago, Illinois.  The Companies were non-resident partners with passive investments in two Tennessee-based partnerships doing business in Kentucky.  The Companies had no property, employees or payroll in Kentucky.   

The Companies filed Kentucky corporation income and license tax returns and paid corporation income tax calculated by using the standard three-factor apportionment formula under KRS 141.120, assimilating their individual property, payroll and sales with those of the Tennessee-based partnerships doing business in Kentucky to determine the amount of income subject to tax by Kentucky. 

The Kentucky Department of Revenue (“Department”) audited Asworth, LLC and issued corporation income tax assessments, contending that it should have apportioned income to Kentucky based solely on a single sales factor.  The Companies filed amended returns seeking refunds of corporation income tax overpayments on the basis that they had no nexus with Kentucky because they did not have any property or employees in Kentucky and because the Commerce Clause and Due Process Clause prohibited taxation of a nonresident corporation with no physical presence in Kentucky.  The Department denied the refund claims.

The Companies sought review of the denied refund claims to the Kentucky Board of Tax Appeals (“Board”).  Before the Board, the Companies contended that they had no nexus with Kentucky.  They also contended, in the alternative, that if they were subject to taxation, traditional three-factor apportionment methodology and assimilation of their apportionment factors with those of the Tennessee-based companies doing business in Kentucky was appropriate to determine the proper amount of income by Kentucky. 

The Board agreed with the Companies and found that they did not have nexus with Kentucky under KRS 141.040.  The Board awarded refunds of all tax overpayments, plus mandatory refund interest, pursuant to KRS 131.183.  The Board found that the Companies did not have the statutory minimum level of contact with Kentucky because they had no property or employees in Kentucky as required for tax nexus under Kentucky law in effect for the involved years. 

The Department appealed the Board’s Order to the Franklin Circuit Court.  The Franklin Circuit Court held that the Companies had nexus with Kentucky, but they were entitled to use the three-factor apportionment and assimilation method to determine the amount of tax due to Kentucky based on property, payroll and sales to calculate their tax refunds.  The Franklin Circuit Court stated that, “Courts have long held that states are limited under the U.S. Constitution, to taxing only those amounts of income that bear a reasonable relationship to activities conducted in that state.”  The Franklin Circuit Court awarded a specific dollar amount of refunds, plus refund interest pursuant to the version of the tax interest statute [KRS 131.183] in effect at the time. 

The Department appealed the Franklin Circuit Court’s Order to the Kentucky Court of Appeals regarding the apportionment issue.  The Companies filed a cross-appeal regarding the nexus issue.  Before the Kentucky Court of Appeals, the Parties filed an unopposed Motion for Leave to Correct Mathematical Error in Circuit Court’s Order and to Allow Parties to Brief Issues Concerning House Bill 704 (“Motion”).  House Bill 704 retroactively amended KRS 131.183 to change the law so that interest on tax refunds such as that awarded by the Board would no longer be calculated beginning 60 days from the latter of the due date of the return or payment of the tax; instead, interest on tax refunds would begin to accrue on the date of the filing of an amended return requesting refunds.  As a result, in all cases in which amended returns are filed after the due date of the original return and after the date of payment of the tax, the amount of interest paid by the Department on all refund claims would be decreased. 

The Parties also advised the Kentucky Court of Appeals of House Bill 216, which was enacted into law after the Motion was filed.  House Bill 216 retroactively amended the law to change the date upon which interest on tax overpayments begins to accrue.  The Kentucky Court of Appeals granted the Motion and ordered supplemental briefing of the issues related to House Bills 704 and 216 (collectively, “Bills”).

The Kentucky Court of Appeals rendered an Opinion affirming the Franklin Circuit Court’s determination that the Companies had nexus with Kentucky for tax purposes and reversing the Franklin Circuit Court’s determination that the three-factor apportionment method was proper and ordering an immediate refund due.  The Kentucky Court of Appeals also took judicial notice of the enactment of the Bills into law, and held that they were valid. 

The Companies’ Motion for Discretionary Review with the Supreme Court of Kentucky was denied on December 21, 2009, which prompted the petition for a writ of certiorari.  The issues for consideration before the United States Supreme Court, as set forth in the petition for certiorari, are “[w]hether a State violates the Commerce Clause of the U.S. Constitution by subjecting an out-of-state corporate partner to income tax when the partner has no property or employees in the State and the partner’s only connection with the State is the holding of passive investment interests in entities that have in-state business operations” and “[w]hether a State violates the Due Process Clause of the U.S. Constitution by enacting non-curative tax legislation that retrospectively denies interest on overpayments of court-ordered tax refunds on a retroactive basis of up to 17 years.”  The petition asserts that the U.S. Supreme Court should accept certiorari to clarify the principles of Quill, Carlton and their progeny. 

The authors’ law firm represents the Companies in this case.

If you have questions about this topic or any other legal issue, please contact any member of the firm's State and Local Tax Team.

 

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