This Week in State Tax

Kansas, one of about six remaining states using an equally weighted three factor apportionment approach, will move to a single sales factor apportionment formula based on receipts starting in tax year 2027 under a bill signed recently by Governor Kelly. Any taxpayer that previously made an irrevocable election to use a two-factor apportionment formula is eligible to revoke that election and adopt the new method starting in 2027. Publicly traded companies will be eligible for a deferred tax impact deduction based on the effects of the change on their deferred tax position. Companies intending to claim the deduction are required to notify the Department of Revenue of the amount of the deduction by July 1, 2027. The deduction may be claimed in 10 percent increments beginning with tax year 2035.

In the same bill, Kansas also switches to market-based sourcing for sales other than sales of tangible personal property starting with tax year 2027. Receipts from sales will be assigned to Kansas if the market for sales is in the state. The specifics of the sourcing rules for various types of receipts are similar to other states, but notably, the bill specifies that the sale of a service will be in Kansas to the extent that the service is “delivered” to a location in Kansas. If the receipt cannot be assigned, the state of assignment may be reasonably approximated, and if the receipt can be neither assigned nor approximated, it will be excluded from the apportionment factor. Any communications service provider may continue to source its sales under the previously existing “income producing activity/cost of performance” rule. A “communications service provider” is a person that provides telecommunications services, internet access, or cable services. Please contact Alexander Karscig with questions about H.B. 2231.

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A state trial court recently upheld the “Internet Activities Rule” promulgated by the New York Department of Taxation and Finance (Department). The regulation adopts parts of the updated statement regarding the application of Public Law 86-272 as articulated by the Multistate Tax Commission (MTC) in the most recent version of their Statement of Information Concerning Practices of Multistate Tax Commission and Supporting States Under Public Law 86-272 (MTC Statement). P.L. 86-272 is a federal law which prevents a state from imposing a net income tax on a person whose sole activity in the state is the solicitation of orders for tangible personal property. Under the MTC Statement, certain activities exceed the solicitation of orders for tangible personal property and therefore disqualify a business from P.L. 86-272 immunity. A few specific examples provided under the MTC Statement include a business placing “cookies” on a user’s computer,  assisting customer’s after a sale via email or electronic chat, and online applications for employment or credit cards among other similar activities conducted over the Internet.  When it adopted the Internet Activities Rule, the Department indicated it would apply retroactively to tax years beginning on or after the effective date of the underlying corporate tax reform legislation--January 1, 2015.  A taxpayer group sought to have the Internet Activities Rule declared invalid for various reasons. The court set forth two issues: (1) general invalidity, due to federal preemption by Public Law 86-272; and (2) violation of the Due Process Clause of the Fourteenth Amendment because of its retroactive application.

On the first issue, the court ruled that the Internet Activities Rule was a valid interpretation of P.L. 86-272. In that the court’s view, P.L. 86-272 does not prohibit states from enacting laws that identify and regulate which internet activities “constitute more than solicitation of orders.” Additionally, the court explained that the Internet Activities Rule does not impermissibly expand on the exemptions from state taxation provided by P.L. 86-272, as internet activities deemed to be ancillary to solicitation are still exempt from taxation, even if the activities are not performed within the state.

With respect to the retroactivity challenge, the court ruled that the Internet Activities Rule could not be applied to any tax period before the date the regulation was published (December 2023). The court determined that taxpayers had “no opportunity to alter their behavior in anticipation of the impact of the retroactive application” and that the length of the retroactivity (nearly nine years) was excessive. The court also questioned whether there was a valid public purpose for retroactive application of the regulation. For questions about American Catalog Mailers Association v. Department of Taxation and Finance, please contact Russell D. Levitt or Aaron Balken.

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The Texas Comptroller of Public Accounts (Comptroller) ruled that a taxpayer’s services to assist health care plan sponsors fulfill their annual prescription drug data collection (RxDC) reporting obligations to the Centers for Medicare and Medicaid Services qualify as taxable data processing services. The taxpayer offers three tiers of service. Level I allows employers to upload their RxDC reports into the taxpayer's system. The taxpayer tests and converts the files into the necessary format to upload to the federal system. Level 2 offers a guided process for data collection and submission, assisting employers in gathering the correct information and reformatting documents as needed. Level 3 (White Glove) minimizes manual data entry by employers, with the taxpayer generating the required Data Files from uploaded documents. Although the taxpayer's compliance team, which includes attorneys and CPAs, analyzes and extrapolates data and performs certain calculations, the service agreement explicitly states that the taxpayer did not serve the customer in a legal capacity.

Under Texas law, sales tax is imposed on all sales of taxable items, including tangible personal property and taxable services. Taxable services encompass data processing, which includes data entry, retrieval, search, information compilation, and other computerized data manipulation. The Comptroller clarified that the taxpayer's first two service tiers involve testing, compiling, storing, and converting employer data, which are activities that fall within the definition of data processing and are therefore taxable. For the third service tier, the Comptroller noted that the taxpayer's activities involve compiling, storing, and extrapolating information from employer documents to generate the required reports. Despite the involvement of attorneys and CPAs, they do not act in their professional capacities and merely assist employers with compiling information for RxDC reporting. The Comptroller concluded that the taxpayer's services were akin to data processing activities such as filing payroll tax returns or preparing W-2 forms, thus classifying the taxpayer’s third service as taxable data processing services. Contact Karey Barton  for more information on Private Letter Ruling No. 20250318L.

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The Washington state legislature recently passed several revenue-raising bills to address a looming budget deficit; the measures are before Governor Ferguson, who has about May 20 to sign or veto them. The package is expected to generate $8.7 billion to address a four-year budget gap projected at $16 billion. Three measures are particularly significant for businesses operating in Washington, including Senate Bill 5814 expanding the retail sales tax base to include certain services,  House Bill 2081 increasing the tax rate for multiple classifications under the business and occupation (B&O) tax, and Senate Bill 5794 repealing several B&O tax preferences. 

Senate Bill 5814 amends the definition of “Sale at Retail”, effective October 1, 2025, to include the following specific services (i) Information technology training, technical support, and other services including, but not limited to, network operations assistance, help desk services, network system support, data entry, and data processing services; (ii) Custom website development services, defined as the design, development, and support of websites provided by developers to customers; (iii) Investigation, security services, security monitoring, and armored car services; (iv)) Temporary staffing services, except when provided to licensed hospitals; and (v)) Live presentations such as lectures, seminars, and courses, either in-person or via the Internet or other telecommunications that allow participants interact in real-time with presenters.

In addition, the bill adds advertising services to the definition of a taxable sale at retail. Advertising services are defined to mean all digital and nondigital services related to creating, preparing, producing, or disseminating advertisements, including certain online marketing strategies, such as online referrals, search engine marketing, and lead generation optimization, campaign planning, monitoring, and evaluation, as well as acquiring advertising space. The definition excludes web hosting as well as services rendered with respect to newspapers, radio, and television broadcasting, and out-of-home advertising (e.g., billboards, point of sale advertising, and signage, but not direct mail).

There is a carve-out for sales between members of an affiliated group of corporations that applies to most of the newly enumerated taxable services described above, with the notable exception of temporary staffing services. Transactions included within the carve-out will not be subject to the sales tax.

Further, SB 5814 adds custom software and the customization of prewritten computer software to the definition of sale at retail (i.e., makes them taxable) along with charges for the right to access such software remotely and to perform data processing, effective October 1, 2025.

Finally, to effectuate the intent of the ‘retail sale’ definition adjustments described above, the bill also eliminates certain carve-outs from the definition of digital automated services in current law, thus making such digital automated services taxable. These newly taxable digital automated services include (i) any services that primarily involve the application of human effort by the seller and the human effort originated after the customer requested the service; (ii) live presentations; (iii) data processing; and (iv) advertising services. Those digital automated services involving human effort, advertising, and data processing will remain exempt if the sale occurs between members of an affiliated group. It also adds a new exclusion from the taxation of digital automated services for telehealth services.

House Bill 2081 makes changes in the B&O tax rate for various business classifications as well as the surcharges currently in place for certain taxpayers. Effective October 1, 2025, the bill restructures the rates for the service and other activities category and imposes a rate of 1.75 percent on taxpayers with greater than $1 million and less than $5 million in gross income in the prior year unless the taxpayer is a member of an affiliated group with greater than $5 million in gross income. For qualifying taxpayers as well as members of an affiliated group with greater than $5 million in gross income, the rate will be 2.1 percent. Further, the additional surcharge imposed on specified financial institutions (as defined) is increased from 1.2 percent to 1.5 percent.

Effective January 1, 2026, the bill introduces a new surcharge for businesses with Washington taxable income exceeding $250 million annually. The surcharge will be 0.5 percent of the income exceeding $250 million, provided that manufacturers (and wholesale and retail sales of manufacturers), entities already subject to the specified financial institutions surcharge and the workforce education investment surcharge, and certain other business categories will be exempt from the surcharge.

The workforce education investment surcharge imposed on select advanced computing businesses (as defined) will also be restructured beginning in 2026. The surcharge rate is increased from 1.22 percent to 7.5 percent of taxable income, and the annual limit on the combined liability of an affiliated group will be raised from $9 million to $75 million.

In addition, the bill addresses the recent Washington supreme court decision in Antio and reinforces that the B&O deduction allowed for certain investment income is applicable only to investment income that it is incidental to the trade or business of the taxpayer, with “incidental” defined as comprising less than 5 percent of the total income of the taxpayer. The bill also includes language providing a statutory deduction of investment income for nonprofit organizations, collective investment vehicles, retirement accounts, and family investment vehicles (as those terms are defined).

Finally, effective January 1, 2027, the measure increases the B&O rate applicable to a range of classifications, including manufacturing and wholesaling, from 0.484 percent to 0.5 percent; the rate on retailing businesses increases from 0.471 percent to 0.5 percent at that time.

The final bill in the package, SB 5794, eliminates several B&O tax preferences, effective January 1, 2026. They include (i) the preferential rate for title insurance agents; (ii) a preference for credit unions that merge with banks; (iii) an exemption for the sale of precious bullions; (iv) certain credits for contributions by gas and power companies as well as the credit for certain employment in investment services; and (v) interest on loans secured by mortgages or deeds of trust currently available to certain financial institutions. Finally, the bill imposes the B&O tax on the rental of space at self-service storage facilities under the service and other activity rate of 1.5 or 1.75 percent, effective April 1, 2026.

For additional questions regarding these changes, please contact Michele Baisler, Alex Low, or Jayson Miller.

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