Losing Battles but Winning Wars

Tennessee Department of Revenue

This article is a discussion of cases in which the Tennessee Department of Revenue has been the losing party in tax litigation, but has been successful in having the Tennessee General Assembly change Tennessee statutes, so that the Department's losing position in tax litigation becomes the correct position for future cases that involve the same issue. These statutory amendments were prospective only; each of them changed the law only for periods of time subsequent to the amendment.

Computer Software Cases

The first example of cases in which the Department of Revenue has lost in litigation, but has succeeded in having Tennessee tax law changed, involved sales and use taxes. (Tennessee's sales and use tax statutes initially were enacted in 1947. Then, as now, the primary impact of sales and use taxes is to tax retail sales and uses of tangible personal property in Tennessee. The sales and use tax statutes also apply to the furnishing of specified types of items and services. The list of taxable items and services has expanded greatly over the years. It has included such diverse things as hotel rooms, laundry and dry cleaning services, admissions to sports and recreation clubs, and the bathing and grooming of animals. The rate of this tax is 7 percent at the state level and 2 ¼ percent to 2 ¾ percent at the local level.)1

The first pair of cases involved the imposition of sales and use taxes to computer software programs. One of these cases was decided in the 1970s, and the other was decided in 2009. When the Tennessee Supreme Court decided Commerce Union Bank v. Tidwell2 in 1976, Tennessee's sales and use tax statutes did not include any specific reference to computer software. Instead, the imposition of sales taxes on computer software depended on the application of the general provision imposing taxes on persons who "engage in the business of selling tangible personal property at retail in this state."3 Tangible personal property was statutorily defined as "personal property, which may be seen, weighed, measured, felt or touched, or is in any other manner perceptible to the senses."4 The taxpayer involved in Commerce Union Bank v. Tidwell purchased specialized computer software programs that were introduced into the taxpayer's computers by means of punch cards, magnetic tapes or discs. The issue before the court was whether the use of these items caused a purchase of computer software to be regarded as a purchase of tangible personal property for Tennessee sales tax purposes. The court described the parties' respective arguments as follows:

[The taxpayer] argues that while the intellectual processes may be embodied in tangible and physical material ... the logic or intelligence of the program is an intangible property right; and it is this intangible property right which is acquired when computer software is purchased or leased.
[In contrast, the Department of Revenue] views the purchase of [this] software as analogous to the purchase of a phonograph record or the purchase or lease of a motion picture film.

In deciding the issue against the Department of Revenue, the Supreme Court stated:

What is created and sold here is information, and the magnetic tapes which contain this information are only a method of transmitting these intellectual creations from the originator to the user. It is merely incidental that these intangibles are transmitted by way of a tangible reel of tape that is not even retained by the user. ... Magnetic tapes and cards are not a crucial element of software.

Unhappy with the court's decision in Commerce Union Bank v. Tidwell, the Department of Revenue convinced the General Assembly in 1977 to amend to Tennessee's sales and use tax statutes to treat sales of computer software as sales of tangible personal property.5 Thus, even though the Department of Revenue lost the litigation in Commerce Union Bank v. Tidwell, following the enactment of the specific computer software provision in 1977, it would not lose subsequent cases involving the same issue.

In Teksystems Inc. v. Farr,6 the Tennessee Court of Appeals dealt with a later version of Tennessee's sales and use tax statutes as they related to computer software. The taxpayer involved was a company that specialized in providing, on a temporary basis, information technology professionals who worked in the information technology departments of its clients, providing computer programming services as directed by the clients. The sales and use tax provided an "in-house exception" for "the fabrication of computer software by a person for such person's own use or consumption."7 The issue was whether that exception applied in a case in which the employees of a staff augmentation company fabricated computer software for the staff augmentation company's client. The exception would apply only if the workers who performed the fabrication services were, with respect to the client, employees (and not independent contractors). The contract between the staff augmentation company and the client provided that "no agency or employment relationship is intended nor shall be construed to exist between the client and the staff augmentation company or between the client and any employee of the staff augmentation company who performs services under this agreement." The court concluded that the contract did not control the issue, stating:

It is undisputed that on a day-to-day basis, the staff augmentation company's employees worked under the direct supervision and control of the client company's managers. ... The contracts between the staff augmentation company and its clients notwithstanding, the undisputed facts in this case demonstrate that the client exercised complete control over the staff augmentation company's employees. ... The principal distinction in the law between one who functions as an independent contractor with that of one who functions as an [employee] of its principal is based on the extent of control exercised over the [employee] or independent contractor.

Dissatisfied with the litigation result in Teksystems Inc. v. Farr, the Department of Revenue was successful in getting the General Assembly to enact an amendment to the statute providing an in-house exception for the fabrication of computer software. As amended effective July 1, 2009, the in-house exception in Tenn. Code Ann.  § 67-6-387 now applies only to fabrication work performed by a "direct employee," which is defined as "an employee to whom the person is obligated to issue a federal form W-2 ... and with respect to whom the person has responsibility for withholding [federal income taxes and social security taxes]."

Business Earnings Cases

An area in which the Department of Revenue has lost a series of cases is the characterization of a corporation's income, for Tennessee excise tax purposes, as business earnings or non-business earnings. (The Tennessee excise tax is a tax of 6.5 percent on a corporation's "net earnings."8 This tax also applies to other specified limited liability entities, such as limited partnerships and limited liability companies. For purposes of Tennessee's excise tax, the term "net earnings" is defined as federal taxable income, with specified modifications.)9

If a corporation or other entity subject to the Tennessee excise tax does business wholly within Tennessee, all of its net earnings are subject to the Tennessee excise tax. If it does business both in Tennessee and outside the state, then only the portion of net earnings that are attributable in some way to Tennessee are subject to this state's excise tax. The manner in which net earnings are attributable to Tennessee or another state depends on whether the net earnings constitute business earnings or nonbusiness earnings.

To the extent that net earnings constitute business earnings, they are apportioned to Tennessee or elsewhere, pursuant to an apportionment formula that includes a "property factor," a "payroll factor," and a "receipts factor."10 To the extent that a company's earnings constitute nonbusiness earnings, they are allocated to Tennessee or elsewhere. In general, rents from real property and tangible personal property that constitute nonbusiness income are allocated to Tennessee if the property is in this state or if the company's commercial domicile is in Tennessee. The same general allocation formula applies with respect to capital gains and losses from sales of real property and tangible personal property. Interest, dividends, and capital gains from sales of intangible personal property, to the extent that they constitute nonbusiness earnings, generally are allocated to the state in which the company has its commercial domicile.11

Holiday Day Inns Inc. v. Olsen12 was an early case that involved classifying a corporation's earnings as business earnings or nonbusiness earnings. When that case was decided in 1985, the term "business earnings" was defined as "earnings arising from transactions and activity in the regular course of the taxpayer's trade or business and includes earnings from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations." The term "nonbusiness earnings" was defined in a residual manner as "all earnings other than business earnings."13

The taxpayer in Holiday Inns Inc. v. Olsen was a Tennessee corporation that also had its commercial domicile in Tennessee. The type of income being characterized was interest earned on its working capital. The Department of Revenue (contrary to its usual position) took the position that the taxpayer's interest on working capital was nonbusiness income because this characterization would cause all of this interest income to be allocated to Tennessee.

The Supreme Court in Holiday Inns Inc. v. Olsen concluded, "During the years at issue, the plaintiff's working capital was managed by its Corporate Cashier Department which had a full-time staff of from six to eight employees. ...The principal and interest of these funds were expended in operating the plaintiff's hospitality business." The court thus determined that the taxpayer's interest from working capital should be classified as business earnings (and thus apportioned to several states rather than allocated entirely to Tennessee).

In General Care Corporation v. Olsen14 the Department of Revenue took its more usual position that the income involved should be classified as business earnings; under the facts of that case, more of the income involved would be apportioned to Tennessee if classified as business earnings than would be allocated to Tennessee if classified as nonbusiness earnings. The parent corporation of the taxpayer corporation sold all of the stock in the taxpayer corporation to a third corporation. This transaction was characterized under Tennessee's excise tax statutes as a sale of assets by the taxpayer corporation.15 Applying what it called a "transactional test," rather than a "functional test," the Supreme Court concluded:

Under the functional test, the income from the sale of an asset will be considered business income if the asset produced business income while it was owned by the taxpayer. ... We [find that] the Commissioner's position that the "disposition" of property need not be within the scope of the taxpayer's regular business operations in order to give rise to business income contrary to the plain language of the statute.

Our position in this regard is reinforced by the decisions of our sister states which have held that the disposition of assets as a part of a corporate liquidation is not within the taxpayer's regular business activities, and therefore produces nonbusiness income.

The same statutory definitions of business earnings and nonbusiness earnings continued to apply in 1992, when the Supreme Court decided Federated Stores Realty Inc. v. Huddleston.16 The taxpayer, which had its commercial domicile in Ohio, was engaged in the business of developing and managing 13 retail shopping centers, only one of which was located in Tennessee. The taxpayer decided to discontinue that line of business, and it sold all 13 shopping centers. The court rejected the Department of Revenue's position and concluded that the income earned upon the sale of the shopping centers was nonbusiness earnings, finding that:

The gain realized by Federated upon its sale of regional shopping centers did not constitute "business earnings" under the transactional test adopted by Court in General Care Corporation v. Olsen, unless the dispositions of such property were "transactions and activity in the regular course of the taxpayer's trade or business." ... Under the facts and circumstances of this case, the taxpayer's trade or business during the assessment period can fairly and accurately be described as developing, leasing, and managing regional shopping centers. The sales of those centers ... was not in the regular course of business. It follows that the gains from such sales were, for excise tax purposes, nonbusiness earnings.

Another case in which the Department of Revenue was on the losing side of the business earnings/ nonbusiness earnings issue was Union Carbide Corporation v. Huddleston.17 The corporate taxpayer had its commercial domicile in Connecticut. Union Carbide Corporation became financially strapped, and it was forced in 1986 to raise money by selling seven of its lines of business. Throughout its history, the taxpayer had engaged in many transactions in which it had acquired or sold business assets. The Supreme Court, however, determined that the 1986 divestiture was so unusual that it was not part of "the taxpayer's regular trade or business operations." The court's analysis included the following:

The 1986 disposition of assets was different from previous divestitures in that the proceeds of the 1986 sales were distributed to Union Carbide's shareholders. In all prior divestitures of business assets, the proceeds were reinvested in Union Carbide's ongoing business operations. ...

Finally, the 1986 dispositions ... were of a magnitude vastly larger than all prior divestitures combined. From 1973 to 1988, excluding 1986, Union Carbide had combined divestitures totaling $875.2 million. In 1986, Union Carbide had divestitures totaling $3.652 billion.


Associated Partnership I Inc. v. Huddleston18 was a case in which the Department of Revenue was again on the losing side of the business earnings/nonbusiness earnings issue. The taxpayer involved did not have its domicile in Tennessee. Applying the same definitions and the transactional test described above, the Supreme Court concluded that the disposition by the taxpayer of a partnership interest did not produce business earnings "because we conclude that the capital gain did not arise from a transaction in the regular course of the taxpayer's business."
Having concluded (probably correctly) that business entities that do business both in Tennessee and in other states collectively would pay more Tennessee excise taxes if a greater share of their income is classified as business earnings, the Department of Revenue was successful in obtaining a change in the statutory definition. The current definition is stacked heavily in favor of a finding of business earnings; that definition is:

"Business earnings" mean earnings arising from transactions and activity in the regular course of the taxpayer's trade or business or earnings from tangible and intangible property, if the acquisition, use, management or disposition of the property constitutes an integral part of the taxpayer's regular trade or business operations. In essence, earnings that arise from the conduct of the trade or trades of business operations of a taxpayer are "business earnings," and the taxpayer must show by clear and cogent evidence that particular earnings are classifiable as non-business earnings. ... This [statute] expresses the legislative intent to implement and clarify distinctions between business and non-business earnings, as found in the Uniform Division of Income for Tax Purposes Act, as [statute] interpreted by states adopting the Act.19

Another area in which the Department of Revenue was unsuccessful in litigation, but successful in getting the applicable statute changed, involved the calculation of a net operating loss for Tennessee excise tax purposes. The taxpayer in Southern Railway Co. v. Taylor,20 received dividends from corporations in which it held 100 percent of the stock in 1984 and several prior years; it included the dividends in gross income, but it was allowed to deduct such dividends in computing its net earnings in each of those years.21 In the years prior to 1984 the taxpayer had experienced operating losses. In computing its 1984 net earnings, it was allowed (in addition to the deduction for such dividends) a net operating loss deduction, based on Tenn. Code Ann.  § 67-4-805(b)(2)(C), which allowed a deduction for:

Any net operating loss incurred [in a prior year], which is defined as the excess of allowable deductions over total income allocable to this state for the year of the loss, and which may be carried over and allowed in succeeding tax years until fully utilized in the next succeeding taxable year or years in which the taxpayer has net income.

The Department's position in Southern Railway Co. v. Taylor was that, while the taxpayer was allowed a dividends received deduction for 1984, in computing the amount of its net operating loss in prior years it was not entitled to such a deduction. This position was based on a Department of Revenue regulation that provided:

The term "net operating loss" is defined ... as the excess of allowable deductions over the total income allocable to this state for the [prior] year of the loss. ... There shall be added to the net [operating] loss as determined for excise tax purposes all ... dividends [that were] excluded from net earnings [in the prior year].22

The Supreme Court found that the Department's regulation was invalid, deciding:

A 100 percent deduction for dividends received from subsidiaries [in which the taxpayer corporation owns 80 percent or more of the stock] offsets the inclusion of such dividends in gross income. Such an offsetting deduction is justifiable from a tax policy standpoint because, to the extent that two corporations are under common ownership, the payment of a dividend from one corporation to the other does not represent real economic income, but merely the transfer from one commonly owned corporate pocket to another.
There is nothing in the language or legislative history of Tenn. Code Ann.  § 67-4-805 that suggests that the "allowable deductions" referred to ... for purposes of computing a net operating loss, are any different than the deductions that are allowable for purposes computing "net earnings."

...

The court holds that the deduction for dividends received from 80 percent subsidiaries, which is an allowable deduction in computing "net earnings" for Tennessee corporate excise tax purposes, is also an allowable deduction in computing a "net operating loss" ... The provision in Rule 1320-6-1-.21(2)(a) calling for such dividends to be added to a net loss as determined for excise tax purposes has the effect of disallowing the deduction for such dividends for purposes of [computing a net operating loss deduction] and is inconsistent with the statute; accordingly, such rule is void.

Once again the Department of Revenue succeeded in getting the law changed. The statute dealing with deductions for net operating losses from prior years now provides, "There shall be added to the net loss [from prior years] as determined for excise tax purposes, all ... dividends ... excluded from net earning pursuant to this Section."23

Industrial Machinery Exemption Case

Another example of cases in which the Department of Revenue has lost, and then caused the statutory law to be changed, also involved sales taxes. No Tennessee sales or use taxes are due with respect to property that constitutes "industrial machinery."24 The statutory definition of industrial machinery is:

Machinery, apparatus and equipment with all associated part, appurtenances and accessories ... necessary to and primarily for, the fabrication or processing of tangible personal property for resale and consumption ... where the use of such machinery [or] equipment ... is by one who engages in such fabrication or processing as one's principal business. (emphasis added)25

For the industrial machinery exemption to apply, the items fabricated or processed by such machinery must constitute "tangible personal property." In 2002, when the Court of Appeals decided Freedom Broadcasting of Tennessee Inc. v. Tennessee Department of Revenue,26 tangible personal property was defined as "personal property, which may be seen, weighed, measured, felt, or touched or is in any other manner perceptible to the senses."27 The issue in that case was whether television and radio broadcast signals produced by towers owned by the taxpayer constituted tangible personal property, and thus whether the towers were industrial machinery. In deciding the case against the Department of Revenue, the court stated:

In the present case, the administrative law judge found that characteristics of taxpayers' signals can be measured. These characteristics included the frequency, transmitter output, and amplitude of the broadcast signals. Further, the administrative law judge found that the programming carried on the broadcast signals can be viewed and heard by the general public, providing one has the appropriate device. Therefore, the broadcast signals are "in any manner perceptible to the senses." Because the signals are capable of measurement and perceptible to the sense, the broadcast signals, like electricity, meet the definition of tangible personal property.

In what can be seen as part of a pattern of behavior, the Department of Revenue succeeded in getting the definition of tangible personal property changed. That definition now includes the phrase, "Tangible personal property does not include signals broadcast over the airways."28 This statutory amendment had the effect of narrowing the definition of tax exempt industrial machinery.

Conclusion

Based on its track record in losing litigation but then convincing the General Assembly to amend tax statutes to be in accord with the Department of Revenue's (previously erroneous) interpretation, the Department should be expected to continue this practice. Therefore, Tennessee taxpayers, when reviewing court decisions in which the Department loses, should keep watch for subsequent statutory amendments.

Notes

  1. Tenn. Code Ann.  § § 67-6-202 and 67-6-702.
  2. Commerce Union Bank v. Tidwell, 538 S.W. 2d 405 (Tenn. 1976).
  3. Tenn. Code Ann.  § 67-2-202(a).
  4. Tenn. Code Ann.  § 67-6-102(92)(A).
  5. Tenn. Code Ann.  § 67-6-231(a).
  6. Teksystems Inc. v. Farr, 2009 WL 1312835 (Tenn. Ct. App. 2009).
  7. Tenn. Code Ann.  § 67-6-387.
  8. Tenn. Code Ann.  § 67-4-2007(a).
  9. Tenn. Code Ann.  § 67-4-2006.
  10. Tenn. Code Ann.  § 67-4-2012.
  11. Tenn. Code Ann.  § 67-4-2011.
  12. Holiday Day Inns Inc. v. Olsen, 692 S.W.2d 850 (Tenn. 1985).
  13. In 1985, Tenn. Code Ann.  § 67-4-804.
  14. General Care Corporation v. Olsen, 705 S.W.2d 642 (Tenn. 1986).
  15. Tenn. Code Ann.  § 67-4-2006.
  16. Federated Stores Realty Inc. v. Huddleston, 852 S.W.2d 206 (Tenn. 1992).
  17. Union Carbide Corporation v. Huddleston, 854 S.W.2d 87 (Tenn. 1993).
  18. Associated Partnership I Inc. v. Huddleston, 889 S.W.2d 190 (Tenn. 1994).
  19. Then Tenn. Code Ann..  § 2004(4).
  20. Southern Railway Co. v. Taylor, 812 S.W.2d 577 (Tenn. 1991).
  21. Under then Tenn. Code Ann.  § 67-4-805(b)(2)(A).
  22. Rule 1320-6-1-.21(2)(a).
  23. Tenn. Code Ann.  § 67-4-2006(c)(5).
  24. Tenn. Code Ann..  § 67-6-206(a).
  25. Tenn. Code Ann.  § 67-6-102(47).
  26. Freedom Broadcasting of Tennessee Inc. v. Tennessee Department of Revenue, 83 S.W.3d 776 (Tenn. Ct. App. 2002)
  27. Tenn. Code Ann..  § 67-6-102(92)(A).
  28. Tenn. Code Ann.  § 67-6-102(92)(B).

JAMES D. ANDERSON is counsel with Frost Brown Todd LLC in Nashville and was previously with Bass, Berry & Sims. For 18 years he served as the sole tax attorney for the Supreme Court of Tennessee, assisting the court on every state and local tax case that came before it. In this role he enabled the court to establish a logical and clear framework for Tennessee state and local tax law. He received law degrees from Vanderbilt in 1977 and New York University (LL.M. in taxation) in 1979.