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Eureka – There’s Hope! Kentucky Court of Appeals Affirms Lower Court’s Award of $5.7M Refund Claim

By Erica Horn

In Department of Revenue v. AT&T Corporation, Kentucky Court of Appeals, No. 2008-CA-001888-MR (July 3, 2014)(not to be published), the Kentucky Court of Appeals affirmed the judgment of the trial court holding the Department’s denial of the taxpayer’s refund claim was not supported by statute. While the decision will have limited applicability due to the changes in Kentucky’s statutes since the periods in question, it is still good to see a taxpayer victory when a refund claim was at issue.

Today’s version of KRS § 141.200, Kentucky’s consolidated filing statute, requires a corporation have nexus with Kentucky before the corporation may be included in a consolidated group. The version of KRS § 141.200 at issue was for tax years 1995, 1996 and 1997 and required corporations electing to file a consolidated return to use their federal consolidated affiliated group. This meant a corporation did not have to have nexus with Kentucky to be included in the consolidated group.

Initially, AT&T filed its corporation income tax returns using the federal consolidated group. Later, the corporation amended its returns to include only those corporations with nexus in Kentucky. The Court refers to the non-nexus companies as the “non-Kentucky subsidiaries”. The amended returns reflected an overpayment by AT&T of approximately $5.7M.

The version of KRS § 141.200 in effect during the tax periods at issue stated, in pertinent

part:

(1) As used in this section, unless the context requires otherwise:

  1. “Affiliated group” means affiliated group as defined in Section 1504(a)[1] of the Internal Revenue Code and related regulations;
  2. “Consolidated return” means a Kentucky corporation income tax return filed by members of an affiliated group in accordance with this section. The determinations and computations required by this chapter shall be made in accordance with the provisions of Section 1502 of the Internal Revenue Code and related regulations, except as required by differences between this chapter and the Internal Revenue Code, Corporations exempt from taxation under KRS 141.040 shall not be included in the return;

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(2) Every corporation doing business in this state, except those exempt from taxation under KRS 141.040, shall, for each taxable year, file a separate return unless the corporation was, for any part of the taxable year, a member of an affiliated group electing to file a consolidated return in accordance with subsection (3) of this section.

(3)(a) An affiliated group, whether or not filing a federal consolidated

return, may elect to file a consolidated return which includes all members of the affiliated group.

(b) An affiliated group electing to file a consolidated return under paragraph (a) of this subsection shall be treated for all purposes as a single corporation under the provisions of this chapter. All transactions between corporations included in the consolidated return shall be eliminated in computing net income in accordance with KRS 141.010(13), and in determining the property, payroll, and sales factors in accordance with Section 1 of this Act.

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(e) For each taxable year for which an affiliated group has made an

election in accordance with paragraph (a) of this subsection, the consolidated return shall include all corporations which are members of the affiliated group.

Subsections (1)(b), (2) and (3)(e) each reference KRS § 141.040. Subsection (1) of KRS § 141.040 was Kentucky’s corporation income tax nexus statute during the periods at issue. In relevant part, the statute provided:

(1) Every corporation organized under the laws of this state, every corporation having its commercial domicile . . . in this state, and every foreign corporation owning or leasing property located in this state or having one (1) or more individuals receiving compensation . . . in this state, except those corporations listed in paragraphs (a) to (i) of this subsection, shall pay for each taxable year a tax to be computed by the taxpayer on taxable net income at the rates specified in subsections (2), (3), and (4) of this section:….

As KRS § 141.040(1) provides, Kentucky’s nexus standard at the time was “physical presence”.

The Court of Appeals avoided the obvious constitutional question by solely relying on rules of statutory construction, specifically on the rule, “Taxing laws should be plain and precise, for they impose a burden on the people.” The Court found KRS § 141.200 ambiguous because Sections (3)(a)(b) and (e) stated all members of the affiliated group had to be included in the return, but KRS § 141.040(1) stated corporations had to own or lease property or pay compensation in the state before being subject to income tax.

AT&T’s non-Kentucky subsidiaries did not own or lease property in Kentucky or pay compensation here. The Court concluded, “Therefore, [the non-Kentucky subsidiaries] cannot be taxed. … We are required to resolve ambiguities in taxing statutes in favor of the taxpayer. By doing so in this case, we find persuasive AT&Ts argument that only the Kentucky subsidiaries are to be included on the consolidated return ….”

The Department likely will seek review by the Kentucky Supreme Court.