During its 2018 legislative session, the Kentucky Legislature passed two tax bills that broadly change Kentucky’s corporate and personal income tax system, as well as make a number of sales and use tax and property tax changes. The Legislature was required to override the Governor’s veto of one bill (H.B. 366), while the other bill (H.B. 487) became law without the Governor’s signature.
On April 13, 2018, the Kentucky Legislature voted to override the Governor’s veto of H.B. 366. In addition to updating Kentucky’s fixed-date conformity to the Internal Revenue Code (IRC) to December 31, 2017 (for tax years beginning after December 31, 2017), H.B. 366 enacts a flat five percent corporate and personal income tax rate (in lieu of the current graduated rate structure with a maximum rate of six percent), changes Kentucky’s standard income apportionment formula for most corporate and pass-through entity (PTE) filers to a single sales factor formula, adopts market-based sourcing, and makes a number of changes to Kentucky tax credits, among other tax changes.
On April 27, 2018, H.B. 487 became law without the Governor’s signature and makes even more sweeping changes to the Kentucky tax system. The most significant of the changes will be mandatory unitary combined reporting for most Kentucky corporate taxpayers.
Most of the Kentucky tax reform provisions are effective for the 2018 tax year, although mandatory unitary combined reporting is effective for tax years beginning on or after January 1, 2019.
Kentucky’s principal tax reform law, H.B. 366, is effective for tax years beginning on or after January 1, 2018.
Federal Tax Reform
The new law updates Kentucky’s fixed-date conformity to the IRC “in effect on” December 31, 2017, for tax years beginning on or after January 1, 2018. Therefore, Kentucky will adopt those federal tax reform provisions enacted as part of the Tax Cuts and Jobs Act, but only those applicable to the 2018 tax year (i.e., not those enacted as part of IRC section 965, for example). In addition, H.B. 366 specifically decouples from 100-percent federal bonus depreciation and the $1 million and $2 million investment phase-out limits for the IRC section 179 deduction. Taxpayers may claim a depreciation and IRC section 179 deduction computed without regard to federal 100-percent bonus depreciation or IRC section 179 amounts exceeding $25,000 or $200,000 investment phase-out limits. The legislation also eliminates certain other tax deductions.
Tax Rate Changes
For corporate income tax purposes, Kentucky currently imposes a graduated rate structure of four percent, five percent, and six percent (on taxable income over $100,000). Likewise, a graduated personal income tax structure is imposed that ranges from two percent (on taxable income up to $3,000) to six percent on taxable income over $75,000. For tax years beginning on or after January 1, 2018, Kentucky will adopt a flat five percent rate of tax on corporate and personal taxable income.
Income Apportionment Formula Changes
Kentucky applied a standard four-factor income apportionment formula consisting of property, payroll, and a double-weighted sales factor for apportioning corporations and PTEs. For tax years beginning on or after January 1, 2018, Kentucky will now require a single sales factor formula for most such taxpayers. (However, H.B. 487, see below, retained the four-factor formula for cable, communications services, and internet-access companies.) The legislation also applies the single sales factor formula to “apportionable income” instead of “business income,” although it retains the traditional “transactional test” and “functional test” for defining “apportionable income,” as well as the catch-all income that is apportionable under the U.S. Constitution. H.B. 366 also amends a number of Kentucky’s special industry apportionment formulas.
In addition to adopting a single sales factor formula, H.B. 366 also adopts market-based sourcing for sales of services and sales/licenses of intangibles. While this legislative change will likely require the issuance of regulations by the Kentucky Department of Revenue to fully implement market-based sourcing, services receipts are generally sourced based on the location of the delivery of the service.
Changes to Kentucky Tax Credits
H.B. 366 makes a number of changes to Kentucky tax credits. It creates a new non-refundable, non-transferable business inventory tax credit for state and local property taxes. However, PTEs are allowed to apply the credit to the limited liability entity tax. The legislation modifies the Kentucky film production tax credit by imposing a $100 million annual statewide cap, makes it non-refundable and non-transferable, and removes commercials from credit eligibility, among other changes.
A number of Kentucky tax credits are eliminated or suspended. For example, the Kentucky Industrial Revitalization Act (KIRA) credit, the Kentucky Investment Fund Act (KIFA) credit, and the angel investment program credit are suspended until July 1, 2022. Several other income tax credits were eliminated, including the Kentucky Jobs Retention Act (KJRA) credit, although the KJRA was restored by H.S. 487.
H.B. 366 extends the period of time to report federal audit changes resulting from a final federal audit determination from 30 days to 90 days after the conclusion of a federal audit examination. However, H.B. 487 further extended this time period from 90 days to 180 days.
For a taxpayer that is seeking to use an alternative method of apportionment, the taxpayer must prove (a) that the standard apportionment formula does not fairly represent the taxpayer’s Kentucky business activity, and (b) that the alternative formula is reasonable. The Department of Revenue does not bear this burden of proof if it can demonstrate that the taxpayer used an alternative formula in any two of the preceding five tax years. If the Department grants a taxpayer the right to use an alternative formula, such permission cannot be withdrawn by the Department unless there has been (a) a material change in facts on which the Department relied, or (b) the taxpayer materially misrepresented facts.
Income Tax Changes
While H.B. 366 enacted the most substantial components of Kentucky’s 2018 tax reform, H.B. 487 also makes major changes. The most significant of the changes is the adoption of mandatory unitary combined reporting for Kentucky corporate taxpayers, excepting “Kentucky affiliated groups” that elect to file a Kentucky consolidated tax return. A unitary group of corporations required to file a Kentucky unitary combined report is generally limited to U.S. organized corporations, but also includes foreign “tax haven” corporations.
H.B. 487 also incorporates a federal-style consolidated return for the new Kentucky consolidated return election. Under current law, a “Kentucky affiliated group” is comprised of affiliates with Kentucky nexus that are connected through a chain of ownership with a common parent corporation that has Kentucky nexus. Such group is required to file a Kentucky consolidated return. As a result of H.B. 487, a federal affiliated group, regardless of the Kentucky nexus of its individual members, will comprise a “Kentucky affiliated group.” These changes are effective for tax years that begin after December 31, 2018.
Although Kentucky starts the determination of an individual’s Kentucky taxable income with federal adjusted gross income, H.B. 487 imposes an add-back requirement for individuals who claim a federal qualified business income deduction with respect to a PTE under IRC section 199A.
H.B. 487 also makes certain changes to Kentucky electronic income tax return filing, including reducing the electronic filing threshold for employers who issue withholding statements from 100 to 25 statements annually. The new law mandates electronic filing for corporations and PTEs that report $1 million or more in federal gross receipts for the tax year.
As noted in the discussion of H.B. 366, H.B. 487 also maintains a four-factor apportionment formula for cable and communications services companies (and retains some other existing apportionment formulas for transportation companies and some other special industries), extends the time period to report federal RAR changes to 180 days from the conclusion of a federal audit examination, and restores the KJRA credit that had been repealed by H.B. 366.
Sales and Use Tax and Property Tax Changes
Effective July 1, 2018, H.B. 366 and H.B. 487 make significant Kentucky sales and use tax changes. Economic nexus is imposed, effective July 1, 2018, on any “remote retailer” that, in the current or prior calendar year, has $100,000 or more of sales to Kentucky consumers or that has 200 separate transactions with Kentucky consumers. However, a “marketplace facilitator” or “referrer” is exempted from the new economic nexus provision.
H.B. 366 also broadens Kentucky’s sales and use tax base to make a number of previously non-taxable services taxable. In addition to services such as landscaping, janitorial, industrial laundry, and non-medical diet and weight-reducing services becoming taxable, H.B. 366 imposes sales and use tax on extended warranty services. The bill also modifies the definition of taxable “admissions” to include fitness and recreational sports centers, private and public golf courses, and health spas. The terms “gross receipts” and “sales price” were amended to include charges for labor or services of installing or applying any tangible personal property, digital product, or service sold. These amounts were previously specifically excluded from “gross receipts” and “sales price.”
H.B. 487 modifies the definition of “prewritten software” and “industrial processing.” The definition of “prewritten software” will exclude any modification or enhancement to prewritten software as long as there is a reasonable, separately stated charge for the modification or enhancement. In addition, H.B. 487 amends the exemption for tangible personal property used in manufacturing to require its direct use in manufacturing or industrial processing. The bill also exempts labor or services to apply, install, repair, or maintain tangible personal property used directly in manufacturing or industrial processing.
As noted, the sales and use tax changes enacted by H.B. 366 and H.B. 487 are effective July 1, 2018.
With regard to state and local property tax, H.B. 487 exempts computer software from state and local ad valorem taxes, but not prewritten software. This change is effective for assessment dates on or after January 1, 2019.