By votes of 57 to 40 in the House and 20 to 18 in the Senate, the Kentucky Legislature overrode Gov. Matt Bevin’s veto of House Bill (HB) 366 on April 13, 2018, and HB 487 was filed on April 26 without Gov. Bevin’s signature, meaning the legislation is now considered law. The most significant changes affect the corporate income tax, individual income tax and sales and use tax. This article summarizes the enacted legislative changes by tax type.
Corporate Income Tax
Effective for tax years beginning on or after January 1, 2018, HB 366 makes significant changes to the Kentucky corporate income tax. From an apportionment perspective, there is a change from the current three-factor formula, consisting of property, payroll and double-weighted sales, to a single sales factor formula. The sales factor sourcing methodology switches from cost-of-performance to market-based sourcing for nontangible personal property sales. Examples for this change would be the sourcing of service revenue if the service is delivered to a location in Kentucky and revenue from the use of intangible property to the extent the property is used in Kentucky. Kentucky excludes sales of intangible property/services from the factor if the sourcing cannot be reasonably approximated. HB 366 excludes all receipts from treasury functions from the definition of gross receipts, which means they are not included in calculation of the sales factor. HB 487 states communication, cable or internet access service providers would continue to use the current three-factor apportionment formula and the cost-of-performance sourcing for computing their Kentucky sales factor.
HB 366 updates Kentucky’s conformity to the Internal Revenue Code (IRC) as of December 31, 2017, for tax years beginning on or after January 1, 2018. Consistent with prior legislation, Kentucky continues to decouple from bonus depreciation (IRC Section 168(k)) and the expanded IRC §179 expensing. HB 366 also removes the Kentucky Domestic Production Activities Deduction to conform to the Tax Cuts and Jobs Act’s elimination of that provision (IRC §199). Finally, HB 366 decreases the corporate tax rate from 6 percent to 5 percent.
For tax years beginning on or after January 1, 2019, HB 487 requires a change from nexus combined reporting to a mandatory water’s-edge combined reporting for members of a unitary group, or an elective consolidated return with all members of an affiliated group. The water’s-edge combined group includes any member earning more than 20 percent of its income from intangible property or service-related activities and includes members doing business in tax havens. The bill provides for taxpayers to make an eight-year election to file as a consolidated group in accordance with IRC §1502. Taxpayers not qualifying to file water’s-edge combined or consolidated returns must file on a separate company reporting basis.
For sales tax purposes, HB 366 includes an expansion of Kentucky’s sales tax base. Receipts from services such as landscaping, janitorial, pet care and grooming, small animal veterinary services, laundry, linen supply, fitness and recreation sports centers, extended warranties and other personal services will be subject to sales tax. Furthermore, the base expansion includes charges for labor or services rendered in installing or applying tangible personal property, digital property or services sold. These changes apply to transactions occurring on or after July 1, 2018.
HB 487 also modifies Kentucky's manufacturing exemption to exempt labor to apply, install, repair or maintain tangible personal property directly used in the manufacturing process for transactions occurring on or after July 1, 2018.
HB 366 updates the definition of a retailer engaged in business in Kentucky to include any remote retailer selling tangible personal property or digital property delivered electronically to Kentucky residents if the remote seller had 200 or more separate transactions in either the previous or current calendar year or gross receipts that exceed $100,000. This update is in response to the possibility of the U.S. Supreme Court overturning Quill Corp. v. North Dakota in its hearing of South Dakota v. Wayfair. The Quill Corp. v. North Dakota decision currently provides that physical presence is necessary for a state to require a taxpayer to collect and remit sales and use tax for purchases made by in-state customers.
Individual Income Tax
HB 366 also makes changes to Kentucky’s individual income tax regime. The IRC conformity date for Kentucky’s individual income tax regime is updated to be as of December 31, 2017. This means the only itemized deductions allowed for Kentucky are charitable donations, mortgage interest and Social Security income. Deductions for medical expenses, taxes paid, interest expense on investments and casualty and theft losses are no longer allowed. In addition, HB 366 adopts a 5 percent tax rate for all individuals, eliminating the graduated income tax rate that ranges from 2 to 6 percent, depending on income levels. The legislation decreases the amount of the pension income exclusion from $41,110 to $31,110. Net income also is changed to disallow the 20 percent deduction for pass-through income pursuant to IRC §199A. All changes are effective for tax years beginning on or after January 1, 2018.
Credits & Incentives
HB 487 changes the end date of the suspension of the Investment Fund Tax Credit and the Angel Investment Act Tax Credit to January 1, 2021, rather than July 1, 2022, as provided by HB 366. Each credit would have a new cap set at $3 million annually beginning each calendar year on or after January 1, 2021. HB 487 also retains the Kentucky Industrial Revitalization Act tax credit.
Protest Period & Reporting of Federal Audit Changes
HB 366 increases the current protest period from 45 days to 60 days for tax assessments issued on or after July 1, 2018. HB 487 increases the period to notify Kentucky of a final Revenue Agent Report from a federal audit from 30 days to 180 days.
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