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Colorado enacts digital tax, ‘tax haven,’ and passthrough entity tax measures

July 2021

In brief

Legislation enacted on June 23 in Colorado subjects sales of digital goods and mainframe computer access to sales and use tax, requires ‘tax haven’ corporation inclusion and ‘Finnigan apportionment’ for corporate income tax purposes, provides a passthrough entity tax as a federal ‘SALT cap’ workaround, and adopts limitations on individual itemized deductions, among other provisions.

[H.B. 1311, H.B. 1312, and H.B. 1327, enacted, 6/23/21]

Action item: While the adoption of digital goods sales tax provisions is intended to reflect the Department of Revenue’s current policy, mainframe computer access could be deemed to encompass a broad range of server or data center charges, effective July 1, 2021. Further, ‘tax haven’ entity inclusion and Finnigan apportionment could impact a broad range of corporate taxpayers, effective beginning with the 2022 tax year.

Also beginning in 2022, a passthrough entity election will be available, intended to mitigate the impact of federal deductibility limitations for state taxes. Among other provisions, a limitation on Colorado itemized deductions could have a significant tax impact on taxpayers with federal adjusted gross income of at least $400,000.

In detail

Digital goods, mainframe computer access, and other sales tax changes

H.B. 1312 includes ‘digital goods’ within the definition of ‘tangible personal property,’ and provides that “the method of delivery does not impact the taxability of a sale of tangible personal property.”  Such delivery methods include compact disc, electronic download, and internet streaming. A ‘digital good’ is defined as any item of tangible personal property that is delivered or stored by digital means, including video, music, or electronic books.

The legislation states that this new definition of digital goods “codifies the department of revenue’s long-standing treatment of digital goods, as reflected in its rule, and neither expands nor contracts the definition of ‘tangible personal property’” (see PwC’s Insight on the Department’s January 2021 rule adoption here). Further, the legislation provides, “It is the general assembly's intent to tax sales of tangible personal property no matter the delivery method[.]”

Observation: The Department’s rule and the legislative amendments suggest that Colorado’s focus is on taxing the digital equivalent of tangible personal property, regardless of delivery method. The legislation includes examples -- video, music, or electronic books -- consistent with this interpretation. Further, the statute continues to exclude electronically delivered or accessed software from the definition of tangible personal property. However, the broad definition of digital goods in the legislation likely could give rise to questions about taxability of certain digital products.

The legislation also expresses an “intent to clarify that amounts charged for mainframe computer access, photocopying, and packing and crating are sales and purchases of tangible personal property subject to the state sales tax.” Mainframe computer access means “access to computer equipment for the purpose of storing or processing data.”

Under the legislation, mainframe computer access does not include providing access to computer equipment:

  • For the purpose of examining or acquiring data maintained by the vendor or
  • Incident to electronic computer software delivery or to the use of computer software hosted by an application service provider.

Observation: The legislative changes regarding mainframe computer access appear to be focused on taxing access to servers or data centers but exclude information services and software as a service. However, it remains unclear how these changes might be applied in the context of remote access (including sourcing and multiple points of use) and lease transactions (including payment of tax up front versus on the lease stream).

Colorado allows a vendor discount for timely filing; the amount that may be retained by the vendor is equal to 4% of the tax collected, but this allowance is capped at $1,000 per filing period. The legislation provides, beginning January 1, 2022, that a retailer is not permitted to retain any portion of the vendor discount for any filing period where the vendor’s total taxable sales were greater than $1 million.

Except as otherwise provided, the sales tax provisions take effect July 1, 2021.

‘Tax haven’ corporation inclusion, Finnigan apportionment, and captive insurance companies

Under H.B. 1311, for tax years beginning or after January 1, 2022, corporate taxpayers must include in their combined filing group any affiliated group member incorporated in a foreign jurisdiction for the purpose of ‘tax avoidance.’ A corporation is presumptively incorporated in a foreign jurisdiction for the purpose of tax avoidance if it is incorporated in a listed jurisdiction under Colorado law. However, a taxpayer may prove “to the satisfaction of the Executive Director” that such corporation is incorporated in a listed jurisdiction for reasons that meet the economic substance doctrine under IRC Sec. 7701(o).

A ‘listed jurisdiction’ is defined as Andorra, Anguilla, Antigua and Barbuda, Aruba, The Bahamas, Bahrain, Barbados, Belize, Bermuda, Bonaire, British Virgin Islands, Cayman Islands, Cook Islands, Curaçao, Cyprus, Dominica, Gibraltar, Grenada, Guernsey-Sark-Alderney, Isle of Man, Jersey, Liberia, Luxembourg, Malta, Marshall Islands, Mauritius, Monaco, Montserrat, Nauru, Niue, Panama, Saba, Samoa, San Marino, Seychelles, Sint Eustatius, Sint Maarten, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Turks and Caicos Islands, US Virgin Islands, and Vanuatu.

The legislation provides adjustments for GILTI, Subpart F income, and IRC Sec. 78 gross-up attributable to a ‘tax haven’ incorporated entity.

Observation: With this legislation, Colorado becomes only the second state (in addition to Montana) to have a statutory list of ‘tax haven’ jurisdictions. Oregon repealed its tax haven list as part of conformity to federal tax reform, and certain other states (and DC) have a “criteria”-based tax haven inclusion.

The legislation also provides that the apportionment (receipts) factor numerator includes “amounts sourced to the state, regardless of the separate entity to which those factors may be attributed.” As such, the legislation adopts a ‘Finnigan’ apportionment method, effective for tax years commencing on or after January 1, 2022.

Further, the legislation disqualifies certain ‘captive insurance companies’ from the income tax exclusion under Colo. Rev. Stat. Sec. 39-22-112. A captive insurance company will be disqualified if it has gross receipts for the tax year that consist 50% or less of premiums from arrangements that constitute insurance for federal income tax purposes. These provisions are effective upon enactment (June 23).

The legislation also requires a corporate and individual income tax addback for 50% of allowed expenses under IRC Sec. 274(n)(2)(D), concerning meals and entertainment expenses for food and beverage provided by a restaurant. This addition is required only for tax years commencing on or after January 1, 2022, and before January 1, 2023. IRC Sec. 274(n)(2)(D) only applies to expenses paid before January 1, 2023.

Individual and passthrough entity tax provisions

H.B. 1327 allows S corporations and partnerships to elect annually to be subject to tax at the entity level for tax years commencing on or after January 1, 2022, and continuing as long as the federal ‘SALT cap’ remains in place. The election is binding on all the electing entity’s owners.

The tax is imposed at a 4.55% rate at the entity level. However, the tax base comprises each electing passthrough entity owner’s pro rata or distributive share of the entity’s income attributable to Colorado and, for resident owners only, income not attributable to Colorado. The electing passthrough entity is allowed a credit for taxes paid to other states (by the entity or its owners) on income not attributable to Colorado.

Owners of electing passthrough entities are allowed a deduction equal to their distributive share of the entity’s income subject to the elective passthrough entity tax.

Observation: The provision is intended to provide passthrough entity owners with the benefit of a federal income tax deduction for state and local taxes which otherwise would be limited to $10,000 per year. Colorado’s adoption is different from some other states in that it provides a deduction for the electing passthrough entity owner as opposed to a credit to account for the tax at the entity level. This approach could create challenges where there is ownership in multiple passthrough entities. 

Among other provisions impacting individual income taxpayers, H.B. 1311 requires an addition modification for federal itemized deductions over $30,000 (single filers) or $60,000 (joint filers), applicable to taxpayers with federal adjusted gross income of at least $400,000. This addition is required for tax years commencing on or after January 1, 2022. The legislation also repeals the state income tax deduction for certain federally taxable capital gains after tax year 2021, except for qualified agricultural property.

Observation: The limitation on itemized deductions could have a significant impact on taxpayers with large deductible expenses or casualty, disaster, or theft losses, as well as impact charitable giving. According to the legislation’s fiscal analysis, “In tax year 2022, the bill is expected to require income tax additions averaging $252,000 for 10,600 taxpayers.”

Insurance premium, property tax, and severance tax

H.B. 1312 amends other areas of Colorado tax law including:

  • Changing qualifications for “regional home office” insurance company designation and narrowing the exclusion for annuity plan premiums.
  • Raising the business personal property tax threshold from $7,900 on a single tax schedule to $50,000 (as adjusted for inflation).
  • Limiting certain severance tax deductions for oil and gas transportation, manufacturing, and processing costs and phasing-out certain exemptions and credits for coal production.

The takeaway

Taken together, these three bills enact significant changes in Colorado tax policy impacting a broad range of in-state and out-of-state taxpayers.

The sales tax changes regarding digital goods and, more significantly, mainframe computer access will require immediate action by sellers and purchasers given the July 1, 2021 effective date for these provisions. While the corporate income tax changes will not take effect until 2022, they may need to be taken into account (based on the June 23 enactment date) from a tax accounting perspective. Further, as with other states that provide a passthrough entity tax election, careful consideration is required regarding the impact on the passthrough entity’s owners and procedural requirements for claiming the benefit.

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Peter Michalowski

Partner, State and Local Tax Consulting Leader, PwC US

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