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November 26, 2012
The Effect of Proposition 39 on California Corporate Taxpayers

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by Cara Griffith

On November 6 California voters approved Proposition 39, which requires corporate taxpayers to use single-sales-factor apportionment for tax years beginning after January 1, 2013.1 As with any state's enactment of single sales factor, there are winners and losers. In general, single-sales-factor apportionment is beneficial for profitable businesses that have significant business activity in the taxing state and make most of their sales outside the state. But for many other corporate taxpayers, single-sales-factor apportionment is not good news. For example, the measure is detrimental to the manufacturing industry, said Gino DiCaro, vice president for communications at the California Manufacturers and Technology Association.

Cara Griffith However, there may be some hope for taxpayers that will see a higher California tax liability because of the requirement to use single-sales-factor apportionment. The pending Gillette litigation and the possibility that SB 1015 is invalid have created a window of opportunity for taxpayers to avoid using single sales factor and instead use the equally weighted three-factor formula provided for in the Multistate Tax Compact -- at least for another year.2

Proposition 39

As stated on the ballot, Proposition 39 "requires multistate businesses to calculate their California income tax liability based on the percentage of their sales in California." The stated purpose of Proposition 39 is to repeal "existing law giving multistate businesses an option to choose a tax liability formula that provides favorable tax treatment for businesses with property and payroll outside California." The initiative is expected to raise an additional $1 billion or more in state revenue each year.

Although major corporations were initially inclined to speak out against Proposition 39, the campaign in support of the initiative, including Tom Steyer, hedge fund manager and major donor to the campaign, singled out each corporation in ads and alleged the corporations were "fighting to keep a billion-dollar corporate tax loophole that gives tax breaks to companies for shipping jobs out of the state." In the end, the corporations were unwilling to risk a major public relations fiasco, so they did not publicly oppose the initiative. After the corporations told Steyer they would not oppose Proposition 39, the ads were pulled. In the end, more than $33 million was spent promoting the initiative; a mere $55,000 was spent opposing it.

Single Sales Factor in California

Most taxpayers in California could already elect to use single sales factor. California's budget for the 2009 shortfall and fiscal 2010 permitted taxpayers to make an irrevocable annual election for tax years beginning on or after January 1, 2011, to apportion income using a single-sales-factor formula, rather than a three-factor apportionment formula with a double-weighted sales factor.3 Taxpayers in qualified businesses, meaning they derive more than 50 percent of their gross business receipts from agriculture, extractive industry, savings and loan, banking, or financial business activities, are not permitted to make the single-sales-factor election.

Given the passage of Proposition 39, the use of a single-sales-factor apportionment formula will soon no longer be an election; it will be mandatory. Revenue and Taxation Code section 25128.7 will be added to the state's tax code and will provide:

    Notwithstanding Section 38006, for taxable years beginning on or after January 1, 2013, all business income of an apportioning trade or business, other than an apportioning trade or business described in subdivision (b) of section 25128, shall be apportioned to this state by multiplying the business income by the sales factor.

Taxpayers that elect to use single-sales-factor apportionment for tax years beginning before January 1, 2013, and taxpayers that are required to use single-sales-factor apportionment for tax years beginning after January 1, 2013, will use market-based sourcing for sales of services or intangibles. California's market-based sourcing rules generally source sales of services to California if the taxpayer's customer receives the benefit of the service in the state. Receipts from intangibles are sourced to California to the extent they are used in the state.

Problems With Sourcing and Alternative Apportionment

After the single-sales-factor election became effective, the Franchise Tax Board promulgated detailed rules addressing how taxpayers should make determinations regarding the sourcing of services and intangibles.4 Given that Proposition 39 merely added the above language that would apply for tax years after January 1, 2013, and does not otherwise amend RTC section 25128, there is nothing in Proposition 39 that changes the manner in which single-sales-factor apportionment or market-based sourcing will be applied, said Carl Joseph, counsel-multistate Tax Affairs at the FTB. Therefore, the previously issued regulations will continue to provide guidance for tax years beginning after January 1, 2013, when single sales factor becomes mandatory, Joseph said.

The regulations put out by the FTB regarding market-based sourcing outline the various sourcing rules for services (including rules for individual and business customers), and sales of intangible property (with distinctions being made between complete transfers and licensing, leasing, or renting intangibles, as well as a distinction between "marketing intangibles," "nonmarketing and manufacturing intangibles," and "mixed intangibles"). For each type of sale of a service or intangible property, the regulation provides cascading rules to determine the appropriate market.

Some have argued that the regulations, by providing the cascading rules, rebuttable presumptions, and numerous detailed examples, became exceedingly complex. However, Steve Wlodychak, a principal with Ernst & Young LLP's Indirect Tax practice, said the regulations are good and comprehensive, and if drilled down, not overcomplex. Joseph said the rules were intended to balance taxpayers' need for certainty with their need for flexibility.

When taken in the most general terms, sales from services are presumed to be sourced to California if the purchaser received the benefit of the service in California; sales from intangible property are presumed to be sourced to California to the extent the property is used in California; sales from the sale, lease, rental, or licensing of real property are presumed to be sourced to California if the real property is located in California; and sales from the lease, rental, or licensing of tangible personal property are presumed to be sourced to California if the property is located in California.

If taxpayers believe the presumptions do not apply, they can use an alternative method based on either a contract between the taxpayer and the taxpayer's customer or the taxpayer's books and records kept in the normal course of business. The FTB may challenge the taxpayer's alternative method to determine whether it reasonably reflects where the benefit of the service was received. Because the regulations are new, it is still unclear how a challenge to an alternative method of sourcing will proceed. Wlodychak said that clients so far have been satisfied with the results they have obtained from following the default sourcing provisions. As a result, he has not had the opportunity to see how the FTB will respond to a taxpayer that argues for an alternative apportionment method.

Joseph also confirmed that when single sales factor becomes mandatory on January 1, 2013, taxpayers engaged in a qualified business (those engaged in agriculture, extractive industry, savings and loan, banking, or financial business activities) will continue to be unable to use single-sales-factor apportionment. Likewise, special industries, such as the motion picture and television industries, will continue to be precluded from using single-sales-factor apportionment. Those industries now use an alternative apportionment formula (generally a three-factor formula) to prevent a distortive result from using single sales factor. Proposition 39 does not affect the special industry rules incorporated by referance in Reg section 25136-2, said Joseph.

Proposition 39 and Gillette

Although there is some certainty regarding how single-sales-factor apportionment will be applied, one of the biggest questions for taxpayers and practitioners with Proposition 39 is its interaction with the California Court of Appeal's recent opinion in Gillette v. Franchise Tax Board. As readers are undoubtedly aware, the appellate court concluded that for the years in which California was a full signatory member of the compact, taxpayers were permitted to use the equally weighted three-factor apportionment formula provided for in the compact rather than California's statutory double-weighted sales factor formula.

Although the decision itself creates uncertainty, the state added to the uncertainty by attempting to withdraw from the compact on June 27, while Gillette was still pending before the appellate court. California attempted to do so by passing SB 1015, which, among other things, purported to repeal the corporation income tax provisions in California's tax code that permitted taxpayers to elect to use the compact's apportionment provisions.

However, SB 1015 is arguably invalid because it was passed without a supermajority. According to Proposition 26, "any change in state statute which results in any taxpayer paying a higher tax" must pass by a two-thirds vote. It is difficult to come up with a scenario in which the withdrawal from the compact and the elimination of taxpayers' ability to elect to use the equally weighted three-factor formula would not result in a higher tax for "any taxpayer," particularly those that would benefit from making that election.

Practitioners and commentators have been speculating for weeks that SB 1015 will be challenged. The only real question is when. It is likely that, when it is challenged, SB 1015 will be declared invalid because it not only violates Proposition 26 but also improperly applies the judicially created doctrine of election.5 If SB 1015 is declared invalid, California did not withdraw from the compact and is still a member of the compact. Until the point when the state properly withdraws from the compact or the appellate court's opinion in Gillette is overturned, taxpayers would be able to elect to use the apportionment formula provided for in the compact.

The uncertainty of the situation is compounded by Proposition 39, which mandates single-sales-factor apportionment for tax years beginning after January 1, 2013. Given the possibility -- some would argue the probability -- that SB 1015 will be declared invalid sometime during the course of 2013, taxpayers may want to consider electing to use the three-factor formula provided for in the compact, though potentially only for tax years beginning before January 1, 2013.

The reason is that if SB 1015 is struck down in 2013, the California Legislature could go back and properly readopt the legislation, effectively withdrawing California from the compact sometime in 2013.6 As long as the legislation is readopted before December 31, 2013, it could be effective for the entire year. Wlodychak explained that California has a policy that tax legislation can be retroactive for the tax year in which it is enacted. That would mean that for 2012, taxpayers would have the ability to elect to use the apportionment formula in the compact (provided Gillette is not overturned), but for 2013, the state could eliminate that option.

Conversely, however, there is always the possibility that SB 1015 will be held valid. If that occurs, California is no longer a member of the compact, which eliminates the ability of taxpayers to elect to use the compact's apportionment formula for the 2012 tax year. However, SB 1015's invoking of the doctrine of election is still problematic. Taxpayers can make a solid argument that the state cannot use the doctrine to prevent taxpayers from filing amended returns for prior tax years using the compact's apportionment formula.7

Unfortunately for taxpayers, none of that will happen quickly. SB 1015 has yet to be challenged and the Gillette litigation is ongoing. An appeal in Gillette was filed on November 13 with the California Supreme Court.8 Most in the state and local tax community agree that it is likely the supreme court will accept the case for review, given the budgetary ramifications for the state and the implication of compact laws, which could have an effect on the more than 200 multistate compacts nationwide.

It is likely, but far from certain, that Gillette will be upheld on review. One of the arguments made in the appeal to the supreme court is that the appellate court misapplied the state constitution's reenactment rule, which provides that a "statute may not be amended by reference to its title. A section of a statute may not be amended unless the section is re-enacted as amended."9 On the basis of that rule, the appellate court concluded that the FTB could not repeal the language of section 38006 (the provision incorporating the compact into state statute), by amending RTC section 25128 with the "nothwithstanding section 38006" language.

The reenactment rule is not often invoked in California, but the appellate court's interpretation of the rule in Gillette is consistent with the purpose of the rule. The purpose of the reenactment rule, as explained in 1896 in Hellman v. Shoulters, is to avoid the "enactment of statutes in terms so blind that legislators themselves [are] sometimes deceived in regard to their effect, and the public, from the difficulty of making the necessary examination and comparison, fail[s] to become appraised of the changes made in the laws."10

The FTB cannot, by simply referring to the section, repeal RTC section 38006, particularly while the language of section 38006 remained unchanged in statute. The court's interpretation is also consistent with other states' courts' application of similar reenactment rules in their state constitutions. For example, the Washington Supreme Court said that the purpose of its reenactment rule is to prevent a statute from being amended "simply by striking out or inserting certain words, phrases, or clauses" through which laws become "complicated and their real meaning often difficult" to ascertain.11

In another argument in its appeal to the California Supreme Court, the FTB alleges on the one hand that the appellate court took too literal an interpretation of the compact's language, and in doing so "contradicts established principles of contract and statutory law and fails to take into account the unique status of the Compact as an agreement between sovereign entities." But on the other hand, the FTB later argues that the appellate court was too restrictive in its interpretation of the compact by requiring "California to withdraw from the Compact entirely in order to enact subsequent legislation that alters or amends its apportionment formula." That, the FTB said, is "contrary to the member states' intent and course of action."

The FTB will have an uphill battle arguing that the appellate court did not properly interpret the compact. The appellate court's reasoning was well researched and well supported by case law. Even though states wanted a completely flexible solution that would work on uniformity projects and demonstrate that states were working toward uniformity in state administration, creating a multistate compact may not have been the right option. And regardless of what states wanted when the Multistate Tax Commission and the compact were created, a compact is not a compact if it is not binding and offers states significant choice on whether to follow its terms.

The taxpayers in Gillette certainly have the upper hand in their legal arguments, but the appeal to the California Supreme Court has just been filed. Whether the FTB's arguments will be enough to persuade the supreme court to reverse the appellate court's opinion in Gillette is yet to be seen. Assuming that Gillette is upheld, Proposition 39 changes the double-weighted formula in RTC section 25128 with a single-sales factor formula. Proposition 39 has no effect on the state's membership in the compact. The initiative still incorporates the "notwithstanding" language in the amended version of RTC section 25128, and unless the appellate court's reasoning is overturned, the state cannot repeal the compact by implication.


In the end, the taxpayers must weigh the risks of any decision they make regarding their corporate tax returns. Unfortunately, there is risk with any decision. Initially, or at least until California properly withdraws from the compact, taxpayers have the option of filing original returns using the compact's equally weighted three-factor formula but risk that the California Supreme Court will overturn the appellate court's opinion; then they would potentially be subject to the large corporation underpayment penalty (LCUP). Alternatively, taxpayers can file using the state's double-weighted sales factor formula or single-sales-factor formula (after January 1, 2013), and file an amended return using the compact's formula and requesting an election. The risk with that option is that SB 1015 must be declared invalid or an election to use the compact's formula cannot be made on an amended return under the doctrine of election.

The ramifications of Gillette are wide-reaching. Even without adding Proposition 39 into the mix, the opinion has created significant uncertainty for taxpayers in California. Now the opinion could also have a significant effect on the ability of Proposition 39 to raise the revenue voters believed it would. That said, although Proposition 39 adds to the complication and confusion in California, it does not in itself affect Gillette and it does not withdraw the state from the compact. The result of Proposition 39, at it simplest, is that taxpayers have the option to file using a single-sales-factor method for tax years beginning after January 1, 2013, or electing to use the compact's three-factor method. But there are many other factors in play and taxpayers must wait to see how the Gillette litigation and potential challenges to SB 1015 unfold.

* * * * *

Cara Griffith is a legal editor of State Tax Notes.


1 For prior coverage of the initiative, see State Tax Notes, Nov. 12, 2012, p. 460, Doc 2012-22960 , or 2012 STT 217-8 .

2 The Gillette Co. v. Franchise Tax Board, California Court of Appeal, First District, No. A130803, July 24, 2012. For the October 2 opinion, see Doc 2012-20514 or 2012 STT 192-7 . For the July 24 opinion, see Doc 2012-15737 or 2012 STT 143-20 . For SB 1015 as enacted, see Doc 2012-13996 or 2012 STT 127-14 .

3 For prior coverage of the budget, see State Tax Notes, Aug. 3, 2009, p. 289, Doc 2009-17171 , or 2009 STT 144-7 .

4 Cal. Code Regs. tit. 18, section 25136-2, applicable to taxable years beginning on or after January 1, 2011.

5 For more on the doctrine of election, see Cara Griffith, "The Doctrine of Election: Implications for California Taxpayers," State Tax Notes, Sept. 17, 2012, p. 789, Doc 2012-18798 , or 2012 STT 180-2 .

6 Interestingly, California will now have a supermajority in both houses, so it is entirely possible that the Legislature could readopt SB 1015 if it is struck down.

7 An election to use the compact's formula requires taxpayers to follow all its taxpayer provisions, including cost-of-performance sourcing and a variety of definitions (for example, business and nonbusiness income).

8 For the brief, see Doc 2012-23369 or 2012 STT 220-8 .

9 Article IV, section 9 of the California Constitution. For prior coverage of the conference, see State Tax Notes, Nov. 12, 2012, p. 459, Doc 2012-22589 , or 2012 STT 213-2.

10 114 Cal. 136, 45 P. 1057 (1896).

11 Flanders v. Morris, 88 Wn.2d 183, 558 P.2d 769 (1977).


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