The California Court of Appeal's decision in Gillette Co. et al. v. Franchise Tax Board1 has taken the state tax world by storm, leaving taxpayers, practitioners, the Multistate Tax Commission, and the state tax authorities of Multistate Tax Compact member states2 scrambling in its wake. The premise of the decision is simple and elegant. The ramifications, however, are overwhelming and may prove to be more disruptive to multistate tax certainty and uniformity than even Geoffrey, Inc. v. South Carolina Tax Commissioner.3
Gillette is centered on three logically connected determinations. First, the provisions of the compact are binding on all member states.4 Second, those provisions cannot be unilaterally amended by the member states.5 Third, regardless of member state law to the contrary, Article III, section 1 of the compact (election) allows taxpayers to elect to use the apportionment provisions under Article IV of the compact in lieu of the apportionment provisions under the laws of the member state.6
Granted, Gillette is not precedential outside California, and even in California, it is far from settled law.7 Furthermore, the weight that other member states will place on the reasoning in Gillette remains to be seen, and, with litigation pending only in Michigan,8 Oregon,9 and Texas,10 the question of the validity and effect of the election is likely to be outstanding long after the MTC has amended the compact to eliminate the election entirely or severely limit its benefits.11 However, let's assume that Gillette or one of its sister cases works its way up to the U.S. Supreme Court, a majority of the justices decide in favor of the taxpayer, and the election is validated as the law of the land in all the member states. What happens next?
Assuming that the compact and the laws of the member states still exist in something resembling their present form, taxpayers will be able to make the election prospectively. Also, taxpayers will demand payment on refund claims that were held in abeyance while the nature and effect of the election were in dispute. It is reasonable to assume that the tax authorities of the member states will respond by trying to drain the value out of making the election, or even by turning the election to a taxpayer's detriment, by asserting that Article IV of the compact is subject to interpretation under the MTC's regulations and other administrative pronouncements promulgated under Article VII of the compact. Alternatively or additionally, member states may use Article IV, section 18 of the compact to equitably apportion an electing taxpayer's income under an alternative method that is substantially similar to the member state's apportionment laws, or even a method that combines multiple apportionment approaches to arrive at a more punitive calculation.
Opt Out, Opt In -- Here Comes the Shock
The compact is an interstate agreement that was made effective, and given legal standing as a statute, through the enactment of its provisions by the member states.12 The core principles underpinning the compact are:
- facilitation of the proper determination of the tax liability of multistate taxpayers in the member states;
- promotion of uniformity in the member states' income tax laws;
- facilitation of taxpayer convenience and compliance in the filing of tax returns and tax administration; and
- avoidance of double taxation.13
One of the compact's major mechanisms in its effort to promote its stated goals is the election under Article III, section 1, which provides in pertinent part:
Any taxpayer subject to an income tax whose income is subject to apportionment and allocation for tax purposes pursuant to the laws of a party State [ . . . ] may elect to apportion and allocate his income in the manner provided by the laws of such States [ . . . ] without reference to this compact, or may elect to apportion and allocate in accordance with Article IV.14
On its face, Article III, section 1, allows a multistate taxpayer to elect to apportion its income to a member state under either the laws of the member state or Article IV of the compact. The election is wholesale. A taxpayer cannot pick and choose between specific provisions of the compact and the laws of the member state in which the taxpayer makes the election. Similarly, a member state cannot assert that any of its apportionment laws apply to a taxpayer that has made the election, even if those laws are substantially identical to the provisions of Article IV.15 Accordingly, by the express terms of Article III, section 1, when a taxpayer makes the election in a member state, it opts out of the member state's laws regarding the apportionment of income in their entirety and opts into the provisions of Article IV of the compact in their entirety.
Article III of the compact does not define the term "laws" for the purpose of determining the extent to which a taxpayer making the election opts out of a member state's constitution, statutes, jurisprudence, and administrative pronouncements. However, a definition of the term "laws" can be inferred in a broader context from the negative implications of Article XII of the compact, which states in pertinent part:
The provisions of this compact shall be severable and if any [ . . . ] provision of this compact is declared to be contrary to the constitution of any State or of the United States or the applicability thereof [ . . . ] is held invalid, the validity of the remainder of this compact and the applicability thereof [ . . . ] shall not be affected thereby.16
Essentially, under Article XII, the compact cannot operate contrary to a member state's constitution, but it can operate contrary to all statutory, judicial, or administrative guidance promulgated by a member state. Therefore, when Article III, section 1 refers to the laws of a member state, it is referring to the statutes, judicial decisions, regulations, and other administrative pronouncements of the member state, and not to the member state's constitution. Consequently, when a taxpayer makes the election in a member state, it opts out of every vestige of the member state's law except for its constitution.
On the flip side of the election, Article III of the compact does not explain what it means to "apportion and allocate in accordance with Article IV."17 Clearly, an electing taxpayer must follow the provisions of Article IV of the compact. The question then is whether an electing taxpayer also opts into, and is bound by, the MTC's regulations and other administrative pronouncements promulgated under Article VII, section 1, which states:
Whenever any two or more party States [ . . . ] have uniform or similar provisions of law relating to income tax [ . . . ] the Commission may adopt uniform regulations for any phase of the administration of such law. . . . The Commission may also act with respect to the provisions of Article IV of this compact.18
As with much of the analysis regarding the mechanics of opting out of the laws of a member state, the key to understanding exactly what an electing taxpayer opts into lies in the clear distinction between administrative materials promulgated by in Article VII the MTC regarding the laws of the member states and those promulgated regarding Article IV. In either case, a regulation promulgated by the MTC is subject to notice and comment and must be submitted to the member states for their consideration.19 The member states may then adopt any of the MTC's regulations into their own law, though they are not required to.20 However, nothing in the language of Article VII requires a regulation to be adopted into the laws of the member states to have full force regarding the interpretation of Article IV of the compact. Accordingly, the administrative materials promulgated under Article VII serve a dual role: first, as model regulations and administrative pronouncements that the member states can adopt into their own laws and, second, as mandatory interpretive guidance for the provisions of Article IV.
The impact of interpreting the compact through the lens of the MTC's regulations can be substantial. For example, assume that a newspaper publisher has nexus in State X, which is a member state, and State Y, a nonmember state. Furthermore, assume that 80 percent of the publisher's newspaper circulation and 49 percent of its costs of performing newspaper advertising services are incurred in State X, and 20 percent of its newspaper circulation and 51 percent of its costs of performing newspaper advertising services are incurred in State Y. Finally, assume that the laws of State Y and State X provide that a newspaper publisher's advertising service receipts are sourced according to circulation. If the newspaper publisher makes the election in State X, the circulation sourcing rule applicable under the Laws of State X would be superseded by Article IV, section 17 of the compact, which provides:
Sales, other than sales of tangible personal property, are in this State if:
(a) the income-producing activity is performed in this State; or
(b) the income-producing activity is performed both in and outside this State and a greater proportion of the income-producing activity is performed in this State than in any other State, based on costs of performance.21
Accordingly, based solely on the compact's language, the newspaper publisher would apportion none of its advertising service receipts to State X because the greater proportion of its costs of performance were incurred in State Y, and only 20 percent of its advertising service receipts would be sourced to State Y under State Y's circulation sourcing rule, leaving 80 percent of the newspaper publisher's advertising service receipts sourced to no state. However, this analysis is incomplete. On July 30, 1993, the MTC issued Reg. IV.18(j), which provides that under the compact, a newspaper publisher is required to source its advertising service receipts based on circulation rather than the cost-of- performance rule.22 Consequently, if the newspaper publisher in this example filed State X returns using the Article IV cost-of-performance rule rather than the circulation rule provided by Reg. IV.18(j) to source its receipts from advertising services, it would have underpaid its State X tax due and would be subject to interest and penalties.
Equitable Apportionment -- And Now for the Awe
When challenging the apportionment method used by a taxpayer that has made the election, the member states have an even more powerful tool at hand than the MTC's regulations: equitable apportionment. The compact's equitable apportionment rules are embodied in Article IV, section 18, which provides:
If the allocation and apportionment provisions of this Article do not fairly represent the extent of the taxpayer's business activity in this State, [ . . . ] the tax administrator may require, [ . . . ] if reasonable:
[ . . . ]
(c) the employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer's income.23
Before July 29, 2010, Reg. IV.18(a) provided that the tax authorities of the member states could invoke Article IV, section 18 to depart from the provisions of Article IV only "in specific cases where unusual fact situations (which ordinarily will be unique and nonrecurring) produce incongruous results under the apportionment and allocation provisions contained in Article IV."24 Effective July 29, 2010, Reg. IV.18(a) was amended to eliminate the "unusual fact situations" requirement and allow tax authorities of the member states to invoke equitable apportionment anytime the apportionment provisions of Article IV produce incongruous results.25 An administrative memorandum prepared by counsel for the MTC to analyze the application of Article IV, section 18, lays out the purpose behind that change:
Because of section 18's inherent flexibility in an otherwise static statutory framework, a more dynamic utilization of state equitable adjustment authority under section 18 may be necessary for states to properly and effectively administer their corporate income tax systems in the face of [ . . . ] increased use of tax minimization strategies.26
Limiting the effectiveness of tax minimization strategies was not a particularly controversial use for Article IV, section 18, before the 2010 amendment to Reg. IV.18(a), and is not now. However, the amendment clearly made equitable apportionment under the compact a more robust doctrine and enhanced its ability to address deliberate, widespread, and systematic use of various techniques and positions that take advantage of weaknesses in Article IV. Thus, post-amendment, the only limitations on the application of this enhanced doctrine are:
- the statutory apportionment must fail to fairly represent the business activities of a taxpayer in the member state;
- the alternative apportionment method applied must more fairly represent the business activities of the taxpayer in the member state than the provisions of Article IV; and
- the only provisions that can be modified through equitable apportionment are those of Article IV.
Neither the compact nor the MTC's regulations describe the process by which either a member state or a taxpayer shows that the statutory apportionment method does not fairly represent the business activities of the taxpayer and a proposed alternative method is more equitable. Internally, counsel for the MTC has indicated that Article IV, section 18, requires a party to prove that the statutory method is distortive and that the alternative method corrects that distortion.27 However, outside jurisprudence of questionable use gives its limitations in relation to interpreting the compact. Distortion is a broad concept that is largely undefined outside a list of soft qualitative and quantitative factors and can mean anything from the equally undefined "incongruous" to "absurd."28 Counsel for the MTC would have us believe that those are all the same thing and that we should, somehow, sense disharmony in the application of the tax system.29 This type of amorphous analysis leaves a great deal of discretion in the hands of the member states.
Furthermore, neither the compact nor the MTC's regulations describe which party has the burden of proving the application of Article IV, section 18 is appropriate, or what level of proof is required. Counsel for the MTC has indicated that the burden of proof lies on the party seeking equitable apportionment;30 however, divisions in related jurisprudence may encourage the MTC to shift in favor of the member states in that regard.31 The only indicator of the level of proof required to prevail in applying equitable apportionment lies in case law, in which the burden of proof has been set as low as prima facie evidence and as high as clear and convincing evidence.32 Again, we are left with an amorphous "standard" that gives the member states a great deal of discretion.
Even the limitation that only Article IV provisions can be modified using equitable apportionment gives taxpayers no protection from member states attacking the benefits of the election through the application of an alternative apportionment method. Clearly, taxpayers can argue that the election is provided for under Article III, section 1 of the compact and therefore not properly the subject of equitable apportionment under Article IV, section 18. However, the election is given effect through Article IV, and although it may, itself, seem incongruous, the broad application of the amended version of Reg. IV.18(a) makes it possible for the member states to nullify the effect of the election directly on Article IV without having to challenge the election itself.
Taken as a whole, it would be fairly easy for a member state to defend using Article IV, section 18, to effectuate equitable apportionment by applying the apportionment provisions of the member state's law as if the election had never been made. From an internal perspective that has great appeal for a state, proving distortion would not be difficult. Furthermore, that approach would promote internal consistency and provide more uniform treatment of taxpayers within the member state.
Also, and perhaps most importantly, unlike the election itself, Article IV, section 18, does not bar a member state from picking and choosing between provisions of Article IV and the member state's laws in applying equitable apportionment. If the burden of proof is on the member state in taking that approach, it would be a more difficult path than simply forcing a taxpayer to use the member state's statutory method. If, however, the burden of proof falls on the taxpayer, it would be an expensive and complicated proposition for a taxpayer to defend against a member state's use of that discretion. Consequently, while the laws of a member state may provide protections from equitable apportionment, Article IV, section 18, makes it entirely possible for a member state to require a taxpayer that has made the election to apportion using a method that combines the worst of both worlds.
The California Court of Appeal's decision in Gillette regarding the validity and effect of the election appears to provide the basis for an unprecedented taxpayer assault on the various apportionment methods imposed under the laws of the member states. However, the general construction and express language of the compact provide member states with two highly flexible and powerful tools to limit or eliminate the effect of the election, or even to turn the election to a taxpayer's detriment. Consequently, even if Gillette and its sister cases in other member states stand on appeal, a second round of disruptive and unpredictable litigation is on the horizon.
* * * * *
SALT Matters is a new column by McGladrey LLP. Brian J. Kirkell is a director in the Washington National Tax office of McGladrey LLP. Craig Ridenour is a partner in McGladrey's State and Local Tax Practice and is the partner in charge of McGladrey's Income & Franchise Tax Service Line.
1 Gillette Co. et al. v. Franchise Tax Board, 147 Cal. Rptr. 3d 603 (Oct. 2, 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 .)
2 The member states are Alabama, Alaska, Arkansas, Colorado, the District of Columbia, Hawaii, Idaho, Kansas, Michigan, Minnesota, Missouri, Montana, New Mexico, North Dakota, Oregon, South Dakota, Texas, Utah, and Washington. California statutorily repealed the compact and withdrew from the compact under SB 1015, which became effective on July 27, 2012. It is uncertain whether this repeal is valid, as it may be considered a tax increase, and SB 1015 was passed by a simple majority rather than the two-thirds supermajority required for a tax increase under Article XIII A, section 3 of the California Constitution.
3 Geoffrey, Inc. v. South Carolina Tax Comm., 437 S.E.2d 13 (1993).
4 147 Cal. Rptr. 3d 603 at 613-615.
5 Id. at 615-616.
6 Id. at 616-618. See also Multistate Tax Compact, Article III, section 1.
7 On November 13 the California Franchise Tax Board submitted a Petition for Review of the Court of Appeal's decision in Gillette to the California Supreme Court.
8 International Business Machines Corp. v. Department of Treasury, Docket No. 306618. Nov. 20, 2012, an published Michigan Court of Appeals, holding that the compact was not binding and that a taxpayer could not elect to use the MTC apportionment election in calculating its Michigan tax liability. (For the decision, see Doc 2012-24137 or 2012 STT 228-14.)
9 Health Net, Inc. and Subsidiaries v. Department of Revenue, Case No. 120649D.
10 Graphic Packaging Corp. v. Combs.
11 The MTC has already started taking steps in this direction and is considering substantial changes to the compact. See Multistate Tax Commission, "Multistate Tax Compact Article IV Recommended Amendments" (May 3, 2012).
12 Multistate Tax Compact, Article X, section 1. See also 147 Cal. Rptr. 3d 603.
13 Multistate Tax Compact, Article I, section 2.
14 Id. at Article III, section 1.
15 Article IX, section 3 of the compact provides that a taxpayer adversely affected by an administrative determination of the tax authorities of a member state may secure arbitration by the MTC regarding the determination whenever the taxpayer has elected to apportion its income using Article IV of the compact or the apportionment provisions under the laws of the member state are substantially identical to the provisions of Article IV. This section of the compact clearly delineates between Article IV and substantially identical member state laws, and separately subjects both to the compact's arbitration rules. That separation should carry through to Article III, section 1.
16 Id. at Article XII.
17 Id. at Article III, section 1.
18 Id. at Article VII, section 1.
19 Id. at Article VII, sections 2 and 3.
20 Id. at Article VII, section 3.
21 Id. at Article IV, section 17.
22 Multistate Tax Commission Regulations, Reg. IV.18(j).
23 Multistate Tax Compact, Article IV, section 18.
24 Multistate Tax Commission Regulations, Reg. IV.18(a), as in effect prior to July 29, 2010.
25 Multistate Tax Commission Regulations, Reg. IV.18(a).
26 Multistate Tax Commission Memorandum, "Proposal to Amend Compact Model Regulation IV.18.(A) to Expand Permissible Application of Equitable Apportionment Formulas Under UDITPA Section 18" (Mar. 9, 2007).
28 See, e.g., Twentieth-Century Fox Film Corp. v. Department of Revenue, 700 P.2d 1035 (Ore. 1985). See also CarMax Auto Superstores West Coast Inc. v. Dep't of Revenue, Case No. 4953 (S.C. Ct. App. Mar. 14, 2012); Dep't of State Rev. v. Rent-A-Center East, Inc., 952 N.E.2d 387 (Ind. Tax Ct. 2011), rev'd and remanded, 963 N.E. 2d 463 (Ind. 2012).
29 Multistate Tax Commission Memorandum, supra note 2.
31 952 N.E.2d 387 (Ind. Tax Ct. 2011), rev'd and remanded, 963 N.E.2d 463 (Ind. 2012).
32 Case No. 4953 (S.C. Ct. App. Mar. 14, 2012); 952 N.E.2d 387 (Ind. Tax Ct. 2011), rev'd and remanded, 963 N.E. 2d 463 (Ind. 2012).
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