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Alternative Apportionment: Recent Taxpayer Successes and Snags

Posted on Jan. 1, 2018

Patrick K. Skeehan is a state and local tax manager in Grant Thornton LLP’s Philadelphia office. The author wishes to thank Nick Caputi, state and local tax senior associate in Philadelphia, for his assistance in drafting this article.

In this edition of Taking SALT for Granted, Skeehan looks at recent court cases involving alternative apportionment.

As it is often impossible to precisely measure the division of income across states, statutory apportionment formulas are used to approximate the amount of income that a business earns within a state. Naturally, occasions arise in which income apportioned to a state under the standard method is inconsistent with the true extent of taxpayer activity in that state. Such distortion of income has become increasingly common with the move to a service-based economy and the resulting influx of nontraditional industries such as information technology and other service providers.

Enter alternative apportionment provisions, which provide taxpayers limited relief when a state’s standard apportionment formula fails to accurately reflect a taxpayer’s business activities in that state. But taxpayers beware: state tax administrators are permitted to invoke these provisions as well. This tension raises the question whether taxpayers and states have equal access to alternative apportionment relief. Are taxpayers at an inherent disadvantage in requesting alternative apportionment relief? Are state taxing authorities granted too much discretionary authority in requiring taxpayers to adjust apportionment formulas?

This article addresses the most recent developments in alternative apportionment, including a review of the latest case law in this evolving area. Throughout this discussion, it will compare relative taxpayer success in requesting alternative apportionment versus state taxing authority efforts to require the same. Finally, the recent efforts of the Multistate Tax Commission in rewriting its model alternative apportionment regulations will be discussed.

I. Background and Alternative Apportionment Framework

As with other areas of state taxation, apportionment is concerned first and foremost with fairness. Fair apportionment makes up one prong of the four-part test articulated by the U.S. Supreme Court to determine whether a state tax satisfies the commerce clause of the U.S. Constitution.1 Under this prong, a state tax must be “fairly apportioned,” or apportioned in a manner that reasonably approximates the relationship between a taxpayer’s income attributed to a state and the taxpayer’s business activities in that state.2 Taxpayers may challenge the constitutionality of state standard apportionment formulas that they believe are unreasonable and arbitrary as applied and seek the application of an alternative apportionment formula, but they carry a heavy burden. The Court has established that a taxpayer making such a challenge bears the burden of proving, by clear and cogent evidence, that the standard apportionment formula leads to a grossly distortive result, and that the requested alternative apportionment method solves that distortion in a manner that more fairly represents the taxpayer’s business activities in the state.3 Otherwise, the Court has been hesitant to impose strict constitutional constraints on a state’s selection of a particular statutory formula.4

Separate from the constitutional considerations stated above, most states have enacted alternative apportionment provisions to address less egregious situations in which a statutory apportionment formula does not rise to a constitutional violation, but still does not fairly represent a taxpayer’s in-state business activities. Most state alternative apportionment schemes provide that the taxpayer may petition for — or the tax administrator may require — a different apportionment method to effectuate an equitable allocation and apportionment of the taxpayer’s income. Many states have adopted some form of section 18 of the Uniform Division of Income for Tax Purposes Act, the model statute adopted by the MTC as Article IV of the Multistate Tax Compact. Under the model statute, when circumstances may require, income may be apportioned or allocated in one of the following ways:

1. the use of separate accounting;

2. the exclusion of one or more apportionment factors from the formula;

3. the inclusion of additional factors; or

4.4 any other method that may result in an equitable allocation of income.5

II. Alternative Apportionment in the Courts

Although the language in state alternative apportionment provisions is usually similar, states have taken different approaches in interpreting and applying those provisions. This section reviews the latest cases addressing alternative apportionment, whether requested by the taxpayer or sought by state taxing authorities.

A. Vodafone Americas Holdings Inc. v. Roberts

In a puzzling result, the Tennessee Supreme Court upheld the authority of the Tennessee commissioner of revenue to require an alternative method of apportionment when the state’s statutory cost-of-performance (COP) method did not fairly represent the extent of the taxpayer’s business activity in the state.6 The court found that the commissioner properly exercised his discretion under the state’s alternative apportionment statute in requiring Vodafone, a wireless telecommunications service provider, to source its receipts based on customer billing addresses rather than the statutory method in place at the time.7

The Vodafone litigation stemmed from a refund claim in which the taxpayer argued that it was entitled to use the statutory COP method in calculating its Tennessee sales factor.8 Under the COP method, the majority of the costs associated with Vodafone’s wireless services were incurred in New Jersey. Thus, the use of a COP method resulted in over $1 billion in previously taxable earnings no longer being subject to tax in Tennessee or any other state, thereby reducing Vodafone’s Tennessee sales receipts by approximately 89 percent.

The court concluded that market-based sourcing of income was appropriate under the facts and circumstances because otherwise, “billions of dollars in Vodafone’s revenue would become invisible for tax purposes under the standard franchise and excise tax apportionment formula.” Such outcome-determinative reasoning focused solely on the fact that less tax would have been owed under the statutory approach. Choosing not to explain why Tennessee’s COP method did not accurately measure Vodafone’s business activities in the state, the court instead upheld the commissioner’s variance on the basis that the commissioner should be afforded significant deference in determining whether alternative apportionment was necessary. The court’s decision is worrisome because it adhered to an “abuse of discretion” standard, which required the taxpayer to show that the commissioner’s deviation was an abuse of discretion, even though the commissioner was the party seeking alternative apportionment.

B. Rent-A-Center West Inc. v. Department of Revenue

Unlike the Tennessee court in Vodafone, South Carolina courts have refused to place the burden of proof on the taxpayer when state tax administrators assert alternative apportionment. Instead, the courts have clarified that the state tax authority bears the burden of proof when the state tax authority seeks alternative apportionment. In Rent-A-Center West Inc. v. Department of Revenue, the South Carolina Court of Appeals rejected the South Carolina Department of Revenue’s attempt to require alternative apportionment based on the argument that the statutory method used by the taxpayer was distortive.9

The taxpayer, Rent-A-Center West (RAC West), was engaged in a unitary business that involved both retail selling and licensing of intangibles. However, no retail sales occurred in South Carolina; the taxpayer’s only activity in South Carolina was royalty payments from its parent, Rent-A-Center East (RAC East), for the use of intellectual property by RAC East’s South Carolina stores. RAC West filed South Carolina corporate tax returns for the 2003-2005 tax years using the state’s standard three-factor apportionment formula.10 However, the South Carolina DOR attempted to bifurcate the retail and licensing operations of RAC West and excluded the retail income it earned in other states. The result essentially ignored the presence of a single unitary business and required the use of separate accounting.

In rejecting the DOR’s request to include retail receipts in the denominator of the taxpayer’s apportionment factor, the court concluded that the department had not proven by a preponderance of the evidence that South Carolina’s statutory formula failed to represent the taxpayer’s activity in the state. The court’s decision is consistent with the decision reached by the South Carolina Supreme Court in CarMax Auto Superstores West Coast Inc. v. South Carolina, a case involving a similar corporate structure and alternative apportionment.11 These cases firmly established that the party proposing alternative apportionment — whether a state tax authority or the taxpayer — must prove that (1) the state statutory formula does not fairly represent the taxpayer’s business activity in the state, and (2) the proposed alternative accounting method is reasonable.

Interestingly, the department has appealed the South Carolina Court of Appeals’ decision in Rent-A-Center West to the state supreme court. Practitioners question the reasons for the appeal, as the issue has arguably been resolved in light of the high court’s CarMax decision.

C. Corporate Executive Board v. Virginia Department of Taxation

Recent litigation in Virginia provides an example of taxpayer difficulties in meeting the burden of proof to justify the departure from a state’s standard apportionment formula. In Corporate Executive Board v. Virginia Department of Revenue, Corporate Executive Board (CEB) challenged the state’s COP apportionment method12 in favor of a single-sales-factor, market-based sourcing approach.13 CEB’s property and income-producing activities were located almost entirely within Virginia. However, only a small portion of its sales (roughly 6 percent) occurred within the state. CEB filed its returns for the 2008-2010 tax years using the statutory formula along with a petition for alternative apportionment.

Appealing the Virginia Department of Taxation’s denial of its previous request for alternative apportionment,14 CEB argued that Virginia’s statutory formula resulted in an unconstitutional, grossly distorted, and inequitable apportionment of income to the state. CEB proposed that a market-based sourcing method more reasonably approximated the extent of its business activity in the state. Under the statutory formula, nearly 100 percent of CEB’s sales were sourced to Virginia due to most of its employees working in the state and the majority of its costs of business being located there. CEB contended that a destination-based apportionment method would best approximate Virginia activity based on its customers’ use of its service outside the state.

Similar to its prior ruling on the same matter, the Circuit Court of Arlington County ruled that CEB did not meet its burden of proof demonstrating that the statutory apportionment method was unconstitutional or inequitable. The court determined that based on CEB’s operations and business model, the income apportioned to Virginia was reasonably attributable to the services it provided in the state. Further, the court found that CEB failed to prove that the statute was grossly distortive as applied to CEB, instead finding that the existing statutory method led to a more rational and consistent result because it focused on the operations of CEB and concentrated on the fact that the company’s information and data accessed by customers was stored in Virginia.

The court’s decision follows a consistent approach taken by Virginia courts in rejecting proposed alternative applications of apportionment, and the state’s formalistic adherence to statutory COP apportionment. Noting that the statutory method was the accepted rule and law, the court also recognized that other states have instituted market-based sourcing and single-sales-factor apportionment methods to address the economic shift toward service-based revenue streams. Amidst growing concerns that service providers headquartered in Northern Virginia may relocate their operations to neighboring states with more favorable tax policies, the Virginia legislature introduced a bill to adopt market-based sourcing in early 2016, but further action has not been taken to date.15

D. Associated Bank N.A. v. Commissioner of Revenue

In Associated Bank N.A. v. Commissioner of Revenue, the Minnesota Tax Court rejected the Minnesota commissioner of revenue’s attempt to change the apportionment factor of a financial institution that was organized as a captive partnership, which structure was subject to standard statutory apportionment rules under Minnesota law.16 The taxpayer, a nationally chartered bank, created two new limited liability companies, which earned interest income after a series of transactions for the years at issue. The affiliates each filed partnership returns using Minnesota’s general three-factor apportionment formula.17 As partnerships, the LLCs did not consider themselves to be financial institutions as defined under Minnesota law.18 Had they been considered financial institutions, the entities would have been subject to special apportionment rules that required interest income from loans to be included in the sales factor and the value of loans to be included in the property factor.

The commissioner of revenue later applied an alternative apportionment method to the taxpayer’s returns, which substantially increased the apportionment ratio by including the LLCs’ interest income and loan value to “fairly allocate taxable net income of the Minnesota unitary group to Minnesota.” In upholding the taxpayer’s chosen apportionment method, the tax court held that the corporate structure employed by the taxpayer complied with Minnesota law and that the commissioner could not seek an alternative apportionment method to disregard a lawfully created corporate structure. Although the taxpayer admittedly structured its business to minimize its Minnesota tax liability, the tax court respected the apportionment treatment because the taxpayer’s corporate structure ultimately complied with the law. The Minnesota Supreme Court has granted an appeal by the commissioner, and a decision is expected in the coming months. The Legislature responded to this decision by expanding the statutory definition of a financial institution for tax years beginning after December 31, 2016, to include an entity that (1) is more than 50 percent owned by an entity defined as a financial institution, (2) derives more than 50 percent of its gross revenue from finance leases, or (3) derives more than 50 percent of its gross income from activities that an entity defined as a financial institution is authorized to transact.19

Both Associated Bank and Rent-A-Center West demonstrate cases in which courts have denied state tax authority efforts to seek alternative apportionment based on the fact that the statutory formula produces a lower tax liability because of the taxpayer’s entity structure. Even when taxpayers specifically engineer a corporate structure to minimize or avoid state taxes, courts seem unwilling to allow alternative apportionment in such instances.

III. Recent MTC Efforts Addressing Alternative Apportionment

Under its mission to promote uniformity in the application of state tax laws and regulations across state taxing regimes, the MTC adopted recommended amendments to UDITPA Article IV, section 18 of the compact in 2015 in response to increased litigation and regulatory activity surrounding alternative apportionment.20

A significant component of the section 18 amendments more clearly establishes how the burden of proof in favor of alternative apportionment should be applied. Although facially it may appear obvious that the party proposing alternative apportionment must provide sufficient evidence in support of its claim, the belief that the taxing authority is granted an amount of discretionary authority risks placing the burden solely on the taxpayer. Thus, the section 18 amendments require that the party requesting alternative apportionment must prove (1) that the existing statutory allocation and apportionment provisions do not fairly represent the extent of the taxpayer’s activity in the state, and (2) that the alternative method advanced by the petitioning party is reasonable.21 Interestingly, the second prong of this test does not go so far as to require that the alternative method be the most reasonable method that could be used, but instead only necessitates that such method be reasonable. The amendments also provide that the same burden of proof applies to taxpayers and tax administrators equally, theoretically putting taxpayers and tax administrators on equal footing.

The amendments also seek to address increased taxpayer penalties stemming from a taxing authority’s use of alternative apportionment. If a tax administrator requires application of an alternative apportionment method to a taxpayer, the amendments provide that the taxing authority cannot impose any civil or criminal penalty on the taxpayer stemming from the taxpayer’s reasonable reliance solely on the standard allocation and apportionment provisions.22

Following the MTC’s adoption of the recommended amendments to section 18, the MTC formed a working group to draft model regulations interpreting and implementing the section 18 amendments. For the past two years, the working group has focused on drafting model regulations to address perceived sales factor distortion when a taxpayer has taxable income in a given state but less than 3.33 percent “receipts” derived from transactions and activities that are not otherwise allocable under Article IV of the compact. In November the MTC Uniformity Committee approved the working group’s proposed draft model regulation for the sourcing of gross receipts of taxpayers with apportionable income but no minimal receipts.23

The MTC Uniformity Committee also approved a proposed draft model regulation for the apportionment of income to bank holding companies and their subsidiaries.24 The proposed draft model regulations will next be considered by the MTC Executive Committee. Both draft model regulations necessarily follow the MTC’s amendments to Article IV of the compact, which reflect a gradual shift by states toward market-based sourcing provisions and away from COP sourcing for purposes of apportioning business income.

Conclusion

The above cases demonstrate that alternative apportionment provisions continue to be applied unevenly across the states. Taxpayers have recently been successful in ensuring that the burden of proof is equitably applied to the party seeking alternative apportionment. However, taxpayers and practitioners should also be aware of cases in which the state may be overreaching in its use of alternative apportionment, asking the question whether the proposed formula fairly represents a taxpayer’s in-state activities.

What does the future hold for alternative apportionment? Cases such as Vodafone and Corporate Executive Board may become less common as states continue to enact market-based sourcing along with single-sales-factor apportionment formulas to keep pace with the rise of service-based revenue streams. Future alternative apportionment disputes will likely focus on defining the extent of a company’s market and the specific income-generating activities and locations involved. As states continue to amend existing alternative apportionment regulations, it remains to be seen whether they will adopt the model rules after they are approved by the MTC. In light of these events, taxpayers should continue to use all avenues available to ensure that alternative apportionment provisions are fairly and uniformly applied.

FOOTNOTES

1 Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977).

2 See Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983) (describing the internal consistency test, which looks to the overall structure of the tax at issue and asks whether interstate commerce would be disadvantaged compared with intrastate commerce if every state enacted an identical taxing scheme); and Oklahoma Tax Commission v. Jefferson Lines Inc., 514 U.S. 175 (1995) (setting out the external consistency test, which looks to the economic realities of how the tax applies in order to determine whether the tax “reaches beyond that portion of value that is fairly attributable to economic activity within the taxing state”).

3 Moorman Manufacturing Co. v. Bair, 437 U.S. 267 (1978) (citing Hans Rees’ Sons Inc. v. North Carolina, 283 U.S. 123 (1931), and Norfolk & Western Railway Co. v. Missouri State Tax Commission, 390 U.S. 317 (1968)).

4 Id. at 273.

5 UDITPA section 18.

6 Vodafone Americas Holdings Inc. v. Roberts, 486 S.W.3d 496 (Tenn. 2016).

7 Tenn. Code Ann. sections 67-4-2102(i) and 67-4-2111(i). Effective for tax years beginning on or after July 1, 2016, Tennessee enacted market-based sourcing for sales other than sales of tangible personal property.

8 On its originally filed Tennessee franchise and excise tax returns, the taxpayer calculated its Tennessee sales factor by using a primary-place-of-use method that sourced to Tennessee sales of services made to customers with a Tennessee billing address.

9 792 S.E.2d 260 (S.C. Ct. App. 2016).

10 S.C. Code Ann. section 12-6-2250.

11 767 S.E.2d 196 (S.C. 2014).

12 Va. Code Ann. section 58.1-408.

13 Corporate Executive Board v. Virginia Department of Taxation, Case No. CL-16-1525 (Va. Cir. Ct. Sept. 1, 2017).

14 Corporate Executive Board v. Virginia Department of Taxation, Case No. CL-13-3104 (Va. Cir. Ct. Nov. 30, 2015).

15 H.B. 966, introduced Jan. 12, 2016.

16 No. 8851-R, Apr. 18, 2017.

17 Minn. Stat. section 290.191, subd. 2.

18 Minn. Stat. section 290.01, subd. 4a(a).

19 Ch. 1 (H.F. 1), Laws 2017 (1st Special Session).

20 Multistate Tax Compact Article IV.18.

21 Multistate Tax Compact Article IV.18(c).

22 Multistate Tax Compact Article IV.18(d).

23 Proposed Draft Model Reg. IV.18(c), as approved by the MTC Uniformity Committee on Nov. 16, 2017.

24 Proposed Draft Model Reg. IV.18(d), as approved by the MTC Uniformity Committee on Nov. 16, 2017.

END FOOTNOTES

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