Kendall Houghton and Matt Hedstrom were prominently featured in a BNA article entitled “Assessing Taxpayer Risks While Gillette Litigation Continues to Unfold,” which focused on how, in Gillette Co. et al. v. California Franch. Tax Bd., the California Court of Appeal held that the formula under the Multistate Tax Compact for allocating and apportioning income remains available to California multistate taxpayers, notwithstanding the state's attempt to repeal and supersede the Compact formula with a double-weighted sales factor for most business activity, and the “shock waves” the case has sent through the member states of the Multistate Tax Compact.
Houghton and Hedstrom, of the firm’s Washington, D.C. and New York offices, respectively, noted that “Gillette has persuasive weight,” but also that taxpayers “must weigh the risks in light of the opposite reasoning and result reached by the court in Michigan in IBM.” That court's view of the issue was quite different from the California court's, and “[a]lthough the decision was unpublished (and from an intermediate court), it deserves consideration.” In the article, Houghton cautioned that taxpayers should also be following the Graphic Packaging Corp. litigation pending in Texas. “These risks implicate the necessity of conducting a financial statement reserves analysis.”
In the article, Hedstrom explained the California court’s decision: Faced with what it saw as two conflicting statutory provisions, and finding no way to harmonize them, the court concluded that the Business Tax Act, in essence, repealed by implication the election provision found in the Compact. While the court acknowledged that repeals by implication are disfavored, and that “enacting a conflicting statute might arguably be an improper way to repeal the Compact, [it was] not an impermissible one.”
Hedstrom noted that there are now two very distinct rulings and disparate analytical processes on an issue that implicates and creates some tension with the U.S. Supreme Court's analysis in U.S. Steel, which upholds the constitutionality of the Compact.
Houghton further explained the issues at the crux of the cases. Article III of the Compact allows a multistate taxpayer to elect to apportion its income to a member state under the laws of the member state or Article IV of the Compact, which is often referred to as the Uniform Division of Income for Tax Purposes Act (UDITPA). The Compact election entails using the three-factor apportionment formula and “everything else that goes along with UDITPA,” said Houghton, in the article. The following analytical framework for deciding whether to go forward with a Compact election was posed by Houghton:
- Making a Compact election means using the UDITPA provisions as incorporated into the Compact. A taxpayer would not be able to pick and choose among the specific Compact provisions of Article IV and conflicting laws of the member state.
- But does making a Compact election mean the taxpayer ignores all non-UDITPA provisions? UDITPA addressed a set number of issues, but not all tax issues a taxpayer may confront in filing its return. At issue is whether using the additional provisions of the state that UDITPA does not itself include or address would be consistent with making a Compact election. In these circumstances, the taxpayer might conclude that it is appropriate to use both Compact and state “add-on” provisions, and perhaps it could characterize such a hybrid usage as an “alternate apportionment” election under UDITPA's Article IV, § 18.
- What part do the Multistate Tax Commission's (the MTC's) interpretative regulations play in a taxpayer's Compact election? Is the taxpayer bound by those regulations if the state has adopted them? If the state has not adopted the MTC regulations into its law, would the regulations nevertheless serve as mandatory—or elective— interpretative guidance regarding Article IV (UDITPA) provisions of the Compact, or of a Compact election?
- May electing taxpayers use state-promulgated regulations that are on point but not part the MTC regulations?
Under the three-factor formula, all business income is apportioned to a state by multiplying the income by a fraction, the numerator of which is the property factor, plus the payroll factor, plus the sales factor and the denominator of which is three.
Section 18 of UDITPA provides that ‘‘[i]f the allocation and apportionment provisions of this Act do not fairly represent the extent of the taxpayer's business activity in this state, the taxpayer may petition for or the tax administrator may require, in respect to all or any part of the taxpayer's business activity, if reasonable: (a) separate accounting; (b) the exclusion of any one or more of the factors; (c) the inclusion of one or more additional factors which will fairly represent the taxpayer's business activity in this state; or (d) the employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer's income.’’
“This is the heart of the election analysis, and the number of decisions that are to be made as part of this ‘Compact decision tree’ practically guarantees that taxpayers with identical facts and figures will produce different Compact election tax returns,” Houghton said.
The BNA article also reported that, “[i]n recent years, with respect to services and ‘sales other than tangible personal property,’ states have moved away from a costs-of-performance sourcing regime toward a market sourcing regime. UDITPA § 17(b) requires that sales of other than tangible personal property be sourced to a state if ‘a greater portion of the income-producing activity is performed in [the state] than in any other State, based on costs of performance.’ As a result, the Compact election would implicate using the three-factor apportionment formula and UDITPA sales factor sourcing—i.e., costs of performance—for sourcing sales of services and intangibles, rather than market-based sourcing.”
Hedstrom responded that, presumably, such an election would benefit taxpayers that are subject to market-based sourcing regimes with significant out-of-state presence. However, whether such an election would benefit any particular taxpayer would involve a multistate review and analysis. “Notably, since a taxpayer would not be able to pick and choose among the specific Compact provisions of Article IV and conflicting laws of the member state, the impact of the Compact election will be dynamic.”
He added, “The Compact election would also impact conflicting state regulations that specifically address the sourcing of receipts from the license and/or sale of intangibles.”
According to the article, California voters in November passed Proposition 39, mandating the single-sales factor and market based sourcing for tax years beginning on or after Jan. 1, 2013. Thus, under current California law, the law does not source receipts from services and intangibles using costs of performance, while the compact provisions generally do.
“The question now becomes,” Hedstrom noted, “what options exist for California taxpayers going forward, that is, for tax years 2012 and 2013? May taxpayers elect to apportion using the Compact election for California purposes in either or both tax years?”
The answer, according to Hedstrom, implicates what will likely be the subject of future litigation: S.B. 1015, Proposition 39, and the concept of implied repeal/withdrawal (a concept that was addressed by the Michigan Court of Appeals in IBM). Did S.B. 1015 and/or Proposition 39 effectively repeal the Compact? And although Proposition 39 was approved by a majority of California voters, it is highly unclear whether the single-sales factor apportionment formula it requires will become the exclusive method of apportioning income for multistate corporations doing business in California. He advises taxpayers to stay tuned as the Gillette (and IBM) litigation continues to unfold, and other states introduce repealing legislation of their own.
In answering the question, Would the taxpayers benefiting from a costs-of-performance sourcing rule generally be the taxpayers who would also benefit from an equally weighted three-factor apportionment formula?, Hedstrom stated that as a general rule, when looking at the issue isolated to a particular state, out-of-state taxpayers would prefer both costs-of-performance sourcing and three-factor apportionment (as opposed to single sales and market). However, the bottom-line impact for any particular taxpayer would be a fact-specific analysis.