Alternative Apportionment - The Process and the Impact

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1 Alternative Apportionment - The Process and the Impact Current Issues in State & Local Taxation TEI Philadelphia Chapter February 22, 2017 Maria Todorova Open Weaver Banks 2017 (US) LLP All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland and the recipient. (US) LLP and (International) LLP, together with their controlled, managed, affiliated and member firms, are separate legal entities that operate in combination under the name and brand. For a full description of our structure and a list of our offices, please visit

2 Agenda Background Constitutional parameters UDITPA and Section 18 MTC regulation Invoking Alternative Apportionment Burden of proof Distortion Reasonable alternative (or disguised deviation from statutory method!) Practical Considerations

3 Background Dividing the Corporate Income Tax Base A states may tax a fair share of profits earned from activity conducted within its borders using apportionment. Underwood Typewriter (1920). Linchpin of apportionability in the field of state income taxation is the unitary business principle. Mobil Oil (1980). States have significant leeway in adopting an apportionment formula; however, the apportionment method selected by a state cannot be arbitrary and must not produce unreasonable results. Underwood Typewriter (1920); Hans Rees Sons (1931). Underwood Typewriter v. Chamberlain, 254 U.S. 113 (1920); Mobil Oil Corp. v. Comm r of Taxes, 445 U.S. 425 (1980); Hans Rees' Sons v. North Carolina, 283 U.S. 123 (1931). 3

4 Background Uniform Division of Income for Tax Purposes Act (UDITPA) State apportionment methodologies vary UDITPA s three-factor formula uses property, payroll, sales Other (single, double or triple-weighted factors) Why the emphasis on the sales factor? Because the standard apportionment formula may produce unreasonable results, Section 18 provides an alternative apportionment method. Acts as a pressure valve for when standard apportionment formula produces arbitrary and unreasonable results Intended to be applied only in unusual or unique circumstances 4

5 Background UDITPA, cont d Under Section 18, if a state s statutory method does not fairly represent the extent of the taxpayer s business activity in [the] state, the taxpayer may petition for or the [Department] may require, in respect to all or any part of the taxpayer s business activity, if reasonable: (a) Separate accounting; (b) The exclusion of 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. 5

6 Background Multistate Tax Commission (MTC) Regulation Regulation IV.18(a) provides: Original:.... only in specific cases where unusual fact situations (which usually will be unique and non-recurring) produce incongruous results.... As Amended:... only in limited and specific cases where the apportionment and allocation provisions contained in Article IV produce incongruous results.... States have increasingly applied alternative apportionment methodologies where the statutory apportionment formula results in less income apportioned to the state than the state believes is fair. 6

7 7

8 Moving Party Assert Distortion Yes No Proposed Alternative Reasonable Yes No Alternative Apportionment No Alternative Apportionment No Alternative Apportionment Burden of proof is on the party seeking to diverge from the standard apportionment formula to prove that distortion exists, and that a proposed alternative method is reasonable 8 8

9 Standard for Alternative Apportionment A proponent (a state or taxpayer) of an alternative apportionment method bears the burden of proof in showing that: (1) The statutory formula does not fairly represent the taxpayer s business activities in the state; and (2) A proposed alternative method is reasonable. 9

10 Burden of Proof 10

11 Burden of Proof Two Primary Issues: Who bears the burden of proving that alternative apportionment is appropriate? What is the standard of proof? 11

12 Burden of Proof Who Bears the Burden of Proof? Why it matters Is the taxing authority still entitled to a presumption of correctness on assessments? Most states place the burden of proof on the proponent of the alternative apportionment method. 12

13 Burden of Proof Equifax (Miss. 2013) Types of Burdens Abuse of discretion, de novo review, or something else? Preponderance of the evidence Clear and Convincing Evidence Clear and Cogent Evidence Prima Facie Evidence Twentieth Century Fox (Or. 1985) CarMax (S.C. 2014) Microsoft (Cal. 2006) British Land (N.Y. 1995) Equifax, Inc. v. Miss. Dep t of Revenue, 125 So.3d 36 (Miss. 2013); Twentieth Century Fox v. Dep t of Revenue, 700 P.2d 1035 (Or. 1985); Carmax Auto Superstores West Coast, Inc. v. Dep t of Revenue, 767 S.E.2d 195 (S.C. 2014); Microsoft v. Franchise Tax Bd., 139 P.3d 1169 (Cal. 2006); British Land (Maryland) Inc. v. N.Y. Tax App. Trib., 85 N.Y.2d 139 (N.Y. 1995). 13

14 Burden of Proof Equifax Burden on Taxpayer, Plus Legislative Response Mississippi Supreme Court held that taxpayer bears the burden of proving that the alternative apportionment method proposed by the Department of Revenue was arbitrary and unreasonable Review of Department s use of alternative apportionment methodology was limited to whether that decision was supported by substantial evidence or whether it was arbitrary and capricious HB 799 was a response to Equifax put burden of proof on party invoking alternative apportionment to prove by a preponderance of the evidence that (1) statutory method does not fairly represent activity in state; and (2) selected method more fairly represents that activity than any other reasonable method available. Can be invoked only in limited and unique, nonrecurring circumstances. Equifax, Inc. v. Miss. Dep t of Revenue, 125 So.3d 36 (Miss. 2013). 14

15 Burden of Proof Massachusetts Department of Revenue Released Proposed Amendments to Alternative Apportionment Regulation, 830 CMR , in December 2016 Timing Taxpayer must request alternative apportionment at the time it files its tax return but must pay tax using statutory method and wait for Commissioner's subsequent determination with respect to the application If the application is granted, taxpayer must seek a refund Application deemed denied after 9 months Commissioner will look at overall combined group s apportioned income in determining whether individual member entitled to alternative apportionment Disparate burdens of proof Taxpayer must show by clear and cogent evidence that statutory method does not fairly reflect its in-state business activities Commissioner uses his judgment in deciding whether to grant taxpayer s application but is otherwise not subject to any standards 15

16 Distortion 16

17 Distortion What Is A "Fair" Representation of In-State Business Activity? Most states have found that the constitutional gross distortion requirement (a la Hans Rees) is not necessary to justify alternative apportionment; some lesser standard usually applies Consistent with Section 18 of UDITPA, many states require only a showing that the statutory formula does not fairly reflect the extent of the taxpayer s in-state activities But how does one measure what is fair? More or less tax Prevent over- or under-taxation 17

18 Distortion Microsoft California s Standard for Distortion Qualitative Analysis Examines type of business conducted by the taxpayer in comparison to any activity that may create distortion Quantitative Analysis Quantitative distortion may be demonstrated by various methods, including separate accounting, comparison of profit margins, comparison of apportionment percentages, comparison of income and gross receipts from various activities, etc. Profit Margin from a taxpayer s primary business is several orders of magnitude different from the profit margin on the treasury function Court found distortion where operational profit margin was 167 times greater than treasury profit margin Microsoft Corp. v. Franchise Tax Bd., 39 Cal.4th 750 (Cal. 2006). 18

19 Distortion Canon Financial If Distortion, What s Appropriate? Under prior law, taxpayer without regular place of business outside New Jersey had to use 100% apportionment factor, while taxpayer with regular business outside state used three-factor formula New Jersey-headquartered company without regular place of business outside state requested alternative apportionment on distortion grounds New Jersey Tax Court concluded that 100% apportionment factor, even with credit for taxes paid in separate return states, was distortive; but taxpayer was not entitled to use three-factor formula Remanded to Division of Taxation to craft appropriate relief Canon Fin. Servs., Inc. v. Director, Div. of Taxation, No (N.J. Tax Ct. Oct. 13, 2016). 19

20 Reasonable Alternative (or disguised deviation from statutory method!) 20

21 Reasonable alternative (or disguised deviation from statutory method!) Vodafone Administrative Market-Based Sourcing Tennessee Supreme Court upheld Department of Revenue s use of alternative apportionment for a wireless company because the statutory costs of performance method did not fairly represent the extent of the taxpayer s business activity in the state Court held that the method employed by the Commissioner, which was similar to a market-based approach, satisfied regulatory standards for the imposition of alternative apportionment Keep an eye out for variance cases coming down the pike Vodafone Am. Holdings, Inc. & Subs. v. Roberts, 486 S.W.3d 496 (Tenn. 2016). 21

22 Reasonable alternative (or disguised deviation from statutory method!) Arkansas More Administrative Market-Based Sourcing Taxpayer originally filed using market-based sourcing and subsequently filed an amended return (refund claim) using statutory pro rata costs of performance ALJ upheld Director s and Administration s exercise of his discretionary power to apply market-based sourcing to the taxpayer s sales of services; found that using the discretionary market-based sourcing method was not an unreasonable methodology because the taxpayer originally used this method on return [Taxpayer Name Redacted], Nos & (Ark. Dep t of Fin. & Admin., Off. of Hearings & Apps., May 27, 2016). 22

23 Reasonable alternative (or disguised deviation from statutory method!) Rent-A-Center West Alternative Sourcing for Receipts Factor Rejected Under statutory method, the numerator of R-A-C West s receipts factor included South Carolina receipts from licensing IP and the denominator included all revenue from retails stores and licensing activities Department of Revenue argued that including the retail sales in the denominator diluted the receipts factor; Department s expert opined that including both royalty and retail receipts in the denominator was like putting apples in the numerator and apples and oranges in the denominator South Carolina appellate court held that Department failed to satisfy its burden of showing that the statutory formula did not fairly represent taxpayer s in-state business activity Rent-A-Center West Inc. v. Dep t of Revenue, 418 S.C. 320 (S.C. Ct. App. 2016). 23

24 Reasonable alternative (or disguised deviation from statutory method!) Target Brands Adjusting Other Factors Colorado district court found that despite lacking any physical presence in state, subsidiary that managed company s brands had substantial nexus in Colorado because its IP licenses were used there However, Department of Revenue s use of its alternative apportionment authority to exclude subsidiary s substantial out-of-state property and payroll from apportionment factors was unreasonable Target Brands, Inc. v. Dep t of Revenue, No. 2015CV33831 (Colo. 2nd Dist. Ct., Jan. 20, 2017). 24

25 Reasonable alternative (or disguised deviation from statutory method!) Rent-A-Center East Combined Reporting as Alternative Rejected Indiana Tax Court rejected combination as an alternative apportionment methodology Court rejected the Department s claim that R-A-C East s income would be distorted unless it filed a combined return with two affiliates Court relied in part on an IRC 482 transfer pricing study and the parties stipulation of valid business purposes Rent-A-Center East, Inc. v. Dep't of State Revenue, 42 N.E.3d 1043 (Ind. T.C. 2015). 25

26 Reasonable alternative (or disguised deviation from statutory method!) Duke Energy Absurd Results End-Run Burden of Proof South Carolina Supreme Court affirmed appellate court s determination that receipts from sale of short-term investments may not be included in the sales factor According to court, including the principal recovered from the sale of shortterm investments would lead to absurd results by greatly distorting the calculation and by defeating the intent and purpose of the applicable statutes Court did not require Department to satisfy the CarMax dual burden of proof for deviating from the statutory apportionment formula Duke Energy Corp. v. Dep t of Revenue, 415 S.C. 351 (S.C. 2016). 26

27 Practical Considerations 27

28 Practical Considerations Offensive and Defensive Considerations Anticipating states assertion of alternative apportionment and/or asserting alternative methods offensively Documentation (contemporaneous) is key Market-sourcing changes will lead to tax return positions Identifying the applicable burden of proof 28

29 Practical Considerations Timing and Formalities The majority of states require taxpayer to petition or request an alternative apportionment formula in advance (e.g., California, Idaho, Michigan) Other states require that pre-approval and/or alternative apportionment be in the form of a refund (e.g., Illinois, New Mexico) Some states may require both (e.g., Massachusetts, if proposed reg adopted) 29

30 Questions? Maria Todorova (US) LLP Open Weaver Banks (US) LLP