State Tax Return. Is There A Constitutional Standard for UDITPA 18 Alternative Apportionment?

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1 April 2007 Volume 14 Number 4 State Tax Return Is There A Constitutional Standard for UDITPA 18 Alternative Apportionment? Charolette Noel Kristi L. Stathopoulos Dallas Atlanta (214) (404) This article will be published in the June 2007 edition of Corporate Business Taxation Monthly, a monthly journal published by CCH Incorporated, a Wolters Kluwer business. Pre-printed with permission. Increasingly states are invoking alternative apportionment provisions to assert tax based on an apportionment formula that is not mandated by the state taxing statute. For example, multiple recent cases and rulings have addressed the use of alternative apportionment to avoid treating the return of investment principal as gross receipts. Most, if not all, state alternative apportionment provisions were derived from Section 18 of the Uniform Division of Income for Tax Purposes Act ( UDITPA ). Unfortunately, UDITPA provisions are often unclear as to exactly when and how states or taxpayers may rely on Section-18-type alternative apportionment provisions. States generally have discretion to apply different tax rules to different types of income. The U.S. Supreme Court has allowed states wide latitude to choose a formula or set of factors for generally apportioning and taxing income of an interstate business. But this latitude is not without constitutional limits. While different taxes may apply to different categories of income, constitutional standards generally require a determinable and uniformly-applied method of apportionment be selected for each category of income. State apportionment statutes must satisfy Due Process, Equal Protection and Commerce Clause standards. One key element of these constitutional standards is fairness fairness in notice and application of the tax, fairness in uniform treatment of similarly-situated taxpayers, fairness in designing the apportionment system to avoid inevitable multiple taxation and fairness in avoiding gross distortion of income attributed to a state. History UDITPA was promulgated in 1957 by the National Conference of Commissioners on Uniform State Laws to bring about uniformity among the states in taxing multistate corporate income and to provide a basis for avoiding duplicate taxation of the same

2 income by fairly assigning taxable income among the states. 1 Seeking to avoid the possible application of an arbitrary or unreasonable apportionment formula, the drafters added Section 18 of UDITPA as a safeguard for fairness. UDITPA 18 provides: If the allocation and apportionment provisions of [UDITPA] 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, with respect to all or any part of the taxpayer s 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. The Multistate Tax Commission ( MTC ) issued advisory regulations interpreting UDITPA 18. These regulations state that UDITPA 18 was designed to serve as an exception, applying only in limited factual situations when deviation from the standard formula is necessary to fairly reflect the taxpayer s activities in the state. 2 Standard of Proof State courts disagree with respect to the standard of proof necessary to invoke UDITPA 18 adjustments to a taxpayer s apportionment formula. Some states require the party seeking to implement UDITPA 18 to prove by clear and convincing evidence that the standard statutory formula produces an unreasonable result, including, most recently, the California Supreme Court. 3 Other states, including Illinois, have adopted the constitutional standard of clear and cogent evidence for making UDITPA 18 adjustments. 4 Still others, such as Oregon, have held that a mere preponderance of the evidence is all that is necessary to invoke UDITPA Many states do not address the issue of the necessary standard of proof at all; rather, they simply approve or disapprove of the application of UDITPA 18 with respect to a specific set of facts. 6 On audit states, including New York and New Jersey, have taken 1 See Larry D. Scheafer, Annotation, Construction and Application of Uniform Division of Income for Tax Purposes Act, 8 A.L.R. 4 th 934 (1981). 2 See MULTISTATE TAX COMMISSION REG. IV. 18.(a). 3 See Microsoft Corporation v. Franch. Tax Bd., 139 P.3d 1169 (Cal. 2006); General Motors Corporation v. Franch. Tax Bd., 139 P.3d 1183 (Cal. 2006); Donovan Construction Co. v. Dept. of Treasury, 337 N.W.2d 297 (Mich. App. 1983). 4 See Miami Corp. v. Dept. of Revenue, 571 N.E.2d 800 (Ill. App. 1991); Lakehead Pipeline Co., Inc. v. Dept. of Revenue, 549 N.E.2d 598 (Ill. App. 1989). 5 See Crocker Leasing, Inc. v. Dept. of Revenue, 838 P.2d 552 (Or. 1992); Twentieth Century Fox Film Corp. v. Dept. of Revenue, 700 P.2d 1035 (1985). 6 See Kennocott Copper v. State Tax Commission, 493 P.2d 632 (Utah 1972).

3 the position that the very fact that the use of an alternative apportionment formula results in a higher income tax liability serves as proof that the standard formula does not fairly represent a taxpayer s activities in the state. The founding principles of uniformity are severely undermined if UDITPA 18 is interpreted to permit rejection of a constitutional, statutorily-prescribed rule and substitution of a facts-and-circumstances analysis whenever the tax administrator believes it is fair under the circumstances. Similarly, the principles of uniformity and fairness are threatened if a tax administrator is allowed to selectively substitute among several fair apportionment methods on a case-by-case basis. Typically, taxpayers are held to a higher Hans-Rees 7 constitutional standard of distortion. If such a high standard applies to taxpayers, tax administrators should not be permitted to deviate from the statutory formula absent the tax administrator s showing of a similar level of distortion. To permit otherwise results in an inherent inconsistency among taxpayers. If a broad-based concern exists with a state s constitutional apportionment statute, an appropriate remedy would be to amend the statute uniformly and fairly to apply consistently to all similarly-situated taxpayers. Taxpayers should have appropriate legislative notice before the apportionment statute is administratively re-written, particularly if the existing statute is not unconstitutional. Recent cases show that the temptation for states to selectively apply UDITPA 18 is simply too great and a fair standard for application is needed. Recent Application of UDITPA 18 in Kansas and California The Kansas Department of Revenue Office of Administrative Appeals (the Kansas DOR ) is the latest body to weigh in on the debate whether the return of principal on short-term investments constitutes gross receipts for purposes of the apportionment sales factor. 8 The Kansas DOR largely adopted selective portions of the California Supreme Court s holdings in Microsoft 9 and General Motors. 10 In those cases, the California court held that the state could adjust a taxpayer s sales factor to remove recycled investment capital under the state s UDITPA 18 provision where inclusion of such receipts would not fairly reflect the taxpayer s income attributable to the state. The Kansas DOR concluded that, as in California, an adjustment should be made for a Kansas taxpayer to remove the return of principal from the receipts factor because California and Kansas are both UDITPA states. Nevertheless, the Kansas DOR 7 See Hans Rees Sons, Inc. v. North Carolina, 283 U.S. 123 (1931) (finding income out of all appropriate proportion to the business transacted [in the] state ). 8 Kan. Dept. of Rev. Office of Admin. App., Docket No. WFD-P (Jan. 8, 2007). 9 Microsoft Corporation v. Franch. Tax Bd., 139 P.3d 1169 (Cal. 2006). 10 General Motors Corporation v. Franch. Tax Bd., 139 P.3d 1183 (Cal. 2006).

4 departed from California law, concluding that receipts from investment capital generated by churning or recycling do not constitute gross receipts at all and, thus, should always be excluded from the sales factor. Essentially the Kansas DOR was consistently inconsistent with the California Supreme Court in Microsoft and General Motors. With respect to the distortion analysis, the Kansas DOR applied a different standard by creating an unrebuttable presumption that the return of the capital is not gross receipts, rejecting the case-by-case evaluation in Microsoft and General Motors. The Kansas DOR also rejected the California Supreme Court s interpretation of gross receipts by concluding that a return of capital is never included in such definition. Agreeing, however, with the final result in Microsoft and General Motors, the Kansas DOR disallowed the return of capital for securities redemptions as gross receipts during an audit of an unnamed taxpayer. For securities held to maturity, the Kansas DOR counted as gross receipts only the price differential between the redemption price and the purchase price. Variation from Standard Apportionment The Kansas DOR began its analysis with an interpretation of Kan. Stat. Ann. Section , the UDITPA provision for varying from the standard apportionment and allocation rules if such rules do not fairly represent the extent of a taxpayer s business activity in Kansas. Section corresponds to the UDITPA Model Act Section 18, but clearly states that the taxing authority has the burden of proof: If the allocation and apportionment provisions of this act including the provisions of K.S.A , do not fairly represent the extent of the taxpayer's business activity in this state, the taxpayer may petition for or the secretary of revenue 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; or (e) in the case of two or more businesses, whether or not incorporated and whether or not organized in Kansas, owned or controlled directly or indirectly by the same interests, which contrive through intercompany transactions to evade taxes imposed under this act, the secretary of revenue may distribute or allocate the gross income and deductions between or among such businesses or may require returns on a consolidated basis. The burden of proof of any contrivance to evade taxes under this act shall rest upon the director of taxation or secretary of revenue. (emphasis added). Although the Kansas DOR did not address the burden of proof distinction, it cited the Microsoft and General Motors cases as controlling with respect to deviation from the standard apportionment formula because Kan. Stat. Ann. Section contains the same UDITPA language as the California Supreme Court relied upon from Cal. Rev. & Tax. Code In fact, rather than going through an independent analysis, the

5 Kansas DOR liberally block quoted several pages of the California Supreme Court s opinion in Microsoft. In so doing, the Kansas DOR concluded that the exclusion of the returned capital portion of the redemptions from the taxpayer s sales factor was authorized under Kan. Stat. Ann. Section Accordingly, if only with respect to the ultimate conclusion of distortion, the Kansas DOR determined that the California decisions provide a sound basis for the department s administrative action of disallowing the inclusion of gross investment proceeds from the taxpayer s sales factor denominator in Kansas as well. Gross Receipts Analysis Apparently as an alternative justification for its holding, the Kansas DOR next addressed the issue of whether the redemption of marketable securities held to maturity generated gross receipts includible in the sales factor. Under Kan. Admin. Reg , the term sales is defined for purposes of the apportionment sales factor to mean all gross receipts derived by the taxpayer from transactions and activity in the regular course of such business. The term gross receipts is not defined in the statutes or regulations. In evaluating the meaning of gross receipts, the Kansas DOR dismissed the California Supreme Court s opinion in Microsoft, finding more persuasive the California Court of Appeals decision in General Motors. 11 The Kansas DOR also cited decisions from New Jersey, Indiana, and Tennessee in addition to the California Court of Appeals decision as persuasive authority for the proposition that the return of principal on short-term investments is not a sale for purposes of the sales factor. 12 Acknowledging the inconsistency between the UDITPA 18 issue and the gross receipts position, the Kansas DOR noted, this inconsistency is of no consequence here since the underlying facts support both legal theories, whether inconsistent or not. 13 As further support for the ultimate holding, the Kansas DOR quoted from the instructions included in the 2007 Kansas Corporate Income Tax booklet for authority: In the case of a taxpayer engaged in the sale of [sic] redemption of investment securities, sales includes the interest of [sic] other income 11 Kan. Dept. of Rev. Office of Admin. App., Docket No. WFD-P (Jan. 8, 2007), citing General Motors Corp. v. Franchise Tax Board, 120 Cal. App. 4 th 114 (2004). 12 See American Tel. & Tel. v. Taxation Div. Director (A.D. 1984) 476 A.2d 800 (N.J. Super.); Sherwin-Williams v. Dept. of State Revenue, 673 N.E.2d 849 (Ind. Tax 1996); Sherwin-Williams Co. v. Johnson, 989 S.W.2d 710 (Tenn. App. 1998). 13 Kan. Dept. of Rev. Office of Admin. App., Docket No. WFD-P (Jan. 8, 2007), citing Western Machinery Co. v. Consolidated Uranium Mines, Inc., 247 F.2d 685, (10 th Cir. 1957), citing Blazer v. Black, 196 F.2d 139, 144 (10 th Cir. 1952); see also K.S.A Supp (e)(2).

6 from such transactions. The term sales does not include the return of capital or the recovery of principal utilized to make such investment. Because these same instructions were published in all 1997 to 2006 Kansas Corporate Income Tax booklets, the Kansas DOR concluded that the taxpayer had constructive knowledge of the Kansas DOR s policy on the issue when it filed its returns. Proposed California Regulation We have yet to hear the final word on UDITPA 18 from California. The California Franchise Tax Board ( FTB ) voted 2-1 on April 4, 2007 to begin drafting regulations to clarify the treatment of gross receipts from treasury functions in the wake of the Microsoft and General Motors decisions. According to the FTB, the related regulation, if promulgated, would apply prospectively and would include in receipts only the overall net gain from liquid assets. The regulation would not apply to banks, financial institutions, or broker/dealers. Notwithstanding the California Supreme Court guidance to apply a case-by-case analysis, the FTB opted, perhaps reasonably, to apply a bright-line rule to apply to such receipts under California s regulatory version of UDITPA 18, CAL. CODE REGS The proposed addition to the regulation provides as follows: 25137(c)(1)(D) If a taxpayer holds liquid assets in connection with the treasury functions of the taxpayer, and the liquid assets produce business income when sold, exchanged or otherwise disposed, the overall net gain from those transactions for the tax period is included in the sales factor. 1. For purposes of this subsection, a liquid asset is an asset (other than functional currency or funds held in bank accounts) held to provide a relatively immediate source of funds to satisfy the liquidity needs of the trade or business. Liquid assets include foreign currency (and trading positions therein) other than functional currency used in the regular course of the taxpayer s trade or business; marketable instruments (including stocks, bonds, debentures, options, warrants, futures contracts, etc.); and mutual funds that hold such liquid assets. An instrument is considered marketable if it is traded in an established stock or securities market and is regularly quoted by brokers or dealers in making a market. Stock in a corporation which is unitary with the taxpayer, or which has a substantial business relationship with the taxpayer is not considered marketable stock. 2. For purposes of this subsection, a treasury function is the pooling and management of liquid assets for the purpose of satisfying the cash flow needs of the trade or business, such as providing liquidity for a taxpayer s business cycle, providing a reserve for business contingencies, business

7 acquisitions, etc. A taxpayer principally engaged in the trade or business of purchasing and selling instruments or other items included in the definition of liquid assets set forth herein is not performing a treasury function with respect to income so produced. 3. Overall net gain refers to the total net gain from all transactions performed by the treasury function for the entire tax period, not the net gain from a specific transaction. Although the FTB may aspire to a quick fix of the gross versus net issue and seek to avoid having to decide the issue on a case-by-case basis, the proposed regulation seems unlikely to achieve the goal. Any regulatory attempt to shift to the taxpayer the burden of proof that the inclusion of gross receipts from treasury function activities would likely be challenged as invalid due to the inconsistency with the California Supreme Court s holding in Microsoft. The Microsoft Court held that California Revenue & Taxation Code 25120(e) defines the term sales to mean all gross receipts of the taxpayer not allocated [as nonbusiness income]; thus, a regulation requiring something other than gross receipts to be included in the sales factor would conflict with the statutory definition of sales. The Microsoft Court plainly held that the party attempting to deviate from the standard apportionment formula had the burden of proving by clear and convincing evidence that the statutorily-prescribed formula did not fairly represent the taxpayer s activities in the state. An attempt to create a presumption requiring a sales factor other than the standard sales factor appears to conflict with that holding. So what does this proposed regulation really mean? Taxpayers who want to include only net gains from treasury functions in their sales factors, often California-based taxpayers, would be allowed to report such positions on original returns without advance permission from the FTB. For taxpayers seeking to defend the inclusion of gross proceeds in their sales factors, the implications are a little murkier. The FTB, following the regulation, will likely amend the taxpayers sales factor to include only net gains. Any resulting assessment will be presumptively correct. 14 To overcome this presumption, the taxpayer must show that the adjustments were made under CAL. CODE REGS and that the California Supreme Court held in Microsoft that any adjustments require the party invoking the authority under to prove by clear and convincing evidence that the standard formula does not fairly represent the taxpayer s activities in the state. Because the burden of proof should shift back to the state, the proposed regulation should have little if any significant legal effect. 14 See Todd v. McColgan, 201 P.2d 414 (Cal. App. 2d 1949); Appeal of First Federal Savings and Loan Association of Altadena, 60-SBE-008 (1960).

8 Implications for Taxpayers Taxpayers should expect taxing authorities to more frequently assert adjustments to the standard apportionment formula. As businesses become more complicated and diverse, the likelihood that the standard apportionment formulas will fairly represent the in state activity of specific taxpayers arguably decreases. As aptly noted by the Microsoft Court, the primary inquiry is whether the formula fairly represents a unitary business s activities in a given state, and when it does not, the relief provision may apply. The biggest uncertainty is the standard for determining when the standard formula fairly represents the business. Lack of a clear standard may result in unequal and nonuniform application of tax laws, in contradiction to the core principles of UDITPA. States have become increasingly bold in invoking UDITPA 18 authority, often overlooking their burden of proving that the standard apportionment formula does not fairly represent the extent of the taxpayer s business activities in the state. Principles of uniformity and fairness generally dictate that variations from statutorily-mandated formulas should be invoked only in unusual situations. However, as Microsoft, General Motors and other rulings show, the trend has moved in the other direction, with many state tax administrators and courts finding that the alternative apportionment provisions of UDITPA may be more broadly applied.

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