State & Local Tax Alert
Breaking state and local tax developments from Grant Thornton LLP
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California Supreme Court Denies Use of Multistate Tax Compact’s
Equally-Weighted Three-Factor Apportionment Election
On December 31, 2015, the California Supreme Court unanimously reversed a 2012
decision reached by the California Court of Appeal, and held that taxpayers are precluded
from making the election under the Multistate Tax Compact to use the equally-weighted
three-factor apportionment formula for purposes of the California franchise (income)
tax.1 After determining that the Compact is not a binding contract among its members,
the Court concluded that the California legislature had the unilateral authority to eliminate
the Compact’s election provision. Also, the Court determined that the 1993 legislation
enacting a double-weighted sales factor did not violate the state’s reenactment rule.
Finally, the legislature’s intent to supersede the Compact’s election provision was
supported by the statutory language adopting the double-weighted sales factor and the
accompanying legislative history.
Background
The Uniform Division of Income for Tax Purposes Act (UDITPA) was promulgated in
1957 in an effort to provide uniformity in the apportionment of corporate income among
states. Under UDITPA, income is apportioned to a state using an equally-weighted
formula that consists of property, payroll and sales factors.2 The Compact, which was
created in 1967, created the Multistate Tax Commission (MTC) and adopted the
apportionment methodology from UDITPA. Specifically, Article IV of the Compact
provides for an equally-weighted three-factor formula. Article III of the Compact
expressly allows taxpayers the option of apportioning income under the standard
UDITPA formula or a state’s alternative apportionment provisions. In 1966, the
California legislature codified the UDITPA provisions.3 California ratified the Compact in
19744 and required corporations to apportion their business income to the state using the
standard equally-weighted three-factor formula.5 For tax years beginning on or after
Release date
January 8, 2016
States
California
Issue/Topic
Corporate Income Tax
Contact details
Michael Boykin
Los Angeles
T 213.596.8420
E [email protected]
Christian Burgos
Irvine
T 949.608.5210
E [email protected]
Jamie C. Yesnowitz
Washington, DC
T 202.521.1504
E [email protected]
Chuck Jones
Chicago
T 312.602.8517
E [email protected]
Lori Stolly
Cincinnati
T 513.345.4540
E [email protected]
Priya Nair
Washington, DC
T 202.521.1546
E [email protected]
www.GrantThornton.com/SALT
1
The Gillette Co. v. Franchise Tax Board, California Supreme Court, No. S206587, Dec. 31, 2015.
UDITPA § 9.
3 CAL. REV. & TAX. CODE § 25120 et seq.
4 CAL. REV. & TAX. CODE §§ 38001 to 38021.
5 CAL. REV. & TAX. CODE § 25128(a) as in effect for tax years beginning prior to January 1, 1993.
2
.
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January 1, 1993, California adopted a three-factor apportionment formula consisting of
property, payroll and double-weighted sales, notwithstanding the Compact.6
In January 2010, the taxpayers filed claims with the California Franchise Tax Board (FTB)
for the refund of taxes and argued that the California apportionment statute did not
override or repeal the standard UDITPA apportionment formula. The taxpayers appealed
the FTB’s denial of their refund claims to the trial court.7 The FTB argued that the
amended California apportionment statute required the exclusive use of the doubleweighted sales factor. The trial court ruled in favor of the FTB and agreed that the
California apportionment statute clearly expressed an intention to eliminate the alternative
apportionment formula allowed under the Compact. The taxpayers appealed this decision
to the California Court of Appeal.
On June 27, 2012, in contemplation of a decision adverse to the state, California enacted
legislation, S.B. 1015, repealing the Compact.8 The legislation, which was an attempt to
limit potential tax refunds, clarified that since 1993, the use of an equally-weighted threefactor formula by a multistate taxpayer has been disallowed.
Court of Appeal Allowed Three-Factor Election
The California Court of Appeal reversed the trial court and agreed with the taxpayers that
California was bound by the provisions of the Compact and could not override and
eliminate the taxpayers’ ability to elect the equally-weighted three-factor apportionment
formula.9 In reaching its decision, the Court rejected the FTB’s argument that the plain
language of the California apportionment statute required the exclusive use of the doubleweighted sales apportionment formula. According to the Court, California could only
eliminate a taxpayer’s election to use the equally-weighted three-factor formula by
completely withdrawing from the Compact. California could not enact a statute that
repealed the provisions of the Compact to the extent necessary to impose a mandatory
apportionment formula on taxpayers. The California Supreme Court granted the FTB’s
petition to review the decision.
6
Note that the three-factor formula with the double-weighted sales factor applies to taxable years
beginning before January 1, 2013. CAL. REV. & TAX. CODE § 25128(a). For taxable years beginning
on or after January 1, 2013, most taxpayers use a single sales factor apportionment formula. CAL.
REV. & TAX. CODE § 25128.7. However, there are certain industry-specific exceptions to the
standard apportionment formula, including agriculture businesses, extractive businesses, savings
and loan activities, and banking and financial businesses. These entities continue to use an equallyweighted three-factor formula. CAL. REV. & TAX. CODE § 25128(b), (c).
7 The case was considered by the San Francisco Superior Court.
8 Ch. 37 (S.B. 1015), Laws 2012.
9 Note that the California Court of Appeal originally released its decision on July 24, 2012, but this
opinion did not address S.B. 1015. The Gillette Co. v. Franchise Tax Board, 144 Cal. Rptr. 3d 555 (Cal.
Ct. App. 2012). For a discussion of this decision, see GT SALT Alert: California Court of Appeal
Allows Taxpayers to Elect Equally-Weighted Three-Factor Apportionment Formula under
Multistate Tax Compact. The Court subsequently vacated this decision and ordered a rehearing of
the case. On October 2, 2012, the Court released a revised opinion that was very similar to its
original opinion, but the new opinion addressed S.B. 1015. The Gillette Co. v. Franchise Tax Board, 147
Cal. Rptr. 3d 603 (Cal. Ct. App. 2012). For a discussion of the revised opinion, see GT SALT Alert:
California Court of Appeal Issues Revised Gillette Opinion Concerning Multistate Tax Compact
Apportionment Election.
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Supreme Court Holds Legislature Eliminated Election Provision
In reversing the California Court of Appeal, the California Supreme Court held that the
California legislature had not retained the Compact’s election provision. The Court began
its analysis by explaining that the Compact does not have the force of federal law because
it was never ratified by Congress as required by the Compact Clause of the U.S.
Constitution.10 However, in U.S. Steel Corp. v. Multistate Tax Commission, the U.S. Supreme
Court held that states could enter into an agreement with each other without congressional
approval provided the agreement does not increase the political power of the states to the
extent it would interfere with the federal government’s power.11 The Court held in U.S.
Steel that the Compact does not violate the Compact Clause because it does not authorize
the member states to exercise any additional powers and does not delegate sovereign
powers to the MTC. Furthermore, each state retains the ability to adopt or reject the
MTC’s rules or regulations and may withdraw at any time.12 In the instant case, the
taxpayers argued that interstate compacts take precedence over other state laws even if the
compact lacks congressional approval. The Court explained, however, that it was not
required to decide whether a compact not approved by Congress takes precedence over
other state laws. According to the Court, the relevant question was whether the Compact
is a binding contract among its members.
Compact Not Binding Contract for Member States
In determining that the Compact is not a binding reciprocal agreement, the Court relied on
an amicus curiae brief filed by the MTC that contended the Compact is an “advisory
compact” that contains apportionment provisions that are “in the nature of model
uniform laws.” To support this interpretation, the MTC asked the Court to consider the
factors indicating a binding interstate compact that were enunciated by the U.S. Supreme
Court in Northeast Bancorp v. Board of Governors.13 The U.S. Supreme Court explained a
binding interstate compact is indicated by: (i) reciprocal obligations; (ii) conditional or
unilateral action; and (iii) a regulatory organization. The California Supreme Court agreed
with the MTC in the instant case that the Compact does not satisfy any of these factors.
According to the California Supreme Court, the Compact does not create reciprocal
obligations among the member states. The taxpayers argued that while the member states
do not have obligations to each other, the member states’ commitment to the UDITPA
apportionment formula prevented congressional action and that maintenance of this
formula “is mutual, reciprocal, and ‘critical to the effectiveness of the Compact.’” The
Court agreed that the possibility of congressional action encouraged states to adopt the
Compact, but the taxpayers failed to explain how a state’s elimination of the formula
makes the Compact less effective. The Compact’s election provision does not create an
obligation of member states to each other. Furthermore, the MTC did not argue in its
amicus curiae brief that California’s decision to discontinue use of the standard
apportionment formula undermined the Compact’s effectiveness. The Court noted that
UDITPA was promulgated as a model law and was adopted by California years before
10
U.S. CONST. art. I, § 10, cl. 3.
434 U.S. 452 (1978).
12 Id.
13 472 U.S. 159 (1985).
11
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joining the Compact. The legislature is free to amend its own legislation even if it is based
a model law. The Compact does not contain any language that changes the legislature’s
authority to amend the apportionment formula.
The Court held that the Compact also failed to satisfy the conditional or unilateral action
factors indicating that it is a binding compact. Specifically, these factors include whether a
compact’s effectiveness depends on the conduct of other members and whether any
provision prohibits unilateral member action. The Court noted that the Compact has not
required any member action since the requisite number of states enacted the Compact in
1967. The Compact already had been effective for seven years when California joined it
and no existing members were required to take action. The fact that any state may leave or
join the Compact without notice supports a conclusion that it is not a binding interstate
agreement. Also, the presence of a withdrawal provision does not address a member’s
ability to unilaterally modify the Compact. There is a history of states taking unilateral
action regarding the Compact and only seven of the Compact’s 16 members still use the
standard apportionment formula. The Court concluded that the ability of states to engage
in unilateral action under the Compact is inconsistent with a binding agreement.
The Compact did not satisfy the final factor under Northeast Bancorp because the MTC does
not have the authority ordinarily associated with a regulatory organization. In its amicus
curiae brief, the MTC acknowledged that its powers “are strictly limited to an advisory and
informational role.” The MTC may promulgate administrative regulations, but these
regulations only are advisory and have no force until they are adopted by a state. Similarly,
the MTC has the power to conduct taxpayer audits but only if a member state enacts
separate authorizing legislation and expressly requests the audit. The Court concluded that
the MTC is not a joint regulatory organization under Northeast Bancorp because it lacks any
binding authority over member states.
Reenactment Rule Did Not Bar Double-Weighted Sales Factor Legislation
After determining that the legislature had the authority to eliminate the Compact’s election
provision, the Court held that the state’s reenactment rule did not bar the legislature’s 1993
amendment to the apportionment statute that enacted a double-weighted sales factor. This
rule is derived from a provision of the California Constitution that “[a] section of a statute
may not be amended unless the section is re-enacted as amended.”14 The Court explained
that the reenactment rule generally does not apply to statutes that “amend” others only by
implication. The 1993 legislation expressly referenced the Compact by providing that the
double-weighted sales factor applied “notwithstanding” the statute enacting the Compact.
The Court held that even without a reenactment of California’s Compact statute to
eliminate the election language, the amendment of the apportionment statute did not
violate the reenactment rule.
Compact’s Election Provision Intentionally Superseded
14
CAL. CONST. art. IV, § 9.
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The Court held that the California legislature intentionally eliminated the Compact’s
election provision. The taxpayers unsuccessfully argued that the legislature intended the
double-weighted sales factor formula enacted in 1993 to apply only if a taxpayer decides
not to make the election under the Compact. The Court determined that the statutory
language and legislative history defeated the taxpayers’ claim. The statutory language
provides that “all business income shall be apportioned to this state by” using the doubleweighted formula notwithstanding the statute adopting the Compact.15 The Court
concluded that there is no ambiguity in this language. Also, the legislative history from
1993 explains that the legislature intended to adopt an apportionment formula that placed
extra weight on the sales factor in place of the standard formula. The Court concluded that
“[i]n light of the statute’s language and this legislative history, there is no credible
argument that the Legislature intended to retain the Compact’s election provision.”
Commentary
The question of whether taxpayers are allowed to elect to use the Compact’s equallyweighted three-factor apportionment formula has received considerable attention during
the past few years. Following the California Court of Appeal’s taxpayer-favorable decision
in Gillette in 2012, there appeared to be some momentum to this argument. In 2014, the
Michigan Supreme Court allowed a taxpayer to make the Compact’s three-factor
apportionment election for the 2008 tax year.16 However, the historic high-water mark of
the position in the Compact states was short-lived, beginning with Michigan’s
subsequently enacted legislation that retroactively repealed the Michigan statutes adopting
the Compact effective January 1, 2008.17
The momentum behind the argument further dissipated during 2015. Courts in several
different states rejected taxpayers’ arguments that they could make the apportionment
election under the Compact. The Minnesota Tax Court granted the Minnesota
Commissioner of Revenue’s motion for summary judgment and denied a taxpayer’s
apportionment election under the Compact.18 The Texas Court of Appeals affirmed a trial
court’s decision that a taxpayer cannot make the apportionment election provided by the
Compact, and therefore must use a single receipts factor to compute its Revised Texas
Franchise Tax (RTFT).19 Finally, the Oregon Tax Court granted the Oregon Department
of Revenue’s motion for summary judgment and denied a taxpayer’s apportionment
15
CAL. REV. & TAX. CODE § 25128(a).
International Business Machines Corp. v. Department of Treasury, 852 N.W.2d 865 (Mich. 2014), reh’g
denied, 855 N.W.2d 512 (2014). For a discussion of this case, see GT SALT Alert: Michigan
Supreme Court Allows Multistate Tax Compact Three-Factor Apportionment Election for 2008
MBT Return.
17 Act 282 (S.B. 156), Laws 2014. For a discussion of this legislation, see GT SALT Alert: Michigan
Enacts Legislation Designed to Eliminate Multistate Tax Compact Apportionment Election
Refunds Allowed by IBM Case.
18 Kimberly-Clark Corp. v. Comm’r of Revenue, Minnesota Tax Court, File No. 8670-R, June 19, 2015.
See GT SALT Alert: Minnesota Tax Court Denies Use of Multistate Tax Compact’s EquallyWeighted Three-Factor Apportionment Formula Election. This case is on appeal before the
Minnesota Supreme Court and oral arguments will be held on January 11, 2016.
19 Graphic Packaging Corp. v. Hegar, 471 S.W.3d 138 (Tex. Ct. App. 2015). See GT SALT Alert: Texas
Appeals Court Denies Use of Compact’s Three-Factor Formula As Revised Texas Franchise Tax Is
Not Considered an Income Tax.
16
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election under the Compact.20 In light of these recent holdings, the potential financial
impact of a taxpayer-favorable decision to the state of California, and the lengthy wait for
the decision, the California Supreme Court’s decision in Gillette is not surprising.
The California Supreme Court’s decision is interesting because it largely relies on the amicus
curiae brief that was filed by the MTC, giving relatively short shrift to other briefs that were
filed in support of the taxpayers. In its brief, the MTC acknowledged that the Compact is
not a binding contract among its members, and by doing so, may have hampered itself in
the organization’s long-term pursuit of promoting state tax uniformity. Existing state
members in the Compact may decide that the need to maintain Compact and by extension,
MTC membership may not be worthwhile or necessary if the terms of membership are
nonbinding. On the other hand, as a potential counterpoint, if the Compact is
unanimously found not to be considered a binding contract by state tax courts, this
determination conceivably could inspire states that have recently opted out of the
Compact to rejoin.
In any event, the argument that the Compact does not bind state legislatures from further
action, and the conclusions reached by the California Supreme Court in this area, are likely
to continue to be presented by state tax authorities in the remaining states in which the
Compact litigation will be waged. The states’ inconsistent changes to major provisions of
the Compact (including apportionment formulas and sourcing regimes) without fear that
those changes would result in expulsion from the Compact, also are likely to be presented
as evidence that the Compact does not have “contract” status.
The taxpayers intend to appeal this decision to the U.S. Supreme Court. Although it would
be interesting to see how the U.S. Supreme Court would decide this case, it is always a
challenge to obtain a hearing in front of the high court, and given the current state of play
in the multistate litigation, it seems unlikely that the Court would grant review. The task of
obtaining certiorari could be made somewhat easier if a taxpayer-favorable decision by
another state supreme court is reached in the future, on the grounds that the Compact is a
binding contract. In that instance, a clear conflict would then exist between states
regarding the characterization of the Compact, something that might heighten the interest
of the U.S. Supreme Court.
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20
Health Net, Inc. v. Department of Revenue, Oregon Tax Court, No. TC 5127, Sep. 9, 2015. See GT
SALT Alert: Oregon Tax Court Denies Use of Multistate Tax Compact’s Three-Factor
Apportionment Formula Election.
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