alternative apportionment: can two play that game? · franchise tax bd., 139 p.3d 1169 (cal. 2006)...

Alternative Apportionment: Can Two Play That Game?

Eric Tresh – Partner, Sutherland Maria Todorova – Counsel, Sutherland STARTUP – Spring Conference 2015 Richmond, VA May 20, 2015

©2015 Sutherland Asbill & Brennan LLP

Agenda

1. Background

2. Invoking Alternative Apportionment

3. Burden of Proof

4. Practical Considerations

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BACKGROUND

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Background: Dividing the Corporate Income Tax Base

• States may tax “fair share” of profits earned from activity conduced within their borders using apportionment. Underwood Typewriter v. Chamberlain, 254 U.S. 113 (1920)

• “Linchpin of apportionability in the field of state income taxation is the unitary business principle” Mobil Oil, 445 U.S. 425 (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, 254 U.S. 113 (1920) Hans Rees' Sons v. State of North Carolina, 283 U.S. 123 (1931)

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Background: UDITPA

• States’ apportionment methods vary UDITPA’s three-factor method (property, payroll, sales) Other (double-weighted sales; single sales factor)

• Because the standard apportionment formula may produce unreasonable results, UDITPA Section 18 provides an alternative apportionment method Acts as a pressure valve for when the standard

apportionment formula provides arbitrary and unreasonable results

Intended to be applied only in unusual or unique circumstances

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Background: UDITPA

• UDITPA Section 18 provides that 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”

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Background: MTC Regulation

• MTC 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...”

• However, states have increasingly applied alternative apportionment methods where the statutory apportionment rules result in less income apportioned to the state than the state believes is fair

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INVOKING ALTERNATIVE APPORTIONMENT

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Invoking Alternative Apportionment

Burden of proof on the party (tax authority or taxpayer) seeking to diverge from the standard apportionment formula to prove that distortion exists, and that a proposed alternative method is reasonable

Moving Party

Assert Distortion

Yes

No

No Alternative Apportionment

Proposed Alternative Reasonable

Yes

No Alternative Apportionment

Alternative Apportionment

No

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Invoking 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

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Distortion

• What is a “fair” representation of business activity in the state?

Most states have found that the constitutional “gross distortion”

(see Hans Rees) requirement is not necessary to justify alternative apportionment – some lesser standard usually applies

Consistent with Section 18, many states require only a showing

that the statutory formula does not fairly reflect the extent of the taxpayer’s activities in the state

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Distortion

• How can one measure whether the standard apportionment method produces a “fair” representation of the extent of the taxpayer’s business activity in the state? More or less tax? Prevent over or under taxation?

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Distortion

• California Standard for Distortion - Microsoft Corp. v. Franchise Tax Bd., 139 P.3d 1169 (Cal. 2006) Qualitative Analysis

The qualitative analysis examines the 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

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Distortion

• California Standard for Distortion - Microsoft Corp. v. Franchise Tax Bd., 139 P.3d 1169 (Cal. 2006) Courts in Microsoft and Square D found distortion where

operational profit margin far exceeded treasury profit margin Microsoft – Operational margin 167x greater than treasury

profit margin Square D – Operational margin 74x greater than treasury profit

margin

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Distortion

• Fla. Tech. Asst. Adv. No. 08C1-006 (July 25, 2008) Illustrates the difficulty in obtaining alternative apportionment Taxpayer requested alternative apportionment formula because

it pays an income tax on over 150% of its federal consolidated income

Department denied request and noted that the fact taxpayer was filing on different bases contributed to why the taxpayer paid tax on more than 100%

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Reasonable Alternative or Disguised Deviation from Statutory Method?

• Combined Reporting vs. Separate Accounting Carmax Auto Superstores West Coast, Inc. v. South Carolina

Dept. of Revenue, 767 S.E.2d 195 (S.C. 2014) DOR used alternative apportionment that imposed separate accounting Court held the DOR failed to meet its burden of proof in showing that the

statutory apportionment method resulted in distortion

Media General, Inc. et al. v. S.C. Dep’t of Revenue, 694 S.E.2d 525 (S. Car. 2010) DOR agreed with taxpayer that the state’s apportionment was not fairly

reflecting the taxpayer’s activity in the state, but held combined reporting was not allowed as a method of alternative apportionment to fix the distortion

Court held combined reporting could be used as an alternative apportionment method

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• SC has issued draft guidance relating to its future use of alternative apportionment. S.C. Rev. Rul. #15-X (Draft – 4/21/2015); S.C. Rev. Proc. #15-X (Draft – 4/21/2015) Will follow Carmax decision - preponderance burden on the moving

party DOR will not limit use of alternative apportionment to unique or

nonrecurring factual situations DOR will generally use a water’s edge method; Finngan rule for

calculating sales factor DOR will not apply understatement penalties or extend SOL for

understatements Will combined reporting be the primary, or only, alternative method

use by the DOR? Joyce? Worldwide combined group?

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• Combined Reporting vs. Separate Accounting Letter of Findings 02-20130215 (Ind. Dep’t of Rev. Oct. 30, 2013)

DOR determined that a taxpayer and its two affiliated entities were not required to report their income using a separate accounting method because the Department’s audit staff failed to prove the standard apportionment formula did not fairly reflect the taxpayer’s business activities in Indiana

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http://www.in.gov/legislative/iac/20131030-IR-045130462NRA.xml.html



• Adjustments to Sales Factor Vodafone Americas Holdings, Inc. v. Roberts, No. M2013-00947-

COA-R3-CV (Tenn. Ct. App. 2014), petition for cert. granted (Tenn. Nov. 20, 2014) Court of Appeals determined the Commissioner properly

required Vodafone to apportion sales using market-based sourcing instead of the statutory cost of performance method

Equifax, Inc. v. Mississippi Dep’t of Revenue, 125 So. 3rd 36 (Miss. 2013) Equifax apportioned its income to MS used IPA / COP method

for refund claims; DOR determined that Equifax should have used an alternative market-based sourcing formula

Internal Consistency Concerns Is it Constitutional to tax out of state services providers

differently then in-state service providers absent a unique circumstance?

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• Adjustments to Sales Factor While Florida law requires COP to source revenue from services,

the DOR has determined in multiple rulings that market-based sourcing was more appropriate: Fla. TAA 12C1-006 (May 17, 2012) (Online courses were sourced to the

location of the student and not where costs of performance (COP) were incurred)

Fla. TAA 13C1-004 (May 21, 2013) (Receipts from licensing television programming to cable operators were sourced to the location of the operator/customer)

Fla. TAA 13C1-011 (Nov. 21, 2013) (Company providing TV viewing data and analytics services must source service receipts to the location of its customers)

But, Florida, like many states including Illinois, Indiana, and California, has been willing to settle COP cases using reasonable alternative methodologies

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• Statutory Construction and “absurd result”? Duke Energy Corp. v. South Carolina Dept. of Revenue, 764 S.E.2d 712

(S.C. Ct. App. 2014), petition for certiorari granted in part (S.C. 2015) South Carolina law required that the “total gross receipts” from sales

be included in the sales factor The Court of Appeals held that receipts other than interest from

sales of securities are not “receipts” and should be excluded from sales factor because as matter of law, including such receipts in the sales factor does not fairly represent the taxpayers business activities in the state

Lower court ruled that construing “gross receipts” to include sales of securities was “absurd

Cert denied on manufacturing issue Issues to be decided by the South Carolina Supreme Court include

whether the Department should bear the burden of proving an absurd result and whether this case is simply an end run around the alternative apportionment statute

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• Disguised Deviation form Statutory Method? Powerex Corp. v. Oregon Dep’t of Revenue, 357 Or. 40 (Or. 2015)

Oregon Tax Court – Electricity = Intangible Property Electricity is intangible personal property and sourced based on

cost of performance – Canada Oregon Supreme Court – Electricity = TPP

Statutory Construction – “the scientific debate…seems beside the point” UDITPA does not define TPP; Court looks to legal dictionary

definitions and statute’s context and legislative history TPP can be (1) located physically within a state; and (2) can

be delivered or shipped to a place Powerex did not advance argument that electricity can be sale of

service Sales sourced based on ultimate destination of electricity sales

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• Use of State Section 482 Provisions as Tool for Expense Disallowance Many states have enacted statutory provisions similar to IRC §

482. See e.g.: Ala. Code § 40-2A-17 Fla. Stat. § 220.44 Ga. Code Ann. § 48-7-58 Tenn. Code Ann. § 67-4-2014 N.C. Gen. Stat. Ann. § 105-130.6

Some states have interpreted their § 482 authority to disallow deductions in full Instead of attempting to prevent base erosion (see e.g.,

BEPS), states are simply ignoring the tax consequences of certain intercompany transfers

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• Use of State Section 482 Provisions as Tool for Expense Disallowance Pending litigation and settled cases in Louisiana and Utah

State does not argue that taxpayer’s intercompany transactions are not at arm’s length – no arm’s length analysis conducted

State argues intercompany pricing, by definition, cannot be at arm’s length and must be disregarded under its 482 statute in order to prevent evasion of taxes

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Other Alternative Apportionment Issues

• Widespread application without regulations? How important is unusualness?

MTC rejected suggestions that regulations must be adopted

• Imposition of penalties for using statutory method? MTC amendment prevents

• Retroactive revocation? MTC amendment prevents

• Appropriate for use in Economic Development? Should it be statutory or by administrative policy/decision

making?

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BURDEN OF PROOF

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Burden of Proof: Who has it?

Two primary issues :

(1) Who bears the burden of proving that alternative apportionment is appropriate?

(2) What is the standard of proof?

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• Who bears the burden of proof? Is the Department still entitled to a presumption of correctness

on assessments? Most states place the burden of proof on the proponent of the

alternative apportionment method But see Equifax, Inc. v. Miss. Dep’t of Revenue, 125 So.3d 36

(Miss. 2013) Court reversed the Court of Appeals and held that the taxpayer bears the

burden to prove that the alternative apportionment method proposed by the DOR was arbitrary and unreasonable Court’s review of Department’s imposition of alternative methodology is

limited to whether that decision was supported by substantial evidence or that it was arbitrary and capricious

Result: taxpayer may find it much more difficult to challenge Department’s assertion of alternative methodology

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• Legislative Response to Equifax (HB 799) (Eff. 1/1/15) Places burden of proof on party invoking alternative

apportionment method to prove by a preponderance of the evidence that: Statutory method does not fairly represent activity in

state; and Selected method more fairly represents that activity than

any other reasonable method available Requires that alternative apportionment be invoked only in

“limited and unique, nonrecurring circumstances” Prohibits DOR from invoking forced combination until

regulations have been promulgated No penalties from forced combination unless DOR finds no

reasonable basis or nontax business purpose 29


Burden of Proof: Standard of Proof

• Abuse of discretion, de novo review or something else? Equifax

• Preponderance of the evidence Oregon - Twentieth Century-Fox South Carolina - Carmax

• Clear and Convincing Evidence Somewhere between preponderance of evidence and beyond a reasonable

doubt - California – Microsoft v. Franchise Tax Board, 139 P.3d 1169 (Cal. 2006)

• Clear and Cogent Evidence Must demonstrate by clear and cogent evidence that the standard

apportionment formula does not properly reflect a taxpayer’s presence. British Land (Maryland) Inc. v. N.Y. Tax App. Trib., 85 N.Y.2d 139, 147-48 (N.Y. Ct. App. 1995)

• Prima facie evidence

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PRACTICAL CONSIDERATIONS

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Practical Considerations

• Anticipating states’ assertion of alternative apportionment, asserting alternative methods offensively

• Documentation (contemporaneous) is key • Market sourcing changes will lead to tax

return positions • Identifying the applicable burden of proof

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Practical Considerations re: Alternative Apportionment

• Majority of states require taxpayer to petition or request an alternative apportionment formula in advance California – Requires prior approval from the FTB. Cal. Franchise Tax Bd.

Notice No. 2004-5 (Aug. 6, 2004) Idaho – A written request to use an alternative apportionment formula must

be filed with the Tax Commission at least thirty (30) days prior to the due date for filing the return. Idaho Admin. Rules § 35.01.01.585

Michigan – Taxpayer must petition the Department of Treasury. Mich. Comp. Laws Ann. § 206.667(1)

• Other states require that pre-approval and/or alternative apportionment be in the form of a refund Illinois – Must petition 120 days before return is due, or file using statutory

method and attach amended return applying alternative method. ILCS Ch. 35 § 5/304(f); Ill. Admin. Code 86 § 100.3380(a)

New Mexico –Taxpayer must submit written petition, file return applying statutory formula, and submit an amended return applying the requested method. In an appropriate case, the petition will be considered a claim for refund. N.M. Admin. Code § 3.5.19.9(A)

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©2015 Sutherland Asbill & Brennan LLP 34

Practical Considerations

• Violation of State Administrative Procedures Act? • The broad application of Alternative Apportionment

may violate state administrative procedures acts that limit a state agency’s ability to rely on ad hoc adjudication when the adoption of a rule is more appropriate

• Separation of Powers arguments?

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Questions?

Eric Tresh

Partner Sutherland Asbill & Brennan LLP

404-853-8579 [email protected]

Maria Todorova

Counsel Sutherland Asbill & Brennan LLP

404-853-8214 [email protected]

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mailto:[email protected]

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alternative apportionment: can two play that game? · franchise tax bd., 139 p.3d 1169 (cal. 2006)...

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