California Court Affirms State Must Offer Income Formula in Multistate Tax Compact

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

By Laura Mahoney

SACRAMENTO, Calif.—A state appellate court Oct. 2 affirmed its own earlier ruling that California must allow corporate taxpayers to apportion multistate income based on a formula that tax administrators argued was repealed in 1993, leaving the viability of the Multistate Tax Compact underpinning the case in doubt. [Gillette Co. v. Cal. Franch. Tax Bd., Cal. Ct. App., No. A130803, 10/2/12]

The court's new ruling makes two clarifications that reflect issues raised by the Franchise Tax Board and Gillette Co., the taxpayer in the case, in court filings since the court's original ruling in July.

The clarifications are minor and do not change the core outcome of the case, Amy Silverstein, an attorney with Silverstein and Pomerantz in San Francisco, representing Gillette, told BNA Oct. 2.

The FTB is reviewing the ruling and does not have a comment, spokeswoman Susan Maples told BNA Oct. 2.

Compact Is Binding Contract

As it did in July, the Court of Appeal for the First Appellate District said the compact adopted in California in 1973 is a binding contract that obligates member states to allow taxpayers to apportion their income using a three-factor formula based equally on property, payroll, and sales in California versus sales elsewhere. The compact's formula trumps California's adoption in 1993 of an alternative formula to require taxpayers to apportion income based on property, payroll, and two-times sales.

The only way to eliminate the three-factor formula is to repeal the compact, the court said.

The three-judge appellate panel issued the new opinion two months after announcing it would revisit its July ruling, on its own motion.

States May View Ruling as Threat to Revenue

With the core holdings of the original ruling intact, the viability of the compact and its promise of tax law uniformity among states remain in doubt, tax practitioners have told BNA. Fourteen of the 19 states that have adopted the compact have also strayed from the apportionment formula in the compact and adopted alternatives. Taxpayers in those 14 states could have claims similar to those raised by Gillette.

If other MTC states view Gillette as a threat to revenue, they may also consider a repeal of the compact, tax practitioners have told BNA.

California Repealed Compact

In the new 22-page ruling, the court clarified that the compact is no longer part of state law.

California lawmakers repealed the compact in June as a hedge against an unfavorable ruling in Gillette and a potential loss of at least $500 million in tax revenue. They enacted the repeal between the time that oral arguments were presented to the court in May and the court issued its original ruling in July.

The new ruling reflects that the compact was repealed by referring to it as a former state statute. The court did not evaluate the law repealing the compact, S.B. 1015, which was enacted with a majority vote of the Legislature. The repeal will likely face a legal challenge based on an argument that S.B. 1015 required a two-thirds vote of the Legislature because it increased taxes.

In a letter to the court Aug. 8, Silverstein asked the court to acknowledge California's repeal of the compact in its ruling, without expressing an opinion as to the repeal's validity.
Alternative Formula Unconstitutional

The court also addressed an issue the FTB raised in a petition for rehearing filed Aug. 8, asking the court to clarify why the 1993 alternative apportionment formula was unconstitutional.

California's adoption of the alternative apportionment formula violated a prohibition against the impairment of contracts during the years at issue in the case, the court said. The prohibition, in federal and state constitutions, extends to interstate compacts, the court said.
In addition, the FTB's adoption of the 1993 alternative formula “notwithstanding” the existence of the compact in state law ran afoul of the re-enactment rule in the state Constitution, which says a statute cannot be amended by reference to its title.
“The opinion essentially answers both the taxpayer's request for clarification of the opinion and the FTB's arguments in its petition for rehearing,” Gregory Turner, senior tax counsel with the Council On State Taxation (COST), told BNA Oct. 2.
Turner filed a friend-of-the-court brief for COST supporting Gillette in the case.

Gillette is one of six corporations that filed lawsuits in 2010 seeking state income tax refunds based on use of the compact's three-factor apportionment formula. The six cases have been consolidated into one action. Gillette is seeking a refund of $4.1 million for tax years 1997 through 2004.

Justice Timothy Reardon wrote the opinion, with Presiding Justice Ignazio J. Ruvolo and Justice Patricia K. Sepulveda concurring.

Full text of the opinion is available at