The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.
By Joe Huddleston and Rebecca Helmes
Joe Huddleston is Executive Director with Ernst & Young LLP in Washington, D.C. Rebecca Helmes is a Tax Senior with Ernst & Young LLP in Washington, D.C. The views expressed in this article are those of the authors and do not necessarily reflect the views of Ernst & Young LLP.
Cases addressing whether certain taxpayers may elect to use the equally weighted, three-factor apportionment formula provided under the Multistate Tax Compact (compact) or whether they must use another apportionment formula codified in a state's laws have been percolating in five state court systems for several years. Now that California's high court has issued its opinion on the matter, will the U.S. Supreme Court grant certiorari? Will the outcomes of the pending cases in the four other states—Michigan, Minnesota, Oregon and Texas—build some kind of consensus on whether taxpayers can exercise a compact election?
The following article will consider how the compact election issue got started in California, how it spread to other states, the status of pending cases in those states and what these decisions mean going forward.
On New Years' Eve 2015, the California Supreme Court (CSC) unanimously reversed the California Court of Appeal's ruling in Gillette Co.1 and held that corporate taxpayers cannot elect to use the compact's equally weighted three-factor apportionment formula (compact election) for reporting income to California in lieu of the statutorily mandated formula (e.g., double-weighted sales or single sales factor formulae). In reaching this conclusion, the CSC agreed with the California Franchise Tax Board (FTB) that the Legislature's enactment of a new apportionment formula controls and the state is not bound by the compact election.
In 1967, the compact became effective when it was enacted by nine states (two more than required for it to become effective) and the Multistate Tax Commission (MTC) was formed.2 In 1974, California adopted the compact.3 Compact Article IV adopts the Uniform Division of Income for Tax Purposes Act (UDITPA) (the first draft of which was issued in 1957 by the National Conference of Commissioners on Uniform State Laws4) and its evenly weighted three-factor formula for the state's apportionment formula (i.e., the sum of the payroll, property and sales factors, divided by three), while compact Article III allows taxpayers to elect to use either the compact ’s three-factor formula or the state's statutory apportionment formula for apportioning income to the state.
During 1993, California modified its apportionment provisions, moving from an equally weighted three-factor formula to a double-weighted sales factor formula (i.e., sum of the payroll factor, the property factor and a doubling of the sales factor, divided by four) that applied to most taxpayers.5 In adopting the double-weighted sales factor, the Legislature left the compact (and the compact election) in place, but specifically provided, by reference to the section of the California Revenue & Taxation Code (Cal. Rev. & Tax Code) in which UDITPA was adopted and codified by California,6 that affected taxpayers must use the double-weighted sales factor.
When taxpayers are given a choice of methods by which to compute tax due, it is foreseeable that they would run each calculation and choose, within the law, the one that best fits the taxpayer's needs. At issue in Gillette was whether in adopting the mandatory double-weighted sales factor, the Legislature also precluded a taxpayer's ability to make the compact election. Several taxpayers argued that by purporting to deny taxpayers the opportunity to make the compact election, California violated the compact's express terms. They argued further that the only way that the Legislature can deny the right to make the compact election is to repeal the compact in its entirety—effectively withdrawing from the compact itself. The FTB argued, and the trial court agreed, that Cal. Rev. & Tax Code § 25128 mandated use of the double-weighted sales factor apportionment formula, eliminating a taxpayer's ability to use the compact election.7
In October 2012, in a unanimous three-judge ruling, the California Court of Appeal (CCOA) held that the 1993 amendment to Cal. Rev. & Tax Code § 25128 mandating use of a double-weighted sales factor did not supersede or eliminate the compact election under former Cal. Rev. & Tax Code § 38006.8 Rather, the CCOA essentially held that taxpayers may use the compact election for apportioning income during the operative time frame (e.g., the period during which it was a signatory member of the compact), because the manner in which the Legislature amended the use of the compact violated the contract clauses of the U.S. and California constitutions and the reenactment clause of the California constitution (which prescribes that a statute cannot be amended solely by reference to its title).9
On appeal, the CSC reversed the CCOA, holding instead that the state-mandated apportionment provision controls and the state is not bound by the compact. In reaching this conclusion, the CSC did not decide whether the compact took precedence over state law but instead determined that the compact is not a binding contract between and among its members. The CSC agreed with the MTC's argument in its amicus brief that “the compact does not satisfy any of the indicia of binding interstate compacts noted in [the U.S. Supreme Court's ruling in] Northeast Bancorp.”10 The CSC found the compact did not create reciprocal obligations among member states as the party states do not perform or deliver obligations to one another and the compact's election provision does not create member state obligations. Instead, the CSC found application of the compact to be “more akin to the adoption of a model law rather than the creation of any mutual obligations among compact member [state]s.”
As for other indicia of a binding compact articulated in Northeast Bancorp.—(1) whether its effectiveness depends on the conduct of other members, (2) whether any provision prohibits unilateral member action and (3) whether a regulatory organization has been established—the CSC held that a state's unilateral ability to join and leave the compact without notice “militates against a finding that the compact is a binding interstate agreement under Northeast Bancorp.” The Court noted that there is a history of unilateral state action amending the compact, citing Florida's elimination of the Article III election provision and subsequent MTC recognition of Florida as a member in good standing in 1972 just five years after adopting the compact. In regard to the MTC, the CSC concluded that it lacks binding authority over the member states as its powers (e.g., to promulgate model statutes and regulations, to conduct audits) “are strictly limited to an advisory and informational role.” As such, neither the compact nor the MTC were the joint type of regulatory organization contemplated by Northeast Bancorp. that would be the hallmark of a formal, binding compact among the states.
The CSC also rejected the taxpayer's argument that the Legislature violated the reenactment clause of the California Constitution (which requires a statute to embrace one subject that is expressed in its title) by amending the apportionment provisions in the manner in which it did to eliminate the compact apportionment election. The CSC noted that the reenactment rules generally do not apply to statutes that amend other statutes by implication and, moreover, found that both the Legislature and the public were provided with sufficient notice of the purpose of the amendment in satisfaction of the clause itself.
Lastly, the CSC held that the Legislature intended to eliminate the compact election. By adopting the following language—“Notwithstanding Section 38006 [i.e., the Cal. Rev. & Tax Code numerical citation under which the provisions of the compact were codified], all business income shall be apportioned to this state by…”11 using the formula it sets out—the Legislature unambiguously intended the statutory sales factor formula set forth in Cal. Rev. and Tax Code § 25128 (e.g., double-weighted sales factor or single sales factor, depending upon the year) to supersede the compact election provision as well. The CSC concluded its opinion stating, “[T]here is no credible argument that the Legislature intended to retain the compact's election provision.”
Immediately following the CCOA's ruling in Gillette, similar compact litigation spread to Michigan, Minnesota, Oregon and Texas. It has been simmering in those places ever since. While all of the cases revolve around the same general issue—whether a state's enactment of the compact (including its apportionment formula election under UDITPA) and later adoption of a different apportionment formula still retained the ability of taxpayers to elect between the two formulas for apportioning their income to the state—all of the cases and their outcomes have been distinctly different. In fact, although the compact election issue is omnipresent, none of the other states have shown an appetite to actually rule on this. All of these cases so far have been decided on state statutory grounds, and all of these statutory grounds followed by the courts have been different. Let's take a look at each of these states in succession:
Texas' compact election case might be the simplest one of the group, because the Texas Court of Appeals held in Graphic Packaging12 that the compact election is unavailable to multistate corporations under the revised franchise tax, i.e., Margin Tax, because the Margin Tax is not a tax based on net income as defined by the compact. According to the court, by its express terms, UDITPA and the compact election only apply to taxes based on net income and because the Margin Tax was not so based, the compact election cannot apply. Instead, taxpayers must use the apportionment formula mandated by the Margin Tax law—a single gross receipts factor formula.
The taxpayers have appealed the court of appeals ruling in Graphic Packaging and it is currently being briefed before the Texas Supreme Court. Nevertheless, it is unclear whether Texas' highest court will even accept the case. The taxpayer filed its petition for review with the Texas Supreme Court Dec. 14, 2015, and the state has until April 13, 2016, to file its response.13
In its September 2015 decision in Health Net,14 the Oregon Tax Court (Tax Court) granted the state's motion for summary judgment upholding legislation “disabling” the compact election. The Tax Court concluded that the Oregon Department of Revenue properly and validly denied an insurance provider's refund claim based on the use of the compact election because the Legislature's adoption of a statute15 requiring taxpayers to use a single sales factor apportionment formula acted to “disable” another Oregon statute16 that gave taxpayers the option to use the compact election. The Tax Court also concluded that this disablement did not violate state or federal law.17 Now Health Net18 is being appealed to the Oregon Supreme Court, but it is unclear whether that court will accept the case for review.
In Minnesota, Kimberly-Clark Corp. is waiting for the Minnesota Supreme Court to issue its opinion after oral arguments in its compact election case were held this past January.19 In the case, Kimberly-Clark argued that it is due a refund because Minnesota was bound by all of the compact's terms once Minnesota enacted it in 1983. Previously, the Minnesota Tax Court rejected Kimberly-Clark's use of the compact election and upheld the state's repeal of the provision.
Similar to cases and issues being heard in compact election cases in other states, Kimberly-Clark filed amended returns for its 2007, 2008 and 2009 tax years claiming that the Minnesota Legislature's repeal, in 1987, of Articles III and IV of the compact, which had been enacted in 1983, was ineffective because Minnesota had contractually obligated itself both to furnish the apportionment election and to refrain from using its sovereign power to repeal the election.
However, of the several arguments the state made in defending the effectiveness of its 1983 law change to repeal Articles III and IV of the compact, the Minnesota Tax Court focused on the state's position that it cannot surrender its sovereign taxing power without doing so in “unmistakable terms,” invoking what the court phrased as the judicially accepted “unmistakability doctrine” (which, frankly, these authors had never heard of before).
Michigan's compact election litigation is the most convoluted of this group of cases, and the saga continues. In concert with the compact election issue, Michigan courts are addressing the effects of a retroactively effective statute on several incarnations of different kinds of business taxes imposed by Michigan over the last several years—such as the Michigan Business Tax (MBT) and the Single Business Tax (SBT) as well as the current Corporate Income Tax. Still, like the other states, all of Michigan's decisions related to compact election cases have been on state law grounds rather than on issues that deal directly with the compact, never having to fully address the constitutional questions raised by the taxpayers.
The stream of compact election and related cases that have wound through Michigan's court system in the past few years has been steady, particularly since the Michigan Supreme Court (MSC) found in IBM20 that IBM was permitted to use the compact election to determine tax liability under the since-repealed MBT, and was not required to use the statutory single sales factor formula for the MBT. Ultimately, the MSC found that the statutes could be “harmonized,” which allowed the MSC to rule in IBM's favor. However, it is noteworthy that IBM was a plurality decision, split 3-1-3 with a vigorous dissent penned by Justice McCormack.
During the pendency of the state's motion to rehear IBM, Michigan enacted 2014 Public Act 282 (PA 282) to expressly repeal the entire compact, retroactive to January 1, 2008, the result of which, if applied, prevented taxpayers from receiving refunds resulting from IBM. However, after the MSC remanded the case to the Michigan Court of Claims (COC) for a summary disposition in IBM's favor, the Michigan Department of Treasury (Department) filed a motion for reconsideration with the COC, asserting the retroactive change in law applied to and controlled the outcome of the case. The COC granted the Department's motion and then ruled that legislation enacted in 2014 to retroactively repeal the compact to 2008 applied to IBM as well and prevented IBM from receiving any refunds even after successfully appealing its case all the way to the MSC.21
Taxpayers have rigorously litigated the effect of the retroactive statute, and results so far have been mixed and even, depending on whether the taxpayers sought refunds of the MBT or SBT.
Beginning in the late 1970s and continuing through 2007, Michigan businesses paid the SBT; the MBT and the Corporate Income Tax would later replace it. In February, the Michigan Court of Appeals (COA) ruled in AK Steel Holding Corp. that for tax years 2005-07 the mandatory apportionment provisions of the former SBT did not impliedly repeal provisions of Michigan's enactment of the compact that allowed multistate taxpayers to elect to apportion their tax base using the compact election.22 The COC held that it was reasonably possible to construe the SBT and the compact election in harmony with each other. Accordingly, for the tax years at issue, the Legislature gave taxpayers the option of using either the compact election or the SBT apportionment formula in the COC's view. The Michigan COA also confirmed the Michigan COC ruling that the SBT was an income tax, as defined by the compact, but it rejected the Department's arguments that the retroactive repeal of the compact to 2008 extended to tax years at issue under the SBT. The Department had until April 7 to appeal this decision to the Michigan Supreme Court, but it did not do so.23
At the end of March, the U.S. Supreme Court granted the taxpayer's request for an extension until May 29, 2016, to file a petition for certiorari of California's compact election case.24 Procter & Gamble Manufacturing Co. (P&G) has taken over as the lead plaintiff in the case, rather than Gillette Co., and P&G is joined in the litigation by Kimberly-Clark and Sigma-Aldrich Inc. In their extension request filing, P&G argued that the compact “guarantees” that the taxpayer can choose to use the neutral UDITPA apportionment formula.25 Whether the high court will grant the cert. petition remains to be seen.
What all of this means to taxpayers, state governments and the MTC is a very good question. We suspect that the ultimate answer may be, “not much.” With a potential appeal to the U.S. Supreme Court by P&G still in the wings and a number of state appeals still pending, we will have to wait for the final shoe to drop. The issue of Federal supremacy under the compact clause of the U.S. Constitution has not gotten much traction from the state courts, under the current facts, but some taxpayers continue to hold out hope that someone somewhere may agree with this argument. Lore has it that Chief Justice John Roberts while in private law practice had a particular interest in and had prosecuted a number of compact clause cases and perhaps he may have an interest in considering this case. So until that happens, most of us will move on to the next topic and see if the states can mount an effective attack on Quill.26 See you in court!
1 The Gillette Co. v. Cal. FTB, No. S206587 (Cal. S. Ct. December 31, 2015).
2 The compact was never put before the U.S. Congress for approval.
3 Former Cal. Rev. & Tax Code § 38006.
4 The Uniform Law Commission (ULC, also known as the National Conference of Commissioners on Uniform State Laws), established in 1892, provides states with non-partisan, well-conceived and well-drafted legislation that brings clarity and stability to critical areas of state statutory law. ULC members must be lawyers, qualified to practice law. The ULC's current model UDITPA law (which has not been amended since 1966) can be found at http://www.uniformlaws.org/shared/docs/uditpa/uditpa66.pdf (last accessed April 8, 2016).
5 Cal. Rev. & Tax Code § 25128.
6 Cal. Rev. & Tax Code § 25120 et seq.
7 The Gillette Co. et al. v. Cal. FTB, Nos. CGC-10-495911, CGC-10-495912, CGC-10-495916, CGC-10-496437, CGC-10-496438, CGC-10-499083 (Cal. Super. Ct. San Francisco City & County 2011).
8 The Gillette Co. et al. v. Cal. FTB, 209 Cal. App. 4th 938 (Cal. Ct. App., 1st Dist. Oct. 2, 2012) rev'd.
9 Cal. Const., art. IV, § 9.
10 Northeast Bancorp. v. Board of Governors, FRS, 472 U.S. 159 (1985).
11 Cal. Rev. & Tax Code § 25128(a).
12 Graphic Packaging Corp. v. Hegar, No. 03-14-00197-CV (Tex. Ct. App. July 28, 2015).
13 Graphic Packaging Corp. v. Hegar, No. 15-0669 (Tex. S. Ct. petition for review filedSept. 3, 2015).
14 Health Net, Inc. v. Or. Dept. of Rev., No. TC 5127 (Or. Tax Ct. Sept. 9, 2015).
15 Or. Rev. Stat. §314.606.
16 Id. §305.655.
17 Health Net,Inc. v. Or. Dept. of Rev., No. TC 5127 (Or. Tax Ct. Sept. 9, 2015).
18 Health Net, Inc. v. Or. Dept. of Rev., No. 0603625 (Or. S. Ct.).
19 Kimberly-Clarke Corp. v. Minn. Comr. of Rev., No. A15-1322 (Minn. S. Ct., oral arguments held Jan. 11, 2016).
20 IBM v. Mich. Dept. of Treas., No. 146440 (Mich. S. Ct. July 14, 2014).
21 IBM v. Mich. Dept. of Treas., No. 11-000033-MT (Mich. Ct. Cl. April 28, 2015). This case has been appealed to the Michigan Court of Appeals.
22 AK Steel Holding Corp., et al. v. Mich. Dept. of Treas., No. 327175 (Mich. Ct. App. Feb. 25, 2016).
23 Amy Hamilton, State Tax Notes, Tax Analysts, Michigan Treasury will not appeal Compact ruling in favor of SBT taxpayers (April 8, 2016).
24 Procter & Gamble Mfg. Co. v. Cal. FTB, No. 15A967 (U.S. S. Ct. extension grantedMarch 28, 2016).
25 Laura Mahoney, U.S. Supreme Court Grants Extension in 'Gillette’ Case, Daily Tax Report, Bloomberg BNA (March 30, 2016).
26 Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
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