The South Carolina Supreme Court recently handed taxpayers an important victory against the imposition of alternative apportionment formulas by state tax authorities. In CarMax Auto Superstores West Coast Inc. v. South Carolina Dept. of Rev., No. 2012-212203 (S.C. Dec. 23, 2014), the court ruled that the party seeking an alternative apportionment formula under S.C. Code Ann. § 12-6-2320(A) bears the burden of proof by a preponderance of the evidence that “(1) the statutory formula does not fairly represent the taxpayer’s business activity in South Carolina and (2) its alternative accounting method is reasonable.”
During the years at issue, CarMax West operated retail used-car stores in the western U.S. It was also a member, and 93.5% owner, of a limited liability company, CarMax Business Services (CBS). CBS held intellectual property and performed corporate overhead functions on behalf of both CarMax West and CarMax East, a related party who operated the same retail used-car stores in the eastern U.S., including South Carolina. Although CarMax West did not otherwise do business in South Carolina, it received pass-through income from CBS that represented intangible income received from payments made by CarMax East to CBS from its operations, in part, in South Carolina.
CarMax West originally filed returns apportioning the income received from CBS based on a standard three-factor formula. Following an audit and assessment, CarMax West filed amended South Carolina income tax returns electing to use one of the special statutory apportionment formulas available, specifically, the gross receipts method found in S.C. Code Ann. § 12-6-2290. Under the gross receipts method, CarMax West apportioned the intangible income based on the ratio of its receipts from financing and intangibles in South Carolina compared to receipts from financing, intangibles and retail sales everywhere. The department rejected this method, imposing an alternative apportionment formula under S.C. Code Ann. § 12-6-2320(A)(4) that excluded the retail sales from the denominator of the calculation.
CarMax West unsuccessfully appealed the department’s determination to an administrative law court (ALC) who found that the taxpayer’s method did not fairly represent its income in South Carolina and that the department’s alternative apportionment formula was reasonable. On further appeal, the South Carolina Court of Appeals reversed the ALC’s decision on the grounds that the ALC had applied the wrong burden of proof. In reaching its decision, the appeals court read Media Gen. Commc'ns., Inc. v. South Carolina Dep. of Rev., 694 S.E.2d. 525 (S.C. 2010) to require that in establishing that an alternative apportionment formula is reasonable, the moving party must demonstrate that the proposed method is “more appropriate than any competing methods.” After both parties applied on writ of certiorari, the South Carolina Supreme Court ruled on both the appropriate burden of proof and the application of that burden to the issue of the alternative apportionment formula.
On the appropriate burden of proof, the South Carolina Supreme Court distinguished Media Gen. finding that the moving party must only establish by a preponderance of the evidence that the proposed alternative formula is reasonable. The court went on to conclude that the evidence submitted by the department to prove that the taxpayer’s structure was “linked with tax minimization strategies” and that the statutory formula resulted in a lower apportionment percentage for CarMax West in comparison to CarMax East was insufficient to support the determination that the statutory formula did not fairly represent the taxpayer’s income in the state as a matter of law.
The CarMax decision clearly puts the South Carolina Department of Revenue on the same footing as taxpayers in carrying the burden in alternative apportionment controversies. It also appears to require the department to demonstrate that a statutory apportionment formula does not fairly represent the taxpayer’s income in the state through means other than establishing its own proposed formula results in a higher tax.
However, assessments by a tax authority are presumptively valid and, in practice, it may still be difficult to get an objective evaluation by a state tax department as to whether the department has met the statutorily required burden of proof. A taxpayer subjected to an assessment based on a departure from a statutory apportionment formula will invariably have to challenge the burden in administrative hearings or before state courts.
It will be interesting to see if the Tennessee Supreme Court follows South Carolina’s lead in establishing a more level playing field for both taxpayers and state tax authorities when it hears the Vodafone appeal next year.
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