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By Tripp Baltz
Jan. 12 — The recent ruling by the California Supreme Court in a much-watched case on calculation of corporate income and excise taxes represents a pivot point in the debate over whether companies can elect to apportion their business income according to the three-factor formula provided in the Multistate Tax Compact, tax practitioners told Bloomberg BNA.
The court ruled Dec. 31 in Gillette Co. v. Franchise Tax Bd. that the California Legislature can preclude corporations from using the business income apportionment provisions of the compact. It was the first decision by a state high court to address the question of compact election directly.
The California Gillette decision might influence the outcome of court cases related to the compact election pending in Michigan, Minnesota, Oregon and Texas, although each case is different and includes unique state statutory and constitutional issues, sources told Bloomberg BNA.
“I would think the other four states would look to it for guidance,” said Steven Wlodychak, a principal with EY LLP's indirect state and local tax practice. “But each of the states is sovereign and independent of one another.”
Taken together, the Gillette ruling and the cases pending in the other states raise significant questions about the compact, drafted 50 years ago. If the ultimate legal consensus is that the compact is a voluntary agreement that isn't binding on its members, practitioners say, will such rulings ultimately render the compact incapable of achieving its chief purpose of state tax uniformity?
Issuing its 7-0 decision on the last day of 2015, the California Supreme Court court said lawmakers “may properly preclude a taxpayer from relying on the compact's election provision.” In so ruling, the court held that the compact isn't binding on its members, but is rather an “advisory” agreement containing apportionment provisions “which are more in the nature of model uniform laws.”
California is saying, in effect, “the compact is nothing more than a state statute that can be amended at will by a legislature,” Richard Pomp, a professor at the University of Connecticut School of Law, told Bloomberg BNA Jan. 5. “A state adopting the compact has no obligation to any other state to maintain the integrity of the compact. There is no obligation to any other state, which implicitly rejects the contract argument the taxpayers made below in California as well as before the Oregon Tax Court.”
If the other states ultimately rule in a manner similar to the California Gillette decision, it could mean that states—and the Multistate Tax Commission (MTC), an intergovernmental state tax agency created in 1967 to administer the compact—have turned a corner in legal battles over compact election, sources told Bloomberg BNA.
After the ruling, the MTC issued a statement noting the Gillette court found the commission isn't a regulatory body with the power to regulate taxation in the member states. Additionally, the MTC said, “the compact does not require its members to take any reciprocal action in order to carry out its purposes” and “each member is free to modify or repeal its laws unilaterally.”
The ruling means the MTC “is a voluntary organization of its members, who pay dues, participate in various ways in the commission's work and are subject to the rules the commission establishes for membership,” Pomp said. “States are free to come and go as they wish, and the commission is free to decide whether a state is a member or not.”
After the ruling, Joe Huddleston, who was executive director of the MTC for 10 years before leaving in August to become executive director of EY LLP's National Indirect Tax group, told Bloomberg BNA that “the compact question is seemingly going to be ending more with a whimper and not with a bang.”
“The question being litigated is, does being a member of the compact bar a state from being able to alter tax policy on its own?” Huddleston said. “Courts have said no, it's not that kind of compact.”
Going forward in 2016, “the discussion of compact election will largely be off the board, although it will be interesting to see how these cases wind up,” he said.
Several key legal issues remain in the wake of Gillette. Gillette and five other multistate corporate entities—Procter & Gamble Manufacturing Co., Kimberly-Clark Worldwide, Sigma-Aldrich Inc., RB Holdings (USA) Inc. and Jones Apparel Group—are now raising questions about the ruling's implications for the federal contract clause and compact law more broadly, and say they will seek answers in their appeal to the U.S. Supreme Court.
The ruling could cause problems for other multistate compacts with similar terms, the companies said. PricewaterhouseCoopers LLP estimates there are more than 200 interstate compacts in the country.
Another major question that remains is the future of state tax uniformity.
“Uniformity clearly seems to be dead” as an aim of the compact, Mark Nachbar, principal in the Chicago office of Ryan LLC, told Bloomberg BNA.
The compact “really was formed initially on behalf of both taxpayers and states trying to come up with something uniform and reflecting fairness across the various jurisdictions, and now that's clearly gone away,” he said. Proponents of the compact “are really more proponents of states' rights to tax income however they want to, even if that undermines uniformity.”
Nachbar said the ruling that the compact is “not binding” contradicts the history as to why and how the compact was formed “and why the federal government did not move forward” with its own uniformity mandate.
The compact was always intended to be binding, and for the states and the MTC to argue otherwise is “revisionism,” he said. “I don't know how the MTC and the states can make that argument with a straight face.”
Pomp said the California ruling wasn't surprising “given the tenor of the oral arguments” made in early October. The justices asked probing questions of the attorneys representing the six corporations. The plaintiffs were seeking $34.6 million in refunds, but the total exposure of pending claims filed with the California Franchise Tax Board by thousands of taxpayers was estimated to be in excess of $750 million.
The justices seemed to be skeptical of the taxpayers' argument that the compact binds California, as a compact member, to allowing companies to use the three-factor formula based on their property, payroll and sales in the state instead of single-sales-factor weighting, an approach that most states are moving toward or have already adopted, Pomp said.
Sources told Bloomberg BNA that the U.S. Supreme Court isn't likely to take up the case. For the court to do so, there would have to be some division in state rulings. While the Michigan Supreme Court found in favor of the taxpayer in Int'l Bus. Machs. Corp. v. Dep't of Treasury, 2014 BL 196103, 852 N.W. 865 (2014), that ruling has been rendered irrelevant by the state Legislature, and the case hasn't been appealed, practitioners said.
“The Supreme Court could wait until a split develops or at least until other state supreme courts have chimed in,” Pomp said. For the sake of the plaintiffs' attorneys “who have been passionate and tireless defenders” of the taxpayer right to an election, Pomp said, he hopes the court will be “intrigued” by the Gillette case.
But because Gillette is the only state supreme court case to date that addresses the compact issue directly, the case is less likely to be granted certiorari “than if there were a split among the highest courts,” he said.
The discussion of whether the compact is binding on the states reaches back to the early years of states' pursuit of uniformity with respect to taxation of business entities.
Following the U.S. Supreme Court's decision in Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. 450 (1959), which prohibits a state from taxing the income of a corporation with limited business activities within the state, Congress created a special subcommittee that became known as the Willis Committee to study the taxation of interstate business income and to propose federal legislation establishing uniform corporate income tax standards among the states.
The Willis Committee issued its report in 1964, recommending that all corporate income be apportioned to the states by a two-factor formula based on property and payroll attributed to the state, with no provision for state-specific formulas and with no factoring in of sales.
Having companies apportion their business income based on property and payroll reflected a state taxation purpose that was “more true,” Nachbar said. “It was based on who maintained a physical presence in the state, and the idea you have to pay for the services you receive,” he said. The recent trend of states going to a single sales factor for apportionment turns that idea “totally on its head,” he said.
Now a majority of states are moving toward single sales factor apportionment “because they see it as an economic development tool, and because it generates more revenue for the state,” he said. “The theory is you are paying for the market element instead of paying for the services you receive. It favors in-state companies, essentially rewarding them for moving into the state, and meanwhile out-of-state companies have no vote. It's taxation without representation.”
In Minnesota, “the business community did approach the Legislature to adopt single sales because many other states have done it, but also to encourage companies to create jobs and add locations in Minnesota while being taxed only on sales,” Dale Busacker, state and local tax director in Grant Thornton LLP's Minneapolis office, told Bloomberg BNA.
The Willis Report also expressed some doubt that any real uniformity could be attained by state action alone, and it recommended giving the Treasury Department authority to issue uniform rules and regulations governing state income taxes. Several bill proposals cropped up in Congress.
In this same time period, the National Conference of Commissioners on Uniform State Laws approved the Uniform Division of Income for Tax Purposes Act (UDITPA), which stated, in its prefatory note, that there was a “need for a uniform method of division of income for tax purposes among the several taxing jurisdictions.”
Seeking to craft a state solution as an alternative to federal legislation mandating uniformity, the National Association of Tax Administrators held a special meeting that resulted in the creation of Article IV of the compact, concerning division of income, and the establishment of the MTC.
Approval of the compact staved off attempts at congressional intervention. After the compact, although several federal proposals were introduced in Congress, none was enacted.
In its more recent arguments, the MTC isn't contending “the history is irrelevant,” Helen Hecht, general counsel for the commission in Washington, told Bloomberg BNA. “There was a sense that the compact would be the basis for a federal bill, and it would have improved the compact. All that does in my mind is show that while there were some states who thought that we might have to have this as the foundation for federal legislation, that's not how history turned out.”
Nachbar said Congress would have acted if it thought the compact wasn't binding. “The federal government did not move forward because the compact was intended to be binding on the states.”
The California Legislature repealed the three-factor apportionment formula in 1993 (Cal. Rev. & Tax Code Section 25128) and adopted a double-weighted sales factor, but didn't withdraw the state from the compact. The Gillette plaintiffs filed complaints with the Franchise Board for the refund of taxes, saying they had each elected to compute their apportionable business income using the three-factor formula. The Legislature's adoption of the double-weighted factor didn't override the compact's three-factor formula, they said. The Franchise Board denied their claims.
The trial court consolidated the six cases and ultimately ruled that the Legislature “clearly express[ed] an intention to take away the alternative” three-factor formula, and that it could repeal the formula without withdrawing the state from the compact. The parties appealed to the California Court of Appeals.
In June 2012, following arguments before the appellate court, California withdrew from the compact. Later that year, voters approved Proposition 39, moving the state to a single-sales-factor apportionment formula effective Jan. 1, 2013.
The Court of Appeals then vacated the lower court's decision, concluding the compact is a valid multistate compact and California was bound by it and its apportionment election provision. The Franchise Board appealed that decision, resulting in the latest ruling, a reversal of the appellate judgment by the state supreme court.
Similar questions are in play before the Minnesota Supreme Court, which heard oral arguments Jan. 11, although there are some key distinguishing elements in the case (Kimberly-Clark Corp. v. Comm'r of Revenue, Minn., No. A15-1322, oral arguments, 1/11/16).
The state high court is reviewing a decision of the Minnesota Tax Court, which in June 2015 rejected Kimberly-Clark's arguments that the state was bound by provisions of the compact. The Tax Court also upheld the state revenue commissioner's denial of the company's filing for a refund of $1.2 million after it used the three-factor apportionment election and formula under Articles III and IV of the compact.
The state Tax Court said the state didn't cede its taxation powers when it joined the compact in 1983. The court rejected the Minnesota Department of Revenue's claim that the compact was only a model law with only an advisory effect; it wrote that under the “unmistakability doctrine,” government contracts must be strictly construed against the relinquishment of sovereign powers.
None of Kimberly-Clark's submissions identify any compact provision that satisfies the unmistakability doctrine, it said.
Further, the compact contains no language that says Minnesota laws that conflict with it are superseded or that the actions of the Multistate Tax Commission are binding on the state, the court said. The absence of such language, it said, counts heavily against the company's interpretation that the state surrendered its sovereign powers in agreeing to the compact.
“It is a contract the state can change,” Busacker said. “One issue is whether the Legislature can repeal parts of the compact, but not withdraw from the contract,” he said. Following the California Court of Appeals ruling against the California Franchise Tax Board, Minnesota repealed the compact in 2013.
Busacker said he expects the Minnesota Supreme Court to issue a ruling within 90 days of oral arguments.
Michigan is the sole state to have a supreme court ruling in favor of the taxpayer, but, because the state hasn't appealed that ruling, there is no question for the U.S. Supreme Court to consider, sources told Bloomberg BNA. Additionally, the state's situation involves compelling questions about Michigan's attempt to retroactively repeal its membership in the compact.
The Michigan Supreme Court in IBM Corp. v. Dep't of Treasury ruled IBM could elect to use the three-factor apportionment formula under the compact because the state Legislature had only repealed the state's compact election provision effective Jan. 1, 2011. Although the ruling isn't on appeal, the state Legislature responding to it by passing an act repealing the state's compact provision retroactively to Jan. 1, 2008. That act essentially rendered the court's ruling in IBM irrelevant.
Also since then, the state court of claims has dismissed refund claims based on the new law. For that reason, taxpayers—including Gillette—have challenged the validity and constitutionality of the act of the Legislature (2014 P.A. 282), especially with regard to its retroactive application. In addition to repealing Michigan's compact provision, 2014 P.A. 282 withdrew the state as a member of the MTC.
In Gillette Comm. Operations N. Am. v. Dep't of Treasury, the Michigan Court of Appeals consolidated 50 appeals by corporate taxpayers—seeking total refunds in excess of $1 billion—and upheld the retroactive repeal of Michigan's membership in the compact. That appellate ruling is now before the Michigan Supreme Court.
Steven Grob, a member of Dykema Gossett PLLC in Detroit, told Bloomberg BNA the Michigan Supreme Court has yet to grant the appellants the right to have their case heard before the court. “The pleadings to get it before the Supreme Court have only recently been filed,” he said.
In other cases, the Michigan Supreme Court has vacated appellate decisions favorable to the taxpayer and remanded them for consideration in light of 2014 P.A. 282.
In Texas, the question before the state Supreme Court isn't directly a compact election issue, but it concerns a taxpayer—Graphic Packaging Corp.—which filed a refund claim for tax years 2008, 2009 and 2010 based on its election to use the three-factor apportionment formula. A district court entered judgment in favor of the state on the basis that the Texas Franchise Tax isn't an income tax (Graphic Packaging Corp. v. Hegar, Tex., No. 15-0669, petition for review filed, 12/14/15).
When the Texas Court of Appeals reviewed the case, it further found that the Texas Franchise Tax isn't “a tax imposed or measured by net income,” concluding that the three-factor apportionment formula under Texas' compact provisions wasn't an alternative available to the company. The court held that the taxpayer is required to use the single-factor formula applicable to the franchise tax. Graphic Packaging has appealed the ruling, which is now pending before the Texas Supreme Court.
The case in Oregon is the least far along, Hecht said. The parties in the case “seem to think the briefing before their Supreme Court wouldn't get started until late spring,” she said. “They could hear argument in 2016, but it's less likely than in the other states.”
The Oregon case has strong parallels with the California Gillette case. In October, Health Net Inc., a managed care organization based in Woodland Hills, Calif., appealed the Oregon Tax Court's denial of the company's bid for a refund of corporation excise taxes to the Oregon Supreme Court.
Health Net elected to use the three-factor apportionment formula under Oregon's compact provisions for the 2005, 2006 and 2007 tax years on amended returns (Health Net, Inc. v. Dep't of Revenue, 2015 BL 291105,Or. T.C., No. TC 5127, 9/9/15).
In October 2012, Health Net's refund claims were specially designated for a hearing in the Regular Division of the Oregon Tax Court. One year later, in October 2013, Oregon repealed apportionment under the compact.
The Tax Court then ruled the Oregon Legislature intended to disable the compact election, and such an action didn't violate constitutional limitations. While the appeal is now pending before the state Supreme Court, Oregon remains a member in good standing in the MTC.
The issue of Health Net's amended returns is an interesting wrinkle in the case, Hecht told Bloomberg BNA. “The question of whether you can elect it as an alternative in an amended return is an issue that hasn't gotten much play,” she said.
As in the California Gillette case, if the taxpayers lose at the state Supreme Court level, they are expected to appeal to the U.S. Supreme Court. On state tax policy, courts tend to defer to the legislatures, Wlodychak said. “They don't want to step into the shoes of legislators in setting tax policy. So long as lawmakers are not treating taxpayers harshly or oppressively, courts don't want to wade into that,” he said.
While the cases proceed, the MTC's Uniformity Committee continues its work on model regulations, Hecht said. At present, it is moving forward with model market-based sourcing regulations and related regulatory definitions with a goal of advancing the regulations through the promulgation process for the MTC's adoption at its annual meeting in July 2016. The committee approved the draft regulations Dec. 10, 2015.
Pomp said the Gillette ruling will have “no effect” on the MTC's continued efforts at reforming UDITPA “and its Herculean efforts at reforming regulations.”
In the future, as more courts decide cases with the conclusion the compact isn't binding on states, crafting model regulations is the work the MTC will be doing with respect to uniformity, Huddleston told Bloomberg BNA.
“Uniformity at a different level is still desired,” Huddleston said. “It will be focusing more on regulations than statutes. I think the states have seen the strong value of the MTC, which clearly began on the concept of providing uniform and model statutes. The real benefit that has grown out of that is the benefit of states acting together,” he said
“If you want to get to full uniformity, the only way to do that is to get a federally mandated compact on state taxes,” Wlodychak said. “The irony is, I think we are going toward uniformity,” he said, especially now with more states moving to single-sales factor apportionment. “I think it's been that way since 1967.”
With assistance from Laura Mahoney in Sacramento, Calif., and Cannon-Marie Green in Washington.
To contact the reporter on this story: Tripp Baltz in Denver at email@example.com
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