The Multistate Tax Compact on Trial: Franchise Tax Board Files for California Supreme Court Review in ‘Gillette’ Case

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

By J. Pat Powers and Amanda Kottke

J. Pat Powers is a tax partner in the Palo Alto, Calif., office of Baker & McKenzie LLP. Powers focuses his practice on state tax planning and controversies.

Amanda Kottke is a tax associate in the Palo Alto, Calif., office of Baker & McKenzie LLP, where she advises on all areas of domestic and international tax law, with a particular focus on the structuring of international operations, high-technology tax issues, and federal income tax controversies.

The California Franchise Tax Board (FTB) Nov. 13 filed a petition with the California Supreme Court requesting review of the California Court of Appeal's decision in Gillette Co. v. Franchise Tax Board.1

Reflecting the far-reaching impact of the case, tax authorities from three other states (Utah, Oregon, and Idaho) submitted letters to the California Supreme Court supporting the FTB's petition for review.

Taxpayers filed their answer to the petition for review Dec. 3, laying out the reasons why the California Supreme Court should not grant review of the “thorough, well-reasoned and unanimous opinion” of the Court of Appeal. Taxpayers' answer defends the reasoning of each of the three independent grounds upon which the Court of Appeal opinion rests: well-settled compact law; impairment of contacts; and the reenactment clause of the California Constitution. According to taxpayers' answer, the FTB's petition “raises no serious question that any of these holdings was incorrect or that review is necessary.”

The final resolution in Gillette has huge implications for California taxpayers. According to the FTB, more than $750 million in refund claims may exist and approximately 80,000 tax returns per year could be affected.

The California Supreme Court has 90 days from the receipt of the FTB's petition to grant or deny review. If at least four of the seven justices vote in favor of review, the case will be heard by the court.

The FTB's petition follows other recent developments in California's apportionment law, including the passage of Proposition 39 on Nov. 6 and California's withdrawal from the Multistate Tax Compact during the summer.2 Unfortunately, these developments leave taxpayers with more questions than answers.


“One must lie low, no matter how much it
went against the grain, and try to understand that
this great organization remained, so to speak, in a state of delicate balance, and that if someone took it upon himself to alter the dispositions of things around him, he ran the risk of losing his footing and falling to destruction, while the organization would simply right itself by some compensating reaction in another part of its machinery--since everything interlocked--and remain unchanged, unless, indeed, which was
very probable, it became still more rigid, more
vigilant, severer, and more ruthless.”



Franz Kafka, The Trial

Given the uncertain landscape of apportionment law in California, taxpayers must take care to preserve their rights to California tax refunds, while remaining mindful of their options for future filings.

This article attempts to make sense of the recent developments in California's apportionment law, and piece together the consequences for California taxpayers. The article also touches on the implications for other state tax regimes.

History of Apportionment Law

Any state tax imposed on a multistate business must be “fairly apportioned.”3 In 1957, the Uniform Law Commission promulgated the model Uniform Division of Income for Tax Purposes Act (UDITPA) setting forth, among other things, a three-factor equally weighted formula to allocate and apportion income to a specific state based on property, payroll, and sales receipts.

Until the mid-1960s, states largely ignored UDITPA. However, in 1965, Congress took up the issue of state uniformity, creating a special subcommittee (the “Willis Committee”) to study state business taxes.4

The Willis Committee reported a lack of uniformity within state tax practices, and recommended federal action to establish uniformity.5 Worried about federal legislation restricting the ability of states to tax, many states adopted UDITPA's three-factor formula directly into their statutes.

The Multistate Tax Commission

Continued concern over state sovereignty led states to form the Multistate Tax Commission (MTC). The authorizing instrument, the Multistate Tax Compact (the Compact), created the MTC as an administrative agency to promote uniformity and comparability of state tax systems and avoid duplicative tax.

The Compact set forth a uniform set of standards, which member states adopted. Among its provisions, Article IV of the Compact set forth UDITPA's equally weighted three-factor apportionment formula. Article III provided taxpayers in member states with the option of apportioning and allocating income by applying the Compact's three-factor formula or by applying an alternative apportionment formula adopted by the state.

California Apportionment Law

California joined the MTC and enacted the Compact in 1974, including the provisions on apportionment.6 The Compact formula aligned with California's existing apportionment law, enacted in 1966.7

This three-factor formula remained in place until 1993 when California revised its apportionment method to double-weight the sales factor, making sales one-half (rather than one-third) of the apportionment equation.8 The goal of this double-weighted sales formula was to encourage economic development by reducing the tax burden from locating jobs and investment in California and increasing tax on “out-of-state” corporations exploiting California's market.

As amended in 1993, California Revenue and Taxation Code Section 25128 provided:  

Notwithstanding Section 38006 [the Compact], all business income shall be apportioned to this state by multiplying the income by a fraction, the numerator of which is the property factor plus the payroll factor plus twice the sales factor, and the denominator of which is four ….



The amended statute required taxpayers to apply the double-weighted sales factor formula unless the business earned more than 50 percent of its gross receipts from financial, agricultural, or extractive activities (i.e., businesses described in Section 25128(c)), which were required to apply the equally weighted three-factor formula.

Overview of 'Gillette v. FTB'

Despite the statutory four-factor formula, Gillette Co. and similarly situated taxpayers sought to apportion California income under the evenly weighted three-factor formula provided for under the Compact. The taxpayers filed refund claims and, when denied, filed suit for the tax refunds, asking the court to rule on the significance of California's “ratification and approval” of the Compact.

The taxpayers argued that California Revenue and Taxation Code Section 25128(a) (the double-weighted sales formula) did not repeal and could not override the option of using the three-factor formula under the Compact.

The Court of Appeal Oct. 2 ruled in favor of the taxpayers, holding that the California Legislature could not “override and eliminate” the section of the Compact that allowed taxpayers to elect the Compact formula. The court concluded that the “Compact is both a statute and a binding agreement among sovereign signatory states [and] having entered into it, California cannot, by subsequent legislation, unilaterally alter or amend its terms.”

The FTB argued that California withdrew from the Compact when it adopted the double-weighted sales factor formula. The Court of Appeal dismissed this argument, noting that such action would violate federal and state constitutional prohibitions against impairment of contracts and California's own constitutional requirements regarding the reenactment of statutes.

With its ruling, the Court of Appeal opened up the door for taxpayers to file refund claims for open years to apply the Compact's equally weighted three-factor formula.

Legislative Response to 'Gillette'

In anticipation of an adverse decision in Gillette, California's Legislature June 27 passed S.B. 1015. With S.B. 1015, California withdrew from membership in the MTC.

The bill also wrote into law a retroactive requirement that any election affecting a taxpayer's computation of tax must be made on an original timely filed return. This election requirement, known as the “doctrine of elections” if applicable, would prevent taxpayers from filing refund claims or amending returns to elect alternative apportionment formulas, such as the three-factor Compact formula.

The validity of S.B. 1015 has been called into question. The Legislature passed the law by a simple majority rather than the two-thirds majority required for a tax increase in California. California law requires a two-thirds legislative vote for “any change in state statute which results in any taxpayer paying a higher tax.”9

The definition of a tax includes any “levy, charge or exaction of any kind” paid by taxpayers.10 The state of California bears the burden of proving by a preponderance of the evidence that a levy, charge, or other exaction is not a tax.

S.B. 1015 stands as a backstop to prevent apportionment using the three-factor Compact formula. If the California Supreme Court upholds Gillette, challenges to S.B. 1015 are expected.

Implications of 'Gillette' Case

The opinion in Gillette has major implications for California taxpayers. In addition to invalidating the mandatory nature of California's double-weighted sales factor, the Gillette case also calls into question any legislation, regulation, or practice that requires treatment contrary to that allowed under the Compact.

For example, the Gillette decision threatens the validity of California's special industry regulations. Under California Revenue and Taxation Code Section 25137, California developed specific apportionment regulations for certain industries (including, for example, contractors, franchisors, commercial fishermen, railroads, motion picture producers, and television film producers). Depending on the legitimacy of S.B. 1015, taxpayers historically required to report under these special industry-specific formulas may be able to amend open years to apportion based on the Compact's three-factor formula.

As the court in Gillette noted, the option to use the standard three-factor formula “… is one of the Compact's key mandatory provisions designed to secure a baseline level of uniformity in state income tax systems, a central purpose of the agreement.”

California has enacted several other provisions arguably in conflict with the Compact, and taxpayers may have a basis for challenging these provisions as well. For example, the statutory exclusion of treasury and hedging receipts in California Revenue and Taxation Code Section 25120(f)(2) may be subject to challenge. In addition, regarding the inclusion of sales by affiliates protected by Pub. L. No. 86-272, California resolved its long history of flip-flopping between the Joyce and Finnigan approaches by statutory enactment of the Finnigan method. Taxpayers benefiting from the Joyce rule may have a basis to challenge this provision.

Voters Change California's
Apportionment Law

In another interesting twist on California's apportionment law, California voters Nov. 6 passed Proposition 39. The measure requires application of a single sales factor apportionment formula for all multistate businesses (except agricultural, extractive, or financial businesses) doing business in California, for taxable years beginning on or after Jan. 1, 2013. Proposition 39 would change California's elective apportionment rules.

In 2009, California adopted an elective single-sales factor formula available to multistate businesses for taxable years beginning on or after Jan. 1, 2011. Proposition 39 eliminates this election by requiring use of the single-sales factor formula and market-based sourcing. Whether the measure will take effect is likely dependent on the outcome in Gillette, and potentially the validity of S.B. 1015 as well.

Practical Considerations For California Taxpayers

The recent developments in California's apportionment law leave uncertainty surrounding practical application for California taxpayers.

Because the Gillette decision is not a final determination, the FTB has taken the position that taxpayers may not rely on the decision to avoid penalties. More specifically, the FTB stated that if the holding in Gillette is subsequently reversed or vacated, corporate taxpayers filing in reliance on Gillette (i.e., apportioning based on the Compact's three-factor formula) will face California's 20 percent large corporation underpayment penalty (LCUP) for understatements of tax in excess of $1 million in a taxable year.

Although the FTB issued guidance on filing protective refund claims under Gillette, the FTB position is that such claims are not valid under the doctrine of elections.11 The FTB will accept protective claims from taxpayers that retroactively elect the three-factor Compact method; however, the FTB will take no action on these claims until Gillette reaches final resolution.

If the California Supreme Court grants review, as it is predicted to do, a decision is not expected for many months. In the meantime, California taxpayers are in a difficult position of having to file returns and calculate apportionable income in California where the method to apply remains uncertain.

Despite the Kafkaesque outlook, in many situations, there may be ways to mitigate these risks while protecting the right to utilize alternative apportionment options that may be available.

Challenges in Other States

For other states that are members of the MTC, all eyes are on Gillette. Similar challenges based on the Compact have already been mounted in Michigan,12 Texas, and Oregon. A decision from the California Supreme Court upholding the taxpayer's right to elect the three-factor Compact formula will certainly add legitimacy to taxpayer challenges arguing for the Compact formula in these as well as other MTC states.

1 Gillette Co. v. Franchise Tax Board, No. A130803 ( Cal. Ct. App., 7/24/12; aff'd on reh'g 10/2/12).

2 S.B. 1015 (June 27, 2012).

3 Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977). A state tax will be sustained against a Commerce Clause challenge if it: (1) is applied to an activity with a substantial nexus with the taxing state; (2) is fairly apportioned; (3) does not discriminate against interstate commerce; and (4) is fairly related to the services provided by the state.

4 Pub. L. No. 86-272, tit. II, 73 Stat. 555 (1959).

5 The Willis Committee's study was sanctioned by Pub. L. No. 86-272, tit. II, 73 Stat. 555, 556 (1959).

6 CR&TC Section 38006.

7 CR&TC Section 25120 et. seq.

8 CR&TC Section 25128.

9 Cal. Const., Art. XIIIA, Section 3.

10 Cal. Const., Art. XIIIC, Section 1.

11 FTB Notice 2012-1 (Oct. 5, 2012).

12 The Michigan Court of Appeals affirmed a decision in favor of the Michigan Treasury finding the Michigan Legislature intended to override, and in fact repealed by implication, the election provisions available under the Compact when it enacted the Michigan Business Tax. IBM Corp. v. Michigan Department of Treasury, Mich. Ct. App. No. 306618 (Nov. 20, 2012).

Copyright 2012, The Bureau of National Affairs, Inc.

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