Philip Morris Asks California for Lower Tax Bill

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By Laura Mahoney

Tobacco giant Philip Morris USA Inc. is asking California tax authorities for an exception to rules that base corporate income tax liability solely on the amount of sales in the state because it says the rules don’t accurately represent its business.

The company’s petition for an alternative income apportionment formula is the first public test of a 2013 law that shifted California from a formula based on sales, property, and payroll in the state to one that just measures sales. The three-member Franchise Tax Board will weigh the petition for the 2013 tax year at a June 15 hearing.

Philip Morris is using a petition mechanism under California Revenue and Taxation Code Section 25137 to claim the state must consider its business activity in its home state of Virginia and other states.

The FTB staff argues the company’s state tax liability of $35.5 million on $1.8 billion in California sales in 2013 is reasonable and is expected to be higher under the new formula that focuses solely on a company’s market in the state.

National Trend

When California switched to single-sales factor apportionment, it stopped allowing taxpayers to use a formula that compared property, payroll, and double-weighted sales in the state to those factors elsewhere. California’s switch was part of a national trend among states to look only at sales as a way to favor companies that locate and employ people inside their borders.

Philip Morris isn’t asking to use the previous formula, but is asking the FTB to use an unusual formula that compares sales, payroll, and double-weighted property factors in California to those factors elsewhere to account for its manufacturing operations in Virginia. If the FTB would allow the formula it proposes, Philip Morris’ income subject to California franchise tax in California would drop to 2.6 percent from 7.7 percent.

In its petition, the company argued that excluding property and payroll from its income apportionment formula creates distortion because it unfairly excludes the factors that are “causally related to the production of income.” The company said it has highly specialized equipment and 2,200 employees at its main Virginia campus.

Heavily Regulated

Distortion under the single-sales factor formula is aggravated in Philip Morris’ case because the tobacco industry is heavily regulated, the company said. For example, the industry is barred from advertising on billboards, public transportation, radio, television, and major magazines. In addition, the company doesn’t sell directly into the state but uses a network of third-party distributors.

The point of the alternative formula petition rules is to allow relief when the statutory formula doesn’t fairly represent a company’s activities in the state, the company said. If the FTB doesn’t allow an alternative, it would nullify the ability of taxpayers to petition.

“The FTB’s argument implies that the single-sales factor itself defines what is fair,” the company said. “But that cannot be correct, because it would render section 25137 a nullity; under that logic, no petition, either by the state or by a taxpayer, would ever succeed.”

Business Activity

In its brief, the FTB staff said the tax agency and Philip Morris have a fundamental disagreement about the meaning of business activity.

“Contrary to taxpayer’s fixation on all the factors contributing to the production of income, business activity reflects and is measured by a taxpayer’s market in the state,” the FTB said. “The SSF formula, to which 22 states have currently conformed, disregards capital and labor in favor of the market only.”

Voters in 2012 approved Proposition 39 to enact mandatory single-sales factor apportionment, with narrow exceptions for some businesses such as banks and financial institutions. It is intentional that Philip Morris, and most other corporate taxpayers, are subject to the exclusion of payroll and property from their apportionment calculation, the FTB said.

Heavy regulation, advertising restrictions, and the use of third-party distributors existed under the apportionment rules before 2013, the FTB said. The state calculates the sales factor using the same method it did before 2013 as well, and Philip Morris accepted it then, the tax agency said.

Unusual Formula

The FTB also pointed out that the three-factor formula with double-weighted property that Philip Morris requests has never been used in California and isn’t used by any other states.

A 7.7 percent apportionment factor under a single-sales calculation is reasonable considering that California has 12 percent of the U.S. population, the FTB said. The percentage change may appear significant, but isn’t based on the market potential in the state.

Philip Morris’ argument boils down to comparing two formulas and saying the one with a higher tax liability is distortive, the FTB said. A percentage difference between two formulas isn’t enough to show distortion, and therefore the company failed to meet its burden under Revenue and Taxation Code Section 25137, according to the tax agency.

“This argument is insufficient for purposes of R&TC section 25137 because the ultimate tax liability will always vary under different taxing schemes, so that difference cannot reasonably evince an unfair reflection of business activity,” the FTB said.

The three FTB members who will hear the petition are state Controller Betty T. Yee (D), Board of Equalization Chair Diane Harkey (R), and Department of Finance Director Michael Cohen. Yee and Cohen may have deputies representing them.

Philip Morris is represented by Jeffrey A. Friedman with Eversheds Sutherland (US) LLP in Washington.

To contact the reporter on this story: Laura Mahoney in Sacramento, Calif., at LMahoney@bna.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bna.com

For More Information

The petitions from Philip Morris and the FTB are at http://src.bna.com/pAJ.

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