### IN THE COURT OF APPEALS OF TENNESSEE AT NASHVILLE Ju ne 25 , 20 09 Ses si on

BEL LSO UTH ADVERTI SI NG & PUBLI SHI NG CORPORATI ON, v. LORE N L. CHUMLEY, COMMI SSI ONER OF REVENUE, ST ATE OF TENNES SEE

Direc t Appeal from the Chancer y Court for Davidson Cou nty No. 04-2232-IVHon. Richard H. Din kin s, Chancellor

No. M2008- 01929-COA-R 3-CV - F iled Augu st 26, 2009

Plaintiff is subject to excise and fra nchise taxes in the State of Tenne ssee. For the five y ear period
at issue the Commi ssioner issued a varia nce pursuant to the Uniform Divis ion of Income for Tax Purposes Act which has been ad o p t ed b y T ennessee. The varia nce enable d the Commi ssioner to alter the taxi ng formula and incre ase the amount of reve nue assessed to plaintiff. Plaintiff filed this

ac t i o n i n Chance ry Court and the Chance llor voided the varia nce. On appea l, we hold that th e Commi ssioner proper ly exercised her discretion in issuing the varia nce. We reve rse the Chance llor and re mand.

Tenn. R. App. P .3 Appeal as of Right; Judg ment of the Chancery Court Reve rsed and Rem anded.

H E R S C H E L P I C K E N S F R A N K S , P.J
., delivere d the opinion of the court, in which D. M I C H A E L S W I N E Y , J
., and J O H N W. M C C L A R T Y , J ., joined.

Robert E. Cooper, J r., Attorney Gene ral and Reporter
, Michae l E. Moore, Solicitor Gene ral, Charles L

. L ewis, Deputy Attorney Gene ral, and J oe C. Peel, Senior Counsel, Nas h v i lle, Tenne ssee, for Appellant, Commissi oner of Revenue

.

J ames W. McB ride, Washington, D.C., and Caroly n W. Schott, Nashville, Tenne ssee, for Appellee
, Be llsouth Advertising & Publis hing Corpor ation.OP INION

The determinative is sue i n this case is whether the def en d ant/ appellant, Tennessee Depa rtment of Revenue (Commissi oner) proper ly issued a var iance pursuant to Tenn. Code Ann. §§ 67-4-2014 and 67-4-2112 which require d plaintiff/appellee Be llSout h Adver tising & Publis hing Corporation (B APCO) to depar t from the standard statutory apportionment formula in deter mining its Tenne ssee excise and fra nchise tax. The y ear s at issue are 1997-2001. The excise and fra nchise
tax statutes curr ently in eff ect g overn th e y ea rs 1 9 99-2001. The excise and fra nchise tax statutes

wer e sub s t an t i al l y re vised and reena cted in 1999. For the 1997-1998 y ear s at i ssue, we aff irm the controll i n g s t at u tes are former Tenn. Code Ann. §§ 67-4-81 and 67-4-910. Howeve r, the parties

corr ectly ag ree d that for the issues under consideration in this case , the p ro v i s i o n s o f the curr ent

ex ci s e and fra

nchise tax statutes and of those repe aled in 1998 are substantially the same. The

curr ent statutes will be utiliz ed with a f ootnote ref

ere nce to the c itations of the repe aled statutes.

Background

Tenne ssee has adopted the Uniform Division o f I n come for Tax Purposes Act (UDI TPA) an d th e Multist ate Tax Commi ssion (MTC) regulations, which provide the allocation and
ap p ortionment provisions for taxpay ers who are taxable in more than one state. The g oal of th e UDI TPA and the Tenne ssee statutes modeled on it is to e nsure that eac h state taxes a n appropr iate portion of a corpor ation’s income, so that no more than 100% of its income will be subject to tax in all jurisdict i o n s. See Donovan Constr. Co. v. Michigan Dept. of Treasury
, 337 N.W.2d 297, 300 (Mich. 1983). As BA PCO conducts business and derive s income in nine states, its income is taxable within Tennessee and in those other states.

Tennes s ee ’s fr anchise and excise taxes are imposed upon all corpor ations for the privileg e of doing business in the state. First Am. Nat’l Bank v. Olsen
, 751 S. W. 2d 417, 421 (Tenn. 1987); Cook Export Corp. v

. King
, 652 S.W .2d 896, 900 (Tenn. 1983). Tenn. Code Ann. § 67-4- 2001 et seq. perta ins to e x cess tax and Tenn. Code Ann. § 67-4-2101 et seq. perta ins to fra nchise 1 2 tax. Tenn. Code Ann. § 67-4-2007 provides for the impositi on of an e x cise tax: 3

(a) All persons, except those having not-for- profit status, doing business in Tenne ssee shal l, without exception other than as provided in this part, pay to the commissioner, annually
, an excise tax, in addition to all other taxes, equal to six and

one half perc en t (6 1⁄2 %) of the net ear nings for the next prec eding fiscal y ear for business done in this state during that fiscal year

.

For merly § 67-4-801 et seq. (Repl. 1998). 1

For merly § 67-4-901 et seq. (Repl. 1998). 2

For merly § 67-4-806 et seq. (Repl. 1998). 3

-2-The Ex cise Tax L aw of 1999 also provides for multis tate taxpay ers like BA PCO to

allocate and apportion their taxable income to Tenne ssee under a statutorily presc ribed formula. The applicable allocation and a pportionment provisions are se t out in Tenn. § 67-4-2010. 4 5

(a) Any taxpay er ha

ving busine ss activities that are taxable both insi de and outside the stat e of Tenne ssee shall allocate or apportion its net ear nings or losses as provided in this part. (b) For purposes of allocation and apportionment of net ear nings or losses under this
part, a taxpay er is taxable in another state if: (1) In that state it is subject to a net incom e tax, a fra nchise tax measure d by net income, a fra

nchise tax for the privileg e of doing business, or a corpor ate stock tax;

or (2) That state has jurisdiction to subje ct the taxpay er to a net income tax reg ardle ss of whe ther, in fa ct, the state doe s or does not.

The Tenne ssee Gene ral Assembly adopted a formula for dividing income among the various states wher e a taxpay er does business based on the UDI TPA. Tenn. Code Ann. § 67-4-2012 6 define s the standard apportionment ratio as a fra ction, the numerato r o f wh ich is the sum of the
proper ty , pay roll and sales fac tors of eac h taxpay er as define d in the statute and the denominator is four (4). Tenn. Code Ann. § 67-4-2012( a). The statute define s eac h fac tor as a f rac tion in which
t h e n u m er ator is the taxpay er' s respe ctive proper ty , pay roll or sales values in Tenne ssee and t h e denominator is the taxpay er' s respe ctive proper ty , pay roll or sales values in all jurisdictions. Tenn. Code Ann. § 67-4-2012( b)-( g ). Of critica l importance to the issues under consideration here are the provisions found in Tenn. Code Ann. § 67- 4-2012(h) and (I ):

h) Sales of ta

ng ible persona l property

are in this st ate, if:

(1) The proper

ty is delivere d or shipped to a purcha ser, other than the United States
g overnme nt, inside this state reg ardle ss of the F.O.B

. point or other conditions of the sale; or

For merly Tenn. Code Ann. 67- 4-809. 4

Tenn. Code Ann. 67-4-2010 was amende d in 2006, howeve r as the amendment applies to 5 tax y ear s beg inning on or afte r January

1, 2006 it has no impli cation her e.

For mally Tenn. Code Ann. § 67- 4-2012. 6

-3-(2) The proper ty is shipped from an of

fice
, store, wa

rehouse , fac tory

or other pla ce of storag e in this state and the pur chase r is the United States g overnme nt.

(I ) Sales, o t h er t h an sales of tang ible persona l proper ty , are in this state, if the earnings-producin g activity is perfor med: (1) In this state; or (2) Both in and outside this state and a g reater proportion of the ear nings- producing activity is perf

ormed in this state than i n an y o t h er state, based on costs of perform ance . (Emphasis supplied).

The parties stipulated that BA PCO’s sales at issue in the case are sales other than sales of tang ibl e p ersona l proper ty and that BA PCO ear

ned its income by providing adver tising service s. They further stipulated that unless a varia nce is proper , the provisions found in Tenn. Code Ann. §§ 67-4-2012( i)(excise) and 6 7 -4 -2 1 11(i) (fr anchise ) for deter mining the numerator of the 7

rec eipts fac tor are applicable

.

Fr anchise & Ex cise Tax Rule 1320-6-1- .34(2) (Ru l e 34) provides definitions and rules contained in Tenn. Code Ann. § 67-4-2012( i) as follows. The rule ref ere nces Tenn. Code Ann. § 67-4-811( i), the for

mer de signation of what is now § 67-4-2012( i) :

(1) In Gene ral. T.C.A. § 67-4-811( i) [now § 67-4-2012( i)] provides for the inclusion in the numerator of t h e s ales fac tor of g ross rec eipts from transac tions other than sales of tang ible persona l property (including transac tions with the United States Gover nment); under this section g ross rec eipts are attributed to thi s s tate if the

ear nings producing activity which g ave rise to the rec eipts is perf ormed wholly within this state. Also, g ross rec eipts are attributed to this state if, with r espec t to a p articula r item of income, the ear ning producing activity is perf ormed within an d wi thout this state but the g reatest proportion of the ear nings producing activity is perf ormed in this state, based on c ost of perf ormanc e.

(2) Earning s Produ ci n g Activity ; Def ined. The term “ea

rning producing activity ” applies to ea ch separ ate item of income and means the transac tions and activity direc tly eng ag ed in by

the taxpay er in the r egular c ourse of its trade or business for the ultimate purpose of obtaining g ains or profit. Such activity does not include
transac tions perf

ormed on behalf of a taxpay er, such as those conducte d on its behalf by an independe nt contra ctor. Acc ording ly
, the ear nings producing activity includes but is not l imited to the following:

For mally Tenn. Code Ann. § 67- 4-911. 7

-4-(a) The rende ring of persona l service s by employ ees or the utiliz ation of tang ible and intang ible proper

ty by the taxpay er in pe rfor

ming a service

. (b) The sale, re ntal, leasing , licensingor other use of re al prope rty

. (c) The re ntal, leasing , licensingor other use of tang ible persona l property

. (d) The sale, lice nsing or

other use of

intang ible persona l property

. The mere holding of intangi ble persona l proper ty is not, of itself, an ear ning producingactivity

.

(3) Cost of Perfor

mance ; Def

ined. The t er m “costs of perf ormanc e” means direc t costs deter

mined in a manner consis t en t with g ener ally acc epted acc ounting principles and in acc ordanc e with acc ept ed conditions or prac tices in the trade or business of the taxpay er.

(4) Application. (a) In Gene ral. Rece ipts (other than fr o m s ales or tang ible persona l proper ty) in
respe ct to a par

ticular e arning s producingactivity are in this st ate if:
1. the ea rning s producingactivity

is perfor med wholly

within this state; or
2. the earning s producingactivity is perfor med both in and outside this state and a
g reater propor

tion of the ea

rning s producingactivity

is perfor med in this state than in any other state, ba sed on costs of pe rfor mance

.

UDI TPA contemplates that at times a taxpay er or the depar tment of reve nues may believe that a varia

nce from the apportionment formula is neede d. Tenne ssee’ s excise and fra nchise
tax statutes and regulations follow UDI TPA’s rec ommended provisions. Tenn. Code Ann. § 67-4- 2014 provides:

(a) I f the tax computation, allocation or apportionment provi s i o n s of this part or

ch ap t er 2 of this title do not fairly repr esent the extent of the taxpay er’ s busine s s activity in this state, or the taxpay er’ s net ear nings, the taxpay er may petition for, or the depar tment thr oug h its de leg ates may require
, in r espec t to all or any part of the taxpay er’ s business activity , if rea sonable: (1) Sepa rate acc ounting;

(2) The exclusion of any

one (1) or more of

the formula f

actor s;

-5-(3) The inclusion of one (1) or more additional apportionment for mula fac tors that will fairly repr esent the tax payer' s business activity in this st ate;

(4) The use of any other method to source rec eipts for purposes of the rec eipts fac tor
or fa ctors of the apportionment for mula numerator or numer ators; or

(5) The employ

ment of any other method to eff ectuate an equitabl e co m putation,
allocation an d apportionment of the taxpay er' s net ear nings or losses that fairly
repr esents the e x tent of the business entity ' s activities in Tennesse e.

The corr esponding regulation to the varia nce s ta tu tes is found at Tenne ssee Rules and Reg ulations, Rule 1320-6-1-.35 (Rule 35) as follows:

(1) In Gene ral. (a) T.C.A. § § 6 7 -1 -911 and 67-4-812 [now Tenn. Code Ann. §§ 67-1- 2014 and 67-4-2012] provide that if the allocation and apportionment provisions do not fairly repr esent the extent of the taxpay er’ s business activity in this state, the taxpay er may petition for or t he Commi ssioner of Re v en u e may require
, in respe ct t o all or any part of the taxpay er’ s business activity , if rea sonable:

* * * *
4. T h e employ

ment of any other method to eff ectuate an equitable allocation an d apportionment of the taxpay er’ s capital and net

ear nings for purposes of comput i ng fra nchise and excise taxes. §§ 67-1-911 and 67-4-812 [now Tenn. Code Ann. §§ 67-1-2014 and 67- 4-2012] permit a depar

ture fr o m the allocation and apportionment provisions only in limit ed and specific case s. §§ 67-1-911 and 67-4- 8 1 2 m ay be invoked only in specific case s wher e unusual fact situations (which o r d in a

rily will be unique and nonrec urring ) produce incong ruous results under the apport ionment and allocation provisions contained in the F ranc hise and Excise Tax L aws.

P leadings

BA PCO filed a complaint to challeng e the assessment of excise and fra nchise taxes for the y ear s 1997 to 2001 ag ainst L oren L

. Chumley in her capa cit y as t h e C o m missioner of Revenue for the State of Tenne ssee on J uly 29, 2004 in the Chance ry Court, pursuant to Tenn. Code

-6-Ann. § 6 7

- 1

- 1801(a) (1)( B)

. In the complaint BA PCO char acte rized itself as eng ag ed in the business 8 of compiling and publishing telephone direc tories pursuant to contra ct s wi t h regulated and other telecommunications providers including Be llSout h Telec ommunications, Inc., which is an aff iliated
corpor ation that provides telecommunications serv ic e s in T e nn e s s e e a n d e ig ht o the r Southern States. BA PCO repr esente d that its reve nues wer e predominate ly derive d from providin g ad v er tising service s for the direc t o ries it published and that these adver tising service s wer e associate d with various functions that wer e all perf ormed outside the state of Tenne ssee. An aff iliated corpor ation of B APCO’s., L . M. Be rry , solicited adver tising sales for the direc tories publ ished by BA PCO in Tenne ssee an d other states. L

. M. Be rry functions as an independe nt contra ctor and is subject to Tenne ssee excise and fra

nchise taxes on its own net ear nings derive d from its a ctivities pe rfor med

on behalf of BA PCO in Tenne ssee. BA PCO likewise eng ag es another aff iliated c o r p o r a ti o n , St e v e ns Gra phics, In c. , as an independe nt contra ctor to print the direc tories BA PCO publishes for distribution in Tenne ssee and other states. Stevens prints a ll of the direc tories outside the state of Tenne ssee. The fi n i s h ed d irec tories are then distributed by an independe nt contra ctor that is not corpor ately

aff iliated with BAPCO.

The complaint stated that followi n g an audit by the Tenne ssee Depa rtment of Revenue
, Audit Depa

rtment, BA PCO rec eived a Notice of Assessment dated May 15, 200 4 for fra nchise and excise taxes for the period beg inning J anuar y 1, 1997 and ending Dec ember 31, 2001. The Notice of Assessment set forth tax liability in the amount of $9,866,769.0 and interest of $3, 243,892.00, for a total of $13,110,661.00. BA PCO’s complaint chal le n g e s th e Notice of Assessment pursuant to Tenn. Code Ann. § 67-1-1801( a)( 1)(B ), based on its position that it corr ectly calc ulated its Tenne ssee tax liability for the t ax p er i o d s at issue by utiliz ing the cost of perf ormanc e meth o dology presc ribed by Tenn. Code Ann. § 67-4-2012( i) and by the rules and regulations promulg ated there under. BA PCO asked the Court for a judgme nt finding that it owes no additional fra nchise or e x cise taxes for the pe riod at issue and f or an a war d of costs, expenses and attorney ’s fee s.

The Commi ssioner filed an answe r and cou n t er cl aim on September 27, 2004, and stated the Commi ssioner’s position that the statutory formula does not operate to fairly repr esent the
extent of BA PCO’s activities in Tenne ssee and that the C ommissi oner was wit hin her s t at u t o ri ly
g rante d discre t i o n t o ap ply a varia nce with respe ct to the tax y ear s at issue. The counter claim
reque sted a judgme nt for the amount of the assessment plus interest, costs, expenses and attorney ’s fee s. The par

ties then conduc ted discovery during 2005 and 2006 and the ca se wa s set for tria l on J anuar y 29, 2007.

BA PCO filed a motion for partial summary judgme nt which addre ssed the threshold issue of whether BA PCO’s sales are sales of tang ible persona l proper ty or if its sales are other than sales of tang ible persona l proper ty

. I t asser

ted that if the Court held that BA PCO’s business was that of selling tang ible persona l proper ty , telephone direc tories, Tenn. Code Ann. § 67-4-2012( h) would

Tenn. Code Ann. § 67-1-1801( a)( 1)(B ) provides a taxpay er the rig ht to file suit ag ainst the 8 Commi ssioner cha lleng ing a tax assessment.

-7-provide the apportionment formula for sourcing BA PCO’s r ece ipts to Tenne ssee. Howeve r, if the

Court held that BA PCO’s business was providing the service of adver ti s i ng to its customers, the individuals and businesses that place adver tisements in the direc tories, Tenn. Code Ann. § 6 7 -4- 2 0 1 2 ( i) w o u ld p r o v ide the applicable apportionment formula based on a cost of perf ormanc e method, but for the issuanc e of a

varia nce.

On the heels of the motion for summary judgme nt, the p ar t i es enter ed into a stipulation that was int ended to make a ruling on BA P C O’ s m o t i o n unnece ssary

. The sti pulation provides:

“B APCO’s sales at issue in the case are sales other than sales of tan gi b l e persona l

proper ty and that BA PCO ear

ned its reve nue by providing adver tising servic es

. Unless a varia

nce is proper under T. C. A

. §§ 67-4-2014, 67-4-2112 and Tenne ssee Reg ulation, Rule 1320-6-1- .35, the statutory provision s fo r deter mining the

numerator of the rec eipts fac tor of the standard apportionment formula for BA PCO

are T. C. A. § 67-4-2012( i) and § 67-4-2111( i). I t is un d er s t o o d an d ag ree d that, from time to time, BA PCO does sell some books which are sales of tang ible persona l
proper ty and which a

re pr operly

included in the numer ator of the rec eipts fac tor.

The Court enter ed a pre- trial order
, which reiter ated the stipulati on the parties enter ed into and set for t h t h e co n t enti ons of BA PCO and the Commi ssioner. BA PCO’s contentions are summarized as follows:

The sole issue in this case is whether the Depa rtment may require BA PCO to depar t from the otherwise applicable statute for sourcing rec eipts to Tenne ssee for purpose of t he sales fac tor in its apportionment formula by issuing a varia nce claiming that the statutory formula does not fairly ref lect BA PCO’s business activity in the state.

The De partment set f

orth two alternative contentions as follows:

First, the Depa

rtment contende d that use of the c ost of performanc e analy sis under Tenn. Code Ann. 67-4-2012( i) was corr ect but that BA PCO’ s co n clusion that most of its perf ormanc e assoc iated with adve rtising wa s outside of Tenne ssee was wrong

. The Depa rtment’s position was that as BA PCO ear ns its Tenne ssee adver

tising reve nues throug h its distribution of the direc tories in Tenne ssee, the rec eipts from adver tising should be place d in the numerator of the sales fac tor. Additionally
, the Depa rtment contende d that the costs paid to BA P C O’ s aff iliates, L

. M. Be rry and B ellSouth, shoul d be included in the c osts of perf ormanc e ana ly sis.

The Depa rtment also contende d, appar ently in t h e alt erna tive, that as BA PCO’s computation of its apportionment formula under Tenn. Code Ann. 6 7 -4-2012( i)(2) did not fairly ref lect its business activity in Tenne ssee, the Commi s sioner proper ly imposed a varia nce of the standard apportionment formula pursuant to statute. The Commi ssioner’s varia nce, which included

-8-BA PCO’s Tennessee adver tising re ceipts in the numerator of the sales fac tor more fairly ref lected BA PCO’s business activity in Tenne ssee than BA PCO’s application of the formula wher ein its cost of per formanc e outside of the state was not include d in the numerator.

The Pretr ial Orde r also set for th the following burdens of proof:

1. BA PCO has the burden of showing whether Tenn. Code An n

. § 67-4- 2012(i)(2) (cost of pe rfor mance for se rvice s) applies.

2. The De partment ha s the burden of showingthat a var iance was prope r.

The Trial

At the trial, BA PCO prese nted evidenc e reg arding its business and descr ibed the flow of work from the sales of adver tising throug h the distribution of the Yellow Pag es to individuals and businesses in Tenne ssee. Ninety -five perc ent of BA PCO’s reve nue is derive d from the delivery of adver tising services to businesses and individuals who advertise i n t h e Ye l l o w page s direc tories. BA PCO provides adver

tising service s for local and nat i o n al businesses. L ocal adver tising in Tenne ssee is solicited and handled by sal es re prese ntatives from the L

. M. Be rry company , a corpor ation, and is subject to Tenne ssee exci s e t ax liability

. In addition to the sale of local adver tising, L

. M. Be rry provides g raphic artwor k service s to the adver

tisers in the direc tory , and during the y ear s at issue, L

. M. Be rry was headqua rtere d in Day

ton, Ohio and maintained one of its
reg ional office s in Br entwood, Tenne ssee. BA PCO prepa res and maintains sales information in its Atlanta office for use by L

. M. Be rry in marke ting to t h e fi v e states cover ed by its sales ag ency contra ct with BA PCO. BAPCO has no sales pe rsonnel in Tenne ssee.

National advertising sales for the Yellow P ag es are handled by cer tified marke ting
repr esentatives located throug hout the United States who sell and place adver tisements fo r big national companies such as U-Ha ul, Her tz and Meineke

. BA PCO’s national adver tising order s are proce ssed from B APCO’s production offic e in Atlanta, Ge org ia.

BA PCO also has a production office in Birmingham, Alabama wher e it maintains its listi n g d at a base for both white and y ellow pag es. The sales support and adver tising production
personne l are located a

t the Birming ham offic e.

BA PCO’s Atlanta, Geor g ia production office houses marke ting support, financ e, billing, leg al human resour ces and distribution. The multipl e consumer g uides and community information pag es conta ined in the Yellow Pag es ar e compiled by BA PCO at the Atlanta fa cility

. The c overs of

the direc tories ar e likewise de signe d and produc ed in Atlanta by BA PCO.

BA PCO transfe rs the finished direc tories in elec tronic form to a serve r for elec tronic pickup by Stevens Gra

phics, an independe nt company owned by BSC. Stevens Gra phics prints and

-9-binds the Yellow Pag es in plants in either Birming ham or Atlanta. Once the direc tories are printed

and bound, they are transfe rre d for distribution to Direc tory Distribution Associates (DDA ) for the
actua l de livery of the direc tories to home s and businesses in the cover ed are a. DDA perf orms this function in Tenne ssee. The g oal of BA PCO is to have the Yellow Pag es rea ch ever y residenc e and 9 business in the are a cove red by a par ticular e dition of the director y

. . During the y ear s at issue, BA PCO produce d and cause d to be distributed 23,715, 829 direc tories in Tenne ssee. The direc tories wer e provide d at no cost to the end- user, a nd almost all of BA PCO’s reve nues wer e derive d from the sale of adver tising in the direc tories. BA PCO’s y ear ly

reve nues during the period at issue wer e betwee n $160,000,000 and $200,000,000. ®. Vol. I X, pp. 505 - 506). BA PCO’s adver tising customers are not obligated to pay for the adver tisements in the direc tories until they are distributed. I f the customer’ s adver tisement is not included in the direc tory , the customer is not re quired to pay for the a dvertisement.

The parties develope d the background for the issuance of the varia nce at trial throug h the testimony of BA PCO’s senior tax manag er, Kimberly Hill. Ms. Hill explained that in 1 9 97, Ernst &Y oung , an outside acc ounting firm BA PCO consulted with, broug ht to BA PCO’s attention

corr espondenc e dating back to 1995 betwee n the Tenne ssee Depart m ent of Revenue and Ernst & Young reg arding a taxpay er (not BA PCO) with operations almost identical to those of BA PCO. The subject matter of the letter from Ernst & Young was how tel ep h o n e direc tory reve nues should be

source d to Tenne ssee. The 1995 letter was enter ed into evidence. A repr esentative of the Depa rtment responde d to the Ernst & Yo ung inquiry and stated that the cost of perf ormanc e regulation, Rule 1320-6-1.34 (Rule 34) was the “appr opriate rule for this ty pe of rec eipt.” Ms. Hill explained that afte r revie wing the 1995 corr espondenc e betwee n Ernst & Yo u n g a n d th e D ep a

rtment,

s he st udied t he Tennessee regulations and st atutes wit h Ernst & Young and a decision wa s m ad e, based on the letters and statutes, that BA PCO had not been filing its returns for Tenne ssee excise and fra nchise tax corre ctly . BA PCO amended its 1993, 1994 and 1995 returns and filed its re turn for the tax y ear 1996 in Oc t o b er o f 1997 using the cost of perf ormanc e method of apportionment pursuant to Rule 34.

In the fall of 1998, the Depa rtment commence d an audit of the amende d 1993 throug h 1996 returns which resulted in a defic iency assessment ag ainst BA PCO. The Depa rtment’s auditor did not find that BA PCO had any direc t cost in Tenne ssee and stated in the audit that “[t] he wording of the Tenne ssee statutes and the fac ts a n d c irc u ms ta nces involved with BA PCO’s business activities

are not in disput e.” Ms. Hill stated the Depa rtment did not like the use of the cost of per formanc e method and wa

nted B APCO to file using a marke t/circulation base d method of sourc ing r evenue s to Tenne ssee. Ms. Hill ex plained that the c irculation base d method is simi lar to the method used for the sale of tan gi b l e proper ty which looks at wher e the sales take place rathe r than the cost of perf ormanc e method used when there is a sale of a service

. The differ ence betwee n the sales fac tor

on BA PCO’s orig inal retu rn s an d t he amende d returns for the y ear s 1993, 1994 and 1995 was

The white and y ellow pag es in Tenne ssee are published toge ther as one direc tory in a ll of 9 the direc tory

cover ag e ar eas e x cept Na shville and Memphis.

-10-signific ant. The total amount on the orig inal returns ba sed on the c irculation method wa s close to

$400,000,000 while the amende d returns for those three y ear s showed a sales fac tor o f j u st over $180,000. BA PCO fi l ed s u i t ag ainst the Depa rtment in J anuar

y 2000 based on the defic iency assessment for

the y ear s 1993 to 1996 and that suit was settled in May 2003. 1 0

The evidence shows that an audit for the y ear s 1997 throug h 2001 took place from Fe bruar y to April 2003 and was conducte d by Chris Atherton, a Tax Auditor I I for the Depa rtment. The result of the audit was a rec ommendation that the Commi ssioner issue a varia nce reg arding the calc ulation of BA PCO’s Tenne sse e e xc is e a n d fra nchise tax beca

use the Depa

rtment deter

mined that BA PCO’s use of the location of its perf ormanc e costs to allocate its adver tising rec eipts under Tenn. Code Ann. § 67-4-2012( i) did not fairly repr esent the extent of its business activities in Tenne ssee. Mr. Atherton was asked to descr ibe the major fac tors reg arding BA PCO’s business act i v i t i es h e considere d when rec ommending that the Depa rtment issue the varia

n c e

. H e s tated that he considere d the following :

1. BA PCO is eng ag ed in the selling of adver tising and the production of telephone dir ector ies. 2. The selling of the adver tising in Tenne ssee was not conducte d by BA PCO but by an af filiated compa

ny , L . M. Be rry

. 3. BA PCO did not ha ve any employ ees in T ennesse e eng ag ed in the selling of adver tising. 4. BA PCO did not produce the direc tories in Tenne ssee, they wer e produce d by an af filiated compa

ny , Steven’s Gr aphics outside of Te nnessee

. 5. BA PCO had minimal proper ty interest in Tenne ssee, had no pay roll in Tenne ssee and very minimal sales in Tenne ssee. Thus the numerator in the sales fa ctor a

pportionment calc ulation used by BA PCO was minimal. 6. During t h e time period audited, BA PCO had imported into Tenne ssee betwee n four and five milli on direc tories a y ear which gen er ated betwee n $163,000,000 to almost $200,000,000 a y ear in adver tising re venues. 7. I t was the auditor’s opinion that these reve nue amounts “we re not repr esente d in the apportionment fac tors BA PCO used in its excise and fra nchise tax returns.

Mr. Atherton conclude d that BA PCO had no direc t costs in Tenne ssee for purposes of the cost of perf

ormanc e methodology
, and he also used the same words he had used in the ear lier audit: “The wording of the Tenne ssee statutes and the fac t s an d circumstances involved with BA PCO’s business activities are not in dispute.” Ba sed on these finding s, the auditor rec ommended that the Depa

rtment issue a varia

nce to include BA PCO’s rec eipts from adver tising reve nues ear

ned from the direc tories shipped into Tenne ssee during the audit period in the sales fac tor numerator to

more fairly ref

lect BA PCO’s busi n es s activity in Tenne ssee. On November 14, 2003, the

BA PCO claims in its appellate brief that the settlement was “hig hly favor able to BA PCO” 1 0 but there is no evide nce in the r ecor d to support that statement.

-11-Commi ssioner issued a varia nce letter to BA PCO which sets forth the rea sons for the varia nce and is helpful to understandingthe issues raise d on appea l. The letter states in part:

After car eful revie w of the fa cts in this matter, it has been deter mined that the statutory allocation and apportionment provision do not fairly repr esent the extent of business activities conducte d in T ennesse e by BA PCO. According ly
, the decision has been made to require a varia nce for tax y ear s subsequent to 1996 pursuant to the authority g rante d by

T.C.A. §§ 67-4-2014 and 67-4-2112 ( T.C.A. §§ 67-4-812 a nd 67-4-911 unde r prior la

w).

BA PCO is a subsidiary of Be llSout h Corporation. I t is eng ag ed in the busine s s of selling adver

tising and in compiling, publishing and distributing the y ellow p age s direc tories . . . to [t elec ommunication] customers . . . fr ee of char g e.

In Tenne ssee, BA PCO uses L

. M. Be rry

. . . to solicit adver tisements f

or its y ellow
pag e direc tories. BA PCO’s artwor k, direc tory p ro d u cti on, data proce ssing and administrat i v e d epar

tments are located in Alabama and Geor g ia. BA PCO uses a printer located outside Tenne ssee to p ri nt the direc tories. Independe nt contra ctors deliver the direc tories to customers of B ellSouth in Tennessee.

In the tax y ear 2001, BA PCO g ener ated $198,752,347 (10. 2352% of [i ts] ever y wher e g ross rec eipts) in a dvertising and other reve nues from its Tenne ssee marke ts. Eac h
y ear BA PCO imports sever al milli on copi es of y ellow pag es direc tories and telephone direc tories into Tenne s s e e to f u lf il l it s a d v e r ti s in g contra cts with Tenne ssee customers.

Howeve r, BA PCO has a rela tively small phy sical prese nce in Tenne ssee. In the tax y ear 2001, its Tenne ssee assets amounted to only $400,660 (0.1511% of total assets)

. . . and its Tenne ssee pay roll amounted to only $97,124 (0.0530% of total pa y roll).

On fra nchise and excise tax returns filed with the Depa rtment for the cale ndar y ear s 1997 throug h 2001, BA PCO included all of its adver tising reve nues in its ev ery wher e apportionment formula rec eipts fac tor. Howe ver, none of the a dvertising reve nues g ener ated from Tenne ssee marke ts wer e included in its Tenne ssee apportionment formula rec eipts fac tors. BA PCO claims that this is in acc ordanc e with T.C.A.§§ 67- 4-2012(i) and 67-4-2111( i)

. . . . which provide that sales, other than sales of tang ible
p er s o n al p roper

ty , are in Tenne ssee only if the g reater proportion of the earningsproducing activity is perf ormed in Tenne ssee. BA PCO contends that the g reater proportion of its ear

nings- producing activity occur s outsid e Tenne ssee and thus

source s none of its adver

tising rec eipts from Tenne ssee customers to Tenne ssee for purposes of its appor

tionment formulas.

When Tenne ssee adver

tising rec eipts are included in the Tenne ssee rec eipts fac tors

-12-of the apportionment formula, the rec eipts fac tors and t he overa ll apportionment ratios for eac h y ear are incre ased substantially

. For example, for the tax y ear 2001, inclusion of Tenne ssee adver tising rec eipts in the apportionment formula Tenne ssee

rec eipts fac tors incre ase the rec eipts fac tor ratios from 0.1098% to 10.2352% and the

overa ll apportionment ratio from .105925% to 5.168625%.

Application of the statutory cost-of perf ormanc e method to s o u rc e rec eipts allows BA PCO to derive substantial rec eipts from Tenne ssee marke ts without such rec eipts being acc ounted for in the Tenne ssee rec eipts fac tors of its apportionment formulas. For example, in the tax y ear 2001, BA PCO derive d rec eipts of almost $200 milli on dollars from Tenne ssee marke ts. This repr esente d over 10% of its total rec eipts for the y ear 2001. Howeve r, BA PCO included only a littl e over $2 MI L L I ON (0.1098%) of such rec eipts in its apportionment formula. As a result, the overa ll apportionment ratio is reduc ed from about 5% to about 1/10 of 1%. Results for o t h er y ea rs are t h equally dramatic.

Consist ent wit h the above fac ts, I have determined that application of the s tatutory apportionment formula does not opera te t o fairly repr esent the extent of BAPCO’s business activities in Tenne ssee. When this is the case , T.C.A. §§ 67-4-2014 and 67- 4-2112

. . . permit the Depa rtment of Revenue
, throug h its deleg ates, to require the

use of any other method to source rec eipts for purposes of the rec eipts fac tors of the apportionment formula numerators. Our auditors did this for the tax y ear s 1997 throug h 2001 by requiring re ceipts from the sales of adver tising to Tenne ssee customers to be included in the nu m erators of BA PCO’s apportionment formula

rec eipts fac tors for eac h y ear and I am aff irming the require ment of such a varia nce, not only for the year s under a

udit, but for tax y ear s subsequent to the ca lendar y ear 2001 as we ll.

In order fo r i t s apportionment formula to fairly repr esent the extent of its business
operations in Tenne ssee, beg inning with the tax y ear 1997 BA PCO will be require d
to include all rec eipts fr o m the sale of adver tising to Tenne ssee customers in the

numerators of its franc hise, excise tax apportionment formula rec eipts fac tors.

These varia

nce require ments will continue in eff ect so long as the circumstances justify ing the variation rema in substantially unchang ed o r until chang ed or discontinued by

this Department, whic hever occur s first.

The varia

nce letter require d BA PCO to substit u t e t h e cost of perf ormanc e methodology require d by Tenn. Code Ann. § 67-4-2012 (i) for sales of other than tang ible proper ty , such as sales of adver

tising, with the methodology found in Tenn. Code Ann. § 67-4-2012 (h), which is applicable to the sale of tang ible proper ty

. Thus, the varia

nce require d BA PCO to include in the

numerator of the sales fac tor of the apportionment formula its re ceipts from the sale of adver tising

as if it wer e selling tang ible proper ty

. The imposit ion of the varia nce resulted in a tax defic iency of

-13-$9,866,769 and intere st of $3,243,892, a total of $13, 110,661.

Following trial, the Trial Court enter ed a memorandum opinion and order on J uly 31, 2008. The Trial Court stated that: “the standard apportionment formula provided by statute is to be presumed to be corr ect and the varia nce provision is to be narr owly construed. AT& T v. Huddleston
, 880 S. W. 2d 682 (Tenn. Ct. App. 1994). The statutory authority for impos ing a variance require s that the standard formulas ‘not fairly repr esent the extent of the taxpay er’ s business activity in this state.” Id. at 692. “The sole fac t that a signific ant amount of reve nue is rec eived from the sale of adver tisement in Tenne ssee that is not apportioned to Tenne ssee, which is the only fac tual basis cited by th e C o m missioner for impos ing the varia nce, does not in and of itself justify the i mpositi on of

a varia nce. The Commi ssioner has not identified a g reater proportion of BA P C O’ s ea rning s producing activity perf

ormed in Tenne ssee, as define d by the regulations.” The Court held that the
proper formulas for

deter mining the r ece ipts factor of the standar d apportionment for BA PCO are Tenn. Code Ann. §§ 67-4-2012( i) and 67-4-2111( i) and that BA PCO’s use of the cost perf ormanc e method was appropr iate and consistent with the applicable statutes and regulations. The Trial Court voided the ac tion of the Commis sioner in imposing a varia nce.

Issues Pr esente d f

or Re view on Appeal

A. When BA PC O p rovides adver tising in the telephone direc tories it produce s that are distributed in Tenne ssee, does BA PCO’ s cost of perf ormanc e o f t h e s ervic e of adver tising take place solely in Tenne ssee f

or purpose s of Tenn. Code Ann. §§ 67-4-2012( i)(1) a nd 67-4-2111( i)(1) even though all activities involved in producingthe direc tories are ei t h er perf ormed by BA PCO in other states or are perf ormed by independe nt contra ctors on behalf of BA PCO in and out of Tenne ssee?

B. Did the Commiss ioner of Re venue pr operly issue a var iance ?

A trial court’s finding s of fac t in a non-jury trial are revie wed de novo upon the

rec ord. The trial court is aff orded a presumption of correc t n es s u nless the preponde ranc e of the evidenc e is otherwise . Tenn. R. App. P. 13 (d); W right v. City of Knoxv ille, 898 S. W .2d 177, 181 (Tenn. 1995). The trial court’s conclusions of law are revie wed under a purely de novo standard with

no presumption of corr ectne ss. Taylor v. Fezell , 158 S. W.3d 352, 357 (Tenn. 2005)

, Union Carbide Corp. v. Huddleston 854 S. W .2d 87, 91 (Tenn. 1993)

.

This case involves the construction and application of t he Tenne ssee Ex cise and Fr anchise L aw of 1999, and the standard of revie w in tax case s is well settled: “The construction of
statutes and of reg

ulations promulg ated pursuant to statutes and the application of those statutes and
regulations to undisputed fac ts are questions of law.” Beare Co. v. Tennessee Dept. of Rev enue, 858 S. W. 2d 906, 907 (Tenn.1993)

. Ambiguities in statutes imposing taxes must be resolved in f avor of the taxpay er. Pan Am W orld Servic es, Inc. v. Jack

son, 754 S. W. 2d 53, 55 (Tenn. 1988) ( quoting

-14-TennesseeFarmers' Co-op. v. Jac kson, 736 S. W . 2d 87, 90 (Tenn.1987) ).

The parties stipulated that BA PCO had the burden of showing that Tenn. Code Ann. § 6 7 -4 -2 0 1 2 (i )(2) (cost of perf ormanc e for service s) applied to its operations and that the Commi ssioner had the burden of showing that a varia nce was proper

. In American Tel. & Tel. Co.

v. Hu ddleston, 880 S. W. 2d 682, 691 -692 (Tenn. App. 1994), the C ourt discussed t he bur d en o f proof in an e x cise tax varianc e ca se:

The standard statutory apportionment formula is presumed to be corr ect, and the part y seeking to employ an alternate method has the burden of showing that the statutory method is inappropriate. Donald M. Drake Co. v. Dept. Rev enue., 500 P.2d 1041,1043-44(Or g

. 1972); Donovan Constr. v. Michigan Dept. Treasury, 337 N. W. 2d 297, 300 (Mich. 1983). The varia nce provi s i o n ap p l ies only in unusual and limit ed circ umstances and is to b e i n terpre ted narr owly in order to car ry out the
purpose of uniform apportionment under the act. Donald M. Drake Co., 500 P.2d at 1044. The burden is on the party seeking a varia nce to est ablish that the formula does not fairly repr esent [t he taxpay ers] busine s s activities in the taxi ng state. Donald M. Drake Co., 500 P.2d at 1041; Dese ret Pharm. Co. v. State Tax Comm'n., 579 P.2d 1322, 1326-27 (Utah 1978)

.

Id. at 691-692.

The Commi ssioner’s first argu m en t on appea l is that the Tenne ssee excise and fra nchise tax assessed to BA PCO should have been proper ly calc ulated pursuant to Tenn. Code Ann. §§ 67-4-2012( i)(1) and 67-4-2111( i)(1) instead of Tenn. Code Ann

. §§ 67-4-2012( i)(2) and 67-4- 2111(i)(2)

. BA PCO, in its returns, calc ulated the excise tax under §2012(i)(2) and not §2012(i)(1) beca use it contende d that a g reater proportion or all of its ear ning producing activity was perf ormed in another state . Tenn. Code Ann. §§ 67- 4-2012(h) and (i) pr ovide:

h) Sales of ta

ng ible persona l property

are in this st ate, if:

(1) The proper

ty is delivere d or shipped to a purcha ser, other than the United States
g overnme nt, inside this state reg ardle ss of the F.O.B

. point or other conditions of the sale; or (2) The proper

ty is shipped from an of

fice , store, wa

rehouse , fac tory

or other pla ce of storag e in this state and the pur chase r is the United States g overnme nt.

(i) Sales, other than sales of t ang ible persona l proper ty , are in this state, if the

ear nings- producingactivity

is perfor med: (1) In this state; or (2) B oth in and outside this state a nd a g reater propor

tion of the ea

rning s-produc ing activity is perf

ormed in this state t h an i n any other state, based on costs of

-15-perf ormanc e.

The parties stipulated that, absent the issuance of a varia nce, Tenn. Code Ann. §§ 67- 4-2012(i) and 67-4-2111( i) are applicable for determining the num er at o r o f t he sales fac tor for the

numerator or the apportionment formula. They did not stipulate, howeve r, whether part (i)(1) or (i)(2)

was a ppropriate to deter

mine BA PCO’s assessment. When the Commi ssioner issued the varia nce and No t i ce of Assessment of additional tax due, the utiliz ation of part (i)(2) by BA PCO was not questioned and the auditor stated in the audit and at trial that there was no dispute about the wording of the T ennessee statutes or BA PCO’s business activities. Shortly befor e trial, the Commi ssioner raised the argument that BA PCO had wrong ly calc ulated its excise and fra nchise tax under §§ 67-4- 2012(i )( 2 ) an d 67-4-2111( i)(2) and that, beca use all of BA PCO’s ear

ning producing activity took place in Tenne ssee, p ar t (i )(1) was applicable and all of its reve nues from the sale of adver tising should have properly been placed in the numerator of the apportionment formula. The application of part (i)(1) rea ches the same result as the Commi ssioner rea ched when she applied the varia nce, i.e. all of the rec eipts from the sale of adver tising is included in the sales fac tor of the numerator. In the
pre- trial brief, the Commi ssioner reje cted for the first time BA PCO’s position that beca use its costs of perf ormanc e for the Tenne ssee direc tories wer e incurre d overwhelmingly in Geor g ia and Alabama and littl e or no costs of perf ormanc e wer e incurre d in Tenne ssee, the sales of the adver tising service s

s h o u l d n o t be included in the numerator of the apportionment formula under § 67-4-2012( i)(2). Instead, the Commi ssioner argued that BA PCO’s ear ning- producing activity that gen erates its Tenne ssee adver

tising reve nues is the perf

ormanc e of its adver

tising service in Tenne ssee throug h its providing and distributing th e y ellow pag es direc tories in Tenne ssee. Fur ther, the Commi ssioner
argued that BA PCO uses the Tenne ssee direc tories to fulfill its contra ct obligations to its adver tising
customers who pay to have their adver tisements published in the direc tories and if it wer e not for the publication and distribution of the direc tories in Tenne ssee, BA PCO would not ear n the s e adver

tising

reve nues.

On appea l, the Commi ssione r takes the position that the Trial Court err ed when it found that the Commi ssioner had f ailed to support its a

rgument that all costs of perf ormanc e of the sale of a dvertisingtook place in Te nnessee . The Commissioner’s brief argues as f

ollows:

BA PCO’s ear

ning producing activity with respe ct to its adver tising sales fo r t h e Tenne ssee direc tories is perf ormed enti r e ly in Tenne ssee beca use it is paid to adver

tise only in Tenne ssee. Th u s , the rec eipts from that activity are subject to tax in Tenne ssee. This is the core principle of fra nchise and excise taxation - that companies should be taxed based on the benef its they derive from the privileg e of doing business in this state. In this instance, this is acc omplished throug h Tenn. Code Ann. §§ 67-4- 2012(i)(1) (excise tax) and 67-4-2111( i)(1)( fra nchise tax), which provide that rec eipts from BA PCO’s adver

tising in Tenne ssee must g o into the numerator of its Tenne ssee apportionment for

mu la

. Wh il e B A PC O ma

y perf orm preliminary work in other states, its reve nues are entirely due to its perf ormanc e of adver

tising service s in Tenne ssee. That is what its adver

tisers in the Tenne ssee white and y ellow pag es pay for, and that adver tising service is acc omplished purely throug h its distribution of telephone

-16-d i re ctories in Tenne ssee. BA PCO’s adver tisers

. . . are paying purely for th e distribution of adver

tising in Tenne ssee. This is the very service for which its customers pa

y

.

The Commi ssioner’s example of how BA PCO conducts “ea rning -produc ing activity ” in Tennesse e, foc uses on the fa ct that the dire ctories e nd up in Tennesse e.

Tenn. Code Ann. § 67-4 -2 0 1 2 (i ) instructs that the s ale of things other than t ang ible
persona l proper

ty , like the sale of adver

tising, is in Tenne ssee based on wh e th e r ( 1 ) ear ning- producing activity is perf

ormed in this state or (2) earning -produc ing activity i s both in this state and in other
st ates and a g reater proportion of t he earning -produc ing activity occur s in Tenne ssee, based on the
cost of perf

ormanc e. I f ei t h er scena rio (1) or (2) are answe red aff irmatively
, the sales fac tor is included in the numerator of the apportionment formula

. Ho we v er, if ear ning- producing activity takes place predominate ly in another state, the sales are not in Tenne ssee and not incl u d ed i n the apportionment for

mula.

The Commi ssioner did not offe r a ny te s ti mo ny th a

t T e n n

. Co d e Ann

. § 67-4-2012( i)(1) should apply rathe r than part (i)(2)

. T he Depa rtment’s employ ee who perf ormed the audit, Chris Atherton, off

ere d testimony

as follows:

Q. Okay

. And, i n fac t, y ou didn’t find that they [BAPCO] had an y direc t costs in Tennesse e, did y ou?

A. Idid not see whe re the y had any costs. They did not produce the direc tories in Tenne ssee, nor did they have a staff in Tenne ssee that solicited the adver tisements or produced layouts or for a ny costs such as that would have been attributable t o the production of d irec tories t hat ul timately ended up in Tenne ssee.

Atherton fur

ther testified that he ce rtified to the Commissi oner that BAPCO had no direc t costs in Tenne ssee as part of the audit and that he included in the audit the following languag e: “The wording of the Tenne ssee Statutes and the fac ts and circ umstances involved wi t h BA PCO’s business activities and not in dispute.” He also aff irmed that the tax assessment issued to BA PCO was based on the varia

nce letter by the Commi ssioner, thus the ass es s m en t was not based on the application of Te nn. Code Ann. § 67-4- 2012(i)(1) as the Commissioner now argues.

BA PCO’s ear

nings producing activity is not just the distribution of the Yellow Pag es, as i ts ear ning pr oducingactivity

is a serie s of i nteg rate d, interdepe ndent s teps to the s atisfac tion of the adver tisers from whom BA PCO derive s its income. Wit hout these numerous steps BA PCO would have no a dvertising to include in a dire ctory , reg ardle ss of the mode of de livery

.

The Commi ssioner has a

ppeale d the Chance llor’s finding that the varia nce imposed by the C ommissi oner was i mproper. The Com mission er argues t hat even if the gover ning statutes

-17-wer e rea d t o au thorized a cost of perf ormanc e methodology
, the rec eipts from the adver tising contained in the direc tories distributed in Tenne ssee should be source d to Tenne ssee by the imposit ion of a varia

nce. The Commi ssioner contends that the answe r to the key question of whether the computation of ex cise tax based on a cost of performanc e formula, as applied by both BAPCO and the Depa

rtment, rea sonably ref

lects BA PCO’s business activity in Tenne ssee is “obviously no”. In support of this position, the Commi ssioner points to the fac t that on BA PCO’s returns for the five
y ear s at issue, using the cost of per formanc e formula to allocate its earning s, BAPCO re ported a nd paid onl y $296,140 in Tennesse e excise and franc hise tax but derive d adver tising i ncome from the distribution of 23,715,829 direc tories in Tenne ssee of $897,488,193 over the same five y ear period. The Commi ssioner pointedly conclude s that “[i] t is patently absurd to contend that a tax pay ment of $296,140 is commensurate with the business BA PCO conducte d in Tenne ssee over the five y ear s involved in this case .” Acc ording ly
, the Commi ssioner ar gu es that under the fac ts prese nted by BA PCO’s business activities, the cost of per formanc e for mula has malfunc tioned and the sit uation is precise ly

one for which the Commissioner was ve sted with varianc e powe rs by the leg islature.

Tenne ssee courts have repe atedly rec og nized that the Commi ssioner of Revenue may proper ly exercise her discretion in vary ing the statutory apportionment formula when application of the formula does not fairly repr esent the taxpay er' s business in the state. See Sherwin-W illiams Co.

v. Johnson
, 989 S. W.2d 710, 716 (Tenn. Ct. App. 1998); American Tel. & Tel. Co. v. Huddleston 880 S. W.2d 682, 691-692 (Tenn. App. 1994); Fede rated Stores Realty, Inc. v. Huddleston 852 S. W.2d 206, 213-214 (Te nn.1992)(statutorily overr uled on other grounds); Peterson Mfg. Co. v. State, 779 S. W.2d 784, 786-787 (Tenn.1989) ; S. Coach Lines, I nc. v. McCanless, 191 Tenn. 634, 638, 235 S. W.2d 804 (1951); Am. Bembe rg Corp. v. Carson, 188 Tenn. 263, 268-271, 219 S. W.2d 169 (1949). There are no Tenne ssee case s, howeve r, that consider the issuance of a var i an ce fr o m t he cost of perf ormanc e for

mula in connec tion with the sale of adve rtising.

In support of its argument that the varia nce issued by the Commi ssioner was entirely
appropr iate, the Commi ssioner cites to the authors of the UDI TPA an d t h eir specific conce rns reg arding the application of the cost of perf ormanc e formula in the are na of income from adver tising in publications. Whil e the Commi ssioner acknowledg es t hat t he UDI T P A as originally develope d by the Multist ate Tax Commi ssion and as adopted in Tenne ssee, uses formulas desig ned to apply to all businesses, it points out that the authors of the uniform act rec og nized that those formulas did not function very well for ce rt ai n t y pes of businesses, and provided for varia nces in Section 18 of the uniform act, which is codified as Tenn. Code Ann. §§ 67-4-2014( a) and 67-4-2112( a). Specifica lly
, the authors of the uniform act rec og nized that Section 17, which is t h e co u nterpa rt of Tenn. Code An n. § 67-4-2012( i)(2) and at issue here
, did not alway s adequately deal with all of the t y p es o f

rec eipts of sales from other than tang ible proper ty

. The Commi ssioner cites to Professor Wil liam J

. Pierce
, the “father” of UDI TPA, who n o t ed the defic iency in this are a and the need for a varia nce under Section 18 to deal with cer tain situations not cover ed by Section 17 (Tenn. Code Ann. § 67-4- 2012(i)(2) ) as f

ollows:

Another problem arises in conjunction with sales other than sales of tang ible persona l
proper ty

. Section 17 of the uniform act attributes these sales to the state in which the

-18-income-pr oducing activity is perf ormed. I f the activity is perf ormed in more than one state, the sales are attributed to the state in which the g reater proportion of the activity

was perf ormed, based upon costs of perf ormanc e. In many ty

pes of service functions, this appro ac h ap pear s adequate. Howeve r, there are many unusual fac t situations

connec ted with this ty

pe of income and probably the g ener al provisions of Section 18

s h o u l d be utiliz ed for these case s. I f we assume that the activity involved i s t h e servicing of i ndustrial equipm en t , the formula provided in the uni form act could be easily applied and the result appears eq u i table. In contrast , assume that th e sal es item involved is advertising reve nue rec eived by a national m agazine pub lish er. The state of activity wou ld be dif fi cult, if not im possib le, to ascer tain, so it wou ld appear that this type of incom e m ay wel l b e a p p o rt i oned on the sam e basis as sub scription incom e. The national confe renc e considere d this problem at leng th and concl u d ed t hat for cer

tain ty pes of sales income, exceptions would have to be established by the tax collection ag encie s, since no formula seeme d to be satisfac tory for ever y conce ivable fac tual situation. Gene rally
, it was felt that t h e provisions of Section 17 wer e the best that could be desig ned to cover the gre at er proportion of

case s.

Wil liam J. Pierc e, The Uniform Division of I ncome for State Tax Purposes
, 35 Taxes 474, 780-781 (1957)( emphasis adde d).

The Commi ssioner insists that Professor Pierce ’s analy sis is on point and that the sales from adver

tisin g in the direc tories distributed in Tenne ssee should be apportioned acc ording to a circ ulation or distribution m ethod , as the Commissioner did when the va rianc e wa s imposed.

Ba sed on the stated intent of the framers of the UDI TPA that a varia nce from the cost of perf ormanc e formula may be appropr iate under cer tain circ umstances, including the speci fi c mention of sale of ad v er t i s i n g i n a publication, and based on the fac t that BA PCO has paid only $296,140 in Tenne ssee excise and fra nchise tax but derive d adver tising income from the distribution of 23,715,829 direc tories in Tenne ssee of $897,488,193 during the five y ear s at issue, the application of the cost of perf

ormanc e formula does not fairly repr esent BA PCO's business in the state and that the issuance of the varia

nce was appropr iate. BA PCO raises sever al objections to the propriety of the application of the varia

nce. BA PCO argues that the varia nce is improper beca

use the Tenne ssee cost of perf orm an ce s t at ute is an “all or nothing” statute which for BA PCO produce d a sales fac tor of almost zero and that there is nothing unique and nonrec urring about the fac ts of BA PCO’s business activity in Tennesse e, or a

bout the costs of per formanc e ca lculation.

BA PCO disag ree s with the Commi ssioner’s repr esentation t h at the cost of perf ormanc e formula “malfunc tioned” in this case

. BA PCO’s position is that Tenn. Code Ann. § 67- 4-2012(i) is an “all or nothing” statute and t h at , as such, it is a “double- edg ed sword”. BA PCO

asser ts that to the ex t en t that a service business has the larg est proportion of its direc t costs in T en n es s ee , all of such taxpay er’ s rec eipts are source d to Tenne ssee in the calc ulation of the sales fac tor portion of the formula even if some of the costs of perf ormanc e occur

red elsewhe re. L ikewise,

-19-if the g reater proportion of the direc t c osts a re elsewhe re, then the sales fac tor is zero. Fur ther, the statutory form u l a, which the parties stipulated to as applicable
, contemplates that the sales fac tor could very well be zero or near zero, as it appea rs to be in BA PCO’s case

. BA PCO argues that for the Commi ssioner to the n issue a varia nce when a

particula r business’s sale s fac tor is zero beca use the
g reater proportion of its direc t costs o cc u r outside Tenne ssee rende rs section 67-4-2012( i) meaning less. Whil e BA PCO argues that UDI TPA makes a specific provision to deal with BA PCO’s
exact situation, Tenne ssee did not adopt t he reg ulation. Our ana ly sis of UDI TPA, when c ompare d to the Tenne ssee statutes, demonstrates that Tenne ssee has essentially adopted all provisions of the UDI TPA.

Whil e BA PCO’s “all or nothing” argument is appea ling, in that the Commi ssioner can virtually ignor e the statutorily require d cost of perf ormanc e formula when the results are unfavor able to the Depa

rtment, the fa ct re mains that Tenn. Code Ann. §§ 67-4-2014( a) a nd 67-4-2112( a) w ere

enac ted by the leg islature to provide the Com m i s s i o n er with the authority to permit or require a depar ture from the standard apportionment formula when application of the formula does not fairly
repr esent the extent of the taxpay er’ s business activity in Tenne ssee and the Commi ssioner is g iven the authority to use any method to source rec eipts for purposes of the rec eipts fac tor or fac tors of the apportionment formula num er at or or numerators. Moreove r, the authors of the UDI TPA, and the Tenne ssee Gene ral Assembly wer e awa re that under cer

tain fac tual scena

rios, specific ally when the sale of adver

tising is at issue, the s t at u t o ry formulas just do not work and the tax collector would

nece ssarily have to impose a varia nce. Thus, BA PCO’s “all or nothing” argument is not persua sive.

BA PCO also makes t h e ar gument that the Commi ssioner did not demonstrate that there wa s s o m ething unique and nonrec urring about the fac ts of BA PCO’s business activity in Tenne ssee or about the costs of perf ormanc e calc ulati o n t o justify the imposit ion of a varia nce. BA PCO’s relianc e on t h e T ennessee Rules and Reg ulations, Rule 1320-6-1- .35, (Rule 35) is misplaced.

Rule 4 provides:

The employ

ment of any other method to eff ectua t e an equitable allocation and apportionment of the t axpay er’ s capital and net earning s for purposes of computi ng fra nchise and excise taxes, §§67-4-911 and 67-4-812 permit a depar ture from the allocation and apportionment provisions only in limit ed and specific case s. §§67-4- 911 and 67-4-812 may be invoked only in specific case s wher e unusual fac t situations ( which ordinarily will be unique and nonrec urring ) produce incong ruous res u lt s u n d e r the appointment and allocation provision contained in the Fr anchise and Ex cise Tax L aws.

The unusual fac t situation in this case is that all of t he costs of p ro d u cti on occur red outside of Tenne ssee, but the reve nue derive d from the end product only occur red when the product

was distributed in Tenne ssee which only then obligated the purcha sers to pay the re venue pr ocee ds
to the produce r for the sale of the adver tising. Certainly
, the circ umstances of this case have a unique

-20-quality
, an d wh i l e the proce ss can be rec urring
, the “ordina rily ” qualifier under the rule does not proscr ibe the issuance of a va rianc e in all such c ases.

In American Tel. & Tel. Co. V. Huddleston, 880 S.W

. 2 d 682, 691-692 (Tenn. App. 1994), the Court said at pag e 691: “The Commi ssioner may there fore exercise rea sonable discretion in deter mining whether fac ts or circ umstances justify depar ture from the statutory formula.” We hold that the Commi ssioner car ried t h e b u rd en o f proof that the fac ts and circ umstances of this case enable d her to exercise her rea sonable discretion in de clar ing a varia nce for the purpose of revising this formula to establish the basis for the reve nue assessed. We reve rse the ruling of the Chance llor on this iss ue.

The cause is rema nded to enter J udg ment pursuant to t h e Commi ssioner’s
counter claim for the full amount of the assessment, plus statutory interest and rea sonable attorney ’s fee s and expense of litig ation as re quired by Tenn. Code Ann. § 67- 1-1803(d)

.

The cost of the appea l is assessed to Be llsouth Adver tising & Publis hing Corporation.

_________________________ H E R S C H E L P I C K E N S F R A N K S , P.J

.

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