Source: http://taxexecutive.org/unfair-apportionment-consider-the-alternatives/
Timestamp: 2019-04-19 02:52:42+00:00

Document:
The internal consistency test looks to the overall structure of the tax at issue and asks whether the tax would necessarily disadvantage interstate commerce when compared with intrastate commerce if every state enacted an identical taxing scheme.3 Inasmuch as an internally inconsistent tax impermissibly burdens interstate commerce on its face, the tax is per se invalid in all cases, without the need for further consideration of the economic reality of how the tax applies.
The external consistency test looks to the specific economic realities of how the tax applies in order to determine whether the tax impermissibly “reaches beyond that portion of value that is fairly attributable to economic activity within the taxing State.”4 Inasmuch as the external consistency test is concerned with the underlying economic realities of how the tax applies in practice, the analysis is undertaken on a case-by-case basis to determine whether a tax is fairly apportioned as applied to particular taxpayers. A state’s statutory apportionment formula may be externally consistent as applied to one taxpayer but externally inconsistent as applied to another, depending on the economic realities of their respective business activities in the state. If it is determined that a normal statutory apportionment formula is externally inconsistent as applied to a particular taxpayer, then the U. S. Constitution requires an alternative method of apportionment to be applied that more fairly reflects the extent of that taxpayer’s business activities within the taxing state.
Distinct from U.S. Constitution considerations, states have enacted statutory alternative apportionment provisions to address situations where the normal statutory apportionment formula does not fairly represent in-state business activities or income. Pursuant to these alternative apportionment statutes, typically either the state or the taxpayer may assert that the statutory apportionment formula does not fairly represent the in-state business activities or income and may propose that an alternative method of apportionment be used to fairly reflect in-state activities. Such provisions aim to provide an additional safeguard to ensure fair apportionment in cases where the normal statutory apportionment formula yields a result that does not fairly represent in-state business activities but is not so manifestly unfair as to rise to the level of a constitutional violation. However, it is important to note that whereas all state apportionment formulas are required to be internally and externally consistent in accord with the U.S. Constitution, statutory alternative apportionment provisions are state-made laws and therefore tend to vary by state.
We will consider constitutionally required and statute-based alternative apportionment in turn.
Conversely, in Moorman Manufacturing Co. v. Bair, Director of Revenue of Iowa, the Supreme Court found that Iowa’s single sales factor apportionment formula was not per se invalid and that, as to fair apportionment, the taxpayer failed to produce evidence that a significant portion of its income had been improperly attributed to Iowa.10 Moorman manufactured and sold animal feed. Although all products were manufactured in Illinois, the taxpayer maintained 500 salespeople in Iowa and owned six warehouses in the state. Moreover, Iowa sales accounted for approximately twenty percent of the taxpayer’s total sales. Inasmuch as all products sold in Iowa were manufactured outside the state, the taxpayer argued that it should have been permitted to use an alternative apportionment method (i.e., equally weighted property, payroll, and sales factors). The distortion between Iowa’s statutory single sales factor formula and the alternative three-factor formula ranged from between approximately forty percent and sixty percent during the tax years in question. The Court concluded that while Iowa law permitted the taxpayer an opportunity to demonstrate that the statutory formula was arbitrary as applied to it, “this record contains no such showing and therefore the Director’s assessment is not subject to [constitutional] challenge.”11 Effectively the purported distortion was the mathematical difference between a single factor and the three-factor formula.
When a taxpayer challenges a state’s statutory apportionment formula on the grounds that it violates the U.S. Constitution, the burden is on the taxpayer to put forth evidence demonstrating that an alternative apportionment method is required to reasonably reflect in-state business activities. Moreover, the cases show that the distortion must be substantial. The Supreme Court has observed that states’ apportionment formulas occasionally over-reflect or under-reflect income attributable to the taxing state. “Yet despite this imprecision, the Court has refused to impose strict constitutional restraints on a State’s selection of a particular formula.”12 Statutory alternative apportionment provisions have therefore been enacted, in part, to alleviate the effects of distortive apportionment in cases where such distortion does not rise to the level of a constitutional violation.
In General Mills v. Franchise Tax Board, amounts received in connection with commodity futures sales that were made to hedge against price fluctuations were held to distort the sales factor. General Mills was distinguishable from Microsoft on the grounds that General Mills’ hedging activities were not short-term investment activities, but rather were “a support activity integral to the company’s main line of business.”19 Nonetheless, the California Court of Appeals found that the “qualitative” and “quantitative” tests are not independent and separate requirements and that General Mills’ sales factor was distorted because, among other reasons, “hedging activities produced at most 2 percent of [General Mills’] income (and in two of six years operated at a loss) while it generated between 8 and 30 percent of [General Mills’] gross receipts.”20 California courts have struggled to articulate clear explanations of the “qualitative” and “quantitative” tests and the extent to which each test matters in determining whether the apportionment formula fairly represents in-state activities.
Inasmuch as the external consistency test is concerned with the underlying economic realities of how the tax applies in practice, the analysis is undertaken on a case-by-case basis to determine whether a tax is fairly apportioned as applied to particular taxpayers.
The “any other method” alternative apportionment language has been broadly construed as to whether an alternative apportionment method is appropriate in a particular situation. The South Carolina Supreme Court interpreted the “any other method” language of its alternative apportionment provision to include combined reporting (the normal method of reporting in South Carolina was separate company reporting).25 The court reasoned that the state’s alternative apportionment provision “clearly authorizes the Department to use ‘any other method’ to effectuate an equitable apportionment of the taxpayer’s income, including the combined entity apportionment method.”26 Therefore, in both Tennessee and South Carolina, courts have permitted the use of alternative apportionment methods that fundamentally conflict with legislative preferences regarding the states’ apportionment methodology (i.e., cost of performance sales sourcing in Tennessee and separate company reporting in South Carolina).
Simple examples are: 1) a manufacturer whose headquarters and plant are in one state, with sales in all fifty states, and 2) a service provider whose headquarters and idea-generating employees are in one state, with sales in all fifty states. With respect to both Constitution-based and statutory alternative apportionment, the critical threshold question is whether the statutory apportionment formula fails to yield an apportionment factor that accurately reflects the taxpayer’s in-state activities. If the distortion is substantial enough, then the taxpayer has a constitutional basis for asserting an alternative apportionment method. If the distortion is not substantial enough to raise constitutional issues but is nonetheless meaningful, then statutory alternative apportionment comes into play.
The question of whether the statutory apportionment formula fails to reflect the taxpayer’s in-state activities ultimately depends upon how the taxpayer generates its income. The sales factor should reflect the economic reality of where revenue is generated, whereas the property factor and payroll factor should reflect the economic reality of where expenses are incurred to generate the income. The absence of one of these factors (or the use of a single factor) could result in a formula that apportions either according to revenue or to expenses alone. Furthermore, a sales factor may better reflect economic reality for a high-profit-margin business with relatively minimal expenses. In contrast, a property factor or a payroll factor may better reflect economic reality for low-profit-margin businesses with relatively large expenses.
Moreover, it should also be considered whether the methodology for computing a factor accurately reflects the underlying economics of the taxpayer’s in-state activities with respect to that factor. For example, a software company outsourced most of its development work to employees in India. The company had many employees located in India, whereas it had only a few (though highly paid) employees in New York. Due to wage discrepancies between employees in New York and employees in India, the New York payroll factor was distortedly high. The software company applied for alternative apportionment, and an administrative law judge (and, on appeal, the Tax Appeals Tribunal) agreed that alternative apportionment was warranted and that the payroll factor should be alternatively computed as what percentage the headcount of New York billable employees constituted of the total headcount of billable employees everywhere, including India.30 This is just one example of methodologies that might sway a state taxing authority or a court to agree to an alternative apportionment method when a taxpayer believes that the statutory method does not fairly reflect in-state activities.
Taxpayers should also consider the possible reactionary positions that the state could take with respect to alternative apportionment. For example, consideration should be given to the risk that the state may assert alternative apportionment in a situation where the taxpayer believes that the statutory formula does accurately reflect in-state activities. Moreover, a taxpayer who asserts alternative apportionment should consider what potential alternative methods the state may counter with and whether such alternative methods fairly reflect activity but are worse than the normal statutory method.
Ultimately, if a taxpayer believes that the statutory method of apportionment does not accurately reflect in-state business activities, a number of options are available. Procedurally speaking, no special requirements are necessary to assert that the application of a normal apportionment formula is unconstitutional (i.e., the taxpayer takes the position, and if the state disagrees and issues an assessment, the taxpayer may challenge that assessment on constitutional grounds in court). Conversely, states may require that certain special procedural rules be followed to assert statutory alternative apportionment (e.g., filing a specific form or making the request to use alternative apportionment by a specified deadline), and, if those requirements are not met, the taxpayer may be precluded from asserting statutory alternative apportionment.
A taxpayer could consider whether it could use an alternative method of apportionment on its originally filed return. It is important to note that state statutes may bar taking a statutory alternative apportionment position on an original return without prior state approval, in which case the taxpayer may be limited to arguing that the standard apportionment method is unconstitutional. Taxpayers could also formally request, in accordance with any special state procedural rules, that the state permit the taxpayer to use an alternative apportionment method on its return. In lieu of seeking to take the position on an original return, taxpayers could take the alternative apportionment position on an amended return and seek a refund. Taxpayers could also consider taking an alternative apportionment position to counter unfavorable audit work papers. However, special state procedural rules may bar the taxpayer from asserting statutory alternative apportionment as late as during an audit of the return. In this case, the taxpayer may have only a constitutional alternative apportionment argument available.
Finally, if the state asserts alternative apportionment, the taxpayer needs to think about what the state’s basis is for doing so and whether it is justified. Does the statutory apportionment formula actually fail to represent in-state activities fairly, or is the state overreaching? If the taxpayer agrees that the statutory formula is incorrect, then the taxpayer should consider whether there is a better alternative apportionment method available other than the method the state is asserting. If so, the taxpayer can counter the state’s assertion with its own alternative method.
Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977) (holding also that a state tax passes constitutional muster only when “the tax is applied to an activity with a substantial nexus with the taxing State,…does not discriminate against interstate commerce, and is fairly related to the services provided by the State”).
Oklahoma Tax Comm’n v. Jefferson Lines, 514 U.S. 175, 185 (1995).
Hans Rees’ Sons, Inc. v. North Carolina ex rel. Maxwell, Comm’r of Revenue, 283 U.S. 123, 133 (1931).
390 U.S. 317, 320-321 (1968).
437 U.S. 267, 272-273 (1978).
N.J. Stat. Ann. § 54:10A-8.
Gen. Mills v. Franchise Tax Bd., 92 Cal. Rptr. 3d 208, 218 (Cal. Ct. App. 2009).
17139 P.3d 1169 (Cal. 2006).
Id. at 1178, n. 17.
Gen. Mills v. Franchise Tax Bd., 146 Cal. Rptr. 3d 475, 484 (Cal. Ct. App. 2012).
Vodafone Ams. Holdings, Inc. & Subsidiaries v. Roberts, 486 S.W.3d 496 (Tenn. 2016).
Former Tenn. Comp. R. & Regs. R. 1320-06-01-.35(1)(a)(4) (2015).
Vodafone Ams. Holdings, supra, 486 S.W.3d at 529.
In 2010, the MTC revised the model regulation to eliminate the “unusual fact situations (which ordinarily will be unique and nonrecurring)” language. Moreover, in 2014, the MTC adopted a proposed revision to the UDITPA alternative apportionment provision which added new language permitting state tax administrators to establish regulations determining alternative apportionment methodologies for particular industries if it is determined that the statutory apportionment formula does not fairly represent the business activity in the state of taxpayers engaged in that industry. Multistate Tax Commission, Suggested Revisions to the Hearing Officer’s Section 18 Proposed Amendments, as approved by the Uniformity Committee (July 28, 2014).
Media Gen. Commc’n, Inc., & Media Gen. Broad. of S.C. Holdings, Inc. v. South Carolina Dep’t of Revenue, 694 S.E.2d 525 (S.C. 2010).
See id.; see also, Rent-A-Center West Inc. v. South Carolina Dep’t of Revenue, 792 S.E.2d 260 (S.C. Ct. App. 2016).
But see, Equifax, Inc. v. Mississippi Dep’t of Revenue, 125 So. 3d 36 (Miss. 2013) (finding that the taxpayer bears the burden of proof when the Department asserts alternative apportionment). However, in the wake of the Equifax decision, the Mississippi legislature amended its statute to expressly place the burden of proof on the party requesting or requiring alternative apportionment. See Miss. Code Ann. § 27-7-24.
In re Infosys Technologies Limited, DTA No. 820669 (N.Y.S. Div. of Tax App., Feb. 15, 2007), aff’d, (N.Y.S. Tax App. Trib., Feb. 21, 2008).

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