Source: http://taxexecutive.org/fair-is-fair-how-to-assert-for-and-defend-against-alternative-apportionment/
Timestamp: 2019-04-23 02:52:21+00:00

Document:
The concept of apportionment in state taxation is an exception to the rule that life can be unfair. State apportionment must be fair. A wooden reading of a generally applicable apportionment law may not stand if that law yields an unfair result in a particular case. Alternative apportionment exists to ensure that apportionment is always fair. From the taxpayer’s perspective, alternative apportionment can present opportunities (i.e., when the taxpayer believes that the generally applicable apportionment law is operating unfairly) and challenges (i.e., when a state asserts that the generally applicable apportionment law is operating unfairly).
Where does alternative apportionment come from? The U.S. Constitution requires that a state tax on a business engaged in interstate commerce must meet four requirements, one of which is that the tax must be “fairly apportioned.”2 The U.S. Supreme Court has further held that a state apportionment formula that is “not intrinsically arbitrary . . . will be sustained until proof is offered of an unreasonable and arbitrary application in particular cases.”3 For a taxpayer to demonstrate that the statutory apportionment formula is unconstitutional, the taxpayer must prove “by ‘clear and cogent evidence’ that the income attributed to the State is in fact ‘out of all appropriate proportions to the business transacted . . . in that State’ or has ‘led to a grossly distorted result.’”4 A state cannot assert that the statutory apportionment formula is unconstitutional because it taxes too little, because the legislature can always tax less than allowed under the Constitution.
Subsequent to Butler Brothers, the U.S. Supreme Court held that Missouri’s standard statutory apportionment formula yielded “a grossly distorted result” and that the state was required to “make the accommodations necessary to assure that its taxing power is confined to its constitutional limits.”9 In Norfolk & Western Railway Co. v. Missouri State Tax Commission, Missouri’s standard statutory formula required that railroad rolling stock be apportioned to the state for property tax purposes based on the proportion of the taxpayer’s railroad track miles in Missouri relative to the taxpayer’s railroad track miles everywhere. During the year at issue, the taxpayer, a primarily coal-carrying railroad, leased all of the property of another railroad company that engaged in a substantial amount of business in Missouri. Under the statutory formula, eight percent, or approximately $20 million, of the taxpayer’s rolling stock was apportioned to Missouri. However, the taxpayer offered evidence that the actual percentage of its rolling stock located in Missouri on the assessment date was three percent, or approximately $7.6 million, a distortion of approximately 165 percent. The taxpayer also demonstrated that: (1) its coal operations required a substantial amount of specialized equipment that rarely ever entered Missouri; and (2) the company had leased the vast majority of its rolling stock regularly present in Missouri and that Missouri had assessed such property in the year before the lease at approximately $9 million. The Court stated that, when a taxpayer comes forward with strong evidence tending to prove the formula yields a grossly distorted result, the state cannot merely assert that the discrepancy resulting from application of the statutory formula is due to “nonparticularized increase in intangible value.”10 That is, the state cannot simply dismiss or ignore the distortion.
Butler Brothers makes clear that a mere showing of a different result using separate accounting principles will likely not suffice for the taxpayer to meet its burden. However, Hans Rees’ Sons, Inc. and Norfolk & Western Railway Co. provide examples of the requisite level of distortion, the kind of evidence that is necessary to meet the burden of proving that the statutory apportionment formula produces an unconstitutional result and the burden of disproving unfairness in a particular case.
The U.S. 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.”11 Therefore, statutory alternative apportionment provisions have been enacted, in part, to provide “a salutary ‘safety valve’ to avoid unfair results that may not rise to the level of unconstitutional distortion.”12 Of course, one does not need a statute to remedy unconstitutionally unfair apportionment inasmuch as constitutional violations are always wrong.
Unlike in the constitutional context, statutory alternative apportionment can be asserted by both the taxpayer and the state. Therefore, the taxpayer must be aware that the state may also seek to deviate from the standard statutory formula by using the statutory authority, to the taxpayer’s detriment.
The following are examples of fact patterns under which taxpayers have successfully persuaded state courts to grant their requests for alternative apportionment.
A state’s standard apportionment formula may include a factor that makes little or no contribution to the generation of the taxpayer’s income. Some states have enacted provisions to ensure the exclusion of immaterial factors from the apportionment formula. For example, Massachusetts requires the exclusion of any factor “if the denominator of the factor is less than ten per cent of one third of the taxable net income or if it is otherwise determined to be insignificant in producing income.”16 However, in the absence of such a provision, taxpayers can argue that including a factor arising from an immaterial activity distorts its apportionment formula and results in an apportionment that does not fairly represent its in-state activities.
In Stonebridge Life Insurance Co. v. Department of Revenue, the Oregon Tax Court held that Oregon’s standard three-factor apportionment formula for insurance companies (i.e., insurance sales, payroll, and real estate/interest income) was unconstitutional as applied to the taxpayer.17 The taxpayer was engaged in the business of providing life, accident, and health insurance coverage. For the year at issue, less than one percent of the taxpayer’s premiums were received from Oregon policies (i.e., approximately $6 million of $661 million), and the taxpayer had no Oregon payroll (i.e., $0 out of approximately $39 million). However, the taxpayer received approximately $250,000 from Oregon real and tangible property in connection with two loans secured by Oregon property and received approximately $1.5 million from all real and tangible personal property (i.e., an Oregon percentage of approximately sixteen percent). The three factors were averaged and resulted in an Oregon apportionment percentage of approximately 5.7 percent due entirely to the equal weighting of the real estate/interest income percentage, which was relatively small and not an integral part of the taxpayer’s insurance business.
A commonsense approach to ensuring “fair apportionment” is that if a state requires that a particular item of income be included in the taxpayer’s apportionable tax base, then the factors associated with generating that income should be included in the taxpayer’s apportionment formula. Moreover, one U.S. Supreme Court justice has explained why inclusion of the factors associated with generating apportionable income is required by the U.S. Constitution.19 Therefore, to the extent that the state’s standard apportionment formula or the regulations promulgated thereunder do not permit representation in the apportionment factor denominators of those factor values that generated the income, the taxpayer can argue that such exclusion is unconstitutional and, at a minimum, does not fairly represent its in-state activities.
While a state’s standard statutory apportionment formula may include factors that are critical to how the taxpayer generates its income, the methodology by which the factor is computed may itself be distortive by including values that are not integral to generating income or excluding values that are integral to generating income. In these cases, the taxpayer can argue that a particular factor should include or exclude certain types of value to fairly represent the extent of the taxpayer’s business activity in the state.
In British Land (Maryland), Inc. v. Tax Appeals Tribunal, the taxpayer was a real estate investment company that purchased a property in Baltimore and held the property for nine years before purchasing an office building in New York City.23 Shortly after the taxpayer entered the New York City real estate market, the taxpayer sold its interest in the Baltimore property and recognized a capital gain of approximately $13 million. Inasmuch as the New York City property was valued at approximately three times the value of the Baltimore property, the New York property factor in the year of the sale significantly contributed to the statutory New York formula yielding a sixty-four percent apportionment of the gain from the sale of the Baltimore property to New York.
A taxpayer may also consider asserting alternative apportionment to counter unfavorable audit workpapers. However, there may be state-specific procedural rules barring the taxpayer from asserting statutory alternative apportionment as late as during an audit of the return.
The following are examples of fact patterns under which taxpayers have successfully persuaded state courts to overrule a state’s tax administrator’s assertion of alternative apportionment.
Courts have been nearly uniform in placing the burden of proof on the state when it is the state’s tax administrator asserting alternative apportionment.31 Taxpayers have successfully defended against state assertions of alternative apportionment in cases where the only evidence offered by the state is that its alternative method would result in a larger tax liability or that “tax considerations” with respect to the taxpayer’s transactions resulted in the standard statutory formula yielding a more favorable result for the taxpayer. Taxpayers should use to their advantage the burden on the state when they seek to apply alternative apportionment.
In CarMax Auto Superstores West Coast, Inc. v. South Carolina Department of Revenue, the taxpayer owned and operated used car superstores on the West Coast (i.e., not in South Carolina), where it sold used automobiles at retail.32 For the first two of the years at issue, the taxpayer owned intellectual property that it licensed to a related party (CarMax East) that engaged in used automobile retailing on the East Coast, including in South Carolina. For the subsequent four of the years at issue, the taxpayer owned an interest in a limited liability company that was treated as a partnership and that licensed the intellectual property and provided financing services to CarMax East.
The framers of UDITPA “contemplated that states would enact ‘separate legislation’ embodying specialized formulas appropriate to particular industries,” such as public utilities, transportation, and other industries.35 However, in states where such legislation has not been adopted, tax administrators have frequently required specialized formulas asserting their purported authority under the state’s statutory alternative apportionment provision.
Nonetheless, in the absence of a properly enacted regulation setting forth alternative apportionment rules for particular industries, taxpayers have successfully defended against assertions of alternative apportionment when the tax administrator seeks to implement its policy through case-by-case adjudication. Two examples come from the high courts of New Jersey and Maryland.36 In both cases, the taxpayers were operators of television stations and the issue was the proper method of apportioning receipts from the sale of airtime to advertisers (“advertising receipts”). For the years at issue, the tax administrators asserted alternative apportionment and required the taxpayers to source their advertising receipts using the “audience share” method by which advertising receipts were sourced to the states using the ratio of the station’s in-state audience to its total audience.
With respect to procedure, if a taxpayer believes that the standard statutory method of apportionment does not fairly represent in-state business activities, a number of options are available. There are no state-specific procedural requirements necessary for asserting that the application of the statutory apportionment formula is unconstitutional. Conversely, states may require that certain specific procedural rules be followed to assert statutory alternative apportionment (e.g., filing a specific form or requesting 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. Practically speaking, while not required, following a state’s prescribed procedures for asserting alternative apportionment may be the best option for a taxpayer seeking to make a constitutional argument inasmuch as statutory alternative apportionment carries a lower burden (in many states) and can provide a fallback option if the constitutional argument does not ultimately pass muster.
Although a taxpayer could consider asserting alternative apportionment on its original return, state statutes may bar a taxpayer from taking a statutory alternative apportionment position on an original return without receiving prior state approval. In this case, the taxpayer may be limited to trying to meet the burden of proving that the standard apportionment method is unconstitutional. A taxpayer could consider formally requesting alternative apportionment to comply with any state-specific procedural rules in order to preserve its statutory alternative apportionment argument. Moreover, rather than seeking to take the position on an original return, a taxpayer could consider asserting alternative apportionment on an amended return and seek a refund.
A taxpayer may also consider asserting alternative apportionment to counter unfavorable audit workpapers. However, there may be state-specific procedural rules barring the taxpayer from asserting statutory alternative apportionment as late as during an audit of the return. In this case, the taxpayer may be left with only its argument that the statutory apportionment formula is unconstitutional.
Last, when defending against the state’s assertion of alternative apportionment, the taxpayer should consider the state’s basis for doing so and whether it is justified. As discussed above, the fact that the tax administrator has identified an alternative method of apportionment that yields a greater tax liability than the statutory formula should never, by itself, be sufficient for the department to meet its burden to show that the statutory formula does not fairly represent in-state activities. As a fallback position, the taxpayer could consider whether there is a better alternative apportionment method available, other than the method asserted by the state. If so, the taxpayer should counter the state’s asserted alternative method with its own alternative method.
Alternative apportionment presents both opportunities and challenges to taxpayers. Taxpayers know their businesses very well. When considering a state’s standard statutory apportionment formula, taxpayers should always remember the golden rule that the “factor or factors used in the apportionment formula must actually reflect a reasonable sense of how income is generated.”39 Taxpayers always need to consider whether an apportionment formula meets that requirement and be prepared to assert for or defend against alternative apportionment. Whether through litigation or by being prepared to litigate the issue, successes abound.
Craig B. Fields and Mitchell A. Newmark are partners and Eugene J. Gibilaro is an associate in the New York City office of Morrison & Foerster LLP.
For more information regarding alternative apportionment, see Craig B. Fields, Mitchell A. Newmark, & Eugene J. Gibilaro, “Unfair Apportionment: Consider the Alternatives,” Tax Executive, May 22, 2017. http://taxexecutive.org/unfair-apportionment-consider-the-alternatives/.
Hans Rees’ Sons, Inc. v. North Carolina ex rel. Maxwell, 283 U.S. 123, 133 (1931).
Moorman Mtg. Co. v. Bair, 437 U.S. 267, 274 (1978) (citations omitted).
Container Corp. of Am. V. Franchise Tax Bd., 463 U.S. 159, 184 (1983).
Hans Rees’ Sons, Inc., 283 U.S. at 135.
315 U.S. 501, 508 (1942).
Norfolk & W. Ry. Co. v. Mo. State Tax Comm’n. 390 U.S. 317, 329 (1968).
Moorman Manufacturing Co., 437 U.S. at 273.
Hellerstein, Hellerstein & Swain, State Taxation § 9.20(3)(a) (3d ed. 2001 & supp. 2017-3).
UDITPA § 18 (1957) (Nat’l Conference of Comm’rs of Unif. State Laws, amended 1966).
See, e.g., Cal. Rev. & Tax. Code § 25137; S.C. Code Ann. § 12-6-2320; Tenn. Code Ann. § 67-4-2014.
See, e.g., N.J. Stat. Ann. § 54:10A-8.
Mass. Gen. Laws Ann. ch. 63, § 38(g).
18 Or. Tax 423, 441 (2006).
Id. at 441 (citation omitted).
595 A.2d 1039 (Me. 1991).
Id. at 1045 (citation omitted).
647 N.E.2d 1280 (N.Y. 1995).
571 N.E.2d 800 (Ill. App. Ct. 1991).
524 N.E.2d 1389 (Ohio 1988).
DTA No. 820669 (N.Y.S. Div. of Tax App., February 15, 2007), aff’d, (N.Y.S. Tax App. Trib., February 21, 2008).
But see Equifax, Inc. v. Miss. Dep’t of Revenue, 125 So. 3d 36 (Miss. 2013), which found 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.
767 S.E.2d 195 (S.C. 2014).
Id. See also Rent-a-Ctr. W. Inc. v. S.C. Dep’t of Revenue, 792 S.E.2d 260 (S.C. Ct. App. 2016), which held that the department failed to meet its burden of proof based on similar evidence produced by the department on facts similar to those in the CarMax case, and Associated Bank, N.A. v. Comm’r of Revenue, No. 8851-R, 2017 Minn. Tax LEXIS 19 (Minn. T. C. April 18, 2017), which denied the commissioner’s assertion of alternative apportionment despite the taxpayer’s stipulation that it had created the entities at issue in the case for the purpose of limiting its Minnesota tax liability; the Minnesota Supreme Court heard oral arguments in the case on November 1, 2017.
Hellerstein, Hellerstein & Swain, supra note 11, at §9.20(1).
Metromedia, Inc. v. Dir., Div. of Taxation, 478 A.2d 742 (N.J. 1984); CBS, Inc. v. Comptroller of the Treasury, 575 A.2d 324 (Md. 1990).
Metromedia, Inc., 478 A.2d at 755.
CBS, Inc., 575 A.2d at 330.
Container Corp., 463 U.S. at 169.

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