On December 23, 2014, the South Carolina Supreme Court issued its decision in CarMax Auto Superstores West Coast, Inc. v. South Carolina Dep’t of Revenue, Opinion No. 27474, holding that where a party seeks to deviate from South Carolina’s statutory apportionment method, the proponent of such alternative apportionment method bears the burden of proving by a preponderance of the evidence that: (1) the statutory formula does not fairly represent the taxpayer’s business activity in South Carolina; and (2) its alternative apportionment method is reasonable. The court found that the South Carolina Department of Revenue (“Department”), the proponent of the alternative apportionment method in this case, had not carried its burden of proof, resulting in a taxpayer victory. This decision modified and affirmed the decision of the South Carolina Court of Appeals, which had ruled that the alternative-apportionment proponent bears not only the burden of proving that the statutory formula does not fairly represent the taxpayer’s business activity in South Carolina, but also the burden of proving that the alternative method is more appropriate than any other competing apportionment method. The South Carolina Supreme Court’s modification to the Court of Appeals decision clarified the conditions under which alternative apportionment may be obtained in South Carolina.
CarMax, Inc. (“CarMax”), a used automobile retailer, operated its retail stores through two subsidiaries: (1) CarMax Auto Superstores West Coast, Inc. (“CarMax West”), which operated CarMax retail stores throughout the western United States; and (2) CarMax Auto Superstores, Inc. (“CarMax East”), which operated CarMax retail stores throughout the eastern United States. From 2002 to 2004, CarMax West owned substantially all of CarMax’s intellectual property and licensed it to CarMax East in exchange for royalties. CarMax East managed all of the financial operations and corporate overhead for CarMax.
In 2004, CarMax reorganized to centralize various corporate and financing services and intellectual property management functions in CarMax Business Services, LLC (“CBS”), a limited liability company owned by CarMax West, a 93.5% member, and CarMax East, a 6.5% member. Following the restructuring, the role of CarMax East and CarMax West was limited to retailing, and CBS provided corporate overhead services and certain financing services. CBS charged CarMax West and CarMax East a per vehicle management fee which included an intellectual property management component. Both CarMax East and CarMax West received distributive share income from CBS, an entity classified as a partnership for federal income tax purposes, but, unlike CarMax East, CarMax West’s financial connection to South Carolina from 2005-2007 was limited to the distributive share of income that it received from CBS. Similarly, from 2002-2004, CarMax West’s financial connection to South Carolina was limited to the royalties it received from CarMax East.
From 2002-2007 (“Period at Issue”), South Carolina corporate taxpayers were generally required to apportion their income using a three-factor apportionment formula, which consisted of a property factor, a payroll factor, and a double-weighted sales factor. CarMax West initially filed South Carolina corporate income tax returns in this manner for the Period at Issue, and, after being audited and assessed by the Department, CarMax West filed amended South Carolina corporate income tax returns using a single-sales factor apportionment formula (“Gross Receipts Method”) that was statutorily provided for corporate taxpayers that principally derived income from sources other than tangible personal property
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and that did not belong to certain enumerated industries not applicable to CarMax (e.g., pipelines, airlines, railways, etc.). CarMax West’s sales factor pursuant to the Gross Receipts Method was computed by dividing its South Carolina receipts by its overall gross receipts, including its gross receipts from its automobile retail operations, derived from everywhere it conducted business.
The Department rejected CarMax West’s use of the Gross Receipts Method and proposed to employ an alternative apportionment method. The Department’s proposed alternative apportionment method was similar to the Gross Receipts Method, except it excluded CarMax West’s retail sales receipts from the denominator of the sales factor. The Department issued a Final Agency Determination upholding its alternative apportionment method position, and, after CarMax West appealed to the South Carolina Administrative Law Court (“ALC”), the ALC upheld the Department’s alternative apportionment method. In making its determination, the ALC held that “. . . [t]he standard of proof is a preponderance of the evidence. [Internal cite omitted.] Additionally, the burden of proof is generally upon the party asserting the affirmative in an adjudicatory administrative proceeding. 2 Am. Jur. 2d Administrative Law § 354 (2004). The taxpayer in this matter requested a contested case hearing to challenge the Department’s proposed assessment; thus the taxpayer bears the burden of proof.”
South Carolina Court of Appeals Decision
On appeal, CarMax West alleged that the ALC erred in failing to place the burden of proof on the Department to establish by clear and convincing evidence that the standard statutory apportionment method used by CarMax West did not reflect the extent of CarMax West’s business in South Carolina. CarMax West acknowledged that the burden of proof in tax cases generally falls on the petitioner, with the evidentiary standard of proof being a preponderance of the evidence. With respect to alternative apportionment cases, however, CarMax West argued that the burden shifts to the party seeking to invoke alternative apportionment. In addition, CarMax West implored the court to adopt a “clear and convincing” standard of proof, citing to various cases from other jurisdictions as support. In response, the Department agreed that it had the initial burden of proving that CarMax West’s chosen method of apportionment was unreasonable; however, once that burden was met, the Department argued that the burden shifted to CarMax West to prove by clear and convincing evidence that the Department’s alternate method leads to a “grossly distorted” result.
The Court of Appeals, relying on Media General Commc’ns, Inc. v. South Carolina Dep’t of Revenue, 694 S.E.2d 252 (S.C. 2010), reversed the ALC’s decision on the issue of which party bears the burden of proof in alternative apportionment cases. The court stated that the proponent of alternative- apportionment must establish (1) that the statutory formula does not fairly represent the taxpayer’s activity in the state, and (2) that its alternative method is reasonable and not only appropriate, but more appropriate than any competing methods. With respect to the evidentiary standard, however, the Court of Appeals declined to adopt a clear-and-convincing standard. The court held that “CarMax West . . . failed to cite any South Carolina authority supporting its position and the statutes do not indicate a legislative intent to apply the clear and convincing standard.” As such, the Court of Appeals reversed the ALC’s determination that CarMax West had the burden of proof and remanded the case to the ALC for reconsideration applying the preponderance-of-the-evidence standard. The parties each filed petitions for a writ of certiorari with the South Carolina Supreme Court, with the Department appealing the alternative- apportionment burden of proof standard adopted by the Court of Appeals.
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South Carolina Supreme Court Decision
On appeal, the South Carolina Supreme Court agreed with the Court of Appeals that the application of alternative apportionment requires a two-part inquiry. Although the Supreme Court agreed that the first prong can be met if the proponent demonstrates by a preponderance of the evidence that the statutory formula does not fairly represent the taxpayer’s business activity in South Carolina, the Supreme Court took issue with the Court of Appeals’ articulation of the second prong, which required the proponent to establish that its alternative apportionment method is more appropriate than any competing methods.
In reviewing the second prong, the Supreme Court noted that the Court of Appeals had misapplied Media General. The Supreme Court distinguished this case from Media General, noting that the parties in Media General agreed that the statutory alternative method did not fairly reflect the taxpayer’s business in South Carolina. In such circumstance, a situation arises where either party could propose an alternative apportionment method for comparison and consideration. In contrast, in a situation where only one party is seeking to deviate from the statutory formula, the Supreme Court held that, after demonstrating that the statutory formula does not fairly represent a taxpayer’s business activity in the state, the proponent of alternative apportionment is only required to prove that its proposed alternative apportionment method is reasonable. Notwithstanding its correction of the second prong of the two-part test, the Supreme Court ruled in favor of CarMax West after finding that the Department had not satisfied the first prong of the two-part test by failing to prove that the statutory formula did not fairly represent CarMax West’s South Carolina business activity.
The South Carolina Supreme Court’s modification to the alternative- apportionment test set forth by the Court of Appeals is significant in that it provides guidance for obtaining alternative apportionment, which is a result that both taxpayers and the Department may seek. While proving that the statutory formula is not fairly representative of the taxpayer’s in-state business activities may be a significant challenge, the challenge of proving that an alternative apportionment method is more appropriate than any competing method, as proposed by the Court of Appeals, would likely have been exceedingly difficult, as it could require the consideration of all such competing methods. The South Carolina Supreme Court’s modification relaxes the Court of Appeals’ proposed standard, takes a more practical approach to the administration of alternative apportionment, and provides the parties applying for, or defending against, alternative apportionment with a framework to evaluate the potential outcome.
By John Paek, Palo Alto and Michael C. Tedesco, New York