The South Carolina Supreme Court issued its decision in CarMax Auto Superstores West Coast, Inc. v. S.C. Dep’t of Revenue, Opinion No. 27474 (S.C. Dec. 23, 2014), holding that the South Carolina Department of Revenue (the “Department”) bore the burden of proof to invoke the use of an alternative apportionment method and failed to meet its burden.
CarMax Auto Superstores West Coast, Inc. (CarMax West) apportioned its income from vehicle sales, royalties and financing to South Carolina using the statutory required apportionment formula for multi-state taxpayers, based on the taxpayer’s payroll, property and sales.
On audit, the Department determined that the statutory formula did not fairly represent CarMax West’s business activity in the state. The Department invoked its authority to apply an alternative apportionment method by apportioning CarMax West’s income from royalties and financing separately from its retail income. The bifurcation approach used by the Department produced a significantly higher South Carolina apportionment ration than the statutory apportionment formula.
CarMax appealed the Department’s determination. The Administrative Law Court (ALC) held that the Department satisfied its burden of proving that the standard statutory apportionment method did not fairly reflect the taxpayer’s South Carolina business activities and that the taxpayer had the burden to show that the apportionment formula applied by the Department was not reasonable. The ALC held that the Department’s apportionment method was reasonable because it considered only the taxpayer’s business conducted in South Carolina, and separate accounting was a method expressly authorized by South Carolina law.
South Carolina Court of Appeals Decision
As previously reported, on appeal, the South Carolina Court of Appeals reversed the ALC and found that the Department, as the party seeking to deviate from the statutory apportionment method, had a dual burden. First, the Department had the burden of proving that the standard statutory formula did not fairly represent CarMax West’s business activity in South Carolina. Second, the Department had to prove that its alternative method “is not only appropriate, but more appropriate than any competing methods.” The Court of Appeals remanded the case back to the ALC for reconsideration of all issues.
Petitions for Writ of Certiorari and the South Carolina Supreme Court’s Certification
Following the appellate court’s decision, both the Department and CarMax West filed petitions for certiorari with the South Carolina Supreme Court.
In its cert petition, the Department argued that the Court of Appeals erroneously found that the Department bore the burden of proof to show that an alternative apportionment method is more appropriate than any other competing methods. The Department did not challenge the first prong of the dual-burden test – that it has the initial burden to show that an application of the statutory apportionment formula does not fairly represent the taxpayer’s business activities in the state. However, the Department asserted that once that burden is met, its proposed alternative method should be upheld as reasonable unless there is evidence to the contrary.
The Supreme Court also agreed to review the following questions presented by CarMax:
- Whether the Courts of Appeals erred in failing to rule that CarMax West was a unitary business?
- Whether the Court of Appeals erred in failing to rule that CarMax West’s financing receipts should not be sourced to South Carolina?
- Whether the Court of Appeals erred in failing to rule that the Department’s tax assessment violates CarMax West’s constitutional rights?
South Carolina Supreme Court Decision
In a 2-1 decision, the Court affirmed the Court of Appeals decision that the proponent of an alternative apportionment method must satisfy two burdens and show by 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, and not more appropriate than any competing methods as the Court of Appeals had previously held.
Sutherland Observations: The issue of which party bears the burden of proof in alternative apportionment cases is critical and has been the subject of litigation in a number of states. Microsoft Corp. v. Cal. Franch. Tax Bd., 139 P.3d 1169 (Cal. 2006); Vodafone Americas Holdings Inc. v. Roberts, No. M2013-00947-COA-R3-CV (Tenn. Ct. App. June 23, 2014). All too often, state tax administrators invoke alternative apportionment without proof that the statutory method does not clearly reflect income in the state.
Sutherland Observations: The Supreme Court’s holding lowers the second burden of proof for alternative apportionment purposes. Under the new standard announced in CarMax, a party seeking to deviate from the statutorily provided apportionment formula need only provide that its proposed formula is reasonable. To prevail under the Court of Appeals’ standard, a proponent of an alternative apportionment formula had a much higher burden of showing that its proposed alternative apportionment method was not only appropriate but also more appropriate than any other proposed method.
The Supreme Court determines that the Department has not satisfied its first burden, i.e., that the statutory required formula does not fairly represent CarMax’s South Carolina business activities. The Court explains that while the evidence in the record satisfies the Department’s second burden, the Department failed to meet its first burden.
The Court points out that to satisfy its first burden, the Department offered evidence showing that the business structure of CarMax West is often “linked with tax minimization strategies” and that CarMax West’s apportionment ratio resulted in a significantly lower tax. The Court concluded that: “Even if these findings accurately characterize CarMax West’s motives, they do not provide a sound evidentiary basis to support the conclusion that the statutory formula did not fairly represent CarMax West’s business in South Carolina.”
Sutherland Observations: Like many states, South Carolina’s alternative apportionment statute is modeled after the Uniform Division of Income for State Tax Purposes Act’s alternative apportionment provision. See S.C. Code Ann. § 12-6-2320; UDITPA § 18. The framers of UDITPA recognized that alternative apportionment should only be applied in “unusual cases.” William J. Pierce, The Uniform Division of Income for State Tax Purposes, 35 Taxes 747, 781 (1957). Prof. William J. Pierce, the main drafter of UDITPA, cautioned that the fundamental purpose of UDITPA would be seriously undermined if section 18 “were interpreted to give administrators in the different states broad discretion in the selection of alternative methods.” Id. Consistent with those principles, theCarMax court correctly concludes that state revenue agencies should not be permitted to adjust state income apportionment simply because use of the standard apportionment provision produces a lesser tax liability.
Sutherland Observations: In recent years, states increasingly have relied on alternative apportionment statutes to deviate from the state’s statutory apportionment method. Despite the growing reliance on alternative apportionment, there is little guidance on how those rules should be applied. The CarMax Westcase demonstrates the difficulty facing multistate businesses in determining how best to apportion their income. If a corporation apportions its income under the statutory required method, it may find that a state revenue department concludes that the method does not fairly reflect the corporation’s business activities in the state. The corporation may then be required to bear the burden of showing that its use of the statutory formula is appropriate. Therefore, the Supreme Court’s holding in CarMax West provides a much needed directive that a taxpayer may not be forced to defend its use of the statutory apportionment formula unless and until the Department offers substantiating evidence showing that that formula does not fairly reflect the taxpayer’s business activities and the state and that the Department’s proposed alternative apportionment formula is reasonable.
The dissenting opinion agreed with the majority’s modification of the burden-of-proof standard established by the Court of Appeals. However, the dissent disagreed with the majority’s ultimate holding and instead would have remanded the case back to the ALC for determination of whether the Department could meet its burdens of proof.