In a disappointing decision released yesterday, the Tennessee Supreme Court upheld the intermediate appellate court in Vodafone Holdings v. Roberts. In that case, the Supreme Court allowed the Department of Revenue to utilize alternative apportionment where "nearly all of the taxpayer's sales receipts for services to its Tennessee customers... would not be subject to Tennessee franchise and excise taxes." Notwithstanding the legislature's determination to utilize an income producing activity test, the court concluded that this approach did not reasonably reflect the taxpayer's business activities in Tennessee, and that the reasonable alternative would be to look at the taxpayer's market. Unfortunately, such a ruling grants the Department the authority to deviate from the statutory formula where convenient, notwithstanding the legislature's clear intent to focus on where income producing activity occurs as opposed to where it is received. That is, a service will always be performed in one location and received in another; a state should not be able to change its manner of measurement of tax based on which measurement results in a greater activity in the state.  

Based upon its review of legislative history, the Court found that the Tennessee legislature intended the Commissioner to have the authority to impose variance where the application of the statutory formula does not fairly represent the extent of a taxpayer's business activity in the state. The Court further noted that over time the legislature has steadily expanded the Commissioner's discretion to exercise his variance power.  The Court opined that the taxpayer could not honestly argue that Tennessee's statutory formula, as it existed during the years at issue, accurately reflected its business in the state, because the taxpayer would have a relatively small Tennessee Tax liability notwithstanding significant sales to Tennessee customers.  This case strikes another blow to multistate taxpayers' right to fair and consistent treatment by taxing authorities. 

Based on the Court's reasoning the internal consistency test is rendered pointless.  Under the internal consistency test, a tax is considered a violation of the Commerce Clause if the tax would result in the income could be subject to tax in multiple states assuming the tested tax were enacted in its identical form by other states.  Here, the Court's holding flies directly in the face of the bedrock principle of the internal consistency test, i.e., a protection against multiple taxation of interstate commerce.  Although Tennessee adopted the income producing test, theVodafonedecision would allow the department to freely deviate from that test where a taxpayer's market presence in a state outweighs its income producing activity.  However, if Tennessee were the location for the income producing activity, its standard formula would still apply.  Tennessee thus is permitted to maximize the tax liability regardless of the circumstances of a particular taxpayer.

Another significant problem with the decision is that it undermines the original purpose for granting taxing authorities the ability to invoke alternative apportionment. The original purpose of alternative apportionment was to address constitutional problems as well as the "unusual cases," and to provide a better reflection of a taxpayer's business conducted in the state.  Hence, the focus should be on the business conducted in the state, not the income\ sourced to the state.  The Court reasoned that, "if Vodafone were permitted to apply the COP method as it advocates," it would result in "billions of dollars of Vodafone's revenue from Tennessee customers would become invisible…"  This reasoning leads to an inverse application of the alternative apportionment burden meant to be imposed on the moving party.  Instead of insisting that the Department and Commissioner prove that the statutory method is distortive and the proposed method is reasonable, the Court instead imposed this burden on Vodafone.  Vodafone was left to demonstrate why it should be permitted to source its income pursuant to the statutorily provided method!  The Court was blinded by the amount of income being sourced to the state instead of what was statutorily proper and fair. With states moving to single sales factor and market-based sourcing, taxpayers are encountering more sourcing regimes that are not reflective of their income producing activities; however, at least in states that have adopted single-sales factor or market-based regimes, a taxpayer is put on notice of what will be required of them. 

Lastly, and perhaps most concerning, is the timing of the Commissioner's issuance of the variance letter. The Commissioner issued the variance letter on May 21, 2010, well after the February 2009 complaint, and significantly after the 2002 through 2006 tax years. Hence, rather than thoughtfully analyzing the taxpayer's business activity in the state and issuing a variance letter for prospective treatment, the Department utilized alternative apportionment during litigation to justify its otherwise clearly wrong argument. Neither the majority nor dissenting opinions expressed any concern with the clear unfairness in invoking alternative apportionment at such a late stage.  By upholding the Commissioner's exercise of his variance power the Court tacitly approved the artificial justification employed by the Commissioner to export Vodafone's tax base in order to increase the revenue apportioned to Tennessee.  

For our previous discussion of Vodafone and the trend in alternative apportionment cases across the states, please see here and here.