A victory won by Gillette at a California Court of Appeal on July 24th has significant implications for multistate corporate taxpayers. Under the logic of the court’s opinion, states that signed the Multistate Tax Compact (the “Compact”) must permit corporate taxpayers to elect to apportion their income using the methodology provided for in Article IV of the Compact, even if the states have subsequently enacted legislation mandating a different methodology.
The opinion has been vacated and the reissued opinion is eagerly awaited. Until a new opinion is issued, the July 24th opinion will remain the best insight into the California Court of appeal’s thinking process. Corporations operating in states that have signed the Compact should at least consider filing protective refund claims based on the logic of the opinion.
The Genesis of the Multistate Tax Compact
In the 1960s a report was issued calling for the adoption of federal legislation that would provide for a uniform nationwide state tax apportionment system. State tax administrators viewed such federal legislation as an unwelcome intrusion on their taxing power. To head off concerns about lack of uniformity and to lessen the perceived necessity for federal legislation, several states signed the Compact, which contains a model state tax apportionment regime in Article IV of the Compact called the Uniform Division of Income for Tax Purposes Act (“UDITPA”). The Compact provides that taxpayers can elect to apportion their income using UDITPA. California enacted the Compact in 1974.
Gillette: the July 24th Opinion
California and many other signatories of the Compact have enacted statutes that diverge from the apportionment provisions provided for in UDITPA and that mandate that corporate income tax returns be filed using other methodologies.
Gillette filed California corporate income tax returns using the California statutory apportionment methodology and then filed a refund claim making the Compact election to use UDITPA apportionment.
On July 24th, the California Court of Appeal upheld Gillette’s refund claim, holding that, because California was a signatory to the Compact, Gillette could elect UDITPA apportionment and California could not override the binding multi-state compact that it had signed with contrary legislation due to the Contract Clause of the United States Constitution.
Shortly after the opinion was issued, both the Franchise Tax Board (“FTB”) and Gillette submitted filings with the court requesting clarification.
The FTB submitted a motion for rehearing, arguing that the opinion did not sufficiently address whether the California statute mandating that corporations use a sales/sales/property/payroll apportionment formula was unconstitutional.
Gillette requested that the court modify the opinion to address the impact of Senate Bill 1015 (“S.B. 1015”), which withdraws California from the Compact. Gillettepointed out that the decision implies in several sentences that California had not withdrawn from the Compact, when in fact it had as of the date the opinion was issued. Gillette suggested that a footnote be added acknowledging that S.B. 1015 purports to repeal the Compact but that S.B. 1015 was not properly before the court.
On August 9th, by its own motion, the California Court of Appeal vacated its July 24th decision. Rehearing has not been scheduled and the parties have not to date been asked to brief a new issue, so it is difficult to state with certainty what the California Court of Appeal intends to do.
Next Steps in California
It seems likely that the California Court of Appeal’s final decision will be appealed to the California Supreme Court and ultimately to the United States Supreme Court. Assuming that the taxpayer continues to prevail on the merits, the FTB may nonetheless refuse to pay refunds on the grounds that S.B. 1015 states that elections cannot be made on amended returns (the bill asserts that it does not constitute a change in position). Therefore, litigation concerning the retroactive applicability of S.B. 1015 and the doctrine of election may be ahead.
Accordingly, it seems likely that final resolution in California is still a long way away.
The availability of the Compact election is not an issue that is unique to California. The Multistate Tax Commission’s website presently lists the District of Columbia and 18 states (Alabama, Alaska, Arkansas, Colorado, Hawaii, Idaho, Kansas, Michigan, Minnesota, Missouri, Montana, New Mexico, North Dakota, Oregon, South Dakota, Texas, Utah and Washington) as full members of the Multistate Tax Compact.
There is scant guidance in those jurisdictions addressing the availability of a Compact election. A Texas administrative law judge decision denies the Compact election in summary fashion, but there is no Texas court decision fully exploring the issue.1
In Michigan, IBM is litigating the availability of a Compact election before the Michigan Court of Appeals.2
Litigation in other Compact states seems likely following Gillette.
Advantages of Making a Compact Election
The chief advantage of making a Compact election that most commentators have noted is the availability of three-factor apportionment. But there might be other advantages to making a Compact election (such as the availability of cost of performance sourcing for sales other than sales of tangible personal property and the availability of the UDITPA business income definition) that might be worthy of consideration for multistate corporations.
Filing Refund Claims: the Cost/Benefit Analysis
It is likely that refund claims filed making a Compact election will be denied in all states. In many states the administrative appeal of a refund claim denial will likely continue for years while the nationwide litigation unfolds. However, some states may want to settle cases on this issue, rather than risk an adverse decision as in Gillette, so it may be possible for some taxpayers to achieve a short term benefit by settling their refund claim based on the substantial hazards of litigation the Compact election issue presents for state tax departments.
It is also possible that taxpayers could continue to prevail on this issue in higher courts based on the Contract Clause argument and the logic set forth by the court in the July 24th Gillette opinion.
Given the significant potential upside, it seems prudent for taxpayers to at least consider the implications of a Compact election and whether it would be advisable to file refund claims in states that have signed the Compact.