On July 24, 2012, the California Court of Appeal reversed the trial court decision and granted the taxpayers’ requested refund claims that utilized an equally weighted three-factor apportionment formula. This despite the fact that in 1993 the California legislature enacted a law that attempted to override the Multistate Tax Compact (the “Compact”), to which California was a party, by adopting a double-weighted sales factor (“DWSF”). The Gillette Company v. Franchise Tax Board, Case No. A130803 (Cal. Ct. App. July 24, 2012). The court held “that the Compact is a valid multistate compact, and California is bound by it and its apportionment election provision unless and until California withdraws from the Compact by enacting a statute that repeals [its adoption of the Compact].”

The Franchise Tax Board filed an application for rehearing regarding whether the court’s decision should be interpreted as holding California’s DWSF amendment was invalid or whether taxpayers have the option to elect either a three-factor or DWSF apportionment formula. Surprisingly, the court vacated its order last week and granted a rehearing on its own motion. While this case was pending, Governor Brown signed S.B. 1015 into law, withdrawing California from the Compact, and it is rumored that the court’s decision to order a rehearing is related to the impact of this new legislation.

The rehearing order and the legislature’s response to Gillette indicate that the litigation over this issue in California is far from settled. Moreover, the court’s conclusion that the Compact’s standards for apportioning and allocating income among the states in which a taxpayer conducts business are available as an election to the taxpayer could have a far-reaching impact on other full member MTC states, such as Alabama, that have enacted legislation modifying certain provisions of the Compact. Depending on the particular facts and circumstances, protective refund claims may now be in order.

Alabama adopted the Compact in 1967, but with a delayed effective date. However, when the Alabama Code was recodified in 1977, that contingency mysteriously vanished. In State Dept. of Revenue v. MGH Management, Inc., 627 So. 2d 408 (1993), the Court of Civil Appeals held “that the Multistate Tax Compact has been in full force and effect in Alabama since the effective date of the recodification of the Alabama Code in 1977.” The next step occurred in 2001, when the Alabama Legislature (like most other member states) expanded the statutory definition of business income and effectively repealed the Compact’s narrower definition, which had been at issue in the Uniroyal case. Ala. Code § 40-27-1.1. Last year, Alabama de-conformed again by amending its version of the Compact to provide a DWSF instead of the three-factor apportionment formula and adopting market-based sourcing for receipts from sales of other than tangible personal property, thus repealing the Compact’s cost-of-performance sourcing methodology. Acts of Ala. 2011-616, effective for all tax years beginning on or after December 31, 2010.

In light of the California court’s rationale and strongly-worded opinion in Gillette, it is possible that multistate taxpayers doing business in Alabama may still have the option to elect to use the standard three-factor apportionment formula or the cost-of-performance sourcing methodology for sales of other than tangible personal property to apportion their business income to Alabama. It should be noted, however, that unlike California’s method of adopting DWSF, Alabama’s 2011 legislation actually amended the text of Alabama Code section 40-27-1, which is Alabama’s statutory adoption of the Compact. It is unclear whether that would have any effect on an Alabama court’s decision to follow the Gillette rationale. It is also unclear what impact the Gillette rationale, if upheld, may have on Alabama’s and other MTC member states’ efforts to expand the Compact’s definition of business income to include both a transactional and functional test, or on the validity of various special industry apportionment regulations.