In a now-vacated decision that has potentially enormous implications both in the tax context and many others, the California Court of Appeal invalidated 20-year-old California state tax legislation that had sought to modify provisions of the Multistate Tax Compact which California had adopted in 1966, without formally withdrawing from the Compact. Gillette Co. et al. v. Franchise Tax Board.1
On August 9, just 16 days after issuing its opinion, the court vacated it on its own motion and ordered a rehearing without requesting further briefing or argument from the parties — a rare action for any California court to take. At least one knowledgeable observer, the executive director of the Multistate Tax Commission, has stated that he does not expect the court to change its holding after it issues a new opinion in the case, although the tenor of the opinion may well be altered.
Specifically, the court’s original opinion held that multistate businesses required to allocate and apportion their income could continue to do so under an equally weighted three factor formula (generally known as sales, property, and payroll), despite the Legislature’s enactment of a statute requiring most such taxpayers to use a double-weighted sales factor, and could file refund claims to recover taxes paid when income was computed under the legislative formula. This decision appears to be unprecedented in the Multistate Tax Compact context.
If the opinion, and its subsequent vacation, were not striking enough, the Legislature’s response to a potential defeat following the oral argument in the Court of Appeal was perhaps even more so. Less than a month before the decision was released, the Legislature enacted a budget trailer bill (S.B. 1015, codified as Stats. 2012, c. 37) that has the apparent intent of cutting off the possibility for other taxpayers — and possibly even the litigants in Gillette — from using the case either prospectively or even retroactively, based on filing amended returns. The bill did not receive a two-thirds vote, which would be required for any legislation that increases taxes on any taxpayer, under Article XIII-A of the State Constitution, as amended by Proposition 26 in 2010. The validity of this aspect of the legislation is certain to be challenged on constitutional grounds.
The Gillette Decision Prior to Vacation
In 1966, California adopted the Uniform Division of Income for Tax Purposes Act (UDITPA), and became a signatory to the Multistate Tax Compact that essentially incorporated the provisions of UDITPA as it was originally proposed and enacted.
Among many other provisions affecting state taxation of enterprises doing business in multiple states, the Compact, like UDITPA, provided a formula for apportioning business income that gave equal weight to the location of the taxpayer’s (or enterprise’s, in the case of passthrough entities) assets or property, employees or payroll, and revenue or sales. Further, the Compact included a provision (Article III, par. 1) that gave affected taxpayers the ability to apportion their income either on the basis of the state law that would apply if the Compact had not been enacted, or on the basis of the Compact’s apportionment formula. Finally, the Compact authorized any member state to withdraw unilaterally from the Compact by enacting a statute repealing it.
In 1993, California followed the lead of several other states that were seeking to shift some of the corporate tax burden from companies based in the state (thereby having relatively high property and payroll factors, but potentially lower sales factors), to those based out of state but having a market for their products in the state (thereby having relatively high sales factors and relatively low property and payroll factors). This was done by requiring most interstate business to apportion income on a formula that weighted the sales factor at 50 percent and the other two at 25 percent each, rather than equally. The legislation specified that this requirement applied notwithstanding any provision of the Compact.
Between 2003 and 2007, several non-California based businesses that were disadvantaged by the 1993 requirements filed claims for refund with the FTB, asserting that they had the right to determine apportionment under the Compact provisions regardless of the 1993 legislation. A trial court dismissed the complaint, but the Court of Appeal reversed the dismissal.
Basis of the Decision
Central to the court’s holding is the dual nature of interstate compacts as “not only law, but a contract which may not be amended, modified, or otherwise altered without the consent of all parties,” and which provides third-party beneficiary rights to affected private parties. Because the Legislature failed to follow the withdrawal procedure specified in the Compact, the court found that the statutory modification of the apportionment formula violated the binding contractual provisions of the Compact and was thus void.
It is noteworthy that the court reached its conclusion despite the fact that the Multistate Tax Commission, the agency charged with administering and enforcing the Compact, had filed a brief supporting the FTB’s position. The Commission pointed out that only one member state (out of a total of 20) was still giving taxpayers the election right, that many had modified the equal weight formula in the Compact by subsequent legislation, and that no court had ever held such legislation invalid.
Impact on other Compacts
California appears to have enacted at least 20 interstate compacts on many subjects, including child custody, water and environmental issues, and vehicle and driver licensing. The Gillette decision could have an impact on a variety of statutes that in one way or another have modified or altered the effect of some of these compacts. The decision could also have significant implications in other states that have signed either the Multistate Tax Compact or other compacts, if courts there find its reasoning persuasive.
Responsive Legislation — Open to Substantial Attack
Presumably because the FTB had alerted the State Legislature that a reversal of the trial court decision was possible or likely, the Legislature in June quickly wrote and passed, and the governor signed, SB 1015, effective on June 27, 2012 (Stats. 2012, Chapter 37). (The court’s opinion in Gillette does not mention this statute; it is not known whether any litigant had brought the enactment to the court’s attention prior to release of the opinion).
Section 3 of the bill repealed the entire Multistate Tax Compact Legislation (Rev. & Tax. Code Section 38001 et seq.). Presumably, this action prospectively eliminates the right of taxpayers to use the equal-weighting approach with respect to years for which returns have not yet been filed, or at least for the current and future taxable years.
Much more controversially, Section 4 of the bill (i) makes reference to a so-called doctrine of election which, the Legislature states, requires that “an election affecting the computation of tax must be made on an original timely filed return for the taxable period for which the election is to apply and once made is binding” and (ii) declares that the so-called doctrine of election “applies to any election that affects the computation of tax under [the personal income and corporation tax law] unless otherwise provided.”
In what may be a legislative first, the new law cites a 65-year-old case, Pacific National Co. v. Welch,2 as the basis for the “doctrine of election.” This case involved a taxpayer that sought to file an amended return to elect the installment method of accounting for sales, after first using the so-called “closed transaction” method in which receivables received on sales were taken into income immediately rather than as they were paid. The basis of the Supreme Court’s opinion was that taxpayers could not use amended returns to change their method of accounting, over the objections of the Internal Revenue Service, because of the complexity that a change would add, as the change would require amendments to many other years’ returns.
Interestingly, the IRS on several occasions has actually granted permission to taxpayers to file amended returns regarding installment sale treatment in various contexts. See, e.g., Rev. Rul. 65-297.3 Under California’s general practice of conformity, the Franchise Tax Board has apparently followed these interpretations. It is unclear whether the new statute essentially deprives the FTB of the ability to allow elections to be made on amended returns.
California case law (primarily in the Board of Equalization on appeal from FTB determinations) already generally holds that unless a statute expressly provides otherwise, statutory elections cannot be made on amended returns over the FTB’s objections.4 However, there are numerous specific statutory provisions in both California law and the Internal Revenue Code that allow elections to be made on amended returns, and these provisions are probably not affected by the new legislation.
What is unique about the situation after Gillette (assuming that the holding is not changed on the rehearing, or reversed by the California Supreme Court) is that the Legislature is apparently attempting to cut off refund claims by businesses that initially filed returns using the double-weighted sales factor, because they were following the law. The Legislature is apparently now saying that no refunds will be available to businesses unless they had perfect foresight and had initially filed returns on the basis of an election that the Legislature had specifically sought to cut off, because they realized that a court would declare that attempt invalid. Clearly, this will be a tempting target for future litigation.
If the legislative attempt to eliminate refunds is ultimately not upheld, and the original Gillette holding remains the law of California, refunds could be available for up to four years following the filing of a return.