United States: California Court Of Appeal Decides To Rehear "Gillette" Case Concerning Multistate Tax Compact Apportionment Election, Vacates Earlier Decision

On August 9, the California Court of Appeal surprisingly filed an order that mandates a rehearing of its decision in the Gillette case that was released on July 24.¹ The Court granted the motion on its own order and vacated the decision and opinion for the case. In Gillette, the Court had ruled in favor of a group of taxpayers electing to use the equally-weighted three-factor apportionment formula provided by the Multistate Tax Compact, in lieu of California's statutory apportionment formula requiring use of a double-weighted sales factor. The Court of Appeal had held in the vacated decision that California was contractually bound by the Compact and its apportionment election provision until withdrawal from the Compact.

Background

The Compact provides for a standard equally-weighted apportionment formula that consists of property, payroll and sales factors. Under the Compact, taxpayers expressly are allowed the option to elect to apportion income under the standard formula in lieu of a state's own apportionment provisions. California ratified the Compact in 1974² and originally required corporations to apportion their business income to the state using the standard equally-weighted three-factor formula.³ For tax years beginning on or after January 1, 1993, California adopted and required use of a new three-factor apportionment formula consisting of property, payroll and double-weighted sales, notwithstanding the election provided in the Compact.⁴

In January 2010, the taxpayers filed claims with the California Franchise Tax Board (FTB) for tax refunds and argued that the California apportionment statute did not override or repeal the standard apportionment formula. The taxpayers sought reversal of the FTB's denial of their refund claims in the trial court.⁵ The FTB argued that the amended California apportionment statute required the exclusive use of the double-weighted sales factor and negated the taxpayers' claim of entitlement to elect the equally-weighted apportionment formula. The trial court ruled in favor of the FTB and agreed that the amended California apportionment statute clearly expressed an intention to eliminate the election to use the equally-weighted apportionment formula allowed under the Compact. The taxpayers appealed this decision to the California Court of Appeal.

On June 27, in contemplation of a decision adverse to the state, California enacted legislation, S.B. 1015, repealing the Compact.⁶ The legislation, which was an attempt to limit the tax refunds that the state might be required to pay for open tax years, clarifies that since 1993, the use of an equally-weighted three-factor formula by a multistate taxpayer has been disallowed.

Vacated Decision Allowed Apportionment Election

On July 24, the Court of Appeal reversed the trial court and agreed with the taxpayers that California was bound by the provisions of the Compact and could not override and eliminate the taxpayers' ability to elect the equally-weighted three-factor apportionment formula. In reaching its decision, the Court rejected the FTB's argument that the plain language of the California apportionment statute required the exclusive use of the double-weighted sales apportionment formula. According to the Court, California could only eliminate a taxpayer's election to use the equally-weighted three-factor formula by completely withdrawing from the Compact. California could not enact a statute that repealed the provisions of the Compact to the extent necessary to impose a mandatory apportionment formula on taxpayers.⁷

In response to the decision, on August 8, the FTB filed a petition for rehearing claiming the decision failed to address whether the amended apportionment provisions are still valid and enforceable in light of its ruling that the taxpayers were still eligible to make the Compact election. Specifically, the FTB requested a resolution of whether the Court interpreted the meaning of the phrases "notwithstanding" and "shall" contained in the apportionment statute⁸ in a manner conflicting with established principles of statutory construction. In the alternative, if the Court interpreted the meaning of the statutory language consistent with well-established precedent, the FTB asked whether the Court determined that the apportionment statute was unconstitutional. In tandem, the taxpayers filed a request for the Court to modify the opinion to clarify its statement that any legislation repealing the Compact⁹ must be prospective in nature. The taxpayers also sought clarification that for the tax years at issue, California had not repealed its statute adopting the Compact and had not withdrawn from the Compact. Further, the taxpayers requested that the opinion be revised so that any reference to S.B. 1015 that attempts to repeal the Compact be accompanied by a statement that the Court expresses no opinion on the validity of S.B. 1015. The next day, the Court of Appeal vacated the decision and ordered a rehearing of the case. The Court of Appeal did not set a timetable for further action, and did not request additional briefing from the parties indicating that it already had sufficient information.

Commentary

The question of whether taxpayers are allowed to elect to use the equally-weighted three-factor apportionment formula in California has received considerable attention. The Court of Appeal's order vacating the decision only 16 days after it was released was unexpected. A taxpayer-favorable decision potentially could cost California a considerable amount of money in taxpayer refunds. As discussed above, California recently has enacted legislation, S.B. 1015, that attempts to repeal the Compact.¹⁰ Pursuant to the legislature's finding and declaration contained in S.B. 1015, an election that affects the computation of tax must be made on an originally timely filed return for the taxable period for which the election is to apply.¹¹

The fact that the Court completely vacated its decision indicates very little for the moment. It is within the realm of possibility that the Court will make technical revisions to the previously issued opinion, without changing the ultimate result. Alternatively, the Court's action could portend further reconsideration, requests for additional information from the litigants involved, and the development of a future opinion that could differ considerably from the previous decision. Given that the vacated decision did not explicitly address the legislation that repealed the Compact, it is possible that a future decision may explicitly reference this recent legislation, despite the fact that the tax years involved in the case clearly do not include the year in which California actually took action to withdraw from the Compact. Accordingly, at this point, it is very difficult to predict whether the Court of Appeal will rule in favor of the taxpayers or the state. Regardless of the outcome, it is likely that any decision rendered by the Court of Appeal will be appealed to the California Supreme Court. Thus, taxpayers and practitioners are unlikely to have clear guidance on this issue for several months, if not much longer.

Despite the Court of Appeal's order to vacate the Gillette decision, taxpayers should continue to consider filing protective refund claims relating to the Compact's three-factor election issue, as well as consider whether such position should be taken on original returns, and even in other states that have adopted the Compact. Because the favorable Court of Appeal's decision has been vacated, taxpayers have less support for making an apportionment election than they had prior to the Court's order vacating the decision. Taxpayers will also have to consider how to disclose the existence of the three-factor election, as well as the potential for penalties to be imposed if the three-factor election is taken on an amended or original return and the FTB is ultimately victorious in the Gillette litigation.

Footnotes

1 The Gillette Co. v. Franchise Tax Board, California Court of Appeal, First District, No. A130803, July 24, 2012.

2 CAL. REV. & TAX. CODE §§ 38001 to 38021.

3 CAL. REV. & TAX. CODE § 25128(a) as in effect for tax years beginning prior to January 1, 1993.

4 CAL. REV. & TAX. CODE § 25128(a). Note that there are certain industry exceptions to the standard apportionment formula, including agriculture business, extractive business, savings and loan activities, and banking and financial businesses. These entities continue to use an equally-weighted three-factor formula. CAL. REV. & TAX. CODE § 25128(b), (c).

5 The case was considered by the San Francisco Superior Court.

6 Ch. 37 (S.B. 1015), Laws 2012.

7 In support of its decision, the Court explained that interstate compacts are binding and enforceable contracts between states. The Court determined that the Compact was an enforceable interstate tax compact. Also, the Court held that states cannot unilaterally repeal compact terms.

8 CAL. REV. & TAX. CODE § 25128(a).

9 Note that the full text of the Compact is codified at CAL. REV. & TAX. CODE § 38006.

10 Ch. 37 (S.B. 1015), Laws 2012.

11 S.B. 1015, § 4(a). Note that questions already have been raised by the state's attempt to retroactively withdraw from the Compact, which was explicitly challenged by the Court's ruling that only a prospective withdrawal would be acceptable. Further, a potential argument that the state's withdrawal from the Compact was ineffective could be raised, in that California implicitly enacted a tax increase when it withdrew from the Compact, and pursuant to Proposition 26, all tax increases must be approved by a two-thirds margin in the state Assembly and Senate. As the state legislature did not pass the legislation by the required supermajority margins, the withdrawal from the Compact may have been ineffective.

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