United States: California Court Of Appeal Issues Revised "Gillette" Opinion Concerning Multistate Tax Compact Apportionment Election

On October 2, the California Court of Appeal issued a revised opinion in Gillette ruling 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 an apportionment formula requiring use of a double-weighted sales factor.¹ This opinion is very similar to the previous opinion that the Court released for this case on July 24 and subsequently vacated on August 9. However, the new opinion acknowledges legislation, S.B. 1015, enacted on June 27 that repealed the Compact. Because this legislation repealing the Compact was enacted after the years involved in the case, this legislation did not change the Court's holding.

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. 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.⁵ 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.⁶ The decision did not address S.B. 1015.

In response to the decision, the FTB filed a petition for rehearing and the taxpayers filed a request with the Court to modify the opinion. On August 9, the Court vacated the decision and ordered a rehearing of the case.

Revised Opinion Still Allows Apportionment Election

On October 2, the California Court of Appeal released an opinion that is very similar to its July 24 opinion that was subsequently vacated. The Court followed the reasoning discussed above, but revised the opinion to provide that California was a signatory to the Compact "[a]t the operative times." In a footnote, the Court acknowledged that California enacted S.B. 1015 after the oral argument in this case. Also, the footnote clarified that S.B. 1015, and any issue concerning its effect or validity, was not before the Court. Because this legislation was enacted after the years at issue, it did not change the Court's previous decision. The Court concluded "that the Compact is a valid multistate compact, and California was bound by it and its apportionment election provision throughout the years in question because California had not repealed [the Compact provisions] and withdrawn from the Compact during that timeframe." Throughout the opinion, the Court amended its references to the California statutes that adopted the Compact to indicate that they were "former" statutes that are no longer in effect. In all other respects, the Court essentially reissued its opinion from July 24. Reaching the same conclusions as in the prior decision, the Court reversed the trial court's decision that was in favor of the FTB.

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's opinion issued on July 24 was favorable to taxpayers, but its subsequent order to vacate this decision produced a great deal of uncertainty. The fact that the Court decided to make technical revisions to the previously issued opinion, without changing the ultimate result, is a taxpayer-favorable development.

As discussed above, California has enacted legislation, S.B. 1015, that attempts to repeal the Compact.⁷ 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.⁸ However, many unanswered questions remain. First, because the validity of S.B. 1015 was not an issue before the Court, the decision did not address the effect or validity of S.B. 1015, which is subject to challenge in light of the fact that it passed the legislature with only a simple majority rather than the two-thirds required for any tax increase.⁹ Second, the decision also did not resolve the inevitable controversy arising from the bill's attempt to retroactively deny the election. Ultimately, considering the significance of this decision, it is almost certain that the FTB will appeal the verdict to the California Supreme Court.

Thus, the drama continues, with taxpayers and practitioners left to debate whether the Court of Appeal's decision ultimately will be upheld, and whether further litigation will address whether the Compact election specifically can be made on an amended return. Accordingly, taxpayers who briefly considered the effect of the original Gillette decision by the California Court of Appeal in July again face the consideration of filing protective refund claims relating to the Compact's three-factor election issue on an amended and/or original return, in California and in other states that have adopted the Compact. Taxpayers also need 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 a return and the FTB is ultimately victorious in the Gillette litigation. On a positive note, California calendar year taxpayers are fortunate to receive the published opinion before the impending October 15th deadline for 2011 tax returns for which an extension was requested.

Footnotes

1 The Gillette Co. v. Franchise Tax Board, California Court of Appeal, First District, No. A130803, Oct. 2, 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 Ch. 37 (S.B. 1015), Laws 2012.

6 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.

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

8 S.B. 1015, § 4(a).

9 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, it can be argued that California's withdrawal from the Compact was ineffective.

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