California’s apportionment regime applicable to multistate businesses is unexceptional on its face. A corporation generally applies a single-factor fraction based on sales to determine the part of its income derived from, or reasonably attributed to, a trade or business carried on in the state. See Cal. Rev. & Tax. Code Section 25128(b).
Like many other states, California provides a statutory relief mechanism for situations where the standard apportionment formula does not result in a fair representation of a corporate taxpayer’s California business activity, i.e., alternative apportionment. In those situations, either the California Franchise Tax Board (FTB) may require or a taxpayer may request application of an alternative apportionment methodology.
While the FTB may invoke alternative apportionment as it sees fit, a taxpayer must follow a specific, yet often murky path, in seeking such relief. With limited formal guidance, California taxpayers invoking alternative apportionment must be wary of pitfalls along the way, which could result in penalties, or worse, jurisdictional bars to future litigation.
This article is the first of a three-part series looking at the issue of alternative apportionment in California. This first installment presents an overview of alternative apportionment generally and a deeper look at the issue in California specifically. Future installments will examine the unique aspects of California’s alternative apportionment petition process and common issues faced by California taxpayers during that process, and discuss the FTB’s ongoing project to amend California’s alternative apportionment regulation.
Overview of Alternative Apportionment
Apportionment of multistate income is not an exact science, but instead resembles “slicing a shadow.” Container Corp. of America v. Franchise Tax Bd. Accordingly, a state’s standard apportionment formula is designed merely “to obtain a ‘rough approximation’ of the corporate income that is ‘reasonably related to the activities conducted within the taxing State.’” Exxon Corp. v Wisconsin Dept. of Revenue. Nevertheless, there are situations where a state’s standard apportionment formula, as applied to the facts of a particular taxpayer, produces incongruous results. Enter alternative apportionment.
Generally, state rules regarding alternative apportionment apply when the standard apportionment formula does not “fairly represent” the extent of a taxpayer’s business activities in the state. A number of states have adopted standardized language regarding alternative apportionment, commonly referred to as Section 18 of the Uniform Division of Income for Tax Purposes Act (UDITPA). See, e.g., Ark. Code Section 26-51-718; Colo. Rev. Stat. Section 39-22-303.6(9)(b); Haw. Rev. Stat. Section 235-38; N.D. Cent. Code Section 57-38.1-18; W. Va. Code Section 11-23-5(p).
The Multistate Tax Commission (MTC) drafted this model language as part of its mission to create uniformity across states. Under UDITPA Section 18, if a state’s statutory method does not “fairly represent the extent of the taxpayer’s business activity in [the] state, the taxpayer may petition for or the [Department] may require, in respect to all or any part of the taxpayer’s business activity, if reasonable: (a) Separate accounting; (b) The exclusion of one or more of the factors; (c) The inclusion of one or more additional factors which will fairly represent the taxpayer’s business activity in this state; or (d) The employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer’s income.”
Originally, alternative apportionment under UDITPA Section 18 was intended to apply only in unusual circumstances. A prior version of MTC Model General Allocation and Apportionment Regulation IV.18(a) provided that alternative apportionment was appropriate “only in specific cases where unusual fact situations (which usually will be unique and non-recurring) produce incongruous results.” MTC Model General Allocation and Apportionment Regulation IV.18(a) (1973).
Many states promulgated rules consistent with that prior version. See, e.g., 1 Colo. Code Regs. 201-2:39-22-303.5-9(1); Fla. Admin. Code r. 12C-1.0152(3); 45 Ind. Admin. Code 3.1-1.62; Tenn. Comp. R. & Regs. 1320-06-01-.35(1)(d). The MTC model regulation currently provides that Section 18 “permits a departure from the allocation and apportionment provisions of Article IV only in limited and specific cases where the apportionment and allocation provisions contained in Article IV produce incongruous results.” MTC Model General Allocation and Apportionment Regulation IV.18(a) (2017).
California’s Alternative Apportionment Provisions
California adopted Section 18 of UDITPA, which is codified at Section 25137 of the California Revenue and Taxation Code (CRTC). This statute provides that a taxpayer may petition for, or the FTB may require, the use of alternative apportionment. In keeping with UDITPA Section 18, the California statute provides for alternative apportionment in the form of: separate accounting; exclusion of one or more factors; inclusion of one or more additional factors; or any other method to effectuate an equitable allocation and apportionment of income. Cal. Rev. & Tax. Code Section 25137. Generally, a taxpayer or the FTB must demonstrate that the standard apportionment formula does not “fairly represent the extent of the taxpayer’s business activity” in California to use alternative apportionment.
The FTB’s accompanying regulation mirrors the original MTC model regulation, providing that alternative apportionment is to apply only “in limited and specific cases” and may be invoked “only in specific cases where unusual fact situations (which ordinarily will be unique and nonrecurring) produce incongruous results” under the standard apportionment provisions. 18 Cal. Code Regs. Section 25137(a). The FTB’s regulation provides little guidance regarding the taxpayer petition process, other than to note the three-member Franchise Tax Board may elect to hear and decide such petitions. 18 Cal. Code Regs. Section 25137(d). That hearing is public, however, and a taxpayer must affirmatively waive confidentiality to have its petition considered by the Board.
Beyond its regulation, the FTB has issued guidance reminding taxpayers that alternative apportionment provisions do not apply in determining whether two companies are operating as a single unitary business or whether income is properly classified as apportionable business income or allocable nonbusiness income, and do not modify the mechanics of California’s water’s-edge election. See FTB Chief Counsel Ruling 2019-01 (May 1, 2019) (describing four sample fact patterns and concluding that only one of the four, involving a taxpayer that has not begun making sales and therefore does not have any material representation in its sales factor, is an appropriate scenario for seeking alternative apportionment). The FTB has also issued guidance indicating it may assert penalties where a taxpayer applying alternative apportionment does not first petition for the use of alternative apportionment with the FTB. See FTB Notice 2004-5 (Aug. 6, 2004).
California Courts’ Application of CRTC Section 25137
Cases decided by California courts applying CRTC Section 25137 provide some guidance as to when alternative apportionment is appropriate. In one such case, Microsoft Corp. v. Franchise Tax Bd. (2006), the California Supreme Court upheld the FTB’s use of alternative apportionment to include only the net gain from a taxpayer’s treasury function receipts in the sales factor denominator where the taxpayer’s profit margin from operations was roughly 170 times greater than the profit margin generated from its treasury function.
In a separate but similar case, General Mills, Inc. v. Franchise Tax Bd., a California Court of Appeal upheld the FTB’s application of alternative apportionment to include the net gain from a taxpayer’s hedging activities in the sales factor denominator where those activities produced at most 2% of the taxpayer’s income but between 8% and 30% of its gross receipts, and that the profit margin for General Mills’ sales of consumer products was approximately 81 times the profit margin from its hedging activities. These cases set forth the legal framework for interpreting and applying CRTC Section 25137.
As a threshold matter, the party invoking CRTC Section 25137 bears the burden of proving alternative apportionment is warranted. Microsoft. Specifically, that party must show by clear and convincing evidence that: (1) the standard apportionment formula does not result in a fair representation of the taxpayer’s in-state activity; and (2) that the proposed alternative method is reasonable.
The analysis under the first prong involves both a qualitative and quantitative component—the former analyzing the nature of the activity at issue in light of the taxpayer’s overall operations and the latter analyzing various metrics such as profit margin to assess whether the activity distorts the standard apportionment formula. For example, in Microsoft, the court found there was a qualitative distinction between Microsoft’s core software business and its treasury function transactions, and that quantitatively, the treasury function transactions generated under 2% of Microsoft’s business income, but accounted for approximately 73% of its gross receipts for the tax year. See also General Mills (noting the qualitative and quantitative effects are not two separate tests, but lead to “assessing whether the standard formula fairly represents the company’s business activity in California”).
The second prong looks to whether the proposed alternative methods effectuate an equitable apportionment of income. See Microsoft; General Mills. Notably, the court in Microsoft cautioned that an approach may fail the test of reasonableness if it “exaggerates the resulting California tax.” Microsoft. Finally, while CRTC Section 25137 “‘ordinarily’ applies to nonrecurring situations, it does not apply only to such situations.” Microsoft.
Next Installment: California’s Behind-the-Scenes Petition Process
The courts have constructed the legal framework for analyzing and applying CRTC Section 25137. However, there is little formal guidance detailing the alternative apportionment petition process itself. In our next installment, we will shed light on that process, highlighting the steps along the way, introducing the FTB’s informal 25137 Committee and providing insight for taxpayers seeking alternative apportionment relief.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Tim Gustafson is a Partner and Justin Brown is an Associate at Eversheds Sutherland (US) LLP.