Taxpayer Victory in Gillette Case May Lead to Widespread Income Tax Refund Claims
Author: Jim Matthews
In a prior BKD Alert, John Wright discussed the California Court of Appeals’ decision in Gillette Co. v. California Franchise Tax Bd., which states that multistate taxpayers were entitled to elect the equally weighted three-factor formula under the Uniform Division of Income for Tax Purposes Act (UDITPA) to apportion business income. That Alert also advised that on August 9, 2012, the Appeals Court vacated its decision and ordered a new hearing on its own motion.
On October 2, 2012, the court issued its rehearing decision, which essentially affirmed its earlier decision. The court’s new ruling makes two clarifications that reflect issues raised by the Franchise Tax Board and Gillette in court filings since the original decision in July. The clarifications are minor and do not change the core outcome of the case.
The core holding in the original decision was that California signed the Multistate Tax Compact (MTC), which allows taxpayers to elect apportionment under the UDITPA formula regardless of whether other formulas are prescribed. Since California and other MTC member states have enacted numerous statutes that prohibit use of various UDITPA rules in favor of other tax calculation rules, many taxpayers are likely to file refund claims based on their right to use UDITPA rules.
California adopted the UDITPA apportionment formula in 1966, passing statutes through which it became an MTC member in 1974. However, in 1993, the California legislature enacted a separate statute that both denied further use of the UDITPA apportionment formula and mandated use of a four-factor apportionment formula, which double-weighed the sales factor. Starting in 2006, the Gillette Company, its subsidiaries and other corporate entities filed franchise tax refund claims with the California Franchise Tax Board (FTB). Their lowered tax liability came from use of the UDITPA apportionment formula, and they argued that the 1993 California apportionment statute did not override or repeal their right to use the UDITPA apportionment formula. The FTB denied all of the claims; appeals were taken to the California courts.
On June 27, 2012, in contemplation of an adverse decision, California enacted legislation that repealed the MTC statutes and withdrew from the MTC, leaving the four-factor apportionment formula as the only permitted choice going forward. Whether this legislation was validly enacted may be called into question; California Proposition 26 requires a two-thirds vote in both houses of the California legislature to enact a law that increases taxes, and this legislation did not satisfy this requirement. However, the legislation’s effect or validity was not considered in this case.
This legislation also limits tax refunds that California might be required to pay for open tax years by prohibiting taxpayers from filing refund claims to recover franchise tax based on use of an apportionment method other than the one used in the original return. Since all original returns were prepared using the four-factor formula, the obvious purpose for this provision was to retroactively bar taxpayers from filing refund claims based on an election to use UDITPA apportionment.
The court’s decision rested on the premise the MTC was not just a set of taxing statutes, but the codification of a binding and enforceable compact by California with the member states to provide uniform laws regulating state income taxation. While MTC member states can enact alternatives to these uniform laws, they cannot not override or eliminate availability of these uniform laws without repealing the MTC and withdrawing from the compact. This was not done until recently. Moreover, while the MTC provides for a state’s unilateral withdrawal, it can only be done if such legislation is prospective in nature. Accordingly, the refund claims of Gillette and other taxpayers based on UDITPA apportionment were upheld, and the retroactive aspect of California’s recent legislation was of no moment.
The Gillette decision has nationwide ramifications and likely affects most multistate businesses—not just those doing business in California. With California’s withdrawal from the MTC, there are still 19 full member states. At least 10 of these members—Alabama, Arkansas, Colorado, Idaho, Michigan, Minnesota, Oregon, Texas, Utah and Washington, D.C.—have apportionment provisions that in one way or another do not allow use of UDITPA apportionment while mandating one or more other formulas, e.g., single factor sales. While California court decisions are not binding in other MTC member states, the court’s rationale appears applicable to these similar, if not identical, taxing regimes. A large number of refund claims based on earlier denial of UDITPA formula apportionment can be expected, both in California and in these other MTC member states.
Other refund claim opportunities could be found from extrapolation of the Gillette case rationale. The case calls into question a taxpayer’s right to compute its taxes using a provision in the MTC from which California or an MTC member state has departed. Examples include the UDITPA Section 1 definition of “business income,” which is very important in distinguishing apportionable business income from allocable nonbusiness income, as well as UDITPA Section 17 rules for sourcing sales of services and intangibles, where several states including California have moved from “costs of performance” to market-based sourcing of receipts. Taxpayers who paid more state income tax under statutes that depart from their UDITPA counterpart, like those mentioned above, can be expected to consider refund claims as well.
The FTB likely will appeal the Gillette case to the California Supreme Court once it becomes final on November 1. However, while the appeal runs its course, the statute of limitations on refund claims will continue to run in California and the remaining MTC member states. Now is a prudent time to file protective refund claims to recover taxes overpaid by reason of not being allowed by a state to use UDITPA taxing statutes. FTB Notice 2012-1 advises corporate taxpayers they can file protective refund claims based on the Gillette decision, but they cannot file amended returns using the UDITPA formula for open tax years. The FTB advises any choice to use the three-factor formula must be made on an original return for the taxable period for which the election applies.
If you are interested in evaluating your refund claim opportunities in California or any of the MTC member states, contact your BKD advisor or Bryan Neuendorf.