Separate Accounting, Alternative Apportionment, & Transfer Pricing
As states continue to move away from the traditional three-factor apportionment formula to an approach that places more or all of the weight on the sales factor, the potential for distortion, i.e., the state claiming more than its fair share of income, becomes more prevalent. If too much income is attributed to the state, the prescribed formula, as applied to the taxpayer, may be violative of the U.S. Constitution’s Due Process Clause or Commerce Clause. Fortunately, the vast majority of states have an equitable provision to allow the taxpayer to administratively petition to use an alternative formula. These provisions, however, place the onus on the taxpayer to prove the prescribed formula has attributed too much income to the state.
In terms of providing evidence, taxpayers typically rely on separate accounting computations, i.e., a transfer pricing study, as the basis for their contention that the state’s formula apportions too much income to the taxing state, citing the U.S. Supreme Court case Hans Rees’ Sons, Inc. v. North Carolina ex rel. Maxwell (Hans Rees). “Separate accounting” is a method for determining the geographic source of a taxpayer’s income through segregation of the profits attributable to a state through identification of state-specific receipts, costs, and expenses from the taxpayer’s books and records. Separate accounting involves identifying all items of income and costs that are related to the taxpayer’s activities within the taxing state and constructing a statewide net income from these items.
In Hans Rees, the state implemented a single-property factor formula. Hans Rees does stand for the proposition that separate accounting evidence of the geographic source of income is probative of unconstitutional distortion if the difference between the result under separate accounting and the result under formulary apportionment is substantial. As the court stated in Hans Rees, “evidence may always be received which tends to show that a state has applied a method, which, albeit fair on its face, operates so as to reach profits which are in no just sense attributable to transactions within its jurisdiction.”
Later, in Moorman Manufacturing Co. v. Bair, the court held a single-sales factor formula is presumptively valid. But the court also noted the taxpayer failed to show “a significant portion of the income attributed to Iowa in fact was generated by its Illinois operations” and failed to provide “any separate accounting analysis showing what portion of appellant’s profits was attributable to sales, to manufacturing, or to any other phase of the company’s operations.”
Other cases have repudiated the notion that a separate accounting can invalidate the traditional, equally weighted three-factor formula (sales, property, and payroll) but have not repudiated the use of such evidence for single-factor formulas. Overall, taxpayers should examine their tax liability in single-sales factor states in light of their operations. A transfer pricing study may alleviate a portion of this liability.
For additional guidance on an alternative apportionment request, contact your BKD Trusted Advisor™ or submit the Contact Us form below.