In its much anticipated ruling in Vodafone,¹ the Tennessee Supreme Court (Court) upheld the imposition by the Tennessee Commissioner of Revenue (Commissioner) of a variance requiring a multistate mobile telecommunications company to use an alternative apportionment method to source its sales receipts for services to Tennessee customers in order to more accurately reflect its business activity in the state. The Court further held the Commissioner's variance, which uses the primary-place-of-use (PPU), or market sourcing method, instead of the statutory costs of performance method (COP), is not an abuse of discretion as it is within the range of acceptable alternatives available to the Commissioner.

Background

By Tennessee law, which for the years at issue was based on the apportionment and variance provisions set forth in the Uniform Division of Income for Tax Purposes Act (UDITPA) as adopted by Tennessee, the Commissioner has the authority to issue a tax variance (i.e., mandating an alternative method of apportionment to the state) if application of the statutory apportionment method fails to "fairly represent" the business activities of a Tennessee taxpayer in the state.² By the Commissioner's own regulation, tax variances can only be issued in limited and specific circumstances — when unusual factual situations of a case, which are ordinarily unique and nonrecurring, produce an incongruous result.³ Although the Commissioner has the discretion to issue a variance under the regulations, the Commissioner also bears the burden to prove that the variance was proper and necessary to effectuate an accurate and fair result.

Vodafone and its subsidiaries own a 45% partnership interest in a partnership (Cellco, which does business as Verizon Wireless) that provides multistate mobile telecommunications services to customers throughout the United States, including Tennessee. Vodafone initially claimed that, under Tennessee law, it was not engaged in business in Tennessee simply because of its partnership interest in Cellco but eventually amended its refund claim to assert that it was entitled to compute its Tennessee franchise and excise tax liabilities using the statutorily mandated COP method, as opposed to the PPU method used on its originally filed tax returns. (Vodafone's partner in Cellco, Verizon Communications, Inc. (which owned 55% of Cellco) had no involvement in the appeal.)

The Commissioner denied Vodafone's refund claim and issued a variance requiring it to use the PPU apportionment method to source receipts from cell phone services it provided to customers with Tennessee billing addresses on the basis that issuance of a variance was necessary to ensure that Vodafone accurately represented its Tennessee business activities.

On appeal, the Tennessee Court of Appeals affirmed the Chancery Court's decision, holding that the Commissioner was within his statutorily prescribed discretion to issue the tax variance. Although the use of a variance may provide precedent for other similarly situated companies, the Chancery Court noted, those companies would be a small part of all entities that must pay tax, and the variance applied in this case will not lead to an evisceration of the COP method of sourcing. A dissenting judge disagreed, finding that the Commissioner was bound to apply the statutory method unless he was able to demonstrate unusual circumstances and concluding that, based on the facts, the Commissioner failed to meet his burden of proof. Vodafone appealed to the Court.

Court upholds use of variance

Three issues were presented to the Court on appeal: whether the Commissioner abused his discretion under statutory law by imposing a variance (1) that requires the taxpayer to use an alternative sourcing method directly contrary to the statutory COP method or (2) that is in complete absence of "unusual circumstances" and "incongruous results"; and (3) whether the Commissioner violated the separation of powers required by the Constitution by imposing a variance on the taxpayers when application of the statutorily prescribed apportionment method reaches the proper result the General Assembly intended. The Court dismissed the third claim because it was not raised in the lower courts, and in regard to the abuse of discretion questions the Court concluded that the Commissioner's imposition of the variance is not an abuse of discretion.

The Court explained that the threshold inquiry in reviewing the Commissioner's decision to impose a variance is: (1) whether the statutory apportionment formula fairly represents the extent of the taxpayer's business activity in Tennessee; and (2) if it does not, whether the Commissioner's alternate formula in the variance is reasonable.

Application of statutory apportionment method not a fair representation

Vodafone argued that application of the statutory COP method fairly represents its business activity within Tennessee because "that is the mathematical result from application of the formula the legislature chose." The Court, however, rejected this argument, finding this reasoning to be circular, and further stating that the variance statute "presupposes" that there will be instances in which "an arithmetically correct tax computation utilizing the statutory apportionment formula will not fairly represent the extent of the taxpayer's business activity in Tennessee." The Court also said that adoption of Vodafone's argument "would effectively leave the Commissioner without any discretion to impose a variance in any situation."

The Court further noted that a similar argument had been rejected by the Tennessee appeals court in the BellSouth Advert. & Publ. Corp.⁴ (BAPCO) case. In BAPCO, the appeals court upheld the Commissioner's use of a variance, noting that the fact that application of the statutory formula resulted in the taxpayer owing less than $300,000 in franchise and excise tax on nearly $900 million in Tennessee advertising revenue was an appropriate basis for the Commissioner to conclude that application of the statutory formula did not fairly represent the taxpayer's business activity in the state. Likewise in Vodafone, the Court found that application of the statutory apportionment formula does not fairly represent Vodafone's business activity in the state. If Vodafone were allowed to apply the standard COP sourcing method to exclude service receipts from its Tennessee apportionment formula, the resulting sales factor would decrease from $1.3 billion in receipts from telecommunication services for Tennessee customers to approximately $150 million in such receipts, thus excluding 89% of its total Tennessee sales receipts from taxation.

The Court also rejected Vodafone's argument that upholding the Commissioner's variance would " allow the Commissioner to 'usurp' the legislature's authority to make tax policy choices," finding the argument "contrary to the legislative history of the variance statute." Rather, the Court observed that the Tennessee legislature had over time expanded the Commissioner's discretion under the variance statute by allowing the Commissioner to impose a variance in addition to granting a taxpayer's request for a variance, removing the Attorney General's approval of variances in all instances, and expanding the remedies the Commissioner could adopt through the variance process (making it broader than UDITPA's variance provisions). The Court found the legislature's "methodical enhancement of the Commissioner's discretionary variance authority demonstrates that [it] saw the variance as integral to its efforts to prevent corporations doing business in Tennessee from shifting income and profits, and thus tax revenues, out of the State."

Vodafone also argued that the Commissioner should not "be allowed to have 'unfettered discretion' to impose a new apportionment formula on a taxpayer just because he does not like the result under the statutory formula." The Court agreed, but found that the variance statute contains standards and safeguards that would prevent such unfettered discretion. Under Tennessee law, the Commissioner can impose or grant a variance only if the facts show that application of the statutory formula does not fairly reflect the extent of the taxpayer's business activity in Tennessee and that the alternate method is objectively reasonable. In this instance, the Court found that the Commissioner's variance letter demonstrated his awareness of the standards he must meet in order to impose a variance. Additionally the Court noted that its review of the Commissioner's actions (as the third level of judicial review following that of the trial court and the Court of Appeals), demonstrates that the Commissioner's discretion to impose a variance is "hardly unfettered." Moreover, the Court found that both lower courts had engaged in a comprehensive review of the evidence in concluding that the Commissioner did not abuse his discretion and had "ample basis" to conclude the application of the statutory apportionment formula would not result in a fair representation of Vodafone's business activity in Tennessee.

Variance is a reasonable alternate formula

Next, the Court addressed whether the Commissioner's alternate apportionment formula — the PPU method used by Vodafone on its original return — is reasonable. The PPU method treats as Tennessee receipts payments from Tennessee customers/residents based on billing address. The Commissioner noted that this method not only is straightforward and conceptually satisfying, but is also administrable because the Tennessee Department of Revenue could verify through audit the state to which receipts from Vodafone's cellphone services should be attributable. The Court agreed with the Commissioner that the PPU method imposed in the variance fairly represented Vodafone's business activity in Tennessee.

The Court also considered whether the Commissioner's alternate formula was consistent with the goal of UDITPA to not tax more than 100% of a taxpayer's receipts. As urged by the Commissioner, if the variance were not imposed and the statutory COP method applied, Vodafone's Tennessee receipts would go untaxed, as "nowhere income." The Court found that the Commissioner's alternative method "appears to present no danger of double taxation, and it comports with the overarching UDITPA goals."

Accordingly, the Court found that the statutory requirement for the alternative formula to be reasonable had been satisfied.

Variance imposed not inconsistent with variance regulation

The Court also considered whether the variance regulation limits the Commissioner's authority to impose a variance. The variance regulation states that the variance statute permits a departure from the statutory apportionment method only in limited and specific cases, when unusual fact situations produce incongruous results and that such situations "ordinarily will be unique and nonrecurring."

Vodafone argued that the Commissioner's variance in this case did not fall within these limits as its business model is not "unusual." Thus, the variance is not imposed in a "limited and specific" case, but in essence is imposed on the entire telecommunications industry. Further, Vodafone asserted that the term "incongruous results" means results not intended by the Legislature; since application of the COP method is what the legislature intended, there is no "incongruous result" in this case.

The Commissioner, on the other hand, asserted that the phrase "unusual fact situation" does not mean "peculiar to a specific taxpayer" or "rare," but rather means a situation in which application of the standard apportionment formula does not reflect the extent of the taxpayer's economic activity in the state. The Commissioner asserted that Vodafone's situation qualifies as "unusual" because the multistate wireless telecommunications industry was unknown to the UDITPA drafters, and that an "unusual fact situation" may arise when, as in this case, the application of the standard apportionment is not administrable.

The Court agreed with the Commissioner that the subject variance in fact applies in a "limited and specific case," and found Vodafone's argument that the Commissioner will impose similar variances on the entire telecommunications industry, thereby effectuating industry-wide change in tax policy, to be without basis, noting that there is no evidence in the record of other similar variances. The Court also agreed with the Commissioner's interpretation of the phrase "unusual fact situation," reasoning that application of the statutory apportionment formula would cause millions of dollars from Vodafone's Tennessee customers to be removed for tax purposes, thereby qualifying as an "unusual fact situation" that produces "incongruous results." And the Court agreed with the Commissioner that Vodafone's situation may be considered an "unusual fact situation" that produces "incongruous results" under the variance regulation when application of the COP method would leave the Department unable, as a practical matter, to verify Vodafone's representation regarding the situs for the greater proportion of its costs.

In regard to Vodafone's "unique and nonrecurring" argument, the Court held that the variance statute specifically provides for the continuation of the alternate formula as long as the circumstances justifying the variation remain substantially unchanged. Thus, while a variance ordinarily applies to nonrecurring situations, it does not apply only to such situations. As such, the Commissioner can issue a variance in a recurring situation as long as the application of the standard method or formula does not fairly reflect the taxpayer's business activity in the state.

Alternative method within range of acceptable alternatives

Lastly, the Court considered whether the Commissioner's alternative method was within the range of acceptable alternatives. The Court determined that the Commissioner did not abuse his discretion in imposing the variance because the alternative formula was within the range of acceptable alternatives available to the Commissioner.

Dissenting opinion

Justice Bivins concurred in part and dissented in part with the majority opinion. While Justice Bivins agreed with the majority that the Commissioner demonstrated that application of the statutory apportionment formula does not fairly represent the extent of the taxpayer's business activity in Tennessee, he disagreed with the majority on the issue of the Commissioner's compliance with his own variance regulation. Justice Bivins found the Commissioner's variance letter made no attempt to demonstrate his compliance with the variance regulation and found the Commissioner's approach "incorrectly places the burden of proof upon the taxpayer."

Implications

Although the decision by the Court is binding only in Tennessee, many states have variance or alternative apportionment statutes that mirror those of Tennessee. Moreover, this ruling shows a great deal of deference by the state's highest court to the determinations of the state's executive taxing authority. It also bears striking similarities to the Mississippi Supreme Court's ruling in Equifax,⁵ which sparked outrage from the business community and ultimately resulted in a change of law to clarify that the party propounding an alternative method of apportionment has the burden of proof in all such cases,⁶ as well as the adoption by the Multistate Tax Commission of changes to the model alternative apportionment rule in UDITPA.⁷ Additionally, since the Court agreed with the Commissioner, taxpayers should be wary that, even if they follow the state's statutorily prescribed method, this decision's application of the abuse-of-discretion standard likely makes it easier for the Commissioner to impose a variance.

Further, the Court upheld the justification that Vodafone presented a fact scenario that was "specific," "nonrecurring," and "unique," which may allow the Commissioner to require a variance with a lower burden of proof in other scenarios. In his letter imposing the variance on Vodafone, the Commissioner concluded that the COP method was not straightforward but rather complex, unreliable and difficult to verify. In contrast, the Commissioner asserted that the PPU method was straightforward and easy to determine. Even if it is true that use of the PPU method may ease an administrative burden, the Court seems to have applied a standard to which the Commissioner is held to issue a variance that does not necessarily more accurately reflect a taxpayer's business in Tennessee. As a result, the decision permits the Commissioner to enact a policy decision that controverts what the legislature established.

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ENDNOTES

¹ Vodafone Americas Holdings, Inc. & Subsidiaries v. Roberts, No. M2013-00947-SC-R11-CV(Tenn. S. Ct. March 23, 2016).

² See Tenn. Code Ann. Section 67-4-2014 and 67-4-2112.

³ See Tenn. Comp. R. & Regs. Section 1320-06-01-.35(1)(a)(1).

⁴ BellSouth Advert. & Publ. Corp. v. Chumley, 308 S.W.3d 350 (Tenn Ct. App. 2009).

⁵ Equifax, Inc. v. Miss. Dep't of Revenue, 125 So. 3d 36 (Miss. 2013) rehearing denied, modified by Equifax, Inc. v. Miss. Dep't of Revenue, 2013 Miss. LEXIS 604 (Miss., Nov. 21, 2013) cert. denied 134 S. Ct. 2872 (US 2014).

⁶ Miss. Laws 2014, ch. 476 (H.B. 799) (amending Miss. Code Ann. Section 27-7-23(c)(2)(B)).

⁷ The MTC undertook a comprehensive review of the model alternative apportionment rule, adopted the Revised Model Multistate Compact Article IV, and passed Resolutions adopting conforming amendments to Article IV and amendments to Section 18. (links to which are available on the Internet here (last accessed April 1, 2016)).