The California Supreme Court (Court) unanimously reversed the Court of Appeal's ruling in Gillette Co.,¹ holding that corporate taxpayers cannot elect to use the equally weighted three-factor apportionment formula under the Multistate Tax Compact (Compact) for reporting income to California in lieu of the statutorily mandated formula (e.g., double-weighted sales or single sales factor formulae). In so concluding, the Court agreed with the Franchise Tax Board (FTB) that the Legislature's enactment of a new apportionment formula controls, and that the state is not bound by the Compact election.

Background

In 1967, the Compact became effective when it was enacted into law by nine states (two more than the required number in order for the Compact to become effective) and the Multistate Tax Commission was formed.² During 1974, California adopted the Compact.³ Article IV of the Compact adopts the Uniform Division of Income for Tax Purposes Act (UDITPA) and its evenly weighted three-factor formula (i.e., the sum of the payroll, property and the sales factors, divided by three), while Article III of the Compact purportedly allows taxpayers to elect to use either the Compact's three-factor formula or the state's apportionment formula (Compact election) for apportioning income to the state. During 1993, California modified its apportionment provisions, moving from an evenly weighted three-factor formula to a double-weighted sales factor formula (i.e., sum of the payroll factor, property factor and a doubling of the sales factor, divided by four) that applied to most taxpayers.⁴ In adopting the double-weighted sales factor, the Legislature left the Compact (and the Compact election) in place, but specifically provided by reference to the section of the California Revenue & Taxation Code (Cal. Rev. & Tax Code) in which UDITPA was adopted and codified by California, that affected taxpayers must use the double-weighted sales factor.

At issue in Gillette was whether, in adopting the mandatory double-weighted sales factor, the Legislature also precluded a taxpayer's ability to make the Compact election. Several taxpayers argued that, by purporting to deny taxpayers the opportunity to make the Compact election, California violated the Compact's express terms; the only way that the Legislature can deny the right to make the Compact election is to repeal the Compact in its entirety — effectively withdrawing from the Compact itself. FTB argued, and the trial court agreed, that Cal. Rev. & Tax Code Section 25128 mandated use of the double-weighted sales factor apportionment formula, thereby eliminating a taxpayer's ability to use the Compact election.

In October 2012, in a unanimous three-judge ruling, the California Court of Appeal (Court of Appeal) held that the 1993 amendment to Cal. Rev. & Tax Code Section 25128 mandating use of a double-weighted sales factor did not supersede or eliminate the Compact election under former Cal. Rev. & Tax Code Section 38006.⁵ Rather, the Court of Appeal essentially held that taxpayers may use the Compact election for apportioning income during the operative time frame (e.g., the period during which it was a signatory member of the Compact), because the manner in which the Legislature amended the use of the Compact violated the contract clauses of the US and California constitutions and the reenactment clause of the California constitution (which prescribes that a statute cannot be amended solely by reference to its title).⁶

California Supreme Court reverses, rules state not bound by the "Compact"

On appeal, the Court reversed the Court of Appeal, holding instead the state-mandated apportionment provision controls and the state is not bound by the Compact. In reaching its conclusion, the Court did not decide whether the Compact took precedence over state law but instead determined that the Compact is not a binding contract between and among its members. The Court agreed with the Multistate Tax Commission argument in its amicus brief that "the Compact does not satisfy any of the indicia of binding interstate compacts noted in Northeast Bancorp."⁷ The Court found the Compact did not create reciprocal obligations among member states as the party states do not perform or deliver obligations to one another and the Compact's election provision does not create member state obligations. Instead, the Court found application of the Compact to be "more akin to the adoption of a model law rather than the creation of any mutual obligations among Compact members."

As for other indicia of a binding compact articulated in Northeast Bancorp — (1) whether its effectiveness depends on the conduct of other members, (2) whether any provision prohibits unilateral member action and (3) whether a regulatory organization has been established — the Court held that a state's unilateral ability to join and leave the Compact without notice "militates against a finding that the Compact is a binding interstate agreement under Northeast Bancorp." The Court noted that there is a history of unilateral state action amending the Compact, citing Florida's elimination of the Article III election provision and subsequent Commission recognition of Florida as a member in good standing. In regard to the Commission, the Court concluded that it lacks binding authority over the member states as its powers (e.g., to promulgate model statutes and regulations, to conduct audits) "are strictly limited to an advisory and informational role." As such it is not a joint type of regulatory organization contemplated by Northeast Bancorp.

The Court also rejected the taxpayer's argument that the Legislature violated the reenactment clause of the California Constitution (which requires a statute to embrace one subject that is expressed in its title) by amending the apportionment provisions in the manner in which it did to eliminate the Compact apportionment election. The Court noted that the reenactment rules generally do not apply to statutes that amend other statutes by implication and moreover, found that both the Legislature and the public were provided with sufficient notice of the purpose of the amendment in satisfaction of the clause itself.

Lastly, the Court held that the Legislature intended to eliminate the Compact election. By adopting the following language — "Notwithstanding Section 38006 [i.e., the Cal. Rev. & Tax. Code numerical citation under which the provisions of the Compact were codified], all business income shall be apportioned to this state by ... " using the formula it sets out — the Legislature unambiguously intended the statutory sales factor formula set forth in Cal. Rev. and Tax Code Section 25128 (e.g., double-weighted sales factor or single sales factor, depending upon the year) to supersede the Compact election provision as well. The Court concluded its opinion stating, "there is no credible argument that the Legislature intended to retain the Compact's election provision."

Implications

We expect several of the taxpayers who are party to this litigation will appeal the Court's ruling to the US Supreme Court (USSC). If so, the litigation continues and will not conclude until the USSC acts on the matter. This process could take months or years, depending on whether the USSC denies or grants certiorari. If the USSC denies certiorari the litigation process will be over. If the USSC grants certiorari and hears arguments in the case during its 2016 term, a decision likely would be issued sometime before July 2017.

Even if USSC grants certiorari to the taxpayers in Gillette or any one of the companion cases in other states, the Court's decision will stand for California tax purposes until reversed by the USSC. The validity of Gillette could affect: (1) a taxpayer's filing position in California tax returns filed after December 31, 2015 for purposes of the Large Corporate Understatement Penalty (LCUP), (2) financial statement provisions or FIN 48 disclosure, or (3) the need to file amended returns for prior years.

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ENDNOTES

¹ The Gillette Co. et al. v. Franchise Tax Board, No. S206587 (Cal. S. Ct. Dec. 31, 2015).

² The Compact was never put before the US Congress for approval.

³ Former Cal. Rev. & Tax Code Section 38006.

⁴ Cal. Rev. & Tax Code Section 25128.

⁵ The Gillette Co. et al. v. Franchise Tax Board, 209 Cal. App. 4th 938 (Cal. Ct. App., 1st Dist. Oct. 2, 2012) rev'd..

⁶ Cal. Const., art. IV, Section 9.

⁷ Northeast Bancorp v. Board of Governors, FRS, 472 U.S. 159 (1985).