In Associated Bank, N.A. and Affiliates., ¹ the Minnesota Supreme Court (Court) reversed the Minnesota Tax Court and held that the Court's prior ruling in HMN Financial ² did not preclude the Minnesota Tax Commissioner (Commissioner) from applying an alternative apportionment formula to include the income from a bank's two related non-financial-institution entities when the Commissioner proved that the application of the standard apportionment formula did not "fairly reflect" the bank's Minnesota income sources while the proposed alternative method did. In so holding, the Court distinguished HMN Financial, finding that the Commissioner in HMN Financial relied on Minn. Stat. Sec. 290.20 (the alternative apportionment statute) as "as an example of general implicit statutory authority" to tax a transaction based on its economics, whereas the Commissioner in this case relies on Minn. Stat. Sec. 290.20 "as specific authority" to use an alternative apportionment formula to fairly reflect the bank's taxable net income allocable to Minnesota.

Background

Associated Bank, N.A. (the Bank) was a member of two related Wisconsin limited liability companies (each an LLC and collectively the LLCs) that were not financial institutions. The Bank paid Minnesota corporate franchise tax on the LLCs' flow-through income, but because the LLCs were not financial institutions, applied different apportionment methods to their income from the Bank's own method.³ During the tax years at issue (2007 and 2008), the financial institutions' apportionment formula (applicable to the Bank) included loan interest and intangible property, while the general apportionment method (applicable to the LLCs) did not. The LLCs reported an overall apportionment factor of zero on both the 2007 and 2008 Minnesota partnership tax returns and to their members. Thus, the Bank's sales factor excluded Minnesota loan interest earned by the LLCs, and its property factor excluded the LLCs' Minnesota loans' value.

Following an audit, the Commissioner determined that the application of the general apportionment formula did not fairly reflect the Bank's Minnesota taxable net income. To combat this distortion, the Commissioner exercised her authority under Minn. Stat. Sec. 290.20 to use an alternative apportionment method and, in effect, treated the LLCs as financial institutions, including in the Bank's Minnesota apportionment calculation each LLC member's pro-rata share of the LLCs' property and payroll factors.

The Bank challenged the assessment, and the Tax Court ruled in favor of the Bank. The Tax Court noted that the Commissioner failed to prove that the application of the standard apportionment method did not fairly and correctly apportion Bank's net income to Minnesota, and that the Commissioner could not, under HMN Financial, "look through or disregard" the Bank's corporate structure to apply the financial institution apportionment provisions to the LLCs. The Commissioner appealed the Tax Court's decision, which the Court reversed.

HMN Financial distinguished

While noting some factual similarities, the Court held that its ruling in HMN Financial did not preclude the Commissioner from using her alternative apportionment authority, since the Commissioner exercised plain statutory authority to challenge the apportionment method used and did not merely challenge the results of the applied method. Specifically, the Commissioner relied on Minn. Stat. Sec. 290.20 as specific authority to use an alternative apportionment method since the standard, statutory apportionment formula does not "fairly reflect" the taxpayer's Minnesota-allocable taxable net income, and the alternative apportionment method does.⁴ In contrast, in HMN Financial, the Commissioner relied on the alternative apportionment statute as an example of general implicit statutory authority to impose tax obligations according to a transaction's economics.

Alternative apportionment: burden and fair reflection of Minnesota net taxable income

After concluding that the Commissioner was not precluded from applying an alternative apportionment formula, the Court turned to whether the Commissioner met her burden to apply the proposed alternative apportionment formula. As the party invoking the alternative apportionment method, the Commissioner has the burden of proving her method was reasonable. Moreover, because this case did not include a constitutional challenge to an applied apportionment method, the Commissioner had to meet the substantial evidence standard (and not the higher "grossly inequitable" standard) to show that the Bank's allocation of net taxable income using the standard apportionment formula did not fairly reflect its taxable net income allocable to Minnesota, and that her proposed alternative method did.

Based on the common meaning of "fairly reflect," the Court concluded that the Commissioner presented substantial evidence that the apportionment method applied by the Bank (i.e., allowing the flow-through LLCs to use a general method and not that applicable to the Bank) did not fairly reflect its taxable net income allocable to Minnesota. The Bank held partnership interests in the LLCs, the LLCs held loans secured by Minnesota real estate, and transfers of the loans from the Bank to the LLCs generally did not change the loans' management. Additionally, the Bank remained the mortgagee of record for all Minnesota loans that the LLCs held, borrowers directly paid the Bank as the LLCs' collection agent, and the LLCs collectively generated more than $142 million in interest income for the 2007 and 2008 tax years. By stipulation, all of the LLCs' interest income earned in 2007 and 2008 was attributable to Minnesota loans, but each LLC reported zero sales, gross earnings or receipts using the statutory apportionment method. Therefore, applying the general apportionment formula at the LLC level did not fairly reflect the Bank's taxable net income allocable to Minnesota, since the Bank had no taxable income arising from the LLCs' contracts with Minnesota under that method.

In addressing issues of first impression, the Court determined that the Commissioner's alternative apportionment method, which includes each LLC member's pro-rata share of its LLC receipts and intangible property, fairly reflects the Bank's net income from the LLCs' Minnesota business activities. The Court reasoned that the statutory language of the alternative apportionment provisions is broad and requires only that the Commissioner use "another method" that "fairly reflects net income," and that the only restriction is that the alternative method must be a method that differs from the statutorily prescribed method.

Implications

Corporate entities, financial institutions or otherwise, should consider whether flow-through entity structures in their combined filing groups may make them vulnerable to potential alternative apportionment efforts by the Minnesota Department of Taxation. Furthermore, the case provides helpful insight on what is required for the Commissioner to assert alternative apportionment, and when it is more likely to be upheld.

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ENDNOTES

¹ Associated Bank, N.A. and Affil. v. Minn. Comr. of Rev., No. A17-0923 (Minn. S. Ct. July 5, 2018).

² HMN Financial, Inc. and Affil. v. Minn. Comr. of Rev., 782 N.W.2d 558 (Minn. S. Ct. 2010).

³ Effective for taxable years beginning after December 31, 2016, partnerships may be classified as financial institutions (Minn. Stat. Sec. 290.01, subd. 4a).

⁴ Minn. Stat. Sec. 290.20, subd. 1.