January 22, 2024
South Carolina administrative court upholds forced combination as an equitable and reasonable alternative apportionment method for achieving fair representation of taxpayer's in-state activity
On January 3, 2024, the South Carolina Administrative Law Court (Court) denied the taxpayer's request to reconsider,1 for a second time, its rulings in Tractor Supply Co.2 Last August, the Court issued a decision upholding the Department's use of combined unitary reporting as an alternative apportionment method under South Carolina Code Section 12-6-2320(A)(4) to fairly represent the taxpayer's business activity in the state. On December 4, 2023, the Chief Administrative Law Judge (Judge) of the ALC granted the taxpayer's first motion for reconsideration and while it reached the same result, the Judge issued an amended final order to clarify his reasoning that combined unitary reporting is an appropriate method to determine the taxpayer's South Carolina corporate income tax liability.
Notably in the amended final order the Judge made clear that the South Carolina Supreme Court's ruling in Media General,3 in which it affirmed the ALC's order without change, "leaves no doubt that when the ALC discussed 'combined entity apportionment,' it was referring to 'combined unitary reporting,' and the two linguistic formulations of this 'method' are interchangeable." Further, the Court in Medial General interpreted the state's alternative apportionment provision as allowing combined unitary reporting.
The taxpayer, Tractor Supply Company (TSC), is a Tennessee-based rural lifestyle retailer. During the years of the Department's original audit, tax years 2014—2016 (Years at Issue), TSC operated in most states, including numerous stores within South Carolina (the State). Further, TSC provided administrative services and employed the C-suite of executives in support of the Company and its subsidiaries (the TSC Group).
Following a restructuring in 2001, Tractor Supply Company of Michigan, LLC (TSCM) operated retail stores in Michigan, and Tractor Supply Company of Texas (TSCT) operated retail stores, a distribution center, and a mixing center in Texas. In addition to its own operations, TSCT provided certain services for the TSC Group, including procurement services (i.e., inventory sourcing, vendor management, inventory management and product development). The employees who performed these functions were located in Tennessee. As part of the procurement services, TSCT entered into procurement contracts with suppliers, but TSC ultimately disbursed the funds to purchase the products. TSCT also had responsibility for inventory pricing, which was done in conjunction with TSC.
TSC, TSCM and TSCT had four intercompany agreements to cover the interactions between the affiliated entities following the 2001 restructuring. In the agreement most applicable to this case, TSCT provided procurement services to TSC and TSCM.
South Carolina audit determination
During the Years at Issue, TSC filed its original South Carolina corporate income tax returns using separate entity reporting as required by statute. In accordance with separate entity reporting principles, TSCT and TSCM activity was not reported as part of taxable income, nor were their sales included in the sales factor.
During its audit of TSC, the Department determined that separate entity reporting did not fairly represent TSC's business activity in South Carolina. Specifically, the Department noted that TSC appeared to be part of a unitary business group with TSCM and TSCT, and that intercompany transactions amongst the group distorted TSC's income.
In an attempt to achieve a fair representation of TSC's business activity in South Carolina, the Department recalculated TSC's tax liability for the Years at Issue using unitary combined reporting. Under unitary combined reporting, intercompany transactions are eliminated both in the taxable income base, as well as in the sales factor.
Following the unitary combined approach, the Department assessed TSC for underpayment of tax.
Court's analysis of whether TSC's business activity in the state is fairly represented
Under South Carolina's alternative apportionment provisions, S.C. Code Section 12-6-2320(A)(4), the Department may require, or a taxpayer may request, the use a reasonable method to effectuate an equitable allocation and apportionment of the taxpayer's income, if the statutory allocation and apportionment method fails to fairly represent the taxpayer's South Carolina business activities. While "business activity" is not statutorily defined in this regard, the Judge asserted that TSC's retail sales acted as a good barometer for the business activities of a retailer. As part of his decision, the Judge stated that, "the Department found TSC's business activity was not being fairly represented by separate entity reporting because TSC was utilizing intercompany transactions to shift income from its retail sales to Texas, thereby significantly reducing its South Carolina taxable income."
Based on South Carolina's judicial precedence, a party seeking alternative apportionment must support its claim with detailed evidence.4 As part of his analysis, the Judge specifically analyzed the group's procurement agreement, under which TSC paid TSCT for its procurement services. Through expert witness testimony, it was agreed by both parties that the transfer pricing study used to determine the markup within the procurement agreement was flawed and unreliable. Moreover, a reliable transfer pricing study was not presented to the Court.
Because the Judge found that he could not rely on the transfer pricing associated with the intercompany transactions between TSC and TSCT, he asserted that substantial income was improperly shifted from TSC to TSCT, such that TSC's South Carolina business activity was not fairly represented by the statutory separate reporting method.
Department's ability to use unitary combined reporting
Once the Judge determined that TSC's South Carolina business activity was not fairly represented by the statutory separate reporting method, he analyzed the Department's ability to use unitary combined reporting as a reasonable alternative apportionment method. Notably, the decision emphasized that the mere existence of a unitary business group and the presence of intercompany transactions did not necessitate unitary combined reporting.
The Judge relied upon witness testimony in concluding that separate entity reporting did not accurately represent TSC's business activity within the state. The Decision stated that if a reliable transfer pricing study were available, it could have concluded that, after appropriate adjustments to the transfer pricing, separate entity reporting fairly represented TSC's South Carolina business activity. The Judge also found that that the Department is not required to propose an alternative transfer pricing method before using combined unitary reporting. Once the Department demonstrates that single entity reporting does not fairly represent a taxpayer's South Carolina tax liability, the Department can use either a transfer pricing adjustment or combined unitary reporting as a remedy.
The Court then considered whether combined unitary reporting reasonably reflected TSC's business activity within South Carolina. The Judge found that unitary combined reporting was a "reasonable and equitable alternative method of apportionment under subsection 12-6-2320(A)(4) because it (1) corrects the income shift from TSC to Texas as a result of the Procurement Agreement such that (2) it reasonably and equitably approximates the taxable net income attributable to TSC's business activity in South Carolina."
This case highlights the Department's ability to require the use of unitary combined reporting when a taxpayer's business activities within South Carolina are determined to not be fairly represented by the statutorily required, separate reporting method. It also highlights a taxpayer's ability to request alternative apportionment if they feel as though separate reporting does not fairly represent their business activities within the State.
Additionally, the decision emphasizes the importance of taxpayers having robust transfer pricing documentation in place for situations where they operate a unitary business with the flow of value between affiliates via intercompany transactions. Further, Taxpayers seeking additional certainty or looking to avoid future controversy may inquire with departments of revenue about an advance pricing agreement (APA), which provides for an agreed upon transfer pricing methodology for multiple tax periods.
Lastly, it's worth noting that the South Carolina legislature is considering a bill, SB 298, which, similar to the law in North Carolina, would set forth a process that the Department must follow in order to use combined reporting as alternate method for allocating and apportioning income.