The Minnesota Department of Revenue (Department) presented sufficient evidence to support the use of an alternative apportionment method that substituted net income for gross receipts from forward-exchange contracts in a multinational company's sales factor denominator, the Minnesota Tax Court held in E.I. duPont de Nemours and Co. & Subsidiaries.¹

Facts

The taxpayer, a multinational science and technology company headquartered in Delaware, operates in approximately 90 countries. Sixty percent of its consolidated net sales were to customers outside the United States (US), which resulted in significant foreign-currency transactions from international sales. For US financial reporting purposes, the taxpayer must report its global earnings in US dollars even though it receives payment for the sale of its goods in foreign currencies.

As a result of its activities, the taxpayer experienced foreign-currency risk in the fluctuation of the reported book value of foreign-denominated receivables or payables between the original transaction date and settlement date. To manage this risk, the taxpayer implemented a policy called the NMA Program, under which its treasury personnel in Delaware bought and sold forward exchange contracts (FECs) to offset the taxpayer's net exposure from transactions in the corresponding foreign-currency pairings. The NMA Program enabled investors to see the taxpayer's true operating performance unaffected by currency fluctuations.

The terms of the FECs were on a gross basis, and the taxpayer included those gross receipts in the denominator of its Minnesota apportionment factor on its 2013-15 corporate returns because none of the activities related to the NMA Program were conducted in the State. The Department found the taxpayer's inclusion of the FEC gross receipts improperly increased the company's worldwide sales and in turn, decreased the share of sales taxable in Minnesota. As a result, the Department assessed the taxpayer based on the application of an alternative apportionment method, which substituted net income in the taxpayer's sales factor denominator in place of the gross receipts. The taxpayer appealed to the Minnesota Tax Court.

Minnesota Tax Court analysis

The court observed that Minn. Stat. 290.20, subd. 1 presumes that the general apportionment methodology prescribed by Minn. Stat. 290.191, subd. 2(a) fairly determines a taxpayer's income from Minnesota activities. The statute, however, also allows taxpayers to petition for, or the Department to require, an alternative method of apportionment if that method fairly reflects income. The court noted that the statutory scheme first requires a rebuttal of the presumption that the prescribed statutory method is correct.

The court indicated that the party (in this case the Department) seeking to use an alternative method need not show that the general statutory method resulted in a distortion, but that it did not "fairly reflect" net income allocable to Minnesota. If the presumption is rebutted, then substantial evidence must be presented to show that the proposed alternative method fairly reflects income.

In analyzing whether the Department met its burden of rebutting the presumption that the general statutory method fairly reflected income, the court first observed that the FEC transactions did not occur independently of transactions with customers but served a supportive risk-management function. The court rejected the taxpayer's contention that the FEC transactions arose in the ordinary course of its business and the Minnesota statutory scheme did not require gross receipts to arise from a taxpayer's "core business." The court noted that both the Department's and taxpayer's expert witnesses² agreed that the FEC transactions' purpose was to manage foreign-currency risk, not serve as a stand-alone profit center for the taxpayer. While the FEC transactions were a regular, recurring, and integral part of the taxpayer's business, the court said, they differed qualitatively³ from its other for-profit sales.

The court then considered whether the taxpayer's inclusion of gross receipts from FEC transactions resulted in a "quantitative distortion" of income. The court found persuasive the Department's expert testimony that the inclusion of gross receipts affected apportionment by increasing the taxpayer's everywhere sales more than threefold. Because the FEC transactions did not serve an independent profit-oriented purpose, the inclusion of FEC gross receipts quantitatively distorted the taxpayer's total sales, net income, and apportionment. The court thus concluded that including gross receipts from FEC transactions in the apportionment factor denominator did not fairly reflect the taxpayer's income allocable to Minnesota.

After concluding the Department met its burden of showing that the statutory formula did not fairly reflect income, the court analyzed the Department's proposed alternative method. The court agreed with the Department that using net income from FEC transactions in the denominator maintained a relationship between the FEC transactions and the apportionment factor without "overwhelming" the factor with the gross FEC activity. As such, the court determined that the alternative method fairly reflected the taxpayer's Minnesota net income.

Implications

It is unknown whether the taxpayer will appeal the court's decision. The decision generally aligns with other state decisions on the apportionment-factor treatment of treasury functions. While the court's decision is based on the taxpayer's specific facts and circumstances, it may create concerns for similarly situated taxpayers that include gross receipts from FEC contracts in their apportionment factor denominator.

Both the Department's expert and the court noted that the taxpayer used the net approach in Delaware, where it conducted the majority of its FEC activity; accordingly, employing the same method in Minnesota would promote "fair and consistent economic distribution" of the taxpayer's income, as well as ensure that all of its domestic income is allocated to "one state or another." This reasoning aligns with states' general distaste for what they term "nowhere income," which results from inconsistent sourcing provisions taken amongst the states.

EY will continue to monitor developments in this area.