The Massachusetts Appellate Tax Board (ATB) in Smithfield Packaged Meats Corp. and Combined Affiliates,¹ upheld the validity of regulations (referred to as the Combination Provisions) used by the Department of Revenue (DOR) to aggregate the activities of separate combined group members and the reclassification of certain group members as a Section 38 manufacturing corporation required to use a single sales factor formula.

The ATB, however, rejected the DOR's application of the Finnigan adjustment to group members that do not have nexus with Massachusetts (non-nexus group members) and have income that was protected from taxation by P.L. 86-272,² finding such application violated the Supremacy Clause of the US Constitution. Accordingly, the sales of those non-nexus group members were not properly reallocated to group members with Massachusetts nexus (nexus group members) for purposes of determining sales included in the numerator of the Massachusetts sales factor. Lastly, the ATB upheld the imposition of underpayment penalties for two of the tax years at issue.

Massachusetts tax law

Massachusetts law requires corporations engaged in a unitary business to file a combined report.³ Each member of the unitary business calculates the apportionment factor numerator based on its own statutorily prescribed apportionment formula,⁴ and calculates the apportionment factor denominator by determining and aggregating the denominators of every group member, including non-nexus group members. The Combination Provisions⁵ promulgated by the DOR, provide guidance on how a group member determines its apportionment formula in relation to intercompany transactions. Under these provisions, the activities of the group member that produced the property and the member selling the property to an unrelated third party are jointly considered in determining the appropriate apportionment formula of the selling member — e.g., whether the member is a Section 38 manufacturer. Each group member classified as a Section 38 manufacturer must use a single sales factor apportionment formula. Corporations that do not qualify as such must use a three-factor apportionment formula. However, all corporations must use single sales factor apportionment effective for tax years beginning on or after January 1, 2025.

Massachusetts tax law also adopts the "Reallocation Rule,"⁶ which provides that "[e]ach taxable member of the group shall include in its sales factor numerator a portion of the aggregate Massachusetts sales of nontaxable members based on a ratio … " the numerator of which is the taxable member's Massachusetts sales and the denominator is the aggregate Massachusetts sales of all taxable members. For purposes of determining whether sales are in Massachusetts, the Reallocation Rule applies a Finnigan adjustment. Under this adjustment, if one member of a unitary group has nexus with Massachusetts, the Massachusetts sales of all members of the unitary business group, including nontaxable members, will be included in the sales factor numerator.

Background

The taxpayers, Smithfield Packaged Meats Corp. and combined affiliates, filed Massachusetts combined corporate excise tax returns for the tax years at issue, 2015 through 2017. For these years, the taxpayers' principal domestic business lines were hog production (Farmland), fresh pork products (Fresh Meats Sales), and packaged meats (Packaged Meats Sales).

For the 2015 tax year, the DOR aggregated the activities of Fresh Meats Sales (a taxable member of the combined group that sold products produced by members of the combined group) with Farmland (a non-taxable member of the combined group that manufactured and sold processed pork to Fresh Meats Sales) and reclassified Fresh Meats Sales as a Section 38 manufacturer. For the 2016 tax year, the DOR (1) reclassified Packaged Meats Sales (a taxable member of the combined group that sold products produced by members of the combined group) as a Section 38 manufacturer, (2) aggregated the activities of Package Meats Sales and Morrell (a taxable member of the combined group that both parties agreed was a Section 38 manufacturer), and (3) reclassified Fresh Meats Sales as a Section 38 manufacturer. For the 2017 tax year, the DOR reclassified Package Meats Sales as a Section 38 manufacturer (the 2017 combined group only included Morrell and Packaged Meats Sales).

In addition, in 2017, Fresh Meats Sales stopped being a taxable member of the combined group under P.L. 86-272. Nevertheless, on the original 2017 Form 355U, the taxpayers initially applied the Finnigan adjustment and assigned receipts Fresh Meats Sales derived from sales to Massachusetts purchasers to taxable members of the combined group.

In each of the years, the DOR assessed the taxpayers additional corporate excise tax, penalties and interest. The taxpayers appealed these assessments to the ATB.

Findings of the ATB

The ATB found that the DOR's application of the Combination Provisions was proper, and that Fresh Meats Sales (for tax years 2015 and 2016) and Packaged Meats Sales (for tax years 2016 and 2017) were properly classified as Section 38 manufacturers. However, the ATB found that inclusion of a portion of Fresh Meats Sales, a company with P.L. 86-272 protection, in the apportionment factor numerator of each taxable member of the combined group was improper and in violation of the Supremacy Clause. The ATB also upheld the assessment of an underpayment penalty under Ma. G.L. Section 35A for tax years 2015 and 2016, but not for 2017, finding no underpayment for that year.

Section 38 manufacturer

The ATB rejected the taxpayers' challenge to the validity of the Combination Provisions used by the DOR to aggregate the activities of separate combined group members and reclassify Fresh Meats Sales and Packaged Meats Sales as Section 38 manufacturers. The ATB reasoned that as a general matter each member of a combined group must separately determine its tax liability, however, this notion "overlooks the fact that the Commissioner [of the Massachusetts Department of Revenue] was given explicit authority to promulgate regulations that address the elimination of intercompany transaction."⁷ The ATB found the express grant of regulatory authority under Ma. G.L. c. 63, Section 38B(f) is broad and not limited to the elimination and deferral of income. Rather, "the authority extends to the elimination or deferral of apportionment factors associated with the intercompany transaction" — i.e., the authority "gives the Commissioner the discretion to address the appropriate apportionment methodology after an intercompany transaction between unitary group members (one a manufacturer and the other a sales entity) has been eliminated." Accordingly, the Commissioner's promulgation of the Combination Provisions was within the statutory authority granted to it to prescribe regulations.

The ATB also rejected the taxpayers' argument that the Combination Provisions contravened statutory provisions directing manufacturing corporation status be determined on a single-corporation basis, finding instead that the regulation "simply coordinates" the combined reporting provisions in M. G.L. c. 63, Section 38B and the provisions in Ma. G.L. c. 63, Section 38(l)(1) that define a Section 38 manufacturer.

The Reallocation Rule - the Finnigan adjustment

The ATB agreed with the taxpayers that the application of the Finnigan adjustment to include a pro-rata portion of the sales of a nontaxable combined group member (whose income was exempt from taxation under P.L. 86-272) in the sales factor improperly frustrated the objectives of P.L. 86-272 in violation of the Supremacy Clause of the U.S. Constitution. In so finding, the ATB considered (1) whether P.L. 86-272 prevented a state only from directly taxing an out-of-state entity that falls within its protection, and (2) whether the "person" referenced in P.L. 86-272 included an entire unitary group so that if one group member is taxable in Massachusetts because it has nexus with the state, all group members, even entities protected by P.L. 86-272, are deemed to have nexus with the state.

As to the first question, the ATB determined that P.L. 86-272 does more than prevent a state from directly taxing an out-of-state entity protected from taxation. The ATB stated that "[t]he income earned by a P.L. 86-272 protected entity is tax-exempt, without qualification. On whose tax return that income is reportable is not relevant." Turning to the second question, the ATB concluded that no support could be found in the wording or legislative history of P.L. 86-272 that the term "person" includes multiple entities that make up a combined group.

In this case, the combined group taxable income reported on the taxpayers' 2017 return included income of a P.L. 86-272 protected entity through the operation of the state's apportionment formula. In support of its position that the Finnigan adjustment did not violate P.L. 86-272, the DOR argued that the state "was not taxing a nontaxable member but rather was applying an apportionment formula in context of combined reporting that fairly reflected income attributable to Massachusetts." The ATB found the case law cited by the DOR non-persuasive, saying those decisions "subsume the activities of a P.L. 86-272 protected entity within the activities of a combined or consolidated reporting group as a whole — placing combined and consolidated reporting, and concepts of apportionment, ahead of the constitutional principles embedded in the Supremacy Clause … " The ATB noted that while apportionment principles have passed muster under the Due Process, Equal Protection and Commerce Clauses, "the Supremacy Clause raises a different concern".

The ATB also found that Massachusetts, in apportioning the Massachusetts sales of Fresh Meats Sales to taxable members of the combined group via the application of the Reallocation Rule, has indirectly done what it could not do directly — i.e., indirectly imposing a tax on the income of a P.L. 86-272 protected entity. The ATB noted that "the fact that this result was achieved indirectly rather than by direct taxation does not validate Massachusetts' action."

Implications

It is unknown if the DOR will appeal this decision. Unitary business groups filing combined returns in Massachusetts with the sales of P.L. 86-272 protected group members included in the numerator of the sales factor under the Finnigan adjustment should consider their procedural options, including filing amended returns and protective refund claims. The ruling may also create exposure for some group filers who have relied on Finnigan to not be subject to the throwback rule.

Taxpayers should also consider monitoring constitutional challenges that may arise in other unitary states that impose Finnigan on P.L. 86-272 protected members.