Tax Analysts Blog

When State Taxes and Interstate Compacts Collide

Posted on Jan 22, 2014

Even those outside the state tax community should take note of some ongoing state tax litigation. I know that’s a lofty statement, but the reason is that it involves interstate compact law. With more than 200 interstate compacts that administer a variety of programs, such as ports and public transportation, any court opinion that affects interstate compact law could have broad implications.

Several cases are pending, but the first to address this issue was Gillette v. California Franchise Tax Board. Before turning to the litigation, a little background is helpful.

The compact at issue is the Multistate Tax Compact. The impetus for it was the creation of some uniformity among state tax systems, which was seen to be lacking in the 1950s, and avoidance of federal intervention in the state taxation of interstate businesses. The stage was set for the compact when, in 1957, the National Conference of Commissioners on Uniform State Laws adopted the Uniform Division of Income for Tax Purposes Act, which provides for the apportionment of a multistate business's income using an equally weighted three-factor formula.

But by 1959, few states had adopted UDITPA. In that year, the U.S. Supreme Court, in Northwestern Cement Co. v. Minnesota, upheld Minnesota's ability to impose corporate franchise tax on an Iowa corporation that had an office in Minnesota and salespeople soliciting orders in the state. The Court held that "net income from the interstate operations of a foreign corporation may be subjected to state taxation provided the levy is not discriminatory and is properly apportioned to local activities within the taxing State forming sufficient nexus to support the same."

The opinion was troublesome for multistate businesses because it was unclear what gave rise to the Iowa corporation's nexus with the state and whether the solicitation of orders in the state was sufficient to create nexus. In response to businesses' concerns, Congress enacted P.L. 86-272 and created a subcommittee to study the state taxation of multistate businesses. The resulting study, known as the Willis Report, recommended federal legislation that limited states' ability to tax multistate businesses and the imposition of a uniform apportionment formula.

Out of fear that Congress would eventually enact legislation that infringed on states' taxing powers, several state tax officials, through the Council of State Governments and the National Association of Tax Administrators, came up with the idea of a multistate tax compact. The compact and the commission were officially enabled on August 4, 1967, after seven states adopted its provisions. The compact was not conceived as a formal congressionally sanctioned compact with binding regulatory authority. Instead, it was intended to permit states to retain the ability to pursue their own policy agendas via their tax systems.

California ratified the compact in 1974. At that time, it required corporations to apportion business income using the equally weighted three-factor formula provided for in the compact. However, after the compact was ratified, California retained its corporate income tax statutes. As a result, California's corporate income tax and the compact are separately codified in state law.

The state has made various changes to its corporate income tax since 1974, including adopting a double-weighted sales factor apportionment formula for tax years beginning on or after January 1, 1993. In 2011 the state added an election for some corporate taxpayers to use a single-sales-factor formula for apportioning income to the state. Those changes to the state's corporate income tax laws had the effect of creating two very distinct sets of apportionment rules: one in the state corporate income tax laws and the other in the provisions that codified the compact. However, the Franchise Tax Board did not appear to acknowledge the compact's three-factor formula as an option for taxpayers.

In January 2010 six corporate taxpayers filed claims for refunds of corporate income tax totaling approximately $34 million. They argued that the double-weighted sales factor formula in Revenue and Taxation Code section 25128, as amended in 1993, did not override the three-factor apportionment formula set forth in RTC section 38066, the statute codifying the compact. The taxpayers argued that under Article III in the compact, known as the "taxpayer option," taxpayers may elect to apportion and allocate income under state law "without reference to this compact, or may elect to apportion and allocate in accordance" with the compact.

On July 24, 2012, a California court of appeal held that California's ratification of the compact was a valid contract, and that the state was therefore bound by the provisions of the compact. For taxpayers, that meant California could not eliminate the option for corporate taxpayers to elect to apportion using the equally weighted three-factor apportionment formula. The court concluded that the state could eliminate that option only by withdrawing from the compact.

Similar litigation is pending in Texas, Oregon, Michigan, and Minnesota, but the opinions have not been uniform. A Michigan court came to an opinion contrary to Gillette, and just recently, a Texas court dismissed without analysis the taxpayer’s assertion that it properly elected to use the compact’s equally weighted three-factor formula. The mix of opinions leaves taxpayers with no clear guidance.

While state courts may be hesitant to rule in favor of the taxpayers because it will result in a revenue loss for the state, they should be cautious of the broader implications for other interstate compacts. The compact was created not because states truly wanted uniformity, but because they didn't want the federal government interfering in matters of state taxation. As a result, state representatives created what they believed to be a solution that would both encourage uniformity and not get in the way of individual state tax policy. But states can't have their cake and eat it too; a compact cannot be both binding and offer states significant choices on whether to follow its terms.

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