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California: Appeals court upholds taxpayer’s election to apportion income using Multistate Tax Compact

July 26, 2012 | No. 2012-353

A California appeals court held that a taxpayer could apportion its income to California using the Multistate Tax Compact’s evenly weighted three-factor formula, despite statutory language mandating the use of a three-factor double-weighted sales formula for general corporations. The Gillette Co. v. Franchise Tax Board, No. A130803 (Cal. Ct. App. July 24, 2012)

In the state appeals court’s view, when California became a signatory to the Multistate Tax Compact (MTC), it entered into a binding agreement that, absent repeal, requires California to offer multistate taxpayers the option of using the MTC allocation and apportionment provisions.

MTC in California law

The Multistate Tax Compact (MTC) was enacted by California in 1974, and is codified at Cal. Rev. & Tax. Code § 38006.

The MTC provides that taxpayers have the option of using (1) the UDITPA allocation and apportionment rules, or (2) state-specific apportionment provisions.

In 1993, the California legislature amended Cal. Rev. & Tax. Code § 25128 to provide that“notwithstanding” Cal. Rev. & Tax. Code § 38006all business income for general corporations must be apportioned to the state using a double-weighted sales-factor formula.

In other words, the 1993 amendments mandated the use of a double-weighted sales formula for certain taxpayers—despite the fact that the MTC remained part of California’s law and was never modified.


The taxpayer filed amended returns electing to use the MTC’s allocation and apportionment provisions. In the taxpayer’s view, the 1993 amendments did not override or repeal the MTC, and thus it could elect to use the MTC’s allocation and apportionment rules.

After the Franchise Tax Board (FTB) denied the taxpayer’s refund claims resulting from the application of the MTC provisions, this litigation ensued. The trial court held in favor of the FTB, and the taxpayer appealed.

Before the appeals court, the FTB argued that:

  • The plain language of the 1993 amendments indicates the legislature’s intention to mandate that taxpayers use a double-weighted sales-factor apportionment methodology.
  • If the 1993 amendments ran afoul of the MTC, the taxpayer lacked standing to challenge any purported violation of the MTC.


Appeals court decision

The appeals court first reviewed the nature of interstate compacts, observing that they “have dual functions as enforceable contracts between member states and as statutes with legal standing within each state.” Upon entering a compact, the court noted, the compact “takes precedence over the subsequent statutes of signatory states and, as such, a state may not unilaterally nullify, revoke or amend one of its compacts if the compact does not so provide.”

The court next addressed the standing issue, noting that the right to elect to apportion using the MTC provisions was a right specifically extended to taxpayers under the MTC. As such, the taxpayer in this case had standing to enforce this right.

Having reviewed the unique nature of interstate compacts and having addressed the standing issue, the appeals court next determined that the MTC was a valid, enforceable contract that had survived constitutional challenges before the U.S. Supreme Court and that had been recognized as such by the California Attorney General.

The appeals court rejected the FTB’s assertion that the MTC was only a “model law.” While this may be how the MTC is treated in some states, the MTC was binding on California because the state was a full signatory member of the MTC, the court found. In the court’s view, the only way for California to withdraw from the MTC was to repeal it. Also, as the court noted, any repealing legislation must be prospective in nature because it could not “…affect any liability already incurred by or chargeable to a party State prior to the time of such withdrawal.”

Furthermore, the court rejected the argument that California lawmakers could unilaterally repeal the MTC’s terms. If the issue were two conflicting statutes, the court noted that it might “entertain” the FTB’s statutory construction argument—i.e., that the 1993 enactment repealed the availability of the election.

However, in the court’s view, the FTB’s argument ignored the fact that the MTC was not simply a statute, but was a binding, enforceable agreement entered into with other signatory states. The appeals court found that " an interstate compact the [MTC] is superior to prior and subsequent the statutory law of member states” [emphasis in original] and, as such, the MTC—which requires states to offer the election—trumps California law.

The FTB also argued that “extrinsic evidence”—e.g., the fact that a number of parties to the MTC deviated from its provisions over the years—ought to be considered. In the FTB’s view, this indicated that the MTC was reasonably susceptible to an interpretation that its provisions were nonbinding and capable of being amended, superseded, and/or repealed, in whole or part.

After finding that the FTB’s arguments also ran afoul of certain other federal and state constitutional prohibitions, the appeals court reversed the lower court’s judgment of dismissal and ordered that the FTB bear the appeal costs.

The appeals court did not specifically hold that the taxpayer was entitled to refunds, as claimed.

KPMG observation

The repercussions from this decision are potentially significant. If courts in other MTC full-signatory states follow this decision, it appears that any statute or regulation not promulgated under the authority of the MTC, and that mandates a different apportionment methodology other than that contained in the MTC, would potentially be unenforceable.

For example, if a full-signatory state has amended the MTC or has adopted a separate statute mandating that a double-weighted (or even more heavily weighted) sales factor must be used, the statute would appear to be unenforceable as long as the state remained a full signatory member of the MTC.

In other words, as long as the state has not withdrawn from the MTC, a taxpayer could elect to use the MTC provisions.

In addition to sales-factor weighting, this same line of reasoning could have relevancy to other apportionment sourcing provisions—e.g., costs of performance vs. market sourcing, special industry apportionment formulas, etc.—and definitions that mandate a treatment that departs from the methodology contained in the MTC.


What’s next?

It is not yet known whether the FTB will appeal the decision, although it seems likely given the amount of dollars at stake.

Also, the situation was made somewhat more complicated as a result of enactment of California’s June 27, 2012 legislation (S.B. 1015) that repealed the MTC. This legislation also provides that an election affecting the computation of tax must be made on an original, timely filed return for the tax period for which the election applies and is binding, once made. According to the legislation, this “doctrine of election” does not constitute a change in law, but is merely declaratory of existing law.

Further complicating matters, S.B. 1015 was adopted by a simple majority—rather than a two-thirds majority. As such, an issue has already been raised as to whether the legislation was validly enacted under Proposition 26 (which provides that “any change in state statute which results in any taxpayer paying a higher tax” is subject to the two-thirds requirement).

KPMG observation

Regardless of the MTC repeal in California—which would appear to eliminate the ability to make an election to use the MTC apportionment provisions for tax years beginning on or after January 1, 2012—the benefits of the election must be considered in filing original 2011 California returns (as these returns would not be imperiled by the “doctrine of elections” provision contained in S.B. 1015).

In addition, as has been observed by tax professionals, the mandate that elections only be made on originally filed returns is “suspect” so that prudent taxpayers would consider an analysis as to the potential benefits of filing amended California returns for all open tax years.

Lastly, the potential benefits of taking such positions in other states that are full signatory members of the MTC—Alabama, Alaska, Arkansas, Colorado, District of Columbia, Hawaii, Idaho, Kansas, Michigan, Minnesota, Missouri, Montana, New Mexico, North Dakota, Oregon, South Dakota, Texas, Utah, and Washington state—both on originally filed 2011 returns and on amended returns, would need to be evaluated.



For more information, contact a tax professional with KPMG’s State and Local Tax practice:

Doug Bramhall, (480) 459-3491

Scott Salmon, (202) 533-4202

John Harper, (213) 593-6704

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The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

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