Press Room: Tax Release

July 27, 2012

California Refund Opportunity: Single-Weighted Sales Factor

The California Court of Appeal handed taxpayers a victory in its decision in The Gillette Company & Subs. v. Franchise Tax Board. The First District Court of Appeal held that California, as a signatory to the Multistate Tax Compact, must offer its multistate taxpayers the option of using the Compact’s three-factor formula to apportion business income to the state, in addition to the state’s own formula.

The Compact adopts the Uniform Division of Income for Tax Purposes Act’s equally weighted, three-factor apportionment formula of property, payroll, and sales, and then allows taxpayers the option of using the state’s alternative apportionment provisions. California amended its apportionment formula in 1993 to require the double-weighting of the sales factor and specified that the new formula was mandatory. The taxpayers filed suit after the Franchise Tax Board denied their refund claims, which were based on an election to compute their apportionable income using the equally weighted, three-factor formula under the Compact.

The Court found that the Compact is a valid, binding and enforceable agreement, and as long as California is part of the Compact, the Legislature cannot override or eliminate the option of electing the Compact’s formula. The election provision in the Compact is not optional because the Compact is meant to give taxpayers the advantage of uniformity among the member states. If a state is a member of the Compact, it must offer taxpayers the choice of electing either the Compact’s formula or the state’s own formula. The only way to end that election is for the state to withdraw from the Compact entirely by enacting a repealing statute; it cannot unilaterally repeal Compact terms.

Impact Beyond California

The Court was not persuaded by the FTB’s argument that 14 of 20 member states have passed some variation of a mandatory, state-specific apportionment formula that differs from the Compact, signaling that the issue is far from isolated. While the trial courts in Michigan and Texas have found that each state may require use of a state-specific formula, this California decision is the first to be decided at the appellate level.

Taxpayer Remedy

In advance of this decision, the California legislature passed legislation as part of the budget that repeals the state’s membership in the Compact. The Court in this case emphasized that withdrawal from the Compact would only affect the prospective application, so the years covered by the case would be unaffected. In addition, because the budget bills were only passed by a simple majority, the repeal may run afoul of Proposition 26 language that requires any revenue-raising bill to be passed by a two thirds vote. This calls into question the effectiveness of the repeal and could possibly leave the election in place regardless of whether the case is appealed to the California Supreme Court.

For now, taxpayers should consider the benefits of a single-weighted sales factor and entertain amending tax returns to protect open tax years.