Emerging Issues in Apportionment
Detroit TEI – December 9, 2014
Jane Wells May
McDermott Will & Emery
227 W. Monroe Street
Chicago, IL 60606
Jmay@mwe.com
312-984-2115
Lindsay M. LaCava
McDermott Will & Emery
340 Madison Avenue
New York, NY 10173
Llacava@mwe.com
212 547-5344
www.mwe.com
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Agenda
 Overview of Apportionment Principles.
 Single Receipts Formula.
– Constitutionality.
– Availability of MTC Election (Gillette).
 Sales Factor Sourcing.
– COP.
– Market-Based Sourcing.
 Alternative Apportionment.
 Opportunities.
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Apportionment Overview
 What is apportionment?
 Historical approach to apportionment.
 Trend to more heavily weight sales.
 Hot Issues:
– Is a single factor receipts formula constitutional?
– In states that are members of the Multistate Tax Compact, must taxpayers be
allowed to elect the Compact’s three-factor formula if they choose?
– Sourcing of taxable services.
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Apportionment – Sourcing Trends
 Aggressive state audit behavior.
– Application of market-based sourcing absent legislation.
– Application of special sourcing rules for certain activities absent
legislation.
– One-sided application of COP rules.
– Default to alternative apportionment.
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Single Receipts Formula
 Is a single factor receipts formula constitutional?
– Hans Rees’ Sons, Inc. v. North Carolina, 283 U.S. 123 (1918).
– Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978).
– Due Process Clause – “out of all proportion.”
– Commerce Clause.
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Single Receipts Formula – Recent
Challenge
 Texas.
– Graphic Packaging Corp. v. Combs, (Texas Dist. Ct., Petition filed
Sept. 27, 2012).
• Taxpayer argued violations of Due Process and Commerce Clauses.
• Single-factor formula did not account for the fact that taxpayer had no
manufacturing operations in Texas.
• In January 2014, the court denied taxpayer’s motion for summary
judgment.
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Apportionment: MTC Election
 Right to file using three-factor formula in MTC states.
– Article III of the Multistate Tax Compact.
• “any taxpayer subject to an income tax…may elect to apportion and allocate
his income in the manner provided by the laws of such States…or may elect
to apportion and allocate in accordance with Article IV.”
– Article IV provides for a three-factor apportionment formula.
• Also provides for Cost of Performance sourcing.
– States with challenges filed: CA, MI, MN, OR and TX.
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Apportionment: MTC Election
 California.
– Gillette Co. and Subs. v. California Franchise Tax Board, 209 Cal. App. 4th 938 (Oct. 2,
2012), aff’d on reh’g (Oct. 25, 2012).
• Multistate Tax Compact is a binding contract and its provision allowing out-of-state taxpayers to
elect to apportion income under evenly weighted formula supersedes conflicting state law.
• FTB filed petition for review to California Supreme Court, which was granted on January 16,
2013.
– California FTB Notice No. 2012-01 (Oct. 15, 2012).
• Procedure for protective refund claims.
– California repealed the Compact (S.B. 1015).
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Apportionment: MTC Election
 Michigan.
– International Business Machines Corp. v. Dept. of Treas., Case No. 146440
(Mich. Sup.Ct., July 14, 2014).
• The taxpayer sought three-factor formula from the Compact (adopted by Michigan in
1969).
• Michigan Appellate Court – Compact repealed by implication.
• Michigan Supreme Court reversed – IBM entitled to use Compact provisions.
• 3 judge dissent.
• State’s request for rehearing alleges $1.1 billion revenue loss.
– Anheuser-Busch v. Michigan Dept. of Treas., Case No. 11-85-MT (Mich. Ct.
Claims June 6, 2013).
• Compact was binding – Anheuser-Busch entitled to use Compact provisions.
– Retroactive legislation.
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Apportionment: MTC Election
 Texas.
– Comptroller of Public Accounts, Hearing No. 106,503 (Aug. 10, 2012).
– Texas margin tax requires the use of single-factor sales apportionment
formula; taxpayers may not use the MTC election.
 Oregon.
– Health Net Inc. v. Dept. of Rev., Case No. 120649D (filed July 2, 2012).
– Oregon repealed and reenacted Compact (10-8-13).
 Minnesota.
– Kimberly-Clark Corp. v. Comm’r, MN Tax Court Docket No. 8670 (filed
December 12, 2013).
– Minnesota repealed Compact (5-24-13).
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MTC Viability Issues
 Valid enforceable interstate compact?
 Effect of federal/state constitutional prohibitions regarding
impairment of contracts.
 Retroactive legislation.
 Repeal/reenact strategies.
 Effect on MTC’s audit authority.
 Impact of proposed MTC amendments.
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Sales Factor Sourcing: General Rules
 Sourcing determined by the nature of what is sold.
 Sourcing receipts from sales of tangible personal property.
– Generally sourced to state of delivery.
 Sourcing receipts from sales of services or from “other than
TPP.”
– Cost of performance.
– Trend toward market-based sourcing.
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Apportionment Factors: Characterization
 What is being sold.
– Under UDITPA: tangible personal property versus other.
– Under trend to market sourcing:
• TPP: destination.
• Intangible property: where “used.”
• Services: where benefit received/delivered/etc.
 Microsoft Corp. v. Franchise Tax Board, No. A131964 (Cal. Ct. App., 12-18-12).
– Receipts from the right to replicate software sourced as sales “other than
tangible personal property” using COP.
– Court observed: “We find it troubling, however, that defendant appears to
have advocated a position in Adobe that is directly contrary to the position it
advances against plaintiff in the present case… the inconsistency suggests a
result-orientated bias based on the domicile of the taxpayer.”
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Sales Factor: Cost of Performance
 Income from sales of services generally sourced to state if
“income-producing activity” takes place there.
 If income-producing activity is performed in more than 1 state.
– Generally where greater portion of the income-producing activity is
performed based on “costs of performance” (COP).
– Some states use “greater proportion” (i.e., more than 50%).
– Some states avoid all or nothing result by sourcing based on
percentage of income-producing activity performed in each state.
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Sales Factor: Cost of Performance
 Income-producing activity generally.
– Applies to each separate item of income.
– Means transactions and activity directly engaged in by the taxpayer in
the regular course of trade or business for the ultimate purpose of
obtaining profit.
– If income-producing activity occurs solely in state, never reach COP.
 Costs of performance.
– Means “direct costs” determined consistent with GAAP and in
accordance with conditions/practices of taxpayer’s trade or business.
– Use of cost accounting.
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Sales Factor: Cost of Performance
 COP Issues.
– Determining “income-producing activity” or activities.
• If multiple IPAs, each activity is evaluated separately.
• Can IPA cross company lines in unitary group?
– Determine if IPA is performed in more than one state.
– Determine location of “performance costs” (i.e., the direct costs that are
necessary to conduct the IPA).
• Which costs are “direct”?
• Do third party costs count?
– Transactional v. operational approach.
• At what level must the COP analysis be done to accurately reflect cost locations?
– Can an argument be made for alternative apportionment?
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Sales Factor: Cost of Performance
 Payments to third parties.
– Historical rule:
• To determine income producing activity: Third party transaction and activities
performed on behalf of taxpayer not included.
• To determine COP: “means direct cost.”
– MTC and some states have changed position:
• To determine income producing activity: Includes third party transactions and
activities performed on behalf of a taxpayer.
• To determine COP: Includes payments to an agent or independent contractor for
the performance of personal services and utilization of tangible and intangible
property which give rise to the particular item of income.
– Significant misunderstanding as to application.
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Sales Factor: Cost of Performance
 Transactional v. Operational Approach.
– Relates to the level at which the COP analysis is done.
– If, for example, the IPA is trades of securities:
• Transactional approach could result in a separate evaluation of costs associated with each
individual trade in order to source revenue from that trade.
• Operational approach could result in sourcing trading revenues from the entire multistate trading
activity (or subsets of that activity) based on costs associated with that multistate activity.
– Cost accounting experts use transactional approach when cost locations associated
with IPA differ, but operational approach when costs are undifferentiated (i.e., occur in
the same location).
• For example, if the costs associated with trades executed for Chicago customers occur in
different states than costs associated with trades executed for Los Angeles customers, a
transactional approach will be employed to source the receipts from those trades separately
based on their unique COP.
• At the other extreme, if the costs associated with trades occur in the same states regardless of
where the trades are initiated, an operational approach will be employed to source the receipts
from all trading activity.
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Sales Factor: Cost of Performance
 Compare AT&T Corp. v. Comm’n, No. C293831 (Mass. App.
Tax Bd. June 8, 2011) with AT&T Corp. v. Dep’t of Rev., No.
TC 4814 (Ore. Tax Ct. June 28, 2011, amended opinion
January 12, 2012).
– Same company, same facts, generally same COP law – opposite
conclusions.
– Cases went opposite ways on:
• Transactional v. operational approach.
• Applicability of third party costs.
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Sales Factor: Recent COP Case
 Michigan.
– Michiana Metronet, Inc. v. Dep’t of Treas., Dkt. No. 306219 (Mich. Ct.
App. Nov. 8, 2012) (unpublished).
• Taxpayer provided wireless services to customers in Indiana, Ohio and
Michigan. Under former SBT law, sales of other than tangible property
were sourced to Michigan if the greater proportion of costs of performance
occurred in Michigan than in any other state.
• Department argued that service receipts should be sourced to customers’
billing addresses because there was no way of determining direct costs of
performance.
• Court of Appeals concluded that taxpayer’s service network was located in
Indiana and therefore larger proportion of costs of performance were
incurred in Indiana; customers’ billing addresses likely had no direct
correlation to where costs to generate the sales occurred.
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Sales Factor: Market-Based Sourcing
 No consistent definition of what is “market” for sales of other
than tangible personal property.
 Services.
– Where delivered or received.
– Where purchaser received the benefit.
– Where indicated in contract or books and records.
– Where performed.
– Where customer located (e.g., billing address, domicile, HQ, etc.).
– If derived from buyer within the state.
– Proxies (e.g., relative population, relative GDP, other statistics).
– Other.
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Sales Factor: Market-Based Sourcing
 States with IPA/COP sourcing statute, but adopting
market in regulations.
– New Jersey proposed a regulation for services: statute
provides that receipts will assigned to “where performed.”
• Draft revision: if receipts “derived from customers within the
state.” (45 N.J. Reg. 886(a) (Apr. 15, 2013)).
• Failed regulation attempt.
– Raises questions (and refund opportunities) based on current
regulation.
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Sales Factor: Market-Based Sourcing
 Default or safe-harbor provisions.
– Cascading approach.
– “Readily determinable” versus “reasonable approximation.”
– Examples:
• Office of customer from which the service was ordered. Me. Rev. Stat. Ann. 36 §
5211(16-A); CA (fallback if other sourcing unknown); Ill.
• Billing address: CA; Ill.
• Reasonable approximation.
 If receipts related to multiple states, pro-rata based on benefit/use?
– Utah: if the purchaser of the service receives a greater benefit of the service in
Utah than in any other state. Utah Code Ann. § 59-7-319(3); Utah Admin. R. §
R865-6F-8(10(g)(i).
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Sales Factor: Market-Based Sourcing
 MTC proposed revisions to UDITPA.
– Services.
• If and to the extent the service is delivered to a location in a state.
• If delivery of the service cannot be determined, the sourcing location can be
reasonably approximated.
• If no reasonable approximation, throw out.
– Intangibles.
• Based on whether the intangible is used in the state.
• Adopts look-through for marketing intangibles.
• Distinction between receipts from licensing intangibles and receipts from the actual
sale of an intangible.
– Receipts from sale only included in factor if.
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intangible property associated with a contractual right in a specific geographic area or
»
Contingent on subsequent use of intangible.
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Sales Factor: Market-Based Sourcing
 Intangible Property.
– Where used.
• Where employed to produce a product.
• Where the royalties are used.
– Where property located.
– Commercial domicile of licensee or purchaser.
– If received from sources within the state.
– If receipts from within the state.
– Where billed.
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Sales Factor: Market-Based Sourcing
 Look-through Rule for Intangible property : Adopted by Massachusetts,
California, and Alabama; pending adoption by MTC.
– If used by taxpayer’s licensee in marketing a good or service to a consumer.
– Receipts sourced to state where good or service is purchased.
 Default or safe-harbor provisions if location not readily determinable.
– Office of customer from which the service was ordered. Me. Rev. Stat. Ann. 36 §
5211(16-A).
– Commercial domicile. Mass. Regs. Code 63.38.1 (presumed for receipts from nonmarketing intangibles unless other location established).
– Customer billing address: California – for sales to individuals.
– Books and records: California – sales to businesses (look to contract or taxpayer’s
books and records).
– Reasonable approximation: census.
 If receipts related to multiple states, pro-rata based on benefit/use.
– Utah: if the purchaser of the service receives a greater benefit of the service in Utah
than in any other state. Utah Code Ann. § 59-7-319(3); Utah Admin. R. § R865-6F8(10(g)(i).
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Lack of Uniformity
 The unique approaches to market-based sourcing often producing
dramatically different results.
– PA and CA have examined the same fact pattern, with divergent results:
• The PA department draft guidance contains the following example:
– Taxpayer is a provider of third-party payroll processing services for Company A. Half
of Company A’s employees are located in PA and half are located in NY. Company
A’s headquarters and human resources functions are located in PA. Taxpayer
sources all of the payroll services to PA. Note in this example that payroll services
are really used by the corporation and not the employee because the service is
designed to meet the needs of the company, and it is the company that uses the
processing service, not the employee.
– This result is directly contrary to California’s regulation, which provides
that the payroll servicing company should assign its receipts by
determining the ratio of employees of the customer in California compared
to all employees of the customer and assign that percentage of the
receipts to California. Cal. Code Regs. 25136-2(b)(1).
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Market Sourcing: Example
 Suppose Law Firm A, with taxable nexus in all 50 states, provides
litigation consulting services to Corporate Client B that is commercially
domiciled in PA.
– A is engaged by B after B executes a letter of engagement from its office in MA
(where the legal department resides).
– MA is also the state from which the litigation consulting services are managed by
B.
– The litigation consulting services provided to B involve trial preparation that occurs
in NY and PA (for example, meeting with witnesses in NY and PA).
– All the services provided by A to B are provided by A’s attorneys located in NY and
PA.
– All of A’s bills are sent to and approved by B’s legal department in MA.
– How does A source its receipts from the performance of its litigation consulting
services to B in MA, NY, and PA?
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Alternative Apportionment: Overview
 Generally permits the use of one or more alternative methods if the
apportionment provisions “do not fairly represent” the taxpayer’s business
activity in the state.
 References separate accounting, exclusion/inclusion of one or more
factors, or “employment of any other method to effectuate an equitable
allocation and apportionment” of taxpayer’s income.
 Availability.
 Special election/procedure.
 Current issues.
– When is alternative apportionment appropriate?
– Who bears the burden when raising alternative apportionment?
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Alternative Apportionment: Background
 Professor William Pierce, the principal draftsperson of
UDITPA, stated that:
– “Section 18 permits…some other method…where unreasonable
results ensue from the operation of the other provisions of the Act. …
Of course, departures from the basic formula should be avoided
except where reasonableness requires. Nonetheless, some
alternative method must be available to handle the constitutional
problems as well as the unusual cases.”
– “In many types of service functions, [the COP] approach appears
adequate. However, there are many unusual fact situations connected
with this type of income and probably the general provisions of Section
18 should be utilized for these cases.”
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Alternative Apportionment: Background
 A number of states have determined that alternative
apportionment may only be required in unusual cases.
– See, e.g., Appeal of Crisa Corp., No. 2002-SBE-004 (Cal. St. Bd.
Equal. 6-20-02); Union Pacific Corp. v. Idaho State Tax Comm’n, 83
P.3d 116 (Idaho 2004); Roger Dean Enterprises v. State Dep’t of Rev.,
387 So. 2d 358 (Fla. 1980); Deseret Pharm. Co. v. State Tax Comm’n,
579 P.2d 1322 (Utah 1978).
 States have also recognized that alternative apportionment is
an exceptional remedy.
– See, e.g., St. Johnsbury Trucking v. State, 385 A.2d 215 (N.H. 1978);
Donald M. Drake Co. v. Dep’t of Rev., 500 P.2d 1041 (Or. 1972).
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Alternative Apportionment
 CarMax Auto Superstores West Coast, Inc. v. South Carolina Dept. of
Rev., No. 4953 (S.C. Ct. App. Mar. 14, 2012).
– The Department, as the party seeking to deviate from the standard formula,
must satisfy two burdens:
• (1) standard statutory formula did not fairly represent CarMax West’s in-state
business activity; and
• (2) alternative formula is appropriate, and it is more appropriate than any other
competing method.
– “It is only logical that a party seeking to override the legislatively determined
apportionment method bears the burden of proving that method is not
appropriate and an alternative method more accurately reflects the taxpayer’s
business activity within the state.”
 Significance of standard statutory approach.
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Alternative Apportionment
 Indiana Dept. of Rev. v. Rent-A-Center East, Inc., No. 49510-1112-TA683 (Ind. Mar. 9, 2012).
• Tax Court held that the Department could force combination only if the
Department could first show that other alternatives did not fairly reflect
income.
• Indiana Supreme Court reversed and remanded.
– The Department’s notice of proposed assessment served as prima facie
evidence that its claim for the unpaid tax was valid.
– The burden then shifts to the taxpayer to show that an alternative apportionment
method would more properly reflect its income.
– Pending the Tax Court’s decision on remand, the Indiana Supreme Court’s
decision now means that taxpayers can no longer argue that the Department
must first show that use of other alternatives did not fairly reflect the taxpayer’s
Indiana income before forcing combination.
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Alternative Apportionment
 Equifax, Inc. and Equifax Credit Info. Services, Inc. v. Dept.
of Rev., Dkt. No. 2010-CT-01857-SCT.
– Equifax reported no taxable income in the state after following the
state’s regulations for service companies, despite generating approx.
$22.6 million in gross receipts from Mississippi customers.
– Department used market sourcing as alternative apportionment
method.
– Mississippi Court of Appeals – Department had burden of proving that
the use of an alternative apportionment method was appropriate.
– Mississippi Supreme Court reversed – Equifax bore burden of
challenging the commission decision.
– Petition for cert. denied by US Supreme Court.
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Alternative Apportionment
 Vodafone Americas Holdings, Inc. v. Roberts, M2013-00947COA-R3-CV (Ct. App. Tenn. 6-23-14).
– Taxpayer’s historic use of customer billing address to source receipts
was used against it when it applied for refunds based on statutory
COP, which would have reduced receipts by 89%.
– Tennessee Supreme Court accepted Vodafone’s petition for review.
 Increasing use of alternative apportionment in COP states to
produce market-based sourcing.
– Ameritech Publishing, Inc. v. Wisconsin Dep’t of Revenue, 788 NW2d
383 (Wisc. Ct. App. 2010); Bellsouth Adver. & Publishing v. Chumley,
308 SW3d 350 (Tenn. App. 2009).
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Opportunities
 Consider nature of what is being sold.
 In COP states, consider:
– Determination of IPA or IPAs.
– Direct costs.
– Transactional v. operational.
 If market, consider using “reasonable approximation.”
 Consider alternative apportionment.
– Does “standard” statute provide opportunity for alternative?
– Remember burdens if trying to oppose alternative apportionment.
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Jane W. May
Jane Wells May is a partner in the law firm of McDermott Will & Emery LLP and is based in the Firm’s
Chicago office. Jane heads the Firm’s State & Local Tax Practice Group. She focuses her practice on
state and local tax matters.
Contact
Chicago
312.984.2115
jmay@mwe.com
Education
Vanderbilt University
School of Law, J.D.,
1986
Wittenberg University,
B.A. (with honors),
1980
Jane represents businesses in connection with state and local tax controversies at the audit, administrative
and judicial levels around the United States. Her clients include companies in manufacturing, retailing,
pharmaceuticals, automotive, health care, energy, technology and insurance industries. She has
successfully litigated state and local tax matters raising a variety of statutory and constitutional issues.
Jane has defended numerous internet sellers in several states against cases brought under state
whistleblower statutes, including the Illinois False Claims Act, alleging fraudulent failures to collect and
remit use tax.
Jane also advises business clients on tax planning matters and represents athletes and entertainers in
connection with employment contract issues.
A member of the Taxpayer’s Federation of Illinois Policy Committee, Jane is a regular speaker at seminars
on state and local tax issues. She is a member of the Chicago Bar Association’s State and Local Tax
Committee and is admitted to practice in Illinois. Jane was named a leading tax lawyer in the 2009, 2010
and 2011 editions of The Legal 500 United States, which states that she has “built a noteworthy local and
state taxes practice.” She was also ranked by Chambers USA in 2008, 2009, 2010 and 2011, which notes
that she “is full of energy and brings a wealth of experience to the work.” Furthermore, say the Chambers
rankings, Jane is “excellent from an advocacy point of view” and is considered a “strategic leader” in state
and local tax. She has also been named an Illinois Super Lawyer in the tax area by Law & Politics.
At Vanderbilt University, Jane was senior articles editor of the Vanderbilt Law Review and a member of
Order of the Coif and Moot Court Board.
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Lindsay M. LaCava
Lindsay M. LaCava is a partner in the law firm of McDermott Will & Emery LLP and is based in the Firm's
New York office. She focuses her practice on state and local tax. Lindsay assists businesses and
individuals with state and local tax planning and litigation matters. In the controversy area, she represents
clients at all stages of state and local tax disputes including the audit, administrative appeal, state trial
court, and state appellate and supreme court stages. In the transactional planning and consulting area,
Lindsay advises clients with respect to the state and local business activity tax, sales and use tax, and
personal income tax consequences of various transactions and activities.
Contact
New York
Tel: +1 212 547 5344
eFax: +1 646 390 3387
Llacava@mwe.com
Education
University of
Connecticut , B.S.
Quinnipiac University
School of Law , J.D.
In addition to speaking on a variety of state tax topics, Lindsay recently co-authored a chapter on the state
tax appeals process for the “State Business Taxes” treatise published by ALM Media. She is a member of
the Connecticut Bar Association Tax Section’s Executive Committee and the American Bar Association
Tax Section’s State and Local Tax Committee.
Lindsay has advised individual and corporate clients regarding state and local, federal, and international
tax consequences of various business transactions, and has represented taxpayers in all aspects of
federal and state tax controversy matters. In addition, she previously worked at a “Big Four” accounting
firm, where her practice focused exclusively on state and local tax.
Lindsay is admitted to practice in Connecticut, New York and the United States Tax Court. She is also a
certified public accountant.
New York University,
School of Law, LL.M.
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