Apportionment of Corporate Income in California: Gillette, SB 1015, and Proposition 39
Apportionment of corporate income has been a hot topic in California over the last year. Generally speaking, single-sales-factor apportionment benefits profitable businesses that have significant business activity in the taxing state but make most of their sales outside the state. On the other hand, the equally-weighted three-factor formula for apportionment tends to benefit businesses with more business activity outside the state. Until recently, California Revenue and Taxation Code section 25128 (“Section 25128”) seemed to require double-weighted sales three-factor apportionment of income. Then, in July of this year, the California Court of Appeal held that because California is a member of the Multistate Compact ("Compact"), the state is prohibited from requiring taxpayers to utilize Section 25128’s double-weighted sales three-factor formula of apportionment. As a result, in Gillette Co. v. Franchise Tax Board, No. A130803 (Cal. Ct. App., July 24, 2012), aff’d on reh’g, No. A130803 (Cal. Ct. App., October 2, 2012), the Court of Appeal allowed the taxpayer, Gillette, to elect to apportion its income using the equally-weighted three-factor formula set forth in the Compact.
While Gillette was pending, the California State Assembly, fearing the ramifications of the Court of Appeal’s decision, quickly enacted SB 1015, which repeals the Compact in its entirety and deprives taxpayers of any prospective benefit that could otherwise be gained from the Gillette holding, including election of the equally-weighted formula for apportionment. SB 1015’s validity, however, is unclear because it was not passed by two-thirds majority of the Assembly as required by Proposition 26 (which states that “any change in state statute which results in any taxpayer paying a higher tax” must pass by a two-thirds vote). Many believe that SB 1015 will be challenged and found invalid because its prohibition of election of the equally-weighted three-factor formula almost inevitably results in a higher tax for at least one taxpayer.
Then, on Election Day, California voters voted in favor of Proposition 39, a ballot initiative which amends, repeals, and adds sections to the California Public Resources Code and the California Revenue and Taxation Code. This statutory amendment requires multistate corporations to apportion their income using a single-sales factor apportionment formula with market-based sourcing for sales of services and intangibles. As a result, unless a corporation derives more than 50 percent of its gross business receipts from an agricultural business activity, an extractive business activity, a savings and loan activity, or a banking or financial business activity, Proposition 39 requires the corporation to use the single-factor formula for tax years beginning after January 1, 2013. Proponents argue that Proposition 39 closes a "loophole" and will encourage businesses to locate in California and create new jobs. Critics argue that the measure will negatively impact out-of-state corporations doing business in California by raising their taxes because most of these corporations apportion their income using the weighted three-factor formula.
All of this means that there is significant uncertainty in the area of corporate income tax apportionment—the Gillette decision has been appealed to the California Supreme Court, SB 1015’s validity likely will be challenged, and Proposition 39’s “mandatory” single-factor apportionment may not be so mandatory for the next year or so as everything plays out. For example, if Gillette is upheld, and SB 1015 is found invalid, the Compact is still in effect in California and taxpayers may elect to apportion their income using either the three-factor Compact formula or the single-sales factor formula mandated by Proposition 39. On the other hand, if SB 1015 is found valid (which means that the Compact was repealed successfully), then taxpayers likely will be paying higher tax because they cannot elect to use the Compact’s apportionment formula for the 2012 tax year. Thus, despite the passage of Proposition 39, whether the single-sales factor apportionment formula will in fact become the exclusive method of apportioning income for multistate corporations doing business in California is unclear. We believe, however, that, given the strong likelihood that SB 1015 will be stuck down as invalid sometime in the next year, taxpayers may still want to consider electing to use the Compact’s equally-weighted three-factor formula instead of Proposition 39’s single-sales-factor formula, if beneficial, on their corporate tax returns for tax years beginning before January 1, 2013. Please contact one of the Winston & Strawn attorneys listed below if you have questions about how this complex and changing area of the law applies to your situation.
If you need assistance analyzing your assessment or filing an assessment appeal, please feel free to contact one of the Winston & Strawn lawyers listed below.
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| Jasmine I. Tollette |