MTC THREE-FACTOR ELECTION IN CALIFORNIA, MICHIGAN, AND TEXAS

Transcription

1 MTC THREE-FACTOR ELECTION IN CALIFORNIA, MICHIGAN, AND TEXAS Giles Sutton, Jamie C. Yesnowitz, Chuck Jones, Terry Conley, Terry Gaul, and Ralph Ourlian* of Grant Thornton LLP look at whether the business tax laws of California, Michigan, and Texas supersede those states' adoption of the Multistate Tax Compact's three-factor apportionment formula. INTRODUCTION In an era when state tax planning opportunities appear to be few and far between, many taxpayers have tried to resurrect an election available under Article IV of the Multistate Tax Compact to apportion income based on an equally weighted property, payroll, and sales-factor apportionment formula in lieu of a state's standard apportionment formula. In general, such an election typically benefits companies that are commercially domiciled outside the state in which the election is sought to be made. That is because equally weighted three-factor apportionment provides greater apportionment dilution for those companies in states that double-weight the sales factor (double-weighted three-factor apportionment), disproportionately weight the sales factor, or use a single sales factor to apportion income. This article will discuss the technical basis underlying the ability to take such an election in California, Michigan, and Texas. General Description of the Compact Election to Use Equally Weighted Three-Factor Apportionment The compact, created by the Multistate Tax Commission in 1967, now has 19 states and the District of Columbia as full members, and is designed to achieve the following purposes: to facilitate proper determination of state and local tax liability of multistate taxpayers, including the equitable apportionment of tax bases and settlement of apportionment disputes; to promote uniformity or compatibility in significant components of tax systems; to facilitate taxpayer convenience and compliance in the filing of tax returns and in other phases of tax administration; and to avoid duplicative taxation. n1 The U.S. Supreme Court has held that the compact generally does not impermissibly encroach on congressional power or violate the commerce clause of the U.S. Constitution or the 14th Amendment. n2 Types of Taxes the Compact Addresses The compact defines the term "income tax" as "a tax imposed on or measured by net income including any tax imposed on or measured by an amount arrived at by deducting expenses from gross income, one or more forms of which expenses are not specifically and directly related to particular transactions." n3 "Gross receipts tax" means a tax, other than a sales tax, that is imposed on or measured by the gross volume of business, in terms of gross receipts or in other terms, and in the determination of which no deduction is allowed that would constitute the tax an income tax. n4 Finally, the term "tax" is defined as "an income tax, capital stock tax, gross receipts tax, sales tax, use tax, and any other tax which has a multistate impact." n5 The general definition of tax acts to limit the universe of taxes under the compact to state and local taxes and to exclude federal taxes. The limitation of the election to income taxes significantly narrows the applicability of the compact election, because the compact defines income taxes to include taxes imposed on or measured by net income. Accordingly, gross income taxes are not subject to the election. Neither are gross receipts taxes, capital stock taxes, sales and use taxes, or any other tax with a multistate impact. Only net income taxes are eligible. Although the compact does not contain a definition of what constitutes a net income tax, the explanatory language in the definition of income tax requires that the tax allow for the deduction of expenses from gross income. The term "gross income" is not defined in the compact. Finally, the phrase "any other tax which has a multistate impact" contemplates that there are taxes outside the defined taxes that are likewise ineligible for the election. 1

2 Option to Elect Article IV Treatment Article III of the compact provides the following taxpayer election that is available in compact states that impose an income tax (as defined by the compact): Any taxpayer subject to an income tax whose income is subject to apportionment and allocation for tax purposes pursuant to the laws of a party State or pursuant to the laws of subdivisions in two or more party States may elect to apportion and allocate his income in the manner provided by the laws of such states and subdivisions without reference to this compact, or may elect to apportion and allocate in accordance with Article IV. This election for any tax year may be made in all party states or subdivisions thereof or in any one or more of the party states or subdivisions thereof without reference to the election made in the others. n6 Article III explicitly confirms that the article (and hence, the ability to make this election) applies solely to the reporting of income taxes. n7 Although the compact allows for a taxpayer to elect equally weighted three-factor apportionment on an annual basis, the compact does not provide additional details on how to make the election, including whether the election must be made on an original return or can be made on an amended return, or how the election is to be disclosed to a state tax authority. Allocation and Apportionment Provisions Article IV of the compact contains all of the MTC's allocation and apportionment provisions. While generally providing for equally weighted three-factor apportionment of business income, Article IV of the compact also governs additional areas, including determination whether income is business or nonbusiness income, allocation rules for nonbusiness income, and equitable apportionment for situations in which the allocation and apportionment provisions in Article IV do not fairly reflect the taxpayer's activity in the state. Although the focus of this article is on whether the equally weighted three-factor apportionment of business income may be applied by a taxpayer subject to the California corporation income tax, the Michigan business tax (MBT) or the revised Texas franchise tax (RTFT), we note that the other areas of Article IV could also be brought into play in the event that an election under the compact is available. n8 CALIFORNIA ANALYSIS California Statutory Apportionment of Net Income Corporations calculate their California corporation income tax on the basis of net income, subject to various statespecific modifications. n9 Net income is divided into business income, which is apportionable, and nonbusiness income, which is allocable. n10 Under California's standard apportionment provision and as discussed below, all net income that is classified as business income is apportioned to California by multiplying business income by a ratio of instate to everywhere property, payroll, and double-weighted sales factors. n11 Following apportionment of the California corporation income tax, an 8.84 percent tax is imposed on the remaining California corporation income tax base. n12 Interplay Between the California Corporation Income Tax and the Compact As a member of the MTC, California adopted the compact in n13 The enacting statute reads as follows: The "Multistate Tax Compact" is hereby enacted into law entered into with all jurisdictions legally joining therein, in the form substantially as set forth in Section of this part. n14 The act enacting the compact in California provided for a repeal and withdrawal from the compact on the 10th day after the occurrence of one of several enumerated events after the operative date of the act: adoption by the MTC of a regulation placing Article IX of the compact in effect (regarding the power of the MTC to serve in an arbitration role for allocation and apportionment disputes); 2

3 the MTC placing in effect a bylaw, regulation, or parliamentary ruling for the conduct of its business permitting an adoption of a matter by other than majority vote of member states and majority of total population of all member states; or entry of a final judgment requiring the MTC to place Article IX of the compact into effect, or requiring or approving any matter to be adopted by the MTC by other than majority vote of member states or majority of total population of all member states. n15 For tax years beginning before January 1, 1993, California used the equally weighted three-factor apportionment formula in the compact and in the state's tax code. n16 For tax years beginning on or after January 1, 1993, California adopted the double-weighted three-factor apportionment formula by enacting the following statute: Notwithstanding Section 38006, all business income shall be apportioned to this state by multiplying the business income by a fraction, the numerator of which is the property factor plus the payroll factor plus twice the sales factor, and the denominator of which is four. n17 Is the Compact in Effect in California? According to a California attorney general opinion, "no provision of the Compact allows for a state to withdraw from the Commission separate and apart from withdrawing from the Compact. The latter must be accomplished by the enactment of a state statute repealing the Compact." n18 Because sections and of the California Revenue and Taxation Code have not been repealed or altered, and none of the conditions for repeal of the compact contained in the California enacting act have occurred, the compact should be in effect in California. If the Compact Is Currently in Effect in California, Can the California Corporation Income Tax Be Considered an Income Tax That Would Qualify for the Election? The California corporation income tax is assessed on a measure of net income, which is federal taxable income, subject to various state-specific adjustments. Accordingly, the California corporation income tax should be classified as a tax measured by net income, as that term is defined by the compact. If the California Corporation Income Tax Can Be Considered an Income Tax for Purposes of the Compact, Does the California Corporation Income Tax Have Specific Apportionment Provisions That Supersede the Compact? Calif. Revenue and Taxation Code section 25128(a) requires that notwithstanding section 38006, which authorizes the election of equally weighted three-factor apportionment, all business income is apportioned to California by using double-weighted three-factor apportionment. The issue is whether the amendment of section 25128(a) for tax years beginning on or after January 1, 1993, supersedes the election provision in the compact. It can be argued that the requirement in the California statute to use double-weighted three-factor apportionment, particularly through the use of the word "notwithstanding" as a preface to the statute, precludes a taxpayer from using the compact to use equally weighted three-factor apportionment. In general, from a practical construction of the amended language, "notwithstanding" means "in spite of," or "despite the presence of." Therefore, according to a common reading, despite the presence of section 38006, all business income will be apportioned to California using double-weighted three-factor apportionment. However, it can be argued that the failure to repeal the election in the compact by stating that Article III of the compact is inoperative, or by otherwise amending sections or 38006, means that the compact's three-factor election can still be used because the compact is in effect and that the California corporation income tax should be considered an income tax. If the current version of section 25128(a) does not implicitly supersede the compact, and both section 25128(a) and the compact can be considered to be fully operative under California law, conflicting statutory construction issues would arise. In cases in which a statutory construction issue exists, a general rule of statutory construction is to favor specific language over general language. Following that convention, section 25128(a) applies to the California corporation income tax and was designed to be used for that tax so that section would supersede the compact language, which is generally designed to be used for a generic tax system. It is also a rule of statutory construction that conflicting statutes should be read so as to effect both provisions. Following that convention, the election under the compact could exist in harmony with section 25128(a). 3

4 It should be noted that California recently enacted Calif. Revenue and Taxation Code section , which allows a taxpayer to use a single sales factor for tax years beginning on or after January 1, The statute again uses the word "notwithstanding" to distinguish section 38006: (a) Notwithstanding Section 38006, for taxable years beginning on or after January 1, 2011, any apportioning trade or business, other than an apportioning trade or business described in subdivision (b) of Section [referring to a corporation using special industry apportionment], may make an irrevocable annual election on an original timely filed return, in the manner and form prescribed by the Franchise Tax Board to apportion its income in accordance withthis section, and not in accordance with Section (b) Notwithstanding Section 38006, for taxable years beginning on or after January 1, 2011, all business income of an apportioning trade or business making an election described in subdivision (a) shall be apportioned to this state by multiplying the business income by the sales factor. n19 Is There Any Legislative Intent Reflecting the Desire to Allow an Election to Use Equally Weighted Three-Factor Apportionment? Other than the use of the word "notwithstanding" in the amended version of Calif. Revenue and Taxation Code section 25128(a), we have found no indication of legislative intent to permit or preclude the use of the equally weighted threefactor election under the compact for purposes of the California corporation income tax. It appears clear from the legislative history that California adopted the double-weighted three-factor apportionment formula in part to encourage investment in California. n20 Further, the California tax code has explicitly stated the following with reference to the Uniform Division of Income for Tax Purposes Act: This act shall be so construed as to effectuate its general purpose to make uniform the law of those states which enact it. Enactment of Article IV of the Multistate Tax Compact (as set forth in Section of the code) pertaining to the allocation and apportionment of income shall be construed as a reenactment of Sections to 25137, inclusive, without any inference that a change in interpretation is implied by such enactment. n21 Since California's adoption of this apportionment formula in 1993, few taxpayers have attempted to make the election provided by Article III of the compact adopted into law by California in Technical Analysis of the Compact's Terms on Taxpayer Rights Under the California Revenue and Taxation Code The MTC is a binding contract between California and other MTC states under the terms of the compact. n22 Since the compact is a contract among the states, California is contractually obligated to abide by the elections in the compact. Arguably, if California's adoption of section 25128(a) eliminated the opportunity to use the election available under the compact, unilaterally abrogating provisions contained within the compact might give rise to a cause of action as a potential violation of the compact. But who would have a right to allege the violation? In this instance, the cause of action likely would lie between California and other member states that are parties to the compact. A taxpayer seeking to use an equally weighted three-factor apportionment formula under the compact following the amendment of section 25128(a) by the California State Legislature does not have privity of contract under the compact, and may not have any recourse to use equally weighted three-factor apportionment on the grounds that the taxpayer is not a party to the compact. n23 Therefore, if California has, in fact, violated the compact by amending section 25128(a) contrary to Article IV or the amendment to Calif. Revenue and Taxation Code section (addressing the stated legislative purpose of adopting the MTC), taxpayers might not have any recourse because they are not parties to the compact. What Would Be the Procedure Necessary to Make the Election in the Compact? The compact allows for a taxpayer to elect equally weighted three-factor apportionment, but it does not provide additional details on how to make the election. n24 The California corporation income tax forms do not note the ability to make an election to use equally weighted three-factor apportionment. Accordingly, a taxpayer would have to make disclosures to first claim the election, and then calculate equally weighted three-factor apportionment. Further, the compact does not provide guidance on whether that election must be made on an original return, or whether an amended return 4

5 can be filed to make such election. Absent that guidance, amended returns within the standard California statute of limitations may suffice to allow a taxpayer to make an equally weighted three-factor election. While some elections under the California corporation income tax expressly include rules governing how those elections are made, n25 most California corporation income tax statutes authorizing elections generally do not. MICHIGAN BUSINESS TAX ANALYSIS Apportionment The MBT is a hybrid tax, consisting of a modified gross receipts tax (MGRT) component composed of gross receipts less purchases from other firms before apportionment, n26 and a business income tax (BIT) component composed of business income subject to various state-specific modifications. n27 In general, both the BIT and MGRT components established under the MBT legislation use a single sales factor for apportionment. The authorizing statute states: Except as otherwise provided in this act, each tax base established under this act shall be apportioned in accordance with this chapter. n28 Except as otherwise provided in subsection (2) and section 311, the sales factor is a fraction, the numerator of which is the total sales of the taxpayer in this state during the tax year and the denominator of which is the total sales of the taxpayer everywhere during the tax year. n29 Following apportionment of the MGRT, an additional deduction is allowed for some operations related to qualified affordable housing projects. n30 A 0.8 percent tax is imposed on the remaining MGRT base. n31 Following apportionment of the BIT, additional deductions are allowed for Michigan business losses and for some operations related to qualified affordable housing projects. n32 A 4.95 percent tax is then imposed on the remaining BIT base. n33 Requirements Regarding When or How to Make the Election and the Availability of a Retroactive Election As a member of the MTC, Michigan adopted the compact under Act 343 (effective July 1, 1970) and is still a compact member. n34 The compact is incorporated into Chapter 205, the tax chapter of the Michigan Compiled Laws. n35 Chapter 208 of the Michigan tax code has never contained, and does not contain, any explicit provisions under which the compact was not applicable. Is the Compact in Effect in Michigan? Because the provision incorporating the compact into Chapter 205 of the Michigan tax code has not been repealed or altered to date, the compact should still be in effect. In reviewing the current version of the MBT in Chapter 208 of the Michigan tax code, there are no specific references to the compact, and there are no explicit provisions under which the compact is not applicable. If the Compact Is in Effect in Michigan, Can the MBT Be Considered an Income Tax That Would Qualify for the Election? In determining whether the MBT is an income tax, the threshold issue to resolve is how the MGRT and BIT components would be treated under the compact if each were considered to be a separate tax. Following that determination, both components should be considered together in an effort to classify the MBT under to the compact. n36 The MGRT is based on gross receipts, which consists of all federal income tax receipts less a variety of deductions, including a separate deduction for "purchases from other firms." The issue of whether the MGRT can be considered an income tax imposed on or measured by net income is made more complex by the lack of definitional guidance in the compact. From the definitions in the compact, it would appear that a tax could be classified as a net income tax that qualifies as an income tax, a gross receipts tax that does not qualify as an income tax, or an "other tax with a multistate impact" that does not qualify as an income tax, like a gross income tax. 5

6 Gross receipts are defined by first looking at all amounts received under the particular method of accounting used for federal income tax purposes and then subtracting a series of industry-specific and other deductions. While the amounts received do not necessarily correspond to the amounts included in federal Form 1120, and in some cases may be broader or narrower than that measure, many of the deductions are contained in the deductions section of federal Form 1120, which transform a gross receipts tax into a net income tax. The additional provision for purchases from other firms (which is broader than a cost-of-goods-sold measure that would transform a receipts-based tax to an income-based tax) allows for a deduction of a number of expenses, some of which again are contained in the deductions section of Form The allowance of such a deduction bolsters the argument that several expenses are being deducted from a measure of gross income, and those items are not directly related to particular transactions. Accordingly, the MGRT component of the MBT, when viewed separately from the BIT component, likely would be classified as an income tax under the compact. The BIT is assessed on federal taxable income from business activity, subject to a variety of state-specific adjustments. n37 Because federal taxable income is a measure of net income, this component of the MBT, if considered by itself, likely would be considered a tax measured by net income, as defined by the compact. Therefore, the MBT likely would be classified as an income tax under the compact. It should be noted that further guidance on the characterization of the MBT can be found in the enacting statute, as well as in the treatment of the MBT under Accounting Standards Codification (ASC) 740 (formerly Financial Accounting Standards Board Statement No. 109 (FAS 109), as interpreted by FASB Interpretation No. 108 (FIN 48)). The enacting statute states that the MGRT component of the MBT is levied and imposed on the privilege of doing business, and not on income or property. n38 That statement alone could negate the effect of the compact regarding the election. It is believed that characterizing the MGRT component of the MBT as not an income tax was done to ensure that taxpayers with limited solicitation activities within Michigan could not claim protection from taxation under P.L Under P.L , the definition of net income tax is similar to that found in the compact: "For purposes of this title, the term 'net income tax' means any tax imposed on, or measured by, net income." n39 ASC 740 addresses accounting for income taxes and defines income taxes as "domestic and foreign federal (national), state, and local (including franchise) taxes based on income." n40 Under ASC 740, and in contrast to the self-characterization of the MBT as not being a tax on income, members of the accounting profession uniformly have concluded that the MBT constitutes an income tax for which the use of ASC 740 would be required. It should be noted that the Michigan Department of Treasury, in a published letter, said that it did not consider the SBT to be an income tax that would allow a taxpayer to use equally weighted three-factor apportionment under the compact. n41 To date, the department has not published its view on whether the MBT should be treated as an income tax that would allow the equally weighted three-factor apportionment election under the compact. However, the department informally indicated at the 2009 Michigan Association of Certified Public Accountants Michigan Tax Forum that the election under the compact is not valid for purposes of MBT apportionment. Again, it should be noted that the MTC has promulgated regulations explaining terms of the compact that have not been adopted by Michigan to date. The following MTC regulation details the interplay between the definitions of income tax and gross receipts tax: The definitions of "income tax" and of "gross receipts tax" shall be read together. Any doubt as to whether a particular taxing measure falls under one definition or the other shall be resolved in favor of construction as an income tax in order to more effectually make available the application of the substantive provisions of the Multistate Tax Compact. However, whenever the tax measure in question shall have been construed by the courts in an action involving other than Compact provisions, and a ruling made as to the nature of the tax, such construction will be given great weight, but shall not be conclusive upon the Commission unless the ruling is by the Supreme Court of the United States. n42 If the MBT Can Be Considered an Income Tax for Purposes of the Compact, Does the MBT Have Specific Apportionment Provisions That Supersede the Compact? Mich. Comp. Laws section (1) requires that except as otherwise provided in "this act" (referencing the MBT Act), each tax base established under the act (the MGRT and the BIT, which were created in the MBT Act) must be 6

7 apportioned in accordance with "this chapter" (Chapter 208). Mich. Comp. Laws section (1) (which is within the MBT Act) requires single sales factor apportionment, except as otherwise provided in Mich. Comp. Laws sections (2) and The compact provision is in section (part of Chapter 205), which is a different chapter than Chapter 208. Further, all provisions in Chapter 208, including Mich. Comp. Laws sections (2) and , address only special apportionment rules applicable to particular industries and fact patterns, and do not refer to the compact, the ability to use the compact's apportionment, or the ability to use equally weighted three-factor apportionment. The issue is whether the enactment of section supersedes the provisions in the compact. It can be argued that the requirement in the Michigan statute to use single sales factor apportionment precludes a taxpayer from using equally weighted three-factor apportionment under the compact, because the taxpayer must apportion in accordance with Chapter 208 and not in accordance with any other chapter, including Chapter 205. This argument is supported in that there was no intent by any of the drafters of the MBT to allow for three-factor apportionment in any form. However, it can be argued that the failure to repeal, neuter, or even mention the compact means that the compact's equally weighted threefactor election can still be used because the compact is in effect, and that the MBT can be considered an income tax. That argument can be supported by the fact that the Michigan Legislature easily could have repealed equally weighted three-factor election under the compact but failed to do so. If the enactment of section does not supersede the compact, and both section and the compact can be considered to be fully operative under Michigan law, conflicting statutory construction issues would arise. In cases in which a statutory construction issue exists, a general rule of statutory construction is to favor specific language over general language. Following that convention, section specifically applies to the MBT and was designed to be used for such tax, so that section would supersede the compact language that is generally designed to be used for a generic tax system. It is also a rule of statutory construction that conflicting statutes should be read so as to give effect to both provisions. Following that convention, the election under the compact could exist in harmony with section Is There Any Legislative Intent Reflecting the Desire to Allow an Election to Use Equally Weighted Three-Factor Apportionment? We have not found any indication of legislative intent to permit the use of the equally weighted three-factor election under the compact for purposes of the MBT. However, without any explicit guidance from the Legislature on this issue, the inference to be drawn regarding legislative intent is uncertain. What Procedure Would Be Necessary to Make the Election in the Compact? The compact allows for a taxpayer to elect equally weighted three-factor apportionment, but it does not provide additional details on how to make the election. The MBT forms do not note the ability to make an election to use equally weighted three-factor apportionment, and because the statute requires single sales factor apportionment, there is no place on the form to calculate property and payroll factors. Accordingly, a taxpayer would have to make significant disclosures to first claim the election and then calculate equally weighted three-factor apportionment. Further, the compact does not provide guidance on whether such an election must be made on an original return, or whether an amended return can be filed to make that election. Absent that guidance, amended returns within the standard Michigan statute of limitations may suffice to allow a taxpayer to make an election to use equally weighted three-factor apportionment. It should be noted that in looking at elections under the MBT for other items, the statutes generally do not provide significant guidance on how those elections must be made, except in one instance. n43 TEXAS ANALYSIS Apportionment The revised Texas franchise tax is based on total margin, which is calculated by determining an apportioned share of total revenue less an available elective deduction that is the greatest of three different components: cost of goods sold (COGS), compensation, and a flat 30 percent deduction from total gross revenue. n44 Total margin is apportioned 7

8 through the use of a single sales factor ratio the numerator of which is the taxpayer's gross receipts from business done in Texas and the denominator of which is the taxpayer's gross receipts from its entire business. n45 The authorizing statute says: Except as provided by this section, a taxable entity's margin is apportioned to this state to determine the amount of tax imposed under Section by multiplying the margin by a fraction, the numerator of which is the taxable entity's gross receipts from business done in this state, as determined under Section , and the denominator of which is the taxable entity's gross receipts from its entire business, as determined under Section n46 Following apportionment of total margin, deductions for the cost of solar energy devices and clean coal projects are allowed. n47 Applying those deductions to apportioned margin results in taxable margin. n48 Interplay Between the RTFT and the Compact As a member of the MTC, Texas adopted the compact on August 4, 1967, and is still a compact member. n49 For Texas franchise tax reports originally due before January 1, 2008, Texas law provided that the compact was not applicable. n50 That provision was repealed when the RTFT was enacted for reports due on or after January 1, Is the Compact in Effect in Texas? Because the provision rendering the compact inapplicable for purposes of the Texas franchise tax was repealed during the enactment of the RTFT, the compact should be in effect in Texas. In reviewing the current version of the RTFT, one reference to Chapter 141 (the compact) exists, and that reference relates to the composition of the combined group. n51 The Chapter 141 property and payroll factor calculations (which appear in Article IV) are used to determine whether an entity conducting business outside the United States has 80 percent or more of the taxable entity's property and payroll outside the United States. If the 80 percent tests are met, the entity is excluded from the Texas combined group. The inclusion of the reference to Chapter 141 strongly suggests that the compact is in effect in Texas. If the Compact Is in Effect in Texas, Can the RTFT Be Considered an Income Tax That Would Qualify for the Election? The RTFT is based on total revenue, less the largest of three different deductions: COGS, compensation, or the flat 30 percent deduction. The issue of whether the RTFT can be considered an income tax imposed on or measured by net income under the RTFT is made more complex by the relative lack of definitional guidance in the compact and the fact that the compact was written many years before alternative taxes like the RTFT were enacted. From the definitions in Article II of the Compact, the RTFT could be classified as a net income tax that qualifies as an income tax, a gross receipts tax that does not qualify as an income tax, or an "other tax with a multistate impact" that does not qualify as an income tax, like a gross income tax. To make this determination, an examination of the RTFT base and applicable deductions is appropriate. Total revenue under the RTFT is defined by adding amounts reportable as income on line 1c and lines 4-10 on federal Form 1120, and subtracting (to the extent related to or otherwise includable in total revenue) bad debt expense, foreign royalties and foreign dividends, Schedule C deductions, and other amounts authorized by Texas Tax Code section n52 Also, the definition of total revenue contains several industry-specific exclusions. Many of those deductions are contained in the deductions section of federal Form 1120 (lines and line 29), which transform a gross income tax into a net income tax. The additional deduction for COGS, compensation, or the flat 30 percent deduction from total revenue supports the argument that a number of expenses are being deducted from a measure of gross income, and those items are not directly related to particular transactions. n53 Accordingly, this type of tax likely would be classified as an income tax under the compact. It should be noted that further guidance on the characterization of the RTFT can be found in the enacting statute, as well as in the treatment of the RTFT under ASC 740. The enacting statute states that the RTFT is not an income tax and P.L does not apply to the tax. n54 That statement by itself could be shown to negate the effect of the compact regarding the election under the compact. It is believed that the characterization of the RTFT as not an income tax was to 8

9 ensure that taxpayers with limited solicitation activities within Texas could not claim protection from taxation under P.L Under P.L , the definition of net income tax is similar to that found in the compact: "For purposes of this title, the term 'net income tax' means any tax imposed on, or measured by, net income." n55 ASC 740 addresses accounting for income taxes. When the RTFT was originally enacted, FASB staff performed research and obtained input from the accounting profession, concluding that the RTFT would constitute an income tax for which the use of ASC 740 would be required. n56 Again, while not dispositive, it should be noted that the MTC has promulgated regulations explaining terms of the compact that have not been adopted by Texas to date. The following MTC regulation details the interplay between the definitions of income tax and gross receipts tax: The definitions of "income tax" and of "gross receipts tax" shall be read together. Any doubt as to whether a particular taxing measure falls under one definition or the other shall be resolved in favor of construction as an income tax in order to more effectually make available the application of the substantive provisions of the Multistate Tax Compact. However, whenever the tax measure in question shall have been construed by the courts in an action involving other than Compact provisions, and a ruling made as to the nature of the tax, such construction will be given great weight, but shall not be conclusive upon the Commission unless the ruling is by the Supreme Court of the United States. n57 If the RTFT Can Be Considered an Income Tax for Purposes of the Compact, Does the RTFT Have Specific Apportionment Provisions That Supersede the Compact? Texas Tax Code section (a) requires that taxable margin be apportioned by a single sales factor, except to the extent that a provision within section states something different. The compact provision is in section , a different section than section Further, the remaining provisions in section involve special apportionment rules applicable to particular industries and do not reference the compact, the ability to use the compact's apportionment, or the ability to use equally weighted three-factor apportionment. n58 As a result, the requirement in the Texas statute to use single sales factor apportionment implicitly precludes a taxpayer from using the compact to use equally weighted three-factor apportionment. Even if one were to argue that the enactment of section did not supersede the compact, and both section and the compact are operative under Texas law, a statutory construction issue would exist. In cases in which a statutory construction issue exists, a general rule of statutory construction is to favor specific language over general language. It is also a general rule of statutory construction that conflicting statutes should be read so as to give effect to both provisions. Section specifically applies to the RTFT and was designed to be used for that tax. In contrast, the compact language is generally designed to be used for a generic tax system. Accordingly, the specific rule requiring single sales factor apportionment in section arguably would control. Is There Any Legislative Intent Reflecting the Desire to Allow an Election to Use Three-Factor Apportionment? We have found no indication of legislative intent to permit the use of the equally weighted three-factor election under the compact for purposes of the RTFT. The repeal of the statute that had precluded use of the compact in any form could have been done simply for the limited purpose of allowing the Legislature to refer to the compact, for purposes of referencing the payroll and property factors needed to determine whether some foreign entities would be included in the combined return. Alternatively, the repeal of the statute that had precluded the use of the equally weighted three-factor election under the compact could have been done to specifically allow other uses of the compact, including the election to use equally weighted three-factor apportionment. But without any explicit guidance from the Legislature, the legislative intent is uncertain. What Procedure Would be Necessary to Make the Election in the Compact? The compact allows for a taxpayer to elect equally weighted three-factor apportionment, but it does not provide details on how to make the election. The RTFT forms do not note the ability to make an election to use equally weighted three- 9

10 factor apportionment, and since the RTFT statute requires single sales factor apportionment, there is no place on the form to calculate property and payroll factors. Accordingly, a taxpayer would have to make significant disclosures to first claim the election and then calculate equally weighted three-factor apportionment. Further, the compact does not provide guidance on whether that election must be made on an original return, or whether an amended return can be filed to make that election. Absent that guidance, amended returns within the standard Texas statute of limitations may suffice to allow a taxpayer to make a three-factor election. It should be noted that in looking at elections under the RTFT for other items, the statutes provide guidance on how those elections must be made and do not allow for a retroactive election for the elective deduction for COGS, compensation, or the 30 percent flat deduction. CONCLUSION Although there is some basis for making the equally weighted three-factor election for purposes of the California corporation income tax, the MBT, and the RTFT, taxpayers should be prepared for the likely state responses to such filing positions. The California Franchise Tax Board, the Michigan Department of Treasury, and the Texas comptroller all would likely reject tax returns claiming an election to use equally weighted three-factor apportionment, whether on an original or amended return, on the basis that there was no legislative intent to allow for the election in the compact to continue to apply on enactment of a new standard apportionment formula. That posture would require the taxpayer to resort to litigation to achieve that treatment. The California, Michigan, and Texas legislatures could clarify their states' tax legislation to explicitly deny equally weighted three-factor apportionment treatment, and could do so retroactively. Currently, corrective retroactive legislation is particularly likely in 2010 in Michigan to eliminate any ability to use the compact election for purposes of the MBT. If that legislation is adopted, there could be a legal challenge to the MBT on the grounds that such a retroactive change is not allowed. n59 Also, for purposes of the California corporation income tax, if the taxpayer's election to use equally weighted threefactor apportionment results in a large corporation understatement, which is an understatement of tax determined by the FTB to be in excess of $ 1 million, that taxpayer would be subject to a special 20 percent penalty on the understatement. n60 Because the election could substantially change a taxpayer's California corporation income tax liability, that potential penalty should be considered. Finally, for purposes of the MBT and the RTFT, because the equally weighted three-factor apportionment position tends to benefit out-of-state taxpayers, it is unlikely that a Michigan or Texas court would be sympathetic to that type of challenge to the intended statutory apportionment of the MBT or RTFT. n61 FOOTNOTES * Giles Sutton is a partner and practice leader of the State and Local Tax Technical Services practice of Grant Thornton LLP. Jamie C. Yesnowitz is a senior manager in the State and Local practice in the firm's National Tax Office in Washington. Chuck Jones is a manager in the State and Local Tax practice of Grant Thornton in the firm's Chicago office. Terry F. Conley is the firm's State and Local Tax Practice Leader for the state of Michigan. Terry Gaul is a senior manager in the State and Local Tax practice of Grant Thornton in the Houston office. Ralph Ourlian is a senior manager in the State and Local Tax practice in the firm's Detroit office. The authors can be reached via at: giles.sutton@gt.com, jamie.yesnowitz@gt.com, chuck.jones@gt.com, terry.conley@gt.com, terry.gaul@gt.com, and ralph.ourlian@gt.com. The views expressed in this article are those of the authors and do not necessarily reflect the views of any organization or firm with which the authors are associated. 1 Multistate Tax Compact, Article I United States Steel Corp. et al. v. Multistate Tax Commission et al., 434 U.S. 452, 98 S. Ct. 799 (1978). 3 Multistate Tax Compact, Article II.4. 4 Multistate Tax Compact, Article II.6. 5 Multistate Tax Compact, Article II.9. 10

11 6 Multistate Tax Compact, Article III.1 (emphasis added). 7 Multistate Tax Compact, Article III.3. 8 It should be noted that activity as a financial organization or public utility is not subject to Article IV of the compact. Multistate Tax Compact, Article IV.2. 9 Calif. Revenue and Taxation Code sections 23151, Business income is defined as "income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations." Calif. Revenue and Taxation Code section 25120(a). 11 Calif. Revenue and Taxation Code section 25128(a). 12 Calif. Revenue and Taxation Code section 23151(e). 13 As discussed above, the 19 states and the District of Columbia that are considered to be full members of the MTC have adopted the compact. 14 Calif. Revenue and Taxation Code section Ch. 93, Laws 1974, section Calif. Revenue and Taxation Code section 25128(a) as in effect for tax years beginning before January 1, Calif. Revenue and Taxation Code section 25128(a) (emphasis added). It should be noted that there are some industry exceptions to the standard apportionment formula, including agriculture businesses, extractive businesses, savings and loan activities, and banking and financial businesses. Calif. Revenue and Taxation Code section 25128(b), (c). 18 Opinion , Cal. Atty. Gen., Aug. 5, It should be noted that the MTC was created under Article VI of the compact. 19 Calif. Revenue and Taxation Code section See generally the California Franchise Tax Board "Internal Procedures Manual -- Multistate Audit Technique Manual," section 7500 (Sales Factor), reviewed Sept Calif. Revenue and Taxation Code section As stated in Article X of the compact: 22 Entry Into Force and Withdrawal: (1) This compact shall enter into force when enacted into law by any seven States. Thereafter, this compact shall become effective as to any other State upon its enactment thereof. The Commission shall arrange for notification of all party States whenever there is a new enactment of the compact. (2) Any party State may withdraw from this compact by enacting a statute repealing the same. No withdrawal shall affect any liability already incurred by or chargeable to a party State prior to the time of such withdrawal. (3) No proceeding commenced before an Arbitration Board prior to the withdrawal of a State and to which the withdrawing State or any subdivision thereof is a party shall be discontinued or terminated by the withdrawal, nor shall the Board thereby lose jurisdiction over any of the parties to the proceeding necessary to make a binding determination therein. 22 Enacted in the California corporation income tax code as Calif. Revenue and Taxation Code section 38006, Article X. 23 Privity of contract is the connection, via the enforcement of contract rights, that exists between contracting parties. In general, absent unusual circumstances, such as specific regulatory statutes governing specific industries or fact patterns, general common-law rules will not extend contract rights to noncontracting parties. 24 For years there have been a plethora of tax elections available to taxpayers under the Internal Revenue Code. Often there was a lack of guidance regarding how to make, rescind, or amend and subsequently make elections. See Aubree L. Helvey and Beth Stetson, "The Doctrine of Election," The Tax Lawyer, 62 Tax Law. 335 (2009). It is uncertain whether, or to what extent, federal common law regarding tax elections would be applied to any state tax election. However, that common law might inform a given state's analysis. Technical advice issued by the IRS summarized the common-law doctrine of election as follows: 11

12 The doctrine of election, as it applies to federal tax law, consists of two elements: (i) a free choice between two or more alternatives, and (ii) an overt act by the taxpayer communicating the choice to the Commissioner; i.e., a manifestation of choice. A taxpayer who makes such an election may not, without the consent of the Commissioner, retroactively revoke or amend it merely because another alternative now appears to be more advantageous. TAM (Sept. 10, 2002) (citations omitted). If that doctrine applies or informs a state election analysis, the question then arises whether a taxpayer's previous filing without having made the three-factor election under the compact constitutes an election. If that filing does constitute an election, can that election be retracted on a timely filed amended return? The answers may vary from state to state. 25 The water's-edge election is an example of an election with substantial guidance. Calif. Revenue and Taxation Code section 25113(a), (c); FTB Notice , California Franchise Tax Board, May 3, 2004; Instructions, 2007 Form 100W, "California Corporation Franchise or Income Tax Return -- Water's-Edge Filers." 26 Mich. Comp. Laws section Mich. Comp. Laws section Mich. Comp. Laws section (1). 29 Mich. Comp. Laws section (1). Subsection (2) states: 29 Except as otherwise provided under this subsection, for a taxpayer that is a unitary business group, sales include sales in this state of every person included in the unitary business group without regard to whether the person has nexus in this state. Sales between persons included in a unitary business group must be eliminated in calculating the sales factor. Section 311 (Mich. Comp. Laws section ) is a "last resort" sales factor sourcing rule for receipts that cannot be sourced under the existing MBT apportionment rules. 30 Mich. Comp. Laws section (6)-(8). 31 Mich. Comp. Laws section (1). 32 Mich. Comp. Laws section (5)-(9). 33 Mich. Comp. Laws section (1). 34 See the MTC website ( 35 Mich. Comp. Laws section Interestingly, the classification of the Michigan single business tax (SBT), the predecessor to the MBT, has been considered in several cases, including the Trinova Corp. v. Michigan Department of Treasury, 498 U.S. 358 (1991), Gillette Co. v. Dept. of Treasury, 497 N.W.2d 595 (Mich. App. 1993), and Guardian Industries Corp. v. Dept. of Treasury, 499 N.W.2d 349 (Mich. App. 1993). While these cases may be informative, they are not dispositive in determining the classification of the SBT, or, for that matter, the MBT as an income tax. 37 Mich. Comp. Laws sections (2), (2). 38 Mich. Comp. Laws section (2). 39 P.L , section 383. ASC 740 addresses accounting for income taxes and defines the term "income taxes" as "domestic and foreign federal (national), state, and local (including franchise) taxes based on income." ASC 740, Appendix E. In Accounting Standards Update , FASB declined the opportunity to further define the term "income tax." 40 ASC 740, Appendix E. 41 Letter, Department of Treasury, June 30, In the letter, the department stated: Although Michigan is a member of the Multistate Tax Compact and Article 3 of the Compact permits a taxpayer to opt for apportionment and allocation pursuant to Article 4 of the Compact (which is UDITPA) such taxpayer option is only available in reference to an income tax. The SBT is not an income tax but is rather a tax upon "value-added". Multistate taxpayers subject to the SBT must apportion their tax base as provided in MCL Sec et seq., unless permission has been secured in advance to use an alternative method. 12

13 Although the department has said that the SBT does not qualify as an income tax for purposes of the compact, we do not necessarily think that the department's argument is ironclad, and litigation on that point may arise by taxpayers seeking to amend open SBT returns to make the election under the compact. The department's letter did not examine the definition of income tax as stated in the compact that was in effect when the SBT was still the state's business tax law. The SBT allows the deduction of some expenses from a measure of gross income and could be considered an income tax. That result would not necessarily be inconsistent with the classification in Trinova as a value-added tax because the definition in the compact of an income tax may be different than that envisioned by the Trinova court. 42 MTC Reg. II. 4. Income Tax-Gross Receipts Tax. 43 See Mich. Comp. Laws section , which details the election available to a spun-off company relating to the calculation of the Michigan sales factor. 44 Texas Tax Code Ann. section (a). 45 Texas Tax Code Ann. section (a). 46 Id. 47 Texas Tax Code Ann. sections , Texas Tax Code Ann. section (a)(3). 49 See the MTC website ( 50 Texas Tax Code Ann. section (g), repealed effective Jan. 1, Texas Tax Code Ann. section (a). 52 Texas Tax Code Ann. section (c)(1). 53 It should be noted that the flat 30 percent deduction could be considered as an exclusion of an additional, nonspecified item of revenue, rather than a pure deduction. 54 Texas HB 3 (S79S3), section 21. It should be noted that a challenge to this law is anticipated to be filed. 55 P.L , section See FASB Minutes of the August 2, 2006, Board Meeting on Potential FSP: Texas Franchise Tax, finding that there was no need to undertake a formal project to determine whether the RTFT should be considered an income tax subject to ASC MTC Reg. II. 4. Income Tax-Gross Receipts Tax. 58 See Texas Tax Code Ann. section (b)-(f-1). 59 It is unlikely that such a retroactive law could be applied to the SBT, and hence taxpayers may attempt to concentrate their efforts on obtaining refunds for compact elections under the SBT, rather than the MBT. 60 Calif. Revenue and Taxation Code section It is probable that the California Franchise Tax Board, Michigan Department of Treasury, and Texas comptroller all would reject tax returns claiming an election to use equally weighted three-factor apportionment. 61 The recent litigation surrounding the constitutionality of the Ohio commercial activity tax (CAT) is instructive. On September 17, 2009, the Ohio Supreme Court held that the imposition of the CAT on the sale of food did not violate the Ohio Constitution. Ohio Grocers Assn. v. Levin, slip op Ohio-4872, Sept. 17, The court concluded that the CAT is a tax on the privilege of doing business and is not a prohibited excise tax on food. In reaching that decision, the court agreed with the trial court's analysis and went to great lengths to distinguish an excise tax imposed on the sale of food from a privilege tax measured by the sale of food. The former is clearly prohibited under the Ohio Constitution, while the latter has always been permitted under the constitution. The court explained that three fundamental principles governed its analysis. First, Ohio law permits a tax on the privilege of doing business that must be valued in order to impose the tax. Second, Ohio courts "have long recognized a distinction between a tax upon a certain factor and a privilege measured by that factor." Third, the "measuring stick" used to determine a tax based on the privilege of doing business may include factors that are exempt from tax. Applying those factors, the court concluded that the Ohio Constitu- 13

14 tion allows a privilege tax measured by gross receipts that include proceeds from the sale of food. The court found that the structure and history of the constitutional provisions showed that its interpretation of the provisions was correct. The court also reviewed the CAT and concluded that like the state's corporate franchise tax, the CAT is a tax on the privilege of doing business. In reaching that conclusion, the court said that the following factors required classification of the CAT as a privilege tax: the legislature described the CAT as a privilege tax (Ohio Rev. Code section (A)); the CAT is imposed on the person enjoying the privilege of doing business in Ohio (Id.); the CAT is not billed to anyone other than the privilege holder, and the CAT cannot be collected from others (that is, consumers) (Ohio Rev. Code section (B); the CAT is imposed for the exercise of the privilege to do business during any part of a calendar year (Ohio Rev. Code section (A)); the CAT is calculated on a periodic basis, not on a transactional basis (Id.); and the CAT is calculated using a broad measure of market access that is rationally related to the enjoyment of the privilege of doing business (Ohio Rev. Code section (A)). Further, the court also determined that the CAT does not operate like a tax imposed on the sale or purchase of food, because the court viewed the relationship between a sale of food and CAT obligations as "attenuated and unpredictable." Although the CAT clearly is being imposed on food sellers, it is not necessarily being imposed on the sale or purchase of food itself. The six-point analysis of the nature of the CAT that the court listed in distinguishing the CAT as a permissible "privilege tax" rather than an impermissible excise tax, in our view, is logically flawed for the following reasons: names and labels assigned to taxes should never be determinative in characterizing a tax, any more than names and labels assigned to taxpayer transactions should be taken on their face, an often-litigated point; the imposition of the tax on the seller, rather than the buyer, does not change the economic character of the tax (a direct or indirect excise tax); the party who pays the tax, buyer or seller, does not change the economic impact of the tax, which the Ohio Constitution sought to prevent; the CAT may be remitted periodically, but practically it must be calculated on a transaction by transaction basis; and the rational relationship, if any, of the tax to the privilege of doing business is irrelevant in determining whether the CAT is, in fact, an excise tax. The point of this extensive analogy is that state courts are increasingly likely to look for any rationale to save an existing state tax revenue stream. Therefore, if Ohio Grocers Association is any indication, in Michigan the classification of the MGRT component of the MBT as a nonincome tax under the statute likely will provide a Michigan court sufficient justification to find that the equally weighted three-factor election under the compact, available only for income taxes (regardless of how defined), is at the very least not applicable to the MGRT. Further, if a Michigan court views the MBT as one discrete tax, under which the MGRT and BIT are inseparable components, the classification of the MGRT as a nonincome tax could render the entire MBT a nonincome tax (though it could just as easily be argued that the classification of the BIT as an income tax could render the entire MBT an income tax). Likewise, a Texas court likely would have sufficient justification to find that the equally weighted three-factor election under the compact is not applicable for the RTFT because of the classification of the RTFT as a nonincome tax under the statute. 14