SALT Top Stories Of 2013

For the second consecutive year, the two dominant stories in state and local taxation (SALT) related to the challenges surrounding an apportionment election contained in the Multistate Tax Compact, and the sales and use tax treatment of remote sellers.

Interestingly, the California Supreme Court did not decide The Gillette Co. v. Franchise Tax Board,1 the California Court of Appeal case which inspired widespread action on the Compact in the state courts, administrative branches, legislatures and even the Multistate Tax Commission (MTC) in 2013. The interest level of apparent bystanders to the outcome in Gillette is staggering due to the potential revenue effect in impacted states if refund claims on the Compact's three-factor election are allowed. While numerous events this year demonstrated how states are preparing for life with an altered Compact, or perhaps no Compact at all, the activity in this area may pale in comparison to what happens next year, when Gillette is expected to be addressed by California's high court.

Interest in the Compact expands beyond the availability of the three-factor election. Specifically, growth in the use of market-based sourcing of sales of items other than tangible personal property, as well as the expanded use of alternative apportionment, both touch upon provisions contained in the Compact.

On the sales tax side of the ledger, the Marketplace Fairness Act of 2013 (MFA) became the second SALT bill in two years to pass one chamber of Congress, but not the other. The relative progress of the MFA did not stop states from continuing to push click-through nexus and related legislation designed to resolve the remote seller issue, and defend such legislation from constitutional attacks.

In addition to the Compact and the MFA, continuing economic pressures faced by many states and localities still recovering from the Great Recession led to several other important developments. The stagnation of the sales tax from a revenue perspective forced states to at least reconsider the structure and purpose of the sales tax, with taxation of a broader swath of service-based transactions threatened in many instances, and achieved in a few. The "worst-case scenario" of financial disaster occurred in the city of Detroit, where the failure to determine how to balance budgets and pay for future obligations to which the city is committed is resulting in the largest municipal bankruptcy case in U.S. history. On the opposite end of the fiscal spectrum, the state of Texas afforded businesses significant corporate and sales tax breaks, showing that an abundance of highly valued natural resources can protect against fiscal distress.

In our annual end-of-year alert, we summarize the ten stories which in our view constituted the most material SALT developments of the year:

The multi-faceted issues surrounding the Multistate Tax Compact Market-based sourcing incrementally progresses Equifax and alternative apportionment challenges Allied Domecq and the application of the "sham transaction" doctrine in restructurings The Texas budget legislation offers expansive tax relief Detroit's bankruptcy filing Marketplace Fairness Act takes center stage on the Senate floor Sales tax click-through nexus and notice litigation: The legal, the illegal, and the uncertain Broadening the sales tax base and raising the tax rate Property tax and the treatment of intangibles 1. The multi-faceted issues surrounding the Multistate Tax Compact

If 2012 could be considered the year of Gillette, 2013 may best be remembered as the year in which state courts, legislatures and taxpayers began to respond to Gillette, in preparation for the California Supreme Court's decision in the case expected early next year.

On the litigation front, activity in Michigan illustrated that two courts in one state could come to different conclusions. In 2012, the Michigan Court of Appeals held in International Business Machines Corp. v. Department of Treasury2 that a taxpayer was not allowed to elect to use the Compact's three-factor apportionment formula for purposes of the Michigan Business Tax (MBT). The Court concluded that the MBT apportionment statute repealed by implication the apportionment election provision found in the Compact. The Court also held that the Compact is not a binding contract that prevents the state from enacting modifications to the state tax base and apportionment statutes. The IBM case was accepted by the Michigan Supreme Court for review this year, with oral arguments to be presented in the coming weeks, and a decision expected soon thereafter.3

The Michigan Court of Claims came to a starkly different result this year in Anheuser-Busch, Inc. v. Michigan Department of Treasury,4 holding that the Compact was a binding compact on Michigan that could not be repealed by a conflicting state statute. While the Court agreed with the taxpayer that for purposes of the MBT the election could be made to apportion the business income tax (BIT) component of the MBT, the Court also held that the MGRT component of the MBT was not an "income tax" under the Compact, and therefore, the election was inapplicable to the MGRT. The result in Anheuser-Busch has been appealed to the Michigan Court of Appeals, which now faces the task of reconciling its opinion in IBM with the Court of Claims' Anheuser-Busch analysis.5 One senses that the ultimate determination in IBM could inform the Court of Appeals' approach in Anheuser- Busch, and it will be interesting to see whether the eventual decision in Gillette has any effect on both Michigan cases.

In Texas, a series of letter rulings issued by the Comptroller has made it clear that a position to elect three-factor apportionment under the Compact for purposes of the Revised Texas Franchise Tax (RTFT) will not be accepted by the Comptroller at any time in the near future.6 In fact, one of the rulings expressly rejected a taxpayer's reference to the Gillette decision by the California Court of Appeals as not being citable because the California Supreme Court granted review of the case.7 It should be noted that the first challenge on the subject to reach the Texas judicial system is presently under consideration by a state trial court, with a decision expected soon.8

In response to the potential results a taxpayer-favorable decision in Gillette could bring, state legislatures spent a significant amount of time and energy attempting to protect themselves from refund claims and prospective tax benefits by removing themselves from the Compact, or at the very least legislating out of Articles III and IV of the Compact. Following California's lead in 2012,9 the District of Columbia,10 Minnesota,11 Oregon,12 South Dakota,13 and Utah14 all enacted legislation in 2013 repealing all or certain portions of the Compact. Of course, due to the Gillette litigation and other cases, it is still uncertain as to whether states can effectively insulate themselves from litigation concerning the three-factor apportionment election by repealing certain provisions of the Compact.

Finally, the MTC's effort to amend the Uniform Division of Income for Tax Purposes Act (UDITPA), along with the recommendations contained in the Report of the Hearing Officer which analyzes proposals and makes recommendations for amending key provisions of Article IV of the Compact,15 has potential implications on the ongoing vitality of the Compact. The Compact currently provides for a three-factor apportionment formula consisting of equally-weighted property, payroll and sales factors.16 However, many states have moved away from this standard formula and require that multistate taxpayers apportion income using a single sales factor or a three-factor formula with a double-weighted sales factor. One of the MTC Uniformity Committee's recommendations was for the Compact to be amended to recommend a double-weighted sales factor to Compact states, but ultimately allow these states to define their own factor weighting. This amendment would allow states to essentially reset the Compact from the equally-weighted three-factor formula to a formula including a more heavily-weighted sales factor so that the MTC election (which would remain under the Uniformity Committee's recommendation) would no longer provide taxpayers with an obvious apportionment formula benefit. The Hearing Officer's Report noted that the "proposal to allow states to define the factor weighting fraction is a concession to reality" and that "[t]he recommendation of double weighting is unlikely to have much effect."17

2. Market-based sourcing incrementally progresses

   States are continuing to shift from the cost of performance (COP) method of sourcing sales of services for purposes of income tax apportionment to the market-based sourcing method. In 2013, Massachusetts and Pennsylvania took steps to adopt market-based sourcing in the near future, though the states differ somewhat in how to determine the marketplace. As judged by the Massachusetts and Pennsylvania enactments, sourcing via the location of the benefit of the customer appears to be going out of vogue, while the location where the service is delivered is becoming more popular.

   In Massachusetts, the change will become effective for tax years beginning on or after January 1, 2014.18 The legislation requires sourcing of sales of items other than sales of tangible personal property to Massachusetts if the corporation's market for the sale is in Massachusetts.19 In the case of the sale of services, such items are sourced to Massachusetts if the services are delivered to a location in the state.20 Five other market-based sourcing rules are provided to source items other than the sale of services:

   The sale, rental, lease or license of real property is sourced to the location of such property. The rental, lease or license of tangible personal property is sourced to the location of the property. The lease or license of intangible...