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The Gillette Company et al v. Franchise Tax Board

July 24, 2012


Trial Court: San Francisco Superior Court Trial Judge: Hon. Richard A. Kramer Super. Ct. Nos. CGC-10-495911, CGC-10-495912, CGC-10-495916, CGC-10-496437, CGC-10-496438, CGC-10-499083)

The opinion of the court was delivered by: Reardon, J.


(San Francisco City & County)

California is a signatory to the Multistate Tax Compact (Compact). (Rev. & Tax. Code,*fn1 § 38001, California's enactment of the Compact.) This binding, multistate agreement obligates member states to offer its multistate taxpayers the option of using either the Compact's three-factor formula to apportion and allocate income for state income tax purposes, or the state's own alternative apportionment formula. (§ 38006, art. III, subd. 1.) This is one of the Compact's key mandatory provisions designed to secure a baseline level of uniformity in state income tax systems, a central purpose of the agreement.

Prior to 1993, California subscribed to a single method of apportioning and allocating income, the Compact formula, which ascribed equal weight to three factors: property, payroll and sales. (Former § 25128, as added by Stats. 1966, ch. 2, § 7, p. 179.) Then, in 1993 the Legislature amended section 25128 to give double weight to the sales factor for most business activity, specifying that "[n]otwithstanding 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 . . . ." (Former § 25128, subd. (a), italics added, as amended by Stats. 1993, ch. 946, § 1, p. 5441.)*fn2

These consolidated appeals brought by appellants the Gillette Company and its subsidiaries, and other corporate entities (Taxpayers),*fn3 present the issue of whether, for the tax years at issue since 1993, Taxpayers were entitled to elect the Compact formula, or, as respondent Franchise Tax Board (FTB) asserts, did the 1993 amendment to section 25128 repeal and supersede that formula, thereby making the state formula mandatory? We conclude that the Compact is a valid multistate compact, and California is bound by it and its apportionment election provision unless and until California withdraws from the Compact by enacting a statute that repeals section 38006. Accordingly, since California has not repealed section 38006 and withdrawn from the Compact, we reverse the trial court's order sustaining the FTB's demurrer without leave to amend.*fn4


A. Historical Context Leading to Enactment of the Compact

Recognizing the need for uniformity in the apportionment of corporate income for tax purposes among the various taxing states, in 1957 the National Conference of Commissioners on Uniform State Laws promulgated the Uniform Division of Income for Tax Purposes Act (UDITPA). (7A pt. 1 West's U. Laws Ann. (2002) pp. 141-142 & § 9.) To apportion a multistate corporation's business income among the various taxing states, UDITPA uses a three-factor, equally weighted formula consisting of property, payroll and sales receipts. (Id., § 9.) California adopted the UDITPA in 1966. (§ 25120 et seq.; Stats. 1966, ch. 2, § 7, pp. 177-181.)

By 1959, only a few states had adopted the UDITPA. (7A pt. I, West's U. Laws Ann., supra, p. 141.) That year, the United States Supreme Court delivered its decision in Northwestern Cement Co. v. Minn. (1959) 358 U.S. 450, 452 (Northwestern Cement), holding that "net income from the interstate operations of a foreign corporation may be subjected to state taxation provided the levy is not discriminatory and is properly apportioned to local activities within the taxing State forming sufficient nexus to support the same." Northwestern Cement raised concerns in the business community and within weeks of the decision, Congress commenced hearings, culminating in the passage of Public Law No. 86-272 as an emergency, temporary measure some six months later. This law was intended to restrict the application of Northwestern Cement and created a subcommittee to study state business taxes and recommend legislation establishing uniform standards which states would observe in taxing income of interstate companies. (Fatale, Federalism and State Business Activity Tax Nexus; Revisiting Public Law No. 86-272 (Spring 2002) 21 Va. Tax Review, 435, 475-476; U.S. Steel Corp. v. Multistate Tax Comm'n (1978) 434 U.S. 452, 455 (U.S. Steel).) The subsequent study, commonly referred to as the "Willis Report" after Congressman Edwin E. Willis who chaired the subcommittee,*fn5 called for federal legislation that would have limited state authority to tax interstate business operations and imposed a uniform apportionment regime on the states. (State Taxation of Interstate Commerce, Rep. of the Special Subcommittee on State Taxation of Interstate Commerce of the Com. on the Judiciary, House of Representatives (Sept. 2, 1965) vol. 4, chs. 38, 39, pp. 1135-1136, 1143, 1161.)

In the wake of the Willis Report, Congress introduced a number of bills incorporating its recommendations. (U.S. Steel, supra, 434 U.S. at p. 456, fn. 4; Sharpe, State Taxation of Interstate Businesses and the Multistate Tax Compact: The Search for a Delicate Uniformity (1974) 11 Colum. J. of Law and Social Problems, 231, 242 & n. 43.) To stave off federal encroachment on their taxing powers and devise workable alternatives that would eliminate the need for congressional action, state tax administrators and other state leaders drafted the Compact; by June 1967, nine states had enacted the Compact, which by its terms became effective after seven states had adopted it. (Multistate Tax Com., First Ann. Rep. (1968) pp. 1-2; § 38006, art. X, subd. 1.)

B. Compact Provisions

California enacted the Compact in 1974. (§ 38001, Stats. 1974, ch. 93, § 3, p. 193.) Its purposes are to "1. Facilitate proper determination of State and local tax liability of multistate taxpayers, including the equitable apportionment of tax bases and settlement of apportionment disputes. [¶] 2. Promote uniformity or compatibility in significant components of tax systems. [¶] 3. Facilitate taxpayer convenience and compliance in the filing of tax returns . . . . [¶] 4. Avoid duplicative taxation." (§ 38006, art. I.)

Article IV adopts the UDITPA and its equally weighted, three-factor apportionment formula, stating in part: "All business income shall be apportioned to this State by multiplying the income by a fraction, the numerator of which is the property factor plus the payroll factor plus the sales factor, and the denominator of which is three." (§ 38006, art. IV, subd. 9.) However, article III allows taxpayers the option of apportioning and allocating income pursuant to the UDITPA formula or pursuant to a given state's alternative apportionment provisions: "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 . . . may elect to apportion and allocate his income in the manner provided by the laws of such State . . . without reference to this compact, or may elect to apportion and allocate in accordance with Article IV." (§ 38006, art. III, subd. 1.) As noted in the Multistate Tax Commission's Third Annual Report (1969-1970),*fn6 "The Multistate Tax Compact makes UDITPA available to each taxpayer on an optional basis, thereby preserving for him the substantial advantages with which lack of uniformity provides him in some states. Thus a corporation which is selling into a state in which it has little property or payroll will want to insist upon the use of the three-factor formula (sales, property and payroll) which is included in UDITPA because that will substantially reduce his tax liability to that state below what it would be if a single sales factor formula were applied to him[;] on the other hand, he will look with favor upon the application of the single sales factor formula to him by a state from which he is selling into other states, since that will reduce his tax liability to that state. The Multistate Tax Compact thus preserves the right of the states to make such alternative formulas available to taxpayers even though it makes uniformity available to taxpayers where and when desired." (Id. at p. 3.)

Article V sets out the rules for sales and use tax credits and exemptions, therein obligating each party state to provide a full credit to taxpayers who previously paid sales or use tax to another state with respect to the same property, and to honor sales and use tax exemption certificates from other states. (§ 38006, art. V, subd. 1.)

The Compact leaves other matters entirely to state control. For example, it reserves to the states control over the rate of tax (§ 38006, art. XI, subd. (a)), and simply does not address the composition of a corporation's tax base.

As well, the Compact creates the Multistate Tax Commission (Commission) with powers to study state and local tax systems, develop and recommend proposals for greater uniformity of state and local tax laws, and compile and publish information helpful to the states. (§ 38006, art. VI, subds. 1, 3.) Each party state appoints a member to the Commission and pays its share of expenses. (Id., art. VI, subds. 1(a), 4(b).) The Commission may adopt uniform regulations in cases where two or more states have uniform or similar provisions relating to specific types of taxes. (Id., art. VII.) However, such regulations are advisory only--each state makes its own decision whether to adopt the regulation in accordance with its own law. (Id., art. VII, subd. 3.) Additionally, the Commission may perform interstate audits, if requested by a party state; the governing article applies only in states that specifically adopt it by statute. (Id., art. VIII, subds. 1, 2.)

Finally, under the Compact, states are free to withdraw from the Compact at any time "by enacting a statute repealing the same." (§ 38006, art. X, subd. 2.)

C. U.S. Steel

In 1972, a group of multistate corporate taxpayers brought an action on behalf of themselves and all other such taxpayers threatened with audits by the Commission. The complaint challenged the constitutionality of the Compact on several grounds, including that it was invalid under the compact clause of the United States Constitution.*fn7 (U.S. Steel, supra, 434 U.S. at p. 458.)

The high court acknowledged that the compact clause, taken literally, would require the states to obtain congressional approval before entering into any agreement among themselves, "irrespective of form, subject, duration, or interest to the United States." (U.S. Steel, supra, 434 U.S. at p. 459.) However, it endorsed an interpretation, established by case law, that limited application of the compact clause " 'to agreements that are "directed to the formation of any combination tending to the increase of political power in the States, which may encroach upon or interfere with the just supremacy of the United States." [Citations.]' This rule states the proper balance between federal and state power with respect to compacts and agreements among States." (Id. at p. 471, initial quote from Virginia v. Tennessee (1893) 148 U.S. 503, 519.)

Framing the test as whether the Compact enhances state power with respect to the federal government, the court concluded it did not: "This pact does not purport to authorize the member States to exercise any powers they could not exercise in its absence. Nor is there any delegation of sovereign power to the Commission; each State retains complete freedom to adopt or reject the rules and regulations of the Commission. Moreover . . . , each State is free to withdraw at any time." (U.S. Steel, supra, 434 U.S. at p. ...

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