Cert denial leaves in place hostile-to-business decision

The recent saga of Gillette Company & Subsidiaries v. Franchise Tax Board ended last week when the U.S. Supreme Court denied review. The legal question was whether a multistate corporation like Gillette was allowed to determine the amount of income earned in California by applying an apportionment formula that equally weighted property, payroll and sales or a formula that double weighted sales. The equally weighted formula resulted in a tax refund; the double weighted sales formula did not. Gillette lost.

The reason that there were two formulas goes back more than 50 years and revolves around the Constitution's due process and commerce clauses, which prohibit a state from taxing income earned outside its borders. For multistate businesses, figuring out how much of its income is earned within a particular state has been a vexing question since just after the Civil War. For example, in Union Pac. Ry. Co. v. Cheyenne (1885), the Supreme Court noted that what made a railroad valuable was the ability to travel the length of the track, and not a particular section of track. Figuring out the value of the particular track in one state was, however, no easy task.

The states began to develop a wide variety of formulas to determine and allocate the value of a multistate business for tax purposes. Concerns about administrative burden and over taxation grew, as the same income could be subjected to tax more than once by different states depending upon the formula used. By the 1950s, there was some support for adopting a uniform law across the states to solve these problems.

By the early 1960s, Congress was studying the problem of multistate taxation. The "Willis Committee" proposed imposing a uniform apportionment formula upon all states. In response to a perceived threat to their sovereignty, the states adopted the Multistate Tax Compact. The compact contained a uniform apportionment formula, but also allowed states to enact alternative formulas of their choosing. A key feature of the compact was a company's right to elect which formula to use: the uniform formula or whatever alternative formula a state adopted.

The adoption of the compact successfully staved off congressional interference with the states' sovereign tax powers. Congress backed off, and in Moorman Mfg. Co. v. Bair (1978), the Supreme Court found that the Constitution does not mandate any particular apportionment method, while also acknowledging that "national uniform rules for the division of income" are necessary to prevent duplicative taxation. But the issue did not go away.

For nearly 30 years in California, the election was academic because California's own formula mirrored the compact's formula, which California had adopted. That changed in 1994, when California changed its formula to double weight sales. In making this change, the Legislature eliminated the right of a company to elect the compact's formula instead of California's double weighted sales formula. When Gillette made an election anyway, the FTB denied it and Gillette sued.

The trial court sided with the FTB, noting that California repealed the compact's election. The appellate court reversed. Holding that California was a signatory to the compact, which was a binding contract among the states who adopted it, the legislature lacked the authority to just repeal the election provision , although California could repeal the compact in full. The court further noted that the election was "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."

The FTB appealed, and the California Supreme Court reversed, holding that the compact was "more in the nature of model uniform laws" and thus not binding. Translation: Gillette was not allowed to elect the compact's formula and thus no tax refund. Further, fearing substantial tax refunds on the horizon, in 2012 California did in fact repeal the compact in full. In doing so, the Legislature implicitly signaled both that uniformity and concerns about over taxation or administrative burden were of little importance compared to seeking as much revenue from corporations as the state could obtain.

With the Supreme Court's denial of Gillette's request for review, the question to resolve is: What does the case mean for businesses that operate in California and other states? The answer is, not much, as least from a legal perspective. The Legislature's decision to repeal the compact, coupled with its decision to move to a single sales factor formula for all apportioned income in 2013 means that California views itself solely as a market state for corporate income tax purposes. In some ways this is fairer than the old three-factor formula that double weighted sales, which likely taxed non-California corporations more than California corporations.

What Gillette means from a political perspective is that the desire of the state of California to extract revenue from multistate businesses takes precedence over concerns about national uniformity or even fairness. That in turn increases the risk of double taxation and administrative burden that the states previously sought to alleviate through the compact. Decisions like this contribute to California's reputation as among the worst states in which to do business. Of course, there is no reason for California to put the national interest ahead of its own. The abandonment of the compact by California and several other states because of the election, and reversion of the states to a single formula of their choosing, puts us where we were more than 50 years ago. Perhaps Congress will revisit the issue it abandoned in light of the states' failure to uphold the bargain they struck.