United States: Tennessee Court Of Appeals Affirms Variance Requiring Telecommunications Company To Use Market-Based Sourcing

The Tennessee Court of Appeals has held that the state's Revenue Commissioner properly issued a variance requiring a telecommunications company to apportion sales using market-based sourcing based on a customer's billing address rather than the statutory cost of performance (COP) method.¹ In affirming the trial court, the Court of Appeals agreed that the Commissioner properly exercised his discretion in requiring the variance because the COP apportionment method did not fairly represent the taxpayer's business activity in the state.

Background

The taxpayer, a telecommunications company based in California, held a 45 percent interest in a partnership (Cellco) that operated a telecommunications business known as Verizon Wireless. During the relevant years, Verizon Wireless conducted a wireless voice and data business throughout the United States and had customers with billing addresses in Tennessee. In its original Tennessee franchise and excise tax returns, the taxpayer calculated its apportionment formula sales factor by using a pay-per-use or primary-place-of- use (PPU) methodology that sourced to Tennessee any sales of Cellco's telecommunications services that were made to customers with a Tennessee billing address.

After filing its returns, the taxpayer filed a refund claim and argued that it was not subject to Tennessee franchise and excise taxes because it only had a 45 percent interest in Cellco and did not control its day-to-day operations. Following a denial by the Tennessee Department of Revenue on that issue, the taxpayer commenced litigation, and subsequently filed an amended complaint that first raised the alternative argument that a COP analysis should be used to apportion the income instead of the PPU method. The use of the COP method resulted in over $1 billion in previously taxable earnings no longer being taxable in Tennessee or any other state, which resulted in an 89 percent reduction in the formula used to compute tax liability. In response, the Revenue Commissioner issued an apportionment variance letter and argued that the sales should be sourced using the PPU method.²

The trial court rejected the taxpayer's nexus argument and granted the Commissioner's motion for summary judgment on this issue. Following a bench trial, the court held that the Commissioner properly issued the apportionment variance.³ According to the trial court, the variance was issued in response to a "tax computation, allocation or apportionment" which did not "fairly represent the extent of the taxpayer's business activity in the state."⁴ The taxpayer appealed this decision to the Tennessee Court of Appeals.

Tennessee's Apportionment Methodology

Tennessee follows the traditional apportionment methodology provided by the Uniform Division of Income for Tax Purposes Act (UDITPA) and the Multistate Tax Commission (MTC) in corresponding regulations. Under Tennessee law, sales, other than sales of tangible property, are in the state if the earnings-producing activity is performed (1) in the state or (2) both within and outside the state and a greater proportion of the activity is performed in Tennessee, based on COP.⁵ If the statutory apportionment provisions "do not fairly represent the extent of the taxpayer's business activity in this State," the taxpayer may request, or the Department may require, the use of an alternative apportionment method.⁶ A regulation explains that the variance statute will "permit a departure from the allocation and apportionment provisions only in limited and specific cases."⁷ Further, the regulation provides that a variance "may be invoked only in specific cases where unusual fact situations (which ordinarily will be unique and nonrecurring) produce incongruous results under the apportionment and allocation provisions contained in the Franchise and Excise Tax Laws."⁸

Commissioner Properly Required Variance

In affirming the trial court, the Court of Appeals explained that the determinative question was whether the Commissioner acted within his discretion when he issued the variance.⁹

The Commissioner found that the COP apportionment methodology did not fairly represent the extent of the taxpayer's business in Tennessee. In fact, the COP approach resulted in no (or minimal) tax liability in Tennessee and no liability anywhere else for Tennessee receipts. Under the COP method, the taxpayer's sales factor decreased by 89 percent. In contrast, the PPU methodology sourced receipts to where the customers are located and resulted in a tax liability of over $13 million. Thus, the Commissioner used reasonable discretion in requiring a variance from the standard apportionment method. Furthermore, the PPU method was within the options provided under the alternative apportionment statute.¹⁰

The Court closely examined the regulation providing that an alternative apportionment method may be used in limited and specific cases involving unusual fact situations which are ordinarily unique and nonrecurring when the statutory formula produces an incongruous result.¹¹ According to the Court, this was a limited and specific case. Although this decision might provide a precedent for similar companies in the future, these companies would be a very small portion of the entities subject to tax. Also, the Court determined that this variance will not erode the statutory formula. Furthermore, the variance does not burden the taxpayer because it is easier to compute than the statutory COP method. The Court also concluded that this was an unusual fact situation because the drafters of UDITPA probably did not anticipate the emergence of the wireless industry.

After examining the first requirements of the alternative apportionment regulation, the Court considered whether the facts in this case were ordinarily unique and nonrecurring. The facts were unique to this taxpayer or industry, but they did not seem to be nonrecurring. The Court explained that the use of the word "ordinarily" indicated that it was "not a hard and fast requirement." Also, the apportionment statute envisions recurrence.¹²

The Court determined that application of the standard apportionment methodology would produce an incongruous result. The Court addressed the arguments that the lack of taxation is a policy choice and that imposition of the tax is not supported by the fact that other states are not taxing the receipts. First, the legislature also made a policy choice by authorizing the taxing authority to issue apportionment variances in certain situations. In addition, the fact that other states do not tax the Tennessee receipts indicates that it is not unfair for Tennessee to tax these receipts. Finally, the Court determined that it was not reasonable to allow the taxpayer's Tennessee receipts to remain untaxed simply because a call may be routed through other states.

Commentary

Tennessee continues to use a COP apportionment methodology pursuant to statute and has not formally enacted market-based sourcing. In contrast, many states have enacted market-based sourcing statutes¹³ and the MTC is considering the adoption of a market-based sourcing approach by making substantial revisions to UDITPA and the MTC's corresponding regulations. There has been controversy surrounding cases in COP states where the state tax authority has been allowed to impose market-based sourcing to increase the receipts subject to tax in the state. This is not the first Tennessee case where the Commissioner has been allowed to require market-based sourcing. In BellSouth Advertising & Publishing Corp. v. Chumley, the Tennessee Court of Appeals similarly allowed the Commissioner to use an alternative apportionment method instead of the statutory COP method.¹⁴

A strong argument can be made that tax authorities in some COP states are unofficially adopting market-based sourcing principles for certain types of taxpayers.¹⁵ Last year, a Mississippi case, Equifax, Inc. v. Department of Revenue, which concerned the state's imposition of an apportionment variance to apply market-based sourcing garnered considerable attention.¹⁶ In Equifax, the Mississippi Department of Revenue determined that the standard COP method used by the taxpayer did not reflect the extent of its business in the state. Accordingly, the Department required the use of an alternative apportionment method consisting of market-based sourcing. The Mississippi Supreme Court held that the trial court properly applied an arbitrary-and-capricious standard in reviewing the case. Also, the Court approved placing the burden of proof by the preponderance of the evidence on the taxpayer, rather than the Department, since the taxpayer was petitioning the court for relief. This decision received considerable attention and criticism as being adverse to Mississippi's business climate. In response to Equifax, the state of Mississippi enacted legislation effective January 1, 2015 clarifying the ability of the Department and corporate taxpayers to use alternative apportionment, and specifically outlining the burden of proof necessary to support an alternative apportionment claim.¹⁷

Taxpayers in COP states need to be aware that they may be required to use market-based sourcing if such a result favors the state. The Mississippi legislation may encourage other states that use a COP methodology to enact legislation to dissuade revenue departments from routinely applying a market-based sourcing approach to a variety of industry sectors to the extent such approach benefits the state.

Footnotes

1 Vodafone Americas Holdings Inc. v. Roberts, Tennessee Court of Appeals, No. M2013-00947-COAR3- CV, June 23, 2014.

2 In the variance letter, the Commissioner claimed that the PPU method was readily substantiated, but the COP was potentially subject to arbitrary assignment of costs to particular states. The Commissioner argued that the taxpayer's COP calculations included its costs everywhere and did not capture costs specific to Tennessee. As a result, over $1 billion in taxable receipts from Tennessee customers were not taxable in Tennessee or any other state.

3 Vodafone Americas Holdings, Inc. v. Roberts, Tennessee Chancery Court, 20th Judicial District, Davidson County, No. 07-1860-IV, March 19, 2013. For a discussion of this decision, see GT SALT Alert: Tennessee Trial Court Approves Variance Requiring Telecommunications Company to Use Market-Based Sourcing.

4 Id.

5 TENN. CODE ANN. §§ 67-4-2012(i); 67-4-2111(i).

6 TENN. CODE ANN. §§ 67-4-2014; 67-4-2112.

7 TENN. COMP. R. & REGS. 1320-6-1-.35(1)(a)(4).

8 Id.

9 Both the trial and appellate decisions repeatedly cited BellSouth Advertising & Publishing Corp. v. Chumley, 308 S.W.3d 350 (Tenn. Ct. App. 2009), leave to appeal denied, Tenn. Supreme Court, March 1, 2010. In this case, the Tennessee Court of Appeals held that the Commissioner correctly used an alternative apportionment method instead of the statutory COP method where a telephone directory publisher incurred all of its costs outside Tennessee but earned its advertising revenue from the distribution of directories within the state.

10 See TENN. CODE ANN. § 67-4-2014(a)(4), (5).

11 TENN. COMP. R. & REGS. 1320-6-1-.35(1)(a)(4).

12 Specifically, the apportionment statute provides that "[w]hen another method of tax computation, allocation or apportionment as set out above has once been established, it shall continue in effect so long as the circumstances justifying the variation remain substantially unchanged, or until changed or discontinued by the department, whichever occurs first." TENN. CODE ANN. § 67-4-2014(d).

13 For example, the following states have adopted market-based sourcing fairly recently: Alabama, California, Illinois, Maine, Massachusetts, Michigan, Nebraska, New York, Oklahoma, Pennsylvania, Rhode Island, Utah and Wisconsin.

14 308 S.W.3d 350 (Tenn. Ct. App. 2009), leave to appeal denied, Tenn. Supreme Court, March 1, 2010.

15 Note that Florida also has been allowing variances that apply market-based sourcing (see Technical Assistance Advisement No. 13C1-011, Florida Dept. of Revenue, Nov. 21, 2013; Technical Assistance Advisement No. 13C1-004, Florida Dept. of Revenue, May 21, 2013).

16 125 So. 3d 36 (Miss. 2013), cert. denied, June 30, 2014. For further discussion of this case, see GT SALT Alert: Mississippi Supreme Court Upholds Use of Alternative Apportionment Method.

17 H.B. 799, Laws 2014, enacted April 10, 2014. This legislation benefits taxpayers by replacing the Equifax burden of proof standard that favored the state with a new standard that places the burden on the moving party and clarifying that an alternative apportionment method should only be used in "limited and unique, nonrecurring circumstances." For a discussion of this legislation, see GT SALT Alert: Mississippi Enacts Legislation Addressing Equifax Decision.

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