Taxpayers filing Tennessee franchise and excise tax returns should take note of the recent Tennessee Court of Appeals ruling in BellSouth Advertising & Publishing Corp. v. Chumley, in which the Court concluded that the Commissioner had properly exercised her power to vary the statutory apportionment formula that was based on cost of performance to impose, instead, a market-based apportionment factor. This ruling is particularly noteworthy for service providers and other entities filing returns in Tennessee based on cost of performance and may subject taxpayers to risk of future assessments by the Department of Revenue.
In this case, Bellsouth Advertising & Publishing Corp. (BAPCO) compiled and published telephone directories and derived most of its revenue from the provision of advertising services. In filing its Tennessee franchise and excise tax returns for the years under audit, BAPCO utilized the all-or-nothing "cost of performance" method set forth in Tenn. Code Ann. §67-4-2012(i), which resulted in BAPCO including none of its receipts from advertising sales as "Tennessee sales" for purposes of determining its sales factor for apportionment purposes. On audit, the Commissioner challenged BAPCO's use of the cost of performance method and imposed a variance requiring BAPCO to calculate its sales factor by including advertising sales receipts from Tennessee customers in the numerator. This resulted in BAPCO being required to calculate its sales factor as if its receipts from advertising sales constituted receipts from the sale of tangible personal property. The Commissioner asserted that the variance was proper because use of the cost of performance formula "did not fairly reflect" BAPCO's business activity in Tennessee.
The Trial Court concluded that the variance was improper, but on appeal, the Court of Appeals reversed, concluding instead that "the authors of the UDITPA, and the Tennessee General Assembly[,] were aware that under certain factual scenarios, specifically when the sale of advertising is at issue, the statutory formulas do not work and the tax collector would necessarily have to impose a variance." The Court of Appeals further noted the great disparity between BAPCO's reported franchise and excise tax liability and the amount of gross receipts it received from the distribution of directories in Tennessee. Specifically, BAPCO's utilization of cost of performance had reduced its overall Tennessee apportionment factor from approximately five percent (5%) to approximately one tenth of a percent (1/10%) for the 2001 tax year, with equally dramatic reductions in the other tax years. As a result, BAPCO paid $296,140 in total franchise and excise tax for the 1997-2001 tax years while deriving $897,488,193 in income from the distribution of directories in Tennessee during the same period.
It is anticipated that BAPCO will apply for a discretionary appeal to the Tennessee Supreme Court on this issue, and interested taxpayers should consider whether they may want to file amicus briefs to encourage the Tennessee Supreme Court to accept an appeal of this decision. In the interim, Taxpayers relying on cost of performance should analyze the disparity between cost of performance and market-based sourcing to evaluate whether this ruling presents any risks as they should expect that auditors will be looking more closely at these calculations to evaluate the reasonableness of cost of performance in future audits.
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