In a case involving the application of sales factor sourcing methods, the Mississippi Court of Appeals has held that the Mississippi Department of Revenue had the burden of proving that the use of alternative apportionment on the taxpayer's income to Mississippi was appropriate.1 The Court of Appeals rejected a lower court determination that there was a rebuttable presumption in favor of the Department's use of the alternative apportionment method. Because the lower court did not use the correct standard of review, the Court reversed and remanded the case.
Background
The taxpayer, a Georgia corporation in the business of consumer credit reporting, employed three Mississippi residents and had approximately 800 Mississippi+based customers, but did not have any property located in the state. The taxpayer's primary services were providing credit reports, credit scores and fraud alerts. These transactions usually occurred electronically and took approximately three seconds from the time the customers requested the credit report or score to the time they received the information. Applying the standard method of apportionment for service companies,2 the taxpayer concluded that it had no income subject to tax in Mississippi, arguing that none of its income+producing activity occurred in Mississippi. The Department determined that the standard apportionment method used by the taxpayer did not reflect the extent of its business in the state. Accordingly, the Department used an alternative apportionment method consisting of market+based sourcing, and issued an assessment against the taxpayer driven by the significant number of the taxpayer's Mississippi customers. On appeal to the Mississippi Tax Commission Board of Review,3 the Board upheld the assessment in a reduced amount. The taxpayer paid the assessment, under protest, and appealed the assessment to a county chancery court. In affirming the assessment, the chancery court determined there was a rebuttable presumption in favor of the Department. The taxpayer subsequently appealed this judgment to the Mississippi Court of Appeals.
Department Had Burden of Proof
The Mississippi Court of Appeals did not address the substantive issue of whether cost of performance or market+based sourcing should be used for this taxpayer. Rather, the Court determined that the chancery court did not apply the correct standard of review. In reversing and remanding the decision, the Court held that the Department had the burden of proving that the standard apportionment formula did not fairly represent the activities of the taxpayer within Mississippi, and the alternative formula to be used was reasonable. In Mississippi, the standard of review for an appeal from an administrative agency decision generally is the "arbitrary and capricious" standard. Under this standard, a court may reverse an administrative agency's decision only if the decision was: (i) unsupported by substantial evidence; (ii) arbitrary and capricious; (iii) beyond the agency's power; or (iv) violative of the complaining party's statutory or constitutional right.4 However, Mississippi law provides that a different appellate standard of review should be used when considering findings of the Department. Specifically, "the chancery court shall give deference to the decision and interpretation of law and regulations by the Department of Revenue as it does with the decisions and interpretation of any administrative agency, but it shall try the case de novo and conduct a full evidentiary judicial hearing on the issues raised."5
In reaching its decision, the chancery court cited the "arbitrary and capricious" standard and stated that a rebuttable presumption existed in favor of the Department's decision and findings. The Court of Appeals held that the chancery court applied the incorrect standard and should have conducted a trial de novo. Thus, the chancery court's review of the Department's decision should have been conducted as if the chancery court were sitting as the Department. The statutory requirement that the Department's decision be given deference would interfere with the chancery court's ability to try the case anew. Mississippi has not adopted the Uniform Division of Income for Tax Purposes Act (UDITPA), but Mississippi's regulation that allows the Department to use an alternative apportionment formula is modeled after a provision contained in UDITPA.6 Therefore, the Court considered other jurisdictions regarding the burden of proof when alternative apportionment is used. The Court cited to courts in California,7 Tennessee8 and Utah9 holding that the party seeking to use an alternative apportionment method has the burden of proof.
The Court held that the chancery court committed reversible error when it gave the Department the benefit of a rebuttable presumption and when it applied the "arbitrary and capricious" standard. By applying this standard, the chancery court did not conduct the necessary de novo review of the matter. Therefore, the decision was reversed and remanded to the chancery court.
Commentary
The use of alternative apportionment methods has received considerable attention by taxpayers, state tax authorities and courts. Recently, there has been uncertainty in some states regarding the burden of proof when a state requires the use of an alternative apportionment method compared to the burden of proof when a taxpayer requests the use of an alternative method. For example, the burden of proof when proposing an alternative apportionment method recently was litigated in South Carolina.10
Even though this particular decision was procedural and did not address the substantive merits of whether the Department can use market+based sourcing11 instead of cost of performance sourcing for this taxpayer, this decision merits consideration because it highlights the fact that in some circumstances, a state's iron+clad statutory method of sourcing services can be overturned. For example, the Department might render the Mississippi cost of performance service sourcing rule moot for taxpayers that have an insubstantial physical footprint in Mississippi, as compared to their Mississippi customer base, by insisting on market+based sourcing via the alternative apportionment rules. Likewise, taxpayers with significant Mississippi physical presence that disproportionately sell services outside the state could argue for the application of a market+based sourcing method in lieu of statutory cost of performance sourcing.
Due to the lack of multistate consistency on how to source sales of services, it is likely that more of these disputes will be litigated around the country as taxpayers and state tax authorities look to use their preferred sourcing methodology, regardless of what the general statute and interpretive regulations say. As a result, the Mississippi chancery court's reconsideration of this case may serve as a model for other state courts that surely will be facing these issues in the future.
Footnotes
1 Equifax, Inc. v. Department of Revenue, Mississippi Court of Appeals, No. 2010+CA+01857+COA, May 1, 2012.
2 For sales other than sales of tangible personal property, sales are sourced to Mississippi to the extent the income+producing activity is performed within the state (commonly called the proportional cost of performance method). CODE MISS. R. 35+III+8.06:402.09.
3 Note that the Mississippi State Tax Commission has changed its name to the Mississippi Department of Revenue.
4 Buffington v. Mississippi State Tax Commission, 43 So.3d 450 (Miss. 2010).
5 MISS. CODE ANN. § 27+77+7(5). Note that this statute was amended effective July 1, 2010. Prior to amendment, the quoted language was contained in subsection (4). Also, the amendment included several nonsubstantive changes. Because the assessments concerned tax years prior to 2010, the Court cited to subsection (4) of the statute.
6 CODE MISS. R. 35+III+8.06:402.09. This is based on UDITPA § 18.
7 Microsoft Corp. v. Franchise Tax Board, 139 P.3d 1169 (Cal. 2006).
8 American Tel. & Tel. Co. v. Huddleston, 880 S.W.2d 682 (Tenn. Ct. App. 1994).
9 Deseret Pharmaceutical Co. v. State Tax Commission, 579 P.2d 1322 (Utah 1978).
10 The South Carolina Court of Appeals recently held that when the South Carolina Department of Revenue proposes an alternative apportionment method, it has the burden of proving that this alternative method of apportionment is the most appropriate. CarMax Auto Superstores West Coast, Inc. v. Department of Revenue, South Carolina Court of Appeals, No. 4953, March 14, 2012.
11 Note that legislation was introduced in Mississippi in early 2012 that would have adopted market+based sourcing, but the legislation died in committee. H.B. 970.
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