On June 27, California Governor Jerry Brown signed budget trailer legislation that repeals the Multistate Tax Compact and clarifies that an election to use the equally - weighted three - factor apportionment formula provided in the Compact is not permitted in California.1 The legislation also clarifies more generally that tax elections must be made on original, timely filed returns and are binding on the taxpayer. In addition, the legislation expands the definition of "state tax liability" for which the state is authorized to issue a withholding order and the definition of a "delinquent tax debtor" that falls within the reach of the collection authority of the Franchise Tax Board (FTB).
Repeal of Compact
Effective June 27, 2012, the legislation repeals the Compact,2 as well as several provisions relating to California's representation and membership in the Multistate Tax Commission (MTC). In eliminating the Compact, the legislation also clarifies that since 1993, the use of an equally - weighted three - factor apportionment formula by a multistate taxpayer has been disallowed. The Compact, which was originally ratified by California in 1974, generally requires a taxpayer to apportion its business income based on an equally - weighted three - factor formula (property, payroll and sales). For tax years beginning prior to January 1, 1993, California used the equally - weighted three - factor formula contained within the Compact and the state's tax code.3 For tax years beginning on or after January 1, 1993, California adopted a double - weighted three - factor apportionment formula (property, payroll and double - weighted sales).4 For taxable years beginning on or after January 1, 2011, certain taxpayers are allowed to make an election to use a single sales factor apportionment formula in lieu of the double - weighted three - factor apportionment formula.5 It should be noted that there are certain industry exceptions to the standard apportionment formula, including agriculture business, extractive business, savings and loan activities, and banking and financial businesses. These entities continue to use an equally - weighted three - factor formula, and are not allowed to elect single sales factor treatment.6
Pursuant to the legislature's finding and declaration contained in the bill, an election that affects the computation of tax must be made on an original timely filed return for the taxable period for which the election is to apply.7 Once the election is made, it is binding. The language of the bill adds that this doctrine of election does not constitute a change to existing law.8 Moreover, the legislation also states that the repeal of the Compact "shall not be construed to create any inference that a change in interpretation with respect to that part, or any reference to that part, prior to its repeal is implied ..."9
Definition of "State Tax Liability" Expanded
The term "state tax liability" for purposes of the issuance of an earnings withholding order by the FTB is expanded to include any liability under the corporation tax law, personal income tax law, or specified franchise and income tax provisions that are unpaid on or after June 27, 2012.10 Prior to that date, the FTB was only explicitly authorized to issue a withholding order for an amount for which the state had a state tax lien created.
Definition of "Delinquent Tax Debtor" Amended
Beginning October 25, 2012 (120 days after the June 27, 2012 enactment date), the term "delinquent tax debtor" for purposes of utilizing the Financial Institution Record Match System (FIRM),11 is expanded to include taxpayers who have outstanding liabilities owed to the California State Board of Equalization or the California Employment Development Department.12 Currently, FIRM (which is administered by the FTB) is reserved for delinquent taxpayers with debts that were due to the FTB.
To implement the new law, the Board of Equalization and the Employment Development Department will be required to provide their delinquent tax debtor information to the FTB on a quarterly basis starting on or after January 1, 2013.13 The Board of Equalization and the Employment Development Department will also be required to reimburse the FTB for their costs relating to the use of FIRM.
Even though California law generally provides that taxpayers must use a double-weighted three-factor apportionment formula, in recent years, taxpayers have argued that the Compact allows them to make an election to use an equally-weighted three-factor formula. Specifically, Article III of the Compact expressly allows taxpayers to elect to use the apportionment provisions of their state or elect to use the apportionment provisions contained in Article IV of the Compact, which provides for equally-weighted three-factor apportionment.
The legislation is, in large part, a quick attempt by the state to defensively respond to what may happen in Gillette Co. v. Franchise Tax Board, a pending case at the California Court of Appeal in San Francisco.14 The taxpayers in Gillette are arguing that an election to use an equally - weighted three - factor apportionment formula is valid, despite the California statute that specifies use of the double - weighted three - factor apportionment formula. The FTB disagrees, construing the California law enacting the double - weighted three - factor apportionment formula in 1993 to specifically override the election to use equally - weighted three factor apportionment under the Compact. If the Court of Appeal decides that the use of an equally - weighted three - factor formula is permitted, the state could be required to pay a significant amount of refunds for open tax years and absent a repeal of the Compact, the state would prospectively lose additional revenue.
By requiring that taxpayers make elections affecting the computation of tax on an original return, the legislation is preventing taxpayers from filing refund claims. Thus, taxpayers that previously filed returns using the double - weighted three - factor formula are not able to file a refund claim seeking to use an equally - weighted three - factor formula. It is rare to see a state legislature respond to an undecided tax case by enacting legislation that would effectively prevent the taxpayers in that case (and all other similarly situated taxpayers) from obtaining relief. Moreover, the provision prevents taxpayers from making any election on an amended tax return unless otherwise authorized by California law, not just an election based on the use of the Compact's apportionment method. Accordingly, taxpayers that inadvertently do not make an election on an original return may be prevented from fixing the mistake by filing an amended return.
Given the repeal of the Compact, the state effectively clarifies its position that multistate taxpayers are and were, since 1993, prohibited from using an equally - weighted three - factor apportionment formula. However, taxpayers may challenge whether California has the power to enact legislation that has the practical effect of retroactively applying back to 1993 and prohibiting refund claims. Also, in 2010, California voters approved a measure, Proposition 26, which requires two - thirds of the members of each house to approve a measure resulting in a tax increase. As neither house passed this legislation with a two - thirds vote, this legislation may be challenged by taxpayers as violative of Proposition 26.
Finally, what remains open to question is whether the Compact can survive the defection of one of its most influential members. The Compact was designed as a vehicle for uniformity between the states. Though many of the states that have adopted the Compact have changed some of their underlying allocation and apportionment provisions, California's rejection of the Compact may signal the beginning of the end for state uniformity efforts in the corporation income tax arena. This development may also change the dynamic in the MTC, as California, which was one of the MTC's most influential Compact member states, no longer has status with the MTC as a Compact member. While California may still participate in the MTC as an associate or sovereignty member, it remains to be seen whether California will continue to have a significant say on what should be contained in the MTC's model statutes and regulations, along with other MTC policy matters.
1 Ch. 37 (S.B. 1015), Laws 2012; Bill Analysis for S.B. 1015, Senate Rules Committee, June 27, 2012.
2 S.B. 1015, § 3, repealing Part 18 of Division 2 of the Revenue and Taxation Code (CAL. REV. & TAX. CODE §§ 38001 to 38021, including CAL. REV. & TAX. CODE § 38006, which contained the full text of the Compact).
3 CAL. REV. & TAX. CODE § 25128(a) as in effect for tax years beginning prior to January 1, 1993.
4 CAL. REV. & TAX. CODE § 25128(a).
5 CAL. REV. & TAX. CODE § 25128.5.
6 CAL. REV. & TAX. CODE § 25128(b), (c).
7 S.B. 1015, § 4(a). The provision specifically cites the doctrine of election as explained in Pacific Nat. Co. v. Welch, 304 U.S. 191(1938).
8 S.B. 1015, § 4(c).
9 S.B. 1015, § 5.
10 CAL. CIV. PROC. CODE § 706.010.
11 FIRM is a system of automated data exchanges that allows the state to match its list of delinquent taxpayers with lists provided by financial institutions.
12 CAL. REV. & TAX. CODE § 19266(h)(3).
13 CAL. REV. & TAX. CODE § 19266(k)(1).
14 Cal. Ct. App. No. A130803, Oral argument in this case was held on May 8, 2012, and a decision is expected next month. According to the May 2012 Franchise Tax Board Public Litigation Roster, the issues in this case are: (i) whether California's amendment of CAL. REV. & TAX. CODE § 25128 in 1993 is precluded by California's participation in the Compact, and (ii) whether California's denial of the taxpayer's claim for refund, premised on the claim that the 1993 amendment to CAL. REV. & TAX. CODE § 25128 is precluded by California's participation in the Compact, violates the U.S. and California Constitutions.
15 In the 40-member Senate, the amended legislation was approved by 24 senators. In the 80&member Assembly, the legislation was approved by 50 representatives.
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