United States: Tennessee Trial Court Approves Variance Requiring Telecommunications Company To Use Market-Based Sourcing

A Tennessee chancery court 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 According to the court, 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.


The taxpayer was a telecommunications company based in California that held a 45 percent interest in a partnership (Cellco) that operated a telecommunications business known as Verizon Wireless. During the relevant years, Verizon Wireless engaged in the wireless voice and data business in Tennessee and contracted with customers with billing addresses in the state. 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 return, 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 Department on that issue, the taxpayer commenced litigation, and subsequently filed an amended complaint in which the taxpayer argued for the first time that as an alternative to a complete refund on the grounds that the taxpayer had no nexus in Tennessee, 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. A trial was held to determine whether the Commissioner properly issued the apportionment variance.

Tennessee's Apportionment Methodology

Tennessee follows the traditional apportionment methodology provided by the Uniform Division for Income Tax Purposes Act (UDITPA) and the Multistate Tax Commission's (MTC) corresponding regulations. Under Tennessee law, sales, other than sales of tangible personal 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 costs of performance.3 However, 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.4 A regulation explains that the variance statute will "permit a departure from the allocation and apportionment provisions only in limited and specific cases."5 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."6

Commissioner Properly Required Variance

In determining that the Commissioner did not abuse his discretion in requiring the alternative apportionment methodology, the trial court explained that the Commissioner's statutory and regulatory authority to issue variances is both narrow and discretionary.7 Once the Commissioner uses his narrow discretion to determine that the standard formula does not accurately reflect the taxpayer's income in the state, the Commissioner has broader authority in choosing an alternative apportionment method.

The trial court noted that the Commissioner issued a variance after examining the taxpayer's decision to change from the PPU method it had previously used in Tennessee to the COP method. According to the court, this was an unusual factual situation specific to the taxpayer, in which the change in method would have resulted in a substantial amount of reduction in the Tennessee sales factor. Therefore, the court held that it was reasonable for the Commissioner to conclude that the COP method did not fairly reflect the extent of the taxpayer's business activity in the state. The Commissioner's issuance of the variance was reasonable and not an abuse of discretion.

In reaching its decision, the court determined that "the Commissioner has not yet issued additional variances that would begin to show a trend toward a general application of his rationale to other companies that generate receipts in Tennessee, but incur most of their costs elsewhere." The court explained that the fact the Commissioner's rationale could be applied broadly to other companies and industries did not invalidate the variance for two basic reasons. First, the variance at issue only applied to the taxpayer. If the Commissioner begins to issue variances for other companies using the same rationale, these decisions would need to be reviewed on a case-by-case basis and the court would need to consider if there were a pattern. Second, as explained by the Tennessee Court of Appeals in BellSouth Advertising & Publishing Corp. v. Chumley, another case allowing the Commissioner to impose an apportionment variance, the statutory COP formula "did not function very well for certain types of businesses."8 Thus, the Commissioner may properly consider certain types of businesses for an apportionment variance.

The trial court also held that the Commissioner's decision to use the PPU approach was reasonable. After the Commissioner properly exercised his narrow discretion to issue a variance, he had broad authority to change the apportionment formula. The Court concluded that the Commissioner reacted to the taxpayer's "limited and specific" situation. According to the court, this case presented an unusual situation due to the taxpayer's ownership structure, tax history in the state and the fact that a substantial portion of the previously taxable income would no longer be taxed under the COP method. Therefore, the court determined that the Commissioner's decision to issue the variance was supported by the Tennessee statutes and regulations because this was an unusual case.


While many states have sought to enact market-based sourcing statutes,9 and the MTC is considering adopting a market-based sourcing approach by making substantial revisions to UDITPA and the MTC's corresponding regulations, Tennessee continues to use a COP methodology pursuant to statute and has not formally enacted market-based sourcing to date. However, this decision appears to be representative of an increasing resistance to the use of COP when such method results in the sourcing of receipts outside of a particular state. This is not the first reported instance of the Tennessee Commissioner utilizing alternative apportionment to reach such a result. As noted in the opinion, the Commissioner was allowed to require market-based sourcing in the BellSouth case that was issued in 2009. The court implicitly warned that "[i]f the Commissioner begin[s] to issue variances that apply to other companies using the same rationale, those decisions will have to be viewed on a case-by-case basis in light of a pattern that can be brought to a court's attention."

Although it is true that the instant case was unusual because the taxpayer used marketbased sourcing and then changed to COP, the Commissioner seems to be favoring the use of market-based sourcing in cases where most of the costs are incurred outside Tennessee. If the facts were different and the taxpayer actually performed a preponderance of its costs in Tennessee, query whether the court would have supported a request from the taxpayer for alternative apportionment to use market-based sourcing instead of COP as a means to lower the taxpayer's Tennessee sales factor.

Also, it was unclear in the court's decision as to whether the parties considered COP sourcing on a transaction-by-transaction basis, rather than broadly looking at costs of the entire operation. Perhaps the transactional approach could have resulted in a sourcing result that both the Commissioner and the taxpayer could have accepted without resorting to litigation.

Finally, if the result in this litigation is ultimately upheld, it will be interesting to see how this decision impacts the taxpayer's apportionment positions in other states that have similar UDITPA provisions statutorily requiring COP sourcing, given that the taxpayer's sales factor methodology may have changed in these jurisdictions (and may now be subject to challenge).


1 Vodafone Americas Holdings, Inc. v. Roberts, Tennessee Chancery Court, 20th Judicial District, Davidson County, No. 07-1860-IV, March 19, 2013.

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 taxed in Tennessee or any other state.

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

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

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

6 Id.

7 The court 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.

8 308 S.W.3d 350 (Tenn. Ct. App. 2009), leave to appeal denied, Tenn. Supreme Court, March 1, 2010.

9 For example, Alabama, Arizona, California, Illinois, Maine, Michigan, Nebraska, Oklahoma, Utah and Wisconsin have adopted market-based sourcing fairly recently, and New Jersey has promulgated regulations that would adopt market-based sourcing despite its current statute in which COP sourcing is implied.

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