United States: Tennessee Supreme Court Upholds Commissioner-Imposed Variance Requiring Use Of Market-Based Sourcing

The Tennessee Supreme Court recently upheld the authority of the Tennessee Commissioner of Revenue to require an alternative method of apportionment when the statutory cost-of-performance (COP) method did not fairly represent the extent of a taxpayer's business activity in the state.¹ The imposed variance required a telecommunications company to source its receipts using a market-based approach.

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. Under the COP method, the majority of the costs associated with its wireless services were incurred in New Jersey. Thus, 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 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, which held in a split decision that the Commissioner properly issued a variance requiring the taxpayer to apportion sales using market-based sourcing based on a customer's billing address rather than the statutory COP method.⁵ 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. 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.⁶ Notably, the dissent believed that the Commissioner's authority to issue a variance was limited by the Department's regulations and that issuance of the variance had exceeded his authority.

On appeal, the taxpayer asked the Tennessee Supreme Court to address the following issues: (i) whether the Commissioner abused his discretion by imposing a variance requiring the use of a sourcing methodology directly contrary to the statutory COP method; (ii) whether the Commissioner abused his discretion by imposing a variance in complete absence of the "unusual circumstances" and "incongruous result" demanded by law; and (iii) whether the Commissioner violated the separation of powers required by the Constitution by imposing a variance in circumstances where application of the franchise and excise tax apportionment statutes reached the precise result the legislature intended when adopting those statutes.⁷ Because the third issue had not been raised at the trial court level, the Court considered only whether the Commissioner's imposition of a variance was an abuse of discretion.

Tennessee's Apportionment Methodology

For the tax years at issue, Tennessee followed 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.⁸ Under Tennessee law, sales, other than sales of tangible property, are in the state if the earnings-producing activity is performed (i) in the state or (ii) both within and outside the state and a greater proportion of the activity is performed in Tennessee, based on COP.⁹ 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.¹⁰ A regulation explains that the variance statute will "permit a departure from the allocation and apportionment provisions only in limited and specific cases."¹¹ 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."¹²

Commissioner's Imposition of Variance Not Abuse of Discretion

Apportionment and Variance Statutes and Regulations

The Tennessee Supreme Court first examined the history of Tennessee's relevant franchise and excise tax statutes and regulations. Notably, Tennessee's original tax variance statute only allowed the Commissioner to issue a variance at the request of the taxpayer. With Tennessee's 1976 repeal of this statute and concurrent adoption of UDITPA, including its Section 18 variance provision,¹³ the Commissioner gained authority to impose a variance on a taxpayer.¹⁴ Also, the Commissioner gained authorization to issue a variance if UDITPA's allocation and apportionment provisions do not fairly represent a taxpayer's business activities in the state. Such variance can be required with respect to all or any part of the taxpayer's business activity. When a variance is warranted, the statute authorizes the Commissioner to require a variance by employing one of four alternatives, if reasonable: (i) separate accounting; (ii) the exclusion of one or more statutory factors; (iii) the addition of one or more factors that would fairly represent the taxpayer's business activity in the state; or (iv) any other method that would effectuate an equitable solution and apportionment of the taxpayer's income.¹⁵ In 1977, Tennessee promulgated the regulation described above permitting a variance departing from the allocation and apportionment provisions only in limited and specific cases, where "unusual fact situations (which ordinarily will be unique and nonrecurring) produce incongruous results . . .."¹⁶

In 1999, the Tennessee legislature adopted a new, non-uniform provision not contained in UDITPA, authorizing the Commissioner to use "any other method to source receipts for purposes of the receipts factor" in the numerator of the apportionment formula.¹⁷ Pursuant to the legislative history, the change was intended to broaden the Commissioner's authority to issue a variance in order to prevent companies from shifting income out of Tennessee.

Based on these rules, the Court clarified that the threshold inquiry under the variance statute is whether the standard statutory tax apportionment provisions do not fairly represent the extent of the taxpayer's business activity in the state. If that threshold is met, then whether the alternate formula selected by the Commissioner in the variance is "reasonable" must be considered.

Fair Reflection of Income

First, the Court determined that the Commissioner did not abuse his discretion by concluding that the use of the statutory apportionment formula did not result in a fair representation of the taxpayer's business activity in Tennessee. Specifically, the taxpayer's argument that the Commissioner's variance was contrary to the intent of the legislature was rejected on the grounds that the legislature expressly granted the Commissioner the right to issue variances in cases in which the statutory apportionment formula did not fairly reflect the taxpayer's business activity in the state. The Court commented that this argument was circular because the legislature both prescribed a statutory apportionment formula and granted the Commissioner the ability to issue variances from that formula in certain cases. Also, the Court noted that the taxpayer's argument that the mathematical result of applying the statutory formula necessarily fairly reflected its income would result in the Commissioner effectively not having the authority to issue variances in any case.

Notably, the Court referenced another case in which a similar argument was rejected by the Court of Appeals. Specifically, in BellSouth Advertising & Publishing Corp. v. Chumley,¹⁸ the Court of Appeals noted that the legislature, in enacting the variance statute, was aware that statutory formulas sometimes "just do not work," and held that the Commissioner's imposition of a variance in such an instance was not an abuse of discretion. In the present case, the Court noted that the taxpayer's receipts for telecommunications services for Tennessee customers totalled over $1.3 billion. If the taxpayer were permitted to apply its requested COP method as advocated, its sales factor would be reduced to approximately $150 million, leaving billions of dollars in revenue from Tennessee customers invisible for tax purposes under the statutory formula. As explained by the Court, "[i]t is difficult to imagine a more extreme example of a situation in which application of the statutory apportionment formula does not 'fairly represent the extent of the taxpayer's business activity in this state.'"

Reasonableness of Proposed Variance

After determining that the statutory apportionment formula did not result in a fair representation of the taxpayer's Tennessee business activity, the Court addressed whether the alternate formula selected by the Commissioner in the variance was "reasonable."¹⁹ Citing the Commissioner's original finding, the Court found that the alternate formula was reasonable because it was the formula the taxpayer originally used on its returns and because it treated as Tennessee receipts the payments made by Tennessee customers for wireless services. The Court also noted that the taxpayer did not present much argument over whether the alternate formula was reasonable, focusing instead on whether the Commissioner had the power to issue a variance at all. Importantly, the Court considered whether the Commissioner's variance was consistent with the UDITPA goal of taxing no more or less than 100 percent of the taxpayer's income. In this instance, adopting the taxpayer's proposed apportionment method would result in its Tennessee receipts becoming "nowhere income" not taxed by any jurisdiction. On the other hand, the Court noted that the Commissioner's method proposed no danger of double taxation. Therefore, the variance was consistent with UDITPA goals because it did not result in double taxation and prevented nowhere income.

Limitations Imposed by Variance Regulation

With respect to the pertinent regulatory language allowing a departure from the statutory apportionment formula "only in limited and specific cases . . . where unusual fact situations . . . produce incongruous results,"²⁰ the Court considered the taxpayer's argument that imposition of the variance exceeded these prescribed limits. Specifically, the taxpayer contended that the subject variance is in essence imposed on the entire telecommunications industry. Rejecting this argument, the Court found that the Commissioner may exercise his discretion to impose a variance for an individual taxpayer even in a recurring situation, so long as the standard methodology or formula does not fairly reflect that taxpayer's business activity in the state. Further, the Commissioner then has the option of following this action with efforts to promulgate regulations or statutory modifications if necessary. Therefore, the Court found that the variance imposed did not violate the regulatory limits.

Within Range of Acceptable Alternatives

Finally, the Court considered whether the variance imposed was within the range of acceptable alternatives available to the Commissioner, given the facts and circumstances. The taxpayer received substantial receipts from Tennessee customers, and the statutory apportionment formula, as reflected in its refund request, would leave it "reaping millions of dollars in receipts from doing business in Tennessee while paying no tax for the privilege of doing so." Alternatively, the imposed variance would not subject the taxpayer to taxation on more or less than 100 percent of its receipts from Tennessee customers.

Therefore, the Court agreed with the conclusions reached by both the trial court and Court of Appeals that the Commissioner did not abuse his discretion by imposing the variance on the taxpayer for the relevant period. Specifically, the Court concluded that the taxpayer did not meet its burden of proving that the Commissioner's exercise of his variance authority amounted to an abuse of discretion.

Commentary

The Tennessee Supreme Court seemed very concerned about the concept of nowhere income in this decision. Given the legislative history surrounding Tennessee's efforts to prevent income shifting out of state, and the significant dollar amount involved, it is not surprising that the state disagreed with Vodafone's attempted sourcing of its Tennessee receipts to New Jersey. It is worth noting that Vodafone's primary argument was that it should have been sourcing its Tennessee sales using the state's statutory apportionment formula all along. Seemingly because this resulted in less income being apportioned to Tennessee than another method, the Commissioner rejected the statutory method and issued a variance. The decision could embolden the Department to continue using its power of discretionary authority. Conversely, taxpayers with significant Tennessee property and payroll could challenge COP sourcing and request a variance using market-based sourcing based on similar arguments.

Taxpayers in cases in which the statutory formula results in less income being sourced to Tennessee than another apportionment method should be wary of the potential impact of this decision. In such cases, the only thing preventing the state from requiring the use of the apportionment method that sources the most income to the state is the requirement that variances be issued only in limited and specific cases. It remains to be seen how narrowly Tennessee courts will construe that limitation on the use of variances, especially in light of recent legislative changes.

Notably, for tax years beginning on or after July 1, 2016, Tennessee replaces the COP method for sourcing sales other than sales of tangible personal property with a market-based sourcing method.²¹ Also, a special sourcing provision applies to certain qualified telecommunications companies that are members of a qualified group.²² For such taxpayers, total receipts in Tennessee equal the receipts from all sales of tangible personal property sourced to the state under the standard apportionment provisions plus the average of the receipts from all sales other than tangible personal property that are in Tennessee determined under each of the following alternative methods: (i) all sales sourced to Tennessee under the new market-based sourcing provisions; and (ii) all sales sourced to Tennessee based on COP.²³ Interestingly, to be subject to the telecommunications sourcing provision, a taxpayer must meet a rather significant revenue threshold. By adopting this legislation, Tennessee joined the ranks of many other states in adopting market-based sourcing rules for sales other than sales of tangible personal property.²⁴ The Tennessee market-based sourcing provisions differ from the statutes in other states because they allow taxpayers to elect to use the COP method if it results in a higher apportionment factor than market-based sourcing.

Tennessee's adoption of market-based sourcing and special apportionment rules for telecommunications companies seems especially fitting in light of this decision and the similar BellSouth Advertising & Publishing Corp. v. Chumley²⁵ decision in which the Commissioner had been issuing variances requiring the use of market-based sourcing rather than the statutory COP method. Time will tell whether these newly adopted rules will result in more variances being issued by the Commissioner and even more controversies regarding sales factor apportionment methodology.

Footnotes

1 Vodafone Americas Holding, Inc. v. Roberts, Tennessee Supreme Court, No. M2013-00947-SC-R11- CV, March 23, 2016.

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 Vodafone Americas Holdings Inc. v. Roberts, Tennessee Court of Appeals, No. M2013-00947-COAR3- CV, June 23, 2014; leave to appeal granted, Tennessee Supreme Court, Nov. 20, 2014. For a discussion of this case, see GT SALT Alert: Tennessee Court of Appeals Affirms Variance Requiring Telecommunications Company to Use Market-Based Sourcing.

6 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, Tennessee 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.

7 Specifically, Vodafone argued that: (i) the Tennessee franchise and excise tax statutes mandate that the receipts from its wireless telecommunications services be sourced by the statutory COP methodology and there is a strong presumption in favor of the standard apportionment formula; (ii) the Commissioner has only limited authority to impose a variance, which it exceeded in this case by imposing a variance requiring use of the market-based sourcing method used in the taxpayer's originally filed returns; (iii) the Department's own regulations circumscribe the Commissioner's authority to impose a variance, allowing imposition only in "limited and specific cases," to address "incongruous results" not intended by the legislature, that arise out of "unusual fact situations" that are unique to the taxpayer and nonrecurring; and (iv) the variance issued contravenes the legislature's authority to enact laws and impose taxes and allowing the variance would create chaos for taxpayers who rely upon the predictability of the franchise and excise tax statutes.

8 In 2015, Tennessee enacted legislation making major changes to its apportionment provisions, including the adoption of market-based sourcing for sales of other than tangible personal property for tax years beginning on or after July 1, 2016. Also, the new law adds specific apportionment provisions applicable to telecommunications companies. H.B. 644, Laws 2015. For a discussion of this legislation, see GT SALT Alert: Tennessee Enacts Major Legislation Expanding Nexus, Adopting Market-Based Sourcing.

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

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

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

12 Id.

13 Section 18, Uniform Division of Income for Tax Purposes Act.

14 TENN. CODE ANN. §§ 67-2723; 67-2918.

15 Id.

16 TENN. COMP. R. & REGS. 1320-06-01-.35(1)(a)(4).

17 TENN. CODE ANN. §§ 67-4-2014(a)(4); 67-4-2112(a)(4).

18 308 S.W.3d 350 (Tenn. Ct. App. 2009), leave to appeal denied, Tennessee Supreme Court, March 1, 2010.

19 TENN. CODE ANN. §§ 67-4-2014(a); 67-4-2112(a).

20 TENN. COMP. R. & REGS. 1320-06-01-.35(1)(a)(4).

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

22 TENN. CODE ANN. §§ 67-4-2012(j); 67-4-2111(j). This special provision applies to a qualified group member that is principally engaged in the sale of telecommunications, mobile telecommunications service, Internet access service, video programming service, direct-to-home satellite television programming service, or a combination of services, as each term is used or defined for sales and use tax purposes. "Qualified group" means an affiliated group that meets both of the following criteria: (i) one or more of the members of the group is a qualified member; and (ii) the members of the group either (a) incur aggregate, qualified expenditures exceeding $150 million; or (b) make sales that are subject to sales and use tax in excess of $150 million.

23 TENN. CODE ANN. §§ 67-4-2012(j)(1); 67-4-2111(j)(1).

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

25 308 S.W.3d 350 (Tenn. Ct. App. 2009), leave to appeal denied, Tenn. Supreme Court, March 1, 2010.

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