United States: Did You Make The Multistate Tax Compact Apportionment Election In California? Watch Out For Penalties

On December 31, 2015, the California Supreme Court ruled against the taxpayer in The Gillette Company v. Franchise Tax Board.1 The United States Supreme Court denied review of Gillette on October 11, 2016. Thus, Gillette is final. With this finality, the Franchise Tax Board issued FTB Notice 2016-03, which explains its plan for taxpayers that made the Multistate Tax Compact apportionment election. That plan includes the possibility of penalties for taxpayers that made the election on an original return. Before paying any penalties—or any tax for that matter—we recommend reading the following.

Gillette involved the question of whether taxpayers could elect to use the method of apportionment prescribed by the Multistate Tax Compact instead of California's standard corporate apportionment formula2. Under the "Compact method," a taxpayer was permitted to apportion income using an equally weighted, three-factor formula composed of property, payroll, and sales. In contrast, under California's standard corporate apportionment formula, income was apportioned using a formula in which the property and payroll factors each comprised 25%, and the sales factor made up the other 50%. Thus, the Compact method typically helped out-of-state taxpayers by allowing them to place more weight on their property and payroll—inputs that were typically located largely in states other than California.

In July 2012, a California Court of Appeal held that taxpayers could elect the Compact method.3 Just prior to that decision, the California Legislature passed Senate Bill 1015. That Bill purported to do two things: (1) it eliminated the Compact election and (2) it adopted the "Doctrine of Election," which would require taxpayers to make elections, like the Compact election, on an original return. The adoption of the "Doctrine of Election" had no effect on California's penalty regime, which still included the strict liability Large Corporate Understatement Penalty (LCUP). Shortly after the adoption of Senate Bill 1015, Brian W. Toman, of Reed Smith, wrote a letter to the Franchise Tax Board (the "FTB") explaining that the Doctrine of Election, when coupled with the LCUP, placed taxpayers between a rock and a hard place. A taxpayer making the Compact election on an original return would face penalties, including the LCUP, but a taxpayer that did not make the Compact election on its original return would be forever barred from making the election as part of an amended return under the Doctrine of Election. In the letter, Toman also argued that the LCUP should not apply to taxpayers that made the Compact election on an original return in reliance on the Court of Appeal's opinion in Gillette, because any reversal of the Court of Appeal's decision would trigger the change in law exception to the LCUP.

Having little choice, many taxpayers made the Compact election as part of a refund claim. Many others made the Compact election on their original returns in reliance on the Court of Appeal decision in Gillette. Ultimately, of course, the California Supreme Court overturned the Court of Appeal's decision in Gillette, and the U.S. Supreme Court has now denied review.

In early November 2016, in the wake of the denial of certiorari, the FTB issued Notice 2016-03. That notice described the FTB's plans for handling taxpayers who made the Compact election on either an original return or as part of a refund claims. In the notice, the FTB noted that any pending refund claims on the Compact election issue will be denied. But the notice included a statement that "[p]enalties will be imposed as appropriate on a case-by-case basis." This vague statement is troubling because the Legislature had essentially given taxpayers two unattractive options: (1) making the Compact election on an original return and facing potential penalties, or (2) forfeiting the right to make a timely Compact election. And now, in Notice 2016-03, the FTB has indicated that these taxpayers who made the Compact election on an original return in reliance on the Court of Appeal's decision in Gillette may still be penalized.

Our view continues to be that the LCUP penalty should not apply because of the "change in law" exception that we discussed in our letter to the FTB.

Taxpayers that made the Compact election on an original return in reliance on the Court of Appeal's decision in Gillette should not be subject to other California penalties, in addition to the LCUP. Many California penalties—including the accuracy-related penalty—are subject to a reasonable-cause exception. In this instance, the complexity of the law and the reliance on a Court of Appeal opinion should support a finding of reasonable cause. Thus, taxpayers that made the Compact election on an original return in reliance on the Court of Appeal's decision in Gillette should be protesting any penalties assessed.

According to the Notice, taxpayers that made the Gillette election on an original return should soon be receiving Notices of Proposed Assessment ("NPA"). We ask any taxpayer receiving a Gillette-related NPA to consider the consequences of their response, even if the NPA does not indicate any penalty amount.

If your NPA includes a penalty, we suggest you consider protesting the penalty.

If your NPA does not include a penalty, remember that many California penalties, including the LCUP, are not assessed until the taxpayer receives a bill. Therefore, even if your NPA does not contain any penalties, we suggest a review of your circumstances to ensure no penalty will be imposed.

Reed Smith's team of lawyers is available to discuss the best course of action in dealing with the FTB's response to the finality of the Gillette decision. For more information, contact the authors of this Alert or another member of the Reed Smith State Tax Group.


1 62 Cal.4th 468 (2015).

2 Revenue and Taxation Code § 25128.

3 The Gillette Company v. Franchise Tax Board, 209 Cal.App.4th 938 (2012).

This article is presented for informational purposes only and is not intended to constitute legal advice.

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