On October 13, 2015, the U.S. Supreme Court issued a summary disposition for First Marblehead Corp. v. Commissioner of Revenue1 that granted the taxpayer's petition for certiorari, vacated the judgment, and remanded the case to the Massachusetts Supreme Judicial Court (MSJC) for further consideration in light of the U.S. Supreme Court's recent decision in Comptroller of the Treasury v. Wynne.2 In First Marblehead, the MSJC held that the fair apportionment requirement of the dormant Commerce Clause was not violated. The MSJC reached this conclusion after determining that the internal consistency test was met because the application of the apportionment statute did not actually subject the taxpayer to double taxation. Several months after First Marblehead was decided, the U.S. Supreme Court held in Wynne that the Maryland personal income tax statutes violated the internal consistency test because there hypothetically would be double taxation if each state imposed the same tax structure. In its petition for certiorari, the taxpayer in First Marblehead contended, based on Wynne, the MSJC did not correctly apply the internal consistency test.3
First Marblehead Decision
On January 28, 2015, the MSJC held, for purposes of the Massachusetts financial institution excise tax, the apportionment of income of a taxpayer that facilitated student loans did not violate the internal or external consistency tests. The taxpayer, which had its commercial domicile in Massachusetts, was essentially a holding company without employees or tangible assets that outsourced the servicing of the student loans. To apportion its income, the taxpayer used an equally-weighted formula based on property, payroll and sales factors. The loan portfolio represented substantially all of the taxpayer's property. For the 2004 through 2006 tax years at issue, the taxpayer filed a Massachusetts return reporting an apportionment percentage of one percent, which was the average of a two percent sales factor and zero percent property factor.4 For purposes of the property factor, the taxpayer assigned the loans to the location of the servicers. After the Massachusetts Appellate Tax Board determined that all of the loans should be assigned to the taxpayer's commercial domicile in Massachusetts, the taxpayer's apportionment factor rose from one percent to 51 percent, which was the average of its two percent sales factor and 100 percent property factor. The main issue of the case focused on how the taxpayer's property factor should be calculated. Specifically, the MSJC was required to determine whether the loan portfolios should be treated as being located completely or partially within Massachusetts.
The MSJC clarified that with respect to apportionment, both the U.S. Supreme Court and the MSJC have found that the Due Process and Commerce Clauses require fairness in apportioning the income of a multistate business.5 As explained by the MSJC, "[t]he first . . . component of fairness in an apportionment formula is what might be called internal consistency – that is, the formula must be such that, if applied by every jurisdiction, it would result in no more than all of the unitary business'[s] income being taxed. The second and more difficult requirement is what might be called external consistency – the factor or factors used in the apportionment formula must actually reflect a reasonable sense of how income is generated."6
In considering the internal consistency test, the MSJC summarily determined that "we have no reason to conclude that application of the apportionment statute as we have interpreted it produces duplicative taxation of [the taxpayer's] income, given that [the taxpayer's] Massachusetts apportionment percentage for the tax year at issue was approximately fifty-one per cent, and the record reflects that [the taxpayer] filed tax returns only in Massachusetts and Florida for the relevant years." In considering the "more difficult requirement" of the external consistency test, the MSJC concluded that assigning the loans to the taxpayer's commercial domicile, rather than at the place of the loan servicers, resulted in the most appropriate approximation of how the taxpayer generated income. The MSJC emphasized that the taxpayer could have, but did not request alternative apportionment under which it may have been able to obtain some relief from the statutory result. Thus, the MSJC held that the taxpayer did not meet its burden of showing that the apportionment was unreasonable or unfair.
Wynne Decision
On May 18, 2015, the U.S. Supreme Court held in Wynne that the failure of Maryland law to allow a credit against county personal income tax for Maryland residents for their passthrough income from an S corporation's out-of-state activities that was taxed by other states was unconstitutional. In affirming the judgment of the Maryland Court of Appeals by a 5-4 decision, the U.S. Supreme Court held that the Maryland tax system impermissibly exposed taxpayers to the possibility of double taxation. Also, the Maryland tax system was held to violate the fair apportionment requirement of the dormant Commerce Clause because it failed the internal consistency test. This test supported the conclusion that Maryland's tax method was inherently discriminatory and operated as a tariff.
In Wynne, the Court explained that the internal consistency test is used to identify tax systems that discriminate against interstate commerce. Specifically, the test "looks to the structure of the tax at issue to see whether its identical application by every State in the Union would place interstate commerce at a disadvantage as compared with commerce intrastate."7 The Court clarified that "[b]y hypothetically assuming that every State has the same tax structure, the internal consistency test allows courts to isolate the effect of a defendant State's tax scheme." The internal consistency test was formally introduced by the Court more than 30 years ago8 and previously had been applied in seven cases that reached the Court. In three of these cases, application of the test invalidated the tax.9
Arguments Raised in Petition for Certiorari
On May 29, 2015, the taxpayer in First Marblehead filed a petition for certiorari with the U.S. Supreme Court.10 In its petition, the taxpayer asked the Court to consider: (i) whether the MSJC followed the Court's precedents when it only considered the taxes actually paid by a taxpayer in determining that the Massachusetts statutory apportionment formula was internally consistent; and (ii) whether a factor that disregards the activities and entities involved in producing and collecting income by arbitrarily assigning income to the commercial domicile of an owner of the income-producing entities reasonably reflects how the income is generated. As discussed below, the taxpayer raised three primary arguments supporting its request that the Court consider the case.
Double Taxation
The taxpayer argued that the MSJC's opinion "gives rise to serious concerns of double taxation." Specifically, the taxpayer asserted that the MSJC "applied a test that is plainly inconsistent with both Wynne and prior decisions by [the U.S. Supreme Court] in determining that its construction of [the Massachusetts] statutes was internally consistent." As a result, the taxpayer argued that First Marblehead conflicted with the U.S. Supreme Court's cases that applied the internal consistency test. The taxpayer contended that the MSJC failed to apply the correct internal consistency test because "[i]t did not focus on the text of the statute or the structure of the tax at issue, nor did it consider what the result would be if the other states passed or applied an identical statute."
In further support of its double taxation argument, the taxpayer alleged that the apportionment formula in First Marblehead was not internally consistent. If every state applied the same apportionment formula as Massachusetts used for financial institutions, the taxpayer would be subject to state taxes on more than 100 percent of its income. Double taxation could occur in situations where a financial institution owns loans and outsources the loan servicing function. Also, based on Wynne, the taxpayer argued that the "Massachusetts property factor is tantamount to a tariff on out-of-state activities." As explained by the taxpayer, "a taxpayer that outsources the servicing of its loans to a servicer outside of its commercial domicile would be subject to higher taxes in the aggregate than a taxpayer that uses a servicer located in the taxing jurisdiction."
External Consistency
The taxpayer also argued that the apportionment formula violated the external consistency test because it "captures tax revenues rightly belonging to other jurisdictions." As discussed above, the external consistency test requires that "the factor or factors used in the apportionment formula must actually reflect a reasonable sense of how income is generated."11 Under this test, an examination must be made of "the instate business activity which trigger[ed] the taxable event."12 The taxable event in this case was the receipt of interest payments by the trusts that owned the loans. A portion of this interest income was allocated to the taxpayer. According to the taxpayer, there was no connection between its activities in Massachusetts and the way that the income was generated. Thus, the taxpayer concluded that Massachusetts impermissibly taxed income that should have been taxed by other states.
Implications of Decision
Finally, the taxpayer contended that the First Marblehead decision has broad implications because "[i]t authoritatively established the law in Massachusetts both as to the construction of the property factor provisions in [the Massachusetts financial institution excise tax apportionment statute] and as to the constitutionality of those provisions, as so construed." Also, the taxpayer argued that the decision may be considered as a model for applying the similar provisions that have been enacted by more than 20 other states.13 Furthermore, the taxpayer explained that "the constitutional analysis adopted by the [Massachusetts] Supreme Judicial Court is not limited to the treatment of loans for property factor purposes or to the taxation of financial institutions." The taxpayer argued that "the court's departure from the established precedents governing the application of the internal consistency test" may invite "other courts to disregard the analysis required" by the U.S. Supreme Court's decisions such as Wynne.
Massachusetts Department of Revenue's Response
In its response to the taxpayer's brief requesting U.S. Supreme Court action, the Massachusetts Department of Revenue stated that the MSJC "correctly articulated the internal consistency and external consistency tests."14 After acknowledging that the MSJC did not perform the hypothetical analysis under the internal consistency test, the Department argued that the apportionment statutes satisfy both tests. According to the Department, the apportionment provisions meet the internal consistency test because if they hypothetically were adopted by every state, the taxpayer's income would not be double taxed. The Department also argued that the apportionment provisions satisfied the external consistency test because the taxpayer failed to show that the income attributed to Massachusetts was out of proportion to the business that it transacted in the state. In response to an amicus brief requesting that the U.S. Supreme Court grant certiorari, vacate the judgment, and remand the case for reconsideration,15 the Department argued that there was no intervening change in law and a remand to the MSJC would not change the outcome of the litigation. Finally, the Department argued that the U.S. Supreme Court reaffirmed rather than changed the internal consistency test in Wynne.
Taxpayer's Reply Brief
In response to the Department's arguments, the taxpayer argued in its reply brief that: (i) the Department's concession that the MSJC failed to apply the U.S. Supreme Court's precedents was sufficient to justify a remand on the internal consistency issue; (ii) there was no reason to disregard the MSJC's erroneous analysis of the internal consistency test; and (iii) the Massachusetts tax statutes as construed by the MSJC were not externally consistent.16
Commentary
The U.S. Supreme Court's action of granting certiorari, vacating the judgment, and remanding the case for further consideration in light of Wynne is a significant and relatively rare development. Because this was a summary disposition, the Court did not explain the reasons for its action. However, there is a basis for inferring that the Court was not satisfied with the internal consistency analysis performed by the MSJC. As acknowledged by the Department, the MSJC did not consider whether the hypothetical adoption of the same law by all of the states would violate internal consistency. The MSJC addressed internal consistency, but its analysis was cursory. Presumably, on remand, the MSJC will perform a more robust internal consistency analysis by considering the hypothetical adoption of the apportionment statute by all states.
Although First Marblehead concerned the Massachusetts financial institution excise tax and the proper location of loans that were outsourced from an apportionment standpoint, the case could have much broader implications. The proper application of the internal consistency test applies to the numerous states that impose income taxes. The fact that the Court decided to grant certiorari, vacate and remand this case may be interpreted as a reaffirmation that state courts must correctly apply the internal consistency test, and a reminder that the external consistency test must be followed as well. The Court's action in First Marblehead may encourage other taxpayers to seek review of decisions where courts did not properly apply the internal consistency test. Further, the Court's decision highlights the uncertain, yet conceivably far-reaching implications of Wynne outside the state and local individual income tax context.
Footnotes
1 23 N.E.3d 892 (Mass. 2015).
2 U.S. Supreme Court, Docket No. 14-1422, Oct. 13, 2015. For a discussion of Comptroller of the Treasury v. Wynne, 135 S. Ct. 1787 (2015), see GT SALT Alert: U.S. Supreme Court Holds Lack of County Personal Income Tax Credit for Taxes Paid to Other States Violates Commerce Clause.
3 Note that there are two taxpayers in this case. The focus of the case was the financial institution excise tax liability of a taxpayer (Gate Holdings, Inc.) that was a wholly-owned subsidiary of the other taxpayer (First Marblehead Corporation) during the relevant tax years. The summary of this case primarily concerns the first taxpayer. The subsidiary was sold by the parent following the tax years at issue in this litigation.
4 Because the taxpayer did not have a payroll factor, its tax apportionment formula was the average of its sales and property factors.
5 First Marblehead, 23 N.E.3d 892, citing Container Corp. v. Franchise Tax Board, 463 U.S. 159 (1983); Exxon Corp. v. Department of Revenue, 447 U.S. 207 (1980); Gillette Co. v. Commissioner of Revenue, 683 N.E.2d 270 (Mass. 1997).
6 First Marblehead, 23 N.E.3d 892, citing Gillette Co. 683 N.E.2d 270, quoting Container Corp., 463 U.S. 159.
7 Wynne, 135 S. Ct. 1787, citing Oklahoma Tax Comm'n v. Jefferson Lines, Inc., 514 U.S. 175 (1995).
8 Container Corp., 463 U.S. 159.
9 See American Trucking Assns., Inc. v. Michigan Pub. Serv. Comm'n, 545 U.S. 429 (2005); Jefferson Lines, Inc., 514 U.S. 175; Goldberg v. Sweet, 488 U.S. 252 (1989); American Trucking Assns., Inc. v. Scheiner, 483 U.S. 266 (1987); Tyler Pipe Industries v. Department of Revenue, 483 U.S. 232 (1987); Armco, Inc. v. Hardesty, 467 U.S. 638 (1984); Container Corp., 463 U.S. 159.
10 Petition for Writ of Certiorari, First Marble Corp. v. Commissioner of Revenue, U.S. Supreme Court, Docket No. 14-1422, filed May 29, 2015.
11 Container Corp., 463 U.S. 159.
12 Goldberg, 488 U.S. 252.
13 The taxpayer's petition notes that the Massachusetts apportionment provisions for financial institutions are based on a formula recommended by the Multistate Tax Commission in 1994
14 On Petition for Writ of Certiorari to the Supreme Judicial Court of the Commonwealth of Massachusetts, First Marblehead Corp. v. Commissioner of Revenue, U.S. Supreme Court, Docket No. 14- 1422, filed Sep. 9, 2015.
15 On July 2, 2015, the Tax Executives Institute (TEI) filed an amicus curiae brief with the U.S. Supreme Court that supported the taxpayer's petition. In that brief, TEI argued that the U.S. Supreme Court should grant certiorari, vacate the MSJC's decision and remand the action back to the MSJC for further consideration. TEI stated that such an action is appropriate to provide state courts with the opportunity to consider decisions that are later issued by the U.S. Supreme Court, and that this action was appropriate here in light of Wynne's conception of the internal consistency test, and the MSJC's failure to conduct the Wynne internal consistency analysis. Brief for Tax Executives Institute, Inc., as Amicus Curiae in Support of Petitioners, First Marblehead Corp. v. Commissioner of Revenue, U.S. Supreme Court, Docket No. 14-1422, filed July 2, 2015.
16 Reply Brief, First Marblehead Corp. v. Commissioner of Revenue, U.S. Supreme Court, Docket No. 14- 1422, filed Sep. 18, 2015.
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