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Canadian Companies May be Entitled to California Income Tax Refunds - by John S. Lee and Colin Webster  

Global Tax Adviser

 

August 07, 2012

 

John S. Lee and Colin Webster
Montreal, U.S. Corporate Tax

 

Canadian companies doing business in California may be entitled to tax refunds following a recent court decision in that state. The California Court of Appeal issued a decision on July 24, 2012 in The Gillette Co., et al. v. Franchise Tax Board that invalidates California’s requirement for taxpayers to double-weight the proportion of in-state sales in computing California taxable income. If this ruling stands, many California taxpayers may be entitled to significant refunds. [Note that, in a somewhat unusual procedural move, the California Court of Appeal has now vacated its decision. For details see, Global Tax Adviser article, "Gillette Take Two - U.S. Appeals Court to Reconsider California Income Tax Refund Decision"].

It is expected that the state will request review by the California Supreme Court. This will be the final level of review and, should review be granted, the decision should be published within one year.

 

Taxpayers should consider filing protective refund claims for any tax years that may become statute-barred during the course of judicial review of this case. Taxpayers should also consider making an election to use the single-weighted sales factor for any 2011 returns that have not yet been filed.

 

Background 
As with many states, California determines the amount of a taxpayer`s taxable income apportioned to the state by a combination of the proportion of property, payroll and sales a business has in the state. Prior to 1993, the total apportionment percentage was a simple average of these three factors. In 1993, California amended its apportionment statutes such that the sales factor was required to be double-weighted. Effectively, the apportionment factor became the average of four ratios: property, payroll, sales and sales.

 

This change significantly increased the apportionment, and therefore amount of tax paid, by many out-of-state taxpayers, who will generally have property and payroll factors that are small, or even zero. For example, an out-of-state taxpayer with no California property or payroll and 12% of its sales in the state would see its apportionment jump from 4% ((0+0+12)/3) to 8% ((0+0+12+12)/4), and its tax liability double. While the original, simple average apportionment formula was enacted as part of California’s entry into the Multistate Tax Compact (the Compact), the modified apportionment formula was adopted unilaterally by California.

 

Court of Appeal’s ruling 
The Court of Appeal, overturning the decision at the trial court level, found that while California could unilaterally withdraw from the Compact completely by repealing the enacting legislation, it did not do so. The Compact, as is the case with other multi-state agreements, is enacted in the law of the signatory states. Thus it plays two roles: as an enforceable contract between the states and as a statute with legal standing in each state. While the statute enacting the double-weighted sales formula refers to the original statute providing for uniform apportionment factors amongst the signatory states of the Compact, it leaves untouched the contract itself.

 

Within the Compact, a provision states that taxpayers may electively use either the apportionment method in the Compact itself, or the apportionment method in state statute. The taxpayers filed for refunds based upon this provision, electing to use the single-weighted sales factor for apportionment as per the Compact.

 

Although California believed that the plain language in the amended statute in effect repealed the option for taxpayers to use the Compact method of apportionment, the court disagreed. The Court of Appeal, reversing the trial court’s decision, held that the Compact remained in force in its role as a contract and that California did not have the right to interfere with it under the Contract Clause of the U.S. Constitution. 

 

State reaction
California enacted legislation repealing the Compact effective June 27, 2012. In an attempt to proactively deny refund claims via amended returns, the legislation provided that all elections regarding apportionment can only be made on original, timely filed returns. There are questions regarding the validity of this legislation (it passed with a simple majority rather than the 2/3 required for any tax raising measure) but if it stands, then the election to use the single sales factor in the California apportionment will be valid only through the effective date of June 27, and only on originally filed returns.

 

For more information, contact your KPMG adviser.

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