On December 31, 2015, the California Supreme Court issued its long-awaited opinion in Gillette Co., et al. v. Franchise Tax Board, 363 P.3d 94, addressing whether The Gillette Company and several other California corporate taxpayers (collectively, “Gillette”) were permitted to elect to use the Multistate Tax Compact’s evenly-weighted, three-factor apportionment formula comprised of property, payroll, and sales factors (“MTC Formula”) in lieu of the three-factor apportionment formula with a double-weighted sales factor (i.e., property, payroll, and double-weighted sales factors) subsequently enacted by the state (“Double-weighted Sales Formula”) in 1993. The California Supreme Court held that the California legislature not only had the power to override the Compact election contained in the California statutes, but that it also intentionally exercised that power when it statutorily mandated the use of the Double-weighted Sales Formula. This holding would result in a denial of the taxpayers’ refund claims of approximately $34 million, which were premised on the election and application of the MTC Formula to their franchise tax returns filed between 1993 and 2005.
The court’s decision unanimously reversed the Court of Appeal’s holding that California’s adoption of the Compact, which provided taxpayers with the ability to elect to use the MTC Formula, superseded the subsequent implementation of the Double-weighted Sales Formula. The Court of Appeal’s decision was based on its finding that the Compact was a valid, enforceable interstate compact, i.e., a binding contract between member states that ceded sovereignty over the covered subject matters. Accordingly, the Court of Appeal elevated the Compact over unilateral state legislation such as California’s adoption of the Double-weighted Sales Formula and further held that the attempt to remove the option to elect the MTC Formula would be in violation of the federal and state Contract Clauses, forbidding enactment of state laws impairing contractual obligations, and the Reenactment Rule of the California Constitution, providing that “[a] section of a statute may not be amended unless the section is reenacted as amended.”
When is a Compact not a compact?
The California Supreme Court’s reversal of the Court of Appeal appears to be the natural result of a fundamental disagreement over the nature of the Compact. Unlike the Court of Appeal, the California Supreme Court found that Compact was not a binding, reciprocal agreement. In making its determination, the court, at the urging of the Multistate Tax Commission (“Commission”) that was created by the Compact, applied a test derived from Northeast Bancorp v. Board of Governors, FRS, 472 US 159 (1985), to determine whether the Compact was a binding compact or merely a model uniform law. The Northeast Bancorp test examines the following factors to determine whether a compact exists: (i) whether a joint organization was formed to regulate the subject matter; (ii) whether there was conditional consent by member states which prevented member states from unilaterally modifying or repealing their law; and, most importantly, (iii) whether reciprocal obligations between member states were created. The court found that none of these factors were present, and that the Compact was not a binding, interstate compact.
As for the first factor, the court found that, although the Compact established the Commission, the Commission was not a joint regulatory organization because it “…has no authority ordinarily associated with a regulatory organization.” The court agreed with the Commission’s characterization of its powers as being “strictly limited to an advisory and informational role” and noted that “[t]he Commission simply has no binding regulatory authority upon member states. Whatever power the Commission has to promulgate regulations or conduct audits exists solely at the pleasure of each member state.”
With respect to the second factor, the court found that the effectiveness of the Compact did not depend on the conduct of other members, because any state may join the Compact by enacting its provisions into law and may unilaterally decide to leave the Compact without notice. In further support of its finding that the Compact did not prohibit unilateral state action, the court noted the fact that the Commission continued to recognize Florida as a member in good standing of the Compact and the Commission even after Florida unilaterally eliminated certain Compact articles from its statutes.
In its review of the third and most important factor of the Northeast Bancorp test, the court found that reciprocal obligations did not exist as a result of the Compact, as the availability of the MTC Formula election provision in a state benefited taxpayers regardless of whether the taxpayer is from a member or nonmember state. The court’s conclusion was supported by Gillette’s admission “…that ‘party states do not perform or deliver obligations to one [another]’ and ‘have no incentive to enforce the Compact,’ which ‘is not the type of contract where the parties exchange obligations and are in a meaningful position to gauge each other’s compliance.’” Ultimately, the Compact was deemed to be “more akin to the adoption of a model law rather than the creation of any mutual obligations among compact members.”
Because none of the indicia of the Northeast Bancorp test existed, the Compact election adopted in the California statutes was merely state law subject to change at the legislature’s discretion, not a binding, interstate compact that should be elevated over subsequent state legislation, such as California’s adoption of the Double-weighted Sales Formula. As the Compact was not a contract, presumably the federal and state Contract Clauses were not violated by the adoption of the Double-weighted Sales Formula, though this point was not specifically addressed by the court. The court did address the Reenactment Rule and found that the statutory language implementing the Double-weighted Sales Formula did not violate the Reenactment Rule because it expressly referenced the Compact, which was “strong evidence that the Legislature acted with the Compact in mind.”
If the Compact isn’t a compact in California, is it a compact anywhere?
Taxpayers have made similar Compact election arguments in several other states, namely Michigan, Minnesota, Oregon, and Texas, and it remains to be seen how the litigation in those states will be impacted by the California Supreme Court’s decision in Gillette, which is the first state supreme court to directly address the nature of the Compact. (N.B.: Although the Michigan Supreme Court previously ruled on the availability of the Compact election in International Business Machines Corp. v. Dept. of Treasury, 496 Mich. 642 (2014), the nature of the Compact was not specifically addressed. In an unusual turn of events involving retroactive legislation, the Michigan Supreme Court could potentially revisit the MTC Formula election issue later this year. For previous updates regarding Compact litigation, please refer to prior Tax News and Development article, Multistate Tax Compact Litigation: 3-Factor Apportionment Election Update, published in October 2015 and available under publications at www.bakermckenzie.com.)
The California Supreme Court’s decision could influence how other states view the Compact, but it is quite possible that other states view the Compact differently, perhaps in line with the California Court of Appeal. If there was a disagreement among the states as to the nature and effect of the Compact, the US Supreme Court could be more inclined to grant certiorari, if Gillette appeals to the US Supreme Court, as expected. Even if there was not a split among the states on this issue, the US Supreme Court could plausibly grant certiorari on one of the several federal questions surrounding the nature and effect of the Compact. If the US Supreme Court denies certiorari, Gillette will be the end of the road for taxpayers with California Compact Election cases, but it is fair to say that it will not be the end of Compact election drama in other states.
This article was originally published in the February 2016 edition of Tax News and Developments (Volume XIV, Issue 1) and is available under insights at www.bakermckenize.com.
