There is a robust body of judicial and administrative decisions in California that focus on whether the statutory apportionment formula is distortive. California tribunals oftentimes use a two prong analysis to analyze distortion. First, the tribunals look to the qualitative connection between activities that have “a direct profit-making purpose” and the activities reflected in the apportionment factors.⁵ Second, and to a lesser degree, California tribunals look to whether the disparate activities are quantitatively different and whether this difference confirms the qualitative distortion.

A formula may be qualitatively distortive if it is dominated by a “particular function or activity [that] is qualitatively different from the taxpayer’s principal business.”⁶ Likewise, the reverse is also true—a formula may be distortive if the formula entirely ignores a “particular function or activity that is qualitatively”⁷ essential to the taxpayer’s principal business. For example, California’s statutory apportionment formula, as applied to manufacturers, completely discounts the contribution of individuals engaged in designing, engineering, manufacturing, and marketing of products, and also completely discounts the contribution of research facilities, manufacturing plants, and marketing operations. Under California case law, the apportionment formula may exclude activities that “play only a supportive function” to a taxpayer’s business.⁸ But no one could possibly argue that research, manufacturing, and marketing functions “play only a supporting function” in the business of a manufacturer. Unlike a treasury function, it is implausible that research, manufacturing, and marketing functions are “only incidental to the principal corporate business purposes” of a manufacturer.⁹ And unlike a hedging function, the functions of research, manufacturing, and marketing not only support a manufacturer’s “main business,” they are a manufacturer’s main business.¹⁰

While a quantitative distortion analysis is largely unnecessary once the qualitative distortion threshold is satisfied,¹¹ some California tribunals may require a taxpayer to demonstrate quantitative distortion as a means to confirm qualitative distortion. This analysis largely compares and contrasts the impact between using the standard versus proposed alternative apportionment formulas. For some context, California courts have found that a percentage change in apportionment formula between the statutory and proposed alternative ranging from 3.6 percent to 24 percentage was substantial enough to justify the application of CRTC section 25137.¹² With the right set of facts, a typical manufacturer may meet the California statutory threshold for alternative apportionment.

CRTC 25137 Petition Process

The CRTC 25137 Petition process is complex, to say the least. While this alert discusses the CRTC 25137 Petition process at a high level, it is important to note that there are taxpayer-specific considerations that must be evaluated while a CRTC 25137 Petition moves through the various stages at the FTB.

A taxpayer may file a CRTC 25137 Petition prior to filing an original return, with an amended return or refund claim, or while defending an audit or engaged in a protest. However, the petition must be filed at a time that the statute of limitations for the tax year at issue remains open. In our recent experience, the FTB is typically unwilling to consider distortion claims at the protest or audit stage if a taxpayer has not gone through the CRTC 25137 Petition process first.

Once a CRTC 25137 Petition is submitted, it is reviewed by FTB staff, in either the Audit or Legal Division. However, the three-member board (“the Board”) “may elect to hear and decide petitions filed pursuant to Section 25137 instead of having this function performed by the [FTB] staff.”¹³ In its review of a CRTC 25137 Petition, the FTB staff may prepare an initial written recommendation, which will include whether the reviewer agrees or disagrees with taxpayer’s petition, and the taxpayer is given the opportunity to respond in the event of a recommendation to deny a petition. Further, FTB Notice 2017-05 provides a taxpayer with the opportunity to make an oral presentation before an FTB committee (the “25137 Committee”).¹⁴ This committee is comprised of FTB attorneys, including the Assistant Chief Counsel and Deputy Chief Counsel for Multistate.¹⁵

The 25137 Committee reviews the written submissions and oral presentations (if applicable) and issues a written decision to either uphold or overturn the recommendation of the FTB staff. If the 25137 Committee denies a taxpayer’s CRTC 25137 Petition, the taxpayer may appeal to the Board for a full hearing. Such matters before the Board are public and a taxpayer must file a waiver of confidentially.

Board hearings for a CRTC 25137 Petition are rare (there have been three in the last 20 years). However, in March of 2021, Smithfield Package Meats Corporation (“Smithfield”) appealed a denial by the 25137 Committee to the Board. Smithfield petitioned the Board to utilize an equally-weighted property, payroll, and sales apportionment formula for 2014 through 2017, arguing the statutory single-sales factor apportionment distorts its business activity in the state. Smithfield is the world's largest pork processor and hog producer with four key business segments under a single corporate umbrella: (1) Hog Production, (2) Fresh Pork, (3) Packaged Meats, and (4) International.¹⁶ Smithfield argued its out-of-state activities, specifically the production activities, were ignored under the single-sales factor apportionment. As a result, the single-sales factor formula overstated Smithfield’s California business activity by focusing solely on the California marketplace and thus did not fairly represent Smithfield's business activities in California.¹⁷ The Board ultimately denied Smithfield’s petition.¹⁸ Smithfield filed a complaint in Los Angeles County Superior Court on October 27, 2021 suing the FTB for a refund¹⁹ on the grounds that it is an agricultural business under CRTC 25128 required to use three-factor apportionment, and, alternatively, that use of single-sales factor apportionment creates impermissible distortion warranting relief under CRTC 25137.

Was single-sales factor validly enacted?

While Smithfield’s complaint argues that the single-sales factor apportionment, as applied to Smithfield, requires the use of an alternative apportionment formula, the taxpayer in One Technologies v. FTB case is arguing that the enabling proposition for mandatory single-sales factor is invalid under the California Constitution.²⁰ One Technologies, a Texas-based technology company, filed a complaint in Los Angeles Superior Court challenging the validity of Proposition 39 (Prop 39) – the 2012 ballot measure that enacted a mandatory single-sales factor and market-based sourcing in California. At the heart of the challenge is the way Prop 39 was presented on the ballot. Specifically, One Technologies argues that Prop 39 contained three, distinct elements: (1) single-sales factor apportionment and market-based sourcing; (2) a special reduced sales factor for cable companies; and (3) an earmark of funds for clean energy projects. This, according to One Technologies, violates the single-subject rule of the California Constitution.²¹ That rule provides that any “initiative measure embracing more than one subject may not be submitted to the electors or have any effect.”²² Thus, because Prop 39 had three elements, where possibly one or more of the elements are unrelated, One Technologies argues the proposition is invalid.

If One Technologies ultimately prevails with its lawsuit and Prop 39 is struck down, One Technologies argues that it should be allowed to apportion its income using the pre-2013 statutory apportionment formula. That formula was composed of single-weighted payroll and property factors and a double-weighted sales factor with cost-of-performance sourcing for sales of other than tangible personal property.²³

On November 10, 2021, the court granted the FTB’s demurrer, noting that “the initiative power must be liberally construed to promote the democratic process.”²⁴ However, One Technologies will likely appeal the decision and any potential resolution on the constitutional issue raised by One Technologies may take several years.

Considerations and practical next steps

Between Smithfield and One Technologies, as well as numerous taxpayer-initiated CRTC 25137 Petitions, California’s single-sales factor apportionment formula, especially as applied to taxpayers in capital or labor intensive industries, like manufacturing, appears to be on shaky ground. Taxpayers that may benefit from a three-factor apportionment formula should consider filing protective refund claims and/or a CRTC 25137 Petition before the statute of limitations period for any tax year lapses. This opportunity applies largely to taxpayers with substantial payroll and property located outside of California.

Taxpayers that could benefit from this opportunity should do the following:

• File protective claims and CRTC 25137 Petitions. A refund claim form and CRTC 25137 Petition is available for download here.
• Keep your Gillette Multistate Tax Compact claims and protests alive. Many taxpayers still have pending refund claims claiming the right to use the Multistate Tax Compact three-factor apportionment formula, based on the California Court of Appeal decision in Gillette, or protests of proposed assessments resulting from taking the Multistate Tax Compact election on their originally filed returns. Although the California Supreme Court ultimately reversed the California Court of Appeal decision in Gillette, the theories outlined above provide alternative rationales that could support these claims and/or protests. Thus, if you have a Gillette claim or protest outstanding, you should keep it alive and raise these additional arguments entitled taxpayers to three-factor apportionment formula while the CRTC section 25137 and Prop 39 litigation continue.

1. Container Corp. v. Franchise Tax Board, 463 U.S. 159, 183 (1983).
2. Cal. Rev. & Tax Code § 25137.
3.  See, e.g., Microsoft Corp. v. Franchise Tax Board, 39 Cal. 4th 750, 765–772 (2006)(discussing the general intent of section 25137 to correct “distortions”).
4. Transcript of the Testimony of former FTB Chief of Multistate Benjamin Miller in the Trial of General Mills, Inc. v. Franchise Tax Board, San Francisco Superior Court, No. 439929 at 467.
5. General Mills, Inc. v. Franchise Tax Board, 208 Cal. App. 4th 1290, 1300 (2012).
6. General Mills, 208 Cal. App. 4th at 1301. Cf Appeal of Oscar Enterprises L.T.D., 1987 Cal. Tax LEXIS 22 (1987) (property in standard formula excludible if taxpayer had no property used in the production of income) and State of Georgia v. Coca Cola Bottling Co. 212 Ga. 630 (1956) (apportionment must include factors causally related to the production of the income). See also Appeal of Putnam Fund Distributors, Inc., 1977 Cal. Tax LEXIS 2 (1977) and Appeal of John Blair & Co., 1965 Cal. Tax LEXIS 42 (1965) (items in factor must correlate with income in base).
7. General Mills, 208 Cal. App. 4th at 1301
8. General Mills, 208 Cal. App. 4th at 1305.
9. General Mills, 208 Cal. App. 4th at 1306.
10. General Mills, 208 Cal. App. 4th at 1307.
11. See General Mills, 208 Cal. App. 4th at 1301. (The Court of Appeal noted that the quantitative and qualitative tests are not separate tests, “but rather the discussion concerns both effects” and “[t]he ultimate goal is assessing whether the standard formula fairly represents the company’s business activity in California.”). See also Appeal of Crisa Corporation, Cal. St. Bd. of Equal., June 20, 2002. (The State Board of Equalization stated that the qualitative differences are shown by various quantitative measures and that therefore are not two separate tests).
12. See General Mills, Cal. App. 4th at 1312 and Square D. v. Franchise Tax Board, CGC 05-442465 (Cal. Sup. Ct. Apr. 11, 2007).
13. Cal. Code Regs. § 25137(d). However, as a condition to having such petition considered by the Board, the petitioning taxpayer must waive in writing the confidentiality provisions of Section 19542 with respect to such petition and to any other facts which may be deemed relevant in making a determination. Cal. Code Regs. § 25137(d).
14. FTB Notice 2017-05 (Oct. 19, 2017).
15. FTB Summary of First Interested Parties Meeting, Reg. 25137 (June 30, 2017).
16. Section 25137 Petition of Smithfield Package Meats Corporation, FTB Opening Brief, p. 3 (Jun. 20, 2020).
17. Transcript of statement by Derick Brennan of PricewaterhouseCoopers for Smithfield at FTB Public Meeting, March 4, 2021 at p. 78.
18. FTB Board voted to deny Smithfield’s CRTC 25137 Petition on March 4, 2021.
19. Notably, during the hearing, a member of the Board recommended Smithfield pursue other remedial measures. (Transcript of comments of Member Vasquez of the Franchise Tax Board at the FTB Public Meeting, March 4, 2021 at p. 151. (“And it’s my understanding, at the end of the day, the petitioner still has other avenues to appeal this.”) Member Vasquez, FTB Public Meeting, March 4, 2021 - Transcript page 151.).
20. One Technologies LLC v. Franchise Tax Board, Cal. Super. Ct., 21STCV21844, complaint for refund of taxes 6/11/21.
21.  Cal. Const. Art. II, § 8(d).
22. Cal. Const. Art. II, § 8(d).
23. See Cal. Rev. Tax. Code § 25128.5 (eff. 1/1/2011 to 12/31/2012).
24. Defendant Franchise Tax Board’s Demurrer to Plaintiff’s Complaint For Refund of Taxes, Tentative Order (Nov. 10, 2011).

In-depth 2022-005