What’s the Option? We’re all still waiting for a final decision in Gillette.¹ In the meantime, taxpayers have an option for the returns due this fall. They may compute their apportionment using one of the following two methods:

• Default method. For most taxpayers, this is a sales-factor-only method, with market-based sourcing for sales of services and intangibles.²
• Compact method. This is the method available under the Multistate Tax Compact. It is a three-factor method with a single-weighted sales factor; the sales factor uses a cost-of-performance sourcing rule for sales other than sales of tangible personal property.³

In our view, as discussed in this alert, most taxpayers who want to make the Compact election should strongly consider doing so on their 2013 original return—even though the FTB may assert LCUP penalties if Gillette loses its case. Why? Because we believe it would be difficult for the FTB to sustain those penalties.

Why is there still an option? In Gillette, a California Court of Appeal held that the Multistate Tax Compact allows taxpayers an option to apportion income using an equally-weighted three-factor apportionment formula. Under that formula, receipts from services and intangibles are sourced based on costs-of-performance. In the middle of the Gillette litigation, the Legislature attempted to repeal the Compact—but it did so by majority vote only. (Senate Bill 1015). This legislation is clearly a tax increase under California law, since it would raise taxes for all taxpayers who prefer the Compact method. And any legislative tax increases in California require a two-thirds supermajority of both houses, which SB 1015 lacks. Because SB 1015 was unlawfully enacted, the Compact election is still valid.

In 2012, California voters passed Proposition 39, which changed the default apportionment method to the single-sales-factor method. Proposition 39 did not repeal the Compact election. So if the California Supreme Court sustains Gillette, the Compact election is still available.

The 20% LCUP penalty dilemma. In addition to the purported repeal of the Compact election, Senate Bill 1015 also provided that “an election affecting computation of tax must be made on an original timely filed return for the taxable period for which the election is to apply and once made is binding.”⁴ It is less clear whether this election provision is an unlawful tax increase under California law. If it is legal, taxpayers would need to make the Compact election on an original return.

But what if the Compact election is ultimately invalidated? Would taxpayers be subject to the 20% strict liability large corporate understatement penalty (LCUP)?⁵ The LCUP applies to taxpayers with an understatement of both $1 million and 20% as shown on an original return. For many corporations, this penalty is often a deterrent to taking positions on an original return. But the language of the LCUP statute suggests that taxpayers who elect the Compact method would not be penalized. Section 19138(f)(1) provides that no “penalty shall be imposed…on any understatement to the extent that the understatement is attributable to a change in law that…becomes final after the earlier of…” the date the taxpayer files its return or the extended due date for filing. And “change in law” includes “an interpretation of law or rule of law by…a published federal or California court decision.” The FTB must “implement this [exception] in a reasonable manner.”⁶ So even if the Gillette decision is ultimately overturned, taxpayers who elect the Compact before the date it is overturned should be covered by this exception. As we discussed before, taxpayers must be able to rely on the latest statement of the law by a Court of Appeal. Thus, we believe the LCUP should not apply to taxpayers electing the Compact method.

What do I do? If making the Compact election won’t trigger a 20% or $1 million understatement, the solution is easy: elect the Compact method on the return you file this fall. But if electing the Compact method would potentially subject you to the LCUP, the question is harder. Each corporation should consider: (1) the likelihood of Gillette being reversed; and (2) the potential of being subject to the LCUP, balanced against the risk that the “doctrine of election” prohibits an election on an amended return.

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Should you have questions about the Gillette case or California apportionment in general, please contact the authors of this alert, or the Reed Smith lawyer with whom you usually work. For more information on Reed Smith’s California tax practice, visit California State Tax.

About Reed Smith State Tax Reed Smith’s state and local tax practice is comprised of more than 30 lawyers across seven offices nationwide.  The practice focuses on state and local audit defense and refund appeals (from the administrative level through the appellate courts), as well as planning and transactional matters involving income, franchise, unclaimed property, sales and use, and property tax issues. Click here to view our State Tax team.

1. The Gillette Company & Subs. v. California Franchise Tax Board, CA. Ct. App., 1st Dist, Dkt. No. A130803; appeal from SF Sup. Ct. Dkt. No. CGC-10-495911.
2. Cal. Rev. & Tax Code § 25128.5. If an apportioning trade or business derives more than 50 percent of its “gross business receipts” from an agricultural, extractive, savings & loan or banking or financial business activity, an equally weighted three-factor formula of property, payroll and sales is to be utilized to apportion income. Cal. Rev. & Tax. Code § 25128.
3. Cal. Rev. & Tax Code § 38006 (the compact method).
4. SB 1015, Sec. 4.
5. Cal. Rev. & Tax. Code § 19138.
6. Cal. Rev. & Tax. Code § 19138(f)(3).

Client Alert 2014-220