Recent Changes in California Apportionment
During 2012 some very significant developments emerged in California that will impact California corporations that operate in other states and out-of-state corporations that operate in California. These recent decisions impact how taxable income (or losses) are apportioned for California corporate income tax purposes.
Income apportionment determines the ratio of income that is subject to tax in a particular state. There are several different methods used to determine state apportionment and acceptable methods for determining apportionment vary by the applicable state law. The acceptable methods have changed numerous times over the past couple of years in California due to a law change beginning with the 2011 tax year, the recent court decision in the Gillette Case and the passage of Proposition 39 in November 2012. Click here for a reference chart showing the different apportionment formulas referred to in this article.
Prior to 2011, companies were required by California to determine their taxable income using a four-factor apportionment. Four factor apportionment takes into consideration the proportion of payroll, property and sales that can be sourced to California. Sales are then double-weighted, representing the fourth factor, and a percentage is calculated. This percentage is then applied to total taxable income to determine state taxable income.
Beginning in tax year 2011 and continuing for tax year 2012, most multi-state business were permitted to elect to calculate their California apportionment using a single sales factor or the four-factor apportionment. The single sales factor method calculated a percentage based on California sales over total sales. This percentage was then applied to total taxable income to determine state taxable income. This provided businesses a benefit of selecting the most favorable method. The apportionment election is made on an original, timely filed return and is irrevocable. Therefore, a corporation can calculate taxable income using both apportionment factors and elect to use the method that is most favorable. Although the election is irrevocable once made for a particular tax year, it is an annual election so a different method could be used each year.
In July 2012 the California Court of Appeal handed down a decision in the Gillette Case. The Gillette Case arose because The Gillette Company argued that since California was a part of the Multi-state Tax Compact (MTC), California was obligated to offer a choice between three-factor and four-factor apportionment. The MTC is a cooperative effort among state governments to ease the tax burden of multi-state enterprises and the states that are a part of it are assumed to offer three-factor apportionment. Three-factor apportionment differs from four-factor because sales are only weighted once. In response to the suit, California moved to remove itself from the MTC. The court originally sided with Gillette but has since indicated that it will revisit this case. The implications of the uncertainty surrounding the Gillette case are that if the ruling is upheld, many corporations may be permitted to amend prior returns electing to use the three-factor method. Multi-state taxpayers may file a protective claim in order to retroactively elect to utilize the apportionment method contained in the MTC. The Franchise Tax Board has released instructions on how to properly file a protective claim and any corporation that thinks that they may benefit from three-factor apportionment for tax years still open for amendment under statute should consider doing this until further guidance on the issue is decided. As it stands currently, taxpayers have the option of using four-factor or single sales factor apportionment for the 2012 tax year.
Yet more changes were put into place for tax year 2013 when Proposition 39 was passed in November 2012 by the California electorate. Prop 39 mandates that all businesses use single sales factor apportionment and changes certain definitions when it comes to defining how sales are sourced from California. This mandatory change of method will cause higher taxes for business with little California property or payroll but high California sales and lower taxes for those corporations with large payroll and property but low sales. The law will likely result in higher taxes for out-of-state corporations conducting business in California, which was the intent of the law.
This issue will have relevance to a corporation that has a significant business presence in another state — an office, property, employees or sales to customers. It may be necessary and beneficial for a corporation to track where its resources are allocated so it can be in compliance and assure that it is not paying unnecessary taxes to California. Please contact LMGW should you have any questions about navigating state apportionment issues or other state tax issues.
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