Alternative apportionment is essentially a statutorily created tool that allows a taxpayer (or taxing authority) to deviate from the statutory apportionment methodology when that formula fails to fairly reflect a taxpayer’s business activity in a state. Many states offer alternative apportionment provisions based on the Uniform Division of Income for Tax Purposes Act, subsection 18, model law. Although alternative apportionment is available to both states and taxpayers, in recent years, states have become more active in employing an alternative methodology, especially considering the trend of states adopting single sales factor apportionment. Following that trend, South Carolina has not shied away from utilizing alternative apportionment methodologies.
Background
On Oct. 26, 2016, the South Carolina Court of Appeals issued its decision in Rent-A-Center West, Inc. v. Dep’t of Revenue, reversing the Administrative Law Court’s decision, and finding that the South Carolina Department of Revenue did not meet its burden in proving that the state’s apportionment formula fairly represented the taxpayer’s business activity in the state.
The taxpayer, a wholly-owned subsidiary of a rent-to-own business, owns and operates its parent’s intellectual property in South Carolina and operates retail stores in various western states. The taxpayer did not operate any retail stores in South Carolina during the periods at issue.
The department audited the taxpayer’s corporate income tax returns for the years 2003, 2004, and 2005 tax periods, taking the position that the taxpayer’s use of the three-factor apportionment formula did not fairly represent the taxpayer’s business activities in the state. The department utilized an alternative apportionment method based on the taxpayer’s royalty agreement resulting in a tax liability of over $200,000, including penalties and interest. Prior to a requested hearing, the taxpayer amended its corporate income tax returns, changing the three-factor apportionment formula to a single sales factor apportionment as permitted by statute, resulting in an additional tax liability of $1,326 to the taxpayer’s original filing.
On appeal to the administrative law court, the department argued that the taxpayer diluted the gross receipts ratio by including its retail sales in the denominator because the taxpayer’s only activity in South Carolina was the licensing of the intellectual property. The administrative law court ultimately found in favor of the department, determining that the taxpayer’s apportionment formula did not fairly represent its business activity in the state and that the department’s alternative was reasonable.
The taxpayer was granted a stay at the South Carolina Court of Appeals until a decision was issued in CarMax Auto Superstores West Coast Inc. v. South Carolina Department of Revenue, a 2014 alternative apportionment decision where the South Carolina Supreme Court found the burden of proof for alternative apportionment is on the party requesting the alternative method.
Opinion
In reversing the administrative law court’s determination, the South Carolina Court of Appeals relied upon CarMax, finding that the department did not meet its burden. According to CarMax, in order to deviate from an apportionment formula, the proponent of the apportionment adjustment must prove by a preponderance of the evidence, that the statutory formula did not fairly represent the taxpayer’s business activity and that the proponent’s alternative accounting method is reasonable. In CarMax, the court concluded that the department failed to meet its burden because it did not point to any evidence showing that the standard apportionment method did not fairly represent the taxpayer’s business activities.
In this case, the court similarly found the department failed to meet its burden because it presented the same level of evidence as it did in CarMax. According to the department auditor, the investigation began because the taxpayer’s parent was comprised of multiple entities and the auditor believed that management service fees were too high. A department expert witness testified that excluding the taxpayer’s retail operations from the calculations was essential to come up with the correct tax burden. The central concern for the court, however, was that neither the auditor nor the expert was able to point out any specific evidence that the standard apportionment method used by the taxpayer did not fairly represent its business activities in the state. The court agreed that because a small amount of the taxpayer’s business came from royalties, that business should be reflected in a small amount of its taxes.
Takeaway
Guided by the state’s Supreme Court decision in CarMax, the South Carolina Court of Appeals reinforced that the burden to establish alternative apportionment is on the party moving to deviate from the standard statutory method. In order to meet that burden, the party must provide sufficient evidence to show that the statutory method does not fairly reflect the taxpayer’s business activity.
Given these recent decisions, South Carolina taxpayers should be encouraged that the department needs more than “bald assertions” to change a taxpayer's apportionment methodology. Accordingly, the party moving for a change in standard apportionment must show that 1) the statutory formula does not fairly represent the taxpayer’s business activity and 2) the alternative method is reasonable. However, taxpayers should be cautious when applying alternative apportionment formulas because that same burden applies to taxpayers, as well as the department, looking to deviate from the standard methodology.
Finally, while not cited in Rent-A-Center, taxpayers should consider reviewing South Carolina Revenue Ruling #15-5, published after the CarMax decision, and providing guidance on the use of alternative apportionment methods, including combined unitary reporting. Taxpayers considering alternative apportionment or who have been subject to alternative apportionment by the department should contact their tax advisers to discuss the impacts of CarMax, Rent-A-Center, and Revenue Ruling #15-5.
