Minnesota allows including net income in sourcing FEC gains

The Minnesota Supreme Court upheld a lower court decision determining that the Minnesota Commissioner of Revenue properly used alternative apportionment to source gains from forward exchange contracts (FECs) used to manage currency fluctuations. Finding that the standard apportionment formula that would have allowed the inclusion of gross receipts from the FEC transactions in the sales factor did not fairly reflect taxable net income allocable to Minnesota, the Court concluded that the Commissioner’s alternative of including net income from the FEC transactions was appropriate.¹

Facts and procedural history

The taxpayer, a major science and technology company based in Delaware, had operations in approximately 90 countries worldwide during the 2013-2015 tax years at issue. At all relevant times, the taxpayer conducted significant international operations resulting in many currency transactions from international sales, purchases, investments, and borrowings, including numerous subsidiaries engaged in business with foreign customers. For U.S. financial reporting purposes, the taxpayer was required to report its global earnings in U.S. dollars, although it received payment for the sale of goods in foreign currencies. The taxpayer adopted a risk management policy that bought and sold FECs to offset its aggregate or net exposure from business transactions in the corresponding currency pairings. None of the FECs was conducted in Minnesota during the years at issue.

Under the standard apportionment methodology, the taxpayer included the FEC gross receipts in the sales factor denominator, as the sales occurred in the ordinary course of business.² The FEC gross receipts as a percentage of the taxpayer’s total gross receipts ranged between 70.94% and 73.66% in the tax years at issue, and since the receipts were sourced outside Minnesota, this resulted in substantial dilution to the sales factor percentage. The Commissioner disagreed with this treatment and decided to assert alternative apportionment³ under which it included only the net income from the FEC transactions in the apportionment formula. Because the net receipts as a percentage of the taxpayer’s total income ranged between 0.48% to 4.49%, this treatment resulted in a significantly larger Minnesota apportionment factor even though none of these receipts were sourced to Minnesota. The Commissioner’s treatment resulted in a tax assessment of nearly $11.5 million. The taxpayer appealed the Commissioner’s assessment to the Minnesota Tax Court.

Minnesota Tax Court decision

The Minnesota Tax Court held that the Commissioner met his burden of proving that the general apportionment method did not fairly or accurately reflect all the taxpayer’s taxable net income allocable to Minnesota.⁴ The Tax Court relied on California precedents in which the transactions at issue were reviewed to determine whether they were qualitatively different from the taxpayer’s main business, and if inclusion of the gross receipts resulted in substantial quantitative distortion.⁵

From a qualitative perspective, the Tax Court ruled that the purposes of the FEC transactions were to protect the taxpayer’s earnings and provide visibility to investors regarding the taxpayer’s true operating performance independent of currency fluctuations. As the activities were not undertaken for an independent profit-oriented purpose, they were different from the taxpayer’s pure operating activities as a science and technology company. The Tax Court determined that from a quantitative perspective, since the FEC transactions produced a small percentage of its total income, but generated a very large percentage of its gross receipts, that constituted quantitative distortion in the apportionment formula.

Finally, the Tax Court considered whether the Department’s use of an alternative formula that used a net income rather than gross receipts inclusion in the sales factor fairly reflected the taxpayer’s activities in the state. In ruling that the Department’s alternative formula was appropriate, the Tax Court concluded that such formula maintained a connection between the FEC transactions and the apportionment formula, without overwhelming the sales factor denominator calculation, and ensured that the taxpayer’s apportionment of income was fair across all the states in which the taxpayer was doing business.

Consideration of taxpayer’s arguments at the Minnesota Supreme Court

The Minnesota Supreme Court first considered the taxpayer’s argument that from a factual perspective, its gross receipts from FEC operations were earned in the ordinary course of its business, and as such were a part of the taxpayer’s core business. While that may have been the case, the Court agreed with the Tax Court’s view that the taxpayer’s FEC transactions were qualitatively different from the taxpayer’s other business activities as reflected in a joint stipulation of facts. Specifically, the FEC transactions were oriented toward risk management and were different than the listed activities in the joint stipulation which included a variety of diverse operational markets. The Court also noted that the task of protecting outstanding earnings was not tied to creating incidental profit, the taxpayer’s profitability goals, or the profitability of other sectors.

In addition, the Court rejected the taxpayer’s argument that its FEC transactions created profit and hence constituted a profit center. In addressing this issue, the Court noted that even though a certain level of profit was generated by the FEC transactions, the purpose of these transactions was not focused on profitability but instead was designed to serve a purpose qualitatively different than the profit motive evident in its operational markets.

The Court then turned to the taxpayer’s legal arguments, first by reviewing whether the Tax Court had impermissibly created two categories of income in its separation of FEC transactions from other business activities. The Court disagreed with this conception, noting that the dispute in question related to whether an alternative apportionment provision could be utilized by the Commissioner, not the application of the general sales factor statute in which gross receipts typically are not treated differently unless specifically excluded from the sales factor calculation. The Court found that the Commissioner was within his rights to use a net income inclusion rather than gross receipts in fashioning alternative apportionment.⁶

The taxpayer next challenged the Commissioner’s finding of alternative apportionment on the basis that it failed to analyze whether the taxpayer’s sales factor was allocable to Minnesota pursuant to statute. The Court focused on the fact that the Commissioner did not have to examine whether sales were supposed to be included in the numerator of the Minnesota sales factor. Rather, the Commissioner needed to (and was able to) demonstrate that the taxpayer’s gross receipts were qualitatively different than its other sales, and quantitative distortion resulted from such inclusion in the denominator of the Minnesota sales factor. In reaching this conclusion, the Court emphasized that a determination on whether alternative apportionment is appropriate must be done on a case-by-case basis, as no bright-line test has been created to determine what is considered substantial evidence showing a fair reflection of allocable income.

Finally, the Court considered the taxpayer’s allegation that the Commissioner had argued the final apportionment percentage was too low, rather than the fact that the general apportionment method did not fairly reflect the taxpayer’s Minnesota-allocated income. Finding that this argument did not fairly characterize the Commissioner’s position, the Court viewed the controversy as one where the ability to use the general apportionment method in this instance was at issue, and involved consideration of both qualitative and quantitative factors. Having determined that the Commissioner properly challenged the use of the general apportionment formula and met the burden of proof that the use of the alternative formula was proper, the Court concluded in favor of the Commissioner.