A California trial court has held that a taxpayer engaged in an agricultural business was entitled to use an equally-weighted three-factor apportionment formula instead of a single sales factor formula. In doing so, the court invalidated a California Franchise Tax Board (FTB) regulation that was inconsistent with the governing statute authorizing the use of the three-factor formula. Further, the court found that the taxpayer was entitled to alternative apportionment even if it did not qualify as an agricultural business, as the taxpayer was able to show that the single sales factor formula produced a distortive and unfair result.1
Facts and background
The taxpayer, an affiliated group (Smithfield), is engaged in the business of hog farming, and harvests hogs into a variety of pork products (including fresh pork and packaged meats). Smithfield’s business of farming, harvesting and packaging is intertwined, with its agricultural activities significantly supporting its ability to develop fresh pork and packaged meat.
As an example of the extent of Smithfield’s agricultural activities, for the 2014 tax year, approximately 61.34% of Smithfield’s overall gross receipts arose from agricultural activities. During the tax years at issue, Smithfield had minimal physical presence in California as measured by property and payroll, with a more significant percentage of sales sourced to California based on the location of its customers.
The disparity between Smithfield’s in-state physical presence and the location of its customer base led to the litigation at issue. For California corporation franchise tax purposes, most businesses are required to apportion their income to California via a single sales factor.2
In contrast, certain industry-specific businesses are required to apportion their income to California via an equally-weighted three-factor formula consisting of payroll, property and sales.3 Under statute, agricultural businesses, one of these specifically enumerated industries, are required to use the three-factor formula when they derive more than 50% of their gross business receipts from conducting an agricultural business activity.4
Ability to use three-factor formula
The court determined that Smithfield qualified as an agricultural business entitled to use the three-factor formula instead of a single sales factor. In reaching this decision, the court noted the broad nature of the statutory term “agricultural business activity.” This definition includes “activities relating to any stock . . . [and] includes activities relating to cultivating the soil or raising or harvesting any agricultural or horticultural commodity, including, but not limited to, the raising, shearing, feeding, caring for, training, or management of animals on a farm.”5
The court found that the application of the statute to Smithfield was consistent with the intent of the statute to provide agricultural businesses with a three-factor formula. Specifically, this intent was to require businesses whose operations are geographically constrained to reflect their physical presence in the apportionment factor used to calculate their tax liability through a three-factor formula.
Further, the Court observed the legislature’s intent in providing a three-factor formula was not to penalize businesses without a feasible choice in establishing their physical operations.6 At trial, Smithfield presented extensive expert testimony indicating key reasons why its operations were tied to the Midwest and Eastern states (primarily driven by feed costs and suboptimal weather for raising hogs) instead of California.
Next, the court concluded that Smithfield derived more than 50% of its revenue from agricultural business activity. Smithfield engaged in raising, feeding, caring and managing animals on its farms, and engaged in hog production activities because those activities related to stock.7 Finally, Smithfield harvested agricultural commodities. Based on a holistic review and calculation of Smithfield’s activities, the court concluded that the 50% agricultural business activity test had been met.
The court then invalidated the FTB’s regulation as applied to Smithfield as the regulation impermissibly narrowed the scope of the statute. The court first looked to the governing statute, which requires use of the three-factor formula to the extent a business conducts an industry-specific activity. The FTB’s regulation, in contrast, endorsed a product-based approach, wherein only receipts from unprocessed products would qualify as an agricultural business activity. The court held that the statute did not require an analysis of products or processing activities to determine whether a business qualified for three-factor apportionment.
Since Smithfield engaged in agricultural business activities to produce practically all of its pork products, it was unacceptable for the FTB to conclude that none of the receipts from the sale of fresh packaged meat products came from agricultural business activities. The court also alluded to the fact that slaughtering animals should not be treated any differently than harvesting them, based on the substantial overlap of the terms “slaughter” and “harvest.”
Approval of alternative apportionment as alternate ground
Following its determination regarding Smithfield’s qualification as an agricultural business and its invalidation of the FTB’s regulation, the court provided additional analysis with respect to an alternate ground that Smithfield had raised. This alternate ground related to the potential application of alternative apportionment, on the basis that application of a single sales factor would not fairly represent Smithfield’s California business activity.8
In determining that Smithfield would be entitled to a refund via alternative apportionment, the court provided insight into why the single sales factor applicable to most taxpayers in California did not fairly represent Smithfield’s business activity in California. The court noted that the single sales factor disregarded Smithfield’s substantial activities (production, harvesting, and processing) located outside California.
According to the court, business activity must reflect factors related to the production of a taxpayer’s income, not just sales. Therefore, the FTB’s limitation of the use of alternative apportionment by interpreting business activity solely as the location where sales occur was not appropriate.
In this case, Smithfield’s activities that resulted in products available for sale were largely performed in locations outside California. According to the court, only 1.02% of Smithfield’s activities actually occurred in California, but California’s single sales factor would have resulted in an apportionment factor of over 6.6%. This 600% difference, in the court’s view, justified alternative apportionment.9 Finally, the court concluded that Smithfield’s proposed alternative, the three-factor formula, was reasonable in comparison to use of the single sales factor.
The court then summarily disposed of the FTB’s arguments addressing Smithfield’s claim. In response to the FTB’s claim that Smithfield exhausted its administrative remedies, the court provided that Smithfield was allowed to introduce evidence not presented during the administrative process.
Moreover, the court concluded that Smithfield provided the FTB with notice of the statutory activity-based approach, as it was raised in Smithfield’s refund claim, and during the FTB’s administrative review of the refund claim. Further, the court noted that even though it did so, Smithfield did not have to raise the activity-based approach during the review of its claim because doing so was characterized as “futile.”10
Proposed decision practically left untouched in final version
Interestingly, the court issued a proposed statement of this decision approximately two months before it went final.11 The differences between the proposed statement of decision and the final decision were not significant. The final decision added a statement emphasizing the fact that the FTB’s regulation interpreting the definition of agricultural business ignored the plain language of the statute.
In addition, when addressing alternative apportionment, the court highlighted the fact that Smithfield proved that the FTB was not open to an evaluation of the issue of distortion to the extent it varied from the application of a single sales factor. The court also added a paragraph explaining that while it examined and weighed all of the testimony provided by the FTB, it afforded Smithfield’s testimony greater weight. Finally, the court added a paragraph confirming that Smithfield did not engage in litigation tactics that would have resulted in an unfair surprise at trial.
Commentary
In what can best be described as a complete victory for the taxpayer at the trial court level, the decision covered significant breadth. The court could have limited its decision by simply allowing the taxpayer to use the three-factor apportionment formula based on an examination of its agricultural activities and how it contributed through the supply chain to the sale of its goods to the marketplace. However, the court went much further by invalidating the FTB’s regulation to the extent that it was inconsistent with the governing statute as applied to Smithfield.
This action highlights the need for taxpayers to consider whether guidance provided by a state tax authority, even when couched in the form of a regulation, may be challenged on the basis that it does not reflect the substance or intent of the statute.
The court then took an even more expansive step by addressing the need to allow Smithfield the ability to use alternative apportionment to reach a three-factor formula result regardless of whether it had met the industry-specific requirements for such treatment as an agricultural business. This aspect of the decision raises important questions regarding the propriety of mandatory single sales factor formulas for practically all taxpayers, particularly where the use of such formula can lead to a distortive and unfair result.
Given the number of states that have drastically shifted to mandatory single sales factor formulas in recent years, a decision that calls this policy into question could have far-reaching effects for all multistate businesses.
It is reasonable to expect that the FTB will appeal this decision, and if so, a final determination by the upper-level California courts could be deferred for a long period of time.
Nevertheless, taxpayers that have been using a single sales factor formula but are engaged in businesses closely aligned with agriculture or another industry for which the three-factor formula is beneficial and appropriate in California should closely evaluate their facts and circumstances. This analysis will be necessary in order to determine whether filing protective claims for refund through use of the three-factor formula might be worthwhile. Likewise, this decision opens up the potential for alternative apportionment requests in industry-agnostic situations where the application of a single sales factor to businesses with minimal presence in California results in outsized apportionment.
1 Smithfield Packaged Meats Corp. (F/K/A John Morrell & Co.) v. California Franchise Tax Board, Cal. Sup. Ct. (LA County), Case No. 21STCV39637 (proposed statement of decision issued Feb. 26, 2026; statement of decision issued Apr. 28, 2026).
2 CAL. REV. & TAX. CODE § 25128(a).
3 CAL. REV. & TAX. CODE § 25128(b), (c).
4 CAL. REV. & TAX. CODE § 25128(c)(1).
5 CAL. REV. & TAX. CODE § 25128(d)(2).
6 See Smithfield Packaged Meats Corp. v. Franchise Tax Board, 21STCV39637 at n. 14.
7 See CAL. CODE REGS. tit. 18, § 25128-2(c)(2)(C).
8 7 See CAL. CODE REGS. tit. 18, § 25128-2(c)(2)(C).
9 The court cited to several cases in support of this proposition, including decisions involving the sales factor treatment of treasury receipts (Microsoft Corporation v. Franchise Tax Board, 139 P.3d 1169 (Cal. 2006)) and hedging activities (General Mills, Inc. v. Franchise Tax Board, 208 Cal. App 4th 1290 (2012)).
10 The FTB also claimed that Smithfield did not comply with its discovery requests, on the basis that it did not timely disclose its activity-based approach and as such, Smithfield should not have been permitted to argue this theory or introduce evidence supporting this theory. The court again found for Smithfield, noting that Smithfield was in full compliance with relevant statutory discovery provisions, which included 14 requests for production of documents, 14 special interrogatories, supplemental responses, and 11 witnesses produced for deposition.
11 Per California procedural provisions, a proposed statement of decision is tentative, does not constitute a judgment, and is not binding on the court. Cal. Rules of Court, Rule 3.1590(b). The tentative decision was subject to a party’s objection within 15 days of the tentative decision and judgment being served. Cal. Rules of Court, Rule 3.1590(g).
Ultimately, the court had to sign and file the judgment within 50 days following the later of the announcement or service of the tentative decision, or within 10 days after a hearing addressing the objection to the court’s tentative decision, though the court had some discretion to extend these time limits prior to issuing its final, binding decision. Cal. Rules of Court, Rule 3.1590(l), (m).
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