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Taxpayer prevails in New Mexico alternative apportionment dispute

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On Dec. 21, 2018, the New Mexico Administrative Hearings Office ruled against the Department of Revenue in its attempt to apply alternative apportionment to a financial institution taxpayer.1 In doing so, the taxpayer proved that it was entitled to use a regulation governing special apportionment for financial institutions, while the Department failed to prove that inclusion of a de minimis payroll factor in the apportionment calculation resulted in an unfair reflection of the taxpayer’s activities in the state.

Background The taxpayer, Discover Bank, is a Delaware-based financial institution with a national customer base. The taxpayer lends money to its customers through credit cards and personal loans and has no business locations or employees in New Mexico. Its only connection to the state is through customers residing in the state. During the relevant period, Discover had approximately 1,000 employees engaged in the management and dispatch of $60 billion in capital and more than $44 million in payroll expense.

In its originally filed New Mexico income tax returns for the 2011-2014 tax periods,2 the taxpayer apportioned its income using the special financial institution formula which included equally-weighted property, payroll and sales factors. The formula resulted in a sales factor of approximately 0.6% and property and payroll factors of 0%. The tax returns were processed through the state’s computer system, which automatically flags for review returns where a denominator of an apportionment factor in relation to income is below a 3% de minimis amount. The taxpayer’s payroll factor denominator as reported on its 2011-2014 tax returns fell below the 3% amount, catching the attention of the computer system and resulting in further review by the Department.

On audit, the New Mexico Department of Revenue determined that the taxpayer’s inclusion of the payroll factor in the apportionment calculation that it classified as de minimis resulted in distortion. The Department made an equitable adjustment to the 2011-2014 tax returns to exclude the payroll factor and issued assessments of additional tax due. The taxpayer initially paid the 2011 and 2012 assessments, but protested the 2013 and 2014 assessments, which the Department abated. Based on the abatement, the taxpayer then filed for refund of the 2011-2012 assessments. After the Department failed to take action to grant or deny the refund claims, the taxpayer protested, leading to the hearing and ruling in question.

Ruling The primary issue addressed by the Administrative Hearings Office was whether the Department appropriately and reasonably made equitable adjustments to the taxpayer’s 2011 and 2012 tax returns by eliminating the payroll factor from the special regulatory apportionment formula for financial institutions.

The hearings officer began his analysis by considering New Mexico’s overall corporation income tax apportionment structure. New Mexico statutes generally adopt the apportionment tenets included in the Uniform Division of Income for Tax Purposes Act (UDITPA) to apportion and allocate income earned by corporations doing business in multiple states.3 Special apportionment rules for financial institutions are contained in a regulation interpreting UDITPA which include an equally-weighted three factor formula consisting of property, payroll and sales.4 Specifically, the rules for financial institutions require that the property factor be adjusted to include intangible assets, and for sales factor purposes, source revenue such as loan interest to the location of the customer. The financial institution regulation also includes a provision allowing for the use of alternative apportionment in cases where the general rule does not fairly represent a taxpayer’s activities in the state.5 The allowable adjustments include the exclusion of one or more apportionment factors.6

The Department’s argument to exclude the taxpayer’s payroll factor centered on its administrative practice considering any total apportionment factor of less than 3% of net income to be de minimis. In support of this position, it referenced instructions to the 2012 New Mexico tax return which indicate that taxpayers should use only “significant” factors (i.e., those with denominators which are greater than 3 percent of net income) in computing apportionment.7

The hearings officer addressed the appropriate burdens of proof in this matter relevant for both the taxpayer and the Department. As the taxpayer was arguing for a refund claim, the taxpayer was required to overcome the burden to establish its entitlement to the refund claim. The parties agreed that the taxpayer was a financial institution required to apportion pursuant to the special regulation, and so the taxpayer overcame this burden. As the Department was seeking to depart from the standard apportionment formula, the Department carried the burden of proof as to why the deviation is necessary.8 Specifically, to prevail, the Department was required to prove: (i) that the statutory formula does not fairly reflect the extent of the taxpayer’s business activity in the state, and (ii) that the proposed alternative apportionment methodology is reasonable. To overcome this burden, the Department had to provide substantial evidence that the standard apportionment formula was distortive.9

In its analysis of the taxpayer’s returns, the Department found that, for the years at issue,10 the taxpayer’s average total payroll denominator was 1.69% of its apportionable total income. Therefore, it argued, payroll was not a significant contributor to the taxpayer’s generation of income such that inclusion of the payroll factor was distortive of its business activity in New Mexico. The taxpayer countered that its employees were critical to its generation of income as they were responsible for managing the taxpayer’s lending activities on a day-to-day basis, including setting credit policies, originating loans and accounting for credit transactions. The Department presented little evidence, beyond the quantitative analysis, to prove that inclusion of the payroll factor was distortive. Instead, it simply argued that the taxpayer’s payroll had an insignificant impact on its ability to generate income, citing previous cases in which the Department had prevailed in successfully excluding the payroll factor.11 The hearing officer distinguished the cited cases in which there was a much more particularized justification with significant witness testimony and analysis of the taxpayer’s activities and income generation, which did not occur in this matter. Further, the hearing officer summarily rejected the Department’s position which “requires the assumption that de minimis necessarily means distortive,” noting that “there is no statutory or regulatory finding that any factor whose denominator is under 3% of net income is de minimis.” On this basis, the taxpayer was granted its refund claim, but not awarded costs, as the Department’s argument was found to be reasonable based on the facts in this matter.

Commentary The conclusions in this ruling highlight that the Department’s application of law was reasonable as applied to this taxpayer, in spite of the fact that it did not present sufficient evidence to prevail. While this ruling was a victory for the taxpayer, it appears the authority of the Department to apply alternative apportionment has not been eroded. In a different fact pattern, with a greater body of evidence presented by the Department, the outcome could be far less favorable for the taxpayer.

In an interesting twist, the Department attempted to rebut the taxpayer’s argument by trying to disregard its own regulation,12 claiming that any regulation which restricts its authority to apply alternative apportionment must be invalid. The ruling highlighted that without these provisions, financial institutions based outside the state could potentially have no sales sourced to New Mexico, and therefore no income tax liability or filing requirement in the state. The hearing officer remarked that “a Department argument that requires rejecting the Department’s own regulation in order to prevail in one discrete protest is not particularly persuasive.” It appears that the Department has chosen to accept the result in this case, as no appeal had been filed by the deadline.

In this matter, the Department was seemingly over-reliant on a series of quantitative indicators, specifically one which was initially identified by the Department’s automated computer system. While taxpayers can expect to see increasing use of data analytics and automated audit systems by states to identify potential issues and errors, the subjective facts and circumstances of a given taxpayer situation remain pertinent to reaching a reasonable outcome.

Notably, the Multistate Tax Commission adopted amendments to its Model General Apportionment and Allocation rules for financial institutions during 2018.13 Although the adopted amendments provide new sourcing rules which apply when a taxpayer’s receipts are less than 3.33% of its gross receipts, and extend application of the financial institution rules to bank holding companies, they do not specifically address a situation where a taxpayer’s other apportionment factors are de minimis. Instead, the amendments focus solely upon the calculation of the receipts factor. The revisions do not modify the existing option for a taxpayer or the Department to pursue alternative apportionment in cases where general rules fail to accurately reflect a taxpayer’s business activity in a state.  



1 Discover Bank v. New Mexico Taxation and Revenue Department, New Mexico Administrative Hearings Office, No. 18-44, Dec. 21, 2018.
2 The taxpayer’s 2011-2014 tax period consisted of two short periods (Dec. 1, 2011 – Nov. 30, 2012, and Dec. 1, 2012 – Dec. 31, 2012), and two full-year periods (the 2013 and 2014 calendar years).
3 N.M. STAT. ANN. §§ 7-4-1 to 7-4-21. UDITPA was promulgated by the Uniform Law Commission in 1957 to provide uniform laws that states could adopt to assign the taxable income of multistate corporations among the states in which they do business. The allocation and apportionment provisions of UDITPA have been adopted by the Multistate Tax Commission and have undergone substantial revision in the last several years.
4 N.M. ADMIN. CODE tit. 3, § 5.19.17.A.(1), (2).
5 N.M. STAT. ANN. § 7-4-19; N.M. ADMIN. CODE tit. 3, § 5.19.17.A.(4).
6 N.M. STAT. ANN. § 7-4-19.B; N.M. ADMIN. CODE tit. 3, § 5.19.17.A.(4)(b).
7 Instructions, 2012 Form CIT-1, Corporate Income and Franchise Tax Return, New Mexico Taxation and Revenue Department. Taxpayers including an “insignificant" factor in the computation are instructed to attach an explanation to the return.
8 Citing Kmart Corp. v. Taxation and Revenue Department, 131 P.3d 22 (N.M. 2005).
9 The hearing officer dismissed the taxpayer’s argument that because it had used the special regulatory apportionment method for financial institutions, the Department had no provision to seek equitable adjustment.
10 In this calculation, the Department included relevant amounts from the 2011-2014 tax years.
11 In re Wal-Mart Stores, Inc., New Mexico Administrative Hearings Office, No. 06-07, May 1, 2006; Kmart Corp. v. Taxation and Revenue Department, 131 P.3d 22 (N.M. 2005).
12 N.M. ADMIN. CODE tit. 3, § 5.19.17.A.(4).
13 Model Apportionment Reg. IV.18.(c),(k).



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