Virginia upholds constitutionality of apportionment statute


Joel Waterfield
Metro DC - Arlington
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Guinevere Seaward Shore
Metro DC - Arlington
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Chris Tran
Metro DC - Arlington
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Sonia Shaikh
Metro DC - Arlington
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Isabella Kron
Metro DC - Arlington
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Jamie C. Yesnowitz
Washington, DC
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Chuck Jones
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Lori Stolly
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On Feb. 7, 2019, the Virginia Supreme Court held that the Virginia Department of Taxation’s use of the state’s statutory apportionment formula, and denial of a taxpayer’s request to use alternative apportionment, did not violate the Due Process or Commerce Clauses of the U.S. Constitution. In finding for the Department, the Court concluded that the taxpayer could not use alternative apportionment because it failed to prove that the standard formula was inequitable.1

Background The taxpayer, Corporate Executive Board Co. (“CEB”), is a multi-jurisdictional, Virginia-based best practices advisory firm. CEB’s “core product” provides clients with electronic access to research and information stored on secure data servers located in Arlington, Virginia. Although most of its employees work at its headquarters and its costs of performance are incurred within the state, relatively few of its sales are made to local clients, as less than 5% of CEB’s customers had a Virginia billing address. However, under the statutory apportionment formula, because the costs of business primarily occurred in the state, the sales were sourced to Virginia. Accordingly, for its 2011-2013 tax years, CEB filed original returns in 24 states in compliance with the Virginia statutory method. However, the taxpayer later filed a refund claim and petitioned the Department to use an alternative apportionment method that would better reflect its level of activity and benefits received by its customers in Virginia. After the Department denied the taxpayer’s claim,2 the taxpayer filed a complaint in the Circuit Court of Arlington County.

In the Circuit Court, CEB had the burden of proving the statutory apportionment method was both unconstitutional and inequitable, and that the proposed method better reflected its Virginia sales.3 Initially, CEB challenged the constitutionality of the statutory method because it was grossly distortive. CEB asserted that although the data and information were generated in Virginia, their actual use was outside the Commonwealth. Accordingly, CEB argued that the Department should apply a destination-based sourcing method using client locations, as the income captured by the statutory method was not “rationally related” to in-state transactions. Specifically, CEB requested two changes to the statutory method: (i) the use of a single sales factor formula; and (ii) the use of a market-based sourcing methodology for sales of items other than tangible personal property according to the location where the benefit of the transaction was received. The Circuit Court rejected the taxpayer’s proposed alternative formula, holding that because CEB conducted income-producing activities in Virginia, a rational relationship was apparent and the statutory method was not grossly distortive. CEB filed an appeal with the Virginia Supreme Court.

Virginia apportionment In Virginia, the statutory apportionment method is a three-factor, double-weighted sales formula.4 The statute sources sales of other than tangible personal property to the state if “a greater proportion of the income-producing activity is performed in the Commonwealth than in any other state, based on costs of performance.”5 Taxpayers have the right to petition for alternative apportionment if the statutory method does not accurately reflect the taxpayer’s in-state activities.6 If the Department determines the apportionment method is “inapplicable or inequitable,” the Department is directed to apply a methodology that taxes the portion of income that is “reasonably attributable” to the taxpayer’s business and sources within Virginia.7 Under the Department’s alternative apportionment regulation, the statutory apportionment method is “inapplicable” if it produces an unconstitutional result for the taxpayer.8 The statutory apportionment method is “inequitable” if: (i) “[i]t results in double taxable of the income, or a class of income, of the taxpayer;” and (ii) “[t]he inequity is attributable to Virginia, rather than to the fact that some other state has a unique method of allocation and apportionment.”9

Statutory apportionment method was constitutional The Virginia Supreme Court held that the use of the statutory formula to apportion the taxpayer’s income did not violate the Due Process or Commerce Clauses of the U.S. Constitution. The Due Process Clause requires “a ‘minimal connection’ between the interstate activities and the taxing State, and a rational relationship between the income attributed to the State and intrastate values of the enterprise.”10 Under the Commerce Clause, Congress is authorized to “regulate Commerce with foreign Nations, and among the several States.”11 States must also satisfy the Dormant Commerce Clause, which limits “the power of the States to enact laws imposing substantial burdens on [interstate] commerce.”12 In Complete Auto Transit, Inc. v. Brady, the U.S. Supreme Court created a four-prong test that a taxing scheme must satisfy under the Dormant Commerce Clause.13 The instant case concerned the “fairly apportioned” prong. The same test is used for determining fair apportionment under both the Due Process Clause and the Commerce Clause.14 Under this test, a tax must be both internally and externally consistent.15 The parties in the instant case agreed that the internal consistency test was met, but the Court was required to determine whether the external consistency test was satisfied.

The U.S. Supreme Court has explained that the external consistency test “asks whether the State has taxed only that portion of the revenues from the interstate activity which reasonably reflects the in-state component of the activity being taxed.”16 In the instant case, the Court held that the external consistency test was satisfied because the content of the taxpayer’s core product was developed by employees in Virginia and the product was stored on servers in the state.

The Virginia Supreme Court acknowledged the existence of double taxation, but focused on the ruling in Moorman Manufacturing Co v. Bair17 that “the existence of duplicative taxation does not, by itself, violate the Constitution . . . [s]o long as the State’s method of apportionment is itself fair.” CEB conceded that double taxation is not inherently unconstitutional, but claimed that an apportionment regime is unconstitutional when it “wholly disregards the existence of interstate commerce, and that thereby produces a much higher apportionment of taxable income and a substantial double taxation.”18 The Supreme Court rejected the taxpayer’s more specific interpretation of the law, determining that materiality of the tax burden is irrelevant when Virginia’s tax scheme reasonably reflects the economic activity within the state. Accordingly, the Court affirmed the lower court’s determination that although such policy statements are relevant when presented to the state legislature, the U.S. Supreme Court has not “embraced” such standards.

Interestingly, the Virginia Supreme Court adopted the same analysis as the Circuit Court by relying on the U.S. Supreme Court’s decision in Western Live Stock v. Bureau of Revenue.19 Western Live Stock, which preceded Complete Auto by nearly 40 years, provided a general framework for determining whether a tax unduly burdens interstate commerce in violation of the Dormant Commerce Clause. However, the case failed to provide specific procedures to conclusively determine when such violations occur. Although Complete Auto was mentioned, the focus of the Court’s analysis appeared to be based on the more sweeping conclusion found in Western Live Stock. Similar to the Circuit Court’s approach, the Supreme Court opted for a higher level analysis drawing parallels between the circumstances of the taxpayer in Western Live Stock and those of CEB. The Virginia courts summarized that both taxpayers’ costs of business were primarily derived from income-producing activities in one state and thus should not be sourced elsewhere. Finally, the Virginia Supreme Court concluded that the apportionment formula did not produce a “grossly distorted” result.20

Taxpayer not entitled to alternative apportionment The taxpayer also argued that it was entitled to use alternative apportionment because the statutory apportionment formula was “inequitable.” As discussed above, a regulation provides that the statutory method is “inequitable” when it (i) results in double taxation; and (ii) the “inequity is attributable to Virginia, rather than to the fact that some other state has a unique method of allocation and apportionment.”21 The Court held that the first requirement was satisfied because application of the standard formula resulted in the double taxation of a portion of the taxpayer’s income. In considering the second requirement, the Court determined that any double taxation was not “attributable” to Virginia because it resulted from the trend of other states adopting single sales factor apportionment. Also, the Court considered whether the sourcing methods adopted by other states were “unique.” The taxpayer argued that “[t]he destination-based sourcing method used by these 23 other states . . . can in no sense be considered unique.” The Court disagreed, explaining that the taxpayer merely cited other states’ adoption of market-based sourcing formulas at a high level. Sufficient evidence disproving the uniqueness of the states’ sourcing methods would require a more granular examination of specific allocation and apportionment applications.

The Court supported its rejection of CEB’s argument with specific examples “that each State has adopted is own distinctive method, even if those methods share some [broad] conceptual similarities.” The Court expanded its analysis by examining four states that taxed CEB’s sales of services during the years in question: California, Wisconsin, Alabama and Illinois. All four states have broadly termed “market based” apportionment methods, but their regimes differ in sourcing approach.22 The sourcing details also vary even when the approach may be the same.23

Furthermore, the Court concluded that CEB’s double taxation resulted from “changes adopted more recently by other States in their apportionment formulas,” specifically the growing trend of adopting single-factor sales apportionment. Virginia has adhered to its apportionment formula for almost 60 years. Therefore, the double taxation did not result from an inequitable change in Virginia’s statute.

Finally, the Court emphasized the lower court’s holding that the statutory method is accepted rule and law, and the Commissioner appropriately applied that law to CEB’s circumstances. It also affirmed that the proposed market-based sourcing method was properly rejected, as CEB was unable to demonstrate the unconstitutionality of the statutory method. Although there is a growing trend among other states to adopt market-based sourcing, the Commissioner could not be faulted for following the current law.

Commentary The recent trend toward market-based sourcing and single-sales factor apportionment formulas is due in part to the economic shift toward service-based revenue streams. By moving in this manner, states that place less weight on the location of property and payroll for purposes of apportionment and sourcing rules become more attractive to companies from the perspective of the corporate income tax. For some entities headquartered in Northern Virginia, moving even relatively small components of a business “across the river” to Maryland or Washington, DC could serve to significantly reduce their overall Virginia corporation income tax calculation.

While Virginia has conducted repeated studies on whether to change its apportionment formula for services in light of this potential issue, the Virginia legislature has yet to act. Until Virginia makes a legislative change, the state will remain one of the most reliable with respect to its policy on requiring cost of performance sourcing for sales of items other than tangible personal property, even when alternative apportionment would seem reasonable under a certain set of circumstances.

The Virginia Supreme Court’s decision did provide an unusually detailed analysis with respect to the manner in which the states have moved toward market-based sourcing, in its attempt to determine whether other states’ apportionment methods were unique. While the Court did not conclude either way on the issue of uniqueness, its analysis reflects the differing (and one can imply, unique) methods by which many of the states have adopted market-based sourcing. In other words, while the trend viewed as a whole may not be unique given the number of states that have made the switch, the individual efforts by the states certainly can be viewed as such. These disparate efforts from states shifting to market-based sourcing have occurred despite recent activity by the Multistate Tax Commission to endorse a standardized model approach in this area.

1 Corporate Executive Board Co. v. Virginia Department of Taxation, Virginia Supreme Court, Record No. 171627, Feb. 7, 2019.
2 Because the Department failed to act within three months after the refund claim was filed, the Department effectively denied the taxpayer’s claim.
3 Corporate Executive Board v. Virginia Department of Taxation, Circuit Court of Arlington County, Virginia, No CL 16-1525, Sep. 1, 2017.
4 VA. CODE ANN. § 58.1-408.
5 VA. CODE ANN. § 58.1-416.
6 VA. CODE ANN. § 58.1-421.
7 Id.
8 23 VA. ADMIN. CODE § 10-120-280.B.4.a.
9 23 VA. ADMIN. CODE § 10-120-280.B.4.b.
10 Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425, 436-37 (1980).
11 U.S. CONST. art. 1, § 8, cl. 3.
12 South-Central Timber Dev., Inc. v. Wunnicke, 467 U.S. 82, 87 (1984).
13 430 U.S. 274 (1977). The taxing scheme must satisfy the following: (1) there must be a substantial nexus between the taxpayer and the state; (2) the tax must be fairly apportioned; (3) the tax must not discriminate against interstate commerce; and (4) the tax must be fairly related to the services provided by the state.
14 See Container Corp. v. Franchise Tax Board, 463 U.S. 159, 169 (1983).
15 Goldberg v. Sweet, 488 U.S. 252, 260-61 (1989).
16 Id. at 262.
17 437 U.S. 267, 274 (1978).
18 Emphasis in original.
19 303 U.S. 250 (1938).
20 Norfolk & Western Railway v. Missouri State Tax Commission, 390 U.S. 317, 326 (1968).
21 23 VA. ADMIN. CODE § 10-120-280.B.4.b.
22 California and Wisconsin source income where the benefit is received, while Alabama and Illinois source income where the service is delivered. ALA. CODE § 40-27-1, art. IV(17)(a)(3); CAL. REV. & TAX. CODE § 25136(a)(1); 35 ILL. COMP. STAT. 5/304(a)(3)(C-5)(iv); WIS. STAT. § 71.25(9)(dh)(1).
23 For example, California sources income to where a customer received the benefit, regardless of billing address, whereas Wisconsin ties received benefits to a physical presence within the state, such as real property, tangible personal property or a place of business. Alabama’s three-factor formula distinguishes between whether or not services have a substantial connection to a geographic location (e.g. cleaning services as opposed to accounting services), while Illinois’ single sales factor formula limits income sourcing to states where a business has a fixed business.

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