California’s First District Court of Appeals issued an opinion on July 24, 2012 giving corporations relief from a 1993 California state law that gave double weight to sales, thereby increasing corporate income taxes on out-of-state corporations while giving those based in California possible relief from taxes. In Gillette Co. v. Franchise Tax Board, the Court ruled that California must comply with the multi-state compact which determines a corporation’s taxable income based on three equally weighted factors: payroll, property and sales.

The underlying issue in Gillette was whether the Multistate Tax Compact (Compact) obligates California to provide multistate taxpayers with the option of using the Compact’s formula in apportioning income to the state or whether, notwithstanding adoption of the Compact’s provisions, California may bind taxpayers to a different formula.

Under the Compact, taxpayers in member states may elect to apportion and allocate their income either under state law or under the Compact’s formula. Article III (1) of the Compact, in relevant part, provides:

Any taxpayer subject to an income tax whose income is subject to apportionment and allocation for tax purposes pursuant to the laws of a party State or pursuant to the laws of subdivisions in two or more party States may elect to apportion and allocate his income in the manner provided by the laws of such State or by the laws of such States and subdivisions without reference to this compact, or may elect to apportion and allocate in accordance with Article IV (emphasis added)

Other member states will certainly take note of the opinion. Currently, 18 states have joined the compact which was adopted in order to facilitate the proper determination of state and local tax liability of multistate taxpayers, avoid a duplicative tax burden, promote uniformity, facilitate convenience and tax compliance.

In this case, the Franchise Tax Board (FTB) argued that legislation enacted in 1993 repealed and supersedes the compact’s formula, thereby making the state’s double-weighted sales factor formula mandatory. The Court was not swayed by the FTB’s arguments, noting that the Ninth Circuit Court of Appeals had set forth three primary indicia on the nature of interstate compacts: “establishment of a joint organization for regulatory purposes; conditional consent by member states in which each state is not free to modify or repeal its participation unilaterally; and state enactments which require reciprocal action for their effectiveness.” (Seattle Master Builders v. Pacific N.W. Elec. Power (9th Cir. 1986) 786 F.2d 1359, 1363.) Because the Compact had these three indicia present, California was bound to the Compact and had to honor Gillette’s election under the Compact despite the 1993 legislation.

Moreover, when a state, like California, enters into a compact, California “effectively surrenders a portion of its sovereignty the compact governs the relations of the parties with respect to the subject matter of the agreement and is superior to both prior and subsequent law.” Further, “because the Compact is both a statute and a binding agreement among sovereign signatory states, having entered into it, California cannot, by subsequent legislation, unilaterally alter or amend its terms.” Indeed, “as an interstate compact the Compact is superior to prior and subsequent statutory law of member states.” Thus, the Compact vitiates California Revenue and Taxation Code Section 25128, which aimed to prohibit a Compact election. According the Court, the only way for a state, like California, that has adopted the Compact to relieve its obligations under the Compact is to withdraw from the Compact entirely. Additionally, the Court explained that California’s legislative withdrawal from the Compact may only occur on a prospective basis and may not have any retroactive effect.

While the case is likely to be appealed to the California Supreme Court, California Governor Jerry Brown has already signed S.B. 1015 which repeals California’s participation in the Compact. Given the precarious financial conditions of most state governments, other Compact members may be reconsidering their participation in the Compact if it impedes their ability to capture tax revenue.

You can click here to read the Court’s slip opinion.