The South Carolina Supreme Court has affirmed the Court of Appeals' holding that the party proposing the use of an alternative apportionment method has the burden of proof.1 Specifically, the moving party must prove by a preponderance of the evidence that: (i) the statutory formula does not fairly represent the taxpayer's business activity in the state; and (ii) its alternative method is reasonable. In reaching its decision, the Supreme Court disagreed with the Court of Appeals that the moving party is further required to satisfy the second part of the test by proving that the alternative formula more fairly represents the taxpayer's business activity in the state. Furthermore, the Court of Appeals misapplied Media General Communications, Inc. v. Department of Revenue2 by requiring the moving party to prove that the alternative formula is more reasonable than any competing methods.
Background
CarMax, Inc. (CarMax), the nation's largest retailer of used cars and light trucks, operated prior to 2004 as a holding company with two wholly owned subsidiaries: (i) CarMax West, which sold used vehicles in the western United States and owned substantially all of CarMax's intellectual property; and (ii) CarMax East, which sold used vehicles in the eastern and midwestern United States, including South Carolina. CarMax East paid CarMax West a royalty for its use of the intellectual property.
In 2004, CarMax's corporate structure was reorganized. CarMax Business Services, LLC (CBS) was created to: (i) house CarMax's financing operations, CarMax Auto Finance (CAF); (ii) provide certain shared services to the companies in the group; and (iii) own the intellectual property. CBS was created as a limited liability company with CarMax West owning a 93.5 percent interest and CarMax East owning the remaining 6.5 percent interest. CBS charged CarMax West and CarMax East a per vehicle management services fee, which included an intellectual property royalty component. The income from the management fee, in addition to the financing income generated through CAF, was distributed to CarMax West and CarMax East based on their ownership percentages. As a result, CarMax West had South Carolina source income after 2004 even though it did not have any retail operations in South Carolina.3
CarMax West filed South Carolina corporate income tax returns for the years 2002-2007 utilizing the standard three-factor apportionment formula.4 After auditing CarMax West, the Department adjusted the apportionment formula because in its view, neither the standard formula nor the gross receipts formula fairly represented the extent of CarMax West's business in South Carolina. The Department applied an alternative apportionment formula that divided CarMax West's income from royalties and financing receipts from within South Carolina by its royalties and financing receipts from everywhere CarMax West conducted business.5 The Department's method did not include the retail income from the sale of vehicles earned by CarMax West in other states, which if included would have substantially lowered CarMax West's apportionment factor.
In response, CarMax West filed amended tax returns, utilizing a different statutory formula known as the gross receipts formula.6 Using this method, CarMax West calculated its apportionment factor by dividing its receipts from intangibles in South Carolina by its receipts from financing, intangibles and retail sales everywhere.
ALC Determined Taxpayer Had Burden of Proof
After disputing its methodology with the Department, CarMax West filed for a contested case hearing before the Administrative Law Court (ALC). The ALC determined that CarMax West had the burden of proving that the Department's alternate accounting method was not reasonable. The ALC held that the Department's apportionment method was reasonable because: (i) its method considered only the business conducted in South Carolina; and (ii) separate accounting is a method expressly permitted by South Carolina law.7
Court of Appeals Held Department Had Burden of Proof
The South Carolina Court of Appeals reversed the ALC finding and remanded the case for reconsideration of all issues.8 First, the Court held that the Department had the burden of proving the gross receipts formula did not fairly represent CarMax West's business activity in South Carolina.9 Second, the Court held that the Department had the burden of proving its alternative accounting method was reasonable and more fairly represented CarMax West's business activity in South Carolina. Based on Media General, the Department, as the proponent of an alternative apportionment method, must establish that its alternative method is not only appropriate, but more appropriate than any competing methods. However, the Court held that the Department must prove its alternative method by a preponderance of the evidence rather than by clear and convincing evidence as advocated by CarMax West. Both parties appealed the decision to the South Carolina Supreme Court.
Supreme Court Clarifies Burden of Proof
The South Carolina Supreme Court agreed with the Court of Appeals in finding the Department, as the proponent of an alternate apportionment formula, bore the burden of proof. It also concurred with the application of the two-prong test that requires the moving party to prove that: (i) the statutory formula does not fairly represent the taxpayer's business activity in the state; and (ii) its alternative accounting method is reasonable. However, the Supreme Court did not agree with the Appellate Court that the moving party also must prove that the alternative method more fairly represents the taxpayer's business activity in the state. Also, the Supreme Court disagreed with the Appellate Court's application of Media General as requiring the moving party to prove that its alternative formula is more reasonable than any competing method.
In Media General, both parties agreed the statutory method did not fairly represent the taxpayer's business in the state. The Department adopted the statutory formula as its alternative. The fact that each party agreed the statutory method was not fairly representative created a scenario of competing alternatives which necessitated the requirement that the alternative be the most reasonable of any competing method. In the instant case, the Department was the only party asserting the statutory method was not representative. Therefore, the Department only bears the burden of proving the alternative is reasonable, not that it is more representative than any competing method.
Ultimately, the determination of whether the alternative must simply be reasonable versus the most appropriate of any competing method was moot in the instant case. The Department failed the first prong in demonstrating the statutory method was not a fair representation of business done in the state. As a result, the second requirement did not apply.
In its order, the ALC relied on the auditor's testimony that the structures utilized by CarMax were often "linked with minimization strategies." The Supreme Court noted the auditor's conjectures regarding the taxpayer's motives for its organizational structure were speculation. Further, the Court noted that motives of tax minimization are not sufficient support for the conclusion that the statutory formula is not a fair representation of business in the state.
The Supreme Court declined to rule on any other substantive aspects of the case including the inclusion or exclusion of certain revenue streams from the sales factor numerator and denominator or the presence of a unitary business and the ability to apply separate accounting to a unitary business.
Commentary
The issue of alternative apportionment and the burden proof has received considerable attention. In Equifax, Inc. v. Department of Revenue, the Mississippi Supreme Court held that the taxpayer had the burden of proving by a preponderance of the evidence that the alternative apportionment method imposed by the Department of Revenue was arbitrary and capricious or violated its constitutional rights.10 However, in response to Equifax, Mississippi enacted legislation providing that the party requesting alternative apportionment bears the burden of proving by a preponderance of the evidence that: (i) the statutory or regulatory method does not fairly represent the taxpayer's business activity in the state; and (ii) the proposed method more fairly represents the activity than any other reasonable method.11 Thus, the second prong of the test in Mississippi is more stringent than the second prong of the test as expressed by the South Carolina Supreme Court.
The Multistate Tax Commission has issued a proposed amendment to the Multistate Tax Compact that would add a two-prong test with a "reasonable method" standard that is very similar to the standard that now applies in South Carolina.12 It appears that states are beginning to uniformly accept the notion that the party requesting alternative apportionment normally must carry the weight of proving why the alternative method is necessary. However, the circumstances that result in the acceptance of alternative apportionment and the question of when a method actually constitutes a "reasonable" apportionment alternative still lack clarity, and are likely to be the subject of future controversies.
By modifying the second prong of the test, this decision makes it easier for the proponent of an alternative apportionment methodology to meet its burden of proof. The moving party no longer needs to prove that its proposed method is more reasonable than any competing methods. Depending on the facts, this could benefit either the Department or the taxpayer. This may expand the Department's options when it determines that the statutory formula is not representative, including the ability to require combined reporting where separate filings are perceived to distort income reported to the state. However, it also should be easier for a taxpayer to prove that alternative apportionment is warranted. In addition, this decision benefits taxpayers by providing further support that the presence of a tax-efficient structure, and even the tax minimization motive, do not provide a reasonable basis for the Department to require the use of alternative apportionment.
Footnotes
1 CarMax Auto Superstores West Coast, Inc. v. South Carolina Department of Revenue, South Carolina Supreme Court, No. 27474, Dec. 23, 2014.
2 694 S.E. 2d 525 (S.C. 2010).
3 The royalty and financing income that passed through from CBS to CarMax West created economic nexus with South Carolina for CarMax West according to Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993).
4 S.C. CODE ANN. § 12-6-2250.
5 See S.C. CODE ANN. § 12-6-2290.
6 S.C. CODE ANN. § 12-6-2320(A).
7 See S.C. CODE ANN. § 12-6-2320(A)(1).
8 725 S.E.2d 711 (S.C. Ct. App. 2012).
9 Note that both the Department and CarMax West agreed that the Department had the burden of proving the gross receipts formula did not fairly represent CarMax West's business activity in South Carolina. The dispute concerned whether the Department had the burden of proving its alternative method was reasonable and more fairly represented CarMax West's business activity in the state.
10 125 So. 3d 36 (Miss. 2013), cert. denied, 134 S. Ct. 2872 (2014).
11 H.B. 799, Laws 2014. For a discussion of this legislation, see GT SALT Alert: Mississippi Enacts Legislation Addressing Equifax Decision.
12 For a discussion of the final and proposed changes to the Compact, see GT SALT Alert: Multistate Tax Commission Finalizes Compact Provision Amendments.
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