The South Carolina Department of Revenue has issued a draft revenue ruling and revenue procedure relating to alternative apportionment that may have significant application to taxpayers. The draft ruling outlines the Department's position with respect to alternative apportionment methods which may be requested by the taxpayer or required by the Department, and specifically discusses the applicability of unitary reporting as a method of alternative apportionment.1 The draft procedure details the steps necessary for a taxpayer seeking approval for an alternative apportionment method to submit an application with the Department.2
Draft Revenue Ruling #15-x
South Carolina has historically utilized separate entity reporting, requiring a taxpayer to compute and apportion its income to the state separately for each legal entity within an organizational structure.3 When either the taxpayer or the Department believes the statutory reporting method does not fairly represent the income earned in the state, the taxpayer may request, or the department may require, the use of a reasonable alternative apportionment method.4 In the ruling, the Department describes the subjectivity related to the determination as to whether a proposed alternative method is reasonable. There is no bright-line test for determining whether the statutory method is fair. The petitioning party must identify by a preponderance of the evidence the facts which cause the statutory method to be unfair. The petitioner must then propose a reasonable method that corrects the issue.
The draft ruling also describes the applicability of combined unitary reporting as an alternative method of apportioning income to the state. In Media General Communications, Inc. v. South Carolina Dept. of Revenue,5 the South Carolina Supreme Court held that the combined unitary reporting method is an appropriate method of alternative apportionment. The Department has required or approved alternative apportionment in situations involving purchasing companies, management companies and "east-west" organizational structures. Of note in the draft ruling, the Department indicates that transfer pricing studies supporting charges between related entities is not determinative of fair and representative apportionment.
The Department indicated in the draft that it will generally utilize a water's edge approach in determining the includable income of group members, including: domestic corporations, domestic international sales corporations (DISCs), export trade corporations, controlled foreign corporations (CFCs) and any affiliated member earning more than 20 percent of its income from intangible property or services which are deducted from the income of other group members. The water's edge method of reporting is common by default or election in most unitary reporting states, though the Department's conception of the water's edge group is relatively broad. However, it is possible to utilize a group other than water's edge when agreed by both parties.
The Department intends to apply a Finnigan approach in computing the South Carolina sales factor.6 Under this approach, the numerator will include South Carolina sourced revenue for all members of the group, regardless of whether each member has nexus. The Department will then allocate the apportioned income among those group members with nexus in South Carolina based upon each member's relative share of the cumulative South Carolina revenue.
Credits and net operating loss carryforwards may be shared among members of the unitary group. Eligibility for and calculation of credit amounts will be determined at the separate entity level. However, the utilization of a credit is allowed against the group's South Carolina income. When the unitary group generates a net loss for the year, the loss will be allocated to each group member based on each separate loss relative to the total of the separate losses of the group for that year.
The statute of limitations in South Carolina is generally 36 months but may be extended to 72 months for substantial understatement (20 percent or more) of the total tax required to be shown on a return.7 The Department generally will not apply the 72-month statute when alternative apportionment is required as the result of an audit. However, the Department will apply the 72-month statute when the taxpayer failed to utilize an alternative method previously agreed to by the Department which results in a substantial understatement. Additionally, the Department will not apply the 25 percent substantial understatement penalty8 when an alternative apportionment method is required for a previously filed tax year through audit or settlement. The Department will apply the penalty when a taxpayer fails to utilize a previously agreed upon method without permission by the Department to change methods and the result is a substantial understatement.
Draft Revenue Procedure #15-x
The Department's draft revenue procedure describes the application process and requirements for a taxpayer seeking approval for an alternative apportionment method.9 The Department requires that applicants address sixteen specific questions, including providing details regarding similar requests by the taxpayer in other jurisdictions and a projection of South Carolina tax liabilities for the current and three future years under both the statutory and proposed methods.
Taxpayers must continue to utilize the statutory or previously agreed alternative method until written approval for a new method is received. The procedure stipulates that approval of an alternative method is applicable only to the periods stipulated in the agreement and amended returns for prior periods not covered by the agreement will not be allowed.
The taxpayer and Department may mutually agree to terminate the alternative apportionment agreement. If the Department believes that the agreed upon alternative no longer fairly apportions income to the state or that the statutory formula more fairly represents South Carolina income, the Department may revoke permission. Taxpayers under an alternative method must notify the Department of all material changes in facts and must receive permission in order to change to the statutory method or any other alternative method. Should the taxpayer disagree with the Department's determination, the taxpayer may appeal in accordance with the procedures established for a proposed assessment.
Commentary
The issue of alternative apportionment has received considerable attention in recent years in several southeast states including Mississippi, South Carolina and Tennessee.10 The South Carolina Department of Revenue has been utilizing unitary reporting and other forms of alternative apportionment through the audit process for several years and appears to be memorializing their policies. With the short turnaround between issuance of these drafts and the end of the public comment period that expired on May 14, the documents could become final in the near future.
There are several interesting items to note regarding the draft ruling and procedure. First, the identification of specific transactions and the disregard of transfer pricing studies appear targeted, and somewhat contradictory. The Department provides several examples of facts that may indicate unfair apportionment including non-arm's length terms of related-party transactions, yet the presence of transfer pricing typically intended to create arm's length terms in related-party transactions is not determinative.
Second, the application of Finnigan reporting and the Department's overarching view that a unitary group may be treated in the absence of legislation as a single taxpayer in a historic separate filing state, is a dramatic departure from the historic posture of the state. While the utilization of credits and loss attributes is computed with the view that a unitary group is a single taxpayer, the generation and carryforward of the attributes still adopts a separate entity view. Further, the state also allows elective post-apportioned consolidated reports under current law which more closely resembles a Joyce approach, and allows the sharing of attributes among the elective consolidated group members.
Third, the Department has provided some relief in not applying the 72-month statute of limitations when application of an alternative method resulted in substantial underpayments, an approach that had previously been applied in several audits. The Department will also waive the 25 percent understatement penalty, which had generally not been applied through audit, provided the taxpayer has adhered to the statutory method or a previously agreed upon alternative if applicable. Taxpayers should also be aware of changes in facts such as changes to organizational structure, acquisitions, divestitures or changes in business models which may require notification and open the door for the Department to terminate an existing agreement.
Lastly, there are several procedural issues which may raise some eyebrows among taxpayers and practitioners. Taxpayers must model the tax benefit or detriment anticipated for the current and three preceding years in their application which may serve to remove any estimation by the Department and reduce the decision to simple economics. The Department also seeks to preclude taxpayers from applying an agreed-upon alternative method retroactively to periods prior to the agreement, although the language in the statute allows a taxpayer to petition for a reasonable alternative whenever the statutory method is not fairly representative. The presence of a prospective filing agreement should not impact the taxpayer's statutory ability to seek proper apportionment with respect to previously filed years still in statute. Finally, while the taxpayer and the Department may mutually agree to terminate the agreement at any time, the Department may unilaterally terminate the agreement in certain circumstances.
Footnotes
1 S.C. Rev. Rul. #15-x, April 21, 2015.
2 S.C. Rev. Proc. #15-x, April 21, 2015.
3 See S.C. CODE ANN. §§ 12-6-2252; 12-6-2290.
4 S.C. CODE ANN. § 12-6-2320(A).
5 694 S.E. 2d 525 (S.C. 2010).
6 The Joyce and Finnigan methods are named after cases decided by the California Board of Equalization. Appeal of Joyce Inc., No. 66-SBE-069, California Board of Equalization, Nov. 23, 1966; Appeal of Finnigan, No. 88-SBE-022, California Board of Equalization, Aug. 28, 1988. California has used both approaches in the past, but currently is using the Finnigan method.
7 S.C. CODE ANN. § 12-54-85(A), (C)(3).
8 S.C. CODE ANN. § 12-54-155.
9 See S.C. CODE ANN. § 12-6-2320(A).
10 See Equifax, Inc. v. Mississippi Department of Revenue, 125 So. 3d 36 (Miss. 2013); CarMax Auto Superstores West Coast, Inc. v. South Carolina Department of Revenue, 767 S.E.2d 195 (S.C. 2014); Vodafone Americas Holdings, Inc. v. Roberts, Tennessee Court of Appeals, No. M2013-00947-COA-R3-CV, June 23, 2014.
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