Investors keeping a close eye on pending legislation (the Promoting Economic Growth and Job Creation Through Technology Act of 2014, Bill 20-0945) promoting investments in D.C. Qualified High Technology Companies (QHTC) will be happy to know it passed—but not without a serious caveat. While the bill was originally set to allow investors to cash in their investments after being held continuously for a 24-month period, the enrolled Act (D.C. Act 20-514) was amended to make the rate reduction applicable January 1, 2019 (at the earliest).

Background

In September 2014, the D.C. Council began reviewing a proposal from Mayor Gray that would lower the tax rate to 3 percent for capital gains from the sale or exchange of eligible investments in QHTCs, as previously discussed by the authors here. As introduced, the bill was set to be applicable immediately; however, all that changed when an amendment was made on December 2 that restricts applicability of the Act to the latter of:

  • January 1, 2019 to the extent it reduces revenues below the financial plan; or
  • Upon implementation of the provisions in § 47-181(c)(17).

As noted in the engrossed amendment, this was done to “ensure that the tax cuts . . . codified by the 2015 Budget Support Act (BSA) take precedence.” These cuts, previously discussed by the authors here and here, include the implementation of a single sales factor, a reduction in the business franchise tax rate for both incorporated and unincorporated businesses, and switch from cost of performance sourcing to market-based sourcing for sale of intangibles and services.

The Act was quickly passed on December 22 with the amendment language included and a heavy dose of uncertainty regarding when the reduced rate will apply (if at all), since it is tied to the financial plan and BSA. Practically, this leaves potential investors with the green light to begin purchasing interests in QHTCs, since the Act is effective now, yet leaves these same investors with uncertainty about the applicability of the reduced rate.

Practical Questions Unresolved 

The enrolled Act retains the same questionable provisions that were originally present upon its introduction, raised by the authors here. Specifically the language provides that the Act applies “notwithstanding any other provision” of the income tax statute and only to “investments in common or preferred stock.” The common or preferred stock provisions appear to arbitrarily exclude investments in pass-through entities, despite the fact that they are classified as QHTCs, disallowing investors that otherwise would be able to take advantage of the rate reduction. In addition, the Act lacks clarity regarding the practical application of basic tax calculations, such as allocation and apportionment. The Act seems to stand for the proposition that the investments should be set apart from the rest of the income of an investor, but to what extent? Absent regulations or guidance from the Office of Tax and Revenue (OTR), taxpayers taking advantage of the rate reduction in 2019 may fall into a Wild West-like situation and are encouraged to take advantage of the most favorable positions regarding categorization, allocation and apportionment, and losses.

Constitutional Limitation or Opportunity?

Because the favorable tax rate in this Act is imposed on investments in in-state companies only (since by definition a QHTC must be located in the District), serious constitutional questions are raised. The dormant Commerce Clause prohibits state taxation or regulation that discriminates against or unduly burdens interstate commerce and thereby ‘imped[es] free private trade in the national marketplace.’ ” Gen. Motors Corp. v. Tracy, 519 U.S. 278, 287 (1997). “No State, consistent with the Commerce Clause, may ‘impose a tax which discriminates against interstate commerce … by providing a direct commercial advantage to local business.” Boston Stock Exch. v. State Tax Comm’n, 429 U.S. 318, 329 (1977) (invalidating New York statute that reduced the transfer tax on securities sales if the sale of securities took place on an exchange within the state because the tax scheme “foreclos[ed] tax neutral decisions” and “creat[ed] both an advantage for the exchanges in New York and a discriminatory burden on commerce to its sister States.” Along the same lines, the Supreme Court found in Fulton Corp. v. Faulkner, 516 U.S. 325, 333 (1996), held that a North Carolina intangibles tax was impermissibly discriminatory because it “taxe[d] stock only to the degree that its issuing corporation participates in interstate commerce [and] favors domestic corporations over their foreign competitors in raising capital among North Carolina residents . . . discourag[ing] domestic corporations from plying their trades in interstate commerce.”

The QHTC rate reduction with “no doubt . . . facially discriminates against interstate commerce” like the Court found in Fulton and Boston Stock Exchange. Any investor in the District is impermissibly incentivized to keep their investments local (based on the favorable rates allowed on the basis of the company’s location) and not invest in the interstate market, where D.C. would tax their gains at an increased rate. This is a classic example of the economic protectionism the dormant Commerce Clause is aimed to prevent. While the violation is clear, the implications of this violation are not. There is a real possibility that far more companies will be able to take advantage of the rate reduction (e.g,. investments in otherwise QHTC-qualifying companies located outside the District). Because the QHTC qualifications are extremely broad, available here, there is a strong argument that OTR may be compelled to honor the lower rate for investments in companies outside the District.

The questionable constitutionality of in-state rate reductions is not specific to the QHTC or even the District. Taxing jurisdictions routinely adopt protectionist measures that run afoul of the commerce clause. For example, New York offers a reduced rate for “eligible qualified New York manufacturer” that similarly should be expanded beyond New York due to discrimination and economic protectionism. Oklahoma has a similar deduction that allows a taxpayer to adjust its Oklahoma taxable income for qualifying gains receiving capital treatment that result from the “sale of all or substantially all of the assets of an Oklahoma company,” which is defined as “an entity whose primary headquarters have been located in Oklahoma for at least three (3) uninterrupted years prior to the date of the transaction from which the net capital gains arise.” Just like the QHTC provision in the Act, these rate reductions based on an in-state interest are facially discriminatory and should be broadened—not struck down—so they fall outside the limitations of the dormant Commerce Clause. Taxing jurisdictions that adopt such constitutionally suspect measures put their taxpayers and fisc at risk. This is unfortunate, because it is not difficult to craft an effective incentive package that is also constitutional.

Practice Note: Any company that invests in a technology company should consider taking the stance that they are entitled to the reduced rates offered by the Act on capital gains. As noted, short-term investments do not qualify under the Act—they must be held for at least 24 months—and the applicability of the rate reduction will not begin until 2019 (or beyond).

The authors encourage any District taxpayer considering investing in or selling a businesses to contact the authors and explore the possibility of classifying the investment as a QHTC, regardless of whether the investment is in a D.C. company.

On Friday, November 14, 2014, an administrative law judge (ALJ) issued three identical orders granting the taxpayer’s motion for summary judgment in Hess v. OTR, Shell v. OTR and ExxonMobil v. OTR.  In these orders, the ALJ determined that based on an early ruling that the challenged methodology was fatally flawed, the Office of Tax and Revenue was barred from re-litigating the issue in the current cases under the doctrine of non-mutual collateral estoppel.

Transfer Pricing Implications

The transfer pricing litigation in D.C. has been a frustrating road for taxpayers because the flaws in the methodology OTR applied have been apparent from the outset.  The first case to be litigated was Microsoft v. OTR, OAH Case. No. 2010-OTR-00012 (May 1, 2012).  In this case, an ALJ ruled that the methodology the District used was fatally flawed because the methodology  failed to (i) separate controlled from uncontrolled transactions and (ii) individually analyze different product lines and different functions.  As a result, the ALJ concluded that the analysis was flawed, arbitrary and unreasonable.  OTR initially appealed the Microsoft order to the D.C. Court of Appeals, only to withdraw shortly after by filing a motion to dismiss its own petition for review.

When Microsoft was decided in 2012, it appeared that the faulty transfer pricing methods used by the District had been permanently debunked.  Nevertheless, OTR renewed the contract for the business performing the transfer pricing audits and did not materially modify the assessment methods.  As a result, taxpayers continued receiving assessments from the OTR based on the same methodology previously ruled invalid in Microsoft.  At least 10 taxpayers have challenged these assessments post-Microsoft, and the orders issued Friday are the first of these challenges to be resolved by the Office of Administrative Hearings (OAH).

The taxpayers in the Hess/Shell/ExxonMobil cases all challenged the substantive validity of the assessment methodology and argued that the Microsoft decision should be controlling.  OTR asserted that the doctrine of non-mutual collateral estoppel did not apply to the government and, even if it did, the elements were not met in this case.  The ALJ disagreed with OTR’s analysis and found “the failure to apply [non-mutual collateral estoppel] would allow [DC] to keep issuing proposed assessments to taxpayers using the same flawed Chainbridge analysis, with the hope that some taxpayers won’t have the wherewithal to challenge the assessment and will find it economically advantageous to simply pay rather than fight.”

The three orders issued on Friday should provide a definitive signal to OTR that the method is flawed as a matter of law and cannot be validly used to assess D.C. taxpayers going forward.  These decisions are essentially decisions on the merits for the pending cases and, assuming no appeal is filed, D.C. should face sanctions if it continues to pursue assessments using the methodology at issue in these cases.

Broad Implications

Perhaps more importantly than the narrow (but important) transfer pricing issue in these decisions, OAH has made is clear that non-mutual collateral estoppel can be applied against OTR in any tax case as long as the elements of the doctrine are met.  This gives real weight and importance to OAH as a venue for resolving complex tax questions.

Up Next?

The OTR has until December 15, 2014 to appeal to the D.C. Court of Appeals.  In addition to the transfer pricing cases already resolved, five cases are still pending before the OAH challenging D.C.’s transfer pricing methods.

With both Halloween and the Multistate Tax Commission (MTC) Income Tax Audit selection nearing, taxpayers should prepare themselves for the possibility of being spooked in the near future.  On Thursday, October 30, from 2-4 pm EST, the MTC Audit Committee—including representatives from the 22 states participating in the upcoming round of joint income tax audits—will be holding a teleconference that will begin with a public comment period.  Because of the inevitable disclosure of confidential taxpayer information, the bulk of this meeting—including selecting the various companies to audit—will take place during the second half of the agenda and be closed to the general public.  Just because a company has completed an audit in the past does not mean this season will be all treats.  The authors have noticed that companies previously audited by the MTC can remain on the list of targets and are often repeat selections.

Unique Complexities

The MTC audit process is not without its share of traps for the unwary.  First and foremost is the effort a taxpayer must expend in managing a multistate audit.  Issues such as differing statute of limitations, the effects of federal Revenue Agent’s Reports (RAR) and net operating loss (NOL) differences on limitations periods, timing of protests, and tax confidentiality become of heightened importance when one auditor is reviewing a taxpayer for multiple states.  Audited taxpayers should also keep in mind that the MTC does not issue the actual deficiency notices – these must come from the states.  As a result there may be certain areas such as credits or refunds that the MTC does not review and must be raised directly with a participating state.

On the substantive side, a primary area of inquiry of an MTC audit has been and is likely to continue to be inter-company transactions.  Historically MTC audits have taken a variety of approaches to disallow a taxpayer’s intercompany structure, including collapsing separate affiliates, applying the sham transaction doctrine, or using aggressive addback concepts.      Another similar concern for taxpayers audited by the MTC is the increased likelihood of transfer pricing issues being raised.  This comes in the wake of the creation of the MTC Arm’s-Length Adjustment Service (ALAS) this summer, led by former Montana Department of Revenue Director Dan Bucks.  The group recently held a transfer pricing summit at which it designed the MTC services to include third-party economic consultants at every stage.  The MTC transfer pricing services are expected to be implemented in mid-2015—just in time for companies selected for an MTC Income Tax Audit to be the test subjects.  Notably, of the nine states committing seed money to the development of a multistate transfer pricing audit service, five (Alabama, Hawaii, Kentucky, New Jersey and the District of Columbia) are participating in the MTC Income Tax Joint Audit Program.  It is not clear whether the two MTC-sponsored audit programs will be intertwined; however, the option was proposed this past summer and remains a possibility as we approach the upcoming audit selections.

Finally, it remains to be seen whether the MTC can audit for non-Compact states.  See Gillette Co. v. Franchise Tax Bd., 147 Cal. Rptr. 3d 603 (Cal. Ct. App. 2012) review granted and opinion superseded sub nom. Gillette v. Franchise Tax Bd., 291 P.3d 327 (Cal. 2013).  Audit authority stems from a provision in the compact giving the MTC authority to audit any “party state or subdivision thereof;” however, nowhere does the MTC define “party state.”  The bylaws of the MTC do distinguish between party states and mere member states—affording more rights to party states.  With this in mind, there appears to be a continued and unresolved argument to be made that non-Compact states (increasing by the day) are not “party states” and therefore have no authority to participate in the Joint Audit Program under the narrowly construed terms of the compact.

To participate in the public comment portion of the upcoming MTC Audit Committee meeting, dial (866) 546-3377, conference code 852212.   

Practice Note:  Taxpayers chosen as the subject of an MTC audit should carefully craft their audit strategy to address the unique issues raised by a multistate audit and by the MTC’s specific areas of focus.  Finally, while this post has focused on income tax issues, the MTC also audits for sales tax compliance.

On September 23, District of Columbia Council Chairman Mendelson introduced the Promoting Economic Growth and Job Creation Through Technology Act of 2014 (Bill 20-0945 , hereinafter the “Act”) at the request of Mayor Vincent Gray.  This marks the second time that the Council has considered the introduced language; it was originally included as part of the Technology Sector Enhancement Act of 2012 (Bill 19-747), but was deleted prior to enactment.  The Act would add a new provision to the D.C. Code (§ 47-1817.07a) to impose a lower tax rate on capital gains from the sale of an investment in a Qualified High Technology Company (QHTC) beginning in 2015.  The rate would be 3 percent as compared with the current rate of 9.975 percent for business taxpayers.  Notably the proposed provision is limited in scope and only applies when the following three elements are satisfied:

  1. The investment was held by the investor for at least 24 continuous months;
  2. The investment is in common or preferred stock or options of the QHTC Company; and
  3. During the taxable year, the investor disposed or exchanged of some or all of his or her investment in the QHTC.

As introduced, the proposed tax is explicitly applied “notwithstanding” any provision of the income tax statutes.

Good Thought, Poor Drafting

The intent of this legislation is clear, but the practical application is not.  As a threshold matter, the second element requires the investment to be “in common of preferred stock or options,” which by definition excludes partnerships and limited liability companies since only corporations can issue stock.  On its face, the language of the bill appears to be limited to investments in a QHTC organized as a corporation, despite the fact that other entities are eligible for QHTC status under D.C. law.  Therefore, limited partners and members investing in pass-through QHTC’s appear to fall outside the scope of the proposed legislation.

Second, by imposing a different rate on only a certain type of income and by taxing the gains notwithstanding any other provision of the income tax statute, the proposal fails to account for basic tax calculations necessary to arrive at taxable income in the District for a business taxpayer.  For example, the allocation and apportionment provisions would seem to be negated both practically and legally.   What part of a multistate taxpayer’s gain from a QHTC is subject to the 3 percent rate?  Is it all of the gain; an apportioned part of the gain – and if so, based on whose apportionment percentage?  What if the gain would have been categorized as non-business income and the taxpayer is a non-resident?  The answer is certainly not obvious from the legislation.  Similarly, how do a taxpayer’s losses, both in the current year and carried over, affect the amount of gain available to tax?  Can all of the losses be used against other types of income first?  Can the losses be used at all against the QHTC gain?

Third, how is a taxpayer notified that the gain qualifies for the special QHTC rate?  Similarly, are companies at risk for shareholder lawsuits if they fail to elect QHTC status?

Finally, existing constitutional and categorization problems with the QHTC designation complicate the special tax rate application.  Investors may find that what they thought was a QHTC is ultimately determined not to qualify or the whole designation is invalidated on constitutional grounds.  Or, the QHTC designation may actually be available to far more companies based on Commerce Clause objections to D.C.’s current standard and thus available to far more investors than D.C. anticipates.

Practice Note:  The Act would seem to apply only to direct investments in a QHTC organized as a corporation.  Many investors finance such business endeavors through holding companies and other investment vehicles.  Gains from sales of an interest in an entity owning a QHTC may not qualify for the special tax rate.  Taxpayers holding investments in any technology company operating in the District of Columbia are encouraged to contact the authors and discuss the effect this legislation would have on the taxation of their investment, if enacted.  The proposed legislation was referred to the Committee on Finance and Revenue immediately after introduction and is being closely monitored by the authors.

On October 6 and 7, 2014, the Multistate Tax Commission (MTC) will hold an Arm’s-Length Adjustment Service (ALAS) Advisory Group Conference at the Atlanta Airport Marriott.  On the first day, third-party contract auditors will give presentations on transfer pricing issues.  An ALAS Advisory Group meeting will be held on the second day.

This past year, the MTC has been designing a joint transfer pricing program.  So far, nine members have committed money to the development of this program: Alabama, the District of Columbia, Florida, Georgia, Hawaii, Iowa, Kentucky, New Jersey and North Carolina.

Dan Bucks, former executive director of the MTC and former director of the Montana Department of Revenue, is the project facilitator.  In the lead-up to the event, he discussed arm’s-length issues with numerous third-party contract auditors.  On October 6, the contract auditors will explain how they believe a multistate transfer pricing program should work and how the MTC would best use their services to conduct transfer pricing audits on behalf of member states.

The list of contract auditors includes Chainbridge Software, Economics Analysis Group, Economists Incorporated, NERA, Peters Advisors, RoyaltyStat and WTP Advisors.  While project facilitator, Dan Bucks, has indicated that this meeting is not an audition for a procurement process, the discussion seems to be headed in that direction and the MTC has not ruled out utilizing third-party audit assistance in the transfer pricing program.

Businesses concerned with the overall direction of the ALAS Advisory Group, including the possibility of subjecting taxpayers to Chainbridge-style audits on a nationwide scale, should contact the authors.  For more information on the conference, please visit the MTC ALAS webpage.

On July 14, 2014, the Fiscal Year 2015 Budget Support Emergency Act of 2014 (2015 BSEA) was enacted after the D.C. Council voted to override Mayor Vincent Gray’s veto.  The act includes a tax relief package recommended by the D.C. Tax Revision Commission, and includes a change to D.C.’s apportionment formula, moving the city to single sales factor apportionment.

Since January 1, 2011, D.C. has required taxpayers to apportion their business income by the property-payroll double-weighted sales factor formula.  D.C. Code Ann. § 47-1810.02(d-1).  Among the provisions enacted in the 2015 BSEA, the District will require the apportionment of business income via a single sales factor formula, starting with tax years beginning after December 31, 2014.  D.C. Act 20-0377, § 7012(c)(10) (2014).  While the 2015 BSEA has only a temporary effect and expires on October 12, 2014, it serves as a stopgap until the process of enacting the permanent version, the Fiscal Year 2015 Budget Support Act of 2014 (2015 BSA) is completed.  (See the single sales factor apportionment provision at D.C. Bill 20-0750, § 7012(a)(10) (2014).)  The 2015 BSA has not yet been enrolled and transmitted to the mayor.  After the mayor signs the 2015 BSA or the D.C. Council overrides his veto, the 2015 BSA will be sent to Congress for review.  If Congress and the President do not enact a joint resolution disapproving of the 2015 BSA, the 2015 BSA will become law, and the switch to single sales factor apportionment will be effective as of January 1, 2015. 

Even with this legislative change, D.C. taxpayers may have an argument for apportioning their business income under the three-factor apportionment formula.  In 1981, the District adopted the Multistate Tax Compact (Compact) as 1981 D.C. Law 4-17.  The Compact provides for the use of the evenly weighted three-factor sales-property-payroll formula.  Multistate Tax Compact, art. IV, sec. 9.  The Compact permits the taxpayer to elect to apportion his business income under the city’s apportionment formula or under the Compact’s three-factor formula.  Multistate Tax Compact, art. III, sec. 1.  In 2013, D.C. repealed and reenacted the statute codifying the Compact, D.C. Code § 47-441.  However, D.C. did not re-enact Article III, Elements of Income Tax Laws, and Article IV, Division of Income.  The repeal of the two articles was effective as of July 30, 2013.  D.C. Act 20-130, §§ 7342(a), (b) (2013); D.C. Act 20-204, §§ 7342(a), (b) (2013); D.C. Law 20-61, §§ 7342(a), (b) (2013).

D.C. repealed and reenacted the Compact in reaction to litigation involving taxpayers that elected to use the three-factor apportionment formula under the Compact instead of the state-mandated apportionment formulas.  See Gillette Co. et al. v. Franchise Tax Bd., 209 Cal.App. 4th 938 (2012); Int’l Bus. Mach. Corp. v. Dep’t of Treasury, No. 146440 (Mich. Jul. 14, 2014); Health Net, Inc. v. Dep’t of Revenue, No. TC 5127 (Or. T.C. 2014).  The California Court of Appeal and Michigan Supreme Court have upheld the taxpayers’ use of the Compact election.

Following the theories being advanced in the above mentioned litigation, while D.C. is switching to the single sales factor formula, taxpayers may have the opportunity to apportion their business income under the Compact’s three-factor apportionment formula.  An argument exists that the three-factor Compact apportionment formula election is still available even though D.C. repealed and partly reenacted the Compact in 2013.  Article X of the Compact permits a party state to withdraw from the Compact “by enacting a statute repealing the same.”  An argument can be made that the partial repeal was impermissible under article X of the Compact and that the three-factor formula election is still available to D.C. taxpayers.  Once a member of the Compact, always a member?!?

Practice Note:  D.C. taxpayers should keep in mind that the Compact apportionment formula election may be available when they file their returns for the 2015 taxable year.  Because out-of-state taxpayers typically do not have significant property or payroll in D.C., they will likely benefit from electing to use the three-factor apportionment formula.

The FY 2015 District of Columbia Budget Request Act (BRA, Bill 20-749) is currently being reviewed by the D.C. Council after being introduced on April 3 at the request of Mayor Vincent Gray. This year’s Budget Support Act (BSA, Bill 20-750), the supplementary bill implementing changes based on the BRA, contains several significant modifications to the tax provisions of the D.C. Code. The changes include provisions recently recommended by the D.C. Tax Revision Commission (TRC), an independent body created by the Council to evaluate possible changes to tax policy in the District with a focus on broadening the tax base and providing “fairness in tax apportionment.” In particular, the BSA proposes to adopt a single sales factor formula for the apportionment of business income and to reduce business income tax rates (both corporate and unincorporated) from nearly 10 to 9.4 percent. Two additional amendments are pulled directly from the Multistate Tax Commission (MTC) rewrite of the Uniform Division of Income for Tax Purposes Act (UDITPA), including a change to the District’s definition of “sale” and the elimination of cost-of-performance sourcing.

Under the District’s existing apportionment statute, all businesses must apportion business income using a four factor formula consisting of property, payroll and double weighted sales factors. If the BSA is enacted, the statute would be amended to also apportion all business income using a single sales factor. While it is clear that the intent of the BSA provision is to adopt a single sales factor in D.C. going forward, a major ambiguity exists in drafting that would require apportionment using both a single sales and double weighted sales factor formula for taxable years starting after December 31, 2014—which of course is impossible. Thus, without a legislative amendments by the D.C. Council prior to passage on May 28, it is unclear whether the single sales factor formula will be optional or mandatory (as recommended by the TRC) for FY 2015. The budget projection released by Mayor Gray in conjunction with the legislation suggests that the single sales factor would be mandatory, since it is projected that this change would raise an additional $20 million in tax revenue for the District for FY 2015. If the single sales factor were optional, it is unlikely the provision would raise that much revenue.

In addition to statutory modifications to the apportionment formula, the BSA also would reduce the tax rate imposed on corporate and unincorporated businesses from 9.975 percent to 9.4 percent.  This is still higher than Maryland (8.25 percent) and Virginia (6 percent).

Picking up where the MTC left off with its ongoing UDITPA rewrite, the District would adopt the MTC draft definition of “sale” to explicitly exclude receipts from hedging transactions and other investment related activity (including the sale, exchange or other disposition of cash or securities).

In addition, BSA would adopt market-based sourcing for sales of intangibles and services, using the language of the MTC draft to do so.  The BSA does not pick up the remaining provisions of the MTC draft UDITPA rewrite.

The full text of the BSA is available here.

Practice Note: Since the vast majority of large multistate businesses making sales in the District do not have significant property or payroll in D.C., most corporations will likely be subject to greater tax liability under a single sales factor approach.  The expected legislative timetable for adoption of the BSA is below:

FY 2015 Budget Timeline:

  • April 3, 2014: Mayor Gray submits FY 2015 Proposed Budget to D.C. Council
  • April 7, 2014: Committee of the Whole Briefing on Mayor’s proposed budget
  • May 9, 2014: Committee of the Whole Public Hearing on BRA and BSA
  • May 13-15, 2014: Council Committee Mark-Ups
  • May 19-27, 2014: Council closed door markup and negotiation
  • May 28, 2014: Council will conduct its first reading and vote on the BRA and BSA (only one reading of the BRA is required since it must be sent to Congress for approval under the D.C. Home Rule Act)
  • June 11, 2014: Council second vote on the BSA. Shortly after both the BRA and BSA are approved by the Council, they will be submitted to Congress for approval. Congress approves the D.C. Budget in conjunction with their federal appropriations legislation (which may take months)
  • October 2014: Fiscal Year 2015 begins

The recent decision in Alenia N. America, Inc. v. District of Columbia Office of Tax and Revenue in the District of Columbia Office of Administrative Hearings (OAH) could present opportunities for District taxpayers to receive corporate franchise tax refunds by including their joint ventures’ apportionment factors in the taxpayers’ District apportionment percentage calculation.  Alenia N. America v. District of Columbia Office of Tax and Revenue, Dkt. 2012-OTR-00015 (D.C. O.A.H.  Mar. 11, 2014).

Through an unwritten, internal policy, the District of Columbia Office of Tax and Revenue (OTR) prohibited separate filers from including the apportionment factors of joint ventures in which a taxpayer was a member/partner in the apportionment percentage calculation while permitting consolidated filers to do so.  Alenia N. America challenged this interpretation of the District’s apportionment formula, filing a protest in OAH.  Alenia is a separate filer C Corporation headquartered in the District.  A portion of Alenia’s 2010 tax year income resulted from its 51 percent ownership in a Mississippi LLC, Global Military Aircraft Systems (GMAS).  Because OTR required Alenia to include the income resulting from ownership of GMAS in its apportionable tax base but exclude the apportionment factors of GMAS, Alenia’s District apportionment percentage increased from 55.1899 percent to 86.1993 percent.  OTR effectively asserted the power of taxation over income derived from sources outside of the District.

OAH granted a summary decision in favor of Alenia, holding that GMAS’ apportionment factors could be included by Alenia because Alenia and GMAS were unitary and the District’s apportionment statute was designed with the purpose to create uniformity; most states applying formulaic apportionment allow for the inclusion of the apportionment factors (see Homart Development Co. v. Norberg, 529 A.2d 115 (R.I. 1987); Malpass v. Dep’t of Treasury, 494 Mich. 237, 833 N.W.2d 272 (2013)); and factor inclusion was necessary to reflect the source of the GMAS income.  Reading the District’s apportionment statute, D.C. Code § 47-1810.02, “consistently with its constitutional underpinnings and its general purpose to promote uniformity” overcame the silence as to whether the inclusion of factors applied to separate filers.  OTR’s misinterpretation of District law was “in conflict with the statute.” Alenia, Dkt. 2012-OTR-00015 at *26.

In light of the holding in Alenia allowing for the inclusion of the apportionment factors of joint ventures, taxpayers should consider whether District refunds are now available to them.  Further, an argument can be made that the holding in Alenia continues to apply despite the District’s switch to a combined reporting regime because of the court’s insistence that factor inclusion is necessary to reflect the source of the taxpayer’s income.

For a copy of the decision, contact one of the authors.