State Income Tax Refund Claims

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Publication November 12, 2015

State income tax refund claims are proliferating as states move to drop out or nullify parts of a multistate tax compact that companies are using to make refund claims.

Michigan is the latest state in the crosshairs. Taxpayers in 50 consolidated tax cases lost before the state court of appeals in September in a lawsuit against the state tax department. The issues may be headed ultimately to the state Supreme Court. 

Each US state taxes income earned in the state. Because the states have different approaches to determining how much income a large company operating nationally earned in each, there is the potential for double taxation. A House subcommittee recommended in 1965 that Congress impose a uniform apportionment regime on the states. State tax administrators from nine states drafted a multistate tax compact in 1967 in an effort to avoid federal action. More states joined later. The multistate compact adopts a three-factor formula in which a company apportions income to the state based on the share of the company’s total property, payroll and sales in the state. The three factors are given equal weight.  

In 2008, Michigan shifted to a sales-only formula. The companies involved in the lawsuit argue they should still have been able to use the three-factor formula in the multistate tax compact to determine their Michigan incomes, at least until September 2014 when the state dropped out of the compact retroactively to January 1, 2008. The companies have large sales, but little payroll or property in Michigan. 

The state is facing as much as $1.1 billion in refunds if it loses in the courts. 

The case is Gillette Commercial Operations North America v. Department of the Treasury. Other companies joining in the suit include IBM, Dollar Tree, Anheuser-Busch, Michelin, Sonoco Products, Cargill, Goodyear, Fluor, T-Mobile and Hallmark. 

The court of appeals said the state has a right to change its tax laws retroactively and doing so is not a denial of due process to taxpayers under either the federal or state constitution. Both federal and state courts have held that retroactive amendments to tax statutes do not offend due process as long as there is a legitimate business purpose that is furthered by rational means. It is not enough for taxpayers to show they did something in reliance on the tax law at the time. (For a discussion about when retroactive tax law changes go too far, see the November 2012 Project Finance NewsWire article Retroactive Taxes.)  

The case may end up next before the Michigan Supreme Court. That court held in July 2014 that IBM was entitled to use the three-factor formula for calculating its taxes in 2008 after concluding there was no evidence that the state legislature wanted to repeal the multistate compact provision allowing companies to elect use of the three-factor formula when it adopted a single-factor approach in 2008. The state legislature responded to the Supreme Court decision by quickly repealing the multistate compact retroactively the start of 2008.    

Meanwhile, the California Supreme Court heard oral arguments in early October in a case in which Gillette and other companies are arguing they are entitled to use the multistate tax compact formula for calculating California source income. California adopted the multistate compact in 1974. However, in 1993, its changed its law to require double weighting be given to the sales factor. 

Gillette and five other companies sued the state for $34 million in refunds in 2010 arguing that they are entitled by law to use the multistate formula. A California appeals court agreed in a decision in 2012. (For earlier coverage, see the September 2012 Project Finance NewsWire article Gillette.) 

The state legislature voted, shortly before the appeals court released its decision, to withdraw from the multistate compact and to bar refund claims unless a company elected to use the apportionment formula in the multistate compact when it originally filed its tax return.

Similar battles are playing out in other states. Fourteen of the 20 states that belonged to the multistate compact had moved away from the three-factor formula by 2012. North Dakota replaced the three-factor formula in the compact with a single sales factor in April 2015.


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