Alternative apportionment: fairness is not the only factor.

• Author: Yesnowitz, Jamie C.

ALITRNATIVE APPORTIONMENT IS A STATUTORY device that provides taxpayers and tax administrators with a means to obtain ad hoc relief when the application of a state's standard apportionment formula fails to reflect a taxpayer's business activities in the state. It has its roots in a series of U.S. Supreme Court cases that established a narrowly applied constitutional analysis that provided for substantive limitations designed to ensure that practicality and certainty were not sacrificed in favor of fairness in apportionment cases, except in the most egregious circumstances. However, because state statutes that permit alternative apportionment and administrative and judicial interpretations of these provisions are ambiguous, many of these constitutional limitations were not carried over to the states in their individual alternative apportionment statutes.

The narrow application of these constitutional limitations has in recent years resulted in more frequent use of alternative apportionment by both taxpayers and tax administrators, which, in turn, has caused many states to place significant obstacles in the path of taxpayers seeking the benefits of alternative apportionment. Consequently, taxpayers are often faced with an inequitable apportionment outcome with no way to achieve relief from that result in a practical, certain manner. As a means to correct this problem, perhaps the statutory alternative apportionment analysis should be shifted back toward its constitutional progenitor.

Constitutional and Statutory Basis for Alternative Apportionment

The historical basis for alternative apportionment lies in the U.S. Constitution, which, pursuant to the Due Process and Commerce Clauses, requires state income tax on interstate commerce to be apportioned in a manner that reasonably approximates the relationship between a taxpayer's income attributed to a state and the taxpayer's business activities in that state. (1)

The Supreme Court has determined that a state's standard apportionment formula adequately reflects the required relationship if the apportionment formula is internally and externally consistent both facially and when applied to a particular taxpayer's facts and circumstances. (2) Under the internal consistency test, a state's standard apportionment formula is constitutionally valid if, when applied in every taxing jurisdiction, "it would result in no more than all of the unitary business' income's being taxed." (3) The external consistency test looks "to the economic justification for the State's claim upon the value taxed, to discover whether a State's tax reaches beyond that portion of value that is fairly attributable to economic activity within the taxing State." (4)

Where a state's standard apportionment formula fails either the internal or external consistency test for a particular taxpayer, that taxpayer is entitled to challenge, on an original or amended return or via appeal, the constitutionality of the standard apportionment formula as applied to the taxpayer, and seek the application of an alternative apportionment formula. A taxpayer that makes such a challenge bears the burden of proving, by clear and cogent evidence, that the standard apportionment formula leads to a grossly distortive result, and that the requested alternative apportionment method alleviates that distortion in a manner that more fairly represents the taxpayer's business activities in the state. (5)

This ad hoc relief is intended to ensure fairness when a state's standard apportionment formula yields the most egregious and nonsensical results, while requiring a high burden of proof and placing other limitations on a challenging taxpayer acknowledges "the practical impossibility of a state's achieving a perfect apportionment of expansive, complex business activities" (6) and the importance of tax certainty as a policy consideration.

Most states have enacted statutory relief provisions that adopt the judicial doctrine of alternative apportionment, with the addition that alternative apportionment may be used by both taxpayers and tax administrators. Largely, these statutes mirror, or are patterned after, Uniform Division of Income for Tax Purposes Act (UDITPA) Section 18, which provides:

If the allocation and apportionment provisions of this Act do not fairly represent the extent of the taxpayer's business activity in this state, the taxpayer may petition for or the tax administrator may require, in respect to all or any part of the taxpayers business activity, if reasonable: (a) separate accounting; (b) the exclusion of any one or more of the factors; (c) the inclusion of one or more additional factors which will fairly represent the taxpayer's business activity in this State; or (d) the employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer's income. One of the problems with UDITPA Section 18 is that it does nor clearly state whether it is merely an extension of the constitutional alternative apportionment analysis to tax administrators or represents an additional extra-constitutional relief mechanism. William...