Gillette Decision Upheld, But Beware

The California Court of Appeals for the First District upheld its earlier ruling in Gillette v. Franchise Tax Board. This means that for tax years from 1993 – 2011 a three-factor formula for apportioning income is valid. Earlier, the same appellate court ruled the same way; this decision clarified the earlier decision.

However, this decision is subject to appeal. The FTB sent an email to tax practitioners this week. Spokesperson Susan Maples sent out this staff opinion:

On October 2, 2012, the Court of Appeal issued its decision in Gillette v. Franchise Tax Board, Calif. First Dist. Ct. App. Dkt. No. A-130803. Questions have arisen regarding whether a taxpayer that chooses to elect the use of the Compact method of apportionment on its taxable year 2011 tax return that is filed by October 15, 2012, runs the risk of having the penalty under Revenue and Taxation Code section19138 (The Large Corporate Underpayment Penalty or “LCUP”) imposed if, after October 15, the decision of the Court of Appeal is vacated or modified by the Court of Appeal, or vacated or overturned by the California Supreme Court.

Staff believes that taxpayers choosing to elect the use of the Compact method of apportionment on a timely filed original return for the 2011 taxable year, that is filed before the decision of the Court of Appeal in Gillette v. Franchise Tax Board is final, will run the risk of incurring the LCUP if that decision is subsequently vacated, reversed, or overturned. The reason is that the decision of the Court of Appeal is not final until November 1, 2012, — 30 days after the decision was issued (Cal. Rules of Court rule 8.264(b)(1)). Because the decision is not final, it should not be treated as the state of the law until November 1, 2012.

Section 19138, subdivision (f), that provides for relief from the LCUP if the penalty is imposed on an understatement due to a change in law occurring after a return is filed, is not applicable to the question raised because the state of the law on October 15, 2012 does not include the decision of the Court of Appeal in Gillette v. Franchise Tax Board, as it has not yet become final. Therefore, there is no “change in law” that will occur should the decision be vacated or overturned after October 15, 2012. The law would be the same as it was at the time the taxpayer filed the return.

So what should multi-state businesses do? One strategy would be to file returns using the California formula (a 3-factor formula with sales doubled), and then file a protective claim for refund based on the Gillette decision.

One other aspect is quite clear: Expect the FTB to appeal. Reading between the lines of the staff opinion, this is fairly clear. Finally, California is no longer a member of the multi-state Compact so for 2012 and future years this is no longer relevant.

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