United States

South Carolina: State Supreme Court Clarifies Burden of Proof in Alternative Apportionment Case

Jan 12, 2015
From KPMG TaxWatch

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The South Carolina Supreme Court recently addressed whether the Department of Revenue could apply an alternative apportionment methodology to apportion a taxpayer’s income. The taxpayer at issue, West, was a subsidiary of a multistate used car retailer. West sold automobiles in western states. Another subsidiary, East, sold automobiles in eastern states, including South Carolina. As a result of a restructuring, the intangible property used by both businesses and the overall financing operations were transferred to a pass-through entity. West received over 90 percent of the pass-through entity’s royalty and financing fee income. However, because West had non-South Carolina vehicle sales, it had low South Carolina apportionment, despite the fact that it indirectly received South Carolina source royalties from East and financing fees related to South Carolina transactions.

Under South Carolina law, an alternative apportionment method can be applied if the standard apportionment method does not fairly reflect a taxpayer’s income. After an audit, the Department applied an alternative method that excluded the vehicle sales from the apportionment factor and took into account only West’s receipts from royalties and financing within South Carolina over its everywhere royalties and financing receipts. Initially, the case went before an Administrative Law Judge (ALJ) who determined that West had the burden of proving the Department's proposed alternative method was not reasonable. As West, in the ALJ’s view, did not meet this burden, the ALJ concluded that the Department’s suggested alternative apportionment method was appropriate. The taxpayer subsequently appealed to the appeals court, which held that the party seeking to apply alternative apportionment bore the burden of proving that the statutory method was not reasonable. The appeals court also held that the Department then had to prove that its proposed alternative method not only fairly represented the taxpayer’s business activity in South Carolina, but was more reasonable than any competing methods.  

On appeal, the South Carolina Supreme Court held that the appeals court erred when it required the Department to show that its alternate method was not only reasonable, but more reasonable than any competing method. In the court’s view, the Department simply had to prove that its proposed alternative was reasonable. As such, the high court concluded that the proponent of an alternative formula bears the burden of proving by a preponderance of the evidence that: (1) the statutory formula does not fairly represent the taxpayer's business activity in South Carolina and (2) its alternative accounting method is reasonable. Applying this holding to the instant case, the court further held that the Department failed to prove the first prong of the test—that the statutory formula did not fairly represent West’s business activity in South Carolina. At trial, the ALJ relied on testimony from an auditor that West’s business structure was “linked with “tax minimization strategies” and that West’s apportionment (due to dilution) was lower than East’s. In the court’s view, even if these findings accurately characterized West’s motives, they did not provide a sound evidentiary basis to support the conclusion that the statutory formula did not fairly represent West’s business in South Carolina. Due to the parties’ agreement, the case was not remanded to the ALJ. Thus, it appears that the Department has no further avenue to provide ample evidence. Please contact Mike Raley at 704-371-8160 with questions on Carmax Auto Superstores West Coast, Inc. v. South Carolina Department of Revenue.

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.