State Discretionary Authority and Alternative Apportionment

By Charles Britt, CPA, J.D., and Craig Ridenour, CPA, MBA, Raleigh, NC

Editor: Rick Klahsen, CPA

Every state taxing authority has some measure of discretion to determine a taxpayer’s income under alternative methods if the taxing authority believes the taxpayer’s income, as determined under the state’s tax code, does not fairly represent the extent of the taxpayer’s activity in the state. A state taxing authority can generally allow or require a taxpayer to:

  • Use separate accounting in lieu of formulary apportionment;
  • Exclude any one or more of the standard apportionment factors;
  • Include one or more additional apportionment factors; or
  • Use any other method to effectuate an equitable allocation and apportionment of the taxpayer’s income (see Uniform Division of Income for Tax Purposes Act §18).

With state tax revenues falling, states have ramped up enforcement measures in an effort to ensure that taxpayers comply with state tax laws and remit the full amount of tax they owe. Many states are actually hiring more tax auditors even as they lay off government employees in other positions. As a result, state audit activity has both increased in frequency and become more aggressive in nature.

State taxing authorities have shown a growing predilection to use their discretionary power in their favor as they have become increasingly desperate for revenue. Several recent cases highlight this unsettling trend.

Bell South

In BellSouth Advertising & Publishing Corp. v. Chumley, No. M2008-01929COA-R3-CV (Tenn. Ct. App. 8/26/09), the Tennessee Court of Appeals upheld the commissioner of revenue’s exercise of discretionary authority to vary the statutory apportionment formula based on the cost of performance methodology and to instead require the use of a market-based sales factor.

The taxpayer used the all-or-nothing cost of performance approach as set forth in Tennessee Code Ann. Section 67-4-2012(i). As a result, the taxpayer computed a relatively small sales factor for Tennessee franchise and excise tax purposes because a greater proportion of its costs of performance were outside Tennessee. The commissioner recalculated the taxpayer’s income using a market sourcing approach, which resulted in an increased sales factor and an increased tax liability. The case did not reveal whether the commissioner conversely would offer a taxpayer relief if the all-or-nothing cost of performance approach resulted in a significantly higher sales factor than under a market approach.

This decision unfortunately highlights Tennessee’s broad authority to disregard statutory provisions requiring use of the cost of performance approach when varying from the statute is advantageous to the state. Taxpayers using the cost of performance methodology, such as those in service-oriented businesses, can expect increased scrutiny from state taxing authorities, particularly in states where that approach results in a lower sales factor than market sourcing.

United Parcel Service

In United Parcel Service General Services Co. v. Director, Div. of Taxa tion, Nos. 007845-2004, 007879-2004, 007889-2004, 007890-2004, and 007891-2004 (N.J. Tax Ct. 6/5/09), the New Jersey Tax Court upheld the New Jersey Division of Taxation director’s exercise of discretionary authority to make adjustments to the taxable income of affiliated taxpayers in “order to correct distortions.” The director concluded that cash sweeps pursuant to the UPS group’s cash management system should be treated as loans between the entities and imputed interest for these “loans” under the director’s statutorily granted discretionary authority.

The taxpayer emphasized a lack of loan documentation, the absence of repayment schedules or due dates, the absence of collateral, the inability of the subsidiaries to receive earnings from the investments, and the fact that centralized cash management systems are ubiquitous among large corporate groups. The Tax Court set all these factors aside and held that the director’s discretionary adjustments are entitled to a presumption of validity and are rebuttable only by cogent evidence, a standard that the court said the taxpayer failed to meet.

This case highlights the ability of states to recast intercompany transactions when it is advantageous to the state. Taxpayers engaging in intercompany transactions with affiliates should therefore expect increased scrutiny from state taxing authorities, particularly in states that require separate reporting.


Similarly, a recent North Carolina case demonstrates the state taxing authority’s ability to force affiliated taxpayers to file a combined report even though the state generally allows only separate company filings. In Wal-Mart Stores East, Inc. v. Hinton, 676 S.E.2d 634 (N.C. Ct. App. 2009), the taxpayer argued that the secretary of revenue could force taxpayers to file a combined return only when payments between the affiliates were in excess of fair compensation. The North Carolina Court of Appeals found no such restriction on the secretary’s discretionary authority and held that the secretary may require combined reporting whenever doing so is necessary to disclose the taxpayer’s “true earnings.”

Fortunately, the discretionary authority of state taxing authorities is not unlimited and cannot be used to the exclusive benefit of the state. Taxpayers have been successful in asserting that taxing authorities have either abused their discretion in restating income or erroneously failed to exercise their discretion to correct unfair results.

Other Decisions

In Media General Communications, Inc. v. SC Dep’t of Revenue, No. 07-ALJ17-0089-CC (S.C. Dep’t of Rev. Admin. Law Ct. 5/4/09), the taxpayer asked to use combined apportionment. The Department of Revenue agreed that the standard apportionment methodology did not fairly represent the taxpayer’s activity in the state and that combined apportionment was more appropriate. However, the department asserted that it did not have the authority to allow the taxpayer to file using combined apportionment. The judge determined that the department did in fact have that authority and that the department’s denial of the taxpayer’s request for alternative apportionment was improper.

In Delhaize America, Inc. v. Hinton, No. 07-CVS-020801 (N.C. Sup. Ct., Wake Co.), a lawsuit currently being litigated at the trial court level in North Carolina, the taxpayer is arguing that the state’s Department of Revenue has a policy of withholding from taxpayers the criteria it uses in exercising its discretionary authority when determining whether affiliated corporations will be forced to file a combined return. The taxpayer alleges that this policy is unconstitutional in that it constitutes a “secret law” designed to increase taxes, interest, and penalties assessed against certain North Carolina taxpayers. If successful, this challenge could limit the state’s ability to indiscriminately wield its discretionary authority against taxpayers.

As these cases illustrate, state taxing authorities are aggressively using their discretionary authority to adjust the income of taxpayers in a variety of circumstances. However, taxpayers should be prepared to evaluate the reasonableness of such adjustments and, when necessary, to fight against abuses of discretion. In some cases, taxpayers entitled to alternative apportionment or other relief should be willing to assert their positions even if the state taxing authority initially denies their request for relief.


Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or

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