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California court rules that single-sales factor initiative survives constitutional challenge
October 2023
In brief
The California Court of Appeal recently concluded that Proposition 39 - which eliminated the three-factor apportionment option and imposed a mandatory single-sales factor apportionment formula - does not violate the state’s constitutional single-subject rule for ballot initiatives. Thus, the taxpayer, an out-of-state corporation, could not utilize a three-factor formula when apportioning its income to California.
Observation: Unless overturned by the California Supreme Court, this decision may close the door on single-sales factor challenges based on violations of the single-subject rule. At this same time, this decision should not be viewed as precluding taxpayers from examining in their particular circumstances whether application of the single-sales factor yields a distortive result when apportioning income to California.
[One Technologies LLC v. Franchise Tax Board, Cal. Ct. App. (2nd) No. B318787, 10/23/23]
In detail
California apportionment and Proposition 39
Prior to the effective date of Proposition 39, most taxpayers had two options for apportioning income to California: (1) a three-factor formula, based on property, payroll, and double weighted sales; and (2) a single-sales factor formula. Taxpayers engaged in certain industries, including banks, and certain extractive industries (hereinafter, the “excluded industries”) were and are required to use an evenly-weighted three factor formula.
California voters, on November 6, 2012, approved an initiative measure, Proposition 39, which removed three-factor apportionment as an option. As a result, taxpayers, other than those engaged in the excluded industries, must use a single-sales factor formula. The goals of the proposition (as outlined in the ballot materials) and the shift to a single-factor formula were to increase revenues to the state (by requiring out-of-state taxpayers to source more of their income to California) and to dedicate a portion of that increased revenue to fund job creation in the energy efficiency and clean energy sector. However, Proposition 39 also created an exception for certain qualified companies operating cable systems and meeting other criteria; these businesses were allowed to effectively treat 50% of their in-state sales as out-of-state sales.
The taxpayer’s challenge and the single-subject rule
Article II, section 8(d), of the California Constitution provides that “[a]n initiative measure embracing more than one subject may not be submitted to the electors or have any effect.” This rule was enacted to minimize the risk of voter confusion and deception.
The taxpayer, a Texas-based seller of credit scores and credit reports, initially employed the single-sales factor formula and then recalculated its liability using the three-factor formula, which was repealed by Proposition 39. The recalculation resulted in a refund claim, which was rejected by the Franchise Tax Board (FTB). The taxpayer claimed that it was entitled to use the three-factor formula because Proposition 39 violated the single-subject rule and, therefore, was invalid. This claim was rejected by the FTB and the trial court.
Proposition challenge rejected
The Court of Appeal (court) detailed a two-part test for compliance with the single-subject rule. Under the first test, an initiative measure does not violate the rule if, despite its varied collateral effects, all of its parts are “reasonably germane” to each other and to the general purpose or object of the initiative. An initiative satisfies the second test if its provisions are functionally related.
The taxpayer argued that the Proposition 39 provision establishing special treatment for cable companies is not reasonably germane to the creation of clean energy jobs because that provision reduced revenues that otherwise would be available to the clean energy jobs program. The court rejected this claim, explaining that “[w]hat plaintiff characterizes as a tax break is just one of many decisions the drafters made when determining who should pay for the clean energy jobs program, and how much each should contribute.”
The court rejected claims that the single-subject rule requires that an initiative cannot contain taxing provisions addressing one subject (multistate businesses) and then use the revenues generated by those provisions to address a second, unrelated subject (clean energy). Looking at California Supreme Court precedent, the court concluded that increasing taxes on multistate businesses is “reasonably germane and functionally related to the creation of clean energy jobs when the former is used to fund the latter.” The court also rejected the taxpayer’s claim that inclusion of the cable company provision was deceptive.
Observation: Noting the “important and favored status” of the initiative process in the state’s constitutional scheme, the court said that it would not interpret the single-subject requirement “in an unduly narrow or restrictive fashion.” Thus, the Court of Appeal seemed hesitant to rule against the state on this issue.
However, the California Supreme Court currently is considering a single-subject challenge to another initiative petition, involving a nontax matter. The outcome of that case could impact any appeal of this case.
Challenges to the state’s single-sales factor continue, and multistate businesses still are allowed pursuant to Cal. Rev. & Tax Code Sec. 25137 to pursue alternative apportionment where the standard apportionment formula does not accurately reflect the taxpayer’s in-state business activity. Multistate businesses apportioning income to California should examine the results yielded by the single-sales factor formula to determine whether pursuing an alternative apportionment petition might be possible.
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