State and Local Tax Alert - April 2016

April 2016

Tennessee Supreme Court Upholds Department's Use of Market Sourcing for Sales Factor Apportionment Purposes

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In Vodafone Americas Holdings, Inc. & Subsidiaries v. Richard H. Roberts, Commissioner of Revenue, No. M2013-00947-SC-R11-CV (Mar. 23, 2016), the Tennessee Supreme Court affirmed a lower court’s decision and upheld the imposition of alternative apportionment on Vodafone to require the use of a market-sourcing method for sourcing receipts for sales factor purposes instead of the state’s standard costs of performance method.


Vodafone is a mobile telecommunications network company that is commercially domiciled in California.  Vodafone directly and indirectly owned a 45 percent interest in Cellco Partnership, a Delaware general partnership that operates across the United States as Verizon Wireless.  The other 55 percent interest in Cellco was owned by Verizon Communications.
Vodafone filed Franchise and Excise Tax returns for the period January 1, 2002 through March 31, 2006, and applied a primary-place-of-use method (based on customer billing address) to source receipts from Cellco’s sales of telecommunications services for purposes of calculating the factor used to apportion its income to Tennessee.  Using this method, Vodafone sourced $1,357,566,794 of receipts from Cellco to Tennessee, and paid $13,645,288 in Franchise and Excise Tax.
Vodafone filed a complaint in Tennessee Chancery Court seeking a refund of the full-amount of Franchise and Excise Tax paid on the basis that it lacked nexus with the state.  Subsequently, Vodafone filed an amended complaint in which it alternatively asserted that it was entitled to source receipts from Cellco’s sales using the statutorily required greater costs of performance method (based on where the greater costs of the service is performed).  According to the study Vodafone used to support its use of the costs of performance method, higher costs occurred in California, Georgia and New Jersey than in Tennessee.  California, Georgia and New Jersey did not follow this method for sourcing sales.  Using the costs of performance method, Vodafone sourced $150,896,965 of receipts from Cellco to Tennessee, an 89-percent reduction in the receipts as reported on its originally filed returns. 
The Commissioner responded to the amended complaint with a variance letter (a letter asserting the use of alternative apportionment), which served to deny Vodafone’s refund claim.  The variance letter requires Vodafone to use the primary-place-of-use method, and notes that the primary-place-of-use is easier to administer in this case, the costs of performance method does not fairly reflect Vodafone’s activity in the state, and the necessity of the primary-place-of-use method  to fairly represent the extent of Vodafone’s business activities in the state.  The variance and the related apportionment issue then became the focal point of the litigation.
The Chancery Court dismissed Vodafone’s complaint, and held that the variance was properly issued, the Commissioner properly exercised his discretion in issuing the variance, and the primary-place-of-use methodology fairly represented the extent of Vodafone’s business activity in the state.  Vodafone appealed the matter to the Court of Appeals of Tennessee, who affirmed the trial court’s decision.  Vodafone then petitioned the Supreme Court of Tennessee for review, and the petition was granted.
The Supreme Court of Tennessee’s Holding and Reasoning
 Applying an abuse of discretion standard of review, the Tennessee Supreme Court adopted the Court of Appeals’ threshold inquiry under the variance statute – whether the standard statutory formula (the costs of performance method) fairly represented the extent of the taxpayer’s business activity in Tennessee, and whether the alternative formula (the primary-place-of-use method) in the Department’s variance is reasonable.  The court agreed with the Chancery Court and the Court of Appeals that the 89-percent aggregate reduction in Vodafone’s gross receipts sourced to Tennessee using the costs of performance method was sufficient to show that the costs of performance method did not fairly reflect Vodafone’s business activity in Tennessee.  The court rejected Vodafone’s argument that such reasoning usurped the Tennessee legislature’s authority to make tax policy decisions by citing the discretionary authority granted the Commissioner by the variance statute and the expansion of that authority by the legislature over time.1
On the question of whether the Department’s variance was reasonable, the Tennessee Supreme Court, as had the lower courts, used Vodafone’s original tax returns against it.  Although Vodafone never itself requested a variance to permit it to do so, Vodafone filed its original Tennessee tax returns using the primary-place-of-use method.  According to the court, “Vodafone would be hard-pressed to argue that the alternative formula required in the variance is unfair, since it employs the very methodology used by Vodafone in its original tax return.”  In addition, the court ruled that the Commissioner’s alternative formula was reasonable, because it believed the primary-place-of-use method was easier to administer than the costs of performance method.  Lastly, the court reasoned that because the state with the greatest proportion of Vodafone’s costs of performance (New Jersey) did not employ the costs of performance method, the primary-place-of-use method was more consistent with an asserted goal of the Uniform Division of Income for Tax Purposes Act (“UDITPA”) to prevent so-called “nowhere income.”
In addition to the variance statute, the Department of Revenue regulation interpreting the statute has been in existence since Tennessee enacted UDITPA in 1976.  See Tenn. Comp. R. & Regs. Rule 1320-06-01-.35.  After repeating the statutory language of the variance statute, the regulation states that the variance statute permits a departure from the standard apportionment formula: (i) “only in limited and specific cases[;]” (ii) “where unusual fact situations . . . produce incongruous results[;]” and (iii) that such situations “ordinarily will be unique and nonrecurring[.]”  Vodafone argued that its business was not “unusual” and, as a result, the variance was not imposed on a “limited and specific” case, but on the telecommunications industry as a whole.  It also argued that the results of the costs of performance method could not be considered “incongruous,” because that was the standard method intended by the Tennessee legislature.  The Tennessee Supreme Court again relied on the 89-percent sourcing disparity between use of the primary-place-of-use method and the costs of performance method as proof that Vodafone’s business activity presented an “unusual fact situation” and that the standard formula produced an “incongruous result.”  The Tennessee Supreme Court also agreed with the Commissioner that the use of the costs of performance method by Vodafone presented an “unusual fact situation” that produced “incongruous results” because of the alleged administrative difficulties confronting the Department when verifying the location of the greatest proportion of Vodafone’s costs of performance.  As a result, the court agreed that the administrative burden on the Department to verify where a taxpayer incurs its costs is an appropriate consideration in determining whether a taxpayer presents an “unusual fact situation.”
In a dissenting opinion, Justice Bivins reasoned that the Commissioner ignored its own regulation and, therefore, exceeded its authority in issuing the variance.  According to the dissent, imposition of the variance was tantamount to imposing a variance on an entire industry and, thus, could not be a response to an “unusual fact situation” that was “unique.” 

BDO Insights

  • The Vodafone Americas decision illustrates the challenges facing a taxpayer who is confronted by an alternative apportionment adjustment, especially when “abuse of discretion” is the standard of review that the taxing authority must satisfy.  In addition, Vodafone Americas highlights, rightly or wrongly, the importance of a taxpayer’s filing history, apportionment rule consistency between the adjusting state and others where the taxpayer does business, and that policy arguments opposed to the taxing authority’s alternative formula are often unavailing, given the discretionary nature of the adjustment.
  • The Tennessee Supreme Court’s emphasis on the 1999 amendments to the variance statute and the expanded authority granted that the Commissioner, by those amendments, could aid taxpayers confronting variance adjustments going forward.  First, the 1999 amendments’ addition of arm’s-length transfer pricing adjustment authority and authority to use substance over form doctrines under the Tennessee variance statute were not applicable in Vodafone Americas, because income shifting resulting from a tax motivated structure or transaction was not implicated.  Second, the 1999 amendments’ addition of combined reporting as a potential alternative should have required the Commissioner to compare the apportionment results under its primary-place-of-use method to combined reporting as one of the other acceptable alternatives under the statute.
  • With Tennessee’s adoption of market-based sourcing for taxable years beginning on or after July 1, 2016, the Tennessee Supreme Court’s holding that the Commissioner’s primary-place-of-use method was reasonable compared to the costs of performance method because the former was less burdensome to administer, might be one aspect of Vodafone Americas that could render the result a pyrrhic victory for the Commissioner.   

For more information, please contact one of the following regional practice leaders:

West:   Atlantic:
Rocky Cummings
Tax Partner

  Jeremy Migliara
Tax Senior Director

Paul McGovern
Tax Senior Director
  Jonathan Liss
Tax Senior Director

Northeast:   Central:
Janet Bernier 
Tax Partner

  Angela Acosta
Tax Senior Director

Matthew Dyment
Tax Principal

  Nick Boegel
Tax Senior Director


  Joe Carr
Tax Principal

Ashley Morris
Tax Senior Director

  Mariano Sori
Tax Partner

Scott Smith
Tax Senior Director
  Richard Spengler
Tax Senior Director

    Gene Heatly
Tax Senior Director

    Tom Smith
Tax Partner

[1] The Tennessee variance statute was originally enacted in 1956, but only allowed a taxpayer to request to use an alternative apportionment formula.  When Tennessee enacted UDITPA in 1976, the original variance statute was repealed and replaced by UDITPA Section 18’s alternative apportionment statute, and the Commissioner also was granted discretionary authority to require an alternative formula or variance.  Again in 1999, Tennessee’s legislature made substantial amendments to the franchise and excise tax, including expanded authority to the Commissioner under the variance statute.  Among other options, the Department was granted the authority to use “any other method to source receipts” and combined reporting as alternative apportionment formulae.