Tax Law Insights

The income of a multi-state business subject to tax in South Carolina is ordinarily determined by allocating certain income to South Carolina and apportioning the remainder of the business's income based on the ratio of South Carolina sales to gross sales everywhere. However, the law permits a taxpayer or the South Carolina Department of Revenue to use an alternative method when the ordinary allocation and apportionment rules do not fairly represent the extent of a taxpayer's business activities in South Carolina.

On December 23, 2014 the South Carolina Supreme Court issued an important decision, CarMax Auto v. South Carolina Department of Revenue, addressing when a taxpayer or the Department of Revenue may use an alternative allocation and apportionment formula. The Court determined that the party seeking to deviate from the ordinary allocation and apportionment provisions bears the burden of proving by a preponderance of the evidence that: (1) the ordinary provisions do not fairly represent the taxpayer's business activity in South Carolina and (2) that the alternative allocation and apportionment formula is reasonable.

The CarMax Auto case involves an often used corporate structure where one subsidiary entity owns intellectual property (licensing entity) and licenses its use to another subsidiary that then utilizes the intellectual property to market products for sale (sales entity). The sales entity pays a licensing fee to the licensing entity, thereby reducing the taxable income of the sales entity. The licensing entity does not operate in the same state as the sales entity, and the licensing fee is therefore not subjected to income tax in the sales entity's state.

In CarMax Auto, the South Carolina Department of Revenue believed that the ordinary allocation and apportionment provisions of South Carolina law did not fairly represent CarMax Auto's business activity in South Carolina. The Department of Revenue calculated an alternative allocation and apportionment formula, and sought to have the licensing fee included in South Carolina income under this formula. The South Carolina Supreme Court determined that the South Carolina Department of Revenue failed to meet its burden of showing that the ordinary allocation and apportionment formula did not fairly represent the taxpayer's business activity in South Carolina. As a result, CarMax Auto's income taxable in South Carolina was determined under the ordinary allocation and apportionment formula, and the licensing fee it paid was not subject to tax in South Carolina.

Taxpayer Impact

The CarMax Auto decision now explains the burden of proof that a taxpayer or the South Carolina Department of Revenue must generally make in order to use an alternative allocation and apportionment formula. The opinion does not provide direct guidance, however, on the specific facts and elements of what must be demonstrated, factually, to carry this burden.

The South Carolina Department of Revenue has held a series of recent public meetings during the pendency of the CarMax Auto decision to discuss alternative allocation and apportionment formulas and the circumstances in which an alternative use may be appropriate. The Department of Revenue is expected to issue administrative guidance in the near future which will identify circumstances when an alternative apportionment method may be used. Bright line rules from the Department of Revenue may be unlikely in this guidance, however, given the wide variety of intercompany transactions which are common between related entities.

Taxpayers should continue to expect challenges to the use of the ordinary allocation and apportionment provisions when transactions between related entities reduce income that could otherwise be taxable in South Carolina. With the CarMax Auto decision, if taxpayers believe that the ordinary South Carolina allocation and apportionment provisions do not fairly represent their business activities in the state, they should be prepared to prove, by a preponderance of the evidence, that the ordinary allocation method does not fairly represent these business activities in South Carolina and that any alternative method advanced is reasonable. Both of these issues will depend on the facts.