Rulings of the Tax Commissioner

VIRGINIA:

IN THE CIRCUIT COURT OF ARLINGTON COUNTY

CORPORATE EXECUTIVE BOARD
        Plaintiff

v.                                                                                                         Case No. CL13-3104

VIRGINIA DEPARTMENT OF TAXATION
       Defendant

MEMORANDUM OPINION

Issues Presented

This case arose from the application of Virginia's statutory apportionment of corporate income for tax liability under Virginia Code §§ 58.1-405 through 58.1-420, realized by Corporate Executive Board ("CEB"), a multi-jurisdictional corporate taxpayer.  The subject covers tax years 2008, 2009 and 2010, and the case is before the Court on cross motions for summary judgment.  The Court sits without a jury and the parties presented all material facts by stipulation.  CEB and the Virginia Department of Taxation ("the Department") asked the Court to definitively decide the issues upon the record without further evidence or a trial.  Under that condition, the Court applied Va. Sup. Ct. R. 3:20.

Pursuant to Va. Code § 58.1-421, CEB challenged the Department's method of allocation, arguing, in effect, that it should not have paid Virginia tax on a portion of its income.[1] CEB wanted the Department to apply an apportionment of income formula different from the method created by the Virginia General Assembly, through a deliberate statutory scheme.  After CEB did not receive the relief it requested from the Department, this appeal followed.  The questions presented are: whether, as applied to CEB, (1) the Statutory Method, as defined below, is unconstitutional; (2) the Statutory Method is inequitable; and (3) if the Court finds that the Statutory Method is either unconstitutional or inequitable, has CEB proven that its proposed apportionment formula was better calculated to assign CEB's income to the Commonwealth of Virginia for taxation.  On each of these issues CEB carried the burden of proof.

               A challenge to the constitutionality of the Statutory Method carries a showing by clear and cogent evidence; a challenge to the equity of that method requires a showing by the preponderance of the evidence; and whether CEB's proposed method was better calculated to assign CEB's income also requires proof by a preponderance of the evidence.  For the latter two issues, CEB must show that the Department (through the tax commissioner) acted in an arbitrary, capricious, or unreasonable manner, and abused discretion.  CEB failed to meet its burdens and, therefore, judgment will be entered in favor of the Virginia Department of Taxation.

Stipulated Facts

According to the parties, there are no material facts genuinely in dispute.  The material facts were established either from the parties' joint stipulations or by admissions made in their respective pleadings, which the Court has considered along with the entirety of the record.  The dispute in this case is over the sales that were assigned to Virginia when calculating what is called the "sales factor" of income apportionment to a corporate taxpayer who conducts multi-jurisdictional business.  The sales factor comprises the last two of the four factors in the Statutory Method that apportions income of a multi-jurisdictional corporate taxpayer, as it is double weighted.

During all relevant time, Corporate Executive Board ("CEB") has been headquartered in Arlington, Virginia, and employed over 1,400 persons in Arlington.  CEB also maintained offices and employees in several other states and in foreign countries.  While the parties did not stipulate to the number of non-Virginia based employees, the reasonable inference is that most of its employees have been located at the Arlington headquarters.  According to CEB, "nearly all of its costs of performance are incurred at its Rosslyn [Arlington County] headquarters rather than where its customers are located."  Thus, whether by direct evidence or by reasonable inference, CEB's headquarters serves CEB in Virginia, nationwide, and in other countries.

CEB generated income from selling a bundled product to CEB's customers in consideration of a fixed-fee subscription charged annually.  Customers were able to access, through the Internet, CEB's bundled product of best practices research, executive education, and networking events, in addition to tools used by executives to analyze business function and processes.  The subscription also included delivery of data, insights, classroom-based development resources, webinars, and other services governing best practices for the customers to follow.  At its headquarters, CEB analyzed and disseminated business practices from its global client network.  Customers, whether local, national or international, accessed CEB's servers that were managed and controlled by CEB's Information Technology function, also located at CEB's headquarters in Arlington, Virginia.  CEB also held meetings with customers and presented seminar-type formats to educate the customers.  The vast majority of these meetings were not held in Virginia.  There is nothing in the record to suggest anything other than the information presented at the meetings was created at headquarters.  During calendar years 2008-2010 ("Tax Years"), less than five percent (5%) of CEB's customers had a Virginia billing address.  CEB argues that over ninety-five percent (95%) of its profit producing "transactions" took place outside of Virginia.  A "transaction" is "an occurrence in which services pass from one person to another." Transaction Definition, MERRIAM-WEBSTER.COM, www.merriam-webster.com/dictionary/transaction (last visited Nov. 25, 2015).  CEB's customers included ninety-seven (97%) percent of the Fortune 100 companies, along with over 10,000 participating organizations in more than fifty countries.

CEB filed corporate income tax returns in Virginia for the Tax Years, complying with the apportionment formula together with sales factor sourcing rule pursuant to Va. Code §§ 58.1-406 through 58.1-420, as applicable.  The formula considers a property factor, a payroll factor, and a double-weighted sales factor to apportion income (the "four-factor method" or "Statutory Method").[2]  More states use a four-factor method apportionment than any other method in assessing corporate income tax.  The focus of the issues presented in this case involved the sales factor.  CEB argued that the sales factor should simply be the mailing address for its customer — where CEB argued the "transaction" occurred.

On September 28, 2012, CEB timely filed a claim with the Virginia Department of Taxation for a refund of a part of the income tax it paid for the Tax Years. CEB based its claim on Va. Code § 58.1-421, alleging that the Statutory Method caused CEB to pay significantly more tax than the tax to which the Commonwealth was constitutionally entitled, and that the Statutory Method resulted in double taxation to CEB.  Based on its claim, CEB filed amended returns that applied a single sales factor apportionment method with destination-based servicing in the sales factor. In other words, CEB sought to eliminate from capture by Virginia all sales to customers that did not have billing addresses in Virginia (“[L]ess than five percent of CEB's . . . sales was derived from customers with a Virginia billing address."  Joint Stipulations of Fact ¶ 12).  The Court refers to this as the "zip code factor method."

CEB referred to its proposed zip code factor method as destination-based sourcing in the sales factor.  The destination is determined by the customer's billing address.  CEB's proposed method did not alter the Property Factor of 73.442% or the Payroll Factor of 68.28% used by CEB within the Tax Years, thereby demonstrating that most of its operations (the creation of information) occurred in Virginia.  The Statutory Method resulted in CEB reporting, for tax years 2008 and 2009, 100% of sales in Virginia and in tax year 2011, 93.519%.  During this period, other states required CEB to pay income tax on 20-25% of its sales.  Under the proposed zip code factor method, the sales by customers' billing addresses changed the sales factor to 2.221%, 3.238% and 2.870% respectively.  The stipulations included charts showing the apportionment methods used by most states and the tax on sales CEB incurred in various states.

A customer could change its billing address at any time, though very infrequently.  In such event, the income would follow the new zip code, though by inference the customer's headquarters might not move and, in fact, the operations, data storage and access, and business practices of CEB would remain functioning, as is, in Virginia.

Discussion

1. Constitutionality of the Virginia Four-Factor Apportionment Method.

A corporate taxpayer may attack an income tax attributable to it as unconstitutional.  While headquartered in Virginia, CEB had business transactions in several states, so it disputed the way Virginia captured income.  CEB alleged that the Statutory Method had extraterritorial effect.  In other words, Virginia captured income that was generated beyond Virginia, shown by the location of CEB's customers.  It is well settled that it is impossible for a state to specifically allocate the taxable income earned within its borders.  Butler Bros. v. McColgan, 315 U.S. 501, 504, 62 S. Ct. 701, 703, 86 L. Ed. 991, 994 (1942); Container Corp. of Am. v. Franchise Tax Bd, 463 U.S. 159, 103 S. Ct. 2933, 77 L. Ed. 2d 545 (1983).  The taxpayer who attacks a State's apportionment as unconstitutional must prove by clear and cogent evidence that it results in extraterritorial values being taxed.  Butler Bros., 315 U.S. at 507.

Under the due process clause of the U.S. Constitution regarding an income tax upon a multi-jurisdictional corporate taxpayer, for the tax to be declared unconstitutional the corporate taxpayer must prove by clear and cogent evidence that there was not a minimal connection between activities generating the income and the taxing state, and that the income attributed to the taxing state was not rationally related to values connected with the taxing state.  Moorman Mfg Co. v. Bair, 437 U.S. 267, 273, 98 S. Ct. 2340, 2344, 57 L. Ed. 2d 197, 204 (1978) (emphasis added).  "Activity" means "something that is done as work or for a particular purpose."  Activity Definition, MERRIAM-WEBSTER.COM, www.merriam-webster.com/dictionary/activity (last visited Nov. 25, 2015).  While CEB focused on transactions, established law finds activity to be relevant. Id.; see also Va. Code §58.1-416 (referencing "income-producing activity").[3]  CEB had the burden to prove by clear and cogent evidence that income attributed to Virginia through the Statutory Method was in fact out of all appropriate proportion to CEB's business activity in Virginia or that the Statutory Method led to a grossly distorted result.  Container Corp., 463 U.S. at 164.

CEB failed to meet its burden.  The record fails to support a proper finding that, based on CEB's operations and business model, the income captured under the Statutory Method was not reasonably attributable to its business or services within the Commonwealth.  The Court finds on this record that CEB's inter-state activities related in some concrete way to the in-state activities at its Virginia headquarters; that CEB's activities that resulted in the income that was taxed under the Statutory Method had some minimal connection with Virginia; that the income produced was rationally related to CEB's activities at its Virginia headquarters and to values connected with Virginia; and that Virginia's four-factor apportionment formula is not in fact out of all appropriate proportion to CEB's business activities at its Virginia headquarters.  The Court finds that the record shows, at least by reasonable inference, that CEB sold subscriptions to data or information that CEB created at its headquarters, and that the data or information was accessible by CEB's customers on-line through CEB's servers located and fully maintained by a team of technicians at its headquarters in Virginia.  Passing the information on to the customers by way of a meeting or seminar did not alter, on this record, the Court's analyses or findings as to activities, minimal connection or rational relationship to Virginia.

CEB argued that its proposed zip code factor method would more accurately reflect the actual connection between its inter-state activities and its income, calling it an "elegant solution", and that the zip code factor method showed that Virginia's Statutory Method was either out of all appropriate proportion to CEB's business activities in Virginia or that it led to a grossly distorted result.

The zip code factor method would lead to an arbitrary result.  Application of that method would assume that a zip code is determinative of CEB's income producing activity, which is unsupported by the record.  There is no direct evidence or reasonable inference that using a customer's zip code negates the type or extent of business CEB conducted within Virginia in relation to income.  Commonwealth Dep't of Taxation v. Lucky Stores, Inc., 217 Va. 121, 129, 225 S.E.2d 870, 875 (1976).  Virginia's apportionment formula captures in a reasonable sense how CEB's income is generated.  CEB sells information to its customers and the customers then access that information, stored in Virginia.  Based on this record, the Court is not persuaded that CEB proved by clear and cogent evidence that the income tax was, in fact, out of all appropriate proportion to its business activities in Virginia.  Container Corp., 463 U.S. 159.

The remaining question is whether the Statutory Method led to a grossly distorted result.  Exhibit 8 to the Supplemental Stipulations of Fact is a worksheet demonstrating that the Statutory Method (CEB referenced it as the "Greater Method") is the preferred apportionment method to be applied to multi-jurisdictional corporate taxpayers among the 47 listed states.  Applying the stipulated facts in the Joint Stipulations of Fact, paragraph 38, the record shows that the states that do not use the apportionment method similar to Virginia captured income based on market receipt or benefit to that market.  The Statutory Method does not include a determination of whether CEB's services landed in a particular market or benefited another state.

For 2008, states that used the market factor apparently taxed 18.41% of CEB's income, in 2009 16.58%, and in 2010 17.61%.  For example, Michigan used the market formula and captured CEB's income because the recipient received the benefit in Michigan.  A simple example could be where a CEB customer from Michigan accessed the CEB-created best practices stored on CEB's Virginia servers and the customer applied those best practices to its Michigan business; the benefit was in Michigan.  Michigan then taxed CEB on that income.  That may be appropriate for Michigan or other market based formula states, but it did not address the legal issues under analysis here.  Virginia did not determine whether there was any benefit to Michigan or, if there was, tax that benefit. Virginia did not double tax CEB's income.  The Court finds that the Statutory Method under this record did not result in a grossly distorted result.

2. CEB's Argument that Virginia's Four-Factor Apportionment Method is Inequitable.

The General Assembly of Virginia provided relief for corporate taxpayers who believed the Statutory Method resulted in "a taxation on a greater portion of its Virginia taxable income than is reasonably attributable to business, or services within this Commonwealth..." Va. Code § 58.1-421 (emphasis added).  This requires the taxpayer to file with the Department a statement of its objections and an alternative method of allocation or apportionment the taxpayer believed to be proper under the circumstances with such detail and proof as the Department may reasonably prescribe.  Id.  If the Department does not grant the taxpayer relief, the taxpayer may seek relief in the circuit court by proceeding with an action at law, with the Court sitting without a jury.  The burden of proof is on the taxpayer to show that the tax attributed to the taxpayer is erroneous or otherwise improper.  Va. Code § 58.1-1825.

There is a presumption of validity to the tax administrator's denial of relief that the Court is asked to review.  If the taxpayer proves by a preponderance of the evidence that the tax it is required to pay is contrary to law or that the administrator acted in an arbitrary, capricious, or unreasonable manner, and abused his discretion, relief may be granted.  Lucky Stores, 217 Va. at 187 ("The evidence must be sufficiently strong to 'satisfy' the trial court that the taxpayer was erroneously assessed."); see also Va. Code § 58.1-1826.  This part of the analysis addresses whether Virginia's four-factor apportionment method is inequitable.  While CEB did not directly or sufficiently address whether the administrator acted in an arbitrary, capricious, or unreasonable manner, and abused his discretion, the Court will address those issues.

At the outset, the tax commissioner did not misapply the law. This dispute arose because the Statutory Method was applied.  There is no absolute right of a corporate income taxpayer to use an alternative method of allocation or apportionment other than the Statutory Method, which is the rule and not the exception. Lucky Stores, 217 Va. at 187.  The Statutory Method was inequitable if it produced a result of double taxation that was attributable to Virginia rather than to another unique method used in some other state.  Id.  CEB's dispute is not that the tax assessed was not according to the Statutory Method, but that the sales factor should be replaced with zip code factor method.  The Court has rejected the zip code factor method.  The record is void of evidence for the Court to find that, were an inequity to exist, it was attributable to Virginia rather than to another unique method used in some other states.  Lucky Stores, 217 Va. at 126.  Again, Virginia did not reach out and look to the benefits other states realized or any benefits other markets received; thus, Virginia did not tax those benefits.

The remaining question is whether, in denying CEB the relief sought, the tax commissioner acted in an arbitrary, capricious, or unreasonable manner, and abused his discretion.  The Court may only decide these issues upon the record submitted by the parties for this final adjudication, as they agreed there is no material fact genuinely in dispute.  CEB did not meet its burden to prove by a preponderance of the evidence that the tax commissioner acted in an arbitrary, capricious, or unreasonable manner.  "Actions are defined as arbitrary and capricious when they are ‘willful and unreasonable’ and taken ‘without consideration or in disregard of facts or law or without determining principle’.”  School Bd of the City of Norfolk v. Wescott, 254 Va. 218, 224, 492 S.E.2d 146, 150 (1997). An act may be arbitrary and capricious where the determination made departed from the appropriate standard for decision-making. Id.

Exhibit 3 to the Joint-Stipulation of Fact is the tax commissioner's determination.  There is a presumption of correctness, and considering the facts presented in that determination, the facts stipulated in this action, and the applicable legal principles, the Court finds that the tax commissioner properly considered and denied CEB's request to disregard the Statutory Method.  CEB failed to prove that it was subject to taxation on a greater portion of its Virginia taxable income than was reasonably attributable to its business or sources within the Commonwealth.  The Court is not persuaded that the Statutory Method should be declared inequitable.  It appears on this record that the income captured under the Statutory Method is, in fact, reasonably attributable to CEB's business or sources within Virginia.  Based on the record, Court finds that CEB did not present sufficiently strong evidence that the tax under the Statutory Method was erroneous or otherwise improper.

The Court also finds the tax commissioner did not abuse his discretion in applying the Statutory Method to CEB's income activities.  CEB made a forceful argument for change on policy reasons.  It argued that customer-based sourcing (where the customer is located - its zip code) is not unique and reflects the overwhelming trend in the country.  Part of the evidence the Court considered was the report by CEB's expert, Professor Richard D. Pomp, attached as Exhibit 1 to CEB's Memorandum of Law in Support of Plaintiff s Motion for Summary Judgment.  According to Pomp, “[i]f the states could agree on the same formula, multiple taxation would be minimized.”[4] Id. at 6.  Pomp added, "The robust trend today is for state legislatures and tax departments to replace their cost of performance approach used for services and intangibles with customer-based sourcing.”  Id. at 8.  The tax commissioner is not faulted for not adopting a policy change and denying CEB's request.  A trial court also does not set policy.

A trend is relevant to setting policy and does not negate the foregoing well-established legal principles when analyzing the issues in this case.  The Court finds Mr. Pomp's written expert testimony to be a policy statement that, in Virginia, may be more appropriately addressed to the legislature.  The legislature has the sole responsibility to enact the laws of the state. Va. Const. 'Art. IV., § 1 (“the General Assembly shall enact general laws”); see also Standard Drug Co. v. Gen. Elec. Co., 202 Va. 367, 375, 117 S.E. 289, 295 (1960) (explaining that legislative power is vested in the General Assembly and can only be delegated to official agencies, not private individuals or unofficial groups with "arbitrary capacity to make their will prevail as law”).  The judiciary alone has the power to interpret the laws enacted by the General Assembly.  Wayman v. Southard, 23 U.S. 1, 46, 6. L. Ed. 253, 263 (1825) (“The difference between the departments undoubtedly is, that the legislature makes, executive executes, and the judiciary interprets the law.”).  Based on this Court's interpretation, CEB is not entitled to the relief it seeks.[5]

        The Virginia General Assembly determined that where a corporation operates in multiple states, income should be apportioned under a formula that is acceptable and used by more states than any other apportionment method.  See Va. Code §§ 58.1-406 through 58.1-420; see also Supplemental Stipulation of Facts, Ex. 8.  The Court may determine, pursuant to Va. Code § 58.1-­1826, that the applicant was erroneously or improperly assessed with any taxes (whether the tax is unconstitutional or inequitable, but not judge whether it makes bad taxing policy for the Commonwealth), and order a different assessment.  However, this record does not support an assessment different than the Statutory Method.

The Court sua sponte will vacate its order dated March 30, 2015, consolidating this case with Civil Action 15-490 and a final order will be entered in this action.

Counsel for the Department shall prepare an appropriate order that incorporates by reference this Memorandum Opinion and forward it to counsel for CEB for endorsement.  The parties shall note any exceptions at the end of the order, which shall be filed with the Court no later than December 9, 2015.  This matter is placed on the Court's Friday Motion Docket on December 11, 2015 at 10:00 a.m. for entry of the order, and civil action 15-490 will also be on that docket for status.

November 30, 2015

Daniel S. Fiore II, Judge
           Arlington County Circuit Court 

VIRGINIA:

IN THE CIRCUIT COURT OF ARLINGTON COUNTY 

CORPORATE EXECUTIVE BOARD

Petitioner,
v.                                                                                                         Case No. CL13-3104 

VIRGINIA DEPARTMENT OF TAXATION

Respondent.

ORDER 

THIS MATTER came before the Court sua sponte regarding the Court's order of the 30^th day of March 2015, consolidating this Civil Action with Civil Action CL15-490, also between these parties but regarding different tax years, and upon reconsideration by the Court.

ORDERED that this action and Civil Action CL15-490 are not consolidated and that a copy of this Order shall be filed in CL15-490.

ENTERED this 30th day of November 2015.

                                                                        Daniel S. Fiore, II, Judge
                                                                        Arlington County Circuit Court 

Signatures of the parties are dispensed with pursuant to Rule 1:13.