Maine denies alternative apportionment from sale

On June 4, 2020, the Maine Supreme Judicial Court affirmed a Maine Business and Consumer Court’s ruling that a taxpayer was not entitled to use alternative apportionment in determining its tax on the sale of its frozen pizza business.¹ The Court also vacated the lower court’s decision to partially abate substantial underpayment penalties assessed by Maine Revenue Services (MRS) related to the taxpayer’s treatment of the gain on its tax return. Finally, the Court ruled that a separate assessment by the Maine State Tax Assessor (Assessor) for the same period at issue was not barred by the statute of limitations, as the taxpayer did not provide substantial authority for its original reporting of the gain.

Background

Kraft Foods Group, Inc. and its affiliated entities (collectively, Kraft) manufactured and sold various food products throughout the United States, including Maine, during the periods at issue. Over several years, Kraft developed a frozen pizza product line that was manufactured, sold, and distributed through Kraft Pizza Company (KPC), its subsidiary. On March 1, 2010, Kraft sold its frozen pizza product line assets for roughly $3.7 billion, most of which was paid to KPC, with some proceeds paid to other Kraft affiliates. Kraft reported roughly $3.35 billion of federal taxable income related to this sale for the 2010 tax year.

On its unitary Maine corporate income tax return for the 2010 tax year (which included KPC in the unitary group), Kraft subtracted roughly $3 billion of the gain from the tax base and excluded the related proceeds/gain from the Maine sales factor on the basis that the income was not a sale in the ordinary course of Kraft’s unitary business activities. Following an audit of the return in August 2013, MRS disallowed the subtraction adjustment and included the related proceeds/gain in the Maine sales factor, resulting in an assessment of approximately $1.8 million of tax, interest, and substantial understatement penalty.

Kraft appealed the assessment to the Maine Board of Tax Appeals (Board) which determined that the gain at issue should be apportioned separately from Kraft’s other unitary income. Additionally, the Board abated the substantial understatement penalties assessed by MRS, as it determined that Kraft had shown reasonable cause for its filing position to exclude the gain as non-unitary. The Assessor filed a petition for judicial review of the Board’s decision. Concurrently, the Assessor issued a second assessment to Kraft on May 3, 2017 related to a separate issue on Kraft’s 2010 Maine corporate income tax return imposing an additional $345,728 of tax penalties and interest. After the Assessor upheld the second assessment in response to Kraft’s request to reconsider, Kraft filed a petition for review in Maine Superior Court asserting that the state’s statute of limitations barred the second assessment. That petition was consolidated with the Assessor’s petition for review of the original assessment and transferred to the Maine Business and Consumer Court (MBCC).

MBCC decision

On appeal, the MBCC considered three separate issues.² First, the MBCC addressed whether the gain at issue should be apportioned separately from Kraft’s other unitary income. Next, the MBCC addressed whether substantial underpayment penalties applied to Kraft’s original return position to subtract the gain from the tax base. Finally, the MBCC addressed whether the Assessor’s second assessment was within the statute of limitations.

Alternative apportionment

For purposes of apportioning unitary business income, the default method in Maine is to multiply such income by a sales factor consisting of an in-state to everywhere ratio of total sales,³which includes “all gross receipts of the taxpayer.”⁴ However, the statute also indicates that an alternative apportionment method may be allowed or required if the default apportionment provision does not fairly represent the extent of the taxpayer’s business activity in the state.⁵ Kraft and the Assessor agreed that when the taxpayer petitions for alternative apportionment, the burden of proof is on the taxpayer to establish that the default apportionment provision does not fairly represent the taxpayer’s business activity in the state.

As a result, Kraft argued that the gain at issue was so different in magnitude and substance from Kraft’s other income, that the application of the same apportionment factor to the combined net income could not reach a fair result. Supporting this argument, Kraft explained that receipts from its sales of other products were roughly $21 billion, but noted those receipts only generated roughly $190 million of taxable income. Kraft argued that applying the default apportionment factor to the $3 billion gain at issue (netted from roughly $3.7 billion of proceeds) was substantially distortive. Kraft also argued the gain at issue had limited connection to Maine as most of the assets were not located in the state. Finally, Kraft argued that the default apportionment methodology violated the Due Process Clause of the U.S. Constitution.

The MBCC was not persuaded by Kraft’s arguments and concluded that Kraft did not address whether the default apportionment methodology failed to fairly represent the extent of Kraft’s business activity in the state. Supporting this conclusion, the MBCC asserted that Kraft confused the concept of distortion with an increased tax burden in the state due to an increase in taxable income. Because the default apportionment methodology requires that the total proceeds from the gain be included in the sales factor denominator and only the receipts attributable to Maine included in the numerator, the MBCC posited that the default factor fairly reflected the extent of Kraft’s business activity in Maine. The MBCC’s opinion also noted that separately apportioning the gain from the sale of Kraft’s frozen pizza product line apart from its other operational income would effectively circumvent the requirement that unitary corporations in Maine be taxed as a group. Ultimately, the MBCC found that Kraft failed to meet the required burden of proof and reversed the Board’s holding.

Substantial understatement penalties

Under Me. Rev. Stat. Ann., tit. 36, Sec. 187-B.4-A, Maine taxpayers that substantially understate tax on a filed return may be liable for a penalty of up to 25% of the understatement. The statute indicates that an understatement is substantial where it “exceeds 10% of the total tax required to be shown on the return.”⁶ However, the penalty does not apply where a taxpayer has established reasonable cause for a position including substantial authority justifying the failure to pay.⁷

As previously noted, Kraft subtracted roughly $3 billion of the gain at issue in computing Maine net income on its 2010 corporate income tax return on the basis that the income was not a sale in the ordinary course of Kraft’s unitary business activities. While Kraft conceded that this original position was flawed, it provided some evidence supporting that KPC was not part of Kraft’s unitary business and, therefore, argued substantial understatement penalties should not apply. While the MBCC was not convinced that such evidence supported a conclusion that KPC was excluded from Kraft’s unitary business, it did find that Kraft provided substantial authority for the position and ultimately abated only the penalties assessed related to the exclusion of the gain realized by KPC.

Statute of limitations

Under Me. Rev. Stat. Ann., tit. 36, Sec. 141.1, assessments of Maine taxes are generally barred after three years from the date a return was filed or required to be filed except in certain circumstances. One such circumstance is when a taxpayer reports less than half of the proper tax liability where substantial authority for the understatement of tax has not been provided.⁸ In such instances, assessments are only barred after six years from the date the return was filed.

While Kraft did not claim that substantial authority existed for the position for which the second assessment was made, it instead argued that substantial authority existed for the original exclusion of the gain from the sale of the pizza business. Assuming substantial authority existed for that position in its entirety, Kraft would not have met the threshold for the six-year statute of limitations. However, as the MBCC determined that Kraft did not have substantial authority for that position in its entirety, it also determined that Kraft still met the threshold for the six-year statute of limitations. Therefore, it upheld the second assessment in full.

Kraft appealed all of the MBCC’s judgments to the Maine Supreme Judicial Court and specifically requested that the Board’s decision be applied. The Assessor cross-appealed the finding that Kraft was entitled to partial abatement of the substantial understatement penalties.

Maine Supreme Judicial Court decision

The Maine Supreme Judicial Court considered each issue in turn and first focused on whether Kraft was entitled to alternative apportionment. While agreeing with and echoing some of the MBCC’s conclusions, the Court also pointed out that Kraft’s 2010 Maine sales factor was in line with its 2008 and 2009 factors and noted that the extent of Kraft’s business activities in the state did not change significantly over the years. Therefore, the Court explained that recognizing significantly more income in one year does not necessarily mean that the sales factor failed to fairly represent the extent of the taxpayer’s business activity in Maine. Ultimately, the Court concluded that the facts in this case did not present the exceptional circumstances necessary to justify the application of an alternative apportionment methodology.

With respect to the issue of whether substantial understatement penalties applied to Kraft, the Court disagreed with the MBCC that substantial authority existed to subtract the gain on the 2010 return. While the Court acknowledged that KPC maintained some degree of independence from Kraft, it pointed to a significant degree of overlap among directors and officers of Kraft and KPC, as well as the provision of intercompany services to KPC not noted by the MBCC evidencing a unitary business. Therefore, the Court held that Kraft failed to demonstrate that there was substantial authority supporting Kraft’s original return position, and vacated the MBCC’s judgment partially abating the penalties. Given the finding that Kraft lacked substantial authority for its position to subtract the gain, the Court upheld the MBCC’s ruling that the six-year statute of limitations applied to the Assessor’s additional unrelated assessment.

Commentary

States often argue for the application of alternative apportionment provisions where they assert certain significant taxpayer receipts that dilute the sales factor reportable to the state, but which generate little or no actual profit, are distortive. In this case, the taxpayer argued that application of the default sales factor was distortive when applied to a roughly $3 billion gain generated from roughly $3.7 billion of receipts. The Court even acknowledged that the facts in this case are almost the inverse of the facts of the other cases cited by the Court, the taxpayer, and the Assessor. Despite this distinctive fact pattern, the Court asserted that alternative apportionment provisions do not exist merely to circumvent unitary taxation principles.

In a reply brief to the Court, Kraft argued that its business activities in Maine in 2010 were not substantially different than in prior years. Therefore, it argued, Kraft should pay roughly the same amount of Maine income tax in 2010 as it did in prior years. While this may seem to be a logical argument, the Court asserted that consistency in the level of Kraft’s Maine sales factor percentage actually worked against the argument that the default methodology did not fairly represent Kraft’s business activities in the state. The result demonstrates the difficulties for taxpayers in arguing for the application of alternative apportionment provisions. Typically, to separately apportion specific items of income, taxpayers bear the burden of proving that such items of income have very little connection to the rest of their unitary operating businesses and that can be a very difficult hurdle to meet.

1 State Tax Assessor v. Kraft Foods Group, Inc., Maine Supreme Judicial Court, Dkt. No. BCD-18-524, June 4, 2020.
2 Maine Business and Consumer Court, Dkt. No. BCD-AP-16-02, Dec. 4, 2018.
3 ME. REV. STAT. ANN., tit. 36, § 5211.14.
4 ME. REV. STAT. ANN., tit. 36, § 5210.5.
5 ME. REV. STAT. ANN., tit. 36, § 5211.17.D.
6 ME. REV. STAT. ANN., tit. 36, § 187-B.4-A.
7 ME. REV. STAT. ANN., tit. 36, § 187-B.7.
8 ME. REV. STAT. ANN., tit. 36, § 141.2.

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