The Louisiana First Circuit Court of Appeal once again recognized the primacy of legislation as a source of law in the state and that the power to tax is reserved to the Legislature alone, not the Louisiana Department of Revenue (the “Department”). In Davis-Lynch Holding Co., Inc. v. Robinson, 2019-1574 (La. App. 1 Cir. 12/30/20), ___ So.3d ___, the court invalidated a regulation that had the effect of increasing the corporate taxpayer’s Louisiana apportionment percentage and, therefore, its corporate tax liability. The Davis-Lynch court held that the Department’s regulation (LAC 61:I.1134(D), the “Regulation”)  improperly excluded sales not made in the regular course of a corporation’s business from the sales factor used to determine its Louisiana apportionment percentage and was, therefore, invalid, because it exceeded the scope of the underlying statute and intruded on the Legislature’s sole authority to tax.

La. R.S. 47:287.95(F) (the “Apportionment Statute”) provides the three ratios used to determine the taxpayer-corporation’s Louisiana apportionment percentage. The only ratio at issue – the sales ratio – includes “net sales made in the regular course of business and other gross apportionable attributable to [Louisiana]” in the numerator and includes “total net sales made in the regular course of business and other gross apportionable income of the taxpayer” in the denominator. The Apportionment Statute does not exclude income from sales that were not made in the regular course of a taxpayer’s business. In contrast, the Department’s Regulation excludes sales not made in the regular course of business from the numerator and the denominator, which inflates an affected corporation’s Louisiana apportionment percentages. After reviewing the rules of statutory construction and the Apportionment Statute’s legislative history, the Davis-Lynch court concluded that the Legislature did not intend to exclude sales not made in the regular course of business from the sales factor. Therefore, the court held that the Regulation impermissibly exceeded the scope of the Apportionment Statute and as a result, was invalid.

Background

Davis-Lynch Holding Co., Inc. (“Davis-Lynch”) is a Texas Corporation that, during the relevant tax period, did not do business in the state of Louisiana. Its only business activity consisted of holding its interest in Davis-Lynch, LLC (“D-L LLC”), a Texas single-member limited liability company authorized to do business in Louisiana and that was disregarded for federal and state income tax purposes. D-L LLC manufactured float and cementing equipment and sold its products to, among others, customers drilling oil wells in Louisiana and the Gulf of Mexico. Davis-Lynch maintained a warehouse in Louisiana. In 2011, Davis-Lynch sold its interest in D-L LLC and realized a gain on the sale of its investment.

During the tax year at issue, 2011, Davis-Lynch derived Louisiana net apportionable income from: (i) D-L LLC’s manufacturing activities; and (ii) the gain realized from the sale of its interest in D-L LLC (the “Gain”). Davis-Lynch used the three-factor apportionment formula, described in the Apportionment Statute and consisting of sales; property; and payroll factors, to determine its 2011 Louisiana apportionment percentage. For the sales factor, Davis-Lynch included the Gain in its tax base and in the ratio’s denominator.

On audit, the Department removed the Gain from the sales factor ratio completely, relying on LAC 61:I.1134(D) (the “Regulation”), which provides that “[s]ales not made in the regular course of business are not included in the formula provided by R.S. 47:287.95(F).” Removing the Gain from the ratio resulted in a higher Louisiana apportionment percentage and, as a result, a corporation income tax deficiency. The Department assessed Davis-Lynch for the alleged deficiency and the taxpayer appealed to the Louisiana Board of Tax Appeals (the “BTA”) for redetermination of the assessment.

Applicable Louisiana Law

Under Louisiana’s corporate income tax laws, every item of corporate income falls into one of two categories:  allocable or apportionable. “Allocable” income consists of the exclusive, enumerated list of income provided in La. R.S. 47:287.92(B). “Apportionable” income is a residual class, which includes all income that is not defined as allocable, by default. See, La. R.S. 47:287.92(C). A corporation’s allocable income is taxable only by the state in which it was earned. A corporation’s apportionable income is taxable in proportion to its activities in a given state. The Gain was not a type of income enumerated in 2011 as “allocable” income. It was, therefore, apportionable, by default.

Before 2006, the Gain would have been classified as allocable income, because “profits…from the sale or exchange of property…not made in the regular course of business” was among the enumerated items of allocable income. See, La. R.S. 47:287.92(B)(2) (West 2005). But, in 2005, the Legislature amended the categories of allocable income for tax years beginning January 1, 2006 and removed profits from the sale or exchange of property as an enumerated category. See, La. Acts 2005, No. 401 (Reg. Sess.). As a result, after 2005, the profits from the sale of property not made in the regular course of business were included in the residual class – apportionable income.

To determine what proportion of Davis-Lynch’s apportionable income Louisiana may tax (i.e., its Louisiana apportionment percentage), the starting point is La. R.S. 47:287.95(F)(1). The sales factor ratio during the Taxable Period was as follows:

The ratio of net sales made in the regular course of business and other gross apportionable income attributable to this state to the total net sales made in the regular course of business and other gross apportionable income of the taxpayer.

La. R.S. 47:287.95(F)(1)(c). Davis-Lynch included the Gain in the denominator as “other gross apportionable income of the taxpayer.” On audit, the Department removed the Gain from the sales factor pursuant to the Regulation, which provides that “[s]ales not made in the regular course of business are not included in the formula provided by [the Apportionment Statute].”

The Board of Tax Appeals Decision

After receiving the assessment from the Department, Davis-Lynch filed a Petition for Redetermination with the BTA. At issue in the case was: (i) whether the Regulation exceeded the scope of the underlying statute; and (ii) whether Davis-Lynch properly included the Gain in the denominator of the sales factor ratio under the Apportionment Statute. The BTA ruled, after a trial, that the Apportionment Statute required inclusion of the Gain in the sales factor ratio’s denominator but not its numerator. The BTA determined that the Regulation exceeded the scope of the underlying statute. In so holding, the BTA reasoned that “the clear meaning of [the Apportionment Statute] requires that the ‘other gross apportionable income’ be included in the ratio” and that the Department’s  attempt to “exclude entirely the income recognized by Davis-Lynch on the sale of the LLC from the three factor ratio”  was “a result clearly not contemplated by the statute.”  The BTA found that the Department’s interpretation would “render the phrase ‘other gross apportionable income’ meaningless.” Thus, the Board found the Gain was properly included in the denominator of the sales factor ratio.

The First Circuit Court of Appeal’s Decision

The Department appealed the BTA’s judgment to the Louisiana First Circuit Court of Appeal. On appeal, the Department argued that the Regulation is applicable, operates with the full force and effect of law, and mandates that sales not made in the regular course of business, such as the sale of D-L LLC, be excluded from the sales factor.  In response, Davis-Lynch asserted that the Apportionment Statute required the Gain be included in the denominator of the sales factor as “other gross apportionable income of the taxpayer” and that the Regulation exceeded the scope of the statute and was invalid.

On review, the First Circuit recognized the well-established principle that, even though the Department “has the authority to prescribe rules and regulations to carry out the purposes of Louisiana’s tax statutes, and such rules and regulations will have the full force and effect of law,” the Department’s regulations cannot “extend the taxing jurisdiction of the statute, as taxes are imposed by the legislature, not the Department.” In addition, the court noted, the Department’s “construction of its own regulation cannot be given effect where it is contrary to or inconsistent with the legislative intent of the applicable statute.” Thus, it was necessary to determine whether the Regulation was a reasonable interpretation of the Apportionment Statute or “a prohibited expansion of the scope of the statute.”

The First Circuit began its analysis by considering prior legislative actions related to the classification and treatment of the Gain. In La. Acts 1993, No. 690 (“Act 690”), the Legislature first attempted to reclassify “profits or losses from the sales or exchanges of property…not made in the regular course of business” from allocable to apportionable income. Act 690 would have, further, amended the statute providing specific apportionment formulas (i.e., La. R.S. 47:287.95) to expressly provide that “gross apportionable income…shall not include sales not made in the regular course of business…” See, La. Acts 1993, No. 690 (emphasis supplied). However, Act 690 was later declared unconstitutional. In 2005, the Legislature again attempted to reclassify “profits or losses from the sales or exchanges of property…not made in the regular course of business” as apportionable income, but it declined to exclude sales not made in the regular course of business from “gross apportionable income” as it had in Act 690. See, La. Acts 2005, No. 401 (“Act 401”). Nevertheless, in 2006, the Department adopted the Regulation, which provided, simply, that sales not made in the regular course of business are not included from the sales factor ratio.

The First Circuit found significant and determinative that the Legislature’s previous expression in Act 690, that sales not made in the regular course of business were not included as “gross apportionable income,” was not contained in the 2005 legislation (Act 401). The court, recognizing the primacy of law in the state, stated:

Legislation is the superior source of law in Louisiana. Where the Legislature expressly repealed the provisions of La. R.S. 47:287.95 stating “gross apportionable income shall not include…income not made in the regular course of business” and the language was not reintroduced in subsequent amendments, we find the Legislature’s intent was not to include this language in La. R.S. 47:287.95.

As a result, the court concluded that the Department’s exclusion of sales not made in the regular course of business from the sales factor was “contrary to the clear wording of the [Apportionment Statute] as well as the legislative history excluding similar language from the [Apportionment Statute].” Thus, the court held that the Gain should be included in the denominator as “other gross apportionable income” (but not the numerator) and that the Regulation impermissibly expanded the scope of [the Apportionment Statute].

Implications

The Davis-Lynch decision directly impacts any business whose Louisiana apportionment percentage is determined using the ratio provided in the Apportionment Statute. This includes pipeline transportation companies; businesses whose net apportionable income is derived primarily from the manufacture, production, or sale of tangible personal property; and any business whose net apportionable income is not derived primarily from (i) transportation by aircraft; (ii) transportation by means other than by aircraft or pipeline; (iii) services; or (iv) the exploration, production, refining or marketing of oil and gas. See, La. R.S. 47:287.95(F)(b)(i)-(ii). If the decision becomes final or is otherwise affirmed by the Louisiana Supreme Court on review, all gross apportionable income, from whatever source, must be included in the sales factor ratio’s denominator.

In Davis-Lynch’s case, the Gain was a significant amount from a sale not made in the regular course of its business and including the Gain in the ratio’s denominator had the effect of reducing the taxpayer’s Louisiana apportionment percentage. For other taxpayers, including such sales may not have a similarly beneficial effect on its sales factor. Louisiana taxpayers who determined their Louisiana apportionment percentage and corporate income tax liability using the Regulation – that is, excluding sales not made in the regular course of business – should consider reviewing their returns for whether refund opportunities exist.

The decision is also important because it is yet another example of a Louisiana court recognizing the primacy of legislation as a source of law and denying the Department’s ability to make law through regulation when that regulation exceeds the scope of the statute it purports to interpret. The First Circuit’s decision in UTELCOM, Inc., et al. v. Bridges, 2010-0654 (La. App. 1 Cir. 9/12/2011), 77 So.3d 39 is the most prominent example of this in recent years. The courts’ fidelity to this well-established principle of law is an important check on the Department’s expansive view of its rule-making authority.

As of the date of publication, it is unclear whether the Department will move the First Circuit Court of Appeal for a rehearing or seek a writ of certiorari from the Louisiana Supreme Court.

Other Considerations

The decision makes note of a second assessment the Department issued Davis-Lynch for the 2011 tax period. After the audit, and more than a year into the litigation, the Department determined that Davis-Lynch should have used single-factor versus three-factor apportionment, because it earned income from D-L LLC and D-L LLC derived its income primarily from the manufacturing, production, or sale of tangible personal property. The Department relied on La. R.S. 47:287.95(F)(2)(b)(i), which provides: “For taxable periods beginning on or after January 1, 2006, and for the purpose of this Subsection, the Louisiana apportionment percent of any taxpayer whose net apportionable income is derived primarily from the business of manufacturing or merchandising shall be computed by means of a single ratio consisting of the ratio provided for in Subparagraph (1)(c) of this Subsection.” – i.e., the sales factor ratio.

The Department reversed the three-factor apportionment formula Davis-Lynch used and recomputed its Louisiana apportionment percentage using a single sales factor ratio (excluding the Gain). The reversal had the effect of further increasing the Davis-Lynch’s alleged deficiency for the 2011 year. Davis-Lynch appealed the second assessment to the BTA arguing that, because the Gain far exceeded the income it earned from D-L LLC, its net apportionable income for 2011 was not derived “primarily from the business of manufacturing or merchandising,” but from the sale of D-L LLC. The Department conceded the matter and withdrew the assessment in open hearing before the BTA. Davis-Lynch, thereafter, formally dismissed its appeal.

It is important to note the second assessment in order to make clear that the appropriate apportionment formula is determined by a taxpayer’s net apportionable income for the year in question, not necessarily its primary business.

Conclusion

In summary, the Davis-Lynch court determined that, because the Legislature had included language in its previous attempt in 1993 (Act 690) to remove “profits…from the sales or exchanges of property…not made in the regular course of business” as allocable income, rendering it apportionable, and expressly provided that “gross apportionable income shall not include income…not made in the regular course of business,” its decision declining to include similar language in its subsequent attempt in 2005 (Act 401) showed that the Legislature did not intend to exclude sales not made in the regular course of business from the sales factor. Thus, the Department improperly decided on its own to make such a change through regulation. While state regulations are generally given a large amount of deference by state courts, it is important to remember, as this case demonstrates, that a regulation may not constrain or expand the scope of a taxing statute in any way. Taxpayers should not hesitate to test the validity of any regulation that exceeds the underlying taxing statute.

If you are interested in discussing the Davis-Lynch decision and whether or how it impacts the determination of your business’s Louisiana apportionment percentages for current or past periods, please contact: Jason R. Brown at (504) 293-5769, Willie J. Kolarik II at (225) 382-3441, or Michael W. McLoughlin at (504) 620-3351.

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Jason R. Brown and Willie J. Kolarik II of Kean Miller LLP represented Davis-Lynch Holding Co., Inc. in this litigation.