MN: Commissioner not barred from requiring use of alternative apportionment

The Minnesota Supreme Court recently reviewed a decision in which the tax court had held that the Tax Commissioner erred when she attempted to adjust a banking group’s apportionment to include the interest income and loans of certain LLCs taxed as partnerships. The LLCs at issue were formed by the taxpayer, a bank, and affiliated entities to hold loans secured by property in Minnesota. Under Minnesota law in effect at the time, LLCs could not be classified as financial institutions (the law has since been revised to expand the definition of a financial institution to capture entities that are more than 50 percent owned by other financial institutions). The stated purpose for the formation and transfer of the loans to the LLCs was to reduce the taxpayers’ Minnesota tax liability. Under the general corporate apportionment rules, rather than the financial institution apportionment rules, interest income is excluded from the sales factor and intangible property (i.e., loans) is excluded from the property factor. Applying the general corporate apportionment rules, the LLCs reported zero Minnesota apportionment on their partnership returns. Thus, none of the income and property of the LLC’s was included in the bank taxpayers’ apportionment. On audit, the Commissioner adjusted the taxpayers’ apportionment to include their pro-rata share of the LLCs’ interest income and loans. The taxpayers protested the adjustment and the matter came before the tax court. The tax court, relying on the Minnesota Supreme Court’s ruling in HMN Financial, held that the Commissioner could not use her alternative apportionment authority to disregard the taxpayers’ lawfully created structure and apply the financial-institution apportionment formula to the LLCs. The Commissioner appealed.

On appeal, the Minnesota Supreme Court first determined that its decision in HMN was distinguishable from the facts in the present case and did not preclude the Commissioner from exercising her alternative apportionment authority. In HMN, the Commissioner attempted to use the alternative apportionment statute as general authority to disregard a taxpayer’s structure. In other words, in HMN the Commissioner challenged the result of the application of the statutory apportionment method, but did not assert or establish that the statutory method itself produced unfair and incorrect results. In the instant case, in contrast, the Commissioner was exercising her “plain statutory authority” to rebut the presumption that the statutory method produced fair and correct results.

Having determined that the Commissioner was not barred under HMN from challenging the taxpayer’s use of the statutory method, the court next held that its role was to review whether the Commissioner presented substantial evidence to show that the taxpayers’ use of the statutory method did not fairly reflect their taxable net income allocable to Minnesota and that the alternative method did so.  With respect to the first prong of this test, the court concluded that applying the general apportionment formula at the LLC level did not fairly reflect the bank’s taxable income because use of that method resulted in the bank having no taxable income arising from the LLCs’ contacts with Minnesota. Furthermore, despite the taxpayers arguments otherwise, the court concluded that the Commissioner’s proposed alternative method—including in the bank’s apportionment their pro-rata share of the LLCs’ interest income and loans— was an appropriate method under the alternative apportionment statute. The court, concluding that the tax court’s decision was erroneous and not supported by the evidence, remanded the case to the tax court to enter a judgment consistent with its opinion. Please contact Mike O’Brien at 612-305-5441 with questions on Assoc. Bank. v. Commissioner of Revenue.The Minnesota Supreme Court recently reviewed a decision in which the tax court had held that the Tax Commissioner erred when she attempted to adjust a banking group’s apportionment to include the interest income and loans of certain LLCs taxed as partnerships. The LLCs at issue were formed by the taxpayer, a bank, and affiliated entities to hold loans secured by property in Minnesota. Under Minnesota law in effect at the time, LLCs could not be classified as financial institutions (the law has since been revised to expand the definition of a financial institution to capture entities that are more than 50 percent owned by other financial institutions). The stated purpose for the formation and transfer of the loans to the LLCs was to reduce the taxpayers’ Minnesota tax liability. Under the general corporate apportionment rules, rather than the financial institution apportionment rules, interest income is excluded from the sales factor and intangible property (i.e., loans) is excluded from the property factor. Applying the general corporate apportionment rules, the LLCs reported zero Minnesota apportionment on their partnership returns. Thus, none of the income and property of the LLC’s was included in the bank taxpayers’ apportionment. On audit, the Commissioner adjusted the taxpayers’ apportionment to include their pro-rata share of the LLCs’ interest income and loans. The taxpayers protested the adjustment and the matter came before the tax court. The tax court, relying on the Minnesota Supreme Court’s ruling in HMN Financial, held that the Commissioner could not use her alternative apportionment authority to disregard the taxpayers’ lawfully created structure and apply the financial-institution apportionment formula to the LLCs. The Commissioner appealed.

On appeal, the Minnesota Supreme Court first determined that its decision in HMN was distinguishable from the facts in the present case and did not preclude the Commissioner from exercising her alternative apportionment authority. In HMN, the Commissioner attempted to use the alternative apportionment statute as general authority to disregard a taxpayer’s structure. In other words, in HMN the Commissioner challenged the result of the application of the statutory apportionment method, but did not assert or establish that the statutory method itself produced unfair and incorrect results. In the instant case, in contrast, the Commissioner was exercising her “plain statutory authority” to rebut the presumption that the statutory method produced fair and correct results.

Having determined that the Commissioner was not barred under HMN from challenging the taxpayer’s use of the statutory method, the court next held that its role was to review whether the Commissioner presented substantial evidence to show that the taxpayers’ use of the statutory method did not fairly reflect their taxable net income allocable to Minnesota and that the alternative method did so.  With respect to the first prong of this test, the court concluded that applying the general apportionment formula at the LLC level did not fairly reflect the bank’s taxable income because use of that method resulted in the bank having no taxable income arising from the LLCs’ contacts with Minnesota. Furthermore, despite the taxpayers arguments otherwise, the court concluded that the Commissioner’s proposed alternative method—including in the bank’s apportionment their pro-rata share of the LLCs’ interest income and loans— was an appropriate method under the alternative apportionment statute. The court, concluding that the tax court’s decision was erroneous and not supported by the evidence, remanded the case to the tax court to enter a judgment consistent with its opinion. Please contact Mike O’Brien at 612-305-5441 with questions on Assoc. Bank. v. Commissioner of Revenue.