Avanade, Inc. v. City of Seattle

211 P.3d 476

151 Wn. App. 290

AVANADE, INC., Appellant, v. CITY OF SEATTLE, Respondent.

No. 61594-7-I.

Court of Appeals of Washington, Division 1.

July 20, 2009.

Scott M. Edwards, Perkins Coie LLP, Seattle, WA, for Appellant.

Kent C. Meyer, Seattle City Attorney's Office, Seattle, WA, for Respondent.

DWYER, A.C.J.

¶ 1 This is a taxation case. The sole issue is whether the City of Seattle used an unlawful method to calculate Business and Occupation (B & O) taxes owed by Avanade, Inc., between January 2000 and June 2004 (the audit period). On cross-motions for summary judgment, the superior court ruled that the City properly calculated that portion of Avanade's revenue subject to the B & O tax—revenue obtained from business conducted within Seattle—by using Avanade's payroll costs to estimate the revenue generated by Avanade's Seattle employees (the "cost apportionment" method). Avanade appeals, contending that the City was required to use the actual bills that clients paid for work done by Avanade's Seattle employees (the "separate accounting" method). We conclude that, while the City was not required to utilize separate accounting, the manner in which it utilized cost apportionment improperly attributed revenue to Seattle that should have been attributed elsewhere. Because of this, the City's approach violated the United States Constitution's commerce clause.¹ Accordingly, we reverse.

I

¶ 2 Avanade is an information technology consulting company. Its headquarters are located in Seattle. It also has 10 other offices in the United States, divided into four operating regions—West, South, Central, and East. In the West region, the only cities in which Avanade has offices are Seattle, San Francisco, and Denver.

¶ 3 Because of the nature of its work, most of Avanade's consulting is done on-site at its clients' locations. Many of Avanade's employees do not work regularly at any office, but instead are physically located in states and cities in which Avanade has no office at all.

¶ 4 Avanade bills for its services on an hourly basis. Its employees record the amount of time that they work on any project and the location where the work is performed. In the words of Avanade's tax manager, all work performed by Avanade employees that is billed to clients, "whether performed by an employee working in the field at a client's location or a manager working at one of Avanade's offices, is recorded to the project and the associated revenue is allocated to the location where that billable activity was performed." Most of the company's corporate officers are located in Seattle, as is the West region manager. Thus, although many employees in the Seattle office do not do work that is billed to clients, they do formulate company policy, plan company strategy, and generate and manage clients.

¶ 5 In 2006, the City audited Avanade for B & O tax compliance. Avanade had paid $129,106.91 in B & O taxes to the City during the audit period. The audit revealed that Avanade had, during the audit period, erroneously paid Seattle B & O taxes on all revenue from services performed anywhere in Washington, not just those that were performed in Seattle. Based on the number of hours that employees actually working in Seattle billed to clients (i.e., the separate accounting method), Avanade should have owed only $81,584.56 in City B & O taxes during the audit period. Stated another way, correct separate accounting would have resulted in a $47,552.35 tax refund to Avanade.

¶ 6 But the City did not use separate accounting. Instead, the City stated:

Seattle Municipal Code, subsection 5.45.080 D and 5.44.428,[²] state that if the allocation of gross income does not fairly reflect gross income derived from business activities within Seattle, gross income subject to the Seattle B & O tax can be determined by the ratio that the cost of doing business within the City bears to the cost of doing business both within and without the City. Accordingly, we have used the cost apportionment method for this audit.

. . . .

For 2002, 2003, and the first six (6) months of 2004, the Seattle costs were calculated strictly from the payroll expenses. Per Seattle Rule 5-032, Service and Other business Activities, the payroll expenses were assigned to an office location. The salaries of the employees located in California and Colorado were sourced to the San Francisco and Denver offices, respectively. The salaries of the other employees located in the West Region were source [sic] to the Seattle office, which controls the employees. All payroll expenses sourced to the Seattle office were compared to the total company payroll to calculate the Seattle ratio.

The rule referenced by the City, Seattle Revenue Rule 5-032, is for all pertinent purposes the 2005 reenactment of former Seattle Business Tax Rule 5-44-194, which was in effect until December 31, 2001, but was repealed thereafter. The rule provides that:

Persons engaged in a business taxable under the service classification with offices or places of business located both within and without the City shall apportion their gross revenue to the office or place of business which rendered or generated the revenue or to which the revenue is attributable. Where it is not practical to determine such apportionment by separate accounting methods or such methods results in an inappropriate or unacceptable apportionment of revenue according to the Director, the taxpayer shall apportion to the City that proportion of gross revenue which the cost of doing business within the City bears to the total cost of doing business both within and without the City. For apportionment purposes all costs must be assigned to an office location.

This rule reflects Seattle Municipal Code (SMC) 5.45.080, which provides:

C. A person who maintains an office or place of business in the City and also elsewhere ... [s]hall be taxable on that portion of his gross income or gross proceeds of sales, or value of products that is derived from business activity rendered by, generated from, or attributable to the office or place of business located within the City.

. . . .

Allocations of amounts under this Section shall be made in accordance with and in full compliance with the provisions of the interstate commerce clause of the United States Constitution where applicable.

D. If the Director determines that the allocation of gross income from business activities for a person subject to subsection C above ... does not fairly reflect gross income derived from business activities within the City, the Director shall determine such gross income by either of the following methods: (a) by a fair and equitable formula agreed upon by the Director and the taxpayer after a consideration of the facts; or (b) by the ratio that the cost of doing business within the City bears to the cost of doing business both within and without the City. For apportionment purposes, all costs must be assigned to an office location.

¶ 7 Based on Avanade's payroll records (including the salaries of all of Avanade's corporate officers located in Seattle), the City assessed $302,449.80 in B & O taxes, including interest and penalties, against Avanade for the audit period. Avanade paid the tax under protest.

¶ 8 It then filed this lawsuit seeking a refund of all payments above $81,584.56 and a declaration that the City's "assessment of tax is contrary to its tax ordinance, exceeds the City's taxing authority under Washington law and is unconstitutional."

¶ 9 On cross-motions for summary judgment, the superior court upheld the City's tax assessment. Avanade appeals.

II

¶ 10 This case "was resolved below on cross-motions for summary judgment, and thus our review is de novo." Cmty. Telecable of Seattle, Inc. v. City of Seattle, 164 Wash.2d 35, 41, 186 P.3d 1032 (2008). Likewise, the proper construction of a city taxation ordinance is a legal question that is reviewed de novo on appeal, but the "`burden is on the taxpayer to prove that a tax paid by him or her is incorrect.'" Group Health Co-op. v. City of Seattle, 146 Wash.App. 80, 88, 189 P.3d 216 (2008) (quoting Ford Motor Co. v. City of Seattle, 160 Wash.2d 32, 41, 156 P.3d 185 (2007)).

III

¶ 11 The sole issue on appeal is whether the City lawfully utilized cost apportionment accounting to calculate that portion of Avanade's revenue subject to the City's B & O tax during the audit period. We conclude that, contrary to Avanade's contention, neither the City's own tax ordinances nor our cases interpreting the federal constitution required the City to utilize separate accounting methods. However, we also conclude that the specific manner in which the City utilized cost apportionment in this case unconstitutionally burdened interstate commerce by improperly attributing revenue to Seattle that should have been attributed elsewhere. Thus, this method failed to meet the SMC 5.45.080(C) requirement that "[a]llocations of amounts under this Section shall be made in accordance with and in full compliance with the provisions of the interstate commerce clause of the United States Constitution."

¶ 12 Avanade does not dispute that it is subject to the City's B & O tax, or that this tax requires some method of apportionment between Avanade's in-city and out-of-city revenues. Rather, Avanade's initial contention is that the City's decision to utilize cost apportionment rather than separate accounting violated the City's own B & O tax ordinance because that ordinance contains a presumption that separate accounting will be used. According to Avanade, the City has failed to articulate a legitimate basis upon which to conclude that separate accounting does not "fairly reflect" Avanade's gross income derived from its Seattle business activities.

¶ 13 The problem with Avanade's contention is that, under Seattle's municipal code, the determination of whether separate accounting does or does not "fairly reflect gross income derived from...