Arizona Court of Appeals Division One Holds That, When Apportioning Arizona Income, the Denominator of the Sales Factor Should Include Only the Net Gains from the Sales of Mortgages and Mortgage Servicing Rights.

MDC was the parent corporation of a group of companies engaged in the construction, sale, and financing of housing.  One of its subsidiaries, HomeAmerican, transferred its mortgages to private investors within fifteen to forty-five days of origination.  HomeAmerican also accumulated mortgage loans and sold them in packages to secondary market investors.  Moreover, MDC sold the right to service the mortgages, either at the time it sold the mortgage or at a later time.  MDC filed its 1996 income tax return on a unitary basis, including HomeAmerican’s income.  On its tax returns, MDC reported the net income from the sale of mortgages and servicing rights, not the gross amounts it received. 

Several years later, MDC sought to change the amount of its multistate income attributable to Arizona by including gross receipts from the sales of mortgages and servicing rights in the denominator of its sales factor.  MDC also argued that the sales of mortgages and servicing rights occurred outside of Arizona and should not have been included in the numerator of the sales factor.  After the Department of Revenue and the Arizona Board of Tax Appeals disallowed the changes, MDC filed an action in the Arizona Tax Court.  The tax court rule in favor of the Department of Revenue and this appeal followed.

The Arizona Appeals Court held that only the net proceeds from selling mortgages and servicing rights should be included in the denominator of the sales factor.  The Court explained that MDC’s primary purpose in selling the mortgages was to recover its principal.  Moreover, MDC included only the net proceeds from mortgage origination, and thus including the gross receipts from the sale of the same mortgages on the secondary market would artificially distort the sales factor by including the principal on only one side of the transaction. 

Lastly, the Appeals Court concluded that the numerator of the Arizona sales factor should not include the net proceeds from the sales of mortgages and servicing rights because MDC incurred the costs of performance in Colorado, not Arizona.  Unless Arizona expressly adopts the Multistate Tax Commission’s regulations, which would look to the physical location of the income-producing property, A.R.S. § 43-1147 requires courts to look to where the cost of the income producing activity is incurred.

Judge Irvine authored the opinion; Judges Winthrop and Hall concurred.