- A judge in the Superior Court of California for the County of Los Angeles issued a proposed statement of decision in Smithfield Packaged Meats Corp. v. Cal. Franchise Tax Bd., No. 21STCV39637 (Cal. Super. Ct. L.A. Cnty. Feb. 26, 2026).
- The judge concluded that Smithfield Packaged Meats Corp. and its affiliates (“Smithfield”) were entitled to use three factor apportionment as Smithfield qualified for such treatment as an agricultural business as required by the statute. In the alternative, he also concluded that Smithfield was entitled to relief via alternative approval, even if it did not qualify as an agricultural business, and that requiring Smithfield to use a single factor formula led to a distortive result.
- The February 26th decision is not yet final and is likely to be the subject of an appeal from the Franchise Tax Board (“FTB”) but could have significant ramifications for California taxpayers.
Background
Smithfield is the world’s largest hog farmer. It converts its fully grown hogs into various cuts of pork, referred to as primal cuts, sub-primal fresh pork products or converted into packaged meat products such as bacon or sausage at eight harvesting facilities. It has three business segments – Hog Production, Fresh Pork, and Packaged Meats.
Hog Production is exactly what it sounds like. This segment raises the hogs and ends with slaughter and production of primal cuts. Fresh Pork sells these primal cuts or processes them further as sub-primal fresh pork products. Packaged Meats converts some of the primal cuts into packaged meat products for sale. Smithfield’s hog farming was located in the Midwest as corn, the main ingredient in the feed, is produced in large quantities there. The packaged meats facilities were typically located near the hog harvesting facilities.
Smithfield’s real estate footprint for its various facilities was minimal in California – it did not own any land in California, nor did it engage in any herd management activities in the state. None of the eight harvesting facilities were in California during the years at issue, and only one small processing facility (of thirty) was in California.
An expert in financial analysis and modeling employed by Smithfield estimated that the percentage of Smithfield’s receipts and profits, using the comparable profits method, in California was a little bit over 1%.
Smithfield filed its 2014 California franchise tax return as a non-agricultural business for that year. In 2018, it filed a timely claim for refund, meeting all the requirements of Cal. Rev. and Tax Code § 19322. The refund was sought on three grounds: that Smithfield qualified as an agricultural business under Cal. Rev. and Tax Code § 25128 and was required to use a three-factor formula; that 18 Cal. Code Regs. §25128-2 was invalid; and in any event, Smithfield was entitled to alternative apportionment under Cal. Rev. and Tax Code § 25137 as the single sales factor did not fairly represent its activities in California. The FTB audited Smithfield, who responded to two information and document requests from the agency. When the FTB did not mail a notice of action as required under the statute, it considered its refund disallowed and commenced litigation.
The Agricultural Business Statute
The court, after laying out the basis for, and purpose of, apportioning income for state tax purposes, noted that the reason that agricultural businesses were excluded from the single sales factor requirement was because they have little control over where they can conduct their business as they are captive to such factors as soil, climate and the like. It found that Smithfield was entitled to use the three-factor formula because it derived more than 50% of its gross receipts from “agricultural business activities”. Cal. Rev. and Tax Code § 25128(d)(2) defines the term to mean: “…activities relating to any stock, dairy, poultry, fruit, furbearing animal, or truck farm, plantation, ranch, nursery, or range. “Agricultural business activity” also includes activities relating to “…cultivating the soil or raising or harvesting any agricultural or horticultural commodity, including, but not limited to, the raising, shearing, feeding, caring for, training, or management of animals on a farm….”
The court determined that classifying Smithfield as an agricultural business was appropriate under the statute. The statutory purpose behind allowing the three-factor formula for such businesses is that they have less geographical flexibility, which applied to Smithfield’s business needs to locate its facilities in the Midwest near feed production and the difficulty in transporting live hogs. Treating these activities as agricultural in nature was consistent with the legislature’s stated intent to avoid penalizing businesses with less discretion as to geographical location.
The court then evaluated what percentage of Smithfield’s gross receipts were attributable to agricultural activities to determine whether these receipts exceeded the 50% threshold as required by statute. It determined that over 60% of its gross receipts were from agricultural business activity and that it qualified for three factor treatment under the statute.
The Regulation
The court turned to the FTB’s contention that, under 18 Cal. Code Regs. § 25128-2, Smithfield did not qualify as an agricultural business. It noted that under the California Government Code, a regulation is not valid unless it is consistent with and not in conflict with the statute. Further, when reviewing the regulation, the court is required to exercise independent judgment and not defer to the agency’s interpretation, and it must construe ambiguities in the statutory language in favor of the taxpayer.
According to the court, the regulation endorses what it terms a “product-based approach” – if a product has undergone processing, the regulation requires that such receipts be considered non-agricultural. It noted that the statute does not use the words product or processing, and that such an approach is inconsistent with the legislative purpose behind the statute – the avoidance of punishment on those businesses that have little to no leeway as to where to locate their businesses. The regulation, by operating to exclude the revenue from the sale of fresh pork or packaged meat products as considered from an agricultural business, ignores Smithfield’s core business activities and is inconsistent with the statute. The court focused on Smithfield’s activities, as required by the statute, rather than its products, as suggested by the regulation.
In invalidating the regulation, it noted that the statute contained a reference to “harvesting,” and the dictionary definition of the word includes “to…kill…for human use” and “to remove…from a living or recently deceased body.” Given the overlap between this definition and the word “slaughtering,” the court found that the regulation was inconsistent with the statute by excluding slaughtering as an agricultural business activity.
Forvis Mazars Insight: The decision is a reminder to carefully consider regulatory language in light of the applicable statute, to consider the regulation by the appropriate deference standard applicable to the jurisdiction, to use the rules of statutory construction in evaluating the text of the law, and to consider challenging the agency’s position when the regulation is inconsistent with the statute.
Alternative Apportionment
As an alternative to the arguments about the regulation and the definition of “agricultural business activity”, Smithfield also contended that it was entitled to alternative apportionment – namely, the same three factor apportionment required for a business engaging in agricultural business activities – because the single factor apportionment formula did not fairly represent the extent of its business activity in California.
Initially, the court considered whether the words “business activity” as used in Cal. Rev. and Tax Code § 25137 (the alternative apportionment statute) included all income generating activities, including payroll as reflected in the payroll factor and property as reflected in the property factor. According to the FTB, the term only includes sales. The court found the FTB’s interpretation inconsistent with prior jurisprudence and the language of the statute itself and determined that an evaluation of all income generating activities was in order.
According to the court, the use of the single sales factor did not accurately reflect the activities which gave rise to Smithfield’s income. Expert testimony, considering the location of the harvesting and processing facilities, which encompassed critical business activities, and the small size of California operations, resulted in 1.02% of Smithfield’s business activities occurring in California. Single sales factor would require an apportionment percentage of over 6.6%, a six-fold difference. Under prior California case law, this multiple more than satisfied a justification for alternative apportionment.
Having determined that alternative apportionment formula is appropriate, it found the historic three factor formula under the Uniform Division for Income Tax Purposes Act (“UDITPA”) was the proper methodology for Smithfield as it had been a benchmark for apportionment in the past. The court considered, and dismissed, several defenses that the FTB raised regarding Smithfield’s exhaustion of administrative remedies, procedural claims around the audit, and arguments around the discovery process.
Forvis Mazars Insight: While on its face Smithfield is an agricultural company, it seems reasonable that other capital and labor intensive businesses with limited geographical flexibility to relocate, perhaps because of supply chain issues, could raise an argument that the single sales factor is distortive relative to its business.
How Forvis Mazars Can Help
We can monitor this case as it proceeds through the appellate process and help you consider the applicability of the holding to your business, in California and elsewhere. Reach out to a professional at Forvis Mazars.