Implementing State Corporate Income Taxes in the Digital Age

To date discussion of state taxation of electronic commerce has focused on the sales and use tax. There are, however, also interesting and important issues involving application of the state corporate income tax to income from electronic commerce. Satisfactory resolution of these issues is crucial to the fiscal health of states that impose the tax. Moreover, the current uncertainty is inimical to business, which increasingly will be conducted electronically. This paper reviews some of these issues. It begins by discussing the conceptual foundation and the basic structure of the tax ? the choice between separate reporting and formula apportionment, the role of unitary combination, and the choice of apportionment factors. Then it discusses nexus (jurisdiction to tax) and determination of the income to be taxed by a state that invokes nexus. It is difficult to justify state corporate income taxes. Neither the ability-to-pay nor the benefit principle does so; at best the tax is justified by a state's "entitlement" to tax income originating within its boundaries. Whether or not one accepts that theory, the objective should be to attribute income to the states where it originates. Nexus is often uncertain. States assert jurisdiction to tax within guidelines established by federal law and judicial decisions. Unlike the situation in the sales tax area, federal legislation limits nexus for state income tax, but the U.S. Supreme Court has remained silent. Because the Court denied certiorari in Geoffrey, in which a state supreme court ruled that the in-state presence of intangible assets provides nexus, states are asserting "Geoffrey nexus." Both Geoffrey and the federal legislation limiting nexus lack economic rationality; the former can lead to over-taxation and the latter to under-taxation; both create discrimination. Moreover, Geoffrey nexus may not stand judicial scrutiny. Electronic commerce exacerbates the basic problems of dividing income of multistate corporations among the states where they operate ? economic interdependence and manipulation of transfer prices to place income in low-tax states. States that currently allow related corporations to file separate returns may be induced to require unitary combination. Under it, related firms deemed to be engaged in a unitary business file a single report, eliminating all intra-group transactions in calculating taxable income and using the apportionment factors of the group to apportion the group's income among the states. Two of the apportionment factors, property and sales, are especially problematical in a world of electronic commerce, because of the importance of intangible assets and sales of intangible products and services. Intangible assets often have no geographic location, and the standard rule used to assign sales of intangibles ? to the state where cost of performance occurs ? is inconsistent with the destination-based standard used to assign sales of tangible products, as well as difficult to implement. There are no good answers to many issues investigated in the paper. The best that can be achieved may be a set of arbitrary rules that are reasonable and mutually consistent (e.g., nexus rules that are consistent with apportionment rules).