Opinion ID: 1717682
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Heading: Foreign Dividend Gross-Up

Text: In computing its federal income tax liability, a corporate taxpayer which pays income tax to a foreign country may either deduct the tax paid to the foreign country under I.R.C. § 164(a)(3) or credit that amount under I.R.C. § 901 against its tax liability. While § 901 provides a credit for foreign taxes a corporation actually paid, I.R.C. § 902 additionally allows a domestic corporation, owning at least ten percent of the voting stock of a foreign subsidiary from which it receives a dividend, a derivative credit for the foreign income taxes paid by its foreign subsidiary on its accumulated profits. In effect, under § 902 the domestic corporation is deemed to have paid a portion of the foreign taxes actually paid or accrued by the foreign subsidiary. See B. Bittker and J. Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 17.11 (4th ed. 1979); 34 Am.Jur.2d Federal Taxation ¶ 8412 (1987). If a corporate taxpayer elects to take the § 902 deemed paid foreign tax credit rather than the deduction, I.R.C. § 78 requires that the domestic corporation add to its gross income the amount of the deemed paid foreign taxes. This amount, commonly referred to as gross-up, is treated under § 78 as a dividend received by the domestic corporation from the foreign subsidiary. See B. Bittker and J. Eustice, supra. The purpose of the gross-up provision was to eliminate an unjustified tax advantage for domestic corporations choosing to conduct foreign business through the use of subsidiaries rather than unincorporated branches. S.Rep. No. 1881, 87th Cong.2d Sess., reprinted in 1962 U.S.Code Cong. & Ad.News 3304, 3368. Prior to Congress's adoption of § 78, a domestic corporation, in effect, received both a deduction and a credit for its foreign subsidiary's foreign taxes because they served the dual function of reducing the amount of dividend taxable to the parent corporation and of constituting a credit against the parent's federal taxes on that dividend. See B. Bittker and J. Eustice, supra. The effect of § 78 was to increase the overall tax rate on foreign dividend income received by a domestic corporation and to more closely equalize the tax burden on the use of subsidiaries and branches. See B. Bittker and J. Eustice, supra; S.Rep. No. 1881, supra. Nevertheless, it generally remains more advantageous for a domestic corporation to elect the deemed paid foreign tax credit than to take a deduction since a deduction from income serves only to cut taxable income while the credit reduces dollar for dollar the actual federal tax due. See 34 Am.Jur.2d Federal Taxation ¶ 8419 (1987). During the years involved here, IMC received dividends from foreign subsidiaries that paid foreign taxes. IMC elected to take the federal deemed paid foreign tax credit and therefore was required to include the gross-up amount in its income for federal tax purposes. Under North Dakota law, federal taxable income is the simplified starting point for computing state income tax. See §§ 57-38-01(8) and 57-38-01.1, N.D.C.C.; Erdle v. Dorgan, 300 N.W.2d 834, 837 (N.D.1980). IMC, however, excluded the gross-up amount from its apportionable income on its state tax returns. The Commissioner disallowed this exclusion because North Dakota's income tax statutes do not expressly allow corporations a deduction for taxes paid to a foreign country. [3] The district court upheld IMC's exclusion of the gross-up, concluding that North Dakota cannot constitutionally require a U.S. corporation to include as `income' ... foreign taxes paid by a foreign subsidiary. IMC asserts that F.W. Woolworth Co. v. Taxation and Revenue Department of New Mexico, 458 U.S. 354, 102 S.Ct. 3128, 73 L.Ed.2d 819 (1982), holds a state cannot constitutionally tax the foreign dividend gross-up. F.W. Woolworth Co. held that New Mexico lacked power under the due process clause to tax actual dividends Woolworth received from four of its foreign subsidiaries because Woolworth and its subsidiaries were not engaged in a unitary business relationship. The Court found insufficient evidence of the three `factors of profitability' arising `from the operation of the business as a whole' which evidence the operation of a unitary business: `functional integration, centralization of management, and economies of scale.' F.W. Woolworth Co., supra, 458 U.S. at 364, 102 S.Ct. at 3135, 73 L.Ed. 2d at 828 [quoting Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425, 438, 100 S.Ct. 1223, 1232, 63 L.Ed.2d 510, 521 (1980)]. About foreign dividend gross-up amounts which New Mexico had also sought to include in Woolworth's apportionable tax base, the Court said: We need not be detained by New Mexico's reaching out to tax `gross-up' amounts that even the Supreme Court of New Mexico recognized as `fictitious.'... The gross-up computation is a figure that the Federal Government `deems' Woolworth to have received for purposes of part of Woolworth's federal foreign tax credit calculation.... In this case the foreign tax credit arose from the taxation by foreign nations of Woolworth foreign subsidiaries that had no unitary business relationship with New Mexico. New Mexico's effort to tax this income `deemed received'with respect to which New Mexico contributed nothingalso must be held to contravene the Due Process Clause. F.W. Woolworth Co., supra, 458 U.S. at 372-373, 102 S.Ct. at 3139, 73 L.Ed.2d at 833 (Footnote omitted.) F.W. Woolworth Co. is not controlling here. The Supreme Court did not hold that it is always unconstitutional for a state to tax gross-up dividends, but only that a state could not tax gross-up dividends, just as it could not tax actual dividends, where the foreign subsidiaries had no unitary business relationship with the state. That is not the situation here. IMC does not contest the State's taxation of actual dividends it received from foreign subsidiaries and concedes that its foreign subsidiaries had a unitary business relationship with the State. IMC claims that it makes no difference whether a unitary business relationship exists, because it is the fictitious character of the gross-up which offends due process. IMC also contends that if the gross-up income is taxed by the state, some offsetting adjustment is needed to correct an unconstitutional distortion caused by inclusion of the gross-up income without recognizing the amount of foreign taxes paid. We cannot accept IMC's argument that inclusion of the gross-up amount, without recognizing an offsetting adjustment for state tax purposes, is a violation of IMC's due process rights. Several courts, although not directly deciding the question on constitutional due process grounds, have recognized that a state may require corporations to include gross-up income without any offsetting adjustments in calculating state tax liability. See Ex Parte Kimberly-Clark Corp., 503 So.2d 304 (Ala. 1987); Caterpillar Tractor Co. v. Lenckos, 77 Ill.App.3d 90, 395 N.E.2d 1167 (1979), aff'd, 84 Ill.2d 102, 49 Ill.Dec. 329, 417 N.E.2d 1343 (1981), appeal dismissed sub nom. Chicago Bridge & Iron Company v. Caterpillar Tractor Company, 463 U.S. 1220, 103 S.Ct. 3562, 77 L.Ed.2d 1402 (1983); Comptroller v. NCR Corp., 71 Md. App. 116, 524 A.2d 93 (1987), cert. granted, 310 Md. 275, 528 A.2d 1287 (1987). [4] A domestic corporation required to compute gross-up income under § 78 has received economic benefit from its election to take the § 902 foreign tax credit. By making this voluntary election, IMC has reduced its federal income tax liability. While § 78 was enacted for § 902 foreign tax credit purposes, [i]t should be noted that § 78 dividends constitute `gross income' for all purposes, not merely the computation of the shareholder's foreign tax credits; thus, unfavorable collateral effects under [other sections of the Internal Revenue Code] can be created by the gross-up rules of § 78. B. Bittker & J. Eustice, supra, at p. 17-36 n. 85; see also 34 Am.Jur.2d Federal Taxation ¶ 8414, at p. 1021 (1987) [`gross-up' income is treated as a dividend for all U.S. tax purposes except the dividends received deduction. (Emphasis in original.) ] In this case, it is conceded that IMC's foreign subsidiaries had a unitary business relationship with IMC and North Dakota. Therefore, the due process clause does not preclude North Dakota from taxing actual dividends IMC received from its foreign subsidiaries. See F.W. Woolworth Co., supra ; Mobil Oil Corp., supra . Having elected the benefit of the § 902 deemed paid foreign tax credit, IMC in effect chose not to deduct the foreign taxes paid by its foreign subsidiaries but to instead treat them as dividends and therefore gross income for purposes of the Internal Revenue Code. We do not believe due process requires that IMC be freed from this choice for state tax purposes. The propriety of a deduction does not turn upon general equitable considerations ... [but] `depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.' Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149, 94 S.Ct. 2129, 2137, 40 L.Ed.2d 717 (1974) [quoting New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440, 54 S.Ct. 788, 790, 78 L.Ed. 1348 (1934) ]. Because North Dakota does not statutorily recognize a deduction for § 78 gross-up income, IMC may not exclude the gross-up from the amount of federal taxable income reported on its state income tax return. Accordingly, the judgment of the district court is reversed. ERICKSTAD, C.J., and LEVINE and GIERKE, JJ., concur. VANDE WALLE, J., concurs in result.