Opinion ID: 2106518
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Heading: The Foreign Commerce Clause and Kraft General Foods

Text: In Kraft General Foods, Inc. v. Iowa Dep't of Revenue and Finance, 505 U.S. 71, 112 S.Ct. 2365, 120 L.Ed.2d 59 (1992), the Supreme Court held that Iowa's tax treatment of dividends received by a domestic parent corporation from foreign subsidiaries unconstitutionally discriminated against foreign commerce in violation of the Foreign Commerce Clause. The taxing scheme at issue in Kraft was similar to the one currently used in Maine in that Iowa used the federal tax system's calculation of corporate income as its starting point for determining a corporation's apportionable income. Id. at 74, 112 S.Ct. at 2367-68. Pursuant to the federal tax statutes, a parent corporation is permitted to deduct from gross corporate income the dividends it received from domestic subsidiaries. 26 U.S.C.A. § 243 (West 1988 & Supp.1995) (this deduction is known as the dividends received deduction). Although parent corporations cannot deduct dividends paid by foreign subsidiaries from their gross income, the federal formula permits a tax credit for foreign income taxes paid by the subsidiary on the income from which the dividends were paid, and for the foreign taxes withheld from the dividends, to mitigate the consequences of international double taxation. 26 U.S.C.A. § 78 (West 1988 & Supp.1995). Alternatively, the federal system allows a taxpayer to deduct foreign income taxes imposed. 26 U.S.C.A. § 164 (West 1988 & Supp.1995). Iowa included the foreign subsidiary's dividends in a corporation's gross income and permitted no corresponding deduction or credit for foreign taxes paid. Kraft, 505 U.S. at 76, 112 S.Ct. at 2368-69. Based on this scheme, the Supreme Court concluded that the only subsidiary dividend payments taxed by Iowa are those reflecting the foreign business activity of foreign subsidiaries, and that the Iowa tax scheme violated the Foreign Commerce Clause. Id. at 77, 112 S.Ct. at 2369. Like Iowa, Maine includes the foreign subsidiary's dividends in Du Pont's gross income and permits no corresponding deduction or credit for foreign taxes paid. Maine, however, uses a combined reporting method, while the Iowa system used a single entity reporting system. [9] Courts and commentators are divided on the significance of the taxing authority's use of the combined reporting method on the applicability of the Supreme Court's holding in Kraft to a challenged tax scheme. In the immediate wake of the Supreme Court's decision, commentators identified Maine's tax scheme as one of the taxing schemes subject to challenge as a result of Kraft. See Wary States, Refund Claims, Uncertainties Seen After Supreme Court's Kraft Ruling, Daily Rep. for Executives (BNA) (Monday, June 22, 1992); James R. Potts, State Taxing Schemes Discriminating in Violation of the Foreign Commerce Clause: Kraft General Foods, Inc. v. Iowa Dep't of Revenue and Finance, 46:2 TAX LAW. 555 (1993). The highest courts of two states have addressed the applicability of Kraft to challenges to their taxing methods, and have reached opposite conclusions. Most recently, in Dart Industries, Inc. v. Clark, 657 A.2d 1062 (R.I.1995), the Rhode Island Supreme Court struck down that state's corporate taxing scheme, concluding that Rhode Island's tax statutes [10] contained the same fatal flaw that was present in the Iowa statute, i.e., a facial preference for domestic commerce over foreign commerce. Id. at 1066. In Appeal of Morton Thiokol, 254 Kan. 23, 864 P.2d 1175 (1993), the Kansas Supreme Court found Kansas' use of a domestic combined reporting method [11] dispositive in its determination that Kraft was inapplicable to a taxpayer's challenge that Kansas's taxing scheme unconstitutionally discriminated against foreign commerce. Id. at 1186. We find the reasoning of the Kansas Supreme Court persuasive. Indeed, as Kansas's high court points out,  Kraft does not address the taxation of foreign dividends by domestic combination states. Id. In Kraft, the Supreme Court considered the constitutionality only of Iowa's single entity reporting system. Kraft, 505 U.S. at 74 n. 9, 112 S.Ct. at 2367 n. 9. Pursuant to this taxing method Iowa directly taxed neither the income nor dividends of a domestic subsidiary if the subsidiary did not do business within the state. Iowa, however, did tax the dividends paid by the foreign subsidiary to the domestic parent. Cf. Kraft, 505 U.S. at 74, 112 S.Ct. at 2367-68 (stating that Iowa is not a state that taxes an apportioned share of the entire income of a unitary business nor does it directly tax the income of a subsidiary unless the subsidiary itself does business in Iowa). In contrast, the combined reporting method by definition includes within the amount apportioned to Maine part of the income earned by the unitary business's domestic subsidiaries. With the taxpayer's federal tax figures as the starting point, Maine effectively captures some of the value of the business activity of the domestic subsidiaries by directly taxing an apportioned part of the domestic subsidiary's income. Having captured this value, the Assessor does not add the domestic subsidiary's dividends back into the parent's apportioned income. With respect to the dividends of foreign subsidiaries, however, Maine's use of the water's edge combined reporting method limits the State to the nation's boundaries in calculating corporate income, and hence no income of foreign subsidiaries is apportioned to Maine. The Assessor adds the dividends paid by the foreign subsidiaries to the domestic parent because these dividends represent value earned by the parent that is not otherwise captured. Far from discriminating against foreign commerce, Maine's water's edge combined reporting method provides a type of taxing symmetry that is not present under the single entity system. Although the dividends paid to parent corporations with domestic subsidiaries are not taxed, the apportioned income of the domestic subsidiaries is subject to tax. Because the income of the unitary domestic affiliates is included, apportioned, and ultimately directly taxed by Maine as part of the parent company's income, the inclusion of dividends paid by foreign subsidiaries does not constitute the kind of facial discrimination against foreign commerce that caused the Supreme Court to invalidate Iowa's tax scheme in Kraft. Thus, Maine's use of a water's edge combined reporting method distinguishes Maine's taxing scheme from the scheme invalidated by the United States Supreme Court in Kraft.