Opinion ID: 1423388
Heading Depth: 1
Heading Rank: 2

Heading: Background: State Taxation of International Income

Text: Limitations on taxation by the states of the income of corporations doing business in more than one jurisdiction inevitably implicate the sufficiency of quantitative measures used to identify that portion of taxable value reasonably attributable to the taxpayer's intrastate activities. (1a) This pivotal role of technique arises from the stricture of the commerce and due process clauses of the federal Constitution that a State may not tax value earned outside its borders. ( ASARCO Inc. v. Idaho State Tax Comm'n (1982) 458 U.S. 307, 315 [73 L.Ed.2d 787, 794, 102 S.Ct. 3103] ( ASARCO ).) To meet this limitation, state tax schemes must comply with multiple criteria designed to produce a substantially accurate distribution of income so that only values created by business within its borders are taxed. ( Butler Bros. v. McColgan (1942) 315 U.S. 501, 507 [85 L.Ed. 991, 996, 62 S.Ct. 701] ( Butler Bros. ).) Two distinct models have long competed for supremacy in identifying the required division of multijurisdictional income. (2) One model, known as the arm's length/separate accounting or AL/SA method, calculates income on a discrete and circumscribed basis, whether geographical, transactional, or functional. In a multicorporate interjurisdictional setting, the AL/SA method allocates income to a single taxing sovereign rather than apportioning it among jurisdictions, and treats intercorporate transfers of value between commonly held or related entities as if they were arm's length transactions between unaffiliated businesses. There seems little reason to doubt that, as an operational matter, the AL/SA model is the dominant method employed by corporations both in the United States and internationally; that is, a majority of businesses use the AL/SA or a variant method for their own internal accounting purposes. (3) The competing model for taxation purposes is the unitary business/formula apportionment method. Founded on the perception that [i]n the case of a more-or-less integrated business enterprise operating in more than one State ... arriving at precise territorial allocations of `value' is often an elusive goal, both in theory and in practice ( Container, supra, 463 U.S. at p. 164 [77 L.Ed.2d at p. 552]), formula apportionment relies on mathematical generalization to distribute an aliquot share of income or taxable value among taxing jurisdictions. The dominant variation of formula apportionment  the so-called three-factor model employed by the Board in this case  defines the multijurisdictional scope of the unitary enterprise of which the taxable intrastate activities are a part, calculates the combined income of the components of the unitary group, and distributes a portion of that result to the taxing state using a mathematical formula based on an averaged ratio of property, payroll, and sales in the taxing jurisdiction to that of the unitary enterprise overall. [2] (See Container, supra, 463 U.S. at p. 165.) So far as taxation of United States-derived income is concerned, the use of formula apportionment is both established and noncontroversial, being the preferred method of a majority of the states; a substantially smaller number of American jurisdictions  California among them  combine and apportion the worldwide income of multinational corporate taxpayers, a variant sometimes referred to as the worldwide combined reporting or WWCR method. [3] Although AL/SA is the method of choice for corporate operational and internal accounting purposes, its recognized deficiencies in purporting to locate and assign taxable value to a particular jurisdiction reduce its appeal among state tax administrators, the chief proponents of competing apportionment methods. These critics cite several shortcomings in the AL/SA method: comparative distortions in measuring income, and a resulting overtaxation or undertaxation; administrative complexity generated by the need to analyze thousands of intercorporate transactions; and the common absence of uncontrolled comparable prices by which to verify the value of intercorporate arm's length transactions. [4] More fundamentally, critics of the AL/SA method have pointed to a theoretical failure of the model to account for income created by the effects of unitary interdependency. As the high court has stated in the case of a unitary business enterprise, separate [geographical] accounting, while it purports to isolate portions of income received in various States, may fail to account for contributions to income resulting from functional integration, centralization of management, and economies of scale. [Citation.] Because these factors of profitability arise from the operation of the business as a whole, it becomes misleading to characterize the income of the business as having a single identifiable `source.' ( Mobil Oil Corp. v. Commissioner of Taxes (1980) 445 U.S. 425, 438 [63 L.Ed.2d 510, 521-522, 100 S.Ct. 1223] ( Mobil Oil ).) Of course, formula apportionment has its critics, as well. They too point to distortions in the measurement of taxable income, especially in a multinational setting where a relatively larger proportion of foreign to United States activities may result in overtaxation of the income of foreign-based unitary businesses; the substantial administrative burden of complying with income reporting requirements in United States dollars and accessing financial information that in some cases may be in the hands of literally hundreds of worldwide corporate affiliates; and the absence of uniform standards among the states for defining a unitary business. [5] Not surprisingly, partisans on both sides of the issue contend that their method is the accepted standard  in the international arena in the case of AL/SA, and in the taxation of multijurisdictional unitary groups in the case of formula apportionment. [6]
The United States Supreme Court first considered the sufficiency of formula apportionment in the constitutional sense over 70 years ago, upholding Connecticut's use of a single-factor formula to apportion the income of a Connecticut business machine manufacturer whose products were marketed nationally. The high court rejected the taxpayer's due process claim that the formula taxed business conducted beyond the boundaries of the State. As the Supreme Court explained, [t]he profits of the [company are] largely earned by a series of transactions beginning with manufacture in Connecticut and ending with the sale in other states.... The legislature in attempting to put on this business its fair share of the burden of taxation was faced with the impossibility of allocating specifically the profits earned by the processes conducted within its borders. ( Underwood T'writer Co. v. Chamberlain (1920) 254 U.S. 113, 120-121 [65 L.Ed. 165, 169-170, 41 S.Ct. 45] ( Underwood ).) Since Underwood, supra, 254 U.S. 113, the Supreme Court has confronted recurrent claims of the comparative superiority of each of these two theoretically irreconcilable techniques in responding to the distributive imperatives of the commerce clause. Despite claims of the surpassing merit of the separate accounting method, the court has refused to erect a theoretical constitutional preference for one method of taxation over another by mandating its use. ( Mobil Oil, supra, 445 U.S. at p. 444 [63 L.Ed.2d at p. 525].) Likewise, it has rejected appeals to prescribe a variant of the formula apportionment method as a uniform national standard for interstate taxation. ( Moorman Mfg. Co. v. Bair, supra, 437 U.S. 267, 278 [57 L.Ed.2d 197, 207-208] ( Moorman ).) Although the high court has refused to impose national uniform rules for the division of income rooted in the commerce clause ( Moorman, supra, 437 U.S. at p. 279), it has repeatedly validated the comparative empirical accuracy and constitutional adequacy of formula apportionment. Thus, not long after upholding the due process sufficiency of formula apportionment in Underwood, supra, 254 U.S. 113, the court authorized its use in a multinational setting to apportion the combined income of a United Kingdom-headquartered brewer whose separate accounting showed no United States net income for the tax years at issue. Contending that the state was in effect taxing foreign income, the taxpayer asserted violations of the foreign commerce and due process clauses. ( Bass, Etc., Ltd. v. Tax Comm. (1924) 266 U.S. 271 [69 L.Ed. 282, 45 S.Ct. 82] ( Bass ).) The high court rejected the challenge. The taxpayer's business, the court explained, was a unitary enterprise conducted transitionally, in which its profits were earned by a series of transactions beginning with the manufacture in England and ending in sales in New York and other places  the process of manufacturing resulting in no profits until it ends in sales.... The state was thus justified in attributing to [itself] a just proportion of the profits earned by the Company from such [a] unitary business. Moreover, since the taxpayer had failed, as in Underwood, supra, 254 U.S. 113, to show that formula apportionment produced an unreasonable result, its use was not unconstitutional. ( Bass, supra, 266 U.S. at pp. 282, 283 [69 L.Ed. at p. 287].) In Butler Bros., supra, 315 U.S. 501, the taxpayer also challenged the state's use of formula apportionment on the ground that separate accounting showed its sales office in the taxing jurisdiction had no net income for the tax year at issue and that apportionment thus resulted in the taxation of extraterritorial value. The court rejected this showing as insufficient, explaining that it need not impeach the integrity of [the separate] accounting system to say that it does not prove [taxpayer's] assertion that extraterritorial values are being taxed.... A particular accounting system, though useful or necessary as a business aid, may not fit the different requirements when a State seeks to tax values created by business within its borders. ( Id., at p. 507.) And in Exxon Corp. v. Wisconsin Dept. of Revenue (1980) 447 U.S. 207 [65 L.Ed.2d 66, 100 S.Ct. 2109], the court rejected the attempt of a vertically integrated, multistate petroleum company to demonstrate, based on its internal use of the separate accounting method applied to distinct operating divisions, that income was allocable to extrastate components and thus constitutionally was not subject to apportionment. [A] company's internal accounting techniques are not binding on a State for tax purposes, the court wrote. Exxon's use of separate functional accounting ... does not defeat the clear and sufficient nexus between [its] interstate activities and the taxing State upon which the finding of corporate unity was based. ( Id., at pp. 221 [65 L.Ed.2d at pp. 80, 82], 225.) Again, in Mobil Oil, supra, 445 U.S. 425, a nondomiciliary corporate taxpayer challenged the state's inclusion in its apportionment formula of foreign-source dividend income received by the taxpayer from subsidiaries and affiliates, on the ground that its foreign origin made it constitutionally unapportionable. Although the taxpayer was able to isolate its foreign dividend income using separate accounting, the court observed that the linchpin of apportionability in the field of state income taxation is the unitary business principle. ( Id., at p. 439 [63 L.Ed.2d at p. 522].) The divisibility of income produced by a separate accounting treatment, the court said, may fail to account for contributions to income resulting from functional integration, centralization of management, and economies of scale.... Although separate geographical accounting may be useful for internal auditing, for purposes of state taxation it is not constitutionally required. ( Id., at p. 438 [63 L.Ed.2d at p. 521-522].) (See also ASARCO, supra, 458 U.S. 307; F.W. Woolworth Co. v. Taxation & Revenue Dept. (1982) 458 U.S. 354 [73 L.Ed.2d 819, 102 S.Ct. 3128]; and Amerada Hess Corp. v. N.J. Taxation Div. (1989) 490 U.S. 66, 74 [104 L.Ed.2d 58, 67-68, 109 S.Ct. 1617].) In a slightly different context, the high court recently reaffirmed its views of both the theoretical problems inherent in locating the source of multijurisdictional income, and the validity for commerce clause purposes of the formula apportionment method. Last term, in upholding Michigan's value added tax against commerce clause challenge, the court wrote that the discrete components of a state income tax may appear in isolation susceptible of geographic designation. Nevertheless, since Underwood ... we have recognized the impracticability of assuming that all income can be assigned to a single source. ( Trinova Corp. v. Michigan Dept. of Treasury, supra, 498 U.S. 358, ___ [112 L.Ed.2d 884, 907, 111 S.Ct. 818, 831].) The court went on to reiterate its statement in Container, supra, 463 U.S. at page 170 [77 L.Ed.2d at page 556], that the three-factor formula has become something of a benchmark against which other apportionment formulas are judged, noted its incorporation into UDITPA, adopted by almost half of the states, and acknowledged its accuracy in reflecting the activities by which [taxable] value is generated. The same factors, the court wrote, that prevent determination of the geographic location where income is generated, factors such as functional integration, centralization of management, and economies of scale, make it impossible to determine the location of value added with exact precision. ( Trinova Corp. v. Michigan Dept. of Treasury, supra, 498 U.S. at p. ___ [112 L.Ed.2d at p. 908, 111 S.Ct. at p. 832].) (1b) Thus, the rule that has emerged from this series of high court encounters  spanning over 70 years  with the contending merits of two theoretically incommensurate systems ( Mobil Oil, supra, 445 U.S. at p. 444 [63 L.Ed.2d at p. 525]) is that, for state tax purposes, neither the commerce clause nor the due process clause of the federal Constitution mandates the use of a particular methodology to allocate or distribute multijurisdictional income. Either of the two principal methods and their variants are constitutionally permissible, as long as the one chosen does not operate unreasonably and arbitrarily to attribute to the taxing state a percentage of total income out of all appropriate proportion to the business transacted by the [taxpayer] in that State. ( Hans Rees' Sons v. No. Carolina (1931) 283 U.S. 123, 135 [75 L.Ed. 879, 907-908, 51 S.Ct. 385].) Or, as the high court stated in Moorman, supra, 437 U.S. 267, 274, the States have wide latitude in the selection of apportionment formulas and ... a formula-produced assessment will only be disturbed when the taxpayer has proved by clear and cogent evidence that the income attributed to the State is in fact out of all appropriate proportion to the business transacted... in that State. (Internal quotation marks omitted.) We present this extended account of the competing division-of-income methods and their treatment at the hands of the high court in order to meet at the outset the Bank's unpersuasive contention that formula apportionment is an inherently inequitable method, at least when applied to foreign-based unitary groups such as the Bank and its affiliates. [7] In substance, this argument is no different from the one explicitly rejected by the court in Container, supra, 463 U.S. 159. There the taxpayer presented related challenges to California's use of the three-factor formula to apportion the global income of a domestic-based unitary enterprise. Specifically, the taxpayer claimed that its foreign affiliates were significantly more profitable, and that by ignoring underlying economic realities such as lower wage and production costs among its foreign subsidiaries, three-factor formula apportionment systematically distorted the true allocation of income between unitary components, unfairly inflating the income apportioned to California. The problem with this argument, the court said, is ... [that] the profit figures relied on by [the taxpayer] are based on precisely the sort of formal geographical accounting whose basic theoretical weaknesses justify resort to formula apportionment in the first place. And the difficulty with the taxpayer's evidence of differing costs, the court said, is that it does not by itself come close to impeaching the basic rationale behind the three-factor formula.... [¶] Both geographical accounting and formula apportionment are imperfect proxies for an ideal which is not only difficult to achieve in practice, but also difficult to describe in theory.... ( Container, supra, 463 U.S. at pp. 181, 182 [77 L.Ed.2d at pp. 563-564].) Of course, even the three-factor formula is necessarily imperfect, the court continued, [b]ut we have seen no evidence demonstrating that the margin of error (systematic or not) inherent in the three-factor formula is greater than the margin of error (systematic or not) inherent in the sort of separate accounting urged upon us by [taxpayer]. ( Id., at pp. 183-184.) In light of this analysis and the precedents summarized above, we conclude that, in considering the Bank's case for relief, neither of the two methods can lay claim to a decisive technical superiority or greater constitutional stature than the other. [8] (4a) We turn, then, to the merits of the Bank's contention that a dormant foreign commerce clause analysis renders unconstitutional the Board's application of the three-factor apportionment formula to the Bank's unitary enterprise.