State Unitary Taxes Applied to Worldwide Income

However, combined reporting made it even more vital to establish criteria for what constituted a unitary business. The courts developed the Three Unities test, approved by the Supreme Court in Butler Brothers. v McColgan 1942. These were the unity of ownership, of operation and of management. Unity of ownership and management do not normally cause much difficulty; it is operational unity that is harder to define. In Butler Brothers, the unity of operation was held to be satisfied for a distribution company whose purchasing was centralised; the court held that the loss shown on a separate accounting basis on sales from the wholesale warehouse in California unfairly disregarded the benefit from bulk purchasing created by the extra volume of California sales. Nevertheless, it appears that state tax authorities were relatively selective in requiring the submission of a combined report, and confined its use to situations where it seemed that the separate accounts might not fairly reflect profitability. This selectivity also meant that, despite the early decision in the Bass case approving the application of the formula approach to foreign companies, the question of the application of combined reporting on a worldwide basis did not become important until the mid­1960s.

2. State Unitary Taxes Applied to Worldwide Income

Worldwide unitary taxation did not emerge from any deliberate policy on the part of state tax authorities, but as a result of the developing momentum of the unitary tax approach being applied to an increasingly internationalised business environment. A key element has been the developments in California. This state had pioneered combined reporting in the 1930s, to prevent motion picture companies siphoning off profits to their distribution subsidiaries in low­tax jurisdictions, especially in neighbouring Nevada. The 3­unities test developed by the California courts, was approved by the Supreme Court in the Butler Brothers case mentioned above, and Californias system of combined reporting for affiliated corporations was approved by the California courts in Edison California Stores v McColgan 1947. The policy of Californias Franchise Tax Board had nevertheless been to require a combined report only where it seemed necessary. A significant change took place following the decisions of the California Supreme Court in 1963 in two cases involving oil companies. 1 The cases concerned oil drilled in California and sold at the well­head to independent third parties; since their non­ Californian drilling was less profitable, it was the companies who wanted all their US oil business to be treated as unitary, over the objections of the Franchise Tax Board FTB. The Court rejected the FTB view that unity of operations existed only where 1 Superior Oil v Franchise Tax Board 1963; Honolulu Oil v Franchise Tax Board 1963. the operations were `necessary and essential ¶to each other; unity existed wherever operations `contributed to or were dependent on ¶ each other. The `necessary and essential ¶ test had proved most difficult to apply to horizontally­integrated firms, especially those with diversified businesses or conglomerates. The 1963 decisions, as well as Californias adoption of UDITPA in 1966, established combined reporting as a requirement in that state. The court decisions, in particular, `gave taxpayers the unequivocal right to require combination when it benefited them and made the audit staff even more aware of the foreign combination issue ¶ Miller in McLure ed. 1984, p. 139. The state tax authorities needed little further incentive to try to replenish or increase state revenues by the active use of the unitary approach. While some, primarily American, firms found they could reduce their state tax assessments through unitary combination by setting off losses made outside California, other companies acquiring or setting up businesses in California would be subject to much higher local taxes based on worldwide profits. Since formula apportionment had been approved when applied to the domestic and foreign business of a foreign corporation as early as 1924 in the Bass case, there seemed no legal obstacle to its application to either American or non­American TNCs, on their global activities. 1 In the late 1960s and early 1970s therefore, TNCs doing business in California began suddenly to find themselves required to complete a Combined Report covering their worldwide operations. This meant in many cases considerable additional effort, since the combined report differed from the consolidated accounts which the parent company would normally prepare. Separate profit and loss statements were required for each affiliate engaged in unitary business ­ but with factors such as amortization calculated according to US rules whereas the accounts of affiliates or subsidiaries would normally comply with the requirements of its country of registration or residence. Further computation was necessary to convert net income to unitary business income subject to apportionment. Finally, figures were to be supplied for the property, payroll and sales, within and outside California, of each affiliate, for the calculation of the formula. 2 Firms which failed or refused fully to comply were subject to a tax penalty and a Notice of tax payable based on the state tax authorities 1 The California courts had already held that the statute applied both to interstate and foreign commerce in 1935, and this had been confirmed by legislative amendment in 1939: see Miller, in McLure ed 1984, p.138. 2 The high cost of compliance was emphasised by the California courts which struck down combined reporting as unconstitutional: in Barclays Bank v. Franchise Tax Board 1990, the California Court of Appeals pointed out that the Barclays group consisted of over 220 subsidiaries operating in some 60 countries, but only three of these did business in the United States, and only 1.5 percent of the income generated by the Barclays group worldwide in 1977 could be attributed to California; yet it would cost millions of dollars for Barclays to establish and maintain the global system necessary literally to comply with Californias tax method: estimates ranged from 6.4 million to 7.7 million to establish the system, and from 2 million to 3.8 million a year to maintain it. However, the Tax Board argued that regulations permitted approximations to be used which could be readily ascertained from data in the published accounts. best estimate. These were in many cases for very large sums, especially significant since state and local taxes constitute a high proportion of the tax bill in the US. As with domestic formula apportionment, the most difficult issue has been deciding what constitutes a unitary business. Even supporters of the unitary approach concede that this judgment can become very subjective. It has been difficult to establish clear criteria to decide whether activities involving different product lines or services, under the same overall ownership and central management, are sufficiently distinct operationally to escape being treated as unitary. In two cases involving oil companies, the Supreme Court had little difficulty in holding the oil business is unitary. In Exxon v Wisconsin Dept. of Revenue 1980, although Exxon showed that its global organization was structured in three major Divisions, and that only marketing and no exploration, production or refining took place in Wisconsin, a unanimous Court upheld the Wisconsin Department of Revenues assessments; these showed a 4.5m profit over a three­year period when the Wisconsin subsidiary was treated as unitary, rather than the losses showed by the separate accounts filed by Exxon. In Mobil Oil v. Vermont 1980 the Court, with only one dissent, ruled that dividend income from overseas affiliates could be included as apportionable business income by any US state where an American TNC is taxable; the State of incorporation of the US parent does not have exclusive power to tax its overseas income. 1 Outside the oil business, however, there was less certainty. Thus, in two cases in 1982, the Court by majority held that foreign affiliates were not operated as a unitary business with their US parents, even though they were in a similar line of business, because that business was not operated as an integrated whole. In ASARCO v Idaho State Tax Commission 1982, a nonferrous metal mining, smelting and refining company received dividends, interest on loans and capital gains in respect of substantial equity holdings in foreign mining companies. Although one such affiliate was essentially controlled by ASARCO and was rightly treated as operationally integrated, the Court held that the others were operationally autonomous, and should be treated as mere investments. A similar decision was given in respect of the Woolworth companys dividend income from its overseas affiliates, which were found to have `little functional integration ¶with the parent, despite managerial links 1 Vermont does not have combined reporting; where this is used the net income of all unitary affiliates is combined, which eliminates intra­firm dividends, at least from affiliates with which there is unity of ownership, i.e. effective control. It is still necessary however to consider whether dividends received from minority shareholdings, such as Mobils 10 share in Aramco, are apportionable as `business LQFRPH¶RUVKRXOGEHWUHDWHGDVQRQ­business or investment income. It should be noted that Mobil did not deny in this case that its business was unitary, but argued that foreign dividend income should be taxed only by the state where the parent was incorporated. See Harley 1981, 365­7. and frequent communication with the parent, which had to approve major financial decisions Woolworth v. New Mexico 1982. In Container Corporation 1983, however, the Court majority went the other way. It agreed with the California Supreme Courts view that where an investment is in a subsidiary which is in the same line of business, there is a presumption that it is likely to be unitary, since the aim is likely to be a better use of the parents resources. Evidence of directives from the parent on professionalism, profitability, and ethical practices was sufficient to confirm that the business was unitary. Significantly, the Court rejected a proposed `bright line rule ¶that a substantial flow of goods was the test of operational unity; although this might be a reasonable and workable rule, it was not constitutionally mandated ­ the constitutional requirement was a flow of value, not goods. The `bright line ¶approach had been put forward as objective test which would require substantial interdependent basic operations between companies under common control J. Hellerstein 1982. The difficulty lies in deciding what are `basic ¶ operations: Jerome Hellerstein excludes central service functions, including intellectual property management and even finance, so that the essential requirement seems to be a flow of goods. McLure has suggested that a transactional analysis perspective is more appropriate for analysing interdependency McLure in McLure ed. 1984 ch.3, but concedes that this increases indeterminacy ibid. p.112. It may be that the only way to ensure uniformity in deciding when a business is unitary is procedurally, by establishing a single, multi­representative body to take this decision Harley 1981 p.354. These Supreme Court decisions were the tip of an iceberg of litigation which had been generated by the growing use of WUT by an increasing number of states. For example, the Mobil and Exxon cases were the eventual outcome of taxes levied by a number of states in the wake of the oil crisis of 1973­4. The sharp increases in prices of petroleum products which followed the measures taken by OPEC had an immediate impact on consumers, who found it hard to understand how the major oil TNCs could declare increased profits, based on the increased profitability of their exploration and production activities in the new world of dearer oil, while at the same time the higher product prices resulted in reduced sales and lower profits, or losses, for oil product marketing companies. Taxpayers were not sympathetic when the local marketing subsidiaries of the oil majors, which themselves were declaring large profits overall, declared a loss in the State. Nor were legislators sympathetic to the argument that such firms should not be taxed as unitary businesses, when the same corporations were resisting antitrust investigations and proposals for divestiture of some of their business, on the grounds that they were more efficient because they were highly integrated. 1 1 Harley 1981, p. 399 fn. 94, citing Senate Judiciary Committee hearings, The Petroleum Industry 1976 94th Congress 1st session, and a speech by Senator Kennedy 1978 124 Cong.Rec. S.9434­5. Hence, at a time of increasing international competitiveness, many foreign TNCs which had with difficulty established themselves in the important US markets, found their state tax assessments abruptly and unpredictably increased by substantial sums; this especially angered firms such as Barclays and Alcan, whose ventures into the US had been unfortunate and had sustained repeated heavy losses. However, in this period of intensifying pressure on state treasuries, and taxpayer revolts leading to moves to reduce personal taxation where, again, the lead was taken in California, there was not much sympathy for the problems of large, especially foreign­owned corporations. The two main steps that they could take to attempt a reversal of WUT were to lobby government and to appeal cases through the courts.

3. The Constitutionality of Worldwide Combination