Formula Apportionment in the USA.

9 T HE W ORLDWIDE U NITARY T AXATION C ONTROVERSY . During the 1970s an increasingly publicised dispute developed over what has been referred to as Worldwide Unitary Taxation WUT. The dispute arose over the application by a number of American state jurisdictions of their system of formulary apportionment of the taxable income of a unitary business to the combined worldwide activities of TNCs doing business within the state. Attempts to prevent the widening application of this approach developed into a worldwide campaign, led by non­ American, in particular British, TNCs doing business in the US. Although this campaign obtained support from the American Federal as well as most other national governments, and eventually succeeded in checking the application of unitary taxation to worldwide income, at the same time it focussed attention on the problem of allocation of the income of globally integrated businesses. This in turn led to increased scrutiny of the effectiveness of enforcement of the arms length pricing principles under the separate accounting approach, and stimulated renewed efforts by the US Internal Revenue Service to justify and develop its systems of audit of TNC accounts, as discussed in the previous chapter. It also encouraged the IRS to take the lead in pressing for further development of the international arrangements for coordination of the taxation of international business. Despite the widespread criticism of WUT, it became clear that a formula approach would be a necessary element of an improved system of international taxation.

1. Formula Apportionment in the USA.

Formula apportionment had originated as a means of allocating taxes of cross­ jurisdictional business within the USA. In the State Railroad Tax Cases 1875, the US Supreme Court upheld the validity of an Illinois state railroad tax of 1872 which was levied on the value of buildings, track, rolling stock and other property within the state, apportioned as to each county, city or town according to the proportion of the length of track within that locality in relation to the total length of track of that railroad. In the early years of the 20th century, as states began to levy income taxes or franchise taxes on business profits, the principle of apportionment became commonly used to allocate the income of a multistate business or corporation. 1.a Constitutionality In 1920, in a landmark judgment by Brandeis J. Underwood Typewriter v. Chamberlain, the Supreme Court held that such an allocation was not unconstitutional under the Commerce or Due Process clauses, since there was nothing to show that it was arbitrary or produced an unreasonable result. In 1924 the Court also approved formula apportionment applied to a foreign corporation importing beer brewed in Britain for sale in New York Bass, Ratcliff Gretton Ltd v. State Tax Commission 1924. New Yorks business franchise tax originating in 1909 was levied at 3 of net income; corporations which earned some of their income from outside the state paid according to the proportion of the value of assets located in the state. This was upheld as valid in the Bass Beer case, despite the fact that under the Federal income tax rules the British company had no US income assessable to tax; the court agreed that manufacturing and selling ale constituted a unitary business, and the allocation of profits by New York was legitimate. Within the federal framework, formula apportionment posed two questions: how far the approach of different states should be harmonised, and whether this was the task of the courts or the Congress. The courts were sometimes willing to strike down an allocation if it could be shown to be arbitrary or irrational. In Hans Rees Sons v. N. Carolina 1930, the Supreme Court stated that `evidence may always be received which tends to show that a State has applied a method which, albeit fair on its face, operates so as to reach profits which are in no just sense attributable to transactions within its jurisdiction ¶ p.134. There, a company manufacturing belting in North Carolina and selling in many states from warehouses and a sales base in New York, showed that its profit was in three separate components: that from buying hides on the markets; that from manufacturing which it assessed at the difference between tanning done by independent contractors and tanning done in its own plant; and that from sales. The Court agreed that although `the ultimate gain is derived from the entire business ¶ nevertheless the activities conducted in different jurisdictions did not form `component parts of a single unit ¶ However, in Butler Bros. v McColgan 1942, the Court stressed that `One who attacks a formula of apportionment carries a distinct burden of showing by `clear and cogent evidence that it results in extraterritorial values being taxed ¶p.507, per Douglas, J.. The spread of state corporate taxation, and divergences between the approaches of different states, led to a flood of court cases. These came to a head in two cases which reached the Supreme Court in 1959. 1 By this time, 35 states had direct net income taxes on corporations, and there had been over 300 cases reaching the stage of full­ dress opinions in the Supreme Court. The Northwestern Portland Cement case of 1959 squarely put the issue to the Court, whether a corporation engaged in `exclusively interstate commerce ¶ could be subject to state income tax at all. Frankfurter J., in particular, stated the robust view that the Commerce clause of the Constitution precluded the states from taxing a corporation `on income related to the state by virtue of activities within it when such activities are exclusively a part of the process of doing interstate commerce ¶ However, a 6­3 majority of the Court held that a non­discriminatory and fairly apportioned state tax on interstate corporate income was constitutional. While there has been a continuing split on the Supreme Court between those holding restrictionist and expansionist views of state powers, the Court has tried to hold consistently to the principle that state taxation `must bear a rational relationship, both on its face and in its application, to property values connected with the taxing state ¶ 2 In the Norfolk Western Railway case 1968, the Court rejected Missouris treatment as unitary of the profits of two different railroads which had not been operationally integrated but acquired by the same company for diversification. However, this principle falls short of giving the Court the role of ensuring the full harmonization of the approaches of different states, a role which the majority of Justices has felt is reserved for the Congress, although the Court has not been averse to giving Congress a push. Following the Northwestern Portland Cement case, the Congress did succeed in passing an Act 3 which prohibited states from taxing a corporation present within the state only through sales, solicited and filled entirely from outside the state. Despite further continual threats of and attempts at Congressional action, no comprehensive federal legislation has yet reached the statute book. 1.b Harmonization of State Formula Apportionment In the meantime, the states have attempted themselves to harmonise their activities. The Uniform Division of Income for Tax Purposes Act UDITPA, drafted in 1957 by the National Conference of Commissioners on Uniform State Laws, was adopted as Article IV of a Multistate Tax Compact in 1966. The Compact established the Multistate Tax Commission with the power to formulate regulations and develop practice to ensure optimal harmonization in the application of UDITPA. UDITPA laid down a three­factor formula based on tangible property, payroll and sales, and its acceptance by many states from the 1960s, with the explicit aim of heading off 1 Northwestern Portland Cement Co. v Minnesota ; T.V. Williams v. Stockham Valves 1959. 22 Fortas, J., in Norfolk Western Rly Co. v Missouri State Tax Commission 1968. 3 Public Law 86­272 of 1959. federal legislation, established widespread harmonization in the allocation of the profits of a unitary business. By 1982 over 23 states had adopted UDITPA, there were 19 full and 11 associate members of the Compact, and the Multistate Tax Commission was carrying out audits of multistate firms on behalf of its member states. 1 Divergences between states arise in particular in relation to i the formula used, and ii the criteria for determining whether a business is unitary. As regards the formula, some states specify in the taxing statute the formula to be used, while others merely require a fair apportionment, which is left to be decided by commissioners, on the basis of regulations, which frequently give the taxpayer the right to object and propose an alternative. Divergences arise in particular between states which are the home of manufacture and the primarily agricultural states where manufactured products are sold. UDITPA gives the taxpayer the right to elect the application of the 3­factor formula, which aims to provide a balance of these competing interests. However the Supreme Court has refused to put pressure on states to fall in line with the 3­factor formula. Thus in Moorman Manufacturing Co. v Bair 1978, an Illinois animal feed corporation had 20 of its sales in Iowa; assessments using a single­ factor formula based on sales were upheld as valid by a 6­3 majority of the Supreme Court. Iowas formula conflicted with that of Moormans home state, Illinois, which had adopted UDITPA and its 3­factor formula, but the judgment of Stevens, J., while conceding that the single­factor formula was imprecise, nevertheless held that neither the Due Process nor the Commerce clauses of the Constitution required the elimination of all double taxation. A strong dissenting judgment by Powell, J. stressed that it was the duty of the Court to establish a balance between the interests and rights of the several states, and that the single­factor formula effectively acted as a tariff on goods imported from manufacturing states. What constitutes a unitary business has, however, proved to be the more difficult problem. Under UDITPA, the 3­factor allocation formula applies only to `business income ¶ The first step is therefore to distinguish non­business income from business income, which is defined as: ... income arising from transactions and activity in the regular course of the taxpayers trade or business and includes income from tangible and intangible property if the acquisition, management and disposition of the property constitute integral parts of the taxpayers trade or business operations. Non­business income is allocated not by the formula but according to geographical source. Thus, rent from real property unconnected with the business is allocated to the state where the property is located; patent and copyright royalties unconnected 1 An attempt to invalidate the formation of the Compact as an unconstitutional compact or treaty among the states was rejected by the Supreme Court in US Steel v. Multistate Tax Commission 1978. For an example of a joint audit of a TNC carried out by the Commission, see ASARCO v Idaho State Tax Commission 1982. with the carrying on of the business are allocated to the state where those rights are utilized. Secondly, a corporation may engage in different lines of business, which may or may not be regarded as unitary. Here the UDITPA does not help, and it is left to the courts to determine what constitutes a unitary business. On the whole, little difficulty is caused by vertically­integrated activities carried out by a single corporation in several states. R D, purchasing, manufacturing, financing and marketing activities of a single corporation in relation to a single product line are normally highly integrated although this was, exceptionally, found not to be so in the Hans Rees case. More problematic has been the situation where similarly vertically­integrated activities were carried out by separate but affiliated corporations registered in different states. In a case involving the auto manufacturer Studebaker Studebaker Corp. v Gilchrist 1926, it was revealed that Studebakers Indiana manufacturing affiliate showed substantial profits, while the prices it charged to its sales subsidiaries produced losses or minimal profits for them. The New York Court of Appeals held invalid an attempt by New York to tax on the basis of the consolidated accounts of the group filed for federal tax purposes. Where an out­of­state corporation operated in New York through a branch, the profits could be allocated, as was decided in the Bass beer case. Where it operated through a group of subsidiaries, the New York tax statute gave the power to adjust intra­group prices to ensure that their relationship was `as liberal and just as it would be if the subsidiary were a stranger ¶Cardozo, J., at p.71. However, since the Indiana subsidiary was not doing business in New York, it was not subject to New York tax at all. The Tax Commission had erred in neither attempting to adjust the intra­firm prices, nor even apportioning the profits shown by the consolidated return. This posed a real problem, since many vertically­integrated firms could use a network of subsidiary companies to ensure that most profits appeared in low­tax states. To overcome this, several states began to apply formula apportionment to the taxable profits of an entire unitary business, taking account of the assets and activities of related corporations engaged in that same business. This could not be done by means of a consolidated return, since a state could not subject to its jurisdiction corporations not registered or doing business within the state, even if one of the affiliates of a corporate group was so present. Instead, they required the affiliate which was within the state to file a combined report covering all affiliated corporations engaged in the same unitary business, giving the information necessary to compute the combined profit and to apportion according to the formula. In computing the combined profit, the important step was to eliminate from the total gross receipts and expenses of the entire unitary business the effects of all inter­affiliate transactions relating to the unitary business. This made it irrelevant to investigate whether inter­affiliate pricing had been used to shift profits. Hence, taxation of a corporate group on a unitary basis by individual states is an alternative to joint taxation by states based on a single consolidated return. 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