Understanding uniformity and diversity in state corporate income taxes.

Faced with the prospect of federal legislation that would significantly restrict their sovereignty, in 1967 a group of states adopted the Multistate Tax Compact (the Compact) and created the Multistate Tax Commission (MTC). Since the Compact incorporated UDITPA, any state adopting it was also adopting that model statute. Among the stated purposes of the Compact is to "Promote uniformity or compatibility in significant components of tax systems." Among it's unstated goals, according to its first executive director, was--and is--"heading off federal legislation that long threatened the taxing sovereignty of the states" (see Corrigan, 2007, p. 530). In other words, in entering into the Compact and establishing the MTC, the states acted pre-emptively in an effort to avoid federal legislation. Significantly, the U.S. Supreme Court rejected the claim by 16 large corporations that the Compact was unconstitutional because it had not been sanctioned by Congress, clearing the way for states to use the MTC as a vehicle for promoting uniformity. (20) The MTC has had some success in promoting uniformity, but that success has been limited, precisely because the states do not want to cede sovereignty to the MTC--or to the collective of states acting through it--any more than to the federal government. See Hildreth, Murray, and Sjoquist (2005, pp. 583-87).

FORMULA APPORTIONMENT: MOORMAN AND ITS AFTERMATH

By the late 1960s the apportionment formulas employed by the states had reached near uniformity. Virtually all the states were using the Massachusetts formula. But Iowa had long since realized that it could reduce the tax burden on local manufacturers if it would eliminate the payroll and property factors and increase the weight on the sales factor to 100 percent. (21) Of course, the juxtaposition of sales-only apportionment in Iowa and the three factor formula used by other states automatically made gaps and overlaps in taxation inevitable.

Noting the multiple taxation that would occur if products it manufactured in Illinois were sold in Iowa, the Moorman Manufacturing Company sued the state of Iowa, arguing that its apportionment formula violated the Commerce Clause. (22) Without denying the risk of multiple taxation and backing away from a statement in one of its an earlier decisions that "The use of an apportionment formula based wholly on the sales factor, in the context of general use of the three-factor approach, will ordinarily result in multiple taxation ..." (General Motors Corp. v. District of Columbia, 380 US 553, 1965, at 559), the U.S. Supreme Court ruled that Iowa could not be blamed for the lack of consistency between its apportionment formula and that employed by other states. It stated (pp. 278 and 280):

The only conceivable constitutional basis for invalidating the Iowa

statute would be that the Commerce Clause prohibits any overlap in

the computation of taxable income by the States.... [S]ome risk of

duplicative taxation exists whenever the States in which a

corporation does business do not follow identical rules for the

division of income. Accepting appellant's view of the Constitution,

therefore, would require extensive judicial lawmaking.

It is clear that the legislative power granted to the Congress by

the Commerce Clause of the Constitution would amply justify the

enactment of legislation requiring all States to adhere to uniform

rules for the division of income. It is to that body, and not this

court, that the Constitution has committed such policy decisions.

The Moorman decision opened the floodgates for states wanting to change their apportionment formulas for competitive reasons (Mazerov, 2005). Almost 80 percent of states that tax corporate income now assign at least one-half the weight to sales, and six states use only sales to apportion income, with another five slated to join this group by 2013. (23) What was once near uniformity has, thus, deteriorated into diversity, at least for now, producing gaps and overlaps in taxation, with the inequities and distortions inevitably implied.

There is every reason to believe that many more states may adopt sales-only apportionment, in which case relative uniformity may increase. On the other hand, some states may resist the shift to sales-only apportionment. (24) Of course, as emphasized repeatedly, at best sales-only apportionment makes no sense. At worst, it can be combined with the nexus rule of P.L. 86-272 to produce nowhere income.

It is interesting to contrast the aftermath of the decisions in Northwestern Portland Cement (and similar cases) and in Moorman, in both of which the U.S. Supreme Court refused to limit state taxing power. The first decision led to the passage of P.L. 86-272, federal legislation that limits state assertion of nexus. The second has produced a continuing flurry of state legislation that increases the weight placed on sales in apportionment formulas. Why, we might ask, have the reactions been so different?

Absent the enactment of P.L.86-272, Northwestern Portland Cement would have cleared the way for states to assert nexus over corporations whose economic connections to the taxing state were limited to solicitation for sales--in other words, for states of destination of sales to impose tax on the income of out-of-state corporations. Business fears that states would assert nexus in these circumstances may have been justified, since doing so would have raised revenues, without increasing the tax liability of corporations with more substantial activities (and more political influence) in the state and, thereby, harming the state's business climate.

It might seem anomalous that business would support increasing the weight placed on sales, which would also seem to increase the destination-based component of the corporate income tax and allows states to increase revenues without harming their business climate. The current (post-Moorman) situation is, however, very different from that prevailing after Northwestern Portland Cement. First, the reduction in the weights placed on payroll and property reduces the taxation of corporations with production in the taxing state and improves the competitive position of the taxing state, unlike the mere assertion of nexus based on sales. It is thus popular with both those corporations and lawmakers fearful of losing their productive activities. Second, out-of-state corporations whose activities are protected by P.L. 86-272 have little to fear from adoption of sales-only apportionment, especially by states that do not require combination of the activities of related corporations engaged in a unitary business.

COMBINATION

As noted, UDITPA is silent regarding the identity of the taxpayer whose income is being divided. This has contributed to several problems.

The Failure to Combine and Diverse Standards for Combination

Some states have adopted combination as a means of minimizing tax planning based on the use of separate entities to conduct various parts of a single business, but others have not. Besides contributing to diversity, with all it implies, a state's failure to require combination is, of course, an open invitation for corporations to use separate entities to shift income from it. This is an especially effective tax-planning tool when employed in conjunction with the nexus rule of P.L. 86-279 and sales-only apportionment.

Nor do all states that do require or allow combination employ the same standards for when to combine. The U.S. Supreme Court has sanctioned this diversity by proclaiming in the Container case, "A final point that needs to be made about the unitary business concept is that it is not, so to speak, unitary: there are variations on the theme, and any number of them are logically consistent with the underlying principles motivating the approach." Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983), at 167. Thus states may use inconsistent definitions of a unitary business, increasing costs of compliance and administration (including costs of litigation), and creating the possibility of either reduced or multiple taxation.

Geoffrey Nexus: A Backdoor Approach

As noted earlier, states that do not require combination of entities engaged in a unitary business are especially susceptible to tax planning. Among the common ways of shifting income from such a state is to establish a holding company in a state that has no income tax (commonly Delaware) and have that company hold intangible assets such as trademarks used by the operating companies. Royalties paid to the holding company substantially reduce the taxable income of the operating company.

Rather than adopting combination, which would automatically prevent this abuse, states have attempted second-best solutions such as rigorous enforcement of transfer pricing rules, denial of deductions (sometimes via "add-back" statutes), and claims that the in-state presence of intangible assets allows it to assert nexus over the out--of-state holding company--a situation not protected by P.L. 86-272. By refusing to review cases challenging the legality of Geoffrey nexus (so-called because Geoffrey, Inc. holds the trademark on the reverse "R" and other trademarks used by Toys "R" Us), the U.S. Supreme Court has left this questionable practice in constitutional limbo, opening the door to diverse decisions of lower courts and, thus, lack of uniformity in this area (Geoffrey, Inc. v. South Carolina, 510 U.S. 992,1993). The clear trend in recent years has, however, been to reaffirm the rule of Geoffrey (Hellerstein and HellersteIn, [paragraph] 96.11 [3] (2007)).

Worldwide Combination