Understanding uniformity and diversity in state corporate income taxes.

Twenty-five to 30 years ago the most contentious issue in state corporate income taxation was whether foreign entities--foreign parents of domestic subsidiaries and the foreign sister subsidiaries thereof, as well as foreign subsidiaries of domestic parents--should be included in a combined return, an issue that UDITPA does not address. Whereas most income tax states limited combination to the "water's edge," several states, most notably California, combined the activities (income and apportionment factors) of entities deemed to be engaged in a unitary business, no matter where located. Such worldwide unitary combination created consternation in foreign capitals, as well as the boardrooms of both U.S. and foreign multinationals, and efforts to prevent it were undertaken in various venues.

In 1977 the federal government negotiated a treaty with the United Kingdom that would have prohibited combination of foreign members of corporate groups based in the United Kingdom, but the states succeeded in efforts to have the Senate "reserve" this clause when it ratified the treaty. In late 1983, following an unsuccessful court challenge to worldwide combination in the Container case, which involved a U.S. parent, and in response to growing dissatisfaction in foreign capitals, (25) the U.S. Treasury Department convened the "Worldwide Unitary Taxation Working Group," which was charged with "producing recommendations ... that will be conducive to harmonious international economic relations, while also respecting the fiscal rights and privileges of the individual states" (see McLure, 1984, 1985). Although the Working Group could not reach agreement, Treasury Secretary Donald Regan told President Reagan that state, business, and federal representatives appeared to be in "basic agreement" on three principles, one of which was water's edge unitary combination for both U.S. multinationals and foreign-based multinationals (U.S. Department of the Treasury (1984, p. ii)). The Reagan administration increased pressure on the states to "voluntarily" limit combination to the water's edge or face federal legislation that would mandate it, and within a few years the states had reacted preemptively by imposing such limitations.

THE WILLIS COMMITTEE RECOMMENDATIONS: THE ROAD NOT TAKEN

The Willis Committee made recommendations, both substantive and procedural, for federal legislation intended to improve state corporate income taxes. The key substantive proposals were a uniform jurisdictional standard based on the in-state presence of an employee or realty; substantial conformity to the federal definition of taxable income; full apportionment of all income (and, thus, elimination of the distinction between business and non-business income); a uniform apportionment formula based on payroll and property (excluding from the denominator of the property factor personal property located in a state where the taxpayer lacks nexus); group consolidation (which could be required and must be permitted) based solely on more than 50 percent common ownership; and exemption for foreign-source income, as defined under federal law--an exemption that would not have precluded state taxation of foreign-source dividends, which are subject to federal taxation (U.S. House of Representatives, 1965, pp. 1135, 1143-61). On the procedural side, the Willis Committee recommended giving the U.S. Treasury Department authority to issue uniform rules and regulations and create a uniform tax return, to prescribe use of a modified apportionment formula or separate accounting by particular taxpayers, and to resolve multistate conflicts (U.S. House of Representatives, 1965, pp. 1135-36, 1161-63).

It is not surprising that many states objected to adoption of the recommendations of the Willis Committee, which would have involved an unprecedented loss of state fiscal sovereignty, as well as a feared loss of revenue for some states. Although the states won that battle, they may have lost the larger war, as they are left with the complexity, tax planning, and revenue losses of the present system. In McLure (2006, p. 181) I offered the following appraisal of the substantive proposals:

Their enactment would have produced a system that would be far

better than the current one. With both jurisdiction to tax and

apportionment based on payroll and property (real property, in the

case of nexus), the nexus test of P.L. 86-272 would have become

moot, states could not assert jurisdiction to tax based on the

presence of intangible assets, throwback of sales would not be an

issue, and sales-only apportionment would not threaten state

corporate income tax revenues. Consolidation based on common

ownership would eliminate tax planning involving Delaware holding

companies. The undesirable distinction between business and

non-business income would have been eliminated. The primary defects

are the fact that sales alone could not produce nexus--a defect

shared with P.L. 86-272--and the lack of sales in the apportionment

formula, an issue that the Willis Committee concluded was

relatively insignificant as a quantitative matter. Against this

must be set the simplification of eliminating sales from the

apportionment formula. (Of course, P.L. 86-272 also simplified

compliance and administration, but at the cost of substantial

amounts of revenue.) On balance, the system would have been far

more uniform, much more compliance-friendly, and a lot more

sensible.

INTERPRETING HISTORY

We turn now to interpreting these historical episodes in terms of the forces described in the second section.

The Northwestern Portland Cement Episode

First, the stage was set when the states adopted overly vague and potentially overly expansive nexus standards, a defect that UDITPA did not even address. In other words, neither convergence via unilateral state action nor voluntary harmonization worked to produce a sensible answer to the question of nexus. Through its decisions in Northwestern Portland Cement and Stockham Valves and its refusal to hear International Shoe the U.S. Supreme Court generated a demand for federal protection from unreasonable state assertions of nexus.

Second, Congress enacted P.L. 86-272, which imposed on the states a nexus standard that is uniform, as far as it goes, but is not sensible. When combined with separate accounting, it creates opportunities for tax planning and the generation of nowhere income, opportunities that are magnified by the increased weight being put on sales in apportionment formulas.

Third, the Willis Committee proposed comprehensive federal legislation that would have brought substantial uniformity to state income taxes, but at the cost of significant loss of state fiscal sovereignty. In response, the states quickly moved preemptively to enact the Compact, create the MTC, and adopt UDITPA, a model statute that was far from comprehensive and whose implementation has created a system that is far from uniform. As noted, the states may have been better advised to embrace the Willis proposals.

The Moorman Episode

Initially convergence and then harmonization, via the adoption of UDITPA or similar statutes, led to a system of formula apportionment that exhibited substantial uniformity by the end of the 1960s. With the exception of the District of Columbia, whose sales--only apportionment formula the Court invalidated on statutory grounds in 1965, (26) Iowa, with its long-standing single-factor sales formula, had been the single "rogue" state. Nevertheless, the U.S. Supreme Court refused to require it to abandon that formula in favor of the then-standard Massachusetts' formula, and the Congress has not accepted the Court's invitation to legislate in this area. Since then many other states have increased the weight on the sales factor, presumably not because they believe it reflects where income is earned more accurately than the Massachusetts formula, but to gain a competitive advantage--or to avoid a competitive disadvantage. Widespread adoption of this beggar-thy-neighbor policy by individual states may eventually produce convergence to a uniform system, albeit one that does not have much to recommend it. To the extent that does not occur, gaps and overlaps in taxation will continue.

The Worldwide Combination Episode

Convergence has not led to universal adoption of combination, and the harmonization efforts of UDITPA do not extend to this important issue. Moreover, the U.S. Supreme Court has said that there is no single definition of what constitutes a unitary business. Thus diversity abounds. Some states that do not require combination use various second-best measures to fight the tax planning that results, further aggravating matters.

The federal government has not shown any interest in enacting legislation that would either require or prohibit combination or that would provide a single definition of a unitary business since the Willis Committee recommended compulsory consolidation based on common ownership. By comparison, both the Carter and Reagan administrations made efforts to end worldwide combination, the former by negotiating a treaty with the United Kingdom that would outlaw the practice and the latter by threatening to introduce federal legislation that would do so. Faced with the latter threat--and under pressure from foreign and domestic multinationals-the states abandoned worldwide combination.

LOOKING AHEAD: UDITPA REDUX