Unconstitutional Taxation of Foreign Dividends Continues

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1 Unconstitutional Taxation of Foreign Dividends Continues 5/1/2001 State + Local Tax Client Alert Although the decision of the United States Supreme Court in Kraft General Foods, Inc. v. Iowa Department of Revenue & Finance, 505 U.S. 71 (1992), effectively has eliminated discriminatory taxation of foreign dividends in separate-company filing states, the practice continues in certain states that employ water's-edge (domestic) combined reporting or domestic consolidated reporting regimes to determine the tax base. See, e.g., Colo. Rev. Stat (9)-(10); Fla. Stat. ch (1)(b)(2)(b); Kan. Stat. Ann ,138. (Hereinafter, we refer to states that employ either the water's-edge combined reporting method or the domestic consolidated reporting method as "WECR" states.) These states argue that Kraft does not apply to their tax regimes because the taxation of dividends paid by foreign corporations is not discriminatory when compared with the taxation of earnings of domestic subsidiaries whose income has been included in a combined report. They argue that because the total earnings of a domestic subsidiary have been "taxed" by the state (through inclusion in the combined report), while the income of the foreign subsidiary is taxed only in part and only upon receipt as a dividend, no discrimination exists in the taxation of the two forms of commerce. See, e.g., Bernard Egan & Co. v. Fla. Dep't of Revenue, 769 So. 2d 1060 (Fla. 2000); In re Appeal of Morton Thiokol, Inc., 864 P.2d 1175 (Kan. 1993). In a prior article, we criticized this line of reasoning on the grounds that inclusion of a domestic subsidiary's earnings in the combined report is accompanied by factor representation of the subsidiary's factors of production, which at least in theory precludes the combination state from taxing income earned in other states. See Thomas H. Steele & Neil I. Pomerantz, Source-Based Taxation of Intangible Income: A Critique of Morton Thiokol and Ohio's Add-Back Provisions, State & Local Tax Insights, September In contrast, a WECR state's failure to provide factor representation for the activities of the foreign subsidiary necessarily means that the state virtually always will tax some portion of the subsidiary's income that plainly was earned in other jurisdictions. Thus, we maintained, discrimination against foreign commerce is clearly present in WECR systems that impose taxes upon foreign dividends but not upon domestic dividends. In this article, we revisit the controversy, focusing upon identifying the doctrinal misstep that has led, in our view, to erroneous decisions by the Kansas and Florida courts upholding this discriminatory taxation of foreign dividends.1 The problem, we believe, stems in large part from the failure of the courts to test claims of offsetting domestic tax burdens under the rubric of the compensatory tax doctrine. See Fulton Corp. v. Faulkner, 516 U.S. 325 (1996), discussed below. Rather than acknowledging that foreign dividends are treated differently from domestic dividends and then testing whether the different treatment is justified by the compensatory tax doctrine, the courts have collapsed the analysis and simply concluded that no discrimination existed because the different treatment is required to avoid double taxation of domestic income. When the compensatory tax doctrine is applied to the claims of the WECR state, the state must bear the burden of showing that the tax on foreign commerce is no greater than the tax imposed on domestic commerce. The lack of any apportionment mechanism for the foreign dividends essentially guarantees that foreign earnings which are repatriated as dividends will be taxed by the WECR state even though the underlying earnings are plainly attributable to and have been taxed by a foreign jurisdiction. Thus, they necessarily bear a heavier tax burden than domestic dividends which are taxed only in the jurisdiction where the income was earned. Summary of the Kraft Decision

2 As noted, in Kraft, the Supreme Court held that Iowa's corporate income tax unconstitutionally discriminated against foreign commerce because it included dividends from foreign subsidiaries, but not dividends from domestic subsidiaries, in the taxpayer's tax base. In reaching that conclusion, in a footnote, the Court considered but rejected other comparison classes wherein the discrimination might not be manifested so clearly: If one were to compare the aggregate tax imposed by Iowa on a unitary business which included a subsidiary doing business throughout the United States (including Iowa) with the aggregate tax imposed by Iowa on a unitary business which included a foreign subsidiary doing business abroad, it would be difficult to say that Iowa discriminates against the business with the foreign subsidiary. Iowa would tax an apportioned share of the domestic subsidiary's entire earnings, but would tax only the amount of the foreign subsidiary's earnings paid as a dividend to the parent. In considering claims of discriminatory taxation under the Commerce Clause, however, it is necessary to compare the taxpayers who are "most similarly situated." Halliburton Oil Well Cementing Co. v. Reily, 373 U.S. 64, 71 (1963). A corporation with a subsidiary doing business in Iowa is not situated similarly to a corporation with a subsidiary doing business abroad. In the former case, the Iowa operations of the subsidiary provide an independent basis for taxation not present in the case of the foreign subsidiary. A more appropriate comparison is between corporations whose subsidiaries do not do business in Iowa. Id. at 81, n.23. The Decision of the Kansas Supreme Court in Morton Thiokol Following the issuance of Kraft, the Kansas Supreme Court considered whether Kansas, like Iowa, had discriminated against foreign commerce by eliminating domestic dividends from the tax base while including foreign dividends. Morton Thiokol, 864 P.2d In defense of its statute, the Kansas Department of Revenue argued that its statute should be distinguished from the Iowa statute struck down in Kraft because Kansas law authorizes the WECR method. Relying upon footnote 23 in Kraft, quoted above, the Department argued that WECR eliminated any facial discrimination under the Foreign Commerce Clause because the combined report included the full measure of domestic subsidiaries' earnings in the apportionable tax base while limiting the inclusion of foreign earnings to the amount of the dividend paid. The Kansas Supreme Court agreed: Clearly, Kraft does not hold that the taxation of foreign dividends by a combination method is facially unconstitutional. Revenue contends that the aggregate tax imposed by Kansas on a unitary business with a domestic subsidiary would not be less burdensome than that imposed by Kansas on a unitary business with a foreign subsidiary because the income of the domestic subsidiary would be combined, apportioned, and taxed while only the dividend of the foreign subsidiary would be taxed. Allowing a deduction for the domestic dividend avoids double taxation. It is the use of the domestic combination method which distinguishes the Kansas and the Iowa tax schemes..... In a combined filing state, such as Kansas, the hypothetical parent's tax base includes the combined federal taxable income of its combined domestic subsidiaries as well as dividends from foreign subsidiaries. We conclude there is no showing that this method is discriminatory under the holding in Kraft; therefore, it is not violative of the federal Constitution's Commerce Clause (Art. I, 8, cl. 3). Morton Thiokol, 864 P.2d at 1186; see also Bernard Egan, 769 So. 2d 1060 (holding that Florida's "piggybacking" off the federal definition of "taxable income," which excludes dividends received from domestic subsidiaries but includes dividends

3 from foreign subsidiaries, did not violate the Commerce Clause because the earnings of the domestic subsidiaries were included within the consolidated return of the parent). The Ohio Supreme Court Follows Kraft In contrast to the Kansas Supreme Court, the Ohio Supreme Court recently concluded that Ohio's system of distinguishing between foreign and domestic dividends did violate the Commerce Clause. Emerson Elec. Co. v. Tracy, 735N.E.2d 445 (Ohio 2000). In that case, the taxpayer challenged an Ohio statute which permitted a 100% deduction of dividends paid from domestic subsidiaries while permitting a lesser deduction (85%) for foreign dividends. In determining that this system should be struck down, the Ohio Supreme Court distinguished the Morton Thiokol line of authority: A number of courts have concluded that the single-entity reporting system involved in Kraft raises constitutional concerns that are not present under the domestic combination system. See, e.g.,[morton Thiokol]  864 P.2d at 1186; Caterpillar, 568 N.W.2d at ; E.I. Du Pont de Nemours, 675 A.2d at 87; Caterpillar Fin. Serv. Corp. v. Whitley (1997), 288 Ill. App. 3d 389, 399, 223 Ill. Dec. 879, 680 N.E.2d 1082, Accordingly, these courts have held that Kraft does not apply to the taxation of foreign dividends by domestic combination states. These courts reason that in domestic combination states, the disparate treatment of foreign and domestic dividends is necessary to produce a kind of "taxing symmetry" that is not present under the single-entity method. [Citations omitted.] In a domestic-combination state, the apportioned earnings of the domestic subsidiaries are taxed as income of the unitary business. Because the state has taxed the earnings out of which dividends are paid, the dividends themselves are not subject to taxation. This prevents dividends from domestic subsidiaries from being taxed twice  once as earnings of the domestic subsidiary and once as separate income to the unitary business. At the same time, the income of foreign subsidiaries is not taxed in a domestic-combination state. Thus, no discrimination results from taxing, in whole or in part, dividends derived from foreign subsidiaries. Id. at 448 49. Because the Ohio tax regime, like that in Kraft, permitted inclusion in a combined report only of those subsidiaries which derived income from within the state, the Ohio court concluded that Kraft was indistinguishable and thus, inclusion of even 15% of the foreign dividends was impermissible in light of the complete exclusion afforded domestic dividends: Clearly, Ohio's system of combined reporting does not produce the "tax symmetry" that combined reporting does in other states. Because domestic subsidiaries that do not earn income from sources within Ohio do not have their income combined with that of the parent company, dividends from these subsidiaries are not at risk of being taxed twice. Id. at 449. Analysis of Morton Thiokol's Claim Regarding the Effects of WECR The Ohio Supreme Court's analysis of the arguments made by Kansas correctly pinpoints that the domestic combination states' position simply repackages arguments frequently used by states faced with a charge of discrimination against interstate or foreign commerce. Rather than explicitly acknowledging that the state tax scheme is facially discriminatory and that the discriminatory tax is necessary to compensate for another tax burden borne by local commerce, the Kansas

4 court and others have postulated that the existence of these other taxes simply eliminates any claim of discrimination. Accordingly, they fail to reach the real issue of the case. A recent decision of the California Court of Appeal illustrates the proper framework for the analysis. Ceridian Corp. v. Franchise Tax Bd., 85 Cal. App. 4th 875 (2000). In Ceridian, the court considered a challenge to Revenue & Taxation Code Section which governed California's system of taxing insurance dividends. That statute provided that the payee of an insurance dividend could eliminate the dividend from the tax base, but only to the extent the dividend was paid from earnings already taxed by the state based upon the payor's relative California apportionment factors. Like the Revenue Department in Morton Thiokol, the Franchise Tax Board in Ceridian claimed that Section did not discriminate against interstate commerce because it was designed simply to eliminate double taxation of earnings that had already been subject to tax in California. The Court of Appeal responded: Significantly, the Board is not contending that the tax scheme under consideration here can be justified as a "compensatory tax." Indeed, the Board has gone so far as to [claim] Â that "Fulton is distinguishable because this appeal does not involve a tax on interstate commerce intended to compensate for the burden on intrastate commerce imposed by a different tax." This concession is well taken, since the tax scheme at issue does not meet the three requirements for a "compensatory tax." [Footnote omitted.] Instead, the Board's contention is that section subdivision (b) "does not discriminate against interstate commerce" and thus it is not even necessary to reach the "compensatory tax defense" issue. In other words, the Board is contending that the statute is not discriminatory because it avoids double taxation. This is a non-sequitur. If subdivision (b) discriminates against interstate commerce, as we conclude it does, then it is virtually per se invalid unless it is a component of a valid "compensatory tax." The fact that the tax scheme may serve some other laudatory purpose does not save it from a commerce clause challenge. Id. at 886. Inclusion of Domestic but Not Foreign Earnings in the WECR Does Not Eliminate, Per Se, the Discriminatory Tax on Foreign Dividends As the court observed in Ceridian, claims that a taxing system on its face discriminates against foreign commerce are not dismissed simply by pointing out that local commerce is subject to a different, and arguably equal, tax and that the preference afforded local commerce is simply intended to eliminate double taxation of the income. Similarly, arguments that domestic commerce bears a tax burden not borne by foreign commerce by reason of the inclusion of domestic earnings in the water's-edge combined report do not, by themselves, negate a showing that a tax system, on its face, taxes foreign, but not domestic, dividends. As in Ceridian, the fact that earnings associated with the dividend of a domestic subsidiary already have been included in the tax base of a WECR state does not mean no discrimination exists. Rather, it means that the state may use that fact to justify, if possible, the apparent discrimination by satisfying the compensatory tax doctrine. Fulton Corp. v. Faulkner The Supreme Court's most recent articulation of the requirements of the compensatory tax doctrine occurred in Fulton. In that case, the Court considered a North Carolina intangible property tax that applied to corporate stock in inverse proportion to the issuing corporation's presence in North Carolina. The tax was imposed at a rate of 0.25% of the stock's fair market value, reduced by a percentage equal to the percentage of the issuing corporation's income subject to tax in North Carolina,

5 as determined by the issuing corporation's apportionment factor in the state. Thus, stock of a corporation doing 100% of its business in North Carolina was free of tax, while stock of a corporation operating exclusively out of state was fully taxable. The taxpayer challenged the tax on the basis that allowing a deduction from the tax base in proportion to the in-state activities of the corporation whose stock was being taxed discriminated against interstate commerce in violation of the Commerce Clause. In its defense of the tax, North Carolina asserted that the facially discriminatory effects of the tax upon interstate commerce merely compensated for another burden borne by in-state businesses, i.e., the payment of the North Carolina income tax. In analyzing this argument, the Court applied the three-pronged inquiry articulated in Oregon Waste Systems, Inc. v. Department of Environmental Quality, 511 U.S. 93, 103 (1994), which the Court described as follows: First, the state must identify the intrastate tax burden for which the state is attempting to compensate. Second, the tax on interstate commerce must be shown to approximate, but not exceed, the amount of the tax on intrastate commerce. Third, the events on which the interstate and intrastate taxes are imposed must be "substantially equivalent" (i.e., they must be sufficiently similar in substance to serve as mutually exclusive proxies for each other). Applying this test to the tax at issue in Fulton, the Court concluded that the North Carolina tax failed all three prongs. First, the Court rejected the state's attempt to justify its higher tax on foreign corporate stock by reference to North Carolina's income tax, which was borne only by in-state corporations. Because "North Carolina has no general sovereign interest in taxing income earned out of state," the state must "identify some in-state activity or benefit in order to justify the compensatory levy." Fulton, 516 U.S. at 334. While North Carolina argued that the benefit of accessing the state's capital markets constituted such an in-state benefit, it could not prove that corporations paying state income tax (which was a "general revenue measure"), in fact, paid the tax to support that activity. Second, the North Carolina tax scheme failed the second prong of the test because the state could not show that whatever portion of the general state income tax borne by in-state companies which might be attributable to supporting the capital markets was not less in amount than the applicable intangibles tax. Compare Associated Indus. of Mo. v. Lohman, 511 U.S. 641 (1994) (invalidating a state use tax on the basis that, in some jurisdictions, it exceeded the local sales tax for which it was intended to compensate). Finally, the Court concluded that the state had not demonstrated that the compensating tax on in-state companies fell upon an event which was "substantially equivalent" to the event subject to the intangibles tax. Here, because the taxes fell upon different groups of taxpayers, employed different rates, were imposed upon different tax bases, and raised revenues for different purposes, the state "has the burden of showing that the actual incidences of the two tax burdens are different enough from their nominal incidences so that the real taxpayers are within the same class, and that therefore a finding of combined neutrality on interstate competition would at least be possible." Fulton, 516 U.S. at 340. The Court found that the state had failed to meet the burden and, accordingly, that the state had failed to satisfy the third leg of the test as well. Application of Compensatory Tax Doctrine to Domestic Combination States' Treatment of Foreign Dividends Presumably, domestic combination states would claim that the tax on foreign dividends is intended to compensate for taxes which arise from including the earnings of domestic subsidiaries in the water's-edge combined report. Putting aside issues that might arise regarding whether the two taxes are imposed upon substantially equivalent events, the state's claim almost certainly runs afoul of the requirement that the tax on the domestic payors' earnings "roughly  approximate[s]  but does not exceed" the tax on the foreign dividends. Fulton, 516 U.S. at (quoting Or. Waste Sys. Inc. v. Dep't of Envtl. Quality, 511 U.S. 93, 103 (1994)). Taxation of the foreign dividends fails that requirement because the foreign subsidiary's

6 apportionment factors are not represented while the domestic subsidiary's factors are represented in the combined report. Thus, the foreign dividends are inevitably taxed by the WECR state while the domestic earnings are attributed to the states in which they were earned, again assuming the apportionment formula fulfills its purpose of attributing earnings to their proper location. Double taxation of domestic commerce may be eliminated. But double taxation of foreign commerce is inevitable. An Appropriate Remedy for the Discrimination Plainly, the cleanest method of resolving the discriminatory taxation of foreign dividends by WECR states would be simply to eliminate the dividends from the tax base in the same manner as domestic dividends are eliminated. See Conoco, Inc. v. Taxation & Revenue Dep't of N.M., 931P.2d 730 (N.M. 1996) (foreign dividends eliminated from the tax base to ensure no discrimination against foreign commerce). However, providing representation for the factors of the foreign corporations may also be a_cceptable since inclusion of the foreign factors of production resolves the conceptual flaw that produces the systemic discrimination against foreign commerce and should ensure that the foreign earnings are taxed no more heavily than domestic earnings. Thus, taxpayers considering renewed challenges to taxation of foreign dividends by WECR states should evaluate the level of relief that may be available with factor representation. In the event that the potential savings are significant, one should not be deterred by the judicial decisions which have considered the issue to date.