for State Income Tax Purposes
BY DAVID W. JOY AND JO LYNNE KOEHN
The key point in determining the state income tax for a company conducting interstate commerce is how the unitary business concept applies to the computation of taxable income. For example, the apportionment of income between business and non-business income typically depends upon how a state applies the unitary business concept. States also use the unitary business concept to determine the apportionable amount of taxable business income for a corporation conducting an interstate business. Furthermore, many states use the unitary business concept to determine when corporations must file either combined or consolidated tax returns.
Individual states have chosen to apply the unitary business income concept in various ways. States may either establish rules and regulations that permit or deny the taxpayer to determine when the unitary business concept requires combined reporting. Other states do not allow combined reporting. Likewise, some states apply the unitary business concept on a worldwide basis while other states permit taxpayers to make a waters-edge election. (The waters-edge election provides that taxable income is comprised only of income earned within the borders of the United States.) The rules for implementing the waters-edge approach are not uniform among the states that permit its use.
Despite the complexity surrounding the unitary concept, most states do not provide clear guidelines as to when or how the unitary business concept should be applied. States typically attempt to use the unitary business concept to increase taxable income. Not surprisingly, states often also try to deny the use of unitary business concept when its application decreases taxable income.
The Supreme Court acts as an overseer for the application of the unitary business concept under the Interstate Commerce provision in the U.S. Constitution. Unfortunately, the Supreme Court rulings concerning unitary business operations also fail to clearly define the unitary business.
Unitary Business Concept
Related business activities conducted in various states typically constitute a unitary business. For example, states may deem a unitary business exists when a company manufactures a product in one state and sells it in another. The transportation of the product from the manufacturing plant to the sales outlet and storage facilities during this process are typically parts of a unitary business. An interstate railway that uses track and terminals located in different states is another example of a unitary business. Likewise, other transportation and communications companies are typically unitary businesses.
The question becomes how to apportion the business income between the states in which a unitary business conducts its activities. One solution is to use transfer prices to partition the income between the various states. For example, the United States government chooses to use transfer pricing to determine the source of business income for international commerce.
In contrast to the Federal government, state governments have considered transfer pricing to be an imprecise method of accounting. States purport that transfer pricing lacks objectivity due to the absence of market prices for similar transactions. The Federal government attempts to deal with the lack of market data by establishing complex rules and regulations to monitor the use of transfer pricing. Despite these rules, managers still have considerable latitude for manipulation of the transfer price.
State governments have decided they do not wish to allow businesses an opportunity to manipulate transfer prices. Accordingly, states have elected to establish tax rules for the apportionment of taxable business income between the various states in which a unitary business operates. The first step in the apportionment process is to determine the taxable income for the composite of the various business activities that constitute a unitary business. The state then uses an apportionment factor that can consist of sales, property, and payroll or any combination of these three factors. The numerator for each factor represents the amount of the factor attributable to the business activities a taxpayer conducts in the state levying the tax. The denominator for each factor represents the aggregate amount of such factor attributable to the business activities the unitary business conducts either within the U.S. or worldwide. The states then compute a weighted average of these factors as defined in their state income tax law. For example, most states weigh each factor equally as defined in their income tax laws [1/3 (sales within state/total sales) + 1/3 (payroll incurred within the state/total payroll) + 1/3 (basis of property located in the state/total property basis)]. The taxable income for each state is the product of the unitary business income and the apportionment factor.
A corporation can conduct more than one unitary business. In this situation, the business income of the corporation should be decomposed into separate unitary business income groups. The corporate management then files separate tax returns for each unitary business group. These returns could also be filed in different states or in the same states depending upon the circumstances. The application of the unitary business concept to complex corporations can become quite onerous.
States have chosen to take different approaches in the application of the unitary business concept for controlled groups. Many states have enacted provisions that require the filing of combined tax returns. In a combined return, a taxpayer must apply the unitary concept to a group of corporations. Most states have established a 50% ownership rule for combined reporting purposes although some states have chosen to use a different percentage. A large number of these states have enacted attribution rules for determining indirect ownership in the determination of the specified percentage. Combined reporting may be required when the corporation providing nexus to a state is either the parent or a subsidiary of a controlled group or a brother-sister corporation.
States have taken different approaches to the application of combined reporting. Some states simply require combined reporting whenever a unitary relationship exists. Other states allow either the state taxing authority, the taxpayer, or both to elect when combined reporting rules and regulations become applicable.
The combined reporting rule requires immediate recognition of the unitary relationship. States using the combined reporting rule do not tax dividends arising from income previously reported as part of the combined unitary income.
All states except the three states (Louisiana, New Hampshire, and Ohio) that require combined reporting, allow taxpayers to elect to file a consolidated return for parent-subsidiary groups. The percent of required direct or indirect ownership however becomes 80% in lieu of the 50% typically used for combined reporting. A large portion of these states also require that each corporation included in the consolidated return either do business in the state or have a unitary relationship with a corporation doing business in the state. Some states also require the filing of a Federal consolidated return before a consolidated return can be filed for state purposes.
The unitary business concept requires the decomposition of taxable income into business and nonbusiness income on a consolidated basis. In turn, the business income must be decomposed into different business groups when a unitary business relationship does not exist between all of the business activities.
Tax results for consolidated returns and combined returns may differ. One reason is that the modifications to Federal taxable income are not the same for combined and consolidated reporting. In combined reporting, the taxable income for each separate return is modified on a separate return basis and then added together. Intercompany transactions are eliminated in the same manner for both combined and consolidated returns.
Another difference is that the combined rules typically do not provide for increases and decreases to the parent's basis in subsidiary stock for profits and losses of the subsidiary. Accordingly, the parent can incur double taxation when it sells the subsidiary's stock for profits realized during the time the parent company held the subsidiary's stock. This may be advantageous for a corporate group when one or more subsidiaries are incurring losses.
Individual Corporate Status
Many states do not permit combined reporting. Most of these same states also deny consolidated reporting. Accordingly, corporations conducting business in these states must file separate tax returns.
Many of these states have chosen to treat dividend income meeting certain requirements as business income. Accordingly, dividends received by a parent corporation from a subsidiary are part of the unitary business income subject to apportionment. Many of these states did not adopt the Federal government's dividend exclusion rules. Some of these states adopted their own tax rules for dividend exclusions while others deny any exclusion for dividend income. The net result of this process can be double taxation at the state level. However, the filing of separate returns does deter the shifting of income to subsidiaries of an affiliated group.
Some states treat all dividends as non-business income. If the parent corporation has a home office in a state that provides for such tax treatment, the parent may in fact incur triple taxation on a portion of its subsidiary's income at the state level. Thus, separate reporting for a controlled group may ultimately result in higher taxes than would result under either combined or consolidated reporting.
The Federal government has taken the position that it does not want its income tax laws to impede international commerce. To accomplish this objective, the Federal government classifies income as either U.S. source or foreign source. Using this classification system, the U.S. government taxes foreign corporations only on their U.S. source income and the repatriation of the foreign source earnings. In contrast, the U.S. government taxes domestic corporations on a worldwide basis. However, domestic corporations are entitled to use foreign tax credits to offset the taxes assessed against the foreign source income. Most countries also provide similar tax treatment for
Many states have chosen to apply the unitary theory on a worldwide basis. Accordingly, the business income subject to apportionment is computed on a worldwide basis and the denominators for the various factors incorporate worldwide data. The primary reason for this approach is that the states can typically impose higher taxes on taxpayers involved in international commerce.
As the Federal tax laws require the inclusion of foreign dividends in taxable income and do not provide for any dividend exclusion, 100% of the dividends received from foreign subsidiaries are included in the taxable income of a U.S. parent. Moreover, many states do not allow any adjustment for dividends received from foreign corporations. Accordingly, many states levy taxes on foreign corporate dividends received by a parent corporation unless combined or consolidated returns have been filed. This tax treatment can trigger multiple taxation of international business income.
State Tax Laws
As California has been a leader in the application of unitary theory for combined reporting, its tax laws have had substantial impact on the implications of the unitary business concept. California uses two tests to determine the existence of a unitary business. The most common test is the three-utilities test that focuses on the three factors of ownership, operations, and use to determine if a unitary business exists. Unity of ownership is deemed to be 50% ownership, either directly or indirectly. Unity of operations is concerned with the centralization of staff functions such as legal, accounting, purchasing, personnel, advertising, or financing. Unity of use focuses upon the integration of executive forces and common operating systems such as intercompany purchases and sales.
The alternative approach used by California is the contributions or dependency test. This test examines whether business activities conducted within the taxing jurisdiction contribute to or are dependent upon business activities conducted without the taxing jurisdiction. Both of these tests are very subjective and do not provide quantitative guidelines to determine the threshold as to when combined reporting is required.
One state, Colorado, has an objective test to determine when combined reporting is required. No other state has chosen to use a similar objective test. The underlying reason for this may be that the other states do not wish to provide opportunities for taxpayers to manipulate their operations to either avoid or use combined reporting. Moreover, states may use more vague guidelines to gain flexibility in the determination as to when combined reporting is required.
Supreme Court Decisions
Historically, the Supreme Court has taken a hands-off approach in applying either the interstate commerce clause or the international commerce clause to issues involving the unitary business concept. However, it has rendered seven landmark cases that provide some guidance for application of the unitary business concept.
In 1980, the Supreme Court ruled in the Mobil Oil case [Mobil Oil Corporation v. Commissioner of Taxes, 445 U.S. 425 (1980)] that Vermont's inclusion of dividends from affiliated corporations in business income was proper. The percent of ownership that Mobil had in the various affiliates ranged from a minority interest to 100% ownership. The basis of this ruling was that the taxpayer had conceded that the vertical, integrated multicorporate group was a unitary business, the linchpin of apportionability in the field of state income tax law.
In 1980, the Supreme Court also ruled in the Exxon case [Exxon Corp. v. Wisconsin Dept. of Revenue, 447 U.S. 207 (1980)] that vertically integrated divisions constitute a unitary business. This decision conclusively disposed of longstanding efforts by taxpayers such as Exxon that various stages of production could be treated as separate businesses. The court also pointed out that separate accounting fails to account for contributions to income resulting from the operation of a business as a whole. Thus the fact that Exxon treats its operational departments as independent profit centers does not change the facts that Exxon is a highly integrated business that benefits from an umbrella of centralized management and controlled information.
In 1982, the Supreme Court ruled in the ASARCO case [ASARCO, Inc. v. Idaho State Tax Comm., 99 Idaho 924, 592 P.2d (1979)] that the receipt of dividends from controlled subsidiaries did not constitute business income. The underlying reason for this decision was that the dividends were paid by out-of-state subsidiaries with discrete businesses.
Similarly, the court ruled in the Woolworth case [F.W. Woolworth Co. v. Taxation and Revenue Dept. of New Mexico, 624 P. 2d 28 (N.M. 1981)] the fact subsidiaries are in the same business is not a sufficient reason for treating them as a unitary business. The court pointed out that either functional integration, centralized management, or economies of scale is a necessary condition for the existence of a unitary business. As none of these factors existed in the Woolworth case, the court ruled the dividends from its foreign subsidiaries were nonbusiness income.
In 1983, the Supreme Court failed to take the active stance taken in the Woolworth and ASARCO cases. Instead, the court pointed out that if reasonably possible it would defer to the judgment of state courts in deciding whether a particular set of activities constitutes a "unitary business."
In 1992, the Supreme Court noted in the Allied-Signal case [Allied-Signal, Inc. (Bendix Corporation) 112 S Ct 2251 (1992)] that a capital transaction must constitute an operational rather than an investment function for gains from stock sales to be apportionable business income. Accordingly, the Supreme Court appears to have taken a flow of value as a criterion for a group of business activities to be a unitary business.
In the 1983 Container case [Container Corporation of America v. Franchise Tax Board, 77 L.Ed. 2d 545 (1983)], the court ruled that states could require U.S. corporations to file a combined return on a worldwide basis. Subsequently the court ruled in the Barclays case in 1994 that states could also require non-U.S. corporations to file combined returns [Barclay's Bank PLC v. Franchise Tax Board of California 114 S Ct 2268 (1994)].
The ruling in the Barclays case created considerable controversy on the international scene. Foreign companies expressed deep dissatisfaction with the possibility of reporting taxable income on a worldwide basis for state tax purposes. In fact, many foreign companies threatened to not conduct business in states that required taxable income to be computed on a worldwide basis. Given this turmoil, members of Congress considered proposed legislation that would resolve this international problem. In response to these actions, all but three states (Montana, Alaska, and North Dakota) enacted legislation that now allow companies to elect combined reporting on a waters-edge basis. Given that these three states have little impact on the international markets, Congress did not choose to enact any legislation since the concerns of the international companies had subsided.
However, a waters-edge election is not a costless decision. For example, California imposes a fee for making such election. In addition, taxpayers who make such elections must agree to treat dividend income received from an affiliated foreign company or any other foreign company, that either purchases 15% or more of output of the unitary business, or supplies 15% or more of the unitary business' raw material or other input, as business income. Although California state law provides for a 75% exclusion for dividends, the benefit of this exclusion can be mitigated by the loss of interest expense. Depending upon interpretation of the law, only interest expense in excess of the dividend exclusion may be deductible for tax purposes.
In the case of U.S. companies, the waters-edge election in many states does not apply to affiliated U.S. corporations used to conduct international business including domestic international sales companies. Some states also deny the waters-edge election for foreign sales companies and subpart F income of controlled foreign corporations.
Unitary Business Relationships
When is the unitary business concept applicable? One is a situation where a system is used to provide linkage between various states such as a transportation system, communication systems, utilities, or computer data processing systems. Companies in these systems have typically chosen to conduct interstate business due to economies of scale that result from an increased customer base.
The Supreme Court has pointed out that vertically integrated companies usually constitute unitary businesses. The primary reason the court has given for treating vertically integrated companies as a unitary business is that they benefit from an umbrella of centralized management and controlled interaction. For example, the focus of the cases involving vertically integrated companies has been on the interaction between the various components in the long range planning rather than daily operations. In addition, the focus of these cases has also been on the development of functional policies and procedures. Other central management activities that have received attention include financing, accounting systems, legal advice, public relations, and personnel. Examples of companies that have these characteristics are large oil and gas companies and those such as Kennecot Copper, which uses production from its mines to produce various products.
The primary focus of Supreme Court cases involving horizontal companies has been the economies of scale resulting from centralized purchasing rather than centralized management. The court has also considered other issues such as intercompany financing, common use of facilities, interflow of personnel, common identity, and common benefit agreements. Other aspects of horizontal companies that may indicate a unitary business relationship may be company advertising, standardized marketing and operating systems, and common layouts. Examples of such companies are McDonalds, WalMart, and Safeway.
Although the Supreme Court has not considered any tax cases involving a complementary business relationship, such business relationships may well constitute a unitary business. For example, businesses that use the same marketing channels can substantially reduce the marketing cost for each business. The availability of a diverse product line can result in a larger volume of sales for each individual product within the product line. Other companies can share the same input resources for different purposes such as radio and television stations and newspapers. Other complementary relationships that may create unitary business relationships include common distribution systems, diverse product lines from common research efforts, sharing of common manufacturing facilities by seasonal business, and sharing of popular trade names.
Even diverse companies may be unitary businesses if they use centralized management. This situation may occur when the strength of a company is its management team. Such companies often acquire companies that have been poorly managed with the intention of increasing their profits through efforts of their management team. In many cases, such companies intend to sell these newly acquired companies at substantial profits after they revitalize them. This increase in value could be compared to the profits realized through the manufacturing process.
The major problem encountered in determining whether or not a unitary business exists is the extent that any of these factors must exist in a given scenario. For example, what percent of the output from one part of the company must be used by another part, or what part of the input of one business must be provided by another business for a unitary business to exist? In the case of horizontal and complementary businesses there are few guidelines as to the degree of relationship that must exist between the individual businesses for a unitary business to exist. Also, there are no clear guidelines as to the degree of centralization of management necessary for a unitary business to exist. Accordingly, considerable doubt may often exist as to the existence of a unitary business. *
David W. Joy, PhD, CPA, is an associate professor, and Jo Lynne Koehn, PhD, CPA, an assistant professor, both at Central Missouri State University.
The states reach out for their true share.In Brief
The article examines the multiple aspects of the unitary business concept and its current status. The authors discuss the following issues:
* How the unitary business concept impacts the computation of taxable income for a single corporation,
* How the unitary business concept is applied when a taxpayer files either a combined or a consolidated tax return,
* How the unitary business concept is applied to dividends received from subsidiaries when a related corporate group does not file either a combined or a consolidated tax return,
* The primary rules and regulations that various states have established for application of the unitary business concept,
* An overview of the court rulings in Supreme Court cases concerning the unitary business concept,
* The implications of the water-edge elections with respect to the application of the unitary business concept, and
* Identification of situations where the unitary business concept may be applicable.
©2009 The New York State Society of CPAs. Legal Notices
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