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June 1993

Investment income of multistate corporations. (State & Local Taxation)

by Unger, Joseph

    Abstract- Multistate corporations are taxed in each of the states in which it conducts business. The amount of tax due to each state depends on the income earned in that state. The income is computed based on property located in the state, the sales gained in the state and the wages given to employees situated in the state. In its 1980 'Exxon Corp vs Wisconsin Dept of Revenue' decision, the US Supreme Court held that a state is not allowed to tax nondomicile firms on income earned from activities that have absolutely nothing to do with the activities companies perform within the state, particularly dividend income derived from affiliates not linked to the recipient's operations. This segregation of activities requires the absence of any link between them. In sebsequent cases, the high court held up its original stand on the issue and further restricted states from taxing income derived from other states. Nevertheless, some states continue taxing firms for income from other states.

Even though a corporation is subject to taxation in a particular state, the U.S. Supreme Court in its 1980 decision, Exxon Corporation vs. Wisconsin Dept. of Revenue, in interpreting the due process clause and the commerce clause Of the constitution, held that a state may not tax a nondomiciliary corporation on income derived from an activity totally unrelated to the activity which the corporation conducts within the state. This principal of segregating the activities of a business applies to all types of activities. What is required for such segregation of activities is that there be no connection between them. Activities which are connected are called "unitary." A state can tax all "unitary" activities conducted by a nondomiciliary business, even these conducted outside the state. An example of activities which might be considered not to be unitary would be a real estate rental operation and a manufacturing operation which does not utilize the real estate. Another example is an investment activity and a business activity where the investment assets and income derived therefrom are not used in die business.

After the U.S. Supreme Court's Exxon decision, the issue was revisited in 1982 by the U.S. Supreme Court in ASARCO Inc. vs. Idaho and Container Corporation of America vs. California in 1983. The U.S. Supreme Court upheld its prior decision and based on the due process clause and the commerce clause, limited the states in their ability to tax income earned in other states, specifically dividend income received from affiliates that were not connected to the operations of the recipient.

Although the issue had been consistently decided in favor of the taxpayer, a number of states continued to tax income earned from outside their borders. The primary type of income which was taxed was investment income. New Jersey, Massachusetts, and Connecticut are examples of states which have maintained this approach. However, the New Jersey Courts in a number of cases held against the New Jersey Division of Taxation on this issue.

A New Trust

The issue recently came to the U.S. Supreme Court again in Allied Signal, Inc. vs. New Jersey Division of Taxation with a different twist. Based on prior decisions, the court concluded that investment income such as dividends and interest could be considered business income if the investments were linked to the business operations. An example of such linkage is the temporary investment of working capital which might occur during a slow period. Investment income might also be considered business income if the funds generating the income were earmarked for use in the company's business activity, such as expansion.

The twist in Allied Signal, Inc. was that the company had acquired stock in other companies as part of its business expansion plan. One of these acquisitions in the late 1970's was 20.6% of ASARCO, which k sold in 1981 at a substantial gain. The New Jersey court ruled in favor of the New Jersey Division of Taxation because it considered the acquisition to be business connected. In its view it was motivated by the company's desire to expand rather than a desire to invest funds. In fact, Allied Signal, Inc. attempted to gain control of ASARCO.

The U.S. Supreme Court ruled in favor of Allied Signal, Inc. and held that New Jersey, under the due process clause and the commerce clause of the U.S. Constitution, could not tax the income earned by Allied Signal on the sale of ASARCO. The court stated that a corporate strategy of the acquisition and sale of stock in other companies does not convert a passive investment to a business activity. To do so, there must be an operational connection between the two companies so as to cause them to be "unitary."

While Allied-signal, Inc. does not radically change the law, it does serve to severely challenge the positions of these states that continue to tax the activity there. Moreover, it illustrates the concern that the justices of the U.S. Supreme Court have for protecting the rights of companies that are engaged in multistate operations.

Massachusetts Concedes,

Massachusetts was a state which did not distinguish between business and investment income and, irrespective of prior Supreme Court decisions, taxed both types of income earned by nondomiciliary corporations, by treating them separately. Those earning significant investment income found themselves subject to tax in Massachusetts on their business income and investment income, a result which clearly was contrary to the U.S. Constitution. Moreover, the Massachusetts taxing authorities had been adamant in this approach.

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