United States: Surveying Constitutional Theories for Challenges to the Add Back Statutes

The Commerce Clause Does Not Prohibit Multiple Taxation Per Se

Finally, under current Supreme Court precedents, the Commerce Clause does not appear to prohibit multiple taxation of income per se. Thus, where the multiple taxation arises from a conflict in the tax systems of different states, the Commerce Clause is unlikely to provide relief. See, e.g., Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978) (approving of a single sales factor apportionment formula in the face of the three-factor apportionment formula commonly used by other states); Container Corp. of Am. v. Franchise Tax Bd., supra (approving the use of worldwide combined reporting in the face of the widespread adoption by other countries of separate accounting); Zelinsky v. Appeals Tribunal, 801 N.E.2d 840 (N.Y. 2003), cert. denied, 124 S. Ct. 2068 (2004) (approving of New York’s taxation of income earned by a resident of Connecticut who was working in Connecticut based on the "convenience of the employer doctrine," despite the fact that Connecticut also claimed the income). But see Japan Line, Ltd. v. County of Los Angeles, 441 U.S. 434 (1979) (finding discrimination in violation of the Commerce Clause under a more rigorous test applied for foreign commerce where Los Angeles imposed a nondiscriminatory apportioned property tax on foreign-owned containers used in international shipping in conflict with the rule applied in Japan and other foreign countries that imposed a full (unapportioned) tax on containers that were owned, based and registered in the country).

Using these constitutional principles as a template, we hereafter identify theories that may be available to challenge certain of the add back statutes.

Any challenge based upon the substantial nexus prong of Complete Auto presumably would be based on the notion that the disallowance of an otherwise generally allowable deduction is effectively the equivalent of taxing the income to which it is linked.¹⁶ See Hunt-Wesson, Inc. v. Franchise Tax Board, 528 U.S. 458 (2000).¹⁷ Thus, while a state generally has broad license to determine what expenses are to be deductible from income where the deduction is tied specifically to one category of income, the disallowance of the deduction would be subject to attack if the state lacked substantial nexus to tax that income. Id.

While it may be possible to challenge the reach of the add back statutes based upon such an argument, prevailing on that position would appear to be an uphill battle. As described above, the constitutional standard governing this issue was established in the Allied Signal v. Director, Division of Taxation, supra. Under that decision, a state must simply demonstrate that the income is from operational sources rather than investment sources, a standard that would appear readily met in most cases. Allied Signal, of course, did not deal with a factual pattern such as those triggering the add back statutes, where the issue is not so much a question of the character of the income as a question of whose income it is. If one views the income as belonging to the recipient, one might well conclude that the state ought to have to show a unitary relationship between the payor and the recipient in order to compute the payor’s income by reference to the recipient’s income. Again, however, one would expect that in most cases a state would have little problem in establishing a unitary relationship between the recipient and the payor. Given that the statute is limited to affiliated taxpayers and directed toward a specific item of income (e.g., royalties) paid by one company to the other, proving such a relationship is not likely to represent a significant hurdle in most cases. See Container Corp. of Am. v. Franchise Tax Bd., supra.

Nonetheless, there may be cases where raising the issue could be determinative.

Obviously, the question here is whether a state can effectively tax to Company A income that appears to belong to Company B without having to meet the requirement of showing the two businesses are, in fact, engaged in a single unitary business.

In contrast, it would appear that a more serious Commerce Clause challenge could be waged against certain add back statutes based upon the discriminatory effect of their exceptions. For example, where the add back statute provides relief from double taxation only in those circumstances where both the payor and the recipient are taxable in the add back state, the exception would appear to violate the internal consistency test.

Connecticut’s tax regime appears to violate the Commerce Clause in this case because the transaction between A and B is taxed only once when it occurs within a single state but is subject to multiple taxes when conducted between two states. See D.D.I., Inc. v. North Dakota, 657 N.W.2d 228 (N.D. 2003); Farmer Bros. Co. v. Franchise Tax Bd., supra (applying the internal consistency clause to transactions between two different taxpayers). ¹⁸

At least two states, Connecticut and New Jersey, condition their exception to the add back statute by looking at whether the recipient is taxable in another state at a tax rate considered acceptably high. In this regard, the exception apparently ignores the aggregate state tax burden borne by the recipient.

Discriminating against one form of interstate commerce over another (i.e., between business operations conducted in multiple states rather than a single state) would certainly seem to be the type of tax prohibited by the Commerce Clause, although the authors are aware of no authority directly addressing the issue. However, such a notion draws inferential support from the Supreme Court’s decision in Kraft General Foods v. Iowa Department of Revenue & Finance, 505 U.S. 71 (1992), where the Court stuck down a tax scheme that favored domestic commerce over foreign commerce. In so doing, the Court made it clear that the absence of a benefit for local commerce does not excuse an otherwise discriminatory tax. Rather, it is the effect upon the commerce generally (in that case providing a more favorable dividend deduction for domestic dividends than for foreign dividends) that determines whether the system offends the Commerce Clause. Cf. Halliburton Oil Well Cementing Co. v. Reily, 373 U.S. 64, 72 (suggesting that Commerce Clause protections are intended to protect taxpayers from having to make economic decisions to concentrate or disburse business operations based upon state tax laws).

It would appear that a challenge might also be possible against add back statutes that favor foreign commerce over domestic commerce, although the authority for any such challenge is considerably less clear. The Connecticut add back statute also serves as an example for this type of challenge. Under that statute, if the recipient of a royalty operates in a country in which there is a comprehensive income tax treaty with the United States, the payor need not add back the royalty, regardless of the rate of taxation imposed upon the recipient. See Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004. In contrast, where the royalty is paid to a domestic entity, the payor must show that the recipient is taxed on the item at a tax rate in excess of Connecticut’s tax rate less three percent to qualify for the exception to the add back requirement. See 2003 Conn. Acts § 78(c) (Spec. Sess.). Arguably, providing a more favorable tax deduction for foreign commerce may be viewed as unconstitutional discrimination against domestic commerce.

As noted, there is authority establishing that domestic commerce may not be favored over foreign commerce. See Kraft Gen. Foods v. Iowa Dep’t of Revenue and Fin., supra. However, we are aware of no authority for the converse proposition. Indeed, one may well argue that the Supreme Court’s decision in Japan Line, Ltd v. County of Los Angeles, supra, establishes just the opposite because the Court in that case suggested that the Commerce Clause is more protective of commerce in the international setting than it is of domestic commerce.

Perhaps the most fundamental constitutional question presented by the add back statutes is whether a state, by its tax regime, may effectively penalize a taxpayer for doing business with an affiliate that operates in another state with a favorable tax regime.¹⁹ A taxpayer bringing such a challenge must largely operate in uncharted territory although, on a visceral level, the theory for such a challenge finds support in Supreme Court decisions approving of state tax incentives as a means for states to compete in interstate commerce.²⁰ Consider the following example:

Whether viewed from the point of view of Company A or the point of view of the New York policy makers, Connecticut’s reaction to the New York change in policy seems to thrust Connecticut beyond its boundaries into matters properly within the discretion of New York. In effect, Connecticut’s imposition of the tax on Company A directly frustrates New York’s policy change. While this example may seem a bit far fetched, consider the result where Company B simply decides to move to Nevada, which currently forgoes the taxation of income in order to attract business to the state. Or consider states like Ohio, where state tax authorities encourage relocation of industry by offering credits against tax for extended periods of time. If Connecticut can frustrate such policies by disallowing a deduction for interest and royalty payments, could Connecticut broadly disallow a deduction for other business transactions where the recipient is operating in a tax-favored jurisdiction?

While Connecticut may be expected to argue that its add back statute is surgically directed at "abusive tax planning" involving loans and trademarks, in actual fact, the statutes reach many commonplace business transactions, such as intercompany financing done wholly for nontax reasons. Nonetheless, if the lender of such amounts is located in a unitary combination state or a state with no income tax, the borrower is denied a deduction. If, instead, the lender moves to a separate-company filing state, the borrower is now permitted to deduct the interest. Again, there seems to be something odd, and untoward, if not unconstitutional, about Connecticut’s influence over that decision.

The authors are aware of no direct authority supporting a challenge on this theory. However, the add back statutes may be generally compared to the New Hampshire tax considered in Austin v. New Hampshire, 420 U.S. 656 (1975). In that case, the New Hampshire tax was imposed only on nonresidents from states that would grant a credit for the amount of the New Hampshire tax. New Hampshire sought to defend the discriminatory tax by arguing that the other states could simply repeal their credit for the New Hampshire tax to "reclaim" the taxable income. Thus, the state argued:

Id. at 665-666. But the Court rejected this argument:

Id. at 666-667. It is important, of course, to recognize that the tax considered in Austin was facially discriminatory in that no similar tax was imposed upon New Hampshire residents. Thus, the opinion may be limited to the simple proposition that an otherwise discriminatory tax may not be upheld merely because another state may by legislation eliminate the tax by imposing its own tax. However, the decision itself appears also to be grounded in the notion that New Hampshire was overreaching in imposing its tax. Certainly, the taxpayer suffered no significant harm through New Hampshire’s imposition, as the New Hampshire tax simply replaced, dollar-for-dollar, the tax that Maine would have imposed. See Justice Blackmun in dissent at 668-669; compare Private Truck Council, Inc. v. Secretary of State, 503 A.2d 214 (1986), cert. denied 476 U.S. 1129 (1986) (striking down a "third structure" flat tax imposed only on trucks registered in other states imposing a similar "third structure" tax where the purpose of Maine’s discriminatory tax was to coerce the other states to repeal these taxes).

In this regard, the taxes imposed upon the payor of a royalty or interest by the payor state could similarly be eliminated by a decision of the state in which the recipient is located to adopt a separate-company filing requirement and impose a tax at a rate sufficiently high to meet the benchmark set by the payor state.²¹ Yet, like the tax considered in Austin, there would seem to be something misdirected about a state simply imposing its tax because its sister state has a tax regime that allows for it.

At the end of the day, the add back statutes may simply be viewed as a state’s attempt to allocate the income associated with the intangible asset, whether it be a loan or a trademark, into the state where the payor is located.²² When one considers that a state is effectively taxing income theoretically earned by another taxpayer (e.g., the lender in an intercompany loan situation), it may be argued that the add back state’s taxing system must provide for some factor representation of the recipient in addition to the unitary relationship, discussed earlier. Certainly that would be true if the state simply required the payor and the payee to file a combined report because they were unitary. The issue may be illustrated by reference to the example we described in our discussion of the requirement that there be substantial nexus with the income the add back state seeks to tax:

In the prior discussion, we asked whether a state should be able to tax the royalty income of Company B by disallowing the deduction for A, without meeting the requirement of showing that the two businesses were engaged in a unitary relationship. Here, we pose a related question, should the state be required to provide some factor representation for B’s operation in deciding the source of the income taxed to A?

Because the taxation occurs as a result of the disallowance of A’s deduction and a tax imposed on A, the closest authority concerning this issue may be that which has arisen in the context of whether dividend income received by a taxpayer from foreign entities must be apportioned under a system that provides for factor representation for the dividend paying entities. Unfortunately, such arguments have not fared well in the courts, although the principles continue to seem unassailable to the authors. See also Hellerstein & Hellerstein, State Taxation, 9.15[4][a] (2004 Cumm. Supp. No. 2).

Litigation testing the new add back statutes has just begun. Attacks based upon existing Commerce Clause precedents are most likely to be directed toward the working of particular discrete exceptions rather than the general add back rules themselves. However, because the exceptions often go to the fundamental mechanics of the statutes, a successful attack on the workings of an exception may have the effect of invalidating the entire disallowance statute. See Calfarm Ins. Co. v. Deukmejian, 48 Cal. 3d 805, 821 (1989) ("The final determination [whether a statute or portion thereof is severable] depends on whether the remainder . . . is complete in itself and would have been adopted by the legislative body had the latter foreseen the partial invalidity of the statute. . . or constitutes a completely operative expression of the legislative intent. . ."); Hotel Employees & Restaurant Employees Int’l Union v. Davis, 21 Cal. 4th 585, 612-13 (1999) (an "invalid part can be severed if, and only if, it is ‘grammatically, functionally and volitionally separable.’")

An attack based upon the core issue, namely the right of a state to penalize a taxpayer for doing business with an affiliate in a state that provides a favorable tax regime, will probably require blazing new ground. Whether those types of challenges will be successful remains to be seen.

Finally, it should be noted that the constitutional issues presented by the add back statutes may be readily resolved simply by adopting a combined reporting system such as that pioneered by California. Because the add back statutes have been adopted to resolve a perceived "loophole," it seems unlikely that separate-company filing states will simply accept a return to the prior state of affairs if such statutes are successfully challenged. Thus, taxpayers should be mindful of the ultimate results a successful challenge to the statute might bring.

Footnotes

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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