Making Taxes More Certain: Iowa State Legislators' Guide to Combined Reporting

• Author: Lindsay C. McAfee
• Position: J. D. Candidate, The University of Iowa College of Law, 2010
• Pages: 01

J. D. Candidate, The University of Iowa College of Law, 2010; B.A., The George Washington University, 2004. I would like to thank the following people for reading and editing, and for their support: Joseph Crosby (Council On State Taxation), Ed Wallace (Iowa Taxpayers Association), the editors and writers for Volumes 94 and 95, and my family and friends.

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I Introduction

Benjamin Franklin once said, "[I]n this world nothing can be said to be certain, except death and taxes."¹ Taxes certainly exist, but what they will look like and how much they will be for businesses is uncertain. The state corporate income tax ("CIT") has been the subject of recent scrutiny in many states, as the changing and tightening economy forces states to look to new sources for more revenue. Politically, state policymakers are loath to raise taxes on individuals—those who are more prone to vote with their pocketbooks. Thus, the trend is for state lawmakers across the nation to propose CIT reform measures that would capitalize on the widely misunderstood and scorned corporate-tax structure.²

The situation is no different in Iowa, where relatively low costs of living and real-estate prices, low crime, and family-oriented policies make it an attractive place for a business to locate its operations. Because of rising unreliability, growing inequity, and expensive compliance and administration costs, Iowa's CIT is in serious need of repair. Policymakers and corporate watchdogs strongly believe that some corporations—admittedly, a very small minority of U.S. corporations—have found ways to funnel a significant portion of their income into structures that enable such income to go tax-free. Something needs to be done—even those companies who have found ways to minimize their CIT liabilities to manageable levels agree. In the past few years, the Iowa General Assembly has considered several CIT reform proposals, and large deficits in the state budget will force the legislature to act soon.

If Iowa policymakers consider combined reporting as a tax-reform option, it is imperative that they take adequate time and use proper resources to review corporate-taxpayer concerns and features of existing combined reporting regimes. Combined reporting, on its face, seems like a simple reform, but as with anything related to tax law, hastily written laws and regulations can end up defeating the very purpose of reform. Part II of this Note explains the background and theory of the CIT, including the nuances that lead to states' dilemmas today. Part II also describes combined reporting and how it works in comparison to other methods of reporting corporate-income-tax liability. Part III discusses why combined reporting garners so much attention from state-tax experts and reformers, including how laws governing corporate organization and structure give rise to activities that state departments of revenue decry. Part III also describesPage 248 widely accepted principles of good tax policy and how combined reporting fulfills those principles.

Any investigation into combined reporting must also consider several key questions, which Part IV examines in detail. Simply subscribing to and enacting the theory is one feat, but actually practicing it can lead to several other problems if lawmakers and agency officials do not address particular issues, including: (1) which taxpayers comprise the unitary group; (2) how to combine the group's income; (3) how to treat intercompany transactions, net operating losses, credits and deductions, and nonbusiness income; (4) how to apportion income; and (5) how combined reporting's effects relate to Iowa's economic-development goals. From an economic-development perspective, policymakers have to answer subjective questions: Is combined reporting good for Iowa's existing and future companies? Will combined reporting lead Iowa in the direction its citizens want to go in the future?

Part V discusses how combined reporting affects economic development. The numerous, unknown, immeasurable, and often overlooked factors of combined reporting make its application inherently difficult. Part V argues that state policymakers must be vigilant of how combined reporting affects the economic vitality of their state, especially in examining revenue projections.

Finally, Part VI looks at the corporate-tax climate in Iowa and what previous tax-reform proposals have looked like. Part VI notes that Iowa's budgetary shortfalls are not necessarily rooted in corporate-tax evasion, and while taxpayers and tax collectors alike are calling for tax reform, policymakers would be wise to carefully consider shaky revenue estimates and other empirical data before reshaping Iowa's corporate income tax. Iowa policymakers must focus on reforming the CIT in a revenue-neutral way with fewer exceptions, which would enhance its predictability, equity, compliance and administration costs, and Iowa's competitiveness with other states. If Iowa's policymakers decide that combined reporting is the right CIT reform for Iowa, they are wise to consider the issues discussed here.

II The State Tax Background

States have been taxing businesses' income for almost one hundred years.³ Income taxes were a major source of revenue and a way for states to spread costs of services between the businesses and individuals who used them. State governments' power to tax citizens and those who do business in a state is fundamental to our federalist system: states "need revenue to fund the services sought by their constituents."⁴ Forty-seven states impose taxes inPage 249 some form on corporate income.⁵ The CIT is the most widespread, albeit complicated and controversial, way that states raise revenue. This section gives a general overview of the CIT's and its purported purpose in most states, and describes combined reporting, the most recent and popular form of CIT reform.

A What Is the State Corporate Income Tax?

The corporate income tax is a tax on corporate profits after subtracting allowable expenses and capital depreciation.⁶ States impose their own CIT, separate from that of the federal government, for a variety of reasons.⁷ One rationale for taxing business profits is the deficiencies in the state property tax.⁸ A more widely cited reason is to maintain the integrity of the personal income tax: "Without a levy on corporate income, taxpayers might have an incentive to shelter personal income in corporate holdings."⁹ Regardless, the increasing number of corporate-tax credits and exemptions allow corporations to reduce their taxable income, while other federal laws prevent taxpayers from using a corporate entity to shield personal income from taxation.¹⁰

The more convincing rationale for levying a state income tax on corporate profits is one of policy: corporations should reimburse states for the significant services they provide to the business community.¹¹ States arePage 250 providing more services than ever before—primarily in areas where the federal government used to dominate, such as welfare, Medicaid, Medicare, highway maintenance, and homeland security—and they need a way to pay for those services.¹² When corporations are not paying their "fair share" of taxes to a state, both the corporation and its shareholders are "free riders" of services for which they do not pay.¹³ Additionally, a more federalist rationale is that states should have the authority to impose a tax on income that originates in their jurisdiction.¹⁴

Corporate income taxes, as we recognize them today, can be traced back to Wisconsin's Income Tax Law of 1911.¹⁵ By 1940, forty states had adopted CITs.¹⁶ In the early twentieth century, the nation's and states' economies were based primarily on manufacturing.¹⁷ Thus, CITs were based primarily on taxing corporations that manufactured tangible personal property.¹⁸ In addition, tax competition between states was not nearly as prevalent as it later became.¹⁹ While the economy and business climate has changed, the tax has remained the same: the national economy is now largely based on services and intellectual property, and businesses, notwithstanding their relative sizes, produce and sell in several states andPage 251 around the world.²⁰ However, the CIT maintains its traditional form while the world around it has changed.

States' coffers are feeling the effects of their corporate income taxes bringing in less revenue than they once did. Revenues from state CITs declined 34% between 1980 and 2001.²¹ In Iowa, the CIT comprised only 2.4% of state revenue during 2001-2004, down from 6.9% of state revenue in the early 1980s.²² In 2005, CIT revenues comprised only 2.1% of total state revenues compared to general sales tax (13.0%) and property tax (16.6%).²³

Some tax-reform advocates blame tax-planning strategies, which skilled tax professionals devised to avoid state income taxes, for the decline in revenues.²⁴ However, several factors have contributed to the decline in the...