Common control and the delineation of the taxable entity.

Author:Aikins, Michael

NOTE CONTENTS INTRODUCTION 1. AN INTRODUCTION TO THE PROBLEM A. Apportionment and Combined Reporting B. Unitary and Nonunitary Businesses C. The Constitutional Dimension II. THE UNITARY BUSINESS TEST A. The Unitary Business Test Is Fact-Intensive and Costly To Administer B. The Unitary Business Test Is Arbitrary C. The States Differ in Their Application of the Unitary Business Test III. THE COMMON CONTROL TEST A. An Outline of the Common Control Test B. Benefits of Adopting the Common Control Test C. Why the Common Control Test Is Superior to the Affiliated Groups Test D. Predecessors of the Common Control Test IV. COUNTERARGUMENTS A. The Constitutionality of the Common Control Test B. Tax Avoidance Opportunities Under the Common Control Test C. Barriers to Implementation CONCLUSION INTRODUCTION

Where income is earned by operations spanning multiple jurisdictions, taxing that income involves (very roughly) a determination of: (1) the scope of the business whose profits are considered in levying a tax, and (2) what proportion of those profits are taxable by the jurisdiction at issue.' This Note is concerned exclusively with the first of these problems: how a state draws the line around the entity whose profits it considers in taxing. Despite considerable scholarly attention, this remains "the great unsolved problem" (2) in state corporate taxation.

This Note proposes a novel solution that would have the states "piggyback" on a test currently used by the Internal Revenue Code to treat the profits of related entities in the aggregate. (3) The idea is simple. The federal government already combines the income of related entities so that businesses cannot funnel their profits into multiple subsidiaries to take advantage of the lowest corporate tax rates. States could piggyback on these efforts, treating the commonly controlled group-as determined for federal tax purposes-as the taxable entity for state purposes.

Currently, the states use the "unitary business test" to delineate the taxable entity. Under this test, where the business in question shows a sufficient degree of integration and interdependence with operations in the taxing state, that state can levy a tax on a portion of the business's aggregate earnings. Thus, for instance, if a lumber mill in Vermont was sufficiently integrated with a pulp and paper plant in Connecticut, Vermont could tax a portion of the profits earned by the entire operation.

Although simple enough to articulate, the unitary business test has proven extremely burdensome to administer. The test requires a fact-intensive inquiry into the workings of interstate businesses because absolutely everything--from joint financing, to management overlap, to use of intellectual property--is relevant to the analysis. Moreover, determining what degree of integration is sufficient to satisfy the test is a matter of judgment, and reasonable minds disagree in all but the clearest of cases. The test has therefore offered little guidance to businesses about the tax consequences of their operations. Compounding these difficulties, the states often disagree about whether a given business is unitary, which results necessarily in either double taxation of certain corporate profits or else in no taxation at all of those profits ("nowhere income," in tax parlance).

For these reasons, the test has been widely disparaged by both commentators and tax administrators. In the context of European Union tax integration, where the experience of the American states has been heavily drawn upon as a parallel, commentators have largely rejected imitation of the unitary business test. (4) And in a 1992 case, the Supreme Court considered the arguments of tax administrators from New Jersey that the test was unworkable, though the Court declined to abandon it. (5)

The unitary business test is seen by most as a kind of necessary evil: an evil for the reasons listed above, and necessary both because no workable alternatives have been put forward and because an inquiry into the economic substance of these businesses is thought to be necessary to prevent states from taxing profits generated by activities unconnected to the taxing state-a violation of the Fourteenth Amendment's Due Process Clause.

This Note offers a formal solution to the problem and contends that this solution does not run afoul of the Constitution. The idea was inspired principally by the observation that the federal government is already engaged in a kind of delineation exercise of its own. The federal government uses an objective, ownership-based rule for aggregating the income of related entities to prevent businesses from fragmenting themselves into multiple corporations in order to take advantage of lower tax brackets and multiply the number of certain deductions and credits to which they would otherwise be entitled. The problem encountered at the federal level (income-spreading among many entities) bears a resemblance to the problem of profit-shifting to states with low taxes, and the solution to both problems involves aggregating the income of the entities involved so as to render moot the profit-shifting in question.

Beginning with this conceptual parallel, this Note argues that the states should use the administration of the federal common control test to delineate the scope of the entities they tax. This shift would produce a number of important advantages. First, it would allow the states to "outsource" the costs of refining and administering the test to the federal government. Second, it would achieve uniformity (the sought-after value in interstate taxation), as well as greater objectivity and predictability. Third, it would increase the stability of state revenues in times of local or regional economic volatility.

Use of the common control test would not violate the Due Process Clause. The constitutional objection hinges entirely on the possibility that commonly controlled entities would be swept into the taxing power of a state even though these entities lack the economic integration and synergy with activities in that state that would justify extension of its taxing power. This Note offers reasons to believe that this will rarely be the case. Common ownership always creates certain synergies between businesses, and the market for corporate control ensures that other, particularized synergies will exist. We can also assume that synergies between commonly controlled entities will be sufficiently large as to outweigh the disadvantage that the group incurs at the federal level by being denied double use of the lowest bracket and other benefits-otherwise the entities would not be commonly owned. Any remaining concerns as to extraterritorial taxation could be mitigated by including relief provisions that allow taxpayers to challenge particular applications of the common control test.

The argument proceeds as follows. Part I introduces the mechanics of state corporate taxation that are essential to understanding this Note's proposal. Part II explains why the unitary business test is unadministrable. Part III argues that states should adopt the federal common control test and shows why this test is a superior choice to the federal affiliated groups test. Part IV addresses three counterarguments: first, that adoption of the common control test would result in taxation of profits unconnected to the taxing state in violation of the Due Process Clause; second, that the formalism of the common control test invites manipulation because the test's ownership standard is a fixed target around which tax planners will be able to structure; and third, that states will be unwilling or unable to adopt the common control test unilaterally. The Note then concludes.


    The common control test is a means by which states can simply and objectively delineate the entity whose profits they consider in taxing. It should be thought of as an improvement of one part of the entire mechanism by which states tax interstate businesses. In order to situate the improvement, then, a description of this mechanism is necessary. This Part thus presents as brief an overview as possible of apportionment, combined reporting, and the distinction between unitary and nonunitary businesses. It can be skipped by the reader who is already familiar with these concepts.

    1. Apportionment and Combined Reporting

      Two great problems underlie and animate-and therefore also explain- much of the unique structure of state corporate income taxation. First, states must decide how to divide up the income of interstate businesses when that income often arises from integrated operations and thus cannot be separated and attributed to discrete geographic areas. Second, states must prevent interstate businesses from manipulating transfer prices or using other mechanisms to shift their profits from high-tax to low-tax states. Apportionment and combined reporting are two mechanisms by which these problems are addressed, and are briefly outlined in turn here.

      Let us begin with a simple (and stylized) example: a timber operation in Oregon provides wood to a furniture manufacturer in Washington whose goods are then sold at stores in Connecticut. The whole operation has centralized financing, advertisement, and management and is owned by a corporation with headquarters in New York ("X Corp."). Which of these four states should be allowed to tax what proportion of the $10 million in profits that the corporation as a whole reports? Where the enterprise generates its profits as an integrated and interdependent whole-as an "organic system," in the words of Justice Holmes (6)--it is impossible to disaggregate the contributions that its parts make to overall profitability. (7) The business has intra-enterprise synergies (for example, lower costs of capital because of the corporation's total assets) and centralized costs (for example, advertising and management salaries) that are all...

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