Implications of the Supreme Court's 1991-1992 state tax decisions.

• Author: Rosen, Arthur R.

The Supreme Court's 1991-1992 term produced an avalanche of state tax cases that substantially (but not completely) clarify the permissible range of state tax jurisdiction. Viewed together, the cases demonstrate the dual approach to be utilized in determining the constitutionality of state tax impositions, the standards that will be applied for each part of the dual approach, and the amount of flexibility the states will be accorded in utilizing classifications and distinctions in structuring their taxing schemes.

This article discusses the six most significant state tax cases of the Court's October 1991 term. It begins with a explanation of each case, next discusses ways taxpayers can take advantage of the Court's decision, and concludes with speculations about subsequent events. The six cases -- Allied-Signal, Quill, Nordlinger, Chemical Waste, Kraft, and Wrigley -- address a variety of taxes, but, with limited exceptions in two of the cases, the principles involved are relevant to the entire spectrum of state taxation.(1*)

Allied-Signal(2)

The corporate franchise/income tax statutes in several states -- New York, New Jersey, and Connecticut, for example -- provide that once a corporation is subject to tax in that state, the corporation's entire modified federal taxable income is apportioned by formula to the state; the statutory tax rate is then applied to this amount. (These are often called "full apportionment" states.) In contrast, most states have directly or indirectly adopted the UDITPA principle of first bifurcating income into "business" and "nonbusiness" components, and then apportioning only business income to each state in which the corporation is subject to tax while allocating each item of nonbusiness income to a specific state. In reality, however, administrative and judicial interpretations in some jurisdictions have virtually emasculated the concept of "nonbusiness income" and a result similar to that experienced in full apportionment states often occurs. The constitutionality of the full apportionment scheme was the ultimate question addressed in Allied-Signal.

Bendix, which was Allied-Signal's predecessor-in-interest, was a Delaware corporation that conducted business throughout the United States and the world. The business was directed from Bendix's principal office in Michigan. During the tax period at issue, the company engaged in four major types of business, each through a separate operating group, as follows: automotive; aerospace/electronics; industrial/energy; and forest products. In New Jersey, Bendix's activities related to its aerospace business and the manufacturing of electric power-generating systems; the company also sold its full range of products to customers located in New Jersey and stored inventory there as well.

In 1965, Bendix began "an aggressive policy of growth through acquisition." By the late 1970s, the company had acquired more than 44 companies and had sold at least eight. In its annual report to stockholders, Bendix management emphasized that "acquisitions have played a significant role in the growth of your [c]orporation during the past decade."

During 1977 and 1978, Bendix acquired slightly more than 20 percent of ASARCO's stock. According to the CEO of Bendix, the purchase was consistent with the company's strategy of diversifying and broadening its holdings in basic commodities. (ASARCO, a New Jersey corporation, engages in copper mining in the United States and abroad.) In the course of the dispute, the New Jersey Division of Taxation and Bendix stipulated that "[d]uring the period that Bendix held its investment in ASARCO, Bendix and ASARCO were unrelated business enterprises each of whose activities had nothing to do with the other."

In 1981, Bendix sold its ASARCO stock to reduce its investment in natural resource businesses and to realize the appreciation in the value of the stock; the sale resulted in more than $200 million in capital gain. This gain fit the corporation's goal of providing liquidity for future acquisitions in targeted areas. The New Jersey Division of Taxation included this capital gain in Bendix's income subject to apportionment for purposes of the state's corporation business tax.

The New Jersey corporation tax statute requires apportionment of a corporate taxpayer's entire modified federal taxable income. State tax officials, however, were cognizant of the U.S. Supreme Court's 1982 decisions in ASARCO Inc. v. Idaho State Tax Commission(3) and F.W. Woolworth Co. v. Taxation and Revenue Department of New Mexico.(4) In those cases, states were stopped from taxing the part of corporate taxpayers' income that was attributable to their stock ownership in corporations when those investee corporations were not engaged in unitary businesses with the corporate taxpayers. In sum, the Supreme Court had held that a state may not tax income that has nothing to do with the taxpayer's activities in the state. New Jersey, faced with these rulings, attempted to sustain its tax on Bendix by asserting that the state had a right to tax the income earned by Bendix from its ASARCO investment, not because Bendix and ASARCO were unitary -- the stipulation entered into by the state and Bendix had effectively precluded the state from making such an assertion -- but rather because part of Bendix's overall corporate strategy was acquiring and disposing of businesses. Accordingly, the state argument continued, the ASARCO gain was derived as part of Bendix's single business that was partly conducted in New Jersey and therefore partly taxable in New Jersey. The state was successful in making this argument in the New Jersey courts. In its initial brief to the U.S. Supreme Court, the state repeated this argument while the taxpayer consistently had maintained that ASARCO and Woolworth prohibited New Jersey from taxing income that was earned independently of the taxpayer's activities in New Jersey.

In a move that shocked the tax community, New Jersey dramatically changed its position during oral argument. Rather than attempting to fit the "square peg" Bendix situation into the unitary business "round hole," the state averred that ASARCO and Woolworth should be overruled: New Jersey argued that every state that has the jurisdiction to tax a particular corporation should be permitted to tax an apportioned share of that corporation's entire income. In response to this bold move, the Court ordered rebriefing and reargument addressing three issues:

1. Should the court overrule ASARCO and Woolworth?

2. If ASARCO and Woolworth are overruled, should

   the decision apply retroactively?

3. If ASARCO and Woolworth are overruled, what

   constitutional principles should govern state taxation

   of corporations doing business in several

   states?

   In response, Allied-Signal demonstrated that there was a wealth of precedence on which ASARCO and Woolworth were based. Starting with the original railroad and telegraph unitary property tax cases,(5) continuing through the express company cases(6) and ending with cases such as Underwood Typewriter Co. v. Chamberlain,(7) Mobil Oil Corp. v. Commissioner of Taxes,(8) and Exxon Corp. v. Wisconsin Department of Revenue,(9) Allied-Signal asserted that there existed a fundamental principle that a state may constitutionally impose tax only on income organically related to the taxpayer's activity in the state. In response, New Jersey proposed that each corporate entity simply be viewed as a single economic unit. The state argued that modem corporate entities treat all assets -- whether an investment in a nonunitary subsidiary or a manufacturing facility -- as effectively fungible. Therefore, according to New Jersey, every state in which a corporation is subject to tax should be able to impose tax on a portion of the corporation's entire income. On oral argument, New Jersey agreed with the Multistate Tax Commission (whose raison d'etre is uniformity) that New Jersey's "full apportionment" scheme should be allowed to coexist with UDITPA and UDITPA-like states (where 100 percent of nonbusiness income is specifically allocated to certain jurisdictions) and appeared unconcerned about fair apportionment and multiple taxation, proposing that those issues could be addressed over time.

   Relying on the Due Process Clause as well as the Commerce Clause, the Supreme Court held that two distinct nexus requirements must be met to sustain the validity of a state tax on (or measured by) the income of a nondomicilary corporation. The first nexus requirement mandates a connection between the state and the taxpayer; the second nexus requirement mandates a connection between the state and the activities that produced the income sought to be taxed. (This conclusion was reached by relying on the 100-year history of cases cited in Allied-Signal's brief.) With reference to the Due Process Clause, the Court cited Quill, which quoted Miller Bros. V. Maryland,(10) and stated "we have not abandoned the requirement that, in the case of a tax on an activity, there must be a connection to the activity itself, rather than a connection only to the actor the State seeks to tax." New Jersey's arguments -- that a corporate entity's taxability in a state justifies that state's taxing an apportioned part of the entity's entire income -- was thus rejected. The nine Justices unanimously agreed with this rejection. Quoting Exxon, which in turn quoted Mobil, the Court stated:

   It remains the case that "[i]n order to exclude certain

   income from the apportionment formula, the

   company must prove that the income was earned in

   the course of activities unrelated to [those carried

   out in the taxing] State."

   There was no question in this case that the first connection -- or nexus --test was met: Bendix, as a corporate entity, was clearly doing business in New Jersey and thus subject to the taxing jurisdiction of the state. Applying the second test to the facts in this case (whether the...