Justice in New Mexico - the Conoco and Intel cases.

• Author: Schwartz, Curtis W.

Introduction

The New Mexico Supreme Court has dealt a serious, and perhaps fatal, blow to New Mexico's attempt to save the constitutionality of the manner in which it taxes a corporation's dividend income. See Conoco, Inc. and Intel Corporation v. Taxation and Revenue Department of the State of New Mexico, Docket Nos. 22, 995 & 23, 045 (Nov. 26, 1996). On November 26, 1996, the New Mexico Supreme Court unanimously held that New Mexico's practice of including foreign dividend income, but not domestic dividend income, in its corporate income tax base violates the Commerce Clause of the United States Constitution. Furthermore, and perhaps more important, the court turned aside the State's attempt to keep monies unlawfully collected from corporate taxpayers pursuant to that unconstitutional tax scheme. The court has ordered the State to pay refunds due Conoco and Intel to eliminate the effects of the discriminatory taxation they suffered. Following the court's decision, the Department filed a motion asking the court to reconsider its decision. That motion is still pending. If the court does not grant the Department's motion, the Department has indicated it may seek review by the U.S. Supreme Court.

The case is remarkable not only for the ingenuity demonstrated by the New Mexico Taxation and Revenue Department in its attempt to remedy the unconstitutionality of its statute but also for the Department's tenacious refusal to pay full refunds to taxpayers harmed by New Mexico's unconstitutional statute.

In the Beginning: The Kraft Decision

The saga began in the summer of 1992 wl Supreme Court ruled in Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, 506 U.S. 71 (1992), that Iowa's method of taxing corporate dividends was unconstitutional. Iowa, like many states including New Mexico, uses federal taxable income as its corporate income tax base. Federal taxable income includes dividend income received from foreign corporations but not dividend income received from domestic corporations. International multiple taxation at the federal level is eliminated through the foreign tax credit mechanism -- applied, of course, after the effects on U.S. taxes are ascertained. Domestic dividend income is for the most part eliminated from federal taxable income by operation of the federal dividends received deduction (in section 243 of the Internal Revenue Code). Most states make some accommodation in order to tax the dividends flowing in foreign and domestic commerce identically. Neither Iowa nor New Mexico did so. That failure created the unconstitutional discrimination.

In Kraft, the U.S. Supreme Court held in the context of Iowa's separate-entity reporting method that inclusion of foreign dividend income, but not domestic dividend income, in Iowa's tax base placed a tax burden on dividends flowing in foreign commerce but not on dividends flowing in domestic commerce. The court found therefore that Iowa's scheme for taxing dividend income facially discriminated against foreign commerce in violation of the Commerce Clause of the U.S. Constitution. It concluded that the two streams of dividend income must be taxed identically. As the New Mexico Supreme Court noted, "New Mexico's [separate-entity] tax scheme is virtually identical to Iowa's. . . ." Conoco and Intel, Slip Op. at 7.

New Mexico Refund Claims

The similarity of Iowa and New Mexico's tax schemes was not lost on corporate taxpayers, especially those who elected to report to New Mexico using the separate-entity reporting method. Shortly after the Kraft decision was announced, New Mexico began receiving claims for refund from corporate taxpayers, including Conoco and Intel. Most of the refund claims were based on excluding foreign dividends from the tax base just as domestic dividends had been excluded.

By the end of 1992 New Mexico had received 30 to 40 refund claims. The number of refund claims and the total dollar amount of the requested refunds would likely not be considered significant for larger states. For a non-industrial state like New Mexico, however, where 30 corporate taxpayers (mainly in the extractive industry) account for more than 50 percent of corporate income tax revenues, the refund claims posed more than a minor blip in revenues.

The Revenue Department's Response

The Department's immediate response was to deny all Kraft-based refund claims. It did that based on two theories. The first theory for denial was that Kraft should be given prospective application only. That is, corporate taxpayers were allegedly not entitled to any relief with respect to the taxes they had overpaid in the past as a result of New Mexico's unconstitutional scheme for taxing dividend income. In taking this position, New Mexico relied on what is known as the doctrine of selective prospectivity. See Chevron Oil Co. v. Huson, 404 U.S. 97 (1971). The Department's second theory, which was ultimately rejected by the Department's internal hearing officer as well as every court that considered it, was premised on its belief that New Mexico's method of dividend taxation in the context of combined and federal consolidated reporting was constitutional. After all, the Department argued, Kraft applied only to those corporate taxpayers that used the separate-entity reporting method and since, under New Mexico's scheme of corporate income tax reporting, corporations could have elected to use combined or federal consolidated reporting, they presumably had a constitutional reporting method available. Therefore, the Department's argument went, such taxpayers were not harmed by the constitutional infirmities of separate-entity reporting; any harm was a problem of the taxpayer's own making.

The Department made a third argument with respect to taxpayers like Conoco and Intel that had sought to exclude federal Subpart F income and PFIC income on the same basis as actual repatriated foreign dividend income was excluded. With regard to deemed dividend income, the Department argued that the doctrine established in Kraft was simply inapplicable.

In late 1992, at the same time the Department was denying...