Drop shipments, destination sales, and the multi-factor apportionment statute: a critical review of Stryker Corporation v. Director, Division of Taxation.

• Author: Crabtree, David E.
• Position: Corporate taxation; multi-state businesses - New Jersey

Most States use a three-factor apportionment formula in apportioning corporate income and net worth taxes of multi-state businesses(1). Those factors are property, payroll, and sales.(2) New Jersey is among those States. The relevant statute(3) requires that the three factors (or fractions) be averaged, with double weight now given to the sales factor, which is defined, as follows:

The sales fraction is the receipts of the taxpayer, computed on the cash or accrual basis according to the method of accounting used in the computation of its net income for federal tax purposes, arising during such period from --

1) sales of its tangible personal property located within this State at the time of the receipt of or appropriation to the orders where shipments are made to points within this State,

2) sales of tangible personal property located without the State at the time of the receipt of or appropriation to the orders where shipment is made to points within the State,

3) (Deleted by amendment)

4) services performed within the State,

5) rentals from property situated, and royalties from the use of patents or copyrights within the State,

6) all other business receipts (excluding dividends excluded from entire net income by [N.J.S.A.54: 10A-4]) earned within the State, divided by the total amount of the taxpayer's receipts, similarly computed, arising during such period from all sales of its tangible personal property, services, rentals, royalties and all other business receipts, whether within or without the State.(4)

Courts in other jurisdiction containing statutes similar to New Jersey's have held that so-called destination sales -- i.e., sales of tangible personal property originally located in State A but shipped to the purchaser's location in State B -- are not apportionable to State A, absent the application of a "throwback" rule.(5)

This background leads to an examination of the decision of the Tax Court of New Jersey in Stryker Corporation v. Director, Division of Taxation,(6) where the court held that the taxpayer's sales of tangible personal property in New Jersey to its wholly owned New Jersey subsidiary were apportionable to New Jersey, even though the taxpayer made drop shipments of the product directly to its subsidiary's out-of-state customers. The court ruled that the drop shipment sales to the subsidiary's out-of-state customers were not taxable (i.e., were not apportionable) in New Jersey under N.J.S.A. 54:10A-6(B)(1) as sales of tangible personal property shipped to points in New Jersey, but that the sales were taxable in New Jersey as "other business receipts" within the purview of N.J.S.A. 54:10A-6(B)(6).

The relevant facts may be readily stated. The taxpayer, a Michigan corporation doing business in New Jersey, manufactured orthopedic hips and knees in New Jersey, and sold them to Osteonics Corp., its wholly owned subsidiary. Osteonics was a New Jersey corporation whose only business was marketing and sale of the orthopedic hips and knees manufactured in New Jersey by the taxpayer. Osteonics and the taxpayer occupied space in the same buildings in Allendale, New Jersey.

During the audit years (1988-1992),(7) the orthopedic hips and knees manufactured by the taxpayer were sold to Osteonics for resale to the latter's customers. Those customers placed orders with Osteonics, which upon receipt of an order entered it into Osteonics's computer system, identifying the customer and its billing address, the shipping address, the product purchased, and the price at which it was sold to the customer. After inputting and processing a customer order, Osteonics placed its order with the taxpayer via an in-line computer. The taxpayer performed all shipping, receiving, warehouse, and distribution functions. Thus, upon receipt of the order from Osteonics, the taxpayer's personnel located the product ordered, packed it, and, pursuant to the delivery instructions entered on the computer system by Osteonics, shipped the product to Osteonics's customer either within or outside of New Jersey. If a product was not available in the taxpayer's inventory, the order would be sent to the taxpayer's manufacturing...