State taxation: the role of Congress in developing apportionment standards.

May 6, 2010

On May 6, 2010, Tax Executives Institute testified before the Subcommittee on Commercial and Administrative Law of the House Committee on the Judiciary on State Tax Apportionment Rules. The Institute's testimony, which was presented by Daniel B. De Jong of the Institute's legal staff, was reprinted in the Spring 2010 issue of The Tax Executive and is available on the Institute's website. After the hearing, members of the congressional panel submitted a number of follow-up questions, the responses of which are set forth below.

Questions from the Honorable Steve Cohen, Chairman

1. In your written statement, you suggest that Congress adopt "a national, uniform threshold for the taxation of nonresident workers." Please explain.

   TEI (1) has supported earlier versions of the Mobile Workforce State Income Tax Fairness and Simplification Act, currently introduced as H.R. 2110. Employers nationwide have a direct stake in the development of fair and uniform rules governing nonresident taxation and withholding, regardless of whether they are large multinational corporations or small businesses that pursue opportunities outside their home state. Establishment of a national standard providing a minimum threshold for taxation of nonresident workers would bring a measure of certainty and uniformity to an area of the tax law where uncertainty and inconsistency cannot help but impede economic growth and efficiency. A national standard would also enhance taxpayer compliance by making it easier for employers to develop standardized systems and processes for tracking and reporting information necessary to accurately withhold state income taxes for traveling employees.

   In today's mobile economy, a business' activities or customers are rarely confined to a single state. Regardless of whether a company is large or small, privately held or publicly traded, the pursuit of new business is not limited by geographic boundaries. Employees regularly travel from their usual place of employment (i.e., their "home" or residence state) to other states to fulfill their employment obligations. When they do, they and their employers become subject to a wide array of disparate tax and withholding regimes. The tax and compliance burdens are not limited to any particular class of employee (e.g., those who work for large multinational corporations). Thus, employees of the American Red Cross or another social service/welfare organization whose jobs take them to one or more states devastated by a hurricane to coordinate relief efforts are subject to the same tax consequences as a privately employed individual.

   The current patchwork of divergent and sometimes inconsistent regulatory regimes makes it difficult for employers and their employees to comprehend and comply with their obligations. The challenge of analyzing the rules, developing procedures to ensure compliance, training employees, and then undertaking to collect the necessary information and perform the required calculations remains significant. Moreover, while some states may not vigorously enforce their rules in respect of all employers and employees (e.g., where the employer has adopted rules of administrative convenience to withhold tax when employees exceed a certain number of days in the state), the potential for enforcement action cannot be ignored.

   TEI recognizes the states' prerogative to design taxing systems to meet their particular needs. The Mobile Workforce bill, however, does not strip states of the ability to tailor their tax systems to fit their diverse economies and specific policy goals; rather, it establishes a reasonable threshold regulating when nonresident individuals engaging in interstate commerce and their employers are subject to those tax systems.

2. In your written statement, you describe the complexities created when business enterprises are composed of multiple entities, and how those entities are considered for tax purposes. You indicate that there is no uniformity among the states. Is there a way to simplify that calculation? Should we look for uniformity?

   Of the 45 states that impose a corporate income tax, 22 require each member within an affiliated group of corporations with nexus to file a separate state tax return - even if the group files a consolidated federal return. Corporations subject to tax in these states account for intercompany transactions with affiliated entities using an arm's-length standard. In the remaining 23 states, affiliated entities conducting a unitary business must file a single combined return. States vary in their definitions of both "affiliated entities" and "unitary business." Generally, entities must be connected by direct or constructive ownership of more than either 50% or 807;, to meet the definition of an affiliate. While unitary groups generally exhibit characteristics of interdependence "so as to form one integral business rather than several business entities,'' (2) states employ varying factors to determine whether the members of an affiliated group are engaged in a unitary business. (3)

   The goal for including these entities in a single combined return is to better capture "the many subtle and largely unquantifiable transfers of value that take place among the components of a single enterprise." (4) The Supreme Court has upheld the constitutionality of mandatory unitary combined reporting in a number of cases. (5) The analysis of whether entities are unitary, however, is often fact-intensive, prone to subjective conclusions, time consuming and administratively difficult. A lack of a consistent definition of a "unitary" business among the states adds to the burdens on taxpayers filing in multiple combined reporting jurisdictions.

   For businesses with international operations, the identification of the entities included in a "unitary group" can be even more daunting. During the 1970s and early 1980s, a number of states required taxpayers with international operations to include those activities in their combined returns (commonly referred to as the "worldwide unitary method")--even where those international operations were conducted through separate, foreign legal entities. The Supreme Court ultimately held that the application of these principles to the international operations of multinational business groups did not violate the U.S. Constitution, without regard to whether those businesses were headquartered outside of the country. (6)

   In response to criticism of the worldwide combined reporting, states have migrated to a...