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

May 6, 2010

On May 6, 2010, the Subcommittee on Commercial and Administrative Law of the Committee on the Judiciary of U.S. House of Representatives held a hearing on the role of Congress in development apportionment standards. Tax Executives Institute was represented by Daniel B. De Jong, a member of TEI's legal staff who serves as staff liaison to the State and Local Tax Committee. TEI's testimony was prepared under the aegis of that committee, whose chair is Cathleen Stevens of Brunswick Corporation, and many members of the committee contributed to the development of the testimony. Mr. De Jong's written statement follows.

Chairman Cohen, Ranking Member Franks, and Members of the Subcommittee: Thank you for your invitation to Tax Executives Institute to provide the business perspective on issues related to the apportionment of income for state corporate tax purposes. TEI is the preeminent worldwide association of in-house tax professionals, with more than 7,000 members representing 3,000 of the largest companies in the United States, Canada, Europe, and Asia. A member of TEI's legal staff, I concentrate on state and local tax matters.

TEI members represent a broad cross-section of the business community whose U.S. employers are, almost without exception, engaged in interstate commerce. The multijurisdictional companies represented by the Institute's membership are directly and materially affected by the rules governing allocation and apportionment of income among the various states.

The subject of today's hearing, multistate apportionment, challenges even the most seasoned state tax practitioner. When a business operates in multiple jurisdictions, it is necessary to determine which of the business's activities and investments (and how much of the income derived from those activities and investments) should be attributed to each jurisdiction. Understandably, it is not an easy task, and there is no single, simple, correct answer. Supreme Court Justice William Brennan aptly noted in a seminal 1983 case that dividing income among the several states bears some resemblance to "slicing a shadow." (1)

These challenges are not confined to the United States and the domestic multijurisdictional tax context. Other countries also struggle to fashion rules that ameliorate double taxation of income earned overseas. Here in the United States, where taxpayers are subject to a system that taxes their worldwide income, double taxation at the federal level is ameliorated--but not entirely eliminated--through a complex foreign tax credit mechanism and a broad network of bilateral income tax treaties.

In recent years, the countries of the European Union (EU) have considered establishing a common consolidated corporate tax base for their EU-wide activities. (2) Even if the EU achieves a common tax base, the member states will need to grapple with the politically delicate balancing necessary to establish a system for apportioning that base. (3) This underscores the complexity associated with attempting to achieve consistency and uniformity in the allocation and apportionment of income across multiple jurisdictions.

TEI's testimony today will focus on (1) the practical effect of the current patchwork of apportionment rules among the states, i.e., how they affect multistate businesses, and (2) the challenges that exist to achieving consensus on how to "slice the shadow."

Determining the Apportionaable Tax Base

In February, the Subcommittee heard testimony on the issue of state tax nexus. Because the concept of nexus limits the states' right to tax a nonresident, multistate business, crossing the nexus threshold can trigger the requirement to file a tax return in a state and necessitate calculations to determine the tax due to the state, which includes properly apportioning the taxpayer's income among the states in which the taxpayer conducts business.

Before applying an apportionment ratio, multistate businesses must determine the tax base that will be apportioned among the states with which they have nexus. In most states, the calculation of state taxable income begins with federal taxable income, which provides an initial degree of uniformity. From that point, the amount of uniformity among the states decreases dramatically. For instance, some states require taxpayers to add back certain items of income or deduction while others require subtraction of certain items. The differences often derive from Individual, state-specific policy considerations; others may be attributable to a state decision to avoid a revenue loss caused by retaining existing conformity with the Internal Revenue Code. For example, many states require taxpayers to "add back" the federal domestic manufacturing deduction permitted under section 199 of the Internal Revenue Code in computing their state taxable income. Thus, even if a uniform standard for apportionment could be achieved, the tax base would differ from state to state.

Constitutional on Apportionablility

In order to encourage the free flow of trade throughout the states, the Constitution limits the states' ability to tax income from transactions that bear no, or only a marginal connection--or nexus--with the taxpayer's activities in the state. (4) Permitting states to apportion that income would result in the state's overreaching and taxing value earned wholly outside its borders. Accordingly, income that falls into this category must be removed from the income subject to formulary apportionment and instead allocated in full to the state in which it was earned.

More than a century ago, the Supreme Court first addressed the question of what connection must exist between a state and a nondomiciliary taxpayer's income from...

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