Current issues in taxation of U.S.-controlled foreign corporations.

• Author: Schadewald, Michael S.

Searching for ways to increase revenues, some state governments have required U.S. corporations to include in their apportionable state income dividends received from foreign affiliates. This, in turn, has led to the question of whether the affiliates' property, payroll and sales should be represented in the state apportionment formula. This article examines the current status of this and related issues.

U.S. companies have historically earned most of their profits within the U.S. In recent years, however, income from foreign operations has become an increasing share of total U.S. corporate profits. For example, in 1995, U.S. companies derived more than $84 billion in profits from foreign direct investments and repatriated almost $32 billion via dividend distributions; U.S. companies derived over $6 billion in interest, more than $19 billion in royalty and license fees and nearly $12 billion in service charges from their direct investments abroad.(1) Because state lawmakers are well aware of these trends, the state taxation of income from foreign operations is certain to be an important tax issue for the foreseeable future.

Federal tax law plays a major role in state taxation of foreign income; virtually all of the states that tax corporate income use Federal taxable income as the starting point for computing state taxable income. A domestic corporation's(2) U.S. and foreign earnings are taxed under Sec. 61, but a credit is allowed under Sec. 901 for foreign income or withholding taxes imposed on foreign earnings. If a U.S. multinational operates abroad through locally incorporated subsidiaries, the subsidiaries' earnings are generally not subject to U.S. taxation until repatriated to the U.S. parent via a dividend distribution.(3) Although the U.S. parent generally is not allowed a Sec. 243(a) dividends-received deduction (DRD), it can claim a deemed-paid foreign tax credit (FTC) under Sec. 902 for the foreign income taxes paid by a 10%-or-more-owned foreign affiliate on its earnings. Interest, royalties or service charges received by a U.S. parent from a foreign affiliate are also subject to U.S. taxation.

The principal components of any state system for taxing the earnings of U.S.-controlled foreign corporations include the group reporting method, the regime for taxing dividends received from foreign affiliates and the rules for taxing interest and royalties received from foreign affiliates. Each of these components is discussed below, with a focus on factor representation, currently the most unsettled issue in the area.

The Status of Worldwide Combined Reporting

Generally, for Federal tax purposes, every corporate entity must compute and report its tax separately; however, members of an affiliated group can elect to file a consolidated return. Sec. 1504(a) defines an affiliated group as a parent-subsidiary structure in which all affiliates (other than the common parent) are at least 80% owned by other members of the group. According to Sec. 1504(b)(3), foreign affiliates cannot be included in a Federal consolidated return.(4)

Group reporting rules are more diverse at the state level. Some states require separate-return reporting, under which each affiliate computes income and files a return on a separate basis. Another approach is a consolidated return, under which the U.S. affiliates filing a Federal consolidated return (or some subset of those affiliates, e.g., affiliates with nexus in the taxing state) are included in the state return. A third approach is a combined return, which is similar to a consolidated return, except that the requisite common ownership percentage is often only 50%.

One variation of combined reporting is a unitary combination, under which only those commonly controlled corporations that exhibit a high degree of interdependence (e.g., functional integration, centralization of management and economies of scale) are included in the combined return. Unitary combinations can take the form of a domestic combination (that includes only the U.S. affiliates), a water's-edge combination (that includes any U.S. or foreign affiliate whose U.S. business activity exceeds a threshold level, e.g., 20% or more of the affiliate's total business activity) or a worldwide combination (that includes all affiliates, regardless of their place of incorporation or level of U.S. business activity).

Constitutionality

A number of states have required worldwide combined reporting (WWCR); California is the leading example. The constitutionality of WWCR was a major issue in the 1980s and early 1990s. Constitutional challenges to state income tax schemes are usually based on the Due Process or the Commerce Clause. The Due Process Clause requires a minimal connection and fair apportionment,(5) while the Commerce Clause requires a substantial nexus, fair apportionment, nondiscrimination and a fair relation to services provided.(6) In the case of foreign commerce, a state tax cannot create an enhanced risk of multiple taxation, and must not adversely affect the Federal government's ability to speak with one voice in regulating international trade.(7)

In Container Corp. of America v. Franchise Tax Board (FTB),(8) the Supreme Court held that California's WCR scheme was constitutional as applied to U.S.-based multinationals. Container had challenged California's tax scheme on the grounds that it violated the Due Process and Commerce Clauses' fair apportionment requirements. Relying on data generated by its own internal accounting system, Container had argued that its foreign operations were significantly more profitable than its U.S. operations; therefore, WWCR (which assumes homogeneous rates of return) attributed too much income to California. The Court rejected this argument, as well as Container's claim that WWCR violated the Foreign Commerce (Clause. noting that the alternative system (i.e. arm's-length transfer pricing) would not guarantee an end to double taxation, and that, absent an explicit directive from the Federal government,WWCR did not impair the Federal government's ability to speak with one voice in international trade.

Eleven years later, in the consolidated cases of Barclays Bank PLC v. FTB and Colgate-Palmolive Company v. FTB,(9) the Court held that California's WWCR scheme was constitutional as applied to foreign-based multinationals, and reaffirmed the constitutionality of WWCR with respect to U.S.-based multinationals.

Current Policy

After Container and Barclays, it is clear that states can require the use of WWCR. However, the business community takes a dim view of WWCR, and has persuaded state lawmakers that WWCR impedes a state's efforts to attract economic development.(10) As a result of this political pressure, only a handful of states (including Alaska, California, Idaho, Montana, North Dakota and Utah) have adopted some form of WWCR; each also provides taxpayers with the option of using the more limited water's-edge method of reporting. Despite winning its legal battles, California repealed the mandatory use of WWCR for tax years beginning after 1987, and significantly eased the burden of making a water's edge election for tax years beginning after 1993.

Taxation d Dividends From Foreign...