Unfair apportionment: consider the alternatives; the taxpayer's task is to assess both constitutional and statute-based options.

• Author: Fields, Craig B.

When must state apportionment be fair? Always. If a states normal apportionment formula is operating unfairly with respect to your company, you need to consider the alternatives. The United States Supreme Court has articulated a four-part test for determining whether a state tax burdens interstate commerce in violation of the Commerce Clause of the United States Constitution. Pursuant to one part of that test, a state tax is constitutional when the tax is "fairly apportioned." (1) What is fair apportionment? To be fairly apportioned, a state tax must be both "internally consistent" and "externally consistent." (2)

The internal consistency test looks to the overall structure of the tax at issue and asks whether the tax would necessarily disadvantage interstate commerce when compared with intrastate commerce if every state enacted an identical taxing scheme. (3) Inasmuch as an internally inconsistent tax impermissibly burdens interstate commerce on its face, the tax is per se invalid in all cases, without the need for further consideration of the economic reality of how the tax applies.

The external consistency test looks to the specific economic realities of how the tax applies in order to determine whether the tax impermissibly "reaches beyond that portion of value that is fairly attributable to economic activity within the taxing State." (4) Inasmuch as the external consistency test is concerned with the underlying economic realities of how the tax applies in practice, the analysis is undertaken on a case-by-case basis to determine whether a tax is fairly apportioned as applied to particular taxpayers. A states statutory apportionment formula may be externally consistent as applied to one taxpayer but externally inconsistent as applied to another, depending on the economic realities of their respective business activities in the state. If it is determined that a normal statutory apportionment formula is externally inconsistent as applied to a particular taxpayer, then the U. S. Constitution requires an alternative method of apportionment to be applied that more fairly reflects the extent of that taxpayer's business activities within the taxing state.

Distinct from U.S. Constitution considerations, states have enacted statutory alternative apportionment provisions to address situations where the normal statutory apportionment formula does not fairly represent in-state business activities or income. Pursuant to these alternative apportionment statutes, typically either the state or the taxpayer may assert that the statutory apportionment formula does not fairly represent the in-state business activities or income and may propose that an alternative method of apportionment be used to fairly reflect in-state activities. Such provisions aim to provide an additional safeguard to ensure fair apportionment in cases where the normal statutory apportionment formula yields a result that does not fairly represent in-state business activities but is not so manifestly unfair as to rise to the level of a constitutional violation. However, it is important to note that whereas all state apportionment formulas are required to be internally and externally consistent in accord with the U.S. Constitution, statutory alternative apportionment provisions are state-made laws and therefore tend to vary by state.

We will consider constitutionally required and statute-based alternative apportionment in turn.

Constitutional Aspects of Alternative Apportionment

The U.S. Supreme Court has stated that a statutory apportionment formula that is "not intrinsically arbitrary ... will be sustained until proof is offered of an unreasonable and arbitrary application in particular cases." (5) A normal statutory apportionment formula will be invalidated when the taxpayer demonstrates that the formula operates in a way that attributes to the taxing state "a percentage of income out of all appropriate proportion to the business transacted" within the state. (6)

For example, in Hans Rees' Sons, Inc. v. North Carolina Ex Rel. Maxwell, North Carolina's normal statutory apportionment formula was a single property factor based on real and personal property located within the state. The taxpayer was in the business of tanning, manufacturing, and selling belting and other leather products, was incorporated in New York, and owned a manufacturing plant in North Carolina. A sales office and a warehouse were located in New York. Sales were made throughout the United States, including to customers in North Carolina. All sales originated in New York, with approximately forty percent of orders shipped to customers from the New York warehouse and approximately sixty percent of orders shipped directly from the North Carolina plant. The taxpayer demonstrated that around seventeen percent of its net income had a North Carolina source; in contrast, the state's single property factor formula yielded a North Carolina apportionment percentage of between approximately sixty-six and eighty percent during the tax years in question, proving a distortion of between approximately 270 percent and 370 percent. The Supreme Court concluded that the state's formula was out of all appropriate proportion to the activities transacted by the taxpayer in the state. (7)

Similarly, in Norfolk & Western Railway Co. et al. v. Missouri State Tax Commission, Missouri's normal formula required that railroad rolling stock be apportioned to the state for property tax purposes based on the proportion of the taxpayer's railroad track miles in Missouri relative to the taxpayer's railroad track miles everywhere. (8) The taxpayer maintained much of its equipment in the coal regions of Virginia, West Virginia, and Kentucky. The taxpayer leased all of the property of another railroad company that engaged in a substantial amount of business in Missouri. Using the normal statutory apportionment...