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U.S. Supreme Court Upholds Worldwide
Combined Reporting Methodology

By Toni Rembe, a tax partner in the San Francisco office of Pillsbury Winthrop Shaw Piittman LLP. This information is only of a general nature, intended simply as background material, omits many details and special rules and cannot be regarded as legal or tax advice.

In the Barclays Bank case, decided June 20, 1994, the U.S. Supreme Court put to rest the issue, raised in Container some 11 years ago, of whether the California worldwide combined report apportionment method can be applied to determine the taxable income of a corporate taxpayer forming part of a foreign based multinational enterprise. Barclays Bank PLC v. Franchise Tax Board and Colgate-Palmolive Company v. Franchise Tax Board, 62 U.S. Law Week 4552 (1994). Justice Ginsburg, writing for the majority, succinctly summarized the guiding principles in the concluding paragraph of her opinion:

Having determined that the taxpayers before us had an adequate nexus with the State, that worldwide combined reporting led to taxation which was fairly apportioned, nondiscriminatory, fairly related to the services provided by the State, and that its imposition did not result inevitably in multiple taxation, we leave it to Congress — whose voice, in this area, is the Nation's — to evaluate whether the national interest is best served by tax uniformity, or state autonomy. 62 U.S. Law Week at 4561.

Thus, the Court found that absent Congressional action, California could tax a corporate member of a foreign based multinational business enterprise under the same set of combined report unitary business apportionment rules as those applied to a member of a U.S. based multinational business enterprise and upheld in Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983). Under the unitary apportionment method used by California, a commonly controlled affiliated group of corporations forming part of an integrated business enterprise is in essence treated as one entity for purposes of determining the income tax liability of the members of the group doing business in the state. Accordingly, the separate accounts of the California corporate members are disregarded and the combined net income of the affiliated group is determined and attributed to the California members by application of a three-factor apportionment formula. The formula takes into account the property, payroll and sales of the instate taxpayers as a percentage of the worldwide property, payroll and sales of the group as a whole. This method of dividing the income of a multicorporate unitary group for state tax purposes has generally been accepted as "proper and fair" insofar as a U.S. group of corporations is concerned. In the Container case, the Court approved the use of this method to determine the California income tax liability of a U.S. parent corporation with foreign subsidiaries, finding the tax satisfied the four-pronged Complete Auto standard, i.e., it applied to an entity with a substantial nexus, was non-discriminatory, fairly apportioned and fairly related to instate services. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). Container had argued that the inclusion of its foreign subsidiaries in a combined report and application of the worldwide apportionment methodology ran contrary to the internationally accepted "arm's-length" method of dividing income among countries and violated both the Commerce and Due Process Clauses.

A similar situation to that in Container was before the Court in the companion case to Barclays involving Colgate-Palmolive, another U.S. parent company with some 75 foreign subsidiaries. In deciding Colgate-Palmolive, a unanimous Court had no trouble in finding that the application of California's combined report worldwide apportionment method to the U.S. based Colgate group was governed by its decision in Container and that subsequent evidence of the federal executive's opposition to the tax did not enhance Colgate's Commerce Clause position. however, the Container Court had expressly refrained from addressing the constitutionality of California's method as applied to "domestic corporations with foreign parents" or to "foreign corporations with either foreign parents or foreign subsidiaries."

Barclays involved both a domestic corporation and a foreign corporation doing business in California and forming part of a United Kingdom based multinational banking group, comprised of more than 220 corporations operating in 60 different countries. Barclays argued that California's combined report unitary apportionment method did not pass muster in the foreign parent situation because of the additional Commerce Clause scrutiny required where a state tax affecting foreign commerce is involved, i.e., whether application of the tax (1) creates an enhanced risk of multiple taxation, or (2) impairs the Federal Government's ability to "speak with one voice when regulating commercial relations with foreign governments."

The Court dismissed Barclays' argument that application of the combined reporting obligation to foreign based multinationals creates a more aggravated risk of double taxation, by noting that the so called separate accounting "arm's-length" method employed by the federal government and most developed nations could also result in over or under taxation of a multi-jurisdictional enterprise, even with adjustment mechanisms such as those provided under IRC section 482. The Court went on to note that multiple taxation, while it could occur, was not the "inevitable result" of California's application of the unitary apportionment method. Unlike Justices O'Connor and Thomas, who were willing to strike down the tax in Barclays because of a "substantial risk of international double taxation" in an area where California departed from the international norm, the majority adhered to the Container rationale:

We refused in Container Corp. "to require California to give up one allocation method that sometimes results in double taxation in favor of another allocation method that also sometimes results in double taxation." The foreign domicile of the taxpayer (or the taxpayer's parent) is a factor inadequate to warrant retraction of that position (62 U.S. Law Week at 4558).

Turning to Barclays' "speak with one voice" argument, the Court relied again on Container, and its more recent Wardair decision in finding the argument had been addressed to the wrong forum. Wardair Canada, Inc. v. Florida Dept. of Revenue, 477 U.S. 1 (1986). The Court noted that Congress, not the Judiciary and not the Executive, had the power to regulate foreign commerce in the state income tax arena, and Congress had repeatedly failed to adopt legislation limiting the states' power in this regard. The Court also pointed to the Senate's failure, as early as 1978, to ratify similarly limiting language in the U.S./U.K. tax treaty.

The Court also rejected Barclays' Due Process and Commerce Clause discrimination arguments that were based on the increased cost of compliance with California's regime. While recognizing that "compliance burdens, if disproportionately imposed on out-of-jurisdiction enterprises, may indeed be inconsonant with the Commerce Clause, the Court found that California's implementing regulations with their provisions for "reasonable" approximations reduced the compliance burden for foreign based multinational groups and appeared, in the absence of any showing to the contrary, to be administered in a manner compatible with due process.

The fact that the Court took Colgate and consolidated the two cases did not bode well for Barclays, particularly in view of the "comprehensive" challenge previously rejected by the Court in Container. Absent reversing Container, would the Court be willing, particularly in the absence of some directive from Congress, to sanction or indeed require radically different tax sourcing schemes, depending on the parentage of the instate corporate taxpayer? If so, would new discrimination issues be presented? Depending on the configuration of the worldwide unitary business, should a foreign based enterprise disadvantaged by a water's edge approach be allowed to continue to file on the worldwide unitary basis available to U.S. based multinationals? Should California be free, in the words of the dissent, to discriminate against a U.S. owned corporation in favor of an overseas owned?

Nor was Barclays' plea to the Judiciary helped by the fact that California, the last of the states to give way, no longer requires worldwide combined reporting. Under legislation first enacted in 1986, both domestic and foreign based multinational groups may elect to file on a "water's edge" basis that more closely approximates the Federal approach. The Court noted that the water's edge election as originally enacted required, among other things, payment of a substantial annual fee and that, effective for year commencing in 1994, the fee and certain other requirements surrounding the election had been repealed by the California Legislature. The Court pointedly observed that California, in enacting water's edge election legislation, had in essence responded to the barrage of "diplomatic notes, amicus briefs, and even retaliatory legislation" mounted by foreign governments.

Clearly, the Court in deciding Barclays helped to alleviate a budget problem in California in view of the number of cases (both refund and deficiency) involving the worldwide unitary issue for prior years. However, because Barclays and Colgate stipulated that their respective worldwide businesses were unitary, there remain a series of questions concerning the application of the unitary method in the international and domestic arena that will need to be resolved on a case by case basis, such as:

  1. The question of whether a commonly controlled group of affiliated corporations are engaged in a single unitary business or in two or more separate unitary businesses. The courts have made it clear that common control is not enough absent a meaningful degree of integration. Unitary determinations are frequently intensely factual and can have a substantial impact on a corporation's California tax liability.

  2. The question of whether the three-factor apportionment formula fairly represents the taxpayers' instate activity. Although neither Barclays nor Colgate seriously questioned whether the formula fairly operated in their respective cases, there are many situations where the amount attributed to the taxing state appears inordinately excessive and grossly disproportionate given the instate activity involved. While there is a heavy burden of proof for a party seeking to prove the formula operates unfairly, many situations clearly merit some type of factor adjustment, if not a separate accounting approach. Distortion problems may also be exacerbated given California's recent departure from the traditional three-factor formula (referred to in the Barclays opinion as "a long-accepted method of apportionment") through legislation that gives double weight to the sales factor, effective for taxable years beginning on or after January 1, 1993.

  3. The question of whether particular items, such as interest, dividends, rents and royalties are unitary business income which is included in the apportionable tax base, or nonbusiness income which is assigned in its entirety to a single out-of-state or instate situs. Similar to the unitary business issue these determinations are heavily factual and can cause tremendous swings in some corporations' state tax liability.

Most of the ongoing issues concerning application of the unitary method which should be carefully considered, will vary in accordance with the circumstances of the individual taxpayer involved. In light of Container and Barclays there seems little room for attacking the unitary system per se as a method for arriving at a fair division of income where a far flung but unitary enterprise is concerned. However, there remain questions concerning the constitutionality of some of the provisions of the 1986 and 1988 water's edge election legislation. (The election fee, which was repealed effective January 1, 1994, is being challenged by various taxpayers on a number of grounds.) There may also be ongoing questions in certain foreign jurisdictions as to whether particular treaty provisions in the commercial or trade areas (which were not before the Court in Barclays) could be construed to impact a state's power to tax on a worldwide unitary basis.

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