INTRODUCTION

The Senate Committee on Finance has scheduled a public hearing on September 29, 1986, on legislative proposals to limit State taxation of multinational business (S. 1113 and S. 1974).

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Part I of the document is a summary. Part II is an explanation of present law regarding State and Federal taxation of multinational corporations and State taxation of interstate business transactions. Part III provides a discussion of possible Federal limitations on State taxation of foreign source income. Part IV sets forth the principal issues involved. Part V is a description of the provisions of S. 1113, and Part VI is a description of S. 1974.

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This document may be cited as follows: Joint Committee on

Taxation, State Taxation of Multinational Business

(JCX-27-86), September 29, 1986.

At present, States generally tax the income of corporations doing business within and outside the State by apportioning the income pursuant to a formula--this is commonly referred to as the unitary method. The States have adopted several different approaches to apply the unitary method to apportion the income of affiliated groups of corporations. Some States take into account the operations of foreign affiliates of the corporation doing business in the State to the extent that the foreign affiliates and the U.S. corporation are engaged in phases of a single "unitary" business. The practices of States in taxing dividend income from affiliated corporations also vary, depending in part on whether the income from which the dividend was paid was already subject to tax pursuant to apportionment. These State rules for determining the amount of income subject to tax differ in a number of respects from the methods employed by the Federal Government in determining the tax liability of multinational corporations.

Federal limitations on State taxation of corporations

The

Although the Constitution imposes some limitations on State apportionment methods, the States generally have considerable flexibility in determining their rules. Congress in 1959 enacted limited legislation dealing with State jurisdiction to tax, but has not prescribed any additional rules.

Legislative proposals

S. 1113

S. 1113 (introduced by Senator Mathias) would limit the manner in which States could tax income of foreign affiliates. Under the bill, States and localities would generally be prohibited, in applying their income tax to a corporation, from taking into account the income of any related foreign corporation. The provisions of the bill would apply regardless of whether the parent corporation of the group is foreign or domestic. In addition, the bill would limit the ability of States and localities to apply an income tax to dividends received by a corporation from foreign corporations or U.S. corporations, substantially all of whose income is from foreign sources. Generally, some or all of the dividends would be exempted from State taxation in order to take into account foreign taxes paid on that income. A separate exemption is provided in the case of dividends from corporations making an election under Code section 936. The bill would be effective for taxable years beginning after

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1986.

S. 1974

S. 1974 (introduced at the request of the Administration by Senators Wilson, Mathias, and Hawkins) would prohibit State use of the worldwide unitary combined reporting method. The bill would allow use of the combined reporting method for corporations within a water's edge group, consisting generally of corporations, both U.S. and foreign, with some threshold level of U.S. activity. The bill would limit State taxation of foreign source dividends (except in the case of the State of legal or commercial domicile). Further, the bill would impose reporting requirements on corporations subject to State tax, and would provide for sharing of

Federal information with States. The bill would be effective for taxable years beginning after 1986.

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Unitary method of apportionment for State taxation of corporate income

The question of State taxation of foreign source income is one aspect of the larger question of State taxation of businesses operating in more than one State. This larger question involves the problem of determining a State's jurisdiction for taxing a corporation's income and rules for apportioning and allocating that income among the States in which a corporation does business. Of the 45 States which impose a corporate income tax, all use some kind of formula to apportion business income between the various States in which a corporation operates. However, the specific formula used varies substantially from State to State.

In 1969, a group of States reacted to the possibility of Federal legislation (which would have required greater uniformity in apportionment) by adopting a multi-state tax compact, which established the Multistate Tax Commission whose duties are to establish uniform income tax regulations, auditing standards, and tax forms for member States. The Commission also established uniform rules regarding the allocation and apportionment of State corporate income. Presently, 19 States are members of the compact (the majority of the States are Midwestern and Western States). Under the compact, the regulations of the Multistate Commission are effective in all member States, but any member State can adopt overriding regulations if it chooses. Since most of these States have adopted some overriding regulations, the methods of taxing corporations still vary among States which are members of the compact. (The authority of the Multistate Tax Commission to operate as agent of the States in enforcing their corporate income tax laws was upheld by the U.S. Supreme Court in United States Steel Corp v. Multistate Tax Comm'n, 434 U.S. 452 (1978).)

Unitary method

The unitary method requires two steps for the apportionment of income to a particular State. First, the total amount of income subject to apportionment is determined. Second, the apportionable income is multiplied by a formula intended to reflect the portion of that income earned within the State. The resulting product is subject to the State's taxation.

Formula.--In determining income earned within a State, most States use some variation of a basic three-factor apportionment formula. Under this formula, the income of a

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business is apportioned to each State according to the average ratio of three factors: the ratio of sales, payroll, and tangible property values of the business in the State to the respective sales, payroll, and tangible property values of the total business. For example, a corporation which has one-half of the value of its tangible property, three-fourths of its payroll, and one-fourth of its sales in a particular State would take the average of these three fractions to determine the amount of income subject to tax in that State.2

Apportionable income.--A State's apportionment formula is applied only to that income of a corporation which is from a unitary business. In general, a corporation has a unitary business when the business activity from within the State is dependent upon, or contributes to, business activities of the same corporation outside of the State. Where the business activity in the State is unrelated to other businesses of the corporation outside of the State, so that there is no unitary business which is conducted in part within and in part outside of the State, all of the income from that business within that State is allocated to, and thus is taxed by, that State, and the income from the other businesses conducted outside the State is not allocated to, or taxed by, the State. Virtually all States include the income, and tangible property, payroll, and sales of foreign branches of domestic corporations in the income which is subject to their apportionment formula.

In general, a unitary business is considered to exist where, for example, a product is manufactured in one State and sold in another State, or where a product is partially manufactured in one State and then shipped to another State where the manufacturing is completed. The requirement to apportion income derives from the difficulty in determining how much of the total net income is attributable to the manufacturing operation and how much to the sales activity, in the first situation, and to the two manufacturing operations, in the second situation. However, such direct integration of business operations is not the sole criterion that has been used by the States to establish the existence

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Those States which do not follow this three-factor formula use other apportionment formulas, some based on sales only and others based on a combination of sales and property or sales and payroll or property and payroll. Even among those States which do use the three-factor formula, the manner of measuring the three items in the formula may differ. example, in some States a sale is taken into account by the State where the sale originated (generally, the location of the seller) while in other States the sale is allocated to the State of destination (generally where the buyer is located).