State And Local Tax Insights: Spring 2013

Edited by Jenny Choi and Nicole L. Johnson

FACTOR REPRESENTATION: IS IT UNCONSTITUTIONAL FOR A STATE TO HAVE IT BOTH WAYS?

By Mitchell A. Newmark and William T. Pardue

A state cannot include income in the apportionable base and then exclude the receipts and related factors that generated that very same income from the apportionment formula. Factor representation is not only a matter of being fair, it is mandated by the U.S. Constitution.

Factor representation ensures that the property, payroll and/or sales factors of a state's apportionment formula include the amounts that are attributable to the generation of that income which a state included in its apportionable base. For example, in the case of a gain realized by a corporation from the sale of a business that operated outside the United States, if the gain is included in apportionable income, the sales factor should include the receipts from the sale. Factor representation can be accomplished either by: (1) including the gain in the apportionable income base and including the receipts in the sales factor; or (2) excluding the gain from the apportionable income base and excluding the receipts from the sales factor. States that include the income in the base and exclude the receipts from the sales factor are trying to have it both ways by not matching the income base with the factors related to the production of that same income. The result of the mismatch will almost always be an overstatement of the income apportioned to that state.

Despite the importance of factor representation, a number of state legislatures have enacted statutory apportionment formulas in which the factors do not match the apportionable income base. For example, Minnesota excludes sales of capital assets from its sales factor, but it has no statute providing for their mandatory exclusion from the apportionable income base.1 The result is a violation factor representation. States have the option of either matching the income in the base with the factors that contributed to the generation of that income or excluding income from the base when it is too difficult to determine the matching factors.

Factor representation should not be confused with what is frequently referred to as "factor relief." Factor relief can be necessary when a state's normal allocation and apportionment formula does not fairly represent the taxpayer's business activity in that state.2 In such a case, an alternative apportionment formula could be utilized in order to provide relief from the unfair application of the state's normal apportionment formula.

U.S. Constitutional Requirement of Factor Representation

Justice Stevens' Dissent in Mobil Oil Corp. v. Vermont

U.S. Supreme Court Justice John Paul Stevens explained factor representation in his dissenting opinion in Mobil Oil Corp. v. Vermont.3 That case involved Mobil Oil's challenge to Vermont's treatment of dividend income that Mobil Oil received from subsidiaries and affiliates conducting business outside of the United States.4 The majority opinion held that Vermont was not precluded from taxing foreign-source dividend income received by a non-domiciliary corporation.5

Specifically, the Vermont apportionable income computation for Mobil Oil (which was organized under the laws of New York and headquartered in New York) included foreign-source dividend income.6 However, the factors that created the dividend income, namely the payroll, property and sales of the subsidiaries and affiliates that were conducting business outside of the United States, were not included in the computation of Mobil Oil's apportionment formula.7 Vermont refused to grant Mobil Oil's request for factor representation.8

The majority of Justices declined to rule on the factor representation issue on the basis that Mobil Oil expressly did not challenge the formula in its briefs and, instead, only challenged inclusion of the foreign sourced dividend income in its apportionable income base.9

After concluding that the factor representation issue was sufficiently before the Court, Justice Stevens wrote in his dissenting opinion that:

[u]nless the sales, payroll, and property values connected with the production of income by the payor corporations are added to the denominator of the apportionment formula, the inclusion of earnings attributable to those corporations in the apportionable tax base will inevitably cause Mobil's Vermont income to be overstated.10

The Majority Opinion in Container Corp. of America v. Franchise Tax Board

Only three years later, the U.S. Supreme Court majority saw the wisdom of Justice Stevens' explanation of factor representation and so commented in Container Corp. of America v. Franchise Tax Board.11 Although the Court did not make a formal endorsement of factor representation, it spent several pages of the opinion discussing the constitutional requirements for apportionment formulas.12 As explained by the Court, a state must apply an apportionment formula that is fair under the Due Process Clause and the Commerce Clause under both an internal consistency test and an external consistency test.13 An apportionment formula is fair under the internal consistency test when the formula, if applied by every jurisdiction, would not result in more than all of the unitary business' income being taxed.14 An apportionment formula is fair under the external consistency test when the factor or factors used in the formula actually reflect a reasonable sense of how the income being apportioned was generated.15

The U.S. Supreme Court placed additional limits on apportionment formulas.16 For example, the Court stated that an apportionment formula may not result in discrimination against interstate or foreign commerce (under the Commerce Clause) and may not be distortive (under the Due Process and Commerce Clauses).17 The U.S. Supreme Court reminded states that it "will strike down the application of an apportionment formula if the taxpayer can prove 'by clear and cogent evidence' that the income attributed to the State is in fact 'out of all appropriate proportions to the business transacted in that State' or has led to a grossly distorted result."18

External Consistency and Factor Representation

A lack of factor representation in an apportionment formula causes the formula to fail the test for external consistency. Take the example of Vermont's apportionment formula in Mobil Oil wherein Vermont included the dividends received from non-United States subsidiaries and affiliates in the apportionable income base of a foreign corporate taxpayer, but did not include any of the property, payroll or sales of those same affiliates in Mobil Oil's apportionment factors.19 To be valid under the external consistency test, the apportionment formula must include factors that reflect a reasonable sense of how the income was generated.20 As the factors in Vermont's apportionment formula excluded all of the inputs that created the dividends that were apportioned, the factors did not reflect the generation of the income by the non-United States subsidiaries and affiliates. Therefore, Vermont's formula employed in Mobil Oil fails the external consistency test from Container Corp.21 Factor representation is an important aspect of ensuring that an apportionment formula satisfies the constitutional test for external consistency. A formula lacking factor representation does not meet the U.S. Supreme Court's requirements for apportionment formulas.22

The Difficulty of Apportionment Is No Defense for Denial of Factor Representation

The U.S. Supreme Court has explained the requirements for apportionment formulas in depth and put states on notice that a formula will be struck down if it does not meet constitutional requirements.23 States that rely upon the purported difficulty of creating a perfect apportionment formula as a defense for adopting formulas that do not provide factor representation are misguided. Perhaps Justice Stevens said it best when he explained that if it was too difficult for Vermont to determine how to arrive at the correct apportionment factors, Vermont could simply exclude the dividend income from the apportionable base.24 Although apportionment is not an exact science, the defects created by failing to provide for factor representation can be easily remedied. A taxing authority can either include the factors that contributed to the generation of any income included in the apportionable base or, if it proves too difficult to ascertain those factors, the taxing authority can exclude that income from the apportionable base. Both scenarios result in factor representation.

State Courts Requiring Factor Representation

Some state courts have recognized the constitutional requirement of factor representation and have invalidated attempts by taxing authorities to deny factor representation. For example, Rhode Island included the distributions from partnerships not conducting business in the State in the corporate taxpayer's apportionable income base but excluded the factors of those same partnerships from the apportionment formula.25 The Rhode Island Supreme Court correctly held that the exclusion of proportionate property, payroll and sales factors from the apportionment equation while including the income from those same partnerships was "manifestly inequitable."26 Further, the court stated that the State had a "duty" to employ an alternative apportionment formula to remedy the denial of factor representation.27

Similarly, the Wisconsin Court of Appeals held that an apportionment formula that lacked factor representation was invalid under the Due Process and Commerce Clauses of the U.S. Constitution, as well as State law.28 Specifically, with respect to a foreign corporate taxpayer, Wisconsin included income from dividends, interest and royalties paid by AT&T's subsidiaries in AT&T's apportionable income base, but excluded the subsidiaries' significant property from AT&T's...