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

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 Affiliates

In states that neither require nor permit WWCR, the first opportunity for taxing the earnings of foreign affiliates occurs when they are repatriated to the U.S. parent via a dividend distribution. The receipt of a dividend from a foreign affiliate raises a number of issues, including whether it is included in apportionable income, the availability of a state DRD and whether factor relief is available.

Inclusion in Apportionable Income

In a series of decisions, the Supreme Court has established that dividends received from unitary affiliates or from equity interests that serve an operational function in the taxpayer's business can be constitutionally included in apportionable income. On the other hand, dividends received from affiliates engaged in discrete, nonunitary business enterprises or from equity interests that serve an investment function are taxable only in the state in which the taxpayer is commercially domiciled.(11) These principles apply whether the dividends are received from a domestic or a foreign corporation. For example, in Mobil Oil Corp. v. Comm'r of Taxes, (12) the Supreme Court held that Vermont was not constitutionally barred from taxing an apportioned share of the dividends that Mobil received from foreign affiliates that were part of its worldwide petroleum business enterprise, which included sales of petroleum products in Vermont.

The Court reaffirmed these principles in ASARCO, Inc. v. Idaho Tax Comm'n,(13) F.W. Woolworth Co. v. Tax'n and Rev. Dep't,(14) and, most recently, in Allied-Signal Inc. v. Director, Div. of Tax'n.(15) In Allied-Signal, the Court ruled that the taxpayer could exclude gain on the sale of stock from apportionable income because there was no unitary relationship between the taxpayer and the corporation whose stock it sold. The Court also indicated that stock ownership that serves an operational, rather than an investment, function in the taxpayer's business (e.g., stock held as working capital or a supplier's stock held to ensure a source of raw materials) can give rise to apportionable income.

DRD Availability

Under Sec. 243(a), corporate taxpayers can claim a DRD for 70% -100% of dividends received from domestic corporations; a DRD is generally not available for dividends received from foreign corporations.(16) Most states also provide some form of DRD, but the specific rules vary. Some states closely follow the Federal rules; others allow deductions in amounts and at ownership levels that differ from the Federal.(17)

In Kraft General Foods, Inc. v. Iowa Dep't of Rev.,(18) the Supreme Court ruled unconstitutional an Iowa taxing scheme that allowed taxpayers to deduct dividends received from domestic, but not foreign, corporations. During the years in question, Iowa used Federal taxable income after the DRD and net operating loss deduction as the starting point for computing Iowa taxable income, and provided no dividend-related state modifications. By strictly following the Federal rules, Iowa allowed taxpayers to exclude dividends received from domestic affiliates, while taxing dividends received from foreign affiliates (unless they represented distributions of domestic earnings). Because Iowa taxed only those dividends paid by foreign affiliates out of their foreign earnings, the Court ruled that the Iowa taxing scheme facially discriminated against foreign commerce, in violation of the Commerce Clause.

Since 1992, a number of state courts have struck down DRD schemes similar to that invalidated in Kraft.(19) In addition, a number of states have amended their laws so as to provide equal treatment of dividends from domestic and foreign affiliates. On the other hand, some combined reporting states continue to tax foreign, but not domestic, dividends, based on the theory that Kraft is limited to separate reporting states, such as Iowa Under a water's--edge combined reporting (WeCR) scheme, the earnings of unitary domestic affiliates are included in the combined return, but foreign affiliates' earnings are excluded; thus, a deduction for domestic dividends is necessary to avoid taxing domestic earnings twice, while foreign dividends represent the state's first opportunity to tax a foreign affiliate's earnings. Based on this line of reasoning, Kansas and Maine courts have ruled that their respective state taxing schemes do not discriminate against foreign commerce, despite taxing foreign, but not domestic, dividends.(20)

Factor Representation

The inclusion of dividends received from a foreign affiliate in the U.S. parent's apportionable income raises the corresponding issue of whether the parent's apportionment factors should reflect the affiliate's property, payroll and sales.(21) Justice Stevens raised the issue of factor representation in his dissent in Mobil, stating that,"unless 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."(22)

Example 1: USP, a domestic corporation, owns 100% of FSUB, a unitary foreign subsidiary. USP has nexus in state X, a separate-return state that taxes foreign dividends. X uses a sales-only apportionment formula. USP's and FSUB's sales and profits are as follows:

                 USP     FSUB     Total
Sales: Total   $1,000   $9,000   $10,000
        X         100      100       100
Profits            50      450       500

The amount of USP's income apportioned to X depends on the dividends paid by FSUB and whether X provides factor relief, as follows:

                   Apportionable   Apporntionment   State X
                      income         percentage      income

Case 1:
  FSUB pays no
  dividend            $ 50            10%[1]          $  5
case 2:
  FSUB pays $450
  dividend
  No factor
  representation       500(2)         10%(1)            50
Case 3:
  FSUB pays $450
  dividend
  Factor relief        500(2)          1%(3)             5

(1) $100 USP / $1,000 USP
(2) $50 USP profits + $450 dividend from FSUB
(3) ($100 USP + #0 FSUP) / ($1,000 USP + $9,000 FSUB)

In case 1, the $5 of income apportioned to X appears reasonable in light of USP's X100 of X sales and the 5% margin that USP realized on its total sales ($50 profits . $1,000 total sales). In case 2, $50 of income is apportioned to X an unreasonably high amount in light of USP's X sales. In case 3, factor relief brings the amount of income apportioned to X in line with USP's X sales and USP's typical profit margin.

Is Factor Relief Constitutionally Required?

The Due Process and Commerce Clauses require that"the factor or factors used in the apportionment formula must actually reflect a reasonable sense of how income is generated."23 The basis for treating dividends as apportionable business income is that the dividends are, in substance, operating income of a unitary business jointly carried on by the payor and payee corporations.(24) If dividends are to be characterized as operating income of a unitary enterprise that includes the payor corporation, one could argue that the applicable apportionment factors will reflect a "reasonable sense of how income is generated" only if those factors include the payor's property, payroll and sales.(25)

Although the Supreme Court has yet to address this issue, numerous state courts have; the taxpayers in those cases were parent corporations with nexus in a state that has adopted a group reporting method that does not allow an affiliates factors in the apportionment formula. The principal issue in these cases is whether such apportionment schemes violate the Due Process and Commerce Clauses' fair apportionment requirement. To strike down a state's apportionment scheme as unfair, the taxpayer must prove "by `clear and cogent evidence' that the income attributed to the state is in fact tout of all proportion to the business transacted in that...state' (26)...or has `led to a grossly distorted result.'" (27) Therefore, these cases often turn on the highly subjective issue of whether the apportionment in question falls"within the substantial margin of error inherent in any method of attributing income among the components of a unitary business."(28) Thus, it is not surprising that the results of these cases have been mixed, with some courts denying factor relief and other courts recognizing it to varying degrees.(29)

The Detroit Formula

One approach to providing factor relief is the "Detroit formula," named after a 1979 agreement between Ford Motor Company and the city of Detroit.(30) Under this method, if a foreign affiliate's dividends are included in the U.S. parent's apportionable income, the parent's apportionment factors are modified by including in their denominators the percentage of the subsidiary's property, payroll and sales that the dividends received from the affiliate bear to the affiliate's net profits (not to exceed 100%).(31)

Example 2: The facts are the same as in Example 1; in addition, FSUB distributed a $50 dividend to USP

The amount of USP's income apportioned to X depends on whether and how X provides factor relief, as follows:

                     Apportionable   Apportionment   State X
                        income        percentage     income
Case 1:
  FSUB pays $50
  dividend
  No factor relief      $100(1)       10%(2)          $10

Case 2:
  FSUB pay $50
  dividend
  Full factor relief     100(1)        1%(3)            1

Case 3:
  FSUB pay $50
  dividend
  Detroit formula         100(1)        5%(4)            5

(1) $50 USP + $50 dividend from FSUB

(2) $100 USP / $1,000 USP

(3) ($100 USP + $0 FSUB) / ($1,000 USP + $9,000 FSUB)

(4) ($100 USP + $0 FSUB) / ($1,000 USP + $50/$450($9,000 FSUB))

In case 1, the lack of factor relief results in $10 of income being apportioned to X, which seems high in light of USP's $100 of X sales and the 5% margin that USP realized on its total sales ($50 profits - X1,000 total sales). In case 2, full factor relief overcompensates for this distortion, and apportions just $1 of income to X In case 3, the Detroit formula brings the amount of income apportioned to X in line with USP's X sales and USP's typical profit margin.

The Augusta Formula

An alternative approach to providing factor relief is the "Augusta formula," which was developed by the Maine State Tax Assessor in response to the Maine Supreme Court's decision in Tambrands, Inc. v. State Tax Ass'r.(32) Under the Augusta formula, a corporate taxpayer must compute its taxable income in three ways:

1. Using WeCR without a DRD for foreign dividends and without factor relief (WeCR-no DRD).

2. Using WeCR with a DRD for foreign dividends (WeCR-DRD). (Factor relief is a moot issue because dividends are not included in apportionable income.)

3. Using WWCR, under which unitary foreign affiliates' earnings are included in apportionable income, and the apportionment factors reflect the affiliates' properly, payroll and sales.

If a taxpayer's income under WeCR-no DRD exceeds that under WWCR, the taxpayer can use WWCR, which provides factor relief. However, if the taxpayer's income under WWCR is less than that under WeCR-DRD, the taxpayer must use the latter.(33) Example 3: USP, a domestic corporation, owns 100% of FSUB, a unitary foreign subsidiary. USP has nexus in state X, which is a WeCR state that taxes foreign dividends. X uses a sales-only apportionment formula. USP's and FSUB's sales and profits are as follows:

                  USP     FSUB     Total

Sales: Total    $1,000   $9,000   $10,000
       X           100   0        100

Profits             30   470      500

Dividends
  (from FSUB)      470

The amount of USP's income apportioned to X under the Augusta formula is $5, computed as follows:

                      Apportionable   Apportionment   State X
                         income        percentage     income

Case 1: WeCR-no DRD     $500(1)          10%(2)         $50
Case 2: WeCR-DRD          30             10%(2)           3
Case 3: WWCR             500(3)           1%(4)           5

(1) $30 USP profits + dividend from FSUB

(2) $100 USP / $1,000 USP

(3) $30 USP profits + $470 FSUB profits

(4) ($100 USP + $0 FSUB) / ($1,000 USP + $9,000 FSUB)

In case 1, the lack of factor relief results in X50 of income being apportioned to X which seems unreasonably high in light of USP's $100 of X sales and the 3% margin that USP realized on its total sales ($30 profit X1,000 total sales). Factor relief is provided by allowing USP to use WWCR, which brings the income apportioned to X ($5) in line with USP's X sales and its typical profit margin.

The California Twist-Cap Formula

A third approach to providing factor relief is the "California twist cap formula," which is similar to the Augusta formula in that WWCR is used to check the fairness of a state's standard approach.(34) Under this method, the foreign affiliate's earnings multiplied by the U.S. parent's ownership percentage in that entity are included in apportionable income. Factor relief is provided by including in the denominators of the parent's factors the parent's ownership percentage multiplied by the subsidiary's property, payroll and sales. This is a modified WWCR approach (i.e., the California method with a "twist"). If this approach results in less income being apportioned to the taxing state than the state's standard approach, the taxpayer may use it. If WWCR apportions more income to the taxing state than the standard approach, the standard approach is used (i.e., the "cap" on the twist method).

Example 4: USP, a domestic corporation, owns 100% of FSUB, a unitary foreign subsidiary. USP has nexus in state X which is a separate-return state that taxes foreign dividends. X uses a sales-only apportionment formula. USP's and FSUB's sales and profits are as follows:

                  USP     FSUB     Total

Sales: Total    $1,000   $9,000   $10,000
       X           100        0       100
Profits             50      450       500
Dividends
  (from FSUB)      450

The amount of USP's income apportioned to X under California twist-cap formula is $5, computed as follows:

                         Apportionable   Apportionment   State X
                            income         percentage    income
Separate-return method     $500(1)           10%(2)       $50
WWCR                        500(3)            1%(4)         5

(1) $50 USP profits + $450 dividend from FSUB

(2) $100 USP profits + $1,000 USP

(3) $50 USP profits + $450 FSUB profits

(4) ($100 USP + $0 FSUB / ($1,000 + USP + $9,000 FSUB)

Because the amount of income apportioned to X under WWCR ($5) is less than that under X's separate-return approach ($50), USP can use WWCR to compute its X income tax.

Sec. 78 Gross-Up Income and Subpart F Inclusions

For Federal tax purposes, a U.S. parent is generally taxed on the dividends received from foreign affiliates. However, because the amount of dividend income recognized is net of foreign income taxes incurred by the foreign affiliate, the U.S. parent is implicitly allowed a deduction for those foreign taxes. The U.S. parent can also claim a deemed-paid FTC under Sec. 902 for the foreign income taxes incurred by a 10%-or-more-owned foreign affiliate. To prevent a double tax benefit, Sec. 78 requires the U.S. parent to gross up its dividend income by the amount of the deemed-paid credit, thereby eliminating the implicit deduction.(35) The rationale for the "Sec. 78 gross-up" amount does not apply for state tax purposes, because no state allows a credit for foreign income taxes; thus, most states allow taxpayers to exclude Sec. 78 gross-up amounts from state taxable income, either by extending the DRD to such amounts or by providing a subtraction modification.(36)

Under subpart F, certain types of undistributed foreign earnings of a controlled foreign corporation (CFC) are subject to immediate U.S. taxation at the U.S.-shareholder level.(37) Specifically, a U.S. shareholder of a CFC must include in gross income a deemed dividend equal to its pro rata share of the CFC's insurance and foreign base company sales income, as well as any earnings invested in U.S. property.(38) As with the Sec. 78 gross-up, most states allow taxpayers to exclude subpart F inclusions from state taxable income, either by extending the DRD to such amounts or by providing a subtraction modification.

Interest and Royalties

The determination of whether a state can constitutionally require a U.S. parent to include interest and royalties received from foreign affiliates in apportionable income is similar to that for dividends. As with dividends, interest and royalties received from unitary affiliates or from assets that serve an operational function in the taxpayer's business can be constitutionally included in the recipient's apportionable income. On the other hand, interest and royalties received from affiliates engaged in discrete, nonunitary business enterprises or from assets that serve an investment function are taxable only in the state in which the domiciled.

The inclusion of interest and royalties in the U.S. parent's apportionable income raises the corresponding issue of whether the parent's apportionment factors should reflect the subsidiary's property, payroll and sales.(39) As with dividend income, the Supreme Court has yet to address the issue of whether factor relief is constitutionally required for interest and royalties; state court decisions have yielded mixed results.(40) However, the analysis is somewhat different; unlike dividends (which represent distributions of a foreign affiliate's earnings), the foreign affiliate does not pay foreign income tax taxpayer is commercially on deductible interest or royalty payments, because the U.S. parent is the entity that earns the interest and royalties in question. In addition, to the extent interest and royalties are treated as business income, these receipts are generally included in the denominators of the U.S. parent's sales factor under Multistate Tax Commission Reg. IV. 15.(a).(1), which provides some factor relief.

Conclusion

Economic globalization has made state taxation of a U.S. multinational corporation's foreign operations a cutting-edge tax issue for the foreseeable future. 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. Although states can constitutionally require WWCR, presently, no state mandates its use. Factor relief is the most unsettled issue with respect to the taxation of foreign dividends, interest and royalties, and probably will remain so until the Supreme Court considers the matter.

(1) U.S. Department of Commerce, "U.S. Direct Investment Abroad: Detail for Historical-Cost Position and Related Capital and Income Flows, 1995," 76 Survey of Current Business 9 (Sept. 1996), pp. 103-105, Tables 6, 8 and 9.

(2) Sec. 7701(a)(4) defines a domestic corporation as any corporation created or organized in the U.S. or under the law of the U.S. or any state.

(3) See Secs. 881 and 882.

(4) An exception under Sec. 1504(d) applies to Mexican and Canadian subsidiaries formed to comply with local laws.

(5) See e.g., Mobil Oil Corp. v. Comm'r of Taxes, 445 US 425, 436 (1980).

(6) Complete Auto Transit, Inc. v. Brady, 430 US 274, 279 (1977).

(7) Japan Line, Ltd. v. County of Los Angeles, 441 US 434, 444 (1979).

(8) container Corp. of America v. FTB, 463 US 159 (1983).

(9) Barclays Bank PLC v. FTB and Colgate-Palmolive Company v FTB, 114 Sup. Ct. 2268 (1994).

(10) WWCR creates a number of administrative difficulties, such as defining the bounds of a worldwide unitary business, conforming foreign financial statements to U.S. generally accepted accounting principles, translating financial statement amounts maintained in a foreign currency into their U.S. dollar equivalents, and making the books and records of foreign affiliates accessible to state auditors.

(11) Uniform Division of Income for Tax Purposes Act Section 1(b) defines a corporation's commercial domicile as the principal place from which the trade or business is directed or managed.

(12) Mobil, note 5

(13) ASARCO, Inc. v Idaho Tax Comm'n, 458 US 307 (1982).

(14) F.W. Co. v Tax'n and Rev Dep't, 458 US 354 (1982).

(15) Allied-Signal Inc. v Dir, Div. of Tax'n, 504 US 768 (1992).

(16) An exception applies under Sec. 245(a) if a domestic corporation owns at least 10% of a foreign corporation that distributes a dividend out of post-1986 undistributed earnings attributable either to income effectively connected with the conduct of a US. trade or business or to dividends received from a domestic subsidiary.

(17) The rationale for allowing a state DRD is presumably the same as that for Federal purposes (i.e., to avoid taxing a corporate group's earnings a second time when a subsidiary distributes a dividend to its parent). However, a state DRD can also result in no state taxation of the underlying earnings, if the subsidiary operates solely in a state that does not tax corporate income.

(18) Kraft General Foods, Inc. v. Iowa Dep't of Rev., 505 US 71 (1992).

(19) See, e.g., Conoco, Inc., and Intel Corp. v. Tax'n & Rev. Dep't, N.M. Sup. Ct., No. 22,995 and 23,045 (11/26/96); Dart Industries, Inc. v Clark, 657 A2d 1062 (R.I. 1995); and Wisc. Dep't of Rev. v. NCR Corp., Wisc. Cir. Ct., No. 92 CV 1516 and 92 CV 1525 (4/30/93).

(20) See Appeal of Morton Thiokol Inc., 864 P2d 1175 (Kans. 1993), and E.I. du Pont de Nemours & Co. v. State Tax Ass'r, 675 A2d 82 (Me. 1996); see also Ruez, Mathews and Boucher, "Current Corporate Income Tax Developments '28 The Tax Adviser 164 (March 1997).

(21) Factor relief is moot when a dividend is treated as nonbusiness income; nonbusiness income is taxable only in the state in which the recipient is commercially domiciled.

(22) Mobil, note 5, p. 461.

(23) Container, note 8, p. 169.

(24) To exclude dividends from apportionable income, the taxpayer must "demonstrate something about the nature of the income that distinguishes it from operating income." Mobil, note s, p. 437.

(25) A different analysis may be required if the dividend is apportionable income, because the equity interest in the payor corporation serves an operational (rather than an investment) function in the recipient's business.

(26) Container, note 8, p. 169, citing Moorman Mfg. Co., 437 US 267, 274 (1978). The Court referred to this requirement as the "external consistency" standard; apportionment schemes must also satisfy an "internal consistency" standard, which requires that no more than 100% of a taxpayer's income would be taxed if all states adopted the formula in question.

(27) Container, note 8, p. 169, citing Norfolk & W.R. Co. v. Missouri State Tax Comm'n, 390 US 317,326 (1968).

(28) Container, note 8, p. 184.

(29) See e.g., American Tel. & Tel. Co. v. Dep't of Rev., 422 NW 2d 629 (Wise. Ct. App. 1988); NCR Corp. v. Comptroller of the Treasury, 544 A2d 764 (Md. 1988); NCR Corp. v. Comm'r of Revenue, 438 NW2d 86 (Minn. 1989), cert. denied; NCR Corp. v. Tax Comm'n, 439 SE2d 254 (S.C. 1993), cert. denied; NCR Corp. v. New Mexico Tax'n & Rev. Dep't, 856 P2d 982 (N.M. Ct. App. 1993), cert. denied; Wisc. Dep't of Rev. v. NCR Corp., note 19; Albany Int'l Corp. v. Wisc. Dep't of Rev., Wisc. Tax App. Comm'n, No. 90-1-290 (5/23/94); NCR Corp. v. Comm'r of Rev., Mass. App. Tax Bd., No. 147997, 168150, 168151 and 168152 (5/30/96); and Caterpillar, Inc. v. Comm'r of Rev., Minn. Tax Ct.. No. 6633 (11/14/96).

(30) For a discussion of New Mexico's use of the Detroit formula, see Conoco, note 19.

(31) By scaling the amount of factor relief by the ratio of dividends received to net profits, the Detroit formula takes into account not only the percentage of current-year profits distributed by the affiliate, but also the parent's percentage ownership of that affiliate. On the other hand, the Detroit formula does not take into account differences between the year in which an affiliate earns (as opposed to distributes) its income, nor does it make adjustments for affiliate-level earnings from nonunitary activities.

(32) Tambrands, Inc. v. State Tax Ass'r, 595 A2d 1039 (Me. 1991); see E.I. du Pont de Nemours, note 20.

(33) This exception would apply if the taxpayer's U.S. operations were more

(34) For discussion of the California twist-cap method, see NCR Corp. v. Wisc. Dep't of Rev., Wisc. Tax App. Comm'n, No. I-8669 and 87-I-359 (2/10/92), aff'd in part, rev'd in part and rem'd sub nom. Wisc. Dep't of Rev. v. NCR Corp., note 19.

(35) U.S. corporations claiming an FTC in 1992 reported over $13.2 billion of Sec. 78 gross-up income; see IRS, "Corporate Foreign Tax Credit, 1992: An Industry and Geographic Focus," SOI Bulletin (Winter 1995-1996), p. 115, Table 1.

(36) By excluding Sec. 78 gross-up amounts from taxation, states are effectively allowing the implicit deduction for foreign income taxes incurred by the foreign affiliate to flow through for state tax purposes.

(37) See Secs. 951-964. According to Sec. 957(a), a foreign corporation is a CFC if U.S. shareholders own more than 50% of the foreign corporation's stock (by vote or value). The benefits of deferral are also denied to U.S. shareholders of a passive foreign investment company or a foreign personal holding company.

(38) U.S. corporations claiming an FTC in 1992 reported almost $12.6 billion in subpart F inclusions; see SOI Bulletin, note 35, Table 1.

(39) Factor representation is a moot issue when interest or royalties are treated as nonbusiness income; such income is generally taxable only in the state in which the taxpayer is commercially domiciled.

(40) Many of the decisions cited in note 29 also address the issue of factor relief for interest and royalties.

RELATED ARTICLE: EXECUTIVE SUMMARY

* 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.

* Although states can constitutionally require WWCR, at present, no state strictly requires its use; thus, a state's first opportunity for taxing the earnings of foreign affiliates typically occurs when those earnings are repatriated to the U.S. parent through a dividend distribution.

* Dividends, interest and royalties received from unitary affiliates or from assets that serve an operational function in the taxpayer's business can be constitutionally included in the recipient's apportionable income; in the case of dividends, most states provide some form of a DRD.