Drop shipments, destination sales, and the multi-factor apportionment statute: a critical review of Stryker Corporation v. Director, Division of Taxation.

Most States use a three-factor apportionment formula in apportioning corporate income and net worth taxes of multi-state businesses(1). Those factors are property, payroll, and sales.(2) New Jersey is among those States. The relevant statute(3) requires that the three factors (or fractions) be averaged, with double weight now given to the sales factor, which is defined, as follows:

The sales fraction is the receipts of the taxpayer, computed on the cash or accrual basis according to the method of accounting used in the computation of its net income for federal tax purposes, arising during such period from --

1) sales of its tangible personal property located within this State at the time of the receipt of or appropriation to the orders where shipments are made to points within this State,

2) sales of tangible personal property located without the State at the time of the receipt of or appropriation to the orders where shipment is made to points within the State,

3) (Deleted by amendment)

4) services performed within the State,

5) rentals from property situated, and royalties from the use of patents or copyrights within the State,

6) all other business receipts (excluding dividends excluded from entire net income by [N.J.S.A.54: 10A-4]) earned within the State, divided by the total amount of the taxpayer's receipts, similarly computed, arising during such period from all sales of its tangible personal property, services, rentals, royalties and all other business receipts, whether within or without the State.(4)

Courts in other jurisdiction containing statutes similar to New Jersey's have held that so-called destination sales -- i.e., sales of tangible personal property originally located in State A but shipped to the purchaser's location in State B -- are not apportionable to State A, absent the application of a "throwback" rule.(5)

This background leads to an examination of the decision of the Tax Court of New Jersey in Stryker Corporation v. Director, Division of Taxation,(6) where the court held that the taxpayer's sales of tangible personal property in New Jersey to its wholly owned New Jersey subsidiary were apportionable to New Jersey, even though the taxpayer made drop shipments of the product directly to its subsidiary's out-of-state customers. The court ruled that the drop shipment sales to the subsidiary's out-of-state customers were not taxable (i.e., were not apportionable) in New Jersey under N.J.S.A. 54:10A-6(B)(1) as sales of tangible personal property shipped to points in New Jersey, but that the sales were taxable in New Jersey as "other business receipts" within the purview of N.J.S.A. 54:10A-6(B)(6).

The relevant facts may be readily stated. The taxpayer, a Michigan corporation doing business in New Jersey, manufactured orthopedic hips and knees in New Jersey, and sold them to Osteonics Corp., its wholly owned subsidiary. Osteonics was a New Jersey corporation whose only business was marketing and sale of the orthopedic hips and knees manufactured in New Jersey by the taxpayer. Osteonics and the taxpayer occupied space in the same buildings in Allendale, New Jersey.

During the audit years (1988-1992),(7) the orthopedic hips and knees manufactured by the taxpayer were sold to Osteonics for resale to the latter's customers. Those customers placed orders with Osteonics, which upon receipt of an order entered it into Osteonics's computer system, identifying the customer and its billing address, the shipping address, the product purchased, and the price at which it was sold to the customer. After inputting and processing a customer order, Osteonics placed its order with the taxpayer via an in-line computer. The taxpayer performed all shipping, receiving, warehouse, and distribution functions. Thus, upon receipt of the order from Osteonics, the taxpayer's personnel located the product ordered, packed it, and, pursuant to the delivery instructions entered on the computer system by Osteonics, shipped the product to Osteonics's customer either within or outside of New Jersey. If a product was not available in the taxpayer's inventory, the order would be sent to the taxpayer's manufacturing department. After the product was manufactured, the taxpayer would package and ship it directly to Osteonics's customer pursuant to computerized shipping instructions. The taxpayer thereafter confirmed the shipment of each order to Oestonics for the latter's billing to its customer. The products were shipped from the taxpayer's Allendale facility via common carrier F.O.B. Allendale.

The taxpayer did not provide a written bill or invoice to Osteonics for each product order. Rather, personnel of the taxpayer and Osteonics would meet quarterly to review Osteonics's receipts and sales in order to determine and implement price and profit allocations. The upshot was an allocation designed to provide the taxpayer with certain expense reimbursements, including the cost of administrative services provided to Osteonics by the taxpayer and a profit margin.

Osteonics's pricing to its customers included a gross profit margin of approximately 20 percent. Thus, in allocating Osteonics's receipts from sales between Osteonics and the 20-percent gross profit to Osteonics was subtracted and the balance allocated to the taxpayer.

For that purposes, the taxpayer allocated to the destination state all sales to Osteonics that the taxpayer drop-shipped to the latter's out-of-state customers, thereby excluding those sales from the numerator of the receipts fraction under N.J.S.A. 54:10A-6(B). The taxpayer included in the numerator of such fraction Osteonics's sales that the taxpayer drop-shipped to Osteonics's New Jersey customers. Following an audit, the Director determined that the numerator of the taxpayer's receipts fraction should include all sales to Osteonics, regardless of the destination to which products were shipped. Thus, the Director assessed additional Corporation Business Tax of $1,326,204, plus interest calculated to February 15, 1996.

The taxpayer thereafter filed a timely complaint with the Tax Court seeking review of the Director's decision. In response, the Director argued that the taxpayer's sales to Osteonics were taxable under N.J.S.A. 54:10A-6 (B)(1), even though the products involved were drop-shipped directly by the taxpayer to Osteonics's out-of-state customers. The Tax Court thoroughly reviewed both cases from other jurisdictions and the specific language of N.J.S.A. 54:10A-6(B)(1) and then rejected the Director's position, concluding that there was no "shipment" of merchandise to points within New Jersey; rather, the shipments were made directly to Osteonics's out-of-state customers. Accordingly, the court held, Osteonics's sales of products to its out-of-state customers, drop-shipped by the taxpayer directly to those customers in accordance with a pre-existing agreement, were not taxable in New Jersey under N.J.S.A. 54:10A-6(B)(1).(8)

It is difficult to disagree with the court's conclusion on the applicability of N.J.S.A. 54:10A-6(B)(1). The court's holding on the application of N.J.S.A. 54:10A-6(B)(6) is another matter entirely. The court concluded that the sales from the taxpayer-manufacturer to its subsidiary-retailer were taxable as "all other business receipts earned in [New Jersey]" pursuant to N.J.S.A. 54:10A-6(B)(6)(9) In arriving at this conclusion, the court rejected the taxpayer's argument that N.J.S.A. 54:10A-6(B)(1) is dispositive of the taxability of receipts from shipments of tangible personal property.(10) It held that the receipts previously excluded from the application of N.J.S.A. 54:10A- 6(B)(1) as sales to out-of-state customers should be swept back into the numerator of the receipts (now sales) fraction under subsection (B)(6) as "all other business receipts" earned in New Jersey on the ground that the drop shipment transactions were sales for resale to Osteonics, shipped directly to the latter's customers by the taxpayer, thereby generating receipts "earned in New Jersey" by the taxpayer.(11)

The court was wrong. The statute is crystal clear. It sets forth four specific categories of receipts:(12)

1) sales of tangible personal property located in New Jersey where shipments are made to points in New Jersey;

2) sales of tangible personal property located outside New Jersey where shipments are made to points within New Jersey;

3) services performed within New Jersey; and

4) rentals from New Jersey property, and royalties from the user of patents or copyrights within New Jersey.

The enumeration of these specific categories is followed by subsection (B)(6), which includes in the receipts fraction "all other business receipts [excluding non-taxable dividends] earned within the State." (Emphasis supplied.)

The word "other" is key to the subsection (B)(6) catch-all, because it limits the types of receipts to be caught in the (B)(6) basket to receipts other than those theretofore enumerated in sub-sections (B)(1) that are otherwise through (5).(13)

Because the receipts (now sales) fraction of N.J.S.A. 54:10A-6(B) is designed to include and allocate all items includible as income in the tax base,(14) subsection (B)(6) is designed to capture all other business income not covered specifically by the prior subsections. The relevant regulations clarify that these (B)(6) leftover items of income will generally be intangibles, such as interest income, dividends, governmental subsidies, or proceeds from the sale of scrap.(15) The plain language of the receipts fraction precludes the use of (B)(6) as a catch-all for sales of tangible personal property that are otherwise excluded from the numerator of the fraction because they are beyond the ambit of (B)(1) or (B)(2). That is to say, there is no physical shipment to a point within New Jersey.

It is a fundamental principle of statutory construction that the more specific language of a statute (here (B)(1) and (B)(2))prevails over the merely general (here (B)(6).(16) Also, the language of (B)(1), (B)(2), and (B)(6) leaves no doubt that "sales of ... tangible personal property" and "all other business receipts" do not overlap. Any other reading would require a finding of superfluous language, a result at variance with well-established canons of statutory construction.(17)

There is another flaw in the court's analysis: The strained construction of (B)(6) as sweeping in sales of tangible personal property excluded from income by (B)(1) is at variance with a cardinal principle of the interpretation of taxing statutes, namely, taxing provisions are not extended by implication beyond the clear import of the language used.(18) In case of doubt, the statute is construed most strongly against the government and in favor of the citizen.(19)

The court's Procrustean attempt to apply the analysis in Steelcase, Inc. v. Director, Division of Taxation,(20) a sales and use tax case, to the facts in Stryker to justify the court's construction of (B)(6) is simply unsound. The court in Steelcase was concerned only with whether drop shipments by the manufacturer to a retail dealer's customer were exempt from sales tax as a sale for resale. The concept of the drop shipment as an implementation of a destination sale played no role in the court's decision.(21) The court's conclusion in Stryker that there were two sales involved in each transaction,(22) as there were in Steelcase, is irrelevant. In each transaction, there was only one shipment, and the shipment determines the locus of taxation.

The New Jersey Legislature, by its enactment of N.J.S.A. 54:10A-6(B)(1), has adopted the "destination sale" concept that prevails in all 46 states that employ a receipts or sales factor in their apportionment statutes.(23) Indeed, the Stryker court acknowledged that the concept was embedded in N.J.S.A. 54:10A-6(B)(1). The court unfortunately attempted to vitiate the destination sale concept by ascribing a contrary meaning to subsection (B)(6), notwithstanding the clear statement concerning "all other receipts."

The effect of the court's holding is to impose a "throwback" rule where no statute authorizes it. That is to say, the court's interpretation of subsection (B)(6) is tantamount to sourcing sales back to New Jersey, notwithstanding the statutory sanction of destination sales, because the taxpayer has no constitutional nexus with the destination state, and is, therefore, not taxable in that state. The so-called throwback rule, as set forth in section 16(b) of the Uniform Division of Income for Tax Purposes Act (UDITPA), a uniform statute adopted in many states (but not in New Jersey), sources sales of tangible personal property in the state of origin where the seller is not taxable in the state of the purchaser (i.e., the destination state).(24)

The throwback cannot be based on an administrative regulation alone; there must be statutory authorization for the rule.(25) And no such authorization exists under New Jersey law.

Finally, the court's reliance upon Hercules Inc. v. Utah State Tax Commission(26) is misplaced for two reasons. First, the Utah apportionment statute does not contain the equivalent of N.J.S.A. 54:10A-6(B)(6). Secondly, the Utah court's holding that the rocket motors sold and delivered to the purchaser in Utah were taxable in Utah, even though the purchaser intended to ship the rocket motors to Washington or California where they were to be used by the purchaser in the assembly of missiles, is at sharp variance with the destination sale concept that, as stated earlier, is the underlying rationale of N.J.S.A. 54:10A-6(B)(1).

Stryker is a case of first impression on two counts. First, there are no decisions in New Jersey and there appears to be none elsewhere -- dealing with the interaction of statutes such as N.J.S.A. 54:10A-6(B)(1) and (B)(6). Secondly, there appear to be no cases dealing with the role of drop shipments in the application of the destination sale rule.(27)

One can only hope that the Superior Court, Appellate Division, and, possibly, the New Jersey Supreme Court, will provide the necessary guidance in this area.

(1) See Jerome R. Hellerstein & Walter Hellerstein, 1 State Taxation [paragraph] 8.06 (2d ed. 1993).

(2) Id.

(3) N.J.S.A. [sections] 54:10A-6.

(4) The laws of two neighboring States, New York and Connecticut, contain similar provisions. See N.Y. Tax Law [subsections] 210(3)(a)(2)(A),(D); Conn. Gen. Stat. 8 12-218(c).

(5) Department of Revenue v. Parker Banana Co., 391 So.2d 762 (Dist Ct. of Appeal of Florida 1980); Olympic Brewing Co. v. Commissioner of Revenue, 326 N.W.2d 642 (Minn. Sup. Ct. 1982); Revenue Cabinet v. Rohm and Haas Kentucky, Inc., 929 S.W.2d 741(Ky. Ct. of App. 1996). The "throwback" rule is discussed in the text that follows.

(6) 18 N.J. Tax 270 (Tax 1999), appeal pending.

(7) The audit years antedated the change in N.J.S.A. [sections] 54:10A-6 giving double weight to the sales factor.

(8) 18 N.J. Tax at 282-83.

(9) Id. at 285-86.

(10) Id. at 284-85.

(11) Id. at 286-87.

(12) After the audit period in issue the name of what was formerly the "receipts" fraction was changed to the "sales" fraction. L. 1995, c. 245.

(13) (B)(3) was deleted by amendment.

(14) American Telephone & Telegraph Co. v. Director, Division of Taxation, 4 N.J. Tax 638 (Tax 1982), aff'd, 194 N.J. Super. 168, 476 A.2d 800 (App. Div. 1984), certif. denied. 97 N.J. 627, 483 A.2d 157 (1984).

(15) N.J.A.C. [sections] 18:7-8.12(a).

(16) Kingsley v. Wes Outdoor Advertising Co., 55 N.J. 336,262 A.2d 193 (1970); New Jersey Transit Corp. v. Somerville, 139 N.J. 582, 661 A.2d 778 (1995); 296 N.J. Super. 501, 687 A.2d 309 (App. Div. 1997); Everest Reinsurance Co. v. Newark Division of Tax Abatement, 18 N.J. Tax 50 (Tax 1998).

(17) Franklin Tower One, L.L.C. v. N.M., 157 N.J. 602, 725 A.2d 1104 (1999).

(18) Gould v. Gould, 245 U.S. 151 (1917); Kingsley v. Hawthorne Fabrics, Inc., 41 N.J. 521, 197 A.2d 673 (1964); Smith v. Director, Division of Taxation, 108 N.J. 19, 527 A.2d 843 (1987).

(19) Gould v. Gould, 245 U.S. 151 (1917), quoted in Kingsley v. Hawthorne Fabrics, Inc., 41 N.J. 521, 197 A.2d 673 (1964).

(20) 13 N.J. Tax 182 (Tax 1995). The case is discussed in some detail in Crabtree, State and Local Taxation, [sections] 30.2 (43 New Jersey Practice) (1999).

(21) The facts of the case disclosed the classic drop-shipment scenario: The manufacturer sold the product to a retailer, who in turn sold it to its New Jersey customer. The manufacturer had its principal place of business in Grand Rapids, Michigan, and none of the retailers was located in New Jersey. The court was able to avoid the constitutional nexus issues because the manufacturer had a physical presence in New Jersey by virtue of its lease of warehouse space in North Bergen, New Jersey; it had employees who lived in New Jersey and served as sales representatives in New Jersey, Pennsylvania, and New York; and it was registered to do business in New Jersey.

(22) 18 N.J. Tax at 286-87.

(23) See Jerome R. Hellerstein & Walter Hellerstein, supra note 1, [paragraph] 9.21[1][b]. See also cases cited in note 5.

(24) See Jerome R. Hellerstein & Walter Hellerstein, supra note 1, [paragraph] 9.21[1][b].

(25) Miller International, Inc. v. Colorado Department of Revenue, 646 P.2d 341 (Colo. Sup. Ct. 1982).

(26) 877 P.2d 133 (Utah Sup. Ct. 1994).

(27) Although there appear to be no judicial decisions on the issue, the New York Department of Taxation and Finance, in Advisory Opinion TSB-A-93(18)C (October 18, 1993), ruled that a New York manufacturer who drop-ships products directly to its New York wholesaler's out-of-state customers, at the wholesaler's direction, must allocate the receipts from the sales to the wholesaler to the state to which the products are shipped, not to New York. (New York's apportionment statue is the same as the New Jersey statute.)

DAVID E. CRABTREE was a judge of the Tax Court of New Jersey from 1979 until 1997. The New Jersey Tax Court reports contain more than 135 of Judge Crabtree's opinions, many of which deal with corporate and individual income tax issues. Judge Crabtree has lectured frequently on state and local tax matters and is the author of a work on state and local taxation published as volume 43 of West's New Jersey Practice series.