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Implications of the Supreme Court's 1991-1992 state tax decisions.

The Supreme Court's 1991-1992 term produced an avalanche of state tax cases that substantially (but not completely) clarify the permissible range of state tax jurisdiction. Viewed together, the cases demonstrate the dual approach to be utilized in determining the constitutionality of state tax impositions, the standards that will be applied for each part of the dual approach, and the amount of flexibility the states will be accorded in utilizing classifications and distinctions in structuring their taxing schemes.

This article discusses the six most significant state tax cases of the Court's October 1991 term. It begins with a explanation of each case, next discusses ways taxpayers can take advantage of the Court's decision, and concludes with speculations about subsequent events. The six cases -- Allied-Signal, Quill, Nordlinger, Chemical Waste, Kraft, and Wrigley -- address a variety of taxes, but, with limited exceptions in two of the cases, the principles involved are relevant to the entire spectrum of state taxation.(1*)


The corporate franchise/income tax statutes in several states -- New York, New Jersey, and Connecticut, for example -- provide that once a corporation is subject to tax in that state, the corporation's entire modified federal taxable income is apportioned by formula to the state; the statutory tax rate is then applied to this amount. (These are often called "full apportionment" states.) In contrast, most states have directly or indirectly adopted the UDITPA principle of first bifurcating income into "business" and "nonbusiness" components, and then apportioning only business income to each state in which the corporation is subject to tax while allocating each item of nonbusiness income to a specific state. In reality, however, administrative and judicial interpretations in some jurisdictions have virtually emasculated the concept of "nonbusiness income" and a result similar to that experienced in full apportionment states often occurs. The constitutionality of the full apportionment scheme was the ultimate question addressed in Allied-Signal.

Bendix, which was Allied-Signal's predecessor-in-interest, was a Delaware corporation that conducted business throughout the United States and the world. The business was directed from Bendix's principal office in Michigan. During the tax period at issue, the company engaged in four major types of business, each through a separate operating group, as follows: automotive; aerospace/electronics; industrial/energy; and forest products. In New Jersey, Bendix's activities related to its aerospace business and the manufacturing of electric power-generating systems; the company also sold its full range of products to customers located in New Jersey and stored inventory there as well.

In 1965, Bendix began "an aggressive policy of growth through acquisition." By the late 1970s, the company had acquired more than 44 companies and had sold at least eight. In its annual report to stockholders, Bendix management emphasized that "acquisitions have played a significant role in the growth of your [c]orporation during the past decade."

During 1977 and 1978, Bendix acquired slightly more than 20 percent of ASARCO's stock. According to the CEO of Bendix, the purchase was consistent with the company's strategy of diversifying and broadening its holdings in basic commodities. (ASARCO, a New Jersey corporation, engages in copper mining in the United States and abroad.) In the course of the dispute, the New Jersey Division of Taxation and Bendix stipulated that "[d]uring the period that Bendix held its investment in ASARCO, Bendix and ASARCO were unrelated business enterprises each of whose activities had nothing to do with the other."

In 1981, Bendix sold its ASARCO stock to reduce its investment in natural resource businesses and to realize the appreciation in the value of the stock; the sale resulted in more than $200 million in capital gain. This gain fit the corporation's goal of providing liquidity for future acquisitions in targeted areas. The New Jersey Division of Taxation included this capital gain in Bendix's income subject to apportionment for purposes of the state's corporation business tax.

The New Jersey corporation tax statute requires apportionment of a corporate taxpayer's entire modified federal taxable income. State tax officials, however, were cognizant of the U.S. Supreme Court's 1982 decisions in ASARCO Inc. v. Idaho State Tax Commission(3) and F.W. Woolworth Co. v. Taxation and Revenue Department of New Mexico.(4) In those cases, states were stopped from taxing the part of corporate taxpayers' income that was attributable to their stock ownership in corporations when those investee corporations were not engaged in unitary businesses with the corporate taxpayers. In sum, the Supreme Court had held that a state may not tax income that has nothing to do with the taxpayer's activities in the state. New Jersey, faced with these rulings, attempted to sustain its tax on Bendix by asserting that the state had a right to tax the income earned by Bendix from its ASARCO investment, not because Bendix and ASARCO were unitary -- the stipulation entered into by the state and Bendix had effectively precluded the state from making such an assertion -- but rather because part of Bendix's overall corporate strategy was acquiring and disposing of businesses. Accordingly, the state argument continued, the ASARCO gain was derived as part of Bendix's single business that was partly conducted in New Jersey and therefore partly taxable in New Jersey. The state was successful in making this argument in the New Jersey courts. In its initial brief to the U.S. Supreme Court, the state repeated this argument while the taxpayer consistently had maintained that ASARCO and Woolworth prohibited New Jersey from taxing income that was earned independently of the taxpayer's activities in New Jersey.

In a move that shocked the tax community, New Jersey dramatically changed its position during oral argument. Rather than attempting to fit the "square peg" Bendix situation into the unitary business "round hole," the state averred that ASARCO and Woolworth should be overruled: New Jersey argued that every state that has the jurisdiction to tax a particular corporation should be permitted to tax an apportioned share of that corporation's entire income. In response to this bold move, the Court ordered rebriefing and reargument addressing three issues:

1. Should the court overrule ASARCO and Woolworth?

2. If ASARCO and Woolworth are overruled, should

the decision apply retroactively?

3. If ASARCO and Woolworth are overruled, what

constitutional principles should govern state taxation

of corporations doing business in several


In response, Allied-Signal demonstrated that there was a wealth of precedence on which ASARCO and Woolworth were based. Starting with the original railroad and telegraph unitary property tax cases,(5) continuing through the express company cases(6) and ending with cases such as Underwood Typewriter Co. v. Chamberlain,(7) Mobil Oil Corp. v. Commissioner of Taxes,(8) and Exxon Corp. v. Wisconsin Department of Revenue,(9) Allied-Signal asserted that there existed a fundamental principle that a state may constitutionally impose tax only on income organically related to the taxpayer's activity in the state. In response, New Jersey proposed that each corporate entity simply be viewed as a single economic unit. The state argued that modem corporate entities treat all assets -- whether an investment in a nonunitary subsidiary or a manufacturing facility -- as effectively fungible. Therefore, according to New Jersey, every state in which a corporation is subject to tax should be able to impose tax on a portion of the corporation's entire income. On oral argument, New Jersey agreed with the Multistate Tax Commission (whose raison d'etre is uniformity) that New Jersey's "full apportionment" scheme should be allowed to coexist with UDITPA and UDITPA-like states (where 100 percent of nonbusiness income is specifically allocated to certain jurisdictions) and appeared unconcerned about fair apportionment and multiple taxation, proposing that those issues could be addressed over time.

Relying on the Due Process Clause as well as the Commerce Clause, the Supreme Court held that two distinct nexus requirements must be met to sustain the validity of a state tax on (or measured by) the income of a nondomicilary corporation. The first nexus requirement mandates a connection between the state and the taxpayer; the second nexus requirement mandates a connection between the state and the activities that produced the income sought to be taxed. (This conclusion was reached by relying on the 100-year history of cases cited in Allied-Signal's brief.) With reference to the Due Process Clause, the Court cited Quill, which quoted Miller Bros. V. Maryland,(10) and stated "we have not abandoned the requirement that, in the case of a tax on an activity, there must be a connection to the activity itself, rather than a connection only to the actor the State seeks to tax." New Jersey's arguments -- that a corporate entity's taxability in a state justifies that state's taxing an apportioned part of the entity's entire income -- was thus rejected. The nine Justices unanimously agreed with this rejection. Quoting Exxon, which in turn quoted Mobil, the Court stated:

It remains the case that "[i]n order to exclude certain

income from the apportionment formula, the

company must prove that the income was earned in

the course of activities unrelated to [those carried

out in the taxing] State."

There was no question in this case that the first connection -- or nexus --test was met: Bendix, as a corporate entity, was clearly doing business in New Jersey and thus subject to the taxing jurisdiction of the state. Applying the second test to the facts in this case (whether the required connection between the income-producing activity and the state existed), however, caused a 5-4 split among the Justices. The majority decided that Bendix's investment was passive, inadequately related to Bendix's activity in New Jersey, and part of a "discrete business enterprise." The five Justices noted that --

contrary to the view expressed below by the New

Jersey Supreme Court . . . the mere fact that a

intangible was acquired pursuant to a long-term

corporate strategy of acquisitions and dispositions

does not convert an otherwise passive activity into

an operational one. Indeed, in Container Corp. . . .

we noted the important distinction between a capital

transaction which serves an investment function

and one which serves an operational function.

. . . (Citations omitted.)

That income may be fungible (as may be certain capital transactions) and passive investment income may ultimately be used for operational purposes is not controlling; otherwise, the distinction between adequately and inadequately connected income-producing activities could never be made. The majority emphasized, however, that certain capital transactions, as in the case of short-term investments utilized for working capital purposes, can constitute operational investments. Income from such investments is apportionable to all states in which the business that utilizes the working capital, for example, operates. The Court concluded that Bendix's ownership in the ASARCO stock was a passive capital transaction unrelated to Bendix's business activities in New Jersey and, therefore, any income generated by that transaction was not apportionable to, or taxable by, New Jersey. Although the minority, consisting of four Justices, concurred in the majority's legal analysis, it would have sustained New Jersey's tax imposition because it viewed Bendix's stock ownership in ASARCO as a temporary use of idle funds pending an ordinary-course-of-business use (the intended acquisition of a company engaged in the aerospace industry). The minority believed Bendix's investment in ASARCO was equivalent to working capital serving an operational purpose, and that the distinction between short-term and long-term investments, alluded to by the majority, should not be given any constitutional standing.

This decision is important because it confirms that for a state franchise/income tax to be valid under the U.S. Constitution, both the taxpayer and its income-producing activities must have connection (or nexus) with the state. The decision also confirms that the connection between the income-producing activities and the state, when the activities do not actually take place in the state, is adequate only when those activities are related to the taxpayer's in-state activities in a unitary or other operational manner. In other words, the UDITPA principle of apportioning business income and specifically allocating nonbusiness income appears to be constitutionally mandated. ASARCO and Woolworth did not question the validity of the principle but merely questioned its application. Those cases restricted state tax officials from using such a narrow definition of nonbusiness" that the principle would have been meaningless.

For prior, current, and future taxable years, taxpayers need to review the various components of their income, identifying items of income generated by nonoperational investments. (The same analysis needs to be made regarding items of capital for those taxpayers that are subject to tax in states that impose capital-based franchise taxes.) Income generated by nonoperational investments should not be apportioned to, or taxed by, any state except for the one in which the corporation is commercially domiciled. This rule applies to all states: not only to UDITPA and UDITPA-like states, but also to states -- such as New York, New Jersey, and Connecticut -- whose statutes require full apportionment. Each taxpayer will need to decide how aggressive it wishes to be in determining which of its investments are nonoperational. Inasmuch as Allied-Signal did not establish any new principles of law, refunds should be available for all claims that are filed on a timely basis (according to the applicable statute of limitations).

The future should see some, but not a large amount, of activity in this area, most of which will likely focus on methods of bifurcating investment income into the portion attributable to working capital and the portion attributable to nonoperational portfolio investments. Another area that may warrant attention concerns determining what jurisdiction can tax the nonapportionable income. For example, if a corporation's investment activity is conducted in State A, but the Chairman of the Board maintains his or her office in State B where the Board of Directors also meets, and the President and Executive Vice Presidents work in State C, which state should be able to tax the income from nonoperational investments? Even if the investment activities, the Chairman, and the executive officers are all in one state when an investment is made, what happens if they all relocate to another state midway through the period during which the investment is held?

Quill Corp.(11)

Allied-Signal confirms that there are two requirements that must be met for a state tax imposition to be constitutionally valid. One of these requirements is that there be a connection (or nexus) between the taxpayer and the state. Quill focuses on this test and applies it specifically in the context of a mail-order seller and its duty under a state's sales and use tax statute; the connection between the activity and the taxing state was clearly present.

During the late 1980s, numerous states enacted statutes purporting to expand nexus for purposes of requiring use tax collection by out-of-state sellers. In 1987, North Dakota amended its sales and use tax statute by expanding the definition of "retailer" (those required to collect the state's sales tax on sales occurring in the state and to collect the state's use tax on sales to residents of the state), as follows:

A retailer also includes every person who engages

in regular or systematic solicitation of a consumer

market in this state by the distribution of catalogs,

periodicals, advertising fliers or other advertising,

or by means of print, radio or television media,

telegraphy, telephone, computer data base, cable,

optic, microwave, or other communication system.

[Section 57-40.3-01(6).]

Regulations were promulgated that defined "regular or systematic solicitation" as "three or more separate transmittances of any advertisement or advertisements" during a 12-month month period.(12) Pursuant to these provisions, North Dakota attempted to require out-of-state mail-order companies that sold to residents to register as retailers and to collect and remit use taxes relating to sales shipped to North Dakota addresses. One of these companies was Quill Corporation.

Quill (a Delaware corporation) maintains its principal place of business in Illinois and has offices and warehouses in California and Georgia. Through soliciting customers and prospects via catalogs, advertising flyers, and telephone, Quill sells office supplies nationwide. It did not advertise in North Dakota newspapers or through broadcasters within the state. Quill shipped goods into the state by mail or common carrier. The company had no office, warehouse, or any other place of business in North Dakota and had no agents, salesmen, or other representatives in the state; neither did it have a telephone listing or toll-free telephone line in the state. Quill's annual sales to its nearly 3,500 active customers in North Dakota generated about $1 million in revenue, making it the sixth largest office supplies vendor in the state. Quill mailed more than 60 different catalogs and flyers to its North Dakota customers annually, comprising approximately 230,000 pieces of mail, weighing over 24 tons.

In resisting North Dakota's attempt at requiring it to register as a retailer, Quill relied on the Supreme Court's 1967 decision in National Bellas Hess v. Department of Revenue.(13) Bellas Hess, which seemed to rely on Due Process as well as Commerce Clause grounds, had held that an out-of-state mail-order seller could not be required to collect and remit a state's use tax because there was insufficient connection between the seller and the state merely into which advertising matter and sold goods were shipped (utilizing U.S. mails or common carriers).

The North Dakota Supreme Court had rejected Quill's argument, finding that "wholesale changes' in both the economy and the law made it inappropriate to follow Bellas Hess today," and concluded that Quill's business activities relating to North Dakota residents provided the requisite constitutional nexus. The state Court had further assumed that Complete Auto Transit v. Brady(14) effectively abolished the legal foundation upon which Bellas Hess had been based.

The U.S. Supreme Court made it clear during oral argument that it does not now believe (if it ever did) that its decision in Bellas Hess could be

sustained on Due Process grounds. The Court ruled that the Due Process Clause mandates only a minimal connection between the taxpayer and the state. In the context of state taxes, this minimal connection standard is comparable' to the standard for in personam jurisdiction utilized to determine when a state court can assert its jurisdiction over a person; this standard requires only that there be economic presence, or business exploitation, within the jurisdiction. The Court explained its analysis by noting that the purpose of the Due Process Clause is to ensure traditional notions of fair play and substantial justice (quoting International Shoe Co. v. Washington).(15) According to Justice Stevens's concurrence, this purpose is fully served if the person subjected to the state's jurisdiction has "fair warning that [its] activity may subject [it] to the jurisdiction of a foreign sovereign."(16) The Court quoted from Burger King Corp. v. Rudzewicz(17) to state the current rule to be used in determining whether Due Process requirements are met:

So long as a commercial actor's efforts are "purposefully

directed" toward residents of another

State, we have consistently rejected the notion that

an absence of physical contacts can defeat personal

jurisdiction there.

Examining Quill's activities relating to its North Dakota customers, the Court determined that the company clearly met this standard. Consequently, the State's attempt at requiring out-of-state mail-order sellers such as Quill to perform use tax collection duties could not be stopped on Due Process grounds. Accordingly, to the extent it may have been based on Due Process grounds, Bellas Hess was overruled.

The Court then stated that a higher nexus standard was appropriate for Commerce Clause purposes than for Due Process purposes. This is because the Due Process Clause ensures adequate notice and "fair play," but dormant Commerce Clause requirements (those requirements that the Court has found to exist when Congress has not enacted a relevant statute) ensure that interstate commerce can flow without interference and that multiple taxation does not occur. As a result, Commerce Clause jurisprudence requires that there be substantial nexus between the taxpayer and the state before a state's taxing jurisdiction can reach to that taxpayer.

The Court determined that substantial nexus, in the context of sales and use taxes especially when mail-order sellers are at issue) is present when the taxpayer (or, more properly, the tax collector/remitter) has a physical presence in the state. This presence can be established if the company has employees, agents, or property that is not insignificant. (Minor property, such as some computer disks in Quill's case, does not reach constitutional significance.) Somewhat defensively, the Court emphasized that this bright-line test of physical presence was to relate only to sales and use tax matters and was adopted largely because of stare decisis principles (including taxpayers' reliance on Bellas Hess). The oral argument in the case and the decision demonstrate the Court's concern about the profound retroactive effect that an overruling of Bellas Hess would likely have. The decision also noted that Complete Auto Transit had no direct effect on Bellas Hess; Complete Auto Transit did not overrule all bright-line tests but merely consolidated previous rulings and exalted substance over form in a single context.

Every taxpayer that sells goods through the mails needs to decide either (1) voluntarily to commence collecting and remitting use taxes (pursuant to negotiations currently being conducted to make the administrative burden on mail-order sellers reasonable while allowing them some minor "presence" in the state) or (2) to isolate its pure mail-order operation (no service or credit activities in the recipient states, for example) into a distinct corporate entity. Distinct mail-order corporate entities must be careful about their relationships with any affiliate that is taxable in the state in order to prevent the state from asserting jurisdiction over the mail-order corporation because of an agency or alter ego relationship with the company that is in the state.(18) Those mail-order sellers that had no physical presence in a state but nevertheless voluntarily registered there may wish to cancel their registration and seek refunds of any use taxes that they themselves paid.

Taxpayers in other businesses will likely be the focus of significant activity in the future. The issue of what constitutes substantial nexus under the Commerce Clause will be raised in many contexts. For example, financial institutions with credit card holders in a state will likely face state efforts to impose tax simply because the institution has customers in the state. Many observers hope, however, that fair apportionment and reasonable administration will result in a diminution of the importance of substantial nexus.

In summary, a taxpayer's minimal nexus (or connection) with a taxing jurisdiction can be established by the taxpayer's economic activity relating to the jurisdiction, and substantial nexus (or connection) is obviously greater than minimal connection. Thus, the question becomes whether the types of activities that are used to find minimal connection needed for Due Process purposes can also be used to find substantial connection needed for Commerce Clause purposes, when the quantity or magnitude of the activities is large enough. Alternatively, can the minimal connection requirement be met through occasional or episodic activities, whereas the substantial connection requirement can be met only through more permanent activities? These questions, along with issues of fair apportionment, may well be the focus of state tax litigation during the balance of this millennium.

Article XIIIA of the California constitution, established through Proposition 13, requires that ad valorem tax assessments generally be capped at each real property's 1975-1976 assessed value. The major exception is for additions to property and changes in ownership. In such cases, the property's value at the date of the addition or the change becomes a new cap. The tax rate is set at one percent. Inflation may be taken into account to increase assessments, but not at a rate greater than two percent for each year. In sum, California's property tax system uses "acquisition value" instead of the usual "current value."

Stephanie Nordlinger bought a house in Los Angeles in 1988 for $170,000; she had previously rented an apartment there. Because the assessment placed on her recently acquired property reflected her acquisition value, Ms. Nordlinger's property tax bills were about five times greater than those of some of her neighbors who had owned their comparable properties since 1975. This great disparity in treatment formed the basis of Ms. Nordlinger's claim that Article XIIIA violated the U.S. Constitution's Equal Protection clause.

The U.S. Supreme Court began its analysis with the general rule that applies in Equal Protection cases: ". . . unless a classification warrants some form of heightened review because it jeopardizes exercise of a fundamental right or categorizes on the basis of an inherently suspect characteristic [race, religion, etc.], the Equal Protection Clause requires only that the classification rationally further a legitimate state interest." (Citations omitted.)(20)

The Court had no difficulty in ascertaining at least two rational or reasonable considerations of difference or policy that justify denying petitioner the benefits of her neighbors' lower assessments." The first of these policies is the preservation of neighborhoods and the discouragement of rapid turnover of real estate. This policy was accepted by the majority as an obvious legitimate state interest. The second of these policies is affording property owners some degree of certainty regarding the magnitude of their future property tax burdens. In concluding that this policy is a legitimate state interest, the Court stated that it previously has acknowledged that classifications serving to protect legitimate expectation and reliance interests do not deny equal protection of the laws."

Ms. Nordlinger's argument was grounded on the Court's 1989 decision in Allegheny Pittsburgh Coal Co. v. Webster County, W. Virginia.(21) The Court, however, distinguished that case because there an acquisition value assessment system was practiced solely by an individual county assessor and accordingly was found to be violative of the Equal Protection Clause. The pivotal distinction between Allegheny Pittsburgh Coal and Nordlinger was that the Webster County practice was under a state constitution that mandated taxation at a uniform rate according to estimated market values; the Webster county assessor's practice thus could not be sustained as being in furtherance of any state policy. The Court stressed that although the "Equal Protection Clause does not demand for purposes of rational-basis review that a legislature or governing decision-maker actually articulate at any time the purpose or rationale supporting its classification . . . this Court's review does require that a purpose may conceivably or may reasonably have been the purpose and policy' of the relevant governmental decision-maker." Whereas no such purpose or policy could be found in Allegheny Pittsburgh, such purpose was clearly present in the California situation.

In upholding Article XIIIA on the grounds that the resulting unequal treatment furthered a legitimate state purpose and that therefore the Equal Protection Clause was not violated, the Court let it be known that it will allow states much leeway in structuring their tax systems, as long as taxpayers (see Quill discussion above) and the item income, property, or transaction) being taxed (see Allied-Signal discussion above) are legitimately subject to the system, and neither interstate commerce (see Chemical Waste discussion below) nor foreign commerce (see Kraft discussion below) is unduly burdened.

The question whether Proposition 13 violates the Commerce Clause (by erecting a barrier for businesses entering the state) has not yet been addressed. This is because Ms. Nordlinger's case involved a property tax assessment on her home rather than on any business property. Although a business taxpayer may seek to challenge California's property tax system on Commerce Clause grounds, the Court seemed very hesitant to disturb the system in a manner that would cause huge and dramatic repercussions to millions of homeowners.

Chemical Waste Management owned and operated Alabama's only commercial facility for hazardous waste land disposal. The wastes include substances that are inherently dangerous to human health and safety and to the environment." In 1990-1991, Alabama enacted a statute that set the maximum amount of waste that could be disposed at such a facility each year. In addition, the law imposed a disposal fee at a rate of $25.60 per ton for all hazardous wastes and substances, plus an additional $72.00 per ton for wastes and substances generated outside of Alabama.

Chemical Waste Management asserted that the additional charge for out-of-state waste violated the Commerce Clause. Alabama defended the charge by arguing that the additional fee was required to further a legitimate local purpose (protecting Alabama's citizens and environment from contamination) that could not be reasonably furthered by any nondiscriminatory alternative.

The Supreme Court easily rejected Alabama's argument and struck down the additional fee. The Court first noted that items of waste constitute articles of commerce, according to prior decisions. It then stated that "[n]o state may attempt to isolate itself from a problem common to the several States by raising barriers to the free flow of interstate trade." Quoting from Philadelphia v. New Jersey,(23) the decision states:

The evil of protectionalism can reside in legislative

means as well as legislative ends. . . . The Court

has consistently found parochial legislation of this

kind to be constitutionally invalid, whether the ultimate

aim of the legislation was to assure a steady

supply of milk . . . or to create jobs. . . or to preserve

the State's financial resources. . . "

In refusing to accept Alabama's argument that the additional fee was rationally related to the legitimate state goal of reducing the amount of hazardous waste to which Alabama residents and the Alabama environment are exposed, the Court noted that there was no evidence to the effect that waste generated out of state posed any greater danger than waste generated in Alabama and, further, that if the state were serious about reducing the amount of hazardous waste in the state, the state would have placed greater restrictions on total hazardous waste.

In summary, Chemical Waste stands for the proposition that even if a state purpose appears eminently legitimate, means that interfere with interstate commerce to achieve that purpose cannot be used unless that interstate commerce itself is a specific cause of the problem being addressed (such as keeping certain diseased fish out of a state when local fish are free of that disease). The ramification of this case are best analyzed in light of the Court's decision in Kraft.

Kraft General Foods(24)

Most states impose their business corporation tax based on a computation that follows, or is tied to, federal taxable income as calculated under the Internal Revenue Code. Under the Internal Revenue Code, dividends from domestic subsidiaries are deducted in determining federal taxable income while dividends from foreign subsidiaries generally are not deducted; a federal tax credit, however, is allowed for foreign taxes attributable to such dividends to avoid double taxation. Consequently, when states conform to federal taxable income in the treatment of dividends but not to federal tax credits, foreign dividends are subjected to state taxation but domestic dividends escape such tax. Is this disparate treatment constitutional?

Kraft operated a unitary business throughout the United States and in several foreign countries. In computing its taxable income on its 1981 tax return for Iowa (a state that follows the federal tax scheme regarding dividend deductions), the company deducted dividends received from its domestic subsidiaries, consistent with Iowa's statutory conformity to federal tax law. In addition, however, the company also deducted dividends received from foreign subsidiaries, in direct disregard of Iowa's law. Kraft argued that the disparate treatment afforded domestic and foreign dividends violated both the Equal Protection Clause and the Commerce Clause.

The Iowa Supreme Court had determined that the Commerce Clause had not been violated because the Iowa tax system did not provide a commercial advantage to Iowa businesses over foreign commerce; there was no less tax imposed on a subsidiary incorporated and operating in Iowa from one incorporated in a foreign country. Further, the Equal Protection Clause had not been violated because the state's conformity to federal taxable income and the resulting ease of tax administration were legitimate state goals providing adequate justification for the different dividend treatment. Accordingly, Kraft's arguments had been rejected in the state courts.

In the early stages of its analysis, the U.S. Supreme Court recognized that the domicile of a corporation (the determining factor for dividend deductions in the Iowa law) does not always indicate where the corporation's business is conducted. Nevertheless, the Court concluded that the relationship between the country in which a business is incorporated and the country where it conducts its business is generally close enough to establish that the taxation of foreign dividends is comparable to the taxation of income earned in foreign commerce. The Court was not persuaded by Iowa's argument that the detrimental effect of Iowa's law could be avoided by companies such as Kraft simply having their foreign subsidiaries owned by a domestic subsidiary. It explained:

We find no authority for the different proposition

advanced here that a tax that does discriminate

against foreign commerce may be upheld if a taxpayer

could avoid that discrimination by changing

the domicile of the corporations through which it

conducts its business. Moreover, the Court dismissed Iowa's argument that the Commerce Clause was not violated simply because Iowa businesses are not given an economic advantage:

We are not persuaded, however, that such favoritism is an essential element of a violation of the Foreign Commerce Clause . . . we think that a State's preference for domestic commerce over foreign commerce is inconsistent with the Commerce Clause even if the State's own economy is not a direct beneficiary of the discrimination.

In rejecting Iowa's defense to Kraft's Equal Protection claim, the Court first acknowledged the important role that federal tax conformity has in state tax administration. Nevertheless, the Court concluded:

[A]bsent a compelling justification, however, a State

may not advance its legitimate goals by means that

facially discriminate against foreign commerce. . . .

In this instance, Iowa could enjoy substantially the

same administrative benefits by utilizing the federal

definition of taxable income, while making adjustments

that avoid the discriminatory treatment

of foreign subsidiary dividends. Many other states

have adopted this approach. (Citations omitted.)

Kraft, therefore, is another case (in line with Armco v. Hardesty(25)) where the Court has been willing to analyze the internal workings of a state tax scheme to determine whether interstate or foreign commerce is effectively -- even if indirectly -- burdened greater than local or domestic commerce.

When reviewing the composition of their income for purposes of the Allied-Signal nonoperational analysis (discussed above), taxpayers also need to note which items of income are generated by or in foreign commerce (such as dividends paid by a corporation incorporated abroad, whether the investee corporation is a subsidiary or merely a portfolio investment) and make sure that those items are subjected to no greater tax burden than domestically generated income. Refunds should also be available with respect to this issue, although some states may resist the payment of refunds pending the Supreme Court's decision next term in Harper v. Virginia.(26)

Taxpayers should consider whether those state statutes that deny certain exemptions to corporations whose owners are foreign citizens are constitutional and, if not, whether appropriate action should be taken. Taxpayers should also review the various state tax statutes to determine whether other components are unconstitutional because they discriminate against foreign or interstate commerce. For example, are combined reporting criteria based on the in-state presence of the constituent companies valid? What about laws that limit investment credits or accelerated depreciation to in-state property?


The other state tax cases decided by the Supreme Court during this past term and discussed in this article involved a constitutional challenge to a state tax imposition. Wrigley, in contrast, involved the application of federal Public Law No. 86-272.(28)

Public Law No. 86-272 prohibits any state from taxing the income of a business where the "only" business activities in the state consist of 'solicitation of orders' for tangible personal property, if the orders are accepted outside the state, and the personal property is shipped from outside the state. Since Public Law No. 86-272 was enacted in 1959, the question of what is "solicitation" has been the core of state tax controversies throughout the country. These controversies have been resolved in very different ways by state courts and administrative agencies. In Wrigley, the Supreme Court has offered some guidance regarding this issue as well as the significance of the statute's use of the term "only."

Wrigley employed a regional manager and several sales representatives in Wisconsin. The regional manager spent 95 percent of his time working with his sales representatives or contacting key accounts; he spent the balance of his time on administrative activities, including writing and receiving company reports; recruiting and evaluating sales representatives; making recommendations regarding the hiring, firing, and compensation of sales representatives; and presiding over full-day sales strategy meetings once or twice a year. One Wisconsin regional manager had intervened two or three times a year in credit disputes between Wrigley's home office and important local accounts; his successor claimed that he had never performed such activities, though the applicable job description called for such a function. Wrigley furnished no office to the regional manager.

Each sales representative was furnished a company car, a stock of gum (that had an average wholesale value of about $1,000), supply racks, and promotional literature. Sales representatives distributed promotional material and free samples, provided retailers with free display racks, and directly requested orders of Wrigley products. They occasionally (perhaps once a month) completed the filling of a rack with merchandise from their cars, for which the retailer ultimately was charged (usually $15 to $20) either by Wrigley in Chicago or by Wrigley's local wholesaler. Sales representatives also checked the retailer's stock and took back any stale product (such stale merchandise amounted to about 40 percent of the sales representative's car "inventory").

The Wisconsin Supreme Court determined that Wrigley's activities in the state were "closely associated" with solicitation and, accordingly, held that Public Law No. 86-272 insulated the company from the Wisconsin tax. The state department of revenue appealed.

The U.S. Supreme Court begin its analysis by recounting the impetus for Public Law No. 86-272 -- the Court's 1959 decision in Northwestern States Portland Cement Co. v. Minnesota.(29) The taxpayer in that case employed salesmen who operated out of a three-room office in the taxing state, solicited for sales of cement, and forwarded complaints from customers back to the taxpayer's office outside the state. In that case, the Court upheld the state tax imposition and had stated We conclude that net income from the interstate operation of a foreign corporation may be subjected to state taxation provided the levy is not discriminatory and is properly apportioned . . ."

In its argument, Wisconsin noted that during the years since its enactment, Public Law No. 86-272 has been interpreted by several states to deny the law's protection to taxpayers that engaged in "any activity other than requesting the customer to purchase the product." The Court rejected this approach as unreasonably narrow, noting that the statute "describes 'the solicitation of orders' as a subcategory, not of in-state acts, but rather of in-state business activities' . . ." Further, the Court refused to accept the approach that only those activities that are essential" to solicitation should be included in protected 'solicitation' because such an approach would leave the law that existed prior to Public Law No. 86-272 unchanged and necessarily would lead to absurd results. (Would use of a car or a hotel room by a salesman be essential considered to the taking of orders?)

At the other extreme, the Court also rejected the approach offered by Wrigley that any activities 'customarily performed' by salesmen or "routinely associated" with solicitation be protected by Public Law. No. 86-272. Accepting such an interpretation would allow each industry, or the major participant in that industry, to define the statutory term itself. The Court also rejected what it perceived to be the Wisconsin Supreme Court's interpretation -- that "solicitation" includes activities that are "closely associated" with solicitation. Defining "closely associated" would be as difficult as defining "solicitation" has been in the absence of any other guidance.

The Court then set forth the standard to be utilized in determining what activities of a taxpayer will be considered protected "solicitation." The demarcation between protected solicitation and other activities that can result in taxation is the 'clear line... between those activities that are entirely ancillary to requests for purchase -- those that serve no independent business function apart from their connection to the soliciting of orders -- and those activities that the company would have reason to engage in anyway but chooses to allocate to its in-state sales force." For example, providing a car and free samples to local salesmen is protected because "the only reason to do it is to facilitate requests for purchases." Servicing goods in the state by salesmen, on the other hand, would not be protected solicitation "since there is good reason to get that done whether or not the company has a sales force." The statute does contain one explicit exception to this ancillary' approach, however: the maintenance of an office in the state, even if solely for sales representatives, loses the protection offered by Public Law No. 86-272.

The Court also rejected Wisconsin's claim that the use of the term "only" in Public Law No. 86-272 means that any activities other than solicitation may result in taxation. The Court noted that 'the venerable maxim de minimis non curat lex ('the law cares not for trifles') is part of the established background of legal principles against which all enactments are adopted, and which all enactments (absent contrary indication) are deemed to accept." In the case of Public Law No. 86-272, "only" refers to the category of protected activities, and so if all of a company's nonsolicitation activities are "trivial" (a term left undefined by the Court), the statutory insulation will remain intact.

Focusing on the specific facts in Wrigley's case, the Court concluded that the replacement of stale gum, the occasional supplying of gum to fill racks, and the storage of gum were not ancillary to solicitation. Gum replacement may have facilitated sales, but it did not facilitate the requesting of sales; occasionally supplying gum to fill racks may have been protected promotion, but retailers paid for the gum, so there was a business purpose other than mere solicitation. Because Wrigley carried on these nonsolicitation activities in Wisconsin, its was found to have lost its Public Law. No. 86-272 protection.

The Court noted that many of Wrigley's Wisconsin activities were ancillary to solicitation and would not, by themselves, have resulted in taxation. Included in this category were the recruitment, training, and evaluation of sales representatives, the use of homes and hotel rooms for solicitation-related functions, and the credit liaison work of the sales representatives.

In dismissing Wrigley's claim that its nonsolicitation activities were de minimis, with its occasional sales of product used to fill racks accounting for only 0.00007 percent of Wrigley's sales, the Court stated "We need not decide whether any of the non-immune activities were de minimis in isolation; taken together, they clearly are not." Even though the relative magnitude of this activity may have been small, the activity was part of regular company policy, carried out on a continuing basis.

Any taxpayer wishing to take advantage of the protections offered by Public Law No. 86-272 must carefully isolate its solicitation activities (and activities ancillary to solicitation) into a separate corporate entity and ensure that this entity operates as an independent corporation that deals with its affiliates on an arm's-length, independent basis. This should insulate income attributable to sales activities (such as arm's-length sales commissions) from taxation in nonunitary" states and also reduce the apportionment factors of the affiliates in such states. The result in "unitary" states will, to some extent, be determined by the resolution of the "Joyce/Finnigan" dispute.(30)


Although many taxpayers and commentators have voiced the usual complaint that the Supreme Court's state tax decisions have not solved any problems but have merely altered the questions, the foregoing review of this past term's cases reveals some significant advances in state tax jurisprudence. Guidelines for what activities a state can tax have been clarified. The standard regarding on whom tax jurisdiction can be imposed has been explained, though the application of this standard to various industries will take some time. Significant restrictions have been placed on taxing schemes' disparate treatment of various items, but the restriction is clearly not all-inclusive. Finally, the protection offered by Public Law No. 86-272 have been defined in a manner that should greatly reduce the number of controversies in this area.

Of course, the overall effect of these cases will not be known for many years. Issues that are not even fathomable now will surely arise as tax administrators and taxpayers continue to investigate the extent of tax creativity.


(1) This article does not discuss two of this past term's state tax cases due to their relatively narrow effect. These are Barker v. Kansas, 112 S. Ct. 1619 (1992), which dealt with the effect of Davis v. Michigan, 489 U.S. 803 (1989), on retired military personnel and County of Yakima v. Confederated Tribes and Bands of the Yakima Indian Nation, 112 S. Ct. 683 (1992), which dealt with taxation relating to Indian reservation lands. (2) Allied-Signal, Inc. v. Director, Division of Taxation, 60 U.S.L.W 4554 (U.S. June 15, 1992). (3) 458 U.S. 307 (1982). (4) 458 U.S. 354 (1982). (5) E.g., Pullman's Place Car Co. v. Pennsylvania, 141 U.S. 18 (1891). (6) E.g., Adams Express Co. v. Ohio State Auditor, 165 U.S. 194 (1897). (7) 254 U.S. 113 (1920). (8) 445 U.S. 425 (1980). (9) 447 U.S. 207 (1980). (10) 347 U.S. 340, 344-45 (1954). (11) Quill Corp. v. North Dakota, 112 S. Ct. 1904 (1992). (12) N.D. Admin. Code [section] 81-04.1-01-03.1 (1988). (13) 386 U.S. 753 (1967). (14) 430 U.S. 274 (1977). (15) 326 U.S. 310 (1940). (16) Shaffer v. Heitner, 433 U.S. 186, 218 (1977). (17) 471 U.S. 462 (1985). (18) Arthur R. Rosen, State Taxation of Corporations: The Evolving Danger of Attributional Nexus, 41 The Tax Executive 553 (Nov.-Dec. 1989); Arthur R. Rosen, Update on Attributional Nexus, 43 The Tax Executive 46 (Jan.-Feb. 1991). (19) Nordlinger v. Hahn, 60 U.S.L.W. 4563 (U.S. June 18, 1992). (20) The Court, on standing rounds, dismissed Ms. Nordlinger's assertion that this case involved possible violation of the fundamental constitutional right to travel because there was no indication that Ms. Nordlinger's own right to travel had been affected in any way; she had been a California resident prior to her house purchase. The Court's decision thus concentrated on whether California's acquisition value property tax system furthered a legitimate state interest. (21) 488 U.S. 336 (1989). (22) Chemical Waste Management, Inc. v. Hunt, Governor of Alabama, 60 U.S.L.W. 4582 (U.S. June 1, 1992). (23) 437 U.S. 617 (1978). (24) Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, 60 U.S.L.W. 4582 (U.S. June 18,1992). (25) 467 U.S. 638 (1984). (26) Harper v. Virginia Department of Taxation, U.S. Docket No. 91-794, petition for certiorari granted, May 18, 1992. (27) Wisconsin Department of Revenue v. William Wrigley, Jr., 60 U.S.L.W. 4622 (U.S. June 19, 1992). (28) 15 U.S.C. [section] 381(a). (29) 358 U.S. 450 (1959). (30) In the Matter of the Appeal of Finnegan Corp., No. 85A-623-DB, State Board of Equalization of the State of California, 1990 Cal. Tax Lexis 4, 88-SBE-022-A (Jan. 24, 1990); In the Matter of the Appeal of Joyce, Inc. 1966 Cal. Tax Lexis 18 (Nov. 23, 1966).

ARTHUR R. ROSEN is a partner with Morrison & Foerster in New York City. Mr. Rosen was formerly the Deputy Counsel of the New York State Department of Taxation and Finance and Has held executive tax management positions at Xerox and AT&T. He is a past chairman of the Committee on State and Local Texas of the American Bar Association's Tax Section, a member of the Executive Committee of the New York State Bar Association and the National Association of State Bar Tax Sections, and Editor of the monthly news-letter, Inside New York Taxes.
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Author:Rosen, Arthur R.
Publication:Tax Executive
Date:Jul 1, 1992
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