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Justice in New Mexico - the Conoco and Intel cases.

Introduction

The New Mexico Supreme Court has dealt a serious, and perhaps fatal, blow to New Mexico's attempt to save the constitutionality of the manner in which it taxes a corporation's dividend income. See Conoco, Inc. and Intel Corporation v. Taxation and Revenue Department of the State of New Mexico, Docket Nos. 22, 995 & 23, 045 (Nov. 26, 1996). On November 26, 1996, the New Mexico Supreme Court unanimously held that New Mexico's practice of including foreign dividend income, but not domestic dividend income, in its corporate income tax base violates the Commerce Clause of the United States Constitution. Furthermore, and perhaps more important, the court turned aside the State's attempt to keep monies unlawfully collected from corporate taxpayers pursuant to that unconstitutional tax scheme. The court has ordered the State to pay refunds due Conoco and Intel to eliminate the effects of the discriminatory taxation they suffered. Following the court's decision, the Department filed a motion asking the court to reconsider its decision. That motion is still pending. If the court does not grant the Department's motion, the Department has indicated it may seek review by the U.S. Supreme Court.

The case is remarkable not only for the ingenuity demonstrated by the New Mexico Taxation and Revenue Department in its attempt to remedy the unconstitutionality of its statute but also for the Department's tenacious refusal to pay full refunds to taxpayers harmed by New Mexico's unconstitutional statute.

In the Beginning: The Kraft Decision

The saga began in the summer of 1992 wl Supreme Court ruled in Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, 506 U.S. 71 (1992), that Iowa's method of taxing corporate dividends was unconstitutional. Iowa, like many states including New Mexico, uses federal taxable income as its corporate income tax base. Federal taxable income includes dividend income received from foreign corporations but not dividend income received from domestic corporations. International multiple taxation at the federal level is eliminated through the foreign tax credit mechanism -- applied, of course, after the effects on U.S. taxes are ascertained. Domestic dividend income is for the most part eliminated from federal taxable income by operation of the federal dividends received deduction (in section 243 of the Internal Revenue Code). Most states make some accommodation in order to tax the dividends flowing in foreign and domestic commerce identically. Neither Iowa nor New Mexico did so. That failure created the unconstitutional discrimination.

In Kraft, the U.S. Supreme Court held in the context of Iowa's separate-entity reporting method that inclusion of foreign dividend income, but not domestic dividend income, in Iowa's tax base placed a tax burden on dividends flowing in foreign commerce but not on dividends flowing in domestic commerce. The court found therefore that Iowa's scheme for taxing dividend income facially discriminated against foreign commerce in violation of the Commerce Clause of the U.S. Constitution. It concluded that the two streams of dividend income must be taxed identically. As the New Mexico Supreme Court noted, "New Mexico's [separate-entity] tax scheme is virtually identical to Iowa's. . . ." Conoco and Intel, Slip Op. at 7.

New Mexico Refund Claims

The similarity of Iowa and New Mexico's tax schemes was not lost on corporate taxpayers, especially those who elected to report to New Mexico using the separate-entity reporting method. Shortly after the Kraft decision was announced, New Mexico began receiving claims for refund from corporate taxpayers, including Conoco and Intel. Most of the refund claims were based on excluding foreign dividends from the tax base just as domestic dividends had been excluded.

By the end of 1992 New Mexico had received 30 to 40 refund claims. The number of refund claims and the total dollar amount of the requested refunds would likely not be considered significant for larger states. For a non-industrial state like New Mexico, however, where 30 corporate taxpayers (mainly in the extractive industry) account for more than 50 percent of corporate income tax revenues, the refund claims posed more than a minor blip in revenues.

The Revenue Department's Response

The Department's immediate response was to deny all Kraft-based refund claims. It did that based on two theories. The first theory for denial was that Kraft should be given prospective application only. That is, corporate taxpayers were allegedly not entitled to any relief with respect to the taxes they had overpaid in the past as a result of New Mexico's unconstitutional scheme for taxing dividend income. In taking this position, New Mexico relied on what is known as the doctrine of selective prospectivity. See Chevron Oil Co. v. Huson, 404 U.S. 97 (1971). The Department's second theory, which was ultimately rejected by the Department's internal hearing officer as well as every court that considered it, was premised on its belief that New Mexico's method of dividend taxation in the context of combined and federal consolidated reporting was constitutional. After all, the Department argued, Kraft applied only to those corporate taxpayers that used the separate-entity reporting method and since, under New Mexico's scheme of corporate income tax reporting, corporations could have elected to use combined or federal consolidated reporting, they presumably had a constitutional reporting method available. Therefore, the Department's argument went, such taxpayers were not harmed by the constitutional infirmities of separate-entity reporting; any harm was a problem of the taxpayer's own making.

The Department made a third argument with respect to taxpayers like Conoco and Intel that had sought to exclude federal Subpart F income and PFIC income on the same basis as actual repatriated foreign dividend income was excluded. With regard to deemed dividend income, the Department argued that the doctrine established in Kraft was simply inapplicable.

In late 1992, at the same time the Department was denying corporate taxpayers' Kraft refund claims, it was revising its corporate income tax instructions for 1992. For the 1992 tax year, the Department ordered separate-entity taxpayers to exclude foreign dividend income just as domestic dividend income was excluded.(1) Thus, for 1992 the Department adopted the same method to remedy the unconstitutional discrimination that Conoco and Intel were claiming for prior years.

The Department was also keeping the New Mexico Legislature informed of its activities. In late 1992 and early 1993, the Department repeatedly submitted written reports stating that it thought that Kraft was applicable to New Mexico's scheme for taxing dividend income of separate-entity corporate taxpayers. The Department, however, requested that the Legislature take no action to cure the problem because it felt it could avoid paying the requested refunds under its prospectivity theory.

In the summer of 1993, the U.S. Supreme Court caused the Department to abandon its prospectivity theory. That abrupt about-face occurred when the Court held in Harper v. Virginia, 509 U.S. 86 (1993), that the doctrine of selective prospectivity was dead in the context of state tax claims based on violations of federal law, including the U.S. Constitution. Harper requires states to afford all taxpayers "meaningful backward-looking relief" to remedy the effects of state tax provisions that violate federal law. Having had its principal reason for refusing to pay the refunds clearly eliminated, the New Mexico Taxation and Revenue Department went back to the drawing board in an effort to figure out some way to keep these taxpayer monies.

Administrative Hearings

In the summer of 1993, the Department was also pushing the litigation track with Conoco and Intel. Both had timely filed administrative protests to the refund denials. In New Mexico, there is no independent tax court or independent administrative law proceeding. Taxpayers' protests are heard by the Department's internal hearing officer at a formal administrative hearing. At a formal administrative hearing testimony is taken, documentary evidence is introduced and a record is made. The party that loses at the formal hearing -- either the taxpayer or the Department -- is entitled as a matter of right to take an appeal to the New Mexico Court of Appeals. There is no de novo proceeding. Hence, a taxpayer's only opportunity to make its record is at the Department's internal formal administrative hearing.

The Department put both the Conoco and Intel cases on a fast track. In late April 1993, the Department set a formal administrative hearing for Conoco in late July, a mere 90 days after the notice. Conoco requested a continuance to give it more time to prepare and the Department's internal hearing office granted a continuance of an additional eight weeks until September 21, 1993, when the Conoco matter was tried.

Intel's case was similarly expedited, with a formal administrative hearing slated for early October 1993. Because of scheduling conflicts, the Intel case was then moved back until early 1994 when it was heard before the Department's internal hearing officer.

The Detroit Formula

Continuing to work on ways to avoid paying refunds, the Department's counsel developed a clever -- but ultimately incorrect -- legal theory. The Department's newest position was that more fairly apportioning a corporate taxpayer's foreign dividend income would eliminate the Commerce Clause discrimination inherent in New Mexico's tax scheme. The Department's remedy for the discrimination was to grant factor representation with respect to foreign dividends using what has become known as the "Detroit Formula." The formula, which owes its name to an agreement reached between Ford Motor Company and the City of Detroit, operates to reduce a state's taxable income base by adding to the denominators of the parent's property, payroll, and sales a portion of the property, payroll, and sales of dividend-paying foreign subsidiaries.

The Department's theory in adopting the formula was that formulary apportionment sources to a particular jurisdiction, in this case a state, only that income that is earned within the state. After all, it is settled law that a state can only tax income earned within its borders, and formulary apportionment has for the better part of this century been the preferred method for doing such. See, e.g., ASARCO Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982). The Department reasoned that, if it sought to more fairly apportion a corporate taxpayer's foreign dividend income, then the resulting income apportioned to New Mexico would be only that income earned in New Mexico; therefore, the discrimination problem would be cured. This change of posture meant that the Department was willing to concede a small portion of the refunds claimed.

For the periods open to refund, the Department had included a corporation's foreign dividend income in the New Mexico corporate tax base and apportioned that income using only domestic apportionment factors (property, payroll, and sales). Its proposed Detroit Formula remedy allowed corporate taxpayers to include all or a portion of the foreign dividend-paying subsidiary's factors in the denominator of the apportionment formula. This, the Department reasoned, would apportion away from New Mexico the dividend income not actually earned in New Mexico.

The Department's theory is premised on its view that foreign dividends paid by a non-U.S. member of a unitary business enterprise to a U.S. member of the same unitary business enterprise are in part earned because of contributions to the foreign member made outside of the actual geographical area in which the foreign member conducts business. In this case, the Department argued that those contributions had come, in part, from New Mexico. Therefore, the Department's argument continued, by including the factors of the dividend-paying foreign corporation in the apportionment formula, foreign dividends would be apportioned away from New Mexico and would bear no tax burden. As for foreign dividend income not apportioned away from New Mexico, the Department's theory continued, because those dividends were fungible, they lost their character as foreign dividend income. Therefore, when New Mexico, through the use of formulary apportionment, determined income earned in New Mexico, it purportedly was not taxing foreign dividends. Moreover, the Department asserted, in theoretical situations where foreign and domestic efficiencies were absolutely identical or in situations where domestic efficiencies were far greater than foreign efficiencies, the application of the Detroit Formula would apportion all or more than all foreign dividend income away from New Mexico. Hence, the constitutional problem of discrimination against dividend income flowing in foreign commerce was, according to the Department's theory, eliminated.

Does the Detroit Formula Eliminate Discrimination?

Unfortunately for the Department, even if its theory resulted in true equality for a theoretical taxpayer, that was not the result when the theory was applied to Conoco and Intel. The theory was just that -- a theory. In practice, application of the Detroit Formula's factor representation provisions did neither Conoco nor Intel much good. In fact, Conoco demonstrated at its formal administrative hearing that, even after the application of the Detroit Formula, 57 percent to 93 percent of its foreign dividends were being subjected to tax by New Mexico. Intel's calculations showed similar results.

The failure of the Department's approach and its ultimate rejection by the New Mexico Supreme Court resulted from its viewing the facts through theoretical blinders. The simple fact remains that discrimination against a constitutionally protected form of commerce can occur even under the fairest of apportionment methodologies. While the Commerce Clause requires both fair apportionment and no discrimination, the two concepts are not mutually exclusive and they do not implicate the same concerns.

Fair apportionment focuses on whether a state is acting reasonably and fairly in how it determines income earned within its borders. The Supreme Court has given the states great latitude in determining apportionment methodologies and, in turn, in determining what income is earned in a particular state. See, e.g., Barclays Bank v. Franchise Tax Board, 512 U.S. 298 (1994); Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983); Moorman Manufacturing Co. v. Bair, 437 U.S. 268 (1977). Iowa, for example, uses only a single factor (sales), while New Mexico uses the prototypical three-factor formula and, in the case of manufacturers, allows for the use of a four-factor formula by double weighting the sales factor. When one considers New Mexico's three different reporting methods coupled with the use of either a three-factor or four-factor formula, the use of each of these methodologies by a manufacturing corporation could result in as many as six different amounts of apportioned income to New Mexico, each of which could be considered under the U.S. Constitution to be income earned only in New Mexico. The Department's theory would allow a seventh amount, which it contended would magically eliminate the discrimination that Kraft found to be constitutionally offensive.

The principal limitations on apportionment formulas are the internal and external consistency tests. Those tests ask whether no more than 100 percent of a corporation's income would be taxed in all states if a particular state's apportionment formula were applied and whether the formula, as applied, fairly represents where the income is earned. Container Corp., 463 U.S. 159 (1983).

Commerce Clause discrimination, on the other hand, is absolute and there is no room for imprecision. The court has been clear to state that a "strict rule of equality" is mandated. See, e.g., Halliburton Oil Well Cement Co. v. Reily, 373 U.S. 64 (1963); Associated Industries v. Lohman, 511 U.S. 641 (1994). Furthermore, the Supreme Court has pointed out that there is no need to know the actual amount resulting from the discriminatory tax, Maryland v. Louisiana, 451 U.S. 725, and there is no such thing as a de minimis amount of discrimination. Fulton Corp. v. Faulkner, 116 S. Ct. 848 (1996). Protected forms of commerce -- whether intrastate, interstate, domestic, or foreign must be treated equally. This principle of "equality" ultimately formed the analytical cornerstone of the New Mexico Supreme Court's decision.

The Department first presented its Detroit Formula argument to its internal hearing officer during Conoco's formal administrative hearing. At approximately the same time, the Department promulgated a proposed regulation, UDI 19:10, that granted factor representation to separate-entity filers. The Department also informed the legislature that it could fix the Kraft problem by this regulation and that statutory changes were not necessary.

The adoption of the Detroit Formula approach facilitated settlement of many of the smaller Kraft refund claims. It provided the Department with what it believed was a principled settlement basis -- granting factor representation. The application of the Detroit Formula method of factor representation, however, in general only provides a reduction of 25 percent to 35 percent. But for corporate taxpayers faced with potential litigation and relatively small claims, apparently some relief was better than litigation.

The Conoco case was decided by the Department's internal hearing officer in early February 1994. The Decision and Order entered by Department's internal hearing officer had a little something for each side; the bottom line, however, was unfavorable to Conoco. Most significantly, the Department's internal hearing officer ruled that Conoco had suffered the effects of an unconstitutionally discriminatory tax. He also ruled that deemed foreign dividends must be treated identically to actual foreign dividends. In addition, the internal hearing officer ruled that, even if dividend taxation pursuant to New Mexico's combined or consolidated reporting methods did not suffer from the constitutional infirmities that plagued the State's separate-entity method, Conoco had elected to report using the separate-entity method and it was entitled to have that method applied to it in a constitutional manner. That was exactly what Conoco was asking. Unfortunately for Conoco, that is where the good new ended, for the internal hearing officer then ruled that the Detroit Formula provided an adequate remedy to redress the ill effects of the unconstitutional discrimination that Conoco incurred. Accordingly, Conoco's refund claim was denied.

The Appellate Hearings

Conoco then appealed its case to the New Mexico Court of Appeals. Shortly thereafter, two things of importance occurred. First, on March 17, 1994, the Department finalized its Detroit Formula regulation, UDI 19:10. The regulation was adopted with a retroactive effective date of January 1, 1988. That date by no mere coincidence was the beginning of the period open for refund claims filed by both Conoco and Intel. Second, the Intel case was tried before the same hearing officer. To no one's surprise, the hearing officer entered a Decision and Order in Intel not materially different from the Decision and Order he had entered in Conoco. Intel then filed its appeal the New Mexico Court of Appeals.

In the Spring of 1995, a three-judge panel of the New Mexico Court of Appeals entered a 2-1 decision in Conoco. The majority held that the adjustments to the apportionment formula mandated by the Department's new, retroactive Detroit Formula regulation created "comparability" between apportionment of foreign dividend income and exclusion of domestic dividend income. That was so, the court held, even though the regulation was not adopted until after the Conoco case had been tried and was pending on appeal. In short, the Court of Appeals held that New Mexico's method of taxing foreign dividends was constitutional. Judge Thomas Donnelly dissented concluding that the retroactive Detroit Formula regulation did not correct the problem of Commerce Clause discrimination. Judge Donnelly concluded that Kraft clearly controlled and no amount of fancy theoretical footwork could avoid that simple conclusion.

With knowledge that it had no appeal as a matter of right to the New Mexico Supreme Court and that the last time the New Mexico Supreme Court had agreed to hear a corporate income tax case was in 1980, Conoco nevertheless persisted and filed a petition for certiorari with the New Mexico Supreme Court asking for its review of the Court of Appeals decision. Intel, whose case was still pending in the Court of Appeals, filed an amicus brief with the Supreme Court asking it to hear the Conoco case as did the Committee on State Taxation.

The Court of Appeals decision in Intel -- an unpublished memorandum decision -- was announced shortly after Conoco filed its petition for certiorari and before the time the Supreme Court was to rule on the petition. The three-judge panel in Intel ruled that it was bound by the other panel's decision in Conoco but noted that it questioned the decision of the majority and urged review by the New Mexico Supreme Court. Judge Donnelly was also on the Intel panel and entered a similar dissenting opinion as he had in Conoco. Interestingly, it appeared as if five judges of the Court of Appeals had considered the issues presented in the Conoco and Intel cases and three of the judges appeared to agree with the taxpayers' arguments. Nevertheless, the taxpayers lost both cases. Intel then filed a petition for certiorari with the New Mexico Supreme Court, requesting review of the Court of Appeals' decision in its case.

The New Mexico Supreme Court's Decision

In July 1995, the New Mexico Supreme Court granted certiorari and agreed to hear both cases. It ordered the cases consolidated and set oral argument for late September 1995, telling the parties that no further briefing was necessary.

In late November 1996, the Court announce its decision that New Mexico's scheme of taxing foreign dividend income in the context of separate-entity reporting was an unconstitutional violation of the Commerce Clause, citing Kraft. It further held that the Department's Detroit Formula regulation did not save the tax scheme. Key to the court's ruling was the concept of equality. The court was unequivocal in its statement that Kraft and other U.S. Supreme Court cases mandated that protected forms of commerce be treated equally and not comparably, especially when theoretical comparability resulted in foreign dividends' being included in the tax base and subject to taxation. Both taxpayers had argued that their foreign dividends were still being taxed even with factor representation. That fact was not lost on the court and, indeed, was crucial to its decision. The court noted that the Detroit Formula "does not eliminate dividends paid by foreign subsidiaries in every case. In particular, it did not do so in these cases." Conoco and Intel, Slip Op. at 8. The court continued (id. at 9):

The Detroit formula does not remove all of the

dividends paid by foreign subsidiaries from the tax

bases of these taxpayers. It fails to neutralize the

discriminatory effect of the separate corporate

entity method for taxpayers with foreign dividend

income. . . .

While this particular litigation may be pursued to the U.S. Supreme Court by New Mexico, the New Mexico Supreme Court's decision will likely be cited in many other jurisdictions because of its clarity. The court did not get caught up in the Department's theories nor did it confuse the concepts of discrimination and fair apportionment. Rather, the court, with little discussion of the underlying constitutional theory, looked at clear and well-reasoned constitutional authority and acknowledged that a fairly apportioned tax can still have components that discriminate against protected forms of commerce and, further, that states must act to eliminate such discrimination.

Conclusion: Additional Refunds Could Be Available

Many corporate taxpayers, especially those who file in New Mexico using the separate-entity reporting method, may have additional New Mexico corporate income tax refunds available. Only for the 1992 tax year did the Department allow separate-entity filers to exclude foreign and domestic dividends in an identical manner. For 1993 and subsequent tax years, the Department has permitted separate-entity filers to apportion foreign dividends through the use of the Detroit Formula method of factor representation, but it has not permitted foreign dividend exclusion. As a result of the Conoco and Intel cases, it is now clear that separate-entity corporate taxpayers are entitled to foreign dividend exclusion. Accordingly, many such New Mexico corporate taxpayers will likely want to amend corporate tax returns for 1993 and subsequent years to exclude foreign dividend income just as domestic dividend income was excluded. That will, of course, likely result in refunds for many affected taxpayers.

(1) "The Iowa statute struck down by the U.S. Supreme Court is substantially similar to the separate-entity method of reporting allowed as an option by New Mexico's corporate income tax statutes and may be applicable to New Mexico taxpayers filing under that method of reporting. In order to ensure that New Mexico's corporate income taxes are administered in a constitutional manner prior to legislative action, the Department will allow an additional deduction for certain foreign dividends. . . ." 1992 New Mexico Instructions for Corporate Income and Franchise Taxes, Form CIT-1, at 3.

RELATED ARTICLE: Epilogue

Shortly after the original decision in Conoco and later, New Mexico's Taxation and Revenue Department filed a Motion for Reconsideration in which it sought, among other things? a remand to the administrative hearing officer for a determination of an appropriate remedy. To say the least, that motion did not produce the result sought by the Department. Indeed, on January 23, 1997, the New Mexico Supreme Court denied the Department's motion, withdrew its previous opinion and issued a new, more strongly-worded, unanimous opinion in Conoco's and Intel's favor.

Unlike the earlier opinion, the revised opinion was issued by the entire Supreme Court, not just a three-justice panel. As part of its request for reconsideration, the Department had asked the court to give it yet another opportunity to avoid paying the taxpayers the refunds which they had sought. That was the reason the Department requested a remand of the case to the Department's hearing officer -- to give the officer an opportunity to consider the adequacy of yet another remedy (other than the payment of refunds). The Department, however, did not spell out what its newest proposed remedy would be. For that reason -- or because it otherwise concluded that taxpayers had waited long enough -- the court sharply rebuffed:

Serial litigation of multiple efforts to craft a remedy

for specific taxpayers would be an affront to judicial

economy and the principle of finality.

Conoco and Intel, Slip Op. at 15 (Jan. 23, 1997). Moreover, the court in its Mandate to the Department left no doubt about the actions it expected:

[T]his cause is remanded to you to allow the refunds

sought by the taxpayers and abate the assessment

levied by the department. . . .

Mandate of the New Mexico Supreme Court (issued Jan. 23, 1997).

CURTIS W. SCHWARTZ is an attorney with the Santa Fe, New Mexico, office of Modrall, Sperling, Roehl, Harris & Sisk, P.A. He chairs that firm's tax practice and works extensively in the state and local tax area. PAUL H. FRANKEL is an attorney with the New York office of Morrison & Foerster LLP. He co-chairs that firm's extensive state and local tax practice, and is a frequent speaker at educational programs sponsored by Tax Executives Institute whose State and Local Tax Committee he once chaired. Mr. Schwartz was trial counsel for Conoco, Inc. and Messrs. Schwartz and Frankel served as trial co-counsel for Intel Corporation and co-counsel for both Conoco and Intel in the New Mexico Supreme Court in the ease that is the subject of this article. They wish to express their appreciation to Charles Drury and David L. Conway of E.I. duPont de Nemours and Company (the parent company of Conoco) and Robert H. Perlman and RaeAnn M. Dixon of Intel.
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Author:Frankel, Paul H.
Publication:Tax Executive
Date:Jan 1, 1997
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