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To the water's edge: repeal of the worldwide unitary tax.

Alaska has jumped in with everyone else and changed its corporate tax law. The state's lawmakers hope Alaska will clean up financially, rather than take a bath.

Mention corporate tax law and most people's eyes begin glazing over -- immediately. So why did legislators in the first year of a legislative session perk up and with uncharacteristic speed approve a major change shifting Alaska's corporate tax law -- for everyone except oil and gas companies -- to the use of the so-called "water's edge" method of taxation from Alaska's current method of "worldwide combined" tax reporting?

There is no one answer. A constellation of motives and events, the desires to attract foreign investment and please big business, fears over future court decisions, the revenue surplus caused by the Persian Gulf war and the political changes prompted by the new administration of Gov. Walter Hickel all aligned to prompt lawmakers not only to run to the water's edge, but also to jump in, getting both feet wet.

The question for the future is whether the change will act as a tide, washing new international investment dollars onto Alaska's shore, or whether the proponents of "water's edge" taxation will be proven all wet. The state ultimately could take a mini-revenue bath from the switch if the change does not generate new economic investment and thus offset lost revenues.

For the moment, there is no question that supporters of the tax change far outnumber the skeptics. Says Gov. Hickel, whose administration strongly backed and lobbied for the switch, "Repealing (the unitary tax) sends a signal to the business community that we want to provide a good atmosphere for business and industry."

Adds Commissioner of Commerce and Economic Development Glenn Olds, "This administration has clearly stated its intent to promote economic diversification as a primary objective to compensate for pending revenue declines. Amending the unitary tax demonstrates to the international business community that the legislature is willing to work cooperatively with the administration to reduce disincentives for Alaskan investments."

Scott Hawkins, president of the Anchorage Economic Development Corp., says Alaska had little choice but to pass the tax change. "The international business community saw the tax as very onerous. Once Alaska became the last state in the nation to use the worldwide taxing method, we just had to change," he explains.

Rep. Kay Brown (D-Anchorage) was one of the co-sponsors for the switch. She says, "The state clearly will get a benefit from the change. The new method should increase economic development and investment and help remove the perception, which was real whether justified or not, that Alaska wasn't a good place for international investment."

Changing Horses. Almost all states -- 45 of them and the District of Columbia -- use some form of the unitary tax concept to collect corporate revenues. Under a unitary tax, the total income of a corporation, or of an affiliated group of corporations engaged in a related business, is divided up among the states based on the portion of total payroll, property and sales that is attributable or is conducted in each state.

So if a big multinational corporation, whether based in New York or in Tokyo, say IBM, had 1 percent of its work force and offices and made 1 percent of its total computer sales in Alaska, it would pay Alaska tax based on 1 percent of its profits. So far, so good.

What has differed among the states is how big the playing field should be. Based on its experience in oil and gas taxation -- in which oil company payrolls and sales are small in Alaska compared to the value of the profits made from marketing refined petroleum products worldwide -- Alaska has for nearly two decades taxed a multinational corporation's entire operation. Using the worldwide combined reporting system, companies were expected to total up profits from their operations worldwide and pay Alaska a percentage based on their presence in the state.

During the past two decades, however, many states increasingly have shied away from taxing companies on their worldwide performance, limiting taxes to only their performance in the United States -- to the "water's edge" of the continent. Since 1984, according to the House Legislative Research Agency, 11 states have retreated from pure worldwide combined reporting, leaving Alaska as the only state to use the system.

The retreat came for a variety of reasons. While the U.S. Supreme Court, so far, has avoided requiring states to use any single method of taxation, the federal government has made it clear that it opposes worldwide combined reporting and favors water's edge taxation. That is partially because foreign governments argue that worldwide combined reporting can result in double taxation of foreign-parented multinational corporations.

Foreign countries argue that because most foreign governments tax companies based on operations inside their boundaries, if U.S. subdivisions also levy taxes on foreign operations based on their profits outside of the United States, an additional tax expense for the corporation -- a deduction -- is produced. The company then subtracts the tax deduction from its profits, further lowering foreign tax takes.

The Reagan administration, threatened with reprisals even by such allies as Great Britain, started in the early 1980s to get states to back off and tax a company only on its business activities in America. The switch also alleviated the national government's concern that states were interfering in foreign trade -- a power constitutionally delegated to the federal government.

As more and more states stopped using the worldwide-combined taxing method, the hassle for corporations of filing tax returns for the ones that didn't became greater and greater, increasing the interest of multinationals to get everyone to change. And that brought more pressure on Alaska to revamp its tax system.

"The practical problems became horrendous," says former state Assistant Attorney General Susan Burke, who represented IBM during the debate before the bill's passage. "It was terribly confusing, given currency fluctuations and overseas tax laws, for companies to convert all of their business transactions worldwide into ones following American accounting principles, just so they could file an Alaska tax return. It was very real that companies wouldn't want to locate in Alaska because of the expense and time of having to revamp their entire financial reporting systems just to satisfy Alaska's reporting requirements."

Another problem was that foreign companies were becoming increasingly vocal against worldwide reporting because they didn't like the requirement that they had to open their worldwide financial ledgers for inspection of state auditors at the time of every tax audit.

"Clearly there was reluctance, especially among the Japanese companies, to our having access to all of their books. They felt part of what we wanted to see was proprietary and should have been off-limits to us," says Carl Meyer, chief of the Department of Revenue's Income and Excise Audit Division.

Adds Anchorage Economic Development Corp.'s Hawkins, "Foreign companies really objected to the lack of confidentiality that worldwide reporting produced. It was a very real issue."

Rep. Tom Moyer (D-Fairbanks), another co-sponsor of the worldwide repeal bill, says Alaska was being hurt in gaining international investment because of maintaining the tax. He notes that Alaska in April earned a D from the Corporation for Enterprise Development, a private research group, for economic performance, in part because of the unpopular taxing system.

Another leg in the repeal campaign was supplied by the California Court of Appeals. In November 1990, the California state court ruled that use of worldwide combined reporting, as applied to corporations with foreign parents, was an unconstitutional violation of the foreign commerce clause of the U.S. Constitution. The decision has yet to be upheld by the California Supreme Court, much less the U.S. Supreme Court.

But if the decision in a case involving Barclays Bank of California is confirmed, it would have directly undermined Alaska's law. According to a memorandum from a law firm hired to advise lawmakers, the ruling could have affected revenues from returns filed up to three years in the past -- complicating the state's future revenue picture.

Dollar Sense. Actually, the amount of money directly at stake isn't very large. While the state's corporate income tax usually nets about $200 million, only about 8 percent of the total comes from the corporate tax on non-petroleum sources. According to legislative research agency statistics, the state in 1988 netted just $181.4 million from the corporate income tax and only $23.4 million from non-petroleum sources.

According to Department of Revenue estimates, the switch from worldwide to water's edge taxation will cost the state between $500,000 and $1.5 million in its first partial year, state fiscal year 1992 (beginning next July 1), and will cost between $1 million and $3 million a year in all later years. The tax change will go into effect in calendar year 1992, but the first firm indications of its effect won't be known until after April 15, 1993, when 1992 returns have to be filed.

The comparatively tiny price tag, in a year when higher oil prices caused by the Persian Gulf war had boosted the state's revenues by several hundred million dollars over forecasted amounts, was another argument in favor of the bill's passage. Says Commerce's Olds, "We believe (the $1 million to $3 million) annual revenue loss is a small price to pay for the business incentive it provides and anticipate that these losses, which assume no increase in economic activity in the state, will be compensated by an expansion in the state's industrial base."

Still another argument for approval of the switch is purely practical. While the tax change probably only applies to several hundred firms, the state, with its fewer than 60 tax auditors, is hopelessly understaffed and largely at the mercy of foreign multinational corporations to honestly list their more profitable subsidiaries in their worldwide corporate returns.

Explains Burke, "As the only state still practicing worldwide reporting, the state had no help out there in conducting audits. If a company simply left large chunks of its operations out of its returns, how would Alaska know, barring the astronomical expense of hiring a lot more investigators? Now the state at least will be able to rely on the Internal Revenue Service to help it catch any obvious violators." She notes that IRS is beefing up its international auditing division, looking for international tax avoiders.

Rebuttals. Arguments for the change didn't go totally unanswered, however. Hugh Malone, former commissioner of Revenue, argued that the change will cut state tax revenues as income from Prudhoe Bay petroleum begins falling. "The reduction in the total tax base size will mean that the legislature has to get more blood out of a lot smaller turnip," says Malone. He claims that the break is going to non-Alaska firms at the expense of instate firms.

That argument is strangely similar to one that scuttled the tax change last year. While the Hickel administration strongly supported the tax change, it was first proposed by former Democratic Gov. Steve Cowper in 1987.

Cowper, who studied the proposal for two years, in 1989 had legislation introduced that would have ended worldwide reporting for foreign-owned multinational corporations, but not for American-owned multinationals. Limiting the bill narrowly to foreign firms was estimated to cost the state as little as $60,000 a year in lost revenues.

But the limitation aroused opposition from American-owned multinationals, which argued it would have given a competitive advantage to foreign firms. That argument carried the day and caused the bill to die at the close of the 1990 legislature.

Malone also contends that the change to water's edge hasn't meant more investment in states where the new tax system is already in practice. "There is no objective evidence to support the claim that retreating from worldwide apportionment adds one dollar more of investment or one more job anywhere in the world," says Malone, echoing the views of Montana's director of revenue, John LaFaver.

LaFaver, in a 1988 presentation at the Multi-State Tax Commission, maintained that the change from worldwide to water's edge simply has increased the cost of compliance for both taxpayers and tax agencies. "We have reduced the tax base in a number of states. ... We have shifted the tax burden, and we have looked for an economic boom that has not happened. I have to wonder if somewhere down the road, we are going to have to reinvent the worldwide unitary (system)," said LaFaver.

But supporters of the tax repeal argue that it will remove one stumbling block to investment, even if it won't guarantee a rush of dollars into the state. Alaska economist Gregg Erickson, the state's former chief economist, said during a House hearing on the bill, "There is a correlation between corporate income taxes and business location decisions, and perceptions by businesses about a jurisdiction's taxing attitude also affect those decisions."

For opponents of the change, the big concern was whether the switch would encourage corporations to play corporate shell games, using so-called transfer pricing techniques to hide profits and avoid Alaska taxes. Nationally, there is a hunt on for up to $25 billion in tax revenues that the U.S. government thinks multinational corporations may be evading paying by shifting reported profits to subsidiaries in low-tax-rate countries, such as Ireland, versus higher tax-rate nations, such as the United States.

Supporters of the water's edge tax system, however, argue that tax avoidance will have to be fought under any system, it being no different under water's edge than under the worldwide reporting method. Brown, a member of the House finance panel, says, "Enforcement is a problem you have no matter what tax system you use. It's physically not possible to monitor everything one does. At least with the new system we get the chance of getting enforcement help from IRS."

Rapid Revision. As for why the change passed so quickly, most observers say lawmakers thought the change had few risks connected with it and that it made good political sense. Says one Capitol observer, "Normally it would be Democrats who would have questioned the bill, but a number of them looked around and saw that there are advantages to supporting anything that might increase outside investment to the state."

Anchorage's Hawkins also credits the bill's last-minute passage to personal lobbying by Hickel, who convinced Senate leaders to move the bill in the closing days of the session.

Whatever the reason, businesses will be seeing new instructions on their tax forms, telling some of them to jump into the process of computing next year's taxes differently. It is a change that should provide small tax cuts for many multinationals operating in Alaska, and tax cuts always are popular.
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Title Annotation:includes related article
Author:Kleeschulte, Chuck
Publication:Alaska Business Monthly
Article Type:Industry Overview
Date:Nov 1, 1991
Previous Article:Reaching for tourism revenues: increasingly, native-owned enterprises are venturing into the visitor industry.
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