Client Alert

Surveying Constitutional Theories for Challenges to the Add Back Statutes

2/1/2005

Over the last few years, eleven separate-company filing states have enacted so-called "add back statutes" that disallow a deduction for certain payments made to affiliates. [fn1] All of these states target royalties paid for the use of trademarks, tradenames or patents. Most also disallow interest deductions. [fn2] In this article, we briefly survey the basic structure of these statutes with the purpose of identifying Commerce Clause arguments that might be available for challenging all or parts of these statutes. [fn3]

The Basic Add Back Statute

Add back statutes are directed at what states perceive to be an abusive transaction, i.e., a transaction in which a taxpayer creates deductions in separate-company filing states while sourcing the related income to states with favorable tax regimes (e.g., tax regimes that either as a matter of theory or legislative grace don’t tax such income or tax it at a favorable rate).

Maryland’s add back statute is typical. Like most states, Maryland imposes a corporate income tax on a corporation’s Maryland taxable income, which is generally defined as the corporation’s federal taxable income, as modified. See Md. Code §§ 10-102, 10-301 and 10-304(1). With the passage of its add back statute, one of the modifications is a requirement that taxpayers add back the following expenses when calculating their Maryland income:

[O]therwise deductible interest expense or intangible expense if the interest expense or intangible expense is directly or indirectly paid, accrued, or incurred to, or in connection directly or indirectly with one or more direct or indirect transactions with, one or more related members.

Md. Code § 10-306.1(b)(2). For this purpose, "interest expense" is defined as "an amount directly or indirectly allowed as a deduction under section 163 of the Internal Revenue Code . . . ." Md. Code § 10-306.1(a)(7). Maryland defines "intangible expense" broadly; it includes an expense directly or indirectly related to the "acquisition, use, maintenance, management, ownership, sale, exchange or any other disposition of intangible property," a loss in connection with discounting and factoring transactions, a "royalty, patent, technical or copyright fee," a licensing fee, as well as any other similar cost or fee. Md. Code § 10-306.1(a)(5). [fn4] "Related members" include stockholders and entities related to them within the meaning of Internal Revenue Code ("IRC") §318 that own at least 50% of the taxpayer’s outstanding stock, component members within the meaning of IRC § 1563, and persons to or from whom there is an attribution of stock ownership within the meaning of IRC § 1563. See Md. Code § 10-306.1(a)(8)-(9).

In contrast to this typical model, North Carolina’s add back statute takes a slightly different tack. Instead of disallowing the expense itself (essentially on a pre-apportioned basis), the North Carolina statute targets only royalty payments received for the use of trademarks in North Carolina and treats all such payments effectively as taxable income derived from doing business in the state. See N.C. Gen. Stat. § 105-130.7A.(a). In the event the payor and the recipient of the royalties are related members, the payments may either (a) be included in the income of the recipient and deducted by the payor, or (b) added back to the income of the payor and excluded from the income of the recipient. See N.C. Gen. Stat. § 105-130.7A.(a). Thus, North Carolina effectively allocates to the state all royalties relating to use of trademarks within the state and then provides the parties a choice as to which (related) entity is to report and pay tax on the income.

Exceptions to the Disallowance

Various exceptions provided in the statutes or the regulations temper the broad sweep of the add back statutes. Although the scope and requirements of these exceptions vary between the states, [fn5] the types of exceptions found in the add back statutes may be placed in broad categories to provide a framework for considering their constitutionality.

Business Purpose and Arm’s Length Pricing

Before discussing the specifics, it is important to note that certain of the exceptions described below require the taxpayer to demonstrate that the transaction was not entered into for tax avoidance purposes and that the payments reflect arm’s length pricing. [fn6] Moreover, certain of the add back exceptions require the taxpayer to seek approval from the state’s tax agency before the exception may be claimed. [fn7] Because these requirements do not appear to implicate the constitutionality of the statutes directly, we do not dwell on them further. Nonetheless, these requirements play an important role in qualifying for many of the exceptions, and thus taxpayers seeking to avoid, rather than challenge, the add back statutes should consult with the state’s requirements to determine whether they should obtain documentation of a business purpose and arm’s length pricing to support their claim of an exception.

Categorizing the Exceptions

In general, the exceptions to the add back statutes fall into seven broad categories. The first exception discussed is the most important and requires a somewhat more extensive discussion. Thereafter we address the other exceptions in a more summary form.

The recipient is taxable on the income by the add back state or another state.

Although the specific form of this exception varies from state to state, several states allow taxpayers to avoid the add back requirement if the recipient is subject to state tax on the associated income. [fn8] The key variants among statutes adopting this exception are (1) the benchmark for determining whether the related income is subject to tax, (2) the method for establishing the recipient’s tax burden, and (3) the manner for calculating the add back.

The Benchmark

The most distinctive variant is the benchmark, or standard, for determining whether the recipient is subject to a sufficient amount of tax on the related income. Virginia’s exception is the broadest, and merely requires that the recipient be subject to "a tax based on or measured by net income or capital," without specifying a minimum tax rate. Va. Code § 58:1-402(B)(8)(a)(1), (9)(a)(4)(i); see also Ark. Code § 26-51-423(g)(1)(A). The instructions to the Virginia return specify that the inclusion of the income in the recipient’s net income or capital must result "in a non-trivial increase in tax liability (or reduction of an operating loss) after consideration of all of the deductions, credits, exemptions and other tax policies and preferences affecting the tax liability of the related member." Va. Instructions for Form 500-AB (2004).

Most states establish a more significant hurdle by declaration or by using a formula based on the state’s tax rate. For example, Maryland specifies that the recipient must be subject to tax at a rate not less than four percent, see Md. Code § 10-306.1(c)(3)(ii), whereas Connecticut and Massachusetts each condition their exception on the recipient being subject to tax at a rate that is equal to or greater than the state’s statutory rate of tax less three percentage points, see 2003 Conn. Acts § 78(c) (Spec. Session); Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004 (Connecticut’s statutory rate of tax is 7.5%; therefore, the taxpayer "must establish that the interest paid to the related member was actually taxed at a rate no less than 4.5% (7.5% - 3%)); Mass. Gen. Laws ch. 63 § 31J. Finally, New Jersey’s interest add back statute ties its benchmark to the rate of tax applicable to the payor, by requiring the rate of tax applicable to the recipient to be equal to or greater than the rate of tax applied to the payor less three percentage points. See N.J. Rev. Stat. § 54:10A-4(k)(2)(I). [fn9]

The Recipient’s Tax Burden

The second variant is the method used to calculate the recipient’s tax burden to determine whether it has met the benchmark. Several factors affect this calculation. First, the formula itself differs. Connecticut’s statute focuses on the amount of tax the recipient actually pays, and thus determines the recipient’s rate of tax by dividing the amount of tax paid (after credits have been applied) by the recipient’s taxable income before apportionment and net operating loss carryforwards. See Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004.

Maryland makes this calculation by considering the recipient state’s statutory rate of tax and the recipient’s apportionment percentage. See Md. Code § 10-306.1(a)(4); N.J. Reg. 18:7-5.18(a)4.viii. As illustrated in the following example, New Jersey’s interest add back statute similarly considers the state’s statutory rate of tax and the apportionment percentage, but does so for both the payor and the recipient.

Suppose Company A does 99% of its business in California, a combined return state, and 1% of its business in New Jersey. Company A lends funds to Company B, an affiliate, which does 60% of its business in California and 40% of its business in New Jersey. New Jersey’s tax rate is 9%.

Under this scenario, Company A’s rate of tax would be 0.09% (1% times 9%), and Company B’s rate of tax would be 3.6% (40% times 9%). Company B would not qualify for New Jersey’s exception under these facts because Company A’s rate of tax (0.09%) is not equal to or greater than Company B’s rate of tax (3.6%) less 3% (0.6%).

However, suppose Company B did 33% of its business in New Jersey, and 67% of its business in California. Under this scenario, Company B would qualify for New Jersey’s exception because Company A’s rate of tax (0.09%) is equal to or greater than Company B’s rate of tax (3.0%) less 3% (0%).

Thus, a taxpayer will meet this benchmark as long as its New Jersey apportionment factor is 33% or less and the recipient is subject to tax in New Jersey (even at a nominal amount).

Another factor affecting the calculation of recipient’s tax burden is whether taxes paid in combination or consolidated states count against the benchmark. Most add back statutes only consider taxes paid by the recipient in separate-company filing states. See, e.g., N.J. Reg. 18:7-5.18(a)(5), Ex. 5; Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004; Va. Instructions for Form 500-AB (2004). The theory, of course, is that unitary combination or consolidation states eliminate intercompany payments from income and that, in the simplest of terms, the recipient has no item of income to tax. Maryland, however, recognizes that the tax consequences of combination or consolidation are not necessarily so simple, and thus provides that the payment of the royalty or interest will be treated as taxed to the extent of the lesser of the recipient’s apportionment factor or the combined (or consolidated) group’s apportionment factor. See Md. Code § 10-306.1(e). The effect of this provision can be illustrated as follows:

Suppose Company A operates wholly in California, has $150 of gross income from third parties, $25 of deductible expenses involving payments to third parties, and receives a royalty from its affiliate, B, of $25 which is eliminated because it is a transaction among members of a combined report. Also suppose that Company A has a combined factor (property, payroll and sales) of $600.

Suppose Company B operates entirely within Maryland, also has $150 of gross income from third parties, $25 of deductible expenses involving third parties and pays a $25 royalty to A. Also suppose Company B has a combined factor (property, payroll and sales) of $400.

Under these facts, Company A, by reason of filing a combined report with Company B, reports to California net income of $150, ($300 less $50 times 6/10), which California taxes to A. Although the shift of the $25 into California does not arise as the result of the payment of the royalty (which is eliminated in the combined report), $25 of B’s income nonetheless effectively has been shifted to A and taxed by California.

Another factor affecting the calculation of the recipient’s tax burden is whether the state considers the amount of tax paid to one state or the total amount of tax paid to all states. For example, Maryland seeks to determine the recipient’s "aggregate effective tax rate," which it defines as "the sum of the effective rates of tax imposed by all states, including this state and other states or possessions of the United States, where a related member receiving a payment of interest expense or intangible expense is subject to tax and where the measure of the tax imposed included the payment." Md. Code § 10-306.1(a)(2). New Jersey and Connecticut, on the other hand, only consider the rate of tax paid to one state. See N.J. Rev. Stat. § 54:10A-4(k)(2)(I); Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004. [fn10]

Relief from the Add Back

The third variant that comes into play is the manner in which relief is provided once the payor has proven that the recipient was taxable on the associated income. In most cases, this exception is essentially binary: if the recipient is taxed at a rate at or above the benchmark set by the state, the taxpayer obtains the deduction; however, if the recipient is taxed on the payment but at a rate below the benchmark, the payor obtains no relief. See Ark. Code § 26-51-423(g)(1); N.J. Rev. Stat. § 54:10A-4(k)(2)(I); Md. Code § 10-306.1(c)(3)(ii); 2003 Conn. Acts § 78(c) (Spec. Session). Thus, these exceptions only eliminate double taxation if the corresponding income is subject to tax above a certain threshold, and differ from a typical credit mechanism where the tax imposed by another state reduces the tax imposed upon the taxpayer claiming the credit on a dollar-for-dollar basis.

However, Alabama’s exception allows relief from the add back statute on a sliding scale. More specifically, Alabama requires taxpayers to add back otherwise deductible interest and intangible expenses unless the corresponding item of income is "subject to a tax based on or measured by the related member’s net income." Ala. Code 40-18-35(b)(1). Alabama does not set a minimum rate of tax as its benchmark, but rather specifies that the exception is "allowed only to the extent that the recipient related member includes the corresponding item of income in post-allocation and apportionment income reported to the taxing jurisdiction." Ala. Admin. Code r. 810-3-35-.02(2)(g). In other words, taxpayers are provided relief to the extent that the recipient allocates or apportions its income to separate-company filing states. Thus, if the recipient allocates or apportions 5% of its income to separate-company filing states, the taxpayer is required to add back only 95% of its intercompany interest and intangible expenses. See Ala. Admin. Code r. 810-3-35-.02(3)(g)(1).

In contrast to the exceptions described above, the other exceptions typically found in add back statutes may be readily described.

The recipient is located in a country that has a comprehensive income tax treaty with the United States.

Many states provide a special exception that is available where the taxpayer demonstrates that the ultimate recipient of the payment is located in a foreign country that has a comprehensive tax treaty with the United States. [fn11] Some states incorporate this exception into their general exception that applies if the recipient is subject to state tax on the corresponding income, and thus similarly require the recipient’s foreign rate of tax to exceed a certain threshold. See 2003 Conn. Acts § 78(c) (Spec. Session); Mass. Gen. Law Ch. 63 § 31J(b); N.J. Rev. Stat. § 54:10A-4(k)(2)(I). However, Arkansas, Connecticut and Virginia have specified that the foreign country exception will apply regardless of the tax rate applicable to the recipient. See Ark. Code § 26-51-423(g)(1)(A); Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004; Va. Code § 58.1-402B(8).

The recipient is not an intangible holding company.

Several states have attempted to limit their add back statute to address only pure intangible holding company structures. [fn12] For example, Alabama provides that the taxpayer will not be required to add back otherwise deductible expenses if it can establish that the transaction giving rise to the expenses did not have tax avoidance as its principal purpose and the recipient is "not primarily engaged in the acquisition, use, licensing, maintenance, management, ownership, sale, exchange, or other disposition of intangible property, or in the financing of related entities." Ala. Code § 40-18-35(b)(3); see also Miss. Code § 27-7-17(2)(c)(ii) (providing a similar exception where the recipient’s primary business is not related to intangibles).

Virginia provides an exception to its intangible add back provision if the recipient "derives at least one-third of its gross revenues from the licensing of intangible property to parties who are not related members" and the transaction was entered into at arm’s length rates and terms. See Va. Code § 58.1-402B(8)(a)(2).

The payor and payee are subject to a special industry exception.

Certain add back statutes provide an exception for members of specified industries, presumably in recognition that those industries engage in transactions involving intangible assets or intercompany loans as a matter of ordinary business practice. For example, Maryland provides an exception to its add back statute for interest paid by a bank to a bank. See Md. Code § 10-306.1(c)(3)(iii). Virginia also provides an exception to its interest expense add back provision if the recipient has substantial business operations relating to interest-generating activities that require at least five full-time employees; the interest expenses are not related to the acquisition, maintenance, management or disposition of intangible property; and certain other requirements are met. See Va. Code § 58.1-402B(9)(a). Connecticut has a special exception for insurance companies, hospitals and medical service corporations. See 2003 Conn. Acts § 78(c) (Spec. Session); Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004.

The recipient is a "conduit" and passes the income through to a third party.

Numerous states provide an exception when the income passes through the recipient to a unrelated party. [fn13] For example, Maryland’s statute provides that the add back statute does not apply if the recipient "directly or indirectly paid, accrued, or incurred the interest expense or intangible expense to a person who is not a related member" during the same taxable year. Md. Code § 10-306.1(c)(3)(i). New Jersey’s exception to its interest add back statute is more narrow in that it requires that the payor also guarantee the debt for the conduit exception to apply. See N.J. Rev. Stat. § 54:10A-4(k)(2).

The payor and recipient are unitary and elect to file a combined report or consolidated return.

Two states (Ohio and Connecticut) also provide an exception that is tied to a combined report or consolidated tax return. In Ohio, this exception limits the tax payable under the add back statute to the amount that would have been payable had the parties filed a combined return. See Ohio Rev. Code § 5733.042(D)(4). In Connecticut, at least in regard to the interest add back, the taxpayer must actually elect to file on a combined basis with all members of the unitary group with which there are substantial intercompany transactions. See 2003 Conn. Acts § 78(d)(3) (Spec. Session). Such an election is irrevocable for five successive income years. Id.

The result reached is unreasonable.

Finally, most add back statutes also contain a catch-all exception that allows the tax authorities and the taxpayer to override the add back where the disallowance of the deduction is "unreasonable" or the parties agree to some alternative apportionment method under an analogue to section 18 of the Uniform Division of Income for Tax Purposes Act. [fn14] In general, these statutes provide that the taxpayer must carry a heavy burden of proof and may require filing a petition establishing that conclusion prior to filing its tax return. See, e.g., Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004 (construing 2003 Conn. Acts § 78(d)(1) (Spec. Session) and indicating that evidence that the add back is unreasonable must be "clear and convincing" and so "clear, direct and weighty" that the Commissioner comes to a "clear conviction without hesitancy" as to the validity of the taxpayer’s claim).

Some states provide guidance as to what would qualify for this exception. For example, New Jersey suggests that the taxpayer must demonstrate the extent to which the recipient pays New Jersey tax on the corresponding income or that the taxpayer is being taxed on more than 100% of its income, see N.J. Reg. 18:7-5.18(a)2 and N.J. Questions and Answers Regarding the Business Tax Reform Act of 2002, Question 7, whereas Alabama suggests that the taxpayer must show that the application of the add back statute causes the tax to bear no fair relationship to the taxpayer’s Alabama presence, see Ala. Admin. Code r. § 810-3-35-.02(3)(h).

Other exceptions contemplate that the taxing authority may issue regulations to provide exceptions for transactions not currently contemplated by the state’s exceptions. For example, Maryland Code § 10-306.1(d)(2) authorizes the issuance of regulations to provide for an alternative treatment where the recipient is subject to tax in another state that is measured by gross receipts, net capital or net worth, rather than income.

Elimination of the Payment from the Recipient’s Income To Prevent Double Tax

In addition to providing exceptions to the add back rule, certain of the add back statutes provide that the computation of taxable income of the taxpayer and the recipient are to be coordinated such that the income associated with the payment is not subject to double tax. Conceptually, this provision is a mirror image of the exception described above where the deduction is allowed if the recipient is subject to tax on the corresponding income. Whereas that exception eliminates the payment from the payor’s income (i.e., the deduction is allowed); here the payment is eliminated from the recipient’s income.

In any event, the scope of this provisim varies among the states. Connecticut, for example, states that the recipient’s Connecticut income and receipts factor is not to include any amounts added back to the payor’s income as a result of the Connecticut add back statute. See 2003 Conn. Acts § 78(f) (Spec. Session). Similarly, New York permits a taxpayer to deduct royalty payments received from related members "unless such royalty payments would not be required to be added back under [New York’s add back provision] or other similar provision in this chapter." N.Y. Tax Law § 208(9)(o)(3). Moreover, North Carolina’s regime effectively reaches the same result by giving the payor and the recipient the choice of which entity is to report the income. See N.C. Gen. Stat. § 105-130-7A.(a), (c).

Maryland’s relief measure goes farther and eliminates the payment from the recipient’s income if that payment has been subject to Maryland’s or another state’s add back provision; however, this adjustment is only permitted if the transaction has a valid business purpose and arm’s length pricing and terms, and is limited to the extent that the aggregate effective tax rate imposed on the recipient exceeds the taxpayer’s aggregate effective tax rate. See Md. Code § 10-306.1(f).

Overview of the Commerce Clause Constraints

Since the Supreme Court’s decision in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the constitutionality of taxes imposed upon interstate commerce has been evaluated against a four prong test.

  • Does the state have substantial nexus with the activity taxed?
  • Is the tax fairly apportioned?
  • Does the tax discriminate against interstate commerce?
  • Is the tax fairly related to the services provided by the state?

To provide a framework for evaluating the constitutionality of the add back statutes, we focus upon the first three of those prongs: namely whether the state has substantial nexus; whether the royalty add back statutes discriminate against interstate commerce; and whether the taxes produced by the add back statutes are fairly apportioned.

Substantial Nexus

The Commerce Clause requirement that a tax on interstate commerce have substantial nexus generally involves two distinct but related inquiries. First, a state must have jurisdiction over the taxpayer it seeks to tax. Generally, this requirement is developed in the context of the physical presence standard of Quill Corporation v. North Dakota, 504 U.S. 298 (1992). Recently, however, states have begun to challenge the fundamental assumption that the physical presence standard is applicable to taxes other than sales and use taxes, e.g., income taxes. Compare A&F Trademark, Inc. v. Tolson, 605 S.E. 2d 187 (2004) (concluding that North Carolina had jurisdiction to impose income tax upon the recipient of royalty payments for the use of intangible property within the state even though the recipient had no physical presence in North Carolina) with Lanco, Inc. v. Dir, Div. of Taxation, 21 N.J. Tax 200 (2003), appeal pending, No. A-003285-03T1 (N.J. Super. Ct. App. Div.) (concluding that New Jersey could not impose income tax on a Delaware intangible holding company because the taxpayer had no physical presence in the state).

The second nexus inquiry involves whether a state has jurisdiction over the income, transaction or property it seeks to tax. In the context of reaching specific items of income earned by a taxpayer doing business within a state (other than the state of the taxpayer’s commercial domicile), the Supreme Court’s decision in Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992) sets the outer boundary as requiring a showing that the income in question serves an "operational" as opposed to an "investment" purpose. Particularly where the state seeks to measure a corporate taxpayer’s income by reference to the income of other corporations (i.e., by requiring a combined report of income), this requirement is also articulated as the unitary business test, typically requiring some showing of functional integration, centralization of management and economies of scale between the entities to be combined. See Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159 (1983).

Discrimination Against Interstate Commerce

In simplest terms, the discrimination prong prohibits a state from taxing interstate commerce more harshly than in-state commerce. See Halliburton Oil Well Cementing Co. v. Reily, 373 U.S. 64 (1963). Thus, a state may not impose a heavier tax burden upon a transaction that crosses state lines than would be imposed on a purely intrastate transaction. See Boston Stock Exch. v. State Tax Comm’n, 429 U.S. 318 (1977). Nor may a state’s tax system coerce a taxpayer to move its operations into the taxing state or pressure a taxpayer to limit its investments to in-state entities. See Armco, Inc. v. Hardesty, 467 U.S. 638 (1984); Fulton Corp. v. Faulkner, 516 U.S. 325 (1996).

A state may save a tax that appears to discriminate against interstate commerce by showing that the state’s tax system contains a compensatory or complementary tax on intrastate commerce that effectively levels the playing field. Id. However, a state cannot save a discriminatory tax by showing that the lower tax on local commerce is simply an attempt to avoid a double tax on local businesses. See Armco Inc. v. Hardesty, supra; Farmer Bros. Co. v. Franchise Tax Bd., 108 Cal. App. 4th 976 (2003), cert. denied, 540 U.S. 1178 (2004). In other words, if a state moves to eliminate double taxation of income (e.g., either through a "multiple activities exemption" or through a specific deduction for income that has previously been taxed), the state must extend that relief to eliminate double taxation arising from taxes imposed by other states as well. Id.

The Apportionment Requirement

In recent years, the apportionment prong of the Complete Auto test has been expressed in the internal and external consistency tests first articulated in Container Corporation of America v. Franchise Tax Board, supra[fn15]. Under the internal consistency test, a tax will be struck down if (assuming other states adopt an identical tax) the tax regime would impose a multiple tax burden on interstate commerce where intrastate commerce would bear a single tax burden. See Armco, Inc. v. Hardesty, supra. Thus, under the internal consistency test, the logical risk of multiple taxation is evaluated rather than the actual imposition of multiple taxes. Id.

Under the external consistency test, a tax will be struck down if it extends to values that are not fairly attributable to activity within the taxing state. See Oklahoma Tax Comm’n v. Jefferson Lines, 514 U.S. 175 (1995). The external consistency requirement focuses upon whether the state has adopted a mechanism for apportioning the tax base rather than whether the actual results are supportable as an economic matter. Id.; see also Philadelphia Eagles Football Club, Inc. v. City of Philadelphia, 823 A.2d 108 (Pa. 2003); Northwood Constr. Co. v. Township of Upper Moreland, 573 Pa. 189 (2004). However, broadly viewed at least, the external consistency requirement operates in coordination with the requirement (often expressed in Due Process terms) that a state may not extend its taxing powers to claim income that is all out of proportion to the income earned within the jurisdiction. See Hans Rees’ Sons, Inc. v. North Carolina, 283 U.S. 123 (1931).

The Commerce Clause Does Not Prohibit Multiple Taxation Per Se

Finally, under current Supreme Court precedents, the Commerce Clause does not appear to prohibit multiple taxation of income per se. Thus, where the multiple taxation arises from a conflict in the tax systems of different states, the Commerce Clause is unlikely to provide relief. See, e.g., Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978) (approving of a single sales factor apportionment formula in the face of the three-factor apportionment formula commonly used by other states); Container Corp. of Am. v. Franchise Tax Bd., supra (approving the use of worldwide combined reporting in the face of the widespread adoption by other countries of separate accounting); Zelinsky v. Appeals Tribunal, 801 N.E.2d 840 (N.Y. 2003), cert. denied, 124 S. Ct. 2068 (2004) (approving of New York’s taxation of income earned by a resident of Connecticut who was working in Connecticut based on the "convenience of the employer doctrine," despite the fact that Connecticut also claimed the income). But see Japan Line, Ltd. v. County of Los Angeles, 441 U.S. 434 (1979) (finding discrimination in violation of the Commerce Clause under a more rigorous test applied for foreign commerce where Los Angeles imposed a nondiscriminatory apportioned property tax on foreign-owned containers used in international shipping in conflict with the rule applied in Japan and other foreign countries that imposed a full (unapportioned) tax on containers that were owned, based and registered in the country).

Application of the Commerce Clause to the Add Back Statutes

Using these constitutional principles as a template, we hereafter identify theories that may be available to challenge certain of the add back statutes.

Substantial nexus

Any challenge based upon the substantial nexus prong of Complete Auto presumably would be based on the notion that the disallowance of an otherwise generally allowable deduction is effectively the equivalent of taxing the income to which it is linked. [fn16] See Hunt-Wesson, Inc. v. Franchise Tax Board, 528 U.S. 458 (2000). [fn17] Thus, while a state generally has broad license to determine what expenses are to be deductible from income where the deduction is tied specifically to one category of income, the disallowance of the deduction would be subject to attack if the state lacked substantial nexus to tax that income. Id.

While it may be possible to challenge the reach of the add back statutes based upon such an argument, prevailing on that position would appear to be an uphill battle. As described above, the constitutional standard governing this issue was established in the Allied Signal v. Director, Division of Taxation, supra. Under that decision, a state must simply demonstrate that the income is from operational sources rather than investment sources, a standard that would appear readily met in most cases. Allied Signal, of course, did not deal with a factual pattern such as those triggering the add back statutes, where the issue is not so much a question of the character of the income as a question of whose income it is. If one views the income as belonging to the recipient, one might well conclude that the state ought to have to show a unitary relationship between the payor and the recipient in order to compute the payor’s income by reference to the recipient’s income. Again, however, one would expect that in most cases a state would have little problem in establishing a unitary relationship between the recipient and the payor. Given that the statute is limited to affiliated taxpayers and directed toward a specific item of income (e.g., royalties) paid by one company to the other, proving such a relationship is not likely to represent a significant hurdle in most cases. See Container Corp. of Am. v. Franchise Tax Bd., supra.

Nonetheless, there may be cases where raising the issue could be determinative.

Suppose for example that in year one Company A, a large computer manufacturer, licenses valuable operating systems from Company B, a large software company. Suppose Company A and B are both publicly traded companies with no ownership overlap. Suppose that in year two, Company A acquires more than 50% of the stock of Company B and continues to pay royalties to Company B on the same terms as before the acquisition. Finally, suppose that Company A and B otherwise operate as fully autonomous businesses that do not meet the requirements of a unitary business.

Obviously, the question here is whether a state can effectively tax to Company A income that appears to belong to Company B without having to meet the requirement of showing the two businesses are, in fact, engaged in a single unitary business.

Eliminating Double Taxation in the Add Back State

In contrast, it would appear that a more serious Commerce Clause challenge could be waged against certain add back statutes based upon the discriminatory effect of their exceptions. For example, where the add back statute provides relief from double taxation only in those circumstances where both the payor and the recipient are taxable in the add back state, the exception would appear to violate the internal consistency test.

Suppose for example, that Company A and Company B are both located 100% in Connecticut. Suppose further that Company A pays a $100 royalty to Company B and that the add back statute would otherwise apply to this payment. Under 2003 Conn. Acts § 78(f) (Spec. Session), Company B will be permitted to eliminate from income any payments that were added back to Company A’s income under the add back statute.

LSuppose now that Company B moves its operation into Pennsylvania, also a separate-company filing state. Company A must again add back to income the royalty paid to Company B. Assuming Pennsylvania were to adopt Connecticut’s tax system in its entirety, Pennsylvania also would tax B on the royalty received from Company A since the add back of the royalty did not arise under Pennsylvania’s statute.

Connecticut’s tax regime appears to violate the Commerce Clause in this case because the transaction between A and B is taxed only once when it occurs within a single state but is subject to multiple taxes when conducted between two states. See D.D.I., Inc. v. North Dakota, 657 N.W.2d 228 (N.D. 2003); Farmer Bros. Co. v. Franchise Tax Bd., supra (applying the internal consistency clause to transactions between two different taxpayers). [fn18]

Benchmarking the Recipient’s Tax Burden by a Single State

At least two states, Connecticut and New Jersey, condition their exception to the add back statute by looking at whether the recipient is taxable in another state at a tax rate considered acceptably high. In this regard, the exception apparently ignores the aggregate state tax burden borne by the recipient.

Suppose for example, that Company A, located 100% in New Jersey, pays a $25 royalty to Company B, whose operations are located in four separate states: New York, Connecticut, North Carolina and Ohio. While each of these states has a tax rate that is sufficiently high to trigger an exception to the New Jersey add back statute, because B does business in all four states, the benchmark is not met.

Discriminating against one form of interstate commerce over another (i.e., between business operations conducted in multiple states rather than a single state) would certainly seem to be the type of tax prohibited by the Commerce Clause, although the authors are aware of no authority directly addressing the issue. However, such a notion draws inferential support from the Supreme Court’s decision in Kraft General Foods v. Iowa Department of Revenue & Finance, 505 U.S. 71 (1992), where the Court stuck down a tax scheme that favored domestic commerce over foreign commerce. In so doing, the Court made it clear that the absence of a benefit for local commerce does not excuse an otherwise discriminatory tax. Rather, it is the effect upon the commerce generally (in that case providing a more favorable dividend deduction for domestic dividends than for foreign dividends) that determines whether the system offends the Commerce Clause. Cf. Halliburton Oil Well Cementing Co. v. Reily, 373 U.S. 64, 72 (suggesting that Commerce Clause protections are intended to protect taxpayers from having to make economic decisions to concentrate or disburse business operations based upon state tax laws).

Discrimination in Favor of Foreign Commerce

It would appear that a challenge might also be possible against add back statutes that favor foreign commerce over domestic commerce, although the authority for any such challenge is considerably less clear. The Connecticut add back statute also serves as an example for this type of challenge. Under that statute, if the recipient of a royalty operates in a country in which there is a comprehensive income tax treaty with the United States, the payor need not add back the royalty, regardless of the rate of taxation imposed upon the recipient. See Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004. In contrast, where the royalty is paid to a domestic entity, the payor must show that the recipient is taxed on the item at a tax rate in excess of Connecticut’s tax rate less three percent to qualify for the exception to the add back requirement. See 2003 Conn. Acts § 78(c) (Spec. Sess.). Arguably, providing a more favorable tax deduction for foreign commerce may be viewed as unconstitutional discrimination against domestic commerce.

As noted, there is authority establishing that domestic commerce may not be favored over foreign commerce. See Kraft Gen. Foods v. Iowa Dep’t of Revenue and Fin., supra. However, we are aware of no authority for the converse proposition. Indeed, one may well argue that the Supreme Court’s decision in Japan Line, Ltd v. County of Los Angeles, supra, establishes just the opposite because the Court in that case suggested that the Commerce Clause is more protective of commerce in the international setting than it is of domestic commerce.

Disallowance Based Upon the Recipient’s Presence in a State With a Favorable Tax Regime

Perhaps the most fundamental constitutional question presented by the add back statutes is whether a state, by its tax regime, may effectively penalize a taxpayer for doing business with an affiliate that operates in another state with a favorable tax regime. [fn19] A taxpayer bringing such a challenge must largely operate in uncharted territory although, on a visceral level, the theory for such a challenge finds support in Supreme Court decisions approving of state tax incentives as a means for states to compete in interstate commerce. [fn20] Consider the following example:

Suppose that Company A is located 100% in Connecticut and borrows all of its capital from Company B, located 100% in New York. Suppose further that Company A pays $100 in interest to Company B. Because New York taxes Company B on the receipt of that interest at the NY tax rate of 7.5%, Connecticut allows Company A to reduce its income by the amount of the interest payment.

Suppose now that New York determines that to retain its status as a financial center, it must amend its state income tax to reduce the tax rate on interest to 1%. As a consequence, Connecticut now disallows Company A’s $100 interest deduction.

Whether viewed from the point of view of Company A or the point of view of the New York policy makers, Connecticut’s reaction to the New York change in policy seems to thrust Connecticut beyond its boundaries into matters properly within the discretion of New York. In effect, Connecticut’s imposition of the tax on Company A directly frustrates New York’s policy change. While this example may seem a bit far fetched, consider the result where Company B simply decides to move to Nevada, which currently forgoes the taxation of income in order to attract business to the state. Or consider states like Ohio, where state tax authorities encourage relocation of industry by offering credits against tax for extended periods of time. If Connecticut can frustrate such policies by disallowing a deduction for interest and royalty payments, could Connecticut broadly disallow a deduction for other business transactions where the recipient is operating in a tax-favored jurisdiction?

While Connecticut may be expected to argue that its add back statute is surgically directed at "abusive tax planning" involving loans and trademarks, in actual fact, the statutes reach many commonplace business transactions, such as intercompany financing done wholly for nontax reasons. Nonetheless, if the lender of such amounts is located in a unitary combination state or a state with no income tax, the borrower is denied a deduction. If, instead, the lender moves to a separate-company filing state, the borrower is now permitted to deduct the interest. Again, there seems to be something odd, and untoward, if not unconstitutional, about Connecticut’s influence over that decision.

The authors are aware of no direct authority supporting a challenge on this theory. However, the add back statutes may be generally compared to the New Hampshire tax considered in Austin v. New Hampshire, 420 U.S. 656 (1975). In that case, the New Hampshire tax was imposed only on nonresidents from states that would grant a credit for the amount of the New Hampshire tax. New Hampshire sought to defend the discriminatory tax by arguing that the other states could simply repeal their credit for the New Hampshire tax to "reclaim" the taxable income. Thus, the state argued:

[T]he argument advanced in favor of the tax is that the ultimate burden it imposes is "not more onerous in effect," [citation omitted] on nonresidents because their total state liability is unchanged once the tax credit they receive from their State of residence is taken into account.

Id. at 665-666. But the Court rejected this argument:

According to the State’s theory of the case, the only practical effect of the tax is to divert to New Hampshire tax revenues that would otherwise be paid to Maine, an effect entirely within Maine’s power to terminate by repeal of its credit provision for income taxes paid to another State. The Maine Legislature could do this, presumably, by amending the provision so as to deny a credit for taxes paid to New Hampshire while retaining it for the other 48 States. Putting aside the acceptability of such a scheme, and the relevance of any increase in appellants’ home state taxes that the diversionary effect is said to have, [footnote omitted], we do not think the possibility that Maine could shield its residents from New Hampshire’s tax cures the constitutional defect of the discrimination in that tax.

Id. at 666-667. It is important, of course, to recognize that the tax considered in Austin was facially discriminatory in that no similar tax was imposed upon New Hampshire residents. Thus, the opinion may be limited to the simple proposition that an otherwise discriminatory tax may not be upheld merely because another state may by legislation eliminate the tax by imposing its own tax. However, the decision itself appears also to be grounded in the notion that New Hampshire was overreaching in imposing its tax. Certainly, the taxpayer suffered no significant harm through New Hampshire’s imposition, as the New Hampshire tax simply replaced, dollar-for-dollar, the tax that Maine would have imposed. See Justice Blackmun in dissent at 668-669; compare Private Truck Council, Inc. v. Secretary of State, 503 A.2d 214 (1986), cert. denied 476 U.S. 1129 (1986) (striking down a "third structure" flat tax imposed only on trucks registered in other states imposing a similar "third structure" tax where the purpose of Maine’s discriminatory tax was to coerce the other states to repeal these taxes).

In this regard, the taxes imposed upon the payor of a royalty or interest by the payor state could similarly be eliminated by a decision of the state in which the recipient is located to adopt a separate-company filing requirement and impose a tax at a rate sufficiently high to meet the benchmark set by the payor state. [fn21] Yet, like the tax considered in Austin, there would seem to be something misdirected about a state simply imposing its tax because its sister state has a tax regime that allows for it.

Disallowing a Deduction Has the Effect of Re-Sourcing Income to the Add Back State

At the end of the day, the add back statutes may simply be viewed as a state’s attempt to allocate the income associated with the intangible asset, whether it be a loan or a trademark, into the state where the payor is located. [fn22] When one considers that a state is effectively taxing income theoretically earned by another taxpayer (e.g., the lender in an intercompany loan situation), it may be argued that the add back state’s taxing system must provide for some factor representation of the recipient in addition to the unitary relationship, discussed earlier. Certainly that would be true if the state simply required the payor and the payee to file a combined report because they were unitary. The issue may be illustrated by reference to the example we described in our discussion of the requirement that there be substantial nexus with the income the add back state seeks to tax:

Recall that in this example, Company A licenses software from Company B. In year one, both are large publicly traded entities. In year two, Company A acquires more than 50% of Company B’s stock but otherwise the two large companies continue to operate independently.

In the prior discussion, we asked whether a state should be able to tax the royalty income of Company B by disallowing the deduction for A, without meeting the requirement of showing that the two businesses were engaged in a unitary relationship. Here, we pose a related question, should the state be required to provide some factor representation for B’s operation in deciding the source of the income taxed to A?

Because the taxation occurs as a result of the disallowance of A’s deduction and a tax imposed on A, the closest authority concerning this issue may be that which has arisen in the context of whether dividend income received by a taxpayer from foreign entities must be apportioned under a system that provides for factor representation for the dividend paying entities. Unfortunately, such arguments have not fared well in the courts, although the principles continue to seem unassailable to the authors. See also Hellerstein & Hellerstein, State Taxation, 9.15[4][a] (2004 Cumm. Supp. No. 2).

Conclusion

Litigation testing the new add back statutes has just begun. Attacks based upon existing Commerce Clause precedents are most likely to be directed toward the working of particular discrete exceptions rather than the general add back rules themselves. However, because the exceptions often go to the fundamental mechanics of the statutes, a successful attack on the workings of an exception may have the effect of invalidating the entire disallowance statute. See Calfarm Ins. Co. v. Deukmejian, 48 Cal. 3d 805, 821 (1989) ("The final determination [whether a statute or portion thereof is severable] depends on whether the remainder . . . is complete in itself and would have been adopted by the legislative body had the latter foreseen the partial invalidity of the statute. . . or constitutes a completely operative expression of the legislative intent. . ."); Hotel Employees & Restaurant Employees Int’l Union v. Davis, 21 Cal. 4th 585, 612-13 (1999) (an "invalid part can be severed if, and only if, it is ‘grammatically, functionally and volitionally separable.’")

An attack based upon the core issue, namely the right of a state to penalize a taxpayer for doing business with an affiliate in a state that provides a favorable tax regime, will probably require blazing new ground. Whether those types of challenges will be successful remains to be seen.

Finally, it should be noted that the constitutional issues presented by the add back statutes may be readily resolved simply by adopting a combined reporting system such as that pioneered by California. Because the add back statutes have been adopted to resolve a perceived "loophole," it seems unlikely that separate-company filing states will simply accept a return to the prior state of affairs if such statutes are successfully challenged. Thus, taxpayers should be mindful of the ultimate results a successful challenge to the statute might bring.


Footnotes

1:See Ala. Code § 40-18-35(b); Ark. Code § 26-51-423(g)(1); Conn. Stat. § 12-218c; 2003 Conn. Acts § 78 (Spec. Session); Md. Code § 10-306.1; Mass. Gen. Laws ch. 63 §§ 30.4, 31I, 31J, 31K; Miss. Code § 27-7-17(2); Ohio Rev. Code § 5733.042; N.C. Stat. §§ 105-130.5, 105-130.6, 105-130.7A; N.J. Rev. Stat. § 54:10A-4(k)(2)(I); N.J. Rev. Stat. § 54:10A-4.4; N.Y. Tax Law § 208(9)(o); Va. Code § 58.1-402B(8)-(9).
Other separate-company filing states have enacted provisions that address intercompany transactions, but which are not conventional add back statutes. See, e.g., Del. Code tit. 30 § 1903; Ky. Rev. Stat. § 141.205; La. Rev. Stat. § 47:287.738; Tenn. Code § 67-4-2004.

2: Alabama, Connecticut, Maryland, New Jersey and Ohio disallow all intercompany interest expense. See Ala. Code § 40-18-35(b); Conn. Stat. § 12-218c.(a)(4); 2003 Conn. Acts § 78(a)(2) (Spec. Session); Md. Code § 10-306.1(a)(7); N.J. Rev. Stat. § 54:10A-4(k)(2)(I); Ohio Rev. Code § 5733.042(A)(4). However, Massachusetts, Mississippi, New York, North Carolina and Virginia disallow interest payments to affiliates only when such payments are associated with intangible property. See Mass. Gen. Laws ch. 63 §§ 31I(a); Miss. Code § 27-7-17(2)(a)(iii); N.Y. Tax Law § 208(9)(o)(1)(C); N.C. Stat. §§ 105-130.7A(b)(6); Va. Code § 58.1-302.

3: For an overview of these statutes, also see Hellerstein & Hellerstein, State Taxation, 7.13[3] (2004 Cumm. Supp. No. 2).

4: The definition of what constitutes an intangible expense or interest subject to disallowance varies among the statutes. For example, New Jersey requires I.R.C. section 197 amortization costs to be added back if they are attributable to an intangible asset acquired from a related member. See N.J. Div. of Taxation, Questions and Answers Regarding the Business Tax Reform Act 2002, Jan. 6, 2004, Question No. 13. Also, as illustrated by the Maryland statute, some states include losses incurred while selling receivables (factoring) to an affiliate within the definition of an intangible expense. See Ala. Code § 40-18-1(9); Conn. Stat. § 12-218c.(a)(2); Md. Code § 10-306.1(a)(5)(ii); Mass. Gen. Laws ch. 63 § 31I(a)(2); Miss. Code § 27-7-17(2)(a)(i); N.J. Rev. Stat. § 54:10A-4.4(a); Ohio Rev. Code § 5733.042(A)(3); Va. Code § 58.1-302. Other states appear not to require such expenses to be added back.

5: Indeed, in some states, the exceptions provided for intangible expenses are different from those provided for interest expenses. For example, Connecticut provided different exceptions when it enacted its interest disallowance during a different legislative session than its intangible disallowance. See, e.g., Conn. Stat. § 12-218c; 2003 Conn. Acts § 78 (Spec. Session).

6: See, e.g., Md. Code § 10-306.1(c).

7: See, e.g., Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004.

8: A variation of this exception is available in Alabama, Arkansas, Connecticut, Maryland, Massachusetts, New Jersey and Virginia. See Ala. Code § 40-18-35(b)(1); Ark. Code § 26-51-423(g)(1)(A); 2003 Conn. Acts § 78(c) (Spec. Session); Md. Code § 10-306.1(c)(3)(ii); Mass. Gen. Laws ch. 63 § 31J; N.J. Rev. Stat. § 54:10A-4(k)(2)(I); Va. Code § 58:1-402(B)(8)-(9).

9: As discussed below, although New Jersey’s formula technically looks to whether the recipient is taxable at a sufficient high rate, in many cases, the payor’s New Jersey apportionment factor actually will be determinative of whether the exception applies.

10: Despite the limitation in the statutory exception, Connecticut explicitly provides an opportunity to seek relief if the recipient’s aggregate rate of tax (for all states) exceeds the benchmark. See Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004. However, to obtain such relief, a taxpayer must seek relief under the state’s reasonableness exception, which requires the taxpayer to file a petition prior to paying the tax and establish, by clear and convincing evidence, that the add back of such expenses is unreasonable. Id.

11: A variation of this exception can be found in Alabama, Arkansas, Connecticut, Massachusetts, New Jersey, New York and Virginia. See, e.g., Ala. Code § 40-18-35(b)(1); Ark. Code § 26-51-423(g)(1)(A); 2003 Conn. Acts § 78(c) (Spec. Session); Mass. Gen. Laws ch. 63 § 31J(b); N.J. Rev. Stat. § 54:10A-4(k)(2)(I); N.J. Rev. Stat. § 54:10A-4.4(c)(1)(a); N.Y. Tax Law § 208(9)(o)(2)(B); Va. Code § 58.1-402B(8).

12: A variation of this exception can be found in Alabama, Mississippi and Virginia. See, e.g., Ala. Code § 40-18-35(b)(3); Miss. Code § 27-7-17(2)(c)(ii); Va. Code § 58.1-402B(8)-(9).

13: A variation of this exception can be found in Connecticut, Maryland, Massachusetts, Mississippi, New Jersey, New York, Ohio and Virginia. See, e.g., Conn. Stat. § 12-218c.(c)(2); Md. Code § 10-306.1(c)(3)(i); Mass. Gen. Laws ch. 63 § 31I(c)(ii); Miss. Code § 27-7-17(2)(c)(i); N.J. Rev. Stat. § 54:10A-4(k)(2); N.J. Rev. Stat. § 54:10A-4.4(c)(3); NY. Tax Law § 208(9)(o)(2)(B)(i); Ohio Rev. Code § 5733.042(D)(2)(a); Va. Code § 58.1-402B(8)(a)(3).

14: A variation of this exception can be found in Alabama, Arkansas, Connecticut, Massachusetts, New Jersey, Ohio and Virginia. See, e.g., Ala. Code § 40-18-35(b)(2); Ark. Code § 26-51-423(g)(1)(C); Conn. Stat. § 12-218c.(c)(1); 2003 Conn. Acts § 78(d)(1) (Spec. Session); Mass. Gen. Laws ch. 63 §§ 31I(c)(i), 31J(a); N.J. Rev. Stat. § 54:10A-4(k)(2)(I); N.J. Rev. Stat. § 54:10A-4.4(c)(1)(b)-(c); Ohio Rev. Code § 5733.042(D)(1); Va. Code § 58.1-402B(8)(b) and 9(b).

15: In more recent decisions, the Court has acknowledged that the internal consistency test also serves to identify whether a tax is discriminatory. See Armco, Inc. v. Hardesty, supra; Farmer Bros. Co. v. Franchise Tax Bd., supra.

16:Because the add back statute seeks to impose a tax on the payor (by disallowing the deduction), who is present in the taxing state, these statutes effectively sidestep the related nexus issue, i.e., can the state impose a tax on a recipient that has no physical presence within the state? As noted, this issue is currently the subject of judicial litigation in a number of states. See A&F Trademark, Inc. v. Tolson, supra, Lanco, Inc. v. Dir., Div. of Taxation, supra. The two issues are, of course, related. Assuming that the add back state can establish that the income arose from sources within the state, i.e., that the state has transactional nexus with the income (and that it is fairly apportioned), there would appear to be no constitutional impediment to the add back state’s decision to collect the tax from the payor even if the tax itself may be viewed as being imposed upon the recipient. See International Harvester Co. v. Wisconsin Dep’t of Taxation, 322 U.S. 435 (1944)) (based upon the fact that the earnings involved arose from within the taxing state, the Court required a corporation to pay a tax on dividends declared even though Wisconsin courts had previously construed the statute as imposing the tax on the shareholders (including out-of-state shareholders)).

17: In Hunt Wesson, supra, of course, the interest deduction was calibrated to income items (non business dividends) that were independent of the payment of the interest. Here the state is effectively disallowing a deduction that produces the income that the state wishes to re-source to itself. Thus, the deduction and the income items (viewed from the perspective of the recipient) are inextricably intertwined in the add back statutes, making any challenge based upon the remoteness of the income item perplexing.

18: As described above, the North Carolina add back statute similarly limits relief for the payor to those cases where the payee includes the item in its income. See N.C. Gen. Stat. § 105-130.7A.(a). However, because the North Carolina statute explicitly limits its reach to income arising from the use of intangibles within the state of North Carolina, were that statute to be replicated in other states, there would not appear to be any meaningful risk of multiple taxation since each state would simply impose tax on intangible income arising from within its borders. However, such a conclusion may be overly simplistic in that it assumes that the state would not, under its general income tax principles, otherwise impose a tax on royalties received by a company doing business within the state that arise from the use of intangible property used in other states. Assuming that the general income tax does impose such a tax under those circumstances, then North Carolina’s system could be viewed as violating the internal consistency because it apparently relieves multiple taxation only where both the recipient and payor are fully taxable in the state on income earned from within the state.

19: We recognize that a state might well argue that the exception mechanism described in this section operates in many ways like a typical tax credit by which a taxpayer may be relieved of, say, a use tax if it proves the transaction was previously subject to a sales tax. So viewed, it is difficult to argue that the add back exception presents unsettled constitutional problems. Nonetheless, the parallel to such credit mechanisms seems incomplete. In particular, because the add back statutes are an exception to an otherwise generally allocable deduction, the add back seems directly targeted at the income that otherwise would be taxed by another state. See Hunt-Wesson, Inc. v. Franchise Tax Board, supra. Moreover, in contrast to a typical credit mechanism, as described above, the exception mechanism is not fully calibrated to the amount of tax claimed by the other state. Rather, the exception requires that the recipient state adopt a tax policy that the payor state considers acceptable (i.e., that the recipient state utilize a separate company filing regime and adopt a tax rate that this sufficiently high to discourage any advantage to locating within the recipient state). Because of these features, the add back statutes and their exceptions simply seem more intrusive on the policies of their sister states.

20: But see Cuno v. DaimlerChrysler, Inc., 383 F.3d 379 (6th Cir. Ohio 2004), petition for reconsideration pending (striking down as violative of the Commerce Clause Ohio investment tax credits granted to DaimlerChrysler for purchasing new manufacturing machinery and equipment during the qualifying period, provided that the new manufacturing machinery and equipment are installed in Ohio).

21: See the discussion regarding the exception that applies where the recipient is taxable on the income by the add back state or another state, supra.

22: See Thomas H. Steele & Neil I. Pomerantz, Source-Based Taxation of Intangible Income: A Critique of Morton Thiokol and Ohio’s Add-Back
Provisions, State & Local Tax Insights, Sept. 1998.


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