States Clip Wings of Corporate Tax Flight

Taxation, according to one tax practitioner, is "the art of getting the most feathers with the least squawks." If so, a new court ruling on corporate taxation plucks too many feathers, judging from recent squawking from multinationals.

On June 27, the U.S. Supreme Court upheld the right of a state to tax the worldwide income of a multinational corporation according to its share of global business activities conducted in the state. The ruling denies a bid by Container Corporation of America, a subsidiary of Mobil Corporation, to overturn California's use of the tax method, known as "unitary taxation."

The decision is a "major defeat" for multinationals, says Ken Cory, California's state tax controller. Cory adds that the state-which has used the unitary tax method for twenty years-had $500 million in yearly tax revenues at stake in the case. Eleven other states that apply unitary taxation to multinationals retain hundreds of millions of dollars as a result of the ruling.

Most states, as well as the federal government, use a method known as "arm's length" to tax multinationals. Under this method, collectors assume a corporation treats its subsidiaries as it would an outside customer-at arm's length. To determine taxable income, auditors sort through the multinational's transactions with its subsidiaries invoiceby-invoice - which in some case can pile up at an astronomical rate-and tax each transaction separately. As tax expert and journalist Jonathan Rowe has written, "In effect, the IRS tries to untangle the contents of the corporate spaghetti bowl, strand by strand."

Under the unitary method, however, states recognize a corporation as an integrated, centrally managed operation. States take three different indexes of business activity - property, payroll, and sales - compare them to the multinational's overall activity, and calculate the amount of business activity falling within the state. Thus if eight percent of Xerox's worldwide property, payroll, and sales occurred in California, and Xerox's total income was $200 million, California would be entitled to taxes on $16 million.

The Supreme Court decision is a clear victory for individual taxpayers and states, which could save as much as $1.2 billion if all states adopted the tax form, according to an estimate by the National Governors Association. But citizen taxpayer advocates say that the choice between the unitary and arm's length methods is not simply a question of higher or lower taxes. Rather, it is a question of choosing an accurate, enforceable method which reflects the structure of modern corporations.

Critics assert that while the arm's length method may once have been appropriate, it has little relevance in an era of conglomerates and electronic transfers of capital. The U.S. Department of Commerce estimates that approximately 38 percent of total U.S. trade in goods is between parts of the same corporation. Many of these dealings involve below-market interest rates on loans, shared services and resources, and reduced prices on equipment and technical assistance.

Dean Tipps, director of Citizens for Tax Justice, explains that the arm's length method also "opens the door to creative accounting schemes" by which the multinational squirrels away profits in tax havens and low-tax jurisdictions. "Income goes untaxed because a corporation will tell a state it made the income in its subsidiary in a tax-free country, or it sets up paper corporations that buy its products and then sell them back at a 'loss'." Mobil Oil Corporation, for example, claimed that it owed only $1900 in state income tax to Vermont for three years during which it did over $27 million worth of business in the state.

In addition, critics claim that the arms length method is virtually impossible to administer. The sheer volume of transactions means that "no state can effectively audit all a company's internal business dealings," says Tipps. "So-the company and the tax auditors end up negotiating a tax settlement." To a large degree, then, taxation becomes a series of offers and counteroffers between companies and government officials.

At present, a total of 24 states apply unitary taxation to a corporation with branches or subsidiaries in other states. Twelve of them also tax foreign subsidiaries in the same way. After the Supreme Court gave the green light to the unitary method in June, the Florida legislature acted quickly to extend its unitary taxation from domestic to worldwide subsidiaries. The state claims it needs the $95 million in additional revenue to improve its education system.

The Supreme Court ruling has been roundly denounced by most major multinationals, foreign-based companies with U.S. affiliates, and foreign governments. "We are deeply disappointed in the ruling," says IBM spokesperson Dennis Arvay. "We believe the unitary system is unfair and discriminatory, and results in double taxation." Many companies insist that lower foreign wage rates distort the unitary formula.

Calling the method "arbitrary and inequitable," Bob Dillon, an executive vice president with Sony Corporation, contends it puts a "huge administrative burden" on corporations like Sony with headquarters abroad. "When you bring in the different accounting methods [of the corporation's home country], different currency, and different laws, you run into mind-boggling problems," says Dillion. He concedes, however that such paperwork becomes necessary only when a corporation decides to dispute the state's assessment.

Dillion is clearly miffed when he reflects on Sony's brand-new investment in Florida. "If we had known Florida was going to pull this, we would have thought twice about investing there," he says.

But corporations are quick to support the unitary method when it works to their advantage. This can happen when a company's headquarters is in a state using the system or when its out-of-state operations are less profitable than its in-state operations. Several years ago Caterpillar Corporation found itself in the bizarre position of fighting for the right to be taxed under the unitary method in the Illinois Supreme Court, facing a group of corporations led by Coca-Cola that opposed the method. Caterpillar won its case then (the U.S. Supreme Court reaffirmed the ruling in July) and became one of the most vocal opponents of pending Congressional legislation that would outlaw unitary taxation of multinationals. "The [unitary] method is the most accurate and fairest means of determining profitability," company literature states. "Caterpillar believes the principle is sound."

Other corporations are less altruistic in their praise of the unitary system. "We support it because it's to our benefit - it's purely dollars," asserts Darryl Coppin, a tax attorney for McDonald's Corporation, which backed Caterpillar in its court battle. Exxon has even been known to argue in favor of unitary taxation in one state, and against it in another, as it suited its interest.

The main reason corporations so vigorously oppose the unitary system, critics say, is that they are afraid the federal government and Third World countries will begin to use it. The arm's length method is currently the reigning international practice, endorsed by international tax treaties. Jim Rosapepe of the Multistate Tax Commission, a cooperative tax enforcement body that recommends unitary taxation, tells of being approached by a British government minister several years ago: "He said to me, `Don't you realize what you're doing? If less developed countries start using this method, they will sock it to American companies and European companies.' He belived it was inherently obvious that it's bad to tax."

At present tax departments in Third World countries do not have the technical capability to handle a corporation's computer-based accounting. As with many U.S. states and the federal government, they end up negotiating tax settlements - a situation that clearly works to the advantage of the multinationals. The unitary approach would be a simple and enforceable alternative. But most observers agree that until Third World countries can gain access to more information about a company's operations, as well as build up needed confidence to break with tradition, they are likely to stay the arm's length course.

Similarly, the U.S. Treasury Department stands firmly behind the arm's length method, primarily due to "habitual thinking and ideological bias," in the words of one observer. But support for the unitary system is growing among the ranks of Treasury bureaucrats as they recognize the need for increased government revenue and for simple, uniform standards.