Congress Considers Tax Apportionment: How States Divvy Up Corporate Taxes

May 7, 2010

Click here to listen to a podcast interview with Prof. Swain.

Congress is exploring creating standards for state taxation. The Committee on the Judiciary’s Subcommittee on Commercial and Administrative Law has recently held three hearings relating to these issues, including one yesterday entitled “The Role of Congress in Developing Apportionment Standards.”

The Subcommittee heard from Professor John A. Swain of the University of Arizona Rogers College of Law, Tax Executives Institute (TEI) Tax Counsel Daniel B. DeJong, and Federation of Tax Administrators (FTA) Executive Director James R. Eads, Jr. (speaking on the basis of written testimony submitted by the Massachusetts Revenue Commissioner Navjeet Bal). The witnesses addressed the historical, practical, policy, and constitutional considerations surrounding the push for simplicity and stability in state corporate income taxes.

At one time, states’ rules for dividing up corporate income were relatively uniform. The predictability that came out of the adoption of the Uniform Division of Income Practices Act (UDITPA), however, has been eroded as states have steadily moved away from voluntarily uniform tax apportionment standards. UDITPA’s three factor, equal weight apportionment formula of property, payroll, and sales, has given way as many states employ mixed approaches, resulting in heavy compliance burdens, over-taxation and under-taxation, and overreach of state nexus as states move toward destination-based apportionment approaches.

State budgetary and business policy interests have been partly responsible for this result. DeJong noted that states have designed apportionment formulas to “benefit and encourage in-state investment.” Overweighting sales in the formula benefits in-state business because they can increase payroll and property in-state without increasing their tax liability. DeJong also pointed out that states often adjust the standard formulas for specific businesses and industries on an ad hoc basis, mostly leading to increased tax burdens on multistate businesses.

Congress has made past attempts to bring uniformity to state tax apportionment rules. In 1966, Rep. Edwin E. Willis (D-LA, 1904-72) sponsored a bill known as the Interstate Taxation Act, which would have mandated a two-factor property-and-payroll approach for all states. The bill resulted from congressional impatience and concern with states’ unwillingness to adopt UDITPA (only three states had done so at the time). The bill did not survive due to hostile response from states and certain business communities, but it gave enough impetus for states to quickly adopt UDITPA in large numbers.

It didn’t take long for states to try to game the system. The 1978 Supreme Court case Moorman Mfg. v. Blair, which upheld Iowa’s use of a single sales factor apportionment formula, triggered the mixed bag approaches states use today. According to Swain’s estimates, 14 states use a single sales factor, 10 states use the UDITPA three factors, and over 18 states double or 100% weight the sales factor. States have also moved away from the origin-based approach to a destination-based approach for taxing intangibles and services receipts, creating problems of state overreach, as DeJong testified.

Eads of the FTA urged that Congress should refrain from legislating in this area for constitutional and policy reasons. Citing states’ budgetary shortfalls and economic instability, the FTA argued that states are the best-suited in terms of knowledge and experience to develop coordinated apportionment rules that would be flexible enough to meet state-specific business needs. However, Eads acknowledged that recent state-led uniformity efforts have faced significant resistance because of diverging economic and policy interests among states and specific industries.

Uniformity in states’ apportionment standards is lacking because most states have diverged from the traditional approach of UDITPA. At the time of UDITPA’s drafting, states recognized that separate methods of corporate income tax accounting were “cumbersome, expensive, and vulnerable to manipulation.” History has repeated itself, and there is now a need for substantial coordination efforts at the federal level to resolve the lack of apportionment uniformity.

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