STRUCTURING A STATE CORPORATE INCOME TAX

1
STRUCTURING A STATE CORPORATE INCOME TAX

• WILLIAM F. FOX
• LEANN LUNA
• MATTHEW N. MURRAY
• September 2004

2
Role of the Corporate Income Tax in State Finance

• Corporate income tax generates only about 9
  percent of business taxes
• CIT declining as a share of tax revenues
• 10 in the 70s
• 5.9 in 2002
• Over 7 now
• The revenue decline combined with the general
  attention to business taxes and corporate
  governance have drawn focus to the tax and tax
  planning

3
Design the Tax Structure Based on a Goal for the
Tax Instrument

• Optimal taxation
• Horizontal competition
• Tax retained earnings
• Externalities
• Tax portfolio balance
• Revenue handles
• Equity corp. privileges tax exporting

4
Benefit Principle

• Tax businesses for their public service benefits
  to avoid cross subsidies from/to households and
  properly distribute costs
• Cannot expect Tiebout effects and voting to
  create a very precise state benefit tax
• Corporate income taxes in particular are a poor
  basis for taxing benefits
• Benefit tax should be on all businesses, not just
  corporations
• Profits a poor proxy for benefits Ability to pay
  introduced
• Special provisions mean unequal burdens across
  firms

5
Source-Based Entitlement Principle

• Specific to the state CIT
• Source-based taxation of nonresident income a
  state entitlement
• Net value added (profits) as tax base
• Ideally a uniform tax across states
• Apportionment to the extent supply and demand
  sides of market contribute to income creation no
  specific formula

6
What Should Guide Policy?

• Recognize taxes wont necessarily coincide with
  benefits received
• Recognize uniformity does not prevail across
  states
• Revenue focus will be defeated by market and
  political forces
• Important role for neutrality considerations
  because of openness of economy
• Administrative costs and compliance costs
• But little empirical evidence to guide policy

7
Five Key Issues

• Defining the taxable business
• Nexus
• Combined versus separate reporting
• Distribution of tax base across states for
  multijurisdictional firms
• Throwback rules

8
Defining the Taxable Business

• C Corps under the CIT
• Should pass-through entities be included under
  the CIT?
• Neutrality should help guide policy
• The challenge posed by LLC subsidiaries which may
  not have nexus
• Personal v. entity tax
• Double taxation and need for credits if PIT exists

9
Nexus

• Current practice varies across states
• Physical presence
• Doing business
• Earning income
• Components of nexus
• 1. Substantive nexus power to tax, which arises
  either from origin or residence basis
• 2. Enforcement nexus ability to compel
  collection, which arises either from personal
  jurisdiction or agency jurisdiction

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Nexus Standard

• Economic presence want to tax corporations
  where income is earned, which is both at origin
  and destination
• Problems
• Better on substantive than enforcement nexus
• International businesses
• Why not a physical presence standard?
• Income also earned at destination
• Creates planning opportunities like PL 86-272
• Destination basis more consistent with production
  efficiency

11
Separate vs Combined Reporting

• Separate treat each entity on a stand alone
  basis
• Combined file combined return for members of
  the unitary group
• Recommend combined reporting
• For neutrality, not to raise revenue
• Combine entities with losses and profits
• Transfer pricing for tangible goods
• Intangibles like royalties
• Sharing costs for overhead, mgt expertise
• Benefits from vertical integration

12
The Piecemeal Approach

• Specific policies for specific issues
• Disallow deductions between related companies -
  Massachusetts
• Impose nexus on passive investment companies
  South Carolina
• Examine PIC for valid business purposes -
  Maryland
• Audit transfer prices
• All will be incomplete combined reporting
  represents a more general solution

13
Issues with Combined Reporting

• What is a unitary business?
• States use different criteria
• Combined Control?
• Shared economies of scale/scope, vertical
  integration?
• Are these substantial?
• International businesses
• Combined and separate reporting states

14
Tax Base Distribution for Multijurisdictional
Firms

• Neutrality is a key goal
• The closed economy case firms producing and
  selling in only one state
• The open economy case producer prices may be
  affected by both origin and destination
  components of tax
• Partial factor taxes (capital and labor)
• Partial commodity tax (sales)

15
Apportionment and Allocation

• Business income income earned in the regular
  course of business and apportioned
• Nonbusiness income all other income and
  allocated to where real property or corporation
  is located
• Apportion income to the maximum extent allowed by
  law to reduce distortions
• Relocate allocated income to low tax or not tax
  state
• Incentive to create non-business income

16
Apportionment Origin vs Destination

• Origin component appropriate to tax firms for
  benefits at point of production
• Destination component appropriate to tax firms
  for benefits at point of sale
• Origin and destination taxation consistent with
  source-based entitlement principle
• Destination taxes are superior at the margin
  because of smaller distortions (production and
  tax planning)

17
Apportionment Issues

• Requires reconsideration of services/intangibles
• Cost of performance/real property for services
• Destination for tangibles
• Joyce v. Finnigan, combined reporting and firms
  without nexus
• Sales factor only in denominator
• Sales factor in numerator and denominator

18
Throwback Rules

• Include in the numerator of the origin states
  sales factor those sales that are not taxed in
  destination states 23 states
• Achieves locational neutrality if all states tax
  corporate income at the same ratebut they dont
• Tax planning still possible unless all state have
  rule
• Taxing all corporate income fairness and revenue

19
The Case Against Throwback Rules

• Resulting base is inconsistent with intended tax
  base
• Imposed not because a state determines that
  income is earned, but because another state is
  unwilling or unable to tax it
• Levied at the home not destination state rate
• Increases the origin component of the base
• Increases incentive to move firms selling
  tangible personal property
• Inconsistent with heavy weighting of the sales
  factor

20
Summary

• Define the taxable business carefully
• Economic nexus standard
• Combined reporting
• Weight sales more heavily than other factors
• No throwback rule