Appellants Brief — Container Corp. of America v. Franchise Tax Bd.

No. 81-523

In the Supreme Cougs “*®'%”

OF THE ALEXAND

United States :

Ocroser Term, 1982

ConTAINER CORPORATION OF AMERICA,

Appellant,

Vs.

Francuise Tax Boarp,

Appellee.

On Appeal from the Court of Appeal

of the State of California

for the First Appellate District

APPELLANT'S BRIEF ON THE MERITS

Frankui C. LatcHamM

COUNSEL OF RECORD

Prentiss WILLSoN, Jx

JAMES P. KLEreR

One Market Plaza

Spear St. Tower,

34th Floor

San Francisco, CA 94105

Telephone: (415) 777-6000

Of Counsel Counsel fer Appellant

Morrison & Forrster Container Corpora-

One Market Plaza tion of America

Spear Street Tower

San Francisco, CA 94105

BOWNE-PERNAU WALSH © 190 NINTH ST. © &.F., CA 94103 * (415) 864-2300

No. 81-523

In the Supreme Court

OF THE

United States

Octoser Term, 1982

ConTAINER CoRPORATION OF AMERICA,

Appellant,

Vs.

Francuise Tax Boar,

Appellee.

On Appeal from the Court of Appeal

of the State of California

for the First Appellate District

APPELLANT'S BRIEF ON THE MERITS

QUESTION PRESENTED

Whether requiring the income of foreign subsidiaries of

a United States corporation doing business in California

to be included in the parent corporation’s tax base for de-

termining the income to be apportioned to California for

purposes of the California franchise tax is repugnant to the

foreign commerce and due process clauses of the federal

constitution, when:

1. The inclusion of the foreign subsidiaries’ income in

the parent’s unitary tax base results in a significant dis-

tortion of the parent’s taxable income and in double taxa-

tion of the foreign subsidiaries’ income through misattri-

bution of that income to California; and

2. The apportionment method used by California con-

flicts with the separate accounting, arm’s-length method

of allocation, which is an essential component of United

States foreign policy; and

3. The foreign subsidiaries are organized and operat-

ing exclusively in foreign countries and are not part of a

functionally integrated br:siness with the parent and no

significant property is transferred between the parent and

the foreign subsidiaries.

ii

TABLE OF CONTENTS

IT IIIS, scinnskcctennstannctpictaieniadiditieemepuceiiaianat

IEEE SINUY cciscirocvsennentresentitddennseitiaicapeiiiendtiianmis olan

SII: scnsnisecsenicenssssisccniitiapnasitaiaiiitiaieiitliccsiaieida aaa

Constitutional, Statutory wad Regulatory Provisions ..

eaten OF Gib GOOD ccontcccteeianniitcntnieaes

a. Flow of Goods Between Container and the For-

Se TIO viiensscississccicntieneniniitercitcensieteinniniasaas

b. Managerial Relationship Between Container

and the Foreign Subsidiaries -..............................

Exchange of Technology .....................-.-...-csc-ssesoee

Bimchamae Of Perec .....cceccccsacescoscssesesecseseoseses

BONED sniicnccsrevsitsiscrensstisienncteiticainggalisieiaiaapialinndatiianmaa

CGR TID ciicsreccentiiciicescccinteieene

ce a9

Worldwide Apportionment Violates the Due Process

Clause Because It Distorts Income Attribution and

Produces Extraterritoria) Taxation; It Violates

the Commerce Clause Bevause It Results in Multiple

Taxation of Foreign Source Income and Prevents the

Federal Government from Speaking With One Voice

in Regard to Foreign Policy ~........2..2.........:.:.---ceceee++

A. California’s Apportionment of Income on a

Worldwide, Combined Basis Results in the Tax-

tion of Income Earned in Foreign Countries ....

1. Container’s foreign subsidiaries, and for-

eign subsidiaries in general, operate in

countries with an average wage rate signifi-

cantly lower than that of the United States

11

11

12

iii

TABLE OF CONTENTS

Page

2. Container’s foreign subsidiaries, and for-

eign subsidiaries in general, operate at a

substantially higher rate of profitability

IID TRIIIET ‘cccnenincsisshipeesennisitipteanistiassssse 14

3. Because combined apportionment on a

worldwide basis fails to account for the

lower wage rates and greater profitability

of foreign operations, such apportionment

results in the extraterritorial taxation of

income earned in foreign countries ............ 15

a. Comparison of Container’s Earnings

Calculated by Separate Accounting and

by Apportionment ............................-...0-+ 16

b. Differences in Profitability Vis-a-Vis

STII <crccinsinsiisbildiessesiainbatndinpalentiecinenteeapieeencents 18

B. By Taxing Income Which Was Earned in For-

eign Countries, and Not in California, Califor-

nia’s Apportionment Violates the Due Process

RN iat teteainaciiahitninicsincimanistneeeesccccsnetencaniestmmnnaninte 19

C. California’s Apportionment of Income on a

Worldwide, Combined Basis Results in the Tax-

ation of Income Also Taxed by Foreign Coun-

tries, Thereby Violating the Commerce Clause 21

I. California’s Tax Prevents the Federal Govern-

ment from Speaking with One Voice in Regard

to Foreign Policy, Thereby Violating the Com-

III Sisniniiecncssstieltapcninncsbnitinentbsdinietenptintsennenennenesns 27

1. The Federal Tax System Is Based upon

Separate Accounting, Deferral of Recogni-

tion of Income, and Sourcing of Income

with Regard to Foreign Subsidiaries .......... 29

2. The Income Tax Treaties of the United

States Implement Federal Policy ................ 30

iv

TABLE OF CoNTENTS

3. The Worldwide Unitary Combined Report-

ing System, Which Imposes an Entirely

Different Method of Apportioning Income

upon Multinational Corporate Groups, Is

in Irreconcilable Conflict with the Federal

System .... " semnlnanbsseantidinieatinateiats

E. The Analysis Contained in the Solicitor General

Anvicus Memorandum in Chicago Bridge & Iron

Requires Reversal of the Judgment Below ..........

Il

Because There Is No Substantial Operational Interde-

pendence Between Container and Its Foreign Sub-

sidiaries, the Due Process Clause Prohibits the Tax-

ation of Container and the Foreign Subsidiaries as a

Single Unitary Business, Regardless of Whether or

Not Woildwide Formula Apportionment in General

Is Permissible

Conclusion

Page

49

V

TABLE OF AUTHORITIES CITED

Cases

Page

Federal:

ASARCO, Ine. v. Idaho State Tax Comm., ........ US.

iaadinel , 50 U.S.L.W. 4962 (1982) .........2.-....-.--c-cee-eeeeee

aninania 10, 40, 41, 42, 43, 44, 45, 46, 47, 48

Bass, Ratcliff & Gretton Ltd. v. State Tax Commis-

sion, 266 U.S. 271 (1924) ...................-c.c--c-00-0- 8, 9, 46, 47

Board of Trustees v. United States, 289 U.S. 48

(1933) iinet ie laiaeeaiiiahaien 27

Butler Bros. v. McColgan, 315 U.S. 501 (1942) .......... 46

Cooley v. Board of Wardens, 53 U.S. (12 How.) 299

SUTEED <xcihicanpuiinnieinigiasiititonaplainuaiapdiadininatessiinbisagueases 27

Eveco v. Jones, 409 U.S. 91 (1972) -....2.222.22-..-.-nceeceeeees 21, 24

Han’ s ‘Rees’ Sons, Inc. v. North Carolina, 283 US.

Be IED. cccsincchounibiiihtetipietiasaidicuipadnienscieaiiisathithientennantiieien 19

Hines v. Davidowitz, 312 U.S. 52 (1941) —...... 35

Internationa! Harvester Co. v. Evatt, 329 U.S. 416

SUITE | \diastisdninsiecesunesdntnieenbentbiniandiadseds iiinianaipeetnimenmntitiits 19

Japan Line Ltd. v. County of Los Angeles, 441 U.S.

434 (1979) ....9, 21, 23, 24, 25, 26, 29, 33, 34, 35, 36, 38, 39

McGoldrick v. Gulf Oil Corp., 309 U.S. 414 (1940) _.. 35

Michelin Tire Corp. v. Wages, 423 U.S. 276 (1976) 27

Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S.

SD I aihiittictinguiitheniceiiaithibiadibdpptnineniccctitpianetin 10,40

Moorman Manufacturing Co. v. Bair, 437 U.S. 267

GPUEEED sins:divitenicninccaguinntalgstlieecdjingummatenitaiisiniaaticettinays 24, 46

Norfolk & Western Ry. Co. v. Missouri State Tax

Comm., 390 U.S. 317 (1968) ....9, 19, 20, 45

Underwood Typewriter Co. v. Chamberlain, 254 U.S.

Ee CN eetetestecetncssniterntisincenectnisncinintiintanincenen ..9, 19, 46

Wallace v. Hines. 253 U.S. 66 (1920) 19

vi

Taste or AutTnorities CiTep

Cases

Western Live Stock v. Bureau of Revenue, 303 U.S.

STEP CITI sidiigiaitnninniitasdidisiatuntstuintaminigmeincinesiasnanad 9, 21, 22

Wisconsin v. J. C. Penney Co., 311 U.S. 435 (1940) . 40

F. W. Woolworth v. Taxation & Revenue Dept., ........

IE cece , 50 U.S.L.W. 4957 (1982) ....................---

sunita 10, 30, 31, 34, 41, 42, 43, 44, 45, 46, 48

Zschernig v. Miller, 389 U.S. 429 (1968) .................... 9, 27

State:

Ash Grove Cement Co., Or. T. R. (CCH) § 203-211

Te 8 A, ee reece 47

Beecham, Inc., Appeal of, Cal. Tax Rep. (CCH)

{ 205-635 (Cal. St. Bd. of Equalization, 1977) ........ 32

Commonwealth v. ACF Industries, Inc., 441 Pa. 129,

Be Re le IE setetrtnrccccsetenitercieteievieneneneetee 47

Safeway Stores, Inc. v. Franchise Tax Board, 3 Cal.

3d 745, 91 Cal. Rptr. 616, 478 P.2d 48 (1970) -...... 17

Shachihata, Inc., U.S.A., Appeal of, Cal. Tax Rep.

(CCH) { 206-076 (Cal. St. Bd. of Equalization,

1979) .... i 32

U.S. Constitution

Commerce Clause, Art. I, § 8, Cl. 3 -...2....2.-2.2--2eceececeeeeoeee 1

Fourteenth Amendment, §1 1

Statutes and Regulations

RR a een 28

22 U.S.C. Section 2351(b) (3) -................-.---..-c.ceeseerseneneee 28

28 U.S.C. Section 1257 (2) ae

er ene 30

pO a ee 29

LB.C. Sections 861 et 8€q. -.........-..-----cseserseceeseseeeesesneeneeees 30

Vii

TasLe or AutHorities CrTEep

STATUTES AND REGULATIONS

I.R.C. Sections 901-04

L.R.C. Sections 951-64

Title 18, California Administrative Code, Section

self

25120 2, 32, 45

California Revenue and Taxation Code, Section 25101

Treaties

Convention for the Avoidance of Double Taxation and

the Prevention of Fiscal Evasion With Respect to

Taxes on Income, March 30, 1955, United States—

Italy, 7 U.S.T. 2999, T.LA.S. No. 3679 0...

Convention for the Avoidance of Double Taxation

With Respect to Taxes on Income, July 22, 1954,

United States—Federal Republic of Germany, 5

FL me | BAe | Penner

Convention with Respect to Taxes on Income and Cer-

tain Other Taxes, April 29, 1948, United States—The

Netherlands, 62 Stat. 1757, T.ILA.S. No. 1855 —........

Other Authorities

Address by President Reagan, World Affairs Council,

Philadelphia (October 15, 1981) ~.......-2------

Arthur Andersen & Co., Tax and Trade Guide—Colom-

ae Ne en Ue One

Arthur Andersen & Co., Tax and Trade Guide—Italy,

(1962) .. seietdlaiidlciiieipi abatement Miia ia atin

Arthur helio & Co., Tax and Trade Guide—Ger-

ih TE ccecoieelcentererrncenestepetncevieninsttiitiiatitntiinintinmtncses

Arthur Andersen & Co., Tax and Trade Guide—Mexz-

SS _; ee

Arthur Andersen & Co., Tax and Trade Guide—The

Netherlands, (1965)

1

26

26

26

27

25

25

25

viii

Taste or AutHorities CiTep

Orner AUTHORITIES

Page

Arthur Andersen & Co., Tax and Trade Guide—V ene-

CE TED cccrumiccssistulstcastubisesicttbbicimniniiasaniimiueaiitebe 25

Board of Inland Revenue, 3 Income Taxes Outside the

United Kingdom (1967) ............----------c-c-esececeneeenseseneeees 25

Board of Inland Revenue, 5 Income Taxes Outside the

United Kingdom, (1967) ............---ceccececceeceesencsesenseeneeeees 25

Federalist Papers No. 42 (Madison) ................-.--..--.-----+- 27

Foreign Tax Law Assoc., Inc., Tax Laws of the World

see, GED ccccscicsnscncsistenephiieneinnitindienemenn 26

Foreign Tax Law Assoc., Inc., Tax Laws of the World

III SITET susbsteisencscesarcesnapbactneinsametiichnamsditiiebsnimiianaiiviaiaanes 26

Foreign Tax Law Assoc., Inc., Tax Laws of the World

SIN IED Linesiacconthhsintunsianbleinisideententciancimvinemenpiniiatii 26

Foreign Tax Law Assoc., Inc., Tax Laws of the World

EINE: CERIEIIED ‘cneptiiniossecissttinnddncosbncecnediumnncessiidessiios 26

Foreign Tax Law Assoc., Inc., Tax Laws of the World

—West Germany, (1979) ........-..---cececeee--secsssessseeseeeees 26

Foreign Tax Law Assoc., Inc., Tax Laws of the World

eS 26

G.A.O. Report to the Chairman, House Committee on

Ways and Means: Key Issues Affecting State Taxa-

tion of Multijurisdictional Corporate Income Need

RR > earn 20, 22, 34

Harvard University, World Tax Series—Taxation in

CTE, GD cctenterestttttncttimmmianicermmenennmnnanene 25

Harvard University, World Tax Series—Tazxation in

RAE aL ETS Lee a ae 25

Harvard University, World Tax Series—Tasration in

Ps MIU ‘cildsnteginsinsisebiitadachiissihsncenicsinppicesiclancshuinignie 25

Harvard University, World Tax Series—Taxation in

the Federal Republic of Germany, (1969) ...............-.- 25

ix

Taste or AutTuHoexities CiTep

OTHER AUTHORITIES

Hellerstein, “Recent Developments in State Tax Ap-

portionment and the Cireumscription of Unitary

Business,” 21 Nat'l. Tax J. 487 (1968) ........ intimal 47, 48

Hellerstein and Hellerstein, State and Local Taration,

ESE TIIUIID sccccssescssteieviswennetacitovesutienscniiadscentnniatiin 11

Hufbauer and Foster, “U.S. Taxation of the Undis-

tributed Income of Controlled Foreign Corpora-

tions,” Tax Policy Research Study No. 3, Essays in

International Taxation: 1976 Dept. of the Treasury

EIUUIEE ctcniscsstauitesinncitisinattntenalitacastiiisunmimntiesiiaesieabiesdbesiatniees 29

Income Tax Treaties: Hearing Before the Subcomm.

on Oversight of the H. Comm. on Ways and Means,

96th Cong., 2nd Sess. 61 (1980) (Statement of H.

David Rosenbloom) ....................-----ss-ssesseeeseseseeseneeeeenees 30

International Bureau of Fiscal Documentation, The

Taxation of Companies in Europe, Netherlands

(1977) 26

International Bureau of Fiscal Documentation, The

Taxation of Companies in Latin America, Venezuela

(1981) -_ 20, 26

Memorandum for the United States as Amicus Cuslen,

Chicago Bridge & Iron Co. v. Caterpillar Tractor

ig Hs Ee CD ecacccctstrcncennsecnstinassasinstncrsntnsieaennd 34, 36

OECD Model Convention for the Avoidance of Double

Taxation With Respect to Taxes on Income and on

Capital (1977) 1 Tax Treaties (CCH) 7151 -.......... 31

Petersen, “California Franchise Tax: Combined In-

come Report Affects Foreign Companies,” 44 J. Tax

184 (1976) ——

Surrey “Reflections on the Allocation of Income and

Expenses Among National Tax Jurisdictions,” 10

Harv. J. of Law and Policy in Int'l. Bus. 409 (1978) 32

xX

Taste or AvutHorities Crrep

OrHerR AUTHORITIES

Page

Statements by Myer Rashish and Robert D. Hormats

before the Subcomm. on Trade of the H. Comm.

on Ways and Means (October 29, 1981) printed in

Dep’t. St. Bull., Dec. 1981, at 44 ....................--..cscececeeoee 28

Tax Treaties with the United Kingdom, the Republic

of Korea, and the Republic of the Philippines, Hear-

ings Before the S. Comm. on Foreign Relations, 95th

Cong. 1st Sess. 28 (1977) (Statement of Laurence N.

ME icc icnien ren nihats tia icdecallieeinimnasaiesinadadiddaniands 29

Transcript of Oral Argument, Chicago Bridge & Tron

Co. v. Caterpillar Tractor Co., No. 81-349 (1982) ....

United Nations Model Taxation Convention Between

Developed and Developing Countries, 1 Tax Treaties

SPNIIIEE TANTEI ccccculncnessienie-censnsamenssstvatibadaniatasnnsascianisteisihaneaa 31

United States Model Income Tax Treaty (1981) 1 Tax

Ry IE WF IEE iciiseninciicincxseibesisiceiniicatbsbiichbinisiensomeianats 3L

OPINIONS BELOW

The opinion of the California Court of Appeal is re-

ported at 117 Cal.App.3d 988, 173 Cal.Rptr. 121 (1981).

The memorandum opinion and judgment of the California

Superior Court are not reported. Complete texts are set

forth as appendices A and B respectively to Appellant’s

Jurisdictional Statement (“J.S.”) at A-1 and A-27.

JURISDICTION

The Court of Appeal rendered its opinion and judg-

ment on April 14, 1981, affirming the California trial

court’s judgment. Appellant’s petition for rehearing was

filed April 29, 1981, and was denied by the Court of Appeal

on May 4, 1981 (.\ppendix D, J.S. at A-35). Appellant’s

petition for hearing in the California Supreme Court was

filed May 22, 1981, and was denied June 17, 1981 (Appen-

dix ©, J.S. at A-37).

A notice of appeal was filed in the Court of Appeal on

July 31, 1981 (Appendix F, J.S. at A-37). The time within

which to docket this appeal expired on September 15, 1981,

and timely docketing was made. Probable jurisdiction

was noted by the Court on May 3, 1982. The time for filing

this brief was extended on June 4, 1982 to July 31, 1982.

The jurisdiction of this Court is invoked under 28 U.S.C.

§ 1257(2).

CONSTITUTIONAL, STATUTORY AND

REGULATORY PROVISIONS

Commerce Clause (Art. I, § 8, el. 3):

The Congress shall have power... to regulate com-

merce with foreign Nations and among the several

States, and with the Indian Tribes;

Due Process Clause (Amend. XIV, § 1):

[NJjor shall any State deprive any person of life,

liberty, or property, without due process of law;

California Revenue and Taxation Code, Section 25101

(during the tax years at issue, 1963-1965) provided:

2

When the income of a taxpayer subject to the tax im-

posed under this part is derived from or attributable

to sources both within and without the State, the tax

shall be measured by the net income derived from or

attributable to sources within this State. Such income

shall be determined by an ailocation upon the basis

of sales, purchases, expenses of manufacture, payroll,

value and situs of tangible property or by reference

to any of these or other factors or by such other

method of allocation as is fairly caleulated to deter-

mine the net income derived from or attributable to

sources within this State ....

California Administrative Code, title 18, section 25120(b)

is set forth in Appendix G to the Jurisdictional Statement.

STATEMENT OF THE CASE

Container Corporation of America (“Container”) is a

Delaware corporation headquartered in Chicago, Illinois,

engaged in the production and distribution of paperboard

and paperboard-based packaging. In addition to its opera-

tions in the United States, during the years at issue (1963-

65), Container owned controlling interests in twenty cor-

porations organized and located in Latin America and

Western Europe, the general businesses of which were

the same as Container’s. The Latin American operations

(Colombia, Venezuela and Mexico) accounted for approxi-

mately 84% of the subsidiaries’ net income. Stipulation of

Facts (“Stip.”) 26, Joint Appendix (“J.A.”) at 15-16.

1Appellant has relied on the Stipulation of Facts rather than on

the lower court’s opinion in summarizing the facts because the

Court of Appeal misstated facts in a number of instances. For ex-

ample, the Court of Appeal stated that Container made loans to its

subsidiaries totalling over $18 million during the period in question.

J.S. at A-4, A-10. However, the Stipulation states only that “the

total loan advances from CCA outstanding at year end for the years

at issue” were $7,704,987 for 1963, $7,155,714 for 1964, and

$3,223,371 for 1965. Stip. { 133, J.A. 69-70 (emphasis added ). Since

any advances which had been made were primarily long-term in

3

The operations of the foregoing subsidiaries were highly

decentralized, so that the subsidiaries located in each par-

ticular country operated as fully integrated, self-sustaining

business operations. Stip. § 61, J.A. 30. Management of

the foreign subsidiaries was comprised predominantly

of citizens of the countries involved. Stip. § 74, J.A. 39-40.

In most of the Latin American subsidiaries, local investors

held substantial minority stock interests (7.e., in Colombia

approximately 33% and in Venezuela approximately 20% ).

In nearly half of the foreign subsidiaries locai representa-

tives constituted a majority of the board of directors. Stip.

q 25, 78, J.A. 14, 40; Exhibit FE to the Stipulation of Facets.

nature, the advances outstanding at year end far exceeded any

advances which may have been made during a particular year.

Thus, the Court of Appeal greatly exaggerates the amount of loans

from Container to the foreign subsidiaries. Elsewhere, the Court of

Appeal gives weight to the unsupported assertion that “the parent

corporation was involved with the training of local nationals for

management positions.” J.S. at A-13. However, the Stipulation

states that “there was no United States training program for the

foreign subsidiaries’ employees.” Stip. { 132, J.A. 69. While em-

ployees of the foreign subsidiaries occasionally visited United

States operations, there is no indication that Container was in-

volved in the training program, or that those managing the foreign

subsidiaries were required to make the trips as part of their

training.

Other errors typify the lack of care which the Court of Appeal

employed in reviewing the facts. Thus, for example, at one point

the court states that “all the foreign operations were audited by the

same accounting firm that audited appellant’s books,” J.S. at A-9,

but elsewhere acknowledges the true state of affairs, i.e., the sub-

sidiaries in the Netherlands and Germany used their own account-

ing firms for audits. J.S. at A-4. The opinion also refers to 38 of

Container’s employees being “assigned” to foreign subsidiaries. J.S.

at A-2, A-3. However, the Stipulation shows that these 38 individ-

uals were actually employees of the foreign subsidiaries who were

carried on Container’s payroll as an accommodation to employees

in special circumstances, Maintenance of the employees on Con-

tainer’s payroll required little effort, and Container was reimbursed

for the service, as well as the payroll costs, by the foreign sub-

sidiaries. Stip. {{] 124-125, J.A. 64-65.

4

While Container’s majority interest in the subsidiaries

gave Container the potential for control and domination

of the subsidiaries, Container did not dominate the subsid-

iaries, but instead left management of the businesses and

control over business decisions to the subsidiaries. Stip.

™9 74, 130, J.A. 39-40, 67-8. Especially within the develop-

ing countries (Colombia, Mexico, and Venezuela), pru-

dence dictated that high profile participation by United

States personnel in the local business be kept to a mini-

mum. Stip. {f 27, 62, 130 J.A. 16, 30-31, 67-68.

(a) Flow of Goods Between Container and the Foreign

Subsidiaries

Container purchased no raw materials or finished prod-

ucts from the foreign subsidiaries. Container did not sell

any finished products to the foreign subsidiaries and sold

only an insignificant amount of unfinished products to the

subsidiaries. Stip. 1] 26, 64, 141, 143, J.A. 15-6, 32, 73, 74.

In all cases, the prices paid for unfinished products (raw

materials and paperboard) were the same as Container

would charge other independent purchasers, and in all

cases the materials could have been obtained from sources

other than Container. Stip. {| 141, J.A. 73.

Container and the foreign subsidiaries had no master

contract or formal arrangement to make sales to customers

located in both the United States and in foreign countries.

There were no joint marketing efforts between Container

and the foreign subsidiaries, and Container did not solicit

sales for its foreign subsidiaries. Stip. | 65, J.A. 32-34.

(b) Managerial Relationship Between Container and the

Foreign Subsidiaries

The management of the foreign subsidiaries had complete

authority and control over day-to-day business decisions.

Such business decisions were not reviewed or subject to

review by Container. Major policy matters, defined as con-

sisting exclusively of capital appropriations, were also

the responsibility of the foreign subsidiaries, but were

5

generally subject to review by Container. All other policy

matters were the complete responsibility of the foreign

subsidiary. Even in matters involving a major capital ex-

penditure, the initiative rested with the foreign subsid-

iary, and local management reserved the right to forego

initiation of previously authorized projects. Stip. 174, J.A.

39-49. Fach subsidiary had total responsibility for its own

performance. Stip. {] 127, 130, J.A. 65-66, 67-68.

During this period, Container’s foreign operations staff,

charged with overseeing the 20 foreign subsidiaries, con-

sisted entirely of two full-time operations officers and three

individuals, a senior executive officer, a controller, and a

lawyer, who devoted part of their time to matters involving

Container’s investment in the foreign subsidiaries. Stip.

7 126, J.A. 65.

(c) Exchange of Technology

Container provided technical assistance to the foreign

subsidiaries only in limited instances. For example, the

foreign subsidiaries, generally either internally or with the

help of independent consultants, developed their own tech-

niques for processing raw material and for adapting

machinery to different grades of paperboard. Container

offered little material assistance in developing this vital

technology. Stip. 1] 76, 84, 85, 146, J.A. 41, 44-5, 45-6, 75-6.

Similarly, Container had little or no role in the production

of paperboard-based packaging by its subsidiaries, since

the functional and graphic designs of the packages which

Container manufactv..*d were generally ill-suited to the

products and markets served by the foreign subsidiaries.

Stip. 1] 56, 57, 67-70, 73, J.A. 27-8, 35-7, 39. In any event,

in those instances where Container provided technical.

assistance to the foreign subsidiaries, the information was

paid for unless prohibited by local law. Stip. {if 66, 144-146,

J.A. 34-5, 74-6. Even in instances where Container had

useful information, the foreign affiliates often sought assis-

tance from local consultants, not affiliated with Container,

6

rather than taking advantage of existing technical services

agreements with Container. Stip. § 146, J.A. 75-76.

(d) Exchange of Personnel

The personnel departments of the various foreign sub-

sidiaries, except to the limited extent discussed below,

were fully independent operations and were expected to

recruit and train local nationals to fill positions at every

level. Stip. 17 79, 89, 95, 109, J.A. 42-3, 48, 51, 56. There

was no general policy of transferring Container employees

to foreign subsidiaries. Stip. 120, J.A. 62.

The number of employees who actually transferred from

Container to a foreign subsidiary, or who were known to

have become employed with a foreign subsidiary after

having worked for Container, were few. During the period

in question, only 26 former Container employees were

working for foreign subsidiaries. This figure should be

compared with the approximately 13,400 persons employed

by Container during the same period and the 6,800 persons

employed by foreign subsidiaries during the period. Stip.

7119, J.A. 60-1. During the period in question, 38 em-

ployees (which includes all of the 26) of the foreign sub-

sidiaries were also on the payroll of Container, not because

of any substantive relationship with Container, but gen-

erally as a matter of convenience to employees in special

circumstances. Stip. 7 124, J.A. 64-65.

(e) Loans

The foreign subsidiaries generally obtained financing

from local sources. Stip. 7133, J.A. 69-70. In certain

instances, Container acted as guarantor for those loans.

However, for the most part, Container had no involvement

in the arrangement of such loans.

Container also made some direct loans to its subsidi-

aries during the period in question. The total balance of

advanees from Container outstanding at the end of each

of the years at issue were as follows:

1963 1964 1965

$7,704,987 $7,155,714 $3,223,371

7

These figures compare with the following balances of out-

standing loans for the foreign subsidiaries at the end of

each year:

1963 1964 1965

$18,596,000 $15,497,000 $14,441,000

Stip. 1 133, J.A. 69-70.

(f) Centralized Services

There were no significant centralized services performed

by the parent for the subsidiaries (or vice versa). The

foreign subsidiaries hired their own personnel, operated

their own manufacturing facilities, purchased their own

supplies, and conducted their own marketing, advertising

and accounting. Stir. {J 66, 88-9, 93, 95, 104, 107, 116-18,

J.A. 34-35, 47-48, 50-51, 54-55, 58-59.

In rare instances Container sold used equipment to

foreign subsidiaries. Stip. § 147, J.A. 76-7. During the

entire period in question, the total amount of such pur-

chases by the foreign subsidiaries was less than $80,000.

Exh. A-8, Joint Appendix: Exhibits (“J.A.E.”) at 8.

Container also assisted the foreign subsidiaries, mainly

those in Latin America, with the purchase of equipment,

generally from suppliers located in the United States. In

those instances Container acted only as an “independent

broker” for the foreign subsidiary, for which it generally

charged the subsidiary five percent of the purchase price.

Stip. 7148, J.A. 77. Container also acted as a broker in

obtaining some waste paper for the subsidiaries. Stip.

143, J.A. 74.

e * *

During the tax years at issue, Container filed California

franchise tax returns and paid franchise tax to California

based on an apportioned share of its net income. The

income of Container itself was $25,362,000, $28,975,000 and

$30,027,000. Over Container’s objection, California insisted

that the income of the foreign subsidiaries be included in

Container’s tax base, increasing the tax base to $36,158,000,

8

$43,055,000 and $45,916,000, respectively. Sch. VI to Exh. 1,

Stip. re Testimony, J.A. 109-13.

Container commenced this refund action on April 8, 1974,

in the Superior Court of the State of California for the

City and County of San Francisco. The complaint was

based upon, and incorporated, claims for refund previously

filed by Container and denied by the California Franchise

Tax Board. The claims demanded refunds upon the ground,

inter alia, that the state is prohibited from including these

foreign subsidiaries in a unitary return with Container

under the due process and foreign commerce clauses of the

Constitution. Container has resisted imposition of the tax

on the grounds that California’s method of taxation, on its

face and as applied to the instant facts, is repugnant to the

foreign commerce and due process clauses of the Constitu-

tion. Both the Superior Court and the California Court of

Appeal refused to grant relief from the due process and

foreign commerce clause violations. The opinions of these

courts are attached to the Jurisdictional Statement as Ap-

pendices A and B. The California Supreme Court denied a

petition for hearing on June 17, 1981.

INTRODUCTION AND

SUMMARY OF ARGUMENT

This case, together with the case of Chicago Bridge &

Iron Co. v. Caterpillar Tractor Co., et al. (No. 81-349),

represents the Court’s first occasion to consider the con-

stitutional issues arising from the application of combined

apportionment to a corporation and its foreign subsidiaries

on a worldwide basis.* An examination of these issues

*Bass, Ratcliff & Gretton Ltd. v. State Tax Commission, 266 U.S.

271 (1924), has no bearing on the question presented herein, That

case involved an English corporation which brewed ale in England

and sold it in the United States. Significantly, no question concern-

ing a subsidiary was present because all operaticns were conducted

by a single corporate taxpayer. Moreover, the taxpayer adduced no

proof of misattribution of income to New York, the taxing state, in

(footnote continued )

9

reveals that California’s system of unitary apportionment

on a combined, worldwide basis violates the due process

and commerce clauses of the United States Constitution,

both inherently and as applied to the facts of this case.

Application of worldwide unitary combination to multi-

national corporate groups fails to meet constitutional

standards in three broad areas. First, the apportionment

formula frequently (including in this case) misapportions

income to the United States members of the group, result-

ing in extraterritorial taxation in violation of the due

process clause. Norfolk € Western Railway Co. v. Missouri

State Tax Commission, 390 U.S. 317 (1968); Underwood

Typewriter Co. v. Chamberlain, 254 U.S. 113 (1920). See-

ond, because the income misapportioned to the United

States members of the group is fully taxed in the foreign

country where it was earned, the income is subject to dou-

ble taxation, in violation of the commerce clause. Japan

Line, Ltd. v. County of Los Angeles, 441 U.S. 434 (1979);

Western Live Stock v. Bureau of Revenue, 303 U.S. 250

(1938). Finally, the inconsistency of worldwide apportion-

ment with the separate accounting, arm’s-length method

used by the United States and by foreign governments

results in double taxation which impairs the ability of the

United States to speak with one voice in carrying out its

foreign policy, thereby violating the commerce clause.

Japan Line, Ltd. v. County of Los Angeles; Zschernig v.

Miller, 389 U.S. 429 (1968).

Any one of these three constitutional violations, in and

of itself, requires invalidation of worldwide combination,

both as a general matter and as applied to the facts of this

case. The issues of distortion, double taxation and im-

contrast to the clear showing of distortion made in the present case.

Finally, the Bass case was decided almost sixty years ago, before

the advent of the United States tax treaty network and before de-

velopment of the separate accounting, arm’s-length method as a

part of United States foreign policy.

10

pairment of federal policy are addressed in the present

case in Part I of this brief. .

In addition to the three constitutional problems described

in the preceding paragraphs, California is prohibited from

applying combined apportionment in this case because

Container and its foreign subsidiaries are not parts of a

single unitary business. This fact alone also prohibits

combined apportionment.

The three cases in which the Court has recently con-

sidered the constitutional implications of state taxation

of foreign source income (in the context of dividends from

foreign subsidiaries), relate only to the unitary business

issue in this case. Mobil Oil Corp. v. Commissioner of Tazes,

445 U.S. 425 (1980); ASARCO, Inc. v. Idaho State Tax

Comm., ...... U.S. .....; 50 U.S.L.W. 4962 (1982); F. W.

Woolworth Co. v. Taxation & Revenue Dept. ...... US. ......3

50 U.S.L.W. 4957 (1982). In Mobil, the Court approved

state taxation of foreign dividends as a part of the recipi-

ent’s apportionable income, only because the Court assumed

that the payor subsidiaries were unitary with Mobil. Fur-

thermore, Mobil did not introduce evidence of distortion

in the apportionment formula.

In ASARCO and Woolworth, the Court prohibited state

taxation of foreign dividends as part of apportionable

income of the parent corporation on the ground that the

subsidiaries were not part of a unitary business with the

parent. The Court’s opinions on the unitary issue in these

two cases, especially Woolworth, which is strikingly similar

to Container on the facts, are controlling precedents here

and require a holding that Container and its subsidiaries

are not unitary. This issue is discussed in Part II of the

brief.

11

ARGUMENT

I

WORLDWIDE APPORTIONMENT VIOLATES THE

DUE PROCESS CLAUSE BECAUSE IT DISTORTS

INCOME ATTRIBUTION AND PRODUCES EXTRA-

TERRITORIAL TAXATION; IT VIOLATES THE

COMMERCE CLAUSE BECAUSE IT RESULTS IN

MULTIPLE TAXATION OF FOREIGN SOURCE IN-

COME AND PREVENTS THE FEDERAL GOVERN-

MENT FROM SPEAKING WITH ONE VOICE IN

REGARD TO FOREIGN POLICY

A. California’s Apportionment of Income on a Worldwide,

Combined Basis Results in the Taxation of Income

Earned in Foreign Countries

California, thiough its system of worldwide unitary com-

bination, has misallocated a substantial amount of unre-

patriated foreign income, not earned in California, to Cali-

fornia’s income tax base. This misallocation occurs because

the basic assumption underlying unitary combination

breaks down when that system is applied to foreign oper-

ations. As a result, unitary combination, when applied on

a worldwide basis, generally produces extraterritorial tax-

ation that is unconstitutional under the due process clause.

Container itself operates entirely within the United

States. Hach subsidiary of Container operates entirely

within a foreign country. Combined apportionment under

the unitary method assumes that a dollar of property, pay-

roll or sales of the parent (Container) produces approxi-

mately the same amount of income as a dollar of property,

payroll or sales of a subsidiary. Hellerstein and Leller-

stein, State and Local Taxation, 539 (4th ed. 1978). Llow-

ever, as demonstrated below, Container’s principal foreign

subsidiaries (and foreign operations in general) produce a

greater amount of income per dollar of property, payroll

and sales than the parent’s United States operations. This

difference in profitability is compounded by the fact that

the subsidiaries operate in foreign countries where wage

rates are substantially lower.

12

Because California’s apportionment on a _ worldwide,

combined basis necessarily ignores differences in payroll

costs or profitability, it apportions income earned by the

companies with lower payroll and/or greater profitability

(here, the foreign subsidiaries) to the tax base of compa-

nies with higher payroll and/or lesser profitability (here,

Container). Thus, the remainder of this subsection will set

forth various data comparing wage rates, productivity and

profitability in the United States with the foreign countries

where Container’s subsidiaries operate. This data forms

the basis for the separate arguments made below in sub-

sections B (distortion), C (double taxation) and D (impair-

ment of the ability of the United States to speak with one

voice in regard to foreign policy).

1. Container’s foreign subsidiaries, and foreign sub-

sidiaries in general, operate in countries with an

average wage rate significantly lower than that of

the United States

The costs of production in foreign countries are generally

significantly lower than in the United States, primarily

as a result of the lower wage rates of workers in countries

other than the United States. Because wages are one of the

three factors used in formulary apportionment, the use of

the formula unfairly inflates the amount of income appor-

tioned to United States operations, where wages are higher.

Although the wage rates in several of the more advanced

industrial courtries are, in recent years, approaching, and

in some cases exceeding, those in the United States, never-

theless wage rates in the less industrialized countries

remain well below those in this country. In Appendix A, at

A-1, comparative wage rates compiled from United Nations

sources for the years 1963-1965 show wages for under-

developed countries at ranges between 10° and 30% of

United States wages. United Nations statistics for the

years 1974-1980, in Appendix B at A-3, show that while

wages throughout the world are increasing, the same dis-

parity between wages paid United States workers and those

13

in less industrialized countries continues to exist. Further-

more, as the United States Tariff Commission has demon-

strated (see Appendix C at A-5), these differences in wage

rates are not offset by lower levels of productivity for

workers in various economic settings. These studies are

corroborated by other sources."

Container’s own experience also confirms these findings.

A study by Container relating to production of corrugated

containers shows that the differences in productivity for

1974 were as follows:

Ail

Cali, California

Colombia Plants

Labor Cost per thousand square feet $1.19 $2.85

Sch. II to Exh. 1, Stip. re Testimony, J.A. 105.

As this study demonstrates, workers in California are

paid almost two and a half times the amount paid to

workers in Colombia to produce the same quantity of

corrugated containers. To the extent the payroll faetor

in Colombia consists of the wages paid to such workers,

the distortion will lead directly to a misapportionment of

net income. As demonstrated below, less dramatic, but

similar, results occur with regard to the sales factor.

%As stated in Petersen, “California Franchise Tax: Combined

Income Report Affects Foreign Companies,” 44 J. Tax 184, 187

(1976):

. . . wage levels are considerably lower in Japan, Italy or

almost any other country than in tie United States for the

same work. In 1969, the cost of engineering work in Japan was

only 70% of that in the U.S. (England was 75%, Holland 80%,

France 90%)... .

The same type of disparity exists as to the cost of plant or

property. For example, . . . in 1964-70, the average investment

needed to provide employment to one person in the rubber

industry in the U.S. was $137,000, while an average of only

$58,000 was required outside the U.S.

An apportionment of worldwide income based on property

and payroll could never, under these circumstances, properly

apportion the income to the local activities which produced it.

14

Because California's apportionment formula, as applied to

the combined report, attributes income in major part (one

third) upon the basis of payroll costs, the variations in

wage levels have produced a substantial misapportionment

of income toward California, which has the higher wage

rates.

2. Container’s foreign subsidiaries, and foreign sub-

sidiaries in general, operate at a substantially

higher rate of profitability than Container itself

On the average, the rate of profitability of Container’s

subsidiaries, particularly those in Colombia and Venezuela,

is substantially higher than that of Container in the United

States. Thus, Container’s net income as a percentage of

sales in the United States for 1963 through 1965 averaged

9.43%, while Colombia averaged 20.30% and Venezuela

22.95%. Container’s net income as a percentage of invested

capital averaged 13.11%, Colombia 20.51%, and Venezuela

31.56%. Sch. VI to Exh. 1, Stip. re Testimony, J.A. 109-13.

The uncontroverted testimony of Container’s expert wit-

ness, Professor John C. McDonald of Stanford, confirms

that because of the greater profitability of the foreign sub-

sidiaries, the basic premise of apportionment on a com-

bined basis breaks down when applied to foreign operations.

As Professor McDonald stated, an individual U.S. company

will invariably require a higher “hurdle rate” (i.e., mini-

mum anticipated rate of return on investment) for a for-

eign investment than for a similar domestic investment.

Thus, companies expect to receive a greater rate of return

on a foreign investment than on a similar domestic invest-

ment. Generally, this greater rate of return is achieved. The

reasons for this include lower labor costs, more rapidly

expanding economies, greater market share, governmental

protection from competition, ete. J.A. 131-144, 154-167.

' Professor McDonald also testified that Container’s “hurdle

rate” and rate of profitability for its foreign subsidiaries

were typical of foreign operations in general. J.A. 175-76,

186-7.

15

3. Because combined apportionment on a worldwide

basis fails to account for the lower wage rates and

greater profitability of foreign operations, such

apportionment results in the extraterritorial taxa-

tion of income earned in foreign countries

Formula apportionment, when applied to the worldwide

income of Container and affiliates, attributes far more

income to the domestic operations of Container than Con-

tainer reported for federal income tax purposes by apply-

ing the arm’s-length method of accounting prescribed by the

Internal Revenue Code and adopted by the international

community. Correspondingly, this apportionment attrib-

utes far less income to the foreign operations of Con-

tainer’s subsidiaries than was earned, reported and taxed

in the foreign countries in which the subsidiaries operate.

This results in California’s taxation of income earned not

in the state, but in foreign countries.

Formula apportionment fails to recognize the variations

in profitability between corporations. The profit of the

total group is apportioned among the members of the

unitary group according to the factors used in the formula

(in California, property, payroll and sales). If the factors

of the various members are approximately equal, the for-

mula will apportion the income about equally among the

members, even if actual incomes are not equal.‘

‘For example, if two corporations, one doing business exclusively

in California and the other exclusively in Colombia, are combined

and have the same total property, payroll and sales, formula appor-

tionment would apportion one half of the combined income of the

two companies to each, even if only one was actually profitable.

Thus, even if the Colombian corporation earned $100,000 and the

California corporation lost $30,000, California’s apportionment on a

combined basis would attribute $35,000 of income to each. Mis-

attribution of income has also occurred in the present case, prin-

cipally between Container and its Latin American subsidiaries.

16

(a) Comparison of Container’s Earnings Calcu-

lated by Separate Accounting and by Appor-

tionment

The magnitude of misattribution wrought by apportion-

ment on a combined, worldwice basis can be demonstrated

by comparing the income of Container from its domestic

operations, as reported to the Internal Revenue Service,

to the amount of income attributed to those operations by

California’s formula. That is to say, if one applied the

three-factor formula with the numerator being domestic

payroll, property and sales and the denominator being

worldwide payroll, property and sales, and if the percent-

age produced by averaging those three fractions is multi-

plied by worldwide income, the result is the following in-

crease in domestic Container income over that reported to

the Internal Revenue Service for domestic Container op-

erations ;°

1963 1964 1965

$2,407,000 $3,996,000 $5,466,000

‘That leads, in turn, to an apportionment of income to

California which is greater than when the base income used

is domestic only, rather than worldwide. The increase in

California income from the use of worldwide apportion-

ment over the income produced by apportionment of do-

mestic income can be shown as follows:

1963 1964 1965

1. World-wide income

apportioned to

ASS $3,141,635 $3,579,413 $3,523,222

2. Domestic income

i to

ee $2,888,547 $3,139,629 $2,947,125

3. Increase of lover2.... $ 253,008 $ 439,784 $ 576,097

This misattribution is confirmed by a comparison of the

income attributed to the various countries under a sep-

arate accounting, arm’s-length analysis with that assigned

‘Exhibit A to the Stipulation of Facts, J.A.E. 1-8, contains the

basic data used in the calculations to prepare the following two

tables.

17

to the countries by the use of California’s apportionment

formula :*

Container (United States) ...... $28,121,000 $32,068,000

RE. do Nc cuaehesesaaen 4,254,000 2,203,000

Mexico 1,605,000 1,430,000

Venezuela 4,246,000 1,907,000

Panama 1,286,000 —

Austria (13,000 ) 11,000

Germany 1,793,000 2,906,000

Holland ___. 384,000 197,000

Italy ..... WA A ee 34,000 968,000

SR RE Se ee 13,588,000 9,642,000

PE ss inc ccc ccdeenss $41,710,000 $41,710,000

Thus, California’s formula attributes an average of $4

million per vear more to United States operations (and

$4 million per year less to foreign operations) than the

method of accounting used by the United States and the

major trading countries in the world.

As the above table illustrates, the distortion produced

by the formula is particularly acute hetween the underde-

veloped and the highly-industrialized countries. For ex-

ample, the apportionment formula attributes to other coun-

tries approximately one half of the income produced in

Colombia and Venezuela according to the arm’s-length

principles applied in those countries. In Colombia’s case,

this produces the ludicrous result of apportioning little

more pretax income to Colombia (and in some vears less)

than the Colombian subsidiaries paid in Colombian income

taxes. The income attributed to Colombia by the California

formula for the years in questidn is, respectively,

$1,960,000, $2,454,000, $2,195,000. For the same vears, the

actual Colombian tax liability was determined to be

"Sch. VI to Exh. 1, Stip. re Testimony, J.A. 109-113, This method

of using the California formula to determine the income attri-

butable to the parent and subsidiary was approved by the Califor-

nia Supreme Court in Safeway Stores, Inc. v. Franchise Tax Board,

3 Cal. 3d 745, 91 Cal. Rptr. 616, 478 P.2d 48 (1970).

18

$2,508,086, $2,533,755, and $1,484,104, respectively. Second

Addendum to Stip. 159, J.A. 83-84.

As a further example, by application of its formula

California has alleged that on average for the years in

issue only $197,000 of income can be attributed to the Dutch

subsidiary. In fact, the Dutch subsidiary paid Dutch taxes

on the basis of an average income of $384,000 per year.

Actual taxes paid to the Dutch government averaged 97%

of income attributed to Holland by the formula. /d.

(b) Differences in Profitability Vis-a-Vis Factors

The record also demonstrates the difference in the re-

lationship between the factors and the net income produced

in various countries in which Container and its subsidiaries

operate throughout the world. That data is summarized in

the following table which compares the relationship be-

tween dollars of sales, of payroll and of property required

to produce $1.00 of net income computed for Container

domestically and for Container’s foreign subsidiaries in

each particular country.’

Amount Required to Produce $1.00 of Net Income

For the Years 1963-65

Country Payroll Sales Property

awa cea $3.34 $10.65 $4.83

I EE Be _ 027 5.17 4.74

Mexico .......... ee ees 1.53 10.69 6.29

Ro a 0.81 4.73 3.40

ASRS SS ene 3.95 17.62 9.73

I rc rE 0.96 7.98 1.59

As can be seen from this table, the distortion in the

apportionment of Container’s income can be traced primar-

ily to a dramatic difference in the relationship of payroll!

cost to net income in the United States as compared to

other countries and to a lesser extent to a difference in

the relationship of sales to net income.

"Italy is not included because the data is incomplete and be-

cause one of the Italian units was sold in 1964. These figures are

derived by dividing the net income produced in each country by the

respective sales, payroll, and property factors for that country. Exh.

Al1-8, J.A.E. 1-8, contain the basic data used to prepare this table.

19

B. By Taxing Income Which Was Earned in Foreign

Countries, and Not in California, California’s Appor-

tionment Violates the Due Process Clause

As noted above, the primary reason that the three-factor

payroll, property and sales formula is an acceptable

method of dividing the taxable income of multistate enter-

prises among the states is that a dollar of payroll or prop-

erty expended or used in one state, and a dollar of sales

realized in one state, typically produce roughly the same

amount of income as a dollar spent or sales made in other

states. To be sure, it is recognized that there are state-by-

state variations in wage and property cosis that produce

imprecision in apportionment, but these differences fall

within the area of constitutional tolerance for “rough

approximation” in the division of income from operations

within the United States. International Harvester Co. v.

Yvatt, 329 U.S. 416, 422 (1947).

However, when apportionment is extended to foreign

countries, wages, property costs and profits on sales vary

so dramatically that the premise is no longer viable. In-

stead of producing a fair approximation of income earned

in California, the apportionment formula results in taxa-

tion of income earned outside the state. Hence, the at-

tempted extension of the three-factor formula beyond the

borders of the United States violates the due process

clause becaus: ©’ is “inherently arbitrary” and produces

“an unreasonable result.” Underwood Typewriter Co. v.

Chamberlain, 254 U.S. 113, 120 (1920) ; see also Hans Rees’

Sons, Inc. v. North Carolina ex rel. Macwell, 283 U.S. 123

(1931); Wallace v. Hines, 253 U.S. 66 (1920).

Even if the California apportionment formula produced

a reasonable result in apportioning income between foreign

and domestic operations of another taxpayer, the formula

cannot be sustained here because of the substantial mis-

attribution of income which results. As stated in Norfolk €

Western Railway Co. v. Missouri State Tax Commission,

390 U.S. 317, 327 (1968) :

The facts of life do not neatly lend themselves to the

niceties of constitutionalism ; but neither does the Con-

stitution tolerate any result, however distorted, just

because it is the product of a convenient mathematical

formula which, in most circumstances, may produce a

tolerable product.

The facts in many cases,* including this one, demonstrate

that the formula leads to ar unacceptable level of distor-

tion so as to violate the due process and commerce clauses.

We urge the Court to reiteraie its conclusion in Norfolk,

where, in the context of distortion resulting from the for-

mula used by Missouri to value railroad rolling stock for

property tax purposes, the Court stated as follows:

We repeat that it is not necessary that a State dem-

onstrate that its use of the mileage formula has re-

sulted in an exact measure of value. But when a tax-

payer comes forward with strong evidence tending to

prove that the mileage formula will yield a grossly

distorted result in its particular case, the State is

obliged to counter that evidence or to make the accom-

modations necessary to assure that its taxing power

is confined to its constitutional limits. If it fails to do

so and if the record shows that the taxpayer has sus-

tained the burden of proof to show that the tax is so

excessive as to burden interstate commerce, the tax-

payer must prevail.

Id. at 329. California has not and, as shown above, cannot

carry such a burden. Thus, California cannot apportion the

income of Container on a combined, worldwide basis.

*See, G.A.O., Report to the Chairman, House Committee on

Ways and Means: Key Issues Affecting State Taxation of Multi-

jurisdictional Corporate Income Need Resolving at 32 (1982)

(hereinafter “G.A.O. Report”).

21

C. California’s Apportionment of Income on a Worldwide,

Combined Basis Results in the Taxation of Income

Also Taxed by Foreign Countries, Thereby Violating

the Commerce Clause

As demonstrated above, California’s system of world-

wide combination apportions to California income which,

under the separate accounting system adopted by the

Internal Revenue Code, was earned in foreign countries.

However, * « not only the separate accounting system as

applied by the United States government which demon-

strates that California is attempting to tax income earned

in foreign countries. Rather, this same separate accounting

system is used to allocate and tax income by all the foreign

countries in which Container’s subsidiaries operate (and,

in fact, by the major trading countries of the world). As

a result, California is not only taxing income which has

been earned in foreign countries under the system of allo-

cation applied in those countries, California is taxing

income which is, in fact, also tared by the foreign coun-

tries in which Container’s subsidiaries operate. The result-

ing multiple taxation of the same income subjects foreign

commerce to a burden which is not borne hy intrastate

commerce and is prohibited by the commerce clause. Erco

vr. Jones, 409 U.S. 91 (1972); Western Live Stock Co. v.

Bureau of Revenue, 303 U.S. 250 (1938); Japan Line Ltd.

v. County of Los Angeles, 441 U.S. 434 (1979).°

As the table set forth at page 17 illustrates, an average

of approximately $4 million in income per year, which

was taxed on a separate accounting basis in foreign coun-

tries, is apportioned to the United States, where it is

*Subsections C and D of this section of the brief show how use

of worldwide unitary combination results in international double

taxation and prevents the United States from “speaking with one

voice when regulating commercial relations with foreigu govern-

ments.” As the court said in Japan Line, “If the state contravenes

either of these precepts, it is unconstitutional under the Commerce

Clause.” 441 U.S. at 451 (emphasis added).

subject to tax again by the California formula. Some of

the $4 million was actually taxed by California (Con-

tainer’s average California factors are approximately 10%

of the total United States factors, so approximately 10%

of the average income shifted to the United States was

taxed by California).

More importantly, under California’s theory, all of the

approximately $4 million per year is subject to being taxed

a second time by some © ‘». In fact, 12 other states now

use a system of apportioiin.eut almost identical to Califor-

nia’s,’° so that these states could also impose a multiple tax

burden on the income of Container’s forcign subsidiaries.

Thus, the total cumulative impact of California’s method

of apportionment must be considered in addition to the

multiple burden imposed by California itself. As Justice

Stone stated in his landmark opinion setting forth the

multiple taxation doctrine:

The vice characteristic of those [taxes] which have

been held invalid is that they have placed on the com-

meree burdens of such a nature as to be capable, in

point of substance, of being imposed ... or added

to... with equal right by every state which the com-

merce touches, merely because interstate commerce is

being done, so that without the protection of the com-

merce clause it would bear cumulative burdens not

imposed on local commerce.

Western Live Stock v. Bureau of Revenue, 303 U.S. at

255-56 (citations omitted).

The multiple Surdens resulting from California’s appor-

tionment formula are also illustrated by the fact that the

apportionment formula attributes to other countries (prin-

cipally the United States) approximately one half of the

income produced in Colombia and Venezuela according to

"The thirteen states imposing worldwide combination are:

Alaska, California, Colorado, Idaho, Illinois, Indiana, Massachu-

setts, Montana, New Hampshire, New York, North Dakota, Oregon,

and Utah. See G.A.O. Report at 31.

23

the arm’s-length principles actually applied in those coun-

tries. As noted above, in Colombia’s case, this produces the

ludicrous result of apportioning little more pretax income

to Colombia (and in some years less) than the Colombian

subsidiaries paid in Colombian income taxes. Also as noted

above, the actual taxes paid by Container’s Dutch subsirli-

ary to the Dutch government average 97% of the income

attributed to Holland by the California formula. Thus, the

income of the Colombian and Dutch subsidiaries has been

taxed twice—once fully in Colombia or Holland and once

again in California. This is also true of the Venezuelan

and Mexican subsidiaries. Second Addendum to Stip. J 159,

J.A. 83-84.

In the case of foreign commerce, this Court has noted

an “enhanced risk of multiple taxation” which demands

that state taxes be reviewed with an especially high level of

scrutiny. Japan Line, Ltd. v. County of Los Angeles, 441

U.S. 434, 446-48 (1979). In Japan Line, the Court explained

the reasons why multiple taxation resulting from differing

allocation and apportionment methods may be constitution-

ally tolerable in dealing with state taxation of interstate

commerce, but is not tolerable in dealing with state taxation

of foreign commerce. In invalidating the tax, the Court

stated:

The basis for this Court’s approval of apportioned

property taxation, in other words, has been its ability

to enforce full apportionment by all potential taxing

bodies.

Yet neither this Court nor this Nation can ensure

full apportionment when one of the taxing entities is a

foreign sovereign. If an instrumentality of commerce

is domiciled abroad, the country of domicile may have

the right, consistently with the custom of nations, to im-

pose a tax on its full value. If a State should seek to

tax the same instrumentality on an apportioned basis,

multiple taxation inevitably results. Hence, whereas

the fact of apportionment in interstate commerce

means that “multiple burdens logically cannot oceur,”

24

Washington Revenue Dept., 435 U.S., at 746-747, the

same conclusion, as to foreign commerce, logically can-

not be drawn. Due to the absence of an authoritative

tribunal capable of ensuring that the aggregation of

taxes is computed on no more than one full value, a

state tax, even though “fairly apportioned” to reflect

an instrumentality’s presence within the State, may

subject foreign commerce “ ‘to the risk of a double tax

burden to which [domestic] commerce is not exposed,

and which the commerce clause forbids’.” Evco v.

Jones, 409 U.S., at 94, quoting J. D. Adams Mfg. Co.,

304 U.S. at 311.

441 U.S. at 447-48 (footnote omitted).

The Court’s discussion of Moorman Mfg. Co. v. Bair,

437 U.S. 267 (1978) further illustrates this point:

[Japan Line], by contrast, involves no mere mathe-

matical imprecision in apportionment; it involves a

situation where true apportionment does not exist

and cannot be policed by this Court at all. Moorman,

finally, concerned interstate commerce. This case con-

cerns foreign commerce. Even a slight overlapping of

tax—a problem that might be deemed de minimis in

a domestic context—assumes importance when sensi-

tive matters of foreign relations and national sov-

ereignty are concerned.

441 U.S. at 455-56 (footnote omitted).

In other words, the Court can assure fair apportionment

in interstate commerce (thus preventing imposition of

multiple tax burdens) because the Court has the power to

review the formulas of all the jurisdictions levying a tax.

Where apportionment formulas conflict, the Court can

determine whether any one formula is “to blame,” and

invalidate the unfair formula. In foreign commerce, how-

ever, no tribunal exists to ensure that income earned in

foreign commerce is taxed in the aggregate only once.

Tius a state’s apportionment method, even if (unlike here)

a fair one, may subject foreign commerce “ ‘to the risk of

ee)

a double tax burden to which [domestic] commerce is not

exposed, and which the commerce clause forbids’.” 441 U.S.

at 448.

It is clear that in this case California’s apportionment

must yield to the allocation made by the foreign coun-

tries in which Container’s subsidiaries operate, regard-

less of whether a state’s apportionment must always

yield to the allocation made by a foreign government.

Japan Line indicates that at the very least a state's

formula must yield when it either results in the imposition

of a multiple tax burden on foreign commerce, or the state's

formula, as California’s formula here and as the formula

invalidated in Japan Line, is contrary to the eustom of

nations and the policy of the federal government. “Cali-

fornia’s tax ... must he evaluated in the realistic frame-

work of the custom of nations.” 441 U.S. at 454. The

foreign nations in which the subsidiaries of Container do

business have the right and the power to tax the income of

these subsidiaries on an arm’s-length, separate accounting

basis, and do so."' Because this taxation is consistent

“\Containei’s foreign subsidiaries filed their income tax returns on

a separate accounting basis. Stip. { 140, J.A. 72. This method of

determining the income of those subsidiaries for income tax pur-

poses is in accordance with the laws of their respective countries

as in effect during the years in issue. See generally Arthur Ander-

sen & Co., Tax and Trade Guide—Colombia, 49-112 (1965); Arthur

‘Andersen & Co., Tax and Trade Guide—Italy, 47-105 (1962);

Arthur Andersen & Co., Tax and Trade Guide—Germany, 15-63

(1964); Arthur Andersen & Co., Tax and Trade Guide—Mexico,

27-75 (1967); Arthur Andersen & Co., Tax and Trade Guide—The

Netherlands, 23-69 (1965); Arthur Andersen & Co., Tax and Trade

Guide—Venezuela, 21-75 (1966); Board of Inland Revenue, 3 In-

come Taxes Outside the United Kingdom, 129-59 (1967) (Ger-

many); Board of Inland Revenue, 5 Income Taxes Outside the

United Kingdom, 213-17 (1967) (The Netherlands); Harvard Uni-

versity. World Tax Series—Taxation in Colombia, 218-36, 240-45,

335-6 (1964); Harvard University, World Tax Series—Taxation in

Italy, 335, 354-89, 395-401 (1964); Harvard University, World Tax

Series—Taxation in Mexico, 119-30, 139-58 (1957); Harvard Uni-

versity, World Tax Series—Taxation in the Federal Republic of

Germany, 830, 2208-14, 2255-63 (1969); International Bureau of

26

with the custom of nations and foreign policy, California’s

contrary apportionment method cannot be upheld.

In Japan Line the Court prohibited California from tax-

ing the containers on an apportioned basis because of the

resulting double taxation of foreign commerce which the

Court had no authority to limit, and because the California

tax would impair the conduct of the Nation’s foreign

policy. Appellant submits that California is likewise pro-

hibited from taxing the income of the foreign subsidiaries

on an apportioned basis, a basis contrary to the established

custom of nations, because of the resulting double taxa-

tion which this Court cannot ameliorate and because the

California tax again would impair federal policy.

In short, California’s use of worldwide combination on

a unitary besis results in the imposition of a double tax

burden or foreign commerce to which domestic commerce

is not subjected and which the commerce clause forbids.

Fiscal Documemation, The Taxetion of Companies in Latin Amer-

ica, Venezuela, C-3 to C-5 (1981); International Bureau of Fiscal

Documentation, The Taxation of Companies in Europe, Nether-

lands, 134 (1977).

Reporting income on a separate accounting basis also accords

with the tax treaties in effect between the United States and these

foreign countries. Convention for the Avoidance of Double Taxa-

tion With Respect to Taxes on Income, July 22, 1954, United States

—Federal Republic of Germany, art. IV, T.LA.S. No. 3133; Con-

vention for the Avoidance of Double Taxation and the Prevention

of Fiscal Evasion with Respect to Taxes on Income, March 30,

1955, United States—Italy, art. IV, T.I.A.S. No, 3679; Convention

with Respect to Taxes on Income and Certain Other Taxes, April

29, 1948, United States—The Netherlands, art. IV, §§ 1-2, T.LA.S.

No. 1855. Finally, the separate accounting, arm’s-length standard is

embodied in the current laws of those foreign countries. See, For-

eign Tax Law Assoc., Inc., Tax Laws of the World—Colombia 9-22

(1979); Foreign Tax Law Assoc., Inc., Tax Laws of the World—

Italy 1-6, 12-19, 38-48 (1979); Foreign Tax Law Assoc., Inc., Tax

Laws of the World—Mexico 65-70, 162-75 (1978); Foreign Tax

Law Assoc., Inc., Tax Laws of the World—Netherl ands 1-21 (1979);

Foreign Tax Law Assoc., Inc., Tax Laws of the World—West Ger-

many, 23-59, 62-72 (1979); Foreign Tax Law Assoc., Inc., Tax Laws

of the World—Venezuela 8-24 (1979).

27

D. California’s Tax Prevents the Federal Government

from Speaking with One Voice in Regard to Foreign

Policy, Thereby Violating the Commerce Clause

The Framers of the Constitution clearly recognized that

the federal government must have sole power in dealing

with foreign nations.

The second class of powers lodged in the General Gov-

ernment consists of those which regulate the inter-

course with foreign nations, to wit, to make treaties;

... to regulate foreign commerce ... .

This class of powers forms an obvious and essential

branch of the federal administration. If we are to be

one nation in any respect, it clearly ought to be in

respect to other nations.

The Federalist Papers No. 42, at 279 (Madison) (J. Cooke

ed. 1961).

The Court has long confirmed the preeminence of the

national government in regard to foreign commerce, “In

international relations and with respect to foreign inter-

course and trade the people of the United States act

through a single government with unified and adequate

national power.” Board of Trustees v. United Siates, 289

U.S. 48, 59 (1933). “[T he Federal Government must speak

with one voice when regulating commercial relations with

foreign governments ... .” Michelin Tire Corp. v. Wages,

423 U.S. 276, 285 (1976).

Especially since World War II, it has been the foreign

policy of the United States to promote the free interna-

tional flow of capital and technology to foster the: social

and economic progress of the United States and other na-

tions of the world.” In order to promote this foreign policy

"See also Cooley v. Board of Wardens, 53 U.S. (12 How.) 299,

319 (1852); Zschernig v. Miller, 389 U.S. 429 (1968).

“The current administration has recently reaffirmed the long-

established importance to the foreiga policy of the United States

of efforts to remove impediments to the free flow of trade and

investment. See, remarks by President Reagan to the World Affairs

(footnote continued )

28

objective, the United States has developed a series of rules,

both in the Internal Revenue Code and in its tax treaties, to

provide a coherent allocation system for eliminating double

taxation of multinational corporate groups. In this regard,

the United States has determined that double taxation is a

major impediment to its policy of promoting the free flow

of capital and technology. As a United States Treasury

official has stated:

We view tax treaties as an important element in the

international economic policy of the United States.

One of our fundamental objectives is to minimize im-

pediments to free international flows of capital and

technology, and this objective is fostered by having the

broadest possible network of income tax treaties.

Among the major impediments to freer capital and

technology flows are the rules of national tax systems

and their interaction with the systems of other coun-

tries. Tax treaties seek to eliminate, or at least

mitigate the impact of, these impediments.

Treaties accomplish this minimization of impedi-

ments by a variety of means, the principal ones being

the elimination or reduction of double taxation and the

elimination, to the extent possible, of discriminatory

Council of Philadelphia, October 15, 1981, excerpted in the N. Y.

Times, Oct. 16, 1981, § 1, at 12. See also, statements by Myer Rash-

ish, Under Secretary of State for Economic Affairs, and Robert D.

Hormats, Assistant Secretary of State for Economic Affairs before

the Subcommittee on Trade of the H. Ways and Means Comm.

on October 29, 1981, printed in Dep't. St. Bull., Dec. 1981, at 44.

Further, Congress has declared that it is the policy of the United

States “to increase the flow of international trade” and “to encour-

age the contribution of United States enterprise toward the eco-

nomic strength of less developed friendly countries through, [inter

alia] private trade and investment abroad.” 22 U.S.C. § 2351(a).

To this end the President is directed in 22 U.S.C. § 2351(b)(3) to:

accelerate a program of negotiating treaties for commerce and

trade, including tax treaties, which shall include provisions to

encourage and facilitate the flow of private investment to, and

its equitable treatment in, friendly countries and areas par-

ticipating in programs under this chapter.

29

tax rules which distinguish unreasonably between

domestic and foreign investment.”

Because California’s method of taxation conflicts with the

system set forth in the Internal Revenue Code and in

United States treaties, which are used as a basis for imple-

menting United States foreign policy, California’s tax

“impair[s} federal uniformity in an area where federal

uniformity is essential,” and hence violates the commerce

clause. Japan Line, 441 U.S. at 448.

1. The Federal Tax System Is Based upon Separate

Accounting, Deferral of Recognition of Income,

and Sourcing of Income with Regard to Foreign

Subsidiaries

In allocating the income of corporate members of a

multinational group, the basic position of the federal sys-

tem is a recognition of the separate character of each

member. Thus the income of a United States member of the

group is determined on a separate accounting basis, i.e., by

separately determining the income earned and the expenses

ineurred hy the United States corporation. Under this

method, if the parent of the affiliated group is a United

States corporation, the taxable income of the parent is

separately determined without taking into account the

income of its foreign subsidiaries. Federal taxation of the

income of the foreign subsidiaries is therefore deferred

until the subsidiaries pay a dividend to the parent.** Double

“Tax Treaties with the United Kingdom, the Republic of Korea,

and the Republic of the Philippines, Hearings Before the S. Comm.

on Foreign Relations, 95th Cong., Ist Sess. 28 (1977) (Statement

of former Assistant Secretary of Treasury for Tax Policy, Laurence

N. Woodworth) [Hereinafter “Woodworth” ].

**Hufbauer and Foster, “U. S. Taxation of the Undistributed In-

come of Controlled Foreign Corporations,” Tax Policy Research

Study No. 3, Essays in International Taxation: 1976, Dept. of the

Treasury (1976) p. 1, et seq. A limited exception to deferral oc-

curs in I.R.C. §§ 951-964 wherein shareholders are currently taxed

on income of a controlled foreign corporation in certain potential

“tax abuse” situations, and in LR.C. §§ 551-558, relating to foreign

personal holding companies.

30

taxation is eliminated by granting to United States domes-

tie corporations credits against income taxes paid to

foreign governments. I.R.C. §§ 901-904.

To ensure that the United States collects a fair share of

the tax revenues from businesses engaged in foreign com-

merce, the Internal Revenue Service is given authority to

monitor transactions between a United States corporation

and its foreign affiliate. I.R.C. § 482. This system recognizes

the integrity of separate corporate organizational struc-

tures in terms of tlieir primary liability for taxes, but

grants the IRS authority to reallocate any income, dedue-

tion or other item affecting taxable income among affiliated

corporations, if such reallocation is necessary to determine

the true taxable income of each based on arm’s-length

standards. Thus, the United States system is based upon

and policed by the principles of separate accounting.

Coincident with the separate accounting rules are the

so-called source rules—that is, the rules for determining

whether and to what extent certain types of income are to

be considered as derived from sources within the United

States or from foreign sources. A mechanism exists at the

federal level and in the tax treaties for determining the

amount of foreign source income. I.R.C. §§ 861, et seq.

2. The Income Tax Treaties of the United States

Implement Federal Policy

The separate accounting, arm’s-length standard not only

is the method used by the tax laws of the United States for

allocating income among related taxpayers, it is also “the

internationally accepted norm” for such allocation.”* All

the income tax treaties in force between the United States

and the other countries of the world apply the arm’s-length

Woodworth at 33. See also, Income Tax Treaties: Hearing Be-

fore the Subcomm. on Oversight of the H. Comm. on Ways and

Means, 96th Cong., 2nd Sess. 61 (1980) (statement of H. David

Rosenbloom, International Tax Counsel, Department of the Trea-

sury ).

31

standard.” There are 25 such income tax treaties currently

in force between the United States and other countries; 10

others are signed but not yet in effect.

Thus the federal government utilizes a series of measures

for allocating and taxing income earned by corporate mem-

bers of a multinational group: (i) taxation of United

States members by the separate accounting, arm’s-length

method; (ii) deferral of taxation of the income of foreign

subsidiaries of a United States parent until dividends are

paid; (iii) specific sourcing of a number of items of income.

These measures are designed to produce an appropriate

allocation of income between the United States and foreign

countries, and together with the foreign tax credit, are

aimed at eliminating double taxation, thereby promoting

the policy of the United States to encourage the free flow

of capital and technology.

Woodworth at 33.

The separate accounting, arm’s-length standard is embodied in

the model convention proposed by the OECD (Organization for

Economic Cooperation and Development) of which there are 24

members, including the United States. Article 9(1), OECD Mode!

Convention for the Avoidance of Double Taxation With Respect to

Taxes on Income and on Capital (1977), 1 Tax Treaties (CCH)

{ 151 (hereinafter “OECD Model Convention”). On June 16, 1981,

the Treasury Department released its revised draft of the United

States Model Income Tax Treaty which also adopts the separate ac-

counting, arm’s-length standard. As with most recently concluded

United States tax treaties, the new model closely follows the OCCD

Model Convention. See, United States Model Income Tax Treaty

(June 16, 1981), Article 9(1), 1 Tax Treaties (CCH) § 158; see

also the treaties between the United States and other countries cited

in Appendix A to the brief amicus curiae of the Confederation of

British Industry filed in this case, all of which adopt the arm’s-

length standard. The United Nations’ model treaty also provides

for use of the separate accounting, arm’s-length standard. United

Nations Model Taxation Convention Between Developed and De-

veloping Countries, Article 9(1), 1 Tax Treaties (CCH) § 171.

32

3. The Worldwide Unitary Combined Reporting Sys-

tem, Which Imposes an Entirely Different Method

of Apportioning Income upon Multinational Cor-

porate Groups, Is in Irreconcilable Conflict with

the Federal System

Under the unitary system, when an enterprise doing

business in California is part of a group carrying on a

“unitary business” under California’s rules, a combined

report of the group’s worldwide income is required.”*

Where multinational business operations are concerned,

California does not limit its requirement of a combined

report to enterprises in which the parent corporation is

headquartered in California or the United States.”

California’s method of taxation completely contravenes

the three basic tenets of the federal system outlined

above.” The assumption underlying the combined unitary

reporting system is that the income of affiliated corpora-

tions which are members of a “unitary group” cannot be

determined by separate accounting and that intercompany

charges cannot be adequately established. Furthermore, the

unitary system immediately includes the income of the

foreign subsidiaries of United States parents in the appor-

tionable base and does not recognize the necessity of

sourcing various items of income.

These substantial theoretical differences are matched by

equally significant differences when the two systems of

taxation are put into actual practice. For example, the

federal system recognizes the simple fact that a corporate

member of an affiliated group operating in one country

can be more profitable than another member of the same

‘*Title 18, California Administrative Code, § 25120.

1° Appeal of Beecham, Inc., Cal. Tax Rep. (CCH) { 205-635 (Cal.

St. Bd. of Equalization, 1977), Appeal of Shachihata, Inc., U.S.A.,

Cal. Tax Rep. (CCH) § 206-076 (Cal. St. Bd. of Equalization,

1979).

2°Surrey, “Reflections on the Allocation of Income and Expenses

Among National Tax Jurisdictions,” 10 Harv, J. of Law and Policy

in Int'l Bus. 409, 415-16 (1978).

group operating in another country. Unitary apportion-

ment denies that fact. Under the unitary approach, the

profit of the total group is apportioned among its members

according to the factors used in the formula. As discussed

above, at page 15, if some members are in fact more profit-

able with regard to the apportionment factors than others,

the income of the more profitable members will be appor-

tioned to those with lesser profit, or no profit at all.

Thus, the federal system and the unitary system are in

sharp conflict both in theory and in result. Furthermore,

since the foreign governments of the world have also

adopted the separate accounting, arm’s-length standard for

apportioning the income of multinational affiliated corpora-

tions both in their internal laws and in their tax treaties,

California’s use of the unitary system obviously conflicts

with their system of apportionment and, as cliscussed at pp.

21-26 above leads to double taxation.

The resulting conflicts between specific allocation and

apportionment were discussed by the Court in Japan Line:

A state tax on instrumentalities of foreign commerce

may frustrate the achievement of federal uniformity

in several ways. If the State imposes an apportioned

tax, international disputes over reconciling apportion-

ment formulae may arise. If a novel state tax creates

an asymmetry in the international tax structure,

foreign nations disadvantaged by the levy may retali-

ate against American-owned instrumentalities present

in their jurisdictions. Such retaliation of necessity

would he directed at American transportation equip-

ment in general, not just that of the taxing State,

so that the Nation as a whole would suffer. /f other

States , ollowed the taxing State’s example, various in-

strumentalities of commerce could be subject to vary-

ing degrees of multiple taxation, a result that would

plainly prevent this Nation from “speaking with one

voice” in regulating foreign commerce.

441 U.S. at 450-51 (footnotes omitted and emphasis

added).

34

The application of these principles to this case is strik-

ing. California’s novel unitary approach creates an asym-

metry in the international tax structure, since the custom

of nations has been to determine taxable income based on

separate accounting.” This point has been emphasized

many times recently in diplomatic communications which

the United States Treasury and State Departments have

received from foreign governments. See Appendices la-%a

of the United States Memorandum as amicus curiae in

Chicago Bridge a: Iron Co. v. Caterpillar Tractor Co., No.

81-349. More recent communications from Canada and the

ten European Community governments are attached here-

to as Appendices D and FE at A-6 and A-S. Thus, Califor-

nia, like Los Angeles County in Japan Line, has imposed

upon the international community a dramatically different

method of taxation, thereby creating a climate where

“international disputes over reconciling apportionment for-

mulae may arise.” 441 U.S. at 450. Furthermore, retaliation

could easily take place. For example, a recent debate in

the British Parliament discussed the possibility of Great

Britain retaliating against the California system by im-

posing the worldwide unitary method upon United States

corporations with subsidiaries in Great Britain.”

The Court’s sentence beginning with the phrase “if other

states followed . . .” quoted above is particularly appropri-

ate since at least 12 other states have already foliowed

California’s lead. As a result, the ability of the United

States to speak with one voice has been increasingly im-

paired, inasmuch as the states have not agreed, inter alia,

upon a uniform tax base, a uniform definition of a unitary

business, or uniform apportionment formulas.”

2“JIn this connection I would note that the arm’s-length standard

is the internationally accepted norm for apportioning income be-

tween related taxpayers. It is confusing to other countries and dis-

concerting to international relations when our states use a different

standard.” Woodworth at 33 (emphasis added).

*?House of Commons, Official Report, 27 April 1982, vol. 22, No.

105, c. 823-8.

*8G.A.O. Report at 12-21.

35

It is true that Congress has not established a particular

system which states must follow in determining income

earned within the state from foreign commerce. Nor has

Congress expressly prohibited the states from employing

the unitary method for determining the taxable income of a

business engaged in foreign commerce. Nevertheless, tis

Court has invalidated state legislation in conflict with

federal policy even in the absence of an express federal

statute. The test, as stated in a case passing on a Pennsyl-

vania statute, is as follows:

Our primary function is to determine whether. . .

Pennsylvania’s law stands as an obstacle to the accom-

plishment and execution of the full purposes and

objectives of Congress.

Hines v. Davidowitz, 312 U.S. 52, 67 (1941). A similar test

was applied in McGoldrick v. Gulf Oil Corp., 309 U.S. 414

(1940), where the Court invalidated a New York City sales

tax imposed on sales of fuel oil to ocean-going vessels on

the ground that the tax was in conflict with federal policy.

This test was also applied in Japan Line, which presents

the closest analogy to the present case. In that case the

Court invalidated a county property tax on the ground that

the levy would frustrate federal policy, even though there

was no federal statute or treaty explicitly so providing.

The applicable treaty involved exempted from federal

taxes and customs duties containers owned by foreign

based corporations as long as the containers, while in the

United States, were used solely in foreign commerce.

Although the treaty pertained only to federal taxes (as is

true with the income tax treaties in this case), the policy

of the United States was clear. The containers were to be

exempt from taxes and duties while in the United States,

thus leaving taxation of the containers solely to the country

of the owner’s domicile and eliminating double taxation.

The Court held that Los Angeles County’s tax was an

obvious impairment of the federal policy established to

eliminate double taxation in this area.

36

In regard to Container, to the extent that the unitary

method produces an amount of taxable income for Con-

tainer’s United States operations which exceeds the amount

determined on an arm’s-length basis (which is true for each

of the years in issue, see p. 16, supra), necessarily Califor-

nia taxes foreign source income as that term has been

defined for federal income tax purposes. Since no Califor-

nia tax credit or deduction is available for foreign taxes

paid on this income, double taxation of such income is in-

escapable. Such improper apportionment of income and

resulting double taxation unavoidably frustrate the United

States foreign policy of promoting the free international

flow of capital and technology and therefore violates the

commerce clause.

E. The Analysis Contained in the Solicitor General’s

Amicus Memorandum in Chicago Bridge & Iron Re-

quires Reversal of the Judginent Below

Last Term in Chicago Bridge & Iron the Solicitor Gen-

eral filed an amicus memorandum at the behest of the De-

partments of State and Treasury, the Department of Com-

merece (acting at the request of the Delegation of the Com-

mission of the European Communities) and the United

States Trade Representative. In that memorandum, the

Solicitor General urged that the imposition of a com-

parable Illinois income tax on the apportioned combined

worldwide business income of a unitary group of related

corporations violated the Commerce Clause. Since the

Court has restored that case to the calendar for reargu-

ment without setting it in tandem with the argument in the

instant case, we have reproduced the salient portions of the

United States memorandum for the convenience of the

Court in the Appendix, at A-10. Indeed, given the Solicitor

General's explicit suggestions, later reinforced by our own

motion, that the Court note probable jurisdiction here in

order to consider the question “in the context of a case

involving multiple taxation in fact,” Appendix F at A-20,

Appellant believes that his memorandum is highly per-

tinent to the disposition of this case as well.

37

The analysis contained in the Solicitor General’s amicus

memorandum in Chicago Bridge & Iron, in the context of

the facts of this case, requires reversal of the judgment

below. The Solicitor General relied upon Japan Line as the

“seminal decision” (Chicago Bridge & Iron Co. v. Cat-

erpillar Tractor Co., No. 81-349 Transcript of Oral Argu-

ment, April 19, 1982, at 16 [“Tr.”]) that “undermines the

basis of the decision below and invalidates the unitary

apportionment method as applied to multinational corpo-

rate groups,” Appendix F at A-14 (foonote omitted).

As the memorandum stated, id. at A-17:

We submit that analysis of the Tilinois tax wider the

principles of Japan Line requires the conclusion that

the combined apportionment method, applied to a uni-

tary business with foreign corporate constituents, is

barred by the Commerce Clause. Like the ad valorem

tax at issue in Japan Line, the Illinois tax violates

both precepts discussed in that decision insofar as it

creates a substantial risk of international multiple tax-

ation and impairs federal uniformity in the conduct of

foreign relations.

Thus, the Solicitor General identified the two grounds up-

on which the Court rested its decision in Japan Line: “first,

as the Court said, the enhanced risk of multiple taxation,

and second, the need for federal uniformity in the conduct

of international relations and foreign trade.” Tr. 16.

Here, as Container has pointed out (supra, at 21-26),

the application of the California tax in this case does not

simply create a risk of multiple taxation but “creates mul-

tiple taxation in fact.” Japan Line, 441 U.S. at 452, n.17. In

these circumstances, as the Solicitor General observed,

Appendix F at A-19:

both the state and the foreign country would tax such

apportioned income, thereby resulting in international

double taxation of the same income. In this manner,

the state unitary method frustrates the federal policy,

»

vw

consistent with international usage, of avoiding or

mitigating international double taxation.

Moreover, the Solicitor General also emphasized the fact

that a state tax such as California’s “is still invalid because

it impairs federal uniformity” insofar as “it prevents the

federal government from ‘speaking with one voice’ in inter-

national trade.” Appendix F at A-20. In this respect,

he noted, in terms that apply equally to the California levy

at issue here, that:

[T]he United States and most foreign countries use the

arms-length method of allocating income between cor-

porations. Illinois’ variant unitary method impairs the

otherwise uniform international custom that is the

basis of the treaties between the United States and

numerous foreign countries that are intended to pre-

vent international double taxation of income. /7.

Finally, the Solicitor General concluded, Id. at A-21:

In sum, “the freedom of the States to formulate in-

dependent policy in [the] area [of commerce] may

have to yield to an overriding national interest in uni-

formity” Moorman Manufacturing Co. v. Bair, supra,

437 U.S. at 280... . The income taxation of multina-

tional businesses is thus a matter that is subject only

to a national rule conformable with the practice of na-

tions or adopted pursuant to the President's authority

“by and with the Advice and Consent of the Senate to

make Treaties * * *” or Congress’ power “[t]o regulate

Commerce with Foreign Nations * * *.” “[Tllinois], by

its unilateral act, cannot be permitted to place these

impediments before this Nation’s conduct of its foreign

relations and its foreign trade.” Japan Line, Ltd. v.

County of Los Angeles, supra, 441 U.S. at 453.

If, as appellant submits and the Solicitor General has

argued in his amicus memorandum, the Court concludes

that the Californis combined reporting method either:

(a) imposes international double taxation in fact, or

39

(b) impairs federal uniformity in the conduct of foreign

relations, that is the end of the matter, and the judgment

below should be reversed. In these circumstances, the

California combined reporting method cannot be constitu-

tionally applied to any multinational group of corpora-

tions—a result that appellant and the Solicitor General

believe to be compelled by the commerce clause. See

Appendix F at A-22.

To be sure, the United States “views the [case of the]

foreign parent [corporation] with particular and special

concern.” Tr. 23. As the Solicitor General correctly

pointed out, there are “other burdens that the state unitary

method will impose on international trade and foreign

relations,” in the case of the foreign parent corporation.

Appendix F at A-22. But under the analysis that proceeds

from Japan Line, to which appellant and the Solicitor

General both subscribe, there is no meaningfu! constitu-

tional distinction between the case of a United States par-

ent and its foreign subsidiaries and the case of a foreign

parent with United States subsidiaries. In either situation,

the combined reporting method is constitutionally pro-

hibited if, as here, it results in international double taxa-

tion. What is more, the combined reporting method neces-

sarily impairs federal uniformity, and is constitutionally

prohibited, because it aggregates the income of commonly

controlled entities in a manner that is sharply at variance

with the internationally accepted arm’s-length method of

allocating income among related corporations.

4G

II

BECAUSE THERE IS NO SUBSTANTIAL OPERA-

TIONAL INTERDEPENDENCE BETWEEN CON.

TAINER AND ITS FOREIGN SUBSIDIARIES, THE

DUE PROCESS CLAUSE PROHIBITS THE TAXA-

TION OF CONTAINER AND THE FOREIGN SUB.

SIDIARIES AS A SINGLE UNITARY BUSINESS,

REGARDLESS OF WHETHER OR NOT WORLD.-

WIDE FORMULA APPORTIONMENT IN GENERAL

IS PERMISSIBLE

It is a fundamental constitutional principle that the due

process clause prohibits a *tate from taxirg value earned

outside its borders. The taxing power exerted by a state

must bear a substantial relation to the protection, oppor-

tunities, and benefits provided by a state. Thus, the “simple

but controlling question is whether the state has given

anything for which it can ask return.” Wisconsin v. J. C.

Penney Co., 311 U.S. 485, 444 (1940).

In the present case, California asserts a right to include

in the apportionment formula income earned by sub-

sidiaries of Container operating entirely in foreign coun-

tries. However, California cannot include the subsidiaries’

income in the apportionment formula unless Container and

its foreign subsidiaries possessed such substantial op-

erational interdependence that they constitute a single uni-

tary business unc r the criteria enunciated by this Court.

As this Court has recently reiterated, “(tjhe ‘linchpin of

apportionability’ for state income taxation of an inter-

state enterprise is the ‘unitary-business principle’.”

ASARUO Inc. v. Idaho State Tex Commission, .... U.S. ....;

50 U.S.L.W. 4962 (1982) (Slip Op. at 11, quoting Exrvron

Corp. v. Wisconsin Dept. of Revenue, 447 U.S. 207, 223

(1980), in turn quoting Mobil Oil Corp. v. Commissioner of

Taxes, 445 U.S. 425, 489 (1980)). The facts of the presert

case compel the conclusion that, especially under the eri-

teria set forth in the Court’s recent decisions in ASARCO

41

and I’. W. Woolworth Co. v. Taxation & Revenue Dept.,

.. U.S. ...; 50 U.S.L.W. 4957 (1982), Container and its

foreign subsidiaries do not operate as a single unitary

business and California’s combination of them is prohibited

by the due process clause.

This Court has recently decided several cases in which

various states have asserted that a unitary business

existed. In two of the cases, “the states prevailed because

it was clear that the corporations operated unitary busi-

nesses with a continuous flow and interchange of common

products.” ASARCO, Slip. Op. at 22, n.24. In ASARCO

and Woolworth, however, because “‘these essential factors

[were] wheily absent,” the Court found that the businesses

involved were not unitary. /d.; Woolworth Slip. Op. at 16-

17. Here too there is no continuous flow and inter-

change of common products between Container and its

foreign subsidiaries, and because “the parent company’s

operations are not interrelated with those of its sub-

sidiaries so that one’s ‘stable’ operation is important to the

other's ‘full utilization’ of capacity,” Container and its

foreign subsidiaries cannot be taxed as a single unitary

business. Woolworth, Slip Op. at 15 quoting Faxon, 447

USS. at 218.

Exxon, Woolworth, and ASARCO establish beyond per-

adventure that two or more corporations cannot be com-

bined into a single unitary business unless there is a sub-

stantial operational interdependence between the operations

of the corporations. Thus in Excon, a vertically integrate:!

company with a continuous flow of products within the

United States, constituted a single unitary business be-

cause it was a “highly integrated business which benefits

from an umbrella of centralized management and controlled

interaction.” Exxon, 447 U.S. at 224. Where there was no

such functional integration, however, and none of the sub-

stantial operational interdependence which was evident

42

in Exxon, the Court found that a witary business did

not exist. See ASARCO; Woolworth.

The relationship between Container and its foreign sub-

sidiaries is virtually identical to the relationship hetween

Woolworth and its foreign subsidiaries. In both cases, the

foreign subsidiaries engaged in the same general line of

business as the parent. The operations of the subsidiaries

were highly decentralized, so that the subsidiaries located

in each particular country operated as fully integrated,

self-sustaining business operations. Stip. § 61, J.A. 30;

Woolworth, Slip Op. at 9-10. Thus, in both cases, “no

phase of any subsidiary’s business was integrated with the

parent’s.” Woolworth, Slip Op. at 10 (emphasis added).

Here there was an insignificant transfer of goods or

products between Container and its foreign subsidiaries.

In Woolworth there was apparently no transfer at all.

Stip. (926, 141, 148, J.A. 15-16, 73, 74; Woolworth,

Slip Op. at 15. In both cases, the management of the foreign

subsidiaries had complete control over business decisions

affecting their operations. Stip. § 74, J.A. 39-40: Wool-

worth, Slip Op. at 12. Container’s foreign operation staff

consisted of only five people, three of whom devoted only

part of their time io foreign operations, while Woolworth

had one vice president who evidently devoted all of his time

to acting as “liaison man” with the smaller foreign sub-

sidiaries and occasionally contacting the major subsidi-

aries. Jd. at 13, n. 16. The personnel departments of both

Container’s and Woolworth’s foreign subsidiaries were

fully independent operations, dedicated to recruiting and

training nationals to fill positions at every level of the

business. Stip. 7779, 89, 95, 109, J.A. 42-3, 48, 51, 56;

Woolworth, Slip Op. at 12.

In addition, there are a number of other items which the

Court identified in Woolworth and ASARCO to which

43

the facts in the instant ease are similar.** The overriding

fact, however, as emphasized by the Court in both Wool-

worth and ASARCO, is that, as in the present case,

“fe)]xcept for the type of occasional oversight—with re-

spect to capital structure, major debt, and dividends—that

any parent gives to an investment in a subsidiary, there is

little or no integration of the business activities or central-

ization of the management of [the corporations involved].”

Woolworth, Slip Op. at 15.

Furthermore, the approach of the Court of Appeal in

Container to the unitary issue was much like that of the

lower courts in ASARCO and Woolworth. Thus, the Court

of Appeal “in important part analyzed this case under a

different legal standard” than the one adopted by this

Court. Woolworth, Slip Op. at 8. As did its counterparts in

the other two cases, the Court of Appeal in the present case

relied heavily on Container’s potential ability to operate

the foreign subsidiaries as part of the unitary business.

For example, the Court of Appeal noted that Container

bought no raw materials or finished products from its sub-

sidiaries and sold only small quantities of paperboard and

raw materials (and no finished products) to its subsidi-

aries. Nevertheless, the opinion gave weight to the fact that

the subsidiaries could have bought more materials from the

**There are, of course, some small differences between the Wool-

worth and Container cases. In some instances, the facts indicate

that Container and its subsidiaries have fewer links between them.

For example, in Woolworth, the parent and the foreign subsidiaries

all used the same general “F.W. Woolworth” corporate name. Slip

Op. at 14, n.22, while Container’s foreign subsidiaries did not use

the “Container Corporation of America” name. Stip. { 25, J.A. 14-5.

In other instances, the facts indicate that some links in the Wool-

worth case were even more tenuous than in the present case. For

example, the foreign subsidiaries of Container did owe some money

to the parent at the end of each of the years in question and a

very small number of Container employees had transferred to the

foreign subsidiaries.

44

parent.” J.S. at A-8, A-9. Additionally, while the Court of

Appeal did not dispute the fact that the foreign subsidi-

aries controlled their own operations and set their own

policies, the Court emphasized that important decisions

were “subject to” review by Container’s management and

seemed to give this potential review the same significance

as if Container had made the decisions itself. J.S. at A-3.

This Court has made clear that the potential ability to

operate a company as part of a unitary business is not

dispositive, but that the companies must be operated as

an integrated enterprise in fact. Woolworth, Slip Op. at

7-8; ASARCO, Slip Op. at 15-16. The Court noted that in

Woolworth “[djecisions about major financial decisions,

such as the amount of dividends to be paid by the sub-

sidiaries and the creation of substantial debt, had to be

approved hy the parent.” Woolworth. Slip Ov. at 14. How-

ever, this review, and the potential for control which it may

entail, did not warrant combination as a unitary business.

The “different legal standard” used by the Court of

Appeal in this case extended considerably beyond its use

of potential unitary ties as its yardstick. In reaching its

2*In some instances, the Court of Appeal went beyond even

potential unitary features, reasoning that a decision not to integrate

operations was an indication that a unitary business existed. The

Court of Appeal, in listing what it believed were features indicating

operational unity, thus refers to the fact that the foreign subsidi-

aries “followed” Container’s “policy of regional decentralization.”

J.S. at A-12; see also J.S. at A-2. Even if there was any evidence that

the parent imposed such a standard on the subsidiaries (which

there was not), the Court of Appeals position would lead to the

absurd conclusion that if the parent “imposed” anarchy on the for-

eign subsidiaries as a management philosophy, such anarchy would

be an indication that a unitary business existed. This confusion of

the “potential” unitary feature of control with true functional in-

tegration has been rejected in ASARCO and Woolworth, since

“[t]he state court’s reasoning would trivialize [the] due process

limitation.” Woolworth, Slip Op. at 8.

45,

conclusion, the Court of Appeal also failed to require the

existence of meaningful, operational relationships between

Container and the f reign subsidiaries and relied instead,

at least in part, upon an administrative presumption that

corporations engaged in the same line of business are

unitary.” Woolworth and ASARCO clearly indicate that,

just as the potential for a unitary business is not a justi-

fication for combination, an administrative presumption

cannot be used as a basis for combining corporations into

a single unitary group.”

In sum, both Woolworth and the instant case fall on the

same side of the “critical distinction” set out by the Court

in Woolworth:

There is a critical distinction between a retail mer-

chandising business as conducted by Woolworth and

the type of multinational business—now so familiar—-

*6In this connection the court stated as follows:

Appellant engaged in the same business activities as its sub-

sidiaries. The administrative regulations indictate that a strong

inference of a unitary business exists where the taxpayer is

engaged in the same type of business. This administrative con-

struction of the California tax laws “is entitled to great weight,

and the courts generally will not depart from construction un-

less it is clearly erroneous or unauthorized.”

J.S., A-15-A-16 (footnote and citations deleted). The relevant

administrative regulation, Title 18, California Administrative Code,

§ 25120(b) is set forth in full at J.S., A-39-A-40. The relevant por-

tion is quoted in footnote 4 to the lower court’s opinion. J.S. A-15-

A-16.

*?Furthermore, other decisions of the Court indicate that, as in

the present case, an opposite presumption is required. As demon-

strated at pages 11-18, combination of Container and its foreign sub-

sidiaries into a single unitary group results in a substantial misat-

tribution of income to California. As a result of this strong evidence

of distortion, at a minimum the state is required to counter the evi-

dence. Absent such rebuttal, a presumption arises against the state’s

apportionment. This was precisely the approach taken by the Court

in Norfolk & Western Ry. Co. v. Missouri State Tax Commission,

390 U.S. 317 (1968).

in which refined, processed, or manufactured produets

(or parts thereof) may be produced in one or more

countries and marketed in various countries, often

worldwide. In operations of this character there is a

flow of international trade, often an interchange of

personnel, and substantial mutual interdependence.

The uncontradicted evidence demonstrates that Wool-

worth’s international retail business is not comparable.

There is no flow of international business. Nor is there

any integration or unitary operation in the sense which

our eases consistently have used these terms.

Woolworth, Slip Op. at 16-17 (footnote omitted). As noted

above, Container’s subsidiaries in each foreign country

produced and marketed their own products in each country.

As in Woolworth, “there is no flow of international usi-

ness,” ic. no flow of goods, and no “substantial mutual

interdependence.” Id.

The Court’s opinion in Woolworth, as well as its deei-

sions in Exron and ASARCO, indicate that, in the case of

a manufacturing or mercantile business, there can be no

unitary business without a “flow of trade” between the

afliliated corporations. Prior state income tax cases hefore

the Court involving the unitary issue in the context of a

manufacturing or mercantile business have been cases in

which there has been a substantial flow of goods or prod-

ucts between affiliated corporations.” In ASARCO, while

the Court held that a substantial product flow alone did

not mean that affiliated corporations were unitary (sec

the discussion of Southern Peru Copper Corp. at pp. 13-15

28Moorman Manufacturing Co. v. Bair, 437 U.S. 267 (1978) (in-

tegrated manufacture and sale of animal feeds); Butler Bros. v.

McColgan, 315 U.S. 501 (1942) (integrated wholesale business in-

volving centralized purchasing of inventory); Bass, Ratcliff & Gret-

ton, Ltd. v. State Tax Commission, 266 U.S. 271 (1924) (integrated

manufacture and sale of ale); and Underwood Typewriter Co. v.

Chamberlain, 254 U.S. 113 (1920) (integrated manufacture and

sale of typewriters ).

47

of the ASARCO slip opinion), the Court indicated that

a substantial transfer of product was essential to the mni-

tary combination of manufacturing or mercantile enter-

prises. The Court stated that it had previonsly approved

unitary combination of such businesses “hecause it was

clear that the corporations operated unitary businesses

with a continuous flow and interchange of common proed-

nets.” ASARCO, Slip Op. at 22, n. 24.

In the court below, Container urged that a “bright line”

standard be adopted as a sine que non for finding a busi-

ness to be unitary, namely that, as to manufacturing or

mercantile enterprises, there must be a substantial flow of

goods. While this Court has adopted such a standard by

implication in its recent cases, it is respectfully submitted

that express adoption of the standard in this case would

add much needed certainty to this area for lower courts,

tax administrators and taxpayers alike. Such a standard

has been adopted by courts in at least two states and has

been advocated by the leading commentator in the area.

Commonwealth v. ACF Industries, Inc., 441 Pa. 129, 27

A.2d 273 (1970); Ash Grove Cement Co., Or.T.R. (CCH)

{ 203-221 (Or.Tax.Ct. 1977) ; Hellerstein, “Recent Develop-

ments in State Tax Apportionment and the Cireumscrip-

tion of Unitary Business”, 21 Natl Tax J. 487, 501MM

(1968).

Explicit adoption of a substantial flow of goods require-

ment would reflect the reason for the development of for-

mulary apportionment. The use of apportionment origi-

nated in cases where there was such complete operational

interdependence, evidenced by a flow of products or raw

materials, that “[t]he legislature in attempting to put upon

this business its fair share of the burden of taxation was

faced with the impossibility of allocating specifically the

profits earned by the processes conducted within its

borders.” Bass Ratcliff & Gretton Ltd, v. State Tax Com-

missioner, 266 U.S. 271, 281 (1924). Hence, for enterprises

such as those that manufactured goods in one state or

48

country and sold them in others, apportionment became a

useful tool. However, in the absence of such basic opera-

tional interdependence, there is no need, and no justifica-

tion, for apportionment. The reasons for this conclusion

have been thoughtfully described as follows:

[C]entralized operations may be a factor in the greater

profitability of some larger enterprises, as compared

with smaller businesses. But that is not the linchpin

of formulary apportionment. The costs of these cen-

tralized operations can be spread by cost accounting

methods regularly used by accountants for internal

accounting, SEC registration statements, reports to

regulatory agencies for rate making, and for other

purposes. ... The underlying point is . . . that such

matters require a spreading of costs, which can be ac-

ceptably accomplished by distributing charges on a

time, or gross volume basis, or by other workable

methods, and do not involve the elusive effort to segre-

gate profits between interdependent steps in opera-

tions, such as producing in one state and selling in

another.

Consequently, the non-operating functions of an

enterprise, ... although centralized, ought not lay the

basis for holding the enterprise unitary. Not only is

there no reason in the considerations which gave birth

to formulary apportionment to push the technique to

this point, but perhaps of greater moment is the fact

that so broad a sweep of formulary apportionment

tends to push distortion and misallocation to unac-

ceptable levels.

Hellerstein, supra at 501-02.

The substantial flow of goods requirement has the further

advantage of introducing an objective factor into an other-

wise largely subjective determination as to whether the

business is unitary. Adopting such an objective standard

would reduce the number of cases in which it is necessary

49

to refer to more abstract factors such as centralized man-

agement and operations and the like. For example, under

a substantial flow of goods requirement, Container and its

subsidiaries could not be members of a single unitary

business.

In any event, ASARCO and Woolworth require a hold-

ing that Container and its foreign subsidiaries are not

members of a unitary business. Without the existence of a

single unitary business, California’s method of taxation

violates the due process clause of the United States Con-

stitution: Thus, California cannot apply its method of

taxation to Container and its subsidiaries.

CONCLUSION

For the foregoing reasons, Container submits that Cali-

fornia’s system of worldwide combination on a unitary

basis should be invalidated and the decision of the Cali-

fornia Court of Appeal reversed.

Dated: July 30, 1982.

Respectfully submitted,

Frankuin C. LatcHam

COUNSEL OF RECORD

Prentiss WILLson, JR.

James P. KErer

Counsel for Appellant

Container Corpora-

tion of America

Of Counsel

Morrison & Forrsvrr

(Appendices follow)

Appendix A

Hourly Earnings Rates Translated into United States Dollars for

Wage Earners in Manufacturing Industries’

ee i Year te

Country Sex 1963 1964 1965

United States ...... MF 2.46 2.53 2.61

Australia es M 2.05 2.11 2.21

F 1.43 1.49 1.54

Austria _... MF 55 60 65

EE c.cswanekesecke: 2a 74 83 90

F 45 5l 56

ee 7 = 1.88 1.97

Ceylon ....... a Jl 15 16

i ae 24 30 2

Colombia _ MF 30 30 23

Denmark MF 1.17 1.27 1.43

El Salvador ........... MF .28 29

Finland ................. MF 81 92 1.00

EE a>, 6 4s a vende tine MF 54 58 61

Eos cuusnaswew on MF 87 94 1.03

Eee MF 70 76 35

ea ws Fe Ua os MF 28 31 34

Guatemala . MF 36 36 37

ee MF 1.40 155 1.65

Re MF 58 64 7

Ce ce zeta ota: MF OF 59 62

— — MF 43 48 52

ae ee es ned aes, MF 14 09 10

I i de MF 48 53 56

New Zealand .......... MF 2.33 2.44 2.59

ee civ eGitenasias M 1.11 1.18 1.28

F 77 83 92

ee oe o - = 35

Philippines ............. F 2X .22

Puerto Rico... MF 1.13 1.18 1.24

Sweden _. MF 1.4] 154 1.69

Switzerland .............. M 98 1.06 1.14

United Kingdom ........ M 2.48 2.67 2.93

Source: United Nations, Monthly Bulletin of Statistics, Jan-

uary 1968, Table 57 at 132, based on data from the International

Labor Office.

M refers to wages of males, F refers to wages of females, and

MF to a single composite figure. Figures normally include bonuses,

cost of living allowances, taxes, social insurance contributions pay-

A-2

able by the employed person and, in some cases, payments in kind.

They normally exclude social insurance contributions payable by

the employers, family allowances and other social security bene-

fits. In a few instances, family allowances and salaried employees

have been included in the figures. The information published by

the United Nations is stated in terms of the local currency, which

we have translated into dollars by the applicable midpoint ex-

change rates (in most cases) published in the United Nations,

Monthly Bulletin of Statistics, January 1969, Table 64 at 192. In

those cases in which daily, weekly, or monthly wage rates are given

in the U.N. figures, we have assumed an 8-hour day, 44-hour week

or 190.5-hour month for conversion purposes, which we regard as

highly conservative. The foregoing table omits some of the coun-

tries as to which information is provided, most of which are in

the Soviet bloc. In all cases with respect to the countries omitted,

the average hourly earnings are substantially below those of the

United States.

A-3

Appendix B

Hourly Earnings Rates Translated into United States Dollars for

Wage Earners in Manufacturing Industries’

Country 1974 1975 1976 1977 1978 1979 1980

United States . $442 $483 $5.22 ae $6.69 $669 $7.27

Australia ..... 298M 3.37M 3.34M 3.90M 421M 4.37M 5.!16M

251F 3.09F 3.13F 3.68F 3.96F 4.06F 4.78F

ae 2.36 2.48 2.99 3.59 4.30 4.89 4.75

Barbados ..... 85M 1.00M_ 1.12M_ 1.32M = — _-

Belgium .. 3.47 3.65 4.44 5.30 6.40 7.12 —

Canada ...... 4.41] 4.98 5.71 5.83 5.77 6.37 6.85

Chile dora 13 13 24 A2 .60 77 1.18

Colombia . 37 40 A5 54 65 81 .93

Denmark 5.44 5.82 6.93 7.61 9.53 10.06 9.99

“er 43 53 65 .73 .79 — —

EI Salvador .45M 46M 58M 62M .68M .76M —

Finland ... 2.69 3. 3.56 3.63 4.00 4.71 5.14

France 1.39 2.19 2.24 2.63 3.40 3.99 4.09

Germany, F.R 3.71 3.70 4.38 5.29 6.42 7.14 6.73

Creece 93 OF 1.21 1.52 1.85 2.10 2.20

Guatemala 44 46 49 53 60 = —

Ireland 1.95 2.22 2.15 2.81 3.8 4.30 4.40

Italy 1.86 2.62 2.44 3.07 3.91 4.82 —

-— , 2.55 2.82 3.29 4.39 5.79 4.99 6.33

DS ai Lede te 33 A2 56 .75 1.01 1.30 1.17

Malawi ...... 24 .23 .23 .26 30 33 _

Mexico ...... 1.18 1.43 1.13 1.30 1.49 1.74 2.05

New Zealand . 2.92 2.65 2.76 341 4.08 4.36 _-

Norway ...... 4.19M 468M 5.87M 657M 7.26M 7.60M 7.91M

3.22F 3.65F 4.66F 5.25F 5.82F 6.12F 6.48F

Philippines 24 .23 —_ _— — _ —_

sinuses be 1.40 1.75 1.99 — — —_ _

Sweden ..... 4.98 5.43 5.84 5.50 6.51 7.26 7.47

= < 403M 4.24M 4.62M 5.78M_ 7.36M 7.78M 740M

nit

Kingdom .. 262M 2.83M 2.65M 3.22M 3.97M 5.06M 6.35M

Venezuela ... 1.58 1.80 1.85 2.02 2.29 _ -_

‘Source: United Nations, Monthly Bulletin of Statistics, Sep-

tember 1981, Table 57.

M refers to wages of males, and F wages of females; in other

countries single composite figures are given. Figures normally in-

clude bonuses, cost of living allowances, taxes, social insurance

contributions payable by the employed person and, in some cases,

payments in kind. They normally exclude social insurance contri-

butions payable by the employers, family allowances and other

social security benefits. In a few instances, family allowances and

salaried employees have been included in the figures. The informa-

tion published by the United Nations is stated in terms of the lo-

cal currency, which we have translated into dollars by the appli-

cable midpoint exchange rates (in most cases) published in the

A4

United Nations, Monthly Bulletin of Statistics, September 1981,

Table 62. In those cases in which daily, weekly, or monthly wage

rates are given in the U.N. figures, we have assumed an 8-hour day,

44-hour week or 190.5-hour month for conversion purposes, which

we regard as highly conservative. The foregoing table omits some

of the countries as to which information is provided, most of which

are in the Soviet bloc. In all cases with respect to the countries

omitted, the average hourly earnings are substantially below those

of the United States.

A-5

Appendix C

Percentage of U.S. Average Hourly Compensation, Adjusted for

Estimated Differences in Productivity’

Country 1969 1970

DP eto Svch cs 5) Scene onni eens kere eea tens 40 40

ee as els wus’ ihe aeee eae dee 72

EE sd ovuviivces+cewcbuss aka ee 68

SEE Cetus coe Vi astvhss 6 oaerabe Kens . 60 61

EE NES sens eg iehi-s Cae ncer ee aekawk i aeae 79 82

France ... ata a nistana mene aia ae ak .. 38 54

RE ora ees cole ad Seah hc ak a 67 .

EE on. Sleeve beds as dale eue wees 74 7i

GNARL Sate es Sa Reta Re ehh 72 74

The data presented by the study represents, for 1969 and

1970, respectively, the estimated percentage of U.S. hourly

compensation required as the average in each country to

produce a quantity of manufactured goods equivalent to

that produced in the United States.

‘Source: United States Tariff Commission, Competitiveness of

U.S. Industries (T.C. Publication 473) at 30 (1972).

A-6

Appendix D

No. 283

The Embassy of Canada presents its compliments to the

Department of State and has the honour to refer to its

Notes No. 692 and 245 of 22 December, 1981 and 10 May,

1982, together with the exchange of letters between the

Secretary of the Treasury for the United States of Amer-

ica and the Canadian Minister of Finance of 26 September,

1980 on the occasion of the signing of the bilateral conven-

tion with respect to taxes on income and capital.

The Embassy has been instructed to draw again the at-

tention of United States authorities to Canada’s concerns

about the unitary tax apportionment method used by cer-

tain states in the United States to allocate income to United

States offices or subsidiaries of international corporations

based on the corporation’s worldwide earnings. The Ca-

nadian Government continues to be of the view that this

method results in inequitable taxation and imposes ex-

cessive administrative burdens on international companies

doing business in those states. Under this method the

profit of a Canadian company, for example, on its United

States business is not determined on the basis of arm’s-

length relations, but is derived from a formula taking

account of the income of the Canadian company and its

worldwide subsidiaries, as well as the assets, payroll and

sales of each of these.

For a multinational company with subsidiaries in dif-

ferent countries to have to submit its books and records

for all of these companies to a state of the United States

imposes a costly burden.

Against this background the Canadian Government wel-

comed the decision of the Justice Department to file an

amicus curae brief before the Supreme Court concerning

the appeal of the Chicago Bridge and Iron Company

A-7

against the use of the unitary tax method applied by the

State of Illinois. The Embassy has now noted that another

such case will be considered by the Supreme Court later

this year involving an appeal by Container Corporation of

America versus the Franchise Tax Board (California)

(Case 81-523). The Embassy would wish the foregoing con-

cerns of the Canadiar. Government to be drawn to the

attention of the relevant United States authorities and

would welcome these views being referred to in any repre-

sentation that the United States Administration may be

making to the Supreme Court.

The Embassy of Canada avails itself of this opportunity

to renew to the Department of State the assurances of its

highest consideration.

Washington, June 14, 1982

A-8

Appendix E

AMBASSADE DE BELGIQUE

The Embassy of Belgium presents its compliments to the

Department of State and, on behalf of the Ten E.C. Gov-

ernments, of which the Government of Belgium has now

the presidency, it has the honor to forward the attached

Note on the problems of the unitary method of taxation.

The Embassy of Belgium welcomes the opportunity to

renew to the Department of State the assurances of its

highest consideration.

Washington, D.C. June 29, 1982

[Seal]

Attached: Note

The Department of State

Washington, D.C.

UNITARY TAXATION

1. Our Governments refer to their Note on unitary

taxation forwarded on their behalf to the Department of

State on 30 October 1981 by Her Britannie Majesty’s

Embassy.

2. Our Governments remain firmly convinced that the

unitary basis of taxation with combined reporting, par-

ticularly as applied in the international field, is entirely

unsatisfactory.

3. As was pointed out in that Note, unless the same

basic rules for calculating taxable profits are followed gen-

erally by the main trading nations it will be impossible to

achieve the essential objective of providing a consistent

and coherent international tax framework for trade and

investment.

A-9

4. Our Governments wish to draw the attention of the

State Department to the case of Container Corporation of

America vs Franchise Tax Board which we understand is

to be heard in the Supreme Court of the United States

during the October Term 1982, and urge as a matter of

high priority that the Government of the United States

should participate in this case as amicus curiae.

A-10

Appendix F

In the Supreme Court of the United States

October Term, 1981

No. 81-349

Chicago Bridge & Iron Company, Appellant

Vv.

Caterpillar Tractor Co., et al.

On Appeal From the Supreme Court of Illinois

Memorandum for the United States

As Amicus Curiae

INTEREST OF THE UNITED STATES

The federal government is charged with the conduct of

the Nation’s foreign relations. To that end, the Constitu-

tion confers upon Congress the power “To regulate Com-

merce with foreign Nations * * *” (Article I, Section 8,

clause 3) and authorizes the President, “by and with the

Advice and Consent of the Senate, to make Treaties * * *”

(Article II, Section 2, Clause 2). The watchword in the

area of foreign commerce is federal uniformity. “In inter-

national relations and with respect to foreign intercourse

and trade the people of tue United States act through a

single government with unified and adequate national

power.” Board of Trustees v. United States, 289 U.S. 48,

59 (1933).

The United States submits that the imposition of the

Illinois income tax on the apportioned combined world-

wide business income of a unitary group of related cor-

A-l1l

porations, including foreign corporations, impairs federal

uniformity in an area where such uniformity is essential.

The United States, like most countries, employs the arms-

length method of allocating income among commonly con-

trolled corporations, and this method is mandated in nu-

merous treaties, to which the United States is a party,

that are intended to prevent international double taxation.

Under the arms-length method, the income of each corpo-

ration is computed on a separate accounting basis under

the assumption that each member of the group must deal

with other members as if they were wholly separate en-

tities owned by unrelated interests. Cf. 26 U.S.C. 482, and

Treasury Regulations promulgated thereunder. The arms-

length method insures against artificial shifting of income

and deductions among related businesses. The Illinois

apportioned combined method of computing income that

is at issue in this case, however, can result in the alloca-

tion of taxable income to a corporation that incurs a loss

on a separate accounting basis computed in accordance

with the arms-length method. Thus, a domestic corporation

that operates at a loss and has no federal taxable income

may be subject to state taxation on foreign source income

earned by its foreign affiliates (e.9., income of a foreign

parent or income of a foreign subsidiary that the domestic

parent has not repatriated). These sharp differences be-

tween federal and international tax policies, on the one

hand, and state tax policies on the other, undermine the

federal government’s ability to “speak with one voice when

regulating commercial relations with foreign governments.”

Michelin Tire Corp. v. Wages, 423 U.S. 276, 285 (1976).

Moreover, international double taxation can result if

foreign source income subject to the state combined uni-

tary method is also subject to tax in the foreign country

in which it is earned. The federal tax laws provide a for-

eign tax credit in order to mitigate such international

<< TT

A-12

double taxation. See 26 U.S.C. (& Supp. III) 901 et seq.

States employing the worldwide unitary method, however,

do not allow a credit for foreign taxes.

We are accordingly advised by the Departments of State

and Treasury, the Department of Commerce, acting at the

request of the Delegation of the Commission of the Euro-

pean Communities, and the United States Trade Repre-

sentative, that a number of foreign governments have

complained—both officially and unofficially—that the ap-

portioned combined method empowered by Illinois and

other states creates an irritant in their commercial rela-

tions with the United States. Retaliatory taxation may

ensue, with consequent damage to international trade.

Moreover, the method causes uncertainties because it dif-

fers from the federal arm’s-length standard that is gener-

ally accepted in international practice and in bilateral

income tax conventions. Since this case poses much the

same constitutional problems as existed in Japan Line,

Ltd. v. County of Los Angeles, 441 U.S. 434 (1979), in

which we participated as amicus curiae pursuant to the

Court’s invitation, we believe that the same federal inter-

est likewise mandates participation here.

DISCUSSION

The question presented in this state income tax case is

whether Illinois’ imposition ef its income tax on the ap-

portioned combined worldwide business income of a group

of related corporetiens, including foreign corporations,

violates the Commerce Clause.

2 It is settled beyond question that “the entire net

income of a corporation, generated by interstate as well as

intrastate activities, may be fairly apportioned among the

States for tax purposes by formulas utilizing in-state as-

A-13

pects of interstate affairs.” Northwestern States Portland

Cement Co. v. Minnesota, 358 U.S. 450, 460 (1959); Mobil

Oil Corp. v. Commissioner of Taxes, 445 U.S. 425, 436-442

(1980). See also Underwood Typewriter Co. v. Chamber-

lain, 254 U.S. 113 (1920); Hans Rees’ Sons v. North Caro-

lina, 283 U.S. 123 (1931); Butler Brothers v. McColgan,

315 U.S. 501 (1942); Moorman Manufacturing Co. v. Bair,

437 U.S. 267 (1978).

As the Court stated in Mobil Oil Corp. v. Commissioner

of Taxes, supra, 445 U.S. at 439, “the linchpin of appor-

tionability in the field of state income taxation is the uni-

tiary-business principle” (footnote omitted). In accordance

with this principle, the Court has upheld state apportion-

ment formulas, like that of Illinois, which combine the in-

come of several related corporations engaged in a “uni-

tary” business. Income is allocated to the taxing state by

multiplying the total net income of the enterprise by a

percentage comprised of the average of the ratios of in-

state property, payroll, and sales to total property, payroll

and sales. See Section 304(a) of the Illinois Income Tax

Act, (Ill. Rev. Stat. ch. 120) J.S. App. E16-E18; see also

United States Steel Corp. v. Multistate Tax Commission,

434 U.S. 452, 475 n.25 (1978); Exxon Corp. v. Wisconsin

Department of Revenue, 447 U.S. 207, 214 n.3 (1980);

Mobil Oil Corp. v. Commissioner of Taxes, supra, 445 U.S.

at 429-430 nn. 2-4. A unitary business is one in which all of

the corporate constituents are involved in an economically

functionally-related enterprise. As one leading commen-

tator has observed, the “very essence of formulary appor-

tionment [is] that where there are integrated, interde-

pendent steps in the economic process carried on by a busi-

ness enterprise, there is no logical or viable method for

accurately separating out the profit attributable to one

step in the economic process from other steps.” J. Heller-

A-14

stein, State and Local Taration 400 (3d ed. 1969). See also

J.S. App. C11; Butler Brothers v. McColgan, supra, 315

U.S. at 508. Hans Rees’ Sons v. North Carolina, supra,

283 U.S. at 133.

Here, it is not disputed that Caterpillar and its 25 sub-

sidiaries constitute a unitary business enterprise, and the

Illinois Supreme Court so concluded (J.S. App. C11-C12).

Thus, if Caterpillar and its subsidiaries conducted their

business solely within the United States, the foregoing

precedents we have cited would establish that the Illinois

combined apportionment method would pass muster under

the Commerce Clause for purposes of allocating its income

among the several states. But Caterpillar is not a domestic

enterprise. On the contrary, it conducts a worldwide enter-

prise and “Commerce Clause scrutiny may well be more

rigorous when a restraint on foreign commerce is alleged.”

Reeves, Inc. v. Stake, 447 U.S. 429, 438 n.9 (1980).

We submit that the Court’s analysis in Japan Line, Ltd.

v. County of Los Angeles, supra, 441 U.S. at 434, under-

mines the basis of the decision below and invalidates the

unitary apportionment method as applied to multinational

corporate groups.* In Japan Line, the Court struck down a

‘Bass, Ratcliff & Gretton, Ltd. v. State Tax Commission, 266

U.S. 271 (1924) has no bearing on the question presented here.

That case involved the application of a New York apportionment

formula to a single British corporation which manufactured its

product in England and sold it in New York through branch offices.

See id. at 282. The taxpayer did not conduct its business in multi-

national corporate group form, There was accordingly no occasion

for the Court to consider the constitutionality of the combined

apportionment method and its inconsistency with the arms-length

method in a multinational corporate setting. Compare Hans Rees’

Sons v. North Carolina, supra, 283 U.S. at 132-133, with Mobil Oil

Corp. v. Commissioner of Taxes, supra, 445 U.S. at 438-439, 440-

441.

A-15

California ad valorem property tax, as applied to a Japa-

nese company’s shipping containers, as unconstitutional

under the Commerce Clause because it resulted in multiple

taxation of the instrumentalities of foreign commerce, and

prevented this Nation from “speaking with one voice” in

regulating foreign trade and thus was inconsistent with

Congress’ power to “regulate Commerce with foreign Na-

tions” (Article I, Section 8, Clause 3). In so holding, the

Court pointed out that in the domestic context, “[t]he

corollary of the apportionment principle, of course, is that

no jurisdiction may tax the instrumentality in full * * *.

The basis for this Court’s approval of apportioned prop-

erty taxation, in other words, has been its ability to en-

force full apportionment by all potential taxing bodies”

(441 U.S. at 447).

But the Court’s ability to avoid multiple taxation by

ensuring full apportionment in the domestic context has

no counterpart in the international sphere. As the Court

explained (441 U.S. at 447-448; footnote omitted )—

[NJeither this Court nor this Nation can ensure

full apportionment when one of the taxing entities is

a foreign sovereign. If an instrumentality of commerce

is domiciled abroad, the country of domicile may have

the right, consistently with the custom of nations, to

impose a tax on its full value. If a State should seek to

tax the same instrumentality on an apportioned basis,

multiple taxation inevitably results. * * * Due to the

absence of an authoritative tribunal capable of ensur-

ing that the aggregation of taxes is computed on no

more than one full value, a state tax, even though

“fairly apportioned” to reflect an instrumentality’s

presence within the State, may subject foreign com-

merce “*‘ to the risk of a double tax burden to which

A-16

[domestic] commerce is not exposed, and which the

commerce clause forbids.’” Evco v. Jones, 409 US.

[91], at 94 [1972], quoting J. D. Adams Mfg. Co., 304

US., at 311.

Apart from the risk of multiple international taxation,

Japan Line rests upon a second ground—the need for fed-

eral uniformity in an area in which federal uniformity is

essential. As the Court stated, “Foreign commerce is pre-

eminently a matter of national concern” (441 U.S. at 448).

Since “the Federal Government must speak with one voice

when regulating commercial relations with foreign govern-

ments” (Michelin Tire Corp. v. Wages, 423 U.S. 276, 285

(1976)), “[t]he need for federal uniformity is no less

paramount in ascertaining the negative implications of

Congress’ power to ‘regulate Commerce with foreign Na-

tions’ under the Commerce Clause” (footnote omitted) (441

U.S. at 449). As the Court further pointed out (id. at 450-

451) (footnotes omitted) :

A state tax on instrumentalities of foreign commerce

may frustrate the achievement of federal uniformity

in several ways. If the State imposes an apportioned

tax, international disputes over reconciling apportion-

ment formulae may arise. If a novel state tax creates

an asymmetry in the international tax structure, for-

eign nations disadvantaged by the levy may retaliate

against American-owned instrumentalities present in

their jurisdiction. Such retaliation of necessity would

be directed at American transportation equipment in

general, not just that of the taxing State, so that the

Nation as a whole would suffer. If other States fol-

lowed the taxing State’s example, various instrumen-

talities of commerce could be subjected to varying de-

grees of multiple taxation, a result that would plainly

prevent this Nation from “speaking with one voice”

in regulating foreign commerce.

A-17

In determining whether a state tax in the international

context is constitutionally valid, it is necessary to examine

“whether * * * [it] creates a substantial risk of interna-

tional multiple taxation, and, second, whether the tax pre-

vents the Federal Government from ‘speaking with one

voice when regulating commercial relations with foreign

governments’” (441 U.S. at 451). For “[i]f a state tax

contravene either of these precepts, it is unconstitutional

under the Commerce Clause” (ibid.; emphasis supplied).

We submit that analysis of the Illinois tax under the

principles of Japan Line requires the conclusion that the

combined apportionment method, applied to a unitary busi-

ness with foreign corporate constituents, is barred by the

Commerce Clause. Like the ad valorem tax at issue in

Japan Line, the Illinois tax violates both precepts dis-

cussed in that decision insofar as it creates a substantial

risk of international multiple taxation and impairs federal

uniformity in the conduct of foreign relations.’ We turn

now to an examination of the operation of the Illinois tax

in the multinational corporate context.

a. Risk of multiple international taxation. As we have

pointed out (supra, pages 8-9), the Illinois apportionment

formula allocates income on the basis of payroll, property

and sales. Thus, in order te determine what portion of the

worldwide income of a unitary group of corporations is

allocable to Illinois, the total worldwide income of all the

corporations of the group is multipled by a fraction which

‘Hence, there is no basis for the Illinois Supreme Court's con-

clusion (J.S. App. C18) that Japan Line is “obviously distinguish-

le” because “[t]}his appeal does not involve the multiple taxation

of items or mstrumentalities of foreign commerce nor docs unitary

reporting affect Federal authority in governing foreign commerce.”

The same considerstions of international multiple taxation and fed-

eral wiifowmity iw the cemduct of foreign relations upon which

Japan Line rests are equally applicable to a state income tax.

A-18

is the arithmetic average of the three ratios of in-state

payroll, property, and sales to total payroll, property, and

sales. See Mobil Oil Corp. v. Commissioner of Taxes, supra,

445 U.S. at 429-430 n.4, 437 n.13.

The theory underlying the three-factor formula, and in-

deed, the basis for its acceptability for Commerce Clause

purposes, is that a dollar of payroll or property spent or a

dollar of sales made in one state, produces roughly the

same amount of taxable income as a dollar so spent or sales

made in another state. See J. Hellerstein, supra, at 539.

While this assumption may be sound within certain consti-

tutional tolerances in a homogeneous economy such as the

United States and thereby provides a basis for the division

of interstate income, there is no comparable assumption

that can be made in allocating the income of a multinational

group. As the amici Container Corporation (Br. 14-18) and

the Union of Industries of the European Community point

out (Br. 10-11), there are great differences between the

cost of property and payroll in the several states, on the

one hand, and atroad, on the other, especially in developing

nations. These differences would shift a disproportionate

share of the foreign source income of a multinational group

to state taxation if the three-factor formula were used.

Moreover, state use of the unitary apportionment

method, in contrasts to federal, and internationally ac-

cepted, use of the arms-length standard, creates a substan-

tial risk of international multiple taxation. For example, if

a U.S. subsidiary engages in transactions with its foreign

parent (which otherwise engages in no U.S. business ac-

tivity) on an arms-length basis and the U.S. subsidiary

operates at a loss, no portion of the foreign parent’s in-

come would, under the arms-length standard, be subjected

to federal income tax. At the federal level, therefore, there

A-19

would be no international double taxation because only the

foreign country would subject that income to tax. Under

the state unitary method, however, a portion of the foreign

parent’s income would be allocated to the U.S. subsidiary

and would thus be subject to tax in the state. Accordingly,

both the state and the foreign country would tax such ap-

portioned income, thereby resulting in international double

taxation of the same income. In this manner, the state uni-

tary method frustrates the federal policy, consistent with

international usage, of avoiding or mitigating international

double taxation.°

To be sure, the application of the [illinois tax in this case

does not, as the California tax in Jupan Line, “creates mul-

tiple taxation in fact” (see 441 U.S. at 452 n.17). Indeed,

the unitary method has produced a refund for Caterpillar,

a fact which explains its support of Illimois’ position here.

But we believe that the foregoing considerations demon-

strate that the Illinois tax would, in most cases, create a

substantial risk of international multiple taxation that

would be sufficient to invalidate the unitary method in the

international context. It would nevertheless be understand-

able if the Court wishes to resolve the issue in a case with

a more fully developed record in which the state tax can

be shown in fact to impose multiple burdens. This course

of action may be appropriate insofar as the Court has not

decided “under what circumstances the mere risk of mul-

tiple taxation would invalidate a state tax, or whether this

risk would be evaluated differently in foreign, as opposed

°As we have pointed out (supra, page 3), the federal income tax

law mitigates international double taxation through the foreign

tax credit. See 26 U.S.C. (& Supp. III) 901 et seq. Under these pro-

visions, foreign income taxes that are imposed on foreign source

income that is also subjected to U.S. taxation can be credited

against that U.S. tax liability. In marked contrast, the state unitary

method at issue here has no comparable provision.

A-20

to interstate, commerce.” Japan Line, Ltd. vy. County of Los

Angeles, supra, 441 U.S. at 452 n.17 (emphasis in original).

Accordingly, if the Court wishes to consider the question in

this case in the context of a case involving multiple taxa-

tion in fact, it may wish to defer decision in this case and

note probable jurisdiction in Container Corporation of

America v. Franc! ise Tax Board, No. 81-523.

b. Federal Uniformity. FExven assuming arguendo that

there is an insufficient showing in this case that the Illinoie

unitary method creates a risk of international multiple

taxation, the tax is still invalid because it impairs federal

uniformity. Under Japan Line, a state tax is invalid if it

prevents the federal government from “speaking with one

voice” in international trade, “[I]f it be otherwise, a single

State can, at her pleasure, embroil us in disastrous quar-

rels with other nations.” Chy Lung v. Freeman, 92 U.S. 275,

280 (1875).

As we have pointed out (supra, page 2), the United

States and most foreign countries use the arms-length

method of allocating income between corporations. Illinois’

variant unitary method impairs the otherwise uniform in-

ternational custom that is the basis of the treaties between

the United States and numerous foreign countries that are

intended to prevent international double taxation of income.

Indeed, the Secretary of the Treasury and the Secretary

of State have recently received diplomatic communications

from the Governments of Great Britain and Canada, com-

plaining about the state unitary method and emphasizing

its incompatibility with international practice (see Appen-

dix, infra, 1a-9a). Similarly, as appellant points out (J.S.

20), all nine members of the European Common Market

joined in a demarche emphasizing the incompatibility of

worldwide combined reporting with internationally ac-

cepted rules and principles of the OECD. “The risk of re-

A-21

taliation by [foreign countries], under these circumstances,

is acute, and such retaliation of necessity would be felt by

the Nation as a whole” (footnote omitted) (Japan Line,

Ltd. v. County of Los Angeles, supra, 441 U.S. at 453). In

this respect, the amicus Union of Industries of the Euro-

pean Community (Br. 7-9) points out that the application

of the state unitary method may violate certain treaties of

friendship, commerce and navigation. See especially Ar-

ticle IX of the Convention with France which limits state

taxation of French companies to income “ ‘directly related

to their activities within those territories’” (Br. 9 n.12).

In sum, “the freedom of the States to formulate inde-

pendent policy in [the] area [of commerce] may have to

yield to an overriding national interest in uniformity”

Moorman Manufacturing Co. v. Bair, supra, 437 U.S. at

280. “We cannot have trade and commerce in world mar-

kets and international waters exclusively on our terms,

governed by our laws, and resolved in our courts.” Bremen

v. Zapata Off-Shore Co., 407 U.S. 1, 9 (1972). The income

taxation of multinational businesses is thus a matter that

is subject only to a national rule conformable with the prac-

tice of nations or adopted pursuant to the President's au-

thority “by and with the Advice and Consent of the Senate

to make Treaties * * *” or Congress’ power “[t]o regulate

Commerce with Foreign Nations * * *.” “{Illinois], by its

unilateral act, cannot be permitted to place these impedi-

ments before this Nation’s conduct of its foreign relations

and its foreign trade.” Japan Line, Ltd. v. County of Los

Angeles, supra, 441 U.S. at 453."

*Mobil Oil Corp. v. Commissioner of Taxes, supra, 445 U.S. at

425, upon which the decision below relied (J.S. App. C18), has

no bearing on this case. There, the Court held that a New York

corporation having a place of business in Vermont could not ob-

ject, on Commerce Clause grounds, to the imposition of a Vermont

corporate income tax which allocated a portion of foreign source

A-22

3. If, as we submit, the Court concludes that the Illinois

combined reporting requirement either: (a) creates a sub-

stantial risk of international multiple taxation, or (b) im-

pairs federal uniformity in the conduct of foreign relations,

that is the end of the matter, and the judgment below

should be reversed. In those circumstances, the Illinois com-

bined reporting method could not be constitutionally ap-

plied to any multinational group of corporations—a result

we believe to be compelled by the Commerce Clause. If

the Court concludes, however, that the record in this case

is inadequate to support such a disposition, we urge it to

defer resolution of the issue to another case which has a

more fully developed record.

Whatever ruling it may render here, the Court should be

aware that neither this case nor any case presently pending

before it prezents the issue in the context of a unitary busi-

ness consisting of a U.S. subsidiary whose parent corpora-

tion is foreign. It may well be that the multiple tax burdens

and the impairment to federal uniformity in international

trade caused by the state apportionment method will be

more easily demonstrated in a case involving a corporate

group with a foreign parent. In that case, there will be, in

addition to the considerations we have already pointed out,

other burdens that the state unitary method will impose on

international trade and foreign relations. For example, a

foreign parent corporation with no direct U.S. activities

would generally maintain its financial accounts according

to local (i.e. foreign) accounting principles and in the local

currency. Conversion of such accounts to conform to U.S.

accounting principles and to the individual states’ tax ac-

dividend income paid by its foreign subsidiaries. The taxpayer,

however, admitted that New York, as the state of commercial do-

micile, could tax such foreign-source dividends in full. Hence,

Japan Line was not implicated because there was no issue of in-

ternational multiple taxation (see 441 U.S. at 446-447, 448).

A-23

counting rules, as well as conversion of all entries into U.S.

dollars (which are required for apportionment under the

state unitary method), pose a severe administrative and

financial burden on the foreign parent corporation and

other foreign affiliates. Moreover, there will be further bur-

dens on international trade resulting from the demands

by state tax authorities that the foreign corporation pro-

duce and explain its records of business transactions that

are entirely unrelated to activities within the United States.

Accordingly, the Court should not decide this case on any

ground that would foreclose any claims that may be raised

in a future case involving the imposition of the combined

reporting method to a group of corporations with a foreign

parent.

CONCLUSION

For the reasons stated, the judgment of the Supreme

Court of Illinois should be reversed.

Respectfully submitted.

Rex E. Lee

Solicitor General

Sruart A. Smita

Assistant to the Solicitor General

JANUARY 1982