# Appellees Brief — Container Corp. of America v. Franchise Tax Bd. > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385008_0362%3A19 ## Record - **Collection:** Supreme Court brief - **Document type:** Appellees Brief - **Published:** January 1, 1983 - **Citation:** 463 U.S. 159 ## Text AEE Se al - - -T Office-Supreme Court, U.s. fishy | FILED No. 81-523 OCT 15 1982 ye aa : ALEXANDER L. STEVAS, CLERK IN THE SUPREME COURT OF THE UNITED STATES October Term, 1982 CONTAINER CORPORATION OF AMERICA, Appellant, Vv. FRANCHISE TAX BOARD, Appellee. ON APPEAL FROM THE COURT OF APPEAL OF THE STATE OF CALIFORNIA, FOR THE FIRST APPELLATE DISTRICT APPELLEE'S BRIEF ON THE MERITS GEORGE DEUKMEJIAN Atcorney General NEAL J. GOEAR Deputy Attorney General 110 West A Street, Ste 790 San Diego, California 92101 (714) 237-7308 Counsel for Appellee yi 7. 4 nT ad oe ~: a 4 ~~ se ee ae phe eS 5 3 A ‘ oo - ae pe 4 “ rs Rogses pa Sart B 3 x os IPG . 7 are és J» ~ a oF € aba. Bun) he aed ees BT, Sr i aE oe ce OF Es Ae) eae 9 ia ea Ca ee ‘ ~90- III CCA HAS NOT SHOWN DISTORTION BY THE FORMULA CCA advances three arguments in support of its position that the use of the unitary business principle by California in this case results in substantial misattribution of income in violation of the Due Process Clause. First, it argues that formula apportionment attributes significantly more inczome to California than was determined for federal income tax purposes by applying the "sophisticated" accounting techniques prescribed by the Internal Revenue Service. Second, it argues that there are significant differences in wage rates between the United States and foreign countries resulting in misapportionment of income. Finally, it argues that profitability of foreign operations, expected and actual, is higher and this fact is not reflected in the formla. CCA's failu:-e to set out any facts pertaining to these a:-guments in its Statement of the Case should cause peremptory rejection of these arguments. Additionally, examination of each o= the arguments and the evidence submitted in support of them demonstrates that CCA has not established that any misattribution of income occurs. A. Separate Accounting Data Does Not Impeach the Formula The use of separate accounting data to impeach formula results was recently rejected by t:he court in Exxon. "As this court has on several occasions recognized, a conpeny 8 internal accounting techniques are not binding on a State for tax purposes. For example, in Butler Bros. v. McColgan, supra, an interstate business challenged the application of the California apportionment Statute. The company was engaged in the wholesale dry goods and general merchandise business as a middleman,and it had distributing -92- houses in seven States, including one in California. Each house maintained stocks of goods, had a cognizable territory, had its own sales force, did its own solicitation of sales, made its own credit and collection arrangements, and kept its own books. There was, however, a central buying division that was able to purchase goods for resale at a lower price. The company used 'rezognized accounting principles,' [citation] to allo- cate all costs aid charges to each house, with certain centralized expenses allocated among the houses. Based on that ‘separate accounting system,' [citation] the business asserted there was no net income in California. "We concluded that California could constitutionally apply its apportionment formula to the company's total net income to establish taxable income, rather than being limited to the income shown by the tax>ayer's accounting methods to be attributable to che one house in that State. The company had the ‘distinct burden of showing y "clear and cogen: evidence” that it results in extraterritorial values being taxed, '[quoting Norfolk and Western R. Co. v. North Carolina 297 U.S. 682] and the taxpayer's accounting evidence was insufficient to meet that burden. -93- ""lWle need not impeach the integrity of tha: accounting system to say that it does not prove appellant's assextion that extra- territorial values are being taxed. Accounting pract:ices for income statements nay vary considerably according to the problem at hand. . » A particular accounting system, though useful or necessary as a business aid, may not fit the different requirements when a State seeks to tax values created business within its borders . at may be due to the fact, as stated by Mr. Justice Brandeis in Underwood Typewriter Co. v. Chamberlain, 254 U.S. 113, that a State in attempting to place upon a business extencing into several States "its fair share of the burden of taxaticn" is "faced with the impossibility of allocating specifically the profits earned by the processes conducted within its borders." Furthermore, the particular systen used may not reveal the facts basic to the State's determination. [Citation.] In pe Mt Si aspect of the matter, the results of the accounting system employed by appellant do not impeach the bigernees | or propriety of the formula which California has applied here.'" xon Corp. v. Wisconsin, supra, Sa 7, ni Evidence of the merit of the Court's analysis exists both in a general -94- context and in the specifics of this case. The General Accounting Office (GAO) has recently released a study of the Internal Revenue Service's administration of the arm's-length standard and found: "Multinational corporations have both the incentive and the opportunity to shift income between jurisdictions to take advantage of disparate corporate tax rates. One incentive is minimization of taxes. The opportunity lies in the pricing of interorganizational trans- actions. Obviously, possession of incentive and opportunity does not axiomatically lead to abuse--but to tax administrators, American and foreign, it repre- sents a vulnerability to guard against. "IRS, however, has not yet developed baseline information on the incidence and magnitude of multinational corporation non- compliance in terms of improper shifting of income. Thus, IRS has no sound basis for determining the amount of audit resources to be assigned to address the problem, nor for gauging the suc. ess of those resources that are applied to it. "Further, IRS enforcement difficulties are compounded by -95- the complexities involved in measuring the amount of income misallocated in those instances where this is believed to have occurred. ldeally, interorganiza- tional pricing is to be adjusted to that for similar transactions between unrelated parties--the so-called ‘arm's length standard.' "However, in the modern economic system of multinational corporate business, a true arm's length price can rarely be identified. When an arm's length price cannot be identified, Department of Treasury regulations for Internal Revenue Code Section 482 provide both the corporate taxpayer and the IRS examiner some guidance for arriving at a constructed price. The regulations and the resulting enforcement process, however,create an unacceptable level of uncertainty and a significant administrative burden both for corporate taxpayers and IRS examiners." (Report to the Chairman, House Committee on Ways and Means by the Comptroller General, Sept. 30, 1981, pp. 24, 53-54.) In at least three cases, Bass, Butler Bros. and Exxon, this Court has sustained a state's attribution of income to activities in that state even though the company's separate accounting (federal -96- tax return) showed that it earned no net income in that state. For a further comparison of the unitary met:hod and the so-called "arm's length" standard and, specifically, the inadequacies of the érm's-length method, see "Multinational Corporation and Income Allocation Under Section 482 of the Internal Revenue Code," 89 Harvard Law Review 1202 (1975) ard the Harley Treatise, appendix E hereto. In the case at bar, the parties have stipulated to the accuracy of the data contained in a number of exhibits filed with the Califcrnia courts. CCA argues that: this separate accounting data should be controlling in determining the amount of its California income. Similar stipulations and arguments were specifically made in Butler Bros., supra, and in many other cases and have not been found controlling. Examination of the -97= documents and the stipulation in this case discloses why they are not. CCA was not fully compensated for various services rendered to and benefits it conferred upon its foreign subsidiaries. Specifically, CCA stipulated that the value of many such services could not be ascertained; reimbursement received under some Technical Service Agreements was only to the extent allowec by the foreign governmencs; used equipment was sold at book, not fair market value; CCA brokeraged equipment at a fee less than would be charged by a third party; no fees were paid for loan guarantees; interest paid to CCA by its subsidiaries was apparently far below normal interest: rates; other services were provided without: being paid for. (See pp. 32-35, supra.) There were -98- substantial amounts of Subpart F income .23/ (J.A.:Ex p. 7.) In sum, CCA has not established that net income either shown in its Separate accounting records or reported for U.S, income tax purpores accurately reflects the many contributions made by CCA to its subsidiaries, but on the contrary, substantial contributions by CCA «re not reflected accurately or at all. Further, even accepting CCA's separate accounting figures, the formula only apportions less than .01 more of the unitary worldwide net income to California over the .07 which CCA concedes that 23. Subpart F income is determined under Internal Revenue Code, sections 951l- 964. In general it is income ang by a corporate group to a controlled foreign corporation which is redetermined for federal purposes to be taxable to the ent company in the United States. Appellant, its presentation on pages 16 andl7, has not included this income in its calculations of U.S. source income. -99- California may tax. (See pp. 36-37, supra.) B. Differing Wage Rates and oA The second and third arguments advanced by CCA in support of its misattrib- ution of income arguments are dependent upon separate accounting data for their analysis. Such data ias already been shown to be inaccurat2 and in any event, inappropriate for use in state tax on income of a unitary bisiness. Furthermore, even assuming arguend) the separate results of the variou; entities provided valid data for comparative purposes, these arguments fail becaus2 the premise on which they are based is false and because CCA has not offered any supporting relevant data. The premise on which these arguments is based is that a dollar of payroll or property expended or used in one state, and a dollar of sales realized -100- in one state, typically produced roughly the same amount of income as a dollar so spent or sales made in other states. (J.S. p. 17.) This premise is false, as both the California courts and this Court have recognized. "In the agpereionnent of a unitary business the formula used must give adequate weight to the essential elemen-:s responsible for the earning of the income . but its propriety in a given case does not require that the factors appropriately employed be equally productive in the taxing state as le by California to CCA. In the field of income taxation (unlike property taxation) taxation of the same income at both state and federal levels is specifically permitted. "Concurrent federal and state taxation of income, of course, is a well established norm" (Mobil, supra, 445 U.S. at p. 448.) CCA has not attempted to show any state -117- level income tax other than California's .29/ Multiple taxation at a federal (country) level does not invalidate Calif- ornia's tax. In practice, the United States gives tax credits for taxes paid to foreign countries to mitigate (if not eliminate) such national level double taxation. Where U.S.A. has already given a credit for a foreign income tax, the result should be the same as if both California & U.S.A. had originally taxed the same income. Where a credit has been given once (by U.S.A.) for a foreign income tax, 28. California t:axed about 8% of the eoaty income. The soreign countries taxed less than one-third. (AB p. 17.) Less than half of CCA's unitary income has been taxed by California and the foreign countries (even using the evidence which has been rejected by the trial court and is not properly before this Court). CCA has not properly shown any actual double taxation or any reasonable risk of it, (except by both U.S.A. and California perhaps. ) -118- allowing a second credit against California's would be totally unjustified.22/ no unconstitutional multiple tax results from allowing both a federal and state level tax on the same income. Risk of double taxation of income is inevitable because there is, in fact, not uniformity of tax laws (let alone in their application.) Only if absolutely identical income tax laws were identically applied could double tax be certainly avoided. The record shows no such identical tax laws between any two countries (let 29. Assume a taxpayer paid $5 foreign country tax and $20 U.S. tax (minus $5 credit), and $7 California tax, he would end up paying $5 foreign, $15 U.S. and $7 state level tax. If California were required to avoid double tax he would pay $5 foreign $15 U.S, and only $2 state level. But if he paid no foreign tax he would pay $20 U.S., and $7 California taxes. A tax credit should be allowed only once, i.e., against federal income tax. -119- alone as to all of them.) Nor do we believe it can. In this writer's experience, income tax laws vary substan- tially from country to country both as to income taxed and deductions and credits allowed. CCA concedes that even the accounting methods (by which the income and deductions are calculated) vary from country to country. There is no such thing as a uniform "arm's length" method. Indeed, U.S.A. made no "arm's length" adjustments in CCA's income for payments (or lack thereof) by its subsidiaries which were not full value for services rendered by CCA. (J.A. pp. 78-79,4 151.) This shows both non-uniformity in application and inadequacy of the so-called arm's length method. The fect that this Court has no control over the methods of calculating tax used in foreign countries does not deprive the United States or any -120- state of the right to tax a fair share of the income of a multinational unitary enterprise. CCA has proven no unconstitutional double taxation. "Appellant's reasoning tracks the rationale of Japan Line, that is, that separate accounting is required because apportionment necessarily entails some inaccuracy and duplication. This inaccuracy may be tolerable for businesses operating solely within the United States, it is said, because this Court has power rility for decision The A-7 resides with the appropriate executive The superior behaves in such a manner as to encourage sub- ordinates to make decisions, parryirg attempts to evade responsibility Social Climate Relaxec freedom within the rules of the game Communication is two-way, oblique, and horizontal Democratic consultation and interaction without under- mining the essential needs of leadership and discipline Individual self-expression and self-development are encouraged within the limits imposed by organization's resources and needs A-8 III THE DECENTRALIZATION PATTERN IN DETAIL The Formal Structure Two general approaches. There are in general two ways of decentralizing ‘ an industrial structure. One is by leaving the decentralized urits as integral divi- sions, there being only one corporation. In general this is the policy followed by General Motors. The other is to decentra- lize by the organization of subsidiaries, or affiliate companies. The Standard Oil companies have tended to follow the latter method. Three bases of decentralization. Smith's study found three general types of decentralized structure in American industry: (1) by functions; (2) by geographical regions; and (3) by product divisions. Firms organized by function tend to have one main product. In them A-9 the decentralized fectory manager and sales maneger each report to separate functional executives at headquarters, as would other functional people, such as finance. This type of organization has three vertical levels, and the people working in it seem to be less confused about status because it is clear to whom they report. In the second, an organization based on geographical decentralization, everyone reports through the regional man- ager. Functional lines to headquarters are purely staff, similar to the line-and staff model postulated in the previous chapter. Such organizations tend to have four levels. In spite of the fact that this is the type of organization postulated by our model for large comapnies with diversified products, Smith points out that it seems usual "to have strong dif- ferences of opinion between the headquarters A-10 officers, on the one hand, and the branch officers, on the other, as to who should have authority to do what." This is only one more example of -he fact that the decentralized way of life may not be the easiest one. Organization by product line is represented by the Ford Motor Company, General Motors, and Ju Pont. In each case a major division is devoted to making and selling a single product. Each division is organized as an independent unit and the structure of the field units may be functional. geograph:.cal, or a mixture of the two. Committees at the corporate level work toward desirable standardization and uniformity. A-11 FEDERAL DECENTRALIZATION {Excerpts from: Pet2r F, Drucker, Management: Tasks, Responsibilities, Practices, Harper & Row, New York, 1974, pp. 572-57°.] In “federal decentralization" a company is organized in a number of autono- mous businesses. Each unit has responsi- bility for its own performance, its own results, and its own contribution to the total company. Each unit has its ow management which, in effect, runs its own “autonomous business." Federal decentralization (as has been mentioned earlier, in Chapter 41) was first worked out, thcugh only crudely, by Pierre S. de Pont in 1920 in the reorgani- zation of the family-owned Du Pont Company, which had outgrown, during World War I, an older functional structure. When Pierre S. du Pont, shortly thereafter, took over the presidency of General Motors, which was A-12 then in desperate trouble, he found that Alfred P. Sloan, thea GM's executive vice- president, had arrived at a similar, though far more polished version. Sloan's "de- centralized operations with centralized policy control"—put into effect during 1921-22-—became the prototype of decen- tralization. Among the many imitations and adaptations, the one made in 1950-52 for the reorganization of the General Electric Company became, in the years of the “management boom," the standard model worldwide. ket The Strengths of Federal Decentralization Cf all design principles available so far, federal decentralization comes closest to satisfying all design specifications. It also has the widest scope. Both operating work and innovative work can be organized as decentralized A-13 autonomou; businesses. And while top manage- ment can obviously not be set up as an autonomous business, federal decentrali- zation of the business, if done properly, makes for strong and effective top manage- ments. It frees top management for the top-management tasks. The Requirement: of Federal Decentralization Decentralization must not create a weak center. On the contrary, one of the main purposes oj federal organization is to strengthen top management and to make it capable of doing its own work rather than be forced to supervise, co- ordinate, and prop up operating work. Federal decentralizetion will work only if the top-managemert job is clearly defined and thought through. kk * In ether words, there must be a kind of “supremacy clause" reserving A-14 to central management the decisions that affect the business as a whole and its long-range future welfare, and allowing central management to override, in the common interest, local ambitions and pride. Specifica’ly, there must be three reserved areas if the business is to remain a whole rather than splinter into fragments. Top management, and top management alone, can make the decision what technologies, markets, and product's to go into, what businesses to start and what businesses to abandon, and also what the basic values, beliefs, and principles of:the company are. Second, top management must re- serve to itself the control of the allo- cation of the key resource of capital. Both the supply of capital and its invest- ment are top-managerent responsibilities which cannot be turned over to the autonomous units of a federal organization. A-15 The other key resource is people. The people in a fedsrally organized company, and especially manazers and key profes- sionals, are a resoirce of the entire company rather than of any one unit. The company's policies with respect to people and decisions on key appointments in the decentralized autonomous businesses are top-management decisions—though of course, autonomous business managers need to take an active part in them. And a decentra- lized company needs to have a strong, re- spected, and senior executive in top management who is the company’s conscience with respect to peorle. Top management in a decentralized structure has to be separate. It cannot also run any of the autonomous businesses no matter how big or important they are. A-16 Appendix 8 CONTAINER CORPORATION OF AMERICA CCA EMP WORKING IGN IDIARI {Exhibit D to Stipulation of Facts in Evidence] Name, company, position, and date foreign employment commenced, Frank Angeles Cartoenvases de Mexico, Mexico City Art Director - D Septembe:: 1962 Otto H. Atkinson Cartoenvases de Mexico, October 1963 Louis M. Crandall Carton y Papel, corru- gated Carton y Papel, Re foi:ma Division Manager - D August 1963 Donald D. Hartman Carton y Papel, Reforma General Manager - P October 1958 John T. Hutton Carton y Papel, Los Reyes General Manager - P May :.963 Melvin L. Johnson Carton y Papel, Los Reyes . General Manager - P December 1960 Carl Philhower - Carton y Papel, Cerro Gordo Plant Manager - P November 1958 A-17 Ernest A. Robinson Cartoenvases de Mexico, Mexico City General Manager - D July 1959 Stanley B. Tamkin Carton y Papel, Reforma . Vice President - C September 1959 William D. Thorpe Carton y Papel, Corrugated Plant Manager - P February 1961 Epigmenio Guzman Carton y Papel, Corrugated April 1961 Ernest W. Briggs Carton de Colombia, Cali 7 Staff Engineer - P January 1966 Francis J. Sauer Carton de Colombia, Cali General Manager - P April 1962 T. J. Hosted Carton de Colombia, Cali Controller - P May 1965 Edward N. Jacobs + ae de Colombia, Cal Director of Manufac- turing - D August 1950 A-18 Stanley Karpinski Jerry Sanders Donald C. Corse Robert F. Donegan Gordon Healea John Manzella Delos G. Morton Glendie E. Osborne Cartones Nacionales, Valencia February 1961 Fibras, Caracas Resident Manager - P April 1960 Cartones Nacionales, Valencia Division General Manager - D September 1952 Union Grafica, Caracas Vice President - C April 1961 Cartones Nacionales, Valencia Plant Manager - P March 1964 Carton de Venezuela, Petare Division General Manager - D December 1955 Cartones Nacionales, Valencia General Controller-C June 1959 Carton de Venezuela, Petare Mill Manager - P January 1963 A-19 Robert G. Ridings Cartones Nacionales Valencia General Manager - P August 1963 Russell W. Wilson Union Grafica, Caracas Director of Marketing - D July 1962 Richard A. Witte Europa Carton, Heppenheim Generali Manager - P September 1957 C - Corporate D - Division P - Plant A-20 Appendix C Source Variations Computed on the Basis of Taxable Income On page 16 of Appellant's Brief, various figures are set forth by Appellant to demonstrate the amount of foreign in- come allegedly erronously apportioned by California to itself and the United States. Appellee does not believe that Appellant's analysis is relevant in con- text of the unitary theory and in any event is not probative given the admitt- ed inaccuracies of separate accounting data in this case. Nonetheless, the Court should be aware that Appellant's calculations are based upon financial or book income (profits on JA:E Ex A-1 through A-6) not on taxable income as defined by California. As a result, Appellant has overstated the alleged misapportionment. If the Court wishes to consider the argu- ments raised by Appellant in the context of consistent and correct figures, respondent respectfully suggests the following substitutions: 1963 1964 1965 1,470,105 4,675,478 3,660,163 1. Worldwide income apportioned to California 3,355,141 3,835,868 3,704,499 2. Domestic income apportioned to California 3,243,891 3,323,252 3,316,892 3. Increase of 1 over 2 141,250 512,616 387,607 T@-7 £-22 These figures were computed on the following basis: The first set of figures were calculated by Multiplying the United States Apportionnent Factors times Adjusted Unitary Business Income JA:& Ex A-7 and Subtracting United States Source Income. The figures on 1. were calcula- ted by multiplying California Worldwide Apportionment Factors times Adjusted Unitary Business Income JA:E Ex A-/7. The figures of 2. were calcu- lated by multiplying California Domestic Apportionment Factors Times the Total of Unitary Business Income per Return and Federal RAR Adjustments JA:E Ex A-7. The various items involved in these calculations are defined as follows: California Domestic Apportionment Factors CCA Calfornia Factors JA:E Ex A-2, A-4, A-6 * CCA Factors JA:E Ex A-2, A-4, A-6 A-23 Californi.a Worldwide Apportionment Factors CCA California Factors JA:E Ex A-2, A-4, A-6 = CCA Factors JA:E Ex A-2, A-4, A-6 + Total Fectors JA:E Ex:-A-1, A-3, A-5 (Property & Payroll) and Combined CCA Sales JA:E Ex A-2, A-4, A-6 + Total Sales JA:E Ex A-1, A-3, A-5 United States Apportionment Factors CCA Factors JA:E Ex A-2, A-4, A-6 (Property & Payroil) and Combined CCA Sales JA:E Ex A-2, A-4, A-6 + Denominator Figures for Worldwide Above * United States Source Income Unitary Business Income per Return JA:E Ex A-7 + Federal RAR adjust- ments JA: Ex A-7 *An even more appropriate comparison would be Income Subject to Tax by the IRS Adjusted to a California Tax Base which equals Federal Taxable Income per Form 1120 JA:E A-24 Ex A-7 + RAR Adjustments JA:E Ex A-7 + State Taxes Based on Income JA:E Ex A-7 + Interest on Government Obligations JA:E Ex A-7. On this basis, the first set of figures on page 16 of Appellant's Brief would be: 1963 1964 1965 961,922 2,464,394 (1,215,898) A-25 Appendix D Nos. 52818, 52828, 52903 IN THE SUPREME COURT OF ILLINOIS CATERPILLAR TRACTOR CO., CATERPILLAR AMERICAS CO., CATERPILLAR CREDIT CORP., CATERPILLAR FINANCE CORP., and CATERPILLAR MACHINERY CORP., Plaintiffs-Appellants, Cross-Appellees, Vv. ILLINOIS DEPARTMENT OF REVENUE, et al, Defendants-Appellants, Cross-Appellees, and COCA-COLA COMPANY, et al, Intervening Plaintiffs- Appellants. On Appeal from the specs sone Court of Illinois, Third District, No. 79-104 There Heard on Appeal from the Circuit Court of the Tenth Judicial Circuit, Peoria County Illinois. Case No. 78L5615 A-26 Honorable Stephen J. Covey, Presiding Judge BRIEF OF AMICI CURIAE EDWARD C. RUSTIGAN DAVID K. STAUB MARTIN G, ROSENSTEIN Attorneys for Continental Illinois National Bank and Trust Company of Chicago, Anchor Hocking Corporation, Clark Oil and Refining Corporation, Marshall Field & Company, McDonald's Corporation, Nalco Chemical Company, The Northern Trust Company, The Richardson Company, and Zenith Radio Corporation, Amici Curiae. Of Counsel: MAYER, BROWN & PLATT 231 South LaSalle Street Chicago, Illinois 60604 (312) 782-0600 ORAL ARGUMENT REQUESTED [The following pages contain only Argument I of the brief. ] COMBINED REPORTING IS REQUIRED TO FAIRLY APPORTION INCOME OF A UNITARY BUSINESS Where a unitary business is conducted through a number of separate corporations, each corporation in the group will generally maintain separate accounting records. Opponets of the com- bined method of apportionment argue that the existence of such separate records solves the problem of allocating specific items of income and expense to different segments of a unitary business. They conclude that apportionment on a separate basis (corporation by corporation) is the appropriate method for dividing the income of a multicorporate enterprise among the states in which it operates. There are at least two basic reasons why apportionment on a separate A-28 basis in unsound for a truly unitary business. First, apportionment on a separate basis would be extremely difficult, and often impossible, to administer fairly. Second, apportion- ment on a separate >»asis does not result in a fair distribution of profits and losses of individual members of a unitary business among all members of the group. A. Apportionment on Separate Basis Cannot Be Policed Any failure to maintain arm's- length dealings in transactions between members of a multicorporate unitary business will result in distortion of the income of the individual members. With combined reporting, the potential problem of distortion is eliminated by combining the income of each member of the unitary group prior to apportionment. If appor- tionment is made on a corporation by corporation basis, however, any distortion 4-29 is preserved. Thus, if apportionment on a separate basis is permitted, the Depart- ment must closely police all transactions between members of the unitary group to insure that the transactions are conducted at arm's length. If apportionmerit on a separate basis is permitted, some taxpayers may be tempted to manipulate prices in order to reduce tax liability in the taxing state. Although e taxpayer is entitled to struc- ture its transactions to reduce its tax liability, it may not do so by arbitrarily assigning non-arm's-length prices to its goods or services. Without combined reporting, the Department might be forced to sort through thousands of transactions to determine the proper income of a single unitary business. While the overwhelming majority of taxpayers make every effort to comply with the tax laws, it is often very A-30 : difficult to determine proper pricing of intercorporate transactions and there will inevitably be many good faith disagreements between taxpayers and revenue collection agencies. Policing of transactions between related companies to insure that they are arm's-length is particularly difficult when there is a lack of competitive pricing information. In some instances, a product may be unique (e.g., a manuscript, motion picture, or master recording) and informa- tion on property of a similar type may not be very helpful in determining an arm's- length price. In other instances, a product may be transferred at an interim stage in the manufacturing process when no similar sale would be made by unrelated parties, and thus no arm's-length price would be available. Thus, even after the non-arm's-length transactions are identi- fied, the Department may still have A-31 difficulty in determining a proper arim's- length pri.ce. The scope of the problem of policing transactions between related parties is shown by the myriad cases under Section 482 of the Internal Revenue Code, which allows the Internal Revenue Service tc reallocate various items among separate corporations in order to clearly reflect the income of the corporations for Federal income tax purposes. One commentator has noted that such policing at the state level "would require an arny of agents greater than the total number of agents employed by all the states and * the Federal Government combined." Accordingly, permitting a unitary group of corporations to report *Keesling, A Current Look at the Combined Report and Uniformity in Kl lccation Practices. G2 J. Taxation 106 (1975) 4-32 income or a separate basis will create substantial administrative burdens for the Departnent and will prevent fair enforcement of the law. The Court should require combined reporting so that the Department will not he forced to rely on a hit-or-miss method of determining the amount of income atti-ibutable to Illinois. B. Unitary Met:hod Essential for Fair Allocation of Profits anc Losses Even if the state could determine that all transactions among members of a unitary group were conducted at arn's length, reporting the income of each cor- poration on a separate basis is still inappropriate for a unitary business. The cornerstone of unitary apportionment is the assumption that the various segments of a unitary business are interrelated and vital parts of the whole business. Even A--33 though a portion of a unitary business may only »reak even or even be unprofit- able on a separate basis, it may contrib- ute to the profitability of the larger enterprise in numerous ways which may not be recogn:.zed under any separate account- ing systen. The courts of several states have recognized that a unitary business is inseparable even where segments of the business are separately incorporated, The Suprere Court of California concluded in the leading case of Edison California Stores, Inc. v. McColgan, 183 P.2d 16 (Cal. 1947), that a California subsidiary corporation, engaged in selling merchan- dise, contributed to the profits of the whole unitary enterprise in the same way that a California branch contributed to the profits of the unitary business in Butler Brothers v. McColgan, 315 U.S. 501 A-34 (1942), i.e., by enabling the enterprise to obtain more favorable prices on its purchases. Thus, the court applied combined formulary apportionment to the business despite a finding that the sub- sidiary corporation's separate accounts were reasonable and accurate. Contributions to a unitary enterprise may even be less tangible: a rember of the unitary group may be an excellent training ground for management personnel who later ‘work for another member of tle group; a member of the unitary group may serve a role in attain- ing a "national" status for the unitary enterprise. The impossibility of identify- ing, let alone quantifying, the contribu- tions of a segment o:° a unitary business to the enterprise as a whole makes report- ing on a separate basis undesirable. Thus, A-35 combined reporting provides a better means of achieving the lezislature's goal of an equitable method of apportionment. It. COMBINED REPORTING APPROPRIATELY STRESSES SUBS'TANCE OVER FORM Intervenors concede that formu- lary apportionment :.s proper under the Illinois “ncome Tax Act. However, they argue that where a unitary group member is a separate corporate entity, formulary apportionment should apply to that corpo- ration separately. Amici Curiae contend that because of the interdependence of the entities which nake up the unitary group combined reporting is essential to achieve a fair apportionment of income. This interdependence exists whether the unitary group is made up of corporate or noncorporate entities. Accordingly, formulary apportionment should apply on A-36 a combined basis. The application of formulary apportionment to ezch corporate member of a unitary group on a separate basis would elevate form over substance. Assuming that the enterprise is unitary, its tax liability should be the same whether it is structured (i) as a single corporation consisting of separate divi- sions, or (ii) as a multicorporate enter- prise in the form of a parent corporation with separate subsidiary corporations. In applying formulary apportionment Intervenors would distinguish (i) from (ii). Im sitvation (i), they would combine the separaty divisions of the single co:poration and apportion the divisions’ income as a unit. Yet in situation (ii), Intervenors would treat the parent corporation and each of its subsidiaries separately. They would A-37 apply fornulary apportionment to the parent corporation 9n a separate basis and to each subsidiary corporation on a separate »basis. The emphasis on struc- tural form in Intervenors’ argument is apparent. The Illinvis Income Tax Act should be interpreted so that the tax- payer's decision whether to operate his business as a corpoxation with divisions or a corporation with subsidiaries is made on the basis of economic and not tax considerations. Separate reporting might encourage some taxpayers to fracture their business into subsidiaries solely because of the advantage gained under the Illinois Income Ta>: Act. The following example illustra- tes the consequences of ignoring the sub- stance of the unitary enterprise and stressing its structural form. £.-38 EXAMPLE Widget Corporation, Inc. is an Illinois corporation engaged in the isanu- facture and sale of widgets. Widget Corporation, Inc. has a separate unincor- porated division, W2stern Widget Division, which conducts all sales operations for Widget Corporation, Inc. on the West Coast of the United States. Widget Corporation, Inc., also has a wholly-owned subsidiary corporation, Eastern Widget Subsidiary, which conducts all sales operations for its parent corporation on the East Cost of the United State:. The opera-:ions of Eastern Widget Subsidiary are identical to those of Western Widget Division. Neither Western Widget Division nor Eastern Widget Subsidiary manufactures widgets. Widget Corporation, Inc. manufactures all of the widgets which are sold by its division and corporate A-39 subsidiary. Widget Corporation, Inc. engages in no sales operations on its own. It is assumed that Widget Corpora- tion, Inc., its division and its corporate subsidiary constitue a unitary business. Western Widget Division and Eastern Widget Subsidiary are comp:.etely dependent on Widget Corporation, Inc. for the widgets which they sell. In a given year, Western Widget Division and Eastern Widget Subsidiary each earn income of $100,000 on sales. Widget Corporation, Inc. earns no income since it sells at cost. (It is recog- nized that: Widget Corporation, Inc. probably should not sell at cost since it normally would be entitled to a manu- facturing profit. However, see the | discussion of administrative problems in I.A. of the argument at page 8 above). Western Widget Division and Eastern 4-40 Widget Subsidiary each have property, payroll, and sales of $200,000, all of which is the result of sales operations outside Illinois. Widget Corporation, Inc. has $200,000 of property, payroll, and sales inside Illinois as a result of the location of its manufacturing facilities there. ‘fable I summarizes * the amounts set forth above. *The apportionment formula under the Illinois Income Tax Act is a three factor formula based on property, pay- roll and sales. For purposes of simplification, this example treats the factors in the aggregate. Widget Corporation, Inc. Western Widget Division Eastern Widget Subsidiary TABLE I—FACTS Property Propert Payroll Payroli Sales Sales Income Inside Ill. Outside I1l. $200,000 $100 ,000 $200 ,000 $100,000 $200 ,000 Under the combined method of reporting, formulary apportionment would apply to the income of the unitary group as presented in Table II. T9-V¥ TABLE II—Combined Reporting Illinois ate tae spent ) Widget Corporation, Inc. Western Widget Division Eastern Widget Subsidia Tilinois oe No “Tilinote ow oe ayrcoli-Sales Widget Cemmeuenion. Inc. Western Widget Division Eastern Widget Subsidiary $200,000 xX $200,000 $600 , 000 Income of Widget Corporation, Inc. Western Widget Division Eastern Widget Subsidiary $66,667 subject to Illinois Income Tax Income of Unitary Group Subject to Illinois Income Tax = $66,667. > .. nN Table III illustrates how formulary apportionment would apply to the unitary group on a separate basis. TABLE III—Separate Reporting (1) Application of Formulary Apportionment to Widget Corporati Inc. and its unincorporated division, Western Widget Division. Tilinois a fr) Widget Corporation, Inc. Income of Western iidget Division X Widget Corporation, Inc. Tilinois ana Non-IIlinois Western Widget Division eS eee ° Widget Corporation, Inc. Western Widget Division Sraeene X $100,000 = $50,000 subject to Illinois Income Tax TABLE III (Cont'd) €7-V TABLE I1I—Separate Reporting (Cont'd) (2) Application of Formulary Apportionment to Eastern Widget Subsidiary. Illinois ead pean, ° Eastern Midget Subsidiary 4 Income of > nois anc Non- nois Dasiern Widget Subsidiary 5 vias cagned? degectal -Sales Eastern Wideet Subsidiary $0 X $100,000 = #£$0 subject to Illinois $200 , 000 Income Tax Income of Unitary-Group Subject to Illinois Income Tax = $50,000. £-45 As Table III illustrates, appor- tionment of the income of the unitary group on a separate basis results in all of the income earned by Eastern Widget Subsidiary escaping apportionment under the Illinois ' Income Tax Act, even though the manufac- turing facilities upon which this’ income depends are located within Illinois. On the other hand, all of the income earned by Western Widget Division is subject to the Illinois apportionment formula because it operates as a division of Widget Corporation, Inc. rather than as a subsidiary corporation. Hence, if the income of the uritary group is appor- tioned on a separate basis, Widget Cor- poration, Inc. will have benefited under the Illinois Income Tax Act simply by incorporating its East Coast sales opera- tions into a separate corporation. £-46 If the exemple were altered so that either (i) Widget Corporation, Inc. and Western Widget [Division were located outside Illinois while Eastern Widget Subsidiary was located inside Illinois or (ii) Widget Corpcration, Inc. was located outside Illinois while Western Widget Division and Eastern Widget Sub- sidiary were locatec inside Illinois, a greater Illinois tax liability would result under separate reporting than under the combined method. The point of this example, however, is not to show that Illinois exacts a greater or lesser tax depending on which rethod is used. The respective parties would agree there is a difference. Amici Curiae merely wish to illustrate that, given the fact that formulary apportionment has been adopted in Illinois, basing the tax liability of a A-47 group of interdependent and inseperable business activities on whether a particu- lar activity is structured as a separate corporation places a wholly unwarranted emphasis on the structural form of the enterprise. Courts ir other states have recognized that the structural form of the unitery enterprise should not affect the apportiomment cf income and, there- fore, have requirec use of combined reporting. See, Ecison California Stores, Inc. v. McColgan, 183 P.2d 16, 21 (Cal. 1947); Coca-Cola Company v. Department of Revenue, 533 P.2d 788, 792-94 (Ore. 1974); Montana Department of Revenue v. American Smelting & Refining Company, 567 P.2d 901, 908-09 (Mont. 1977). Similar recognition has been accorded in legal commentary. Frank M. Keesling explains that the purpose of the combined A--48 report is to assure that where a business is conducted both inside and outside the taxing st:ate, the business’ income will be apportioned in the same fashion whether the business consists of one corporation or multiple corporations. He notes that in bcth cases the income of the business is computed as a unit, apportioned by applying the appropriate formila, and the amount so apportioned is added to any nonbusiness income which the taxpayer derives from sources within the taxing state. Thus, in determining the amount of business income attribu- table to a particular state, "no advantage is obtained, and no detriment suffered, as the result of employing a number of corporations rather than one to operate a business," Keesling, A Current Look at the Combined Report and Uniformity in Allocation Pract:.ces, 42 J. Taxation A-49 106 (1975). Furthermore, the United States Supreme Court's recent opinion in Mobil Oil Corp. v. Commissioner of Taxes, 48 U.S. L.W. 4306 (March 19, 1980), reflects unwillingness to permit the structural form of a unitary enterprise to affect issues of taxation. In Mobil Oil, the taxpayer argued tha: the inclusion, by a non-domicillary st:ate, of dividends received from the taxpayer's foreign subsidiaries and affiliates in the income tax base subject to apportionment violated the Due Process and Commerce Clauses of the United States Constitution. In the context of the taxpayer's due process challenge, the Court refused to draw any distinctior. on the grounds that the income was received in the form of dividends from separately incorporated entities rather thar derived from A-50 intracorp ?rate divisions. The Court stated: "Superficially, intercor- orate division might appear to e a more attractive basis for limizing apporcionability. But the form of business organization may have nothing to do with the unde:-lying unity or diversity of business enterprise. Had appel- lant chosen to operate its for- eign subsidiar:.es as separate divisions of a legally as well as a functiona:.ly integrated enterprise, there is little doubt: that the income derived from those divisions would meet due process requirements for apportionability. ot General Motors Corp. v. Washington, 3/7 U.S. 436, 441 (1964). Trans- forming the same income into dividends from legally separate entities works no change in the underlying economic realities of a unitary business, and ac- cordingly it ought not to affect the ~epportionatility of income the parent receives." 48 U.S. L.W. at 4310. *Amici Curiae acknowledge that the Court refused to decide whether the Due Process Clause requires combined re- oe 48 U.S.L.W. 4306, n. 15. owever, Amici Curiae believe that the Court's distaste for arguments emphasiz- ing form over substance bears noting. A-51 The purpose of formulary apportiorment under the Illinois Income Tax Act is to fairly and equitably attribute the income earned by a’ unitary enterprise to the business activities which it conducts within the State. Amici Curiae submit that fairness and equity cannot be achieved if a distinc- tion is made merely because a segment of the unitary enterprise operates as a separate corporation, A-52 CONCLJSION In light of the foregoing policy considerations, Amici Curiae respectfully request tnat this Court affirm that por- tion of tie decision of the Aprellate Court which would require the combined method of reporting in the State of Illinois. Respectfully submitted, EDWARD C. RUSTIGAN DAVID K. STAUB MARTIN G. ROSENSTEIN Attorneys for Continental Illinois National Bank and Trust Company of Chicago, Anchor Hocking Corporation, Clark Oil & ae Corporation, Marshall Field & Company, McDonald's Corporation, Nalio Chemical Company, The Northern Trust Com- any, The Richardson ompany, and Zenith Radio | Corporation, Amici Curiae. Of Counsel: Mayer, Brown & Platt 231 South LaSalle Street Chicago, Illinois 60604 (312) 782-0600 A-53 Appendix E THE THEORY OF THE UNITARY BUSINESS PRINCIPLE [Excerpt from International Division of the Income Tax Base o tinationa Enterprise, Publ. Multistate Tax Commission, Ceofiey John Harley, 1981, p. 6.] The unitary enterprise theory rests on economic analysis. Its focus is on the geographic locations of the comp nents of the multinational enterprise itself. It views a group of enterprises under common ownership as components of a single integrated business operation, arranged in a particular way purely to accommodate legal requirements. The central operational premise is that all parts are coordinated by a central management policy and structure which seeks to maximize profits over-all. Accordingly, intercorporate business is irrelevant and profit or loss is determined by transactions with third parties. The intercorporate transactions are A-54 essential factors in producing profit, in the sense that without them, and the peculiar advantages associated with integrated enterprises, there would be no product at the end, but it is the profit itself that: counts. The transactions up to the point of sale to the unrelated third party are irrelevant for tax purposes because profit or loss can only be determined when the entire enterprise completes the process of production. The basic question addressed by the unitary method is how the overall profit of the enterprise is to be assigned, given the fiact that separate tax juris- dicticns do exist. The separate entity theory requires that profits be assigned to the particular units of the organization in each location. The unitary theory treats the units as being irrelevant; what counts is the extent of the profit A-55 making activity in any given location, based on a measure of territorial contribution, The unitary method seeks to assess what factors of production were located in each country, measuring objectively how much labor was used, how much capitéel was employed, and where the sales took place. The formula, based on these factcrs, assigns income to each geographic location on these bases, dividing the entire group's total income among the jurisdictions in which the units happen to be located. --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385008_0362%3A19. Public record. Not legal advice.