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

«Supreme

FILE

OCT 43 1962

IN THE

Supreme Court of the Unit

OCTOBER TERM, 1982

CONTAINER CORPORATION OF AMERICA,

Appellant,

V.

FRANCHISE TAX BOARD,

Appellee.

On Appeal from the Court of Appeal of the

State of California for the First Appellate District

BRIEF OF CITIZENS FOR TAX JUSTICE;

AMERICAN FEDERATION OF STATE, COUNTY

AND MUNICIPAL EMPLOYEES;

CITIZEN/LABOR ENERGY COALITION ;

CONSUMER FEDERATION OF AMERICA;

INTERNATIONAL ASSOCIATION OF MACHINISTS

AND AEROSPACE WORKERS;

INTERNATIONAL UNION

OF OPERATING ENGINEERS;

NATIONAL COUNCIL OF SENIOR CITIZENS; AND

SERVICE EMPLOYEES INTERNATIONAL UNION:

AS AMICI CURIAE IN SUPPORT OF

THE CALIFORNIA FRANCHISE TAX BOARD

ROBERT S. McINTYRE

2020 K Street, NW, Suite 200

Washington, D.C. 20006

(202) 293-5340

Attorney for Amici Curiae

Citizens for Tax Justice;

A. can Federation of State,

County and Municipal Employees;

Citizen/Labor Energy Coalition;

Consumer Federation of America;

International Association of Machinists

and Aerospace Workers;

International Union of Operating

Engineers;

National Council of Seniux Citizens; and

Service Employees International Union

WILSON - EPES PRINTING O. INC. - 789-0096 - WASHINGTON, D.C. 20001

A <a. o-

TABLE OF CONTENTS

Page

TABLE OF AUTHORITIES ..022.220.2222200.2220-..2-ecc-0-00- ii

INTEREST OF AMICI CURIAE 20000. 2220..---000-00000000-- 2

STATEMENT OF GENERAL CONSENT .................. 4

SUMMARY OF ARGUMENT ———— 4

/—“— . ˙ 5

T———A o o 5

I. The facts of this case show that California's de-

termination of Container’s California source in-

come is not “unreasonable,” but is instead well

within the bounds of rough approximation“ 7

II. Formula apportionment of the worldwide in-

come of unitary businesses is an appropriate

means for the states to determine the in-state

income of multinational firms -............................ 13

III. California is not unconstitutionally undermin-

ing the foreign policy of the United States by its

use of worldwide formula apportionment, nor

has Congress violated the constitution by its re-

peated refusals to restrict the power of the states

to use the worldwide formula approach ............. 20

IV. The decision of how to measure the in-state tax-

able income of multinational firms is a political

question which the constitution leaves to the

states and (perhaps) to the Congress 21

R ittdcttt.....ł— / T 25

ii

TABLE OF AUTHORITIES

Cases Page

Exxon Corp. v. Wisconsin Department of Revenue,

rn x

Hans Rees’ Sons, Inc. v. North Carolina ex rel.

Martell, 283 U.S. 123 (198177) 7, 8

Hines v. Davidowitz, 312 U.S. 52 (19417 21

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

TS ETT NT 21

Mobil Oil Corp. v. Commissioner of Taxes of Ver-

mont, 445 U.S. 425 (1980) —..---- ee 6

Moorman Manufacturing Co. v. Blair, 437 U.S.

. 7,22

Norfolk & Ves rn Railway Co. v. Missouri State

Tax Commis n 90 U.S. 317 (196999 7, 8

Underwood Typewriter Co. v. Chamberlain, 254

A 7,8

Statutes and Rules

California Revenue and Taxation Code, section

r ee 18

Internal Revenue Code of 1954

r .. passim

D 16, 17, 24

Subpart F, sections 951 et seg. ore 9

Treas. Regs. § 1.861-8, 42 Feb. REG. 1195 et seq.

, ee 16

Uniform Division of Income for Tax Purposes

. 18

Other Authorities

Burns, How IRS applies the intercompany pricing

rules of Section 482: A corporate survey, 52

J. Tax. 306 (May 1660) 17

Citizen/Labor Energy Coalition, Where Have All

The Profits Gone: A Study of State Undertazxa-

tion of the Oil Industry (Washington, D.C.

1980) (mimeographed copy) .........................-...... 23

Comment, Multinational Corporations and Income

Allocation Under Section 482 of the Internal

Revenue Code, 89 Harv. L. REv. 1202 (1976) 19

111

TABLE OF AUTHORITIES—Continued

Comptroller General, IRS CoULD BETTER PROTECT

U.S. Tax INTERESTS IN DETERMINING THE IN-

COME OF MULTINATIONAL COMPANIES, REPORT

To THE CHAIRMAN, HOUSE COMMITTEE ON WAYS

Page

FG eee passim

Corporate Scoreboard, BUSINESS WEEK, March 16,

D esl

Dexter, The Unitary Concept in State Taxation of

Multistate-Multinational Businesses, 10 URBAN

r Coenen

Harley, International Division of the Income Tax

Base of Multinational Enterprise: An Overview,

Tax NorTEs, Dec. 28, 1981, p. 15668

International Corporate Scoreboard, BUSINESS

WEEK, July 20, 1981, pp. 86 et seq. .

J. Jacobs, BIDDING FOR BUSINESS: CORPORATE Auc-

TIONS AND THE 50 DISUNITED STATES (1979)

M.J. McIntyre, An Inquiry Into the Special Status

of Interest Payments, 1981 DUKE L.J. 765

% led ia

P. Musgrave, The U.K. Treaty Debate: Some Les-

sons for the Future, TAX NOTES, July 10, 1978,

1 —

Parnell, Shraberg, Dunbar, & Jolles, Article 9(4)

and the Constitution, Tax Notes, July 10, 1978,

Ee ee a ok en Mane Ae

Rudolph, State Taxation of Interstate Business:

The Unitary Business Concept and Affiliated

Corporate Groups, 25 TAX L. Rxv. 171 (1970)

Staff of the Joint Committee on Taxation, GEN-

ERAL EXPLANATION OF THE ECONOMIC RECOVERY

. § 4 4 — —__ SEER RAPE RSPR

fax Reform Research Group, Comments on Pro-

‘posed Regulations Dealing with Allocation and

Apportionment of Deductions Between Domestic

and Foreign Source Gross Income, Dec. 16, 1976

(unpublished comments submitted to the Treas-

, ] .....

18

19

19

24

18

iv

TABLE OF AUTHORITIES—Continued

Taz Treaties with the United Kingdom, the Repub-

lic of Korea, and the Republic of the Philip-

pines: Hearings Before the Senate Comm. on

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

U.S. Department of Commerce, Bureau of the

Census, SELECTED CHARACTERISTICS OF FOREIGN-

OWNED U.S. Firms: 1980 (1982)

U.S. Department of Commerce, Bureau of the

Census, SELECTED CHARACTERISTICS OF FOREIGN-

OWNED U.S. FirMs: 1975-1976 (19799 3

U.S. Department of the Treasury, THE PREsI-

DENT’S 1978 TAX PROGRAM (1978), printed in

The President's 1978 Tax Reduction and Reform

Proposals: Hearings Before the House Comm.

on Ways and Means, 95th Cong., 2d Sess. 160

11 EE — 3

Page

IN THE

Supreme Court of the United States

OCTOBER TERM, 1982

No. 81-523

CONTAINER CORPORATION OF AMERICA,

Appellant,

v.

FRANCHISE TAX BOARD,

Appellee.

On Appeal from the Court of Appeal of the

State of California for the First Appellate District

BRIEF OF CITIZENS FOR TAX JUSTICE:

AMERICAN FEDERATION OF STATE, COUNTY

AND MUNICIPAL EMPLOYEES ;

CITIZEN/LABOR ENERGY COALITION ;

CONSUMER FEDERATION OF AMERICA;

INTERNATIONAL ASSOCIATION OF MACHINISTS

AND AEROSPACE WORKERS ;

INTERNATIONAL UNION

OF OPERATING ENGINEERS ;

NATIONAL COUNCIL OF SENIOR CITIZENS; AND

SERVICE EMPLOYEES INTERNATIONAL UNION:

AS AMICI CURIAE IN SUPPORT OF

THE CALIFORNIA FRANCHISE TAX BOARD

INTEREST OF AMICI CURIAE

The decision of the Court in this case will affect the

right of California, as well as other states, to assess a

fair share of the tax burden on multinational corpora-

tions. It will therefore directly affect both state and

local taxpayers and state and local government workers,

since a decision against the State of California in this

case is likely to mean increased personal taxes, reduced

government services, or both in the states which are

affected.

As representatives of middle- and lower-income tax-

payers and of state and local government workers, amici

therefore have a vital interest in the outcome of the case

before the Court:

Citizens for Tax Justice (CTJ) is a coalition of na-

tional public interest organizations, labor unions, and

citizens groups around the country. CTJ was founded in

1979 and is headquartered in Washington, D.C. Through

its member organizations, CTJ represents the interests

of tens of millions of middle and lower-income taxpayers.

Several of CTJ’s members also represent state and local

government workers around the country, including Cali-

fornia.

The American Federation of State, County and Munici-

pal Employees, AFL-CIO, is a national labor organiza-

tion with approximately one million members throughout

the United States and 19,000 members in California.

The Citizen/Labor Energy Coalition (C/LEC) is a

national alliance of over 300 labor, senior, neighborhood,

environmental and religious groups across the United

States. C/LEC was founded in 1978 and is headquar-

tered in Chicago, Illinois. Through its member organiza-

tions, C/LEC represents millions of citizens concerned

that multinational energy companies pay a share of taxes

commensurate with the benefits received from, and busi-

ness conducted in, the various states. Many of these citi-

zens live in California.

The Consumer Federation of America (CFA) is com-

posed of approximately 200 national, state and local or-

ganizations, including consumer, labor, farm, cooperative

and senior citizen groups. CFA was formed in 1968 and

is headquartered in Washington, D.C. Altogether, CFA’s

member organizations represent in excess of thirty mil-

lion consumers, many of whom are California taxpayers.

The International Association of Machinists and Aero-

space Workers, AFL-CIO, is a national labor organiza-

tion representing approximately 900,000 workers in the

airline, aerospace, shipbuilding and auto-related indus-

tries and in general manufacturing. Approximately 130,-

000 of its members are California taxpayers.

The International Union of Operating Engineers, AFL-

CIO, is a national labor organization representing 405,

000 workers, including operators of heavy equipment in

the construction industry and stationary engineers op-

erating plant and equipment in all major industries. It

represents 65,000 workers in California, approximately

10,000 of whom are employed by government agencies.

The National Council of Senior Citizens represents ap-

proximately 4,000,000 senior citizens in 4,000 local clubs,

area and state councils across the United States. Almost

300 of its affiliates are located in California. The Na-

tional Council of Senior Citizens was founded in 1961

and is headquartered in Washington, D.C.

The Service Employees International Union, AFL-CIO,

is a national labor organization representing approxi-

mately 675,000 workers in building service, health care,

4

government and other industries. It has 135,000 members

in California, approximately 80,000 of whom work for

government agencies.

STATEMENT OF GENERAL CONSENT

This brief is filed with the written consent of both

parties, under a general consent on file with the Court,

pursuant to Rule 28 of this Court.

SUMMARY OF ARGUMENT

California’s application of a three-factor formula to

the worldwide profits of unitary businesses is an inher-

ently sensible approach to determining the in-state tax-

able income of multinational companies which has pro-

duced eminently reasonable results on the facts of this

case. In fact, it is the alternative, arm’s-length method

argued by Container to be constitutionally mandated

which has the highest potential for inherent arbitrariness

and which would lead to the most unreasonable results

here.

California’s use of the worldwide formula approach no

more unconstitutionally undermines the foreign policy of

the United States than have Congress’s repeated refusals

to prohibit the states from using the formula system.

At bottom, the controversy in this case is not a consti-

tutional one. Instead, it is a political dispute. California

and several other states seek a fair sharing of their tax

burdens and administrable tax systems, while Container

and some other multinational firms seek reduced state

tax bills. The resolution of this ongoing quarrel should

properly be left to the political process.

5

ARGUMENT

Introduction

The dispute in this case is, on the facts, a narrow

one. Container Corporation, a multinational business

operating in California, numerous other states, and sev-

eral foreign countries,’ contends that California has as-

serted its tax jurisdiction over approximately one per-

cent more of Container’s income in 1963-65 than is per-

missible under the U.S. Constitution. The amount of

California tax in dispute, not counting interest, averages

about $24,000 per year—or less than 1/10th of one

percent of Container’s average pretax income in 1963-65.

Put another way, Container seeks a ruling from this

Court that California has overstepped constitutional

bounds by refusing to reduce Container’s state income

tax bill by 12 percent.

This narrow factual dispute, however, overlays a far

more significant and fundamental issue involving the

constitutional power of the states to adopt reasonable

measures to determine the in-state taxable income of

multinational firms.

Container’s specific complaint in this case is with

California’s inclusion of Container’s worldwide income

in the base for apportioning taxable income to Cali-

fornia under the familiar three-factor, property-payroll-

sales formula. Container maintains that the formula

should have been applied solely to what Container as-

serts are its U.S. profits, determined under a separate

accounting, arm’s-length approach. In support of its

position, Container asserts, first, that its foreign opera-

tions do not constitute a “unitary business” with its U.S.

operations, and, second, that, even if a unitary business

does exist, California’s formula approach is “inherently

1 Since the tax years in question, Container has itself become a

subsidiary of another multinational company, Mobil Corporation.

6

arbitrary” and has produced results which are “unrea-

sonable” on the facts of this case.

This brief will leave to other participants in the case

the task of defending California’s treatment of Container

as a unitary business. Suffice it to say here that we be-

lieve the evidence is overwhelming that the unitary

classification is correct. The remainder of the brief will

explain why we believe that the California formula ap-

plied on a worldwide basis is a reasonable means for

California—and other states—to use in measuring the

share of a multinational corporation’s income properly

taxable within the state.

It should be noted at the outset that, while per force

the appellant in this case is seeking a reduced state tax

bill, California’s use of the worldwide formula approach

is not based on an attempt to tax out-of-state income.

As the non-partisan staff of the congressional] Joint Tax

Committee explained in 1977:

“the application of the combined reporting [system]

does not automatically ‘tax’ the income of the re-

lated corporations whose income, sales, payroll, and

property values are taken into account. It only in-

cludes all of these items in the apportionment for-

mula, and it may either decrease or increase the

taxable income from sources within the State at-

tributed to the corporations. . Viewed in this way

Actually, the questions of whether Container is a unitary bus-

iness and whether California’s formula approach produces a reason-

able result substantially overlap. One of the reasons why Califor-

nia’s system is appropriate—in fact, necessary—to determine Con-

tainer’s California taxable income is the substantial opportunities

for transfers of expertise, good will, borrowing power, technical as-

sistance, and so forth from Container’s U.S. operations to its for-

eign subsidiaries without proper accounting for the costs cf these

items. Thus, just as a finding of “unitary business” is the “linch-

pin” of formula apportionment, Mobil Oil Corp. v. Commissioner of

Taxes of Vermont, 445 U.S. 425, 439 (1980), so a finding that for-

mula apportionment is reasonable suggests the existence of a uni-

tary business.

7

combined reporting is essentially an attempt to define

the amount of income properly attributable to each

entity and for each taxing jurisdiction.” *

Container’s burden in this case is to show either that

“the method of apportionment adopted by [California]

was inherently arbitrary, or that its application to this

corporation produced an unreasonable result.” Under-

wood Typewriter Co. v. Chamberlain, 254 U.S. 113, 121

(1920). It argues both, but proves neither.

In addition, Container maintains that California,

through its use of the worldwide formula approach, and,

apparently, Congress, by its repeated failure to prohibit

the states from so doing, are unconstitutionally under-

mining the foreign policy of the United States. This

argument, too, has no merit.

I. The facts of this case show that California’s determi-

nation of Container’s California-source income is not

“unreasonable,” but is instead well within the bounds

of “rough approximation.”

This Court has stated on numerous occasions that it

will find the results under a formula apportionment ap-

proach “unreasonable” only “when the taxpayer has

proved by ‘clear and cogent evidence’ that the income

attributed to the State is in fact ‘out of all appropriate

proportions to the business transacted . . . in that state,’

[Hans Rees’ Sons, Inc. v. North Carolina ex rel. Mar-

well, 283 U.S. 123, 135 (1931),] or has ‘led to a grossly

distorted result,’ [Norfolk & Western Railway Co. v.

Missouri State Tax Commission, 390 U.S. 317, 326

(1969)].” Moorman Manufacturing Co. v. Blair, 437

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

and the Republic of the Philippines: Hearings Before the Senate

Comm. on Foreign Relations, 95th Cong., Ist Sess. 51-52 (1977)

(Statement of Paul Oosterhuis, Legislative Council, Joint Commit-

tee on Taxation) (emphasis added) [hereinafter Joint Committee

Testimony].

8

U.S. 267, 274 (1978).* Under these standards, the fact

that the dispute in this case is over such a small portion

of Container’s income would seem to dispose of this fac-

tual issue without further investigation.

The California formula apportions a mere one percent

more of Container’s worldwide income to California than

Container claims is correct under the separate-accounting

approach it favors. The 12 percent difference between

the parties in total apportionment to California must

certainly be within the range of “rough approximation”

mandated by the constitution, id. at 273 °—whichever

method of apportionment is theoretically more accurate.

Which is not to concede—as Container’s brief would

have the Court assume—that the income allocation pro-

duced using a separate-accounting approach is presump-

tively correet.“ To the contrary, it is Container’s highly

touted “arm’s-length” standard which leads to the most

unreasonable results on the facts of this case. In par-

* See also Exxon Corp. v. Wisconsin Dept. of Revenue, 447 U.S.

207, 227 (1980).

In Underwood Typewriter Co. v. Chamberlain, 254 U.S. 113

(1920), Connecticut assessed its corporate tax on 47% of Under-

wood’s net income, based on a single-factor property formula, while

the company claimed that only 3% of its profits were actually

earned in Connecticut. The Court held that Underwood had failed

to prove the formula had produced “an unreasonable result.”

In Hans Rees’ Sons, Inc, v. North Carolina ex rel. Maxwell, 283

U.S. 123 (1931), the Court had the opportunity to amplify on what

an “unreasonable” result might be. It found that clear proof that

the formula allocated 83% of the company’s income to the state

while only 17% was earned there would qualify the taxpayer for

relief under the “out of all appropriate proportions” standard. /d.

at 135. A similarly “grossly distorted result” was found in Norfolk

& Western Ry. Co. v. Missouri State Tax Commissioner, 390 U.S.

317, 326 (1968), where the taxpayer made an uncontested case

that the state’s tax assessment—more than double what the tax-

payer claimed to be appropriate—was essentially groundless.

Such a presumption on Container’s part, of course, largely begs

the factual issue before the Court.

9

ticular, Container would have the Court find that it

earned an average of $1.3 million per year on its

Panamanian “operations’—an amount representing over

three times the disputed California apportionment in this

case—even though it admits that the Panamanian sub-

sidiary was a “non-operating holding company,” Jt. App.

30, with no sales, property, payroll, or other business

activity’

Container’s brief makes much of the argument that

California’s apportionment formula produces the “ludi-

crous” result of making it appear that Container paid

close to one-hundred percent tax rates in Colombia and

the Netherlands in the years in question. But Container

fails to acknowledge that its own “separate-accounting”

system produces the far more ludicrous result of showing

a 357 percent tax rate in Italy over the same period.“

The burden is not on California to show how Container

has specifically manipulated the separate-accounting

methodology to produce an unacceptable allocation of its

income to foreign sources. In fact, the whole point of

relying on the formula apportionment approach is to

avoid such impossibly difficult questions. But a look at

the record provides more than sufficient evidence of the

possibilities of such misallocation. In general, Container

took advantage of numerous opportunities to share its

7 The Panamanian subsidiary was set up in part to avoid U.S.

federal taxes, Jt. App. 31. With the advent of Subpart F of the

Internal Revenue Code in 1962, I. R. C. §§ 951 et seq., and its sub-

sequent strengthening, this scheme apparently no longer worked,

and by 1968 the Panamanian subsidiary had been dissolved. In

1964 and 1965, Container’s “Panamanian income” was essentially

treated as earned in the United States for federal tax purposes,

i. e., foreign “deferral” was disallowed under Subpart F. See Jt.

App., Exhibits, at 7.

According to Container’s separate accounting system, the Italian

subsidiaries earned a total of $101,696 in 1963-65, Jt. App., Ex-

hibits, at 1, 3, 5, but Container says these same affiliates paid

$363,433 in Italian income taxes, Jt. App. 84.

10

good will, borrowing power, expertise, and so forth with

its foreign subsidiaries, often apparently at no charge.

Of course, there is nothing wrong with Container helping

its subsidiaries earn higher profits; in fact, such is to be

expected of a unitary, integrated business. But when

the costs of such assistance are assigned to the U.S.

rather than overseas, the result is a misallocation of re-

ported income.“

Some examples: Container made or guaranteed over

half the loans received by its foreign subsidiaries, Jt.

o The Treasury Department has described the general nature of

the tax avoidance opportunities available to U.S. multinationals as

follows:

“U.S. taxpayers have many opportunities to avoid U.S. taxes

by engaging in various pricing and other practices in transac-

tions with their controlled foreign corporations. A multina-

tional enterprise routinely engages in many transactions with

its foreign affiliates. It often sells machinery, parts, com-

ponents, and finished goods to these foreign corporations

It lends them money, leases them equipment, and provides a

wide range of managerial services. Basic research and develop-

ment programs for the mutual benefit of the domestic taxpayer

and its foreign affiliates are often centralized in the United

States. In computing foreign and domestic tax liabilities, a

company must assign transfer prices to such inter-affiliate

transactions. Although many multinational companies fol-

low perfectly acceptable transfer pricing practices, the experi-

ence of the Internal Revenue Service has been that some do

not, and the resultant loss of U.S. tax revenues can be sub-

stantial.”

U.S. Dept. of the Treasury, THE PRESIDENT’S 1978 TAX PROGRAM

286-87 (Jan. 30, 1978), printed in The President’s 1978 Tax Reduc-

tion and Reform Proposals: Hearings before the House Comm. on

Ways and Means, 95th Cong., 2d Sess. 160, 442-43 (1978) [herein-

after Treasury Testimony, with citations to the Ways and Means

hearing record]. A similar description of the tax avoidance/

evasion opportunities available to multinational firms can be found

in Comptroller General, IRS CouLp BETTER Protect U.S. Tax IN-

TERESTS IN DETERMINING THE INCOME OF MULTINATIONAL CoM-

PANIES, REPORT TO THE CHAIRMAN, HOUSE COMMITTEE ON Ways

AND MEANS 1-2 (1981) [hereinafter GAO Report].

11

App. 70. Each percentage point reduction in the interest

rate paid by the subsidiaries would misallocate about

$114,000 per year in net income to them.” Container also

brokered, at a bargain rate, some 90 percent of the equip-

ment purchases by the Latin American subsidiaries,

Jt. App. 77, which could have been worth about $300,000

a year to the subsidiaries. Technical assistance to the

Colombian and Venezuelan subsidiaries often went un-

reimbursed, Jt. App. 74-75, and based on the technical

assistance fees paid by other subsidiaries, this aid may

have been worth at least $400,000 per year. Container

made direct sales of equipment to subsidiaries, apparently

at below market prices in the years in question, Jt. App.

76-77, which may have saved the subsidiaries significant

amounts. Container’s sales of materials and stock in trade,

at alleged arm’s-length prices, averaged over $1 mil-

lion per year, Jt. App., Exhibits, at 8.“ Container shared

its U.S. good will with the subsidiaries, by recommending

them to its U.S. customers for overseas work, Jt. App.

32-33, apparently at no charge. Container’s $4.3-5.5 mil-

lion in annual product, design, and marketing research,

Jt. App. 27, was made freely available to the subsidiaries

10 The total outstanding loan advances from Container to its for-

eign subsidiaries in the years at issue averaged $6,028,000. Total

outside loans outstanding averaged $16,178,000, of which Container

“guaranteed approximately one third,” or about $5,393,000. Thus,

the total of loans made or guaranteed by Container to the sub-

sidiaries averaged approximately $11,421,000, or 51.4% of total out-

standing loans. See Jt. App. 69-70. Each percentage point differ-

ence in the interest rate would therefore be worth about $114,000

per year. During the years in question, the IRS had no standards

for evaluating such inter-affiliate loans. Under rules established in

1968, however, the minimum “safe-haven” interest rate for such

loans averaged over 4 percentage points below the U.S. prime rate

from 1968 to 1980. See GAO Report, supra note 9, at 16.

11 Container tries to belittle these purchases of materials by point-

ing out that they were only a small percentage of total cost of goods

sold. That fact is not dispositive or even important, however. After

all, taxable profits are generally only a relatively small percentage

of costs or sales, too.

12

when appropriate, as were samples of products, Jt. App.

33-35. Subsidiaries were assisted in setting up their

own design laboratories, again taking advantage of Con-

tainer’s expertise, Jt. App. 35. Container helped with

personnel management, Jt. App. 48, 50, 60-62, and applied

its expertise to evaluate all major capital spending de-

cisions, Jt. App. 39. It trained foreign employees in the

U.S., Jt. App. 69. And so on and so on. The total value

of these and other benefits provided to affiliates without

proper reimbursement could easily exceed the approxi-

mately $3.9 million a year at issue between U.S. and

foreign apportionment, not to mention the $2.6 million

at issue if “Panamanian income” is excluded.

Container’s brief makes several detailed economic ar-

guments contending that California’s formula apportion-

ment system produces incorrect results in specific situa-

tions. All these arguments are interesting; none of them

is convineing. But most important, such economic the-

12 For example, Container devotes a significant portion of its

brief to the contention that California’s formula fails to take ac-

count of different levels of profitability in foreign versus domestic

operations. Foreign operations, says Container, are generally more

profitable because they are riskier. For evidence of this economi-

cally rather puzzling contention, it points to the testimony of a wit-

ness who, extrapolating from several studies of the U.S. stock and

bond markets, suggested that “there is a profitability of foreign

operations, across all countries, on average, over time, very often

larger than that on the domestic operation.” Jt. App. 148 (appar-

ent transcription errors have been corrected). If this heavily quali-

fied assertion is supposed to mean that corporate rates of return

are lower in the U.S. than abroad, it would surprise most foreign

corporate executives, since U.S. corporate profitability has gener-

ally been substantially higher than that of foreign firms. Compare,

for example, International Corporate Scoreboard, BUSINESS WEEK,

July 20, 1981, pp. 86 et seg. (showing for foreign-based firms an

average return on equity of 11.7% and an average return on sales

of 3.0%) with Corporate Scoreboard, BUSINESS WEEK, March 16,

1981, pp. 65 et seq. (showing for U.S. based firms an average re-

turn on equity of 15.3% and an average return on sales of 9.0%).

It might also surprise the Treasury Department. One of Treasury’s

13

orizing has no place before this Court. Even absent the

staggering caseload burden faced by the Court, it is not

appropriate for this Court to be asked to pore over

financial statements and evaluate various economic the-

ories every time a corporate taxpayer disputes a state’s

apportionment of its taxable income by a few percentage

points.

II. Formula apportionment of the worldwide income of

unitary businesses is an appropriate means for the

states to determine the in-state income of multinational

firms.

Container argues that formula apportionment of world-

wide unitary income is always “inherently arbitrary.” It

contends that the only allowable method is the arm’s-

length, separate-accounting system. The question before

the Court, then, is whether the arm’s-length approach is

so clearly correct and so clearly superior to the formula

approach that the states are constitutionally required to

use it. The answer to this question is no.

Container’s panegyrical view of the arm’s-length

method is shared by few, if any, analysts who have

studied the IRS efforts to utilize that approach under

section 482 of the Internal Revenue Code. For example,

a 1981 General Accounting Office (GAO) report found:

“Representatives of all groups affected by and

knowledgeable about section 482 enforcement under

the arm’s length standard have voiced continuous

and substantive criticism of the regulations. The

criticisms focus on the fact that section 482 enforce-

ment creates a large administrative burden and that

criteria for choosing which multinational firms to audit under its

arm’s-length approach is: “Consolidated worldwide profits [i.e.,

profitability] are higher than U.S. profits. This type of situation

can be an indication that profits of the U.S. corporations are being

diverted to a tax haven country.” GAO Report, supra note 9, at 37.

14

the end result . . . is too often unpredictable and

subjective.

After reviev tag the years of effort by the Treasury in

attempting to improve enforcement under the arm’s-

length standard, the GAO report concluded as follows:

“RECOMMENDATION TO THE SECRETARY OF

THE TREASURY. We recommend that the Secre-

tary of the Treasury initiate a study to identify and

evaluate the feasibility of ways to allocate income

under Section 482, including formula apportionment,

which would lessen the present uncertainty and ad-

ministrative burden created by the existing regula-

tions.“

We would be remiss not to point out that this recom-

mendation elicited criticism from the Treasury Depart-

meni, which wrote that, while “the arm’s-length prin-

ciple may have both conceptual and practical limitations

in a world of integrated firms selling differentiated prod-

ucts,” “[i]n terms of economic rationale, formula appor-

tionment has little merit” as well.!“ As Container sug-

gests in its brief, Treasury has traditionally criticized

the formula apportionment method in its written state-

ments. But GAO’s conclusion recommending reconsid-

eration of a federal formula approach was based largely

on Treasury’s own statements about the terrible prob-

lems it has encountered in attempting to enforce the

arm’s-length system.

The GAO report quotes a former Deputy Assistant

Treasury Secretary as lamenting how “impossible” it is

to achieve better than “a rough and unproven estimate”

of proper cost allocation under the arm’s-length system."

13 GAO Report, supra note 9, at 43.

14 Jd. at 53-54 (emphasis added).

10 Jd. at 93, 95.

16 See Brief of Appellant, at 29-34.

17 GAO Report, supra note 9, at 48.

15

Similarly, in 1978 the Treasury Department complained

to Congress about the “substantial” revenue loss to the

federal government which results from IRS’s inability to

police the arm’s-length standard effectively, and noted:

“Of course, extensive Regulations setting forth pro-

cedures for determining arm’s-length transfer prices

were published in 1968, and have limited the range

of discretion previously available to taxpayers. But

no one familiar with international tax planning be-

lieves that the Regulations have taken the tax incen-

tive out of transfer pricing.” *

As Treasury’s 1978 statement notes, for the tax years

at issue in this case, there were not even detailed regula-

tions at the federal level to enforce the arm’s-length

standard.” But more important, the issuance of these

regulations has not stemmed the frustration with section

482 and arm’s-length, separate accounting or the criti-

cisms of the inefficiency of tax enforcement under that

approach.

Actions may speak louder than words, and, in fact,

despite its protests to the contrary, Treasury typically

has been unable to utilize a purely arm’s-length approach

in its own enforcement of the tax laws with regard to

multinational companies—and instead has been moving

away from the arm’s-length approach to a significant

degree. The 1981 GAO report found that “only 3 percent

of the . . . IRS recommended section 482 adjustments

[in the cases covered by the GAO study] were based on

arm’s length prices determined through uncontrolled

transactions.“ Twenty-two percent of the adjusted

amounts were based on “safe-haven” rules which may

18 Treasury Testimony, supra note 9, at 443 (emphasis added).

19 The 1981 GAO report explains that the IRS had little need for

detailed regulations, “because it seldom used” section 482. GAO

Report, supra note 9, at 3.

20 Id. at 29.

16

have little or no relation to arm’s-length pricing." And

two-thirds of the amounts adjusted were based on “alter-

native techniques,” including such things as assigning an

assumed profit margins to labor costs or sales.

While some have quibbled with GAO’s exact statistics,”

there is little doubt that in a large proportion of the fed-

eral section 482 cases the information necessary to deter-

mine true arm’s-length transfer prices has been unavail-

able, and “IRS agents and the courts have been left to

determine the proper allocation on whatever ad hoc basis

seems appropriate.“ Faced with these difficulties, Treas-

ury has been attempting to move toward the increased

use of formulas and rules of thumb in international tax

enforcement. Most notably, in 1977 Treasury issued new

rules for apportioning corporate overhead, research and

development costs, and interest expenses between domes-

tic and foreign sources under section 861 of the Internal

Revenue Code, a cousin of section 482. The centerpiece

of the new rules is a series of formula apportionments,

based on sales and assets.“

The complaints about the defects of the arm’s-length

allocation system have not been limited to the grum-

blings of tax collectors. Corporate taxpayers also have

been extremely critical of IRS enforcement under section

482—and not merely of IRS techniques, but of the basic

arm’s-length philosophy. The GAO report cites a 1980

business survey which found that:

21 Id. at 29. As noted supra, for example, the “safe haven“ inter-

est rate has been well below the U.S. prime rate. Id. at 16.

22 Jd. at 29-32.

23 See id. at 33, 83.

24 Joint Committee Testimony, supra note 3 at 52.

25 Treas. Regs. § 1-861-8. See 42 Fep. Rec. 1195 et seq. (Jan. 6,

1977) for the rules and the Treasury explanation of their formula

approach.

17

“Although [multinational firms are] composed of

numerous legally separate entities, [a majority of

the executives of such firms offering an opinion]

reveal that their companies make most intercom-

pany pricing decisions as though the organization is

one economic unit. This basic difference in philos-

ophy between the IRS and multinational corporations

is central t the Section 482 controversy.” **

More specifically, reports the GAO, corporate officials

have called outcomes under section 482 “arbitrary,” and

have complained that “the analytical approach to deter-

mining arm’s length prices often leads to unreasonable

results.” *

“Arbitrary” and “unreasonable.” The striking similarity

between these business criticisms of the arm’s-length

method and the complaints Container nd its corporate

amici are now making about California’s formula ap-

proach suggests that something less than principle may

be at work here. That suspicion is strengthened by the

praise in Container’s brief for the formula approach em-

ployed under the section 861 source rules,“ which several

26 Burns, How IRS applies the intercompany pricing rules of

Section 482: A corporate survey, 52 J. Tax. 308, 314 (May 1980)

(emphasis added), paraphrased in the GAO Report, supra note 9,

at 45. The surveyed executives agreed with the quoted statement

by a 49-41 percent margin, with 10 percent undecided. The Burns

study also found that “[w]hile most [executives] seera to accept

the basic arm’s-length premise,” 52 J. Tax., at 313, this acceptance

went only so far as favoring a system of transfer pricing. In set-

ting those transfer prices, most opposed a true arm’s-length ap-

proach and favored instead such t! igs as cost-plus pricing, safe-

haven rules, profit splitting based on formulas, or other formula

approaches. Id. at 309, 313.

27 GAO Report, supra note 9, at 44.

28 See Brief of Appellant, at 30-31.

18

commentators have criticized as too generous to multi-

national firms.”

No one who has studied this complex area of the tax

laws in depth could honestly argue to this Court that the

formula approach to apportioning multinational corporate

income achieves perfect results in all instances.” But it

is equally clear that the arm’s-length approach is not

the panacea Container claims it to be. The staff of the

congressional Joint Committee on Taxation has sum-

marized the views of international tax experts on the

arm’s-length versus formula apportionment issue as fol-

lows:

“Given the problems which exist with the States’

methods of apportionment under combined reporting

and with the Federal Government’s allocaticu rules,

there is considerable disagreement as to which

method is preferable in various situations.” “

In fact, the large number of distinguished commenta-

tors who have argued in favor of the formula approach

on a worldwide basis should by itself resolve this issue

in California’s favor. While reasonable minds, can, of

20 See, e.g., M.J. McIntyre, An Inquiry Into the Special Status of

Interest Payments, 1981 DUKE L. J. 765, 806 n. 132 (1981) (“The

Treasury’s source rule also contained many special rules that can

only be explained as concessions to political exigencies.” ) ; Tax Re-

form Research Group, Comments on Proposed Regulations Dealing

with Allocation and Apportionment of Deductions Between Domes-

tic and Foreign Source Gross Income, Dec. 16, 1976 (unpublished

comments submitted to the Treasury Department).

0 In fact, California allows companies which feel that the for-

mula produc.s unreasonable results to challenge those results in

administrative proceedings, on a case-by-case basis. See section

25137 of the California Revenue and Taxation Code. The same

provision for modification of formula apportionment on a case-by-

case basis is contained in section 19 of the Uniform Division of

Income for Tax Purposes Act, which has been adopted by 25 states

and the District of Columbia.

31 Joint Committee Testimony, supra note 3, at 52.

19

course, differ on the question of the “best” approach to

apportioning the income of multinational firms, California

has clearly chosen an approach which is by no means

“inherently arbitrary”—either in theory or in the minds

of numerous experts.”

32 See, e.g., Harley, International Division of the Income Taz

Base of Multinational Enterprise: An Overview, TAX Notes, Dec.

28, 1981, at 1563, 1567 (Based on “a measured evaluation” of the

arm’s-length versus the formula approach to allocating multina-

tional corporate income, “the formula approach is the better one.

Perhaps the underlying reason for its superiority is that the formula

approach makes no claims to achieve a perfect result. It recognizes,

rather, that a perfect allocation is impossible, The unitary system

seeks a reasonable division of income by formula. The arm’s-length

standard strives for reasonable accuracy, but it fails to achieve it,

and its theoretical basis is unsound,”); P. Musgrave, The U.K.

Treaty Debate: Some Lessons for the Future, Tax Notes, July 10,

1978, at 27, 28 (“Proponents . . [have] suggested that the arm’s-

length separate-accounting method is inherently closer to establish-

ing the true source of profits and therefore is less arbitrary than

the unitary approach. Such is far from the case. . The use of

the unitary method as implemented by a factor formula is not per-

fect, but it places less of a burden on administrative resources than

does enforcement of the separate-accounting-arm’s-length approach.

... [T]here is less danger of base slippage and discretionary profit

shifting on the part of the taxpayer and there are fewer items

which have to be audited and checked.”) ; Dexter, The Unitary Con-

cept in State Income Taxation of Multistate-Multinational Busi-

nesses, 10 URBAN LAWYER 181, 183 (1978) (“the [unitary] concept,

in my view, . . . is required to determine properly the portion of a

tax base reasonably attributable to a taxing state.”); Comment,

Multinational Corporation and Income Allocation Under Section 482

of the Internal Revenue Code, 89 Harv. L. Rev. 1202, 1228 (1976)

(“The unitary entity theory has certain clear advantages. Principal

among these is its theoretical superiority as a means for ascertain-

ing the true income of various MNC [multinational corporation]

components.“); Rudolph, State Taxation of Interstate Business: The

Unitary Business Concept and Affiliated Corporate Groups, 25 Tax

L. Rev. 171, 207-08 (1970) (“section 482 type adjustments do not

appear to provide a satisfactory alternative to combined reporting.

. . It is, of course, the inadequacy of separate accounting . . . that

provides the underlying rationale for formulary apportionment.”

20

III. California is not unconstitutionally undermining the

foreign policy of the United States by its use of world-

wide formula apportionment, nor has Congress violated

the constitution by its repeated refusals to restrict the

power of the states to use the worldwide formula

approach.

Container’s final attack on worldwide formula appor-

tionment consists of the contention that California is un-

constitutionally subverting the foreign policy of the

United States by failing to follow the IRS regulations on

income allocation. Logically, this argument would seem

to apply equaliy to the U.S. Congress for its refusal to

prohibit the states from using the worldwide combination

approach in taxing multinational companies. And, in

fact, Container rehearses the same arguments it and

others have made to the Congress in this regard, argu-

ments which the Senate explicitly rejected when it

stripped a restriction on state use of worldwide combi-

nation from a proposed tax treaty with the United King-

dom in 1978 and which the full Congress has repeatedly

rebuffed for over 20 years by refusing to enact proposed

legislation to restrict state formula apportionment

powers.“

As Container's brief admits, the standard to be applied

in resolving this issue is whether California’s action and

Congress’ considered inaction “stand[] as an obstacle to

5 In 1978, the Senate refused to ratify the proposed tax treaty

with the United Kingdom until a restriction on the states’ use of

the worldwide combination method with regard to foreign multi-

nationals was deleted. In so doing, the Senate explicitly rejected

contentions by the Treasury Department that such a restriction was

appropriate to avoid “disconcerting .. . international relations.”

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

the Republic of tke Philippines, Hearings before the Sen. Comm. on

Foreign Relations, 95th Cong., Ist Sess. 28 (1977). Since 1965, bills

dealing with state taxation of multistate and multinational corpora-

tions have been introduced in every session of Congress, but none

has been enacted.

21

the accomplishment and execution of the full purposes and

objectives of Congress.” Hines v. Davidowitz, 312 U.S.

52, 67 (1941). Merely to state the question clearly is

to resolve it in California’s favor. Beyond peradventure,

Congress does not believe its “purposes and objectives”

are contravened by California’s use of worldwide formula

apportionment. This Court has no need to protect Con-

gress from a danger our legislators, after careful delib-

eration, have found insufficient to justify national inter-

ference with the sovereign taxing powers of the states.™

IV. The decision of how to measure the in-state income of

multinational firms is a political question which the

constitution leaves to the states and (perhaps) to the

Congress.

The implicit assertion throughout Container’s brief is

that a decision in favor of California in this case would

leave the states with unbridled power to tap unfairly the

“deep pockets” of multinational firms. This is simply not

the case, for a number of reasons.

First of all, the formula approach produces generally

fair results—in the opinion of a great number of experts,

the fairest results attainable given the complexities of

international business transactions. Second, companies

always have the option to move their operations outside

a state’s borders if they find its tax regime intolerable,

a threat which they have used to great advantage in

Se Brief of Appellant, at 35.

35 Container’s attempted reliance on Japan Line Ltd. v. County of

Los Angeles, 441 U.S. 434 (1979), is misplaced. That case involved

a county tax on instrumentalities of foreign commerce which by

treaty were exempted from federal taxes and customs duties under

a policy which the Court found would be clearly undermined by

state taxation. The dispute in the instant case, on the other hand,

is over the measurement of income from various sources, and Con-

gress has repeatedly refused to restrict state use of measurement

techniques different from those spelled out in IRS regulations.

garnering a vast array of state and local tax breaks over

the years.“ Few, if any, states can be expected to adopt

tax approaches which demonstrably drive businesses and

jobs away. In this light, the fact that there has been no

rush by multinational firms away from California, but

instead a steady movement into the state, provides fur-

ther evidence that the formula apportionment approach

does not produce unfair results.“ And finally, Container

and its allies can always petition the U.S. Congress for

relief—although we do not believe Congress should grant

it.“ In fact, multinational companies have brought this

36 See, e.g., J. Jacobs, BIDDING FOR BUSINESS: CORPORATE AUC-

TIONS AND THE 50 DISUNITED STATES. (1979).

* Most notably, California even leads the country in e*tracting

investment by foreign-based multinationals, despite the fact that

many of them, by locating in California, may subject themselves to

taxation based on formula apportionment of their worldwide income.

According to reports published by the U.S. Census Bureau, Califor-

nia leads the nation in the number of foreign-owned firms with two

or more establishments and has widened its lead over other states

since the Bureau began its series of reports in 1975. In 1980, the

last year for which data are available, California had 4,829 such

foreign-owned establishments (1,130 more than second-place New

York), compared to 1,999 in 1975 (325 more than second-place

Ohio). U.S. Dept. of Commerce, Bureau of the Census, SELECTED

CHARACTERISTICS OF FOREIGN-OWNED U.S. Firms: 1980, Table 6

(1982) ; U.S. Dept. of Commerce, Bureau of the Census, SELECTED

CHARACTERISTICS OF FOREIGN-OWNED U.S. Fmus: 1975-1976, Table

7 (1979).

38 As this Court stated in Moorman Mfg. Co. v. Bair, 437 U.S.

267, 280 (1978) (dicta) :

“It is clear that the legislative power granted to Congress by

the Commerce Clause of the Constitution would amply justify

the enactment of legislation requiring all States to adhere to

uniform rules for the division of income. It is to that body,

and not this Court, that the Constitution has committed such

policy decisions.”

At least one congressional analyst has contended that even Congress

may lack power to interfere with the states’ taxing power by re-

stricting worldwide formula apportionment. In a paper prepared in

23

issue repeatedly before Congress, and have been repeat-

edly rebuffed.

At bottom, the arm’s-length versus formula apportion-

ment controversy is not a constitutional question. It is

a political issue, in which states are attempting to protect

their tax bases and some multinational firms are seeking

to lower their tax bills.

Quite naturally, corporate taxpayers, like most natural

citizens, prefer to pay as little in taxes as possible. Ac-

cordingly, companies pursue every opportunity to create

legal devices which allow them to escape taxation of their

income.“ Every dollar of legitimate taxation they are able

to avoid, however, is a doliar which must be paid for by

other taxpayers, either in increased taxes or reduced

services. Particularly in the states, where balanced

budgets generally are constitutionally mandated, tax

avoidance imposes a heavy cost.

1978, Archie Parnell, Senior Staff Counsel to the Ways and Means

Oversight Subcommittee, together with William L. Shraberg, a trial

attorney with the Tax Division of the Justice Department, Gloria

Dunbar, and Abbe Jolles, argued that “a court could conclude that

a state, as a sovereign entity under our federal system, as long as

a non-discriminatory state income tax does not violate the Com-

merce Clause, is free to structure its taxes in any manner it chooses.

Such a conclusion would necessarily mean that [a restriction on the

use of worldwide formula apportionment] would be found to be

unconstitutional.” Parnell, Shraberg, Dunbar, & Jolles, Article 9(4)

and the Constitution, TAX NOTEs, July 10, 1978, at 29.

39 A 1980 study, for example, calculated that in 1980 the 23 larg-

est oil companies would fail to report to state tax departments

almost half the domestic profits they reported to the federal gov-

ernment. The estimated unreported income totalled $9.7 billion,

resulting in a state revenue loss of over $450 million. The study

blamed the failure by state governments to detect this under-

reporting largely on the use by a large number of states of a

separate-accounting approach to allocating interstate income. Citi-

zen/Labor Energy Coalition, Where Have All The Profits Gone:

A Study of State Undertazation of the Oil Industry (Washington,

D.C. 1980) (mimeographed copy).

24

The states therefore have good reason to try to assure

that their tax laws are effectively enforced. California,

along with a number of other states, has concluded that

adoption of the arm’s-length approach would mean ceding

its tax jurisdiction over multinational firms to the

vagaries of federal enforcement under section 482 of the

Internal Revenue Code.“ California reasonably believes

it can obtain the most accurate measurement of the tax-

able income earned in California by multinational firms

such as Container through the use of a simple, fair, and

administrable system of worldwide combined apportion-

ment—a belief sustained by the well-documented short-

comings of the arm’s-length methodology and the strong

expert support for the formula approach.

California’s preference for formula apportionment is a

political choice as to the best way fairly to share its tax

burden and protect its average individual and busi-

ness taxpayers. It is no less a political choice than

was its decision in 1972 to institute a system of tax with-

holding and declaration of estimated taxes. Nor is it any

less political than the decision of states like Nevada and

Texas to impose no corporate income tax at all or the

choice of states such as Connecticut and Florida to im-

pose corporate, but not personal, income taxes.

Having failed to overturn California’s formula ap-

proach through the political process, Container and its

10 California’s adoption of the federal allocation system would

also apparently make it vulnerable to the vagaries of congressional

“tax incentive” policies. In 1981, for example, Congress directed

Treasury to modify at least temporarily its source rules under sec-

tion 861 of the Internal Revenue Code, so that “the expenses related

to all research activities conducted in the United States should be

charged to the cost of generating U.S. source income, whether or

not such research directly or indirectly is a cost of producing for-

eign source income.” Staff of the Joint Committee on Taxation,

GENERAI, EXPLANATION OF THE ECONOMIC RECOVERY TAX ACT OF

1981, 142 (1981). The reason offered for the action was to try to

encourage research activities in the United States. Id.

25

allies have now brought the issue before this Court. Their

challenge, masquerading as constitutional, is actually a

political one. It should be rejected.

CONCLUSION

For the foregoing reasons, we urge the Court to affirm

the judgment of the court below.

Respectfully submitted,

ROBERT S. MCINTYRE

2020 K Street, NW, Suite 200

Washington, D.C. 20006

(202) 293-5340

Attorney for Amici Curiae

Citizens for Tax Justice;

American Federation of State,

County and Municipal Employees;

Citizen/Labor Energy Coalition;

Consumer Federation of America;

International Association of Machinists

and Aerospace Workers;

International Union of Operating

Engineers;

National Council of Senior Citizens; and

Service Employees International Union