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

IN THE

Supreme Court of the United States

OCTOBER TERM, 1981

CONTAINER CORPORATION OF AMERICA,

Appellant,

V.

FRANCHISE TAX BOARD,

Appellee.

On Appeal from the Court of Appeal

of the State of California

BRIEF FOR FINANCIAL EXECUTIVES INSTITUTE

AS AMICUS CURIAE

WILLIAM H. ALLEN *

JOHN B. JONES, JR.

MARK I. LEVY

COVINGTON & BURLING

1201 Pennsylvania Avenue, N.W.

P.O. Box 7566

Washington, D.C. 20044

(202) 662-6000

July 1982

* Counsel of Record

ee ee

QUESTION PRESENTED

Whether a state transgresses the constitutional reser-

vation to the national law-making body of the power

“([t]o regulate Commerce with foreign Nations“ when it

taxes the income of a corporation with foreign affiliates

by treating the entire corporate family as a unit, com-

bining the separate incomes of all its members, and mak-

ing an apportionment of the total to determine the state’s

share, in contradistinction to treating separate national

corporate income accounts separately save as some re-

,allocation may be needed to prevent distortion, which is

the method of income taxation adopted by the national

authorities of the United States and by the United States’

foreign trading partners and which represents the inter-

national norm.

(i)

TABLE OF CONTENTS

Page

Interest of Financial Executives Institute 1

Introduction and Summary of Argument 2

r nSnr c e ee NeeCar ce RN OER DET 4

A State’s Unitary, Combined-Reporting Appor-

tionment of Worldwide Income Violates the For-

eign Commerce Clause Because It Deviates From

and Is Inconsistent With the International

Norm of Separate-Source, Arm’s-Length Alloca-

tion Adopted by the United States Government

and Its Foreign Trading Partners .......................... 4

A. The Federal Government’s Authority Over

Foreign Commerce and International Affairs

Is Preeminent and Fxclusive ..............0000000.0..... 4

1. As this Court Has Recognized From the

Earliest Days to the Present, the Need to

Establish National Control of Foreign

Trade and Other Intercourse Was a Prin-

cipal Animating Reason for the Writing

and Adoption of the Constitution 5

2. This Court Has Recognized the Paramount

Role of the National Government in Inter-

national Matters, Including Foreign Trade,

as an Outgrowth of the Nation’s Constitu-

RATE ec 8

3. This Court in Japan Line Reaffirmed and

Applied the Principles of Exclusive Na-

tional Competence in Foreign Trade Mat-

ters in Invalidating a State Tax That Re-

sulted in Taxation Duplicative of That of

a Foreign Nation and Impaired the Ability

of the United States to Speak With One

Voice in Regulating Commercial Relations

With Foreign Government?́ 10

(iii)

iv

TABLE OF CONTENTS—Continued

B. Because It Deviates From the International

Norm of Separate-Source, Arm’s-Length Al-

location Adopted by the United States and

Other Nations, California’s Worldwide-Com-

bined-Reporting Method of Apportionment

Violates the Foreign Commerce Clause

1.

Conclusion

Congress Has Provided in the Rel want

Provisions of the Internal Revenue Coue for

Separate-Source, Arm’s-Length Taxation of

Multinational Incounmmm

In Treaties as Well as in the Internal Reve-

nue Code, the National Government Has

Commited Itself to Separate-Source, Arm's-

Length Accounting for Income Tax Pur-

California’s Worldwide-Combined-Appor-

tionment Method Results in Duplicative

Taxation and Is at Odds With the Method

of Aliocating Income for Income-Tax Pur-

poses Used by the United States and Its

Trading Partners in the International Com-

.

The Flaws That Inhere in the Worldwide-

Combined-Apportionment Method Under-

score Its Constitutional Impermissibility...

—— ̃ MMUũMm«k«kkkkk˖kk˖lauAkAſ eee rere ee eee eee eee eee eee

Page

13

13

17

19

29

Vv

TABLE OF AUTHORITIES

Cases: Page

American Chicle Co. v. United States, 316 U.S.

r aa a 15

ASARCO, Inc. v. Idaho State Tax Comm., No. 80-

9015 (U.S. June 39, 1968) ...............0...2..-.......... 13, 28, 29

Associated Tel. & Tel. Co. v. United States, 306

F.2d 824 (2d Cir. 1962), cert. denied, 371 U.S.

I I a ode eneiasieanddatiniion 15

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

mission, 266 U.S. 271 (192 28

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

CEE peer eae ene ee 3, 5, 8

Brown v. Maryland. 25 U.S. (12 Wheat.) 419

%%% ͤ—T— ——. 8 6

Burnet v. Chicago Portrait Co., 285 U.S. 1 (1932) 15

Chase Brass & Copper Co. v. Franchise Tax

Board, 400 UB. 961 (19900 ———— 1

Chicago Bridge & Iron Co. v. Caterpillar Tractor

Co., restored to the calendar for reargument,

PS fF ff ee 1, 23

Chinese Exclusion Case, The, 130 U.S. 581 (1889).. 8

Chy Lung v. Freeman, 92 U.S. (2 Otto) 275

SERRA SURES ae misc ye Pr «Kir sence a 9,10

Commissioner V. First Security Bank of Utah,

ee 5 El re 16

Cook v. Pennsylvania, 97 U.S. (7 Otto) 566

%%%%%%XTTTTTTT—T—T—TV—VT—T—T—T—VTV—T—V—T—TV—T—TVTT—T oR eee 6

County of Mobile v. Kimball, 102 U.S. (12 Otto)

r ͥ T 9

Department of Revenue v. Association of Wash-

ington Stevedoring Companies, 435 U.S. 734

%% PTT 8

Exxon Corp. v. Wisconsin Department of Reve-

r 25

F. W. Woolworth Co. v. Taxation and Revenue De-

partment of New Mexico, No. 80-1745 (U.S.

EPR AENEs ne-ttaee ee e 9

Hines v. Davidowitz, 812 U.S. 52 (1941) 8, 10

Inman Steamship Line v. Tinker, 94 U.S. (4 Otto)

Ec 9

vi

TABLE OF AUTHORITIES—Continued

Page

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

U.S. 434 (1979) 3, 6, 10-12, 19, 20, 21, 22, 25

Kassel v. Consolidated Freightways Corp., 450

e EP a eElP SRR ereen 9

Kenrecott Copper Corp. v. State Tax Comm'n,

e aoe 1

Lewis v. BT Investment Managers, Inc., 447 US.

r REA PERSO 6 aca 29

Maryland v. Louisiana, 451 U.S. 725 (1981).......... 23

Merrion v. Jicarilla Apache Tribe, 102 S. Ct. 894

Ecce 9

Michelin Tire Corp. v. Wages, 423 U.S. 276

reer 6, 9, 11, 23

Mobil Oil Corp. v. Commissioner of Taxes, 445

.. rae ene 22, 28

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

267, leave to file briefs as amici curiae granted

and reh. denied, 439 U.S. 885 (1978) ................ 1

National Paper & Type Co. v. Bowers, 266 U.S.

EERE RRR NSIT ane tees see EET OCD 14

New England Power Co. v. New Hampshire, 102

S. Ct. 1096 (1982) „F 29

Railroad Co. v. Maryland, 88 U.S. (21 Wall.)

e NH nEh Sens ERNE A 6

Reeves, Inc. v. Stake, 447 U.S. 429 (1980) 3, 10, 11

Underwood Typewriter Co. v. Chamberlain, 254

r SSE ae Pree 3 21. 28

United States v. Arjona, 120 U.S. 479 (1887) 8

United States v. Belmont, 301 U.S. 324 (1937) 5, 8

United States v. Curtiss-Wright Corp., 299 U.S.

ccc — 5, 9

United States v. Pink, 315 U.S. 203 (194277 8

Zschernig v. Miller, 389 U.S. 429 (1968) 8, 10, 29

Constitution, statutes, treaties, and regulations:

U.S. Constitution:

r / ( 5

D 5, passim

Art. I, § 8, cl. 10 — 5

vii

TABLE OF AUTHORITIES—Continued

Page

. 5

, 5

e ee eae ee mone 5

SER SL a RR a ce a 5

26 U.S.C

r 16, 17, 20

r 15

r AEA OC ATER 15

Es -- 15

Cal. Rev. & Tax. Code (West) :

%% — Rs SEP Oe NRE 2

. „ 2

( 2

1 2

1 CCH Tax Treaties:

"151 (OECD Model Income Tax Conven-

B AAA —— tial ataasins 18

7 158 (Treasury Department’s Model Income

. 18

7171 (U.N. Model Income Tax Convention) 18

. ER SEIT 17

. si hasiiinninlinbeeendddeaesabiniés 17

SESE CRS arenes an ree ne 17

EE SR OE eee eens esos es 17

RET AT te nee OOO a ee 17

2 CCH Tax Treaties:

78103A (United Kingdom)) 17

Treasury Regulations (26 C.F.R.) :

r RE se ee a 16

ER REE OS NE ST 17

Miscellaneous:

Abel, The Commerce Clause in the Constitutional

Convention and in Contemporary Comment, 25

II/ 6

viii

TABLE OF AUTHORITIES--Continued

Page

1 Beveridge, The Life of John Marshall (1916).... 7

3 Bittker, Federal Taxation of Income, Estates

, . ve 14, 17

2 Bittker, Emory, & Streng, Federal Income Tazxa-

tion of Corporations and Shareholders (Forms)

ES . 13, 14, 15, 16

Bittker & Eustice, Federal Income Taxation of

Corporations and Shareholders (4th ed. 1979) 15

Farrand, The Framing of the Constitution of the

ts atenaiie 7

Federalist, The (J. Cooke ed. 19611) 7,9

GAO Report on Determining the Income of Multi-

national Corporations (Sept. 30, 19817 25, 28

J. Hellerstein & W. Hellerstein, State and Local

Taxation (4th ed. 19789 n 21, 24, 25, 27

H.R. Rep. No. 1480, 88th Cong., 2d Sess. (1964) 25

S. Rep. No. 94-938, 94th Cong., 2d Sess. (1976) 15

State Taxation of Foreign Source Income: Hear-

ings on H.R. 5076 Before the House Comm. on

Ways and Means, 96th Cong., 2d Sess. (1980) .. 19, 22,

23

State Taxation of Interstate Commerce: Hearings

Before the Subcomm. on State Taxation of the

Senate Comm. on Finance, 93d Cong., 1st Sess.

STI incedestecsnceseninidndteninndunsiciiaigtiasesnianbariedtabsenitintesinincusies 25

State Taxation of Interstate Commerce and World-

wide Corporate Income: Hearings on S. 983

and S. 1688 Before the Subcomm. on Taxation

of the Senate Comm. on Finance, 96th Cong.,

, RE sna NCR 19, 23

Swisher, American Constitutional Development

ESTERS AISI CRE a Sao 7

Tax Conventions with Belgium, Finland, Trinidad

and Tobago, and the Netherlands: Hearings

Before the Senate Comm. on Foreign Relations,

ge ss 14

ix

TABLE OF AUTHORITIES—Continued

Page

Tax Treaties with the United Kingdom, the Re-

public of Korea, and the Republic of the Philip-

pines: Hearings Before the Senate Comm. on

Foreign Relations, 95th Cong., Ist Sess. (1977) .. 19, 22,

25, 26, 27

Thompson, Federal Income Taxation of Domestic

and Foreign Business Transactions (1980) ....13, 14, 16

Warren, The Making of the Constitution (1937).. 7

1 Watson, The Constitution of the United States

RIN 0s ARP ERIE ER eon ee Rea eh oe 6

IN THE

Supreme Cuurt of the United States

OCTOBER TERM, 1981

No. 81-523

CONTAINER CORPORATION OF AMERICA,

- Appellant,

FRANCHISE TAX BOARD,

Appellee.

On Appeal from the Court of Appeal

of the State of California

BRIEF FOR FINANCIAL EXECUTIVES INSTITUTE

AS AMICUS CURIAE

INTEREST OF FINANCIAL EXECUTIVES INSTITUTE

Amicus Financial Executives Institute is the profes-

sional association of 12,000 senior financial and adminis-

trative officers of 6,000 organizations, large and small,

throughout the United States and Canada. FEI’s mem-

bers represent a broad spectrum of commerce, trade, and

industry. FEI has filed briefs as amicus curiae in Chi-

cago Bridge & Iron Co. v. Caterpillar Tractor Co., re-

stored to the calendar for reargument, No. 81-349 (O. T.

1981); Moorman Manufacturing Co. v. Bair, 437 U.S.

267, leave to file briefs as amici curiae granted and reh.

denied, 439 U.S. 885 (1978); Kennecott Copper Corp. v.

State Tax Comm’n, 409 U.S. 973 (1972); and Chase

Brass & Copper Co. v. Franchise Tax Board, 400 U.S.

961 (1970).

FEI members’ companies do business in more than

125 foreign countries and in each of the 50 states, includ-

ing California and other states that tax on the basis of a

unitary, combined-reporting method for apportioning

worldwide income. In addition, FEI members’ companies

2

are involved in pending litigation concerning the validity

and application of the worldwide-combined-reporting

method. Accordingly, FEI is vitally interested in the

sound and informed resolution of the constitutional issues

raised by appellant.

The written consent of the parties has been obtained

and is being filed with the Clerk of the Court.

INTRODUCTION AND SUMMARY OF ARGUMENT

Appellant Container Corporation of America is a cor-

poration organized under the laws of Delaware with its

principal executive offices in Illinois. (J.A. 6-7.) Con-

tainer engages in business in California and other states

of the Union. In addition, during the years in question

here, Container had a controlling interest in a number of

subsidiaries that were organized under the laws of, and

did business in, foreign countries in Western Europe and

Latin America. (J.A. 7, 14-15, 30.)

California imposes upon corporations doing business

within the state a franchise tax based upon net income—

a state income tax. See Cal. Rev. & Tax. Code § 23151

(West). In accordance with governing provisions of state

law, id. §§ 25101, 25102, 25128, the California Franchise

Tax Board determined Container’s tax liability in the

following way. First, it concluded that Container and its

foreign subsidiaries constituted a unitary business enter-

prise. It then computed the combined worldwide income

of Container and its subsidiaries. Next, the Board calcu-

lated Container’s California income by apportioning a

part of this total worldwide income to the state according

to a three-factor formula. Finally, it applied to the cal-

culated California income the California tax rate. The

state courts rejected Container’s federal constitutional

challenges to this manner of determining its California

income tax and sustained the validity of the worldwide-

combined-reporting method of apportionment.

California’s method of worldwide-combined-apportion-

ment is unconstitutional under the Foreign Commerce

Clause. Federal authority over foreign commerce and

international relations is “exclusive and plenary” and

may not be “limited, qualified, or impeded to any extent

by state action.” Board of Trustees v. United States, 289

U.S. 48, 56-57 (1933). No less is demanded by the his-

tory and purpose of the relevant sections of the Constitu-

tion and the necessary role of our national government in

its relations with other nations. As the Court has re-

cently affirmed:

“Foreign commerce is preeminently a matter of na-

tional concern. . [T]he Framers’ overriding con-

cern [was] that the Federal Government must speak

with one voice when regulating commercial rela-

tions with foreign governments.” Japan Line, Ltd.

v. County of Los Angeles, 441 U.S. 434, 448-49

(1979).

Accordingly, there is a “more rigorous” standard for

judging the validity of state action that impinges on

foreign commerce than state action that affects only in-

terstate commerce, Reeves, Inc. v. Stake, 447 U.S. 429,

438 n.9 (1980). Even in the absence of affirmative fed-

eral preemption, the Commerce Clause serves to protect

the preeminent power of the national government over

foreign commerce by ensuring “federal uniformity .. .

where federal uniformity is essential. [The states]

may not tell this Nation or [foreign countries] how to

run their foreign policies.” Japan Line, Ltd. v. County of

Los Angeles, supra, 441 U.S. at 448, 455.

By statute and treaty, the United States and its

foreign trading partners have adopted the method of

separate-source, arm’s-length allocation for taxing the

income of multinational entities. In essence, this method

consists of determining the national or geographic source

of income for each separate taxpayer and, if necessary,

reallocating income between related taxpayers as if they

had dealt with each other at arm’s-length. By these

means, priority is given to the taxing authority of the

jurisdiction in which income was earned, and duplicative

taxation of income is avoided. The separate-source, arm’s-

length method is the prevailing international norm for

the taxation of multinational enterprises.

4

In contrast, worldwide-combined-apportionment aban-

dons altogether the approach of separate-source account-

ing and arm’s-length reallocation. Instead, it assumes

that income cannot be accounted for by source, and it

seeks to apportion to a state a part of the combined

worldwide income of the separate entities engaged in a

unitary business. It does not recognize the separateness

of taxing jurisdictions let alone give priority to the juris-

diction where income is earned, and it virtually ensures

duplicative taxation of income. Thus, worldwide-combined-

apportionment is irreconcilably at odds with the interna-

tional standard of separate-source, arm’s-length allocation.

The worldwide-combined-apportionment method adopted

by California threatens to impair federal supremacy in

this area and to disturb relations between the United

States and foreign countries. Indeed, a number of for-

eign governments have already complained to the United

States about the use of worldwide-combined-apportionment.

Because of the severe problems it raises—including dupli-

cative taxation, distortion and misapportionment of in-

come, and onerous burdens of compliance—the California

tax interferes with international trade and foreign af-

fairs and should not be allowed to stand.

ARGUMENT

A sTATE’S UNITARY, COMBINED-REPORTING

APPORTIONMENT OF WORLDWIDE INCOME VIO-

LATES THE FOREIGN COMMERCE CLAUSE BE-

CAUSE IT DEVIATES FROM AND IS INCONSIST-

ENT WITH THE INTERNATIONAL NORM OF

SEPARATE-SOURCE, ARM’S-LENGTH ALLOCATION

ADOPTED BY THE UNITED STATES GOVERNMENT

AND ITS FOREIGN TRADING PARTNERS

A. The Federal Government’s Authcrity Over Foreign

Commerce and International Affairs Is Preeminent

and Exclusive

Few constitutional principles are as well-established

as the preeminent authority of the federal government

in the area of foreign commerce and international af-

fairs. The Constitution expressly vests in Congress the

Power . . To regulate Commerce with foreign Na-

tions....” Art. I, 58, el. 3. Likewise, the federal gov-

ernment, acting through the President and the Sent te,

has the power “to make Treaties” with foreign nations.

Art. II, § 2, el. 2. And even where the Constitution is

not explicit, the foreign-affairs power of the federal gov-

ernment has been recognized. See, e.g., United States v.

Curtiss-Wright Corp., 299 U.S. 304, 315-18 (1936);

United States v. Belmont, 301 U.S. 324, 330-31 (1937).'

Concomitant with this authority conferred upon the

federal government, the Constitution removes from the

states the power to act in matters of international com-

merce and foreign relations. Thus, states are generally

prohibited “without the Consent of the Congress” from

laying “any Imposts or Duties on Imports or Exports,”

and any such duties or imposts that are allowed as “abso-

lutely necessary for executing [a state’s] inspection

Laws” are expressly made “subject to the Revision and

Controul of the Congress,” with the revenues therefrom

“for the Use of the Treasury of the United States

Art. I, S 10, el. 2. Similarly, Inlo State shall, without

the Consent of Congress, lay any Duty of Tonnage,”

“enter into any Treaty, Alliance, or Confederation,” or

“enter into any Agreement or Compact . . with a for-

eign Power Art. I. S 10, cl. 3. These specific

inhibitions underscore the majestically simple conferral

on Congress of the affirmative and exclusive power to

regulate commerce with foreign nations. See, e.g., Board

of Trustees v. United States, 289 U.S. 48, 57 (1933).

1. As this Court Has Recognized From the Earliest

Days to the Present, the Need to Establish Na-

tional Control of Foreign Trade and Other Inter-

course Was a Principal Animating Reason for the

Writing and Adoption of the Constitution

The establishment of exclusive federal authority over

foreign affairs, and especially foreign commerce, was a

With respect to federal authority over foreign commerce and

international relations, see also Art. I. § 8, cl. 1; Art. I. §8, cl. 10;

Art. II, § 2, el. 2; Art. II. 5 3.

major reason for the adoption of the Constitution. As

Chief Justice Marshall explained:

“The oppressed and degraded state of commerce pre-

vious to the adoption of the constitution, can scarcely

be forgotten. It was regulated by foreign nations,

with a single view to their own interests; and our

disunited efforts to counteract their restrictions, were

rendered impotent, by want of combination. Con-

gress, indeed, possessed the power of making treaties;

but the inability of the federal government to en-

force them had become so apparent, as to render that

power in a great degree useless. Those who felt the

injury arising from this state of things, and those

who were capable of estimating the influence of com-

merce on the prosperity of nations, perceived the

necessity of giving the contro] over this important

subject to a single government. It may be doubted,

whether any of the evils proceeding from the feeble-

ness of the federal government [prior to the Consti-

tution], contributed more to that great revolution

which introduced the present system, than the deep

and general conviction, that commerce ought to be

regulated by congress.” Brown v. Maryland, 25 U.S.

(12 Wheat.) 419, 445-46 (1827). See also Cook v.

Pennsylvania, 97 U.S. (7 Otto) 566, 574 (1878);

Michelin Tire Corp. v. Wages, 423 U.S. 276, 283

(1976).

At the time of the Convention, “the major concern was

with extranational traffic, with only incidental and minor

regard to interstate commerce. . . . [T]he major preoc-

cupation [regarding trade and commerce] was with for-

eign trade and . . . the power over interstate commerce,

while coordinate in expression, was distinctly secondary

in scope and intended operation.” Abel, The Commerce

Clause in the Constitutional Convention and in Contem-

porary Comment, 25 Minn. L. Rev. 432, 465, 469 (1941),

cited with approval in Japan Line, Ltd. v. County of

Los Angeles, 441 U.S. 434, 448 n.12 (1979). See also

1 Watson, The Constitution of the United States 479-80,

483 (1910); cf. Railroad Co. v. Maryland, 88 U.S. (21

Wall.) 456, 470 (1874).

7

The records of the adoption of the Constitution con-

firm the central importance of the establishment of fed-

eral authority over commercial and diplomatic relations

with foreign governments. See generally 1 Beveridge,

The Life of John Marshall 304-05, 308-12 (1916); Far-

rand, The Framing of the Constitution of the United

Statee 5-12 (1913); Swisher, American Constitutional

Development 25-27 (2d ed. 1954); Warren, The Making

of the Constitution 567-90 (1937). The Federalist Papers

reflect that importance. Madison thought that “[t]he

powers delegated by the proposed Constitution to the

Federal Government. . . will be exercised principally on

external objects, as war, peace, negociation, and foreign

commerce.” The Federalist No. 45, at 313 (J. Cooke

ed. 1961). As Madison observed, [if we are to be one

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

to other nations. . The regulation of foreign commerce

. . . [is] properly submitted to the federal administra-

tion.” The Federalist No. 42, at 279, 281 (J. Cooke ed.

1961). Hamilton also recognized the importance of this

matter. He said that “(t]he want of a power to regulate

commerce is by all parties allowed to be” one of “the

defects . . in the existing Federal system . . which

concur in rendering it altogether unfit for the adminis-

tration of the affairs of the Union.. . . It is indeed evi-

dent, on the most superficial view, that there is no object,

either as it respects the interests of trade or finance

that more strongly demands a Federal superintendence.”

The Federalist No. 22, at 135-36 (J. Cooke ed. 1961).

Without federal superintendence, he went on,

“(njo nation acquainted with the nature of our po-

litical association would be unwise enough to enter

into stipulations with the United States, by which

they conceded privileges of any importance to them

. . . [because t]he treaties of the United States,

under the present constitution, are liable to the in-

fractions of thirteen different Legislatures... .” Id.

at 136, 144. See also id., No. 11, at 65 (Hamilton).

2. This Court Has Recognized the Paramount Role

of the National Government in International Mat-

ters, Including Foreign Trade, as an Outgrowth

of the Nation’s Constitutional History

Consistent with our federal system of government and

the history and intendment of the Constitution, this

Court has long recognized the paramount role of the

national government in international affairs:

“(T]he supremacy of the national power in the gen-

eral field of foreign affairs . . is made clear by the

Constitution, was pointed out by the authors of the

Federalist in 1787, and has since been given con-

tinuous recognition by this Court... The Federal

Government, representing as it does the collective

interests of the . . . states, is entrusted with ful’ and

exclusive responsibility for the conduct of affairs with

foreign sovereignties. ... Our system of government

. . - imperatively requires that federal power in the

field affecting foreign relations be left entirely free

from local interference.” Hines v. Davidowitz, 312

U.S. 52, 62, 63 (1941).

What was said in general terms in Hines v. Davidowitz

of the preeminence of federal power in international

affairs is true in particular regard to the federal power

over foreign commerce. We have quoted above from

Board of Trustees v. United States, 289 U.S. 48, 56-57

(1933), the Court’s forceful comment that the national

power over foreign commerce is “exclusive and plenary”

and “may not be limited, qualified or impeded to any

extent by state action.” The Court went on there to say:

“In international relations and with respect to for-

eign intercourse and trade the people of the United

States act through a single government with unified

and adequate national power.... [This] single con-

2 See also, e.g., Department of Revenue v. Association of Wash-

ington Stevedoring Companies, 435 U.S. 734, 754, 758 (1978);

Zschernig v. Miller, 389 U.S. 429, 440-41 (1968) ; United States v.

Pink, 315 U.S. 203, 232-34 (1942); United States v. Belmont, 301

U.S. 324, 330 (1937); The Chinese Exclusion Case, 130 U.S. 581,

606 (1889); United States v. Arjona, 120 U.S. 479, 483 (1887).

9

trol... [of foreign commerce] was one of the domi-

nant purposes of the Constitution to create.” Id. at

59.*

For this reason, as the Court recently noted, It Ihe

States. . are subject to limitations on their taxation

powers that do not apply to the Federal Government.”

F.W. Woolworth Co. v. Taxation and Revenue Depart-

ment of New Mexico, No. 80-1745 (U.S. June 29, 1982),

slip op. 8. And the Commerce Clause of its own force

protects the paramount authority of the national govern-

ment to regulate commerce even though the federal power

has not been affirmatively exercised by the Congress or

the Executive to limit the actions of the states. See, e. g.,

Kassel v. Consolidated Freightways Corp., 450 U.S. 662,

669 (1981) (plurality opinion); Merrion v. Jicarilla

Apache Tribe, 102 S. Ct. 894, 910 (1982).

The broad federal authority over foreign commerce

and international affairs reflects the realization that

“Tijn this vast external realm” the Nation is confronted

with “important, complicated, delicate and manifold prob-

lems ... United States v. Curtiss-Wright Corp., 299

U.S. 304, 319 (1936). The problems can only be exacer-

bated if states are allowed to chart their own course.

As Hamilton cautioned, The Federalist No. 80, at 536

(J. Cooke ed. 1961), foreign powers have no special re-

gard for our federal system and will hold the national

government accountable for what the states do. In the

context of disabling states from acting in foreign affairs,

this Court has described the potential results of the ac-

countability of the national government for the wrongs

of member states. It has said that “‘[e}xperience has

shown that international controversies of the gravest

moment, sometimes even leading to war, may arise from

real or imagined wrongs to another’s subjects inflicted,

See also, e.g., Michelin Tire Corp. v. Wages, 423 U.S. 276,

285-86 (1976); County of Mobile v. Kimball, 102 U.S. (12 Otto)

691, 696-97 (1880) ; Inman Steamship Co. v. Tinker, 94 U.S. (4 Otto)

238, 245 (1876); Chy Lung v. Freeman, 92 U.S. (2 Otto) 275, 280

(1875).

10

or permitted, by a government.’” Zschernig v. Miller,

389 U.S. 429, 441 (1968), quoting Hines v. Davidowitz,

312 U.S. 52, 64 (1941). And if there should arise

“a difficulty which would lead to war, or to suspen-

sion of intercourse, would California alone suffer, or

all the Union? .. [Tjhe power to regulate com-

merce with foreign nations . . . belongs solely to the

national government. If it be otherwise, a single

State can, at her pleasure, embroil us in disastrous

quarrels with other nations.” Chy Lung v. Freeman,

92 U.S. (2 Otto) 275, 279, 280 (1875).

It is natural, then, given the significance of the foreign

commerce power to the adoption of the Constitution, the

greater importance of foreign commerce than that of in-

terstate commerce at the time the Nation was founded,

and the recognition of the paramount authority of the

federal government in all foreign affairs, that Commerce

Clause inhibitions on state action are “more rigorous

when a restraint on foreign commerce is alleged than

when all that is involved is an interference with inter-

state commerce.” Reeves, Inc. v. Stake, 447 U.S. 429,

438 n.9 (1980).

3. This Court in Japan Line Reaffirmed and Applied

the Principles of Exclusive National Competence

in Foreign Trade Matters in Invalidating a State

Tax That Resulted in Taxation Duplicative of

That of a Foreign Nation and Impaired the Ability

of the United States to Speak With One Voice in

Regulating Commercial Relations With Foreign

Governments

The issue in Japan Line, Ltd. v. County of Los Angeles,

441 U.S. 434 (1979), was the validity of a California

county’s fairly apportioned tax on its small, transient

share of the vaiue of Japanese cargo containers that

were used in international trade. The Court assumed

that such a tax on containers in interstate commerce

would have been constitutional, 441 U.S. at 445, 451.

But the mere fact that Los Angeles County’s tax was

fairly proportional to the length of the containers’ stay

in the county was not enough to save it under the For-

11

eign Commerce Clause as it would have had only inter-

state commerce been involved. The duplication, however

insignificant in amount, mattered in principle because

“Telven a slight overlapping of tax—a problem that

might be deemed de minimis in a domestic context—

assumes importance when sensitive matters of foreign

relations and national sovereignty are concerned.” Id. at

456. The Court emphasized that “[f]oreign commerce is

preeminently a matter of national concern,” and that,

allthough the Constitution . . grants Congress power

to regulate commerce ‘with foreign Nations’ and ‘among

the several States’ in parallel phrases, there is evidence

that the Founders intended the scope of the foreign com-

merce power to be the greater.” Id. at 448.

The Japan Line Court noted that the greater scope of

the foreign commerce power—equivalent to the “more

rigorous” standard of Reeves, Inc. v. Stake, supra—im-

plicates at least two considerations in foreign commerce

tax cases unique to them as opposed to interstate com-

merce tax cases. 441 U.S. at 446. One is the enhanced

risk of double taxation that results from the inability of

this Court or any other tribunal to ensure that, to take

the example then at hand, other jurisdictions capable of

taxing the containers would defer to Los Angeles Coun-

ty’s fairly apportioned tax. Id. at 447, 454. The other

is the necessity of barring exertions of state taxing power

that would prevent “the Federal Government from ‘speak-

ing with one voice when regulating commercial relations

with foreign governments.’” Id. at 451, quoting Michelin

Tire Corp. v. Wages, 423 U.S. 276, 285 (1976).

The fairly apportioned Los Angeles County tax both

resulted in double taxation and prevented the Nation

from speaking with one voice in regulating foreign com-

merce.

It resulted in double taxation because Japan—as was

its right under the custom of nations as the country

of domicile—taxed the containers on their full value with

no allowance for even the most fairly apportioned tax

12

levied by some jurisdiction through which they passed.

441 U.S. at 447, 451-52, 454.

The Los Angeles County tax also prevented the United

States from speaking with one voice to interested foreign

powers. The United States and Japan were parties to a

customs convention on containers, which reflect [ed] a

national policy to remove impediments” to international

traffic and under which American containers were not

taxed in Japan. Id. at 453. The Court found that in

these circumstances “California’s tax . . will frustrate

attainment of federal uniformity.” Ibid. For one thing,

the local tax on the containers “creates an asymmetry in

international maritime taxation operating to Japan’s dis-

advantage.” Ibid. The Court went on:

“The risk of retaliation by Japan, under these cir-

cumstances, is acute, and such retaliation of necessity

would be felt by the Nation as a whole. If other

States follow California’s example (Oregon already

has done so), foreign-owned containers will be sub-

jected to various degrees of multiple taxation, de-

pending on which American ports they enter. This

result, obviously, would make ‘speaking with one

voice’ impossible. California, by its unilateral act,

cannot be permitted to place these impediments be-

fore this Nation’s conduct of its foreign relations

and its foreign trade.” Ibid.

The Customs Convention, it should be noted, applied

only to federal and not to state taxes and therefore did

not by its own force invalidate the California tax. Id.

at 446 n.10. It was the prohibition, residing in the Com-

merce Clause, of state action that prevents the nation

from speaking with one voice in matters of foreign trade

that invalidated the Los Angeles County tax. The Court

made clear that in this area the absence of express fed-

eral preemption of action by the states does not leave the

states at liberty to act.

“We find no merit in th[e] contention ... that a

State is free to impose demonstrable burdens on com-

merce, so long as Congress has not pre-empted the

field by affirmative regulation. California may

13

not tell this Nation or Japan how to run their foreign

policies.” Id. at 454-55.

B. Because It Deviates From the International Norm of

Separate-Source, Arm’s-Length Allocation Adopted by

the United States and Other Nations, California’s

Worldwide-Combined-Reporting Method of Apportion-

ment Violates the Foreign Commerce Clause

The California worldwide-combined-reporting method

of apportionment is unconstitutional uader the Foreign

Commerce Clause.‘ Congress, by statute and treaty, has

adopted a different method—the separate-source, arm’s-

length allocation method—that accords with the custom

of nations and is inconsistent with the use of the world-

wide-combined-reporting method by any of the states.

California’s method, moreover, results in double taxation

and has other conceptual and practical flaws that aggra-

vate the interference it works with federal regulation of

international commerce.

1. Congress Has Provided in the Relevant Provisions

of the Internal Revenue Code for Separate-Source,

Arm’s-Length Taxation of Multinational Income

The United States, like other nations, rests its jurisdic-

tion to levy the national income tax on the domicile of

the taxpayer and, where a domiciliary connection with the

United States is lacking, on the fact thet the source of the

taxpayer’s income is in the United States. See, e.g., 2

Bittker, Emory, & Streng, Federal Income Taxation of

Corporations and Shareholders (Forms) 17-3 to 17-4

(rev. ed. 1982); Thompson, Federal Income Taxation of

Domestic and Foreign Business Transactions 512-14

(1980). Thus, natural persons who are citizens or verma-

nent resident aliens and corporations that owe their ex-

istence to the laws of the United States or any of the

states are obliged to pay tax to the United States on their

Because the California tax violates the Foreign Commerce

Clause, it is unnecessary for the Court to decide whether it also

offends the Due Process Clause. See ASARCO, Inc. v. Idaho State

Tax Comm., No. 80-2015 (U.S. June 29, 1982), slip op. 20 n.14

(O’Connor, J., dissenting).

14

income whatever its geographical source. Non-resident

aliens and foreign corporations that derive income from

the United States are also subject to the federal income

tax but only to the extent that their income does indeed

find its source in the United States. In parallel fashion,

foreign jurisdictions tax the income earned within their

borders, including the foreign-source income of American

corporations or foreign subsidiaries of American compa-

nies. Finally, to ensure that our domiciliaries are not

penalized by the source-based taxing systems of other na-

tions, the familiar foreign income tax credit provisions

allow the domestic corporation that does business abroad

—-te take the most typical example and the relevant ex-

ample for purposes of this case—to credit any taxes paid

to foreign countries in respect of “income from sources

without the United States” against what would other-

wise be its United States income tax liability.

That description summarizes—and no doubt oversimpli-

fies—many pages of technical provisions of the Internal

Revenue Code. But it captures, we believe, the essence of

separate-source income taxation, the system of income

taxation that, in the interest of comity, of the security of

multinational enterprises, and thus ultimately of world

economic development, is pursued almost everywhere the

world round.

We elaborate only so far as necessary to provide au-

thority for what we have just outlined by way of sum-

mary.

As this Court has said, “domestic corporations are re-

quired to pay a tax on their incomes from all sources.”

National Paper & Type Co. v. Bowers, 266 U.S. 373, 376

(1924). See also Bittker, Emory, & Streng, supra, at

17-4; Thompson, supra, at 512; 3 Bittker, Federal Taxa-

5 See Thompson, supra, at 557, quoting Draft Double Taxation

Convention Report of the O.E.C.D. (1963); Tax Conventions with

Belgium, Finland, Trinidad and Tobago, and the Netherlands:

Hearings Before the Senate Comm. on Foreign Relations, 91st

Cong., 2d Sess. 2 (1970) (statement of then Assistant Secretary

of the Treasury Edwin S. Cohen).

15

tion of Income, Estates and Gifts J 65.1, at 65-2 (1981).

The rule, however, is subject to the allowance of a credit

for taxes paid to foreign jurisdictions on income from

sources without the United States. 26 U.S.C. §§ 901 et

seq. Tne credit is also of long standing. This Court ex-

plained in a leading case that “the primary design of the

[eredit] provision was to mitigate the evil of double tax-

ation” resulting from the overlapping jurisdiction of the

United States and foreign countries to tax. Burnet v.

Chicago Portrait Co., 285 U.S. 1, 7 (1932); see also id.

at 8-10 nn.6, 7; American Chicle Co. v. United States,

316 U.S. 450, 451 (1942); Associated Tel. & Tel. Co. v.

United Sites, 306 F.2d 824, 832 (2d Cir. 1962), cert.

denied, 371 U.S. 950 (1963). The Senate Committee on

Finance more recently has explained that the “foreign

tax credit system embodies the principle that the country

in which a business activity is conducted . . . has the first

right to tax the income arising from” that activity even

if it is conducted by a company resident in another coun-

try. S. Rep. No. 94-988, 94th Cong., 2d Sess. 233 (1976).

The country where the company resides “has a residual

right to tax the income arising from” the activity in an-

other country, but the country of the corporation’s resi-

dence “recognizes the obligation to insure that double

taxation does not result.” Ibid. The United States uses

the tax credit to satisfy that obligation by ensuring that

income is caxed initially according to its source.

Foreign corporations “are ordinarily not taxed [in the

United States] on their foreign-source income

Bittker, Emory, & Streng, supra, at 17-3. The Congress

has defined “domestic” corporations and “foreign” cor-

porations. 26 U.S.C. S8 7701(a)(3), (5). Moreover, it has

established source-of-income and source-of-deduction rules,

26 U.S.C. §§ 861-63, which determine It] he geographical

source” of income and deductions, Bittker & Eustice,

Federal Income Taxation of Corporations and Share-

holders J 17.02, at 17.09 (4th ed. 1979). By these rules,

the foreign-source income of foreign corporations is dis-

tinguished from their United States-source income and

16

left to be taxed by the appropriate foreign jurisdiction.

Thompson, supra, at 514. Thus, because the United States

defers to the source jurisdiction’s taxation of the foreign-

source income of foreign corporations, inconsistent treat-

ment and multiple taxation are avoided. These rules

apply even if the foreign corporation is “wholly owned

by U.S. shareholders.” Bittker, Emory, & Streng, supra,

at 17-3. It is only when “the foreign income is repatriated

in the form of dividends to U.S. sharehold that it

will be subjected to U.S. taxation. bid. And in

that event, the United States allows, in accordance with

the credit provisions already discussed, “a credit for for-

eign income taxes... paid when the income was earned

in the foreign jurisdiction.” Ibid.

The separate-source system, then, is quite simple. It is

complicated only by the fact that the geographical source

of income earned by a multinational enterprise is not

always self-evident.

To protect the integrity of the source rules for taxing

income, Section 482 of the Code authorizes the Internal

Revenue Service to reallocate income between two or more

entities owned or controlled by the same interests if “nec-

essary in order to prevent evasion of taxes or clearly to

reflect the income of any of suck [entities].” 26 U.S.C.

§ 482. See Commissioner v. First Security Bank of Utah,

N.A., 405 U.S. 394, 400 (1972). When any reallocation

has to be made, it is done by treating the commonly

owned or controlled entities as if they had dealt with

each other at arm’s length. As explained in the Treasury

regulations implementing Section 482:

“The purpose of section 482 is to place a controlled

taxpayer on a tax parity with an uncontrolled tax-

payer, by determining, according to the standard of

an uncontrolled taxpayer, the true taxable income

from the property and business of a controlled tax-

payer.... The standard to be applied in every case

is that of an uncontrolled taxpayer dealing at arm’s

length with another uncontrolled taxpayer.” Treas.

Reg. § 1.482-1 (b) (1) (emphasis added).

17

Arm’s-length reallocation pursuant to Section 482 is

authorized in “any case in which either by inadvertence

or design the taxable income, in whole or in part, of a

controlled taxpayer, is other than it would have been had

the taxpayer in the conduct of his affairs been an uncon-

trolled taxpayer dealing at arm’s length with another un-

controlled taxpayer.” Treas. Reg. § 1.482-1(c). The ob-

vious case, and the case where the IRS has employed Sec-

tion 482 most extensively in recent years, is that of a

foreign corporation selling products to an affiliated do-

mestic corporation at spurious prices that result in larger

profits abroad, thereby producing smaller profits and

smaller taxable income in the United States. See 3

Bittker, Federal Taxation of Income, Estates and Gifts

79.1, at 79-2 (1981).

2. In Treaties as Well as in the Internal Revenue

Code, the National Government Has Committed

Itself to Separate-Source, Arm’s-Length Account-

ing for Income Tax Purposes

In addition to their inclusion in the Internal Revenue

Code, the two fundamental standards of federal taxation

of multinational enterprises—(1) avoidance of multiple

taxation by deference to the taxing authority of the juris-

diction where the income originated (geographical-source

allocation), and (2) where necessary, arm’s-length re-

allocation to determine the true income for commonly

controlled taxpayers (arm’s-length accounting)—are also

embodied in international tax treaties. They are the

standards of the tax treaties between the United States

and its trading partners, such as Canada, France, Ger-

many, Italy, Japan, and the United Kingdom.“

The Treasury Department’s Model Income Tax Treaty

“for the Avoidance of Double Taxation and the Preven-

* See 1 CCH Tax Treaties, e. g., J 1203 (Canada) (see also J 1301);

2803 (France); 3003 (Germany); 4303 (Italy); {4393

(Japan); 2 CCH Tax Treaties J 8103A (United Kingdom).

Appellant has stated that the arm’s-length method was used in

those foreign countries in which its subsidiaries operated. See J.S.

8.

18

tion of Fiscal Evasion With Respect to Taxes on Income

and Capital” provides that business profits arising in a

foreign country may be taxed in that country and that

the domiciliary country of the taxpayer will not impose

a second tax on that income. 1 CCH Tax Treaties {| 158,

at 257 (Art. 7), 263 (Art. 23) (1981). The Treasury

Model Treaty, having thus described the separate-source

method, goes on to describe the arm’s-length reallocation:

for “associated enterprises” between which “conditions

are made or imposed . . . in their commercial or financial

relations which differ from those which would be made

between independent enterprises, . any profits which,

but for those conditions would have accrued to one of the

enterprises, but by reason of those conditions have not

so accrued, may be included in the profits of that enter-

prise and taxed accordingly.” Id. at 258 (Art. 9). See

also id. at 257 (Art. 7). Similar provisions are also con-

tained in the “Model Convention for the Avoidance of

Double Taxation With Respect to Taxes on Income and

Capital” of the Organization for Economic Co-operation

and Development (of which the United States is a mem-

ber) and in the United Nations “Model Double Taxation

Convention Between Developed and Developing Coun-

tries.“ —

In view of the foregoing, it is clear that separate-

source, arm's-length allocation is the prevailing inter-

national norm adopted by the United States and its in-

ternational trading partners. As Assistant Secretary of

the Treasury Woodworth explained:

“The Federal Government and virtually all other gov-

ernments in the world determine taxable income on

the basis of what are arm’s length transactions in

— related companies. This is the gen-

[T]he arm’s length rule is generally applicable in

the world today .... [It is] the general rule with

71 CCH Tax Treaties $151 (1980).

1 CCH Tax Treaties § 171 (1982).

19

which [other countries and companies of other coun-

tries] are acquainted [and is] used by the Federal

Government.

[T]he Federal Government, and practically all of the

rest of the world, uses the arm’s length procedure.“

3. California’s Worldwide-Combined-Apportionment

Method Results in Duplicative Taxation and Is

at Odds With the Method of Allocating Income

for Income-Tax Purposes Used by the United

States and its Trading Partners in the Interna-

tional Community

In the face of this international acceptance of the

separate-source, arm’s-length method, California’s unitary,

combined-reporting apportionment of worldwide income

cannot be allowed to stand. Like Los Angeles County’s

fairly apportioned property tax, it must be condemned

under the Foreign’ Commerce Clause because it “im-

pairs] federal uniformity in an area where federal

uniformity is essential” and “prevents the Federal Gov-

ernment from ‘speaking with one voice when regulating

commercial relations with foreign governments.’” Japan

Line, Ltd. v. County of Los Angeles, 441 U.S. 434, 448,

451 (1979).

The California method of apportionment includes the

earnings of foreign subsidiaries in the combined world-

wide total of income to be apportioned. The result is to

impose a tax on income that has already been taxed by

Ta 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. 20-21, 24 (1977);

See also id. at 33, 105; State Taxation of Interstate Commerce and

Worldwide Corporate Income: Hearings on S. 983 and S. 1688

Before the Subcomm. on Taxation of the Senate Comm. on Finance,

96th Cong., 2d Sess. 44 (1980) (statement of then Assistant Secre-

tary of the Treasury Donald C. Lubick); State Taæat ion of Foreign

Source Income: Hearings on H.R. 5076 Before the House Comm. on

Ways and Means, 96th Cong., 2d Sess. 4, 5, 7, 9 (1980) (statement

of Assistant Secretary Lubick).

the source jurisdiction abroad on an unapportioned, full-

value basis. (See pp. 14, 16 supra.) Thus, as in Japan

Line, Ltd. v. County of Los Angeles, supra, a second tax

on the identical income “inevitably results . . . if a State

should seek to tax . . . [that foreign-source income] on

an apportioned basis,” 441 U.S. at 447, and this is true

even though the state tax is fairly apportioned,’” id.

at 448.

Nor can it be said recognizing that the duplication is

likely to be of the greatest concern to the other members

of the international community when a foreign parent's

income is attributed to a California subsidiary that this

duplicative tax is of no concern to the foreigi-source

country even in the case of a United States parent with

a foreign subsidiary. In comparison to separate-source

accounting, California’s method of taxation will discour-

age foreign investment by United States companies and

make it less likely that they will establish foreign sub-

sidiaries. Consider an example in which no arm’s-length

adjustment is needed between a domestic parent and its

foreign subsidiary because the intrafamily transfer prices

fairly approximate arm’s-length prices.“ If the unitary,

combined-reporting system attributes to California an

amount of foreign-source income that has been fully

taxed by the foreign jurisdiction, then this duplicative

tax by the state will require the overall operation of the

parent and subsidiary to be more profitable than it would

have to be under the separate-source method in order to

produce the same total after-tax income. Such a disin-

centive to United States investment abroad, as a conse-

10 In this case, appellant’s foreign subsidiaries paid taxes in the

foreign countries on the amounts earned in each country (J.A. 72).

Nevertheless, California attributeſd] to other countries approxi-

mately one-half of the income produced in Colombia and Venezuela

according to arm’s-length principles applied in those countries”

(J.S. 11).

11 In this case, the Internal Revenue Service audited Container

for the years in question here. It accepted Container’s income

figures as accurate and proposed no adjustments to income or de-

ductions under § 482. (J.A. 78-79.)

21

quence of the application of the combined-reporting

method instead of the separate-source standard, would

surely be of considerable importance to foreign govern-

ments. And any repatriation of funds to the United

States necessary to satisfy the duplicative state tax could

well interfere with the internal policies of foreign-source

countries in such areas as the development and retention

of capital for local reinvestment by the subsidiary itself

or by foreign minority shareholders.”

Beyond duplication of tax is the effect of the California

method in preventing the United States from speaking

with one voice. The “custom of nations,” 441 U.S. at

447, 454, in this area—deviated from only by the world-

wide-combined-reporting states — is to avoid overlapping

or duplicative taxation of the same income by according

priority to the jurisdiction that is the source of income

and reallocating income, when required to avoid distor-

tion, on an arm’s-length basis. In essence, this approach

rests on the determination of the geographic source of

income for each separate taxpayer and, if necessary, the

arm’s-length readjustment of income between related

taxpayers.

In contrast, the central premise of unitary, combined-

reporting apportionment is that moat “income . . . cannot

be satisfactorily allocated by source,” J. Hellerstein &

W. Hellerstein, State and Local Taxation 399 (4th ed.

1978)—in other words, “the impossibility of allocating

specifically the profits earned by the processes conducted

within [the state’s] borders,” Underwood Typewriter Co.

v. Chamberlain, 254 U.S. 113, 121 (1920). Under this

system, the worldwide business income of the entire multi-

national unitary enterprise is combined in a single total

12 We note that a substantial number of appellant’s overseas sub-

sidiaries had foreign minority stockholders—in some cases as much

as 33% of total ownership. (J.A. 7, 14-15.)

18 FEI estimates that approximately 10 states have adopted a

system of worldwide-combined-apportionment. Compare Japan Line,

Ltd. v. County of Los Angeles, supra, 441 U.S. at 453 & n.19.

22

and then apportioned to California according to a three-

factor formula, that is, according to how much the Cali-

fornia part of the enterprise represents of its total prop-

erty, payroll, and sales. (See J.S. App. A6 n.2.) It

is thus apparent that California’s unitary, combined-

reporting apportionment of worldwide income is irrec-

oncilably at odds with the international standard of

separate-source allocation. As the Court observed in

Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425,

444-45 (1980), “[t]axation by apportionment and taxa-

tion by allocation to a single situs are theoretically in-

commensurate, and if the latter method is constitutionally

preferred, a tax based on the former cannot be sus-

tained.” The Court held that specific allocation was not

constitutionally preferred in the circumstances of that

case. Here it must be preferred because state unitary

taxation of worldwide income “is not ceding the primacy

of foreign source income . . . to the foreign government.”

State Taxation of Foreign Source Income: Hearings on

H.R. 5076 Before the House Comm. on Ways and Means,

96th Cong., 2d Sess. 10 (1980) (hereinafter Foreign

Source Income Hearings) (statement of then Assistant

Secretary of the Treasury Donald C. Lubick).

Moreover, California’s method “creates an asymmetry

in international . . . taxation,” 441 U.S. at 453, that

threatens to impair federal supremacy in this area and

to disturb relations between the United States and for-

eign countries. As Assistant Treasury Secretary Wood-

worth noted, “it becomes very disconcerting for other

countries and for companies of other countries doing busi-

ness in the United States to have the general rule [of

separate-source accounting] with which they are ac-

quainted used by the Federal Government and to find

that certain State governments do not follow that rule

[I]t is important that we all use the same test.” 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.

21, 24 (1977) (hereinafter Tax Treaties Hearings) ;

see also id. at 33. In fact, the state “practice has created,

and continues to create, an irritant in the international

relations of the United States. A number of foreign gov-

ernments have complained, both officially and informally,

that the unitary system differs from the arm’s-length

method which is used by the Federal Government and is

generally accepted in international practice.” State Taæ-

ation of Interstate Commerce and Worldwide Corporate

Income: Hearings on S. 983 and S. 1688 Before the

Subcomm. on Taxation of the Senate Comm. on Finance,

96th Cong., 2d Sess. 44 (1980); see also Foreign Source

Income Hearings 5, 7 (statement of Assistant Secretary

Lubick).“

We recognize, of course, that the problems caused by

worldwide-combined-apportionment are exacerbated in the

ease of a foreign parent corporation with a domestic sub-

sidiary doing business in California. But application of

the California tax even to a domestic parent and its for-

eign subsidiaries, which is what this case involves, inter-

feres with the federal government’s authority over in-

ternational trade and diplomatic affairs and therefore is

unconstitutional under the Foreign Commerce Clause.“

14 The background and details of these protests by foreign gov-

ernments are set out in the Brief for Appellant (at 23-28) and

the Memorandum for the United States as Amicus Curiae (at 16-

17) in Chicago Bridge & Iron Co. v. Caterpillar Tractor Co.,

No. 81-349 (0.T. 1981).

15 In addition, to create a special rule that discriminates against

domestic companies in favor of foreign organizations would be a

misguided construction of the Constitution, since the Commerce

Clause “cannot be read to accord . [foreign entities] prefer-

ential treatment.” Michelin Tire Corp. v. Wages, supra, 423 U.S.

at 287. See also Maryland v. Louisiana, 451 U.S. 725, 754 (1981)

(the Commerce Clause contains an “antidiscrimination principle

[which] ‘follows inexorably from the basic purpose of the Clause’

to prohibit the multiplication of preferential trade areas destructive

of free commerce anticipated by the Constitution”).

24

4. The Flaws That Inhere in the Worldwide-

Combined-Apportionment Method Underscore Its

Constitutional Impermissibilit

California, one may concede, is seeking only to tax its

fair share of the income of Container Corporation and

other companies that do business both in California and

in foreign lands. Within the community of the states of

the Union, the method it has chosen, we may assume,

would be a permissible one because any distortions it

would yield are likely to be within tolerable bounds and

this Court sits to ensure that California and its sister

states do not unduly burden or discriminate against busi-

nesses that operate across state lines. In this case, how-

ever, the Court’s writ runs only to California and not to

the nations whose taxing systems would have to be ac-

commodated to California’s if the California system were

allowed to stand.

Moreover, the distortions that system yields, when ap-

plied beyond the borders of the United States, far exceed

tolerable limits. The California method, in short, cannot

be defended on the ground that, though different from the

federal and the international system, it comes out at

about the same place. The California method is not cal-

culated to produce a fair or reasonable result when ap-

plied to income earned abroad.

Worldwide-combined-apportionment is impermissibly

susceptible of seriously distorting the income attributed

to the jurisdiction using the method. “The underlying

premise of formulary apportionment under the . . . three-

factor formula is that. ., by and large, every dollar of

wages or property spent in one taxing jurisdiction, along

with receipts from sales in the area, will produce the

same amount of profit in all taxing jurisdictions.”

J. Hellerstein & W. Hellerstein, supra, at 539. As the

Treasury Department has correctly pointed out, [il m-

plicit in the unitary system is the assumption that profit

rates in different units of a corporate family, engaged in

different activities and in different locations, are always

the same.” Tax Treaties Hearings 34 (statement of

Assistant Secretary Woodworth).

Whatever the validity of formula apportionment within

the largely-homogeneous United States, this approach is

unsound and arbitrary in the international context.!“ As

Assistant Treasury Secretary Woodworth explained, it is

“clearly not the case [that multinational profit rates

are the same]. And when it is not the case, the

unitary system will misallocate income. Whenever

profit rates are higher in foreign affiliates than in

domestic activities, the unitary system allocates too

much income to the domestic member or members of

the group. The result is tantamount to taxation by

a state government of the foreign income of a for-

eign corporation.” Tar Treaties Hearings 34; see

also id. at 21, 24; J. Hellerstein & W. Hellerstein,

supra, at 539; H.R. Rep. No. 1480, 88th Cong., 2d

Sess. 168 (1964) ; State Tuxation of Interstate Com-

merce: Hearings Before the Subcomm. on State Tax-

ation of the Senate Comm. on Finance, 93d Cong.,

Ist Sess. 160 (1973) (statement of Professor Jerome

R. Hellerstein) ."7

16 In the context of interstate commerce, “a State may apply an

apportionment formula to the taxpayer’s total [unitary] income in

order to obtain a ‘rough approximation’ of the corporate income that

is ‘reasonably related to the activities conducted within the taxing

State.“ Exxon Corp. v. Wisconsin Department of Revenue, 447

U.S. 207, 223 (1980). In the case of foreign commerce, however,

“felven a slight overlapping of tax—a problem that might be

deemed de minimis in a domestic context—assumes importance

when sensitive matters of foreign relations and national sovereignty

are concerned.” Japan Line, Ltd. v. County of Los Angeles, 441

U.S. 434, 456 (1979).

17 See also GAO Report on Determining the Income of Multi-

national Corporations, App. IX, at 93 (Sept. 30, 1981) (letter from

Assistant Secretary of the Treasury John E. Chapoton) (“formula

apportionment has little merit because a corporation could have an

increased tax burden merely as a result of its affiliates becoming

more profitable or as a result of paying higher wages in the juris-

diction applying the formula”).

26

Such a misapportionment of worldwide income can

occur for any reason that causes the overseas operations

to be more profitable than domestic operations. One

well-recognized example is the significant disparity around

the world in wage rates and payroll costs—one of the

factors employed in California’s apportionment formula.

Once again, this has been acknowledged by the Treasury

Department:

Labor costs vary substantially among countries

very much more so than among regions in the United

States.... [The foreign] labor cost element in the

formula will probably be lower than the California

labor cost. A disproportionate amount of income will

be apportioned to California.” Tax Treaties Hear-

ings 34 (statement of Assistant Secretary Wood-

worth).

Indeed, the record in the instant case clearly proves

this defect in worldwide apportionment. It was demon-

strated below that Container’s overseas businesses were

more profitable than its United States business. (See

J.S. 18-19.) Expert testimony also illustrated the rea-

sons why corporate operations abroad are in general

more profitable than domestic operations. (See J.S. 19-

20.) And, with particular regard to wage rates, Con-

tainer showed that its “workers in California are paid

2½ times the amount paid to workers in Colombia to

produce the same quantity of . . . containers” (J.S. 18),

that worldwide wage rates vary widely and that wage

rates in the United States exceed those in other countries

(J.S. 18 & n.11; J.S. App. A41-A42), and that in 1969-

70 the average hourly worker compensation in developed

countries, as adjusted for differences in productivity, was

only 40 to 82 percent of the average hourly compensation

in the United States (J.S. 18 & n.11; J.S. App. A43).

Such misapportionment is objectionable on several

grounds. As Assistant Treasury Secretary Woodworth

observed, it allows the state effectively to tax the foreign-

source income of a foreign corporation over which the

state would not otherwise have jurisdiction. It also is

27

manifestly unfair to the domestic taxpayer to be required

to pay taxes on the foreign-source income of a separate

corporate entity. And, of particular significance for pur-

poses of the Foreign Commerce Clause, it discourages

American investment in countries in which the profit-

ability rate is significantly different than in the United

States and thereby discriminates against those countries

(generally the developing countries) in favor of nations

(generally the industrialized nations) where profitability

is more comparable to that in the United States.

Furthermore, worldwide-combined-apportionment raises

insurmountable problems of application. It requires that

corporate books and records from all over the world be

converted from foreign currencies and accounting prac-

tices into United States dollars and accounting conven-

tions. The burden of such an undertaking can be enor-

mous,'* and the results of the conversion are often, at

best, arbitrary and inexact. See J. Hellerstein & W.

Hellerstein, supra, at 539; Tax Treaties Hearings 34

(statement of Assistant Secretary Woodworth). In fact,

the record in this case discloses that “[a]ccounting pro-

cedures and methods [for Container and its foreign sub-

sidiaries] were far from standardized . . . . The books

and records of the foreign subsidiaries are kept in accord-

ance with the generally accepted accounting principles,

if any, of the country in which the subsidiary is located.

These accounting principles may vary in material re-

spects from generally accepted accounting principles in

the United States.” (J.A. 40, 72. See also J.S. App.

A29.)

Undoubtedly, of course, foreign subsidiaries already

supply some information to their domestic parent in a

form in which these conversions have been made. But

18 See Tax Treaties Hearings 105 (letter from Secretary of the

Treasury Blumenthal). Moreover, because of foreign laws pro-

hibiting or restricting the disclosure of certain information, it is

sometimes not possible to provide the information required by the

taxing state. Ibid. See also Tax Treaties Hearings 213 (statement

of Valentine Brookes) (United Kingdom Official Secrets Act).

28

that process—which certainly varies for each company—

is a far cry from the detailed and voluminous material

on property, payroll, and sales necessary for California

to apply its method of worldwide-combined-apportion-

ment. Moreover, under the theory that the separate cor-

porations are part of a unitary business enterprise, the

combined-reporting system eliminates all intra-enterprise

dealings and transactions between these entities. Cf.

' ASARCO, Inc. v. Idaho State Tax Comm., No. 80-2015

(U.S. June 29, 1982), slip op. 5; Mobil Oil Corp. v.

Commissioner of Taxes, 445 U.S. 425, 441 n.15 (1980).

To effect the required elimination would impose on a

taxpayer an extraordinary burden, well beyond anything

corporations usually do in the ordinary course of business.

For all these reasons, the worldwide-combined-report-

ing method of apportionment violates the Foreign Com-

merce Clause.“ Congress, we may assume, could author-

ize the states to apply worldwide-combined-apportionment

—despite its inconsistency with Congress’ own chosen

method and despite its inherent defects—for “Congress,

if it chooses, may exercise [its Commerce Clause] power

. .. by conferring upon the States an ability to restrict

the flow of . . . commerce that they would not otherwise

19 The validity of the California tax is not saved by the decision

of this Court in Bass, Ratcliff & Gretton, Ltd. v. State Tax Com-

mission, 266 U.S. 271 (1924). Bass presented no conflict between

state apportionment of worldwide income and the international

norm of separate-source, arm’s-length accounting, since it was not

until “1934 [that] the Department of the Treasury adopted the

‘arm’s length standard’ for allocating income.” GAO Report on

Determining the Income of Multinational Corporations, at 2 (Sept.

30, 1981). The ensuing development of tax treaties and the inter-

national acceptance of the arm’s-length method that now prevails

make the instant case a much different one than Bass. Moreover,

Bass was “controlled,” 266 U.S. at 280, by the decision in Underwood

Typewriter Co. v. Chamberlain, 254 U.S. 113 (1920), which involved

the apportionment of interstate income; but as the Court has now

held (see pp. 10, 11, 25 n.16 supra), a more rigorous test is applicable

to foreign commerce than to interstate commerce. Finally, unlike

the instant case, the taxpayer in Bass had “not even attempted

to show,” 266 U.S. at 282, any misapportionment of income.

29

enjoy.” Lewis v. BT Investment Managers, Inc., 447

U.S. 27, 44 (1980). See also New England Power Co. v.

New Hampshire, 102 S. Ct. 1096, 1101 (1982) ; ASARCO,

Inc. v. Idaho State Tax Comm., supra, slip op. 20 n.14

(O'Connor, J., dissenting). But, “{i]f there are to be

such restraints, they must be provided by the Federal

Government.” Zschernig v. Miller, 389 U.S. 429, 441

(1968). Unless and until Congress grants this authority,

the states may not depart from the international norms

of commerce recognized by tie United States and its

trading partners.

CONCLUSION

The California method of unitary, combined-reporting

apportionment of worldwide income is unconstitutional

under the Foreign Commerce Clause. Accordingly, the

judgment below should be reversed.

Respectfully submitted.

WILLIAM H. ALLEN *

JOHN B. JONES, JR.

MARK I. LEvy

COVINGTON & BURLING

1201 Pennsylvania Avenue, N.W.

P.O. Box 7566

Washington, D.C. 20044

(202) 662-6000 2°

July 1982

* Counsel of Record

20 We gratefully acknowledge the able and invaluable assistance

of Joseph Neuhaus in the preparation of this brief.