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

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NO. 81-523

In The

Supreme Court of the United States

October Term, 1982

CONTAINER CORPORATION OF AMERICA,

Appellant,

vs.

FRANCHISE TAX BOARD,

Appellee.

On Appeal from the Court of Appeals

of the State of California

for the First Appellate District

BRIEF OF THE STATE OF MONTANA AS AMICUS

CURIAE IN SUPPORT OF APPELLEE

“w

MICHAEL J. RIELEY

Special Assistant Attorney General

Montana Department of Revenue

Mitchell Building

Helena, Montana 59620

Telephone : (496) 449-2852

Attorney for the State of Montana

COCKLE PRINTING CO., 231! Douglas St., Omaha 68102

TABLE OF CONTENTS

Pages

I. Introductory Statement 1

II. Interest of Amicus Curiae 2

III. Summary of Argument 3

IV. Argument:

A. Multinational businesses give rise to unique

audit problems.

B. The approach of the federal government to

the problem

C. Criticism of the Federal Approach 0.

D. The States’ approach

1. Criticism of the States’ approach —

2. Response to criticisms of the States’

approach

3. Comparison of the Federal and State

approach

V. Conelusion : 7 nahn

TABLE OF AUTHORITIES

Caszs:

Butler Brothers v. MeColgan, 315 U.S. 501 (1941)...

Complete Auto Transit Inc. v. Brady, 430 U.S. 274

(1977)

Container Corp. v. Franchise Tax Bd., 117 Cal. App.

3d 988, 173 Cal. Rptr. 121 (1981)

TABLE OF AUTHORITIES—Continued

Pages

International Harvester Co. v. Evatt, 329 U.S. 416

(1947) ni 13

Northwestern States Portland Cement Co. v. Min-

nesota, 358 U.S. 450, 462 (1959) . 14

Underwood Typewriter v. Chamberlain, 254 U.S.

113 (1920) alee Ce

Wisconsin v. J. C. Penney Co., 311 U.S. 435 (1940) 0 1

STATUTE:

ee RNs. UII ciccienbiteigusttpieindiatanmmantiidateataetieinuipebtimavinei —

Feperat Ruves & Recuiations:

Treas. Reg. § 1.482-1, et seq. 7

Treas. Reg. § 1.482-2 (e) 7

OrHER AUTHORITIES:

Burns, “How IRS Applies the Intereompany Pricing

Rules of Section 482: A Corporate Survey”,

The Journal of Taxation, (May, 1980), p. 308.0000. «= 9

89 Harv. L. Rev. 1202 (1976) 8, 9, 10, 14, 15

United States Supreme Court Rule 36 1

NO. 81-523

In The

Supreme Court of the United States

October Term, 1982

eee

CONTATNER CORPORATION OF AMERICA,

Appellant,

vs.

FRANCHISE TAX BOARD,

Appellee.

On Appeal from the Court of Appeals

of the State of California

for the First Appellate District

BRIEF OF THE STATE OF MONTANA AS AMICUS

CURIAE IN SUPPORT OF APPELLEE

_ INTRODUCTORY STATEMENT

Pursuant to United States Supreme Court Rule 36,

the State of Montana submits this Brief as an Amicus

Curiae in support of the Appellee. Be- parties to this

proceeding have consented to the filing of this Brief.'

‘Originals of the “blanket” consent letters of both parties

have been filed with the Clerk of the Court.

II.

INTEREST OF AMICUS CURIAE

The interest of the State of Montana as an Amicus

in this matter revolves around the potentially far reaching

effects of this Court’s final decision as it relates to the

ability of a state to tax multi-jurisdictional businesses. The

State of Montana is concerned with the Appellant’s posi-

tion that the application of combined apportionment to a

corporation and its foreign subsidiaries on a worldwide

basis constitutes a violation of the due process and com-

merce clauses of the United States Constitution.

It is essential that this Court affirm the decision of

the California Court of Appeals in Container Corp v.

Franchise Tax Bd., 117 Cal. App. 3d 988, 173 Cal. Rptr. 121

(1981). A decision from this Court reversing the Californ-

ia Court of Appeals will effectively erode several years of

effort in producing relative uniformity among the states

in the area of state income taxation, as well as seriously

subvert the ability of the State of Montana to tax ration-

ally the multi-jurisdictional taxpayers operating in this

State.

Another ramification of such a reversing decision

would be the further erosion of the Montana tax base at

a time when state and local governments can ill afford the

revenue loss. A multi-jurisdictional business enterprise

must be subject to a state taxing authority in the same

capacity as a smaller, completely localized enterprise. Any

method to the contrary would create the inherently unfair

result of smaller enterprise shouldering the state and local

tax burden of the multinational business entity.

“~

ITI.

SUMMARY OF ARGUMENT

This Brief will focus on an examination of the audit-

ing problems posed by a multi-jurisdictional corporation

to both federal and state governments as well as the re-

spective approaches taken in determining and ultimately

taxing the income of such taxpayers. This amicus submits

that the approach taken by the states in utilizing the uni-

tary business principle not only meets basic constitutional

standards but also possesses clear advantages to the sep-

arate-entity “arms-length” approach of the Federal Gov-

ernment in attributing multinational corporate income for

tax purposes.

ts.

—— 4

IV.

ARGUMENT

A. Multinational businesses give rise to unique

audit problems.

In this age of the supercompany with its sophisticated

pettern of world-wide operations and financial deal-

| «, there is perhaps no more difficult problem for the

tax administrator than the examination of the tax re-

turns of multinational corporations.’

Since the end of World War II, there bas been an ex-

plosion in the size of the international business community.

?7Donald Alexander, Commissioner of Internal Revenue,

“Auditing Multinational Corporations,” Address to the Assem-

bly of Inter-American Center of Tax Administration, Ottawa,

June 13, 1975.

Companies which once restricted their activities to a single

country are now involved in the domestic economies of a

number of countries. Business opportunities now exist on

a global scale and the modern business enterprise tailors

its operations to exploit the advantages offered by a vari-

ety of circumstances. As a result of this growth of busi-

ness, the problems of the tax administrator have become

ever more complex and exasperating. Not only are global

market forces at work in shaping business decisions, but

also the presence of a business in numerous jurisdictions

allows significant opportunities for corporate planning to

take advantage of tax opportunities or shields offered by

a variety of countries.

Multinational businesses almost invariably operate

through a number of legally separate entities. This does

not mean that they operate as separate businesses how-

ever. In almost all cases they function as a single busi-

ness. Shareholders in major corporations are concerned

with bottom line results, not where income is earned. Cor-

porate managers function in a way which satisfies stock-

holder expectations or they look for new jobs.

The nature of multinational businesses gives rise to

unique problems for the tax administrator hecause they

are unrestrained by the economics of a single country in

making business decisions and in particular in transferring

goods between related entities. Transfer prices may be

relevant to a local manager if his performance is judged

solely by the results he obtains in his serment of the busi-

ness, but they are irrelevant to the business as a whole.

The only relevant figure for the business is the difference

between the cost of an item and the amount realized when

it is sold to a third party. As a consequence, transfer

pricing can be utilized to influence tax results. This may

not be the only reason for establishing particular transfer

prices, but the fact that beneficial tax results can be

achieved through appropriate pricing strategies cannot

be ignored.

A multinational business may give rise to economies

of scale which generate large amounts of income. This

can occur whenever there is a decreasing marginal cost

of production. Decreased costs may make sales profitable

at a price level below those justified by the exploitation of

a single market. Does the additional sale give rise to the

increased profit or is the profit the result of all sales?

Beyond the direct results evident from the lowering

of per-unit costs, there can also exist a number of syner-

gistic benefits which are even more elusive of measurement.

Economic benefits can arise from size alone in terms of

borrowing capacities, credit requirements, supplier pref-

erence, ete. Sometimes these benefits are measurable; at

other times they are intangible. In any event, they cannot

be specifically identified with one activity. The synergism

results from the interaction of all of the elements of the

business, or at times from the existence of all of the ele-

ments as a part of the whole. In such a case the income

which results should be divided among each of the constitu-

ents. It cannot be assigned to any one or several of them.

An example of a real but intangible benefit unidenti-

fiable by source was discussed in Butler Brothers v. Me-

Colgan, 315 U.S. 501 (1941). In that ease, the Court con-

sidered the effect of volume discounts and the stipulated

fact that the elimination of California purchases would

have no effect on the amount of the discount. The Court

responded in the following manner:

If the omission of the California sales would

have no effect on the purchasing power, the omission

of sales in an equal amount wherever made would like-

wise have no effect on the company’s ability to pur-

chase at a saving. Thus, by proceeding in turn from

state to state, it could be shown that none of the sales

in any of the states should be credited with the in-

come resulting from the purchasing of goods in large

quantities. ...

315 U.S. at 508-09.

B. The approach of the federal government to

the problem.

The Internal Revenue Code operates on the basic

premise that residents of the United States, individual or

corporate, are taxable on all of their income. Credits are

allowed to the extent foreign jurisdictions assert tax over

a portion of a resident’s income because it has a source

in the foreign jurisdiction. In some instances, a deferral

is granted for United States taxation until the income is

repatriated. Allowing credits or classifying income as

being “non source” are the exception rather than the rule.

As an aid in administering the system, § 482 of the

Internal Revenue Code (26 U.S.C. § 482) provides the

Internal Revenue Service with policing power. It pro-

vides :

In any case of two or more organizations, trades, or

businesses (whether or not incorporated, whether or

not organized in the United States, and whether or not

affiliated, owned, or controlled directly or indirectly

by the same interests, the Secretary may distribute,

apportion, or allocate gross income, deductions, cred-

its, or allowances between or among such organiza-

tions, trades, or businesses, if he determines that such

distribution, apportionment, or allocation is necessary

in order to prevent evasion of taxes or clearly to re-

flect the income of any of such organizations, trades,

or businesses.

The Department of Treasury has adopted implement-

ing regulations (Treas. Reg. § 1.482-1, et seq.). The regu-

lations establish three specific methods and a fourth gen-

eral method for adjusting intercorporate transactions on

the basis of the arm’s-leneth standard (Treas. Reg. § 1.482-

2(e).) Under the regulations, transactions between com-

monly control'ed entities are reviewed and compared to

hypothetical comparable transactions between unrelated

entities. The regulations establish a hierachy of compari-

sons: the comparable uncontrolled price, the resale price,

cost plus, and any other method that is clearly more ap-

propriate.

The regulations attempt to compare intercorporate

transactions to those conducted by separate entities. It

views each corporation as separate and independent and

uninfluenced by the existence or opportunities to deal with

related entities.

. . . Since each commonly-controlled entity is viewed

as separate and independent, the government will cal-

culate its true taxable income by adjusting intercom-

pany transactions to conform to the results of bar-

gains which would have been negotiated between un-

related parties dealing at arm’s length in similar

goods or services in similar circumstances. Moreover,

each entity’s profit or loss on any intercompany trans-

action does not depend on whether the MNC [Multi-

national Corporation] as a whole has yet made or ever

will make any real profit through ultimate resale to

third parties of the goods or services. (89 Harv. L.

Rev., infra, 1202 at 1205.)

C. Criticism of the Federal Apprcach.

The separate entity approach followed by the Federal

Government has been subject to substantial criticism. This

criticism has come from legal scholars Geoffry John Har-

ley, ‘‘Internationa) Division of the Income Tax Base of

Multinational Enterprise”, 89 Harv. L. Rev. 1202 (1976),

the Treasury itself (The President’s 1978 Tax Program,

January 30, 1978, pp. 282-297), and the General Accounting

Office (“IRS Could Better Protect U.S. Tax Interests in

Determining the Income of Multinational Corporations,”

September 30, 1981) among others.

As the following extracts demonstrate, the federal ap-

proach is theoretically inappropriate because the separate

entity approach does not conform with economic reality.

Commonly controlled corporations are aware that addi-

tional benefits to the business as a whole may be derived

from dealing with one another; therefore, they do so.

Whenever commonly-controlled entities directly con-

tribute, either horizontally or vertically, to a single

production-distribution process, opportunities for cost

savings through economies of scale and reduced trans-

action costs may result. Even where no direct trans-

fers are made, centralized managerial control over a

group of affiliates may produce efficiencies in man-

agement, in raising capital, in obtaining quantity dis-

counts, and in advertising. In addition, diversifica-

tion of risk creates potential savings where there are

few similarities between affiliates.

Finally, political and eeonomie power, which may be

used to increase long-run profits of the whole MNC,

may stem from large size alone regardless of the de-

gree of compatibility between the affiliates. As a re-

sult of all of these considerations, transfer prices may

vary from urm’s langth to reflect the increased profit-

ability of intercompany transactions.

89 Harv. L. Rev., supra, 1202 at 1215.

Some [corporate] officials believed the fundamental

concept of arm’s length dealing between related cor-

porations is unrealistic. In a world of competition

among multinational firms, they ask why the parent

corporation should not favor its subsidiaries over

unaffiliated corporations. The subsidiaries are ex-

pected to pay dividends while the unaffiliated corpo-

rations are not.

GAO, supra, at p. 44.

Section 482 is based on the premise that a subsidiary

is legally and economically separate from its parent

corporation. In contrast, only 41% of the partici-

pants state their organizations actually operate in this

manner. Although composed of numerous legally

separate entities, 49% of the participants reveal that

their companies make most intercompany pricing de-

cisions as though the organization is one economic

unit. This basic difference in philosophy between the

IRS and multinational corporations is central to the

Section 482 controversy. Without this fundamental

difference, many tax problems involving intercom-

pany transfer pricing would disappear.

Burns, “How IRS Applies the Intereompany Pricing

Rules of Section 482: A Corporate Survey”, The

Journal of Taxation, (May, 1980), p. 308.

Such an approach may give rise to artificially created

records and may eliminate the use of one of management’s

tools for evaluating employees or rewarding perform-

ance.

... The government’s insistence on the separate en-

tity theory for tax purposes may result in the adop-

tion by MNC’s of arm’s length pricing rather than an

administered transfer pricing system more appropri-

ate for internal control and motivational purposes.

Such a system, which is designed to reflect the fact

that an affiliate may have contributed to long-run

MNC profits despite its failure to produce short-run

profits measured in terms of arm’s length prices, is

crucial to the promotion of full cooperation by all

affiliates in achieving the MNC’s world-wide goals,

even when it is not in their individual interest as

profit maximizers.

89 Harv. L. Rev., supra, 1202 at 1217.

In addition, the separate entity approach may give

rise to significant administrative costs and burdens.

Some [corporate] officials drew attention to the ex-

pense and labor involved in international examina-

tions. The officials objected to what they considered

an unnecessary load of paperwork. For example, the

tax manager of one company declined to guess the

cost of satisfying IRS examiners that international

transactions do not violate section 482 regulations,

although he believed the costs to be considerable. He

said that he did not object because he considers the

defense against IRS allocations a necessary function

of his tax department. He did state, however, that

the examiners raise many questions that take time

and trouble to answer without being closely related

to the examination.

GAO, supra, at 44.

Finally, the separate entity approach as represented

by the arm’s-length standard does not work,

... The arm’s-length standard is a necessary and val-

uable tax measure, but it is sometimes difficult to ad-

minister: multinational firms often invest abroad be-

cause no well-established market exists for the goods

and services which are transferred in inter-affiliate

transactions. .. . Although many multinational com-

panies follow perfectly acceptable transfer pricing

practices, the experience of the Internal Revenue

Service has heen that some do not, and the resultant

loss of U.S. tax revenues can be substantial.

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

diseretion previously available to taxpayers. But

no one familiar with international tax planning be-

lieves that these Regulations have taken the tax in-

centive out of transfer-pricing. The 1968 Regula-

tions reduced, but by no means eliminated, the flexi-

bility which companies have in setting inter-affiliate

prices.

President’s Tax Program, supra, pp. 286-287.

and constitutes an administrative and taxpayer night-

mare,

In its review of current IRS examination data on 519

U.S. multinationals, each having assets over $250

million and having engaged in transactions with its

foreign subsidiaries, GAO found that only 3 percent

(12 of 403) of IRS’ total recommended section 482

adjustments to reported income were based on a true

arm’s length price. The remaining adjustments were

based on estimated prices constructed by IRS using

complex guidelines prescribed by the department of

the Treasury-guidelines which have caused admin-

istrative burden and uncertainty both for IRS and

taxpayers.

GAO, supra.

D. The States’ approach.

The States, in applying their corporate income taxes,

are limited to source income by due process considerations.

Wisconsin v. J. C. Penney Co., 311 U.S. 435 (1940); Com-

plete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977).

In order to make source determination, the States

have adopted the unitary business principle. Under this

approach, the States first determine the nature of the

business undertaken in their state and then include all

the income, wherever and by whomever earned, of that

business in an apportionment base. This base is then

assigned to the various jurisdictions where the business

is taxable upon the basis of a mathematical formula re-

fleeting business activities. The formula typically in-

cludes property, payroll and sales.

The unitary business principle is uneoncerned with

where income is assigned on the corporate books or ree-

ords. It assumes that all elements of a business contrib-

ute to the earning of income. If the buiiness does not

earn income on an overall basis, then there is no income

to assign anywhere.

1. Criticism of the States’ approach.

The unitary approach is criticized on the grounds

that the elements of the apportionment formula (prop-

erty, payroll and sales) are not equally productive of

income in every jurisdiction.

Second, it is asserted the perimeters of a unitary

business are difficult to define and frequently shift solely

on the basis of the amount of taxes which accrue to a

state based upon a particular configuration.

Third, it is alleged that compliance costs under the

unitary method are excessively burdensome because tax-

payers do not maintain adequate records to calculate

property, payroll and sales on a uniform basis.

Finally, it is claimed that the use of the unitary

method may give rise to multiple taxation in the inter-

national context where foreign countries utilize the arm’s-

length method.

2. Response to criticisms of the States’ approach.

Criticism of the formula elements misses the point

of the unitary business principle. The unitary method

is utilized because the income is part of an inseparable

whole. As the Court stated in Underwood Typewriter v.

Chamberlain, 254 U.S. 113 (1920):

. The profits of the corporation were largely earned

by a series of transactions beginning with manufac-

ture in Connecticut, and ending with sale in other

states. In this it was typical of a large part of the

manufacturing business conducted in the state. The

legislature, in attempting to put upon this business

its fair share of the burden of taxation, was faced

with the impossibility of allocating specifically the

profits earned by the processes conducted within its

borders. It therefore adopted a method of appor-

tionment which, for all that appears in this record,

reached, and was meant to reach only the profits

earned within the state... .

254 U.S. at 120-21.

Furthermore, the elements of the formula frequently

offset each other. When property costs are high, pay-

roll costs may be low. Sales may offset both. In order

to overcome the presumption attached to the formula,

the taxpayer must demonstrate how all the elements to-

gether have unfairly apportioned income. It should also

be kept in mind that mathematical precision is unneces-

sary. A rough approximation is sufficient. Jnternational

Harvester Co. v. Evatt, 329 U.S. 416 (1947).

In the instant case, the perimeters of the unitary

business are defined on a line-of-business approach. This

meets the requirements of the Multistate Tax Commission

Regulation Reg. IV.(1).(b), and is in conformity with the

suggestions of commentators. (See, 89 Harv. L. Rev.,

supra, at 1235.) This Court should not speculate on the

effects of the use of the unitary method in cases not be-

fore it.

The compliance cost arguments are raised with re-

spect to either the arm’s-length method or the single en-

tity approach. The unitary method, by ignoring individ-

ual transactions, should be less burdensome in any event.

The existence of additional costs in the instant case are

virtual’ precluded by the Securities and Exchange Com-

mission -.ling requirements with respect to its Form

10-K.

The use of an apportionment approach precludes

multiple taxation. “Logically it is impossible, when the

tax is fairly apportioned, to have the same income taxed

twice.” Northwestern States Portland Cement Co. v.

Minnesota, 358 U.S. 450, 462 (1959).

3. Comparison of the Federal and State approach.

The unitary entity theory has certain clear advan-

tages over the separate entity approach now embodied

in the section 482 regulations. Principal among these

is its theoretical superiority as a means for ascer-

taining true income of various MNC components.

Treatment of the MNC as a unitary entity reflects

the fact that strong interdependence from common

contro! may exist which renders unrealistic any anal-

ogy to a collection of unrelated, competitive com-

panies. Furthermore, the unitary entity theory does

not create taxable income on the basis of intercom-

pany transfers, since such transfers do not make the

MNC as a whole better off until income is realized

‘from ultimate sales to unrelated parties. Finally,

a unitary formula provides management with the

flexibility necessary to make efficient use of trans-

fer pricing for internal and external non-income tax

purposes, thus avoiding the frustration of legitimate

business behavior which may accompany application

of the separate entity theory.

89 Harv. L. Rev., supra, 1202 at 1228.

The GAO in its report, supra, recommended that the

Department of Treasury:

Begin a study to identify and evaluate the feasibility

of ways to allocate income under section 482, includ-

ing formula apportionment, which would lessen the

present uncertainty and administrative burden cre-

ated by the existing regulations. (Emphasis added.)

GAO, supra, at pp. viii-ix.

CONCLUSION

It is respectfully requested that this Court sustain

the unitary business principle and affirm its application

by California in this case.

Respectfully submitted,

MONTANA DEPARTMENT OF REVENUE

Mitchell Building

Helena, Montana 5962C

MICHAEL J. RIELEY

Special Assistant

Attorney General

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