Amicus Curiae Brief — Barclays Bank PLC v. Franchise Tax Bd. of Cal.
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No. 92-1384
In The
Supreme Court of the United States
October Term, 1993
BARCLAYS BANK PLC,
Petitioner,
Vv.
FRANCHISE TAX BOARD,
An Agency of the State of California,
Respondent.
On Writ of Certiorari to the Court of Appeal of the State of
California for the Third Appellate District
BRIEF FOR KEIDANREN (JAPAN FEDERATION
OF ECONOMIC ORGANIZATIONS) AS AMICUS
CURIAE IN SUPPORT OF PETITIONER
C. David Swenson’
Dennis I. Meyer
Leonard B. Terr
Harry A. Franks, Jr.
BAKER & MCKENZIE
815 Connecticut Avenue, N.W.
Washington, D.C. 20006-4078
(202) 452-7000
Attorneys for Keidanren
‘Counsel of Record
December 15, 1993
“] BEST AVAILABLE COPY
TABLE OF CONTENTS
Page
INTEREST OF THE AMICUS CURIAE ............ l
ISSUES ADDRESSED BY THE AMICUS CURIAE ..... 3
INTRODUCTION AND SUMMARY OF ARGUMENT... 3
REDE 660 66s eee see 7
I. THE CALIFORNIA SUPREME COURT'S
RELIANCE UPON UNITED STATES TAX
TREATIES AS SUPPORTING THE UNITARY
METHOD IS INCORRECT. ............... 7
A. The California Supreme Court’s
Interpretation That Congressional Silence
on State Taxation in United States Tax
Treaties Negatively Implies Congress’
Acquiescence in the Unitary Method Is
eT re eer een Pee 8
B. The Failure of Congress to Adopt the
U.S.-U.K. Tax Treaty Without the
Limitation on State Taxation Contained in
Article 9(4) Cannot Be Interpreted as
Congress’ Acceptance of the Unitary
ME sed eenue we SECue eee 11
C. Even If This Court Accepts the California
Supreme Court’s Interpretation of the
Ratification of the U.S.-U.K. Tax Treaty
with the Reservation to Article 9(4), Such
Interpretation Should Have No Effect
upon a Tax Treaty (Such as the U.S.-
Japan Tax Treaty) Adopted Prior to
California’s Adoption of the Unitary
Peres a Caw ebecceece scare 14
D. Uniformity in the Taxation of Foreign-
based Multinational Groups Is Essential in
Order for the Federal Government to
Speak with One Voice Through the United
States Tax Treaty Network and in Order
to Prevent Double Taxation ........... 15
Il. THE CALIFORNIA SUPREME COURT'S
RELIANCE UPON PROVISIONS OF THE
INTERNAL REVENUE CODE AS
SUPPORTING THE UNITARY METHOD IS
DE Cee eGG hd ees bnsensccscece 21
Il. THE CALIFORNIA SUPREME COURT'S
RELIANCE UPON UNITED STATES
TREATIES OF FRIENDSHIP, COMMERCE
AND NAVIGATION AS SUPPORTING THE
UNITARY METHOD IS INCORRECT ....... 26
i aa ak ie sus 66 6656 606+ Ws 0c 29
TABLE OF AUTHORITIES
Page(s)
CASES
Aiken Indus., Inc. v. Commissioner,
gM 13
Barclays Bank int’! Lid. v. Franchise
Tax Bd., No. 325059, Cal. Super. Ct.
(Aug. 20, 1987) reprinted in Appendix A
to Petitioner's Cert. Brief... .. 2... .....002200... 2, 15
Barclays Bank Int'l, Lid. v.
Franchise Tax Bd., 3 Cal. App.
DTT sepadceeee@ecccececccececss 11, 12
Barclays Bank Int'l, Ltd. v.
Franchise Tax Bd., 829 P.2d 279
EE passim
Colgate-Palmolive Co., Inc. v.
Franchise Tax Bd., 4 Cal. App. 4th 1681 (1991)... .. 10, 16
Complete Auto Transit, Inc. v. Brady,
ee 5
Container Corporation of Am. v.
Franchise Tax Bd., 463 U.S. 159 (1983)... . 4,5, 10, 17, 21
Estate of Burghardt v. Commissioner,
SE on eebcabetbeucencceececcu’ 13
Hines v. Davidowitz, 312 U.S. 52 (1941) ......... 10, 28
Itel Containers Int'l Corp. v. Huddleston,
122 L. Ed. 2d 421 (1993)... 2... 2... eee 19
iv
Japan Line, Lid. v. County of Los Angeles,
ee es SEE occu reece care eee be e849 5, 6, 15
Johansson v. United States, 336 F.2d 809
cea i i a Se de eee en 13
Maximov v. United States, 299 F.2d 565
a eh es ee es GD 6s ooo oa ewes vous 13
Moline Properties, Inc. v. Commissioner,
er 6 ona ede Nenad ww we dal sie eiies 26
Rocca v. Thompson, 223 U.S. 317 (1912) ......... 13, 27
Seminole Flavor Co. v. Commissioner,
Se SE cen ccccmhieeereusectSeauhs 24
Sumitomo Shoji America, Inc. v. Avagliano,
ee Ee ec cuescde eee ene neue ees 27
Union Pac. R.R. v. Commissioner,
Py a EE 8 4 BAN Obs 000366068665 408 23
Wardair Canada Inc. v. Florida Dep’t of
Se ae Ss OED Wieeceveeneucestese 5-9
STATUTES
te? alc en Dea. eae 5, 6, 22
EE re ae 25
DPE? oosenteadeesvscseuceeeees 18
26 U.S.C. 68 1501, ISOC) ... ee eee eee 25
PP ED Goad oceeeeésuvatdesseceeer 21
<i
CaL. Rev. & Tax Cope § 25110 (West 1992) .......... 4
CauiF. Rev. & Tax Cope, §§ 25128-25136 (West 1992) ... 4
Rev. Act of 1918, ch. 18, § 240, 40 Stat. 1057. ........ 23
Rev. Act of 1921, ch. 136, § 240(d), 42 Stat. 227....... 23
Rev. Act of 1928, ch. 852, § 45, 45 Stat. 806 ......... 24
REGULATIONS
Reg. 41, art. 77, T.D. 2694 (1918) .............5.. 23
Reg. 41, art. 78, T.D. 2694 (1918). ............... 23
“=
TREATIES
Convention Between the Government of
the United States and the Government
of the United Kingdom of Great Britain
and Northern Ireland for the Avoidance
of Double Taxation and the Prevention
of Fiscal Evasion with Respect to Taxes
on Income and Capital Gains,
31 U.S.T. 5668, T.A.1.S. No. 9682
i i a eee eee ago 6 68 2 2, 6, 11, 17, 20
Convention Between the United States
of America and Japan for the Avoidance
of Double Taxation and the Prevention
of Fiscal Evasion with Respect to Taxes
on Income, 23 U.S.T. 967,
T.A.LS. No. 7365 (March 8, 1971). ........... 2, 17, 20
Convention of Establishment Between H.R. Rep. No. 350, 67th Cong., Ist Sess. (1921) ....... 24
the United States and France,
11 U.S.T. 2398, T.1.A.S. No. 4625 (Nov. 25, 1959) ..... 28 S. Rep. No. 617, 65th Cong., 3d Sess. (1918) ......... 23
Convention on International Civil Aviation, The Federalist No. 32 (Alexander Hamilton) .......... 10
open for signature Dec. 7, 1944,
a 4
Organization for Economic Cooperation
and Development, Model Tax Convention
on Income and on Capital (1992) .............. 17, 20
Treaty of Friendship, Commerce and
Navigation Between the United States of
America and Japan, 4 U.S.T. 2065,
T.1.A.S. No. 2863 (Apr. 2, 1953)............... 2, 27
MISCELLANEOUS
124 Cong. Rec. 18416 (1978) ...............04-. 7
American Law Institute, INTERNATIONAL
ASPECTS OF UNITED STATES INCOME TAXATION
Il: PROPOSALS ON UNITED STATES INCOME TAX
REE ge re 16
Committee on Foreign Relations, Rep. on
the Third Protocol to the 1975 Income Tax
Convention with the United Kingdom of Great
Britain and Northern Ireland, as Amended,
Exec. Rep. No. 5, 96th Cong., Ist Sess. (1979). ....... 12
Foreign Income Tax Rationalization and
Simplification Act of 1992, H.R. 5270,
a
In The
Supreme Court of the United States
October Term, 1993
No. 92-1384
BARCLAYS BANK PLC,
Petitioner,
Vv.
FRANCHISE TAX BOARD,
An Agency of the State of California,
Respondent.
On Writ of Certiorari to the Court of Appeal of the State of
California for the Third Appellate District
BRIEF FOR KEIDANREN (JAPAN FEDERATION OF
ECONOMIC ORGANIZATIONS) AS AMICUS CURIAE IN
SUPPORT OF PETITIONER
INTEREST OF THE AMICUS CURIAE
The Amicus is the Keidanren (Japan Federation of Economic
Organizations), a private, non-profit organization representing all
branches of economic activity in Japan and consisting of over 1000
members, 125 of which are trade associations and regional
economic organizations, and the balance of which are leading
Japanese corporations.' Many of the Japanese corporate members
or their affiliates conduct business in the state of California either
directly or through United States subsidiaries. Many of these
‘All parties to this action have consented to the filing of this brief. Copies
of the written consents have been lodged with the Clerk of the Court.
* Such Japanese-owned multinational corporate groups are referred to herein
as “Japan-based Multinational Groups” and are included in the parallel term
“Foreign-based Multinational Groups,” as the context requires.
Japan-based Multinational Groups were subject to California’s
worldwide combined formula apportionment method (hereinafter
the “Unitary Method”) during the year in issue.
The interest of the Amicus differs from the interest of the
Petitioner because of the decisive effect on the issue at bar of two
treaties between the United States and Japan. These treaties are
not applicable to United Kingdom residents such as the Petitioner.
The first treaty is the “Convention Between the United States of
America and Japan for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with Respect to Taxes on Income”
(the “U.S.-Japan Tax Treaty”).? The second treaty is the “Treaty
of Friendship, Commerce and Navigation Between the United
States of America and Japan (the “U.S.-Japan FCN Treaty”).*
Both of these treaties were signed prior to the time California
began applying the Unitary Method with respect to Foreign-based
Multinational Groups.°
Although the Amicus believes that the decision of the
California Supreme Court is incorrect and should be reversed, the
Amicus believes also that these two treaties between the United
States and Japan distinguish the Amicus’ situation from that of the
Petitioner. If this Court finds that the Unitary Method does not
violate the Foreign Commerce Clause with respect to United
Kingdom resident corporations because Congress’ reservation in
respect of Article 9(4) of the U.S.-U.K. Tax Treaty® constituted
>: 23: U.S.T. 967, T.A.LS. No. 7365 (March 8, 1971).
* 4 U.S.T. 2065, T.1.A.S. No. 2863 (Apr. 2, 1953). Other nations have
entered into Treaties of Friendship, Commerce and Navigation with the United
States. These treaties are referred to herein as “FCN Treaties.”
* Barclays Bank Int’! Lid. v. Franchise Tax Bd., No. 325059, Cal. Super. Ct.
(Aug. 20, 1987) reprinted in Appendix A to Petitioner’s Cert. Brief., at A-17.
* Convention Between the Government of the United States and the
Government of the United Kingdom of Great Britain and Northern Ireland for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect
to Taxes on Income and Capital Gains (herein “U.S.-U.K. Tax Treaty”), 31
U.S.T. 5668, T.A.1.S. No. 9682 (Dec. 31, 1975).
Congress’ acquiescence in the Unitary Method as applied to United
Kingdom corporations, this Court should reserve on the issue of
whether the same result should apply in the case of Foreign-based
Multinational Groups that are entitled to protection provided by a
different United States tax treaty. Further, a decision against
Petitioner in this case should not control the issue of the Unitary
Method’s validity in the case of Japan-based Multinational Groups
entitled to the benefits of the U.S.-Japan FCN Treaty because there
is no FCN Treaty between the United Kingdom and the United
States and the U.S.-Japan FCN Treaty proscribes application of the
Unitary Method.
ISSUES ADDRESSED BY THE AMICUS CURIAE
Whether the basis for the California Supreme Court s finding
Congressional approval of the Unitary Methoc and upholding the
constitutional ity of the Unitary Method as applied to Foreign-based
Multinational Groups was fatally flawed? If so, whether a correct
analysis leads to the conclusion that the Unitary Method, as applied
to Foreign-based Multinational Groups, is unconstitutional under
the Foreign Commerce Clause, because the Unitary Method results
in double taxation and prevents the Federal Government from
speaking with “one voice when regulating commercial relations
with foreign governments,” as evidenced by recent foreign
government retaliation against the United States in response to
continued use of the Unitary Method? If not, whether the issue
nevertheless should be reserved as to whether a different result is
appropriate in the case of Japan-based Multinational Groups
entitled to the protections of the U.S.-Japan Tax Treaty and the
U.S.-Japan FCN Treaty?
INTRODUCTION AND SUMMARY OF ARGUMENT
Under the Unitary Method, Japanese and other foreign parent
corporations are required to file a combined return with all of their
worldwide subsidiaries (the “combined report”). A portion of the
total worldwide income of the combined group is then allocated to
California under a “three-factor formula” apportionment method
that is based on the proportion of property, payroll and sales in the
taxing state compared to the same factors of the worldwide
consolidated group.’ Under California’s Unitary Method,
corporations that are more than fifty percent foreign-owned are
included in the combined report without regard to whether they
have (i) engaged in business in California or elsewhere in the
United States, (ii) derived income from sources within California
or elsewhere in the United States, or (iii) engaged in any
transactions with a related corporation incorporated in California
or elsewhere in the United States.*
The Unitary Method is fundamentally different from and
irreconcilable with the arm’s length standard and the separate
entity accounting method (the “arm’s length method”). The arm’s
length method is the international standard universally used and
accepted by the nations of the world and by multinational
corporations. It is the method required by United States tax
treaties, FCN treaties and the Internal Revenue Code. The arm’s
length method treats each corporation as “an independent entity
dealing at arm’s length with its affiliated corporations, and subject
to taxation only by the jurisdictions in which it operates and only
for the income it realizes on its own books.” Container
Corporation of Am. v. Franchise Tax Bd., 463 U.S. 159, 185
(1983). In the international context, the arm’s length method
allocates income to a single taxing jurisdiction rather than
arbitrarily apportioning the income among jurisdictions, and treats
intercorporate transfers of value between commonly controlled
entities in accordance with the terms that would have been obtained
’ See CALIF. REV. & TAX CODE $§ 25128-25136 (West 1992).
* Under legislation enacted in 1986 (and effective in 1988), California
provided corporations with a “water’s edge” election to avoid application of
worldwide formulary apportionment to income of their foreign affiliates anc!
parents. See CAL. REV. & TAX CODE § 25110 (West 1992). California further
limited the obligation to use the Unitary method in October 1993. Because the
year in issue is prior to the legislative changes, we have not addressed whether
these changes “cure” the constitutional defects of the Unitary Method.
nn nt ally
had such transfers occurred between uncontrolled entities in similar
circumstances.°
In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279
(1977), this Court found that if a state tax “is applied to an activity
with a substantial nexus with the taxing state, is fairly apportioned,
does not discriminate against interstate commerce, and is fairly
related to the services provided by the State,” no impermissible
burden on interstate commerce will be found. In Japan Line, Lid.
v. County of Los Angeles, 441 U.S. 434, 451 (1979), this Court
identified two additional criteria under the Foreign Commerce
Clause for testing the validity of a state tax affecting foreign
commerce. A state tax will violate the Foreign Commerce Clause,
notwithstanding its compliance with the four criteria in Complete
Auto Transit, if it “creates a substantial risk of international
multiple taxation” or “prevents the Federal Government from
‘speaking with one voice when regulating commercial relations
with foreign governments.’”
In Container, this Court held that California’s Unitary Method
did not violate the Foreign Commerce Clause when applied to
United States-owned domestic corporations with foreign
subsidiaries (“U.S.-based Multinational Groups”). However, the
Container opinion specifically reserved on the issue of whether
California’s Unitary Method violated the Foreign Commerce
Clause as applied to Foreign-based Multinational Groups."
In Wardair Canada Inc. v. Florida Department of Revenue,
477 U.S. 1 (1986), this Court upheld Florida’s aviation fuels tax
as applied to Canadian air carriers engaged in international
commerce. The carrier and the United States had conceded that
no risk existed of multiple taxation so that only the “one voice”
° The power to enforce such treatment by allocating income among related
parties and jurisdictions under the arm’s length method is established by section
482 of the Internal Revenue Code, 26 U.S.C. § 482, and the Associated
Enterprises article of United States tax treaties.
0 Container, 463 U.S. at 189 0.26, 195 n.32.
test under Japan Line was applicable. The Court found it
dispositive under this test that while a United States-Canada
aviation treaty (and other similar treaties) were silent on limiting
state taxation of aviation fuel, the Federal Aviation Act expressly
permitted the states to tax such fuels.
In the case below, the California Supreme Court concluded
that Wardair had “reoriented” dormant Foreign Commerce Clause
analysis so as to make such analysis inappropriate in this case.
Specifically, the California Supreme Court cited a number of
“negative implications” that it believed were created by United
States Senate or Congressional actions. The California Supreme
Court relied on these alleged “negative implications” to support its
conclusion that Congress had in effect affirmatively approved of
the Unitary Method." Among the actions from which the
California Supreme Court extracted these “negative implications”
were the Senate’s reservation to Article 9(4) of the U.S.-U.K. Tax
Treaty, the Senate’s ratification of other United States tax and
FCN treaties, and Congress’ enactment of certain provisions of the
Internal Revenue Code, particularly section 482.
The California Supreme Court’s interpretation and analysis are
incorrect. In fact, the Unitary Method, when applied to Foreign-
based Multinational Groups such as the Petitioner herein, is
completely irreconcilable with the relevant provisions of United
States tax and FCN treaties, as well as the Internal Revenue Code.
In addition, the taxation of a Foreign-based Multinational
Group’s income demands that the Federal Government speak with
“one voice” to foreign governments. The failure to find the
Unitary Method violative of the Foreign Commerce Clause will
result in our treaty partners hearing “many voices” on the issue of
the appropriate taxation of Foreign-based Multinational Groups.
All treaty jurisdictions must follow the internationally agreed norm
of the arm’s length method as embodied in tax treaties in order for
multinational corporations to engage in international commerce and
'! $29 P.2d 279, 295 (1992).
att oe hed Sow Rad > alien
avoid multiple taxation of the same income. Further, while certain
practical problems may exist with the application of the arm’s
length method, only the arm’s length method makes possible a
mechanism to prevent double taxation—the Competent Authority
procedures contained in United States tax treaties.
If this Court finds California’s Unitary Method constitutional
when applied to United Kingdom-based Multinational Groups, this
Court should nevertheless reserve on the issue of whether the same
interpretation applies to Japan-based Multinational Groups entitled
to the protections of the U.S.-Japan Tax Treaty and the U.S.-Japan
FCN Treaty.
ARGUMENT
I. THE CALIFORNIA SUPREME COURT’S RELIANCE
UPON UNITED STATES TAX TREATIES AS
SUPPORTING THE UNITARY METHOD IS
INCORRECT.
In upholding the Constitutionality of California’s Unitary
Method, the California Supreme Court cited two instances of
Senate inaction in the tax treaty context which the court believed
created decisive “negative implications.” Based upon these
“negative implications,” the court concluded that Congress had
affirmatively approved the Unitary Method. As the opinion stated,
paraphrasing Wardair:
(I]nternational agreements demonstrate that the Federal
government has affirmatively acted, rather than remained
silent, with respect to the power of the states to employ
formula apportionment in so-called foreign parent
cases"?
2 $29 P.2d at 294.
According to the California Supreme Court’s opinion, the “din of
‘governmental silence’ that cannot be ignored”” was evidenced
by two treaty-related phenomena. First, the court found it decisive
that United States tax treaties uniformly obligate the Federal
Government to utilize the arm’s length method, but uniformly
exclude the state governments from all treaty obligations except
those contained in the non-discrimination article. Second, the
court found decisive the Senate’s lodging of a reservation to
Article 9(4) of the U.S.-U.K. Tax Treaty, which would have
prohibited the states’ use of the Unitary Method with respect to
U.K.-based Multinational Groups.
Based in significant part on these “negative implications” the
California Supreme Court ruled that the case at bar was not an
appropriate case for dormant Foreign Commerce Clause analysis,
because that analysis “‘only operates where the Federal
Government has not spoken.’”* According to the court, in this
case, the Federal Government had indeed spoken and had approved
the states’ use of the Unitary Method.
The ensuing sections of this brief address why the California
Supreme Court’s analysis is wrong, why such analysis should not
be applied in any event under earlier tax treaties (such as the U.S.-
Japan Tax Treaty), and why the correct analysis leads inescapably
to the conclusion that the arm’s length method must prevail over
the Unitary Method.
A. The California Supreme Court’s Interpretation That
Congressional Silence on State Taxation in United
States Tax Treaties Negatively Implies Congress’
Acquiescence in the Unitary Method Is Incorrect.
The California Supreme Court noted that the “bilateral income
tax treaties negotiated by the United States with many of its trading
partners typically prescribe use of the [arm’s length] method by the
- @
'* $29 P.2d at 293 (quoting Wardair, 477 U.S. at 12).
ah: ia ditwthntigs, ee ee eh et ae,
signatory governments” but “they do not ... impose such a
requirement on taxation by subnational levels of government.”"°
Because subnational levels of government are included for
purposes of the nondiscrimination article, the California Supreme
Court concluded that:
We think this latter evidence substantially parallels the
Wardair paradigm, where the high court concluded that
the “negative implications” arising from the Convention's ~
limited ban on state taxation of fuel “on board” arriving
foreign aircraft demonstrated an awareness of subnational
taxation issues and represented “a decision by the parties
... to address the problem by curtailing and limiting only
some of the localities’ power to tax, while implicitly
preserving other aspects of that authority.”"*
The convention referred to was the Convention on International
Civil Aviation.” This Court found that Article 24(a) of that
convention “by its terms precluded the imposition of local taxes on
fuel only when the fuel is ‘on board an aircraft ... on arrival ...
and retained on board on leaving’ a contracting party.” In
Wardair this Court found direct language contained in an
international agreement that limited a state’s power to tax. This
Court found that the negative implication of this limitation was
Congress’ approval of state taxation that was not directly
proscribed in the agreement.
In the case at bar, the California Supreme Court, citing the
absence of any explicit tax treaty limit on the power of states to tax
(except that the states not discriminate), found such Federal
Government silence on state taxation to be evidence of the Federal
'" open for signature Dec. 7, 1944, art. 24(a), 61 Stat. 1180, 1186, 3 Bevans
944, 950.
" Wardair, <77 U.S. at 10.
10
Government's affirmative acquiescence in state use of the Unitary
Method. Such an interpretation goes far beyond Wardair’s
“negative imp!ications,” and elevates silence on an issue to a new
level of communication.
The conclusion of the California Supreme Court overlooks a
far simpler explanation for the exemption of state taxes from the
tax treaties: the general principle of state sovereignty. Both the
Federal Government and the states have concurrent taxing
powers."® The Federal Government is cognizant of the friction
caused by the Federal Government’s Foreign Commerce Clause
power and state taxing sovereignty. In that regard, the Executive
Branch has not seen fit to regulate states’ taxation authority until
the state tax laws cause international concerns.”
Further, respecting the states’ sovereignty over taxation, while
attempting to provide coverage for state taxation within the scope
of United States tax treaties, is unworkable. The United States
cannot negotiate a treaty with 50 additional participants at the
table. Moreover, not covering state taxes in the treaties was never
intended to give the states free and unfettered license to tax in a
way that conflicts with federal taxation principles the same
international parties and transactions as are covered by the treaties.
Such an approach would effectively frustrate the very purpose of
the tax treaty to harmonize national systems and prevent double
taxation.
The California Supreme Court’s reliance upon the exclusion of
state taxes from United States tax treaties—a recognition of our
federal system—as the Federal Government’s affirmative approval
'% Hines v. Davidowitz, 312 U.S. 52, 68 (1941); The Federalist No. 32
(Alexander Hamulton).
*® Following California’s adoption of the Unitary Method and this Court's
decision in Container, the Executive Branch has repeatedly studied and proposed
measures to restrict the application of the Unitary Method to Foreign-based
Multinational Groups. See generally Colgate-Palmolive Co., Inc. v. Franchise
Tax Bd., 4 Cal. App. 4th 1681, 1701-8 (1991) vacated and remanded, 831 P.2d
798 (Cal. 1992).
of the Unitary Method cannot be supported. The Federal
Government’s silence on state taxation issues cannot overcome its
loud voice in support of the arm’s length method as expressed in
and through the tax treaty network.
B. The Failure of Congress to Adopt the U.S.-U.K. Tax
Treaty Without the Limitation on State Taxation
Contained in Article 9(4) Cannot Be Interpreted as
Congress’ Acceptance of the Unitary Method.
As detailed in the opinions in the case below, Article 9(4) of
the U.S.-U.K. Tax Treaty explicitly limited Federal and state
taxation to the arm’s length method. The Treaty, signed in 1975,
was one of the first treaties negotiated after California enacted the
Unitary Method.
When the Treaty was considered by the Senate Foreign
Relations Committee, Senator Frank Church introduced a
reservation to Article 9(4). The reservation provided “that the
provisions of paragraph (4) of Article 9 ... shall not apply to any
political subdivision or local authority of the United States.””
When voted on in committee, the reservation was rejected 10 to 5.
On the Senate floor, the reservation was again defeated by a vote
of 44 to 34. The Treaty as signed then received a vote of 49 to
32, five votes short of the two-thirds needed. Thereafter, Article
9(4) was reserved without a vote and the treaty was ratified with
the reservation. The reservation was effectuated by the Third
Protocol to the U.S.-U.K. Tax Treaty.
The California Court of Appeals appropriately stated that it
“fail[ed] to see how three majority votes in the Senate essentially
approving article 9(4) could be transmogrified into a congressional
policy of disapproval” of the treaty provision.” The Court of
Appeals also noted that the opposition to the treaty-based
124 Cong. Rec. 18416 (1978).
” Barclays Bank Int'l, Lid. v. Franchise Tax Bd., 3 Cal. App. 4th 1034, 1055
(1990).
12
restriction was not rooted in the substance of the article, but was
instead reflected in certain Senators’ opposition to dealing with this
problem on a piecemeal basis instead of by comprehensive
legislation.” Legislation that would restrict the states’ ability to
use the Unitary Method has been introduced in Congress,” but
has never reached a vote in committee or on the floor.”
The California Supreme Court wrongly concluded that
Congress’ adoption of the U.S.-U.K. Tax Treaty with the
reservation as to Article 9(4) reflected Congress’ affirmative
= In fact, Senator Howard Baker stated:
in adopting its reservations to Article 9(4) in June of 1978, the Senate
appeared to reach a consensus that domestic legislation, as an
alternative to international treaty language, is preferable in regulating
that conduct of the States which may affect foreign commerce.
ses
[T]he States may incorrectly interpret the Senate’s reservation to
Article 9(4), and the Third Protocol to this Convention, as an invitation
to establish policies applicable to foreign source income which are
inconsistent or incompatible with broad National tax policies.
Committee on Foreign Relations, Rep. on the Third Protocol to the 1975 Income
Tax Convention with the United Kingdom of Great Britain and Northern Ireland,
as Amended, Exec. Rep. No. 5, 96th Cong., 1st Sess. 15 (1979).
* It should also be noted that none of these bills dealt solely with restricting
the states’ ability to use the Umstary Method. Therefore, Congress’ unaction could
be the result of an entirely unrelated provision in those bills.
* Barclays Bank Int'l, Lid. v. Franchise Tax Bd., 3 Cal. App. 4th at 1054.
The California Supreme Court used this lack of action on these bills as further
evidence of Congress’ acquiescence in the Unitary Method. 829 P.2d at 296.
If inaction on the part of Congress is correctly interpreted as action on the
opposite point, then Congress’ failure to vote on the Foreign Income Tax
Rationalization and Simplification Act of 1992, H.R. 5270, 102d Cong., 2d
Sess., which would have required a foreign-owned corporation engaged in
substantal related party transactions to report a mimmmum formulary amount of
taxable income, should be interpreted as evidence of Congress’ affirmation that
formulary methods that deviate from the arm’s length standard are inappropnate.
We are not necessarily advocating this position; we simply believe Congress’
silence should be interpreted as that—silence.
13
approval of the Unitary Method, thereby removing this case from
a dormant Foreign Commerce Clause analysis. A reservation is
not an affirmative statement.
The California Supreme Court’s interpretation is inconsistent
with the intent of both Congress and the United Kingdom
Government. Given the majority votes in favor of the original
treaty provision, and the various reasons Senators may have voted
for the treaty with the reservation, it is impossible to conclude as
a factual matter that Congress intended to authorize the Unitary
Method. Similarly, given the United Kingdom’s outspoken
Opposition to the Unitary Method, it is impossible to interpret
Congress’ reservation as the United Kingdom’s acceptance and
approval of the Unitary Method.
The California Supreme Court’s interpretation of the treaty
reservation is completely at odds with this Court’s standards for
treaty interpretation: “Like other contracts, [treaties] are to be read
in the light of the conditions and circumstances existing at the time
they were entered into, with a view to effecting the objects and
purposes of the states thereby contracting." The only
interpretation consistent with the intent of both parties is that the
reservation nullified the provision.
If the California Supreme Court’s interpretation of the
reservation to Article 9(4) is approved by this Court, such
approval will establish an entirely new standard for treaty
interpretation. Such standard would allow the courts of the United
States to interpret treaty provisions in a manner wholly inconsistent
with the intent of the treaty partner. Therefore, such a standard
* Rocca v. Thompson, 223 U.S. 317, 331-32 (1912) (emphasis added). This
rule of treaty construction has been adopted by many other courts. See Maximov
v. United States, 299 F.2d 565, 568 (2d Cir.) (The objective is to “give the
specific words of a treaty a meaning consistent with the genuine shared
expectation of the contracting parties.”) aff'd, 373 U.S. 49 (1963); Johansson v.
United States, 336 F.2d 809, 813 (Sth Cir. 1964); Estate of Burghardt v.
Commissioner, 80 T.C. 705, 708 (1983); Aiken Indus., Inc. v. Commissioner, 56
T.C. 925, 933 (1971).
14
will attract widespread international protest, and could ultimately
impair the ability of the Executive Branch to negotiate and
conclude treaties.
C. Even If This Court Accepts the California Supreme
Court’s Interpretation of the Ratification of the U.S.-
U.K. Tax Treaty with the Reservation to Article 9(4),
Such Interpretation Should Have No Effect upon a Tax
Treaty (Such as the U.S.-Japan Tax Treaty) Adopted
Prior to California’s Adoption of the Unitary Method.
Taxpayers entitled to the protections of treaties negotiated and
signed prior to California’s adoption of the Unitary Method, such
as Japan-based Multinational Groups, should not be held to any
“negative implication” of Congress’ reservation with respect to
Article 9(4) of the U.S.-U.K. Tax Treaty. Tax treaty negotiations
are bilateral negotiations. The Japanese government and the
United States Government negotiated their treaty prior to
California’s adoption of the Unitary Method. Japan had no reason
to request a provision requiring the states to use an arm’s length
method when that was the method already generally employed by
the states in taxing Japan-based Multinational Groups.
The Senate’s reservation to Article 9(4) and the adoption of the
Third Protocol to the U.S.-U.K. Tax Treaty by the United
Kingdom Parliament should in no way be binding on treaties
negotiated prior to California’s adoption of the Unitary Method.
If this Court should rule that the Senate’s reservation with regard
to Article 9(4) of the U.S.-U.K. Tax Treaty results in a negative
implied approval of the Unitary Method, this Court should reserve
on the issue of whether that reservation has a similar effect on
corporations entitled to benefits under treaties that pre-date both
the Senate’s vote and California’s adoption of the Unitary Method.
15
D. Uniformity in the Taxation of Foreign-based
Multinational Groups Is Essential in Order for the
Federal Government to Speak with One Voice Through
the United States Tax Treaty Network and in Order to
Prevent Double Taxation.
The California Supreme Court never addressed the Japan Line
tests of Foreign Commerce Clause analysis (namely, the “one
voice” and multiple taxation tests). The Amicus believes that the
California Supreme Court’s analysis is incorrect, and that this
Court should apply the Japan Line “one voice” and double
taxation tests.
With regard to the “one voice” test, the extraordinary
consensus of nations regarding the arm’s length method, as
embodied not only in the United States tax treaty network but in
the tax treaty networks of virtually all other countries (both
developed and developing), attests to the importance of permitting
the United States to speak with “one voice,” rather than 50 or
more voices. Thus, the California Superior Court found as a
factual matter that:
There is an international standard of accounting
universally practiced by all nations of the world, including
the United States, the AL/SA [Arm’s Length/Separate
Accounting] method. It is used to determine income of
business entities derived from operations in countries other
than their own, for purposes of income taxation by those
countries. It operates on the assumption that only the
income actually earned within a foreign country should be
taxed by it (no double taxation), but because that cannc:
always be determined with exactitude, AL/SA uses
formulary allocations when and as needed. But it is
indisputable that its aim is to determine as closely as
possible what actual income is derived from activities
within the geographical boundaries of the taxing nation,
and tax that income only.
16
As the above-quoted finding suggests, the country-by-country
approach to determining “actual income” derived from and taxable
by each country is a unique hallmark of the arm’s length method
which, in part because the method respects geographic boundaries
(and national sovereignty), is the sole internationally accepted
method.”” The method is deeply ingrained in the prevailing
OECD and U.N. Model Treaties which are the starting points for
the negotiation of new or revised bilateral treaties. Such method
is the main foundation of common ground upon which national tax
systems (and in many instances subnational tax systems) are
harmonized in and through tax treaties. It requires only the most
summary view of how United States tax treaties determine tax
jurisdiction under the separate country arm’s length method to see
how any material departure from this method, such as California’s
application of the Unitary Method to Foreign-based Multinational
Groups, could disrupt treaty relationships and cause multiple
taxation.
There are two bases on which the treaties permit taxation to be
exercised—source and business presence. First, source-based
taxation is predicated upon certain types of income derived from
sources within the paying country being subject to a limited tax
based on the gross amount of the payment. Some treaties exempt
certain of these payments entirely from taxation by the source
country. The purpose of the reduced or zero taxation is to foster
the free flow of capital into the nation of the payor of the income.
Second, the United States may generally tax a corporation,
resident in a treaty partner country that earns “business profits” in
the United States if the corporation maintains a “permanent
establishment” in the United States. In general, a permanent
establishment is defined under most treaties as a fixed place of
business through which the business of an enterprise is wholly or
77 The arm’s length method may be considered a “custom of nations.” See
Colgate-Palmolive Co., Inc. v. Franchise Tax Bd., 4 Cal. App. 4th 1681, 1710
(1991) vacated and remanded, 831 P.2d 798 (Cal. 1992); American Law
Institute, INTERNATIONAL ASPECTS OF UNITED STATES INCOME TAXATION II:
PROPOSALS ON UNITED STATES INCOME TAX TREATIES, 2-10 (1991).
17
partly carried on.” Under the permanent establishment articles,
minor actions taken in the United States, e.g. auxiliary or
preparatory activities, or merely holding the stock and overseeing
United States subsidiary corporations, will not rise to the level of
a permanent establishment,” i.¢., income from these activities will
not be taxable. The “permanent establishment” standard, as
agreed by the international community, is a more difficult nexus
test than the “flow of value”™ test required to include a foreign
corporation in the Unitary Method’s “combined report.”
The treaties also provide mechanisms to ensure that the amount
of net income reported in each treaty partner country in connection
with inter-branch or inter-company transactions with the
multinational group is properly determined under the arm’s length
method. Thus, the “business profits” articles of United States tax
treaties contain an arm’s length independent entity standard for
determining the taxable income of a permanent establishment.
Similarly, the Associated Enterprises articles of United States tax
treaties allow either treaty partner to allocate profits from a
corporation to a related corporation in the other country to the
extent necessary to ensure that the transactions are on an arm’s
length basis. If related parties engage in non-arm’s length
transactions, the treaties do not necessarily prohibit the use of a
formulary method to place the transaction on an arm’s length
basis. However, any allocation of income from a United States
corporation to a related foreign corporation, regardless of the
method utilized, is only permitted to the extent there are actual
transactions between related parties and such transactions have
been conducted on a non-arm’s length basis.
* Organization for Economic Cooperation and Development, Model Tax
Convention on Income and on Capital, art. 5 (1992) (hereafter “OECD Model
Treaty”). See also U.S.-U.K. Tax Treaty, Article 5; U.S.-Japan Tax Treaty,
Article 9 (“a fixed place of business through which a resident of a Contracting
State engages in industrial or commercial activity”).
» Ibid.
*° Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159, 178 (1983).
18
While the specific rules implementing the foregoing concepts
may differ somewhat from country to country, the concepts and
the framework on which they operate are universally accepted. On
the other hand, the Unitary Method is inconsistent with the
foregoing internationally agreed norms of taxation contained in the
treaties. The Unitary Method determines income attributable to
California by including all of the worldwide income of the unitary
group, without regard to the fact that a large portion of that
income has its source outside California, and in fact outside the
United States.
The Unitary Method includes all of the income of a Foreign-
based Multinational Group into the “pool” of income from which
California allocates a portion to the state, even if the foreign parent
and affiliate have no United States source income, are not engaged
in a trade or business in the United States through a permanent
establishment, and do not engage in non-arm’s length transactions
with related parties in the United States. United States tax treaties
uniformly concede tax jurisdiction in respect of this income to the
foreign treaty partner jurisdiction. Unless the foreign jurisdiction
has a zero percent tax rate, double taxation will result when
California taxes this income.
The Unitary Method further violates the underlying principles
of international taxation embodied in United States tax treaties by
allocating the income of a foreign parent and its foreign
subsidiaries to the parent’s United States subsidiary. United States
tax treaties do not allow the United States to tax the income of a
foreign parent corporation merely because its subsidiary is engaged
in business in the United States. Similarly, while the United States
provides for certain deemed inclusions from subsidiaries to the
parent,” a deemed inclusion from a parent to its subsidiary is
without precedent where the parties are otherwise dealing with one
another on an arm’s length basis. Without a finding of non-arm’s
length transactions, the Unitary Method’s combination of the
income of a foreign parent (and its other foreign subsidiaries) with
See Subpart F, 26 U.S.C. §§ 951-964.
ee ee
Ce ee He ee
19
the income of a corporation engaged in business in the United
States is without foundation or justification under the
internationally accepted norms contained in tax treaties.
The fact that the Unitary Method is fundamentally inconsistent
with the arm’s length method embodied in the treaties has already
attracted international protest and retaliation. Most significantly,
if the Unitary Method were upheld, as applied to Foreign-based
Multinational Groups, it would interfere with and disrupt the
Federal Government's ability to negotiate and conclude future tax
treaties. Accordingly, the Amicus submits that the need for federal
uniformity in this area is compelling and that the Unitary Method
should be held suspect under the “one voice” test.
Under the second Japan Line test relating to multiple taxation
of the same income, the Unitary Method also must fail because it
provides no method for eliminating such double taxation. Because
the Unitary Method taxes a California corporation on an amount
determined by a formula to be California taxable income without
regard to whether such income is also being reported as the income
of a foreign affiliate for foreign tax purposes, instances of double
taxation almost certainly will occur. Double taxation will always
occur where, under international normative rules as embodied in
United States tax treaties, the income taxed by California is
reserved for taxation by a treaty partner. The Unitary Method,
however, provides no mechanism to relieve this double taxation.”
On the other hand, the arm’s length method does provide such a
system to relieve international double taxation.
2 Compare Itel Containers Int'l Corp. v. Huddleston, 122 L. Ed. 2d 421, 436
(1993), where this Court recognized that Tennessee’s provision of a credit for
foreign or domestic taxes paid on the same transaction to which Tennessee was
levying its tax, reduced, if not eliminated, the risk of international multiple
taxation. It should be noted that California has no such foreign tax credit
mechanism.
20
The Associated Enterprises or Mutual Agreement article of
most United States tax treaties contains a provision similar to the
following provision from the OECD Model Treaty:”
Where a Contracting State includes in the profits of an
enterprise of that State—and taxes accordingly—profits on
which an enterprise of the other Contracting State has
been charged to tax in that other State and the profits so
included are profits which would have accrued to the
enterprise of the first mentioned state if the conditions
made between the two enterprises had been those which
would have been made between independent enterprises,
then that other State shall make an appropriate adjustment
to the amount of tax charged therein on those profits. In
determining such adjustment, due regard shall be had to
the other provisions of this Convention and the competent
authorities of the Contracting States shall if necessary
consult each other.
The competent authorities referred to are authorized by the Mutual
Agreement articles of United States tax treaties to endeavor to
resolve disputes between the two states relating to, among other
things, the taxation of transactions between related parties and the
prevention of double taxation.
The availability of the competent authority procedure, and of
the correlative adjustment mechanism to ensure consistent
treatment of intercompany transactions in both jurisdictions,
substantially reduces the risk of double taxation. California has no
mechanism available to a taxpayer subjected to double taxation
caused by the Unitary Method.
This Court has noted that California, because it is not a party
to United States tax treaties and is not authorized by the
constitution to negotiate its own tax treaties, may not avail itself
% OECD Model Treaty, Article 9(2). See also U.S.-lapan Tax Treaty, Article
25(2); U.S.-U.K. Tax Treaty, Article 9(3).
21
directly of this competent authority process.“ | However,
California may receive information from the United States
regarding competent authority negotiations and adjustments made
to a taxpayer's transfer prices as a result of competent authority
negotiations.» If California required taxpayers to use the same
intercompany prices as reflected on their federal returns, and to
amend those returns if any adjustment was made (either by the IRS
or the competent authorities), California could effectively eliminate
the risk of double taxation.
The competent authority process has proven effective. In
addition, there are procedures either in place or pending with many
of our treaty partners to enter into bilateral “advance pricing
agreements” relating to particular taxpayers, whereby the
competent authorities agree on a correct intercompany pricing
methodology on a prospective basis. This procedure, also only
available under treaties, may further reduce the incidence of double
taxation.
Because no mechanism whatever exists to prevent or relieve
the multiple taxation resulting from application of the Unitary
Method to Foreign-based Multinational Groups, the Unitary
Method fails the second Japan Line test by creating a substantial
risk of multiple taxation.
Il. THE CALIFORNIA SUPREME COURT’S RELIANCE
UPON PROVISIONS OF THE INTERNAL REVENUE
CODE AS SUPPORTING THE UNITARY METHOD IS
INCORRECT.
The notion that section 482 of the Internal Revenue Code
supports the Unitary Method is preposterous. Yet, the California
* Container, 463 U.S. at 192 0.31.
= 26 U.S.C. § 6103(d) provides that returns and return information shall be
open for inspection by, or disclosure to “any State agency, body or commission,
or its legal representative, which is charged under the laws of such State with
responsibility for the administration of State tax laws...”
22
Supreme Court’s opinion cites the term “apportion” in section 482
as evidence that Congress in effect has long sanctioned state
application of the Unitary Method. According to the opinion:
{I]n enacting the Internal Revenue Code of 1956,
Congress authorized the Secretary of the Treasury to
“distribute, apportion, or allocate gross income ...
between or among” multi-corporate enterprises, including
those with foreign domiciles, “in order ... clearly to
reflect [their] income” (26 U.S.C. § 482, italics added),
a formulation that reflects at least an awareness of
apportionment methodologies.”
The implication of the above-quoted passage is that Congress
had knowledge of “apportionment methodologies” similar in
concept to the Unitary Method and, far from prohibiting or
limiting their use, actually endorsed their use to allocate income
under section 482.
The proposition that the term “apportion” in section 482 had
anything to do with a formulary, non-separate accounting concept
similar to the Unitary Method is clearly wrong. The California
Supreme Court’s error is based on a misunderstanding of the
legislative history of section 482. That history demonstrates
Congress’ overriding objective to prevent abuses involving the use
of intercompany transactions to avoid tax by placing income
improperly in a tax-favored entity and/or a tax-favored country.
Congress authorized the IRS to correct such misallocations of
income by reallocating the income back to the entity or country
where it properly belonged. Only the arm’s length method
contemplates and provides for such entity-by-entity and country-by-
country allocation. Because the Unitary Method is totally
indifferent to whether income properly “belongs in” or is properly
earned by or within any particular entity or country, Congress
could not possibly have had a Unitary Method in mind when it
% 829 P.2d at 297.
23
originally enacted the predecessor of section 482. A brief review
of the legislative history confirms this Congressional focus.
The antecedent of section 482 was contained in regulations
promulgated under the authority of the Revenue Act of 1917 which
required affiliated corporations to provide sufficient information
about _ Intercorporate relationships that would allow the
Commissioner “to compute the amount of the tax properly due
from each corporation on the basis of an equitable and lawful
accounting. . In addition, the regulations generally authorized
the Commissioner to allocate income and deductions among
affiliated corporations and also to consolidate the accounts of such
affiliated corporations “whenever necessary to more equitably
determine the invested capital or taxable income....”“ This
authority to “consolidate accounts” was continued in section 240
of the Revenue Act of 1918.” The Senate Committee on Finance
Report explained that such “consolidation ... prevent{s] evasion
which cannot be successfully blocked in any other way. Among
affiliated corporations it frequently happens that the accepted
intercompany accounting assigns too much income ... to Company
A [and] not enough to Company B.””
Section 240(d) of the Revenue Act of 1921 similarly
authorized the Commissioner to “consolidate the accounts of ...
related trades and businesses, in any proper case, for the purpose
of making an accurate distribution or apportionment of gains,
profits, income, deductions, or capital between or among such
related trades or businesses.’ The House Ways and Means
Committee clarified that the provision’s purpose was to prevent
a
Reg. 41, art. 77, T.D. 2694 (1918) (emphasis added).
Reg. 41, art. 78, T.D. 2694 (1918). See Union P, Commissione
17 B.T.A. 793 (1929), acq. — c
* ch. 18, § 240, 40 Stat. 1057.
“
S. Rep. No. 617, 65th Cong., 3d Sess. 8-9 (1918).
“ch. 136, § 240(d), 42 Stat. 227.
24
arbitrary profit-shifting and other abuses, such as the use of a
foreign subsidiary to “milk” the parent corporation “or otherwise
improperly manipulate the financial accounts of the parent
company,” not to compute tax on the basis of a consolidated
return.2 That is, section 240(d) was not intended to allow the
Commissioner to combine and apportion the incomes of related
parties as if a consolidated return had been filed.
The provision first assumed substantially its modern
appearance when reenacted as section 45 of the Revenue Act of
1928." Section 45 specifically predicated the Commissioner's
authority to reallocate income or deductions upon the objective to
prevent tax avoidance and ensure the clear reflection of the income
of the related parties (to determine their “true tax liability” in the
words of the House Ways and Means Report)“ Neither in the
1928 Act nor in any predecessor legislation was the Commissioner
given the authority to combine and apportion the otherwise
separate net incomes of related taxpayers.
The proposition that section 482 and its predecessors could not
be used by the Internal Revenue Service to combine and apportion
the income of two or more related taxpayers or otherwise place
them in effect on a consolidated return basis is made abundantly
clear by the case law. Construing the scope of section 45 of the
1928 Act in this connection, the Tax Court in Seminole Flavor Co.
v. Commissioner, 4 T.C. 1215, 1231-32 (1945), rejected the
Commissioner's attempt to combine the incomes of a partnership
and a corporation owned by the same interests, stating:
The statute authorizes the Commissioner to “distribute,
apportion, or allocate ... between or among such
organizations, trade or business,” but it does not
specifically authorize him “to combine.” Certainly, the
@ H.R. Rep. No. 350, 67th Cong., Ist Sess. 14 (1921) (emphasis added).
® ch. 852, § 45, 45 Stat. 806.
“ H.R. Rep. No. 2, 70th Cong., Ist Sess. 16-17 (1928).
25
Commissioner's own regulations, section 19.45-1,
Regulations 103, negative the use of section 45 for the
purpose of combining or consolidating the separate net
incomes of two or more organizations, trades or business
as it states:
** * It [sec. 45] is not intended (except in the
case of computation of consolidated net income
under a consolidated return) to effect in any case
such a distribution, apportionment, or allocation of
gross income deductions, or any item of either, as
would produce a result equivalent to a computation
_of consolidated net income under section 141.
am te panne aeng ioner’s action here has
a t ivalent
— bing to the computation of
As the foregoing makes clear, the suggestion in the California
Supreme . Court opinion that section 482 contains explicit
Congressional authorization to utilize a Unitary Method of taxation
ee the income of the combined enterprise is totally
In fact, other provisions of the Internal Revenue Code
demonstrate Congress’ cumin anh aaiemsatiamecs 2 On
arm’s length method, particularly in the international context. As
regards United States taxation of foreign parent-owned foreign
corporations, the Code provides for tax jurisdiction in respect of
these corporations only on their U.S. source income or income
effectively connected with a United States trade or business.”
While the Code authorizes the filing of consolidated returns which
combine” the income of a number of separate corporations
foreign corporations generally may not be included in such a
consolidated return. In fact, this Court has held as a general
rule that except in instances where the corporate form is a “sham
or unreal” the separate existence of corporations and their
© 26 U.S.C. §§ 881-882.
26 U.S.C. §§ 1501, 1504(>)(3).
26
shareholders must be respected.*” In short, there is no basis for
the California Supreme Court’s suggestion that section 482
supports or authorizes the use of the Unitary Method or indeed any
method other than the arm’s length method.
Ill. | THECALIFORNIA SUPREME COURT’S RELIANCE
UPON UNITED STATES TREATIES OF
FRIENDSHIP, COMMERCE AND NAVIGATION AS
SUPPORTING THE UNITARY METHOD IS
INCORRECT.
Another factor relied upon by the California Supreme Court
for the proposition that Congress has evidenced its “approval” of
California’s Unitary Method was Congress’ ratification of a
number of United States Treaties of Friendship, Commerce and
Navigation. The California Supreme Court noted that these
treaties, dating from the late 1940's, incorporated provisions that
“preserve the states’ freedom to employ methods that produced a
tax ‘reasonably allocable or apportionable’ to the taxing
jurisdiction...“ The California Supreme Court cited in
particular an annotated draft of a FCN Treaty with Portugal. It
should be clarified that the U.S.-Portugal FCN Treaty has never
entered into force. Unlike the draft U.S.-Portugal FCN Treaty,
the U.S.-Japan FCN Treaty did enter into force and thus is an
appropriate subject of analysis.
If the California Supreme Court, rather than relying on the
uneffectuated draft treaty with Portugal, had examined the U.S.-
Japan FCN Treaty, coupled with a later FCN Treaty negotiated
with France, the court would have been unable to conclude that the
U.S.-Japan FCN Treaty supports the Unitary Method. In fact, the
U.S.-Japan FCN Treaty requires the states to utilize the arm’s
length method with respect to the taxation of Japanese
corporations.
“ Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 439 (1943).
* 829 P.2d at 297.
27
FCN Treaties generally provide restrictions on the taxation of
corporations resident in the other country.” The U.S.-Japan
FCN Treaty provides that:
In the case of companies of either Party engaged in trade
or other gainful pursuit within the territories of the other
party ... such other Party shall not impose or apply any
tax, fee or charge upon any income, capital or other basis
in excess of that reasonably allocable or apportionable to
its territories, nor grant deductions and exemptions less
than those reasonably allocable or apportionable to its
territories.”
Although the California Supreme Court found that similar language
in the draft U.S.-Portugal FCN Treaty was consistent with a
finding that Congress approved of the Unitary Method, this
interpretation is in error.
The U.S.-Japan FCN Treaty was negotiated in the 1950’s prior
to the widespread adoption of the Unitary Method, and as this
Court has held, a treaty must “be read in light of the conditions
and circumstances existing at the time they were entered
into... Because the arm’s length method was, and is, the only
internationally accepted method, the reasonably allocable or
apportionable amount must be determined on the basis of the arm’s
length method. This conclusion becomes inescapable in view of
the effect of the taxation provision in the later ratified U.S.-France
FCN treaty.
Article XI(3) of the U.S.-Japan FCN Treaty provides that
Japanese corporations shall not be subject to taxes more
burdensome than those borne by companies of any third country.
This “most favored nation” clause in effect restricts subnational
Sumitomo Shoji Am., Inc. v. Avagliano, 457 U.S. 176 (1982).
U.S.-Japan FCN Treaty, Article X1(4).
Rocca v. Thompson, 223 U.S. 317, 331-32 (1912).
$1
28
(e.g., state) taxation of Japanese corporations as a result of the
taxation provisions of other international agreements to which the
United States is a party, including the Convention of Establishment
Between the United States of America and France.” Article 9(4)
of this Convention provides that:
[French corporations] shall not be subject, within the
territories of the [United States], to any form of taxation
upon capital, income, profits or any other basis, except by
reason of the property which they possess within those
territories, the income and profits derived from sources
therein, the business in which they are there engaged, the
transactions which they accomplish there, or any other
basis of taxation directly related to their activities within
those territories.
By reason of the “most favored nation” clause in the U.S.-Japan
FCN Treaty, this Article in the Convention with France imposes
the obligation to utilize the arm’s length method, including at the
state level,” in determining the tax liability of Japanese
corporations. The Article is entirely consistent with the arm’s
length method as reflected in United States tax treaties and the
Internal Revenue Code. It provides for source taxation, taxation
of business profits derived from an active trade or business, and
transaction based taxation. Failure to require the application of the
arm’s length method demanded by this provision, when applied to
a Japanese company, will violate the U.S.-Japan FCN Treaty.
The California Supreme Court never considered the effect of
this later treaty with France, and therefore misinterpreted the
“negative implication” of Congress’ ratification of FCN Treaties.
The existence of FCN Treaties not only fails to support the
2 11: U.S.T. 2398, T.1.A.S. No. 4625 (Nov. 25, 1959).
*% Hines v. Davidowitz, 312 U.S. at 64-65 (“This country ... has entered into
numerous treaties of amity and commerce since its incepuon—treates entered into
under express constitutional authority, and binding upon the states as well as the
nation.”).
29
California Supreme Court’s conclusion; it directly supports the
Opposite conclusion. '
The United Kingdom and the United States are not Parties to
an FCN Treaty. Therefore, if this Court concludes that the
Unitary Method as applied to the Petitioner is constitutional, this
Court should reserve on the issue of whether the Unitary Method
is nevertheless invalid when applied to a Japanese company
protected by the U.S.-Japan FCN Treaty.
CONCLUSION
The California Supreme Court incorrectly upheld the Uni
Method on the basis of “negative imp ications.” re Peder
Government silence is actually Federal Government speech. It
declared Federal Government inaction to be Federal Government
action. This analysis is wrong and dangerous, and must he
rejected. Absent such “negative implications,” the application of
this Court’s “one voice” and multiple taxation tests demonstrates
that the Unitary Method violates both of these tests, while the
arm's length method does not. If, however, this Court determines
that the Unitary Method as applied to U.K.-based Multinational
Groups is constitutional, this Court should reserve on the issue of
whether the same conclusion may be reached when applied to a
30
Japan-based Multinational Group entitled to the protections of the
U.S.-Japan Tax Treaty and the U.S.-Japan FCN Treaty.
‘Counsel of Record
December 15, 1993.
Respectfully submitted.
C. David Swenson’
Dennis I. Meyer
Leonard B. Terr
Harry A. Franks, Jr.
BAKER & MCKENZIE
815 Connecticut Avenue, N.W.
Washington, D.C. 20006-4078
(202) 452-7000
Counsel for Keidanren
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