Amicus Curiae Brief — Barclays Bank PLC v. Franchise Tax Bd. of Cal.

‘Ad09 FIGVTIVAY 1839

QUESTION PRESENTED

Whether California’s worldwide combined reporting

method of determining the portion of the income of a

unitary business attributable to its activities in California

is constitutional under the foreign Commerce Clause and

the Due Process Clause as applied to either a unitary

group with a foreign parent (Barclays) or a unitary group

with a domestic parent (Colgate-Palmolive).

(i)

TABLE OF CONTENTS

Page

QUESTION PRESENTED ................. islaaasatiin en i

TABLE OF AUTHORITIBS .................................... siaabbs Vv

INTEREST OF THE AMICI CURIAE ..........0.0............ 1

STATEMENT ............ ES ceiiiiidiaieiamenn 2

INTRODUCTION AND SUMMARY OF ARGU-

8 ee 3

ARGUMEN T..............-.c0ccccescccccecccceses ED 7

I. CALIFORNIA’S FORMULARY METHOD

DOES NOT VIOLATE THE FOREIGN COM-

CC EE 7

A. The Basic Theoretical Weaknesses Of The

Arm’s Length Approach, Recognized By

This Court, Require Resort To Formulary

meemsssmmessstocs 8

B. California’s Formulary Method Does Not

Violate The “One Voice” Requirement Of

The Foreign Commerce Clause Because The

Federal Government Uses Formulary Ap-

portionment Itself In Conjunction With The

Arm’s Length Method o.oo. 14

1. The Federal Government Uses Formulary

Ap, ortionment In Conjunction With

ee 14

2. The Federal Government’s Use of Formu-

lary Methods In Conjunction With Arm’s

Length Does Not Violate Its Treaty Obli-

LETT EE 19

C. California’s Formulary Method Does Not

Pose More Risk Of Multiple Taxation Than

The Arm’s Length Method As Applied By

The Federal Government ...........000000000000- 0000. 25

(iii)

iv

TABLE OF CONTENTS—Continued

Il. CALIFORNIA’S FORMULARY METHOD

DOES NOT VIOLATE THE DUE PROCESS

CLAUSE, AS IT IMPOSES NO HEAVIER

BURDEN ON MULTINATIONAL CORPORA-

TIONS THAN IS IMPOSE. .'NDER CUR-

RENT FEDERAL LAW uw. oo. eccceeeeeeee

SPIT cecrsnscesernnsensenscntunninianntsiniinitingsinticiismiiiamiimmais =

Page

Pe ee «

v

TABLE OF AUTHORITIES

Cases Page

Amerada Hess Corp. v. Director, Div. of Taxation,

fF eee 9

Pass, Ratcliff & Gretton, Ltd. v. State Tax

Comm'n, 266 U.S. 271 (1924) 2.0 8

Bausch & Lomb, Inc. v. Comm’r, 92 T.C. 525

(1989), aff'd, 933 F.2d 1084 (2d Cir. 1991)... 12

Container Corporation of America v. Franchise

Taz Bd., 463 U.S. 159 (1983) ............................... passim

EJ. Du Pont De Nemours & Co. v. United States,

608 F.2d 445 (Ct. Cl. 1979), cert. denied, 445

a aa eenieaieieaameic 12, 29, 30

Eli Lilly & Co. v. Comm’r, 84 T.C. 996 (1985),

aff'd in part and rev'd in part, 856 F.2d 855 (7th

REPRE Ce Ee ARES 12

GD. Searle & Co. v. Comm’r, 88 T.C. 252

TE asccienalenenieshasanbainidaacsatnshinsiadeininnianiesbiatdesambeentibdameedtion 12

Hospital Corporation of America v. Comm’r, 81

5 SRR ane eee 12

Intel Corp. and Consolidated Subsidiaries v.

Comm’r, 100 T.C. No. 39 (June 28, 1993),

reprinted in BNA Daily Tax Report, June 29,

1993, 1993 U.S. Tax Ct. LEXIS 38.00.0000... 6, 15,17

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

eee ee 5, 25

Merck & Co., Inc. v. United States, 24 Cl. Ct. 73

EEE ree ee eee mee we 12

Mobil Oil Corp. v. Commissioner of Taxes of Vt..

Ge i Se GI citerectcctetietemiabitertnrmintcettoreiteieenise 4,8,9

Panhandle Oil Co. v. Mississippi ex rel. Knox, 277

U.S. 218 (1928), overruled by Alabama v. King

& Boozer, 314 U.S. 1 (1941) .........0. nn... 30

Perkin-Elmer Corp. v. Comm’r, T.C. Memo 1993-

414, 1993 Tax Ct. Memo LEXIS 424 (Sept. 8

EEE EIT NRE NO are eT ee 11,12

Phillips Petroleum Co. v. Comm’r, 101 T.C. No. 6

(July 27, 1993), BNA Daily Tax Report, July

28, 1998, 1993 U.S. Tax Ct. LEXIS 47... 16, 16-17

Quill Corp. v. North MPekota, 112 S.Ct. 1904

I chelate ae tes 29

vi

TABLE OF AUTHORITIES—Continued

Page

Sundstrand Corp. v. Comm’r, 96 T.C. 226 (1991) .. 12

Trinova Corp. v. Michigan Dept. of Treasury, 498

Statutes

U.S. 358 (1991). os 9

United States Steel Corp. ' v. Comm’r r, 617 F. 2d 942

I, Ta siieeeerinieiemnisamienibiaas 12

United States v. Toyota Motor Corp., 561 F. Supp.

RE 28

United States v. Toyota Motor Corp., 569 F. Supp.

1158 (C.D. Cal. 1983) .......... PE ORE LE ee 28

Cal. Rev. & Tax Code § 25185 ..................ccccccccccecceeeeee 16

Omnibus Budget Reconciliation Act of 1993, Pub.

L. No. 103-66, 107 Stat. 312, 496-501 (August

10, 1993) (to be codified at 26 U.S.C. § 956A) _.. 18

Pub. L. No. 101-239, § 7403, 103 Stat. 2358 (1989) .. 28

Pub. L. No. 101-508, § 11315, 104 Stat. 1388-456

(1990)... 28

Revenue Act of 1921, a. 136, 42 Stat. 207 (1921) . 15

Revenue Act of 1962, Pub. L. No. 87-834 § 12, 76

Stat. 960, 1006-27 (1962) 18

eee passim

26 U.S.C. § 868 (b) .......................-...-.... dancisiidaendiadel 4, 15, 20

26 U.S.C. § 882(c) ............... pitectaaasdibeitshaaiisiaspilealiaideidisalinin 17, 20

26 U.S.C. §§ 951-960 saviieealesiiiiesidndaiaisaaibiiiaiiddamaliin 17

I eee 7

STEEL: UTI nincnccninetdtinniiignrtinsmmsrettninionineetimeesinppeuesss 7

Treaties

Convention Between the United States and the

United Kingdom for Avoidance of Double Taxa-

tion, Dec. 31, 1975, U.S.-U.K., 31 U.S.T. 5670__. 20, 21,

22, 23, 24

OECD Model (Income and Capital) Tax Treaty,

Sept. 1, 1992... OT Ne eee a 22

U.S. Model Double Taxation Treaty (1981), re-

printed in Model Income Tax Treaties (Kees

van Raad ed., 1983) .......... ee 20, 21, 22, 23

vii

TABLE OF AUTHORITIES—Continued

Regulations Page

Cal. Admin. Code Tit. 18 § 25137-60000 29

Intercompany Transfer Pricing Regulations Under

Section 482, 58 Fed. Reg. 5310 (1993) (codified

at 26 C.F.R. §§ 1.482-0T through 7T) 5,13

Proposed Regulation § 1.482-6, 58 Fed. Reg. 5310,

5311 (Jan. 21, 1998) 2200 eee 19

BI, Gi GR I CI ceccccecccoeecesscecvecccercneensinnemasone 15

26 C.F.R. § 1.482-1T (b) (2) (iii) 19

i 13, 19

26 C.F.R. § 1.482-5T (e) 00. ieiaienneaiaasiabindeioeniatadatae: 19

ae ie OF I eccteetececcecccscneconsccccenensmssnsnmecnsens 16

26 C.F.R. § 1.863-3(b) (2), Example1.__. aiieicannies 15, 16

26 C.F .R. § 1.BGB-BT (i) oo... cccnccccecccccccccocecceee 4

26 C.F.R. § 1.863-3T(b) (2), Example2. 15, 16

26 C.F.R. § 1.863-3(b) (2), Example3 ES 15

26 C.F-.R. § 1.882-5 (bb) 2... eee cece ec eetecceeeeecenee 17

26 C.F-.R. § 1.964-1 ce eeeeeereeneeee 29

26 CFR § 1.6088A-3(c) (1).

26 CFR § 1.6088A-3(c) (2)

28

26 CFR § 1.6038A-3(c) (3)-(6) 0. 28

SS CPR § 1.GGGBA-B (2) q.....-....-.cccsecceceoseccereceneseeeceeeees 28

Legislative Materials

Foreign Income Tax Rationalization & Simplifica-

tion Act of 1992, H.R. 5270, § 201, 102 Cong.,

I A 18

H.R. Rep. 426, 99th Cong., Ist Sess. (1985) 10, 13

H.R. Rep. 841, 99th Cong., 2d Sess. (1986), re-

printed in 1986 U.S.C.C.A.N. 4075 13

H.R. Rep. 2508, 87th Cong., 2d Sess. (1962) 19

S. Exec. Rep. 5, 96th Cong., Ist Sess. (1979)... 23, 24

S. Rep. No. 1881, 87th Cong., 2d Sess. (1962), re-

printed in 1962 U.S.C.C.A.N. 3304... 18

Government Documents

Notice 88-123, 1988-2C.B.458 18

Notice 89-10, 1989-1 C.B. 631-32 ecco 16

viii

TABLE OF AUTHORITIES—Continued

Rev. Rul. 85-7, 1985-1 C.B. 188 ........ eee

Rev. Rul. 89-115, 1989-2 C.B. 130

U.S. General Accounting Office, GGD-81 81, IRS

Could Better Protect U.S. Tax Interests in De-

termining the Income of Multinational Corpora-

ee Gs Ge, ED ecccecccceeecsscbnteecncoundsnastcnnatecties

U.S. General Accounting Office, GAO ‘GGD-92-89,

International Taxation: Problems Persist in

Determining Tax Effects of Intercompany

Prices (June 1992) . S

U.S. Treasury and IRS, Joint Statement of Policy

and Action Plan on International Tax Com-

pliance (Dec. 17, 1993), reprinted in BNA Daily

Tax Report (Dec. 20, 1993) .............o- ee ee.

U.S. Treasury and IRS, Report on the Application

and Administration of Section 482 (April 9,

1992), reprinted in BNA Special Supplement 2,

Report No. 70 (April 10, 1992) (bound with

. 11,13

24

BNA Daily Tax Report) ......................-..............- 12-13, 22

Other Authorities

Brian J. Arnold and Thomas FE. McDonnell, Re-

port on the Invitational Conference on Transfer

Pricing: The Allocation Of Income And Ex-

penses Among Countries, €1 Tax Notes 1377

(Dec. 13, 1993) ae

Chevron Not Required to Label 1.8 Million Pages

Turned Over To The IRS, BNA Tax Manage-

ment, Transfer Pricing Report (July 7, 1993)...

James P. Fuller and Ernest F. Aud, Jr., The New

Temporary and Proposed Section 482 Regula-

tions: A Wolf in Sheep’s Clothing?, 6 Tax Notes

Int’] 525 (March 1, 1998) ............................-.......

Jerome R. Hellerstein, Federal Income Taxation

of Multinationals: Replacement of Separate

Accounting With Formulary Apportionment, 60

Tax Notes 1131 (August 23, 1993)...

esiahameastbiantets eevee ty 8, 15

13

19

oe te

ix

TABLE OF AUTHORITIES—Continued

IRS Grants Two APAs In Derivative Products

Area, Tax Notes Today, 92 TNT 96-1 (May 6,

1992) ...................

Louis M. Kauder, The Unepecifie ‘Federal: Tax

Policy of Arm’s Length: A Comment On The

Continuing Vitality of Formulary Apportion-

ment At The Federal Level, 60 Tax Notes 1147

Page

24

(Aug. 29, 1993) ........ Siiiieiudiaanniemnttietiaitaad bec 6, 20, 22

Stanley I. Langbein, The Unitary Method and the

Myth of Arm's Length, 30 Tax Notes 625 (Feb.

il DD svcccdpsinsccllipgencesoubnicnsinianeueninenibaadiitaisltieal 4,10, 11

Letter of International Chamber of Commerce of

4/22/93, reprinted in International Chamber of

Commerce Attacks New Transfer Pricing Regs.,

Tax Notes Today, 98 TNT 113-24 (May 27,

STITT cupssacanicinetieeeaiaiatenladeon daiasiteirtclitaaactiaieh lala tila

Letter of Christof S. Klitz of 7/19/93, reprinted

in German Industry Rep Takes Aim At Pro-

posed Regs., Tax Notes Today, 93 TNT 163-64

nn

Letter of Tsunekazu Sakano of 7/13/93, ‘reprinted

in Keidanren Urges IRS to Take Another Look

at Proposed Regs., Tax Notes Today, 983 TNT

158-24 (July 29, 1998) 22.......2.....0.....ccccccccccesceceeeeeee

Letter of Rah-Yong Uhm of 8/9/93, Director Gen-

eral for Tax Affairs, Ministry of Finance, Re-

public of Korea, reprinted in Korean Finance

Ministry Comments on Tranfer Pricing Regs.,

Tax Notes Today, 93 TNT 181-49 (Aug. 31,

1998) ........ Ee Ns FI rater Oe cn

David R. Tillinghast, An American View of Inter-

national Intercompany Pricing Problems, in

1979 Conference Report: Report of the Pro-

ceedings of the Thirty-First Tax Conference 169

(Canadian Tax Foundation 1980).

Dale W. Wickham & Charles J. Kerester, New

Directions Needed for Solution of the Interna-

tional Tranfer Pricing Tax Puzzle: Interna-

tionally Agreed Rules or Tax Warfare?, 56 Tax

Notes 339 (July 20, 1992) 0

7, 26

11

11

BRIEF OF THE

COUNCIL OF STATE GOVERNMENTS, NATIONAL

GOVERNORS’ ASSOCIATION, U.S. CONFERENCE OF

MAYORS, INTERNATIONAL CITY/COUNTY

MANAGEMENT ASSOCIATION,

NATIONAL LEAGUE OF CITIES,

NATIONAL ASSOCIATION OF COUNTIES, AND

NATIONAL CONFERENCE OF STATE LEGISLATURES

AS AMICI CURIAE IN SUPPORT OF RESPONDENT

INTEREST OF THE AMICI CURIAE

Amici, organizations whose members include state,

county, and municipal governments and officials through-

out the United States, have a compelling interest in legal

issues that affect state and local governments. Among the

most important of such issues are those raised by federal

limitations on state and local taxing authority. The peti-

tions in these two cases raise constitutional challenges

under the foreign Commerce Clause and the Due Process

Clause to California’s worldwide combined reporting

method of taxation. With more than $2 billion in tax

revenues at stake in California alone (Colg. Supp. Br. on

Petition 4, Resp. Op. Cert. Colg. 15), this case presents

a grave challenge to the existing tax schemes, revenue-

raising powers, fiscal health and leg .tive discretion of

State governments. Amici have a vital interest in seeing

that this threat is turned back and the decisions below

affirmed.’

STATEMENT

These cases involve the application of two methods of

determining the portion of the income of a unitary multi-

national business attributable to its activities in a tax-

ing jurisdiction. The two methods are worldwide com-

bined reporting (WWCR), which is a type of formulary

1 The parties’ letters of consent to the filing of this brief have

been filed with the Clerk pursuant to Rule 37.3 of the Rules of this

Court.

2

apportionment, and arm’s length/separate accounting

(AL SA).

Under WWCR, as applied by California in the income

years in question (1970-1973 and 1977), once a multi-

national business has been determined to be unitary (i.e.,

Operating as a single economic enterprise, even though

divided into many subsidiaries or branches), the multi-

national is treated as one unit and the portion of its in-

come attributable to California is determined based on a

formula that takes into account the taxpayer’s capital

(property), labor (payroll), and the use of the market

(sales) in California compared to the same factors on a

worldwide basis. Pet. Br. Colg. 5-6.

Under AL SA, instead of treating the unitary group as

a single business, each separate subsidiary or branch of

the multinational group is treated as if it were an inde-

pendent enterprise dealing with ail other units of the

multinational group on an arm’s length basis. /d. at 4-5.

Both petitioners have conceded that their operations in

California (directly by the parent in the case of Colgate,

and through a separate subsidiary (Barcal) and a branch

of a U.K. corporation (BBI) in the case of Barclays)

were part of single unitary businesses which included all

other corporations in their controlled groups (approxi-

mately 220 corporations in the case of Barclays, and ap-

proximately 75 corporations in the case of Colgate). /d.

at 4; Pet. Br. Barc. 3.

Barclays filed its income tax returns in California, with

Barcal filing a separate accounting return and BBI filing

a worldwide combined return for itself and all of its U.S.

and foreign subsidiaries, including Barcal. Pet. Br. Barc.

11-12. Colgate fi'ed its California return for the parent

only, excluding its foreign subsidiaries. Pet. Br. Colg.

10. On audit, the California Franchise Tax Board de-

termined (as petitioners here concede) that both peti-

tioners constitute unitary businesses and therefore should

file combined returns for their entire worldwide unitary

groups. /d.; Pet. Br. Barc. 11. This change in method

3

of filing resulted in more of petitioners’ income being at-

tributed to California. Pet. Br. Colg. 10; Pet. Br. Barc.

11-12.

Petitioners now challenge the resulting increase in their

tax burden on constitutional grounds, arguing that WWCR

violates the foreign Commerce Clause and (in the case

of Barciays) the Due Process Clause. Thus, petitioners

argue that the Constitution mandates that California use

AL SA in taxing either a multinational unitary group

with a foreign parent (Barclays) or a multinational uni-

tary group with a U.S. parent (Colgate).

INTRODUCTION AND SUMMARY OF ARGUMENT

Petitioners’ arguments depend on their portrayal of

WWCR as a radical method used by California that is

the antithesis of the arm’s length method used by the fed-

eral government and the rest of the world. Pet. Br. Barc.

16; Pet. Br. Colg. 4-6. In reality, however, arm’s length

and WWCR approaches are not incompatible opposites, as

petitioners would have this Court believe, but are part of

a continuum. At a recent conference, both proponents

and opponents of WWCR from the international com-

munity agreed that

the arm’s length principle and formulary apportion-

ment should not be seen as polar extremes; rather,

they should be viewed as part of a continuum of

methods ranging from [comparable uncontrolled

prices] to predetermined formulas. It is not clear

where the arm’s length principle ceases and formu-

lary apportionment begins, and it is counterproduc-

tive and unimportant to attempt to apply labels to

the methods.

Brian J. Arnold and Thomas E. McDonnell, Report on

the Invitational Conference on Transfer Pricing: The

Allocation Of Income And Expenses Among Countries,

61 Tax Notes 1377, 1381 (December 13, 1993).

Formulary methods similar to WWCR are commonly

used in conjunction with the arm’s length method by the

4

federal government and other countries. In recent decades,

the federal income tax rules relating to the allocation of

income in the international context have been evolving

under the pressure of economic reality away from a pure

arm’s length approach based on comparable transactions,

to a combination of comparable transactions and formu-

lary approaches in the absence of comparables. See

e.g., 26 U.S.C. § 863(b); 26 C.F.R. § 1.863-3T(b). In

this context, the United States is leading the world toward

a new consensus that arm’s length and formulary ap-

proaches are both parts of an acceptable continuum of

methods.

The federal government’s resort to formulary methods

in conjunction with arm’s length arises out of a central

flaw in the arm’s length approach which precludes its use

in “pure” form. Indeed, Professor Langbein has com-

mented that, because of these flaws, “arm’s length, defined

as the antithesis of fractional apportionment, not only is

not a norm, it is not even meaningfully a concept.” Stan-

ley I. Langbein, The Unitary Method and the Myth of

Arm’s Length, 30 Tax Notes 625, 655 (February 17,

1986).

The arm’s length method seeks to allocate the profits of

each member (or branch) of a unitary group “as if those

profits were earned by a separate enterprise.” Barc. Peti-

tion 5. The obvious problem with this approach is that

in the absence of actual comparable transactions between

unrelated enterprises, it is often impossible to reconstruct

what the hypothetical profits of the related enterprises

should be. As this Court has recognized, the failure of

separate geographic accounting to account for “factors of

profitability [which] arise from the operation of the busi-

ness as a whole” makes it “misleading to characterize the

income of the business as having a single identifiable

‘source.’ ” Mobil Oil Corp. v. Commissioner of Taxes of

Vt., 445 U.S. 425, 438-39 (1980).

This problem led the federal courts, in a series of cases

beginning in the 1970s, to apply a variety of formulary

5

methods to allocating the profits of the related enterprises.

The federal government, which has long used formulary

methods in combination with arm’s length, formalized

its use of this approach in 1993 with the issuance of tem-

porary regulations applying a formulary approach in the

absence of comparable arm’s length transactions. See

Intercompany Transfer Pricing Regulations Under Sec-

tion 482, 58 Fed. Reg. 5310 (1993) (codified at 26

C.F.R. §§ 1.482-0T through 7T) (“temporary regula-

tions”).

Once the false dichotomy between WWCR and arm’s

length (as applied by the federal government) is exposed,

petitioners’ arguments crumble. It becomes clear that Cal-

ifornia’s taxation method is permissible under this Court’s

foreign Commerce Clause* and Due Process Clause

precedents.

1. As enunciated in Japan Line, Ltd. v. County of Los

Angeles, 441 U.S. 434 (1979), and elaborated in Con-

tainer Corporation of America v. Franchise Tax Bd., 463

U.S. 159 (1983), the foreign Commerce Clause requires

that a state tax scheme implicating international com-

merce meet two tests: first, it must not prevent the federal

government from “ ‘speaking with one voice’ in interna-

tional trade,” Container, 463 U.S. at 193 (quoting Japan

Line, 441 U.S. at 453), and, second, it must not result in

international multiple taxation that can reasonably be

eliminated by the State. Container, 463 U.S. at 189-90.

California’s formulary method does not violate the “one

voice” requirement of the foreign Commerce Clause be-

cause it is consistent with the method applied by the federal

government itself in apportioning the income and deduc-

tions of corporations engaged in international commerce.

?The Franchise Tax Board argues that because Congress has

acted to permit it to use WWCR, dormant Commerce Clause anal-

ysis is inapplicable to this case. Amici agree. However, to avoid

duplicating respondent’s extensive treatment of this issue, this

brief will focus on demonstratin; the constitutional validity of

California’s WWCR methodology, even assuming that dormant Com-

merce Clause analysis is applicable.

6

In fact, the federal government applies formulary ap-

proaches, in conjunction with the arm’s length method, to

U.S. branches of foreign corporations (including banks,

such as BBI), to foreign corporations controlled by U.S.

parents (such as Colgate and its subsidiaries), and to U.S.

subsidiaries of foreign parents (such as Barcal); by in-

ternational consensus, those formulary approaches do not

violate the tax treaties entered into by the federal gov-

ernment. See Louis M. Kauder, The Unspecific Federal

Tax Policy of Arm’s Length: A Comment On The Con-

tinuing Vitality of Formulary Apportionment At The Fed-

eral Level, 60 Tax Notes 1147 (Aug. 29, 1993).

Moreover, in the context of allocating profits between

a foreign corporation and its U.S. branch, the federal

government has used a formulary approach virtually iden-

tical to California’s since 1922. See Intel Corp. and Con-

solidated Subsidiaries v. Comm’r, 100 T.C. No. 39 (June

28, 1993), reprinted in BNA Daily Tax Report, June 29,

1993 at K-5, K-7—K-8, 1993 U.S. Tax Ct. LEXIS 38 (cit-

ing 42 Stat. 227, 244-45 (1921); Regs. 62, art. 327

(1922)). These methods are fully compatible with the

arm’s length approach and have achieved international

acceptance. Thus, this Court should not hold that WWCR

violates the “one voice” prong of the foreign Commerce

Clause, since the federal government itself uses formu-

lary methods akin to WWCR ubiquitously in its interna-

tional tax regime.

2. In addition, as this Court held in Container,

WWCR does not violate the multiple taxation prong of

the foreign Commerce Clause because it does not pose

more risk of multiple taxation than the arm’s length

method, as applied by the federal government. See Con-

tainer, 463 U.S. at 191. Developments in the federal tax

arena since 1983, when Container was decided, have

dramatically demonstrated that “California would have

trouble avoiding double taxation even if it adopted the

‘arm’s length’ approach” as it is applied by the United

States and interpreted by the courts under 26 U.S.C.

§ 482. Container, 463 U.S. at 192, In fact, the Inter-

7

national Chamber of Commerce, in commenting on the

recently issued temporary regulations implementing the

federal approach to this issue under 26 U.S.C. § 482, has

stated that the regulations “will inevitably lead to double

taxation.” Letter of International Chamber of Commerce

of 4/22/93, © 21, reprinted in International Chamber of

Commerce Attacks New Transfer Pricing Rees., Tax

Notes Today, 93 TNT 113-24 (May 27, 1993).

3. California’s WWCR does not violate the Due Proc-

ess Clause because it is no more burdensome or arbitrary

than analogous federal provisions, which have not been

challenged on due process grounds. California does not

impose a heavier burden on U.S. subsidiaries of foreign

parents, such as Barcal, than is already imposed on domes-

tic corporations that are 25 percent or more foreign-

owned (under 26 U.S.C. § 6038A and the regulations

thereunder) or for U.S. branches of foreign corpora-

tions, such as BBI (under 26 U.S.C. § 6038C). Nor are

the standards used by California in applying WWCR any

more vague or capricious than the standards used by the

federal government under the corresponding provision of

federal tax law, 26 U.S.C. § 482, which was first enacted

in substantially its present form in 1928. Hence, WWCR

cannot be invalidated on due process grounds without

casting a heavy shadow over analogous, generally accepted

provisions of federal tax law.

ARGUMENT

I. CALIFORNIA’S FORMULARY METHOD DOES NOT

VIOLATE THE FOREIGN COMMERCE CLAUSE

Petitioners’ contention that California’s use of WWCR

violates the foreign Commerce Clause is premised on

two core arguments: first, that WWCR prevents the fed-

eral government from “ ‘speaking with one voice’ in in-

ternational trade,” and, second, that it results in interna-

tional multiple taxation that can reasonably be eliminated

by the use of arm’s length. Each of these arguments is

meritless.

8

Petitioners’ one voice argument depends on their depic-

tion of WWCR as an idiosyncratic tax system that is

“separate and different” from, and “incompatible with,”

the “international standard” of arm’s length. Pet. Br.

Barc. 16. This reductionist portrayal is irreconcilable

with reality. Formulary apportionment is not idiosyncra-

tic and has been repeatedly upheld by this Court. See,

e.g., Bass, Ratcliff & Gretton, Ltd. v. State Tax Comm'n,

266 U.S. 271 (1924); Mobil Oil, 445 U.S. at 438-40;

Container, 463 U.S. at 197. Equally important, formu-

lary apportionment and arm’s length are not, as peti-

tioners would have this Court believe, polar opposites,

but are part of a continuum. See, e.g., Arnold & McDon-

nell, Report on the Invitational Conference, 61 Tax Notes

at 1381. Indeed, as employed by the federal government,

arm’s length commonly uses formulary components.

There is no basis for petitioners’ assertion that California

prevents the federal government from speaking with one

voice, because the federal government uses formulary

methods ubiquitously in its international tax regime.

Petitioners’ multiple taxation argument is likewise un-

availing. WWCR does not violate the multiple taxation

prong of the foreign Commerce Clause because it does

not pose more risk of multiple taxation than the arm’s

length method as applied by the federal government.

The errors in petitioners’ analysis of these two issues

flow from a common source. As amici show immediately

below, the inherent limitations of the arm’s length method

as applied to multinational parents and subsidiaries rou-

tinely compel taxing authorities, including the United

States, to use elements of formulary apportionment in

conjunction with tax systems denominated “arm’s length.”

A. The Basic Theoretical Weaknesses Of The Arm’s

Length Approach, Recognized By This Court, Re-

quire Resort To Formulary Methods

In upholding the constitutional validity of formulary

apportionment, the Court has repeatedly emphasized the

theoretical failings inherent in the arm’s length method.

9

In Mobil Oil, and again in Container, the Court ex-

plained that

separate [geographical] accounting, while it pur-

ports to isolate portions of income received in various

States, may fail to account for contributions to in-

come resulting from functional integration, centrali-

zation of management, and economies of scale. Be-

cause these factors of profitability arise from the op-

eration of the business as a whole, it becomes mis-

leading to characterize the income of the business as

having a single identifiable “source.” Although sep-

arate geographical accounting may be useful for in-

ternal auditing, for purposes of state taxation it is

not constitutionally required.

Mobil Oil, 445 U.S. at 438 (internal citation omitted),

quoted in Container, 463 U.S. at 181; see also Trinova

Corp. v. Michigan Dept. of Treasury, 498 U.S. 358, 378

(1991); Amerada Hess Corp. v. Director, Div. of Taxa-

tion, 490 U.S. 66, 74 (1989). It is not possible to deter-

mine accuratcly the income of each component of a uni-

tary business on a separate, geographic basis because, as

the Court has observed, the underlying profit figures “are

based on precisely the sort of formal geographical ac-

counting whose basic theoretical weaknesses justify resort

to formula apportionment in the first place.” Container,

463 US. at 181; see also Jerome R. Hellerstein, Federal

Income Taxation of Multinationals: Replacement of Sepa-

rate Accounting With Formulary Apportionment, 60 Tax

Notes 1131, 1140-41 (August 23, 1993).*

“[S]licing a shadow,” as the Container Court called the

attempt to allocate the income of a unitary group geo-

graphically, 463 U.S. at 192, does not become any easier

if the unitary group, as in this case, crosses national as

well as state boundaries. A simple example illustrates the

problem.

° The Court's reasoning defeats Barclays’ argument (Pet. Br.

Barc. 24) that formulary methods erroneously assume equal profita-

bility of all portions of the unitary enterprise. Formulary methods

are necessary precisely because there is no way of establishing

accurate profit figures for each component of a unitary enterprise.

10

Suppose foreign parent (FP) manufactures a widget at

a cost of 50 and sells it to domestic subsidiary (DS)

which resells it for 100. If DS has marketing costs of 20,

it would have a profit if it bought the widget for any

price below 80, while FP would have a profit if it sold

the widget for any price above 50. The interval, between

50 and 80. represents a potential profit continuum, and

the related parties can split it in any way they wish and

still each make a profit. In the absence of comparable

transactions with unrelated taxpayers, it is virtually im-

possible to definitively allocate the profit of 30 to either

party.

Ordinarily, one could attempt to split the profit based

on the economic functions performed by the parties. In

the context of a unitary group, however, there is an ad-

ditional economic reality that complicates this task: Like

any organization, unitary groups exist because of market

and non-market advantages that are derived from their

structure. See, e.g., J. Hellerstein, Federal Income Taxa-

tion of Multinationals, 60 Tax Notes at 1135-36. Thus,

even if one applies a market rate of return separately to

each of the components of the unitary group, the result is

less than the actual return of the organization as a whole.

The synergistic interaction among the constituent parts

of the organization results in a residual that cannot be

assigned to any separate geographic component.‘

Any rule that arbitrarily assigns this residual to a mem-

ber of the group distorts economic reality, because there

is no single correct arm’s length result. See H.R. Rep.

426, 99th Cong.. Ist Sess., 423-24 (1985) (“A recurrent

problem is the absence of comparable arm’s length trans-

actions between unrelated parties, and the inconsistent

results of attempting to impose an arm’s length concept

4If there is a large residual resulting from the advantages

afforded by the group’s unitary structure, that same residual!

drives competitors out of the market, making comparables even

less likely to be found. See Stanley I. Langhein, The Unitary

Method and the Myth of Arm’s Length, 30 Tax Notes 625, 654-55,

666-69 (February 17, 1986).

11

in the absence of comparables.”) (footnotes omitted);

David R. Tillinghast, An American View of International

Intercompany Pricing Problems, in 1979 Conference Re-

port: Report of the Proceedings of the Thirty-First Tax

Conference 469, 476 (Canadian Tax Foundation 1980)

(where comparable uncontrolled transactions do not

exist, “the plain fact . . . is that there is no such thing

as an arm’s-length price”), quoted in J.A. 827 (trial testi-

mony of Tillinghast as Barclays’ expert witness ).°

In a long series of cases since 1980, this problem has

bedevilled the federal courts in their attempts to deal with

transfer pricing issues under 26 U.S.C. § 482 in the ab-

sence of comparables. The result has been a series of

stupendously long, fact-based opinions in which the courts

eventually split the residual profit between the related

parties based on some vague understanding of their re-

spective functions. Judge Tannenwald recently described

the dilemma the Tax Court faces in making allocation

decisions in Section 482 cases as a task that is “most diffi-

cult to perform in light of the [c]ourt’s inevitable lack of

knowledge of the realities of the workings of a specific

industry and of the business world generally, including

particularly the international competitve atmosphere which

those realities reflect.” Perkin-Elmer Corp. v. Comm’r,

T.C. Memo 1993-414, 1993 Tax Ct. Memo LEXIS 424

at 97-98 (Sept. 8, 1993). The court must nevertheless

find “precise answers based on an imprecise record,” id. at

98, usually by “find[ing] a middle ground—a task which

® See also J.A. 829 (expert testimony of Tillinghast) (“the

basis on which [the] division of profit is made varies according to

the judgment of the auditing agent and the IRS as to what would

produce a reasonable approximation of what an arm’s-length price

would be”) ; Langbein, The Unitary Method, 30 Tax Notes at 654-

55; Dale W. Wickham & Charles J. Kerester, New Directions

Needed for Solution of the International Transfer Pricing Taz

Puzzle: Internationally Agreed Rules or Tax Warfare?, 56 Tax

Notes 339, 345-47 (July 20, 1992); U.S. General Accounting Office,

GAO GGD-92-89, International Taxation: Problems Persist in

Determining Tax Effects of Intercompany Prices 6062 (June

1992).

12

it has disavowed, in other contexts.” /d. (citation omitted).

“The task thus thrust upon us is,” ——- - put it

ildly, frustrating.” Jd. at 96. See also Hospital Corpora-

ae ye egal Comm’'r, 81 T.C. 520, 596-97, 601

(1983) (noting “the lengthy and inconclusive record but

finding “as a fact that 75 percent of the taxable income

of LTD in 1973 was attributable to petitioner”); Eli Lilly

& Co. v. Comm’r, 84 T.C. 996, 1191 (1985), aff'd in

part and rev'd in part, 856 F.2d 855 (7th Cir. 1988);

G.D. Searle & Co. v. Comm'r, 88 T.C. 252, 376 (1987)

(“best judgment” allocation of profit): Sundstrand Cc orp.

vy. Comm’r, 96 T.C. 226, 375 (1991) (“best estimate” by

court of appropriate transfer price ).°

Alternatively, to avoid such “rough justice” approxi-

mations, the federal courts have strained to find com-

parables where no economic comparables exist. Thus, in

United States Steel Corp. v. Comm’r, 617 F.2d 942, 951

(2d Cir. 1980), the court of appeals found that a com-

parable existed despite widely different volume and risks,

even though it realized that the result did not reflect

“economic reality.” A similar outcome was reached in

Bausch & Lomb, Inc. v. Comm’r, 92 T.C. 525 (1989),

aff'd, 933 F.2d 1084 (2d Cir. 1991). The Tax Court

held that a comparable was valid despite the extremely

different economic conditions existing between the related

parties, and the court of appeals affirmed, reasoning that

such differences “will always be the case when transactions

between commonly controlled entities are compared to

transactions between independent entities.” 933 F.2d at

1091.

This burgeoning series of cases, which threatens to over-

whelm the IRS and the Tax Court,’ has led to increasing

®In the United States Claims Court (and its predecessor, the

Court of Claims), the result has been one-sided victories for either

side. Compare E.J. Du Pont De Nemours & Co. v. United States,

608 F.2d 445 (Ct. Cl. 1979), cert. denied, 445 U.S. 962 (1980), with

Merck & Co., Inc. v. United States, 24 Cl. Ct. 73 (1991).

7™“For the foreseeable future, transfer pricing litigation will

place a heavy burden on the Service and the Tax Court.” U.S.

13

criticism by the General Accounting Office and by Con-

gress of AL SA as applied at the federal level. See U.S.

General Accounting Office, GGD-81-81, IRS Could Bet-

ter Protect U.S. Tax Interests in Determining the Income

of Multinational Corporations (Sept. 30, 1981); H.R.

Rep. 426, 99th Cong., Ist Sess. 423-25 (1985). The

Conference Report on the 1986 Tax Reform Act in-

structed the IRS to conduct a study of the problem and

to consider carefully “whether the existing regulations

[implementing AL SA] could be modified in any re-

spect.” H.R. Rep. 841, 99th Cong., 2d Sess. 11-638

(1986), reprinted in 1986 U.S.C.C.A.N. 4075, 4726.

The result of these criticisms has been, first, a lengthy

study by the Treasury Department recommending signifi-

cant changes to AL’SA, Notice 88-123, 1988-2 C.B. 458

(the “White Paper”); second, proposed regulations with

additional changes; and finally, in January 1993, the

adoption of temporary regulations which significantly

modify AL SA at the federal level. 58 Fed. Reg. 5310

(1993) (codified at 26 C.F.R. § 1.482-0T through 7T).

The most significant change in these temporary regulations

is the express incorporation of formulary approaches into

AL SA in the absence of exact comparables. See id. at

§ 1.482-5T. As discussed immediately below, this is only

the most recent development in the United States’ long-

standing use of formulary methods in conjunction with

arm’s length.

Treasury and IRS, Report on the Application and Administration

of Section 842 at 6-3 (April 9, 1992), reprinted in BNA Special

Supplement 2, Report No. 70 at S-34 (April 10, 1992) (bound with

BNA Daily Tax Report) (hereinafter “Treasury and IRS Report”) ;

ef. GAO, International Taxation at 47 (“transfer pricing cases in

general can be very burdensome, time-consuming, and expensive

for the courts, IRS, and the companies involved”).

In recent transfer pricing litigation under Section 482, Chevron

produced 1.3 million pages of unlabelled documents to the IRS.

See Chevron Not Required to Label 1.8 Million Pages Turned Over

To The IRS, BNA Tax Management, Transfer Pricing Report, at

135-36 (July 7, 1993).

14

B. California’s Method Does Not Violate The “One

Voice” Requirement Of The Foreign Commerce

Clause Because The Federal Government Uses

Formulary Apportionment itself In Conjunction

With The Arm’s Length Method

1. The Federal Government Uses Formulary Ap-

portionment In Conjunction With Arm’s Length

Petitioners’ entire “one voice” argument is based on a

false dichotomy between the “pure” AL SA allegedly

used by the federal government and other countries, and

WWCR. See, e.g., Pet. Br. Barc. 4-5, 16. However, the

federal government—like other nations—does not adhere

to pure AL/SA; instead, it commonly uses a combination

of AL’SA and formulary approaches. Once this is recog-

nized, the key assumption underlying petitioners’ “one

voice” argument crumbles. For why should California be

forced to change its taxing method to comply with a

single federal voice, when that voice itself uses methods

similar to California’s?

As this Court recognized in Container, AL SA as ap-

plied by the United States is neither pure nor simple. It

is a “qualified” arm’s length approach under which every

corporation is treated “for most—but decidedly not all—

purposes as if it were an independent entity. 463 USS. at

184-85. And there are “elaborate regulations implement-

ing the ability of the IRS to “ ‘distribute, apportion or

allocate gross income’” among related taxpayers under

26 U.S.C. § 482. 463 U.S. at 190-91 (quoting 26 U.S.C.

§ 482).

Since Container, there have been significant develop-

ments in this area that have further modified AL SA as

applied by the federal government. These developments

have led a group of experts—including senior officials of

the U.S. Treasury, U.K. Inland Revenue, the Fiscal Af-

fairs Division of the OECD, and the Japanese National

Tax Administration—to conclude recently that “the arm's

length principle and formulary apportionment should not

be seen as polar extremes” and that “it is not clear where

the arm’s length principle ceases and formulary appor-

15

tionment begins.” Arnold and McDonnell, Report on the

Invitational Conference, 61 Tax Notes at 1381 (Decem-

ber 13, 1993).

The easiest case to show that the federal government

uses formulary approaches is the taxation of a U.S.

branch of a foreign corporation, such as BBI. Since the

Revenue Act of 1921, the Internal Revenue Code has

included a provision like 26 U.S.C. § 863(b), which

States:

In the case of gross income derived from sources

partly within and partly without the United States,

the taxable income may first be computed by deduct-

ing the expenses, losses, or other deductions appor-

tioned or allocated thereto and a ratable part of any

expenses, losses or other deductions which cannot

definitely be allocated to some item of gross income;

and the portion of such taxable income attributable

to sources within the United States may be deter-

mined by processes or formulas of general apportion-

ment prescribed by the Secretary.

26 U.S.C. $ 863(b) (emphasis added).*

Regulations for the sale of personal property were

promulgated under this section in 1922 and remain es-

sentially unchanged today. Intel, 100 T.C. No. 39, BNA

Daily Tax Report, June 29, 1993 at K-8 & n.4 (quoting

Regs. 62, art. 327 (1922)). Operation of these regula-

tions involves three examples, two of which are pertinent

here: Example 1, which applies an arm’s length meth-

odology and Example 2, which employs a formulary ap-

proach. See 26 C.F.R. $§ 1.863-3(b)(2), Example 1

and 1.863-3T(b) (2), Example 2.° |

Example | applies only if the taxpayer “regularly sells

part of his output to wholly independent distributors or

* See Revenue Act of 1921, ch. 136, 42 Stat. 227, 244-45 (1921).

The history of 26 U.S.C. § 868(b) is described in Intel Corp. v.

Comm’r, 100 T.C. No. 39, BNA Daily Tax Report, June 29, 1993 at

K-7—K-8.

® Example 3 allows the taxpayer to apply “for permission to base

the return upon the taxpayer’s books of account.” 26 C.F.R.

§ 1.863-3(b) (2), Example 3.

16

other selling concerns in such a way as to establish fairly

an independent factory or production price,” i.e., if there

is an independent arm’s length transaction. See 26 C.F.R.

§ 1.863-3(b)(2), Example 1. Under rules promulgated

by the IRS, it is exceedingly hard to find an “independent

factory price” (IFP) under Example 1. The IFP must

be derived from sales of the same manufacturer (not un-

related comparables) which are regular and substantial,

must involve a wholly independent distributor, must not

involve significant income-generating activity of the tax-

payer other than manufacturing, and must reasonably re-

flect the income from manufacturing. Notice 89-10,

1989-1 C.B. 631-32.

In the many instances in which Example | is inappli-

cable, the IRS and the taxpayer generally must apply the

method set forth in Example 2. Under Example 2, the

annual taxable income attributable to sales of property

produced abroad and sold in the United States is first

split in half; then, the 50% allocated to manufacturing is

apportioned between the U.S. and the foreign jurisdiction

based on a property factor, and the 50% allocated to

sales is apportioned based on a sales factor. 26 C.F.R.

§ 1.863-3T(b) (2), Example 2."° This method of appor-

tionment is substantially similar to the formulary appor-

tionment employed by California, except that payroll is

not a factor and the federal sales factor is more open to

manipulation because the location of sales is based on

passage of title (a fact wholly within the taxpayer's con-

trol) and not on destination. Compare 26 C.F.R. § 1.863-

3T(b)(2) and § 1.861-7(c) with Cal. Rev. & Tax Code

§ 25135.

Given the constraints on the use of Example 1, it is not

surprising that the courts have repeatedly rejected IRS

attempts to force taxpayers to use Example |! rather than

the formulary method of Example 2. See, e.g., Phillips,

10 For an explanation of how Example 2 is applied, see Phillips

Petroleum Co. v. Comm’r, 101 T.C. No. 6 (July 27, 1993), BNA

Daily Tax Report, July 28, 1993 at K-5, 1993 U.S. Tax Ct. LEXIS

47,

17

101 T.C. No. 6, and Intel, 100 T.C. No. 39. Thus, for

the substantial number of foreign unitary groups engaged

in the manufacture of tangible property abroad and its

sale in the U.S. through a branch, the federal government

applies a formulary method highly similar to California’s

in the vast majority of cases.

Moreover, it should not be overlooked that the Calli-

fornia business of BBI is not just a branch of a foreign

corporation—it is a branch of a foreign bank. One of the

most important activities of banks is accepting funds on

deposit, and thus one of the most important determinants

of their income is the allocation of interest expense. The

federal government has recognized that because interest

is fungible, the interest expense of branches must be ap-

portioned based on a formula that takes into account the

worldwide interest expense of the foreign taxpayer, and

this method has been applied specifically to U.S. branches

of foreign banks. Under 26 U.S.C. § 882(c), deductions

allocated to foreign corporations engaged in a U.S. trade

or business are apportioned and allocated under regula-

tions prescribed by the Treasury. Under the relevant regu-

lations, BBI’s deductible interest expense in the U.S. is

calculated based on a formula that compares BBI’s U.S.

assets to a ratio based on its worldwide assets and liabili-

ties. 26 C.F.R. § 1.882-5(b). This formula is based on

the same theoretical underpinnings as WWCR—that it is

impossible to allocate income and expense among the

parts of a unitary business based on pure AL/SA.

In the case of subsidiaries of a U.S. parent such as

Colgate, the situation is slightly more complex. In this

context the U.S. generally does not need to apply formu-

lary methods because it has adopted a more extreme so-

lution: Since 1962, the U.S. has considered it entirely

legitimate to include the entire income of “controlled for-

eign corporations” such as Colgate’s subsidiaries in the

annual taxable income of their U.S. parent as a deemed

dividend. See 26 U.S.C. §§ 951-960. This proposal, orig-

inally made by the Kennedy administration, was subse-

quently modified to include only certain types of income

18

in the U.S. parent’s income currently, and to permit de-

ferral of hy other types. See S. Rep. No. 1881, 87th

Cong., 2d Sess. (1962), reprinted in 1962 U.S.C.C.A.N.

3304, 3381-83; Revenue Act of 1962, Pub. L. No. 87-834

§ 12, 76 Stat. 960, 1006-27 (1962). But this privilege

of deferral, granted for competitiveness reasons, has been

steadily eroded and in the most recent tax act has been

substantially limited, based on a sactongecag gg

the foreign corporation’s passive versus active asscts.

Omnibus Budget Reconciliation Act of 1993, Pub. L. No.

103-66, 107 Stat. 312, 496-501 (August 10, 1993) (to

be codified at 26 U.S.C §$ 956A) In any case, It has not

been suggested that the U.S. is breaching an international

consensus in currently taxing controlled foreign corpora-

tions, and there are recurrent proposals to end deferral

altogether with no objection from abroad. See, e.g., For-

eigen Income Tax Rationalization & Simplification Act of

1992, H.R. 5270, § 201, 102d Cong., 2d Sess. (1992).

Clearly, it is much more drastic to allocate the entire in-

come of ail controlled foreign corporations to the US.

than to apply WWCR to a domestic parent unitary group,

such as Colgate.

Even under the classic arm’s length situation, that of

a U.S. subsidiary of a foreign parent (such as Barcal),

the federal government applies a formulary approach in

a large number of cases. This is the result of the re-

examination of the regulations under 26 U.S.C. § 482

which was described above (at p. 13), which culminated

in the current temporary regulations under that section.

As a preliminary matter, it is necessary to recognize

that 26 U.S.C. § 482 itself, which has not been signifi-

cantly changed since 1928, does not mandate the use of

AL/SA or bar the use of WWCR: all it does is state

that in the case of affiliated organizations, “the Secretary

may distribute, apportion, or allocate income, deductions,

credits, or allowances between or among such organiza-

tions” if necessary to clearly reflect their income. The

actual apportionment can be done by pure AL’SA, pure

WWCR, or any method in between.

19

In fact, under the current temporary regulations, if

there is no comparable transaction the Secretary may

base his § 482 adjustment on the “comparable profits

method.” This approach constructs a formula based on

the profits of comparable, unrelated taxpayers and forces

the related parties to adjust their transactions so that

their profits fall within the comparable “arm’s length”

range of profits constructed by the formula. 26 C.F.R.

§ 1.482-5T." This formula is used in a broad range of

cases. Under a “best method rule” provided in the regu-

lations, the formula will be applied when there is no

exact comparable to be found, i.e., in the majority of

cases in which disputes arise between taxpayers and the

IRS. See 26 C.F.R. § 1.482-1T(b)(2) (iii); James P.

Fuller and Ernest F. Aud, Jr., The New Temporary and

Proposed Section 482 Regulations: A Wolf in Sheep's

Clothing?, 6 Tax Notes Int'l 525 (March 1, 1993).”

2. The Federal Government’s Use of Formulary

Methods In Conjunction With Arm’s Length

Does Not Violate Its Treaty Obligations

The federal government thus applies formulary meth-

ods, in conjunction with AL/SA, to U.S. branches of

foreign corporations (BBI), to foreign subsidiaries of

U.S. parents (Colgate), and to U.S. subsidiaries of for-

cign parents (Barcal). Why, therefore, has there not been

an outcry of protest by foreign governments that the U.S.

is violating its tax treaties? Because, contrary to peti-

tioners’ suggestions, see Pet. Br. Barc. 4-6; Pet. Br. Colg.

4-5, the use of formulary methods to apportion income

™ The formula relies on “profit level indicators” that include

ratios of profit to operating assets, costs (e.g., payroll), and sales,

i.e., the same factors California uses. 26 C.F.R. § 1.482-5T (e).

See also Proposed Regulation § 1.482-6, 58 Fed. Reg. 5310, 5311

(Jan. 21, 1993) (proposing a profit split method based on a formula

that incorporates an assets factor).

12 The use of such formulas in the new temporary and proposed

regulations is but an implementation, delayed by over 30 years,

of a congressional request to the Treasury Department to develop

“formulas” for the application of 26 U.S.C. § 482. See H.R. Rep.

2508, 87th Cong., 2d Sess. 18-19 (1962).

20

and expenses on a worldwide basis, in conjunction with

AL SA, is fully compatible with the treaty obligations of

the United States.”

First, let us look at the treaty rule on branches, or

“permanent establishments,” which is Article 7(2) of the

U.S. Model Treaty. In Container, this Court cited the

branch rule as “requir[ing] the Federal Government to

adopt some form of ‘arm’s-length’ analysis in taxing the

domestic income of multinational enterprises.” 463 U.S.

at 196. The branch rule states:

Subject to the provisions of paragraph 3, where an

enterprise of a Contracting State carries on busi-

ness in the other Contracting State through a perma-

nent establishment situated therein, there shall in

each Contracting State be attributed to that perma-

nent establishment the business profits which it might

be expected to make if it were a distinct and inde-

pendent enterprise engaged in the same or similar

activities under the same or similar conditions.

U.S. Model Double Taxation Treaty, art. 7(2) (1981),

reprinted in Model Income Tax Treaties (Kees van Raad

ed., 1983); cf. Convention Between the United States and

the United Kingdom for Avoidance of Double Taxation,

art. 7(2), Dec. 31, 1975, U.S.-U.K., 31 U.S.T. 5670,

5675 (U.S.-U.K. Treaty) ."*

How, then, can the U.S. tax permanent establishments

under formulary methods, as it does under 26 U.S.C.

§§ 863(b) and 882? Three observations can be made in

response. First, within the arm’s length context estab-

lished by Article 7(2), the treaty does not forbid the

use of all formulary apportionment; it merely mandates

the attribution to the branch of the same income that

13 The following discussion of treaties is based on the analysis

contained in Kauder, The Unspecific Federal Tax Policy of Arm’s

Length, 60 Tax Notes 1147.

14 As discussed by respondent, these provisions govern only the

taxing methodology of the federal government and have no ap-

plicability to the States. See Resp. Br. Barc. 16.

21

would have been attributed to it under AL/SA. Con-

trary to Barclays’ assertions, it is quite possible for AL/

SA and worldwide formulary apportionment to reach the

same result—indeed, WWCR is intended to capture those

synergies of a unitary business that would have been

taken into account by a valid arm’s length calculation.

Two related businesses, if they were truly dealing with

each other at arm’s length, would take the synergies that

result from their being part of a unitary enterprise into

account in allocating the profit of the enterprise between

them. Thus, if formulary methods reach the same or

similar results as AL/SA in taxing the branch, this would

be acceptable under Article 7(2).

Second, Article 7(3) of the U.S. Model Treaty, to

which Article 7(2) is subject, expressly requires a “rea-

sonable ailocation” of expenses to the branch based on

the expenses of the enterprise as a whole. U.S. Model

Treaty, art. 7(3); U.S.-U.K. Treaty, art. 7(3), 31 U.S.T.

at 5675-76. Thus, the formulary methods of allocating

expenses under 26 C.F.R. § 1.882-5 are fully compatible

with the U.S. treaty obligations, as the IRS has repeatedly

stated. See Rev. Rul. 89-115, 1989-2 C.B. 130 (inter-

preting art. 7(3) of the U.S.-U.K. Treaty); Rev. Rul.

78-423, 1978-2 C.B. 194 (interpreting similar provision

in U.S.-Japan Treaty); see also Rev. Rul. 85-7, 1985-1

C.B. 188 (same under 26 C.F.R.§ 1.882-5).

Finally, as noted above, formulary apportionment

branch income has been the euditiceed cesates of oo

United States since 1922. It is well understood that such

an established practice may continue under the AL/SA

language of Article 7(2). Indeed, because formulary

methods are commonly used by countries that are parties

to treaties that require some form of AL SA, the new

OECD model treaty expressly provides:

Insofar as it has been customary in a Contracting

State to determine the profits to be attributed to a

permanent establishment on the basis of an ap-

portionment of the total profits of the enterprise to

its various parts, nothing in paragraph 2 shall pre-

22

clude that Contracting State from determining the

profits to be taxed by such an apportionment as may

be customary; the method of apportionment adopted

shall, however, be such that the result shall be in

accordance with the principles contained in_ this

Article.

OECD Model (Income and Capital) Tax Treaty, Sept.

1, 1992, art. 7(4).”° Thus, the United States can con-

tinue to tax branches of foreign corporations, such as

BBI, based on formulary methods, without violating its

treaty obligations.

Let us next look at the treaty rule regarding U.S. sub-

sidiaries of foreign corporations, such as Barcal. Article

9(1) of the U.S.-U.K. treaty provides that “[wlhere an

enterprise of a Contracting State is related to another

enterprise” and the relations between the two depart from

arm’s length, an adjustment to achieve arm’s length con-

ditions “may” be made, and in that case, the other state

“shall make such adjustment as may be appropriate” to

prevent double taxation resulting from the adjustment.

U.S.-U.K. Treaty Art. 9(1) and 9(2), 31 US.T. at

5677; cf. U.S. Model Treaty Art. 9(1) and 9(2).

Louis M. Kauder suggests that Article 9(1) does not,

by its terms, require the United States to do anything re-

garding the taxation of domestic corporations controlled

by foreign parents. Kauder, The Unspecific Federal Tax

Policy of Arm's Length, 60 Tax Notes at 1149-50. The

18 For further evidence of the use of formulary in conjunction

with arm’s length by OECD member nations, see Treasury and IRS

Report, Appendix E (Report of Agreed Discussions Between the Tax

Administrations of France, Germany, the United Kingdom, and the

United States) © 3.5, BNA Special Supplement 2, Report No. 70 at

S-41 (“In some industries and in some circumstances the use of a

formula might be appropriate assuming that the formula attempted

to approximate an arm’s length result. One [such| area would be

global trading .. . .”); id., "3.6 (“Each one of us has expressed

varying levels of support for using carefully tailored formulae in

specific situations. The United States sees considerable advantages

in this approach in particular cases. Germany and the United

Kingdom have agreed to consider the use of such formulae in those

cases.”).

23

Senate Foreign Relations Committee, in its report on the

Third Protocol of the US UK Treaty, viewed Article

9(1) as “recogniz{ing] the right of each country to make

an allocation of income in the case of transactions be-

tween related persons, if an allocation is necessary to re-

flect the conditions and arrangements which would have

been made between unrelated persons.” S. Exec. Rep. 5,

96th Cong., Ist Sess. 6 (1979). Thus, Article 9(1) cer-

tainly does not forbid the United States from using

formulary apportionment, at least within the arm’s length

context.

In addition, as the Container Court pointed out, all of

the U.S. treaties generally reserve the right to tax domestic

corporations as if the treaty never came into effect. 463

U.S. at 196; cf. U.S. Model Treaty, art. 1(3). Thus, the

United States could apply any formulary method to do-

mestic subsidiaries of foreign parents, or to United States

parents with foreign subsidiaries. without violating any

treaty, as long as it is not considered to be taxing the

foreign corporations included in the group. See also U.S.

Model Treaty, art. 9(3) (permitting apportionment

under language similar to 26 U.S.C. § 482).

. Finally, the U.S.-U.K. treaty contains one unique pro-

vision not found in any other United States treaty—the

notorious Article 9(4), 31 U.S.T. at 5677, which is the

subject of much of the debate in this case. While the

Church reservation prevented Article 9(4) from ever ap-

plying to California, see Resp. Br. Barc. 20-21, it does

apply to the federal government, and prevents it from

taking into acount the income of a related foreign enter-

prise in determining the tax liability of its domestic sub-

sidiary. The inclusion of this Article makes it clear that

Article 9(1), standing alone, does not prevent the U.S.

from using formulary methods. Nor does Article 9(4)

prevent the application of WWCR to U.K. subsidiaries of

U.S. corporations, which are explicitly excluded from its

scope. But even in the case of U.S. subsidiaries of U.K.

corporations, the Senate Foreign Relations Committee

report on Article 9(4) states that:

24

The limitation in Article 9(4) applies only to cases

where an allocation is made without regard to any

application of the arm’s-length standard. Of course,

both countries may apply apportionment formulas,

including formulas that take into account attributes

of related entities, as a method of achieving an arm’s-

length price for a transaction between related en-

tities. Moreover, apportionment formulas may be

used as a method of apportioning income of related

entities to the extent that it is established that they

are not dealing on an arm’s-length basis.

S. Exec. Rep. 5, 96th Cong., Ist Sess. 6 (1979).

Thus, even Article 9(4) does not prevent the federal

government from using formulary methods, as long as

they reach arm’s length results, or it can be established

that the related parties were not dealing at arm’s length

(as will frequently be the case ).”*

In sum, the “one voice” that petitioners contend Cali-

fornia must adhere to employs formulary methods akin

to California’s ubiquitously in its international tax rules, in

conjunction with AL SA. This action by the federal gov-

ernment (and any further federal action along the same

lines) does not violate any treaty obligations. And the

international pressure on California, compared to the lack

of foreign governmental protestations against the federal

government, is a reflection of the relative political power

of the United States and California, not of the merits of

the issue.

161t has been reported that Barclays’ own “advance pricing

agreement” (APA) with the IRS and the U.K. taxing authorities,

relating to a significant portion of its business, is based on taxing

“the company’s international affairs as one global business” and

allocating the profits among jurisdictions based on an undisclosed

“formulary methodology.” See IRS Grants Two APAs In Deriva-

tive Products Area, Tax Notes Today, 92 TNT 96-1 (May 6, 1992)

(discussing APAs for Barclays and Sumitomo). See also US.

Treasury and IRS, Joint Statement of Policy and Action Plan on

International Tax Compliance (Dec. 17, 1993), reprinted in BNA

Daily Tax Report (Dec. 20, 1993), at L-2 (in negotiating APAs,

the IRS “has made every effort to agree with the taxpayer on an

appropriate methodology, and has applied, in appropriate cases, the

25

C. California’s Formulary Method Does Not Pose

More Risk Of Multiple Taxation Than The Arm’s

Length Method As Applied By The Federal Govern-

ment

California’s use of WWCR also satisfies the remaining

prong of the foreign Commerce Clause test—it does not

create a heightened risk of international multiple taxa-

tion. See Japan Line, 441 U.S. at 446-48: Container,

463 U.S. at 185. Colgate does not even contest this

point, and Barclays’ multiple taxation argument is incon-

sistent both with this Court’s precedents and with subse-

quent developments in the arena of _ international

taxation.

In Container, this Court addressed the multiple taxa-

tion prong of the foreign Commerce Clause test as ap-

plied to WWCR and held that WWCR does not violate

this test because arm’s length as applied by the federal

government, may also lead to double taxation:

A serious problem, however, is that even though most

nations have adopted the ‘arm’s-length’ approach in

its general outlines, the precise rules under which

they reallocate income among affiliated corporations

often differ substantially, and whenever that difference

exists, the possibility of double taxation also exists.

Thus, even if California were to adopt some ver-

sion of the ‘arm’s-length approach,’ it could not elim-

inate the risk of double taxation of corporations sub-

ject to its franchise tax, and might in some cases end

up subjecting those corporations to more serious

double taxation than would occur under formula

apportionment.

463 U.S. at 191 (footnotes omitted).

Developments since 1983, when Container was de-

cided, have dramatically demonstrated the correctness of

methods specified in section 482, variations on those methods, and

other methods, such as formulary apportionment”).

This report suggests that Barclays acknowledges that formulary

methods are appropriate for taxing its worldwide unitary business.

26

these observations. The potential for double taxation

under AL.SA results from the basic theoretical flaw of

AL SA—the fact that it does not provide a uniform or

consistent way of making allocations where comparables

are not available. See discussion at pages 8-12, supra.

International double taxation is the likely outcome of

AL SA because one cannot expect foreign taxing authori-

ties to respect allocations which the U.S. courts admit

are based on a “best estimate” slicing of the shadow, or

on economically inappropriate “comparables.”

That multiple taxation is as likely under AL SA (as

applied by the federal government) as under WWCR is

indicated by the reactions to the temporary regulations ol

foreign interested parties, many of whom are amici in

this case in support of petitioners. They have vigorously

objected to the most recent federal AL SA plus formulary

approach based on their contention that it will lead to

international double taxation, and that the temporury regu-

lations do not comport with the arm’s length standard,

Thus, the International Chamber of Commerce has stated

unequivocally:

We object to this new formulation both on general

grounds, in view of the likely damaging consequences

for international trade and investment .. . and,

more specifically, because within the temporary reg-

ulations it is evidently designed to confer arm’s

length validity on a method—the comparable profits

method—which in fact does not accord with the arm’s

length principle.

Letter of International Chamber of Commerce of

4/22/93, © 11, reprinted in International Chamber of

Commerce Attacks New Transfer Pricing Regs., Tax

Notes Today, 93 TNT 113-24 (May 27, 1993). The In-

ternational Chamber of Commerce went on to assert that

the federal government’s methodology “is contrary to the

arm’s length principle and will inevitably lead to double

taxation. /d. at § 21."

17 The Korean Ministry of Finance has made the same point by

complaining that “the revised regulations are still not fully con-

27

It is thus clear that AL/SA, as applied by the federal

government, is at least as likely to lead to international

double taxation as WWCR. As the Court has already

held, “it would be perverse, simply for the sake of avoid-

ing double taxation, to require California to give up one

allocation siiethod that sometimes results in double taxa-

tion in favor of another allocation method that also some-

times results in double taxation.” Container, 463 U.S.

at 193 (citation omitted).

Il. CALIFORNIA’S FORMULARY METHOD DOES NOT

VIOLATE THE DUE PROCESS CLAUSE, AS IT

IMPOSES NO HEAVIER BURDEN ON MULTI-

NATIONAL CORPORATIONS THAN IS IMPOSED

UNDER CURRENT FEDERAL LAW

Barclays’ due process argument ignores the exten-

sive requirements imposed on foreign-based multination-

als under federal law, which have not been chal-

lenged on due process grounds. While California only

needs worldwide payroll, asset, and sales data, and net

worldwide income, the federal government needs a much

broader range of information on the business of the for-

eign-based enterprise to implement AL/SA. In 1989 and

sistent with the internationally accepted arm’s length standard.”

Letter of Rah-Yong Uhm of 8/9/93, Director General for Tax

Affairs, Ministry of Finance, Republic of Korea, reprinted in

Korean Finance Ministry Comments on Transfer Pricing Regs.,

Tax Notes Today, 98 TNT 181-49 (Aug. 31, 1993). The Repre-

sentative of German Industry and Trade has likewise stated that

“[wle continue to have fundamental, grave objections to the

temporary intercompany transfer pricing regulations” on the

grounds that they lead to incorrect results and “contradict[] the

Arm’s Length Standard.” Letter of Christof S. Klitz of 7/19/93,

reprinted in German Industry Rep Takes Aim At Proposed Regs.,

Tax Notes Today, 93 TNT 163-64 (Aug. 5, 1993). Keidanren, the

Japan Federation of Economic Organizations, asserts that the

principal innovation of the temporary regulations “is not in accord-

ance with the international rule of transfer pricing taxation ... .

[which] places great emphasis on an arm’s length pricing system

among entities.” Letter of Tsunekazu Sakano of 7/13/93, 1, re-

printed in Keidanren Urges IRS to Take Another Look at Pro-

posed Regs., Tax Notes Today, 93 TNT 158-24 (July 29, 1998).

28

1990, Congress amended the Internal Revenue Code to

authorize the Treasury to prescribe broad record keeping

requirements for corporations that are 25% foreign

owned, such as Barcal, and for foreign corporations en-

gaged in a U.S. business, such as BBI, in both cases with

penalties for noncompliance. See Pub. L. No. 101-239,

§ 7403, 103 Stat. 2358 (1989) (amending 26 U.S.C.

§$ 6038A); Pub. L. No. 101-508, § 11315, 104 Stat.

1388-456 (1990) (adding 26 U.S.C. § 6038C)."

The following is just an illustrative list of the records

required to be kept by foreign-owned corporations and

foreign corporations under regulations promulgated to

implement these sections in 1991: original entry books

and transaction records relevant to transactions with the

U.S. subsidiary; records from which “material profit and

loss statements” can be constructed, including an ex-

planation of any differences with United States generally

accepted accounting principles (GAAP); “all documents

relevant to establishing the appropriate price or rate for

transactions” between the U.S. subsidiary and “any for-

eign related party”: all relevant “[floreign country and

third party filings”; “[o]wnership and capital structure

records”: and “[rlecords of loans, services, and other non-

sales transactions.” 26 CFR § 1.6038A-3(c)(2)." The

foreign party must deliver those documents to the Inter-

nal Revenue Service, or give the Service access to the

records in the U.S., within 60 days of a request, and

provide a translation of the records within 30 days of an

IRS request. 26 CFR § 1.6038A-3(1). A substantial

portion of the records must be created if they do not

exist. 26 CFR § 1.6038A-3(c)(1).

Compared to these broad requirements, the burden im-

posed by California’s rules, subject as they are to a “rea

1s Until 1989, it was difficult for the IRS to obtain the required

information from foreign entities. See, ¢.g., U.S. v. Toyota Motor

Corp., 561 F.Supp. 354 (C.D. Cal. 1983); U.S. v. Toyota Motor

Corp., 569 F.Supp. 1158 (C.D. Cal. 1983).

1% See also the elaborate rules for determining what is a “ma-

terial profit and loss statement” under 26 CFR § 1.6058A-3(c) (3)-

(6).

29

sonably approximate” standard, pales to insignificance.

Of course, “while Congress has plenary power to regu-

late commerce . . . it does not similarly have the power

to authorize violations of the Due Process Clause.”

Quill Corp. v. North Dakota, 112 S. Ct. 1904, 1909

(1992). If this Court strikes down California’s WWCR

as unconstitutional on due process grounds, it jeopard-

izes the constitutionality of significant federal transfer

pricing enforcement powers as well, which Congress has

judged necessary to ensure that foreign-owned U.S. cor-

porations pay their fair share of taxes.

The same analysis applies with even greater force to

Barclays’ argument that California’s rules are too vague

and arbitrary, despite being subject to court supervision.

See Pet. Br. Bare. 47 (citing Cal. Admin. Code Tit. 18

§ 25137-6).” It has been commonplace in litigation

under 26 U.S.C. § 482 for courts to complain that in the

absence of specific standards to guide them when there

are no comparables, and given the extremely broad lan-

guage of the statute, the IRS and the courts are required

to reach decisions that are essentially arbitrary.’ Perhaps

the classic statement comes from a case decided in favor

of the federal government, where the court’s task was

likened to “making bricks without straw.” Du Pont, 608

F.2d at 461 (citation omitted) (Nichols, J. concurring).

Judge Nichols went on to elaborate:

[T]he Congressional request to write regulations to

govern these § 482 reallocations is one sentence long:

‘it is believed that the Treasury should explore the

possibility of developing and promulgating regulations

under this authority [$ 482] which would provide ad-

ditional guidelines and formulas for the allocation

of income and deductions in cases involving foreign

income.’ Clearly the result of our decision is that

“It is worth noting that California’s Regulation 25137-6, the

subject of Barclays’ attack (see Pet. Br. Barc. 47-49), is derived

from IRS regulations. See 26 C.F.R. § 1.964-1 (1992). If § 25137-6

is invalid, the federal regulation is similarly suspect.

*! See the cases cited above in Part 1.A; see also J.A. 829 (expert

testimony of David R. Tillinghast).

30

this has not been done . . . and it remains in the

almost if not wholly unreviewable discretion of the

Treasury, as it was when the suggestion was made.

Id, at 462 (internal citation omitted).

This lack of guidelines persisted until the temporary

regulations were issued in 1993. However, the federal

government’s discretion under 26 U.S.C. § 482 has never

been attacked on due process grounds, because (as in

California) the courts were available to ensure that it

was not applied in an arbitrary and capricious fashion,

and in fact the courts have repeatedly struck down IRS

assessments under 26 U.S.C. § 482. The same analysis

applies to California’s analogous provisions. If this Court

strikes down California’s WWCR on due process grounds,

it would cast a heavy shadow of doubt on the hundreds

of cases that are currently pending under the federal law

that preceded the issuance of the temporary regulations in

1993.

CONCLUSION

The judgments below should be affirmed.

Respectfully submitted,

REUVEN S. AVI-YONAH RICHARD RUDA *

1525 Massachusetts Avenue Chief Counsel

Cambridge, MA 02138 LEE FENNELL

(617) 496-8262 STATE AND LOCAL LEGAL CENTER

444 North Capitol Street, N.W.

Suite 345

Washington, D.C. 20001

(202) 434-4850

* Counsel of Record for the

January 19, 1994 Amici Curiae

22 See, e.g., cases cited above in Part I.A. Cf. Panhandle Oil Co.

v. Mississippi ex rei. Knox, 277 U.S. 218, 223 (1928) (Holmes, J.,

dissenting) (“The power to tax is not the power to destroy while

this Court sits.”), overruled by Alabama v. King & Boozer, 314

U.S. 1 (1941).