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Worldwide Combined Reporting: Might Be Déjà Vu

Posted on May 31, 2021
Roxanne Bland
Roxanne Bland

Roxanne Bland is Tax Notes State’s contributing editor. Previously, Bland spent 17 years with the Multistate Tax Commission, where she worked with state revenue agency representatives to draft model legislation regarding sales and use taxation and corporate income, analyzed and reported on proposed federal legislative initiatives affecting state taxation, worked with legislative consultants and representatives from other state organizations on international issues affecting states, and assisted member state representatives in federal lobbying efforts. Before that, she was an attorney with the Federation of Tax Administrators for over seven years.

In this installment of The SALT Box, Bland examines the past, present, and future of worldwide combined reporting.

The states’ use of worldwide combined reporting has always been controversial, both at home and abroad. The controversy abated in the last fourth of the 20th century, because of mitigating efforts by states to provide taxpayers with a choice to use worldwide or water’s edge to report income. Today, worldwide may have been given new life in several state legislatures. The question is whether the new effort will cause as much consternation today as it did in yesteryear.

The Road to Worldwide Combined Reporting

The unitary business principle, and hence combined reporting, had its origins in the 1870s after the U.S. Supreme Court ruled that states could constitutionally levy a real property tax on an apportioned share of the value of an entire interstate railroad system rather than only the parts of the system that lie within the state’s jurisdiction.1 States developed formulas to determine the portion of a railroad’s value that should be attributed to a state. Shortly thereafter, the Court extended this ruling to apply to intangible property.2 In the ensuing decades, the states transferred the unit principle outside the property tax context when they began to impose income taxes on the business activities of non-railroad interstate corporations, and they developed formulas appropriate to apportioning income. The unitary business principle as applied to income was also upheld by the Court3 and sanctioned the states’ use of varied apportionment formulas.4

As corporate business activities expanded from interstate to international, California, one of the 12 states at the time that implemented combined reporting, mandated that multinationals report income earned by foreign subsidiaries for inclusion in the apportionment tax base. The United States’ foreign trading partners were apoplectic, with none more vocal than Japan and the United Kingdom. Japan, for example, threatened to make no new investments in the United States until the rule was changed. During negotiations between the United States and the United Kingdom on the 1978 income tax treaty, the United Kingdom insisted on a provision prohibiting states from using worldwide combined reporting but was rebuffed by the U.S. Senate. After the Supreme Court upheld California’s use of worldwide combined reporting for a U.S.-based corporation,5 the tax saber rattling from the United States’ foreign trading partners intensified; indeed, Japan and the United Kingdom threatened to enact retaliatory legislation. Then-President Ronald Reagan, bowing to international pressure, appointed the Worldwide Unitary Taxation Working Group to meliorate the situation. Although the working group and the states were able to reach agreement on some issues, other issues, such as the state tax treatment of foreign dividends, went unresolved. In response Reagan proposed, and the Senate introduced, the Unitary Tax Repealer Act6 to prohibit the states’ use of worldwide combined reporting and restrict state taxation of foreign dividends. Before the legislation could be considered, California amended its statute to provide multinationals with an option to elect to file under worldwide or water’s-edge combined reporting.7 Today all states that have implemented combined reporting8 allow multinationals this election to choose which method is more beneficial to the taxpayer. The election remains in force for a period of years, which varies from state to state, before a taxpayer is permitted to elect another option.

Is Worldwide Making a Comeback?

During their last legislative sessions, Illinois,9 Kentucky,10 Maryland,11 Minnesota,12 New Hampshire,13 and Oregon14 introduced bills to include worldwide combined reporting in their tax codes. Over decades, many in the business community have registered their objections to worldwide combined reporting, arguing that aside from geopolitical complications, worldwide combined reporting has built-in inequities and complexities that make compliance difficult. One oft-cited concern is the potential for double taxation of foreign-source income.15 Others involve the complexities inherent in determining if a multinational’s subsidiaries — which can number in the hundreds — are unitary with their U.S. parents or affiliates, determining foreign exchange rates, and reconciling foreign accounting methods.

Minnesota’s bill is notable in that a controlled foreign corporation will be deemed a domestic corporation if, for federal tax purposes, a U.S. shareholder is required to include global intangible low-taxed income in its gross income. Fredrick Nicely, senior tax counsel at the Council On State Taxation, objects to this provision. The statute, as amended, generally allows a taxpayer to elect worldwide combined reporting instead of water’s edge, but, he says, “you almost have to use worldwide combined reporting in the instance where if you have a CFC with losses, [the only way] to claim [those losses is] to use worldwide combined reporting. I look at it as [a] ‘back door’ to mandatory worldwide combined reporting.”

Another interesting observation is that the Kentucky and New Hampshire bills repeal the water’s-edge election and institute mandatory worldwide combined reporting. If mandatory, does worldwide combined reporting prevent the federal government from “speaking with one voice” on international tax policy?16 A recent example is the Trump administration pressuring France into stepping back from its proposed digital services tax by threatening to impose tariffs on imported French goods. At the same time, a few states were heading toward enacting DST. The federal policy concerning DST was not enshrined in a formal statement, but it was clear that the United States was against those measures. Given the United States’ stance, the DST contemplated by the states arguably hindered the federal government in presenting a singular position on the issue in the international arena. Could these recent events have some impact on the reporting regime mandated in the Kentucky and New Hampshire bills?

Regarding worldwide combined reporting, it is granted that nothing compels states to march in lockstep with federal tax policy. And granted, the international uproar over worldwide combined reporting is almost 40 years past. However, the Reagan administration’s position on the issue, although no formal statement had been forthcoming, was abundantly clear to the point that congressional legislation banning the states’ use of worldwide combined reporting was introduced. It is also clear that the brouhaha was resolved only because California amended its statute to allow a water’s-edge election. Because no state since then has mandated worldwide combined reporting, there has been no occasion for the federal government to express its policy on the matter. Can it be said that the federal policy still stands, or does the passage of time negate what came before, as no formal policy was issued? Regardless of the decades, the inclination is to say the policy stands unless and until the federal government, in whatever form or fashion, announces its reversal.

The (International) Tax Rules, They Are A-Changin’

Almost a decade ago, the OECD began the base erosion and profit-shifting project to curb widespread corporate income tax avoidance, in particular the practice of large multinational firms moving intangible assets to low-tax jurisdictions with favorable tax rules. Participation in the project has expanded from the 37 countries that make up the OECD to include the G-20 and 139 other nations, all of which have a substantial stake in the overhaul of the international income tax rules. Pillar 1 of the proposal addresses taxation in the digital economy, while pillar 2 addresses the restructuring of the individualized, nation-by-nation corporate income tax patchwork by implementing a worldwide income tax system to ensure that multinationals pay a minimum amount of tax, wherever they are headquartered or in the jurisdictions in which they operate.

Karl Frieden, vice president and general counsel at COST, shared his thoughts on pillar 2, explaining that “the purpose of worldwide was to give states a better snapshot of where income was earned, [and] the wide range of tax rates between countries was the reason why multinationals engaged in income shifting. BEPS aims to decrease that, mainly by imposing a minimum tax rate in each country. If countries have the same or nearly the same tax rate — although there will always be some that have low rates — there’s less incentive [for multinationals] to shift income.” So, what does that mean for worldwide combined reporting? Frieden says, “The world is headed to a place where we’re going to have a better snapshot anyway on where income is earned. [If that is so], what would be the need for worldwide combined reporting?”

Conclusion

Judging from the many cases handed down by the Supreme Court, domestic combined reporting is a hot topic, although the controversy has greatly died down in the last 45 years. If domestic combined reporting is hot, however, worldwide combined reporting has been incendiary on the international front. Although the fire was put out by the introduction of water’s-edge combined reporting, some states are attempting to amend their combined reporting statutes by reintroducing or newly incorporating worldwide. Doing so raises questions about the status of federal policy on the issue and whether the states’ actions would hinder the federal government in the international arena. There is also the question of the proposed changes in the international income tax regime, which could obviate the need for worldwide combined reporting. While the states’ proposed legislation did not see any movement in the sessions recently concluded, they could always pop up again in the future. If one or more of these bills manage to become law, it will be very interesting to see the international reaction.

FOOTNOTES

1 In re State Railroad Tax Cases, 92 U.S. 575 (1875).

4 See Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978).

6 S. 1974 (1985). The act also would have required multinationals to file a full disclosure spreadsheet with the IRS. Full disclosure required multinationals to individually list income earned in all states and the District of Columbia, whether a jurisdiction imposed an income tax or not. The IRS would have shared the spreadsheet with the states under federal/state exchange of information agreements.

7 Under water’s-edge combined reporting, a unitary business, whether U.S.- or foreign-based, need include only the income and apportionment factors stemming from operations within the United States. Note that after California amended its statute to allow a worldwide or water’s-edge election, the Supreme Court upheld worldwide combined reporting when the parent is based outside the United States. Barclays Bank PLC v. Franchise Tax Board, 512 U.S. 298 (1994).

8 Alaska continues to mandate worldwide combined reporting for the oil and gas industry.

9 H.B. 3477 (2021).

10 H.B. 356 (2021). The bill repealed the water’s-edge election, thereby mandating worldwide combined reporting for all unitary taxpayers.

11 H.B. 172/S.B. 511 (2021).

12 H.F. 2114 (2021).

13 H.B. 102 (2021). The bill repealed the water’s-edge election, thereby mandating worldwide combined reporting for all unitary taxpayers.

14 H.B. 2975 (2021).

15 The Supreme Court’s Barclays decision on this point has been severely criticized. Internationally, separate accounting — that is, when tax is calculated according to the book income of each entity — is the norm. If income using the worldwide combined reporting method results in taxable amounts of income greater than that derived from separate accounting, a worldwide combined reporting state inevitably taxes foreign-source income already subject to tax in the foreign country. Combined reporting works domestically because, if necessary, the Supreme Court can intervene to enforce fair apportionment, which it cannot do in the international realm. See Douglas S. Pelley, “Victory for a World Parish: Analysis and Criticism of Barclays Bank v. Franchise Tax Board of California,” Cornell Int’l L.J. (1996).

END FOOTNOTES

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