ARTHUR YOUNG CALLS FOR WITHDRAWAL OF SECTION 861 REGULATIONS ON ALLOCATION OF STATE INCOME TAXES.

The firm asserts that the regulations are incorrect in assuming that foreign-source income is taxed by states when taxable income for state purposes exceeds U.S.-source income for Federal tax purposes. Numerous state tax modifications to Federal taxable income routinely result in higher state taxable incomes, the firm argues, citing depreciation deductions, state and municipal interest income, net operating loss deductions, and interest expense.

"The general principle of the regulations," the firm says, "is flawed in its presumption that states tax foreign source income." Furthermore, it argues, "the fact that states use a different method for sourcing income does not support the presumption that foreign source income is in fact taxed." Citing Container Corporation of America v. Franchise Tax Board, 463 U.S. 159 (1983), the firm argues that differences will always result when any two methods of accounting are compared.

The regulations' inclusion of those state franchise taxes which are measured by net income in the expense allocation is beyond the intended scope of the regulations, the firm asserts. "Franchise taxes are imposed for the privilege (franchise) of doing business in a state," the firm says, and "are not a tax on the generation of net income." Franchise taxes should be sourced only to the state that imposes the tax, the firm contends.

According to the firm, compliance with the proposed regulations will add substantial costs and administrative burdens to U.S. multinationals and worsen their international competitive standing. Not only do the regulations require more calculations, Arthur Young says, but the period for preparing tax returns will be compressed because the state returns will now have to be prepared prior to the filing of the Federal return.

I am enclosing a copy of comments mailed February 10, 1989 relating to proposed and temporary regulation section 1.861-8T. These comments were originally submitted by certified mail.

If you have any questions concerning these regulations, please contact any of the individuals listed on page 9 of the comments.

Very truly yours,

On December 12, 1988, proposed temporary Income Tax Regulations were issued as a supplement to existing temporary Regulations under Sections 861(b), 862(b), and 863(a) of the Internal Revenue Code. These temporary Income Tax Regulations propose to add paragraph (e)(6) and examples (25) through (29) of paragraph (g) to Section 1.861-8T. As promulgated, these regulations provide general principles and specific examples of the allocation and apportionment of the deduction for state income taxes in the computation of taxable income from sources inside and outside the United States.

For the reasons stated below, we believe these proposed regulations should not become final, and should be withdrawn pending further study of the general principles involved and the impact of their implementation on U.S. multinationals. Our comments are both general and specific as follows.

GENERAL COMMENTS:

1. The basic principle of the regulations is flawed in its assumption that foreign source income is taxed when taxable income for state purposes exceeds U.S. source income for Federal tax purposes. This presumption fails to take into account the numerous state tax modifications to Federal taxable income (other than state taxes) that routinely result in higher state taxable incomes. Following are four specific areas wherein Federal and state differences occur in the determination of base income.

o DEPRECIATION DEDUCTIONS - Most states do not allow ACRS and MACRS depreciation deductions in arriving at taxable income. This modification alone significantly increases state income bases which will greatly distort the intended result of the proposed regulations.

o STATE AND MUNICIPAL INTEREST INCOME - Generally all states require the inclusion in taxable income of interest income received on obligations of all state and municipal governments, with the frequent exception from such inclusion of the taxing state's obligations. Therefore, the regulations will attribute state taxes on such income to foreign sources.

o NET OPERATING LOSS DEDUCTIONS - Most states that permit such deductions (and several do not) have adopted different rules than those for Federal tax purposes under Code Section 172. Many states do not provide for the carryback of such losses to prior periods, but rather, limit such deductions to future years only. Further, such carryforward deductions are frequently limited to Federal taxable income before state adjustments. Thus, corporations that have such deductions will generally always have higher state than Federal domestic source taxable income, with the result under these regulations that these state taxes will be attributed to foreign sources. Even when the deduction is the same as for Federal purposes, a proper matching of the tax years would still be required to avoid distortion.

o INTEREST EXPENSE - Several states require corporations to add back to Federal taxable income all or some portion of interest expense paid or accrued to related parties. These states require such modification to avoid debt vs. equity determinations. Other states require the attribution of interest expense (disallowance) to state exempt income (i.e. dividends from subsidiaries), or to non-business income (i.e. rents or royalties) which is directly allocated to the state where earned. The net effect of such modifications again causes state taxable income to be greater than Federal.

The above are just a few of the state modifications to Federal taxable income that result in higher state tax bases. Others include depletion and amortization expenses, bad debt deductions, and even salary and wage expenses to the extent they relate to stockholders or officers of the corporations.

As stated, the regulations fail in their presumption that where state taxable income is higher than Federal domestic source income, foreign source income is therefore taxed. Due to the various state modifications required, state taxable income will generally always be greater than Federal regardless or any foreign source income. Therefore, the regulations will result in significant distortion by sourcing state taxes attributable to such modifications to foreign sources.

2. The general principle of the regulations is flawed in its presumption that states tax foreign source income. The regulations presume that arm's-length separate accounting is the proper method for determining U.S. and foreign source income, and that formula apportionment used by the states is improper and results in the taxation of foreign source income. The courts have addressed this issue and have determined that formula apportionment is merely a different method to arrive at the same result. The fact that states use a different method for sourcing income does not support the presumption that foreign source income is in fact taxed.

The U.S. Supreme Court in Container Corporation of America v. Franchise Tax Board, 463 US 159 (1983), reaffirmed the standing principle that under both the Due Process and the Commerce Clauses of the Constitution, a state may not "tax value earned outside its borders." In addition, the Court stated that "Both geographical accounting and formula apportionment are imperfect proxies for an ideal which is not only difficult to achieve in practice, but also difficult to describe in theory." The Court further stated in Container, "But we have seen no evidence demonstrating that the margin of error (systematic or not) inherent in the three-factor formula is greater than the margin of error (systematic or not) inherent in the sort of separate accounting urged upon us by appellant." Thus, the Court has recognized formula apportionment as a viable alternative to separate accounting in arriving at the same intended result. Therefore, the presumption that this method automatically results in the taxation of foreign source income is incorrect.

Further, the regulations result in an inherent distortion by comparing the results of each method to the other in the various examples. Such comparisons cannot be made where the resulting difference is automatically presumed to relate to foreign source income. Differences will always result when any two methods of accounting are compared. The U.S. Supreme Court has recognized this fact; the regulations should likewise take this into account.

3. The inclusion of state franchise taxes measured by net income in the expense allocation is beyond the intended scope of the regulations. Whereas the basic principle previously promulgated in the regulations states that state, local and foreign income taxes are definitely related and allocable to the gross income subject to tax, such is not the case with respect to state franchise taxes. By their very nature, franchise taxes are imposed for the privilege (franchise) of doing business in a state. As such, franchise taxes should be sourced only to the state that imposes the tax (i.e. U.S. source only). The fact that a franchise tax is measured by net income should not change this result. As stated, the franchise (the right to do business) is only measured (valued) by net income, and, therefore, such taxes are not a tax on the generation of net income.

To support this position one need only look to the U.S. Code which forbids states from imposing a net income tax on interest income from obligations of the U.S. Government. Franchise taxes are not so restricted. The U.S. Supreme Court has stated that franchise taxes measured by net income are not a direct tax on such income, but rather that such income is merely used in the measurement of the franchise (see Northern Finance Corp. v. Tax Commission (1933), 290 US 601). This also pertains to foreign source income, which only serves to further support the position that such taxes should be excluded from the regulations.

4. The proposed regulations will have a significant adverse impact on U.S. multinationals due to the increased cost and administrative burden of complying with the required calculations. The cost of state and local tax compliance has increased dramatically over the last few years. Corporations are now forced to create entire tax departments and information support units just to comply with the various state filing requirements. These regulations in effect require additional preparation for each jurisdiction taxpayers currently file in. They also require the calculation of hypothetical taxes for jurisdictions where the taxpayer currently does not file. Compliance with these regulations will clearly add substantial costs to U.S. multinationals and will put them in an even greater disadvantage when competing overseas, (please see enclosed study).

Further, the calculations required by the regulations will create an enormous administrative burden, and will be extremely difficult to complete on a timely basis so that the results may be included in a Federal tax return. Generally, state taxable income is based on Federal taxable income, therefore, state tax returns cannot be completed until after the Federal tax return has been finished. Nearly all of the states recognize this fact by having a filing due date after the Federal due date or by providing extensions beyond the Federal six-month period.

Compliance with these regulations will require that state returns be completed prior to the filing of the Federal tax return. As can be seen from the above, this will be virtually impossible for those taxpayers that require the entire extension period to complete their Federal tax returns. Such compliance is clearly an added burden on taxpayers by compressing the time period in which tax returns must be prepared.

SPECIFIC COMMENTS:

1. As discussed above, the basic premise of example #25 of the regulations is flawed in that it fails to account for the various state modifications to Federal taxable income in arriving at state taxable income. The example will automatically source the state taxes applicable to such modifications to foreign source income. This result is distortive and must be corrected.

2. Depending upon the required modifications to Federal taxable income and the presence of the taxpayer in each state (apportionment percentage), example #26 can result in substantially different answers.

In the example state A does not tax foreign source income, hence $550,000 of the $800,000 federal domestic base is allocated entirely domestic. This leaves states B and C. States B and C impose state tax on $400,000, but only $250,000 can be domestic base ($800,000 - $550,000). Therefore, their tax is apportioned as follows:

          Total Tax $14,000 X ($150,000/$400,000) = $ 5,250 Foreign

3. Example #27 fails to account for differences in the various state apportionment factor calculations. Many states require a double weighted receipts factor, or a single factor based on sales. Other states require "throwout" or "throwback" sales to be added to instate sales. These different rules can have a substantial distortionary affect. Suppose Company A is headquartered in California and substantially all of its property and payroll are located there. However, it has sales in all 50 states, with minimal presence in "no tax states." Since the throwback rule would apply, virtually all income would be attributed to California. If, in addition, income is attributed by the regulations to the "no tax states," the result will be a higher aggregate and, therefore, higher foreign source result.

In essence, example #27 ignores the fact that due to different apportionment rules employed by the states, the sum of the state numerators for any factor frequently (if not always) add to more than 100%. Thus, imputing hypothetical taxes for other states will result in a distorted amount of state tax deemed attributable to foreign sources. This result is distortive and must be corrected. To provide relief from such an inequity, the numerator should be reduced so that the factor will not exceed 100%.

4. Example #28 presents an interesting dilemma. It calls for the direct attribution of state taxes to foreign dividend income where such income is included in state taxable income, but only when the factors of the payor are NOT included in the state apportionment factor. This example appears to recognize that formula apportionment is a viable alternative to separate accounting. However, why should the result be different under examples 25 - 27? Since foreign branch Y's factors are included in the state apportionment factors, there should be no need to assume foreign source income is taxed.

Further, this example only adds to the distorted effect of the regulations by requiring direct sourcing of state taxes before applying the general rules for allocation. It ignores the effect of state modifications to Federal taxable income and the differences in apportionment factors outlined above. Thus, the inherent distortion present in the general rules is further exacerbated.

5. As previously stated, the examples in the regulations result in a distortion by failing to account for the various differences in computing individual state taxable income and apportionment factors. Example #29 merely compounds the problem by adding a hypothetical water's edge tax to all of the previous examples. Besides the obvious administrative burden this example presents, it fails in its presumption that the worldwide unitary apportionment method automatically results in the taxation of foreign source income. This is simply not the case, especially given that the factors of the foreign entities are included in the apportionment formula.

CONCLUSION AND REQUEST FOR HEARING:

For the reasons outlined above, we believe the regulations, as drafted, should be withdrawn pending further study. First and foremost, the regulations incorrectly presume that states tax foreign source income, (which is not the case). Therefore, state taxes should be directly allocated to U.S. source income only.

However, if the regulations cannot be withdrawn, the distortions that these regulations create must in any event be corrected.

Furthermore, in light of recent state tax decisions regarding worldwide unitary taxation, (i.e. Cologate-Palmolive Co. v. Franchise Tax Board (12/12/88) Cal. Super.Ct.), and required factor relief for includable dividend income in the States of Wisconsin and Maryland, the general principle of and the need for the regulations may be moot.

We respectfully request a public hearing so that we may express our concerns and recommendations. Through mutual cooperation we are certain that any inadvertent inequities can be corrected.

If you wish to contact us concerning our comments, please call any of the persons listed below:

Philip L. Krevitsky 212-407-2181