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Whirlpool Properties, Inc. v. Director, Division of Taxation

208 N.J. 141, 26 A.3d 446 (2011)

TAXATION; CORPORATE BUSINESS TAX — The Throw-Out Rule, adopted in 2002 and since repealed, was a constitutionally permissible taxation rule so long as receipts taxed by a state that chooses not to have an income tax are not treated as if those receipts were collected in New Jersey.

New Jersey uses a three-factor formula to calculate a multi-state corporation’s New Jersey Corporate Business Tax (CBT) by disbursing income between New Jersey and the rest of the world. For taxpayers with regular places of business outside of New Jersey, the portion of entire net worth and entire net income that is subject to New Jersey tax is determined by multiplying each component by an allocation factor that is the sum of the property fraction, the payroll fraction, and two times the sales fraction, divided by four. The sales fraction was at issue in the present case. Without the Throw-Out Rule, the sales fraction would be calculated by dividing a taxpayer’s receipts in New Jersey (from sales of tangible personal property, services, and all other business receipts) by its total receipts. The Throw-Out Rule, adopted in 2002 and since repealed, increased a corporation’s New Jersey tax liability by “throwing out,” from the denominator of the sales fraction, sales receipts that are not taxed by other jurisdictions. That always increases the sales fraction, causing the apportionment formula and resulting CBT to increase.

A corporation had its principal place of business in Michigan and conducted all of its activities outside of New Jersey. The corporation earned income by licensing brand names that it owned and managed. It filed no New Jersey tax returns and paid no CBT from 1996 to 2003. The Director of the Division of Taxation calculated allocable income using information collected from related entities and issued the corporation a CBT deficiency assessment of nearly $25 million for those years. Before the Throw-Out Rule became effective, the portion of income allocated to New Jersey for 1996 through 2001 ranged between 0.9546 and 1.3337 percent. Using the Rule, the corporation’s 2002 income was allocated to New Jersey 29.2572 percent and 41.8647 percent, respectively.

The corporation appealed the assessment to the Tax Court and challenged the constitutionality of the Throw-Out Rule. On motions for partial summary judgment as to the Rule’s facial constitutionality, the Tax Court determined that the proper standard of review was set forth in United States v. Salerno, 481 U.S. 739, and that case upholds a statute if the challenged statute could operate constitutionally in some instances. Then, turning to the Rule’s viability under Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Tax Court focused on fair apportionment. In the end, the Tax Court concluded that the Rule satisfied Salerno by operating constitutionally when income excluded from the sales fraction denominator is generated in part by New Jersey activities, when the Rule has no material effect on the sales fraction, and when the property and payroll fractions substantially temper its impact.

The taxpayer appealed, and the Appellate Division affirmed. Addressing the due process claim, it noted that apportionment formulas need only avoid attributing income to the taxing state “out of all appropriate proportion” to business conducted in the state. Explaining that the corporation did not argue that it “had a nexus with New Jersey” independent from its “unitary business,” or that “sales to non-taxing states were part of that business,” the panel determined that New Jersey had a “constitutionally sufficient nexus to those sales.” The panel also found that the Throw-Out Rule did not discriminate against interstate commerce because it did not result in double taxation and avoided the “forbidden impact on interstate commerce” of “pressuring” out-of-state corporations to increase New Jersey activity. Then, the Court granted the corporation’s motion for leave to appeal further.

In that further appeal, the New Jersey Supreme Court held that for corporate taxpayers having a substantial nexus to New Jersey, the Throw-Out Rule, constitutionally, may apply only to untaxed receipts from states that lack jurisdiction to tax the corporation due to insufficient connection with the corporation or due to congressional action, but not to receipts that are untaxed because a state chooses not to impose an income tax.

Under the formula apportionment method used by many states to tax multi-state corporations, all receipts, property, and income of a “unitary business” are included in the tax base and then multiplied by a formula to determine what portion of the tax base the state may tax. The most common approach is the three-factor formula that averages property, payroll, and sales factors; it has been justified as a practical approximation of the distribution of a corporation’s income sources or social costs. Under the Complete Auto test for analyzing constitutionality under the Commerce and Due Process Clauses, a state’s formula will be upheld when it: (1) is applied to an activity that has a “substantial nexus” with the state; (2) is fairly apportioned; (3) does not discriminate against interstate commerce; and (4) is fairly related to services provided by the state.

“Substantial nexus” requires a minimum connection between the state and the transaction it seeks to tax. Fair apportionment requires internal and external consistency. A formula is internally consistent if, when hypothetically applied by all jurisdictions, it would result in a tax on no more than all of the corporation’s income. It is externally consistent only if it reflects a “reasonable sense of how income is generated,” which requires a practical inquiry into the interstate activity taxed in relation to the in-state activity. The discrimination prong reflects the dormant Commerce Clause bar against a state imposing a heavier tax burden on out-of-state businesses than on the state’s residents when they are competing in an interstate market. The fair relation prong examines whether the taxpayer received benefits from the state. Here, the facial constitutionality of the Throw-Out Rule did not turn on the substantial nexus prong because income that is so separate from New Jersey activity that it could not be constitutionally taxed would not be part of the taxpayer’s unitary business or its tax base regardless of the Throw-Out Rule. Also, for a general revenue tax, the fair relation prong requires only that a taxpayer was accorded the benefits of an organized society.

Whether the Throw-Out Rule is fairly apportioned depends on what types of receipts are thrown out: (1) receipts not taxed by a state because it lacks sufficient constitutional contact or because of action by Congress setting a lower threshold for what activity is sufficient for a state to tax it, such as P.L. 86-272, which prohibits state income tax on businesses whose only in-state activity is selling or soliciting orders for property shipped into the taxing state; and (2) receipts not taxed because a state chooses not to have an income tax. The Rule is internally consistent because if all states threw out untaxed receipts, no more than 100% of income would be taxed. However, throwing out receipts because a state chooses not to tax is externally inconsistent because that decision is independent of a taxpayer’s business activity and has no bearing on how much income is attributable to New Jersey. On the other hand, the Rule arguably is externally consistent when untaxed receipts are thrown out due to a state’s lack of jurisdiction to tax. While this increases New Jersey’s share, New Jersey may have contributed more to receipts than what is suggested by the sales factor without the Rule; thus, it may be reasonable to allocate a greater percentage to New Jersey. That this interpretation may not always lead to a fair outcome does not render the Rule facially unconstitutional; unfairness may be addressed through an as-applied challenge. Construing the Throw-Out Rule narrowly so that it generally operates constitutionally, the Court interprets the Rule as operating only to throw out receipts from states without taxing jurisdiction. According to the Court, this was consistent with the legislative intent to close a loophole and throw out “nowhere sales” (sales that result in income assigned so it is taxed nowhere) from the sales fraction, causing more income to be assigned where a corporation actually operates. As so construed, the Court held the Rule was facially constitutional.

Turning to Complete Auto’s remaining prong, a rule is not facially discriminatory when it applies equally to in-state and out-of-state businesses; and in light of the limiting interpretation, it has no discriminatory effect. The Throw-Out Rule passed this test. Finally, the Court’s construction, which resulted in a facially constitutional operation regarding fair apportionment, made it unnecessary to wade deeply into whether the Salerno standard of review should have been applied here.

In conclusion, in applying the Complete Auto test and based on the Court’s limiting interpretation, the Throw-Out Rule was held not to be facially unconstitutional. But, for corporate taxpayers having a substantial nexus to New Jersey, the Rule may apply constitutionally only to untaxed receipts from states that lack jurisdiction to tax the corporation.

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