United States: Alaska Supreme Court Holds Combined Group Must Include Portion Of Foreign Dividends In Income Tax Base

The Alaska Supreme Court has determined that a unitary group was required to include 20 percent of foreign dividends in its combined corporation net income tax return.1 Under the Alaska net income tax, corporations must include 20 percent of dividend income received from foreign corporations. However, Internal Revenue Code (IRC) Section 882 requires a foreign corporation to report only income effectively connected with the conduct of business within the United States. Because the federal provision was inconsistent with Alaska law and not adopted by reference, Alaska law controlled and the taxpayer was required to include a portion of the foreign dividends.

Background

Schlumberger Limited ("Limited"), a multinational company incorporated in the Netherlands Antilles, engaged in services limited to the management of its subsidiaries. In addition to the fees it received for this service, Limited received dividends from its subsidiaries around the world. In Alaska, Limited operated through a wholly-owned subsidiary, Schlumberger Technology Corporation ("Technology"), which owned and operated all of Limited's associated domestic companies. Technology filed a consolidated federal tax return for all of these subsidiaries. For Technology's 1998-2000 tax years, Technology filed Alaska corporate income tax returns that included only the domestic subsidiaries in the oilfield services industry, its primary line of business.

As a result of an audit, the Alaska Department of Revenue found that Limited was engaged in a unitary business with Technology for purposes of the Alaska combined reporting statute that requires members of affiliated groups to include in their income tax returns corporations whose "property, payroll, and sales factors in the United States average 20 percent or more."2 The auditor thus concluded that Limited was a "water's edge" affiliate of Technology within the meaning of the statute. Based on these determinations, the Department assessed additional corporate income tax.

After an informal conference decision affirmed that Technology must include 20 percent of Limited's foreign dividend income in the group's apportionable income, Technology appealed to the Alaska Office of Administrative Hearings. The administrative law judge denied Technology's motion for partial summary judgment on whether Technology could be assessed based on amounts received by a related foreign corporation that were earned outside the United States. According to the judge, Alaska's change to water's edge accounting limited the types of corporations included in the unitary group for purposes of determining apportionable income but did not limit the types of income to be apportioned from the members. Accordingly, the judge concluded that Alaska's apportionment methodology should be applied to determine Technology's taxable income, declining to apply a federal provision, IRC Section 882, which excludes income not "effectively connected with the conduct of a trade or business within the United States."

Technology appealed the administrative order to the superior court, which affirmed the decision. In addition, the superior court determined that Technology did not preserve its argument that the taxation of the foreign dividends would violate the Commerce and Foreign Commerce Clauses of the United States Constitution because Technology had stipulated to withdraw this issue from consideration. Technology appealed the superior court's decision to the Alaska Supreme Court.

Federal Foreign Dividend Sourcing Rules Inconsistent with Alaska Law

In affirming the superior court, the Alaska Supreme Court began its analysis by describing the Alaska net income tax as it pertains to the filing requirements for "affiliated groups." Under Alaska's mandatory water's edge combined reporting method, the affiliated group includes only corporations that are part of a unitary business with the taxpayer and that meet a certain threshold for domestic business activity.3

With the members identified, the net business income of the affiliated group is then subject to apportionment under the Multistate Tax Compact as adopted by Alaska.4 Under the Compact, a corporation's in-state income is determined by multiplying "[a]ll business income" by an apportionment fraction, which is the average of three factors— property, payroll, and sales—which operate to compare a corporation's in-state and worldwide business activities.5

While Alaska includes 20 percent of foreign dividend income in the group's apportionable income,6 the federal sourcing regime excludes all foreign dividends received by a foreign corporation.7 Acknowledging that Alaska net income tax statutes incorporate certain IRC provisions unless "excepted to or modified by other provisions," the Court resolved the inconsistency in favor of the state statute. In support of this result, the Court cited its decision in Department of Revenue v. OSG Bulk Ships, Inc., in which the Court declared that conformity with IRC Section 883, which excludes foreign shipping income from federal taxable income, was inconsistent with the provisions of the Compact incorporated into Alaska's statutes.8 After reiterating that the sourcing provisions of the IRC are fundamentally inconsistent with the apportionment required by the Compact, the Court concluded that the Alaska statute including 20 percent of foreign dividends was an exception to Alaska's general rule of IRC conformity.

Adoption of "Water's Edge" Statute Did Not Change Reportable Income

The Court also rejected Technology's argument that, by adopting the water's edge combined reporting method—which excludes foreign companies with less than 20 percent United States activities from the affiliated group—the legislature intended to exclude all foreign income, thereby superseding the rationale behind OSG. Alaska law defines the water's edge method as a reporting method in which the only corporations that may be included in the return are the corporations that are part of a unitary business with the taxpayer and satisfy certain tests for domestic business activity.9 Because the description speaks only to the types of corporations included in the group, the Court reasoned, "[t]his language limits the corporations that must be joined in a return; it does not limit the types of income that must be reported." The Court also noted that the water's edge amendment was enacted at the same time as the provision subjecting to allocation 20 percent of foreign dividends income. According to the Court, "[i]t thus seems unlikely that the legislature intended the water's edge amendment to have the effect of excluding all dividend income received by a foreign corporation."

Subsequent Legislation Did Not Incorporate All Federal Sourcing Rules

The Court rejected Technology's contention that the post-OSG Alaska statutory amendment providing that nothing in the Alaska net income tax statutes or in the Compact may be construed as an exception to or modification of IRC Section 883 requires the federal sourcing provisions to be followed when computing Alaska taxable income.10 The Court held that Technology's argument went too far because the legislature's decision to exclude the categories of foreign income listed in IRC Section 883 did not change the fact that the total exclusion of foreign dividends under IRC Section 882 is facially inconsistent with the 80 percent exclusion provided by Alaska law.

Constitutional Claim Intentionally Withdrawn

The Court did not consider Technology's argument that the Alaska net income tax statute violates the Interstate and Foreign Commerce Clauses of the United States Constitution because the state discriminates against dividends paid by foreign corporations in favor of dividends paid by domestic corporations. According to the Court, Technology withdrew this claim in a stipulation filed during the agency proceedings. After the administrative judge denied Technology's motion for summary judgment, the parties entered into a stipulation providing that Technology withdrew any potential disputed issues not addressed in the denial order, including any issues identified in the notice of appeal. The Court rejected Technology's argument that it did not explicitly waive this constitutional argument.

Commentary

The Court's refusal to follow IRC Section 882, holding that a portion of the foreign dividends are subject to tax, was based on the conception of the Court that "the Internal Revenue Code does not use the same apportionment formula as the Multistate Tax Compact." IRC Section 882 concerns the sourcing of a foreign corporation's income to the United States. This is not the same concept as the apportionment of income between states that is addressed by the Compact. The question that arises is whether it is fair to characterize IRC Section 882 and the Compact as being in conflict, given the distinct purposes of IRC Section 882, which addresses federal income tax issues, and the Compact, which addresses multistate income tax issues.

The Court's refusal to abandon its rationale in OSG confirms its support of Alaska income tax law in the event of an inconsistency with the federal income tax approach endorsed in the IRC. In both cases, the Court took this position notwithstanding an Alaska statute that explicitly adopts by reference numerous sections of the IRC unless excepted to or modified by other provisions of the Alaska net income tax statutes.11 It thus appears the preference for Alaska law rests largely on the Court's willingness to broadly apply this language and imply such an exception should a conflict of law arise.

The Alaska Supreme Court's decision did not substantively consider Technology's constitutional argument based on the conclusion that Technology waived the right to make this argument at the administrative level. Technology argued that the Alaska net income tax statute violates the Interstate and Foreign Commerce Clauses by discriminating against dividends paid by foreign corporations in favor of dividends paid by domestic corporations.

In support of its constitutional argument, Technology cited a U.S. Supreme Court case, Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, which held that Iowa's statutory scheme of taxing the dividends that a corporation received from its foreign subsidiaries while not taxing dividends received from its domestic subsidiaries facially discriminated against foreign commerce and violated the Foreign Commerce Clause.12 As summarized by the New Hampshire Supreme Court, Kraft contains a widely-cited footnote in which the U.S. Supreme Court "distinguishes between a single entity filing system where income from out-of-state domestic subsidiaries is not taxed at all and a combined reporting method system where out-of-state domestic income is taxed through apportionment."13 Because Kraft involved a separate entity tax return of a parent company, some state courts considering similar challenges by combined groups have distinguished Kraft and held that there is no constitutional violation.14 After considering these decisions from other states, it is likely that the Alaska Supreme Court would have found against the taxpayer on the substantive constitutional arguments based on Kraft had the taxpayer been permitted to raise them.

Footnotes

1. Schlumberger Technology Corp. v. Department of Revenue, Alaska Supreme Court, No. S-14729, July 18, 2014.

2. ALASKA STAT. § 43.20.145(a).

3. ALASKA STAT. § 43.20.145(a).

4. ALASKA STAT. § 43.19.010, art. IV, ¶ 9.

5. Id.

6. ALASKA STAT. § 43.20.145(a), (b)(1).

7. IRC § 882(a)(1).

8. 961 P.2d 399 (Alaska 1998). As discussed below, the Alaska legislature responded to this decision by clarifying that nothing in the Alaska corporate income tax law or the Compact could be construed as an exception or modification to IRC § 883.

9. ALASKA STAT. § 43.20.145(a), (h)(4).

10. ALASKA STAT. § 43.20.021(h). IRC § 883 excludes income of foreign corporations derived from ships, aircraft and communications satellite systems.

11. ALASKA STAT. § 43.20.021(a).

12. 505 U.S. 71 (1992). Iowa allowed a deduction for dividends received from domestic subsidiaries, but not for those received from foreign subsidiaries. In reaching its decision, the Court determined that "commerce" includes the flow of dividends from a foreign subsidiary to its parent.

13. General Electric Co. v. Commissioner, New Hampshire Department of Revenue Administration, 914 A.2d 246 (N.H. 2006), cert denied, 552 U.S. 989 (2007). In affirming New Hampshire's dividends received deduction statute, the Court decided to "assess New Hampshire's taxing regime as a whole and look at the aggregate tax imposed upon a unitary business."

14. Id.; Fujitsu IT Holdings, Inc. v. Franchise Tax Board, 15 Cal. Rptr. 3d 473 (Cal. Ct. App. 2004); Appeal of Morton Thiokol, Inc., 864 P.2d 1175 (Kan. 1993); Du Pont de Nemours v. State Tax Assessor, 675 A.2d 82 (Me. 1996).

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