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Hoist v. Director

Decided: June 26, 1985.


On certification to the Superior Court, Appellate Division.

For reversal and remandment -- Chief Justice Wilentz and Justices Clifford, Handler, Pollock, O'Hern and Garibaldi. For affirmance -- None. The opinion of the Court was delivered by O'Hern, J.


This appeal concerns the validity of a franchise tax assessment against a New York corporation doing business in New Jersey. The taxpayer challenged the inclusion, as part of the value of its franchise, of allocated portions of (1) income derived from investment of corporate funds, and (2) certain machinery sales in New Jersey and elsewhere. We agree with the Director of the Division of Taxation that the taxpayer conducts its business as a "unitary business" and consequently we hold that the assessment reflects the value of the franchise fairly apportioned to New Jersey and thus does not offend the Due Process or Commerce Clauses of the United States Constitution. Accordingly, we reverse the judgment below that disallows the assessment.


State Taxation of Interstate Business

For over sixty years it has been a settled principle of federalism that a state tax on corporations doing business within a state is not limited to transactions within that state so long as the tax is fairly apportioned. Underwood Typewriter Co. v. Chamberlain, 254 U.S. 113, 41 S. Ct. 45, 65 L. Ed. 165 (1920). That case, like this one, involved the manufacture of products in one state and their sale in another. Connecticut used a single-factor formula to allocate Underwood's income from typewriter sales based on property located in Connecticut. Underwood contended that the formula taxes "income arising from business conducted beyond the boundaries of the state," in violation of the Due Process Clause. Id. at 120, 41 S. Ct. at 46, 65 L. Ed. at 169. Justice Brandeis rejected the claim, stating that Connecticut "adopted a method of apportionment which, for all that appears in this record, reached, and was meant to reach, only the profits earned within the state," id. at 121, 41 S. Ct. at 47, 65 L. Ed. at 169, and held that the taxpayer had failed to carry its burden of proving that "the method of

apportionment adopted by the state was inherently arbitrary, or that its application to this corporation produced an unreasonable result." Id. at 121, 41 S. Ct. at 47, 65 L. Ed. at 169-70 (footnotes omitted).

This underlying principle has continually informed the Supreme Court's treatment of state taxation of businesses that gain income from more than one state. A state is not constitutionally limited to taxing only that slice of an interstate enterprise operating physically within the state. See, e.g., Hans Rees' Sons, Inc. v. North Carolina ex rel. Maxwell, 283 U.S. 123, 51 S. Ct. 385, 75 L. Ed. 879 (1931); Bass, Ratcliff & Gretton, Ltd. v. State Tax Comm'n, 266 U.S. 271, 45 S. Ct. 82, 69 L. Ed. 282 (1924); Underwood Typewriter Co., supra, 254 U.S. 113, 41 S. Ct. 45, 65 L. Ed. 165. In a long series of decisions the Court has also discarded the formalisms that had obscured its analysis. Thus, in Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. 450, 79 S. Ct. 357, 3 L. Ed. 2d 421 (1959), the Court held that the Constitution did not bar, as a direct tax on interstate commerce, states from taxing, on an apportioned basis, the net income of foreign corporations that sold their products solely in interstate commerce. Id. at 461-62, 79 S. Ct. at 363-364, 3 L. Ed. 2d at 429-30. Finally, in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 97 S. Ct. 1076, 51 L. Ed. 2d 326 (1977), the Court abandoned altogether "'the use of magic words or labels'" that "could 'disable an otherwise constitutional levy'," and "recognized that the rule against taxing the 'privilege' of doing interstate business" no longer served an analytic function. Id. at 284, 97 S. Ct. at 1081, 51 L. Ed. 2d at 334 (quoting Railway Express Agency v. Virginia, 358 U.S. 434, 441, 79 S. Ct. 411, 416, 3 L. Ed. 2d 450, 456 (1959)). Because "[t]he Court long since had recognized that interstate commerce may be made to pay its way," Complete Auto Transit, supra, 430 U.S. at 284, 97 S. Ct. at 1082, 51 L. Ed. 2d at 334, the Court shifted the focus of analysis to "the question whether the tax produces a forbidden effect." Id. at 288, 79 S. Ct. at 1084, 51 L. Ed. 2d at 337.

Having replaced formalisms with economic reality, the Court developed a simpler, more straightforward approach based on the analysis of the effects of a tax, and will sustain a tax against a Commerce Clause challenge

when the tax is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State. [ Id. at 279, 79 S. Ct. at 1079, 51 L. Ed. 2d at 331.]

The Court has used this test interchangeably to test Due Process challenges to state taxation as well. See, e.g., ASARCO, Inc. v. Idaho State Tax Comm'n, 458 U.S. 307, 316-19, 102 S. Ct. 3103, 3108-3111, 73 L. Ed. 2d 787, 795-96 (1982).

In its most recent pronouncement, Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 103 S. Ct. 2933, 77 L. Ed. 2d 545 (1983), the Court combined its analysis of both Due Process and Commerce Clause challenges. The Court reviewed and summarized its development of the law. Beginning with the premise that Justice Brandeis made in Underwood that a state may not "tax value earned outside its borders," Container, supra, 463 U.S. at 164, 103 S. Ct. at 2939, 77 L. Ed. 2d at 552, the Court explained that formal and transactional accounting, limiting values to one situs, does not reflect economic reality. The problem it sees "is that formal accounting is subject to manipulation and imprecision, and often ignores or captures inadequately the many subtle and largely unquantifiable transfers of value that take place among the components of a single enterprise. See generally Mobil Oil Corp., 445 U.S. at 438-439, 100 S. Ct. 1223 at 1232, 63 L. Ed. 2d 510, and sources cited." Id. at 164, 100 S. Ct. at 2940, 77 L. Ed. 2d at 553. These transfers of value had long been measured in the case of interstate business such as railroads, utilities or freight lines by the "unit rule." J. Hellerstein, "State Taxation Under the Commerce Clause: The History Revisited," The State Corporation Income Tax, Issues in Worldwide Unitary Combination 53, 65 (C. McClure, Jr. ed. 1984). Thus, a share of the value of railroad rolling stock could be apportioned to a state on the basis of track mileage there. Such an enterprise connected

physically and by "unit[y] of use and management" possessed an instate value "in combination and from use in connection with the property and capital elsewhere" in excess of the bare value of the track or line. Adams Express Co. v. Ohio State Auditor, 165 U.S. 194, 222, 41 L. Ed. 683, 695 (1897).

In keeping with the premise of such measures, the Court has recognized the unitary business/formula apportionment method as an acceptable approach to the problem of taxing businesses operating in more than one jurisdiction.

It rejects geographical or transactional accounting, and instead calculates the local tax base by first defining the scope of the "unitary business" of which the taxed enterprise's activities in the taxing jurisdiction form one part, and then apportioning the total income of that "unitary business" between the taxing jurisdiction and the rest of the world on the basis of a formula taking into account objective measures of the corporation's activities within and without the jurisdiction. [ Container, supra, 463 U.S. at 165, 103 S. Ct. at 2940, 77 L. Ed. 2d at 553.]

In general, the formula determines a taxpayer's income tax base within a particular state by the average ratio of:

Receipts in state/Receipts everywhere Property in state/Property everywhere Payroll in state/Payroll everywhere.

That ratio applied to the taxpayer's total taxable income from all sources, yields the income attributable to the state.

This method has now gained wide acceptance, and is, in one of its forms, the basis for the division of income for state taxation of interstate commerce in forty-five states. See Report of General Accounting Office, "Key Issues Affecting State Taxation of Multijurisdictional Corporate Income Need Resolving," (July 1, 1982) (The Comptroller General). The method is the "benchmark against which other apportionment formulas are judged." Container, supra, 463 U.S. at 170, 103 S. Ct. at 2943, 77 L. Ed. 2d at 556.

We therefore must set forth with precision the only restraints that the Supreme Court has imposed upon a state

employing the unitary business/formula apportionment method of taxation of interstate businesses.

The Due Process and Commerce Clauses of the Constitution do not allow a State to tax income arising out of interstate activities -- even on a proportional basis -- unless there is a "'minimal connection' or 'nexus' between the interstate activities and the taxing State, and 'a rational relationship between the income attributed to the State and the intrastate values of the enterprise.'" Exxon Corporation v. Wisconsin Dept. of Revenue, 447 U.S., at 219-220, 65 L Ed 2d 66, 100 S Ct 2109, quoting Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S., at 436, 437, 63 L Ed 2d 510, 100 S Ct 1223. [ Id. at 165, 103 S. Ct. at 2940, 77 L. Ed. 2d at 553.]


Finding the "Nexus" or "Minimal Connection"

In the classic context, let us say, of an oil company, refining its product in New Jersey and selling it in Pennsylvania, there is little difficulty in finding the "nexus." But in the more complex business organizations of today that may engage in multiple lines of endeavor, as, for example, an oil company that also sells office products and motion pictures, finding the nexus is less clear. But one thing remains constant. If the business is unitary, the taxing authority is not constitutionally required to unravel the conglomerate structure. All that the Constitution requires is:

(1) that a State not tax a purported "unitary business" unless at least some part of it is conducted in the State * * * ;

(2) that there be some bond of ownership or control uniting the purported "unitary business;" [and]

(3) that the out-of-State activities of the purported "unitary business" be related in some concrete way to the in-State activities * * *.

(The functional meaning of this requirement is that there be some sharing or exchange of value not capable of precise identification or measurement -- beyond the mere flow of funds arising out of a passive investment or a distinct business operation -- which renders formula apportionment a reasonable method of taxation.) [ Container, supra, 463 U.S. at 165, 103 S. Ct. at 2940, 77 L. Ed. 2d at 553-54 (emphasis, numeration and parentheses added).]

In the highly complex series of cases that preceded Container, dealing largely with taxation of income from worldwide operations of overseas subsidiaries of corporations doing some instate business, the Court disagreed on the application of the

principles that determine whether a "unitary business" has been found. See, e.g., ASARCO, supra, 458 U.S. 307, 102 S. Ct. 3103, 73 L. Ed. 2d 787; F.W. Woolworth Co. v. Taxation and Revenue Dep't of New Mexico, 458 U.S. 354, 102 S. Ct. 3128, 73 L. Ed. 2d 819 (1982); Exxon Corp. v. Wisconsin Dep't of Revenue, 447 U.S. 207, 100 S. Ct. 2109, 65 L. Ed. 2d 66 (1980).

Notwithstanding repeated invitations, Congress, with the one exception of the Interstate Income Act, Pub.L.No. 86-272, has declined to step in to resolve the problems of federalism under its Commerce Clause powers.*fn1 In Container,

supra, the Court appeared resolved to take itself out of the business of being a tax commission and made it clear that the taxpayer has the "distinct burden of showing by 'clear and cogent evidence' that [the state tax] results in extraterritorial values being taxed . . . .," 463 U.S. at 164, 103 S. Ct. at 2939, 77 L. Ed. 2d at 552 (quoting Exxon Corp., supra, 447 U.S. at 221, 100 S. Ct. at 2119, 65 L. Ed. 2d at 80), and that the only restraints that it will impose are "to determine whether the state court applied the correct standards to the case; ...

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