1. STRUCTURING A STATE CORPORATE INCOME TAX WILLIAM F. FOX LEANN LUNA MATTHEW N. MURRAY September 2004

2. 2 Role of the Corporate Income Tax in State Finance Corporate income tax generates only about 9 percent of business taxes CIT declining as a share of tax revenues 10% in the 70s 5.9% in 2002 Over 7% now The revenue decline combined with the general attention to business taxes and corporate governance have drawn focus to the tax and tax planning

3. 3 Design the Tax Structure Based on a Goal for the Tax Instrument Optimal taxation Horizontal competition Tax retained earnings Externalities Tax portfolio balance Revenue handles Equity; corp. privileges; tax exporting

4. 4 Benefit Principle Tax businesses for their public service benefits to avoid cross subsidies from/to households and properly distribute costs Cannot expect Tiebout effects and voting to create a very precise state benefit tax Corporate income taxes in particular are a poor basis for taxing benefits Benefit tax should be on all businesses, not just corporations Profits a poor proxy for benefits; Ability to pay introduced Special provisions mean unequal burdens across firms

5. 5 Source-Based Entitlement Principle Specific to the state CIT Source-based taxation of nonresident income a state entitlement Net value added (profits) as tax base Ideally a uniform tax across states Apportionment to the extent supply and demand sides of market contribute to income creation; no specific formula

6. 6 What Should Guide Policy? Recognize taxes won’t necessarily coincide with benefits received Recognize uniformity does not prevail across states Revenue focus will be defeated by market and political forces Important role for neutrality considerations because of openness of economy Administrative costs and compliance costs But little empirical evidence to guide policy

7. 7 Five Key Issues Defining the taxable business Nexus Combined versus separate reporting Distribution of tax base across states for multijurisdictional firms Throwback rules

8. 8 Defining the Taxable Business C Corps under the CIT Should pass-through entities be included under the CIT? Neutrality should help guide policy The challenge posed by LLC subsidiaries which may not have nexus Personal v. entity tax Double taxation and need for credits if PIT exists

9. 9 Nexus Current practice varies across states Physical presence Doing business Earning income Components of nexus: 1. Substantive nexus – power to tax, which arises either from origin or residence basis 2. Enforcement nexus – ability to compel collection, which arises either from personal jurisdiction or agency jurisdiction

10. 10 Nexus Standard Economic presence – want to tax corporations where income is earned, which is both at origin and destination Problems Better on substantive than enforcement nexus International businesses Why not a physical presence standard? Income also earned at destination Creates planning opportunities like PL 86-272 Destination basis more consistent with production efficiency

11. 11 Separate vs Combined Reporting Separate – treat each entity on a stand alone basis Combined – file combined return for members of the unitary group Recommend combined reporting For neutrality, not to raise revenue Combine entities with losses and profits Transfer pricing for tangible goods Intangibles like royalties Sharing costs for overhead, mgt expertise Benefits from vertical integration

12. 12 The Piecemeal Approach Specific policies for specific issues Disallow deductions between related companies - Massachusetts Impose nexus on passive investment companies – South Carolina Examine PIC for valid business purposes - Maryland Audit transfer prices All will be incomplete; combined reporting represents a more general solution

13. 13 Issues with Combined Reporting What is a unitary business? States use different criteria Combined Control? Shared economies of scale/scope, vertical integration? Are these substantial? International businesses Combined and separate reporting states

14. 14 Tax Base Distribution for Multijurisdictional Firms Neutrality is a key goal The closed economy case: firms producing and selling in only one state The open economy case: producer prices may be affected by both origin and destination components of tax Partial factor taxes (capital and labor) Partial commodity tax (sales)

15. 15 Apportionment and Allocation Business income – income earned in the regular course of business and apportioned Nonbusiness income – all other income and allocated to where real property or corporation is located Apportion income to the maximum extent allowed by law to reduce distortions Relocate allocated income to low tax or not tax state Incentive to create non-business income

16. 16 Apportionment: Origin vs Destination Origin component appropriate to tax firms for benefits at point of production Destination component appropriate to tax firms for benefits at point of sale Origin and destination taxation consistent with source-based entitlement principle Destination taxes are superior at the margin because of smaller distortions (production and tax planning)

17. 17 Apportionment Issues Requires reconsideration of services/intangibles Cost of performance/real property for services Destination for tangibles Joyce v. Finnigan, combined reporting and firms without nexus Sales factor only in denominator Sales factor in numerator and denominator

18. 18 Throwback Rules Include in the numerator of the origin state’s sales factor those sales that are not taxed in destination states – 23 states Achieves locational neutrality if all states tax corporate income at the same rate…but they don’t Tax planning still possible unless all state have rule Taxing all corporate income; fairness and revenue

19. 19 The Case Against Throwback Rules Resulting base is inconsistent with intended tax base – Imposed not because a state determines that income is earned, but because another state is unwilling or unable to tax it Levied at the home not destination state rate Increases the origin component of the base Increases incentive to move firms selling tangible personal property Inconsistent with heavy weighting of the sales factor

20. 20 Summary Define the taxable business carefully Economic nexus standard Combined reporting Weight sales more heavily than other factors No throwback rule