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The Utah Supreme Court recently upheld the constitutionality of Utah’s personal income tax treatment of local, interstate and foreign income earned by a business owned by Utah residents.1
Specifically, the Court rejected the District Court’s determination that the state’s treatment of foreign business income violated the foreign Commerce Clause.2
The taxpayers were Utah residents and shareholders of a subchapter S corporation during the 2011-2013 tax years. As Utah residents, the taxpayers were subject to taxation on all of their worldwide income at a flat rate.3
Under the Utah income tax structure, Utah residents who earn out-of-state income are allowed to take a credit for taxes paid in other states.4
However, Utah does not allow residents to take a similar credit for taxes paid in foreign jurisdictions. Utah does provide for equitable adjustments in certain circumstances to prevent taxpayers from being subject to double taxation.5
Faced with this regime and the potential for double taxation on a portion of their business income, the taxpayers filed Utah personal income tax returns claiming the available state tax credit on income earned and taxed in other states. Also, the taxpayers claimed equitable adjustments under Utah Code Ann. Sec. 59-10-115, and removed from their Utah taxable income base their business income from states that did not tax such income, along with all of their federally reported foreign business income.
The Utah State Tax Commission denied the equitable adjustments, assessed a deficiency on the taxpayers’ business income, and recalculated the state tax credit for taxes paid to other states. The taxpayers appealed to the Commission, asserting that Utah’s tax structure was unconstitutional because of its treatment of interstate and foreign business income of S corporation shareholders. The Commission denied the appeal, holding that the taxpayers did not qualify for the adjustment and that they had no authority to address the constitutional issues. Upon review, the District Court determined that the state’s treatment of foreign business income violated the foreign Commerce Clause, and concluded that an equitable adjustment could be applied to prevent double taxation of that income. However, it rejected the taxpayer’s contention that only the portion of its business income apportioned to Utah should be included in Utah taxable income and disallowed the equitable adjustment sought by the taxpayer for business income earned in other states which did not tax the income. Both parties appealed the decision.
Supreme Court decision
Like the District Court, the Utah Supreme Court addressed whether Utah’s personal income tax violates the Commerce Clause6
of the U.S. Constitution. Specifically, the Court addressed: (i) whether the Dormant Commerce Clause requires Utah to apportion a residency-based income tax instead of simply granting a credit for taxes paid to other states; (ii) whether the Dormant Foreign Commerce Clause requires Utah to allow a deduction for income earned in foreign countries; and (iii) whether Utah’s equitable adjustment statute7
requires a deduction for foreign income. Before considering these questions, however, the Court laid out its general approach to Dormant Commerce Clause issues, noting a desire to faithfully apply controlling U.S. Supreme Court precedent, but refrain from extending such precedent into new territory.8
Income earned in the United States but outside Utah
Like most states, Utah taxes its residents on all of their income, regardless of where it is earned. The taxpayers claimed that Utah’s tax system granting residents credits for taxes paid to other states violates the Dormant Commerce Clause because it taxes a disproportionate share of their income earned outside Utah. To analyze this claim, the Court looked to the four-prong test established by the U.S. Supreme Court to evaluate compliance with this clause in Complete Auto Transit
Specifically, it evaluated whether the tax was fairly apportioned, considering both the internal consistency and external consistency tests later established in Container Corp
While the taxpayer contended that both tests must be met, the Court turned to the Wynne11
decision for guidance in its analysis. In applying the Dormant Commerce Clause to evaluate the constitutionality of Maryland’s individual income tax, the U.S. Supreme Court in that instance assessed the Maryland tax at issue solely on internal consistency grounds. After determining that the tax at issue failed the internal consistency test, the U.S. Supreme Court proposed a solution which according to the Utah Supreme Court would fail the external consistency requirement. Based on that decision, the Court noted that “whatever life external consistency might have left, it is highly unlikely that it continues to apply in the context of an individual taxpayer’s challenge to a state’s taxation system.”
Applying this conclusion to the issue at hand, the Court found it necessary to analyze only whether Utah’s tax regime satisfied the internal consistency test to conclude on fair apportionment. It found no need to consider whether the external consistency test could be met. To evaluate internal consistency, it must be hypothetically assumed that every state imposes an identical tax. If, under this hypothetical assumption, interstate commerce is not placed at a disadvantage as compared with intrastate commerce, then the tax is internally consistent. Applying this analysis to the tax at hand, the Court concluded that Utah’s tax code satisfies the internal consistency test and passes Dormant Commerce Clause scrutiny.
Income earned in foreign countries
The taxpayer also contended that Utah’s failure to grant a credit for taxes paid to foreign countries was discriminatory. Citing its own decision in DIRECTV
, the Court reiterated that the U.S. Supreme Court has never indicated that a “state – taxing an individual
based on his residency in that state – could run afoul of the Constitution by failing to grant a tax credit against taxes levied by foreign countries.” Further, it noted Wynne
’s novel application of the Dormant Commerce Clause to a state tax levied against an individual state resident. Noting the absolute lack of guidance regarding how to treat individuals in the context of foreign commerce, the Court declined to extend the concepts established in Wynne
to extend the protections of the Dormant Foreign Commerce Clause to individuals.12
Instead, it cited that decision in concluding that “a nation or State ‘may tax all the income of its residents, even income earned outside the taxing jurisdiction.’”13
Further, the Court found Utah’s tax consistent with general foreign commerce principles, including its interaction with the federal tax code and exclusion of a credit for foreign taxes paid. Specifically, the Court cited the common lack of availability of a foreign tax credit at the state level as being implicitly endorsed by Congress, due to its lack of action to prohibit the practice or preempt such laws.
Finally, the taxpayer argued that Utah’s equitable adjustment statute allows the deduction of foreign income from the tax base. Reversing the District Court decision as to this matter, the Court found the statute inapplicable. The statute provides for an adjustment to “adjusted gross income of a resident or nonresident individual if the resident or nonresident individual would otherwise… suffer a double tax detriment under this part
Applying a plain reading of the statute, the Court found the adjustment only available if the Utah tax code itself
imposes double taxation. In this instance, Utah only taxed the foreign income once. Since the second tax detriment was imposed at the hands of a foreign government, the statute was inapplicable.
This decision highlights the importance of the Wynne
decision to the evaluation of constitutional arguments in the individual state income tax realm. The Court repeatedly relied upon the language and reasoning provided by the U.S. Supreme Court to determine that it only needed to apply the internal consistency test to evaluate fair apportionment in the individual income tax context. This decision appears to mark the first time that a state high court has chosen to completely depart from using the external consistency test based on its interpretation of the Wynne
case. If an appeal to the U.S. Supreme Court is undertaken by the taxpayers, this interpretation undoubtedly will comprise a relevant part of the challenge to this decision. In the meantime, other jurisdictions handling Wynne
-related constitutional challenges may take this decision as a cue to adopt a similar approach.
The Court highlighted that the taxpayers in this case raised some plausible arguments and identified some potential policy concerns with Utah’s tax regime, yet still held in favor of the state of Utah. The Court appeared hesitant to extend Wynne
to the arena of foreign taxation, given the uncertain nature of the law in its entirety. As flow-through businesses continue to expand their presence into multinational markets, the issue of foreign taxation and its effect on owners when a credit mechanism does not cure double taxation will likely become more prevalent, potentially compelling the U.S. Supreme Court to address the issue and revisit the Wynne approach either in this matter or in prospective litigation.
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