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Jamie C. Yesnowitz
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In a decision released on Nov. 27, 2018, the Utah District Court examined the constitutionality of Utah’s income tax treatment of local, interstate and foreign income earned by a business owned by Utah residents.1
The Court affirmed the constitutionality of the Utah tax with respect to local and interstate business income. However, the Court concluded 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.
The taxpayers were Utah residents and shareholders of Steiner, LLC, a subchapter S corporation, during the 2011-13 tax years. About 2% of Steiner LLC’s income was generated from activities within Utah, while the remaining 98% was from interstate and foreign business activities. As Utah residents, the taxpayers were subject to taxation on all of their worldwide income at a flat rate.2
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.3
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.4
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 and assessed a deficiency on the taxpayers’ business income. 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.
District Court Decision
The threshold question for the Court to address was whether Utah’s personal income tax violates the Commerce Clause5
of the U.S. Constitution. The taxpayers claimed that, as currently interpreted and as applied, Utah’s tax structure violates the second and third prongs of the four-prong test established by the U.S. Supreme Court in Complete Auto Transit, Inc. v. Brady
In other words, the tax was not fairly apportioned and discriminated against interstate commerce. The Court first referenced the U.S. Supreme Court decision in Comptroller of the Treasury v. Wynne
which stated that Commerce Clause protections afforded to C corporations likewise apply to S corporations and their shareholders, so that a denial of a credit for taxes paid to another state is a violation of the Commerce Clause since interstate business income would impermissibly be taxed twice. Also, the Court cited the U.S. Supreme Court decision in Kraft General Foods, Inc. v. Iowa Dept. of Revenue and Finance8
which held that foreign commerce is due even greater protection from discrimination than interstate commerce.
Discrimination Against Interstate Commerce
For a tax to be nondiscriminatory, the U.S. Supreme Court has established that it must be internally consistent.9
To make this determination, 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.
As applied to interstate business income, the taxpayer and the Commission agreed that Utah’s tax structure is internally consistent. However, the taxpayer claimed that the tax structure failed the internal consistency test as applied to the taxation of foreign business income. Specifically, since Utah does not provide a credit or other adjustment for foreign taxes paid, business income is subject to double taxation – once by the foreign jurisdiction and a second time by Utah. Thus, prior to consideration of equitable adjustments, the Court determined that the tax violates the Commerce Clause with respect to the treatment of foreign income. The Court rejected the Commissioner’s arguments that the federal tax credit and various tax treaties provided the necessary relief to cure the double taxation, because such remedies only addressed double taxation from a federal tax perspective, not a state tax perspective.
The Court noted that generally, a tax must be fairly apportioned “to ensure that each State taxes only its fair share of an interstate transaction.”10
To meet this test, a state may not reach beyond that portion of value that is fairly attributable to economic activity within the state. Notably, the external consistency test has not previously been applied to invalidate an income tax based on residency. Instead, the Court referenced a well-established principle that a jurisdiction may tax all the income of its residents, even income earned outside the taxing jurisdiction.11
Thus, the Court denied the taxpayers’ request to invalidate Utah’s residence-based income tax on this basis and rejected the argument that the tax structure was improper because it could result in a tax liability greater than the total business income generated in Utah or in a disproportionately high effective tax rate. Under this analysis, Utah’s tax does not violate the fair apportionment prong of the Complete Auto
Utah provides an equitable adjustment provision which requires the Commission to approve equitable adjustments if the taxpayer “would otherwise suffer a double tax detriment.”12
The taxpayer argued that an equitable adjustment should have been allowed to eliminate earnings from states that do not impose an income tax and to avoid a double tax related to their foreign business earnings. The Court rejected this argument with respect to interstate income, finding the income properly subject to Utah’s residence-based tax and no double taxation existed.
With respect to foreign business earnings, however, the Court focused on a plain reading of the statute and quickly rejected the Commission’s argument that it was precluded from interpreting the provision to apply to double taxation on foreign business income because it had never previously been so interpreted. Also rejected were arguments that the provision was intended by the Utah legislature to apply only to double taxes imposed by Utah and that if the legislature wanted the statute to address double foreign taxation, it would have explicitly referenced foreign business income. Unpersuaded by these arguments, the Court found the statute facially unconstitutional, interpreting the equitable adjustment provisions to allow an adjustment for foreign business income taxed in a foreign jurisdiction.
In summary, the Court found that the tests for internal and external consistency were met by Utah’s tax structure for local and interstate business income. However, because Utah’s tax structure as currently applied to the taxation of foreign business income passed through to the shareholder of an S corporation may result in double taxation of that income, the tax structure violates the foreign Commerce Clause. As such, the Court reversed and remanded the decision with respect to the foreign business income claim.
It is possible that this decision could have significant implications for taxpayers with ownership interests in worldwide businesses. While not going so far to allow the taxpayers to completely exclude income derived in “non-tax” states from their resident tax base, the ability for the taxpayers to apply an equitable adjustment to avoid double taxation on foreign source income could provide a dramatic benefit depending on the level of foreign activity in their business. Given this decision was steeped in constitutional considerations, it would not be surprising if the Commissioner were to appeal the decision through the Utah court system.
Utah’s tax scheme is somewhat unique in its treatment of foreign income for personal income tax purposes. While most states utilize federal adjusted gross income as the starting point for computing their personal income tax base, they do use various methods to except foreign income from taxation or allow credit for foreign taxes paid. Other states with similar tax structures could find themselves faced with like challenges by astute taxpayers. Interestingly, the analysis erroneously attributed its applied internal consistency test to the discrimination prong of the four-prong test established in Complete Auto
, rather than the apportionment prong. Other states’ courts could apply different standards in a constitutional analysis to determine whether discrimination exists.
Finally, the decision reflects the importance that a Wynne
hypothetical analysis will carry in these types of cases. Although the interpretation of relevant state statutes obviously played a key role in the decision, the Wynne
decision was a pertinent precursor to this challenge, and the inspiration for the hypothetical analysis that guided the Court to its determination affirming the constitutionality of the tax structure with respect to the treatment of interstate, but not foreign income.
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