SALT Blawg – State and Local Tax
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Chamberlain Hrdlicka Blawgs
By Paul Masters
The long-contested constitutional issue concerning the New Jersey throw-out rule has finally culminated in a New Jersey Supreme Court decision recognizing the general constitutionality of the rule, but for its application to sales receipts attributable to states that choose not to impose an income tax. But first, we summarize what this decision did not do. The decision did not address in any significant way the current challenges to nexus that the states confront. Rather, the decision reaffirmed existing federal law, 15 U.S.C.A. §§ 381-84 (commonly referred to as “P.L. 86-272”), and looked to well-grounded constitutional law by the United States Supreme Court. Cases regarding nexus continue to move forward, with KFC reaching an unfavorable decision at the Iowa Supreme Court, on petition for a writ of certiorari at the United States Supreme Court, and Texas also in that mix with the current Taco Bell litigation (examining whether Taco Bell has nexus with Texas by sending a third-party to inspect its Texas franchisees). However, the decision does push back against state attempts to expand its tax base, by placing a firm limit on expansion where a state is able to claim and tax revenue from another state because such state, such as Nevada, has elected not to impose an income tax on activities in which the constitutional nexus standard has been reached.
The throw-our rule that was challenged excluded certain income from the sales fraction’s denominator of the modified three-factor formula used by New Jersey, as provided for in New Jersey’s statutory scheme. N.J. Laws, L. 2002, c. 40, § 8. The modified three-factor formula employed by this legislation weighed a taxpayer’s property, payroll and sales in the numerator, while the denominator was the taxpayer’s total taxed sales, as opposed to the general provision for taxpayers to use total sales. The non-taxed sales are thus “thrown out,” hence the name for the rule. The New Jersey legislature subsequently amended the statute to eliminate the throw-out rule, but only after the date of the operative facts in these cases. N.J. Laws, L. 2008, c. 120.
This decision is a partial affirmation of prior decisions by both the New Jersey Tax Court and the Appellate Division of the New Jersey Superior Court. In these prior decisions, both courts upheld the constitutionality of the throw-out rule. The courts looked to the constitutional standard provided in United States v. Salerno, 481 U.S. 739, 107 S. Ct. 2095, 95 L. Ed. 2d 697 (1987). Tax Court found three general circumstances where the throw-out rule operates constitutionally: (i) the income excluded from the denominator relates in whole or in part by activities in New Jersey, (ii) the application of the throw-out rule has no material effect on the sales fraction because the income in the non-taxing state is insignificant to the total income of the taxpayer, and (iii) the property and payroll fractions significantly temper the impact of the disputed sales fraction.
The Appellate Division agreed with the application of the Salerno standard, pointed to the lack of any case law in which an allocation formula was struck down as facially unconstitutional, and observed that it is unlikely that any person can actually demonstrate that “a given formula will yield allocations for most out-of-state taxpayers that are unconstitutionally disproportionate.” Because Whirlpool did not contest that it had nexus with New Jersey, and that sales to non-taxing states were not part of that business, the Appellate Division concluded the constitutional conditions were satisfied for application of the throw-out rule by New Jersey. The Appellate Division summarized that the throw-out rule does not result in double taxation, does not pressure taxpayers to increase their business activities in New Jersey at the expense of other states, and is thus facially constitutional.
The Supreme Court disagreed, in part. In doing so, the focus turned to four-prong approach used in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279, 97 S. Ct. 1076, 1079, 51 L. Ed. 2d 326, 331 (1977). This four-prong approach will sustain a state’s formula apportionment methodology for income tax when the tax: (i) is applied to an activity with a substantial nexus with the taxing state, (ii) is fairly apportioned, (iii) does not discriminate against interstate commerce, and (iv) is fairly related to the services provided by the state. Complete Auto, 430 U.S. at 279, 97 S. Ct. at 1079, 51 L. Ed. 2d at 331. The Whirlpool court focused on the second prong: fair apportionment.
Fair apportionment has two requirements: (i) internal consistency and (ii) external consistency. Internal consistency is where an application of the formula by every state would result in no more than all the taxpayer’s business income being taxed. Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159, 169, 103 S. Ct. 2933, 2942, 77 L. Ed. 2d 545, 556 (1983). It is a hypothetical analysis of what the world would be like if every state had New Jersey’s throw-out rule. The second requirement is an actual analysis of whether the state’s reach goes beyond that portion of revenue that is fairly attributable to economic activity within the taxing state. Okla. Tax Comm'n v. Jefferson Lines, Inc., 514 U.S. 175, 185, 115 S. Ct. 1331, 1338, 131 L. Ed. 2d 261, 271-72 (1995). In other words, whether New Jersey’s throw-out rule reasonably reflects the activity within its jurisdiction.
Whirlpool argued that by including out-of-state receipts in New Jersey’s tax base, New Jersey taxed more than its “fair share.” The New Jersey Supreme Court divided these receipts into two parts: (i) receipts from states that could not impose an income tax due the lack of nexus in that state, and (ii) receipts from states that chose not to impose an income tax. As to the first, the Court ruled that the throw-out rule was constitutional, but as to the latter, the answer is “no.”
The reasoning as to the former is that another state’s decision tax, or not tax, its income would cause a change in New Jersey’s share of the income it is entitled to tax. Thus it is not externally consistent. The change is not reflected on the taxpayer’s activities (the economic activity in within the taxing state), but merely a reflection of another state’s legislature to impose tax. But as to the second, regardless of the other state’s choice regarding income tax, the amount that New Jersey would be able to tax via the throw-out rule remains the same. The only way the result would change is if the taxpayer alters its contacts with the other state.