The Constitution gives the power to Congress, and Congress alone, to regulate commerce with foreign nations. This means the individual states cannot regulate commerce with foreign nations. This concept is known as the Foreign Commerce Clause. While it seldom comes up in the area of state taxation, the Foreign Commerce Clause states, “Congress shall have Power . . . To regulate Commerce with foreign Nations, and among the several States . . .” This idea seems fairly simple conceptually, however, it can be difficult in practice to determine whether a state tax impedes on Foreign Commerce.
Since 2009, Indiana has been wrestling whether a provision of its state corporate income tax impermissibly burdens interstate commerce. Specifically, Caterpillar Inc., the world’s largest manufacturer of construction and mining equipment, took exception with a portion of Indiana’s corporate income tax law. As it turned out, Caterpillar incorporated in Delaware and had its headquarters in Peoria, Illinois and had one of its many plants in Lafayette Indiana. It also happened to own some 250 subsidiaries, most of which were foreign corporations.
With that brief background in mind, Caterpillar attempted to deduct its foreign sourced income when determining its net operating loss (NOLs) from 2000 through 2003. In 2005, Caterpillar used the NOLs and amended its Indiana corporate income tax returns for 1996 through 1999 and attempted to secure a refund for the tax it overpaid. Indiana corporate income tax law allows a corporation to deduct foreign sourced dividend income when calculating its income. However, Indiana law has no such provision to allow a corporation to increase an NOL by deducting foreign source income. Conversely, a corporation could increase its NOL by deducting domestic sourced income. Caterpillar simply argued that Indiana is discriminating based on the source of the income or loss (domestic vs foreign), and, therefore, it is violating the Foreign Commerce Clause. This seems like a clear indication that the state of Indiana is discriminating against foreign sourced income in favor of domestic income. This would regulate commerce with foreign Nations in violation of the Foreign Commerce Clause.
Caterpillar is not the first company to make this argument, as this type of provision is common in state corporate income tax law nationwide. In fact, in 1992, Kraft Foods took a similar issue to the Supreme Court of the United States. In Kraft Gen. Foods Inc. v. Iowa Dep’t of Rev, 505 US 71 (1992), Iowa denied a deduction from foreign sourced income in calculating taxable income for Iowa state corporate income tax. The Supreme Court of the United States determined that treating a foreign dividend differently than a domestic dividend violated the foreign commerce clause. However, Indiana distinguished the Caterpillar case because it states that “Kraft does not address how the treatment of foreign source dividend deductions apply to NOLs.” In other words a state cannot discriminate against foreign sourced dividends in its AGI computation but it is allowed to discriminate against foreign dividends for NOLs. How can that be?
In my view, the court in Caterpillar got it wrong. Whether the foreign sourced dividend is used to compute taxable income or compute an NOL, a state cannot show favoritism for domestic dividends without violating the foreign commerce clause. In Oklahoma Tax Comm’n v. Jefferson Lines, Inc., 514 U.S. 175, 185 (1995), Court articulated the requirement of “internal consistency.” Internal consistency requires taxes not burden interstate commerce any more than intrastate commerce, and that result must be the same if every state were to impose a tax identical to the tax being called into question. Here, where Caterpillar disallowed from taking the deduction to increase its NOL in every state, the effect would be to disallow a company from deducting losses from it’s NOL altogether.
Interestingly, Florida considered this same issue in Colgate-Palmolive v. Fla. Dep’t of Rev., 988 So 2d 1212 (Fla. 1st DCA 2008), and took the same approach as Indiana. Indiana appears to piggyback the Florida decision by arguing that if Florida can discriminate with regards to foreign dividends in calculating NOLs, then Indiana can discriminate as well. It also considered Kraft Gen. Foods Inc. v. Comptroller of Treas., No. 98-IN-OO-0353, in which a Maryland court said that a state cannot discriminate against foreign sourced dividends when a company increases an NOL. However, Indiana said that being that Florida found the Maryland case unpersuasive so do we. In a perfect world, the Supreme Court of the United States will take the Caterpillar case and set the record straight. Until then, I hope Taxpayers continue to hire a state and local tax attorney and continue fighting this issue because it simply does not make sense.
About the author: Mr. Donnini is a multi-state sales and use tax attorney and an associate in the law firm Moffa, Gainor, & Sutton, PA, based in Fort Lauderdale, Florida. Mr. Donnini’s primary practice is multi-state sales and use tax as well as state corporate income tax controversy. Mr. Donnini also practices in the areas of federal tax controversy, federal estate planning, Florida probate, and all other state taxes including communication service tax, cigarette & tobacco tax, motor fuel tax, and Native American taxation. Mr. Donnini received his LL.M. in Taxation at NYU. If you have any questions please do not hesitate to contact him via email JerryDonnini@Floridasalestax.com or phone at 954-642-9390..