Did New Mexico violate the Foreign Commerce Clause by taxing Xerox's dividends and Subpart F income from unitary foreign subsidiaries while excluding income from nonunitary domestic subsidiaries?

Plain-English summary

New Mexico could tax Xerox's dividends and Subpart F income from unitary foreign subsidiaries without violating the Foreign Commerce Clause. The state excluded income from Xerox's domestic subsidiaries because they were nonunitary and constitutionally outside New Mexico's tax base—not because they were domestic. The foreign and domestic subsidiaries Xerox compared were therefore not similarly situated.

Xerox filed combined New Mexico returns with its unitary subsidiaries for 1995, 1996, and 1998. It took large "special deductions" that removed foreign dividends, Subpart F income, and the federal Section 78 gross-up from New Mexico taxable income.

On audit, the Department disallowed the foreign-dividend and Subpart F deductions but allowed exclusion of the Section 78 gross-up. It treated the foreign-source income as apportionable business income and gave Xerox factor relief under the Detroit formula.

The resulting assessment totaled $137,026.42: $27,644 tax and $27,723.06 interest for 1995; $36,785 tax and $31,400.41 interest for 1996; and $8,671 tax and $4,802.95 interest for 1998.

Combined reporting taxed the unitary business

New Mexico used federal taxable income as the starting point for state base income and UDITPA's property, payroll, and sales factors to apportion a multijurisdictional unitary business.

Under the combination-of-unitary-domestic-corporations method, the income of domestic unitary members was included in the combined base, while foreign members not doing business in the United States were outside the reporting group. Dividends and other income paid by unitary foreign subsidiaries to the U.S. parent could still enter the parent's tax base.

This differed from separate-entity filing, where domestic unitary subsidiaries' earnings and dividends could both remain outside the parent's state base while foreign dividends were included. Conoco had held that separate-entity treatment discriminatory, but the decision found that holding did not control Xerox's combined returns.

Foreign unitary income was apportionable

All of Xerox's foreign-source income payors were unitary with its worldwide imaging business. Under the unitary-business principle, New Mexico could include that income in the apportionable base and then apply a formula to approximate the share reasonably related to New Mexico.

The Department also granted Detroit-formula factor relief by adding a percentage of the foreign subsidiaries' property, payroll, and sales to the apportionment denominators. Xerox did not show by clear and cogent evidence that the resulting formula taxed extraterritorial value or failed to fairly approximate its New Mexico activity.

Nonunitary domestic income was excluded for a different reason

Xerox excluded domestic insurance subsidiaries Talegen Holdings and Ridge Reinsurance because they were not unitary with Xerox and lacked New Mexico nexus. The Department did not challenge that status.

The decision held that this exclusion was constitutionally required: a state may not tax income of nonunitary affiliates unrelated to the state or the taxpayer's unitary business. It was not a voluntary dividends-received deduction favoring domestic commerce.

If Xerox had received dividends from nonunitary foreign subsidiaries, those dividends also would have been excluded. The differing treatment turned on unitary versus nonunitary status, not foreign versus domestic location.

The comparison did not show foreign-commerce discrimination

Commerce Clause discrimination analysis compared taxpayers or income streams that were most similarly situated. Xerox compared value flowing from unitary foreign subsidiaries with passive investment income from nonunitary domestic subsidiaries.

Because those relationships differed in functional integration, centralized management, and economies of scale, the decision found no discriminatory preference for domestic commerce.

Result: protest DENIED. Xerox was not entitled to deduct the foreign dividends and Subpart F income received from unitary subsidiaries, and the $137,026.42 assessment remained.

What this means for you

Multinational corporate groups filing combined returns

Classify affiliates by unitary relationship before comparing the treatment of domestic and foreign income. Combined reporting can include foreign-source income received from a unitary affiliate.

Companies relying on foreign-commerce discrimination cases

Separate-entity cases may not control a combined-reporting return. The tax base's treatment of domestic unitary earnings is part of the comparison.

Taxpayers excluding nonunitary affiliate income

An exclusion required by constitutional limits is different from a discretionary dividend deduction. The same nonunitary rule must apply without regard to whether the affiliate is domestic or foreign.

Businesses challenging an apportionment formula

Develop evidence showing that the formula actually taxes extraterritorial value or does not reasonably reflect in-state activity. Xerox did not make that showing after factor relief was granted.

Common questions

Q: Which tax years were assessed?
A: 1995, 1996, and 1998.

Q: What foreign income did the Department include?
A: Dividends and Subpart F income received from Xerox's unitary foreign subsidiaries.

Q: Was the Section 78 gross-up included?
A: No. The Department allowed Xerox to exclude it.

Q: Why were the domestic insurance subsidiaries excluded?
A: They were nonunitary with Xerox and lacked New Mexico nexus.

Q: Did the Department give factor representation for the foreign income?
A: Yes. It applied Detroit-formula factor relief.

Citations and references

Statutes:

• NMSA 1978, § 7-2A-2(C) — federal taxable income as the starting point for New Mexico base income
• NMSA 1978, §§ 7-2A-8, 7-2A-8.3, and 7-2A-8.4 — corporate reporting methods
• NMSA 1978, §§ 7-4-1 et seq. — UDITPA allocation and apportionment
• NMSA 1978, §§ 7-4-10 through 7-4-18 — property, payroll, and sales apportionment factors
• NMSA 1978, § 7-4-19(C) — alternative apportionment and factor relief
• 26 U.S.C. § 243 — federal dividends-received deduction
• 26 U.S.C. § 78 — foreign tax gross-up

Cases cited:

• Kraft General Foods, Inc. v. Iowa Department of Revenue & Finance, 505 U.S. 71 (1992)
• Conoco, Inc. v. New Mexico Taxation and Revenue Department, 1997-NMSC-005, 122 N.M. 736, 931 P.2d 730
• Mobil Oil Corp. v. Commissioner of Taxes of Vermont, 445 U.S. 425 (1980)
• Container Corporation of America v. Franchise Tax Board, 463 U.S. 159 (1983)
• NCR Corp. v. Taxation and Revenue Department, 115 N.M. 612, 856 P.2d 982 (Ct. App. 1993)
• Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992)
• F. W. Woolworth Co. v. Taxation and Revenue Department of New Mexico, 458 U.S. 354 (1982)
• ASARCO Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982)
• In re Appeal of Morton Thiokol, 864 P.2d 1175 (Kan. 1993)

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Xerox Corporation
• Decision PDF: D&O 03-22

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST OF
XEROX CORPORATION, FEIN 16-0468020, No. 03-22
CORPORATE INCOME TAX ASSESSMENTS
FOR TAX YEARS 1995, 1996, and 1998,
ISSUED UNDER LETTER ID L0821166080

DECISION AND ORDER

A formal hearing on the above-referenced protest was held August 12, 2003, before

Margaret B. Alcock, Hearing Officer. The Taxation and Revenue Department was

represented by Bruce J. Fort, Special Assistant Attorney General. Xerox Corporation was

represented by Mark Sheivachman, its Director of Tax Planning. The final brief on the legal

issues raised by the parties was received by the Hearing Officer on November 12, 2003, at

which time the matter was submitted for decision. Based on the evidence and arguments

presented, IT IS DECIDED AND ORDERED AS FOLLOWS:

FINDINGS OF FACT

1. Xerox is a New York corporation with its worldwide business headquarters

located at 800 Long Ridge Road, Stamford, Connecticut.

2. Xerox’s worldwide imaging business, which is comprised of xerographic

equipment and printing sales, rentals, and service, is managed from its Stamford, Connecticut

headquarters. Neither Xerox nor any of its combined subsidiaries has any corporate

management resident in New Mexico.

3. In June 2002, the Department completed a field audit of Xerox’s reporting and

payment of New Mexico corporate income tax for tax years 1995, 1996, and 1998.

4. For each of the audit years in question, Xerox filed a combined return with its

unitary subsidiaries.

5. During the audit years, Xerox reported the following “special deductions” on

its New Mexico returns:

1995: $552,720,255
1996: $ 48,569,698
1998: $ 45,269,338

6. Upon audit, the Department’s auditor determined that in calculating New

Mexico taxable income, Xerox had deducted its foreign dividends and Subpart F income, as

well as the foreign gross-up required under Section 78 of the Internal Revenue Code.

7. The Department disallowed Xerox’s deduction of foreign dividends and

Subpart F income, but allowed the exclusion of the Section 78 gross-up.

8. None of Xerox’s Subpart F income was related to boycott income.

9. In determining Xerox’s corporate income tax liability for tax years 1995, 1996,

and 1998, the Department included the dividends and Subpart F income Xerox received from

its foreign subsidiaries as apportionable business income and then allowed factor relief using

what is commonly referred to as the “Detroit formula.” See Department Exhibit 2.

10. Xerox’s foreign-source income payors during the audit years were all unitary

with Xerox’s domestic unitary operations.

11. Included in the group of foreign source income payors was Bessemer

Insurance Company, a captive Bermuda insurance company.

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12. Xerox did not include in its unitary group any domestic property and casualty

insurance companies owned by its 100% indirectly owned subsidiary Talegen Holdings, Inc.

(“Talegen”) and Ridge Reinsurance Limited (“Ridge Reinsurance”), because Talegen and

Ridge Reinsurance were not unitary with Xerox. The nonunitary nature of Talegen and

Ridge Reinsurance was not challenged on audit by the Department.

13. Talegen and Ridge Reinsurance did not have nexus in New Mexico during the

audit years.

14. Xerox owned 100% of Xerox Financial Services, Inc. (“XFSI”), a domestic

holding company that was included in the New Mexico combined return. XFSI owned 100%

of Talegen.

15. During the audit years, insurance was a significant portion of Xerox’s

business.

16. On November 26, 2002, the Department issued a Notice of Assessment of

Taxes under Letter ID L0821166080, assessing Xerox for the following amounts:

Tax Year Tax Principal Interest Total

1995 $27,644.00 $27,723.06 $55,367.06
1996 $36,785.00 $31,400.41 $68,185.41
1998 $ 8,671.00 $ 4,802.95 $13,473.95
$137,026.42

17. On December 23, 2003, Xerox filed a written protest to the Department’s

assessment.

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ISSUE TO BE DECIDED

The issue to be decided is whether New Mexico’s corporate income tax scheme, which

taxes a combined filer on dividends and Subpart F income received from foreign affiliates that

are part of the taxpayer’s unitary group, but excludes from tax income received from domestic

affiliates that are not part of the unitary group, impermissibly discriminates against foreign

commerce.

Xerox maintains that the United States Supreme Court’s decision in Kraft General

Foods, Inc. v. Iowa Department of Revenue & Finance, 505 U.S. 71 (1992) and the New

Mexico Supreme Court’s decision in Conoco, Inc. v. New Mexico Taxation and Revenue

Department, 122 N.M. 736. 931 P.2d 730 (1996), cert. denied, 521 U.S. 1112 (1997) mandate a

finding of discrimination. It is the Department’s position that the holdings of Kraft and Conoco

are limited to separate entity filers and have no application to corporations filing combined

returns. In addition, the Department argues that a finding of discrimination cannot be based on

a comparison of the tax treatment of income received from unitary affiliates with the tax

treatment of income received from nonunitary affiliates.

DISCUSSION

In addressing the arguments raised by the parties, this decision will first set out the

framework of the New Mexico income tax scheme challenged by Xerox, followed by a

discussion of the appropriate comparison class to be used in determining the existence of

discrimination under this scheme, and an examination of how New Mexico’s tax applies within

this comparison class.

I. New Mexico’s Corporate Income Tax Scheme.

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A. Constitutional Limitations and Formulary Apportionment. Both the Due

Process Clause and the Commerce Clause of the United States Constitution prohibit a state

from imposing an income-based tax on value earned outside of its borders. ASARCO Inc. v.

Idaho State Tax Commission, 458 U.S. 307 (1982). When dealing with income that has been

earned by a multistate or multinational taxpayer, most states, including New Mexico, use the

guidelines set out in the Uniform Division of Income for Tax Purposes Act (“UDITPA”) to

allocate and apportion the taxpayer’s income. See, NMSA 1978, §§ 7-4-1, et seq. Under

UDITPA, a state must first distinguish between nonbusiness income, which is allocated to a

single state (usually the state of the taxpayer’s commercial domicile), and business income,

which is apportioned among all of the states in which the taxpayer has nexus. Business income

is apportioned according to a three-factor formula based on the amount of a corporation’s

property, payroll, and sales within a state compared with the amount of its property, payroll,

and sales everywhere. A percentage is calculated for each of the three factors, and the average

of the three is then applied against the corporation’s total income to determine the amount the

state will tax. NMSA 1978, §§ 7-4-10 through 7-4-18.

Formulary apportionment is based on the unitary business concept, which treats a

commonly controlled group of affiliated corporations forming part of an integrated business

enterprise as one entity, without regard to whether the enterprise crosses geographic boundaries

or conducts its business through separate corporate entities. Once the scope of a unitary

enterprise is defined, the taxable income of all of the entities making up the unitary group is

determined, and the apportionment formula is applied to approximate the business income that

is reasonably related to the group’s activities within the taxing jurisdiction. Through a long line

5
of cases, the United States Supreme Court has upheld the states’ use of the unitary business

principle. See, e.g., Container Corporation of America v. Franchise Tax Board, 463 U.S. 159

(1983); Mobil Oil Corp. v. Commissioner of Taxes of Vermont, 445 U.S. 425 (1980); Hans

Rees' Sons, Inc. v. North Carolina ex rel. Maxwell, 283 U.S. 123 (1931); Bass, Ratcliff &

Gretton, Ltd. v. State Tax Commission, 266 U.S. 271 (1924). The Court has been equally

consistent in holding that a state may not include in its tax base the income of nonunitary

members of a taxpayer’s corporate group whose activities are unrelated to the state or to the

common business enterprise of the unitary group. See, e.g., Allied-Signal, Inc. v. Director,

Division of Taxation, 504 U.S. 768 (1992); F. W. Woolworth Co. v. Taxation and Revenue

Department of New Mexico, 458 U.S. 354 (1982); ASARCO, supra.

B. Federal Returns as the Basis for State Reporting. Like most states, New

Mexico uses federal taxable income as the starting point for determining New Mexico “base

income” subject to tax. NMSA 1978, § 7-2A-2 (C). Section 243 of the Internal Revenue Code

(“IRC”) allows corporations to deduct dividends received from domestic subsidiaries in

calculating federal taxable income. The purpose of this dividends-received deduction is to

prevent double taxation of the same earnings—once as income of the subsidiary, which is

included on the federal return, and a second time in the form of dividends paid by the subsidiary

to its parent corporation. In contrast, the income of a U.S. corporation’s foreign subsidiaries is

not included in the federal tax base, and no federal deduction is allowed for dividends paid by a

foreign subsidiary to its parent company. As a result of using this federal tax scheme as the

starting point for its own calculations, New Mexico excludes domestic dividends but includes

foreign dividends in the state tax base.

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C. Application of New Mexico’s Tax Scheme to Separate Entity Filers. For tax

years 1995 forward, New Mexico has offered corporations a choice of three filing methods to

report income to New Mexico (see, NMSA 1978, §§ 7-2A-8, 7-2A-8.3, and 7-2A-8.4):

separate corporate entity; combination of unitary domestic corporations; and federal

consolidated group. The separate corporate entity filing method allows each corporation

doing business in the state to file a separate tax return, even when the corporation is unitary

with a larger group of affiliated corporations. Using this method, only the income of the

individual corporation is reported to New Mexico; the income of its unitary affiliates is not

part of the tax base. In these circumstances, New Mexico’s reliance on federal taxable

income as the starting point for calculating state tax results in more favorable treatment of

domestic income than foreign income, i.e., while neither the earnings nor the dividends of

domestic subsidiaries are included in the state tax base, the dividends of unitary foreign

subsidiaries are subject to tax.

In Conoco, Inc. v. New Mexico Taxation and Revenue Department, 1997-NMSC-005,

122 N.M. 736, 931 P.2d 730, cert. denied, 521 U.S. 1112 (1997), the New Mexico Supreme

Court concluded that the favorable treatment accorded to the domestic dividends of separate

entity filers resulted in unconstitutional discrimination. Relying on the United States Supreme

Court’s decision in Kraft General Foods, Inc. v. Iowa Department of Revenue & Finance, 505

U.S. 71 (1992), which struck down a similar tax scheme in Iowa, the New Mexico court held

that “[t]axation of dividends from foreign subsidiaries under the separate corporate entity

method violates the Foreign Commerce Clause of the United States Constitution.” 1997-

NMSC-005, ¶ 26. The court further held that New Mexico’s application of factor relief under

7
the so-called “Detroit formula” was not a sufficient remedy since it reduced, but did not

completely eliminate, the discriminatory treatment between foreign and domestic dividends.

D. Application of New Mexico’s Tax Scheme to Domestic Combined Filers.

Under New Mexico’s combination of unitary domestic corporations reporting method, the

combined income of all domestic corporations (and foreign corporations engaged in trade or

business in the United States) that are members of an affiliated group engaged in a unitary

business is reported on the New Mexico return. UDITPA’s three-factor formula is then applied

to apportion this income between New Mexico and the other states in which the group does

business. As a result of using federal taxable income to determine New Mexico base income,

intercompany transactions among the domestic members of the unitary group are eliminated in

determining taxable income. Foreign members of the unitary group that do not engage in

business in the United States are excluded from the reporting group, but income (including

dividends) paid by foreign subsidiaries to their U.S. parent is included in the state tax base.

Following the Supreme Court’s decision in Kraft, supra, a number of taxpayers

challenged the inclusion of foreign-source income in the calculation of state taxes using

domestic or “water’s edge” combined reporting methods.1 These taxpayers argued that under

Kraft, the exclusion of dividends received from domestic members of the unitary group

mandated exclusion of dividends received from foreign members of the group. In In re Appeal

of Morton Thiokol, 864 P.2d 1175, 1186 (Kan. 1993), the state of Kansas rejected this

1
At one time, a number of states calculated taxable income using worldwide combined reporting, which
includes both foreign and domestic subsidiaries in the unitary reporting group. Most states now allow
corporations to elect a method under which the total combined income to be apportioned is limited to the
"water's edge" or geographic boundaries of the United States, even when the scope of the unitary business

8
argument, finding that the combined reporting method eliminated any facial discrimination

under the Foreign Commerce Clause because the full measure of domestic subsidiaries’

earnings is included in the apportionable tax base while the inclusion of foreign earnings is

limited to the amount of the dividend paid:

Clearly, Kraft does not hold that the taxation of foreign dividends by a
combination method is facially unconstitutional. Revenue contends that the
aggregate tax imposed by Kansas on a unitary business with a domestic
subsidiary would not be less burdensome than that imposed by Kansas on a
unitary business with a foreign subsidiary because the income of the domestic
subsidiary would be combined, apportioned, and taxed while only the dividend
of the foreign subsidiary would be taxed. Allowing a deduction for the domestic
dividend avoids double taxation. It is the use of the domestic combination
method which distinguishes the Kansas and the Iowa tax schemes.... In a
combined filing state, such as Kansas, the hypothetical parent’s tax base includes
the combined federal taxable income of its combined domestic subsidiaries as
well as dividends from foreign subsidiaries. We conclude there is no showing
that this method is discriminatory under the holding in Kraft; therefore, it is not
violative of the federal Constitution’s Commerce Clause (Art. I, § 8, cl. 3).

The same conclusion was reached by the Maine Supreme Court in E. I. Du Pont de Nemours

& Co. v. State Tax Assessor, 675 A.2d 82, 88 (Me. 1996), which upheld the constitutionality

of Maine’s water’s edge combined reporting method against a challenge based on the Kraft

decision:

Although the dividends paid to parent corporations with domestic
subsidiaries are not taxed, the apportioned income of the domestic
subsidiaries is subject to tax. Because the income of the unitary domestic
affiliates is included, apportioned, and ultimately directly taxed by Maine as
part of the parent company’s income, the inclusion of dividends paid by
foreign subsidiaries does not constitute the kind of facial discrimination
against foreign commerce that caused the Supreme Court to invalidate
Iowa’s tax scheme in Kraft.

crosses national borders. See, Barclays Bank PLC v. Franchise Tax Board of California, 512 U.S. 298, 306
(1994).

9
See also, Bernard Egan & Co. v. Florida Department of Revenue, 769 So. 2d 1060 (Fla.

2000), cert. denied, 534 U.S. 995 (2001).

New Mexico has not addressed the application of Kraft to taxpayers filing under the

combination of unitary domestic corporations method. The New Mexico Supreme Court’s

decision in Conoco, supra, is limited to separate entity filers. While the court expressed

reservations on the issue, it was careful to distinguish the facts of other state cases upholding

the combined reporting method from the facts presented in Conoco:

Like the Supreme Court of Kansas in Thiokol, the Du Pont Court was able to
distinguish the challenged tax scheme from Iowa’s tax scheme because Maine
included a portion of the domestic subsidiaries’ income in the tax base of the
parent. However, this “taxing symmetry” is not present in the New Mexico tax
scheme.

1997-NMSC-005, ¶ 12. The supreme court ultimately concluded that New Mexico’s

“[t]axation of dividends from foreign subsidiaries under the separate corporate entity method

violated the Foreign Commerce Clause….” (emphasis added). Id, ¶ 26.

II. Application of New Mexico’s Tax Scheme to Xerox.

A. Xerox’s 1995, 1996, and 1998 Corporate Income Tax Returns. During the

tax years at issue, Xerox filed a combined return with its unitary subsidiaries. Xerox excluded

two of its domestic subsidiaries, Talegen Holdings, Inc. and Ridge Reinsurance Limited, from

the combined return because those subsidiaries were not unitary with Xerox. Xerox also

excluded income from its unitary foreign subsidiaries by taking “special deductions” for foreign

dividends and Subpart F income on its New Mexico returns. On audit, the Department agreed

that Talegen and Ridge Reinsurance were not unitary with Xerox and that the income and

dividends from these entities were properly excluded from the state tax base. The Department

10
disallowed Xerox’s deduction of dividends and Subpart F income from its foreign subsidiaries,

all of which were unitary with Xerox’s worldwide imaging business. The Department did

allow Xerox factor relief for its foreign-source income pursuant to NMSA 1978, § 7-4-19(C).

In challenging New Mexico’s taxation of income received from its foreign subsidiaries,

Xerox raises an issue of discrimination that has not been addressed in either the Kraft line of

cases dealing with separate entity filers or the Morton Thiokol line of cases dealing with

domestic combined filers. While those cases addressed the disparate treatment of dividends

from domestic and foreign subsidiaries that were unitary with the U.S. parent subject to tax,

Xerox’s protest challenges the disparate treatment of dividends from unitary foreign

subsidiaries when compared with the treatment of dividends from nonunitary domestic

subsidiaries.

B. New Mexico’s Taxation of Xerox’s Foreign-Source Income Conforms to the

Unitary Business Principle Approved by the United States Supreme Court. As discussed

in Part I(A), above, the unitary business principle used to calculate the amount of state tax due

from multijurisdictional taxpayers has been sanctioned by a long line of United States Supreme

Court decisions. In Mobil Oil, supra, 445 US at 439, the Court characterized this principle as

the “linchpin of apportionability in the field of state income taxation." In that case, the Court

held that the Commerce Clause does not bar a state from including foreign-source dividends

in a corporate taxpayer’s apportionable tax base, as long as the dividends are received from a

corporation that is unitary with the taxpayer. In NCR Corp. v. Taxation and Revenue

Department, 115 N.M. 612, 856 P.2d 982 (Ct. App.), cert. denied, 115 N.M. 677, 857 P2d 788,

cert. denied, 512 U.S. 1245 (1994), the New Mexico Court of Appeals reached a similar

11
conclusion, rejecting a claim that New Mexico’s taxation of a corporate taxpayer’s foreign-

source income violates the Due Process and Foreign Commerce Clauses of the U.S.

Constitution. As stated by the court:

The income the Department seeks to tax is derived from NCR's subsidiaries
that operate together as a fully-integrated unitary business. Cf. Kewanee
Indus., Inc. v. Reese, 114 N.M. 784, 788 n. 5, 845 P.2d 1238, 1242 n. 5 (1993).
The tax in question is not a tax on any of NCR's foreign subsidiaries; instead,
the tax falls upon an apportioned share of NCR's income which it receives in
the form of royalties, interest, and dividends from its unitary foreign
subsidiaries. The fact that the tax is apportioned in part upon NCR's foreign
income sources does not constitute a bar to state taxation. See Mobil Oil
Corp., 445 U.S. at 439-40, 100 S. Ct. at 1232-33.

115 N.M. at 617, 856 P.2d at 987.

In this case, New Mexico’s taxation of Xerox’s 1995, 1996, and 1998 income followed

the unitary business principle. Here, as in NCR, the Department required Xerox to include in

New Mexico base income the dividends and Subpart F income that Xerox received from its

unitary foreign subsidiaries. Under the combined filing method (and in contrast to the separate

filing method discussed in Conoco), Xerox was also required to include on its return the income

of any domestic subsidiaries that were part of Xerox’s unitary business. UDITPA’s three-factor

formula was then applied to apportion the income of Xerox’s unitary business operations

between New Mexico and the other jurisdictions in which Xerox does business.

An issue of continuing dispute in the area of corporate income taxation is whether a

state that includes foreign dividends in its tax base is also required to provide factor

representation for the activities of the foreign subsidiary producing that income. The United

12
States Supreme Court has not yet addressed this issue2, while state courts are split in their

decisions. Compare, e.g., Tambrands, Inc. v. State tax Assessor, 595 A.2d 1039 (Me. 1991)

and E. I. Du Pont de Nemours & Co. v. State Tax Assessor, 675 A.2d 82, 88 (Me. 1996)

(holding that factor relief is required when foreign dividends are included in the tax

base); with NCR Corp. v. Commissioner of Revenue, 438 N.W.2d 86 (Minn.), cert. denied,

493 U.S. 848 (1989); and NCR Corp. v. South Carolina Tax Commission, 402 S.E.2d 666

(S.C. 1991) (holding that factor relief is not required).

In NCR Corp. v. Taxation and Revenue Department, 115 N.M. 612, 856 P.2d 982 (Ct.

App.), cert. denied, 115 N.M. 677, 857 P2d 788, cert. denied, 512 U.S. 1245 (1994), the New

Mexico Court of Appeals held that New Mexico was not required to include the property,

payroll, and sales of NCR’s foreign subsidiaries in the denominator of the appor-tionment

factor applied to the taxable portion of NCR’s foreign income. Nonetheless, in determining

Xerox’s state tax liability in the present case, the Department did provide factor relief under

the so-called “Detroit formula,” which includes in the denominators of the parent corporation's

property, payroll, and sales factors a percentage of the property, payroll, and sales of the

dividend-generating foreign subsidiary. See, Jerome R. Hellerstein & Walter Hellerstein, State

Taxation, Vol. I, ¶ 9.15(2)(a), n.487 (3d ed. 2000) for a more complete discussion of the

Detroit formula.

The United States Supreme Court has held that the Constitution imposes no single

apportionment formula on the states. Wisconsin v. J.C. Penney, 311 U.S. 435, 445 (1940). See

2
While Justice Steven’s dissent in Mobil Oil, supra, concluded that factor representation is required in these
circumstances, the majority declined to rule on the issue, finding that it had not been properly raised in the

13
also, NCR, supra, 115 N.M. at 616, 856 P.2d at 986. A taxpayer challenging a state's

apportionment formula has the burden of showing by clear and cogent evidence that a state tax

results in the taxation of extraterritorial values. Container, supra, 463 U.S. at 161. Here,

Xerox has not presented any evidence or argument to show that New Mexico’s apportionment

formula—as applied under the combined filing method and modified by the Detroit formula—

does not result in a fair approximation of the corporate income that is "reasonably related” to

Xerox’s activities in New Mexico. Moorman Manufacturing Co. v. Blair, 437 U.S. 267, 273

(1978); Exxon Corp. v. Wisconsin Department of Revenue, 447 U.S. 207, 223 (1980).

C. New Mexico’s Exclusion of Dividends from Xerox’s Nonunitary

Subsidiaries is Based on the Constitutional Prohibition Against Taxing Extraterritorial

Value. Xerox attempts to equate the exclusion of its nonunitary domestic dividends with the

deduction of unitary domestic dividends in Kraft and Conoco, which was based on the

federal dividends-received deduction (“DRD”) incorporated as part of Iowa’s and New

Mexico’s corporate income tax schemes. In its reply brief, however, Xerox states that “[i]t is

not Xerox’s position that the Hearing Officer must find New Mexico’s dividend received

deduction statute unconstitutional.” Reply Brief, page 1. This is not surprising, since such a

finding would leave Xerox in exactly the same position it is now: the dividends Xerox receives

from its unitary foreign subsidiaries would be included in the tax base, while the dividends

Xerox receives from its nonunitary domestic subsidiaries would be excluded from the tax base.

This is because, unlike the deduction of domestic dividends in Kraft and Conoco—or in the

Morton Thiokol line of cases—New Mexico’s exclusion of Xerox’s nonunitary domestic

lower court proceedings.

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dividends is not based on the federal DRD. Instead, it is based on the United States Supreme

Court’s long-standing position that it is unconstitutional for a state to tax the income of

nonunitary members of a taxpayer’s corporate group whose activities are unrelated to the state

or to the group’s unitary business enterprise. This rule applies equally to the income of both

foreign and domestic subsidiaries. See, Allied-Signal, supra; ASARCO, supra; Woolworth,

supra.

A constitutionally-mandated tax exclusion is not the same as a tax deduction voluntarily

granted by the state. Because the income Xerox receives from its nonunitary subsidiaries does

not qualify as business income subject to apportionment, that income is not subject to state tax

in the first place, and there is nothing to deduct. Even if New Mexico changed its law to deny

corporate taxpayers the DRD for domestic dividends, the Constitution still would require the

exclusion of Xerox’s nonunitary domestic dividends from New Mexico’s tax base. For this

reason, Xerox’s focus on the DRD and its reliance on the Kraft and Conoco decisions is

misplaced.

Equally misplaced is Xerox’s reliance on recent state court decisions involving special

deductions granted to corporations based on their activities within a particular state. See,

DDI, Inc. v. State of North Dakota, 657 N.W.2d 228 (N.D. 2003) (striking down North

Dakota’s limitation of its DRD to dividends paid out of income previously taxed by North

Dakota); Farmer Brothers v. Franchise Tax Board, 108 Cal.App.4th 976, 134 Cal.Rptr.2d

390 (2d Dist. 2003) (striking down California’s limitation of its DRD to dividends paid out of

income previously taxed by California); Ceridian Corporation v. Franchise Tax Board, 85

Cal.App.4th 875, 102 Cal.Rptr.2d 611 (1st Dist. 2000) (striking down California’s limitation

15
of the DRD for insurance dividends to corporations domiciled in California and dividends

received from payors subject to California’s gross premiums tax). In each of these cases, the

state had structured its corporate income tax scheme in such a way as to favor in-state

commerce by allowing a special deduction for income the state was constitutionally permitted

to tax. In DDI, supra, 657 N.W.2d 228, 229, the North Dakota Supreme Court explained the

state tax commissioner’s application of that state’s DRD as follows:

The Commissioner determined those dividends were business income subject
to apportionment, and to the extent the Commissioner determined the
dividends were includable in the taxpayers’ North Dakota apportioned
income, the Commissioner applied the dividends received deduction.
(emphasis added)

The DRD was not applied to dividend income not subject to apportionment in North Dakota

(which would include dividends the taxpayer received from nonunitary subsidiaries) because

that income was never part of the state’s tax base.

In this case, New Mexico’s exclusion of Xerox’s nonunitary domestic dividends from

the New Mexico tax base is mandated by the U.S. Constitution. Unlike the tax schemes

addressed in Kraft and Conoco and the other state cases relied upon by Xerox, this tax

exclusion does not result from the manner in which New Mexico has chosen to structure its

corporate income tax system or on the state’s voluntary decision to allow a DRD for income

otherwise subject to tax.

III. The Disparate Treatment of Dividends from Unitary and Nonunitary
Subsidiaries Does Not Violate the Foreign Commerce Clause.

In considering claims of discriminatory taxation under the Commerce Clause, the

United States Supreme Court has noted that “it is necessary to compare the taxpayers who are

16
'most similarly situated.'" Kraft, 505 U.S. 71, 81, n. 23 (1992) (quoting Halliburton Oil Well

Cementing Co. v. Reily, 373 U.S. 64, 71 (1963)). See, e.g., General Motors Corp. v. Tracy,

519 U.S. 278 (1997) (Ohio's differential tax treatment of natural gas sales by local public

utilities and interstate gas marketers did not violate the Commerce Clause in the absence of a

similarly situated comparison class). In Kraft, 505 U.S. at 76, the domestic commerce

advantaged by Iowa’s allowance of the federal DRD was the “flow of value” between Kraft and

its unitary domestic subsidiaries, while the foreign commerce disadvantaged by Iowa’s tax

scheme was the flow of value between Kraft and its unitary foreign subsidiaries. This flow of

value between a parent corporation and its subsidiaries is a hallmark of the unitary business

relationship. See, Container, supra, 463 U.S. at 178. The same relationship does not exist

between a parent corporation and its nonunitary subsidiaries, who do not share the “functional

integration, centralization of management, and economies of scale” that define the unitary

group. Mobil Oil, 445 U.S. 425, 438.

During the tax years at issue, the income Xerox received from its nonunitary domestic

subsidiaries represented the return on a passive investment that had no relation to Xerox’s

unitary imaging business or to Xerox’s business activities in New Mexico. Xerox’s attempt

to compare the tax treatment of dividends from its nonunitary domestic subsidiaries with the tax

treatment of dividends from its unitary foreign subsidiaries is like comparing the proverbial

apples and oranges. As the Supreme Court stated in Kraft, 505 U.S. at 78:

We have previously found that the Commerce Clause is not violated when the
differential tax treatment of two categories of companies “results solely from
differences between the nature of their businesses, not from the location of their
activities.” Amerada Hess Corp. v. Director, Div. of Taxation, N.J. Dept. of
Treasury, 490 U.S. 66, 78, 109 S.Ct. 1617, 1624, 104 L.Ed2d 58 (1989).

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Here, New Mexico’s exclusion of dividends Xerox received from its domestic subsidiaries was

based on the nonunitary relationship between Xerox and those subsidiaries. If Xerox had

received dividends from nonunitary foreign subsidiaries, those foreign dividends also would

have been excluded from the tax base. The differential tax treatment of which Xerox complains

was not based on the location of a subsidiary’s activities, i.e., foreign or domestic, but on

whether the subsidiary’s activities were unitary or nonunitary with the business operations of its

parent corporation. This differential treatment does not violate the Foreign Commerce Clause.3

CONCLUSIONS OF LAW

1. The Taxpayer filed a timely, written protest to the Notice of Assessment of

Taxes issued under Letter ID L0821166080, and jurisdiction lies over the parties and the

subject matter of this protest.

2. New Mexico’s corporate income tax scheme, which taxes a combined filer on

dividends and Subpart F income received from foreign affiliates that are part of the taxpayer’s

unitary group, but excludes from tax income received from domestic affiliates that are not part

of the unitary group, does not violate the Foreign Commerce Clause.

3. Xerox was not entitled to deduct the income it received from its unitary foreign

subsidiaries when filing its 1995, 1996, and 1998 New Mexico corporate income tax returns

using the combination of unitary domestic corporations reporting method.

For the foregoing reasons, the Taxpayer’s protest IS DENIED.

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DATED December 3, 2003.

3
Based on this decision, it is not necessary to address the Department’s argument concerning the distinction
between foreign dividends and Subpart F income.

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