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The Arizona Court of Appeals recently issued a decision in the Home Depot case, which involves determining when the state has jurisdiction to tax a corporation. The case is about a domestic multi-state business but it has interesting implications for the taxation of multinationals. In brief, Home Depot (a Delaware corporation headquartered in Georgia) formed a subsidiary in 1991 to hold its trademarks. It then entered into a licensing agreement with the sub, Homer, under which it paid a royalty for the use of the trademarks. The royalty started at 1.5% of gross sales, and increased to 4% in the years at issue. The Arizona Department of Revenue decided that Homer and Home Depot constituted a unitary business for Arizona state tax purposes, the Arizona Tax Court agreed, and the Court of Appeals affirmed.So here we have a Delaware corporation, headquartered in Georgia, doing business in Arizona through retail stores, but stripping its income out of the state in order to avoid the state level corporate income tax. That is, of course, the basic modus operandi of Google, Apple, Starbucks, GE, Amazon, et al, each of which sells products and services around the world yet pays low single digit corporate tax rates in each jurisdiction by stripping out its income in the form of license fees, interest, and other inter-company payments to subsidiaries located in low-tax jurisdictions.Internationally the defense that countries employ against this behavior is the arm's length standard, under which each government that claims jurisdiction over any part of the multinational treats that part as if it was an independent party acting at arm's length with respect to the rest of the company. Indeed Home Depot raised its compliance with the arm's length standard as a reason for the court to dismiss the Arizona revenue authority's jurisdictional claim over Homer. But the Court points out that compliance with arm's length is not the issue in a question about establishing a jurisdictional claim:
Home Depot, nevertheless, argues its transactions with Homer have been at arm’s length, and points out that the Department has not challenged the appraisal establishing the legitimacy of the royalty it pays Homer. [Under prior case law] the principle [is] that unitary treatment will be imposed or allowed whenever the activities of the affiliated organizations affect the other(s) in ways that are "so pervasive as to negate any claim that they function independently from each other."
Under a statutory regime that allows for unitary taxation, in other words, the state can claim jurisdiction to tax with respect to any corporation anywhere, if it can establish pervasive links among affiliated corporations, or "operational integration." And what are the marks of such operational integration, such that the state's jurisdiction to tax is established? The Court lists fifteen, pursuant to Arizona state law:
1. The same or similar businesses conducted by components;2. Vertical development of a product by components, such as manufacturing, distribution, and sales;3. Horizontal development of a product by components, such as sales, service, repair, and financing;4. Transfer of materials, goods, products, and technological data and processes between components;5. Sharing of assets by components;6. Sharing or exchanging of operational employees by components;7. Centralized training of operational employees;8. Centralized mass purchasing of inventory, materials, equipment, and technology;9. Centralized development and distribution of technology relating to the day-to-day operations of the components;10. Use of common trademark or logo at the basic operational level;11. Centralized advertising with impact at the basic operational level;12. Exclusive sales-purchase agreements between components;13. Price differentials between components as compared to unrelated businesses;14. Sales or leases between components; and15. Any other integration between components at the basic operational level.
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