Constitutional Limitations on State Taxation of Securities Transactions

Constitutional Limitations on State Taxation of Securities Transactions

by Andrew W. Singer, Esq.*

I. Introduction

Income from securities transactions may be subject to both federal and state income taxes, at least in the substantial majority of States that impose income taxes. The US Constitution imposes limits on State taxes to which the federal income tax is not subject, and which therefore require consideration...

... One of the most important limits, with significant implications for State taxation of income from securities transactions, is that, in general, "[t]he Due Process and Commerce Clauses forbid the states to tax "extraterritorial values." [MeadWestvaco Corp. v. Ill. Dep't of Revenue, 553 U.S. 16 (U.S. 2008).] In accordance with this principle, a State may not tax income arising from a nondomiciliary taxpayer's activities outside the State's borders, notwithstanding that the taxpayer is engaged in business activities within the State, unless the tax:

  1. "is applied to an [extraterritorial] activity with a substantial nexus with the taxing State,
  2. "is fairly apportioned,
  3. "does not discriminate against interstate commerce, and
  4. "is fairly related to the services provided by the State." [Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (U.S. 1977).]

[The actual holding in Complete Auto was that a State income tax imposed on the "privilege of doing business" in the State does not violate the Commerce Clause as applied to a taxpayer engaged solely in interstate transactions, because the Commerce Clause does not, as it was once thought to do, immunize interstate transactions from even nondiscriminatory State taxation.]


II. The Nexus Requirement

A State's jurisdiction to tax depends initially on a showing of "some definite link, some minimum connection, between...[the] State and the person, property or transaction it seeks to tax." [ Miller Bros. Co. v. Maryland, 347 U.S. 340 (U.S. 1954).]

Often referred to as the "nexus" requirement, "the simple but controlling question is whether the State has given anything for which it can ask return."[Wisconsin v. J. C. Penney Co., 311 U.S. 435 (U.S. 1940). This does not require that the taxing State be able to point to specific public services (e.g., trash collection) that facilitated the taxpayer's production of income; a State may "ask return" simply for maintaining an "orderly, civilized society" in which the taxpayer was able to earn income. "A State is free to pursue its own fiscal policies, unembarrassed by the Constitution, if by the practical operation of a tax the State has exerted its power in relation to opportunities which it has given, to protection which it has afforded, to benefits which it has conferred by the fact of being an orderly, civilized society." Id.] In addition, any "income attributed to the State for tax purposes must be rationally related to 'values connected with the taxing State.'" [Moorman Mfg. Co. v. Bair, 437 U.S. 267 (U.S. 1978).]


"[T]he 'substantial nexus' requirement [of the negative Commerce Clause] is not, like the due process' "minimum contacts" requirement, a proxy for notice, but rather a means for limiting State burdens on interstate commerce. Accordingly...a corporation may have the "minimum contacts" with a taxing State as required by the Due Process Clause, and yet lack the 'substantial nexus' with that State...required by the Commerce Clause." [Quill Corp. v. N.D., 504 U.S. 298 (U.S. 1992). The "substantial nexus requirement" referred to in the quotation refers to the first of the four requirements listed by the Supreme Court in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (U.S. 1977), that State taxes must meet to pass muster under the negative Commerce Clause: the tax must be "applied to an activity with a substantial nexus with the taxing State."]


III. Fair Apportionment Requirement

[1] The Unitary Business Principle

Where there is no dispute that the taxpayer has conducted business activities in the taxing State, the inquiry shifts from whether the State may tax to what it may tax. [MeadWestvaco Corp. v. Ill. Dep't of Revenue, 553 U.S. 16 (U.S. 2008).] The threshold issue is whether the State is limited to taxing only net income allocable directly to the taxpayer's in-state activities, "as if the taxpayer were carrying on a discrete business within the confines of the taxing State," [See Hellerstein, State Taxation of Corporate Income From Intangibles: Allied-Signal and Beyond48 Tax L. Rev. 739.] or may instead assert the right to tax income generated by the taxpayer outside the State if its in-state activities somehow contributed to the production of its out-of-state income.

The Supreme Court has rejected the "separate accounting" approach whenever it has found that the taxpayer engaged in a single but multijurisdictional "unitary business" which it conducted both within and outside the State. In these circumstances, the State may require that a fraction of the total net income from the unitary business be apportioned to the State on some "fair" basis, even though apportionment theoretically results in the taxation of income allocable, in a separate accounting sense, to activities conducted by the taxpayer outside the taxing State.


[a] Application of Unitary Business Principle to Income from Securities Transactions

In contrast to the permitted apportionment of business income among the various states in which a unitary business is conducted, investment income has traditionally been allocated to the State in which the taxpayer's domicile is located... [H]owever, the Supreme Court [has] held that if an out-of-State securities transaction is related to the taxpayer's regular business, a State may, under the unitary business principle, require that the income therefrom be apportioned to all States in which that regular business is conducted, notwithstanding that the income takes the form of dividends, interest, capital gain, or other types of income normally classified as "investment income." [Mobil Oil Corp. v. Comm'r of Taxes, 445 U.S. 425 (U.S. 1980).]


[b] Testing for Apportionability

Mobil Oil justified formula apportionment of the income of a unitary business, as had earlier Supreme Court cases, because when a single unitary business is conducted in more than one jurisdiction, separate accounting may "fail to account for contributions to income resulting from functional integration, centralization of management, and economies of scale." [Mobil Oil Corp. v. Comm'r of Taxes, 445 U.S. 425 (U.S. 1980).] In subsequent decisions, the Court seized on these three factors as "'hallmarks' of a unitary relationship" to be used in identifying a unitary business. [See MeadWestvaco Corp. v. Ill. Dep't of Revenue, 553 U.S. 16 (U.S. 2008); Allied-Signal, Inc. v. Dir., Div. of Taxation, 504 U.S. 768 (U.S. 1992).] The Court also pointed out that, to establish the required "rational relationship between the income attributed to the State and the intrastate values of the enterprise" [Exxon Corp. v. Dep't of Revenue, 447 U.S. 207 (U.S. 1980), citing Mobil Oil Corp. v. Comm'r of Taxes, 445 U.S. 425 (U.S. 1980).], "there [must] be some sharing or exchange of value not capable of precise identification or measurement -- beyond the mere flow of funds arising out of a passive investment or a distinct business operation -- which renders formula apportionment a reasonable method of taxation." [Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159 (U.S. 1983).]


[c] Allocation of Deductions Between Unitary and Nonunitary Income

... In Hunt-Wesson, Inc. v. Franchise Tax Bd., 528 U.S. 458 (U.S. 2000), the geographical scope of the taxpayer's unitary business and, conversely, the identification of out-of State assets that were not unitary, were not in dispute. Rather, the issue involved calculation of the amounts of the taxpayer's unitary and nonunitary income and, in particular, determining whether the State improperly allocated an otherwise deductible interest expense of the taxpayer's unitary business to its nonunitary income, disallowing the taxpayer's deduction for the expense and thereby increasing the tax on its unitary income. The Court recognized that this seemingly prosaic allocation issue takes on a constitutional dimension because the improper allocation increases the taxpayer's unitary income while reducing its otherwise nontaxable nonunitary income by the same amount, which is the equivalent of imposing an unconstitutional tax on the extraterritorial nonunitary income.


[2] Constitutionality of Apportionment Under the Foreign Commerce Clause

The Constitution reserves to Congress the power to regulate commerce both "among the several States," and "with Foreign nations. [US Const, Art I, Sec 8, Cl 3.] The grant of the latter authority is sometimes referred to as the Foreign Commerce Clause and, like the Interstate Commerce Clause, has been interpreted by the Supreme Court as possessing a "negative" or "dormant" dimension which provides "protection against State legislation inimical to the national commerce [even] where Congress has not acted . . . ." [See Barclays Bank Plc v. Franchise Tax Bd., 512 U.S. 298 (U.S. 1994), quoting from S. Pac. Co. v. Arizona, 325 U.S. 761 (U.S. 1945).] To avoid violating the negative Foreign Commerce Clause, a State tax must not only satisfy the four requirements imposed by the negative Interstate Commerce Clause laid down in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (U.S. 1977):

  1. a substantial nexus between the taxpayer and the taxing State,
  2. fair apportionment,
  3. nondiscriminatory, and
  4. fairly related to the services provided by the State...

-- it must also pass two additional tests...

IV. Nondiscriminatory Tax Requirement

The modern law of what has come to be called the dormant Commerce Clause is driven by concern about economic protectionism -- that is, regulatory measures designed to benefit in-State economic interests by burdening out-of-State competitors....The point is to effectuate the Framers' purpose to prevent a State from retreating into the economic isolation that had plagued relations among the Colonies and later among the States under the Articles of Confederation..." [Dep't of Revenue v. Davis, 553 U.S. 328 (U.S. 2008) (citations and quotation marks omitted).]

On the other hand, "[t]he law has had to respect a cross purpose as well, for the Framers' distrust of economic Balkanization was limited by their federalism favoring a degree of local autonomy." [Dep't of Revenue v. Davis, 553 U.S. 328 (U.S. 2008).]...

In Boston Stock Exch. v. State Tax Comm'n, 429 U.S. 318 (U.S. 1977), the balance was struck against the taxing State. The Supreme Court there held that a New York tax on in-State securities transactions, which included any transfer or delivery of securities within the State, discriminated against interstate commerce when it provided substantial tax relief to nonresidents, and under certain circumstances to residents, on condition that the securities transferred or delivered in New York were also sold in New York... New York argued, however, that the tax relief legislation was compensatory rather than discriminatory, designed merely to neutralize an artificial competitive advantage enjoyed by stock exchanges located outside New York in States that did not impose a securities transaction tax. While the tax relief legislation created an incentive in certain cases for persons subject to the tax to sell their securities in New York rather than outside the State, New York deemed the situation analogous to the constitutionally approved practice of imposing State use taxes on residents who purchased goods out-of-State and brought them back into the State to avoid paying the State's sales tax on in-State purchases of those goods. [See, e.g., Henneford v. Silas Mason Co., 300 U.S. 577 (U.S. 1937); International Harvester Co. v. Department of Treasury, 322 U.S. 340 (U.S. 1944); Alaska v. Arctic Maid, 366 U.S. 199 (U.S. 1961).]

The Supreme Court, however, rejected New York's premise that the securities transaction tax as amended by the tax relief legislation was merely compensatory.


* Andrew W. Singer is the author of the LexisNexis 2-volume treatise titled Taxation of Securities Transactions. Andrew is a retired partner of the Washington DC firm of Covington & Burling. Mr. Singer specializes in all areas involving federal and state taxation and has extensive experience in international taxation.

LEXIS users can view the complete commentary HERE. Additional fees may apply. (Approx. 44 pages)


RELATED LINKS: For on the taxation of foreign securities and foreign shareholders, see:

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