Tax Analysts Blog

Single Sales Factor May Be Inevitable, but Is It Fair?

Posted on Sep 17, 2014

Fair apportionment is a constitutional requirement. According to Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977), to be fairly apportioned, a state tax on corporate income must be limited to the portion of a multistate business's net income that is "fairly attributable" to the business's activity in the taxing state. But translating “fairly attributable” to “fair apportionment” has been difficult – and the subject of much debate. The U.S. Supreme Court has stopped short of describing exactly how a state should determine what income is fairly attributable, acknowledging in Allied Signal Inc. v. Dir., N.J. Division of Taxation, 504 U.S. 768 (1992), that states have “wide authority to devise formulae for an accurate assessment of a corporation's intrastate value or income.”

Despite the wide latitude given to states regarding apportionment, those with a corporate income tax have historically chosen to adopt the apportionment language or principles found in the Uniform Division of Income for Tax Purposes Act. The method of allocation and apportionment included in UDITPA and adopted as Article IV of the Multistate Tax Compact was a three factor formula. With three factor apportionment, the three factors -- property, payroll, and sales -- are computed as ratios of the taxpayer's presence in the state over the taxpayer's presence everywhere.

Although the three-factor formula once had nearly universal application, and was referred to by the Court in Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983), as a “benchmark against which other apportionment formulas are judged,” it has in recent years undergone significant modifications in many adopting states. In some states, the sales factor is given additional weight. For example, some states double weight the sales factor for all taxpayers or for taxpayers with specific qualifications. In other states, a single sales factor method is used. Under that method, the sales factor is the only factor considered when determining the tax base.

Even UDITPA is changing. This summer, member states of the Multistate Tax Compact unanimously voted to adopt new model language that would change UDITPA’s evenly weighted three factor apportionment formula. The new model language recommends that each state adopt a three factor formula that double weights the sales factor, but that is merely a recommendation. Each state would be permitted to individually determine UDITPA’s factor weighting.

The problem with single-sales-factor apportionment is that it is questionable whether the formula presents an accurate depiction of a company’s activity in a state. A strong argument can be made that the sales factor is a poor indicator of a company’s activity and should be minimized and that property and payroll would be better indicators.

The move away from three factor apportionment is happening because it can be seen as penalizing increases in property and payroll investments, thereby discouraging investment and job creation in the state. By contrast, single sales factor apportionment deemphasizes property and payroll factors and is therefore seen as an aid when states compete with each other for jobs. Many states reasoned that moving to single sales factor apportionment or increasing the weight of the sales factor could reduce the tax liabilities of businesses that have significant property and payroll in the state, thereby rewarding those businesses. Then, given the choice between a state with three factor apportionment and one with single sales factor apportionment, businesses would choose to locate additional capital in the state with single sales factor apportionment.

Unquestionably, single sales factor apportionment can benefit some taxpayers (typically in-state businesses) while burdening others (typically out-of-state businesses). What is worrying is that the motive for states making the switch from a three factor formula to a single sales factor formula is not that the latter is a more accurate representation of “fair apportionment” but that states are seeking to encourage job creation and investment within their borders and shift some of the tax burden to out-of-state companies.

Unfortunately, there is little empirical evidence to prove a connection between the adoption of single sales factor apportionment and increased in-state jobs or investment. There is evidence to show that because single sales factor apportionment disregards property and payroll, it will have the effect of increasing the tax liability of out-of-state companies (assuming they have nexus with the state) that have little property and payroll in the taxing state but make substantial sales into the state. In other words, single sales factor apportionment can provide a more favorable taxing environment for in-state businesses than for out-of-state businesses.

Whether taxpayers are in favor of or against a move to single sales factor will depend on individual taxpayer circumstances. Because the effect of single sales factor apportionment depends largely on the nature of a taxpayer's business, there will always be companies on both sides of the equation.

The rise of single sales factor apportionment is interesting, though it should come as no surprise. Once one state adopted single-sales-factor apportionment seeking to create jobs and increase investments, other states followed suit not to miss out.They did so not because single sales factor apportionment produced more accurate results, but because it was perceived as making a state's tax laws more competitive or business friendly. While single sales factor apportionment may benefit some businesses, it is far from being universally beneficial for taxpayers. In the end, if state officials are truly concerned with making their state more attractive to businesses, perhaps they should consider retaining (or returning to) the three factor apportionment method and focus on a less burdensome corporate tax system overall.

Read Comments (2)

emsig beobachterSep 17, 2014

Single sales factor apportionment would have one salient benefit, if all states
adopted -- it would be geographically neutral. That is, the state corporate
income tax would have little impact on where a firm chooses to produce,
although it would obviously affect where a firm chooses to sell its output.

Net income of companies that extract natural resources should be taxed
according to the traditional three factor formula. Other businesses that are
location-based but not dependent on resource extraction should be taxed using
double or tripled weighted sales factors. Or, we could ditch fairness
completely and adopt the 150% sales factor, negative 25% payroll and negative
25% property factors (it's OK, the weights add to one)if the states would stop
adding special credits, exemptions, etc.

The major problem with state corporate income tax is that the tax is asked to
do too many things -- raise revenue, attract and/or retain businesses and to
favor certain types of businesses or industries. However, universal adoption of
single sales factor apportionment would result in greater geographic
neutrality.

Reuben RichardSep 18, 2014

Single sales factor can be beneficial in case when you are going to calculte it
in a linear term and you are going to check the payroll of the employees.

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