Comptroller of Treasury, Income Tax Div. v. Armco, Inc.

• Decision Date: 01 September 1986
• Docket Number: No. 744,744
• Citation: 521 A.2d 785,70 Md.App. 403
• Parties: COMPTROLLER OF the TREASURY, INCOME TAX DIVISION v. ARMCO, INC. ,
• Court: Court of Special Appeals of Maryland

Page 403

70 Md.App. 403

521 A.2d 785

COMPTROLLER OF the TREASURY, INCOME TAX DIVISION v. ARMCO, INC.

No. 744, Sept. Term, 1986.

Court of Special Appeals of Maryland.

March 5, 1987.

Gerald Langbaum, Asst. Atty. Gen., Annapolis (Stephen H. Sachs, Atty. Gen., Baltimore, and John K. Barry, Asst. Atty. Gen., Annapolis, on the brief), for appellant.

Harry D. Shapiro (Neil C. Kahn and Venable, Baetjer and Howard, on the brief), Baltimore, for appellee.

Argued before GILBERT, C.J., and ALPERT, and POLLITT, JJ.

POLLITT, Judge.

Constitutional questions concerning the State's power to tax have long occupied this country's courts. Chief Justice John Marshall declared almost 200 years ago that "The power to tax involves the power to destroy," in finding unconstitutional the efforts of the State of Maryland to tax a national bank. ¹ In this appeal, we find the State's efforts to apply a tax exclusion to corporate subsidiaries engaged in the export of domestic goods must meet a similar fate, because the exclusion discriminates against corporations doing the majority of their business in other states, and thereby violates the Commerce Clause. ² We also find that the State may constitutionally tax the interest income of a nondomiciliary corporation doing some business in this state, if that income is earned in the course of activities related to the corporation's business in Maryland.

Disturbed by this country's trade deficit, Congress gave special recognition to a corporate entity it described as a Domestic International Sales Corporation (DISC). ³ Westinghouse Electric Corp. v. Tully, 466 U.S. 388, 390, 104 S.Ct. 1856, 1858, 80 L.Ed.2d 388 (1984). DISCs are purely fictional subsidiary corporations that afford their U.S.-based parent tax incentives to increase their exports. These "federal phantasms" have no assets, no property, and no personnel; they are hollow bookkeeping entities that serve to isolate export profits of a domestic enterprise. The profits so isolated are eligible for preferential tax treatment. Only a portion of this profit--the deemed dividend--is taxed currently to the parent company, the rest--the accumulated income--is not taxed to either the parent or the DISC until it is actually distributed to the parent (the shareholder), or until the DISC no longer exists. ⁴ As a result, under the federal tax scheme, no income is taxed to the DISC itself. The parent corporation is thus able to defer tax payment on a portion of its profits which would otherwise be immediately taxable. The parent can use the DISC's accumulated income for further export activities without losing the tax benefit.

Maryland uses a corporation's net income for federal tax purposes as its basis for computing that corporation's state tax liability. Maryland Code (1957, 1980 Repl.Vol., 1985 Supp.) Art. 81, § 280A(a). Maryland taxes only that portion of the federally determined net income that is allocable to the State, as that term is defined by § 316 of the Tax Code. ⁵

We have previously commented that it is not surprising that state courts and legislatures were unprepared to deal with DISCs. Ward Europa, Inc. v. Comptroller, 66 Md.App 332, 337, 503 A.2d 1371, 1373 (1986). This case is the result of the state legislature's attempt to tax DISCs and further Maryland's economic interests.

DISCs, because they are, technically speaking, distinct corporate entities, are subject to Maryland tax on their net income. See § 295 of the Tax Code. In the federal tax scheme this income, as previously noted, is tax-exempt with the exception of the portion that is "deemed" distributed to the parent. This deemed distribution is federally taxed once only, as part of the parent's income. In contrast, the Maryland tax scheme, until 1978, did not contain any special provision for DISCs. In the absence of any such provision DISCs with any net income allocable to Maryland faced the spectre of "double taxation" by the State. The State could tax the DISC's allocable income directly when the income was in the "hands" of the DISC, and then tax the allocable deemed distributed income a second time when the income was in the hands of the parent.

The General Assembly attempted to alleviate the burden of this double tax in 1978. Chapter 359 of the Laws of 1978 repealed and reenacted, with amendments, then Maryland Code (1957, 1975 Repl.Vol., 1977 Supp.) Art. 81, § 280A(c). The preamble to the Act states that its purpose is to tax

dividends received by a Maryland corporation from the earnings of an affiliated subsidiary domestic international sales corporation [DISC] to the same extent as dividends received by Maryland corporation[s] from any other affiliated corporation.

The amended legislation seemingly accomplishes this purpose by providing for an exclusion of deemed income in the parent's taxable income. The first sentence of § 280A(c)(7) provides that:

(c) There shall be subtracted from taxable income of the taxpayer the following items to the extent included in federal income: ... (7) to the extent that the dividends are included in taxable income, the percentage of dividends received from an affiliated domestic international sales corporation [DISC] (as defined by Internal Revenue Code of 1954 § 992(a)), which is equivalent to the percentage that would be excluded if the domestic international sales corporation was not qualified under § 992(a).

The legislation that is constitutionally challenged here is the immediately following sentence of § 280A(c)(7) which limits the applicability of the deemed income exclusion.

However, this exclusion shall be available only if at least 50 percent of the net taxable income of the domestic international sales corporation is subject to Maryland taxation....

Simply stated, the benefit of the tax exclusion is limited to those parent corporations whose DISCs have at least 50% of their net income allocable to the State. Those parent corporations whose DISCs do not meet the 50% standard do not qualify for the exclusion. Thus, a DISC doing over half its business in Maryland qualifies its parent for preferential treatment vis-a-vis a DISC doing less than half its business in Maryland.

Armco, Inc. (Armco) is the parent corporation and sole shareholder of Armco Export Sales Corporation (Armco Export), Armco's affiliated DISC. In 1978, Armco received from its DISC a deemed distribution of $17,643,847, representing that portion of the DISC's profits that federal law deemed distributed to its parent. ⁶ Armco included the deemed distribution in its federal taxable income, but excluded the distribution in determining its state taxable income. Upon audit, the Comptroller disagreed, and added back the deemed distribution to Armco's state taxable income. After applying the relevant allocation and tax percentage to the dividend, the Comptroller asserted deficiencies attributable to this exclusion in Armco's return of $23,499.

Armco appealed this assessment to the Maryland Tax Court. Armco did not dispute that it did not qualify for the exclusion under § 280A(c)(7), which denies the exclusion to parents whose affiliated DISC's taxable income in Maryland is less than 50% of its federal taxable income. Armco and the Comptroller agreed that only 2% of Armco Export's net income was subject to Maryland tax. ⁷ Armco asked the Tax Court instead to declare that the limitation of the exclusion in § 280A(c)(7) violated the Commerce Clause of the U.S. Constitution.

The Tax Court declined to address this constitutional question declaring, sua sponte, that it lacked subject matter jurisdiction to declare part of a statute constitutionally invalid. ⁸ It therefore affirmed the assessment. Armco appealed this order of the Tax Court to the Circuit Court for Baltimore City, again challenging the constitutionality of the limitation of the exclusion before Judge Martin B. Greenfeld. Judge Greenfeld found the provision violated the Commerce Clause, deleted the offending sentence of § 280A(c)(7) and reversed the order of the Tax Court. The Comptroller appeals from that order, and we now affirm the judgment of Judge Greenfeld in that respect.

Armco also excluded from its 1978 taxable income $282,570 in interest income generated by a loan to the Iron Ore Company of Canada (IOCC). Again taking issue with Armco the Comptroller disallowed this exclusion and added back the interest income to Armco's state taxable income, resulting in the assessment of a deficiency against Armco. Armco also appealed this assessment to the Tax Court. At the Tax Court the Comptroller conceded that Armco and IOCC were not a unitary business. Armco also established that the loan was not made by its financial services subsidiary, but instead was handled as a general corporate transaction. The Tax Court reversed the Comptroller's assessment with respect to the interest from IOCC on the grounds that the activities of Armco and IOCC were not unitary. The Comptroller appealed the order of the Tax Court to the circuit court, where the circuit court reversed the Tax Court on this issue, reasoning that, because Armco operated a financial services subsidiary, the State could properly tax any interest Armco received from its loan to IOCC. From the order of the circuit court reversing the Tax Court, Armco cross-appeals. We find that due process principles as enunciated by the U.S. Supreme Court require the interest income at issue to be related to Armco's business in this State. Because the evidence contained in the record before us is inconclusive on this issue, we vacate the order of the circuit court and remand for further fact-finding. ⁹

We address first the Commerce Clause question.

I

The Supreme Court has acknowledged that the adjustment of state taxation within the confines of the Commerce Clause is a delicate one, leaving little in the way of precise guides to the States. Nevertheless, "From the quagmire there emerge ... some firm peaks of decision which remain...