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extends should adopt this same law. If the methods of apportionment herein recommended are any improvement, it is believed that this will be found mainly in the greater recognition given to existing legislative tendencies and to the importance of harmonizing such tendencies, if the recommendations are to be generally adopted. The committee did a considerable amount of work by correspondence prior to the Bretton Woods conference in September, 1921, and during the conference held a number of meetings, at some of which it was assisted by the presence and suggestions of other members of the association, particularly Mr. Thomas E. Lyons, of the Wisconsin Tax Commission, and Prof. Charles J. Bullock. The committee felt itself unable to make any final report to the Bretton Woods conference and was accordingly directed to continue its work and report at the next annual conference. Since that time the committee has held meetings at Chicago and Minneapolis, as a result of which this report is now presented. The specific recommendations of the committee are incorporated in revised drafts for certain sections of the model business income tax and personal income tax, which are attached to this report, but these drafts would be meaningless and cannot be properly judged without a rather full discussion of the questions involved and the considerations which influenced the committee in its various decisions. The remainder of this report will take up these various matters substantially in the order in which they were considered and decided by the committee.
1. EXISTING APPORTIONMENT Laws
The question of apportionment has come up mainly in connection with corporation excise, franchise or license taxes, levied on the portion of the capital stock of the company or the portion of its income allocated or apportioned to the state by some method which is assumed to be fair as between states. However, a review of exising legislation, including formulas adopted by regulations of the taxing bodies, reveals great differences of opinion as to what constitutes a fair division and a wide range of formulas for carrying out these ideas.
An enumeration of the factors entering into different formulas and given more or less weight therein, would include tangible property, intangible property, receivables, sales, manufacturing costs, wages, salaries, purchases, etc. At one extreme we find states, where presumably manufacturing predominates over merchandising, which think it fair to apportion the income on the basis of the location of the tangible property alone. Under this formula, if the factory is in one state and the products of the factory are sold through a rented sales office in another state, orders being filled by shipment direct from the factory, there is no tan
gible property in the state where the selling business is conducted, except insignificant office supplies, and practically the entire income would be allocated to and taxed by the state where the factory is located. At the other extreme would be found states, where presumably merchandising predominates over manufacturing, which consider it fair to make an apportionment on the basis of sales alone. Under this formula, in the case above supposed, practically the entire income would be allocated for taxation to the state of sale and none to the state of manufacture.
In this situation it is evident that the taxpayer would be taxed on the same income in two places and practically pay on two hundred per cent of his income. Some states have gone to even further extremes, by authorizing or permitting the tax officials to use alternative methods of apportionment, either on the basis of tangible property alone or sales alone, thus taking advantage of the most favorable rule in each particular case. While the case sup posed is an extreme one, the same thing happens in a greater or lesser degree, wherever business is carried on in two states having different formulas for apportionment. No one can blame the taxpayer for using every legal effort to get out from under, by the expedient of separate corporations in the different states or otherwise, and no one can expect these expedients to be discontinued until the various states can get a little closer together in their ideas of what is a fair division. It should be recognized that this is primarily a question of comity between states, not merely a question between the state and the taxpayer, to be settled without regard to how the taxpayer is being treated in other states.
The tendencies to shift the basis of taxation from capital stock to income and to increase the amount of the taxes and to bring unincorporated business concerns under the law, have greatly increased the importance of the apportionment question both to the states and to the taxpayers. The question is a very live one at the present time. Different states are experimenting with different formulas and changing them from year to year. The whole matter is in a stage of development and evolution. It is fair to say, however, that the great majority of states have not gone to either of the extremes above mentioned and are experimenting with formulas giving recognition to the two main elements of investment and business activity, measured in various ways and combined with varying weights. The fact that the problem of allocation and apportionment is still in the development stage, reasonably accounts for the scarcity of court decisions that might, if made, materially clarify the problem under consideration.
2. A UNIFORM METHOD OF APPORTIONMENT IN ALL STATES THE PRIME ESSENTIAL
The members of the committee are all agreed that from the standpoint of the taxpayer, uniformity between states is by all odds the most essential requisite. It might make little difference to the taxpayer whether he is taxed on seventy-five per cent of his income at the place of manufacture and twenty-five per cent at the place of sale, or vice versa, so long as he is taxed only on one hundred per cent altogether. The fairest apportionment rule conceivable would be of little help to the taxpayer if only one state adopted it and the others continued to use a different rule. It seemed essential to the committee, therefore, that any formula now recommended should take account of existing legislative tendencies and consider the line of least resistance; that is, on what basis they may be most easily compromised, with a view to increasing the probability of general adoption of a compromise rule. From this standpoint particular consideration might well be given to the Wisconsin, Massachusetts and New York practice, as these states have been pioneers in income taxation; have given considerable study to the problem of apportionment, and their legislation and practices serve more or less as models for other states.
3. NO SEPARATE INCOME IN EACH STATE. NO ONE CORRECT WAY OF APPORTIONMENT
Items of interest, rents and dividends come from a definite source which it is entirely feasible to allocate specifically to one state or another; but this is not true of the great mass of the income of a manufacturing or mercantile company-that is, the profit derived from the sale of goods. Where material and goods are collected and purchased by an office in one state, converted by manufacture at a factory in a second state, and distributed and sold through an office in a third state, it is evident that the investment and activities in all three states have yielded a certain trading profit. At particular times this trading profit may be enhanced by the efforts of one department more than another, by cheap purchasing, efficient manufacturing or successful salesmanship, but no one can measure the ups and downs of these elements and all that can be said is that they are all necessary and all contribute to the trading profit, which could not have been made if any part of the organization had not been functioning. Obviously, in such cases there is no pre-existent separate income for any state, which can be ascertained by looking in the right place or by the use of any particular accounting method or formula. The committee emphasizes this obvious fact for two reasons: first, that the methods of apportionment hereafter recommended may not be unduly criticized, simply on the ground that they are arbitrary. All methods of apportionment of trading
profits are arbitrary-the cutting of the Gordian knot. second place, this fundamental fact may well be borne in mind in any state disinclined to compromise, for the sake of uniformity because it believes it already has the one right rule; there is no one right rule of apportionment, notwithstanding that there probably are a number of different rules, all of which may work substantial justice. For the present purposes the only right rule of procedure is a rule on which the several states can and will get together as a matter of comity. Getting together by the uniform adoption of some equitable method and finding the right rule of apportionment are, in our opinion, synonymous.
No consideration of the source of trading profit would be complete without mentioning the school of thought which holds the sale to be the source of the entire income. The reasoning is that the net income is a portion of the gross income, and as all gross income results from sales, and as there is no income until sale, the place of sale is, therefore, the source of all income. This view overlooks a distinction, well recognized in accountancy, between the place of realization of profits and the real source of such profits, —that is, the investment and the activities preceding the realization. (See Journal of Accountancy, Mch. 1922, p. 196.) Nevertheless, it is a view which has had a very general influence on apportionment legislation and practice, and still has. However, it has been definitely discarded by the United States Supreme Court in the recent case of Underwood Typewriter Co. vs. Chamberlain. 254 U. S. 113. This case involved a Connecticut income tax law, under which a tax had been imposed on a portion of the profits of a company having its factory in Connecticut but making all sales from offices outside of Connecticut. The court definitely discarded the argument of counsel that the net income was derived wholly at the place of sale. The court said: "The profits of the corporation were largely earned by a series of transactions beginning with manufacture in Connecticut and ending with sale in other states." And the court held that the State of Connecticut could tax the portion of the total net income "reasonably attributable" to the State of Connecticut. The words "reasonably attributable" will be the starting point for many court decisions in the future and they may well be the starting point of any rule of apportionment. It was presumably in view of the Underwood case that the 1921 United States Revenue Act adopted a different conception of the source of income from that contained in the 1918 Revenue Act. The 1918 Revenue Act taxed the entire profits made by foreign concerns selling goods in this country, while the 1921 Revenue Act recognizes that a portion of the profit is attributable to the manufacture of the goods in a foreign country before shipment to the United States for sale.
4. SPECIFIC ALLOCATION OF TRADING PROFIT VS. STATUTORY APPORTIONMENT FORMULA
While all methods of apportioning the unit trading profit are arbitrary, it may be granted that some methods are more arbitrary than others and that the least arbitrary results may be obtained by individual study of each business. In many cases, no doubt, interdepartment prices and accounts could be set up which would reflect departmental profits, aimed to approximate the assumed profit which each department would make if it were an independent concern instead of a branch of an integrated business. Even this method, however, involves many estimates and assumptions, and in many cases the division of the business operations between states might be such as to make this method impracticable. The individual handling of each business along the above lines will be referred to hereafter in this report as specific allocation, in contrast to apportionment by mathematical formula applied direct to net income. The most serious objection to this method is a practical one. If done properly it would involve a detailed study of each individual case, prohibitive in cost to the state and unduly expensive and annoying to the taxpayer. Furthermore, this same study would have to be repeated in every state where the taxpayer carried on any portion of his business, and it is hardly likely that the specific allocation made by the tax commission of one state would be identical with that made by the tax commission of another state. Lack of uniformity between states would creep in and the divergencies would probably increase as time went on. The members of the committee are, therefore, unanimous that a uniform and fair mathematical formula for apportionment of the net trading profit, incorporated in the statute of each state, is preferable to leaving the entire matter to be determined individually in each case or under rules and regulations of the tax commission. It is believed that such a formula will be acceptable both to the taxpayer and to the commission in more than ninety per cent of the cases and, if so, progress has been made and time and expense saved for study of the remaining ten per cent of the cases, where it may be claimed that the general formula is inapplicable.
5. PROPERTY AND BUSINESS-THE TWO FACTORS TO BE CONSIDERED IN ANY APPORTIONMENT RULE
All merchandising and manufacturing involve two main elements the investment of capital in tangible property and the recurrent turning over of money in goods, materials and labor, the product being sold and the money being reinvested in the same way. Both of these factors contribute to the income. A majority of the members of the committee are agreed that a fair apportion