TAX TALK

Published by the Section of Taxation of the Maryland State Bar Association, Inc.

· Robert L. Zouck, Chair ·  
Bryan W. Young, Editor, Stephanie Ketchum, Asst. Editor

Kraft General Foods, Inc. v. Comptroller – Subtraction Modification Held to Be Unconstitutional
By Stephanie W. Ketchum

In Kraft General Foods, Inc. v. Comptroller, Md. Tx. Ct. No. 98-IN-00-0353 (June 8, 2001), the Maryland Tax Court addressed the constitutionality of a Maryland subtraction modification for dividends received from foreign corporations and its relationship to federal net operating losses. Kraft, a Delaware corporation with its commercial domicile in Illinois, is a multi-national food company. For purposes of computing its Maryland income tax, Kraft was entitled to subtract from its federal taxable income the dividends received from certain foreign subsidiaries (the "Subtraction"). See Md. Code Ann., Tax-Gen. §10-307(d). However, for Maryland income tax purposes, a taxpayer is not permitted to increase its federal net operating loss ("NOL") by the amount of the subtraction.

Section 10-307(d) provides that a taxpayer is permitted to subtract from the federal taxable income of a corporation dividends received from a foreign corporation (i.e., one that is organized under the laws of a foreign country) if the taxpayer owns, directly or indirectly, 50% or more of the foreign corporation’s stock. The Maryland Tax Court explained that the intent of the Subtraction is to eliminate from Maryland taxable income dividends from foreign subsidiaries because domestic subsidiary dividends are generally deducted from federal taxable income (i.e., via the federal dividends received deduction). As such, the dividends received deduction results in a larger federal NOL. This NOL is available for use as a carryback or carryforward in determining Maryland taxable income. Under Maryland law, a subtraction modification, such as the Subtraction, may only be used to offset federal taxable income or Maryland additions realized in the same taxable year, but may not increase an NOL. Thus, if the Subtraction exceeds addition modifications in a year in which a federal NOL is incurred, a portion of the Subtraction is lost for purposes of computing Maryland taxable income.

Kraft argued that this different treatment results in a higher Maryland corporate income tax on the taxpayer with foreign subsidiary dividend income (as opposed to domestic source dividend income) and, therefore, the statute is unconstitutional.

The Court noted the 6-prong test to be applied in a Commerce Clause analysis - whether the tax is:

1. applied to an activity with substantial nexus with the taxing state;

2. is fairly apportioned;

3. non-discriminatory;

4. fairly related to the services provided;

5. creates a substantial risk of international multiple taxation; and

6. prevents the federal government from speaking with one voice when regulating commercial relations with foreign governments.

Kraft focused on the "discrimination" prong and the Supreme Court case of Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, 505 U.S. 71 (1992). In the Supreme Court case, the court held that an Iowa statute, which provided for the taxation of foreign dividends but not of that of domestic dividends, facially discriminated against foreign commerce and, therefore, violated the foreign commerce clause.

In this Maryland Tax Court case, the Comptroller conceded that the taxpayer received a larger benefit from the non-taxability of domestic dividends than that from the non-taxability of a foreign dividend. However, the Comptroller explained that, unlike the Supreme Court Kraft case, the Maryland statute does not "facially" discriminate against foreign commerce because the disparate benefit is not inherent in the Maryland statute (the tax treatment of domestic dividends is determined under the federal, not Maryland, tax scheme). Additionally, the Comptroller contended that the Subtraction was intended to avoid the type of consequences which arose under the Iowa statute in the Supreme Court case.

The Maryland Tax Court concluded that the Supreme Court takes a broader view by looking outside the text of the statute in determining whether facial discrimination exists in an enacted tax. Further, the Maryland Tax Court concluded that the Subtraction treats two taxpayers (one receiving domestic source dividends and the other foreign source dividends) in otherwise identical situations (in the years following a loss year), differently. The corporation receiving the domestic source dividends can realize the benefit of the federal deduction through an NOL carryback or carryforward, while the Subtraction will be lost if there is not sufficient income from which to subtract the foreign dividends. Thus the Maryland Tax Court concluded that the Subtraction failed to meet the Commerce Clause requirements and is invalid.