The Unitary Concept for State Income Tax Purposes
Joy, David W., Koehn, Jo Lynne, The CPA Journal
The key point in determining the state income tax for a company conducting interstate commerce is how the unitary business concept applies to the computation of taxable income. For example, the apportionment of income between business and nonbusiness income typically depends upon how a state applies the unitary business concept. States also use the unitary business concept to determine the apportionable amount of taxable business income for a corporation conducting an interstate business. Furthermore, many states use the unitary business concept to determine when corporations must file either combined or consolidated tax returns. Individual states have chosen to apply the unitary business income concept in various ways. States may either establish rules and regulations that permit or deny the taxpayer to determine when the unitary business concept requires combined reporting. Other states do not allow combined reporting. Likewise, some states apply the unitary business concept on a worldwide basis while other states permit taxpayers to make a waters-edge election. (The waters-edge election provides that taxable income is comprised only of income earned within the borders of the United States.) The rules for implementing the waters-edge approach are not uniform among the states that permit its use.
Despite the complexity surrounding the unitary concept, most states do not provide clear guidelines as to when or how the unitary business concept should be applied. States typically attempt to use the unitary business concept to increase taxable income. Not surprisingly, states often also try to deny the use of unitary business concept when its application decreases taxable income.
The Supreme Court acts as an overseer for the application of the unitary business concept under the Interstate Commerce provision in the U.S. Constitution. Unfortunately, the Supreme Court rulings concerning unitary business operations also fail to clearly define the unitary business.
Unitary Business Concept
Related business activities conducted in various states typically constitute a unitary business. For example, states may deem a unitary business exists when a company manufactures a product in one state and sells it in another. The transportation of the product from the manufacturing plant to the sales outlet and storage facilities during this process are typically parts of a unitary business. An interstate railway that uses track and terminals located in different states is another example of a unitary business. Likewise, other transportation and communications companies are typically unitary businesses.
The question becomes how to apportion the business income between the states in which a unitary business conducts its activities. One solution is to use transfer prices to partition the income between the various states. For example, the United States government chooses to use transfer pricing to determine the source of business income for international commerce.
In contrast to the Federal government, state governments have considered transfer pricing to be an imprecise method of accounting. States purport that transfer pricing lacks objectivity due to the absence of market prices for similar transactions. The Federal government attempts to deal with the lack of market data by establishing complex rules and regulations to monitor the use of transfer pricing. Despite these rules, managers still have considerable latitude for manipulation of the transfer price.
State governments have decided they do not wish to allow businesses an opportunity to manipulate transfer prices. Accordingly, states have elected to establish tax rules for the apportionment of taxable business income between the various states in which a unitary business operates. The first step in the apportionment process is to determine the taxable income for the composite of the various business activities that constitute a unitary business. …