On Oct. 27, 2016, the Supreme Court of Mississippi held that the state's dividend exclusion statute violates the commerce clause and is unconstitutional. As written, the statute exempts from gross income dividends received from affiliates that do business and file income tax returns in Mississippi (domestic corporations), but it does not exempt any dividends received from any affiliate that does not do business in the state (foreign corporations). The Court concluded that this language improperly favors domestic corporations over foreign corporations and discourages corporations from choosing to locate their operations outside Mississippi. The Court struck the language requiring that the affiliate must have been subject to Mississippi tax and granted the tax benefits to the taxpayer in the case for the years at issue.
Upon audit, the Mississippi Department of Revenue (DOR) assessed income tax, penalty, and interest on AT&T Corp. (AT&T) for the tax years December 1997 through December 1999. The assessment was a result of dividends received by AT&T from subsidiaries that were deemed nontaxable in Mississippi in the year of distribution being included in business income. AT&T appealed the assessment, claiming that Section 27-7-15(4)(i) of the Mississippi Code establishes a discriminatory method of taxation in violation of the commerce, due process, and equal protection clauses of the United States Constitution by improperly favoring taxpayers owning subsidiaries doing business in Mississippi.
Mississippi Code Section 27-7-15(4)(i) exempts from taxation “income from dividends that has already borne a tax as dividend income under the provisions of this article, when such dividends may be specifically identified in the possession of the recipient.” The DOR has interpreted this statute to exclude intercompany dividends received from subsidiaries doing business and filing income tax returns in Mississippi from the recipient’s gross income. Conversely, the DOR interpreted the same provision to disallow the exclusion if the intercompany dividend received is from a subsidiary that is not doing business or filing income tax returns in Mississippi. The DOR further stipulated that there is no consideration of whether the income of the distributing subsidiary was taxed by its home state, state of domicile, or states in which it conducted business or was taxable.
The commerce clause of the U.S. Constitution authorizes Congress to regulate commerce among the states. The Court applied the four-part test outlined by the U.S. Supreme Court in Complete Auto Transit Inc. v. Brady, which provides that in order to comply with the commerce clause a tax must 1) be imposed on an activity with a substantial nexus with the taxing state, 2) be fairly apportioned, 3) not discriminate against interstate commerce, and 4) be fairly related to the services provided by the taxing state.
Focusing on the second prong of the Complete Auto analysis, the Court analyzed whether the dividend-received exemption is fairly apportioned under both the internal and external consistency tests. The exemption was found to fail the internal consistency test and, thus, the Court did not engage in an analysis of the external consistency test. Internal consistency is achieved when there is no increased burden to interstate commerce if the tax in question is imposed in an identical fashion by every state. The Court held that the Mississippi statute resulted in a disparate tax burden. The foreign corporation subsidiary distributes already-taxed income to its parent as a dividend. The parent then is subjected to a second layer of taxation on the dividend. However, dividends received from the domestic corporation subsidiaries are exempt from the second layer of taxation. The two categories of income are identical except for the tax footprint of the distributing subsidiary. Concluding that the statute was internally inconsistent, the Court held that it was in violation of the dormant commerce clause.
The Court struck the phrase “under the provision of this article” from Section 27-7-15(4)(i). Such action effectively eliminates the taxation of foreign corporation dividends by permitting all dividends from affiliates that were subject to tax somewhere to be excluded from income. (Note that dividends from affiliates that operate exclusively in jurisdictions that do not impose income taxes would not be excluded.)
Mississippi taxpayers should review the income tax returns filed for potential refunds related to foreign corporation subsidiary dividends.