United States: Mississippi Chancery Court Again Holds Dividends Received

The Chancery Court of Hinds County, Mississippi, recently has held that the state's corporate income tax dividends received exclusion statute violates the Commerce Clause of the U.S. Constitution because the exclusion is limited to dividends received from affiliates that are doing business in Mississippi and file income tax returns in the state.¹ The Court held that the statute does not allow the exclusion of dividends received from an affiliate that does not do business in Mississippi. As a result, the Court determined that the dividend exclusion statute is discriminatory because it clearly favors domestic corporations over foreign competitors. The Court held that the statute is unconstitutional and granted the taxpayer's motion for summary judgment. The decision is substantially similar to a 2006 decision that the Court issued to the same taxpayer which ultimately was overturned by the Mississippi Supreme Court on procedural grounds.

Background

The taxpayer, AT&T, and some of its affiliates filed group Mississippi income tax returns for the 1997 through 1999 tax years. Following an audit for these years, the Mississippi Department of Revenue made adjustments to change: (i) the computation method used by the taxpayer to a "combined" method;² (ii) the computation of interest expense attributable to non-business assets that was added back to business income; and (iii) the inclusion of business income dividends received by the taxpayer from its subsidiaries which the auditors determined were not taxable in Mississippi in the year in which the dividend was included in the taxpayer's business income. In 2003, the Department issued an assessment of income taxes against the taxpayer and its subsidiaries for the relevant tax years of nearly $12 million, inclusive of interest and penalties. After the Department and the taxpayer reached a resolution concerning some of the adjustments, the only issue remaining for consideration was the taxation of intercompany dividends.

As a result of the contested treatment of the dividends, the taxpayer appealed the additional income tax assessment to the Mississippi Tax Commission Board of Review. After the Board upheld the assessment, the taxpayer promptly appealed the order to the full Tax Commission. The Commission affirmed the assessment but reduced the amount by approximately $1 million. The taxpayer subsequently appealed this order to the Chancery Court of Hinds County by filing a Petition for Appeal of Additional Income Tax Assessment Ordered by State Tax Commission, for Declaratory and Injunctive Relief, and for Refund of Overpayment of Tax. As required by statute, the taxpayer also filed an appeal bond equal to twice the revised assessment.³

Dividends Received Exclusion Statute

Under Mississippi law, "gross income" does not include "[i]ncome from dividends that has already borne a tax as dividend income under the provisions of this article [Mississippi income tax], when such dividends may be specifically identified in the possession of the recipient."⁴ According to the Chancery Court, this provision "permits a recipient of an intercompany dividend to exclude that dividend from the calculation of its gross income if the distributing corporation is doing business in Mississippi in the year of the distribution and files a Mississippi Income Tax Return for that year." Taxpayers are not permitted to exclude from gross income any dividends received from affiliates that had no business activities or income tax filing obligations in Mississippi.

Statute Violates Commerce Clause

The Chancery Court held that the dividends received exclusion statute violates the Commerce Clause because it is discriminatory. The Department and the taxpayer acknowledged that the contested statute permits a taxpayer to only exclude dividends received from domestic affiliates which do business and file income tax returns in Mississippi. The Chancery Court determined that "the statute denies taxpayers a benefit, the ability to deduct intercompany dividends from gross income in computing Mississippi income tax, based solely upon the choice of the taxpayer and its subsidiaries not to locate any operations in Mississippi or to file a Mississippi income tax return."

In Marx v. Truck Renting and Leasing Association, Inc.,⁵ the Mississippi Supreme Court expressly adopted the four-prong test specified by the U.S. Supreme in Complete Auto Transit v. Brady⁶ that a statute must satisfy to survive a Commerce Clause challenge. The following four-prong test must be considered in determining the constitutionality of a state tax statute: (i) the tax must be applied to an activity with a substantial nexus with the taxing state; (ii) the tax must be fairly apportioned; (iii) the tax must not discriminate against interstate commerce; and (iv) the tax must be fairly related to the services provided by the state.

The U.S. Supreme Court has defined discrimination as the "differential treatment of instate and out-of-state economic interests that benefits the former and burdens the latter."⁷ Based on this definition, the Chancery Court found that the "dividend exclusion statute is discriminatory in nature and on its face." As a result, the statute violated the third prong of the Complete Auto test, clearly favoring domestic corporations over foreign corporations and discouraging corporations from choosing to locate their operations outside Mississippi.

If there is a discriminatory tax scheme, under U.S. Supreme Court precedent, the state must establish that the tax is a "compensatory tax" designed to make the interstate commerce bear a burden already borne by intrastate commerce.⁸ The burden shifts to the state to satisfy each of the following conditions: (i) the state must, as a threshold matter, identify the intrastate tax burden from which the state is attempting to compensate; (ii) the tax on interstate commerce must be shown to roughly approximate, but not exceed, the amount of the tax on intrastate commerce; and (iii) the events on which the interstate and intrastate taxes are imposed must be substantially equivalent.⁹ In the instant case, the Department provided no evidence or assertions that the dividend exclusion statute is a compensatory tax. The Court disagreed with the Department that the statute was an avoidance of double taxation. The statute is not linked to the amount of tax paid by the distributing corporation and actually results in double taxation to certain distributing corporations.

The Chancery Court's holding was consistent with decisions of North Dakota and California courts that considered similar statutes. In March 2003, the North Dakota Supreme Court struck down a similar dividend exclusion statute.¹⁰ Like the Mississippi statute, the statute at issue in the North Dakota case exempted dividends based solely on the amount of business the distributing company did in the state. Also, the California Court of Appeal invalidated a virtually identical California dividend exemption statute under the Commerce Clause.¹¹ Although the Mississippi Chancery Court was not bound by these decisions from other states, the Court explained that it was of probative value to note that at least two other states have invalidated virtually identical statutes as unconstitutional.

After concluding that the dividend exclusion statute was unconstitutional, the Court was required to determine the appropriate remedy for the taxpayer. The Department recommended that the proper remedy was to rescind the statute and disallow the tax benefits to all taxpayers. In rejecting this remedy, the Court explained that this retroactive change would have significant constitutional and statutory limits. For example, the tax years at issue were 1997 through 1999, but Mississippi law generally prohibits the Department from assessing additional income tax more than three years after the taxpayer has filed its return.¹² The Court determined that the only appropriate remedy that would place the taxpayer on an even footing with the taxpayers that received the benefits is to strike the offensive limitations and grant those applicable tax benefits to the taxpayer for the tax years at issue. The application of the dividend exclusion would result in no additional income tax liability for the taxpayer for the relevant tax years.

Commentary

This is the latest decision in a continuing controversy between AT&T and Mississippi. In 2006, the same Chancery Court considered similar arguments raised by the taxpayer for the 1993 through 1996 tax years.¹³ The Chancery Court held that the dividends exclusion statute as well as a statute in effect for the relevant tax years that limited the filing of consolidated returns to affiliated groups with members doing business and taxable solely in Mississippi both violated the Commerce Clause.¹⁴ However, based on procedural grounds, the Mississippi Supreme Court held in 2012 that the Chancery Court lacked jurisdiction and should not have considered the merits of the case.¹⁵ The Supreme Court specifically held that the taxpayer failed to comply with the statutory requirement that its petition to the Chancery Court "be accompanied with a bond . . . in a sum double the amount in controversy."¹⁶ In reaching its decision, the Supreme Court did not address the taxpayer's constitutional arguments. The Chancery Court's constitutional analysis in the instant case is virtually identical to its analysis of the dividends exclusion statute in its 2006 decision.

In the instant case, the taxpayer apparently complied with the statutory procedural requirement by filing a bond with the Chancery Court that equaled twice the amount in controversy. Thus, in contrast to the earlier case, it appears that the Chancery Court had proper jurisdiction to consider the instant case. The Department is likely to appeal this decision to the Mississippi Supreme Court based on the issue and the history of this case.¹⁷ If the Supreme Court hears this case, it probably will consider the taxpayer's underlying constitutional argument this time. There also is a possibility that the legislature may decide to amend the dividends exclusion statute.

If ultimately upheld, the decision could benefit other taxpayers that have been denied the dividend exclusion for dividends received from affiliates that did not do business in Mississippi. These taxpayers should consider potential refund opportunities. Also, based on this decision, taxpayers may want to argue that they should receive the dividend exclusion on prospective returns for dividends received from affiliates that are not doing business in the state.

Footnotes

1 AT&T Corp. v. Mississippi Department of Revenue, Mississippi Chancery Court, Hinds County, Cause No. G-2004-1393, March 20, 2015.

2 Under MISS. CODE ANN. § 27-7-37(2)(a)(ii), the Department may require certain affiliated corporations to file a combined income tax return.

3 See MISS. CODE ANN. § 27-7-73.

4 MISS. CODE ANN. § 27-7-15(4)(i).

5 520 So. 2d 1333 (Miss. 1988).

6 430 U.S. 274 (1977).

7 Oregon Waste Systems, Inc. v. Department of Environmental Quality, 511 U.S. 93, 99 (1994).

8 Fulton Corp. v. Faulkner, 516 U.S. 325, 331 (1996).

9 Id.

10 D.D.I., Inc. v. State, 657 N.W.2d 228 (N.D. 2003).

11 Farmer Brothers Co. v. Franchise Tax Board, 134 Cal. Rptr. 2d 390 (Cal. Ct. App. 2003).

12 See MISS. CODE ANN. § 27-7-49.

13 AT&T Corp. v. State Tax Commission, Mississippi Chancery Court, Hinds County, Cause No. G-2000-31 S/2, May 26, 2006.

14 Former MISS. CODE ANN. § 27-7-37(2)(a)(i). This statute was amended to eliminate consolidated filings by Ch. 371 (H.B. 1333), Laws 2004, effective Jan. 1, 2004.

15 Mississippi Department of Revenue v. AT&T Corp., 101 So.3d 1139 (Miss. 2012).

16 See MISS. CODE ANN. § 27-7-73. The Supreme Court also determined that the taxpayer failed to timely invoke an alternative statute, MISS. CODE ANN. § 11-13-11, which provides jurisdiction to the Chancery Court.

17 The Department has 30 days to appeal this decision to the Mississippi Supreme Court. MISS. CODE ANN. § 27-77-7(5); MISS. R. APP. P. 3, 4.

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