COMPTROLLER OF TREASURY, IT DIV. v. Armco, Inc.

⁴⁰⁶ POLLITT, Judge. Constitutional questions concerning the State’s power to tax have long occupied this country’s courts. Chief Justice John Marshall declared almost 200 years ago that “The power to tax involves the power to destroy,” in finding unconstitutional the efforts of the State of Maryland to tax a national bank. 1 In this appeal, we find the State’s efforts to apply a tax exclusion to corporate subsidiaries engaged in the export of domestic goods must meet a similar fate, because the exclusion discriminates against corporations doing the majority of their business in other states, and thereby violates the Commerce Clause. 2 We also find that the State may constitutionally tax the interest income of a nondomiciliary corporation doing some business in this state, if that income is earned in the course of activities related to the corporation’s business in Maryland. Disturbed by this country’s trade deficit, Congress gave special recognition to a corporate entity it described as a Domestic International Sales Corporation (DISC). 3 Westinghouse Electric Corp. v. Tully, 466 U.S. 388, 390 , 104 S.Ct. 1856, 1858 , 80 L.Ed.2d 388 (1984).

DISCs are purely fictional subsidiary corporations that afford their U.S.-based parent tax incentives to increase their exports. These “fed ⁴⁰⁷ eral phantasms” have no assets, no property, and no personnel; they are hollow bookkeeping entities that serve to isolate export profits of a domestic enterprise. The profits so isolated are eligible for preferential tax treatment. Only a portion of this profit—the deemed dividend—is taxed currently to the parent company, the rest—the accumulated income—is not taxed to either the parent or the DISC until it is actually distributed to the parent (the shareholder), or until the DISC no longer exists. 4 As a result, under the federal tax scheme, no income is taxed to the DISC itself.

The parent corporation is thus able to defer tax payment on a portion of its profits which would otherwise be immediately taxable. The parent can use the DISC’S accumulated income for further export activities without losing the tax benefit. Maryland uses a corporation’s net income for federal tax purposes as its basis for computing that corporation’s state tax liability. Maryland Code (1957, 1980 Repl.Vol., 1985 Supp.) Art. 81, § 280A(a).

Maryland taxes only that portion of the federally determined net income that is allocable to the State, as that term is defined by § 316 of the Tax Code. 5 6 We have previously commented that it is not surprising that state courts and legislatures were unprepared to deal with DISCs. Ward Europa, Inc. v. Comptroller, 66 Md. ⁴⁰⁸ App. 332, 337, 503 A.2d 1371, 1373 (1986). This case is the result of the state legislature’s attempt to tax DISCs and further Maryland’s economic interests. DISCs, because they are, technically speaking, distinct corporate entities, are subject to Maryland tax on their net income.

See § 295 of the Tax Code. In the federal tax scheme this income, as previously noted, is tax-exempt with the exception of the portion that is “deemed” distributed to the parent. This deemed distribution is federally taxed once only, as part of the parent’s income. In contrast, the Maryland tax scheme, until 1978, did not contain any special provision for DISCs.

In the absence of any such provision DISCs with any net income allocable to Maryland faced the spectre of “double taxation” by the State. The State could tax the DISC’S allocable income directly when the income was in the “hands” of the DISC, and then tax the allocable deemed distributed income a second time when the income was in the hands of the parent. The General Assembly attempted to alleviate the burden of this double tax in 1978. Chapter 359 of the Laws of 1978 repealed and reenacted, with amendments, then Maryland Code (1957, 1975 Repl.Vol., 1977 Supp.) Art. 81, § 280A(c).

The preamble to the Act states that its purpose is to tax dividends received by a Maryland corporation from the earnings of an affiliated subsidiary domestic international sales corporation [DISC] to the same extent as dividends received by Maryland corporation^] from any other affiliated corporation. The amended legislation seemingly accomplishes this purpose by providing for an exclusion of deemed income in the parent’s taxable income. The first sentence of § 280A(c)(7) provides that: (c) There shall be subtracted from taxable income of the taxpayer the following items to the extent included in federal income: ... (7) to the extent that the dividends are included in taxable income, the percentage of dividends received from an affiliated domestic international ⁴⁰⁹ sales corporation [DISC] (as defined by Internal Revenue Code of 1954 § 992(a)), which is equivalent to the percentage that would be excluded if the domestic international sales corporation was not qualified under § 992(a).

The legislation that is constitutionally challenged here is the immediately following sentence of § 280A(c)(7) which limits the applicability of the deemed income exclusion. However, this exclusion shall be available only if at least 50 percent of the net taxable income of the domestic international sales corporation is subject to Maryland taxation____ Simply stated, the benefit of the tax exclusion is limited to those parent corporations whose DISCs have at least 50% of their net income allocable to the State. Those parent corporations whose DISCs do not meet the 50% standard do not qualify for the exclusion. Thus, a DISC doing over half its business in Maryland qualifies its parent for preferential treatment vis-a-vis a DISC doing less than half its business in Maryland.

Armco, Inc. (Armco) is the parent corporation and sole shareholder of Armco Export Sales Corporation (Armco Export), Armco’s affiliated DISC. In 1978, Armco received from its DISC a deemed distribution of $17,643,847, representing that portion of the DISC’S profits that federal law deemed distributed to its parent. 6 Armco included the deemed distribution in its federal taxable income, but excluded the distribution in determining its state taxable income. Upon audit, the Comptroller disagreed, and added back the deemed distribution to Armco’s state taxable income. After applying the relevant allocation and tax percentage to the dividend, the Comptroller asserted deficiencies attributable to this exclusion in Armco’s return of $23,499. ⁴¹⁰ Armco appealed this assessment to the Maryland Tax Court.

Armco did not dispute that it did not qualify for the exclusion under § 280A(c)(7), which denies the exclusion to parents whose affiliated DISC’S taxable income in Maryland is less than 50% of its federal taxable income. Armco and the Comptroller agreed that only 2% of Armco Export’s net income was subject to Maryland tax. 7 Armco asked the Tax Court instead to declare that the limitation of the exclusion in § 280A(c)(7) violated the Commerce Clause of the U.S. Constitution. The Tax Court declined to address this constitutional question declaring, sua sponte, that it lacked subject matter jurisdiction to declare part of a statute constitutionally invalid. 8 It therefore affirmed the assessment. Armco appealed this order of the Tax Court to the Circuit Court for Baltimore City, again challenging the constitutionality of the limitation of the exclusion before Judge Martin B. Greenfeld.

Judge Greenfeld found the provision violated the Commerce Clause, deleted the offending sentence of § 280A(c)(7) and reversed the order of the Tax Court. The Comptroller appeals from that order, and we now affirm the judgment of Judge Greenfeld in that respect. Armco also excluded from its 1978 taxable income $282,-570 in interest income generated by a loan to the Iron Ore Company of Canada (IOCC). Again taking issue with Arm- ⁴¹¹ co, the Comptroller disallowed this exclusion and added back the interest income to Armco’s state taxable income, resulting in the assessment of a deficiency against Armco.

Armco also appealed this assessment to the Tax Court. At the Tax Court the Comptroller conceded that Armco and IOCC were not a unitary business. Armco also established that the loan was not made by its financial services subsidiary, but instead was handled as a general corporate transaction. The Tax Court reversed the Comptroller’s assessment with respect to the interest from IOCC on the grounds that the activities of Armco and IOCC were not unitary.

The Comptroller appealed the order of the Tax Court to the circuit court, where the circuit court reversed the Tax Court on this issue, reasoning that, because Armco operated a financial services subsidiary, the State could properly tax any interest Armco received from its loan to IOCC. From the order of the circuit court reversing the Tax Court, Armco cross-appeals. We find that due process principles as enunciated by the U.S. Supreme Court require the interest income at issue to be related to Armco’s business in this State. Because the evidence contained in the record before us is inconclusive on this issue, we vacate the order of the circuit court and remand for further fact-finding. 9 We address first the Commerce Clause question.

I The Supreme Court has acknowledged that the adjustment of state taxation within the confines of the Commerce Clause is a delicate one, leaving little in the way of precise guides to the States. Nevertheless, “From the quagmire there emerge ... some firm peaks of decision which remain unquestioned____ No State may ... ‘impose a tax which discriminates against interstate commerce ... by providing a direct commercial advantage to local business.’ ” Boston Stock Exchange v. State Tax Comm’n, 429 U.S. 318, 329 , ⁴¹² 97 S.Ct. 599, 607 , 50 L.Ed.2d 514 (1977), quoting Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. 450, 457 , 79 S.Ct. 357, 361 , 3 L.Ed.2d 421 (1959). This cardinal rule of Commerce Clause construction is grounded in elementary economic principles. The Commerce Clause is designed to protect free trade.

The concept of free trade is ill-served by the “multiplication of preferential trade areas” that would result if individual states enacted laws granting economic benefits to in-state businesses at the expense of out-of-state businesses. Boston Stock 429 U.S. at 329 , 97 S.Ct. at 607 . The Supreme Court has considered the constitutionality of a myriad of state taxes in the last ten years. The Court has taken pains to note that the states are free to structure their tax systems to encourage the growth and development of intrastate commerce and industry, and are free to compete with one another.

Id. at 337 , 97 S.Ct. at 610 . Nor is a state tax per se invalid because it burdens interstate commerce. Interstate commerce may constitutionally be made to pay its way. Maryland v. Louisiana, 451 U.S. 725, 754 , 101 S.Ct. 2114, 2133 , 68 L.Ed.2d 576 (1981).

In the process of this competition, however, no state may discriminatorily tax the products manufactured or the business operations performed in any other State. Boston Stock 429 U.S. at 337 , 97 S.Ct. at 610 (emphasis added). 10 Stripped of all the verbiage with which the Comptroller clothes it, the issue in this case is simply one of discrimination. Section 280A(c)(7) discriminates against parent corporations who conduct less than 50% of their business in Maryland by denying them the same tax exclusion permit ⁴¹³ ted corporations who conduct 50% or more of their business in Maryland. The language “subject to Maryland tax” in the exclusion refers to Maryland’s apportionment formula, which is specifically designed to measure the percentage of business a corporation conducts in Maryland.

A parent corporation conducting 50% of its business in Maryland will not be taxed on any of the income deemed distributed from its DISC. A parent corporation conducting less than 50% of its business in Maryland will be taxed on the allocable portion of the income deemed distributed from its DISC. The former corporation therefore enjoys a tax benefit denied the latter corporation, solely because of the former’s greater business ties to this State. Because the tax exclusion impermissibly discriminates on the basis of location of a corporation’s business, it is unconstitutional.

The Comptroller defends the exclusion as a legitimate attempt by the legislature to exempt income from taxation when a risk of double taxation exists. 11 The Legislature, according to the Comptroller, “merely provided that if double taxation by Maryland approaches a certain level, that double tax is removed.” This argument serves only to obscure the issue. A corporation with 49% of its income allocable to Maryland will always be forced to pay a double tax under § 280A(c)(7) as presently constituted no matter how great its deemed dividend. In contrast, a corporation with 50% of its income allocable to Maryland will never pay a double tax, because the parent can exclude the dividend from its taxable income. While the Legislature may certainly decide what to exclude from taxable income, it may not limit that exclusion to Maryland businesses only. ⁴¹⁴ The Comptroller disputes this, implying that Maryland may enact tax criteria differentiating between corporations on the basis of “the amount of business done by the taxable entity in the taxing state.” The Comptroller seeks to find support for this in both Westinghouse and Ward Europa.

In Ward Europa, we held that a DISC’S apportionment formula may be based on the property and payroll factors of the parent corporation. From this holding, the Comptroller somehow deduces that a tax exclusion may be conferred or withdrawn on the basis of “a properly constructed apportionment formula.” In Westinghouse, the Supreme Court considered a New York state tax credit issued to parent corporations which had the effect of lowering the tax rate on their affiliated DISCs. The Court invalidated the credit because the credit was based on the percentage of the parent’s total exports that were shipped from New York. The Comptroller asserts that the Court’s holding in Westinghouse was limited only to statutes discriminating on the basis of place of export, and does not apply to statutes discriminating on the basis of Maryland’s apportionment formula.

As Judge Greenfeld observed in his memorandum opinion and order, this is truly a distinction without a difference. It is similar to the argument made by the Tax Commissioner in Westinghouse, and we simply adopt the Court’s language in its wholesale rejection of the Tax Commissioner’s argument. The Tax Commission’s argument that New York employs a constitutionally acceptable allocation formula, in our view, serves only to obscure the issue in this case. The acceptability of the allocation formula employed by the State of New York is not relevant to the question before us.

The fact that New York is attempting to tax only a fairly apportioned percentage of a DISC’S accumulated income does not insulate from constitutional challenge the State's method of allowing the DISC export credit. New York’s apportionment procedure determines ⁴¹⁵ what portion of a business’ income is within the jurisdiction of New York. Nothing about the apportionment process releases the State from the constitutional restraints that limit the way in which it exercises its taxing power over the income within its jurisdiction. Here, Westinghouse argues that the State of New York has sought to exercise its taxing power over accumulated DISC income in a manner that offends the Commerce Clause and the Equal Protection Clause of the Fourteenth Amendment.

This challenge is not foreclosed by our holding that New York’s allocation of DISC income is constitutionally acceptable. See 459 US 1144 , 74 L Ed 2d 991 , 103 S Ct 784 (1983) (dismissing for want of a substantial federal question Westinghouse’s challenge to method of allocating DISC income to parent). “Fairly apportioned” and “nondiscriminatory” are not synonymous terms. It is to the question whether the method of allowing the credit is discriminatory in a manner that violates the Commerce Clause that we now turn. The Court went on to emphasize that it is the effect a tax exerts on interstate commerce, rather than the particular means of achieving that effect, that is the focus of inquiry.

Whether the discriminatory tax diverts new business into the State or merely prevents current business from being diverted elsewhere, it is still a discriminatory tax that “forecloses tax-neutral decisions and ... creates ... an advantage” for firms operating in New York by placing “a discriminatory burden on commerce to its sister States.” Further demonstration of the irrelevancy of the Comptroller’s position is provided in both Armco v. Hardesty, 467 U.S. 638 , 104 S.Ct. 2620 , 81 L.Ed.2d 540 (1984), and Bacchus Imports, Ltd. v. Dias, 468 U.S. 263, 104 S.Ct. 3049 , 82 L.Ed.2d 200 (1984). II Having determined that the limitation § 280A(c)(7) imposes on the deemed dividend exclusion unconstitutional ⁴¹⁶ ly discriminates against interstate commerce, we must further determine whether to invalidate the entire provision providing for the exclusion or to sever the constitutionally infirm limitation. The established rule of construction in such situations requires us to determine whether the Legislature would have enacted the exclusion if it knew the limitation was invalid. Sanza v. Maryland State Board of Censors, 245 Md. 319, 338 , 226 A.2d 317, 327 (1967).

In determining the legislative intent in this regard the Court of Appeals has directed us to presume that the Legislature generally intended its enactments to be severed if possible. Ocean City Taxpayers v. Mayor & City Council, 280 Md. 585, 600 , 375 A.2d 541, 550 (1977). In the earlier case of Davidson v. Miller, 276 Md. 54, 83 , 344 A.2d 422, 439 (1975), the Court stated the principle in more imperative terms: Likewise we mention that even though constitutional and unconstitutional provisions of a law are contained in the same section, the entire section or enactment is not invalid unless the provisions are essentially and inseparably connected in substance____ It thus becomes the duty of the court whenever possible to separate the valid from the invalid provisions____ Cities Service v. Governor, 290 Md. 553 , 431 A.2d 663 (1981), tempers this declaration by noting that when a statute contains both a general provision and an invalid exception, “courts have often refused to sever when the severed statute would impose a duty, sanction or substantial hardship on the otherwise excepted class.” 290 Md. at 576 , 431 A.2d at 676 . The desired goal is to avoid imposing a duty, sanction or substantial hardship on members of a class which the Legislature intended to exempt.

Id. Thus, in Burning Tree Club v. Bainum, 305 Md. 53 , 501 A.2d 817 (1985), the Court refused to sever “where the invalid portion of a statute is an exception to a prohibition, ... and severing would enlarge that prohibition beyond its reach as enacted." 305 Md. at 82 , 501 A.2d at 831 . ⁴¹⁷ Applying these principles to this case compels us to sever the constitutionally infirm limitation from the provision granting the benefit of the exclusion to parent corporations of DISCs. The provision provides a benefit to all parents of DISCs, while the unconstitutional limitation denies the benefit to those parents without the required ties to the State. Striking the entire provision would deny a tax benefit to all parent corporations, while severance extends this benefit to all parents, regardless of their state taxable income.

This conclusion is reinforced by the preamble to Chapter 359 of the Laws of 1978, which declared that the amendment’s purpose was to insure that dividends received from DISCs were taxed to the same extent as dividends received from any other affiliated corporation. Even the Comptroller argues that the Legislature enacted § 280A(c)(7) as a “reasonable response to the spectre of double taxation.” Severance preserves this response. The last sentence of § 280A(c)(7) is therefore deleted, with the effect that dividends received by a parent corporation from any DISC are excluded from the parent’s state taxable income, regardless of the percentage of the DISC’S income subject to Maryland tax. Ill Armco also challenges the Comptroller’s refusal to exclude from taxable income interest payments received on a loan made to IOCC. 12 This challenge is premised on due process grounds.

Armco, at one time a small steel company, has now expanded to several lines of business including oil and gas drilling rigs, fabricated metal products, industrial products and services, financial services, and material resources. ⁴¹⁸ Armco is incorporated in Ohio, where it also maintains its corporate headquarters. Armco’s business in Maryland consists of the production of specialty steel products in a Baltimore plant. As previously