UT: Equitable Adjustment Provisions Apply to Avoid Double Taxation of Foreign Business Income

The Utah Tax Court recently addressed a constitutional challenge to Utah’s individual income tax structure, as it applied to foreign and interstate business income of S corporation shareholders. The taxpayers, residents of Utah, were shareholders in an S Corporation that generated about 98 percent of its income from activities outside of Utah. Utah’s individual income tax, like any typical state income tax on individuals, taxes residents on all income, whether generated within Utah or another state or foreign country. Also, like any typical state income tax on individuals, Utah provides residents with a credit against their Utah taxable income for income taxes paid to other states. However, residents do not receive credit for taxes paid to foreign jurisdictions. In addition, Utah law allows qualified taxpayers to claim “equitable adjustments” to their Utah adjusted gross income if a lack of an adjustment would result in a “double tax determent.” The taxpayers at issue claimed an equitable adjustment by removing their foreign business income from their Utah taxable income. The Utah State Tax Commission denied the adjustment and the taxpayers appealed to the Utah Tax Court, arguing that Utah’s individual income tax structure, as applied to them, violated the Commerce Clause because it discriminated against foreign commerce and was not fairly apportioned.

The tax court agreed that Utah’s failure to allow the taxpayers a credit for taxes paid to foreign jurisdictions discriminated against foreign commerce. In reaching this conclusion, the tax court applied the “internal consistency” test. This test assumes every state has the same tax structure and looks to see whether the application of this tax structure by every state would place interstate or foreign commerce at a disadvantage as compared to intrastate commerce. The tax court concluded that Utah’s tax structure was not internally consistent as applied to the taxation of the taxpayers’ foreign business income. Specifically, income earned by Utah residents in foreign countries had a potential to be double taxed because Utah does not provide a credit or other adjustment for foreign taxes paid. In reaching its conclusion, the tax court noted that the Supreme Court’s Commerce Clause precedent provides an even greater level of protection to foreign commerce than interstate commerce. The tax court also addressed the taxpayers’ argument that Utah’s individual income tax was not fairly apportioned because Utah taxes residents on all income wherever earned. The tax court rejected the taxpayers’ attempt to invalidate Utah’s residency-based income tax, finding that a state’s ability to tax residents on all income is a well-established principal of interstate and international taxation. Finally, the tax court held that, by denying the equitable adjustment, Utah’s tax structure was invalid because it discriminated against foreign commerce. As such, the tax court remanded the case to the Commissioner with instructions to apply the equitable adjustment provision to avoid double taxation of the taxpayers’ foreign income. Please contact Michael Larkin at 801-237-1335 with questions on Steiner v. Utah State Tax Commission.