Look to Case Law to Decide Border Tax Credits’ Constitutionality

Several states bordering Canada provide a credit to residents for personal income taxes paid to Canada’s provinces, but to no other nation’s political subdivisions—effectively favoring commerce with Canada over commerce with other countries. Given the Trump administration’s planned 25% tariff on Canadian imports, these states’ tax policies may unconstitutionally frustrate the federal government’s ability to speak with one voice when regulating commercial relations with foreign governments.

In the seminal Japan Line Ltd. v. County of Los Angeles, the US Supreme Court articulated that it’s unconstitutional for state laws to prevent the federal government from speaking with one voice when regulating commercial relations with foreign governments. Despite the need to speak with one voice, as indicated in the chart below, states bordering Canada and Mexico provide a wide array of credits for taxes paid to other jurisdictions.

To be constitutional, a state tax must comply with the four-prong test established in Complete Auto Transit v. Brady:

• There must be substantial nexus
• The tax must be fairly apportioned
• The tax can’t discriminate against interstate commerce
• It must be fairly related to services provided by the state

Per Japan Line, two additional prongs also apply when foreign commerce is implicated: Tax can’t create a substantial risk of international multiple taxation regardless of apportionment, and it can’t stop the federal government from speaking with one voice in its commercial relations with foreign governments.

In Japan Line, the Supreme Court specifically noted Congress’ power under the Foreign Commerce Clause to “regulate commerce with foreign nations.” To date, Congress hasn’t delegated the regulation of foreign commerce to the states.

In In re Barton-Dobenin, the Kansas Supreme Court addressed the application of the Foreign Commerce clause in the context of Kansas’ denial of a credit against resident income tax to the petitioners for income taxes paid to the Czech Republic.

The court reasoned that the rule laid down in Japan Line was inapplicable to the petitioner’s facts. The Kansas personal income tax wasn’t a “tax on the use of the channels of interstate or foreign commerce as in Container Corp.” or “a tax on the instrumentalities of foreign commerce, or persons or things in foreign commerce.” The US Supreme Court denied review.

The Barton-Dobenin reasoning held largely intact until 2015, when the US Supreme Court determined in Comptroller of Treasury of Md. v. Wynne that the Interstate Commerce Clause did apply to personal income tax, with Maryland’s disparate imposition of tax on residents and nonresidents discriminating against interstate commerce.

The Supreme Court held that the state’s tax structure violated the internal consistency test (part of fair apportionment in Complete Auto Transit). It also addressed the dissent’s contention that individual income tax was held to a different standard than corporate income and similar taxes. Crucially, the court held that individual income tax and the activities inducing that tax burden were as much a part of interstate commerce as corporate activity and related state taxes.

This suggests that if a case like Barton-Dobenin were to reach the US Supreme Court, the court could determine that state income tax is indeed a tax on channels of interstate or foreign commerce, overturning the Kansas Supreme Court’s holding. The US Supreme Court would be determining that the failure of the state to provide a credit against such tax is unconstitutional under the “fairly apportioned” prong or the Foreign Commerce Clause, and extending Wynne to foreign tax paid by individuals.

This could also complicate the validity of Steiner v. Utah State Tax Commission, a post-Wynne Utah Supreme Court case. In Steiner, Utah residents were denied credit for tax paid to foreign jurisdictions because the US Supreme Court “has never indicated that a state—taxing an individual based on his residency in that state—could run afoul of the Constitution by failing to grant a tax credit against taxes levied by foreign countries.”

The handful of states offering a resident credit for taxes paid to Canadian provinces provide an effectively lower level of taxation for income earned within the provinces, but higher levels of taxation for income earned in other foreign jurisdictions. This provides Canadian employers an unfair advantage over all other similarly situated employers in other countries because the Canadian employer can offer lower compensation to a resident in New York or a similarly structured state—knowing that the state will subsidize its resident employee.

The border states that offer a credit for taxes paid exclusively to Canadian provinces do so in support of the many residents who conduct business across the border. To protect this benefit from the risk of litigation—as well as offer relief from double taxation for all state residents, wherever they are employed—Arizona, Maine, Montana, and New Mexico offer a model that appears to align with the Supreme Court’s reasoning in Japan Line and Wynne.

It extends the credit to all foreign jurisdictions. It may also be constitutional not to offer any credit to any foreign jurisdictions. But offering credit to some foreign jurisdictions and not others is the most untenable position.

The current credit systems for taxes paid in states such as New York and Michigan are non-uniform and result in double taxation of income. They also favor commerce with one nation above all others and may encroach on the federal government’s prerogative to regulate foreign trade.

The credit’s goal of alleviating the burden of residents working in a neighboring location may be laudable. But absent a fix that adopts a neutral stance, there’s still a risk of unconstitutionality. These states should revise their systems to benefit either all foreign jurisdictions—or none.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Michael Puzyk is tax partner at McCarter & English, focusing on domestic and international businesses, organizations, and individuals in state and local taxation, with emphasis on New Jersey tax matters.

Paul Buonaguro is an associate at McCarter & English and a member of the firm’s tax and employee benefits group.

Write for Us: Author Guidelines