A constitutional challenge to New Jersey's throw-out rule

Impacting New Jersey and beyond

In 2002, New Jersey transformed its sales factor from a measure of total receipts to a measure of total taxed receipted when it adopted the "throw-out rule". Advocated as a "loophole" closer, the throw-out rule modified New Jersey's sales factor by excluding receipts assigned to jurisdictions in which the taxpayer was not subject to an income tax. Throwing out such receipts had the effect of increasing the taxpayer's New Jersey sales factor and, accordingly, the taxpayer's New Jersey "corporation business tax" (CBT) liability.

New Jersey’s throw-out rule

Whirlpool Properties, Inc. ("Whirlpool") challenged the constitutionality of the throw-out rule on the grounds that it was facially unconstitutional, since it operated to tax income earned outside of New Jersey. In July 2011, in Whirlpool Properties, Inc. v. Director, Division of Taxation,3 the New Jersey Supreme Court held that, "for corporate taxpayers having a substantial nexus to New Jersey, the [Throw-Out] Rule may apply constitutionally only to untaxed receipts from those states that lack jurisdiction to tax the corporation either due to insufficient connection with the corporation or due similarly to congressional action such as P.L. 86-272." Accordingly, the throw-out rule would operate in an unconstitutional manner if applied to receipts that are untaxed in a state that has jurisdiction but chooses not to impose an income tax. Thus, the court interpreted the phrase "subject to a tax on or measured by profits or income" in the throw-out rule statute to mean subject to the state's taxing jurisdiction rather than that the taxpayer actually had to have paid a tax to the state.

The following discussion summarizes the Whirlpool decision by providing a background on the throw-out rule, explaining the New Jersey Supreme Court's approach to facial constitutional challenges, and discussing the court's application of the external consistency test to render the throw-out rule unconstitutional with regard to certain sales receipts but constitutional with respect to other sales receipts.

by Alex Meleney and Mike Santoro of Deloitte Tax LLP, originally published in the January 2012 issue of the Journal of Multistate Taxation and Incentives

3 208 N.J. 141, 26 A3d 446 (2011), aff'g and modifying 25 NJ Tax 519, 2010 WL 2795154 (Super. Ct. App. Div., 2010)

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