Foreign Dividends were a problem for Amerada Hess Corp. when paying state income taxes in North Dakota.

North Dakota taxes large companies doing business in the state under the unitary method, meaning that rather than try to sort out which subsidiaries of a large corporate group earned what income in the state, it lumps the income of the parent and all the subsidiaries together and then apportions a share of the group income to the state based on the ratio of the group’s total payroll, property and sales that are in the state.

Companies have the option of doing this calculation on a “water’s-edge” basis, or a basis where only the income earned in the United States is subject to potential apportionment to North Dakota.

Dividends that the group receives from subsidiaries outside the United States are taken into account, even in the water’s-edge calculation. However, only 30% of such dividends are taken into account.The state has a “partial exclusion” for foreign dividends.

Amerada Hess has lots of foreign dividends. When it comes time to pay its federal income taxes, the company claims foreign tax credits. The United States taxes US companies on their worldwide incomes, but it allows them a credit for any taxes that were already paid on the income to other countries. In many cases, a condition for claiming foreign tax credits is the company must “gross up” the dividend, or report the taxes that it is claiming as a credit as additional income. However, even with this gross up, the company comes out ahead since a dollar of foreign tax credit reduces US taxes by a full dollar while having to report the foreign taxes as income only adds 35¢ to the company’s US tax bill.

North Dakota told Amerada Hess that it had to include the full gross-up amounts in its income.

The company objected. It argued that if the underlying dividend qualifies for a partial exclusion, then the gross-up of the dividend must qualify, as well. It lost before the state supreme court. The court said that the state legislature had consciously decided against treating dividend gross ups as part of the dividend.

The case is a warning to be aware of the potential issue in other states. The case is Amerada Hess Corp. v. North Dakota. The court released its decision in late August.