Amicus Curiae Brief — Hunt-Wesson, Inc. v. Franchise Tax Bd. of Cal.

In THE

Supreme Court of the United States

HUNT-WESSON, INC.,

Petitioner,

Vv.

FRANCHISE TAX BOARD,

Respondent.

On Writ of Certiorari to the

Court of Appeal of California

for the First Appellate District

BRIEF OF

TAX EXECUTIVES INSTITUTE, INC.

AS AMICUS CURIAE

IN SUPPORT OF PETITIONER

TIMOTHY J. MCCORMALLY *

MArY L. FAHEY

JEFFERY P. RASMUSSEN

TAX EXECUTIVES INSTITUTE, INC.

1200 G Street, N.W.

Suite 300

Washington, D.C. 20005-8814

(202) 638-5601

Counsel for Amicus Curiae

* Counsel of Record Tax Executives Institute, Inc.

WILSON-Eres PrintTiNG Co., Inc. - (202) 789-0096 - WASHINGTON, D.C. 20001

TABLE OF CONTENTS

TABLE OF AUTHORITIES ..........

INTEREST OF AMICUS CURIAE

SUMMARY OF ARGUMENT

ARGUMENT ........

Oe

ii

TABLE OF AUTHORITIES

CASES: Page

Allied-Signal, Inc. v. Director, Division of Taza-

tion, 504 U.S. 768 (1992) ............-.....ccccseeeee- 5-6, 15-16, 20

ASARCO Ine. v. Idaho State Tax Commission, 458

U.S. 307 (1982) 15, 16-17

Baldwin v. G.A.F. Seelig, Inc., 294 U.S. 511 ©

(1985) 3,7

Bass, Ratcliff & Gretton, Ltd. v. State Tax Com-

mission, 266 U.S. 271 (1924) 17

Boston Stock Exchange v. State Tax Commission,

429 U.S. 318 (1977) a 3, 7, 8, 12

Camps Newfound/Owatonna, Inc. v. Town of Har-

rison, 520 U.S. 564 (1997) 18-14

Complete Auto Transit, Inc. v. Brady, 480 U.S.

274 (1977) 8

Connecticut General Life Ins. Co. v. Johnson, 303

U.S. 77 (1938) 7

Container Corp. v. Franchise Tax Board, 463 U.S.

159 (1983) 4, 7-8, 14

Fulton Corp. v. Faulkner, 516 U.S. 325 (1996) ......passim

Halliburton Oil Well Cementing Co. v. Reily, 373

U.S. 64 (1963) . 12

Kraft General Foods, Inc, v. lowa Department of

Revenue & Finance, 505 U.S. 71 (1992) ............... 14-15

Macallen Co., The v. Massachusetts, 279 U.S. 620

(1929) 17

Maryland v. Louisiana, 451 U. S. 725 (1981).......... 12

National Life Ins. Co. v. United States, 277 U.S.

eS Se ee eS 15, 17

Northwestern States Portland Cement Co. v. Min-

nesota, 358 U.S. 450 (1959) 9

Oregon Waste Systems, Inc. v. Department of En-

vironmental Quality, 511 U.S. 93 (1994) ............. passim

Pacific Tel. & Tel. Co. v. Franchise Tax Board,

7 Cal. 83d 544 (1972) passim

Philadelphia v. New Jersey, 487 U.S. 617 (1978).. 14

South Central Bell Tel. Co. v. Alabama, 119 S. Ct.

1180 (1999) ..... ....4-5, 11, 18

Trinova Corp. v. Michigan Dep’t of Treasury, 498

U.S. 358 (1991) 17, 20-21

iii

TABLE OF AUTHORITIES—Continued

Page

United States v. Gaudin, 515 U.S. 506 (1995) ........ 11, 21

Westinghouse Electric Corp. v. Tully, 466 U.S. 388

EEL TO 17

Willamette Indus., Inc. v. Franchise Tax Board, 39

Cal. Rptr. 2d 757 (Ct. App. 1995) ........................ 15-16

Wisconsin v. J.C. Penney Co., 311 U.S. 485 (1940)... 8

FEDERAL CONSTITUTIONAL PROVISIONS:

EE 6, 11-12

US. Cosmmr. amend. ZIV, § 2 ......-ccnccecceecoccccceeeeee---- 6

STATE STATUTES:

CAL. Rev. & Tax Cope (West 1992) :

SUUIIIIED ceiensentnttasessetnesnsnscnssnscssesanenscnsesessscescensecesees 9

Ee passim

EEE 9

CEE 9

ee 9

UNIFORM LAWS:

MISCELLANEOUS:

Form 100 (California Corporation Franchise or

Ircome Tax Return), Schedule R-5 (Computa-

i 18

HELLERSTEIN, JEROME R., & HELLERSTEIN, WALTER,

STATE TAXATION I: CORPORATE INCOME AND

FRANCHISE TAXES (3d ed. 1998) .00000...---cc eee 8

In THE

Supreme Court of the United States

No. 98-2043

HuNT-WEsSON, INC.,

Petitioner,

v.

FRANCHISE TAX BOARD,

Respondent.

On Writ of Certiorari to the

Court of Appeal of California

for the First Appellate District

BRIEF OF

TAX EXECUTIVES INSTITUTE, INC.

AS AMICUS CURIAE

IN SUPPORT OF PETITIONER

INTEREST OF AMICUS CURIAE

Pursuant to Rule 37 of the Rules of the Supreme Court,

Tax Executives Institute, Inc. respectfully submits this

brief as amicus curiae in support of Petitioner. Tax

1 Pursuant to Rule 37.6, amicus TEI states that no counsel for a

party has written this brief in whole or in part and that no person

or entity, other than amicus, its members, or its counsel, has made

a monetary contribution to the preparation or submission of this

brief. Tax Executives Institute has received the written consents

of Petitioner and Respondent to the filing of this brief; those con-

sents have been filed with the Clerk of the Court.

2

Executives Institute (hereinafter “TEI” or “the Institute”)

is a voluntary, nonprofit association of corporate and other

business executives, managers, and administrators who are

responsible for the tax affairs of their employers. The

Institute was organized in 1944 and currently has approxi-

mately 5,000 members who represent nearly 2,800 of

the leading businesses in the United States and Canada,

nearly all of which are engaged in interstate commerce.

The members of the Institute represent a cross-section

of the business community in North America. The Insti-

tute is dedicated to promoting the uniform and equitable

enforcement of the tax laws throughout the Nation, to

reducing the costs and burdens of administration and com-

pliance to the benefit of both the government and tax-

payers, and to vindicating the due process and Commerce

Clause rights of business taxpayers.

Tax Executives Institute’s members have a vital interest

in this case, which involves the unconstitutional effect of

the so-called interest-offset rule in section 24344 of the

California Revenue and Taxation Code. Many of the

companies represented by TEI are directly and adversely

affected by the interest-offset rule, which reduces a com-

pany’s interest expense deduction for each dollar of divi-

dends received from non-unitary subsidiaries. Even those

TEI members whose companies are not doing business in

California are, almost without exception, engaged in inter-

state commerce. Consequently, they benefit from, and are

entitled to, the positive business environment ensured by

the Commerce Clause and Due Process Clause of the

United States Constitution.

Because TEI members and the businesses by which they

are employed will be materially affected bv the Court's

decision in this case, the Institute has a special interest in

the outcome of this case.

3

SUMMARY OF ARGUMENT

The question presented in this case is whether the State

of California’s system of taxation for out-of-state com-

panies violates the Commerce Clause and Due Process

Clause of the Constitution. It is well settled that a State

may not tax value outside its borders. Such taxation is

proscribed because the “fundamental purpose of the

[Commerce] Clause is to assure that there be free trade

among the several States,” Boston Stock Exchange v. State

Tax Comm'n, 429 U.S. 318, 335 (1977), and because

extraterritorial taxation offends fundamental notions of

due process and constitutes an “unreasonable clog on the

mobility of commerce,” Baldwin v. G.A.F. Seelig, Inc.,

294 U.S. 511, 527 (1935).

Like many states, California imposes a corporate fran-

chise tax for the privilege of doing business in the State,

using an apportionment formula in respect of corporations

with income from sources within and without the State.

In calculating a taxpayer’s net taxable income, business

interest expense is generally deducted from business in-

come. Under section 24344 of the California Revenue

and Taxation Code, however, taxpayers must offset their

business interest expense—on a dollar-for-dollar basis—

with non-business income not allocable to the State. Thus,

out-of-state corporations (such as Petitioner Hunt-Wesson )

are compelled to reduce their interest deduction by the

amount of their nontaxable income, without regard to

whether the interest expense is related to the nontaxable

income. It is this statute that is at issue here.

In this case, the trial court concluded that section 24344

violates the Due Process, Commerce, and Equal Protection

Clauses of the Constitution. This latter decision was re-

versed by the Court of Appeal, First Appellate District,

largely on the force of the Supreme Court of California's

4

1972 decision in Pacific Tel. & Tel. Co. v. Franchise Tax

Board, 7 Cal. 3d 544 (1972). Subsequent decisions of

this Court, however, unequivocally demonstrate that the

State’s 1972 decision cannot stand. South Central Bell

Tel. Co. v. Alabama, 119 S. Ct. 1180 (1999); Fulton

Corp. v. Faulkner, 516 U.S. 325 (1996); Oregon Waste

Systems, Inc. v. Department of Environmental Quality,

511 U.S. 93 (1994).

In Pacific Telephone, the taxpayer challenged the

California interest-offset statute as it applied to nondomi-

ciliary corporations. In reviewing the rule, the California

Supreme Court conceded that “when viewed in the light of

a domiciliary corporation,” the rule “does not deprive the

taxpayer of any of its interest deduction, but is merely an

attempt to provide how the interest expense shall be allo-

cated as between income from operations and income from

investments.” 7 Cal. 3d at 551 (emphasis in original).

The court also commented that the allocation of interest

expense is “very favorable” to the domiciliary corporation.

Id. As applied to out-of-state companies, however, the

allocation is manifestly not favorable. Hence, on its face,

the rule violates the overarching principle of the Com-

merce and Due Process Clauses that an apportionment

formula must, first and foremost, be fair. Container Corp.

v. Franchise Tax Board, 463 U.S. 159, 169 (1983).

Commerce Clause jurisprudence has evolved signifi-

cantly since California’s decision in Pacific Telephone.

Nowhere has this evolution been more profound than in

respect of statutory schemes that facially discriminate

against out-of-state commerce. ‘Last term, in South Central

Bell, this Court invalidated Alabama’s franchise tax as

facially discriminatory because it gave “domestic corpora-

tions the ability to reduce their franchise tax liability simply

by reducing the par value of their stock, while it denies

:

‘

’

5

foreign corporations that same ability.” 119 S. Ct. at

1185. Five years ago, in Oregon Waste, the Court simi-

larly struck down a surcharge on the disposal of waste

generated out of state, holding that the taxing scheme

was virtually per se invalid. Id. Accord Fulton Corp.,

516 U.S. at 331.

By its very terms, the interest-offset rule at issue here

violates the Commerce Clause. As the trial court found,

“the offset provisions treat two corporations in an identical

business transaction differently based solely on their state

of domicile, which difference results in increased taxes for

foreign corporations.” (App. at 28a-29a.)? Under extant

Commerce Clause jurisprudence, the California statute

must therefore fall.

The law also offends the Due Process Clause, which

requires a minimal connection between the interstate ac-

tivities and the taxing State, as well as a rational relation-

ship between the income attributed to the taxing State

and the intrastate value of the corporate business. Allied-

Signal, Inc. v. Director, Division of Taxation, 504 U.S.

768, 772-73 (1992) (citations omitted). California does

not contend that the non-business income at issue here

bears any relation to Petitioner’s in-state activities.

Rather, the State seeks to tax Petitioner’s extraterritorial

activities by requiring a dollar-for-dollar offset of consti-

tutionally protected income against interest expense.

Under Allied-Signal, a State may tax dividend income

only where the payee and payer of the dividend are en-

gaged in a unitary business or the capital transaction

serves an operational—rather than an investment—func-

2“App.” references are to the various appendices bound with the

Petitioner’s Petition for a Writ of Certiorari to the Court of Ap-

peal of California for the First Appellate District in Hunt-Wesson,

Ine. v. Franchise Tax Board, No. 98-2043 (filed June 21, 1999).

6

tion. 504 U.S. at 787. The dividend income sought to

be taxed here bears no relationship to Petitioner’s in-state

activities and thus California’s covert attempt to tax it

should be rejected as violative of due process.

Moreover, the State’s semantics—that the interest-offset

rule is not a “tax” and therefore the precedents of this

Court are not controlling—cannot change the substance

of the statute. It is clear that California could not tax

Petitioner’s dividend income directly. It is also clear that

a State may not, through constitutional alchemy, indirectly

tax constitutionally protected income.

In Allied-Signal, the Court validated the “necessary limit

on the States’ authority to tax value or income that can-

not in fairness be attributed to the taxpayer’s activities

within the State.” 504 U.S. at 780. The state court did

not dispute this holding. Indeed, although rejecting the

Petitioner’s challenge on stare decisis grounds, it acknowl-

edged that “[i]f we were writing on a clean slate, these

arguments [against the interest-offset rule] might appear

persuasive.” (App. at 8a.) This Court can wipe the slate

clean by striking down the interest-offset rule because it

violates the Due Process Clause of the Constitution.

For the foregoing reasons, the Court should reverse

the decision below.

ARGUMENT

I.

The question presented here is whether the State of

California’s system of taxation for out-of-state companies

violates the Commerce Clause and Due Process Clause of

the Constitution. That California’s taxation scheme can-

3 U.S. Const. art. I, § 8, cl. 8 (Commerce Clause); U.S. Const.

amend. XIV, § 1 (Due Process Clause).

a ==.

7

not pass constitutional muster was made manifest in this

Court’s decision in Fulton Corp v. Faulkner, 516 U.S. 325

(1996). In that case, the Court examined a North Carolina

intangibles tax on the fair market value of stock owned

by state residents. Under the state statute, residents own-

ing stock in a corporation earning income solely within

the state paid no intangibles tax, whereas residents with

stock of foreign corporations having no in-state activities

paid the full amount. Because the tax was computed on

a different net base depending on the corporation’s in-state

activities, it was “virtually per se invalid.” 516 U.S. at

331, 333 & n.3. The same constitutional infirmity char-

acterizes the California tax here.

It is well settled that a State may not tax value outside

its borders. E.g., Connecticut General Life Ins. Co. v.

Johnson, 303 U.S. 77, 80-81 (1938). Such taxation is

proscribed because the “fundamental purpose of the

[Commerce] Clause is to assure that there be free trade

among the several States,” Boston Stock Exchange v. State

Tax Comm'n, 429 U.S. 318, 335 (1977), and because

extraterritorial taxation offends fundamental notions of

due process and constitutes an “unreasonable clog on the

mobility of commerce,” Baldwin v. G.A.F. Seelig, Inc.,

294 U.S. 511, 527 (1935).

This Court has rightly observed that dividing income

among the several States resembles “slicing a shadow.”

Container Corp. v. Franchise Tax Board, 463 U.S. 159,

192 (1983).* Absolute consistency among taxing authori-

#The unitary business principle calculates the local tax base by

first defining the scope of the unitary business of which the taxed

enterprise’s activities in the taxing jurisdiction form one part, and

then apportioning the total income of the unitary business between

the taxing jurisdiction and the rest of the world based on a formula

“taking into account objective measures of the corporation’s activi-

g

ties “may just be too much to ask,” id., but there are

constitutional limits on a State’s use of an apportionment

formula, especially in. respect of income derived from for-

eign commerce.’ In other words, a balance must be

struck between the State’s need for revenue and the tax-

payer’s legitimate right to protection from overreaching

taxing authorities. It is for this Court to ensure that the

balance is a reasonable one. See Boston Stock Exchange,

429 U.S. at 329 (the Court has a duty “to make the

delicate adjustment between the national interest in free

and open trade and the legitimate interest of the indi-

vidual States in exercising their taxing powers”). If the

State has not “given anything for which it can ask return”

in respect of the person, property, or transaction it seeks

to tax, Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444

(1940), the Commerce and Due Process Clauses operate

as a constitutional brake upon the State’s raw power to

tax. The overarching principle of the Commerce and Due

Process Clauses is that an apportionment formula must,

first and foremost, be fair. Container Corp., 463 U.S. at

169.

ties within and without the jurisdiction.” Container Corp., 463 U.S.

at 165. Although the terms “allocation” and “apportionment” are

often used interchangeably in respect of the division of income

among various jurisdictions, “allocation” properly refers to the

“attribution of a particular type of income to a designated state,

[and] ‘apportionment’ refers to the division of the tax base by

formula.” JEROME R. HELLERSTEIN & WALTER HELLERSTEIN, STATE

TAXATION I: CORPORATE INCOME AND FRANCHISE TAXES { 9.01 (3d

ed. 1998).

5In evaluating challenges to state taxing schemes, the Court

examines the practical effect of a challenged tax to determine

whether it “is applied to an activity with a substantial nexus with

the taxing State, is fairly apportioned, does not discriminate

against interstate commerce, and is fairly related to the services

provided by the State.” Complete Auto Transit, Inc. v. Brady, 430

U.S. 274, 279 (1977).

9)

Like many states, California imposes a corporate fran-

chise tax for the privilege of doing business in the State,

which is based on the net income derived from or attribut-

able to sources within the State. Cat. Rev. & Tax Cope

§3 23151 & 25101 (West 1992). Consistent with the

constitutional requirements for corporations doing business

both inside and outside the State, taxability of income

turns first on the unitary business principle which allocates

income to the State—i.e., on whether the out-of-state item

sought to be taxed is “unitary” with, or functionally related

to, the taxpayer’s in-state activities. The amount of oper-

ating income earned in California is then determined by

calculating the net operating income of the unitary busi-

ness and apportioning part of it to California by use of a

formula.* For the years in issue, California used the

apportionment formula set forth in the Uniform Division

of Income for Tax Purposes Act (UDITPA), which com-

pares (i) the taxpayer’s property, payroll, and sales (re-

ceipts) within the taxing State to (ii) the taxpayer’s total

property, payroll, and sales. Cat. Rev. & Tax Cope

§ 25128 (West 1992) (App. at 37a); UDITPA §§ 9-17.

“Non-business income”—such as dividends derived from

an unrelated business activity—is neither allocated nor

apportioned to the State unless the corporation is domi-

ciled there. CAL. REv. & Tax Cope § 25126 (West 1992)

(App. at 37a).

In calculating a taxpayer’s net taxable income, business

interest expense is generally deducted from business in-

6 The formulary apportionment of income by a State has been

recognized by this Court as a valid means of taxation. North-

western States Portland Cement Co. v. Minnesota, 358 U.S. 450, 460

(1959) (“the entire net income of a corporation, generated by in-

terstate as well as intrastate activities, may be fairly apportioned

among the States for tax purposes by formulas utilizing in-state

aspects of interstate affairs’).

10

come. CaL. Rev. & Tax Cope § 24344(a) (West 1992)

(App. at 35a). Under California law, however, taxpayers

must offset their business interest expense—on a dollar-

for-dollar basis—with non-business income not allocable

to the State. CaL. Rev. & Tax Cope § 24344(b) (West

1992) (App. at 35a). Thus, out-of-state corporations

(such as Petitioner Hunt-Wesson) are compelled to reduce

their interest deduction by the amount of their nontaxable

income, without regard to whether the interest expense is

related to the nontaxable income. It is this statute—which

increases Petitioner’s California tax liability—that is at

issue here.

In this case, the trial court concluded on the merits

that section 24344 violates the Due Process, Commerce,

and Equal Protection Clauses of the Constitution. This

latter decision was reversed by the Court of Appeal, First

Appellate District, largely on the force of the Supreme

Court of California’s decision in Pacific Tel. & Tel. Co. v.

Franchise Tax Board, 7 Cal. 3d 544 (1972). As ex-

plained by the Court of Appeal:

Hunt-Wesson contends that the interest offset pro-

vision of section 24344 impermissibly taxes dividends

which are constitutionally immune from taxation by

California, and therefore violates the federal Due

Process Clause. The Due Process Clause limits a

state’s power to impose a tax on an activity which is

not connected with the taxing state. Thus, a state

may not constitutionally tax income [from] dividends

which a nondomiciliary corporation receives from

subsidiary corporations having no other connection

with the state.

Hunt-Wesson argues that the interest offset provision

of section 24344 constitutes an indirect tax on im-

mune income, increasing a nondomiciliary corpora-

IPE LOO SOOT re,

11

tion’s tax liability solely because it receives nontax-

able dividends. Hunt-Wesson also argues that the

interest offset [rule] is overbroad, because it fails to

apportion interest expense, but creates a dollar-for-

dollar offset. If we were writing on a clean slate,

these arguments might appear persuasive. In Pacific

Telephone, however, the California Supreme Court

explicitly held that inclusion of nontaxable dividends

in the statutory offset computation under section

24344 does not constitute taxation of the dividends

themselves.

(App. at 7a-8a (citations omitted).) The Court of Appeal

reached a similar conclusion in respect of Petitioner’s ar-

gument that the interest-offset rule violates the Commerce

Clause, but essentially held that the Pacific Telephone

decision compelled it to sustain the statute. (App. at 9a-

10a.) The California Supreme Court subsequently refused

to review the case. (App. at 43a.)

The Court of Appeal’s decision flows from the principle

of stare decisis—unquestioned reliance on the Pacific

Telephone decision. Subsequent decisions of this Court,

however, unequivocally demonstrate that the 1972 decision

of the California Supreme Court cannot stand. South

Central Bell Tel. Co. v. Alabama, 119 S. Ct. 1180, 1185

(1999); Fulton Corp., 516 U.S. at 327; Oregon Waste

Systems, Inc. v. Department of Environmental Quality,

511 U.S. 93, 99 (1994). See United States v. Gaudin,

515 U.S. 506, 521 (1995) (“stare decisis cannot possibly

be controlling when . . . the decision has been proved

manifestly erroneous, and its underpinnings eroded, by

subsequent decisions of this Court.”).

II.

The Commerce Clause of the Constitution provides that

“Congress shall have Power . . . [t]o regulate Commerce

12

. » » among the several States. . . .” U.S. Const. art. I,

§ 8, cl. 3. The clause not only provides Congress with

broad regulatory powers, but also embodies a negative

command forbidding States from discriminating against

interstate commerce. Oregon Waste, 511 U.S. at 98. Its

fundamental purpose “is to assure that there be free trade

among the several States.” Boston Stock Exchange, 429

U.S. at 335. To effectuate this purpose, a state taxing

scheme will be invalidated if it imposes a higher tax

burden on foreign corporations than on domestic corpora-

tions engaged in comparable activity. Jd. at 329 (“[pler-

mitting the individual States to enact laws that favor local

enterprises at the expense of out-of-state businesses ‘would

invite a multiplication of preferential trade areas destruc-

tive’ of the free trade which the Clause protects” [citations

omitted]); see Maryland v. Louisiana, 451 U.S. 725, 754

(1981); Halliburton Oil Well Cementing Co. v. Reily,

373 U.S. 64, 72-74 (1963). Justifications for discrim-

inatory restrictions on commerce must pass the strictest

scrutiny. Oregon Waste, 511 U.S. at 101.

In this case, the Court of Appeal felt bound by a 1972

decision of the California Supreme Court upholding the

interest-offset provision. (App. at la.) In Pacific Tele-

phone, the taxpayer challenged the California interest-

offset statute as it applied to nondomiciliary corporations.

In reviewing the rule, the California Supreme Court

acknowledged its discriminatory effect on non-residents.

Specifically, the State court conceded that “when viewed

in the light of a domiciliary corporation,” the rule “does

not deprive the taxpayer of any of its interest deduction

but is merely an attempt to provide how the interest ex-

pense shall be allocated as between income from opera-

tions and income from investments.” 7 Cal. 3d at 551

(emphasis in original). The court also commented that

13

the allocation of interest expense is “very favorable” to the

domiciliary corporation. Id. As applied to out-of-state

companies, however, the allocation is manifestly not favor-

able—a fact known to the State when the interest-offset

rule was enacted. /d. at 554 (citing a letter by the Fran-

chise Tax Board to the Governor that the rule will “in-

crease taxes on foreign corporations while reducing those

of domestic corporations” ).”

Commerce Clause jurisprudence has evolved signifi-

cantly since California’s decision in Pacific Telephone.

Nowhere has this evolution been more profound than in

respect of statutory schemes that facially discriminate

against out-of-state commerce. Last term, in South Cen-

tral Bell, this Court invalidated Alabama’s franchise

tax as facially discriminatory because it gave “do-

mestic corporations the ability to reduce their franchise

tax liability simply by reducing the par value of their

stock, while it denies foreign corporations that same abil-

ity.” 119 S. Ct. at 1185. Five years ago, in Oregon

Waste, the Court similarly struck down a surcharge on

the disposal of waste generated out of state, holding that

it impermissibly discriminated against interstate commerce

because it provided “differential treatment of in-state and

out-of-state economic interests that benefits the former

and burdens the latter.” 511 U.S. at 99. Indeed, the

Court held that such a scheme was virtually per se invalid.

Id. Accord Fulton Corp., 516 U.S. at 331 (quoting the

“virtually per se invalid” language of Oregon Waste in

striking down an intangibles tax that was discriminatory

on its face).®

7 The constitutional aspects of the statute were apparently not

challenged in Pacific Telephone.

8 Several other decisions of this Court since Pacific Telephone

also undermine that decision’s continuing vitality. See Camps

14

By its very terms, therefore, the California rule violates

the Commerce Clause. The trial court here acknowledged

the discrimination Petitioner was subjected to: “[{T]he

offset provisions treat two corporations in an identical

business transaction differently based solely on their states

of domicile, which difference results in increased taxes for

foreign corporations.” (App. at 28a-29a.) Hence, if

Petitioner’s subsidiaries were domiciled in California, they

would not face the double taxation effected by the interest-

offset rule. Clearly, for some companies enduring the

rigamarole of relocating their domicile within the State

may be economically worthwhile (compared with the level

of double taxation they could avoid), but other taxpayers

may not have that flexibility owing to the nature of their

businesses or the regulatory regimes in other States.° This

option, moreover, would not be effective should other

States choose to enact similar schemes.2® More funda-

mentally, taxpayers should not be forced to jump through

Newfound /Owatonna, Inc. v. Town of Harrison, 520 U.S. 564 (1997)

(reduction of state property tax exemption for charities operated

principally for the benefit of nonresidents is facially discriminatory

and thus invalid) ; Philadelphia v. New Jersey, 4837 U.S. 617 (1978)

(New Jersey law banning waste imported from other States vio-

lates the Commerce Clause).

® Indeed, even assuming that it would be constitutionally per-

missible to require taxpayers to establish a separate subsidiary in

every State, that option might not be available to some businesses.

For example, a transportation company whose assets and employees

move across state lines would find it impossible to operate in inter-

state commerce through a series of domesticated subsidiaries.

10 In Container Corp., the Court explained that an apportionment

formula will offend the Commerce Clause unless it is marked by

“internal consistency”—*that is to say, unless it is such that “if

applied by every jurisdiction, it would result in no more than all

of the unitary business’ income being taxed.” 463 U.S. at 169. The

California taxing scheme fails this test because, if other States

adopted similar rules, more than 100 percent of Petitioner’s income

would be taxed.

15

the hoop of domesticating their business activities or es-

tablishing subsidiaries in every State in order to avoid

discrimination. See Kraft General Foods, Inc. v. lowa

Department of Revenue & Finance, 505 U.S. 71, 78

(1992). Because the Commerce Clause does not afford

States leeway to discriminate, the California statute must

fall.

III.

The Constitution sets a limit on the power of a single

State to tax the multistate income of a nondomiciliary

corporation. A minimal connection between the interstate

activities and the taxing State is required, as is a rational

relationship between the income attributed to the taxing

State and the intrastate value of the corporate business.

Allied-Signal, Inc. v. Director, Division of Taxation, 504

U.S. 768, 772-73 (1992); ASARCO Inc. v. Idaho State

Tax Comm'n, 458 U.S. 307, 328 (1982). The Due

Process Clause requires that “there must be a connection

to the activity itself, rather than a connection only to the

actor the State seeks to tax.” Allied-Signal, 504 U.S. at

778. In other words, “{[o]ne may not be subjected to

greater burdens upon his taxable property solely because

he owns some that is free.” National Life Ins. Co. v.

United States, 277 U.S. 508, 519 (1928).

In this case, the State of California does not assert that

the taxpayer’s non-business income bears any relation to

its in-state activities. (App. at 16a (“all of the nonbusi-

ness dividends were not taxable by the State of Califor-

nia”).) Nor does the State assert a relationship of any

great moment between that nontaxable, non-business in-

come and the taxpayer’s interest expense. Rather, the

State seeks to tax Petitioner Hunt-Wesson’s extraterritorial

activities by requiring a dollar-for-dollar offset of consti-

tutionally protected income against interest expense. See

Willamette Indus., Inc. v. Franchise Tax Board, 39 Cal.

‘16

Rptr. 2d 757, 760-61 (Ct. App. 1995) (the tax is “ex-

actly the same amount” whether nontaxable dividends are

treated as taxable income or are applied against interest

expense). Such taxing legerdemain—seeking to do indi-

rectly what it cannot do directly—must not stand.

Under Allied-Signal, a State may tax dividend income

only where the payee and payer of the dividend are en-

gaged in a unitary business or the capital transaction

serves an operational—rather than an investment—func-

tion. 504 U.S. at 787. Here, the State seeks to rationalize

its taxation of dividend income by claiming it is closing

a so-called loophole, i.e., that a foreign corporation should

not be permitted to borrow money and build up its interest

expense deduction and then receive tax-exempt dividends

on the basis of investments made with the borrowed

money. Pacific Telephone, 7 Cal. 3d at 554. A suspi-

ciously similar argument was advanced by the State of

New Jersey in the Allied-Signal case. There, in seeking

to repudiate the unitary business principle, the State argued

that multistate corporations regard all their holdings as

asset pools and therefore any distinction between opera-

tional and investment assets is artificial and should be

ignored. 504 U.S. at 784-85. The Court wisely reiected

this strained contention, noting instead that the relevant

inquiry must focus on “the objective characteristics of the

asset’s use and its relation to the taxpayer and its activities

within the taxing State.” Jd. at 785. The dividend income

sought to be taxed here bears no relationship to Petition-

er’s in-state activities and thus California’s contrived at-

tempt to tax it should be rejected as violating due process.

Moreover, the State’s semantics—that the interest-offset

rule is not a “tax” and therefore the precedents of this

Court are not controlling—cannot change the substance

of the statute. It is clear that California could not tax

Petitioner’s dividend income directly. ASARCO Inc., 458

17

U.S. at 327-29. It is also clear that a State may not,

through constitutional alchemy, indirectly tax income be-

yond its jurisdiction. In Westinghouse Electric Corp. v.

Tully, 466 U.S. 388 (1984), the Court clarified that the

denial of a tax exemption (or a deduction) is the eco-

nomic equivalent of a tax:

Nor is it relevant that New York discriminates

against business carried on outside the State by dis-

allowing a tax credit rather than by imposing a

higher tax. The discriminatory economic effect of

these two measures would be identical.

Id. at 404. See also National Life Ins. Co., 277 U.S. at

520 (“What remains after subtracting all allowances is

the thing really taxed.”).™ In other words, formal dis-

tinctions lacking in economic substance have no constitu-

tional significance. Westinghouse Electric Corp., 466 U.S.

at 405. Thus, “[a] tax on sleeping measured by the

number of pairs of shoes you have in your closet is a tax

on shoes.” Trinova Corp. v. Michigan Dep’t of Treasury,

498 U.S. 358, 374 (1991) (citation omitted). Cf. Bass,

Ratcliff & Gretton, Ltd. v. State Tax Comm'n, 266 U.S.

271, 282-83 (1924) (States’ efforts to tax income from

non-unitary entities is “a mere effort to reach profits

earned elsewhere under the guise of legitimate taxation”).

The State characterizes the interest-offset rule as a

rational attempt to “correlate expenses between taxable

and nontaxable income in order to determine the extent

to which a deduction should be allowed.” Brief of Fran-

chise Tax Board in Opposition to Petition for Writ of

11 The Macallen Co. v. Massachusetts, 279 U.S. 620, 629 (1929)

(“The fact that a tax ostensibly laid upon a taxable subject is to be

measured by the value of a non-taxable subject at once suggests

the probability that it was the latter rather than the former that

the law-maker sought to reach.”).

18

Certiorari, Hunt-Wesson, Inc. v. Franchise Tax Board,

No. 98-2043, at 16 (hereinafter cited as “Br. Op.”). The

State’s argument conveniently ignores that non-business

interest expense is deducted before the interest-offset rule

is applied.» What is more, the statute makes no attempt

to allocate the business interest expense to related income.

Rather, it requires a dollar-for-dollar offset of the expense

against non-business income, with no matching of expense

to income being permitted.

That California’s taxing scheme indirectly taxes constitu-

tionally protected income cannot be denied. Consider the

following example of the effect of the law on in-state and

out-of-state companies:

Example 1. Parent (P), domiciled in Illinois with a

non-unitary subsidiary (Sub A), does business in

California. P has business income of $200, business

interest expense of $150, non-business interest ex-

pense of $25, and no business interest income. Sub

A pays no dividends to P.

The $25 in non-business interest expense is excluded,

since none of that expense is deductible in Califor-

nia.*¥ The $150 in business interest expense is de-

ducted from the $200 in business income. Thus, P’s

income subject to apportionment by California is

$50.

12 In opposing the Court’s review of the decision below, the State

claimed (Br. Op. 17 n.9) that nothing in the statute requires the

elimination of non-business interest expense as part of the calcula-

tion of the interest expense deduction. The State stipulated, how-

ever, that the interest-offset rule applies only to business interest

expenses after the deduction of non-business interest. Stip. { 11.

The form used to calculate the offset is consistent with this stipula-

tion. See Form 100 (California Corporation Franchise or Inccme

Tax Return), Schedule R-5 (Computation of Interest Offset).

13 Non-business interest expense is allocated entirely to the state

of domicile, in this example, to Illinois.

19

Now consider what happens to P’s apportionable income

if P receives dividend income:

Example 2. Assume the same facts in Exampie 1,

except that Sub A pays to P a $100 dividend. Be-

cause Sub A is not a unitary business with P, the

dividend is non-business income, and because P is

domiciled in Illinois, the $100 is allocated entirely to

that State and is not subject to California tax.

The $25 in non-business interest expense is still ex-

cluded, since none of that expense is deductible in

California. The $150 in business interest expense,

however, is now offset against the $100 dividend,

leaving only a deduction of $50. Hence, only $50 is

subtracted from P’s $200 in business income, thereby

increasing P’s income apportionable by California to

$150.

As P receives non-business income—income indisput-

ably immune from California taxation by virtue of the

Commerce Clause—its California tax liability should not

change. Instead, under California law, P’s tax base sub-

ject to apportionment actually increases—an_ increase

solely attributable to the effect of the interest-offset rule.

By linking the interest deduction to the receipt of non-

taxable dividends, California indirectly exacts a tax on the

on-business income of out-of-state corporations.

The State of California asserts (in its brief in opposi-

tion) that the interest-offset rule is necessary to close a

“loophole” and prevent taxpayers from realizing a “wind-

fall.” (Br. Op. 11-12.) The argument that the Constitu-

tion creates a loophole speaks volumes about the State’s

motivation here, for the interest-offset rule was designed

to yield an impermissible windfall to the State, without

regard to whether it resulted in double taxation. Consider

the following example:

20

Example 3. P, domiciled in Illinois, does business

equally in that State and in California. P has a total

net income of $125, computed, as follows: $200

business income, $100 non-business dividend income,

$150 business interest expense, and $25 non-business

interest expense. P is taxed on this income, as

follows:

California Illinois

Business Income $200 $200

Busines Interest Expense (150) (150)

Interest Offset 100 0

apportionable Income $150 $ 50

Apportionment % 50% 50%

Taxable Business Income $75 $25

Non-business Div. Income 0 $100

Non-business Interest Exp. 0 (25)

Taxable Non-business Inc. Pu. 2 $75

Aggregate Net Taxable

Income $75 $100

Thus, as a result of California’s interest offset, P is

taxed on $175 of income, rather than its net income of

$125; $50 in income is therefore subject to double taxa-

tion.

In Allied-Signal, the Court vivified the “necessary limit

on the States’ authority to tax value or income that cannot

in fairness be attributed to the taxpayer’s activities within

the State.” 504 U.S. at 780. “[{Acting] as a defense

against state taxes which, whether by design or inadvert-

ence, . . . attempt to capture tax revenues that, under the

theory of the tax, belong of right to other jurisdictions,”

Trinova Corp., 498 U.S. at 386, the Court must suspend

its disbelief about the true effect of California’s taxing

21

scheme here. It is to impose an unconstitutional burden on

Petitioner Hunt-Wesson and similarly situated taxpayers.

The State’s attempt to reach Petitioner’s nontaxable

income by reducing its interest expense has the same effect

as a direct tax on that income and cannot in fairness be

sustained. The Court of Appeal did not dispute this.

Indeed, while rejecting Petitioner's challenge on stare

decisis grounds, the court below observed that “[i]f we

were writing on a clean slate, these arguments might

appear persuasive.” (App. at 8a.) The court’s reliance

on the manifestly erroneous decision in Pacific Telephone,

however, was clearly misplaced. See United States v.

Gaudin, 515 U.S. at 521. This Court can correct the error

by wiping the slate clean and striking down the interest-

offset rule because it violates the Due Process Clause of

the Constitution.

CONCLUSION

For the foregoing reasons, the Court should reverse

the decision below.

Respectfully submitted,

TIMOTHY J. MCCORMALLY *

MARY L. FAHEY

JEFFERY P. RASMUSSEN

TAX EXECUTIVES INSTITUTE, INC.

1200 G Street, N.W.

Suite 300

Washington, D.C. 20005-3814

(202) 638-5601

Counsel for Amicus Curiae

* Counsel of Record Tax Executives Institute, Inc.

November 10, 1999