Amicus curiae brief on behalf of Tax Executive Institute, Inc. in support of plaintiffs-appellants.

IN THE SUPREME COURT OF THE STATE OF CALIFORNIA No. S127086

GENERAL MOTORS CORPORATION, et al., Plaintiffs and Appellants,

v.

FRANCHISE TAX BOARD, Defendant and Appellant.

On April 27, 2005, Tax Executives Institute filed the following brief amicus curiae in General Motors Corporation v. Franchise Tax Board with the Supreme Court of California regarding the Franchise Tax Board's failure to adhere to the unitary business principle in administering California's research tax credit. Last August, TEI sent letter a supporting General Motors' petition requesting the California Supreme Court review the case; that letter appears in the September-October 2004 issue of The Tax Executive at page 412. The brief was prepared under the aegis of the Institute's State and Local Tax Committee, whose chair is Janet M. Wilson of Halliburton Company. Ed. note: Because no member of the Institute's legal staff is admitted to practice in California, Kendall L. Houghton of Sutherland Asbill & Brennan LLP agreed to serve as TEI's counsel of record.

I. Introduction

Tax Executives Institute, Inc. ("TEI" or "the Institute") respectfully requests that the decision of the Court of Appeal that only one member of General Motors Corporation's California unitary group ("unitary group") is entitled to a research credit against the group's California tax liability be reversed.

TEI, organized in 1944, is a voluntary, non-profit association of corporate and other business executives, managers, and administrators who are responsible for the tax affairs of their employers. The more than 2,800 multi-jurisdictional companies represented by the Institute's nearly 5,700 members are significantly affected by the allocation and apportionment of income and expenses--along with the attendant issues related to computation of tax liability--among the various states.

Today, TEI has five California-based chapters and a majority of its non-California-based members work for companies with property, payroll, or sales in the state. Moreover, the companies represented by TEI members collectively engage in substantial research activities, both in California and elsewhere. Thus, the disposition of the research tax credit issue in this case is a concern not only for members within the Institute's five chapters located in California, but for all its members whose companies conduct research activities within the state.

General Motors Corporation and certain affiliated commercial enterprises ("General Motors") compose a unitary business for California tax purposes. California uses the definition of unitary business recognized by the Supreme Court of the United States a quarter-century ago: a business that exhibits "contributions to income resulting from functional integration, centralization of management, and economies of scale." Mobil Oil Corp. v. Comm'r of Taxes, 445 U.S. 425, 438 (1980). The Franchise Tax Board ("FTB") acknowledges that to pass constitutional muster, a finding of a unitary business must be predicated on "a flow of value, not a flow of goods." Container Corp. v. Franchise Tax Bd. 463 U.S. 159, 178 (1983). See FTB Publication 1061, 2004 Guidelines for Corporations Filing A Combined Report 3 (2004) ("[O]nce it is determined that a business with income from sources within and outside the state is unitary, formulary apportionment MUST be utilized.").

Pursuant to Section 23609 of the Revenue and Taxation Code of California, in 1988 General Motors claimed a research credit for its qualifying activities in the state. Section 23609 authorizes a tax credit for California research expenses, based in substantial part on the federal research tax credit provided by Section 41 of the Internal Revenue Code. (1) On audit, the FTB limited the entire amount of the credit to the one member of the unitary group (Delco Electronics) that had nominally incurred the research expenses for the benefit of the unitary group, even though the research expenses had been apportioned among the members of the unitary group in accordance with California's mandatory apportionment formula. As a result of the FTB determination, General Motors was denied the benefit of more than half of the research credit for the 1988 tax year. (2) The FTB's determination was upheld by the Court of Appeal.

No dispute exists regarding the composition of the unitary group subject to California's franchise tax. There is also no dispute regarding the apportionment of income and expenses (including California research expenses) among the members, or even the computation and amount of the California research credit. Rather, this case arises because of the FTB's unfounded singling-out of one member of the unitary group and insistence that it be treated as a separate entity insofar as California's research tax credit is concerned.

II. Argument

By upholding the FTB's single-entity limitation on the application of California's research tax credit in this case, the Court of Appeal ignores the doctrinal underpinnings of the unitary business principle. It likewise misapprehends the operation of California's research tax credit, and, in so doing, renders it inconsistent with unitary theory. The FTB limitation thwarts the intended policy and purpose of the tax credit.

A. General Motors Properly Apportioned the Research Tax Credit In a Manner Consistent with the Unitary Business Principle.

The unitary business principle provides a framework for taxing the income of multistate enterprises. Under the unitary business doctrine, a taxing authority may treat a business conducted by related entities earning income both within and without the state as one unit in determining the income attributable to the state. Jerome R. Hellerstein & Walter Hellerstein, State Taxation I: Constitutional Limitations and Corporate Income and Franchise Taxes [paragraph] 8.07[1] (3d ed. 1998). Inherent in the unitary concept is the tenet that one cannot attribute any element of income or expense to any specific member of the unitary group because the activities of all members contribute to the income and expenses of the combined group:

   In the case of a unitary business, the expenses
   incurred in any particular state are not incurred
   solely in furtherance of the business within the
   state's borders and should not be so considered.
   Instead they are incurred in furtherance of the
   business as a whole and should be so charged.

F.M. Keesling & J.S. Warren, The Unitary Concept in the Allocation of Income, 12 Hastings L. J. 42 (1960).

Under California's unitary system, the in-state tax base is calculated by first defining the scope of the unitary business, of which the taxed enterprise's activities in the taxing state form one part, and then apportioning the total income and expenses of the unitary business between the taxing state and other jurisdictions based on a formula that takes into account objective measures of the corporation's activities within and without the jurisdiction. Container, 463 U.S. at 165. Because the income and expenses--including the California research expenses giving rise to the California research tax credit--were apportioned among the members of the unitary group, General Motors rightly divided the credit among the members of the group, applying a proportionate share to each just as it had done in determining each member's net income subject to tax.

In contrast to the approach used by General Motors, the FTB's determination--unfettered by principle or consistency--distorts the unitary tax system by artificially imposing a separate-entity limitation on the availability of the credit. The research credit is based upon research expenses--expenses the FTB concedes were properly apportioned among the members of the unitary group in determining net income for California tax purposes. Nevertheless, the FTB balks at apportioning the credit. The sine qua non of the unitary business principle is the elimination of artificial line-drawing between entities engaged in the same general enterprise. To apportion research expenses but not the related credits is to rob the rules of their logic, exalt form over substance, and undermine the foundation--and, ultimately constitutionality--of California's business tax system.

Moreover, the FTB's position defeats one of the primary purposes of the unitary concept. The unitary concept was designed to obviate the artificial shifting of income and expenses between related entities. If the Court of Appeal decision upholding the FTB's approach is not reversed, businesses will be tempted to change the way they do business or otherwise engage in unnecessary modifications to their organizational structures to enable members of the unitary group to fully utilize the research credit. This Court should reverse the decision below, which will result in a consistent application of the unitary business principle and re-invigorate California's research tax credit.

States are free to employ either a separate-entity or unitary apportionment approach in taxing multi-jurisdictional businesses as long as they respect constitutional restraints and consistently apply their approach. Regrettably, what the FTB has done here is adopt a "heads I win, tails you lose" approach to unitary apportionment by isolating a tax attribute (in this case the research tax credit) generated by a unitary enterprise. The FTB's attempt to gerrymander California's tax system should not stand.

B. General Motors Properly Apportioned the Research Tax Credit Consistent with California's Tax Law In Light of the Unitary Business Principle.

The Court of Appeal devotes a considerable amount of its opinion discussing the term "taxpayer," since under California's tax regime, tax liability ultimately falls on, and payment is remitted by, the individual members of a unitary group. (3) The court suggests the credit cannot be separated from the unitary group member that performed the research activities (Delco Electronics), despite the unitary business principle underlying California's tax system. The relevant question, however, is not whether California imposes a separate tax on each member of a unitary group, but how that tax is determined. (4) Thus, the issue before this Court is which corporations, under California's unitary system, are deemed to have incurred the research expense.

Under the unitary business principle, unitary group members are deemed to have shared the income and expenses of the entire group. This is the essence of the "flow of value" that exists among the members. Therefore, because each member of the unitary group is deemed to have shared a portion of the research expense, each member of the group is entitled to a proportionate share of the research credit. Indeed, R.T.C. Section 23036(g) invites just such an approach for unitary businesses:

   Unless otherwise provided, if two or more taxpayers
   share in costs that would be eligible for a tax credit
   allowed under this part, each taxpayer is eligible
   to receive the tax credit in proportion to his or her
   respective share of the costs paid or incurred.

Members of the unitary group, among which income and expenses are deemed to be shared as a matter of law, are eligible to take credits in proportion to their share of expenses. This is precisely what General Motors did in this case. When applied in a manner consistent with California's unitary tax regime, Section 23036(g) prescribes apportionment of tax credits--in the same manner that the expenses giving rise to the credits are apportioned--among members of the unitary group.

The FTB also argues that because California's research tax credit statute is based on the federal research tax credit authorized in I.R.C. Section 41, the mechanics of applying the federal credit among a group of controlled corporations justifies the FTB's approach. Their analogy to the controlled-group mechanics of Section 41 is inapposite, however, without being guided by unitary theory. Complete harmonization of the federal and California research tax credit provisions is impossible, given the fundamental distinction between the concept of a controlled group of corporations for federal taxation and the concept of a unitary group of businesses for state taxation. (5) The FTB's reliance on the federal provision's controlled-group mechanics in order to limit California's research credit is misplaced. The mechanics of the federal rule were designed to deal specifically with members of a controlled group of corporations. They were not designed to deal specifically with members of a unitary group for state tax purposes. Moreover, under R.T.C. Section 23051.5(h)(7), the incorporation of I.R.C. Section 41(f)(1) into California's statute is to be read in terms of the unitary concept because "account shall be made for differences in federal and state terminology." (6)

III. Conclusion

This case has ramifications well beyond the dollars at stake for General Motors Corporation and other business enterprises operating in California. Because of the significance of the state's economy and its status as a compact member of the Multistate Tax Commission, California plays a prominent role in the development of tax policy among the states. Should California apportion gross income and expenses in accordance with the unitary principle while allocating the credits arising from the very same (unitary) expenses to separate members of the unitary group, the unitary business principle will be undermined. Equally important, the incentive effect of the research tax credit will languish. In upholding the FTB's determinations, the Court of Appeal misconstrued California's research tax credit and how it can and should be cohesive with the unitary business principle. Therefore, this Court should reverse the decision below.

(1) R.T.C. Section 23609 allows a tax credit "in an amount determined in accordance with Section 41 of the Internal Revenue Code" for research expenses.

(2) Although the balance of the credit has been carried over to subsequent tax years by Delco Electronics, a portion of the credit remains unused.

(3) In fact, the issue associated with the availability of the research tax credit is distinct from the apportionment calculation issues considered in Appeal of Joyce, Inc., Cal. St. Bd. of Equaliz., Dkt. No. 66-SBE-070 (Nov. 23, 1966) and Appeal of Finnigan, Cal. St. Bd. of Equaliz., Dkt. No. 88-SBE-022 (Aug. 25, 1988).

(4) Under California's unitary tax regime, the ultimate liability for tax does indeed fall on the individual members of a unitary group and is remitted individually. The income and expenses giving rise to the research credit and the tax liability of each member, however, are determined on a group basis and apportioned to the members of the unitary group.

(5) The FTB acknowledges this distinction, Respondent's Answer Brief on the Merits, p.50, n.21.

(6) R.T.C. Section 23051.5(h)(7). In any event, Section 41 was incorporated into R.T.C. Section 23609 for purposes of determining the amount of the credit, and not its application. To the extent Section 41 does apply, it supports the General Motors' approach because in determining the amount of the credit "all members of the same controlled group of corporations shall be treated as a single taxpayer," with each member of the group entitled to a credit equal to "its proportionate share of the increase in qualified research expenses giving rise to the credit." I.R.C. Section 41(f)(1).