California interest-offset rule is discriminatory and should be struck down, TEI urges Supreme Court.

A California statute that requires out-of-state corporations to offset their legitimate interest expense against non-taxable income violates the United States Constitution, Tax Executives Institute told the Supreme Court of the United States in a "friend of the court" brief filed on July 22. In Hunt-Wesson, Inc. v. Franchise Tax Board, TEI urged the Court to review the case and strike down California's interest-offset rule for violation of the Constitution's Commerce Clause and Due Process Clause.

Like many states, California imposes a corporate franchise 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 income. 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 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 TEI believes is unconstitutional.

In this case, the trial court concluded that section 24344 violates the Due Process and Commerce Clauses of the Constitution. This decision was reversed by the Court of Appeal, First Appellate District, largely on the force of the Supreme Court of California's 1972 decision in Pacific Telephone & Telegraph Co. v. Franchise Tax Board. TEI pointed out, however, that subsequent decisions of the U.S. Supreme Court -- such as the South Central Bell Telephone case decided earlier this year -- "unequivocally demonstrate that the State's 1972 decision cannot stand."

In Pacific Telephone, the taxpayer challenged the California interest-offset statute as it applied to nondomiciliary 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 allocated as between income from operations and income from investments. The court also commented that the allocation of interest expense is "very favorable" to the domiciliary corporation. "As applied to out-of-state companies, however, the allocation is clearly not favorable," TEI stated. "Hence, on its face, the rule violates the overarching principle ... that an apportionment formula must, first and foremost, be fair."

The Institute also urged the Supreme Court to overturn the statute under the Due Process Clause, which requires a minimal connection between the interstate activities and the taxing state. "California does not contend that the non-business income at issue here bears any relation to [Hunt-Wesson's] in-state activities," TEI said. "Rather, the state taxes the income indirectly by requiring a dollar-for-dollar offset of constitutionally protected income against interest expense." The Institute urged the Court to reject California's covert attempt to tax the income as violative of due process.

TEI also noted that 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 Hunt-Wesson's dividend income directly," the Institute stated. "It is also clear that a state may not, through sleight of hand, indirectly tax constitutionally protected income."

A decision by the U.S. Supreme Court concerning whether to review the case is expected this fall.

TEI's brief is reprinted in this issue of The Tax Executive, beginning on page 357.