Constitutionality of California's interest offset rule.

February 23, 1998

On February 23, 1999, Tax Executives Institute urged the California Supreme Court to review two cases involving the constitutionality of the State's so-called interest offset rule. In two cases pending before the court -- Hunt-Wesson, Inc. v. Franchise Tax Board, Cal. Supreme Court No. S096104, and F.W. Woolworth Co. v. Franchise Tax Board, Cal. Supreme Court No. S076083 -- the issue is whether the offset provision, which reduces a nondomiciliary company's interest expense deduction, dollar-for-dollar, for dividends received from nonunitary subsidiaries, discriminates against out-of-state companies and therefore violates both the Commerce and Due Process Clauses of the United States Constitution. The Institute's submission, which took the form of a letter to the Chief Justice and Associate Justices of the Court and was prepared under the aegis of the Institute's State and Local Tax Committee, whose chair is Amy J. Eisenstadt of the General Electric Company, recommends that the court review local court decisions upholding the statute.

Pursuant to Rule 14(b) of the California Rules of Court, Tax Executives Institute ("TEI" or "the Institute") submits this letter in support of the petitions for review in the above-captioned cases.

Nature of Amicus Curiae's Interest

Tax Executives 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 approximately 5,000 members who represent 2,800 of the leading businesses in the United States and Canada, nearly all of which are engaged in interstate commerce and, indeed, in commerce with California.

The members of the Institute represent a cross-section of the business community in North America, with nearly 650 of TEI's members belonging to chapters in California. The Institute 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 compliance to the benefit of both the government and taxpayers, and to vindicating the due process and Commerce Clause rights of business taxpayers.

Tax Executives Institute's members have a vital interest in the resolution of these cases, which involve the validity 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 provides for reduction of a company's interest expense deduction for each dollar of dividends received from nonunitary subsidiaries. Even those members whose companies are not doing business in California are, almost without exception, engaged in interstate commerce. Consequently, they benefit from, and are entitled to, the positive business environment assured 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 by the Court's decision whether to review the Hunt-Wesson and F.W. Woolworth cases, the Institute has a special interest in the outcome of these cases.

This Court Should Grant Review

The issue involved in these cases is the constitutionality of the interest offset rule in section 24344 of the California Revenue and Taxation Code. Under this rule, a non-California domiciled company may deduct interest expense to the full extent of business interest income, but must reduce its deduction for interest expense, dollar for dollar, for its non-business (specifically, dividend) income, which is not subject to apportionment but rather is allocated to, and subject to tax by, the company's state of domicile. California-based companies, however, are not subject to the interest offset rule. Because of the disparate treatment, non-California companies have challenged the rule, arguing that it facially discriminates against them in violation , both the Commerce Clause and the Due Process Clause.

In the F.W. Woolworth case, the trial court upheld the statute again a constitutional challenge. In contrast, the trial court in Hunt-Wessor concluded on the merits that section 24344 violates the Due Process Equal Protection, and Commerce Clauses of the Constitution. This later decision was reversed by the Court of Appeal, First Appellate District largely on the force of this Court 1972 decision in Pacific Tel. & Tel. Co. v. Franchise Tax Board, 7 Cal.3d 544 (1972). As explained by the Court of Appeal:

   Hunt-Wesson contends that the interest offset provision 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 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 immune income, increasing a nondomiciliary
   corporation's tax liability solely because it receives nontaxable
   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. (Citations omitted.)

The Court of Appeal reached a similar conclusion in respect of Hunt-Wesson's argument that the interest offset rule violates the Commerce Clause; the court concluded that the Pacific Telephone decision impelled it to sustain the statute.

Hence, the Court of Appeal's decision in Hunt-Wesson is essentially based on the principle of stare decisis -- reliance on the Pacific Telephone decision. It is respectfully suggested, however, that the persuasive force of this Court's 1972 decision in Pacific Telephone has been greatly attenuated if not vitiated by the passage of time and the development of the controlling constitutional doctrine. Indeed, although the Court of Appeal attempts to distinguish several intervening decisions of the Supreme Court of the United States, amicus TEI submits that the court's continued adherence to Pacific Telephone cannot withstand scrutiny.

Commerce Clause jurisprudence has significantly evolved since this Court's decision in Pacific Telephone, and nowhere has this evolution been more profound than in respect of statutory schemes that facially discriminate against out-of-state commerce. For example, in Oregon Waste Systems, Inc. v. Department of Environmental Quality, 511 U.S. 93 (1994), the U.S. Supreme Court invalidated 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 instate and out-of-state economic interests that benefits the former and burdens the latter." Id. at 99. Indeed, the Supreme Court held that such a scheme was invalid virtually per se. Similarly, in Fulton Corp. v. Faulkner, 516 U.S. 325 (1996), the U.S. Supreme Court quoted the "virtually per se invalid" language of Oregon Waste in striking down an intangibles tax that was discriminatory on its face. Id. at 331.(1)

These two decisions are especially important because this Court in Pacific Telephone -- long before the U.S. Supreme Court confirmed that facial discrimination was per se unconstitutional -- acknowledged the discriminatory effect of the interest offset rule. Specifically, this Court said that the rule "when viewed in the light of a domiciliary corporation ... does not deprive the taxpayer of any of its interest deduction," 7 Cal.3d at 551, whereas such a deprivation clearly occurs in respect of out-of-state companies. Moreover, the Court noted that at the time of its enactment the Franchise Tax Board explained the interest offset rule would "increase taxes on foreign corporations while reducing those of domestic corporations." Id. at 554.

Conclusion

Stated simply, the interest offset rule operates to the disadvantage of taxpayers that are domiciled outside of California, and accordingly, its ongoing constitutionality is quite dubious. Given the virtual per se rule that the United States Supreme Court has adopted to test such statutes in recent years, there is a compelling reason for this Court to grant the petitions in these cases and to review the cases. Accordingly, amicus TEI respectfully requests that the Court do SO.

TEI's 1999 Federal Tax Courses

Level I: May 2-7, 1999 Michigan State University's Kellogg Center

The Level I course is designed for individuals with less than four years' experience in federal tax matters, and will provide a basic overview of the taxation of corporations. Topics include:

* Tax Accounting Periods and Methods

* Uniform Capitalization Rules

* Tax Accounting

* Capital Asset Accounting

* Taxation of Employee Compensation

* Alternative Minimum Tax

* Preparing Form 1120

* Financial Accounting for Taxes

* Foreign Source Income

Level II: June 20-25, 1999 Michigan State University's Kellogg Center

The Level II course, aimed generally at individuals with between four and eight years of federal tax experience, provides a more advanced study of corporate taxation. Topics include:

* Corporate Organizations, Distributions, and Liquidations

* Consolidated Returns

* Mergers, Acquisitions, and Reorganizations

* Joint Ventures and Partnership Issues

For information, call TEI at [phone].

(1) There have been several other decisions of the U.S. Supreme Court since Pacific Telephone that undermine that decision's continuing vitality. See Camps Newfound/Owatonna, Inc. v. Town of Harrison, 520 U.S. 564 (1997) (reduction of state property tax exemption for charities operated principally for benefit of nonresidents was facially discriminatory and thus invalid); Philadelphia v. New Jersey, 437 U.S. 617 (1978) (New Jersey law banning waste imported from other States violated the Commerce Clause).