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For whom the South Central Bell tolls.

The U.S. Supreme Court strikes a blow for the Commerce Clause.

Since the early days of our nation, the authority of the individual states to tax and the U.S. Constitution's commandment to allow interstate commerce to flow unimpeded have been at cross-purposes. In South Central Bell Telephone Co. v. Alabama, 526 U.S. 160, 119 S. Ct. 1180 (1999), the U.S. Supreme Court has penned the latest chapter in the struggle. In its decision, the Court clearly and succinctly declared that the franchise tax Alabama assesses on "foreign" (out-of-state) corporations violates the Constitution's Commerce Clause (see box, below) and is therefore unenforceable. This decision has important implications for corporations that do business in more than one state and find they may be subject to similar taxes.


The facts of the case are relatively straightforward. Alabama requires any corporation doing business within its borders to pay a franchise tax based on the company's capital. A corporate entity organized under Alabama law must pay a tax of 1% of the par value of company stock. This tax exists not only in Alabama statute but is part of the state's constitution as well. However, a corporation organized under the laws of another state--a so-called foreign corporation--must pay Alabama a tax equal to 0.3% of the value of the "actual amount of capital employed" (the capital used or invested) in the state. This tax also is a matter of statute and part of the Alabama constitution.

Alabama law grants a resident company considerable leeway in controlling both its tax base and its tax liability. An Alabama corporation may set its stock's par value at a level well below its book or market value. However, this freedom is not granted to any foreign corporation doing business in the state. Instead, Alabama uses a more complicated formula to calculate its foreign corporation franchise tax. A foreign entity must use the value of its "actual" capital, which includes not only capital stock but other accounting items as well, including long-term debt and surplus, all of which depend on the corporation's financial status.

South Central Bell and its fellow plaintiffs contended that the Alabama franchise tax substantially discriminated against foreign corporations. Moreover, the company said the Alabama domestic shares tax--which foreign corporations do not pay--did not offset the discrimination resulting from the foreign corporation franchise tax.

The Alabama state court agreed with the plaintiffs. When viewed in light of U.S. Supreme Court rulings on the Commerce Clause, the evidence clearly demonstrated the Alabama foreign franchise tax was discriminatory in assessing a greater burden on the plaintiffs simply because they were incorporated in a state other than Alabama. Nonetheless, the state court dismissed South Central Bell's claims for reason of res judicata--it said the matter had been settled in a previous Alabama case with different parties and thus need not be tried a second time. South Central Bell decided, however, to appeal the case to the U.S. Supreme Court. Given the constitutional implications, it's not surprising the Court granted the company's petition for review.


A unanimous Supreme Court wasted no time in resolving this dispute. Writing for the Court, Justice Breyer began by saying "the basic question is whether the franchise tax Alabama asserts on foreign corporations violates the Commerce Clause." The justices concluded the tax was in violation and therefore unconstitutional.

Of critical importance, according to Justice Breyer, was that Alabama law defined a domestic corporation's tax base as including only one item--the par value of capital stock--which a domestic company could set at whatever level it chose. On the other hand, a foreign corporation's tax base contained "many additional balance sheet items that are valued in accordance with generally accepted accounting principles, rather than by arbitrary assignment by the corporation."

Accordingly, and as Alabama admitted, state law gave domestic corporations the "ability to reduce their franchise tax liability simply by reducing the par value of their stock, while it denies foreign corporations the same ability." No one, Justice Breyer said, claimed the different tax rates for foreign and domestic corporations offset these significant differences in their tax bases.

The Court held the tax "therefore facially discriminates against interstate commerce and is unconstitutional unless the State can offer a significant justification for it." (See Fulton Corp. v. Faulkner, 516 U.S. 325 [1996], which concerned a state tax that required shareholders in out-of-state corporations to pay tax on a higher percentage of share value than shareholders of corporations operating solely within the state. According to the decision, that state discriminated on its face in violation of the Commerce Clause). The Supreme Court called the discrimination in South Central Bell not merely theoretical; the undisputed record showed the average Alabama domestic corporation paid only 20% of the franchise tax it would pay if treated as a foreign corporation.

The justices said Commerce Clause jurisprudence demanded that the state demonstrate a "sufficient justification" for discriminatory taxation in order to preserve the validity of such assessments. Alabama could not do so. (Compare Henneford v. Silas Mason Co., 300 U.S. 577 [1937], where the court upheld a discriminatory use tax as "complementary" to a domestic sales tax).

Justice Breyer wrote that Alabama could not justify its discrimination on the ground that its foreign franchise tax was a "complementary" or "compensatory" tax to offset the burden the domestic shares tax imposed on Alabama corporations. A discriminatory tax could not be upheld as compensatory unless the state proved the special burden the franchise tax imposed on foreign corporations was "roughly ... approximate" to the burden on domestic corporations and the taxes were similar enough "in substance" to be "mutually exclusive" proxies for one another. (See Oregon Waste Systems, Inc. v. Department of Environmental Quality of Oregon, 511 U.S. 93, 103 [1994].)

In South Central Bell, the tax burdens were not roughly approximate. Indeed, the facts amply showed the burden of Alabama's foreign franchise tax far exceeded that of its domestic franchise and domestic shares taxes combined. Notably, added the Court, Alabama made no effort to persuade the Court the facts were other than as stated by South Central Bell.

Alabama's two tax burdens also failed the second --"substantially similar"--prong of the test. Alabama, the Court explained, imposed its foreign franchise tax based on a company's decision to do business in the state. By contrast, the state imposed its domestic shares tax on the basis of ownership of a certain form of property--shares in Alabama corporations. "No one," said Justice Breyer, "has explained to us how the one could be seen as a `proxy' for the other."

In summary, the Court unequivocally held that Alabama's foreign corporation franchise tax was unconstitutional, as a violation of the Commerce Clause, and therefore could not be enforced. The high court remanded the South Central Bell case to the Alabama state courts for further proceedings consistent with its ruling.


South Central Bell is the latest in a long line of Commerce Clause cases. It is an unfortunately typical example of a state attempting to enforce what is arguably a discriminatory tax. Surprisingly, Alabama was not subtle in its discrimination. There was a marked difference in the components of the franchise tax base for domestic and foreign corporations. The latter had virtually no leeway to minimize their Alabama franchise tax liabilities. Given those Facts, it was not surprising the Supreme Court found the Alabama foreign franchise tax to be unconstitutional.

The basic guarantee of the Commerce Clause is to prohibit discrimination absolutely. Such wrongful action impedes, if not destroys altogether, the free flow of goods and services between states. Interstate commerce is the economic lifeblood of the United States. The Court has never tolerated any state's discrimination against citizens of other states even when those citizens were corporate entities and the discrimination was supposedly merely one of taxation.

In these days of overlapping tax jurisdictions, it is even more imperative that the constitutional guarantee of the Commerce Clause be honored in fact as well as in theory. South Central Bell clearly does that; state lawmakers should draw the right lesson from the high court's edict and eliminate tax structures that run counter to the decision. This nation's founders correctly concluded that anything other than a completely neutral state tax structure would choke off interstate commerce, to the detriment of all. It is to be hoped state lawmakers will not try, instead, to legislate taxes that discriminate in more subtle ways in an effort to circumvent South Central Bell entirely.


South Central Bell has many implications for U.S. corporations. The mere issuance of this opinion requires every multistate corporation to carefully compare its individual tax burden in states where it is a foreign corporation to the burden borne by its native counterparts. In striking down Alabama's discriminatory tax, the justices practically invited corporate America to undertake such a review to weed out similarly flawed state tax assessments. Indeed, while the tax formula in this case was so obviously skewed against outside businesses, other states may be much subtler in their favoritism.

This means a company--working within the guidelines set by the high court--must undertake a careful analysis to uncover such discrimination. For an out-of-state corporation, doing so may be as simple as obtaining the tax forms for domestic corporations and recalculating its tax liability as if it were headquartered in the state. If the resulting tax is lower, the company must do more research to determine why the differences exist. In some cases, a more sophisticated comparison of a state's tax laws may be required.

When it finds active discrimination, corporate America should not hesitate to act by undertaking a legal challenge. Given the U.S. Supreme Court's latest edict, it's clear lower courts will not tolerate any state tax they find offensive. Corporations seeking to ease their tax burdens lawfully should proceed at full speed with a high degree of confidence that South Central Bell will go a long way toward assuring them a victory in court.

The Supreme Court's decision is not a call to action only for businesses. Progressive states also should take heed and examine their own tax policies. If they are found to be defective based on South Central Bell, the state government should take steps to eliminate the problem by adjusting tax rates to acceptable levels. Any jurisdiction that does so will sacrifice nothing (since it is not entitled to the extra revenue anyway) and may gain recognition from the business community for its fair treatment. If nothing else, local authorities can avoid pointless litigation.

Finally, corporations recognizing discrimination in certain state taxes can simply refuse to do business in such jurisdictions. Without spending a penny on litigation--and only temporarily forgoing business opportunities--a company can serve notice on offending jurisdictions that it is time to change their tax policies in line with South Central Bell or give up significant legitimate tax revenue.


South Central Bell is a critical landmark in the ongoing evolution of the Commerce Clause and the power of the individual states to tax. The boundaries of what a state can and cannot do in assessing tax against its own citizens and citizens of other states have been clearly set and marked over the centuries. For parties that have been discriminated against in matters of state taxation, South Central Bell represents a welcome development as they seek to vindicate their rights. For any state guilty of such discrimination, it is a stern warning that such activity must cease and that future activity will not be tolerated.

The Commerce Clause

U.S. Constitution, Article I, Section 8, Clause 3: "Congress shall have the Power ... To regulate Commerce with foreign Nations and among several States, and with the Indian Tribes."


* WITH ITS SOUTH CENTRAL BELL TELEPHONE decision, the U.S. Supreme Court settled another skirmish in the battle between individual states and their powers to tax and the U.S. Constitution's Commerce Clause. The Court declared a franchise tax Alabama assessed on out-of-state corporations to be unenforceable because it violated the Commerce Clause.

* ALABAMA ASSESSES A 1% TAX ON DOMESTIC corporations based on the par value of company stock. So-called foreign corporations pay a 0.3% tax on the actual amount of capital used or invested in the state. Because the latter tax is more easily manipulated, a domestic corporation ends up paying only 20% of the franchise tax it would pay if it were a foreign corporation.

* THE SUPREME COURT UNANIMOUSLY RULED that Alabama's tax on foreign corporations "discriminates against interstate commerce and is unconstitutional." Alabama was unable to demonstrate that its foreign franchise tax was "complementary" or "compensatory" to offset other taxes imposed on domestic corporations.

* BASED ON THE SOUTH CENTRAL BELL DECISION, U S. corporations should examine the taxes they pay in states where they are considered foreign corporations. When they find discrimination, companies should not hesitate to challenge the tax in court since the decision should assure them a victory.

* TO AVOID FUTURE LITIGATION, STATES THAT ASSESS taxes on foreign corporations that might be considered discriminatory under the Commerce Clause should consider taking steps to eliminate the unfair burden.

RELATED ARTICLE: Another Challenge

South Central Bell has already emboldened at least one corporate taxpayer to challenge a state tax it considers discriminatory. The U.S. Supreme Court has agreed to bear Hunt-Wesson, Inc. v. Franchise Tax Board of California, S.Ct., no. 98-2043 (September 28, 1999). The well-known food company has challenged a California tax provision that permits domestic corporations to reduce their income by means of an interest expense deduction but denies the same deduction to out-of-state businesses.

Hunt-Wesson's case hinges largely on South Central Bell, claiming the California tax is no different from the Alabama law the Court struck down. The Supreme Court's decision to grant review in Hunt-Wesson could mean it intends to reaffirm its unanimous South Central Bell decision.

ANTHONY MICHAEL SABINO, ESQ., is a partner of Sabino & Sabino, PC, Mineola, New York. He is also assistant professor of law at St. John's University Graduate School of Business, in Jamaica, New York. His e-mail address is
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Article Details
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Author:Sabino, Anthony Michael
Publication:Journal of Accountancy
Geographic Code:1USA
Date:Jan 1, 2000
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