This article summarizes the Farmer Bros. opinion, describes the effects of the litigation on pending and future refund claims, and outlines some of the theories that might be available to claim a continuing DRD in the face of FTB opposition. Finally, we describe the current status of the pending legislation regarding the insurance company dividend received deduction on the assumption that any legislative fix to the DRD is likely to follow a similar path.
Background of the Litigation
Farmer Bros. Co., a California coffee manufacturer, received dividends from investments in various companies engaged in business in other states as well as, in some cases, in California. Based upon section 24402, Farmer Bros. Co. obtained a deduction in the amount up to 70% of the dividends based on its stock ownership in the payor corporations. (The deduction was available in increasing percentages as the stock ownership percentage increased.) However, section 24402 limited the deduction to dividends considered to have been paid from income that had previously been subject to California tax, which determination rested upon the dividend payor's relative apportionment factors within the State of California.
Farmer Bros. Co. challenged the limitation placed on the section 24402 deduction as violating the Commerce Clause -- citing, among other things, that the statute provides a tax benefit based upon the relative presence of the payor in the State in violation of the U.S. Supreme Court's ruling in Fulton Corp. v. Faulkner, 516 U.S. 325 (1996). The FTB, in turn, countered that the statute does not discriminate against interstate commerce because its purpose is to eliminate double taxation of California income and not to favor in-state commerce. The FTB also argued that the section 24402 scheme, in effect, imposes a "compensatory tax" upon a stream of earnings that originates in other states, and that the imposition of this tax insures that the out-of-state earnings bear a California tax equal to that borne by earnings generated from within the State.
The Court of Appeal Ruling
In holding that the DRD violated the Commerce Clause, the court relied principally upon three authorities: Fulton Corp. v. Faulkner, 516 U.S. 325 (1996) which struck down a North Carolina "intangibles tax" which taxed "a fraction of the value of corporate stock owned by North Carolina residents inversely proportional to the corporation's exposure to the State's income tax"; Ceridian Corp. v. Franchise Tax Bd., 85 Cal. App. 4th 875 (2000) which struck down a California dividend received deduction for dividends paid by insurance subsidiaries that was closely similar in concept to the DRD at issue in Farmer Bros.; and D.D.I., Inc. v. North Dakota, 657 N.W.2d 228 (N.D. 2003) which struck down a North Dakota dividends received deduction that apparently mirrored the DRD at issue in Farmer Bros. Co. In reliance upon these authorities, the court held:
We conclude that section 24402 is discriminatory on its face because it affords to taxpayers a deduction for dividends received from corporations subject to tax in California, while no deduction is afforded for dividends received from corporations not subject to tax in California. As a result, the dividends received deduction scheme favors dividend-paying corporations doing business in California and paying California taxes over dividend-paying corporations which do not do business in California and pay no taxes in California. The deduction thus discriminates between transactions on the basis of an interstate element, which is facially discriminatory under the commerce clause.Farmer Bros. Co., 108 Cal. App. 4th at 986-87.
Thereafter, the court went on to conclude that the DRD also violated the "internal consistency doctrine" because, assuming California's DRD was replicated in other states, the combined tax burden of the dividend payor and the dividend recipient would be greater if the payor and recipient operated in different states than the tax burden would be if the payor and recipient did business wholly within a single state.
The Denial of the DRD Cannot Be Justified As a Compensatory Tax
After concluding that the DRD constituted facial discrimination against interstate commerce, the court then rejected the FTB's argument that the discrimination could be justified because the restriction on the DRD operated to compensate for the fact that in-state commerce, i.e., dividends qualifying for the DRD, had previously borne a California franchise tax while interstate commerce, i.e., non-qualifying dividends, had been exempt from that tax burden. In doing so, the court noted that the Supreme Court has rejected comparisons under the compensatory tax doctrine based simply upon the fact that out-of-state earnings had not been subjected to the state's general income tax. Instead, the Supreme Court has required a showing that the in-state commerce has borne some specific burden or paid for some benefit for which the state may fairly ask for analogous compensation from interstate business. Thus, absent compelling proof that the state's income tax could be traced to funding a specific program, which was also utilized by the interstate commerce, the court found that it could not "even begin to make the sorts of qualitative assessments that the compensatory tax doctrine requires." id. (quoting Fulton, 516 U.S. 325 at 338). And the court noted the doctrine would be particularly difficult to satisfy, where, as here, the identified tax burden was imposed at a different level of commerce (the payor level) from the level subject to the purported compensatory tax (the payee level).
No Ruling on Remedies
In contrast to the lower court proceeding where the FTB vigorously disputed whether tax refunds were the appropriate remedy, the Court of Appeal proceeding did not involve the question of remedies for the simple reason that the FTB did not appeal that item of the lower court's judgment. The FTB's determination not to appeal apparently may be traced to its realization that the statute of limitations on all of the years at issue in Farmer Bros. would be closed before the court's resolution of the case. Thus, while the Supreme Court's decision in McKesson Corp. v. Division of Alcoholic Beverages & Tobacco, 496 U.S. 18 (1990) provides a theoretical foundation for remedying discrimination either by granting a refund to the interstate commerce that suffered the discrimination or by increasing the tax on the favored intrastate commerce, that choice would not be available in Farmer Bros. Because the general statute of limitations had closed (or would close soon) for the years at issue in the litigation, the FTB acknowledged that it would not be in a position to tax the favored commerce and therefore refunds to the disfavored commerce were appropriate. See Ceridian Corp. v. Franchise Tax Bd., 85 Cal. App. 4th 875 (2000) (where the statute of limitations bars any assessment of additional tax from the favored class of taxpayers, the only permissible remedy is a refund).
Implications for the Future
Based upon the FTB's reaction to the Ceridian litigation, it appears that the FTB intends to take the position following a final adverse court decision that section 24402 as a whole is void and no taxpayer may claim the benefits of the deduction. Cf. Memorandum from Winston Mah and Dale Isaac, FTB, to General Tax Audit Staff and Multistate Tax Audit Staff (Apr. 26, 2002) (on file with author) (instructing the FTB Audit Staff that no deduction under section 24410 is to be allowed for tax years ending on or after Dec. 1, 1997).
Taxpayers, on the other hand, no doubt will take the position that the deduction continues based presumably upon one or more of the following arguments. First, the court's decision in Farmer Bros. goes only to the offending restriction on the DRD. By excising the unconstitutional restriction, the statute continues to operate in a manner consistent with legislative intent in eliminating multiple taxation of corporate earnings. See Kopp v. Fair Political Practices Comm'n, 11 Cal. 4th 607, 660-61 (1995) (recognizing a court's authority to reform statutes in accord with legislative intent if the Legislature would have preferred the reform to the statute as a whole being found unconstitutional). Second, the court's reliance upon the internal consistency doctrine suggests that the offense of the current DRD is that it effectively seeks to tax income earned in other states. See Hunt-Wesson, Inc. v. Franchise Tax Bd., No. 98-2043, 2000 LEXIS 1010 (U.S. Feb. 22, 2000) (disallowance of an otherwise allowable deduction based upon the amount of out-of-state income is effectively an extraterritorial tax on the out-of-state income). This infirmity was also acknowledged by the Superior Court in its opinion in Farmer Bros. Given that the infirmity is taxing income beyond California's jurisdiction to tax, the proper remedy is simply to extend the deduction and eliminate the unconstitutional tax. Third, any attempt to disallow the DRD provided by section 24402 also may be viewed as violating the Equal Protection Clause of the U.S. and California Constitutions since a dividend paid by legal entities included within a combined report of unitary income will continue to enjoy a full dividend received deduction under section 25106 even though no rational basis exists for distinguishing between the multiple tax burden that arises in that context and the multiple tax that would be imposed by a repeal of section 24402.
Finally, the Legislature may act to reform section 24402 along the same lines being considered for the reform of section 24410. On June 5, 2003, the Assembly passed a bill (A.B. 263, 2003-2004 Leg., Reg. Sess. (Cal. 2003) ("A.B. 263")) amending section 24410 to resolve the uncertainties resulting from the court's decision in Ceridian. The bill received a unanimous vote in the Appropriations Committee on June 2, 2003. On June 19, 2003, the bill was referred to the Senate Committee on Revenue and Taxation, and a hearing on the bill was set before the committee on July 9, 2003.
For tax years beginning January 1, 2003, A.B. 263 in its current form provides a deduction to all corporations, whether or not domiciled in California, for 80% of dividends received from insurance companies if at the time of payment the recipient corporation owns 80% or more of each class of stock of the insurance company. For back tax years ending on or after December 1, 1997 but before January 1, 2003, A.B. 263 would provide a deduction equal to 90% of the dividends received from the insurance company. The 80% ownership threshold is the same for back tax years. Since the portion of dividend income eligible for the deduction is not calculated in relation to the insurance corporation's California source income, A.B. 263 seems to avoid the constitutional defects of current section 24410.
Notably, A.B. 263 includes a provision that effectively repeals section 24410 if the FTB collects less than $15 million in tax in the first 180 days after it goes into effect. As currently proposed, this provision would flatly repeal section 24410, making it appear that there would be no deduction at all if the revenue target is not reached. Given the impact of this provision, it is expected to be the subject of further inquiry and debate.
[Thomas H. Steele is co-counsel for the taxpayer in the Farmer Bros. litigation.]