Taxpayer Challenges To Discriminatory State Taxes: The Likely Battlegrounds Of Future Litigation
There can be little doubt today about the fate of facially discriminatory state taxes. In its most recent Commerce Clause assault on interstate discrimination, the United States Supreme Court reiterated that "State laws discriminating against interstate [or foreign] commerce on their face are ‘virtually per se invalid." Fulton Corp. v. Faulkner, 516 U.S. 325, 331 (1996). The Court proceeded to strike down as unconstitutional North Carolina's discriminatory intangibles tax levied on the value of corporate stock owned by state residents, but which allowed a deduction proportional to the issuing corporation's presence in North Carolina. The Court also practically shut down the one avenue that remained for states to defend their discriminatory taxes, namely the compensatory tax doctrine. The Fulton Court's language strongly suggests that the compensatory tax doctrine is essentially reserved for use taxes intended to compensate for state sales taxes.
It would be surprising if many people reading Fulton needed to be reminded about the virtually per se rule against taxes that discriminate against interstate or foreign commerce. The Court regularly and systematically has invalidated discriminatory state taxes in nearly every relevant case in which it has granted certiorari. West Lynn Creamery, Inc. v. Healy, 512 U.S. 186 (1994), and Associated Industries of Missouri v. Lohman, 511 U.S. 641 (1994), constitute recent examples of cases in which discriminatory taxes or fees did not survive constitutional scrutiny. Just over a month ago, the Court again revealed its distaste for discrimination against interstate transactions in Lunding v. New York Tax Appeals Tribunal, 118 S. Ct. 766 (1998). Relying on the Privileges and Immunities Clause, the Court struck down New York State's denial of a deduction for alimony payments by nonresidents of the state when residents were allowed to deduct their alimony payments.
In the light of the Supreme Court's virtually per se rule against facial discrimination, taxpayers have achieved some important victories in the state courts as well. For example, in R.J. Reynolds Tobacco Co. v. City of New York Dept. of Fin., 667 N.Y.S. 2d 4 (N.Y. App. Div. 1997) (appeal pending), the Appellate Division (First Department) of the New York Supreme Court struck down New York City's allowance of more favorable depreciation for a corporation's property placed in service in New York State than for property placed in service outside of the state. In St. Ledger v. Kentucky Rev. Cabinet, 942 S.W.2d 893 (Ky. 1997), the Kentucky Supreme Court invalidated both an intangibles tax on deposits in out-of-state banks that was more burdensome than the tax on deposits in in-state banks, and an exemption from the intangibles tax for stock in corporations paying Kentucky taxes on at least 75% of their total property. In Conoco, Inc. and Intel Corp. v. Taxation and Revenue Department of New Mexico, 931 P.2d 730 (N.M. 1996), the New Mexico Supreme Court held that New Mexico's taxation of foreign dividends, when domestic dividends were exempt, violated the Foreign Commerce Clause, notwithstanding the state's attempt to salvage the tax through factor representation. And, in Perini Corp. v. Commissioner, 647 N.E. 2d 52 (Mass. 1995), the Massachusetts Supreme Court struck down two state excise tax deductions for the value of a subsidiary, one of which was available to a domestic intangible property corporation only if the subsidiary was incorporated in Massachusetts.
If the law is really this clear, one might ask why facially discriminatory statutes endure. Foremost, while taxing authorities generally are familiar with the constitutional limitations on state taxation, as a matter of administrative law, and sometimes state statute or state constitutional law, administrative agencies are required to enforce the law on the books and may not declare statutes unconstitutional. Consequently, legislators must repeal unconstitutional taxes. Unfortunately, due to either ignorance or indifference, to a large extent they have not accepted this responsibility. Whatever their reason for not acting, legislators may be unpleasantly surprised when a taxpayer victory requires them to find the resources to pay huge refunds.
Additionally, unconstitutional statutes remain on the books because taxpayers do not challenge them. Not all discriminatory statutes are motivated by illicit discriminatory intent. For example, among the benign justifications for some facially discriminatory taxes is the desire to avoid double-taxation. Where a statute appears justified by a reasonably sympathetic purpose, taxpayers may be misled into believing it is not discriminatory, or their sympathies may deter them from challenging the statute, even while recognizing the discrimination. Taxpayers also may choose not to challenge facially discriminatory statutes because individually they do not have a sufficient amount at issue. A class action lawsuit might address that issue. However, perhaps because their procedural complexity can be daunting or because frequently they are not sufficiently lucrative to justify practitioners incurring the substantial costs, class actions in tax cases are rare.
In our judgment, taxpayers as a whole have not been as aggressive as they could and should be in attacking unconstitutional taxes. For example, for many years, practitioners have widely recognized Cal. Rev. & Tax. Code §§ 24344 (interest offset), 24410 (deduction for dividends received from insurance companies), and 24402 (deduction for dividends received from general corporations), as facially discriminatory, but even today only the first two statutes are being challenged in court. See "States Cannot Tax Indirectly Income They Cannot Tax Directly: California Interest Offset Statute Held Unconstitutional," State & Local Tax Insights, September 1997. These, and many other facially discriminatory statutes across the country, are ripe for constitutional challenge.
What does the future hold for litigation in the arena of facially discriminatory state taxes? First, taxpayers, it seems, are becoming more bullish about challenging discriminatory taxes, and consequently there is certain to be much future litigation over the many remaining facially discriminatory taxes. Second, we would be remiss if we did not communicate clearly to our readers that taxpayers do sometimes lose challenges to statutes that appear to be facially discriminatory. One reason is that statutes that appear to be discriminatory may not be discriminatory in fact. We expect much future litigation to center on the question of whether a statute is truly discriminatory. Third, another potential pitfall is that even if a taxpayer successfully challenges a discriminatory statute, some states will resist returning the taxpayer's unconstitutional taxes. Another area ripe for future litigation is the appropriate remedy for unconstitutional taxes. Fourth, we expect the proliferating, but heretofore mostly unchallenged, state tax incentives to spawn significant litigation in the future. We discuss each of these likely battlegrounds for future litigation, in turn, in the following sections.
Which Currently Enforced Statutes Are Ripe For Challenge?
Identifying all of the facially discriminatory state taxes currently on the books obviously is beyond the scope of this article. However, we can do justice to this subject by exposing some of them. With this introduction, we are hopeful that taxpayers will become increasingly vigilant in identifying discriminatory state taxes to which they are subject.
One of the most significant, currently enforced, discriminatory state taxes is California's dividends received deduction, which limits the deductible portion of the dividend, based upon the dividend payor's California apportionment factors. Under Cal. Rev. & Tax. Code § 24402, a taxpayer may deduct dividends only if it has invested in a corporation located in California but not if it has invested in a corporation outside California. Moreover, the deduction increases as the dividend payor's presence in California increases. A similar California statute, currently in litigation, applies to dividends received from insurance companies. Cal. Rev. & Tax. Code § 24410.
A number of other states limit corporate dividend deductions based upon the in-state presence of the dividend payor. Arizona allows a deduction for dividends received from corporations not owned or controlled by the dividend recipient, but only if at least 50% of the dividend payor's apportionment factors are in Arizona. Ariz. Rev. Stats. § 43-1128(A). Hawaii allows a deduction for dividends received from nonaffiliated corporations, but only if at least 15% of the dividend payor's factors are in Hawaii. Haw. Rev. Stat § 235-7(c)(3). Rhode Island allows a dividends received deduction only if the dividend payor is subject to Rhode Island tax. R.I. Gen. Laws § 44-11-12. South Dakota allows taxpayers to deduct dividends received from financial institutions, but only if the financial institution was subject to South Dakota franchise tax. S.D. Codified Laws § 10-43-10.2(7).
Another area of state taxation rife with discrimination is taxation of interest from state bonds. At last count, more than half of the states exempted interest earned on bonds issued by the taxing state but taxed interest earned on all other state-issued bonds. When taxpayers have challenged these types of discriminatory statutes, they have almost universally prevailed. See, e.g., Dominion National Bank v. Olsen, 771 F.2d 108 (6th Cir. 1985) (taxpayer successfully challenged Tennessee's exemption for interest from certificates of deposit issued by in-state but not out-of-state financial institutions); Smith v. New Hampshire Dept. of Rev. Admin., 692 A.2d 486 (N.H. 1997) (striking down New Hampshire's discriminatory taxation of interest and dividends based upon the identity or situs of the payor); St. Ledger v. Kentucky Rev. Cabinet, supra. In notable contrast, in Shaper v. Tracy, 647 N.E.2d 550 (Ohio App. 1994), an Ohio court rejected a Commerce Clause challenge to Ohio's taxation of the interest from bonds of other states when interest from Ohio bonds was exempt. However, Shaper does not deter us from our belief that these statutes are facially discriminatory.
Unapportioned taxes (e.g., unapportioned local gross receipts taxes) and flat taxes each constitute a form of facial discrimination against interstate commerce not always recognized as such. These taxes facially discriminate against interstate commerce because a taxpayer engaged in business solely in the taxing jurisdiction pays a tax on only 100% of its gross receipts or on the flat tax amount, whereas, assuming a comparable tax in every jurisdiction, the interstate taxpayer would pay tax on 100% of its gross receipts in each jurisdiction in which it engages in business (e.g., 400% if it engages in business in four jurisdictions), or on the flat amount multiplied by the number of jurisdictions. The additional burden on interstate commerce is unconstitutionally discriminatory.
States discriminate against interstate and foreign commerce in numerous other ways. A few additional examples are tax-free exchanges of like-kind property limited to in-state property, more favorable depreciation for in-state than out-of-state property, and exemptions from sales and use taxes that favor local industries. Each of these discriminatory taxes is ripe for challenge and, generally, taxpayers should feel optimistic about the prospects for victory.
Identifying The Class Of Similarly Situated Taxpayers: Is The Tax Truly Discriminatory?
Considering the Supreme Court's vigilant guard against facially discriminatory taxes, some taxpayers and their representatives were surprised when the Court declined to invalidate Ohio's imposition of sales and use tax on out-of-state natural gas purchases in General Motors Corp. v. Tracy, 117 S. Ct. 811 (1997). Many believed that the sales and use tax exemption for purchases from a natural gas company, but not for purchases from producers and independent marketers, was facially discriminatory and should have been struck down. After all, the preferred class of sellers, natural gas companies, was defined as an Ohio state-regulated natural gas utility, or a local distribution company, and was limited, by definition, to in-state companies. By contrast, the burdened class of sellers, producers and independent marketers, overwhelmingly consisted of out-of-state companies.
The reason that the Court could uphold a tax that appeared facially discriminatory, even in the face of Fulton and the plethora of Supreme Court precedents assailing discriminatory taxes, was that the Court defined the comparison classes in a manner that rendered them not similarly situated. In particular, rather than comparing purchases of gas from in-state companies with purchases of gas from out-of-state companies, the Court compared purchases from highly regulated local distribution companies, on the one hand, and purchases from mostly non-regulated producers and independent marketers, on the other hand. By framing the comparison that way, the Court set up the case as a comparison of purchases from entities that were not similarly situated, and consequently it defined the discrimination issue out of the case. Some might distinguish General Motors as an aberration because it involved a heavily regulated industry. Indeed, as the Court acknowledged, it felt incompetent to delve into that domain, which was more appropriately occupied by Congress and, by extension, state legislatures. Yet, General Motors illustrates an important principle that is sure to emerge as taxpayers accelerate the rate at which they challenge allegedly discriminatory taxes, namely that the definition of the comparison classes may remove an apparently discriminatory provision from the realm of discrimination.
A case that recently received considerable attention, Caterpillar Inc. v. Commissioner of Revenue, 568 N.W. 2d 695 (Minn. 1997), cert. denied, 66 U.S.L.W. 3555 (Feb. 23, 1998), also illustrates the issue. The taxpayer in Caterpillar objected to Minnesota's taxation of interest and royalties received from unitary foreign affiliates excluded from the combined return under the state's water's-edge filing system, because the state eliminates interest and royalties from unitary domestic affiliates included in the combined return. Relying on Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, 505 U.S. 71 (1992), which struck down Iowa's tax scheme requiring separate return taxpayers to include dividends from foreign subsidiaries in income when dividends from domestic subsidiaries were fully deductible, Caterpillar claimed that Minnesota's treatment of interest and royalties paid by foreign unitary affiliates was facially discriminatory and must be struck down. Whereas other similarly situated taxpayers have argued for factor relief (largely unsuccessfully), Caterpillar apparently sought an exclusion of the interest and royalties from income.
The differential treatment of interest and royalties from foreign subsidiaries certainly appears discriminatory on its face. Yet, in his Brief in Opposition to the petition for certiorari, the Commissioner of Revenue argued, among other things, that the taxpayer did not show facial discrimination. The Commissioner explained that "[w]hile the exclusion of a foreign subsidiary's factors increases the tax, the exclusion of its net income from the tax base decreases the tax." The Commissioner continued, "When both the apportionment formula and the entire tax base are considered, it is not possible to establish that the Minnesota corporate franchise tax will be higher for a parent corporation with a foreign subsidiary than for a parent corporation with a domestic subsidiary." The taxpayer responded that the Court's precedents do not require it to prove under the state's entire system of taxation that it is worse off. To a certain extent, the taxpayer's and the Commissioner's arguments read like ships passing in the night.
Although not stated explicitly, lurking within this debate is the principle that facial discrimination may occur only to similarly situated payors, or income, or deductions, etc. In Caterpillar, the taxpayer viewed the comparison as one between the treatment of interest and royalties paid by foreign unitary subsidiaries versus the treatment of those paid by domestic unitary subsidiaries, which indeed suggests facial discrimination. However, as the Minnesota Supreme Court observed, an alternative comparison is between, on the one hand, interest and royalties paid by foreign subsidiaries (treated as unrelated due to the water's-edge method) and, on the other hand, interest and royalties paid by unrelated domestic entities. Under this view, the interest and royalties are included in the payee's income regardless of whether the payor is foreign or domestic. Because interest and royalties paid by each of these noncombined entities are treated the same, there is no facial discrimination. Thus, as in General Motors, the framing of the comparison classes is critical to evaluating whether the tax is discriminatory.
As mentioned, the state in Caterpillar also argued, in effect, that even if the taxpayer properly framed the comparison, and thus the tax provision in isolation appeared to be facially discriminatory, in the context of the state's entire tax scheme the taxpayer could not prove that it actually suffered discrimination. Indeed, although royalties and interest are eliminated when paid by a domestic unitary subsidiary, the taxpayer also must include the domestic subsidiary's income and factors in the combined return. Because the foreign unitary subsidiary's income and factors are not included in the return, it is not necessarily true that the inclusion of interest and royalties paid by those companies is discriminatory. In fact, it may be impossible to prove discrimination under these circumstances. While the taxpayer in Caterpillar vigorously resisted this argument, citing several cases in which, by its actions, the Court defied the notion that it is appropriate to examine the state's whole tax structure, and instead considered only whether the specific provision in question was discriminatory (see, e.g., Associated Industries of Missouri, supra), Minnesota's suggested approach is not unprecedented.
The Ohio Supreme Court accepted precisely this defense against a facially discriminatory tax in Nacco Industries, Inc. v. Tracy, 681 N.E.2d 900 (Ohio 1997), cert. denied, 118 S. Ct. 882 (Jan. 26, 1998). In response to the taxpayer's challenge to Ohio's discriminatory taxation of gain on the sale of federal bonds but not on the sale of Ohio bonds, the court cited Washington v. United States, 460 U.S. 536, 542 (1983), for the rule that determining whether a tax is discriminatory "requires an examination of the state's whole tax structure." Under Ohio's scheme, taxpayers not only excluded gain from the sale of state bonds, but also could not deduct losses on the sale of state bonds. Because the taxpayer's expert was unable to opine on any distortion of purchasers' preference for state versus federal bonds when taking into account the treatment of both gains and losses of each type of bonds, the court believed the taxpayer did not prove discrimination. Thus, even when the parties agree on a comparison that appears on the surface to be discriminatory, a state may be able to argue successfully that the taxpayer should be required to prove that it has in fact suffered discrimination before its claim may be approved.
While there are many interesting subtleties inherent in each of the variations of this issue, unfortunately, due to space limitations in this newsletter, this discussion cannot do justice to those subtleties. However, there will be plenty of time for that, as we feel confident the issue whether an apparently facially discriminatory tax is in fact discriminatory will surface again in future cases.
Assuming The Challenge Succeeds, What Is The Proper Remedy?
For some time, the question concerning the constitutional requirements for remedies where taxes had been struck down centered on whether retroactive relief was required or whether prospective relief would suffice. Today, that debate appears to have been settled. In two of the most recent state tax Commerce Clause cases, Associated Industries and Fulton, by remanding solely for consideration of the proper remedy without reserving the question whether its decision should apply retroactively or only prospectively, the Court implicitly determined that its decision should apply retroactively. As Professor Hellerstein's treatise observes about Fulton: "In short, the Court, without saying so explicitly, may well have put the final nail in the coffin of the civil prospectivity doctrine by refusing even to entertain the notion that the prospectivity issue was an appropriate matter to be addressed on remand." Hellerstein & Hellerstein, I State Taxation, Supp. 4.12[c], at S4-39.
Yet, even with that debate settled, the question remains: what form of retroactive relief is required for facially discriminatory taxes? McKesson v. Division of Alcoholic Beverages & Tobacco, 496 U.S. 18 (1990), established the principle that when a state denies predeprivation remedies, the taxpayer is entitled to meaningful backward-looking relief from unconstitutional state taxes. In this context, McKesson adverted to a state's right to impose retroactively equal burdens on the tax's former beneficiaries rather than to refund the additional taxes imposed on the victims of its discrimination. However, if a state chooses the former remedy, it must do so in a manner consistent with other constitutional provisions (notably due process), and in a manner that in fact remedies the discrimination. For a more complete discussion of taxpayer remedies, see Amy L. Silverstein, "The Rewards and Frustrations of Constitutional Challenges to State Taxes," Journal of Taxation, August 1997.
Indeed, there would seem to be significant limitations on a state's ability to provide a true remedy for the taxpayer litigant through retroactive taxation of previously favored taxpayers rather than through a refund. First, while states are permitted to enact retroactive taxes, due process limits the period of retroactivity. Moreover, in many states, one or two decades can pass before a tax is finally adjudicated. In the meantime, at least for some periods, the statute of limitations certainly will have expired for the taxpayers who were favored by the discriminatory provision. If the statute of limitations prohibits a state from actually imposing back taxes, this would seem to be a hollow remedy and one that should not satisfy constitutional requirements. Finally, if the previously favored class of taxpayers is reasonably large, as a practical matter it may be impossible to ensure that a significant percentage of those taxpayers actually will pay the new tax such that back-taxation will constitute a true remedy.
The Court's most recent pronouncement on this subject suggests a decreasing tolerance for states' attempts to withhold discriminatory taxes. Newsweek, Inc. v. Florida Dept. of Rev., 66 U.S.L.W. 3553 (Feb. 23, 1998), involved Florida's sales tax exemption for newspapers but not magazines, which the Florida Supreme Court had held unconstitutional under the First Amendment in a prior case. Newsweek filed a claim for refund of sales taxes paid on magazines under Florida's general claim for refund statute. Fla. Stat. § 215.26(1). However, Florida refused to refund the discriminatory taxes, claiming that McKesson did not apply because the taxpayer had a predeprivation remedy, i.e., the taxpayer could have paid the taxes into the court registry, posted a bond, or obtained a court order approving an alternative arrangement.
Unsympathetic to Florida's behavior, the Court firmly ordered Florida to refund the discriminatory taxes because the taxpayer reasonably could have believed that it would receive a refund if it paid its taxes and litigated successfully. The Court stated, "While Florida may be free to require taxpayers to litigate first and pay later, due process prevents it from applying this requirement to taxpayers, like Newsweek, who reasonably relied on the apparent availability of a postpayment refund when paying the tax."
Of course, rather than arguing that it could remedy the discrimination through retroactive taxation of newspapers, it appears Florida argued only that it was not required to remedy the discrimination at all. Nevertheless, the Court stated unequivocally that "Newsweek is entitled to a clear and certain remedy and thus it can use the refund procedures to adjudicate the merits of its claim." The Court did not say that Newsweek is entitled to a meaningful backward-looking relief generally, nor did the Court advert to any other permissible remedy besides a refund. In essence, the Court seems to be saying that if a state requires a taxpayer to give the state its money before litigating a constitutional issue, including a discrimination issue, and the taxpayer wins, the state must return the money to the taxpayer. It is hard to imagine how the Court left any room for a state to argue, for any reason, that it is not required to pay a refund to a taxpayer that was denied predeprivation remedies.
Are All State Tax Incentives Constitutionally Suspect?
We also expect state tax incentives to spawn significant litigation in the future. A typical incentive, and one that has been adopted by California, affords an income tax or sales tax credit when certain types of manufacturing property are placed in service in the state and remain in service for a specified length of time. See Cal. Rev. & Tax. Code §§ 23649, 6902.2. Suppose a California taxpayer purchases qualified property and places it in service for the requisite time period in a qualified activity in Nevada. The taxpayer would have taken every action necessary to receive the credit, except it would have taken all of those actions in Nevada, not California. The fact that, statutorily, the taxpayer would not be entitled to the credit, we submit, constitutes facial discrimination against interstate commerce. Constitutionally, it would seem necessary for California to afford the taxpayer a credit against its California taxes, perhaps to the extent of the taxpayer's California apportionment factor.
While all state tax incentives involve some coercion of taxpayers to engage in activity in the taxing state, some courts and legal scholars have suggested that some state tax incentives might be constitutional. There is, at least, a tendency for some people to search for theories that would permit some state tax incentives to be upheld. This tendency may be motivated by the tension in the Court's constitutional doctrine involving state subsidies, on the one hand, and state tax incentives, on the other hand. Courts have long recognized that a state constitutionally can encourage behavior, including engaging in activity in the taxing state, through direct subsidies (i.e., cash payments or beneficial expenditures). However, encouraging the same behavior through tax breaks is constitutionally suspect. Indeed, this tension can be perplexing, and when called upon to defend their tax incentives, states certainly will try to use it to their advantage. The challenge for the future will be to determine which, if any, state tax incentives are permissible.
Pelican Chapter, Associated Builders & Contractors, Inc. v. Edwards, 901 F. Supp. 1125 (M.D. La. 1995), offers one perspective on this problem. In Pelican Chapter, a Louisiana statute granted an ad valorem tax exemption to owners of new manufacturing facilities. In administering the exemption, the state adopted a formal rule mandating a preference for Louisiana materials, labor, and suppliers in constructing the exempt facilities. The court found the preference for Louisiana labor and materials discriminatory because in penalizing contractors for not using Louisiana products and labor, it favored local industry and discriminated against out-of-state competition.
In striking down the tax, the court provided some useful insight into which state tax incentives might pass muster. The key observation was that while "[t]here certainly can be no constitutional objection to Louisiana's granting a tax exemption or a tax reduction to those who construct manufacturing plants within the state's borders," Louisiana could not "condition the tax exemption carrot upon discrimination against interstate commerce." Professor Hellerstein's treatise analyzes the case as follows:
[T]he court has made an effort to draw a line between the constitutional carrot and the unconstitutional stick in State tax incentive cases. Those incentives that merely invite the taxpayer to invest in the State, for example, by granting an exemption for new construction, are constitutionally palatable because they put no price on failure to engage in in-state activity. Those incentives that attach collateral conditions to the exemption, however, such as a requirement that the taxpayer hire only in-state employees or use only in-state materials, run into constitutional trouble. In these circumstances, the State is no longer merely offering the taxpayer an attractive invitation to locate its activities in the State, but is attaching to that invitation "downstream" conditions that violate the rule that States may not require taxpayers to engage in in-state activities.
I Hellerstein & Hellerstein, State Taxation, Supp. ¶ 4.12[k], at S4-21. Pelican Chapter, as analyzed by the Hellerstein Treatise, suggests a plausible distinction between permissible and unconstitutional state tax incentives. Importantly, we note, other scholars have expressed considerable pessimism regarding whether any state tax incentives may be upheld in the face of constitutional attack. See Peter D. Enrich, "Saving the States from Themselves: Commerce Clause Constraints on State Tax Incentives for Business," 110 Harv. L. Rev. 377 (1996).
We cannot resolve this debate here. However, we hope this short discussion will give the reader a flavor of the complex issues surrounding state tax incentives, as well as remind him or her that there may be significant opportunities for taxpayers to challenge unconstitutional state tax incentives.
The law condemning facially discriminatory taxes provides a significant advantage to taxpayers who litigate the constitutionality of such taxes. Indeed, we believe there are many opportunities available for taxpayers to challenge facially discriminatory state tax statutes. We expect states to become increasingly creative in their defenses to taxpayer challenges. However, with a carefully planned attack, taxpayers should prevail in many of these challenges, and thereby continue to decrease their state tax burden.
By Peter B. Kanter
It's 1998. The economy has been booming for at least two years. Companies are finally shrugging off the shackles of the early Nineties, and are looking to compete vigorously in the new marketplace. This often means considering reorganization or growth through merger and acquisition. For businesses that hold substantial pieces of real property in California, that could mean a major property tax reassessment. This article will discuss the rules governing reassessment under California's Proposition 13, and how they can easily trigger a reassessment of California property. It also will discuss some of the important exclusions that allow taxpayers to avoid such reassessments with some foresight and planning. Because the real estate market in California has been booming along with the rest of the economy, such foresight and planning could substantially decrease a company's tax burdens.
Proposition 13's Base Year Value Protection
Under California's Proposition 13 property tax regime, a property's "base year value" establishes a ceiling for its assessment. A base year value is set at the fair market value of the property as of the date the property has experienced either a change in ownership, or new construction. Future assessments can then rise no more than two percent per year above the base year value until the property either changes ownership again or has new construction added. Proposition 13's base year value protection only governs property tax assessments for real property in California. Personal property, including equipment and machinery that is separately assessed from a structure, does not receive any base year value protection from increases in assessment; however, this is not usually troublesome for most taxpayers, as most personal property, especially equipment and machinery, depreciates rather than appreciates over time.
The phrase "change in ownership" is a legal term that was left undefined in the California Constitution when Proposition 13 was added. Shortly after Proposition 13 was passed by the voters, a Task Force was formed to draft guidelines for the legislation necessary to implement the new amendment, and the report produced by the Task Force suggested that the Legislature adopt several provisions that would provide definition to the term change in ownership. Most of the Task Force's recommendations were adopted by the Legislature and codified in sections 60 through 69 of the California Revenue and Taxation Code. Those statutory provisions, and the regulations promulgated by the California State Board of Equalization to help administer them, have defined two broad categories under which a change in ownership is deemed to occur. The first category includes transfers of real property from one entity or person to another. The second category includes transfers of ownership interests in legal entities that own real property, such as corporations, partnerships, and limited liability companies.
Transfers Of Real Property
Under the provisions defining changes in ownership, a transfer of real property from one person or entity to a different person or entity is generally regarded as a change in ownership of the property. Rev. & Tax. Code § 60; SBE Rule 462.001. The general rule governing transfers of real property is broad and applies to transfers regardless of whether they are "voluntary, involuntary, by operation of law, by grant, gift, devise, inheritance, trust, contract of sale, addition or deletion of an owner, property settlement, … or any other means." SBE Rule 462.001. However, there are several statutory exceptions for many types of property transfers. Some of these exceptions are for intra-familial transfers, but others apply frequently to commercial properties transferred by partnerships, corporations and limited liability companies.
One often invoked exception to the rule is for transfers between corporations both of which are members of the same affiliated group. Rev. & Tax. Code § 64(b). "Affiliated group" is defined as a group of corporations in which 100% of the voting stock, exclusive of any share owned by a director, of each corporation, except the parent corporation, is owned by one or more of the other corporations in the group, and the common parent corporation owns directly 100% of the voting stock, exclusive of any shares owned by a director, of at least one of the subsidiaries. Id.
Although the Section 64(b) exception is very useful in allowing a corporation to transfer properties between itself and its wholly-owned subsidiaries, or between the subsidiaries themselves, the prerequisites of the rule must be adhered to strictly. It is not uncommon for the unwary taxpayer to initiate a transfer between subsidiaries in reliance on the exception for transfers between members of an affiliated group, only to find out after the transfer that the exception will not apply because strict conformity to the statute is lacking. Thus, it is crucial to note that the Section 64(b) exception includes only transfers between corporations and does not include transfers to or from partnerships or limited liability companies. Moreover, the definition of affiliated group does not include partnerships or limited liability companies, and therefore, even if the transfer of property is between two wholly-owned corporations, they will not be deemed members of an affiliated group if the indirect ownership of the common parent is through any non-corporate entities.
The exclusion of shares owned by directors from the 100% ownership requirement is another common stumbling block for taxpayers. Often, a parent corporation will give small percentages of a subsidiary's voting stock to officers and other upper-level management personnel. Such stock transfers are commonly used to provide an incentive to management or to satisfy local regulatory rules requiring that a resident individual be part-owner. Although the parent usually does not intend to allow any outside control by granting the shares, and may even restrict their transferability, if they are owned by anyone who is not a director of the corporation it will likely remove the corporation from the definition of affiliated group and destroy the Section 64(b) exception. Finally, the requirement that the parent corporation must own directly 100% of the voting stock (exclusive of shares owned by directors) of at least one of the subsidiary corporations could exclude some corporate families from the definition, even though all ownership is traced directly or indirectly to the parent.
In planning transfers of real property among members of a corporate family, it is important to keep the requirements of Section 64(b) in mind. However, even if strict conformity to those requirements cannot be shown, a transfer of real property can often fall under another broad exception for property transfers: the Section 62(a)(2) exclusion.
Perhaps the most important and frequently applied exception for property transfers is the rule contained in Section 62(a)(2) of the Revenue and Taxation Code. The exclusion covers any transfer of real property from one entity to another that "results solely in a change in the method of holding title to the real property and in which proportional ownership interests of the transferors and transferees, whether represented by stock, partnership interest, or otherwise, in each and every piece of real property transferred, remain the same after the transfer." Rev. & Tax. Code § 62(a)(2). This exclusion frequently applies when a corporation or partnership chooses for business purposes to transfer real property to another legal entity which is wholly-owned, either directly or indirectly, by the transferor or the transferor's parent. In that way, it is similar to the Section 64(b) exclusion; however, many transfers that do not fall within the affiliated group exclusion of Section 64(b) may fall under Section 62(a)(2).
The key requirement of Section 62(a)(2) is that the "proportional ownership interests of the transferors and the transferees, . . . in each and every piece of real property transferred, remain the same after the transfer." (The other statutory requirement, that the transfer result solely in a change in the method of holding title, does not appear to impose any requirement that would not always be satisfied as long as the preservation of identical proportional ownership is met.) Thus, Section 62(a)(2) does not exclude, for example, a transfer of properties of equal value that are transferred by their respective owners into a partnership in which each transferor takes a 50% partnership interest. Rather, Section 62(a)(2) basically looks through the legal form of a transferor to determine the proportional ownership interests of the owners of that entity, and requires that those "real owners" hold exactly the same proportional interests in the transferees. Any divergence from this strict requirement of mirror ownership will disqualify a transfer from Section 62(a)(2) protection.
One question regarding the identity of proportional ownership interests requirement that remains unresolved is how long must ownership interests remain identical between the transferor and the transferee. This is of particular concern to large publicly-traded corporations or limited partnerships, in which shares or partnership interests are transferred every day. Although nothing in the Revenue and Taxation Code or the State Board of Equalization's property tax regulations provides a clear answer to this question, the State Board of Equalization's staff has stated informally that the Section 62(a)(2) exclusion applies even when the transferor is a large publicly traded corporation or limited partnership as long as the proportional ownership interest remains the same between the transferor and the transferee immediately after the transfer, and any subsequent transfers of ownership interests do not invoke application of the "step-transaction" doctrine. Although a thorough review of the step-transaction doctrine is beyond the scope of this article, it is unlikely the doctrine would be invoked for subsequent transfers of small percentages of ownership interests of a publicly traded transferor. (Note, however, that even the transfer of a small percentage of ownership interests in a transferor or transferee will likely trigger a change in ownership if it causes a person or entity to obtain a majority ownership interest in the entity. Rev. & Tax. Code § 64(c).)
Transfers Of Interests In Legal Entities
A change in ownership under Proposition 13 can also result from the transfer of ownership interests in a legal entity that owns real property in California. Although the general rule is that transfers of ownership interests in legal entities do not trigger a change in ownership, there is a very broad exception to that rule. As noted above, if the transfer of ownership interests in an entity causes an investor to obtain a majority ownership interest, a change in ownership has occurred. Rev. & Tax. Code § 64(c). Thus, the transfer of even 1% of the voting stock of a corporation, or of the profits and capital interests in a partnership, will trigger a change in ownership if the transferee obtains more than 50% as a result of the transfer.
In addition, there is a special provision applicable to legal entities that were previously the transferee in a transfer of real property under the Section 62(a)(2) exception. As described above, such transfers will not trigger a change in ownership as long as the proportional ownership interests in the transferor and transferee are identical at the time of the transfer and there are no subsequent changes of ownership interests that would cause the step transaction doctrine to apply. However, the owners of the transferee after a Section 62(a)(2) transfer are deemed to be "original co-owners." Any subsequent transfer of interests in the transferee that causes an aggregate of more than 50% of the original co-owners' interests to have transferred since the Section 62(a)(2) transaction will now trigger a change in ownership. Rev. & Tax. Code § 64(d). Thus, even if no person or entity obtains a majority ownership interest in a Section 62(a)(2) transferee, if more than an aggregate of 50% of the transferee is sold by the original co-owners over any period of time, a change in ownership is triggered.
Taxpayers can easily be caught off guard and suffer a substantial reassessment if they are not aware of the intricacies of the rules and exceptions governing changes in ownership under Proposition 13. Simple reorganizations and reallocations of property, which may seem to be all within a corporate family, can still cause changes in ownership. In the booming real estate markets of the late Nineties, a reassessment could double the property tax burden of properties that had not been reassessed previously for several years. However, with careful planning and a thorough understanding of the relevant rules, a base year value can survive many reorganizations.
By Thomas H. Steele
Seldom debated today is the proper origin, for sales factor purposes, of income earned from tangible personal property. Whether a state subscribes to UDITPA's apportionment formula or follows its own apportionment rules, there is little controversy that sales of tangible personal property should be sourced to the destination of the property following its sale.
By contrast, far less certainty and far less uniformity typify states' rules regarding the proper source of income from intangibles, such as personal services and intellectual property. These sourcing rules have assumed particular importance of late due to a convergence of factors. First, following the South Carolina Supreme Court's decision in Geoffrey, Inc. v. South Carolina Tax Comm'n, 437 S.E.2d 13 (S.C. 1993), cert. denied, 114 S. Ct. 550 (1993), states have proven increasingly aggressive in asserting their jurisdiction to tax entities which only license the use of intangibles within their borders. Consequently, in many states, the inquiry has shifted from the more theoretical issue of whether the state may tax income from intangibles to the more practical issue of what income may be sourced to the state. Second, as we are often reminded, intangibles account for an ever-increasing share of corporate income in the modern economy. Third, many states have modified their apportionment schemes to weight the sales factor more heavily, thus magnifying the consequences of any sourcing decision. This article highlights a few of the core issues arising from the sourcing of intangible income, and explains the manner in which a few states have approached those issues.
In general, states appear to have employed one of three approaches to sourcing income from intangibles in the context of the apportionment formula's sales factor. First, some jurisdictions, either explicitly or implicitly, have adopted a "market state" approach, which effectively attempts to identify where the ultimate consumption of the intangible occurs. Second, some states examine whether the income from the intangible can be associated with some physical operation of the taxpayer in the state so as to provide a business situs for the income. Third, some states (at least in some circumstances) simply assign the receipts to the commercial domicile of the owner of the intangible, apparently on the assumption that the rights and protections afforded by the home state provide as good a justification to tax as any. Unfortunately, these broad generalizations at best permit a preliminary classification of any state's sourcing regime. Indeed, upon careful analysis, particular state statutes and regulations often seem to point to more than one approach (and therefore, more than one right answer) in deciding where the intangible income should be sourced.
To focus the discussion which follows, consider the following simple hypothetical:
HighTech Research, Inc. licenses its intellectual property (e.g., trademarks or patents) to Manufacturer, Inc. in return for royalty payments. HighTech is located in State A, where HighTech maintains its research and development staff, its legal staff and its upper management. HighTech and Manufacturer negotiate the license and execute their agreements in State B. Finally, Manufacturer conducts business in State C, where it employs HighTech's intellectual property in its manufacturing facilities. Where should HighTech's royalty income be sourced?
UDITPA - Focus On The "Income-Producing Activity"
The most common standard for apportioning income from intangibles, is that found in § 17 of UDITPA which sources sales, other than sales of tangible personal property, to the taxing state if:
- the income-producing activity is performed in this State [the taxing state]; or
- the income-producing activity is performed both in and outside this State and a greater proportion of the income-producing activity is performed in this State than in any other State, based on costs of performance.
This language appears to require two separate inquiries. Initially, one must identify the "income-producing activity" which gives rise to the subject income. Thereafter, if that income-producing activity takes place in more than one state, one must determine where the "greater proportion" of that activity takes place, by reference to the costs associated with the activity. Though this second inquiry gives rise to a number of challenging issues (e.g., determining what constitutes a "cost of performance" and developing an accurate means of measuring those costs), we believe the first inquiry generates the more interesting and complex questions. Therefore, we will focus on issues surrounding the identification of "the income-producing activity."
Applying the UDITPA standard to the hypothetical above, it would appear that at least three states could present themselves as the situs of the income-producing activity: (1) State A: where HighTech designs, maintains, and protects the intellectual property; (2) State B: where HighTech and Manufacturer negotiate and execute their licensing agreements; and (3) State C: where Manufacturer utilizes the intellectual property in the production of finished goods.
Each state has a compelling argument for including the royalty income in the numerator of its sales factor. State A may argue that it is the situs of the "income-producing activity" on the grounds that, but for HighTech's efforts to develop the intellectual property and to preserve the vitality of the property over time (e.g., through research and development or appropriate legal action), the property either would not exist at all or would lose its ability to generate income for HighTech. State B may argue that the licensing agreement actually produces the income, for that agreement actually obligates Manufacturer to make the royalty payments to HighTech. State C may argue that the ultimate consumption of the intellectual property by Manufacturer generates the income, because absent Manufacturer's ability to derive benefit from the property, Manufacturer would have no incentive to enter into any licensing agreement with HighTech.
Finally, in resolving this conflict, two additional issues seem relevant. First, it is not clear that there must be a single right answer. Any of the three states may argue that § 17's reference to "the income-producing activity" does not require the identification of a single activity, but rather, encompasses every activity which contributes to the production of income. This position, if endorsed, effectively would shift the sourcing exercise to an inquiry into where the majority of the costs of performance of the activities were incurred. Second, the right answer may vary depending upon the time frame viewed. For example, states which require an annual reevaluation of the source of the intangible income might reach different conclusions from year to year depending on the conduct of HighTech and Manufacturer during each particular year.
Application Of The UDITPA Standard
Given the ambiguities arising from the language of UDITPA § 17, it is not surprising that most UDITPA states (and states which have adopted the substantial equivalent of the UDITPA language) have supplemented that language with regulations and rulings designed to clarify the meaning of the term "income-producing activity." Oftentimes, the success of these efforts is questionable.
Indiana is illustrative. A section of the Indiana Administrative Code defines "income-producing activity" to mean "the act or acts directly engaged in by the taxpayer for the ultimate purpose of obtaining gains or profit." 45 IAC 3.1-1-55. Such acts are further defined to include "the sale, licensing the use of or other use of intangible personal property." Id. Applying this language to our hypothetical, State A could assert that the income-producing activity is located within its jurisdiction; certainly, HighTech designs, maintains, and protects its intellectual property for the ultimate purpose of obtaining profits. However, State B also could lay claim to the royalty income, as HighTech "licens[es] the use" of the intellectual property in that state. And even State C is not without a persuasive argument. It could argue that HighTech exploits the market in State C through its licensing arrangement, and therefore, effectively "uses" its intellectual property in the state. Unfortunately, no Indiana regulations or case law exists which sheds light on which of these states has the superior claim to the royalty income.
Reading further into the Indiana Administrative Code adds yet another layer of analysis. The Code advises:
Income-producing activity is deemed performed at the situs of real, tangible and intangible personal property … . The situs of intangible personal property is the commercial domicile of the taxpayer (i.e., the principal place from which trade or business of the taxpayer is directed or managed), unless the property has acquired a "business situs" elsewhere.
45 IAC 3.1-1-55. Another section of the Code clarifies that intangible property will acquire a business situs in the state only if it "forms an integral part of a business regularly conducted at a situs in Indiana … ." 45 IAC 1-1-51. Thus, if Indiana were State A, B, or C, it would relinquish its claim to the subject income unless HighTech's activities with respect to the intellectual property were part of a "business regularly conducted" within Indiana. See Indiana Dept. of State Revenue v. Bethlehem Steel Corp., 639 N.E.2d 264 (Ind. 1994) (taxpayer's sale of federal tax credits arising from purchase of equipment used in Indiana did not produce Indiana-source income because the income was not an integral part of the taxpayer's other in-state business activities, manufacturing and selling iron and steel products).
The statute and regulations discussed above resemble those found in a number of other states. For example, Tennessee, which has adopted an apportionment statute nearly identical to UDITPA § 17, by regulation defines "earnings producing activity" as "the transactions and activity directly engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of obtaining gains or profit." Tenn. Dept. of Revenue, Franchise and Excise Tax Rules and Regulations, Rule No. 1320-6-1-.34 (Dec. 1984). The regulation adds that the term includes "the sale, licensing or other use of intangible personal property." Id. Wisconsin has adopted a very similar scheme. See Wis. Dept. of Revenue, Tax Bulletin No. 94 (Oct. 1995). Thus, the ambiguities discussed within the context of the Indiana apportionment rules are by no means unique.
Non-UDITPA Apportionment Standards
States which have departed from the UDITPA standard have avoided the difficulties associated with identifying the "income-producing activity." However, the standards which they have adopted in its place often simply generate a new set of uncertainties. Moreover, the different standards adopted by the states heighten the possibility that multi-jurisdictional taxpayers will face claims by more than one state.
As an example, Texas has adopted a rather curious approach to apportioning income from intangibles. Under the state's franchise tax law, royalties from patents and copyrights will be sourced to Texas if they arise from the "use of a patent or copyright in [the] state." Tex. [Tax] Code §§ 171.1032, 171.103. It seems that State A, B, or C could assert a claim to such income based upon different interpretations of the word "use."
By contrast, it appears that all other income from intangibles must be sourced according to the "location of the payor." See, e.g., Humble Oil & Refining Co. v. Calvert, 414 S.W.2d 172, 180 (Tex. 1967); Decision of the Comptroller of Public Accounts, Hearing No. 12,557 (Dec. 1983). A Texas regulation defines the "location of the payor" as the "legal domicile of the payor." 34 Tex. Admin. Code § 3.549(b)(7). One may view this test as a type of market state approach, as it seemingly reflects an assumption that the domicile of the payor most often will be the location of the "use" of the intangible. Of course, this assumption often may not be accurate. For example, under our hypothetical, HighTech's income from any licensing of its trademarks would be sourced to the legal domicile of Manufacturer even if no other activities took place in that state.
In Colorado, taxpayers may elect annually whether they wish to apportion their income under the UDITPA three-factor formula or under a statutory two-factor (property and revenue) formula. Colo. Rev. Stat. § 39-22-303(1); Colo. Tax Reg. 39-22-303.1. Under the two-factor formula, royalties from patents and copyrights are sourced to Colorado only "if, and to the extent that, the patent or copyright is utilized by the payer in Colorado." Colo. Rev. Stat. § 39-22-303(4)(d)(VII). This rule resembles the Texas standard for sourcing patent and copyright royalties. However, unlike the Texas scheme, the Colorado statute clarifies that "a patent is utilized in a state to the extent that it is employed in production, fabrication, manufacturing, or other processing in the state or to the extent that a patented product is produced in the state." Under this standard, it would seem, State C would prevail, as that is where the "payer" under the licensing agreement, Manufacturer, utilizes the intellectual property to produce finished goods.
Finally, it is noteworthy that Colorado's two-factor formula provides that if the basis of copyright or patent royalties "cannot be reasonably assigned" to any state, the income should be sourced to the taxpayer's commercial domicile. One wonders what level of uncertainty is required before a taxpayer or the state may invoke this provision.
So What Does It All Mean?
The coming years almost surely will witness renewed challenges to Geoffrey. Yet, in the meantime, taxpayers must remain aware that the jurisdictional issues addressed in Geoffrey represent only the first step in an analysis of their tax exposure. Even if the Due Process and Commerce Clauses may be read to tolerate a state's assertion of jurisdiction to tax an entity which merely licenses the use of intangibles within the state's borders (itself a highly controversial proposition), one still must determine whether the particular state's apportionment formula produces any income to tax. When the taxpayer maintains no property or payroll within the jurisdiction, a careful analysis of the authorities suggests that the answer may well be "no."
Sourcing rules, as a general matter, are inherently imprecise; multi-jurisdictional taxpayers seldom pay tax on exactly 100% of their income. Such imprecision is particularly apparent in the realm of income from intangible assets. Thus, while the absence of clearly articulated rules regarding the sourcing of income from intangibles presents significant challenges, it presents substantial opportunities as well.